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92116_1993.txt

92116

1993

Item 1. Business General Southern California Water Company (the "Registrant") is a public utility company engaged principally in the purchase, production, distribution and sale of water. The Registrant also distributes electricity in one community. The Registrant, regulated by the California Public Utilities Commission ("CPUC"), was incorporated in 1929 under the laws of the State of California as American States Water Services Company of California as the result of the consolidation of 20 water utility companies. From time to time additional water companies and municipal water districts have been acquired and properties in limited service areas have been sold. The Registrant's present name was adopted in 1936. At December 31, 1993, the Registrant provided service in 17 separate operating districts, 16 of which were water districts and one an electric district, located in 75 communities in ten counties throughout the State of California. Total population of the service areas on December 31, 1993 was approximately 1,000,000. As of that date, about 73% of the Registrant's water customers were located in the greater metropolitan areas of Los Angeles and Orange Counties. The Registrant provided electric service to the City of Big Bear Lake and surrounding areas in San Bernardino County. All electric energy sold is purchased from Southern California Edison Company ("SCE") on a resale rate schedule. The Registrant served 236,985 water customers and 20,131 electric customers at December 31, 1993, or a total of 257,116 customers compared with 255,966 total customers at December 31, 1992. For the year ended December 31, 1993, approximately 90% of the Registrant's operating revenues were derived from water sales and approximately 10% from the sale of electricity, ratios which are generally consistent with prior years. Operating income before taxes on income of the electric district was 9.2% of the Registrant's total operating income before taxes. The material contained in Note 12 of the Notes to Financial Statements included in the 1993 Annual Report to Shareholders provides additional information on business segments while Note 13 provides information regarding the seasonal nature of the Registrant's business. Page 15 of the 1993 Annual Report to Shareholders lists the geographical distribution of customers. During 1993, the Registrant supplied, from all sources, a total of 178,196 acre feet of water compared with 172,500 acre feet for the previous year. Of the total water supplied in 1993, approximately 43% was purchased from others, principally from member agencies of the Metropolitan Water District of Southern California ("MWD"), and 1% was furnished by the Bureau of Reclamation under contract, at no cost, for the Registrant's Arden-Cordova District and to the Registrant's Clearlake district by prescriptive right to water extracted from Clear Lake. These amounts reflect a continued reduction in reliance on imported water supplies. The MWD is a water district organized under the laws of the State of California for the purpose of delivering imported water to areas within its jurisdiction which includes most of coastal Southern California from the County of Ventura south to and including San Diego County. The Registrant has 52 connections to the water distribution facilities of MWD and other municipal water agencies. MWD imports water from two principal sources: the Colorado River and the State Water Project ("SWP"). Available water supplies from the Colorado River and the SWP have historically been sufficient to meet most of MWD's requirements even though the State's major reservoirs were significantly impacted by six years of drought. The drought officially ended in February, 1993. The price of water purchased from MWD, however, is expected to continue to increase. MWD announced a 7% rate adjustment on March 8, 1994, effective for the 1994-1995 fiscal year. In those districts of the Registrant which pump groundwater, overall groundwater conditions continue to maintain at adequate levels. The Registrant drilled six new wells during 1993 in order to improve the Registrant's ability to use more groundwater in its resource mix and further decrease its dependence on purchased water. The Registrant is continuing its efforts to become a participant in the Coastal Aqueduct extension of the State Water Project (the "Project"). The Registrant believes that participation in the Project is necessary in order to provide another source of water for its Santa Maria water district. Should the Registrant be allowed to participate in the Project at a 500 acre-foot level, the Registrant will prepare a filing with the CPUC in order to recover costs associated with that participation under normal rate-making methods. A final decision of the CPUC on the application would not be anticipated until late 1994 or early 1995. Rates and Regulation The Registrant is subject to regulation by the CPUC as to its water and electric business and properties. The CPUC has broad powers of regulation over public utilities with respect to service and facilities, rates, classifications of accounts, valuation of properties and the purchase, disposition and mortgaging of properties necessary or useful in rendering public utility service. It also has authority over the issuance of securities, the granting of certificates of convenience and necessity as to the extension of services and facilities and various other matters. Water rates of the Registrant vary from district to district due to differences in operating conditions and costs. Each operating district is considered a separate entity for rate-making purposes. The Registrant continuously monitors its operations in all of its districts so that applications for rate changes may be filed, when warranted, on a district-by-district basis in accordance with CPUC procedure. Under the CPUC's practices, rates may be increased by three methods - general rate increases, offsets for certain expense increases and advice letter filings related to certain plant additions. General rate increases typically are for three year periods and include "step" increases in rates for the second and third years. General rate increases are established by formal proceedings in which the overall rate structure, expenses and rate base of the district are examined. Rates are based on estimated expenses and capital costs for a forward two-year period. A major feature of the proceeding is the use of an attrition mechanism for setting rates for the third of the three year test cycle assuming that the costs and expenses will increase in the same proportion over the second year as the increase projected for the second test year increased over the first test year. The step rate increases for the second and third years are allowed to compensate for the projected cost increases, but are subject to tests including a demonstration that earnings levels in the district did not exceed the latest rate of return authorized for the Registrant. Formal general rate proceedings typically take about twelve months from the filing of a Notice of Intent to increase rates to the authorization of new rates. Rate increases to offset increases in certain expenses such as costs of purchased water, energy costs to pump water, costs of power purchased for resale and groundwater production assessments are accomplished through an abbreviated "offset" procedure that typically takes about two months. CPUC regulations require utilities to maintain balancing accounts which reflect differences between specific offset cost increases and the rate increases authorized to offset those costs. The balancing accounts are subject to amortization through the offset procedure or through general rate decisions. An advice letter, or rate base offset, proceeding is generally undertaken on an order of the CPUC in a general rate proceeding wherein the inclusion of certain projected plant facilities in future rates is delayed pending notification that such facilities have actually been placed in service. The advice letter provides such notification and, after CPUC approval, permits the Registrant to include the costs associated with the facilities in rates. During 1993, 1992 and 1991, the Registrant's rates for all water districts were increased, among other reasons, to directly offset increases in certain expenses, principally purchased water, as well as increased levels of capital improvements. The Registrant decreased rates in its Bear Valley electric district by approximately 28% in November, 1991 as a result of amortizing large refunds from the Registrant's wholesale power supplier. The following table lists information related to the Registrant's rate increases for the last three years: The Registrant filed an application for general rate increases in six of its water operating districts in May, 1992. In June, 1993, the CPUC issued its decision and the Registrant requested rehearing on two matters - the rate of return on rate base and an authorized rate increase for the Registrant's Bay Point water district. The CPUC granted the Registrant's request for rehearing on the two issues and established an interim rate of return on rate base of 9.5% applicable for certain attrition, step rate filings and other earnings test filings with respect to the Registrant's other operating districts. For further information, please see the caption "Rates and Regulation" under Management's Discussion and Analysis herein and Note 10 of the Notes to Financial Statements in the 1993 Annual Report to Shareholders. The Registrant has filed its case on the two matters set for rehearing, which was held on March 15, 1994. Prior to commencement of hearings, the Registrant and the Division of Ratepayer Advocates ("DRA") of the CPUC had stipulated to a rate of return on common equity of 10.10%. In addition, DRA had agreed that an increase in rates applicable to the Registrant's Bay Point water district was appropriate with certain modifications as to the level of rate base. A final decision on these matters, however, is still subject to the CPUC and is not expected until the Summer of 1994. The Registrant anticipates filing applications with the CPUC in July, 1994 for rate increases, effective in 1995, in all of its operating districts for certain cost-effective recommendations resulting from the recently completed Management Audit of the Registrant conducted under the auspices of the CPUC. In addition, the Registrant will file a general rate case in one of its water operating districts. The requested annual increase in rates will also seek step increases for 1996 and 1997. No assurance can be given that the CPUC will authorize any or all of the rates for which the Registrant applies. Industrial Relations The Registrant had 486 paid employees as of December 31, 1993. Seventeen employees in the Bear Valley Electric District were members of the International Brotherhood of Electrical Workers. Their present labor agreement is effective through June 30, 1994. Seventy-three of the Registrant's water utility employees, unionized under the Utility Workers of America ("UWA"), are covered by a contract which expires March 31, 1996. The Registrant has no other unionized employees. Environmental Matters The Environmental Protection Agency ("EPA"), under provisions of the Safe Drinking Water Act, as amended, is required to establish Maximum Contaminant Levels ("MCL's") for the 83 potential drinking water contaminants initially listed in the Act, and for an additional 25 contaminants every three years thereafter. The California Department of Health Services ("DOHS"), acting on behalf of the EPA, administers the EPA's program. The Registrant continues to test its wells and water systems for more than 90 contaminants. Water from wells found to contain levels of contaminants above the established MCL's has either been treated or blended before it is delivered to customers. Only 2 of the Registrant's 306 wells have been permanently taken out of service due to high levels of contamination. The Registrant is aware of two new rules pending implementation by the EPA which may significantly affect the Registrant: the Radon Rule and the Arsenic Rule. The EPA did not meet the October 1, 1993 deadline for establishing an MCL for radon. Because of this inaction, the rule is presently in the hands of the United States Congress where it is believed that an MCL will be established primarily to implement the regulation. However, the 1994 budget as drafted by the Appropriations Committee has specifically excluded funds for further work on radon regulation, basically setting a moratorium on the regulation. The EPA is continuing its review of data on the Arsenic Rule although the Registrant anticipates an MCL will be proposed by September, 1994. The Registrant is unable to predict, until the MCL's are established, what effects, if any, these new rules will have on its financial condition or results of operation. The Registrant has experienced increased operating costs for testing to determine the levels (if any) of the contaminants in the Registrant's source of supply and costs to lower the level of any contaminants found to a level that meets standards. Such costs and the control of any other pollutants may include capital costs as well as increased operating costs. The rate-making process provides the Registrant with the opportunity to recover capital and operating costs associated with water quality, and management believes that such costs are properly recoverable. Item 2

Item 2 - Properties Franchises, Competition, Acquisitions and Condemnation of Properties The Registrant holds the required franchises from the incorporated communities and the counties which it serves. The Registrant holds certificates of public convenience and necessity granted by the CPUC in each of the 17 districts it serves. The business of the Registrant is substantially free from direct competition with other public utilities, municipalities and other public agencies. The Registrant's certificates, franchises and similar rights are subject to alteration, suspension or repeal by the respective governmental authorities having jurisdiction over such matters. The laws of the State of California provide for the acquisition of public utility property by governmental agencies through their power of eminent domain, also known as condemnation. The Registrant has been, within the last three years, involved in activities related to the condemnation of its Big Bear and Bay Point water districts. The Registrant continues to oppose the condemnation actions with respect to its Bay Point water district initiated by the Contra Costa Water District in 1992. Note 8 of the Notes to Financial Statements contained in the 1993 Annual Report to Shareholders herein describes condemnation actions related to the Registrant's properties in greater detail. Water Properties As of December 31, 1993, the Registrant's physical properties consisted of water transmission and distribution systems which included over 2,560 miles of pipeline together with services, meters and fire hydrants and approximately 438 parcels of land (generally less than 1 acre each) on which are located wells, pumping plants, reservoirs and other utility facilities. The Registrant's operating properties have been maintained and improved in the ordinary course of business. As of December 31, 1993, the Registrant owned and operated 306 wells equipped with pumps with an aggregate capacity of 265.7 million gallons per day ("MGD"). Other production facilities include filter plants with an aggregate capacity of 29.4 MGD and 52 connections to the water distribution facilities of the MWD and other municipal water agencies. The Registrant's storage reservoirs and tanks have an aggregate capacity of 156.6 million gallons. There are no dams in the Registrant's system. Electric Properties The Registrant's electric properties are all located in the Big Bear area of San Bernardino County. As of December 31, 1993, the Registrant operated 28.8 miles of overhead 34.5 KV transmission lines, 0.6 miles of underground 34.5 KV transmission lines, 172.7 miles of 4.16 KV or 2.4 KV distribution lines, 41.7 miles of underground cable and 14 sub-stations. There are no generating plants in the Registrant's system. Other Properties The Registrant's general offices are housed in a single-story office building located in San Dimas, California. The land and the building, which was completed and occupied in early 1990, are owned by the Registrant. Certain of the Registrant's district offices are housed in leased premises. During 1993, the Registrant refinanced a significant portion of its then outstanding debt in order to lower interest costs. In doing so, the Registrant redeemed all outstanding First Mortgage Bonds. In early 1994, the Trustee filed for release of the lien of an indenture securing the previously outstanding First Mortgage Bonds. As of December 31, 1993, the Registrant had no mortgage debt outstanding. Financing of Construction Expenditures The Registrant's construction program is designed to ensure its customers with high quality service. The Registrant has an ongoing distribution main replacement program, throughout its service areas, based upon the priority of leaks detected, fire protection enhancement and a reflection of the underlying replacement schedule. In addition, the Registrant upgrades its electric and water supply facilities and is aggressively scheduling meter replacements. The Registrant anticipates gross capital expenditures of $26,700,000, $17,500,000 and $34,500,000 in 1994, 1995 and 1996, respectively. During 1993, the Registrant issued 1,107,000 Common Shares (on a post-split basis) in two separate public offerings for aggregate net proceeds of $23,935,000. The net proceeds were applied against then outstanding short-term bank borrowing incurred to temporarily finance construction expenditures. The Registrant issued additional common equity through its Dividend Reinvestment and Common Share Purchase Plan and its 401-k Plan. The Registrant issued 47,828, 28,416 and 29,146 shares under the Dividend Reinvestment and Common Share Purchase Plan in the three years ended December 31, 1993, 1992 and 1991, respectively. The Registrant issued 7,741 and 7,102 Common Shares under the 401-k Plan in the two years ended December 31, 1993 and 1992. The Registrant did not issue any Common Shares through its 401-k Plan in the year ended December 31, 1991. During 1993 and 1992, the Registrant did not undertake any long-term debt financing to provide additional funds for construction. In 1993, however, the Registrant did refinance $37 million of its long-term debt, in order to reduce interest expense, through its Medium Term Note Program. In 1992, the Registrant entered into a $2,247,000 fixed rate obligation due 2013 for financing construction of a new reservoir serving one of the Registrant's water operating districts. In May, 1991, the Registrant completed the sale of $28,000,000 in long-term Notes Due 2031, $13,500,000 of which was used to repay then outstanding short-term bank loans which had been used to fund the Registrant's construction program. In addition, in December, 1991, the Registrant redeemed, at a premium, $6,000,000 principal amount of 11-3/4% Notes. The remainder of the proceeds from the May, 1991 issue was utilized to fund the Registrant's capital expansion program. Item 3.

Item 3. Legal Proceedings On October 20, 1993, the Registrant and the Internal Revenue Service ("IRS") reached a tentative settlement on the results of the IRS examination of the Registrant's 1987, 1988 and 1989 tax returns. Based on the settlement, the Registrant remitted an additional $438,000 in taxes. The Registrant anticipates signing the final agreement in late March, 1994. On March 8, 1994, the Registrant and the Contra Costa County Board of Supervisors (the "County") reached a tentative settlement of issues related to the County's taking on the Registrant's Madison Treatment plant in its Bay Point water district. The County's Highway Department had taken possession of the property on June 24, 1993. The tentative settlement of $2.3 million includes remuneration to the Registrant for the value of the property taken, severance damages, if any, and reimbursement for treated water purchased from the City of Pittsburg. The amount determined as remuneration for the value of the property taken is to be applied against the value of the Registrant's Bay Point district, currently under condemnation by the Contra Costa Water District ("CCWD"). The Registrant and CCWD, however, are continuing their negotiations concerning the CCWD's condemnation of the Registrant's Bay Point water district. At this time, however, the Registrant is unable to predict the final outcome of these negotiations. In 1993, water revenues from the Registrant's Bay Point water district were approximately $2.7 million or 2.75% of its total annual water revenues. There are no other material pending legal proceedings, other than litigation incidental to the ordinary course of business, to which the Registrant is a party or of which any of its properties is the subject. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders No matter was submitted during the fourth quarter of the fiscal year covered by this report to a vote of security holders through the solicitation of proxies or otherwise. PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters (a) Market Price for Common Shares Information responding to Item 5(a) is included in the 1993 Annual Report to Shareholders, under the caption "Trading of Stock" located on the inside back cover, filed herein by the Registrant with the Commission pursuant to Regulation 14A and is incorporated herein pursuant to General Instruction G(2). (b) Approximate Number of Holders of Common Shares As of February 28, 1994, there were 4,342 holders of record of Common Shares. (c) Frequency and Amount of Any Dividends Declared and Dividend Restrictions Information responding to Item 5(c) is included in the 1993 Annual Report to Shareholders, under the caption "Trading of Stock" located on the inside back cover, filed herein by the Registrant with the Commission pursuant to Regulation 14A and is incorporated by reference herein pursuant to General Instruction G(2). For the last three years, the Registrant has paid dividends on its Common Shares on March 1, June 1, September 1 and December 1. Additional information responding to Item 5(c) is included in the 1993 Annual Report to Shareholders, under Note 3 of the Notes to Financial Statements captioned "Common Share Dividend Restriction" on page 31, filed herein by the Registrant with the Commission pursuant to Regulation 14A and is incorporated herein by reference pursuant to General Instruction G(2). Item 6.

Item 6. Selected Financial Data Information responding to Item 6 is included in the 1993 Annual Report to Shareholders, in the section entitled "Financial Information" under the caption "Statistical Review from 1989 to 1993" on Page 36, filed herein by the Registrant with the Commission pursuant to Regulation 14A and is incorporated herein by reference pursuant to General Instruction G(2). Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation Information responding to Item 7 is included in the 1993 Annual Report to Shareholders, under the caption "Management's Discussion and Analysis" on Pages 17 through 23, filed herein by the Registrant with the Commission pursuant to Regulation 14A and is incorporated herein by reference pursuant to General Instruction G(2). Item 8.

Item 8. Financial Statements and Supplementary Data Information responding to Item 8 is included in the 1993 Annual Report to Shareholders, under the captions contained on Pages 24 through 35, filed herein by the Registrant with the Commission pursuant to Regulation 14A and is incorporated herein by reference pursuant to General Instruction G(2). Balance Sheets - December 31, 1993 and 1992 Statements of Capitalization - December 31, 1993 and 1992 Statements of Income for the years ended December 31, 1993, 1992 and 1991 Statements of Changes in Common Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991 Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 Notes to Financial Statements Report of Independent Public Accountants Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant Information responding to Item 10 was included in the Proxy Statement, under the caption "Executive Officers Experience and Compensation", filed by the Registrant with the Commission on or about March 18, 1994 pursuant to Regulation 14A and is incorporated by reference herein pursuant to General Instruction G(3). Item 11.

Item 11. Executive Compensation Information responding to Item 11 was included in the Proxy Statement, under the captions "Executive Officers Experience and Compensation" and "Board Report on Executive Compensation", filed by the Registrant with the Commission on March 18, 1994 pursuant to Regulation 14A and is incorporated by reference herein pursuant to General Instruction G(3). Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management Information responding to Item 12 was included in the Proxy Statement, under the captions "Election of Directors" and "Executive Officers Experience and Compensation", filed by the Registrant with the Commission on March 18, 1994 pursuant to Regulation 14A and is incorporated by reference herein pursuant to General Instruction G(3). Item 13.

Item 13. Certain Relationships and Related Transactions Information responding to Item 13 was included in the Proxy Statement, under the caption "Election of Directors", filed by the Registrant with the Commission on March 18, 1994 pursuant to Regulation 14A and is incorporated by reference herein pursuant to General Instruction G(3). PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K _____________________ * Filed herewith REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON THE SUPPLEMENTAL SCHEDULES To the Shareholders and the Board of Directors Of Southern California Water Company: We have audited, in accordance with generally accepted auditing standards, the financial statements included in Southern California Water Company's 1993 Annual Report to Shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated February 15, 1994. Our audit was made for the purpose of forming an opinion on those basic financial statements taken as a whole. The supplemental schedules listed in Part IV of this Form 10-K, which are the responsibility of the company's management, are presented for purposes of complying with the Securities and Exchange Commission's rules and regulations and are not part of the basic financial statements. These supplemental schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Los Angeles, California February 15, 1994 SOUTHERN CALIFORNIA WATER COMPANY SCHEDULE V - TANGIBLE & INTANGIBLE PROPERTY, PLANT & EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1993 (1) Includes property added under install and convey contracts of $819,000. (2) Additions to Construction Work in Progress are net of transfers to plant in service which are shown as additions to the various operating plant classifications. SOUTHERN CALIFORNIA WATER COMPANY SCHEDULE V - TANGIBLE & INTANGIBLE PROPERTY, PLANT & EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1992 (1) Includes property added under install and convey contracts of $3,119,000. (2) Additions to Construction Work in Progress are net of transfers to plant in service which are shown as additions to the various operating plant classifications. SOUTHERN CALIFORNIA WATER COMPANY SCHEDULE V - TANGIBLE & INTANGIBLE PROPERTY, PLANT & EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1991 (1) Includes property added under install and convey contracts of $1,398,000. (2) Additions to Construction Work in Progress are net of transfers to plant in service which are shown as additions to the various operating plant classifications. SOUTHERN CALIFORNIA WATER COMPANY SCHEDULE VI - RESERVES FOR ACCUMULATED DEPRECIATION FOR THE YEAR ENDED DECEMBER 31, 1993 (1) A remaining life method of calculating depreciation is used by the Company with rates varying from a minimum of .01% to a maximum of 27.73%, for 1993. The annual calculation is based on depreciable plant at the beginning of each year. SOUTHERN CALIFORNIA WATER COMPANY SCHEDULE VI - RESERVES FOR ACCUMULATED DEPRECIATION FOR THE YEAR ENDED DECEMBER 31, 1992 (1) A remaining life method of calculating depreciation is used by the Company with rates varying from a minimum of .05% to a maximum of 27.73%, for 1992. The annual calculation is based on depreciable plant at the beginning of each year. SOUTHERN CALIFORNIA WATER COMPANY SCHEDULE VI - RESERVES FOR ACCUMULATED DEPRECIATION FOR THE YEAR ENDED DECEMBER 31, 1991 (1) A remaining life method of calculating depreciation is used by the Company with rates varying from a minimum of .05% to a maximum of 26.91%, for 1991. The annual calculation is based on depreciable plant at the beginning of each year. SOUTHERN CALIFORNIA WATER COMPANY SCHEDULE VIII - RESERVES FOR UNCOLLECTIBLE ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. SOUTHERN CALIFORNIA WATER COMPANY By : s/ JAMES B. GALLAGHER . ----------------------------- James B. Gallagher Secretary, Treasurer and Chief Financial Officer Date: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

103730_1993.txt

103730

1993

Item 1. DESCRIPTION OF BUSINESS - - - -------------------------------- General Vishay Intertechnology, Inc. (together with its consolidated subsidiaries, "Vishay" or the "Company") is a leading international manufacturer and supplier of passive electronic components, particularly resistors and tantalum and film capacitors. Resistors, the most common component in electronic circuits, are used to adjust and regulate levels of voltage and current. Capacitors perform energy storage, frequency control, timing and filtering functions in almost all types of electronic equipment. The Company's products are used in a broad variety of electronic applications, including those in the computer, telecommunications, military/aerospace, instrument, industrial, automotive, office equipment and entertainment industries. Through a series of acquisitions over the last eight years, the Company has grown from a small manufacturer of precision resistors and strain gages to one of the world's largest manufac- turers and suppliers of a broad line of passive electronic compo- nents. The Company's acquisition strategy has focused on acquiring manufacturers of those types of quality products in which the Company has strong marketing organizations and technical expertise but who have encountered operating, financial or management difficulties. In connection with each acquisition, the Company has implemented programs to realize synergies between its existing businesses and the acquired business. These programs have focused on reducing selling, general and administrative expenses and maximizing production efficiencies, including the integration of redundant sales offices and administrative functions and the transfer of some production operations to regions where the Company can take advantage of lower labor costs and available tax and other incentives. The Company's first major acquisition was the purchase in 1985 of a 50% interest in Dale Electronics, Inc. ("Dale"), a United States producer of precision and commercial resistors, magnetic components and plasma displays. In 1987, the Company established a major presence in Germany with the acquisition of Draloric Electronic GmbH ("Draloric"), strengthening the Company's metal film resistor and specialty resistor businesses. In 1988, the Company acquired the remaining 50% interest in Dale as well as all of the outstanding shares of Sfernice, S.A., a French manufacturer of resistors, potentiometers and printed circuit boards. Subse- quently, Vishay acquired several small United States inductor manufacturers and one French inductor manufacturer. In 1992, the Company acquired the worldwide tantalum capacitor and United States thick film resistor network businesses of American Annuity Group, Inc., formerly Sprague Technologies, Inc. ("STI"). In January 1993, Vishay exercised its option to purchase 81% of the outstanding share capital of Roederstein Spezialfabriken fur Bauelemente der Elektronik und Kondensatoren der Starkstromtechnik GmbH ("Roederstein"). Vishay acquired its initial 19% interest in Roederstein in February 1992. Roederstein's principal products include film, aluminum electrolytic and tantalum capacitors as well as resistors. It also manufactures single layer ceramic capacitors, heavy current capacitors and triplers. Most recently, on July 2, 1993, Vishay acquired the assets of the tantalum capacitor business of Philips Electronics North America Corporation, a subsidiary of Philips Electronics N.V., for approximately $11 million. The Company currently operates as five separate business units: (i) Vishay Electronic Components, U.S., which is comprised of Dale, a manufacturer and supplier of resistors, the Vishay Resistive Systems Unit, which primarily manufactures high performance foil resistors and thin film resistor networks, and Sprague, which consists of the tantalum capacitor and thick film resistor network manufacturing businesses acquired from STI; (ii) Draloric/Roederstein, German-based manufacturers and suppliers of resistors and capacitors in Europe; (iii) Sfernice, S.A., a resistor producer in France; (iv) Measurements Group, Inc., which produces resistive sensors and other stress measuring devices in the United States; and (v) Vishay Components (UK) Ltd., a manufacturer and supplier of the Company's products in the United Kingdom. Vishay was incorporated in Delaware in 1962 and maintains its principal executive offices at 63 Lincoln Highway, Malvern, Pennsylvania 19355-2120. The telephone number is (610) 644-1300. Products Vishay designs, manufactures and markets electronic components that cover a wide range of products and technologies. The products primarily consist of fixed resistors, tantalum and film capacitors, and, to a lesser extent, inductors, specialty ceramic capacitors, transformers, potentiometers, plasma displays and thermistors. Resistors are basic components used in all forms of electronic circuitry to adjust and regulate levels of voltage and current. They vary widely in precision and cost, and are manufactured in numerous materials and forms. Resistive components may be either fixed or variable, the distinction being whether the resistance is adjustable (variable) or not (fixed). Resistors can also be used as measuring devices, such as Vishay's resistive sensors. Resistive sensors, or strain gages, are used in electronic measurement and experimental stress analysis systems, as well as in transducers, for measuring loads (scales), acceleration and fluid pressure. Fixed resistive components can be broadly categorized as discrete components or networks. A discrete component is designed to perform a single function and is incorporated by the customer in the circuitry of a system which requires that particular function. A network, on the other hand, is a microcircuit (consisting of a number of resistors placed on a ceramic base), which is designed to perform a number of standard functions. Vishay manufactures discrete resistors and networks both of which are principally sold in the precision or higher quality segments of the resistor market (i.e., fixed precision wirewound, metal film and foil resistors and network resistors). The Company's resistive products primarily consist of fixed resistors (foil and thin film resistors, wire-wound resistors, metal film resistors, oxide film resistors, thermistors, thick film resistor chips, networks (microcircuits) and resistive sensors); variable resistors (trimmers and potentiometers); magnetic components (inductors and transformers) and printed circuit boards. Vishay produces resistors for virtually every segment of the resistive product market, from resistors used in the highest quality precision instruments for which the performance of the resistors is the most important requirement, to resistors for which price is the most important factor. Capacitors perform energy storage, frequency control, timing and filtering functions in most types of electronic equip- ment. The more important applications for capacitors are (i) electronic filtering for linear and switching power supplies, (ii) decoupling and bypass of electronic signals or integrated circuits and circuit boards, and (iii) frequency control, timing and conditioning of electronic signals for a broad range of applica- tions. The Company's capacitor products primarily consist of solid tantalum chip capacitors, solid tantalum leaded capacitors, wet/foil tantalum capacitors and film capacitors. The tantalum capacitor is the smallest and most stable type of capacitor for its range of capacitance. Markets The Company's products are sold primarily to other manufacturers and, to a much lesser extent, to United States and foreign government agencies. Its products are used in, among other things, the circuitry of measuring instruments, industrial equip- ment, automotive applications including engine controls and fuel injection systems, process control systems, computer-related products, telecommunications, military and aerospace applications, medical instruments and scales. Approximately 41% of the Company's net sales for the year ended December 31, 1993 was attributable to sales to customers in the United States while the remainder was attributable to sales primarily in Europe. In the United States, products are marketed primarily through independent manufacturers' representatives (who are compensated solely on a commission basis), the Company's own sales personnel and independent distributors. The Company has regional sales personnel in several locations to provide technical and sales support for independent manufacturers' representatives throughout the United States, Mexico and Canada. In addition, the Company uses independent distributors to resell its products. Internationally, products are sold to customers in Germany, the United Kingdom, France, Israel, Japan, Singapore, South Korea and other European and Pacific Rim countries through Company sales offices, independent manufacturers' representatives and distributors. The Company endeavors to have its products incorporated into the design of electronic equipment at the research and proto- type stages. Vishay employs its own staff of application and field engineers who work with its customers, independent manufacturers' representatives and distributors to solve technical problems and develop products to meet specific needs. One of the fastest growing markets for passive electronic components is for surface mounted devices. These devices adhere to the surface of a circuit board rather than being secured by leads that pass through holes to the back side of the board. Surface mounting provides certain advantages over through-hole mounting, including the ability to place more components on a circuit board. The Company believes it has taken advantage of the growth of the surface mount market and is an industry leader in designing and marketing surface mount devices. The Company offers a wide range of these devices, including both thick and thin film resistor chips and networks, capacitors, inductors, oscillators, transformers and potentiometers, as well as a number of component packaging styles to facilitate automated product assembly by its customers. Sales of the Company's products to manufacturers in defense-related industries have continued to decline over the past year, primarily as a result of reduced governmental procurements of defense-related products. The Company has qualified certain products under various military specifications, approved and monitored by the United States Defense Electronic Supply Center ("DESC"), and under certain European military specifications. Classification levels have been established by DESC based upon the rate of failure of products to meet specifications (the "Classifi- cation Level"). In order to maintain the Classification Level of a product, tests must be continuously performed, and the results of these tests must be reported to DESC. If the product fails to meet the requirements for the applicable Classification Level, the product's classification may be reduced to a less stringent level. In that event, the Company's product may not qualify for use as a component in other products required to meet a more stringent Classification Level, although the Company's product may still be sold for use in other products requiring a less stringent classifi- cation. After completion of additional retesting, however, the product may again be classified at its original level. Sales of the product may be adversely affected pending the completion of any such additional retesting and the resumption of the original Classification Level. Various United States manufacturing facili- ties from time to time experience a product Classification Level modification. During the time that such level is modified for any specific product, net sales and earnings derived from such product may be adversely affected. The Company is undertaking to have the quality systems at all of its major manufacturing facilities approved under the established ISO 9000 international quality control standard. ISO 9000 is a comprehensive set of quality program standards developed by the International Standards Organization. Several of the Company's manufacturing operations have already received ISO 9000 approval and others are actively pursuing such approval. Vishay's largest customers vary from year to year, and no customer has long-term commitments to purchase products of the Company. No customer accounted for more than 10% of the Company's sales for the year ended December 31, 1993. Research and Development The Company maintains separate research and development staffs and promotes separate programs at a number of its production facilities to develop new products and new applications of existing products, and to improve product and manufacturing techniques. This decentralized system encourages individual product development and, from time to time, developments at one manufacturing facility will have applications at another facility. Most of the Company's products and manufacturing processes have been invented, designed and developed by Company engineers and scientists. Company research and development costs were approximately $7.1 million for 1993, $7.1 million for 1992 and $7.0 million for 1991. The Company spends additional amounts for the development of machinery and equipment for new processes and for cost reduction measures. See "Competition". Sources of Supplies Although most materials incorporated in the Company's products are available from a number of sources, certain materials (particularly tantalum) are available only from a limited number of suppliers. In order to protect itself from manufacturing disruptions due to potential supply shortages, the Company maintains a supply of certain critical materials, the nondelivery of which could have a materially adverse effect on the Company. Tantalum metal is the principal material used in the manufacture of tantalum capacitor products. Tantalum is purchased in powder form, primarily under annual contracts with domestic suppliers, at prices that are subject to periodic adjustment. The Company is a major consumer of the world's annual tantalum production. Tantalum, and other required raw materials have generally been available in sufficient quantities, but have been subject to wide price variations. Disruptions in the supply of, or substantial increases in the price of, tantalum metal could have a materially adverse effect on the Company. Inventory and Backlog Although Vishay manufactures standardized products, a substantial portion of its products are produced to meet specific customer specifications. The Company does, however, maintain an inventory of resistors and other components. Backlog of outstand- ing orders for the Company's products was $198.4 million, $134.3 million and $104.5 million, at December 31, 1993, 1992 and 1991, respectively. The increase in backlog at December 31, 1993 and 1992, as compared with prior periods, is attributable to the acquisitions of Roederstein and Sprague, respectively. The current backlog is expected to be filled during the next 12 months. Most of the orders in the Company's backlog may be cancelled by its customers, in whole or in part, although sometimes subject to penalty. To date, however, cancellations have not represented a material portion of the backlog. Competition The Company faces strong competition in its various product lines from both domestic and foreign manufacturers that produce products using technologies similar to those of the Company. Certain of the Company's products compete on the basis of its marketing and distribution network, which provides a high level of customer service, such as design assistance, order expediting and prompt delivery. In addition, the Company's competitive position depends on its product quality, know-how, proprietary data, marketing and service capabilities, business reputation and price. A number of the Company's customers are contractors or subcontractors on various United States and foreign government contracts. Under certain United States Government contracts, retroactive adjustments can be made to contract prices affecting the profit margin on such contracts. The Company believes that its profits are not excessive and, accordingly, no provision has been made for any such adjustment. In several areas the Company strengthens its market position by conducting seminars and educational programs for customers and for potential customers. Although the Company has numerous United States and foreign patents covering certain of its products and manufacturing processes, and acquired various patents with the acquisition of the STI tantalum capacitor and network lines, no particular patent is considered material to the business of the Company. Manufacturing Operations The Company conducts manufacturing operations in three principal geographic regions: the United States, Europe and Israel. At December 31, 1993, approximately 40% of the Company's identifiable assets were located in the United States, approximately 50% were located in Europe, approximately 9% were located in Israel and 1% in other regions. In the United States, the Company's main manufacturing facilities are located in Nebraska, South Dakota, North Carolina, Pennsylvania and Maine. In Europe, the Company's main manufacturing facilities are located in Selb and Landshut, Germany and Nice and Tours, France. In Israel, manufacturing facilities are located in Holon and Dimona. The Company also maintains manufacturing facilities in Juarez, Mexico and Toronto, Canada. For the year ended December 31, 1993, sales of products manufactured in Israel accounted for approximately 8% of the Company's net sales. The Company conducts manufacturing operations in Israel in order to take advantage of the relatively low wage rates in Israel and several incentive programs instituted by the Government of Israel, including certain tax abatements. These programs have contributed substantially to the growth and profitability of the Company. The Company may be materially and adversely affected if these incentive programs were no longer available to the Company or if hostilities were to occur in the Middle East that materially interfere with the Company's operations in Israel. Due to a shift in manufacturing emphasis, resulting from the growing market for surface mount devices, over-capacity at a number of the Company's manufacturing facilities and the relocation of some production to regions with lower labor costs, portions of the Company's work force and certain facilities may not be fully utilized in the future. As a result, the Company may incur significant costs in connection with work force reductions and the closing of additional manufacturing facilities. Environment The Company's manufacturing operations are subject to various federal, state and local laws restricting discharge of materials into the environment. The Company is not involved in any pending or threatened proceedings which would require curtailment of its operations at this time. However, the Company is involved in various legal actions concerning state government enforcement proceedings and various dump site clean-ups. These actions may result in fines and/or clean-up expenses. The Company believes that any fine and/or clean-up expense, if imposed, would not be material. The Company continually expends funds to ensure that its facilities comply with applicable environmental regulations. The Company has nearly completed its undertaking to comply with new environmental regulations, relating to the elimination of chlorofluorocarbons (CFCs) and ozone depleting substances (ODS), and other anticipated compliances with the Clean Air Act amendments of 1990. The Company anticipates that it will undertake capital expenditures of approximately $1,000,000 in fiscal 1994 for general environmental enhancement programs. Employees As of December 31, 1993, the Company employed approximately 14,200 full time employees of whom approximately 8,600 were located outside the United States. The Company hires few employees on a part time basis. While many of the Company's foreign employees are members of trade unions, none of the Company's employees located in the United States are represented by unions except for approximately 172 employees at the North Adams, Massachusetts facility acquired from STI, who are represented by three unions. The Company is currently negotiating the collective bargaining agreements of such domestic employees with each of these unions. The Company believes that its relationship with its employees is excellent. Item 2.

Item 2. PROPERTIES - - - ------- ---------- The Company maintains 53 manufacturing facilities. The principal locations of such facilities, along with available space including administrative offices, are: Approx. Available Owned Locations Space (Square Feet) - - - --------------- ------------------- United States ------------- Malvern and Bradford, PA 223,000 Columbus and Norfolk, NE 336,000 Wendell and Statesville, NC 193,000 Sanford, ME 212,000 Foreign ------- Germany (11 locations) 1,375,000 France (11 locations) 606,000 Israel (2 locations) 400,000 Portugal 100,000 Vishay owns an additional 239,000 square feet of manufac- turing facilities located in Colorado, Maryland, South Dakota and Florida. Available leased facilities in the United States include 420,000 square feet of space located in New York, California, New Jersey, South Dakota, Texas, Massachusetts and New Hampshire. Foreign leased facilities consist of 206,000 square feet in Mexico, 151,000 square feet in France, 130,000 square feet in England, 109,000 square feet in Canada and 98,000 square feet in Germany. The Company also has facilities in Japan, Austria, Switzerland, and the Czech Republic. In September 1993, Vishay entered into negotiations to build an additional manufacturing facility in Israel. The facility, which will be approximately 200,000 square feet, will be located near Haifa. Management believes it has sufficient manufacturing space for its current business. Item 3.

Item 3. LEGAL PROCEEDINGS - - - ------- ----------------- The Company, from time to time, is involved in routine litigation incidental to its business. Management believes that such matters, either individually or in the aggregate, should not have a materially adverse effect on the Company's business or financial condition. Item 4.

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - - - ------- --------------------------------------------------- During the fourth quarter of the fiscal year covered by this report, no matter was submitted to a vote of security holders of the Company. Item 4A. EXECUTIVE OFFICERS OF THE REGISTRANT - - - -------- ------------------------------------ The following table sets forth certain information regarding the executive officers of the Company as of March 25, 1994. Name Age Positions Held - - - ---- --- -------------- Felix Zandman* 65 Chairman of the Board, President, Chief Executive Officer and Director Robert A. Freece* 53 Vice President, Treasurer, Chief Financial Officer and Director Henry V. Landau 47 Vice President; President -- Measurements Group, Inc. Moshe Shamir 70 Vice President; President -- Vishay Israel Limited William J. Spires 52 Vice President and Secretary Donald G. Alfson 48 Vice President, Director; President -- Vishay Electronic Components, U.S. and Asia and President -- Dale Electronics, Inc. Gerald Paul 45 Vice President, Director; President -- Vishay Electronic Components, Europe and Managing Director -- Draloric Electronic GmbH. * Member of the Executive Committee of the Board of Directors. Felix Zandman, a founder of the Company, has been President, Chief Executive Officer and a Director of the Company since its inception. Dr. Zandman has been Chairman of the Board since March 1989. Robert A. Freece has been Vice President, Treasurer, Chief Financial Officer and a Director of the Company since 1972. Henry V. Landau has been a Vice President of the Company since 1983. Mr. Landau has been the President and Chief Executive Officer of Measurements Group, Inc., a subsidiary of the Company, since July 1984. Mr. Landau was an Executive Vice President of Measurements Group, Inc. from 1981 to 1984 and has been employed by the Company since 1972. Moshe Shamir has been the President of Vishay Israel Limited since its inception in 1969. Mr. Shamir has been a Vice President of the Company since 1972. Mr. Shamir is also a member of the Board of Directors of Teva Pharmaceuticals Industries, Ltd. and Chairman of the Executive Committee thereof. William J. Spires has been a Vice President and Secretary of the Company since 1981. Mr. Spires has been Vice President - Industrial Relations since 1980 and has been employed by the Company since 1970. Donald G. Alfson has been a Vice President since May 1993, a Director of the Company since May 1992 and the President of Vishay Electronic Components U.S. and Asia, and President of Dale Electronics, Inc. since April 1992. Mr. Alfson has been employed by the Company since 1972. Gerald Paul has been a Vice President and a Director of the Company since May 1993 and President of Vishay Electronic Components, Europe since January 1994. Dr. Paul has been Managing Director of Draloric Electronic GmbH since January 1991. Dr. Paul has been employed by the Company since February 1978. PART II ------- Item 5.

Item 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SECURITY - - - ------- HOLDER MATTERS --------------------------------------------------------- The Company's Common Stock is listed on the New York Stock Exchange under the symbol VSH. The following table sets forth the high and low sale prices for the Company's Common Stock as reported on the New York Stock Exchange Composite Tape for the quarterly periods within the 1993 and 1992 fiscal years indicated. Stock prices have been restated to reflect stock dividends. The Company does not currently pay cash dividends on its capital stock. Its policy is to retain earnings to support the growth of the Company's business and the Company does not intend to change this policy at the present time. In addition, the Company is restricted from paying cash dividends under the terms of the Company's revolving credit and term loan agreement (see Note 6 to the consolidated financial statements). Holders of record of the Company's Common Stock totalled approximately 1,441 at March 25, 1994. COMMON STOCK MARKET PRICES Calendar 1993 Calendar 1992 High Low High Low ------ ------ ------ ------ First Quarter $35.48 $27.38 $21.31 $14.74 Second Quarter 36.25 25.48 24.29 18.59 Third Quarter 37.75 31.63 26.67 22.03 Fourth Quarter 35.38 28.75 35.48 25.36 On October 1, 1990, the Company commenced a stock repur- chase program pursuant to which the Company was authorized to purchase up to $5 million worth of its Common Stock. The purchases of Common Stock by the Company under the repurchase program are made in open-market transactions, subject to the availability of stock in accordance with the rules of the Securities and Exchange Commission and at the discretion of management. As of December 31, 1990 the Company had repurchased 36,600 shares at an approximate cost of $459,000. No repurchases were made in 1991, 1992 or 1993. In addition at March 25, 1994, the Company had outstanding 3,590,232 shares of Class B Common Stock, par value $.10 per share (the "Class B Stock"), each of which entitles the holder to ten votes. The Class B Stock generally is not transferable and there is no market for those shares. The Class B Stock is convertible, at the option of the holder, into Common Stock on a share for share basis. Substantially all such Class B Stock is beneficially owned by Dr. Felix Zandman, Mr. Moshe Shamir and a revocable trust for the benefit of Mr. Alfred P. Slaner. Dr. Felix Zandman is an executive officer and director of the Company, and Mr. Shamir is a director. Mr. Slaner and his wife, Luella B. Slaner, are Trustees of the Slaner Trust, and accordingly, Mrs. Slaner, a Vishay director, may also be deemed beneficially to own such shares. Item 6.

Item 6. SELECTED FINANCIAL DATA - - - ------- ----------------------- The following table sets forth selected consolidated financial information of the Company for the fiscal years ended December 31, 1993, 1992, 1991, 1990 and 1989. This table should be read in conjunction with the Consolidated Financial Statements of the Company and the related notes thereto included elsewhere in this Form 10-K. - - - --------------- (1) Includes the results from January 1, 1993 of the Roederstein acquisition. (2) Includes the results from January 1, 1992 of the businesses acquired from STI. Item 7.

Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL - - - ------- CONDITION AND RESULTS OF OPERATIONS ------------------------------------------------- Introduction and Background The Company's sales and net income have increased significantly in the past several years primarily as a result of its acquisitions. Following each acquisition, the Company implemented programs to take advantage of distribution and operating synergies among its businesses. This implementation is reflected in an increase in the Company's sales and in the decline in selling, general and administrative expenses as a percentage of the Company's sales. Since mid-1990, sales of most of the Company's products have been adversely affected by the worldwide slowdown in the electronic components industry. In addition, sales to defense-related industries have declined since the first quarter of 1991. These trends are continuing. Year ended December 31, 1993 compared to Year ended December 31, 1992 Results of Operations - - - --------------------- Net sales for the year ended December 31, 1993 increased by $192,046,000 over the comparable period of the prior year. The increase resulted from the acquisition of Roederstein, effective January 1, 1993. Net sales of Roederstein were $212,124,000 for the year ended December 31, 1993. Net sales, exclusive of Roederstein, decreased by $20,078,000, compared to the same period of the prior year. This decrease in net sales is attributable to the strengthening of the U.S. dollar against foreign currencies, which resulted in a decrease in reported Vishay sales of $15,671,000 for the year ended December 31, 1993, and recessionary pressures in Europe. Costs of products sold for the year ended December 31, 1993 were 77.5% of net sales as compared to 76.5% for the comparable period of the prior year. The reason for this increase is that the costs of products sold for Roederstein (prior to the full implementation of synergistic cost reductions) are approx- imately 80% of net sales, while Vishay's business, exclusive of Roederstein, has been operating in the 76% to 78% range. In 1993, grants of $3,424,000 received from the government of Israel, which were utilized to offset start-up costs of new facilities, were recognized as a reduction of costs of products sold. Selling, general, and administrative expenses for the year ended December 31, 1993 were 13.9% of net sales as compared to 15.3% for the comparable period of the prior year. The current year's lower rates reflect the effect of the acquisition of Roederstein and the ongoing cost savings programs implemented with the acquisition of certain businesses of STI during 1992. Restructuring charges of $6,659,000 for the year ended December 31, 1993 consist primarily of severance costs related to the Company's decision to downsize its European operations, primarily in France, as a result of the European business climate. Income from unusual items of $7,221,000 for the year ended December 31, 1993 represents proceeds received for business interruption insurance claims principally related to operations in Dimona, Israel. Interest costs increased by $1,514,000 for the year ended December 31, 1993 as a result of increased debt incurred for the acquisition of Roederstein. Other income for the year ended December 31, 1993 decreased by $4,410,000 over the comparable period of the prior year because other income for the year ended December 31, 1992 included consulting fees of $2,307,000 from Roederstein. These fees to Vishay were for time and expenses of Vishay personnel utilized by Roederstein in its attempt to restructure itself. Also, other income for the year ended December 31, 1992 included fees of approximately $3,325,000 from STI under one-year sales and distribution agreements. Foreign currency losses for the year ended December 31, 1993 were $1,382,000, as compared to foreign currency losses of $1,594,000 for the year ended December 31, 1992. The effective tax rate of 16.2% for the year ended December 31, 1993 reflects the non-taxability of certain insurance recoveries. The 1993 rate was also affected by increased manufacturing in Israel, where the Company's average income tax rate was approximately 4% in 1993. The effective tax rate for the year ended December 31, 1993, exclusive of the effect of the non- taxable insurance proceeds, was 18.6%. The effective tax rate for the year ended December 31, 1992 was 19.8%. Accounting Changes - - - ------------------ Effective January 1, 1993, the Company changed its method of accounting for income taxes from the deferred method to the liability method required by FASB Statement No. 109, "Accounting for Income Taxes". The cumulative effect of adopting Statement 109 as of January 1, 1993 was to increase net income by $1,427,000. Application of the new income tax rules also decreased pretax earnings by $2,870,000 for the year ended December 31, 1993 because of increased depreciation expense as a result of Statement 109's requirement to report assets acquired in prior business combinations at their pretax amounts. The Company also adopted FASB Statement No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", effective January 1, 1993. The Company has elected to recognize the transition obligation on a prospective basis over a twenty-year period. In 1993, the new standard resulted in additional annual net periodic postretirement benefit costs of $1,200,000 before taxes, and $792,000 after taxes, or $0.04 per share. Prior-year financial statements have not been restated to apply the new standard. Year ended December 31, 1992 compared to Year ended December 31, 1991 Net sales for the year ended December 31, 1992 increased $221,943,000 over the comparable period of the prior year. The increase was the result of the inclusion of the businesses acquired from STI effective as of January 1, 1992. Net sales of the acquired businesses were $230,492,000 for the year ended December 31, 1992. For the year ended December 31, 1992, net sales, exclusive of the acquired businesses, decreased by $8,549,000 compared to the same period of the prior year when recessionary pressures affecting sales were not as great. The weakening of the U.S. dollar against foreign currencies resulted in an increase in reported Vishay sales of $10,418,000 for the year ended December 31, 1992. Costs of products sold for the year ended December 31, 1992 were 76.5% of net sales as compared to 71.9% for the comparable period of the prior year. The reason for this increase is that the costs of products sold for the newly purchased businesses from STI (prior to any synergistic cost reductions) are 80% of net sales, while Vishay's resistor businesses traditionally operate at levels of 70% to 75%. Selling, general, and administrative expenses for the year ended December 31, 1992 were 15.3% of net sales compared to 17.2% for the comparable period of the prior year. The 15.3% rate reflects the effect of the businesses acquired from STI. The rate applicable to the businesses acquired from STI (approximately 11%) includes the effects of initial cost saving programs installed subsequent to the acquisition. For the year ended December 31, 1992, selling, general and administrative expenses of the Vishay resistor business (approximately 17%) were comparable to the levels experienced in the prior year. Interest costs increased by $3,903,000 for the year ended December 31, 1992 as a result of the increased debt incurred for the purchase of the businesses from STI. Other income for the year ended December 31, 1992 includes consulting fees of $2,307,000 from Roederstein. Other income for the year ended December 31, 1992 also includes fees of approxi- mately $3,325,000 from STI under one-year sales and distribution agreements expiring February 14, 1993, which were entered into in connection with the acquisition of the businesses from STI. The effective tax rate was 19.8% for the year ended December 31, 1992. The effective rate is comparable to the rate of 23.3% for 1991. The 1992 rate was in part affected by increased manufacturing in Israel where the Company's average income tax rate was 7% for 1992. Year ended December 31, 1991 compared to Year ended December 31, 1990 Net sales decreased by $3,313,000 or approximately 1% to $442,283,000 for the year ended December 31, 1991 from $445,596,000 for the year ended December 31, 1990. Sales increased in the United States by 2.7% as a result of acquisitions, which partially offset the effect of the worldwide recession. Sales in Western Europe declined 4.9% compared to the year ended December 31, 1990 as a result of the recession and the strengthening of the dollar against foreign currencies. Price increases did not materially affect sales. Costs of products sold increased to $318,166,000 or 71.9% of sales for the year ended December 31, 1991 from $312,925,000 or 70.2% of sales for the year ended December 31, 1990. The increase in costs of products sold as a percentage of sales reflects increased production costs of relatively flat sales in addition to certain manufacturing inefficiencies during the latter part of 1991. Selling, general, and administrative expenses decreased to $75,973,000 or 17.2% of sales for the year ended December 31, 1991 from $77,740,000 or 17.4% of sales for the year ended December 31, 1990 primarily because of the continuation of cost reduction programs introduced during 1990. Expenses of approximately $3,700,000 for layoff costs at the Company's European subsidiaries were incurred during the latter half of 1991. This correction to the work force was made to strengthen the subsidiaries' ability to attain earnings goals and to respond to the current recession. Interest expense decreased by $4,219,000 to $15,207,000 for the year ended December 31, 1991 from $19,426,000 for the year ended December 31, 1990 primarily as a result of payments made on long-term debt and lower interest rates. Other expenses for the year ended December 31, 1991 were $289,000 compared to income of $2,344,000 for the year ended December 31, 1990, primarily due to decreases in investment grants from Israel and interest income. Investment grants and interest income for the year ended December 31, 1991 were $106,000 and $797,000, respectively, compared to $980,000 and $2,257,000, respectively, for the year ended December 31, 1990. The effective tax rate for the year ended December 31, 1991 was 23.3% versus 31.5% for the year ended December 31, 1990. The decrease in the effective tax rate resulted from a reduced tax rate for certain Israeli operations and an increase in the propor- tion of earnings taxable in Israel. The lower rate was primarily due to tax advantages of doing business in Israel where the Company's effective average tax rate was approximately 10% at that time. Financial Condition Cash flows from operations were $50,114,000 for the year ended December 31, 1993 compared to $54,357,000 for the prior year and were used primarily to finance capital expenditures. Purchases of property and equipment were $76,813,000 for the year ended December 31, 1993 compared to $49,801,000 for the prior year primarily due to additions of manufacturing equipment for surface mount products and expansion of manufacturing facilities in Israel. The Company's financial condition at December 31, 1993 is strong with the Company's current ratio of 2.1 to 1. The Company's ratio of long-term debt to stockholders' equity was .7 to 1 at December 31, 1993 as compared to .4 to 1 at December 31, 1992. The increase in this ratio resulted from additional borrowings in connection with the acquisition of Roederstein. In connection with the Roederstein acquisition, Vishay entered into a DM 104,316,000 term loan agreement with its lending banks in January 1993. In addition, an Israeli subsidiary of Vishay borrowed $20 million pursuant to an unsecured credit agreement. The funds from the credit facilities were used in connection with the Roederstein acquisition and the refinancing of Roederstein's debt. Vishay and the Banks also amended certain terms of the outstanding $170,000,000 Revolving Credit and Term Loan Agreement dated as of January 10, 1992 among Vishay and the Banks and the Amended and Restated DM 42,375,000 Revolving Credit and DM 57,036,000 Term Loan Agreement dated as of January 10, 1992 among Vishay, Draloric and the lending banks in order to, among other things, allow Vishay to draw upon its revolving credit facilities to refinance a portion of Roederstein's debt. See Note 6 to the Company's Consolidated Financial Statements elsewhere herein for additional information with respect to Vishay's loan agreements, long-term debt and available short- term credit lines. Management believes that available sources of credit, together with cash expected to be generated from operations, will be sufficient to satisfy the Company's anticipated financing needs for working capital and capital expenditures during the next twelve months. Inflation Normally, inflation has not had a significant impact on the Company's operations. The Company's products are not generally sold on long-term contracts. Consequently, selling prices, to the extent permitted by competition, can be adjusted to reflect cost increases caused by inflation. Item 8.

Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - - - ------- ------------------------------------------- The following Consolidated Financial Statements of the Company and its subsidiaries, together with the report of independent auditors thereon, are presented under Item 14 of this report: Report of Independent Auditors Consolidated Balance Sheets -- December 31, 1993 and 1992. Consolidated Statements of Operations -- for the years ended December 31, 1993, 1992 and 1991. Consolidated Statements of Cash Flows -- for the years ended December 31, 1993, 1992 and 1991. Consolidated Statements of Stockholders' Equity -- for the years ended December 31, 1993, 1992 and 1991. Notes to Consolidated Financial Statements -- December 31, 1993. Item 9.

Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON - - - ------- ACCOUNTING AND FINANCIAL DISCLOSURE ------------------------------------------------ None. PART III -------- Information with respect to Items 10, 11, 12 and 13 on Form 10-K is set forth in the Company's definitive proxy statement, which will be filed within 120 days of December 31, 1993, the Company's most recent fiscal year. Such information is incor- porated herein by reference, except that information with respect to Executive Officers of Registrant is set forth in Part I, Item 4A hereof under the caption, "Executive Officers of the Registrant". PART IV ------- Item 14.

Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON - - - -------- FORM 8-K ------------------------------------------------------ (a) (1) All Consolidated Financial Statements of the Company and its subsidiaries for the year ended December 31, 1993 are filed herewith. See Item 8 of this Report for a list of such financial statements. (2) Financial Statement Schedules for Vishay, set forth immediately following this Item 14 are as follows: Schedule V -- Property, Plant and Equipment Schedule VI -- Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment Schedule IX -- Short-Term Borrowings Schedule X -- Supplementary Income Statement Information All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instruction or are inapplicable and therefore have been omitted. (3) Exhibits -- See response to paragraph (c) below. (b) Reports on Form 8-K None (c) Exhibits: 2.1 Purchase and Sale Agreement, dated as of November 14, 1991, among Sprague Technologies, Inc., Sprague Electric Company and Vishay Intertechnology, Inc. Incorporated by reference to Exhibit 1 to the Current Report on Form 8-K dated November 14, 1991. 3.1 Certificate of Incorporation of Registrant, as amended and Certificate of Amendment of Restated Certificate of Incorporation of Registrant dated May 18, 1993. 3.2 Amended and Restated Bylaws of Registrant. Incorporated by reference to Exhibit 3.2 to Registration Statement No. 33-13833 of Registrant on Form S-2 under the Securities Act of 1933 (the "Form S-2") and Amendment No. 1 to Amended and Restated Bylaws of Registrant. 10.1 Performance-Based Compensation Plan for Chief Executive Officer of Registrant. 10.2 Second Amendment dated as of January 29, 1993 to Amended and Restated Vishay Intertechnology, Inc. $170,000,000 Revolving Credit and Term Loan Agreement by and among Comerica Bank, NationsBank of North Carolina, N.A., Signet Bank Maryland, CoreStates Bank, N.A., Bank Hapoalim, B.M., Meridian Bank, Bank Leumi le-Israel, B.M., Berliner Handels-und Frankfurter Bank and ABN AMRO Bank N.V. (collectively, the "Banks"), Comerica Bank, as agent for the Banks (the "Agent"), and Vishay Intertechnology, Inc. ("Vishay"), dated as of January 10, 1992. Incorporated by reference to Exhibit (10.1) to the Current Report on Form 8-K, dated January 29, 1993. 10.3 Second Amendment dated as of January 29, 1993 to Amended and Restated Draloric Electronic GmbH DM 42,375,000 Revolving Credit and DM 57,036,000 Term Loan Agreement by and among the Banks, the Agent and Draloric Electronic GmbH ("Draloric"), dated as of January 10, 1992. Incorporated by reference to Exhibit (10.2) to the Current Report on Form 8-K, dated January 29, 1993. 10.4 Roederstein DM 104,315,990.20 Term Loan Agreement dated as of January 29, 1993 by and among the Banks, the Agent, Draloric and Vishay. Incorporated by reference to Exhibit (10.3) to the Current Report on Form 8-K, dated January 29, 1993. 10.5 Agreement between First International Bank of Israel and Vishay Israel Ltd. dated January 28, 1993. Incorporated by reference to Exhibit (10.4) to the Current Report on Form 8-K, dated January 29, 1993. 10.6 Amended and Restated Vishay Intertechnology, Inc. $170,000,000 Revolving, Credit and Term Loan Agreement by and among Manufacturers Bank, N.A., NationsBank of North Carolina, N.A., Signet Bank Maryland, CoreStates Bank, N.A., Bank Hapoalim, B.M., Meridian Bank and Bank Leumi le-Israel, B.M. (collectively, the "Prior Banks"), the Agent and Vishay, dated as of January 10, 1992. Incorporated by reference to Exhibit (10.1) to the Current Report on Form 8-K, dated January 10, 1992. 10.7 Amended and Restated Draloric Electronic, GmbH DM 42,375,000 Revolving Credit and DM 57,036,000 Term Loan Agreement by and among the Prior Banks, the Agent and Draloric, dated as of January 10, 1992. Incorporated by reference to Exhibit (10.2) to the Current Report on Form 8-K, dated January 10, 1992. 10.8 Amended and Restated Guaranty by Vishay to the Banks, dated as of January 29, 1993. Incorporated by reference to Exhibit (10.5) to the Current Report on Form 8-K, dated January 29, 1993. 10.9 Amended and Restated Guaranty by Dale Holdings, Inc., Dale Electronics, Inc., Bradford Electronics, Inc., and Measurements Group, Inc. to the Banks, dated as of January 29, 1993. Incorporated by reference to Exhibit (10.6) to the Current Report on Form 8-K, dated January 29, 1993. 10.10 Amended and Restated Permitted Borrowers Guaranty by Vilna Equities Holding B.V., Visra Electronics Financing, B.V., Draloric, E-Sil Components, Ltd., Vishay Components (U.K.) Limited, Sfernice, S.A., Ultronix, Inc., Techno Components Corporation and Ohmtek, Inc. to the Banks, dated as of January 29, 1993. Incorporated by reference to Exhibit (10.7) to the Current Report on Form 8-K, dated January 29, 1993. 10.11 Guaranty by Vishay Sprague, Inc., Sprague North Adams, Sprague Sanford and Roederstein Electronics, Inc. to the Banks, dated January 29, 1993. Incorporated by reference to Exhibit (10.8) to the Current Report on Form 8-K, dated January 29, 1993. 10.12 Guaranty Agreement, dated as of November 29, 1989 between the Company and Societe Generale, New York Branch. Incorporated by reference to Exhibit 10.3 to the Company's Annual Report on Form 10-K for December 31, 1989. 10.13 Option Agreement for the Assets of the Resista Division of Roederstein by and among Vishay, Mr. Jorg Roederstein, Roederstein Spezialfabriken fur Bauelemente der Elektronik und Kondensatoren der Starkstromtechnik GmbH ("Roederstein") and Mr. Till Roederstein, dated February 18, 1992. Incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K, dated February 18, 1992. 10.14 Purchase and Transfer Agreement concerning Shares by and among, Mrs. Ute Roederstein, Mrs. Cornelia Bodinka, nee Roederstein, Ms. Claudia Roederstein, Mr. Jorg Roederstein, Mr. Till Roederstein and Vishay dated February 18, 1992. Incorporated by reference to Exhibit 10.2 to the Current Report on Form 8-K, dated February 18, 1992. 10.15 Notarial Offer for a Purchase and Transfer Agreement concerning Shares by Mr. Till Roederstein and Vishay Intertechnology, Inc. dated February 18, 1992. Incorporated by reference to Exhibit 10.3 to the Current Report on Form 8-K, dated February 18, 1992. 10.16 Fiscal Agency Agreement, dated July 28, 1988, between the Company and Citibank, N.A. Incorporated by reference to Exhibit (10(i)) to the Current Report on Form 8-K, dated August 30, 1988. 10.17 Management Fee Agreement between Dale Holdings, Inc. and the Company, dated May 14, 1986. Incorporated by reference to Exhibit 10.15 to the Form S-2. 10.18 Employment Agreement, dated as of March 15, 1985, between the Company and Dr. Felix Zandman. Incorporated by reference to Exhibit 10.12 to the Form S-2. 10.19 1986 Employee Stock Plan of the Company. Incorporated by reference to Exhibit 4 to the Company's Registration Statement on Form S-8 (No. 33-7850). 10.20 1986 Employee Stock Plan of Dale Electronics, Inc. Incorporated by reference to Exhibit 4 to the Company's Registration Statement on Form S-8 (No. 33-7851). 10.21 Money Purchase Plan Agreement of Measurements Group, Inc. Incorporated by reference to Exhibit 10(a)(6) to Amendment No. 1 to the Company's Registration Statement on Form S-7 (No. 2-69970). 10.22 Distributor Agreement between Nytron Inductors and VSD, Inc. dated as of January 1, 1991. Incorporated by reference to the Company's Annual Report on Form 10-K for December 31, 1990. 10.23 Distribution Sales Agreement between Sprague Electric Company and Vishay Intertechnology, Inc., dated February 14, 1992. Incorporated by reference to Exhibit (10.1) to the Current Report on Form 8-K, dated February 14, 1992. 10.24 Sales Representation Agreement between Sprague Electric Company and Vishay Intertechnology, Inc. dated February 14, 1992. Incorporated by reference to Exhibit (10.2) to the Current Report on Form 8-K, dated February 14, 1992. 10.25 Agreement for Transfer of Computer Software License Administration Services Agreement between Sprague Electric Company and Vishay Intertechnology, Inc., dated February 14, 1992. Incorporated by reference to Exhibit (10.3) to the Current Report on Form 8-K, dated February 14, 1992. 10.26 Lease of Concord Facility, dated February 14, 1992. Incorporated by reference to Exhibit (10.4) to the Current Report on Form 8-K, dated February 14, 1992. 10.27 Sublease of Hudson Facility, dated February 14, 1992. Incorporated by reference to Exhibit (10.5) to the Current Report on Form 8-K, dated February 14, 1992. 10.28 Lease of El Paso Property, dated February 14, 1992. Incorporated by reference to Exhibit (10.6) to the Current Report on Form 8-K, dated February 14, 1992. 10.29 Non-Competition Agreement among Sprague Technologies, Inc., Sprague Electric Company and Vishay Inter- echnology, Inc., dated February 14, 1992. Incorporated by reference to Exhibit (10.7) to the Current Report on Form 8-K, dated February 14, 1992. 10.30 Agreement between Sprague Technologies, Inc. and Vishay Israel, Ltd., dated February 14, 1992. Incorporated by reference to Exhibit (10.8) to the Current Report on Form 8-K, dated February 14, 1992. 11. Statement regarding Computation of Per Share Earnings. 22. Subsidiaries of the Registrant. 23. Consent of Independent Auditors. Report of Independent Auditors Board of Directors and Stockholders Vishay Intertechnology, Inc. We have audited the accompanying consolidated balance sheets of Vishay Intertechnology, Inc. as of December 31, 1993 and 1992, and the related consolidated statements of operations, cash flows, and stockholders equity for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Vishay Intertechnology, Inc. at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in the Notes to Consolidated Financial Statements, in 1993 the Company changed its methods of accounting for income taxes (Note 5) and postretirement benefits other than pensions (Note 10). /s/ ERNST & YOUNG Philadelphia, Pennsylvania February 10, 1994 except for Note 6, as to which the date is March 25, 1994 Vishay Intertechnology, Inc. Consolidated Balance Sheets (In thousands, except per share and share amounts) December 31 1993 1992 -------------------------- Assets Current assets: Cash and cash equivalents $ 10,931 $ 15,977 Accounts receivable, less allowances of $5,150 and $3,885 125,284 102,757 Inventories: Finished goods 85,783 50,874 Raw materials and work in process 138,872 99,901 Prepaid expenses and other current assets 33,365 18,192 -------------------------- Total current assets 394,235 287,701 Property and equipment--at cost: Land 33,791 12,917 Buildings and improvements 136,432 87,623 Machinery and equipment 398,885 288,527 -------------------------- 569,108 389,067 Less allowances for depreciation (149,004) (117,448) -------------------------- 420,104 271,619 Goodwill 118,286 74,872 Other assets 15,481 27,451 -------------------------- $948,106 $661,643 ========================== December 31 1993 1992 -------------------------- Liabilities and stockholders' equity Current liabilities: Notes payable to banks $ 22,695 $ 18,966 Trade accounts payable 48,404 42,727 Payroll and related expenses 28,942 23,124 Other accrued expenses 54,112 25,984 Income taxes 3,740 - Current portion of long-term debt 30,536 31,573 -------------------------- Total current liabilities 188,429 142,374 Long-term debt--less current portion 266,999 139,540 Deferred income taxes 26,080 9,786 Other liabilities 24,081 1,021 Accrued pension costs 66,014 22,297 Stockholders' equity: Preferred Stock, par value $1.00 a share: Authorized--1,000,000 shares; none issued Common Stock, par value $.10 a share: Authorized--35,000,000 shares; 17,639,081 and 16,795,234 shares outstanding after deducting 47,441 and 47,432 shares in treasury 1,763 1,679 Class B convertible Common Stock, par value $.10 a share: Authorized-- 15,000,000 shares; 3,590,232 and 3,419,385 shares outstanding after deducting 125,965 and 119,967 shares in treasury 359 342 Capital in excess of par value 288,980 253,446 Retained earnings 105,849 97,156 Foreign currency translation adjustment (13,109) (5,864) Unearned compensation (60) (134) Pension adjustment (7,279) - -------------------------- 376,503 346,625 -------------------------- $948,106 $661,643 ========================== See accompanying notes. Vishay Intertechnology, Inc. Consolidated Statements of Operations (In thousands, except per share and share amounts) Year ended December 31 1993 1992 1991 ------------------------------------------ Net sales $856,272 $664,226 $442,283 Costs of products sold 663,239 508,018 318,166 ------------------------------------------ Gross profit 193,033 156,208 124,117 Selling, general, and administrative expenses 118,906 101,327 75,973 Restructuring expense 6,659 - 3,700 Unusual items (7,221) - - ------------------------------------------ 74,689 54,881 44,444 Other income (expense): Interest expense (20,624) (19,110) (15,207) Amortization of goodwill (3,294) (2,380) (1,695) Other 123 4,533 (289) ------------------------------------------ (23,795) (16,957) (17,191) ------------------------------------------ Earnings before income taxes and cumulative effect of accounting change 50,894 37,924 27,253 Income taxes 8,246 7,511 6,363 ------------------------------------------ Earnings before cumulative effect of accounting change 42,648 30,413 20,890 Cumulative effect of accounting change for income taxes 1,427 - - ------------------------------------------ Net earnings $44,075 $30,413 $20,890 ========================================== Earnings per share: Before cumulative effect of accounting change $2.01 $1.71 $1.25 Accounting change for income taxes 0.07 - - ------------------------------------------ Net earnings $2.08 $1.71 $1.25 ========================================== Weighted average shares outstanding 21,228,000 19,366,000 16,649,000 ========================================== See accompanying notes. Vishay Intertechnology, Inc. Consolidated Statements of Cash Flows (In thousands) See accompanying notes. Vishay Intertechnology, Inc. Consolidated Statements of Stockholders' Equity (In thousands, except share amounts) See accompanying notes. Vishay Intertechnology, Inc. Notes to Consolidated Financial Statements December 31, 1993 1. Summary of Significant Accounting Policies Principles of Consolidation The consolidated financial statements of Vishay Intertechnology, Inc. include the accounts of the Company and its subsidiaries, after elimination of all significant intercompany transactions, accounts, and profits. Inventories Inventories are stated at the lower of cost, determined by the first-in, first-out method, or market. Depreciation Depreciation is computed principally by the straight-line method based upon the estimated useful lives of the assets. Depreciation of capital lease assets is included in total depreciation expense. Depreciation expense was $43,493,000, $30,995,000, and $23,706,000 for the years ended December 31, 1993, 1992, and 1991, respectively. Goodwill Goodwill, representing the excess of purchase price over net assets of businesses acquired, is being amortized on a straight-line basis over 40 years. Accumulated amortization amounted to $10,945,000 and $7,679,000 at December 31, 1993 and 1992, respectively. Cash Equivalents For purposes of the Statement of Cash Flows, the Company considers demand deposits and all highly liquid investments with maturities of three months or less when purchased to be cash equivalents. Research and Development Expenses The amount charged to expense aggregated $7,097,000, $7,149,000, and $6,967,000 for the years ended December 31, 1993, 1992, and 1991, respectively. The Company spends additional amounts for the development of machinery and equipment for new processes and for cost reduction measures. Grants Grants received from governments by certain foreign subsidiaries are recognized as income when conditions for receipt are met. In 1993, grants of $3,424,000 received from the government of Israel, which were utilized to offset startup costs of new facilities, were recognized as a reduction of costs of products sold. Vishay Intertechnology, Inc. Notes to Consolidated Financial Statements (continued) 1. Summary of Significant Accounting Policies (continued) Earnings Per Share Earnings per share is based on the weighted average number of common shares and dilutive common equivalent shares (from the assumed conversion of convertible subordinated debentures) outstanding during the period. In October 1992, the convertible subordinated debentures were converted into 2,536,783 shares of Common Stock. For the year ended December 31, 1992, where assumed conversion of the debentures has a dilutive effect, net earnings used in the computations are adjusted for interest expense, net of income taxes, on the convertible subordinated debentures. Earnings per share amounts for all periods presented reflect 5% stock dividends paid on June 11, 1993, June 16, 1992, and June 11, 1991. Earnings per share for the years ended December 31, 1993 and 1992 reflect the weighted effect of the issuance of 1,800,000 shares of Common Stock on December 24, 1992. Accounting Changes In 1993, the Company changed its methods of accounting for income taxes (Note 5) and postretirement benefits other than pensions (Note 10). Reclassifications Certain prior-year amounts have been reclassified to conform with the current presentation. 2. Acquisitions During January 1993, Vishay exercised its option to purchase the remaining 81% of the outstanding share capital of Roederstein GmbH, a passive electronic components manufacturer with headquarters in Germany for 4,050,000 Deutsche Marks ("DM") ($2,502,000) pursuant to an option agreement dated February 18, 1992. Vishay had acquired its initial 19% interest in Roederstein on February 18, 1992 for DM 950,000 ($577,000). In connection with the acquisition, Vishay refinanced all of Roederstein's existing bank debt of DM 160,381,000 ($99,062,000). Funds to refinance Roederstein's debt were provided by a DM 104,316,000 term loan with a group of banks, $20,000,000 borrowed under an unsecured credit agreement, and borrowings under an existing line of credit. Effective January 1, 1992, the Company acquired the worldwide tantalum capacitor and U.S. thick film resistor network businesses of Sprague Technologies, Inc. Under the terms of the purchase agreement, Vishay paid $127,000,000 cash, transferred to Sprague real property with a fair value of $4,771,000, and assumed certain liabilities relating to the businesses. Vishay also entered into certain ancillary agreements with the seller, including one-year sales and distribution agreements under which Vishay received fees of $3,325,000 during 1992, which are included in other income. The purchase price was funded primarily from a $125,000,000 term loan facility. Vishay Intertechnology, Inc. Notes to Consolidated Financial Statements (continued) 2. Acquisitions (continued) The acquisitions have been accounted for under the purchase method of accounting. The operating results of Roederstein and Sprague have been included in the Company's consolidated results of operations from January 1, 1993 and January 1, 1992, respectively. Excess of cost over the fair value of net assets acquired (Roederstein--$45,210,000; Sprague--$19,534,000) is being amortized on a straight-line basis over forty years. Had the Roederstein and Sprague acquisitions been made at the beginning of the year prior to their acquisition, the Company's pro forma unaudited results would have been (in thousands, except per share amounts): Year ended December 31 1992 1991 ------------------------- Net sales $913,398 $679,183 Net earnings (loss) (22,992) 20,591 Earnings (loss) per share $(1.19) $1.24 The unaudited pro forma results are not necessarily indicative of the results that would have been attained had the acquisitions occurred at the beginning of the periods presented or of results which may occur in the future. Pro forma net earnings for 1992 reflect $31,860,000 of restructuring costs incurred by Roederstein for work force reductions. During 1992, Vishay provided Roederstein with management and sales support, short-term working capital advances, and assistance in renegotiating Roederstein's bank debt. Vishay also assisted Roederstein in developing a cost-savings program involving reductions in the Roederstein work force, including the closing of an unprofitable division. Vishay recognized consulting fees, which are included in other income, from Roederstein of $2,307,000 for the year ended December 31, 1992 for its assistance to Roederstein. As of December 31, 1992, Vishay had investments in Roederstein of $3,229,000, advances to Roederstein, included in other assets, of $16,918,000, accounts receivable and other current receivables from Roederstein of $5,166,000, and accounts payable to Roederstein of $1,158,000. The Company made several minor acquisitions in 1993 and 1991, all of which were accounted for under the purchase method. The results of operations of these businesses have been included in the consolidated results of the Company from the dates of acquisition. 3. Restructuring Expense and Unusual Items Restructuring expenses of $6,659,000 for 1993 related to the downsizing of some of the Company's European operations. Income from unusual items of $7,221,000 for 1993 represents insurance recoveries the Company has received for business interruption insurance claims. The Company incurred restructuring costs of $3,700,000 in 1991 relating primarily to costs associated with layoffs in France. Vishay Intertechnology, Inc. Notes to Consolidated Financial Statements (continued) 4. Foreign Subsidiaries The following amounts relating to foreign subsidiaries are included in the consolidated financial statements (in thousands): 5. Income Taxes Effective January 1, 1993, the Company changed its method of accounting for income taxes from the deferred method to the liability method required by FASB Statement No. 109, "Accounting for Income Taxes." As permitted under the new rules, prior years' financial statements have not been restated. The cumulative effect of adopting Statement 109 as of January 1, 1993 was to increase net earnings by $1,427,000, or $.07 per share. For the year ended December 31, 1993, application of the new income tax rules decreased pretax income by $2,870,000 because of increased depreciation expense as a result of Statement 109's requirement to report assets acquired in prior business combinations at their pretax amounts. At December 31, 1993, the Company has net operating loss carryforwards for tax purposes of approximately $96,300,000 in Germany (no expiration date), $3,100,000 in France (expire December 31, 1998), and $1,800,000 in Portugal (expire December 31, 1997). Approximately $70,800,000 of the carryforward in Germany, and the full $1,800,000 in Portugal, resulted from the Company's acquisition of Roederstein. For financial reporting purposes, a valuation allowance of $34,862,000 has been recognized to offset deferred tax assets related to German net operating loss carryforwards. If tax benefits are recognized in the future through reductions of the valuation allowance, such amounts will reduce goodwill of acquired companies. The valuation allowance decreased from January 1, 1993 by $6,584,000 primarily due to a decrease in German tax rates which had the effect of reducing the deferred tax asset for German net operating loss carryforwards. Vishay Intertechnology, Inc. Notes to Consolidated Financial Statements (continued) 5. Income Taxes (continued) Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company's deferred tax liabilities and assets as of December 31, 1993 are as follows (in thousands): Deferred tax liabilities: Tax over book depreciation $57,401 Other--net 2,685 --------- Total deferred tax liabilities 60,086 --------- Deferred tax assets: Pension and other retiree obligations 20,179 Net operating loss carryforwards 38,773 Restructuring reserves 7,354 Other accruals and reserves 12,300 --------- Total deferred tax assets 78,606 Valuation allowance for deferred tax assets (34,862) --------- Net deferred tax assets 43,744 --------- Net deferred tax liabilities $16,342 ========= For financial reporting purposes, earnings before income taxes and cumulative effect of accounting change includes the following components (in thousands): Year ended December 31 1993 1992 1991 ---------------------------------- Pretax income: Domestic $13,136 $10,252 $8,519 Foreign 37,758 27,672 18,734 ---------------------------------- $50,894 $37,924 $27,253 ================================== Vishay Intertechnology, Inc. Notes to Consolidated Financial Statements (continued) 5. Income Taxes (continued) Significant components of income taxes attributable to continuing operations are as follows (in thousands): Liability Method Deferred Method -------------------------------- Year ended December 31 1993 1992 1991 -------------------------------- Current: U.S. Federal $3,032 $1,639 $3,558 Foreign 2,706 2,521 1,706 State 332 502 675 -------------------------------- 6,070 4,662 5,939 Deferred: U.S. Federal 1,960 1,760 103 Foreign 36 832 312 State 180 257 9 -------------------------------- 2,176 2,849 424 -------------------------------- $8,246 $7,511 $6,363 ================================ For the year ended December 31, 1992, deferred income taxes resulted from accelerated methods of depreciation used for tax purposes ($2,494,000) and restructuring reserves ($2,012,000). These amounts were partially offset by differences relating to inventory valuation methods ($900,000) and other items ($757,000). For the year ended December 31, 1991, deferred taxes resulted principally from use of accelerated methods of depreciation for tax purposes. A reconciliation of income tax at the U.S. federal statutory income tax rate to actual income tax expense is as follows (in thousands): Liability Method Deferred Method -------------------------------- Year ended December 31 1993 1992 1991 -------------------------------- Tax at statutory rate $17,304 $12,894 $9,266 State income taxes, net of federal tax 396 501 452 Effect of foreign income tax rates (10,532) (5,649) (5,166) Effect of purchase accounting adjustments 717 939 1,291 Other 361 (1,174) 520 -------------------------------- $8,246 $7,511 $6,363 ================================ Vishay Intertechnology, Inc. Notes to Consolidated Financial Statements (continued) 5. Income Taxes (continued) At December 31, 1993, no provision has been made for U.S. income taxes on approximately $169,678,000 of foreign earnings which are expected to be reinvested indefinitely. Income taxes paid were $6,933,000, $5,729,000 and $8,418,000 for the years ended December 31, 1993, 1992, and 1991, respectively. 6. Long-Term Debt Long-term debt consisted of the following (in thousands): December 31 1993 1992 ------------------------ Revolving Credit Loan $51,500 $7,500 Term Loan 102,500 117,500 Deutsche Mark Revolving Credit Loan 23,035 10,500 Deutsche Mark Term Loan 10,948 23,486 Deutsche Mark Term Loan II 60,073 - Unsecured Credit Agreements 38,638 - Industrial Development Revenue Bonds 578 2,581 French Industrial Bonds 3,147 1,952 Other Debt and Capital Lease Obligations 7,116 7,594 ------------------------ 297,535 171,113 Less current portion 30,536 31,573 ------------------------ $266,999 $139,540 ======================== As of December 31, 1993, five facilities were available under the Company's amended and restated Revolving Credit and Term Loan and Deutsche Mark Revolving Credit and Term Loan agreements with a group of banks; a multicurrency revolving credit loan (interest 4.25% at December 31, 1993), a U.S. term loan (interest 4.44% at December 31, 1993), a Deutsche Mark revolving credit loan (interest 7.50% at December 31, 1993), a Deutsche Mark term loan (interest 7.69% at December 31, 1993), and an additional Deutsche Mark term loan (interest 8.25% at December 31, 1993). During March 1994, the Company's bank group agreed to amend the Revolving Credit and Term Loan and Deutsche Mark Revolving Credit and Term Loan agreements in effect at December 31, 1993. The terms of the five facilities, as agreed in March 1994, are summarized below. The first facility is a $90,000,000 multicurrency revolving credit facility which is available to the Company on a revolving basis until December 31, 1996, at which time the Company may elect a term out option, with quarterly payments due beginning March 31, 1997 through December 31, 2000. Interest is payable at prime or at other interest rate options. The Company is required to pay a commitment fee equal to 3/8% per annum on the average unused line. The second facility is a $102,500,000 term loan, with interest payable at prime plus 1/8% or at other interest rate options. Principal payments are due as follows: 1994 -- $5,000,000; 1995--$10,000,000; 1996--$10,000,000; Vishay Intertechnology, Inc. Notes to Consolidated Financial Statements (continued) 6. Long-Term Debt (continued) 1997--$15,000,000; 1998--$20,000,000; 1999--$20,000,000; 2000--$22,500,000. Additional principal payments may be required based on excess cash flow as defined in the agreement. The loan agreements also provide a German subsidiary of the Company with three Deutsche Mark ("DM") facilities. The first DM facility is a DM 40,000,000 ($23,035,000) revolving credit facility which is available until December 31, 1996, at which time the Company may elect a term out option, with quarterly payments due beginning March 31, 1997 through December 31, 2000. Interest is based on DM market rates plus 15/16%. The Company is required to pay a commitment fee equal to 3/8% per annum on the average unused line. The second DM facility is a DM 19,012,000 ($10,948,000) term loan. Principal of DM 4,753,000 ($2,737,000) and interest at DM market rates plus 1-1/8% is due quarterly with final payment on December 31, 1994. The third DM facility is a DM 104,316,000 ($60,073,000) term loan. Interest is based on DM market rates plus 1-11/16%. Principal payments of DM 18,700,000, 34,100,000, 37,000,000, and 14,516,000 ($10,769,000, $19,637,000, $21,307,000, and $8,360,000) are due on or before December 31, 1994, 1995, 1996, and 1997, respectively. Additional principal payments may be required based on excess cash flow as defined in the agreement. Under the loan agreements, the Company is restricted from paying cash dividends and must comply with other covenants, including the maintenance of specific ratios. The Company is in compliance with the restrictions and limitations under the terms of loan agreements, as amended. All of the Company's U.S. assets and the stock of certain foreign subsidiaries are pledged as collateral under loan agreements. Borrowings under a $20,000,000 unsecured credit agreement with First International Bank of Israel are at LIBOR plus 1-1/8% (4.25% at December 31, 1993). Principal payments of $5,000,000, $6,666,666, and $8,333,334 are due on or before December 31, 1997, 1998, and 1999, respectively. Other unsecured borrowings are at various interest rates ranging from 3.9% to 7.2%. The industrial development revenue bonds are at various interest rates ranging from 8% to 12% and mature at various dates from 1996 through 1999. The French industrial bonds are payable in French francs and bear interest at rates ranging from zero to 10% and require periodic payments through 2004. Aggregate annual maturities of long-term debt, as revised to reflect the agreement reached with the Company's bank group in March 1994 and excluding payments which may be required based on excess cash flow, are as follows: 1994--$30,536,000; 1995--$32,132,000; 1996--$41,729,000; 1997--$50,393,000; 1998--$48,305,000; thereafter--$94,440,000. The Company has short-term credit lines with various banks aggregating $64,667,000, of which $29,030,000 was unused at December 31, 1993. Interest paid was $20,587,000, $16,496,000, and $12,775,000 for the years ended December 31, 1993, 1992, and 1991, respectively. Vishay Intertechnology, Inc. Notes to Consolidated Financial Statements (continued) 7. Stockholders' Equity The Company's Class B Stock carries ten votes per share while the Common Stock carries one vote per share. Class B shares are transferable only to certain permitted transferees while the Common Stock is freely transferable. Class B shares are convertible on a one-for-one basis at any time to Common Stock. Unearned compensation relating to Common Stock issued under employee stock plans is being amortized over a 36-month period. 132,153 shares are available for issuance under stock plans at December 31, 1993. 8. Other Income Other income (expense) consists of the following (in thousands): Year ended December 31 1993 1992 1991 --------------------------------------- Foreign exchange gains (losses) $(1,382) $(1,594) $41 Investment income 722 1,565 797 Sales and distribution fees from Sprague Technologies, Inc. - 3,325 - Roederstein consulting fees - 2,307 - Other 783 (1,070) (1,127) --------------------------------------- $123 $4,533 $(289) ======================================= 9. Employee Retirement Plans Two U.S. subsidiaries of Vishay, Dale Electronics, Inc. and Sprague North Adams, Inc., which was acquired effective January 1, 1992, maintain defined benefit pension plans (the "Plans"). Substantially all full-time employees of Dale and hourly employees of Sprague's North Adams facility are eligible to participate. The benefits under the Dale Plan are based on the employees' compensation during all years of participation. The benefits under the Sprague Plan are based on number of years of credited service. The Plans are tax qualified subject to the minimum funding requirements of ERISA. Employees participating in the Dale Plan are required to contribute an amount based on annual earnings. The Company's funding policy is to contribute annually amounts that satisfy the funding standard account requirements of ERISA. The assets of the Dale Plan are invested primarily in guaranteed investment contracts issued by an insurance company and mutual funds. The assets of the Sprague Plan are invested primarily in fixed income securities and common stock. Vishay Intertechnology, Inc. Notes to Consolidated Financial Statements (continued) 9. Employee Retirement Plans (continued) Net pension cost for the Plans included the following components (in thousands): The expected long-term rate of return on assets was 9.5%. The following table sets forth the funded status of the Plans and amounts recognized in the Company's financial statements (in thousands): The following assumptions have been used in the actuarial determinations of the Plans: 1993 1992 -------------------- Discount rate 7.5% 8.0%-8.5% Rate of increase in compensation levels 4.5% 4.5% Vishay Intertechnology, Inc. Notes to Consolidated Financial Statements (continued) 9. Employee Retirement Plans (continued) The Company's U.S. subsidiary, Measurements Group, Inc., maintains a defined contribution pension plan covering substantially all full-time employees. Contributions are made based on participants' compensation. Costs for this plan were $530,000, $512,000, and $485,000 for the years ended December 31, 1993, 1992, and 1991, respectively. In addition, many of the Company's U.S. employees are eligible to participate in 401(k) Savings Plans, some of which provide for Company matching under various formulas. The Company's matching expense for the plans was $1,996,000, $1,894,000, and $1,170,000 for the years ended December 31, 1993, 1992, and 1991, respectively. The Company provides pension and similar benefits to employees of certain foreign subsidiaries consistent with local practices. German subsidiaries of the Company (including Roederstein, which was acquired in January 1993) have noncontributory defined benefit pension plans covering management and employees. Pension benefits are based on years of service. Net pension cost for the German Plans included the following components (in thousands): The following table sets forth the funded status of the German Plans and amounts recognized in the Company's financial statements (in thousands): Vishay Intertechnology, Inc. Notes to Consolidated Financial Statements (continued) 9. Employee Retirement Plans (continued) The following assumptions have been used in the actuarial determinations of the German Plans: December 31 1993 1992 ------------------------ Discount rate 7.0% 6.0% Rate of increase in compensation levels 3.0% 4.0% 10. Postretirement Medical Benefits The Company pays limited health care premiums for certain eligible retired U.S. employees. Prior to 1993, the cost of these benefits, which was not significant, was charged to expense when the benefits were paid. Effective January 1, 1993, the Company adopted FASB Statement No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." Under this new standard, the Company recognizes the cost of postretirement benefits over the active service period of its employees. The Company elected to recognize the transition obligation, which represents the previously unrecognized prior service cost, on a prospective basis over a twenty-year period. In 1993, the new standard resulted in additional annual net periodic postretirement benefit cost of $1,200,000 before taxes and $792,000 after taxes, or $0.04 per share. Prior-year financial statements have not been restated to apply the new standard. Net postretirement benefit cost for the year ended December 31, 1993 included the following components (in thousands): Service cost $ 351 Interest cost 713 Net amortization and deferral 424 ------- Net postretirement benefit cost $ 1,488 ======= The cost information does not include the effects of Plan amendments made at the end of 1993, which are expected to reduce future costs. Cash payments for these benefits were $288,000 for 1993. The Company continues to fund postretirement medical benefits on a pay-as-you-go basis. The status of the plan and amounts recognized in the Company's consolidated balance sheet as of December 31, 1993 were as follows (in thousands): Accumulated postretirement benefit obligation: Retirees $(2,234) Actives eligible to retire (956) Other actives (3,028) ------------ Total (6,218) Unrecognized loss 955 Unrecognized transition obligation 4,063 ------------ Accrued postretirement benefit liability $(1,200) ============ The accumulated postretirement benefit obligation reflects Plan amendments made at the end of 1993 which capped employer contributions for each participant at the 1993 dollar amounts. The discount rate used in the calculation was 7.5%. Vishay Intertechnology, Inc. Notes to Consolidated Financial Statements (continued) 11. Leases Total rental expense under operating leases was $7,528,000, $9,577,000, and $4,435,000 for the years ended December 31, 1993, 1992, and 1991, respectively. Future minimum lease payments for operating leases with initial or remaining noncancelable lease terms in excess of one year are as follows: 1994-- $5,694,000; 1995--$4,226,000; 1996--$3,582,000; 1997--$2,947,000; 1998-- $2,602,000; thereafter--$7,492,000 12. Financial Instruments Financial instruments with potential credit risk consist principally of accounts receivable. Concentrations of credit risk with respect to receivables are limited due to the Company's large number of customers and their dispersion across many countries and industries. At December 31, 1993 and 1992, the Company had no significant concentrations of credit risk. The amounts reported in the balance sheet for cash and cash equivalents and for short-term and long-term debt approximate fair value. 13. Segment and Geographic Information Vishay operates in one line of business--the manufacture of electronic components. Information about the Company's operations in different geographic areas is as follows (in thousands): Vishay Intertechnology, Inc. Notes to Consolidated Financial Statements (continued) 13. Segment and Geographic Information (continued) * Includes export sales of $78,793, $63,606, and $34,282 for the years ended December 31, 1993, 1992, and 1991, respectively. Sales between geographic areas are priced to result in operating profit which approximates that earned on sales to unaffiliated customers. Operating profit is total revenue less operating expenses. In computing operating profit, general corporate expenses, interest expense, and income taxes were not deducted. Vishay Intertechnology, Inc. Notes to Consolidated Financial Statements (continued) 14. Summary of Quarterly Financial Information (Unaudited) Quarterly financial information for the years ended December 31, 1993 and 1992 is as follows: (1) Included in net earnngs for the first quarter of 1993 is a one-time tax benefit of $1,427 or $.07 per share resulting from the adoption of FASB Statement No. 109, "Accounting for Income Taxes". (2) Adjusted to give retroactive effect to 5% stock dividends in June 1993 and June 1992. Fourth quarter 1992 earnings reflect the difference between the Company's actual effective income tax rate of 19.8% and the estimated effective rate of 23.1% used through the third quarter. Vishay Intertechnology, Inc. Schedule V -- Property, Plant, and Equipment (In thousands) (1) $18,406 recorded for the adoption of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes". Statement 109 requires assets acquired in prior business combinations to be reported at their pretax amounts. Offset principally by foreign currency translation adjustments. (2) $93,022 of the additions and $5,798 of the retirements relate to the Sprague acquisition. (3) $109,961 of the additions relate to the Roederstein acquisition. (4) Principally foreign currency translation adjustments. Vishay Intertechnology, Inc. Schedule VI -- Accumulated Depreciation, Depletion, and Amortization of Property, Plant, and Equipment (In thousands) (1) Principally foreign currency translation adjustments. (2) $1,026 of the retirements relates to the Sprague acquisition. Vishay Intertechnology, Inc. Schedule IX Short-Term Borrowings (In thousands, except percentages) (1) Notes payable to bank represent borrowings under lines of credit borrowing arrangements which have no termination date but are reviewed annually for renewal. (2) The average amount outstanding during the period was based on quarter ending balances. (3) The weighted average interest rate during the period was computed by dividing the actual interest expense by average short-term debt outstanding. Vishay Intertechnology, Inc. Schedule X -- Supplementary Income Statement Information (In thousands) COL. A COL. B - - - ----------------------------------------------------------------------------- ITEM Charged to Costs and Expenses - - - ----------------------------------------------------------------------------- Year ended December 31, 1993 1992 1991 ---------------------------------- Maintenance and repairs $23,177 $18,344 $12,131 Amounts for depreciation and amortization of intangible assets, taxes, other than payroll and income taxes, royalties, and advertising costs are not presented as such amounts are less than 1% of total sales and revenues. SIGNATURES Pursuant to the requirement of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. VISHAY INTERTECHNOLOGY, INC. March 30, 1994 /s/Felix Zandman ------------------------------------- Date Felix Zandman, Chairman of the Board, President, Chief Executive Officer & Director Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated below. /s/Robert A. Freece /s/Felix Zandman - - - -------------------------- ------------------------------ Robert A. Freece Felix Zandman, Chairman Director, Vice President, of the Board, Director, Treasurer and Chief President and Chief Financial Officer Executive Officer (Principal Financial and (Principal Executive Officer) Accounting Officer) /s/Luella B. Slaner /s/Avi D. Eden - - - -------------------------- ------------------------------ Luella B. Slaner, Director Avi D. Eden, Director /s/Edward B. Shils /s/Guy Brana - - - -------------------------- ------------------------------ Edward B. Shils, Director Guy Brana, Director /s/Donald Alfson /s/Jean-Claude Tine - - - -------------------------- ------------------------------ Donald Alfson, Director, Jean-Claude Tine, Director Vice President, President of Vishay Electronic Components, U.S. and Asia, and President of Dale Electronics, Inc. /s/Gerald Paul /s/Mark I. Solomon - - - -------------------------- ------------------------------ Gerald Paul, Director, Mark I. Solomon, Director Vice President, President of Vishay Electronic Components, Europe, and Managing Director of Draloric Electronic GmbH March 30, 1994 Date

100240_1993.txt

100240

1993

ITEM 1. BUSINESS BACKGROUND Turner Broadcasting System, Inc. (the "Company") is a diversified information and entertainment company which was incorporated in the State of Georgia in 1965. Through its subsidiaries at December 31, 1993, the Company owned and operated three domestic entertainment networks, three international entertainment networks (together the "Entertainment Networks"), and three news networks. The Company produces, finances and distributes entertainment and news programming worldwide, with operations in motion picture, animation and television production, video, television syndication, licensing and merchandising, and publishing. In December 1993, the Company acquired Castle Rock Entertainment ("Castle Rock"), a motion picture and television production company, and in January 1994, the Company completed its acquisition of New Line Cinema Corporation ("New Line"), an independent producer and distributor of motion pictures. Also in December 1993, the Company acquired the remaining 50% interest in HB Holding Co., which owns over 3,000 one-half hours of animated programming. BUSINESS SEGMENTS As a result of the Company's recent acquisitions and expanded emphasis on entertainment production and distribution, beginning with the 1993 year-end reporting period and reclassified for prior periods, the Company's operations were divided into two primary industry segments: Entertainment and News. The Entertainment Segment consists of Entertainment Networks and Entertainment Production and Distribution; the revenue generated by this segment (after elimination of intersegment revenues) represented 60% of the Company's consolidated revenue for the year ended December 31, 1993. The News Segment is comprised of domestic and international news networks and generated 31% of the Company's consolidated revenue for the year ended December 31, 1993. For financial information about the Company's industry segments for each of the three years ended December 31, 1993, see Note 14 of Notes to Consolidated Financial Statements on page 47 in the Company's 1993 Annual Report to Shareholders, which is incorporated herein by reference. ENTERTAINMENT The Company's Entertainment Segment consists of Entertainment Networks and Entertainment Production and Distribution. ENTERTAINMENT NETWORKS At December 31, 1993, Entertainment Networks included three domestic networks (TBS SuperStation, Turner Network Television ("TNT") and the Cartoon Network) and three international networks (TNT Latin America, Cartoon Network Latin America, and TNT & Cartoon Network Europe). For selected information concerning household coverage, viewership and ratings of the Entertainment Networks, refer to page 17 in the Company's 1993 Annual Report to Shareholders incorporated herein by reference. Domestic TBS SuperStation is a 24-hour per day independent UHF television station located in Atlanta, Georgia, which is transmitted over-the-air to the Atlanta market and is also retransmitted by common carrier via satellite to cable systems located in all 50 states, Puerto Rico and the Virgin Islands. TBS SuperStation relies principally on advertising revenue and receives no compensation for its signal from cable systems (other than indirectly from copyright fees paid and allocated through the Federal Copyright Royalty Tribunal ("CRT") for Company-owned programs) or from Southern Satellite Systems, Inc. ("Southern"), the common carrier which delivers its signal to the cable systems. Generally, the Company does not have contracts with the local cable systems controlling coverage of the TBS SuperStation signal; nor does the Company have a contract with Southern, which is a common carrier controlled by Tele-Communications, Inc. (see Items 10, 12 and 13 of the amendment to this Form 10-K to be filed pursuant to General Instruction G(3) of Form 10-K), requiring retransmission of the TBS SuperStation signal. Local cable systems contract with Southern for use of the TBS SuperStation signal. This retransmission of the TBS SuperStation signal could be discontinued by the carrier subject to Southern's contracts with the local cable systems. In view of the substantial aggregate fees received by Southern from the local cable systems for the TBS SuperStation signal, the Company considers voluntary discontinuance of such retransmission by Southern unlikely. TNT is a 24-hour per day advertiser-supported cable television entertainment program service that was launched in October 1988. The Cartoon Network is a 24-hour per day advertiser-supported cable television animated program service that was launched in October 1992. Both networks are transmitted via satellite for distribution by cable television operators and other distributors. They derive revenue primarily from two sources: the sale of advertising time on the networks and the receipt of per-subscriber license fees paid by cable operators and other distributors. The sale of advertising time is affected by viewer demographics, viewer ratings and market conditions. In order to evaluate the level of its viewing audience, the Company makes use of the metered method of audience measurement. This method, which provides a national sample through the use of meters attached to television sets, produces a continuous measurement of viewing activity within those households. The Company utilizes the services of A.C. Nielsen ("Nielsen"), the metered estimates of which are widely accepted by advertisers as a basis for determining advertising placement strategy and rates. The rating measurements supplied by Nielsen are translated into advertising revenues on the basis of the average cost per thousand homes charged for advertising ("CPM"), which is negotiated by the advertiser and the telecaster. The CPM will vary depending upon the type and schedule of the program that will carry the advertisement, as some programs and time slots are viewed by advertisers as delivering a more valuable audience segment than others. Total advertising revenues are a function of the audience sold, the CPM charged to advertisers and the number of advertising spots sold. International TNT Latin America, which was launched in January 1991, is a 24-hour per day trilingual entertainment program service distributed principally to subscribing cable systems in Latin America and the Caribbean. At December 31, 1993, TNT Latin America was available in 30 countries and territories via satellite. Revenues from this service are derived almost entirely from subscription fees based on contracts with cable operators that specify minimum subscriber levels. Cartoon Network Latin America is a 24-hour per day trilingual animated program service which was launched in April 1993 and is distributed principally to subscribing cable systems in Latin America and the Caribbean. Cartoon Network Latin America is available via satellite in 24 countries and territories and derives most of its revenue from subscription fees based on contracts with cable operators. TNT & Cartoon Network Europe is a 24-hour per day program service consisting of European versions of the Cartoon Network and TNT, originating in the United Kingdom and distributed throughout Europe. This dual programming service features 14 hours of animated programming during the day and ten hours of film product at night. Approximately 40% of its schedule is dubbed audio or subtitled in six languages -- English, French, Spanish, Swedish, Norwegian and Finnish. This service was launched in September 1993, and derives most of its revenue from advertising sales and subscription revenues. Programming The Entertainment Networks telecast 24-hours per day, 7 days per week. The Company fulfills its programming needs through use of its copyright owned libraries, syndicated programming, original productions and program rights to sports events. Copyright ownership consists chiefly of the world's largest film and animation libraries: 3,400 films, 8,600 cartoon episodes and over 2,200 hours of made-for-television programming. The Company also has the capability to produce four of the most popular and universal types of programming: news, sports, movies and cartoons. The Company has acquired programming rights from the National Basketball Association (the "NBA") to televise a certain number of regular season and playoff games in each of the 1994-1995 through 1997-1998 seasons in return for rights fees aggregating $352 million plus a share of the advertising revenues generated under the agreement in excess of specified amounts. The Company also entered into an agreement with the National Football League to televise a certain number of pre-season and regular season Thursday and Sunday night games in each of the 1994 through 1997 seasons in return for rights fees aggregating $496 million. In addition to basketball and football, the Company has acquired programming rights to televise the 1994 Winter Olympics on TNT and to televise the Atlanta Braves on TBS SuperStation. The Company will also produce and telecast the Goodwill Games in 1994. The Goodwill Games is a quadrennial international multi-sport event which provides approximately 128 hours of programming for the Company. The suppliers of substantially all programming telecast by TBS SuperStation, other than programming owned by the Company, own or have rights to the copyrights to such programming. The use and telecast of such programming by TBS SuperStation is subject to TBS SuperStation's licensing agreements with these suppliers and the Copyright Act of 1976, as amended (the "Copyright Act"). A small number of the licensing agreements contain provisions which restrict the broadcast of the programming by TBS SuperStation to the Atlanta market. The Company typically pays program suppliers a license fee significantly in excess of the market rate for programming aimed at the Atlanta market alone. In addition, the program suppliers collect copyright royalties from the CRT funded by all cable operators that carry the TBS SuperStation signal. Although it is possible that program suppliers could initiate legal action against the Company alleging breach of licensing agreements, no such actions have been instituted to date and the Company believes the probability of litigation against the Company in this regard is remote. Furthermore, as a basis for the position that the nationwide transmission of TBS SuperStation programming by Southern does not infringe upon the rights of copyright owners or their licensees, the Company has relied upon the Copyright Act which exempts certain secondary transmissions by carriers from copyright liability. See "Business -- Regulation -- Copyright License System." Competition TBS SuperStation, TNT and the Cartoon Network compete with other cable programming services for distribution to viewers, and compete for viewers with other forms of programming provided to cable subscribers, such as broadcast networks and local over-the-air television stations, home video viewership, movie theaters and all other forms of audio/visual entertainment, news and information services. In the Atlanta market, TBS SuperStation vies for viewers with affiliates of the four major networks, two other independent stations and two affiliates of the Public Broadcasting System, in addition to other programming available to local cable subscribers. The continued carriage of the TBS SuperStation signal, or the addition of that signal to cable system operators, could be adversely affected relative to other cable-delivered programming by the requirement that cable operators pay copyright royalty fees for each distant non-network signal carried by their systems. See "Business -- Regulation -- Copyright License System." Internationally, TNT Latin America, Cartoon Network Latin America and TNT & Cartoon Network Europe compete with cable programming services for distribution to viewers, and compete for viewers with other forms of programming provided to cable subscribers, such as broadcast networks and local over-the-air television stations, home video viewership, movie theaters and all other forms of audio/visual entertainment, news and information services. ENTERTAINMENT PRODUCTION AND DISTRIBUTION The Entertainment Production and Distribution companies are involved in the creation of programming or the distribution of original and library product to the Entertainment Networks or third parties. Production companies include Turner Pictures, Inc., which produces original movies for distribution in various markets; TBS Productions, which specializes in non-fiction entertainment and documentary productions; Hanna-Barbera Cartoons, Inc., an animation studio; and the newly acquired Castle Rock Entertainment ("Castle Rock"), a motion picture and television production company. Additionally, in January 1994 the Company purchased New Line Cinema Corporation, a motion picture production and distribution company. The Company owns two major copyright libraries. The Turner Entertainment Co. library (the "TEC Library") contains approximately 3,400 Metro-Goldwyn-Mayer, Inc. ("MGM"), RKO Pictures, Inc. ("RKO") and pre-1950 Warner Bros. films, 3,000 short subjects and 1,850 cartoon episodes, and a number of television shows. The Hanna-Barbera library (the "HB Library") consists of over 3,000 half-hours of animation programming. Programming from both libraries has been used to launch Entertainment Networks, such as TNT and the Cartoon Network, and as cost-effective sources of on-going programming needs. The Company-owned programming is marketed and distributed in the domestic theatrical, pay-per-view, home video, syndication and basic cable network markets principally through its own organization, except for certain pre-existing agreements related to the TEC Library and Castle Rock product. Pursuant to a 1986 agreement with its predecessor, MGM became the designated distributor in the home video market of the MGM and pre-1950 Warner Bros. films in the TEC Library, both domestically and internationally. The distribution agreement (the "Home Video Agreement") provides for a fifteen-year term commencing June 6, 1986, with distribution fees payable based primarily on the suggested retail price of the films sold. Under the agreement, TEC is responsible for all recording and releasing costs and has significant consultation rights with respect to marketing, distribution and exploitation of the films. In November 1990, MGM entered into an agreement with Warner Home Video, Inc. with respect to certain of MGM's obligations under the Home Video Agreement. Also, pursuant to a 1986 agreement with a term of 10 years with its predecessor, MGM became the designated distributor in the theatrical and non-theatrical exhibition markets of the TEC Library; however, the Company has international distribution rights to certain RKO product in certain international markets. In addition, the Company has licensed original TNT productions for theatrical distribution through several distributors in various countries outside the United States and has also entered into domestic licensed theatrical distribution agreements. After the expiration of pre-existing distribution agreements with Columbia Pictures, Castle Rock product will become available for international home video and theatrical distribution by the Company in 1995, domestic home video distribution in 1996 and domestic theatrical distribution in 1998. The Company's ancillary distribution capabilities include licensing and merchandising, publishing, educational applications, video games and interactive activities. The licensing of the Company's programming is accomplished through sales offices located in Atlanta, Chicago, Los Angeles and New York domestically, and internationally in Argentina, Australia, Brazil, France, Hong Kong, Japan, Mexico, the Netherlands, Puerto Rico and the United Kingdom. Competition Programming for television and the production of major motion pictures are highly competitive businesses in which the main competitive factors are quality and variety of product and marketing. Production companies compete with numerous other motion picture and television production companies, and with television networks and pay cable systems, for the acquisition of literary properties, the services of performing artists, directors, producers, and other creative and technical personnel as well as for paying audiences. NEWS At December 31, 1993, the Company's News Segment consisted of two domestic networks (Cable News Network ("CNN") and Headline News) and one international network (Cable News Network International ("CNN International")) (all such networks, the "News Networks"). For selected information concerning household coverage, viewership and ratings of the News Networks, refer to page 23 in the Company's 1993 Annual Report to Shareholders incorporated herein by reference. DOMESTIC CNN is a 24-hour per day cable television news service which was launched in June 1980. CNN uses a format consisting of up-to-the minute national and international news, sports news, financial news, science news, medical news, weather, interviews, analysis and commentary. CNN obtains reports from 28 news bureaus (as of December 31, 1993), of which nine are in the United States (Atlanta, Chicago, Dallas, Detroit, Los Angeles, Miami, New York, San Francisco and Washington, D.C.) and 19 are located outside the United States (Amman, Bangkok, Beijing, Berlin, Brussels, Cairo, Jerusalem, London, Manila, Mexico City, Moscow, Nairobi, New Delhi, Paris, Rio de Janeiro, Rome, Santiago, Seoul and Tokyo). In addition to these permanent bureaus, CNN maintains satellite newsgathering trucks in the United States, portable satellite up links (flyaways) in the United States and abroad and a network of hundreds of broadcast television affiliates in the United States and abroad which permit CNN to report live from virtually anywhere in the world. The affiliate arrangements, from which CNN derives substantial news coverage, are generally represented by contracts having terms of one or more years. In addition, news is obtained through wire news services, television news services and from free-lance reporters and camera crews. CNN is also a member, together with other news reporting companies, of various news pools including the White House pool which, under certain conditions, provides coverage of Presidential activities and White House events. Headline News is a 24-hour per day cable television news service launched in December 1981 which uses a concise, fast-paced format to provide constantly updated half-hour newscasts. Although Headline News has its own studio and transmission facilities, it utilizes CNN's newsgathering operations for the accumulation of its own news stories. Revenues for CNN and Headline News are derived from the sale of advertising time and subscription sales of the services to cable system operators, broadcasters, hotels and other clients as well as from distribution of the service in the over-the-air markets. See "Entertainment -- Entertainment Networks -- Domestic" for a discussion of the effects of the items affecting the sale of advertising time. The programming of CNN and Headline News is transmitted via satellite to local cable systems and others which have contracted directly with CNN to obtain these news program services. The fee structure is based upon (i) the level of carriage on a cable system on which the program is retransmitted and (ii) the penetration of the Company's other programming services on the cable system, subject to a discount based upon the number of subscribers. INTERNATIONAL CNN International is a 24-hour per day television news service consisting of programming produced by CNN and Headline News, as well as original programming, which was distributed to cable systems, broadcasters, hotels and other businesses on a network of 10 satellites outside the United States at December 31, 1993. Subject to government and regulatory approval, at December 31, 1993 CNN International was available in over 200 countries and territories on five continents. CNN International is marketed by a wholly-owned subsidiary of the Company throughout Europe, large portions of Africa and the Middle East, the Pacific Rim and Central and South America. CNN International derives its revenues primarily from fees charged to cable operators based on the number of subscribers and the level of carriage, fees paid by other users (principally hotels and embassies) of the CNN International signal, the sale of advertising time, and fees charged to international over-the-air television stations for the use of the CNN International signal. COMPETITION CNN and Headline News compete nationally and CNN International competes internationally with other cable program services for distribution to viewers, and compete for viewers with other forms of programming provided to cable subscribers, such as broadcast networks and local over-the-air television stations, with home video viewership, newspapers, news magazines, movie theaters and all other forms of audio/visual entertainment, news and information services. For other factors relating to competition, see "Business Segments -- Entertainment -- Competition." OTHER BUSINESSES In addition to its Entertainment and News Segments, the Company owns or has an interest in a number of other businesses, among them ownership of professional sports teams. THE ATLANTA BRAVES In January 1976, the Company acquired the Braves, a major league baseball club, through a wholly-owned subsidiary, Atlanta National League Baseball Club, Inc. ("ANLBC"). In addition to the Braves, ANLBC operates minor league farm clubs in Richmond, Virginia; Greenville, South Carolina; and Macon, Georgia. ANLBC also operates rookie league clubs in West Palm Beach, Florida and Pulaski, Virginia, and utilizes facilities under player development contracts in Durham, North Carolina and Idaho Falls, Idaho. The Braves lease office, locker room and storage space and play all home games in the Atlanta-Fulton County Stadium in Atlanta, Georgia. ANLBC is a member of the National League of Professional Baseball Clubs (the "National League"). ANLBC receives a pro-rata distribution of revenues generated through contracts negotiated with television networks, certain other broadcast revenues and a portion of gate receipts from games away from home. During 1993, the Office of the Commissioner of Baseball entered into a new agreement with Entertainment and Sports Programming Network ("ESPN") covering the 1994 through 1999 seasons and entered into an agreement to form a joint venture with American Broadcasting Company ("ABC") and National Broadcasting Company ("NBC") to telecast certain major league games over six seasons beginning in 1994. Due to National League expansion, a reduction in the annual rights fees to be paid by ESPN, and the revenue sharing provisions contained in the joint venture agreement with ABC and NBC, ANLBC is uncertain as to whether its future pro-rata share of revenues related to these agreements will equal or exceed its 1993 pro-rata revenues from the prior Columbia Broadcasting System ("CBS") and ESPN agreements. ANLBC is subject to payment of ongoing assessments and dues to the National League and to compliance with the constitution and bylaws of the National League, as the same may be modified from time to time by the membership, as well as with rules promulgated by the Commissioner of Baseball. These rules include standards of conduct for players and front office personnel; methods of operation; procedures for drafting new players and for purchasing, selling and trading player contracts; rules for implementing disciplinary action relative to players, coaches and front office personnel; and certain financial requirements. In January 1985, an agreement was reached between ANLBC and the Commissioner of Baseball relative to the nationwide television exposure afforded the telecasts of the Braves games on TBS SuperStation. The agreement, extended through the 1993 season, requires the Company to make rights fee payments into the Major League Central Fund for equal distribution to all major league baseball clubs including the Braves. In exchange for these fees, the Commissioner of Baseball, among other things, will not seek to prohibit the telecast of a specified number of Braves games on TBS SuperStation and the accompanying nation-wide satellite distribution of the TBS SuperStation signal by common carrier. TBS SuperStation expects to televise approximately 120 Braves games during 1994. Also, SportSouth Network, Ltd., an unconsolidated entity in which the Company holds a 44% interest, intends to telecast 34 games in 1994. The baseball players under contract with clubs belonging to the National League or to the American League of Professional Baseball Clubs (collectively, the "Major Leagues") are represented for collective bargaining purposes by the Major League Baseball Players' Association (the "Baseball Players' Association"). On March 19, 1990, the Major Leagues and the Baseball Players' Association agreed to a collective bargaining agreement to be in effect until December 31, 1993. Under the terms of that agreement, once a player was drafted and executed a contract with a club, the club retained exclusive rights to that player until he had completed six years of Major League service. At the conclusion of this period, if the club and the player could not reach agreement as to the terms of his contract, the player became a free agent and could negotiate and enter into a contract with another club. The club losing a free agent to another club was entitled to compensation for such loss only in the form of additional amateur draft rights. The agreement also allowed for all players with three years of Major League service and 17% of players with between two and three years of Major League service to enter into salary arbitration. The opportunity for "free agent" status and the players' rights to salary arbitration have resulted in increased payroll cost for the major league clubs, including the Braves. The agreement specifies that either the Major Leagues or the Baseball Players' Association could reopen for negotiation certain provisions of the agreement, specifically minimum salary levels, salary arbitration and free agency issues, by providing written notice at least 30 days prior to January 10, 1993. In December 1992, the Major Leagues reopened the collective bargaining agreement. At the present time, there is no agreement between the Major Leagues and the Baseball Players' Association and, as a consequence, either party has the right to take concerted action (i.e., a lock-out by the Major Leagues or a strike by the Baseball Players' Association). THE ATLANTA HAWKS The Company, through Hawks Basketball, Inc., a wholly-owned subsidiary of the Company, has a 96% limited partnership interest in the Atlanta Hawks, L.P. (the "Hawks"), a member of the NBA. The Hawks play their home games in the 16,300-seat Omni Coliseum in Atlanta, Georgia, which is operated by a wholly- owned subsidiary of the Company. Professional basketball is organized in a manner similar to professional baseball, except that there is presently only one league and basketball clubs do not share in gate receipts from games away from home. The NBA, through its constitution, has established rules governing club operations, including drafting of players and trading player contracts. A portion of the Hawks' revenues are from a pro-rata share of network broadcast fees derived by the NBA, pursuant to its four-year broadcast rights agreement awarded to NBC in 1989. A portion of the Hawks' future revenues will be derived from a pro-rata share of the network broadcast rights fees derived by the NBA, pursuant to a new four-year broadcast rights fee agreement covering the 1994-1995 through 1997-1998 seasons awarded to NBC in 1993. The NBA has a separate agreement with the Company to televise a different package of games. On November 29, 1989, the Company and the NBA entered into an agreement for TNT to televise a certain number of regular season and playoff games in each of the 1990-91 through 1993-94 seasons, in return for rights fees aggregating $275 million. Pursuant to an agreement between the Company and the Hawks dated June 1, 1978, as supplemented, TBS SuperStation has the right to telecast some portion of the regular and post-season Hawks' games, as determined by the NBA, not otherwise subject to agreements between the NBA and other broadcasters. Pursuant to this agreement, TBS SuperStation televised 25 regular season Hawks' games during the 1990-91 season and 30 regular season Hawks' games during both the 1991-92 and the 1992-93 seasons. In addition, TBS SuperStation intends to broadcast up to 30 regular season Hawks' games during the 1993-94 season. On September 22, 1993, the Company and the NBA entered into an agreement whereby both TNT and TBS SuperStation will telecast a certain number of regular season and playoff games in each of the 1994-1995 through 1997-1998 seasons in return for rights fees aggregating $352 million plus a share of the advertising revenues generated in excess of specified amounts. As a result of entering into this contract, TBS SuperStation will discontinue its telecast of Hawks' games after completion of the 1993-1994 season. NBA players are represented for collective bargaining purposes by the National Basketball Players' Association (the "NBPA"). During June 1988, the NBA and the NBPA agreed in principle to a new six-year collective bargaining agreement, that, among other things, reduced the NBA draft to three rounds for the 1988-89 season (two rounds in subsequent years), continued the salary cap which ties a team's payroll to the league's gross revenues, as defined, and altered free agency guidelines regarding the right of first refusal. A player may, under certain circumstances, become a total free agent upon termination of his contract. SPORTSOUTH NETWORK In May 1990, Turner Sports Programming, Inc. ("TSPI"), a wholly-owned subsidiary of the Company, entered into an agreement with LMC Southeast Sports, Inc. (formerly TCI Southeast Sports, Inc.) and Scripps Howard Production, Inc. to form SportSouth Network, Ltd. ("SportSouth"). SportSouth and Wometco Cable Corporation ("Wometco") entered into a separate agreement whereby Wometco agreed to carry SportSouth Network on certain of its cable systems in exchange for a future partnership interest in SportSouth, subject to the occurrence of certain events. SportSouth Network, a regional sports network serving the Southeast United States, was launched in August 1990. As of December 31, 1993, TSPI had a 44% interest in the partnership. SportSouth Network programming includes Braves baseball, Hawks basketball and various programs from Prime Networks, a national service offering sports programming to affiliated sports networks, cable operators and home satellite dish owners. SportSouth's revenues are principally derived from the sale of advertising time and the sale of its service to cable operators. At December 31, 1993, SportSouth Network served approximately 4 million U.S. television households. n-tv The Company acquired a 27.5% interest in n-tv in March 1993. n-tv is a 24-hour per day German language news network currently reaching 17 million homes in Germany and parts of Austria and Switzerland, primarily via cable systems. Like TBS SuperStation in the United States, n-tv relies principally on advertising revenues and receives no compensation for its signal from those cable systems. The studio and offices of n-tv are located in the former Eastern Berlin. OTHER The Company's corporate and news operations are headquartered in CNN Center, a multi-use office, retail and hotel complex in Atlanta, Georgia. The Airport Channel is a CNN produced service that provides newscasts to travelers at airports across the United States. Through World Championship Wrestling ("WCW"), the Company produces wrestling programming for TBS SuperStation, the domestic syndication markets, and pay-per-view television. It also stages live wrestling events. REGULATION BROADCAST REGULATION Television broadcasting is subject to the jurisdiction of the Federal Communications Commission (the "FCC" or the "Commission") under the Communications Act of 1934, as amended (the "Communications Act"). Among other things, FCC regulations govern the issuance, term, renewal and transfer of licenses which must be obtained by persons to operate any television station. The current broadcast license of TBS SuperStation was renewed on April 15, 1992 and will expire on April 1, 1997. In addition, FCC regulations govern certain programming practices. On June 12, 1992, the FCC released a Notice of Proposed Rulemaking under which it proposes to re-examine current regulations and ownership restrictions on television broadcasters. Among other things, the FCC is proposing liberalizing the number of television stations a single entity may own or altering the rule that currently prohibits an entity from owning more than one station in a local market. Any regulatory change, if adopted, could affect the Atlanta and national markets in which the Company operates. The Company at this time cannot predict the outcome of this proceeding or the overall effect it may have. CABLE REGULATION Cable television systems are regulated by municipalities or other local government authorities. Municipalities generally have the jurisdiction to grant and to review the transfer of franchises, to review rates charged to subscribers, and to require public, educational, governmental or leased-access channels, except to the extent that such jurisdiction is preempted by federal law. Any such rate regulation or other franchise conditions could place downward pressure on subscriber fees earned by the Company, and such regulatory carriage requirements could adversely affect the number of channels available to carry the Company's networks. On October 5, 1992, the Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Act") became law. The principal provisions of the 1992 Act that may affect the Company's operations are discussed below. The Company cannot predict the full effect that the 1992 Act will have on its operations. Rate Regulation Section 623 of the Communications Act, as amended by the 1992 Act, establishes a two-tier rate structure applicable to systems not found to be subject to "effective competition" as defined by the statute. Rates for a required "basic service tier" are subject to regulation by practically every community. Rates for cable programming services other than those carried on the basic tier are subject to regulation if, upon complaint, the FCC finds that such rates are "unreasonable." Programming offered by a cable operator on a per-channel or per-program basis, however, is exempt from rate regulation. On April 1, 1993, the FCC adopted implementation regulations for Section 623. The text of its Report and Order was released on May 3, 1993. The FCC adopted a benchmark approach to rate regulation. Rates above the benchmark would be presumed to be unreasonable. Once established, cable operators could adjust their rates based on appropriate factors and could pass through certain costs to customers, including increased programming costs. On February 22, 1994, the Commission adopted further regulations. Among other things, the additional regulations will govern the offering of bona fide "a la carte" channels that are exempted from rate regulation. The Commission also adopted a methodology for determining rates when channels are added to or deleted from regulated tiers. These regulations may adversely affect the Company's ability to sell its existing or new networks to cable customers and/or may adversely affect the prices the Company may charge for its services, although at this time the Company cannot predict their full effect on its operations. On April 5, 1993, the FCC also froze rates for cable services subject to regulation under the 1992 Act for 120 days. On June 11, 1993, the FCC deferred the implementation of rate regulation from June 21, 1993 to October 1, 1993, and extended the freeze on rates for cable services subject to regulation from August 4, 1993 to November 15, 1993. On November 10, 1993, the Commission further extended the freeze until February 15, 1994, and on February 8, 1994, extended the expiration date of the freeze until May 15, 1994. On July 27, 1993, the FCC moved the effective date of rate regulation back to September 1, 1993. Additionally, among other things, the FCC permitted cable operators to structure rates and service offerings up until September 1, 1993 without prior notice to subscribers. On July 16, 1993, the FCC issued a Notice of Proposed Rulemaking to add the regulatory requirements to govern cost-of-service showings that cable operators may submit under this provision to justify rates above the benchmarks. On February 22, 1994, the Commission adopted interim rules to govern the cost of service proceedings. The constitutionality of these provisions has been challenged in litigation filed in the United States District Court for the District of Columbia. On September 27, 1993, the district court upheld the constitutionality of these provisions. An appeal of that decision is pending in the U.S. Court of Appeals for the District of Columbia Circuit. Appeals of the Commission's implementing regulations have also been taken to the United States Court of Appeals for the District of Columbia Circuit. The Company cannot predict the ultimate outcome of the litigation. Must Carry and Retransmission Consent The 1992 Act contains provisions that would require cable television operators to devote up to one-third of their channel capacity to the carriage of local broadcast stations and provide certain channel position rights to the local broadcast stations. The 1992 Act also includes provisions governing retransmission of broadcast signals by cable systems, whereby retransmission of broadcast signals would require the broadcaster's consent and provides each local broadcaster the right to make an election between must carry and retransmission consent. The retransmission consent provisions of the 1992 Act became effective on October 5, 1993. On March 11, 1993, the Commission adopted a Report and Order implementing these provisions. The provisions could affect the ability and willingness of cable systems to carry cable programming services. The Company has filed litigation challenging the provision as unconstitutional, which is pending in the United States Supreme Court (see "Legal Proceedings -- Turner Broadcasting System, Inc. v. Federal Communications Commission and the United States of America"). Program Access On April 1, 1993, the Commission issued regulations implementing a provision that, among other things, makes it unlawful for a cable network, in which a cable operator has an attributable interest, to engage in certain unfair methods of competition or unfair or deceptive acts or practices, the purpose and effect of which is to hinder significantly or prevent any multichannel video programming distributor from providing satellite cable programming or satellite broadcast programming to cable subscribers or consumers. The provisions contain an exemption for any contract that grants exclusive distribution rights to a person with respect to satellite cable programming or that was entered into on or before June 1, 1990. While the Company cannot predict the regulations' full effect on its operations, they may affect the rates charged by the Company's cable programming services to its customers and could affect the terms and conditions of the contracts between the Company and its customers. The constitutionality of this provision has been challenged in litigation filed in the United States District Court for the District of Columbia. On September 27, 1993, the district court upheld this provision. An appeal of that decision is pending in the United States Court of Appeals for the District of Columbia Circuit. Appeals of the Commission's implementing regulations have also been taken to the United States Court of Appeals for the District of Columbia Circuit. The Company cannot predict the ultimate outcome of the litigation. Regulation of Carriage Agreements The 1992 Act contains a provision that requires the FCC to establish regulations governing program carriage agreements and related practices between cable operators and video programming vendors, including provisions to prevent the cable operator from requiring a financial interest in a program service as a condition of carriage and provisions designed to prohibit a cable operator from coercing a video programming vendor to provide exclusive rights as a condition of carriage. On October 22, 1993, the Commission issued regulations implementing this provision. The Company at this time cannot predict the effect of this provision on its operations. The constitutionality of this provision has been challenged in litigation filed in the United States District Court for the District of Columbia. On September 27, 1993, the district court upheld the constitutionality of this provision. An appeal of that decision is pending in the United States Court of Appeals for the District of Columbia Circuit. The Company cannot predict the outcome of the litigation. Ownership Litigation Section 11 of the 1992 Act directed the Commission to prescribe rules and regulations establishing limits on the number of cable subscribers a person is authorized to receive by cable systems owned by such person and the number of channels that can be occupied by video programmers in which a cable operator has an attributable interest. The Commission must also consider the necessity of imposing limitations on the degree to which multichannel video programming distributors may engage in the creation or production of video programming. On December 28, 1992, the FCC issued a Notice of Proposed Rulemaking and Notice of Inquiry with respect to these provisions. On October 22, 1993, the FCC adopted a Second Report and Order that established a 40% limit on the number of channels that may be occupied by programming services in which the particular cable operator has an attributable interest. The Company is subject to this provision. The FCC has also established a national limit of 30% on the number of homes passed that any one person can reach through cable systems owned by such person, but stayed the implementation of that provision pending judicial review of its constitutionality. Petitions for reconsideration are pending. The Company cannot at this time predict the effect of this provision or of these proposals on its operations. The constitutionality of these provisions has been challenged in litigation filed in the United States District Court for the District of Columbia. On September 27, 1993, the district court found the national limit on homes passed unconstitutional, but upheld the constitutionality of the channel capacity limits. An appeal of that decision is currently pending in the United States Court of Appeals for the District of Columbia Circuit. Appeals of the Commission's implementing regulations have also been taken to the United States Court of Appeals for the District of Columbia Circuit. The Company cannot predict the ultimate outcome of the litigation. Sports Migration The 1992 Act directs the FCC to submit an interim report by July 1, 1993 and a final report by July 1, 1994 to Congress on the migration of sports programming from the broadcast networks to cable networks and cable pay-per-view. The interim report was submitted on June 24, 1993. CABLE NETWORK CROSS-OWNERSHIP Under current FCC regulations, television broadcast networks are not permitted to own cable systems. On June 17, 1992, the FCC voted to modify its regulations to permit television broadcast networks to own cable systems so long as a network's owned systems have less than 10% of cable subscribers nationally and have less than 50% of the subscribers in an individual local market. The Company cannot predict the effect, if any, of this change on its operations. COPYRIGHT LICENSE SYSTEM The Copyright Act provides for the grant to cable systems of compulsory licenses for carriage of distant, non-network copyrighted programming (as typically originally transmitted by a broadcast television station). The Copyright Act also provides for payments of royalty fees by the cable systems for the benefit of copyright owners or licensors, which fees are payable for the privilege of retransmitting such programming to their subscribers. Under the Copyright Act, the amount of such royalty payments is generally based upon a formula utilizing the amount of the system's semi-annual gross receipts and the number of distant non-network television signals carried by the system. Therefore, cable systems that carry TBS SuperStation must contribute to the Copyright Office for distribution. However, no royalties are paid by cable systems in connection with their carriage of TNT, the Cartoon Network, CNN or Headline News. There have been several legislative initiatives in Congress during the past several years to alter the present compulsory copyright license system provided under the Copyright Act, but none have been adopted into law. In October 1988, the FCC recommended that Congress phase out the compulsory license. The FCC, in its July 1990 Report to Congress, also proposed that Congress should repeal the compulsory copyright license under certain circumstances. The Company cannot predict the ultimate impact on the competitive position of TBS SuperStation if legislation repealing the compulsory license were enacted. SATELLITE AND MICROWAVE REGULATION The Company operates various satellite transmission and reception equipment in the vicinity of its offices in Atlanta, at various bureau locations and at the sites of special events such as sporting events and breaking news sites. These radio transmission facilities are required to be licensed by the FCC prior to use and their operation must comply with applicable FCC regulations. EMPLOYEES At December 31, 1993, the Company and its wholly-owned subsidiaries had 5,317 full-time employees. In April 1987, CNN received a petition for a representation election filed with the National Labor Relations Board ("NLRB") by Local 11 of National Association of Broadcast Employees and Technicians ("NABET"). NABET sought a representation election with respect to 61 production employees in CNN's New York news bureau. Although the NLRB conducted a hearing in 1987 and 1988, it did not render a decision as to the proper scope of the voting unit until January 29, 1993. Pursuant to the NLRB's decision, 88 employees would have been in the voting unit. The NLRB directed that an election be conducted for such unit at a date to be determined by it. Based on the substantial changes in the unit and the business operation during the six years since the petition was initially filed, CNN expected to file a Request for Review with the NLRB in Washington, D.C. However, on April 8, 1993, NABET withdrew its petition for election, bringing this matter to a close. TEC and certain of its subsidiaries are signatories to collective bargaining agreements with two unions. These agreements cover approximately 45 employees of TEC and its affected subsidiaries and expire in 1994. In addition, certain subsidiaries of the Company are signatories to one or more of the following collective bargaining agreements: the Writers Guild of America Basic Agreement, the Directors Guild of America Basic Agreement, the Screen Actors Guild Basic Agreement, the American Federation of Television and Radio Artists Network Television Code, the International Alliance of Theatrical Stage Employees Agreement, the American Federation of Musicians Basic Agreement, the Union of British Columbia Performers Agreement, the British Actors Equity Association Agreement and/or a member of the Alliance of the Motion Picture and Television Producers. ITEM 2.

ITEM 2. PROPERTIES The Company owns CNN Center, a hotel and office complex in Atlanta, Georgia, which houses the Company's corporate offices, the operations of CNN, Headline News and CNN International and the operations of certain other subsidiaries. CNN Center Ventures entered into a revolving credit agreement, as subsequently amended, under which it could borrow up to $125 million with borrowings to be guaranteed by the Company and secured by a first mortgage lien on CNN Center and the adjacent parking deck facility. The $40 million balance outstanding at December 31, 1992 was paid off in January 1993. The agreement was terminated in December 1993. The Company subleases until December 27, 2043, a parking facility next to the complex with approximately 2,000 parking spaces. The Company also manages and operates the Omni Coliseum pursuant to an operating agreement which expires in October 2002. The agreement requires the Company to apply certain revenues generated by the operation of the Omni Coliseum toward payment of the revenue bonds issued to finance the acquisition, construction and equipping of the Omni Coliseum. The Company owns buildings with approximately 205,000 square feet on approximately 32 acres of land in Atlanta, Georgia. The primary building currently houses the studios and offices of TBS SuperStation, TNT and the Cartoon Network. In addition, adjacent to the primary building are twelve seven-meter, two ten-meter, two eleven-meter and one fifteen-meter earth stations used to transmit and monitor the signals of TBS SuperStation, TNT, the Cartoon Network, CNN and Headline News to various satellites and to receive satellite feeds for use by CNN and Headline News, and five smaller operative antennas for receiving backhaul from various satellites. The Company also owns a building of approximately 85,000 square feet in Atlanta, Georgia. A portion of the building is used for general purposes and the remainder is available for lease to unaffiliated third parties. The Company leases office or studio space in major cities around the United States and abroad which is used by the Company for its news bureaus, for sales of advertising time, for cable sales and marketing, for program production operations, for film servicing operations and for program syndication operations. The Hawks currently play their home games and occupy office, locker room and storage space at the Omni Coliseum. The space is rented from a wholly-owned subsidiary of the Company which operates the Omni Coliseum for an amount equal to 10% of net gate receipts. ANLBC leases office, locker room and storage space (aggregating approximately 70,000 square feet), and the Braves play all home games in the Atlanta-Fulton County Stadium pursuant to a lease running through December 31, 1994. ANLBC has the option to extend the agreement through December 31, 1996. This lease gives ANLBC priority in the scheduling of baseball games, exclusive year-round concession rights in the stadium and the non-exclusive right to use the stadium for other events. Lease payments are specified percentages of gate receipts and concession sales with a minimum of $650,000 per year. The Braves also lease facilities for use by its farm clubs in Richmond, Virginia; Greenville, South Carolina; Macon, Georgia and its spring training facility in West Palm Beach, Florida. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS LITIGATION Storer Cable Communications, et al. v. The City of Montgomery, Alabama, et al. On September 6, 1990, Storer Cable Communications ("Storer"), ESPN, Inc. and Satellite Services, Inc. commenced an action in the United States District Court for the Middle District of Alabama, Northern Division, against the City of Montgomery, Alabama, and Emory Folmar, in his capacity as Mayor of Montgomery. In their Complaint, Plaintiffs claim that City of Montgomery Ordinance No. 9-90, which attempts to regulate the construction, operation and control of cable television systems in Montgomery, and City of Montgomery Ordinance No. 48-90, which regulates competition among cable operators and franchisees in Montgomery, are unconstitutional and violate various other provisions of federal and state law. The Plaintiffs seek declaratory and injunctive relief, compensatory damages in excess of $50,000 and attorney's fees. On September 7, 1990, TNT moved to intervene in this action. The claims asserted by TNT are similar to those asserted by Plaintiffs in the action although TNT has only challenged the legality of Ordinance No. 48-90. Additionally, TNT's Complaint-in-Intervention adds Montgomery Cablevision and Entertainment, Inc. ("MCE") as a defendant. On October 5, 1990, the State of Alabama moved to intervene in the action. Additionally, on October 10, 1990, MCE also moved to intervene in the action. MCE's proposed Answer-in-Intervention and Counterclaim alleges that Tele-Communications, Inc., Storer, Mile Hi Cablevision, Inc. (d/b/a Satellite Services, Inc.), the Company, TNT, Turner Cable Network Sales, Inc. ("TCNS") and ESPN, Inc. have violated the Sherman Act by, among other things, entering into exclusive distribution arrangements for the provision of programming in the Montgomery area. In its Counterclaim, MCE seeks declaratory and injunctive relief, an undisclosed amount of compensatory and punitive damages and attorney's fees. On November 27, 1990, the Court granted MCE's Motion to Intervene. On December 19, 1990, the Court granted TNT's and the State of Alabama's Motion to Intervene and, at the same time, the Court stayed any action on MCE's Counterclaim until the main claim is decided. On January 4, 1991, TNT filed a Motion for Summary Judgment on all counts. On February 25, 1991, all Defendants responded and filed Cross Motions for Summary Judgment. Oral argument on these motions was heard on April 11, 1991. On October 9, 1992, the Court entered an Order on all outstanding Motions for Summary Judgment. In its Order, the Court struck portions of Ordinance 48-90 and Ordinance 9-90, and denied summary judgment as to the remaining aspects of the two ordinances. On October 23, 1992, the Court lifted the stay on MCE's Counterclaim, which was amended on December 15, 1992. On February 4, 1993, the Company, TNT and TCNS filed a Motion to Dismiss the Counterclaim and Amended Counterclaim for failure to state a claim. On June 17, 1993, the Court entered an order denying the Motion of the Company, TNT and TCNS to dismiss Montgomery Cablevision and Entertainment, Inc.'s Counterclaim and Amended Counterclaim for failure to state a claim. On or about September 24, 1993 this action was settled with no payment by or adverse effect on the Company. On September 27, 1993, the Court vacated its June 17, 1993 Order. A Joint Stipulation of Dismissal was filed with the Court on October 20, 1993 and the litigation was dismissed with prejudice by Order dated October 21, 1993. United States of America v. Cable News Network, Inc. and Turner Broadcasting System, Inc. In October and November of 1990, CNN was involved in investigating and reporting a story concerning potential government audio taping of telephone calls made by General Manuel Noriega from his cell in the Miami Correctional Center, including the taping of conversations with his attorneys and defense team. CNN obtained copies of some of the alleged tapings and telecast segments thereof. Judge William M. Hoeveler, United States District Court for the Southern District of Florida, entered orders on November 8, 1990 and November 9, 1990 which temporarily prohibited the telecast of Noriega's privileged attorney-client conversations. Judge Hoeveler has appointed a special prosecutor, Robert F. Dunlap, to investigate whether CNN violated his Orders in a telecast on November 9, 1990, and to prepare an application for an Order to Show Cause "why those entities and individuals responsible for" the telecast should not be held in contempt of the Court's Orders. To date, no Order to Show Cause has been presented, contempt proceedings have not been initiated against CNN or any other entities or individuals involved. On January 15, 1993 CNN was advised by Special Prosecutor Dunlap that it was a target of a grand jury investigation into these alleged contempts. CNN has responded to grand jury subpoenas issued at that time. CNN has been informed by the court that criminal information alleging contempt charges may be presented at the end of March 1994, at which time the Company will enter a plea and a date for trial will be selected. Fines and/or penalties of an undetermined amount could be imposed against CNN as a result of these contempt proceedings. CNN denies it telecast any privileged conversations and therefore denies that it violated or intended to violate the Court Orders. CNN intends to vigorously defend the contempt proceedings. Turner Broadcasting System, Inc. v. Federal Communications Commission and The United States of America On October 5, 1992, the Company filed a lawsuit in the United States District Court for the District of Columbia challenging the provisions of the Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Act") that would require cable television operators to devote up to one-third of their channel capacity to the carriage of local broadcast stations and provide certain channel positioning rights to local broadcast stations (see "Business -- Regulation -- Cable Regulation -- Must Carry and Retransmission Consent"). The Company's complaint alleges that these provisions violate the First Amendment of the United States Constitution. The Company cannot predict the outcome of the litigation at this time. Under a provision of the 1992 Act, the case was heard by a three-judge court. On April 8, 1993, the Court upheld the constitutionality of these provisions by a 2-1 vote. On May 3, 1993, the Company filed its Notice of Appeal of that decision to the United States Supreme Court. The Company filed its Jurisdictional Statement with the Supreme Court on July 2, 1993. On September 28, 1993, the Supreme Court noted probable jurisdiction and heard oral argument on this case on January 12, 1994. The parties are awaiting a decision by the Supreme Court. Slovitt v. Turner Broadcasting System, Inc. et al, and Farrell Brokerage, Inc. Pension Plan and Farrell Brokerage, Inc. Profit Sharing v. Turner Broadcasting System, Inc. et al On April 14, 1993, shareholder J. Slovitt filed suit in the Superior Court of Fulton County, Georgia, and shareholders Farrell Brokerage, Inc. Pension Plan and Farrell Brokerage, Inc. Profit Sharing filed suit in the Supreme Court of the State of New York, County of New York. Each of these shareholders (the "Plaintiffs") had the same legal counsel and purported to bring a class action on behalf of all minority common shareholders of the Company who are similarly situated to the Plaintiffs. The Defendants included the Company, all directors of the Company, Time Warner, Inc. and Tele-Communications, Inc. (the "Defendants"). Each class action made identical allegations that the Defendants dominate and control the Company through their stock ownership, directorships and management positions and have wrongfully utilized these positions to deprive the Company's minority common shareholders of their investment. The Plaintiff's allegations were allegedly based on public reports, including newspaper articles. The Plaintiffs sought class action status, injunctive relief, unspecified damages and a constructive trust for the benefit of class members. The case filed by shareholder J. Slovitt was dismissed in December 1993. The Plaintiffs in the Farrell suit initiated proceedings in March 1994 to dismiss the suit. MUSIC LICENSES In the television industry, programming is usually obtained from suppliers lacking the necessary license to perform publicly the music associated with the programming. Those performance rights are traditionally secured by obtaining blanket licenses to the entire repertories. Such blanket licenses are held by music performance societies, principally the American Society of Composers, Authors and Publishers ("ASCAP") and Broadcast Music, Inc. ("BMI"). As a local television station, TBS SuperStation has music licenses with both ASCAP and BMI and has paid monies pursuant to those licenses. In 1986, in connection with an audit for the years 1981 and 1982, ASCAP indicated that it believed the Company owed an additional $800,000 under that license. The Company denied that it had any additional liability, and the matter has remained in negotiation. In January 1989, ASCAP threatened to pursue the same demand for additional payments for the entire period 1981-88 and contended that the additional payment would represent approximately $6 million. The Company again denied any additional liability. The matter, if litigated, would raise novel and unresolved legal questions. In September 1988, the Company made formal applications for licenses from ASCAP and BMI for all of its programming services. The Company currently has a license with BMI. Under an antitrust consent decree, if any entity seeking a license from ASCAP cannot reach agreement with ASCAP as to the fee associated with that license, it is entitled to ask the United States District Court for the Southern District of New York to establish such a fee. On January 13, 1989, the Company filed an application asking that a fee be set for the period commencing October 3, 1988. The Court has set interim fees as a result of the Company's application. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS By unanimous written consent dated as of December 15, 1993, the holders of the Company's Class C Preferred Stock (12,396,976 shares) approved (i) the issuance of an aggregate of 250,000 shares of the Company's Class B Common Stock to the five principals of Castle Rock Entertainment in connection with the acquisition of Castle Rock by the Company and the employment of such principals following such acquisition and (ii) the issuance of an aggregate of 52,500 shares of the Company's Class B Common Stock to three of the Company's executive officers in connection with the execution by such officers of employment agreements with the Company. EXECUTIVE OFFICERS OF THE COMPANY The following table lists the executive officers of the Company, their ages and their positions as of February 28, 1994*: - --------------- * Effective January 2, 1994, John M. Barbera resigned his position as Vice President -- Sales. Effective January 31, 1994, Paul D. Beckham resigned his position as Vice President -- Cable Sales. ** William H. Grumbles and Julia W. Sprunt are married to each other. The executive officers of the Company are elected by the Board of Directors to serve until their successors are elected and qualified. The following is a brief description of the business experience of the executive officers of the Company for at least the past five years. R. E. Turner has been Chairman of the Board, President and controlling shareholder of the Company since 1970. Christian L. Becken joined the Company in December 1983 as Vice President of Financial Planning and was promoted to Vice President and Treasurer in 1986. William S. Ghegan, who joined the Company as Corporate Controller in 1985, was promoted to Vice President, Controller and Chief Accounting Officer in 1987. Formerly, he was a Senior Manager with Price Waterhouse, an international accounting firm, from 1979 to 1985. William H. Grumbles, who joined the Company in 1989 as Executive Vice President of TCNS, was promoted to President of Turner International, Inc. in 1991 and Vice President -- International Sales of the Company in 1992. In 1993, his title became Vice President -- Worldwide Distribution. Previously, he served as Vice President -- Affiliate Relations for HBO. Elahe Hessamfar joined the Company in 1993 as Vice President and Chief Information Officer. Previously Ms. Hessamfar was Vice President, Information Systems for PacBell Directory from 1987 until joining the Company. W. Thomas Johnson joined the Company in 1990 as Vice President -- News. He also serves as President of CNN. Previously, Mr. Johnson was Chairman of the Los Angeles Times from 1989 until joining the Company, and also Vice Chairman of the Times Mirror Company from 1987 until joining the Company. From 1980 he had served as Publisher and Chief Executive Officer of the Los Angeles Times. Steven W. Korn joined the Company in September 1983 as Assistant Vice President and Deputy General Counsel. He became Vice President in 1986, Secretary in 1987 and General Counsel in 1988. Formerly, he was an attorney with the law firm of Troutman Sanders. Terence F. McGuirk joined the Company in 1972 as an Account Executive. In 1975, he assumed the duties of Director of Cable Relations and three years later became the Director of Special Projects. He was promoted to Vice President of the Company in 1979 and was elected as a director in 1987. Mr. McGuirk was promoted to Executive Vice President in 1990. He also serves as President of the Company's sports division. Wayne H. Pace joined the Company in July 1993 as Vice President -- Finance and Chief Financial Officer. From 1981 until July 1993, he was a partner with Price Waterhouse, an international accounting firm. Scott M. Sassa rejoined the Company in 1988 as Executive Vice President of TNT, Inc. He became Vice President -- Entertainment Networks in 1990 and was elected a director in 1992. Before rejoining the Company, Mr. Sassa served as Vice President of New Business Development of Ohlmeyer Communications Company in 1987 and prior to that as Vice President of Network Management at Fox Broadcasting Company. William M. Shaw joined the Company in 1981 as Director of Personnel and was promoted to Vice President -- Personnel in 1982. He was promoted to Vice President -- Administration in 1991. Previously, he served as Director of Personnel at Siemens-Allis Corp. Julia W. Sprunt, who joined the Company in 1981 as a Marketing Manager of TCNS, became Director -- Southeast Region of TCNS in 1985. She was promoted to Vice President -- Western Region of TCNS in 1986 and became Senior Vice President of TCNS in 1987. Ms. Sprunt was promoted to Vice President -- Marketing of TBS SuperStation in 1989 before becoming Vice President -- Corporate Marketing and Communications in 1990. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Information regarding the principal markets on which the Company's two classes of common stock are traded, the high and low sales price for the stock on the American Stock Exchange for each quarterly period during the past two years, the Company's dividend policy and the approximate number of holders of each class of the common stock at December 31, 1993, is included under the caption entitled "Investor Information" on page 54 of the 1993 Annual Report to Shareholders and is incorporated herein by reference. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA A summary of selected financial data for the Company for the five years ended December 31, 1993 is included under the caption entitled "Selected Financial Data" on page 28 of the 1993 Annual Report to Shareholders and is incorporated herein by reference. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Company reported consolidated revenue of approximately $1.9 billion for the year ended December 31, 1993, a 9% increase over the same period last year. Operating profit, defined as income before interest expense, interest income, income taxes, extraordinary items, and the cumulative effect of a change in accounting principle, rose 4% over 1992 to $302 million. The Company incurred a net loss of $244 million, which included a nonrecurring charge of $306 million for the cumulative effect of a change in accounting for income taxes, and $11 million in extraordinary charges, net of tax benefits, for the early termination of certain of the Company's bank credit facilities and the redemption of its convertible debt due 2004. Income before these charges and the provision for income taxes was $121 million, or a 21% increase over 1992. The consolidated financial statements and all related information included in the 1993 Annual Report to Shareholders incorporated herein by reference should be read in conjunction with the following review. See the financial statements set forth on pages 29 through 51 of the 1993 Annual Report to Shareholders, incorporated herein by reference. For a discussion of regulatory and legislative matters affecting the Company, refer to Part I -- Item 1, "Business -- Regulation." OVERVIEW The Company's present operations and future prospects are influenced by many factors, primarily the growth of the cable television industry and the economic climate both in the United States and abroad, as well as the availability of programming for its entertainment and news networks. Additionally, governmental regulation and information technology changes relating to the cable television industry also influence domestic and international prospects. Because of the Company's recent acquisition of Castle Rock and New Line, future prospects will also be influenced by the profitability of the motion picture industry. U.S. CABLE TELEVISION INDUSTRY The growth of the Company's Entertainment and News Segments is influenced by the growth of the U.S. cable industry since that medium represents the principal distribution system for TBS SuperStation, TNT, the Cartoon Network, CNN and Headline News. At the end of 1993, homes subscribing to cable television service in the United States reached approximately 63 million, which represented 67% of all U. S. television households and a 1% increase over 1992. Homes served by cable television are expected to grow through 1996 and are expected to represent approximately 72% of all U.S. television households by the end of that year. The growth of the Company's Entertainment and News Segments is also influenced by the channel capacity of individual cable system operators. ECONOMIC CLIMATE The state of the U.S. economy influences the results of the Entertainment and News Segments as those segments derive a significant portion of their revenues from advertising, which is sold largely within three to nine months of airing and which, under certain conditions, can be cancelled by the buyers. Overall, domestic advertising revenues totaled $828 million in 1993, $750 million in 1992 and $662 million in 1991, representing 43%, 42% and 45%, respectively, of total revenues in those years. The impact of changes in the economy is mitigated by the fact that the Company derives a portion of its revenues from subscription fees, which are relatively resistant to short-term domestic economic factors. Domestic subscription fees from cable system operators, which totaled $502 million in 1993, $429 million in 1992 and $386 million in 1991, representing 26%, 24% and 26% of total revenues in those respective years, are generally received under contracts with three to five year terms. PROGRAMMING The Company continues to make significant investments in original, sports and licensed entertainment programming and in newsgathering capabilities to increase the viewership of its Entertainment and News Networks. The Entertainment Networks use high-profile original movies, specials and sporting events to define identity and provide a base of highly promotable programming from which to attract viewers to their entire slate of offerings. The Company has acquired programming rights to two of the most promotable sporting franchises available. Under a contract entered into in 1990, TNT telecast three pre-season and nine regular season National Football League ("NFL") games in 1993 and 1992. The Company has reached an agreement with the NFL to telecast a similar number of pre-season and regular season games each year over a four-year period beginning in 1994. Since 1989, TNT has also telecast NBA regular season and playoff games. The Company has entered into a new contract with the NBA covering the 1994-1995 through 1997-1998 seasons. Under the new contract, TNT and TBS SuperStation will telecast NBA regular season and playoff games. In addition, affiliations with sporting events such as the 1992 and 1994 Winter Olympics, telecast on TNT, and the Company's own Goodwill Games, telecast on TBS SuperStation, provide exposure on an international level. In 1990, the Company negotiated a long-term television license agreement with MGM-Pathe Communications Co. (now Metro-Goldwyn-Mayer Inc. ("MGM")) for approximately 1,000 feature films, over 300 cartoon shorts and selected television series. In December 1991, the Company acquired a 50% interest in HB Holding Co., a newly-formed joint venture. The joint venture, through a merger, acquired Hanna-Barbera, Inc. and the HB Library, which provided the Company access to a library of over 3,000 half-hours of animated programming and afforded exposure to a new facet of entertainment programming. Coupled with the 1,850 cartoon episodes in the TEC Film Library, the Company now has access to a vast source of animated programming. In October 1992, the Company used access to this programming to launch the Cartoon Network, a 24-hour per day cable program service which has revenue streams from both advertising and subscription fees. On December 22, 1993, the Company acquired all of the equity interests in Castle Rock, a motion picture and television production company, and on December 29, 1993, the Company acquired the remaining 50% interest in HB Holding Co. In addition, on January 28, 1994, the Company completed the acquisition of New Line, an independent producer and distributor of motion pictures. See Note 2 and Note 16 of Notes to Consolidated Financial Statements in the 1993 Annual Report to Shareholders incorporated herein by reference. When combined with existing arrangements for programming and the extensive library of feature films, cartoons and televisions series, these new acquisitions continue to build core programming for the Entertainment Networks and allow for control of programming from production through various stages of distribution. The Company will continue to use this programming for new networks, such as the launch of a 24-hour satellite and cable distributed family entertainment network -- Turner Classic Movies -- during 1994. Programming costs in the News Segment primarily relate to personnel, travel costs and satellite and communications access. CNN presently operates nine news bureaus in the United States and 19 bureaus in countries outside the United States. In the near future, the Company anticipates expanding staff and facilities internationally, increasing staff working on breaking news stories, and modifying its daily programming mix as necessary, all with the objective of increasing viewership. INTERNATIONAL While most of the Company's revenues are derived from domestic distribution of its products and services, the Company views the international market as an important source for future revenue growth. Historically, the Company has derived the majority of its international revenues from syndication and licensing to television stations, the sale of home videos of feature films from the TEC Film Library and, to a lesser degree, from theatrical release of original productions made for TNT. These operations continue to contribute an important revenue stream to the Company; in 1993 international syndication and licensing revenues (defined as broadcast fees, syndication, home video and licensing and merchandising revenues), were $149 million, representing approximately 62% of total international revenue. This is an increase of 2% over 1992. The Company believes the greatest potential for growth internationally is in the area of satellite delivered programming. Currently, CNN International is the Company's predominant programming vehicle outside the United States. CNN International is distributed via satellite primarily to cable systems, broadcasters, hotels and private satellite dish owners. Subscription levels in Europe grew from 12 million households at the end of 1991 to 45 million households by the end of 1993. CNN International's programming is generally either CNN product as viewed in the United States or in a reformatted version which conforms to retransmission restrictions imposed by certain agreements under which CNN collects international news stories from certain overseas suppliers. It also includes segments specifically produced for the international markets. Revenues, which are derived from subscriber fees, broadcast fees, and advertising sales, are principally generated from Europe. Total revenues from CNN International increased from $74 million in 1992 to $93 million in 1993. It is anticipated that these revenues will continue to increase as the Company capitalizes on the growing international reputation of CNN and the increased international opportunities to market the service, both in terms of increases in international advertising and in terms of overall growth in international television media and markets. In January 1991, the Company launched TNT Latin America, a 24-hour per day trilingual entertainment program service serving Latin America and the Caribbean via satellite. Relying largely on existing programming from the TEC Library, this service allows the user to customize the service using Spanish, Portuguese and English audio tracks and subtitles. Contracts for carriage of this service are offered by the Company's sales and marketing organizations to operators of cable systems and similar technologies. Revenues from this service, which in many areas is being marketed together with CNN's news programming, are almost entirely from subscription fees based on contracts with cable operators which specify minimum subscription levels. Revenues for TNT Latin America continue to increase with a 50% growth over 1992. In March 1993, the Company acquired a 27.5% limited partnership interest in n-tv, a 24-hour German language news channel. The partnership provides for cooperation in newsgathering, exchange of news footage and cooperative access to facilities. In April 1993, the Company launched Cartoon Network Latin America, a 24-hour per day programming service in Latin America utilizing animated programming from both the HB Library and TEC Library. In September 1993, the Company also launched TNT & Cartoon Network Europe, which consists of European versions of the Cartoon Network and TNT, originating in the United Kingdom, and distributed throughout Europe. Both of these new networks have revenue streams from advertising and subscription fees. The Company is also committed to a 50% joint venture interest in an over-the-air television station in Moscow. Programming for this joint venture will primarily be in the Russian language and will include classic films from the TEC Library, sports and children's programming and CNN International programming. The Company is planning the launch in 1994 of a 24-hour movie and cartoon network in Asia (TNT & Cartoon Asia). Programming for this new international network will come primarily from the TEC Library and the HB Library. The Company believes international markets provide substantial opportunities for revenue growth in the future. Such growth will be significantly influenced by, among other things, competition, governmental regulation, access to satellite transmission facilities, improvements in encryption technologies, the continued growth of distribution system alternatives to over-the-air broadcast technology, the availability of effective intellectual property protection and local market economic conditions in the countries served. LIQUIDITY AND CAPITAL RESOURCES SOURCES AND USES OF CASH As part of its ongoing strategic plan, the Company has invested, and will continue to invest, significant amounts of capital for network and television programming development, filmed entertainment and programming acquisition. Historically, the Company has relied primarily on debt to finance these initiatives and as a result has maintained a high degree of financial leverage. This approach continued in 1993 enabling the Company to implement its growth plans. See Note 2, Note 5 and Note 16 of the Notes to Consolidated Financial Statements included in the 1993 Annual Report to Shareholders incorporated herein by reference. Additionally, see "Liquidity and Capital Resources -- Credit Facilities and Financing Activities." The Company expects that internally generated funds supplemented by existing credit facilities and debt that may be issued pursuant to its shelf registration filed in May 1993 will be sufficient to meet operating needs and scheduled debt maturities through the end of 1994 and beyond. Cash provided by operations for the year ended December 31, 1993, aggregated $136 million, net of cash interest payments of $138 million, payments of $75 million for accreted amounts upon redemption of the zero coupon notes due 2004 (the "Convertible Notes due 2004") completed in August 1993, and payment of debt issue costs of $16 million related to the issuance of 8 3/8% Senior Notes and the execution of the 1993 Credit Agreement, both of which occurred in July 1993. Other primary sources of cash included borrowings under the 1993 Credit Agreement of $1.225 billion and approximately $297 million of gross proceeds from the 8 3/8% Senior Notes. Cash was primarily utilized for the retirement of indebtedness, including the Convertible Notes due 2004 ($216 million, net of payments of accreted amounts) and amounts outstanding under the 1989 Credit Agreement ($710 million) and the CNN Center Ventures Credit Agreement ($40 million). In addition, the Company acquired an equity interest in and advanced funds to the German limited partnership, n-tv ($35 million), purchased the remaining 50% interest in HB Holding Co. and its subsidiaries ($243 million, net of cash) and acquired Castle Rock Entertainment ($314 million, net of cash). Cash was also used during the period for additions to property and equipment ($51 million) and payments of cash dividends ($18 million). See the Consolidated Statements of Cash Flows for details regarding sources and uses of cash, Note 2 of Notes to Consolidated Financial Statements for a detailed discussion of the acquisitions, and Note 5 of Notes to Consolidated Financial Statements for a detailed discussion of definitions, terms and restrictive covenants associated with the Company's indebtedness, all of which are included in the 1993 Annual Report to Shareholders incorporated herein by reference. CREDIT FACILITIES AND FINANCING ACTIVITIES The Company had approximately $2.3 billion of outstanding indebtedness at December 31, 1993, of which $1.2 billion was outstanding under an unsecured revolving credit facility with banks. On July 1, 1993, the Company entered into a credit agreement (the "1993 Credit Agreement") with a group of banks pursuant to which such banks extended a $750 million unsecured revolving credit facility. On December 15, 1993, the 1993 Credit Agreement was amended, among other things, to increase the amount available for borrowing to $1.5 billion. Amounts available for borrowing or reborrowing under this revolving facility will automatically decrease by $75 million as of the last business day of the calendar quarters ending March 31, 1998, June 30, 1998, September 30, 1998, and December 31, 1998, and by $150 million as of the last business day of each quarter thereafter until December 31, 2000, at which time the revolving credit facility will terminate. Under the 1993 Credit Agreement, amounts repaid under the revolving credit facility may be reborrowed subject to borrowing availability. The amount of borrowing availability is subject to other provisions of the 1993 Credit Agreement, including requirements that (a) minimum ratios, as from time to time are in effect, of funded debt to cash flow, cash flow to interest expense and cash flow to fixed charges be maintained; and (b) there does not exist, and that such borrowing would not create, a default or event of default, as defined. Those covenants are similar to, though generally less restrictive than, those provided in the credit agreement entered into by the Company in 1989, as amended (the "1989 Credit Agreement"). Approximately $1.2 billion of the Company's indebtedness bears interest on a floating basis tied to short-term market indices. The Company has interest rate swap agreements having a total notional principal amount of $780 million with commercial banks to mitigate possible rising interest rates. The contracts have expiration dates ranging from March 1994 to March 1995. The weighted average receipt and payment rates associated with the swap agreements were 4.16% and 9.07%, respectively, at December 31, 1993 and were 4.44% and 9.80%, respectively, at December 31, 1992. The Company designates these interest rate swaps as hedges of interest rates and the differential paid or received on interest rate swaps is accrued as an adjustment to interest expense as interest rates change. The Company has exposure to credit risk, but does not anticipate nonperformance by the counterparties to these agreements. On May 6, 1993, the Company filed a registration statement with the Securities and Exchange Commission to allow the Company to offer for sale, from time to time, up to $1.1 billion of unsecured senior debt securities or unsecured senior subordinated debt securities (together, the "Debt Securities") consisting of notes, debentures or other evidence of indebtedness. The Debt Securities may be offered as a single series or as two or more separate series in amounts, at prices and on terms to be determined at the time of the offering. The Debt Securities may be sold to or through one or more agents designated from time to time. On July 8, 1993, the Company sold $300 million of 8 3/8% Senior Notes due July 1, 2013 (the "Notes") under the registration statement. The net proceeds to the Company were approximately $291 million after market and underwriting discounts. The Notes bear interest at the rate of 8 3/8% per annum payable semi- annually on January 1 and July 1 of each year, commencing January 1, 1994. The Notes are not redeemable at the option of the Company. Each holder has the right to require the Company to repurchase such holder's Notes in whole, but not in part, upon the occurrence of certain triggering events, including, without limitation, a change of control, certain restricted payments or certain consolidations, mergers, conveyances or transfers of assets, each as defined in the indenture relating to the Debt Securities. The covenants governing the Notes limit the Company's ability to incur additional funded debt by requiring the maintenance of a minimum consolidated interest coverage ratio, as defined. On July 9, 1993, the Company called for redemption of all of its Convertible Notes due 2004, of which $291 million, net of unamortized discount of $409 million, was outstanding at August 9, 1993, to be funded by the issuance of the Notes. The Convertible Notes due 2004 could have been converted into shares of Class B Common Stock, par value $0.0625 per share, at any time before the close of business on August 9, 1993, at the rate of 15 shares of Class B Common Stock for each $1,000 principal amount at maturity. All Convertible Notes due 2004 which were not converted into shares of Class B Common Stock were redeemed on August 9, 1993, at a redemption price of $415.01 in cash for each $1,000 principal amount at maturity. The price reflects accrued original issue discount at the rate of 8% compounded semiannually to the redemption date. On December 21, 1993, the Company cancelled a $125 million revolving credit agreement governed by the CNN Center Ventures Credit Agreement that was guaranteed by the Company and secured by a first mortgage lien on the CNN Center and adjacent parking deck facility. The redemption of the Convertible Notes due 2004 and cancellation of the 1989 Credit Agreement and the CNN Center Ventures Credit Agreement resulted in an extraordinary charge of $11 million, net of approximately $6 million of tax benefits, representing the write-off of unamortized debt issue costs. Scheduled principal payments for all outstanding debt for 1994 total approximately $2 million, the majority of which relates to capital leases and other debt. On February 3, 1994, the Company sold $250 million of 7.4% Senior Notes due 2004 (the "Senior Notes") and $200 million of 8.4% Senior Debentures due 2024 (the "Senior Debentures") under the shelf registration dated May 6, 1993. The Company used substantially all of the net proceeds to repay amounts outstanding under the 1993 Credit Agreement incurred in connection with the acquisitions of Castle Rock and the remaining 50% interest in HB Holding Co. See Note 2 and Note 16 of Notes to Consolidated Financial Statements in the 1993 Annual Report to Shareholders incorporated herein by reference. CAPITAL RESOURCES AND COMMITMENTS During 1994, the Company anticipates making cash expenditures of approximately $320 million for sports programming, primarily rights fees, approximately $640 million for original entertainment programming (excluding promotional and advertising costs) and approximately $85 million for licensed programming. Also, during 1994, the Company expects to make total expenditures of approximately $105 million for additional or replacement property and equipment. Of the anticipated programming and capital expenditures described above, firm commitments exist for approximately $520 million. Other capital resource commitments consist primarily of lease obligations, some of which are contingent on revenues derived from usage. Management expects to continue to lease satellite facilities, sports facilities and office facilities not already owned by the Company. Management expects to finance these commitments from working capital provided by operations and financing arrangements with lessors, vendors, film suppliers and additional borrowings. RESULTS OF OPERATIONS 1993 VS. 1992 ENTERTAINMENT SEGMENT Entertainment Segment revenue increased 8%, or $84 million. Advertising revenue contributed $56 million to the advance, which reflected an increase in the amount charged per thousand viewing homes on TBS SuperStation and TNT. Subscription revenue increased $49 million, through an increase in the monthly amount charged and a higher number of subscribers for TNT. These advances were offset somewhat by a $26 million decrease in 1993 in domestic and international home video revenue. This decrease was due to a refinement of previously recorded estimates resulting from the resolution of several uncertainties. Operating profit (defined as income before interest expense, interest income, income taxes, extraordinary items and the cumulative effect of changes in accounting for income taxes) for the Entertainment Segment decreased 6%, or $9 million, to $143 million, despite significant revenue advances in the core networks. Operating losses of $25 million in 1993 associated with new networks contributed to the operating profit decrease. New networks consist of the Cartoon Network, which was launched in 1992, and Cartoon Network Latin America and TNT & Cartoon Network Europe, which were launched in 1993. Also contributing to the operating profit decrease were a $21 million increase in original programming and related promotion and advertising costs, $15 million in costs related to the theatrical release of "Gettysburg," and increased selling, general and administrative costs. These higher costs were offset somewhat by a $34 million decrease in home video costs, reflecting the related cost effects of the refinement of previously recorded estimates and generally lower 1993 cost of sales. NEWS SEGMENT News Segment revenue increased 13%, or $68 million, to $599 million. Advertising revenue contributed $29 million to the increase, up 11% from 1992, primarily from an increase in the amount charged per thousand viewing homes domestically. Subscription revenue contributed $31 million, up 16% from 1992, due to an increase in the monthly amount charged for CNN and a higher number of subscribers. CNN International contributed $93 million, or 16%, to total 1993 News Segment revenue due primarily to continued global expansion. Operating profit for the News Segment increased 19% to $212 million. This increase was due to the advances in revenue, offset by an increase in total costs of $34 million. The total cost increase arose from higher production costs, expenses associated with covering events in Somalia and Bosnia and higher international sales costs. OTHER Other Segment revenues remained constant at $182 million. Increased Braves home game and broadcasting revenue in 1993 offset the non-recurring effects of $12 million in Major League Baseball expansion fees received in 1992, as well as a decline in WCW revenue. Operating losses for this Segment declined to $33 million, a net decrease of $4 million, primarily due to a $16 million charge related to discontinuance of the Checkout Channel in 1992, offset somewhat by higher Braves team expenses and other increases in general and administrative costs. EQUITY (LOSS) IN UNCONSOLIDATED ENTITIES/OTHER CONSOLIDATED INFORMATION Equity in the losses of unconsolidated entities increased $16 million over 1992 results to $20 million. This increase arose primarily from the Company's investments in new international ventures. In March 1993, the Company acquired a 27.5% interest in n-tv, a 24-hour German news channel. The Company's share of 1993 losses was approximately $19 million. The Company is also committed to a 50% joint venture interest in an over-the-air television station in Moscow. See Note 2 of Notes to Consolidated Financial Statements in the 1993 Annual Report to Shareholders incorporated herein by reference. Extraordinary items represent $11 million, net of tax benefits, associated with the early termination of certain of the Company's bank credit facilities and the redemption of the Convertible Notes due 2004. The 1992 extraordinary item of $44 million represents the utilization of operating loss carryforwards. See Note 5 and Note 7 of Notes to Consolidated Financial Statements in the 1993 Annual Report to Shareholders incorporated herein by reference. The Company also reflected a $306 million non-recurring charge for the cumulative effect of adopting Statement of Financial Accounting Standards No. 109. This charge was primarily related to the TEC Library and, to a lesser degree, the Company's 50% interest in the HB Holding Co. As a result of the information discussed, the Company reported a net loss of $244 million in 1993 ($0.92 net loss per common share and common share equivalent). This compares to net income of $78 million in 1992 ($0.30 net income per common share and common share equivalent). RESULTS OF OPERATIONS 1992 VS. 1991 ENTERTAINMENT SEGMENT Entertainment Segment revenue increased 24%, or $210 million. Advertising revenue contributed $73 million to the increase, which reflected higher rates charged per thousand viewing homes, the amount of national inventory sold and the size of the viewing audience. Subscription revenue rose $35 million due to an increase in the size of TNT's subscriber base and a rate increase effective January 1, 1992. Businesses launched in late 1991, TNT Latin America, Hanna-Barbera, Inc. and Turner Publishing, contributed $10 million, $15 million and $12 million, respectively, to the increase in total revenue for 1992. In addition, home video revenues grew by $72 million, primarily related to the refinement of previously recorded estimates resulting from the resolution of several uncertainties and increases in international revenues. Operating profit for the Entertainment Segment increased 4%, or $5 million, to $152 million, despite much greater revenue advances in the core networks. TNT Latin America, Hanna-Barbera, Inc. and Turner Publishing reflected an entire year of operating expense in 1992 operating profit, or an additional $37 million over 1991. Also contributing to the modest operating profit increase were $50 million in increased home video costs commensurate with revenue increases, additional rights fees and production costs of $23 million associated with TNT's telecast of the 1992 Winter Olympics and $21 million for the NFL games telecast and increased selling, general and administrative costs. NEWS SEGMENT News Segment revenue increased 11%, or $53 million, to $531 million. Advertising revenue rose $24 million and subscription revenues grew $26 million, reflecting an increase in the number of subscribers and a rate increase as well as overall growth experienced by CNN International. CNN International contributed $23 million to the News Segment's total increase in revenues. Operating profit for the News Segment increased 8%, to $178 million. Revenue increases were offset by CNN International expansion and the related increases in satellite and production costs. Higher domestic newsgathering costs associated with political and election coverage were mitigated somewhat by reduced international newsgathering costs due to the 1991 coverage of the Persian Gulf crisis. OTHER Other Segment revenues increased 26%, or $37 million. The continued strong performance of the Braves resulted in higher stadium attendance and concession revenues. In addition, expansion fees from Major League Baseball contributed $12 million to the increase in revenues for the year. Operating losses for these companies increased to $37 million, a net change of $22 million, due to increased Braves' player salaries, the development of the Airport Channel and $16 million of costs accrued in conjunction with the termination of the Checkout Channel. EQUITY (LOSS) IN UNCONSOLIDATED ENTITIES/OTHER CONSOLIDATED INFORMATION Equity in the losses of unconsolidated entities increased $4 million. This increase arose primarily from the Company's investment in HB Holding Co. Extraordinary items represent the utilization of $44 million of net operating loss carryforwards, compared to operating loss carryforwards reflected in 1991 of $43 million. As a result of the information discussed above, the Company reported net income of $78 million in 1992 ($0.30 net income per common share and common share equivalent). This compares to 1991 net income of $86 million ($0.24 net income per common share and common share equivalent). NEW ACCOUNTING PRONOUNCEMENTS The Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Post-Employment Benefits." This standard requires companies to recognize the obligation to provide post-employment benefits (benefits provided to former or inactive employees after employment but before retirement) if the obligation is attributable to employees' services already rendered, employees' rights to these benefits vest or accumulate and the payment of the benefits is probable and can be estimated. The new standard, which the Company will adopt January 1, 1994, is not anticipated to have a material impact on its financial position. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Consolidated financial statements and notes thereto for the Company and the report of the independent accountants, which are included on pages 29 through 51 of the 1993 Annual Report to Shareholders under the following captions listed below, are incorporated herein by reference. Consolidated Statements of Operations for the three years ended December 31, 1993. Consolidated Balance Sheets at December 31, 1993 and 1992. Consolidated Statements of Changes in Stockholders' Equity (Deficit) for the three years ended December 31, 1993. Consolidated Statements of Cash Flows for the three years ended December 31, 1993. Notes to Consolidated Financial Statements. Report of Independent Accountants. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information relating to directors of the Company will be filed by amendment to this Report on Form 10-K pursuant to General Instruction G(3) of Form 10-K. Certain information concerning the executive officers of the Company is set forth in Part I of this Report on Form 10-K pursuant to General Instruction G(3) of Form 10-K under the caption entitled "Executive Officers of the Company." ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION Information regarding compensation of officers and directors of the Company will be filed by amendment to this Report on Form 10-K pursuant to General Instruction G(3) of Form 10-K. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information regarding ownership of certain of the Company's securities will be filed by amendment to this Report on Form 10-K pursuant to General Instruction G(3) of Form 10-K. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information regarding certain relationships and related transactions with the Company will be filed by amendment to this Report on Form 10-K pursuant to General Instruction G(3) of Form 10-K. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)(1) Financial Statements The financial statements set forth on pages 29 through 51 of the 1993 Annual Report to Shareholders are incorporated herein by reference (see Exhibit 13). (a)(2) Financial Statement Schedules for the three years ended December 31, 1993 The report of the Company's independent accountants with respect to the above-referenced financial statement schedules appears on page 35 of this report. All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. (a)(3) Exhibits - --------------- * Management contract or compensatory plan or arrangement. (B) REPORTS ON FORM 8-K On December 28, 1993, the Company filed a Form 8-K announcing that the Company had acquired Castle Rock Entertainment ("Castle Rock") from Main Street Partners, Sony Pictures Entertainment, Inc. and Group W Investments, Inc. for $100 million in cash together with the repayment of the indebtedness of Castle Rock, and submitted the following documents in connection with such acquisition: Purchase Agreement, dated as of December 22, 1993, by and among the Company, CR Acquisition Co., Castle Rock Entertainment, Inc., Rain Productions, Padnick Productions, Inc., Rob Reiner Productions, Scheinman Productions, Inc., Shafer Productions, Inc., Castle Rock Holding, Inc. and Group W Investment Inc.; Audited Castle Rock Entertainment Consolidated Balance Sheets as of December 31, 1991 and 1992 and the related Consolidated Statements of Operations, Partners' Equity and Cash Flows for the years then ended; Unaudited Castle Rock Entertainment Condensed Consolidated Balance Sheet as of September 30, 1993 and the Condensed Consolidated Statements of Operations and Cash Flows for the nine months ended September 30, 1992 and 1993; Unaudited Company Pro Forma Condensed Combined Balance Sheet as of September 30, 1993 and Unaudited Pro Forma Condensed Combined Statement of Operations for the year ended December 31, 1992 and the nine months ended September 30, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. TURNER BROADCASTING SYSTEM, INC. (Registrant) By: /s/ R. E. TURNER --------------------- R. E. Turner Chairman of the Board of Directors and President (Chief Executive Officer) Dated: March 28, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of Turner Broadcasting System, Inc. Our audits of the consolidated financial statements referred to in our report dated February 15, 1994 appearing on page 51 of the 1993 Annual Report to Shareholders of Turner Broadcasting System, Inc. (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed in Item 14(a)(2) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. PRICE WATERHOUSE Atlanta, Georgia February 15, 1994 SCHEDULE II TURNER BROADCASTING SYSTEM, INC. AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES (IN THOUSANDS) Non-interest bearing advance secured by salary and earned deferred compensation payable in 240 monthly installments beginning January 1, 1983. SCHEDULE VIII TURNER BROADCASTING SYSTEM, INC. VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (IN THOUSANDS) SCHEDULE X TURNER BROADCASTING SYSTEM, INC. SUPPLEMENTARY INCOME STATEMENT INFORMATION (IN THOUSANDS) - --------------- (1) Costs relate primarily to advertising the Company's products and services in a variety of media. EXHIBIT INDEX

58696_1993.txt

58696

1993

Item 1. Business (a) General Development of Business. Lennar Corporation (together with its subsidiaries, the "Company") is a full service real estate company. It is primarily engaged in homebuilding, in the development and management of commercial and residential income-producing properties and other real estate related assets and in real estate related financial services. In 1992, the Company, through its Investment Division (formerly referred to as the Asset Management Division) began acquiring portfolios of commercial real estate assets, including real estate related loans, which it believed it could liquidate at a profit. During 1992, Lennar Florida Partners, a partnership between a subsidiary of the Company and the Morgan Stanley Real Estate Fund was formed to acquire and manage a portfolio of assets which it purchased from the Resolution Trust Corporation. During 1993, the Company acquired an interest in LW Real Estate Investments L.P., a partnership between Westinghouse Electric Corporation and an affiliate of Lehman Brothers. This partnership also selected the Company to manage its portfolio of commercial real estate assets. The Company shares in the profits and losses of these partnerships and also receives fees for the management and disposition of the partnerships' assets. The Company has also invested in smaller portfolios of real estate assets for its own account. The Company believes that there will continue to be opportunities to acquire, restructure and manage these types of portfolios on its own and in partnerships. Also, during 1993, the Company expanded its Homebuilding Division by entering the Houston, Texas and the Port St. Lucie, Florida markets. (b) Financial Information about Industry Segments. The Company operates principally in two industry segments. The first of these is reported in the Company's financial statements as the "real estate" segment and includes the activities of the Company's Homebuilding and Investment Divisions, as well as the support staff functions of the parent company (Lennar Corporation). The second industry segment is reported as "financial services" and includes certain activities of Lennar Financial Services ("LFS"), but excludes its limited-purpose finance subsidiaries. The financial information related to these industry segments is contained in the financial statements included in this Report. (c) Narrative Description of Business. HOMEBUILDING The Company and its predecessor have been building homes since 1954. The Company believes that, since its acquisition of Development Corporation of America in 1986, it has each year delivered more homes in Florida than any other homebuilder. The Company has been building homes in Arizona since 1972, where it currently is one of the leading homebuilders. In 1991, the Company began building homes in the Dallas/Fort Worth area of Texas and in 1993 it began building homes in Houston, Texas and Port St. Lucie, Florida. The Company has constructed and sold over 100,000 homes to date. The Company's homebuilding activities in Florida are principally conducted through Lennar Homes, Inc. In Arizona and Texas, they are conducted through Lennar Homes of Arizona, Inc. and Lennar Homes of Texas, Inc., respectively. The Company is involved in all phases of planning and building in its residential communities, including land acquisition, site planning, preparation of land, improvement of undeveloped and partially developed acreage, and design, construction and marketing of homes. The Company subcontracts virtually all segments of development and construction to others. The Company sells single-family attached and detached homes and condominiums in buildings generally one to five stories in height. Homes sold by the Company are primarily in the moderate price range for the areas in which they are located. They are targeted primarily at first time homebuyers, first time move-up homebuyers and, in some communities, retirees. The average sales price of a Lennar home was $111,100 in fiscal 1993. Current Homebuilding Activities The table on the following page summarizes information about the Company's recent homebuilding activities: Property Acquisition The Company continuously considers the purchase of, and from time to time acquires, land for its development and sales programs. It generally does not acquire land for speculation. In some instances, the Company acquires land by acquiring options enabling it to purchase parcels as they are needed. Although some of the Company's land is held subject to purchase money mortgages or is mortgaged to secure $50 million of term loans, most of the Company's land (including most of the land on which it currently is building or expects to build during the next year) is not subject to mortgages. The Company believes its land inventory gives it a competitive advantage, particularly in Florida. Construction and Development The Company supervises and controls the development and building of its own residential communities. It employs subcontractors for site improvements and virtually all of the work involved in the construction of homes. In almost all instances, the arrangements between the Company and the subcontractors commit the subcontractors to complete specified work in accordance with written price schedules. These price schedules normally change to meet changes in labor and material costs. The Company does not own heavy construction equipment and generally has only a small labor force used to supervise development and construction and perform routine maintenance and minor amounts of other work. The Company generally finances construction with its own funds or borrowings under its unsecured working capital lines, not with secured construction loans. Marketing The Company always has an inventory of homes under construction. A majority of these homes are sold (i.e., the Company has received executed sales contracts and deposits) before the Company starts construction. Subsidiaries of the Company employ salespersons who are paid salaries, commissions or both to make onsite sales of the Company's homes. The Company also sells through independent brokers. The Company advertises its residential communities through local media and sells primarily from models that it has designed and constructed. In addition, the Company advertises its retirement communities in areas in which potential retirees live. Mortgage Financing The Company's financial services subsidiaries make conventional, FHA-insured and VA-guaranteed mortgage loans available to qualified purchasers of the Company's homes. Because of the availability of mortgage loans from the Company's financial services subsidiaries, as well as independent mortgage lenders, the Company believes access to financing has not been, and is not, a significant problem for most purchasers of the Company's homes. Competition The housing industry is highly competitive. In its activities, the Company competes with other developers and builders in and near the areas where the Company's communities are located, including a number of homebuilders with nationwide operations. The Company has for the past twenty years been one of the largest homebuilders in South Florida and for the past several years has delivered more homes in the State of Florida than any other homebuilder. Further, the Company is a leading homebuilder in Arizona and is establishing a market position in Dallas and Houston, Texas. Nonetheless, the Company is subject to intense competition from a large number of homebuilders in all of its market areas. INVESTMENT DIVISION The Company has been engaged for more than 20 years in developing and managing commercial and residential income-producing properties. The Company has also, on a number of occasions, developed properties under arrangements with financial institutions which had acquired the properties through foreclosures or similar means. This Division also leases land to businesses which construct their own facilities. Currently, through its Investment Division, the Company owns and manages more than 2,800 rental apartment units (which are approximately 94% occupied) and approximately 1,400,000 square feet of low rise office buildings, warehouses and neighborhood retail centers (which are approximately 85% occupied), as well as a 297 room hotel, a mobile home park, and golf and other recreational facilities in various communities. In 1992, the Investment Division began acquiring, on its own and through partnerships, pools of real estate assets which it believes it can liquidate at a profit and from which it can generate rental, interest and other income during the liquidation process which is anticipated to last several years. Its first transaction of this type was the acquisition by a partnership between a subsidiary of the Company and The Morgan Stanley Real Estate Fund, L.P. from the Resolution Trust Corporation, of a portfolio consisting of more than 1,000 mortgage loans and 65 properties, many of which had been acquired through foreclosure of mortgage loans or by similar means. In addition to the Company's participating in the purchase, the Investment Division is overseeing the partnership's management of this portfolio. In July 1993, Lennar invested $29 million to acquire a 9.9% equity interest in LW Real Estate Investments L.P., a partnership between Westinghouse Electric Corporation and an affiliate of Lehman Brothers. The partnership selected the Company to manage its portfolio of commercial real estate assets. The management agreement provides for reimbursement to the Company for the direct costs of management and for the payment of fees tied directly to the cash flow performance of the partnership. Additionally, in 1993, the Company purchased a pool of 10 assets from the Resolution Trust Corporation which consisted of commercial properties, performing loans and non performing loans which were collateralized by income-producing properties. During 1993, the Company purchased the former partners' interest in three of its joint ventures which were formed to develop and build homes, or to develop land or other properties for investment or sale to other builders or developers. The activities related to these former joint ventures have been consolidated into the accounts of the Company as of the respective dates of acquisition. FINANCIAL SERVICES The Company's financial services subsidiaries originate mortgage loans, service mortgage loans which they and other lenders originate, purchase and re-sell mortgage loan pools, arrange title insurance and provide closing services for homebuyers. Mortgage Origination Through three of the financial services subsidiaries, Universal American Mortgage Company, AmeriStar Financial Services, Inc. and Lennar Funding Corporation, the Company provides conventional, FHA- insured and VA-guaranteed mortgage loans from twenty-one offices located in Florida, California, Arizona, Texas, North Carolina, Illinois and Oregon. The Company entered the mortgage banking business in 1981 primarily to provide financing to Lennar homebuyers. In 1993, loans to buyers of the Company's homes represented approximately 10% of the Company's $1.3 billion of loan originations. The Company sells the loans it originates in the secondary mortgage market, generally on a non-recourse basis, but usually retains the servicing rights. One of the principal reasons for originating loans is to increase the mortgage servicing portfolio. Until new loan originations can be pooled for sale, they are financed with borrowings under the financial services subsidiaries' $200 million lines of credit (secured by the loans and by certain servicing rights) or from the parent if that will reduce consolidated borrowing costs. In most instances, the Company hedges against any exposure to interest rate fluctuations. Mortgage Servicing The Company obtains significant revenues from servicing loans originated by its financial services subsidiaries before and after the loans are sold in the secondary market. In addition, the Company from time to time purchases servicing rights from others (it is approved as a servicer by the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac) and other mortgage investors). Additionally, the Company sometimes purchases and sells mortgage loan pools and retains servicing rights. At November 30, 1993, it had a servicing portfolio of approximately 47,000 loans with an unpaid principal balance of approximately $3.4 billion. Revenues from servicing mortgage loans include servicing fees, late charges and other ancillary fees and all, or in some states part, of the interest on sums held in escrow for tax, insurance and other payments. However, proposed Federal legislation, if enacted, would establish uniform regulations regarding payment of interest on escrow accounts and otherwise regulate escrow accounts in ways which would reduce the benefit a mortgage servicer derives from those accounts. Purchase and Sale of Loan Pools The Company, from time to time, purchases pools of mortgage loans originated by financial institutions and then re-sells the loans in the secondary market. The benefits to the Company from these transactions include gains from the sales of the loans and retention of the right to service the loans after they are sold in the secondary market. Insurance and Closing Services The Company arranges title insurance for and provides closing services to customers of the Company and others from offices in Florida. OTHER ACTIVITIES The limited-purpose finance subsidiaries of LFS have placed mortgages and other receivables as collateral for various long-term financings. These subsidiaries pay the debt service on the long-term borrowings primarily from the cash flows generated by the related pledged collateral. The Company believes that the cash flows generated by these subsidiaries will be adequate to meet the required debt payment schedules. REGULATION Homes and residential communities built by the Company must comply with state and local regulations relating to, among other things, zoning, treatment of waste, construction materials which must be used, certain aspects of building design and minimum elevation of properties and other local ordinances. These include laws in Florida and other states requiring use of construction materials which reduce the need for energy- consuming heating and cooling systems. The State of Florida has also adopted a law which requires that commitments to provide roads and other offsite infrastructure be in place prior to the commencement of new construction. The provisions of this law are currently being implemented and administered by individual counties and municipalities throughout the state and may result in additional fees and assessments or building moratoriums. It is difficult at this time to predict the impact of this law on future operations, or what changes may take place in the law in the future. However, the Company believes that most of its Florida land presently meets the criteria under the law, and it has the financial resources to provide for development of the balance of its land in compliance with the law. As a result of Hurricane Andrew, there have been changes to various building codes within Florida. These changes have resulted in higher construction costs. To date, these additional costs have been recoverable through increased selling prices without any apparent significant adverse effect on sales volume. Virtually all areas of the United States have adopted regulations intended to assure that construction and other activities will not have an adverse effect on local ecology and other environmental conditions. These regulations have had an effect on the manner in which the Company has developed certain properties and may have a continuing influence on the Company's development activities in the future. In order to make it possible for purchasers of some of the Company's homes to obtain FHA-insured or VA-guaranteed mortgages, the Company must construct those homes in compliance with regulations promulgated by those agencies. The Company has registered condominium communities with the appropriate authorities in Florida. It has registered some of its Florida communities with authorities in New Jersey and New York. Sales in other states would require compliance with laws in those states regarding sales of condominium homes. Both the Company's title insurance agency and general insurance agency subsidiaries must comply with the applicable insurance laws and regulations. EMPLOYEES At November 30, 1993, the Company employed 1,660 individuals, of whom 457 were management, supervisory and other professional personnel, 181 were construction supervisory personnel, 238 were real estate salespersons, 136 were hospitality personnel and 648 were professional support personnel, accounting, office clericals and skilled workers. Some of the subcontractors utilized by the Company may employ members of labor unions. The Company does not have collective bargaining agreements relating to its employees. Item 2.

Item 2. Properties. For information about properties owned by the Company for use in its residential and commercial activities, see Item 1. The Company maintains its executive offices, financial services subsidiary headquarters, Investment Division headquarters, Dade County homebuilding division offices and Dade County mortgage and title company branch offices at 700 and 730 Northwest 107th Avenue, Miami, Florida in office buildings built and owned by the Company. These offices occupy approximately 58,000 square feet. Other regional offices or financial services branch offices are located either in Company-owned communities or retail centers, or in leased office facilities. Item 3.

Item 3. Legal Proceedings. The Company is a defendant in various lawsuits brought by condominium and homeowner associations in communities constructed by the Company. Although the specific allegations in the lawsuits differ, in general, each of the lawsuits asserts that the Company failed to construct the community involved in accordance with plans and specifications and applicable construction codes, and each of them seeks reimbursement for sums the plaintiff association claims it will have to spend to remedy the alleged construction deficiencies. Associations in other communities have threatened similar suits. The Company views suits of this type as a normal incident to the business of building homes. The Company does not believe that these lawsuits or threatened lawsuits will have a material effect upon the Company. During 1993, the Company settled two lawsuits and a number of claims in which owners of approximately 550 homes built by the Company sought damages as a result of Hurricane Andrew. There still remain approximately 125 additional homeowners who have asserted claims. Other homeowners or homeowners' insurers are not precluded from making similar claims against the Company. Four insurance companies have contacted the Company seeking reimbursement for sums paid by them with regard to homes built by the Company and damaged by the storm. There are two pending lawsuits in which homeowners or homeowners' insurers seek relatively minor damages. Other claims of this type may be asserted. The Company's insurers have asserted that their policies cover some, but not all, aspects of these claims. However, to date, the Company's insurers have made all payments required under settlements. Even if the Company were required to make any payments with regard to Hurricane Andrew related claims, the Company believes that the amount it would pay would not be material to the results of operations or financial position of the Company. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders. No matters were submitted to a vote of security holders during the fourth quarter of fiscal 1993. EXECUTIVE OFFICERS OF THE REGISTRANT The following people were the executive officers of Lennar Corporation on February 7, 1994: Mr. Leonard Miller has been the Chief Executive Officer and a director of the Company since it was founded. Mr. Cole was, until December, 1983, a member of Mershon, Sawyer, Johnston, Dunwody & Cole, a firm of attorneys in Miami, Florida. Since then he has been of counsel to that firm and has been a consultant to the Company on business and legal affairs, as well as Chairman of the Company's Executive Committee and the Company's Secretary and General Counsel. Messrs. Bolotin, Pekor, Kronick, Ames, Krasnoff and Saleda have each held substantially their present positions with the Company for more than five years. Mr. Stuart Miller (who is the son of Leonard Miller) has held various executive positions with the Company for more than five years. Mr. Timmons has been employed by the Company since 1992. Prior to joining Lennar Corporation Mr. Timmons was employed as a Financial Auditor with Burger King Corporation and KPMG Peat Marwick. Mr. Saiontz (who is the son-in-law of Leonard Miller) has held substantially the same position with the Company for more than five years. PART II Item 5.

Item 5. Market for the Registrant's Common Stock and Related Security Holder Matters. The Company's common stock is traded on the New York Stock Exchange under the symbol LEN. The following table sets forth, for the periods indicated, the high and low sales prices as reported on the New York Stock Exchange Composite Tape and per share cash dividends paid by the Company. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations RESULTS OF OPERATIONS OVERVIEW Lennar's earnings increased in 1993 to $52.5 million ($2.27 per share) from 1992 earnings of $29.1 million ($1.42 per share) on total revenues in 1993 of $666.9 million compared to $429.4 million of revenues in 1992. Fiscal 1992 earnings had increased from 1991 earnings of $21.1 million ($1.05 per share), and revenues in 1992 had increased from 1991 revenues of $325.7 million. REAL ESTATE OPERATIONS Homebuilding The Homebuilding Division constructs and sells single family attached and detached and multi-family homes. These activities accounted for 87%, 86% and 84% of total real estate operations revenues for the fiscal years ended November 30, 1993, 1992 and 1991, respectively. Revenues from the sale of homes increased 71% in 1993 and 37% in 1992, due primarily to the number of homes delivered (4,634, 3,039 and 2,480 in 1993, 1992 and 1991, respectively). Additionally, the average price of a home delivered in 1993 increased 9% to $111,100 from $101,700 in 1992, having increased 9% during 1992 from $93,100 in 1991. The higher average sales prices were due to price increases for existing products, as well as a proportionately greater number of sales of higher-priced homes. In fiscal 1993, new sales orders increased by 31% when compared to 1992, which had increased by 40% over 1991. The 1993 increase resulted in an increase of 18% in the Company's backlog of home sales contracts to 2,105 at November 30, 1993, as compared to a backlog of 1,788 contracts a year earlier. The dollar value of contracts in backlog increased 39% to $264.3 million at November 30, 1993 from $190.7 million a year earlier. Gross profits from the sales of homes, as a percentage of total homebuilding revenues, averaged 12.3% in 1993, 12.1% in 1992 and 10.2% in 1991. The increases in the gross profit percentages were mainly attributable to the higher volume of homes delivered in both years as construction and selling overhead were absorbed by a greater number of home deliveries. Start-up costs, construction overhead and selling costs are expensed as incurred and included in cost of homes sold. The increase in 1993 gross profits was achieved despite start-up costs in the Company's new homebuilding operations in Houston, Texas and Port St. Lucie, Florida and increases in lumber prices on homes which were under contract for sale at the time of the price increases. Gross profit percentages are not significantly different for the various types of homes which the Company builds. During 1993, 1992 and 1991, interest costs of $19.7 million, $16.8 million and $14.2 million, respectively, were incurred, and $17.1 million, $15.0 million and $14.2 million, respectively, were capitalized by the Company's real estate operations. Previously capitalized interest charged to cost of sales was $13.1 million in 1993, $9.5 million in 1992 and $9.3 million in 1991. Interest amounts incurred in 1993 were higher than those incurred in 1992 and 1991 due to higher debt levels in both the real estate and financial services operations. The higher debt at November 30, 1993 is a reflection of the expansion of both the real estate and financial services operations along with the assumption of debt related to the Company's acquisition of partners' interests in various joint ventures. The higher amount of interest charged to cost of sales in 1993, when compared to 1992 and 1991, is a result of the higher volume of homes delivered. This increase was partially offset by lower interest rates and the increase in land and construction inventories as the Company's business volume increased. The amount of interest capitalized by the Company's real estate operations in any one year is a function of the assets under development, outstanding debt levels and interest rates. In August 1992, Hurricane Andrew, which had winds believed to be substantially in excess of those contemplated by the South Florida Building Code, severely damaged a wide range of homes, commercial structures and schools, and substantially destroyed a United States Air Force base in south Dade County, Florida. Damage was incurred at several communities which were in the process of being built by the Company and at several of the Company's commercial properties. In the third quarter of fiscal 1992, the Company made an unusual charge against pre-tax earnings of $7.6 million ($4.9 million after taxes or $.24 per share) to provide for the damage to Company properties and other associated costs, net of insurance recoveries, due to the storm. During 1993, the Company was involved in the repairing or rebuilding of homes in south Dade County communities that were damaged by Hurricane Andrew. Revenues and costs related to this activity are included in other sales and revenues and cost of other sales and revenues. These activities did not have a significant impact on the Company's net earnings during 1993 and were substantially completed by November 30, 1993. Investment The Investment Division (formerly referred to as Asset Management), is involved in the development, management and leasing, as well as the acquisition and sale, of commercial and residential rental properties and land. During 1992 and 1993, the Company became a participant in two partnerships which manage portfolios of mortgage loans, real properties and business loans. The Company shares in the profits or losses of the partnerships and also receives fees for the management and disposition of the partnerships' assets. These partnerships are capitalized primarily by long-term debt of which none is guaranteed by the Company. Other sales and revenues which include, for the most part, the activities of the Investment Division increased in 1993 to $79.8 million from $50.8 million in 1992. The higher revenues were partially the result of additional management fees and earnings from the Company's two Investment Division partnerships. Additionally, rental income on operating properties owned directly by the Company increased during 1993 due to the addition of operating properties, increased occupancy rates and rent increases. As previously discussed, 1993 amounts also include revenues from the repair or rebuilding of homes damaged by Hurricane Andrew in the amount of $13.7 million. Other sales and revenues increased from $42.9 million in 1991 to $50.8 million in 1992 primarily as a result of increases in rental income, revenues from the Company's hotel operation and management fees. Gross profits from other sales and revenues increased to $33.9 million in 1993 from $23.2 million in 1992 and $14.4 million in 1991. These increases were due primarily to increases in earnings and management fees from the Company's partnerships as well as increases in rental income. These increases were partially offset by lower sales of real estate in 1993 when compared to the prior two periods. General and administrative expenses increased during 1993 to $28.1 million from $20.4 million in 1992. In 1991, these expenses totaled $17.3 million. The increase in general and administrative expenses in 1993, as compared to 1992, was due primarily to increases in personnel and other costs resulting from the expansion of the Company's operations. However, as a percentage of real estate revenues, these expenses decreased in 1993 to 4.7%, compared to 5.8% in 1992 and 6.6% in 1991. FINANCIAL SERVICES Financial services activities are conducted primarily through five subsidiaries of Lennar Financial Services, Inc. ("LFS"). LFS subsidiaries perform mortgage servicing activities, and arrange mortgage financing, title insurance and closing services for a wide variety of borrowers and homebuyers. Financial services' earnings before income taxes decreased to $12.9 million in 1993, from $14.0 million and $13.2 million in 1992 and 1991, respectively. The decrease in 1993 earnings was the result of fewer sales of packages of home mortgage loans. Gains recorded on these dispositions contributed $0.7 million, $2.0 million, and $4.1 million to earnings in 1993, 1992 and 1991, respectively. Also contributing to the decrease in earnings in financial services were lower earnings from servicing and origination activities. Earnings from these activities have decreased due to higher costs associated with the expansion of loan origination activities and increased mortgage payoffs. The aforementioned decreases in earnings were partially offset by increases in interest income and gains on bulk sales of mortgage loan servicing rights which contributed $3.3 million to earnings in 1993. There were no bulk sales of mortgage servicing rights in 1992 or 1991. INCOME TAXES The provision for income taxes was 36.0% of pre-tax income in 1993, 35.7% in 1992 and 36.0% in 1991. The 1993 provision was higher than that of 1992 due to the increase in the federal tax rate from 34% to 35% during the Company's fiscal year. This increase was partially offset by additional differences between book and tax basis deductions during 1993. Fiscal 1991 had fewer book and tax basis deductions when compared to the other two periods. IMPACT OF ECONOMIC CONDITIONS Real estate development during 1993, both nationally and in Florida, continued to be affected by the reduced number of thrift institutions and more restrictive credit criteria of commercial banks. The Company does not, however, borrow from thrift institutions to finance any of its activities. Instead, the Company finances its land acquisition and development activities, construction activities, mortgage banking activities and general operating needs primarily from its own base of $467.5 million of equity at November 30, 1993, as well as from commercial bank borrowings. The Company has maintained excellent relationships with the commercial banks participating in its financing arrangements, and has no reason to believe that such relationships will not continue in the future. The availability of financing based on corporate banking relationships may provide a competitive advantage to the Company. The Company anticipates that there will be adequate mortgage financing available for the purchasers of its homes during 1994 through the Company's own financial services subsidiaries as well as external sources. Low interest rates during 1993 increased demand for the Company's homes. In addition, the Company's financial services subsidiaries originated a larger volume of new mortgage loans and benefited from reduced borrowing costs. The Company's mortgage servicing operations were adversely affected by lower interest rates as an increased number of borrowers prepaid their mortgage loan. The prepayment of a loan results in the termination of the future stream of servicing revenue from such loans and reduces the value of the Company's servicing portfolio. The Company expects the refinancing trend to slow during 1994 and believes that the lower interest rate loans originated during 1993 will be less susceptible to refinancing and will therefore increase the stability and value of its servicing portfolio. Total revenues and earnings in 1994 will be affected by both the new sales order rate during the year and the backlog of home sales contracts at the beginning of the year. The Company is entering fiscal 1994 with a backlog of $264.3 million, which is 39% higher than at the beginning of the prior fiscal year. Revenues and earnings will also be positively affected by the increased activities of the Company's Investment Division partnerships as 1994 will be the first year in which both partnerships will contribute a full fiscal year of earnings. Inflation can have a long-term impact on the Company because increasing costs of land, materials and labor result in a need to increase the sales prices of homes. In addition, inflation is often accompanied by higher interest rates, which can have a negative impact on housing demand and the costs of financing land development activities and housing construction. In general, in recent years the increases in these costs have followed the general rate of inflation and hence have not had a significant adverse impact on the Company. GOVERNMENT REGULATIONS Governmental bodies in the areas where the Company conducts its business have at times imposed laws and other regulations that affect the development of real estate. These laws and regulations are often subject to change. The State of Florida has adopted a law which requires that commitments to provide roads and other offsite infrastructure be in place prior to the commencement of new construction. This law is being administered by individual counties and municipalities throughout the State and may result in additional fees and assessments, or building moratoriums. It is difficult to predict the impact of this law on future operations, or what changes may take place in the law in the future. The Company may have a competitive advantage in that it believes that most of its Florida land presently meets the criteria under the law, and it has the financial resources to provide for development of the balance of its land in compliance with the law. As a result of Hurricane Andrew, there have been changes to the various building codes within Florida. These changes have resulted in higher construction costs. The Company believes these additional costs have been recoverable through increased selling prices without any significant, adverse effect on sales volume. FINANCIAL CONDITION AND CAPITAL RESOURCES Lennar meets its short-term financing needs for its real estate activities with cash generated from operations and funds available under its unsecured revolving credit agreement. During 1993, the Company entered into a new $175 million unsecured revolving credit agreement with nine banks. The agreement currently extends until July 29, 1996, however, on each annual anniversary date of the agreement each bank has the option to participate in a one year extension. On December 3, 1993, this agreement was expanded to $190 million by admitting an additional bank. At November 30, 1993, there was $129.7 million outstanding under this agreement as compared to $44.9 million outstanding under a similar agreement as of the same date in the prior year. During 1993, a net of $68.5 million of cash was used in the Company's operations, compared to a net of $72.3 million used by operations in 1992. Cash of $87.4 million was used in 1993 to increase inventories through construction of homes, land purchases and land development. This compares to $54.5 million of cash used in 1992 to increase inventories. Additionally, $49.7 million in cash was used in 1993 to increase loans held for sale or disposition by the financial services subsidiaries, compared to $65.3 million used to increase the balance of these loans in 1992. Partially offsetting these uses of cash in 1993 was $27.2 million of cash provided by an increase in accounts payable and accrued liabilities in 1993, compared to an increase of $15.3 million in 1992. This resulted from a significant increase in real estate accounts payable due to the increased volume of homebuilding activities, and a large increase in mortgage fundings payable due to a higher volume of loan originations in the last few days of the year. Net cash used in investing activities increased during 1993 to $58.3 million from $48.7 million in 1992. In 1993, investing activities included a $21.4 million use of cash for the acquisition of additional operating properties. In addition, $20.2 million of cash was used to increase investments in and advances to partnerships and joint ventures. This increase includes $28.8 million of cash used for the acquisition of a 9.9% equity interest in a new Investment Division partnership. The increase in investments in and advances to partnerships and joint ventures was partially offset by capital distributions from the Investment Division partnership entered into in 1992. During 1993, the Company further strengthened its financial position with a successful public offering of 3,450,000 additional shares of common stock which generated net proceeds to the Company of approximately $97 million. The proceeds were used for the expansion of the Company's operations as well as the investing activities discussed above. REAL ESTATE OPERATIONS The Company finances its land acquisitions with its revolving lines of credit or purchase money mortgages or buys land under option agreements, which permit the Company to acquire portions of properties when it is ready to build homes on them. The financial risk of adverse market conditions associated with longer term land holdings is managed by strategic purchasing in areas that the Company has identified as desirable growth markets along with careful management of the land development process. The Company believes that its land inventories give it a competitive advantage, especially in Florida, where developers face government constraints and regulations which will limit the number of available homesites in future years. Based on its current financing capabilities, the Company does not believe that its land holdings have any adverse effect on its liquidity. The Company has also borrowed on a secured term loan basis in order to supplement its short-term borrowings. These term loans, which are collateralized principally by certain real estate held for future use and operating properties, amounted to $50 million at November 30, 1993 and are due in 1996. Total secured borrowings, which include the term loan debt, as well as mortgage notes payable on certain operating properties and land, were $108.4 million at fiscal year-end 1993 and $132.8 million at November 30, 1992. A significant portion of inventories, land held for investment, model homes and operating properties remained unencumbered at the end of the current fiscal year. Total real estate operations borrowings increased to $242.2 million at November 30, 1993 from $177.7 million at November 30, 1992. However, due to increased equity, the real estate debt-to-equity ratio improved to 51.8% at the end of fiscal 1993, compared to 55.6% one year earlier. The increase in real estate debt is attributable to increases in construction in progress, land inventories, partnership investments, and the assumption of liabilities upon the purchase of three former real estate joint ventures. FINANCIAL SERVICES Lennar Financial Services subsidiaries finance their mortgage loans held for sale on a short-term basis by either pledging them as collateral for borrowings under two lines of credit totaling $200 million or borrowing funds from Lennar in instances where, on a consolidated basis, the overall cost of funds is minimized. Total borrowings under the two lines of credit were $167.6 million and $144.4 million at November 30, 1993 and 1992, respectively. This increase is due mainly to the $52.7 million increase in loans held for sale or disposition described below. LFS subsidiaries dispose of the mortgage loans they originate or purchase and convert the majority of such mortgage loans to cash within thirty to sixty days of origination or purchase. At November 30, 1993, the balance of loans held for sale or disposition was $243.1 million, compared with $190.4 million one year earlier. The increase represents greater mortgage production by LFS' mortgage banking subsidiaries. LIMITED-PURPOSE FINANCE SUBSIDIARIES Limited-purpose finance subsidiaries of LFS have placed mortgage loans and other receivables as collateral for various long-term financings. These subsidiaries pay the debt service on the long-term borrowings primarily from the cash flows generated by the related pledged collateral; and therefore, the related interest income and interest expense, for the most part, offset one another in each of the three years ended November 30, 1993. The Company believes that the cash flows generated by these subsidiaries will be adequate to meet the required debt payment schedules. Based on the Company's current financial condition and credit relationships, Lennar believes that its operations and borrowing resources will provide for its current and long-term capital requirements at the Company's anticipated levels of growth. NEW ACCOUNTING PRONOUNCEMENTS Statement of Financial Accounting Standards ("SFAS") No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions", becomes effective for fiscal years beginning after December 15, 1992, and SFAS No. 112, "Employers' Accounting for Postemployment Benefits", becomes effective for fiscal years beginning after December 15, 1993. Neither SFAS No. 106 nor SFAS No. 112 will have a material impact on the Company's financial statements. SFAS No. 109, "Accounting for Income Taxes", must be adopted by the Company in fiscal 1994. SFAS No. 109 requires a change from the deferred method under APB Opinion 11 to the asset and liability method of accounting for income taxes. Under the asset and liability method of SFAS No. 109, deferred income taxes are recognized for future tax consequences attributable to the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under SFAS No. 109, the effect on deferred taxes of a change in tax rates is recognized in the period that includes the enactment date. Upon adoption of SFAS No. 109, the Company plans to apply the provisions of the Statement without restating prior years' financial statements. It is estimated that the adoption of SFAS No. 109 will result in a reduction of the net deferred tax liability by approximately $5.0 million and that this amount will be reported separately as the cumulative effect of a change in the method of accounting for income taxes in the consolidated statement of earnings for the year ending November 30, 1994. KPMG PEAT MARWICK CERTIFIED PUBLIC ACCOUNTANTS ONE BISCAYNE TOWER TELEPHONE 305 358-2300 TELEFAX 305 577 0544 SUITE 2900 2 SOUTH BISCAYNE BOULEVARD MIAMI, FL 33131 INDEPENDENT AUDITORS' REPORT The Board of Directors Lennar Corporation: We have audited the accompanying consolidated balance sheets of Lennar Corporation and subsidiaries as of November 30, 1993 and 1992, and the related consolidated statements of earnings, cash flows and stockholders' equity for each of the years in the three-year period ended November 30, 1993. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in Item 14(a)2. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Lennar Corporation and subsidiaries as of November 30, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended November 30, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG PEAT MARWICK January 18, 1994 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - --------------------------------------------------------------------------- Lennar Corporation and Subsidiaries November 30, 1993, 1992 and 1991 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF CONSOLIDATION The accompanying consolidated financial statements include the accounts of Lennar Corporation and all wholly-owned subsidiaries (the "Company"). The Company's investments in partnerships and joint ventures are accounted for by the equity method. All significant intercompany transactions and balances have been eliminated. REVENUE RECOGNITION Revenues from sales of homes are recognized when the sales are closed and title passes to the new homeowners. Revenues from sales of other real estate (including the sales of land and operating properties) are recognized when a significant down payment is received, the earnings process is complete, and the collection of any remaining receivables is reasonably assured. INVENTORIES Inventories are stated at the lower of accumulated costs or market. Market value is evaluated at the community level and is defined as the estimated proceeds upon disposition less all future costs to complete and sell. Inventory adjustments to market value in 1993, 1992 and 1991 were not material to the Company. Start-up costs, construction overhead and selling expenses are expensed as incurred and are included in cost of homes sold. Homes held for sale are classified as construction in progress until delivered. Land, land development, amenities and other costs are accumulated by specific area and allocated proportionately to homes within the respective area. CAPITALIZATION OF INTEREST AND REAL ESTATE TAXES Interest and real estate taxes attributable to land, homes and operating properties are capitalized and added to the cost of those properties as long as the properties are being actively developed. During 1993, 1992 and 1991 interest costs of $19.7 million, $16.8 million and $14.2 million, respectively, were incurred, and $17.1 million, $15.0 million and $14.2 million, respectively, were capitalized by the Company's real estate operations. Previously capitalized interest charged to cost of sales was $13.1 million in 1993, $9.5 million in 1992 and $9.3 million in 1991. OPERATING PROPERTIES AND EQUIPMENT Operating properties and equipment are recorded at cost. Depreciation is calculated to amortize the cost of depreciable assets over their estimated useful lives using the straight-line method. The range of estimated useful lives for operating properties is 15 to 40 years and for equipment is 2 to 10 years. WARRANTIES Warranty liabilities are not significant as the Company subcontracts virtually all segments of construction to others and its contracts call for the subcontractors to repair or replace any deficient items related to their trade. Extended warranties are offered in some communities through independent homeowner warranty insurance companies. The costs of these warranties are expensed in the period the homes are delivered. - --------------------------------------------------------------------------- INCOME TAXES The Company and its subsidiaries file a consolidated federal income tax return. Income taxes are accounted for under the Accounting Principles Board Opinion ("APB") No. 11, however, the Company will be required to adopt Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes", which supersedes APB No. 11 effective December 1, 1993. NET EARNINGS PER SHARE Net earnings per share is calculated by dividing net earnings by the weighted average number of the total of common shares and Class B common shares outstanding during the year. The weighted average number of shares outstanding was 23,139,000, 20,495,000 and 20,114,000 in 1993, 1992 and 1991, respectively. FINANCIAL SERVICES Mortgage loans held for sale or disposition by Lennar Financial Services Inc. ("LFS") are recorded at the lower of cost or market, as determined on an aggregate basis. Discounts recorded on these loans are presented as a reduction of the carrying amount of the loans and are not amortized. LFS enters into forward sales and option contracts to protect the value of loans held for sale or disposition from increases in market interest rates. Adjustments are made to these loans based on changes in the market value of these hedging contracts. When LFS sells loans or mortgage-backed securities in the secondary market, a gain or loss is recognized to the extent that the sales proceeds exceed, or are less than, the book value of the loans or the securities. Loan origination fees, net of direct origination costs, are deferred and recognized as a component of the gain or loss when loans are sold. LFS generally retains the servicing on the loans and mortgage-backed securities it sells. LFS recognizes servicing fee income as those services are performed. FAIR VALUE OF FINANCIAL INSTRUMENTS Statement of Financial Accounting Standard No. 107, "Disclosures about Fair Value of Financial Instruments", requires companies to disclose the estimated fair value of their financial instrument assets and liabilities. The estimated fair values have been determined by the Company using available market information and appropriate valuation methodologies. The fair values are significantly affected by the assumptions used including the discount rate and estimates of cash flow. Accordingly, the use of different assumptions may have a material effect on the estimated fair values. The estimated fair values presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange. RECLASSIFICATION Certain prior year amounts in the consolidated financial statements have been reclassified to conform with the 1993 presentation. - --------------------------------------------------------------------------- 2. LINES OF BUSINESS The Company operates principally in two lines of business: (1) real estate, which includes the activities of the parent company (Lennar Corporation), the Homebuilding Division and the Investment Division (formerly referred to as Asset Management); and (2) financial services, which includes certain activities of LFS, but excludes the limited-purpose finance subsidiaries. The Homebuilding Division constructs and sells single-family (attached and detached) and multi-family homes. The Investment Division is involved in the development, management and leasing, as well as the acquisition and sale, of commercial and residential properties and land. This division also manages and participates in partnerships with financial institutions. Financial services activities are conducted primarily through five LFS Subsidiaries: Universal American Mortgage Company ("UAMC"), AmeriStar Financial Services, Inc., Universal Title Insurors, Inc., Lennar Funding Corporation and Loan Funding, Inc. These subsidiaries arrange mortgage financing, title insurance, and closing services for Lennar homebuyers and others, acquire, package and resell home mortgage loans, and perform mortgage loan servicing activities. The limited-purpose finance subsidiaries of LFS have placed mortgages and other receivables as collateral for various long-term financings. These limited-purpose finance subsidiaries are not considered a part of the financial services operations for lines of business purposes and, as such, are reported separately. - --------------------------------------------------------------------------- 3. UNUSUAL ITEM - HURRICANE DAMAGE On August 24, 1992, the South Florida area was hit by a severe hurricane which affected a portion of the Company's Dade County real estate operations. The results of operations for the year ended November 30, 1992 include an unusual charge of $7.6 million, before income taxes, representing the cost of the damage to the Company's inventories, properties and similar costs associated with the destruction caused by Hurricane Andrew. - --------------------------------------------------------------------------- 4. RESTRICTED CASH Cash includes restricted deposits of $4,154,000 and $2,041,000 as of November 30, 1993 and 1992, respectively. These balances are comprised primarily of escrow deposits held related to condominium purchases and security deposits from tenants of commercial and apartment properties. - --------------------------------------------------------------------------- 5. SUMMARY OF NONCASH INVESTING AND FINANCING ACTIVITIES During the first quarter of 1993, the Company acquired a portfolio of loans from the Resolution Trust Corporation for $24.8 million. Of this amount, $5.0 million was paid in cash, and the Company issued a non-recourse note in the amount of $19.8 million for the remainder. Also, during 1993, the Company purchased the other partners' interests in three of its joint ventures. As a result, the operations of these ventures were consolidated into the accounts of the Company as of the respective dates of acquisition. The net result of these transactions was to decrease investments in and advances to partnerships and joint ventures by $34.9 million, increase all other assets by $73.7 million and increase liabilities by $38.8 million. - --------------------------------------------------------------------------- 7. INVESTMENTS IN AND ADVANCES TO PARTNERSHIPS AND JOINT VENTURES (CONTINUED) During 1993, the Company acquired a 9.9% equity interest in LW Real Estate Investments L.P., a partnership between Westinghouse Electric Corporation and an affiliate of Lehman Brothers. This partnership has selected the Company to manage its portfolio of commercial real estate assets. During 1992, Lennar Florida Partners, a partnership between a subsidiary of the Company and The Morgan Stanley Real Estate Fund, L.P., was formed to acquire and manage a portfolio of mortgage loans, business loans and real property. The Company's initial contribution to this partnership amounted to 25% of the partnership's total equity. After the partners have recovered their investment, plus a return, the Company will be entitled to 50% of the partnership's cash flows. The Company shares in the profits or losses of both partnerships, and also receives fees for the management and disposition of the assets. The outstanding debt of the partnerships is not guaranteed by the Company. The Company acquired the other partners interest in three of its joint ventures during 1993. As a result, the operations of the ventures have been consolidated into the accounts of the Company as of the respective dates of acquisition. - --------------------------------------------------------------------------- 9. MORTGAGE NOTES AND OTHER DEBTS PAYABLE (CONTINUED) On July 29, 1993, the Company entered into a new $175 million unsecured revolving credit agreement with nine banks. The agreement was expanded to $190 million on December 3, 1993 by admitting an additional bank. The term of the agreement is three years. On every anniversary date of the agreement each bank has the option to participate in a one year extension. The interest rate under this agreement fluctuates with market rates and was 4.8% at November 30, 1993. At November 30, 1993, the Company was party to interest rate swap agreements which replaced the floating interest rates on $45 million of debt, with fixed rates ranging from 8.7% to 10.2%. These agreements expire in 1994 and 1996. The minimum aggregate principal maturities of mortgage notes and other debts payable required during the five years subsequent to November 30, 1993, assuming that the revolving credit agreement is not extended, are as follows (in thousands): 1994-$23,027; 1995-$5,551; 1996-$180,284; 1997- $8,439 and 1998-$12,419. All of the notes secured by land contain collateral release provisions for accelerated payment which may be made as necessary to maintain construction schedules. The fair value of interest rate swaps at November 30, 1993 was $3.5 million. The estimated fair values represent a net unrealized loss. The value is based on dealer quotes and generally represents an estimate of the amount the Company would pay to terminate the agreement at the reporting date, taking into account current interest rates and the credit worthiness of the counterparties. The fair values of the Company's fixed rate borrowings are estimated using discounted cash flow analyses, based on the Company's current incremental borrowing rates of similar type of borrowing arrangements. The fair values of these borrowings at November 30, 1993 approximated their carrying value. The interest rates on variable rate borrowings are tied to market indices. Accordingly, fair value approximates their carrying value. - ---------------------------------------------------------------------------- The Financial Services Division finances its activities through its two bank lines of credit, which amount to $200 million, or borrowings from Lennar Corporation, when on a consolidated basis the Company can minimize its cost of funds. The two lines of credit expire in March and July 1994, unless otherwise extended. Borrowings under these agreements were $167.6 million and $144.4 million at November 30, 1993 and 1992, respectively, and were collateralized by mortgage loans with outstanding principal balances of $155.9 million and $137.4 million, respectively, and by servicing rights to approximately $2.2 billion and $1.8 billion, respectively, of loans serviced by LFS. There are several interest rate pricing options which fluctuate with market rates. The borrowing rate has been reduced to the extent that custodial escrow balances exceeded required compensating balance levels. The effective interest rate on these agreements at November 30, 1993 was 2.4%. The Financial Services Division is party to financial instruments in the management of its exposure to interest rate fluctuations. Forward sales contracts and options are used by the division to hedge mortgage loans held for sale and in its pipeline of loan applications in process. By hedging in the instruments that the division will create, market interest rate risk is reduced. Gains and losses on these hedging transactions have not been material to the Company. Exposure to credit risk is managed through evaluation of trading partners, limits of exposure, and monitoring procedures. At November 30, 1993 and 1992, the Financial Services Division was a party to approximately $212 million and $183 million, respectively, of forward sales contracts and options. Certain of the division's servicing agreements require it to pass through payments on loans even though it is unable to collect such payments and, in certain instances, be responsible for losses incurred through foreclosure. Exposure to this credit risk is minimized through geographic diversification and review of the mortgage loan servicing created or purchased. Management believes that it has provided adequate reserves for expected losses based on the net realizable value of the underlying collateral. Provisions for these losses have not been material to the Company. The division is also subject to prepayment risk on the servicing portfolio. Exposure to prepayment risk is managed by the division's ongoing evaluation of prepayment possibilities, and by the Company's active involvement in the refinancing business. The fair value of loans held for sale at November 30, 1993 approximated carrying value. The fair value was based on quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics, net of the difference between the settlement value and the quoted market values of forward commitments and options to buy and sell mortgage-backed securities. - --------------------------------------------------------------------------- 12. LIMITED-PURPOSE FINANCE SUBSIDIARIES In prior years, limited-purpose finance subsidiaries of LFS placed mortgages and other receivables as collateral for various long-term financings. These limited-purpose finance subsidiaries pay the principal of, and interest on, these financings primarily from the cash flows generated by the related pledged collateral which includes a combination of mortgage notes, mortgage- backed securities and funds held by trustee. The fair value of the collateral for the bonds and notes payable at November 30, 1993 was $135.5 million and was based on quoted market prices for similar securities. BONDS AND NOTES PAYABLE At November 30, 1993 and 1992, the balances outstanding for the bonds and notes payable were $121.4 million and $174.2 million, respectively. The borrowings mature in years 2013 through 2018 and carry interest rates ranging from 5.1% to 14.3%. The annual principal repayments are dependent upon collections on the underlying mortgages, including prepayments, and cannot be reasonably determined. The fair value of the bonds and notes payable at November 30, 1993 was $128.0 million and was based on quoted market prices for similar securities. - --------------------------------------------------------------------------- 14. CAPITAL STOCK COMMON STOCK The Company has two classes of common stock. The common stockholders have one vote for each share owned, in matters requiring stockholder approval, and during 1993 received quarterly dividends of $.03 per share. Class B common stockholders have ten votes for each share of stock owned and during 1993 received quarterly dividends of $.025 per share. As of November 30, 1993, Mr. Leonard Miller, Chairman of the Board and President of the Company, owned 6.6 million shares of Class B common stock, which represents approximately 79% voting control of the Company. STOCK OPTION PLANS The Lennar Corporation 1980 Stock Option Plan ("1980 Plan") expired on December 8, 1990. However, under the terms of the 1980 Plan, certain options granted prior to the plan termination date are still outstanding. Unless exercised or cancelled, the last options granted under the 1980 Plan will expire in December 1995. - --------------------------------------------------------------------------- The Lennar Corporation 1991 Stock Option Plan ("1991 Plan") provides for the granting of options to certain key employees of the Company to purchase shares at prices not less than market value as of the date of the grant. No options granted under the 1991 Plan may be exercisable until at least six months after the date of the grant. Thereafter, exercises are permitted in varying installments, on a cumulative basis. Each stock option granted will expire on a date determined at the time of the grant, but not more than 10 years after the date of the grant. - --------------------------------------------------------------------------- EMPLOYEE STOCK OWNERSHIP/401(K) PLAN The Employee Stock Ownership / 401(k) Plan ("Plan") provides shares of stock to employees who have completed one year of continuous service with the Company. All contributions for employees with five years or more of service are fully vested. The Plan was amended in 1989 to add a cash or deferred program under Section 401(k) of the Internal Revenue Code. Under the 401(k) portion of the Plan, employees may make contributions which are invested on their behalf, and the Company may also make contributions for the benefit of employees. The Company records as compensation expense an amount which approximates the vesting of the contributions to the Employee Stock Ownership portion of the Plan, as well as the Company's contribution to the 401(k) portion of the Plan. This amount was (in thousands): $361 in 1993, $366 in 1992 and $356 in 1991. In 1993, 1992 and 1991, 9,200, 39 and 5,968 shares, respectively, were contributed to participants' accounts. Additionally, in 1992 and 1991, 8,716 and 5,340 shares, respectively, were credited to participants' accounts from previously forfeited shares. RESTRICTIONS ON PAYMENT OF DIVIDENDS Other than as required to maintain the financial ratios and net worth requirements under the revolving credit and term loan agreements, there are no restrictions on the payment of common stock dividends by the Company. The cash dividends paid with regard to a share of Class B common stock in a calendar year may not be more than 90% of the cash dividends paid with regard to a share of common stock in that calendar year. Furthermore, there are no agreements which restrict the payment of dividends by subsidiaries to the Company. As of November 30, 1993, the Company's share of undistributed earnings from partnerships was not significant. 15. COMMITMENTS AND CONTINGENT LIABILITIES The Company and certain subsidiaries are parties to various claims, legal actions and complaints arising in the ordinary course of business. In the opinion of management, the disposition of these matters will not have a material adverse effect on the financial condition of the Company. During 1993, the Company settled two lawsuits and a number of claims in which owners of approximately 550 homes built by the Company sought damages as a result of Hurricane Andrew. There still remain approximately 125 additional homeowners who have asserted claims. Other homeowners or homeowners' insurers are not precluded from making similar claims against the Company. Four insurance companies have contacted the Company seeking reimbursement for sums paid by them with regard to homes built by the Company and damaged by the storm. Other claims of this type may be asserted. The Company's insurers have asserted that their policies cover some, but not all, aspects of these claims. However, to date, the Company's insurers have made all payments required under settlements. Even if the Company were required to make any payments with regard to Hurricane Andrew related claims, the Company believes that the amount it would pay would not be material. 15. COMMITMENTS AND CONTINGENT LIABILITIES (CONTINUED) The Company is subject to the usual obligations associated with entering into contracts for the purchase, development and sale of real estate in the routine conduct of its business. The Company is committed, under various letters of credit, to perform certain development and construction activities in the normal course of business. Outstanding letters of credit under these arrangements totaled approximately $41.0 million at November 30, 1993. Quarterly and year-to-date computations of per share amounts are made independently. Therefore, the sum of per share amounts for the quarters may not agree with per share amounts for the year. - --------------------------------------------------------------------------- Item 9. Disagreements on Accounting and Financial Disclosure. Not applicable. *************************************************************************** PART III Item 10. Directors and Executive Officers of the Registrant. Information about the Company's directors is incorporated by reference to the Company's definitive proxy statement, which will be filed with the Securities and Exchange Commission not later than March 30, 1994 (120 days after the end of the Company's fiscal year). Information about the Company's executive officers is contained in Part I of this Report under the caption "Executive Officers of the Registrant". Item 11. Executive Compensation. The information called for by this item is incorporated by reference to the Company's definitive proxy statement, which will be filed with the Securities and Exchange Commission not later than March 30, 1994 (120 days after the end of the Company's fiscal year). Item 12. Security Holdings of Certain Beneficial Owners and Management. The information called for by this item is incorporated by reference to the Company's definitive proxy statement, which will be filed with the Securities and Exchange Commission not later than March 30, 1994 (120 days after the end of the Company's fiscal year). Item 13. Certain Relationships and Related Transactions. The information called for by this item is incorporated by reference to the Company's definitive proxy statement, which will be filed with the Securities and Exchange Commission not later than March 30, 1994 (120 days after the end of the Company's fiscal year). PART IV Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) Documents filed as part of this Report. 1. The following financial statements are included in Item 8:

46207_1993.txt

46207

1993

ITEM 1. BUSINESS HEI HEI was incorporated in 1981 under the laws of the State of Hawaii and is a holding company with subsidiaries engaged in the electric utility, financial services, freight transportation, real estate development and other businesses, in each case primarily or exclusively in the State of Hawaii. HEI's predecessor, HECO, was incorporated under the laws of the Kingdom of Hawaii (now the State of Hawaii) on October 13, 1891. As a result of a 1983 corporate reorganization, HECO became an HEI subsidiary and common shareholders of HECO became common shareholders of HEI. HECO and its subsidiaries, MECO and HELCO, are regulated operating public utilities providing the only public utility electric service on the islands of Oahu, Maui, Lanai, Molokai and Hawaii. HEI also owns directly or indirectly the following nonelectric public utility subsidiaries which comprise its diversified companies: HEIDI and its subsidiary, ASB, and ASB's subsidiaries; HTB and its subsidiary; MPC and its subsidiaries; HEIIC; and LVI. HEIDI is also the holder of record of the common stock of HIG, which was acquired in 1987 and provided property and casualty insurance primarily in Hawaii. HIG is currently in rehabilitation proceedings and it is expected that HEIDI will relinquish all ownership rights in HIG and its subsidiaries during 1994. See "Discontinued operations--The Hawaiian Insurance & Guaranty Co., Limited." ASB was acquired in 1988, is the second largest savings bank in Hawaii as measured by total assets as of September 30, 1993, and has 45 retail branches as of December 31, 1993. HTB was acquired in 1986 and provides ship assist and charter towing services and owns YB, a regulated intrastate public carrier of waterborne freight among the Hawaiian Islands. MPC was formed in 1985 and develops and invests in real estate. HEIIC was formed in 1984 and is a passive investment company which has sold substantially all of its investments in marketable securities over the last few years and currently plans no new investments. In March of 1993, pursuant to the decision made at the end of the third quarter of 1992, the stock of HERS, formerly an HEI wind energy subsidiary, was sold to The New World Power Corporation and LVI became a direct subsidiary of HEI. See "Discontinued operations -- Hawaiian Electric Renewable Systems, Inc." The financial information about the Company's industry segments is incorporated herein by reference to page 28 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a). For additional information about the Company, reference is made to "Management's Discussion and Analysis of Financial Condition and Results of Operations," incorporated herein by reference to pages 29 to 39 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a). RATING AGENCIES' ACTIONS On February 8, 1993, Standard & Poor's (S&P) lowered HEI's and HECO's long- term credit ratings. S&P lowered HEI's medium-term note credit rating to BBB from BBB+, citing HECO's reduced credit worthiness and the write-off of HEI's investment in HIG. S&P noted that considerable political and financial uncertainty will remain until the ultimate impact of HIG on HEI is determined. S&P maintained a negative rating outlook reflecting downward pressure on HEI's and HECO's earnings which could intensify in the absence of adequate rate relief for HECO. HEI's commercial paper rating of A-2 was reaffirmed. On February 26, 1993, Duff & Phelps Credit Rating Co. (D&P) lowered HEI's medium-term note rating to BBB+ from A- due to the continuing uncertainty surrounding HEI and its decision to cease operations at HIG. D&P noted that the extent of additional financial responsibility ultimately required, if any, is unknown, which adds risk that was not reflected in D&P's prior rating. HEI's commercial paper rating of Duff 1- (one-minus) was reaffirmed. On February 11, 1994, in response to HEI's announcement that it signed an agreement to settle the lawsuit filed by the Hawaii Insurance Commissioner and Hawaii Insurance Guaranty Association against HEI relating to losses sustained by HIG from Hurricane Iniki, D&P stated that the settlement and additional charge to income fit within the assumptions pertinent to D&P's current ratings for HEI. The settlement agreement is subject to court approval. (See "Discontinued operations -- The Hawaiian Insurance & Guaranty Co., Ltd. for a further discussion on the settlement agreement.) On April 28, 1993, Moody's Investor Service (Moody's) confirmed the credit ratings of HEI, citing HEI's plans to issue additional common equity in order to rebalance its capital structure. Moody's stated that its concerns regarding a lawsuit associated with HIG and stemming from Hurricane Iniki are partially mitigated by the possible long period before a fully litigated decision is reached. The confirmation concluded a review for possible downgrade initiated on December 4, 1992. In October 1993, S&P completed its review of the U.S. investor-owned electric utility industry and concluded that more stringent financial risk standards are appropriate to counter mounting business risk. "S&P believes the industry's credit profile is threatened chiefly by intensifying competitive pressures," the agency said in a statement. It also cited sluggish demand expectations, slow earnings growth prospects, high dividend payouts and environmental cost pressures. Under the new guidelines, S&P rated HECO's business position as average. As of February 11, 1994, HEI's and HECO's S&P, Moody's and D&P security ratings were as follows: N/A Not applicable. (1) S&P. Debt rated BBB or BBB+ is regarded as having an adequate capacity to pay interest and repay principal. Whereas it normally exhibits adequate protection parameters, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity to pay interest and repay principal for debt in this category than in higher rated categories. The ratings may be modified by the addition of a plus or minus sign to show relative standing within the major categories. A commercial paper rating is a current assessment of the likelihood of timely payment of debt having an original maturity of no more than 365 days. Commercial paper rated A-2 indicates that capacity for timely payment on issues is satisfactory. (2) Moody's. Bonds which are rated Baa2 or Baa1 are considered as medium grade obligations, i.e., they are neither highly protected nor poorly secured. Interest payment and principal security appear adequate for the present but certain protective elements may be lacking or may be characteristically unreliable over any great length of time. Such bonds lack outstanding investment characteristics and in fact have speculative characteristics as well. Bonds which are rated A3 possess many favorable investment attributes and are to be considered as upper medium grade obligations. Factors giving security to principal and interest are considered adequate but elements may be present which suggest a susceptibility to impairment sometime in the future. Preferred stock rated baa1 is considered to be a medium grade preferred stock, neither highly protected nor poorly secured. Earnings and asset protection appear adequate at present but may be questionable over a great length of time. Numeric modifiers are added to debt and preferred stock ratings. Numeric modifier 1 indicates that the security ranks in the higher end of its generic rating category and numeric modifier 2 indicates a mid-range ranking. Commercial paper rated P-2 is considered to have a strong ability for repayment of senior short-term obligations. This will normally be evidenced by the following characteristics: a) leading market positions in well- established industries, b) high rates of return on funds employed, c) conservative capitalization structure with moderate reliance on debt and ample asset protection, d) broad margins in earnings coverage of fixed financial charges and high internal cash generation and e) well established access to a range of financial markets and assured sources of alternate liquidity. Earnings trends and coverage ratios, while sound, may be more subject to variation. Capitalization characteristics, while still appropriate, may be more affected by external conditions. Ample alternate liquidity is maintained. (3) Duff & Phelps. Debt rated BBB+ is regarded as having below average protection factors, but still considered sufficient for prudent investment. There may be considerable variability in risk during economic cycles. Debt rated A or A- is considered to have protection factors that are average but adequate. However, risk factors are more variable and greater in periods of economic stress. Commercial paper rated Duff 1- indicates a high certainty of timely payment. Liquidity factors are strong and supported by good fundamental protection factors. Risk factors are very small. Each security rating listed above is not a recommendation to buy, sell or hold securities. Each rating may be subject to revision or withdrawal at any time by the assigning rating organization and should be evaluated independently of any other rating. Neither HEI nor HECO management can predict with certainty future rating agency actions or their effects on the future cost of capital of HEI or HECO. ELECTRIC UTILITY HECO AND SUBSIDIARIES AND SERVICE AREAS HECO, MECO and HELCO are regulated operating electric public utilities engaged in the production, purchase, transmission, distribution and sale of electricity on the islands of Oahu; Maui, Lanai and Molokai; and Hawaii, respectively. HECO acquired MECO in 1968 and HELCO in 1970. In 1993, the electric utilities contributed approximately 77% of HEI's consolidated revenues from continuing operations and approximately 76% of HEI's consolidated operating income from continuing operations, excluding unallocated corporate expenses and eliminations. At December 31, 1993, the assets of the electric utilities represented approximately 38% of the total assets of the Company, excluding assets at the corporate level and eliminations. For additional information about the electric utilities, see "Management's Discussion and Analysis of Financial Condition and Results of Operations," incorporated herein by reference to pages 29 to 39 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a) and pages 3 to 9 of HECO's 1993 Annual Report to Stockholder, portions of which are filed herein as HECO Exhibit 13(b). The islands of Oahu, Maui, Lanai, Molokai and Hawaii have a combined population estimated at 1,104,000, or approximately 95% of the population of the State of Hawaii, and cover a service area of 5,766 square miles. The principal communities served include Honolulu (on Oahu), Wailuku and Kahului (on Maui) and Hilo and Kona (on Hawaii). The service areas also include numerous suburban communities, resorts, U.S. Armed Forces installations and agricultural operations. HECO, MECO and HELCO have nonexclusive franchises from the state covering certain areas and authorizing them to construct, operate and maintain facilities over and under public streets and sidewalks. HECO's franchise covers the City & County of Honolulu, MECO's franchises cover the islands of Maui, Lanai and Molokai in the County of Maui and the small County of Kalawao on the island of Molokai, and HELCO's franchise covers the County of Hawaii. Each of these franchises will continue in effect for an indefinite period of time until forfeited, altered, amended or repealed. SALES OF ELECTRICITY HECO, MECO and HELCO provide the only electric public utility service on the islands they serve. The following table sets forth the numberEof their electric customer accounts as of December 31, 1993, 1992 and 1991 and their electric sales revenues for each of the years then ended: (1) Includes the effect of the change in the method of estimating unbilled kilowatthour sales and revenues. Revenues from the sale of electricity in 1993 were from the following types of customers in the proportions shown: Total electricity sales for all three utilities in 1993 were 8,325 million kilowatthours (KWH), a 0.1% decrease from 1992 sales. The relatively low sales in 1993 reflect cooler weather, the slowing in the state economy and conservation efforts. Approximately 10% of consolidated operating revenues of HECO and its subsidiaries was derived from the sale of electricity to various federal government agencies in 1993, 1992 and 1991. HECO's fifth largest customer, the Naval Base at Barbers Point, Oahu, is expected to be closed within the next four to five years. On March 8, 1994, President Clinton signed an Executive Order which mandates that each federal agency develop and implement a program with the intent of reducing energy consumption by 30% by the year 2005 to the extent that these measures are cost-effective. The 30% reductions will be measured relative to the agency's 1985 energy use. HECO is working with various Department of Defense installations to implement demand-side management programs which will help them achieve their energy reduction objectives. It is expected that several Department of Defense installations will sign a Basic Ordering Agreement under which HECO will implement the energy conservation projects. Neither HEI nor HECO management can predict with certainty the impact of President Clinton's Executive Order on the Company's or consolidated HECO's future results of operations. SELECTED CONSOLIDATED ELECTRIC UTILITY OPERATING STATISTICS * Sum of the peak demands on all islands served, noncoincident and nonintegrated. ** Includes the effect of the change in the method of estimating unbilled KWH sales and revenues. *** Excluding the effect of the change in the method of estimating unbilled KWH sales and revenues, losses and system uses would have been 5.6%. GENERATION STATISTICS The following table contains certain generation statistics as of December 31, 1993, and for the year ended December 31, 1993. The capability available for operation at any given time may be less than the generating capability shown because of temporary outages for inspection, maintenance, repairs or unforeseen circumstances. (1) HECO units at normal ratings less 14.0 MW due to capability restrictions, and MECO and HELCO units at reserve ratings. (2) Noncoincident and nonintegrated. (3) Independent power producers - 180.0 MW (Kalaeloa), 180.0 MW (AES-BP) and 46.0 MW (HRRV). (4) Non-utility generation-MECO: 16.0 MW (Hawaiian Commercial & Sugar Company) and HELCO: 25.0 MW (Puna Geothermal Ventures), 18.0 MW (HCPC) and 8.0 MW (Hamakua Sugar Company). Hamakua Sugar Company filed for bankruptcy in 1992 and is expected to discontinue operations in 1994. REQUIREMENTS AND PLANS FOR ADDITIONAL GENERATING CAPACITY Each of the three utilities completed its first Integrated Resource Plan (IRP) in 1993. These plans identified and evaluated a mix of resources to meet near- and long-term consumer energy needs in an efficient and reliable manner at the lowest reasonable cost. The IRPs include demand-side management (DSM) programs to reduce load and fuel consumption and consider the impact on the environment, culture, community lifestyles and economy of the state. On July 1, 1993, HECO filed its first Integrated Resource Plan with the Hawaii Public Utilities Commission (PUC). This plan was subsequently modified in January 1994 due to a change in load forecast. The decrease in the load forecast, the inclusion of the impact of proposed DSM programs, and the deferred retirement of Honolulu Unit Nos. 8 & 9 until 2004, allowed HECO to defer its next generating unit addition to the year 2005. In its plan, HECO recommended that this next generating unit be a coal-fired atmospheric fluidized bed combustion unit to provide a fuel alternative to oil. Because of the uncertainty of the impact of new environmental regulations and the political pressure to remove Honolulu Power Plant from downtown Honolulu earlier than the 2004 time frame, alternate plans are being developed to add generating capacity earlier if necessary. MECO completed construction of its first 58-MW dual-train combined-cycle facility in 1993 at a cost of $78 million. On December 15, 1993, MECO filed its first IRP with the PUC. MECO plans to add a second dual-train combined-cycle unit with the addition of a 20-MW combustion turbine (CT) in 1996, another 20-MW CT in 1999 and the conversion of these units into a 58-MW combined-cycle unit with the addition of an 18-MW steam turbine in 2000. MECO's Molokai Division plans to purchase three 2.2-MW diesel units; two in 1995 and one in 1996. MECO's Lanai Division plans to add three 2.2-MW diesel units in 1996. On October 15, 1993, HELCO filed its first IRP with the PUC. HELCO has a power purchase agreement with Puna Geothermal Ventures (PGV) for 25 MW which became a firm source of power on June 27, 1993. Hamakua Sugar Company filed for bankruptcy in 1992 and ceased power production on May 7, 1993, but resumed on July 15, 1993, under a court-approved harvest plan which is expected to continue over a period of 10 to 16 months. It is expected that Hamakua's capacity of 8MW will be unavailable to HELCO by the end of 1994. Hilo Coast Processing Company (HCPC) will discontinue harvesting sugar cane in late 1994 and has indicated that it may increase its power export capability and switch its primary fuel from bagasse (sugarcane waste) to coal. This would require a new modified power purchase agreement, which would be subject to PUC approval. For capacity planning, HELCO assumed that HCPC would continue to provide 18 MW of firm power to HELCO under the existing power purchase agreement. The installation of a phased combined-cycle unit is proceeding. The service date for the first CT, CT-4, is scheduled for July 1, 1995 pending Conservation District Use Application approval at the existing Keahole Power Plant site. Although capacity after CT-4 is not required until April 1996, CT-5 is scheduled to be installed immediately after CT-4 in September 1995 based on economies of the earlier schedule which allows HELCO to use the same construction contract as CT-4. In addition, the earlier schedule permits HELCO to proceed with the planned retirements of its older, less efficient units and to mitigate uncertainties with respect to deliveries from HELCO's power purchase producers. Conversion of CT-4 and CT-5 to combined-cycle operation with the addition of a steam unit, ST-7 is expected to occur by October 1997. NONUTILITY GENERATION The Company has supported state and federal energy policies which encourage the development of alternate energy sources that reduce dependence on fuel oil. Alternate energy sources range from wind, geothermal and hydroelectric power, to energy produced by the burning of bagasse. Other nonoil projects include a generating unit burning municipal waste and a fluidized bed unit burning coal. HECO currently has three major power purchase agreements. In general, HECO's payments under these power purchase agreements are based upon available capacity and energy. Payments for capacity generally are not required if the contracted capacity is not available, and payments are reduced, under certain conditions, if available capacity drops below contracted levels. In general, the payment rates for capacity have been predetermined for the terms of the agreements. The energy charges will vary over the terms of the agreements and HECO may pass on changes in the fuel component of the energy charges to customers through energy cost adjustment clauses in its rate schedules. HECO does not operate nor does it participate in the operation of any of the facilities that provide power under the three agreements. Title to the facilities does not pass to HECO upon expiration of the agreements, and the agreements do not contain bargain purchase options with respect to the facilities. In March 1988, HECO entered into a power purchase agreement with AES Barbers Point, Inc. (AES-BP), a Hawaii-based cogeneration subsidiary of Applied Energy Services, Inc. (AES) of Arlington, Virginia. The agreement with AES-BP, as amended in August 1989, provides that, for a period of 30 years, HECO will purchase 180 MW of firm capacity, under the control of HECO's system dispatcher. The AES-BP 180-MW coal-fired cogeneration plant utilizes a "clean coal" technology and became operational in September 1992. The facility is designed to sell sufficient steam to qualify under the Public Utility Regulatory Policies Act of 1978 (PURPA) as an unregulated cogenerator. HECO entered into an agreement in October 1988 with Kalaeloa Partners, L.P. (Kalaeloa) a limited partnership whose sole general partner is an indirect, wholly owned subsidiary of ASEA Brown Boveri, Inc., which has guaranteed certain of Kalaeloa's obligations and, through affiliates, has contracted to design, build, operate and maintain the facility. The agreement with Kalaeloa, as amended, provides that HECO will purchase 180 MW of firm capacity for a period of 25 years. The Kalaeloa facility, which was completed in the second quarter of 1991, is a combined-cycle operation, consisting of two oil-fired combustion turbines and a steam turbine which utilizes waste heat from the combustion turbines. The facility is designed to sell sufficient steam to qualify under PURPA as an unregulated cogenerator. HECO has also entered into a power purchase contract and a firm capacity amendment with Honolulu Resource Recovery Venture (HRRV), which has built a 60- MW refuse-fired plant. The HRRV unit began to provide firm energy in the second quarter of 1990 and currently supplies HECO with 46 MW of firm capacity. The PUC has approved and allowed rate recovery for the costs related to HECO's three major power purchase agreements, which provide a total of 406 MW of firm capacity, representing 24% of HECO's total generating and firm purchased capability on the island of Oahu as of December 31, 1993. Assuming that the three independent power producers operate at the minimum availability criteria in the power purchase agreements, aggregate fixed capacity charges under the three major agreements are expected to be between approximately $95 million and $98 million annually from 1994 through 2015, $73 million in 2016, between $59 million and $62 million annually from 2017 through 2021, and $46 million in 2022. As of December 31, 1993, HELCO and MECO had power purchase agreements for 51 MW and 16 MW of firm capacity, respectively, representing 25% and 7% of their respective total generating and firm purchased capabilities. Assuming that the independent power producers operate at the minimum availability criteria in the power purchase agreements, aggregate fixed capacity charges are expected to be approximately $9 million annually in 1994 and 1995, $8 million from 1996 through 1999, $6 million from 2000 through 2002 and $4 million annually from 2003 through 2028. HELCO has a power purchase agreement with PGV for 25 MW of firm capacity. PGV, an independent geothermal power producer which experienced substantial delays in commencing commercial operations, passed an acceptance test in June 1993 and is now considered to be a firm capacity source for 25 MW. HERS owned and operated a windfarm on the island of Oahu and sold the electricity it generated to HECO. The windfarm consisted of 14 600-KW and one 3,200-KW wind turbines. In March 1993, HEI sold the stock of HERS to The New World Power Corporation with the power purchase agreements between HERS and HECO continuing in effect. The stock of LVI was transferred to HEI prior to the sale of HERS. LVI's windfarm on the island of Hawaii consists of 54 20-KW and 34 17.5-KW wind turbines. LVI sells its electricity to HELCO and the Hawaii County Department of Water Supply. See "Discontinued operations--Hawaiian Electric Renewable Systems, Inc." Hamakua Sugar Company has been operating under Federal Bankruptcy Court protection since August 1992. Hamakua is presently in a Chapter 11 bankruptcy proceeding and is conducting a final sugar cane harvest over a period of 10 to 16 months, which began in July 1993. During the harvest, Hamakua has agreed to supply HELCO with 8 MW of firm capacity under an amendment to HELCO's existing power purchase agreement. HELCO has a power purchase agreement with Hilo Coast Processing Company (HCPC) for 18 MW of firm capacity. On July 31, 1992, C. Brewer and Company, Limited publicly announced that Mauna Kea Agribusiness, which is the primary supplier of sugar cane processed by HCPC, will begin converting its acreage to macadamia nuts, eucalyptus trees and other diversified crops as of November 1, 1992, and will discontinue harvesting sugar cane in late 1994. The announcement also indicated that, after the last sugar harvest, HCPC's primary fuel would be coal, supplemented by macadamia nut husks and other biomass material. It is HELCO's understanding that HCPC plans to continue supplying power after 1994 (and may even be in a position to supply more than 18 MW after its sugar processing operations are discontinued), and HELCO has assumed that HCPC's commitment to provide 18 MW of capacity will remain in effect for the current term of the contract, which ends December 31, 2002. BHP Petroleum Americas (Hawaii) Inc. (BHPH), formerly Pacific Resources, Inc., stopped hauling heavy fuel oil from Oahu to the other Hawaiian Islands at the end of May 1992. This may continue to affect the ability of the sugar companies, which relied on the oil delivered by BHPH, to supply power to HELCO and MECO. In light of this situation, some of the sugar companies have or are considering conversion to alternative fuels. Although it currently appears that heavy fuel oil will continue to be commercially available, in the event of the unavailability of heavy fuel oil, certain nonutility generators of electricity with contracts with HELCO and MECO may need to use a more expensive alternative fuel such as diesel. The legislation amending the state Environmental Response Law allows these producers, subject to PUC approval, to charge the utilities rates for energy purchases reflecting their higher fuel costs rather than the currently approved rates and, in turn, permits each utility to pass on the increases to its customers through an automatic rate adjustment clause. To minimize the rate increase of any one utility, the legislation permits the PUC, under certain conditions, to utilize a statewide automatic adjustment clause. In 1993, HELCO received PUC approval for recovery of the higher fuel costs incurred by HCPC. FUEL OIL USAGE AND SUPPLY All rate schedules of the Company's electric utility subsidiaries contain energy cost adjustment clauses whereby the charges for electric energy (and consequently the revenues of the subsidiaries generally) automatically vary with the weighted average price paid for fuel oil and certain components of purchased energy, and the relative amounts of company-generated and purchased power. Accordingly, changes in fuel oil and purchased energy costs are passed on to customers. See "Electric utility -- Rates." HECO's steam power plants burn low sulfur residual fuel oil. HECO's combustion turbines (peaking units) on Oahu burn diesel fuel. MECO and HELCO burn medium sulfur industrial fuel oil in their steam generating plants and diesel fuel in their diesel engine and combustion turbine generating units. In the second half of 1993, HECO concluded agreements with Chevron, U.S.A., Inc. (CUSA) and BHP Petroleum Americas Refining Inc. (BHP), formerly Hawaiian Independent Refinery, Inc., to purchase supplies of low sulfur fuel oil for a two-year term commencing January 1, 1994. The PUC approved these agreements and issued a final order in December 1993 permitting inclusion of costs under the contracts in the energy cost adjustment clause. HECO pays market-related prices for fuel purchases made under these contracts. HECO, MECO and HELCO have extended a contract with CUSA under which they will purchase No. 2 diesel fuel over a period of two years beginning January 1, 1994. The Company's utility subsidiaries jointly purchase medium sulfur residual fuel oil under this same contract and together purchase diesel fuel and residual fuel oil under a recently extended contract with BHP. The contracts with CUSA and BHP have been approved by the PUC which issued a final order in December 1993 permitting inclusion of costs under the contracts in the respective utility's energy cost adjustment clause. Diesel fuel and residual fuel oil supplies purchased under these agreements are priced on a market-related basis. The diesel fuel supplied to the Lanai Division of MECO is provided under an agreement with the CUSA jobber (i.e., wholesale merchant) on Lanai. The Molokai Division of MECO receives diesel fuel supplies through the joint purchase contract between HECO, MECO and HELCO and CUSA referred to above. The low sulfur residual fuel oil burned by HECO on Oahu is derived primarily from Indonesian and domestic crude oils. The medium sulfur residual fuel oil burned by MECO and HELCO is generally derived from domestic crude oil. The fuel oil commitments information in Note 11 to HECO's Consolidated Financial Statements is incorporated herein by reference to page 24 of HECO's 1993 Annual Report to Stockholder, portions of which are filed herein as HECO Exhibit 13(b). The following table sets forth the average costs of fuel oil used to generate electricity in the years 1993, 1992 and 1991: The average cost per barrel of fuel oil used to generate electricity for HECO, MECO and HELCO reflects the different fuel mix of each company. HECO uses primarily low sulfur residual fuel oil, MECO uses a significant amount of diesel fuel and HELCO uses primarily medium sulfur residual fuel oil and a lesser amount of diesel fuel. In general, medium sulfur fuel oil is the least costly per barrel and diesel fuel is the most expensive. During 1993, the prices of diesel fuel and low sulfur oil declined, while the price of medium sulfur fuel oil displayed no sustained trend. HTB was contractually obligated to ship heavy fuel oil for HELCO and MECO through December 1993. Effective December 31, 1993, HTB exited the heavy fuel oil shipping business. See "Regulation and other matters -- Environmental regulation -- Water quality controls." HELCO and MECO carried out a bidding process to determine who would ship heavy fuel oil beyond 1993. Several bids were received and evaluated and two contracts have been signed with Hawaiian Interisland Towing, Inc., subject to PUC approval (which has been obtained on an interim basis). HELCO and MECO have also begun to convert their generating plants from burning heavy fuel oil to burning either heavy fuel oil or diesel fuel in the event heavy fuel oil is no longer available in the future. Diesel fuel does not pose the same environmental liability concerns as heavy fuel oil, but it is more expensive and the use of diesel fuel could significantly increase HELCO's and MECO's electric rates. Conversion would assure HELCO and MECO more flexibility by permitting use of another type of fuel besides heavy fuel oil. In 1994, it is estimated that 75% of the net energy generated and purchased by HECO and its subsidiaries will come from oil, down from 77% in 1993. Failure by the Company's oil suppliers to provide fuel pursuant to the supply contracts and/or extremely high fuel prices could adversely affect HECO and its subsidiaries' and the Company's financial condition and results of operations. RATES HECO, MECO and HELCO are subject to the regulatory jurisdiction of the PUC with respect to rates, standards of service, issuance of securities, accounting and certain other matters. See "Regulation and other matters -- Electric utility regulation." All rate schedules of HECO and its subsidiaries contain an energy cost adjustment clause to reflect changes in the price paid for fuel oil and certain components of purchased power, and the relative amounts of company-generated and purchased power. Under current law and practices, specific and separate PUC approval is not required for each rate change pursuant to automatic rate adjustment clauses previously approved by the PUC. Rate increases, other than pursuant to such automatic adjustment clauses, require the prior approval of the PUC after public and contested case hearings. PURPA requires the PUC to periodically review the energy cost adjustment clauses of electric and gas utilities in the state, and such clauses, as well as the rates charged by the utilities generally, are subject to change. The PUC has broad discretion in its regulation of the rates charged by the Company's utility subsidiaries. Any adverse decision by the PUC concerning the level or method of determining electric utility rates, the authorized returns on equity or other matters or any delay in rendering a decision in a rate proceeding could have a material adverse effect on consolidated HECO's and the Company's financial condition and results of operations. Upon a showing of probable entitlement, the PUC is required to issue an interim decision in a rate case within 10 months from the date of filing a complete application if the evidentiary hearing is completed -- subject to extension for 30 days if the evidentiary hearing is not completed. However, there is no time limit for rendering a final decision. HECO Rate increase. On July 29, 1991, HECO applied to the PUC for permission to increase electric rates on the island of Oahu in 1992. The rates requested would have provided approximately $138 million in annual revenues, or approximately 26.4% over HECO's then existing rates, based on January 1, 1992 fuel oil and purchased energy prices. The request was based on a 13.5% return on average common equity. On June 30, 1992, HECO received a final decision and order from the PUC. The decision and order granted an increase of $124 million in annual revenues, based on a 13.0% return on average common equity. The increase took effect in steps in 1992. $28 million of the $124 million increase was granted in the interim decision effective April 1, 1992. A step increase of $2.3 million in annual revenues became effective July 8, 1992. Approximately $93 million of the $124 million increase represented a pass-through of costs when HECO began purchasing generating capacity from independent power producer AES-BP in September 1992. The increase is subject to possible adjustments for postretirement benefits other than pensions. The major reason for the difference between revenues requested in HECO's application and the revenues granted by the PUCO's final decision and order relates to postretirement benefits other than pensions expense. HECO requested $11 million in annual revenues to cover the additional expense required under SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The PUC has opened a separate generic docket on postretirement benefits other than pensions and indicated that the total increase granted in the final decision and order will be adjusted to reflect its decision in that docket. The PUC has not yet issued a final decision and order in this generic docket. The information on postretirement benefits other than pensions in Note 10 to HECO's Consolidated Financial Statements is incorporated herein by reference to pages 23 to 24 of HECO's 1993 Annual Report to Stockholder, portions of which are filed herein as HECO Exhibit 13(b). Pending rate requests. On July 26, 1993, HECO applied to the PUC for permission to increase electric rates, using a 1994 test year and requesting rates designed to produce an increase of approximately $62 million in annual revenues over the revenues provided by rates currently in effect. HECO subsequently revised its rate request from $62 million to approximately $54 million by the close of the evidentiary hearings held in March 1994. The revision resulted primarily from rescheduling certain capital projects from 1994 to 1995, and agreements among the parties with respect to certain issues. The requested increase, as revised, is based on a 12.75% return on average common equity and is needed to cover rising operating costs and the cost of new capital projects to maintain and improve service reliability. In addition, the requested increase includes approximately $9 million for costs arising out of the change to accrual accounting for postretirement benefits other than pensions, and the amount of the required increase will be reduced to the extent that rate relief for these costs is received in another proceeding. The information on postretirement benefits other than pensions in Note 10 to HECO's Consolidated Financial Statements is incorporated herein by reference to pages 23 to 24 of HECO's 1993 Annual Report to Stockholder, portions of which are filed herein as HECO Exhibit 13(b). HECO has requested an interim increase of approximately $39 million by April 1994, and the remainder of the requested increase in steps in 1994. On December 27, 1993, HECO applied to the PUC for permission to increase electric rates, using a 1995 test year and requesting rates designed to produce an increase of approximately $44 million in annual revenues over revenues provided by the initially proposed 1994 rates. As a result of revisions to the rate increase requested in 1994, the requested increase would be approximately $52 million over revenues provided by proposed 1994 rates. The increase requested by HECO is based on a 12.3% return on average common equity. The rate request based on a 1995 test year is in addition to HECO's pending $54 million rate increase requested for 1994. Both requests combined represent a 16.7% increase, or $106 million, over present rates. Revenue from the proposed increase would be used in part to cover the costs of major transmission and distribution projects on Oahu, including an important transmission corridor to connect power plants on the island's west side with customers throughout Oahu. The 1995 application includes requests for approximately $15 million for additional expenses associated with proposed changes in depreciation rates and methods and $7 million to establish a self-insured property damage reserve for transmission and distribution property in the event of catastrophic disasters. HECO seeks to establish the requested reserve because HECO is self-insured for damage to its transmission and distribution property, except substations. (HECO's subsidiaries are similarly self-insured.) Also, a heightened concern for the risk of loss of this property has grown out of the loss of virtually the entire transmission and distribution system of the unaffiliated electric utility serving the island of Kauai as a result of Hurricane Iniki in September 1992. HECO anticipates that evidentiary hearings on the 1995 application will be held in late 1994. HELCO Rate increase. On July 31, 1991, HELCO asked the PUC to increase rates by $7.5 million a year, or 7.5%. The request was based on a 13.5% return on average common equity and a 1992 test year. On October 2, 1992, HELCO received a final decision and order from the PUC authorizing a total increase of $3.9 million in annual revenues, based on a 13.0% return on average common equity. HELCO's original request for rate increase included approximately $1.9 million to cover the increased cost of postretirement benefits other than pensions, and this request will be considered in a separate generic docket. The PUC has not yet issued a final decision and order in this generic docket. The information on postretirement benefits other than pensions in Note 10 to HECO's Consolidated Financial Statements is incorporated herein by reference to pages 23 to 24 of HECO's 1993 Annual Report to Stockholder, portions of which are filed herein as HECO Exhibit 13(b). Other rate adjustments could be made based on the results of the PUC's study of HELCO's service reliability. See "Item 3. Legal Proceedings--HELCO reliability investigation." Pending rate request. On November 30, 1993, HELCO applied to the PUC for permission to increase electric rates, using a 1994 test year and requesting rates designed to produce an increase of approximately $15.8 million in annual revenues, or 13.4%, over revenues provided by rates currently in effect. The requested increase is based on a 12.4% return on average common equity and is needed to cover plant, equipment and operating costs to maintain and improve service and provide reliable power for its customers. HELCO anticipates that evidentiary hearings will be held later this year. MECO Pending rate request. In November 1991, MECO filed a request to increase rates by approximately $18.3 million annually, or approximately 17% above the rates in effect at the time of the filing, in several steps. Most of the proposed increase reflected the costs of adding a 58-MW combined-cycle generating unit on Maui in three phases and the costs related to the change in the method of accounting for postretirement benefits other than pensions. Evidentiary hearings were held in January 1993. At the conclusion of the hearings, MECO's final requested increase was adjusted to approximately $11.4 million annually, or approximately 10%, in several steps in 1993. The decrease in the requested rate increase resulted primarily from a reduced cost of capital, lower administrative and general expenses and other revisions to MECO's estimated revenue requirements for the 1993 test year used in the rate case. MECO's revised request reflected a return on average common equity of 13.0%. On January 29, 1993, MECO received an initial interim decision authorizing an annual increase of $2.8 million, or 2.4%, effective February 1, 1993. This interim decision covered, among other things, the costs associated with the first phase of the 58-MW combined-cycle generating unit, which had been placed in service on May 1, 1992. In the interim decision the PUC used a rate of return on average common equity of 12.75% in light of a drop in interest rates and changes in economic conditions since HECO's and HELCO's most recent rate case decisions and orders. The PUC also stated that MECO is less dependent on purchased power than HECO or HELCO, and that MECO's return on average common equity will be more extensively reviewed for purposes of the final decision and order. On May 7, 1993, MECO received a second interim decision authorizing a step increase of an additional $4 million in annual revenues, or 3.6%, effective May 8, 1993. This step increase covered the estimated annual costs of the second phase of the 58-MW combined-cycle generating unit, a combustion turbine which was placed into service on May 1, 1993. On October 21, 1993, MECO received a third interim decision authorizing a step increase of an additional $1 million in annual revenues, or 0.9%, effective October 21, 1993. This step increase covered the estimated annual costs of the third and final phase of the combined-cycle generating unit, which was placed into service on October 1, 1993. On December 9, 1993, MECO received a fourth interim decision authorizing a step increase of an additional $0.4 million in annual revenues, effective December 10, 1993, to cover wage increases that became effective on November 1, 1993. These interim increases are subject to refund with interest, pending the final outcome of the case. MECO's management cannot predict with certainty when a final decision in MECO's rate case will be rendered or the amount of the final rate increase that will be granted. SAVINGS BANK -- AMERICAN SAVINGS BANK, F.S.B. GENERAL ASB was granted a charter as a federal savings bank in January 1987. Prior to that time, ASB operated as the Hawaii division of American Savings & Loan Association of Salt Lake City, Utah since 1925. At September 30, 1993, ASB's total assets were $2.5 billion and it was the second largest savings and loan institution in Hawaii based on total assets. ASB was acquired by the Company for approximately $115 million on May 26, 1988. The acquisition was accounted for using the purchase method of accounting. Accordingly, tangible assets and liabilities were recorded at their estimated fair values at the acquisition date. The acquisition was approved by the Federal Home Loan Bank Board (FHLBB) which required HEI to enter into a Regulatory Capital Maintenance/Dividend Agreement (the FHLBB Agreement). Under the FHLBB Agreement, HEI agreed that ASB's regulatory capital would be maintained at a level of at least 6% of ASB's total liabilities, or at such greater amount as may be required from time to time by regulation. Under the FHLBB Agreement, HEI's obligation to contribute additional capital was limited to a maximum aggregate amount of approximately $65.1 million. HEI elected to contribute additional capital of $0.8 million and $24.0 million to ASB during 1993 and 1992, respectively. The FHLBB Agreement also included limitations on ASB's ability to pay dividends. Under the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA), the regulations of the FHLBB and the FHLBB Agreement were transferred to the Office of Thrift Supervision (OTS). Effective December 23, 1992, ASB was granted a release from the dividend limitations imposed under the FHLBB Agreement. ASB is subject to the OTS regulations for dividends and other distributions applicable to financial institutions regulated by the OTS. ASB acquired First Nationwide Bank's Hawaii branches and deposits on October 6, 1990. The acquisition increased ASB's statewide retail branch network from 36 to 45 branches and its deposit base by $247 million, and provided approximately $239 million in cash. ASB's earnings depend primarily on its net interest income -- the difference between the interest income earned on interest-earning assets (loans receivable, mortgage-backed securities and investments) and the interest expense incurred on interest-bearing liabilities (deposit liabilities and borrowings). Deposits traditionally have been the principal source of ASB's funds for use in lending, meeting liquidity requirements and making investments. ASB also derives funds from receipt of interest and principal on outstanding loans receivable, borrowings from the Federal Home Loan Bank (FHLB) of Seattle, securities sold under agreements to repurchase and other sources, including collateralized medium-term notes. For additional information about ASB, reference is made to Note 5 to HEI's Consolidated Financial Statements, incorporated herein by reference to pages 53 through 57 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a). The following table sets forth selected data for ASB for the periods indicated: (1) Net income includes amortization of goodwill and core deposit intangibles. (2) Reflects allocation of corporate-level expenses for segment reporting purposes, which were not billed to ASB. In the second quarter of 1992, HEI changed its method of billing corporate-level expenses to ASB. Under the new billing procedure, only certain direct charges, rather than fully-allocated costs, are billed to ASB. However, no change was made by HEI in the manner in which corporate-level expenses were allocated for segment reporting purposes. CONSOLIDATED AVERAGE BALANCE SHEET The following table sets forth average balances of major balance sheet categories for the periods indicated. Average balances for each period have been calculated using the average month-end balances during the period. ASSET/LIABILITY MANAGEMENT Interest rate sensitivity refers to the relationship between market interest rates and net interest income resulting from the repricing of interest-earning assets and interest-bearing liabilities. Interest rate risk arises when an interest-earning asset matures or when its interest rate changes in a time frame different from that of the supporting interest-bearing liability. Maintaining an equilibrium between rate sensitive interest-earning assets and interest-bearing liabilities will reduce some interest rate risk but it will not guarantee a stable net interest spread because yields and rates may change simultaneously or at different times and such changes may occur in differing increments. Market rate fluctuations could materially affect the overall net interest spread even if interest-earning assets and interest-bearing liabilities were perfectly matched. The difference between the amounts of interest-earning assets and interest-bearing liabilities that reprice during a given period is called "gap." An asset-sensitive position or "positive gap" exists when more assets than liabilities reprice within a given period; a liability-sensitive position or "negative gap" exists when more liabilities than assets reprice within a given period. A positive gap generally produces more net interest income in periods of rising interest rates and a negative gap generally produces more net interest income in periods of falling interest rates. As rates in 1993 have remained at low levels, the gap in the near term (0-6 months) was a negative 4.1% of total assets as compared to a cumulative one-year positive gap position of 3.2% of total assets as of December 31, 1993. The negative near-term gap position reflects customers moving more interest sensitive funds into liquid passbook deposits. The cumulative one-year 1993 "positive gap" was primarily due to a very low interest rate environment that led to faster prepayments of fixed rate loans with high interest rates coupled with the increase of noninterest rate sensitive passbook deposits with a life expectancy of greater than a year. The following table shows ASB's interest rate sensitivity at December 31, 1993: (1) The table does not include $183 million of noninterest-earning assets and $53 million of noninterest-bearing liabilities. (2) The difference between the total interest-earning assets and the total interest-bearing liabilities. INTEREST INCOME AND INTEREST EXPENSE The following table sets forth average balances, interest and dividend income, interest expense and weighted average yields earned and rates paid, for certain categories of interest-earning assets and interest-bearing liabilities for the periods indicated. Average balances for each period have been calculated using the average month-end balances during the period. (1) ASB has no material amount of tax-exempt investments for periods shown. (2) Excludes nonrecurring items. The following table shows the effect on net interest income of (1) changes in interest rates (change in weighted average interest rate multiplied by prior period average portfolio balance) and (2) changes in volume (change in average portfolio balance multiplied by prior period rate). Any remaining change is allocated to the above two categories on a pro rata basis. OTHER INCOME In addition to net interest income, ASB has various sources of other income, including fee income from servicing loans, fees on deposit accounts, rental income from premises and other income. Other income totaled approximately $11.1 million in 1993, compared to $10.4 million in 1992 and $9.7 million in 1991. LENDING ACTIVITIES General. ASB's net loan and mortgage-backed securities portfolio totaled approximately $2.4 billion at December 31, 1993, representing 90.3% of its total assets, compared to $2.2 billion, or 88.3%, and $2.0 billion, or 89.7%, at December 31, 1992 and 1991, respectively. ASB's loan portfolio consists primarily of conventional residential mortgage loans which are not insured by the Federal Housing Administration (FHA) nor guaranteed by the Veterans Administration. At December 31, 1993, mortgage-backed securities represented 26.7% of the loan and mortgage-backed securities portfolio, compared to 32.7% at December 31, 1992 and 41.1% at December 31, 1991. The following tables set forth the composition of ASB's loan and mortgage- backed securities portfolio: (1) Includes renegotiated loans. (1) Includes renegotiated loans. Origination, purchase and sale of loans. Generally, loans originated and purchased by ASB are secured by real estate located in Hawaii. As of December 31, 1993, approximately $11.9 million of loans which were purchased from other lenders were secured by properties located in the continental United States. For additional information, including information concerning the geographic distribution of ASB's mortgage-backed securities portfolio, reference is made to Note 20 to HEI's Consolidated Financial Statements, incorporated herein by reference to page 67 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a). The following table shows the amount of loans originated for the years indicated: Residential mortgage lending. During 1993, the demand for adjustable rate mortgage (ARM) loans over fixed rate loans decreased compared with 1992. ARM loans carry adjustable interest rates which are typically set according to a short-term index. Payment amounts may be adjusted periodically based on changes in interest rates. ARM loans represented approximately 24.7% of the total originations of first mortgage loans in 1993, compared to 34.0% and 27.4% in 1992 and 1991, respectively. ASB intends to continue to emphasize the origination and purchase of ARM loans to further improve its asset/liability management. ASB is permitted to lend up to 100% of the appraised value of the real property securing a loan. Its general policy is to require private mortgage insurance when the loan-to-value ratio of owner-occupied property exceeds 80% of the lower of the appraised value or purchase price. On nonowner-occupied residential properties, the loan-to-value ratio may not exceed 80% of the lower of the appraised value or purchase price. Construction and development lending. ASB provides both fixed and adjustable rate loans for the construction of one-to-four residential unit and commercial properties. Construction and development financing generally involves a higher degree of credit risk than long-term financing on improved, occupied real estate. Accordingly, all construction and development loans are priced higher than loans secured by completed structures. ASB's underwriting, monitoring and disbursement practices with respect to construction and development financing are designed to ensure sufficient funds are available to complete construction projects. As of December 31, 1993, 1992 and 1991, construction and development loans represented 1.5%, 2.2% and 2.1%, respectively, of ASB's gross loan portfolio. See "Loan portfolio risk elements." Multi-family residential and commercial real estate lending. Permanent loans secured by multi-family properties (generally apartment buildings), as well as commercial and industrial properties (including office buildings, shopping centers and warehouses), are originated by ASB for its own portfolio as well as for participation with other lenders. In 1993, 1992 and 1991, loans on these types of properties accounted for approximately 6.0%, 8.2% and 7.5%, respectively, of ASB's total mortgage loan originations. The objective of commercial real estate lending is to diversify ASB's loan portfolio to include sound, income-producing properties. Consumer lending. ASB offers a variety of secured and unsecured consumer loans. Loans secured by deposits are limited to 90% of the available account balance. ASB also offers VISA cards, automobile loans, general purpose consumer loans, second mortgage loans, home equity lines of credit, checking account overdraft protection and unsecured lines of credit. In 1993, 1992 and 1991, loans of these types accounted for approximately 4.3%, 4.9% and 11.1%, respectively, of ASB's total loan originations. Corporate banking/commercial lending. ASB is authorized to make both secured and unsecured corporate banking loans to business entities. This lending activity is designed to diversify ASB's asset structure, shorten maturities, provide rate sensitivity to the loan portfolio and attract business checking deposits. As of December 31, 1993, 1992 and 1991, corporate banking loans represented 1.2%, 1.2% and 1.67%, respectively, of ASB's total net loan portfolio. Loan origination fee and servicing income. In addition to interest earned on loans, ASB receives income from servicing of loans, for late payments and from other related services. Servicing fees are received on loans originated and subsequently sold by ASB and also on loans for which ASB acts as collection agent on behalf of third-party purchasers. ASB generally charges the borrower at loan settlement a loan origination fee ranging from 2% to 3% of the amount borrowed. Loan origination fees (net of direct loan origination costs) are deferred and recognized as an adjustment of yield over the life of the loan. Nonrefundable commitment fees (net of direct loan origination costs, if applicable) to originate or purchase loans are deferred. The nonrefundable commitment fees are recognized as an adjustment of yield over the life of the loan if the commitment is exercised. If the commitment expires unexercised, nonrefundable commitment fees are recognized in income upon expiration of the commitment. Loan portfolio risk elements. When a borrower fails to make a required payment on a loan and does not cure the delinquency promptly, the loan is classified as delinquent. If delinquencies are not cured promptly, ASB normally commences a collection action, including foreclosure proceedings in the case of secured loans. In a foreclosure action, the property securing the delinquent debt is sold at a public auction in which ASB may participate as a bidder to protect its interest. If ASB is the successful bidder, the property is classified in a real estate owned account until it is sold. At December 31, 1993, there was only one real estate property, a residential property, acquired in settlement of a loan totaling $0.2 million, or 0.01% of total assets. At December 31, 1992 there was only one real estate property, a commercial property, acquired in settlement of a loan totaling $2.0 million, or 0.08% of total assets. There was no real estate owned at December 31, 1991, 1990 and 1989. In addition to delinquent loans, other significant lending risk elements include: (1) accruing loans which are over 90 days past due as to principal or interest, (2) loans accounted for on a nonaccrual basis (nonaccrual loans), and (3) loans on which various concessions are made with respect to interest rate, maturity, or other terms due to the inability of the borrower to service the obligation under the original terms of the agreement (renegotiated loans). ASB has no loans which are over 90 days past due on which interest is being accrued for the years presented in the table below. The level of nonaccrual and renegotiated loans represented 0.5%, 1.0%, 0.1%, 0.1% and 0.2%, of ASB's total net loans outstanding at December 31, 1993, 1992, 1991, 1990 and 1989, respectively. The following table sets forth certain information with respect to nonaccrual and renegotiated loans for the dates indicated: ASB's policy generally is to place mortgage loans on a nonaccrual status (interest accrual is suspended) when the loan becomes more than 90 days past due or on an earlier basis when there is a reasonable doubt as to its collectability. Loans on nonaccrual status amounted to $5.7 million (0.32% of total loans) at December 31, 1993, $14.2 million (0.94% of total loans) at December 31, 1992, $1.0 million (0.08% of total loans) at December 31, 1991, $1.0 million (0.10% of total loans) at December 31, 1990 and $1.2 million (0.14% of total loans) at December 31, 1989. The significant increase in loans on nonaccrual status from year-end 1991 to 1992 was primarily due to the effects of Hurricane Iniki on the island of Kauai, such as higher unemployment. As of December 31, 1992, real estate loans with remaining principal balances of $8.9 million were restructured to defer monthly contractual principal and interest payments for three months with repayments of the entire deferred amounts due at the end of the three-month period. These loans had been classified as nonaccrual loans as of December 31, 1992. Substantially all of these loans have resumed their normal repayment schedule and are classified as performing loans as of December 31, 1993. For additional information, see "Potential problem loans." There were no loan loss provisions with respect to renegotiated loans in 1993, 1992, 1991, 1990 and 1989 because the estimated net realizable value of the collateral for such loans was determined to be in excess of the outstanding principal amounts of these loans. For additional information, see "Potential problem loans." Potential problem loans. A loan is classified as a potential problem loan when the ability of the borrower to comply with present loan covenants is in doubt. In September 1992, the island of Kauai suffered substantial property damage from Hurricane Iniki. The high unemployment rate on Kauai due to Hurricane Iniki resulted in loan payment defaults or deferrals requiring such loans to be placed on a nonaccrual status. As of December 31, 1992, delinquencies of ASB's Kauai loans were $2.2 million, $2.5 million, $3.1 million and $0.4 million for 1-29 days, 30-59 days, 60-89 days and 90 days and over delinquent, respectively. In anticipation of additional loans falling into the 90 days and over category, ASB added reserves during 1992 of $0.6 million for Kauai loans. As of December 31, 1993, substantially all of these loans have resumed their normal repayment schedule improving delinquencies of ASB's Kauai loans to $2.1 million, $0.5 million, $0.3 million and $0.7 million for 1-29 days, 30-59 days, 60-89 days and 90 days and over delinquent, respectively. Due to the losses created by Hurricane Iniki, several insurance companies have discontinued the sale and/or renewal of homeowners' insurance on real estate in Hawaii. If a borrower is unable to obtain insurance, ASB has procedures to "force place" insurance coverage. The "force place" policies are underwritten by two U.S. insurance companies and would protect ASB, as lender, for loans secured by real estate covered by such policies. The cost of the policy is charged to the borrower. Based on the current circumstances, management believes that the current shortage of homeowners' insurance in Hawaii and the effect of Hurricane Iniki on ASB's future earnings will not be material to the Company's financial condition or results of operations. Allowance for loan losses. The provision for loan losses is dependent upon management's evaluation as to the amount needed to maintain the allowance for loan losses at a level considered appropriate in relation to the risk of future losses inherent in the loan portfolio. While management attempts to use the best information available to make evaluations, future adjustments may be necessary as circumstances change and additional information becomes available. The following table presents the changes in the allowance for loan losses for the periods indicated. ASB's ratio of provisions for loan losses during the period to average loans outstanding was 0.05%, 0.11%, 0.06%, 0.07% and 0.06% for the years ended December 31, 1993, 1992, 1991, 1990 and 1989, respectively. The increase in provisions for loan losses during 1992 was primarily due to the 27% increase in average loans outstanding and a $0.6 million additional provision for Kauai loans anticipated to be affected by Hurricane Iniki. See "Potential problem loans." Without the additional $0.6 million provision on Kauai loans, the ratio of provision for loan losses to average loans outstanding for the year ended December 31, 1992 would have been 0.07%, which would be consistent with prior years. The allowance for loan losses for the year ended December 31, 1993 includes the additional provision and charge-off of a single commercial loan of $0.3 million, offset by the reversal of $0.6 million in provisions for Kauai loans reclassified as performing. The ratio of provision for loan losses to average loans outstanding for the year ended December 31, 1993 would have been 0.07%, if the reversal of the $0.6 million in provisions for Kauai loans and the additional provision of $0.3 million for the commercial loan were excluded. INVESTMENT ACTIVITIES In recent years, ASB's investment portfolio has consisted primarily of mortgage-backed securities, federal agency obligations and stock of the FHLB of Seattle. The following table sets forth the composition of ASB's investment portfolio, excluding mortgage-backed securities to be held-to-maturity, at the dates indicated: (1) On investments during the year ended December 31. DEPOSITS AND OTHER SOURCES OF FUNDS General. Deposits traditionally have been the principal source of ASB's funds for use in lending and other investments. ASB also derives funds from receipt of interest and principal on outstanding loans, borrowings from the FHLB of Seattle, securities sold under agreements to repurchase and other sources. ASB borrows on a short-term basis to compensate for seasonal or other reductions in deposit flows. ASB also may borrow on a longer-term basis to support expanded lending or investment activities. Deposits. ASB's deposits are obtained primarily from residents of Hawaii. In 1993, ASB had average deposits aggregating $2.1 billion. Savings outflow for 1993 was approximately $9 million excluding interest credited to deposit accounts. Savings inflows for 1992 and 1991 were approximately $343 million and $31 million, respectively, excluding interest credited to deposit accounts. The substantial decrease in savings flow for 1993 was due primarily to the low interest rate environment and the withdrawal of a trust company deposit account of $92 million. The trust company was recently acquired by another financial institution. The substantial increase in savings inflow for 1992 was due to ASB's strategy to increase its retail market by paying higher rates of interest on savings accounts than most of its competitors in Hawaii during this period. The weighted average rate paid on deposits during 1993 decreased to 3.74%, compared to 5.01% and 6.36% in 1992 and 1991, respectively. In the three years ended December 31, 1993, ASB had no deposits placed by or through a broker. The following table shows the distribution of ASB's average deposits and average daily rates by type of deposit for the years indicated. Average balances for a period have been calculated using the average of month-end balances during the period. At December 31, 1993, ASB had $166 million in certificate accounts of $100,000 or more maturing as follows: Borrowings. ASB obtains advances from the FHLB of Seattle, provided certain standards related to credit-worthiness have been met. Advances are secured under a blanket pledge of the common stock ASB owns in the FHLB of Seattle and each note or other instrument held by ASB and the mortgage securing it. FHLB advances generally are available to meet seasonal and other withdrawals of deposit accounts, to expand lending and to assist in the effort to improve asset and liability management. FHLB advances are made pursuant to several different credit programs offered from time to time by the FHLB of Seattle. At December 31, 1993, 1992 and 1991, advances from the FHLB amounted to $290 million, $194 million and $259 million, respectively. The weighted average rate on the advances from the FHLB outstanding at December 31, 1993, 1992 and 1991 were 6.24%, 7.39% and 7.60%, respectively. The maximum amount outstanding at any month-end during 1993, 1992 and 1991 was $290 million, $259 million and $259 million, respectively. Advances from the FHLB averaged $210 million, $221 million and $203 million during 1993, 1992 and 1991, respectively, and the approximate weighted average rate thereon was 6.84%, 7.65% and 7.99%, respectively. At December 31, 1992 and 1991, securities sold under agreements to repurchase consisted of mortgage-backed securities sold to brokers/dealers under fixed- coupon agreements. The agreements are treated as financings and the obligations to repurchase securities sold are reflected as a liability in the consolidated balance sheets. The dollar amount of securities underlying the agreements remains in the asset accounts. There were no outstanding securities sold under agreements to repurchase as of December 31, 1993. At December 31, 1992 and 1991, $27.2 million (including accrued interest of $0.2 million) and $131.0 million (including accrued interest of $1.8 million), respectively, of the agreements were to repurchase identical securities. The weighted average rates on securities sold under agreements to repurchase outstanding at December 31, 1992 and 1991 were 3.34% and 5.78%, respectively. The maximum amount outstanding at any month-end during 1993, 1992 and 1991 was $27 million, $125 million and $136 million, respectively. Securities sold under agreements to repurchase averaged $20 million, $66 million and $124 million during 1993, 1992 and 1991, respectively, and the approximate weighted average interest rate thereon was 3.39%, 5.15% and 6.67%, respectively. Subject to obtaining certain approvals from the FHLB of Seattle, ASB may offer collateralized medium-term notes due from nine months to 30 years from the date of issue and bearing interest at a fixed or floating rate established at the time of issue. At December 31, 1993, 1992 and 1991, ASB had no outstanding collateralized medium-term notes. The following table sets forth information concerning ASB's advances from FHLB and other borrowings at the dates indicated: (1) On borrowings at December 31. COMPETITION The primary factors in competing for deposits are interest rates, the quality and range of services offered, marketing, convenience of office locations, office hours and perceptions of the institution's financial soundness and safety. Competition for deposits comes primarily from other savings institutions, commercial banks, credit unions, money market and mutual funds and other investment alternatives. Additional competition for deposits comes from various types of corporate and government borrowers, including insurance companies. To meet the competition, ASB offers a variety of savings and checking accounts at competitive rates, convenient business hours, convenient branch locations with interbranch deposit and withdrawal privileges at each office and conducts advertising and promotional campaigns. The primary factors in competing for first mortgage and other loans are interest rates, loan origination fees and the quality and range of lending services offered. Competition for origination of first mortgage loans comes primarily from other savings institutions, mortgage banking firms, commercial banks, insurance companies and real estate investment trusts. ASB believes that it is able to compete for such loans primarily through the interest rates and loan fees it charges, the type of mortgage loan programs it offers and the efficiency and quality of the services it provides its borrowers and the real estate business community. OTHER FREIGHT TRANSPORTATION -- HAWAIIAN TUG & BARGE CORP. AND YOUNG BROTHERS, LIMITED GENERAL HTB and its wholly owned subsidiary, YB, were acquired from Dillingham Corporation in 1986 for $18.7 million. HTB provides interisland marine transportation services in Hawaii and the Pacific area, including charter tug and barge and harbor tug operations. YB, which is a regulated interisland cargo carrier, transports general freight and containerized cargo by barge on a regular schedule between all major ports in Hawaii. YB moved 3.1 million revenue tons of cargo between the islands in 1993, compared to 3.2 million tons of cargo in 1992. A substantial portion of the state's commodities are imported, and almost all of Hawaii's overseas inbound and outbound cargo moves through Honolulu. Cargo destined for the neighbor islands is trans-shipped through the Honolulu gateway. Access to the interisland freight transportation market is generally subject to state or federal regulation, and HTB and YB have active competitors, such as interstate common carriers and, in certain instances, unregulated contract carriers. YB has a nonexclusive Certificate of Public Convenience and Necessity from the PUC to operate as an intrastate common carrier by water. The Certificate will remain in effect for an indefinite period unless suspended or terminated by the PUC. Although YB encounters competition from, among others, interstate carriers and unregulated contract carriers, YB is the only authorized common carrier under the Hawaii Water Carrier Act. YB RATES YB generally must accept for transport all cargo offered. YB rates and charges must be approved by the PUC and the PUC has broad discretion in its regulation of the rates charged by YB. In June 1987, the PUC commenced a proceeding to determine whether YB's rates and charges should be reduced to reflect the effect of the Tax Reform Act of 1986 (TRA). During the period from January 1, 1988 through June 30, 1993, several rate reductions were imposed by the PUC as well as YB voluntarily reducing its rates for selected commodities. On February 13, 1992, YB filed a motion to rescind a 1.1% interim rate reduction which was implemented on January 1, 1989. On June 30, 1993, the PUC approved YB's motion to rescind the 1.1% interim rate reduction, effective July 8, 1993, and in January 1994, the PUC rendered a decision to close the TRA docket. In September 1992, YB filed an application for a tariff change in its minimum bill of lading from $10.43 to $21.03 (later increased to $21.62). This application was suspended on October 7, 1992. On November 5, 1992, YB filed a general rate increase application with the PUC for a 17.1% across the board increase in rates effective December 20, 1992. On December 18, 1992, the PUC ordered that the two applications be consolidated and that the consolidated application be suspended for a period of six months to and including June 19, 1993. On February 12, 1993, YB reduced its general rate increase request to 15.7% from the 17.1% originally requested. The decrease in the request was primarily due to a decrease in rate base resulting from the change in the test year period and an adjustment to YB's capital structure to reflect more leverage. The revised request was based on a rate of return of 16.7% on an imputed equity of 55%. Hearings for this general rate increase and the tariff change were held in May 1993. On June 30, 1993, the PUC issued a decision granting an $18.00 minimum bill of lading charge and a 4.3% general rate increase on all rates excluding the Minimum Bill of Lading and Marine Cargo Insurance rates. The new rates and charges became effective on July 8, 1993. This decision was based on a rate of return of 15.15% on an imputed equity of 55%. YB is also participating in the PUC's generic docket to determine whether SFAS No. 106 should be adopted for rate-making purposes. The information on postretirement benefits other than pensions in Note 18 to HEI's Consolidated Financial Statements is incorporated herein by reference to pages 64 to 66 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a). On March 15, 1994, YB filed a Notice of Intent with the PUC informing them that YB will be filing an application for a general rate increase. REAL ESTATE-MALAMA PACIFIC CORP. GENERAL MPC was incorporated in 1985 and engages in real estate development activities, either directly or through joint ventures. MPC's real estate development investments in residential projects are targeted for Hawaii's owner-occupant market. MPC's subsidiaries are currently involved in the active development of five residential projects (Kipona Hills, Kua' Aina Ridge, Westpark, Piilani Village Phase 1 and Sunrise Estates Phase 1) on the islands of Oahu, Maui and Hawaii encompassing approximately 500 homes or lots, of which more than 260 have been completed and sold. Either directly or through its joint ventures, MPC's subsidiaries have access to nearly 450 acres of land for future residential development. Residential development generally requires long lead time to obtain necessary zoning changes, building permits and other required approvals. MPC's projects are subject to the usual risks of real estate development, including fluctuations in interest rates, the receipt of timely and appropriate state and local zoning and other necessary approvals, possible cost overruns and construction delays, adverse changes in general commerce and local market conditions, compliance with applicable environmental and other regulations, and potential competition from other new projects and resales of existing residences. In 1993, Malama's real estate development activities continued to be impacted by the economic conditions affecting the entire nation. Although interest rates remained low, the real estate market experienced slowdowns due to the weakness in the U.S. and Hawaii economies and lack of consumer confidence. Sales prices and velocities are expected to remain relatively flat through most of 1994, with improvement anticipated in late 1994 or 1995. For a discussion of MPC's transactions with related parties, pages 21 to 23 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994 and filed herein as HEI Exhibit 22, are incorporated herein by reference. JOINT VENTURE DEVELOPMENTS Makakilo Cliffs. In 1990, MDC and JGL Enterprises Inc. formed Makakilo Cliffs Joint Venture for the development of a 280-unit multi-family residential project on approximately 26 acres in Makakilo, Hawaii (island of Oahu). MDC's partnership interest was assigned to Malama Makakilo Corp., another wholly owned subsidiary of MPC, in August 1990. Sales of the first 81 units closed in 1991 and all remaining units closed in 1992. The joint venture was dissolved in December 1993. Sunrise Estates. In 1990, MDC and HSC, Inc. formed Sunrise Estates Joint Venture to develop and sell 165 one-acre house lots in Hilo, Hawaii (island of Hawaii). In 1993 and 1992, sales of three lots and 153Elots closed, respectively. Sales of the remaining nine lots are expected in 1994. In 1991, HSC, Inc. and Malama Elua Corp., a wholly owned subsidiary of MPC, formed Sunrise Estates II Joint Venture to develop and sell approximately 140 one-acre house lots in Hilo, Hawaii, adjacent to the Sunrise Estates Joint Venture project. Rezoning was completed in 1993 and site work is expected to commence in late 1994 or early 1995. Ainalani Associates. In 1990, MDC and MDT-BF Limited Partnership (MDT) formed a joint venture known as Ainalani Associates for the acquisition and development of five residential projects on the islands of Kauai, Maui and Hawaii. In 1990, the project on the island of Kauai was completed and sold. In 1992, the land for a project on the island of Maui was sold in bulk. Ainalani Associates also acquired a 50% interest in Palailai Associates, a partnership for the development of residential housing on Oahu. The five projects and partnership interest originally (i.e., before sales) encompassed approximately 270 acres of land. During 1990, MDC assigned its interest in Ainalani Associates to MMO, another wholly owned subsidiary of MPC. On August 17, 1992, MMO acquired MDT's 50% interest in Ainalani Associates. Upon closing of the purchase, Ainalani Associates was dissolved. The amount of consideration for the transfer, which was not material to the Company's financial condition, was determined by arbitration which ended on March 31, 1993 and was based primarily on the net present value of MDT's partnership interest in Ainalani Associates as of June 30, 1992. MMO plans to complete the development and sale of Ainalani Associates three projects on the islands of Maui and Hawaii, described below under "MMO projects," and has assumed Ainalani Associates' 50% partnership interest in Palailai Associates, a partnership with Palailai Holdings, Inc. Baldwin*Malama. In 1990, MDC acquired a 50% general partnership interest in Baldwin*Malama, a partnership with Baldwin Pacific Properties, Inc. (BPPI) established to acquire about 172 acres of land for potential development of about 780 single and multi-family residential units in Kihei on the island of Maui. The project has completed site work for the first phase of single family units. At December 31, 1993, 23 homes were completed and sold, four homes were under construction and six completed units were available for sale. In May 1993, Baldwin*Malama was reorganized as a limited partnership in which MDC is the sole general partner and BPPI is the sole limited partner. In conjunction with the dissolution of the Baldwin*Malama general partnership and formation of the limited partnership, MPC agreed to loan $1.6 million to BPPI and up to $15 million to the limited partnership, and beginning in May 1993, MDC consolidated the accounts of Baldwin*Malama. Previously, MDC accounted for its investment in Baldwin*Malama under the equity method. At December 31, 1993, the outstanding balance on MPC's loan to BPPI was $1.6 million. Palailai Associates. MMO assumed Ainalani Associates' interest in Palailai Associates on August 17, 1992 upon acquiring MDT's 50% interest in Ainalani Associates. In 1993, Palailai Associates completed the development and sale of the first increment of 107 homes and lots and completed the bulk sale of its 38.8 acres of multi-family zoned land in Makakilo, Oahu. The second increment of 69 single family homes is currently in progress, with 35 homes completed and sold as of December 31, 1993. Palailai Associates owns approximately 62 acres of adjacent land zoned for residential development. MMO PROJECTS On August 17, 1992, MMO acquired the Kipona Hills, Kua' Aina Ridge and Hanohano projects of Ainalani as a result of MMO's acquisition of MDT's 50% interest in Ainalani Associates and Ainalani Associates' subsequent dissolution. Kipona Hills is a 66-unit subdivision located in Waikoloa on the island of Hawaii. Through December 31, 1993, 42 homes or lots were completed and sold, and five completed homes and 19 lots were available for sale. Kua' Aina Ridge is a 92-lot-only subdivision in Pukalani, Maui. Subdivision improvements have been completed and sales closings commenced in 1993. As of December 31, 1993, five lots were sold. Kehaulani Place (formerly known as Hanohano), consisting of approximately 50 acres of land in Pukalani, Maui, is currently zoned for agriculture. Rezoning and land-use reclassification will be required before development can commence. Land planning and presentations to local community groups commenced in 1993. PROJECT FINANCING At December 31, 1993, MPC or its subsidiaries were directly liable for $11.5 million of outstanding construction loans and had additional construction loan facilities of $5.8 million. In addition, at December 31, 1993, MPC or its subsidiaries had issued (i) guaranties under which they were jointly and severally contingently liable with their joint venture partners for $2.1 million of outstanding construction loans and (ii) payment guaranties under which MPC or its subsidiaries were severally contingently liable for $4.6 million of outstanding construction loans and $4.7 million of additional undrawn construction loan facilities. In total, at December 31, 1993, MPC or its subsidiaries were liable or contingently liable for $18.2 million of outstanding construction loans and $10.5 million in undrawn construction loan facilities. At December 31, 1993, HEI had agreed with the lenders of construction loans and loan facilities, of which approximately $10.5 million was undrawn and $16.1 million was outstanding, that it will maintain ownership of 100% of the stock of MPC and that it intends, subject to good and prudent business practices, to keep MPC financially sound and responsible to meet its obligations. MPC or its subsidiaries may enter into additional commitments in connection with the financing of future phases of development of MPC's projects and HEI may enter into similar agreements regarding the ownership and financial condition of MPC. MALAMA WATERFRONT CORP. Malama Waterfront Corp., a wholly owned subsidiary of MPC, entered into an agreement to purchase HECO's Honolulu Power Plant in a sale and leaseback transaction. However, HECO is reconsidering the sale of the plant. See a further discussion in "Item 2.

ITEM 2. PROPERTIES HEI leases 17,612 square feet of office space in downtown Honolulu. The leases expire at various dates from March 31, 1996 to April 30, 1999 (with an option for HEI to extend one of the leases on most of the office space to March 31, 2001). The properties of HEI's subsidiaries are as follows: ELECTRIC UTILITY HECO owns and operates three generating plants on the island of Oahu at Honolulu, Waiau and Kahe, with an aggregate generating capability of 1,263 MW at December 31, 1993. The three plants are situated on HECO-owned land having a combined area of 535 acres. In addition, HECO owns a total of 114 acres of land on which are located substations, transformer vault sites, distribution base yards and the Kalaeloa cogeneration facility site. Electric lines are located over or under public and nonpublic properties. Most of HECO's leases, easements and licenses have been recorded. At December 31, 1993, HECO owned approximately 828 miles of overhead transmission lines, 1,171 miles of overhead distribution lines, 2,007 miles of underground cables, 70,395 fully-owned or jointly-owned poles and 194 steel or aluminum high voltage transmission towers. The transmission system operates at 46,000 and 138,000 volts. The total capacity of HECO's transmission and distribution substations was 5,414,000 kilovoltamperes at December 31, 1993. HECO owns a building and approximately 11.5 acres of land located in Honolulu which houses its operating, engineering and information services departments and a warehousing center. It also leases an office building and certain office spaces in Honolulu. The lease for the office building expires in November 2002, with an option to further extend the lease to November 2012. The leases for certain office spaces expire on December 31, 1996 with options to extend to December 31, 2001. HECO owns 19.2 acres of land at Barbers Point used to situate fuel oil storage facilities with a combined capacity of 970,700 barrels. HECO also owns fuel oil tanks at each plant site with a total maximum usable capacity of 915,400 barrels. The properties of HECO are subject to a first mortgage securing HECO's outstanding first mortgage bonds. On December 20, 1989, HECO applied to the PUC for the approval of the sale to Malama Waterfront Corp. and leaseback of the Honolulu power plant and Iwilei tank farm, the approval of the transfer values and the approval of the accounting and rate-making treatments thereof. Prior to the PUC rendering a decision on this application, HECO determined that changing conditions altered the economics of the proposed sale such that a later retirement of the Honolulu power plant may be more favorable. As such, HECO withdrew its application for the sale and leaseback of the plant in July 1993. A brief description of the properties of HECO's two electric utility subsidiaries follows: MECO owns and operates two generating plants on the island of Maui, at Kahului and Maalaea, with an aggregate capability of 201.3 MW. The plants are situated on MECO-owned land having a combined area of 28.6 acres. MECO also owns fuel oil storage facilities at these sites with an aggregate maximum usable storage capacity of 145,300 barrels. MECO's administrative offices and engineering and distribution departments are located on 9.1 acres of MECO-owned land in Kahului. MECO also owns and operates smaller distribution and generation systems on the islands of Lanai and Molokai. The properties of MECO are subject to a first mortgage securing MECO's outstanding first mortgage bonds. HELCO owns and operates five generating plants on the island of Hawaii. These plants at Hilo (2), Waimea, Kona and Puna have an aggregate generating capability of 154.6 MW (excluding two small run-of-river hydro units). The plants are situated on HELCO-owned land having a combined area of approximately 43 acres. HELCO owns 6.0 acres of land in Kona, which are used for a baseyard, and it leases 4.0 acres of land for its baseyard in Hilo. The lease expires in 2030. The deeds to the sites located in Hilo contain certain restrictions which do not materially interfere with the use of the sites for public utility purposes. The properties of HELCO are subject to a first mortgage securing HELCO's outstanding first mortgage bonds. SAVINGS BANK ASB owns its executive office building located in downtown Honolulu. The following table sets forth certain information with respect to offices owned and leased by ASB and its subsidiaries at December 31, 1993. The net book value of office facilities is approximately $31 million. Of this amount, $25 million represents the net book value of the land and improvements for the 13 offices owned by ASB. The remaining $6 million represents the net book value of ASB's leasehold improvements. OTHER FREIGHT TRANSPORTATION HTB, currently owns seven tugboats ranging from 1,430 to 2,668 HP, two tenders of 500 HP and three flatdecked barges. HTB owns no real property, but rents on a month-to-month basis or leases its pier property used in its operations from the State of Hawaii under a revocable permit and two-year lease. It is expected that expiring leases will be renewed as necessary. YB, HTB's subsidiary, currently owns four charter tugs, two doubledecked and six flatdecked barges and most of its shoreside equipment, including 20-foot containers, chassis, refrigerated containers, container vans, hi-lifts, flatracks, automobile racks and other related equipment. YB has three- and four-year leases expiring at various dates in 1994 through 1995 for shoreside equipment (containers, flatracks and chassis) at a monthly cost of approximately $8,500. YB owns no real property, but rents on a month-to-month basis or leases various pier property and warehouse facilities from the State of Hawaii under a revocable permit, or under a two-year or five-year lease. All lease terms began on January 1, 1992. It is expected that expiring leases will be renewed as necessary. REAL ESTATE DEVELOPMENT MPC. See Item 1, "Business--Other--Real estate--Malama Pacific Corp." OTHER HEIIC. See Item 1, "Business--Other--HEI Investment Corp." LVI operates a windfarm on the island of Hawaii with a generating capability of 1.7 MW. LVI leases 78 acres of land for its windfarm. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS Except as provided for below and in "Item 1. Business," there are no known pending legal proceedings, other than ordinary routine litigation incidental to their respective businesses, to which HEI or any of its subsidiaries is a party or of which any of their property is the subject. HECO POWER OUTAGE On April 9, 1991, HECO experienced a power outage that affected all customers on the island of Oahu. One major transmission line was de-energized for routine maintenance when two major transmission lines tripped, causing another major transmission line to become overloaded and automatically trip. An island-wide power outage resulted. Power was restored over the next twelve hours. The PUC initiated an investigation of the outage by its order dated April 16, 1991. This investigation was consolidated with a pending investigation of an outage that occurred in 1988. The PUC held an initial hearing on the April 9, 1991 outage in May 1991. In July 1991, HECO filed a report of its internal investigative task force with the PUC. The report indicated that the results of the investigation were inconclusive with respect to why one of the major lines tripped and recommended actions to strengthen system reliability. The parties to the investigation (HECO, Consumer Advocate and U.S. Department of Defense) agreed that HECO should retain an independent consultant to investigate the cause of the line trip. By an order dated October 23, 1991, the PUC approved HECO's retention of Power Technologies, Inc. (PTI) and directed that the objectives of the study be to assess the reliability and overall stability of HECO's electric power system, to identify possible weaknesses, deficiencies and conditions within the system that contributed to the island-wide power outage, and to recommend a plan to increase the reliability of HECO's system and minimize the occurrence of future island-wide outages. In its order, the PUC also stated that: "[n]either the [PUC] nor HECO nor any of the other parties to this docket is bound by PTI's report or analysis or is precluded from retaining other consultants." In August 1993, PTI's report was submitted to the PUC. In its report, PTI made more than 100 recommendations for HECO to improve reliability, including selective use of herbicides to control the growth of trees under power lines. PTI said some recommendations are for implementation, some are for further study and possible implementation and some are for consideration. Some of the recommendations relate to the 1991 outage and some do not. PTI identified four recommendations as deserving immediate attention: (1) perform a detailed inspection of 138-kilovolt overhead transmission lines to ensure that present clearance distances to trees, wire crossings and other conductive objects are sufficient for at least one year; (2) determine relationships between tree clearances and "line sag" changes that result from lines carrying different amounts of electricity; (3) build the Waiau-Campbell Industrial Park 138-kilovolt transmission line as soon as possible and consider building the line to operate at higher voltage in the future; and (4) increase the number of "live-line" overhead transmission linemen and engineering and management personnel to support line and right-of-way functions. Regarding the outage, PTI concluded that the fault on the third of four transmission lines was the result of tree contact. This conclusion conflicts with the finding of another consultant who found that certain evidence favored a fault in the line over a pineapple field with no trees. Other PTI recommendations include (1) reviewing reporting systems used by co-generators and independent power producers from whom HECO buys power to be sure they are adequate to reveal problems that could affect system reliability, and (2) keeping in service the downtown Honolulu power plant previously scheduled for retirement in 1996. HECO filed its comments on the PTI recommendations with the PUC in November 1993. Further proceedings have not been scheduled at this time. Management cannot predict the timing and outcome of any decision and order to be issued by the PUC with respect to the outages or with respect to the recommendations made by PTI. HECO's PUC-approved tariff rule states that "[t]he Company will not be liable for interruption or insufficiency of supply or any loss, cost, damage or expense of any nature whatsoever, occasioned thereby if caused by accident, storm, fire, strikes, riots, war or any cause not within the Company's control through the exercise of reasonable diligence and care." Under the rule, customers had 30 days from the date of the power outage to file claims. HECO received approximately 2,900 customer claims which totaled approximately $7 million. Of the 2,900 claims, approximately 1,450 are for property damage. As of December 31, 1993, HECO had settled approximately 542 of these property damage claims, had settlement offers outstanding with respect to approximately 119 more of these claims and anticipates making settlement offers with respect to the remaining property claims upon receipt and review of appropriate supporting documentation. The settlement offers are being made for purposes of settlement and compromise only, and without any admission by HECO of liability for the outage. Not covered in the settlement offers and requests for documentation are approximately 1,450 claims involving alleged personal injury or economic losses, such as lost profits. On April 19, 1991, seven direct or indirect business customers on the island of Oahu filed a lawsuit against HECO on behalf of themselves and an alleged class, claiming $75 million in compensatory damages and additional unspecified amounts for punitive damages because of the April 9, 1991 outage. The lawsuit was dismissed without prejudice in March 1993 and subsequently refiled by the plaintiffs. HECO has filed an answer which denies the principal allegations in the complaint, sets forth affirmative defenses, and asserts that the suit should not be maintained as a class action. Discovery proceedings have been initiated. No trial date has been set. A motion for an order denying class certification of the lawsuit has been filed and is set for hearing in March 1994. A reserve equal to the deductible limits with respect to HECO's insurance coverage has been recorded with respect to claims arising out of the April 1991 outage. In the opinion of management, losses (if any), net of estimated insurance recoveries, resulting from the ultimate outcome of the lawsuit and claims related to the April 9, 1991 outage will not have a material adverse effect on the Company or consolidated HECO. HELCO RELIABILITY INVESTIGATION In July 1991, following service interruptions and rolling blackouts instituted on the island of Hawaii, the PUC issued an order calling for an investigation into the reliability of HELCO's system. An evidentiary hearing was held in September 1991 and public hearings were held in October 1991. In light of approximately 20 subsequent incidents of rolling blackouts and service interruptions resulting from insufficient generation margin, further evidentiary hearings were held in July 1992. With the input from an independent consultant and the parties to the proceedings, the PUC may formulate minimum reliability standards for HELCO, use the standards to assess HELCO's system reliability, and re-examine the rate increase approved in October 1992 to see whether any adjustments are appropriate. HELCO's generation margin has improved with the addition of a 20-MW combustion turbine in August 1992, PGV's commencement of commercial operations and Hamakua's temporary return to commercial operation (see "Item 1. Business--Electric utility-Nonutility generation"). HELCO is proceeding with plans to install two 20-MW combustion turbines in 1995, followed by an 18-MW heat steam recovery generator in 1997, at which time these units will be converted to a combined-cycle unit, subject in each case to obtaining necessary permits. In the opinion of management, the PUC's adjustment, if any, resulting from the reliability investigation will not have a material adverse effect on the Company's or HECO's consolidated financial condition or results of operations. HECO POWER PURCHASE AGREEMENTS DISPUTES HECO is disputing certain amounts billed each month under its power purchase agreements with Kalaeloa Partners, L.P. (Kalaeloa) and AES Barbers Point, Inc. (AES-BP) and has withheld payment of some of the disputed amounts pending resolution. With respect to the billings from Kalaeloa, HECO believes that it has counterclaims which would mitigate, if not more than offset, the disputed amounts billed by Kalaeloa. Disputed amounts billed by Kalaeloa and AES-BP through December 31, 1993 totaled approximately $2.1 million and $1.5 million, respectively. Approximately $0.5 million of the total disputed amounts, if paid, are includable in HECO's energy cost adjustment clause, and would be passed through to customers. HECO has not recognized any portion of the disputed amounts as an expense or liability in its financial statements. Discussions between HECO and Kalaeloa, and HECO and AES-BP to resolve the disputed billing amounts are continuing. In the event the parties are unable to settle the disputes, both the Kalaeloa and AES-BP power purchase agreements contain provisions whereby either party to the agreement may cause the dispute to be submitted to binding arbitration. Kalaeloa has requested that its dispute with HECO be arbitrated and this arbitration process has commenced. Based on information currently available, HECO's management believes that the ultimate outcome of these disputes will not have a material adverse effect on the Company's or HECO's consolidated financial condition or results of operations. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS HEI and HECO: During the fourth quarter of 1993, no matters were submitted to a vote of security holders of the Registrants. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANTS' COMMON EQUITY AND RELATED STOCKHOLDER MATTERS HEI: The information required by this item is incorporated herein by reference to pages 67 and 69 (Note 19, "Regulatory restrictions on net assets" and Note 22, "Quarterly information (unaudited)," of the Notes to HEI's Consolidated Financial Statements) and page 27 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a). Certain restrictions on dividends and other distributions of HEI are described in "Item 1. Business--Regulation and other matters--Restrictions on dividends and other distributions." The total number of holders of record of HEI common stock as of March 21, 1994, was 24,672. HECO: Market information and holders--not applicable. Since the corporate restructuring on July 1, 1983, all the common stock of HECO has been held solely by its parent, HEI, and is not publicly traded. The dividends declared and paid on HECO's common stock for the four quarters of 1993 and 1992 are as follows: The regulatory restrictions on net assets are incorporated herein by reference to page 27 (Note 12 to HECO's Consolidated Financial Statements, "Regulatory restrictions on distributions to parent") of HECO's 1993 Annual Report to Stockholder, portions of which are filed herein as HECO Exhibit 13(b). ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA HEI: The information required by this item is incorporated herein by reference to page 27 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a). HECO: The information required by this item is incorporated herein by reference to page 2 of HECO's 1993 Annual Report to Stockholder, portions of which are filed herein as HECO Exhibit 13(b). ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS HEI: The information required by this item is incorporated herein by reference to pages 29 to 39 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a). HECO: The information required by this item is incorporated herein by reference to pages 3 to 9 of HECO's 1993 Annual Report to Stockholder, portions of which are filed herein as HECO Exhibit 13(b). ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA HEI: The information required by this item is incorporated herein by reference to the section entitled "Segment financial information" on page 28 and to pages 41 to 69 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a). HECO: The information required by this item is incorporated herein by reference to pages 10 to 29 and to the section entitled "Consolidated quarterly financial information (unaudited)" on page 31 of HECO's 1993 Annual Report to Stockholder, portions of which are filed herein as HECO Exhibit 13(b). ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE HEI AND HECO: None PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTS HEI: The following persons are, or may be deemed, executive officers of HEI. Their ages are given as of March 10, 1994. Officers are appointed to serve until the meeting of the Board of Directors following the next Annual Meeting of Stockholders (which shall occur on April 19, 1994) and/or until their successors have been appointed and qualified (or until their earlier resignation or removal). Company service includes service with an HEI subsidiary. HEI's executive officers, with the exception of Peter C. Lewis, Charles F. Wall and Andrew I. T. Chang, are officers and/or directors of one or more of HEI's subsidiaries. There are no family relationships between any executive officer or director of HEI and any other executive officer or director of HEI. The list of current directors of HEI is incorporated herein by reference to page 70 of HEI's 1993 Annual Report to Stockholders, portions of which are filed herein as HEI Exhibit 13(a). Information on their business experience and directorships is incorporated herein by reference to pages 3 to 5 of the registrant's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. Thurston Twigg-Smith (who is not standing for reelection as a Director) is President, Chief Executive Officer and Director of Persis Corporation; Chairman, Chief Executive Officer and Director of Northwest Media, Inc., and Maryville Alcoa Daily Times; Chairman of the Board of The Honolulu Advertiser; Director of HECO, ASB and The Museum of Contemporary Art (Los Angles); Trustee of the McInerny Foundation, Punahou School, Honolulu Academy of Arts, The Contemporary Museum (Honolulu), Old Sturbridge Village (Massachusetts), The Skowhegan School (Maine) and The Philatelic Foundation, N.Y.; and member of the Governing Board of The Yale Art Gallery (Connecticut). HECO: The following table sets forth certain information concerning the executive officers of HECO. Their ages are given as of March 10, 1994. Officers are appointed to serve until the meeting of the Board of Directors following the next Annual Meeting and/or until their respective successors have been appointed and qualified. Company service includes service with HECO affiliates. HECO's executive officers, Robert F. Clarke, Harwood D. Williamson, Edward Y. Hirata, Paul A. Oyer and Molly M. Egged, are officers of one or more of the affiliated HEI companies. There are no family relationships between any executive officer or director of HECO and any other executive officer or director of HECO. The list of current directors of HECO is incorporated herein by reference to page 33 of HECO's 1993 Annual Report to Stockholder, portions of which are filed herein as HECO Exhibit 13(b). Information on the business experience and directorships of directors of HECO who are also directors of HEI is incorporated herein by reference to pages 3 through 5 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. Mildred D. Kosaki, age 69, and Paul C. Yuen, age 65, as of March 10, 1994, are the only outside directors of HECO who are not directors of HEI. Mrs. Kosaki has been a Director of HECO from 1973 to the present. She resigned from the HEI Board in 1987. She was also a Director of the International Pacific University from 1989 to 1991 and a Director on the Board of The Honolulu Advertiser from 1983 to 1989. She is a specialist in education research. Dr. Yuen, who was elected a Director of HECO in April 1993, is Senior Vice President for the University of Hawaii and Executive Vice Chancellor for the University of Hawaii-Manoa. In the past five years, he has had various administrative positions at the University of Hawaii-Manoa. He also serves on the Boards of Cyanotech Corporation, the Pacific International Center for High Technology Research and Hawaii Cultured Pearls, Inc. Information on Mr. Oyer's business experience and directorship is indicated above. The information required under this item by Item 405 of Regulation S-K is incorporated by reference to page 9 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION HEI: The information required under this item for HEI is incorporated by reference to pages 6 to 7 and 9 to 22 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. HECO: The following tables set forth the information required for the chief executive officer of HECO and the four other most highly compensated HECO executive officers serving at the end of 1993. All executive compensation amounts presented for Harwood D. Williamson are duplicative of the amounts presented in HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. SUMMARY COMPENSATION TABLE The following is the summary compensation table which sets forth the annual and long-term compensation of the chief executive officer of HECO and the four other most highly compensated executive officers of HECO serving at the end of 1993. SUMMARY COMPENSATION TABLE (1) Includes directors' fees of $28,000 in 1993 and $25,000 in 1992 for Mr. Williamson and directors' fees of $5,600 in 1993 and $4,700 in 1992 for Mr. Oyer. (2) The named executive officers are eligible for an incentive award under the Company's annual Executive Incentive Compensation Plan (EICP). A decision on EICP bonus payouts is made at the beginning of each year for the previous year's performance period. (3) Covers interest earned on deferred compensation and includes above-market earnings in the amount of $63,467 for 1993 and $57,498 for 1992 on deferred annual and Long-Term Incentive Plan (LTIP) payouts for Mr. Williamson. Also includes above-market earnings in the amount of $10,806 for 1993 and $9,790 for 1992 on deferred annual payouts for Mr. Oyer. (4) Includes a special one-time, premium-priced grant of 40,000 shares without dividend equivalents for Mr. Williamson in 1992. Other options granted in each of the three years for Mr. Williamson included dividend equivalents. For each of the other named executive officers, options granted in 1993 and 1991 did not include dividend equivalents. (5) LTIP payouts are determined in April each year for the three-year cycle ending on December 31 of the previous calendar year. In 1993, only Mr. Williamson was eligible to receive a LTIP payout; however, no LTIP payout was received for the 1990-1992 performance cycle because none of the minimum earnings threshold levels were achieved. The determination of whether there will be a payout for Mr. Williamson under the 1991-1993 LTIP will not be made until April 1994. (6) Represents amounts accrued by the Company in 1993 for certain death benefits provided to the named executive officers. In 1992 and 1991, the Company did not accrue for these benefits. Additional information is incorporated by reference to page 19 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. Covers reimbursement of moving expenses for Mr. May in 1992. (7) Mr. May joined HECO as the Senior Vice President on February 1, 1992. OPTION GRANTS IN LAST FISCAL YEAR The following table shows the HEI stock options which were granted in 1993 to the executives named in the HECO Summary Compensation Table, all of which are nonqualified stock options. The practice of granting stock options, which may include dividend equivalent shares, has been followed each year since 1987. (1) For the 20,000 option shares granted with an exercise price of $38.27 per share, additional dividend equivalent shares are granted to Mr. Williamson at no additional cost throughout the four-year vesting period (vesting in equal installments) which begins on the date of grant. Dividend equivalents are computed, as of each dividend record date, both with respect to the number of shares under the option and with respect to the number of dividend equivalent shares previously credited to the participant and not issued during the period prior to the dividend record date. Accelerated vesting is provided in the event a Change-in-Control occurs. No stock appreciation rights have been granted under the Company's current benefit plans. (2) Based on a Binomial Option Pricing Model which is a variation of the Black-Scholes Option Pricing Model. For the stock options granted with a 10-year option period, an exercise price of $38.27, and with additional dividend equivalent shares granted for the first four years of the option, the Binomial Value is $9.66 per share. The following assumptions were used in the model: Stock Price: $38.27; Exercise Price: $38.27; Term: 10 years; Volatility: .55; Interest Rate: 6.0%; and Dividend Rate: 6.4%. The following were the valuation results: Binomial Option Value: $5.03; Dividend Credit Value: $4.63; and Total Value: $9.66. AGGREGATED OPTION EXERCISES AND FISCAL YEAREND OPTION VALUE TABLE The following table shows the HEI stock options, including dividend equivalents, exercised in 1993 by the named executive officers in the HECO Summary Compensation Table. Also shown is the number and value of unexercised options and dividend equivalents at the end of 1993. Under the Stock Option and Incentive Plan, dividend equivalents were granted to Mr. Williamson as part of the stock option award, except for the one-time, premium-priced grant in May 1992. For each of the other named executive officers, options granted in 1993 and 1991 did not include dividend equivalents. Dividend equivalents permit a participant who exercises a stock option to obtain at no additional cost, in addition to the option shares, the amount of dividends declared on the number of shares of common stock with respect to which the option is exercised during the period between the grant and the exercise of the option. Dividend equivalents are computed, as of each dividend record date throughout the four-year vesting period (vesting in equal installments), which begins on date of grant, both with respect to the number of shares underlying the option and with respect to the number of dividend equivalent shares previously credited to the executive officer and not issued during the period prior to the dividend record date. AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAREND OPTION VALUES (1) Includes dividend equivalents of $79,916 exercisable and $26,296 unexercisable for Mr. Williamson and dividend equivalents of $25,830 exercisable for Mr. Oyer. All options were in the money (where the option price is less than the closing price on December 31, 1993) except the 1990 stock option grant at $36.01 per share, the 1992 stock option grant at $35.94 per share, and the 1993 stock option grant at $38.27 per share and the 1992 premium-priced grant at $41.00 per share. Value based on closing price of $35.875 per share on the New York Stock Exchange on December 31, 1993. LONG-TERM INCENTIVE PLAN AWARDS TABLE A Long-Term Incentive Plan award was made to one of the named executive officers in the HECO Summary Compensation Table, Mr. Williamson. Additional information required under this item is incorporated by reference to page 13 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. PENSION PLAN The Retirement Plan for Employees of Hawaiian Electric Industries, Inc. and Participating Subsidiaries (the Retirement Plan) provides a monthly retirement pension for life. Additional information required under this item is incorporated by reference to pages 14 to 15 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. As of December 31, 1993, the named executive officers in the HECO Summary Compensation Table had the following number of years of credited service under the Retirement Plan: Mr. Williamson, 37 years; Mr. May, 1 year; Mr. Oyer, 27 years; Mr. Rodrigues, 23 years; and Mr. Iwahiro, 34 years. CHANGE-IN-CONTROL AGREEMENT Messrs. Williamson and May are the only named executive officers in the HECO Summary Compensation Table in which HEI has entered into a Change-in-Control Agreement. Additional information required under this item is incorporated by reference to page 15 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. Based on W-2 earnings for the five most recent years (1989-1993) or the portion of such period during which the executive performed personal service for HEI and its subsidiaries, the lump sum severance would be as follows: Mr. Williamson - $1,035,551 and Mr. May - $869,890. COMPENSATION COMMITTEE REPORT ON EXECUTIVE COMPENSATION INTRODUCTION Decisions on executive compensation for the named executive officers are made by the Compensation Committee of the HEI Board of Directors which is composed of six independent nonemployee directors. All decisions by the Compensation Committee are reviewed by the full HEI Board except for decisions about HEI's stock based plans, which must be made solely by the Committee in order to satisfy Securities Exchange Act Rule 16b-3. The Committee has retained the services of an independent compensation consulting firm to assist in executive compensation matters. Except for specific compensation decisions regarding Mr. Williamson which are discussed below, additional information required under this item is incorporated by reference to pages 16 through 19 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. BASE SALARY Mr. Williamson's base salary is determined based on the recommendation of Robert F. Clarke, President and Chief Executive Officer of HEI and Chairman of the Board of HECO, within the recommended salary range and the Committee's approval. Mr. Clarke's recommendation is based on an overall evaluation of Mr. Williamson's performance during the preceding year. This evaluation is subjective in nature and takes into account all aspects of Mr. Williamson's responsibilities at the discretion of Mr. Clarke. Mr. Williamson's base salary was raised from an annual rate of $300,000 to an annual rate of $320,000, effective May 1, 1993. This action by the Committee was subsequently ratified by the HECO Board of Directors. STOCK OPTIONS The 1993 stock option award to Mr. Williamson of 8,000 shares of HEI Common Stock plus dividend equivalents was based on the consultant's recommendation and the independent evaluation of an appropriate award level by Mr. Clarke and the HEI Compensation Committee. In this evaluation, the Committee took into account prior awards to Mr. Williamson and an overall subjective evaluation of Mr. Williamson's job performance. HECO BOARD OF DIRECTORS COMMITTEES OF THE HECO BOARD The Board of Directors of HECO has only one standing committee, the Audit Committee, which is comprised of three nonemployee directors: Ben F. Kaito, Chairman, and Mildred D. Kosaki and Diane J. Plotts. In 1993, the Audit Committee held four meetings to review with management, the internal auditor and HECO's independent auditors the activities of the internal auditor, the results of the annual audit by the independent auditor and the financial statements which are included in HECO's 1992 Annual Report to Stockholder. The Audit Committee holds such meetings as it deems advisable to review the financial operations of HECO. REMUNERATION OF THE HECO DIRECTORS AND ATTENDANCE AT MEETINGS In 1993, William G. Foster (who passed away in October 1993), Mildred D. Kosaki and Paul C. Yuen were the only nonemployee directors of HECO who were not also directors of HEI. They were paid a retainer of $12,000, one-half of which was distributed in the common stock of HEI pursuant to the HEI Nonemployee Director Stock Plan and one-half of which was distributed in cash. The number of shares of stock distributed was based on a price of $38.27 per share, which is equal to the average of the daily high and low sales prices of HEI common stock for all trading days in March 1993, divided into $6,000, with a cash payment made in lieu of any fractional share. In addition, a fee of $700 was paid in cash to each director for each Board and Committee meeting attended by the director. The Chairman of the Audit Committee was paid an additional $100 for each Committee meeting attended. In 1993, there were six regular bi-monthly meetings and one special meeting of the Board of Directors. All incumbent directors, except William G. Foster, attended at least 75% of the total number of meetings of the Board and Committee on which they served. HECO participates in the Nonemployee Director Retirement Plan described on page 7 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT HEI: The information required under this item is incorporated by reference to pages 8 and 9 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. HECO: HEI owns all of the common stock of HECO, which is HECO's only class of voting securities. HECO has also issued and has outstanding various series of preferred stock, the holders of which, upon certain defaults in dividend payments, have the right to elect a majority of the directors of HECO. The following table shows the shares of HEI common stock beneficially owned by each HECO director, named HECO executive officers as listed in the Summary Compensation Table on page 57 and by HECO directors and officers as a group, as of February 10, 1994, based on information furnished by the respective individuals. * Also a named executive officer listed in the Summary Compensation Table on page 57. ** Excludes HECO directors Messrs. Clarke, Henderson, Kaito, and Williamson and Ms. Plotts, who also serve on the HEI Board of Directors. The information required is incorporated by reference to pages 8 and 9 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. Messrs. Clarke and Williamson are also named executive officers listed in the Summary Compensation Table on page 10 of the above-referenced Definitive Proxy Statement of HEI. ***The number of shares of common stock beneficially owned by any HECO director or by all HECO directors and officers as a group does not exceed 1% of the outstanding common stock of HEI. (1) Sole voting and investment power. (2) Shared voting and investment power (shares registered in name of respective individual and spouse). (3) Shares owned by spouse, children or other relatives sharing the home of the director or an officer in the group and in which personal interest of the director or officer is disclaimed. (4) Stock options exercisable within 60 days after February 10, 1994, under the 1987 Stock Option and Incentive Plan, as amended. Shares for Mr. Oyer include accompanying dividend equivalents (720 shares) for stock options awarded in 1988 only. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS HEI: The information required under this item is incorporated by reference to pages 21 to 23 of HEI's Definitive Proxy Statement, prepared for the Annual Meeting of Stockholders to be held on April 19, 1994, and filed herein as HEI Exhibit 22. HECO: As of December 31, 1992, T. Michael May, Senior Vice President of HECO, was indebted to HECO in the amount of $290,000 by reason of loans made to him by HECO in 1992 for relocation purposes. The noninterest-bearing notes were due in 1993. In 1993, $110,000 of Mr. May's indebtedness was paid and the remaining $180,000 was converted to a 15-year note bearing interest at 6.28%. The note is due in 2008 or upon demand, if Mr. May ceases to be employed by HECO, and is secured by a second mortgage on real estate. As of December 31, 1993, Mr. May was indebted to HECO in the amount of $180,000. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)(1) FINANCIAL STATEMENTS The following financial statements contained in HEI's 1993 Annual Report to Stockholders and HECO's 1993 Annual Report to Stockholder, portions of which are filed by HEI as Exhibit 13(a) and, portions of which are filed by HECO as Exhibit 13(b), respectively, are incorporated by reference in Part II, Item 8, of this Form 10-K: (a)(2) FINANCIAL STATEMENT SCHEDULES The following financial statement schedules for HEI and HECO are included in this Report on the pages indicated below: Certain Schedules, other than those listed, are omitted because they are not required, or are not applicable, or the required information is shown in the consolidated financial statements or notes included in HEI's 1993 Annual Report to Stockholders and HECO's 1993 Annual Report to Stockholder, which financial statements are incorporated herein by reference. (a)(3) EXHIBITS Exhibits for HEI and HECO and their subsidiaries are listed in the "Index to Exhibits" found on pages 87 through 94 of this Form 10-K. The exhibits listed for HEI and HECO are listed in the index under the headings "HEI" and "HECO," respectively, except that the exhibits listed under "HECO" are also considered exhibits for HEI. (b) REPORTS ON FORM 8-K HEI AND HECO: During the fourth quarter of 1993, HEI and HECO filed three Current Reports, Forms 8-K, with the SEC. In the Form 8-K dated October 5, 1993, HEI and HECO filed information under Item 5 regarding HECO and its subsidiaries kilowatthour sales forecast, PTI's report on HECO's power outage, and income taxes. In the Form 8-K dated November 17, 1993, HEI and HECO filed information under Item 5 regarding the HELCO rate case filed in November 1993, MECO rate case filed in November 1991, HECO's comments on PTI's report on HECO's power outage, HELCO and MECO transportation of heavy fuel oil, liquidity and capital resources- electric utility, Kalaeloa Partners, L.P. and AES Barbers Point, Inc. and discontinued operations-insurance companies. In the Form 8-K dated December 27, 1993, HEI and HECO filed information under Item 5 regarding HECO filing its 1995 rate case. (KPMG Peat Marwick Letterhead) INDEPENDENT AUDITORS' REPORT The Board of Directors and Shareholders Hawaiian Electric Industries, Inc.: Under date of February 11, 1994, we reported on the consolidated balance sheets of Hawaiian Electric Industries, Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 annual report to shareholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules as listed in the accompanying index. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in note 15 to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for income taxes. Additionally, as discussed in note 18 to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for postretirement benefits other than pensions. /s/ KPMG Peat Marwick Honolulu, Hawaii February 11, 1994 [KPMG Peat Marwick letterhead] The Board of Directors and Shareholder Hawaiian Electric Company, Inc.: Under date of February 11, 1994, we reported on the consolidated balance sheets and consolidated statements of capitalization of Hawaiian Electric Company, Inc. (a wholly-owned subsidiary of Hawaiian Electric Industries, Inc.) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 annual report to shareholder. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules as listed in the accompanying index. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in note 7 to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for income taxes. Additionally, as discussed in note 10 to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for postretirement benefits other than pensions. /s/ KPMG Peat Marwick Honolulu, Hawaii February 11, 1994 Hawaiian Electric Industries, Inc. SCHEDULE I -- MARKETABLE SECURITIES - OTHER INVESTMENTS December 31, 1993 * Represents cost of each issue, except for: ASB's other securities held for trading, which are stated at market, and mortgage-backed securities, which are stated at amortized cost; and MPC's investment in real estate partnerships, which are stated in accordance with the equity method of accounting. ** Secured by residential property. *** Not actively traded. Fair value considered to equal cost basis or amount at which security is carried in the balance sheet. Hawaiian Electric Industries, Inc. and Hawaiian Electric Company, Inc. SCHEDULE II--AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES December 31, 1993 (a) Two unsecured promissory notes payable. Interest rate is based on Bank of Hawaii's prime rate plus 2% for the first note and Bank of Hawaii's prime rate plus 0.75% for the second note. (b) In May 1993, Baldwin*Malama (B*M) was reorganized as a limited partnership in which Malama Development Corp. (MDC) is the sole general partner and Baldwin Pacific Properties, Inc. (BPPI) is the sole limited partner. In conjunction with the dissolution of the B*M general partnership and formation of the limited partnership, MPC agreed to loan $1.6 million to BPPI and up to $15 million to the limited partnership, and beginning in May 1993, MDC consolidated the accounts of B*M. Previously, MDC accounted for its investment in B*M under the equity method. At December 31, 1993, the outstanding balances on MPC's loan to B*M was $10.6 million, which was eliminated in consolidation as an intercompany account. The interest rate is based on one-half of Bank of Hawaii's prime plus 8.5%. The loan matures in May 1995 and is secured by security interest in real property, option to purchase land, and assignments of BPPI and MDC's partnership interests. (c) Two unsecured noninterest-bearing notes payable from T. Michael May, Senior Vice President of Hawaiian Electric Company, Inc. (HECO), due and collected in 1993. (d) Unsecured noninterest-bearing note payable from Warren H. W. Lee, President of Hawaii Electric Light Co., Inc. (HELCO), which note was extended and is currently due in 1995 or upon demand, if he ceases to be employed by HELCO. Hawaiian Electric Industries, Inc. and Hawaiian Electric Company, Inc. SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES December 31, 1992 (a) On August 17, 1992, Malama Mohala Corp. (MMO), a wholly owned subsidiary of Malama Pacific Corp. (MPC), acquired MDT BF Limited Partnership's (MDT) 50% interest in Ainalani Associates (Ainalani), a joint venture between MMO and MDT. Prior to the acquisition of MDT's interest in Ainalani, MMO accounted for its investment in Ainalani under the equity method. Subsequent to the acquisition, MMO consolidated all of Ainalani's assets and liabilities. Consequently, $19,497,000 of accounts receivable from Ainalani was eliminated as a result of the acquisition. Thus, only $1,001,000 of cash was actually collected. (b) Two unsecured promissory notes payable, due December 31, 1992, extension of maturity dates are being arranged. Interest rate is based on Bank of Hawaii's prime rate plus 2% for the first note and Bank of Hawaii's prime rate plus 0.75% for the second note. (c) Two unsecured noninterest-bearing notes payable from T. Michael May, Senior Vice President of Hawaiian Electric Company, Inc. (HECO), due in 1993 or upon demand, if he ceases to be employed by HECO. (d) Unsecured noninterest-bearing note payable from Warren H. W. Lee, President of Hawaii Electric Light Co., Inc. (HELCO), due in 1993 or upon demand, if he ceases to be employed by HELCO. Hawaiian Electric Industries, Inc. SCHEDULE II--AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES December 31, 1991 (a) Promissory note payable, due July 1992 with an option to extend to July 1993. Interest rate is based on Bank of Hawaii's prime rate plus 3.5%. Promissory note is secured by real estate, the joint venture's interest in a partnership and contract rights. (b) Promissory note payable, due in 1995, except certain events may trigger earlier partial repayment. Interest rate is based on Bank of Hawaii's prime rate plus 2%. Promissory note is secured by real estate, the joint venture's interest in a partnership and contract rights. (c) Unsecured promissory note payable, due December 1992. Interest rate is based on Bank of Hawaii's prime rate plus 2%. Hawaiian Electric Industries, Inc. SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT HAWAIIAN ELECTRIC INDUSTRIES, INC. (PARENT COMPANY) BALANCE SHEETS As of December 31, 1993, HEI guaranteed debt of its subsidiaries and affiliates amounting to $13 million. In addition, in connection with the acquisition of HIG, HEI has agreed to indemnify HIG with respect to 1985 and 1986 claims that exceed an aggregate of $10.8 million up to $12.8 million and 50% of the claims that exceed an aggregate of $12.8 million up to $13.8 million. HEIDI has made a provision for the estimated liability related to these claims. Pursuant to the settlement agreement with the Rehabilitator of HIG entered into in early 1994, which agreement is subject to court approval, HEI will be relieved of all obligations with respect to the indemnification of HIG. The aggregate payments of principal required on long-term debt subsequent to December 31, 1993 are $26 million in 1994, $1 million in 1995, $37 million in 1996, $51 million in 1997, $21 million in 1998 and $65 million thereafter. Hawaiian Electric Industries, Inc. SCHEDULE III--CONDENSED FINANCIAL INFORMATION OF REGISTRANT (continued) HAWAIIAN ELECTRIC INDUSTRIES, INC. (PARENT COMPANY) STATEMENTS OF INCOME Hawaiian Electric Industries, Inc. SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT (continued) HAWAIIAN ELECTRIC INDUSTRIES, INC. (PARENT COMPANY) STATEMENTS OF CASH FLOWS Supplemental disclosures of noncash activities: In December 1992, the Board of Directors of HEI adopted a resolution which converted $9.5 million of long-term debt of HERS to equity. HEI assumed the $9.5 million of HERS' long-term debt in a noncash transaction. Common stock dividends reinvested by stockholders in HEI common stock in noncash transactions amounted to $17 million in 1993, $15 million in 1992 and $14 million in 1991. Hawaiian Electric Industries, Inc. SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT Year ended December 31, 1993 (a) Additions at cost include a $7.0 million allowance for equity funds used during construction and noncash contributions in aid of construction received in 1993 with an estimated fair value of $2.8 million. (b) Includes transfers, adjustments and other charges and credits. (c) Includes the estimated fair value of noncash contributions in aid of construction of $23 million received in prior years, but recognized in 1993. Hawaiian Electric Industries, Inc. SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT December 31, 1992 and 1991 (a) Neither additions nor retirements in 1992 and 1991 amounted to more than 10% of the ending balance as of the end of each of those respective years. (b) Additions at cost and retirements amounted to $197.4 million and $13.4 million, respectively, in 1992. The additions include a $6.8 million allowance for equity funds used during construction. (c) Additions at cost and retirements amounted to $161.5 million and $6.9 million respectively, in 1991. The additions include a $4.0 million allowance for equity funds used during construction. Hawaiian Electric Company, Inc. SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT Year ended December 31, 1993 (a) Additions at cost include a $7.0 million allowance for equity funds used during construction and noncash contributions in aid of construction received in 1993 with an estimated fair value of $2.8 million. (b) Includes transfers, adjustments and other charges and credits. (c) Includes the estimated fair value of noncash contributions in aid of construction of $23 million received in prior years, but recognized in 1993. Hawaiian Electric Company, Inc. SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT Year ended December 31, 1992 (a) Additions at cost include a $6.8 million allowance for equity funds used during construction. (b) Includes transfers, adjustments and other charges and credits. Hawaiian Electric Company, Inc. SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT December 31, 1991 (a) Neither additions nor retirements in 1991 amounted to more than 10% of the ending balance as of December 31, 1991. (b) Additions at cost and retirements amounted to $145.9 million and $4.9 million, respectively, in 1991. The additions include a $4.0 million allowance for equity funds used during construction. Hawaiian Electric Industries, Inc. and Hawaiian Electric Company, Inc. SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT Year ended December 31, 1993 (a) Gross salvage on plant retired, cost of removal, transfers and adjustments. Hawaiian Electric Industries, Inc. and Hawaiian Electric Company, Inc. SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT Year ended December 31, 1992 (a) Gross salvage on plant retired, cost of removal, transfers and adjustments. Hawaiian Electric Industries, Inc. and Hawaiian Electric Company, Inc. SCHEDULE VI--ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT Year ended December 31, 1991 (a) Gross salvage on plant retired, cost of removal, transfers and adjustments. Hawaiian Electric Industries, Inc. and Hawaiian Electric Company, Inc. SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS Years ended December 31, 1993, 1992 and 1991 (a) Primarily bad debts recovered. (b) Bad debts charged off. (c) Net charge-offs. Hawaiian Electric Industries, Inc. SCHEDULE IX--SHORT-TERM BORROWINGS Years ended December 31, 1993, 1992 and 1991 (a) Unsecured promissory notes sold through dealers with a term of three months or less. (b) Borrowed under a formal credit arrangement with a bank with a term of six months. (c) Borrowed under formal credit agreements which, as of yearend, had maturities of less than twelve months. (d) Computed by multiplying the principal amounts of short-term borrowings by the number of days during which those borrowings were outstanding and dividing the sum of the products by the number of days in the year. (e) Computed by dividing interest expense on short-term borrowings for the period by the average amount of short-term borrowings outstanding during the period. Hawaiian Electric Company, Inc. SCHEDULE IX--SHORT-TERM BORROWINGS Years ended December 31, 1993, 1992 and 1991 (a) Unsecured promissory notes sold through dealers with a term of three months or less. (b) Computed by multiplying the principal amounts of short-term borrowings by the number of days during which those borrowings were outstanding and dividing the sum of the products by the number of days in the year. (c) Computed by dividing interest expense on short-term borrowings for the period by the average amount of short-term borrowings outstanding during the period. Hawaiian Electric Industries, Inc. and Hawaiian Electric Company, Inc. SCHEDULE X--SUPPLEMENTARY INCOME STATEMENT INFORMATION Years ended December 31, 1993, 1992 and 1991 INDEX TO EXHIBITS The exhibits designated by an asterisk (*) are filed herein. The exhibits not so designated are incorporated by reference to the indicated filing. A copy of any exhibit may be obtained upon written request for a $0.20 per page charge from the HEI Stock Transfer Division, P.O. Box 730, Honolulu, Hawaii 96808-0730. Hawaiian Electric Industries, Inc. EXHIBIT 11 -- COMPUTATION OF EARNINGS PER SHARE OF COMMON STOCK Years ended December 31, 1993 1992,1991, 1990 AND 1989 Note: The dilutive effect of stock options is not material. Hawaiian Electric Industries, Inc. EXHIBIT 12(a) -- COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES Years ended December 31, 1993, 1992, 1990 AND 1989 (1) Excluding interest on ASB deposits. (2) Including interest on ASB deposits. (3) Total interest charges exclude interest on nonrecourse debt from leveraged leases which is not included in interest expense in HEI's consolidated statements of income. Hawaiian Electric Industries, Inc. EXHIBIT 12(a) -- COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES Years ended December 31, 1993, 1992, 1991, 1990 and 1989--Continued (1) Excluding interest on ASB deposits. (2) Including interest on ASB deposits. (3) Total interest charges exclude interest on nonrecourse debt from leveraged leases which is not included in interest expense in HEI's consolidated statements of income. Hawaiian Electric Company, Inc. EXHIBIT 12(b) -- COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES Years ended December 31, 1993, 1992, 1991, 1990 and 1989 * Does not reflect corporate-level segment cost and tax allocation policy adjustments in 1990. Hawaiian Electric Industries, Inc. EXHIBIT 21(a) -- LIST OF SUBSIDIARIES The following is a list of all subsidiary corporations of the registrant as of March 21, 1994: Hawaiian Electric Company, Inc. EXHIBIT 21(b) -- LIST OF SUBSIDIARIES The following is a list of all subsidiary corporations of the registrant as of March 21, 1994: [KPMG Peat Marwick letterhead] HEI EXHIBIT 23 The Board of Directors Hawaiian Electric Industries, Inc.: We consent to incorporation by reference in Registration Statement Nos. 33-52520 and 33-58820 on Form S-3 and in Registration Statement Nos. 33-65234 and 33-43892 on Form S-8 of Hawaiian Electric Industries, Inc. of our report dated February 11, 1994, relating to the consolidated balance sheets of Hawaiian Electric Industries, Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, retained earnings and cash flows for each of the years in the three-year period ended December 31, 1993, which report is incorporated by reference in the 1993 annual report on Form 10-K of Hawaiian Electric Industries, Inc. Our report refers to changes in the method of accounting for income taxes and postretirement benefits other than pensions effective January 1, 1993. We also consent to incorporation by reference of our report dated February 11, 1994 relating to the financial statement schedules of Hawaiian Electric Industries, Inc. in the aforementioned 1993 annual report on Form 10-K, which report is included in said Form 10-K. /s/ KPMG Peat Marwick Honolulu, Hawaii March 22, 1994 Hawaiian Electric Company, Inc. EXHIBIT 99(b) -- RECONCILIATION OF ELECTRIC UTILITY OPERATING INCOME PER HEI AND HECO CONSOLIDATED STATEMENTS OF INCOME SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrants have duly caused this report to be signed on their behalf by the undersigned, thereunto duly authorized. The signatures of the undersigned companies shall be deemed to relate only to matters having reference to such companies and any subsidiaries thereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrants and in their capacities at March 22, 1994. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named companies and any subsidiaries thereof. SIGNATURES (continued) SIGNATURES (continued)

60041_1993.txt

60041

1993

ITEM 1. BUSINESS General Development of Business Loctite Corporation (the "Company") was organized as a Connecticut corporation in 1953 to manufacture and sell industrial adhesives and sealants. The Company reincorporated in Delaware in 1988. Its current line of such industrial products is sold in essentially all industrialized countries, in most cases through wholly owned subsidiaries. The Company expanded its activities to encompass the manufacture and sale of adhesives, sealants, and related products through automotive aftermarket and consumer channels, primarily by the acquisition of Permatex Company, Inc. in 1972 and Woodhill Chemical Company in 1974. The domestic businesses of these two companies were consolidated in 1976, and in 1980 were merged into a single division to conduct business as Loctite Corporation, Automotive and Consumer Group. During 1992, the Company moved ahead with its decision to consolidate the industrial, consumer, and automotive aftermarket divisions into the North American Region. The North American Region includes all of the Company's U.S., Canadian, Mexican, and Caribbean business activities, except for its electroluminescent lamp business. All of the Company's remaining operations are managed by its three other primary worldwide marketing regions. Financial Information About Industry Segments Loctite operates in one dominant segment: "adhesives, sealants, and related products". Applicable segment information is contained in Note 3 of the Notes to Consolidated Financial Statements. Description of Business The majority of the Company's adhesives, sealants, and related products are manufactured from raw materials at the Company's plants. Selected other products are purchased in bulk form and packaged for resale. A limited number of products are purchased in final packaged form. The principal materials and supplies used by the Company in the manufacture and packaging of products are generally commercially available from several sources in both the United States and Western Europe. While certain raw materials used by the Company, principally of petrochemical origin, have from time to time in the past been subject to supply shortages and price increases, the Company anticipates that adequate supplies of such raw materials will be available over the next several years. The basic monomer resins used in the compounding of the Company's sealants and adhesives are manufactured in Sabana Grande, Puerto Rico; Dublin, Ireland; and Greater Sao Paulo, Brazil. The compounding of these products and the manufacturing of the Company's consumer and automotive aftermarket sealants and adhesives are done at Sabana Grande, Puerto Rico; Dublin, Ireland; Kansas City, Kansas; Warrensville Heights, Ohio; and at smaller facilities in several other countries. The Company manufactures and sells a broad range of chemical sealants and adhesives having different chemical properties designed to suit a wide variety of applications. Special and standard equipment for the application of sealants and adhesives is also marketed by the Company, along with a variety of specialty chemical items which complement the sealants and adhesives line. The principal products are anaerobic sealants and adhesives and cyanoacrylate adhesives. Anaerobics. Anaerobic sealants and adhesives remain liquid in the presence of air but cure in the absence of air. These liquids are used to replace or augment mechanical means for locking, sealing, retaining and structurally bonding machine elements, providing extra strength and reliability to these assemblies, and increasing resistance to loosening or damage caused by shock or vibration. Anaerobic sealants and adhesives can be used without solvent removal processes, and in many cases permit the relaxation of machining tolerances. The net result is less complexity in manufacture and assembly operations for the user, frequently providing substantial overall cost savings. Anaerobic sealants and adhesives have an indefinite shelf life and are produced with a wide variety of chemical and physical properties to meet the demands of their numerous industrial applications. They are used primarily on metal surfaces in equipment such as vehicles, household appliances, electronic equipment, and numerous other mechanical subassemblies. Cyanoacrylates. Cyanoacrylate adhesives, known commonly as superglues, differ from anaerobic sealants and adhesives in that they cure upon exposure to moisture, which is present in trace amounts on the surfaces to be bonded. They cure in times ranging from a few seconds to several minutes to form thin, transparent bonds. Because of the speed and strength of cyanoacrylate bonds, these materials require care in handling and use. In general, cyanoacrylates have a shelf life in excess of one year and do not require extensive surface preparation prior to use. Cyanoacrylate adhesives may be used to bond metal, plastics, rubber, glass, ceramic, or wood, either together or in combination. Typical uses include the assembly of certain rubber and vinyl products, glass containers, auto accessories, electronic components, and office equipment, especially where speed of cure is an important consideration. Other Sealants, Adhesives and Related Products. The Company manufactures and sells other engineering adhesives, principally silicone sealants and adhesives, as well as epoxies and modified acrylic adhesives; ultraviolet light and primer cured sealants and coatings used in a wide variety of industrial applications; a line of home and auto-care products for consumer use, including high viscosity, noncuring sealants which are used principally to coat conventional gaskets and rust converters; and other related specialty chemicals, principally lubricating, and cleaning compounds. Other Products. The Company manufactures and sells various amounts of other products, primarily for household use, including metal-care products and cleaners for tile, porcelain, wood, metal, and fiberglass surfaces, as well as hand cleaners. The Company began in 1985 to manufacture and sell electroluminescent lamps, a new and versatile type of lighting device. This business expanded following the acquisition in November, 1986 of Luminescent Systems, Inc. of Lebanon, New Hampshire. In 1987, the Company merged its subsidiary, Loctite EL Systems, Inc. with Luminescent Systems, Inc., which created Loctite Luminescent Systems, Inc. Marketing The Company sells its products in essentially all industrialized countries of the world. Sales in North America and in Europe for the year ended December 31, 1993 accounted for approximately 44% and 36%, respectively, of consolidated net sales. Sales in the balance of the world accounted for approximately 20% of consolidated net sales. The Company has three principal user markets for its products: the industrial market, the consumer market, and the automotive aftermarket. The Company reaches user markets through its four regional marketing organizations: North American; European; Latin American; and Asia/Pacific. Each marketing organization has the responsibility for developing marketing strategies and techniques for its area of operation within the framework of overall corporate marketing plans. In the North American Region, sales are made under the Loctite,(R) Duro,(R) and Permatex(R) trademarks through a network of nonexclusive distributors, jobbers, and sales agents, some of which also sell adhesives and sealants made by others. In addition, sales are made through a direct sales force maintained by the Company. The Company provides close and continuing contact with its major end users, distributors, and sales agents to provide optimum technical assistance and support for the use of its products. The Company's consumer products are marketed primarily through the hardware, automotive, food, and building supply channels. Internationally, most sales are made primarily through subsidiaries, most of which are wholly owned by the Company. The Company supports these subsidiaries with marketing and/or technical assistance and support from its offices in Greater Milan, Italy; Munich, Germany; Hong Kong; Greater Sao Paulo, Brazil; Newington, Connecticut; Sabana Grande, Puerto Rico; and Dublin, Ireland. The Company's business, on a consolidated basis, has not been subject to significant seasonal trends. However, individual market channels do show some degree of seasonality, particularly with the increasing trend toward the practice of summer plant shutdowns. The backlog of firm orders as of December 31, 1993 was $19,018,000 versus $19,737,000 as of December 31, 1992. The current backlog is expected to be substantially filled within the current fiscal year. Government contracts and purchases do not contribute materially to the Company's consolidated net sales and net earnings. No single customer of the Company accounted for 10 percent or more of consolidated net sales. Research and Development Research and development expenditures were $26,700,000 for the year ended December 31, 1993, $26,152,000 for the year ended December 31, 1992, and $22,498,000 for the year ended December 31, 1991. Competition Competitive products, including anaerobic sealants and adhesives and cyanoacrylate adhesives, are being marketed in countries where the Company conducts business. The Company has patent protection on various aspects of its sealants and adhesives in the United States and, to a lesser extent, in a number of foreign countries. Nearly all competitive anaerobic sealants and adhesives are sold at lower prices than the Company's products and, in some instances, at substantially lower prices. Although the Company has selectively reduced prices to meet competition from time to time, it believes that attention to a superior quality of product, technical service and customer needs has generally enabled it to maintain its market position without significant price reductions. Other liquid sealants and adhesives are available, many of which are produced by companies which are larger and have substantially greater financial resources than the Company. Alternatives to liquid sealants and adhesives, such as gaskets, lock washers, and self-locking nuts, are also available and compete with the Company's products. Environmental Matters Continuing compliance with existing federal, state, and local provisions dealing with protection of the environment is not expected to have a material effect upon the Company's capital expenditures, earnings, and competitive position. As previously reported in its 1992 report on Form 10-K, the Company is presently investigating a soil and groundwater contamination problem at its Newington, Connecticut, facility which has probably resulted from the failure of an underground storage tank and/or historically poor waste handling practices by Company personnel, or by other prior or concurrent users of the site, and/or adjacent sites. The tank, which formerly held chlorinated solvents, has been removed. Consultants hired by the Company have been working closely with officials of the Connecticut Department of Environmental Protection ("DEP") to identify the exact source of the contamination and its parameters. The Company spent approximately $170,000 in fiscal 1993 in continuing evaluation and initial remediation efforts. Approximately $200,000 is expected to be spent in 1994. In the future it is possible that the Company may become subject to a corrective action order under the Resource Conservation and Recovery Act ("RCRA") by the United States Environmental Protection Agency ("EPA"), which would involve an EPA supervised remediation program. However, the Company is currently discussing with the EPA whether the EPA has jurisdiction over the Newington site, since it is the Company's belief that it has never operated as a treatment, storage or disposal facility for hazardous wastes, but only as a generator of such wastes. If the EPA agrees with the Company's position, then remediation of the Newington site would be overseen only by the DEP. Due to the potential differences in remediation approaches which could emerge between the EPA and the DEP, the Company does not intend to begin a remediation program until the question of jurisdiction has been resolved. Consequently, it is not possible at this time to predict accurately total remediation expense. Employees At December 31, 1993, the Company had approximately 4,000 employees. The Company has had no significant strikes or work stoppages and considers employee relations to be satisfactory. Approximately 6% of the Company's employees are covered by collective bargaining agreements, specifically at the Company's plants in Kansas City, Kansas and Dublin, Ireland. There are no significant seasonal fluctuations in employment. Patents The Company owns a number of unexpired United States patents relating to anaerobic sealants and adhesives, and certain other sealants and adhesives, including cyanoacrylate adhesives, or on related products, uses, or manufacturing processes. These patents expire on various dates from 1994 to 2011. The Company also owns a substantial number of pending patent applications. The Company also has obtained patents, and regularly files new patent applications, in foreign countries, particularly the industrialized countries of Western Europe, Australia, Canada, and Japan. Because all applications have not been filed in all foreign countries and because of the varying degrees of protection afforded by foreign patent laws, the Company has somewhat less patent protection abroad than in the United States. The Company has obtained protection for major trademarks in essentially all countries where the trademarks are of commercial importance and regularly files new trademark applications on a worldwide basis. FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES The information required is contained in Note 3 of the Notes to Consolidated Financial Statements. ITEM 2.

ITEM 2. PROPERTIES The Company owns and leases properties located around the world. These properties are deemed adequate to meet the needs of the Company at present levels. The Company's properties are in good condition, well maintained, and modernized as required. Substantially all of the properties are in regular use. Listed below are the approximate square footage numbers by region. -- The North American Region consists of 1,100,000 square feet, of which 220,000 square feet are leased. Major locations include warehouses in Solon, Ohio (180,000 square feet) and Aurora, Illinois (140,000 square feet) for distribution of North American products; the Company's former Automotive and Consumer Group Headquarters in Warrensville Heights, Ohio (166,000 square feet), which includes manufacturing, administrative, and research activities; the North American Region Headquarters in Newington, Connecticut (141,000 square feet), which includes marketing, administrative, research, and warehousing; and a manufacturing, warehousing, and administrative facility in Sabana Grande, Puerto Rico (113,000 square feet). In the second half of 1994, the consolidated North American sales, marketing, and administrative functions, and research and development facilities will be housed in a new 200,000 square foot building on 57 acres in Rocky Hill, Connecticut. U.S. manufacturing, packaging, warehousing, and distribution will be centralized in existing facilities in Warrensville Heights and Solon, Ohio. The Company's operations in Newington, Connecticut and Aurora, Illinois will be phased out. -- The European Region consists of 532,000 square feet, of which 279,000 square feet are leased. The largest facility is in Dublin, Ireland (167,000 square feet) where manufacturing, warehousing, research and development, and administrative activities take place. Other major facilities are in France (103,000 square feet), Italy (82,000 square feet), Germany (70,000 square feet), and the U.K. (41,000 square feet), which include warehousing, marketing, and administrative functions. -- The Latin American Region consists of 227,000 square feet, of which 37,000 square feet are leased. The largest facilities are in Brazil (126,000 square feet) and Costa Rica (64,000 square feet), which are used for manufacturing, marketing, warehousing, and administrative functions. -- The Asia/Pacific Region consists of 261,000 square feet, of which 100,000 square feet are leased. Major facilities are in Japan (76,000 square feet) and Australia (60,000 square feet) where manufacturing, marketing, warehousing and administrative activities take place. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS The Company and its subsidiaries are not a party to any pending legal proceedings in which an adverse decision, in the opinion of the Company, would have a material adverse effect upon the Company. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of the year ended December 31, 1993. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's Common Stock is traded on the New York and Pacific Stock Exchanges. The number of stockholders of record of the Company's Common Stock as of the close of business on March 11, 1994 was 3,116. Information regarding quarterly market prices and dividends declared for the Company's Common Stock is shown below. Market prices are those quoted on the New York Stock Exchange, the principal exchange market for the Company's Common Stock. The Company currently expects that comparable dividends will continue to be paid in the future. (This page intentionally left blank) ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA The following table summarizes information with respect to the operations of the Company. TEN-YEAR FINANCIAL REVIEW (dollars in millions, except per share amounts and as noted) SELECTED FINANCIAL DATA RESTATED TO A CALENDAR YEAR BASIS Financial statements for 1992, 1991, and 1990 have been restated for the adoption of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OPERATIONS YEAR ENDED DECEMBER 31, 1993 VERSUS YEAR ENDED DECEMBER 31, 1992 For the year ended December 31, 1993, net sales were $612.6 million, an increase of $4.6 million or 1% over the prior year. Loctite management measures the results of the Company based on individual business units. Units are consolidated into businesses or regions. Trade sales between regions are reflected as sales of the region servicing the customer. A summary of sales activity (in millions) is as follows: Price changes contributed to the growth in sales for the Company. Average net prices changed as a result of changes in list price, changes in product mix, and changes in customers. Such factors are not quantifiable individually due to the wide variety of markets, product formulations, and product packages. North American sales increased by 7% in both local currency and U.S. dollars when compared to 1992. The North American Industrial business grew 10% on a local currency basis and 9% on a dollar basis as a result of a focus on the maintenance market, as well as a general upturn in industrial output in the U.S. economy. U.S. Automotive Aftermarket (AAM) sales were flat while the Retail (Consumer) business reported an 8% sales gain, for a combined growth of 4%. Volume increases contributed to the growth. Poor economic conditions in Europe held sales growth in local currency to 2% over the prior year. This figure translated to a decline of 10% when converted to dollars because of the impact of the relatively stronger dollar compared to last year. There was a wide range of local currency sales growth reported within the region as each country is affected by different economic conditions. Of the five major countries in Europe (in terms of Loctite sales), France's local currency sales were flat with the prior year, Italy was up 11%, the U.K. was up 6%, Germany was down 9% and Spain had local currency growth of 1%. With respect to products, volume decreases in major industrial products were offset by growth in other products and channel mix. Latin American sales growth in 1993 was 4%. Although Costa Rica, Colombia, and Chile experienced double digit percentage sales growth, Brazil's sales were down slightly. In Brazil, prices are changed monthly to keep up with the effects of inflation (see paragraph under Inflation and Changing Prices). Excluding the effects of inflation, Brazil reported a 5% decrease in sales vs. 1992. Unstable economic conditions were a contributing factor. Local currency sales in the Asia/Pacific region increased by 20% vs. the prior year. This translated into a 27% increase when converted to dollars. All countries except Japan reported strong local currency growth. Although Japan's local currency sales decreased by 7% when compared to 1992, in dollars the growth was 6% due to the strength of the yen relative to the U.S. dollar. Included in this year's results are those of new subsidiaries operating in Malaysia, Singapore, China, and India which resulted in $7.9 million of additional sales. Luminescent Systems sales decreased by 19% in local currency and 20% in U.S. dollars when compared to 1992. Sales continued to suffer in response to the decline in the defense and airline industries. Gross margin decreased from 62% of sales in 1992 to 61% of sales in 1993. The decrease was caused by lower margins in Europe and North America as well as geographic mix. As a percentage of sales, operating expenses were 45% in 1993 and 44% in 1992. In total, expenses increased $8.8 million or 3% over the prior year. Expenses in the Company's new subsidiaries operating in Malaysia, Singapore, India, China, Czech Republic, Slovakia, Hungary, Poland, Slovenia, and Norway accounted for $5.8 million of the increase. Included in administrative expenses is a $1.2 million charge related to the closing of a manufacturing facility of Loctite Luminescent Systems, a small subsidiary which has seen its market shrink. The closing of this Rocky Hill, Connecticut, facility will allow all manufacturing for this business to be concentrated in New Hampshire, adjacent to its management function. Additional monies were spent in the Asia/Pacific area to strengthen our industrial and automotive aftermarket selling skills and in Brazil where we are upgrading our manufacturing, technical, and selling skills to take advantage of an underpenetrated industrial market. North America reported expense increases of 8% primarily to support higher sales levels. In local currencies, European expenses increased by 6% vs. the prior year, but when translated into dollars, current year expenses decreased by 7% when compared to the prior year. Investment income was $0.9 million lower in 1993 than in 1992 primarily as a result of lower average interest rates on deposits in foreign locations translated into dollars at comparatively weaker average exchange rates. Interest expense decreased by $0.2 million year-to-year as the effects of significant increases in average short-term debt levels in the U.S. were offset by benefits derived from the refinancing of maturing long-term debt, the capitalization of certain interest costs associated with the financing of construction-in-progress, and lower average short-term debt levels in Brazil. Net foreign exchange losses decreased by $0.8 million for the 12 month period over the comparable 1992 period due primarily to favorable transaction related exchange results in Ireland. Income taxes, as a percentage of earnings before taxes, were 25% for the year ended December 31, 1993. For further discussion of income taxes, see Notes to Consolidated Financial Statements, Note 6, Income Taxes. YEAR ENDED DECEMBER 31, 1992 VERSUS YEAR ENDED DECEMBER 31, 1991 For the year ended December 31, 1992, net sales were $608.0 million, an increase of $46.8 million or 8% over the prior year. A summary of sales activity (in millions) is as follows: Price changes contributed to the growth in sales for the Company. Average net prices changed as a result of changes in list price, changes in product mix, and changes in customers. Such factors are not quantifiable individually due to the wide variety of markets, product formulations, and product packages. Our North American Industrial business reported strong growth considering the sluggish economic environment in the United States. Major product lines (anaerobics, cyanoacrylates, silicones, and hand cleaners) had both volume increases and price changes which contributed to the positive results. In the U.S. Automotive Aftermarket (AAM) and Retail (Consumer) business, hand cleaner sales increased by double digits with silicones and cyanoacrylates reporting modest growth over the prior year. Both volume and price increases were factors. In Europe, the impact of a comparatively weaker dollar increased European sales by approximately four percentage points when compared to the prior year. On a local currency basis, sales of most products increased with volume increases being a larger factor than price changes. Hand cleaners were introduced to the European product line in 1992 and resulted in 10% of the dollar sales growth over the prior year. It is anticipated that hand cleaners will contribute to additional sales growth in the future. Latin America reported a sales increase of 10%. Much of the increase was due to price increases in the region. In Brazil, prices are changed monthly to keep up with the effects of inflation (see paragraph under Inflation and Changing Prices). Most volumes in the region declined from year to year. Sales in the Asia/Pacific region were flat in dollars vs. the prior year. On a local currency basis, the region's sales decreased 2% with Japan the primary factor. The Japanese original equipment manufacturing industries to which we sell are in a recession, which has affected our sales volume. Current year sales of electroluminescent lamps were disappointing and decreased primarily due to the sluggishness of the U.S. economy. Gross margin increased from 61% of sales in 1991 to 62% of sales in 1992. As a percentage of sales, operating expenses (excluding restructuring charges) were 44% in both 1992 and 1991. The Company has invested in research and development and sales and marketing expenses. Expense growth in these categories was 16% and 12%, respectively, vs. the prior year. Administrative expenses were down 2%. In total, expenses increased 9% over 1991. In the second quarter of 1992, the Company recorded a pretax charge of $12.7 million for restructuring its North American operations. The restructuring charge is the result of a strategic decision to combine the Company's two major businesses in the U.S., the Industrial Group and the Automotive and Consumer Group, to accelerate market penetration and reduce operating expenses, along with the provision of new, centralized research and development facilities. The restructuring charge includes provisions for employee relocations and redundancies of $7.4 million and facilities disposal costs of $5.3 million. Investment income for 1992 was $4.2 million lower than 1991. Lower average deposit levels in foreign locations (due to the acquisition of FRAMET (now Loctite France) in the fourth quarter of 1991) was a significant contributing factor in the year to year decline. The foreign exchange loss for the year was $2.4 million greater than in 1991 primarily due to the translation effects of higher average rates of Cruzeiro devaluation on the Company's Brazilian operations. Income taxes, as a percentage of earnings before taxes, were 24% for the year ended December 31, 1992. YEAR ENDED DECEMBER 31, 1991 VERSUS YEAR ENDED DECEMBER 31, 1990 For the calendar year ended December 31, 1991, net sales were $561.2 million, an increase of $6.0 million or 1% over the prior calendar year. Sales growth in the Automotive and Consumer Group was $5.8 million or 6%, while the Asia/Pacific Region also had a strong growth of $5.3 million or 13%. Sales in the North American Industrial markets were up slightly, while Europe and Latin America experienced declines of $2.7 million and $2.8 million, respectively. The impact of the comparatively stronger dollar decreased sales by approximately one percentage point when compared to the prior year. Volume growth, sales mix and price changes all contributed to the sales growth over the prior year. Gross margin was 61% of sales for the twelve month periods ended December 31, 1991 and 1990. As a percentage of sales, operating expenses were 44% in both 1991 and 1990. In dollars, there was no change year to year as continued expense management throughout the year kept expenses level. In the first quarter of 1991, the Company recorded a charge of $4.4 million for the restructuring of certain activities in a number of countries to reduce ongoing costs and expenses. Pretax investment income for 1991 was $2.4 million higher than 1990. Higher average deposit levels and gains from limited partnership activity contributed to the increase. Pretax interest expense decreased by $1.3 million year to year due to the capitalization of certain interest costs associated with the financing of construction-in-progress and due to lower interest rates, on average, on borrowings in the United States and Brazil. Decreased translation losses in Brazil, the result of reduced rates of currency devaluation, was the primary factor in the $1.2 million decrease in net foreign exchange losses. Income taxes, as a percentage of earnings before taxes, were 27.5% for the calendar year ended December 31, 1991. LIQUIDITY AND CAPITAL RESOURCES At December 31, 1993, the Company had $44.6 million in cash and cash equivalents, an increase of $14.7 million from the previous year's balance. The increase was due primarily to cash provided by operating activities plus the increase in short-term debt partially offset by the cash outflow for the stock repurchase mentioned below, additions to property, plant and equipment, dividends paid, increased trade receivables, and acquisitions. The Company has significant financial resources available for future growth. Capital expenditures and dividend payments are expected to increase in the next few years. Time and certificates of deposit of $51.5 million, cash from operations, and existing unused credit lines at December 31, 1993 will provide additional financing flexibility. During the first quarter of 1993, the Company purchased 1,000,000 shares of its common stock. The cost of this repurchase, $42.6 million, was funded through U.S. short-term borrowings. The stock repurchase reduced retained earnings by $41.4 million and common stock by $1.2 million. The increase in accounts and notes receivable from $111.6 million at December 31, 1992, to $119.3 million at December 31, 1993, was due to an increase in trade receivables in the Company's U.S. Industrial, Automotive and Retail (Consumer) businesses, as well as receivables recorded by the new subsidiaries operating in 1993. The U.S. businesses reported fourth quarter sales that were $5.5 million higher than the comparable 1992 fourth quarter, which resulted in higher receivables at year end. Net property, plant and equipment increased $25.5 million from 1992 to 1993 with a large part resulting from construction-in-progress recorded for the Company's new facility in Rocky Hill, Connecticut. Through December 31, 1993, $25.2 million had been spent on land and buildings, $17.6 million of which was spent in 1993. The 200,000 square foot facility is being built on 57 acres and will house consolidated North American sales, marketing, administrative, and research and development functions. The facility is expected to cost approximately $40.0 million and is expected to be completed in the second half of 1994. Approximately $4.0 million was spent in 1993 to expand our Solon, Ohio warehouse facility. This project is also expected to be completed in 1994. Property recorded by the Company's new subsidiaries operating in 1993 also contributed to the increase in net property, plant and equipment. While not a capital intensive business, the Company's practice is to ensure that sufficient operating capacity is available to meet its customers' needs. In the year ended December 31, 1993, capital expenditures were $44.5 million. The level of capital expenditures for calendar 1994 and the next two years is expected to be approximately $40-$50 million per year. Except for the $14.8 million which will be spent to complete the Rocky Hill facility, the projected capital expenditures are not firm commitments but are subject to final management approval depending on the needs of the individual businesses and the business conditions at the time of the expenditure. Approximately 55% of the expected capital expenditures will be to support increased product sales and product maintenance. Approximately 30% will be for new product developments and research and development, with the remaining expenditures for building improvements, computer equipment and office furniture. There are no planned projects that represent a material commitment for the Company. Short-term debt increased from $23.5 million at December 31, 1992 to $103.0 million at December 31, 1993, primarily due to the funding of the stock repurchase noted above. Other contributory factors were construction-in-progress on the Rocky Hill facility, additional investments in subsidiaries, and the refinancing of the current portion of long-term debt. In 1992, the Company recorded a pretax charge of $12.7 million for restructuring its North American operations. At December 31, 1992, approximately $1.4 million had been spent. During 1993, an additional $3.5 million was spent resulting in $7.8 million remaining as liabilities. $5.4 million is recorded as a long-term liability and $2.4 million is recorded in short-term liabilities. Projects to be completed include the relocation of research and development employees to Rocky Hill and the closing of the Company's plants in Aurora, Illinois and Newington, Connecticut. The $5.0 million decrease in accrued salaries, wages, and other compensation resulted from reduced bonus accruals and payments made against the restructuring accruals mentioned above. Long-term debt declined by $11.1 million due to the reclassification of this debt to current debt because scheduled long-term promissory note payments will be made during 1994 (see Note 9 of the Notes to Consolidated Financial Statements). The unrealized foreign currency translation adjustment included in stockholders' equity changed from a loss of $3.4 million at December 31, 1992 to a loss of $21.9 million at December 31, 1993 due to the impact of a comparatively stronger U.S. dollar on the Company's net asset position at December 31 in its foreign subsidiaries. Since a substantial portion of our business is transacted in foreign locations and currencies, the Company's financial statements are affected by fluctuations in foreign exchange rates. A stronger U.S. dollar decreases the translated results of foreign subsidiaries, while a weaker U.S. dollar increases the translated results. For the year ended December 31, 1993, the effect of a comparatively stronger dollar decreased sales by approximately five percentage points when compared to the prior year. For the year ended December 31, 1992, the effects of a comparatively weaker dollar increased sales by approximately one percentage point when compared to the prior year. For the year ended December 31, 1991, the effect of a comparatively stronger dollar decreased sales by approximately one percentage point when compared to the prior year. ACQUISITIONS During the first quarter of 1993, the Company acquired certain assets from its distributor in Malaysia and Singapore and now operates wholly owned subsidiaries in those countries. Loctite acquired a majority interest in its joint ventures in China and India in the second quarter of 1993 and in Norway in the third quarter of 1993. The cost of these acquisitions was approximately $6.5 million and is not considered material to the Company. During the first quarter of 1994, the Company announced the acquisition of Plastic Padding Holdings Limited, a market leader in automotive aftermarket chemical products with strong brand presence and established distribution networks in the U.K., Ireland, and Scandinavia. The cost of this acquisition was not material to the Company. INFLATION AND CHANGING PRICES The Company prices its products according to value in each of its markets. The Company attempts to offset the effects of inflation in its pricing. Due to the wide variety of pricing situations, currency factors, and inflation rates in the numerous countries in which the Company does business, a meaningful estimate of the effect of price increases is not practical. However, in management's judgment, except for the reasons indicated in the paragraph below, such increases have not been significant to the Company's reported results. The Company's Brazilian subsidiary was subject to a rate of inflation in excess of two thousand percent in 1993, in excess of one thousand percent in 1992, and in excess of four hundred percent in 1991. If the Company excluded the effects of inflation from the Brazilian sales value, Brazilian sales would have been reduced by $8.1 million (1993), $7.0 million (1992), and $4.8 million (1991) from the net sales amounts reported for Latin America. Similarly, Brazilian operating profit would have been reduced by $7.1 million (1993), $5.6 million (1992), and $3.9 million (1991) from the operating profit amounts reported for Latin America. ACCOUNTING CHANGES INCOME TAXES During the first quarter of 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109). The statement requires that deferred taxes be recorded under the liability method rather than the income statement approach previously used by the Company under Accounting Principles Board Opinion No. 11 (APB No. 11). The Company has adopted SFAS No. 109 by restating the financial statements of 1992, 1991, and 1990. For further discussion, see Note 6 of the Notes to Consolidated Financial Statements. POSTRETIREMENT HEALTH CARE AND LIFE INSURANCE BENEFITS During the first quarter of 1993, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" (SFAS No. 106). The statement requires that annual postretirement benefit costs be accrued during an employee's years of active service. In prior years, the Company expensed the cost of such benefits when paid. For further discussion, see Note 12 of the Notes to Consolidated Financial Statements. PROSPECTIVE ACCOUNTING CHANGE POSTEMPLOYMENT BENEFITS In November 1992, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (SFAS No. 112). This statement must be adopted by the Company no later than calendar year 1994 but earlier adoption is permitted. The statement requires the recognition of the cost of postemployment benefits (after employment but before retirement) on an accrual basis. The Company will adopt SFAS No. 112 in 1994. The new standard is not expected to have a significant effect on the Company's annual benefits expense or liabilities. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INDEX TO FINANCIAL STATEMENTS: The individual financial statements of Registrant's subsidiaries have been omitted since Registrant is primarily an operating Company and all subsidiaries included in the consolidated financial statements being filed, in the aggregate, do not have minority equity interests and/or indebtedness to any person other than Registrant or its consolidated subsidiaries in amounts which together exceed five percent of total consolidated assets at December 31, 1993, excepting indebtedness incurred in the ordinary course of business which is not overdue and which matures within one year from the date of its creation. All other schedules are omitted because they are not applicable or the required information is shown in the Consolidated Financial Statements or the Notes thereto. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of Loctite Corporation In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Loctite Corporation and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Corporation's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Note 1 to the consolidated financial statements, the Corporation adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" and Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," effective January 1, 1993. /s/ PRICE WATERHOUSE Price Waterhouse [LOGO] One Financial Plaza Hartford, Connecticut January 25, 1994 CONSOLIDATED STATEMENT OF EARNINGS (dollars in thousands, except per share amounts) See accompanying Notes to Consolidated Financial Statements. CONSOLIDATED STATEMENT OF CASH FLOWS (dollars in thousands) See accompanying Notes to Consolidated Financial Statements. CONSOLIDATED BALANCE SHEET (dollars in thousands) See accompanying Notes to Consolidated Financial Statements. CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 1993, DECEMBER 31, 1992, AND DECEMBER 31, 1991 (dollars in thousands, except share amounts) See accompanying Notes to Consolidated Financial Statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 SUMMARY OF ACCOUNTING POLICIES Consolidation The consolidated financial statements include the accounts of Loctite Corporation and all majority owned subsidiaries. Intercompany balances and transactions have been eliminated. The minority interest income of consolidated subsidiaries that are not 100% owned is included in other expense on the consolidated statement of earnings and in other long-term liabilities on the consolidated balance sheet. Investments in which the Company owns 20% to 50% of the voting stock are accounted for under the equity method. Cash Flows For purposes of the consolidated statement of cash flows, the Company considers all highly liquid investments with a maturity of three months or less at the time of purchase to be cash equivalents. Cash flows from forward exchange contracts and other hedges of identifiable transactions or events are classified in the same category as the cash flows from the items being hedged. Marketable Securities Marketable securities held as current assets are carried at the lower of aggregate cost or market value. Marketable securities held as investments are carried at cost, less provisions for anticipated losses when market value is below cost and the decline is considered to be other than temporary. Inventories Inventories are stated at the lower of cost (first-in, first-out method) or market. Long-Term Venture Capital Investments The Company has investments in seven venture capital limited partnerships. The partnerships invest in and assist growth oriented businesses. The investments are carried at cost. Provisions for anticipated losses are recorded as a reduction of earnings when the aggregate current value, as internally determined by the respective partnerships, is below cost and the decline is considered to be other than temporary. When the aggregate current value is below cost and the decline is considered to be temporary, a charge to stockholders' equity is recorded. Property and Depreciation Property, plant and equipment is recorded at cost. Ordinary maintenance and repairs are expensed; replacements and betterments are capitalized. The cost and related accumulated depreciation of disposed assets are removed from the accounts; any resulting gain or loss is reflected in earnings. Plant and equipment is depreciated using both straight-line and accelerated methods. Estimated lives used to compute depreciation are: land improvements, 3 to 25 years; buildings and improvements, 3 to 40 years; and machinery and equipment, 3 to 10 years. Other Intangibles The cost of other intangibles is amortized on the straight-line basis over the estimated useful life of the intangible. Patents and trademarks are expensed when paid. Business Acquisitions The excess of the purchase price over the fair value of net assets of acquired companies is being amortized on the straight-line method up to 40 years. Income Taxes In 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," under which provision is made for deferred income taxes and future income tax benefits applicable to temporary differences between income tax and financial statement accounting. Earnings Per Share Earnings per share are computed by dividing net earnings by the average number of shares of common stock outstanding during the period. Stock options granted and shares to be issued under restricted stock plans would result in no material dilution of earnings. Translation of Foreign Currencies Foreign subsidiaries' assets and liabilities are translated at exchange rates prevailing on the balance sheet date, revenues and expenses are translated at average exchange rates prevailing during the period, and elements of stockholders' equity are translated at historical rates. Any resulting translation gains and losses are reported separately in stockholders' equity. For the Company's subsidiaries operating in countries with very high inflation rates, the translation is the same except that inventories, cost of sales, property, plant and equipment, and depreciation are translated at historical rates. Resulting translation gains and losses for these subsidiaries are included in income. Forward Foreign Exchange Contracts The Company enters into forward foreign exchange contracts in the normal course of business to hedge identifiable exposures related to foreign currency transactions. The gains and losses on these contracts are recognized in the same period in which gains and losses from the transaction being hedged are recognized. Additionally, forward foreign exchange contracts are used to hedge firm foreign currency commitments. Gains and losses on these contracts are deferred and included in the measurement of the related foreign currency transaction. Interest Rate Swap Agreements The Company enters into interest rate swap agreements as a means of managing interest rate exposure associated with the Company's underlying borrowings. The interest differential to be paid or received under these swap agreements is recorded on an accrual basis as an adjustment to interest expense. Fair Value of Financial Instruments Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments," requires the disclosure of the fair value of financial instruments for which it is practicable to estimate that value. The following methods and assumptions were used by the Company to estimate the fair value of each class of financial instruments: Cash and Cash Equivalents -- The carrying amounts are a reasonable approximation of fair value due to the short-term maturity of these instruments. Marketable Securities -- The fair value of marketable securities is based on quoted market prices. Long-Term Venture Capital Investments -- It is not practicable to estimate the fair value of the Company's investments in limited partnerships as there is no liquid market for these investments and thus no readily available source of market quotes. Short-Term Debt -- The carrying amounts are a reasonable approximation of fair value due to the short-term maturity of these instruments. Long-Term Debt -- The fair value of long-term debt is estimated based on the quoted market prices for the same or similar issues or on the current rates offered to the Company for debt of the same remaining maturities. Forward Foreign Exchange Contracts -- The fair value of forward foreign exchange contracts is estimated by obtaining quoted market prices. Interest Rate Swap Agreements -- The fair value of interest rate swap agreements is estimated from quotes obtained from dealers. This value represents the estimated amount the Company would receive or pay to terminate the agreements, taking into consideration current interest rates. Accounting Changes During 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," and Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions." For further discussion, see Notes 6 and 12, respectively, of the Notes to Consolidated Financial Statements. NOTE 2 COMMON STOCK SPLIT The Company declared a two-for-one stock split effective March 19, 1991. All references in the financial statements to the number of shares, earnings and dividend amounts per share, stock option data, and other per share amounts have been restated to give effect to the stock split. NOTE 3 SEGMENT REPORTING The Company operates in one dominant industry segment, "adhesives, sealants, and related products." Sales of this dominant segment account for approximately 90% of consolidated revenues, operating profit, and operating assets. The Company has no customer which accounts for 10% or more of net sales. Export sales in each of the segments were below 10% in each of the years reported. The Company's management measures results based on individual business units. Units are consolidated into businesses or regions. As a result, interdependencies exist among the Company's business units. Trade sales and operating expenses between regions are reflected as those of the region servicing the customer. The Company has restated the data presented below to a business unit basis. North America includes the Company's operations in the United States, Puerto Rico, Canada, and Mexico. Europe includes the Company's operations in Europe and Africa. Latin America includes the Company's operations in South and Central America. Asia/Pacific includes the Company's operations in Asia and the Pacific Rim. Luminescent Systems includes the Company's business in electroluminescent lamps. New Business Development (NBD) encompasses the efforts of the major laboratories of the Company. This includes the majority of research and development expenses of the Company. Some selling, general, and administrative expenses are also reported in this business. * North American expenses included $12.7 million in restructuring charges in the year ended December 31, 1992, and $2.3 million in restructuring charges in the year ended December 31, 1991. ** Luminescent Systems expenses included $1.2 million in manufacturing consolidation charges in the year ended December 31, 1993. Net sales represents sales to unaffiliated customers. Earnings from operations includes gross margin less selling, general, administrative, and research and development expenses. Investment income, interest expense, foreign exchange gains and losses, intercompany expenses, miscellaneous non-operating expenses, and income taxes are not included in operating profit. Identifiable assets do not include intercompany receivables and intercompany profit-in-inventory. Assets pertaining to NBD are included in the assets of the business unit where the NBD facilities are physically located. Accordingly, Newington and Cleveland NBD facilities are included with North American assets, Irish and German NBD facilities are included with European assets, and the Japanese NBD facility is included with Asia/Pacific assets. Goodwill is included in the business or region's identifiable assets. Corporate assets include cash, investments, property, prepaid assets, and investments in joint ventures as well as the cash and investments of certain holding companies whose records are maintained at Corporate Headquarters. Since a substantial portion of our business is transacted in foreign locations and currencies, the Company's financial statements are affected by fluctuations in foreign exchange rates. A stronger U.S. dollar decreases the translated results of foreign subsidiaries, while a weaker U.S. dollar increases the translated results. Foreign subsidiaries' assets and liabilities are translated at exchange rates prevailing on the balance sheet date. Revenues and expenses are translated at average exchange rates prevailing during the period, and elements of stockholders' equity are translated at historical rates. Any resulting translation gains and losses are reported separately in stockholders' equity. For the Company's subsidiaries operating in countries with very high inflation rates (primarily in Latin America), the translation is the same except that inventories, cost of sales, property, plant and equipment, and depreciation are translated at historical rates. Resulting translation gains and losses for these subsidiaries are included in income. The Company's Brazilian subsidiary was subject to a rate of inflation in excess of two thousand percent in 1993, in excess of one thousand percent in 1992, and in excess of four hundred percent in 1991. If the Company excluded the effects of inflation from the Brazilian sales value, Brazilian sales would have been reduced by $8.1 million (1993), $7.0 million (1992), and $4.8 million (1991) from the net sales amounts reported above for Latin America. Similarly, Brazilian operating profit would have been reduced by $7.1 million (1993), $5.6 million (1992), and $3.9 million (1991) from the operating profit amounts reported for Latin America. Certain of the Company's foreign subsidiaries are subject to the effects of import and export restrictions, exchange controls, and other restrictive regulations. NOTE 4 SUPPLEMENTARY INFORMATION TO THE CONSOLIDATED STATEMENT OF EARNINGS NOTE 5 SHORT-TERM DEBT Short-term debt and bank lines of credit are summarized as follows: * Average and period ending interest rates on consolidated short-term bank debt include the effects of local currency borrowings in highly inflationary environments, where interest rates obtained on borrowings reflect the underlying levels of local inflation. The exception to this is Brazil, where, because of the potential for significant distortion, the inflation components of interest expense, amounting to $6.7 million in 1993 and $7.6 million in 1992, have been reported in the translation component of foreign exchange loss. Substan- tially offsetting these amounts are exchange gains arising from the translation of the short-term bank debt as the Brazilian currency devalues against the U.S. dollar, at a pace generally in line with the pace of local inflation. Substantially all of the Company's bank lines of credit are of an uncommitted or informal nature. As such, the lines of credit may generally be cancelled at any time either by the Company or the bank. Borrowings under these lines are on such terms and conditions as may be mutually agreed upon. There were no significant compensating balance requirements at December 31, 1993. NOTE 6 INCOME TAXES During 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109). Under SFAS No. 109, deferred taxes are recorded under the liability method rather than the income statement approach previously used by the Company under Accounting Principles Board Opinion No. 11 (APB No. 11). Two methods of recognizing the cumulative effect of the adoption of SFAS No. 109 were available to the Company: (1) restating the financial statements of one or more prior year(s), or (2) recognizing the effect in the current year results of operations. The Company elected to restate the financial statements for 1992, 1991, and 1990 rather than reflecting the cumulative adjustment in 1993 earnings. The cumulative adjustment resulting from the adoption of SFAS No. 109 reduced the Company's retained earnings as of December 31, 1992, 1991, and 1990 by $3.7 million, $3.5 million, and $1.2 million, respectively. The effect of restating the financial statements for 1992, 1991, and 1990 may be summarized as follows: In addition to restating the financial statements for 1992, 1991, and 1990, the unaudited quarterly information in Note 14, Quarterly Financial Data, and the selected financial data presented in the Ten-Year Financial Review were also restated for those years to reflect a SFAS No. 109 basis. The Company's consolidated effective tax rates have been less than the United States Federal statutory tax rates for the following reasons: A significant portion of the Company's earnings is derived from operations located in Ireland and Puerto Rico. Substantially all of the earnings of the Company's manufacturing subsidiary in Ireland are subject to a 10% income tax. This reduced tax rate is provided under an industrial relief incentive provided by Irish tax law and is effective through December 31, 2010. Prior to 1994, the earnings of the Company's subsidiary in Puerto Rico were exempt from U.S. tax and could be remitted as dividends without the imposition of U.S. regular income tax. However, such dividends were subject to the U.S. alternative minimum tax and to Puerto Rican withholding taxes equal to 7% of the remitted earnings. The cumulative undistributed earnings of the Puerto Rican subsidiary on which no "tollgate" withholding taxes have been provided total $32.8 million and are indefinitely reinvested in Puerto Rico. Beginning in 1994, a portion of the Puerto Rican subsidiary's earnings will be subject to U.S. tax due to tax law changes passed during 1993. The Company's subsidiary in Puerto Rico currently operates under a grant of partial tax exemption which extends to June 30, 2002. Under the terms of the grant, 10% of this subsidiary's manufacturing income is subject to Puerto Rican corporate income tax. All appropriate Puerto Rican corporate income tax has been provided. At December 31, 1993, applicable U.S. income and foreign withholding taxes have not been provided on $180.2 million of accumulated earnings of foreign subsidiaries because it is the Company's intention to indefinitely reinvest these earnings overseas, or to repatriate these earnings only when it is tax effective to do so. It is not practicable to accurately estimate the amount of unrecognized deferred U.S. tax liability on these undistributed earnings. In January 1992, the Internal Revenue Service commenced an audit of fiscal years 1986 through 1989. The Company anticipates completion of this audit during 1994 and expects no charge to income to result from the audit. The components of income tax expense are as follows: Deferred taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. If it is more likely than not that a deferred tax asset, in whole or in part, will not be realized, a valuation allowance is established which reduces the asset to its realizable value. The following is a summary of the tax effects of the significant temporary differences which comprise the Company's deferred tax assets and liabilities as of December 31, 1993 and December 31, 1992: As of December 31, 1993, the Company has net operating loss (NOL) carryforwards and U.S. tax credit carryforwards which will expire, if unused, as follows: (dollars in thousands) The net operating losses shown above may generate tax benefits of $6.6 million of which only $.5 million have been recognized in the Company's financial statements to date. The balance of $6.1 million has been offset by a valuation allowance because of the uncertainty of ultimate realization. The Company's total valuation allowance increased by $1.3 million during the year principally due to additional foreign net operating losses. During 1993, no changes occurred in the conclusions regarding the need for a valuation allowance in any tax jurisdiction. NOTE 7 FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK AND CONCENTRATIONS OF CREDIT RISK Off-Balance Sheet Risk The Company enters into forward foreign exchange contracts primarily to hedge intercompany receivables and intercompany lending activity. These contracts are not used for speculative purposes and do not subject the Company to risk due to exchange rate movements because gains and losses on these contracts offset gains and losses on the transactions being hedged. Additionally, forward foreign exchange contracts are used to hedge firm foreign currency commitments. In general, the maturities of the contracts coincide with the underlying exposure positions they are intended to hedge, usually less than six months. At December 31, 1993, the fair value of the Company's forward foreign exchange contracts approximated carrying value. The Company has entered into a series of interest rate swap agreements which have effectively fixed interest rates on a portion of its floating rate debt. Under these agreements the Company will pay the counterparties interest at a fixed rate and receive in return interest at a variable rate based on the London Interbank Offered Rate (LIBOR). At December 31, 1993, the Company had contracts in place which served to fix the interest rate on $40.0 million of underlying short-term bank debt. These contracts have final maturities ranging from 1996 to 2003 and carry a weighted average fixed rate payable approximating 5 1/2%. At December 31, 1993, the estimated amount that the Company would receive or pay to terminate the agreements was not significant. The counterparties to the Company's forward foreign exchange contracts and interest rate swap agreements consist of a number of major international financial institutions. The Company monitors its position with, and the credit quality of, these financial institutions and does not anticipate any losses as a result of counterparty non-performance. Concentrations of Credit Risk Financial instruments which potentially subject the Company to concentrations of credit risk consist primarily of cash investments and trade receivables. The Company's cash investments are with major international financial institutions, with limitations established as to the maximum amount of credit exposure to any one financial institution. Concentrations of credit risk with respect to trade receivables are limited due to the large number of customers comprising the Company's customer base and their dispersion across different businesses and geographic areas. As of December 31, 1993, the Company had no significant concentrations of credit risk. NOTE 8 COMMITMENTS AND CONTINGENCIES The Company and its subsidiaries have entered into long-term lease agreements for real property and equipment. The following information reflects rental commitments under noncancellable operating leases in effect at December 31, 1993: The outstanding amount of receivables sold to financial institutions with recourse was $0.8 million at December 31, 1993, and $1.1 million at December 31, 1992. Proceeds from these transactions were $10.6 million for the year ended December 31, 1993, $14.4 million for the year ended December 31, 1992, and $15.4 million for the year ended December 31, 1991. NOTE 9 LONG-TERM DEBT Long-term debt outstanding is summarized as follows: Under the terms of the unsecured domestic promissory notes, the Company must, among other things, maintain a specified level of working capital and limit debt to a percentage of net tangible assets. At December 31, 1993, the fair value of the long-term debt approximates the carrying value due to the near term final maturity of the domestic promissory notes. Long-term debt at December 31, 1993 matures during the following years: NOTE 10 EMPLOYEE STOCK PLANS STOCK OPTION PLANS Under the Company's stock option plans, options have been granted for periods of ten years at prices equal to the market price on the date of grant. Options are exercisable cumulatively at the rate of 20% per year with 20% exercisable at the end of the first year and 20% at the beginning of each succeeding year. Through December 31, 1993, 3,450,000 shares were reserved for the program. Information regarding transactions under these plans is as follows: RESTRICTED STOCK PLAN Under the Company's restricted stock plan, awards are issued without any payment of cash consideration by the participant. The restricted shares become available to the employee at the rate of 50% on the third anniversary of the grant and the remaining 50% on the sixth anniversary of the grant. Expense associated with these shares is amortized over the life of the grant. Compensation expense was $1.2 million for 1993, $1.6 million for 1992, and $2.0 million for 1991. Through December 31, 1993, 900,000 shares were reserved for the program. Information regarding transactions under this plan is as follows: THRIFT INVESTMENT PLAN Under the Company's thrift investment plan, eligible employees may save, by payroll deductions, a portion of their salaries. Up to 25% of the amount saved may be invested in Company stock. In addition, the Company matches, in Company stock, one half of the first 6% saved by the employee. The cost of the Company match was $1.4 million in 1993, $1.2 million in 1992, and $1.0 million in 1991. The average market price of the stock on a monthly basis is used in determining employee purchases and the Company's matching contribution. Vesting of Company contributions takes place after five years of service or after two years of participation in the Plan, whichever is more favorable to the employee. Shares issued under the Plan were 53,965 in 1993, 43,813 in 1992, and 50,283 in 1991. The average issue price was $42.48, $44.32, and $34.13, respectively. NOTE 11 PENSION PLANS On July 1, 1988, the Company revised its United States pension plan to a non-contributory defined benefit plan. Under this cash balance plan, each employee retained the value of his account as of June 30, 1988 and will receive future credits annually based on salary and length of service. Plan assets are invested primarily in guaranteed investment contracts and equity securities. This plan covers all eligible employees in the United States. The Company maintains a nonqualified retirement plan to supplement benefits for designated employees whose pension plan benefits are limited by the provisions of the Internal Revenue Code. The Company also has a pension plan for outside directors and a Supplemental Retirement Agreement with its Chairman and former Chief Executive Officer. Amounts related to these plans are included in the disclosures below. Certain of the Company's international subsidiaries provide retirement benefits to eligible employees under defined benefit plans. The benefits are based on salary and length of service. Plan assets for these plans are invested primarily in equity securities and fixed income securities. It is the Company's policy to make contributions to these plans sufficient to meet the minimum funding requirements of applicable laws and regulations. The Company accounts for the cost of its defined benefit plans in accordance with Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions" (SFAS No. 87). In accordance with the provisions of SFAS No. 87, the Company has recorded an additional minimum liability at the end of each year representing the excess of the accumulated benefit obligations over the fair value of plan assets and accrued pension liabilities. The liabilities have been offset by intangible assets to the extent possible. Because the asset recognized may not exceed the amount of unrecognized prior service cost, the balance of the liability at the end of the period is reported as a separate reduction of stockholders' equity, net of tax benefits. Amounts are summarized as follows: UNITED STATES PLANS Net U.S. periodic pension cost is summarized as follows: The following table sets forth the U.S. plans' funded status and amounts recognized in the Company's consolidated balance sheet: The projected benefit obligation for the U.S. plans was determined using the following assumptions: INTERNATIONAL PLANS Net international periodic pension cost is summarized as follows: The following table sets forth the international plans' funded status and amounts recognized in the Company's consolidated balance sheet: The projected benefit obligation for the international plans was determined using the following assumptions: Certain of the Company's international subsidiaries provide retirement benefits to eligible employees under defined contribution plans. Contributions are determined under various formulas. Certain other international subsidiaries have pension and severance benefits that are not covered under formal pension plans, including those accruing to employees under foreign government regulations. Expenses are determined in accordance with local law. Pension expense for these international subsidiaries amounted to $1.6 million in the year ended December 31, 1993, $2.5 million in the year ended December 31, 1992, and $1.9 million in the year ended December 31, 1991. NOTE 12 POSTRETIREMENT HEALTH CARE AND LIFE INSURANCE BENEFITS The Company provides postretirement health care and life insurance benefits for all eligible employees in the United States and Puerto Rico. The benefit plan is contributory based upon years of service and age at retirement. Health care benefits are also extended to spouses of eligible employees and are fully paid by retiree contributions. During the first quarter of 1993, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" (SFAS No. 106). The statement requires that annual postretirement benefit costs be accrued during an employee's years of active service. In prior years, the Company expensed the cost of such benefits when paid. In accordance with SFAS No. 106, the transition obligation, representing the unfunded and unrecognized accumulated past service benefit obligation for all plan participants, may be recognized as an expense in the year of adoption or may be amortized on a straight-line basis over a period of up to twenty years. The Company has adopted SFAS No. 106 by electing to amortize the transition obligation of $13.3 million over twenty years. Postretirement benefit cost was $2.6 million in 1993, $0.1 million in 1992, and $0.1 million in 1991. Costs recorded in 1992 and 1991 were on a pay-as-you-go basis. The Company continues to fund medical and life insurance benefit costs on a pay-as-you-go basis. Net periodic postretirement benefit cost in 1993 is summarized as follows: The following table sets forth the funded status and amounts recognized in the Company's consolidated balance sheet at December 31, 1993: The weighted average discount rate used in determining the accumulated postretirement benefit obligation at December 31, 1993 was 7.5%. The rate of increase in compensation levels was 5%. The medical inflation rate used was 12% in 1994, decreasing by 1% per year to 6% in 2000, and 5.5% for all years thereafter. The effect of a one percentage point increase in the assumed health care cost trend rate would increase the accumulated postretirement benefit obligation as of December 31, 1993 by approximately $2.3 million and increase the aggregate of the service and interest cost components of the net periodic postretirement benefit cost by approximately $0.3 million in 1993. NOTE 13 POSTEMPLOYMENT BENEFITS In November 1992, the FASB issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (SFAS No. 112). This statement must be adopted by the Company no later than calendar year 1994 but earlier adoption is permitted. The statement requires the recognition of the cost of postemployment benefits (after employment but before retirement) on an accrual basis. The Company will adopt SFAS No. 112 in 1994. The new standard is not expected to have a significant effect on the Company's annual benefits expense or liabilities. NOTE 14 QUARTERLY FINANCIAL DATA (UNAUDITED) ITEM 9.

ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There have been no disagreements between Registrant and its independent accountants on accounting and financial disclosure during the year ended December 31, 1993. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT Executive Officers of the Registrant* *All officers are elected to serve a one year term and until their successors are elected and qualified. The information contained in the Company's 1994 Proxy Statement on pages 2-4, under the headings "ELECTION OF DIRECTORS -- Nominees for Election as Directors" and on page 19 under the heading "ELECTION OF DIRECTORS -- Executive Compensation and Other Information -- Section 16 Reports" is incorporated herein by reference. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information contained in the Company's 1994 Proxy Statement under the heading "ELECTION OF DIRECTORS -- Board of Directors, Committee Meetings and Director Compensation" on pages 6-7, "ELECTION OF DIRECTORS -- Executive Compensation and Other Information -- Summary Compensation Table" and "-- Options" on pages 9-11 and "ELECTION OF DIRECTORS -- Executive Compensation and Other Information -- Pension Benefits" and "-- Executive and Consulting Agreements" on pages 16-18, is incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information contained in the Company's 1994 Proxy Statement, on pages 5 and 19, under the headings "ELECTION OF DIRECTORS -- Stock Ownership of Management" and "ELECTION OF DIRECTORS -- Ownership of the Company's Securities" is incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None reportable in the year ended December 31, 1993. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K No reports on Form 8-K were filed by Registrant during the fourth quarter ended December 31, 1993. (c) Exhibits * Management contracts or compensatory plan or arrangement required to be filed as an exhibit to this form pursuant to Item 14(c) of this Report. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. LOCTITE CORPORATION By /s/ DAVID FREEMAN ---------------------------------- DAVID FREEMAN PRESIDENT AND CHIEF EXECUTIVE OFFICER Date: February 22, 1994 POWER OF ATTORNEY EACH OF THE UNDERSIGNED HEREBY APPOINTS EUGENE F. MILLER AND WILLIAM V. GRICKIS, JR., AND EACH OF THEM SEVERALLY, HIS TRUE AND LAWFUL ATTORNEYS TO EXECUTE ON BEHALF OF THE UNDERSIGNED ANY AND ALL AMENDMENTS TO THIS ANNUAL REPORT ON FORM 10-K AND TO FILE THE SAME, WITH ALL EXHIBITS THERETO AND OTHER DOCUMENTS IN CONNECTION THEREWITH, WITH THE SECURITIES AND EXCHANGE COMMISSION. EACH SUCH ATTORNEY WILL HAVE THE POWER TO ACT HEREUNDER WITH OR WITHOUT THE OTHERS. EACH OF THE UNDERSIGNED HEREBY RATIFIES AND CONFIRMS ALL THAT SUCH ATTORNEYS, OR ANY OF THEM, MAY LAWFULLY DO OR CAUSE TO BE DONE BY VIRTUE HEREOF. ------------------------ PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Prospectuses constituting part of the Post-Effective Amendments to the Registration Statements on Form S-8 (Nos. 2-74537, 2-65775, 2-57724, 2-49684, 33-34061, 33-35125, and 33-32379) of Loctite Corporation of our report dated January 25, 1994 appearing on page 17 of Loctite Corporation's Annual Report on Form 10-K for the year ended December 31, 1993. We also consent to the reference to us under the heading "Experts" in such Prospectuses. /s/ PRICE WATERHOUSE PRICE WATERHOUSE One Financial Plaza Hartford, Connecticut March 16, 1994 SCHEDULE V LOCTITE CORPORATION PROPERTY, PLANT AND EQUIPMENT * Primarily the plant and equipment of companies acquired in 1993. SCHEDULE VI LOCTITE CORPORATION ACCUMULATED DEPRECIATION PROPERTY, PLANT AND EQUIPMENT * Primarily the depreciation of companies acquired in 1993. SCHEDULE VIII LOCTITE CORPORATION VALUATION AND QUALIFYING ACCOUNTS ALLOWANCES FOR DOUBTFUL ACCOUNTS SCHEDULE IX LOCTITE CORPORATION SHORT-TERM BANK DEBT * Weighted Average Interest Rates were influenced by the magnitude and duration of local currency borrowings in highly inflationary environments, where interest rates obtained on borrowings reflect the underlying levels of local inflation. The exception to this is Brazil, where, because of the potential for significant distortion, the inflation components of interest expense have been reported in the translation component of foreign exchange loss. ** Using monthly balances. INDEX TO EXHIBITS

55387_1993.txt

55387

1993

Item 1. Business General Kentucky Utilities Company (Kentucky Utilities) is a wholly owned subsidiary of KU Energy Corporation (KU Energy). Kentucky Utilities is a public utility engaged in producing and selling electric energy. Kentucky Utilities provides electric service to about 409,700 customers in over 600 communities and adjacent suburban and rural areas in 77 counties in central, southeastern and western Kentucky, and to about 27,900 customers in 5 counties in southwestern Virginia. In Virginia, Kentucky Utilities operates under the name Old Dominion Power Company. Of the Kentucky communities, 160 are incorporated municipalities served under unexpired municipal franchises and the rest are unincorporated communities where no franchises are required. Service has been provided in Virginia without franchises for a number of years. This lack of Virginia franchises is not expected to have a material effect on Kentucky Utilities' operations. Kentucky Utilities also sells electric energy at wholesale for resale in 12 municipalities. The territory served by Kentucky Utilities has an aggregate population estimated at 1,000,000. The largest city served is Lexington, Kentucky. The population of the metropolitan Lexington area is estimated at 225,000. The populations of the next 10 largest cities served at retail range from about 21,000 to 9,000. The territory served includes most of the Blue Grass Region of central Kentucky and parts of the coal mining areas in southeastern and western Kentucky and southwestern Virginia. Lexington is the center of the Blue Grass Region, in which thoroughbred horse, burley tobacco and bourbon whiskey distilling industries are located. Among the principal industries in the territory served are coal mining, automotive and related industries, agriculture, primary metals processing, crude oil production, pipeline transportation, and the manufacture of electrical and other machinery and of paper and paper products. Revenues Kentucky Utilities' sources of electric revenues and the respective percentages of total revenues for the three years 1991-1993 were as follows: The electric utility business is affected by varying seasonal weather patterns. As a result, operating revenues (and associated operating expenses) are not generated evenly throughout the year. Operations Kentucky Utilities' net generating capability is 3,164 megawatts. The net generating capability available for operation at any time may be lower because of periodic outages of generating units due to inspection, maintenance, fuel restrictions, or modifications required by regulatory agencies. Kentucky Utilities obtains power from other utilities under bulk power purchase and interchange contracts. At December 31, 1993, Kentucky Utilities' system capability, including purchases from others, was 3,529 megawatts. The all-time system peak demand, on a one-hour integrated basis, occurred on July 28, 1993 and was 3,176 megawatts. During 1993, Kentucky Utilities generated about 89% and purchased about 11% of its net system output. Kentucky Utilities is one of 28 members of the East Central Area Reliability Coordination Agreement, the purpose of which is to augment the reliability of the members' bulk power supply through coordination of planning and operation of generation and transmission facilities. The members are engaged in the generation, transmission and sale of electric power and energy in the east central area of the United States, which covers all or portions of Michigan, Indiana, Ohio, Kentucky, Pennsylvania, Virginia, West Virginia and Maryland. Kentucky Utilities also has interconnections and contractually established operating arrangements with neighboring utilities and cooperatives. Under a contract with Owensboro Municipal Utilities (OMU), Kentucky Utilities has agreed to purchase from OMU the surplus output of the 150 megawatt and 250 megawatt generating units at OMU's Elmer Smith station. Purchases under the contract are made under a contractual formula which has resulted in costs which were and are expected to be comparable to the cost of other power purchased or generated by Kentucky Utilities. Such power constituted about 8% of Kentucky Utilities' net system output during 1993. See Note 5 of the Notes to Financial Statements. Kentucky Utilities owns 20% of the common stock of Electric Energy, Inc. (EEI), which owns and operates a 1,000-MW station in southern Illinois. Prior to 1994, Kentucky Utilities was entitled to receive varying amounts of power from EEI when available. Such power constituted about 1% of Kentucky Utilities' net system output during 1993. Commencing January 1, 1994, Kentucky Utilities' entitlement is 20% of the available capacity of the station. Such power is expected to be about 5% of Kentucky Utilities' net system output in 1994. See Note 5 of the Notes to Financial Statements. Kentucky Utilities has contracted to purchase 75 megawatts of generating capacity from Illinois Power Company from January 1, 1993 to March 31, 1994, and 125 megawatts from April 1, 1994 to December 31, 1994. Kentucky Utilities had approximately 2,260 employees at December 31, 1993, of which about 300 are covered by union contracts expiring August 1994. Fuel Matters Coal-burning generating units provided more than 99% of Kentucky Utilities' net kilowatt-hour generation for 1993. The remainder of Kentucky Utilities' net generation for 1993 was provided by hydroelectric plants, oil and/or natural gas burning units. The average delivered cost of coal purchased, per ton and per million BTU, for the periods indicated were as follows: 1993 1992 1991 Per ton $ 27.92 $ 27.94 $ 27.99 Per million BTU $ 1.15 $ 1.16 $ 1.16 The average delivered costs of coal purchased on a spot basis during 1993 were $26.23 per ton and $1.08 per million BTU. Kentucky Utilities purchased 44%, 42% and 33% of its coal on a spot basis during 1993, 1992 and 1991, respectively. Kentucky Utilities maintains its fuel inventory at levels estimated to be necessary to avoid operational disruptions at its coal-fired generating units. Reliability of coal deliveries can be affected from time to time by a number of factors, including coal mine labor strikes and other supplier operating difficulties. Kentucky Utilities believes there are adequate reserves available to supply its existing base-load generating units with the quantity and quality of coal required for those units throughout their useful lives. Kentucky Utilities intends to meet a substantial portion of its coal requirements with 5 year contracts. Kentucky Utilities anticipates that coal supplied under such agreements will represent about two-thirds of the requirements over the next several years. The balance of coal requirements will be met through spot purchases. See Note 5 of the Notes to Financial Statements for the estimated obligations under fuel contracts for each of the years 1994 through 1998. Kentucky Utilities does not anticipate encountering any significant problems acquiring an adequate supply of fuel necessary to operate its new peaking units. See "Construction" for a discussion of Kentucky Utilities' plans to add peaking capacity. Kentucky Utilities' fuel adjustment clause for Kentucky customers, which operates to reflect changes in the cost of fuel in billings to customers, is designed to conform to a general regulation providing for a uniform monthly fuel adjustment clause for all electric utilities in Kentucky subject to the jurisdiction of the Kentucky Public Service Commission (PSC). The clause is based on a formula approved by the Federal Energy Regulatory Commission (FERC) but with certain modifications, including the exclusion of excess fuel expense attributable to certain forced outages, the filing of fuel procurement documentation, a procedure for billing over and under recoveries of fuel cost fluctuations from the base rate level and provision for periodic public hearings to review past adjustments, to make allowance for any past adjustments found not justified, to disallow any improper expenses and to re-index base rates to include current fuel costs. The fuel adjustment clause mechanism for Virginia customers, which is adjusted annually, uses an average fuel cost factor based primarily on projected test year fuel costs. The fuel cost factor is adjusted for the over or under collection of fuel costs from the previous year. Environmental Matters Federal and state agencies have adopted environmental protection standards which apply to the electric operations of Kentucky Utilities. To comply with these standards, Kentucky Utilities has spent $296 million through 1993 for the installation of pollution control equipment and for the institution of other environmental protection measures. Kentucky Utilities' generating units are operated in compliance with the Kentucky Natural Resources and Environmental Protection Cabinet's (the "Cabinet") State Implementation Plan (the "KYSIP") and New Source Performance Standards developed under the Clean Air Act. The KYSIP is a federally-approved plan for the attainment of the national ambient air quality standards. The KYSIP contains standards relating to the emissions of various pollutants (sulfur dioxide, total suspended particulates and nitrogen oxides) from Kentucky Utilities' fossil-fuel fired steam electric generating units. These emission standards are of varying stringencies and compliance with these standards is attained through a variety of pollution control technologies (scrubbers, electrostatic precipitators, and low NOx burners) and the use of low sulfur coal. Kentucky Utilities' operations are in substantial compliance with current emission standards. The acid rain control provisions of the 1990 Clean Air Act Amendments, which are effective in two phases, will require Kentucky Utilities to further decrease the emissions of sulfur dioxide and nitrogen oxides from its fossil-fuel fired steam electric generating units. Ghent Unit 1, E. W. Brown Units 1, 2 and 3, and Green River Unit 4 have been designated as Phase I affected units which must comply with sulfur dioxide emission reduction obligations by January 1, 1995. Kentucky Utilities has adopted a strategy designed to comply with the acid rain control provisions, which will involve the installation of a scrubber and related facilities on Ghent Unit 1 during the first phase (which begins January 1, 1995) as well as fuel switching to lower sulfur coal on some other Phase I affected units to comply with sulfur dioxide limitations. In addition, the retrofit of low NOx burners on these units will be required in order to comply with nitrogen oxide limitations. On July 21, 1993, the United States Environmental Protection Agency (the EPA) issued final acid rain permits for each of Kentucky Utilities' Phase I affected units. The EPA's approval of Kentucky Utilities acid rain compliance plan was accompanied by bonus allowances awarded for the installation of the scrubber on Ghent Unit 1 and an extension of the Phase I effective date to January 1, 1997, for certain portions of the acid rain control requirements. Kentucky Utilities current plans are to be in compliance with sulfur dioxide emission reduction obligations by January 1, 1995. See Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations - Construction and - Environmental Matters for additional discussion. During 1990, each of Kentucky Utilities' five fossil-fuel fired steam electric generating stations was re-issued a wastewater discharge permit by the Cabinet under the Clean Water Act's National Pollutant Discharge Elimination System. These 5-year permits place water quality-based effluent limitations (i.e., thermal and chemical limits) on each of the power plant's discharges. Kentucky Utilities' operations are in substantial compliance with the conditions in the permits. Pursuant to the Resource Conservation and Recovery Act, utility wastes (fly ash, bottom ash and scrubber sludge) have been categorized as special wastes (i.e., wastes of large volume, but low environmental hazard). The EPA has concluded that the disposal of coal combustion by- products by practices common to the utility industry are adequate for the protection of human health and the environment. The Cabinet also regulates utility wastes as special wastes under its waste management program. Under the Toxic Substances Control Act, the EPA regulates the use, servicing, repair, storage and disposal of electrical equipment containing polychlorinated biphenyls (PCB). To comply with these regulations, Kentucky Utilities has implemented procedures to be followed in the handling, storage and disposal of PCBs. In addition, Kentucky Utilities has completed the mandated phase out of all of its pole-class PCB capacitors and has no vault-type PCB transformers in use, in or near commercial buildings. On February 13, 1990, Kentucky Utilities received a letter from the EPA identifying Kentucky Utilities and others as potentially responsible parties under the Comprehensive Environmental Response Compensation and Liability Act (CERCLA or "Superfund") for a disposal site in Daviess County, Kentucky. The letter also asked Kentucky Utilities, and the other persons or entities named, to proceed voluntarily with a remediation program at the site. Under Superfund, a responsible party may be liable for all or a portion of all monies expended by the government to take corrective action at the site. The EPA has turned over responsibility for investigation of the site and development of a remediation plan to a group (not including Kentucky Utilities) originally named as potentially responsible parties. Kentucky Utilities has entered into an agreement with the group as to the portion of the investigation and development costs to be borne by Kentucky Utilities in connection with the site. The agreement does not cover costs which may be incurred in connection with any remediation plan. Any remediation plan would be subject to approval of the EPA. Although a final plan has yet to be developed or approved, Kentucky Utilities does not believe that any liability with respect to the site will have a material impact on its financial position or results of operations. Regulation Kentucky Utilities is subject to the jurisdiction of the PSC and the Virginia State Corporation Commission (SCC) as to rates, service, accounts, issuance of securities and in other respects. By reason of owning and operating a small amount of electric utility property in one county in Tennessee (having a gross book value of about $212,000), Kentucky Utilities may also be subject to the jurisdiction of the Tennessee Public Service Commission as to rates, accounts, issuance of securities and in other respects. Since 1992, utilities in Kentucky have been allowed to use either a historical test period or a forward-looking test period in rate filings. Rate regulation in Kentucky allows each utility, with a PSC-approved environmental compliance plan and environmental surcharge rider, to recover on a current basis the cost of complying with any federal, state or local environmental requirements, including the 1990 Clean Air Act Amendments, which apply to coal combustion wastes and by-products from facilities utilized for the production of energy from coal. An approved surcharge rider will allow Kentucky Utilities to recover any compliance related operating expenses and to earn a reasonable rate of return on compliance related capital expenditures through the application of the surcharge each month to customers' bills. For information regarding Kentucky Utilities filing with the PSC for approval of a rider, see Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations - Environmental Matters - Environmental Surcharge. Integrated resource planning regulations in Kentucky require Kentucky Utilities and the other major utilities to make biennial filings, with the PSC, of various historical and forecasted information relating to forecasted load, capacity margins and demand-side management techniques. Pursuant to Kentucky law, the PSC has established the boundaries of the service territory or area of each supplier of retail electric service in Kentucky (including Kentucky Utilities), other than municipal corporations, within which each such supplier shall have the exclusive right to render retail electric service. The FERC has jurisdiction under the Federal Power Act over certain of the electric utility facilities and operations and accounting practices of Kentucky Utilities, and in certain other respects as provided in the Act. The FERC has classified Kentucky Utilities as a "public utility" as defined in the Act. Kentucky Utilities is presently exempt from all the provisions of the Public Utility Holding Company Act of 1935, except Section 9(a)(2) thereof (which relates to the acquisition of securities of public utility companies), by virtue of the exemption granted by an order of the Securities and Exchange Commission dated April 19, 1949 and, absent further action by the Commission, by virtue of annual exemption statements filed by Kentucky Utilities with the Commission pursuant to Rule 2 prescribed under the Act. National Energy Policy Act See Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operation - National Energy Policy Act. Item 2.

Item 2. Properties Substantially all properties are subject to the lien of Kentucky Utilities' Mortgage Indenture. Construction The total construction expenditures of Kentucky Utilities for the years 1994 through 1998 are estimated at $631.6 million. Such expenditures include an estimated $326.1 million for generating facilities, $65.5 million for transmission facilities and $240.0 million for distribution and general facilities. Included in total construction expenditures for the 1994 - 1998 period are $137.8 million for 660-MW of peak generating capacity to be added during 1994 - 1998 (220-MW in 1994, and 110-MW in each year 1995-1998) and $152.3 million for environmental compliance (of which $128.6 million is for compliance with the 1990 Clean Air Act Amendments). All necessary permits and approvals for the three units to go on line in 1994 and 1995 have been obtained. An application for a Certificate of Convenience and Necessity to construct the peaking unit to go on line in 1996 was filed with the PSC in December 1993. Kentucky Utilities has no plans to install base load generating capacity before 2010. Construction expenditures for the years 1989 through 1993 aggregated about $440.2 million. See Note 5 of the Notes to Financial Statements for the estimated amounts of construction expenditures for each of the years 1994 through 1998. Kentucky Utilities frequently reviews its construction program and construction expenditures, which may be affected by numerous factors, including the rate of load growth, changes in construction costs, changes in environmental regulations, the adequacy of rate relief and Kentucky Utilities' ability to raise necessary capital (See Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations). Kentucky Utilities' planned additions to its electric generating capacity are based on projections of its future load using estimated load growth rates. Consideration is also given to projections by neighboring utilities of their future loads and capacity. A major effort in the industry is being made to control future construction requirements by managing customer demand. However, forecasts of future loads are subject to numerous uncertainties, including economic conditions and effectiveness of energy conservation measures. Item 3.

Item 3. Legal Proceedings None. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders None. Executive Officers of the Registrant Current Positions Positions Held During at Least the Name and Age Held Last 5 Years John T. Newton Chairman and Chairman of the Board of Kentucky Age 63 President, Utilities since November 1987, and and Director President since January 1987. Director of Kentucky Utilities since December 1974. O. M. Goodlett Senior Vice- Senior Vice-President of Kentucky Age 46 President Utilities since November 1992. Vice-President of Kentucky Utilities from April 1982 to November 1992. James W. Tipton Senior Vice- Senior Vice-President of Kentucky Age 50 President Utilities since November 1986. Michael R. Whitley Senior Vice- Director of Kentucky Utilities Age 50 President and since March 1992, and Senior Vice- Director President since March 1987. Secretary of Kentucky Utilities from July 1978 to November 1992. George S. Brooks II General Corporate Secretary of Kentucky Age 43 Counsel and Utilities since November 1992, and Corporate General Counsel since January 1988. Secretary James M. Allison Vice- Vice-President of Kentucky Age 40 President Utilities since February 1993. President and Chief Operating Officer of Wheeling Power Company from October 1989 to January 1993. South Bend Division Manager of Indiana Michigan Power Company from January 1986 to October 1989. Gary E. Blake Vice- Vice-President of Kentucky Age 40 President Utilities since November 1992. Western Division Manager of Kentucky Utilities from October 1991 to November 1992. Assistant Western Division Manager of Kentucky Utilities from March 1990 to October 1991. Field Operations Coordinator for Kentucky Utilities from April 1986 to March 1990. William E. Casebier Vice- Vice-President of Kentucky Age 51 President Utilities since May 1988. Executive Officers of the Registrant (continued) Current Positions Positions Held During at Least the Name and Age Held Last 5 Years Robert M. Hewett Vice- Vice-President of Kentucky Age 46 President Utilities since January 1982. Wayne T. Lucas Vice- Vice-President of Kentucky Age 46 President Utilities since November 1986. Ronald L. Whitmer Vice- Vice-President of Kentucky Age 61 President Utilities since November 1992. Director of Production and Generation Construction of Kentucky Utilities from May 1985 to November 1992. William N. English Treasurer Treasurer of Kentucky Utilities Age 43 since April 1982. Michael D. Robinson Controller Controller of Kentucky Utilities Age 38 since August 1990. Assistant Controller of Kentucky Utilities from August 1983 to August 1990. John J. Maloy, Jr. Assistant Assistant Treasurer of Kentucky Age 39 Treasurer Utilities since August 1984. (Not an Executive Officer) Note: Officers are elected annually by the Board of Directors. There is no family relationship between any executive officer and any other executive officer or any director. PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters Since December 1, 1991, all of the outstanding common stock of Kentucky Utilities has been held by KU Energy. The following table sets forth the cash distributions (in thousands of dollars) on common stock paid by Kentucky Utilities for the periods indicated: 1993 1992 First Quarter $15,127 $64,749 Second Quarter $15,127 $14,749 Third Quarter $15,127 $14,749 Fourth Quarter $15,127 $14,749 The 1992 first quarter amount includes a $50 million special dividend to the parent company, KU Energy. See Note 6 of the Notes to Financial Statements. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Kentucky Utilities Company (Kentucky Utilities), an electric utility, is a wholly owned subsidiary of KU Energy Corporation (KU Energy). RESULTS OF OPERATIONS Net Income Applicable to Common Stock Net income applicable to common stock was $78.7 million in 1993 compared to $73.8 million in 1992 and $81.7 million in 1991. The increase in 1993 was primarily due to weather-related growth in sales and lower interest charges attributable to debt refinancings and redemptions. Earnings in 1993 were negatively impacted by an increase in other operating expenses and a decline in interest and dividend income. The decline in 1992 earnings was due to unusually mild weather, increases in operating and maintenance costs, and an increase in interest charges attributed to a $35 million increase in long-term debt. Sales increased 6% to 15.8 billion kilowatt-hours (kWh) in 1993. The increase resulted primarily from increases in sales to residential and industrial customers. The rise in residential sales reflects cooler weather in the first and fourth quarters of 1993 and warmer weather during the second and third quarters of 1993 as compared to the corresponding periods of 1992. Due to the exceptionally warm weather in the third quarter of 1993, Kentucky Utilities set an all-time peak demand for electricity on July 28, 1993, of 3,176 megawatts. The increase in industrial sales reflects the general strength of the service area economy as well as an increase in the number of industrial customers. As a result of the increase in sales, revenues rose 5% in 1993 to $606.6 million. Revenues in 1993 were reduced approximately $3.3 million as a result of refunds to customers of amounts recovered from a litigation settlement with a former coal supplier. The $3.3 million, which was charged against revenue, represents $4.1 million of fuel savings less $.8 million for incurred litigation costs. See Note 2 of the Notes to Financial Statements. Despite declines in residential and commercial sales in 1992, total sales increased due to greater sales to industrial customers. The decline in residential and commercial sales was the result of cooler than normal weather in the second and third quarters of 1992, compared to warmer than normal weather in the corresponding periods of 1991. The decline in 1992 revenues was due primarily to lower average fuel costs passed on to customers. 1993 Kilowatt-Hour Sales by Classification Year Ended December 31, 1993 Residential 30% Commercial 20% Industrial 22% Mine Power 6% Public Authorities 8% Other Electric Utilities 14% Total 100% Fuel and Purchased Power Expense Fuel expense in 1993 totaled $178.9 million, a 6% increase over 1992. The increase was largely attributable to greater coal consumption. Fuel expense for 1993 reflects a $4.1 million reduction associated with the refunding to customers of fuel cost savings resulting from the litigation settlement with a former coal supplier. See Note 2 of the Notes to Financial Statements. Purchased power expense increased $2.0 million (6%) in 1993. The increase reflects greater demand charges associated with a new short-term capacity contract with a neighboring utility, partially offset by a 5% decline in power purchases. The decline in power purchases was due to a reduction in the availability of Owensboro Municipal Utilities' (OMU) generating units during scheduled maintenance of those units in the second quarter of 1993. A contract between Kentucky Utilities and OMU allows Kentucky Utilities to purchase, on an economic basis, surplus power from a 400-megawatt generating station owned by OMU. Fuel expense in 1992 declined $14.7 million (8%) to $168.5 million. The reduction was due to a lower average price per ton of coal consumed (6%) and to a decline in coal consumption (2%). The decline in the average price per ton was due to lower cost coal and to the completion in May 1992 of the amortization of buyout costs associated with a terminated coal contract. Coal consumption in 1992 was reduced as a result of increases in power purchases. Purchased power expense rose $6.0 million (22%) in 1992 due to increased power purchases (39%), primarily under the OMU contract. The increase in purchased power costs resulting from greater kWh purchases in 1992 was partially offset by a reduction in the average price per kWh purchased. Other Operating Expenses Other operating expenses for 1993 increased $11.0 million (12%), $6.3 million of which resulted from the adoption of a new accounting standard. See Note 4 (Other Postretirement Benefits) of the Notes to Financial Statements. Other Income and Deductions Other income and deductions in 1993 declined $2.6 million. A reduction in interest and dividend income resulted from lower levels of cash investments. Other income and deductions in 1992 were comparable to 1991. Additional interest and dividend income associated with an increase in the average amounts available for investment and bond proceeds deposited pending retirement of existing debt issues were offset by lower available short- term investment returns. Interest Charges Interest charges decreased $8.2 million (20%) in 1993. The decrease was the result of the redemption of two debt issues near the beginning of the second quarter of 1993 and the refinancing of several debt issues during the second half of 1992 and early in the third quarter of 1993 at significantly lower interest rates. See Note 5 of the Notes to Financial Statements for information pertaining to Kentucky Utilities' refinancing and redemption activities in 1993. Interest charges in 1992 increased $2.8 million (7%). The interest expense associated with the issuance of additional debt was partially offset by the refinancing of higher cost existing debt. The effects of the increase in interest expense were partially offset by the above mentioned interest income on bond proceeds deposited. LIQUIDITY & RESOURCES Capital Structure Kentucky Utilities continues to maintain a strong capital structure. At the end of 1993, common stock equity represented 53.4% of total capitalization while long-term debt stood at 42.7%, and preferred stock was 3.9%. Cash Flow In 1993, cash provided by operating activities accounted for 67% of total cash requirements as compared to 68% in 1992 and 105% for 1991. Cash requirements included in the above percentages exclude optional debt refinancings and redemptions. At the end of 1993, cash and cash equivalents totaled $8.8 million. Cash and cash equivalents were $94.3 million at the end of 1992 and $125.6 million at year-end 1991. Cash and cash equivalents were utilized to redeem $55 million of first mortgage bonds and to help meet expenditures for compliance with the 1990 Clean Air Act Amendments and peaking unit construction, thus lowering cash levels at the end of 1993. Financing During 1993, Kentucky Utilities continued to take advantage of opportunities to reduce its embedded cost of long-term debt through refinancings. A total of $120 million of first mortgage bonds was refinanced in 1993 at significantly lower interest rates. Kentucky Utilities has refinanced over $300 million of long-term debt over the past year and a half. The reduction of interest expense on an annual basis from these refinancings will total about $5.4 million. In 1992, Kentucky Utilities refinanced $53 million of first mortgage bonds (including a $3 million redemption premium) and $133.9 million of pollution control bonds at significantly lower interest rates. As a result of the foregoing activities, Kentucky Utilities' embedded cost of long-term debt declined to 7.23% in 1993 as compared to 8.00% in 1992 and 8.94% in 1991. In December 1993, $50 million of 5 3/4% Collateralized Solid Waste Disposal Facility Revenue Bonds was issued to finance a portion of the costs of environmental compliance facilities currently under construction. Kentucky Utilities also issued $20 million of 6.53% preferred stock in December 1993. Proceeds from the sale of this issue were used to redeem the utility's 7.84% Preferred Stock on February 1, 1994. See Note 5 of the Notes to Financial Statements for additional information on 1993 financing activities. Construction Construction expenditures totaled $177.1 million in 1993 as compared to $86.1 million in 1992 and $65.6 million in 1991. The 1993 increase was largely attributable to $48.7 million expended for compliance with the 1990 Clean Air Act Amendments and $55.5 million expended for construction of peaking units. Projected construction requirements for the 1994-1998 period are $631.6 million. Included in this amount are $152.3 million for environmental compliance measures of which $128.6 million is for compliance with the 1990 Clean Air Act Amendments. Also included in the 1994-1998 construction total is $137.8 million for peaking units. Kentucky Utilities expects to provide about 79% of its 1994-1998 construction requirements through internal sources of funds with the balance primarily from long-term debt. Providing for Customer Growth Kentucky Utilities utilizes a least cost planning strategy to ensure that growth in customer demand is provided for in the most efficient and cost- effective manner. The Kentucky Public Service Commission (PSC) requires filing of an Integrated Resource Plan every two years. Kentucky Utilities filed its 1993 Integrated Resource Plan in October 1993. This plan includes a 15-year load forecast and description of existing and planned conservation programs, load management programs and generation facilities to meet forecasted requirements in a reliable manner at the lowest reasonable costs. The PSC has initiated an informal review of the plan according to existing regulations. As outlined in Kentucky Utilities' 1993 Integrated Resource Plan, annual growth in sales and customer peak demand is forecast at 1.8% and 1.9%, respectively, over the next 15 years. The utility plans to provide for customer growth in the '90s through purchased power and the addition of combustion turbine peaking units. Three 110-megawatt peaking units are currently under construction. Two of the units will be installed in 1994 and the other in 1995. An additional peaking unit may be required in each year from 1996-1998. There are no plans for additional baseload capacity before 2010. ENVIRONMENTAL MATTERS Clean Air Act Compliance Kentucky Utilities' compliance strategy for the 1990 Clean Air Act Amendments includes installing flue gas desulfurization systems (scrubbers), low nitrogen oxide burners and continuous emission monitoring devices as well as fuel switching to lower sulfur coal. The key component of the utility's compliance plan for Phase I requirements, which are effective January 1, 1995, is a scrubber under construction at Ghent Unit 1. The flexible design of the Ghent Unit 1 scrubber provides the option of installing equipment to scrub flue gas from Ghent Unit 2 at an economical cost. Anticipated costs of implementing this option are included in the total estimated 1994-1998 construction expenditures shown above. In 1993, Kentucky Utilities revised its previous cost estimates for compliance to reflect lower than expected costs for construction of the Ghent Unit 1 scrubber. Kentucky Utilities also deferred, until the 2005 time frame, an additional scrubber originally planned at Brown Unit 3 for compliance with Phase II requirements, which are effective January 1, 2000. The utility had anticipated capital spending of about $359 million through 2000 for the 1990 Clean Air Act Amendments ($166 million for Phase I and $193 million for Phase II). With the above mentioned revisions and the anticipated additional equipment to scrub Ghent Unit 2, current estimates of the capital costs for compliance through the year 2000 are about $200 million (over two-thirds of which should be incurred by January 1, 1995). Through December 31, 1993, about $70 million had been spent for compliance. Kentucky Utilities has purchased 12,900 Phase I emission allowances and has been awarded about 114,000 additional allowances through participation in the Environmental Protection Agency's Phase I Extension Plan Program. The allowances give the utility additional flexibility in implementing its compliance plans and will be incorporated into its strategy to achieve the most economical means of compliance. Kentucky Utilities will continue to review and revise its compliance plans to ensure that its obligations are most effectively met. Environmental Surcharge In January 1994, Kentucky Utilities filed plans with the PSC to implement an environmental surcharge. The surcharge will permit the utility to recover certain ongoing operating and capital costs of compliance with any federal, state or local environmental requirements associated with the production of energy from coal, including the 1990 Clean Air Act Amendments. Upon PSC approval, the proposed environmental surcharge would begin August 1, 1994. Kentucky Utilities estimates that under the proposed surcharge, it would recover about $15.5 million in environmental costs during the first twelve months and about $23 million during the second twelve months. Other In 1990, Kentucky Utilities received a letter from the Environmental Protection Agency (EPA) identifying Kentucky Utilities and others as potentially responsible parties under the Comprehensive Environmental Response Compensation and Liability Act of 1980 for a disposal site in Daviess County, Kentucky. The EPA has turned over responsibility for investigation of the site and development of a remediation plan to a group (not including Kentucky Utilities) originally named as potentially responsible parties. Kentucky Utilities has entered into an agreement with the group as to the portion of the investigation and development costs to be borne by Kentucky Utilities in connection with the site. Any remediation plan would be subject to approval of the EPA. Although a final, approved plan has yet to be developed, Kentucky Utilities does not believe that any liability with respect to the site will have a material impact on its financial position or results of operations. NATIONAL ENERGY POLICY ACT The National Energy Policy Act of 1992 (Energy Act) promotes energy efficiency, environmental protection and increased competition. Provisions of the Energy Act of most importance to electric utilities are those that promote competition in the generation and transmission of electricity. The Energy Act removes long-standing constraints on the development of wholesale power generation by establishing a new class of independent power producers which are exempt from traditional utility regulation. The Energy Act also makes it easier for nonutility power producers to gain access to utility-owned transmission networks by allowing the Federal Energy Regulatory Commission to order wholesale "wheeling" by public utilities. While the final impact of the Energy Act is yet to be determined, Kentucky Utilities believes that it will increase competition and may affect the traditional business strategies of the utility industry. Kentucky Utilities further believes it is well positioned for increased competition because Kentucky Utilities' rates continue to be among the lowest in the nation. IMPACT OF ACCOUNTING STANDARDS Refer to Note 8 of the Notes to Financial Statements for information concerning a new standard for accounting for investments in debt and equity securities. INFLATION Kentucky Utilities' rates are designed to recover operating and historical plant costs. Financial statements, which are prepared in accordance with generally accepted accounting principles, report operating results in terms of historic costs and do not evaluate the impact of inflation. Inflation affects Kentucky Utilities' construction costs, operating expenses and interest charges. Inflation can also impact Kentucky Utilities' financial performance if rate relief is not granted on a timely basis for increased operating costs. Item 8.

Item 8. Financial Statements and Supplementary Data REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Kentucky Utilities Company: We have audited the accompanying balance sheets and statements of capitalization of Kentucky Utilities Company (a Kentucky and Virginia corporation) as of December 31, 1993 and 1992, and the related statements of income and retained earnings, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of Kentucky Utilities' management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Kentucky Utilities Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As explained in Notes 3 and 4 to the financial statements, effective January 1, 1993, Kentucky Utilities Company changed its method of accounting for income taxes and postretirement benefits other than pensions. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in Item 14(A)(2) are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state, in all material respects, the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ Arthur Andersen & Co. Arthur Andersen & Co. Chicago, Illinois January 26, 1994 Notes to Financial Statements Kentucky Utilities Company 1. Summary of Significant Accounting Policies General Kentucky Utilities Company (Kentucky Utilities) is the principal subsidiary of KU Energy Corporation. Regulation Kentucky Utilities is a public utility subject to regulation by the Kentucky Public Service Commission (PSC), the Virginia State Corporation Commission (SCC) and the Federal Energy Regulatory Commission (FERC). With respect to accounting matters, Kentucky Utilities maintains its accounts in accordance with the Uniform System of Accounts as defined by these agencies. Its accounting policies conform to generally accepted accounting principles applicable to rate regulated enterprises and reflect the effects of the ratemaking process. Utility Plant Utility plant is stated at the original cost of construction. The cost of repairs and minor renewals is charged to maintenance expense as incurred. Property unit replacements are capitalized and the depreciation reserve is charged with the cost, less net salvage, of units retired. Depreciation Provision for depreciation of utility plant is based on straight-line composite rates applied to the cost of depreciable property. The rates approximated 3.3% in 1993, 1992 and 1991. Cash and Cash Equivalents For purposes of reporting cash flows, Kentucky Utilities considers highly liquid investments with a maturity of three months or less from the date of purchase to be cash equivalents. Kentucky Utilities utilizes a cash management mechanism that funds certain bank accounts for checks as they are presented to those banks. Kentucky Utilities classified checks written but not presented to those banks, which amounted to $9.9 million at December 31, 1993, in accounts payable. Notes to Financial Statements Kentucky Utilities Company Unamortized Loss on Reacquired Debt Kentucky Utilities defers costs (primarily call premiums) arising from the reacquisition or retirement of long-term debt. Costs related to refinanced debt are amortized over the lives of the new debt issues. Costs related to retired debt not refinanced are amortized over the period to the scheduled maturity of the retired debt. Operating Revenues and Fuel Costs Revenues are recorded based on services rendered to customers. Kentucky Utilities accrues an estimate of revenues for electric service furnished from the meter reading dates to the end of each accounting period. Cost of fuel used in electric generation is charged to expense as the fuel is consumed. The cost of fuel for 1991 and 1992 included an amortization of buyout costs associated with the termination of a coal supply contract. A fuel adjustment clause adjusts operating revenues for changes in the level of fuel costs charged to expense. 2. Fuel Litigation Refund Kentucky Utilities had been involved in litigation which began in 1984 with a former coal supplier over the price and other terms of the parties' long-term contract for Ghent Unit 3. Pursuant to an order of the Fayette (KY) Circuit Court, Kentucky Utilities deposited part of the disputed coal prices with the Fayette Circuit Court pending a final decision. During the course of the proceedings, the supplier filed for relief under the Federal Bankruptcy Code. On February 1, 1993, the Bankruptcy Court for the Eastern District of Kentucky approved a settlement agreement disposing of all litigation and claims between Kentucky Utilities and the supplier. All other actions and appeals involving the various parties and claimants have been dismissed. In March 1993, the deposited funds (totaling approximately $44 million, including interest through that date) were released by the Fayette Circuit Court to Kentucky Utilities and have been held by Kentucky Utilities in a segregated escrow account pending disposition in accordance with appropriate orders of regulatory agencies. During 1993, Kentucky Utilities submitted plans to the FERC, PSC and SCC for distributing a portion of the deposited funds to customers. Kentucky Utilities' plan was approved by the SCC, as submitted, and refunds of the Virginia retail portion of the deposited funds (approximately $2.3 million), plus interest, are being made to Virginia retail customers over 12 months beginning August 1, 1993. Kentucky Utilities' plan was approved by the FERC, as submitted, and a refund of that portion of the deposited funds (approximately $3.9 million) relating to wholesale customers was made in lump sum payments in September 1993. In an order which became final in February 1994, the PSC ordered Kentucky Utilities to refund that portion of the deposited funds relating to Kentucky retail customers (approximately $35.5 million), plus interest, to customers on its system from April 1985 through December 1990. The Notes to Financial Statements Kentucky Utilities Company order allows Kentucky Utilities to retain $.8 million of incurred litigation costs and $2.4 million for savings attributable to off-system sales. The PSC order also allows Kentucky Utilities recovery of its costs incurred in administering an approved refund plan. A refund plan in accordance with the PSC order has been filed by Kentucky Utilities for PSC approval. The total escrow funds remaining after the above mentioned FERC and SCC refunds and the withdrawals for savings attributable to off-system sales ($2.4 million) and incurred litigation costs ($.8 million) resulting from the FERC and SCC orders are reflected on the Balance Sheet under the caption "Escrow funds - coal contract litigation." The "Liability to ratepayers - coal contract litigation" represents the fuel cost savings (including interest) that will be credited to Kentucky and Virginia retail customers. Approximately $3.2 million of "Other Deferred Credits" represents the portion of savings attributable to off-system sales and the Kentucky jurisdictional allowed litigation costs. Kentucky Utilities will record a $3.2 million reduction of expense (for the off-system sales and allowed litigation costs) in 1994. 3. Income Taxes Effective January 1, 1993, Kentucky Utilities adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS 109). This statement requires an asset and liability approach for financial accounting and reporting for income taxes rather than the deferred method. It requires Kentucky Utilities to establish deferred tax assets and liabilities, as appropriate, for all temporary differences, and to adjust deferred tax balances to reflect changes in tax rates expected to be in effect during the periods the temporary differences reverse. At the date of adoption, because of the effects of rate regulation, Kentucky Utilities recorded an increase of $22 million in deferred tax assets and a decrease of $53 million in deferred tax liabilities, and established a corresponding regulatory liability of $75 million, primarily to recognize the probable future reduction in rates to flowback to customers amounts previously collected for deferred taxes in excess of current statutory tax rates. The adoption of this standard did not have a material impact on results of operation, cash flows or financial position. Kentucky Utilities is included in the consolidated federal tax return of its parent company, KU Energy. Income taxes are allocated to the individual companies, including Kentucky Utilities, based on their respective taxable income or loss. Investment tax credits result from provisions of the tax law which permitted a reduction of Kentucky Utilities' tax liability based on certain construction expenditures. Such credits have been deferred in the accounts and are being amortized as reductions in income tax expense over the life of the related property. The accumulated deferred income taxes as set forth below and in the Balance Sheet arise from the following temporary differences at Notes to Financial Statements Kentucky Utilities Company December 31 and January 1, 1993: Of the $3.8 million increase in deferred tax assets and the $21.0 million increase in deferred tax liabilities, approximately $1.3 million and $9.6 million, respectively, resulted from an increase in the federal statutory corporate income tax rate from 34% to 35% effective January 1, 1993. This resulted in a net decrease of $8.3 million in the regulatory liability. Notes to Financial Statements Kentucky Utilities Company Kentucky Utilities' effective income tax rate, determined by dividing income taxes by the sum of such taxes and net income, was 35.3% in 1993, 33.5% in 1992, and 34.4% in 1991. The difference between the effective rate and the statutory federal income tax rate is attributable to the following factors: Notes to Financial Statements Kentucky Utilities Company 4. Retirement and Postemployment Benefits Pensions Kentucky Utilities has a noncontributory defined benefit pension plan covering substantially all of its employees. Benefits under this plan are based on years of service, final average base pay and age at retirement. Kentucky Utilities' funding policy is to make such contributions as are necessary to finance the benefits provided under the plan. Kentucky Utilities' contributions meet the funding standards set forth in the Employee Retirement Income Security Act of 1974. The plan assets consist primarily of equity and fixed income investments. Kentucky Utilities also has a Supplemental Security Plan for certain management personnel. Retirement benefits under this plan are based on years of service, earnings and age at retirement. The plan has no advance funding. Benefit payments are made to retired employees or their beneficiaries from the general assets of Kentucky Utilities. Notes to Financial Statements Kentucky Utilities Company Other Postretirement Benefits Effective January 1, 1993, Kentucky Utilities adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS 106). This standard provides accounting and disclosure requirements associated with Kentucky Utilities' obligation to provide postretirement benefits other than pensions to present and future retirees. In accordance with this standard, Kentucky Utilities will accrue, during the years that the employee renders service, the expected cost of providing these benefits for retired employees, their beneficiaries and covered dependents. Kentucky Utilities previously recognized these costs on a pay-as-you-go (cash) basis. Amounts paid for retirees for 1992 and 1991 amounted to $2.3 million and $2.4 million, respectively. Kentucky Utilities provides certain health care and life insurance benefits to eligible retired employees and their dependents. The postretirement health care plan is contributory for employees who retired after December 31, 1992, with retiree contributions indexed annually based upon the experience of retiree medical expenses for the preceding year. Pre-1993 retirees are not required to contribute to the plan. Kentucky Utilities' employees become eligible for retiree medical benefits after 15 years of service and attainment of age 55. The life insurance plan is noncontributory and is based on compensation levels prior to retirement. Notes to Financial Statements Kentucky Utilities Company Employees may purchase additional life insurance equal to the amount provided by Kentucky Utilities. In 1993, Kentucky Utilities began funding, in addition to current requirements for benefit payments, the maximum tax-favored amount allowed through certain tax deductible funding vehicles. Kentucky Utilities anticipates making similar funding decisions in future years, but will consider and make such funding decisions on the basis of tax, regulatory and other relevant conditions in effect at such times. The PSC issued a decision in December 1992 stating that the rate treatment resulting from the adoption of SFAS 106 will be considered on a case-by-case basis in the context of a general rate case. Based on management's interpretation of this PSC Order, Kentucky Utilities is not deferring the Kentucky jurisdictional portion of these costs. The FERC and the SCC both have approved accrual of these costs for ratemaking purposes in accordance with SFAS 106. Kentucky Utilities is deferring, in accordance with the SCC and FERC Orders, the difference between costs determined in accordance with SFAS 106 and the level currently reflected in rates for the portion of costs associated with the Virginia and FERC jurisdictions until the next general rate cases in the respective jurisdictions as a result of the above mentioned Orders. The impact on results of operations, after giving effect to the regulatory treatment discussed above, is an increase in pre-tax expense for the year ended December 31, 1993 of $6.3 million (net of capitalized payroll benefits). Notes to Financial Statements Kentucky Utilities Company For measurement purposes, a 10% annual rate of increase in the per capita cost of covered health care benefits is assumed for 1994. The health care cost trend rate is assumed to decrease gradually to 5.25% through 2004 and remain at that level thereafter over the projected payout period of the benefits. Increasing the assumed health care cost trend rates by 1 percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1993, by $12 million (16%) and the aggregate of the service and interest cost components of the net periodic postretirement benefit cost for the year by $1.6 million (20%). The weighted-average discount rate used in determining the accumulated postretirement benefit obligation was 7.5%. The weighted-average discount rate used in determining the initial transition amount was 8.75%. The rate of increase for compensation levels was assumed to be 4.75%. Other Postemployment Benefits In November 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits". This statement establishes standards of accounting and reporting for the estimated cost of benefits Notes to Financial Statements Kentucky Utilities Company provided by an employer to former or inactive employees after employment but before retirement. Kentucky Utilities provides medical and life insurance benefits to disabled employees that are covered by this statement. Kentucky Utilities adopted this standard effective in 1993. The adoption of this standard did not have a material impact on financial condition or results of operation. 5. Commitments and Contingencies Construction Program Kentucky Utilities frequently reviews its construction program and may revise its projections of related expenditures based on revisions to its estimated load growth and projections of its future load. See Management's Discussion and Analysis of Financial Condition and Results of Operations - Construction for a discussion of future expenditures relating to compliance with the 1990 Clean Air Act Amendments and construction of peaking units. Coal Supply Obligations under Kentucky Utilities' coal purchase contracts are stated at prices effective January 1, 1994 and are subject to changes as defined by the terms of the contracts. Purchased Power Agreements Kentucky Utilities has purchase power arrangements with Owensboro Municipal Utilities (OMU), Electric Energy, Inc. (EEI) and Illinois Power Company (IP). Under the OMU agreement, which expires on January 1, 2020, Kentucky Utilities purchases, on an economic basis, all of the output of a 400-MW generating station not required by OMU. The amount of purchased power available to Kentucky Utilities during 1994- 1998, which is expected to be approximately 8% of Kentucky Utilities' total kWh requirements, is dependent upon a number of factors including the units' availability, maintenance schedules, fuel costs and OMU Notes to Financial Statements Kentucky Utilities Company requirements. Payments are based on the total costs of the station allocated per terms of the OMU agreement, which generally follows delivered kWh. Included in the total costs is Kentucky Utilities' proportionate share of debt service requirements on $30.1 million of OMU bonds outstanding at December 31, 1993. The debt service is allocated to Kentucky Utilities based on its annual allocated share of capacity, which averaged approximately 51% in 1993. In 1995, Kentucky Utilities' total costs will increase to include Kentucky Utilities' proportionate share of debt service requirements on approximately $171.5 million of additional OMU bonds issued to finance capital improvements designed to enable OMU to comply with the 1990 Clean Air Act Amendments. Kentucky Utilities has a 20% equity ownership in EEI, which is accounted for on the equity method of accounting. Through 1993, the equity ownership permitted Kentucky Utilities to share in the output of a 1,000- MW station not needed by EEI. Kentucky Utilities' entitlement beginning January 1, 1994, will be 20% of the available capacity of the station. Payments are based on the total costs of the station allocated per terms of an agreement among the owners, which generally follows delivered kWh. Kentucky Utilities has contracted to purchase 75-MW of capacity from IP for the period of January 1993 through March 1994, and 125-MW of capacity from April 1994 through December 1994. Sinking Fund Requirements and Redemptions Annual sinking fund requirements for Kentucky Utilities' first mortgage bonds may be met with cash or expenditures for bondable property as provided in the Mortgage Indenture. Kentucky Utilities intends to meet the 1994 sinking fund requirements with expenditures for bondable property. Kentucky Utilities redeemed all of the outstanding shares of its 7.84% preferred stock on February 1, 1994, at a total price of $20.3 million. Lines of Credit Kentucky Utilities has aggregate bank lines of credit of $55 million, all of which remained unused at December 31, 1993. These lines of credit may not be withdrawn at the banks' option prior to September 30, 1994. In support of these lines of credit, Kentucky Utilities compensates the banks by paying a commitment fee. Short-Term Borrowings Kentucky Utilities' short-term financing requirements are satisfied through the sale of commercial paper. Beginning November 1993, Kentucky Utilities sold short-term commercial paper at interest rates varying from 3.10 to 3.25 percent. At December 31, 1993, Kentucky Utilities had no short-term commercial paper borrowings outstanding. Notes to Financial Statements Kentucky Utilities Company Long-Term Debt Kentucky Utilities redeemed $30 million of Series M and $25 million of Series L First Mortgage Bonds (including redemption premiums of $1.4 million and $.9 million, respectively) in March and April of 1993, respectively. In June 1993, Kentucky Utilities issued $123.5 million of Series Q First Mortgage Bonds. Proceeds of the issue were used to redeem $25 million of Series H, $30 million of Series I, $35 million of Series J and $30 million of Series N First Mortgage Bonds (plus redemption premiums aggregating $3.3 million) in July 1993. In 1993, Kentucky Utilities entered into a loan agreement with the County of Carroll, Kentucky, to finance the construction of solid waste disposal facilities. The County issued $50 million of the 5 3/4% revenue bonds, with the proceeds held in a construction fund by a trustee. As the construction funds held by the trustee are drawn down, Kentucky Utilities Pollution Control Series 9 Bonds are delivered to the trustee in an amount equal to the amount drawn down. Notes to Financial Statements Kentucky Utilities Company 6. Common Stock Kentucky Utilities is subject to restrictions applicable to all corporations under Kentucky and Virginia law on the use of retained earnings for cash dividends on common stock, as well as those contained in its Mortgage Indenture and Articles of Incorporation. At December 31, 1993, there were no restricted retained earnings. 7. Preferred Stock Kentucky Utilities redeemed all 120,000 shares of its 8.65% preferred stock and 180,000 shares of its 9.96% preferred stock on March 1, 1991, and the remaining 10,000 shares of its 9.96% preferred stock on June 1, 1991 at a total price of $32.7 million. In December 1993, Kentucky Utilities issued 200,000 shares of 6.53% preferred stock. The proceeds were used to redeem 200,000 shares of 7.84% preferred stock on February 1, 1994. As of December 31, 1993, there were 5.3 million shares of Kentucky Utilities preferred stock, having a maximum aggregate stated value of $200 million, authorized for issuance. 8. Financial Instruments The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value: Cash and cash equivalents, escrow funds, construction funds and customers' deposits carrying values approximate fair value because of the short maturity of these amounts. Long-term debt fair values are based on quoted market prices for Kentucky Utilities' first mortgage bonds and on current rates available to Kentucky Utilities for debt of the same remaining maturities for Kentucky Utilities' pollution control bonds and promissory note. Notes to Financial Statements Kentucky Utilities Company Kentucky Utilities has an interest rate swap agreement with a notional amount of $70 million. Fair value of this instrument is the estimated amount the counterparty would pay to Kentucky Utilities to terminate the swap at the date of measurement. If the excess of fair value over carrying value of Kentucky Utilities' long-term debt were settled at amounts approximating those above, the anticipated regulatory treatment would allow recovery of these amounts in rates over a prescribed amortization period. Accordingly, any settlement would not have a significant impact on Kentucky Utilities' financial position or results of operations. In May 1993, the FASB issued Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities". This statement, which must be adopted on January 1, 1994, addresses the accounting and reporting for investments in equity securities that have readily determinable fair values and all investments in debt securities. Kentucky Utilities does not anticipate that the new standard will have a material impact on its financial condition or results of operations. Supplementary Quarterly Financial Information (Unaudited) Kentucky Utilities Company Quarterly financial results for 1993 and 1992 are summarized below. Generally, quarterly results may fluctuate due to seasonal variations, changes in fuel costs and other factors. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant Refer to KU Energy's definitive proxy statement (the "Proxy Statement") filed with the Securities and Exchange Commission in connection with its 1994 Annual Shareholder Meeting under the caption "Election of Directors--General" for the information required by this item pertaining to directors. Such information is incorporated herein by reference and is also filed herewith as Exhibit 99B. Information required by this item relating to executive officers of Kentucky Utilities is set forth under a separate caption in Part I hereof. Item 11.

Item 11. Executive Compensation Refer to KU Energy's Proxy Statement under the caption Election of Directors-- "Directors' Compensation", and -- "Executive Compensation" (but excluding any information contained under the subheadings --"Report of Compensation Committee on Executive Compensation", and --"Performance Graph") for the information required by this item. Such information is incorporated herein by reference and is also filed herewith as Exhibit 99B. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management Refer to KU Energy's Proxy Statement under the caption "Election of Directors--Voting Securities Beneficially Owned by Directors, Nominees and Executive Officers; Other Information" for the information required by this item. Such information is incorporated herein by reference and is also filed herewith as Exhibit 99B. Item 13.

Item 13. Certain Relationships and Related Transactions None. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (A) The following (1) financial statements, (2) schedules, and (3) exhibits, are filed as a part of this Annual Report. (1) Financial Statements Report of Independent Public Accountants, Statements of Income and Retained Earnings for the three years ended December 31, 1993, Statements of Cash Flows for the three years ended December 31, 1993, Balance Sheets as of December 31, 1993 and 1992, Statements of Capitalization as of December 31, 1993 and 1992, and Notes to Financial Statements. (2) Schedules Schedule V Property, plant and equipment. Schedule VI Accumulated depreciation, depletion and amortization of property, plant and equipment. Schedule VIII Valuation and qualifying accounts. Schedule IX Short-term borrowings. Schedule X Supplementary income statement information. The following Schedules are omitted as not applicable or not required under Regulation S-X: I, II, III, IV, VII, XI, XII, XIII, XIV. (3) Exhibits Number Description Page 3.A Amended and Restated Articles of Incorporation of Kentucky Utilities Company. (Exhibits 4.03 and 4.04 to Form 8-K Current Report of Kentucky Utilities Company, dated December 10, 1993). Incorporated by reference. - 3.B By-laws of Kentucky Utilities Company dated December 14, 1992. (Exhibit 3B to Form 10-K Annual Report of Kentucky Utilities Company for the year ended December 31, 1992). Incorporated by reference. - 4.A Indenture of Mortgage or Deed of Trust dated May 1, 1947 between Kentucky Utilities Company and Continental Illinois National Bank and Trust Company of Chicago and Edmond B. Stofft, as Trustees (Amended Exhibit 7(a) in File No. 2-7061), and Supplemental Indentures thereto dated, respectively, January 1, 1949 (Second Amended Exhibit 7.02 in File No. 2- 7802), July 1, 1950 (Amended Exhibit 7.02 in File No. 2-8499), June 15, 1951 (Exhibit 7.02(a) in File No. 2-8499), June 1, 1952 (Amended Exhibit 4.02 in File No. 2-9658), April 1, 1953 (Amended Exhibit 4.02 in File No. 2-10120), April 1, 1955 (Amended Exhibit 4.02 in File No. 2-11476), April 1, 1956 (Amended Exhibit 2.02 in File No. 2-12322), May 1, 1969 (Amended Exhibit 2.02 in File No. 2-32602), April 1, 1970 (Amended Exhibit 2.02 in File No. 2-36410), September 1, 1971 (Amended Exhibit 2.02 in File No. 2-41467), December 1, 1972 (Amended Exhibit 2.02 in File No. 2-46161), April 1, 1974 (Amended Exhibit 2.02 in File No. 2-50344), September 1, 1974 (Exhibit 2.04 in File No. 2-59328), July 1, 1975 (Exhibit 2.05 in File No. 2-59328), May 15, 1976 (Amended Exhibit 2.02 in File No. 2-56126), April 15, 1977 (Exhibit 2.06 in File No. 2-59328), August 1, 1979 (Exhibit 2.04 in File No. 2-64969), May 1, 1980 (Exhibit 2 to Form 10-Q Quarterly Report of Kentucky Utilities for the quarter ended June 30, 1980), September 15, 1982 (Exhibit 4.04 in File No. 2-79891), August 1, 1984 (Exhibit 4B to Form 10-K Annual Report of Kentucky Utilities Company for the year ended December 31, 1984), June 1, 1985 (Exhibit 4 to Form 10-Q Quarterly Report of Kentucky Utilities Company for the quarter ended June 30, 1985), May 1, 1990 (Exhibit 4 to Form 10-Q Quarterly Report of Kentucky Utilities Company for the quarter ended June 30, 1990), May 1, 1991 (Exhibit 4 to Form 10-Q Quarterly Report of Kentucky Utilities Company for the quarter ended June 30, 1991), May 15, 1992 (Exhibit 4.02 to Form 8-K of Number Description Page 4.A Kentucky Utilities Company dated May 14, 1992), (cont.) August 1, 1992 (Exhibit 4 to Form 10-Q Quarterly Report of Kentucky Utilities Company for the quarter ended September 30, 1992), June 15, 1993 (Exhibit 4.02 to Form 8-K of Kentucky Utilities Company dated June 15, 1993) and December 1, 1993 (Exhibit 4.01 to Form 8-K of Kentucky Utilities Company dated December 10, 1993). Incorporated by reference. - 4.B Supplemental Indenture dated March 1, 1992 between Kentucky Utilities and Continental Bank, National Association and M. J. Kruger, as Trustees, providing for the conveyance of properties formerly held by Old Dominion Power Company. (Exhibit 4B to Form 10-K Annual Report of Kentucky Utilities Company for the year ended December 31, 1992). Incorporated by reference. - 10.A Kentucky Utilities' Amended and Restated Performance Share Plan (Exhibit 10A to Form 10-Q Quarterly Report of Kentucky Utilities Company for the quarter ended June 30, 1993). Incorporated by reference. - 10.B Kentucky Utilities' Annual Performance Incentive Plan (Exhibit 10B to Form 10-K Annual Report of Kentucky Utilities Company for the year ended December 31, 1990). Incorporated by reference. - 10.C Amendment No. 1 to Kentucky Utilities' Annual Performance Incentive Plan (Exhibit 10D to Form 10-K Annual Report of Kentucky Utilities Company for the year ended December 31, 1991). Incorporated by reference. - 10.D Kentucky Utilities' Executive Optional Deferred Compensation Plan (Exhibit 10C to Form 10-K Annual Report of Kentucky Utilities Company for the year ended December 31, 1990). Incorporated by reference. - 10.E Amendment No. 1 to Kentucky Utilities' Executive Optional Deferred Compensation Plan (Exhibit 10F to Form 10-K Annual Report of Kentucky Utilities Company for the year ended December 31, 1991). Incorporated by reference. - 10.F Kentucky Utilities' Director Retirement Retainer Program, and Amendment No. 1 (Exhibit 10G to Form 10-K Annual Report of Kentucky Utilities Company for the year ended December 31, 1991). Incorporated by reference. - Number Description Page 10.G Kentucky Utilities' Supplemental Security Plan (Exhibit 10I to Form 10-K Annual Report of Kentucky Utilities Company for the year ended December 31, 1991). Incorporated by reference. - 10.H Amendment No. 2 to Kentucky Utilities' Annual Performance Incentive Plan N/A 10.I Amendment No. 3 to Kentucky Utilities' Annual Performance Incentive Plan N/A 10.J Amendment No. 2 to Kentucky Utilities' Executive Optional Deferred Compensation Plan N/A 10.K Kentucky Utilities' Amended and Restated Director Deferred Compensation Plan N/A 12 Computation of Ratio of Earnings to Fixed Charges N/A 21 List of Subsidiaries N/A 23 Consent of Independent Public Accountants N/A 99.A Description of Common Stock N/A 99.B Director and Executive Officer Information N/A Note - Exhibit numbers 10.A through 10.K are management contracts or compensatory plans or arrangements required to be filed as exhibits to this Form 10-K. The following instruments defining the rights of holders of certain long- term debt of Kentucky Utilities Company have not been filed with the Securities and Exchange Commission but will be furnished to the Commission upon request. 1. Loan Agreement dated as of May 1, 1990 between Kentucky Utili- ties and the County of Mercer, Kentucky, in connection with $12,900,000 County of Mercer, Kentucky, Collateralized Solid Waste Disposal Facility Revenue Bonds (Kentucky Utilities Company Project) 1990 Series A, due May 1, 2010 and May 1, 2020. 2. Loan Agreement dated as of May 1, 1991 between Kentucky Utili- ties and the County of Carroll, Kentucky, in connection with $96,000,000 County of Carroll, Kentucky, Collateralized Pollution Control Revenue Bonds (Kentucky Utilities Company Project) 1992 Series A, due September 15, 2016. 3. Loan Agreement dated as of August 1, 1992 between Kentucky Utilities and the County of Carroll, Kentucky, in connection with $2,400,000 County of Carroll, Kentucky, Collateralized Pollution Control Revenue Bonds (Kentucky Utilities Company Project) 1992 Series C, due February 1, 2018. 4. Loan Agreement dated as of August 1, 1992 between Kentucky Utilities and the County of Muhlenberg, Kentucky, in connection with $7,200,000 County of Muhlenberg, Kentucky, Collateralized Pollution Control Revenue Bonds (Kentucky Utilities Company Project) 1992 Series A, due February 1, 2018. 5. Loan Agreement dated as of August 1, 1992 between Kentucky Utilities and the County of Mercer, Kentucky, in connection with $7,400,000 County of Mercer, Kentucky, Collateralized Pollution Control Revenue Bonds (Kentucky Utilities Company Project) 1992 Series A, due February 1, 2018. 6. Loan Agreement dated as of August 1, 1992 between Kentucky Utilities and the County of Carroll, Kentucky, in connection with $20,930,000 County of Carroll, Kentucky, Collateralized Pollution Control Revenue Bonds (Kentucky Utilities Company Project) 1992 Series B, due February 1, 2018. 7. Loan Agreement dated as of December 1, 1993, between Kentucky Utilities and the County of Carroll, Kentucky, in connection with $50,000,000 County of Carroll, Kentucky, Collateralized Solid Waste Disposal Facilities Revenue Bonds (Kentucky Utilities Company Project) 1993 Series A due December 1, 2023. (B) On December 10, 1993, Kentucky Utilities filed a form 8-K which filed as exhibits the Underwriting Agreement, Amended and Restated Articles of Incorporation, and the Amendment to the Articles of Incorporation establishing a new series of preferred stock. Also filed as an exhibit was a Supplemental Indenture associated with First Mortgage Bonds, Pollution Control Series 9. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on on March 14, 1994. KENTUCKY UTILITIES COMPANY /s/ John T. Newton John T. Newton Chairman and President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities and on the date indicated. Signature Title /s/ John T. Newton John T. Newton Chairman and President (Principal Executive Officer) and Director /s/ Michael R. Whitley Michael R. Whitley Senior Vice-President (Principal Financial Officer) and Director /s/ Michael D. Robinson Michael D. Robinson Controller (Principal Accounting Officer) /s/ Mira S. Ball Mira S. Ball Director /s/ W. B. Bechanan W. B. Bechanan Director /s/ Harry M. Hoe Harry M. Hoe Director /s/ Milton W. Hudson Milton W. Hudson Director /s/ Frank V. Ramsey, Jr. Frank V. Ramsey, Jr. Director /s/ Warren W. Rosenthal Warren W. Rosenthal Director /s/ William L. Rouse, Jr. William L. Rouse, Jr. Director /s/ Charles L. Shearer Charles L. Shearer Director March 14, 1994

40878_1993.txt

40878

1993

Item 1. Business GTE South Incorporated (the Company), was incorporated in Virginia on July 29, 1947. The Company is a wholly-owned subsidiary of GTE Corporation (GTE) and currently provides communications services in the states of Alabama, Illinois, Kentucky, North Carolina, South Carolina and Virginia. Prior to the sale of properties described below, the Company provided communications services in Georgia, Tennessee and West Virginia. On November 1, 1993, the Company in a series of transactions exchanged its telephone plant in service, materials and supplies and customers (representing 244,000 access lines) in the state of Georgia for similar assets (including 38,000 access lines) in ALLTEL Corporation's (ALLTEL) Illinois operations and $446 million in cash. On December 31, 1993, the Company sold its telephone plant in service, materials and supplies and customers (representing 123,000 access lines) in the states of West Virginia and Tennessee to Citizens Utilities Company for $291 million in cash. The Company provides local telephone service within its franchise areas and intraLATA (Local Access Transport Area) long distance service between the Company's facilities and the facilities of other telephone companies within the Company's LATAs. InterLATA service to other points in and out of the states in which the Company operates is provided through connection with interexchange (long distance) common carriers. These common carriers are charged fees (access charges) for interconnection to the Company's local facilities. End user business and residential customers are also charged access charges for access to the facilities of the long distance carriers. The Company also earns other revenues by leasing interexchange plant facilities and providing such services as billing and collection and operator services to interexchange carriers, primarily the American Telephone and Telegraph Company (AT&T). The number of access lines served was 1,051,872 on January 1, 1989 and 968,951 December 31, 1993. The following table denotes the access lines in the states in which the Company operates as of December 31, 1993: Access State Lines Served --------------- ------------ Kentucky 384,450 North Carolina 214,211 South Carolina 155,686 Alabama 143,542 Illinois 38,214 Virginia 32,848 ------------ Total 968,951 ============ The Company's principal line of business is providing telecommunication services. These services fall into five major classes: local network, network access, long distance, equipment sales and services and other. Revenues from each of these classes over the last three years are as follows: Years Ended December 31 --------------------------------------- 1993 1992 1991 -------- -------- --------- (Thousands of Dollars) Local Network Services $ 379,533 $ 371,535 $ 359,419 % of Total Revenues 40% 38% 37% Network Access Services $ 395,480 $ 412,604 $ 340,539 % of Total Revenues 41% 42% 36% Long Distance Services $ 28,783 $ 47,947 $ 138,249 % of Total Revenues 3% 5% 14% Equipment Sales and Services $ 75,141 $ 79,431 $ 79,857 % of Total Revenues 8% 8% 8% Other $ 74,360 $ 63,451 $ 45,359 % of Total Revenues 8% 7% 5% At December 31, 1993, the Company had 4,729 employees. The Company has written agreements with the Communications Workers of America (CWA) and International Brotherhood of Electrical Workers (IBEW) covering approximately 3,200 of the Company's employees. In 1993, agreements were reached on four contracts with the CWA and two contracts with the IBEW. During 1994, three contracts with CWA and two contracts with IBEW will expire. Telephone Competition The Company holds franchises, licenses and permits adequate for the conduct of its business in the territories which it serves. The Company is subject to regulation by the regulatory bodies of the states of Alabama, Illinois, Kentucky, North Carolina, South Carolina and Virginia as to its current intrastate business operations and by the Federal Communications Commission (FCC) as to its interstate business operations. Prior to the sale of properties described above, the state regulatory commissions in Georgia, Tennessee and West Virginia also regulated the Company's intrastate operations. Information regarding the Company's activities with the various regulatory agencies and revenue arrangements with other telephone companies can be found in Note 11 of the Company's Annual Report to Shareholders for the year ended December 31, 1993, incorporated herein and filed as Exhibit 13. The year was marked by important changes in the U.S. telecommunications industry. Rapid advances in technology, together with government and industry initiatives to eliminate certain legal and regulatory barriers are accelerating and expanding the level of competition and opportunities available to the Company. As a result, the Company faces increasing competition in virtually all aspects of its business. Specialized communications companies have constructed new systems in certain markets to bypass the local-exchange network. Additional competition from interexchange carriers as well as wireless companies continues to evolve for both intrastate and interstate communications. During 1994, the Company will begin implementation of a re-engineering plan that will redesign and streamline processes. Implementation of its re-engineering plan will allow the Company to continue to respond aggressively to these competitive and regulatory developments through reduced costs, improved service quality, competitive prices and new product offerings. Moreover, implementation of this program will position the Company to accelerate delivery of a full array of voice, video and data services. The re-engineering program will be implemented over three years. During the year, the Company continued to introduce new business and consumer services utilizing advanced technology, offering new features and pricing options while at the same time reducing costs and prices. During 1993, the FCC announced its decision to auction licenses during 1994 in 51 major markets and 492 basic trading areas across the United States to encourage the development of a new generation of wireless personal communications services (PCS). These services will both complement and compete with the Company's traditional wireline services. The Company will be permitted to fully participate in the license auctions in areas outside of GTE's existing cellular service areas. Limited participation will be permitted in areas in which GTE has an existing cellular presence. In 1992, the FCC issued a "video dialtone" ruling that allows telephone companies to transmit video signals over their networks. The FCC also recommended that Congress amend the Cable Act of 1984 to permit telephone companies to supply video programming in their service areas. Activity directed toward changing the traditional cost-based rate of return regulatory framework for intrastate and interstate telephone services has continued. Various forms of alternative regulation have been adopted, which provide economic incentives to telephone service providers to improve productivity and provide the foundation for the pricing flexibility necessary to address competitive entry into the markets the Company serves. The GTE Consent Decree, which was issued in connection with the 1983 acquisition of GTE Sprint (since divested) and GTE Spacenet, prohibits GTE's domestic telephone operating subsidiaries from providing long distance service beyond the boundaries of the LATA. This prohibition restricts their direct provision of long distance service to relatively short distances. The degree of competition allowed in the intraLATA market is subject to state regulation. However, regulatory constraints on intraLATA competition are gradually being relaxed. In fact, some form of intraLATA competition is authorized in many of the states in which the Company provides service. In September 1993, the FCC released an order allowing competing carriers to interconnect to the local-exchange network for the purpose of providing switched access transport services. This ruling complements similar interconnect arrangements for private line services ordered during 1992. The order encourages competition for the transport of telecommunications traffic between local exchange carriers' (LECs) switching offices and interexchange carrier locations. In addition, the order allows LECs flexibility in pricing competitive services. These and other actions to eliminate the existing legal and regulatory barriers, together with rapid advances in technology, are facilitating a convergence of the computer, media and telecommunications industries. In addition to allowing new forms of competition, these developments are also creating new opportunities to develop interactive communications networks. The Company supports these initiatives to assure greater competition in telecommunications, provided that overall the changes allow an opportunity for all service providers to participate equally in a competitive marketplace under comparable conditions. Item 2.

Item 2. Properties The Company's property consists of network facilities (79%), company facilities (13%), customer premises equipment (1%) and other (7%). From January 1, 1989 to December 31, 1993, the Company made gross property additions of $1.2 billion and property retirements of $1.5 billion. Substantially all of the Company's property is subject to liens securing long-term debt. In the opinion of management, the Company's telephone plant is substantially in good repair. Item 3.

Item 3. Legal Proceedings There are no pending legal proceedings, either for or against the Company, which would have a material impact on the Company's financial statements. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders None. PART II Item 5.

Item 5. Market for the Registrant's Common Equity and Related Shareholder Matters Market information is omitted since the Company's common stock is wholly-owned by GTE Corporation. Item 6.

Item 6. Selected Financial Data Reference is made to the Registrant's Annual Report to Shareholders, page 32, for the year ended December 31, 1993, incorporated herein and filed as Exhibit 13. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Reference is made to the Registrant's Annual Report to Shareholders, pages 27 to 31, for the year ended December 31, 1993, incorporated herein and filed as Exhibit 13. Item 8.

Item 8. Financial Statements and Supplementary Data Reference is made to the Registrant's Annual Report to Shareholders, pages 5 to 25, for the year ended December 31, 1993, incorporated herein and filed as Exhibit 13. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant The names, ages and positions of all the directors and executive officers of the Company as of March 7, 1994 are listed below along with their business experience during the past five years. a. Identification of Directors Director Name Age Since Business Experience - -------------- --- --------- ------------------------------------------- Earl A. Goode 53 1994 President, GTE South Incorporated and GTE North Incorporated; various positions with GTE including President - GTE Southwest and Vice President - General Manager/Wisconsin; Director, Legacy Fund; Director, COMMIT; Executive Committee, GTE North Classic; Director, Indiana State Symphony Society; Director, INB Financial Corporation; Director, United Way of Central Indiana; Director, Goodwill Industries of Central Indiana; Director, Indianapolis Chamber of Commerce; President's Advisory Council of Purdue University; Dean's Advisory Council for the Purdue University Krannert School of Management. Kent B. Foster 50 1994 Vice Chairman of the Board of Directors of GTE Corporation, October 1993. President, GTE Telephone Operations, 1989; Director, GTE Corporation, 1992; Director, all GTE domestic telephone subsidiaries, 1993; Director, BC Telecom, Inc.; Director, Compania Anonima Nacional Telefonos de Venezuela; Director, National Bank of Texas. Richard M. Cahill 55 1994 Vice President - General Counsel of GTE Telephone Operations, 1988; Director, all GTE domestic telephone subsidiaries, 1993; Director, GTE Vantage Incorporated, 1991; Director, GTE Intelligent Network Services Incorporated, 1993. Gerald K. Dinsmore 44 1992 Senior Vice President - Finance and Planning for GTE Telephone Operations, 1994. Vice President - Finance, GTE Telephone Operations, 1993; Vice President - Intermediary Customer Markets, GTE Telephone Operations, 1991. President, South Area, GTE Telephone Operations, 1992; Director, all GTE domestic telephone subsidiaries, 1993. Michael B. Esstman 47 1994 Executive Vice President-Operations, GTE Telephone Operations, 1993; President, Central Area, GTE Telephone Operations, 1991. President, Contel Eastern Region, Telephone Operations Sector, 1983; Director, AG Communications System; Director, all GTE domestic telephone subsidiaries, 1993. Thomas W. White 47 1994 Executive Vice President of GTE Telephone Operations, 1993; Senior Vice President - General Office Staff, GTE Telephone Operations, 1989; Director, all GTE domestic telephone subsidiaries, 1993; Director, Quebec-Telephone. Directors are elected annually. The term of each director expires on the date of the next annual meeting of shareholders, which may be held on any day during May, as specified in the notice of the meeting. There are no family relationships between any of the directors or executive officers of the Company. All of the directors, with the exception of Mr. Dinsmore, were elected January 1, 1994, following the resignations from the Board of John L. Atkins, III, Archie S. Dargan, K.v.R. Dey, Jr., Durward R. Everett, Jr., Robert H. Hillenmeyer, John Hopkins, Mary W. Walker, Richard W. Wilkinson and John W. Woods, III. b. Identification of Executive Officers Year Assumed Current Name Age Position Position with Company - ----------------- --- ------------ ------------------------------- Earl A. Goode (1) 53 1994 President James D. Blanchard (1) 53 1994 Region Vice President - General Manager-North (Illinois, Wisconsin) Clare D. Coxey (1) 55 1994 Area Vice President - Public Affairs Margaret B. Haight (1) 45 1994 State Vice President - General Manager - Kentucky James T. Jeske (1) 48 1994 Area Vice President - Human Resources M. L. Keith, Jr. (1) 51 1994 Area Vice President - Sales C. Sumpter Logan (2) 56 1994 Region Vice President - General Manager - South (Alabama, Kentucky, North Carolina, South Carolina) Jeffrey L. Schmitt (1) 48 1994 Area Vice President - Regulatory and Government Affairs Dale E. Sporleder (1) 53 1994 Area Vice President - General Counsel Roger L. Utzinger (1) 47 1994 Area Vice President - Finance Edward J. Weise (3) 49 1994 Region Vice President - General Manager - South (Virginia) William D. Wilson (1) 46 1994 Area Vice President - General Manager - East Charles J. Somes (1) 48 1994 Secretary Position with GTE Telephone Operations (4) ------------------------------ Kent B. Foster 50 1989 President Michael B. Esstman (5) 47 1993 Executive Vice President - Operations Thomas W. White 47 1989 Executive Vice President Guillermo Amore 55 1990 Senior Vice President - International Gerald K. Dinsmore (6) 44 1993 Senior Vice President - Finance and Planning Robert C. Calafell (7) 52 1993 Vice President - Video Services A. T. Jones 54 1992 Vice President - International Brad M. Krall (8) 52 1993 Vice President - Centralized Services Donald A. Hayes 56 1992 Vice President - Information Technology Richard L. Schaulin 51 1989 Vice President - Human Resources Clarence F. Bercher 50 1991 Vice President - Sales Mark S. Feighner 45 1991 Vice President - Product Management Geoff C. Gould 41 1989 Vice President - Regulatory and Governmental Affairs G. Bruce Redditt 43 1991 Vice President - Public Affairs Richard M. Cahill 55 1989 Vice President and General Counsel Leland W. Schmidt 60 1989 Vice President - Industry Affairs Paul E. Miner 49 1990 Vice President - Regional Operations Support Katherine J. Harless 43 1992 Vice President - Intermediary Markets William M. Edwards, III (9) 45 1993 Controller Each of these executive officers has been an employee of the Company or an affiliated company for the last five years. Except for duly elected officers and directors, no other employees had a significant role in decision making. All officers are appointed for a term of one year. - ----------- NOTES: (1) Effective March 7, 1994 the following individuals became executive officers for both GTE South Incorporated and GTE North Incorporated: Earl A. Goode was appointed President replacing Gerald K. Dinsmore who was appointed Senior Vice President - Finance and Planning for GTE Telephone Operations. James D. Blanchard was appointed Region Vice President - General Manager - North (Illinois, Wisconsin). Clare D. Coxey was appointed Area Vice President - Public Affairs replacing Jorge Jackson who was appointed Area Vice President - Public Affairs - West. James T. Jeske was appointed Area Vice President - Human Resources replacing Margaret B. Haight who was appointed State Vice President - General Manager - Kentucky. M. L. Keith, Jr. was appointed Area Vice President - Sales replacing James D. Bennett who was appointed State Vice President - Sales for GTE Florida Incorporated. Jeffrey L. Schmitt was appointed Area Vice President - Regulatory and Government Affairs replacing Bruce M. Holmberg who retired. Dale E. Sporleder was appointed Area Vice President - General Counsel replacing James V. Carideo who retired. Roger L. Utzinger was appointed Area Vice President - Finance replacing Fassil Gabremariam who was appointed State Vice President - Finance for GTE Florida Incorporated. William D. Wilson, previously Vice President - Business Planning for GTE Telephone Operations, was appointed Area Vice President - General Manager - East replacing Stephen A. Inkrott who was appointed Assistant Vice President - Network Planning for GTE Telephone Operations. Charles J. Somes was appointed Secretary replacing Jerry L. Austin who retired. Charles C. Merritt previously Regional Vice President - General Manager/Southeast was appointed General Manager - North Carolina/South Carolina. (2) C. Sumpter Logan, previously Regional Vice President - General Manager/North, was appointed Region Vice President General Manager - South (Alabama, Kentucky, North Carolina, South Carolina) effective March 7, 1994. (3) Edward J. Weise, previously Regional Vice President - General Manager/Virginia, was appointed Region Vice President - General Manager - South (Virginia) effective March 7, 1994. (4) Position is with, and duties are performed at, the GTE Telephone Operations Headquarters in Irving, Texas. (5) Michael B. Esstman was appointed Executive Vice President - Operations effective April 25, 1993 replacing Charles A. Crain who retired on April 1, 1993. (6) Gerald K. Dinsmore, previously South Area President, was appointed Senior Vice President - Finance and Planning replacing John L. Hume who retired. (7) Robert C. Calafell was appointed Vice President - Video Services effective March 28, 1993. (8) Brad M. Krall was appointed Vice President - Centralized Services effective November 7, 1993. (9) William M. Edwards, III, was appointed Controller effective November 21, 1993 replacing John D. Utzinger. William E. Starkey retired November 21, 1993, George N. King retired May 21, 1993 and Clark W. Barlow retired August 21, 1993. Item 11.

Item 11. Executive Compensation Executive Compensation Tables The following tables provide information about executive compensation. Long-Term Incentive Plan - Awards in Last Fiscal Year The GTE Long-Term Incentive Plan (LTIP) provides for awards, currently in the form of stock options with tandem stock appreciation rights and cash bonuses, to participating employees. The stock options and stock appreciation rights awarded under the LTIP to the five most highly compensated individuals in 1993 are shown in the table on page 11. Under the LTIP, performance bonuses are paid in cash based on the achievement of pre-established goals for GTE's return on equity (ROE) over a three-year award cycle. Performance bonuses are denominated in units of GTE Common Stock ("Common Stock Units") and are maintained in a Common Stock Unit Account. At the time performance targets are established for the three-year cycle, a Common Stock Unit Account is set up for each participant who is eligible to receive a cash award under the LTIP. An initial dollar amount for each account is determined based on the competitive performance bonus grant practices of other major companies in the telecommunications industry and with other selected corporations that are comparable to GTE in terms of revenue, market value and other quantitative measures. That amount is then divided by the average market price of GTE Common Stock for the calendar week preceding the day the account is established to determine the number of Common Stock Units in the account. The value of the account increases or decreases based on the market price of the GTE Common Stock. An amount equal to the dividends declared on an equivalent number of shares of GTE Common Stock is added each time a dividend is paid. This amount is then converted into the number of Common Stock Units obtained by dividing the amount of the dividend by the average price of the GTE Common Stock on the composite tape of the New York Stock Exchange on the dividend payment date and added to the Common Stock Unit Account. Messrs. Dinsmore and Foster are the only individuals of the five most highly compensated individuals eligible to receive a cash award under the LTIP. The number of Common Stock Units initially allocated in 1993 to their accounts and estimated future payouts under the LTIP are shown in the following table. Executive Agreements GTE has entered into agreements (the Agreements) with Messrs. Dinsmore and Foster regarding benefits to be paid in the event of a change in control of GTE (a "Change in Control"). A Change in Control is deemed to have occurred if a majority of the members of the Board do not consist of members of the incumbent Board (as defined in the Agreements) or if, in any 12-month period, three or more directors are elected without the approval of the incumbent Board. An individual whose initial assumption of office occurred pursuant to an agreement to avoid or settle a proxy or other election contest is not considered a member of the incumbent Board. In addition, a director who is elected pursuant to such a settlement agreement will not be deemed a director who is elected or nominated by the incumbent Board for purposes of determining whether a Change in Control has occurred. A Change in Control will not occur in the following situations: (1) certain merger transactions in which there is at least 50% GTE shareholder continuity in the surviving corporation, at least a majority of the members of the board of directors of the surviving corporation consists of members of the Board of GTE and no person owns more than 20% (or under certain circumstances, a lower percentage, not less than 10%) of the voting power of the surviving corporation following the transaction, and (2) transactions in which GTE's securities are acquired directly from GTE. The Agreements provide for benefits to be paid in the event this individual separates from service and has a "good reason" for leaving or is terminated without "cause" within two years after a Change in Control of GTE. Good reason for leaving includes but is not limited to the following events: demotion, relocation or a reduction in total compensation or benefits, or the new entity's failure to expressly assume obligations under the Agreements. Termination for cause includes certain unlawful acts on the part of the executive or a material violation of his or her responsibilities to the Corporation resulting in material injury to the Corporation. An executive who experiences a qualifying separation from service will be entitled to receive up to two times the sum of (i) base salary and (ii) the average of his or her other percentage awards under the EIP for the previous three years. The executive will also continue to receive medical and life insurance coverage for up to two years and will be provided with financial and outplacement counseling. In addition, the Agreements with Messrs. Dinsmore and Foster provide that in the event of a separation from service, they will receive service credit in the following amounts: two times years of service otherwise credited if the executive has five or fewer years of credited service; 10 years if credited service is more than five and not more than 10 years; and, if the executive's credited service exceeds 10 years, the actual number of credited years of service. These additional years of service will apply towards vesting, retirement eligibility, benefit accrual and all other purposes under the Supplemental Executive Retirement Plan and the Executive Retired Life Insurance Plan. In addition, each executive will be considered to have not less than 76 points and 15 years of accredited service for the purpose of determining his or her eligibility for early retirement benefits. However, there will be no duplication of benefits. The Agreements remain in effect until the earlier of July 1 of each successive year or the date on which the executive reaches age 65, unless the Agreement is terminated earlier pursuant to its terms. The Agreements will be automatically renewed on each successive July 1 unless, not later than December 31 of the preceding year, one of the parties notifies the other that he does not wish to extend the Agreement. If a Change in Control occurs, the Agreements will remain in effect until the obligations of GTE (or its successor) under the Agreements have been satisfied. Retirement Programs Pension Plans The estimated annual benefits payable, calculated on a single life annuity basis, under GTE's defined benefit pension plans at normal retirement at age 65, based upon final average earnings and years of employment, are illustrated in the table below: PENSION PLAN TABLE Years of Service Final Average ------------------------------------------------------------ Earnings 15 20 25 30 35 - ----------------------------------------------------------------------------- $ 150,000 $ 31,604 $ 42,138 $ 52,672 $ 63,207 $ 73,742 200,000 42,479 56,638 70,797 84,957 99,117 300,000 64,229 85,638 107,048 128,457 149,867 400,000 85,979 114,638 143,298 172,957 200,617 500,000 107,729 143,638 179,548 215,457 251,367 600,000 129,479 172,638 215,798 258,957 302,117 700,000 151,229 201,638 252,048 302,457 352,867 800,000 172,979 230,638 288,298 345,957 403,617 900,000 194,729 259,638 324,548 389,457 454,367 1,000,000 216,479 288,638 360,798 432,957 505,117 1,200,000 259,979 346,638 433,298 519,957 606,617 GTE Service Corporation, a wholly-owned subsidiary of GTE, maintains a noncontributory pension plan for the benefit of GTE employees based on years of service. Pension benefits to be paid from this plan and contributions to this plan are related to basic salary exclusive of overtime, differentials, incentive compensation (except as otherwise described) and other similar types of payment. Under this plan, pensions are computed on a two-rate formula basis of 1.15% and 1.45% for each year of service, with the 1.15% service credit being applied to that portion of the average annual salary for the five highest consecutive years that does not exceed the Social Security Integration Level (the portion of salary subject to the Federal Security Act), and the 1.45% service credit being applied to that portion of the average annual salary that exceeds said level. As of March 7, 1993, the credited years of service under the plan for Messrs. Dinsmore, Logan, Merritt, Inkrott and Foster are 18, 33, 30, 28 and 23, respectively. Under Federal law, an employee's benefits under a qualified pension plan such as the GTE Service Corporation plan are limited to certain maximum amounts. GTE maintains a Supplemental Executive Retirement Plan (SERP), which supplements the benefits of any participant in the qualified pension plan by direct payment of a lump sum or by an annuity, on an unfunded basis, of the amount by which any participant's benefits under the GTE Service Corporation pension plan are limited by law. In addition, the SERP includes a provision permitting the payment of additional retirement benefits determined in a similar manner as under the qualified pension plan on remuneration accrued under management incentive plans as determined by the Executive Compensation and Organizational Structure Committee. Executive Retired Life Insurance Plan The Executive Retired Life Insurance Plan (ERLIP) provides Messrs. Dinsmore, Logan, Merritt, Inkrott and Foster a maximum postretirement life insurance benefit of three times final base salary. Upon retirement, ERLIP benefits may be paid as life insurance or optionally, an equivalent amount may be paid as a lump sum payment equal to the present value of the life insurance amount (based on actuarial factors and the interest rate then in effect), as an annuity or as installment payments. If an optional payment method is selected, the ERLIP benefit will be based on the actuarial equivalent of the present value of the insurance amount. Directors' Compensation The current directors, all of whom are employees of GTE, are not paid any fees or renumeration, as such, for services on the Board. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management (a) Security Ownership of Certain Beneficial Owners as of February 28, 1994: Name and Shares of Title Address of Beneficial Percent of Class Beneficial Owner Ownership of Class --------------- ------------------ ----------- -------- Common Stock of GTE Corporation 18,936,000 100% GTE South One Stamford Forum shares of Incorporated Stamford, record Connecticut 06904 (b) Security Ownership of Management as of December 31, 1993: Common Stock of Name of Director or Nominee No director GTE Corporation Kent B. Foster 168,299 or nominee or Thomas W. White 83,071 executive Michael B. Esstman 54,051 officer owns Gerald K. Dinsmore 18,503 as much as Richard M. Cahill 37,188 1/10 of ------- 1 percent 361,112 ======= Executive Officers(1)(2) Gerald K. Dinsmore 18,503 C. Sumpter Logan 33,072 Charles C. Merritt 8,032 Stephen A. Inkrott 21,102 Kent B. Foster 168,299 ------- 249,008 ======= All directors and executive Represents officers as a group(1)(2) 782,371 less than 1/10 ======= of 1 percent of outstanding common stock. - ---------- (1) Includes shares acquired through participation in GTE's Consolidated Employee Stock Ownership Plan and/or the GTE Savings Plan. (2) Included in the number of shares beneficially owned by Messrs. Dinsmore, Logan, Merritt, Inkrott and Foster and all directors and executive officers as a group are 16,798; 15,966; 7,300; 13,232; 115,583; and 528,655 shares, respectively, which such persons have the right to acquire within 60 days pursuant to stock options. (c) There were no changes in control of the Company during 1993. Item 13.

Item 13. Certain Relationships and Related Transactions The Company`s executive officers or directors were not materially indebted to the Company or involved in any material transaction in which they had a direct or indirect material interest. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a)(1) Financial Statements - Reference is made to the Registrant's Annual Report to Shareholders, pages 5 - 25 for the year ended December 31, 1993, incorporated herein and filed as Exhibit 13. Report of Independent Public Accountants. Balance Sheets - December 31, 1993 and 1992. Statements of Income for the years ended December 31, 1993-1991. Statements of Reinvested Earnings for the years ended December 31, 1993-1991. Statements of Cash Flows for the years ended December 31, 1993-1991. Notes to Financial Statements. (2) Financial Statement Schedules - Included in Part IV of this report for the years ended December 31, 1993-1991: Page(s) ------- Report of Independent Public Accountants 21 Schedules: V - Property, Plant and Equipment 22-24 VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment 25 VIII - Valuation and Qualifying Accounts 26 X - Supplementary Income Statement Information 27 Note: Schedules other than those listed above are omitted as not applicable, not required, or the information is included in the financial statements or notes thereto. (3) Exhibits - Included in this report or incorporated by reference. 3-1* Restated Articles of Incorporation dated August 24, 1990.(Exhibit 3-1 of the 1989 Form 10-K, File No. 2-36292). 3-2* Amended By-Laws, effective January 1, 1988, File No. 2-36292. 4-1* Indenture of Mortgage and Deed of Trust dated November 1, 1947, as supplemented by the Thirty-First Supplemental Indenture dated September 15, 1989, File No. 33-17141 and the Thirty-Second Supplemental Indenture dated June 15, 1990, File No. 33-35027. 4-2* Indenture dated as of October 1, 1992 between GTE South Incorporated and Chemical Bank Trustee as supplemented by the First Supplemental Indenture dated as of November 15, 1992, File No. 33-53348. 10* Salary Continuation Arrangements in the Event of a Change in Control, File No. 2-36292. 13 Annual Report to Shareholders for the year ended December 31, 1993, filed herein as Exhibit 13. (b) Reports on Form 8-K - No reports on Form 8-K were filed during the fourth quarter of 1993. * Denotes exhibits incorporated herein by reference to previous filings with the Securities and Exchange Commission as designated. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To GTE South Incorporated: We have audited in accordance with generally accepted auditing standards, the financial statements included in GTE South Incorporated's annual report to shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated January 28, 1994. Our report on the financial statements includes an explanatory paragraph with respect to the change in the method of accounting for income taxes in 1992 as discussed in Note 1 to the financial statements. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed under Item 14 are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Dallas, Texas January 28, 1994. GTE SOUTH INCORPORATED SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) - ---------------------------------------------------------------------------- Column A Column B - ------------------ ---------------------------------------- Item Charged to Operating Expenses - ---------------------------------------------------------------------------- 1993 1992 1991 ---------- ---------- ---------- Maintenance and repairs $ 149,645 $ 145,448 $ 160,163 ========== ========== ========== Taxes, other than payroll and income, are as follows: Real and personal property $ 24,353 $ 23,879 $ 22,870 State gross receipts 4,425 4,240 3,691 Other 3,969 4,167 4,265 Portion of above taxes charged to plant and other accounts (2,977) (3,258) (2,901) ---------- ---------- ---------- Total $ 29,770 $ 29,028 $ 27,925 ========== ========== ========== SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. GTE SOUTH INCORPORATED ----------------------------- (Registrant) Date March 21, 1994 By EARL A. GOODE --------------------- -------------------------- EARL A. GOODE President Pursuant to the requirements of the Securities Exchange Act of 1934, this report is signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. EARL A. GOODE President and Director March 21, 1994 - ------------------------ (Principal Executive Officer) EARL A. GOODE GERALD K. DINSMORE Senior Vice President - Finance March 21, 1994 - ------------------------ and Planning and Director GERALD K. DINSMORE (Principal Financial Officer) WILLIAM M. EDWARDS, III Controller March 21, 1994 - ------------------------ (Principal Accounting Officer) WILLIAM M. EDWARDS, III RICHARD M. CAHILL Director March 21, 1994 - ------------------------ RICHARD M. CAHILL MICHAEL B. ESSTMAN Director March 21, 1994 - ------------------------ MICHAEL B. ESSTMAN KENT B. FOSTER Director March 21, 1994 - ------------------------ KENT B. FOSTER THOMAS W. WHITE Director March 21, 1994 - ------------------------ THOMAS W. WHITE

53540_1993.txt

53540

1993

ITEM 1. Business Registrant is not engaged in any business operations and has not been so engaged since 1968. ITEM 2.

ITEM 2. Properties Registrant does not have an interest in any properties. ITEM 3.

ITEM 3. Legal Proceedings None. PART II. ITEM 5.

ITEM 5. Market for the Registrant's Common Stock and Related Security Holder Matters Increase and Decrease in Outstanding Securities Indebtedness None. Changes in Securities and Changes in Securities for Registered Securities None. Defaults Upon Senior Securities None. Approximate Number of Equity Security Holders - 2 - Number of Record Holders Title of Class As of July 31, 1993 -------------- --------------------- Common Stock 785 Submission of Matters to a Vote of Security Holders Not applicable. ITEM 6.

ITEM 6. Selected Financial Data Five Year Summary of Operations Year ended July 31, --------------------------------- The numerical note referred to above is included in the Notes to Financial Statements. Registrant has not conducted any business operations during its last five (5) fiscal years, except that during the above fiscal years it has incurred expenses necessary to keep its good standing in its state of residence. ITEM 7.

ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Refer to notes and financial statements. ITEM 8.

ITEM 8. Financial Statements and Supplementary Data The financial statements of Registrant are attached hereto as Exhibit 14(a). - 3 - PART III. ITEM 10.

ITEM 10. Directors and Executive Officers of the Registrant ITEM 11.

ITEM 11. Management Remuneration and Transaction No officer or director of Registrant receives any remuneration. ITEM 12.

ITEM 12. Security Ownership of Certain Beneficial Owners and Management Leonard M. Ross owns 400,955 shares of the issued and outstanding stock of Registrant which constitutes approximately 89% of such stock. Registrant does not have any subsidiaries. Indemnification of Directors and Officers The by-laws of the Corporation provide that the Corporation shall indemnify each of its officers and directors, whether or not then in office, to the extent permitted by the California General Corporation Law against all reasonable expenses actually and necessarily incurred by such individuals in connection with the defense of any litigation to which he or she may have been made a party because he or she is or was a director or officer of the Corporation. Directors and officers have no right to reimbursement in relation to any matter in which such officer or director has been adjudged liable to the Corporation for gross negligence or comparable misconduct in the performance of his or her duties. PART IV - 4 - ITEM 14.

ITEM 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) The Registrant's financial statements are attached hereto. (b) No materially important events occurred during the fiscal year of Registrant that would require filing of Form 8-K. (c) The Exhibits listed in the accompanying Exhibit Index on Page 12 are filed as part of this Form 10-K. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duty authorized. (Registrant) JILCO INDUSTRIES, INC. By: /s/ MARTHA J. KRETZMER ------------------------ Martha J. Kretzmer President Date: August 7, 1997 - 5 - JILCO INDUSTRIES, INC. List of Financial Statements The following financial statements of Jilco Industries, Inc. are included in Item 8: Balance sheets -- Years ended July 31, 1993 and 1992. Statements of operations -- Years ended July 31, 1993, 1992, and 1991. Statements of cash flows -- Years ended July 31, 1993, 1992, and 1991. Notes to financial statements -- July 31, 1993. - 6 - JILCO INDUSTRIES, INC. BALANCE SHEETS AS OF JULY 31, (UNAUDITED) ASSETS The accompanying notes are an integral part of these financial statements. - 7 - JILCO INDUSTRIES, INC. STATEMENTS OF OPERATIONS AND ACCUMULATED DEFICIT FOR THE YEARS ENDED JULY 31, (UNAUDITED) The accompanying notes are an integral part of these financial statements. - 8 - JILCO INDUSTRIES, INC. STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED JULY 31, The accompanying notes are an integral part of these financial statements. - 9 - NOTE 1 - THE COMPANY The Company has been inactive since April 2, 1968 when it was discharged from bankruptcy under its previous name of Sportways, Inc. The expenses the Company has incurred represent those necessary to keep the Company in good standing in its state of residence. Fair Value of Financial Instruments The Company measures its financial assets and liabilities in accordance with generally accepted accounting principles. For certain of the Company's financial instruments, including cash, accounts payable, and accrued expenses, the carrying amounts approximate fair value due to their short maturities. The amounts shown as notes payable also approximate fair value because current interest rates offered to the Company for notes payable of similar maturities are substantially the same. Estimates In preparing financial statements in conformity with generally accepted accounting principles, management makes estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements, as well as the reported amounts of expenses during the reporting period. Actual results could differ from those estimates. NOTE 2 - LOSS PER SHARE All per share computations are based on 449,991 shares outstanding. There are no common stock equivalents. - 10 - NOTE 3 - NOTES PAYABLE TO SHAREHOLDER Notes payable to shareholder consist of the following: (A) Accrued interest at 9% per annum. Principal and accrued interest due on demand. (B) Accrued interest at 11% per annum. Principal and accrued interest due on demand. (C) Accrued interest at 10% per annum. Principal and accrued interest due on demand. - 11 - EXHIBIT INDEX - 12 -

800287_1993.txt

800287

1993

ITEM 1. BUSINESS. GENERAL Chemical Waste Management, Inc. ("CWM") and its subsidiaries (hereinafter collectively referred to as the "Company" unless the context indicates otherwise) are leading providers of hazardous waste management services and various other environmental and industrial services. The Company furnishes chemical waste management services, including transportation, treatment, resource recovery and disposal, to commercial and industrial customers, as well as to other waste management companies and to governmental entities. The Company also furnishes radioactive waste management services, primarily to electric utilities and governmental entities. Through Rust International Inc. ("Rust"), an approximately 56%-owned subsidiary, the Company also furnishes engineering, construction, environmental and infrastructure consulting, hazardous substance remediation and other on-site industrial and related services, primarily to clients in government and in the chemical, petrochemical, nuclear, energy, utility, pulp and paper, manufacturing, environmental services and other industries. On December 31, 1992, CWM entered into an agreement with The Brand Companies, Inc. ("Brand") and Wheelabrator Technologies Inc. ("WTI"), an approximately 55% owned subsidiary of WMX Technologies, Inc. ("WMX"), pursuant to which CWM and WTI agreed to organize Rust and to acquire newly issued shares of Rust in exchange for contributing certain businesses and assets to Rust. Under that agreement, CWM contributed primarily its hazardous substance remediation services business, its approximately 56% ownership interest in Brand and its 12% ownership interest in Waste Management International plc ("WM International"). WTI contributed to Rust primarily its engineering and construction and environmental and infrastructure consulting services businesses and its international engineering unit based in London. On May 7, 1993, Brand was merged into a subsidiary of Rust, and shares of Brand (other than those owned by Rust) were converted, on a one-for-one basis, into shares of Rust, or, for those Brand stockholders so electing, the right to receive $18.75 per Brand share in cash. Rust is currently owned approximately 56% by CWM, 40% by WTI and 4% by public stockholders. The Company participates internationally in the waste management services industry through its equity interest in WM International, a company owned 12% by Rust, 12% by WTI, 56% by WMX and 20% by public stockholders. WM International provides a wide range of solid and hazardous waste management services (or has interests in projects or companies providing such services) in various countries in Europe and in Argentina, Australia, Brunei, Hong Kong, Indonesia, Malaysia and New Zealand. Through the end of 1992, the Company categorized its operations in two industry segments: hazardous waste management and related services and specialty contracting services. Beginning in 1993, to reflect the Company's acquisition of a majority interest in Rust, the Company has categorized the latter segment (which is composed of all of its non-core businesses) as engineering, construction, industrial and related services. For information relating to revenues, expenses and identifiable assets attributable to the Company's different industry segments, see Note 16 to the Company's Consolidated Financial Statements filed as an exhibit to this report and incorporated herein by reference. Regulatory or technological developments relating to the environment may require companies engaged in environmental services businesses, including the Company, to modify, supplement or replace equipment and facilities at costs which may be substantial. Because certain of the businesses in which the Company is engaged are intrinsically connected with the protection of the environment and the potential discharge of materials into the environment, a material portion of the Company's capital expenditures is, directly or indirectly, related to such items. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" set forth on pages 7 to 14 of the Company's 1993 Annual Report to Stockholders (which discussion is filed as an exhibit to this report and incorporated by reference herein) for a review of property and equipment expenditures by the Company for the last three years. The Company does not expect such expenditures, which are incurred in the ordinary course of business, to have a materially adverse impact on its and its subsidiaries' combined earnings or its or its subsidiaries' competitive position in the foreseeable future because the Company's environmental services businesses are based upon compliance with environmental laws and regulations and its services are priced accordingly. Although the Company strives to conduct its operations in compliance with applicable laws and regulations, the Company believes that in the existing climate of heightened legal, political and citizen awareness and concerns, companies in the environmental services industry, including the Company, will be faced, in the normal course of operating their businesses, with fines and penalties and the need to expend funds for remedial work and related activities with respect to waste treatment, storage and disposal facilities. Where the Company concludes that it is probable that a liability has been incurred, a provision is made in the Company's financial statements for the Company's best estimate of the liability based on management's judgment and experience, information available from regulatory agencies, and the number, financial resources and relative degree of responsibility of other potentially responsible parties who are jointly and severally liable for remediation of a specific site, as well as the typical allocation of costs among such parties. If a range of possible outcomes is estimated and no amount within the range appears to be a better estimate than any other, then the Company provides for the minimum amount within the range, in accordance with generally accepted accounting principles. Such estimates are subsequently revised, as deemed necessary, as additional information becomes available. While the Company does not anticipate that the amount of any such revision will have a material adverse effect on the Company's operations or financial condition, the measurement of environmental liabilities is inherently difficult and the possibility remains that technological, regulatory or enforcement developments, the results of environmental studies or other factors could materially alter this expectation at any time. Such matters could have a material adverse impact on earnings for one or more fiscal quarters or years. The environmental services industry is subject to extensive and evolving regulation by federal, state, local and foreign authorities. Due to the complexity of regulation of the industry and to public awareness, implementation of existing and future laws, regulations or initiatives by different levels of government may be inconsistent and difficult to foresee. The Company makes a continuing effort to anticipate regulatory, political and legal developments that might affect its operations but is not always able to do so. The Company cannot predict the extent to which any legislation or regulation that may be enacted or enforced in the future may affect its operations. The Company was incorporated in Delaware as a wholly-owned subsidiary of WMX in 1978, and since then has acquired certain businesses owned by WMX or others. The Company is approximately 79% owned by WMX. The Company's common stock is listed on the New York Stock Exchange under the trading symbol "CHW" and is also listed on the Chicago Stock Exchange. Unless the context indicates to the contrary, all statistical and financial information under Items 1 and 2 of this report is given as of December 31, 1993, and where such information relates to any period prior to 1993, it is presented as if Rust had been in existence throughout such period. Statistical and financial data appearing under the caption "Hazardous Waste Management and Related Services" relates only to the Company's core business of chemical waste and low-level and other radioactive waste services and does not include any data relating to Rust. See "Engineering, Construction and Related Services." HAZARDOUS WASTE MANAGEMENT AND RELATED SERVICES CWM's principal business (excluding Rust and its subsidiaries) is to provide chemical waste management services, including transportation, treatment, resource recovery and disposal, to commercial and industrial customers, as well as to other waste management companies and to governmental entities. CWM also provides radioactive waste management services, primarily to electric utilities and governmental entities. The principal services provided by CWM and its subsidiaries (excluding Rust) accounted for the following percentages of CWM's hazardous waste management and related services revenue for each of the three years in the period ended December 31, 1993: The revenues and net income from such services can fluctuate for interim periods and from year to year for a number of reasons, including adverse weather conditions and that demand for the services may be seasonal (less demand in the winter months) and may be driven by changes in regulations. CHEMICAL WASTE MANAGEMENT SERVICES In the United States, most chemical wastes generated by industrial processes are handled "on-site" at the generators' facilities. Since the mid- 1970's, public awareness of the harmful effects of unregulated disposal of chemical wastes on the environment and health has led to extensive and evolving federal, state and local regulation of chemical waste management activities. The major federal statutes regulating the management of chemical wastes include the Resource Conservation and Recovery Act of 1976, as amended ("RCRA"), the Toxic Substances Control Act ("TSCA") and the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended ("CERCLA" or "Superfund"), all primarily administered by the United States Environmental Protection Agency ("EPA"). CWM's business is heavily dependent upon the extent to which regulations promulgated under these or similar state statutes and their enforcement over time effectively require wastes to be managed in facilities of the type owned and operated by the Company. The chemical wastes handled by the Company include industrial by-products and residues that have been identified as "hazardous" pursuant to RCRA (see "Regulation--Chemical Waste" herein), as well as other materials contaminated with a wide variety of chemical substances. The Company operates chemical waste treatment, storage or disposal facilities in 18 states and is able to service customers in most parts of the country through this network of facilities. Additionally, certain chemical wastes, such as polychlorinated biphenyls ("PCBs"), are transported greater distances because they can be accepted only at a limited number of treatment or disposal facilities. The Company also owns a majority interest in a subsidiary which operates a resource recovery facility, a disposal facility and storage facilities in Mexico. The ongoing chemical waste management services provided by the Company are typically performed pursuant to nonexclusive service agreements that obligate the Company to accept from the customer chemical wastes conforming to the provisions of the agreement. Fees are determined by such factors as the chemical composition and volume or weight of the wastes involved, the type of transportation or processing equipment utilized and distance to the processing or disposal facility. The Company periodically reviews and adjusts the fees charged for its services. Prior to performing services for a customer, the Company's specially trained personnel review the customer's waste profile sheet prepared by the customer which contains information about the chemical composition of the waste. A representative sample of the chemical waste may be analyzed in a Company laboratory or in an independent laboratory for the purpose of enabling the Company to recommend and approve the best method of transportation, treatment and disposal and to designate a facility permitted to accept the waste. Upon arrival at one of the Company's treatment, resource recovery or disposal facilities, and prior to unloading, a representative sample of the delivered waste is tested for several key characteristics and analyzed to confirm that it conforms to the customer's waste profile sheet. Treatment, Resource Recovery and Disposal The Company's treatment and resource recovery operations involve processing chemical wastes through the use of thermal, physical, chemical or other treatment methods at one or more of the Company's facilities. The residual material produced by these interim processing operations is either disposed of by burial in a secure disposal cell or by deep well injection, or it may be managed through one of the Company's resource recovery programs. For example, when drummed sludges are accepted by the Company for treatment and disposal, any free liquids are decanted, recoverable liquids are separated for subsequent treatment or reclamation, and nonrecoverable liquids are incinerated or stabilized prior to disposal. Thermal Treatment Thermal treatment refers primarily to processes that use incineration as the principal mechanism for waste destruction. Since August 1983, the Company has operated a non-PCB fixed hearth incinerator at its facility in Sauget, Illinois. Between 1986 and 1989, the Company completed three additional incinerators at that facility. The Company also operates a 150 million BTU per hour rotary kiln incinerator at its Port Arthur, Texas facility which is permitted to destroy PCB wastes. The Company's facilities also include a rotary kiln incinerator located in Chicago, Illinois which has not operated since February 1991 when there was an explosion in the kiln. Although the incinerator is fully functional, the Company has not resumed operations at the facility and is continuing to discuss with the Illinois Environmental Protection Agency the conditions under which operations may resume. The Company is seeking joint venture partners and reviewing other strategic alternatives for certain of its incineration facilities. Physical, Chemical and Other Treatment Methods Physical treatment methods include distillation, evaporation and separation. While distillation and evaporation utilize heat to remove liquids from solids or sludges, separation utilizes such techniques as sedimentation, filtration and flocculation to remove solid materials from liquids. Sedimentation involves the settling of particles suspended in a liquid, filtration involves passing a liquid through a porous mass to separate suspended particles, and flocculation causes suspended material to form a loosely aggregated mass. Certain aqueous wastes are also physically treated through the use of a mobile carbon absorption filtration system. These methods may be used alone or in conjunction with chemical, thermal or biological processes, the goal being to reduce the volume of waste material or to make it suitable for further treatment or disposal. Chemical treatment methods include chemical oxidation and reduction, chemical precipitation of heavy metals, hydrolysis and neutralization of acid and alkaline wastes. Also, the Company has developed the CHEM-MATRIX/R/ system for waste stabilization, which reduces the mobility and toxicity of hazardous constituents and chemically binds them into a stable, solid mass prior to disposal. These methods involve the transformation of wastes into inert materials through one or more chemical reaction processes. Resource Recovery The Company has developed a program of reclamation and reuse of certain chemical wastes, particularly solvent-based wastes, that are generated by various industrial cleaning operations and metal finishing and other industrial processes. Spent solvents that can be recycled are processed through thin film evaporators and other processing equipment and are distilled into clean, usable products. Nonrecoverable organic liquids with sufficient heat value are blended to meet strict specifications for use as supplemental fuels for cement kilns, blast furnaces and other high-efficiency boilers. The Company has developed specialized equipment and processes for these purposes and has established relationships with a number of supplemental fuel users around the country that will accept the blended material. Disposal The Company's secure land disposal facilities either have interim status or have been issued permits under RCRA (see "Regulation--Chemical Waste" and "Properties" herein). In general, the Company's land disposal facilities have received the necessary permits and approvals to accept chemical wastes, although some of such sites may only accept certain chemical wastes. Only chemical wastes which are in a stable, solid form and which meet the applicable regulatory requirements may be buried in the Company's secure disposal cells. These land disposal facilities are sited, constructed and operated in a manner designed to provide long-term containment of such waste. In accordance with current applicable regulatory requirements, the Company's secure disposal cells are being designed and engineered with double synthetic liners and double collection systems for leachate (liquid which has percolated through or drained from the buried waste). The synthetic liner system is placed over a three foot layer of compacted clay at the bottom of the cell. Above each high density polyethylene liner is a layer of synthetic or natural drainage material in which any leachate that might form would be collected for removal. Completed secure disposal cells are capped with synthetic material, covered with a layer of topsoil and seeded to reduce the possibility that liquid might enter the cell. Closed cells must be maintained for at least 30 years. At three of its locations, the Company isolates treated chemical wastes in liquid form by injection into deep wells (see "Properties" herein). Deep well technology involves drilling wells in suitable rock formations far below the base of fresh water and separated from it by other substantial geological confining layers. Other Chemical Waste Services The Company furnishes other specialized chemical waste services. For example, the Company provides waste reduction consulting services for industrial clients with the goal of designing site-specific waste minimization programs, and to that end conducts facility inspections and evaluations of alternatives for managing customer waste streams. Customer support services also include assured destruction of sensitive materials (aged, counterfeit or damaged products), on-site management services with respect to chemical process wastes, assistance to small quantity generators in complying with RCRA, and consolidation, secure packaging and transportation of small quantities of aged chemicals, reagents and other laboratory wastes for disposal. Transportation Chemical waste may be collected from customers and transported by the Company or delivered by customers to the Company's facilities. Chemical waste is transported by the Company primarily in specially constructed tankers and semi-trailers, including stainless steel and rubber or epoxy-lined tankers and vacuum trucks, or in containers or drums on trailers designed to comply with applicable regulations and specifications of the U.S. Department of Transportation ("DOT") relating to the transportation of hazardous materials. The Company's chemical waste transportation fleet includes approximately 395 tractors and 920 trailers. Liquid waste is frequently transported in bulk but also may be transported in drums. Heavier sludges or bulk solids are transported in sealed roll-off boxes or bulk trailers. The Company may utilize the services of subcontractors to transport waste in some circumstances. In some locations, the Company may also utilize rail transportation by means of tank cars, piggyback trailers or intermodal containers. The Company operates 35 transportation centers from which its transportation fleet is dispatched or fleet maintenance operations are conducted. The Company also operates several facilities at which waste collected from or delivered by customers may be analyzed and consolidated prior to further shipment. LOW-LEVEL AND OTHER RADIOACTIVE WASTE SERVICES Radioactive wastes with varying degrees of radioactivity are generated by nuclear reactors and by medical, industrial, research and governmental users of radioactive material. Radioactive wastes are generally classified as either high-level or low-level. High-level radioactive waste, such as spent nuclear fuel and waste generated during the reprocessing of spent fuel from nuclear reactors, contains substantial quantities of long-lived radionuclides and is the ultimate responsibility of the federal government. Low-level radioactive waste, which decays more quickly than high-level waste, largely consists of dry compressible wastes (such as contaminated gloves, paper, tools and clothing), resins and filters which have removed radioactive contaminants from nuclear reactor cooling water, solidified wastes from power plants which have become contaminated with radioactive substances and irradiated hardware. The Company provides comprehensive low-level radioactive waste management services in the United States consisting of disposal, processing and various other special services, and transportation. To a lesser extent, it also provides services with respect to radioactive waste which has become mixed with regulated chemical waste. The Company generally enters into long-term service agreements with its customers. A particular agreement may include all or part of the services performed by the Company. Disposal The Company's radioactive waste disposal operations currently involve low- level radioactive waste only. Its Barnwell, South Carolina facility is one of two licensed commercial low-level radioactive waste disposal facilities in the United States, and has been in operation since 1971. Waste accepted for burial at the Barnwell facility is segregated by waste classification and placed in specially engineered disposal cells of various sizes excavated in clay-rich soils. Waste, which must be in approved containers, is placed in a trench, backfilled and covered with compacted clay-rich cap material followed by topsoil. Systematic environmental monitoring is conducted in accordance with state and federal licensing requirements. Fees for burial are set by the Company based upon volume, level of radioactivity and handling considerations. A trust has been established and funded to pay the estimated cost of decommissioning the Barnwell facility. A second fund, for the extended care of the facility, is funded by a surcharge on each cubic foot of waste received. In the event the extra charges collected to restore and maintain the facility are insufficient to cover the costs of restoring or maintaining the site after its closure (which the Company has no reason to expect), the Company may be liable for the extra costs. Through an annual license fee, the State of South Carolina recovers direct and indirect costs it incurs to monitor facility operations. In accordance with the aims of the Low-Level Radioactive Waste Policy Act of 1980, eight southeastern states comprise the Southeast Interstate Low-Level Radioactive Waste Management Compact (the "Southeast Compact"). The Southeast Compact initially designated the Barnwell site as the disposal facility to receive all low-level radioactive waste generated in the eight-state compact region through 1992. Late in 1985, Congress passed the Low-Level Radioactive Waste Policy Amendments Act (the "1985 Act"). In addition to consenting to the Southeast Compact and six other regional compacts, the 1985 Act, among other things, amended prior law to allow continued access to the Barnwell facility by generators located outside the compact region. In exchange for such continued access, generators outside the Southeast Compact region pay surcharges to the State of South Carolina for each cubic foot of waste disposed of by the Company. The 1985 Act also established milestones for states that are not part of a compact region with an operating disposal facility. If the development of new facilities does not progress in accordance with such milestones, penalties may be imposed in the form of higher surcharges and, ultimately, denial of access to the Barnwell facility. During September 1986, the Southeast Compact Commission designated North Carolina as the next state to host the Southeast Compact regional disposal facility, and since then the State of North Carolina has been taking steps toward siting and licensing a regional disposal facility. In December 1993, the North Carolina Low-Level Radioactive Waste Management Authority voted to select a site in that state for development by the Company as a regional disposal facility. During 1992, South Carolina adopted legislation allowing the Barnwell site to continue operating until December 31, 1995, and to continue receiving waste generated outside the Southeast Compact until June 30, 1994. The Southeast Compact subsequently increased the surcharges payable by generators located outside the compact region. The Company expects the South Carolina legislature to consider extending to December 31, 1995 the date the Barnwell site must stop accepting waste generated outside the Southeast Compact, but there can be no assurance that such extension will be obtained. During the third quarter of 1989, the Company entered into contracts with the responsible agencies for the Southeast Compact and the Central Midwest Low- Level Radioactive Waste Compact, whose member states are Illinois and Kentucky (the "Central Midwest Compact"), to site, license, construct, operate and close new regional low-level radioactive waste disposal facilities for those Compacts, which facilities are intended to be located in North Carolina and Illinois, respectively. During the third quarter of 1990, the Company entered into a similar contract for the Appalachian States Low-Level Radioactive Waste Compact (whose member states are Pennsylvania, West Virginia, Maryland and Delaware). The terms of these contracts range from 20 to 30 years. Because of the difficulties associated with the process of siting and licensing such facilities, their development has not proceeded in the manner and on the schedule contemplated by the respective Compact authorities. For example, in October 1992, a special state commission which had been examining the siting of a proposed disposal facility in Illinois declined to approve it, as a consequence of which the timetable for establishing such a facility is uncertain. The Company was subsequently directed to stop certain of its work under its contract with the Central Midwest Compact. At this time the Company is unable to predict the effect which these developments might have upon its business. However, the Company's earnings for one or more fiscal quarters or years could be adversely affected if the Company is unable to open a new facility in North Carolina after the closure of the Barnwell site. Special Services The Company processes low-level radioactive waste at its customers' plants to enable such waste to be shipped in dry rather than liquid form to meet the requirements for receipt at disposal facilities and to reduce the volume of waste that must be transported. Processing operations include solidification, demineralization, dewatering and filtration. The Company's services in this regard include supplying all equipment, containers, associated hardware, operating personnel and quality control programs and procedures. In addition, the Company can design and fabricate specialized equipment and containers to meet the requirements of individual customers. Other services offered by the Company include decommissioning nuclear facilities, which involves dismantling buildings and equipment (projects that typically are nonrecurring), and providing electro-chemical, abrasive and chemical removal of radioactive contamination. In addition, the Company provides management services for spent nuclear fuel storage pools. The Company has developed techniques and equipment such as crusher/shear to process nonfuel components stored in such pools, in order to create more space for spent fuel storage. Through a joint venture and an exclusive domestic licensing agreement with a German company, the Company is developing and marketing in the United States nuclear waste management services and products currently in use in Europe, including casks and other products for handling spent fuel. Transportation Most low-level radioactive waste is transported by truck to burial sites. In order to meet the special needs of its customers, the Company develops transportation plans ranging from per trip service to dedication of equipment. The Company's transportation fleet consists of approximately 25 tractors and 85 heavy-duty trailers, including specialty trailers such as shielded vans, drop decks and lowboys. Transportation terminals are located in South Carolina and Illinois. Low-level radioactive waste requiring additional shielding must be transported in shipping casks licensed by the U.S. Nuclear Regulatory Commission ("NRC"). The Company owns approximately 60 such casks, as well as a variety of other containers designed to meet the varying needs of the nuclear industry. ENGINEERING, CONSTRUCTION, INDUSTRIAL AND RELATED SERVICES Rust is a leading provider, through its subsidiaries, of engineering, construction and environmental and infrastructure consulting services, hazardous substance remediation services and other on-site industrial and related services, primarily to clients in government and in the chemical, petrochemical, nuclear, energy, utility, pulp and paper, manufacturing, environmental services and other industries. The types of engineering, construction and environmental and infrastructure consulting services provided by Rust include process and design engineering, plant, facility and related infrastructure construction, project and construction management and oversight services, site analyses, remedial investigations, feasibility studies, environmental assessments, and architectural services. The types of hazardous substance remediation and other on-site industrial and related services provided by Rust include on-site remediation of hazardous substances, scaffolding, industrial cleaning and maintenance and nuclear and utility services and maintenance. In addition, Rust provides engineering and environmental and infrastructure consulting services to clients in several countries outside of North America. ENGINEERING, CONSTRUCTION AND ENVIRONMENTAL AND INFRASTRUCTURE CONSULTING SERVICES The industrial engineering services provided by Rust are of two general types, process engineering and facility design engineering. Process engineers create the processes by which facilities operate, such as chemical, petrochemical, energy and pulp and paper plants. Design engineering services provided by Rust encompass the following disciplines: architectural; electrical; control systems; process piping; mechanical; structural; heating, ventilation and air conditioning ("HVAC"); and civil. The construction services provided by Rust include primarily the new construction and retrofitting of power generation facilities, including coal-fired power plants, nuclear power plants, gas turbine and cogeneration plants, and industrial facilities, including chemical, petrochemical, pulp and paper, food and beverage, iron and steel, automotive, utility and industrial power and other manufacturing facilities. Rust also requisitions and procures equipment and construction materials for clients, performs quality assurance and quality control oversight of vendor manufacturing practices and provides infrastructure and marine construction, dredging, underwater diving, and dismantling and demolition services. Rust's engineering and construction services are provided on a stand-alone basis but are also provided together under engineering, procurement and construction contracts which include engineering services, procurement of facility equipment and materials and construction services. Rust's environmental and infrastructure consulting services provide alternative solutions for client problems relating to removing and disposing of hazardous and toxic substances, and managing solid waste, water and wastewater, groundwater and air resources. Such services are provided primarily to private industry and also to federal, state and local governments, including the Department of Defense (the "DOD") and the Department of Energy (the "DOE"). The services include performing remedial investigations for the purpose of characterizing hazardous waste sites, preparing risk assessment reports and feasibility studies setting forth recommended alternative remedial actions, and providing engineering design and construction oversight services for remediation projects. The services provided also include the siting, permitting, design and construction oversight of solid and hazardous waste landfills and related facilities. Study, design and construction oversight services are also provided, primarily to municipalities, in connection with wastewater collection and treatment, potable water supply treatment and distribution, and the building of streets, highways, airports, bridges, waterways and rail services. Additional services provided through Rust include environmental assessment services, the design of systems to properly and safely store, convey, treat and dispose of industrial, hazardous and radioactive materials, and consulting services regarding disposal, waste minimization methods and techniques, air quality regulation and industrial hygiene and safety. Through a series of acquisitions completed during the period from late 1992 through February 1994, Rust has developed an international engineering and consulting business performing projects in 24 countries. In Europe, Rust has offices in the United Kingdom, Germany, Sweden and Italy. Rust has offices located throughout the Asia Pacific region, including Australia, Hong Kong, China, Singapore, Malaysia and Indonesia. Rust also has an office in Dubai, U.A.E. Rust's foreign subsidiaries provide process and design engineering services, environmental and infrastructure engineering services and construction management services to national, regional and local governments and to clients in the utility and industrial power and general manufacturing industries. In addition, Rust provides engineering and consulting services to WM International worldwide. Rust received 45%, 43% and 52% of its total consolidated revenues in 1991, 1992 and 1993, respectively, from the performance of engineering, construction and environmental and infrastructure consulting services. The revenues and net income from such services can fluctuate for interim periods and from year to year for any number of reasons, including (i) the seasonal nature of significant portions of the business (less activity during the winter months), and (ii) performance hindrances such as technical problems, labor shortages or disputes, weather and delays caused by other external sources. REMEDIATION AND OTHER ON-SITE INDUSTRIAL AND RELATED SERVICES Hazardous Substance Remediation Services Rust performs on-site hazardous chemical and radioactive substance remediation services for clients in the chemical, petrochemical, automotive and other manufacturing industries and for federal, state and local government entities, including the DOD and the DOE in connection with such projects as the remediation of military bases and other government installations, the EPA in connection with CERCLA projects and various state environmental agencies. Rust treats hazardous substances on-site using a variety of methods and technologies, including, among others, mobile incineration technology, thermal desorption to separate organic contaminants from soils or solids for subsequent treatment of the organic vapor stream, sludge drying, soil washing, stabilization, physical separation and, to a lesser extent, bioremediation, which involves the breakdown of hazardous substances with microorganisms. Rust's hazardous substance remediation services also include the containment and closure of contaminated sites and the cleaning, relining and sealing of liquid containment and treatment ponds, lagoons and other surface impoundments. Hazardous substance remediation services provided to Rust's private industry clients often involve the implementation of "records of decision" promulgated by the EPA in response to results of EPA environmental analysis and investigation. In connection with the remediation of military bases and other government installations, the DOD and DOE are experimenting with awarding multi- disciplined remediation contracts known as Total Environmental Restoration Contracts ("TERCs") and Environmental Restoration and Management Contracts ("ERMCs") to a single company capable of providing the management services necessary to oversee the entire project. The company selected is, in effect, the project's general contractor. In August 1993, the U.S. Army Corps of Engineers awarded to Rust two TERCs under which Rust could be paid up to $350 million over a ten year period. As the TERCs are structured, Rust will perform work pursuant to individual delivery orders negotiated on a project-by-project basis. There can be no assurance that the number of delivery orders ultimately issued or successfully negotiated and performed by Rust will aggregate $350 million in fees. Rust intends to utilize its integrated approach to providing a full range of engineering, construction, environmental consulting, on-site hazardous substance remediation and other industrial services to pursue additional comprehensive federal government contracts. On-Site Industrial and Related Services Rust provides various on-site industrial and related services. Such services consist primarily of scaffolding, industrial cleaning, catalyst handling, plant services and nuclear and utility services. Rust provides scaffolding services primarily to the chemical, petrochemical and utilities industries, as well as other clients. In most cases, the scaffolding services are provided in conjunction with periodic, routine cleaning and maintenance of refineries, chemical plants and utilities, although such services are also performed in connection with new construction projects. Rust performs four types of industrial cleaning services -- water blasting, chemical cleaning, vacuuming and water filtration--primarily for clients in the petrochemical, chemical, and pulp and paper industries, utilities and, to a lesser extent, the government sector. Rust's catalyst handling services include the unloading, screening, classifying for reuse, disposing and reloading of catalyst, primarily to customers in the refining, petrochemical, chemical and gas processing industries using solid catalyst in reactors to convert, through chemical reactions, various hydrocarbon substances into higher grades or specific products and to remove unwanted byproducts. Rust's on-site plant services include providing personnel to perform mechanical and electrical services, equipment installation, welding, HVAC, warehousing and inventory management services and technical support in the area of industrial hygiene and safety training. Rust assists clients in the nuclear and utility industries in solving electrical, mechanical, engineering and related technical services problems. Rust also provides spent fuel storage (rerack) services to the nuclear power industry. Rust received 55%, 57% and 48% of its total consolidated revenues in 1991, 1992 and 1993, respectively, from the performance of hazardous substance remediation and other on-site industrial and related services (including asbestos abatement services until the May 1992 sale of that business as described in "Acquisitions and Dispositions"). The revenues and net income from such services can fluctuate for interim periods and from year to year for a number of reasons, including that (i) the demand for many of these services is seasonal (less activity during the winter months), (ii) the performance of such services on a given project may be affected by technical problems, labor shortages and disputes, weather and delays caused by external sources and fluctuations in the price of materials, (iii) in the case of the hazardous substance remediation business, changes in federal, state and local funding or enforcement priorities, and (iv) in the case of on-site industrial and related services, demand is also affected by the periodic scheduling of outages at utilities and other industrial facilities. BACKLOG Rust's backlog consists of uncompleted portions of engineering, construction, environmental and infrastructure consulting, remediation and on- site industrial and other related services contracts. As of December 31, 1993, Rust had estimated consolidated backlog of work under contracts believed to be firm of $1.022 billion, as compared with an estimated backlog of $902 million as of December 31, 1992. Approximately 73% of Rust's consolidated backlog is expected to be completed in 1994. Although backlog reflects only business considered to be firm and is an indication of future revenues, there can be no assurance that contract cancellations or scope adjustments will not occur, or as to when revenue from such backlog will be realized. Backlog shown above does not include approximately $350 million in respect of TERCs awarded to Rust by the U. S. Army Corps of Engineers in 1993. See "Remediation and Other On-Site Industrial and Related Services--Hazardous Substance Remediation Services." There can be no assurance that specific projects identified and performed by the Company pursuant to such TERCs will result in aggregate revenues of $350 million over the terms of such contracts. EQUITY INVESTMENTS Rust owns approximately 12% of the outstanding ordinary shares of WM International, a leading international provider of comprehensive waste management and related services which conducts substantially all of the waste management operations located outside of North America of WMX and its affiliates. WM International records and reports its earnings in Pounds Sterling. Currency fluctuations affecting the Pounds Sterling exchange rates will cause Rust's earnings from WM International to fluctuate. Rust may from time to time engage in hedging transactions in order to mitigate the effect of such exchange fluctuations. Rust and OHM Corporation each hold approximately 40% of the outstanding shares of NSC Corporation ("NSC"). The remaining outstanding shares are publicly held. NSC is an environmental services company providing asbestos abatement and other related services to a broad range of commercial and industrial clients and governmental agencies throughout the United States. During 1993, NSC consummated a transaction with Brand and WMX, pursuant to which NSC acquired the assets of the asbestos abatement division of Brand in exchange for the issuance to Brand of NSC common stock and all of its interest in several industrial cleaning and maintenance services businesses. See "Acquisitions and Dispositions." COMPLIANCE Because generators remain responsible by law for their hazardous wastes even after the wastes have been transferred to a third party for disposal, the Company believes that an essential part of the services it provides to its customers is a high level of confidence regarding its ability to comply with applicable environmental regulatory requirements. The Company's compliance program has been developed for each of its operational facilities under the direction of its experienced professional compliance staff, many of whose members have prior environmental regulatory experience. The Company's requirements are in certain cases more stringent than those imposed by regulation. See "Regulation" herein. The Company views compliance as the responsibility of all its employees and periodically conducts training programs on various aspects of hazardous materials management. Each treatment and disposal facility has a compliance coordinator assigned to it. Facility laboratories are monitored by the Company's quality assurance and quality control personnel. The Company's in- house environmental attorneys and other professionals closely follow regulatory developments and have extensive experience in dealing with compliance matters. The Company believes that community relations are an integral part of its responsibility and, for each community in which it operates, has set up programs to respond to community concerns. TECHNOLOGY The Company's hazardous waste analytical and development activities include an extensive quality assurance and quality control program involving periodic audits of Company laboratories, verification of laboratory performance and the establishment of standards for analytical work performed at the Company's own facilities as well as at outside laboratories utilized by the Company. Other activities include development of analytical methods, performance of waste sample analyses for certain customers and participation in the federal and state regulatory processes. The Clemson Technical Center (the "Center") located in Anderson, South Carolina and currently being operated by Rust, provides the Company with technical support, including hazardous substance treatability studies and pilot plant design and demonstration services. Such services often are funded by third parties. For instance, the Center is currently performing process development services on behalf of Rust under four programs being funded by the DOE to test specific technology applications at DOE facilities. The Company owns or licenses a number of patents and patent applications or other proprietary technology that are important to various aspects of its business, but the patents and licenses are not considered material to the conduct of any of its businesses. The Company believes that its businesses depend primarily on such factors as quality and cost of services, project development capability, engineering and technical skill, and financial strength rather than on patent protection. CUSTOMERS AND MARKETING CWM's services are primarily marketed by its local sales force located throughout the United States. Sales personnel develop and maintain relationships with clients in an effort to keep abreast of planned future projects and, where applicable, to attempt to ensure that CWM is included on proposal or bid lists. With respect to its chemical waste management services business, sales efforts have been directed at establishing relationships with virtually all of the several hundred largest industrial companies in the United States, with large governmental departments and agencies and, more recently, with small quantity generators of chemical wastes. A portion of such services performed by CWM is arranged through brokers. CWM's radioactive waste management operations provide services primarily to electric utilities operating nuclear power plants, as well as to industrial companies, universities, hospitals and the federal government. Rust's services are primarily marketed by Rust's local sales force located throughout the United States. Rust markets its services by stressing its skills, project performance record, the price at which its services are provided and the efficiency with which its services are performed. Rust also stresses its safety record, particularly with respect to its on-site industrial and related services, the nature of which involve, in some cases, a substantial degree of safety risk. Rust also promotes its engineering and construction services by entering into relationships with third parties for the purpose of developing projects. In connection therewith, Rust may from time to time have some portion of its capital resources at risk in connection with financing, designing, building, owning and operating such projects. Rust received 11.6%, 8.7% and 15.8% of its total consolidated revenues in 1991, 1992 and 1993, respectively, from WMX and its affiliates. Transactions with WMX and its affiliates are conducted on a competitive basis and there is no assurance that Rust will continue to receive substantially similar amounts of revenue from WMX or its affiliates. However, WMX and its affiliates have agreed that Rust will be the preferred provider to WMX and its affiliates (other than WM International) of the types of services provided by Rust, subject to certain limitations. Rust also received 11.6% of its total consolidated revenues in 1993 from direct contracts with the United States Government and its departments and agencies. Business with the United States Government is also highly competitive, and there is no assurance that Rust will continue to receive such business. No other customer or related group of customers accounted for a material portion of the Company's business in 1993. COMPETITION Competition in the chemical waste management services market is encountered from a number of sources, including several national or regional waste management firms, firms specializing primarily in chemical waste management, local waste management firms and, to a much greater extent, generators of chemical wastes which seek to reduce the volume of or otherwise process and dispose of such wastes themselves. The basis of competition is primarily technical expertise and the price, quality and reliability of service. The Company does not believe that any other firm offers as many treatment technologies and as broad a network of chemical waste transportation, treatment, storage and disposal facilities as does the Company. Due to the significant extent to which certain chemical waste generators process and dispose of such wastes themselves, the Company does not believe that any company accounts for a material portion of the total domestic chemical waste management market. As a result of the considerable capital expenditures needed to develop a permitted treatment, storage or disposal facility for chemical wastes, and the difficulty of obtaining permits, companies which have such permitted facilities may have a competitive advantage. In addition to the Company's Barnwell, South Carolina facility, there is only one other licensed commercial low-level radioactive waste disposal facility in operation in the United States, located near Richland, Washington. Since January 1, 1993, that facility accepts waste for disposal only from certain states west of the Mississippi River. Of the electric utilities in the United States that operate nuclear power plants, most are located in the eastern portion of the country. The Company believes that it currently disposes of the majority of low-level radioactive waste generated commercially in states east of the Mississippi River at its Barnwell facility. Because licensed disposal facilities require considerable capital expenditures, and because licenses are difficult to obtain, companies which have licensed facilities may have a competitive advantage. However, many of the Company's utility customers are believed to be considering on-site storage of low-level radioactive waste. Competition in the other nuclear services provided by the Company is encountered from a number of companies. Although Rust is a leading provider of engineering, construction, environmental and infrastructure consulting, hazardous substance remediation and other on-site industrial and related services, the Company does not believe that any entity accounts for a material portion of this decentralized, highly fragmented market. The service industries in which Rust operates are highly competitive and certain aspects require substantial human and capital resources. Rust encounters intense competition, primarily in pricing, quality and reliability of services from various sources in all aspects of its engineering, construction, environmental and infrastructure consulting services and its construction, hazardous substance remediation, and industrial and other on-site and related services operations. Other competitive factors include the ability to deliver an expanded range of environmentally related services, type of equipment used, response time and employee safety record. Some competitors of Rust may have substantially greater financial resources than Rust. Particularly with respect to large contracts, such as for the government sector, or contracts or bids with respect to construction or development of industrial or power facilities, Rust may be required to commit substantial resources over a long period of time without any assurance of being selected to perform, or of successfully completing such projects. Until such time as WMX ceases to own shares having a majority of the voting power in the election of CWM's directors, WMX has agreed not to engage directly or indirectly in the storage, processing, treatment or disposal of (i) low-level radioactive waste in the United States or Canada, (ii) hazardous wastes regulated under RCRA, or wastes the storage, treatment or disposal of which was regulated under TSCA at the time of WMX's agreement with the Company in September 1986 or (iii) such wastes in Canada which would be so regulated in the United States. The Company has also entered into an Amended and Restated International Business Opportunities Agreement with WMX, Rust, WTI, WM International and an affiliate of WM International pursuant to which, in part, the Company agreed that, in order to minimize the potential for conflicts of interest among various subsidiaries under the common control of WMX, WMX has the right to direct all business opportunities to the WMX controlled subsidiary which, in WMX's reasonable and good faith judgment, has the most experience and expertise in that line of business. Opportunities in North America (other than those relating to hazardous substance remediation services which have been allocated to Rust) relating to storage, processing, treatment or disposal of (i) radioactive wastes, or (ii) hazardous wastes regulated under the Resource Conservation and Recovery Act or wastes the storage, treatment or disposal of which as of January 1993 was regulated under the Toxic Substances Control Act in the United States, (iii) such wastes in Canada which would be so regulated in the United States, or (iv) wastes in Mexico which are currently or in the future regulated as hazardous or toxic under Mexican law, have been allocated to the Company. Opportunities worldwide relating to (a) architectural services, (b) engineering and design services, other than those relating to (1) chimneys and air pollution control equipment and facilities, (2) facilities and systems for water, wastewater and sewage treatment outside North America, but only (x) where the customer is seeking third-party operation and maintenance services in addition to those customarily involved in start-up and commissioning tests, or (y) which are designed for treating hazardous waste streams, whether or not the customer is seeking third-party operation and maintenance services, and (3) waste-to-energy facilities outside of North America, (c) procurement, construction and construction management services, including marine construction and dredging, but excluding such services as they relate to (1) hazardous substance remediation services outside North America, (2) chimneys and air pollution control equipment and facilities, (3) facilities and systems for water, wastewater and sewage treatment outside North America, but only (in the case of facilities and systems falling within this item (3)) (x) where the customer is seeking third-party operation and maintenance services in addition to those customarily involved in start-up and commissioning tests, or (y) which are designed for treating hazardous waste streams, whether or not the customer is seeking third-party operation and maintenance services, and (4) waste-to- energy facilities outside North America, (d) scaffolding services, (e) demolition and dismantling services, (f) environmental consulting services, including, without limitation, environmental facility siting and permitting services, remedial investigations and feasibility studies, contaminant assessments, risk assessments and air quality analyses, and (g) industrial facility and power plant maintenance services have been allocated to Rust, as well as opportunities in North America relating to hazardous substance remediation services. Pursuant to that Agreement, the Company and Rust also agreed not to conduct waste management services operations, including, without limitation, collection, transfer, recycling and land disposal of solid wastes; collection, storage, processing, treatment or disposal of hazardous wastes (including hazardous substance remediation services); the design, development, construction, operation and maintenance of waste-to-energy facilities; and the design, engineering and construction (where the customer is seeking third-party operation and maintenance services in addition to those customarily involved in start-up and commissioning tests), operation and maintenance of facilities and systems for water, wastewater and sewage treatment (including facilities for treating hazardous waste streams, whether or not the customer is seeking third- party operation and maintenance services), outside of North America until the later of July 1, 2000 and the date WMX ceases to beneficially own a majority of the outstanding voting equity interests of the Company or Rust, as the case may be, or a majority of all outstanding voting equity interests of WM International. In addition, the terms of the NSC Purchase Agreement (as hereinafter defined) provide, among other things, that none of CWM, Rust, WTI, WMX or their respective affiliates will compete with NSC Corporation in the asbestos abatement business for a period of five years. See "Acquisitions and Dispositions" and Items 12 and 13. INSURANCE While the Company believes it operates professionally and prudently, its business exposes it to risks such as the potential for harmful substances escaping into the environment and causing damage or injuries, the cost of which could be substantial. The Company currently has liability insurance coverage for non-nuclear related occurrences under environmental impairment, primary casualty and excess liability insurance policies maintained by WMX, the costs of which are shared. See Item 13. Pursuant to RCRA, the Company is required to maintain environmental impairment liability insurance coverage with specified minimum policy limits for sudden and nonsudden accidental occurrences. The required minimum coverages are $1,000,000 per occurrence/$2,000,000 aggregate per year for sudden accidental occurrences, and $3,000,000 per occurrence/$6,000,000 aggregate per year for nonsudden accidental occurrences, in each case exclusive of defense costs. The Company believes that its policies comply with applicable environmental regulatory financial responsibility requirements. The market for non-sudden environmental impairment liability insurance is constricted, with only a few insurance companies currently offering coverage and with coverage entailing limited amounts with restrictive terms and high premium costs. Consequently, the Company is utilizing coverage under the one non-sudden environmental impairment liability insurance policy maintained by WMX. Under that policy, losses paid by the carrier must be reimbursed over a period of years, subject to a requirement that WMX make advance deposits with the carrier for such purpose. A claim covered under such an insurance policy which does not transfer risk, if successful and of sufficient magnitude, could have a material adverse effect on the Company's business, earnings or financial condition. The Company has nuclear insurance in an amount substantially exceeding that which is required by the State of South Carolina to cover liabilities arising out of its low-level radioactive waste disposal operations and certain of its transportation services. The Company's other operations at nuclear power plants are insured under the nuclear liability and compensation system established by the Price-Anderson Act amendment to the Atomic Energy Act of 1954. EMPLOYEES The Company (excluding Rust) employed approximately 4,400 persons at December 31, 1993. Of this number, the Company employed approximately 200 as managers or executives, approximately 3,200 in transportation, treatment, resource recovery and disposal activities (including approximately 900 performing technical, analytical or engineering services), and approximately 1,000 in sales, clerical, data processing and other activities. At that date, approximately 250 of such employees were represented by various labor unions under collective bargaining agreements expiring on various dates through 1997. Excluding Rust, five collective bargaining agreements will expire in 1994. Rust employed approximately 16,000 persons at December 31, 1993, of whom approximately 1,400 were employed as managers or executives, approximately 5,100 provided technical or engineering services (excluding craft personnel hired on a temporary basis), approximately 1,500 were employed in sales, clerical and data processing activities and approximately 8,000 were employed in other activities, principally providing hourly rated labor. At that date, approximately 2,100 of Rust's employees were represented by various labor unions under numerous collective bargaining agreements, most of which have one-to three year terms but provide for automatic renewal if not terminated by a party thereto. The Company and its subsidiaries have not experienced a significant work stoppage and consider their employee relations to be good. ACQUISITIONS AND DISPOSITIONS Since commencing operations, the Company's businesses have expanded in part through acquisitions of other companies, and certain assets of other companies, engaged in various phases of the environmental, engineering, construction and industrial services industries. See Note 4 to the Company's Consolidated Financial Statements filed as an exhibit to this report and incorporated herein by reference. In September 1988, CWM acquired newly issued common and convertible preferred shares from Brand equivalent to a 49% ownership interest in Brand. Most of the consideration was paid in cash, with the balance consisting of CWM's asbestos abatement businesses which were transferred to Brand and CWM's agreement, among other matters, to furnish certain services to Brand. In October 1990, CWM exercised options increasing its ownership of Brand capital stock to a majority interest. In January 1993, CWM contributed its Brand shares to Rust. In May 1993, pursuant to an agreement (the "NSC Purchase Agreement") by and among NSC, NSC's wholly owned subsidiary, NSC Industrial Services Corp., Brand, WMX and OHM Corporation, previously an approximately 70% stockholder of NSC, Brand transferred its asbestos abatement business to NSC in exchange for an approximately 41% interest in NSC Corporation and two industrial services companies of NSC. Rust assumed the rights and obligations of Brand under the NSC Purchase Agreement upon consummation of the merger of Brand into a subsidiary of Rust. In August 1993, Rust acquired EnClean, Inc., an industrial and environmental services business providing hydroblasting, industrial vacuuming, chemical cleaning, separation technology, site remediation and catalyst handling services. The acquisition expanded Rust's presence primarily in the Gulf Coast area and added chemical cleaning and catalyst handling to the services already provided by Rust. In September 1993, CWM announced plans to, among other things, eliminate approximately 1,200 positions by year-end 1994, consolidate operations in its treatment and land disposal group, restructure its sales and service regions, sell selected service centers in marginal service lines and geographies, seek joint venture partners and review other strategic alternatives for its Port Arthur, Texas incinerator and centralize additional functions. CWM is restructuring its hazardous waste management and related services operations on the assumption that future base business revenue growth, if any, will not keep pace with the recovery in the general economy, and plans not to make investments which are primarily supported by non-recurring (event business) volumes. REGULATION The environmental services industry is subject to extensive and evolving regulation by federal, state, local and foreign authorities. In particular, the regulatory process requires firms in the Company's industry to obtain and retain numerous governmental permits to conduct various aspects of their operations, any of which may be subject to revocation, modification or denial. As a result of governmental policies and attitudes relating to the environmental services industry which are subject to reassessment and change, the Company believes that its ability to obtain applicable permits from governmental authorities on a timely basis, and to retain such permits, could be impaired. The Company is not in a position at the present time to assess the extent of the impact of such potential changes in governmental policies and attitudes on the permitting processes, but it could be significant. In particular, adverse decisions by governmental authorities on permit applications submitted by the Company may result in abandonment of projects, premature closure of facilities or restriction of operations, which could have a material adverse effect on the Company's earnings for one or more fiscal quarter or years. Due to the complexity of regulation of the industry and to public pressure, implementation of existing or future laws, regulations or initiatives by different levels of government may be inconsistent and difficult to foresee. The Company makes a continuing effort to anticipate regulatory, political and legal developments that might affect its operations, but is not always able to do so. In this regard, federal, state, local and foreign governments have from time to time proposed or adopted other types of laws, regulations or initiatives with respect to the environmental services industry. Included among them have been laws, regulations and initiatives in the United States to ban or restrict the interstate shipment of hazardous wastes, impose higher taxes on out-of-state hazardous waste shipments than in-state shipments and reclassify certain categories of hazardous wastes as non-hazardous. In particular, the federal government currently is considering several fundamental changes to laws and regulations that define which wastes are hazardous, that establish treatment standards for certain wastes that could lead to their reclassification as non- hazardous, and that revise the nature and extent of responsible parties' obligations to remediate contaminated property. While the outcome of these deliberations cannot be predicted, it is possible that some of the changes under consideration could facilitate exemptions from hazardous waste requirements for significant volumes of waste and alter the types of treatment and disposal that will be required. If such changes are implemented, the overall impact on the Company's business is likely to be unfavorable. While the Company cannot predict the extent to which any legislation or regulation that may be enacted or enforced in the future may affect its operations, such matters could have a material adverse impact on earnings for one or more fiscal quarters or years. In addition to environmental laws and regulations, federal government contractors, including the Company, are subject to extensive regulations under the Federal Acquisition Regulation and numerous statutes which deal with the accuracy of cost and pricing information furnished to the government, the allowability of costs charged to the government, the conditions under which contracts may be modified or terminated, and other similar matters. Various aspects of the Company's operations are subject to audit by agencies of the federal government in connection with its performance of work under such contracts as well as its submission of bids or proposals to the government. Under certain circumstances, the government may have the right to modify contract price terms unilaterally. Failure to comply with contract provisions or other applicable requirements may result in termination of the contract, the imposition of civil and criminal penalties against the Company, or the suspension or debarment of all or a part of the Company from federal government work, which could have a material adverse impact upon the Company's operations, financial condition or earnings. Among the reasons for debarment are violations of various statutes, including those related to employment practices, the protection of the environment, the accuracy of records and the recording of costs. Some state and local governments have similar suspension and debarment laws or regulations. Because of heightened public awareness of environmental issues, companies in the environmental service business, including the Company, may in the normal course of their business be expected periodically to become subject to judicial and administrative proceedings. Governmental agencies may seek to impose fines on the Company or revoke, deny renewal of, or modify the Company's operating permits or licenses. The Company is also subject to actions brought by private parties or special interest groups in connection with the permitting or licensing of its operations, alleging violations of such permits and licenses, or other matters. In addition, increasing governmental scrutiny of the environmental compliance records of the Company or one or more of its affiliates could cause a private or public entity seeking environmental services to disqualify the Company from competing for one or more projects, on the grounds that these records display inadequate attention to environmental compliance. CHEMICAL WASTE The Company is required to obtain federal, state, local and foreign governmental permits for its chemical waste treatment (including resource recovery), storage and disposal facilities. Such permits are difficult to obtain, and in most instances extensive geological studies, tests and public hearings are required before permits may be issued. The Company's treatment, storage and disposal facilities are also subject to siting, zoning and land use restrictions, as well as to regulations (including certain requirements pursuant to federal statutes) which may govern operating procedures and water and air pollution, among other matters. In particular, the Company's operations in the United States are subject to the Safe Drinking Water Act (which regulates deep well injection), TSCA (pursuant to which the EPA has promulgated regulations concerning the disposal of PCBs), the Clean Water Act (which regulates the discharge of pollutants into surface waters and sewers by municipal, industrial and other sources) and the Clean Air Act (which regulates emissions into the air of certain potentially harmful substances). In its transportation operations, the Company is subject to the jurisdiction of the Interstate Commerce Commission and is regulated by the DOT and by regulatory agencies in each state. Employee safety and health standards under the Occupational Safety and Health Act ("OSHA") are also applicable. RCRA Pursuant to RCRA, the EPA has established and administers a comprehensive, "cradle-to-grave" system for the management of a wide range of industrial by- products and residues identified as "hazardous" wastes. States that have adopted hazardous waste management programs with standards at least as stringent as those promulgated by the EPA may be authorized by the EPA to administer their programs in lieu of RCRA. Under RCRA and federal transportation laws, all generators of hazardous wastes are required to label shipments in accordance with detailed regulations and prepare a detailed manifest identifying the material and stating its destination before shipment offsite. A transporter must deliver the hazardous wastes in accordance with the manifest and only to a treatment, storage or disposal facility having a RCRA permit or interim status under RCRA. Every facility that treats or disposes of hazardous wastes must obtain a RCRA permit from the EPA or an authorized state and must comply with certain operating standards. The RCRA permitting process involves applying for interim status and also for a final permit. Under RCRA and the implementing regulations, facilities which have obtained interim status are allowed to continue operating by complying with certain minimum standards pending issuance of a permit. Amendments to RCRA enacted in 1984 expanded its scope by, among other things, adding wastes to the hazardous category and providing for the regulation of hazardous wastes generated in quantities greater than 100 kilograms per month (reduced from the prior cutoff of regulatory authority at the 1,000 kilograms per month level). Additionally, the amendments impose restrictions on land disposal of certain hazardous wastes and prescribe more stringent standards for hazardous waste land disposal facilities. The amendments also contain a statement of policy that reliance on land disposal of hazardous wastes should be minimized or prohibited. Land disposal of certain types of untreated hazardous wastes was banned except where the EPA determined that land disposal of such wastes and treatment residuals should be permitted. In accordance with the amendments, the disposal of liquids in hazardous waste land disposal facilities was prohibited in 1985. Since 1983, it has been the Company's practice to prohibit the disposal of liquids in secure land disposal cells. Also under the RCRA amendments, by November 1985, RCRA-regulated hazardous waste facilities with land disposal operations were required to certify compliance with groundwater monitoring and financial responsibility requirements, or be faced with the loss of federal authority to operate. All of the Company's affected facilities for which continued operations are planned certified compliance with these requirements. The requirement to certify applied to approximately 1,500 RCRA-regulated facilities nationwide, although not all of them were then operating or have continued to operate. Of those facilities, approximately one-third were able to certify and remain eligible to operate. EPA currently is considering a number of fundamental changes to its regulations under RCRA that could facilitate exemptions from hazardous waste management requirements, including policies and regulations that could implement the following changes: redefine the criteria for determining whether wastes are hazardous; prescribe treatment levels which, if achieved, could render wastes non-hazardous; encourage further recycling and waste minimization; reduce treatment requirements for certain wastes to encourage alternatives to incineration; establish new operating standards for combustion technologies; and indirectly encourage on-site remediation. Because many of these initiatives are at an early stage of development, the Company cannot predict the final decisions EPA might make or the extent of their impact on the Company's business. Of the Company's chemical waste treatment, resource recovery or disposal facilities in the United States, all but three have been issued permits under RCRA. Such facilities without RCRA permits continue to have interim status. Final permits are to be issued jointly by authorized states subject to EPA oversight and by the EPA. The regulations governing issuance of permits contain detailed standards for hazardous waste facilities on matters such as waste analysis, security, inspections, training, preparedness and prevention, emergency procedures, reporting and recordkeeping. Once issued, a final permit has a maximum fixed term of 10 years, and such permits for land disposal facilities are required to be reviewed five years from the date of issuance. The issuing agency (either the EPA or an authorized state) may review or modify a permit at any time during its term. The Company believes that each of its operating treatment, storage or disposal facilities is in substantial compliance with the applicable requirements promulgated pursuant to RCRA, and the Company expects that each facility with interim status ultimately can qualify to be issued a RCRA permit. It is possible, however, that in some instances the issuance of a permit could be made conditional upon the initiation or completion by the Company of certain modifications or corrective actions at the facility in question. If so, substantial additional capital expenditures on the part of the Company could be necessary. In addition, permits may be issued with restrictions that would limit the Company's future operations at a facility. The Company anticipates that once a permit is issued with respect to a facility, the permit will be reauthorized at the end of its term if the facility's operations are in compliance with applicable requirements. However, there can be no assurance that such will be the case. In addition to the foregoing provisions, RCRA regulations require the Company to demonstrate financial responsibility for bodily injury and property damage to third parties caused by both sudden and nonsudden accidental occurrences (see "Insurance" herein). Also, RCRA regulations require the Company to provide financial assurance that funds will be available when needed for closure and post-closure care, the costs of which could be substantial, at its chemical waste treatment, storage and disposal facilities. Such regulations allow the financial assurance requirements to be satisfied by various means, including letters of credit, surety bonds, trust funds, a financial (net worth) test and a guarantee by a parent corporation. The Company is currently satisfying such requirements through a combination of the various allowable methods, including letters of credit and guarantees in the requisite form provided by WMX, which WMX has agreed to continue to furnish under certain conditions for a limited period of time (see Item 13). The Company accrues for closure costs for individual secure land disposal cells as airspace is utilized. The Company does not accrue for closure costs of other facilities which are not consumed as used. The Company believes that it will continue to be able to satisfy the RCRA financial assurance requirements through WMX or other means, although possibly at an increased cost. Superfund Superfund provides for immediate response and removal actions coordinated by the EPA to releases of hazardous substances into the environment, and authorizes the federal government either to clean up facilities at which hazardous substances have created actual or potential environmental hazards or to order persons responsible for the situation to do so. Superfund assigns liability for these response and other related costs to parties involved in the generation, transfer and disposal of such hazardous substances. Superfund has been interpreted as creating strict, joint and several liability for costs of removal and remediation, other necessary response costs and damages for injury to natural resources. Liability extends to owners and operators of waste disposal facilities (and waste transportation vehicles) from which a release occurs, persons who owned or operated such facilities at the time the hazardous substances were disposed, persons who arranged for disposal or treatment of a hazardous substance at or transportation of a hazardous substance to such a facility, and waste transporters who selected such facilities for treatment or disposal of hazardous substances, as well as to generators of such substances. Liability may be trebled if the responsible party fails to perform a removal or remedial action ordered under the law. See Item 3. Superfund created a revolving fund to be used by the federal government to pay for the cleanup efforts. In late 1990, federal Superfund spending through the end of the government's 1994 fiscal year was authorized up to a maximum of $5.1 billion. The U. S. Congress is expected to reauthorize and revise the Superfund statute in 1994 or 1995. In addition to possible changes in the statute's funding mechanisms and provisions for allocating cleanup responsibility, it is possible that Congress also will fundamentally alter the statute's provisions governing the selection of appropriate site cleanup remedies. For example, Congress is expected to consider whether to continue Superfund's current reliance on stringent technology standards issued under other statutes (such as RCRA) to govern removal and treatment of remediation wastes or to adopt new approaches such as national or site-specific risk based standards. This and other potential policy changes could significantly affect the stringency and extent of site remediation, the types of remediation techniques that will be employed, and the degree to which permitted hazardous waste management facilities will be used for remediation wastes. RADIOACTIVE WASTE The radioactive waste services of the Company are also subject to extensive governmental regulation. Due to the extensive geological and hydrological testing and environmental data required, and the complex political environment, it is difficult to obtain permits for radioactive waste disposal facilities. Various phases of the Company's radioactive waste management services are regulated by various state agencies, the NRC and the DOT. Regulations applicable to the Company's operations include those dealing with packaging, handling, labelling and routing of radioactive materials, and prescribe detailed safety and equipment standards and requirements for training, quality control and insurance, among other matters. Employee safety and health standards under OSHA are also applicable. ENGINEERING, CONSTRUCTION AND RELATED SERVICES RCRA, state law analogues, TSCA, which regulates PCB treatment, storage and disposal, and other environmental statutes and regulations impose strict operational requirements on the performance of certain aspects of remedial work. See Regulation -- Chemical Waste. These requirements specify complex methods for identification, storage, treatment and disposal of wastes generated during a project. Failure to meet these requirements could result in termination of contracts, substantial fines and other penalties. The cost and complexity of permit or license applications for remedial work can be considerable. Furthermore, Rust may not receive necessary permits at the end of the application process, for any of a variety of reasons such as perceived compliance problems, the permitting authority's judgment that the application, even if complete, fails to meet technical or regulatory requirements and community opposition to the project. Any of these reasons can also cause significant delays in the issuance of necessary permits. The practice of engineering and architecture is regulated by state statutes. All states require architects and engineers to be registered by their respective state registration boards as a condition to offering or rendering professional services. Many states also require companies offering or rendering professional services, such as Rust, to obtain certificates of authority. Employee safety and health standards under OSHA are also applicable to Rust's businesses. Rust's utility services business is also subject to NRC regulations concerning rerack services and service related products, such as fire prevention seals, provided to nuclear power plants. ITEM 2.

ITEM 2. PROPERTIES. The principal fixed assets of the Company consist of its network of transportation, treatment, storage and disposal facilities and its fleet of transportation vehicles. At December 31, 1993, vehicles and equipment represented approximately 24% of the Company's hazardous waste management and related assets. Rust's principal fixed assets consist of its headquarters buildings, vehicles, equipment and scaffolding inventory, which as of December 31, 1993 represented approximately 20% of Rust's total assets as reflected in its consolidated balance sheet. At December 31, 1993, the Company's chemical waste facilities with secure land disposal sites (as set forth in the table below) aggregated approximately 10,500 acres, including approximately 3,050 permitted acres. The Company believes that, at current rates of utilization, the permitted and other potentially usable acres included in such total have sufficient capacity to enable the Company to continue to conduct secure land disposal operations for more than 30 years, although not all of the Company's facilities have such capacity. The Company's corporate headquarters are located at 3001 Butterfield Road, Oak Brook, Illinois in premises leased from WMX on a month to month basis. Rust's corporate headquarters are located in Birmingham, Alabama and consist of three office buildings owned by Rust. As of December 31, 1993, the Company's real estate holdings represented approximately 31% of the Company's hazardous waste management and related assets, and the aggregate annual rental payments on real estate (excluding Rust) approximated $4,951,000. Rust's real estate holdings do not represent a material portion of its assets, as its operations are conducted principally from leased office and warehouse space. Rust's aggregate 1993 rental payments on real estate approximated $19,000,000. The following table sets forth certain information regarding the principal treatment, resource recovery or disposal facilities owned or leased by the Company: ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. The business in which the Company is engaged is intrinsically connected with the protection of the environment and the potential for the unintended or unpermitted discharge of materials into the environment. In the ordinary course of conducting its business activities, the Company becomes involved in judicial and administrative proceedings involving governmental authorities at the federal, state and local levels (including, in certain instances, proceedings instituted by citizens or local governmental authorities seeking to overturn governmental action where governmental officials or agencies are named as defendants together with the Company or one or more of its subsidiaries, or both). In the majority of the situations where regulatory enforcement proceedings are commenced by governmental authorities, the matters involved relate to alleged technical violations of licenses or permits pursuant to which the Company operates or is seeking to operate, or of laws or regulations to which its operations are subject, or are the result of different interpretations of the applicable requirements. From time to time, the Company pays fines or penalties in environmental proceedings relating primarily to waste treatment, storage or disposal facilities. At December 31, 1993, the Company was involved in four governmental proceedings (other than those described below) relating to operations of the Company or one of its subsidiaries where the Company believes sanctions may exceed $100,000. On November 12, 1993, the Supreme Court of the State of Louisiana denied the Company's application for a writ of review of an opinion of the Louisiana First Circuit Court of Appeal affirming an administrative order that imposed a fine of approximately $262,000 for certain incidents occurring in 1987 and 1988 at the Company's Lake Charles, Louisiana facility, including alleged unpermitted storage of waste and alleged failures to mark the accumulation date on two containers, to remove or overpack waste from a container in poor condition, to keep hazardous waste containers closed, to properly design and operate the containment system in a fuels loading and unloading area, to provide an adequate number of warning signs, and to take certain actions to prevent fires. On December 30, 1993, a subsidiary of the Company entered into a stipulation of settlement with the New Jersey Department of Environmental Protection and Energy in connection with certain matters occurring in 1992 and 1993 at the Company's Newark, New Jersey facility, including alleged failures to follow required procedures for rejecting hazardous wastes, to comply with certain requirements for managing incompatible wastes and to prepare a manifest before transporting certain waste, and the alleged shipment of waste to an unauthorized facility. The Company's subsidiary agreed to pay civil penalties aggregating approximately $218,000. In settling these matters, the Company's subsidiary did not admit violations of law. The Company has been identified as a potentially responsible party in a number of governmental investigations and actions relating to waste disposal facilities which may be subject to remedial action under Superfund. Generally these proceedings are based on allegations that the Company or certain of its subsidiaries (or their predecessors) transported hazardous substances to the facilities in question, often prior to acquisition of such subsidiaries by the Company. Such proceedings arising under Superfund typically involve numerous waste generators and other waste transportation and disposal companies, and seek to allocate or recover costs associated with site investigation and cleanup, which costs could be substantial. As of December 31, 1993, the Company or its subsidiaries had been notified that they are potentially responsible parties in connection with 22 locations listed on the Superfund National Priority List (the "NPL"). The 22 NPL sites at which claims have been made against the Company are at different procedural stages under Superfund. At some, the Company's liability is well defined as a consequence of a governmental decision as to the appropriate remedy and an agreement among liable parties as to the share each will pay for implementing that remedy. At others, where no remedy has been selected and the liable parties have been unable to agree on an appropriate allocation, the Company's future costs are substantially uncertain. The Company periodically reviews its role, if any, with respect to each such location, giving consideration to the nature of the Company's alleged connection to the location (e.g., owner, operator, transporter or generator), the extent of the Company's alleged connection to the location (e.g., amount and nature of waste hauled to the location, number of years of site operation by the Company or other relevant factors), the accuracy and strength of evidence connecting the Company to the location, the number, connection and financial ability of other named and unnamed potentially responsible parties at the location, and the nature and estimated cost of the likely remedy. Where the Company concludes that it is probable that a liability has been incurred, a provision is made in the Company's financial statements for the Company's best estimate of the liability based on management's judgment and experience, information available from regulatory agencies and the number, financial resources and relative degree of responsibility of other potentially responsible parties who are jointly and severally liable for remediation of a specific site, as well as the typical allocation of costs among such parties. If a range of possible outcomes is estimated and no amount within the range appears to be a better estimate than any other, then the Company provides for the minimum amount within the range, in accordance with generally accepted accounting principles. Sites subject to state action under state laws similar to the federal superfund statute are treated by the Company in the same way as NPL sites. The Company's estimates are subsequently revised, as deemed necessary, as additional information becomes available. While the Company does not anticipate that the amount of any such revisions will have a material adverse effect on the Company's operations or financial condition, the measurement of environmental liabilities is inherently difficult and the possibility remains that technological, regulatory or enforcement developments, the results of environmental studies or other factors could materially alter this expectation at any time. Such matters could have a material adverse impact on financial condition or earnings for one or more fiscal quarters or years. The Company and certain of its subsidiaries are currently involved in civil litigation and governmental proceedings relating to the conduct of their business. While the outcome of any particular lawsuit or governmental investigation cannot be predicted with certainty, the Company believes that these matters will not have a material adverse effect on its results of operations or financial condition. On September 17, 1993, H. Peter Kriendler, a stockholder of the Company, filed suit in the U. S. District Court for the Northern District of Illinois, Eastern Division, alleging that the Company had violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. Two similar suits were filed in that Court on September 30, 1993 and October 13, 1993, and on October 29, 1993 the Court and the parties agreed to consolidate them with the first action. These lawsuits allege that the Company violated federal securities laws by engaging in misrepresentations of, or failures to disclose, material information concerning primarily (i) alleged overvaluation of certain of the Company's assets, principally its incineration facilities, (ii) alleged overstatement of the Company's earnings for 1992 and the first quarter of 1993 due to failure to write down the value of such assets and other matters and (iii) the alleged existence of certain adverse hazardous waste treatment and disposal industry conditions and trends. The lawsuits also allege, among other things, liability on the part of WMX for the above-described alleged violations. The lawsuits seek to represent a class of persons consisting of all purchasers of the Company's common stock during the period of February 4, 1993 through September 3, 1993 and to recover compensation for damages allegedly suffered by such class due to the above-described alleged violations. The Company and WMX believe that they have meritorious defenses to these lawsuits and intend to contest the lawsuits vigorously. The Company and WMX have brought suit against a substantial number of insurance carriers in an action entitled Waste Management, Inc. et al. v. The Admiral Insurance Company, et al. pending in the Superior court in Hudson County, New Jersey. In this action the Company is seeking a declaratory judgment that environmental liabilities asserted against the Company or its subsidiaries, or that may be asserted in the future, are covered by insurance policies purchased by the Company or its affiliates. The Company is also seeking to recover defense costs and other damages incurred as a result of the assertion of environmental liabilities against the Company or its subsidiaries and the defendant insurance carriers' denial of coverage of such liabilities over several years at approximately 34 sites. The defendants have denied liability to the Company and have asserted various defenses, including that environmental liabilities of the type for which the Company is seeking relief are not risks covered by the insurance policies in question. The defendants have indicated that they intend to contest these claims vigorously. Discovery is currently underway in this proceeding and is expected to continue for several years. No trial date has been set. The Company is unable at this time to predict the outcome of this proceeding. No amounts have been recognized in the Company's financial statements for any potential recoveries. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were submitted to the Company's security holders during the fourth quarter of 1993. EXECUTIVE OFFICERS OF THE REGISTRANT. Set forth below are the names and ages of the Company's executive officers (as defined by regulations of the Securities and Exchange Commission), the positions they hold with the Company, their terms as officers and summaries of their business experience. Executive officers are elected by the Board of Directors and serve at the discretion of the Board. D. P. Payne, age 51, has served as President and Chief Executive Officer and a director of the Company since September 1991. From August 1990 to May 1993, he also served as a Senior Vice President of WMX. Prior thereto, Mr. Payne had been Vice President and Area General Manager of the Midwestern Area of International Business Machines Corporation since prior to 1987. Mr. Payne is also a director of Rust. Brian J. Clarke, age 34, has served as Vice President and General Counsel of the Company since January 1994. From July 1992 to January 1994 he served as Regional Vice President and General Counsel of the Company's Thermal Operations Group. Prior thereto he served as Counsel to the Company for more than the past five years. Jerome D. Girsch, age 48, has been Executive Vice President, Treasurer and Controller and Chief Financial Officer and a director of the Company since March 1993. Mr. Girsch served as Vice President of WMX from 1981 to May 1993, as Controller of WMX from 1986 to 1990 and as principal accounting officer of WMX from April 1988 to 1990. From August 1992 until March 1993, Mr. Girsch served as President of the Midwest Group of Waste Management, Inc., a wholly owned subsidiary of WMX ("WMI"). From January 1990 until August 1992, Mr. Girsch served as Executive Vice President of WMI. Dr. Rodger D. Henson, age 50, has served as Vice President of the Company and as President of its Treatment and Land Disposal Operations Group, since December 1992. From July 1992 until December 1992, he served as Vice President- - -Central Region of the Company. From November 1990 until July 1992, he served as Vice President--Southern Region and from January 1990 until November 1990, he served as Vice President--Regional Operations of the Company. Prior thereto he served as General Manager of the Company's Emelle, Alabama facility for more than the past five years. Richard C. Scherr, age 47, has served as Vice President--Environment, Health and Safety of the Company since August 1992. From September 1990 through August 1992, he served as Vice President of the Southern Region of ENSR Consulting and Engineering/American NuKem Corporation, an environmental and engineering consulting firm ("ENSR"). From April 1990 to September 1990, he served as Vice President and General Manager of ENSR. From March 1989 until April 1990, he served as General Manager of the Houston office of ENSR. Prior thereto, he served as Associate Director, Packaged Soap and Detergents Product Supply for The Procter & Gamble Company for more than the past five years. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company's common stock is traded on the New York Stock Exchange and the Chicago Stock Exchange under the symbol "CHW." The following table sets forth by quarter for the last two years the high and low sale prices of the Company's common stock on the New York Stock Exchange Composite Tape, as reported by The Wall Street Journal (Midwest Edition), and the dividends declared by the Company's Board of Directors on its common stock. 1992 Quarterly Summary ---------------------- 1993 Quarterly Summary ---------------------- At March 23, 1994, the Company had approximately 5,107 stockholders of record. In August 1993, the Board of Directors suspended indefinitely the payment of quarterly cash dividends on the Company's common stock. Future cash dividends, if any, will be considered by the Board of Directors based upon the Company's earnings and financial position and such other factors as the Board of Directors considers relevant. Due in part to the high level of public awareness of the business in which the Company is engaged, regulatory enforcement proceedings or other unfavorable developments involving the Company's operations or facilities, including those in the ordinary course of business, may be expected to engender substantial publicity which could from time to time have an adverse impact upon the market price for the Company's common stock. In November 1992, the Company announced a 24-month extension of its authorization to purchase up to an aggregate of 10,000,000 shares of its common stock from time to time in the open market or in privately negotiated transactions. During 1991, 1992 and 1993, the Company purchased 2,610,700 shares, 1,451,100 shares and 3,300,300 shares, respectively. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. The following selected consolidated financial information for each of the five years in the period ended December 31, 1993 is derived from the Company's Consolidated Financial Statements, which have been audited by Arthur Andersen & Co., independent public accountants, whose report thereon is incorporated by reference in this report. The information below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Company's Consolidated Financial Statements, and the related Notes, and the other financial information which are filed as exhibits to this report and incorporated herein by reference. Chemical Waste Management, Inc. and Subsidiaries Selected Consolidated Financial Data for the Years Ended December 31 (000's omitted except per share amounts) /1/ Results for 1993 reflect the consolidation of Rust. See Note 1 to the Company's Consolidated Financial Statements filed as an exhibit to this report and incorporated herein by reference. /2/ Includes special charges of $36 million in 1991, $111.2 million in 1992, and $550 million in 1993. See Note 17 to the Company's Consolidated Financial Statements filed as an exhibit to this report and incorporated herein by reference. /3/ Includes non-taxable gains of $10.7 million in 1991, $47 million in 1992, and $10.5 million in 1993 resulting from issuance of stock by subsidiary and equity investee. See Note 2 to the Company's Consolidated Financial Statements filed as an exhibit to this report and incorporated herein by reference. /4/ In August 1993, the Board of Directors suspended indefinitely the payment of quarterly cash dividends on the Company's common stock. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Reference is made to Management's Discussion and Analysis of Financial Condition and Results of Operations set forth on pages 7 to 14 of the Company's 1993 Annual Report to Stockholders (the "Annual Report"), which discussion is filed as an exhibit to this report and incorporated herein by reference. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. (a) The Consolidated Balance Sheets as of December 31, 1992 and 1993, Consolidated Statements of Income, Stockholders' Equity and Cash Flows for each of the years in the three-year period ended December 31, 1993, and Notes to Consolidated Financial Statements set forth on pages 15 to 35 of the Annual Report, and the Report of Arthur Andersen & Co. on page 36 of the Annual Report are filed as an exhibit to this report and incorporated herein by reference. (b) Selected Quarterly Financial Data (unaudited) are set forth in Note 19 to the Consolidated Financial Statements filed as an exhibit to this report and incorporated herein by reference. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Reference is made to the information set forth in the first 12 paragraphs under the caption "Election of Directors" beginning on page 2 of the Company's proxy statement for the annual meeting scheduled for May 5, 1994 ("Proxy Statement"), incorporated herein by reference, for a description of the directors of the Company, and in the fourth footnote to the table captioned "Ownership of Company Common Stock" on page 5 of the Proxy Statement, incorporated herein by reference, for information with respect to compliance with Section 16(a) of the Securities Exchange Act of 1934. Information concerning the executive officers of the Company is set forth above under "Executive Officers of the Registrant." ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. Reference is made to the information set forth under the caption "Compensation" on pages 8 through 13 of the Proxy Statement, which information, except for the Report of the Compensation and Stock Option Committee and the graph and table of Company Stock Performance included therein, is incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Reference is made to information set forth in the paragraph under the caption "Information With Respect to Certain Stockholder" on pages 1 and 2 of the Proxy Statement and in the tables, including the respective footnotes thereto, set forth under the caption "Securities Ownership of Management," on pages 4, 5 and 6 of the Proxy Statement, for certain information respecting ownership of common stock of the Company, WMX and Rust, which paragraph, tables and footnotes are incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Reference is made to the information set forth under the caption "Certain Transactions" on pages 19 through 23 of the Proxy Statement for information with respect to certain relationships and related transactions, which information is incorporated herein by reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) Financial Statements, Schedules and Exhibits. I. Financial Statements--filed as an exhibit hereto and incorporated herein by reference. (i) Report of Independent Public Accountants; (ii) Consolidated Balance Sheets--December 31, 1992 and 1993; (iii) Consolidated Statements of Income for the Three Years Ended December 31, 1993; (iv) Consolidated Statements of Stockholders' Equity for the Three Years Ended December 31, 1993; (v) Consolidated Statements of Cash Flows for the Three Years Ended December 31, 1993; and (vi) Notes to Consolidated Financial Statements. II. Schedules. (i) Report of Independent Public Accountants on Schedules; (ii) Schedule II--Amounts Receivable from Officers, Employees and Related Parties; (iii) Schedule V--Property and Equipment; (iv) Schedule VI--Accumulated Depreciation and Amortization of Property and Equipment; (v) Schedule VIII--Reserves; (vi) Schedule IX--Short-Term Borrowings; and (vii) Schedule X--Supplementary Income Statement Information. All other schedules have been omitted since the required information is not significant or is included in the financial statements or the notes thereto, or is not applicable. III. Exhibits. The exhibits to this report are listed in the Exhibit Index elsewhere herein. Included in the exhibits listed therein are the following exhibits which constitute management contracts or compensatory plans or arrangements: (i) 1986 Stock Option Plan, as amended, of registrant (Exhibit 10.1 to registrant's report on form 10-K for the year ended December 31, 1989)* (ii) 1986 Stock Option Plan for Non-Employee Directors of registrant (Exhibit 10.2 to the registration statement (no. 33-8509) on form S-1 filed by the registrant under the Securities Act of 1933)* (iii) Corporate Incentive Bonus Plan of registrant** (iv) Chemical Waste Management, Inc. Amended and Restated Long Term Incentive Bonus Plan** (v) Deferred Director's Fee Plan of registrant (Exhibit 10.5 to the registration statement (no. 33-8509) on form S-1 filed by the registrant under the Securities Act of 1933)* (vi) WMX Technologies, Inc. Amended and Restated Supplemental Executive Retirement Plan (Exhibit 10.9 to the report on form 10-K filed by WMX Technologies, Inc. for the year ended December 31, 1993)* (vii) Chemical Waste Management, Inc. Supplemental Executive Retirement Plan** (viii) Director's Charitable Endowment Plan (Exhibit 10.16 to registrant's report on form 10-K for the year ended December 31, 1990)* (ix) Rust International Inc. 1993 Stock Option Plan (Exhibit 10.41 to the report on form 10-K filed by WMX Technologies, Inc. for the year ended December 31, 1992)* (x) Rust International Inc. Stock Option Plan for Non-Employee Directors (Exhibit 10.42 to the report on form 10-K filed by WMX Technologies, Inc. for the year ended December 31, 1992)* (xi) 1992 Stock Option Plan of registrant (Exhibit 10.19 to registrant's report on form 10-K for the year ended December 31, 1991)* (xii) 1992 Stock Option Plan for Non-Employee Directors of registrant (Exhibit 10.20 to registrant's report on form 10-K for the year ended December 31, 1991)* (xiii) Consulting agreement dated May 1, 1993 between registrant and Kay Hahn Harrell** (b) Reports on Form 8-K. The registrant did not file any reports on Form 8-K during the fiscal quarter ended December 31, 1993. - ----------------- * Incorporated by reference to the indicated exhibit and document; in the case of references to documents filed under the Securities Exchange Act of 1934, the registrant's file number under that Act is 1-9253, and WMX Technologies, Inc.'s is 1-7327. ** Filed with this report. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULES To the Stockholders and the Board of Directors of Chemical Waste Management, Inc.: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in Chemical Waste Management, Inc.'s Annual Report to Stockholders for 1993 incorporated by reference in this Form 10-K, and have issued our report thereon dated February 7, 1994. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in the index above are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic consolidated financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic consolidated financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. /s/ Arthur Andersen & Co. ARTHUR ANDERSEN & CO. Chicago, Illinois, February 7, 1994 CHEMICAL WASTE MANAGEMENT, INC. AND SUBSIDIARIES SCHEDULE II--AMOUNTS RECEIVABLE FROM OFFICERS, EMPLOYEES AND RELATED PARTIES ($000'S OMITTED) The Company's general policy is not to advance monies to officers or employees except for relocation or temporary situations. It has, however, adopted a policy of making interest-free loans available to employees whose exercise of non-qualified stock options results in ordinary income to them in excess of $10,000 at the time of such exercise. These receivables are due on or before April 15 of the year following such exercise (extended to November 30, 1992 for loans made during 1991 and to May 31, 1993 for loans made during 1992). Sufficient shares are withheld from the shares issued to the debtor to fully secure the loan at the time it is made. /1/ Interest-free loan related to an acquisition ================================================================================ CHEMICAL WASTE MANAGEMENT, INC. AND SUBSIDIARIES SCHEDULE V--PROPERTY AND EQUIPMENT ($000'S OMITTED) - -------------- (1) Includes writedown of assets relating to special charges in 1992 and 1993. See Note 17 to the Company's Consolidated Financial Statements filed as an exhibit to this report and incorporated herein by reference. (2) Transfers between the Company and WMX Technologies, Inc. and its affiliates, reclassifications and assets contributed by Wheelabrator Technologies Inc. in the 1/1/93 formation of Rust International Inc. ================================================================================ CHEMICAL WASTE MANAGEMENT, INC. AND SUBSIDIARIES SCHEDULE VI--ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY AND EQUIPMENT ($000'S OMITTED) - --------------------- (1) Includes writedown of assets relating to special charges in 1992 and 1993. See Note 17 to the Company's Consolidated Financial Statements filed as an exhibit to this report and incorporated herein by reference. (2) Transfers between the Company and WMX Technologies, Inc. and its affiliates, reclassifications and accumulated depreciation of the businesses contributed by Wheelabrator Technologies Inc. in the 1/1/93 formation of Rust International Inc. ================================================================================ CHEMICAL WASTE MANAGEMENT, INC. AND SUBSIDIARIES SCHEDULE VIII--RESERVES ($000'S OMITTED) - --------------- (1) Reserves of purchased companies, transfers between the Company and WMX Technologies, Inc. and its affiliates, and reserves of the businesses contributed by Wheelabrator Technologies Inc. in the 1/1/93 formation of Rust International Inc. ================================================================================ CHEMICAL WASTE MANAGEMENT, INC. AND SUBSIDIARIES SCHEDULE X--SUPPLEMENTARY INCOME STATEMENT INFORMATION ($000'S OMITTED) ================================================================================ ================================================================================ SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED, IN OAK BROOK, ILLINOIS ON THE 25TH DAY OF MARCH, 1994. CHEMICAL WASTE MANAGEMENT, INC. By: /s/ D. P. Payne -------------------------------------- D. P. Payne, President and Chief Executive Officer PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATE INDICATED. CHEMICAL WASTE MANAGEMENT, INC. EXHIBIT INDEX Number and Description of Exhibit --------------------------------- 1. Inapplicable 2. Inapplicable 3.1 Restated certificate of incorporation of registrant* and amendments thereto (Exhibit 4.1 to registrant's report on form 10-Q for the quarter ended June 30, 1990)** 3.2 Bylaws of registrant (Exhibit 3.2 to registrant's report on form 10-K for the year ended December 31, 1991)** 4.1 Trust Indenture for Liquid Yield Option Notes due 2010 (Exhibit 4.1 to the registration statement (no. 33-36212) on form S-3 filed by the registrant under the Securities Act of 1933)** 5. Inapplicable 6. Inapplicable 7. Inapplicable 8. Inapplicable 9. None 10.1 1986 Stock Option Plan, as amended, of registrant (Exhibit 10.1 to registrant's report on form 10-K for the year ended December 31, 1989)** 10.2 1986 Stock Option Plan for Non-Employee Directors of registrant* 10.3 Corporate Incentive Bonus Plan of registrant 10.4 Chemical Waste Management, Inc. Amended and Restated Long Term Incentive Plan 10.5 Deferred Director's Fee Plan of registrant* 10.6 Intercorporate Agreement dated as of September 3, 1986 between registrant and WMX Technologies, Inc.* 10.7 Second Amended and Restated Corporate and Administrative Services Agreement dated as of May 17, 1993 between registrant and WMX Technologies, Inc. 10.8 Tax Sharing Agreement dated as of September 30, 1986 between registrant and WMX Technologies, Inc.* - -------- * Incorporated by reference to the correspondingly numbered exhibit to the registration statement (no. 33-8509) on form S-1 filed by the registrant under the Securities Act of 1933. ** Incorporated by reference to the indicated exhibit and document; in the case of references to documents filed under the Securities Exchange Act of 1934, the registrant's file number under the Act is 1-9253, and WMX Technologies, Inc.'s is 1-7327. EX-1 Number and Description of Exhibit --------------------------------- 10.9 Registration Rights Agreement dated as of September 30, 1986 between registrant and WMX Technologies, Inc.* 10.10 Lease agreement dated April 6, 1976 between the State of South Carolina and Chem-Nuclear Systems, Inc., and four amendments thereto* 10.11 Lease agreement dated as of November 16, 1990 between the Chicago Regional Port District and a subsidiary of registrant (Exhibit 10.12 to registrant's report on form 10-K for the year ended December 31, 1990)** 10.12 Amendment No. 1 dated as of January 1, 1992 to Intercorporate Agreement dated as of September 3, 1986 between WMX Technologies, Inc. and registrant (Exhibit 10.7(b) to the report on form 10-K filed by WMX Technologies, Inc. for the year ended December 31, 1991)** 10.13 WMX Technologies, Inc. Amended and Restated Supplemental Executive Retirement Plan (Exhibit 10.9 to the report on form 10-K filed by WMX Technologies, Inc. for the year ended December 31, 1993)** 10.14 Chemical Waste Management, Inc. Supplemental Executive Retirement Plan 10.15 Directors' Charitable Endowment Plan (Exhibit 10.16 to registrant's report on form 10-K for the year ended December 31, 1990)** 10.16 Rust International Inc. 1993 Stock Option Plan (Exhibit 10.41 to the report on form 10-K filed by WMX Technologies, Inc. for the year ended December 31, 1992)** 10.17 Rust International Inc. 1993 Stock Option Plan for Non-Employee Directors (Exhibit 10.42 to the report on form 10-K filed by WMX Technologies, Inc. for the year ended December 31, 1992)** 10.18 First Amended and Restated International Business Opportunities Agreement dated as of January 1, 1993 among registrant, WMX Technologies, Inc., Wheelabrator Technologies Inc., Waste Management International, Inc., Waste Management International plc and Rust International Inc. (Exhibit 28 to the registration statement (no. 33- 59606) on form S-3 filed by Wheelabrator Technologies Inc.)** 10.19 Amendment dated as of January 28, 1994 to First Amended and Restated International Business Opportunities Agreement dated as of January 1, 1993 among registrant, WMX Technologies, Inc., Wheelabrator Technologies Inc., Waste Management International, Inc., Waste Management International plc and Rust International Inc. 10.20 Rust Intercorporate Services Agreement dated as of January 1, 1993 among registrant, WMX Technologies, Inc., Wheelabrator Technologies Inc. and Rust International Inc. (Exhibit 10.18 to registrant's report on form 10-K for the year ended December 31, 1992)** 10.21 Amendment No. 1 dated as of August 10, 1993 to Rust Intercorporate Services Agreement dated as of January 1, 1993 among registrant, WMX Technologies, Inc., Wheelabrator Technologies Inc. and Rust International Inc. - -------- * Incorporated by reference to the correspondingly numbered exhibit to the registration statement (no. 33-8509) on form S-1 filed by the registrant under the Securities Act of 1933. ** Incorporated by reference to the indicated exhibit and document; in the case of references to documents filed under the Securities Exchange Act of 1934, the registrant's file number under the Act is 1-9253, and WMX Technologies, Inc.'s is 1-7327. EX-2 Number and Description of Exhibit --------------------------------- 10.22 1992 Stock Option Plan of registrant (Exhibit 10.19 to registrant's report on form 10-K for the year ended December 31, 1991)** 10.23 1992 Stock Option Plan for Non-Employee Directors of registrant (Exhibit 10.20 to registrant's report on form 10-K for the year ended December 31, 1991)** 10.24 Organizational Agreement dated as of December 31, 1992 among registrant, The Brand Companies, Inc. and Wheelabrator Technologies Inc. (Exhibit 7 to Amendment No. 6 to Statement on Schedule 13D filed on January 5, 1993 by WMX Technologies, Inc., the registrant and Wheelabrator Technologies Inc. relating to securities of The Brand Companies, Inc.)** 10.25 Consulting agreement dated May 1, 1993 between registrant and Kay Hahn Harrell 11. None 12. None 13.1 Management's Discussion and Analysis of Financial Condition and Results of Operations 13.2 Financial Statements and Supplementary Data 14. Inapplicable 15. Inapplicable 16. None 17. Inapplicable 18. None 19. Inapplicable 20. Inapplicable 21. List of subsidiaries of registrant 22. Inapplicable 23. Consent of independent public accountants 24. None 25. Inapplicable 26. Inapplicable - -------- * Incorporated by reference to the correspondingly numbered exhibit to the registration statement (no. 33-8509) on form S-1 filed by the registrant under the Securities Act of 1933. ** Incorporated by reference to the indicated exhibit and document; in the case of references to documents filed under the Securities Exchange Act of 1934, the registrant's file number under the Act is 1-9253, and WMX Technologies, Inc.'s is 1-7327. EX-3 Number and Description of Exhibit --------------------------------- 27. Inapplicable 28. None - -------- * Incorporated by reference to the correspondingly numbered exhibit to the registration statement (no. 33-8509) on form S-1 filed by the registrant under the Securities Act of 1933. ** Incorporated by reference to the indicated exhibit and document; in the case of references to documents filed under the Securities Exchange Act of 1934, the registrant's file number under the Act is 1-9253, and WMX Technologies, Inc.'s is 1-7327. EX-4

50178_1993.txt

50178

1993

ITEM 1. BUSINESS General Indiana Bell Telephone Company, Incorporated (the Company) is incorporated under the laws of the State of Indiana and has its principal offices at 240 North Meridian Street, Indianapolis, Indiana 46204 (telephone number 317-265-2266). The Company is a wholly owned subsidiary of Ameritech Corporation (Ameritech), a Delaware corporation. Ameritech is the parent of the Company, Illinois Bell Telephone Company, Michigan Bell Telephone Company, The Ohio Bell Telephone Company and Wisconsin Bell, Inc. (the landline telephone companies), as well as several other communications businesses, and has its principal executive offices at 30 South Wacker Drive, Chicago, Illinois 60606 (telephone number 312-750-5000). The Company is managed by its sole shareholder rather than a Board of Directors as permitted by Indiana Business Corporation Law. In 1993, Ameritech restructured its landline telephone companies and two other related businesses into a structure of customer-specific business units supported by a single, regionally coordinated network unit. The landline telephone companies continue to function as legal entities, owning assets in each state and continue to be regulated by the individual state public utility commissions. Products and services are now marketed under a single common brand identity, "Ameritech," rather than the "Bell" name. While the Ameritech logo is now used to identify all the Ameritech companies, the Company is sometimes regionally identified as Ameritech Indiana. The Company is engaged in the business of furnishing a wide variety of advanced telecommunications services in Indiana, including local exchange and toll service and network access services. In accordance with the Consent Decree and resulting Plan of Reorganization (Plan) described below, the Company provides two basic types of telecommunications services within specified geographical areas termed Local Access and Transport Areas (LATAs), which are generally centered on a city or other identifiable community of interest. The first of these services is the transporting of telecommunications traffic between telephones and other equipment on customers' premises located within the same LATA (intraLATA service), which can include toll service as well as local service. The second service is providing exchange access service, which links a customer's telephone or other equipment to the network of transmission facilities of interexchange carriers which provide telecommunications service between LATAs (interLATA service). About 64% of the population and 28% of the area of Indiana is served by the Company. The remainder of the State is served by other local telecommunications companies. Fort Wayne and Terre Haute are the only cities of over 50,000 population in the State in which local service is provided by another telephone company. Other communications services offered by the Company include data transmission, transmission of radio and television programs and private line voice and data services. The following table sets forth for the Company the number of customer lines in service at the end of each year. Thousands 1993 1992 1991 1990 1989 Customer Lines in Service 1,855 1,770 1,711 1,670 1,619 The Company has an agreement with Ameritech Publishing, Inc. (Ameritech Publishing), an Ameritech business unit doing business as "Ameritech Advertising Services," under which Ameritech Publishing publishes and distributes classified directories under a license from the Company and provides services to the Company relating to both classified and alphabetical directories. Ameritech Publishing pays license fees to the Company under the agreements. Ameritech Services, Inc. (ASI) is a company jointly owned by the Company and the other Ameritech landline telephone companies. ASI provides to those companies human resources, technical, marketing, regulatory planning and real estate asset management services, purchasing and material management support, as well as labor contract bargaining oversight and coordination. ASI acts as a shared resource for the Ameritech subsidiaries providing operational support for the landline telephone companies and integrated communications and information systems for all the business units. Ameritech Information Systems, Inc., a subsidiary of Ameritech, sells, installs and maintains business customer premises equipment and sells network and central office-based services provided by the Company and the other four landline telephone companies. It also provides expanded marketing, product support and technical design resources to large business customers in the Ameritech region. In 1993, about 94% of the total operating revenues of the Company were from telecommunications services and the remainder principally from billing and collection services, rents, directory advertising and other miscellaneous nonregulated operations. About 70% of the revenues from communication services were attributable to intrastate operations. Capital Expenditures Capital expenditures represent the single largest use of Company funds. The Company has been making and expects to continue to make large capital expenditures to meet the demand for telecommunications services and to further improve such services. The total investment in telecommunications plant increased from about $2,717,000 at December 31, 1988, to about $2,983,000 at December 31, 1993, after giving effect to retirements but before deducting accumulated depreciation at either date. Capital expenditures of the Company since January 1, 1989 were approximately as follows: 1989.....$188,700,000 1992.....$201,500,000 1990..... 200,400,000 1993..... 162,900,000 1991..... 196,300,000 Expanding on the aggressive deployment plan began in 1992, in January 1994, Ameritech unveiled a multi-billion dollar plan for a digital network to deliver video services. Ameritech is launching a digital video network upgrade that by the end of the decade will enable six million customers in its region to access interactive information and entertainment services, as well as traditional cable TV services, from their homes, schools, offices, libraries and hospitals. The Company, for its part in the network upgrade, has made an initial filing with the Federal Communications Commission (FCC) seeking approval of the program. The filing reflects capital expenditures of approximately $49,000,000 over the next three years. The Company may also, depending on market demand, make additional capital expenditures under the digital video network upgrade program. The Company anticipates that its capital expenditures for the program will be funded without increasing its recent historical level of capital expenditures. Capital expenditures are expected to be about $146,000,000 in 1994. This amount excludes any capital expenditures that may occur in 1994 related to the above described video network upgrade program. The video network concept, along with other competitive concerns, is discussed on page 11. Consent Decree and Line of Business Restrictions On August 24, 1982, the United States District Court for the District of Columbia (Court) approved and entered a consent decree entitled "Modification of Final Judgment" (Consent Decree), which arose out of antitrust litigation brought by the Department of Justice (DOJ), and which required American Telephone and Telegraph Company (AT&T) to divest itself of ownership of those portions of its wholly owned Bell operating communications company subsidiaries (Bell Companies) that related to exchange telecommunications, exchange access and printed directory advertising, as well as AT&T's cellular mobile communications business. On August 5, 1983, the Court approved a Plan of Reorganization (Plan) outlining the method by which AT&T would comply with the Consent Decree. Pursuant to the Consent Decree and the Plan, effective January 1, 1984, AT&T divested itself of, by transferring to Ameritech, one of the seven regional holding companies (RHCs) resulting from divestiture, its ownership of the exchange telecommunications, exchange access and printed directory advertising portions of the Ameritech landline telephone companies, as well as its regional cellular mobile communications business. The Consent Decree, as originally approved by the Court in 1982, provided that the Company (as well as the other Bell Companies) could not, directly or through an affiliated enterprise, provide interLATA telecommunications services or information services, manufacture or provide telecommunications products or provide any product or service, except exchange telecommunications and exchange access service, that is not a natural monopoly service actually regulated by tariff. The Consent Decree allowed the Company and the other Bell Companies to provide printed directory advertising and to provide, but not manufacture, customer premises equipment. The Consent Decree provided that the Court could grant a waiver to a Bell Company or its affiliates upon a showing to the Court that there is no substantial possibility that the Bell Company could use its monopoly power to impede competition in the market it seeks to enter. The Court has, from time to time, granted waivers to the Company and other Bell Companies to engage in various activities. The Court's order approving the Consent Decree provided for periodic reviews of the restrictions imposed by it. Following the first triennial review, in decisions handed down in September 1987 and March 1988, the Court continued the prohibitions against Bell Company manufacturing of telecommunications products and provision of interLATA services. The rulings allowed limited provision of information services by transmission of information and provision of information gateways, but excluded generation or manipulation of information content. In addition, the rulings eliminated the need for a waiver for entry into non-telephone related businesses. In April 1990, a Federal appeals court decision affirmed the Court's decision continuing the restriction on Bell Company entry into interLATA services and the manufacture of telecommunications equipment, but directed the Court to review its ruling that restricted RHC involvement in the information services business and to determine whether removal of the information services restriction would be in the public interest. In July 1991, the Court lifted the information services ban but stayed the effect of the decision pending outcome of the appeals process. Soon after the stay was lifted on appeal and in July 1993, the U.S. Court of Appeals unanimously upheld the Court's order allowing the Bell Companies to produce and package information for sale across business and home phone lines. In November 1993, the U.S. Supreme Court declined to review the lower court ruling. Members of Congress and the White House are intensifying efforts to enact legislative reform of telecommunications policy in order to stimulate the development of a modern national information infrastructure to bring the benefits of advanced communications and information services to the American people. Intrastate Rates and Regulation The Company, in providing communications services, is subject to regulation by the Indiana Utility Regulatory Commission (IURC) with respect to intrastate rates and services, depreciation rates (for intrastate services), issuance of securities and other matters. Unless otherwise indicated, the amounts of the changes in revenues resulting from changes in intrastate rates referred to below are stated on an annual basis and are estimates without adjustment for subsequent changes in volumes of business. There were no major changes in intrastate rates in 1989. The principal changes in intrastate rates authorized since January 1, 1990 were reductions of intrastate carrier access rates of $11,015,000, $762,000, $1,882,000 and $5,125,000 in 1990, 1991, 1992 and 1993, respectively, in order to achieve parity with interstate rates. As a result of an agreement on a settlement with the IURC, Touch-Tone rates were reduced $12,832,000 in 1992 and intraLATA toll rates were reduced $5,272,000 and $15,518,000 in 1990 and 1993, respectively. FCC Regulatory Jurisdiction The Company is also subject to the jurisdiction of the Federal Communications Commission (FCC) with respect to intraLATA interstate services, interstate access services and other matters. The FCC prescribes for communications companies a uniform system of accounts apportioning costs between regulated and non-regulated services, depreciation rates (for interstate services) and the principles and standard procedures (separations procedures) used to separate property costs, revenues, expenses, taxes and reserves between those applicable to interstate services under the jurisdiction of the FCC and those applicable to services under the jurisdiction of the respective state regulatory authorities. For certain companies, including the Company, interstate services regulated by the FCC are covered by a price cap plan. The Plan creates incentives to improve productivity over benchmark levels in order to retain higher earnings. Price cap regulation sets maximum limits on the prices that may be charged for telecommunications services but also provides for a sharing of productivity gains. Earnings in excess of 12.25% will result in prospective reduction to the price ceilings on interstate services. In January 1994, the FCC began a scheduled fourth-year comprehensive review of price cap regulation for local exchange companies. Access Charge Arrangements Interstate Access Charges The Ameritech landline telephone companies provide access services for the origination and termination of interstate telecommunications. The access charges are of three types: common line, switched access and trunking. The common line portion of interstate revenue requirements are recovered through monthly subscriber line charges and per minute carrier common line charges. The carrier common line rates include recovery of transitional and long-term support payments for distribution to other local exchange carriers. Transitional support payments were made over a four-year period which ended on April 1, 1993. Long-term support payments will continue indefinitely. Effective January 1, 1994, rates for local transport services were restructured and a new "trunking" service category was created. Trunking services consist of two types: those associated with the local transport element of switched access and those associated with special access. Trunking services associated with switched access handle the transmission of traffic between a local exchange carrier's serving wire center and a Company end office where local switching occurs. Trunking services associated with special access handle the transmission of telecommunications services between any two customer-designated premises or between a customer-designated premise and a Company end office where multiplexing occurs. High volume customers generally use the flat-rated dedicated facilities associated with special access, while usage sensitive rates apply for lower-volume customers that utilize a common switching center. Local transport rate elements for switched services assess a flat monthly rate and a mileage sensitive rate for the physical facility between the customer's point of termination and the end office, a usage sensitive and mileage sensitive rate assessed for the facilities between the end office through the access tandem to the customer's serving wire center, and a minute of use charge assessed to all local transport. The flat rate transport rates and structure generally mirror special access rate elements. Customers can order direct transport between the serving wire center or end office and the access tandem and tandem switched transport between the access tandem and the end office. Special access charges are monthly charges assessed to customers for access to interstate private line service. Charges are paid for local distribution channels, interoffice mileage and optional features and functions. State Access Charges Compensation arrangements required in connection with origination and termination of intrastate communications by interexchange carriers are subject to the jurisdiction of the state regulatory commissions. The Ameritech landline telephone companies currently provide access services to interexchange carriers authorized by the state regulatory commissions to provide service between local serving areas pursuant to tariffs which generally parallel the terms of the interstate access tariffs. In the event interexchange carriers are authorized by the state regulatory commissions to provide service within their local serving areas, the Ameritech landline telephone companies intend to provide access service under the same tariffs applicable to intrastate services provided by such carriers between the Ameritech landline telephone companies' local serving areas. Separate arrangements govern compensation between Ameritech landline telephone companies and independent telephone companies for jointly provided communications within the five Ameritech companies' local serving areas and associated independent telephone company exchanges. These arrangements are subject to the jurisdiction of the FCC and the state regulatory commissions. Competition Regulatory, legislative and judicial decisions and technological advances, as well as heightened customer interest in advanced telecommunications services, have expanded the types of available communications services and products and the number of companies offering such services. Market convergence, already a reality, is expected to intensify. The FCC has taken a series of steps that are expanding opportunities for companies to compete with local exchange carriers in providing services that fall under the FCC's jurisdiction. In September 1992, the FCC mandated that local exchange carriers provide network access for special transmission paths to competitive access providers, interexchange carriers and end users. In February 1993, Ameritech filed a tariff with the FCC, which was effective in May, making possible this type of interconnection. In August 1993, the FCC issued an order that permits competitors to interconnect to local telephone company switches. Under the new rules, certain telephone companies must allow all interested parties to terminate their switched access transmission facilities at telephone company central offices, wire centers, tandem switches and certain remote nodes. Ameritech filed a tariff in November 1993 to effect that change in February 1994. Ameritech is seeking opportunities to compete on an equal footing. Although the Company is barred from providing interLATA and nationwide cable services, its competitors are not. Cellular telephone and other wireless technologies are poised to bypass Ameritech's local access network. Cable providers, who currently serve more than eighty percent of American homes, could provide telephone service and have expressed their desire to do so. Certain interexchange carriers and competitive access providers have demonstrated interest in providing local exchange service. Ameritech's plan is to facilitate competition in the local exchange business in order to compete in the total communications marketplace. Customers First: Ameritech's Advanced Universal Access Plan In 1993, Ameritech embarked on a long-range restructuring with the intent of dramatically changing the way it serves its customers, and in the process altered its corporate framework, expanding the nature and scope of its services and supporting the development of a fully competitive marketplace. In March, Ameritech filed a plan with the FCC to change the way local telecommunications services are provided and regulated and to furnish a policy framework for advanced universal access to modern telecommunications services -- voice, data and video information. Ameritech proposes to facilitate competition in the local exchange business by allowing other service providers to purchase components of its network and to repackage them with their own services for resale, in exchange for the freedom to compete in both its existing and currently prohibited businesses. Ameritech has requested regulatory reforms to match the competitive environment as well as support of its efforts to remove restraints, such as the interLATA service restriction, which currently restrict its participation in the full telecommunications marketplace. In addition, Ameritech asks for more flexibility in pricing new and competitive services and replacement of caps on earnings with price regulation. Under the plan, customers would be able to choose from competitive providers for local service as they now can choose a provider for interexchange service. To demonstrate conclusively the substantial customer and economic benefits of full competition, in December 1993, Ameritech proposed a trial of its plan, beginning in 1995. Ameritech has petitioned the DOJ to recommend Federal District Court approval of a waiver of the long- distance restriction of the Consent Decree so that Ameritech can offer interexchange service. At the same time, Ameritech would facilitate the development of local communications markets by unbundling the local network and integrating competitors' switches. The trial would begin in Illinois in the first quarter of 1995 and would last indefinitely. Other states could be added over time. If the trial is approved by the DOJ, the request must be acted on by the Court which retains jurisdiction over administering the terms of the Consent Decree. In February 1994, Ameritech filed tariffs with the Illinois Commerce Commission that propose specific rates and procedures to open the local network in that state. Approval could take up to 11 months. Ameritech has received broad support for the plan from Midwest elected officials, national and Midwest business leaders, and education, health industry, economic development and consumer leaders. The national and local offices of the Communications Workers of America (CWA) and the International Brotherhood of Electrical Workers (IBEW) also support the plan. Ameritech has alternative regulatory proposals pending with the IURC and other state regulatory commissions in its region to support implementation of the plan. Ameritech's Video Network Concept In January 1994, Ameritech filed plans with the FCC to construct a digital video network upgrade that will enable it to reach 6 million customers by the end of the decade. Ameritech expects to spend $4.4 billion to upgrade its network to provide video services, part of a total of approximately $29 billion Ameritech estimates it will spend on network improvements over the next fifteen years. Ameritech is pursuing alliances and partnerships that will position it as a key participant in the emerging era of interactive video experiences. Pending FCC approval of Ameritech's plan and clearing of other regulatory hurdles, the construction of the first phase of the network could begin as soon as the fourth quarter of 1994. The new network, which will be separate from Ameritech's core local communications network, will be expanded to approximately 1 million additional Midwest customers in each of the next five years. Ameritech will be only one of many users of the broadband network. A multitude of competing video information providers, businesses, institutions, interexchange carriers and video telephone customers will also have access to the technology. With the new system, customers will have access to a virtually unlimited variety of programming sources. These will include basic broadcast services, similar to today's cable service, and advanced interactive services such as video on demand, home healthcare, interactive educational software, distance learning, interactive games and shopping, and a variety of other entertainment and information services that can be accessed from homes, offices, schools, hospitals, libraries and other public and private institutions. Cable/Telco Cross Ownership Ban In November 1993, Ameritech filed motions in two federal courts seeking freedom from the ban on providing video services in its own service area. Ameritech asked U.S. District Courts in Illinois and Michigan to declare unconstitutional the provisions of the Cable Act of 1984 that bar the RHCs from providing cable TV service in areas where they hold monopolies on local phone service. In August 1993, a U.S. District Court in Washington, D.C. granted a request by Bell Atlantic Corporation for such an order, but that court denied similar requests by Ameritech and the other RHCs. Legislation has been introduced in Congress that would repeal the cross ownership ban. Employee Relations As of December 31, 1993, the Company employed 5,077 persons, a decrease from 5,486 at December 31, 1992. During 1993, approximately 305 employees left the payroll as a result of voluntary and involuntary workforce programs. This amount includes 45 nonmanagement employees who took advantage of a Supplemental Income Protection Program (SIPP) established under labor agreements to voluntarily exit the workforce. Additional restructuring was done by normal attrition. On March 25, 1994, Ameritech announced that it will reduce its nonmanagement workforce by 6,000 employees by the end of 1995, including approximately 780 at the Company. Under terms of agreements between Ameritech, the CWA and the IBEW, Ameritech is implementing an enhancement to the Ameritech pension plan by adding three years to the age and net credited service of eligible nonmanagement employees who leave the business during a designated period that ends in mid-1995. In addition, Ameritech's network business unit is offering financial incentives under the terms of its current contracts with the CWA and IBEW to selected nonmanagement employees who leave the business before the end of 1995. The reduction of the workforce results from technological improvements, consolidations and initiatives identified by management to balance its cost structure with emerging competition. Approximately 4,067 employees are represented by unions. Of those so represented, about 92 percent are represented by the CWA and about 8 percent are represented by the IBEW, both of which are affiliated with the AFL-CIO. In July and August 1993, the Ameritech landline telephone companies and Ameritech Services reached agreement with the two unions on a workforce transition plan for assigning union-represented employees to the newly established business units. The separate agreements with the CWA and the IBEW extend existing union contracts with the landline telephone companies and Ameritech Services to the new units. The pacts address a number of force assignment, employment security and union representation issues. In 1995, when union contracts are due to expire, the parties will negotiate regional contracts. ITEM 2.

ITEM 2. PROPERTIES The properties of the Company do not lend themselves to description by character and location of principal units. At December 31, 1993, central office equipment represented 36.6% of the Company's investment in telecommunications plant in service; land and buildings (occupied principally by central offices) represented 9.8%; telecommunications instruments and related wiring and equipment, including private branch exchanges, substantially all of which are on the premises of customers, represented 1.4%; and connecting lines which constitute outside plant, the majority of which are on or under public roads, highways or streets and the remainder of which are on or under private property, represented 44.6%. Substantially all of installations of central office equipment and administrative offices are located in buildings owned by the Company situated on land which it owns in fee. Many garages, administrative offices, business offices and some installations of central office equipment are in rented quarters. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS Pre-divestiture Contingent Liabilities Agreement The Plan provides for the recognition and payment of liabilities that are attributable to pre-divestiture events (including transactions to implement the divestiture) but that do not become certain until after divestiture. These contingent liabilities relate principally to litigation and other claims with respect to the former Bell System's rates, taxes, contracts, equal employment matters, environmental matters and torts (including business torts, such as alleged violations of the antitrust laws). With respect to such liabilities, AT&T and the Bell Companies, including the Company, will share the costs of any judgment or other determination of liability entered by a court or administrative agency, the costs of defending the claim (including attorneys' fees and court costs) and the cost of interest or penalties with respect to any such judgment or determination. Except to the extent that affected parties may otherwise agree, the general rule is that responsibility for such contingent liabilities will be divided among AT&T and the Bell Companies on the basis of their relative net investment (defined as total assets less reserves for depreciation) as of the effective date of divestiture. Different allocation rules apply to liabilities which relate exclusively to pre-divestiture interstate or intrastate operations. Although complete assurance cannot be given as to the outcome of any litigation, in the opinion of the Company's management any monetary liability or financial impact to which the Company would be subject after final adjudication or settlement of all such liabilities would not be material in amount to the financial position of the Company. PART II EXHIBIT 28 SELECTED FINANCIAL AND OPERATING DATA INDIANA BELL TELEPHONE COMPANY, INCORPORATED (Dollars in Millions) 1993 1992 1991 1990 1989 Revenues Local service $ 506.7 $ 478.7 $ 477.5 $ 462.6 $ 442.4 Interstate network access 230.6 221.3 215.2 223.8 232.0 Intrastate network access 107.6 100.3 96.3 104.1 97.8 Long distance 148.7 127.2 130.6 128.9 128.6 Other 123.0 118.0 114.3 121.0 117.1 1,116.6 1,045.5 1,033.9 1,040.4 1,017.9 Operating expenses 825.3 775.2 773.1 774.7 757.6 Operating income 291.3 270.3 260.8 265.7 260.3 Interest expense 29.0 34.5 36.8 36.0 37.4 Other income, net (6.4) (5.9) (2.6) (0.9) (2.7) Income taxes 87.2 78.5 73.8 75.9 70.3 Income before extraordinary item and cumulative effect of change in accounting principles 181.5 163.2 152.8 154.7 155.3 Extraordinary item--loss on early extinguishment of debt (14.7) 0.0 0.0 0.0 0.0 Income before cumulative effect of change in accounting principles 166.8 163.2 152.8 154.7 155.3 Cumulative effect of change in accounting principles 0.0 (160.2) 0.0 0.0 0.0 Net income $ 166.8 $ 3.0 $ 152.8 $ 154.7 $ 155.3 Total assets $1,987.5 $2,035.2 $2,044.6 $2,037.8 $1,959.7 Telecommunications plant, net $1,662.3 $1,715.5 $1,722.9 $1,734.4 $1,735.5 Capital expenditures $ 162.9 $ 201.5 $ 196.3 $ 200.4 $ 188.7 Long term debt $ 85.2 $ 392.8 $ 416.5 $ 416.0 $ 416.0 Debt ratio 31.8% 32.8% 33.6% 33.5% 34.4% Pretax interest coverage 10.7 8.6 7.6 7.7 7.5 Return to average equity 20.5% 0.4% 16.7% 17.2% 17.6% Return on average total capital 15.7% 2.8% 13.3% 13.6% 13.7% SELECTED FINANCIAL AND OPERATING DATA INDIANA BELL TELEPHONE COMPANY, INCORPORATED 1993 1992 1991 1990 1989 Customer lines - at end of year (000's) 1,855 1,770 1,711 1,670 1,619 % Customer lines served by digital electronic offices 74.7% 58.7% 49.7% 41.5% 34.3% % Customer lines served by analog electronic offices 25.3% 41.3% 50.3% 55.8% 56.2% % Customer lines served by electromechanical offices 0.0% 0.0% 0.0% 2.7% 9.5% Customer lines per employee 365 323 290 258 241 _____________________________________________________________________________ Local calls per year (000,000's)* 6,382 6,240 5,394 5,341 5,393 Calls per customer line 3,441 3,539 3,152 3,198 3,331 _____________________________________________________________________________ Employees - at end of year 5,077 5,486 5,901 6,477 6,711 * The significant change in local calls from 1991 to 1992 was caused by a change to the Bell Communications Research, Inc. (Bellcore) industry standard for measuring local calls. By using this standard the Company is now measuring local calls under the same method as its Ameritech affiliates. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS (Dollars in Millions) The following is a discussion and analysis of the results of operations of Indiana Bell Telephone Company, Incorporated (the Company) for the year ended December 31, 1993, as compared to the year ended December 31, 1992, which is based on the Statements of Income and Reinvested Earnings on page 23. Other pertinent data are also given in the Selected Financial and Operating Data on page 14. Revenues Total revenues in 1993 and 1992 were $1,116.6 and $1,045.5, respectively, a 6.8% increase. The following paragraphs explain the components of that change: 1993 1992 Increase % Change Local service $506.7 $478.7 $28.0 5.8% Local service revenue increases were primarily due to a $15.2 increase in residence revenues, a $12.2 increase in business revenues, and a $0.3 increase in public revenues. Part of these increases were attributed to a $10.0 credit for business and residence customers from a settlement agreement in 1992. Business access lines increased 8.7% over the same period last year, primarily due to sales of Centrex services and increases in Basic Service. The residence revenue increase occurred despite reductions in Touch-Tone rates effective July 1, 1992 and July 1, 1993. Residence access lines grew 3.0% over the same period last year. As of December 31, 1993, the Company had 1,855,000 total access lines versus 1,770,000 total access lines as of the same date in 1992. 1993 1992 Increase % Change Network access Interstate $230.6 $221.3 $9.3 4.2% Intrastate $107.6 $100.3 $7.3 7.3% Interstate: Interstate access increases included end user revenues of $6.1 from rate and volume increases and carrier common line revenues of $5.7 primarily because of a decrease in NECA settlement payments. These increases were partially offset by decreases in traffic sensitive revenues of $1.7 and special access revenues of $0.8 from rate decreases and volume decreases, respectively. Intrastate: Increases of $6.0 and $1.5 in traffic sensitive and end user revenues, respectively, were offset by a decrease of $0.6 in special access revenues. The traffic sensitive increase was due to higher volume despite lower rates. Revenues increased $6.4 due to a 1993 change in the intrastate settlements process, whereby access expenses are no longer treated as a revenue offset. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS (CONT.) (Dollars in Millions) 1993 1992 Increase % Change Long distance $148.7 $127.2 $21.5 16.9% The increase was due to $31.0 in intrastate and private line revenue previously offset by access expense as discussed in the intrastate network access revenue section above. This increase was offset by $10.1 due to the combined effect of a toll rate reduction effective January 1, 1993 and an increase in volume. These rate reductions also resulted in a decrease in WATS revenue of $1.3. 1993 1992 Increase % Change Other $123.0 $118.0 $5.0 4.2% Other revenues increased due to increases in billing and collection revenue of $1.7, directory advertising revenue of $1.4, and Linebacker, Linebacker Plus, and wire maintenance sales of $3.0. In addition, a $1.3 settlement was received in 1993 from independent companies for directory assisted operator services. These increases were partially offset by an increase in uncollectibles of $2.7. Operating Expenses Total operating expenses were $825.3 in 1993 and $775.2 in 1992. The increase is comprised of the following: 1993 1992 Decrease % Change Employee related expenses $245.1 $265.9 ($20.8) (7.8%) Workforce reductions resulted in decreases in wages, payroll taxes and benefits totaling $27.4. Offsetting the decrease was a normal wage rate increase of $4.2, an increase in overtime of $1.5 and an increase in employee business travel expense of $0.9. During 1993 and 1992, 73 and 326 employees, respectively, and their work functions were transferred to Ameritech Services, Inc. (ASI), an affiliate owned by the Company and the other four Ameritech operating companies. Although this transfer resulted in reduced employee related expenses for the Company, it resulted in an increase in other operating expenses as the Company contracted the transferred services from ASI. As of December 31, 1993, the Company had 5,077 employees versus 5,486 employees as of the same date in 1992. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS (CONT.) (Dollars in Millions) 1993 1992 Increase % Change Depreciation and amortization $215.6 $214.0 $1.6 0.7% The increase in depreciation was a result of plant additions and an intrastate rate represcription in 1993. 1993 1992 Increase % Change Other operating expenses $319.8 $256.0 $63.8 24.9% Other operating expenses consist of contracted services, services from affiliates, materials and supplies, and miscellaneous expenses, such as access charge expenses and advertising. The increase consists of $18.8 in services provided by ASI and $14.4 in contracted services which were both previously provided by Company employees, $4.3 in right- to-use fees, $3.8 in advertising, and $32.1 in access charge expenses which were formerly an offset to revenue. Partially offsetting the increases were decreases of $4.0 in land and building rentals, $1.3 in materials and supplies, and lower service charges from Ameritech Corporation (the Company's parent) and Ameritech Information Systems, Inc. (AIS), an affiliate of the Company, of $4.4 and $0.5, respectively. 1993 1992 Increase % Change Taxes other than income taxes $44.8 $39.3 $5.5 14.0% The increase is primarily comprised of an increase in property taxes of $3.2 and gross receipts taxes of $2.5. The property tax increase is due primarily to an estimated 6.0% rate increase and increased property. The increase in the gross receipts taxes is due to increased revenue and prior year adjustments. Other Income and Expenses 1993 1992 Decrease % Change Interest expense $29.0 $34.5 ($5.5) (15.9%) The decrease from the same period last year resulted primarily from $5.9 in lower interest related to long term debt resulting from bond retirements in 1992 and 1993 offset by an increase in interest paid to the Ameritech short term funding pool. (See Notes D. and E. to the financial statements for further information related to the bond retirements.) MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS (CONT.) (Dollars in Millions) 1993 1992 Increase % Change Other income - net $6.4 $5.9 $0.5 8.5% Other income in 1992 included income of $6.6 from settlements with federal and state taxing authorities, $1.5 in early extinguishment of debt cost and a loss in ASI equity of $1.7. Other income in 1993 does not include early extinguishment of debt costs as these charges have been classified as an extraordinary item on the Statements of Income and Reinvested Earnings. ASI equity in 1993 resulted in income of $3.8. In addition, net interest income from the Ameritech short term funding pool decreased from 1992 to 1993. 1993 1992 Increase % Change Income taxes $87.2 $78.5 $8.7 11.1% The increase in income taxes was due primarily to an increase in taxable income. These increases were partially offset by an unfavorable Federal tax audit settlement in 1992. The effective tax rate for the years ended December 31, 1993 and 1992 was 32.5%. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS (CONT.) (Dollars in Millions) OTHER INFORMATION Regulatory Environment Customer demand, technology and the preferences of policy makers are all converging to increase competition in the local exchange business. The effects of increasing competition are apparent in the marketplace the Company serves. Additionally, increasing volumes of intraLATA long distance services purchased by large and medium sized business customers are sold by carriers other than the Company. Recognizing the trend, the Company's regulatory/public policy activities are focused on achieving a framework that allows for expanding competition while providing a fair opportunity for all carriers, including the Company, to succeed. The cornerstone of this effort is Ameritech's "Customers First Plan" that was filed with the Federal Communications Commission (FCC) on March 1, 1993. In a subsequent filing with the U.S. Department of Justice, Ameritech proposed that the Customers First Plan be implemented on a trial basis beginning in January 1995 in Illinois and other states thereafter. The Customers First Plan proposes to open all of the local telephone business in the Company's service area to competition. In exchange, Ameritech has requested three regulatory changes. First, Ameritech has requested relief from the Modification of Final Judgment (MFJ) interLATA ban. Such relief would mean that the Company would be allowed to offer all long distance services. Second, Ameritech has requested a number of modifications in the FCC's price cap rules. These modifications would apply only to Ameritech, including the Company, and would eliminate any obligation to refund, in the form of its share of future rate reductions, its share of interstate earnings in excess of 12.25%. The modifications would also provide the Company increased ability to price its interstate access services in a manner appropriate to competitive conditions. Third, Ameritech has requested FCC authority to collect in a competitively neutral manner, the social subsidies currently embedded in the rates that the Company charges long distance carriers for access to the local network. Opportunity Indiana On May 4, 1993, the Company filed an alternative regulation proposal with the Indiana Utility Regulatory Commission (the IURC). Under the proposal, traditional rate of return regulation would be eliminated and replaced by a price regulation mechanism, under which future rate changes for basic exchange services would be subject to a predetermined formula reflecting changes in inflation, the Company's historic productivity and actual service quality performance. The proposal would give the Company the ability to set prices for services which are classified as competitive services by the IURC, and the Company would also be able to determine its own depreciation rates. Under the terms of this proposal as originally filed, the Company would agree to freeze basic exchange rates at current levels through the end of 1994, if its proposal was adopted by the IURC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS (CONT.) (Dollars in Millions) On February 21, 1994, the Company entered into a settlement agreement in connection with the proposal with the Office of the Utility Consumer Counselor and other consumer representatives. Under the agreement, the Company agreed to rate reductions totaling $57.5 between May 1994 and June 1996 ($27.7, $13.5 and $16.3 for 1994, 1995 and 1996, respectively), and to price ceilings for basic local service until January 1, 1998 in return for the implementation of its alternative regulation proposal. In addition, the Company also agreed to spend $120.0 in infrastructure investment over the next six years to provide an advanced communications system for schools, hospitals, and major government centers and to contribute an additional $30.0 during that period for equipment and training for schools to take advantage of the advanced system. The agreement remains subject to IURC approval, and the parties to the agreement have requested expedited action by the IURC by April 29, 1994. Effects of Regulatory Accounting The Company presently gives accounting recognition to the actions of regulators where appropriate, as prescribed by Statement of Financial Accounting Standards (SFAS) No. 71, "Accounting for the Effects of Certain Types of Regulation." Under SFAS No. 71, the Company records certain assets and liabilities because of the actions of regulators. Further, amounts charged to operations for depreciation expense reflect estimated useful lives and methods prescribed by regulators rather than those that might otherwise apply to unregulated enterprises. In the event the Company determines that it no longer meets the criteria for following SFAS No. 71, the accounting impact to the Company would be an extraordinary noncash charge to operations of an amount which could be material. Criteria that give rise to the discontinuance of SFAS No. 71 include (1) increasing competition which restricts the Company's ability to establish prices to recover specific costs, and (2) a significant change in the manner in which rates are set by regulators from cost- based regulation to another form of regulation. The Company periodically reviews these criteria to ensure that continuing application of SFAS No. 71 is appropriate. Status of New Business Units In February 1993, following a year-long examination of its business called "Breakthrough Leadership," Ameritech announced it would restructure its business into separate units organized around specific customer groups -- such as residential customers, small businesses, interexchange companies and large corporations -- and a single unit that will run Ameritech's network in Illinois, Indiana, Michigan, Ohio and Wisconsin. The Ameritech Bell Companies will continue to function as legal entities owning current Bell company assets in each state. The network unit will provide network and information technology resources in response to the needs of the other business units. This unit will be the source of network capabilities for products and services offered by the other business units and will be responsible for the development and day-to-day operation of an advanced information infrastructure. All of the business units and the network unit are currently operational. Ameritech has developed a new logo and is marketing all of its products and services under the single brand name "Ameritech." MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS (CONT.) (Dollars in Millions) Digital Video Network In January 1994, Ameritech Corporation (Ameritech), the parent of the Company, announced a program to launch a digital video network upgrade that is expected, by the end of the decade, to make available interactive information and entertainment services, as well as traditional cable TV services, to approximately six million Ameritech customers. The Company has filed an application with the FCC seeking approval of the program. The application reflects capital expenditures of approximately $49.0 over the next three years. The Company may also, depending on market demand, make additional capital expenditures under this program. The Company anticipates that its capital expenditures for the program will be funded without an increase to its recent historical level of capital expenditures. Changes in Accounting Principles Effective January 1, 1993, the Company adopted SFAS No. 109, "Accounting for Income Taxes." The new accounting method is essentially a refinement of the liability method the Company had been following and, accordingly, did not have a material impact on the Company's financial statements upon adoption. As more fully discussed in Note C. to the financial statements, effective January 1, 1992, the Company adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions," and SFAS No. 112, "Employers' Accounting for Postemployment Benefits." The cumulative effect of these accounting changes was recognized in the first quarter of 1992 as a change in accounting principles of $160.2, net of a deferred income tax benefit of $90.3. Workforce Resizing On March 25, 1994, Ameritech announced that it will reduce its nonmanagement workforce by 6,000 employees by the end of 1995, including approximately 780 at the Company. Under terms of agreements between Ameritech, the Communications Workers of America (CWA) and the International Brotherhood of Electrical Workers (IBEW), Ameritech is implementing an enhancement to the Ameritech pension plan by adding three years to the age and net credited service of eligible nonmanagement employees who leave the business during a designated period that ends in mid-1995. In addition, Ameritech's network business unit is offering financial incentives under the terms of its current contracts with the CWA and IBEW to selected nonmanagement employees who leave the business before the end of 1995. The above actions will result in a charge to first quarter 1994 earnings of approximately $68.9, or $42.8 after-tax. A significant portion of the program cost will be funded by Ameritech's pension plan, whereas financial incentives to be paid from Company funds are estimated to be approximately $18.4. Settlement gains, which result from terminated employees accepting lump-sum payments from the pension plan, will be reflected in income as employees leave the payroll. The Company believes this program will reduce its employee-related costs by approximately $39.0 on an annual basis upon completion of this program. The reduction of the workforce results from technological improvements, consolidations and initiatives identified by management to balance its cost structure with emerging competition. INDIANA BELL TELEPHONE COMPANY, INCORPORATED STATEMENTS OF INCOME AND REINVESTED EARNINGS (Dollars in Millions) Year Ended December 31, 1993 1992 1991 REVENUES $1,116.6 $1,045.5 $1,033.9 OPERATING EXPENSES Employee related expenses 245.1 265.9 295.8 Depreciation and amortization 215.6 214.0 209.9 Other operating expenses 319.8 256.0 232.2 Taxes other than income taxes 44.8 39.3 35.2 825.3 775.2 773.1 OPERATING INCOME 291.3 270.3 260.8 Interest expense 29.0 34.5 36.8 Other income - net (6.4) (5.9) (2.6) INCOME BEFORE INCOME TAXES, EXTRAORDINARY ITEM AND CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLES 268.7 241.7 226.6 Income taxes 87.2 78.5 73.8 INCOME BEFORE EXTRAORDINARY ITEM AND CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLES 181.5 163.2 152.8 Extraordinary item--loss on early extinguishment of debt (less income tax benefit of $8.8) (14.7) 0.0 0.0 INCOME BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLES 166.8 163.2 152.8 Cumulative effect of change in accounting principles 0.0 (160.2) 0.0 NET INCOME 166.8 3.0 152.8 REINVESTED EARNINGS, BEGINNING OF YEAR 239.8 346.2 334.9 LESS DIVIDENDS 155.8 109.4 141.5 REINVESTED EARNINGS, END OF YEAR $ 250.8 $ 239.8 $ 346.2 The accompanying notes are an integral part of the financial statements. INDIANA BELL TELEPHONE COMPANY, INCORPORATED BALANCE SHEETS (Dollars in Millions) December 31, December 31, 1993 1992 ASSETS CURRENT ASSETS Cash and temporary cash investments $ 0.6 $ 7.2 Investment in Ameritech funding pool 0.0 3.0 0.6 10.2 Receivables Customers and agents (less allowance for uncollectibles of $5.6 and $3.1, respectively) 160.9 150.0 Ameritech and affiliates 16.6 13.6 Other 9.5 5.9 Material and supplies 6.1 8.8 Prepaid and other 12.7 21.5 206.4 210.0 TELECOMMUNICATIONS PLANT In service 2,945.7 2,901.9 Under construction 37.2 52.1 2,982.9 2,954.0 Less: Accumulated depreciation 1,320.6 1,238.5 1,662.3 1,715.5 INVESTMENTS, principally in affiliate 31.1 25.0 OTHER ASSETS AND DEFERRED CHARGES 87.7 84.7 TOTAL ASSETS $ 1,987.5 $ 2,035.2 The accompanying notes are an integral part of the financial statements. INDIANA BELL TELEPHONE COMPANY, INCORPORATED BALANCE SHEETS (Dollars in Millions) December 31, December 31, 1993 1992 LIABILITIES AND SHAREOWNER'S EQUITY CURRENT LIABILITIES Debt maturing within one year Ameritech $ 75.0 $ 0.0 Other 220.1 0.1 Accounts payable Ameritech Services, Inc. 19.9 21.9 Ameritech and affiliates 13.4 10.7 Other 62.8 79.5 Other current liabilities 178.0 170.7 569.2 282.9 LONG TERM DEBT 85.2 392.8 DEFERRED CREDITS AND OTHER LONG TERM LIABILITIES Accumulated deferred income taxes 163.1 169.7 Unamortized investment tax credits 34.5 41.2 Postretirement benefits other than pensions 224.1 230.8 Long term payable to Ameritech Services, Inc. 9.4 9.9 Other 86.2 103.1 517.3 554.7 SHAREOWNER'S EQUITY Common stock ($40 par value; 15,000,000 shares authorized; 13,490,876 issued and outstanding) 539.6 539.6 Proceeds in excess of par value 25.4 25.4 Reinvested earnings 250.8 239.8 815.8 804.8 TOTAL LIABILITIES AND SHAREOWNER'S EQUITY $ 1,987.5 $ 2,035.2 The accompanying notes are an integral part of the financial statements. INDIANA BELL TELEPHONE COMPANY, INCORPORATED STATEMENTS OF CASH FLOWS (Dollars in Millions) Year Ended December 31, 1993 1992 1991 CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 166.8 $ 3.0 $ 152.8 Adjustments to net income Extraordinary item--loss on early extinguishment of debt 14.7 0.0 0.0 Cumulative effect of change in accounting principles 0.0 160.2 0.0 Depreciation and amortization 215.6 214.0 209.9 Deferred income taxes, net (14.4) (14.7) (13.7) Investment tax credits, net (6.7) (6.3) (8.9) Interest during construction (0.7) (0.5) (0.7) Provision for uncollectibles 7.6 4.9 7.2 Change in accounts receivable (25.7) (1.6) (18.8) Change in materials and supplies 1.2 (1.0) (0.4) Change in prepaid expenses and certain other current assets 1.3 (9.9) (2.9) Change in accounts payable (16.0) 21.3 (13.1) Change in accrued taxes 6.3 (0.3) 7.5 Change in certain other current liabilities 10.8 18.6 34.9 Net change in certain noncurrent assets and liabilities (13.1) (4.2) (20.8) Other (10.4) 2.0 (0.2) Net cash from operating activities 337.3 385.5 332.8 CASH FLOWS FROM INVESTING ACTIVITIES: Capital expenditures, net (162.2) (199.6) (195.6) Proceeds from (cost of) disposals of telecommunications plant 2.0 (1.6) (1.2) Additional investments in ASI (affiliate), principally equity (3.0) (4.0) 0.0 Proceeds from sales of investments 0.0 0.0 1.6 Net cash from investing activities (163.2) (205.2) (195.2) CASH FLOWS FROM FINANCING ACTIVITIES: Net change in short term debt 0.0 0.0 (36.0) Intercompany financing - net 75.0 (43.5) 43.5 Retirements of long term debt (100.0) (24.5) (0.8) Cost of refinancing long term debt (2.9) (1.4) 0.0 Dividend payments (155.8) (109.4) (141.5) Net cash from financing activities (183.7) (178.8) (134.8) The accompanying notes are an integral part of the financial statements. INDIANA BELL TELEPHONE COMPANY, INCORPORATED STATEMENTS OF CASH FLOWS (Dollars in Millions) Year Ended December 31, 1993 1992 1991 Net (decrease) increase in cash and temporary cash investments (9.6) 1.5 2.8 Cash and temporary cash investments at beginning of year 10.2 8.7 5.9 Cash and temporary cash investments at end of year $ 0.6 $ 10.2 $ 8.7 The accompanying notes are an integral part of the financial statements. INDIANA BELL TELEPHONE COMPANY, INCORPORATED NOTES TO FINANCIAL STATEMENTS (Dollars in Millions) Indiana Bell Telephone Company, Incorporated (the Company), is a wholly owned subsidiary of Ameritech Corporation (Ameritech). A. SIGNIFICANT ACCOUNTING POLICIES Basis of Accounting - The financial statements have been prepared in accordance with generally accepted accounting principles. In compliance with Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (SFAS No. 71), the Company recognizes the actions of regulators where appropriate. Such actions can provide reasonable assurance of the existence of an asset, reduce or eliminate the value of an asset, or impose a liability. Actions of a regulator can also eliminate a liability previously imposed by the regulator. Transactions with Affiliates - The Company has various agreements with affiliated companies. Below is a description of the significant arrangements followed by a table of the amounts involved. 1. Ameritech Services, Inc. (ASI) - The Company has a 10% ownership in ASI, an Ameritech controlled affiliate, that provides consolidated planning, development, management, and support services to all of the Ameritech Bell companies. The Company also provides certain services, such as loaned employees, to ASI. 1993 1992 1991 Purchases of materials from ASI $ 87.2 $ 81.0 $ 78.8 Charges for purchases of services from ASI 121.8 100.6 86.8 Recovery of costs for services 12.3 9.2 6.1 provided to ASI 2. Ameritech (the Company's parent) - Ameritech provides various administrative, planning, financial and other services to the Company. These services are billed to the Company at cost. 1993 1992 1991 Charges incurred for services $12.1 $11.5 $13.4 3. Ameritech Publishing, Inc. (API) - The Company has an agreement under which payments are made to the Company by API for license fees and billing and collection services provided by the Company. The Company also purchases directory services from API under the same agreement. 1993 1992 1991 Fees paid to the Company by API $47.8 $46.8 $42.5 Purchases by the Company from API 8.6 8.5 7.5 4. Ameritech Information Systems, Inc. (AIS) - The Company has an agreement whereby the Company reimburses AIS for costs incurred by AIS in connection with the sale of network services by AIS employees. 1993 1992 1991 Charges incurred for services $3.7 $4.4 $5.8 5. Bell Communication Research, Inc. (Bellcore) - Bellcore provides research and technical support to the Company. ASI has a one- seventh interest in Bellcore and bills the Company for the costs. 1993 1992 1991 Charges incurred for services $13.0 $16.0 $15.5 Telecommunications Plant - Telecommunications plant is stated at original cost. The original cost of telecommunications plant acquired from ASI includes a return on investment to ASI. The provision for depreciation and amortization is based principally on the straight-line remaining life and the straight-line equal life group methods of depreciation applied to individual categories of telecommunications plant with similar characteristics. Generally, when depreciable plant is retired, the amount at which such plant has been carried in telecommunications plant in service is charged to accumulated depreciation. The cost of maintenance and repairs of plant is charged to expense. Investments - The Company's investment in ASI (10% ownership and $26.6 and $22.0 at December 31, 1993 and 1992, respectively) is reflected in the financial statements using the equity method of accounting. All other investments are carried at cost. Material and Supplies - Inventories of new and reusable material and supplies are stated at the lower of cost or market with cost determined generally on an average cost basis. Interest During Construction - Regulatory authorities allow the Company to accrue interest as a cost of constructing certain plant and as an item of income, i.e., allowance for debt and equity funds used to finance construction. Such income is not realized in cash currently but will be realized over the service life of the plant as the resulting higher depreciation expense is recovered in the form of increased revenues. Income Taxes - The Company is included in the consolidated Federal income tax return filed by Ameritech and its subsidiaries. Effective January 1, 1993 the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes." The new accounting method is essentially a refinement of the liability method already followed by the Company and, accordingly, did not have a significant impact on the Company's financial statements upon adoption. Consolidated income tax currently payable has been allocated to the Company based on the Company's contribution to consolidated taxable income and tax credits. Deferred tax assets and liabilities are based on differences between the financial statement bases of assets and liabilities and the tax bases of those same assets and liabilities. Under the liability method, deferred tax assets and liabilities at the end of each period are determined using the statutory tax rates in effect when these temporary differences are expected to reverse. Deferred income tax expense is measured by the change in the net deferred income tax asset or liability during the year. In addition, for regulated companies, SFAS No. 109 requires that all deferred regulatory liabilities be recognized at the revenue requirement level. It further requires that a deferred tax liability be recorded to reflect the amount of cumulative tax benefits previously flowed through to ratepayers and that a long-term deferred asset be recorded to reflect the revenue to be recovered in telephone rates when the related taxes become payable in future years. The Company uses the deferral method of accounting for investment tax credits. Therefore, credits earned prior to the repeal of investment tax credits by the Tax Reform Act of 1986 and also certain transitional credits earned after the repeal are being amortized as reductions in the tax expense over the life of the plant which gave rise to the credits. Temporary Cash Investments - Temporary cash investments are stated at cost which approximates market. The Company considers all highly liquid, short term investments with an original maturity of three months or less to be cash equivalents. Short Term Financing Arrangement - During 1991, Ameritech entered into an arrangement with its subsidiaries, including the Company, for the provision of short term financing and cash management services. Ameritech issues commercial paper and notes and secures bank loans to fund the working capital requirements of its subsidiaries and invests short term, excess funds on their behalf. See Notes D. and H. B. INCOME TAXES The components of income tax expense follow: 1993 1992 1991 Federal Current $ 100.8 $ 91.5 $ 84.5 Deferred, net (14.9) (16.0) (15.1) Investment tax credits, net (6.7) (6.3) (8.9) Total 79.2 69.2 60.5 State and Local Current 7.5 8.0 11.9 Deferred, net 0.5 1.3 1.4 Total 8.0 9.3 13.3 Total income tax expense $ 87.2 $ 78.5 $ 73.8 Deferred income tax expense (credit) results principally from temporary differences caused by the change in the book and tax bases of property, plant, and equipment due to the use of different depreciation methods and lives for financial reporting and income tax purposes. Total income taxes paid were $114.2, $102.7, and $95.2 in 1993, 1992, and 1991, respectively. The following is a reconciliation between the statutory federal income tax rate for each of the last three years and the Company's effective tax rate: 1993 1992 1991 Statutory tax rate 35.0% 34.0% 34.0% State income taxes, net of federal benefit 1.9 2.5 3.9 Reduction in tax expense due to amortization of investment tax credits (2.5) (2.6) (3.9) Effect of adjusting deferred income tax balances due to tax law changes (0.9) 0.0 0.0 Benefit of tax rate differential applied to reversing temporary differences (2.2) (2.9) (2.9) Other 1.2 1.5 1.5 Effective tax rate 32.5% 32.5% 32.6% The Revenue Reconciliation Act of 1993, enacted in August of 1993, increased the statutory Federal income tax rate for 1993 to 35%. In accordance with the liability method of accounting, the Company adjusted, on the enactment date, its deferred income tax balances not subject to regulatory accounting prescribed by SFAS No. 71 (see Note A). The result was a reduction in deferred income tax expense of $2.4 million, primarily from increasing the deferred tax assets associated with SFAS Nos. 106 and 112 (see Note C.) As of December 31, 1993, the Company had a regulatory asset of $46.3 million (reflected in Other Assets and Deferred Charges) related to the cumulative amount of income taxes on temporary differences previously flowed through to ratepayers. In addition, on that date, the Company had a regulatory liability of $67.4 million (reflected in Other Deferred Credits) related to the reduction of deferred taxes resulting from the change in the Federal statutory income tax rate to 35% and deferred taxes provided on unamortized investment tax credits. These amounts will be amortized over the regulatory lives of the related depreciable assets concurrent with recovery in rates. The accounting for and the impact on future net income of these amounts will depend on the ratemaking treatment authorized in future regulatory proceedings. As of December 31, 1993 and 1992, the components of long term accumulated deferred income taxes were as follows: 1993 1992 Deferred tax assets Postretirement and postemployment benefits $ 96.2 $ 90.7 SFAS No. 71 accounting 9.8 42.7 Other, net 6.8 8.4 112.8 141.8 Deferred tax liabilities Accelerated depreciation 271.3 289.5 Other 4.6 22.0 275.9 311.5 Net deferred tax liability $ 163.1 $ 169.7 Deferred income taxes in current assets and liabilities are not shown as they are not significant. C. EMPLOYEE BENEFIT PLANS Pension Plans Ameritech maintains non-contributory defined pension and death benefit plans covering substantially all of the Company's management and non- management employees. The pension benefit formula used in the determination of pension cost is based on the average compensation earned during the five highest consecutive years of the last ten years of employment for the management plan and a flat dollar amount per year of service for the non-management plan. Pension credits are allocated to subsidiaries based on the percentage of compensation for the management plan and per employee for the non-management plan. The Company's funding policy is to contribute annually an amount up to the maximum amount that can be deducted for federal income tax purposes. However, due to the funded status of the plans, no contributions have been made for the years reported below. The following data provides information on the Company's credits for the Ameritech plans: 1993 1992 1991 Pension credits $ (9.5) $ (10.0) $ (6.5) Current year credits as a percentage of salaries and wages (4.5)% (4.3)% (2.7)% Pension credits were determined using the projected unit credit actuarial method in accordance with Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions." The resulting pension credits are primarily attributable to favorable investment performance and the funded status of the plans. Certain disclosures are required to be made of the components of pension costs and the funded status of the plans, including the actuarial present value of accumulated plan benefits, accumulated projected benefit obligation and the fair value of plan assets. Such disclosures are not presented for the Company because the structure of the Ameritech plans does not permit the plans' data to be readily disaggregated. The assets of the Ameritech plans consist principally of debt and equity securities, fixed income securities and real estate. As of December 31, 1993, the fair value of plan assets available for the plan benefits exceeded the projected benefit obligation (calculated using a discount rate of 5.8% as of December 31, 1993 and 1992). The assumed long-term rate of return on plan assets used in determining pension cost was 7.25% for 1993, 1992 and 1991. The assumed increase in future compensation levels, also used in the determination of the projected obligation, was 4.5% in 1993 and 1992. Postretirement Benefits Other Than Pensions - Effective January 1, 1992, Ameritech adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS No. 106). SFAS No. 106 requires the cost of postretirement benefits granted to employees to be accrued as expense over the period in which the employee renders service and becomes eligible to receive benefits. The cost of health care and postretirement life insurance benefits for current and future retirees was recognized as determined under the projected unit credit actuarial method. In adopting SFAS No. 106, the Company elected to immediately recognize, effective January 1, 1992, the transition benefit obligation for current and future retirees. The unrecognized obligation was $231.8 million less deferred income taxes of $85.7 million or $146.1 million, net. To this amount, is added the Company's 10% share of ASI's transition obligation of $6.2 million for a total charge of $152.3 million. As defined by SFAS No. 71, a regulatory asset and any corresponding regulatory liability associated with the recognition of the transition obligation was not recorded because of uncertainties as to the timing and extent of recovery in the rate-making process. Substantially all current and future retirees are covered under postretirement benefit plans sponsored by Ameritech. Such benefits include medical, dental, and group life insurance. Ameritech has been prefunding (including cash received from the Company) certain of these benefits through Voluntary Employee Benefit Association trust funds (VEBAs) and Retirement Funding Accounts (RFAs). The associated plan assets (primarily corporate securities and bonds) were considered in determining the transition obligation under SFAS No. 106. Ameritech intends to continue to fund its obligations appropriately and is exploring other available funding and cost containment alternatives. Ameritech allocates its retiree healthcare cost on a per participant basis, whereas group life insurance is allocated based on compensation levels. SFAS No. 106 requires certain disclosures as to the components of postretirement benefit costs and the funded status of the plans. Such disclosures are not presented for the Company as the structure of the Ameritech plans does not permit the data to be readily disaggregated. However, the Company has been advised by Ameritech as to the following assumptions used in determining its SFAS No. 106 costs. As of December 31, 1993 the accumulated postretirement benefit obligation exceeded the fair value of plan assets available for plan benefits. The assumed discount rate used to measure the accumulated postretirement benefit obligation was 7.0% as of December 31, 1993 and 7.5% as of December 31, 1992. The assumed rate of future increases in compensation level was 4.5% as of December 31, 1993 and December 31, 1992. The expected long term rate of return on plan assets was 7.25% in 1993 and 1992 on VEBAs and 8.0% in 1993 and 1992 on RFAs. The assumed healthcare cost trend rate in 1993 was 9.6% and 10% in 1992, and is assumed to decrease gradually to 4.0% in 2007 and remain at that level. The assumed increase in healthcare cost is 9.2% for 1994. The healthcare cost trend rates have a significant effect on the amounts reported for costs each year. Specifically, increasing the assumed healthcare cost trend rate by one percentage point in each year would increase the 1993 annual expense by approximately 18.0%. Postretirement benefit cost under SFAS No. 106 for 1993 and 1992 was $23.5 and $21.8, respectively. During 1991, the cost of postretirement healthcare benefits for retirees was $21.5. As of December 31, 1993, the Company had approximately 4,584 retirees eligible to receive health care and group life insurance benefits. Postemployment Benefits - Effective January 1, 1992, Ameritech adopted Statement of Financial Accounting Standards No. 112, "Employers Accounting for Postemployment Benefits" (SFAS No. 112). SFAS No. 112 requires employers to accrue the future cost of certain benefits such as workers compensation, disability benefits and health care continuation coverage. A one-time charge related to adoption of this statement was recognized as a change in accounting principle, effective as of January 1, 1992. The charge was $12.3, less deferred taxes of $4.6 for a net of $7.7. To this amount, is added the Company's 10% share of ASI's one- time charge of $0.2 for a total charge of $7.9. Previously the Company used the cash method to account for such costs. Current expense levels are dependent upon actual claim experience, but are not materially different than prior charges to income. Workforce Reductions - During 1993, 305 employees left the Company through voluntary early retirement programs and involuntary terminations. The net cost of this effort including termination benefits, settlement and curtailment gains from the pension plan, was a credit to expense of $1.4. The involuntary termination plan remains in effect until June 30, 1994. During 1992, 210 employees left the Company through voluntary early retirement programs and involuntary terminations. The net cost of this effort including termination benefits, settlement and curtailment gains from the pension plan, was a credit to expense of $0.2. During 1991, the Company offered most of its management employees an early retirement program. The net cost of this program, including termination benefits and a settlement gain from the pension plan, was $0.8. D. DEBT MATURING WITHIN ONE YEAR Debt maturing within one year is included as debt in the computation of debt ratios and consists of the following at December 31: Weighted Average Amounts Interest Rates* 1993 1992 1991 1993 1992 1991 Notes payable Bank Loans Parent (Ameritech) $ 75.0 $ 0.0 $ 43.5 - - 5.07% Other Long term debt maturing within one year 220.1 0.1 0.1 Total $ 295.1 $ 0.1 $ 43.6 Average notes payable outstanding during the year $ 32.8 $ 2.2 $ 18.4 3.15% 4.78% 6.26% Maximum notes payable at any month end during the year $ 92.5 $ 6.5 $ 44.5 In December 1993, the Company called $90.0 of 8.000% debentures due in 2014 and $130.0 of 8.125% debentures due in 2017. This debt had been included in Other Debt Maturing Within One Year as of December 31, 1993. These debentures were redeemed in 1994 with an advance from Ameritech. During 1991, Ameritech consolidated the short-term financing of its subsidiaries at Ameritech Corporate. See Note A. - Short Term Financing Arrangement. * Computed by dividing the average daily face amount of notes payable into the aggregate related interest expense. E. LONG TERM DEBT Long term debt consists principally of mortgage bonds and debentures issued by the Company. The following table sets forth interest rates and other information on long term debt outstanding at December 31: Interest Maturities 1993 1992 4.375% 40 year bonds due June 1, 2003 $ 20.0 $ 20.0 4.750% 40 year bonds due October 1, 2005 25.0 25.0 5.500% 40 year bonds due April 1, 2007 40.0 40.0 8.125% 40 year bonds due August 1, 2011 0.0 100.0 8.125% 40 year bonds due March 1, 2017 0.0 130.0 8.000% 37 year bonds due October 1, 2014 0.0 90.0 85.0 405.0 Capital lease obligations 0.1 0.2 Unamortized premium (discount)-net 0.1 (12.4) Total $ 85.2 $ 392.8 In June 1993, the Company redeemed $100.0 of 8.125% debentures due in 2011 using funds obtained from short term borrowings and internal sources. In December 1993, the Company called $90.0 of 8.000% debentures due in 2014 and $130.0 of 8.125% debentures due in 2017. This debt has been included in Other Debt Maturing Within One Year as of December 31, 1993. The $90.0 and $130.0 debentures were redeemed in 1994. The Company has filed a registration statement with the Securities and Exchange Commission for issuance of up to $225.0 in unsecured debt securities for general corporate purposes. As of January 28, 1994, none of these securities had been issued. Early extinguishment of debt costs (including call premiums and write- offs of unamortized deferred costs) in 1993 were $23.5 and have been classified as an extraordinary item on the Statements of Income and Reinvested Earnings. In 1992, the costs were $1.4 and are included in other income. F. LEASE COMMITMENTS The Company leases certain facilities and equipment used in its operations under both operating and capital leases. Rental expense under operating leases was $26.0, $14.9, and $21.3 million for 1993, 1992, and 1991, respectively. At December 31, 1993, the aggregate minimum rental commitments under noncancelable leases were approximately as follows: Years Operating Capital 1994 $ 0.5 $ 0.1 1995 0.3 0.1 1996 0.2 0.1 1997 0.1 0.0 1998 0.1 0.0 Thereafter 0.1 0.0 Total minimum rental commitments $ 1.3 0.3 Less: amount representing interest costs 0.1 Present value of minimum lease payments $ 0.2 G. FINANCIAL INSTRUMENTS The following table presents the estimated fair value of the Company's financial instruments as of December 31, 1993 and 1992: Carrying Fair Value Value Cash and short term investments $ 0.6 $ 0.6 Debt 395.1 381.1 Long-term payable to ASI (for postretirement benefits) 9.4 9.4 Other assets 8.1 8.1 Other liabilities 9.8 9.8 Carrying Fair Value Value Cash and short term investments $ 10.2 $ 10.2 Debt 402.2 395.5 Long-term payable to ASI (for postretirement benefits) 10.2 10.2 Other assets 2.6 2.6 Other liabilities 8.8 8.8 The following methods and assumptions were used to estimate the fair value of financial instruments: Cash and Short Term Investments - Carrying value approximates fair value because of short term maturity of these instruments. Debt - The carrying amount (including accrued interest) of the Company's debt maturing within one year approximates fair value because of the short term maturities involved. The fair value of the Company's long term debt was estimated based on the year end quoted market price for the same or similar issues. Other Assets and Liabilities - These financial instruments consist primarily of long term receivables, other investments, and customer deposits. The fair values of these items are based on expected cash flows or, if available, quoted market prices. Long term Payable to ASI (for Postretirement Benefits) - Carrying value approximates fair value. H. ADDITIONAL FINANCIAL INFORMATION December 31, December 31, 1993 1992 Balance Sheets Other current liabilities: Accrued payroll $ 6.3 $ 6.6 Accrued taxes 63.6 58.6 Income taxes deferred one year (19.0) (25.3) Advance billings and customer deposits 73.7 70.5 Accrued interest 12.7 15.1 Compensated absences 18.0 17.7 Other 22.7 27.5 Total $ 178.0 $ 170.7 1993 1992 1991 Statements of Income Interest expense: Interest on long term debt $ 26.0 $ 31.9 $ 33.1 Interest on notes payable - Ameritech 1.0 0.1 0.9 Other 2.0 2.5 2.8 Total $ 29.0 $ 34.5 $ 36.8 Interest paid was $29.8, $32.9, and $34.7 million in 1993, 1992 and 1991, respectively. 1993 1992 1991 Taxes other than income taxes: Property $ 29.1 $ 25.8 $ 24.3 Gross receipts 14.3 11.8 9.5 Other 1.4 1.7 1.4 Total $ 44.8 $ 39.3 $ 35.2 Maintenance and repair expense $ 173.4 $ 170.4 $ 167.8 Depreciation-Percentage of average depreciable telecommunications plant in service 7.4% 7.5% 7.6% Revenues from AT&T, consisting principally of interstate network access and billing and collection service revenues, comprised approximately 11.6%, 13.2%, and 13.6% of total revenues in 1993, 1992, and 1991, respectively. No other customer accounted for more than 10% of total revenues. I. QUARTERLY FINANCIAL INFORMATION (UNAUDITED) Calendar Operating Net Income Quarter Revenues Income (Loss) 1st $ 264.2 $ 72.0 $ 43.7 2nd 280.1 73.6 42.8 3rd 282.4 68.9 43.4 4th 289.9 76.8 36.9 Total $1,116.6 $ 291.3 $ 166.8 1st $ 260.5 $ 68.5 $ (114.6) 2nd 258.6 67.8 38.2 3rd 261.6 65.5 39.8 4th 264.8 68.5 39.6 Total $1,045.5 $ 270.3 $ 3.0 The fourth quarters of 1993 and 1992 were affected by several income and expense items. The fourth quarter of 1993 was affected by gains from workforce resizing and charges for the early retirement of debt. The fourth quarter of 1992 was affected by higher costs and charges resulting from market realignment efforts and increased advertising. These costs were offset by gains from workforce resizing and higher than expected pension credits. Certain reclassifications have been made in the second quarter of 1993 to reflect $2.3 as an extraordinary loss arising from early extinguishment of debt costs, resulting in $45.1 of ordinary income with no effect on previously reported net income. These reclassifications were required because in the fourth quarter of 1993 an additional charge for early extinguishment of debt costs of $19.8, or $12.4 after tax, was made. These charges were considered material, necessitating classification of all 1993 early extinguishment of debt costs as an extraordinary item. First quarter 1992 results reflect charges related to the adoption of SFAS Nos. 106 and 112 for postretirement and postemployment benefits, as discussed previously in Note C. above. The charges totaled $160.2. All adjustments necessary for a fair statement of results for each period have been included. J. CALCULATION OF RATIO OF EARNINGS TO FIXED CHARGES The ratio of earnings to fixed charges of the Company for the years ended December 31, 1993, 1992, 1991, 1990 and 1989 was 8.13, 7.13, 6.29, 6.47 and 6.56, respectively. For the purpose of calculating this ratio, (i) earnings have been calculated by adding to income before interest expense, extraordinary items and accounting changes, the amount of related taxes on income and the portion of rentals representative of the interest factor, (ii) the Company considers one-third of rental expense to be the amount representing return on capital, and (iii) fixed charges comprise total interest expense and such portion of rentals. K. INTRASTATE RATE SETTLEMENT On March 27, 1992, the Company reached an agreement with the Office of the Utility Consumer Counselor regarding its investigation into the Company's rates and charges. The agreement provided a one-time credit to all subscribers as well as a reduction in toll and Touch-Tone rates. Part of the one-time credit was applied in June of 1992 for $7.0 with the $3.0 remainder accrued in 1992 for application in January of 1993. The Touch-Tone rate reduction, effective July 1, 1992, reduced revenues by $6.0 during the last 6 months of 1992 and by $12.8 during 1993. The toll rate reduction went into effect on January 1, 1993 and reduced 1993 revenue by $15.5. L. PRIOR YEAR RECLASSIFICATIONS Certain reclassifications have been made to the prior year financial statements to conform with current year presentation. These reclassifications have no effect on previously reported net income. M. EVENT SUBSEQUENT TO DATE OF AUDITORS' REPORT (UNAUDITED) On March 25, 1994, Ameritech announced it would reduce its nonmanagement workforce resulting in an after-tax charge to the Company of $42.8. The charge will be recorded in the first quarter of 1994. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE No changes in nor disagreements with accountants on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure occurred during the period covered by this annual report. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Documents filed as part of the report: (1) Financial Statements: Page Selected Financial and Operating Data 14 Statements of Income and Reinvested Earnings 23 Balance Sheets 24 Statements of Cash Flows 26 Notes to Financial Statements 28 Report of Independent Public Accountants 47 (2) Financial Statement Schedules: V - Telecommunications Plant 48 VI - Accumulated Depreciation 52 VIII - Allowance for Uncollectibles 56 Financial statement schedules other than those listed above have been omitted because the required information is contained in the financial statements and notes thereto, or because such schedules are not required or applicable. (3) Exhibits: Exhibits identified in parentheses below, on file with the SEC, are incorporated herein by reference as exhibits hereto. Exhibit Number 3a Articles of Incorporation of the registrant as amended May, 1990, (Exhibit (3)a to Form 10-K for the year ended December 31, 1990, File No. 1-6746). 3b By-laws of the registrant as amended April 7, 1990 (Exhibit (3)b to Form 10-K for the year ended December 31, 1990, File No. 1-6746). 4 No instrument which defines the rights of holders of long term debt of the registrant is filed herewith pursuant to Regulation S-K, Item 601(b)(4)(iii)(A). Pursuant to this regulation, the registrant hereby agrees to furnish a copy of any such instrument to the SEC upon request. 10a Reorganization and Divestiture Agreement among American Telephone and Telegraph Company, American Information Technologies Corporation (n/k/a/ Ameritech Corporation) and Affiliates dated November 1, 1983 (Exhibit (10)a to Form 10-K for 1983 for American Information Technologies Corporation, File No. 1-8612). 12 Statement re: Computation of Ratio of Earnings to Fixed Charges (b) Reports of Form 8-K: No report on Form 8-K was filed by the registrant during the last quarter of the year covered by this report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Indiana Bell Telephone Company, Incorporated By: /s/ Cheryl K. Wooley Cheryl K. Wooley Vice President - Comptroller March 30, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities on the date indicated. Principal Executive Officer: By: /s/Thomas J. Reiman Thomas J. Reiman President Principal Financial and Accounting Officer: By: /s/ Cheryl K. Wooley Cheryl K. Wooley Vice President - Comptroller Ameritech Corporation By: /s/ Richard H. Brown Richard H. Brown Vice Chairman the sole shareholder of the registrant, which has elected under the laws of Indiana to be managed by the shareholder rather than by a board of directors Report of Independent Public Accountants To the Shareholder of Indiana Bell Telephone Company, Incorporated: We have audited the accompanying balance sheets of INDIANA BELL TELEPHONE COMPANY, INCORPORATED (an Indiana corporation) as of December 31, 1993 and 1992, and the related statements of income and reinvested earnings and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Indiana Bell Telephone Company, Incorporated as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Note (C) to the financial statements, the Company changed its method of accounting for certain postretirement and postemployment benefits in 1992. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The financial statement schedules listed in Item 14(a)(2) are presented for purposes of complying with the Securities and Exchange Commission's rules and are not a required part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Indianapolis, Indiana, January 28, 1994. Schedule V - Sheet 1 INDIANA BELL TELEPHONE COMPANY, INCORPORATED SCHEDULE V - TELECOMMUNICATIONS PLANT (Millions of Dollars) Col. A Col. B Col. C Col. D Col. E Col. F Balance Additions Other Balance Beginning at Cost Retirements Changes End of Classification of Period Note (a) Note (b) Note (c) Period Year 1993 Land 11.9 0.0 0.0 0.0 11.9 Buildings 272.1 7.4 2.4 0.6 277.7 Computers and Other Office Equipment 168.6 7.2 10.6 (1.2) 164.0 Vehicles and Other Work Equipment 55.3 6.1 3.9 0.3 57.8 Central Office Equipment 1,082.4 99.6 103.6 (1.8) 1,076.6 Information Origination/ Termination Equipment 38.7 2.7 0.3 (0.1) 41.0 Cable and Wire Facilities 1,267.6 58.6 14.8 0.0 1,311.4 Capitalized Lease Assets 0.9 0.0 0.0 0.0 0.9 Miscellaneous Other Property 4.4 0.0 0.0 0.0 4.4 Total Telecommunications Plant In Service (d) 2,901.9 181.6 135.6 (2.2) 2,945.7 Telecommunications Plant Under Construction 52.1 (17.3) 0.0 2.4 37.2 Total Telecommunications Plant $2,954.0 $ 164.3 $ 135.6 $ 0.2 $2,982.9 The notes on page 51 are an integral part of this Schedule. Schedule V - Sheet 2 INDIANA BELL TELEPHONE COMPANY, INCORPORATED SCHEDULE V - TELECOMMUNICATIONS PLANT (Millions of Dollars) Col. A Col. B Col. C Col. D Col. E Col. F Balance Additions Other Balance Beginning at Cost Retirements Changes End of Classification of Period Note (a) Note (b) Note (c) Period Year 1992 Land 11.6 0.3 0.0 0.0 11.9 Buildings 262.3 11.1 1.4 0.1 272.1 Computers and Other Office Equipment 167.3 14.0 12.2 (0.5) 168.6 Vehicles and Other Work Equipment 54.2 6.8 5.9 0.2 55.3 Central Office Equipment 1,063.9 82.3 64.4 0.6 1,082.4 Information Origination/ Termination Equipment 35.7 5.4 2.4 0.0 38.7 Cable and Wire Facilities 1,224.0 58.9 15.3 0.0 1,267.6 Capitalized Lease Assets 2.7 0.0 1.8 0.0 0.9 Miscellaneous Other Property 4.2 0.0 0.0 0.2 4.4 Total Telecommunications Plant In Service (d) 2,825.9 178.8 103.4 0.6 2,901.9 Telecommunications Plant Under Construction 28.1 24.6 0.0 (0.6) 52.1 Total Telecommunications Plant $2,854.0 $ 203.4 $ 103.4 $ 0.0 $2,954.0 The notes on page 51 are an integral part of this Schedule. Schedule V - Sheet 3 INDIANA BELL TELEPHONE COMPANY, INCORPORATED SCHEDULE V - TELECOMMUNICATIONS PLANT (Millions of Dollars) Col. A Col. B Col. C Col. D Col. E Col. F Balance Additions Other Balance Beginning at Cost Retirements Changes End of Classification of Period Note (a) Note (b) Note (c) Period Year 1991 Land 11.7 0.0 0.0 (0.1) 11.6 Buildings 255.7 9.2 2.6 0.0 262.3 Computers and Other Office Equipment 161.3 14.9 9.5 0.6 167.3 Vehicles and Other Work Equipment 52.2 6.1 4.2 0.1 54.2 Central Office Equipment 1,032.6 100.4 68.5 (0.6) 1,063.9 Information Origination/ Termination Equipment 33.5 3.0 0.8 0.0 35.7 Cable and Wire Facilities 1,170.5 69.0 15.8 0.3 1,224.0 Capitalized Lease Assets 3.4 0.1 0.9 0.1 2.7 Miscellaneous Other Property 3.0 0.0 0.0 1.2 4.2 Total Telecommunications Plant In Service (d) 2,723.9 202.7 102.3 1.6 2,825.9 Telecommunications Plant Under Construction 33.8 (4.7) 0.0 (1.0) 28.1 Total Telecommunications Plant $2,757.7 $ 198.0 $ 102.3 $ 0.6 $2,854.0 The notes on page 51 are an integral part of this Schedule. Schedule V - Sheet 4 INDIANA BELL TELEPHONE COMPANY, INCORPORATED NOTES TO SCHEDULE V - TELECOMMUNICATIONS PLANT (a) These additions, other than additions to Buildings, include material purchased from Ameritech Services, Inc., a centralized procurement subsidiary in which the Company has a 10 percent ownership interest. (See Note (A) to Financial Statements.) Additions shown also include (1) the original cost (estimated if not known) of reused material, which is concurrently credited to material and supplies, and (2) interest during construction. Transfers between the classifications listed are included in Column E. (b) Items of telecommunications plant when retired or sold are deducted from the property accounts at the amounts at which they are included therein or are estimated if not known. (c) Comprised, principally, of reclassifications among plant categories. (d) The Company's provision for depreciation is based principally on the straight-line remaining life and the straight-line equal life group methods of depreciation applied to individual categories of plant with similar characteristics. The Company is allowed by regulatory authorities to use reserve deficiency amortization in conjunction with the remaining life method. For the years, 1993, 1992, and 1991, depreciation expressed as a percentage of average depreciable plant was 7.4%, 7.5%, and 7.6%, respectively. Schedule VI - Sheet 1 INDIANA BELL TELEPHONE COMPANY, INCORPORATED SCHEDULE VI - ACCUMULATED DEPRECIATION (Millions of Dollars) Col. A Col. B Col. C Col. D Col. E Col. F Balance Additions Other Balance Beginning at Cost Changes End of Classification of Period Note (a) Retirements Note (b) Period Year 1993 Buildings 67.3 6.5 3.2 0.0 70.6 Computers and Other Office Equipment 120.8 16.5 10.5 0.0 126.8 Vehicles and Other Work Equipment 28.1 4.1 3.1 0.0 29.1 Central Office Equipment 474.2 114.8 98.9 0.0 490.1 Information Origination/ Termination Equipment 33.8 2.5 0.3 0.0 36.1 Cable and Wire Facilities 513.4 71.2 17.5 0.0 567.1 Capitalized Lease Assets 0.6 0.1 0.0 0.0 0.7 Miscellaneous Other Property 0.3 0.0 0.0 0.0 0.3 Total Accumulated Depreciation $1,238.5 $ 215.6 $ 133.5 $ 0.0 $1,320.6 The notes on page 55 are an integral part of this Schedule. Schedule VI - Sheet 2 INDIANA BELL TELEPHONE COMPANY, INCORPORATED SCHEDULE VI - ACCUMULATED DEPRECIATION (Millions of Dollars) Col. A Col. B Col. C Col. D Col. E Col. F Balance Additions Other Balance Beginning at Cost Changes End of Classification of Period Note (a) Retirements Note (b) Period Year 1992 Buildings 61.8 7.8 2.3 0.0 67.3 Computers and Other Office Equipment 108.0 24.5 11.7 0.0 120.8 Vehicles and Other Work Equipment 27.0 6.1 5.0 0.0 28.1 Central Office Equipment 432.3 105.9 64.0 0.0 474.2 Information Origination/ Termination Equipment 32.8 3.3 2.3 0.0 33.8 Cable and Wire Facilities 466.5 64.8 17.9 0.0 513.4 Capitalized Lease Assets 2.4 0.1 1.9 0.0 0.6 Miscellaneous Other Property 0.3 0.0 0.0 0.0 0.3 Total Accumulated Depreciation $1,131.1 $ 212.5 $ 105.1 $ 0.0 $1,238.5 The notes on page 55 are an integral part of this Schedule. Schedule VI - Sheet 3 INDIANA BELL TELEPHONE COMPANY, INCORPORATED SCHEDULE VI - ACCUMULATED DEPRECIATION (Millions of Dollars) Col. A Col. B Col. C Col. D Col. E Col. F Balance Additions Other Balance Beginning at Cost Changes End of Classification of Period Note (a) Retirements Note (b) Period Year 1991 Buildings 57.8 7.8 3.6 (0.2) 61.8 Computers and Other Office Equipment 91.9 25.3 9.2 0.0 108.0 Vehicles and Other Work Equipment 24.3 6.3 3.6 0.0 27.0 Central Office Equipment 395.7 104.1 67.3 (0.2) 432.3 Information Origination/ Termination Equipment 28.9 4.3 0.8 0.4 32.8 Cable and Wire Facilities 421.5 63.3 18.3 0.0 466.5 Capitalized Lease Assets 2.9 0.4 0.9 0.0 2.4 Miscellaneous Other Property 0.3 0.0 0.0 0.0 0.3 Total Accumulated Depreciation $1,023.3 $ 211.5 $ 103.7 $ 0.0 $1,131.1 The notes on page 55 are an integral part of this Schedule. Schedule VI - Sheet 4 INDIANA BELL TELEPHONE COMPANY, INCORPORATED NOTES TO SCHEDULE VI - ACCUMULATED DEPRECIATION (a) Excludes certain minor amounts which are amortized directly to depreciation expense as stated in the Statements of Income and Reinvested Earnings. (b) Comprises, principally, the depreciation provision for vehicles and other work equipment charged initially to clearing accounts and apportioned to Telecommunications Plant on the basis of the usage of such equipment. INDIANA BELL TELEPHONE COMPANY, INCORPORATED SCHEDULE VIII - ALLOWANCE FOR UNCOLLECTIBLES (Millions of Dollars) Col. A Col. B Col. C Col. D Col. E Col. F Charged Balance to Other Balance Beginning Charged to Accounts Deductions End of Descriptions of Period Expense Note (a) Note (b) Period Year 1993 $ 3.1 $ 7.6 $ 20.7 $ 25.8 $ 5.6 Year 1992 $ 5.7 $ 4.9 $ 9.8 $ 17.3 $ 3.1 Year 1991 $ 4.9 $ 7.2 $ 8.4 $ 14.8 $ 5.7 (a) Includes principally amounts previously written off which were credited directly to this account when recovered and amounts related to interexchange carrier receivables which are being billed by the Company. (b) Amounts written off as uncollectible. EXHIBIT 12 INDIANA BELL TELEPHONE COMPANY, INCORPORATED COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES (Thousands of Dollars) Year ended December 31, 1993 1992 1991 1990 1989 1. Earnings (a) Income before interest expense, income taxes, extraordinary item and cumulative effect of change in accounting principles $297,738 $276,246 $263,380 $266,511 $262,946 (b) Portion of rental expense representative of the interest factor (i) 8,662 4,974 6,060 6,172 3,138 Total $306,400 $281,220 $269,440 $272,683 $266,084 2. Fixed Charges (a) Total interest deductions $ 29,021 $ 34,465 $ 36,767 $ 35,981 $ 37,430 (b) Portion of rental expense representative of the interest factor (ii) 8,662 4,974 6,060 6,172 3,138 Total $ 37,683 $ 39,439 $ 42,827 $ 42,153 $ 40,568 3. Ratio (1. divided by 2.) 8.13 7.13 6.29 6.47 6.56 (i) Earnings are income before income taxes and fixed charges. Since the rental expense has already been deducted, the 1/3 portion of rental expense considered to be fixed charges are added back. (ii) The Company considers 1/3 of rental expense to be the amount representing return on capital and therefore it must be included in fixed charges. NOTE: For the purpose of calculating this ratio, (i) earnings have been calculated by adding to income before interest expense, extraordinary items and accounting changes, the amount of related taxes on income and the portion of rentals representative of the interest factor, (ii) the Company considers one-third of rental expense to be the amount representing return on capital, and (iii) fixed charges comprise total interest expense and such portion of rentals.

725625_1993.txt

725625

1993

ITEM 1. BUSINESS. GENERAL Cornerstone Natural Gas, Inc. (formerly Endevco, Inc.), a Delaware corporation ("Cornerstone"), is engaged in the business of natural gas pipeline and natural gas processing operations. Natural gas pipeline operations include purchasing, gathering, transporting and marketing of natural gas. Natural gas processing operations include recovering and marketing of natural gas liquids ("NGLs") from natural gas and treating natural gas by removing noncommercial components. Natural gas processing operations also include refining condensate and crude oil into various petroleum products. Cornerstone, its subsidiaries and affiliated companies are herein collectively referred to as the "Company", unless the context otherwise indicates. The Company was incorporated under the laws of Texas in 1977 as Endevco, Inc. and was reincorporated under the laws of Delaware in May 1988. The Company changed its name in November 1993 to Cornerstone Natural Gas, Inc. in connection with its emergence from bankruptcy. The Company's principal administrative offices are located at 8080 North Central Expressway, Suite 1200, Dallas, Texas 75206 and the telephone number is (214) 691-5536. RECENT DEVELOPMENTS On June 4, 1993, Endevco, Inc. and its subsidiaries ANGIC, Inc. (formerly known as Cornerstone Natural Gas Company), Mississippi Fuel Company and Endevco Taft Company (collectively, the "Debtors") filed voluntary petitions for reorganization under Chapter 11 of the Bankruptcy Code with the United States Bankruptcy Court for the Eastern District of Texas, Sherman Division (the "Bankruptcy Court"). No other subsidiary of the Company was included in the bankruptcy filing. On September 29, 1993, the Bankruptcy Court confirmed the Debtor's First Amended Joint Plan of Reorganization (the "Plan"), and the Plan was consummated on November 2, 1993. For details about the Plan see Note 2 of "Notes to Consolidated Financial Statements" and Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations". NATURAL GAS PIPELINE OPERATIONS GENERAL. In November 1993, the Company transferred four of its natural gas gathering and transmission systems to its former Noteholders in return for the release of approximately $44.1 million in debt and accrued interest. See Note 2 of "Notes to Consolidated Financial Statements" and Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations". However, management believes that it is essential to own natural gas pipeline systems in order to compete in the natural gas industry. Therefore, the Company will continue to pursue natural gas pipeline projects. Revenues from these operations are generated in two ways. First, natural gas is transported or purchased and sold using Company-owned facilities, resulting in what are termed "System sales". Second, natural gas is purchased and sold using only facilities owned by third parties, resulting in what are termed "Off-system sales". The Company's natural gas pipeline operations accounted for 53%, 49%, and 56% of consolidated revenues in 1993, 1992 and 1991 respectively. For information about revenues, operating earnings and identifiable assets, see Note 9 of "Notes to Consolidated Financial Statements". SYSTEM SALES. System sales accounted for 90%, 91%, and 94% of natural gas pipeline operations gross margin in 1993, 1992 and 1991 respectively. The Company has two primary strategies for utilizing its facilities to generate System sales. One is to aggregate supplies of natural gas connected to its systems and deliver the natural gas to local markets or connecting pipelines. The Company typically gathers natural gas at the wellhead or a central gathering location. This natural gas is primarily owned by independent producers, however, some is owned by major integrated oil companies. The Company either transports for a fee or purchases the natural gas at the wellhead and, if there is no local market, arranges transportation on the intrastate and interstate pipelines and resells it to local distribution companies ("LDCs"), utilities, commercial or industrial end-users or other natural gas marketing companies. The Company generally purchases natural gas under contracts whose prices are determined by prevailing market conditions. Gas is then resold at higher prices under sales contracts with similar pricing terms. The Company earns a margin equal to the difference between the gas purchase price it pays the supplier and the sales price it receives from the purchaser. The Company also offers services such as marketing, gas control, contract administration and pipeline operations which are not usually available to small producers. The Company's other strategy is to identify a utility or industrial end-user whose natural gas is supplied from limited sources. As a result of the limited competition, these end-users often pay a premium price for their natural gas. Typically, the Company will enter into a long-term contract (3-10 years) to construct a pipeline and supply all, or some agreed upon minimum, of the end- user's natural gas needs. The Company generally shares a portion of the price savings with the end-user. This allows the end-user to pay less for their natural gas supply and the Company to recover its capital expenditures over a short period of time. The Company completed one such project in 1993, its Port Hudson System located in East Baton Rouge Parish, Louisiana. OFF-SYSTEM SALES. In addition to marketing natural gas gathered and transported through its systems, the Company purchases and sells gas acquired from others utilizing only third party systems. In such transactions, the Company usually contracts on a short-term "best efforts" basis with producers, pipelines or other suppliers and sells to LDCs, utilities, commercial or industrial end-users or other natural gas marketing companies. The volume of natural gas throughput for Off-system sales can vary significantly from month-to-month. Off-system sales allow the Company to respond quickly to changing market conditions particularly in peak demand periods. Off-system sales also allow the Company to develop new marketing relationships that can later be supplied by the Company's own facilities. GAS SUPPLIES. The Company does not own any natural gas reserves. However, the Company continually seeks new supplies of natural gas connected to its systems, both to offset natural declines and to provide new supplies to increase throughput. The Company purchases Off-system natural gas from a variety of suppliers including independent producers, major integrated oil companies and other natural gas marketing companies. With the advent of "open access" on the interstate pipelines, the Company has an abundant source of natural gas to supply its current markets. NATURAL GAS PROCESSING AND OPERATIONS GENERAL. The Company's original core business was the treating and processing of natural gas. Management is currently refocusing on this core business. The Company is in the process of relocating two cryogenic gas processing plants from Brazoria County, Texas to Lincoln Parish, Louisiana to replace existing refrigerated lean oil facilities. These plants will be used in conjunction with the Company's approximately 492 miles of gathering pipelines in North Louisiana. The plants, with an inlet capacity of 45-50 million cubic feet per day ("MMCFD"), are expected to be operational early in the second quarter of 1994. The Company entered into petroleum refining during the fourth quarter of 1988. Management of the reorganized Company believes it is necessary to decrease its emphasis on refining. Therefore, the Company discontinued operations at one of its two refineries in July 1993. Management is continuing to examine its alternatives to further decrease its emphasis on refining operations. The Company's gas processing and refining operations accounted for 47%, 51%, and 44% of consolidated revenues in 1993, 1992 and 1991 respectively. For more information about revenues, operating earnings and identifiable assets, see Note 9 of "Notes to Consolidated Financial Statements". GAS LIQUIDS EXTRACTION. The Company's gas liquids extraction operations consist primarily of extracting NGLs such as ethane, propane, butane and natural gasoline from a natural gas stream. Gathering facilities collect natural gas from producers' wells and transport it to a Company processing plant where it is separated into NGLs and residue gas. The NGLs are then either fractionated into differentiated component products by the Company or transported by truck to a central location for fractionation. Once fractionated, NGLs are transported by truck and sold to end-users or wholesalers. The Company historically has installed a natural gas processing plant in areas where wells produce natural gas that either contain sufficient NGLs to economically process or that require processing to meet pipeline quality standards. The value of the NGLs is generally greater if extracted than if left in the natural gas stream. The Company agrees to install a natural gas processing plant in exchange for a portion of the proceeds from the NGLs extracted or for a fee. The Company may also receive a portion of the residue gas. Generally, gas liquids extraction services have been performed separately from the Company's natural gas pipeline operations. However, the Company has fully integrated its gathering and processing facilities in North Louisiana to provide full service to the producers. The Company gathers, treats, processes and often markets natural gas and NGLs for a percentage of the proceeds or, in some cases, for a fee. The Company's North Louisiana facilities are located in an area of known hydrocarbon production and although there can be no assurance of continued development, management believes that additional natural gas and gas liquids reserves will be developed to offset normal production declines in the area. The Company is working diligently to put several of its idle gas processing and treating plants back into service. See "Properties - Gas Liquids Recovery/Refining". The Company's gas liquids extraction operations would be adversely affected by a decline in NGL prices or a decline in natural gas throughput. PETROLEUM REFINING. The Company's refining operations consist of manufacturing petroleum products including unleaded gasoline, hydrocarbon solvents, diesel fuel, residual fuel oil and other related products from crude oil and condensate ("feedstock"). The feedstock is gathered by transporters from area leases by truck or pipeline to the plants. The feedstock is separated into major components by a series of processes and then blended and/or converted into finished products. The processes include distillation, hydrosulfurization, catalytic reforming, isomerization and fractionation. A solvent unit at the Claiborne plant adds a further process of splitting the diesel-kerosene stream into hydrocarbon solvents. The finished products are transported by truck or pipeline to wholesalers or end-users. The Company is putting less emphasis on its refining operations as a result of the working capital financing requirements and volatility of refining margins. GAS TREATING. Gas treating operations involve the treating of unmarketable natural gas to remove impurities and thus make it marketable. This service is generally performed for producers under contract, whereby the Company agrees to install and operate a facility to remove noncommercial components from gas dedicated to that facility. The services are normally conducted under long- term contracts for a fixed fee, a per unit fee, or a combination thereof. The Company's gas treating operations would be adversely affected by reduced volumes of gas treated. The Company is actively working to put its idle gas treating facilities back into service. See "Properties - Gas Liquids Recovery/Refining". MARKETS AND MAJOR CUSTOMERS NATURAL GAS PIPELINE OPERATIONS. The Company's reorganization included the transfer of four gas pipeline systems to the Company's former Noteholders. See Note 2 of "Notes to Consolidated Financial Statements" and Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations". This significantly reduced the Company's natural gas pipeline operations. Additionally, the financial difficulties of the Company and associated uncertainties reduced the number of suppliers willing to do business on normal terms. As a result, the Company was limited in the amount of natural gas it could buy. The Company kept its major customers supplied first and sold to others only when supply was available. As such, the Company reduced the overall number of sales customers in 1993. During 1993, the Company's sales to Georgia Pacific Company accounted for 12% of consolidated revenues. During 1992 and 1991, the Company had no single customer from its natural gas pipeline operations responsible for over 10% of consolidated revenues. GAS PROCESSING AND OPERATIONS. The Company has begun to decrease its emphasis on refining operations. As a result, the Company had no single customer from its gas processing operations responsible for over 10% of consolidated revenues in 1993 or 1992. During 1991, the Company's sales to Continental Ozark accounted for 14% of consolidated revenues. PRODUCT PRICES. During the three years ended December 31, 1993, the average sales prices for natural gas, significant NGLs, and refined products were as follows: The Company sometimes receives NGLs in kind as its fee for its gas processing services. Revenues from such operations are directly affected by fluctuations in NGL prices. The natural gas sales contracts and natural gas purchase contracts of the Company are generally interrelated as to term and pricing, and the Company's income is derived from either a fixed spread or a fixed fee per unit of natural gas. Although the margin between purchase and resale prices tends to fluctuate with the increase or decrease in the sales price of natural gas, such fluctuations are generally less severe and not necessarily directly correlative with the changes in natural gas prices. COMPETITION The natural gas pipeline and natural gas processing industries are highly competitive. In marketing natural gas, the Company has numerous competitors, including marketing affiliates of major interstate pipelines, the major integrated oil companies, and local and national gas gatherers, brokers and marketers of widely varying sizes, financial resources and experience. Certain competitors, such as major oil companies, have capital resources many times greater than those of the Company and control substantial supplies of natural gas. Local utilities and distributors of natural gas (some of which are customers of the Company) are, in some cases, engaged directly, and through affiliates, in marketing activities that compete with the Company. The Company competes against other companies in the gathering, marketing and transmission business for supplies of natural gas, for customers to whom to sell its natural gas, and for availability of pipeline capacity. Competition for natural gas supplies is primarily based on efficiency, reliability, availability of transportation and ability to pay a satisfactory price for the producer's natural gas. Competition for customers is primarily based upon reliability of supply and price of deliverable natural gas. Some of the Company's customers have the capability of using alternative fuels. In these cases, the Company also competes against companies capable of providing alternative fuels on the basis of price. Since the capacity of the major interstate pipelines is sometimes less than sufficient to transport all natural gas that could otherwise be purchased, the Company and its customers and suppliers are often in competition with other shippers for pipeline capacity. The Company's ability to transport its natural gas through third party pipelines may be adversely affected during periods of peak demand because the Company and some of its principal suppliers and purchasers have interruptible transportation rights. During periods of peak demand, shippers with firm transportation rights may displace natural gas being shipped by its customers and suppliers. The Company attempts to alleviate these problems by emphasizing sales to local markets or to customers having firm transportation rights on interstate pipelines. The Company has net operating loss ("NOL") carryforwards for income tax purposes of approximately $28.9 million. In addition, the Company has unused investment tax credits of approximately $1.6 million available to offset future federal income tax liabilities. Management expects these tax benefits to give the Company a competitive advantage when bidding on new projects. GOVERNMENTAL REGULATION Governmental regulation has a significant effect on the Company's operations. Its facilities and operations are affected by both federal and state regulatory agencies. State regulatory agencies are responsible for the enforcement of applicable state statutes and regulations, and generally have the responsibility of enforcing the Natural Gas Pipeline Safety Act of 1968 and the regulations promulgated thereunder. The Federal Energy Regulatory Commission ("FERC") is responsible generally for enforcing federal statutes and regulations applicable to the natural gas industry, and the Environmental Protection Agency ("EPA") and other federal and state agencies are responsible for enforcing various environmental laws and regulations. FEDERAL REGULATION. The primary federal statutes associated with the regulation of the natural gas industry are the Natural Gas Act of 1938 (the "NGA") and the Natural Gas Policy Act of 1978 (the "NGPA"). The provisions of the statutes are effected through regulations promulgated by the FERC which are of particular relevance in the regulation of the natural gas industry. The NGA applies to (i) the transportation of natural gas in interstate commerce (ii) sales of natural gas for resale in interstate commerce and (iii) companies engaged in either the transportation of, or sale for resale of, natural gas in interstate commerce. The gathering and local distribution of natural gas, as well as transportation and sales transactions not included in the three aforementioned categories, are specifically excluded from the purview of the NGA. Further, the NGPA provided additional exceptions and exemptions from NGA regulation. The passage of the NGPA addressed partial deregulation of both the sale and the transportation of natural gas. Certain sales and transportation transactions, previously subject to NGA jurisdiction, were exempted from NGA jurisdiction. Section 311 of the NGPA allows, among other things, intrastate pipelines to perform certain specifically described types of transportation and sales transactions in interstate commerce without becoming subject to the NGA. The FERC has promulgated regulations to increase competition in the natural gas industry. The current regulatory scheme of the FERC is designed to make access to natural gas transportation services more available. Through its regulations, FERC has created the "open access" concept. Open access means that natural gas pipelines subject to this regulation must offer natural gas transportation services upon similar terms, and without undue discrimination, to all who desire such services. The FERC has attempted to create more competition in the natural gas industry by requiring interstate pipelines to "unbundle" their services. Unbundling means charging separately for each service (i.e., sales, transportation, storage, swing capacity, etc.), that the pipeline performs. The customer pays only for services actually requested. Although many of these initiatives are new, and their ultimate impact cannot be predicted, these efforts have increased and are generally expected to further increase access to transportation and other services which encourage greater competition among natural gas suppliers and transporters. The Company is dependent upon the transportation services of various interstate pipeline companies. Much of the natural gas purchased and sold by the Company is transported through the facilities of these companies. Thus, changes in the rules, regulations and policies implemented by the FERC with respect to interstate pipelines may impact the Company. The Company offers transportation services through its Texas intrastate pipeline systems on an open access basis subject to certain NGA-exempt provisions of the NGPA and applicable FERC regulations. Rates for transportation services through the Company's systems in Texas are, pursuant to special approval by the FERC, required to be established and approved by the Texas Railroad Commission. Thus, certain of the Company's operations are directly affected by the regulations and policies of FERC. STATE REGULATION. The Company's operations are also subject to regulation by various agencies of the states in which the Company operates. State regulatory requirements and policies, and the effects thereof, vary from state to state. Those of the states of Louisiana, Texas and Pennsylvania have the greatest impact on the Company due to the concentration of the Company's capital in such states and the volume of business associated therewith. The Company's operations in Texas are subject to the Texas Utility Regulatory Act, as implemented by the Texas Railroad Commission. Generally, the Texas Railroad Commission is vested with authority to ensure that rates charged for natural gas sales and transportation services are just and reasonable. The Company's operations within the states of Pennsylvania and Louisiana are subject to regulation by the applicable state regulatory agencies, which generally regulate the rates and services offered by the Company in these states. ENVIRONMENTAL AND SAFETY MATTERS The Company's activities in connection with the operation and construction of pipelines, plants and other facilities for transporting, processing or treating natural gas and other products are subject to environmental regulation by federal and state authorities. This includes state air and water quality control boards and the EPA, which can increase the cost of planning, designing, initial installation and the operations of such facilities. The Occupational Safety and Health Administration's final rule on "Process Safety Management" which became law in February 1992, has been a labor intensive project requiring certain additional manpower. The Company is preparing its process hazard analyses and will implement any required changes. The law requires full compliance by 1996. It is not expected that the Company will be required in the near future to expend amounts that are material in relation to its total capital expenditures to comply with environmental or safety laws. EMPLOYEES At March 21, 1994, the Company had 129 full-time employees. ITEM 2.

ITEM 2. PROPERTIES. GATHERING AND TRANSMISSION SYSTEMS. The Company's gathering and transmission systems are primarily in Texas and Louisiana. The principal systems are the Port Hudson System, the Mountain Creek System, the Elm Grove System, the Gregg County System and the East Texas System. Two other pipeline systems (the Dubach and Claiborne Systems) are utilized in connection with the Company's gas processing operations. The Company completed construction and began initial deliveries through its Port Hudson System in April 1993. This 5.0 mile pipeline system has a capacity of 40 MMCFD and has averaged 20 MMCFD since completion. The Company has a five year contract to deliver natural gas to an industrial end-user in East Baton Rouge Parish, Louisiana. The Company receives natural gas through an interstate pipeline for redelivery. The Company completed construction and began initial deliveries through its Mountain Creek Pipeline System in November 1989. The Company owns 50% and is the operator of this approximately 15.5 mile system located near Dallas, Texas. This system has a capacity of approximately 225 MMCFD and averaged 26 MMCFD in 1993. The system delivers natural gas under a 20 year contract to a plant owned by a local electric company. The plant is obligated under the contract to take at least 50% of its natural gas supply from the Mountain Creek System. The Company completed construction and began initial deliveries through its Elm Grove System in October 1990. This approximately 5.4 mile system receives gas from a central gathering point and delivers it to a gas processing plant in Bossier Parish, Louisiana. The capacity of this system is approximately 20 MMCFD. Although this system only averaged 3 MMCFD in 1993, it is strategically located should new natural gas wells be drilled in the area. The Company completed construction and began initial deliveries through its Gregg County System in May 1990. This 1.6 mile pipeline system has a capacity of 10 MMCFD and averaged throughput in 1993 of approximately 2 MMCFD. The Company had an initial three year contract to deliver natural gas to an industrial end-user in Gregg County, Texas. The Company now operates on a year- to-year contract. The East Texas System consists of two separate pipelines, the Nacogdoches System and the Shelby County System. The East Texas System was constructed in April 1984 and was expanded in 1985. The East Texas System aggregates approximately 84 miles of gathering and transmission lines in Nacogdoches and Shelby Counties, Texas. This system averaged 3 MMCFD in 1993. The system gathers natural gas from the wellhead and is interconnected with four major pipelines (two intrastate and two interstate) that serve the Gulf Coast and Midwest markets. The Dubach System was acquired in November 1988 in connection with the Company's purchase of the Dubach and Calhoun gas processing and refining plants. The system consists of approximately 302 miles of gathering lines and its principal purpose is to gather natural gas to be processed at the Company's North Louisiana facilities. The system averaged 41 MMCFD in 1993. The Company either charges a combined fee or retains a percentage of the products for gathering, treating and processing the natural gas. Residue gas at the tailgate of the Company's plants is delivered to both interstate and intrastate pipeline systems. The Claiborne System was acquired in August 1991 in connection with the Company's purchase of the Claiborne gas processing and refining plants. The system consists of approximately 190 miles of gathering lines and its principal purpose is to gather natural gas to be processed at the Company's Claiborne facilities in Claiborne Parish, Louisiana. The system averaged 25 MMCFD in 1993. The Company retains a percentage of the products for gathering, treating and processing the natural gas. Residue gas at the tailgate of the Company's plants is delivered to several interstate pipelines. The following table sets forth pertinent information with respect to the Company's natural gas gathering and transmission systems at December 31, 1993: GAS LIQUIDS RECOVERY/REFINING. The Company's primary gas processing, treating and refining facilities are located in North Louisiana. The Company also has facilities in Texas, Mississippi and Pennsylvania. Many of the facilities outside Louisiana are underutilized or idle as a result of diminished deliverability of the natural gas reserves behind the plants at then existing locations. Most of the idle or underutilized facilities are skid mounted to facilitate relocation. The Company is focusing on putting these facilities back into service. NORTH LOUISIANA FACILITIES The Company acquired the Calhoun and Dubach gas processing plants along with the Dubach refinery in November 1988. The Calhoun plant has the capacity to process 60 MMCFD of natural gas and averaged 26 MMCFD in 1993. The Calhoun plant is a refrigerated lean oil plant that recovers natural gas liquids and delivers them by pipeline to the Dubach facility for fractionation. The Calhoun plant delivers residue gas into an interstate pipeline. The Dubach gas processing plant was shut down in January 1993 in order to deliver Dubach System gas to the Company's Claiborne facility. All the Company's North Louisiana liquids are currently fractionated at the Dubach facility. The Company discontinued operations at its Dubach refinery in July 1993 as the Company began reducing its emphasis on refining. The Company has two treating plants in North Louisiana, its Cummings and Fandango plants, which are used in conjunction with the Calhoun and Dubach facilities. The Fandango plant is currently idle. The Company acquired the Claiborne gas processing plant and refinery in August 1991. The Claiborne plant has a capacity of 60 MMCFD and with the addition of the Dubach gas, averaged 40 MMCFD in 1993. The Claiborne plant utilizes a refrigerated lean oil recovery system. In September 1993, the Company discontinued operations at its Claiborne fractionation unit and now fractionates all its liquids at the Dubach facility. The Claiborne refinery has a capacity to refine 8,000 barrels per day ("BPD") of crude oil and condensate. The Claiborne facility also has a solvent unit to further process about 2,500 BPD. The Company is in the process of moving its Bear Wallow and Cheyenne cryogenic recovery plants to North Louisiana at the Company's Dubach site. These plants were located in Brazoria County, Texas and have a combined capacity of 45-50 MMCFD. The Cheyenne plant was underutilized and the Bear Wallow plant was idle. Once the move is complete, the Company will discontinue operations at its Claiborne gas processing plant. Initial operation of the cryogenic plants is expected early in the second quarter of 1994. The cryogenic plants are more fuel efficient, achieve greater recoveries of NGLs, are less labor intensive, and have lower operating costs than the Company's current gas processing operations. TEXAS The Company's Cheyenne plant operated until November 1993 and is currently being moved to North Louisiana. The Company's Bear Wallow plant was idle in 1993. The Company owned 50% and was the operator of these plants until acquiring the remaining 50% in July 1993. The Cheyenne plant average inlet volume in 1993 was 10 MMCFD. The Company is treating natural gas in Dewitt County, Texas at its Gun Point III plant. This treating plant has a capacity of 53 MMCFD and averaged 6 MMCFD in 1993. The Company owns all or part of three idle cryogenic and two natural gas treating plants in Texas. OTHER The Company owns a 50% interest in a cryogenic recovery plant in Green County, Pennsylvania. This plant has an inlet capacity of 14 MMCFD and averaged 10 MMCFD in 1993. The Company also owns a gas treating plant in Brandon, Mississippi. This treating plant has a capacity of 17 MMCFD and averaged 12 MMCFD in 1993. The Company charges a fee per million cubic feet ("MCF") for this service. The following table sets forth pertinent information with respect to the Company's significant operating natural gas processing and treating plants at December 31, 1993: ASSETS PLEDGED AS COLLATERAL. Virtually all of the Company's assets are pledged as collateral on various loans. See Note 4 of "Notes to Consolidated Financial Statements". ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. On June 4, 1993, Endevco, Inc. and its subsidiaries ANGIC, Inc., Mississippi Fuel Company and Endevco Taft Company filed voluntary petitions for reorganization under Chapter 11 of the Bankruptcy Code with the United States Bankruptcy Court for the Eastern District of Texas, Sherman Division. No other subsidiary of the Company was included in the bankruptcy filing. On September 29, 1993, the Bankruptcy Court confirmed the Debtor's First Amended Joint Plan of Reorganization, and the Plan was consummated on November 2, 1993. For details about the Plan see Note 2 of "Notes to Consolidated Financial Statements" and Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations". The Company is involved in certain legal actions and claims arising in the ordinary course of their business. It is the opinion of management (based on advice of legal counsel) that such litigation and claims will be resolved without material effect on the Company's financial position. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. The Company did not submit any matters during the fourth quarter of the fiscal year covered by this Annual Report to a vote of security holders. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The common stock of the Company, par value $.10 per share, is traded on the American Stock Exchange under the symbol "CGA." Set forth below are the high and low sales prices for the common stock. On March 21, 1994, the closing price for the common stock, as reported by the American Stock Exchange, was $1.63 per share. As of March 21, 1994, there were 575 holders of record of common stock. The Company believes that there are substantially more beneficial holders of common stock. The Company has not paid any cash dividends on its common stock and intends to retain its earnings for use in operations and for expansion of its business. In addition, the Company is prohibited from paying dividends under the terms of its loan agreements. See Note 4 of "Notes to Consolidated Financial Statements". ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. The following selected financial information for the years ended December 31, 1989 through 1993, is derived from the consolidated financial statements of the Company for such years. The information should be read in conjunction with the consolidated financial statements and the notes thereto included elsewhere herein. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. LIQUIDITY AND CAPITAL RESOURCES REORGANIZATION. On June 4, 1993, the Debtors filed voluntary petitions for reorganization under Chapter 11 of the Bankruptcy Code. On September 29, 1993, the Bankruptcy Court issued an order confirming the Debtor's First Amended Joint Plan of Reorganization. On November 2, 1993, the following transactions resulted from the consummation of the Plan: (1) The Debtors paid approximately $2.1 million in cash and transferred their Mississippi Fuel, Ada, Chalybeate Springs and Leaf River gathering and pipeline systems along with certain contractual rights owned by the Debtors to the holders (the "Noteholders") of the Debtor's 9% Senior Notes, 11.7% Senior Notes and 11.5% Subordinated Convertible Debentures. The cash payments and transfer of assets was in full satisfaction of all allowed claims of the Noteholders (approximately $44.1 million of debt and accrued interest on the financial records of the Debtors). The Company paid in full all other creditors. (2) The Debtors paid approximately $4.6 million in cash and issued promissory notes in the aggregate of $2.5 million (the "Note") to the holders (the "Preferred Stockholders") of the Company's $9.50 Series A Cumulative Convertible Exchangeable Preferred Stock (the "Preferred Stock") in satisfaction of all allowed claims (approximately $27.0 million on the financial records of the Debtors, which includes the liquidation value of the Preferred Stock and all accrued and unpaid dividends thereon). The Note is secured by a lien on the stock of all the subsidiaries of Cornerstone and is guaranteed by its subsidiary, Cornerstone Pipeline Company (formerly known as Endevco Pipeline Company), which holds an interest in the Mountain Creek Joint Venture and also owns the Excelsior gathering system. Pursuant to the terms of the Note, the Company is prohibited from paying dividends or repurchasing shares of its capital stock. (3) All outstanding common stock, par value $.10 per share (the "Former Common Stock"), of Endevco, Inc. was canceled and each holder thereof was issued one share of the common stock of Cornerstone (the "New Common Stock") for each share of Former Common Stock held. Holders of the Former Common Stock constitute approximately 63% of the shares of New Common Stock. All outstanding stock options were canceled. (4) Pursuant to the First Amended Stock Purchase Agreement by and between Ray Davis, Trustee (the "Purchaser") and Cornerstone dated May 28, 1993, Ray Davis and his assigns acquired 4,576,659 shares of New Common Stock and warrants to acquire an additional 2,564,103 shares of New Common Stock with an exercise price of $.78 per share. The aggregate purchase price of such shares of New Common Stock and warrants was $3.0 million. The purchased shares constitute approximately 37% of the Company's issued and outstanding shares of New Common Stock. The purchased shares and the warrants, if exercised, would constitute approximately 47% of the fully diluted capital stock of the Company. (5) The Company entered into a term loan and revolving credit facility (the "Senior Loan") with a financial institution. The term portion of the Senior Loan was for $5.8 million and provides for monthly principal and interest payments. The interest is to be calculated at the applicable prime rate plus two percent. The revolving credit facility allows for working capital loans and standby letters of credit up to an aggregate of $6.0 million. A portion of the proceeds from the new Senior Loan were used to retire the remaining debt associated with the purchase of the original assets of Dubach Gas Company ("Dubach") as well as the debt incurred when the assets of Claiborne Gasoline Company were acquired. (6) The Company amended its Certificate of Incorporation to (1) change the Company's name to Cornerstone Natural Gas, Inc. from Endevco, Inc. and (2) provide for certain restrictions on the transfer of New Common Stock. One of the goals of the Company from the reorganization was to restructure the Company's debt obligations so they could be met from continuing operations. As part of the Plan, the Company is moving two of its cryogenic plants from Brazoria County, Texas to Lincoln Parish, Louisiana. The cost to move and install these plants is estimated to be $2.5 million. The cryogenic plants are expected to be operational early in the second quarter of 1994. The cryogenic plants are more fuel efficient, achieve greater recoveries of NGLs, are less labor intensive, and have lower operating costs than the Company's current gas processing operations. Management expects these plants to significantly improve cash flows from operations by the second half of 1994. CAPITAL EXPENDITURES. The Company made capital expenditures of approximately $3.7 million in 1993. Approximately $1.6 million of these related to the building of a five mile pipeline to service a paper mill in East Baton Rouge Parish, Louisiana (the "Port Hudson Pipeline"). Approximately $1.2 million has been spent towards the moving of the two cryogenic plants to Lincoln Parish, Louisiana. The Company anticipates spending another approximately $1.3 million in 1994 to complete the project. The Company is continuing to evaluate its remaining assets in regard to its current strategic direction. As such, the Company is actively attempting to redeploy existing idle assets into new projects and is evaluating potential sales of nonperforming assets. The Company's Senior Loan requires lender approval to pursue major projects. The Company's capital budget for 1994 is limited under the the Senior Loan to $500,000 (excluding the moving of the two cryogenic gas processing plants). However, the Company continues to pursue projects that would require long-term borrowing. These funds and the approvals necessary under existing loan agreements will be secured prior to committing to any new projects. The Company believes that its current relationships with existing lenders will allow borrowing capacity for future capital requirements. However, each project will be separately evaluated, and must meet its own cash flow requirements. There can be no assurance regarding the Company's ability to obtain additional capital when needed on acceptable terms or that all necessary consents or waivers will be obtained from its lenders. LINE OF CREDIT. On July 1, 1993, Dubach discontinued operations at one of its two condensate refineries. As a result, the Company is buying less condensate and crude oil reducing the amount of standby letters of credit needed. Dubach reduced its line of credit to $10.0 million under which standby letters of credit can be issued. This line of credit expires March 31, 1994. Dubach has replaced this line of credit with a $2.6 million line of credit from a different financial institution. The maturity date of the new line is April 30, 1994. The current line of credit covers Dubach's requirements for buying condensate and crude oil for the refinery through March business. Dubach will need an extension of this line or must reduce its purchases of crude oil for April business. See Note 4 of "Notes to Consolidated Financial Statements." NOL CARRYFORWARDS. The Company has NOL carryforwards for income tax purposes of approximately $28.9 million which, if not previously utilized, will expire at various times from 2001 until 2008. In addition, the Company has unused investment tax credits of approximately $1.6 million available to offset future federal income tax liability. The Company considers such carryforwards and tax credits to be potentially valuable assets which may be used to shelter future taxable earnings from income taxes. If a change of ownership as defined in Internal Revenue Code Section 382 occurs, utilization of the NOL carryforwards could be severely limited. WORKING CAPITAL. The Company's working capital deficit was $5.2 million at December 31, 1993. The Company expects to maintain a working capital deficit throughout 1994 in order to effectively manage cash. Management believes that its improved cash flows from operations combined with amounts available under its $6.0 million line of credit will be sufficient to meet its cash requirements in 1994. RESULTS OF OPERATIONS YEAR ENDED DECEMBER 31, 1993 COMPARED TO YEAR ENDED DECEMBER 31, 1992 GENERAL. The Company's operations were negatively impacted in 1993 by the reorganization. The uncertainty related to the Company's financial condition limited the Company's ability to purchase natural gas. Many suppliers required prepayments or put restrictions on purchases which ultimately resulted in an increase in the cost of natural gas to the Company. Management believes that the negative influences of the reorganization will begin to dissipate in 1994. In addition, average margins on refined products decreased in 1993 from 1992. This combined with a decrease in emphasis on refining is expected to allow the Company to return to profitability. NATURAL GAS PIPELINE OPERATIONS. Sales volumes for natural gas declined in 1993 as the financial condition of the Company required curtailment of certain business activities. The following table provides pertinent information relating to the Company's natural gas pipeline operations. The Company's natural gas pipeline operations contributed 44% of total consolidated gross margin in 1993 compared to 49% in the prior year. Earnings from operations before depreciation declined $3.9 million (47%) primarily as a result of a decrease in throughput of natural gas. As a result of the Company's reorganization, it became increasingly difficult to acquire supplies of natural gas. The Company utilized its supplies to ensure that it fulfilled its commitments on all its term sales contracts. From the limited supply, the Company was forced to curtail certain other marketing activities. This particularly impacted the assets transferred as part of the reorganization. Throughput on the transferred assets declined 63 MMCFD. The Company also experienced a decline in throughput of approximately 7 MMCFD on its Mountain Creek System. This was the result of maintenance performed on the power plant which is supplied by the Mountain Creek System. The maintenance required the plant to be taken off-line for three months. Additionally, this plant will have lower utilization in the future as the utility has replaced some of its needs with nuclear power. These declines in throughput were partially offset by the addition of the Company's Port Hudson System which began operations in April 1993. The Company's Off-system sales throughput declined 5 MMCFD (7%) in 1993. Gross margin on these sales decreased approximately $378,000. This was caused in part by an increase in the cost of supply relative to sales. Additionally, higher natural gas prices during most of 1993 limited the Company's ability to compete with utility tariffs in the northeast market areas. NATURAL GAS PROCESSING OPERATIONS. The following table provides pertinent information relating to the Company's gas processing operations. Gross margin from gas processing operations contributed 56% of consolidated margin compared to 51% in the prior year. Earnings from operations declined $1.4 million (63%) in 1993. The decreased earnings was primarily the result of a decline in margin per barrel sold. The Company discontinued operations at one of its two condensate refineries in July 1993. The Company also consolidated the usage of its North Louisiana facilities and was able to discontinue operations at one of its two fractionating units in September 1993. The Company expects the installation of cryogenic facilities in North Louisiana to significantly increase cash flow in 1994 from its gas processing operations. GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses have declined $823,000 (20%) in 1993. This reflects specific management efforts to reduce overhead costs through consolidation and eliminations of functions and staff reductions. The Company significantly reduced its office space and has reduced its use of outside professional services. OTHER INCOME (EXPENSE). Interest expense decreased $2.4 million (47%) primarily as a result of the debt that was retired as part of the reorganization. The Company sold its interest in Three Rivers Pipeline Company and Allegheny Energy Marketing Company (collectively referred to as "Three Rivers") in January 1993. The Company's share of losses from its interest in Three Rivers was $555,000 in 1992. The Company recorded a gain from the sale of its interest in Three Rivers of $611,000 in 1993. REORGANIZATION ITEMS. The Company recorded a loss on the disposition and write downs of property, plant and equipment of $20.3 million in 1993. This included the assets transferred to the Noteholders and other assets that were considered impaired to the reorganized Company. The professional fees of $4.5 million incurred for the reorganization included primarily legal fees, consultant fees and bankruptcy costs. EXTRAORDINARY ITEM. The Company recorded a $9.1 million gain from the extinguishment of debt in conjunction with the reorganization. YEAR ENDED DECEMBER 31, 1992 COMPARED TO YEAR ENDED DECEMBER 31, 1991 GENERAL. The Company experienced a net loss applicable to common stockholders of $7.5 million in 1992 compared to a net loss of $3.5 million in 1991. The increase in net loss was primarily a result of decreased natural gas volumes on the Company's facilities, decreased unit margins from gas processing and refining, increased operating expenses (primarily repairs, maintenance and treating chemicals) and increased costs related to the negotiations of debt restructuring. NATURAL GAS PIPELINE OPERATIONS. The natural gas operations segment contributed 49% of total revenues and 48% of total gross margin during 1992, as compared to 56% and 57% respectively in 1991. Earnings before depreciation declined $2.0 million (20%) in 1992. This was primarily the result of reduced gross margin on the Company's Mississippi System and the disposition of its Hattiesburg Gas Storage facilities. The Company recorded $1.8 million of gross margin and $1.5 million of operating earnings before depreciation from the Hattiesburg facilities in 1991 before the disposition. The Company moved an average of 208 MMCFD through its facilities during 1992 compared to 241 MMCFD in 1991. The decrease in volume was primarily attributable to a 31 MMCFD decline on the Company's Mississippi System. Third party transportation on the Mississippi System declined 11 MMCFD as reserves were depleting without new drilling. The Company's volumes, bought for resale, declined 20 MMCFD. This was partially a result of the Company's financial difficulties which limited the supply of natural gas. Gross margin decreased $1.4 million (10%) in 1992. The Company's unit margin increased to $.16 per MCF from $.15 per MCF. The gross margin decline was primarily a result of the decreased throughput on the Mississippi System. Decreased third party gas transportation volumes resulted in a decline in gross margin of $964,000 while the decreased volumes, bought for resale, resulted in a decline of $1.1 million. These declines were partially offset by an increase in gross margin on the Company's Ada System of $731,000. The Ada System increase resulted from a greater average gross margin per unit in 1992. The Company's Off-system volumes increased 15% to 68 MMCFD in 1992. The gross margin increased 24% to $1.3 million in 1992. NATURAL GAS PROCESSING OPERATIONS. Gross margin increased $2.4 million (20%) in 1992, primarily as a result of a full year of operations from the Claiborne facilities compared to only five months in the previous year. Earnings from operations declined $2.2 million (46%) primarily from the Company's Dubach and Claiborne facilities. The decreased earnings reflect increased operating expenses and a decline in margin per barrel sold. Operating expenses increased due to (i) several major overhauls of compressors, (ii) repair of lightning damage, (iii) repair of natural gas lines in order to return them to service and (iv) repairs needed to meet environmental and safety standards. GENERAL AND ADMINISTRATIVE. General and administrative costs decreased $1.3 million in 1992. This difference is primarily attributable to project development costs that were written off in 1991 related to projects that did not fit the Company's current strategic direction. OTHER INCOME (EXPENSE). Interest expense decreased $1.4 million in 1991. This was primarily a result of $10.2 million of principal payments made in 1991 and the sale of the Hattiesburg facilities. The $643,000 decrease in equity earnings (losses) of unconsolidated affiliates was largely the result of a $454,000 decrease in earnings from the Company's interest in Three Rivers. The Company sold its interest in Three Rivers in January 1993. In 1991, there was a $3.7 million gain recorded on the sale of the Hattiesburg facilities. Also in 1991, there was a loss of $1.6 million recorded in relation to a sale and leaseback on three of the Company's Texas pipeline systems. There were no sales of significant assets in 1992. OTHER MATTERS ACCOUNTING FOR INCOME TAXES. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," ("FAS 109"). The adoption of FAS 109 changed the Company's method of accounting for income taxes from the deferred method (APB 11) to an asset and liability approach. Under APB 11, the Company has deferred the tax effects of timing differences between financial reporting and taxable income. The asset and liability approach requires the recognition of deferred tax liabilities and assets for the expected future tax consequence of temporary differences between the carrying amounts and the tax bases of assets and liabilities. Adoption of FAS 109 had no material impact on the Company's financial position at January 1, 1993, or the results of its operations for the year ended December 31, 1993. The Omnibus Budget Reconciliation Act of 1993 signed into law by President Clinton on August 10, 1993, contains several provisions affecting corporations. The most notable to the Company is an increase in the top corporate income tax rate from 34% to 35%. Although most provisions of the new law were effective January 1, 1993, it had no impact in 1993 and it is not anticipated to have any significant impact in 1994 due to the net operating loss position of the Company. EFFECTS OF CHANGING PRICES. Natural gas, NGLs and petroleum product prices have fluctuated significantly over the last three years. The Company, however, earns a margin which is the difference between the revenues from sales of products over the purchase costs of such. The change in margin, although it has declined over the three year period, is much less volatile than the change in product prices. Inflation has not had a significant impact on operating expenses in the last three years. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS PAGE ---- CORNERSTONE NATURAL GAS, INC. AND SUBSIDIARIES Report of Ernst & Young, Independent Auditors. . . . . . . . . . . . . 17 Consolidated Statements of Operations for the Years Ended December 31, 1993, 1992, and 1991. . . . . . . . . . . . . . 18 Consolidated Balance Sheets at December 31, 1993 and 1992. . . . . . . 19 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992, and 1991. . . . . . . . . . . . . . 20 Consolidated Statements of Changes in Stockholders' Equity for the Years Ended December 31, 1993, 1992, and 1991. . . . 21 Notes to Consolidated Financial Statements . . . . . . . . . . . . . . 22-33 REPORT OF ERNST & YOUNG, INDEPENDENT AUDITORS The Board of Directors and Stockholders Cornerstone Natural Gas, Inc. We have audited the accompanying consolidated balance sheets of Cornerstone Natural Gas, Inc. and Subsidiaries (the "Company") at December 31, 1993 and 1992, and the related consolidated statements of operations, cash flows and changes in stockholders' equity for each of the three years in the period ended December 31, 1993. Our audits included the financial statement schedules listed in the Index at Item 14(a). These consolidated financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. ERNST & YOUNG Dallas, Texas March 7, l994 CORNERSTONE NATURAL GAS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS The accompanying notes are an integral part of these consolidated financial statements. CORNERSTONE NATURAL GAS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS The accompanying notes are an integral part of these consolidated financial statements. CORNERSTONE NATURAL GAS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS The accompanying notes are an integral part of these consolidated financial statements. CORNERSTONE NATURAL GAS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY THREE YEARS ENDED DECEMBER 31, 1993 The accompanying notes are an integral part of these consolidated financial statements. CORNERSTONE NATURAL GAS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. GENERAL AND SIGNIFICANT ACCOUNTING POLICIES (a) General and Principles of Consolidation Cornerstone Natural Gas, Inc. (formerly Endevco, Inc.), a Delaware corporation ("Cornerstone"), is engaged in the business of natural gas pipeline and natural gas processing operations. Natural gas pipeline operations include purchasing, gathering, transporting and marketing of natural gas. Natural gas processing operations include recovering and marketing of natural gas liquids ("NGLs") from natural gas and treating natural gas by removing noncommercial components. Natural gas processing operations also include refining condensate and crude oil into various petroleum products. The consolidated financial statements include the accounts of Cornerstone and its wholly owned and majority-owned subsidiaries (referred to collectively as the "Company") - Cornerstone Gas Processing, Inc. (formerly Endevco Natural Gas Company); Cornerstone Pipeline Company (formerly Endevco Pipeline Company); Endevco Producing Company; Cornerstone Gas Resources, Inc. (formerly Endevco Oil and Gas Company); Endevco Taft Company; Cornerstone Gas Gathering Company (formerly Cornerstone Pipeline Company); Pentex Petroleum, Inc.; Pentex Pipeline, Inc.; Endevco Three Rivers Company; Dubach Gas Company ("Dubach") and Cengaz Company. On September 30, 1993, ANGIC, Inc. (formerly known as Cornerstone Natural Gas Company) and Mississippi Fuel Company, both wholly owned subsidiaries, were merged into Cornerstone. The consolidated financial statements of the Company also include its proportionate share of the assets, liabilities, revenues and expenses of affiliated companies, partnerships and joint ventures if the Company owns at least a 50% interest. Affiliates in which the Company owns less than a 50% interest are accounted for using the equity method. The consolidated financial statements also include Endevco Industrial Gas Sales Company through 1991. Certain reclassifications of prior years' financial information have been made to conform to the current year presentation. (b) Cash Equivalents The Company considers all highly liquid investments with insignificant interest rate risk and original maturities of three months or less to be cash equivalents. (c) Inventory Inventory is stated at the lower of cost or market, determined by the first in, first out method. (d) Property, Plant and Equipment Depreciation of property, plant and equipment is provided using the straight-line method over the following estimated useful lives: Years ----- Pipelines and pipeline rights-of-way 5-20 Gas liquids recovery, treating and refining plants 10-20 Gas storage facilities 22 Equipment and other 3-15 Most of the Company's gas liquids recovery and gas treating plants are skid-mounted and moveable from one service location to another. The cost of moving the plants between service locations is capitalized and amortized using the straight-line method over the life of the related service contract. (e) Goodwill Goodwill represents the excess of the cost over the net assets of businesses acquired and is amortized on a straight-line basis over periods of twenty to forty years. Goodwill is presented net of accumulated amortization of $496,419 and $379,606 at December 31, 1993 and 1992, respectively. (f) Income Taxes Effective January 1, 1993, the Company adopted the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (FAS 109) changing the method of accounting for income taxes. As permitted under the new rules, prior years' financial statements have not been restated to reflect the change. The adoption of FAS 109 changed the Company's method of accounting for income taxes from the deferred method (APB 11) to an asset and liability approach. Under APB 11, deferred income taxes are provided for income and expense items that are reported for income tax purposes in different years than for financial reporting purposes, whereas under FAS 109 deferred tax liabilities and assets are recognized for the expected future tax consequence of temporary differences between the carrying amounts and the tax bases of assets and liabilities. The measurement of deferred income tax assets is adjusted by a valuation allowance, if necessary, to recognize future tax benefit only to the extent, based on available evidence, it is more likely than not, it will be realized. The effect on deferred taxes of a change in income tax rates is recognized in the period that includes the enactment date. Adoption of FAS 109 had no effect on the Company's financial position at January 1, 1993 or the results of its operations for the year ended December 31, 1993. (g) Earnings (Loss) per Common and Common Equivalent Share Earnings (loss) per common and common equivalent share are based on the weighted average number of shares outstanding during each year as adjusted for outstanding stock options and warrants, if dilutive, using the treasury stock method. Fully-diluted earnings per share for all years are not presented, because the effects of the assumed conversion of the 11.5% Subordinated Convertible Debentures or the Series A Cumulative Convertible Exchangeable Preferred Stock are antidilutive. (h) Concentrations of Credit Risk The Company markets natural gas and refined products to utilities, local distribution companies and industrial end-users. The Company performs ongoing credit evaluations of its customers and if deemed necessary, requires purchasers of the Company's products to prepay or issue standby letters of credit as collateral. Credit losses are provided for in the consolidated financial statements and consistently have been within management's expectations. The Company has cash deposits with various banks consisting principally of demand deposits and time deposits. These deposits generally have maturities of one year or less and bear minimal risk. The Company has not experienced any losses on its cash deposits. 2. Plan of Reorganization On June 4, 1993, Endevco, Inc. and its subsidiaries ANGIC, Inc., Mississippi Fuel Company and Endevco Taft Company (collectively, the "Debtors") filed voluntary petitions for reorganization under Chapter 11 of the Bankruptcy Code with the United States Bankruptcy Court for the Eastern District of Texas, Sherman Division (the "Bankruptcy Court"). No other subsidiary of the Company was included in the bankruptcy filing. On September 29, 1993, the Bankruptcy Court issued an order confirming the Debtor's First Amended Joint Plan of Reorganization (the "Plan"). On November 2, 1993, the following transactions resulted from the consummation of the Plan: (1) The Debtors paid approximately $2.1 million in cash and transferred their Mississippi Fuel, Ada, Chalybeate Springs and Leaf River gathering and pipeline systems along with certain contractual rights owned by the Debtors to the holders (the "Noteholders") of the Debtor's 9% Senior Notes, 11.7% Senior Notes and 11.5% Subordinated Convertible Debentures. The cash payments and transfer of assets is in full satisfaction of all allowed claims of the Noteholders (approximately $44.1 million of debt and accrued interest on the financial records of the Debtors). The Company paid in full all other creditors. (2) The Debtors paid approximately $4.6 million in cash and issued promissory notes in the aggregate of $2.5 million (the "Note") to the holders (the "Preferred Stockholders") of the Company's $9.50 Series A Cumulative Convertable Exchangeable Preferred Stock (the "Preferred Stock") in satisfaction of all allowed claims (approximately $27.0 million on the financial records of the Debtors, which includes the liquidation value of the Preferred Stock and all accrued and unpaid dividends thereon). The Note is secured by a lien on the stock of all the subsidiaries of Cornerstone and is guaranteed by its subsidiary, Cornerstone Pipeline Company, which holds an interest in the Mountain Creek Joint Venture and also owns the Excelsior gathering system. Pursuant to the terms of the Note, the Company is prohibited from paying dividends or repurchasing shares of its capital stock. (3) All outstanding common stock, par value $.10 per share (the "Former Common Stock"), of Endevco, Inc. was canceled and each holder thereof was issued one share of the common stock of Cornerstone (the "New Common Stock") for each share of Former Common Stock held. Holders of the Former Common Stock constitute approximately 63% of the shares of New Common Stock. All outstanding stock options were canceled. (4) Pursuant to the First Amended Stock Purchase Agreement by and between Ray Davis, Trustee (the "Purchaser") and Cornerstone dated May 28, 1993, Ray Davis and his assigns acquired 4,576,659 shares of New Common Stock and warrants to acquire an additional 2,564,103 shares of New Common Stock with an exercise price of $.78 per share. The aggregate purchase price of such shares of New Common Stock and warrants was $3.0 million. The purchased shares constitute approximately 37% of the Company's issued and outstanding shares of New Common Stock. The purchased shares and the warrants, if exercised, would constitute approximately 47% of the fully diluted capital stock of the Company. (5) The Company entered into a term loan and revolving credit facility (the "Senior Loan") with a financial institution. The term portion of the Senior Loan was for $5.8 million and provides for monthly principal and interest payments. The interest is to be calculated at the applicable prime rate plus two percent. The revolving credit facility allows for working capital loans and standby letters of credit up to an aggregate of $6.0 million. A portion of the proceeds from the Senior Loan were used to retire the remaining debt associated with the purchase of the original assets of Dubach as well as the debt incurred when the assets of Claiborne Gasoline Company were acquired. (6) The Company amended its Certificate of Incorporation to (1) change the Company's name to Cornerstone Natural Gas, Inc. from Endevco, Inc. and (2) provide for certain restrictions on the transfer of New Common Stock. The Company has accounted for all transactions related to the Chapter 11 proceedings in accordance with the Statement of Position 90-7 ("SOP 90-7") of the American Institute of Certified Public Accountants entitled, "Financial Reporting by Entities in Reorganization Under the Bankruptcy Code." In addition, certain other property and equipment was written down as a result of the reorganization. These transactions resulted in a loss on disposition and write downs of property, plant and equipment of approximately $20.3 million and an extraordinary gain from the forgiveness of debt of approximately $9.1 million. As a result of the reorganization, the Company believes that cash flows from its remaining operations combined with amounts available under its $6.0 million revolving credit facility will be sufficient to meet its projected cash requirements during 1994. 3. PROPERTY, PLANT, AND EQUIPMENT A summary of property, plant, and equipment follows: Interest cost capitalized during the construction of projects was $8,000 in 1993, $26,000 in 1992, and $69,000 in 1991. As part of the Plan, the Mississippi Fuel, Ada, Chalybeate Springs, and Leaf River pipeline gathering systems were transferred to the Noteholders during 1993. The carrying value of these assets was approximately $47.8 million at the time of the transfer. In addition, certain other property and equipment was written down as a result of the reorganization. These transactions resulted in a loss on disposition and write downs of property, plant, and equipment of approximately $20.3 million. See Note 2. The Company wrote off $131,000 of project development costs during 1992. These costs related to projects that no longer fit the Company's strategic plans. 4. LONG-TERM DEBT A summary of debt follows: (a) In November 1993, the Company entered into the Senior Loan with a financial institution. The $5.8 million term portion of the Senior Loan provides for monthly principal and interest payments. Interest is payable monthly at the applicable prime rate plus two percent. The revolving credit facility allows for working capital loans and standby letters of credit up to an aggregate of $6.0 million subject to a borrowing base as defined. As of December 31, 1993, $5.9 million was available from this line. As of December 31, 1993, there were no working capital loans outstanding and the financial institution had issued, for the Company's benefit, approximately $3.7 million in standby letters of credit for natural gas purchases. The revolving credit facility expires October 31, 1995 unless extended. The Senior Loan is secured by essentially all the assets of the Company and includes provisions for mandatory prepayments of principal if certain financial results are achieved. The Senior Loan requires the Company to maintain certain financial ratios, prohibits the Company from paying dividends and restricts capital expenditures. A portion of the proceeds from the Senior Loan were used to retire the remaining debt associated with the purchase of the original assets of Dubach as well as the debt incurred when the assets of Claiborne Gasoline Company were acquired. (b) In conjunction with the reorganization, the Debtors issued promissory notes in the aggregate of $2.5 million to the Preferred Stockholders in satisfaction of all allowed claims (approximately $27.0 million on the financial records of the Debtors, which included the liquidation value of the Preferred Stock and all accrued and unpaid dividends thereon). The Note bears interest at prime rate plus two percent and is secured by a lien on the stock of all the subsidiaries of Cornerstone and is guaranteed by its subsidiary, Cornerstone Pipeline Company, which holds an interest in the Mountain Creek Joint Venture and also owns the Excelsior gathering system. The note is due in varying annual installments through December 31, 1997, and requires monthly payments of interest during the term of the note. Pursuant to the terms of the Note, the Company is prohibited from paying dividends or repurchasing shares of its capital stock. (c) In September, 1989, the Company's 50% owned Mountain Creek Joint Venture ("MCJV") borrowed $6.0 million from a financial institution. The debt is secured by MCJV pipeline facilities, and bears interest at prime rate plus two percent. The loan is due in varying quarterly installments which began January 1, 1990, with a balloon payment due October 1, 1996. The net book value of assets encumbered by the aforementioned debt at December 31, 1993, was approximately $4.7 million ($2.4 million relating to the Company's 50% ownership interest). (d) In connection with the acquisition of certain refining and processing facilities, Dubach entered into a Term Loan and Revolving Credit Agreement ("Agreement") with a financial institution. The Agreement originally provided for an acquisition loan and a revolving line of credit. Under the revolving line of credit, working capital loans and standby letters of credit were permitted. A portion of the proceeds from the Senior Loan were used to retire the acquisition loan and the working capital loan. The current line of credit permits standby letters of credit only. As of December 31, 1993, the financial institution had issued for the Company's benefit, approximately $10.0 million in standby letters of credit with the maximum available being $10.0 million, subject to a borrowing base. The maturity date of this revolving line of credit is March 31, 1994. Fees related to this revolving line of credit are 2% on letters of credit and a .5% fee on the unused portion of the line. This line is secured by the cash, accounts receivable, and inventory of Dubach. The Company has arranged for a revolving line of credit whereby standby letters of credit are permitted from a financial institution for March 1994 production. The agreement is secured by a second lien through subordination up to $2.6 million on the cash, inventory, and accounts receivable of Dubach. As of March 1, 1994, there were $2.6 million standby letters of credit issued and outstanding under this line of credit with the maximum being $2.6 million. The maturity date of this line of credit is April 30, 1994. Fees related to this agreement are 1 1/2% per annum. (e) Effective August 1, 1991, Dubach acquired the assets of Claiborne Gasoline Company in exchange for a $1.25 million note due to the seller in 120 monthly installments of approximately $25,000, including interest. These assets included approximately 190 miles of gas gathering pipeline facilities and related gas liquid recovery and refining facilities. A portion of the proceeds from the Senior Loan were used to retire the remainder of this debt. (f) In 1992, the Company was operating under a standstill and forbearance agreement (the "Standstill Agreement") with the Noteholders. This obligation was satisfied as part of the Plan (Note 2). Aggregate maturities of long-term debt, for each of the five subsequent fiscal years are as follows: 5. INCOME TAXES Effective January 1, 1993, the Company adopted the provisions of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (FAS 109) changing the method of accounting for income taxes. As permitted under the new rules, prior years' financial statements have not been restated to reflect the change. There is no cumulative effect from the adoption of FAS 109 as of January 1, 1993, and no deferred tax provision for the year ended December 31, 1993. The significant components of the provision (benefit) for income taxes are as follows: Deferred income taxes reflect the net tax effect of temporary differences between the financial reporting carrying amounts of assets and liabilities and income tax carrying amounts. The components of the Company's deferred tax liabilities and assets at December 31, 1993 and January 1, 1993 are as follows: The sources of deferred income taxes and the tax effect of each for the years ended December 31, 1992 and 1991 are as follows: The provision (benefit) for income taxes differed from amounts computed at the statutory federal income tax rate as follows: The Company has NOL carryforwards for income tax purposes of approximately $28.9 million which, if not previously utilized, will expire at various times from 2001 through 2008. In addition, the Company has unused investment tax credits of approximately $1.6 million available to offset future federal income tax liabilities. In general, the credits expire at various times from 1996 through 2001, unless previously utilized. The respective carryforwards are available to the Company in their full amounts unless a "change of ownership", as defined in Internal Revenue Code Section 382, occurs. If a change of ownership occurs utilization of the NOL carryforwards could be severely limited. 6. COMMITMENTS AND CONTINGENT LIABILITIES The Company leases office space, equipment and automobiles under lease obligations classified as operating leases. Rental expense under these leases was approximately $1.7 million in 1993, $2.1 million in 1992, and $1.8 million in 1991. At December 31, 1993, minimum future rental payments due under operating leases were as follows: The Company is involved in certain other legal actions and claims arising in the ordinary course of business. It is the opinion of management (based on advice of legal counsel) that such litigation and claims will be resolved without material effect on the Company's financial position. 7. TRANSACTIONS WITH RELATED PARTIES On May 28, 1993, the Company entered into the First Amended Stock Purchase Agreement (the "Stock Purchase Agreement") with Ray Davis, Trustee. Under the Stock Purchase Agreement, the Purchaser agreed to purchase 4,576,659 shares of New Common Stock and warrants to acquire 2,564,103 shares of New Common Stock (with an exercise price of $.78 per share) for $3.0 million. On June 4, 1993 in connection with the Plan, Mr. Ray C. Davis became the Chairman of the Board of Directors and the Chief Executive Officer of the Company. At the same time, Mr. Kelcy L. Warren returned to the Company in his prior role of President and Chief Operating Officer. The Company felt that it was important that this management team was in place in order for the Company to complete its reorganization and recapitalization. In connection with the Company's emergence from bankruptcy on November 2, 1993, Mr. Davis purchased 381,388 shares of New Common Stock, Mr. Ben H. Cook purchased 1,618,612 shares of New Common Stock and Endevco Investors Joint Venture (the "Joint Venture") purchased 2,576,659 shares of New Common Stock. Mr. Davis is the managing partner of the Joint Venture and Mr. Cook and Mr. Warren each have an interest in the Joint Venture. Pursuant to the Stock Purchase Agreement, a warrant to purchase 769,231 shares of New Common Stock was issued to Mr. Davis, a warrant to purchase 512,821 shares of New Common Stock was issued to Mr. Cook, a warrant to purchase 769,231 shares of New Common Stock was issued to Mr. Warren. Each of the warrants entitle the holder to purchase shares of New Common Stock for $.78 per share. At the same time, the Company elected Mr. Cook, Mr. Ted Collins, Jr. and Mr. Richard D. Brannon to the Board of Directors of the Company pursuant to the terms of the Stock Purchase Agreement. Affiliates of Mr. Collins and Mr. Brannon are each indirectly partners in the Joint Venture. The shares of New Common Stock held by the Joint Venture are to be voted by Mr. Davis pro rata based on the instructions of the partners of the Joint Venture. Mr. David S. Hunt (a director of the Company) is a beneficiary of a trust that is a partner in the Joint Venture. Mr. Hunt has disclaimed beneficial ownership of such shares of New Common Stock. At December 31, 1993, the Company had approximately $120,000 of payables to Capstone Capital Corporation for expenses incurred that are to be reimbursed pursuant to the Plan. Mr. Davis and Mr. Cook own shares of the corporation. The Company is a party to an agreement with Energy Transfer I, Ltd. ("Energy Transfer"). Mr. Warren is the sole shareholder of the general partner of Energy Transfer and Messrs. Davis, Warren and Cook are indirect limited partners in Energy Transfer. Under such agreement, the Company receives a fixed fee to market natural gas and operate a natural gas pipeline for Energy Transfer. The Company received $35,000 from Energy Transfer in the year ended December 31, 1993. Mr. James W. Bryant (a director of the Company) is a party to a consulting agreement with the Company. Under the consulting agreement, which has a three year term, Mr. Bryant is to receive no less than $200,000 per year. Mr. Bryant is obligated under the consulting agreement to present certain projects to the Company which has a right of first refusal. If the Company elects to pursue a project originated by Mr. Bryant, then he is entitled to additional compensation. The Company is also a party to a joint venture agreement with an affiliate of Mr. Collins. Under such joint venture agreement, the Company and the affiliate of Mr. Collins each bear a portion of the costs for developing projects in the natural gas business and have a right of first refusal on such projects. 8. EMPLOYEE BENEFIT PLANS Under the Plan (Note 2) all outstanding stock options were canceled. An incentive stock option plan the ("Stock Plan") was approved by the Board of Directors on December 16, 1993, subject to Stockholders' approval. Under the Stock Plan, options to purchase up to 1,250,000 shares of the Company's authorized but unissued stock could be granted to key employees through 2003. Options under the Stock Plan were granted at an exercise price equal to 100% of the fair market value of the stock on the date of the grant. The options, of which 727,500 were outstanding at December 31, 1993, are exercisable at a rate not to exceed 20% for each year of employment completed (however 100% may be exercised under a change of control, as defined) after the date of grant and expire 10 years after the date of grant. The following is a summary of activity under the Stock Plan and all former stock option plans for the years ended December 31: The Company maintains an incentive savings plan "Savings Plan" under Section 401(k) of the Internal Revenue Code, which is available to all employees who meet certain requirements. Under the Savings Plan, the Company matched participants' contributions up to 5% of the participant's compensation through 1993. Beginning in 1994, the Company will match 20% of the employees' contributions to the Savings Plan up to a maximum of five percent (5%) of the participant's compensation. The Company may, at its discretion, increase the matching percentage at year end and may match in New Common Stock or cash. The Company recorded expense of $250,000, $193,000, and $174,000 for 1993, 1992 and 1991, respectively, for its matching contribution. The Company currently provides no other post-employment benefits. 9. SEGMENT INFORMATION Segment data as of and for the years ended December 31, 1993, 1992 and 1991, follows: The Company believes that the loss of any single customer would not have a material effect on the financial condition of the Company. There were no customers in 1992 that accounted for over 10% of consolidated revenues. Information regarding sales to major customers by segment for the years ended December 31, 1993 and 1991 is as follows: ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III The information required in response to Items 10, 11, 12, and 13 is included in the Company's definitive Proxy Statement to be filed with the Commission on or before April 30, 1994, pursuant to Regulation 14A and is incorporated herein by reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) (1) Consolidated Financial Statements (2) Consolidated Financial Statement Schedules. The consolidated financial statement schedules filed as a part of this report on Form 10-K follow the signature page. The following is a list of those schedules: Schedule V Property, Plant and Equipment Schedule VI Accumulated Depreciation and Amortization of Property, Plant, and Equipment Schedule X Supplementary Income Statement Information Schedules not included have been omitted because they are not applicable or the required information is shown in the consolidated financial statements or notes thereto. (3) Exhibits. Exhibit No. Document - ----------- -------- * 3.1 By-Laws, as Amended and Restated March 21, 1994, currently in effect. 3.2 Restated Certificate of Incorporation of Cornerstone Natural Gas, Inc. (incorporated by reference to Exhibit 2 filed January 10, 1994, Form 8-A). * 10.1 Cornerstone Natural Gas, Inc. 1993 Long-Term Incentive Plan. * 10.2 Amended and Restated Endevco, Inc. Employee Savings Plan effective July 1, 1991. 10.3 Endevco, Inc. Employee Savings Trust (incorporated by reference to 10.3 to Registration Statement No. 2-85830). 10.4 Amendment Number 1 to the Endevco, Inc. Employee Savings Trust (incorporated by reference to Exhibit 10.6 to December 31, 1991, Form 10-K). 10.5 Amendment Number 2 to the Endevco, Inc. Employee Savings Trust (incorporated by reference to Exhibit 10.7 to December 31, 1991, Form 10-K). 10.6 Lease Agreement by and between Endevco, Inc. as Tenant and 8080 Central, Ltd. as Landlord, dated January 11, l985, (incorporated by reference to Exhibit 10.65 to March 31, 1985 Form 10-Q). 10.7 Amendment to the Lease Agreement by and between Endevco, Inc. as Tenant and 8080 Central, Ltd. as Landlord, dated April 24, l985, (incorporated by reference to Exhibit 10.14 to December 31, 1991, Form 10-K). 10.8 Amendment to Lease Agreement by and between Endevco, Inc. as Tenant and 8080 Central, Ltd. as Landlord, dated October 7, l985, (incorporated by reference to Exhibit 10.15 to December 31, 1991, Form 10-K). 10.9 Amendment to Lease Agreement by and between Endevco, Inc. as Tenant and 8080 Central, Ltd. as Landlord, dated October 13, l987, (incorporated by reference to Exhibit 10.16 to December 31, 1991, Form 10-K). 10.10 Amendment to Lease Agreement by and between Endevco, Inc. as Tenant and 8080 Central, Ltd. as Landlord, dated October 22, l988, (incorporated by reference to Exhibit 10.17 to December 31, 1991, Form 10-K). 10.11 Modification and Ratification of Lease Agreement by and between Endevco, Inc. as Tenant and The Prudential Insurance Company of America, as Landlord, dated February 24, l993, (incorporated by reference to Exhibit 10.18 to December 31, 1992, Form 10-K). 10.12 Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated July 26, l991, (incorporated by reference to Exhibit 10.51 to December 31, 1991, Form 10-K). 10.13 First Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated August 28, l991, (incorporated by reference to Exhibit 10.52 to December 31, 1991, Form 10-K). 10.14 Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated December 20, 1991, (incorporated by reference to Exhibit 10.53 to December 31, 1991, Form 10-K). 10.15 Second Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated July 23, l992, (incorporated by reference to Exhibit 10.54 to December 31, 1992, Form 10-K). 10.16 Third Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated September 21, l992, (incorporated by reference to Exhibit 10.55 to December 31, 1992, Form 10-K). 10.17 Fourth Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated October 22, l992, (incorporated by reference to Exhibit 10.56 to December 31, 1992, Form 10-K). 10.18 Fifth Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated November 30, l992, (incorporated by reference to Exhibit 10.57 to December 31, 1992, Form 10-K). 10.19 Sixth Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated January 29, l993, (incorporated by reference to Exhibit 10.58 to December 31, 1992, Form 10-K). 10.20 Seventh Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated February 22, l993, (incorporated by reference to Exhibit 10.59 to December 31, 1992, Form 10-K). 10.21 Eighth Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated March 22, l993, (incorporated by reference to Exhibit 10.60 to December 31, 1992, Form 10-K). * 10.22 Ninth Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated April 26, 1993. * 10.23 Tenth Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated May 24, 1993. * 10.24 Eleventh Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated June 21, 1993. * 10.25 Twelfth Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated July 19, 1993. * 10.26 Thirteenth Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated August 23, 1993. * 10.27 Fourteenth Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated September 21, 1993. * 10.28 Fifteenth Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated October 28, 1993. * 10.29 Sixteenth Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated December 21, 1993. 10.30 Subordination Agreement dated December 15, l988, (incorporated by reference to Exhibit 10.54 to December 31, 1991, Form 10-K). 10.31 Amendment dated March 27, l989, to Subordination Agreement dated December 15, l988, between Endevco, Inc. and Dubach Gas Company (incorporated by reference to Exhibit 10.55 to December 31, 1991, Form 10-K). 10.32 Second Amendment dated August 29, l990, to Subordination Agreement dated December 15, l988, between Endevco, Inc. and Dubach Gas Company (incorporated by reference to Exhibit 10.56 to December 31, 1991, Form 10-K). 10.33 Third Amendment dated September 21, 1990, to Subordination Agreement dated December 15, l988, between Endevco, Inc. and Dubach Gas Company (incorporated by reference to Exhibit 10.96 to December 31, 1990, Form 10-K). 10.34 Loan Agreement dated as of December 16, l988, by and between Dubach Gas Company and Endevco, Inc. (incorporated by reference to Exhibit 2 to December 16, 1988, Form 8-K). 10.35 General Partnership Agreement of Mountain Creek Joint Venture dated as of March 7, l989, by and between Western Natural Gas Company and Cornerstone Natural Gas Company (incorporated by reference to Exhibit 10.79 to December 31, 1989, Form 10-K). 10.36 Pipeline Construction and Operating Agreement dated March 7, l989, by and between Cornerstone Natural Gas Company and Mountain Creek Joint Venture (incorporated by reference to Exhibit 10.80 to December 31, 1989, Form 10-K). 10.37 Loan Agreement dated September 28, l989, by and between Mountain Creek Joint Venture and Chrysler Capital Corporation (incorporated by reference to Exhibit 10.82 to December 31, 1989, Form 10-K). 10.38 Participation Agreement dated July 17, l991, by and between Endevco and First Reserve Gas Storage Inc. (incorporated by reference to Exhibit 10.88 to December 31,1991, Form 10-K). * 10.39 Letter Agreement effective May 17, 1993, by and between Energy Transfer Corporation and Cornerstone Natural Gas, Inc. 10.40 Stock Purchase Agreement dated March 20, l993, by and between Endevco, Inc., and Ray Davis, Trustee (incorporated by reference to Exhibit 10.136 to December 31, 1992, Form 10-K). 10.41 First Amendment Stock Purchase Agreement dated May 28, 1993, by and between Endevco, Inc., and Ray Davis, Trustee (incorporated by reference to Exhibit 10.1 to June 17, 1993, to Form 8-K). * 10.42 Form and Schedule of Warrants to Purchase Common Stock of Cornerstone Natural Gas, Inc. * 10.43 Form and Schedule of Promissory Note dated November 2, 1993, between Cornerstone Natural Gas, Inc. and Preferred Stockholders. 10.44 Revolving Credit and Term Loan Agreement between Cornerstone Natural Gas, Inc. et al, and Bank of Oklahoma, National Association dated November 2, 1993, (incorporated by reference to Exhibit 10.3 to November 2, 1993, Form 8-K). * 10.45 Joint Venture Agreement between Cornerstone Natural Gas, Inc. and Merit Natural Gas Company dated October 28, 1993. * 10.46 First Amended and Restated Intercreditor Agreement dated December 31, 1993, between Union Bank and Bank of Oklahoma, National Association. * 10.47 Subordination Agreement dated February 24, 1994, between Bank of Oklahoma, National Association and Premier Bank. * 10.48 Consulting Agreement between Endevco, Inc. and James W. Bryant dated June 4, 1993. * 22.1 List of Subsidiaries. * 23.1 Consent of Independent Auditors. - -------------------------------------- * Filed Herewith (b) Reports on Form 8-K (1) "Item 3. Bankruptcy." and "Item 7. Exhibits." were reported in a Current Report on Form 8-K filed October 14, 1993. (2) "Item 1. Change of Control of Registrant", "Item 2. Disposition of Assets", "Item 3. Bankruptcy" and "Item 7. Exhibits" were reported in a current report on Form 8-K filed November 15, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CORNERSTONE NATURAL GAS, INC. By:/s/ RAY C. DAVIS ---------------------- Ray C. Davis CHAIRMAN OF THE BOARD AND CHIEF EXECUTIVE OFFICER Date: MARCH 22, l994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Capacity in Signatures Which Signed ---------- ------------ /s/ RAY C. DAVIS Chairman of the Board of Directors March 22, 1994 - ----------------------- and Chief Executive Officer (Ray C. Davis) /s/ KELCY L. WARREN President, Chief Operating March 22, 1994 - ----------------------- Officer and Director (Kelcy L. Warren) /s/ ROBERT L. CAVNAR Senior Vice President and Chief March 22, 1994 - ----------------------- Financial Officer (Robert L. Cavnar) /s/ RICHARD W. PIACENTI Vice President and Controller March 22, 1994 - ----------------------- (Richard W. Piacenti) /s/ RICHARD D. BRANNON Director March 22, 1994 - ----------------------- (Richard D. Brannon) /s/ JAMES W. BRYANT Director March 22, 1994 - ----------------------- (James W. Bryant) /s/ TED COLLINS, JR. Director March 22, 1994 - ----------------------- (Ted Collins, Jr.) /s/ BEN H. COOK Director March 22, 1994 - ----------------------- (Ben H. Cook) /s/ DAVID S. HUNT Director March 22, 1994 - ----------------------- (David S. Hunt) /s/ C. ROBERT SLEDGE Director March 22, 1994 - ----------------------- (C. Robert Sledge) SCHEDULE V CORNERSTONE NATURAL GAS, INC. AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT SCHEDULE VI CORNERSTONE NATURAL GAS INC. AND SUBSIDIARIES ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT SCHEDULE X CORNERSTONE NATURAL GAS, INC. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION INDEX TO EXHIBITS Exhibit No. Document - ----------- -------- * 3.1 By-Laws, as Amended and Restated March 21, 1994, currently in effect. 3.2 Restated Certificate of Incorporation of Cornerstone Natural Gas, Inc. (incorporated by reference to Exhibit 2 filed January 10, 1994, Form 8-A). * 10.1 Cornerstone Natural Gas, Inc. 1993 Long-Term Incentive Plan. * 10.2 Amended and Restated Endevco, Inc. Employee Savings Plan effective July 1, 1991. 10.3 Endevco, Inc. Employee Savings Trust (incorporated by reference to 10.3 to Registration Statement No. 2-85830). 10.4 Amendment Number 1 to the Endevco, Inc. Employee Savings Trust (incorporated by reference to Exhibit 10.6 to December 31, 1991, Form 10-K). 10.5 Amendment Number 2 to the Endevco, Inc. Employee Savings Trust (incorporated by reference to Exhibit 10.7 to December 31, 1991, Form 10-K). 10.6 Lease Agreement by and between Endevco, Inc. as Tenant and 8080 Central, Ltd. as Landlord, dated January 11, l985, (incorporated by reference to Exhibit 10.65 to March 31, 1985 Form 10-Q). 10.7 Amendment to the Lease Agreement by and between Endevco, Inc. as Tenant and 8080 Central, Ltd. as Landlord, dated April 24, l985, (incorporated by reference to Exhibit 10.14 to December 31, 1991, Form 10-K). 10.8 Amendment to Lease Agreement by and between Endevco, Inc. as Tenant and 8080 Central, Ltd. as Landlord, dated October 7, l985, (incorporated by reference to Exhibit 10.15 to December 31, 1991, Form 10-K). 10.9 Amendment to Lease Agreement by and between Endevco, Inc. as Tenant and 8080 Central, Ltd. as Landlord, dated October 13, l987, (incorporated by reference to Exhibit 10.16 to December 31, 1991, Form 10-K). 10.10 Amendment to Lease Agreement by and between Endevco, Inc. as Tenant and 8080 Central, Ltd. as Landlord, dated October 22, l988, (incorporated by reference to Exhibit 10.17 to December 31, 1991, Form 10-K). 10.11 Modification and Ratification of Lease Agreement by and between Endevco, Inc. as Tenant and The Prudential Insurance Company of America, as Landlord, dated February 24, l993, (incorporated by reference to Exhibit 10.18 to December 31, 1992, Form 10-K). 10.12 Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated July 26, l991, (incorporated by reference to Exhibit 10.51 to December 31, 1991, Form 10-K). 10.13 First Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated August 28, l991, (incorporated by reference to Exhibit 10.52 to December 31, 1991, Form 10-K). 10.14 Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated December 20, 1991, (incorporated by reference to Exhibit 10.53 to December 31, 1991, Form 10-K). 10.15 Second Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated July 23, l992, (incorporated by reference to Exhibit 10.54 to December 31, 1992, Form 10-K). 10.16 Third Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated September 21, l992, (incorporated by reference to Exhibit 10.55 to December 31, 1992, Form 10-K). 10.17 Fourth Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated October 22, l992, (incorporated by reference to Exhibit 10.56 to December 31, 1992, Form 10-K). 10.18 Fifth Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated November 30, l992, (incorporated by reference to Exhibit 10.57 to December 31, 1992, Form 10-K). 10.19 Sixth Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated January 29, l993, (incorporated by reference to Exhibit 10.58 to December 31, 1992, Form 10-K). 10.20 Seventh Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated February 22, l993, (incorporated by reference to Exhibit 10.59 to December 31, 1992, Form 10-K). 10.21 Eighth Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated March 22, l993, (incorporated by reference to Exhibit 10.60 to December 31, 1992, Form 10-K). * 10.22 Ninth Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated April 26, 1993. * 10.23 Tenth Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated May 24, 1993. * 10.24 Eleventh Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated June 21, 1993. * 10.25 Twelfth Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated July 19, 1993. * 10.26 Thirteenth Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated August 23, 1993. * 10.27 Fourteenth Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated September 21, 1993. * 10.28 Fifteenth Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated October 28, 1993. * 10.29 Sixteenth Amendment to the Amended and Restated Term Loan and Revolving Credit Agreement between Dubach Gas Company and Union Bank dated December 21, 1993. 10.30 Subordination Agreement dated December 15, l988, (incorporated by reference to Exhibit 10.54 to December 31, 1991, Form 10-K). 10.31 Amendment dated March 27, l989, to Subordination Agreement dated December 15, l988, between Endevco, Inc. and Dubach Gas Company (incorporated by reference to Exhibit 10.55 to December 31, 1991, Form 10-K). 10.32 Second Amendment dated August 29, l990, to Subordination Agreement dated December 15, l988, between Endevco, Inc. and Dubach Gas Company (incorporated by reference to Exhibit 10.56 to December 31, 1991, Form 10-K). 10.33 Third Amendment dated September 21, 1990, to Subordination Agreement dated December 15, l988, between Endevco, Inc. and Dubach Gas Company (incorporated by reference to Exhibit 10.96 to December 31, 1990, Form 10-K). 10.34 Loan Agreement dated as of December 16, l988, by and between Dubach Gas Company and Endevco, Inc. (incorporated by reference to Exhibit 2 to December 16, 1988, Form 8-K). 10.35 General Partnership Agreement of Mountain Creek Joint Venture dated as of March 7, l989, by and between Western Natural Gas Company and Cornerstone Natural Gas Company (incorporated by reference to Exhibit 10.79 to December 31, 1989, Form 10-K). 10.36 Pipeline Construction and Operating Agreement dated March 7, l989, by and between Cornerstone Natural Gas Company and Mountain Creek Joint Venture (incorporated by reference to Exhibit 10.80 to December 31, 1989, Form 10-K). 10.37 Loan Agreement dated September 28, l989, by and between Mountain Creek Joint Venture and Chrysler Capital Corporation (incorporated by reference to Exhibit 10.82 to December 31, 1989, Form 10-K). 10.38 Participation Agreement dated July 17, l991, by and between Endevco and First Reserve Gas Storage Inc. (incorporated by reference to Exhibit 10.88 to December 31,1991, Form 10-K). * 10.39 Letter Agreement effective May 17, 1993, by and between Energy Transfer Corporation and Cornerstone Natural Gas, Inc. 10.40 Stock Purchase Agreement dated March 20, l993, by and between Endevco, Inc., and Ray Davis, Trustee (incorporated by reference to Exhibit 10.136 to December 31, 1992, Form 10-K). 10.41 First Amendment Stock Purchase Agreement dated May 28, 1993, by and between Endevco, Inc., and Ray Davis, Trustee (incorporated by reference to Exhibit 10.1 to June 17, 1993, to Form 8-K). * 10.42 Form and Schedule of Warrants to Purchase Common Stock of Cornerstone Natural Gas, Inc. * 10.43 Form and Schedule of Promissory Note dated November 2, 1993, between Cornerstone Natural Gas, Inc. and Preferred Stockholders. 10.44 Revolving Credit and Term Loan Agreement between Cornerstone Natural Gas, Inc. et al, and Bank of Oklahoma, National Association dated November 2, 1993, (incorporated by reference to Exhibit 10.3 to November 2, 1993, Form 8-K). * 10.45 Joint Venture Agreement between Cornerstone Natural Gas, Inc. and Merit Natural Gas Company dated October 28, 1993. * 10.46 First Amended and Restated Intercreditor Agreement dated December 31, 1993, between Union Bank and Bank of Oklahoma, National Association. * 10.47 Subordination Agreement dated February 24, 1994, between Bank of Oklahoma, National Association and Premier Bank. * 10.48 Consulting Agreement between Endevco, Inc. and James W. Bryant dated June 4, 1993. * 22.1 List of Subsidiaries. * 23.1 Consent of Independent Auditors. - ---------------------------------- * Filed Herewith

66479_1993.txt

66479

1993

Item 1. Business. The Company Millipore Corporation was incorporated under the laws of Massachusetts on May 3, 1954. Millipore and its subsidiaries operate in a single business segment, the analysis, identification and purification of fluids using separations technology. Business segment information is discussed in Note M to the Millipore Corporation Consolidated Financial Statements (the "Financial Statements") included in the Millipore Corporation Annual Report to Shareholders for the year ended December 31, 1993 (the "Annual Report"), which note is hereby incorporated herein by reference. Unless the context otherwise requires, the terms "Millipore" or the "Company" mean Millipore Corporation and its subsidiaries. On November 11, 1993, Millipore announced that its Board of Directors had approved a plan to focus the Company on its membrane business and to divest operations of its Instrumentation Divisions (the Waters Chromatography business and the non-membrane bioscience instrument business). The description of Millipore's business contained herein treats both the Waters Chromatography Business and the non-membrane bioscience business (the "Instrumentation Divisions") as discontinued operations. These Divisions with separate product lines with separate customers are accounted for as discontinued operations. The Company expects to realize a net gain in 1994 upon the disposition of these businesses. Operations of the discontinued Instrumentation Divisions subsequent to November 11, 1993 are set forth in the Company's Balance Sheet and are not material to its financial position; operations prior to that date are included in the Company's 1993 Consolidated Statement of Income. For a description of Millipore's business which includes no discontinued operations reference is made to the Company's Annual Report on Form 10-K for the year ended December 31, 1992. Millipore is a leader in the field of membrane separations technology. The Company develops, manufactures and sells products which are used primarily for the analysis and purification of fluids. The Company's products are based on a variety of membranes and certain other technologies and effect separations, principally through physical and chemical methods. Millipore is an integrated multinational manufacturer of these products. During 1993, approximately 62% of Millipore's net sales were made to customers outside the Americas. For financial information concerning foreign and domestic operations and export sales, see Note M to the Financial Statements. Products and Technologies For analytical applications, the Company's products are used to gain knowledge about a molecule, compound or micro-organism by detecting, identifying and quantifying the relevant components of a sample. For purification applications, the Company's products are used in manufacturing and research operations to isolate and purify specific components or to remove contaminants. The principal separation technologies utilized by the Company are based on membrane filters, and certain chemistries, resins and enzyme immunoassays. Membranes are used to filter either the wanted or the unwanted particulate, bacterial, molecular or viral entities from fluids, or concentrate and retain such entities (in the fluid) for further processing. Some of the Company's newer membrane materials also use affinity, ion-exchange or electrical charge mechanisms for separation. Both analytical and purification products incorporate membrane and other technologies. The Company's products include disc and cartridge filters and housings of various sizes and configurations, filter-based test kits and precision pumps and other ancillary equipment and supplies. The Company has more than 3,000 products. Most of the Company's products are listed in its catalogs and are sold as standard items, systems or devices. For special applications, the Company assembles custom products, usually based upon standard modules and components. In certain instances, the Company also designs and engineers process systems specifically for the customer. Customers and Markets The Company's continuing operations sells its products primarily to customers in the following markets: pharmaceutical/biotechnology, microelectronics, chemical and food and beverage companies; government, university and private research and testing laboratories; and health care and medical facilities. Within each of these markets, the Company focuses its sales efforts upon those segments where customers have specific requirements which can be satisfied by the Company's products. Pharmaceutical/Biotechnology Industry. The Company's products are used by the pharmaceutical/biotechnology industry in sterilization, including virus reduction, and sterility testing of products such as antibiotics, vaccines, vitamins and protein solutions; concentration and fractionation of biological molecules such as vaccines and blood products; cell harvesting; isolation and purification of compounds from complex mixtures and the purification of water for laboratory use. The Company's membrane products also play an important role in the development of new drugs, particularly with respect to the mechanism through which they act. In addition, Millipore has developed and is developing products for biopharmaceutical applications in order to meet the separations requirements of the biotechnology industry. Microelectronics Industry. The microelectronics industry uses the Company's products to purify the liquids and gases used in the manufacturing processes of semiconductors and other microelectronics components, by removing particles and unwanted contaminating molecules. Chemical Industry. This industry uses the Company's products for purification of reagent grade chemicals, for monitoring in the industrial workplace and of waste streams and in the purification of water for laboratory use. Food and Beverage Industry. The Company's products are widely used by the food and beverage industry in quality control and process applications principally to monitor for microbiological contamination; to remove bacteria and yeast from products such as wine and beer, in order to prevent spoilage, and in producing pure water for laboratory use. Universities and Government Agencies. Universities, government and private and corporate research and testing laboratories, environmental science laboratories and regulatory agencies purchase a wide range of the Company's products. Typical applications include: purification of proteins; cell culture, structure studies and interactions; concentration of biological molecules; fractionation of complex molecular mixtures; and collection of microorganisms. The Company's water purification products are used extensively by these organizations to prepare high purity water for sensitive assays and the preparation of tissue culture media. Health Care and Medical Research. Customers in this field include hospitals, clinical laboratories, medical schools and medical research institutions who use the Company's products to filter particulate and bacterial contaminants which may be present in intravenous solutions, and its water purification products to produce high purity water. Sales and Marketing The Company sells its products within the United States primarily to end users through its own direct sales force. The Company sells its products in foreign markets through the sales forces of its subsidiaries and branches located in more than 25 major industrialized and developing countries as well as through independent distributors in other parts of the world. During 1993, the Company's marketing, sales and service forces consisted of approximately 360 employees in the United States and 520 employees abroad. The Company's marketing efforts focus on application development for existing products and on new and differentiated products for other existing, newly-identified and proposed customer uses. The Company seeks to educate customers as to the variety of analytical and purification problems which may be addressed by its products and to adapt its products and technologies to separations problems identified by customers. The Company believes that its technical support services are important to its marketing efforts. These services include assistance in defining the customer's needs, evaluating alternative solutions, designing a specific system to perform the desired separation and training users. Research and Development In its role as a pioneer of membrane separations Millipore has traditionally placed heavy emphasis on research and development. Research and development activities include the extension and enhancement of existing separations technologies to respond to new applications, the development of new membranes, and the upgrading of membrane based systems to afford the user greater purification capabilities. Research and development efforts also identify new separations applications to which disposable separations devices would be responsive, and develop new configurations into which membrane and ion exchange separations media can be fabricated to efficiently respond to the applications identified. Instruments, hardware, and accessories are also developed to incorporate membranes, modules and devices into total separations systems. Introduction of new applications frequently requires considerable market development prior to the generation of revenues. Millipore performs substantially all of its own research and development and does not provide material amounts of research services for others. Millipore's research and development expenses in 1991, 1992 and 1993 with respect to continuing operations were, $32,633,000, $32,953,000 and $34,952,000 respectively. When it believes it to be in its long-term interests, the Company will license newly developed technology from unaffiliated third parties and/or will acquire exclusive distribution rights with respect thereto. Competition The Company's continuing operations face intense competition in all of its markets. The Company believes that its principal competitors include Pall Corporation, Barnstead Thermolyne Corporation, Sartorius GmbH, and Gelman, Inc. Certain of the Company's competitors are larger and have greater resources than the Company. However, the Company believes that it offers a broader line of products, making use of a wider range of separations technologies and addressing a broader range of applications than any single competitor. While price is an important factor, the Company competes primarily on the basis of technical expertise, product quality and responsiveness to customer needs, including service and technical support. Acquisitions, Restructuring, and Divestitures On November 11, 1993 Millipore announced that its Board of Directors had approved a plan to divest its Instrumentation Division (the Waters Chromatography and non-membrane bioscience businesses) in order to focus the Company on its membrane business. The Waters Chromatography business was acquired in 1980. Growth in the analytical instrument market has been limited in the past few years. In the years 1986-1988 the Company expanded its MilliGen division in order to extend its analytical and chemical capabilities into the bio-instrumentation and chemicals field. In 1990 this business was consolidated into Millipore's then existing businesses, in order to achieve better focus and meaningful economics. The Company believes that the divestiture of its chromatography business along with that of its non- membrane bioscience business, will enable Millipore to better serve its membrane customers, improve operating performance and increase shareholder value. It is anticipated that the divestiture of the Instrumentation Divisions will be completed in the first half of 1994 and is anticipated to result in a net gain. At the time of the 1990 consolidation of MilliGen, the Company took certain other actions to improve profitability, these measures in total resulted in a non-recurring charge in the fourth quarter of 1990 amounting to $34,750,000. The Company took a further charge, with respect to the restructuring of its Waters Chromatography Division, of $13,000,000 in the first quarter of 1993. In the five-year period prior to its November 11, 1993 announcement concerning the sale of its Waters Chromatography and non-membrane bioscience business, the Company undertook a number of initiatives to expand its business into new markets within the field of analysis and purification. The Company has made several small, strategic acquisitions to accelerate technology and market development in its several divisions. These included the acquisition of the Bio Image division of Kodak in 1989, Extrel Corporation in February of 1992, and Immunosystems Incorporated in July of 1992. In November of 1989, the Company sold its process water division for approximately $54,000,000 in cash. Included in the transaction were the worldwide facilities and equipment and other assets for developing, manufacturing and marketing that division's complete line of water purification products, other than its laboratory scale water business. Also included were the Company's 18 service deionization branches located throughout the continental United States. This transaction is the subject of litigation brought by Eastern Enterprises (see "Legal Proceedings"). Other Information In April, 1988, the Company adopted a shareholder rights plan (the "Rights Plan") and declared a dividend to its shareholders of the right to purchase (a "Right"), for each share of Millipore Common Stock owned, one additional share of Millipore Common Stock at a price of $160 for each share. The Rights Plan is designed to protect Millipore's shareholders from attempts by others to acquire Millipore on terms or by using tactics that could deny all shareholders the opportunity to realize the full value of their investment. The Rights will be exercisable only if a person or group of affiliated or associated persons acquires beneficial ownership of 20% or more of the outstanding shares of the Company Common Stock or commences a tender or exchange offer that would result in a person or group owning 20% or more of the outstanding Common Stock. In such event, or in the event that Millipore is subsequently acquired in a merger or other business combination, each Right will entitle its holder to purchase, at the then current exercise price, shares of the common stock of the surviving company having a value equal to twice the exercise price. Millipore has been granted a number of patents and licenses and has other patent applications pending both in the United States and abroad. While these patents and licenses are viewed as valuable assets, Millipore's patent position is not of material importance to its operations. Millipore also owns a number of trademarks, the most significant being "Millipore." Millipore's products are made from a wide variety of raw materials which are generally available in quantity from alternate sources of supply; as a result, Millipore is not substantially dependent upon any single supplier. Millipore's business is neither seasonal nor dependent upon a single or limited group of customers. Bringing the Company's facilities into compliance with federal, state and local laws regulating the discharge of materials into the environment or otherwise relating to the protection of the environment has not, to date, had a material effect upon Millipore's capital expenditures, earnings or competitive position. (See "Legal Proceedings.") As of December 31, 1993, Millipore's continuing operations employed 3,664 persons worldwide, of whom 1,938 were employed in the United States and 1,726 overseas. Executive Officers of Millipore There follows a listing as of March 1, 1994 of the Executive Officers of Millipore. All of the following individuals were elected to serve until the Directors Meeting next following the 1994 Annual Stockholders Meeting. First Elected: To An Present Name Age Office Officer Office John A. Gilmartin 51 Chairman of the Board 1980 1986 President and Chief (Chairman Executive Officer of in 1987) the Corporation Geoffrey Nunes 63 Senior Vice President 1976 1980 General Counsel Douglas A. Berthiaume 45* Senior Vice President 1985 1989 of the Corporation Jack T. Johansen 51* Senior Vice President 1987 1989 of the Corporation Glenda K. Burkhart 42 Vice President 1993 1993 of the Corporation Douglas B. Jacoby 47 Vice President 1989 1989 of the Corporation Michael P. Carroll 43 Vice President of the Corporation Chief Financial Officer and Treasurer 1992 1992 Dominique F. Baly 45 President Intertech - 1988 Division of Millipore John E. Lary 47 Senior Vice President - 1993 and General Manager - Americas Operation Geoffrey D. Woodard 54 President of - 1989 Millipore's Analytical Group * It is anticipated that Messrs. Berthiaume and Johansen will leave the employ of the Company to head up the businesses to be divested, Waters Chromatography and non-membrane bioscience respectively. Mr. Gilmartin joined Millipore's finance department in 1978, was elected Vice President and Chief Financial Officer in 1980, Senior Vice President in 1982, and to the additional position of President of the Membrane Division in 1985. In 1986, Mr. Gilmartin was elected President and Chief Executive Officer of the Company and to the additional position of Chairman in 1987. Mr. Nunes joined Millipore in 1976 as Vice President and General Counsel and was elected a Senior Vice President in 1980. Mr. Berthiaume joined Millipore in 1980, was elected Vice President and Chief Financial Officer in 1985, and as a Senior Vice President in 1989. Dr. Johansen joined Millipore in 1987 as Vice President and was elected a Senior Vice President in 1989. Ms. Burkhart joined Millipore in 1993 as Corporate Vice President/Human Resources. Prior to joining Millipore, she was a principal of Mass Burkhart, a strategy consulting firm (1991-1993), responsible for organization development and work force planning for Exxon Chemical (1989-1991), a principal for Synectics, an organizational development consulting firm (1987- 1989), and a consultant for Bain and Co., a strategy consulting firm (1985- 1987). Mr. Jacoby joined Millipore in 1975. After serving in various sales and marketing capacities, Mr. Jacoby became Director of Marketing for the Millipore Membrane Products Division in 1983 and in 1985, he assumed the position of General Manager of the Membrane Pharmaceutical Division. Since 1987, Mr. Jacoby has been responsible for the Company's process membrane business. Mr. Jacoby was elected a Corporate officer in December, 1989. Mr. Carroll joined Millipore in 1986 as Vice President/Finance for the Membrane Products Division following a ten-year career in the general practice audit division of Coopers and Lybrand. In 1988, Mr. Carroll assumed the position of Vice President of Information Systems (worldwide) and in December of 1990, he became the Vice President of Finance for the Company's Waters Chromatography Division. Mr. Carroll was elected to his current position in February, 1992. Mr. Baly joined Millipore, S.A. (France) in 1972. For at least five years prior to relocating to the U.S. to assume his current position as President of the Millipore Intertech Division in 1988, Mr. Baly held positions of increasing sales and marketing responsibility within Millipore's European operations including Vice President/General Manager of the Millipore Products Division (1986-1987) and the Waters Chromatography Division (1984- 1985). Mr. Lary is Senior Vice President and General Manager of the Americas Operation, a position he has held since May, 1993. For the ten years prior to that time, he served as Senior Vice President of the Membrane Operations Division of Millipore. Mr. Woodard joined Millipore (U.K.) Ltd. (England) in 1976 and for the next seven years served in product management and marketing positions in Europe. In 1983, he was named Director of Marketing for Millipore Europe, and, in 1985, he relocated to the U.S. to assume the position of Director of Product Management for the Membrane Products Division. He continued in this position until 1986 when he became Vice President and General Manager of the Laboratory Products Division. In 1989 Mr. Woodard became President of the Membrane Analytical Group. Messrs. Baly, Lary and Woodard were first listed as executive officers in the Company's Annual Report on Form 10-K for 1989, the year it was determined they met the Securities and Exchange Commission's definition of "executive officer". Item 2.

Item 2. Properties. Millipore owns in excess of 1.6 million square feet of facilities located in the United States, Europe and Japan. The following table identifies the principal properties owned by Millipore and describes the purpose, floor space and land area of each. Sq.Ft. of Floor Land Location Facility Space Area Bedford, Executive Offices, research, 346,000 32 acres Mass. pilot production & warehouse Milford,* Manufacturing, research, 410,000 31 acres Mass. office & warehouse Cidra, Manufacturing, warehouse Puerto Rico and office 134,000 36 acres Jaffrey, Manufacturing, warehouse 169,000 32 acres N.H. and office Pittsburgh,* Manufacturing, research 55,000 7 acres PA and office Molsheim, Manufacturing, warehouse 165,200 20 acres France and office Yonezawa, Manufacturing and warehouse 156,300 7 acres Japan Taunton,* Manufacturing 32,000 12 acres Mass. Cork, Manufacturing 83,000 20 acres Ireland St. Quentin Office and research 50,000 5 acres France _____________________________________ * It is anticipated that these properties will be sold in connection with the divestiture of the Waters Chromatography and non-membrane bioscience businesses. In addition to the above properties, Millipore has entered into a long term lease for premises abutting its Bedford facility. This lease makes 75,000 square feet of building available to Millipore and contains rights of first refusal and options with respect to the purchase of the premises by Millipore. During 1988 Millipore entered into a 10-year lease for a building of 130,000 square feet located in Burlington, Massachusetts, approximately 5 miles from its Bedford headquarters. This lease contains a single 5-year extension option. In 1991, the Company entered into two long term lease arrangements. The first was a sublease of a 130,000 square foot office building located in Marlborough, Massachusetts. This lease expires at the end of 1995 and Millipore has obtained from the owner an option to lease these premises for an additional five years. This facility is being used as the consolidated headquarters for all the Company's U. S. sales and support operations. It is anticipated that the Company will vacate these premises in 1994 and will not exercise its renewal option. The second lease arrangement is a 15-year lease with renewal options for an aggregate of 20 years, as well as a purchase option covering a 134,000 square foot building which is adjacent to the Company's Bedford facility and will be used for expansion purposes, initially the consolidation of the Company's Process System Division (part of the Membrane Process Group). In addition to its foregoing properties, Millipore currently leases various manufacturing, sales, warehouse, and administrative facilities throughout the world. Such leases expire at different times through 2017. The rented space aggregate is approximately 1,050,000 square feet and cost was approximately $8,068,000 in 1993. No single lease, in the opinion of Millipore, is material to its operations. Millipore is of the opinion that all the facilities owned or leased by it are well maintained, appropriately insured, in good operating condition and suitable for their present uses. Item 3.

Item 3. Legal Proceedings. Millipore has been sued in the Superior Court for Middlesex County, Massachusetts by Eastern Enterprises and its subsidiary, Ionpure Technologies, Inc. ("Ionpure"), alleging misrepresentations made in conjunction with the sale by Millipore of its Process Water Division to Ionpure in November of 1989. The Company believes it has adequate and complete defenses to this litigation and intends to vigorously defend the action. Although the Company is unable to predict with certainty the outcome of the lawsuit, its ultimate disposition is not expected to have a material adverse effect on Millipore's financial condition. Millipore has been notified in nine instances that the United States Environmental Protection Agency ("EPA") has determined that a release or a substantial threat of a release of hazardous substances (a "Release") as defined in Section 101 of the Comprehensive Environmental Response Compensation and Liability Act of 1980 ("CERCLA") as amended by the Superfund Amendments and Reauthorization Act of 1986 (SARA) (the so-called "Superfund" law) has occurred at certain sites to which chemical wastes generated by the manufacturing operations of Millipore or one of its divisions may have been sent. These notifications typically also allege that Millipore may be a responsible party under CERCLA with respect to any remedial action needed to control or prevent any such Release. Under CERCLA the EPA may undertake remedial action in response to a Release and responsible parties may by liable, without regard to fault or negligence, for costs incurred. As a result it is possible, although highly unlikely given the large number and size of financially solvent corporations participating at each site who have been similarly notified, that the Company might be liable for all of the costs incurred in such a cleanup. In each instance Millipore knows that it is only one of many companies and entities which received such notification and who may likewise be held liable for any such remedial costs. In 1992, the EPA unexpectedly proposed settlements for several of these sites. Based on those proposed settlements and all other information available to management, the Company recorded a provision of $5,800,000 against cost of sales which, in management's best estimate, when combined with previously established reserves, will be sufficient to satisfy all known claims by the EPA. In seven separate instances involving a total of ten such sites; the Company has entered into consent decrees; paid approximately $13.9 million; and received partial releases. The aggregate of any future potential liabilities is not expected to have a material adverse effect on Millipore's financial condition. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders. This item is not applicable. PART II Item 5.

Item 5. Market for Millipore's Common Stock, and Related Stockholder Matters. The information called for by this item is set forth under the caption "Millipore Stock Prices" on page 51 of Millipore's Annual Report to Shareholders for the year ended December 31, 1993, which information is hereby incorporated herein by reference. Item 6.

Item 6. Selected Financial Data. The information called for by this item is set forth under the caption "Millipore Corporation Eleven Year Summary of Operations" on pages 48 and 49 of Millipore's Annual Report to Shareholders for the year ended December 31, 1993, which information is hereby incorporated herein by reference. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The information called for by this item is set forth under the caption "Management's Discussion and Analysis" on pages 33 and 34 of Millipore's Annual Report to Shareholders for the year ended December 31, 1993, which information is hereby incorporated herein by reference. Item 8.

Item 8. Financial Statements and Supplementary Data. The information called for by this item is set forth on pages 35 to 47 and under the caption "Quarterly Results (Unaudited)" on page 50 of Millipore's Annual Report to Shareholders for the year ended December 31, 1993, which information is hereby incorporated herein by reference. Item 9.

Item 9. Disagreements on Accounting and Financial Disclosure. This item is not applicable. PART III Item 10.

Item 10. Directors and Executive Officers of Millipore. The information called for by this item with respect to registrant's directors and compliance with Section 16(a) of the Securities Exchange Act of 1934 as amended is set forth under the caption "Management and Election of Directors--Nominees for Election as Directors" on pages 2 - 8 of Millipore's definitive Proxy Statement, dated March 18, 1994, for Millipore's Annual Meeting of Stockholders to be held on April 21, 1994, which information is hereby incorporated herein by reference. Information called for by this item with respect to registrant's executive officers is set forth under "Executive Officers of Millipore" in Item 1 of this report. Item 11.

Item 11. Executive Compensation. The information called for by this item is set forth under the caption "Management and Election of Directors-Executive Compensation" on pages 8 - 17 of Millipore's definitive Proxy Statement, dated March 18, 1994, for Millipore's Annual Meeting of Stockholders to be held on April 21, 1994, which information is hereby incorporated herein by reference. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management. The information called for by this item is set forth under the caption "Ownership of Millipore Common Stock" on page 18 of Millipore's definitive Proxy Statement, dated March 18, 1994, for Millipore's Annual Meeting of Stockholders to be held April 21, 1994, which information is hereby incorporated herein by reference. Item 13.

Item 13. Certain Relationships and Related Transactions. The information called for by this item is set forth under the caption "Management and Election of Directors - Executive Compensation" on pages 2 - 8 and 12 - 17 of Millipore's definitive Proxy Statement, dated March 18, 1994, for Millipore's Annual Meeting of Stockholders to be held on April 21, 1994, which information is hereby incorporated herein by reference. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) The following documents are filed as part of this report: 1. Financial Statements The financial statements set forth on pages 35 through 47, the Report of Independent Accounts on Page 47 and the Quarterly Results (Unaudited) set forth on page 50 of Millipore's Annual Report to Shareholders for the year ended December 31, 1993, are hereby incorporated herein by reference. Filed as part of this report are: (1) Report of Independent Accountants on the Financial Statement Schedules included in Form 10-K Annual Report. (2) Consent of Independent Accountants relating to the incorporation of their report on the Consolidated Financial Statements and their report on the Financial Statement Schedules into Registrant's Securities Act Registration Nos. 2-72124, 2-85698, 2-91432, 2-97280, 33-37319, 33-37323 and 33-11-790 on Form S-8 and Securities Act Registration Nos. 2-84252, 33-9706, 33-20792, 33- 22196, 33-47213 on Form S-3. 2. Financial Statement Schedules Schedule V Property, Plant and Equipment - Consolidated Schedule VI Accumulated Depreciation of Property, Plant and Equipment - Consolidated Schedule VIII Valuation and Qualifying Accounts Schedule IX Short-term Borrowings Schedule X Supplementary Income Statement Information All Schedules other than those listed above have been omitted because they are not applicable or not required under Regulation S-X. Items 5 through 8 and Item 14 (a) (1) of this Annual Report on Form 10-K incorporate only the indicated portions of Pages 33 through 51 of Millipore's Annual Report to Shareholders for the year ended December 31, 1993; no other portion of such Annual Report to Shareholders shall be deemed to be incorporated herein or filed with the Commission. For purposes of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, the undersigned registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into registrant's Registration Statements on Form S-8 Nos.: 2-72124; 2-85698; 2-91432; 2-97280; 33-37319; 33-37323 and 33- 11-790: Insofar as indemnification for liabilities arising under the Securities Act of 1933 (The "Act") may be permitted to directors, officers and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. 3. Exhibits: A. Incorporated by Reference Document Incorporated Referenced Document on file with the Commission (3) Amendment to Restated Articles Form 10-K Report for of Organization dated May 22, year ended 12/31/87 1987 and By Laws and Form 10-K Report for year ended 12/31/90 respectively (4) Indenture dated as of March 30, Registration Statement 1988, relating to the issuance on Form S-3 (No. of $100,000,000 principal amount 33-20792); and a of Registrant's 9.20% Notes Due Form T-1 (No. 1998 22-18144) (10) Millipore's various employee benefit and executive compensation plans and arrangements are incorporated herein by reference to the indicated documents filed with the Commission: Document Referenced Document on File Incorporated with the Commission: Shareholder Rights Agreement Form 8-K Report for April, 1988 dated as of April 15, 1988 between Millipore and The First National Bank of Boston Long Term Restricted Stock Form 10-K Report for the year (Incentive) Plan for Senior ended December 31, 1984. Management 1985 Combined Stock Option Form 10-K Report for the year Plan ended December 31, 1985 Supplemental Savings and Form 10-K Report for the year Retirement Plan for Key ended December 31, 1984. Salaried Employees of Millipore Corporation Long Term Performance Plan Form 10-K Report for the year for Senior Executives ended December 31, 1984. Executive Termination Form 10-K Report for the year Agreement ended December 31, 1984. B. The following Exhibits are filed herewith: (10) Executive "Sale of Business" Incentive Termination Agreements (2) (11) Computation of Per Share Earnings (13) Annual Report to Shareholders, December 31, 1993 (21) Subsidiaries of Millipore (23) Consents of Experts (see page 21 hereto) (24) Power of Attorney (b) On November 30, 1993 the Company filed a Current Report on Form 8-K reporting on our November 11, 1993 event, the issuance of its press release announcing plans to divest its Waters Chromatography business and exit its non-membrane bioscience business. Said Report contained the following Company financial statements: (i) Consolidated Statements of Income (Restated) for the nine months ended September 30, 1993 and September 30, 1992. (ii) Consolidated Statements of Income (Restated) for each of the first three quarters of 1993 and the nine months ended September 30, 1993. (iii) Consolidated Statements of Income (Restated) for each quarter of 1992 and for the full year ended December 31, 1992. (iv) Consolidated Statements of Income (Restated) for each quarter of 1991 and for the full year ended December 31, 1991. (v) Consolidated Balance Sheet (Restated) as of September 30, 1993 and December 31, 1992. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. MILLIPORE CORPORATION Geoffrey Nunes By /s/ Geoffrey Nunes Senior Vice President Dated: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacity and on the dates indicated. SIGNATURE TITLE DATE JOHN A. GILMARTIN* Chairman, President, February 10, 1994 John A. Gilmartin Chief Executive Officer, and Director /s/ Michael P. Carroll Vice President February 10, 1994 Michael P. Carroll Chief Financial Officer Treasurer CHARLES D. BAKER* Director February 10, 1994 Charles D. Baker ______________________ Director February 10, 1994 Samuel C. Butler MARK HOFFMAN* Director February 10, 1994 Mark Hoffman GERALD D. LAUBACH* Director February 10, 1994 Gerald D. Laubach STEVEN MULLER* Director February 10, 1994 Steven Muller THOMAS O. PYLE* Director February 10, 1994 Thomas O. Pyle JOHN F. RENO* Director February 10, 1994 John F. Reno JAMES L. VINCENT* Director February 10, 1994 James L. Vincent WARREN E. C. WACKER* Director February 10, 1994 Warren E. C. Wacker *By /s/ Geoffrey Nunes Attorney-in-Fact Geoffrey Nunes REPORT OF INDEPENDENT ACCOUNTANTS Our report on the consolidated financial statements of Millipore Corporation has been incorporated by reference in this Form 10-K from Page 47 of the 1993 Annual Report to Shareholders of Millipore Corporation. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in the index (Item 14 (a)2 - Financial Statement Schedules) on Page 14 of this Form 10-K. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. COOPERS & LYBRAND Boston, Massachusetts January 24, 1994, except as to the information presented in Note F, for which the date is March 3, 1994 CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference in the registration statements of Millipore Corporation on Form S-8 (File Nos. 2-91432, 2-72124, 2-85698, 2- 97280, 33-37319, 33-37323, 33-11-790), and on Form S-3 (File Nos. 2-84252, 33- 9706, 33-22196, 33-20792, 33-47213) of our report dated January 24, 1994, except as to the information presented in Note F, for which the date is March 3, 1994, on our audits of the consolidated financial statements and financial statement schedules of Millipore Corporation as of December 31, 1993 and 1992, and for the years ended December 31, 1993, 1992, and 1991, which report is incorporated by reference in this Annual Report on Form 10-K. COOPERS & LYBRAND Boston, Massachusetts March 24, 1994 Millipore Corporation Schedule X - Supplementary Income Statement Information (In Thousands) Charged to Costs and Expenses Year ended December 31, Item 1993 1992 1991 Maintenance and Repairs * * * Depreciation and Amortization of intangible assets, preoperating costs and similar deferrals * * * Taxes, other than payroll and income taxes * * * Royalties * * * Advertising costs $ 7,447 $ 5,950 $ 5,368 * Less than 1% of total sales - ------------------------------------------------------------------------ SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-K ANNUAL REPORT OF MILLIPORE CORPORATION For the Fiscal Year Ended December 31, 1993 **************** EXHIBITS **************** - ---------------------------------------------------------------- INDEX TO EXHIBITS Exhibit No. Description Tab No. (10) Executive "Sales of Business" 1 Incentive Termination Agreements (2) (11) Computation of Per Share Earnings 2 (13) Annual Report to Shareholders, December 31, 1993 3 (21) Subsidiaries of Millipore 4 (23) Consents of Experts (see page 21 hereto) (24) Power of Attorney 5

700674_1993.txt

700674

1993

Item 1. Business -------- (a) General Development of Business ------------------------------- Air Express International Corporation (the "Company" or the "Registrant") is the oldest and largest international airfreight forwarder based in the United States. Through its global network of Company-operated facilities and agents, it consolidates, documents and arranges for transportation of its customers' shipments of heavy cargo throughout the world. During 1993, the Company handled more than 1,480,000 individual shipments, with an average weight of 407 pounds, to nearly 2,600 cities in more than 185 countries. The Company generated revenues of approximately $726 million in 1993, of which approximately 57% were attributable to shipments from locations outside the United States. Although the Company's headquarters are located in the United States, its network is global, serving over 544 cities, including 229 cities in the United States, 123 cities in Europe and 192 cities in Asia, the South Pacific, the Middle East, Africa and Latin America. As of December 31, 1993, this network consisted of 175 Company-operated facilities, including 50 in the United States and 125 abroad, supplemented at 369 additional locations by agents, a substantial number of whom serve the Company on an exclusive basis. The network is managed by experienced professionals, most of whom are nationals of the countries in which they serve. Approximately 75% of the Company's 28 regional and country managers have been employed by the Company for more than ten years. Since 1985, when its current management assumed control, the Company has focused on the international transportation of heavy cargo and devoted its resources to expanding and enhancing its global network and the information systems necessary to more effectively service its customers' transportation logistics needs. In December 1987, the Company acquired the Pandair Group, a European-based international airfreight forwarder with facilities in 14 countries. The Pandair acquisition significantly strengthened the Company's presence in key foreign markets, particularly the United Kingdom and Holland. During 1993, the Company acquired the Votainer group of companies ("Votainer"), a Netherlands-based Non-Vessel Operating Common Carrier ("NVOCC") which provides ocean freight consolidation services, with a network of 34 company-operated facilities in 12 countries. Included in the Company's 1993 results of operations are Votainer revenues and operating loss for the last six months of 1993 of $51.4 million and $.9 million, respectively. The Votainer acquisition was consistent with the Company's strategy to make acquisitions that will serve its goal of strengthening its market position, further enhancing its operating efficiencies and providing its customers a broader range of transportation-related services. (b) Financial Information About Industry Segments --------------------------------------------- The Company currently is engaged in the business of freight forwarding, for both air and ocean freight. See Management's Discussion and Analysis of Financial Condition and Results of Operations (Item 7), and the Company's Consolidated Financial Statements, including the Notes thereto, for data related to the Company's revenues, operating profit or loss and identifiable assets. NYFS03...:\16\12316\0001\7120\FRM32894.P9B (c) Narrative Description of Business --------------------------------- Airfreight Forwarding and Related Services ------------------------------------------ An airfreight forwarder procures shipments from a large number of customers, consolidates shipments bound for a particular destination from a common place of origin, determines the routing over which the consolidated shipment will move, selects an airline serving that route on the basis of departure time, available cargo capacity and rate, and books the consolidated shipment for transportation on that airline. In addition, the forwarder prepares all required shipping documents, delivers the shipment to the transporting airline and, in many cases, arranges for clearance of the various components of the shipment through customs at the final destination. If so requested by its customers, the forwarder also will arrange for delivery of the individual components of the consolidated shipment from the arrival airport to their intended consignees. As a result of its consolidation of customers' shipments, the forwarder is usually able to obtain lower rates from airlines than its customers could obtain directly from those airlines. In addition, in certain tradelanes and with certain airlines, where the forwarder generates a continuing high volume of freight, that forwarder is often able to obtain even lower rates. Accordingly, the forwarder is generally able to offer its customers a lower rate than would otherwise be available to the customer from the airline. However, the rate charged by the forwarder to its customers is greater than that obtained by the forwarder from the airline, and the difference represents the forwarder's gross profit. Ocean Freight Services ---------------------- The Company's revenue from international ocean freight forwarding is derived from service both as an indirect ocean carrier (NVOCC) and as an authorized agent for shippers and importers. Effective July 1, 1993, the Company acquired Votainer, a Non-Vessel Operating Common Carrier ("NVOCC") specializing in ocean freight consolidation. As an NVOCC, through its 34 company-operated facilities in 12 countries, supplemented with 70 agent locations in 37 countries, the Company contracts with ocean shipping lines to obtain transportation for a fixed number of containers between various points during a specified time period at an agreed rate. Votainer solicits freight from its customers to fill the containers, charging rates lower than the rates offered directly to customers by shipping lines for similar type shipments. Operations ---------- The Company has a global network of Company-operated facilities and supporting agents serving over 544 cities, including 229 in the United States, 123 in Europe, 77 in Asia and the South Pacific and 115 in the Middle East, Africa and Latin America. As a consequence, a substantial portion of its revenues and profits is derived from the shipment of goods from, or entirely between, locations outside the United States. For the year ended December 31, 1993, approximately 57% of its revenues and 59% of its gross profits, originated from locations outside the United States. NYFS03...:\16\12316\0001\7120\FRM32894.P9B The Company neither owns nor operates any ships or aircraft. It arranges for transportation of its customers' shipments via steamship lines, commercial airlines and air cargo carriers. On limited occasions, when the size of a particular shipment so warrants, the Company will charter a cargo aircraft. The Company acts solely as a forwarder in respect of approximately 91% of the shipments it handles. When acting as an airfreight forwarder, the Company becomes legally responsible to its customer for the safe delivery of the customer's cargo to its ultimate destination, subject to a limitation on liability of $20.00 per kilo ($9.07 per pound). When acting as an ocean freight consolidator, the Company assumes cargo liability to its customers for lost or damaged shipments. This liability is typically limited by contract to a maximum of $500 per package or customary freight unit. However, because a freight forwarder's relationship to an airline or steamship line (the "Carrier") is that of a shipper to a carrier, the Carrier generally assumes the same responsibility to the Company as the Company assumes to its customers. On occasion, the Company acts in the capacity of a cargo agent for a designated Carrier. In this capacity, the Company contracts for freight carriage, for which it receives a commission from the Carrier, but it does not have legal responsibility for the safe delivery of the shipment. During 1993, shipments for which the Company acted as a cargo agent accounted for less than 2% of its revenues. The Company also offers door-to-door express delivery among 18 European countries through its Pandalink service, which operates from a central hub in Brussels. Pandalink operates predominately as an overnight service to major European cities, with alternative delivery services to outlying areas, within 48 to 72 hours. Ancillary Services ------------------ In connection with its services as a freight forwarder, the Company provides ancillary services, such as door-to-door pick-up and delivery of freight, warehousing, cargo assembly, protective packing, consolidation and customs clearance. In addition, the Company provides other transportation-related services, including acting as a domestic surface freight forwarder, a customs broker and a warehouse operator. The LOGIS System ---------------- The Company introduced its proprietary LOGIS logistics information system for airfreight operations in 1986 and since that time has allocated substantial resources to expand the system's geographic reach and enhance its capabilities. Mainframe computers located at the Company's headquarters in Darien, Connecticut, and a facility near London, England, are linked to, and accessible from, terminals at 220 of its Company-operated facilities and with its agents in substantially all major markets, permitting real-time inputting, processing and retrieval of shipment, pricing, scheduling, space availability, booking and tracking data, as well as automated preparation of shipping, customs and billing documents. NYFS03...:\16\12316\0001\7120\FRM32894.P9B As of December 31, 1993, the LOGIS system permitted electronic interfacing with more than 300 of the Company's major customers in 32 countries, 37 international airlines and customs authorities in the United States, the United Kingdom, Australia, Belgium and France. Electronic data interchange ("EDI") connections to the airlines permit instant retrieval by the Company, and by those of its customers interfacing with the LOGIS system, of information on the status of shipments in the custody of the airlines. With its EDI capabilities, LOGIS can receive a customer's shipping instructions and information with respect to the cargo being shipped and convert these data automatically into shipping documents. Where customs authorities in the country of destination are linked to the system, it can prepare customs declarations, calculate the appropriate customs duties and provide for automatic customs invoicing and clearance. The LOGIS system has enabled the Company to improve the productivity of its personnel and the quality of its customer service and has enabled many of its customers to manage their freight transportation logistics needs more effectively. The system has resulted in substantial reductions in paperwork and expedited the entry, processing, retrieval and dissemination of critical information. Management plans to continually improve and enhance the LOGIS system, including extending its capabilities to support Votainer's ocean freight functions. Management believes that the LOGIS system has positioned the Company to better capitalize on the continuing trend toward outsourcing by large corporations of logistics management functions and reliance by many of these corporations on single-source providers. Regulation ---------- The Company's activities as an IATA cargo agent are subject to the rules and regulations of that organization to the extent the Company acts as an agent for an airline which is an IATA member. Certain IATA rules and regulations are subject to DOT approval. In addition, several states in which the Company operates regulate intrastate trucking. In these states, the Company has obtained the necessary operating authority. The Company is licensed as an ocean freight forwarder by the United States Federal Maritime Commission ("FMC") which prescribes qualifications for acting as a shipping agent, including surety bonding requirements. The FMC does not regulate the Company's fees in any material respect. The Company's ocean freight NVOCC business is subject to regulation, as an indirect ocean cargo carrier, under the FMC tariff filing and surety bond requirements, which require the Company to abide by tariffs filed with the FMC specifying the rates which may be charged to customers. Customers and Marketing ----------------------- The Company's principal customers are large manufacturers and distributors of computers and electronics equipment, pharmaceuticals, heavy industrial and construction equipment, motion pictures and printed materials. During 1993, the Company shipped goods for more than 60,000 customer accounts, none of which accounted for more than 5% of the Company's revenues. The Company markets its services worldwide through an international sales organization consisting of approximately 430 full-time salespersons (as of December 31, 1993), supported by the sales efforts of senior management and the Company's country, regional, branch and NYFS03...:\16\12316\0001\7120\FRM32894.P9B district managers. In markets where the Company does not operate its own facilities, its direct sales efforts are supplemented by those of the Company's agents. The Company's marketing is directed primarily to large, multinational corporations with substantial requirements for the international transportation of heavy cargo. Competition ----------- Competition within the freight forwarding industry is intense. Although the industry is highly fragmented, with a large number of participants, the Company competes primarily with a relatively small number of international firms with worldwide networks and the capability to provide the breadth of services offered by the Company. The Company also encounters competition from regional and local freight forwarders, integrated transportation companies that operate their own aircraft, cargo sales agents and brokers, surface freight forwarders and carriers, certain airlines, and associations of shippers organized for the purpose of consolidating their members' shipments to obtain lower freight rates from carriers. Currency and Other Risk Factors ------------------------------- The Company's worldwide operations engender the risk that some of the many local currencies in which it receives payment may not be easily convertible, or convertible at all, into U.S. dollars. There are also risks from fluctuations in value of currencies, devaluations, or other governmental actions. In addition, the Company's business requires good working relationships with the airlines, which are its largest creditor as a group. To the extent that the airlines decrease cargo space available to forwarders, cut back cargo or passenger flights or enter the forwarding business themselves, the airfreight forwarding business could be adversely affected. The Company considers its working relationship with the airlines to be good. Employees --------- As of December 31, 1993, the Company employed 4,271 people, of whom 2,948 were based at locations outside the United States, including 1,496 in the United Kingdom and Europe, 792 in Asia and 660 in the South Pacific, South America, Africa and Canada. Of the Company's 1,323 U.S.-based employees at that date, approximately 545 were covered by agreements with various locals of the International Brotherhood of Teamsters, the United Auto Workers and the International Association of Machinists and Aerospace Workers. In addition, approximately 16% of the Company's foreign-based personnel are represented by various types of collective bargaining organizations. The Company considers its relationship with its employees to be satisfactory. (d) Financial Information About Foreign and Domestic Operations ----------------------------------------------------------- See the Company's Consolidated Financial Statements including the Notes thereto, for data related to the Company's revenues, operating profit and loss and identifiable assets. NYFS03...:\16\12316\0001\7120\FRM32894.P9B Item 2.

Item 2. Properties ---------- The Company owns its worldwide headquarters building (approximately 30,000 square feet in area) in Darien, Connecticut, which is subject to a $.5 million mortgage, a warehouse and office facility (approximately 78,000 square feet in area) in Sydney, Australia, which is subject to a $3.8 million mortgage, and a warehouse and distribution facility (approximately 59,000 square feet in area) in Venlo, Holland, which is subject to a $1.8 million mortgage. On January 24, 1994 the Company began construction on its new 160,000 square foot warehouse and distribution center in Singapore, which is scheduled to be completed in the fourth quarter of 1994. The Company leases facilities on or near airports at 50 locations in the United States, and 125 offices in 28 other countries. Most facilities have office, dock and warehouse space. The principal facilities are set forth in the following table: Approximate Sq. Feet of Lease Location Floor Space Expiration -------- ------------------------------------ ---------- Amsterdam, The 67,800 sq. ft. of cargo and office 1998 Netherlands Chicago, Illinois 115,666 sq. ft. of cargo and office 1998 Frankfurt, Germany 36,800 sq. ft. of cargo and office 1995 London, England 93,000 sq. ft. of cargo and office 2002 Los Angeles, 54,800 sq. ft. of cargo and office 1994 California Miami, Florida 76,500 sq. ft. of cargo and office 1995 New York, New York 77,000 sq. ft. of cargo and office 1996 Singapore 26,605 sq. ft. of cargo and office 1995 The Company believes that its facilities are adequate for its needs now and in the foreseeable future. Item 3.

Item 3. Legal Proceedings ----------------- None. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders --------------------------------------------------- None. NYFS03...:\16\12316\0001\7120\FRM32894.P9B Executive Officers of the Registrant ------------------------------------ Following is a listing of the executive officers of the Company. The information listed below with respect to age and business experience for the past five years has been furnished to the Company as of March 16, 1994 by each executive officer of the Company. There are no family relationships between any Director or officer of the Company. Positions with the Company and Business Experience for the Name Age Past Five Years ------------------------- --- ----------------------------------- Hendrik J. Hartong, Jr. 54 Chairman of the Company since 1985; Chief Executive Officer of the Company from 1985 through 1989; General Partner of Brynwood Management and Brynwood Management II L.P., which serve, respectively, as managing general partners of Brynwood Partners Limited Partnership and Brynwood Management II L.P., private investment partnerships, since 1985; Director of Hurco Companies, Inc. Guenter Rohrmann 54 Chief Executive Officer of the Company since 1989; President and Chief Operating Officer of the Company since 1985. Dennis M. Dolan 36 Vice President and Chief Financial Officer of the Company since 1989; Controller U.S.A. from 1985 to 1989. Daniel J. McCauley 59 Vice President, General Counsel and Secretary of the Company since 1991; 1990-1991 consultant; Executive Vice President, Secretary and General Counsel, Emery Airfreight Corporation, Wilton, CT, a transportation company for more than five years prior to 1990. NYFS03...:\16\12316\0001\7120\FRM32894.P9B Paul J. Gallagher 48 Vice President-International Controller of the Company since 1989; Director International Finance, Emery Airfreight Corporation, Wilton, CT, a transportation company for more than five years prior to 1989. Walter L. McMaster 61 Vice President and Controller of the Company for more than the past five years. Robert J. O'Connell 57 Vice President-General Manager- North America of the Company since 1989; Vice President-North America Sales, from 1985 to 1989. NYFS03...:\16\12316\0001\7120\FRM32894.P9B Part II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder ------------------------------------------------------------- Matters ------- The Company's common stock, $.01 par value (the "Common Stock"), is traded on the American Stock Exchange. On June 25,1992, the Company's Board of Directors declared a three- for-two split of the Common Stock in the form of a 50% stock dividend. The additional shares were distributed on July 31, 1992 to shareholders of record on July 13, 1992. See Note 2 to the Consolidated Financial Statements. During 1993, the Company declared four quarterly cash dividends on the Common Stock. The table below indicates the quarterly high and low prices of the Common Stock for the years ended December 31, 1993 and 1992. All per share information has been restated to reflect the three-for-two stock split in July 1992. See Note 2 to the Consolidated Financial Statements. At March 24, 1994, there were 1,033 holders of record of the Company's Common Stock. The closing price of the Common Stock on that date was $23.00 per share. The Company's agreements with its principal lenders limit the amounts available for payment of cash dividends and share repurchases. See Note 7 to the Consolidated Financial Statements. NYFS03...:\16\12316\0001\7120\FRM32894.P9B Item 6.

Item 6. Selected Financial Data ----------------------- NYFS03...:\16\12316\0001\7120\FRM32894.P9B Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition ----------------------------------------------------------- and Results of Operations ------------------------- Liquidity and Capital Resources ------------------------------- In January, 1993, the Company issued and sold $74.8 million of 6% Convertible Subordinated Debentures (the "Debentures") due 2003 and received $72.5 million, after commissions and expenses, from the sale of the Debentures. The net proceeds were initially used to repay $5.0 million of outstanding revolving credit balances and for general corporate purposes, including acquisitions of other companies in the same or related businesses. On July 1, 1993, the Company acquired the Votainer group of Companies for a cash purchase price of $11.3 million plus the assumption and payment of certain indebtedness of approximately $3.3 million to the seller. Capital expenditures in 1993, which were largely for the acquisition of data processing equipment and facility improvements totaled $4.9 million. Capital expenditures for 1992 totaled $15.2 million, which included the purchase of a warehouse and office facility in Sydney, Australia for $7.5 million and the construction of a warehouse and distribution facility in Venlo, Holland for $3.0 million. Depreciation and amortization expense totaled $6.3 million in 1993 and $7.0 million in 1992. Capital expenditures for 1994 are anticipated to be approximately $17.0 million. Cash, cash equivalents and short-term investments at December 31, 1993 totaled $65.2 million compared to $14.1 million at December 31, 1992. The increase was largely attributable to the proceeds remaining from the sale of the $74.8 million of Debentures. The Company maintains a revolving credit facility which permits borrowing in amounts up to a maximum of $20.0 million at any time outstanding until maturity in September, 1995. Interest on outstanding borrowings is payable at a variable rate equal, at the Company's election, to (i) the prime commercial rate in effect from time-to-time or (ii) LIBOR in effect from time-to-time plus 2.0%. At December 31, 1993, there were no borrowings under this facility. Management believes that the Company's available cash and sources of credit, together with expected future cash generated from operations, will be sufficient to satisfy its anticipated needs for working capital, capital expenditures and fixed charges. NYFS03...:\16\12316\0001\7120\FRM32894.P9B Results of Operations --------------------- 1993 Compared to 1992 --------------------- Included in the consolidated results of operations for 1993 are the ocean freight activities of Votainer for the last six months of 1993. Votainer was acquired by the Company on July 1, 1993. The consolidated results of airfreight and ocean freight activities for 1993 compared to 1992 (airfreight only) are as follows: Consolidated revenues increased $53.4 million (7.9%) to $725.7 million in 1993 compared with 1992. The increase in revenues was attributable to the inclusion of $51.4 million of revenues from the ocean freight operations from Votainer for the last six months of 1993. Revenues from airfreight operations for 1993 were $674.3 million, largely unchanged from 1992 revenues. Airfreight revenues for 1993 were impacted by the positive effects of a 4.4% increase in the number of shipments and a 11.2% increase in the total weight of cargo shipped, which was offset by the negative effects of lower customer selling rates and the effect of weaker foreign currencies when converting foreign currency revenues into United States dollars for financial reporting purposes. Gross profit (revenue less transportation expense) increased $7.0 million (3.1%) to $229.3 million in 1993 compared with 1992. The increase in gross profit is attributable to the inclusion of $12.2 million of gross profit of Votainer for the last six months of 1993, which was partially offset by a $5.2 million (2.3%) decrease in airfreight gross profit to $217.1 million. The decrease in airfreight gross profit was due to lower gross profit in European airfreight operations and competitive pricing pressures, which reduced gross margin (gross profit as a percentage of revenues) from 33.1% in 1992 to 32.1% in 1993. NYFS03...:\16\12316\0001\7120\FRM32894.P9B The Company's internal operating expenses (terminal and selling, general and administrative) increased $6.9 million (3.6%) to $197.9 million in 1993 compared to 1992. The increase was due entirely to the inclusion of Votainer's internal operating expenses of $13.0 million for the last six months of 1993, which more than offset a $6.1 million (2.3%) reduction in the internal operating expense attributable to the Company's airfreight operations. The latter category of expenses benefitted from the effects of weaker foreign currencies when converting foreign currency expenses into United States dollars for financial reporting purposes as well as lower employee incentive compensation expense. Operating income for 1993 was $31.4 million, unchanged from 1992 operating income, with the $.9 million loss from Votainer's operations being offset by a $1.0 million improvement in airfreight operating income. Net interest expense increased $1.5 million (45%) to $3.7 million in 1993 compared with 1992. The increase was attributable to the interest cost associated with the Company's 6% Convertible Subordinated Debentures issued in January 1993. The effective tax rate for 1993 was 38.0% compared to 37.6% for 1992. The Company's effective tax rates fluctuate due to changes in tax rates and regulations in the countries in which it operates and the level of pre-tax profit earned in each of those countries. United States Operations ------------------------ United States revenues increased $37.8 million (14%) to $308.5 million in 1993 compared to 1992. The increase in United States revenues was comprised of a $6.2 million (21.6%) increase in domestic airfreight revenues, an $11.9 million (4.9%) increase in international airfreight revenues, and the inclusion of $19.7 million of Votainer revenues for the last six months of 1993. The increase in United States airfreight revenues was attributable to a 5.5% increase in the number of shipments (18.1% increase in domestic shipments and 1% increase in international shipments) and a 14% increase in the total weight of cargo shipped (30% increase in domestic cargo and 9% increase in international cargo). The increased domestic and international airfreight shipping volumes resulted in an increase in airfreight profit of $1.8 million (19.4%), which was partially offset by a $1.2 million operating loss in Votainer, resulting in an overall increase in United States operating profit of $.6 million (6.0%) to $9.6 million in 1993. Foreign Operations ------------------ Foreign revenues increased $15.6 million (3.9%) to $417.3 million in 1993 compared with 1992. The increase in revenues was attributable to the inclusion of $31.7 million of Votainer revenues for the last six months of 1993, which was offset by a $16.1 million (4.0%) decrease in foreign airfreight revenues. The decrease in foreign airfreight revenues was attributable to the Company's European operations, where weaker foreign currencies, particularly the NYFS03...:\16\12316\0001\7120\FRM32894.P9B British Pound, accounted for a reduction of $20.7 million (8.6%) in European airfreight revenues when European revenues were converted to United States dollars for financial reporting purposes. The number of shipments and total weight of cargo shipped by the Company's European airfreight operations increased 3.2% and 15.4%, respectively. In the Company's Asia and Others segment, revenues increased $19.4 million (12.1%) to $180.0 million in 1993 compared to 1992. This increase was attributable to the inclusion of $14.8 million of Votainer revenues for the last six months of 1993 and a $4.6 million increase in airfreight revenues. The number of airfreight shipments handled by the Company's Asia and Others operation increased 3.0%, while the total weight of cargo shipped by these operations was unchanged from 1992. Operating profit from foreign operations decreased $.4 million (2.1%) to $21.8 million for 1993 compared with 1992. The decline in foreign operating profit was due entirely to a $1.7 million decrease in European airfreight operating profit, which was partially offset by a $.9 million increase in Asia and Others airfreight operating profit and a $.4 million operating profit in Votainer's foreign operations. In Europe, five of the Company's seven wholly-owned subsidiaries reported lower operating results in 1993 when compared with 1992, including an operating loss incurred by the Company's German subsidiary. These declines are directly attributable to the continuing economic recession in most European countries, particularly Germany, and resulting competitive pricing pressures. The operating results in the Company's United Kingdom and Holland airfreight operations, which comprised 54% of 1993 European revenues and 90% of 1993 European operating profit, were largely unchanged from 1992. 1992 Compared to 1991 Worldwide Operations: -------------------- Consolidated revenues increased $70.3 million (11.7%) to $672.3 million in 1992 compared with 1991. The increased revenues were largely attributable to a 5.7% increase in the number of shipments and a 16.7% increase in the total weight of cargo shipped. Additionally, when converting foreign currency revenues into U.S. dollars for financial reporting purposes, the effect of a weaker U.S. dollar accounted for approximately $9.3 million of the increase in revenues. Gross profit (revenues less transportation expense) increased $24.5 million (12.4%) to $222.3 million in 1992 compared with 1991 due to the increase in the number of shipments and the total weight of cargo shipped. Gross margin (gross profit as a percentage of revenues) for 1992 was 33.1%, compared to 32.8% for 1991. Of the Company's internal operating expenses (terminal and selling, general and administrative expenses), terminal expense increased $8.6 million (8.2%) to $113.2 million while selling, general and administrative expense increased $9.3 million (13.6%) to $77.8 million. The higher internal operating expense was due to increases in shipping volumes, higher advertising and promotional expense and increased employee compensation. NYFS03...:\16\12316\0001\7120\FRM32894.P9B Operating income increased $6.6 million (26.8%) to $31.3 million in 1992 compared with 1991. This increase was attributable to the increased number of shipments and weight of cargo shipped and a decline in internal operating expense as a percentage of revenues to 28.4% in 1992 from 28.8% in 1991. Net interest expense for the year ended December 31, 1992 declined $0.4 million (14.9%) to $2.2 million compared with 1991. The decrease reflected the conversion in April 1992 of the Company's 11.15% Convertible Subordinated Notes due 1999 in the principal amount of $20.0 million into 2,045,407 shares of Common Stock, which shares were then repurchased by the Company. The effective tax rate for 1992 was 37.6% compared to 39.9% for 1991. The lower tax rate was due to higher levels of pre-tax income in 1992, which reduced the impact of nondeductible expenses on the effective tax rate and lower statutory tax rates in four countries where the Company operates. United States Operations: ------------------------ United States revenues increased $23.2 million (9.4%) to $270.6 million in 1992 compared with 1991. The increase in United States revenues was attributable to a 4.0% increase in the number of shipments and a 14.3% increase in the total weight of cargo shipped. The increases in the number and total weight of shipments resulted in an increase in operating income of $1.0 million (11.9%) to $9.0 million in 1992 compared with 1991. Foreign Operations: ------------------ Foreign revenues increased $47.1 million (13.3%) to $401.7 million in 1992 compared with 1991. European revenues for 1992 increased $25.5 million (11.9%) to $241.0 million and Asia and other revenues increased $21.6 million (15.5%) to $160.6 million. A 7.4% increase in the number of shipments and a 18.1% increase in the total weight of cargo shipped accounted for approximately $18.9 million (40.0%) of the increase, while stronger European currencies accounted for approximately $6.6 million (14.0%) of the increase when the Company's European revenues were converted into U.S. dollars for financial reporting purposes. The increase in the Asia and other revenues was primarily due to a 6.4% increase in the number of shipments and a 20.4% increase in the total weight of cargo shipped. Foreign operating income increased $5.6 million (34.0%) to $22.2 million in 1992 compared with 1991. The increase was due to a $3.5 million (34.1%) increase in European operating income and a $2.2 million (33.9%) increase in the Asia and other sector. All six of the Company's wholly-owned subsidiaries in Europe (Belgium, France, Germany, Holland, Ireland and the United Kingdom) reported improved results for 1992. In particular, the Company's operations in the United Kingdom and Holland accounted for approximately 53.9% of its European revenue and 78.2% of its European operating income. NYFS03...:\16\12316\0001\7120\FRM32894.P9B Item 8.

Item 8. Financial Statements and Supplementary Data ------------------------------------------- The financial statements and supplementary data required by this Item 8 are included in the Company's Consolidated Financial Statements and set forth at the pages indicated in Item 14(a) of this Annual Report. Item 9.

Item 9. Changes in and Disagreements with Accountants --------------------------------------------- on Accounting and Financial Disclosures --------------------------------------- None. Part III -------- Item 10.

Item 10. Directors and Executive Officers of the Registrant -------------------------------------------------- The Company's definitive Proxy Statement to be issued in conjunction with the 1994 Annual Meeting of Shareholders is incorporated herein by reference. The Company believes that, during 1993, its officers and directors complied with all filing requirements under Section 16(a) of The Securities Exchange Act of 1934, as amended. Item 11.

Item 11. Executive Compensation ---------------------- The Company's definitive Proxy Statement to be issued in conjunction with the 1994 Annual Meeting of Shareholders is incorporated herein by reference. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and --------------------------------------------------- Management ---------- The Company's definitive Proxy Statement to be issued in conjunction with the 1994 Annual Meeting of Shareholders is incorporated herein by reference. Item 13.

Item 13. Certain Relationships and Related Transactions ---------------------------------------------- The Company's definitive Proxy Statement to be issued in conjunction with the 1994 Annual Meeting of Shareholders is incorporated herein by reference. NYFS03...:\16\12316\0001\7120\FRM32894.P9B Part IV ------- Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports ---------------------------------------------------- on Form 8-K ----------- (a) The following documents are filed as a part of this report on Form 10-K. (1) Financial Statements: Page -------------------- ---- Report of Independent Public Accountants Consolidated Balance Sheets as of December 31, 1993 and 1992. Consolidated Statements of Operations for the years ended December 31, 1993, 1992 and 1991. Consolidated Statements of Stockholders' Investment for the years ended December 31, 1993, 1992 and 1991. Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991. Notes to Consolidated Financial Statements (2) Financial Statement Schedules: ----------------------------- Schedule VIII - Valuation and Qualifying Accounts. Schedule IX - Short-term Borrowings. All other financial statement schedules are omitted because they are not applicable, not required, or because the required information is included in the Company's Consolidated Financial Statements or Notes thereto. Separate financial statements of the Company have been omitted since less than 25% of the net assets of its subsidiaries and equity investments are formally restricted from being loaned, advanced or distributed to the holding company. NYFS03...:\16\12316\0001\7120\FRM32894.P9B (3) Exhibits required to be filed by Item 601 of Regulation S-K. 3a. Certificate of Incorporation, as amended through July 24, 1993. b. The Bylaws, as amended through March 22, 1992. (Incorporated herein reference to Exhibit 3 to the Company's Current Report on Form 8-K, filed March 22, 1992) 4a. Indenture, dated as of January 15, 1993, between the Company and The Bank of New York, as Trustee. (Incorporated herein by reference to Exhibit 1 to the Company's Current Report on Form 8-K, dated February 2, 1993) b. Specimen Convertible Subordinated Debenture. (Incorporated by reference to Exhibit 4(b) to the Company's Registration Statement on Form S-3, dated December 22, 1992) c. Specimen certificate representing the Common Stock. (Incorporated herein by reference to Exhibit 4(c) to the Company's Registration Statement on Form S-3, dated December 22, 1992) 10. Material Contracts: a. Employment Agreement, effective January 1, 1986, between the Company and Hendrik J. Hartong, Jr. (Incorporated herein by reference to Exhibit 10(iii) to the Company's Current Report on Form 8-K, filed March 22, 1992) b. Employment Agreement, effective January 1, 1986, between the Company and Guenter Rohrmann. (Incorporated herein by reference to Exhibit 10(iv) to the Company's Current Report on Form 8-K filed March 22, 1991) c. Non-Qualified Stock Option Agreement, dated January 14, 1988, between the Company and Mr. Hartong. (Incorporated herein by reference to Exhibit 10(vi) to the Company's Current Report on Form 8-K filed March 2, 1990) d. Non-Qualified Stock Option Agreement, dated June 20, 1984, between the Company and Mr. Rohrmann. (Incorporated herein by reference to Exhibit 10(ii) to the Company's Report on Form 8- K filed March 22, 1991) e. Non-Qualified Stock Option Agreement, dated January 19, 1988, between the Company and Mr. Rohrmann. (Incorporated by reference herein to Exhibit 10(vii) the Company's Report on Form 8-K filed March 2, 1990) f. Air Express International Corporation Employees' 1981 Incentive Stock Option Plan, incorporated herein by reference to Exhibit 10(i) to the Company's Report on Form 10-K, dated April 12, 1985. NYFS03...:\16\12316\0001\7120\FRM32894.P9B g. Air Express International Corporation 1984 International Employees' Stock Option Plan. h. Loan Agreement, dated as of December 31, 1981, between the Company and the Connecticut Development Authority, as amended. (Incorporated by reference herein to Exhibit 10(i) to the Company's Report on Form 8-K filed March 22, 1991) i. Lease Agreement, entered into in June 1986, between the Company and The Port Authority of New York and New Jersey for Hangar 5, John F. Kennedy Airport. j. Air Express International Corporation Employees' 1991 Incentive Stock Option Plan, approved by the Shareholders of the Company on June 20, 1991. (Incorporated herein by reference to the Company's Proxy Statement, dated May 17, 1991, furnished to the stockholders in connection with the Annual Meeting of Stockholders held on June 20, 1991) k. Credit Agreement, dated as of September 17, 1993, among the Company, the Guarantors named therein and Pittsburgh National Bank. (Incorporated herein by reference to Exhibit 4(e) of the Company's Registration Statement on Form S-3, dated December 22, 1992) 21. List of Subsidiaries of the Registrant. Exhibit 21. 23. Consent of Independent Public Accountants. Exhibit 23. All other exhibits are omitted because they are not applicable, not required or because the required information is included in the Consolidated Financial Statements or Notes thereto. (b) Reports on Form 8-K: None. NYFS03...:\16\12316\0001\7120\FRM32894.P9B SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. AIR EXPRESS INTERNATIONAL CORPORATION Registrant By: /s/ Dennis M. Dolan ------------------------------------ Dennis M. Dolan Vice President and Chief Financial Officer (Principal Financial Officer) By: /s/ Walter L. McMaster ------------------------------------ Walter L. McMaster Vice President and Controller (Principal Accounting Officer) Date: March 25, 1994 NYFS03...:\16\12316\0001\7120\FRM32894.P9B Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Signature Title Date --------- ----- ---- /s/ John M. Fowler Director March 30, 1994 --------------------------- (John M. Fowler) /s/ Hendrik J. Hartong, Jr. Chairman of the Board --------------------------- of Directors March 30, 1994 (Hendrik J. Hartong, Jr.) /s/ Leo T. Heessels Director March 30, 1994 --------------------------- (Leo T. Heessels) /s/ Donald J. Keller Director March 30, 1994 --------------------------- (Donald J. Keller) /s/ Andrew L. Lewis IV Director March 30, 1994 --------------------------- (Andrew L. Lewis IV) /s/ Richard T. Niner Director March 30, 1994 --------------------------- (Richard T. Niner) /s/ Guenter Rohrmann President, Chief --------------------------- Executive Officer, andMarch 30, 1994 (Guenter Rohrmann) Director (Principal Executive Officer) NYFS03...:\16\12316\0001\7120\FRM32894.P9B REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholders and Board of Directors of Air Express International Corporation: We have audited the accompanying consolidated balance sheets of Air Express International Corporation (a Delaware corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholders' investment and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Air Express International Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index of financial statements are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. New York, New York March 25, 1994 F- NYFS03...:\16\12316\0001\7120\FRM32894.P9B F- NYFS03...:\16\12316\0001\7120\FRM32894.P9B F- NYFS03...:\16\12316\0001\7120\FRM32894.P9B F- NYFS03...:\16\12316\0001\7120\FRM32894.P9B F- NYFS03...:\16\12316\0001\7120\FRM32894.P9B AIR EXPRESS INTERNATIONAL CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands, except per share data) (1) Summary of Significant Accounting Policies: ------------------------------------------ Principles of Consolidation - --------------------------- The consolidated financial statements include the accounts of Air Express International Corporation and its majority-owned subsidiaries (the "Company"), all of which conduct operations in a single line of business, freight forwarding. All significant intercompany accounts and transactions have been eliminated. Investments in 20% to 50% owned affiliates are accounted for using the equity method. With the exception of entities operating in highly inflationary economies, assets and liabilities of foreign subsidiaries are translated at rates of exchange in effect at the close of the period. Revenues and expenses are translated at average exchange rates in effect during the year. The resulting translation adjustments are recorded in a separate component of stockholders' investment, "Cumulative Translation Adjustments." Translation gains or losses of the Company's entities which operate in highly inflationary economies are included as a component of other income. Method of Revenue Recognition - ----------------------------- International revenues for the transportation of international freight are recognized at the time the freight has been exported from the country of origin via commercial carrier. The corresponding transportation costs charged by the commercial carriers are recognized concurrently with the freight revenues. Destination delivery costs are recognized as incurred and subsequently billed to consignees, except door-to-door cargo movements which are accrued concurrently with freight revenue recognition. Domestic revenues for the transportation of freight within the U.S. are recognized on the day freight departs the Company's terminal of origin. Transportation costs and destination delivery costs are recognized concurrently with freight revenues. Property and Equipment - ---------------------- The Company provides depreciation and amortization on the straight- line method over the estimated useful lives of the related assets. Maintenance and repairs are charged to expense as incurred. F- NYFS03...:\16\12316\0001\7120\FRM32894.P9B NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued Goodwill - -------- Goodwill, which represents the excess of purchase price over the fair value of net assets acquired, is being amortized on a straight-line basis over a period of 40 years. Cash and Cash Equivalents - ------------------------- Cash and Cash equivalents include cash on hand, demand deposits, and short-term investments with original maturities of three months or less. Short-Term Investments - ---------------------- Short-term investments consist of highly liquid U.S. Government instruments with original maturities in excess of three months and are carried at cost, which approximates market. Reclassification and Restatement - -------------------------------- Certain prior year amounts have been reclassified to conform with the current year presentation. Additionally, all share and per share information has been restated to reflect a three-for-two split of the Company's common stock (See Note 2). (2) Common Stock Split: ------------------ On June 25, 1992, the Company's Board of Directors declared a three- for-two split of the Company's common stock, payable in the form of a stock dividend. The additional shares were distributed on July 31, 1992 to shareholders of record on July 13, 1992. Accordingly, all share and per share information throughout the consolidated financial statements has been restated to reflect this split. F- NYFS03...:\16\12316\0001\7120\FRM32894.P9B NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued (3) Earnings Per Share: ------------------ Primary earnings per share are computed by dividing net income by the weighted average common and common equivalent shares outstanding during the year. In 1993 and 1991, fully diluted earnings per share have been calculated assuming the conversion of the convertible subordinated securities outstanding in those years, and the elimination of interest expense, net after tax, which approximates $2.7 million and $1.5 million, respectively. The primary and fully diluted earnings per share and number of common and common equivalent shares were as follows: (4) Business Acquisitions: --------------------- On July 1, 1993, the Company acquired Votainer, a Non-Vessel Operating Common Carrier specializing in ocean freight consolidation, for a purchase price of $11.3 million plus the assumption and payment of certain indebtedness of approximately $3.3 million to the seller. During the fourth quarter of 1993, for a total investment of approximately $4.0 million, the Company acquired 100% of the outstanding shares of its agent in Leeds, England, its joint venture in Switzerland, and the operating assets and business of an airfreight/trucking company in New Zealand. These acquisitions completed in 1993 resulted in an increase in goodwill in the amount of $13.9 million. F- NYFS03...:\16\12316\0001\7120\FRM32894.P9B NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued (5) Regional Operations: ------------------- Revenues, operating income and identifiable assets are set forth below by geographic area. Revenues for international shipments are recorded in the country of origin. Certain prior year amounts have been reclassified to conform with the current year presentation. Domestic U.S.A. revenues represent airfreight forwarding only. International revenues represent airfreight forwarding for 1992 and 1991. At December 31, 1993, net assets of foreign subsidiaries including intercompany accounts deemed to be long-term investments amounted to approximately $54.7 million. F- NYFS03...:\16\12316\0001\7120\FRM32894.P9B NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued (6) Property, Plant and Equipment: ----------------------------- A summary of property, plant and equipment, at cost, is as follows: (7) Revolving Credit Loan Agreement and Other Short-term ---------------------------------------------------- Borrowing Facilities: -------------------- The Company maintains a Revolving Credit Loan Agreement (the "Agreement") with a U.S. bank which provides for maximum borrowings of $20.0 million, or a defined borrowing base. The borrowing base is comprised of certain United States eligible receivables, which had a gross value of $31.0 million at December 31, 1993. The interest charged on borrowings is the bank's prime rate, or London Interbank Offered Rate (LIBOR) plus 2%. The commitment fee for the unused portion of the credit facility is .375% per annum. The Agreement contains restrictions and limitations relating to working capital, dividends, investments, capital expenditures, and other borrowings. The Agreement also contains affirmative covenants relating to adjusted tangible net worth, ratio of non-subordinated debt to adjusted tangible net worth, and a minimum required current ratio of 1:1. The Company is in compliance with all the conditions of the Agreement. Payments of cash dividends and the purchase of treasury stock are limited to 50% of consolidated net income earned after September 30, 1992. Accordingly, $6.9 million was available at December 31, 1993 for payments of cash dividends, and purchase of treasury stock. At December 31, 1993 there was no borrowing under this revolving credit agreement. In addition to the above, a number of the Company's foreign subsidiaries have unsecured short-term overdraft facilities with foreign banks which total $12.1 million at December 31, 1993. The largest single facility, extended to the Company's German subsidiary, was $3.7 million. Borrowings under these facilities generally bear interest at .5% to 2.0% over the foreign banks' equivalent of the prime rate. At December 31, 1993, outstanding borrowings from these facilities were $.6 million. F- NYFS03...:\16\12316\0001\7120\FRM32894.P9B NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued (8) Long-Term Debt: -------------- Long-term debt consists of the following: The maturities of long-term debt are as follows: The Industrial Development Bonds are secured by land and a building with a net book value of $4.3 million at December 31, 1993. The Company is in compliance with all the covenants and conditions of the Industrial Development Bonds. The Australia mortgage is secured by land and building with a net book value of $6.2 million at December 31, 1993, used in the operations of the Company's Australia subsidiary. The Holland mortgage is secured by land and building in Venlo, Holland, with a net book value of $2.5 million at December 31, 1993. On January 28, 1993, the Company issued and sold $74.8 million aggregate principal amount of its 6% Convertible Subordinated Debentures due 2003 (the "Debentures") and received net F- NYFS03...:\16\12316\0001\7120\FRM32894.P9B NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued (8) Long-Term Debt - continued: -------------------------- (after commissions and expenses) receipts from the sale of the Debentures of $72.5 million (before deduction of expenses). The Debentures are convertible into Common Stock of the Company through maturity, unless previously redeemed, at $34.0625 per share, subject to adjustment. Interest on the Debentures is payable on January 15 and July 15, commencing July 15, 1993. The Debentures are not redeemable prior to January 15, 1996. Thereafter, the Debentures will be redeemable on at least 30 days' notice at the option of the Company, in whole or in part at any time, initially at 104.2% and at decreasing prices thereafter to 100% at maturity, in each case together with accrued interest. The Debentures also may be redeemed at the option of the holder if there is a Fundamental Change (as defined) at declining redemption prices, subject to adjustment, together with accrued interest. The net proceeds were used, in part, to repay outstanding revolving credit balances, and for general corporate purposes, which may include additions to working capital, enhancement of facilities and operations, and possible acquisitions of other companies in the same or related businesses. At December 31, 1993, the fair value of the Company's long-term debt amounted to $78.4 million compared to the carrying amount of $80 million. The difference was attributable to the Debentures. The fair value was based upon quoted market prices. Interest expense on long-term debt for the years ended December 31, 1993, 1992 and 1991 was $5.7 million, $2.4 million and $3.5 million, respectively. (9) Common Stock Option Plans: ------------------------- The 1981 Employees' Incentive Stock Option Plan authorized the granting of stock options to officers and employees at prices equal to or greater than the fair market value of the common stock on the date of the grant. There were 154,051 options outstanding, of which 129,158 were exercisable at December 31, 1993. There are no options available for future grant under this plan. The 1984 International Employees' Stock Option Plan ("International Plan") authorizes the granting of stock options to officers and employees at prices equal to or greater than the fair market value of the common stock on the date of grant. There were 255,532 options outstanding, of which 14,249 were exercisable at December 31, 1993. Options for 69,947 shares were available for future grant at December 31, 1993, under this plan. F- NYFS03...:\16\12316\0001\7120\FRM32894.P9B NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued The 1991 Employees' Incentive Stock Option Plan, authorizes the granting of stock options and or stock appreciation rights ("SAR'S") to employees at prices equal to or greater than the fair market value of the common stock on the date of the grant. There were 231,657 options outstanding, of which 10,657 were exercisable at December 31, 1993. Options for 513,375 shares were available for future grant at December 31, 1993, under this plan. To date no SAR'S have been granted. At December 31, 1993, 1,224,562 shares of common stock were reserved for issuance pursuant to the Company's option plans. Option activity is summarized as follows: F- NYFS03...:\16\12316\0001\7120\FRM32894.P9B NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued (10) Income Taxes: ------------ The Company and its domestic subsidiaries file a consolidated U.S. Federal income tax return. Foreign subsidiaries file separate corporate income tax returns in their respective countries. The components of income before provision for income taxes and extraordinary item, and the current and deferred components of the provision for income taxes were as follows: The provision for income taxes includes deferred taxes resulting from the recognition of certain revenues and expenses in different periods for financial reporting purposes than for tax reporting purposes. The components of the provision for deferred taxes were as follows: F- NYFS03...:\16\12316\0001\7120\FRM32894.P9B NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued (10) Income Taxes - continued: ------------------------ The difference between the actual provision and the amount computed at the statutory U.S. Federal income tax rate of 35% for 1993 and 34% for 1992 and 1991 is attributable to the following: For tax reporting purposes, the Company and its subsidiaries had available, dependent upon future taxable income, the following net operating loss carryforwards and foreign tax credits as of December 31, 1993: The net operating losses consist of $4,564 incurred by the Pandair companies prior to the December 23, 1987 acquisition and $1,735 incurred by Votainer companies prior to the July 1, 1993 acquisition. Future utilization of Pandair and Votainer losses will be treated as a reduction of goodwill. The use of any loss carryforwards or foreign tax credits is dependent upon future taxable income in the applicable taxing jurisdiction. Tax returns for the years ended December 31, 1990, 1989 and 1988 are currently under examination by the Internal Revenue Service. F- NYFS03...:\16\12316\0001\7120\FRM32894.P9B NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued (10) Income Taxes - continued: ------------------------ Accumulated unremitted earnings of foreign subsidiaries, which are intended to be permanently reinvested for continued use in their operations and for which no U.S. income taxes have been provided, aggregated approximately $66.5 million at December 31, 1993. During the first quarter of 1993, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes". The new standard requires that an asset and liability approach be applied in accounting for income taxes. The adoption of SFAS 109 had no effect on current or prior years net income. The primary effects of the adoption of SFAS 109 on the balance sheet at December 31, 1992 was to create a deferred tax asset, net of a valuation reserve (which is included in "Deposits and Other Assets") and a deferred tax liability and current tax payable. Deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the company's deferred tax assets and liabilities were as follows: F- NYFS03...:\16\12316\0001\7120\FRM32894.P9B NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued (11) Retirement Plans: ---------------- The Company maintains a 401 (k) Retirement Plan, covering substantially all U.S. employees not participating in collective bargaining agreements. The Company contributes 3% of salary for all eligible participants. In addition, the Company matches, dollar for dollar, employee contributions up to 3% of salary, subject to certain limitations imposed by the Internal Revenue Code. The total expense for Company contributions was $1.3 million in 1993, $1.2 million in 1992, and $1.1 million in 1991. Pursuant to collective bargaining agreements with its labor unions, the Company made payments to union sponsored, multi-employer pension plans, based upon the hours worked by covered employees. Such payments approximated $1.3 million, $1.3 million and $1.2 million for the years ended December 31, 1993, 1992 and 1991, respectively. These amounts were determined by the union contracts, and the Company does not administer or control the funds in any way. In the event of plan terminations or Company withdrawal from the plans, the Company may be liable for a portion of the plans' unfunded vested benefits, if any. The Company has been advised by the trustees of one multi-employer pension plan to which the Company contributes that the present value of the plan's vested benefits are significantly in excess of the plan's assets. In February 1994, the trustees further advised that, should the Company withdraw from this plan, the Company's estimated withdrawal liability would be approximately $1.2 million effective of February 1993. The Company continues to make contributions to this plan in accordance with the collective bargaining agreement between the Company and the union that sponsors the plan. If the Company withdraws from this plan, pursuant to negotiations with the union and the plan's trustees, the withdrawal liability will be determined as of the date of withdrawal and may be greater or less than $1.2 million. The Company has not made a determination to seek a negotiated withdrawal from this plan. One foreign subsidiary maintains a defined benefit pension plan (the "Plan") which covers substantially all of its employees. The Plan provides benefits based upon years of service and compensation which are in addition to certain retirement benefits accruing to the employees under government regulations. Participating employees contribute 5% of their annual compensation to the Plan. The net periodic cost for the years ended December 31, 1993, 1992 and 1991 for the Plan are as follows: F- NYFS03...:\16\12316\0001\7120\FRM32894.P9B NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued (11) Retirement Plans - continued: ---------------------------- The funding of the Plan is actuarially determined. The Plan's assets are invested primarily in equity securities, and no contributions were made by the Company to the Plan in 1993, 1992 nor 1991. The funded status of the Plan at December 31, 1993 and 1992 is summarized below: The major assumptions used in determining the funded status of the Plan are set forth below. The first two assumptions are used in determining the Plan's funded status, whereas all three assumptions are used in determining the net periodic cost. These assumptions approximate the rates prevailing in the applicable foreign country. Many of the Company's other foreign subsidiaries maintain either defined benefit or defined contribution plans covering substantially all of their employees. The plan benefits are funded essentially through insurance companies using deferred annuity contracts. The cost is funded on an annual basis by the foreign subsidiary, and the employee if the plan is contributory. For the years ended December 31, 1993, 1992 and 1991, pension expense for these plans approximated $2.3 million, $1.8 million and $1.6 million, respectively. The Company does not sponsor any material post-retirement benefits other than pensions. Post- employment benefits are insignificant. F- NYFS03...:\16\12316\0001\7120\FRM32894.P9B NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued (12) Commitments and Contingencies: ----------------------------- The Company is obligated under long-term operating lease agreements for computer equipment, terminal facilities and automotive equipment. At December 31, 1993, the minimum annual rentals under these long-term leases were as follows: For the years ended December 31, 1993, 1992 and 1991, rental expense for assets leased under long-term operating lease agreements approximated $12.9 million, $12.5 million and $13.2 million, respectively. The Company is involved in various legal proceedings generally incidental to its business. While the result of any litigation contains an element of uncertainty, the Company presently believes that the outcome of any known pending or threatened legal proceeding or claim, or all of them combined, will not have a material adverse effect on its results of operations or consolidated financial position. (13) Foreign Currency Translation: ---------------------------- With the exception of highly inflationary economies, net foreign currency translation adjustments are not recognized in income for financial reporting purposes until the investment which gives rise to the translation adjustment is sold. From time to time, the Company enters into forward exchange contracts to hedge against foreign currency fluctuations. Included in cumulative translation adjustment are net after tax gains of $.1 million and $.4 million for 1993 and 1992, respectively. At December 31, 1993, the Company had forward hedge contracts maturing throughout 1994 to sell $12.8 million in various foreign currencies. During the years ended December 31, 1993, 1992 and 1991, the Company recognized gains or losses from foreign currency transactions and from certain translation adjustments which are included in other income (See Note 14). F- NYFS03...:\16\12316\0001\7120\FRM32894.P9B NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Continued (14) Other Income (Expense): ---------------------- Other income (expense) consists of the following: (15) Statement of Cash Flows: ----------------------- Interest and income taxes paid were as follows: (16) Quarterly Revenues and Earnings (Unaudited): ------------------------------------------- F- NYFS03...:\16\12316\0001\7120\FRM32894.P9B AIR EXPRESS INTERNATIONAL CORPORATION AND SUBSIDIARIES ------------------------------------------------------- F- NYFS03...:\16\12316\0001\7120\FRM32894.P9B AIR EXPRESS INTERNATIONAL CORPORATION AND SUBSIDIARIES ------------------------------------------------------- F- NYFS03...:\16\12316\0001\7120\FRM32894.P9B EXHIBIT INDEX -------------- Exhibit Sequential No. Description Page No. ------- --------------------------------- ---------- 21 List of Subsidiaries of Registrant 43 23 Consent of Independent Public Accountants 44 NYFS03...:\16\12316\0001\7120\FRM32894.P9B

854094_1993.txt

854094

1993

Item 1. Business. Central Newspapers, Inc. (the "Company") is engaged, through its subsidiaries, in newspaper publishing primarily in the metropolitan areas of Phoenix, Arizona and Indianapolis, Indiana. The Company is an Indiana corporation organized in 1934. Through its wholly-owned subsidiary, Phoenix Newspapers, Inc., the Company publishes The Arizona Republic (mornings and Sunday), The Phoenix Gazette (evenings) and the Arizona Business Gazette (weekly). Through its 71.2%-owned subsidiary, Indianapolis Newspapers, Inc., the Company publishes The Indianapolis Star (mornings and Sunday) and The Indianapolis News (evenings). The Company also publishes several daily newspapers serving smaller communities in Indiana. The Company is a partner (13.5% interest) in Ponderay Newsprint Company, a general partnership that owns and operates a newsprint mill in the state of Washington. The Company has published its newspapers in its two primary markets for more than forty-four years. The Company has managed its newspapers with the objective of long-term growth and believes that this philosophy has contributed to the stability of the Company's operations. The Company's ability to establish and maintain its daily newspapers as the only major newspapers in their respective markets has promoted its growth and is of primary importance in attracting and maintaining advertising, the principal source of revenue for the Company. Each of the Company's newspapers has substantial autonomy over editorial policy. PHOENIX NEWSPAPERS, INC. Phoenix Newspapers, Inc. ("PNI") was formed in 1946 by a group of investors, including the Company, to purchase The Arizona Republic and The Phoenix Gazette. The Company originally owned a 30% interest in PNI and has owned 100% of the common stock of PNI since 1977. The newspapers published by PNI are The Arizona Republic (mornings and Sunday), The Phoenix Gazette (evenings) and the Arizona Business Gazette (weekly). Circulation As of December 26, 1993, approximately 82% of the daily and 68% of the Sunday circulation of The Arizona Republic and 88% of the daily circulation of The Phoenix Gazette were home delivered. Single copy sales account for approximately 32% of Sunday newspaper sales and approximately 17% of combined daily newspaper sales. The Arizona Business Gazette contains business news and legal notices relating to the Phoenix metropolitan area. The average paid circulation of the Arizona Business Gazette was 9,686; 8,379; and 9,599 for 1991, 1992 and 1993. The circulation levels of The Arizona Republic and The Phoenix Gazette are seasonal due to the large number of part-year residents of the Phoenix area. Historically, circulation for The Arizona Republic and The Phoenix Gazette achieves its highest levels in February and decreases during the late spring and summer months. During 1993 the seasonal variation in combined daily circulation and Sunday circulation was approximately 89,000 and 95,000. The following table shows the average paid circulation for The Arizona Republic and The Phoenix Gazette for the last three fiscal years. The figures for 1991 and 1992 are based upon annual reports issued by the Audit Bureau of Circulations ("ABC"), an independent agency which audits the circulation of daily and Sunday newspapers and include circulation outside the Phoenix metropolitan statistical area ("MSA"). The figures for 1993 are based upon the records of the Company because, as of the date of this report, the ABC annual report for 1993 has not been released. Net circulation revenue for the last three fiscal years is based upon the records of the Company. 52 Weeks 52 Weeks 52 Weeks Dec. 29 Dec. 27 Dec. 26 Fiscal Years Ended 1991 1992 1993 The Arizona Republic (Sunday) 557,399 560,850 576,576 The Arizona Republic (Daily) 358,269 360,148 366,787 The Phoenix Gazette (Daily) 87,355 86,126 81,497 Net Circulation Revenue (in thousands) $61,930 $70,621 $74,368 The home delivered price for The Arizona Republic (seven days) in the Phoenix MSA is $3.05 per week including a $.55 per week increase during November 1991. The home delivered price for The Phoenix Gazette (six days) is $1.50 per week. During January 1993 the single copy price of the morning paper increased by $.15 to $.50. The single copy price of the afternoon paper is $.35. The single copy price of the Sunday paper is $1.50 including a $.25 increase in January 1991. A weekend package comprising the Sunday paper and the Friday and Saturday edition of either the morning or evening paper is offered at $2.00 per week which reflects a $.50 per week increase effective November 1991. Advertising The newspapers generate revenue from two primary types of advertisements, "run of paper," which are printed in the body of the newspaper, and "pre-printed," which are furnished by the advertiser and inserted into the newspaper. PNI derives the majority of its advertising revenue from run of paper advertisements. However, like other major newspapers, The Arizona Republic and The Phoenix Gazette have experienced an increase in the use by advertisers of pre-printed advertisements in recent years. Because pre-printed advertisements are furnished by the advertisers and can be distributed by alternate means, revenues and profits from pre-printed advertisements are generally lower than would be derived if an advertiser had chosen to use run of paper advertisements. To encourage use of run of paper advertisements, PNI structures its advertising rates to provide more favorable rates to high volume and frequent run of paper advertisers. PNI also structures its advertising format to accommodate the numerous communities that comprise the Phoenix metropolitan area. The Arizona Republic and The Phoenix Gazette publish a common "Community" section that is inserted in up to twelve zoned editions on certain days of the week. Zoned editions, which include news stories and advertisements targeted to specific communities or geographic areas, provide an important means of competing with news coverage of local newspapers and thereby promote circulation. Other part run sections are also provided to accommodate the needs of advertisers for more targeted distribution. The combined run of paper advertising linage for The Arizona Republic, The Phoenix Gazette and the Arizona Business Gazette for the past three fiscal years and the combined advertising revenues of the newspapers for such periods are set forth in the following table: 52 Weeks 52 Weeks 52 Weeks Dec. 29 Dec. 27 Dec. 26 Fiscal Years Ended 1991 1992 1993 Advertising Linage--Run of Paper (in thousands of six- column inches): Full run 3,463 3,371 3,562 Part run 1,763 2,024 2,239 Weekly 410 324 278 Net Advertising Revenue (in thousands) $203,887 $203,267 $218,092 Distribution PNI distributes The Arizona Republic and The Phoenix Gazette primarily by home delivery through a network of independent contractors that deliver newspapers pursuant to agreements with PNI. PNI has implemented a centralized billing system which removes the responsibility for billing and collection from the independent contractors. Newspapers are distributed to the independent contractor network by an outside company which has been under contract with PNI for over thirty-nine years. Production The Arizona Republic and The Phoenix Gazette have separate editorial/news staffs but share the same production facilities and equipment. The editing and composing functions are performed primarily at PNI's facility in downtown Phoenix. To increase efficiency and reduce work force requirements, the editing and composing functions have been computerized. Electronic pagination allows entire pages of the newspaper to be formatted at a computer terminal instead of by manual assembly. Composed pages are electronically transmitted from PNI's downtown facility to its two satellite production facilities. PNI has two satellite production facilities, one located in Deer Valley which is north of downtown Phoenix and one in Mesa, Arizona. Construction of the Deer Valley facility began in 1990 and was completed in 1992. This facility includes four new offset presses and related production equipment as well as circulation, advertising and editorial offices. Production began during the first quarter of 1992 with full operation commencing in the third quarter of 1992. The Mesa facility began operation in 1982 and has been expanded and upgraded since that date. It has three offset presses and related production equipment. Because of the growth expected in the Phoenix area, PNI owns an additional site in western Maricopa County for a future satellite production facility. INDIANAPOLIS NEWSPAPERS, INC. Indianapolis Newspapers, Inc. ("INI") was formed by the Company in 1948. The Company owns all of the issued and outstanding Class B Common Stock and 4.1% of the Class A Common Stock of INI, representing 71.2% of the voting power and equity of INI. The remaining issued and outstanding Class A Common Stock of INI, which represents the remaining 28.8% of the voting power and equity of INI, is held either directly or through trusts by members of the family which previously owned The Indianapolis News. The holders of the Class A Common Stock are entitled to elect a minority of INI's Board of Directors. The primary newspapers published by INI are The Indianapolis Star (mornings and Sunday) and The Indianapolis News (evenings). Circulation As of December 26, 1993, approximately 80% of the daily and 81% of the Sunday circulation of The Indianapolis Star and 83% of the daily circulation of The Indianapolis News were home delivered. Single copy sales account for approximately 18% of Sunday newspaper sales and 17% of combined daily newspaper sales. The following table shows the average paid circulation for The Indianapolis Star and The Indianapolis News for the last three fiscal years. The figures for 1991 and 1992 are based upon annual reports issued by ABC, and include circulation outside the Indianapolis MSA. The figures for 1993 are based upon records of the Company because, as of the date of this report, the ABC annual report for 1993 has not been released. Net circulation revenue for the last three fiscal years is based upon the records of the Company. 52 Weeks 52 Weeks 52 Weeks Dec. 29 Dec. 27 Dec. 26 Fiscal Years Ended 1991 1992 1993 The Indianapolis Star (Sunday) 414,080 413,630 411,261 The Indianapolis Star (Daily) 230,179 229,842 231,123 The Indianapolis News (Daily) 100,123 96,540 93,245 Net Circulation Revenue (in thousands) $36,050 $36,979 $38,523 The home delivered price for The Indianapolis Star (seven days) in the Indianapolis MSA is $3.00 per week which includes a $.25 price increase during May 1993. The home delivered price for The Indianapolis News (six days) is $1.50 per week. The single copy price is $.35 for each daily paper. The single copy price of the Sunday newspaper is $1.50 which includes a $.25 price increase during September 1991. Advertising Newspapers generate revenue from two primary types of advertisements, "run of paper," which are printed in the body of the newspaper, and "pre-printed," which are furnished by the advertiser and inserted into the newspaper. INI derives the majority of its advertising revenue from run of paper advertisements. Like the Company's Phoenix newspapers, The Indianapolis Star and The Indianapolis News have experienced an increase in the use by advertisers of pre-printed advertisements in recent years. To encourage use of run of paper advertisements, INI structures its advertising rates to provide more favorable rates to high volume and frequent run of paper advertisers. The combined run of paper advertising linage for The Indianapolis Star and The Indianapolis News for the past three fiscal years and the combined advertising revenue of the newspapers for such periods are set forth in the following table: 52 Weeks 52 Weeks 52 Weeks Dec. 29 Dec. 27 Dec. 26 Fiscal Years Ended 1991 1992 1993 Advertising Linage--Run of Paper (in thousands of six- column inches): Full run 2,432 2,425 2,458 Part run 33 22 62 Net Advertising Revenue (in thousands) $102,364 $106,056 $114,004 Distribution INI distributes The Indianapolis Star and The Indianapolis News primarily by home delivery through a network of approximately 3,200 carriers. Generally, a carrier is an independent contractor who purchases newspapers from INI and resells them to his or her customers. Production The Indianapolis Star and The Indianapolis News have separate editorial/news staffs but share the same production and distribution facilities. All editorial, production and distribution functions are handled from INI's facility in downtown Indianapolis. INI's production facility is equipped with six offset presses, after the conversion of four letterpress presses and the installation of two new offset presses during 1988 - 1992 at a cost of $57.7 million. SMALLER NEWSPAPERS The Company also publishes several smaller newspapers. Through Muncie Newspapers, Inc., which is 88%-owned by INI and 12%-owned by the Company, the Company publishes The Muncie Star (mornings and Sunday) and The Muncie Evening Press (evenings). These two daily newspapers serve the Muncie, Indiana area, which has a population of approximately 119,000. As of December 26, 1993, the average paid circulation of The Muncie Star was 29,405 daily, and 36,873 Sunday and the average paid circulation of The Muncie Evening Press was 13,174 daily. The Company publishes the Vincennes Sun-Commercial, a daily newspaper which serves the city of Vincennes, Indiana, with a population of approximately 19,800. As of December 26, 1993, the average paid circulation of the Vincennes Sun-Commercial was 13,857 daily (five days) and 15,842 Sunday. During January 1993, the Company formed Topics Newspapers, Inc. as a wholly owned subsidiary to purchase the net assets of two daily newspapers, one weekly newspaper and twelve controlled circulation newspapers that serve the fastest growing area of metropolitan Indianapolis. As of December 26, 1993, the average paid circulation of The Daily Ledger was 9,273 (six days) and the combined weekly circulation was 85,285. The revenues received by the Company from these smaller publications represented approximately 4% of the total revenues of the Company in each of its last three fiscal years. RAW MATERIALS - PONDERAY NEWSPRINT COMPANY The Company consumed approximately 148,700 metric tons of newsprint in fiscal 1993 and estimates that consumption will increase slightly in fiscal year 1994. The Company currently obtains its newsprint from a number of suppliers, both foreign and domestic, under long-term contracts, standard in the industry, which offer dependable sources of newsprint at current market rates. To provide the Company with an additional source of newsprint for a portion of its needs, the Company formed Central Newsprint Company, Inc. and Bradley Paper Company (the "Newsprint Subsidiaries"), both of which are wholly-owned subsidiaries of the Company. The Newsprint Subsidiaries, together with four other newspaper publishing companies and a Canadian newsprint manufacturer, are partners in Ponderay Newsprint Company ("Ponderay"), a general partnership formed to own and operate a newsprint mill in Usk, Washington. The mill began operations in December 1989. PNI has committed to purchase annually the lesser of 13.5% of Ponderay's newsprint production or 28,400 metric tons on a "take if tendered" basis until the debt of Ponderay is repaid. COMPETITION The Company faces competition for advertising revenue from television, radio and direct mail programs, as well as competition for advertising and circulation from suburban neighborhood and national newspapers and other publications. Competition for advertising is based upon circulation levels, readership demographics, price and advertiser results. Competition for circulation is generally based upon the content, journalistic quality and price of the newspaper. In Indianapolis, the Company's newspapers do not receive significant direct competition from suburban newspapers. In Phoenix, several suburban newspapers owned by major media corporations operate in cities that are part of the Phoenix metropolitan area and compete with The Arizona Republic and The Phoenix Gazette for advertising and circulation. EMPLOYEES - LABOR As of January 31, 1994, the Company had approximately 5,000 employees (including 1,280 part-time employees), 42% of whom were covered by collective bargaining agreements. The Company has never had a significant strike or work stoppage at its operations and considers its labor relationships with its employees to be good. EXECUTIVE OFFICERS OF THE REGISTRANT As of February 28, 1994, the executive officers of the Company and their ages are as follows: Name Age Positions Malcolm W. Applegate 58 Director; President and General Manager of INI Eugene S. Pulliam 79 Director and Executive Vice President; President of PNI; Publisher of The Indianapolis Star and The Indianapolis News Frank E. Russell 73 Director; President and Chief Executive Officer Louis A. Weil III 52 Director; Executive Vice President of PNI; Publisher of The Arizona Republic and The Phoenix Gazette Wayne D. Wallace 47 Treasurer Malcolm W. Applegate has been President since May 1993 and General Manager since July 1990 of Indianapolis Newspapers, Inc. From 1985 until assuming his current position with Indianapolis Newspapers, Inc., Mr. Applegate was publisher of the Lansing (Michigan) State Journal. He has been a director of the Company since 1991. Eugene S. Pulliam has been the Publisher of The Indianapolis Star and The Indianapolis News since 1975 and President of Phoenix Newspapers, Inc. since 1979. He has been a director of the Company since 1954. Frank E. Russell has been President of the Company since 1979. He has been a director of the Company since 1974. Louis A. Weil, III has been Publisher of The Arizona Republic and The Phoenix Gazette and Executive Vice President of Phoenix Newspapers, Inc. since July 1991. Mr. Weil served as Publisher of Time from May 1989 to July 1991, and President and Publisher of The Detroit News from May 1987 to May 1989. Mr. Weil serves as a member of the Board of Directors of Global Government Plus Fund, Inc. as well as eleven investment companies within the Prudential family of mutual funds. He has been a director of the Company since 1991. Wayne D. Wallace has been Treasurer of the Company since October of 1989. Previously, he had been Assistant Treasurer of the Company since 1983. Each executive officer will serve as such until his successor is chosen and qualified. No family relationships exist among the Company's executive officers. Item 2.

Item 2. Properties. The corporate headquarters of the Company are located at 135 North Pennsylvania Street, Indianapolis, Indiana. The general character, location and approximate size of the principal physical properties owned by the Company at the end of fiscal year 1993 are set forth below. In addition to those listed, the Company owns employee recreational facilities and other real estate aggregating approximately 130 acres. Approximate Area in Square Feet Printing plants, business and editorial offices and warehouse space Owned Leased Phoenix, Arizona 765,613 16,828 Mesa, Arizona 151,451 --- Indianapolis, Indiana 464,952 168,890 Muncie, Indiana 67,658 --- Vincennes, Indiana 14,000 --- Noblesville, Indiana 7,500 5,412 Carmel, Indiana 13,460 --- The Company believes that its current facilities and planned building projects are adequate to meet the needs of its newspapers. Item 3.

Item 3. Legal Proceedings. The Company becomes involved from time to time in various claims and lawsuits incidental in the ordinary course of its business, including such matters as libel and invasion of privacy actions and is involved from time to time in various governmental and administrative proceedings. Management believes that the outcome of any pending claims or proceedings will not have a significant adverse effect on the Company and its subsidiaries, taken as a whole. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders. No matters were submitted to a vote of shareholders during the quarter ended December 26, 1993 through the solicitation of proxies or otherwise. PART II Item 5.

Item 5. Markets for Registrant's Common Equity and Related Stockholder Matters. The information set forth under the caption "Shareholder Information" on page 31 of the Company's 1993 Annual Report to Shareholders is incorporated herein by reference. Item 6.

Item 6. Selected Financial Data. The information set forth under the caption "Selected Ten-Year Financial Data" on page 29 of the Company's 1993 Annual Report To Shareholders is incorporated herein by reference. Item 7.

Item 7. Management's Discussion and Analysis of Results of Operations and Financial Condition. The information set forth under the caption "Management's Discussion and Analysis of Results of Operations and Financial Condition" beginning on page 11 of the Company's 1993 Annual Report To Shareholders is incorporated herein by reference. Item 8.

Item 8. Financial Statements and Supplementary Data. The Company's Consolidated Financial Statements and Notes thereto, together with the report thereon of Geo. S. Olive & Co. dated February 18, 1994, appearing on pages 14 through 28 of the Company's 1993 Annual Report To Shareholders, and the information contained under the heading "Quarterly Financial Information (unaudited)" on page 30 of such Annual Report are incorporated herein by reference. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant. Incorporated herein by reference is the information set forth under the captions "Election of Directors," on page 4 and "Committees of the Board of Directors and Compensation of Directors" on page 5 and "Compliance with Section 16(a) of the Securities Exchange Act of 1934" on page 12 of the Company's definitive Proxy Statement to be used in connection with the 1994 Annual Meeting of Shareholders. See Part I, Item 1 of this report for information regarding the executive officers of the Company. Item 11.

Item 11. Executive Compensation. Incorporated herein by reference is the information set forth under the captions "Compensation of Executive Officers" on page 6 of the Company's definitive Proxy Statement to be used in connection with the 1994 Annual Meeting of Shareholders. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management. Incorporated herein by reference is the information set forth under the captions "Voting Securities And Principal Holders Thereof" on page 1 and "Security Ownership of Management" on page 3 of the Company's definitive Proxy Statement to be used in connection with the 1994 Annual Meeting of Shareholders. Item 13.

Item 13. Certain Relationships and Related Transactions. Incorporated herein by reference is the information set forth under the captions "Transactions With Certain Related Persons" and "Compensation Committee Interlocks and Insider Participation" on page 12 of the Company's definitive Proxy Statement to be used in connection with the 1994 Annual Meeting of Shareholders. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) List of Documents Included In This Report. 1. Financial Statements. The following financial statements are incorporated into this report by reference to the Company's 1993 Annual Report To Shareholders: (i) Independent Auditor's Report (ii) Consolidated Statement of Income for each of the three fiscal years in the period ended December 26, 1993 (iii) Consolidated Statement of Financial Position at December 26, 1993 and December 27, 1992 (iv) Consolidated Statement of Shareholders' Equity for each of the three fiscal years in the period ended December 26, 1993 (v) Consolidated Statement of Cash Flows for each of the three fiscal years in the period ended December 26, 1993 (vi) Notes to Consolidated Financial Statements 2. Supplementary Data and Financial Statement Schedules. (i) Incorporated herein by reference is the information set forth under the caption "Quarterly Financial Information (Unaudited)" appearing on page 30 of the Company's 1993 Annual Report To Shareholders (ii) The following financial statement schedules and report with respect thereto are filed as a part of this Report: Page in this filing Independent Auditor's Report on Financial Statement Schedules 18 Schedule V Property, Plant and Equipment 19 Schedule VI Accumulated Depreciation and Amortization of Property, Plant and Equipment 20 Schedule VIII Valuation Accounts 21 Schedule X Supplementary Income Statement Information 22 Schedules other than those referred to above have been omitted because they are not required or because the information is included elsewhere in the Consolidated Financial Statements of the Company. 3. Exhibits Required by Securities and Exchange Commission Regulation S-K. (i) The following exhibits are filed as a part of this report: Exhibit Number Description of Document 13 Portions of the 1993 Annual Report To Shareholders of Central Newspapers, Inc. incorporated by reference into the 1993 Annual Report on Form 10-K 21 Subsidiaries of the Registrant 23 Consent of Geo. S. Olive & Co. (ii) The following exhibits are incorporated herein by reference to documents previously filed with the Securities and Exchange Commission as indicated. Exhibit Number Description of Document 3.1 Amended and Restated Articles of Incorporation of Central Newspapers, Inc. (Filed August 10, 1989 with Form S- 1 Registration Statement, No. 33-30436) 3.2 Amended and Restated Code of By-Laws of Central Newspapers, Inc. (Filed with Form 10-K for year ended December 29, 1991) 4.1 Form of Certificate for Class A Common Stock (Filed August 10, 1989 with Form S-1 Registration Statement, No. 33- 30436) 4.2 Indenture between Indianapolis Newspapers, Inc. and the Indiana Trust Company, as trustee, dated as of December 1, 1948 (Filed August 10, 1989 with Form S-1 Registration Statement, No. 33-30436) 10.1 Indenture creating the Eugene C. Pulliam Trust, dated as of December 9, 1965, as amended (Filed August 10, 1989 with Form S-1 Registration Statement, No. 33- 30436) 10.2 Newsprint Purchase Agreement between Ponderay Newsprint Company and Phoenix Newspapers, Inc., dated as of November 18, 1987 (Filed August 10, 1989 with Form S-1 Registration Statement, No. 33-30436) *10.3 Amended and Restated Central Newspapers, Inc. Stock Option Plan (Filed with Form 10-K for year ended December 27, 1992) *10.4 The Phoenix Newspapers, Inc. Nonqualified Supplemental Retirement Plan (Filed with Form 10-K for year ended December 30, 1990) 10.5 Ponderay Newsprint Company Partnership Agreement between Lake Superior Forest Products Inc. and Central Newsprint Company, Inc. dated as of September 12, 1985 (Filed August 10, 1989 with Form S- 1 Registration Statement, No. 33-30436) 10.6 Amendment to Ponderay Newsprint Company Partnership Agreement between Lake Superior Forest Products Inc., Central Newsprint Company, Inc., Bradley Paper Company, Copley Northwest, Inc., Puller Paper Company, Newsprint Ventures, Inc., Wingate Paper Company, Tribune Newsprint Company and Nimitz Paper Company, dated as of June 30, 1987 (Filed August 10, 1989 with Form S-1 Registration Statement, No. 33-30436) 10.7 Guarantee by Central Newspapers, Inc. dated as November 18, 1987 (Filed August 10, 1989 with Form S-1 Registration Statement, No. 33-30436) *10.8 Termination Benefits Agreement dated as of as of August 1, 1991 between Phoenix Newspapers, Inc. and Louis A. Weil, III (Filed with Form 10-K for year ended December 27, 1992) *10.9 Phoenix Newspapers, Inc. Management by Objectives Program (Filed with Form 10-K for year ended December 27, 1992) *10.10 Form of Split-Dollar Life Insurance Agreement for Executive Officers between the Registrant and Malcolm W. Applegate, Wayne D. Wallace and Louis A. Weil, III (Filed with Form 10-K for year ended December 27, 1992) *10.11 Form of Split-Dollar Life Insurance Agreement for Outside Directors between the Registrant and Kent E. Agness, William A. Franke and Dan Quayle (Filed with Form 10-K for year ended December 27, 1992) *10.12 Form of Death Benefit Only Insurance Plan Agreement between the Registrant and Frank E. Russell, Eugene S. Pulliam and James C. Quayle (Filed with Form 10- K for year ended December 27, 1992) * Represents a contract, plan or arrangement providing for executive officer or director benefits. (b) Reports on Form 8-K. No reports on Form 8-K were filed by the Company during the fourth quarter of 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the city of Indianapolis, state of Indiana, on this 16th day of March, 1994. CENTRAL NEWSPAPERS, INC. By: /s/ Frank E. Russell -------------------------------- Frank E. Russell, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed by the following persons on behalf of the Registrant and in the capacities indicated on this 16th day of March, 1994. Signature Title (1) Principal Executive Officer President, Chief /s/ Frank E. Russell Executive Officer --------------------------- and a Director Frank E. Russell (2) Principal Financial and Accounting Officer /s/ Wayne D. Wallace Treasurer --------------------------- Wayne D. Wallace (3) A majority of the Board of Directors /s/ Kent E. Agness Director -------------------------- Kent E. Agness /s/ Malcolm W. Applegate Director -------------------------- Malcolm W. Applegate /s/ William A. Franke Director -------------------------- William A. Franke /s/ Eugene S. Pulliam Director -------------------------- Eugene S. Pulliam /s/ Dan Quayle Director -------------------------- Dan Quayle /s/ James C. Quayle Director -------------------------- James C. Quayle /s/ Louis A. Weil, III Director -------------------------- Louis A. Weil, III INDEPENDENT AUDITOR'S REPORT ON FINANCIAL STATEMENT SCHEDULES Board of Directors and Shareholders Central Newspapers, Inc. We have audited the consolidated statement of financial position of Central Newspapers, Inc. and Subsidiaries as of December 26, 1993 and December 27, 1992, and the related consolidated statements of income, shareholders' equity and cash flows for each of the three fiscal years in the period ended December 26, 1993, and have issued our report dated February 18, 1994. Such financial statements and reports are included in the 1993 Annual Report To Shareholders and are incorporated herein by reference. Our audits also included the financial statement schedules listed under Item 14 (a)(2)(ii). These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these schedules based on our audits. In our opinion, such financial statement schedules are fairly stated in all material respects in relation to the basic financial statements taken as a whole. /s/ Geo. S. Olive & Co. - ------------------------- GEO. S. OLIVE & CO. Indianapolis, Indiana February 18, 1994 Schedule X CENTRAL NEWSPAPERS,INC. AND SUBSIDIARIES Supplementary Income Statement Information Column A Column B Amounts Charged to Costs and Expenses Fiscal Years Ended 52 Weeks 52 Weeks 52 Weeks December 29 December 27 December 26 Description 1991 1992 1993 Maintenance $ 3,834,721 $ 4,689,386 $ 5,128,116 Advertising Costs $ 4,725,153 $ 6,166,394 $ 5,913,739 Sales Taxes $ 3,669,552 $ 4,363,303 $ 5,193,813 Property Taxes $ 3,233,614 $ 5,889,001 $ 6,682,564

846972_1993.txt

846972

1993

Item 1. Business Adience, Inc. ("Adience," and together with its subsidiaries, the "Company") is engaged in the manufacture, sale, installation and maintenance of specialty refractory products through its Heat Technology Division. Refractory products, which are made primarily from fireclays and minerals such as bauxities and aluminas, are used in virtually every industrial process requiring heating or containment at a high temperature of a solid, liquid or gas. Iron and steel producers use Adience's products in various types of iron and steel making furnaces, in coke ovens and in iron and steel handling and finishing operations. Adience also provides installation and maintenance services in connection with its specialty refractory products to the steel, aluminum, glass, petrochemical and other non-ferrous industries. See "Operations of Adience" below. The Company is also engaged, through its 80.3%-owned subsidiary, Information Display Technology, Inc. ("IDT"), in the manufacture, sale and installation of writing, projection and other visual display surfaces; customer cabinetry, work station and conference center casework; and architectural composite panels for building exteriors. See "Operations of Information Display Technology" below. The "Industry Segment Data" note to the Company's consolidated financial statements contained in Item 8 sets forth historical information concerning the net revenues and operating profit by, and identifiable assets attributable to, each of the Company's segments. Operations of Adience Adience's Heat Technology Division consists of four refractory units: BMI, J.H. France, Findlay and Furnco. Through BMI and J.H. France (acquired in 1985 and 1987, respectively), the Heat Technology Division engages in the manufacture, sale, installation and maintenance of specialty unformed refractory products and bricks, which must be replaced, in many cases, as often as several times a day. Refractory products are ceramic materials used as insulation on surfaces that are exposed to high temperatures, such as from contact with molten metals or steam. Through Findlay (acquired in 1989), the Heat Technology Division manufactures and sells specialty refractory block used in the production of glass and glass products. Through Furnco, the Heat Technology Division is engaged in the rebuilding, repair and maintenance of coke ovens. Adience has elected to focus on the specialty material sector, rather than the commodity sector, of the refractory industry and estimates that it is one of the largest producers of specialty refractory products for ironmaking applications. See "Refractory Products and Services" below. Adience's wholly-owned subsidiary, Adience Canada, Inc. ("Adience Canada"), owns and operates its own headquarters and refractory manufacturing facility in Ontario, Canada, from where it markets Adience's full range of products throughout Canada. Background of Adience Adience was incorporated in the State of Delaware in 1985 for the purpose of acquiring BMI, Inc. ("BMI"), a private company principally engaged in the refractory and information display product businesses. From 1986 through 1990, Adience made a number of acquisitions in these and other lines of business. In 1991, Adience determined to streamline and consolidate its overall business by disposing of operations outside its core refractory and information display product businesses and by selling unprofitable operations within such core businesses. In its refractory business, certain Texas operations, which were part of the original BMI, were sold in May 1991. In July 1991, Adience sold its heating and ventilation duct connector business, which was also part of the original BMI operation. In August 1991, Adience sold its Utah electrical and construction contracting business, originally acquired in 1990. In November 1991, Adience sold its Entec operations (engineering and construction of heat exchange devices), which were acquired in June 1988. In 1992, Adience sold its Geotec operations (caisson design and construction and environmental testing services) and Hotworks operations (preheating services to refractory maintenance companies), which were acquired in September 1988 and July 1990, respectively. In 1993, Adience sold its Los Angeles operations. In the information display product area, Adience's 80.3%-owned subsidiary, IDT, sold its "EHB" operations (catalog sales for the office market) in February 1992, which had been acquired in 1986. In 1993, IDT sold its Kensington Lighting operation. See "Operations of Information Display Technology" below. On February 22, 1993, Adience filed a prepackaged plan of reorganization (the "Prepackaged Plan") under Chapter 11 of the Bankruptcy Code, which was confirmed by the United States Bankruptcy Court for the Western District of Pennsylvania on May 4, 1993 and consummated on June 30, 1993. The filing was precipitated by a combination of firstly, an overall decline in the demand for refractory products and services in 1991 and 1992 caused by a decrease in the production of refractory using industries in the United States, particularly steel, and secondly, losses from discontinued operations. The Prepackaged Plan reduced the long-term debt of Adience by exchanging $66 million aggregate principal amount of 15% Senior Subordinated Reset Notes for $49 million aggregate principal amount of new 11% Notes, plus common stock representing 55% of the outstanding common stock of Adience. IDT does not guarantee the 11% Senior Secured Notes issued by Adience under the reorganization plan and IDT did not itself file a plan of reorganization under Chapter 11 of the Bankruptcy Code. IDT is a guarantor of Adience's loan from Congress Financial Corporation (see Liquidity and Sources of Capital). After emerging from the reorganization proceeding, Adience adopted fresh start reporting in accordance with AICPA Statement of Position 90-7, "Financial Reporting by Entities in Reorganization under the Bankruptcy Code." The application of fresh start reporting is set forth in greater detail in the Notes to Adience's Consolidated Financial Statements. Refractory Products and Services The Heat Technology Division primarily manufactures unformed refractory materials. Through its J.H. France operation, the Division also manufactures specialty refractory brick and through the Findlay operation, specialty refractory block. Adience does not focus on the commodity brick market, which are primarily standard pre-formed bricks, and instead focuses on specialty refractory products which are custom designed and often shaped on site to customer requirements. The largest consumer of Adience's refractory products and services is the basic iron and steel industry, followed by the aluminum, glass, petrochemical, cement and cogeneration industries. Adience's products and services are used principally in the production of iron. Adience also performs refractory product installation services on coke ovens. Because of the high temperatures involved in the transportation of molten iron, the coking of coal in coke ovens and the melting or transportation of other non-ferrous materials, the equipment employed in such processes must have linings made of refractory products. These linings deteriorate and must be repaired frequently or replaced as part of regular plant maintenance. In addition to linings, Adience also manufactures blast furnace taphole plugs made from refractory materials. These plugs must be replaced eight to 12 times during a typical full production day. Adience is a major supplier in the United States of such blast furnace taphole plugs, according to internal market data. To expand the scope and value of its services, Adience also provides general plant maintenance services related to refractory products either in specific areas or plant-wide. From 1985 through 1990, Adience experienced significant growth in demand for its specialty refractory products and services. This resulted largely from increasing reliance by the steel industry during this period on the services of outside contractors such as Adience for plant-wide maintenance work, due in part to the lower labor costs maintained by outside contractors. Additionally, steel producers sought to avoid the high overhead associated with carrying the trained personnel and specialized equipment needed for this work. In 1991, Adience experienced a significant decline in demand for its specialty refractory products and services. This resulted primarily from the most serious downturn in the steel industry since the early 1980's coupled with contraction in non-steel industries served by Adience. In the steel industry, one effect of the downturn was increased pressure from the steelworkers union to retain refractory installation work which in the past had been performed by Adience. With the reduction in such work, Adience has been more dependent upon refractory materials sales, which are more price competitive. Manufacturing The manufacturing process for specialty refractory products involves the mixing and kiln firing of various raw materials, particularly fireclays and minerals such as bauxites and aluminas. Adience operates seven refractory product manufacturing plants located near major industrial centers in the United States and Canada. Predominantly all of the refractory products sold by Adience are manufactured in its own plants. Adience custom designs the refractory products it manufactures for specific applications. To better serve the Canadian market, a refractory manufacturing plant was built in Canada by BMI in 1981, and is currently owned and operated by Adience Canada. In November 1989, Adience acquired all of the stock of Cardinal Refractories, Inc. which was engaged in the building, maintenance and repair of refractory-consuming facilities in Canada. In January 1991, Cardinal Refractories, Inc. was merged into Adience Canada. Raw Materials Adience utilizes more than one hundred different raw materials which come from a variety of sources, the majority of which are obtained within the United States. Some of the more important raw materials are alumina, including high purity alumina, bauxite and brown fused alumina; silicon carbide; calcium aluminate cements; and clays. The number of sources of supply varies with each raw material. Adience management believes that it is not dependent in its manufacturing processes on any one source of supply, such that discontinuation of production by any one supplier would seriously jeopardize Adience's competitive position. Installation and Maintenance Adience installs and maintains linings made of specialty refractory products by one of the following processes: guniting, grouting, pumping, ramming, casting of unformed materials and laying of brick. "Guniting" is a process by which granulated refractory products are mixed with water and applied to surfaces through the use of a pneumatic spray gun. In the related process known as "grouting," refractory material is applied to a furnace lining through apertures in the furnace wall without interrupting the normal operation of the furnace. Guniting and grouting are relatively inexpensive methods for maintaining a brick refractory lining and thereby avoiding a major rebuild which involves a substantial capital outlay and lengthy downtime for the furnace. The guniting installation technique requires highly skilled crews and specialized equipment. In the "pumping" process, the refractory product is pumped directly into the refractory lining and cast in a removable mold. In the "ramming" process, a refractory lining is installed on a surface by applying the refractory product to the surface with a pneumatic hammer and in the "casting" process, the refractory lining is cast in a mold and subsequently installed on the surface being lined. The ability to react quickly to customer requests for products or installation and maintenance services is particularly important in the refractory industry because of the extremely high cost of manufacturing downtime. Consequently, the Company maintains refractory service facilities located near its major customers in the United States and Canada. Each facility contains guniting and other equipment required for the installation of refractory products. In addition, each facility is staffed with the supervisory personnel and skilled crews required for specialty refractory applications. All other personnel required for installation projects are hired on an as-needed basis from readily available local union labor pools. These persons are maintained on Adience's payroll only for the duration of each job. The Findlay unit's products are used to line furnaces, troughs, runways and other surfaces exposed to molten glass or the molten tin used in the "float glass" method of production. In the "float glass" method of production, molten glass is poured from the furnace onto a layer of molten tin. The molten glass "floats" on top of the molten tin along specially prepared runways. By controlling the temperature and the rate of flow of the molten glass, the manufacturer is able to achieve the desired thickness of the glass. All of Findlay's products are custom manufactured according to customer specifications. Findlay's products are distinguished by their resistance to corrosion. These product characteristics are particularly important in the glass industry where, unlike the steel industry, certain refractory products are designed to last for up to ten years. Sales and Markets The principal markets for products sold by Adience's Heat Technology Division are the iron and steel, aluminum, glass, petrochemical, cement and cogeneration industries. The iron and steel industry has historically been the major consumer of Adience's refractory products and services, and of products produced by the refractory industry generally. For the six month periods ended December 31 and June 30, 1993 and the fiscal year ended December 31, 1992, direct sales to the iron and steel industry accounted for approximately 52%, 58% and 54%, respectively, of the Heat Technology Division's total revenues. Adience also sells its refractory products to other refractory contractors and buys refractory products produced by other manufacturers in performing its contracting services. Adience also performs specialty refractory product installation and service for the glass, aluminum, petrochemical, cement and cogeneration industries. Each industry is a large consumer of refractory products and services. Many of the competitors in such markets are entities against which Adience already competes in the steel industry. Adience's Findlay unit is among the leading manufacturers in the United States of specialty refractory products used in the glass industry, based on internal market share data. Findlay's customers include major glass producers such as PPG Industries and Corning Glass Works. Findlay markets and sells its products worldwide. Marketing to the steel industry is conducted by an employed sales force working out of sales offices located strategically near major steelmaking centers. Each salesperson is assigned to particular steelmaking facilities, and each handles the full range of Adience products and services. Marketing to customers in the non-steel industries is handled by a sales force working out of sales offices located throughout the country. The refractory products and services sales force is compensated through a base salary plus incentive bonuses based on performance. Within the steel industry, Adience's principal customers have traditionally been the largest companies in the industry. The three largest customers, USX Corp., Bethlehem Steel Corporation and LTV Steel Co., together accounted for approximately 25% and 29% of the Heat Technology Division's revenues for the six month periods ended December 31 and June 30, 1993, respectively, and 26% of such revenues for the fiscal year ended December 31, 1992. USX Corp. alone accounted for approximately 10% of the Division's revenues for the six month periods ended December 31 and June 30, 1993 and the fiscal year ended December 31, 1992. Each of the other companies accounted for less than 10% of the Division's revenues during such periods. Competition In the production of refractory materials, Adience competes with a number of companies, including North American Refractories Co., Indresco Inc., A.P. Green Industries, Inc., National Refractories Co. and Premier Refractories & Chemicals, Inc., some of which are substantially larger than Adience and all of which produce a full line of refractory products, with an emphasis on commodity brick production. Adience has elected to focus on the specialty material sector, rather than the commodity sector, of the refractory industry and estimates that it is one of the largest producers of specialty refractory products for ironmaking applications. Adience's primary competitors in the installation of refractory products are in-house employees of steel companies and also regional refractory service contractors which, unlike Adience, do not engage in the production of the materials. The major refractory producers typically contract with these regional companies to install the product, or the customers install the product in-house. Competition is based primarily on service, price and product performance. Adience believes that it provides an added advantage to its customers due to its ability to produce, install and maintain its refractory products. Research and Development Constant revisions to industry processes and chemistries require changes in refractory products to meet customer demand. Adience maintains fully staffed research and development facilities for improving existing refractory products and installation methods, as well as developing new products for existing and new markets. Research and development expenditures for the Heat Technology Division were approximately $541,000, $541,000 and $1,200,000 for the six month periods ended December 31 and June 30, 1993 and the fiscal year ended December 31, 1992, respectively. Backlog The Heat Technology Division operates on releases from blanket orders and, therefore, does not have a significant amount of backlog orders, except in the case of its Findlay operations which had $2.3 million and $3.1 million in backlog at December 31, 1993 and 1992, respectively. Generally, Adience's customers place orders on the basis of their short-range needs for which sales are made out of inventory or manufactured just in time. Operations of Information Display Technology IDT manufactures and sells custom-designed and engineered writing and projection surfaces (such as chalkboards and markerboards) for instruction and communication; custom cabinets for health care facilities, offices and institutions; modular partitions; and exterior architectural building panels. IDT has its own nationwide marketing network that enables it to market its products to schools, hospitals and offices throughout the country. In certain product areas, IDT operates under the trade name "Greensteel." IDT has achieved its current position in the specialized markets it serves due largely to its integrated approach to customer needs. In many cases, IDT performs a full range of services, including the custom design, production, installation and maintenance of its products. IDT believes that this integrated approach, which many of its competitors do not provide, enhances its responsiveness to customer needs. This approach, which allows the customer to obtain a full line of products and services from a single source, better enables IDT to establish an ongoing relationship with its customers to provide for their future requirements. Competition in IDT's markets is based largely on product quality, responsiveness, reliability and price. Most of the products of IDT are sold in connection with new facility construction or renovation. Such products are generally sold as part of a bid process conducted through architects and general contractors working with IDT's salespeople, and are custom-made to specifications. Successful marketing of these products is dependent upon the maintenance of a strong relationship with architects and general contractors, particularly in the education and health care construction fields. IDT has been advised by its customers that its products have achieved general recognition as quality products. IDT is a publicly-owned corporation whose shares are traded on the American Stock Exchange. Adience owns 10,692,165 shares of IDT's common stock, representing approximately 80.3% of the outstanding shares. On March 29, 1994, the closing sale price of IDT's common stock was $0.8125 per share. Background of IDT IDT was incorporated in the State of New York in May 1987 under the name RT Acquisition Associates, Inc. ("RT") for the purpose of serving as a vehicle for the acquisition of an operating business. Effective April 1, 1990, IDT acquired substantially all of the assets and assumed certain of the liabilities of the Information Display Division of Adience in exchange for 21,100,000 newly-issued shares of IDT's common stock and a convertible note (the "Convertible Note") in the principal amount of $2,500,000, convertible into IDT's common stock at $2.00 per share. In November 1990, IDT prepaid the Convertible Note in full at a price of $2,485,000. Upon the consummation of such acquisition (the "Acquisition"), Adience became the owner of approximately 80.1% of IDT's common stock. In July 1990, RT changed its name to Information Display Technology, Inc. In July 1990, IDT's shareholders approved a one-for-two reverse stock split (the "Reverse Stock Split") pursuant to which 26,350,000 issued and outstanding shares of IDT's common stock (including the 21,100,000 shares issued to Adience pursuant to the Acquisition) were changed into 13,175,000 shares of "new" IDT common stock, on the basis of one "new" share for each two "old" shares. The conversion price for the Convertible Note was automatically changed to $4.00 per share In October 1990, IDT purchased substantially all of the assets of Adience's Kensington Lighting Division in exchange for 142,165 shares of IDT's Common Stock at which time Adience became the owner of approximately 80.3% of IDT's common stock. In November 1990, IDT prepaid the Convertible Note in full for a price of $2,485,000. Substantially all of the assets of the Kensington Lighting Division were sold in 1993. Products IDT manufactures custom-made systems incorporating chalkboards, markerboards, tackboards and bulletin boards. IDT manufactures porcelain and masonite chalkboards which are sold in new construction or as replacements for traditional slate or glass blackboards. Porcelain products are manufactured at IDT's Alliance, Ohio plant, where porcelain is fused to sheet steel in electric furnaces. The porcelain-enameled product is then shipped to one of four other IDT production facilities for fabrication into chalkboards. Porcelain chalkboards, which are available in a range of colors, are virtually unbreakable and maintenance free, and are warranted by IDT to retain their original writing and erasing qualities under normal usage and wear. As a result of these product qualities and the reduced availability of slate for chalkboard production, IDT believes that porcelain chalkboards currently account for approximately 75% of all chalkboard sales in the United States. IDT's chalkboards, markerboards, building panels and cabinetry are typically sold together as a package to finish wall surfaces in school rooms and offices. These products are generally manufactured at one or more of IDT's five production and fabrication facilities and are generally sold together as part of a package to end-users through one sales force operating out of IDT's sales offices. In addition to chalkboards, IDT manufactures dry-marker boards, which are high-gloss porcelain enameled boards on which the user writes with a dry felt-tip marker. IDT also manufactures a variety of other information display surfaces for educational and health care facilities, such as tackboards and pegboards. Unlike most of its competitors, IDT installs as well as manufactures its information display surfaces. IDT designs, engineers and installs manual and motorized information display systems for educational and office use, using combinations of chalkboards, markerboards and other surfaces. IDT manufactures architectural building panels at its porcelain enameling plant using a fusing process similar to that used to manufacture chalkboards and markerboards. Porcelain panels are used for movable dividing walls, store fronts, window walls, window replacements, and the complete "cladding" (the application of a protective covering to the outside surface) of older buildings. Such panels are laminated to an insulation backing to achieve energy conservation. Panels are also manufactured with finishes other than porcelain enamel. Non-porcelain aluminum panels are used in a variety of lightweight architectural applications. IDT manufactures and installs cabinetry in wood or plastic laminate for hospitals, schools, laboratories and industry. The products are manufactured in a variety of surfaces with resistance to heat and chemicals. In addition, IDT manufactures and installs indoor and outdoor display cases. Sales and Markets Most of IDT's products are sold as part of a bid process conducted through architects and general contractors working with IDT's sales staff. Warranties made by IDT with respect to IDT's products and services are consistent with industry standards, except for the lifetime warranty on the writing surface of its porcelain chalkboards, which is in excess of industry standards. IDT markets its products through a sales staff of 25 persons, most of whom work on a commission basis. IDT maintains 13 sales offices in a number of states (see "Properties"). As stated above, IDT's products are generally sold as part of a package to finish wall surfaces in school rooms and offices. While most of the products incorporated into such packages are manufactured by IDT, some components are purchased from other suppliers and distributed by IDT as part of the package. In this way, IDT acts as a distributor for certain related products which it does not manufacture to the extent necessary to complement sale and installation of its own products. Sales of its own products accounted for approximately 52% and 63% of the revenues of IDT in 1993 and 1992, respectively. In 1993, sales to educational institutions and health care facilities accounted for a majority of IDT's revenues. Most of IDT's business is concentrated in the eastern half of the United States and IDT believes that it is the dominant supplier in the Northeast. In order to focus on its core business, IDT has begun to implement a business plan which, among other things, is designed to reduce construction activity and reduce the resale of products manufactured by others. IDT has also sold its Kensington Lighting operation. Raw Materials The porcelain coatings used by IDT are currently produced to its specifications by a single supplier so as to maintain consistent color and quality standards; however, alternative sources of supply are available. IDT has never experienced any difficulty with the quantity or quality of product from its porcelain coatings supplier. All other raw materials are readily available from a variety of sources. Competition IDT competes with a variety of companies which manufacture chalkboards, institutional cabinetry and modular partitions. The competitors are typically privately owned. A number of regional companies manufacture architectural building panels which compete with those produced by IDT, but none has a significant market share. IDT has attained its competitive position primarily as a result of design quality and reliability, both with respect to product and installation. Seasonality IDT's business is seasonal and most of its sales and pre-tax profits occur in the third quarter of the year. This occurs primarily as a result of increased business activity in the summer months when schools are closed and construction activity increases. IDT typically incurs a loss in the first quarter of each year. Backlog At December 31, 1993, total backlog for IDT was approximately $21,300,000, as compared with approximately $27,900,000 as of December 31, 1992. Management expects that all of the backlog will be filled in its next fiscal year. The reduction in the backlog is due to one large project being completed during 1993. IDT believes that its order backlog represents only a portion of the net sales revenue anticipated by IDT in any given fiscal year. Employees of the Company Adience currently employs approximately 800 people in the Heat Technology Division (including Adience Canada) and 32 people in its general and administrative staff. The number of individuals employed in the Heat Technology Division does not reflect members of the building trades, who are hired by Adience as required. Some employees at the South Webster, Ohio plant (approximately 30 persons) are members of the United Steelworkers Union. Some employees at the Smithville, Ontario plant (approximately 10 persons) are members of the Aluminum, Brick and Glassworkers Union. Employees at the Canon City, Colorado plant (approximately 15 persons) are members of the Oil, Chemical and Atomic Workers Union. The current labor contracts at these plants expire in July 1995, July 1994 and October 1995, respectively. All three plants are operated by the Heat Technology Division. Approximately 125 employees at the J.H. France plant in Snow Shoe, Pennsylvania are represented by the Aluminum, Brick and Glassworkers Union under a contract that expires in July 1998. The majority (approximately 60 persons) of the employees at Findlay are represented by the Aluminum, Brick and Glassworkers of America and are working under a labor agreement which expires in August 1994. Of the remaining full-time employees at Adience (approximately 590 persons), approximately 290 are union members who are not covered by collective bargaining agreements. The remaining employees of Adience (approximately 300 persons) are not unionized. IDT currently employs approximately 380 people. About 125 employees at the Dixonville, Pennsylvania plant are members of the Carpenters Union, with the current labor contract expiring in January 1995. Of IDT's remaining employees, approximately 70 persons are union members not covered by collective bargaining agreements. Management considers relations with employees at Adience, IDT and Adience Canada to be good. Patents and Trademarks The Company holds a number of patents and trademarks covering various products and processes relating to its Heat Technology Division and IDT. The Company believes the "Greensteel" trademark is important to IDT, but otherwise its patents and trademarks are not of material importance in terms of the Company's total business. Regulation The Company's manufacturing operations are subject to numerous federal, state and local laws and regulations relating to the storage, handling, emission, transportation and discharge of materials. From time to time, the Company experiences on-site inspections by environmental regulatory authorities who may impose penalties or require remedial actions. Compliance with these laws has not been a material cost to the Company and has not had a material effect upon the capital expenditures, earnings or competitive position of the Company. A violation of such laws or regulations, however, even if inadvertent, could have an adverse impact on the operations of the Company. As more fully described under "BUSINESS -- Legal Proceedings," in February 1992, IDT was cited by the Ohio Environmental Protection Agency (the "Ohio EPA") for violations of Ohio's hazardous waste regulations, including speculative accumulation of waste and illegal disposal of hazardous waste on the site of its Alliance, Ohio facility. IDT had $1,106,000 accrued at December 31, 1992 for the clean-up of this site. In December 1993, IDT and Adience signed a consent order with the Ohio EPA and Ohio Attorney General which required IDT and Adience to pay to the State of Ohio a civil penalty of $200,000 (of which IDT paid $175,000 and Adience paid $25,000). In addition, the consent order requires the payment of stipulated penalties of up to $1,000 per day for failure to satisfy certain requirements of the consent order including milestones in the closure plan. IDT expects that the work to be conducted under the closure plan will be substantially completed in 1994, subject to IDT receiving all necessary approvals from the Ohio EPA. At December 31, 1993, environmental accruals amounted to $783,000 which represents management's reasonable estimate of the amounts remaining to be incurred in this matter, including the costs of effecting the closure plan, bonding and insurance costs, penalties and legal and consultants' fees. Since 1991, Adience and IDT have together paid $341,000 (excluding the civil penalty) for the environmental clean-up related to the Alliance facility. Under the acquisition agreement pursuant to which IDT acquired the property from Adience, Adience represented and warranted that, except as otherwise disclosed to IDT, no hazardous material has been stored or disposed of on the property. No disclosure of storage or disposal of hazardous material on the site was made, accordingly, Adience is required to indemnify IDT for any losses in excess of $250,000. IDT has notified Adience that it is claiming the right to indemnification for all costs in excess of $250,000 incurred by IDT in this matter, and has received assurance that Adience will honor such claim. Adience has reimbursed IDT $196,000; if Adience is financially unable to honor its remaining obligation, such costs would be borne by IDT. Insurance The Company maintains insurance with respect to its properties and operations in such form, in such amounts and with such insurers as is customary in the businesses in which the Company is engaged. Management believes that the amount and form of its insurance coverage is adequate at the present time. Item 2.

Item 2. Properties Adience owns its 15,600 square foot headquarters in Pittsburgh, Pennsylvania along with approximately 37,000 square feet of contiguous commercial space. Adience also owns 14 of its facilities. Substantially all of the real property owned by Adience is subject to liens. Management believes that all of its facilities are well-maintained, in good condition and adequate for its present business. At present and anticipated levels of utilization, Adience's production facilities have sufficient capacity to meet demand for Adience's products. In October 1993, Adience committed to purchase a new plant facility which it currently leases in Altoona, Pennsylvania to expand current production of a specific line of refractory product. See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -- Results of Operations." Heat Technology Division. Adience owns plants at the following locations: The plants located in both Farber, Missouri and South Rockwood, Michigan have been idled and future capital expenditures deferred due to a decline in orders. Adience's lost production capacity has been replaced by its other manufacturing plants. In addition, Adience owns or leases construction yards, sales facilities and other facilities in the following locations: IDT. IDT owns five of its facilities. Real estate owned by IDT is not subject to mortgage. Management believes that all of its facilities are well-maintained, in good condition and adequate for its present business. IDT's production facilities are currently utilized to the extent of one production shift per day. At such level of utilization, IDT's production facilities have sufficient capacity to meet demand for IDT's products. IDT owns or leases production and fabrication facilities at the following locations: IDT also leases sales offices at the following locations: Corona, California; Fraser, Michigan; Millersburg, Ohio; Lakewood, New Jersey; Buffalo, New York; Deer Park, New York; Portland, Oregon; and Lorton, Virginia. Item 3.

Item 3. Legal Proceedings Ohio Environmental Matter. In February 1992, IDT was cited by the Ohio Environmental Protection Agency (the "Ohio EPA") for violations of Ohio's hazardous waste regulations including speculative accumulation of waste and illegal disposal of hazardous waste on the site of its Alliance, Ohio facility. IDT has $1,106,000 accrued at December 31, 1992 for the clean-up of this site. In December 1993, IDT and Adience signed a consent order with the Ohio EPA and Ohio Attorney General which required IDT and Adience to pay to the State of Ohio a civil penalty of $200,000 (of which IDT paid $175,000 and Adience paid $25,000). In addition, the consent order requires the payment of stipulated penalties of up to $1,000 per day for failure to satisfy certain requirements of the consent order including milestones in the closure plan. IDT expects that the work to be conducted under the closure plan will be substantially completed in 1994, subject to IDT receiving all necessary approvals from the Ohio EPA. At December 31, 1993, environmental accruals amounted to $783,000, which represents management's reasonable estimate of the amounts remaining to be incurred in the resolution of this matter, including the costs of effecting the closure plan, bonding and insurance costs, penalties and legal and consultants' fees. Since 1991, Adience and IDT have together paid $341,000 (excluding the civil penalty) for the environmental cleanup related to the Alliance facility.. Under the acquisition agreement pursuant to which IDT acquired the property from Adience in 1990, Adience represented and warranted that, except as otherwise disclosed to IDT, no hazardous material had been stored or disposed of on such property. No disclosure of storage or disposal of hazardous material on the site was made, accordingly, Adience is required to indemnify IDT for any losses in excess of $250,000. IDT has notified Adience that it is claiming the right to indemnification for all costs in excess of $250,000 incurred by IDT in this matter, and has received assurance that Adience will honor such claim. Adience has reimbursed IDT $196,000; if Adience is financially unable to honor its remaining obligation, such costs would be borne by IDT. Resolution of Asbestos Litigation. The Company's J.H. France unit, which was merged into Adience in December 1991, has been named as a party in approximately 8,000 pending lawsuits filed in eight jurisdictions principally by employees and former employees of certain customers of J.H. France, alleging that a single product, a plastic insulating cement manufactured more than 20 years ago by J.H. France, caused asbestosis or silicosis in such persons. Such lawsuits typically involve multiple defendants and seek monetary damages ranging from $20,000 each, which is the minimal jurisdictional requirement for personal injury cases in a majority of such state courts, to $1,000,000 each. J.H. France and its insurance carriers have historically settled these lawsuits typically for an average amount per case of less than the minimum amount stated. Punitive damages have also been claimed in some cases. In addition to the lawsuits against J.H. France, Adience has been named a party in approximately 250 pending lawsuits filed in the States of Pennsylvania, Ohio, Michigan and West Virginia, principally by employees and former employees of certain customers of the Company alleging that products produced by the Company caused silicosis, not asbestosis, in such persons. The majority of such lawsuits involve multiple defendants and seek unstated monetary damages in excess of $20,000 each, which is the minimal jurisdictional requirement for personal injury cases in a majority of such state courts, to $1,000,000 each. Adience and its insurance carriers have historically settled these lawsuits for an average amount per case of less than the minimum amount stated. All such claims and all costs of defense for these cases are covered by insurance. The insurance companies which had issued policies covering the J.H. France cases had asserted that each insurance company was only responsible for a pro rata share of the liability in these cases, based upon the number of years for which the carriers provided coverage during the period of the exposure, development and manifestation of each plaintiff's asbestosis or silicosis. In June 1993, the Supreme Court of Pennsylvania held that the insurance policies covering the claims in these J.H. France cases covered liabilities and defense costs up to the amounts of the limits of the respective policies, without regard to the period of time said policies were in effect. As a result of this judicial determination and based upon the Company's experience in obtaining dismissals or settlements in closed cases, the Company anticipates, although no assurance can be given, that the expected costs and liabilities in all pending cases will be adequately covered by insurance. The Company believes that the aggregate limits on the insurance policies in effect exceed the potential liabilities and defense costs which will be incurred in the 8,000 J.H. France cases and the other 250 cases for which the scope of coverage has never been an issue. Other Legal Actions. The Company has been engaged in various other legal actions and claims arising in the ordinary course of business. Management believes that, after discussions with internal and external legal counsel, the ultimate outcome of such litigations and claims will not have a material adverse effect on the Company's consolidated financial position. For information regarding Adience's proceedings under Chapter 11, see "BUSINESS -- Background of Adience". Item 4.

Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of security holders of the Company during the fiscal quarter ended December 31, 1993. PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters On January 27, 1994, the Company's Registration Statement on Form S-1 was declared effective by the Securities and Exchange Commission. Pursuant to the Registration Statement, all of the Company's outstanding shares of Common Stock were registered. There currently is no established public trading market for the Common Stock and, accordingly, market prices are not available. Adience has not to date filed any application to list the Common Stock on any stock market or exchange. If a substantial number of Adience's stockholders seek to sell their shares of Common Stock in the public market, the market price of the Common Stock could be adversely affected. Since its inception, Adience has paid only one dividend, in September 1990, of $.10 per share ($1,000,000 in the aggregate). Under the terms of Adience's financing agreement with Congress Financial Corporation and the indenture under which its New Senior Secured Notes were issued, Adience at present is prohibited from declaring or paying any dividends on account of any shares of any class of its capital stock. As a result of this prohibition, it is unlikely that Adience will pay any dividend on its Common Stock in the foreseeable future. See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -- Liquidity and Sources of Capital; Financing Agreements." As of March 29, 1994, the Company had 152 holders of record of its Common Stock (excluding beneficial owners of shares held of record by nominees). Item 6.

Item 6. Selected Consolidated Financial Data The selected consolidated financial statement data presented below for periods subsequent to June 30, 1993 give effect to the consummation of the Prepackaged Plan and to the application of fresh-start reporting by the Company as of that date in accordance with the American Institute of Certified Public Accountants' Statement of Position 90-7, "Financial Reporting by Entities in Reorganization under the Bankruptcy Code." Accordingly, periods through June 30, 1993 have been designated "Pre-emergence," and periods subsequent to June 30, 1993 have been designated "Post-emergence." Selected financial consolidated balance sheet and income statement data of the pre-emergence periods are not comparable to those of the post-emergence periods and a line has been drawn in the tables to separate the post-emergence financial data from the pre-emergence financial data. The following table presents selected (i) historical consolidated financial data of the Company (pre-emergence) for each of the four fiscal years in the period ended December 31, 1992 and the six-month period ended June 30, 1993, (ii) historical consolidated financial data of the Company (post-emergence) for the six-month period ended December 31, 1993, and (iii) pro forma consolidated income statement data for the fiscal year ended December 31, 1993. The pro forma data (i) eliminate the effect of non-recurring transactions resulting from the Reorganization included in the results of the Company, (ii) adjust pre-emergence results of the Company to reflect the assumed implementation of fresh-start reporting as of January 1, 1993 for income statement purposes, and (iii) assume the exchange of $65,975,000 aggregate principal amount of Old Subordinated Notes for $48,628,625 aggregate principal amount of New Senior Secured Notes and the issuance of 10,000,000 shares of Common Stock pursuant to the Prepackaged Plan as of January 1, 1993. The information below should be read in conjunction with "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS," the Company's Consolidated Financial Statements, including the notes thereto, and other information contained elsewhere herein. The historical consolidated financial data presented below for each of the three fiscal years in the period ended December 31, 1991 have been derived from the Company's Consolidated Financial Statements, which were audited by Ernst & Young, independent accountants. Ernst & Young's report on the consolidated financial statements for the year ended December 31, 1991, which appears elsewhere herein, includes a description of uncertainties that might have led to the Company's inability to continue as a going concern. The historical consolidated financial data for the six months ended December 31 and June 30, 1993 and the fiscal year ended December 31, 1992 have been derived from the Company's Consolidated Financial Statements, which were audited by Price Waterhouse, independent accountants. The data should be read in conjunction with the consolidated financial statements, related notes and other financial data included elsewhere herein. (1) Adience's management believes the per share amounts are not meaningful prior to June 30, 1993 due to the Reorganization. (2) Pro forma balance sheet information is not presented since the historical balance sheet data as of December 31, 1993 includes the effects of the Prepackaged Plan and the implementation of fresh-start-reporting. (3) On February 10, 1989, Adience's Board of Directors authorized an amendment to Aidence's Certificate of Incorporation to increase the authorized number of shares of common stock from 200 shares, no par value, to 20,000,000 shares, par value $0.15 per share, and a 100,000-for-1 stock split. On September 30, 1990, Adience's Board of Directors declared a $.10 per share cash dividend. No dividends were declared on Adience's common stock for any other period covered. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Reorganization and Fresh-Start Reporting Adience, Inc. has experienced continued losses from continuing operations (before reorganization items) both pre- and post-emergence under Chapter 11. In addition, a write down of reorganization value in excess of amounts allocable to identifiable assets has been recorded at December 31, 1993, based on management's belief that a permanent impairment of this asset now exists. The Company is currently seeking to replace and improve the terms of its line of credit financing agreement with Congress Financial Corporation (Congress) which expires June 30, 1994. The continued viability of the Company is dependent upon, among other factors, the ability to generate sufficient cash from operations, financing, or other sources that will meet ongoing obligations over a sustained period. Management has prepared detailed operating and financial plans which combine multifunctional resources as teams to respond better to customer needs, make an investment in product and service opportunities expected to produce a significantly greater return on investment, continue a cost control program begun in 1993, and assume refinancing of the line of credit arrangement on improved terms. Management believes that the successful implementation of this plan will enable the Company to continue as a going concern for a reasonable period. There can be no assurance however, that such activities will achieve the intended improvement in results of operations or financial position. On February 22, 1993, Adience and the unofficial committee of noteholders of Adience filed a prepackaged plan of reorganization (the "Prepackaged Plan") under Chapter 11 of the United States Bankruptcy Code (the "Reorganization"). The Prepackaged Plan was confirmed by the United States Bankruptcy Court for the Western District of Pennsylvania on May 4, 1993 and consummated on June 30, 1993. The filing was precipitated by a combination of an overall decline in the demand for refractory products and service during 1991 and 1992 caused by a decrease in the production of refractory-using industries in the United States, particularly steel, and losses from discontinued operations. The primary purposes of the Prepackaged Plan were to reduce Adience's debt service requirements and overall indebtedness, to realign its capital structure and to provide Adience with greater liquidity. Neither IDT nor Adience Canada, Inc. filed a plan of reorganization. The Prepackaged Plan provided for a restructuring of Adience's capital structure and allowed the holders of $65,975,000 aggregate principal amount of Adience's Senior Subordinated Reset Notes ("Old Subordinated Notes") to exchange them for $48,628,625 aggregate principal amount of new 11% Senior Secured Notes ("New Senior Notes") due June 15, 2002, plus common stock representing 55% of the outstanding common stock of Adience. The Prepackaged Plan also included forgiveness of outstanding interest totaling approximately $8,800,000. The value of the cash and securities distributed was $17,480,000 less than the allowed claims; the resultant gain was recorded as an extraordinary gain. In connection with the Reorganization described above, Adience applied the provisions of the American Institute of Certified Public Accountants' Statement of Position No. 90-7, "Financial Reporting by Entities in Reorganization under the Bankruptcy Code" ("SOP 90-7") as of June 30, 1993. The Company's basis of accounting for financial reporting purposes changed as a result of applying SOP 90-7. Specifically, SOP 90-7 required the adjustment of the Company's assets and liabilities to reflect a reorganization value generally approximating the fair value of the Company as a going concern on an unleveraged basis, the elimination of its accumulated deficit, and adjustments to its capital structure to reflect consummation of the Prepackaged Plan. Accordingly, the results of operations after June 30, 1993 are not comparable to the results of the operations prior to such date, and the results of operations for the six months ended June 30, 1993 and the six months ended December 31, 1993 have not been aggregated. Further, the financial position of the Company after June 30, 1993 is not comparable to its financial position at any date prior thereto. Results of Operations Fiscal Year ended December 31, 1993 Compared to Fiscal Year ended December 31, The following table summarizes the Company's consolidated results of operations for 1993 and 1992 and provides a consistent basis for further discussion and analysis of those results. (1) For further discussion, see Note 1 to Consolidated Financial Statements. Excluding the effects of reorganization items, the pre-emergence and post-emergence loss of $4.7 million and 13.6 million, respectively, decreased by $5.7 million from 1992, reflecting primarily a reduction in selling, general and administrative expenses of $2.8 million and a decrease in interest expense of $7.3 million, offset partially by a net increase in depreciation and amortization expense of $7.2 million. Included in the net increase in amortization expense for 1993 is the fourth quarter write down of the Company's reorganization value in excess of amounts allocable to identifiable assets. The amount written down was based on management's comparison of actual cash flows for the post-emergence period through December 31, 1993 with the projected cash flows used to arrive at the reorganization value at June 30, 1993. This charge increased the post-emergence loss by $8 million or $.80 per share. Additional losses from previously discontinued operations and disposals amounted to $400,000 and $84,000 for the pre-emergence and post-emergence periods, respectively, and $5.3 million in 1992. Management's decision to discontinue these operations was made after concluding that these businesses no longer fit Adience's long-term growth plans. Net revenues by industry segment for 1993 and 1992 were as follows: During the Reorganization period, which initially began in December 1992, Adience operated under strict payment terms with many of its suppliers, thereby experiencing higher costs. Increased competition in the refractory product sector prohibited the Company from passing along to customers increases in the costs of some important raw materials. As a result, sales opportunities were lost due to Adience's inability to compete on price and offer extended payment terms. In addition, the necessity of management's concentration of efforts on the Reorganization resulted in a loss of business in certain primary steel markets. During 1993, steel producers generally operated at levels close to capacity. However, Adience's restructuring under the supervision of the Bankruptcy Court did not enable the Heat Technology division to capitalize on these favorable economic conditions in the first half of 1993. The Company reacted to the sales decline during the first half of 1993 by taking several significant steps which, due to timing, only modestly impacted 1993 results. The primary steps included the election of a new Board of Directors and the appointment of a new Chief Executive Officer. The problems experienced in the past are being addressed by the new Board and executive management. As a result, new incentive plans are being implemented for the sales force and a realignment of duties is being accomplished within the internal operations of the Company. The Heat Technology division has also expanded its research and development programs through the hiring of seven new ceramic engineers during 1993. A management focus for 1994 is customer service and product quality. Teams of sales and service representatives have been established to respond to customer needs within the various industries that are supplied or serviced with refractory product. Net revenues for the Heat Technology division increased by 23% for the six month period ended December 31, 1993 compared to the six month period ended June 30, 1993. Net revenues for IDT remained consistent with prior year's net revenues. Included in 1993 and 1992 revenues is one large project with incremental revenues of $4.7 million and $2 million, respectively. Excluding this project, net revenues declined $3 million or 6.4% during 1993 within this segment. This decline is attributable to management's efforts to reduce the number of contracts which require the use of purchased rather than manufactured product because the former generate lower gross margins. The Heat Technology Division's cost of revenues amounted to 80.9% and 87.6% of net revenues for the pre-emergence and post-emergence periods respectively, compared with 83.5% for the year ended December 31, 1992. The increase in the Heat Technology Division's cost of revenues as a percentage of net revenues during the post-emergence period was primarily due to negative variances in the refractory production facilities due to a decline in volume (caused by a decrease in material shipments as opposed to construction activity) and the reduced ability to cover overhead costs. The decrease in direct material sales for the Heat Technology Division which caused these negative variances has been partially offset by the increase in construction revenues during the post-emergence period. Additional depreciation expense on buildings and machinery and equipment written up as a result of fresh start reporting (approximately $500,000) and the write-up of inventory values on June 30, 1993 (approximately $1,287,000) through the application of SOP 90-7, accounted for 3.7% of the increase in cost of revenues during the post-emergence period. Going forward, cost of revenues as a percentage of net revenues is expected to remain close to post-emergence levels due to the impact of additional depreciation expense on buildings and machinery and equipment written up as a result of fresh start reporting. (See Notes to Consolidated Financial Statements for further details). IDT's gross margins increased $300,000 to 18.1% of revenues during 1993. During the first quarter of 1993, IDT won a decision by the order of the Board of Finance and Revenue of Pennsylvania, relating to a reassessment of use tax on casework sold during the period February 1988 through September 1990. As a result, an adjustment to decrease cost of revenues by $438,000 was recorded during 1993 resulting from the reversal of the provision relating to this contingency. IDT's Kensington division, which was sold during the fourth quarter of 1993, contributed to the overall gross margin by $378,000 and $385,000 for the years ended December 31, 1993 and 1992, respectively. IDT's gross margin percentage excluding the Kensington division, the 1993 sales tax adjustment and the one large project, which recognized a loss of $290,000 during 1993, would have been 9% higher than 1992. The improvement in gross margin results principally from significant charges incurred in 1992 related to project cost overruns. The project cost overruns of approximately $600,000 were due to weaknesses in sales and project management in specific territories. Controls have been established during 1993 to minimize these types of overruns. For the pre and post-emergence periods in 1993, selling, general and administrative expenses of the Company amounted to 21.5% and 16.6% of net revenues respectively, compared with 21% for the year ended December 31, 1992. The increase in selling, general and administrative expenses during the pre-emergence period is attributable to the low level of sales during the same period. The major component in the overall decrease in 1993 over 1992 related to insurance expense. Adience was self-insured from November 1988 to June 1992 for workers' compensation and general liability. For this period, Adience is responsible for the first $250,000 of losses per occurrence. A loss calculation is performed at the end of each policy year summarizing incurred losses, paid losses and the outstanding reserve. Based upon this calculation and an estimate for potential changes in reserves and for new claims, Adience recorded an additional $2.3 million in insurance expense during the fourth quarter of 1992. In addition, the reduction in selling, general and administrative expenses is due to significant charges of approximately $1.1 million incurred in 1992 related to clean-up activities and other costs associated with the environmental issue at one of IDT's facilities. These activities were accounted for in 1992 and did not have a significant impact on operating costs in 1993. Other income (expense) for the pre-emergence period in 1993 includes retroactive health insurance premium refunds of approximately $215,000 for the Company's medical self-insurance program for the period September 1991 to February 1992. In addition, during June 1993, the Supreme Court of Pennsylvania held that the insurance policies covering these asbestosis and silicosis claims covered liabilities and defense costs up to the amounts of the limits of the respective policies, without regard to the period of time said policies were in effect. As a result of this judicial determination, the court awarded a refund to J.H. France for its pro rata share of the funds paid in these cases or $265,000. Also included in other income (expense) for the post-emergence period in 1993 is the $220,000 loss on the sale of the Heat Technology Division's Los Angeles operations and the $94,000 loss on the sale of IDT's Kensington division. Both sales were recorded during December 1993. Fiscal Year ended December 31, 1992 Compared to Fiscal Year ended December 31, The following table sets forth as a percentage of net revenues certain items appearing in the Company's consolidated financial statements. Percentage of Net Revenues During 1992, a decline in the demand for refractory products and services caused by a decrease in the production of refractory-using industries in the United States, particularly steel, precipitated the decline in revenues. Compounding the decline in demand for refractory products and services during 1992 was the effect of the Prepackaged Plan which increased customer apprehension. Net revenues for the Heat Technology Division's top ten customers declined by $3,500,000 in 1992. The contributing factors in this revenue decline were customer plant closings and major construction projects which were performed in 1991 and not repeated during 1992. IDT's revenues declined by $10,900,000 from 1991. IDT's primary market depends on the construction or refurbishing of educational buildings which, according to industry statistics, reported a 12% decline in capital expenditures in 1992. Industry reports attributed the decline to unusually conservative state and municipal budgets rather than a result of a permanent decline in demand. IDT's major market in the eastern portion of the United States declined, according to industry reports, by approximately 20%. IDT's revenues from this market segment suffered a corresponding percentage decline, which in turn accounted for 70% of IDT's total decrease in net revenues. In addition, the sale of EHB, one of IDT's divisions, in the first quarter accounted for 3% of the decrease in net revenues. The Heat Technology Division's cost of revenues declined by 8% to 84% of net revenues, compared with 83% in 1991. Included in cost of revenues for 1992 was a $1,100,000 write-down of property, plant and equipment for a facility which was anticipated to close during 1993. IDT's cost of revenues declined in line with the reduction in net revenues. However, project cost overruns in excess of $600,000 and enhanced pricing pressures caused by the market also resulted in the increase in cost of revenues as a percentage of net revenues to 83% compared with 79% in 1991. The project cost overruns were due to weaknesses in sales and project management in specific territories. Management controls have been established by IDT to minimize these types of overruns by the creation of centralized estimating and project management departments which are responsible for the preparation of costs estimates and ongoing cost management of all IDT projects. The increase in selling, general and administrative expenses for the Heat Technology Division reflects an adjustment to the workers' compensation and general liability insurance accrual accounts during the fourth quarter of 1992. Adience is self-insured for workers' compensation and general liability coverage for claims incurred during the period November 1988 to June 1992 for the first $250,000 of losses per occurrence. A loss calculation is performed at the end of each policy year summarizing incurred losses, paid losses and the outstanding reserve plus an estimate for potential changes in reserves and for new claims. Based upon this calculation, Adience recorded an additional $2,300,000 in insurance expense during the fourth quarter of 1992, representing Adience's portion of the outstanding reserves. In addition, as more fully described in the Notes to the Company's Consolidated Financial Statements, Adience agreed to indemnify IDT for any losses in excess of $250,000 resulting from the environmental issue at one of IDT's facilities. As a result of this indemnification, Adience recorded a $1,052,000 environmental liability which represents Adience's portion of IDT's liability for environmental issues. IDT's selling, general and administrative expenses decreased as a result of reduced sales commission expense on lower gross margin dollars. Included in reorganization items was the Company's settlement with its principal shareholder and his son as a result of Adience's Prepackaged Plan under Chapter 11 of the Bankruptcy Code. In addition, professional fees incurred as a result of the restructuring have also been segregated for presentation purposes. Liquidity and Sources of Capital As described above, the Company's financial position at December 31, 1993 as presented in its Consolidated Financial Statements reflects fresh start reporting and the amount of New Senior Notes negotiated under the Prepackaged Plan. Consequently, it is not comparable to prior periods and comparisons normally discussed under this heading would not be meaningful. The following comments on operating cash flows, capital expenditures, working capital and liquidity are considered to be relevant in evaluating the Company's present financial position. The Company's principal sources of liquidity are cash from operations, cash on hand, and certain credit facilities available to the Company. The Prepackaged Plan included forgiveness of accrued interest totaling approximately $8.8 million and the value of the New Senior Secured Notes, cash and securities distributed was $17.5 million less than the allowed claims. Management of the Company believes that cash on hand and funds from operations, together with borrowings under credit facilities described below, will be sufficient to cover its working capital, capital expenditure and debt service requirements through 1994. The Company is actively seeking an increase in its credit line through its current lender or different financing resources. The Company expects average borrowings in 1994 to exceed those of 1993. The Company intends to seek further to strengthen its financial position and increase its financial flexibility and may from time to time consider possible additional transactions, including other capital market transactions. Net cash flows provided by operating activities totaled $1.0 million and $1.2 million for the six months ended December 31 and June 30, 1993, respectively. Included in net cash flows provided by operating activities is $4.3 million received during the six months ended June 30, 1993, which relates to a federal tax refund for net operating loss carrybacks. The Company has exhausted any future refunds for net operating loss carrybacks. As discussed previously, the Company benefited as a result of the Reorganization from a forgiveness of interest on the Old Subordinated Notes during the six months ended June 30, 1993. Future cash flows from operations will no longer receive such benefit. In addition, Adience's restructuring under Chapter 11 of the Bankruptcy Code had forced Adience to comply with stricter payment terms from major vendors beginning in 1992. During the current year, however, these stricter payment terms were suspended and accounts payable and accrued expenses increased by $2,469,000 during the six months ended June 30, 1993. Capital expenditures used $1.7 million of funds through December 31, 1993. During 1993, Adience committed to purchase a new plant facility to expand current production of a specific product line. The estimated total cost of this facility and the necessary capital expenditures for machinery and equipment will be $1.5 million and is expected to be partially financed through the Pennsylvania Industrial Development Authority. It is anticipated that necessary capital expenditures in future years will not exceed depreciation expense but will represent a material use of operating funds. Adience and IDT together had $5,293,000 and $1,762,000 in available credit as of December 31, 1993 and February 28, 1994, respectively, under its short-term borrowing arrangement with Congress Financial Corporation ("Congress"). Short-term liquidity is dependent, in large part, on general economic conditions and the effect of those conditions on the steel industry. Due to the cyclical nature of the steel business and considering current trends and industry forecasts, it appears the recent period of low steel demand has ended. The Company's level of material shipments decreased by 29% during 1993, but construction activity remained relatively strong during the same period. It is anticipated that although construction activity will decline during the first half of 1994, material shipments are expected to increase during the same period. Financing Agreements. On the consummation date of the plan of reorganization, June 30, 1993, Adience entered into a financing agreement with Congress for the twelve month period ending June 30, 1994. Under this agreement, Adience may request loan advances not to exceed the lesser of $12 million or available collateral (80% of eligible accounts receivable less than 90 days plus 30% of raw material and finished goods inventory). The loan is collateralized by accounts receivable, inventory, fixed assets, intangible assets and Adience's shares of IDT. In addition, IDT guaranteed the Adience line of credit and pledged its own accounts receivable, inventory and equipment. The interest rate on the loan is 2.5% over the prime rate (effective rate of 8.5% at December 31, 1993). At December 31, 1993 and February 28, 1994, Adience had borrowed $8,007,000 and $11,595,000, respectively, under the credit facility. Letters of credit issued under the facility totaled $1 million at December 31, 1993, which reduced the availability under the financing arrangement in a like amount. IDT also renewed its financing agreement with Congress through June 30, 1994. Under this agreement, IDT may request loan advances not to exceed the lesser of $3 million or available collateral (80% of eligible accounts receivable less than 90 days plus 30% of raw material and finished goods inventory). The loan is collateralized by accounts receivable, inventory and fixed assets. Adience has guaranteed IDT's debt to Congress. The interest rate on the loan is 2.5% over the prime rate. At December 31, 1993 and at February 28, 1994, no amounts were outstanding under this agreement. Letters of credit issued under the facility totaled $700,000 at December 31, 1993, which reduced the availability under the financing arrangement in a like amount. Both Adience and IDT pay commitment fees on the unused portion of their credit facilities. Under the terms of the financing agreements, both companies are required to maintain minimum levels of net worth of $1,500,000 and working capital of $12,000,000. The agreements additionally contain other restrictive covenants applicable to Adience and its subsidiaries which, among other things, limit (i) the incurrence of additional indebtedness, (ii) the granting of liens, (iii) the making of loans, investments and guaranties, (iv) transactions with affiliates, (v) the payment of dividends and other distributions, (vi) the making of annual capital expenditures, and (vii) the disposition of real property. The following is a summary of certain of these covenants: Indebtedness. Adience may not, and may not permit any subsidiary to, create, incur, assume or permit to exist, contingently or otherwise, any indebtedness, except (a) indebtedness to Congress, (b) indebtedness consisting of unsecured current liabilities incurred in the ordinary course of its business which are not more than 90 days past due, (c) indebtedness incurred in the ordinary course of its business secured only by permitted liens (e.g., purchase money mortgages), (d) indebtedness other than for borrowed money, which is and remains contingent and unmatured, (e) indebtedness pursuant to the New Senior Notes, and (f) indebtedness to or from Adience's subsidiaries. Limitation on Liens. Adience may not, and may not permit any subsidiary to, create or suffer to exist any mortgage, pledge, security interest, lien, encumbrance, defect in title or restriction upon the use of their real or personal properties, whether now owned or hereafter acquired, except (a) the liens or security interest in favor of Congress, (b) tax, mechanics and other like statutory liens arising in the ordinary course of Adience's or its subsidiaries' respective businesses, (c) purchase money mortgages or other purchase money liens or security interest upon any specific fixed assets hereafter acquired, and (d) existing liens. Loans, Investments, Guaranties. Adience may not, and may not permit any subsidiary to, directly or indirectly, make any loans or advance money or property to any person, or invest in (by capital contribution or otherwise) or purchase or repurchase the stock or indebtedness or all or a substantial part of the assets or property of any person, or guarantee, assume, endorse, or otherwise be or become responsible for (directly or indirectly) the indebtedness, performance, obligations or dividends of any person or agree to do any of the foregoing, except (a) intercompany loans from and to Adience and its subsidiaries; (b) guarantees by any subsidiary of Adience with respect to the obligations in favor of Congress and guarantees by Adience and any subsidiary of Adience with respect to the obligations in favor of Congress and guarantees by Adience and any subsidiary of Adience with respect to the obligations of IDT in favor of Congress; (c) the endorsement of instruments for collection or deposit in the ordinary course of business; and (d) after written notice thereof to Congress, investments in the following instruments, which shall be pledged and delivered to Congress upon Congress' request, (i) marketable obligations issued or guaranteed by the United States of America or an instrumentality or agency thereof, maturing not more than one (1) year after the date of acquisition thereof, (ii) certificates of deposit or other obligations maturing not more than one (1) year after the date of acquisition thereof issued by any bank or trust company organized under the laws of and located in the United States of America or any state thereof and having capital, surplus and undivided profits of at least $100,000,000, and (iii) open market commercial paper with a maturity not in excess of two hundred seventy (270) days from the date of acquisition thereof which have the highest credit rating by either Standard & Poor's Corporation or Moody's Investors Service, Inc. Transactions with Affiliates. Adience may not, and may not permit any subsidiary to, directly or indirectly (a) purchase, acquire or lease any property or receive any services from, or sell, transfer or lease any property or services to, any affiliate of Adience, except for any such transactions between Adience and Adience's subsidiaries and except for such transactions on prices and terms no less favorable than would have been obtained in an arm's length transaction with a non-affiliated person; or (b) make any payment of management or other fees or of the principal amount of or interest on any indebtedness owing to any shareholder, officer, director or affiliate of Adience, except, that Adience and any subsidiary may make such payments to Adience or a subsidiary, as the case may be, when due. Dividends. Adience may not, and may not permit any subsidiary to, directly or indirectly, during any fiscal year, declare or pay any dividends on account of any shares of any class of capital stock of Adience or its subsidiary now or hereafter outstanding, or set aside or otherwise deposit or invest any sums for such purpose, or redeem, retire, defease, purchase or otherwise acquire any shares of any class of capital stock (or set aside or otherwise deposit or invest any sums for such purpose) for any consideration other than stock or apply or set apart any sums, or make any other distribution (by reduction of capital or otherwise) in respect of any such shares or agree to do any of the foregoing, except, that, dividends may be declared and paid to Adience by its subsidiaries on any class of capital stock or any other interest in, or measured by its profit, owned by Adience or any subsidiary of Adience, in each case out of legally available funds therefore and otherwise in accordance with applicable law. Capital Expenditures. (a) Adience may not, and may not permit any subsidiary to, in the aggregate for all of them, directly or indirectly, expend or commit to expend, capital expenditures in excess of $6,500,000 in any fiscal year of Adience, excluding capital expenditures paid under existing leases; and (b) Adience may not, directly or indirectly, expend or commit to expend, capital expenditures in excess of $4,000,000 in any fiscal year of Adience, excluding capital expenditures paid under existing leases. IDT is subject to a capital expenditure limit of $2,500,000 in any fiscal year, excluding capital expenditures paid under existing leases. Real Property. Adience may not, and may not, permit any subsidiary to sell, lease (as lessor) transfer, or otherwise dispose of any of its or their, as the case may be, real property or any interest therein. As of December 31, 1993, Adience and IDT were in compliance with the covenants of their respective agreements. Adience's ability to continue to comply with such conditions is dependent upon Adience's ability to achieve specified levels of sales, profitable operations and borrowing availability. Waivers or amendments may be required in the future. Inability to achieve compliance could affect Adience's access to further borrowings or require it to secure additional capital by other means. Both Adience and IDT anticipate that the financing agreements with Congress will be renewed at June 30, 1994 or, alternatively, both companies will be able to secure financing from other sources. However, no commitment letters have been requested or received. Long-term liquidity is dependent upon the Company's ability to operate profitably and generate cash flow following favorable changes made to its capital structure and the restructuring of its management structure. Adience's New Senior Notes are due in June 2002, and may not be redeemed at the option of Adience prior to December 15, 1997. Adience has not yet formulated plans to meet these long-term debt requirements. The Indenture under which the New Senior Notes were issued contains restrictive covenants similar to those included in the financing agreements with Congress, and additionally limits the use of cash proceeds from the sale of Adience's assets. The Indenture provides that Adience may not make any asset sale outside of the ordinary course of business unless (i) such asset sale is for fair value and (ii) at least 50% of the consideration therefor received by Adience is in the form of cash and/or cash equivalents. In the case of the sale by Adience of all or substantially all of the stock of IDT or any other asset for which the gross cash proceeds exceed $2 million, Adience is required, within 180 days after the receipt of the net cash proceeds of such asset sale, to make an offer to repurchase the New Senior Notes at a price equal to 100% of the principal amount of the New Senior Notes plus accrued interest thereon. In addition, a default on the Congress financing agreement will result in a default under the Indenture. Both internal and external factors are material to the Company's long-term liquidity. External factors include general economic conditions, the performance of the steel industry and spending by public school systems. Long- term liquidity is dependent upon the Company's ability to control costs during periods of low demand so as to sustain positive cash flow from operations. The Company, even after the Reorganization, continues to operate with a significant amount of interest-bearing debt. Should additional financing be needed, the Company's access to new sources of capital or the amount of available and unused lines of bank credit may be limited. As more fully described under "BUSINESS -- Legal Proceedings," in February 1992, IDT was cited by the Ohio Environmental Protection Agency (the "Ohio EPA") for violations of Ohio's hazardous waste regulations, including speculative accumulation of waste and illegal disposal of hazardous waste on the site of its Alliance, Ohio Facility. IDT had $1,106,000 accrued at December 31, 1992 for the clean-up of this site. In December 1993, IDT and Adience signed a consent order with the Ohio EPA and Ohio Attorney General which required IDT and Adience to pay to the State of Ohio a civil penalty of $200,000 (of which IDT paid $175,000 and Adience paid $25,000). In addition, the consent order requires the payment of stipulated penalties of up to $1,000 per day for failure to satisfy certain requirements of the consent order including milestones in the closure plan. IDT expects that the work to be conducted under the closure plan will be substantially completed in 1994, subject to IDT receiving all necessary approvals from the Ohio EPA. At December 31, 1993, environmental accruals amounted to $783,000 which represents management's reasonable estimate of the amounts remaining to be incurred in this matter, including the costs of effecting the closure plan, bonding and insurance costs, penalties and legal and consultants' fees. Since 1991, Adience and IDT have together paid $341,000 (excluding the civil penalty) for the environmental clean-up related to the Alliance facility. Under the acquisition agreement pursuant to which IDT acquired the property from Adience, Adience represented and warranted that, except as otherwise disclosed to IDT, no hazardous material has been stored or disposed of on the property. No disclosure of storage or disposal of hazardous material on the site was made, accordingly, Adience is required to indemnify IDT for any losses in excess of $250,000. IDT has notified Adience that it is claiming the right to indemnification for all costs in excess of $250,000 incurred by IDT in this matter, and has received assurance that Adience will honor such claim. Adience has reimbursed IDT $196,000; if Adience is financially unable to honor its remaining obligation, such costs would be borne by IDT. Item 8.

Item 8. Financial Statements and Supplementary Data The following financial statements and related report and supplementary data are filed as part of this annual report. REPORT OF INDEPENDENT ACCOUNTANTS - POST-EMERGENCE CONSOLIDATED FINANCIAL STATEMENTS To the Board of Directors and Shareholders of Adience, Inc. In our opinion, the accompanying consolidated financial statements listed in the Index appearing under Item 14(a)(1) and (2) on Page 58 present fairly, in all material respects, the financial position of Adience, Inc., and its subsidiaries (Adience) at December 31, 1993, and the results of their operations and their cash flows for the six months ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of Adience's management; our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these financial statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for the opinion expressed above. As discussed in Note 1 to the consolidated financial statements, the Adience Plan of Reorganization was confirmed on May 4, 1993, and was consummated on June 30, 1993. Adience has accounted for the reorganization in accordance with the American Institute of Certified Public Accountants Statement of Position 90-7 "Financial Reporting by Entities in Reorganization Under the Bankruptcy Code." Accordingly, Adience's assets and liabilities as of June 30, 1993, were restated by management, with the assistance of independent advisors, to their reorganized value, which approximated their fair value at the date of reorganization. The financial statements subsequent to the emergence from Chapter 11 have been prepared using a different basis of accounting and therefore, are not comparable to the pre-emergence consolidated financial statements. As discussed in Notes 1 and 6, the Adience line of credit financing agreement expires June 30, 1994. Management expects that financing agreements with the lender will be renewed, or alternatively, that financing will be secured from other sources. PRICE WATERHOUSE Pittsburgh, Pennsylvania March 28, 1994 REPORT OF INDEPENDENT ACCOUNTANTS - PRE-EMERGENCE CONSOLIDATED FINANCIAL STATEMENTS To the Board of Directors and Shareholders of Adience, Inc. In our opinion, the accompanying consolidated financial statements listed in the Index appearing under Item 14(a)(1) and (2) on Page 58 present fairly, in all material respects the financial position of Adience, Inc., and its subsidiaries (Adience) at December 31, 1992, and the results of their operations and their cash flows for the six months ended June 30, 1993, and for the year ended December 31, 1992, in conformity with generally accepted accounting principles. These financial statements are the responsibility of Adience's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these financial statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. The financial statements of Adience for the year ended December 31, 1991, were audited by other independent accountants whose report dated April 9, 1992, included an explanatory paragraph as to Adience's ability to continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Adience Plan of Reorganization was confirmed on May 4, 1993, and was consummated on June 30, 1993. Adience has accounted for the reorganization in accordance with American Institute of Certified Public Accountants Statement of Position 90-7 "Financial Reporting by Entities in Reorganization Under the Bankruptcy Code." Accordingly, Adience's assets and liabilities as of June 30, 1993, were restated by management, with the assistance of independent advisors, to their reorganized value, which approximated their fair value at the date of reorganization. PRICE WATERHOUSE Pittsburgh, Pennsylvania March 28, 1994 ERNST & YOUNG ONE OXFORD CENTRE PITTSBURGH, PA 15219 412-644-7800 REPORT OF INDEPENDENT AUDITORS Board of Directors Adience, Inc. We have audited the accompanying consolidated statements of income, cash flows, and shareholders' equity (deficit) of Adience, Inc. (Adience) and subsidiaries for the year ended December 31, 1991. These financial statements are the responsibility of Adience's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated results of operations and cash flows of Adience and subsidiaries for the year ended December 31, 1991, in conformity with generally accepted accounting principles. The accompanying financial statements have been prepared assuming that Adience will continue as a going concern. As discussed in Notes 1 and 7 to the financial statements, it is unlikely that Adience will be able to generate sufficient cash from operations to enable it to meet its debt obligations in June 1992. This condition raises substantial doubt about Adience's ability to continue as a going concern. Management's plans to mitigate these matters are also described in Notes 1 and 7. The 1991 financial statements do not include any adjustments that might result from the outcome of this uncertainty. ERNST & YOUNG April 9, 1992 29A ADIENCE, INC. CONSOLIDATED BALANCE SHEETS (In Thousands of Dollars, Except Share Data) The accompanying notes are an integral part of these financial statements. ADIENCE, INC CONSOLIDATED STATEMENTS OF OPERATIONS (In Thousands of Dollars, Except Per Share Data) * Earnings per common share are not meaningful prior to June 30,1993 due to the reorganization - see Note 1. The accompanying notes are an integral part of these financial statements. ADIENCE, INC CONSOLIDATED STATEMENTS OF CASH FLOWS (In Thousands of Dollars) See Note 1 for significant non-cash transactions not reflected above. The accompanying notes are an integral part of these financial statements. ADIENCE, INC CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (DEFICIT) (In Thousands of Dollars, Except Per Share Data) The accompanying notes are an integral part of these financial statements. ADIENCE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993 (Dollar Amounts in Thousands, Except Share Data, Unless Otherwise Noted) 1. Basis of Presentation and Company Reorganization Adience, Inc. ("Adience" or "Company") has experienced continued losses from continuing operations (before reorganization items) both pre- and post-emergence under Chapter 11. In addition, a write down of reorganization value in excess of amounts allocable to identifiable assets has been recorded at December 31, 1993, based on management's belief that a permanent impairment of this asset now exists. The Company is currently seeking to replace and improve the terms of its line of credit financing agreement with Congress Financial Corporation (Congress) which expires June 30, 1994. The continued viability of the Company is dependent upon, among other factors, the ability to generate sufficient cash from operations, financing, or other sources that will meet ongoing obligations over a sustained period. Management has prepared detailed operating and financial plans which combine multifunctional resources as teams to respond better to customer needs, make an investment in product and service opportunities expected to produce a significantly greater return on investment, continue a cost control program begun in 1993, and assume refinancing of the line of credit arrangement on improved terms. Management believes that the successful implementation of this plan will enable the Company to continue as a going concern for a reasonable period. There can be no assurance however, that such activities will achieve the intended improvement in results of operations or financial position. A Prepackaged Plan of Reorganization under Chapter 11 of the Bankruptcy Code (the "Prepackaged Plan") was filed by Adience and the Unofficial Committee of Noteholders of Adience on February 22, 1993. The Prepackaged Plan was confirmed by the United States Bankruptcy Court for the Western District of Pennsylvania on May 4, 1993 and consummated on June 30, 1993. The Prepackaged Plan provided for a restructuring of Adience's capital structure and allowed the holders of $66 million aggregate principal amount of Adience's 15% Senior Subordinated Reset Notes ("Old Reset Notes") to exchange them for $49 million aggregate principal amount of new 11% Senior Secured Notes ("New Secured Notes") due June 15, 2002, plus common stock representing 55% of the outstanding common stock of Adience. The Prepackaged Plan included forgiveness of the accrued interest totaling approximately $8.8 million. The value of the cash and securities distributed was $17.5 million less than the allowed claims; the resultant gain is recorded as an extraordinary gain. Neither Adience Canada, a wholly-owned subsidiary, or Information Display Technology, Inc. (IDT), a majority-owned subsidiary of Adience, guarantee the new 11% Notes issued by Adience under the reorganization plan. The new Notes are secured by a lien on all the assets of Adience, including the stock of IDT. Adience Canada and IDT did not file plans of reorganization. The sum of allowed claims plus post petition liabilities exceeded the reorganization value of the assets of Adience immediately before the date of consummation. Also, the Company experienced a change in control as pre- reorganization holders of common stock received less than 50% of the new common stock issued pursuant to the Prepackaged Plan. AICPA SOP 90-7, Financial Reporting by Entities in Reorganization under the Bankruptcy Code ("SOP 90-7"), requires that under these circumstances, a new reporting entity is created and assets and liabilities should be recorded at their fair values. This accounting treatment is referred to as "fresh start reporting". The Company's basis of accounting for financial reporting purposes changed on June 30, 1993 as a result of applying SOP 90-7. Specifically, application of SOP 90-7 required the adjustment of the Company's assets and liabilities to reflect a reorganization value generally approximating the fair value of the Company as a going concern on an unleveraged basis, the elimination of its retained deficit, and adjustments to its capital structure to reflect consummation of the Prepackaged Plan. Fresh start reporting has not been adopted by Adience Canada and IDT. Adience has applied SOP 90-7 in preparing its consolidated balance sheet as of June 30, 1993. The balance sheet became the opening balance sheet for Adience, Inc., as reorganized, on July 1, 1993. Since the December 31, 1993 consolidated balance sheet has been prepared as if it is a new reporting entity, a solid black line has been shown to separate it from prior year information since it is not prepared on a comparable basis. The consolidated statements of operations and cash flows after June 30, 1993 are not comparable to the respective financial statements prior to such date, and the consolidated results of operations for the six months ended June 30, 1993 and the six months ended December 31, 1993 have therefore not been aggregated. Reorganization value at the June 30, 1993 consummation date was determined by management with the assistance of independent advisors. The methodology employed involved estimation of enterprise value (i.e., the market value of the Company's debt and shareholders' equity), taking into account a discounted cash flow analysis, as well as the capitalization of earnings and cash flow approaches. The discounted cash flow analysis was based on five-year cash flow projections prepared by management. The five-year cash flow projections were based on estimates and assumptions about circumstances and events that have not yet taken place. Such estimates and assumptions are inherently subject to significant economic and competitive uncertainties and contingencies beyond the control of the corporation, including, but not limited to, those with respect to the future courses of the Company's business activity. Accordingly, there will usually be differences between projections and actual results because events and circumstances frequently do not occur as expected; and those differences may be material. The assumptions included: a rate of sales growth of approximately 2.5% per annum in excess of the anticipated rate of inflation; selling, general and administrative expenses, after adjustment for non-recurring items, increase in line with the rate of sales growth; operating profit margins for each of the five years are approximately equal to one half of the average annual operating profit margins achieved during the most recent profitable period of 1988-1990; and effective tax rates of 33%. At June 30, 1993, the adjustment to record confirmation of the plan of $23 million was allocated to assets and liabilities as follows: Current assets and liabilities were recorded at fair value. Property, plant and equipment was recorded at reorganization value, which approximated fair value in continued use, based on an independent appraisal. In addition, under SOP 90-7, the long-term debt was recorded at present values on June 30, 1993. The resulting unamortized discount is being accreted to interest expense over the term of the New Secured Notes (See Note 7). Based on the allocation of equity value in conformity with SOP 90-7, the portion of the equity value which was not attributed to specific tangible or identifiable intangible assets of the reorganized Company of $18,329 was reported as "reorganization value in excess of amounts allocable to identifiable assets". This value was initially being amortized on a straight line basis in equal annual amounts over 9 years. On a quarterly basis, management will continue to evaluate the recoverability of the unamortized portion of the reorganization value in excess of amounts allocable to identifiable assets by comparing actual cash flows with the projected cash flows used to arrive at the reorganization value. Should a material difference exist, management will then consider whether the assumptions made in the preparation of the projected cash flows are still reasonable. If management is of the opinion that new projected cash flows are required and that a permanent impairment of the remaining reorganization value has occurred, a reduction of some or all of the unamortized value will be immediately recognized. In the fourth quarter of 1993, the Company recorded a charge of $8 million to reduce the recorded reorganization value in excess of amounts allocable to identifiable assets based on management's comparison of actual cash flows post- emergence through December 31, 1993, with the projected cash flows used to arrive at the reorganization value. This comparison resulted in the preparation of new cash flow projections, which in turn led the Company to the conclusion that permanent impairment of the reorganization value has occurred and that an immediate reduction of approximately 50% of the remaining unamortized value needs to be recognized. This special charge increased the net loss for the six months ended December 31, 1993 by $8 million or $.80 per share. At December 31, 1993, accumulated amortization was approximately $9,011. The effect of the plan of reorganization and the adoption of the provisions of SOP 90-7 in the Company's consolidated balance sheet as of June 30, 1993 was as follows: The following entries record the provisions of the Plan and the adoption of fresh start reporting: 2. Summary of Significant Accounting Policies Consolidation The consolidated financial statements include the accounts of Adience, Adience Canada and IDT. All material intercompany accounts and transactions have been eliminated from the consolidated financial statements. Cash Flow Reporting Cash and cash equivalents include all highly liquid investments with a maturity of three months or less. Inventories Inventories are stated at the lower of cost or market with cost determined on the first-in, first-out (FIFO) basis. Inventories consist primarily of raw materials of $7,512 and $9,264, work-in-process of $2,374 and $3,311 and finished goods of $8,764 and $6,993 at December 31, 1993 and 1992, respectively. Revenue Recognition Approximately 59% of the six months ended December 31, 1993, 49% of the six months ended June 30, 1993, 55% of 1992 and 26% of 1991 revenues were recorded on the percentage of completion method of accounting, measured on the basis of costs incurred to estimated total costs which approximates contract performance to date. Provisions for losses on uncompleted contracts are made if it is determined that a contract will ultimately result in a loss. Substantially all remaining revenue is comprised of direct product shipments to customers and short duration refractory material sales, installation and maintenance work, which are recorded as revenue when shipped and/or installed. Property, Plant and Equipment Property, plant and equipment was stated at cost. In conjunction with the adoption of fresh start reporting, all property, plant and equipment was adjusted to reflect reorganization value, which approximates fair value in continued use, based on an independent appraisal. Improvements to existing equipment that materially extend the life of properties are capitalized as incurred. Expenditures for normal maintenance and repairs are charged to expense as incurred and amounted to $2,469 for the six months ended December 31, 1993, $2,167 for the six months ended June 30, 1993, $4,401 in 1992 and $4,033 in 1991. Depreciation expense is computed using both accelerated and straight-line methods based upon the estimated useful lives of the respective assets. Amortization of assets under capital leases is included in depreciation expense. Goodwill Goodwill resulting from acquisitions accounted for on the purchase method of accounting, was being amortized over 15 to 40 years on the straight-line method. Goodwill relating to domestic acquisitions was written off in conjunction with fresh start reporting. Remaining goodwill will be amortized over 15 years. Reorganization Value in Excess of Amounts Allocable to Identifiable Assets Reorganization value in excess of amounts allocable to identifiable assets is amortized on a straight-line basis over its estimated useful life (see Note 1). Income Taxes Deferred income taxes are recorded to reflect certain items of income and expense recognized in different periods for financial reporting and tax purposes. Adience accounts for income taxes in accordance with the liability method. In 1992 Adience adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109), which requires an asset and liability approach in accounting for income taxes. Prior to 1992, Adience applied the provisions of SFAS No. 96. There was no cumulative effect for this change in accounting principle as of January 1, 1992. However, as of December 31, 1993 and 1992, a deferred asset was recognized and an offsetting valuation reserve has been established for carryforwards not meeting the "more likely than not" criterion under SFAS No. 109. Reclassifications Certain items in the December 31, 1992 and 1991 financial statements have been reclassified and restated to conform with changes in classification adopted and required in 1993. Earnings Per Common Share Earnings per common share is computed by dividing income or loss by the weighted average number of shares outstanding. Earnings per share for pre-emergence periods is not presented since such information is not comparable with post- emergence earnings per share. 3. Pro Forma Results of Operations (Unaudited) The following consolidating pro forma statement of operations reflects the financial results of the Company as if the reorganization had been effective January 1, 1993: ADIENCE, INC. CONSOLIDATING PRO FORMA STATEMENT OF OPERATIONS (1) Reflects a six month impact of additional depreciation expense resulting from the write-up of property, plant and equipment and the reduction of goodwill amortization which was written off in conjunction with fresh start reporting. (2) Interest expense on reorganized long-term debt. (3) Elimination of the effect of non-recurring reorganization items on operations. 4. Contracts In Progress The status of contract costs on uncompleted construction contracts was as follows: Accounts receivable at December 31, 1993 and 1992 include amounts billed but not yet paid by customers under retainage provisions of approximately $2,989 and $3,338, respectively. Such amounts are generally due within one year. 5. Other Assets Included in other assets are the following: 6. Lines of Credit On the consummation date of the plan of reorganization, June 30, 1993, Adience entered into a financing agreement with Congress, through the twelve month period ending June 30, 1994. Under this agreement, Adience may request loan advances not to exceed the lesser of $12 million or available collateral (80% of eligible accounts receivable less than 90 days plus 30% of raw material and finished goods inventory). The loan is collateralized by accounts receivable, inventory, fixed assets, intangible assets and Adience's shares of IDT. In addition, IDT has guaranteed the Adience line of credit and has pledged as collateral its own accounts receivable, inventory and equipment. The interest rate on the loan is 2.5% over the prime rate (effective rate of 8.5% at December 31, 1993). At December 31, 1993, Adience had borrowed $8,007 under the credit facility. In addition, IDT entered into a financing agreement with Congress, which was also subsequently renewed through June 30, 1994. Under this agreement, IDT may request loan advances not to exceed the lesser of $3 million or available collateral (80% of eligible accounts receivable less than 90 days plus 30% of raw material and finished goods inventory). The loan is collateralized by accounts receivable, inventory and fixed assets. Adience guarantees IDT's debt to Congress. The interest rate on the loan is 2.5% over the prime rate. At December 31, 1993, there were no borrowings outstanding under this agreement. Both Adience and IDT pay commitment fees on the unused portion of their credit facility of 0.5%. Under the terms of the financing agreements, both companies are required to maintain certain financial ratios and meet other financial conditions. The agreements do not allow the companies to incur certain additional indebtedness, pay cash dividends, make certain investments, advances or loans and limits annual capital expenditures. As of December 31, 1993, Adience and IDT were in compliance with the covenants of their respective agreements. Adience's ability to continue to comply with such conditions is dependent upon Adience's ability to achieve specified levels of sales, profitable operations and borrowing availability. Waivers or amendments may be required in the future to ensure compliance. Inability to achieve compliance could affect Adience's access to further borrowings or require it to secure additional capital by other means. Both companies anticipate the financing agreements with Congress will be renewed at June 30, 1994 or, alternatively, both companies will be able to secure financing from other sources. However, no commitment letters have been requested or received. 7. Long-Term Obligations and Liabilities Subject to Compromise Long-term obligations consisted of the following: In connection with the Plan of Reorganization, $49,079 of New Senior Secured Notes with an annual interest rate of 11% were issued under an indenture agreement dated as of June 30, 1993. The New Secured Notes are redeemable at the option of Adience after December 15, 1997. The New Secured Notes are not guaranteed by the subsidiaries of Adience. The New Secured Notes are secured by a lien on all the assets of Adience, including the stock of IDT. Adience, on a consolidated basis, has agreed to certain restrictive covenants which are ordinary to such financings including, among other things, limitations on additional indebtedness, limitations on asset sales and restrictions on the payment of dividends. Principal maturities of long-term obligations are as follows: Property, plant and equipment at December 31, 1993 and 1992 includes equipment, automobiles and trucks under capital leases with a net book value of $1,642 and $1,387, respectively. During the six months ended December 31 and June 30 1993, and the years ended 1992 and 1991 Adience incurred capital lease obligations of $309, $119, $565 and $1,241, respectively. 8. Operating Leases Adience leases certain buildings, machinery, and equipment under both short- and long-term lease arrangements. Future minimum lease commitments under non- cancelable operating leases are not significant. Rental expense relating to such leases was approximately $1.2 million for the six months ended December 31, 1993, $1.0 million for the six months ended June 30, 1993, $2.0 million in 1992 and $4.8 million in 1991. 9. Discontinued Operations During 1992, the Company's Geotec operation was sold for approximately $1.1 million in cash and $1.2 million in notes receivable, after concluding that Geotec's operations no longer fit Adience's long-term growth plans. In addition, the Company's Hotworks division, which provided preheating services to refractory maintenance companies, was sold during 1992 for $1.2 million in cash. During the six months ended December 31, 1993 and June 30, 1993, adjustments to the previously reported loss were made on these sales of approximately $84 and $400, respectively, which has been reflected as an additional loss on the disposal of discontinued operations in the consolidated statements of operations. In November 1991, Adience sold its wholly owned subsidiary, Energy Technology, Inc. (Entec), for approximately $6.5 million. In addition, during 1991, Adience sold certain assets and all of the businesses of its Texas operations (Texops), Chemsteel, Inc., and Ward Duct Connectors, Inc. During 1992, an adjustment to the previously reported gain was made on these sales of approximately $1.1 million, which has been reflected as an additional loss on disposal of discontinued operations in the consolidated statement of operations. The operating results of the discontinued operations are shown separately in the accompanying consolidated statements of operations. Prior year's statements of operations and related footnotes have been restated for comparative purposes. Net revenues of discontinued operations were $13,180 and $65,232 in 1992 and 1991, respectively. 10. Related Party Transactions Note receivable from the principal shareholder of Adience (current portion included in "Prepaid expenses, deposits and other"; 1993--$515; long-term portion included in "Other assets"; 1993--$669 and 1992--$1,116) is payable in semi-annual installments of principal and interest based on an amortization period of five years, with all remaining amounts outstanding due and payable on December 31, 1997. In connection with the plan of reorganization, Adience entered into a new multi- year agreement, to be effective as of October 1, 1992, with the principal shareholder and a severance compensation agreement with his son for a period of seven and five years, respectively. The present value of these payments has been reflected in "Reorganization items-other" and total approximately $4.8 million for the year ended December 31, 1992. 11. Research and Development Expense Adience incurred research and development expense of $541, $541, $1,191 and $1,660 for the six months ended December 31 and June 30, 1993 and years ended December 31, 1992 and 1991, respectively, which amounts have been included in cost of revenues. 12. Income Taxes (Loss) income from continuing operations before income taxes, minority interest in subsidiary and extraordinary item consisted of: Federal, foreign, and state income taxes (benefits) from continuing operations consisted of the following: The effective income tax rate from continuing operations varied from the statutory federal income tax (benefit) rate as follows: Deferred tax liabilities (assets) are comprised of the following at December 31: SFAS 109 requires a valuation allowance when it is "more likely than not that some portion or all of the deferred tax assets will not be realized." It further states that "forming a conclusion that a valuation allowance is not needed is difficult when there is negative evidence such as cumulative losses in recent years." The ultimate realization of this deferred income tax asset depends on the Company's ability to generate sufficient taxable income in the future. While the Company believes that the deferred income tax asset will be fully or partially realized by future operating results, losses in recent years and a desire to be conservative make it appropriate to record a valuation allowance. As of December 31, 1993, Adience has a net operating loss carryforward for domestic federal income tax purposes of approximately $13,000 which will expire in 2007 and 2008. Minimum tax and foreign tax credits of $945 are also available to offset federal income tax liabilities to the extent that regular tax exceeds tentative minimum tax in subsequent years. Upon consummation of the plan of reorganization, Adience had an ownership change, as defined by Section 382 of the Internal Revenue Code, which may limit Adience's ability to utilize the pre-ownership change portion of its net operating loss and/or credit. In addition under the provisions of SOP 90-7, subsequent utilization of net operating loss carryforwards will be reflected as an adjustment to reorganization value in excess of amounts allocable to identifiable assets or paid-in capital. An examination of Adience's consolidated U.S. income tax returns for 1988 through 1990 is currently underway. Any resulting adjustments for those years will impact Adience's net operating loss carryforwards. 13. Employee Benefits Employee Stock Ownership Plan During 1989, Adience established an Employee Stock Ownership Plan (ESOP) for most salaried and certain hourly U.S. employees who meet minimum age and service requirements. To fund the ESOP, Adience borrowed $2.5 million repayable over five years in equal quarterly payments plus interest. Proceeds of this borrowing were loaned to the ESOP on the same terms and used by the ESOP, along with cash contributions from Adience, to purchase 646,875 shares of Adience's common stock from its principal shareholder during 1990 and 1989. Effective June 30, 1993 all shares held by the ESOP were allocated to the ESOP participants' accounts. On July 1, 1993, the Company suspended any future recognition of expense related to the ESOP. Accordingly, the Company has no intention at this time to issue more shares of its common stock to the ESOP. Contributions to the ESOP charged to expense for the six months ended December 31 and June 30, 1993 and the years ended 1992 and 1991 amounted to $0, $470, $863 and $918, respectively. Contributions by Adience to the ESOP were used to make loan interest and principal payments. With each principal and interest payment, a portion of the common stock was allocated to participating employees. During 1991, Adience repaid the outstanding balance on the ESOP note. Interest expense on the ESOP borrowings amounted to approximately $81 for 1991. Other Employee Benefit Plans During 1992, Adience initiated a 401(k) Savings Plan. This plan covers substantially all non-bargaining employees, including those employed by IDT, who meet minimum age and service requirements. The Company matches employee contributions of up to 8 percent of compensation at a rate of 25 percent. Amounts charged against income totaled $79 for the six months ended December 31, 1993, $84 for the six months ended June 30, 1993 and $105 for the year ended December 31, 1992. Adience and subsidiaries maintain various defined benefit pension plans covering substantially all hourly employees. The plans provide pension benefits based on the employee's years of service or the average salary for a specific number of years of service. Adience's funding policy is to make annual contributions to the extent deductible for federal income tax purposes. Plan assets and projected benefit obligations for service to date for Adience's defined benefit pension plans aggregated approximately $7,466 and $6,220, respectively, at December 31, 1993. The comparable amounts at December 31, 1992 were $6,980 (assets) and $5,573 (obligations). The components of net periodic pension cost for the six months ended December 31 and June 30, 1993 and the years ended December 31, 1992 and 1991 are not material to the consolidated financial statements. Certain union employees of Adience and subsidiaries are covered by multi- employer defined benefit retirement plans. Expense relating to these plans amounted to $828, $632, $1,037 and $1,421 for the six months ended December 31, 1993 and June 30, 1993 and the years ended December 31, 1992 and 1991, respectively. In December 1990, the Financial Accounting Standards Board issued SFAS No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions" (SFAS No. 106), that requires that the projected future cost of providing postretirement benefits, such as health care and life insurance, be recognized as an expense as employees render service instead of when the benefits are paid. The Company currently provides only life insurance benefits to certain of its hourly and salaried employees on a fully insured basis. Adoption of SFAS No. 106 did not have a material impact on the Company's consolidated financial statements. In November 1992, the Financial Accounting Standards Board issued new rules that require that the projected future cost of providing postemployment benefits be recognized as an expense as employees render service instead of when the benefits are paid. The Company believes its accrual for postemployment benefits (workers' compensation) is adequate. 14. Commitments and Contingencies At December 31, 1993, Adience had $1,700 in irrevocable standby letters of credit outstanding, not reflected in the accompanying consolidated financial statements, as guarantees in force for various insurance policies, performance and bid bonds. These instruments are usually for a period of one year or the duration of the contract. The letters of credit reduce Adience's availability under the Congress credit facility. In February 1992, IDT was cited by the Ohio Environmental Protection Agency (the "Ohio EPA") for violations of Ohio's hazardous waste regulations, including speculative accumulation of waste and illegal disposal of hazardous waste on the site of its Alliance, Ohio facility. IDT had $1,106 accrued at December 31, 1992 for the clean up of this site. In December 1993, IDT and Adience signed a consent order with the Ohio EPA and Ohio Attorney General which required IDT and Adience to pay to the State of Ohio a civil penalty of $200 (of which IDT paid $175 and Adience paid $25). In addition, the consent order requires the payment of stipulated penalties of up to $1 per day for failure to satisfy certain requirements of the consent order including milestones in the closure plan. IDT expects that the work to be conducted under the closure plan will be substantially completed in 1994, subject to IDT receiving all necessary approvals from the Ohio EPA. At December 31, 1993, environmental accruals amounted to $783 which represents management's reasonable estimate of the amounts remaining to be incurred in this matter, including the costs of effecting the closure plan, bonding and insurance costs, penalties and legal and consultants' fees. Since 1991, Adience and IDT have together paid $341 (excluding the civil penalty) for the environmental clean-up related to the Alliance facility. Under the acquisition agreement pursuant to which IDT acquired the property from Adience, Adience represented and warranted that, except as otherwise disclosed to IDT, no hazardous material has been stored or disposed of on the property. No disclosure of storage or disposal of hazardous material on the site was made, accordingly, Adience is required to indemnify IDT for any losses in excess of $250. IDT has notified Adience that it is claiming the right to indemnification for all costs in excess of $250 incurred by IDT in this matter, and has received assurance that Adience will honor such claim. Adience has reimbursed IDT $196; if Adience is financially unable to honor its remaining obligation, such costs would be borne by IDT. Adience is also engaged in various other legal actions arising in the ordinary course of business. Management believes after discussions with internal and external counsel that the ultimate outcome of the proceedings will not have a material adverse effect on Adience's consolidated financial position. 15. Industry Segment Data Adience operates in two principal industries-heat technology and through IDT's information display products. All operations in a third industry, the industrial services and products division, were divested by the end of 1992. The heat technology division is engaged in the production, installation, and maintenance of specialty refractory products, principally for the ferrous and nonferrous metal industries, throughout the United States and Canada. The information display segment manufactures and installs writing and projection surfaces, custom cabinets, and external architectural building panels. The information display segment's primary markets are educational facilities and healthcare institutions. The 1991 income statement related data has been restated to reflect continuing operations. See Note 9. Substantially all revenues (91% in 1993) are recorded by domestic operations with the balance by Canadian operations. Intersegment revenues are accounted for at prices comparable to unaffiliated customer sales. Operating (loss) profit is total revenues less operating expenses, excluding interest. Adience performs certain management and administrative services for IDT. The fee paid by IDT for these services has been charged at the rate of $300 per annum in 1993 and $135 per annum in 1992 and 1991. Corporate assets consist primarily of notes receivable, property, plant and equipment and reorganization value in excess of amounts allocable to identifiable assets. Adience's products are sold and revenues are derived from companies in diversified industries. Credit is extended to customers based upon an evaluation of the customers' financial condition and generally collateral is not required. At December 31, 1993 and 1992, accounts receivable from customers in the steel and steel-related industries total approximately $9,548 and $9,521, respectively. Credit losses relating to customers in the steel and steel- related industries have been within management's expectations. Note 16 - Quarterly Data and Fourth Quarter Adjustments (Unaudited) The following table sets forth selected highlights for each of the fiscal quarters during the six months ended June 30 and December 31, 1993 and the year ended December 31, 1992: Net earnings (loss) per common share for the fourth quarter of 1993 included a special charge of $8 million for write-down of the Company's reorganization value in excess of amounts allocable to identifiable assets and a $314 loss on the sale of two divisions. Excluding these adjustments, net earnings (loss) per common share for the fourth quarter was $(0.38). Net loss for the fourth quarter of 1992 included a charge of $5.8 million related to the Company's impending restructuring under the Prepackaged Plan and a $2.3 million charge for insurance expense related to the Company's self- insurance programs for workers' compensation and general liability coverage. Additionally, fourth quarter results were reduced by a pre-tax charge for business divestitures of $2.4 million, a $1.2 million write-down in the value of property, plant and equipment and a $1.1 million charge for the environmental issue at one of the Company's facilities. Excluding these special items, the net loss for the fourth quarter and the year was $9.4 million and $17.1 million, respectively. * Earnings per common share are not meaningful prior to June 30, 1993 due to the reorganization - see Note 1. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Not applicable. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant Information concerning the directors and executive officers of the Company required by this item is incorporated by reference to the material appearing under the heading "Election of Directors" in the Company's Proxy Statement for the 1994 Annual Meeting of its Shareholders. Item 11.

Item 11. Executive Compensation Information required by this item is incorporated by reference to the material appearing under the heading "Executive Compensation" in the Company's Proxy Statement for the 1994 Annual Meeting of its Shareholders, except for Compensation Committee Report and Performance Graph set forth therein, which are not deemed incorporated herein and shall not be deemed filed for purposes of this report. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management Information required by this item is incorporated by reference to the material appearing under the heading "Principal Shareholders" in the Company's Proxy Statement for the 1994 Annual Meeting of its Shareholders. Item 13.

Item 13. Certain Relationships and Related Transactions Information required by this item is incorporated by reference to the material appearing under the heading "Certain Transactions" in the Company's Proxy Statement for the 1994 Annual Meeting of its Shareholders. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K The financial statements, financial statement schedules and exhibits listed below are filed as part of this annual report: (a)(1) Financial Statements: The consolidated financial statements of the Company and its subsidiaries, including a list of such financial statements, are contained in Item 8 of this annual report, and the index thereto is hereby incorporated by reference. (a)(2) Financial Statement Schedules: All other Financial Statement Schedules are omitted either because they are not applicable or are not material, or the information required therein is contained in the consolidated financial statements or notes thereto set forth in Item 8 hereto. (a)(3) Exhibits: Exhibit No. Description 2.1 Plan of Reorganization, as Further Modified, dated May 4, 1993 filed as Exhibit 2.1 to Registration Statement No. 33-72024 (the Registration Statement) and incorporated by reference. 3.1 Restated Certificate of Incorporation of Adience, Inc. filed as Exhibit 3.1 to the Registration Statement and incorporated by reference. 3.2 By-laws of Adience, Inc., filed as Exhibit 3.2 to the Registration Statement incorporated by reference. 4.1 Specimen Common Stock Certificate, filed as Exhibit 4.1 to the Registration Statement incorporated by reference. 4.2 Indenture, dated as of June 30, 1993, between Adience, Inc. and IBJ Schroder Bank & Trust Company, filed as Exhibit 4.2 to the Registration Statement incorporated by reference. 4.3 Specimen Form of Senior Secured Note, filed as Exhibit 4.3 to the Registration Statement incorporated by reference. 10.1 Accounts Financing Agreement [Security Agreement], dated June 30, 1993, between Congress Financial Corporation and Adience, Inc. filed as Exhibit 10.1 to the Registration Statement incorporated by reference. 10.2 Covenant Supplement to Accounts Financing Agreement [Security Agreement], dated June 30, 1993, between Adience, Inc. and Congress Financial Corporation, filed as Exhibit 10.2 to the Registration Statement incorporated by reference. 10.3 Restatement and Acknowledgment, dated June 30, 1993, among Adience, Inc., Information Display Technology, Inc. and Congress Financial Corporation, filed as Exhibit 10.3 to the Registration Statement incorporated by reference. 10.4 Inventory and Equipment Security Agreement Supplement to Accounts Financing Agreement [Security Agreement], dated June 30, 1993, between Adience, Inc. and Congress Financial Corporation, filed as Exhibit 10.4 to the Registration Statement incorporated by reference. 10.5 Trade Financing Agreement Supplement to Accounts Financing Agreement [Security Agreement], dated June 30, 1003, between Adience, Inc. and Congress Financial Corporation, filed as Exhibit 10.5 to the Registration Statement incorporated by reference. 10.6 Amendment to Trademark Collateral Assignment and Security Agreement, dated as of June 30, 1993, between Adience, Inc. and Congress Financial Corporation, filed as Exhibit 10.6 to the Registration Statement incorporated by reference. 10.7 Amendment to Patent Collateral Assignment and Security Agreement, dated as of June 30, 1993, between Adience, Inc. and Congress Financial Corporation, filed as Exhibit 10.7 to the Registration Statement incorporated by reference. 10.8 Pledge and Security Agreement, dated June 30, 1993, between Adience, Inc. and Congress Financial Corporation, filed as Exhibit 10.8 to the Registration Statement incorporated by reference. 10.9 Guarantee and Waiver, dated June 30, 1993, by Information Display Technology, Inc. to Congress Financial Corporation, filed as Exhibit 10.9 to the Registration Statement incorporated by reference. 10.10 Accounts Financing Agreement [Security Agreement], dated June 30, 1993, between Congress Financial Corporation and Information Display Technology, Inc., filed as Exhibit 10.9 to the Registration Statement incorporated by reference. 10.11 Covenant Supplement to Accounts Financing Agreement [Security Agreement], dated June 30, 1993, between Information Display Technology, Inc. and Congress Financial Corporation, filed as Exhibit 10.11 to the Registration Statement incorporated by reference. 10.12 Restatement and Acknowledgment, dated June 30, 1993, among Information Display Technology, Inc., Adience, Inc. and Congress Financial Corporation, filed as Exhibit 10.12 to the Registration Statement incorporated by reference. 10.13 Inventory and Equipment Security Agreement Supplement to Accounts Financing Agreement [Security Agreement], dated June 30, 1993, between Information Display Technology, Inc. and Congress Financial Corporation, filed as Exhibit 10.13 to the Registration Statement incorporated by reference. 10.14 Trade Financing Agreement Supplement to Accounts Financing Agreement [Security Agreement], dated June 30, 1993, between Information Display Technology, Inc. and Congress Financial Corporation, filed as Exhibit 10.14 to the Registration Statement incorporated by reference. 10.15 Amendment to Trademark Collateral Assignment and Security Agreement, dated June 30, 1993, between Information Display Technology, Inc. and Congress Financial Corporation, filed as Exhibit 10.15 to the Registration Statement incorporated by reference. 10.16 Guarantee and Waiver, dated June 30, 1993, by Adience, Inc. to Congress Financial Corporation, filed as Exhibit 10.16 to the Registration Statement incorporated by reference. 10.17 Amendment to Open-End Mortgage and Security Agreement, dated as of June 30, 1993, between Congress Financial Corporation and Adience, Inc., filed as Exhibit 10.17 to the Registration Statement incorporated by reference. 10.18 Security Agreement, dated June 30, 1993, between Congress Financial Corporation and Adience Canada, Inc., filed as Exhibit 10.18 to the Registration Statement incorporated by reference. 10.19 Guarantee, dated June 30, 1993, by Adience Canada, Inc. to Congress Financial Corporation, filed as Exhibit 10.19 to the Registration Statement incorporated by reference. 10.20 Security Agreement, dated as of June 30, 1993, between Adience, Inc. and IBJ Schroder Bank & Trust Company, as trustee, filed as Exhibit 10.20 to the Registration Statement incorporated by reference. 10.21 Trademark Collateral Assignment and Security Agreement, dated June 30, 1993, between Adience, Inc. and IBJ Schroder Bank & Trust Company, as trustee, filed as Exhibit 10.21 to the Registration Statement incorporated by reference. 10.22 Patent Collateral Assignment and Security Agreement, dated June 30, 1993, between Adience, Inc. and IBJ Schroder Bank & Trust Company, as trustee, filed as Exhibit 10.22 to the Registration Statement incorporated by reference. 10.23 Pledge and Security Agreement, dated as of June 30, 1993, between Adience, Inc. and IBJ Schroder Bank & Trust Company, as trustee, filed as Exhibit 10.23 to the Registration Statement incorporated by reference. 10.24 Employment Agreement, dated as of February 25, 1992, between Willard M. Bellows and Adience, Inc., filed as Exhibit 10.24 to the Registration Statement incorporated by reference. 10.25 Employment Agreement, dated as of February 25, 1992, between Stephen M. Grimshaw and Adience, Inc., filed as Exhibit 10.25 to the Registration Statement incorporated by reference. 10.26 Employment Agreement, dated as of February 25, 1992, between Charles C. Torie and Adience, Inc., filed as Exhibit 10.26 to the Registration Statement incorporated by reference. 10.27 Profit Sharing Plan of Adience, Inc., filed as Exhibit 10.27 to the Registration Statement incorporated by reference. 10.28 Employees Stock Ownership Plan of Adience, Inc., filed as Exhibit 10.28 to the Registration Statement incorporated by reference. 24.1 Consent of Ernst & Young. The Company agrees to furnish to the Commission upon request copies of all instruments defining the rights of holders of long-term debt of the Company and its subsidiaries which are not filed as a part of this annual report. (b) Reports on Form 8-K: None SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ADIENCE, INC. By: /s/ Fletcher L. Byrom -------------------------- Fletcher L. Byrom Chairman of the Board of Directors and Chief Executive Officer Date: March 29, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company in the capacities indicated as of March 29, 1994: /s/ Harry Holiday, Jr. - ------------------------------ ------------------------------ Harry Holiday, Jr. Herbert T. Kerr Director Director /s/ James B. Upchurch - ------------------------------ ------------------------------ James B. Upchurch James H. McConomy Director Director /s/ A. Stanley West - ------------------------------ ------------------------------ A. Stanley West Gregory D. Curtis Director Director /s/ Stephen M. Grimshaw /s/ Fletcher L. Byrom - ------------------------------ ------------------------------ Stephen M. Grimshaw Fletcher L. Byrom Vice President-Finance and Treasurer Director (Principal Financial Officer (Principal Executive Officer) and Principal Accounting Officer) EXHIBITS TO FORM 10-K ADIENCE, INC. ADIENCE, INC. FORM 10-K FOR FISCAL YEAR ENDED DECEMBER 31, 1991 EXHIBIT LIST The following exhibits are required to be filed with this annual report on Form 10-K. Exhibits are incorporated herein by reference to other documents pursuant to Rule 12b-32 under the Securities Exchange Act of 1934, as amended, as indicated in the list. Exhibits not incorporated herein by reference follow the list. The page numbers where each such exhibit may be found under the Commission's sequential numbering system are also indicated. Exhibit No. Description - ----------- ----------- 2.1 Plan of Reorganization, as Further Modified, dated May 4, 1993 filed as Exhibit 2.1 to Registration Statement No. 33-72024 (the Registration Statement) and incorporated by reference. 3.1 Restated Certificate of Incorporation of Adience, Inc. filed as Exhibit 3.1 to the Registration Statement and incorporated by reference. 3.2 By-laws of Adience, Inc., filed as Exhibit 3.2 to the Registration Statement incorporated by reference. 4.1 Specimen Common Stock Certificate, filed as Exhibit 4.1 to the Registration Statement incorporated by reference. 4.2 Indenture, dated as of June 30, 1993, between Adience, Inc. and IBJ Schroder Bank & Trust Company, filed as Exhibit 4.2 to the Registration Statement incorporated by reference. 4.3 Specimen Form of Senior Secured Note, filed as Exhibit 4.3 to the Registration Statement incorporated by reference. 10.1 Accounts Financing Agreement [Security Agreement], dated June 30, 1993, between Congress Financial Corporation and Adience, Inc. filed as Exhibit 10.1 to the Registration Statement incorporated by reference. 10.2 Covenant Supplement to Accounts Financing Agreement [Security Agreement], dated June 30, 1993, between Adience, Inc. and Congress Financial Corporation, filed as Exhibit 10.2 to the Registration Statement incorporated by reference. 10.3 Restatement and Acknowledgment, dated June 30, 1993, among Adience, Inc., Information Display Technology, Inc. and Congress Financial Corporation, filed as Exhibit 10.3 to the Registration Statement incorporated by reference. 10.4 Inventory and Equipment Security Agreement Supplement to Accounts Financing Agreement [Security Agreement], dated June 30, 1993, between Adience, Inc. and Congress Financial Corporation, filed as Exhibit 10.4 to the Registration Statement incorporated by reference. 10.5 Trade Financing Agreement Supplement to Accounts Financing Agreement [Security Agreement], dated June 30, 1993, between Adience, Inc. and Congress Financial Corporation, filed as Exhibit 10.5 to the Registration Statement incorporated by reference. 10.6 Amendment to Trademark Collateral Assignment and Security Agreement, dated as of June 30, 1993, between Adience, Inc. and Congress Financial Corporation, filed as Exhibit 10.6 to the Registration Statement incorporated by reference. 10.7 Amendment to Patent Collateral Assignment and Security Agreement, dated as of June 30, 1993, between Adience, Inc. and Congress Financial Corporation, filed as Exhibit 10.7 to the Registration Statement incorporated by reference. 10.8 Pledge and Security Agreement, dated June 30, 1993, between Adience, Inc. and Congress Financial Corporation, filed as Exhibit 10.8 to the Registration Statement incorporated by reference. 10.9 Guarantee and Waiver, dated June 30, 1993, by Information Display Technology, Inc. to Congress Financial Corporation, filed as Exhibit 10.9 to the Registration Statement incorporated by reference. 10.10 Accounts Financing Agreement [Security Agreement], dated June 30, 1993, between Congress Financial Corporation and Information Display Technology, Inc., filed as Exhibit 10.9 to the Registration Statement incorporated by reference. 10.11 Covenant Supplement to Accounts Financing Agreement [Security Agreement], dated June 30, 1993, between Information Display Technology, Inc. and Congress Financial Corporation, filed as Exhibit 10.11 to the Registration Statement incorporated by reference. 10.12 Restatement and Acknowledgment, dated June 30, 1993, among Information Display Technology, Inc., Adience, Inc. and Congress Financial Corporation, filed as Exhibit 10.12 to the Registration Statement incorporated by reference. 10.13 Inventory and Equipment Security Agreement Supplement to Accounts Financing Agreement [Security Agreement], dated June 30, 1993, between Information Display Technology, Inc. and Congress Financial Corporation, filed as Exhibit 10.13 to the Registration Statement incorporated by reference. 10.14 Trade Financing Agreement Supplement to Accounts Financing Agreement [Security Agreement], dated June 30, 1993, between Information Display Technology, Inc. and Congress Financial Corporation, filed as Exhibit 10.14 to the Registration Statement incorporated by reference. 10.15 Amendment to Trademark Collateral Assignment and Security Agreement, dated June 30, 1993, between Information Display Technology, Inc. and Congress Financial Corporation, filed as Exhibit 10.15 to the Registration Statement incorporated by reference. 10.16 Guarantee and Waiver, dated June 30, 1993, by Adience, Inc. to Congress Financial Corporation, filed as Exhibit 10.16 to the Registration Statement incorporated by reference. 10.17 Amendment to Open-End Mortgage and Security Agreement, dated as of June 30, 1993, between Congress Financial Corporation and Adience, Inc., filed as Exhibit 10.17 to the Registration Statement incorporated by reference. 10.18 Security Agreement, dated June 30, 1993, between Congress Financial Corporation and Adience Canada, Inc., filed as Exhibit 10.18 to the Registration Statement incorporated by reference. 10.19 Guarantee, dated June 30, 1993, by Adience Canada, Inc. to Congress Financial Corporation, filed as Exhibit 10.19 to the Registration Statement incorporated by reference. 10.20 Security Agreement, dated as of June 30, 1993, between Adience, Inc. and IBJ Schroder Bank & Trust Company, as trustee, filed as Exhibit 10.20 to the Registration Statement incorporated by reference. 10.21 Trademark Collateral Assignment and Security Agreement, dated June 30, 1993, between Adience, Inc. and IBJ Schroder Bank & Trust Company, as trustee, filed as Exhibit 10.21 to the Registration Statement incorporated by reference. 10.22 Patent Collateral Assignment and Security Agreement, dated June 30, 1993, between Adience, Inc. and IBJ Schroder Bank & Trust Company, as trustee, filed as Exhibit 10.22 to the Registration Statement incorporated by reference. 10.23 Pledge and Security Agreement, dated as of June 30, 1993, between Adience, Inc. and IBJ Schroder Bank & Trust Company, as trustee, filed as Exhibit 10.23 to the Registration Statement incorporated by reference. 10.24 Employment Agreement, dated as of February 25, 1992, between Willard M. Bellows and Adience, Inc., filed as Exhibit 10.24 to the Registration Statement incorporated by reference. 10.25 Employment Agreement, dated as of February 25, 1992, between Stephen M. Grimshaw and Adience, Inc., filed as Exhibit 10.25 to the Registration Statement incorporated by reference. 10.26 Employment Agreement, dated as of February 25, 1992, between Charles C. Torie and Adience, Inc., filed as Exhibit 10.26 to the Registration Statement incorporated by reference. 10.27 Profit Sharing Plan of Adience, Inc., filed as Exhibit 10.27 to the Registration Statement incorporated by reference. 10.28 Employees Stock Ownership Plan of Adience, Inc., filed as Exhibit 10.28 to the Registration Statement incorporated by reference. 24.1 Consent of Ernst & Young. SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, AND EMPLOYEES OTHER THAN RELATED PARTIES ADIENCE, INC. (THOUSANDS OF DOLLARS, EXCEPT IN NOTES) (1) As part of the Prepackaged Plan of Reorganization, Adience agreed to enter into a new multi-year agreement, to be effective as of October 1, 1992, with Herbert T. Kerr in substitution for Mr. Kerr's existing employment agreements with Adience and IDT. The Kerr agreement, which is still being negotiated, calls for semi-annual payments of principal and interest at the annual prime rate on loans previously made to Mr. Kerr by Adience in the aggregate principal amount of approximately $880,000. Interest on the principal amount of such loans that accrued from the date of the making of these loans through December 31, 1992 has been added to the principal of such loans. Mr. Kerr's payment obligations were to begin on June 30, 1993. Beginning with January 15, 1994, payments due have been offset against Adience's obligation under Mr. Kerr's new multi-year agreement, pending the completion of the Kerr agreement. See Schedule IV for details regarding Adience's indebtedness to Mr. Kerr. (2) Up to $34,000 of this note was payable annually on or before April 30 of each year if certain conditions in Mr. Suddarth's employment agreement were met. Mr. Suddarth's employment agreement was terminated during October 1992, and any amounts due Mr. Suddarth under his employment agreement were offset against the Note. (3) Note was written off in accordance with the settlement reached for the termination of Mr. Ward's employment agreement during 1991. (4) Note does not bear interest. (5) Note is collateralized by accounts receivable of the debtor. The payment terms of the note have been renegotiated so that monthly payments of $25,211 are to be made beginning with February 1, 1994. SCHEDULE IV - INDEBTEDNESS OF AND TO RELATED PARTIES - NOT CURRENT ADIENCE, INC. (THOUSANDS OF DOLLARS, EXCEPT IN NOTES) (1) As part of the Prepackaged Plan of Reorganization, Adience agreed to enter into a new multi-year agreement, to be effective as of October 1, 1992, with Herbert T. Kerr in substitution for Mr. Kerr's existing employment agreements with Adience and IDT. The Kerr agreement, which is still being negotiated, is to provide for annual compensation of $750,000 plus certain other items of non-cash compensation, and for certain rights upon termination. SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT ADIENCE, INC. (THOUSANDS OF DOLLARS) (1) As discussed in Note 1 to the consolidated financial statements, in conjunction with the adoption of fresh start reporting, all property, plant and equipment was adjusted to fair value on a continued use basis, based on an independent appraisal. (2) Adjustment to book basis for write-down of buildings and machinery and equipment for a facility which was anticipated to close during 1993. (3) Depreciation expense is computed using both accelerated and straight-line methods based upon the estimated useful lives of the respective assets. Amortization of assets under capital leases is included in depreciation expense. (4) Reclassification. SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT ADIENCE, INC. (THOUSANDS OF DOLLARS, EXCEPT IN NOTES) (1) As discussed in Note 1 to the consolidated financial statements, in conjunction with the adoption of fresh start reporting, all property, plant and equipment was adjusted to fair value on a continued use basis, based on an independent appraisal. (2) Adjustment to book basis for write-down of buildings and machinery and equipment for a facility which was anticipated to close during 1993. (3) Depreciation expense is computed using both accelerated and straight-line methods based upon the estimated useful lives of the respective assets. Amortization of assets under capital leases is included in depreciation expense. SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS ADIENCE, INC. (THOUSANDS OF DOLLARS, EXCEPT IN NOTES) (1) Uncollectible accounts written off, net of recoveries. (2) Payments made related to the Ohio EPA Consent Order (see Note 14 to the Consolidated Financial Statements). SCHEDULE IX - SHORT-TERM BORROWINGS ADIENCE, INC. (THOUSANDS OF DOLLARS, EXCEPT IN NOTES) (1) Under the Company's current revolving credit agreement, it can borrow up to a maximum of $15,000,000. Any borrowings are collateralized by fixed assets, accounts receivable and inventory. The present credit facility has a June 30,1994 termination dale. The former revolving credit agreement had a maximum limit of $25,000,000 and was secured by accounts receivable and inventory. It was terminated December 19, 1991. (2) The average amount outstanding during the period was computed by dividing the total month-end outstanding principal balances by 12 or 6. (3) The weighted average interest rate during the period was computed by dividing the actual interest expense for short-term borrowings by the average short-term debt outstanding. (4) At December 31 and June 30,1993 and December 31, 1992 outstanding checks of approximately $1,178,000, $2,184,000 and $1,338,000, respectively, were reclassed to the balance sheet caption "Revolving lines of credit".

59478_1993.txt

59478

1993

Item 1. BUSINESS Eli Lilly and Company was incorporated in 1901 under the laws of Indiana to succeed to the drug manufacturing business founded in Indianapolis, Indiana, in 1876 by Colonel Eli Lilly. The Company*, including its subsidiaries, is engaged in the discovery, development, manufacture, and sale of products in one industry segment - Life Sciences. Products are manufactured or distributed through owned or leased facilities in the United States, Puerto Rico, and 27 other countries, in 19 of which the Company owns or has an interest in manufacturing facilities. Its products are sold in approximately 120 countries. Most of the Company's products were discovered or developed through the Company's research and development activities, and the success of the Company's business depends to a great extent on the introduction of new products resulting from these research and development activities. Research efforts are primarily directed toward the discovery of products to diagnose and treat diseases in human beings and animals and to increase the efficiency of animal food production. Research efforts are also directed toward developing medical devices. FINANCIAL INFORMATION RELATING TO INDUSTRY SEGMENTS AND CLASSES OF PRODUCTS Financial information relating to industry segments and classes of products, set forth in the Company's 1993 Annual Report at pages 18-19 under "Review of Operations - Segment Information" (pages 12-13 of Exhibit 13 to this Form 10-K), is incorporated herein by reference. Due to several factors, including the introduction of new products by the Company and other manufacturers, the relative contribution of any particular Company product to consolidated net sales is not necessarily constant from year to year, and its contribution to net income is not necessarily the same as its contribution to consolidated net sales. PRODUCTS Pharmaceutical Products Pharmaceutical products include Anti-infectives, including the oral cephalosporin antibiotics Ceclor (Registered), Keflex(Registered), and Keftab(Registered), used in the treatment of a wide range of bacterial infections; the oral carbacephem antibiotic Lorabid(Trademark), used to treat a variety of infections; the injectable cephalosporin antibiotics Mandol(Registered), Tazidime(Registered), Kefurox(Registered), and Kefzol(Registered), used to treat a wide range of infections in the hospital setting; Nebcin(Registered), an injectable aminoglycoside antibiotic used in hospitals to treat a broad range of infections caused by staphylococci and Gram-negative bacteria; and Vancocin(Registered) HCl, an antibiotic used primarily to treat staphylococcal infections; Central-nervous-system agents, including the antidepressant agent Prozac(Registered), a highly specific serotonin uptake inhibitor, indicated for the treatment of depression and, in certain countries, for bulimia and obsessive-compulsive disorder; and the analgesic Darvocet- N(Registered) 100, which is indicated for the relief of mild-to-moderate pain; * The terms "Company" and "Registrant" are used interchangeably herein to refer to Eli Lilly and Company or to Eli Lilly and Company and its consolidated subsidiaries, as the context requires. Diabetic care products, including Iletin(Registered) (insulin) in its various pharmaceutical forms; and Humulin(Registered), human insulin produced through recombinant DNA technology; Oncolytic agents, including Oncovin(Registered), indicated for treatment of acute leukemia and, in combination with other oncolytic agents, for treatment of several different types of advanced cancers; Velban(Registered), used in a variety of malignant neoplastic conditions; and Eldisine(Registered), indicated for treatment of acute childhood leukemia resistant to other drugs; An antiulcer agent, Axid(Registered), an H2 antagonist, indicated for the treatment of active duodenal ulcer, for maintenance therapy for duodenal ulcer patients after healing of an active duodenal ulcer, and for reflux esophagitis; and Additional pharmaceuticals, including cardiovascular therapy products, principally Dobutrex(Registered); hormones, including Humatrope(Registered), human growth hormone produced by recombinant DNA technology; and sedatives. Medical Devices and Diagnostic Products Medical devices include patient vital-signs measurement and electrocardiography systems, intravenous fluid-delivery and control systems, implantable cardiac pacemakers and implantable cardioverter/defibrillators, cardiac defibrillators and monitors, coronary angioplasty catheter systems, peripheral and coronary atherectomy catheter systems, and devices for use during minimally-invasive surgery procedures. Diagnostic products include monoclonal-antibody-based diagnostic tests for colon, prostate, and testicular cancer, as well as for infertility, pregnancy, heart attack, thyroid deficiencies, allergies, anemia, dwarfism, and infectious diseases. Animal Health Products Animal health products include Tylan(Registered), an antibiotic used to control certain diseases in cattle, swine, and poultry and to improve feed efficiency and growth; Rumensin(Registered), a cattle feed additive that improves feed efficiency and growth; Compudose(Registered), a controlled- release implant that improves feed efficiency and growth in cattle; Coban(Registered), Monteban(Registered) and Maxiban(Registered), anticoccidial agents for use in poultry; Apralan(Registered), an antibiotic used to control enteric infections in calves and swine; Micotil(Registered), an antibiotic used to treat bovine respiratory disease; and other products for livestock and poultry. MARKETING Most of the Company's major products are marketed worldwide. In the United States, the Company's Pharmaceutical Division distributes pharmaceutical products principally through approximately 225 wholesale distributing outlets. Marketing policy is designed to assure immediate availability of these products to physicians, pharmacies, hospitals, and appropriate health care professionals throughout the country. Four wholesale distributing companies in the United States accounted for approximately 11%, 9%, 6%, and 5% respectively, of consolidated net sales in 1993. No other distributor accounted for as much as 5% of consolidated net sales. The Company also makes direct sales of its pharmaceutical products to the United States government and to other manufacturers, but those direct sales do not constitute a material portion of consolidated net sales. The Company's pharmaceutical products are promoted in the United States under the Lilly and Dista trade names by one hospital and three retail sales forces employing salaried sales representatives. These sales representatives, approximately half of whom are registered pharmacists, call upon physicians, wholesalers, hospitals, managed-care organizations, retail pharmacists, and other health care professionals. Their efforts are supported by the Company through advertising in medical and drug journals, distribution of literature and samples of certain products to physicians, and exhibits for use at medical meetings. In the past few years, large purchasers of pharmaceuticals, such as managed-care groups and government and long-term care institutions, have begun to account for an increasing portion of total pharmaceutical purchases in the United States. In 1992, reflecting these changes, the Company created special sales groups to service government and long-term care institutions, and expanded its managed-care sales organization. In response to competitive pressures, the Company has entered into arrangements with a number of these organizations providing for discounts or rebates on one or more Company products. Pharmaceutical products are promoted outside the United States by salaried sales representatives. While the products marketed vary from country to country, anti-infectives constitute the largest single group in total volume. Distribution patterns vary from country to country. IVAC Corporation markets its patient temperature-measuring and vital-signs products and intravenous fluid-infusion systems principally to hospitals in the United States. Sales in the United States are conducted by a direct sales force. Sales outside the United States are conducted by both direct sales representatives and independent distributors. Cardiac Pacemakers, Inc. markets pacemaker products and automatic implantable cardioverter/defibrillators to physicians and hospitals. Sales are conducted by direct sales representatives and by independent distributors both inside and outside the United States. Physio-Control Corporation markets cardiac defibrillators and monitors, electrocardiography systems, and vital-signs-measurement equipment to hospitals and emergency care units. In the United States, sales are conducted by direct sales representatives. Sales outside the United States are conducted by both direct sales representatives and independent distributors. Physio-Control suspended production in May 1992 following an inspection of its operations by the U.S. Food and Drug Administration ("FDA"). During 1993, Physio-Control received FDA authorization to resume shipments of the majority of its product line. Physio-Control is seeking FDA authorization to resume shipments of its remaining products. Advanced Cardiovascular Systems, Inc. primarily markets coronary dilatation balloon catheter systems to cardiologists to open obstructed coronary arteries. In the United States, sales are conducted by a direct sales force. Sales outside the United States are conducted by both direct sales representatives and independent distributors. Devices for Vascular Intervention, Inc. markets atherectomy catheter systems for the treatment of coronary vascular disease by the removal of atherosclerotic plaque. In the United States, sales are conducted by direct sales representatives. Sales outside the United States are conducted by independent distributors. Origin Medsystems, Inc., acquired by the Company in 1992, markets devices for use in minimally invasive surgical procedures. Sales in the United States are conducted by direct sales representatives. Sales outside the United States are conducted by independent distributors and a direct sales force. Heart Rhythm Technologies, Inc. is developing catheter-based ablation systems to correct faulty signals at the heart, using a less-invasive approach than current therapy. Heart Rhythm Technologies has no products currently approved for marketing. Hybritech Incorporated and Pacific Biotech, Inc. market their immunodiagnostic products to hospitals, commercial laboratories, clinics, and physicians. Sales are conducted by direct sales representatives and by independent distributors both inside and outside the United States. Elanco Animal Health, a division of the Company, employs field salespeople throughout the United States to market animal health products. Sales are made to wholesale distributors, retailers, feed manufacturers, or producers in conformance with varying distribution patterns applicable to the various types of products. The Company also has an extensive sales force outside the United States to market its animal health products. RAW MATERIALS Most of the principal materials used by the Company in manufacturing operations are chemical, plant, and animal products that are available from more than one source. Certain raw materials are available or are purchased principally from only one source. Unavailability of certain materials from present sources could cause an interruption in production pending establishment of new sources or, in some cases, implementation of alternative processes. Although the major portion of the Company's sales abroad are of products manufactured wholly or in part abroad, a principal source of active ingredients for these manufactured products continues to be the Company's facilities in the United States. PATENTS AND LICENSES The Company owns, has applications pending for, or is licensed under, a substantial number of patents, both in the United States and in other countries, relating to products, product uses, and manufacturing processes. There can be no assurance that patents will result from the Company's pending applications. Moreover, patents relating to particular products, uses, or processes do not preclude other manufacturers from employing alternative processes or from successfully marketing substitute products to compete with the patented products or uses. Patent protection of certain products, processes, and uses - particularly that relating to Ceclor, Dobutrex, Humulin, Prozac, Axid, and Lorabid - is considered to be important to the operations of the Company. The United States product patent covering Ceclor, the Company's second largest selling product, expired in December 1992. The Company holds a U.S. patent on a key intermediate material that remains in force until December 1994. It has been reported that several abbreviated new drug applications for generic formulations of cefaclor (the active ingredient in Ceclor) have been filed in the U.S. and regulatory submissions have been made in other countries. Small quantities of a generic formulation are currently being marketed in India. Although the Company cannot predict the ultimate effect on the sales of Ceclor or the Company's results of operations, the Company believes that the expiration of the U.S. product and intermediate patents will not have a material adverse effect on the Company's near-term consolidated financial position. The United States patent covering Dobutrex expired in October 1993. Prior to the expiration, U.S. sales of Dobutrex accounted for approximately 2% of the Company's worldwide sales. The patent expiration has resulted in a significant decline in U.S. Dobutrex sales, and the Company expects this decline to continue. During the first two months of 1994, U.S. sales of the product declined approximately 75%. The contribution of Dobutrex to the Company's net income is greater than its contribution to net sales. The Company is unable to predict the effect of the expiration on the Company's consolidated results of operations; however, the Company believes the expiration will not have a material adverse effect on its consolidated financial position. The United States patent covering Humulin expires in 2000, the Prozac patent expires in 2001, the Axid patent expires in 2002, and the Lorabid patent expires in 2004. The Company also grants licenses under patents and know-how developed by the Company and manufactures and sells products and uses technology and know- how under licenses from others. Royalties received by the Company in relation to licensed pharmaceuticals, medical devices, and diagnostic products amounted to approximately $56.7 million in 1993, and royalties paid by it in relation to pharmaceuticals, medical devices, and diagnostic products amounted to approximately $92.5 million in 1993. COMPETITION The Company's pharmaceutical products compete with products manufactured by numerous other companies in highly competitive markets in the United States and throughout the world. Its medical devices compete with numerous domestic and foreign manufacturers of conventional mercury-glass thermometers, implantable cardiac pacemakers, cardiac defibrillators and monitors, electronic temperature-measuring systems, vital-signs measuring systems, intravenous systems, angioplasty catheter systems, and minimally- invasive surgery devices. The Company's diagnostic products compete with conventional immunodiagnostic assays as well as with monoclonal-antibody-based products marketed by numerous foreign and domestic manufacturers. Its animal health products compete on a worldwide basis with products of pharmaceutical, chemical, and other companies that operate animal health divisions or subsidiaries. Important competitive factors include price and cost-effectiveness, product characteristics and dependability, service, and research and development of new products and processes. The introduction of new products and the development of new processes by domestic and foreign companies can result in progressive price reductions or decreased volume of sales of competing products, or both. New products introduced with patent protection usually must compete with other products already on the market at the time of introduction or products developed by competitors after introduction. The Company believes its competitive position in these markets is dependent upon its research and development endeavors in the discovery and development of new products, together with increased productivity resulting from improved manufacturing methods, marketing efforts, and customer service. There can be no assurance that products manufactured or processes used by the Company will not become outmoded from time to time as a result of products or processes developed by its competitors. GOVERNMENTAL REGULATION The Company's operations have for many years been subject to extensive regulation by the federal government, to some extent by state governments, and in varying degrees by foreign governments. The Federal Food, Drug, and Cosmetic Act, other federal statutes and regulations, various state statutes and regulations, and laws and regulations of foreign governments govern testing, approval, production, labeling, distribution, post-market surveillance, advertising, promotion, and in some instances, pricing, of most of the Company's products. In addition, the Company's operations are subject to complex federal, state, local, and foreign environmental laws and regulations. It is anticipated that compliance with regulations affecting the manufacture and sale of current products and the introduction of new products will continue to require substantial scientific and technical effort, time, and expense and significant capital investment. In the United States, the federal administration has identified health care reform as a priority and introduced legislation that, if enacted, would make fundamental changes in the health care delivery system. In addition, a number of reform measures have been proposed by members of Congress. Many state legislatures are also considering health care reform measures. The nature of the changes that may ultimately be enacted and their impact on the Company and the pharmaceutical industry are unknown. However, several of the measures currently under discussion, if enacted, could affect the industry and the Company by, among other things, increasing pressures on pricing, restricting physicians' choice of therapies, raising effective tax rates, and reducing incentives to invest in research and development. Outside the United States, governments in several countries, including Germany, Italy, and the United Kingdom, are implementing health care cost-control measures that may adversely affect pharmaceutical industry revenues. The Company is unable to predict the extent to which its business may be affected by these or other future legislative and regulatory developments. RESEARCH AND DEVELOPMENT The Company's research and development activities are responsible for the discovery or development of most of the products offered by the Company today. Its commitment to research and development dates back more than 100 years. The growth in research and development expenditures and personnel over the past several years demonstrates both the continued vitality of the Company's commitment and the increasing costs and complexity of bringing new products to the market. At the end of 1993, approximately 5,600 people, including a substantial number who are physicians or scientists holding graduate or postgraduate degrees or highly skilled technical personnel, were engaged in research and development activities. The Company expended $766.9 million on research and development activities in 1991, $924.9 million in 1992, and $954.6 million in 1993. The Company's research is concerned primarily with the effects of synthetic chemicals and natural products on biological systems. The results of that research are applied to the development of products for use by or on humans and animals, and for other uses. Major effort is devoted to pharmaceutical products. In late 1993, the Company decided to concentrate its pharmaceutical research and development efforts on the search for compounds that will cure or treat diseases in five categories: central nervous system and related diseases; endocrine diseases, including diabetes and osteoporosis; infectious diseases; cancer; and cardiovascular diseases. The Company is engaged in biotechnology research programs involving recombinant DNA and monoclonal antibodies. The Company's biotechnology research is supplemented through its Hybritech and Pacific Biotech subsidiaries, which conduct research using monoclonal-antibody-based product technology for diagnosis of certain diseases or medical conditions. In addition to the research activities carried on in the Company's own laboratories, the Company sponsors and underwrites the cost of research and development by independent organizations, including educational institutions and research-based human health care companies, and contracts with others for the performance of research in their facilities. It utilizes the services of physicians, hospitals, medical schools, and other research organizations in the United States and numerous other countries to establish through clinical evidence the safety and effectiveness of new products. IVAC, Cardiac Pacemakers, Advanced Cardiovascular Systems, Physio-Control, Devices for Vascular Intervention, Origin Medsystems, and Heart Rhythm Technologies conduct research and development in the area of medical devices. Extensive work is also conducted in the animal sciences, including animal nutrition and physiology and veterinary medicine. Certain of the Company's research and development activities relating to pharmaceutical products may be applicable to animal health products. An example is the search for agents that will cure infectious disease. QUALITY ASSURANCE The Company's success depends in great measure upon customer confidence in the quality of the Company's products and in the integrity of the data that support their safety and effectiveness. The quality of the Company's products arises from the total commitment to quality in all parts of the Company, including research and development, purchasing, facilities planning, manufacturing, and distribution. Quality-assurance procedures have been developed relating to the quality and integrity of the Company's scientific information and production processes. With respect to pharmaceutical, diagnostic, and animal health products, control of production processes involves rigid specifications for ingredients, equipment, facilities, manufacturing methods, packaging materials, and labeling. Control tests are made at various stages of production processes and on the final product to assure that the product meets the Company's standards. These tests may involve chemical and physical chemical analyses, microbiological testing, testing in animals, or a combination of these tests. Additional assurance of quality is provided by a corporate quality-assurance group that monitors existing pharmaceutical and animal health manufacturing procedures and systems in the parent company, subsidiaries, and affiliates. The quality of medical devices is assured through specifications of components and finished products, inspection of certain components, certification of certain vendors, control of the manufacturing environment, and use of statistical process controls. Final products are tested to assure conformance with specifications. EXECUTIVE OFFICERS OF THE COMPANY The following table sets forth certain information regarding the executive officers of the Company. All but three of the executive officers have been employed by the Company in executive or managerial positions during the last five years. Randall L. Tobias became Chairman of the Board and Chief Executive Officer in June 1993. He had served as Vice Chairman of the Board of American Telephone and Telegraph Company from 1986 until he assumed his present position. He has been a member of the Board of Directors of the Company since 1986. August M. Watanabe joined the Company in 1990 as Vice President of Lilly Research Laboratories. Previously he had served as Chairman of the Department of Medicine at Indiana University School of Medicine from 1983 through 1990. From 1987 until he joined the Company in August 1990, Mitchell E. Daniels, Jr., President, North American Pharmaceutical Operations, Pharmaceutical Division, served as President and Chief Executive Officer of the Hudson Institute and was of counsel to Baker & Daniels. From 1985 to 1987 he served on former President Reagan's staff as Assistant to the President for Political and Intergovernmental Affairs. Except as indicated in the table below, the term of office for each executive officer indicated herein expires on the date of the annual meeting of the Board of Directors, to be held on April 18, 1994, or on the date his successor is chosen and qualified. No director or executive officer of the Company has a "family relationship" with any other director or executive officer of the Company, as that term is defined for purposes of this disclosure requirement. There is no understanding between any executive officer of the Company and any other person pursuant to which the executive officer was selected. NAME AGE OFFICES Randall L. Tobias 52 Chairman of the Board and Chief Executive Officer (since June 1993) and a Director Mel Perelman, Ph.D. 63 Executive Vice President (since December 1986) and a Director(1) Sidney Taurel 45 Executive Vice President (since January 1993) and a Director Joseph C. Cook, Jr. 52 Group Vice President, Manufacturing, Engineering, and Corporate Quality (since June 1992)(2) James M. Cornelius 50 Vice President, Finance and Chief Financial Officer (since January 1983) and a Director Mitchell E. Daniels, Jr. 44 President, North American Pharmaceutical Operations, Pharmaceutical Division (since April 1993)(3) Ronald W. Dollens 47 President, Medical Devices and Diagnostics Division (since July 1991)(3) Michael L. Eagle 46 Vice President, Manufacturing (since January 1994)(4) Brendan P. Fox 50 President, Elanco Animal Health Division (since January 1991)(3) Pedro P. Granadillo 46 Vice President, Human Resources (since April 1993) J. B. King 64 Vice President and General Counsel (since October 1987) Stephen A. Stitle 48 Vice President, Corporate Affairs (since April 1993) and a Director W. Leigh Thompson, Ph.D., M.D. 55 Chief Scientific Officer (since January 1993)(3) August M. Watanabe, M.D. 52 Vice President (since January 1994) and a Director(4) - -------------------- 1 Retired as an officer and director effective December 31, 1993 2 Retired as an officer effective December 31, 1993 3 Serves in office until his successor is appointed 4 Became executive officer January 1994 EMPLOYEES At the end of 1993, the Company had approximately 32,700 employees, including approximately 11,000 employees outside the United States. A substantial number of the Company's employees have long records of continuous service. Approximately 2,600 employees, including 1,900 U.S. employees, are retiring under voluntary early retirement programs announced in the fourth quarter of 1993. FINANCIAL INFORMATION RELATING TO FOREIGN AND DOMESTIC OPERATIONS Financial information relating to foreign and domestic operations, set forth in the Company's 1993 Annual Report at pages 18-19 under "Review of Operations - Segment Information" (pages 12-13 of Exhibit 13), is incorporated herein by reference. Eli Lilly International Corporation, a subsidiary, coordinates the Company's manufacture and sale of products outside the United States. Local restrictions on the transfer of funds from branches and subsidiaries located abroad (including the availability of dollar exchange) have not to date been a significant deterrent in the Company's overall operations abroad. The Company cannot predict what effect these restrictions or the other risks inherent in foreign operations, including possible nationalization, might have on its future operations or what other restrictions may be imposed in the future. RECENT DEVELOPMENTS On January 18, 1994, the Company announced its intent to divest itself of its medical device and diagnostics ("MDD") businesses. The final form of the divestiture has not been resolved. It will depend on tax, market, and other considerations, including the nature of any offers the Company may receive from prospective purchasers of one or more of the businesses. Current plans call for the creation of a new holding company comprising six of the businesses and the divestiture of the new company through a spin-off to Company shareholders, one or more public offerings of the holding company's shares, or a combination of these methods. These six businesses are Advanced Cardiovascular Systems, Cardiac Pacemakers, Devices for Vascular Intervention, Heart Rhythm Technologies, IVAC, and Origin Medsystems. The Company currently intends to sell separately the three other businesses in the MDD division - Hybritech, Pacific Biotech, and Physio- Control. The agreements under which the Company acquired Hybritech, Pacific Biotech, and Origin Medsystems include provisions that could affect the timing of these transactions. On March 8, 1994, the Company announced that it had signed a letter of intent with Sphinx Pharmaceuticals Corporation for the acquisition of Sphinx by the Company. Sphinx is engaged in drug discovery and development by generating combinatorial chemistry libraries of small organic molecules and by high-throughput screening of compounds for biological activity. The transaction is subject to the signing of a definitive agreement, applicable government approval, and approval by Sphinx shareholders. Three purported class actions have been filed by shareholders of Sphinx seeking, among other things, to enjoin the transaction. Item 2.

Item 2. PROPERTIES The Company's principal domestic and international executive offices are located in Indianapolis. At December 31, 1993, the Company owned 14 production plants and facilities in the United States and Puerto Rico. These plants and facilities contain an aggregate of approximately 12 million square feet of floor area. Most of the plants and facilities involve production of both pharmaceutical and animal health products. The Company owns manufacturing, research, and administrative facilities for medical devices and diagnostic products, containing an aggregate of approximately 1.9 million square feet, in seven cities in the United States and Puerto Rico. The Company's Medical Devices and Diagnostics Division leases manufacturing, research, and administrative facilities in the United States containing an aggregate of approximately 800,000 square feet. The Company also leases sales offices in a number of cities located in the United States. The Company has 25 production plants and facilities in 19 countries outside the United States, containing an aggregate of approximately 3.9 million square feet of floor space. Leased production and warehouse facilities are utilized in some of these countries as well as in nine other countries including Puerto Rico. The Company's main research and development laboratories in Indianapolis and Greenfield, Indiana, consist of approximately 2.8 million square feet. Its major research and development facilities abroad are located in Belgium and the United Kingdom and contain approximately 435,000 square feet. The Company also owns two tracts of land, containing an aggregate of approximately 1,700 acres, a portion of which is used for field studies of products. The Company believes that none of its properties is subject to any encumbrance, easement, or other restriction that would detract materially from its value or impair its use in the operation of the business of the Company. The buildings owned by the Company are of varying ages and in good condition. Item 3.

Item 3. LEGAL PROCEEDINGS The Company is currently a defendant in a variety of product and patent litigation matters. In approximately 205 actions, plaintiffs seek to recover damages on behalf of children or grandchildren of women who ingested diethylstilbestrol during pregnancy. In another approximately 170 actions, plaintiffs seek to recover damages as a result of the ingestion of Prozac. In the patent suits, it is asserted that one or more Company products or processes infringe issued patents. The holders of those patents seek monetary damages and injunctions against further infringement. Products involved include Humulin, Humatrope, bovine somatotropin and certain medical devices. A federal grand jury in Baltimore, Maryland is conducting an inquiry into the Company's compliance with the Food and Drug Administration's regulatory requirements affecting the Company's pharmaceutical manufacturing operations. The Company is cooperating fully with the inquiry. The Company has been named in approximately ten of more than 40 lawsuits filed in various federal courts against a number of U.S. pharmaceutical manufacturers and in some cases wholesalers. Most of the suits in which the Company is a defendant purport to be class actions on behalf of all retail pharmacies in the United States and allege an industry-wide agreement to deny favorable pricing on sales to certain retail pharmacies. At least one also alleges price discrimination. The suits are in an early procedural stage. The Company is also a defendant in other litigation, including product liability suits, of a character regarded as normal to its business. While it is not possible to predict or determine the outcome of the legal actions pending against the Company, in the opinion of the Company such actions will not ultimately result in any liability that would have a material adverse effect on its consolidated financial position. Item 4.

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the fourth quarter of 1993, no matters were submitted to a vote of security holders. PART II Item 5.

Item 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS Information relating to the principal market for the Company's common stock and related stockholder matters, set forth in the Company's 1993 Annual Report under "Review of Operations - Selected Quarterly Data (unaudited)," at page 20 (page 14 of Exhibit 13), is incorporated herein by reference. Item 6.

Item 6. SELECTED FINANCIAL DATA Selected financial data for each of the Company's five most recent fiscal years, set forth in the Company's 1993 Annual Report under "Review of Operations - Selected Financial Data (unaudited)," at page 21 (page 15 of Exhibit 13), are incorporated herein by reference. Item 7.

Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION Management's discussion and analysis of results of operations and financial condition, set forth in the Company's 1993 Annual Report under "Review of Operations - Operating Results" (pages 9-13), "Review of Operations - Financial Condition" (pages 13 and 16), and "Review of Operations - Environmental and Legal Matters" (page 16) (together, pages 1-7 of Exhibit 13), is incorporated herein by reference. Item 8.

Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements of the Company and its subsidiaries, listed in Item 14(a)1 and included in the Company's 1993 Annual Report at pages 12, 14, 15, and 17 (Consolidated Statements of Income, Consolidated Balance Sheets, and Consolidated Statements of Cash Flows), pages 18-19 (Segment Information), and pages 22-33 (Notes to Consolidated Financial Statements) (together, pages 8-13 and 16-30 of Exhibit 13), and the Report of Independent Auditors set forth in the Company's 1993 Annual Report at page 34 (page 31 of Exhibit 13), are incorporated herein by reference. Information on quarterly results of operations, set forth in the Company's 1993 Annual Report under "Review of Operations - Selected Quarterly Data (unaudited)," at page 20 (page 14 of Exhibit 13), is incorporated herein by reference. Item 9.

Item 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III Item 10.

Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information relating to the Company's directors, set forth in the Company's Proxy Statement dated March 14, 1994, under "Election of Directors - Nominees for Election," at pages 2-5, is incorporated herein by reference. Information relating to the Company's executive officers is set forth at pages 6-7 of this Form 10-K under "Executive Officers of the Company." Additional information with respect to the Company's directors and certain of its officers, set forth in the Company's Proxy Statement dated March 14, 1994, under "Other Matters," at page 25, is incorporated herein by reference. Item 11.

Item 11. EXECUTIVE COMPENSATION Information relating to executive compensation, set forth in the Company's Proxy Statement dated March 14, 1994, under "Election of Directors - Executive Compensation," at pages 9-20, is incorporated herein by reference, except that the Compensation and Management Development Committee Report and Performance Graph are not so incorporated. Item 12.

Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information relating to ownership of the Company's common stock by persons known by the Company to be the beneficial owners of more than 5% of the outstanding shares of common stock and by management, set forth in the Company's Proxy Statement dated March 14, 1994, under "Election of Directors - Common Stock Ownership by Directors and Executive Officers," at pages 6-7, and "Election of Directors - Principal Holders of Common Stock," at page 8, is incorporated herein by reference. Item 13.

Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. PART IV Item 14.

Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)1. Financial Statements The following consolidated financial statements of the Company and its subsidiaries, included in the Company's 1993 Annual Report at the pages indicated in parentheses, are incorporated by reference in Item 8: Consolidated Statements of Income - Years Ended December 31, 1993, 1992, and 1991 (page 12) (page 8 of Exhibit 13) Consolidated Balance Sheets - December 31, 1993 and 1992 (pages 14-15) (pages 9-10 of Exhibit 13) Consolidated Statements of Cash Flows - Years Ended December 31, 1993, 1992, and 1991 (page 17) (page 11 of Exhibit 13) Segment Information (pages 18-19) (pages 12-13 of Exhibit 13) Notes to Consolidated Financial Statements (pages 22-33) (pages 16-30 of Exhibit 13) (a)2. Financial Statement Schedules The following consolidated financial statement schedules of the Company and its subsidiaries are included in this Form 10-K: Schedule I Marketable Securities - Other Investments (page) Schedule V Property, Plant, and Equipment (page) Schedule VI Accumulated Depreciation, Depletion, and Amortization of Property, Plant, and Equipment (page) Schedule VII Guarantees of Securities of Other Issuers (page) Schedule VIII Valuation and Qualifying Accounts (page) Schedule IX Short-Term Borrowings (page) Schedule X Supplementary Income Statement Information (page) All other schedules (Nos. II, III, IV, XI, XII, XIII, and XIV) for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions, are inapplicable, or are adequately explained in the financial statements and, therefore, have been omitted. Financial statements of interests of 50% or less, which are accounted for by the equity method, have been omitted because they do not, considered in the aggregate as a single subsidiary, constitute a significant subsidiary. The report of the Company's independent auditors with respect to the schedules listed above is contained herein as a part of Exhibit 23, Consent of Independent Auditors. (a)3. Exhibits 3.1 Amended Articles of Incorporation 3.2 By-laws 4.1 Form of 7% Bond 1984-1994/96 of Eli Lilly Overseas Finance N.V. 4.2 Form of Guarantee dated as of January 9, 1984, by Eli Lilly and Company to Holders of 7% Bonds 1984-1994/96 of Eli Lilly Overseas Finance N.V. 4.3 Form of Letter Agreement dated as of January 9, 1984, between Eli Lilly and Company, Eli Lilly Overseas Finance N.V., and Swiss Bank Corporation 4.4 Form of Bond Purchase Agreement dated as of December 3, 1984, including form of Bond, between City of Clinton, Indiana, Eli Lilly and Company, and Chemical Bank* 4.5 Form of Loan Agreement dated as of December 3, 1984, between Eli Lilly and Company and City of Clinton, Indiana* 4.6 Form of Bond Purchase Agreement dated as of December 3, 1984, including form of Bond, between Tippecanoe County, Indiana, Eli Lilly and Company, and Chemical Bank* 4.7 Form of Loan Agreement dated as of December 3, 1984, between Eli Lilly and Company and Tippecanoe County, Indiana* 4.8 Form of Indenture dated as of May 15, 1985, between Eli Lilly and Company and Merchants National Bank & Trust Company of Indianapolis, as Trustee 4.9 Form of Eli Lilly and Company Convertible Debenture due 1994 4.10 Form of Indenture with respect to Contingent Payment Obligation Units dated March 18, 1986, between Eli Lilly and Company and Harris Trust and Savings Bank, as Trustee - --------------------- * Exhibits 4.4-4.7 are not filed with this report. Copies of these exhibits will be furnished to the Securities and Exchange Commission upon request. 4.11 Rights Agreement dated as of July 18, 1988, between Eli Lilly and Company and Bank One, Indianapolis, NA 4.12 Form of Indenture dated as of February 21, 1989, between Eli Lilly and Company and Merchants National Bank & Trust Company of Indianapolis, as Trustee 4.13 Form of Eli Lilly and Company Five Year Convertible Note 4.14 Form of Indenture with respect to Debt Securities dated as of February 1, 1991, between Eli Lilly and Company and Citibank, N.A., as Trustee 4.15 Form of Standard Multiple-Series Indenture Provisions dated, and filed with the Securities and Exchange Commission on, February 1, 1991 4.16 Form of Indenture dated as of September 5, 1991, among the Lilly Savings Plan Master Trust Fund C, as Issuer; Eli Lilly and Company, as Guarantor; and Chemical Bank, as Trustee* 10.1 1984 Lilly Stock Plan, as amended 10.2 1989 Lilly Stock Plan, as amended 10.3 The Lilly Deferred Compensation Plan, as amended 10.4 The Lilly Directors' Deferred Compensation Plan, as amended 10.5 The Lilly Non-Employee Directors' Deferred Stock Plan, as amended 10.6 Eli Lilly and Company Senior Executive Bonus Plan, as amended 10.7 The Lilly Non-Employee Directors' Retirement Plan 10.8 Letter Agreement dated September 3, 1993, between the Company and Vaughn D. Bryson 11. Computation of Earnings Per Share on Primary and Fully Diluted Bases 12. Computation of Ratio of Earnings to Fixed Charges 13. Annual Report to Shareholders for the Year Ended December 31, 1993 (portions incorporated by reference into this Form 10-K) 21. List of Subsidiaries 23. Consent of Independent Auditors 99. Report to Holders of Eli Lilly and Company Contingent Payment Obligation Units (b) Reports on Form 8-K The Company filed no Reports on Form 8-K during the fourth quarter of 1993. - ----------------- * Exhibit 4.16 is not filed with this report. Copies of this exhibit will be furnished to the Securities and Exchange Commission upon request. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. ELI LILLY AND COMPANY By s/Randall L. Tobias (Randall L. Tobias, Chairman of the Board and Chief Executive Officer) March 21, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. SIGNATURE TITLE DATE s/Randall L. Tobias Chairman of the Board, March 21, 1994 (RANDALL L. TOBIAS) Chief Executive Officer, and a Director (principal executive officer) s/James M. Cornelius Vice President, Finance, March 21, 1994 (JAMES M. CORNELIUS) Chief Financial Officer, and a Director (principal financial officer) s/Keith E. Brauer Chief Accounting Officer March 21, 1994 (KEITH E. BRAUER) (principal accounting officer) s/Steven C. Beering, M.D. Director March 21, 1994 (STEVEN C. BEERING, M.D.) s/James W. Cozad Director March 21, 1994 (JAMES W. COZAD) Director March 21, 1994 (KAREN N. HORN, Ph.D.) s/J. Clayburn La Force, Jr., Ph.D. Director March 21, 1994 (J. CLAYBURN LA FORCE, JR., Ph.D.) s/Kenneth L. Lay, Ph.D. Director March 21, 1994 (KENNETH L. LAY, Ph.D.) s/Ben F. Love Director March 21, 1994 (BEN F. LOVE) s/Stephen A. Stitle Director March 21, 1994 (STEPHEN A. STITLE) s/Sidney Taurel Director March 21, 1994 (SIDNEY TAUREL) s/August M. Watanabe, M.D. Director March 21, 1994 (AUGUST M. WATANABE, M.D.) s/Alva O. Way Director March 21, 1994 (ALVA O. WAY) s/Richard D. Wood Director March 21, 1994 (RICHARD D. WOOD) TRADEMARKS Apralan(Registered) (apramycin sulfate, Elanco) Axid(Registered) (nizatidine, Lilly) Ceclor(Registered) (cefaclor, Lilly) Coban(Registered) (monensin sodium, Elanco) Compudose(Registered) (estradiol controlled-release implant, Elanco) Darvocet-N(Registered) (propoxyphene napsylate with acetaminophen, Lilly) Dobutrex(Registered) (dobutamine hydrochloride, Lilly) Eldisine(Registered) (vindesine sulfate, Lilly) Humatrope(Registered) (somatropin of recombinant DNA origin, Lilly) Humulin(Registered) (human insulin of recombinant DNA origin, Lilly) lletin(Registered) (insulin, Lilly) Keflex(Registered) (cephalexin, Dista) Keftab(Registered) (cephalexin hydrochloride, Dista) Kefurox(Registered) (cefuroxime sodium, Lilly) Kefzol(Registered) (cefazolin sodium, Lilly) Lorabid(Trademark) (loracarbef, Lilly) Mandol(Registered) (cefamandole nafate, Lilly) Maxiban(Registered) (narasin and nicarbazine, Elanco) Micotil(Registered) (tilmicosin phosphate, Elanco) Monteban(Registered) (narasin, Elanco) Nebcin(Registered) (tobramycin sulfate, Lilly) Oncovin(Registered) (vincristine sulfate, Lilly) Prozac(Registered) (fluoxetine hydrochloride, Dista) Rumensin(Registered) (monensin sodium, Elanco) Tazidime(Registered) (ceftazidime, Lilly) Tylan(Registered) (tylosin, Elanco) Vancocin(Registered) (vancomycin hydrochloride, Lilly) Velban(Registered) (vinblastine sulfate, Lilly) ELI LILLY AND COMPANY AND SUBSIDIARIES SCHEDULE I. MARKETABLE SECURITIES - OTHER INVESTMENTS DECEMBER 31, 1993 Col. A Col. B Col. C Col. D Col. E ------ ------ ------ ------ --------- Amount at Which Each Number Portfolio of of Shares Equity or Units- Market Security Issues Principal Value of and Each Other Amount of Cost of Issue at Security Issue Name of Issuer Bonds Each Balance Carried in the and Title of Issue and Notes Issue Sheet Date Balance Sheet - ------------------------------------------------------------------------ (Dollars in millions) CERTIFICATES OF DEPOSIT, TIME DEPOSITS, AND INTEREST-BEARING DEMAND DEPOSITS $ 491.8 $ 491.8 $ 492.1 $ 491.8 REPURCHASE AGREEMENTS Collateralized by U.S. government or U.S. government agency securities 28.0 28.0 28.0 28.0 Collateralized by other investments 42.3 42.3 42.3 42.3 EQUITY INVESTMENTS AND LIMITED PARTNERSHIPS 216.5 216.5 221.3 204.0 EURO COMMERCIAL PAPER AND BONDS 390.4 390.4 388.5 386.0 TOTALS $1,169.0 $1,169.0 $1,172.2 $1,152.1 ======= ======= ======= ======= Classified as: Current asset - Cash equivalent $ 482.9 - Short-term investments 447.5 Noncurrent asset 221.7 ----- TOTAL $1,152.1 ======= Securities classified as cash equivalents $ 482.9 Cash 56.7 ----- Cash and cash equivalents $ 539.6 ===== ELI LILLY AND COMPANY AND SUBSIDIARIES SCHEDULE V. PROPERTY, PLANT, AND EQUIPMENT Col. A Col. B Col. C Col. D Col E Col. F ------ ------ ------ ------ ------------------- ------- Other Balance at Changes Beginning (A) Add (Deduct) Add Balance of Additions Translation (Deduct) At End Classification Period At Cost Retirements Adjustments Describe of Period (Dollars in millions) Year Ended Dec 31, 1991 Land $ 102.1 $ 8.8 $ - $ .6 $ - $ 111.5 Buildings 1,141.3 228.0 9.2 (2.3) - 1,357.8 Equipment 2,376.9 500.2 76.2 (5.6) - 2,795.3 Construction- in-progress 895.5 405.4 - 3.1 - 1,304.0 ------ ----- ----- ----- ------- TOTALS $4,515.8 $1, 142.4 $ 85.4 $ (4.2) $ - $ 5,568.6 ======= ======== ==== ==== ======= Year Ended Dec 31, 1992 Land $ 111.5 $ 3.1 $ 0.3 $ (0.4) $ (1.1)(B) $ 112.8 Buildings 1,357.8 371.6 30.8 (30.4) (12.8)(B) 1,655.4 Equipment 2,795.3 756.5 126.6 (83.6) 2.7 (B) 3,344.3 Construction- in-progress 1,304.0 (218.3) - (16.9) (33.2)(B) 1,035.6 ------- ------ ----- ------- ------ ------- TOTALS $5,568.6 $ 912.9 $157.7 $(131.3) $(44.4)(B) $ 6,148.1 ======= ===== ===== ======= ===== ======= Year Ended Dec 31, 1993 Land $ 112.8 $ 15.4 $ 0.1 $ 0.2 $ 1.9 (B) $ 130.2 Buildings 1,655.4 312.3 10.4 (14.7) 14.7 (B) 1,957.3 Equipment 3,344.3 563.3 60.9 (39.6) (35.4)(B) 3,771.7 Construction- in-progress 1,035.6 (257.5) - (14.5) (56.3)(B) 707.3 ------- ----- ---- ------ ------ ------- TOTALS $6,148.1 $633.5 $ 71.4 $ (68.6) $(75.1)(B) $6,566.5 ======= ===== ==== ====== ====== ======= - ----------------- NOTE A Additions represent cash expenditures for projects in numerous locations both inside and outside the United States. In 1992 and 1993 there were no major projects for which cash expenditures exceeded 2% of total assets at either the beginning or the end of the year. In 1991 the 2% threshold was exceeded by one major project relating to an anticipated new product launch. Expenditures for this project were primarily for additions at Indiana locations. NOTE B Amounts shown are attributable to corporate restructuring, acquisitions, divestitures and miscellaneous reclassifications. The range of annual rates used in computing provisions for depreciation was 2 percent to 10 percent for buildings and generally 4 percent to 25 percent for equipment. ELI LILLY AND COMPANY AND SUBSIDIARIES SCHEDULE VI. ACCUMULATED DEPRECIATION, DEPLETION, AND AMORTIZATION OF PROPERTY, PLANT, AND EQUIPMENT Col. A Col. B Col. C Col. D Col E Col. F ------ ------ ------ ------ -------------------- ------ Other Balance at Additions Changes Beginning Charged to Add (Deduct) Add Balance of Costs and Translation (Deduct) At End Description Period Expenses Retirements Adjustments Describe of Period - ---------------------------------------------------------------------------- (Dollars in millions) Year Ended Dec 31, 1991 Buildings $ 377.1 $ 48.9 $ 6.3 $. 1 $ - $ 419.8 Equipment 1,202.0 218.5 52.5 (1.7) - 1,366.3 ------- ----- ---- ------ ----- ------- TOTALS $1,579.1 $267.4 $58.8 $( 1.6) $ - $1,786.1 ======= ====== ==== ===== ===== ======= Year Ended Dec 31, 1992 Buildings $ 419.8 $ 62.3 $ 21.3 $ (8.4) $ 32.2(A) $ 484.6 Equipment 1,366.3 268.3 97.6 (40.4) 94.8(A) 1,591.4 ------- ----- ----- ----- ----- ------- TOTALS $1,786.1 $330.6 $118.9 $(48.8) $127.0(A) $2,076.0 ======= ===== ===== ====== ===== ======= Year Ended Dec 31, 1993 Buildings $ 484.6 $ 74.1 $ 4.9 $ (4.6) $ 9.2(A) $ 558.4 Equipment 1,591.4 294.5 58.9 (20.1) 1.0(A) 1,807.9 ------- ----- ----- ------ ---- ------- TOTALS $2,076.0 $368.6 $63.8 $(24.7) $ 10.2(A) $2,366.3 ======= ===== ==== ====== ==== ======= NOTE A - Amounts shown are primarily attributable to corporate restructuring, divestitures and transfers between accounts. ELI LILLY AND COMPANY AND SUBSIDIARIES SCHEDULE VII. GUARANTEES OF SECURITIES OF OTHER ISSUERS Col. A Col. B Col. C Col. D Col. E Col. F Col. G ------ ------ ------ ------ ------ ------ ----------- Nature of any default by issuer of securities guaranteed in principal Name of interest, Issuer of sinking fund securities Title of Amount owned or guaranteed Issue Total by person Amount in redemption by person of each amount or persons treasury of provisions, for which class of guaranteed for which issuer of or statement securities and statement securities Nature of payments of is filed guaranteed outstanding is filed guaranteed guarantee dividends - ---------------------------------------------------------------------------- The Harding St. Indianapolis Project Debt Local Public Bonds $35,451,123 -0- Service None Improvement Bond Bank ELI LILLY AND COMPANY AND SUBSIDIARIES SCHEDULE VIII. VALUATION AND QUALIFYING ACCOUNTS Col. A Col. B Col. C Col. D Col.E ------ ------ ------ ------- ------ Additions (1) (2) Balance at Charged to Charged to Balance Beginning Costs and Other Accounts-Deductions- at End Description of Period Expenses Describe Describe of Period - ---------------------------------------------------------------------------- (Dollars in millions) (A) (A) (A) Year Ended December 31, 1991 Allowance for cash discounts and returns $ 6.2 $ 6.6 Allowance for doubtful accounts 17.1 21.0 ---- ---- TOTALS $23.3 $27.6 ==== ==== Year Ended December 31, 1992 Allowance for cash discounts and returns $ 6.6 $ 8.1 Allowance for doubtful accounts 21.0 26.9 ---- ---- TOTALS $27.6 $35.0 ==== ==== Year Ended December 31, 1993 Allowance for cash discounts and returns $ 8.1 $ 8.6 Allowance for doubtful accounts 26.9 23.7 ---- ---- TOTALS $35.0 $32.3 ==== ==== NOTE A - The information called for under columns C and D is not given, as the additions, deductions, and balances are not individually significant. ELI LILLY AND COMPANY AND SUBSIDIARIES SCHEDULE IX. SHORT-TERM BORROWINGS Col. A Col. B Col. C Col. D Col. E Col.F ------ ------ ------ ------ ------ -------- Weighted Average Average Maximum Amount Interest Balance Weighted Amount Outstanding Rate at Average Outstanding During During Category of Aggregate End of Interest During the the the Short-Term Borrowings Period Rate Period Period(C) Period(D) - --------------------------------------------------------------------------- (Dollars in millions) Year Ended December 31, 1991 Payable to banks (A) $315.0 6% $ 324.4 $ 188.5 7% Commercial paper (B) 375.2 5% 1,160.6 482.7 6% ----- Short-term borrowings $690.2 6% Year Ended December 31, 1992 Payable to banks (A) $174.9 6% $350.4 $ 287.3 7% Commercial paper (B) 416.3 3% 837.2 541.6 4% ----- Short-term borrowings $591.2 4% Year Ended December 31, 1993 Payable to banks (A) $178.4 7% $195.2 $114.7 9% Commercial paper (B) 346.4 3% 877.6 434.7 3% ----- Short-term borrowings $524.8 4% - ----------------------- NOTE A - Amounts payable to banks represent worldwide borrowings under lines-of-credit and the current portion of long- term debt. NOTE B - Commercial paper is issued in the United States for periods up to 270 days. NOTE C - Average of daily balances. NOTE D - Total interest divided by average borrowings outstanding. ELI LILLY AND COMPANY AND SUBSIDIARIES SCHEDULE X. SUPPLEMENTARY INCOME STATEMENT INFORMATION - --------------------------------------------------------------------------- Col. A Col. B ------- -------------------------------- Item Charged to Costs and Expenses Year Ended December 31 ------------------------------- 1993 1992 1991 ------------------------------- (Dollars in millions) Maintenance and repairs $178.8 $193.4 $178.7 Taxes, other than payroll and income 77.7 77.4 57.3 Advertising costs 29.6 24.3 21.0 Royalty expense 107.2 87.0 79.4 Amounts for depreciation and amortization of intangible assets are presented in the Statements of Cash Flows. INDEX TO EXHIBITS The following documents are filed as part of this report: Exhibit Location - ------- -------- 3.1 Amended Articles of Incorporated by reference Incorporation from Exhibit 3(i) to the Company's Registration Statement on Form S-8, Registration No. 33-50783 3.2 By-laws Filed herewith 4.1 Form of 7% Bond 1984-1994/96 Incorporated by reference of Eli Lily Overseas Finance from Exhibit 4.1 to the N.V. Company's Report on Form 10-K for the fiscal year ended December 31, 1990 4.2 Form of Guarantee dated as Incorporated by reference of January 9, 1984, by Eli from Exhibit 4.2 to the Lilly and Company to Holders Company's Report on Form of 7% Bonds 1984-1994/96 of 10-K for the fiscal year Eli Lilly Overseas Finance ended December 31, 1990 N.V. 4.3 Form of Letter Agreement Incorporated by reference dated as of January 9, 1984, from Exhibit 4.3 to the between Eli Lilly and Company's Report on Form Company, Eli Lilly Overseas 10-K for the fiscal year Finance N.V., and Swiss Bank ended December 31, 1990 Corporation 4.4 Form of Bond Purchase * Agreement dated as of December 3, 1984, including form of Bond, between City of Clinton, Indiana, Eli Lilly and Company, and Chemical Bank 4.5 Form of Loan Agreement dated * as of December 3, 1984, between Eli Lilly and Company and City of Clinton, Indiana 4.6 Form of Bond Purchase * Agreement dated as of December 3, 1984, including form of Bond, between Tippecanoe County, Indiana, Eli Lilly and Company, and Chemical Bank 4.7 Form of Loan Agreement dated * as of December 3, 1984, between Eli Lilly and Company and Tippecanoe County, Indiana - ------------------ * Exhibits 4.4-4.7 are not filed with this report. Copies of these exhibits will be furnished to the Securities and Exchange Commission upon request. 4.8 Form of Indenture dated as Incorporated by reference of May 15, 1985, between Eli from Exhibit 4(a) to the Lilly and Company and Company's Registration Merchants National Bank & Statement on Form S-15, Trust Company of Registration No. 2-96799 Indianapolis, as Trustee 4.9 Form of Eli Lilly and Incorporated by reference Company Convertible from Exhibit 4(b) to the Debenture due 1994 Company's Registration Statement on Form S-15, Registration No. 2-96799 4.10 Form of Indenture with Incorporated by reference respect to Contingent from Exhibit 4.3 to the Payment Obligation Units Company's Registration dated March 18, 1986, Statement on Form S-4, between Eli Lilly and Registration No. 33-3330 Company and Harris Trust and Savings Bank, as Trustee 4.11 Rights Agreement dated as of Filed herewith July 18, 1988, between Eli Lilly and Company and Bank One, Indianapolis, N.A. 4.12 Form of Indenture dated as Incorporated by reference of February 21, 1989, from Exhibit 4.16 to the between Eli Lilly and Company's Report on Form Company and Merchants 10-K for the fiscal year National Bank & Trust ended December 31, 1988 Company of Indianapolis, as Trustee 4.13 Form of Eli Lilly and Incorporated by reference Company Five Year from Exhibit 4.17 to the Convertible Note Company's Report on Form 10-K for the fiscal year ended December 31, 1988 4.14 Form of Indenture with Incorporated by reference respect to Debt Securities from Exhibit 4.1 to the dated as of February 1, Company's Registration 1991, between Eli Lilly and Statement on Form S-3, Company and Citibank, N.A., Registration No. 33-38347 as Trustee 4.15 Form of Standard Multiple- Incorporated by reference Series Indenture Provisions from Exhibit 4.2 to the dated, and filed with the Company's Registration Securities and Exchange Statement on Form S-3, Commission on, February 1, Registration No. 33-38347 4.16 Form of Indenture dated as * of September 5, 1991, among the Lilly Savings Plan Master Trust Fund C, as Issuer; Eli Lilly and Company, as Guarantor; and Chemical Bank, as Trustee - --------------------- * Exhibit 4.16 is not filed with this report. Copies of this exhibit will be furnished to the Securities and Exchange Commission upon request. 10.1 1984 Lilly Stock Plan, as Incorporated by reference amended from Exhibit 10.2 to the Company's Report on Form 10-K for the fiscal year ended December 31, 1988 10.2 1989 Lilly Stock Plan, as Filed herewith amended 10.3 The Lilly Deferred Incorporated by reference Compensation Plan, as from Exhibit 10.4 to the amended Company's Report on Form 10-K for the fiscal year ended December 31, 1991 10.4 The Lilly Directors' Incorporated by reference Deferred Compensation Plan, from Exhibit 10.5 to the as amended Company's Report on Form 10-K for the fiscal year ended December 31, 1991 10.5 The Lilly Non-Employee Incorporated by reference Directors' Deferred Stock from Exhibit 10.6 to the Plan, as amended Company's Report on Form 10-K for the fiscal year ended December 31, 1991 10.6 Eli Lilly and Company Senior Filed herewith Executive Bonus Plan, as amended 10.7 The Lilly Non-Employee Incorporated by reference Directors' Retirement Plan from Exhibit 10.7 to the Company's Report on Form 10-K for the fiscal year ended December 31, 1988 10.8 Letter Agreement dated Filed herewith September 3, 1993, between the Company and Vaughn D. Bryson 11. Computation of Earnings Per Filed herewith Share on Primary and Fully Diluted Bases 12. Computation of Ratio of Filed herewith Earnings to Fixed Charges 13. Annual Report to Filed herewith Shareholders for the Year Ended December 31, 1993 (portions incorporated by reference in this Form 10-K) 21. List of Subsidiaries Filed herewith 23. Consent of Independent Filed herewith Auditors 99. Report to Holders of Eli Filed herewith Lilly and Company Contingent Payment Obligation Units

5550_1993.txt

5550

1993

Item 1. Business. - ------- --------- Development of Business American Nuclear Corporation, the Company, was incorporated in 1955 as one of the first uranium exploration companies formed after the commercial importance of uranium as a source of energy and fuel was realized. The Company acquired uranium mining properties by locating mining claims and purchasing other mining claims. Uranium Mining for Atomic Energy Commission and Others Starting in 1959 the Company was engaged, with its partner, Federal Resources Corporation, in mining and milling uranium concentrates in the Gas Hills area in central Wyoming for sale to the U.S. Atomic Energy Commission and various utilities that supply electricity. The mining was conducted by open pit surface mining, a method of mining that is subsequently described in this report under Item 2, Properties. The mill was also operated on a custom basis to mill uranium ores for other uranium producers. The Atomic Energy Commission discontinued purchases in 1971 when its inventory goals and strategic plans were met and a United States uranium industry had been created. The partnership continued to operate its mill for producing its own properties and custom milling of uranium ores for other producers for sales to commercial users. Expansion of Uranium Industry in the 1970's The modern uranium industry was shaped in the 1970s in response to growth in nuclear power generation by utilities. The embargoes of imports of foreign oil in the early 1970s caused an energy crisis in the United States and resulted in increased construction of nuclear power plants and plans for more plants. Demand for uranium increased significantly from spot prices for short-term deliveries of less than $10 per pound of uranium concentrate in 1971 to more than $40 per pound by 1978. Tennessee Valley Authority Agreements In 1972 the Company entered into an arrangement with the Tennessee Valley Authority (TVA), an agency wholly owned by the United States, for the joint acquisition of uranium properties to be produced for use by TVA to fuel its nuclear power plants. In 1973 Federal American Partners leased its mining properties to TVA. From 1979 through 1982, the partnership mined its properties and milled its ores for TVA. In the late 1970's annual production reached a level of 1.2 million pounds of uranium concentrates per year. TVA discontinued the operations in 1982 because world-wide production of uranium concentrates exceeded demand and it cost less to purchase from inventoried uranium stocks than to mine and mill. A total of 14.5 million pounds of uranium concentrates had been produced through the mill over its operating life. Termination of Tennessee Valley Authority Agreements In 1984 the Company acquired the uranium mill and associated lands from the partnership, and it also acquired approximately one- half of the uranium lands it had jointly held and explored with TVA. Today these lands remain the base of the Company's approximately 14,800 acres of uranium properties that are being offered for sale. Please see Item 7, "Liquidity and Capital Resources" section of this report for more detail. In 1984 TVA also placed approximately $3.8 million cash in a $4.1 million reclamation bond fund with the Wyoming Department of Environmental Quality (DEQ) to assure the DEQ and the U.S. Nuclear Regulatory Commission (NRC) that the reclamation obligations of TVA, the Company and the partnership for the mill site would ultimately be performed. The fund is the property of the Company, but withdrawal remains subject to the surety provisions for the benefit of the state of Wyoming. Starting in 1984, the Company received the interest earnings and capital gains from the reclamation fund. The Company began reclamation of the land at the mill site in 1984. TVA also entered into a management agreement with the Company under which, in exchange for management fees, the Company closed the mining operations, returned leased mining equipment, and sold the other mining equipment for TVA's account. The Company's entire financial obligation to TVA for the Company's cost of acquiring and exploring its interests in the uranium properties was eliminated. Status of Uranium Business Since the Tennessee Valley Authority terminated its mining activities in 1982 that were conducted through the Company's partnership called Federal American Partners, the Company has not been engaged in mining or milling uranium. The Company has identified significant quantities of uranium resources in the ground among its uranium properties that may be amenable to mining by in situ mining methods. In situ mining is less expensive than the open pit mining methods previously employed. The market for uranium remains depressed, however, and it would not be economically feasible to mine the Company's uranium properties at current prices. Imports of foreign uranium at low prices, especially from Russia and Canada, have continued to dampen prices. In 1993, spot prices for short-term deliveries of uranium were approximately $9.50 per pound. For a more complete discussion of the uranium properties, see Item 2, Properties. Reclamation of Mill Site and Tailings Ponds Based upon the Company's determination that use in the future of its uranium processing mill would not comply with the revised licensing requirements of the NRC, the Company began demolition of the mill in 1988 and completed that work in 1989. Since then the Company has undertaken substantial reclamation work on the mill site as required by the NRC and the DEQ. The mill and associated buildings have been dismantled and the building materials buried in one of the two adjacent tailings ponds where the processed ores produced by the mill (mill tailings) were impounded after milling. The mill tailings in the two impoundments have been graded by earth moving equipment into mounds covering approximately 40 and 80 acres respectively. A cover of native earth has been placed over the mounds of mill tailings, and the tailings piles are being allowed to settle and compact naturally. The remaining reclamation work consists of filling and shaping the side slopes of the tailings piles to such a grade as to preclude soil erosion and exposure of the tailings, placing a final cover of earth over the tailings to limit emission of radon gas into the atmosphere to meet Environmental Protection Agency (EPA) standards, and revegetating and fencing the site. In 1992 the Company submitted to the NRC an alternate design to its original reclamation plan in order to meet new NRC criteria for long term stability of the tailings impoundments. The principal modification the Company has proposed to the NRC utilizes a rock mulch for erosion protection instead of native vegetation. Due to delay by the NRC in responding to the proposed reclamation design, the Company has requested the NRC to extend by one year the requirement for placing radon barrier material on tailings impoundment number 2 by December 31, 1994. The NRC is not expected to respond to the Company's request until mid 1994. If the NRC does not grant the requested extension, the Company may be unable to complete the required work in the limited time remaining after the NRC approves the reclamation design. Reclamation work will continue at minimal levels until the NRC approves a new design. At that time the Company expects the reclamation process to continue at an active level until approximately 1997. Thereafter environmental monitoring and ongoing reclamation obligations at reduced levels of activity are expected to continue for at least five additional years until the reclamation requirements for stabilization of the tailings are deemed satisfied by the NRC, DEQ and EPA. At that time the site will be transferred to the Department of Energy or State of Wyoming as required by law. Byproduct Material Disposal Starting in 1990 the Company shifted most of its efforts to a new, developing industry of byproduct material disposal. The byproduct material consists of waste generated from ores processed by others for their uranium or thorium content. Federal regulations require the generators of these low level radioactive materials to dispose of them in licensed depositories. In part because the Company's mill site is undergoing reclamation work to stabilize the mill tailings, which are low level radioactive materials, the NRC initially granted permission in the fall of 1990 for the Company to accept byproduct materials totaling 1,100 cubic yards from four generators under four specific waste disposal contracts. After the NRC authorized receipt of the initial byproduct material, the NRC amended the Company's license in September of 1991 to authorize it to receive and dispose of an additional 12,500 cubic yards of material from other sources. The material terms of the disposal contracts already completed, as well as the proposed terms of any future contracts, require the generator of the byproduct materials to deliver them to the Company's mill site. The contracts require the generator to pay the contract charges for each shipment of materials, usually within thirty days after delivery of a shipment. The byproduct material is placed on the surface of the mill tailings impoundment number 1, compacted and covered with an interim cover of native soils. The addition of the byproduct materials reduces the volume of earthen fill material that must be placed on the mill tailings to meet the reclamation design requirements. Byproduct material is expected to originate at past and present uranium mining and milling locations owned by others throughout the western region of the United States. There has been no readily available outlet for disposal of these types of waste, and the availability of the Company's reclamation project for such disposal is consistent with federal policy to limit proliferation of small disposal sites. Based upon income received on account of the initial five contracts, the Company generated revenue of $322,624, $318,814, and $120,352 from operations in 1993, 1992, and 1991, respectively. Additional materials will be delivered under one of the existing contracts during 1994 that will utilize a $16,500 prepayment already received during January 1994. Marketing of Disposal Contracts The additional licensed space remaining available for disposal of byproduct materials at December 31, 1993 could be sold and used in a single season. That is not likely, however, because the Company has previously experienced difficulty in obtaining disposal contracts. While the Company has identified and solicited disposal contracts from other parties who hold byproduct materials in quantities that exceed its permitted volume and that must eventually be relocated to licensed disposal sites, few of the generators face short-term deadlines for disposing of their material. Their reluctance to incur the costs of transportation and disposal any earlier than necessary and the continuing lack of a federal deadline for disposal are the primary reasons that the Company has not obtained as many disposal contracts as expected. The Company believes its permitted disposal space will not be available if not utilized by the end of 1995 because the approved reclamation plans call for work during 1996 to close the site during that year. In order to generate revenues and to improve upon its own marketing efforts, the Company granted exclusive marketing rights to American Ecology Corporation (AEC) during September 1993 for 10,000 cubic yards of the Company's permitted disposal space. AEC operates low level radioactive waste disposal facilities and is engaged in other waste management business and services. Net profits from any disposal contract revenues are to be shared equally by the Company and AEC. AEC paid $202,500 when the contract was executed as an advance to the Company against its share of potential disposal revenues. A second advance by AEC in the same amount was not paid when expected in February 1994. AEC's position is that the second advance was not due then because the NRC did not by that date issue its policy allowing for the co-disposal of byproduct materials together with similar materials containing low level radioactive waste. Instead the NRC plans to consider applications for disposal of such similar materials at byproduct material sites on a case by case basis. AEC has not procured any contracts with generators of such materials. The Company will submit an application to the NRC for its consent to dispose of these similar materials in the Company's permitted space after a contract is obtained. The NRC is not expected to act on any application until at least several months after its submittal. There are no assurances that AEC will produce any disposal contracts or pay any additional money for disposal or that NRC approval of disposal of any materials will be obtained. If AEC does not recover its advance deposit of $202,500 from disposal revenues generated through the Company's disposal services, AEC is entitled to receive shares of the Company's common stock. The stock would be issued at the rate of the stocks' average of the thirty day trailing closing sales price at the time of exercise. Abandonment of Efforts to License Commercial Byproduct Disposal During 1993 the Company abandoned its efforts to obtain licenses from the NRC and DEQ to establish a commercial byproduct disposal business near its mill site that is undergoing reclamation. In order to complete the required environmental studies, continue to pursue its license applications, and take other steps for opening such a business, the Company sought to raise $5 million to $8 million through private placements of its common stock. When this effort proved unsuccessful in mid-1993, the Company terminated further efforts to enter the commercial byproduct disposal business. Business Focus The Company has not realized adequate revenues from its byproduct disposal business to fund its operations, and since 1991 has relied for a large part on its operating capital upon loans by Cycle Resource Investment Corporation (CRIC), holder of approximately 30 percent of the Company's outstanding stock. The Company has been unable to obtain additional loans from CRIC or any other source. The Company's efforts to raise capital by placement of its common stock have not been successful. The Company has not been able to obtain joint ventures or long term supply contracts for exploitation of its uranium properties in the future when market prices for uranium are expected to be higher. In order to repay its loan to CRIC and to raise additional capital to continue its reclamation work over the next several years as required by law, the Company has offered its uranium properties for sale at the highest price received. Several prospective buyers have expressed interest in purchasing the uranium properties, but no purchase offers have been received. The Company expects to receive purchase offers in the spring of 1994 and to submit the best offer it receives to a vote of its shareholders at the 1994 meeting of shareholders. There are no assurances that the properties will be sold during 1994 or if sold, that the purchase price or terms will be adequate to meet the Company's needs, either short-term or long-term. Upon a sale of its uranium properties, the Company will retain its byproduct disposal operations through 1995 and continue to be obligated for long-term reclamation work associated with the mill site. Unless firm contracts for disposal made during the remainder of 1994 and 1995 substantially increase over the past levels or the sale of uranium properties produces more proceeds that the amount required to repay the CRIC loans, neither of which is assured, the Company's activities will be restricted to its limited cash, if any. The Company intends to pursue its reclamation obligations. If the Company is unable, for lack of funds or otherwise, to continue reclamation work on a schedule that meets the deadlines or milestones fixed by the NRC, the agencies could take possession of the reclamation bond fund to complete the work. If the bond fund were inadequate to complete reclamation and to establish an additional fund to assure long-term stabilization of the mill tailings, the agencies could seek judgments against the Company. Changes in Fiscal Year Effective December 31, 1991, the Company changed its fiscal year end from May 31 to December 31 to better match the seasonal nature of its business operations. The byproduct disposal business involves earth moving. Drilling for uranium and other maintenance of mining claims also requires field work. These activities start after the ground has thawed and dried in the spring, and they are concluded before the harshest winter months. A fiscal year that is the same as the calendar year, therefore, better reflects a complete business cycle and will enable application of revenues from operations conducted early in the year to expenses incurred that year. Financial Information About Industry Segments Beginning with the seven-month period from June 1 to December 31, 1991, the Company entered into the business of uranium byproduct material disposal. Between 1982 and that time, the Company's only business was winding down its former mining operations with the partnership and TVA, its reclamation activities, and the maintenance of its uranium properties with the intent of eventually producing uranium concentrate. See Note 1 to the financial statements included in Item 14 of this report. The Company has no foreign operations or export sales. It has not segregated its business activities into geographic areas within the United States except to the extent that its operations are located within Wyoming. Other Business Factors The Company's byproduct materials disposal business activities are highly regulated. The presently licensed disposal activities are subject to NRC and DEQ licensing authority and jurisdiction. The Company has a restricted cash deposit of approximately $3.0 million with the Wyoming DEQ to cover the ultimate reclamation costs of its mill site. The Company, DEQ and NRC have estimated that the actual costs remaining for reclamation are approximately between $2.7 and $3 million. There is always some risk that the regulations may be changed and that the amount required to perform the reclamation under such new regulations may increase. Based upon discussions with representatives of the agencies about potential changes and also based on current contract prices obtained by third parties for similar reclamation work in the area, the Company believes any potential increases would be in the range of 10 to 15 percent and that they could be offset by either byproduct disposal revenue or the interest earned on the $3 million reclamation deposit. Employees As of December 31, 1993, the Company had four full-time employees. Item 2.

Item 2. Properties In addition to the mill site under reclamation that is also used for uranium byproduct material disposal as previously described in this report, the Company holds uranium properties that may be developed for the production and sale of uranium concentrates if justified by future price increases. The properties primarily consist of blocks of unpatented mining claims located on the public domain of the United States in the Gas Hills area of central Wyoming. During 1993 the Company discontinued this business segment and began actively marketing the properties for sale to the highest bidder. Peach Properties The Company's principal uranium holdings are the Peach properties which cover approximately 2,700 acres. They are composed of a several contiguous groups of unpatented mining claims located in the Gas Hills area of Central Wyoming. A valuable mineral deposit has been delineated by extensive development drilling, and both open pit and underground mine plans have been prepared for possible future use. The properties may also be suitable for mining by in situ mining techniques, and the Company has previously performed preliminary studies of the suitability of the deposit for production by this mining method. Mining by any method requires an increase in the price for uranium concentrates, a long term supply contract, and financing for the project, none of which are now available to the Company. The Peach properties are subject to a mortgage dated May 20, 1991 by which the Company mortgaged its properties to Cycle Resource Investment Corporation (CRIC), the mortgagee and a shareholder of the Company. The principal balance of the CRIC mortgage as of December 31, 1993 was $2,031,200. Since cash flow was not sufficient to repay the note on the August 31, 1993 due date, CRIC and the Company signed a forbearance agreement extending the notes to June 30, 1994. Upon default, CRIC could foreclose on the Peach properties if it so decides. NUKEM, Inc. owns 100 percent of CRIC which in turn owns 30% of the Company's common stock. NUKEM, Inc. is a New York corporation located in Stamford, Connecticut, that is a wholly owned subsidiary of NUKEM, GmbH, a German corporation located in Alzenau, Germany that in turn is a wholly owned subsidiary of RWE AG, a Germany corporation. RWE is publicly held, and is the largest electric generating utility in Germany and the eighth largest in the world. It is also a worldwide conglomerate active in the production and marketing of petroleum products, coal, uranium, chemicals, and electrical generating equipment. RWE also is active in waste processing and environmental protection and reclamation services. Sweetwater Properties The Sweetwater properties cover approximately 9,700 acres of unpatented mining claims that are located adjacent to the Peach properties on the Sweetwater Plateau, a topographic feature in the southern Gas Hills uranium area. Wide-spaced drilling conducted on the Sweetwater properties has disclosed uranium in numerous drill holes. The Company has retained the Sweetwater properties in anticipation of future favorable market conditions for uranium concentrates from the properties. Other Gas Hills Uranium Properties The Company also owns varying undivided interests, ranging from 13% to 100% undivided interests as tenants in common in unpatented mining claims covering approximately 3,100 acres in the Gas Hills area near the Peach and Sweetwater properties. Mineralization has been found by drilling on some of these properties. Sufficient drilling has not been performed on these properties to assess the extent of the mineralization, that is, evidence of uranium minerals, or to determine if the properties can be economically produced. Nature of Title to Mining Claims Acquisition of mining claims on those parts of the public domain not reserved or withdrawn by the government from location of claims is a right granted by the federal mining law. Explorers for minerals such as uranium are entitled to go upon the land and search for minerals. To initiate mining claims, a locator establishes or locates single claims as a contiguous block of claims by marking the boundaries upon the surface, posting notices of the claims upon the surface, and recording notices in the local county records as well as filing them with the Bureau of Land Management office in the state in which they are located. Upon location, a person searching for uranium by exploratory drilling or other geological methods is entitled to exclusive possession of the land encompassed by the claim or block of claims. Upon discovery of a valuable mineral deposit, the possessory right ripens into a vested interest in real property. Mining claims are interests in real property that may be sold and conveyed. A rival locator is entitled by law to contest the validity of another's claims. The rival or junior location may show it has better possessory rights or vested property rights by proving in a judicial proceeding that the senior claimant has not met the requirements for establishing or maintaining the claim or block of claims, and that the rival locator has the better right by virtue of its own entry onto the lands, relocation of the land for its own claims, and either continuous possession while in pursuit of discovery or actual discovery of a valuable mineral deposit. The Company and other owners of mining claims have no obligation to seek a patent from the government, that is, an instrument conveying the government's record title. Without a patent, a locator or subsequent owner of unpatented mining claims is entitled to mine them and remove and sell the minerals without payment of a royalty or other charges to the government. If a patent is obtained from the United States, the entire record and beneficial interest vests in the patentee, and the claims are no longer subject to defeasance by either the government or a rival locator. Some of the Company's unpatented mining claims were located by it in the 1950s and 1960s. Other of its claims were acquired from other locators in the 1970s. All the Company's mining claims, like those previously mined for its benefit, are unpatented. The Company has no intention to seek patents to its mining claims at this time. In March 1993 the Department of the Interior placed a moratorium upon issuance of patents pending resolution of proposed changes in the federal mining law. Mining Claim Rental Fees and Royalties According to a federal law adopted in 1992, in order to maintain title to mining claims after their location, an owner must pay annual rental fees of $100 per claim to the Department of the Interior. Upon failure to pay a filing fee, the Bureau of Land Management declares the claim void and terminated. Proposed amendments to the mining law now pending in Congress are expected to include imposition of a royalty on production of minerals. The royalty rates being debated in Congress range up to eight percent of gross proceeds, a rate that would make mining uneconomic in many cases. Abandonment of Mining Claims On August 31, 1993 the Company abandoned, through non-payment of the $200 per claim annual fees due on that date for 1993 and 1994, 870 mining claims with a remaining book value of $543,826. The claims abandoned represented approximately 54% of the Company's mineral acreage and approximately 5% of its remaining investment. During December 1993 a mineral property impairment of $3 million for the remaining mining claims was recorded. This represents a 31% reduction of the property valuation. During 1992 there were no property abandonments or mineral property impairments, while during 1991 the Company recorded abandonments of $115,212 and mineral property impairments of $3,180,000. Mining Methods A uranium deposit, once identified and developed, may be produced and the minerals extracted by one of three mining methods. These are surface mining, underground mining, and in situ solution mining. Surface mining by the open pit method is generally used for ore bodies located within approximately 500 feet of the surface. Open pit mining requires removal and saving of the topsoil for later reclamation, removal of the dirt and rock overlying the mineral deposit, digging a pit into the earth to expose the mineral deposit, mining the ore by heavy shovels which load it into large trucks for hauling to an uranium processing mill where the uranium concentrates are extracted, and reclaiming the spent ores, called mill tailings, as well as the open pit, to stabilized conditions consistent with pre-mining uses. Mineral deposits found at depths greater than 500 feet are traditionally mined by underground mining methods. A large shaft is bored from the surface down to the mineral deposit. From there tunnels are bored laterally and perhaps vertically through the deposit. The ore is loaded onto railroad cars located underground, hauled to the shaft, lifted by hoists to the surface, and transported to a mill for processing. In situ solution mining methods are often referred to as in situ leach or ISL mining. In the ISL process, groundwater fortified with solubilizing agents such as sodium bicarbonate (baking soda), for example, are injected into an ore body through a series of injection drill holes. The solutions penetrate the ore body and dissolve the uranium. The mineralized solutions are pumped to the surface through a recovery well for additional processing to extract the uranium concentrates. Solution mining is less labor and capital intensive than the traditional surface mining and underground shaft operations. The expense of licensing, constructing and operating a large uranium processing mill can be avoided because a less complex and less costly precipitation unit is adequate to separate the uranium concentrates from the solutions. ISL mining also usually requires less expense for reclamation because no open pits or large shafts are excavated and smaller quantities of processed waste comparable to mill tailings are produced. ISL processes are generally suitable for ore bodies not much deeper than 2,000 feet which are found in permeable underground formations that the solutions can penetrate, and that have confining layers of rock above and below the ore zone to concentrate the solutions in the ore body. Because of the current low market price for short-term deliveries of uranium concentrates, approximately $9.50 a pound, the Company has been unable to commence mining. The future demand for uranium, and consequently the future price, is susceptible to a number of variables. The principal factors are importation of low- priced uranium, market requirements of nuclear power generators located around the world, and stockpiles of uranium concentrates, both domestic and foreign. As inventories of uranium concentrates are depleted, the need for uranium production should increase. The inventory of uranium available to the nuclear power industry has been declining, and the Company anticipates an eventual increase in uranium prices. Market for Uranium Most of the former uranium producers in the United States have suspended operations because of the current low market price of uranium. The current market for sales of uranium is being filled in large part by inventories of domestic concentrates and imported foreign concentrates. Some U.S. uranium producers are positioning themselves for production because world-wide inventories of uranium concentrates are declining. If current conditions persist, the established consumption level of uranium will exceed the available inventories and current annual production in several years, and demand for uranium may increase as a result of reduced supplies. New production typically requires three to five years of mine and mill permitting. New production can be expected from other producers, both domestic and foreign, to meet increases in demand. The principal market for uranium concentrates consists of utility companies throughout the United States and other countries. The principal market for lands containing uranium which has not been mined, non-producing uranium properties, primarily consists of other mining companies, foreign utilities, and to a lesser extent, utility companies throughout the United States. Some of the utility companies purchase non-producing properties to assure themselves of a supply of uranium for their nuclear reactors. The Company's non- producing uranium properties consist of mining claims that may or may not have proven uranium deposits. Generally, the more a mineral bearing property is developed by drilling the more defined the ore body becomes, and in turn, the more valuable the property becomes. Only close-spaced drilling is adequate to permit reliable quantification of the grade and extent of uranium deposits. The Company's drilling in many cases is not sufficiently close-spaced to permit such quantification. Marketing of non-producing uranium properties as well as uranium concentrates occurs through privately negotiated contracts, by open bid, or both. Uranium brokers may seek buyers and sellers of either uranium properties or concentrates for a commission. There are only a couple of brokers internationally that list uranium properties for sale, and the Company maintains contact with them although its properties are not currently listed through them for sale. There are only a few sales of uranium properties every several years, and each sale is unique. Because of the immediate cash needs of the Company and the long term nature of uranium production and the associated risks involved, the Company must liquidate all or a portion of its uranium properties to continue operations and repay its debt obligations. The Company decided during 1993 to offer its properties for sale and hopes to sell them by June 1994. There are no assurances as to the selling price, terms of sale, or a sale completion date. Please see Item 7, "Liquidity and Capital Resources," in this report for additional details. Item 3.

Item 3. Legal Proceedings. - ------ ----------------- There are no legal proceedings pending against the Company or its properties. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders. - ------ ------------------------------------------- No matters for decision were submitted to a vote of shareholders during the last calendar quarter of the year ended December 31, 1993. PART II ------- Item 5.

Item 5. Market For Registrant's Common Equity and Related Stockholder Matters. - ------ ----------------------------------------- (a) Through January 1994 the common stock of the Company was traded over-the-counter on the NASDAQ national market system under the symbol ANUC. Effective February 1, 1994 the Company's common stock is being traded on the NASDAQ small cap market under the ANUC symbol. The range of high and low sales prices of the stock for each calendar quarter period during the past three years, as quoted by the National Association of Securities Dealers, Inc., are given in the following table, except that high and bid quotation prices are given for the first and second quarters of 1992 and the four quarters for 1991. The over-the-counter market quotations reflect inter-dealer prices, without retail mark-up, mark-down, or commission, and may not necessarily represent actual transactions. The low and high prices for the stock on March 11, 1994 were $.16 and $.16. (b) Based solely upon the number of record holders, the approximate number of stockholders of the common stock of the Company as of March 11, 1994 was 1734. (c) No dividends have been declared with respect to the common stock during the fiscal years ended December 31, 1993 and 1992, the seven-month period ended December 31, 1991, or the previous fiscal year ended May 31, 1991. 4. NOTES PAYABLE TO STOCKHOLDER The Company has notes payable with Cycle Resource Investment Corporation (CRIC), a major shareholder of the Company. The notes payable are collateralized by a security interest in substantially all of the Company's assets. The notes bear interest at 3% over prime of a New York bank (9.5% at December 31, 1993). Balances are as follows: Average short-term borrowings were $1,871,875, $1,227,897, $554,000 and $358,000 with weighted-average interest rates of 9.50%, 9.54%, 11.67% and 10.96% for the year ended December 31, 1993 and 1992, and for the seven months ended December 31, 1991 and the fiscal year ended May 31, 1991. The maximum borrowed during each period was $2,031,200, $1,619,506, $737,000 and $448,000 for the years ended December 31, 1993 and 1992, for the seven months ended December 31, 1991 and the fiscal year ended May 31, 1991. 5. BYPRODUCT MATERIAL DISPOSAL CONTRACTS The Company abandoned its efforts to develop a long-term commercial disposal business and charged the associated costs of $236,866 to expense during 1993. The Company has continued its short term disposal operations and entered into certain byproduct material disposal contracts and received advance payments related to the future performance of these services. The advance payments are recorded as deferred revenue and will be recognized as revenue when the Company takes delivery of the byproduct material. 6. INCOME TAXES The Company adopted Statement 109, Accounting for Income Taxes, as of January 1, 1993. There was no cumulative effect of this change in accounting for income taxes. Prior years' financial statements have not been restated to apply the provisions of Statement 109. The tax effects of the temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1993 are presented below. The valuation increased approximately $1.2 million during 1993. Deferred tax assets: Net operating loss carry forward $ 3,600,000 Estimated reclamation costs 400,000 Tax credit carry forwards 240,000 ----------- Total gross deferred tax assets 4,240,000 Less valuation allowance (2,710,000) ----------- Net deferred tax assets $ 1,530,000 Deferred tax liabilities: Mining properties $(1,530,000) ----------- Net deferred taxes -0- =========== At December 31, 1993 the Company had approximately $12.0 million of net operating loss carryovers which expire during 1997 through 2008. The Company also has investment tax and new jobs credit carryovers of approximately $40,000 and $200,000, respectively, which are available to be offset against future income taxes through 1999. The future utilization of both net operating loss and credit carry- overs are subject to rules and regulations of the internal revenue service that could be significant. 7. STOCKHOLDERS' EQUITY The Company has authorized 25,000,000 shares of $.04 par value common stock. Changes in common stock issued and outstanding during the fiscal year ended May 31, 1991, the seven months ended December 31, 1991 and the years ended December 31, 1992 and 1993 were as follows: Redeemable Preferred Stock --------------- The Company has authorized 15,000,000 shares of $1 par value Series A preferred stock with a liquidation value of $10.00 per share. There were no outstanding preferred shares during the periods ended December 31, 1993, 1992, 1991 or May 31, 1991. Stock Warrants ------------- The Company has warrants outstanding for the purchase of 49,020 shares of common stock, exercisable at $0.875 per share, expiring August 26, 1994. Employee Stock Ownership Plan ------------------------------ The Company had an Employee Stock Ownership Plan (ESOP) for the benefit of its employees. Contributions to the Plan were made at the Company's discretion. On March 6, 1992 the Board of Directors resolved to terminate the ESOP and replace it with a money purchase plan. The money purchase plan received approval by a vote of the shareholders on June 17, 1992. During the years ended December 31, 1992, and May 31, 1991, the Company made contributions to the Plan of 5,272 and 6,851 shares of the Company's common stock. No provision for contributions was made during the seven months ended December 31, 1991. At December 31, 1993 the Plan held 14,958 shares of the Company's common stock for the account of participating employees. Non-qualified Stock Options -------------------------- At December 31, 1993, an option for 257,750 shares of common stock is held by the Company's former president. This option is exercisable in whole or in part at $1.5761 a share and expires on September 9, 1996. At December 31, 1993, options covering 26,546 shares of common stock are held by current directors, officers, and key employees. An additional 311,243 are held by former directors and officers. These 337,789 shares are exercisable in whole or in part at varying prices from $0.5886 to $1.8834 per share with expiration dates ranging through 1996. There were no options exercised during the four years and seven months ended December 31, 1993. 1992 Incentive Stock Option Plan -------------------------------- During June 1992 the shareholders adopted a 1992 Incentive Stock Option Plan (herein ISOP), under which up to 1,000,000 shares of the Company's $0.04 par value common stock have been reserved for granting to employees. The ISOP is intended to meet the requirements of Section 422A of the Internal Revenue Code. Option prices will be no less than the fair market value or 110 percent of fair market value, in certain situations. The term of an option shall be for a period of no longer than ten years from the date of the grant of the option. The ISOP expires on its term anniversary date and will be administered by the compensation committee of the board of directors. During December 1993 options for 120,000 shares that were granted during June 1992 were voluntarily forfeited by the employees. As of December 31, 1993 there were no stock options outstanding under this 1992 Incentive Stock Option Plan. 1992 Stock Option Plan In Lieu of Directors Fees ------------------------------------------------ The 1992 Stock Option Plan In Lieu of Directors Fees was approved by the shareholders in June 1992 and authorizes each non- employee director to elect to receive stock options for service during the previous year rather than to receive cash compensation. The plan would provide each director through an option to buy such number of shares of the Company's stock, at a discount of 37% of the fair market price on the date of grant. The plan is administered by the compensation committee of the Board of Directors. Directors would be entitled to such options only after having served for a full year as a director, and only if they are not regular, full-time employees of the Company. The plan required eligible directors to make an irrevocable election in June of each year whether to receive options, and if so, the number of shares subject to the option and the exercise price are fixed according to the pre-established formula based upon the market price for the stock six months later in January of the next year. As of December 31, 1993, options for 13,546 shares were outstanding. The options were exercisable until January 12, 1994 at a price of $.5906 per share. These options were not exercised. This plan was terminated by the Board of Directors on January 13, 1994 because the extremely low price of the Company's common stock resulted in the granting options in amounts which were considered excessive by the Board of Directors. Money Purchase Pension Plan --------------------------- During 1992 the Company adopted a Money Purchase Pension Plan (herein "Plan"), with a plan year ending each December 31, whereby the Company contributes to all participants. Generally, participants are all full-time Company employees that are at least 21 years of age and have one year of service. The Plan is integrated with the Company's contributions under the Federal Social Security Act (social security taxes). As a result, annual required Plan contributions are between 9.5% and 15% of participants' compensation. Employer contributions vest at the rate of 20% per year beginning at the end of the first year of service. The Company accrued contributions of $26,572 and $39,270 for 1993 and 1992, respectively. Confidential Private Placement Memorandum ----------------------------------------- The Company offered, by a private placement, on a best efforts basis 4,761,905 shares ($5,000,000) minimum, 7,619,048 shares ($8,000,000) maximum, of its restricted $0.04 par value common stock at a price of $1.05 per share. The offering began on January 25, 1993 and continued through June 25, 1993. This confidential private placement memorandum was unsuccessful and terminated on June 25, 1993. Because of this failure to raise additional capital the Company was forced to abandon its efforts towards obtaining a commercial byproduct disposal license. The employment contract between the Company and its then President, Stephen A. Carpenter, was terminated on August 1, 1993. 8. COMMITMENTS Operating Leases ---------------- The Company leases its office space on a month to month basis under an operating lease which expired in November of 1993. At December 31, 1993 there were no annual lease commitments for 1994 or beyond. Rent expense, included in general and administrative expenses, was $20,481, $17,046, $11,867, and $18,738 years ended December 31, 1993 and 1992, for the seven months ended December 31, 1991 and the fiscal year ended May 31, 1991, respectively. Capitalized Lease Obligations ----------------------------- The Company leases one piece of dirt moving equipment and one vehicle under noncancellable capitalized lease obligations which expire in June 1997 and June 1994, respectively. At December 31, 1993 the Company has capitalized costs of approximately $100,000 and recorded accumulated amortization of $31,000. The following is a schedule of future minimum lease payments on capitalized lease obligations as of December 31, 1993. 1994 23,324 1995 20,424 1996 20,424 1997 10,212 -------- Total minimum lease payments 74,384 Less amount representing interest 10,584 -------- Present value of minimum lease payments 63,800 Current maturities of capitalized lease obligations 18,302 -------- Noncurrent capitalized lease obligations $ 45,498 ======== Employment Agreements --------------------- The Company had no employment contracts with any of its employees at December 31, 1993. 9. SUBSEQUENT EVENTS On January 28, 1994 the Company was notified by the NASDAQ surveillance committee that effective February 1, 1994 its common stock would no longer be traded on the National Over the Counter exchange but would be traded on the NASDAQ small cap market.

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1993

Item 1. BUSINESS. General Development of Business Texas - New Mexico Power Company Texas-New Mexico Power Company (Utility) is a public utility engaged in the generation, purchase, transmission, distribution and sale of electricity to customers within the States of Texas and New Mexico. The Utility is qualified to do business as a foreign corporation in the State of Arizona. Business conducted in Arizona is limited to ownership as tenant-in-common with two other electric utility corporations in a 345-KV electric transmission line which transmits electrical energy into New Mexico for sale to customers in New Mexico. The Utility is the principal subsidiary of TNP Enterprises, Inc. (TNPE), a Texas corporation which owns all of the Utility's common stock. TNPE also files a Form 10-K. The Utility and TNPE are holding companies as defined in the Public Utility Holding Company Act but each is exempt from regulation as a "registered holding company" as defined in said act. The Utility is subject to regulation by the Public Utility Commission of Texas (PUCT) and the New Mexico Public Utility Commission (NMPUC). The Utility is subject in some of its activities, including the issuance of securities, to the jurisdiction of the Federal Energy Regulatory Commission (FERC), and its accounting records are maintained in accordance with the FERC Uniform System of Accounts. The Utility has two wholly owned subsidiaries, Texas Generating Company (TGC), organized in 1988, and Texas Generating Company II (TGC II), organized in 1991. All financial information presented herein or incorporated by reference is on a consolidated basis and all intercompany transactions and balances have been eliminated. TNP One Prior to 1990, the Utility purchased virtually all of its electric requirements, primarily from other utilities. In an effort to diversify its energy and fuel sources, the Utility contracted with a consortium consisting of Westinghouse Electric Corporation, Combustion Engineering, Inc. and H. B. Zachry Company to construct TNP One. TNP One is a two- unit lignite-fueled, circulating fluidized bed generating plant in Robertson County, Texas. Unit 1 and Unit 2 of TNP One together provide, on an annualized basis, approximately 30% of the Utility's electric capacity requirements in Texas. The Utility acquired Unit 1 on July 20, 1990, and Unit 2 on July 26, 1991, through TGC and TGC II, respectively. The Utility operates the two units and sells the output of TNP One to its Texas customers. Unit 1 began commercial operation on September 12, 1990, and Unit 2 on October 16, 1991. As of December 31, 1993, the costs of Unit 1 and Unit 2 were approximately $357 million and approximately $282.9 million, respectively. Portions of the costs were funded by the Utility, with the majority of the costs borrowed by TGC and TGC II under separate financing facilities for the two units, which are guaranteed by the Utility. Regulatory Proceedings The Utility has received rate orders from the PUCT placing the majority of the costs of each of the two units of TNP One in rate base. The Utility and other parties to the proceedings have appealed both orders. For a review of the history of the two rate proceedings and the pending judicial proceedings, see Item 3, "Legal Proceedings" and note 5 to the consolidated financial statements. See note 2 to the consolidated financial statements for a discussion of the financings of the two units including, during 1993, substantial reduction of the TNP One construction indebtedness and extension of the payment schedule for the remaining balance of the construction debt. For a discussion of the effects of the construction and financing of TNP One on the Utility's financial condition, including the detrimental regulatory treatment received to date, see Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations." TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Financial Information About Industry Segments 1993 1992 1991 Operating Revenues (thousands of dollars): Residential $193,484 175,885 176,651 Commercial 138,680 128,550 119,745 Industrial 124,474 121,027 128,356 Other 17,604 18,365 16,591 Total $474,242 443,827 441,343 Sales (thousand kilowatt-hours): Residential 2,047,360 1,947,593 2,017,349 Commercial 1,567,083 1,499,927 1,485,211 Industrial 2,567,552 2,508,837 2,798,369 Other 104,882 109,954 115,406 Total 6,286,877 6,066,311 6,416,335 Number of customers (at year-end): Residential 181,298 178,154 174,859 Commercial 30,235 30,359 30,300 Industrial 141 155 160 Other 237 229 230 Total 211,911 208,897 205,549 Kilowatt-hour (KWH) sales in 1993 were assisted by more typical weather experienced in 1993 as compared to 1992. KWH sales declined in 1992 from 1991 due in part to milder than normal temperatures in the Utility's service area in Texas; however, revenues were approximately the same for the two years due primarily to an increase in the Utility's Texas customers' rates in 1992. Also contributing to the sales decline was the failure of new customers and revenues to materialize as expected within the industrial class to ameliorate the loss of KWH sales to certain industrial customers. During 1993, the number of industrial customers decreased by 14, but that decrease included the consolidation of 10 customers into 2 customers for billing purposes and the reclassification of 3 customers to the commercial class of customers. See Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," for a discussion of the changes in operating revenues, including rate increases. It is not possible to attribute operating profit or loss and identifiable assets to each of the classes of customers listed in the above table. Narrative Description of Business The Utility purchases and generates electricity for sales to its customers wholly within the States of Texas and New Mexico. The Utility's purchases of electricity are primarily from other utilities and cogenerators (see "Sources of Energy" in this section). The Utility's current generation of electricity is from TNP One. The Utility owns and operates electric transmission and distribution facilities in 90 municipalities and adjacent rural areas in Texas and New Mexico. The areas served contain a population of approximately 616,000. The Utility's service is delivered to customers in four operating divisions in Texas and one operating division in New Mexico. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES The Utility's Southeast Division, on the Texas Gulf Coast, is adjacent to the Johnson Space Center and lies between the cities of Houston and Galveston. The economy is supported by the oil and petrochemical industries, agriculture and the general commercial activity of the Houston area. This division produced 49.5% of the total operating revenues in 1993. The Utility's Northern Division is based in Lewisville, just north of the Dallas-Fort Worth International Airport, and extends to include municipalities along the Red River and in the Texas Panhandle. This division serves a variety of commercial, agricultural and petroleum industry customers and produced 19.5% of the Utility's revenues in 1993. The economy of the Utility's New Mexico Division is primarily dependent upon mining and agriculture. Copper mines are the major industrial customers in the New Mexico Division. This division produced 16.8% of the total operating revenues in 1993. The Utility's Central Division includes municipalities and communities located to the south and west of Fort Worth. This area's economy is largely dependent on agriculture and to lesser degrees tourism and oil production. In far west Texas, between Midland and El Paso, the Utility's Western Division serves municipalities whose economies are primarily related to oil and gas production, agriculture and food processing. The Utility serves and intends to continue serving members of the public in all of its present service areas. The Utility will construct facilities as needed to meet increasing demand for its service. The Utility will also extend service beyond its present service territories to the extent permitted by law and the orders of regulatory commissions. For a description of the properties utilized to provide this service, see Item 2, "Properties." Operating Revenues Revenues contributed by the Utility's operating divisions in 1993, 1992 and 1991 and the corresponding percentages of total operating revenues are shown below: 1993 1992 1991 Operating Revenues Revenues Revenues Division (000's) %'s (000's) %'s (000's) %'s Central $39,460 8.3% $35,421 8.0% $34,625 7.8% Northern 92,265 19.5 83,626 18.9 84,227 19.1 Southeast 234,895 49.5 222,460 50.1 220,581 50.0 Western 28,084 5.9 27,193 6.1 27,487 6.2 New Mexico 79,538 16.8 75,127 16.9 74,423 16.9 Total $474,242 100.0% $443,827 100.0% $441,343 100.0% In 1993, 1992 and 1991, no single customer accounted for greater than 10% of operating revenues, although the Utility has two affiliated industrial customers in the New Mexico Division which, together, contributed between 8% and 10% of the Utility's revenues in each of these years. Sources of Energy The Utility obtained its electric energy requirements during the year ended December 31, 1993, from sources shown in the following table. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Sources of Energy * The Utility also has a continual contract with Union Carbide to provide energy from natural gas sources for the Texas Gulf Coast. This source did not contribute to the percent of energy required in 1993. ** Except as to one point of delivery, a major source of supply under the contract with an expiration date of 2010, the contract expires in 2006. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES The Utility's future load growth is considered by the Utility and its suppliers in planning their future construction expenditures based on projections or official contract notifications furnished to its suppliers by the Utility. Currently the resources of TNP One and the suppliers' availability of lignite-, coal-, nuclear-, and gas-fired units are adequate to assure projected requirements for power. To the extent the Utility's suppliers experience delays or increases in the costs of construction of new generating facilities, additional costs of complying with regulatory and environmental laws, or increases in the cost of fuel or shortages in fuel supplies, the availability and cost of energy to the Utility will likewise be affected for that portion of supply purchased by the Utility. The Utility does not expect that the factors discussed in this section will result in the inability of its suppliers to provide the portions of power requirements to be purchased by the Utility. Terminations of service by those suppliers regulated by the FERC (El Paso Electric Company, Southwestern Public Service Company, West Texas Utilities Company and Public Service Company of New Mexico) would require authorization by that commission. The Utility anticipates renewing and amending its purchased power contracts with its suppliers as necessary. As a result of the Utility's efforts in contracting for lower costs of purchased power, the Utility's New Mexico customers are expected to benefit from a scheduled decrease of approximately $7.1 million in annualized firm purchased power costs in 1994, the effect of which will be reduced by a $400,000 increase in base rates. In 1990 and 1991, the Utility commenced replacing portions of its Texas purchased power requirements when Unit 1 and Unit 2, respectively, became operational. Beginning in 1992, the full effect of the electric generation of both units was realized. Provisions in the contracts with Texas Utilities Electric Company and Houston Lighting & Power Company allow for reductions in future purchased power commitments. Power generated at TNP One is transmitted over the Utility's own transmission line to other utilities' transmission systems for delivery to the Utility's Texas service area systems. To aid in maintaining a reliable supply of power for its customers and to coordinate interconnected operations, the Utility is a member of the Electric Reliability Council of Texas (ERCOT), the Inland Power Pool and the New Mexico Power Pool. See Item 3, "Legal Proceedings," Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and notes 2 and 5 to the consolidated financial statements for additional information about TNP One. Recovery of Purchased Power and Fuel Costs The Utility expects to refund or collect within two months or less those amounts of total purchased power costs (including supplier fuel costs) billed to the Utility from suppliers that are over- or under- collected in the current month. Purchased power cost recovery adjustment clauses in the Utility's rate schedules have been authorized by the regulatory authorities in Texas and New Mexico. A fixed fuel recovery factor in Texas has also been approved. Both are of substantial benefit to the Utility in efforts to recover timely and adequately these significant elements of operating expenses as described in note 1(g) to the consolidated financial statements. Franchises The Utility holds franchises from each of the 90 municipalities in which it renders electric service. On December 31, 1993, these franchises had expiration dates varying from 1994 to 2039, 86 having stated terms of 25 years or more and two having stated terms of 20 years and two having stated terms of 15 years. The Utility also holds certificates of public convenience and necessity from the PUCT covering all of the territories it serves in Texas. The Utility has been issued certificates for other areas after hearings before the PUCT. These certificates include terms which are customary in the public utility industry. In New Mexico, the Utility operates generally under the grandfather clause of that state's Public Utility Act which authorizes the continuance of existing service following the date of the adoption of such act. Seasonality of Business The Utility's business is seasonal in character. Summer weather causes increased use of air-conditioning equipment which produces higher revenues during the months of June, July, August and September. For the year ended December 31, 1993, approximately 40% of annual revenues were recorded in June, July, August and September, and 60% in the other eight months. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Working Capital The Utility's major demands on working capital are (1) the monthly payments for purchased power costs from the Utility's suppliers, (2) monthly and semi-annual interest payments on long-term debt and (3) semi-monthly payments for the lignite fuel source for TNP One. The purchased power and fuel costs are eventually recovered through the Utility's customers' rates and the purchased power and fuel costs recovery adjustment clauses and fixed fuel factors, more fully described in note 1(g) to the consolidated financial statements. Unlike many other generating utilities, the Utility does not have the requirement of maintaining a large fuel inventory (lignite) due to the proximity of TNP One with the lignite mine site. The Utility sells customer receivables, as do many other utilities. The Utility sells its customer receivables to a nonaffiliated company on a nonrecourse basis. Competitive Conditions As a regulated public utility, the Utility operates with little direct competition throughout most of its service territory. Pursuant to the Texas Public Utility Regulatory Act, the PUCT has issued to all electric utilities in the State certificates of public convenience and necessity authorizing them to render electric service. Rural electric cooperatives, investor-owned electric utilities and municipally owned electric utilities are all defined in such act as public utilities. In 72 of the 81 Texas municipalities served, the Utility has been the only electric utility issued a certificate to serve customers within the municipal limits. The Utility is also the only electric utility authorized to serve customers in some of the rural areas where it has electric facilities. In other rural areas served by the Utility, other electric utilities have also been authorized to serve customers; however, rural electric cooperatives may, under certain circumstances, become exempt from the PUCT's rate regulation. Where other electric utilities have also been certificated to serve customers within the same service area, the Utility may be subject to competition. From time to time, industrial customers of the Utility express interest in cogeneration as a method of reducing or eliminating reliance upon the Utility as a source of electric service, or to lower fuel costs and improve operating efficiency of process steam generation. During 1993, a major industrial customer in the Utility's Southeast Division requested proposals for a cogeneration project for evaluation by the customer. The Utility's operating revenues from this customer during 1993 were approximately $28 million. In January 1994, a potential developer for the proposed project was selected by the customer. The Utility's goal is to retain this customer and to lower overall system operating costs through coordination with the potential developer. Although the Utility cannot predict the ultimate outcome of the process, the current project as proposed by the customer, and as outlined by the potential developer, appears to present a means by which the Utility may retain electric service to this customer, at current levels. The Utility is actively pursuing the development of the necessary agreements with the potential developer to further define the degree to which electric service to this customer is retained and overall system operating costs may be lowered. In New Mexico, a utility subject to the jurisdiction of the NMPUC may not extend into territory served by another utility or into territory not contiguous to its service territory without a certificate of public convenience and necessity from the NMPUC. Investor-owned electric utilities and rural electric cooperatives are subject to the juris- diction of the NMPUC. The Energy Policy Act of 1992, adopted in October 1992, significantly changed the U.S. energy policy, including the governing of the electric utility industry. Among the features of this act is the creation of Exempt Wholesale Generators and the authorization of the FERC to order, on a case-by-case basis, wholesale transmission access. It appears that these particular features will create competition for the generation and supply of electricity. Management continues to evaluate the effects of this act on the Utility. Although the act may not affect the Utility directly, the Utility believes that this increased competition will not have an unfavorable impact on it. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Environmental Requirements Environmental requirements are not expected to materially affect capital outlays or materially affect the Utility directly. As the Utility's electric suppliers may be affected by environmental requirements and resulting costs, the rates charged by them to the Utility may be increased and thus the Utility will be affected indirectly. The Utility's facilities in Texas and New Mexico are regulated by federal and state environmental agencies. These agencies have jurisdiction over air emissions, water quality, wastewater discharges, solid wastes and hazardous substances. The Utility maintains continuous procedures to insure compliance with all applicable environmental laws, rules and regulations. Various Utility activities require permits, licenses, registrations and approvals from such agencies. The Utility has received all necessary authorizations for the construction and continued operation of its generation, transmission and distribution systems. TNP One's circulating fluidized bed technology produces "clean" emissions, without the addition of costly scrubbers. Unit 1 and Unit 2 meet the standards of the Clean Air Act of 1990. Under this act, an entity will be given an allotted number of allowances which permit emissions up to a specified level. The Utility believes the allowances received to be sufficient for the level of emissions to be created by TNP One. The construction costs for TNP One included approximately $89 million for environmental protection facilities. During 1993, 1992 and 1991, as an ongoing operation of air pollution abatement, including ash removal, TNP One incurred expenses of approximately $2.6 million, $2.7 million and $1.9 million, respectively. The Utility anticipates additional capital expenditures of $875,000 by 1995 for air emissions monitoring equipment for TNP One. The operations of the Utility are subject to a number of federal, state and local environmental laws and regulations, which govern the storage of motor fuels, including those regulating underground storage tanks. In September 1988, the Environmental Protection Agency (EPA) issued regulations that required all newly installed underground storage tanks be protected from corrosion, be equipped with devices to prevent spills and overfills, and have a leak detection method that meets certain minimum requirements. The effective commencement date for newly installed tanks was December 22, 1988. Underground storage tanks in place prior to December 22, 1988, must conform to the new standards by December 1998. The Utility currently estimates the cost over the next five years to bring its existing underground storage tanks into compliance with the EPA guidelines will be $100,000. The Utility also has the option of removing any existing underground storage tanks. During 1993, 1992, and 1991, the Utility incurred cleanup and testing costs on both leaking and nonleaking storage tanks of approximately $98,000, $89,000, and $84,000, respectively, in complying with these EPA regulations. A change in the regulations in the State of Texas permitted the Utility to collect in 1992 from the state environmental trust fund $65,000 of expenditures paid in prior years. Both states in which the Utility owns or operates underground storage tanks have state operated funds which reimburse the Utility for certain cleanup costs and liabilities incurred as a result of leaks in underground storage tanks. These funds, which essentially provide insurance coverage for certain environmental liabilities, are funded by taxes on underground storage tanks or on motor fuels purchased within each respective state. The funds require the Utility to pay deductibles of less than $5,000 per occurrence. During 1992, the Texas state environmental trust fund delayed reimbursement payments after September 30, 1992, of certain cleanup costs due to an increase in claims. Because the state and federal government have the right, by law, to levy additional fees on fuel purchases, the Utility believes these cleanup costs will ultimately be reimbursed. Employees The number of employees on December 31, 1993, was 1,051. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Item 2.

Item 2. PROPERTIES. The Utility's electric properties served a total of 211,911 customers at year-end and consisted of the installations described in the following sections. (1) Electric generation, transmission and distribution facilities located in the State of Texas are as follows: (A) Central Division. Electric transmission and distribution systems serving 25 municipalities and 18 unincorporated communities in 17 counties to the south and west of Fort Worth, Texas. The division is based at Clifton, Texas. (B) Northern Division. Electric transmission and distribution systems serving 36 municipalities and 19 unincorporated communities in 14 North Texas counties and 3 counties in the Texas Panhandle. The division is based at Lewisville, Texas. (C) Southeast Division. Electric transmission and distribution systems serving 14 municipalities and 2 unincorporated communities in 3 counties on the Texas Gulf Coast. The division is based at Texas City, Texas. (D) Western Division. Electric transmission and distribution systems serving 6 municipalities and 1 unincorporated community in 5 counties in West Texas. The division is based at Pecos, Texas. (E) Robertson County, Texas. Two 150-megawatt lignite-fueled generating units (Unit 1 and Unit 2, collectively referred to as TNP One) using circulating fluidized bed technology. The Utility also has an 18-mile long transmission line to connect TNP One to a major transmission grid in Texas. (2) Electric generation, transmission and distribution facilities in the State of New Mexico serve 5 municipalities and 5 unincorporated communities in Grant and Hidalgo Counties, and 4 municipalities and 1 unincorporated community in Otero and Lincoln Counties. The New Mexico Division is based at Silver City, New Mexico. (3) The facilities owned by the Utility include those normally used in the electric utility business. The facilities are of sufficient capacity to adequately serve existing customers, and such facilities may be extended and expanded to serve future customer growth of the Utility in existing service areas. The Utility generally constructs its transmission and distribution facilities upon real property held pursuant to easements or public rights of way and not upon real property held in fee simple by the Utility. (4) All real and personal property of the Utility, with certain exceptions such as much of TNP One, is subject to the lien of the Indenture of Mortgage and Deed of Trust (Bond Indenture) under which the Utility's First Mortgage Bonds are issued. Certain exceptions are set forth in the Bond Indenture. The lenders in the Unit 2 financing facility and the holders of all secured debentures hold a second lien on all real and personal Texas property of the Utility. Holders of the Utility's Secured Debentures, due 1999 and Series A, Secured Debentures, due 2003 equally and ratably hold first liens on approximately 59% of Unit 1. The remaining amount of Unit 1 property is subject to a first lien under the Utility's Bond Indenture and a second lien under the secured debentures' indentures. The lenders under the Unit 2 financing facility and the Utility's Secured Debentures, due 1999, equally and ratably hold first liens on approximately 74% of Unit 2. The remaining amount of Unit 2 property is subject to a first lien under the Utility's Bond Indenture and a second lien under the secured debentures' indentures. Under certain conditions, upon repayment of portions of the loans or secured debentures under the financing facilities, the Utility may purchase undivided interests in Unit 1 or Unit 2 from TGC or TGC II, respectively, whereupon such undivided interests become subject to the first lien of the Utility's Bond Indenture. See note 2 to the consolidated financial statements for additional information. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Item 3.

Item 3. LEGAL PROCEEDINGS. Appeals of Regulatory Orders The following summary discusses the Utility's most recent regulatory proceedings before the PUCT and the judicial appeals. While the ultimate outcome of these cases and of other matters discussed below cannot be predicted, the Utility is vigorously pursuing their favorable conclusion. Material adverse resolution of certain of the matters discussed below would have a material adverse impact on earnings in the period of resolution. More detailed discussions of the proceedings and related impacts are included in note 5 to the consolidated financial statements and Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations." PUCT Docket No. 9491 On April 11, 1990, the Utility filed a rate application, Docket No. 9491, with the PUCT for inclusion of the costs of Unit 1 in the Utility's rate base and for the setting of rates to recover the costs of that unit. On February 7, 1991, the Utility received a final order which allowed $298.5 million of the costs of Unit 1 in rate base; however, the PUCT disallowed from rate base $39.5 million of the requested investment costs of $338 million for that unit. The PUCT approved an increase in annualized revenues of approximately $36.7 million, or 67% of the Utility's original $54.9 million rate request. The PUCT also found that the Utility failed to prove that its decision to start construction of Unit 2 was prudent. Nevertheless, the PUCT granted rate base treatment for Unit 2 in Docket No. 10200, as discussed below. On appeal by the Utility of the PUCT's order in Docket No. 9491, a State district court in Travis County, Texas, ruled that the PUCT's disallowance of rate base treatment for certain costs of Unit 1 was in error and that the PUCT's "decision to deny $39,508,409 in capital costs for TNP One Unit 1 is not supported by substantial evidence and is arbitrary and capricious." On appeal of the State district court's order by the Utility , the PUCT and certain of the intervenor cities (the Cities), a Third District Court of Appeals in Austin, Texas, rendered a judgment partially reversing the State district court and affirming the PUCT's disallowances for $30.4 million of the total $39.5 million. The Court of Appeals remanded the cause to the district court with instructions that the cause be remanded to the PUCT for proceedings not inconsistent with the appellate opinion. On September 9, 1993, the Utility, the Cities and the PUCT filed motions for rehearing with the Court of Appeals. The Utility's opponents are seeking, among other things, lower rates and greater disallowances, and the Utility is seeking higher rates and no disallowances. The PUCT is not expected to act upon the district court's ordered remand, discussed above, until the appellate process, including appeals to the Texas Supreme Court, has been completed. Based upon the opinions of the Utility's Texas regulatory counsel, Johnson & Gibbs, a Professional Corporation, management believes that it will prevail in obtaining a remand of a significant portion of the disallowances in Docket No. 9491; however, the ultimate disposition and quantification of these items cannot presently be determined. Accordingly, no provision for any loss that may ultimately be required upon resolution of these matters has been made in the consolidated financial statements. If the Utility is not successful in obtaining a final favorable disposition in the appellate proceedings relating to the disallowances in Docket No. 9491, a write-off of some portion of the $39.5 million disallowances would be required, which could result in a significant negative impact on earnings in the period of final resolution. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES PUCT Docket No. 10200 On April 11, 1991, the Utility filed a rate application, Docket No. 10200, with the PUCT for inclusion of $275.2 million of capital costs of Unit 2 in the Utility's rate base and for the setting of rates to recover the costs of that unit. On March 18, 1993, the Utility received a final order which allowed $250.7 million of the Unit 2 costs in rate base; however, the PUCT disallowed from rate base $21.1 million associated with Unit 2 and $0.8 million additional costs requested for Unit 1. The PUCT also determined that $11.1 million of Unit 2 costs would be addressed in a future Texas rate application. The PUCT approved an increase in annualized revenues of approximately $19 million, or 53% of the Utility's original $35.8 million rate request. The order in Docket No. 10200 also reflects application to the Utility of a new method for calculating the amount of Federal income tax expense allowed in cost of service, which significantly reduced the Utility's level of annualized revenue increase from $26 million to $19 million. The Docket No. 10200 rate order has been appealed to a Texas district court by the Utility and other parties. Because of the Court of Appeals judgment relating to the prudence of starting construction of Unit 2 (FF No. 84 in the docket No. 9491), the presiding judge in the Texas district court for the Docket No. 10200 appeal has ordered that the procedural schedule in this appeal be abated until final resolution of the FF No. 84 issue in Docket No. 9491. The Utility will vigorously pursue reversal of the PUCT's new position regarding Federal income tax expenses, in addition to seeking judicial relief from the disallowances and certain other rulings by the PUCT in Docket No. 10200. The opposing parties are seeking a variety of relief to obtain lower rates and greater disallowances, including overturning the basis of the Utility's case as presented to the PUCT and sustaining the PUCT's adverse Federal income tax position without regard to any IRS ruling on the normalization issue. Based upon the opinions of the Utility's Texas regulatory counsel, Johnson & Gibbs, a Professional Corporation, management believes that it will prevail in obtaining a remand of a significant portion of the disallowances in Docket No. 10200; however, the ultimate disposition and quantification of these items cannot presently be determined. Accordingly, no provision for any loss that may ultimately be required upon resolution of these matters has been made in the consolidated financial statements. If the Utility is not successful in obtaining a final favorable disposition in the appellate proceedings relating to the disallowances in Docket No. 10200, a write-off of some portion of the $21.9 million disallowances would be required, which could result in a significant negative impact on earnings in the period of final resolution. Other Legal Matters The Utility is involved in various claims and other legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the Utility's consolidated financial position. Item 4.

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. There were no matters submitted to a vote of security holders in the fourth quarter of 1993. PART II Item 5.

Item 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS. All of the Utility's issued and outstanding common stock, 10,705 shares, is privately held, beneficially and of record, by its parent, TNPE, and is not publicly traded. For the years ended December 31, 1993 and 1992, the Utility paid $17,344,000, and $13,840,200, respectively, in common dividends to its parent, TNPE. Dividends were paid on a quarterly basis. Restrictions on the Utility's ability to pay dividends are discussed in notes 2 and 3 to the consolidated financial statements. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Item 6.

Item 6. SELECTED CONSOLIDATED FINANCIAL DATA. Included in the First Mortgage Bond sinking fund payments and retirements amount for 1997 is $130 million of First Mortgage Bonds, Series T, which mature January 15, 1997. The Utility anticipates that it will refinance these bonds and the Secured Debentures due in 1999 through the issuance of additional First Mortgage Bonds or other debt securities, and/or the receipt of common equity from TNPE. The Utility does not need additional Available Additions (described below under "Capital Resources") in order to issue First Mortgage Bonds for the purpose of refunding outstanding First Mortgage Bonds. As a result of the assumption of the financing facilities for Unit 1 and Unit 2 in 1990 and 1991, respectively, and related refinancings, the Utility's capital structure consisted of 75.2% debt, 23.7% common equity and 1.1% preferred stock at December 31, 1993. Prior to 1990, the Utility's capital structure contained less than 50% debt. The Utility's long-term goal is to strive for a conservative capital structure with a debt ratio of less than 50%. Capital Resources At any time, the Utility's ability to access the capital markets on a reasonable basis or otherwise obtain needed financing for operating and capital requirements is subject to the receipt of adequate and timely regulatory relief and market conditions. The Utility's ability to access the capital markets at reasonable costs will specifically be impacted by the ultimate resolution of (1) the amount of rate relief granted for Unit 1 and Unit 2, (2) the contested disallowances of up to $40.3 million and $21.1 million of the costs of Unit 1 and Unit 2, respectively, and (3) the adverse PUCT ruling concerning the treatment of the Federal income tax component of the Utility's cost of service. In addition to the aforementioned Unit 2 financing facility, the Utility's external sources for acquiring capital are outlined below: First Mortgage Bonds. Assuming an interest rate of 9.25% and satisfactory market conditions, based upon December 31, 1993 financial information, the Utility could have issued approximately $59 million of additional First Mortgage Bonds under the Interest Coverage Ratio requirement. With certain exceptions, the amount of additional First Mortgage Bonds that may be issued is also limited by the Bond Indenture to a certain amount of physical properties which are to be collateralized by the first lien mortgage of the Bond Indenture (Available Additions). Because of the issuance of the New Bonds in September 1993, the Utility has limited ability to issue additional First Mortgage Bonds until more Available Additions are provided upon further repayment of amounts under the financing facilities. Secured Debentures. The indenture, under which the Series A Secured Debentures were issued, permits, generally, the issuance of additional secured debentures to the extent that the proceeds from such issuance are used to purchase an equal amount of loans under the Unit 1 and Unit 2 financing facilities. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Preferred Stock. Due to interest and dividend coverage tests required for issuance of its preferred stock, the Utility cannot presently issue any preferred stock. The Utility does not expect to have the ability to issue preferred stock through 1996. Receipt of Common Equity One source for repayment of the Unit 2 financing facility is anticipated to be the receipt of common equity from TNPE. Receipt of future equity contributions by the Utility from TNPE will be largely dependent upon TNPE's ability to issue common stock. Since most of the assets, liabilities and earnings capability of TNPE are those of the Utility, the ability of TNPE to issue common stock and pay dividends will be largely dependent upon the Utility's operations and the Utility's restrictions regarding payment of cash dividends on its common stock. The Utility may not pay dividends on its common stock unless all past and current dividends on outstanding preferred stock of the Utility have been paid or declared and set apart for payment and all requisite sinking or purchase fund obligations for the preferred stock of the Utility have been fulfilled. Charter provisions relating to the preferred stock and the Bond Indenture under which First Mortgage Bonds are issued contain restrictions regarding the retained earnings of the Utility. At December 31, 1993, pursuant to the terms of the Bond Indenture, approximately $12.8 million of the Utility's $38.9 million of retained earnings was restricted. In addition, the financing facilities place certain restrictions on the Utility's ability to pay dividends on its common stock, unless certain threshold tests are met. The Utility has satisfied the threshold tests since they became effective, and the Utility does not expect that any of the aforementioned contractual restrictions on the payment of dividends will become operative in 1994. However, the Utility can give no assurance that the Utility will satisfy such tests in the future. The Utility's 1993 common stock dividends of $17.3 million exceeded 1993 earnings available for common stock of $10.6 million; however, the Utility's retained earnings were sufficient to allow the dividends to be paid. Contributing to the low-level of earnings in 1993 were the lower rates from the December 1992 adverse ruling of the PUCT regarding the Utility's Federal income tax component in its cost of service and significant interest charges. As discussed in "Net Earnings" under "Results of Operations", management has implemented cost saving measures during 1993 and is seeking equitable regulatory treatment in efforts to improve future results of operations. Cash dividend payments are subject to approval of the Board of Directors and are dependent, especially in the longer term, on the Utility's and TNPE's future financial condition and adequate and timely regulatory relief, including favorable resolution of pending judicial appeals of rate cases. Other Matters Accounting for Postretirement Benefits On January 1, 1993, the Utility implemented Statement of Financial Accounting Standards No. 106 (SFAS 106), "Employers' Accounting for Postretirement Benefits Other Than Pensions," which addresses the accounting for other postretirement employee benefits (OPEBs). For the Utility, OPEBs are comprised primarily of health care and death benefits for retired employees. Prior to 1993, the costs of these OPEBs were expensed on a "pay-as-you-go" basis. Beginning in 1993, SFAS 106 requires a change from the "pay-as-you-go" basis to the accrual basis of recognizing the costs of OPEBs during the periods that employees render service to earn the benefits. The 1993 accrual for OPEBs of $2,952,000, based on adoption of SFAS 106, was $2,276,000 greater than the amount that would have been recorded under the "pay- as-you-go" basis. In March 1993, the PUCT issued its rules for ratemaking treatment of OPEBs. As part of a general rate case, a utility may request OPEBs expense in cost of service for ratemaking purposes on an accrual basis in accordance with generally accepted accounting principles. The PUCT's rule requires that the amounts included in rates shall be placed in an irrevocable external trust fund dedicated to the payment of OPEBs expenses. Based on the PUCT's rule, the Utility intends to seek recovery of OPEBs expense attributable to its Texas jurisdiction in its next Texas rate case. In order to comply with the PUCT's condition for possible recovery of OPEBs expenses, the Utility established in June 1993 a Voluntary Employees' Beneficiary Association (VEBA) trust fund, dedicated to the payment of OPEBs expenses. Monthly cash payments made to the VEBA, which began in June 1993, will fund OPEBs costs for the Utility's Texas and New Mexico operations. See note 1(j) to the consolidated financial statements for information about the funded status of the plan. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES On August 23, 1993, the Utility filed a rate application with the NMPUC which included a request for recovery of the applicable costs of OPEBs. A stipulated agreement among the parties to the proceeding, dated January 28, 1994, subject to approval by the NMPUC, would include such applicable costs in the proposed New Mexico rates, beginning in 1994. For future periods, the costs of OPEBs will be affected by changes in the assumed interest rate and the trends in health care costs; based on actuarial assumptions, national health care costs are expected to increase in the future, resulting in further increases in the Utility's costs. Accounting for Income Taxes On January 1, 1993, the Utility implemented Statement of Financial Accounting Standards No. 109 (SFAS 109), "Accounting for Income Taxes." The implementation of SFAS 109 did not result in any significant charge to operations. See note 4 to the consolidated financial statements for details relating to the implementation of SFAS 109. Accounting for Postemployment Benefits The FASB has issued Statement of Financial Accounting Standards No. 112 (SFAS 112), "Employers' Accounting for Postemployment Benefits" which addresses the accounting and reporting for the estimated costs of benefits provided by an employer to former or inactive employees after employment but before retirement. SFAS 112 is effective for fiscal years beginning after December 15, 1993. The Utility estimates such costs to be immaterial. Effects of Inflation The Utility does not believe that the effects of inflation, as measured by the Consumer Price Index over the last three years, have had a material impact on the Utility's consolidated results of operations and financial condition. Tax Law Change The Omnibus Budget Reconciliation Act of 1993 was signed into law on August 10, 1993. Beginning in 1994, the act provides for the disallowance of certain business deductions, the effect of which is not expected to be material for the Utility. The act also provided, effective January 1, 1993, for a corporate income tax rate increase from 34% to 35% to be phased in for taxable income between $10 million and $18 million. Results of Operations The following table sets forth the percentage relationship of items to operating revenues in the consolidated statements of earnings: TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Operating Revenues Operating revenues for 1993 and 1992 reflect increases of $30,415,000 and $2,484,000 over the respective prior years. The following table presents the components of the changes in operating revenues: Base operating revenues are affected primarily by changes in base rates resulting from regulatory commission orders and the effects of variations in sales between customer classifications. The significant increase in base operating revenues for 1992 was primarily attributable to bonded rates for Docket No. 10200 being placed into effect in October 1991. The PUCT's final order approving these rates was received on October 16, 1992 and subsequently was amended by the PUCT in an Order on Rehearing on December 22, 1992. The result of this Order on Rehearing was to lower the previously approved increase in annualized revenues by approximately $7 million, from $26 million to approximately $19 million. The PUCT later increased, subject to refund, the annualized revenues by an additional $1.6 million. Because the increase continued to be subject to a possible refund, no additional revenues were recognized in 1992 or 1993 and such amounts were included in revenues subject to refund in the consolidated balance sheets. For more information regarding Docket No. 10200, see note 5 to the consolidated financial statements. Purchased power costs are recovered through cost recovery factor clauses in both Texas and New Mexico. Fuel costs are recovered through a fixed fuel factor approved by the PUCT. Recoveries of purchased power and fuel costs are discussed further in "Operating Expenses." Customer usage increased in 1993 due to a 3.6% increase in kilowatt- hour (KWH) sales to residential, commercial and industrial customers. The residential usage increase related to an increase in the number of residential customers and warmer temperatures in the Texas service areas; in 1992, milder than normal weather was experienced in the Texas service areas. Commercial usage increased in the Utility's Texas service areas as the result of general retail development in the Northern Division and Southeast Division and the addition of a greyhound race track in the Southeast Division. During 1993, the number of industrial customers decreased by 14, but that decrease included the consolidation of 10 customers into 2 customers for billing purposes and the reclassification of 3 customers to the commercial class of customers. The industrial usage increase in the Utility's New Mexico service area resulted from increased consumption of an existing mining customer and the addition of a new mining customer. The 1992 decrease in customer usage primarily reflected a 5.46% KWH sales decline. Part of the decrease in customer usage was attributable to the milder than normal temperatures experienced in Texas during 1992. Also contributing to the sales decline was the failure of new customers and revenues to materialize as expected within the industrial class to ameliorate the loss of KWH sales to certain industrial customers. From time to time, industrial customers of the Utility express interest in cogeneration as a method of reducing or eliminating reliance upon the Utility as a source of electric service, or to lower fuel costs and improve operating efficiency of process steam generation. During 1993, a major industrial customer in the Utility's Southeast Division requested proposals for a cogeneration project for evaluation by the customer. The Utility's operating revenues from this customer during 1993 were approximately $28 million. In January 1994, a potential developer for the proposed project was selected by the customer. The Utility's goal is to retain this customer and to lower overall system operating costs through coordination with the potential developer. Although the Utility cannot predict the ultimate outcome of the process, the current project as proposed by the customer, and as outlined by the potential developer, appears to present a means by which the Utility may retain electric service to this customer, at current levels. The Utility is actively pursuing the development of the necessary agreements with the potential developer to further define the degree to which electric service to this customer is retained and overall system operating costs may be lowered. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES For information relating to actual KWH sales, number of customers, and revenues, see Item 1, "Financial Information about Industry Segments." Operating Expenses As a regulated entity, the Utility must demonstrate to the regulatory commissions in its rate filings that its requests for recovery of operating expenses to provide service to its customers are reasonable and necessary. In order to provide reliable service to its customers at reasonable rates, management endeavors to control costs through budgeting and monitoring of operating expenses. Commencement of commercial operations of Unit 1 in September 1990 and Unit 2 in October 1991 led to increases in certain expenses and interest charges over prior years; however, the Utility experienced decreases in the potential cost of power purchased for resale as a result of the operations of Unit 1 and Unit 2. The 1993 and 1992 levels of expenses each reflect a full year's operations of both units. Variances in expenses from 1991 to 1992 due to a partial year's operation of Unit 2 in 1991 are noted in the following discussion. Power Purchased for Resale Factors affecting the expense of power purchased for resale are (1) the number of KWH purchased from suppliers, (2) the cost per KWH purchased, (3) the recovery or refund of prior under- or over-collections, respectively, of purchased power costs (deferred purchased power costs), and (4) occasional fuel cost refunds from the Utility's suppliers. The Utility's policy regarding the accounting for deferred purchased power costs is discussed in note 1(g) to the consolidated financial statements. Power purchased for resale increased $25,926,000 in 1993, and a decrease of $42,561,000 was experienced in 1992. The increase in purchased power expense for 1993 was mainly due to an increase in the average cost of KWH purchased from suppliers. Information concerning the Utility's suppliers is disclosed in Item 1 under "Sources of Energy." Also contributing to the increase in 1993 was an increase in the number of KWH purchased as a result of increased customer usage, discussed under "Operating Revenues." The decrease in 1992 resulted from a decline in the number of KWH purchased. This KWH decrease was caused by the replacement of purchased power with a full year's generation of Unit 2 of TNP One and the decrease in customer usage, discussed under "Operating Revenues." Partially offsetting the effect of this reduction in the number of KWH purchased in 1992 was an increase in the recovery of deferred purchased power costs. As in 1992, the 1993 level of KWH purchases reflects a full year's generation of TNP One; therefore, KWH purchases for 1993 and 1992 are comparable in this respect. No significant changes in KWH purchased resulting from TNP One's operations are expected in the future. While costs per KWH from purchased power suppliers are not directly controllable, wholesale rates charged by various suppliers are subject to regulatory authority. The Utility has intervened and will continue to intervene in suppliers' rate cases for the purpose of assuring fair and equitable costs to its customers. Fuel Fuel expense decreased $629,000 in 1993, as compared to an increase of $19,204,000 in 1992. The decrease in recovery of fuel costs for 1993 resulted from a slightly lower fuel cost recovery factor than that utilized in 1992. These differing fuel factors resulted from using a factor related to bonded rates in 1992 which was adjusted downward in 1993 to comply with the final order in Docket No. 10200. The large increase in 1992 was related to a full year's commercial operation of both Unit 1 and Unit 2. Fuel expense primarily represents the recovery of fuel costs through a fixed fuel factor set by the PUCT. The fixed fuel factor is intended to permit the Utility to recover the cost of fuel utilized to generate electricity sold in Texas. The factor may be changed only upon approval of the PUCT and is expected to be adjusted for any cumulative under- or over-recovery of fuel costs. At December 31, 1993, the Utility had under-recovered fuel costs, including interest, of approximately $13.6 million related to both units of TNP One. Any requests to the PUCT for recovery of fuel costs require the Utility's demonstration that the costs were reasonable. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Beginning in 1993, a filing with the PUCT for a reconciliation of fuel costs is required if for any given period of time there is an over- or under-recovery of fuel costs of at least 4% of revenues. Under the PUCT's rules, the months in which utilities may initiate fuel reconciliation proceedings are specified; for the Utility, these months are June and December. In the event of an over- or under-recovery of fuel costs less than the 4% threshold, a filing to adjust the fuel factor may be made at the discretion of management. The Utility expects to file a fuel reconciliation with its next Texas rate application during the first half of 1994. Management will continue to monitor its fuel cost recovery to determine the need to request a change in its fixed fuel factor. For a discussion of the fuel supply agreement for TNP One, see "Other TNP One Matters" under "Financial Condition." Other Operating and General Expenses and Maintenance Other operating and general expenses decreased $597,000 in 1993 after an increase of $4,716,000 in 1992. The 1993 decrease represents primarily decreases in employee pension and thrift benefits and payroll costs which were offset somewhat by an increase in employee postretirement medical costs resulting from implementation of SFAS 106. The decrease in the employee benefits for 1993 was due to an amendment to the pension plan and the curtailment of employer thrift plan contributions on January 1, 1993. Payroll costs declined due to a 3.2% reduction in the number of employees. The increase in other operating and general expenses for 1992 was due primarily to additional wheeling costs which were incurred for a full year's transfer of power generated by Unit 2 and to amortization of previously deferred rate case expenses. Wheeling costs are incurred for the transfer of TNP One power over other utilities' transmission systems for delivery to the Utility's Texas systems. The years 1993 and 1992 reflected wheeling costs for both Unit 1 and Unit 2; therefore, any future changes in this level of expense would be the result of changes in monthly wheeling charges. Regarding deferred rate case expenses, a full year's amortization was reflected in both 1993 and 1992, making them comparable in this respect; in 1994, another year's amortization remains for the deferred rate case expenses. As previously discussed under "Financial Condition," implementation of SFAS 106 may lead to additional costs in the future. Other operating and general expenses will be affected in 1994 because of a 3% cost-of-living payroll adjustment for full-time employees effective January 10, and the restoration of employer thrift plan contributions scheduled to resume beginning July 1. Since the last cost-of-living payroll adjustment granted to the Utility's employees was in 1991, these changes were made to maintain the level of experienced personnel necessary for providing quality service to the Utility's customers. No significant variances have occurred in maintenance expense over the last three years. Maintenance outages are scheduled in the first and fourth quarters of 1994 for Unit 2 and Unit 1, respectively. Since prior years reflect expenses for past scheduled outages of the units, no significant increase in maintenance expense is anticipated in 1994. Depreciation of Utility Plant Depreciation expense increased $917,000 and $7,071,000 in 1993 and 1992, respectively. The 1993 increase was related to normal additions to utility plant while the large increase in 1992 reflects a full year's expense for Unit 2 and Unit 1. Future increases in depreciation would be the result of normal utility plant additions and regulatory approvals of changes in depreciation rates as supported by required periodic independent studies. Taxes, Other Than On Income Taxes, other than on income increased $1,046,000 and $5,462,000 in 1993 and 1992, respectively. The 1993 increase related primarily to an increase in revenue-related taxes which resulted from increased revenues upon which the taxes are based. The increase in 1992 was primarily related to an increase in property-related taxes resulting from (1) a full year's expense related to Unit 2 as compared to only a partial year in 1991 and (2) increases in the property tax rates in Texas. Income Taxes Income taxes increased $2,397,000 in 1993 after a decrease of $5,963,000 in 1992. The increase in 1993 resulted from an increase in earnings over 1992, a decline in the regulatory-ordered amortization of excess deferred taxes, and an increase in Federal income tax rates. Income taxes decreased in 1992 due to the decline in net earnings compared to 1991. For the years 1993, 1992 and 1991, the Utility incurred tax net operating losses due to accelerated tax depreciation deductions and increased interest charges on debt related to TNP One and subsequent refinancings; however, payments of current income taxes were required based on minimum tax (MT) requirements. To the extent that the Utility is subject to MT requirements and limitations on the utilization of available credits, payments of current Federal income taxes are expected to be required in 1994. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES As discussed in "Accounting for Income Taxes" under "Financial Condition," implementation of SFAS 109 did not result in any significant charge to earnings. For more information regarding the Utility's income taxes, see note 4 to the consolidated financial statements. As with all areas of the Utility's cost of service, recovery of income tax expenses is expected in rates charged to customers. However, as discussed in "PUCT Docket No. 10200" under "Financial Condition," uncertainties exist with respect to the Utility's Federal income tax expense component of cost of service. The Utility is pursuing reversal of the PUCT's adverse decisions. Other Income, Net of Taxes Other income, net of taxes increased in 1992 by $1,290,000 primarily because of interest earned on short-term investments, principally repurchase agreements and government money trusts, during the year. Considerable cash was used in 1993 to make optional payments under the Unit 2 financing facility thereby reducing cash available for the aforementioned investments. This contributed to the decrease of $901,000 in 1993. Interest Charges Total interest charges decreased slightly by $342,000 in 1993 after an increase of $24,723,000 in 1992. The slight decrease in interest on long-term debt in 1993 was the net result of several transactions. Decreases in 1993 expense resulted from (1) redemption of Series G First Mortgage Bonds at maturity on July 1, 1993, (2) redemption of Series H, I, J and K First Mortgage Bonds to permit issuance of Series U First Mortgage Bonds and (3) prepayments made under the Unit 1 and Unit 2 financing facilities. Partially offsetting these decreases in interest on long-term debt were the issuances of Series U First Mortgage Bonds and Series A Secured Debentures in September 1993. Interest on long-term debt increased in 1992 due to the issuance in January 1992 of $130 million of 11.25% Series T First Mortgage Bonds and $130 million of 12.50% Secured Debentures, due in 1999. The Utility used $194 million of the proceeds from the issuance to retire a portion of the Unit 1 and Unit 2 financing facilities, as was required for extended payment dates under the amended terms of the financing facilities. The notes payable under the financing facilities had lower interest rates than the new securities. Interest charges also increased in 1992 due to the debt for Unit 2 being outstanding for a full year as compared to a partial year in 1991. In 1994, the full effects of the 1993 redemptions and new issuances are expected to result in a net increase in interest on long-term debt. Any changes in the interest rates or balances related to the Unit 2 financing facility in 1994 will also have an effect on long-term debt interest. Other interest and amortization of debt discount, premium and expense for 1993 reflects a fourth quarter amortization of debt expense associated with the issuances of Series U Bonds and Series A Secured Debentures and further amendments to the Unit 1 and Unit 2 financing facilities; therefore, an increase in this expense can be expected in 1994 due to a full year's amortization. In 1993, other interest included interest on the provision for a refund of bonded revenues billed in excess of the amounts allowed under Docket No. 10200. Other interest and amortization of debt discount, premium and expense increased during 1992 primarily as the result of the issuances of the Series T Bonds and Secured Debentures, due 1999 discussed above, as well as the amortization of expenses related to the amendments of the Unit 1 and Unit 2 financing facilities. Other interest expense increased due to the accrual of interest on the provision for a refund of bonded revenues billed in excess of the amounts allowed in Docket No. 10200. Partially offsetting these increases was a decrease in interest on unsecured notes payable to banks. The Utility utilized a portion of the proceeds from the issuance of the Series T Bonds and Secured Debentures, due 1999 to retire $26 million of unsecured notes payable to banks. The remaining $10 million portion of such notes was retired in August 1992. Allowance for borrowed funds used during construction (AFUDC) decreased in 1992 when compared to 1991 because Unit 2 was placed in commercial operation on October 16, 1991. AFUDC for 1991 reflected primarily the qualified capitalization of interest on the financing facility for Unit 2 from the date of assumption (July 26, 1991) until the date Unit 2 began commercial operation. Receipt of equity contributions and proceeds from future issuances of debt securities are anticipated to help satisfy the scheduled repayments of the Unit 2 financing facility. Interest rates on debt securities are expected to be greater than those interest rates under the financing facility. Interest rates on additional debt may be further increased if the Utility's outstanding regulatory matters are not satisfactorily resolved. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Net Earnings Net earnings increased $678,000 in 1993 after a significant decline of $8,995,000 in 1992. The decline of net earnings in 1992 was due primarily to (1) the decrease in customer usage as discussed in "Operating Revenues," (2) the PUCT's abandonment of its long-standing methodology for determination of the Federal income tax expense component of cost of service in the PUCT's Order on Rehearing in Docket No. 10200 and (3) the increases in interest expense. The slight increase in 1993 resulted from increased KWH sales, the effect of which was reduced by increases in depreciation expense, taxes, other than on income and income taxes and a decrease in other income as previously discussed. The level of 1993 net earnings also reflects the adverse tax ruling by the PUCT, discussed above in "PUCT Docket No. 10200" under "Financial Condition." Early in 1993, the Utility implemented cost saving measures such as (1) suspension of the Utility's matching contributions to the employees' thrift plan, (2) revision to the Utility's pension plan and (3) implementation of a general employee salary and wage freeze and limitations on hiring new employees and replacements. These cost saving measures more than offset the increase in expenses related to the health care and death benefits plans resulting from implementation of SFAS 106. With the exception of the Utility's wage-step progression increases reactivated in April 1993, these measures continued in effect throughout 1993. The Utility reduced its labor force by 3.2% during 1993, trimming $1.1 million from operations and maintenance expenses. Even so, the Utility's return on common equity for 1993 and 1992 was 4.97% and 4.80%, respectively, although the Utility's rate of return granted in Docket No. 10200 authorized a return on common equity of 13.16%. Based on the Utility's earnings for 1993 and 1992 and the expected increases in interest on long-term debt and certain other expenses, equitable rate relief in Texas appears to be necessary for any significant improvement in financial results to occur during 1994. Future regulatory treatment and court decisions regarding Docket Nos. 9491 and 10200, as previously discussed, will have a direct bearing on future earnings. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Item 8.

Item 8. Consolidated Financial Statements and Supplementary Data. Independent Auditors' Report The Board of Directors Texas-New Mexico Power Company: We have audited the consolidated financial statements of Texas-New Mexico Power Company (a wholly owned subsidiary of TNP Enterprises, Inc.) and subsidiaries as listed in the accompanying index at Part IV. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Texas-New Mexico Power Company and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in note 5 to the consolidated financial statements, uncertainties exist with respect to the outcome of certain regulatory matters. The ultimate outcome of these matters cannot presently be determined. Accordingly, no provision for any loss that may ultimately be required upon resolution of these matters has been made in the accompanying consolidated financial statements and financial statement schedules. As discussed in note 4 to the consolidated financial statements, the Company changed its method of accounting for income taxes in 1993 to adopt the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes. As discussed in note 1(j), the Company also adopted the provisions of the Financial Accounting Standards Board's SFAS No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions in 1993. KPMG PEAT MARWICK Fort Worth, Texas January 28, 1994 TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprises, Inc.) CONSOLIDATED STATEMENTS OF EARNINGS Three Years Ended December 31, 1993 TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprises, Inc.) CONSOLIDATED BALANCE SHEETS December 31, 1993 and 1992 TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprises, Inc.) CONSOLIDATED STATEMENTS OF COMMON STOCK EQUITY AND REDEEMABLE CUMULATIVE PREFERRED STOCKS Three Years Ended December 31, 1993 TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprises, Inc.) CONSOLIDATED STATEMENTS OF CASH FLOWS Three Years Ended December 31, 1993 TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (1) Summary of Significant Accounting Policies (a) Principles of Consolidation The consolidated financial statements include the accounts of Texas-New Mexico Power Company (Utility) and its wholly owned subsidiaries, Texas Generating Company (TGC) and Texas Generating Company II (TGC II). All intercompany transactions and balances have been eliminated in consolidation. The Utility is a wholly owned subsidiary of TNP Enterprises, Inc. (TNPE). The Utility is a public utility engaged in the generation, purchase, transmission, distribution and sale of electricity within the states of Texas and New Mexico. The Utility is subject to regulation by the Public Utility Commission of Texas (PUCT) and the New Mexico Public Utility Commission (NMPUC). The Utility is subject in some of its activities, including the issuance of securities, to the jurisdiction of the Federal Energy Regulatory Commission (FERC), and its accounting records are maintained in accordance with the FERC's Uniform System of Accounts. TGC and TGC II were incorporated in Texas in 1988 and 1991, respectively, as financing entities for the assumption of ownership and liabilities related to two 150-megawatt lignite-fueled generating units, Unit 1 and Unit 2, respectively, collectively referred to as TNP One. The units were constructed by a nonaffiliated consortium in Robertson County, Texas, and are operated by the Utility under the terms of operating agreements between the Utility and its subsidiaries. Notes 2 and 5 provide additional information about the financings and regulatory treatments of Unit 1 and Unit 2. (b) Utility Plant The costs of additions to utility plant and replacement of retired units of property are capitalized. Costs include labor, materials and similar items and indirect charges for such items as engineering, supervision and transportation. Property repairs and replacement of minor items of property are included in maintenance expense. The cost of depreciable units of plant retired or disposed of in the normal course of business is eliminated from utility plant accounts, and such cost plus removal expenses less salvage is charged to accumulated depreciation. When complete operating units are disposed of, appropriate adjustments are made to accumulated depreciation, and the resulting gains or losses, if any, are recognized. (c) Depreciation Depreciation is provided on a straight-line basis over the estimated service lives of the properties. Depreciation of utility plant, other than transportation equipment, is charged to earnings. Depreciation of transportation equipment is charged to earnings and property accounts in accordance with the equipment's use. Depreciation as a percentage of average depreciable cost was 3.00%, 3.10% and 3.17% in 1993, 1992 and 1991, respectively. (d) Unamortized Debt Expense, Discount and Premium on Debt Expenses incurred in connection with the issuance of outstanding long-term debt and discount and premium related to such debt are amortized on a straight-line basis over the lives of the respective issues. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (1) Summary of Significant Accounting Policies - continued (e) Revenues and Purchased Power Revenues are recognized on the basis of meter readings which are made on a monthly cycle. The Utility does not accrue revenues for power sold but not billed at the end of an accounting period. Power purchased is recorded on the basis of billings from suppliers; no accrual is made for power delivered to the Utility between the dates of such billings and the end of an accounting period. (f) Customer Receivables The Utility sells customer receivables to a nonaffiliated company on a nonrecourse basis. (g) Deferred Purchased Power and Fuel Costs The deferral method of accounting is used for the portions of purchased power and fuel costs which are recoverable in subsequent periods under purchased power costs recovery adjustment clauses. These clauses provide the ability to refund or collect, in the second succeeding month, those amounts of purchased power costs over- or under-collected in the current month. At December 31, 1993 and 1992, the Utility had under-recovered purchased power costs of approximately $1,520,000 and $6,640,000, respectively. At December 31, 1993 and 1992, the Utility also had under-recovered fuel costs of approximately $13,631,000 and $11,095,000, respectively, related to TNP One. A fixed fuel factor approved by the PUCT is intended to permit the Utility to recover the cost of fuel utilized to generate electricity sold in Texas. The factor may be changed only upon approval of the PUCT and is expected to be adjusted for any cumulative over- or under-recovery of fuel costs. (h) Allowance for Borrowed Funds Used During Construction The applicable regulatory uniform system of accounts defines allowance for funds used during construction as including the net cost during the period of construction of borrowed funds used for construction purposes and a reasonable rate on other funds when so used. In that connection, the Utility used an accrual rate of 7.53% in 1993, 5.8% in 1992 and 8.0% in 1991 for borrowed funds used during construction, excluding capitalized interest related to the financing facilities. Capitalized interest related to the financing facility for Unit 2 (note 2) was approximately $4,234,000 in 1991. Interest was capitalized from the date of assumption of the Unit 2 indebtedness, July 26, 1991, until the date on which Unit 2 began commercial operation, October 16, 1991. (i) Income Taxes The Utility and its subsidiaries account for certain income and expense items differently for financial reporting purposes than for income tax purposes. Provisions for deferred income taxes are made for such differences. As discussed in note 4, the Utility changed its method of accounting for income taxes in 1993 to adopt the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." Investment tax credits utilized are deferred and amortized to earnings ratably over the estimated service lives of the related assets. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (1) Summary of Significant Accounting Policies - continued (i) Income Taxes - continued The consolidated Federal income tax return filed by TNPE includes the consolidated operations of the Utility and its subsidiaries. The amounts of income taxes and investment tax credits recognized in the accompanying consolidated financial statements were computed as if the Utility and its subsidiaries filed a separate consolidated Federal income tax return, and the amounts could differ from those recognized as a member of TNPE's consolidated group. (j) Employee Benefit Plans The Utility has in effect a trusteed defined benefit retirement plan available to employees who are 21 years of age and over and have at least one year of service with the Utility. The Utility's funding policy is to contribute annually at least the minimum amount required by government funding standards, but not more than that which can be deducted for Federal income tax purposes. The net pension costs for 1993, 1992 and 1991 included the following components: The following table is a summary of the plan's funded status at December 31, 1993 and 1992: TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (1) Summary of Significant Accounting Policies - continued (j) Employee Benefit Plans - continued The weighted average discount rate and the rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation were 7.15% and 4.15%, respectively, for 1993 and 8.5% and 5.75%, respectively, for 1992. The weighted average expected long-term rate of return on plan assets for 1993 and 1992 was 9.5%. The vested benefit obligations at December 31, 1993 and 1992, were approximately $50,457,000 and $39,757,000, respectively. The defined benefit retirement plan was amended to change, for all participants retiring after December 31, 1992, the determination of average monthly compensation used in calculating the amount of retirement benefits from the average of the three highest consecutive calendar years to the average of the completed calendar years of compensation after 1992. The Utility has a voluntary thrift plan, administered by a trustee, with a provision for the Utility to contribute to the plan amounts equal to certain percentages of amounts contributed by employees. Employees have the option of investing their contributions and contributions of the Utility, if any, in either, or a combination of, certain government securities, TNPE's common stock or, since January 1, 1992, two mutual funds. Effective January 1, 1992, the plan calls for the Utility's contributions to be used to purchase TNPE's common stock which the employees may later convert into investments in one or more of the other investing options. Effective January 1, 1993, the Utility suspended its matching contributions to the thrift plan for an indefinite period; however, the Utility's Board of Directors has approved restoration of the Utility's matching contributions, to be effective for employee contributions made after June 30, 1994. The Utility's contributions to the thrift plan amounted to approximately $1,592,000 and $1,487,000 in 1992 and 1991, respectively. Thrift plan assets included 1,471,213 shares and 1,482,490 shares of TNPE's common stock at December 31, 1993 and 1992, respectively. On November 9, 1993, the Board of Directors of the Utility renewed forms of employment contracts between the Utility and its officers and its other key personnel. The principal purpose of the contracts is to encourage retention of management and other key personnel required for the orderly conduct of the business of the Utility during any threatened or pending acquisition of TNPE or the Utility and during any transition of ownership. The terms of the contracts, from date of execution, are three years as to certain officers and managers of the Utility and two years as to the other key personnel. Upon the expiration date of each contract, the Utility, at its option, may extend the contract for additional three or two year periods, as appropriate. The contracts provide for lump sum compensation payments and other rights to the officers and the other key personnel in the event of termination of employment or other adverse treatment of such persons following a "change in control" of TNPE or the Utility, which event is defined to include, among other things, substantial changes in the corporate structure or ownership of either entity or in the Board of Directors of either entity. Health care and death benefits and an excess benefit plan have been provided at minimal or no cost to retired employees. The excess benefit plan is provided under an insurance policy arrangement and is backed by a letter of credit which will be funded only if a change in control occurs. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (1) Summary of Significant Accounting Policies - continued (j) Employee Benefit Plans - continued On January 1, 1993, the Utility implemented Statement of Financial Accounting Standards No. 106 (SFAS 106), "Employers' Accounting for Postretirement Benefits Other Than Pensions," which addresses the accounting for other postretirement employee benefits (OPEBs). For the Utility, OPEBs are comprised primarily of health care and death benefits for retired employees. Prior to 1993, the costs of these OPEBs were expensed on a "pay-as-you-go" basis. For 1992, these costs were approximately $760,000. Beginning in 1993, SFAS 106 requires a change from the "pay-as-you-go" basis to the accrual basis of recognizing the costs of OPEBs during the periods that employees render service to earn the benefits. SFAS 106 also requires employers to recognize the costs of benefits already earned by active employees and retirees at the date of adoption of SFAS 106 (the transition obligation). For the Utility, an annual accrual for OPEBs is comprised of (1) the portion of the expected postretirement benefit obligation attributed to employee service during that period (the service cost), (2) amortization of the transition obligation and (3) the interest costs associated with the total unfunded accumulated obligation for future benefits. For 1993, these costs amounted to approximately $508,000, $934,000 and $1,510,000, respectively. This total cost of $2,952,000 based on adoption of SFAS 106 was $2,276,000 greater than the amount of $676,000 that would have been recorded under the "pay-as-you-go" basis. The assumed health care cost trend rate used to measure the expected cost of benefits was 11.5% for 1993 and is assumed to diminish to 8.4% for 1994, then trend downward slightly each year to a level of 6% for 2003 and thereafter. The Utility's remaining transition obligation of $17,750,000 at December 31, 1993 is to be amortized over a remaining nineteen-year period. A 1% increase in the assumed health care cost trend rate would result in (1) an increase of $3,235,000 in the Utility's accumulated benefit obligation at December 31, 1993 and (2) an increase of $538,000 for 1993 in the aggregate service and interest costs. In March 1993, the PUCT issued its rules for ratemaking treatment of OPEBs. As part of a general rate case, a utility may request OPEBs expense in cost of service for ratemaking purposes on an accrual basis in accordance with generally accepted accounting principles. The PUCT's rule includes recovery of the transition obligation and requires that the amounts included in rates shall be placed in an irrevocable external trust fund dedicated to the payment of OPEBs expenses. Based on the PUCT's rule, the Utility intends to seek recovery of OPEBs expense attributable to its Texas jurisdiction in its next Texas rate case. In order to comply with the PUCT's condition for possible recovery of OPEBs expenses, the Utility established in June 1993 a Voluntary Employees' Beneficiary Association (VEBA) trust fund, dedicated to the payment of OPEBs expenses. Monthly cash payments made to the VEBA, which began in June 1993, will fund the three OPEBs expense components of the Utility's total Texas and New Mexico operations. On August 23, 1993, the Utility filed a rate application with the NMPUC which included a request for recovery of the applicable costs of OPEBs. A stipulated agreement among the parties in the application, dated January 28, 1994, subject to approval by the NMPUC, would include such applicable costs in the proposed New Mexico rates, beginning in 1994. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (1) Summary of Significant Accounting Policies - continued (j) Employee Benefit Plans - continued The following table presents the plan's funded status reconciled with amounts recognized in the consolidated balance sheets at December 31, 1993 and 1992: The discount rate used in determining the actuarial present value of the accumulated postretirement benefit obligation was 7.15% and 8.50% for 1993 and 1992, respectively. (k) Fair Values of Financial Instruments The fair value amounts of certain financial instruments included in the accompanying consolidated balance sheets at December 31, 1993 and 1992 were as follows: The fair value of cash and cash equivalents approximates the carrying amount because of the short maturity of those instruments. The total estimated fair value of long-term debt was approximately $723 million and $755 million in 1993 and 1992, respectively. The total estimated fair value of preferred stocks was $7.6 million and $7.7 million in 1993 and 1992, respectively. The estimated fair values of long-term debt and preferred stocks were based on quoted market prices of the same or similar issues. (l) Statements of Cash Flows For purposes of the consolidated statements of cash flows, the Utility considers temporary cash investments with original maturities of three months or less to be cash equivalents. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (2) Long-term Debt Long-term debt outstanding was as follows: Issuance of Additional First Mortgage Bonds and Secured Debentures On September 29, 1993, the Utility issued $100 million of 9.25% First Mortgage Bonds, Series U, due September 15, 2000 (New Bonds), and $140 million of 10.75% Secured Debentures, Series A, due September 15, 2003 (Debentures, due 2003). After fees and expenses, combined net proceeds available to the Utility from the issuances of the New Bonds and the Debentures, due 2003, and existing cash were utilized as follows: (a) $146 million was used to prepay or purchase all of the outstanding secured notes payable to lenders under the Unit 1 financing facility, as discussed below; (b) $75.75 million was used to prepay secured notes payable under the Unit 2 financing facility, as discussed below; (c) $21.78 million was deposited for the call for redemption of the aggregate principal amount, including redemption premiums, of Series H, I, J and K First Mortgage Bonds; and (d) $9.14 million was used to reimburse the Utility's treasury for funds used to redeem Series G First Mortgage Bonds at maturity on July 1, 1993. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (2) Long-term Debt - continued Supplemental indentures relating to Series H, I, J and K First Mortgage Bonds contained a requirement that Net Earnings Available for Interest of the Utility for 12 consecutive months out of the preceding 15 months be at least two-and-one-half (2.5) times the aggregate amount of annual Interest Charges on Bonded Indebtedness which gives effect to the interest on the additional Bonds to be issued (the Interest Coverage Ratio). Under the 2.5 times Interest Coverage Ratio required for issuance of additional First Mortgage Bonds, only a minimal amount of additional First Mortgage Bonds could have been issued. Under the supplemental indentures for the series of Bonds outstanding after the deposit of proceeds from the offering for the redemption of Series H, I, J and K Bonds, the Interest Coverage Ratio was reduced to two (2) times. The maturity of Series G Bonds on July 1, 1993, and the call for redemption of Series H, I, J and K Bonds permitted the issuance of additional Bonds and consummation of the offering of $100 million of New Bonds. Amendments to the Financing Facilities At December 31, 1992, secured notes payable represented loans issued under two financing facilities, which were originally entered into by separate subsidiaries of a construction consortium, for the construction of Unit 1 and Unit 2 of the TNP One generating plant. The Unit 1 financing facility was assumed by TGC on July 20, 1990. The Unit 2 financing facility was assumed by TGC II on July 26, 1991. On September 29, 1993, the balance of the secured notes payable under the Unit 1 financing facility was purchased or prepaid, and $75.75 million of secured notes payable under the Unit 2 financing facility was prepaid, reducing that outstanding commitment to $147.75 million; funds used for these prepayments and purchases were provided from issuance of the New Bonds and the Debentures, due 2003, and from existing cash, as discussed above. Thereafter, the Utility made additional unscheduled prepayments of approximately $69 million under the Unit 2 financing facility. The $78.8 million balance at December 31, 1993 represents secured notes payable under the Unit 2 financing facility, consisting of a series of renewable loans from various lenders in a financing syndicate. In contemplation of the prepayments of the Unit 1 and Unit 2 financing facilities, the related credit agreements between the secured lenders and the Utility were amended as of September 21, 1993 to facilitate the issuance of the Debentures, due 2003, and to extend the maturities of the remaining loans from due dates in 1994 and 1995. The effectiveness of the amendments was contingent upon the application of proceeds from the sale of the Debentures, due 2003, and the New Bonds. The extension of the maturities of the remaining loans to be outstanding under the Unit 2 financing facility is subject to further approvals from the FERC and the NMPUC. The Utility expects to receive the necessary approvals within the period required by the amendments. Upon the effective date of the extension, the lenders will receive an extension fee of 1/4 of 1% on their pro-rata share of the $147.75 million commitment. Based upon the December 31, 1993 balance and assuming the regulatory approvals of the extensions of the maturities under the Unit 2 financing facility, $1.6 million will be due on December 31, 1995, $3.4 million will be due on December 31, 1996, with the remaining amounts due in two equal installments of approximately $36.9 million on December 31, 1997 and 1998. Under the amendments to the Unit 2 credit agreement, the Utility is permitted to prepay up to $141.5 million of the $147.75 million commitment under the Unit 2 financing facility and reborrow thereunder up to the amount of such prepayments, subject to scheduled reductions of the commitment of approximately $36.9 million each in 1996, 1997 and 1998. Such reborrowings under the Unit 2 financing facility will be subject to compliance with the EBIT test (as described below) and maintenance of an equity to total capital ratio of 20% or more as defined in the credit agreement. As of December 31, 1993, the unused commitment available to be borrowed under the Unit 2 financing facility was approximately $69 million. A commitment fee of 1/4 of 1% per annum is payable on the unused portion of the reducing commitment. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (2) Long-term Debt - continued The financing facilities contain certain covenants which, under specified conditions, restrict the payment of cash dividends on common stock of the Utility. The most restrictive of such covenants are an interest coverage test and an equity ratio test. Under the interest coverage test, the Utility may not pay cash dividends on its common stock unless its prior twelve months' earnings (exclusive of any writedowns resulting from actions of the PUCT, to the extent included in operating expenses) before interest and income taxes equals or exceeds the sum of all of the interest expense on indebtedness for the same period (said calculation, the EBIT Test). This restriction becomes effective only after the third consecutive calendar quarter during which the Utility does not meet the EBIT Test and continues in effect until after the quarter in which the Utility has met the twelve-month EBIT Test. The Utility has met the EBIT Test at each quarterly date since this test became effective. Under the recently required equity ratio test, the Utility may not pay cash dividends on its common stock if, at the preceding quarterly date, the Utility's ratio of equity capitalization to total capitalization is less than 20%. As of December 31, 1993, this test was met. Under the two financing facilities, interest rates were determined under several alternative methods. During 1993, all rates at the time of each borrowing were no higher than the prime lending rate plus a margin of 1- 3/8%. The effective costs of borrowing under the secured notes payable were 7.23% and 5.61% at December 31, 1993 and 1992, respectively. Under the amended Unit 2 financing facility, the margins will increase by 1/2 of 1% each year in 1994 and 1995 and by 1/4 of 1% each year in 1996, 1997 and 1998. Additional Information Substantially all utility plant owned directly by the Utility is subject to the first lien of the Utility's first mortgage bond indenture, as supplemented (the Bond Indenture). Until repaid, the holders of the secured notes payable and of the secured debentures have a lien junior to the first lien of the Bond Indenture on substantially all utility plant in Texas owned directly by the Utility. The Debentures, due 2003, are secured by a pledge by the Utility to the new debenture trustee of a replacement note (1993 Unit 1 Replacement Note) in an amount equal to the principal amount of the Debentures, due 2003, purchased by the Utility from secured lenders under the Unit 1 financing facility. The 1993 Unit 1 Replacement Note is secured ratably by the original Unit 1 First Lien Mortgage of the Unit 1 financing facility on the assets of TGC, the existing second mortgage lien on the Utility's Bond Indenture trust estate assets in Texas and certain other collateral. The Debentures, due 2003, rank pari passu with the outstanding secured debentures, due 1999, in their Unit 1 mortgage lien on the assets of TGC and other security interests. The secured debentures, due 1999, are secured ratably by a 1992 Unit 1 replacement note and a 1992 Unit 2 replacement note ($65 million each), which are in turn secured by first liens on the assets of TGC and TGC II, respectively, and by the existing second mortgage lien on the Utility's Bond Indenture trust estate assets in Texas and certain other collateral. Under the terms of each financing facility, the secured notes payable and the replacement notes are secured by related first liens on Unit 1 and Unit 2 until undivided interests in Unit 1 and Unit 2 have been purchased from TGC and TGC II, respectively, by the Utility, whereupon such undivided interests become subject to the lien of the Bond Indenture. In connection with the prepayments of the secured notes payable under the Unit 1 and Unit 2 financing facilities in September 1993, the Utility purchased from TGC and TGC II certain undivided direct interests in Unit 1 and Unit 2, respectively; accordingly, these interests were released from the first liens of the financing facilities. These purchases were in addition to interests in Unit 1 acquired by the Utility in 1992 and 1990. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (2) Long-term Debt - continued As of December 31, 1993, TGC owns a 205/345 undivided interest in Unit 1 with the remaining fractional interest being owned directly by the Utility. (The denominator of 345 represents the historical maximum balance of $345 million that was originally borrowed under the Unit 1 financing facility; the numerator of 205 represents $205 million of replacement notes secured by the Unit 1 First Lien Mortgage.) TGC's interest in Unit 1 is subject to the lien of the Unit 1 First Lien Mortgage, which secures equally and ratably the 1993 Unit 1 replacement note of $140 million and the 1992 Unit 1 replacement note of $65 million. As of December 31, 1993, TGC II owns a 212.75/288.50 undivided interest in Unit 2 with the remaining fractional interest being owned directly by the Utility. (The denominator of 288.50 represents the historical maximum balance of $288.50 million that was originally borrowed under the Unit 2 financing facility; the numerator of 212.75 represents $212.75 million of debt and available loan commitment that remains secured by the Unit 2 First Lien Mortgage.) TGC II's interest in Unit 2 is subject to the lien of the Unit 2 First Lien Mortgage, which secures all remaining secured notes payable outstanding under the Unit 2 financing facility and the 1992 Unit 2 replacement note of $65 million. During the repayment periods, the Utility will operate and finance Unit 1 and Unit 2. Under the terms of each financing facility, upon or after each repayment of construction debt or replacement notes by TGC or TGC II through financings by the Utility, the Utility may purchase a proportionate undivided direct interest in the respective unit from TGC or TGC II to the extent such purchase is necessary to enable the Utility to issue, from time to time, first mortgage bonds. Upon such purchase, the undivided interest will be released from the lien of such unit's financing facility. In any event, the Utility may not purchase and the respective subsidiary may not transfer any undivided interest which would cause the fraction of the undivided interest remaining subject to the lien of the respective financing facility to be less than a certain fraction. The numerator of such fraction is the sum of (a) the unused commitment provided by lenders and the outstanding principal amounts owed to the lenders under such financing facility and (b) the principal amount of the respective replacement notes held as security for secured debentures. The denominator of such fraction is (i) $345 million under the Unit 1 financing facility and (ii) $288.5 million under the Unit 2 financing facility. The Utility guarantees the obligations of TGC and TGC II under each respective financing facility. The Utility expects, assuming adequate regulatory treatment, to be able to repay the remaining amount due under the Unit 2 financing facility primarily through the receipt of common equity from the Utility's parent, internal cash generation and issuance of debt. Based upon the December 31, 1993 balance and assuming the approvals of the extensions of the maturities of secured notes payable under the Unit 2 financing facility, maturities and sinking fund requirements for the Utility's long-term debt for the five years following 1993 are as follows: First mortgage bonds Secured notes payable (In Thousands) 1994 $ 1,070 - 1995 1,070 1,600 1996 1,070 3,400 1997 131,070 36,900 1998 1,070 36,900 TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (4) Income Taxes Income taxes as set forth in the consolidated statements of earnings consisted of the following components: The provisions for deferred income taxes for 1992 and 1991 resulted from the following timing differences: 1992 1991 (In Thousands) Charged (credited) to operating expenses: Tax depreciation in excess of book depreciation $13,615 19,540 Deferred charges and other costs expensed for tax purposes, net 674 1,943 Deferred purchased power and fuel costs expensed for tax purposes 1,765 2,049 Unbilled revenues for tax purposes 519 (1,778) Accrual for revenues subject to refund (5,069) - Minimum tax credit (2,608) (8,085) Amortization of excess deferred taxes (1,153) (810) Change in deferred taxes due to tax net operating loss (6,256) - Other (140) 87 $1,347 12,946 TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (4) Income Taxes - continued Total income tax expense for 1993, 1992 and 1991 was less than the amount computed by applying the appropriate statutory Federal income tax rate to income before income taxes. The reasons for the differences were as follows: The Omnibus Budget Reconciliation Act of 1993 (Act) was signed into law on August 10, 1993. Among other provisions, the Act provided, effective January 1, 1993, for a corporate income tax rate increase from 34% to 35% to be phased in for taxable income between $10 million and $18 million. Adjustments have been made to deferred tax amounts to reflect the future reversal of temporary differences at the higher tax rate. Under transitional rules of the Tax Reform Act of 1986, certain capital expenditures incurred after December 31, 1985 continued to qualify for investment tax credits (ITC). Accordingly, ITC adjustments reflect credits for the utilized portion of ITC generated in 1990 associated with ITC applicable to transitional property. The Utility has ITC carryforwards for Federal income tax purposes of approximately $18,700,000 which are available to reduce future Federal income taxes through 2005. The Utility generated a Federal minimum tax (MT) for the year ended December 31, 1993. The MT resulted in a net current Federal income tax expense of approximately $266,000, after utilization of ITC. At December 31, 1993, the Utility has net operating loss (NOL) carryforwards for Federal income tax purposes of approximately $44,600,000 which are available to offset future Federal taxable income through 2008. In addition, the Utility has minimum tax credit carryforwards of approximately $14,900,000 which are available to reduce future Federal regular income taxes over an indefinite period. In order to fully realize the Federal regular tax NOL carryforwards, the Utility will need to generate future taxable income of approximately $44,600,000 prior to expiration of the Federal regular tax NOL carryforwards which will begin to expire in 2006. Based on the Utility's historical and projected pretax earnings, management believes it is more likely than not that the Utility will realize the benefit of the Federal regular tax NOL carryforwards existing at December 31, 1993 before such carryforwards begin to expire in 2006. In addition, the remaining deferred tax assets, exclusive of the MT credit carryforwards, are considered current and expected to reverse in the next twelve months. TNPE's consolidated Federal income tax returns for the years 1987 through 1989 have been examined by the Internal Revenue Service resulting in a revenue agent report (RAR). The Utility's carryforwards referred to above and the accompanying consolidated financial statements reflect adjustments resulting from the RAR. The RAR had no effect on the Utility's results of operations. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (4) Income Taxes - continued On January 1, 1993, the Utility implemented Statement of Financial Accounting Standards No. 109 (SFAS 109), "Accounting for Income Taxes." Prior to implementation of SFAS 109, the Utility accounted for income taxes under Accounting Principles Board Opinion No. 11 (APB 11). Implementation of SFAS 109 changed the method of accounting for income taxes from the deferred method required under APB 11 to the asset and liability method. Under the deferred method, annual income tax expense was matched with pretax accounting income by providing deferred taxes at the then current tax rates for timing differences between pretax accounting income and taxable income. The objective of the asset and liability method is to establish deferred tax assets and liabilities for the temporary differences between the financial reporting basis and the tax basis of assets and liabilities at enacted tax rates expected to be in effect when such temporary differences are realized or settled. The Utility elected to implement SFAS 109 on a prospective basis. SFAS 109 provides that regulated enterprises are allowed to recognize adjustments resulting from the adoption of SFAS 109 as regulatory tax assets or liabilities if such amounts are probable of being recovered from or returned to customers through future rates. Deferred taxes recorded under APB 11 were attributable primarily to differences associated with book and tax depreciation. Temporary differences under SFAS 109 include all items considered timing differences under APB 11, as well as certain new items including (1) a reduction in the depreciable tax basis due to ITC, (2) ITC accounted for under the deferred method and (3) prior flow-through treatment of tax benefits. Adoption of SFAS 109 has affected the consolidated balance sheet due to deferred Federal income tax effects for temporary differences associated with prior flow-through ratemaking accounting practices, treatment of tax rate changes and unamortized ITC. Unamortized ITC represent amounts being "shared" with customers as future revenue requirements are reduced by the amortization of accumulated deferred ITC. This gives rise to a corresponding regulatory liability to reflect the ratemaking treatment. SFAS 109 requires the recognition of regulatory and deferred tax assets and liabilities for the cumulative unrecognized temporary differences. The result as of January 1, 1993 of implementing SFAS 109 was as follows (in thousands): December 31, January 1, 1992 Reclassifications 1993 Assets: Deferred charges $46,689 (17,529) 29,160 Regulatory tax assets - 17,974 17,974 Accumulated deferred taxes on income - current - 6,006 6,006 46,689 6,451 53,140 Liabilities: Accrued taxes $20,136 (890) 19,246 Accumulated deferred taxes on income - noncurrent 84,917 (15,852) 69,065 Regulatory tax liabilities - 23,193 23,193 $105,053 6,451 111,504 The above reclassifications resulted from the recognition of regulatory and deferred tax assets and liabilities for the cumulative unrecognized temporary differences, recognition of the 1992 Federal regular tax NOL carryforward and reclassification of certain other balances to comply with the provisions of SFAS 109. The implementation of SFAS 109 did not result in any significant charge to operations. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (4) Income Taxes - continued The tax effects of temporary differences that gave rise to significant portions of net current accumulated deferred taxes on income and net noncurrent accumulated deferred taxes on income at December 31, 1993 are presented below (in thousands): (5) Commitments and Contingencies In October 1991, the second unit of TNP One, the Utility's two-unit, 300- megawatt, circulating fluidized bed generating facility, was completed and successfully placed in operation. At December 31, 1993, the costs of Unit 1 totalled approximately $357 million and the costs of Unit 2 totalled approximately $282.9 million. The Utility has received rate orders (in Docket Nos. 9491 and 10200) from the PUCT placing the majority of the costs of the two units of TNP One in rate base, resulting in rate increases for the Utility's Texas customers. In Docket No. 9491, the PUCT disallowed from rate base approximately $39.5 million of the costs of Unit 1. On appeal, a State district court overturned the disallowances; however, a Texas Court of Appeals rendered a judgment partially reversing the State district court. In its October 16, 1992 rate order in Docket No. 10200, the PUCT disallowed $21.1 million of the costs of Unit 2 . On rehearing of Docket No. 10200, the PUCT unexpectedly reversed consistent precedent to adopt a new methodology for calculating the amount allowed in rates for Federal income taxes. The immediate result was a reduction in the rate increase previously granted on October 16, 1992. Each of the rate orders is the subject of continuing appellate process in the courts. Further detailed information of Docket Nos. 9491 and 10200 is provided below. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (5) Commitments and Contingencies - continued In litigating Docket Nos. 9491 and 10200, the Utility's opponents are seeking, among other things, lower rates and greater disallowances, and the Utility is seeking higher rates and no disallowances. While the ultimate outcome of these cases and of other matters discussed below cannot be predicted, the Utility is vigorously pursuing their favorable conclusion. Material adverse resolution of certain of the matters discussed below would have a material adverse impact on earnings in the period of resolution. PUCT Docket No. 9491 On February 7, 1991, in Docket No. 9491, the PUCT approved an increase in annualized revenues of approximately $36.7 million, or 67% of the Utility's original $54.9 million rate request filed in 1990. The approval allowed $298.5 million of the costs of TNP One, Unit 1 in rate base; however, the PUCT disallowed $39.5 million of the requested investment costs of $338 million for that unit. Additional Unit 1 costs, not requested in Docket No. 9491, were included in the Utility's subsequent Texas rate request, Docket No. 10200, filed on April 11, 1991. In Docket No. 9491 in Finding of Fact No. 84 (FF No. 84), the PUCT also found that the Utility failed to prove that its decision to start construction of Unit 2 was prudent. Since the costs incurred for Unit 2 construction were not at issue in the Docket No. 9491 proceeding, the quantification of a disallowance, if any, that might result from this finding was to be determined subsequently in Docket No. 10200. On June 5, 1991, the Utility filed a petition in a Travis County district court which sought to overturn the PUCT's ruling regarding the disallowances and prudence decisions in Docket No. 9491. Certain intervenors also appealed other aspects of the PUCT's decisions in Docket No. 9491. On July 6, 1992, the presiding judge of the district court signed a judgment finding that the PUCT's disallowance of rate base treatment for certain costs of Unit 1 was in error and that the PUCT's "decision to deny $39,508,409 in capital costs for TNP One Unit 1 is not supported by substantial evidence and is arbitrary and capricious." The Utility, the PUCT and certain of the intervenor cities (the Cities) appealed the district court's judgment regarding the appeal of the PUCT's decision in Docket No. 9491 to the Third District Court of Appeals in Austin, Texas. The Utility's appeal related to the district court's decision which upheld the PUCT finding that the Utility failed to prove that its decision to start construction of Unit 2 was prudent and certain other matters. The PUCT and the Cities sought to reinstate the disallowances, and the Cities sought, among other things, to deny rate base treatment and to significantly lower rates granted by the PUCT. On August 25, 1993, the Third District Court of Appeals rendered a judgment partially reversing the district court and affirming the PUCT's disallowances for $30.4 million of the total $39.5 million. The Court of Appeals judgment states that the district court erred in (1) reversing that part of the PUCT's order disallowing "the Compressed Schedule Payment, the Force Majeure Payment, and a portion of the increased costs for the installation of a natural gas pipeline in Change Order No. 9, Item 2;" (2) affirming that part of the PUCT's order dealing with the prudence of the decision to construct Unit 2 (FF No. 84); and (3) affirming that part of the PUCT's order that failed to pass on to ratepayers the federal income tax savings for expenses disallowed by the PUCT. The Court of Appeals remanded the cause to the district court with instructions that the cause be remanded to the PUCT for proceedings not inconsistent with the appellate opinion. On September 9, 1993, the Utility, the Cities and the PUCT filed motions for rehearing with the Court of Appeals. The PUCT is not expected to act upon the district court's ordered remand, discussed above, until the appellate process, including appeals to the Texas Supreme Court, has been completed. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (5) Commitments and Contingencies - continued Based upon the opinions of the Utility's Texas regulatory counsel, Johnson & Gibbs, a Professional Corporation, management believes that it will prevail in obtaining a remand of a significant portion of the disallowances in Docket No. 9491; however, the ultimate disposition and quantification of these items cannot presently be determined. Accordingly, no provision for any loss that may ultimately be required upon resolution of these matters has been made in the accompanying consolidated financial statements. If the Utility is not successful in obtaining a final favorable disposition in the appellate proceedings relating to the disallowances in Docket No. 9491, a write-off of some portion of the $39.5 million disallowances would be required, which could result in a significant negative impact on earnings in the period of final resolution. PUCT Docket No. 10200 On April 11, 1991, the Utility filed a rate application, Docket No. 10200, with the PUCT for inclusion of $275.2 million of capital costs of Unit 2 and $16.1 million of additional capital costs of Unit 1 in the Utility's rate base. The Administrative Law Judge (ALJ) in Docket No. 10200 initially required briefs of all parties on the issue of whether the inclusion of Unit 2 in the Utility's rate base would be precluded by the PUCT finding in Docket No. 9491, FF No. 84, that the Utility failed to prove that its decision to start construction of Unit 2 was prudent. In its brief to the ALJ, the Utility argued that FF No. 84 could not have the effect of barring litigation in Docket No. 10200 of all aspects of Unit 2 costs, asserting that evidence as to Unit 2 costs presented in Docket No. 9491 had been presented for the purpose of discussion of facilities which were common to both Unit 1 and Unit 2. The General Counsel of the PUCT argued that the issue of the Utility's prudence as to Unit 2 was barred by FF No. 84 and requested that the Utility's entire prudence testimony in Docket No. 10200 be stricken, along with all associated schedules and exhibits. The ALJ ruled on June 7, 1991 that the PUCT's finding in Docket No. 9491 could not be "relitigated" in Docket No. 10200. However, the ALJ determined that the PUCT did not decide "what specific action by TNP, instead of beginning construction when it did, would have been prudent" and that the PUCT did not "quantify the disallowance resulting from its finding that TNP had failed to prove that beginning construction of Unit 2 was prudent." Therefore, the ALJ concluded that the parties could raise those particular issues in Docket No. 10200. The ALJ further stated that, "The disallowance, if any, will be determined using principles set forth in previous cases regarding prudence." The ALJ determined that, in order for the Utility's request for inclusion of the Unit 2 investment in rate base as plant in service to be considered, the Utility must present a prima facie case in its direct testimony as to how a disallowance resulting from FF No. 84 should be quantified. The Utility appealed the ALJ's ruling to the PUCT, which voted not to hear the appeal. On August 16, 1991, the Utility filed supplemental prudence testimony, under protest, responding to the ALJ's order and supporting the Utility's entitlement to rate base treatment for the costs of Unit 2. In its supplemental testimony, the Utility contended that it prudently could have released Unit 2 for construction in February 1989, rather than September 1988, when the unit was actually released. The Utility argued that this alternative would cost no less than the actual cost of Unit 2, and thus no disallowance should result from any imprudence in releasing Unit 2 for construction in September 1988. Two intervenors in this proceeding objected to the Utility's presentation of a prudent alternative, but the PUCT included such evidence in the record. In a "final" order dated October 16, 1992, the PUCT commissioners approved an increase in annualized revenues of $26 million, or 72% of the Utility's original $35.8 million requested increase. The PUCT's order determined that the reasonable costs for Unit 2 were $261.8 million. The PUCT allowed in rate base $250.7 million of the $275.2 million requested for Unit 2 costs. The difference between the $261.8 million in costs found to be prudent by the PUCT and the $282.9 million total costs of Unit 2 consisted of disallowances of approximately $21.1 million. The PUCT also determined that $11.1 million of Unit 2 costs will be addressed in a future Texas rate application. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (5) Commitments and Contingencies - continued The order in Docket No. 10200 also allowed approximately $15.3 million of the requested approximately $16.1 million of Unit 1 costs not sought by the Utility in Docket No. 9491. The approximately $800,000 disallowance was primarily related to debt service on disallowed costs determined in Docket No. 9491. Subsequent to the issuance of the "final" order on October 16, 1992, motions for rehearing of certain issues were filed by parties to the case. On December 22, 1992, the PUCT issued an Order on Rehearing which reduced the $ 26 million increase in annualized revenues that was originally granted by the PUCT in its order on October 16, 1992. The primary issue in the Order on Rehearing was the PUCT's reversal of its original Docket No. 10200 order as to the use of the "return method" for calculating the amount allowed in cost of service for the Utility's Federal income tax expense. The "return method" of computing Federal income tax expense requested by the Utility followed consistent precedent of the PUCT. The concept of the "return method" is to match a utility's taxes with the same revenues and expenses included in rates. The new method adopted by the PUCT in the Order on Rehearing flowed through to ratepayers the tax benefits of expenses disallowed and not included in rates. The net effect of this Order on Rehearing was a decrease of approximately $7 million from the October 16, 1992 order, resulting in a $19 million increase in annualized revenues. On January 26, 1993, the PUCT considered motions for rehearing on the December 22, 1992 Order on Rehearing but did not alter the $19 million increase in annualized revenues or the disallowances. In its Order on Rehearing, dated February 4, 1993, the PUCT ordered the Utility to seek a private letter ruling from the Internal Revenue Service (IRS) to determine if the Order on Rehearing resulted in violations of the "normalization" rules concerning investment tax credits and accelerated tax depreciation on public utility property. The PUCT's February 4, 1993 Order on Rehearing stated that the tax method utilized does not violate the "normalization" rules of the Internal Revenue Code; however, a December 1992 private letter ruling of the IRS to an unrelated utility indicates that regulatory treatment which flows through tax benefits of investment tax credits on disallowed public utility property violates the "normalization" rules. A "normalization" violation ultimately results in a utility's loss of benefits from investment tax credit and/or accelerated depreciation on public utility property. Without the curative action of the PUCT on March 10, 1993, discussed in the following paragraph, an IRS determination that a "normalization" violation had occurred would subject the Utility to paying additional income taxes for the amount of the accumulated deferred investment tax credits as of the time of the violation and taxes on the amount of tax depreciation in excess of book depreciation for all tax years open for IRS review. On March 10, 1993, the PUCT considered motions for rehearing on the February 4, 1993 Order on Rehearing and expressed its position that its earlier actions not create a "normalization" violation for the Utility. As a result, in its Order on Rehearing, dated March 18, 1993, the PUCT ordered that the Utility be granted, subject to refund, an additional $1.6 million in annualized revenues which matches recovery in rates with only the investment tax credits and accelerated tax depreciation related to utility property included in rate base. Accordingly, the benefits of investment tax credits and accelerated tax depreciation related to disallowed public utility property would not be passed through to ratepayers; therefore, the Utility believes that the "normalization" rules with respect to investment tax credits and accelerated tax depreciation would not be violated. Further, the PUCT affirmed its February 4, 1993 Order on Rehearing directing the Utility to seek a private letter ruling from the IRS to determine if the earlier methodology adopted in the December 22, 1992 Order on Rehearing would violate the "normalization" rules concerning investment tax credits and accelerated tax depreciation on public utility property. If the IRS determines that the PUCT's December 22, 1992 order would not constitute a "normalization" violation, then the additional $1.6 million in annualized revenues would be revoked by the PUCT, and the Utility would be required to refund excess amounts collected. The PUCT did not reverse its December 22, 1992 position to pass through to ratepayers the tax benefits of interest charges related to disallowed public utility property. The net resultant effect of Docket No. 10200 (by the PUCT action of March 10, 1993) is an increase in annualized revenues of $20.6 million, of which $1.6 million is subject to refund. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (5) Commitments and Contingencies - continued The March 18, 1993 Order on Rehearing was appealed by the Utility and certain intervening parties to a State district court. Because of the Court of Appeals judgment relating to FF No. 84 in the Docket No. 9491 appeals, the presiding judge in the State district court for the Docket No. 10200 appeal has ordered that the procedural schedule in this appeal be abated until final resolution of the FF No. 84 issue in Docket No. 9491. The Utility will vigorously pursue reversal of the PUCT's new position regarding Federal income tax expense in addition to seeking judicial relief from the disallowances and certain other rulings by the PUCT in Docket No. 10200. During the third quarter of 1993, the Utility refunded, to the appropriate Texas customers, amounts collected under bonded rates in excess of the $20.6 million in annualized revenues granted on rehearing in Docket No. 10200. The refund (approximately $18 million, including interest) was related to the period beginning on the effective date for bonded rates (October 16, 1991) through April 1993. After receiving PUCT approval on October 19, 1993, the Utility filed, on October 20, 1993, a request with the IRS for a private letter ruling on the issue of a "normalization" violation resulting from the PUCT's proposed treatment of investment tax credits and accelerated tax depreciation. Revenues related to the conditionally granted $1.6 million annualized increase will not be refunded unless the IRS determines that a "normalization" violation would not result from flowing through benefits of investment tax credits and accelerated tax depreciation related to disallowed public utility property. If the IRS so determines, a refund will be made after that determination. Accordingly, revenues associated with the $1.6 million annualized increase have not been recognized in results of operations as of December 31, 1993, and a provision for revenues subject to refund, including interest, has been made for $3.4 million in the consolidated balance sheet as of December 31, 1993. The Utility expects to receive the private letter ruling in 1994. Based upon the opinions of the Utility's Texas regulatory counsel, Johnson & Gibbs, a Professional Corporation, management believes that it will prevail in obtaining a remand of a significant portion of the disallowances in Docket No. 10200; however, the ultimate disposition and quantification of these items cannot presently be determined. Accordingly, no provision for any loss that may ultimately be required upon resolution of these matters has been made in the accompanying consolidated financial statements. If the Utility is not successful in obtaining a final favorable disposition in the appellate proceedings relating to the disallowances in Docket No. 10200, a write-off of some portion of the $21.9 million disallowances would be required, which could result in a significant negative impact on earnings in the period of final resolution. Other TNP One Matters In Docket No. 9491, the Utility requested deferred accounting treatment (DAT) for Unit 1 which would (1) defer $1.4 million and $2.8 million of operating costs and interest costs, respectively, (2) recover such amounts in rates through amortizations over the life of the unit and (3) include such unamortized amounts in the Utility's rate base, thereby recovering a carrying cost on the unamortized amount. The PUCT granted the Utility's DAT request except the inclusion of interest costs ($2.8 million) in rate base. In the final order meeting for Docket No. 9491, the PUCT commissioners indicated that their decision to exclude interest costs from the Utility's rate base was influenced by a recent appeals court ruling. In that ruling, which involved an appeal of a decision by the PUCT granting DAT to an unrelated electric utility, the appeals court found that the DAT component for interest costs could not be included in rate base. The electric utility has filed an application for writ of error with the Texas Supreme Court regarding the appeals court ruling. The ultimate effect of the appeals court ruling on the order granting DAT for Unit 1 is uncertain at this time. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES (a wholly owned subsidiary of TNP Enterprise, Inc.) Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 (5) Commitments and Contingencies - continued The Utility entered into a fuel supply agreement dated November 18, 1987 with Phillips Coal Company (Phillips), owner of a 300-million-ton lignite reserve in Robertson County in proximity to TNP One. The agreement provides for a lignite fuel source for the 38-year life of TNP One. Phillips subsequently entered into an agreement with a subsidiary of Peter Kiewit Sons', Inc. for development of the lignite mine by a joint venture partnership, Walnut Creek Mining Company. Unit 1 and Unit 2 are capable of utilizing Western coal, petroleum coke and natural gas as alternative fuel sources. Legal Actions The Utility is involved in various claims and other legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the Utility's consolidated financial position. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant. Identification of Directors and Directorships Set forth below is certain information concerning the nominees: NOMINEES FOR DIRECTOR Principal occupation Director and business experience of the during past five years; Name/Age Utility since and other directorships R. Denny Alexander, 48 1989 Owner, R. Denny Alexander & Company, since 1978 (investment management) Managing Partner, OPNB Building Joint Venture, since 1978 (real estate investment) Chairman, Overton Bank and Trust, National Association, since May 1984 Director of: Overton Bancshares, Inc., since 1982 Cass O. Edwards, II, 67 1975 Managing Partner, Edwards - Geren Limiated (ranching and farming) Chairman, Overton Bancshares, Inc., since Chairman and President, Cassco Land Company, Inc. Director of: Overton Bank and Trust, National Association John A. Fanning, 54 1984 Executive Vice President, Snyder Oil Corporation, since March 1990 (oil and gas producer) December 1987 to March 1990 Director of: Snyder Oil Company, Inc., since 1981 Harris L. Kempner, Jr., 54 1980 President, Kempner Capital Management, since 1981 (investment advisor) Trustee, H. Kempner Trust Association Chairman Emeritus and Advisor to the Board of United States National Bank, since 1992 Director of: Balmorhea Ranches; Imperial Holly Corp.; Cullen/Frost Bankers, Inc., since 1982; American Indemnity Company, since 1987; American Indemnity Financial, since 1990 TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Dr. Thomas S. Mackey, 63* 1977 President, Key Metals and Minerals Engineering Corporation, since 1970 (consulting engineers) President, Texas Copper Corporation, from 1989 to 1993 (primary copper processing) Thomas S. Mackey, P.C., a law firm, since 1978 President, Airtrust International Corporation, since 1982 (logistic services to oil industry) President, USA Offshore Industries Corporation; USA Logestics Services Corporation since 1982(equipment exports) Chairman, Board of Directors, Neomet Corporation, since 1989 (neodymium eutectic alloy production) President and Director, Neomet Corporation, from 1986 to 1989, and since 1992 President and Director, Cox Creek Refining Company, since 1990 (copper cathode and rod provider) Director of: United States National Bank, since 1970; Reactive Metals and Alloys, Inc., since 1986 (mischmetal and ferro alloy producer); Siltec Corporation and Siltec Epitaxial Corp., since 1986 (silicon wafer manufacturer); Malaysian Titanium Corporation, since 1990 (titanium dioxide pigment for paper and paint industry) D. R. Spurlock, 61 1993 Interim President & Chief Executive Officer of TNPE and the Utility, since November 9, 1993 Sector Vice President - Operations of the Utility, September 1990 through 1992 (Retired) Vice President - Division Manager of the Utility, August 1979 to September 1990 Director of: TNPE, since April 1993; Texas City National Bank, since 1976 R. D. Woofter, 70 1975 Chairman of the Board of TNPE and the Utility, since July 2, 1988 * A member of the Board and Committees, and a nominee until the time of his death on February 25, 1994. Three vacancies currently exist on the Board of Directors of the Utility. One vacancy resulted from the resignation of John Justin as a Director on February 25, 1993 and the unexpected decision of an advisory director not to stand for election to the position previously held by Mr. Justin. The resignation of J. M. Tarpley from the position of President & Chief Executive Officer and from the Board of Directors as of November 9, 1993, resulted in the second vacancy. The third vacancy occurred as the result of the untimely death of Dr. T. S. Mackey on February 25, 1994. It is expected that upon selection of a successful candidate for the position of President & Chief Executive Officer of the Utility, the Board of Directors will appoint that person to the directorship vacated by Mr. Tarpley's resignation. At such time as the Board of Directors has evaluated and selected persons who are qualified to act as directors of the Utility, the Board will make appointments of such persons to fill the two remaining vacant director positions. It is anticipated that appointees will stand for election at the 1995 Annual Meeting of the Shareholders of the Utility. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Identification of Executive Officers Positions & Offices Held Period of with the Utility Such Office Name Age Within the Past 5 Years1 Years Months D. R. Spurlock2 61 Interim President & Chief 0 1 Executive Officer and Director Sector Vice President - 2 4 Operations Vice President - 11 1 Division Manager D. R. Barnard 61 Sector Vice President & 3 8 Chief Financial Officer Vice President & 1 0 Chief Financial Officer Vice President & 17 0 Treasurer J. V. Chambers, Jr. 44 Sector Vice President - 3 8 Revenue Production Vice President - Contracts 3 2 & Regulation M. C. Davie 58 Vice President - Corporate 10 11 Affairs A. B. Davis 56 Vice President - Chief Engineer 1 8 Chief Engineer 1 4 Assistant Chief Engineer 0 1 Manager - Engineering 5 8 L.W. Dillon 39 Vice President - Operations 0 1 Division Manager 3 6 Division Engineering Manager 4 11 R. J. Wright 46 Vice President - 0 6 Corporate Services/Generation Vice President - Manager - Generation 4 8 M. D. Blanchard 43 Corporate Secretary & 6 4 General Counsel Monte W. Smith 40 Treasurer 4 8 Director - Internal Audit 2 11 1 All officers are elected annually by the Utility's Board of Directors for a one-year term until the next annual meeting of the Board of Directors or until their successors shall be elected and qualified. The term of an officer elected at any other time by the Board also will run until the next succeeding annual meeting of the Board of Directors or until a successor shall be elected and qualified. 2 Retired as Sector Vice President effective December 31, 1992; named Interim President & Chief Executive Officer effective November 9, 1993. With the exception of D. R. Spurlock, each of the above-named officers is a full-time employee of the Utility and has been for more than five years prior to the date of the filing of this Form 10-K. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Item 11.

Item 11. Executive Compensation. Compensation Committee Interlocks and Insider Participation The Personnel, Organization & Nominating Committee is responsible for recommending to the Board the appropriate levels of Executive Compensation. The members of the Committee are Messrs. Edwards and Woofter. Prior to his death, Dr. Mackey was a member of this Committee. Mr. Woofter, the Chairman of the Board and formerly the Chief Executive Officer and President of TNPE and the Utility, retired as an officer of both companies in 1988. Mr. Edwards is a director of Overton Bank and Trust, National Association, with which the Utility and TNPE maintain a banking relationship in the ordinary course of business. To the Utility's knowledge, there were no other inter- relationships involving members of the Committee. The following table sets forth information regarding cash compensation paid for services rendered to the Utility and its subsidiaries to the former CEO, the Interim President and CEO, and each of the four most highly compensated executive officers of the Utility whose cash compensation exceeded $100,000, for each of the last three fiscal years. Summary Compensation Table TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Utility's Pension Plan The following table sets forth annual benefits payable to employees of the Utility under the Utility's Pension Plan at the normal retirement age of 65. PENSION PLAN TABLE The Utility maintains for the benefit of all eligible employees a non- contributory defined benefit retirement plan (the "Pension Plan") under which contributions are actuarially determined each year. All employees who have one year of service with the Utility and who are 21 years of age are eligible. As a defined benefit plan, the Utility's Pension Plan contributions, which are computed on an actuarial basis, cannot be readily calculated on a per person basis by Plan actuaries. Benefits for each eligible employee are based on the employee's number of years of service computed through the month in which he or she retires multiplied by a specified percentage of the employee's average monthly compensation for each full calendar year completed after 1993. The average monthly compensation for the named executive officers consists only of amounts included beneath the Salary column of the Summary Compensation Table. Pension benefits are not subject to deduction for Social Security benefits. Pension benefits are subject to reduction for retirement prior to age 62. For 1993, the Utility made no contribution to the Pension Plan. The Utility also maintains an unfunded Excess Benefit Plan to compensate certain highly compensated employees. Such highly compensated employees must first have their pensions subject to being reduced below the amount which would have been provided by the Pension Plan because of compliance with Section 415 of the Internal Revenue Code of 1986, as amended, and must be designated as eligible by the Board of Directors for participation in the Excess Benefit Plan. There are three participants currently designated by the Board of Directors. A Letter of Credit is purchased each year which will provide sufficient funds to the Trust to make payments to all persons who are covered by the Excess Benefit Plan if a "change in control" were to occur as that term is defined in certain employment contracts which are discussed hereafter. The Utility owns life insurance policies on the lives of two employees currently eligible to receive payments under such plan upon their retirement and one retiree who is currently receiving benefits under the Excess Benefit Plan. The proceeds of the policies are payable to the Utility to compensate the Utility for its payments to the eligible employees pursuant to the terms of the Excess Benefit Plan. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES As of December 31, 1993, the years of credited service for calculation of the retirement benefits for the named executive officers of the Utility were as follows: NAME YEARS OF CREDITED SERVICE Mr. Tarpley 35 years, 6 months Mr. Spurlock Retired as of 12-31-92 with 33 years, 7 months Mr. Barnard 32 years, 6 months Mr. Chambers 14 years, 11 months Mr. Davis 28 years, 7 months Mr. Wright 14 years, 10 months Except for the Chairman, each member of the Board of Directors who is not also an officer of the Utility receives an annual retainer fee of $4,500 from each of TNPE and the Utility. The Chairman of the Board of Directors receives an annual retainer fee of $36,000 from each of TNPE and the Utility. The Chairman acts as agent for the Board of Directors and is a member of all Committees of the Board. Each director also receives $500 for attending each meeting of the Board of Directors of either TNPE or the Utility or Board committees of either entity of which he is a member. In the event that meetings of Boards of both entities or their Committees are held on the same day, the meeting fee is limited to $500 and is allocated evenly between TNPE and the Utility. Utility's Employment Contracts Employment contracts between the Utility and its officers and its other key personnel have continued since 1988, in form and substance last reviewed and approved by the Board of Directors of the Utility at the November, 1993 Board meeting. The principal purpose of the contracts is to encourage retention of management and other key personnel required for the orderly conduct of the business of the Utility during any threatened or pending acquisition of the Utility or TNPE and during any transition of ownership. The terms of the contracts, from date of execution, are three years as to certain officers and managers of the Utility and two years as to the other key personnel. Upon the expiration of each contract, the Utility, at its option, may extend the contract for additional three or two year periods, as appropriate. The contracts for certain officers and managers, including the named executive officers, provide for lump sum compensation payments equal to three times their current annual salary, and other rights. The contracts for the other key personnel provide for payments equal to their annual salary. The lump sum payments for both the officers and other key personnel only become effective in the event of termination of employment or other adverse treatment of such persons following a "change in control" of the Utility or TNPE, which event is defined to include, among other things, substantial changes in the corporate structure or ownership of either entity or in the Board of Directors of either entity. Pursuant to an agreement between J. M. Tarpley and TNPE and its subsidiaries, including the Utility, Mr. Tarpley resigned his positions as officer and member of the Boards of Directors of all such companies, including his positions as President, Chief Executive Officer and a member of the Boards of TNPE and the Utility. The agreement provides for November 9, 1993, as the effective time of resignation of such officer and director positions and, effective January 1, 1994, a contract of employment between Mr. Tarpley and the Utility. The agreement also sets forth other covenants and arrangements between the parties safeguarding confidential and proprietary information of TNPE and its subsidiaries and prohibiting areas of participation by Mr. Tarpley in opposition to TNPE and the Utility. Upon attaining age 62 (August 23, 1996), Mr. Tarpley will retire as an employee and have all rights of a retired employee of the Utility. As an employee and in consideration of the safeguarding and restricting covenants of Mr. Tarpley, his annual compensation until retirement, or his earlier death, will aggregate $284,000 per year. Mr. Tarpley has the rights as an employee to participate in the benefit plans and programs of the Utility, including such rights as a retired employee after age 62. Effective as of November 9, 1993, the Utility entered into an agreement with D. R. Spurlock to serve as President and Chief Executive Officer on an interim basis. The agreement provides for the Utility to pay Mr. Spurlock $30,000 per month, and to reimburse him for certain expenses incurred during the interim period. Mr. Spurlock does not receive any benefits generally made available to employees, such as pension accrual and enhanced medical benefits. The agreement is terminable by either party upon twenty-four hour written notice. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management. Director, Nominee and Management Shareholding The following table sets forth information with respect to the beneficial ownership of the common stock of TNPE by its directors, nominees for directors, each executive officer named in the Summary Compensation Table and all directors and officers as a group, as of January 31, 1994. Name of Individual or Group Position with Company Shares Beneficially Owned R. D. Woofter Chairman of the Board 9,893 (1) R. Denny Alexander Director 500 Cass O. Edwards, II Director 6,737 Harris L. Kempner, Jr. Director 200 (2) Thomas S. Mackey * Director 1,386 D. R. Spurlock Director; 1,584 Interim President and CEO since 11-9-93 J. M. Tarpley ** President, Chief 11,347 (3) Executive Officer and Director D. R. Barnard Sector Vice President 18,491 and Chief Financial Officer J. V. Chambers Sector Vice President - 13,964 Revenue Production A. B. Davis Vice President - 4,002 Chief Engineer R. J. Wright Vice President - 10,201 Corporate Services/ Generation Directors and officers as a group (16 persons)(4) 96,370 *** _____________________________________ * A member of the Board and Committees until the time of his death on February 25, 1994. **Resigned effective November 9, 1993 as President and CEO and Director. ***Less than one (1) percent of outstanding shares of Common Stock. (1) Does not include 66 shares owned by the wife of Mr. Woofter as her sole and separate property. Mr. Woofter disclaims any beneficial interest in all such shares. (2) Does not include 200 shares owned by the wife of Mr. Kempner as her sole and separate property. Mr. Kempner disclaims any beneficial interest in all such shares. (3) Subsequent to January 31, 1994, Mr. Tarpley disposed of all shares. (4) Of the nine executive officers of subsidiaries, four are also executive officers of TNPE. All shares held by such officers and directors are shares of TNPE. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Item 13.

Item 13. Certain Relationships and Related Transactions. Mr. R. Denny Alexander is Chairman of the Board and director of Overton Bank and Trust, National Association. Mr. Cass O. Edwards, II is a director of Overton Bank and Trust, National Association. The Utility maintains banking relations with Overton Bank and Trust, National Association. These banking relations are in the ordinary course of business for general banking and short-term investments, and all banking transactions are made on substantially the same terms, including collateral and interest rates, as those prevailing at the time for comparable transactions between such bank and other persons. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) Items Filed as Part of This Report Financial Statements Page Independent Auditors' Report . . . . . . . . . . . . . . . . . . 25 Consolidated Statements of Earnings, Three Years Ended December 31, 1993. . . . . . . . . . . . . . . 26 Consolidated Balance Sheets, December 31, 1993 and 1992 27 Consolidated Statements of Common Stock Equity and Redeemable Cumulative Preferred Stocks, Three Years Ended December 31, 1993. . . . . . . . . . . . . . . 28 Consolidated Statements of Cash Flows, Three Years Ended December 31, 1993. . . . . . . . . . . . . . . 29 Notes to Consolidated Financial Statements . . . . . . . . . . .30-49 Financial Statement Schedules V - Utility Plant, Three Years Ended December 31, 1993. . 58 VI - Accumulated Depreciation of Utility Plant, Three Years Ended December 31, 1993. . . . . . . . . . 59 IX - Short-term Borrowings, Three Years Ended December 31, 1993. . . . . . . . . . 60 X - Supplementary Consolidated Earnings Statement Information Three Years Ended December 31, 1993. . . . . . . . . 61 All other schedules are omitted, as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes. Exhibits See Exhibit Index, Pages 63-72. (b) Reports on Form 8-K None during the last quarter covered by this report. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Utility Plant Schedule V Three Years Ended December 31, 1993 (In Thousands) Other Balance at changes: Balance at beginning Additions add end of Classification of period at cost(1) Retirements(deduct) period Year ended December 31, 1993: Electric plant $1,184,635 17,587 5,436 6,850 1,203,636 Construction work in progress 3,922 8,210 - (6,850) 5,282 $1,188,557 25,797 5,436 - 1,208,918 Year ended December 31, 1992: Electric plant $1,159,511 30,365 (6,683) 1,442 1,184,635 Construction work in progress 2,279 3,085 - (1,442) 3,922 $1,161,790 33,450 (6,683) - 1,188,557 Year ended December 31, 1991: Electric plant $ 850,160 313,259 (6,650) 2,742 1,159,511 Construction work in progress 2,844 2,177 - (2,742) 2,279 $ 853,004 315,436 (6,650) - 1,161,790 Note: See note 1(c) to the consolidated financial statements for disclosure of depreciation method. (1) On July 26, 1991, the Utility's wholly owned subsidiary, TGCII, assumed ownership of TNP One, Unit 2 and assumed the related liabilities totaling approximately $269 million. In addition, approximately $12 million of deferred charges related to TNP One, Unit 2 were reclassified to utility plant. These amounts are included in the 1991 additions above. See note 5 to the consolidated financial statements and Items 1, 2, and 7, for more information about Unit 2. During 1992, the Utility reclassified approximately $12 million of deferred charges to utility plant. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Accumulated Depreciation of Utility Plant Schedule VI TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Supplementary Consolidated Earnings Statement Information Schedule X Three Years Ended December 31, 1993 (In Thousands) Charged to costs and expenses Item 1993 1992 1991 Taxes, other than payroll and income taxes: Gross receipts and street rentals $ 11,386 10,064 9,484 Property 14,119 14,272 10,302 Other 2,448 2,431 1,689 $ 27,95 26,767 21,475 TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. (Registrant) TEXAS-NEW MEXICO POWER COMPANY By \s\ D. R. Barnard D. R. Barnard, Sector Vice President & Date: March 22, 1994 Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Title Date By \s\ R. D. Woofter Chairman March 22, 1994 R. D. Woofter By \s\ Dwight R. Spurlock Interim President & March 22, 1994 D. R. Spurlock Chief Executive Officer By \s\ D. R. Barnard Sector Vice President & March 22, 1994 D. R. Barnard Chief Financial Officer By \s\ Monte W. Smith Treasurer (Principal March 22, 1994 Monte W. Smith Accounting Officer) By \s\ R. Denny Alexander Director March 22, 1994 R. Denny Alexander By \s\ Cass O. Edwards, II Director March 22, 1994 Cass O. Edwards, II By \s\ John A. Fanning Director March 22, 1994 John A. Fanning By \s\ Harris L. Kempner, Jr. Director March 22, 1994 Harris L. Kempner, Jr. No annual report to security holders of the Registrant covering the Registrant's last fiscal year and no proxy material with respect to solicitations during such fiscal year have been sent to the Registrant's security holders. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES EXHIBIT INDEX Exhibits filed herewith are denoted by "*." The other exhibits have heretofore been filed with the Commission and are incorporated herein by reference. Exhibit No. Description 3(a) - Restated Articles of Incorporation of the Utility (Exhibit 4(a), File No. 2-86282). 3(b) - Amendment to Restated Articles of Incorporation dated October 26, 1983 (Exhibit 3(b) to Form 10-K for the year ended December 31, 1984, File No. 1-2660-2). 3(c) - Amendment to Restated Articles of Incorporation dated April 8, 1984 (Exhibit 3(c) to Form 10-K for the year ended December 31, 1984, File No. 1-2660-2). 3(d) - Amendment to Restated Articles of Incorporation dated October 2, 1984 (Exhibit 3(d) to Form 10-K for the year ended December 31, 1984, File No. 1-2660-2). 3(e) - Articles of Merger dated October 3, 1984 (Exhibit 3(e) to Form 10-K for the year ended December 31, 1984, File No. 1-2660-2). 3(f) - Amendment to Restated Articles of Incorporation dated May 22, 1985 (Exhibit 3(a) to Form 10-K for the year ended December 31, 1985, File No. 2-97230). 3(g) - Amendment to Restated Articles of Incorporation dated August 20, 1985 (Exhibit 3(b) to Form 10-K for the year ended December 31, 1985, File No. 2-97230). 3(h) - Amendment to Restated Articles of Incorporation dated October 7, 1985 (Exhibit 3(c) to Form 10-K for the year ended December 31, 1985, File No. 2-97230). 3(i) - Amendment to Restated Articles of Incorporation dated June 12, 1986 (Exhibit 3(a) to Form 10-K for the year ended December 31, 1986, File No. 2-97230). 3(j) - Amendment to Restated Articles of Incorporation dated October 17, 1986 (Exhibit 3(b) to Form 10-K for the year ended December 31, 1986, File No. 2-97230). 3(k) - Amendment to Restated Articles of Incorporation dated July 14, 1987 (Exhibit 3(k) to Form 10-K for the year ended December 31, 1987, File No. 2-97230). 3(l) - Amendment to Restated Articles of Incorporation dated October 23, 1987 (Exhibit 3(l) to Form 10-K for the year ended December 31, 1987, File No. 2-97230). 3(m) - Amendment to Restated Articles of Incorporation dated May 4, 1988 (Exhibit 3(m) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 3(n) - Amendment to Restated Articles of Incorporation dated May 5, 1988 (Exhibit 3(n) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 3(o) - Amendment to Restated Articles of Incorporation dated May 5, 1988 (Exhibit 3(o) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Exhibit No. Description 3(p) - Amendment to Restated Articles of Incorporation dated December 5, 1988 (Exhibit 3(p) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 3(q) - Amendment to Restated Articles of Incorporation dated April 11, 1989 (Exhibit 3(q) to Form 10-K for the year ended December 31, 1989, File No. 2-97230). 3(r) - Amendment to Restated Articles of Incorporation dated July 27, 1989 (Exhibit 3(r) to Form 10-K for the year ended December 31, 1989, File No. 2-97230). 3(s) - Amendment to Restated Articles of Incorporation dated October 23, 1989 (Exhibit 3(s) to Form 10-K for the year ended December 31, 1989, File No. 2-97230). 3(t) - Amendment to Restated Articles of Incorporation dated May 16, 1990 (Exhibit 3(t) to Form 10-K for the year ended December 31, 1990, File No. 2-97230). 3(u) - Amendment to Restated Articles of Incorporation dated June 26, 1990 (Exhibit 3(u) to Form 10-K for the year ended December 31, 1990, File No. 2-97230). 3(v) - Amendment to Restated Articles of Incorporation dated November 27, 1990 (Exhibit 3(v) to Form 10-K for the year ended December 31, 1990, File No. 2-97230). 3(w) - Amendment to Restated Articles of Incorporation dated May 1, 1991 (Exhibit 3(w) to Form 10-K for the year ended December 31, 1991, File No. 2-97230). 3(x) - Amendment to Restated Articles of Incorporation dated July 18, 1991 (Exhibit 3(x) to Form 10-K for the year ended December 31, 1991, File No. 2-97230). 3(y) - Amendment to Restated Articles of Incorporation dated October 18, 1991 (Exhibit 3(y) to Form 10-K for the year ended December 31, 1991, File No. 2-97230). 3(z) - Amendment to Restated Articles of Incorporation dated April 30, 1992 (Exhibit 3(z) to Form 10-K for the year ended December 31, 1992, File No. 2-97230). 3(aa) - Amendment to Restated Articles of Incorporation dated June 19, 1992 (Exhibit 3(aa) to Form 10-K for the year ended December 31, 1992, File No. 2-97230). 3(bb) - Amendment to Restated Articles of Incorporation dated November 3, 1992 (Exhibit 3(bb) to Form 10-K for the year ended December 31, 1992, File No. 2-97230). *3(cc) - Amendment to Restated Articles of Incorporation dated April 7, 1993. *3(dd) - Amendment to Restated Articles of Incorporation dated July 22, 1993. *3(ee) - Amendment to Restated Articles of Incorporation dated October 21, 1993. 3(ff) - Bylaws of the Utility, as amended February 18, 1992 (Exhibit 3(cc) to Form 10-K for the year ended December 31, 1992, File No. 2-97230). 4(a) - Indenture of Mortgage and Deed of Trust dated as of November 1, 1944 (Exhibit 2(d), File No. 2-61323). 4(b) - Seventh Supplemental Indenture dated as of May 1, 1963 (Exhibit 2(k), File No. 2-61323). TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Exhibit No. Description 4(c) - Eighth Supplemental Indenture dated as of July 1, 1963 (Exhibit 2(1), File No. 2-61323). 4(d) - Ninth Supplemental Indenture dated as of August 1, 1965 (Exhibit 2(m), File No. 2-61323). 4(e) - Tenth Supplemental Indenture dated as of May 1, 1966 (Exhibit 2(n), File No. 2-61323). 4(f) - Eleventh Supplemental Indenture dated as of October 1, 1969 (Exhibit 2(o), File No. 2-61323). 4(g) - Twelfth Supplemental Indenture dated as of May 1, 1971 (Exhibit 2(p), File No. 2-61323). 4(h) - Thirteenth Supplemental Indenture dated as of July 1, 1974 (Exhibit 2(q), File No. 2-61323). 4(i) - Fourteenth Supplemental Indenture dated as of March 1, 1975 (Exhibit 2(r), File No. 2-61323). 4(j) - Fifteenth Supplemental Indenture dated as of September 1, 1976 (Exhibit 2(e), File No. 2-57034). 4(k) - Sixteenth Supplemental Indenture dated as of November 1, 1981 (Exhibit 4(x), File No. 2-74332). 4(l) - Seventeenth Supplemental Indenture dated as of December 1, 1982 (Exhibit 4(cc), File No. 2-80407). 4(m) - Eighteenth Supplemental Indenture dated as of September 1, 1983 (Exhibit (a) to Form 10-Q for the quarter ended September 30, 1983, File No. 1-4756). 4(n) - Nineteenth Supplemental Indenture dated as of May 1, 1985 (Exhibit 4(v), File No. 2-97230). 4(o) - Twentieth Supplemental Indenture dated as of July 1, 1987 (Exhibit 4(o) to Form 10-K for the year ended December 31, 1987, File No. 2-97230). 4(p) - Twenty-First Supplemental Indenture dated as of July 1, 1989 (Exhibit 4(p) to Form 10-Q for the quarter ended June 30, 1989, File No. 2-97230). 4(q) - Twenty-Second Supplemental Indenture dated as of January 15, 1992 (Exhibit 4(q) to Form 10-K for the year ended December 31, 1991, File No. 2-97230). *4(r) - Twenty-Third Supplemental Indenture dated as of September 15, 1993. 4(s) - Indenture and Security Agreement for Secured Debentures dated as of January 15, 1992 (Exhibit 4(r) to Form 10-K for the year ended December 31, 1991, File No. 2-97230). *4(t) - Indenture and Security Agreement for Secured Debentures dated as of September 15, 1993. TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Exhibit No. Description Material Contracts Relating to TNP One 10(a) - Fuel Supply Agreement, dated November 18, 1987, between Phillips Coal Company and the Utility (Exhibit 10(j) to Form 10-K for the year ended December 31, 1987, File No. 2-97230). 10(b) - Unit 1 First Amended and Restated Project Loan and Credit Agreement, dated as of January 8, 1992 (the "Unit 1 Credit Agreement"), among the Utility, Texas Generating Company ("TGC"), the banks named therein as Banks (the "Unit 1 Banks") and The Chase Manhattan Bank (National Association), as Agent for the Unit 1 Banks (the "Unit 1 Agent"), amending and restating the Project Loan and Credit Agreement among such parties dated as of December 1, 1987 (Exhibit 10(c) to Form 10- K for the year ended December 31, 1991, File No. 2-97230). 10(b)1 - Participation Agreement, dated as of January 8, 1992, among the banks named therein as Banks, the parties named therein as Participants and the Unit 1 Agent (Exhibit 10(c)1 to Form 10-K for the year ended December 31, 1991, File No. 2-97230). *10(b)2 - Amendment No. 1, dated as of September 21, 1993, to the Unit 1 Credit Agreement. 10(c) - Assignment and Security Agreement, dated as of January 8, 1992, among TGC and the Unit 1 Agent, for the benefit of the Secured Parties, as defined in the Unit 1 Credit Agreement, amending and restating the Assignment and Security Agreement among such parties dated as of December 1, 1987 (Exhibit 10(d) to Form 10- K for the year ended December 31, 1991, File No. 2-97230). 10(d) - Assignment and Security Agreement, dated December 1, 1987, executed by the Utility in favor of the Unit 1 Agent for the benefit of the Secured Parties, as defined therein (Exhibit 10(u) to Form 10-K for the year ended December 31, 1987, File No. 2-97230). 10(e) - Amended and Restated Subordination Agreement, dated as of October 1, 1988, among the Utility, Continental Illinois National Bank and Trust Company of Chicago and the Unit 1 Agent, amending and restating the Subordination Agreement among such parties dated as of December 1, 1987 (Exhibit 10(uu) to Form 10-K for the year ended December 31, 1988, File No. 2- 97230). 10(f) - Mortgage and Deed of Trust (With Security Agreement and UCC Financing Statement for Fixture Filing), dated to be effective as of December 1, 1987, and executed by Project Funding Corporation ("PFC"), as Mortgagor, to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(ee) to Form 10-K for the year ended December 31, 1987, File No. 2-97230). 10(f)1 - Supplemental Mortgage and Deed of Trust (With Security Agreement and UCC Financing Statement for Fixture Filing), executed by TGC, as Mortgagor, on January 27, 1992, to be effective as of December 1, 1987, to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(g)4 to Form 10-K for the year ended December 31, 1991, File No. 2-97230). 10(f)2 - First TGC Modification and Extension Agreement, dated as of January 24, 1992, among the Unit 1 Banks, the Unit 1 Agent, the Utility and TGC (Exhibit 10(g)1 to Form 10-K for the year ended December 31, 1991, File No. 2-97230). TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Exhibit No. Description 10(f)3 - Second TGC Modification and Extension Agreement, dated as of January 27, 1992, among the Unit 1 Banks, the Unit 1 Agent, the Utility and TGC (Exhibit 10(g)2 to Form 10-K for the year ended December 31, 1991, File No. 2-97230). 10(f)4 - Third TGC Modification and Extension Agreement, dated as of January 27, 1992, among the Unit 1 Banks, the Unit 1 Agent, the Utility and TGC (Exhibit 10(g)3 to Form 10-K for the year ended December 31, 1991, File No. 2-97230). *10(f)5 - Fourth TGC Modification and Extension Agreement, dated as of September 29, 1993, among the Unit 1 Banks, the Unit 1 Agent, the Utility and TGC. *10(f)6 - Fifth TGC Modification and Extension Agreement, dated as of September 29, 1993, among the Unit 1 Banks, the Unit 1 Agent, the Utility and TGC. 10(g) - Indemnity Agreement, made as of the 1st day of December, 1987, by Westinghouse, CE and Zachry, as Indemnitors, for the benefit of the Secured Parties, as defined therein (Exhibit 10(ff) to Form 10-K for the year ended December 31, 1987, File No. 2- 97230). 10(h) - Second Lien Mortgage and Deed of Trust (With Security Agreement) executed by the Utility, as Mortgagor, to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(jj) to Form 10-K for the year ended December 31, 1987, File No. 2-97230). 10(h)1 - Correction Second Lien Mortgage and Deed of Trust (with Security Agreement), dated as of December 1, 1987, executed by the Utility, as Mortgagor, to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(vv) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 10(h)2 - Second Lien Mortgage and Deed of Trust (with Security Agreement) Modification, Extension and Amendment Agreement, dated as of January 8, 1992, executed by the Utility to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(i)2 to Form 10-K for the year ended December 31, 1991, File No. 2-97230). *10(h)3 - TNP Second Lien Mortgage Modification No. 2, dated as of September 21, 1993, executed by the Utility to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein. 10(i) - Agreement for Conveyance and Partial Release of Liens, made as of the 1st day of December, 1987, by PFC and the Unit 1 Agent for the benefit of the Utility (Exhibit 10(kk) to Form 10-K for the year ended December 31, 1987, File No. 2-97230). 10(j) - Inducement and Consent Agreement, dated as of June 15, 1988, between Phillips Coal Company, Kiewit Texas Mining Company, the Utility, Phillips Petroleum Company and Peter Kiewit Son's, Inc. (Exhibit 10(nn) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 10(k) - Assumption Agreement, dated as of October 1, 1988, executed by TGC, in favor of the Issuing Bank, as defined therein, the Unit 1 Banks, the Unit 1 Agent and the Depositary, as defined therein (Exhibit 10(ww) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Exhibit No. Description 10(l) - Guaranty, dated as of October 1, 1988, executed by the Utility and given in respect of the TGC obligations under the Unit 1 Credit Agreement (Exhibit 10(xx) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 10(m) - First Amended and Restated Facility Purchase Agreement, dated as of January 8, 1992, among the Utility, as the Purchaser, and TGC, as the Seller, amending and restating the Facility Purchase Agreement among such parties dated as of October 1, 1988 (Exhibit 10(n) to Form 10-K for the year ended December 31, 1991, File No. 2-97230). 10(n) - Operating Agreement, dated as of October 1, 1988, among the Utility and TGC (Exhibit 10(zz) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 10(o) - Unit 2 First Amended and Restated Project Loan and Credit Agreement, dated as of January 8, 1992 (the "Unit 2 Credit Agreement"), among the Utility, Texas Generating Company II ("TGCII"), the banks named therein as Banks (the "Unit 2 Banks") and The Chase Manhattan Bank (National Association), as Agent for the Unit 2 Banks (the "Unit 2 Agent"), amending and restating the Project Loan and Credit Agreement among such parties dated as of October 1, 1988 (Exhibit 10(q) to Form 10-K for the year ended December 31, 1991, File No. 2-97230). *10(o)1 - Amendment No. 1, dated as of September 21, 1993, to the Unit 2 Credit Agreement. 10(p) - Assignment and Security Agreement, dated as of January 8, 1992, among TGCII and the Unit 2 Agent, for the benefit of the Secured Parties, as defined in the Unit 2 Credit Agreement, amending and restating the Assignment and Security Agreement among such parties dated as of October 1, 1988 (Exhibit 10(r) to Form 10-K for the year ended December 31, 1991, File No. 2- 97230). 10(q) - Assignment and Security Agreement, dated as of October 1, 1988, executed by the Utility in favor of the Unit 2 Agent for the benefit of the Secured Parties, as defined therein (Exhibit 10(jjj) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 10(r) - Subordination Agreement, dated as of October 1, 1988, among the Utility, Continental Illinois National Bank and Trust Company of Chicago and the Unit 2 Agent (Exhibit 10(mmm) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 10(s) - Mortgage and Deed of Trust (With Security Agreement and UCC Financing Statement for Fixture Filing), dated to be effective as of October 1, 1988, and executed by Texas PFC, Inc., as Mortgagor, to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(uuu) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 10(s)1 - First TGCII Modification and Extension Agreement, dated as of January 24, 1992, among the Unit 2 Banks, the Unit 2 Agent, the Utility and TGCII (Exhibit 10(u)1 to Form 10-K for the year ended December 31, 1991, File No. 2-97230). 10(s)2 - Second TGCII Modification and Extension Agreement, dated as of January 27, 1992, among the Unit 2 Banks, the Unit 2 Agent, the Utility and TGCII (Exhibit 10(u)2 to Form 10-K for the year ended December 31, 1991, File No. 2-97230). TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Exhibit No. Description 10(s)3 - Third TGCII Modification and Extension Agreement, dated as of January 27, 1992, among the Unit 2 Banks, the Unit 2 Agent, the Utility and TGCII (Exhibit 10(u)3 to Form 10-K for the year ended December 31, 1991, File No. 2-97230). *10(s)4 - Fourth TGCII Modification and Extension Agreement, dated as of September 29, 1993, among the Unit 2 Banks, the Unit 2 Agent, the Utility and TGCII. 10(t) - Release and Waiver of Liens and Indemnity Agreement, made effective as of the 1st day of October, 1988, by a consortium composed of Westinghouse, CE, and Zachry (Exhibit 10(vvv) to Form 10-K for the year ended December 31, 1988, File No. 2- 97230). 10(u) - Second Lien Mortgage and Deed of Trust (With Security Agreement), dated as of October 1, 1988, and executed by the Utility, as Mortgagor, to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(www) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 10(u)1 - Second Lien Mortgage and Deed of Trust (with Security Agreement) Modification, Extension and Amendment Agreement, dated as of January 8, 1992, executed by the Utility to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(w)1 to Form 10-K for the year ended December 31, 1991, File No. 2-97230). *10(u)2 - TNP Second Lien Mortgage Modification No. 2, dated as of September 21, 1993, executed by the Utility to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein. 10(v) - Intercreditor and Nondisturbance Agreement, dated as of October 1, 1988, among PFC, Texas PFC, Inc., the Utility, the Project Creditors, as defined therein, and the Collateral Agent, as defined therein (Exhibit 10(xxx) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 10(v)1 - Amendment #1, dated as of January 8, 1992, to the Intercreditor and Nondisturbance Agreement, dated as of October 1, 1988, among TGC, TGCII, the Utility, the Unit 1 Banks, the Unit 2 Banks and The Chase Manhattan Bank (National Association) in its capacity as collateral agent for the Unit 1 Banks and the Unit 2 Banks (Exhibit 10(x)1 to Form 10-K for the year ended December 31, 1991, File No. 2-97230). *10(v)2 - Amendment No. 2, dated as of September 21, 1993, to the Intercreditor and Nondisturbance Agreement, among TGC, TGCII, the Utility, the Unit 1 Banks, the Unit 2 Banks and The Chase Manhattan Bank (National Association) in its capacity as collateral agent for the Unit 1 Banks and the Unit 2 Banks. 10(w) - Grant of Reciprocal Easements and Declaration of Covenants Running with the Land, dated as of the 1st day of October, 1988 between PFC and Texas PFC, Inc. (Exhibit 10(yyy) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 10(x) - Non-Partition Agreement, dated as of May 30, 1990, among the Utility, TGC and The Chase Manhattan Bank (National Association), as Agent for the Banks which are parties to the Unit 1 Credit Agreement (Exhibit 10(ss) to Form 10-K for the year ended December 31, 1990, File No. 2-97230). TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Exhibit No. Description 10(y) - Assumption Agreement, dated July 26, 1991, to be effective as of May 31, 1991, by TGCII in favor of the Issuing Bank, the Unit 2 Banks, the Unit 2 Agent and the Depositary, as defined therein (Exhibit 10(kkk) to Amendment No. 1 to File No. 33- 41903). 10(z) - Guaranty, dated July 26, 1991, to be effective as of May 31, 1991, by the Utility and given in respect of the TGCII obligations under the Unit 2 Credit Agreement (Exhibit 10(lll) to Amendment No. 1 to File No. 33-41903). 10(aa) - First Amended and Restated Facility Purchase Agreement, dated as of January 8, 1992, among the Utility, as the Purchaser, and TGCII, as the Seller, amending and restating the Facility Purchase Agreement among such parties dated July 26, 1991, to be effective as of May 31, 1991 (Exhibit 10(dd) to Form 10-K for the year ended December 31, 1991, File No. 2-97230). *10(aa)1 - Amendment No. 1 to the Unit 2 First Amended and Restated Facility Purchase Agreement, dated as of September 21, 1993, among the Utility, as the Purchaser, and TGCII, as the Seller. 10(bb) - Operating Agreement, dated July 26, 1991, to be effective as of May 31, 1991, between the Utility and TGCII (Exhibit 10(nnn) to Amendment No. 1 to File No. 33-41903). 10(cc) - Non-Partition Agreement, executed July 26, 1991, to be effective as of May 31, 1991, among the Utility, TGCII and The Chase Manhattan Bank (National Association) (Exhibit 10(ppp) to Amendment No. 1 to File No. 33-41903). Power Supply Contracts 10(dd) - Contract dated May 12, 1976 between the Utility and Houston Lighting & Power Company (Exhibit 5(a), File No. 2-69353). 10(dd)1 - Amendment, dated January 4, 1989, to the Contract dated May 12, 1976 between the Utility and Houston Lighting & Power Company (Exhibit 10(cccc) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 10(ee) - Contract dated May 1, 1986 between the Utility and Texas Electric Utilities Company, amended September 29, 1986, October 24, 1986 and February 21, 1987 (Exhibit 10(c) of Form 8 applicable to Form 10-K for the year ended December 31, 1986, File No. 2-97230). 10(ff) - Amended and Restated Agreement for Electric Service dated May 14, 1990 between the Utility and Texas Utilities Electric Company (Exhibit 10(vv) to Form 10-K for the year ended December 31, 1990, File No. 2-97230). 10(ff)1 - Amendment, dated April 19, 1993, to Amended and Restated Agreement for Electric Service, dated May 14, 1990, As Amended between the Utility and Texas Utilities Electric Company (Exhibit 10(ii)1 to Form S-2 Registration Statement, filed on July 19, 1993, File No. 33-66232). 10(gg) - Contract dated June 11, 1984 between the Utility and Southwestern Public Service Company (Exhibit 10(d) of Form 8 applicable to Form 10-K for the year ended December 31, 1986, File No. 2-97230). TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Exhibit No. Description 10(hh) - Contract dated April 27, 1977 between the Utility and West Texas Utilities Company amended April 14, 1982, April 19, 1983, May 18, 1984 and October 21, 1985 (Exhibit 10(e) of Form 8 applicable to Form 10-K for the year ended December 31, 1986, File No. 2-97230). 10(ii) - Contract dated April 29, 1987 between the Utility and El Paso Electric Company (Exhibit 10(f) of Form 8 applicable to Form 10-K for the year ended December 31, 1986, File No. 2-97230). 10(jj) - Contract dated February 28, 1974, amended May 13, 1974, November 26, 1975, August 26, 1976 and October 7, 1980 between the Utility and Public Service Company of New Mexico (Exhibit 10(g) of Form 8 applicable to Form 10-K for the year ended December 31, 1986, File No. 2-97230). 10(jj)1 - Amendment, dated February 22, 1982, to the Contract dated February 28, 1974, amended May 13, 1974, November 26, 1975, August 26, 1976, and October 7, 1980 between the Utility and Public Service Company of New Mexico (Exhibit 10(iiii) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 10(jj)2 - Amendment, dated February 8, 1988, to the Contract dated February 28, 1974, amended May 13, 1974, November 26, 1975, August 26, 1976, and October 7, 1980 between the Utility and Public Service Company of New Mexico (Exhibit 10(jjjj) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 10(jj)3 - Amended and Restated Contract for Electric Service, dated April 29, 1988, between the Utility and Public Service Company of New Mexico (Exhibit 10(zz)3 to Amendment No. 1 to File No. 33- 41903). 10(kk) - Contract dated December 8, 1981 between the Utility and Southwestern Public Service Company amended December 12, 1984, December 2, 1985 and December 19, 1986 (Exhibit 10(h) of Form 8 applicable to Form 10-K for the year ended December 31, 1986, File No. 2-97230). 10(kk)1 - Amendment, dated December 12, 1988, to the Contract dated December 8, 1981 between the Utility and Southwestern Public Service Company amended December 12, 1984, December 2, 1985 and December 19, 1986 (Exhibit 10(llll) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). 10(kk)2 - Amendment, dated December 12, 1990, to the Contract dated December 8, 1981 between the Utility and Southwestern Public Service Company (Exhibit 19(t) to Form 10-K for the year ended December 31, 1990, File No. 2-97230). 10(ll) - Contract dated August 31, 1983, between the Utility and Capitol Cogeneration Company, Ltd. (including letter agreement dated August 14, 1986) (Exhibit 10(i) of Form 8 applicable to Form 10-K for the year ended December 31, 1986, File No. 2-97230). 10(ll)1 - Agreement Substituting a Party, dated May 3, 1988, among Capitol Cogeneration Company, Ltd., Clear Lake Cogeneration Limited Partnership and the Utility (Exhibit 10(nnnn) to Form 10-K for the year ended December 31, 1988, File No. 2-97230). TEXAS-NEW MEXICO POWER COMPANY AND SUBSIDIARIES Exhibit No. Description 10(ll)2 - Letter Agreements, dated May 30, 1990 and August 28, 1991, between Clear Lake Cogeneration Limited Partnership and the Utility (Exhibit 10(oo)2 to Form 10-K for the year ended December 31, 1992, File No. 2-97230). 10(ll)3 - Notice of Extension Letter, dated August 31, 1992, between Clear Lake Cogeneration Limited Partnership and the Utility (Exhibit 10(oo)3 to Form 10-K for the year ended December 31, 1992, File No. 2-97230). 10(ll)4 - Scheduling Agreement, dated September 15, 1992, between Clear Lake Cogeneration Limited Partnership and the Utility (Exhibit 10(oo)4 to Form 10-K for the year ended December 31, 1992, File No. 2-97230). 10(mm) - Interconnection Agreement between the Utility and Plains Electric Generation and Transmission Cooperative, Inc. dated July 19, 1984 (Exhibit 10(j) of Form 8 applicable to Form 10-K for the year ended December 31, 1986, File No. 2-97230). 10(nn) - Interchange Agreement between the Utility and El Paso Electric Company dated April 29, 1987 (Exhibit 10(l) of Form 8 applicable to Form 10-K for the year ended December 31, 1986, File No. 2-97230). 10(oo) - DC Terminal Participation Agreement between the Utility and El Paso Electric Company dated December 8, 1981 amended April 29, 1987 (Exhibit 10(m) of Form 8 applicable to Form 10-K for the year ended December 31, 1986, File No. 2-97230). Employment Contracts *10(pp) - Texas-New Mexico Power Company Executive Agreement for Severance Compensation Upon Change in Control, executed November 11, 1993, between Sector Vice President and Chief Financial Officer and the Utility (Pursuant to Instruction 2 of Reg. 229.601(a), accompanying this document is a schedule: (i) identifying documents substantially identical to the document which have been omitted from the Exhibits; and (ii) setting forth the material details in which such omitted documents differ from the document). *10(qq) - Texas-New Mexico Power Company Key Employee Agreement for Severance Compensation Upon Change in Control, executed November 11, 1993, between Assistant Treasurer and the Utility (Pursuant to Instruction 2 of Reg. 229.601(a), accompanying this document is a schedule: (i) identifying documents substantially identical to the document which have been omitted from the Exhibits; and (ii) setting forth the material details in which such omitted documents differ from the document). *10(rr) - Agreement between James M. Tarpley and TNPE and the Utility, effective January 1, 1994. *10(ss) - Agreement between Dwight R. Spurlock and TNPE and the Utility, effective November 9, 1993. *21 - Subsidiaries of the Registrant.

738339_1993.txt

738339

1993

Item 1. Business THE COMPANY American Healthcare Management, Inc. (together, unless the context otherwise requires, with its subsidiaries, "AHI" or the "Company") is a health care services company engaged in the operation of 16 general acute care hospitals in nine states, with a total of 2,028 licensed beds. The Company owns 14 of these hospitals and operates two under leases. The Company's hospitals provide a range of medical/surgical inpatient and outpatient services, with a particular focus on primary care services such as obstetrics, pediatrics and minimally invasive and routine surgeries. In 1987, AHI filed for reorganization under Chapter 11 of the Federal Bankruptcy Code. While in bankruptcy, the Company disposed of various assets and properties. On December 29, 1989 (the "Effective Date"), the Company's Internal Plan of Reorganization (the "Plan") became effective and the Company emerged from reorganization proceedings. In connection with the Plan, a new Board of Directors was appointed and a new President and Chief Executive Officer was elected. Since the Effective Date, AHI has sold various assets for aggregate gross proceeds of approximately $32 million. Further, since the Effective Date, AHI has acted to improve operating margin and cash flow by repositioning its operations to focus on primary medical/surgical acute care services, establishing services and programs to increase outpatient revenues, relocating the corporate office, replacing all, and substantially reducing the number of, corporate personnel, implementing a new management information system to monitor costs, cash flow and quality outcome and hiring new administrators at 13 of the Company's hospitals. In addition, the Company's financial management efforts have been focused on deleveraging the capital structure, enhancing cash generation, managing working capital needs and funding capital projects. In July of 1993, the Company issued $100,000,000 of 10%, senior subordinated notes, due 2003 (the "Notes"). The proceeds were used to pay down debt and for general corporate purposes, including capital expenditures. Also, in July 1993, the Company entered into an amended credit facility to provide $42.5 million of a term loan facility, $20 million of a revolving credit line for working capital and a $60 million credit line to fund certain permitted acquisitions (the "Credit Facility"). Since the year ended December 31, 1989, on a same-hospital basis, AHI has increased hospital operating net revenue from $259.8 million in 1989 to $339.4 million in 1993, a 30.6% increase. For the same period, on a same-hospital basis, outpatient gross revenue grew 68.3%, and hospital operating costs were reduced from 89.5% to 84.5% of net revenue. Earnings before interest, taxes, depreciation, write-downs of assets and other charges ("EBITD") from hospitals (i.e., before corporate overhead) increased from $27.2 million in 1989 to $52.7 million in 1993, and EBITD from hospitals as a percentage of net revenue grew from 10.5% to 15.5%. During this period, corporate expenses were reduced $9.1 million and accounts receivable at year-end decreased from $52.9 million in 1989 to $45.8 million in 1993, notwithstanding the fact that during this period net revenue increased. The Company reduced its indebtedness by more than $58.5 million during this period through asset dispositions, internally generated cash flow and a debt-for-equity exchange. The Company's debt to capitalization ratio has been reduced from 89.1% at December 31, 1989 to 55.9% at December 31, 1993. Since the beginning of 1990, AHI has instituted a variety of programs to improve the health care services and operating results of its hospitals as part of a strategy to achieve profitable growth in an environment increasingly dominated by fixed reimbursement payors (such as government-sponsored and managed care insurance programs). These programs include: > emphasizing particular medical and surgical services which management believes will augment market share and produce improved margins; > targeting capital improvement projects to provide or enhance services for which the Company expects demand to remain stable or increase; > managing costs to reduce the impact of the continuing shift to a fixed reimbursement environment and to allow the Company to price its services more competitively to attract managed care plans; > establishing networks of primary-care, medical/surgical physician practices to expand service areas and patient bases and thus to better position the Company to participate in managed care contracts; and > developing a quality outcome measurement system to monitor effectiveness of services provided. PROPOSED MERGER On November 18, 1993, the Company entered into a definitive Agreement and Plan of Merger with OrNda HealthCorp ("OrNda") pursuant to which the Company will merge with and into OrNda. Such Agreement, as amended and restated as of January 14, 1994, is referred to herein as the OrNda Merger Agreement. It is expected the transaction will be a stock-for-stock, tax-free exchange and accounted for as a pooling-of- interests. Under the terms of the OrNda Merger Agreement, which was unanimously approved by the Boards of Directors of both companies, the Company's shareholders will receive 0.6 of a share of OrNda Common Stock in exchange for each share of the Company's Common Stock held. Additionally, pursuant to a Waiver and Consent Agreement dated February 3, 1994 by and among OrNda and the holders of a majority in principal amount of the Notes, as consideration for their agreement to make certain changes to the Notes' Indenture to effect the merger and other matters, OrNda will (i) make consent payments to the holders on the closing date of the merger of $15.00 for each $1,000 principal amount of the outstanding Notes and (ii) following the consummation of the merger, increase the rate of interest on the Notes from 10% per annum to 10 1/4% per annum. The merger will cause a "change of control" under the Notes, which, therefore, will allow each holder of the Notes to require the Company to repurchase all or a portion of the Notes owned by such holder at 101% of the principal amount thereof, together with accrued interest thereon to the date of repurchase. Although the Company does not anticipate that a substantial amount of the Notes will be tendered for repurchase, if any, OrNda has made financial arrangements to provide funding, to the extent necessary, for the repurchase of any Notes tendered. Consummation of the merger is subject to shareholder approval of both companies. A special meeting of the Company's shareholders is scheduled to be held April 19, 1994. Shareholders of the Company representing approximately 44% of the Company's Common Stock outstanding as of March 4, 1994 have informed the Company that they intend to vote such shares in favor of the merger. The Company's management believes that sufficient additional AHI shareholders to approve the merger will vote in favor of the transaction. OrNda shareholders owning approximately 49% of OrNda's common stock outstanding as of the record date have granted irrevocable proxies to AHI pursuant to which AHI has the power to vote the OrNda shares owned by them in favor of the merger. INDUSTRY ANALYSIS Health care expenditures are a large part of the U.S. economy and continue to escalate. In 1993, health care expenditures amounted to approximately $940 billion, an increase of approximately 12.1% from 1992, and approximately 30% of these expenditures were attributable to general acute care hospitals. Since 1989, the average annual compound growth rate in health care spending attributable to general acute care hospitals has been 11%. During this same period, hospital utilization rates (the rate of admissions and patient days per one thousand population) have declined, reflecting more stringent controls and cost-containment efforts by payors of hospital services, and there has been a partial shift of patients from hospital inpatient to hospital outpatient and alternate site settings. Management believes that the acute care hospital will continue to be the centerpiece in the delivery of health care. Notwithstanding growth in the number and type of alternative site providers, management believes that hospitals can, with more efficient operations and effective pricing practices, recover a significant amount of the business which initially shifted to alternate site providers because these providers do not offer the range of care generally available at acute care hospitals and because management believes that the trend toward managed care will continue to put pressure on pricing and profitability levels of alternative site providers. In addition, management believes that in the future the industry will generally experience increasing usage of inpatient and outpatient services as a result of the aging of the population; expanded health coverage, which is an anticipated part of health care reform; and the general growth in population. In management's view, cost containment pressures are causing the role of the primary care physician within the health care delivery system to become more central as compared to that of the specialist. Managed care and fixed reimbursement payor arrangements have created incentives for care to be delivered by primary care physicians rather than specialists. Thus, the role of the primary care physician as gatekeeper, as the professional who chooses whether and when patients should be referred to particular specialists or other providers (such as hospital), has been enhanced. In certain markets, particularly where there is substantial managed care, the enhanced position of the primary care physician has resulted in two parallel developments. First, there has been an increased consolidation of primary care physicians into larger medical groups, some of which can potentially provide professional coverage over broad geographic areas. Second, because of the role of the primary care physician as gatekeeper, there is competition among hospitals for the loyalty of such physicians, and, as a result, there have been increased affiliations, and in some cases consolidations, between hospitals and primary care physicians. Management believes that it will be necessary to respond to such developments in order to maintain the Company's position in these markets. Over the last decade, changes in reimbursement policy have significantly affected hospital revenues. In 1990, Medicare accounted for approximately 33% of hospital revenues in the U.S. Since the advent in 1983 of Medicare's prospective payment system (with fixed reimbursements based upon a system of diagnosis-related groups ["DRGs"] determined by a patient's principal diagnosis) for hospital inpatient reimbursement, hospital Medicare revenues have become tied more to the nature of the diagnosis leading to hospital admission and the volume of admissions and less to patients days, the traditional basis of hospital revenues. Due to these changes in Medicare reimbursement methodology, hospitals are generally focusing on increased admissions and expense reduction measures rather than longer length-of-stay patient procedures. In addition, with the rise of a fixed reimbursement based on DRGs, the management of resources used during each patient stay becomes an important factor in the financial success of a hospital. As health care costs have increased, Medicaid (the federally subsidized and mandated state program for categorical grant programs), insurance companies, and employers have adopted many of the same types of cost containment methodologies employed by the Medicare program. Most notably, employers have turned to HMO- and PPO-sponsored plans as alternatives to indemnity health insurance coverage, and a number of states have moved away from cost-based reimbursement to varying methods to limit hospital expenditures, such as per diem, negotiated rates, and in some cases DRG-based reimbursement. At the end of 1992, approximately 17.5% of the population was covered by HMO plans compared with approximately 13.9% three years earlier. Management believes that a high percentage of the population in the markets in which the Company operates is covered for hospital care by managed care or fixed reimbursement methodologies. In management's experience, these payors have been seeking low-cost providers who can demonstrate that hospitalization at their facilities will generally result in favorable outcomes for patients. In 1993, AHI derived approximately 71% of its gross patient revenues from governmental payors and approximately 12% from non- governmental payors from which it receives fixed reimbursement (through agreements providing for flat pricing). On an industry-wide basis, hospital operating costs per discharge increased an average of 9.4% from 1983 to 1989, and management believes that this trend has continued through 1993. The increases can be attributed to increases in the severity of condition of the patients hospitalized (which can be generally attributed to the incentives payors have created for patients whose conditions are less medically serious to seek treatment in non-hospital settings); the shift to outpatient services; technological innovation; increases in health care labor rates, supplies, equipment and drug costs; trends towards lower lengths of stay; and trends towards more costly physician practice patterns. Generally, revenue increases earned through either price increases or changes in fixed reimbursement levels have not kept up with the cost increases. As a result, hospitals have sought operating efficiencies, changed the focus of business development, and increased the competition for patient volume. On November 20, 1993, President Clinton submitted proposed comprehensive health care reform legislation, The Health Security Act of 1993 (the "Act"), to Congress. A central component of the Act is the restructuring of health insurance markets through the use of "managed competition." Under the Act, states would be required to establish regional purchasing cooperatives, known as "regional alliances," that would be the exclusive source of coverage for individuals and employers with less than 5,000 employees. "Employer Mandates" would require all employers to make coverage available to their employees and contribute 80% of the premium, and all individuals would be required to enroll in an approved health plan. Regional alliances would contract with health plans that demonstrate an ability to provide consumers with a full range of benefits, including hospital services, and the provision of such benefits would be mandated by the federal government. The federal government would provide subsidies to low-income individuals and certain small businesses to help pay for the cost of coverage. These subsidies and other costs of the Act would be funded in significant part by reductions in payments by the Medicare and Medicaid programs to providers, including hospitals. The Act would also place stringent limits on the annual growth in health plan premiums. Other comprehensive reform proposals have been or are expected to be introduced in Congress. These other proposals contain or are expected to contain coverage guarantees, benefit standards, financing and cost control mechanisms which are different than the Act. Many other proposed health reform initiatives have been introduced in the Congress. Therefore, the Company is unable to predict what, if any, reforms will be adopted, or when any such reforms will be implemented. No assurance can be given that such reforms will not have a material adverse impact on the Company's revenues or earnings. BUSINESS STRATEGY Effect of Merger with OrNda ___________________________ In connection with the previously discussed merger between AHI and OrNda, certain aspects of the Company's business strategy may change. For example, certain OrNda hospitals provide tertiary care services versus AHI's emphasis on providing principally primary care services. Furthermore, OrNda's strategy to acquire additional acute care hospitals may be different subsequent to the merger due to differences in the type of services emphasized and because of the terms of a new credit facility negotiated in contemplation of the combined companies. Additionally, different strategies relating to hospital dispositions may need to be developed. Other aspects of the Company's business strategy may also be affected. The following discussion relates to the Company's current business strategy, exclusive of considerations relating to the merger. Emphasis on Specific Services _____________________________ The Company's hospitals focus on the delivery of primary medical/surgical care services, including obstetrics, pediatrics, and minimally invasive and routine surgeries. The Company's strategy is based on its belief that (i) these basic health care services will continue to experience steady or growing demand because health care cost containment efforts are likely to be aimed at costly or redundant services, (ii) services such as obstetrics and pediatrics currently receive generally favorable reimbursements from fixed reimbursement plans (including from Medicare and Medicaid) and are least likely to be adversely affected by future federal, state, and third-party insurance reimbursement policy changes, and (iii) concentration on primary care eliminates the need to maintain costly specialist medical teams and dedicated facilities for more complex tertiary procedures, helping the Company control costs. AHI has responded to the shift of certain procedures to outpatient settings by enhancing its hospitals' outpatient capabilities with improved outpatient diagnostic and surgical services, and by introducing minimally invasive surgery to shorten, and in some cases eliminate, overnight patient stays. The Company's hospitals emphasize outpatient services such as short-stay, minimally invasive surgeries that management believes will experience steady or growing demand, as a result of pressure by third-party payors to shift treatments to the less costly outpatient setting, and offer attractive margins. The Company believes that it is well positioned in relation to alternative site providers of outpatient services because its acute care hospitals can offer a broader range of services at competitive prices. Cost Management _______________ A central aspect of the Company's strategy is to position itself as a low-cost provider of health care services. The Company's management devotes a substantial portion of its efforts on managing costs to improve operating income. Management believes its expertise and efforts in this area will allow the Company to operate successfully in an increasingly fixed reimbursement environment. AHI has developed a centralized management information system which provides both hospital and corporate management with immediate access to financial, operational and clinical data. This system assists the Company in managing resource consumption by allowing it to (i) track patients' lengths of stay, (ii) monitor physician admitting patterns and treatment practices to identify and correct resource overutilization, (iii) continuously monitor and adjust staffing levels in response to hospital census fluctuations, (iv) screen services to identify and eliminate those that are unprofitable, (v) analyze proposed capital expenditures in light of return on investment goals, and (vi) monitor the use of high-cost pharmaceuticals consistent with established protocols. The Company's cost control efforts also include controls over supply purchases, including participation with other providers to take advantage of group purchasing discounts. In addition, AHI's emphasis on primary care medical services, which require, in general, the commitment of a lower "intensity" of resources than tertiary or other types of acute care services, is a fundamental component of AHI's cost management strategy. As a result of the Company's efforts, AHI's payroll and benefits as a percentage of net revenue have declined from 44.6% in 1989 to 42.2% in 1993, and nonpayroll operating costs have been reduced from 47.3% of net revenue in 1989 to 43.9% of net revenue in 1993. Primary, Medical/Surgical Care Physician Practice Development _____________________________________________________________ The number of primary medical/surgical care physician practice groups has recently proliferated in response to the increasing influence of managed care plans as purchasers of health care services. Larger groups of physicians are able to negotiate better with managed care plans, which are seeking multiple primary medical/surgical care access points and favorable rates. The Company has organized groups of physicians to increase the breadth of the geographic base of primary medical/surgical care physicians which support the Company's facilities. The establishment of primary medical/surgical care physician networks, together with the Company's efforts to create a competitive cost structure and strategic alliances with tertiary care hospitals, as discussed below, are intended to improve the attractiveness of the Company's hospitals to purchasers of health care services, particularly managed care plans. All of the Company's hospitals strive to create a physician- supportive atmosphere by involving physicians in the strategic planning of their hospitals and in more tangible decision-making processes, such as those relating to equipment acquisitions and facility improvements. Quality Outcome Management __________________________ A unique feature of the Company's management information system is a proprietary on-line Quality Outcome Measurement System, designed to measure selected outcome indicators (e.g., mortality, returns to operating room during same admission, unplanned transfers to intensive care, pressure ulcers not present on admission) and to identify where modifications to patient care are warranted. Measurement data is used to develop appropriate physician practice protocols, and to change practices where appropriate. Targeted Capital Expenditures _____________________________ Capital expenditures, aside from needed equipment replacements and remodeling, are targeted to increase capacity through expansion of existing services and new services. Allocation of capital to such projects is dependent upon specific criteria, including consistency with existing strategies and estimated return on investment. Currently, the projects expected to generate the greatest returns are at hospitals which are somewhat constrained by capacity, particularly for high-demand services within their service areas. Management believes the rates of return associated with these proposed capital investments are greater than AHI's cost of capital. Prior to July 1993, some of these expenditures had been delayed because of capital limitations inherent in AHI's capital structure. Upon AHI's issuance of $100 million of senior subordinated debt in July 1993, sufficient capital became available to fund these projects. Strategic Alliances with Tertiary Care Hospitals ________________________________________________ AHI has developed an alliance between its Los Angeles area facilities and the Hospital of the Good Samaritan, a major tertiary care hospital in Los Angeles, in order to coordinate a full range of patient services within the Company's Los Angeles service area. Such a system is intended to eliminate duplication of high-cost capital improvements and increase access to managed care contracts for both AHI staff physicians affiliated with the system and AHI hospitals. Management intends to strengthen and expand the Los Angeles alliance with the Hospital of the Good Samaritan through the formation of new physician groups to work within the alliance and through expansion of the alliance's geographic scope to include more of the Company's hospitals in the Southern California market. The Company has targeted certain of the other markets in which it operates for the potential development of relationships similar to that which it is in the process of developing in Los Angeles. Through strategic alliances of this variety, the Company hopes to participate in integrated health care delivery systems in certain of its markets in order to obtain and retain market share. Acquisitions ____________ On December 6, 1993, the Company signed a letter of intent with Quorum Health Group, Inc. ("Quorum") under which the Company will purchase Suburban Medical Center from a subsidiary of Quorum. Suburban Medical Center in Paramount, California, consists of a 184-bed acute care hospital and two medical office buildings, all of which are leased on a long- term basis from an unrelated third party. The proposed transaction is subject to the completion of a definitive agreement and the satisfaction of customary closing conditions and obtaining certain approvals. The Company's management anticipates that OrNda will complete the transaction by May 31, 1994. The Company does not currently have any other agreements or understandings relating to the acquisition of any hospital by the Company, but the Company is periodically made aware of opportunities which the Company evaluates in light of strategic, operational and financial objectives. Hospital Operations ___________________ The Company's hospitals are general acute care hospitals which offer a range of medical services, including inpatient services such as operating/recovery rooms, intensive care and coronary care units, diagnostic services and emergency room care and outpatient services such as same-day surgery, laboratories, pharmacies and rehabilitation services. The Company concentrates on primary care services, such as obstetrics, pediatrics and minimally invasive and routine surgeries. Because the Company's strategy is to provide these basic services on a cost-effective basis, its hospitals generally do not provide more complicated services, such as open-heart and neurosurgeries, which require maintenance of high-cost specialist medical teams and facilities. Certain of the Company's hospitals provide selected specialty services, such as cardiocatheter procedures, lung laser surgery, psychiatric care and neurological care. Each of the Company's sixteen hospitals is managed on a day- to-day basis by a locally based administrator and a financial controller. In addition, a local governing board, which includes members of the hospital's medical staff and community members, monitors the medical, professional and ethical practices at each hospital. Each of the Company's hospitals is responsible for ensuring that it conforms to all applicable regulatory and licensure standards and requirements. The following table sets forth certain information relating to each of the sixteen hospitals operated by the Company at December 31, 1993. The Company's indebtedness under the Credit Facility (see Item 8, Financial Statements and Supplementary Data) is secured by liens on all owned properties listed below, except Plateau Medical Center. Certain properties also secure other debt agreements, principally mortgages. The Company owns or leases at least 10,000 square feet of space in 14 medical office buildings in proximity to 10 of its hospitals. The aggregate square footage of this owned or leased space is approximately 450,000 square feet. Also, the Company leases approximately 17,000 square feet of executive office space in Valley Forge Square, King of Prussia, Pennsylvania. The lease expires October 31, 1995, subject to renewal by the Company until October 31, 2005. Each of the Company's hospitals is a Medicare- and Medicaid- approved provider. Each hospital has established a quality assurance program to support and monitor quality of care standards and to meet applicable accreditation and regulatory requirements. All but one of the Company's hospitals are accredited by the Joint Commission on Accreditation of Health Care Organizations. The Joint Commission is a nationwide commission that establishes standards relating to the physical plant, administration, quality of patient care and operation of medical staffs. The hospital that is not accredited by the Joint Commission is Eastmoreland General Hospital, which is accredited by the American Osteopathic Association. In addition to the hospitals listed above, the Company owns a 37-bed acute care hospital and related medical office facilities in Wylie, Texas (the "Wylie Hospital"). On February 3, 1989, the Company, as lessor, entered into a Lease Purchase Agreement (the "Wylie Lease") for the Wylie Hospital with Physicians Regional Hospital, Inc., a Texas Corporation, the successor to Healthcare Enterprises of North Texas, Ltd., a Texas limited partnership ("HENT"). The Wylie Lease has a ten-year term and contains a purchase option. On March 12, 1993, HENT sought protection under Chapter 11 of the U.S. Bankruptcy Code, and was discharged from bankruptcy on March 1, 1994. The Company expects to fully recognize the benefits of the Wylie Lease. STATISTICAL DATA The following table sets forth certain operating statistics for hospitals operated by the Company during the last three fiscal years. The Company's management believes that occupancy rates have been adversely impacted by the types of services offered at the Company's hospitals and by increasing participation in HMO and PPO programs in the populations served by its hospitals, all of which tends to reduce lengths-of-stay and increase the use of outpatient facilities. In addition, management has implemented cost-management strategies to reduce lengths-of-stay. The occupancy rate of a hospital is further affected by a number of factors, including the number of physicians admitting patients to the hospital and the nature of their practice, changes in the number of beds, the composition and size of the local population, general and local economic conditions and variations in type and quality of other hospitals in the area. There are increasing pressures from many sources to increase the rate of inpatient hospital utilization. Among these pressures is the increasing emphasis on ambulatory and outpatient care, diagnostic services and preventive medicine. The Company is aggressively developing its outpatient business and attempting to increase each hospital's capacity to handle the anticipated increase in outpatient volume. The psychiatric and chemical dependency industry continues to experience declining admissions. Insurers have intensified their efforts to reduce utilization by denying admission and payment, requiring shorter lengths of stay or forcing treatment into an outpatient setting and reducing reimbursement for services. The Company's strategy, with respect to this business, has been to support programs in markets where a need for such programs exists and where reimbursement is favorable, but not to seek other opportunities in these areas or add units in hospitals that do not already provide these services. SOURCES OF REVENUE The Company's hospitals receive substantially all of their payments for health care services from the federal government's Medicare program, state government Medicaid programs, private insurance carriers, HMOs, PPOs and from patients directly. The approximate percentages of gross patient revenue (before contractual allowances and other deductions) and net patient revenue derived by the Company's acute-care hospitals for the following years ended December 31 were as follows: Amounts received under Medicare, Medicaid and cost-based Blue Cross and from managed care organizations, such as HMOs and PPOs, generally are less than the hospitals' customary charges for the services provided. Patients are generally not responsible for any difference between customary hospital charges and amounts reimbursed under these programs for such services, but are responsible to the extent of any exclusions, deductibles or co-insurance features of their coverage. In recent years, the Company's hospitals have experienced an increase in the amount of such exclusions, deductibles and co-insurance. See "Reimbursement." Following the initiative taken by the federal government to control health care costs, other major purchasers of health care, including states, insurance companies and employers, are increasingly negotiating the amounts they will pay for services performed rather than simply paying health care providers the amounts billed. Managed care organizations such as HMOs and PPOs, which offer prepaid and discounted medical service packages, represent an increasing segment of health care payors. REIMBURSEMENT The two primary governmental programs under which the Company's hospitals receive reimbursement for health care services are Medicare and Medicaid. Medicare is a federal program that provides certain hospital and medical insurance benefits to persons age 65 and over, some disabled persons and persons with end-stage renal disease. Medicaid is a federal-state program administered by the states which provides hospital benefits to qualifying individuals who are unable to afford care. All of the Company's hospitals are certified as providers of Medicare and Medicaid services. The Civilian Health and Medical Program of the Uniformed Services ("CHAMPUS") is a program administered by the U.S. Department of Defense which provides hospital benefits to military retirees and dependents of active duty military personnel when these persons are unable to obtain treatment in federal hospitals. Amounts received under Medicare, Medicaid and CHAMPUS programs are generally less than the hospital's customary charges for the services provided. Blue Cross is a nonprofit, private health care program that funds hospital benefits through independent plans that vary in each location. In 1993, Medicare and Medicaid accounted for approximately 67% and 55% of the Company's gross and net patient revenue, respectively. These governmental reimbursement programs are highly regulated and subject to frequent changes which can significantly reduce payments to hospitals. In recent years, changes in these programs have significantly reduced reimbursement rates paid to hospitals. In light of the Company's hospitals' high percentage of Medicare and Medicaid patients, the Company's ability in the future to operate its business successfully will depend in large measure on its ability to adapt to changes in these programs. Medicare ________ Beginning in 1983, reimbursement to hospitals under the Medicare program changed significantly and these changes have had, and are expected to continue to have, significant effects on the Company's hospitals and the health care industry in general. Prior to 1983, Medicare reimbursed acute care hospitals on a cost-based system. In 1983, Medicare established a prospective payment system under which inpatient discharges from acute care hospitals are classified into categories of treatments, known as DRGs, which classify illnesses according to the estimated intensity of hospital resources necessary to furnish care for each principal diagnosis. Hospitals generally receive a fixed amount per Medicare discharge based upon the assigned DRG (the "DRG rates") regardless of how long the patient remains in the hospital or the volume of ancillary services ordered by the attending physician. In certain limited circumstances, Medicare will also pay an extra "outlier" payment for extraordinary Medicare cases involving long hospital stays or significant amounts of costs incurred. Under the prospective payment system, hospitals generally are encouraged to operate with greater efficiency, since they may retain payments in excess of costs but must absorb costs in excess of such payments. No assurance can be given that the operating costs of the Company's hospitals with respect to Medicare inpatients will not exceed their applicable DRG rates. The Secretary of the Department of Health and Human Services ("HHS") is required to establish annual increases in the DRG rates to counter inflationary pressure. In each year since 1984, however, the increases in the DRG rates have been determined by Congress as part of the federal budget process. DRG rates have increased at an average annual rate of approximately 3% over the last three years, an average rate well below market basket inflation. DRG rates effective for discharges on or after October 1, 1993 were increased 1.8% for hospitals in large urban and other urban areas and 3.3% for hospitals in rural areas. Medicare reimbursement for hospital outpatient services is currently based on a blended rate. Depending on the service, a certain percentage of the blend is based on a facility's reasonable costs and the remaining percentage is derived from a fixed fee schedule amount. Because of the fixed nature of the reimbursement for outpatient services, the ultimate impact on a hospital depends upon its ability to control the costs of providing such services. The Secretary of HHS is charged with developing a proposal for a prospective pricing system for all outpatient services. Such a system would cause a hospital with costs above the payment rate to incur losses on such services provided to Medicare beneficiaries. In addition to DRG payments, Medicare provides a payment amount for hospitals ("disproportionate share hospitals") that (a) serve a significantly disproportionate share of low- income patients or (b) that are located in an urban area, have 100 or more beds and can demonstrate that more than 30% of their revenues are derived from state and local government payments for indigent care provided to patients not covered by Medicare or Medicaid. The amount of additional payment varies depending upon the location of the hospital (urban versus rural) and the number of hospital beds. There is no assurance that future changes in federal law will not have an adverse effect on a hospital's qualification as a disproportionate share hospital or on the amount of the additional payment. Through September 30, 1991, payments for hospital capital- related costs of inpatient care were not included in the DRG payments but were reimbursed separately on a "reasonable and allowable cost" basis. However, commencing October 1, 1991, Medicare payments for capital costs are based upon a prospective payment system similar to the inpatient operating cost prospective payment system ("PPS"). A separate per-case standardized amount is paid for capital costs, adjusted to take into account certain hospital characteristics and weighted by DRG. The capital cost PPS is subject to a ten-year transition period. Two alternative payment methods apply during the transition period, one being a prospective method and the other a "hold harmless" method for high capital cost hospitals. The prospective method is a blend of "standard federal rates" and the subject hospital's specific rate, with adjustments to each of those rates based on certain factors. Over a ten-year transition period the federal portion of the rate increases gradually until payment is based entirely on the federal rate. Hospitals with hospital specific rates above the federal rate receive hold harmless payments during the transition period. At any point during the 10-year transition period, a hospital may be paid fully at the federal rate if that rate is more favorable to the hospital. For each fiscal year during the transition period, a payment "floor" will be in effect, which generally provides that at least 70% of allowable capital-related costs for most hospitals (90% for sole community providers and 80% for hospitals located in urban areas and which have over 100 beds and a "disproportionate share" percentage of at least 20.2%) will be paid. For HHS fiscal years 1993 through 1995, HHS proposes to update the federal rate based on actual increases in capital- related costs per case in the previous two years. Beginning in fiscal year 1996, HHS proposes to determine the update using the capital "market basket" index designed to reflect changes in capital requirements and new technology. Of the sixteen hospitals owned or leased by the Company, eleven are located in large urban areas, three are located in small urban areas, and two are located in rural areas, accounting for approximately 67%, 25%, and 8% of the Company's Medicare inpatient gross revenue, respectively, for the year ended December 31, 1993. The Omnibus Budget Reconciliation Act of 1989 established a mechanism by which hospitals can apply for geographical reclassification to improve Medicare payment to the hospital under certain circumstances. Applications for reclassification are made to the Medicare Geographical Classification Review Board and must be renewed annually. Because, under the statute, the aggregate reimbursement effects of geographical reclassifications must be budget neutral, these provisions may have an adverse impact upon Medicare payments to hospitals that are not eligible for reclassification. The Company has received approval for Medicare geographical reclassification for two of its hospitals effective October 1, 1993, having the effect of providing $0.5 million of additional reimbursement to the Company for the Medicare fiscal year ending September 30, 1994. Considerable uncertainty surrounds the future determination of payment levels for DRGs and for other services currently being reimbursed on a cost basis. Congress could consider further legislation in the prospective payment area, such as further reducing or eliminating DRG rate increases or otherwise revising DRG rates. Also, substantial areas of the Medicare program are subject to legislative and regulatory change, administrative rules, interpretations, administrative discretion, governmental funding restrictions and requirements for utilization review (such as second opinions for surgery and preadmission criteria). These matters, as well as more general governmental budgetary concerns, may significantly reduce payments made to the Company's hospitals under such programs, and there can be no assurance that future Medicare payment rates will be sufficient to cover cost increases in providing services to Medicare patients. Medicaid ________ Most state Medicaid payments are made under a prospective payment system or under programs to negotiate payment levels with individual hospitals. Medicaid is currently funded approximately 50% by the states and approximately 50% by the federal government. The federal government and many states are currently considering significant reductions in the level of Medicaid funding while at the same time expanding Medicaid benefits, which could adversely affect future levels of Medicaid reimbursement received by the Company's hospitals. On November 27, 1991, Congress passed the Medicaid Voluntary Contribution and Provider-Specific Tax Amendments of 1991 limiting states' use of provider taxes and donated funds to obtain federal Medicaid matching funds. The legislation prohibits the establishment of new voluntary donation programs and provides that provider taxes will be eligible for federal matching only if taxes apply to all providers in a class and if providers are not held harmless from the cost of the tax by compensating state payments. The legislation provides a transition period whereby voluntary donation programs in effect as of September 30, 1991 and provider tax programs in effect as of November 22, 1991 may continue through September 30, 1992. However, for states with fiscal years beginning after July 1, such programs were permitted to continue through December 31, 1992, and for states with no legislative session scheduled in 1992 or 1993, such programs are permitted to continue through June 30, 1993. The legislation also establishes a national limit on disproportionate share hospital adjustments (additional amounts required to be paid to hospitals providing a disproportionate amount of Medicaid and low-income inpatient services) equal to 12% of total Medicaid spending for each fiscal year effective January 1, 1992. Individual states are subject to a 12% cap; however, states currently using a greater percentage of their Medicaid expenditures for disproportionate share hospital payments may continue at current levels. Adjustments will be made for states with unusually high disproportionate share expenditures. After January 1, 1996, states will not be subject to the disproportionate share payment limits if Congress adopts new maximum payment rules. Because the Company cannot predict precisely what action states will take as a result of this legislation, the Company is unable to assess the effect of this legislation on its business. State Medicaid payments are now generally made under a prospective payment system or under programs to negotiate payment rates with individual hospitals. Such payments, however, generally are substantially less than a hospital's cost of services. The federal government and many states are currently considering ways to limit the increase in the level of Medicaid funding which, in turn, could adversely affect future levels of Medicaid reimbursement received by the Company's hospitals. Other Payors ____________ In 1993, revenue from non-Medicare and non-Medicaid payors represented 33% and 45% of the Company's gross and net patient revenue, respectively. These payors include (i) a number of managed care contractual arrangements, including HMOs, PPOs, most Blue Cross plans, CHAMPUS, and certain workers' compensation arrangements, (ii) commercial insurance carriers, and (iii) those without any other form of health insurance coverage. Managed Care--In 1993, revenue from managed care plans represented approximately 16% and 13% of the Company's total gross and net patient revenue, respectively. Hospitals contract directly with these plans. Payments for services are made directly to hospitals in amounts that are usually less than a particular hospital's established charges. In most cases, payments for inpatient services are calculated on a per diem basis, while outpatient reimbursement is usually based on a percentage of established charges. The percentage of the population covered by managed care varies substantially depending on the geographic area. If changes resulting from health care reform or the general business environment encourage substantially increased managed care, there could be a major adverse financial impact on hospitals in regions where there is a rapid expansion of managed care, either because certain hospitals may not be able to develop the contractual arrangements to participate in managed care programs or because those that do participate may not be able to respond adequately to increased cost containment pressures. The number of managed care plans has declined nationally over the past three years. However, while the number of plans has decreased with the recent consolidation of the HMO industry, the number of HMO enrollees increased, largely due to fast growth of hybrid HMO plans known as "open ended options" and "point of service" plans. Managed care, including HMOs, has also been gaining in political popularity as an effective means of health care cost containment. Hospitals must contend with rapid changes within the managed care movement. As managed care evolves, the Company believes that quality and how it is measured will become more important to purchasers of health care services and more financial risk will be forced on providers. The Company's failure or inability to participate in many managed care plans remains a major impediment for the Company to increase market share. In addition, some of the Company's hospitals (those in California, Las Vegas and Tacoma) participate in the lower priced/lower cost managed care plans. Commercial Insurance--In 1993, revenue from commercial insurance carriers represented 12% and 23% of the Company's gross and net patient revenue, respectively. Commercial insurance companies reimburse their policyholders or make direct payments to hospitals on the basis of the particular hospital's established charges and the coverage provided for within their insurance policies. Revenues from these patients more closely approximate established charges than those from other types of admissions. GOVERNMENTAL REGULATIONS The Company's facilities are generally subject to extensive federal, state, and local regulations relating to licensure, conduct of operations, construction of new facilities, the expansion or acquisition of existing facilities and the offering of new services. Failure to comply with applicable laws and regulations could result in, among other things, the imposition of fines, temporary suspension of admission of new patients to a facility or, in extreme circumstances, exclusion from participation in government health care reimbursement programs (from which the Company derived approximately 55% of its net revenue in 1993) or revocation of facility licenses. The Company believes that it conducts its business in substantial compliance with all laws material to the conduct of its business. EXPANSION Approvals of new facilities to be constructed and for renovations of or additions to existing facilities may be subject to various governmental requirements and approvals, including the issuance of certificates of need by certain state agencies authorizing such projects. Availability of reimbursement under government programs is often contingent upon such authorizations. Some of the states in which the Company's health care facilities are located have adopted certificate of need or equivalent laws which generally require that the appropriate state agency approve certain acquisitions and determine that the need for additional beds, new services and capital expenditures exist prior to implementation. State approvals often are issued for a specified maximum expenditure and require implementation of the proposed improvement within a specified period of time. Failure to obtain necessary state approval can result in the inability to complete the acquisition or addition, the imposition of civil or, in some cases, criminal sanctions, and the revocation of the facility's license. Various states in which the Company's hospitals are located have proposals pending for the expansion of their regulatory schemes. Further, some of the states have other proposals under study and consideration regarding statewide reform of health care delivery systems. Therefore, there can be no assurance that reimbursement will continue to be available for the expenses the Company is currently reimbursed by such state programs, or that the Company will be able to construct or renovate its facilities or add beds or services in such services in such manner and at such time as it deems appropriate. ANTI-KICKBACK STATUTE Section 1128B of the Social Security Act (the "Anti-Kickback Statute") provides criminal penalties for individuals or entities that knowingly and willfully offer, pay, solicit or receive remuneration ("kickbacks") in order to induce business reimbursed under the Medicare or Medicaid programs. An offense is a felony and is punishable by fines up to $25,000 and imprisonment for up to five years. The Office of the Inspector General of the Department of Health and Human Services ("OIG") also has authority to exclude an entity from participation in the Medicare and Medicaid programs if it is determined that the entity is engaged in a prohibited remuneration scheme or other fraudulent or abusive activities. The Anti-Kickback Statute is extremely broad and many business practices common in the health care industry may ultimately be found to be prohibited by the statute. Legal decisions applying the Anti-Kickback Statute to specific facts have held that if some purpose of a payment is to induce future referrals, the statutory provision would be violated even if the payment were also intended to compensate for professional services or had other legal business motivations. So-called "safe harbor" regulations, which specify certain practices that shall not be treated as a criminal offense under the Anti-Kickback Statute even though they might otherwise be considered illegal, have been published as final regulations by the OIG. The OIG recognizes in the preamble to the safe harbor regulations that the failure of a particular business arrangement to comply with the provisions of the safe harbors does not determine whether the arrangement violates the statute. Certain of the Company's practices are not eligible for protection under the safe harbor regulations. In May 1992, the OIG issued a Fraud Alert regarding "Hospital Incentives to Physicians" expressing the OIG's belief that specified common arrangements between hospitals and hospital- based physicians, including some practices engaged in by the Company's hospitals, may violate under certain circumstances the Anti-Kickback Statute. However, although the Company has certain relationships which fall within categories specified in such Fraud Alert, the Company does not believe that its relationships violate the Anti-Kickback Statute. Many states have enacted legislation similar to the Anti- Kickback Statute that prohibits, as a matter of state law, payment for referrals reimbursed by any source. The Social Security Act also prohibits, with limited exceptions, Medicare reimbursement for physician referrals to clinical laboratories with which the referring physician has an ownership interest or a compensation arrangement. There is also proposed federal legislation that would apply the self-referral ban to a wider range of services, including diagnostic and therapy services. Several states have enacted and other states are considering similar prohibitions as a matter of state law. The Company cannot predict how such limitations may be expanded or how such limitations may affect the operation of the Company's hospitals. UTILIZATION REVIEW The Company's hospitals are subject to various forms of governmental and private utilization and quality assurance review. Procedures mandated by the Social Security Act to ensure that services rendered to Medicare and Medicaid patients meet recognized professional standards and are medically necessary include review by a federally funded Peer Review Organization ("PRO") of the appropriateness of Medicare and Medicaid patient admissions and discharges, quality of care, validity of DRG classifications and appropriateness of services being provided in an inpatient setting. Negative PRO reviews may result in denial of reimbursement of payments, assessments of fines or exclusions from such programs. RATE REVIEW Rate or budget review legislation, which affects the Company's hospitals, exists in three of the states where the Company owns hospitals. These laws limit the Company's ability to increase rates at its hospitals. A number of states also have adopted taxes on hospital revenue and/or imposed licensure fees to fund indigent health care within such states. There can be no assurance that these states or other states in which the Company operates hospitals will not enact further or new rate-setting or other regulations that may adversely affect the Company's hospitals. In addition, health care reform initiatives could result in one or more of the following which could have an adverse effect on the revenues or operations of the Company's hospitals: (i) increased efforts by insurers and governmental agencies to limit the cost of hospital services (including, without limitation, the implementation of negotiated rates), to reduce the number of hospital beds, and to reduce utilization of hospital facilities; (ii) imposition of wage and price controls for the health care industry; (iii) future efforts of insurers and of employers to limit hospital costs; and (iv) the possible imposition of rate controls and the resultant inability to maintain the quality and scope of health care services. COMPETITION Competition among hospital providers has intensified in recent years as hospital utilization rates (the rates of hospital admissions per 1,000 population) have declined in the United States as a result of cost containment pressures, changing technology, changes in government regulation and reimbursement, changes in practice patterns (e.g., shifting from inpatient to outpatient treatments), preadmission reviews by insurers, the shift from high-margin commercial insurance to managed care and other lower-margin payors and other factors. In each market in which the Company operates, the Company faces substantial competition from other providers and there is an excess capacity of beds. Such competition can be formidable because of the reputation and position of such providers in the local medical community as well as their substantial resources. The Company's competition ranges from large multifacility companies to small single-hospital owners and freestanding outpatient surgery and diagnostic centers. Hospitals competing with the Company's facilities generally are larger and better equipped, have much larger bases of physician and community support, are more visible and offer a much broader range of services and often are the exclusive providers of services to certain managed care plans in their communities. In most instances, other hospitals in the local areas served by the Company's hospitals provide services similar to those offered by the Company's hospitals. No assurances can be given that the Company will be able to compete successfully with these other providers. In addition, hospitals owned by governmental agencies or other tax-exempt entities benefit from endowment, charitable contributions and tax-exempt financings, which advantages are not enjoyed by the Company's hospitals. In addition, in an effort to contain costs, third-party payors have encouraged a shift in medical and surgical treatment from inpatient to outpatient settings. This shift has supported the growth of various alternative site providers, which have gained some market share that otherwise may have gone to acute care hospitals. The competitive position of a hospital may also be affected by its ability to provide services to managed-care organizations, including HMOs and PPOs. Such managed care organizations represent an increasing segment of health care payors and this trend could accelerate as a result of new networks which may be formed to provide hospital services to insurance-type purchasing cooperatives under the new health reform proposals. See "Sources of Revenue." It is not possible to predict how such private and governmental initiatives may affect the Company's hospitals in the future. Currently, the Company's limited penetration of managed care plans significantly impedes its efforts to increase market share. If the Company's hospitals are unable to maintain or establish contractual relationships with managed care providers in a particular market, those hospitals are likely to be placed at a substantial competitive disadvantage. In the view of management, the national trend is toward integrated health systems that (i) encompass physicians (through ownership of practices or management), (ii) have a number of hospitals in their system (giving them additional economies of scale and broad geographical access), and (iii) own managed care plans (so they and their physicians are exclusive providers). LIABILITY AND INSURANCE The Company maintains hospital professional and comprehensive general liability insurance as well as other typical business-risk insurance policies common to the industry. The Company retains a significant portion of its risk for hospital professional and comprehensive general liability claims. The self-insured retention per claim is $3 million, the annual aggregate is $9 million, and the amount of excess umbrella coverage is $25 million. In addition, the Company is completely self-insured for claims which occurred prior to March 1, 1987, but not reported as of that date. The Company has set aside funds in a trust account to partially provide for its self-insured obligations and retention. The Company believes that its self-insurance reserves and insurance will be adequate to respond to known claims. However, there can be no assurance that the Company's present self-insurance and external coverage will be adequate to respond to claims made against it or that such external coverage will be available at reasonable rates. The amount of expense relating to the Company's malpractice insurance, particularly that with respect to the self- insurance portion, may materially increase or decrease from year to year depending, among other things, on the nature and number of new reported claims against the Company and amounts of settlements of previously reported claims. If trust assets are inadequate to fund actual losses, the Company's cash flow would be adversely affected. HOSPITAL STAFF AND EMPLOYEES At December 31, 1993, approximately 3,500 physicians were members of the medical staffs of the sixteen hospitals operated by the Company and many also serve on the staffs of other nearby hospitals. In addition certain physicians also have arrangements with Company hospitals to staff emergency rooms, serve as directors of departments, provide specific professional services, and/or serve in other support capacities. At December 31, 1993, the Company had approximately 4,800 employees. A small number of employees at one of the Company's hospitals have historically been represented by labor unions. The Company considers its relations with its employees to be satisfactory. Labor costs are a significant component of the Company's operating expenses. In certain regions of the country, the health care industry is currently experiencing a shortage of trained medical professionals, particularly nurses. ENVIRONMENTAL FACTORS The Company's hospitals generate pathological wastes, biohazardous (infectious) wastes, chemical wastes, waste oil and other solid wastes. The Company usually incinerates or contracts for disposal of its wastes. No litigation has been filed against the Company related to waste disposal, and the Company is not aware of any related ongoing investigation by any government agencies. LEGAL PROCEEDINGS Neither the Company nor any of its subsidiaries is party to, and none of their properties is the subject of, any material pending legal proceedings, other than ordinary, routine litigation incidental to the business. TAX CONSIDERATIONS For federal income tax purposes, the Company currently has substantial net operating loss ("NOL") carryforwards that are available to offset the future taxable income of the Company and its affiliates included in a consolidated federal income tax return. These amounts are, however, subject to review and allowance on audit by the Internal Revenue Service (the "IRS"). As of December 31, 1992, the aggregate NOL carryforwards reported on the Company's consolidated tax return were approximately $110.0 million. This figure has been determined by the Company and is not binding on the IRS, and in certain instances is subject to factual and legal uncertainties. At December 31, 1993, this amount was approximately $95.9 million. These carryforwards will expire, if not previously utilized, in the taxable years ending December 31, 2001 through December 31, 2006. Application of Section 382 __________________________ The Company's NOL carryforwards are principally affected by Section 382 of the Internal Revenue Code ("Section 382"). Generally, under Section 382 and the regulations promulgated thereunder, following certain changes after December 31, 1986, in the ownership of more than 50 percentage points (by value) in the stock of a loss corporation during a specified time period (which normally is three years), the amount of a loss corporation's taxable income in a tax year that can be offset by existing NOL carryforwards cannot exceed an amount equal to the value of the stock of the loss corporation (determined, with certain adjustments, as of the date of the ownership change) multiplied by a prescribed rate of return determined as of such date (the "Section 382 Limitation"). Should an ownership change occur in 1994 or thereafter, the Company's NOL carryforwards would be limited as set forth in this paragraph. Implementation of the Plan of Reorganization and the transactions therein contemplated caused an "ownership change" within the meaning of Section 382 to occur in December 1989. Except as discussed below with respect to the Special Bankruptcy Exception, the Plan of Reorganization would cause the Section 382 Limitation to apply to the utilization of the NOL carryforwards of the Company and its subsidiaries for 1990 and subsequent years. The implementation of the Company's recapitalization in September 1991 did not cause an ownership change under Section 382, and therefore, the Company's NOL carryforwards will continue to be fully available to it unless and until a change of ownership results in the application of the Section 382 Limitation. Generally, a change of ownership will have occurred with respect to the Company if the actual or deemed ownership of Common Stock by certain shareholders or groups of shareholders increases, in the aggregate, by more than 50 percentage points in any three-year period. The method of calculating the changes in share ownership under Section 382 is subject to varying interpretations and analyses. In connection with a recapitalization plan effected in September 1991, the Company, among other things, issued approximately 11.8 million shares of Common Stock in exchange for $42.8 million face amount of its bankruptcy reorganization-related senior debt. As a result of the issuance of such 11.8 million shares of Common Stock, as well as certain other changes in ownership of outstanding Common Stock and options and warrants to acquire such stock, based on certain assumptions, which the Company believes to be conservative, certain shareholders and relevant groups of shareholders of the Company could be deemed to have already experienced an aggregate increase of more than 46 percentage points in their actual or deemed ownership of Common Stock under current regulations of the Internal Revenue Service. In order to assist the Company in its efforts to preserve its ability to use its NOL carryforwards without being subject to the Section 382 Limitation, certain transfers of common stock and warrants are prohibited under the Company's Restated Certificate of Incorporation, unless consented to by the Board of Directors, until the Board of Directors terminates, modifies or amends the restriction relating to the sale, assignment or transfer of common stock and warrants. The previously discussed merger between AHI and OrNda, when consummated, will result in an ownership change pursuant to the provisions of Section 382. Consequently, following the merger, the Section 382 Limitation will apply to the use by OrNda, in regard to taxable income of the Company's subsidiaries, of the Company's NOL carryforwards. Special Bankruptcy Exception ____________________________ Section 382 (I)(5) contains a special provision (the "Special Bankruptcy Exception") which provides that in the case of an exchange of debt for stock in a case under the jurisdiction of a Bankruptcy Court brought under Title 11 of the United States Code (relating to bankruptcy) (a "Title 11 Case"), the Section 382 Limitation will not apply to any ownership change resulting from such a proceeding if certain creditors and shareholders immediately before the exchange own, as a result of such exchange, at least 50 percent of the stock of the loss corporation after the exchange. If the Special Bankruptcy Exception applies to a bankrupt corporation, then in lieu of the Section 382 Limitation, such corporation is required to reduce NOL carryforwards as provided by such Special Bankruptcy Exception. Under the Plan of Reorganization, an ownership change occurred under Section 382 in a transaction that should satisfy the requirements of Section 382 (I)(5). As a result, the NOL carryforwards were reduced by $80.8 million upon emergence from bankruptcy on December 29, 1989. Alternative Minimum Tax _______________________ The Tax Reform Act of 1986 added an alternative minimum tax applicable to corporations for taxable years beginning after December 31, 1986. The tax equals 20 percent of the corporation's alternative minimum taxable income ("AMTI") in excess of a $40,000 exemption (which is phased out at higher income levels) and is payable only to the extent it exceeds the corporation's regular federal income tax liability. It is possible that a corporation may have no taxable income or even a loss and still owe an alternative minimum tax. AMTI is computed by modifying the corporation's taxable income (determined before any NOL carryforward is applied) for certain adjustments and preferences. A corporation that has an NOL carryforward may use the NOL carryforward in calculating its regular taxable income and its alternative minimum taxable income. However, the NOL carryforward that is allowable against AMTI may not exceed 90 percent of AMTI, so that AMTI cannot be reduced to zero through use of the NOL carryforward and is subject to the limitations of Section 382, discussed above, in the event that a change of ownership occurs. As a result, the Company may be liable for the alternative minimum tax even if its taxable income in a year is less than the available NOL carryforward. Alternative minimum taxes paid are available on an indefinite carryforward basis to offset the Company's future regular federal income tax liability. Tax Legislation _______________ The Omnibus Reconciliation Act (the "Act") of 1993 was signed into law by President Clinton on August 10, 1993. At present, management is of the opinion that the Act will not have a significant effect on 1993 and future operations. Item 2.

Item 2. Properties The response to this item is included in Item 1. Item 3.

Item 3. Legal Proceedings Neither the Company nor any of its subsidiaries is party to, and none of their properties is the subject of, any material pending legal proceedings, other than ordinary, routine litigation incidental to the business. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders There was no matter submitted to a vote of the Company's security holders during the last quarter covered by this report. PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters On April 16, 1993, the registrant's common stock began trading on the New York Stock Exchange (ticker symbol AHI). Previously, the registrant's common stock was traded on the American Stock Exchange. The table below sets forth the high and low sales price per share for the registrant's common stock on the applicable stock exchange for each quarterly period during 1993 and 1992. Holders of common stock are entitled to receive dividends when and as declared by the board of directors out of funds legally available for the payment thereof. Under the terms of a Credit Facility, the Company may not pay dividends prior to July 21, 1994. Further, dividends in any fiscal year may not exceed the lesser of ten percent of net income or $3.0 million. As of February 28, 1994, there were approximately 585 record- holders of the registrant's common stock. As of February 28, 1994, warrants are outstanding that entitle the holders thereof to purchase an aggregate of 955,524 shares of common stock at any time prior to 5:00 p.m., Central Time on April 28, 1995, at prices equal to $1.60 (as to 691,192 shares) and $2.67 (as to 264,332 shares) per share, subject to adjustments pursuant to the antidilution provisions of the warrants. Warrantholders do not have any voting or other rights as shareholders of the Company. The common stock and warrants are subject to restrictions on transfer by or to holders of 5 percent or more of the common stock (determined after giving effect to the exercise of warrants held by the applicable stockholder) or to persons that will hold 5 percent or more of the common stock as a result of the contemplated transfer. Warrantholders may exercise the warrant by surrendering the certificate evidencing such warrant, with the form of election to purchase on the reverse side of such certificate properly completed and executed, together with payment of the exercise price and any transfer tax to American Stock Transfer & Trust Company, New York, New York (The "Warrant Agent"). If a warrant is exercised for fewer than all of the shares evidenced by the Warrant Certificate, a new certificate will be issued evidencing a warrant for the remaining number of shares. The Company currently has on file with the Securities and Exchange Commission a registration statement relating to the resale of up to 4,791,228 shares of common stock and shares of common stock which will result from the conversion of warrants to purchase 168,336 shares of common stock by certain specified holders of the common stock. The previously discussed merger between the Company and OrNda, when consummated, will result in the exchange of 0.6 of a share of OrNda common stock for each share of the Company's Common Stock. Thereafter, there will no longer be any shares of the Company's Common Stock issued or outstanding. Item 6.

Item 6. Selected Financial Data (in thousands, except per share amounts) The selected financial information presented below has been derived from the audited consolidated financial statements of the Company for each of the years ended December 31, 1989 through December 31, 1993. The information presented below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations," and the consolidated financial statements and related notes thereto appearing elsewhere in this document. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Results of Operations Interest Expense for the Year Ended December 31, 1993 and the Year Ended December 31, 1992 Compared with the Year-Earlier Periods Effective June 30, 1992, the Company refinanced approximately $100 million of the Senior Secured Notes ("Old Debt"), bearing a weighted average annual interest rate (based on stated rate under the indenture for the Old Debt) at June 30, 1992 of 12.8%, with approximately $100 million borrowed under a bank-financed credit facility (the "Old Credit Facility"), with a floating rate of interest (6.5% at December 31, 1992 on a weighted average basis). The Old Debt was accounted for in conformity with Financial Accounting Standards Board (FASB) Statement No. 15, "Accounting by Debtors and Creditors for Troubled Debt Restructurings," which under certain conditions prescribes the calculation of interest for financial reporting purposes. Application of FASB Statement No. 15 rules had the effect of reducing reported interest expense for the year ended December 31, 1992 by $5.9 million. Upon refinancing of the Old Debt, the required application of FASB Statement No. 15 rules to interest expense was eliminated. On July 28, 1993, the Company issued $100 million aggregate principal amount of 10 percent senior subordinated notes due July 2003 (the "Notes") and on July 29, 1993 amended and restated its senior secured credit facility (the "Credit Facility") with a syndicate of commercial bank lenders (the "Lenders") increasing the total facility to $122.5 million. Interest expense increased $5.5 million or 58.5% for the year ended December 31, 1993. The increase was principally due to the previously discussed effect of the application of FASB Statement No. 15 rules decreasing interest expense in the first half of 1992 and, to a lesser extent, the issuance of the Notes in July 1993. On a pro forma basis, interest expense for the year ended December 31, 1993, assuming the 1992 refinancing and 1993 Notes issuance occurred on January 1, 1992, was $17.3 million versus pro forma 1992 interest expense of $16.8 million. Pro forma income before extraordinary item for the year ended December 31, 1993 and 1992 assuming the 1992 refinancing and 1993 Notes issuance occurred on January 1, 1992, would have been $11.3 million or $.39 per share and $8.8 million or $.31 per share, respectively. See footnote 2 to the Company's consolidated financial statements for the year ended December 31, 1993 included in Item 8.

Item 8. Financial Statements and Supplementary Data Report of Independent Auditors Stockholders and Board of Directors American Healthcare Management, Inc. We have audited the accompanying consolidated balance sheets of American Healthcare Management, Inc. as of December 31, 1993 and 1992, and the related consolidated statements of operations, changes in stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also include the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of American Healthcare Management, Inc. at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. /s/Ernst & Young January 26, 1994 American Healthcare Management, Inc. Consolidated Balance Sheets American Healthcare Management, Inc. Consolidated Statements of Operations American Healthcare Management, Inc. Consolidated Statements of Changes in Stockholders' Equity American Healthcare Management, Inc. Consolidated Statements of Cash Flows American Healthcare Management, Inc. Consolidated Statements of Cash Flows (continued) American Healthcare Management, Inc. Notes to Consolidated Financial Statements December 31, 1993 1. Business and Significant Accounting Policies The Company is engaged primarily in the development, ownership, and operation of hospitals and related health-care facilities. Its more significant accounting policies follow. Principles of Consolidation The consolidated financial statements include all subsidiaries. All significant intercompany transactions have been eliminated. Third-Party Payors Net revenue represents patient service revenue and other revenue and is reported at the net realizable amounts from patients, third-party payors, and others for services rendered. Patient service revenue generated from Medicare and Medicaid/Medi-Cal reimbursement programs accounted for approximately 55%, 50%, and 42% in 1993, 1992, and 1991, respectively, of total net patient service revenue. Under these programs, the Company is required to submit annual cost reports which are subject to examination by agencies administering these programs. Management believes that adequate provision has been made in the consolidated financial statements for potential adjustments resulting from such examinations. Net accounts receivable from the Medicare and Medicaid/Medi-Cal reimbursement programs at December 31, 1993 and 1992 were approximately $28.9 million and $26.7 million, respectively. Debt Issuance Costs Costs incurred in connection with the amendment and restatement of the Company's senior secured credit facility (refer to footnote 2) are being amortized using the effective interest method over the term of the related debt. Depreciation Depreciation expense is computed by the straight-line method. The estimated useful lives are: buildings, 30 to 40 years; leasehold improvements, the shorter of the expected useful life or the remaining lease term; equipment, 10 years; and minor equipment, 3 years. Amortization of assets recorded under capital lease is included with depreciation expense. American Healthcare Management, Inc. Notes to Consolidated Financial Statements (continued) 1. Business and Significant Accounting Policies (continued) Earnings Per Share The computation of primary earnings per share is based on the weighted average number of shares outstanding during the period after consideration of the dilutive effects of stock options and warrants (1993--1,557,000; 1992--1,517,000; 1991- - - -586,000 equivalent shares) based on the treasury stock method using the monthly average market price of the stock during the year. The primary weighted average number of shares outstanding is 28,704,772; 28,547,600; and 18,810,708 for the years ended December 31, 1993, 1992, and 1991, respectively. The computation of fully diluted earnings per share considers the dilutive effects of stock options and warrants (1991-- 1,559,032 equivalent shares) based on the treasury stock method using the year-end market price of the common stock. For the year ended December 31, 1991, the fully diluted weighted average number of common shares outstanding is 19,783,929. Notes Receivable Notes receivable includes $1.0 million of advances, principally to officers of the Company. Cash and Cash Equivalents The Company considers all highly liquid debt instruments with maturities of three months or less when purchased to be cash equivalents. 2. Long-term Debt A summary of long-term debt follows: American Healthcare Management, Inc. Notes to Consolidated Financial Statements (continued) 2. Long-term Debt (continued) The fair value of the Company's long-term debt is estimated to approximate the recorded values, based on quoted market prices for the same or similar issues or on the current rates offered to the Company for debt of the same remaining maturities, except that the senior subordinated notes approximate 104% of par value based on recent bid/ask indications. On July 28, 1993, the Company issued $100 million aggregate principal amount of 10 percent senior subordinated notes due July 2003 (the "Notes") and on July 29, 1993, amended and restated its senior secured credit facility (the "Credit Facility") with a syndicate of commercial bank lenders (the "Lenders") under which $42.5 million remained outstanding and a credit facility of up to $80.0 million was made available, thereby increasing the total facility from $105 million to $122.5 million. The proceeds from the issuance of the Notes were used to repay $42.5 million of previously outstanding senior secured term debt, $13.0 million representing all amounts previously outstanding under a senior secured revolving credit facility, $20.5 million of subsidiary mortgages, and transaction fees and expenses. The remainder of the proceeds were invested in short-term investment grade, interest-bearing obligations pending use for general corporate purposes, including capital expenditures. In connection with these transactions, the Company recorded an extraordinary loss of $3.7 million, net of an income tax benefit of $125,000, on early extinguishment of debt in the third quarter of 1993. The loss primarily related to the writeoff of unamortized debt issuance costs on the extinguished indebtedness. The Credit Facility consists of (i) a $42.5 million term loan facility, payable in incremental, semiannual installments beginning January 31, 1994 and maturing July 31, 2000, (ii) a revolving credit facility, restricted for use for working capital purposes and reimbursement for drawings under letters of credit, limited to an aggregate principal amount of $20 million, and (iii) a permitted acquisition facility limited to an aggregate principal amount of $60 million. The revolving credit and permitted acquisition facilities are due July 29, 1995 but may, upon approval by the Lenders, be extended for one-year periods through July 29, 1997. At December 31, 1993, the permitted acquisition and revolving credit facilities were undrawn; however, commitment availability under the revolving credit facility had been reduced by $1.7 million for issued letters of credit. Funds advanced under the Credit Facility bear interest on the outstanding principal at either a rate based on the Prime Rate or London Interbank Borrowing Rate ("LIBOR") as elected from time to time by the Company. Interest is payable monthly if a rate based on the Prime rate is elected or at the end of the LIBOR period if a rate based on LIBOR is elected (but not to exceed three months). The Company has elected various rates on the initial term loan facility representing a weighted average annual interest rate at December 31, 1993 of 6.0%. American Healthcare Management, Inc. Notes to Consolidated Financial Statements (continued) 2. Long-term Debt (continued) In certain circumstances, the Company is required to make principal prepayments on the term loan including the receipt of proceeds from certain sales of material assets and the issuance of additional indebtedness. The Company may prepay all or part of the outstanding Credit Facility without penalty. The Notes are subordinated to the Credit Facility and to indebtedness of the Company's subsidiaries. Interest on the Notes is payable semiannually on February 1 and August 1 of each year. The Notes mature on August 1, 2003 but may be redeemed in whole or in part at the option of the Company on or after August 1, 1998 through July 31, 2000 at specified redemption prices in excess of par and thereafter at par. The Credit Facility Agreement and Note Indenture limit, under certain circumstances, the Company's ability to incur additional indebtedness, sell material assets, acquire the capital stock or assets of another business, or pay dividends. The Credit Facility also requires the Company to maintain a specified net worth and meet or exceed certain coverage, leverage, and indebtedness ratios. Indebtedness under the Credit Facility and under other secured debt and capital lease agreements of the Company is secured by liens on substantially all real and personal property and interests in real and personal property of the Company and its subsidiaries. Effective June 30, 1992, the Company refinanced approximately $100.0 million of fixed-rate senior secured debt ("Troubled Debt") with a floating-rate senior secured credit facility of $105.0 million. The Troubled Debt was issued in connection with a debt restructuring followed by the Company's emergence from bankruptcy on December 29, 1989. The Troubled Debt had been accounted for under Financial Accounting Standards Board Statement No. 15, "Accounting by Debtors and Creditors for Troubled Debt Restructurings." As a result of the refinancing, the Company recognized an extraordinary gain on early extinguishment of debt of $55.6 million. The gain primarily resulted from the income recognition of "future interest" included in long-term debt, less related expenses. The following table sets forth pro forma income and earnings per share before extraordinary item for the years ended December 31, 1993 and 1992 giving effect to (i) the refinancing and related expenses effective June 30, 1992 of the Troubled Debt and (ii) issuance of the Notes on July 28, 1993 and the application of the estimated net proceeds thereof as if such transactions had occurred on January 1, 1992. American Healthcare Management, Inc. Notes to Consolidated Financial Statements (continued) 2. Long-term Debt (continued) On September 22, 1992, the Company entered into interest rate swap agreements effectively fixing the annual interest rate on floating-rate term debt at 7.7% for three years on $25.0 million of debt and 7.0% for two years on $10.0 million of debt. Maturities of long-term debt, exclusive of capital lease obligations, over the next five years and thereafter are as follows (in thousands): A summary of assets under capital lease follows: At December 31, 1993, aggregate amounts of future minimum payments under lease commitments are as follows: American Healthcare Management, Inc. Notes to Consolidated Financial Statements (continued) 2. Long-term Debt (continued) Operations for the years ended December 31, 1993, 1992, and 1991 included rental expense on operating leases of property and equipment of $9.0 million, $7.3 million, and $7.6 million, respectively, a majority of which represents rental expense attributed solely to usage. Certain of these operating leases include provisions for renewal options and escalation clauses. 3. Debt-For-Equity Exchange On September 27, 1991, the Company's stockholders approved a nontaxable recapitalization plan (the "Recapitalization") effective on that date to issue 11,776,768 shares of the Company's common stock to fifteen holders (the "Exchanging B Noteholders") of the Company's Senior Secured B Notes (the "B Notes") in exchange for $42,824,610 principal amount of B Notes. In addition, the Company purchased from the Exchanging B Noteholders at par $2,450,720 principal amount of B Notes held by them. For Exchanging B Noteholders holding warrants to purchase shares of the Company's common stock, which amounted to an aggregate of 897,198 warrants, the Company lowered the exercise price of the warrants from $2.67 per share to $1.60 per share. Accrued interest on the B Notes through September 27, 1991 of $1.5 million was paid on that date to the Exchanging B Noteholders on the B Notes exchanged and purchased. Expenses incurred in connection with the Recapitalization of $3.2 million were recorded as a reduction of additional paid- in capital. 4. Contingencies Liability Risks The general and professional liability risks of the Company are self-insured up to $3.0 million per occurrence and $9.0 million in aggregate per claim year. The Company carries general and professional liability insurance from an unrelated commercial carrier for per-occurrence losses in excess of $3.0 million on a claims-made basis. At December 31, 1993, liabilities for self-insured professional and general liability risks, for both asserted and unasserted claims, are based on actuarially projected estimates discounted at a 7.5% average rate to their present value of $5.0 million based on historical loss payment patterns. At December 31, 1993, the Company maintained $3.0 million in a trust fund for purposes of meeting in part these estimated obligations. Although the ultimate settlement of these liabilities may vary from such estimates, management believes that the amounts provided in the Company's financial statements are adequate. Neither the Company nor any of its subsidiaries is party to, and none of their properties is the subject of, any material pending legal proceedings, other than ordinary, routine litigation incidental to the business. American Healthcare Management, Inc. Notes to Consolidated Financial Statements (continued) 5. Stockholders' Equity and Stock Options The Company has never paid any dividends on its common stock. Under the terms of the Company's Credit Facility, the Company may not pay dividends prior to July 21, 1994. Further, dividends in any fiscal year may not exceed the lesser of ten percent of net income or $3.0 million. At December 31, 1993, warrants to purchase 1,163,284 shares of common stock were outstanding. The warrants may be exercised any time prior to April 29, 1995 at a price of $2.67 per share for warrants for 278,586 shares, and at $1.60 per share for warrants for 884,698 shares. The Company has reserved 1,640,000 shares (less options canceled) of its common stock for issuance to officers and employees under its 1990 Stock Plan and 360,000 shares under its 1990 Non-Employee Directors' Stock Plan. Under both plans, options granted will terminate unless exercised within a ten-year period at the market price on the grant date and are exercisable in three equal annual installments commencing one year from date of grant. The following is a summary of option transactions during 1991, 1992, and 1993: Options available for future grant under the 1990 Stock Plan at December 31, 1993 and 1992 were 610,000 and 1,015,000, respectively. No options were available for future grant under the Non-Employee Directors' Stock Plan at December 31, 1993 and 1992. In addition to the above plans, two officers of the Company were granted options to acquire an aggregate of 470,000 shares of the Company's common stock. The options are fully vested at a price of $1.89 per option. The options expire in April 1995. American Healthcare Management, Inc. Notes to Consolidated Financial Statements (continued) 6. Income Taxes At December 31, 1993, significant deferred tax assets consist of: tax return net operating loss carryforwards ($95.9 million), allowances not yet deducted for tax purposes ($16.8 million), capital lease liabilities ($13.0 million), and tax credit carryforwards ($5.2 million). Significant deferred tax liabilities consist of: accelerated depreciation ($116.9 million) and the unamortized deferral of the effect of changing from the cash method of tax accounting to the accrual method in a prior year ($12.3 million). The ability of the Company to reduce future book income tax expense with net operating loss carryforward benefits is limited. As net operating loss carryforwards are utilized in future years, the Company's taxable temporary differences may exceed deductible temporary differences which will likely require providing deferred income taxes beginning in 1994. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company's deferred tax assets and liabilities are tax effected as follows (in thousands): American Healthcare Management, Inc. Notes to Consolidated Financial Statements (continued) 6. Income Taxes (continued) Significant components of the provision for income taxes attributable to continuing operations are as follows (in thousands): The reconciliation of income tax attributable to continuing operations computed at the U.S. federal statutory tax rates to income tax expense is: American Healthcare Management, Inc. Notes to Consolidated Financial Statements (continued) 6. Income Taxes (continued) The following schedule summarizes approximate tax return net operating loss and tax credit carryforwards, which are currently available on an unlimited basis to offset federal net taxable income (in millions): The Company also has state tax loss carryforwards available in various states in which it is required to file a return. Pursuant to the provisions of Section 382 of the Internal Revenue Code, the NOL carryforward could be subjected to annual use limitations should an ownership change, as therein defined, occur in any three-year period within the carryforward period. Also refer to footnote 8. 7. Quarterly Financial Information (Unaudited) The following tables summarize the quarterly results of operations for the two years ended December 31, 1993: American Healthcare Management, Inc. Notes to Consolidated Financial Statements (continued) 7. Quarterly Financial Information (Unaudited) (continued) 8. Proposed Merger On November 18, 1993, the Company entered into a definitive Agreement and Plan of Merger with OrNda HealthCorp ("OrNda") pursuant to which the Company will merge with OrNda. It is expected the transaction will be tax-free and accounted for as a pooling-of-interests. Under the terms of the agreement, which was unanimously approved by the Boards of Directors of both companies, the Company's shareholders will receive 0.6 of a share of OrNda common stock in exchange for each share of the Company's common stock held. Additionally, pursuant to a Waiver and Consent Agreement dated February 3, 1994 by and among OrNda and the holders of a majority in principal amount of the 10% Senior Subordinated Notes, as consideration for their agreement to make certain changes to the Notes' Indenture to effect the merger and other matters, OrNda will make consent payments to the holders on the closing date of the merger of $15.00 for each $1,000 principal amount of the outstanding Notes resulting in an expense upon completion of the merger of $1,500,000. Following the consummation of the merger, the rate of interest on the Notes will increase from 10% per annum to 10-1/4% per annum. The merger will cause a "change of control" as defined in the Note Indenture, which, therefore, will allow each holder of the Notes to require the Company to repurchase all or a portion of the Notes owned by such holder at 101% of the principal amount thereof, together with accrued interest thereon to the date of repurchase. Although the Company does not anticipate that a substantial amount of the Notes will be tendered for repurchase, if any, OrNda has made financial arrangements to provide funding, to the extent necessary, for the repurchase of any Notes tendered. American Healthcare Management, Inc. Notes to Consolidated Financial Statements (continued) 8. Proposed Merger (continued) The merger, when consummated, will result in an ownership change pursuant to the provisions of Section 382 of the Internal Revenue Code. Consequently, following the merger, annual use of the Company's tax attribute carryforwards will be substantially limited for federal income tax purposes. As of December 31, 1993, costs incurred totaling approximately $800,000 associated with the proposed merger have been deferred and will be charged to expense upon completion of the merger. In addition, loans to employees of approximately $750,000 will be forgiven pursuant to the "change-of-control" provision of the loan agreements. Consummation of the merger is subject to shareholder approval of both companies. Shareholder meetings to vote on the transaction are scheduled for April 19, 1994. If approved, the merger is expected to be completed shortly thereafter. PART III Item 9.

Item 9. Changes in and disagreements with the Accountants on Accounting and Financial Disclosure None. Item 10.

Item 10. Directors and Executive Officers of the Registrant The table below sets forth the name, age, and position of the Company's executive officers and directors. Steven L. Volla joined the Company on December 29, 1989, as its President and Chief Executive Officer, at which time he also became a Director of the Company. Mr. Volla served as the Treasurer of the Company from March 1990 to September 1991 and he also served as Chief Financial Officer of the Company from March 1990 until July 1991. From 1982 until joining the Company, Mr. Volla had been employed by Universal Health Services, Inc., King of Prussia, Pennsylvania, where he most recently served as its Senior Vice President-- Operations. He is also a Director of Kendall, Inc., a medical supply manufacturer; and Foothill Group, Inc., a financial services company. Robert M. Dubbs has served as Vice President, General Counsel and Secretary since February 1990. He was elected a Senior Vice President in 1993. Prior to February 1990, and since June 1984, Mr. Dubbs was General Counsel and Secretary for Universal Health Services, Inc., King of Prussia, Pennsylvania. Robert W. Fleming, Jr. joined the Company on May 29, 1990, as Senior Vice President, Operations. Before joining the Company, he had been the Chief Operating Officer at St. Agnes Medical Center, a 259 bed acute-care hospital in Philadelphia. Prior to that, Mr. Fleming had served in a variety of officer capacities at Universal Health Services, Inc., King of Prussia, Pennsylvania, including Vice President--Operations, Vice President--Management Services, and most recently Vice President--Development. William S. Harrigan joined the Company on July 29, 1991, as Senior Vice President, Chief Financial Officer and was elected Treasurer in September 1991. Prior to that and since March 1986, he was Vice President and Treasurer of Rhone- Poulenc Rorer (formerly Rorer Group, Inc.). Bruce J. Colburn, has served the Company as Vice President, Controller, since February 1993. Prior to that he served as Controller, Hospital Financial Operations since joining the Company in July 1990. From August 1985 to July 1990, Mr. Colburn served as an executive with Ernst & Young's National Accounting and Auditing Group in Cleveland, Ohio and New York, New York. Brian G. Costello joined the Company in July 1990, as its Vice President, Human Resources. From June 1988 to July 1990, Mr. Costello was Vice President at Garfolo, Curtiss & Company, Ardmore, Pennsylvania. From August 1981 to June 1988, Mr. Costello was Vice President of Human Resources at Hahnemann Hospital in Philadelphia. Lois M. Quinn has served as Vice President, Professional Affairs since February 1993, and served as Director, Professional Services since joining the Company in September 1990. From 1983 to 1990 she served in various capacities at Universal Health Services, Inc., King of Prussia, Pa., where she most recently served as Director, Professional Standards. Thomas M. Sposito joined the Company in July 1990, as its Vice President, Materiel Management. From September 1979 to July 1990, Mr. Sposito was Director of Purchasing at Universal Health Services, Inc., King of Prussia, Pennsylvania. John W. Gildea has been President and Sole Director of Gildea Investment Co. since 1983; Managing Director of the Network Company II Limited since 1992; a General Partner of Gildea Management Company, L.P. since 1990; and from 1986 to 1990 Senior Vice President of Donaldson, Lufkin, Jenrette. He has been a Director of the Company since September 27, 1991. William S. Kiser, M.D. has been Medical Director of the Company since 1992. He served as Chairman of the Board of Governors for The Cleveland Clinic Foundation from 1977 to 1989; currently, he is a Director of TRW, Inc. He became a Director of the Company on May 27, 1993. John F. Nickoll has been President and Co-Chief Executive Officer, The Foothill Group, Inc., since 1970; Director, American Shared Hospital Services, Inc., an owner/lessor of mobile CAT-scan equipment; Director, CIM-High Yield Securities, Inc., a closed-end investment company; Director, Care Enterprises, Inc., a nursing home chain. He has been a Director of the Company since September 27, 1991. John J. O'Shaughnessy has been President of Strategic Management Associates, Inc., Washington, D.C. since 1988; from 1986 to 1988 Senior Vice President of Greater New York Hospital Association; from 1983 to 1986 Assistant Secretary for Management and Budget of the Department of Health and Human Services, Washington, D.C. He has been a Director of the Company since December 29, 1989. C. A. Rundell, Jr. has been since 1988 a private investor in Dallas, Texas. Prior to 1988, he was President, CEO, Chairman of the Board of Business Records Corporation (formerly known as Cronus Industries); currently, Chairman of the Board of NCI Building Systems, Inc., Director of Tyler Corporation, Tandy Brands Accessories, Inc., Bollinger Industries, Inc., Inter-Regional Financial Group, Inc., Redman Industries, Inc. and Eljer Industries, Inc. He has been a Director of the Company since December 29, 1989. Gerald L. Sauer, Ph.D. has been a Partner at Strategic Decisions Group, Menlo Park, CA since 1987; from 1982 to 1987, a faculty member at the Amos Tuck School of Business at Dartmouth College. He has been a Director of the Company since December 29, 1989. COMPLIANCE WITH SECTION 16(a) OF THE SECURITIES EXCHANGE ACT OF 1934 Section 16(a) of the Exchange Act requires the Company's directors and executive officers, and persons who own more than ten percent of a registered class of the Company's equity securities to file with the Securities and Exchange Commission initial reports of ownership and reports of changes in ownership of the Company's Common Stock and other equity securities. Officers, directors and greater than ten percent shareholders are required by Commission regulation to furnish the Company copies of all Section 16(a) forms they file. To the Company's knowledge, based solely on a review of the copies of such reports furnished to the Company for the fiscal year ended December 31, 1993, all Section 16(a) filing requirements applicable to its officers, directors and greater than ten percent beneficial owners were complied with. Item 11.

Item 11. Executive Compensation SUMMARY COMPENSATION TABLE The following table sets forth the annual and long-term compensation for the Company's Chief Executive Officer and the four highest paid executive officers, as well as the total compensation paid to each individual for the Company's two previous years. OPTION GRANTS IN LAST FISCAL YEAR The following table sets forth certain information concerning options granted during 1993 to the named executives: AGGREGATED OPTIONS EXERCISED AND FISCAL YEAR-END OPTION VALUES The following table summarizes options exercised during 1993 and presents the value of unexercised options held by the named executives at fiscal year end: Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management The following table sets forth certain information with respect to beneficial ownership of Common Stock of AHM as of March 1, 1994 (i) by each person known by AHM to be the beneficial owner of five percent or more of the outstanding shares of AHM Common Stock, (ii) by each of AHM's directors, (iii) by each of the five most highly compensated executive officers of AHM, and (iv) by all of AHM's directors and executive officers as a group. Item 13.

Item 13. Certain Relationships and Related Transactions INTERESTS OF CERTAIN PERSONS IN THE AHM MERGER Stock Options and Warrants __________________________ Directors and executive officers of AHI are the beneficial owners of approximately 7,857,792 shares of AHI Common Stock. Included within the foregoing are vested options to purchase approximately 1,006,780 shares of AHI Common Stock at prices ranging from $1.00 to $5.63 per share and warrants to purchase approximately 113 shares of AHI Common Stock at $2.67 per share at February 28, 1994. Under the previously discussed merger agreement, options and warrants remaining unexercised at the merger date will be converted into options and warrants to purchase shares of OrNda Common Stock. In addition, on February 28, 1994, the Foothill Group, Inc., of which John F. Nickoll, a director of AHI, is the President and Co-Chief Executive Officer, was the beneficial owner of approximately 6,550,726 shares, of which 3,610,511 shares are included in the 7,857,792 shares referred to in the first sentence of this paragraph. Officer and Director Indemnification and Insurance __________________________________________________ Under the terms of the merger agreement, officers and directors of AHI are entitled to be indemnified by OrNda subsequent to the merger date and OrNda is required to maintain directors and officers liability coverage for such persons for a period of six years following the AHI merger date. Registration Rights ___________________ Under the merger agreement, OrNda is obligated to negotiate in good faith with John F. Nickoll and John W. Gildea, Directors of AHI, with respect to rights of entities with which they are affiliated to obtain registration under the Securities Act of 1933 of shares to be acquired by such entities in the merger. Such entities owned on February 28, 1994 in the aggregate approximately 11,037,600 shares of AHI Common Stock which will be converted into approximately 6,622,560 shares of OrNda Common Stock as a result of the AHI merger. Forgiveness of Indebtedness ___________________________ In December 1991, AHI provided certain key employees an aggregate of $749,993 in interest-free loans (of which an aggregate of $698,198 was provided to executive officers) to enable them to purchase shares of AHI's Common Stock. Under the terms of such loans which are still outstanding, the principal amount thereof would have been due and payable in December 1995 provided that AHI was obligated to forgive 29% of the principal amount thereof due from any employee who remained employed on the maturity date. Under the terms of such loans, the entire principal amount thereof is required to be forgiven by AHI upon a change of control of AHI, as defined in such loans. The merger will constitute a change in control of AHI under the terms of such loans and, accordingly, at the merger date, the entire principal amount of all such loans will be forgiven by AHI. Employment Agreement with Steven L. Volla _________________________________________ AHI is party to an employment agreement with Steven L. Volla, the Chairman, President and Chief Executive Officer of AHI, which provides for Mr. Volla to receive an initial base salary of $550,000, to be increased annually by not less than the higher of: (i) such amount as may be determined by AHI's Board of Directors; or (ii) the average percentage increase in base compensation of other executive officers of AHI. The agreement with Mr. Volla expires on March 26, 1997, and may be extended for additional periods upon the written agreement of the parties. In addition to base salary amounts, Mr. Volla is eligible to receive incentive cash compensation in an amount approved by the AHI Board of Directors. Under his 1990 employment contract, Mr. Volla was granted options to purchase 450,000 shares of the AHI Common Stock at $1.89 per share. These options have fully vested and expire on April 5, 1995. Pursuant to his 1992 amended and restated employment agreement, which was approved by the AHI Board of Directors, Mr. Volla was granted a loan in the amount of $225,000. The principal on this loan is due and payable on April 6, 1995, provided, however, that AHI shall, prior to the due date, forgive the entire unpaid amount of the loan at such time as Mr. Volla exercises the 450,000 options granted him in 1990. The contract also provides that if Mr. Volla resigns following a change in control, his loan is forgiven in full. If the options are exercised in part, the unpaid amount of the loan shall be forgiven pro rata. In February 1993, Mr. Volla was granted 300,000 additional options at $5.375 per share, 100,000 of which vested on February 2, 1994. Mr. Volla's employment agreement provides that, under certain circumstances in connection with a change in control, Mr. Volla will receive severance payments following his voluntary resignation. These payments are based directly upon the then-remaining term of Mr. Volla's employment agreement, his initial base salary and accrued incentive compensation for the year of termination. The merger will constitute a change in control under Mr. Volla's employment agreement, giving Mr. Volla the right to elect to resign and receive such payments. No different contractual arrangements have been made for the continued employment of Mr. Volla by OrNda. If Mr. Volla were to resign immediately following the merger date, he would be entitled to receive an aggregate of approximately $1,700,000 in severance payments, payable over three years, plus accrued incentive compensation in the year of his resignation. Change in Control Severance Contracts for Other Officers ________________________________________________________ The employment agreements of Robert M. Dubbs, Senior Vice President, General Counsel and Secretary of AHI, and William S. Harrigan, Senior Vice President, Chief Financial Officer, and Treasurer of AHI, each provide that if a "change in control," as defined in the agreements, occurs, the employee may terminate the agreement within six months thereafter if his duties are changed in nature or if his compensation is decreased or if other actions specified therein are taken. The AHI merger will be a change of control under such agreements. In the event of such termination by the employee, he would be entitled to severance pay equal to one year, in the case of Mr. Dubbs, and six months, on the case of Mr. Harrigan, of his base compensation plus all accrued incentive compensation and an amount in respect of all unused vacation. At current compensation levels, such amounts would approximate $167,000 for Mr. Dubbs and $78,000 for Mr. Harrigan. In addition, unvested options with respect to 33,333 shares of AHI Common Stock held by Mr. Harrigan would vest. OTHER MATTERS Under Mr. Dubbs' 1990 employment agreement, he has been granted options with respect to 20,000 shares of the Company's Common Stock, all of which are fully vested and which expire on April 5, 1995. Further, Mr. Dubbs has been granted options to purchase 80,000 additional shares of Common Stock, pursuant to the Company's 1990 Stock Plan, which was approved by the Stockholders of the Company on June 15, 1990. Messrs. Fleming and Harrigan, also under the Company's 1990 Stock Plan, have each been granted options to purchase 100,000 shares of Common Stock. Transfers of shares of the Company's Common Stock to holders of 5 percent or more of the Company's Common Stock are prohibited by the Company's Certificate of Incorporation unless consented to by the Board of Directors after a determination by them that the utilization by the Company of its net operating loss carryforward would not be jeopardized by the proposed transfer. John F. Nickoll, President and Co-Chief Executive Officer of The Foothill Group, Inc., is a Director of the Company. The Foothill Group, Inc. is the parent company or ultimate controlling entity of various entities which own Common Stock of the Company. The Foothill Group, Inc. is party to a contract with the Company pursuant to which The Foothill Group, Inc. has agreed that it will not transfer 60,000 shares of Common Stock of the Company which it acquired subsequent to December 29, 1989 without the prior written consent of the Company and will not, without prior written consent, acquire additional Common Stock or warrants of the Company. In November 1992, the Board of Directors authorized the acquisition from time to time by The Foothill Group and its affiliated entities of up to an additional one percent of the outstanding Common Stock of the Company. John W. Gildea, as general partner of Gildea Management Co., exercises sole investment and voting power with respect to the investments of The Network Company II Limited. In November 1992, the Board of Directors authorized the acquisition from time to time by the Network Company II Limited and its affiliated entities of up to an additional one percent of the outstanding Common Stock of the Company. PART IV Item 14.

Item 14. Exhibits (a)(1) Index to Consolidated Financial Statements: Report of Independent Auditors Consolidated Balance Sheets as of December 31, 1993 and 1992 Consolidated Statements of Operations for the years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Changes in Stockholders' Equity for the years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 Notes to Financial Statements (a)(2) Index to Consolidated Financial Statement Schedules for the years ended December 31, 1993, 1992 and 1991: II - Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees other than Related Parties V - Property and Equipment VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment VIII - Valuation and Qualifying Accounts X - Supplementary Income Statement Information All other schedules have been omitted because the required information is not present or not present in material amounts. [*] (a) (3) Exhibits: 3.1 Restated Certificate of Incorporation of the Company, as filed with the Secretary of State of Delaware on December 16, 1991 (incorporated by reference to Exhibit 3.1, 1992 Form 10-K, File No. 1-8756). 3.2 Bylaws of the Company, as amended (incorporated by reference to Exhibit 3.2, 1992 Form 10-K, File No. 1-8756). 4.1 Underwriting Agreement entered into between the Company and Goldman, Sachs & Co. (incorporated by reference to Exhibit 1 the Company's Amendment No. 3 to its Registration Statement-- File No. 33-63552, filed on July 20, 1993). 4.2 Indenture entered into between the Company and NationsBank of Tennessee, National Association, as Trustee (incorporated by reference to Exhibit 4.1 to the Company's Amendment No. 3 to its Registration Statement--File No. 33-63552, filed on July 20, 1993). 4.3 Form of Note (included in Exhibit 4.1) (incorporated by reference to Exhibit 4.2 to the Company's Amendment No. 3 to its Registration Statement--File No. 33-63552, filed on July 20, 1993). 4.4 Amended and Restated Credit Agreement by and among the Company, AHM Capital Management, Inc., CoreStates Bank, N.A., agent, and certain lenders named therein ("Credit Agreement") (incorporated by reference to Exhibit 4.3 to the Company's Amendment No. 3 to its Registration Statement--File No. 33-63552, filed on July 20, 1993). 4.4.(a) Amendment No. 1 to Credit Agreement, dated July 27, 1993, filed herewith. 4.4.(b) Amendment No. 2 to Credit Agreement, dated September 30, 1993, filed herewith. 4.4.(c) Consent Agreement to Credit Agreement, dated November 1, 1993, filed herewith. 4.4.(d) Amendment No. 3 to Credit Agreement, dated December 17, 1993, filed herewith. 4.5 Amended and Restated Agreement and Plan of Merger dated as of January 14, 1994, among OrNda HealthCorp and the Company (incorporated by reference to the Company's Proxy Statement, dated March 14, 1994). 4.6 Irrevocable Proxy, dated as of November 18, 1993, of Joseph Littlejohn and Levy Fund (incorporated by reference to the Company's Proxy Statement, dated March 14, 1994). 4.7 Irrevocable Proxy, dated as of November 18, 1993, of Charles N. Martin (incorporated by reference to the Company's Proxy Statement, dated March 14, 1994). 4.8 Irrevocable Proxy, dated as of November 18, 1993, of M. Lee Pearce, M.D. (incorporated by reference to the Company's Proxy Statement, dated March 14, 1994). 10.1 Employment Agreement with Steven L. Volla (incorporated by reference to Exhibit 10.1, 1992 Form 10-K, File No. 1-8756). 10.2 Employment Agreement with Robert M. Dubbs (incorporated by reference to Exhibit 10.3, 1989 Form 10-K, File No. 1-8756). 10.2(a) Amendment to Employment Agreement with Robert M. Dubbs (incorporated by reference to Exhibit 10.3(a) to the Company's Amendment No. 1 to its Registration Statement--File No. 33-63552, filed on July 2, 1993). 10.3 Employment Agreement with William S. Harrigan (incorporated by reference to Exhibit 10.4, 1991 Form 10-K, File No. 1-8756). 10.4 Specimen of the Company's Stock Plan Agreement (incorporated by reference to Exhibit 10.4, 1990 Form 10-K, File No. 1-8756). 10.5 Lease dated December 27, 1968 by and between Woodland Park Corporation and W.P.H., Inc. (incorporated by reference to Exhibit 10.12, Registration No. 2-92027). 10.6 Ground Lease dated as of November 26, 1979 by and between College Park Realty Co. as lessor ("Lessor") and Nevada Medical Properties, Inc. as lessee ("Lessee"), Agreement for Consent to Assignment of Lease and Guarantee dated as of November 29, 1983 by and among Lessor, Lessee and the Registrant (incorporated by reference to Exhibit 10.25, Registration No. 2-92027). 10.7 Amendment to Ground Lease dated as of July 1, 1991, between College Park Realty Co., as Lessor, and NLVH, Inc., as Lessee (incorporated by reference to Exhibit 10.9, 1991 Form 10-K, File No. 1-8756). 10.8 Lease dated November 25, 1986 by and between Southeast Medical Center as lessor ("Lessor") and Community Hospital of Huntington Park, Inc. as lessee ("Lessee"); Consent to Assignment of Lease dated as of November 22, 1983 by and among Lessor, Lessee and the Registrant; Guarantee dated as of November 22, 1983 by the Registrant (incorporated by reference to Exhibit 10.26, Registration No. 2-92027). 10.9 Lease dated November 25, 1968 by and between Community Hospital Developments, Inc. as lessor ("Lessor") and Community Hospital of Huntington Park, Inc. as lessee ("Lessee"); Consent to Assignment of Lease dated as of November 22, 1983 by and between Lessor, Lessee, and the Registrant; Guarantee dated as of November 22, 1983 by the Registrant (incorporated by reference to Exhibit 10.27, Registration No. 2-92027). 10.10 Lease Agreement by and between the Registrant and The Westover Companies, dated July 10, 1990, and First Amendment to Lease Agreement dated January 10, 1991 (incorporated by reference to Exhibit 10.13, 1990 Form 10-K, File No. 1-8756). 10.11 Lease between Chapman Investment Associates and Chapman General Hospital, Inc. dated as of December 31, 1984; Assignment and Assumption of Lease (Lessee's interest) by and between Chapman General Hospital, Inc., Greatwest Medical Management, Inc. and AHM CGH, Inc. dated as of April 15, 1985; Lease between Chapman Investment Associates and Greatwest Medical Management, Inc. dated as of December 31, 1984; Assignment and Assumption of Lease (Lessee's interest) by and between Chapman General Hospital, Inc., Greatwest Medical Management, Inc., and AHM of California, Inc. dated as of April 15, 1985 (incorporated by reference to Exhibit 10.16, 1989 Form 10-K, File No. 1-8756). 10.12 First Amendment to Amended and Restated Lease dated as of April 1, 1989 between Chapman Investment Associates and AHM CGH, Inc. (incorporated by reference to Exhibit 10.15, 1990 Form 10-K, File No. 1-8756). 10.13 Amendment to Amended and Restated Lease dated as of November 5, 1990 between Chapman Investment Associates and AHM CGH, Inc. (incorporated by reference to Exhibit 10.15, 1991 Form 10-K, File No. 1-8756). 10.14 Lease dated September 15, 1986 between Monterey Park Medical Plaza and Monterey Park Hospital (incorporated by reference to Exhibit 10.17, 1989 Form 10-K, File No. 1-8756). 10.15 Release of Lease and Agreement of Lease dated as of February 1, 1992 among the County Commission of Fayette County, One Valley Bank, National Association, formerly the Kanawha Valley Bank, N.A., as Trustee, and MPC, Inc., regarding Plateau Medical Center (incorporated by reference to Exhibit 10.17, 1990 Form 10-K, File No. 1-8756). 10.16 Registration Rights Agreement dated as of December 19, 1989 relating to the Registrant's Common Stock among certain holders thereof and the Registrant (incorporated by reference to Exhibit 10.20, 1989 Form 10-K, File No. 1-8756). 10.17 Warrant Agreement dated as of December 19, 1989, between the Company and First City, Texas (incorporated by reference to Exhibit 10.23, 1991 Form 10-K, File No. 1-8756). 10.18 Amendment to Warrant Agreement dated as of September 1991, between the Company and First City, Texas (incorporated by reference to Exhibit 10.24, 1991 Form 10-K, File No. 1-8756). 11. Statement Re: Computation of Per Share Earnings, filed herewith. 23.1 Consent of Ernst & Young, filed herewith. 25. Form T-1 Statement of Eligibility and Qualification under the Trust Indenture Act of 1939 of NationsBank of Tennessee, National Association, Trustee (incorporated by reference to the Company's Amendment No. 1 to its Registration Statement--File No. 33-63552). (b) Reports on Form 8-K On December 6, 1993 the Company filed a Form 8-K describing the proposed merger transaction between OrNda HealthCorp and the Company. [* The Registrant will furnish a copy of any exhibit upon the payment of a fee of $.50 per page.] SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in King of Prussia, Pennsylvania, on March 25, 1994. (Date) AMERICAN HEALTHCARE MANAGEMENT, INC. /s/William S. Harrigan ___________________________ William S. Harrigan Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities and on the dates indicated: /s/Steven L. Volla /s/Gerald L. Sauer, Ph.D. ________________________ __________________________ March 25, 1994 (Date) March 25, 1994 (Date) Steven L. Volla Gerald L.Sauer, Ph.D. Chairman, President, Director Chief Executive Officer and Director /s/John W. Gildea /s/William S. Kiser, M.D. ________________________ __________________________ March 25, 1994 (Date) March 25, 1994 (Date) John W. Gildea William S. Kiser, M.D. Director Director /s/John F. Nickoll /s/William S. Harrigan ________________________ __________________________ March 25, 1994 (Date) March 25, 1994 (Date) John F. Nickoll William S. Harrigan Director Chief Financial Officer /s/John J. O'Shaughnessy /s/Bruce J. Colburn ________________________ _____________________________ March 25, 1994 (Date) March 25, 1994 (Date) John J. O'Shaughnessy Bruce J. Colburn Director Chief Accounting Officer /s/C.A. Rundell, Jr. ________________________ March 25, 1994 (Date) C.A. Rundell, Jr. Director SCHEDULE VIII (cont.)

29854_1993.txt

29854

1993

Item 1. Business Douglas & Lomason Company (the "Company" or the "Registrant") is a major supplier of original equipment parts to the North American automotive industry. Automotive products, which have accounted for approximately 93% of the Company's total sales during each of the last three years, include fully trimmed seating, seating components and mechanisms, and decorative and functional body trim parts. These products are manufactured primarily for the three major U.S. automotive manufacturers and other original equipment suppliers. The Company also manufactures material handling systems and custom truck bodies and trailers. These products have accounted for approximately 7% of the Company's total sales during each of the last three years. The Registrant classifies its business into two segments: automotive products and industrial and commercial products. Exclusive of automotive products, no segment accounts for 10 percent or more of consolidated revenues or profits. A summary of certain segment information appears in note (6) of notes to consolidated financial statements on page 24 of the 1993 Annual Report to Shareholders and is incorporated herein by reference. AUTOMOTIVE PRODUCTS Seating Seating systems and components account for the principal portion of the Company's automotive business. The Company is one of the three major independent manufacturers and assemblers of seating systems and components for the North American automotive industry. Seat assemblies produced by the Company satisfy the seat requirements of a full range of vehicles. The Company currently supplies complete seats to customer assembly plants on a "just-in-time" (JIT) "sequenced parts delivery" (SPD) basis for passenger cars, light and medium duty trucks, and vans. The Company's seat frame business has grown significantly over the 47 years it has been supplying seating systems and components to the North American automotive industry. The Company believes it is currently one of the largest independent manufacturers of seat frames in North America. The seat frames manufactured by the Company are incorporated by it into complete seats and sold to vehicle assembly plants and are also sold separately to other seat assemblers. The Company believes that it is recognized as one of the most vertically integrated independent seat manufacturers in North America. The Company is capable of producing seat frames, manual seat mechanisms, foam, covers, suspension systems, and plastic seat trim at its manufacturing facilities. The Company believes that opportunities for growth may emerge in foreign transplant operations in North America and from the expanding trend toward seat assembly outsourcing in Europe. The Company has established technical and business relationships with two Japanese partners to facilitate the exchange of technical information and to establish business relationships with foreign automakers. In 1988, the Company formed a 50/50 joint venture company with Namba Press Works Co., Ltd. of Japan. This company, named Bloomington-Normal Seating Company, is located in Normal, Illinois and manufactures seating systems for Diamond-Star Motors, a subsidiary of Mitsubishi Motors Corporation. The Company also has a license agreement with Imasen Electric of Japan for the manufacture of manual seat adjuster mechanisms. Body Trim Components The Company has been supplying decorative body trim components to the automotive industry since 1902. These products include body side, wheel opening and structural B-pillar moldings, head and tail lamp bezels, bumpers, including those back filled with Azdel, and window and door sealing systems. The Company has the capability of processing large quantities of metal, plastic and composite material parts through injection molding, pressing, rolling, laminating and extruding systems and finishing parts through anodizing and painting. The Company produces a variety of injection molded and extruded plastic moldings including bi-laminate body side and deck lid moldings. These moldings can be finished in a variety of ways such as with a high gloss, in body colors including metallics, or with encapsulated colorful graphics. Product Engineering The Company pursues new products and processes through a 120 person product engineering staff. This staff is customer-focused in that all new projects must be based on a customer's requirements. This facilitates the development of products in shorter lead time and matches products more closely to consumer requirements. Sales and Customers Sales coverage by the Company of the North American automotive industry is maintained by an experienced direct sales staff consisting of 18 account managers, divided into separate and distinct customer-focused groups. The sales group is supported by fully developed program management teams incorporating simultaneous engineering techniques. The percent of sales to total automotive sales of seating systems and body trim components to the three major automotive manufacturers during the past three years is as follows: Sales percentages include sales to other seat assemblers for ultimate sale to the above customers. INDUSTRIAL AND COMMERCIAL PRODUCTS This segment of the Company's business accounted for approximately 7% of total Company sales in each of the three years ended December 31, 1993. Industrial and commercial products include: Material Handling Equipment. The Company designs and manufactures material handling equipment such as conveyors, bagging and packaging machines, pulleys and rollers. The Company also produces related equipment such as elevators, bag flatteners, automatic palletizers and bag placers. These products are sold to the agriculture, mining and transportation industries. Custom Truck Bodies and Trailers. The Company serves the food and beverage industry through the design and manufacture of delivery truck bodies and trailers for soft drinks, beer, bottled water, bakery products, milk and ice cream, meats, frozen foods and other products. These units include side-loading aluminum bodies and trailers, and steel, aluminum or reinforced fiberglass refrigerated truck bodies and trailers. Competition The Company is one of the three major independent seat suppliers to the North American automotive industry. The Company's primary independent competitors are Johnson Controls Inc.'s Automotive Products Group and Lear Seating Inc. The Company also competes with captive seating suppliers, namely: Inland Fisher-Guide Division of General Motors Corporation and the Plastic Trim Products Division of Ford Motor Company. The Company's body trim business competes with a significant number of major competitors. There are 10 to 12 with a full range of material, process and product capabilities similar to the Company's and several competitors with specialized niche products. GENERAL Raw materials purchased by the Registrant consisting of carbon steel, aluminum, stainless steel, plastics, and fabric are generally available from numerous independent sources. Management believes that the trend in its material costs is upward. While the Registrant owns several patents and patent rights, patent protection is not materially significant to its business. To the best of the Registrant's knowledge, its permits are in compliance with all federal, state and local environmental protection provisions. The number of persons employed by the Registrant at December 31, 1993 was 5,697. The Registrant does not consider its business seasonal except to the extent that automotive changeovers to new models affect business conditions. Item 2.

Item 2. Properties The corporate offices of the Company and the product engineering staff are located in Farmington Hills, Michigan in two buildings containing approximately 81,000 square feet. Information as to the Company's 20 principal facilities in operation as of December 31, 1993 is set forth below: The Company believes that substantially all of its property and equipment is in good condition and adequate for its present requirements. Item 3.

Item 3. Legal Proceedings There are no material legal proceedings pending against the Registrant or its subsidiaries. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders Not applicable Executive Officers of the Registrant The names and ages of all executive officers of the Registrant are as follows: Officers of the Registrant are elected each year at the Annual Meeting of the Board of Directors to serve for the ensuing year or until their successors are elected and qualified. All of the executive officers of the Registrant named above have held various executive positions with the Registrant for more than five years except: Mr. Nicholson who has been President and Chief Executive Officer of PVS Chemicals, Inc. and a Director of the Company for more than five years; Mr. Hampton who has been a partner with the law firm of Dickinson, Wright, Moon, Van Dusen and Freeman for more than five years; Mr. Hill who joined the Company in October 1992 after serving in various positions with General Motors Corporation for more than five years, the most recent of which was Director for the Quality Network of the Delco Chassis Division; and Mr. Pniewski who joined the Company in January 1994 after serving in various positions with Ford Motor Company for more than twenty years, the most recent of which was Vehicle Seat Systems Engineering Manager in the Plastics and Trim Products Division. There is no family relationship between any of the foregoing persons. PART II Item 5.

Item 5. Market for the Registrant's Common Equity and Related Shareholder Matters The information set forth under the caption "Shareholder Information" on page 29 the 1993 Annual Report of the Registrant is incorporated by reference herein. As of December 31, 1993 there were 806 holders of record of the Registrant's Common Stock. Item 6.

Item 6. Selected Financial Data The information set forth under the caption "Selected Financial and Other Data" on page 17 the 1993 Annual Report of the Registrant is incorporated by reference herein. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The information set forth under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 16 and 17 of the 1993 Annual Report of the Registrant is incorporated by reference herein. Item 8.

Item 8. Financial Statements and Supplementary Data The information set forth on pages 18 through 27 of the 1993 Annual Report of the Registrant is incorporated by reference herein. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Not Applicable PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant The information set forth under the caption "Information About Directors and Nominees for Directors" on pages 3 and 4 of the definitive Proxy Statement of the Registrant dated March 31, 1994 filed with the Securities and Exchange Commission pursuant to Regulation 14A is incorporated by reference herein for information as to directors of the Registrant. Reference is made to Part I of this Report for information as to executive officers of the Registrant. Item 11.

Item 11. Executive Compensation The information set forth under the caption "Executive Compensation" on pages 6, 7 and 8 of the definitive Proxy Statement of the Registrant dated March 31, 1994 filed with the Securities and Exchange Commission pursuant to Regulation 14A is incorporated by reference herein. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management The information set forth under the caption "Security Ownership" on pages 1 and 2 of the definitive Proxy Statement of the Registrant dated March 31, 1994 filed with the Securities and Exchange Commission pursuant to Regulation 14A is incorporated by reference herein. Item 13.

Item 13. Certain Relationships and Related Transactions The information set forth in footnotes (2) and (3) under the caption "Executive Compensation" and in the last paragraph under the caption "Retirement Plan" on pages 6 and 7 of the definitive Proxy Statement of the Registrant dated March 31, 1994 filed with the Securities and Exchange Commission pursuant to Regulation 14A is incorporated by reference herein. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) The following documents are filed as a part of this report: 1. Financial Statements The following consolidated financial statements of Douglas & Lomason Company and subsidiaries included in the Douglas & Lomason Company 1993 Annual Report to its Shareholders for the year ended December 31, 1993 are incorporated herein by reference: Consolidated Balance Sheets at December 31, 1993 and 1992. Consolidated Statements of Earnings for each of the years in the three year period ended December 31, 1993. Consolidated Statements of Shareholders' Equity for each of the years in the three year period ended December 31, 1993. Consolidated Statements of Cash Flows for each of the years in the three year period ended December 31, 1993. Notes to Consolidated Financial Statements. The consolidated financial information for the years ended December 31, 1993, 1992, and 1991 set forth under "Index to Consolidated Financial Statements and Schedules." EXHIBITS (The Exhibit marked with one asterisk below was filed as an Exhibit to the Form 10-K Report of the Registrant for the fiscal year ended December 31, 1983; the Exhibit marked with two asterisks below was filed as an Exhibit to the Form 10-Q Report of the Registrant for the quarter ended June 30, 1988; the Exhibit marked with three asterisks below was filed as an Exhibit to the Form 10-K Report of the Registrant for the fiscal year ended December 31, 1989; the Exhibits marked with four asterisks below were filed as Exhibits to the Form 10-K Report of the Registrant for the fiscal year ended December 31, 1991; and the Exhibit marked with five asterisks below was filed as an Exhibit to the Form 10-K Report of the Registrant for the fiscal year ended December 31, 1992, and are incorporated herein by reference, the Exhibit numbers in brackets being those in such Form 10-K or 10-Q Reports). (3)(a) Restated Articles of Incorporation of Registrant. (3)(b) By-Laws of the Registrant. (4)(a)** Term Loan Agreement dated as of May 20, 1988 between Registrant and the Banks named in Section 2.1 thereof [1]. (4)(a)(1)**** Amendments to Term Loan Agreement dated as of May 20, 1988. [(4)(a)(1)] (4)(b)**** Term Loan Agreement dated as of December 19, 1991 between Registrant and NBD Bank, N.A. and Manufacturers Bank, N.A., as amended. [(4)(b)] (10)(a)* 1982 Incentive Stock Option Plan of the Registrant [10](1) (10)(b)*** 1990 Stock Option Plan of the Registrant [(10)(b)](1) (10)(c)**** Joint Venture Agreement dated as of July 25, 1986 between Registrant and Namba Press Works Co., Ltd. [(10)(c)] (13) Portions of 1993 Annual Report of Registrant. (22)***** Subsidiaries of the Registrant. [(22)] (24) Consent of KPMG Peat Marwick. (b) Reports on Form 8-K. The Registrant has not filed any reports on Form 8-K during the last quarter of the period covered by this report. (1) This document is a management contract or compensatory plan. SIGNATURES Pursuant to the requirements of the Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on the 29th day of March, 1994. DOUGLAS & LOMASON COMPANY By: /s/H. A. Lomason II ------------------------------- H. A. Lomason II Chairman of the Board, President and Chief Executive Officer (Principal Executive Officer) By: /s/James J. Hoey ------------------------------- James J. Hoey Senior Vice President and Chief Financial Officer (Principal Financial Officer) By: /s/Melynn M. Zylka ------------------------------- Melynn M. Zylka Treasurer (Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on March 29, 1994. Signature Title --------- ----- /s/James E. George Director ---------------------- James E. George /s/H. A. Lomason II Director ---------------------- H. A. Lomason II /s/Dale A. Johnson Director ---------------------- Dale A. Johnson /s/Charles R. Moon Director ---------------------- Charles R. Moon /s/James B. Nicholson Director ---------------------- James B. Nicholson Director ---------------------- Richard N. Vandekieft /s/Gary T. Walther Director ---------------------- Gary T. Walther DOUGLAS & LOMASON COMPANY AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES The consolidated balance sheets of the Company and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, shareholders' equity, and cash flows for each of the years in the three-year period ended December 31, 1993, together with the related notes and the report of KPMG Peat Marwick, independent Certified Public Accountants, all contained in the Company's 1993 Annual Report to Shareholders, are incorporated herein by reference. The following additional financial data should be read in conjunction with the financial statements in the 1993 Annual Report to Shareholders. All other schedules are omitted, as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes. Financial statements and related schedules of the Registrant have been omitted because the Registrant is primarily an operating company and the subsidiaries included in the consolidated financial statements are totally held. Independent Auditors' Report The Board of Directors and Shareholders Douglas & Lomason Company: Under date of January 31, 1994, we reported on the consolidated balance sheets of Douglas & Lomason Company and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, shareholders' equity, and cash flows for each of the years in the three- year period ended December 31, 1993, as contained in the 1993 Annual Report to Shareholders. These financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules as listed in the accompanying index. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in notes 1 and 8 to the consolidated financial statements, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions in 1993. /s/ KPMG Peat Marwick Detroit, Michigan January 31, 1994 Schedule V DOUGLAS & LOMASON COMPANY AND SUBSIDIARIES Property, Plant, and Equipment Years ended December 31, 1991, 1992, and 1993 (Expressed in thousands of dollars) Schedule VI DOUGLAS & LOMASON COMPANY AND SUBSIDIARIES Accumulated Depreciation of Property, Plant, and Equipment Years ended December 31, 1991, 1992, and 1993 (Expressed in thousands of dollars) Schedule VIII DOUGLAS & LOMASON COMPANY AND SUBSIDIARIES Valuation and Qualifying Accounts Years ended December 31, 1992, 1991, and 1990 (Expressed in thousands of dollars) Schedule IX DOUGLAS & LOMASON COMPANY AND SUBSIDIARIES Short-Term Borrowings Years ended December 31, 1992, 1991, and 1990 (Expressed in thousands of dollars, except for percentages) Schedule X DOUGLAS & LOMASON COMPANY AND SUBSIDIARIES Supplementary Income Statement Information Years ended December 31, 1993, 1992, and 1991 (Expressed in thousands of dollars) Other disclosures under Rule 12-11 are omitted because the individual amounts do not exceed 1 percent of total consolidated net sales.

97210_1993.txt

97210

1993

ITEM 1: BUSINESS Teradyne, Inc. is a manufacturer of electronic test systems and backplane connection systems used in the electronics and telecommunications industries. For financial information concerning these two industry segments, see "Note L: Industry Segment and Geographic Information" in Notes to Consolidated Financial Statements. Unless the context indicates otherwise, the term "Company" as used herein includes Teradyne, Inc. and all its subsidiaries. ELECTRONIC TEST SYSTEMS The Company designs, manufactures, markets, and services electronic test systems and related software used by component manufacturers in the design and testing of their products and by electronic equipment manufacturers for the incoming inspection of components and for the design and testing of circuit boards and other assemblies. Manufacturers use such systems and software to increase product performance, to improve product quality, to shorten time to market, to enhance manufacturability, to conserve labor costs, and to increase production yields. The Company's electronic systems are also used by telephone operating companies for the testing and maintenance of their subscriber telephone lines and related equipment. Electronic systems produced by the Company include: (i) test systems for a wide variety of semiconductors, including digital and analog integrated circuits, (ii) test systems for circuit boards and other assemblies, and (iii) test systems for telephone lines and networks. The Company's test systems are all controlled by computers, and programming and operating software is supplied both as an integral part of the product and as a separately priced enhancement. The Company's systems are extremely complex and require extensive support both by the customer and by the Company. Prices for the Company's systems range from less than $100,000 to $5 million or more. BACKPLANE CONNECTION SYSTEMS The Company also manufactures backplane connection systems, principally for the computer, telecom-munications, and military/aerospace industries. A backplane is a panel that supports the circuit boards in an electronic assembly and carries the wiring that connects the boards to each other and to other elements of a system. The Company produces both printed-circuit and metal backplanes, along with mating circuit-board connectors. Backplanes are custom-configured to meet specific customer requirements. The Company has begun to evolve the manufacture of backplane connection systems to the manufacture of fully integrated electronic assemblies that include backplane, card cage, cabling, and related design and production services. MARKETING AND SALES MARKETS The Company sells its products across most sectors of the electronics industry and to companies in other industries that use electronic devices in high volume. The Company believes that it could suffer the loss of one or even a few major customers without serious long-term adverse effects. Sales to Motorola, Inc. were $69.3 million in 1993, which were greater than 10% of the Company's net sales in 1993. No other customer accounted for more than 10% of net sales in 1993. Direct sales to United States Government agencies accounted for approximately 2% of net sales in 1993 and 1992, and 1% in 1991. In addition, sales are made, within each of the Company's segments, to customers who are government contractors. Approximately 33% of all backplane connection systems sales and less than 10% of all electronic test systems sales fell into this category during 1993. The Company's overseas customers are located primarily in Europe, Asia Pacific, and Japan. Sales to overseas customers consist principally of electronic test systems, and these sales occur either through foreign sales subsidiaries or through direct exports. Substantially all of the Company's manufacturing activities are conducted in the United States. Sales to overseas customers accounted for 41% of net sales in 1993, 42% in 1992, and 47% in 1991. Identifiable assets of the Company's foreign subsidiaries, consisting principally of accounts receivable and other operating assets, approximated $65.0 million at December 31, 1993, $86.0 million at December 31, 1992, and $82.0 million at December 31, 1991. Of these identifiable assets at December 31, 1993, $39.0 million were in Europe, $23.0 million were in Japan, and $3.0 million were in Asia Pacific. Since sales to overseas customers have little correlation with the location of manufacture, it is not meaningful to present operating profit by geographic area. The Company is subject to the inherent risks involved in international trade, such as political instability, restrictive trade policies, controls on funds transfer, and foreign currency fluctuations. The Company attempts to reduce the effects of currency fluctuations by hedging part of its exposed position and by conducting some of its foreign transactions in U.S. dollars or dollar equivalents. DISTRIBUTION The Company sells its electronic systems primarily through a direct sales force. Backplane connection systems are sold by direct sales personnel as well as by manufacturers' representatives. The Company has sales and service offices throughout North America, Europe, Asia Pacific, and Japan. COMPETITION Competition is intense in each of the business areas that the Company operates. In each market there are several significant competitors (three to five). Many of these competitors have greater resources than the Company. Competition is principally based on technical performance, equipment and service reliability, reputation and accessibility to the vendor, and price. While relative positions vary from year to year, the Company believes that it operates with a significant market share position in each of its businesses. BACKLOG On December 31, 1993, the Company's backlog of unfilled orders for electronic test systems and backplane connection systems was approximately $238.9 million and $49.1 million, respectively, compared with $183.0 million and $34.8 million, respectively, on December 31, 1992. Of the backlog at December 31, 1993, approximately 75% of the electronic test systems backlog, and substantially all of the backplane connection systems backlog is expected to be delivered in 1994, although the Company's past experience indicates that a portion of orders included in the backlog may be cancelled. There are no seasonal or unusual factors related to the backlog. RAW MATERIALS The Company's products require a wide variety of electronic and mechanical components. In the past, the Company has experienced occasional delays in obtaining timely delivery of certain items. Additionally, the Company could experience a temporary adverse impact if any of its sole source suppliers ceased to deliver products. Management believes, however, that alternate sources could be developed. PATENTS AND LICENSES The development of products by the Company, both hardware and software, is largely based on proprietary information. The various copyrights, trademarks, and patents owned by the Company, together with patent applications pending, are generally not significant in relation to the Company's overall business. However, protection of such proprietary information, through methods such as patents, software license agreements with customers and employee agreements, is important for certain of the Company's products. The Company does not hesitate to assert its rights to intellectual property when, in its view, these rights are infringed upon. Also from time to time, claims have been asserted that certain of its products and technologies infringe the patent rights of third parties. In the opinion of management, none of these claims are expected to have a material effect on the consolidated financial or competitive position of the Company. EMPLOYEES As of December 31, 1993, the Company employed approximately 4,000 persons. Since the inception of the Company's business, there have been no work stoppages or other labor disturbances. The Company has no collective bargaining contracts. ENGINEERING AND DEVELOPMENT ACTIVITIES The highly technical nature of the Company's products requires a large and continuing engineering and development effort. Engineering and development expenditures for new and improved products were approximately $62.4 million in 1993, and $62.0 million in 1992 and 1991. These expenditures amounted to approximately 11% of net sales in 1993, and 12% in 1992 and 1991. ENVIRONMENTAL AFFAIRS The Company's manufacturing facilities are subject to numerous laws and regulations designed to protect the environment, particularly from plant wastes and emissions. These include laws such as the Comprehensive Environmental Response, Compensation and Liability Act of 1980 ("CERCLA"), the Occupational Safety and Health Act, the Clean Air Act, the Clean Water Act, the Hazardous and Solid Waste Amendments of 1984 and Resource Conservation and Recovery Act of 1976. In the opinion of management, compliance with these laws and regulations has not had and will not have a material effect upon the capital expenditures, earnings and competitive position of the Company. EXECUTIVE OFFICERS OF THE COMPANY The following table sets forth the names of all executive officers of the Company and certain other information relating to their positions held with the Company and other business experience. Executive officers of the Company do not have a specific term of office but rather serve at the discretion of the Board of Directors. The Company owns the majority of its manufacturing and office facilities. The Company believes its present and planned facilities and equipment are adequate to service its current and immediately foreseeable business needs. Approximately 120,000 square feet of the Agoura Hills property listed above is currently unoccupied. The Company is subleasing an additional 85,000 square feet of space in Walnut Creek through the expiration of the lease in June 1996. ITEM 3:

ITEM 3: LEGAL PROCEEDINGS The Company is not a party to any litigation that, in the opinion of management, could reasonably be expected to have a material adverse impact on the Company's financial position. ITEM 4:

ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not Applicable. PART II ITEM 5:

ITEM 5: MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SECURITY HOLDER MATTERS The following table shows the market range for the Company's Common Stock based on reported sales prices on the New York Stock Exchange. The number of record holders of the Company's Common Stock at February 25, 1994 was 3,225. The Company has never paid cash dividends because it has been its policy to use earnings to finance expansion and growth. While payment of future dividends will rest within the discretion of the Board of Directors and will depend, among other things, upon the Company's earnings, capital requirements and financial condition, the Company presently expects to retain all of its earnings for use in the business. ITEM 6:

ITEM 6: SELECTED FINANCIAL DATA ITEM 7:

ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS SELECTED RELATIONSHIPS WITHIN THE CONSOLIDATED STATEMENTS OF INCOME RESULTS OF OPERATIONS: 1993 Compared to 1992 Sales increased 5% in 1993, to $554.7 million. The increase in sales was primarily due to a 13% increase in sales of semiconductor test systems and, to a lesser extent, a 7% increase in sales of backplane connection systems. Sales of semiconductor test systems increased as semiconductor manufacturers added capacity in response to rising demand for their products. Sales of circuit-board test systems and telecommunications systems declined 7% and 18%, respectively, in 1993 compared to 1992. Incoming orders increased 19% in 1993 to $625.0 million over 1992 with increased orders occurring in each of the Company's major groups. The Company's backlog grew during 1993 to $288.0 million. Income before taxes increased by $25.3 million from 1992 to 1993 on a sales increase of $25.2 million as the Company continued to control the growth in its operating expenses. In addition, costs in 1993 were lower in the Company's circuit-board test operations following actions taken by the Company in 1992 to consolidate those operations. These lower costs helped to offset the impact of the reduced sales of circuit-board test systems. Cost of sales decreased from 59% of sales in 1992 to 57% in 1993. While sales increased in 1993, the fixed and semi-variable components of cost of sales decreased as a result of the Company's cost reduction programs. The changes in engineering and development expenses and selling and administrative expenses were each less than 1% in 1993, compared to 1992. These expenses have essentially remained at their current level since 1991, as the Company has controlled the growth of its fixed costs. Interest income increased 44% in 1993 as a result of a $76.2 million increase in the Company's cash and cash equivalents balance during the year. Interest expense decreased 12% in 1993 primarily as a result of the Company's retirement of its 9.25% outstanding convertible subordinated debentures in the fourth quarter. The Company's effective tax rate increased from 13.5% in 1992 to 30% in 1993. The Company had been able to utilize net operating loss carryforwards to lower its United States taxable income for financial reporting purposes in 1992, while in 1993 those carryforwards were no longer available. However, the Company's tax rate in 1993 was below the United States statutory rate of 35%, as a result of the utilization of tax credit carryforwards and foreign net operating loss carryforwards. There continue to be tax credit carryforwards and foreign net operating loss carryforward amounts which will lower the Company's prospective tax rate if utilized. The Company adopted Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes" at the beginning of 1993. The effect of this change in accounting principle was not material to the Company's consolidated financial position. See "Note K: Income Taxes" in Notes to Consolidated Financial Statements. In connection with the retirement of the Company's outstanding 9.25% convertible subordinated debentures, the Company incurred, in the fourth quarter of 1993, an extraordinary charge of $0.7 million, net of income taxes, for the costs of the redemption premium of 3.7% and the write off of unamortized debt issuance costs. 1992 Compared to 1991 Sales increased 4% in 1992, to $529.6 million. The sales increase was primarily due to a 13% increase in sales of semiconductor test systems over 1991 and, to a lesser extent, a 7% increase in sales of connection systems. Offsetting the increased sales were reduced sales of circuit-board test systems and telecommunications systems which were down 12% and 5%, respectively. The Company believes that the over-all market for semiconductor test systems declined in 1992 and that, the increase in sales represents market-share growth. The decline in sales of circuit-board test systems was primarily due to a decrease in demand from U.S. government defense contractors. During the year, the Company decided to concentrate its efforts in Electronic Design Automation (EDA) on software products for test generation and design verification. This decision led to the closing of the EDA operation in Santa Clara, California and the consolidation of the EDA operation in Boston, Massachusetts with the circuit-board test division. The Company also decided to move the circuit-board assembly operation in Walnut Creek, California to the central circuit-board assembly operation in Boston. Cost of sales increased as a percent of sales from 58% to 59%. This increase was due to the fact that, while the Company reduced its overhead associated with circuit-board test systems and telecommunications systems, it did not reduce such expenses proportionately with the reduction in sales of these two product lines. Engineering and development expenses were essentially unchanged in 1992, while the amount of selling and administrative expenses increased less than 1% as the Company controlled the growth of these expenses. Interest income increased 78% in 1992 to $2.5 million due to an increase in the Company's cash and cash equivalents balance beginning in the second half of 1991. Cash had grown by $63.8 million from June 29, 1991 to December 31, 1992. Interest expense decreased 21% in 1992 due to a reduction in the average level of debt outstanding during the year and lower average short-term interest rates. The Company's effective tax rate increased from 10% in 1991 to 13.5% in 1992. At the end of 1992, the Company had utilized all of its available U.S. Federal net operating loss carryforwards for financial reporting purposes. LIQUIDITY AND CAPITAL RESOURCES The Company's cash balance increased by $76.2 million in 1993, following an increase of $32.0 million in 1992. Cash flow generated from operations was $91.8 million in 1993 and $40.7 million in 1992. Additional cash of $33.6 million in 1993 and $15.7 million in 1992 was generated from the sale of stock to employees under the Company's stock option and stock purchase plans. In 1992, cash of $3.2 million was also raised from a bank note to finance future construction of a plant in Kumamoto, Japan. Cash was used to fund additions to property, plant and equipment of $32.2 million in 1993 and $28.2 million in 1992. The Company also used $14.7 million of its cash to retire outstanding debt and $2.3 million to purchase stock from its shareholders pursuant to the Company's open market stock repurchase program. The debt retirement included $10.8 million for the repurchase of the outstanding convertible debentures and a cash payment of $3.2 million for the exercise of a purchase option on the Company's headquarters building in Boston, Massachusetts. The Company believes its cash and cash equivalents balance of $143.6 million, together with other sources of funds, including cash flow generated from operations and available borrowing capacity of $80.0 million under its line of credit agreement, will be sufficient to meet future working capital and capital expenditure requirements. Inflation has not had a significant long-term impact on earnings. If there were inflation, the Company's efforts to cover cost increases with price increases would be frustrated in the short term by its relatively high backlog. ITEM 8:

ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY INFORMATION REPORT OF INDEPENDENT ACCOUNTANTS To the Directors and Shareholders of TERADYNE, INC.: We have audited the consolidated financial statements and financial statement schedules of Teradyne, Inc. and Subsidiaries listed below. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Teradyne, Inc. and Subsidiaries as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. COOPERS & LYBRAND Boston, Massachusetts January 24, 1994 TERADYNE, INC. The accompanying notes are an integral part of the consolidated financial statements. TERADYNE, INC. CONSOLIDATED STATEMENTS OF INCOME The accompanying notes are an integral part of the consolidated financial statements. TERADYNE, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS The accompanying notes are an integral part of the consolidated financial statements. TERADYNE, INC. The accompanying notes are an integral part of the consolidated financial statements. TERADYNE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A. ACCOUNTING POLICIES: Basis of Presentation The consolidated financial statements include the accounts of Teradyne, Inc. and its subsidiaries, all of which are wholly owned (referred to collectively in these notes as the "Company"). All significant intercompany balances and transactions have been eliminated. Certain prior years' amounts have been reclassified to conform to the current year presentation. Inventories Inventories are stated at the lower of cost (first-in, first-out basis) or market (net realizable value). Property, Plant and Equipment Property, plant and equipment are stated at cost. Leasehold improvements and major renewals are capitalized and included in property, plant and equipment accounts while expenditures for maintenance and repairs and minor renewals are charged to expense. When assets are retired, the assets and related allowances for depreciation and amortization are eliminated from the accounts and any resulting gain or loss is reflected in operations. The Company provides for depreciation of its property principally on the straight-line method by charges to expense which are sufficient to write off the cost of the assets over their estimated useful lives. Revenue Recognition Revenue is recorded when products are shipped or, in instances where products are configured to customer requirements, upon the successful completion of test procedures. Service revenue is recognized ratably over applicable contract periods or as services are performed. In certain situations, revenue is recorded using the percentage of completion method based upon the completion of measurable milestones, with changes to total estimated costs and anticipated losses, if any, recognized in the period in which determined. Engineering and Development Costs The Company's products are highly technical in nature and require a large and continuing engineering and development effort. All engineering and development costs are expensed as incurred. Income Taxes Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109 (SFAS 109), "Accounting for Income Taxes." This statement superseded the previous accounting standard for income taxes, SFAS 96, which the Company adopted January 1, 1991. The adoption of SFAS 109 had no material effect on the results of operations. Under SFAS 109, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. The measurement of deferred tax assets is reduced by a valuation allowance if, based upon weighted available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. In general, the Company's practice is to provide U.S. federal taxes on undistributed earnings of the Company's foreign sales and service subsidiaries. TERADYNE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A. ACCOUNTING POLICIES -- (CONTINUED) Translation of Foreign Currencies Assets and liabilities of foreign subsidiaries which are denominated in foreign currencies have been remeasured into U.S. dollars at rates of exchange in effect at the end of the fiscal year except fixed assets which have been remeasured using historical exchange rates. Revenue and expense accounts have been remeasured using an average of exchange rates in effect during the year. Net realized and unrealized gains and losses resulting from foreign currency remeasurement are included in operations. Financial Instruments and Related Disclosures Financial instruments consist primarily of investments in cash, cash equivalents and accounts receivables and obligations under accounts payable and debt instruments. Fair value of financial instruments have been determined through information obtained from market sources and management estimates. At December 31, 1993, the fair value of the Company's financial instruments approximates the carrying value. The Company enters into foreign exchange contracts to hedge assets, liabilities, and transactions denominated in foreign currencies on a continuing basis for periods consistent with its committed exposures. The foreign exchange contracts are used to reduce the Company's risk associated with exchange rate movements, as gains and losses on these contracts are intended to offset foreign exchange gains and losses on the assets, liabilities, and transactions being hedged. As of December 31, 1993, the Company had $51.9 million of foreign exchange contracts outstanding, $40.0 million of which were in German marks, $11.0 million in various other European currencies, and $0.9 million in Japanese yen. The German mark contracts have maturities of one to three years. The Company's other foreign exchange contracts generally have maturities which do not exceed six months. All of the foreign exchange contracts require the Company to exchange foreign currencies for U.S. dollars at maturity, at rates agreed to at inception of the contracts. Financial instruments which potentially subject the Company to concentrations of credit risk consist principally of cash equivalents and trade receivables. The Company places its cash equivalents in high grade financial instruments and, by policy, limits the amount of credit exposure to any one financial institution. Concentrations of credit risk with respect to trade receivables are limited due to the large number of diverse and geographically dispersed customers. Net Income Per Common Share Net income per common share is based upon the weighted average number of common and common equivalent shares (when dilutive) outstanding each year. Common equivalent shares result from the assumed exercise of outstanding stock options, the proceeds of which are then assumed to have been used to repurchase outstanding common stock at the average market price during the year. TERADYNE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS B. CASH AND CASH EQUIVALENTS Cash equivalents consist of short-term investments in money market instruments with an original maturity of three months or less. These amounts are carried at cost plus accrued interest, which approximates market value. Of the $143.6 million cash and cash equivalents balance at December 31, 1993, cash equivalents amounted to $125.3 million, which included $112.5 million of U.S. Treasury bills. Of the $67.4 million cash and cash equivalents balance at December 31, 1992, cash equivalents amounted to $58.8 million, which included $50.8 million of U.S. Treasury bills. C. LONG-TERM DEBT Long-term debt at December 31, 1993 and 1992 consisted of the following (in thousands): The total maturities of long-term debt for each of the next five years are $0.5 million. Revolving Credit Agreement The Company has $80.0 million of revolving credit available through January 31, 1996 under a domestic line of credit agreement with its banks. Under the terms of the agreement, any amounts outstanding at December 31, 1996 are converted into a one year term note. As of December 31, 1993, no amounts were outstanding under this agreement. The terms of this line of credit also include restrictive covenants regarding the working capital, tangible net worth and leverage. Interest rates on borrowings are either at the stated prime rate or based upon Eurocurrency or certificate of deposit interest rates. Additional domestic and foreign borrowings up to $30.0 million are permitted outside the agreement provided that the liabilities of the Company, exclusive of deferred income taxes and subordinated debt, shall not exceed 100% of the Company's tangible net worth. Mortgage Note Payable The Company has received a loan of $4.5 million from the Boston Redevelopment Authority in the form of a 3% mortgage loan maturing March 31, 2013. This loan is collateralized by a mortgage on the Company's property at 321 Harrison Avenue which may, at the Company's option, become subordinated to another mortgage up to a maximum of $5.0 million. For the first 4 1/2 years of the note, interest was accrued but not paid ("Accrued Interest"). Beginning September 30, 1987, semi-annual interest payments are being paid on principal and Accrued Interest. The principal and Accrued Interest are payable in full at maturity. Industrial Revenue Bonds At December 31, 1993, the Company has outstanding industrial revenue bonds, in the amount of $1.3 million, maturing in 1998 and 1999. These bonds are payable in quarterly installments, including interest at the higher of 75% of the stated prime rate or 7 1/2%. The bonds are collateralized by mortgage interests on certain properties owned by the Company. TERADYNE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS C. LONG-TERM DEBT -- (CONTINUED) Capitalized Lease Obligations On December 31, 1993, the Company exercised its lease option to purchase the property located at 321 Harrison Avenue, Boston, Massachusetts for $3.2 million. Other Long-term Debts At December 31, 1993, other long-term debt consists principally of a Japanese yen-denominated note in the amount of $3.6 million at an interest rate of 4.8%, secured by land in Kumamoto, Japan, with interest only payable until March 31, 1995, and principal and interest payable in monthly installments from April 29, 1995 to March 30, 2007. D. CONVERTIBLE SUBORDINATED DEBENTURES At December 31, 1992, the Company had outstanding $15.4 million of 9.25% convertible subordinated debentures due March 15, 2012. These debentures were convertible into shares of the Company's common stock any time prior to maturity at a conversion price of $23.50 per share. The amount shown on the Consolidated Balance Sheets at December 31, 1992 was net of $1.0 million unamortized debt issue costs. During 1993, $5.0 million principle amount of debentures were converted into 210,585 shares of common stock resulting in an increase of $4.7 million of shareholders' equity (net of the related $0.3 million unamortized debt issue costs). On November 19, 1993, the Company exercised its option to repurchase the remaining $10.4 million outstanding debentures. The Company used $10.8 million of available cash from operations to repurchase the debentures at a premium of 103.7% of the principal amount. The premium amount and the writeoff of the remaining unamortized debt issue cost resulted in a charge of $1.0 million. This charge, net of the related taxes of $0.3 million, is reflected as an extraordinary loss in the Consolidated Statements of Income. E. COMMITMENTS Rental expense for the years ended December 31, 1993, 1992, and 1991 was $11.2 million, $12.6 million, and $13.0 million, respectively. Minimum annual rentals under all noncancellable leases are: 1994 -- $6.8 million; 1995 -- $5.5 million; 1996 -- $2.6 million; 1997 -- $1.1 million; 1998 -- $0.9 million; and $6.3 million thereafter, totalling $23.2 million. Offsetting the future lease payments, the Company's income from noncancellable subleases totals $1.2 million. TERADYNE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS F. PENSION PLANS The Company has defined benefit pension plans covering substantially all domestic employees and employees of certain international subsidiaries. Benefits under these plans are based on the employee's years of service and compensation. The Company's funding policy is to make contributions to the plans in accordance with local laws and to the extent that such contributions are tax deductible. The assets of the plans consist primarily of equity and fixed income securities. In 1993, the Company established a supplemental defined benefit pension plan in the United States to provide retirement benefits in excess of levels allowed by ERISA. In 1992, the Company established a defined benefit pension plan covering its employees in Japan. The Company's foreign plans were not included in the table below in 1991 because they were not significant in the aggregate. Net pension expense for the domestic plans was $2.4 million in 1993, $1.8 million in 1992, and $1.5 million in 1991. The components of net pension expense are summarized as follows (in thousands): The following table sets forth the plans' funded status at December 31 (in thousands): The Company has recorded an additional minimum pension liability for underfunded plans of $7.5 million at December 31, 1993, representing the excess of unfunded accumulated benefit obligations over previously recorded pension cost liabilities. A corresponding amount has been recognized as an intangible asset to the extent of related unrecognized prior service cost of $5.2 million, with the remaining amount of $1.5 million, net of taxes of $0.8 million, recorded as a charge to stockholders' equity. TERADYNE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS G. STOCK OPTION PLANS Under its stock option plans, the Company has granted options to certain directors, officers and employees entitling them to purchase common stock at 100% of market value at the date of grant. There have been no charges to income in connection with these options other than incidental expenses related to the issuance of shares. TERADYNE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS H. SAVINGS PLAN The Company sponsors a Savings Plan covering substantially all domestic employees. Under this plan, employees may contribute up to 12% of their compensation (subject to Internal Revenue Service limitations). The Company annually matches employee contributions of up to 6% of such compensation at rates ranging from 50% to 100%. The Company's contributions vest after two years, although contributions for those employees with five years of service vest immediately. The trustees of the Savings Plan have been granted an option to purchase 900,000 shares of the Company's common stock, exercisable at $9.50 per share (the fair market value of the Company's common stock at the date of the grant) in five cumulative annual installments beginning in 1990. The trustees exercised 335,000, 200,000, and 100,000 shares respectively in 1993, 1992, and 1991. Under the terms of the Plan, any gains realized from the sale of option shares are first allocated to participants' accounts to fund up to one-half of the minimum Company contribution, with any excess applied to additional funding. Under this plan, the amounts charged to operations were $2.0 million in 1993 and 1992, and $1.8 million in 1991. I. EMPLOYEE STOCK PURCHASE PLAN Under the 1979 Stock Purchase Plan, employees are entitled to purchase shares of common stock through payroll deductions of up to 10% of their compensation. The price paid for the common stock is equal to 85% of the lower of the fair market value of the Company's common stock on either the first or last business day of the year. In January 1994, the Company issued 375,124 shares of common stock to employees who participated in the plan during 1993 at a price of $12.82 per share. Currently there are 405,869 shares reserved for issuance. There have been no charges to income in connection with this plan other than incidental expenses related to the issuance of shares. J. STOCKHOLDER RIGHTS PLAN The Company's Board of Directors adopted a Stockholder Rights Plan on March 14, 1990. Under the Plan, the Company distributed to stockholders a dividend of one Common Stock Purchase Right for each outstanding share of Common Stock. Initially, the Purchase Rights enable a stockholder to purchase one share of Teradyne Common Stock for $40.00. Upon certain events, such as the initiation of a tender offer for more than 30% of the Company's Common Stock, the Purchase Rights allow stockholders to purchase $80.00 worth of Common Stock (or other securities or consideration as determined by Continuing Directors of the Company) for $40.00. Generally, at any time until 10 days following the announcement that a person has acquired 20% of the outstanding shares of the Company, the Company may redeem the Purchase Rights for $0.01 per share. The Plan will expire March 26, 2000, unless earlier redeemed by the Company. K. INCOME TAXES Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109 (SFAS 109), "Accounting for Income Taxes." As permitted by SFAS 109, the Company has elected not to restate its financial statements for any periods prior to 1993. The effect on operations for 1993 was immaterial. However, upon adoption of SFAS 109 the Company increased Additional Paid-in Capital by $5.7 million relating to the tax benefits to be derived from the utilization of U.S. net operating loss carryforward amounts resulting from tax deductions pertaining to the issuance of the Company's stock to employees under its benefit plans. TERADYNE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS K. INCOME TAXES -- (CONTINUED) The components of income before income taxes and extraordinary item and the provision (credit) for income taxes as shown in the Consolidated Statements of Income are as follows (in thousands): Under SFAS 109, deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company's deferred tax assets (liabilities) as of December 31, 1993 are as follows (in thousands): TERADYNE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS K. INCOME TAXES -- (CONTINUED) The valuation allowance applies to U.S. federal and foreign tax credit carryforwards, and net operating losses carryforwards in certain foreign jurisdictions that may expire before the Company can utilize them. For U.S. federal and foreign tax return purposes, the Company has approximately $8.4 million and $10.7 million, respectively of net operating loss carryforwards, of which $5.2 million expire in the years 1995 through 1998, $8.4 million expire in the year 2005, and $5.5 million may be carried forward indefinitely. The Company also has available U.S. federal and foreign tax credits carryforwards of approximately $4.1 million, of which $2.4 million expire in the years 2000 through 2002, $0.5 million in the year 2008, and the remainder indefinitely. The components of the provision (benefit) for deferred income taxes for the years ended December 31, 1992 and 1991 are as follows (in thousands): Below is a reconciliation of the effective tax rates for the three years indicated: TERADYNE, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS L. INDUSTRY SEGMENT AND GEOGRAPHIC INFORMATION The Company operates in principally two industry segments, which are the design, manufacturing and marketing of electronic test systems and backplane connection systems. Corporate assets consist principally of cash and cash equivalents, deferred tax assets and certain other assets. The Company's sales to unaffiliated customers for the three years ended December 31 were made to customers in the following geographic areas: See "Item 1: Business -- Marketing and Sales" elsewhere in this report for information on the Company's export activities, identifiable assets of foreign subsidiaries, and major customers. SUPPLEMENTARY INFORMATION (UNAUDITED) Quarterly financial information for 1993 and 1992 (in thousands of dollars, except per share amounts): ITEM 9:

ITEM 9: DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10:

ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Certain information relating to directors and executive officers of the Company, executive compensation, security ownership of certain beneficial owners and management, and certain relationships and related transactions is incorporated by reference herein from the Company's definitive proxy statement in connection with its Annual Meeting of Stockholders to be held on May 26, 1994, which proxy statement will be filed with the Securities and Exchange Commission not later than 120 days after the close of the fiscal year. For this purpose, the Management Compensation and Development Committee Report and Performance Graph included in such proxy statement are specifically not incorporated herein. (Also see "Item I -- Executive Officers of the Company" elsewhere in this report.) ITEM 11:

ITEM 11: EXECUTIVE COMPENSATION. Certain information relating to directors and executive officers of the Company, executive compensation, security ownership of certain beneficial owners and management, and certain relationships and related transactions is incorporated by reference herein from the Company's definitive proxy statement in connection with its Annual Meeting of Stockholders to be held on May 26, 1994, which proxy statement will be filed with the Securities and Exchange Commission not later than 120 days after the close of the fiscal year. For this purpose, the Management Compensation and Development Committee Report and Performance Graph included in such proxy statement are specifically not incorporated herein. ITEM 12:

ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Certain information relating to directors and executive officers of the Company, executive compensation, security ownership of certain beneficial owners and management, and certain relationships and related transactions is incorporated by reference herein from the Company's definitive proxy statement in connection with its Annual Meeting of Stockholders to be held on May 26, 1994, which proxy statement will be filed with the Securities and Exchange Commission not later than 120 days after the close of the fiscal year. For this purpose, the Management Compensation and Development Committee Report and Performance Graph included in such proxy statement are specifically not incorporated herein. ITEM 13:

ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Certain information relating to directors and executive officers of the Company, executive compensation, security ownership of certain beneficial owners and management, and certain relationships and related transactions is incorporated by reference herein from the Company's definitive proxy statement in connection with its Annual Meeting of Stockholders to be held on May 26, 1994, which proxy statement will be filed with the Securities and Exchange Commission not later than 120 days after the close of the fiscal year. For this purpose, the Management Compensation and Development Committee Report and Performance Graph included in such proxy statement are specifically not incorporated herein. PART IV ITEM 14:

ITEM 14: EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (A)1. FINANCIAL STATEMENTS The following consolidated financial statements are included in Item 8: Balance Sheets as of December 31, 1993 and 1992 Statements of Income for the years ended December 31, 1993, 1992 and 1991 Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 Statements of Changes in Shareholders' Equity for the years ended December 31, 1993, 1992 and 1991 (A)2. FINANCIAL STATEMENT SCHEDULES The following consolidated financial statement schedules are included in Item 14(d): Schedule V -- Property Schedule VI -- Accumulated Depreciation, Depletion and Amortization of Property Schedule IX -- Short-term Borrowings Schedule X -- Supplementary Income Statement Information Schedules other than those listed above have been omitted since they are either not required or the information is otherwise included. (A)3. LISTING OF EXHIBITS Executive Compensation Plans and Arrangements 1. 1987 Non-Employee Director Stock Option Plan (filed as Exhibit 3.10(iii) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992). 2. Teradyne, Inc. Supplemental Executive Retirement Plan (filed as Exhibit 3.10(iv) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992). (B) REPORTS ON FORM 8-K There have been no 8-K filings during the three months ended December 31, 1993. (C) EXHIBITS The Company hereby files as part of this Form 10-K the exhibits listed in Item 14 (a) 3 as set forth above. SIGNATURES PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED THIS DAY OF MARCH, 1994. TERADYNE, INC. By: /s/ OWEN W. ROBBINS ------------------------------------ OWEN W. ROBBINS, EXECUTIVE VICE PRESIDENT PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. S-1 S-2 S-3

7383_1993.txt

7383

1993

ITEM 1. BUSINESS General Armco Inc. ("Armco" or the "Company") was incorporated as an Ohio corporation in 1917 as a successor to a New Jersey corporation incorporated in 1899. Armco is the second largest domestic producer of stainless flat-rolled steels and is the largest domestic producer of electrical steels in terms of sales revenues. The Company also produces carbon steels and steel products and tubular steel goods. The Company is a partner in Armco Steel Company, L.P. ("ASC"), a 50%-owned joint venture with Kawasaki Steel Corporation ("Kawasaki") that produces primarily high-strength, low-carbon flat-rolled steel products. Armco is also a partner in North American Stainless ("NAS"), a 50%-owned joint venture with Acerinox S.A. that finishes chrome nickel flat-rolled stainless steel. The Company owns a 50% partnership interest in National-Oilwell, a distributor of oil country tubular goods and a manufacturer of drilling, production and other oil and gas equipment that operates a network of oil field supply stores throughout North America. Armco also provides insurance services through businesses it intends to sell or liquidate. As part of its strategy to focus on Specialty Flat-Rolled Steel, Armco has continued to evaluate the growth potential and profitability of its businesses and investments, and to rationalize or divest those that do not represent a strategic fit or offer growth potential or positive cash flow. In 1992 and 1993, Armco divested or otherwise rationalized several unprofitable or non-strategic operations. In September 1993, Armco sold its joint venture interest in several wire-drawing operations in its Worldwide Grinding Systems segment, and in November 1993, Armco sold the balance of its Worldwide Grinding Systems business. Also in September 1993, Armco sold Armco do Brasil S.A., its Brazilian sheet and strip business, and made a decision to dispose of several other businesses in its Other Steel and Fabricated Products segment, including Miami Industries (which was sold in October 1993), its Tex-Tube Division, its conversion services businesses and Flour City Architectural Metals. On January 28, 1994, Armco signed a letter of intent to sell its ongoing insurance operations to Vik Brothers Insurance, Inc., a privately owned property and casualty insurance holding company. Under the terms of the letter of intent, approximately $70 million would be received at closing and approximately $15 million would be received in three years, the latter payment being subject to a reserve analysis and potential adjustment at that time. As a result of restructuring certain obligations arising from the 1992 merger plan for the runoff companies, the proceeds from the sale have been pledged as security for certain note obligations due to the runoff insurance companies and will be retained in the investment portfolio of the Armco Financial Services Group runoff companies. The transaction is subject to a number of conditions, including a definitive purchase agreement, approval by regulatory authorities and approval of the boards of directors of Armco and the purchaser. In connection with the foregoing actions, Armco recorded in 1993 charges totaling $250.5 million, which included special charges of $165.5 million reflected in operating losses, and an $85.0 million charge reflected as loss on disposal of discontinued operations, which included a $45.0 million charge for expenses and losses in connection with the proposed sale of the ongoing insurance companies and $40.0 million in connection with the sale of the Worldwide Grindings Systems segment. The previously reported initial public offerings of equity and debt, through which ASC would implement its plan to restructure and recapitalize itself, commenced on March 30, 1994, with the underwritten public offerings by the corporate successor to ASC of approximately 17.6 million shares of common stock, at $23.50 per share, and $325 million of senior notes. The sales of the securities and the restructure and recapitalization are scheduled to be completed on April 7, 1994. Under the terms of the plan, the proceeds from the offerings will be used by ASC primarily to reduce its debt and unfunded pension liability, Armco's obligations to make certain cash payments to ASC will be eliminated and Armco will receive approximately 1 million shares, or approximately 4.2%, of the successor corporation's common stock. Business Segments Following the sale in the fourth quarter of 1993 of the business of Armco's former Worldwide Grinding Systems segment, Armco will report its businesses in two segments -- Specialty Flat-Rolled Steel and Other Steel and Fabricated Products. The information on the amounts of revenue, operating results and identifiable assets attributable to each of Armco's business segments set out in Note 9 of the Notes to Financial Statements in Armco's Annual Report to Shareholders for the year ended December 31, 1993, is incorporated by reference herein. Additional information about Armco's business segments and equity investments is set forth in Management's Discussion and Analysis in Armco's Annual Report to Shareholders for the year ended December 31, 1993, which is incorporated by reference herein. Specialty Flat-Rolled Steel Armco's Specialty Flat-Rolled Steel businesses produce and finish stainless and electrical steel sheet and strip and stainless plate. The Specialty Flat-Rolled Steel group is headquartered in Butler, Pennsylvania, with its principal manufacturing plants in Butler and Zanesville, Ohio, where Armco produces flat-rolled stainless and electrical steel sheet and strip products, and in Coshocton, Ohio, where Armco finishes premium quality flat-rolled stainless steel in strip and sheet form. The segment also includes Eastern Stainless Corporation ("Eastern"), an 84%-owned subsidiary located in Baltimore, Maryland, which is a leading domestic producer of stainless steel plate as well as the results of European trading companies that buy and sell steel and manufactured steel products. Armco has a 50% interest in NAS, located in Carrollton, Kentucky, which began customer shipments in mid-1993 and can finish flat-rolled stainless steel in widths up to 60 inches. The NAS interest is accounted for as an equity investment. The specialty steel industry is a relatively small but distinct segment of the overall steel industry that represented approximately 2% of domestic steel tonnage but accounted for approximately 17% of domestic steel revenues in 1993. Specialty steels refer to alloy tool steel, electrical steel and stainless sheet, strip, plate, bar, rod and wire products. Specialty steels differ from basic carbon steel by their metallurgical composition. They are made with a high alloy content, which enables their use in environments that demand exceptional hardness, toughness, strength and resistance to heat, corrosion or abrasion or combinations thereof. Unlike high-volume carbon steel, specialty steel is generally produced in relatively small quantities utilizing special processing techniques designed to meet more exacting specifications and tolerances. Stainless steel, which represents the largest part of the specialty steel market, contains elements such as chromium, nickel and molybdenum that give it the unique qualities of resistance to rust, corrosion and heat; high strength; good wear characteristics; natural attractiveness; and ease of maintenance. Stainless steel is used, among other things, in the automotive, aircraft, and aerospace industries and in the manufacture of food handling, chemical processing, pollution control and medical and health equipment. Electrical steels are iron-silicon alloys and, through special production techniques, possess unique magnetic properties that make them desirable for use as energy efficient core material in such applications as electrical transformers, motors and generators. Since 1975, usage of stainless steel in the United States has more than doubled. Armco expects that the demand for stainless steel will continue to be positively affected by increasing use in the manufacture of consumer durable goods and industrial applications. Per capita stainless steel usage in many highly developed countries significantly exceeds usage per capita in the United States and Armco believes that this is an indication of the growth potential of demand for stainless steel in the United States. In addition, the 1990 amendments to the Clean Air Act have resulted in the increasing use of corrosion-resistant materials in a number of applications for which stainless steel is well suited, including industrial pollution control devices and motor vehicle exhaust systems for use in the United States, where Armco now has the leading market share. Another factor that Armco believes will affect demand positively is the increasing issuance of new car bumper-to-bumper warranties and the use of stainless steel in passenger restraint systems. Stainless steel products generate higher average profit margins than carbon steel products and, depending on the stainless grade, sell at average prices of three to five times those of carbon steel. Armco produces flat-rolled stainless steel and alloy electrical steel sheet and strip products that are used in a diverse range of consumer durables and industrial applications. Since the acquisition of Cyclops, approximately 70% of Armco's sales of Specialty Flat-Rolled Steel has been stainless steel and 30% has been electrical steel. Major markets served are industrial machinery and electrical equipment, automotive, construction and service centers. In the stainless steel market, Armco is the leading domestic producer of chrome grades used primarily in the domestic market for automotive exhaust components. Stainless steel, which formerly was not used in parts of the exhaust system other than the catalytic converter, is now used in the entire exhaust system from manifold to tailpipe by many auto manufacturers. Armco has developed a number of specialty grades for this application, many of which are patented. Armco is also known for its "bright anneal" chrome grade finishes utilized for automotive and appliance trim and other chrome grades used for cutlery, kitchen utensils, scissors and surgical instruments. Specialty chrome nickel grades produced by Armco are used in household cookware, restaurant and food processing equipment and medical equipment. Commodity chrome nickel stainless steel finished by NAS and marketed by Armco is expected to meet anticipated demand from steel service centers and end users who serve the domestic chemical, pulp and paper, construction and food and beverage industries. Other Armco stainless products include functional stainless steel manufactured for automotive, agricultural, heating, air conditioning and other manufacturing uses and Eastern's stainless steel plate, principally in flat plate form, for use in industrial applications where high resistance to heat, stress or corrosion is required. Typical users of stainless steel plate include the chemical processing, pulp and paper, food and beverage, waste treatment, environmental control and textile industries for applications such as tanks, piping and tubing, flue gas scrubbers and heat exchangers. Eastern is also the only domestic producer of diamond-patterned stainless floor plate that is used primarily in decking for ships and chemical plant construction. Armco is the only United States manufacturer of a complete line of flat-rolled electrical steel sheet and strip products and is the sole domestic producer of certain high permeability oriented electrical steels. It is also the only domestic manufacturer utilizing laser scribing technology. In this process, the surface of electrical steel is etched with high-technology lasers which refine the magnetic domains of the steel resulting in superior electrical efficiency. Major electrical product categories are: Regular Grain Oriented ("RGO"), used in the cores of energy-efficient power and distribution transformers; Cold Rolled Non-Oriented ("CRNO"), used for electrical motors and lighting ballasts; and TRAN COR(R)H, which is used in power transformers and is the only high permeability electrical steel made domestically. In 1993, Armco exported approximately 18.7% of its RGO product to Mexico, South America and other international markets. Armco had trade orders in hand for its Specialty Flat-Rolled Steel segment of $154.8 million at December 31, 1993, and $132.7 million at December 31, 1992. The backlog increased in 1993 due to stronger demand and an improving economy. While substantially all of the orders in hand at year-end 1993 are expected to be shipped in 1994, such orders, as is customary in the industry, are subject to modification, extension and cancellation. Armco's specialty steelmaking operations are concentrated in the four contiguous states of Pennsylvania, Ohio, Kentucky and Maryland, which permits cost-efficient materials flow between plants. Armco's Butler, Pennsylvania facility, which is situated on 1,300 acres with 3.2 million square feet of buildings, continuously casts 100% of its steel. At Butler, melting takes place in three 165-ton electric arc furnaces that feed the world's largest (175-ton) argon-oxygen decarburization unit for refining molten metal that, in turn, feeds two double strand continuous casters. The melt capacity at Butler was approximately 850,000 tons by year-end 1993. Butler also operates a hot-strip mill, anneal and pickle units and a fully-automated tandem cold-rolling mill. It also has various intermediate and finishing operations for both stainless and electrical steels. Armco's Zanesville, Ohio plant, with 508,000 square feet of buildings on 88 acres, is a dedicated finishing plant for some of the steel produced at the Butler facility and has a Sendzimer cold-rolling mill, anneal and pickle units, high temperature box anneal and other decarburization and coating units. The world-class finishing plant in Coshocton, Ohio, located on 650 acres, is housed in a 500,000 square-foot plant and has three Sendzimer mills, four anneal and pickle lines, three "bright anneal" lines, two 4-high mills for cold reduction and other processing equipment, including temper rolling, slitting and packaging facilities. Armco's joint venture, NAS, which began customer shipments in mid-1993, is a state-of-the-art stainless steel finishing facility in Carrollton, Kentucky. NAS produces high volume grades of flat-rolled chrome nickel stainless in coils up to 30 tons and in widths up to 60 inches, a product that offers cost and handling savings to customers. The new plant is highly automated, featuring anneal and pickle lines, a Sendzimer cold-rolling mill, and other related equipment using world-class technology. Since Eastern discontinued its melt operations on July 22, 1993, Eastern's operations consist primarily of a hot plate rolling mill and finishing facility in Baltimore, Maryland, with its slab requirements largely being supplied by Armco's Butler facility. Other Steel and Fabricated Products The Other Steel and Fabricated Products segment includes steelmaking, fabricating and processing plants in Pennsylvania and Ohio; a nonresidential construction company; a steel tubing company; and a snowplow manufacturer. The businesses in this segment currently include: -- Carbon steel operations at Mansfield, Ohio, which produce commodity grades of carbon steel sheet, much of which is coated at a dedicated galvanizing facility at Dover, Ohio. Under a plan to spend approximately $100 million at Mansfield to enhance its steel production capability and improve the operating performance of both the Mansfield and Dover, Ohio operations, Armco has begun installing a thin-slab caster and related plant modifications at Mansfield. Installation is expected to be completed in 1995. The caster is designed to produce carbon steels, functional grades of chrome stainless steels and nonoriented grades of electrical steels. The Mansfield plant currently consists of a 1.4 million square-foot facility, with a melt shop with two electric arc furnaces (170-ton and 100-ton), a 100-ton argon-oxygen decarburization unit, a six-stand hot strip mill, a five-stand tandem cold rolling mill and a newly retrofitted Z-mill for chrome stainless finishing. On March 28, 1994, Armco announced its intention to idle the production facilities at its Empire-Detroit carbon steel plant in Mansfield, Ohio and the Dover, Ohio galvanizing plant. The plants are expected to remain idle until the previously announced construction of a $100 million thin-slab caster is completed, which is scheduled for mid-1995. Armco expects to recognize a special charge of up to $20 million in the first quarter of 1994 for the cost of benefits to employees on layoff and other costs of idling the facilities, as well as costs associated with planned permanent work force reductions. -- Douglas Dynamics, which is the largest North American manufacturer of snowplows for four-wheel drive pick-up trucks and utility vehicles. Douglas Dynamics is headquartered in Milwaukee, Wisconsin, has snowplow manufacturing plants in Rockland, Maine and Milwaukee, Wisconsin and sells its snowplows through independent distributors throughout the United States and Canada. -- Sawhill Tubular, which produces steel pipe and tubing, electric welded and mandrel-drawn steel tubing and electric-resistance welded steel pipe at its plant in Pennsylvania. During 1993, Armco divested or decided to dispose of various businesses previously in this segment: -- Armco sold Miami Industries, a steel tubing company, in October 1993, and has also decided to dispose of Tex-Tube, another steel tubing business. As of September 30, 1993, results for both Miami Industries and Tex-Tube are no longer reported as part of the Other Steel and Fabricated Products segment. -- Flour City Architectural Metals, headquartered in Glen Cove, New York, which designs, fabricates and installs custom curtain wall systems in nonresidential commercial and institutional construction. In February 1993, Armco sold part of its nonresidential construction business. As of September 30, 1993, Armco decided to dispose of the remainder of this business and no longer reports the results of its nonresidential construction businesses as part of the Other Steel and Fabricated Products segment. -- Conversion services (remelting, forging, blooming, anneal and pickling and heat treating) provided in plants in Baltimore, Maryland and Bridgeville, Pennsylvania. As of September 30, 1993, Armco decided to dispose of these businesses and no longer reports their results as part of the Other Steel and Fabricated Products segment. This segment also included the business of Armco do Brasil S.A., a fabricating and processing plant in Brazil that processed semi-finished steel. Armco sold this business in September 1993. Armco had trade orders in hand for its Other Steel and Fabricated Products segment of $73.0 million at December 31, 1993. The segment's backlog decreased in 1993 primarily as a result of the 1993 sale or planned divestiture of a number of businesses. While substantially all of the orders in hand at year-end 1993 are expected to be shipped in 1994, such orders, as is customary in these industries, are subject to modification, extension and cancellation. Employees At December 31, 1993, Armco had approximately 6,600 employees in its continuing operations and approximately 2,300 employees in its insurance and discontinued operations. Most of Armco's domestic production and maintenance employees are represented by international, national or independent local unions, although some operations are not unionized. Eastern recently completed two-year agreements with the United Steelworkers of America ("USWA"), the union that represents employees at the Eastern plant in Baltimore, Maryland. Armco also recently completed 36-month and 33-month agreements, respectively, with the local unions at the specialty steel plants in Butler, Pennsylvania and Zanesville, Ohio. In late June, the USWA employees at Armco's Mansfield and Dover, Ohio plants ratified new six-year contracts, which became effective September 1, 1993. Competition Armco's steel products are subject to wide variations in demand because of changes in business conditions. Armco faces intense competition within the domestic steel industry, from foreign steel producers, from manufacturers of products other than steel, including aluminum, ceramics, plastics and glass, and from foreign producers of steel components and products that typically have lower labor costs. In addition, many foreign steel producers are owned, controlled or subsidized by their governments and their decisions with respect to production and sales may be influenced more by political and economic policy considerations than by prevailing market conditions. Some foreign producers of steel and products made of steel have continued to ship into the United States market despite decreasing profit margins or losses. If certain pending trade proceedings ultimately do not provide relief from unfairly traded imports, if other relevant U.S. trade laws are weakened, if world demand for steel declines or if the U.S. dollars strengthens, an increase in the market share of imports may occur and the pricing of the Company's products could be adversely affected. Competition is based primarily on price, with factors such as reliability of supply, service and quality also being important in certain segments. In addition to the other integrated steel producers, competition is presented by the so-called "mini-mills," which generally have smaller, non-unionized work-forces and are free of many of the employer, environmental and other obligations that traditionally have burdened integrated steel producers. Mini-mills also derive certain competitive advantages by utilizing less capital intensive sources of steel production. At least one of these mini-mills is already producing flat-rolled carbon steel products while others have considered doing the same. In future years, mini-mills may provide increased competition in the higher quality, value added product lines now dominated by the integrated carbon steel producers and stainless steel producers. Import penetration for stainless sheet and strip in 1993 and 1992 was 25.2% and 17.8%, respectively, and for stainless plate was 16.0% and 14.5%, respectively. Import penetration of electrical steel was 22.7% and 17.5%, respectively, during such periods. Voluntary steel import restraint agreements ("VRAs"), intended to achieve certain disciplines over market-distortive trade practices in the carbon and specialty steel industries, expired on March 31, 1992. With the expiration of the VRAs, Armco is unable to predict the level of future steel imports. Existing trade laws or current regulations may not be adequate to prevent unfair trading practices and imports may pose increasingly serious problems for the domestic specialty steel industry. This is particularly so if United States trade laws are weakened in the ongoing General Agreement on Tariffs and Trade Uruguay Round or the Multilateral Steel Agreement trade negotiations. At this time, it cannot be predicted with any degree of certainty what the outcome of such negotiations will be. Armco's carbon steel operations at Mansfield, Ohio, may also be adversely affected by the outcome of recent International Trade Commission ("ITC") and United States Department of Commerce ("Commerce Department") rulings on trade cases. On June 30, 1992, the major carbon steelmakers filed 84 trade cases against foreign producers of carbon steel from 21 countries charging them with selling steel below their home market prices and receiving unfair trade subsidies that are illegal under United States trade laws. On August 21, 1992, the ITC made affirmative preliminary determinations in 72 of the cases (affecting 95% of the volume of imports alleged to have been unfairly traded), finding that there was a reasonable indication that the domestic steel industry had been materially injured or was threatened with material injury by the imports in question. On June 22, 1993, the Commerce Department reached a final determination that foreign producers from 12 countries had unfairly benefited from government subsidies and that certain steel producers from 19 countries had unlawfully dumped steel and steel products in the U.S. market. On July 27, 1993, the ITC ruled that foreign producers had not caused injury to the domestic producers of hot-rolled carbon steel, although about one-third of the claims were upheld against foreign cold-rolled producers, and generally all claims against foreign coated carbon steel producers were upheld. This ruling was generally unfavorable for the domestic carbon steel industry, since it partially reversed previously assessed duties on foreign producers. It is too early to assess the effect, if any, that the rulings will have upon future pricing and demand for domestically produced products. The rulings, however, were generally favorable for coated carbon steel products, one of Mansfield's major product lines. Anti-dumping and countervailing duties might be imposed against those imports for which the ITC made a final affirmative injury determination. These duties are designed to offset "dumping" and the advantages of foreign subsidies and create a "level playing field" for domestic producers in the U.S. market. The Company and other U.S. steel producers have appealed certain of the ITC's determinations to the United States Court of International Trade, and foreign steel producers have appealed certain other of the ITC's determinations, as well as certain of the Commerce Department's determinations. During 1993, steel imports increased to 19.5 million tons, versus 17.1 million tons in 1992, an increase of 14.2%. In 1993, imports accounted for 18.8% of U.S apparent steel supply, versus 18.0% in 1992. Armco, Allegheny Ludlum Corporation, the USWA and the independent unions at Armco's plants in Butler, Pennsylvania and Zanesville, Ohio have filed a petition requesting that the U.S. government impose both antidumping and countervailing duties on imports of grain-oriented electrical steel from Italy. In addition, Allegheny Ludlum Corporation and the USWA petitioned the U.S. government to assess antidumping duties on imports of grain-oriented electrical steel from Japan. In October 1993, the ITC issued a preliminary determination of material injury due to subsidized and dumped grain-oriented electrical steel from Italy and dumped grain-oriented electrical steel from Japan. The Commerce Department announced on January 25, 1994, a preliminary CVD (subsidy) margin of 23.14% against Italy. On February 3, 1994, the Commerce Department announced preliminary anti-dumping margins of 5.62% against Italy and 31.08% against Japan. A final ruling by the ITC is anticipated in June of 1994. Specialty steel (stainless sheet and strip, plate, bar, rod and wire, and electrical steels) imports accounted for approximately 26.5% of the domestic market in 1993, 20.8% in 1992, and 18.1% in 1991. Raw Materials and Energy Sources Raw material prices represent a major component of per ton production costs in the specialty steel industry. The principal raw materials used by Armco in the production of specialty steels are iron and steel scrap, chrome and nickel and their ferroalloys, stainless steel scrap, silicon and zinc. These materials are purchased in the open market from various outside sources. Since much of this purchased raw material is not covered by long-term contracts, availability and price are subject to world market conditions. Chrome and nickel and certain other materials in mined alloy form can be acquired only from foreign sources, many of them located in developing countries that may be subject to unstable political and economic conditions that might disrupt supplies or affect the price of these materials. A significant portion of the chrome and nickel requirements, however, is obtained from stainless steel scrap rather than mined alloys. While certain raw materials have been in short supply from time to time, Armco currently is not experiencing and does not anticipate any problems obtaining appropriate materials in amounts sufficient to meet its production needs. Armco also uses large amounts of electricity and natural gas in the manufacture of its products. It is expected that such energy sources will continue to be reasonably available in the foreseeable future. Compliance with amendments to the Clean Air Act, enacted in November 1990, may increase the operating costs of the utilities providing services to Armco's facilities, and in turn may result in increased costs to Armco for utility services. Environmental Matters Armco, in common with other United States manufacturers, is subject to various federal, state and local requirements for environmental controls relating to its operations. Armco has spent substantial amounts in recent years to control air and water pollution to achieve and maintain compliance with applicable environmental requirements. Armco also has spent and will continue to spend substantial amounts for proper waste disposal and for the investigation and cleanup of properties that require remediation as a result of past waste disposal. Statutory and regulatory requirements in this area are continuing to evolve and, accordingly, it is not possible to predict with certainty the type and magnitude of expenditures that will be required in the future. However, Armco has estimated aggregate expenditures of approximately $30.0 million during the three-year period 1993-1995, of which approximately $20.0 million is related to control of air pollution as required by amendments to the Clean Air Act (enacted in November 1990), corresponding state laws and implementing regulations (which amount does not include approximately $7.0 million in estimated capital expenditures related to Armco Worldwide Grindings Systems segment, the business of which was sold in 1993) for capital projects for pollution control in all its domestic and international operations, with the largest expenditures being made in the Specialty Flat-Rolled Steel segment. This projection has been prepared internally and without independent engineering or other assistance and reflects Armco's current analysis of probable required capital projects for pollution control. Expenditures associated with remediation matters for which Armco is one of a number of potentially responsible parties are generally not included. In addition to the direct impact on Armco, the Clean Air Act amendments are expected to increase the operating cost of electrical utilities which rely on fossil fuels and this, in turn, could result in increased costs for utility services of which certain operations of Armco are significant customers. Armco's capital expenditures for pollution control projects amounted to approximately $4.1 million in 1993. During the period 1982 through 1992, Armco's capital expenditures for pollution control projects amounted to approximately $72.6 million (which amounts do not include such expenditures related to Armco Worldwide Grinding Systems segment, the business of which has been reclassified as a discontinued operation). Armco also is a party to a number of administrative proceedings and negotiations with environmental regulatory authorities. Armco believes that the ultimate liability from environmental-related liabilities will not materially affect the consolidated financial position or liquidity of Armco; however, it is possible that due to fluctuations in Armco's operating results, future developments with respect to such matters could have a material effect on the results of future operations or liquidity in interim or annual periods. Under the federal Comprehensive Environmental Response, Compensation and Liability Act, certain analogous state laws, and the federal Resource Conservation and Recovery Act, past disposal of wastes, whether on-site or at other locations, may result in the imposition of cleanup obligations by federal or state regulatory authorities or other potentially responsible parties, even when the wastes were disposed of in accordance with applicable laws and requirements in existence at the time of the disposal. The federal government has asserted that joint and several liability applies to hazardous waste litigation and courts have held that, absent proof that damages are allocable or subject to allocation, joint and several liability will be applied. Armco has been named as a defendant, or identified as a potentially responsible party, in various proceedings wherein the state or federal government or another potentially responsible party seeks reimbursement for or to compel clean-up of hazardous waste sites. Armco has been required to perform or fund such cleanup or participate in cleanup with others at a number of sites at which its facilities or facilities formerly owned by Armco disposed of wastes in the past and may, from time to time, be required to remediate or join with others in the remediation of other locations as these sites are identified by federal and state authorities. Armco and its subsidiaries are also parties to some lawsuits with respect to alleged property damage and personal injury from waste disposal sites. In addition, environmental exit costs with respect to Armco's ongoing businesses (which costs it is Armco's policy not to accrue until a decision is made to dispose of a property) may be incurred if Armco makes a decision to dispose of additional properties. These costs include remediation and closure costs of clean-up such as for soil contamination, closure of waste treatment facilities and monitoring commitments. While Armco believes that the ultimate liability for the environmental remediation matters identified to date, including the clean-up, closure and monitoring of waste sites, will not materially affect its consolidated financial condition or liquidity, the identification of additional sites, increases in remediation costs with respect to identified sites, the failure of other potentially responsible parties to contribute their share of remediation costs, decisions to dispose of additional properties and other changed circumstances may result in increased costs to Armco, which could have a material effect on its financial condition, liquidity and results of operations. Research and Development Armco carries on a broad range of research and development activities aimed at improving its existing products and manufacturing processes and developing new products and processes. Armco's research and development activities are carried out primarily at a central research and technology laboratory located in Middletown, Ohio. This laboratory is engaged in applied materials research related to iron and steel, non-ferrous materials and new materials. In addition, the materials and metallurgy departments at each operating unit develop and implement improvements to products and processes that are directly connected with the activities of such operating unit. Armco spent $12.9 million, $24.0 million and $23.6 million, respectively, on research in each of the three years ended December 31, 1993, 1992 and 1991 (including $3.9 million, $9.4 million and $11.8 million, respectively, funded by affiliates, primarily ASC, in each of such years). Equity and Other Investments Armco's equity and other investments include ASC, NAS (discussed above under "Specialty Flat-Rolled Steel"), Armco Financial Services Group ("AFSG") and National-Oilwell. Armco Steel Company, L.P. ASC is a joint venture limited partnership formed in 1989 by Armco and Kawasaki. With plants located in Middletown, Ohio and Ashland, Kentucky, ASC produces primarily high strength, low carbon flat-rolled steel. These products are supplied to the automotive, appliance and manufacturing markets, as well as to the construction industry and independent steel distributors and service centers. Effective May 13, 1989, substantially all of the assets, properties, business and liabilities of Armco's former Eastern Steel Division were transferred to, or assumed by, ASC, a Delaware limited partnership managed by a general partner corporation equally owned by subsidiaries of Armco and Kawasaki. The previously reported initial public offerings of equity and debt, through which ASC would implement its plan to restructure and recapitalize itself, commenced on March 30, 1994, with the underwritten public offerings by the corporate successor to ASC of approximately 17.6 million shares of common stock, at $23.50 per share, and $325 million of senior notes. The sales of the securities and the restructure and recapitalization are scheduled to be completed on April 7, 1994. Under the terms of the plan, the proceeds from the offerings will be used by ASC primarily to reduce its debt and unfunded pension liability, Armco's obligations to make certain cash payments to ASC will be eliminated and Armco will receive approximately 1 million shares, or approximately 4.2%, of the successor corporation's common stock. The domestic steel industry is highly competitive. Despite significant reductions in raw steel producing capability by major domestic producers over the last decade, the domestic industry continues to be adversely affected by excess world capacity. Over the last decade, extensive downsizings have necessitated costly restructuring charges that, when combined with highly competitive market conditions, have resulted in substantial losses for most domestic integrated steel producers. Carbon steel consumption in the United States has not grown with the overall economy in recent years. Producers of steel products face substantial competition from manufacturers of plastics, aluminum, ceramics, glass, concrete and other materials. While domestic carbon steel producers have taken action to scale back their operations through corporate reorganizations or as a result of bankruptcy proceedings, which actions have resulted in the closing of numerous production facilities, there still exists significant excess capacity in the domestic carbon steel industry. Overall, domestic steel capability utilization (including specialty steels) was approximately 87% during 1993. From time to time industry overcapacity has created an operating environment in which competing producers engaged in significant price discounting in order to maintain or gain market share. A number of major domestic steelmakers now operate under, or have emerged from, bankruptcy protection and have lower operating costs, which permit them to sell their products at lower prices. Further, domestic integrated carbon steel producers (including ASC) have lost market share to domestic mini-mills and low-cost reconstituted mills in recent years as these mills have expanded their product lines to include large-size structural products and certain carbon steel flat-rolled products, including thin cast slabs. Management believes that, before the cost reductions that have been effected in the last six months, ASC's cost per ton of steel was significantly higher than experienced by its domestic and foreign competitors and that its cost per ton is still higher than those of a number of its competitors, particularly the mini-mills. Imports of carbon steel and steel products have had a particularly adverse impact on domestic carbon steel shipments and pricing. High labor costs, including pension, health and other employee benefit obligations, and restrictive work practices are likely to continue to be competitive disadvantages for ASC and other domestic producers. Furthermore, foreign producers frequently have received subsidized financing and many are owned or controlled by foreign governments and base their decisions with respect to steel production and pricing on political and economic policy considerations as well as business factors. As a result of voluntary steel import restraint arrangements negotiated in 1985 between the United States and certain other steel-producing nations, steel imports declined from the levels of the mid-1980's. However, such arrangements expired in March 1992 without being extended or replaced with other import restrictions. Existing trade laws or trade negotiations may not be adequate to prevent unfair trading practices. On June 30, 1992, the major carbon steelmakers filed 84 trade cases against foreign producers of carbon steel from 21 countries charging them with selling steel below their home market prices and receiving unfair trade subsidies that are illegal under United States trade laws. On August 21, 1992, the ITC made affirmative preliminary determinations in 72 of the cases (affecting 95% of the volume of imports alleged to have been unfairly traded), finding that there was a reasonable indication that the domestic steel industry had been materially injured or was threatened with material injury by the imports in question. On June 22, 1993, the Commerce Department reached a final determination that foreign producers from 12 countries had unfairly benefited from government subsidies and that certain steel producers from 19 countries had unlawfully dumped steel and steel products in the U.S. market. On July 27, 1993, the ITC ruled that foreign producers had not caused injury to the domestic producers of hot-rolled carbon steel, although about one-third of the claims were upheld against foreign cold-rolled producers, and generally all claims against foreign coated carbon steel producers were upheld. On November 30, 1992, and January 27, 1993, the Commerce Department assigned preliminary duties on subsidy and dumping cases, respectively. However, on July 27, 1993, the ITC ruled that foreign producers had not caused injury to the domestic producers of hot-rolled carbon steel, although about one-third of the claims were upheld against foreign cold-rolled producers, and generally all claims against foreign coated carbon steel producers were upheld. This ruling was generally unfavorable for the domestic carbon steel industry, since it partially reversed previously assessed duties on foreign producers. It is too early to assess the effect, if any, that the rulings will have upon future pricing and demand for domestically produced products. The automotive industry, directly or indirectly, comprises the most substantial portion of the total sales of ASC. Significant downturns in the domestic automotive industry have had and likely would have a material adverse effect on ASC's profitability. At December 31, 1993, ASC had approximately 6,400 active employees. Most of the production and maintenance employees are represented by national or independent local unions. ASC steelmaking employees at its Ashland, Kentucky, facility are covered under an agreement with the USWA. The contract, which was originally scheduled to expire on July 31, 1993, has been extended to June 1, 1994. ASC coke-making employees at the Ashland facility are covered under an agreement with the Oil, Chemical & Atomic Workers union, which was scheduled to expire on October 1, 1993, but has been extended to May 1, 1994. No predictions can be made as to the results of the renegotiations of these agreements or the possible effects of the renegotiations upon ASC, although the agreement with the USWA covering hourly employees at the Ashland facility establishes procedures for revising its economic terms upon their expiration and contains no-strike clauses that are effective during the negotiation period. The terms of the agreement with the Armco Employees Independent Federation ("AEIF") covering ASC's hourly employees at its Middletown, Ohio facility have been settled though March 1, 1997 pursuant to an arbitrator's decision. On February 15, 1994, the USWA filed a petition with the National Labor Relations Board seeking to represent the hourly employees at the Middletown facility currently represented by the AEIF. If the USWA is elected as the bargaining representative for those employees, it may seek to renegotiate the terms of the existing AEIF agreement covering those employees prior to March 1, 1997. Armco Financial Services Group AFSG currently consists primarily of insurance companies that Armco intends to sell (the "AFSG companies to be sold") and companies that have ceased writing new business and are being liquidated (the "runoff companies"). The AFSG companies to be sold provide multiple-line casualty insurance, including personal and commercial automobile, workers' compensation, homeowners, multiperil, personal and commercial property and general liability insurance and consist primarily of Northwestern National Casualty Company ("NNCC"), Pacific National Insurance Company ("PNIC") and Statesman Insurance Company ("Statesman"). Armco wrote off, in the fourth quarter of 1991, its advances to the AFSG companies to be sold of $170.3 million. Armco estimates that 61% of future claims against the runoff companies will be paid during the period 1993-1997 and that substantially all remaining claims will be paid by the year 2017. While there have been no charges recorded with respect to the runoff companies since 1990, in the future there may be further adverse developments with respect to the runoff companies, which, if not otherwise offset through favorable commutations or other actions, will require additional charges to income. On January 28, 1994, Armco signed a letter of intent to sell its ongoing insurance operations to Vik Brothers Insurance, Inc., a privately owned property and casualty insurance holding company. Under the terms of the letter of intent, approximately $70 million would be received at closing and approximately $15 million would be received in three years, the latter payment being subject to a reserve analysis and potential adjustment at that time. As a result of restructuring certain obligations arising from the 1992 merger plan for the runoff companies, the proceeds from the sale have been pledged as security for certain note obligations due to the runoff insurance companies and will be retained in the investment portfolio of the Armco Financial Services Group runoff companies. The transaction is subject to a number of conditions, including a definitive purchase agreement, approval by regulatory authorities and approval of the boards of directors of Armco and the purchaser. The insurance business is highly competitive. Many of the competitors of the AFSG companies to be sold offer more diversified lines of insurance and have substantially greater financial resources. In addition, the insurance regulators having supervisory authority over Armco's insurance operations retain substantial control over certain corporate transactions, including the sale of the AFSG companies to be sold and the liquidation of the runoff companies. They also have broad powers to interpret statutory accounting requirements and to initiate rehabilitation and liquidation proceedings. The liability for unpaid losses and loss adjustment expenses includes an amount determined from loss reports and individual cases and an amount, based on past experience, for losses incurred but not reported. Such liability is necessarily based on estimates and, while management believes that the amount is fairly stated, the ultimate liability may be in excess of or less than the amount provided. The methods for making such estimates and for establishing the resulting liability are continually reviewed and any adjustments resulting therefrom are reflected in earnings currently. The Company does not discount the liability for unpaid losses and loss adjustment expenses. The AFSG companies to be sold estimate losses for reported claims on an individual case basis. Case reserves are based on experience with a particular type of risk and the available information surrounding each individual claim. Case reserves are reviewed on a regular basis. As additional facts become available, the case reserves are adjusted as necessary. The stability of the case reserving process is monitored through comparison with ultimate settlement. The estimates of losses for incurred but not reported claims (IBNR), as well as additive reserves for reported claims, are developed primarily from an analysis of historical patterns of the development of paid and incurred losses (dollars and claim counts) by accident year for each line of business. Salvage and subrogation estimates are developed from patterns of actual recoveries. Allocated loss adjustment expense reserves are developed from an analysis of historical patterns of the development of paid allocated loss adjustment expenses to incurred losses, by accident year, by line of business. These historical patterns are then applied to projected ultimate losses for each line of business. Unallocated loss adjustment expense reserves are developed utilizing a cost accounting system. The cost accounting system is based on historical costs modified for anticipated changes in operations and selections of alternative costs. Loss and loss adjustment expense reserves are stated at management's estimate of the ultimate cost of settling all incurred but unpaid claims. Loss and loss adjustment expense reserves are not discounted. On October 25, 1990, Northwestern National Holding Company ("NNHC") purchased Statesman. NNHC has accounted for the Statesman acquisition as a purchase and accordingly, the original purchase price was allocated to assets and liabilities based upon their fair value at the date of acquisition. During 1986, Northwestern National Insurance Company was restructured and its principal book of business was transferred to NNCC. As provided by the agreement, NNCC assumed certain liabilities in connection with this book of business. Additionally, NNCC received securities and cash in connection with the transfer. Activity with respect to loss and loss adjustment expense reserves for the last three years is as follows: A reconciliation of the liability for losses and loss adjustment expenses as reported to net of ceded reinsurance follows: The following table reconciles reserves determined in accordance with accounting principles and practices prescribed or permitted by insurance statutory authorities (Statutory reserve) to reserves determined in accordance with generally accepted accounting principles (GAAP reserve) at December 31, as follows: Effective on January 1, 1993 the AFSG companies to be sold adopted a new statutory accounting principle allowing the recognition of salvage and subrogation recoverable in the determination of the statutory reserve for losses and loss expenses. Prior year financial statements have not been restated for the change in accounting principle. Effective on January 1, 1993 the AFSG companies to be sold adopted Statement of Financial Accounting Standards ("SFAS"), SFAS No. 106 and SFAS No. 112 pertaining to postretirement and postemployment benefits. The new accounting principles were adopted for both statutory and GAAP reporting purposes. However, certain differences exist between statutory and GAAP accounting principles that resulted in larger unallocated loss adjustment expense reserves for statutory reporting. The following table presents a calendar year runoff of the reserve for losses and loss adjustment expenses for the years 1984 through 1993. The top line of the table shows the reserve for losses and loss adjustment expenses recorded as of December 31 for each of the indicated years. This reserve represents the estimated amount of losses and loss expenses for claims arising in all years that are unpaid at the balance sheet date, including losses and loss adjustment expenses that had been incurred but not yet reported. Each column shows the reserve amount at the indicated calendar year end and cumulative data on payments and the re-estimated reserves for all accident years making up that calendar year end reserve. The last entry for each calendar year in the lower section of the table represents the incurred loss and loss expense developed, subsequent to the balance sheet date, through 1993. The estimates are increased or decreased as more information concerning the frequency and severity of claims becomes available. The deficiency depicted for a given year is cumulative for that year and all prior years. The following table shows a $40 million deficiency in 1990 and a $29 million deficiency in 1991. The AFSG companies to be sold experienced a significant number of large losses in 1991 and 1990, predominantly in multi-peril and commercial auto. The deficiencies that occurred in 1991 and 1990 are a result of additional unprecedented developments on these large losses. In addition, approximately $17 million of the deficiency for 1990 pertains to additional development and reserve strengthening that occurred on the 1990 and prior accident year loss and loss expense reserves of Statesman Insurance Company, a company acquired in October 1990. The AFSG companies to be sold implemented new reserving procedures to improve the future adequacy of reserve levels. The table reflects the (deficiency) redundancy on loss and loss expense reserves before the impact of the (deficiency) redundancy on loss and loss expense reserves ceded to unaffiliated insurers. The AFSG companies to be sold limits the maximum net loss which can arise from large risks by reinsuring (ceding) certain levels of risks with other reinsurers. The following table shows the deficiency on net loss and loss expense reserves, which is significantly lower than the deficiency in the table above. Significant development on large losses exceeding the AFSG companies to be sold net retention during 1990 and 1991 resulted in a smaller impact on reserve adequacy on a net of reinsurance basis The (deficiency) redundancy computed net of ceded reinsurance is as follows: The tables do not present accident or policy year development data which readers may be more accustomed to analyzing; therefore, analysis of the effect of loss and loss expense reserving on any particular accident year cannot be discerned. The table reflects adjustments to income in each year for all prior years. Conditions and trends that have affected development of the reserve in the past may not occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on this table. National-Oilwell Armco, through a wholly owned subsidiary, has a 50% partnership interest in National-Oilwell, which was formed in 1987 when Armco and USX Corporation each contributed their oilfield equipment operations to National-Oilwell in exchange for equal interests in the new partnership. National-Oilwell is a distributor of oil country tubular goods and a manufacturer of drilling, production and other oil and gas equipment, and operates a network of oil field supply stores throughout North America through which it distributes products to the oil and gas industries worldwide. National-Oilwell operates in a highly competitive environment. ITEM 2.

ITEM 2. PROPERTIES Armco owns and leases property around the world. This property includes manufacturing facilities, offices and undeveloped property. The locations of Armco's principal plants and materially important physical properties are described in ITEM 1. "BUSINESS" and are used by the Specialty Flat-Rolled Steel and Other Steel and Fabricated Products businesses. Armco believes that all its operating facilities are being adequately maintained and are in good operating condition. All of Armco's principal plants and properties are held in fee. Portions of the Houston plant, shut down in 1983, are leased from the Gulf Coast Waste Disposal Authority (Texas). In most instances, Armco has an option to purchase the leased facilities at the end of the lease period. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS There are various claims pending against Armco and its subsidiaries involving product liability, patent, insurance arrangements, environmental, antitrust, hazardous waste, employee benefits and other matters arising out of the conduct of the business of Armco. Reserve Mining Litigation. On July 17, 1992, Armco was sued in the -------------------------- United States District Court, District of Minnesota, Fifth Division, by a group of former salaried employees of Reserve Mining Company ("Reserve"), a joint venture between a subsidiary of Armco and LTV Corporation that produced iron ore pellets. The complaint alleges that Armco is liable for certain unpaid welfare benefits, including vacation, severance, supplemental layoff, life insurance and health insurance benefits. While Armco cannot determine the possible exposure, if any, from this lawsuit, plaintiffs preliminarily calculated the benefits at about $12 million. On February 17, 1993, the Court dismissed state law, ERISA and fiduciary claims with prejudice and plaintiffs' independent fiduciary claims without prejudice. Plaintiffs filed an amended complaint, in response to which Armco filed a motion to dismiss. On October 22, 1993, the Court granted Armco's motion to dismiss in its entirety. On November 22, 1993, plaintiffs filed a notice of appeal on the February 17 and October 22 decisions. The appeal is currently pending. In August 1992, Armco was sued in the U.S. District Court, District of Minnesota by members of the USWA who declined to participate in the USWA v. Armco settlement. The complaint alleges breaches of the Basic Labor - -------------- Agreement, Supplemental Unemployment Benefit Plan, Insurance Agreement, Pension Agreement and Program of Hospital-Medical Benefits for Pensioners and Surviving Spouses and seeks an unspecified amount of damages. On February 17, 1993, the Court granted Armco's motion to dismiss plaintiffs' state law claims. Plaintiffs' claims based on the labor agreements remain pending. Plaintiffs filed an amended complaint, in response to which Armco filed a motion to dismiss certain claims therein. On October 22, 1993, the Court granted Armco's motion. On November 8, 1993, Armco filed an answer to the allegations in the amended complaint not subject to the motion to dismiss. On May 14, 1993, Armco received a letter from the Pension Benefit Guaranty Corporation ("PBGC") asserting that Armco is liable for certain pension plan obligations of Reserve, a Minnesota general partnership between a subsidiary of Armco and a subsidiary of LTV Corporation. Reserve filed for reorganization under the U.S. Bankruptcy Code on July 16, 1986. In the letter, the PBGC demands payment by Armco of $42.8 million. On May 23, 1993, Armco and the PBGC entered into an agreement, tolling until December 31, 1993 the running of the statute of limitations with respect to the PBGC's claim against Armco and also with respect to any claims Armco may have against the PBGC. The original tolling agreement has been extended to April 29, 1994. While Armco's management believes that it has substantial defenses against these Reserve-related claims, if these creditors and other Reserve creditors are successful in such claims, Armco could become liable for these and other Reserve nondebt obligations in an amount which could be substantial. CRS Litigation. On October 31, 1990, a third-party complaint was served --------------- on Armco in the Circuit Court of Montgomery County, Maryland by the owner of a 6.3 mile potable water tunnel designed by defendant, CRS Sirrine ("CRS") and its predecessor companies, and constructed by Armco and Clevecon Inc. Armco built 3.4 miles of the tunnel; Clevecon built the remaining 2.9 miles. No portion of the tunnel, which was completed in early 1984, has ever been functional. Washington Suburban Sanitary Commission filed suit against CRS seeking damages in the amount of $200 million. CRS filed third-party complaints against Armco and Clevecon seeking damages to the extent of any liability of CRS attributable to Armco's or Clevecon's negligence or negligent misrepresentation in connection with the installation of the potable water tunnel and the third party defendants' alleged defective workmanship in connection with the same. Armco's motion to dismiss or, in the alternative, for summary judgment was denied by the Court. CRS subsequently settled the claims against it by Washington Suburban Sanitary Commission and continued to prosecute its third-party claims against Armco and Clevecon. Oral argument on Armco's re-filed summary judgment motion was held on January 3, 1994. The circuit court denied Armco's summary judgment motion and the case proceeded to trial. On January 28, 1994, a directed verdict was entered by the court in favor of Armco. CRS has filed a notice of appeal of the judgment entered in favor of Armco. Cornerstones Litigation. An action was filed by Cornerstones Municipal ------------------------ Utility District ("Cornerstones") and William St. John, as representative of a class of owners of real property situated within Cornerstones, in the District Court of Harris County, Texas, in July 1989, alleging that Armco Construction Products supplied defective pipe for a sanitary sewer system in three residential subdivisions. The petition sought in excess of $40 million in damages. On May 29, 1991, plaintiffs filed a Third Amended Petition adding Kingsbridge Municipal Utility District ("Kingsbridge") and John Keplinger, as representative of a class of owners of real property situated within Kingsbridge, as additional plaintiffs. The residents of Kingsbridge made similar allegations, sought certification of the class of Kingsbridge homeowners and seek to recover damages for an allegedly faulty sanitary sewer system in four residential subdivisions. The amended petition seeks in excess of $40 million in damages, on behalf of the Kingsbridge and the Cornerstones plaintiffs, which is in excess of the court's jurisdictional limits. On January 13, 1992, the Court granted Armco's Motion for Summary Judgment and dismissed all of the Cornerstones plaintiffs' claims against the defendants on the basis of the statute of limitations. The Cornerstones plaintiffs appealed the decision and, in January 1993, the Appellate Court reversed the dismissal of the Cornerstones action and remanded it to the trial court. In May 1993, the Texas Supreme Court granted Armco's application for leave to appeal the appellate court's decision and heard argument on the matter on September 14, 1993. On November 24, 1993, the Texas Supreme Court reversed the appellate court in favor of Armco, awarding Armco its costs and remanding the case to the appellate court for disposition of unaddressed issues. The Kingsbridge action remains pending and is in discovery. On or about April 3, 1992, Vincent and Linda Adduci and 71 other plaintiffs, owners of real property situated within Cornerstones, filed suit in the District Court of Harris County, Texas, against multiple defendants, including Armco. The suit, similar to the action filed by Cornerstones and William St. John discussed above, alleges damages were sustained as a result of improper design and installation of the sanitary sewer system servicing the subdivision, as well as certain manufacturing and/or design defects of the pipe utilized to construct the sanitary system. The complaint seeks an unspecified amount of damages. On or about September 11, 1992, Harris W. Arthur and other plaintiffs, owners of real property situated within Cornerstones, filed suit in the District Court of Harris County, Texas, against multiple defendants, including Armco. The suit, similar to the action filed by Cornerstones and William St. John and the action filed by Vincent and Linda Adduci and other plaintiffs, alleges damages were sustained as a result of improper design and installation of the sanitary sewer system servicing the subdivision, as well as certain manufacturing and/or design defects of the pipe utilized to construct the sanitary sewer system. The complaint also asserts legal malpractice theories against various counsel for the Municipal Utility District. The complaint seeks an unspecified amount of damages. On March 22, 1993, an action captioned William C. Irons, et al. v. --------------------------- Turner, Collie & Braden, et al. was filed in the District Court of Harris - ------------------------------- County, Texas. This action, which involves approximately 100 additional owners of real property situated within Cornerstones, names multiple defendants, including Armco, and alleges theories of damages similar to those in the Arthur and Adduci matters. The complaint seeks an unspecified amount of - ------- ------ damages. Armco Chile Prodein, S.A. Litigation. On or about November 15, 1991, ------------------------------------- Armco and Armco Chile Prodein, S.A. were sued for damages in the United States District Court for the Southern District of Alabama by a maritime cargo carrier. Plaintiff's claims are based upon allegations of fraud, negligent misrepresentation, negligent interference with contractual relations and wrongful arrest. Plaintiff's allegations arise out of a series of transactions in which it was engaged by Armco Chile Prodein to transport fiberglass reinforced pipe from Jacksonville, Florida to Talcahuano, Chile. Plaintiff made three such shipments of pipe. After discovering damage to the first and second shipments of pipe, which defendants contend was due to negligence by plaintiff, Armco Chile Prodein arrested, pursuant to Chilean law, the vessel which plaintiff utilized to carry the third shipment of pipe. Plaintiff alleges, among other things, that this arrest was wrongful and that the alleged wrongful arrest resulted in such severe damage to plaintiff's business interests and reputation that plaintiff went out of business. Plaintiff's experts claim that the damages suffered by plaintiff range from $38 million to $47 million. Both Armco and Armco Chile Prodein filed motions for summary judgment. On January 25, 1993, the court granted summary judgment discharging Armco and subsequently denied plaintiff's motions for reconsideration of the summary judgment granted to Armco. On April 30, 1993, a jury verdict on plaintiff's wrongful arrest and lost profits claims was rendered in favor of the plaintiff and against Armco Chile Prodein in the amount of $10,500,000. Judgment on the verdict was entered by the Court on May 7, 1993. Thereafter, Armco Chile Prodein filed a motion seeking judgment as a matter of law or, alternatively, for a new trial. On October 12, 1993, finding that the jury's verdict on liability and damages was against the weight of the evidence, the trial court granted the defendant's post-trial motion, entering judgment in favor of Armco Chile Prodein against plaintiff. The court also granted Armco's motion for a conditional new trial in the event the judgment is overturned on appeal. The plaintiff has appealed this ruling to the Federal Circuit Court. Environmental Proceedings. Armco's steelmaking operations have been -------------------------- involved in or subject to a number of consent orders or judgments under local, state or federal environmental laws and regulations which generally require Armco to comply with certain discharge standards and to add certain pollution abatement equipment. Armco continues to be subject to such orders or settlements to the extent that such standards have not been met or the equipment is not installed. In addition, Armco participates directly or indirectly in a number of proceedings challenging various regulations or procedures relating to environmental compliance. Armco becomes involved in such actions when it perceives that the ultimate application of such regulations or procedures could involve significant capital expenditures by Armco or subject Armco to penalties without obtaining a material environmental benefit. In addition, Armco has been named as a defendant in certain litigation wherein the state or federal government or other potentially responsible parties seek reimbursement for or to compel cleanup of hazardous waste sites. Armco has provided information on materials it has deposited at other hazardous waste sites and may be named as a defendant if litigation is commenced with respect to such sites. The federal government has asserted that joint and several liability applies in hazardous waste litigation and courts have held that, absent proof that damages are allocable or subject to allocation, joint and several liability will be applied. The following paragraphs provide information on certain suits and proceedings in which Armco is a participant. On July 31, 1989, the United States filed a civil action in the United States District Court for the Southern District of Texas, Houston Division, under the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA") for cost recovery and injunctive relief associated with the French Limited Superfund site (the "French Limited Site") near Crosby, Texas. Armco and 84 other defendants were named in the action. Concurrently, the United States government filed a Consent Decree requiring the defendants to reimburse the United States in the amount of $1.3 million, to pay certain future oversight costs and to undertake remedial action at the French Limited Site. The Decree was approved and entered by the court. The defendants estimated that the remedy outlined in the Decree would cost approximately $81 million over a five- to eight-year period. Armco's remaining share of costs, which is fully accrued, is approximately $1.6 million. Armco has been one of four remaining defendants in three class actions filed in the 157th Judicial District, District Court of Harris County, Texas on behalf of about 750 residents near the French Limited Site. These cases were Avalos ------ v. Atlantic Richfield Company, ("ARCO") et al., Curette v. ARCO and Adolph - --------------------------------------------------------------- ------ v. ARCO. In December 1992, the Avalos, Curette, and Adolph plaintiffs accepted - -------- a $1.1 million settlement offer made by Armco and two other defendants, of which Armco's share was $549,270.56. The settlement funds were paid out in 1993 and the court dismissed the action with prejudice. As a condition to settlement, about 300 individuals who were not represented by counsel or who had only recently had counsel appear on their behalf and who did not wish to settle their claims were severed from the Avalos action and transferred to a separate action styled Rosa Ann Barrett, et - ------ -------------------- al. v. ARCO, et al., in the United States District Court for the Southern - --------------------- District of Texas, Houston Division. On December 13, 1993, Rhonda Sills, on behalf of herself and two of her children, sued the same defendants as in the Avalos case. In February, a suit on behalf of Rod Luke Chambers and about 30 - ------ other plaintiffs was filed against the ARCO defendants. These suits are based on the same theories as those asserted in the Avalos case and seek an ------ unspecified amount of damages. Armco believes the Barrett, Sills & Chambers ------------------------- lawsuits are not well-founded and, accordingly, no liability has been recorded at this time. An action styled The United States of America, State of Maryland v. -------------------------------------------------- Azrael, et al. v. Armco Steel Corporation, et al. was filed in the United - ------------------------------------------------- States District Court for the District of Maryland pursuant to Section 107 of CERCLA to recover monies expended by the United States and the State of Maryland in response to a release and threatened release (federal allegation) and an imminent and substantial danger to the public health or welfare presented by the release or substantial threat of release (state allegation) of hazardous substances from a waste disposal site at the intersection of Kane and Lombard Streets in Baltimore, Maryland. Armco was served with a third-party complaint on April 19, 1991. The third-party complaint alleges that Armco arranged for the disposal and/or treatment or arranged with a transporter for transport for disposal or treatment of hazardous waste to the Kane and Lombard site. A determination has not been made as to how much waste, if any, Armco sent to the site. To date, settlement discussions with the third-party plaintiffs have been unsuccessful. On or about September 29, 1989, the United States filed a civil action in the United States District Court for the District of Minnesota under CERCLA for declaratory relief and cost recovery associated with the Arrowhead Refining Superfund site (the "Arrowhead Site") in Hermantown, Minnesota. Armco, Reserve and 13 other defendants are named in the action. The United States Environmental Protection Agency's ("USEPA") current estimated cost to clean up the Arrowhead Site is about $30 million. Armco has joined in the filing of a third-party complaint against approximately 300 third-party defendants. Discovery is in progress. During 1990, USEPA and the State of Minnesota issued several orders directing Armco and several other parties to undertake certain remedial actions or risk substantial penalties for not doing so. In early 1991, Armco joined the Minnesota Arrowhead Site Committee ("MASC"), a group of potentially responsible parties ("PRPs"), and has participated in MASC's implementation of the orders. In addition to its compliance activities, MASC also commissioned studies of alternative technologies to remedy sludge and soil contamination at the Arrowhead Site. USEPA is in the process of amending its Record of Decision to include a more cost effective remedy identified by these studies. Armco will be responsible for about 65% of the MASC groups cleanup costs at the site. On or about October 12, 1989, the United States filed a civil action in the United States District Court of Pennsylvania, Western District, against Armco and ten other defendants under CERCLA for cost recovery associated with the Malitovsky Drum Superfund site in Pittsburgh, Pennsylvania. Armco and the other defendants are alleged to have sent materials to the site. The complaint alleges that costs in excess of $1 million have been expended, and additional costs are being incurred through efforts of the United States to recover monies expended in connection with its response actions. Late in 1992, USEPA and the defendants reached an agreement in principle, under which Armco will pay $118,333.33. A definitive settlement agreement has been negotiated, pending final approval by USEPA. In December 1989, Traverse Bay Area Intermediate School District ("TBA") filed suit in the United States District Court for the Western District of Michigan alleging that Parsons Corporation, the predecessor in interest of Hitco, a former subsidiary of Armco, released hazardous substances which contaminated the plaintiff's property. Armco assumed the defense of Hitco pursuant to the terms of the sale of Hitco. The TBA litigation was dismissed with prejudice on January 4, 1993. Armco and TBA jointly performed a remedial investigation, focused feasibility study and risk assessment on TBA's property and submitted the reports to the Michigan Department of Natural Resources ("MDNR"). On March 24, 1993, MDNR sent Armco and TBA a "Notice of Demand for Payment and Response Action", claiming reimbursement of approximately $1.3 million in past costs plus statutory interest and demanding performance of additional investigation and response activities at the site which are estimated to cost about $600,000. Armco's costs are not expected to exceed $1.45 million in resolving Hitco's share of liability at the site. Armco and TBA are working cooperatively with MDNR to settle the matter. On or about June 29, 1992, Armco was served with a complaint, styled as a class action, filed in the Superior Court of California, County of Los Angeles, by Scott Liuzza and approximately 80 named plaintiffs against Armco and a number of other companies, relating to, among other things, a land reclamation site owned by Armco and recently closed under the supervision and with the approval of the appropriate environmental agencies. The plaintiffs are seeking a recovery in an unstated amount for alleged personal and property damages plus injunctive relief. The court sustained Armco's demurrer to the class action counts of the complaint and in March 1994 dismissed plaintiff's claims for the diminution of property values and personal injury. Discovery is in progress with a cutoff date of April 19, 1994. On July 19, 1993, Armco's subsidiary Flour City Architectural Metals, Inc. (formerly E.G. Smith Construction Products, Inc.) ("Flour City") received a request from USEPA under Section 3007 of the Resource Conservation and Recovery Act ("RCRA") for information as part of an ongoing investigation into Flour City's compliance with a Consent Agreement and Final Order dated October 27, 1988 (the "Consent Order") relating to two inactive waste surface impoundments located at the former E.G. Smith plant in Cambridge, Ohio. On February 11, 1993, Armco sold the Flour City Cambridge, Ohio plant, but retained title to 21.5 acres of the Cambridge facility, including the surface impoundments, and responsibility for compliance with the terms of the Consent Order. Armco has established reserves which it believes will be adequate to cover the required remediation. Armco believes that it is in compliance with the Consent Order. Armco submitted a revised closure plan for this site in September, 1993. On or about July 31, 1990, the State of Connecticut filed an action entitled Leslie Carothers, Commissioner of Environmental Protection v. Cyclops ---------------------------------------------------------------------- Corporation, Detroit Strip Division in the Connecticut State Superior Court, - ----------------------------------- Judicial District of Hartford/New Britain at Hartford, seeking certain penalties and a permanent injunction against Cyclops Corporation to restrain it from discharging wastewater into the waters of the State of Connecticut without a permit. The claim involves a closed facility in Hamden, Connecticut. Although Armco, as successor to Cyclops Corporation, and the State of Connecticut have signed a Consent Order by which Armco agreed to perform certain remedial investigations and activities, the penalty claim in the litigation is still outstanding. Settlement discussions are expected to resolve this matter trial which is scheduled for April 16, 1994. An action styled Tammy Fisher Whalen v. AES, Inc., et al. was filed on ---------------------------------------- March 17, 1993 in the 10th Judicial District, District Court of Galveston County, Texas by Tammy Fisher Whalen on behalf of herself and several other plaintiffs against AES, Inc. and approximately 40 other defendants, including Armco and a number of other major corporations, relating to the McGinnis Waste Disposal Site. Substantially identical actions entitled Elizabeth Ewell, et ------------------- al v. AES, Inc., et al. and Bonnie R. Cannon, et al. v. AES, Inc., et al. - ----------------------- --------------------------------------------- were filed in the same court on May 4, 1993 and June 10, 1993, respectively. In each case, the plaintiffs sought $1 billion in alleged actual damages and $4 billion in punitive damages. Based on Armco's demonstration that no Armco materials went to the McGinnis Site, plaintiffs have moved to dismiss these actions. Whalen and Ewell were dismissed on June 21 and June 25, 1993 ------ ----- respectively. The judge is expected to sign the Cannon dismissal shortly. ------ In September 1992, National Supply Company, Inc., a wholly owned subsidiary of Armco ("National Supply") and a 50% general partner in National-Oilwell, received a letter from USEPA, which asserted that National Supply and/or National-Oilwell is a PRP under CERCLA with respect to the Odessa Drum Company, Inc. Superfund site (the "Odessa Site") located in Odessa, Ector County, Texas. Armco has joined a de minimis PRP group to negotiate a settlement for its liability at this site. Armco believes that any response costs National Supply may bear in connection with the Odessa Site will not be material to Armco. In August 1992, Eastern received a letter from USEPA, which asserted that Eastern is a PRP under CERCLA with respect to the Moyer Landfill Superfund site (the "Moyer Landfill Site") in Collegeville, Pennsylvania. Eastern has responded that it did not send waste or other materials to the Moyer Landfill Site. Eastern understands that a cost recovery action has been instituted in the United States District Court, Eastern District of Pennsylvania, against a substantial number of parties, not including Eastern, which are asserted to have potential liability under CERCLA with respect to the Moyer Landfill Site. No claims against Armco are anticipated. E. G. Smith Construction Products, Inc. ("E. G. Smith"), a subsidiary of Armco, is one of four companies that have been identified by USEPA as PRPs at the Fultz Landfill Superfund site in Byesville, Ohio. USEPA's preliminary estimates for remediation cost is $22 million on a present value basis. The USEPA did not provide an estimate of the waste volume at the site alleged to be that of E. G. Smith. The operators of the landfill have stated that any of E. G. Smith's industrial wastes that are of concern to USEPA were not deposited in the landfill but were transported to another site. USEPA is undertaking cleanup at the site, with the expectation that they can recover such costs from the PRP's. Cyclops received a notice from USEPA that it may be a PRP with respect to the anticipated remediation of contaminated soil on certain property in New Boston, Ohio sold by Cyclops to a third party several years ago. No amount was estimated by USEPA as to the cost of such remediation. Prior to such sale, the salvage contractor hired by the current owner (which was then occupying the property as a tenant of Cyclops) engaged in intentional conduct which directly resulted in contamination. As a part of the sentence imposed upon the contractor in response to his guilty plea to the resulting criminal charges, the contractor agreed to remediate the contaminated condition. Armco currently is reviewing its legal position as to the notice, including the defenses which it may have on the basis of the circumstances of the contamination. The current owner of the property and the contractor have also been notified by USEPA that they may be PRPs. Armco and the current owner have collected $825,000 on a $1 million performance bond which had been obtained to secure the contractor's performance. These funds are being used for remediation and oversight of the clean-up. In July of 1990, Eastern entered into a Consent Order with the Maryland Department of Environment to resolve a complaint alleging various violations of environmental requirements. This Order was followed by a voluntary Consent Judgment on April 17, 1992 and an amendment of the Consent Judgment in August of 1993. Pursuant to the Order and Judgment, Eastern spent a total of $4.5 million in 1991, 1992 and 1993 on various pollution prevention projects. In addition, Eastern paid a $0.3 million penalty and agreed to expend an additional $0.9 million on projects in 1994. Additional expenditures of about $1 million will be necessary if Eastern restarts its melting, grinding and coil processing operations. On July 22, 1993, Armco received a request from the Kansas Department of Health and Environment ("KDHE") for information regarding a former Armco Construction Products Division plant located in Topeka, Kansas and now owned by Contech Construction Products, Inc. ("Contech"). Contech and Armco had previously tried to resolve a claim by Contech concerning all environmental contamination at the Topeka plant. The claim arises under indemnity provisions contained in an agreement dated June 30, 1986 between Armco and Contech, formerly a subsidiary of Armco, under which Armco conveyed the property and other assets to Contech pursuant to a management buyout of Contech. The request was issued pursuant to a Kansas law that has liability provisions similar to CERCLA. Despite several meetings among Armco, Contech and other former owners of allegedly contaminated portions of the plant, the parties have been unable to resolve the dispute. Armco answered KDHE's information request in August 1993. The amount, if any, of potential liability cannot be reasonably estimated. In December 1993, Armco and one other company received a notice of nonbinding preliminary allocation of proportionate responsibility from the Pennsylvania Department of Environmental Resources ("PADER") for the William Taylor Estate site. PADER is seeking a voluntary settlement for the recovery of past and future response costs at the site. The notice alleges disposal of material from three facilities operated by the Sawhill Tubular Division. While cleanup costs cannot be estimated, Armco believes, based on information to date, that the response costs will not be material. On February 2, 1994, the Missouri Department of Natural Resources, ("Missouri DNR") issued a Notice of Violation to GS Technologies, Inc. ("GS Technologies") for failure to obtain permits prior to the construction/modification of ten processes or pieces of equipment. These changes were made before the Kansas City facility was sold to GS Technologies as part of its sale of its Worldwide Grinding Systems in late 1993. Armco is taking the lead in working with Missouri DNR to resolve this issue. It is not expected that any penalties will be material. On February 16, 1994, Missouri DNR and the USEPA jointly issued a Part B permit to the Kansas City facility under RCRA. This permit seeks to require "interim measures" including investigation and potentially, remediation at several areas of the facility. Armco has petitioned for review of most of such permit provisions to the Environmental Appeals Board. These provisions are stayed during pendancy of the appeal. It is expected that preliminary investigation costs may reach $1 million; however, other costs cannot be determined until there is more certainty as to the extent of actual permit requirements. On January 18, 1994, Armco received a 104(e) request for information under CERCLA from USEPA regarding shipments from the former E. G. Smith Division of Cyclops to the Granville Solvents site in Ohio. Armco has responded to the request. Cleanup costs and any Armco liability therefor cannot be determined based on available information. In the opinion of management, the ultimate liability resulting from the claims described in the preceding paragraphs in the "Legal Proceedings" section will not materially affect the consolidated financial position or liquidity of Armco and its subsidiaries; however, it is possible that due to fluctuations in Armco's operating results, future developments with respect to such matters could have a material effect on its financial condition, liquidity and results of operations in future interim or annual periods. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of the security holders of Armco during the fourth quarter of the year ended December 31, 1993. Executive Officers of Armco The executive officers of Armco as of March 1, 1994, were as follows: ________________________ (1) Effective January 1, 1994, Mr. Will was elected Chief Executive Officer. He had previously been President and Chief Operating Officer. (2) Effective March 1, 1994. (3) Effective April 1, 1993. (4) Effective as of March 1, 1994. (5) Effective September 1, 1993, Mr. Hildreth was elected Vice President and Secretary. He had previously been General Counsel since February 1, 1993. (6) Effective September 1, 1993. (7) Effective March 1, 1994. (8) All officers are elected annually by the Board of Directors and hold office until their successors are elected and qualified. Each of the officers named above has held responsible positions with Armco or its subsidiaries during the past five years, with the exceptions of Messrs. Will, Harmer, Leemputte, Visokey and Higbee. Immediately prior to joining Armco, Mr. Will was President and Chief Executive Officer of Cyclops Industries, Inc. (a manufacturer of flat-rolled carbon and stainless steel products). Mr. Harmer was Vice President and Controller of FMC Corporation (a broad-based chemicals and manufacturing company). Mr. Leemputte was project manager for Gemini Consulting (specializing in the development and application of leading edge business concepts and practices). Prior to that, Mr. Leemputte held various accounting positions at FMC Corporation. Mr. Visokey was Vice President, Purchasing and Traffic for LTV Steel Company. Mr. Higbee was President of National-Oilwell. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information required by this item is incorporated herein by reference from page 57 of the Annual Report to Shareholders for the year ended December 31, 1993. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA _______________________________ (1) The information in this Item should be read in conjunction with Armco's financial statements and the Notes thereto, which are incorporated by reference in Item 8. (2) In 1993, Armco adopted SFAS 106 and 109 which increased long-term employee benefits and total assets. (3) In April 1992, Armco acquired Cyclops Industries, Inc. (4) Special credits (charges) for the years 1991 through 1993 primarily relate to the shutdown and rationalization of operating facilities. The credit in 1989 is primarily a result of a $109.4 gain on the formation of Armco Steel Company, L.P. from the assets, liabilities and business of the Eastern Steel Division, and a credit for a favorable ruling on certain export commitments, partially offset by corporate restructuring charges. (5) The Class B common stock was issued by Eastern Stainless Corporation prior to Armco's acquisition of this 84%-owned former subsidiary of Cyclops Industries, Inc. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required by this item is incorporated herein by reference from pages 19-31 following the caption "Management's Discussion and Analysis" of the Consolidated Financial Statements in the Annual Report to Shareholders for the year ended December 31, 1993. Subsequent Developments On March 28, 1994, Armco announced its intention to idle the production facilities at its Empire-Detroit carbon steel plant in Mansfield, Ohio and the Dover, Ohio galvanizing plant. The plants are expected to remain idle until the previously announced construction of a $100 million thin-slab caster is completed, which is scheduled for mid-1995. Armco expects to recognize a special charge of up to $20 million in the first quarter of 1994 for the cost of benefits to employees on layoff and other costs of idling the facilities, as well as costs associated with planned permanent work force reductions. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required by this item is incorporated herein by reference from pages 32-56 of the Annual Report to Shareholders for the year ended December 31, 1993. (Unaudited) Subsequent Developments On March 28, 1994, Armco announced its intention to idle the production facilities at its Empire-Detroit carbon steel plant in Mansfield, Ohio and the Dover, Ohio galvanizing plant. The plants are expected to remain idle until the previously announced construction of a $100 million thin-slab caster is completed, which is scheduled for mid-1995. Armco expects to recognize a special charge of up to $20 million in the first quarter of 1994 for the cost of benefits to employees on layoff and other costs of idling the facilities, as well as costs associated with planned permanent work force reductions. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this item as to executive officers of Armco is contained in Part I of this report under "Executive Officers of Armco" and is incorporated herein by reference. The information required as to directors is incorporated herein by reference from the information set forth under the caption "ELECTION OF DIRECTORS" in the registrant's Proxy Statement for the 1994 Annual Meeting of Shareholders filed with the Securities and Exchange Commission pursuant to Rule 14a-6 of the Securities Exchange Act of 1934, as amended (the "Proxy Statement"). ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information required by this item is incorporated herein by reference from the information set forth in the Proxy Statement under the caption "EXECUTIVE COMPENSATION". ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The security ownership in Armco stock of directors, certain executive officers and directors and executive officers as a group and of persons known by Armco to be the beneficial owners of more than five percent of any class of Armco's voting securities is incorporated herein by reference from the information set forth in the Proxy Statement under the caption "MISCELLANEOUS -- Stock Ownership". ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K I. Documents Filed as a Part of this Report ________________ *Incorporated in this annual report on Form 10-K by reference to pages 32-56 of the Annual Report to Shareholders for the year ended December 31, 1993. Financial Statements and Financial Statement Schedules Omitted The financial statements and financial statement schedules for Armco Inc. and Consolidated Subsidiaries, and for Armco Financial Services Group and Armco Steel Company, L.P., other than those listed above, are omitted because of the absence of conditions under which they are required, or because the information is set forth in the notes to financial statements. B. Exhibits The following is an index of the exhibits included in the Form 10-K Annual Report. 3(a). Articles of Incorporation of Armco Inc., as amended as of May 12, 1993(1) 3(b). Regulations of Armco Inc. (2) 4. Armco hereby agrees to furnish to the Securities and Exchange Commission, upon its request, a copy of each instrument defining the rights of holders of long-term debt of Armco and its subsidiaries omitted pursuant to Item 601(b)(4)(iii) of Regulation S-K. 10(a). Incentive Compensation Plan (3)* 10(b). Deferred Compensation Plan for Directors (4)* 10(c). 1983 Stock Option Plan (5)* 10(d). Incentive Compensation Plan (6)* 10(e). 1993 Long-Term Incentive Plan of Armco Inc.* (7) 10(f). Severance Agreements (8)* 10(g). 1988 Stock Option Plan (9)* 10(h). 1988 Restricted Stock Plan (9)* 10(i). Executive Supplemental Deferred Compensation Plan Trust (10)* 10(j). Executive Supplemental Deferred Compensation Plan (11)* 10(k). Rights Agreement dated as of June 27, 1986 between Armco Inc. and Harris Trust and Savings Bank, as amended as of June 24, 1988 (13) 10(l). Joint Venture Formation Agreement dated March 24, 1989 (14) 10(m). Incentive Compensation Plan for Key Management (12)* 10(n). Pension Plan for Outside Directors (12)* 10(o). Key Management Severance Policy (15)* 10(p). Armco Inc. 1991 Long-Term Incentive Plan (Armco Inc. Long-Term Incentive Plan Performance Share Plan) (16)* 10(q). Profit Sharing Plan for Armco Advanced Materials Company (17)* 10(r). Minimum Pension Plan (18)* 10(s). Stainless Steel Toll Rolling Services Agreement 10(t). Armco Inc. Noncontributory Pension Plan As Amended and Restated (Effective As of January 1, 1989.)* 10(u). Armco Inc. Retirement and Savings Plan.* 11. Computation of Income (Loss) Per Share 13. Annual Report to Shareholders for the year ended December 31, 1993. (Filed for information only, except for those portions that are specifically incorporated in this Form 10-K Annual Report for the year ended December 31, 1993.) 21. List of subsidiaries of Armco Inc. 23. Independent Auditors' Consent 28. Schedule P - Analysis of Losses and Loss Expenses 99. Description of Armco Capital Stock The annual reports (Form 11-K) for the year ended December 31, 1993 for the Armco Inc. Retirement and Savings Plan and the Armco Inc. Thrift Plan for Hourly Employees will be filed by amendment as exhibits hereto, as permitted under Rule 15d-21. * Management contract or compensatory plan or arrangement required to be filed as an exhibit to the Form 10-K pursuant to Item 14(c) of Form 10-K. ______________________ (1) Incorporated by reference from Exhibit 4.2 to Armco's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993. (2) Incorporated by reference from Exhibit 3(b) to Armco's Quarterly Report on Form 10-Q for the quarter ended June 30, 1987. (3) Incorporated by reference from Exhibits 10(a) and 10(c) to Armco's Annual Report on Form 10-K for the year ended December 31, 1980. (4) Incorporated by reference from Exhibit 10(f) to Armco's Annual Report on Form 10-K for the year ended December 31, 1981. (5) Incorporated by reference from Exhibit 19 to Armco's Quarterly Report on Form 10-Q for the quarter ended March 31, 1983. (6) Incorporated by reference from Exhibit 10(g) to Armco's Annual Report on Form 10-K for the year ended December 31, 1983. (7) Incorporated by reference from Exhibit 10 to Armco's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993. (8) Incorporated by reference from Exhibit 10(a) to Armco's Quarterly Report on Form 10-Q for the quarter ended June 30, 1988. (9) Incorporated by reference from Exhibits 10(h) and 10(i) to Armco's Annual Report on Form 10-K for the year ended December 31, 1988. (10) Incorporated by reference from Exhibit 10(b) to Armco's Quarterly Report on Form 10-Q for the quarter ended June 30, 1988. (11) Incorporated by reference from Exhibit 10(c) to Armco's Quarterly Report on Form 10-Q for the quarter ended June 30, 1988. (12) Incorporated by reference from Exhibit 10(l) to Armco's Annual Report on Form 10-K for the year ended December 31, 1989. (13) Incorporated by reference from Exhibit 1 to Armco's Form 8-A dated July 7, 1986 and Exhibit 1.1 to Armco's Form 8 dated July 11, 1988. (14) Incorporated by reference from Exhibit 10 to Armco's Form 8-K dated March 27, 1989. (15) Incorporated by reference from Exhibit 10(p) to Armco's Annual Report on Form 10-K for the year ended December 31, 1990. (16) Incorporated by reference from Exhibit 10(p) to Armco's Annual Report on Form 10-K for the year ended December 31, 1991. (17) Incorporated by reference from Exhibit 10(q) to Armco's Annual Report on Form 10-K for the year ended December 31, 1991. (18) Incorporated by reference from Exhibit 10(r) to Armco's Annual Report on Form 10-K for the year ended December 31, 1991. ______________________ II. Reports on Form 8-K The following reports on Form 8-K were filed by Armco since the Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 was filed: SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized as of March 31, 1994. ARMCO INC. JAMES F. WILL By________________________________ James F. Will President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated as of March 31, 1994. JAMES F. WILL OWEN B. BUTLER By ___________________________________ By _______________________________ James F. Will Owen B. Butler President, Director Chief Executive Officer and Director ROBERT L. PURDUM DAVID A. DUKE By ___________________________________ By _______________________________ Robert L. Purdum David A. Duke Director Director DAVID G. HARMER JOHN C. HALEY By ___________________________________ By _______________________________ David G. Harmer John C. Haley Vice President and Director Chief Financial Officer PETER G. LEEMPUTTE PAUL H. HENSON By ___________________________________ By _______________________________ Peter G. Leemputte Paul H. Henson Controller Director WILLIAM B. BOYD JOHN H. LADISH By ___________________________________ By _______________________________ William B. Boyd John H. Ladish Director Director JOHN J. BURNS, JR. BURNELL R. ROBERTS By ___________________________________ By _______________________________ John J. Burns, Jr. Burnell R. Roberts Director Director INDEPENDENT AUDITORS' REPORT Armco Inc.: We have audited the consolidated financial statements of Armco Inc. and consolidated subsidiaries as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993, and have issued our report thereon dated February 9, 1994, which report includes an explanatory paragraph for changes in Armco Inc.'s methods of accounting for postretirement benefits other than pensions, income taxes, certain investments in debt and equity securities, and postemployment benefits; such consolidated financial statements and report are included in your 1993 Annual Report to Shareholders and are incorporated herein by reference. Our audits also included the consolidated financial statement schedules of Armco Inc. and consolidated subsidiaries, listed in Item 14. These consolidated financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such consolidated financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. DELOITTE & TOUCHE Pittsburgh, Pennsylvania February 9, 1994 SCHEDULE I ARMCO INC. AND CONSOLIDATED SUBSIDIARIES MARKETABLE SECURITIES--OTHER SECURITY INVESTMENTS (Dollars in Millions) (1) Joint venture partnerships. The investment represents 50% ownership in these businesses. (2) Discontinued business, 100% owned by Armco. (3) Companies accounted for by the equity method; presented at cost plus equity. (4) Investments represent joint venture ownership and/or investments in restricted deposits, advances or assets held for sale, for which there are no quoted market prices. SCHEDULE V ARMCO INC. PROPERTY, PLANT AND EQUIPMENT (Dollars in Millions) NOTES: (A) Represents foreign currency translation adjustment and reclassifications. (B) Fair market value of assets of purchased businesses. (C) Recorded value of assets of divested businesses. (D) Prior period amounts above have been restated to reflect the assets and accounts of Armco's Worldwide Grinding Systems businesses as discontinued operations. SCHEDULE VI ARMCO INC. ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (Dollars in Millions) NOTES: (A) Represents foreign currency translation adjustment and reclassifications. (B) Recorded value of assets of divested businesses. (C) The rates of depreciation are: land improvements 5%, buildings 2%--5%, and machinery and equipment 5%--33%. (D) Prior period amounts above have been restated to reflect the assets and accounts of Armco's Worldwide Grinding Systems businesses as discontinued operations. SCHEDULE VIII ARMCO INC. AND CONSOLIDATED SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (Dollars in Millions) NOTES: (A) Represents foreign currency translation adjustment and reclassifications. (B) Net balances of consolidated subsidiaries purchased (divested). INDEPENDENT AUDITORS' REPORT Armco Inc.: We have audited the accompanying consolidated balance sheets of Armco Steel Company, L.P. and Subsidiaries (an Investee of Armco Inc.) as of December 31, 1991, 1992 and 1993, and the related consolidated statements of operations and partners' capital (deficit) and cash flows for each of the four years in the period ended December 31, 1993. Our audits also included Financial Statement Schedule V, Property, Plant and Equipment; Schedule VI, Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment; Schedule VIII, Valuation and Qualifying Accounts and Reserves; Schedule IX, Short-term Borrowings; and Schedule X, Supplementary Income Statement Information, of Armco Steel Company, L.P. and subsidiaries (an Investee of Armco Inc.), all for each of the four years in the period ended December 31, 1993. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Armco Steel Company, L.P. and subsidiaries (an Investee of Armco Inc.) at December 31, 1991, 1992 and 1993, and the results of its operations and its cash flows for each of the four years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 5 to the consolidated financial statements, in 1993 the Company changed its method of accounting for retiree health care and life insurance benefits to conform with Statement of Financial Accounting Standards No. 106 and, retroactively, restated its 1990, 1991 and 1992 financial statements for the change. /s/ Deloitte & Touche Cincinnati, Ohio January 26, 1994 ARMCO STEEL COMPANY, L.P. CONSOLIDATED BALANCE SHEETS December 31, 1991, 1992 and 1993 (dollars in millions) ASSETS See notes to consolidated financial statements. ARMCO STEEL COMPANY, L.P. CONSOLIDATED BALANCE SHEETS December 31, 1991, 1992 and 1993 (dollars in millions) LIABILITIES AND PARTNERS' CAPITAL (DEFICIT) See notes to consolidated financial statements. ARMCO STEEL COMPANY, L.P. CONSOLIDATED STATEMENTS OF OPERATIONS AND PARTNERS' CAPITAL (DEFICIT) For the Years Ended December 31, 1990, 1991, 1992 and 1993 (dollars in millions) See notes to consolidated financial statements. ARMCO STEEL COMPANY, L.P. CONSOLIDATED STATEMENTS OF CASH FLOWS For the Years Ended December 31, 1990, 1991, 1992 and 1993 (dollars in millions) See notes to consolidated financial statements. ARMCO STEEL COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (dollars in millions) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation--Armco Steel Company, L.P. (the "Company") is a limited partnership formed pursuant to an agreement dated March 24, 1989 (the "Joint Venture Agreement") between Armco Inc. ("Armco") and Kawasaki Steel Corporation ("Kawasaki"). The general partner of the Company is AK Steel Corporation (the "General Partner"), formerly AK Management Corporation, a Delaware corporation owned one-half by each of AJV Investments Corp., a Delaware corporation and wholly-owned subsidiary of Armco and KSCA, Incorporated, a Delaware corporation and indirect wholly-owned subsidiary of Kawasaki. The limited partners of the Company are Armco and Kawasaki Steel Investments, Inc., a Delaware corporation and indirect wholly-owned subsidiary of Kawasaki ("KSI"). Under the Joint Venture Agreement, on May 13, 1989, Armco sold certain assets, properties and business of its Eastern Steel Division ("Predecessor") to KSI for $350.0. Simultaneously, KSI contributed the purchased assets, properties and business to the Company in exchange for a 39.5% limited partnership interest. Armco transferred to the Company substantially all of the remaining assets, properties and business of Predecessor and the Company also assumed certain of Armco's liabilities and obligations related to or arising out of Predecessor and its properties, assets and the conduct of Predecessor business for a 59.5% limited partnership interest. On May 14, 1990, KSI made a cash contribution to the Company of $70.0. On May 13, 1991 and October 4, 1991, KSI contributed another $70.0 and $33.8, respectively. The latter contribution was in satisfaction of its obligation to make an additional $35.0 capital contribution on March 15, 1992, without any change in its limited partnership interest. As a result of these contributions, on May 14, 1990, KSI's limited partnership interest increased to 44.5% with a corresponding reduction in Armco's interest and on May 13, 1991, KSI's limited partnership interest increased, and Armco's limited partnership interest decreased, to 49.5%. The General Partner has a 1.0% general partnership interest in the Company. The accompanying consolidated financial statements of the Company include the net assets acquired at formation from Armco and Kawasaki on the basis of Armco's and Kawasaki's historical cost, and the changes in the net assets of the Company subsequent to the formation, and the results of operations, partners' capital (deficit) and the cash flows for the periods since inception on such historical cost basis. Kawasaki's historical cost was based on the purchase price paid on May 13, 1989 by Kawasaki for its 40% interest in the net assets of the Company. Armco's historical cost is based on the book value of net assets contributed on May 13, 1989 by Armco for its 60% interest in the Company, adjusted for changes resulting from the 5% reductions in limited partnership interest effective May 14, 1990 and May 13, 1991. The Company consists of the operations and accounts of the Middletown Works, Ashland Works, Headquarters and ASC Investments, Inc. and its group of wholly-owned subsidiaries, (the "ASCII group"). With plants in Middletown, Ohio, and Ashland, Kentucky, the Company provides coated, high strength, low carbon flat-rolled steels to the automotive, appliance, construction and service center markets primarily in the Midwest. The Company had one major customer that accounted for 23.0%, 27.9%, 23.0% and 22.5% of its net sales in 1990, 1991, 1992 and 1993, respectively. Armco and Kawasaki agreed to share a portion of the 1992 Special Charges and Unusual Items (see Note 8) unequally with Armco being allocated 74.5%, Kawasaki 24.5% and the General Partner 1.0%. On August 31, 1992, the Company acquired a 50% ownership interest in Southwestern Ohio Steel, L.P. (SOS), a joint venture to which substantially all of the businesses of Southwestern Ohio Steel, Inc. and SOS Leveling Company, Inc. were transferred by Armco. The Company's interest in SOS was funded through capital contributions from Kawasaki, in the form of cash of $11.1, and from Armco, in the form of a 25% ownership interest in SOS with an estimated fair value of $11.1. ARMCO STEEL COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (dollars in millions) Inventories--Inventories are valued at the lower of cost or market. The cost of the majority of inventories is measured on the last in, first out (LIFO) method. Other inventories are measured principally at average cost. Liquidation of LIFO inventory layers caused by certain inventory reductions reduced the net losses in 1992 and 1993 by $2.6 and $10.4, respectively. Investments--The Company has investments in associated companies (joint ventures and an entity that the Company does not control). These investments are accounted for under the equity method. Because these companies are directly integrated in the basic steelmaking facilities, the Company includes its proportionate share of the income (loss) of these associated companies in cost of products sold. Virginia Horn Taconite Company, a member of the ASCII group ("Virginia Horn"), owns a 56% share of Eveleth Expansion Company ("Eveleth"), a company which produces iron ore pellets, which equates to a 35% interest in Eveleth Mines. In connection with such investment, Virginia Horn has certain commitments to Eveleth. Because Virginia Horn does not control Eveleth, the investment is accounted for under the equity method (see Note 7). ARMCO STEEL COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (dollars in millions) The following are condensed balance sheets of Eveleth at December 31, 1992 and 1993 and condensed statements of Eveleth's operations for the three years in the period ended December 31, 1993. The financial statements are presented on an historical basis and as adjusted to reflect the Company's estimate of net realizable value of the fixed assets of Eveleth. Eveleth Expansion Company (a partnership) Condensed Balance Sheets December 31, 1992 and 1993 (dollars in millions) ARMCO STEEL COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (dollars in millions) Eveleth Expansion Company (a partnership) Condensed Statements of Operations For the Years Ended December 31, 1991, 1992 and 1993 (dollars in millions) Notes General -- Eveleth, a partnership, is in the business of mining taconite and producing iron ore pellets for its partners. The partners of Eveleth, and their respective percentage equity interests in Eveleth, are Virginia Horn (56%), Onco Eveleth Company, a wholly-owned subsidiary of Oglebay Norton Company (ONCO) (20.5%) and Ontario Eveleth Company, a wholly-owned subsidiary of Stelco, Inc. (Stelco) (23.5%). Pellet production is allocated for sale to the partners based upon annual agreements. Partnership Funding -- Under the terms of agreements with Eveleth's lenders and among the partners, each partner is obligated to advance a portion of Eveleth's required operating funds, whether or not pellets are produced. Operating advances by each partner are made pursuant to a formula which allocates certain variable costs based on each partner's share of annually agreed-upon pellet production and certain fixed costs based on each partner's percentage interest in Eveleth. Eveleth is dependent for its continued existence upon the annual pellet purchases and ongoing financial support of its partners. Property, Plant and Equipment--Property, plant and equipment and the related depreciation expense included in the Historical--Adjusted amounts are based on the Company's estimate of the net realizable value of such fixed assets. The Historical--Adjusted amounts reflect amounts recorded by the Company for the impairment of fixed assets of $94.2 recorded prior to 1991 and an additional impairment of $42.0 recorded in 1992. The Historical--Adjusted depreciation amounts recorded by the Company represent reductions of depreciation expense for the previously recognized impairment of fixed assets in the Historical--Adjusted financial statements. Debt--Evelth's debt bears inerest of 9.5-10% and matures in 1995. ARMCO STEEL COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (dollars in millions) The Company records its proportionate share of the losses of Eveleth based on Historical--Adjusted amounts. These losses, which are included in the Company's cost of products sold, were $6.5, $16.1, $17.4 and $14.0 in 1990, 1991, 1992 and 1993, respectively. In addition, in 1992 the Company fully impaired its investment in Eveleth to recognize the Company's estimate of the net realizable value of the fixed assets of Eveleth. The Company's recorded share of Eveleth's losses in 1991 and 1992 exceeded its proportionate percentage interest in Eveleth because the Company purchased a larger percentage of Eveleth's annual pellet production relative to its percentage interest and, therefore, under the cost-allocation formula described above, the Company absorbed a higher percentage of the Eveleth costs. The Company's annual cash funding of Eveleth's fixed costs is appproximately $12.0 per year. See Notes 7 and 8. The following is a summary of the net assets of SOS at December 31, 1992 and 1993 and its operating results for the four months ended December 31, 1992 and the year ended December 31, 1993. Property, Plant and Equipment--Steelmaking plant and equipment are depreciated under the straight line method over their estimated lives ranging from 2 to 31 years. Maintenance and repair expenses for 1990, 1991, 1992 and 1993 were $278.5, $267.1, $265.5 and $261.3, respectively. Financial Instruments--The carrying value of the Company's financial instruments does not differ materially from their estimated fair value. Cash Equivalents--Cash equivalents include short-term, highly liquid investments that are readily convertible to known amounts of cash and are of an original maturity of three months or less. 2. INCOME TAXES The ASCII group will file a consolidated federal income tax return for the year ended December 31, 1993. No federal tax will be due for 1993 due to the incurrence of a consolidated 1993 loss. ARMCO STEEL COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (dollars in millions) Deferred federal income taxes in the accompanying Consolidated Balance Sheets relate to temporary differences of the ASCII group, primarily differences between book and tax carrying values of the group's investments in joint ventures. The ASCII group recorded a consolidated deferred tax benefit of $10.8 in 1992 which represents the net reduction during the year of the group's consolidated deferred tax liability. No deferred tax charge or benefit was recorded in 1993. The ASCII group has consolidated net operating loss (NOL) carryforwards into 1994 of $34.3 under the "regular" tax system ($32.5 under the alternative minimum tax (AMT) system). These NOL's, if unused to offset future consolidated taxable income of the ASCII group, will expire in 2006, 2007 and 2008. In addition, Virginia Horn, one of ASCII's wholly-owned subsidiaries, has available an NOL carryforward into 1994 of $1.5 under the "regular" tax system ($1.7 under the AMT system). This carryforward, if unused to offset future Virginia Horn taxable income, will expire in 2001. However, for federal income tax purposes, the amount of NOL carryforwards arising prior to the Recapitalization (see Note 11) which will annually be available to offset taxable income following the Recapitalization may be restricted by Section 382 of the Internal Revenue Code. As a result, the use of all or a significant portion of these NOL carryforwards may be deferred or disallowed. The ASCII group adopted Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes, effective January 1, 1993. The effect of this standard was not material. Other than for the ASCII group, the financial statements do not reflect U.S. federal income tax liabilities because each of the partners' U.S. federal income tax returns will include their appropriate share of the Company's taxable income or loss. 3. NOTES PAYABLE AND LONG-TERM DEBT At December 31, 1993, the Company had agreements that provide credit facilities for borrowings up to $50.0 with a group of banks on a revolving credit basis until May, 1994. At December 31, 1993, $3.8 letters of credit were issued under these facilities. Under the terms of a Security Agreement between the Company and its lenders, these credit facilities and the majority of the Company's long-term debt are secured by a pool of Company assets which includes accounts receivable, inventories, and property, plant and equipment. The terms of the Security Agreement will permit additional financings, which are yet to be negotiated, of up to $254.0 through 1995 to be secured by the pledged assets. At December 31, 1993, the Company also had a $100.0 unsecured term loan, maturing in 1996, with an affiliate of Kawasaki. The Company has incurred interest expense and commitment fees to an affiliate of Kawasaki of $2.1, $2.4, $1.3 and $4.2 during 1990, 1991, 1992 and 1993, respectively, relating to borrowings under the revolving credit agreement and the unsecured term loan. On January 18, 1994, the Company's various lenders signed amendments to the revolving credit agreements and long-term debt agreements to revise certain financial covenants effective as of December 31, 1993. The Company is required to maintain as of December 31, 1993 a minimum tangible net worth of $650.0, a minimum current ratio of 1.0 and a maximum leverage ratio of 1.0, as defined in the agreements. At December 31, 1993, the Company's actual measures under these financial covenants were a tangible net worth of $742.1, a current ratio of 1.76 and a leverage ratio of 0.85. In addition, on January 18, 1994 the Company entered into an agreement with certain of its lenders whereby the maturity of a portion of its debt will be extended to May 31, 1995 in the event that the proposed recapitalization described in Note 11 is not completed by May 1994 (the original maturity date of the debt). Management believes that the Recapitalization will be completed before that date. As a result, $80.0 of debt has been classified as long-term at December 31, 1993. ARMCO STEEL COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (dollars in millions) At December 31, 1991, 1992 and 1993, the Company's long-term debt, less current maturities, was as follows: - ---------------- (a) Rate fixed in 1992. (b) Debt secured by the No. 1 Electrogalvanizing Line and a $15.0 letter of credit. (c) Debt with extended maturity to May 31, 1995. (d) Unsecured subordinated term loan with an affiliate of Kawasaki. At December 31, 1993, the maturities of long-term debt are as follows: The Company capitalized interest on projects under construction of $12.6, $7.1, $3.5 and $1.2 during 1990, 1991, 1992 and 1993, respectively. 4. OPERATING LEASES Rental expense was $9.7, $11.2, $14.6 and $10.1 for 1990, 1991, 1992 and 1993, respectively. At December 31, 1993, obligations to make future minimum lease payments were as follows: 5. EMPLOYEE AND RETIREE BENEFIT PLANS Pension Plans--The Company provides noncontributory pension benefits to virtually all employees. Benefits are based on years of service and earnings in the highest 60 consecutive months in the last 120 months prior to retirement or a minimum amount per year of service, whichever is higher. The qualified plans are funded in accordance with the minimum funding requirements of the Employee Retirement Income Security Act of 1974, as amended. ARMCO STEEL COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (dollars in millions) The details of the net periodic pension expense for 1990, 1991, 1992 and 1993 are as follows: The funded status of the plans at December 31, 1991, 1992 and 1993, using the assumptions stated below for each period, was as follows: - ----------------- * The change in the discount rate is expected to increase pension expense by $9.1 annually and to have no material effect on funding requirements. The mix of pension assets held at December 31, 1993 was as follows: Of the total accrued pension cost of $110.5, $201.5 and $209.3 at December 31, 1991, 1992, and 1993, respectively, $45.4, $24.9 and $56.6 are included in Other accruals, and $65.1, $176.6 and $152.7 are included in Other liabilities in the accompanying Consolidated Balance Sheets. The 1992 pension disclosures above include the effects on the Company's pension plans of the Special Charges and Unusual Items described in Note 8. The total loss resulting from the related curtailment and special and contractual termination benefits amounted to $105.9. A minimum liability and corresponding intangible asset of $23.2, $25.9 and $35.2 at December 31, 1991, 1992 and 1993, respectively, was recognized for the excess of the accumulated benefit obligation over the total ARMCO STEEL COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (dollars in millions) of plan assets and the accrued pension liability. These balances are included in Other liabilities and Other assets, respectively, in the accompanying Consolidated Balance Sheets. In addition, a direct charge to equity of $113.2 was recorded in 1993 primarily as a result of the reduction in the discount rate for pension liabilities from 8.5% to 7.5%. The corresponding credit is included in Other liabilities. Retiree Health Care and Life Insurance Benefits -- In addition to providing pension benefits, the Company provides certain health and life insurance benefits for retirees. Most employees become eligible for these benefits at retirement. The retiree health and life insurance benefits are funded as claims are paid and for 1990, 1991, 1992 and 1993 the Company paid benefits totalling $24.2, $28.1, $29.7 and $32.2, respectively. In December 1993, the Company adopted SFAS 106, "Employers' Accounting for Postretirement Benefits Other than Pensions", retroactive to January 1, 1990. SFAS 106 requires the Company to accrue the estimated cost of retiree benefit payments during the years the employee provides services. The Company previously expensed the cost of these benefits, which are principally health care, as claims were incurred. SFAS No. 106 allows recognition of the cumulative effect of this obligation in the year of the adoption or the amortization of the obligation over a period of up to twenty years. The Company elected to recognize this obligation immediately effective January 1, 1990 and recorded $491.6 as the cumulative effect of this charge. The Company's cash flows are not affected by implementation of this statement, but implementation increased the operating loss by $23.8, $22.2, and $22.9 in 1990, 1991 and 1992, respectively, and decreased the operating profit by $27.0 in 1993. The Company is presently paying for these plans from its general assets as the benefits become payable. The Company does not anticipate funding these benefits in the foreseeable future. In 1990, 1991, 1992 and 1993, the Company recognized $48.0 $50.3, $52.6 and $59.2, respectively, as an expense for postretirement health care and life insurance benefits. A special charge of $56.5 for retiree health care benefits associated with restructuring and a voluntary salary reduction program was taken in the fourth quarter of 1992. (see Note 8). The following table sets forth the plans' funded status, reconciled with amounts recognized in the Company's statement of financial position at December 31, 1991, 1992 and 1993. ARMCO STEEL COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (dollars in millions) For measurement purposes, health care costs are assumed to increase 10% in 1994 grading down by 1% per year to a constant level of 4.5% annual increase for pre-65 benefits and 7% in 1994 grading down by 1% per year to a constant level of 4.5% annual increase for post-65 benefits. In concluding that health care trend rates will decrease at a rate of 1% per year, the Company has considered future rates of inflation, recent movements toward managed health care programs in negotiated contracts and the trend among larger companies toward the formation of coalitions in an effort to reduce health care costs. The Company is currently finalizing negotiations with health care providers in the Cincinnati- Dayton corridor, a region that includes a significant number of the Company's retirees. In addition, the Company intends to implement similar managed health care programs in other geographic regions containing a concentration of its retirees, and is developing a managed care network for all active and retired salaried and union employees in Ohio. These programs will be in effect in January 1995. The Company has also considered the recent political environment and activities geared towards reducing health care costs and has taken into consideration the level of health care costs in relation to the U.S. Gross National Product (GNP). Despite the assumption that health care trend rates will decrease 1% per year, the combination of assumptions used in the SFAS 106 valuation results in approximately 18% of GNP for health care costs by the year 2000 compared to 14% currently. A one (1) percentage point increase in the assumed health care cost trend rate for each year would increase the accumulated postretirement benefit obligation as of January 1, 1994 by $75.7 and the aggregate of the service cost and interest cost components of net period benefit cost for the year then ended by $6.8. The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7.5% for 1993 and 8.5% for prior years. This 1% reduction in the discount rate associated with a 1% reduction in the ultimate health care trend rate will increase OPEB expense by $0.1. The Company will adopt SFAS 112, Employers' Accounting for Postemployment Benefits, effective January 1, 1993. Adoption of this standard did not have a material effect on the accompanying consolidated financial statements. 6. RELATED PARTY TRANSACTIONS During 1990, 1991, 1992 and 1993, the Company was party to certain transactions with Armco, Kawasaki, and their affiliates. These transactions consisted of charges to and from the Company for various services rendered and received, and are reflected primarily in Selling and administrative expenses in 1990, 1991 and 1992, and in Cost of products sold in 1993 in the accompanying Consolidated Statements of Operations. The following is a summary of such related party services for the periods: Services provided to Armco and affiliates by the Company: ARMCO STEEL COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (dollars in millions) Services provided to the Company by Armco, Kawasaki and their affiliates and inventory purchases from Armco: Processing and conversion increased during 1992 and 1993 as the Company provided services to Armco under a long-term toll rolling agreement, which will continue in effect after completion of the proposed Recapitalization (see Note 11). Research and engineering decreased in 1993 due to Armco transferring a portion of their research staff to the Company on April 1, 1993. The cost of this research staff for the nine-months ended December 31, 1993 was $3.8 and was included in Selling and administrative expenses in the Consolidated Statements of Operations and Partners' Capital (Deficit). In 1993, the Company purchased processing services and other materials of $3.6 from SOS. The Company acquired a 50% ownership interest in SOS to which substantially all of the businesses of Southwestern Ohio Steel, Inc. and SOS Leveling Company, Inc. were transferred by Armco. Sales to Armco, Kawasaki and their affiliates were $101.2, $89.8, $85.9 and $36.7 during 1990, 1991, 1992 and 1993, respectively, and sales to SOS were $26.0 for the four months ended December 31, 1992 and $99.5 for 1993. All of these amounts are included in Total Net Sales in the accompanying Consolidated Statements of Operations. Other miscellaneous sales to Armco, Kawasaki and their affiliates were $5.0, $2.5, $1.7 and $0.7 during 1990, 1991, 1992 and 1993, respectively. Under the Joint Venture Agreement, Armco is obligated to indemnify the Company for certain supplemental unemployment benefit payments up to a maximum of $20.0. As a result, the related receivables are included as reductions in Partners' Capital (Deficit) in the accompanying Consolidated Balance Sheets. 7. COMMITMENTS Virginia Horn is committed to fund its percentage share of certain defined fixed costs of Eveleth. Through an agreement with Armco the Company has assumed Armco's obligations relating to Virginia Horn which include a guarantee of Virginia Horn's performance to the other participants of Eveleth Mines. Under agreement with another owner of Eveleth, the Company purchased 300,000 tons of iron ore from this Eveleth partner in 1993 and is expected to purchase at least 250,000 tons per year through 1996. Beginning in the fourth quarter of 1992, Virginia Horn elected not to nominate to purchase equity iron ore pellets from Eveleth. As a result of that decision together with doubts regarding the continued level of support by the Eveleth Mines partners, in light of worldwide excess iron ore capacity and Eveleth Mines' position as a high cost producer, the Company concluded that its ability to recover its investment was doubtful and therefore impaired its investment in Eveleth Mines (see Note 8). However, the Company continues to record its proportionate share of Eveleth's losses, of which approximately $12.0 per year is funded with cash. See Note 10. As of December 31, 1993, the Company had agreed to purchase a total of 1.6 million tons of iron ore pellets from a Brazilian iron ore company through 1998. Under this contract, the Company also has agreed to purchase sinter feed ore requirements. In addition, the Company has agreed to purchase at least 6.5 million tons through 1997 from a North American pellet producer. In June 1993, the Company and Peabody Coal Company ("Peabody") entered into a six-year agreement that superseded a 1984 agreement. The new agreement provides for a fixed market price from February 1994 through February 1996, after which annual price adjustments will be made based on market prices. In addition, Peabody agreed to a price reduction for the remainder of 1993. ARMCO STEEL COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (dollars in millions) The Company has committed to purchase property, plant and equipment (including unexpended amounts relating to projects substantially under way) amounting to approximately $74.8 (including $38.9 of environmental costs of which $24.2 and $14.7 will be spent in 1994 and 1995 respectively) at December 31, 1993. 8. SPECIAL CHARGES AND UNUSUAL ITEMS The special charges and unusual items recorded in 1992 and 1993 are: - -------------- (a) Net of estimated realizable values. In 1992, the Company recorded charges totalling $379.3 relating to restructuring of facilities, workforce reductions and the impairment of its investment in Eveleth. Restructuring of the facilities and workforce reductions resulted from the determination that the Company had redundant assets, excess capacity and excessive operating costs. The impairment of Eveleth followed the Company's conclusion as to its inability to recover its investment (see Note 7). Most of these actions, which were intended to reduce future operating costs, took place following an operations review conducted by the Company's newly appointed management team and were completed in the fourth quarter of 1992. In 1993, the Company continued to review its operations for the purpose of reducing operating costs. In connection with this review, the Company recorded additional charges of $12.6 for restructuring of facilities, and $5.0 for certain legal, litigation and other unusual items which consist of $3.0 that is reserved for litigation payments resulting from the aborted outsourcing of operations in Ashland that were shut down as part of the Ashland restructuring and $2.0 for legal expenses in connection with defending the Company for existing and potential lawsuits relating to the workforce terminations. See Note 10. 9. EXTRAORDINARY ITEM The extraordinary item recorded in 1992 represents the following: "The Coal Industry Retiree Health Benefit Act" requires that health benefits for any pre-1976 retirees who were previously covered by one of two insolvent United Mineworkers multi-employer welfare funds revert to their former employers. Retirees of employers that no longer exist are also assigned to surviving companies using a formula included in the legislation. The Company was required to assume a portion of their benefits and recorded an extraordinary loss of $12.1 of which $1.2 and $0.9 are included in Other accruals and $10.9 and $11.9 in Other liabilities in the accompanying Consolidated Balance Sheets as of December 31, 1992 and 1993, respectively. ARMCO STEEL COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (dollars in millions) 10. LEGAL, ENVIRONMENTAL MATTERS AND CONTINGENCIES Domestic steel producers, including the Company, are subject to stringent federal, state and local laws and regulations relating to the protection of human health and the environment. The Company has expended, and can be expected to expend in the future, substantial amounts for compliance with these environmental laws and regulations. Capital expenditures for environmental remediation and protection for 1993 totalled $16.4. In addition, the Company made payments for environmental compliance of approximately $38.3 for 1993. The Clean Air Act Amendments of 1990 (the "CAAA" or "Amendments") impose new standards designed to reduce air emissions. The Amendments will directly affect many of the Company's ongoing operations, particularly its coke oven batteries. The Company believes that the costs of complying with the Amendments will not have a material adverse effect on its financial condition, results of operations or cash flows. Federal regulations promulgated pursuant to the Clean Water Act impose categorical pretreatment limits on the concentrations of various constitutions in coke plant wastewaters prior to discharge into publicly owned treatment works ("POTW"). Due to concentrations of ammonia and phenol in excess of these limits at the Middletown Works, the Company, through the Middletown POTW, petitioned the United States Environmental Protection Agency (the "EPA") for "removal credits," a type of compliance exemption, based on the Middletown POTW's satisfactory treatment of the Company's wastewater for ammonia and phenol. The EPA declined to review the Company's application on the grounds that the EPA had failed to promulgate new sludge management rules. As a result of the EPA's refusal, the Company sought and obtained from the Federal District Court for the Southern District of Ohio an injunction prohibiting the EPA from instituting enforcement action against the Company for noncompliance with the pretreatment limitations, pending the EPA's promulgation of the applicable sludge management regulations. Although the Company is unable to predict the outcome of this matter, if the EPA eventually refuses to grant the Company's request for removal credits, the Company could incur additional costs to construct pretreatment facilities at the Middletown Works. The estimated cost of such a facility is in the range of $2.0 to $4.0. The Company believes those costs would not have a material adverse effect on its financial condition, results of operations or cash flows. The Company operates an on-site landfill for the disposal of various sludges and dusts, principally resulting from air and water pollution treatment systems at the Middletown Works. These materials are currently considered non-hazardous wastes. The Company currently intends, subject to approval by the Ohio Environmental Protection Agency (the "Ohio EPA"), to expand the present landfill, which is expected to reach capacity in the next eight to nine years. Based on current projections, the Company estimates that the design and construction of the expansion, which is slated to begin in mid-1994 with an anticipated completion date of January 1, 1996, will cost approximately $6.2 million. If the expansion is not approved by the Ohio EPA, the Company may incur increased disposal costs due to the need for off-site disposal. The Company believes these costs would not have a material adverse effect on its financial condition, results of operations or cash flows. On December 5, 1986, Armco received notification from the EPA advising that it was being considered as a PRP at the Maxey Flats Nuclear Disposal Site near Morehead, Kentucky. Records from the landfill indicated that the Ashland Works had sent approximately 120 cubic feet of material to the site. The Company has been identified as de minimis contributor to the Maxey Flats site, and as a result, anticipates that it will be able to resolve its liability for a nominal amount. ARMCO STEEL COMPANY, L.P. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued) (dollars in millions) The Company will continue to review its businesses to determine if additional facilities should be closed, written down or otherwise restructured or if its workforce should be further reduced. In this regard, the Company is negotiating with the Eveleth partners concerning the potential closure of, or the Company's exit from, Eveleth. If these negotiations are successfully completed, the closure of, or exit from, Eveleth would be subject to other events, including the approval by the Company's Board of Directors, and could result in a charge of approximately $30.0 million. This amount approximates the Company's proportionate share of the potential shutdown costs arising from the potential closure, which costs primarily represent employee and retiree benefits and contract termination fees. In addition, in the second quarter of 1994 the Company may incur a charge of approximately $65.0 million relating to further reductions of its workforce, subject to approval by the Company's Board of Directors. This charge is expected to be comprised of approximately $50.0 million for pension-related curtailments and $15.0 million for health care related curtailments. Although it is not possible at this time for the Company to determine accurately the amounts of any other special charges that may result from the closure, write down or restructuring of other facilities or from additional workforce reductions, additional special charges could be incurred and may be substantial. The company is also involved in routine litigation, other environmental proceedings, and claims pending with respect to matters arising out of the normal conduct of the business. In management's opinion, the ultimate liability resulting from such claims, individually or in the aggregate, will not materially affect the Company's consolidated financial position, results of operations or cash flows. In June 1990, the Company filed an antitrust action against several companies. Effective February 25, 1992, the Company reached a confidential settlement with three of the four remaining defendants. The settlement reduced 1992 Cost of products sold in the accompanying Consolidated Statements of Operations. The Company is continuing to pursue the claim against the remaining defendant. 11. SUBSEQUENT EVENTS On January 13, 1994, the General Partner approved the filing with the Securities and Exchange Commission of registration statements in connection with a proposed Recapitalization of the Company (the "Recapitalization"). The Company is currently negotiating for the sale of its ownership interest in SOS and another subsidiary of ASCII. No prediction can be made concerning the ultimate outcome of such negotiations which, if successful, would be subject to other events including the approval by the Company's Board of Directors. However, the ultimate sale, if any, will not result in a loss. SCHEDULE V ARMCO STEEL COMPANY, L.P. PROPERTY, PLANT AND EQUIPMENT (Dollars in Millions) - -------------- NOTES: (A) Reclass from Lease-rights to Property upon payment of leases. (B) Reclass additional portions of Caster undergoing modification to construction in progress. (C) Transfer of steel processing companies from Armco Inc. (D) Impair and reclass to investments, assets which are to be idled and sold as part of the Company's restructuring plan. SCHEDULE VI ARMCO STEEL COMPANY, L.P. ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (Dollars in Millions) - ---------- NOTES: (A) Reclass from Lease-rights to Property upon payment of leases. (B) Impairment of a blast furnace and other equipment. (C) Reclassification of asset groups. (D) Impairment and reclassification to investments, assets which are to be idled and sold as part of the Company's restructuring plan. (E) Generally, depreciation rates on assets are 5% for land improvements and leaseholds, 3-4% for Buildings and 5% for Machinery and equipment. SCHEDULE VIII ARMCO STEEL COMPANY, L.P. VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (Dollars in Millions) - -------------- NOTES: (A) Represents impairment of Virginia Horn Taconite Company's investment in Eveleth Expansion Company. SCHEDULE IX ARMCO STEEL COMPANY, L.P. SHORT-TERM BORROWINGS (Dollars in Millions) - -------------- NOTES: (A) Borrowings from an affiliate, which are payable within one year. (B) Based on daily balances. (C) Based on average rates for two weeks preceding and following year-end. SCHEDULE X ARMCO STEEL COMPANY, L.P. SUPPLEMENTARY INCOME STATEMENT INFORMATION INDEPENDENT AUDITORS' REPORT - ---------------------------- Armco Inc.: We have audited the statement of consolidated net assets of Armco Financial Services Group - Companies to be Sold as of December 31, 1993 and 1992 and the related consolidated statements of operations and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included Financial Statement Schedule I, Summary of Investments - Other than Investments in Related Parties; Schedule III, Condensed Financial Information; Schedule VI, Reinsurance; Schedule VIII, Valuation and Qualifying Accounts; and Schedule X, Supplemental Information Concerning Property-Casualty Insurance Operations. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Armco Financial Services Group - Companies to be Sold at December 31, 1993 and 1992 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Notes 3 and 6 to the consolidated financial statements, effective January 1, 1993 the Company changed its method of accounting for reinsurance contracts and postretirement benefits other than pensions. As discussed in Note 1 to the consolidated financial statements, effective December 31, 1993 the Company changed its method of accounting for investments in debt securities. DELOITTE & TOUCHE Milwaukee, Wisconsin February 25, 1994 ARMCO FINANCIAL SERVICES GROUP - COMPANIES TO BE SOLD STATEMENT OF CONSOLIDATED NET ASSETS AS OF DECEMBER 31, 1993 AND 1992 (Dollars in thousands) See notes to consolidated financial statements. ARMCO FINANCIAL SERVICES GROUP - COMPANIES TO BE SOLD STATEMENT OF CONSOLIDATED OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands) See notes to consolidated financial statements. ARMCO FINANCIAL SERVICES GROUP - COMPANIES TO BE SOLD STATEMENT OF CONSOLIDATED CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands) (continued) ARMCO FINANCIAL SERVICES GROUP - COMPANIES TO BE SOLD CONSOLIDATED STATEMENT OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands) See notes to consolidated financial statements. - ------------------------------------------------------------------------------ ARMCO FINANCIAL SERVICES GROUP - COMPANIES TO BE SOLD NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - ---------------------------------------------------- 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Armco Financial Services Group - Companies to be Sold (AFSG - Companies to be Sold or the Company) consists of the net assets of Armco Inc.'s (Armco) insurance companies which Armco intends to sell and which continue underwriting activities. These activities principally represent the transactions of Northwestern National Holding Company, Inc. (NNHC), which is a wholly owned subsidiary of Armco Financial Services Corporation (AFSC), which is a wholly owned subsidiary of Armco and is accounted for by Armco as an investment in net assets using the cost recovery method. NNHC owns 100% of the common and preferred stock of Northwestern National Casualty Company and its wholly owned subsidiary, NN Insurance Company (collectively, NNCC), Pacific National Insurance Company and its wholly owned subsidiary, Pacific Automobile Insurance Company (collectively, PNIC), SICO, Inc. and its wholly owned subsidiary, Statesman Insurance Company and Statesman's wholly owned subsidiary Timeco, Inc. (collectively, SICO) and Certified Finance Corporation (CFC). CFC had not commenced operations as of December 31, 1993. Principles of Consolidation - The consolidated financial statements include --------------------------- the accounts of NNHC and its subsidiaries NNCC, PNIC, SICO and CFC. Significant intercompany accounts and transactions have been eliminated. Business Segment - The Company operates in a single business segment, ---------------- property and casualty insurance. Basis of Presentation - The accompanying financial statements have been --------------------- prepared on the basis of generally accepted accounting principles (GAAP) which vary from statutory reporting practices prescribed or permitted for insurance companies by regulatory authorities (see Note 8). Investments - In May 1993, the Financial Accounting Standards Board (FASB) ----------- issued Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." The statement requires fixed maturity investments which are available for sale to be recorded at market value. The Company adopted SFAS No. 115 on December 31, 1993 and reclassified certain investments from the "held to maturity class" into the "available for sale" class on the same date. The financial statement effect of adopting the statement was to increase investments by $13,321,000 and net assets by $13,321,000. Amounts reported in the Statement of Consolidated Cash Flows for 1993 are based on the classification of securities prior to the adoption of SFAS No. 115. Fixed maturity investments include bonds and mortgage-backed securities. Fixed maturity investments which the Company has the positive intent and ability to hold to maturity ("held to maturity") are reported at amortized cost. Fixed maturity investments which are available for sale ("available for sale") are reported at market value as of December 31, 1993 and at the lower of amortized cost or market, determined in the aggregate, as of December 31, 1992. Equity securities are common stocks which are reported at market value. The difference between cost and market value of common stocks, and investments available for sale at December 31, 1993, is reflected as a component of net assets. Short-term investments (cash equivalents) are reported at cost which approximates market value. During 1992, the Company re-evaluated its intentions to hold to maturity all of its bonds and reclassified certain investments as available for sale. Investments classified as available for sale are expected to be held for an indefinite period and may be sold depending on interest rates, cash requirements and other considerations. Because the aggregate market value of these investments exceeded the amortized cost, there was no financial statement effect of this reclassification as of December 31, 1992. Investment income consists primarily of interest which is recognized on an accrual basis. Interest income on mortgage-backed securities is determined on the effective yield method based on scheduled principal payments. Realized capital gains and losses, calculated as the difference between proceeds and book value, are determined by specific identification of the investments sold. Recognition of Premium Revenues - Premiums, net of reinsurance ceded, are ------------------------------- earned on a pro rata basis over the term of the policy. Deferred Policy Acquisition Costs - Policy acquisition costs that vary with --------------------------------- and are directly related to the production of premiums are deferred and amortized over the terms of the policies to which they relate. Amortization for the years ended December 31, 1993, 1992 and 1991 was $46,456,000, $49,912,000 and $56,256,000, respectively. Depreciation - Depreciation on property and equipment is provided primarily ------------ on the straight-line basis over the estimated useful lives of the respective assets. Goodwill - Goodwill, which represents the excess of cost over the fair value -------- of net assets of acquired subsidiaries is amortized on a straight-line basis over periods not exceeding 40 years. Cash Flow - For purposes of reporting cash flows, the Company considers all --------- highly liquid short-term investments purchased with maturities of three months or less to be cash equivalents. Insurance Liabilities - The liability for losses and loss adjustment expenses --------------------- is reported net of a receivable for salvage and subrogation of $7,746,000, $7,523,000 and $7,499,000 at December 31, 1993, 1992 and 1991, respectively. Participating Policy Contracts - Participating business represents ------------------------------ approximately 14%, 13% and 11% of total premiums in force at December 31, 1993, 1992 and 1991, respectively. Participating business is composed entirely of workers' compensation policies. The amount of dividends to be paid on these policies is determined based on the provisions of the individual policies. Dividend expense for the years ended December 31, 1993, 1992 and 1991, was $2,414,000, $2,966,000 and $5,170,000, respectively. 2. INVESTMENTS The amortized cost and market value of the Company's fixed maturity investments as of December 31, 1993 that are designated as held to maturity are as follows: The amortized cost and market value of the Company's fixed maturity investments as of December 31, 1993 that are designated as available for sale are as follows: The amortized cost and market value of the Company's fixed maturity investments as of December 31, 1992 that are designated as held to maturity are as follows: The amortized cost and market value of the Company's fixed maturity investments as of December 31, 1992 that are designated as available for sale are as follows: The amortized cost and market value of the Company's fixed maturity investments at December 31, 1993, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Proceeds from fixed maturity investment sales and gross realized gains and losses during 1993 are as follows: Proceeds from sales and maturities of investments during 1992 and 1991 were $267,030,000 and $230,664,000, respectively. Gross gains of $11,060,000 and $5,514,000 and gross losses of $978,000 and $2,985,000 were realized on those sales. At December 31, 1993 and 1992, the Company's fixed maturity investments carried at amortized cost of $52,845,000 and $44,716,000, respectively, were on deposit with regulatory authorities. Total investment income, investment expense and net investment income for the years ended December 31, 1993, 1992 and 1991 were as follows: 3. REINSURANCE ACTIVITY The Company limits the maximum net loss which can arise from large risks or risks in concentrated areas of exposure by reinsuring (ceding) certain levels of risks with other insurers, either on an automatic basis or under general reinsurance contracts known as "treaties" or by negotiation on substantial individual risks. Ceded reinsurance is treated as the risk and liability of the assuming companies. Reinsurance contracts do not relieve the Company from its obligations to policyholders. In the event that reinsuring companies are unable to meet their obligations under the agreements, the Company would continue to have primary liability to policyholders for losses incurred. The Company evaluates the financial condition of its reinsurers and evaluates concentrations of credit risk when determining reinsurance placements. At December 31, 1993 reinsurance receivables of $18,061,000 and prepaid reinsurance premiums of $2,026,000 were associated with a single reinsurer. The Company has never suffered a significant loss due to reinsurers unable to meet their obligations. The following tables summarize amounts related to reinsurance assumed and ceded as of December 31, 1993, 1992 and 1991 and for the years then ended, respectively. Loss and Loss Adjustment Expense (LAE) Activity: (Dollars in Thousands) In December 1992, the FASB issued SFAS No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts." The statement establishes the conditions required for a contract to be accounted for as reinsurance and prescribes accounting and reporting standards for those contracts. The Company adopted SFAS No. 113 on January 1, 1993. Prior to the adoption of the new statement, assets and liabilities were reported net of the effects of reinsurance. Subsequent to the adoption of the new statement, ceded reinsurance balances due from unaffiliated insurers are reported separately as assets. Ceded reinsurance balances due from affiliated insurers continue to be reported in liabilities. As permitted by the statement, prior period financial statements have been restated. 4. TRANSACTIONS WITH AFFILIATES The Company has entered into a number of agreements or arrangements with affiliated companies in connection with intercompany services. The net amounts charged (credited) to operations during 1993, 1992 and 1991, were as follows: The net amount due from affiliates at December 31, 1993, which includes fees and assessments paid by the Company on behalf of affiliates, was $803,000. At December 31, 1992, $36,000 was due to affiliates. 5. INCOME TAXES Armco and the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109) effective January 1, 1993. SFAS No. 109 requires an asset and liability approach for financial accounting. Armco accounted for the operating results of the AFSG - Companies to be Sold under the cost recovery method, whereby net income is not recognized until realized through a sale of the business, while net losses are charged against income as incurred. These businesses are now presented as discontinued operations with a portion of the consolidated Armco federal tax provision/benefit being allocated to the Company in accordance with the intraperiod tax allocation provisions of SFAS No. 109. Because Armco is in a consolidated net operating loss position for both financial reporting and federal income tax purposes, no federal income tax provision or benefit was allocated to the Company. Because Armco accounts for the Company as an investment which it intends to sell, the cumulative effect of adopting SFAS No. 109 and the deferred federal tax assets and liabilities applicable to the Company are recorded on the books of Armco, rather than by the Company. The Company and its subsidiaries file state income tax returns in several states on both a separate company and combined basis. A provision (benefit) of $223,000, $(166,000) and $246,000 is reported in the Statement of Consolidated Operations for the years ended December 31, 1993, 1992 and 1991, respectively. The 1993 provision includes a current year state income tax provision of $224,000 and adjustments to prior years state income taxes of $(1,000). The 1992 benefit includes a current year state income tax provision of $27,000 and a refund from prior year state income taxes of $(193,000). The 1991 provision includes a current year state income tax provision of $2,000 and an adjustment to prior years state income taxes of $244,000. 6. PENSION, PROFIT SHARING AND BENEFIT PLANS The Company has a noncontributory, trusteed retirement plan covering substantially all of its employees. Pension costs relating to this retirement plan are computed based on accepted actuarial methods. It is the Company's policy to fund pension costs as they accrue, but, in no event at less than the amount required by, nor more than the maximum amount allowable under, the Employee Retirement Income Security Act of 1974 (ERISA). Contributions are intended to provide not only for benefits attributed to service to date but also for those expected to be earned in the future. The following table sets forth the retirement plan's funded status and amounts recognized in the financial statements of the Company at December 31, 1993, 1992 and 1991: Net periodic pension benefit for 1993, 1992 and 1991 included the following components: The following assumptions were used in determining the actuarial present value of the projected benefit obligation as of December 31, 1993, 1992 and 1991: The Company, along with other affiliates, has a benefit plan which provides medical and dental benefits for eligible retired employees. Substantially, all employees become eligible for these benefits if they reach normal retirement age while working for the Company. These benefits are funded as claims are paid. In December 1990, the FASB issued SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." The standard requires the accrual of expense for these benefits during the years the employee is actively employed. The Company adopted SFAS No. 106 on January 1, 1993. The cumulative effect of the accounting change resulted in a decrease in 1993 income of $14,000,000. The following table sets forth the benefit plan's funded status and amounts recognized in the balance sheets of the companies participating in the plan as of December 31, 1993. The accrued postretirement benefit liability applicable solely to the Company is $14,633,000 as of December 31, 1993. Net postretirement benefit cost applicable solely to the Company for the year ended December 31, 1993 is $15,174,000. For measurement purposes, an 11.25% annual rate of increase in the per capita cost of covered health care benefits for non-Medicare eligible participants was assumed for 1994 (8.25% used for Medicare eligible participants); the rate was assumed to decrease gradually to 5.25% for all participants by 2000 and remain at that level thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. To illustrate, increasing the assumed health care cost trend rates by one percentage point in each year would increase the plan's accumulated postretirement benefit obligation as of December 31, 1993 by $2,866,000, and the aggregate service cost and interest cost components of the plan's net periodic postretirement benefit cost for the year by $446,000. The weighted average discount rate used in determining the accumulated postretirement benefit obligation at December 31, 1993 was 7.25%. The Company also has a noncontributory, trusteed profit sharing plan. Annual contributions to the plan (limited to a maximum of 15% of participating salaries) are based upon operating results of the Company. No expense was recorded for the years ended December 31, 1993, 1992 and 1991. The Company provides medical, dental and life insurance benefits to eligible participants on long-term disability, at no cost to the participant. Prior to 1993, the Company expensed these benefits on a pay-as-you-go basis. In December 1992, the FASB issued SFAS No. 112, "Employers' Accounting for Postemployment Benefits." This statement requires recognition of an employer's obligation to provide benefits to former and inactive employees after employment but before retirement. The Company adopted SFAS No. 112 in 1993. The cumulative effect of the accounting change, reported on the Statement of Consolidated Operations as a component of other expenses, resulted in a decrease in 1993 income of $715,000. 7. NOTE PAYABLE As partial financing of the SICO acquisition, the Company entered into a $14,000,000 term loan agreement with a local bank. The Company has the option of electing an interest rate tied to the bank's prime or Eurodollar rate. The interest rate on the loan was 5.875%, 5.625% and 7.69% as of December 31, 1993, 1992 and 1991, respectively. The term loan is secured by the stock of SICO. Under the terms of the loan agreement, the Company is required to make principal payments of $700,000 on March 31, 1994 and each quarter end thereafter through December 31, 1994. The loan is subject to various covenants. At December 31, 1993, the lender waived compliance with certain existing covenants and new covenants were negotiated effective January 1, 1994. The new covenants require the Company to maintain tangible shareholder's equity, as defined, of $120 million during fiscal 1994. At December 31, 1993, as defined, tangible shareholder's equity was $138.1 million. In addition, various covenants applicable to the Company's subsidiaries require minimum statutory surplus levels and maximum premiums to surplus ratios. 8. NET ASSETS NNHC depends on dividends from its subsidiaries to service debt and pay expenses. The payment of shareholder dividends by insurance companies without the prior approval of the state insurance regulators is limited to formula amounts based on net investment income, and capital and surplus determined in accordance with statutory accounting principles. At December 31, 1993, approximately $4.2 million of dividends are available without prior regulatory approval. NNCC paid dividends to NNHC of $3,170,000, $3,896,500 and $3,500,000 during the years ended December 31, 1993, 1992 and 1991, respectively In accordance with the terms of an order dated April 10, 1985 of the Insurance Commissioner of the State of California (the Commissioner), PNIC may not pay any dividend or other distribution unless the dividend is approved by the Commissioner. PNIC received approval for and paid dividends to NNHC of $1,000,000 during the year ended December 31, 1992 and $450,000 during the year ended December 31, 1991. SICO paid dividends to NNHC of $1,500,000 during the year ended December 31, 1992. During the year ended December 31, 1991, PNIC redeemed all 500,000 shares of its preferred stock owned by NNHC at the $10 par value. Simultaneous with this redemption, NNHC made a $2,000,000 capital contribution to PNIC and a $3,500,000 contribution to NNCC. This transaction was approved by the Commissioner. The following information has been prepared on the basis of statutory accounting principles which differ from GAAP. The principal differences relate to deferred acquisition costs and assets not admitted for statutory reporting. 9. FAIR VALUES OF FINANCIAL INSTRUMENTS SFAS No. 107, "Disclosures about Fair Value of Financial Instruments," requires disclosure of the fair value of financial instruments. In developing the fair value of financial instruments, the Company uses available market quotes and data, provided by external pricing services, as well as valuation methodologies where appropriate. As considerable judgment is required in interpreting market data and performing valuation methodologies, the fair value estimates presented below are not necessarily indicative of the amounts the Company might pay or receive in actual current market transactions. Furthermore, as a number of the Company's significant assets and liabilities are excluded from the provisions of SFAS No. 107, the disclosures below do not reflect the Company's statement of net assets on a fair value basis, nor the fair value of the Company as a whole. The following methods and assumptions were used by the Company in estimating the fair value of its financial instruments: Financial Assets ---------------- Fair values for fixed maturity investments are based on quoted market prices. Equity securities are valued based on quoted market prices. Cash and cash equivalents are highly liquid investments with maturities of less than three months; carrying value approximates fair value. Accrued investment income is valued at carrying value as it is short-term in nature. Insurance premium balances receivable are generally collected on a monthly basis. Due to the short-term nature of these receivables, their carrying value approximates fair value. Financial Liabilities --------------------- The Company's insurance reserves are specifically excluded from the provisions of SFAS No. 107. Other financial liabilities are valued at their carrying value due to their short-term nature. As permitted under SFAS No. 107, other financial liabilities exclude postretirement and postemployment benefit obligations for purposes of this disclosure. The fair value of the Company's note payable is based on current rates offered to the Company for debt of the same remaining maturities. 10. COMMITMENTS The Company leases certain office facilities and equipment under operating leases. Minimum rental commitments under noncancelable leases are as follows: Total rental expense was $2,512,000, $2,291,000 and $2,201,000 in 1993, 1992 and 1991, respectively. 11. LITIGATION The Company is involved in various lawsuits that have arisen from the normal conduct of business. These proceedings are handled by corporate and outside counsel. It is the opinion of management that the outcome of these proceedings will not have a material effect on the Company's financial condition or liquidity; however, it is possible that due to fluctuations in the Company's results, future developments with respect to changes in the ultimate liability could have a material effect on future interim or annual results of operations. 12. SUBSEQUENT EVENTS On January 31, 1994, Armco announced that it had signed a letter of intent to sell Northwestern National Holding Company, Inc. and its subsidiaries to Vik Brothers Insurance, Inc. (Vik), a privately held, Raleigh, North Carolina- based property and casualty insurance holding company. In connection with the proposed transaction, Vik would pay approximately $70 million at the closing and approximately $15 million, reduced by a potential adjustment for adverse experience in the insurance reserves, in three years. The final agreement is subject to a number of conditions, including a definitive purchase agreement, and approvals by regulatory authorities and the boards of directors of both companies. - -------------------------------------------------------------------------------- ARMCO FINANCIAL SERVICES GROUP - COMPANIES TO BE SOLD SCHEDULE I SUMMARY OF INVESTMENTS - OTHER THAN INVESTMENTS IN RELATED PARTIES AS OF DECEMBER 31, 1993 (Dollars in thousands) See notes to consolidated financial statements. ARMCO FINANCIAL SERVICES GROUP - SCHEDULE III COMPANIES TO BE SOLD (PARENT ONLY) CONDENSED FINANCIAL INFORMATION CONDENSED STATEMENTS OF NET ASSETS AS OF DECEMBER 31, 1993 AND 1992 (Dollars in thousands) See notes to condensed financial information. ARMCO FINANCIAL SERVICES GROUP - SCHEDULE III COMPANIES TO BE SOLD (PARENT ONLY) CONDENSED FINANCIAL INFORMATION CONDENSED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands) See notes to condensed financial information. ARMCO FINANCIAL SERVICES GROUP - SCHEDULE III COMPANIES TO BE SOLD (PARENT ONLY) CONDENSED FINANCIAL INFORMATION CONDENSED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands) See notes to condensed financial information. - -------------------------------------------------------------------------------- ARMCO FINANCIAL SERVICES GROUP - SCHEDULE III COMPANIES TO BE SOLD (PARENT ONLY) CONDENSED FINANCIAL INFORMATION NOTES TO CONDENSED FINANCIAL INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1. The accompanying condensed financial information should be read in conjunction with the consolidated financial statements of the AFSG - Companies to be Sold. 2. Long-term debt consists of the following: As partial financing of the SICO acquisition, the Company entered into a $14,000,000 term loan agreement with a local bank. The Company has the option of electing an interest rate tied to the bank's prime or Eurodollar rate. The interest rate on the loan was 5.875%, 5.625% and 7.69% as of December 31, 1993, 1992 and 1991, respectively. The term loan is secured by the stock of SICO. Under the terms of the loan agreement, the Company is required to make principal payments of $700,000 on March 31, 1994 and each quarter end thereafter through December 31, 1994. The loan is subject to various covenants. At December 31, 1993, the lender waived compliance with certain existing covenants and new covenants were negotiated effective January 1, 1994. The new covenants require the Company to maintain tangible shareholder's equity, as defined, of $120 million during fiscal 1994. At December 31, 1993, as defined, tangible shareholder's equity was $138.1 million. In addition, various covenants applicable to the Company's subsidiaries require minimum statutory surplus levels and maximum premiums to surplus ratios. 3. NNHC depends on dividends from its subsidiaries to service debt and pay expenses. The payment of shareholder dividends by insurance companies without the prior approval of the state insurance regulators is limited to formula amounts based on net investment income, and capital and surplus determined in accordance with statutory accounting principles. At December 31, 1993, approximately $4.2 million of dividends are available without prior regulatory approval. NNCC paid dividends to NNHC of $3,170,000, $3,896,500 and $3,500,000 during the years ended December 31, 1993, 1992 and 1991 respectively. In accordance with the terms of an order dated April 10, 1985 of the Insurance Commissioner of the State of California (the Commissioner), PNIC may not pay any dividend or other distribution unless the dividend is approved by the Commissioner. PNIC received approval for and paid dividends to NNHC of $1,000,000 during the year ended December 31, 1992 and $450,000 during the year ended December 31, 1991. SICO paid dividends to NNHC of $1,500,000 during the year ended December 31, 1992. During the year ended December 31, 1991, PNIC redeemed all 500,000 shares of its preferred stock owned by NNHC at the $10 par value. Simultaneous with this redemption, NNHC made a $2,000,000 capital contribution to PNIC and a $3,500,000 contribution to NNCC. This transaction was approved by the Commissioner. 4. In May 1993, the FASB issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." The statement requires fixed maturity investments which are available for sale to be recorded at market value. The Company adopted SFAS No. 115 on December 31, 1993. ARMCO FINANCIAL SERVICES GROUP - COMPANIES TO BE SOLD SCHEDULE VI REINSURANCE FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands) ARMCO FINANCIAL SERVICES GROUP - COMPANIES TO BE SOLD SCHEDULE VIII VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands) ARMCO FINANCIAL SERVICES GROUP - COMPANIES TO BE SOLD SCHEDULE X SUPPLEMENTAL INFORMATION CONCERNING PROPERTY/CASUALTY INSURANCE OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Dollars in thousands) ARMCO FINANCIAL SERVICES GROUP - COMPANIES TO BE SOLD DISCLOSURE OF CERTAIN DATA ON LOSS AND LOSS EXPENSE RESERVES The liability for unpaid losses and loss adjustment expenses includes an amount determined from loss reports and individual cases and an amount, based on past experience, for losses incurred but not reported. Such liability is necessarily based on estimates and, while management believes that the amount is fairly stated, the ultimate liability may be in excess of or less than the amount provided. The methods for making such estimates and for establishing the resulting liability are continually reviewed and any adjustments resulting therefrom are reflected in earnings currently. The Company does not discount the liability for unpaid losses and loss adjustment expenses. AFSG companies to be sold estimates losses for reported claims on an individual case basis. Case reserves are based on experience with a particular type of risk and the available information surrounding each individual claim. Case reserves are reviewed on a regular basis. As additional facts become available, the case reserves are adjusted as necessary. The stability of the case reserving process is monitored through comparison with ultimate settlement. The estimates of losses for incurred but not reported claims (IBNR), as well as additive reserves for reported claims, are developed primarily from an analysis of historical patterns of the development of paid and incurred losses (dollars and claim counts) by accident year for each line of business. Salvage and subrogation estimates are developed from patterns of actual recoveries. Allocated loss adjustment expense reserves are developed from an analysis of historical patterns of the development of paid allocated loss adjustment expenses to incurred losses, by accident year, for each line of business. These historical patterns are then applied to projected ultimate losses for each line of business. Unallocated loss adjustment expense reserves are developed utilizing a cost accounting system. The cost accounting system is based on historical costs modified for anticipated changes in operations and selections of alternative costs. In December 1992, the FASB issued SFAS No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration contracts." The statement establishes the conditions required for a contract to be accounted for as reinsurance and prescribes accounting and reporting standards for those contracts. The Company adopted SFAS No. 113 in 1993. Prior to the adoption of the new statement, assets and liabilities were reported net of the effects of reinsurance. Subsequent to the adoption of the new statement, ceded reinsurance balances due from unaffiliated insurers are reported separately as assets. Ceded reinsurance balances due from affiliated insurers continue to be reported in liabilities. As permitted by the statement, prior period financial statements have been restated. Loss and loss adjustment expense reserves are stated at management's estimate of the ultimate cost of settling all incurred but unpaid claims. Loss and loss adjustment expense reserves are not discounted.

80661_1993.txt

80661

1993

ITEM 1. BUSINESS (a) General Development of Business The Progressive Corporation, an insurance holding company formed in 1965, has 52 operating subsidiaries and one mutual insurance company affiliate. The Progressive Corporation's insurance subsidiaries (collectively, the "Insurance Group") provide personal automobile insurance and other specialty property-casualty insurance and related services throughout the United States and in Canada. The Company's property-casualty insurance products protect its customers against collision and physical damage to their motor vehicles and liability to others for personal injury or property damage they caused. Of the approximately 250 United States insurance company groups writing private passenger auto, the Company estimates that Progressive ranks ninth in size. Except as otherwise noted, all industry data and Progressive's market share or ranking in the industry were derived either directly from data published or reported by A.M. Best Company Inc. ("A.M. Best") or were estimated using A.M. Best data as the primary source. For 1993, the estimated industry premiums written, which include personal auto insurance in the United States and Ontario, Canada, as well as insurance for commercial vehicles, were $115 billion, and Progressive's share of this market was approximately 1.5%. (b) Financial Information About Industry Segments Incorporated by reference from Note 11, SEGMENT INFORMATION, on page 46 of the Company's Annual Report. (c) Narrative Description of Business INSURANCE SEGMENT The Insurance Group underwrites a number of personal and commercial property-casualty insurance products. Net premiums written were $1,819.2 million in 1993, compared to $1,451.2 million and $1,324.6 million in 1992 and 1991, respectively. The underwriting profit (loss) was 10.7% in 1993, compared to 3.5% and (3.7)% in 1992 and 1991, respectively. The Insurance Group's core business writes insurance for private passenger automobiles and small commercial and recreational vehicles. This business frequently has more than one program in a single state, with each targeted to a specific market segment. The core business accounted for 93% of the Company's 1993 total net written premiums. The bulk of the Insurance Group's Core business consists of nonstandard insurance products for people cancelled and rejected by other insurers. The size of the nonstandard automobile insurance market changes with the insurance environment. Volume potential is influenced by the actions of direct competitors, writers of standard and preferred automobile insurance and state-mandated involuntary plans. The total 1993 nonstandard automobile insurance market was about $18 billion, compared to $17 billion in 1992 and $16 billion in 1991. Approximately 125 independent specialty companies and more than 25 subsidiaries of large insurance companies wrote nonstandard auto premiums in 1993. In this market, the Insurance Group ranked fourth in 1992 in direct premiums written and near the top in underwriting performance. It is estimated that the 1993 ranking and underwriting performance will be consistent with 1992. The core business is continuing its experiment of writing standard and preferred automobile risks in several states. These experiments accounted for 4.5% of the Company's total private passenger auto premiums in 1993. The strategy is to build towards becoming a low-cost provider of a full line of auto insurance and related services, distributed through whichever channel the customer prefers. The Insurance Group's goal is to compete in the standard and preferred market, which comprises 81% of the personal automobile insurance market. The Insurance Group's specialty personal lines products are dominated by motorcycle insurance. Other products offered include recreational vehicle, mobile home and boat insurance. The Insurance Group's competitors are specialty companies and standard insurance carriers. Although industry figures are not available, based on the Company's analysis of this market, the Company believes that it is a significant participant in this market. Nonstandard commercial vehicle insurance covers commercial vehicle risks that are rejected or cancelled by other insurance companies. Based on the Company's analysis of this market, approximately 40 companies compete for this business on a nationwide basis. State assigned risk plans also provide this coverage. The core business insurance products are marketed by thirteen divisions headquartered in or near the markets served: the Florida and Southeast divisions in Tampa, Florida; the North East, New York, Central States, Ohio, Commercial Vehicle and National Accounts divisions in Cleveland, Ohio; the South Central division in Austin, Texas; the Mountain division in Colorado Springs, Colorado; the Mid-Atlantic division in Richmond, Virginia; the Canada division in Ontario, Canada; and the West division in Sacramento, California. Each division is responsible for its own marketing, sales, processing and claims. In 1993, over 80% of the core business' net premiums were written through a network of more than 30,000 independent insurance agents located throughout the United States and in Canada. Subject to compliance with certain Company-mandated procedures, these independent insurance agents have the authority to bind the Company to specified insurance coverages within prescribed underwriting guidelines. These guidelines prescribe the kinds and amounts of coverage that may be written and the premium rates that may be charged for specified categories of risk. The agents do not have authority on behalf of the Company to settle or adjust claims, establish underwriting guidelines, develop rates or enter into other transactions or commitments. The Company also markets its products through intermediaries such as employers, other insurance companies and national brokerage agencies, and direct to customers through employed sales people and owned insurance agencies. The core business currently markets personal automobile insurance directly to the public through its Miami and Tampa, Florida operations. It is anticipated that this activity may be expanded to other selected markets in Florida, Texas and Ohio. The Insurance Group's diversified businesses - the Financial Services, Risk Management Services and Motor Carrier divisions, as well as the run-off of the former Transportation division - accounted for 7% of total volume in 1993. These divisions, which are organized by customer group, are headquartered in Cleveland, Ohio. The choice of distribution channel is driven by each customer group's buying preference and service needs. Distribution channels include financial institutions, equipment lessors and vehicle dealers. Distribution arrangements are individually negotiated between such intermediaries and the Company and are tailored to the specific needs of the customer group and the nature of the related financial or purchase transactions. The diversified businesses also market their products directly to their customers through company-employed sales forces. The Financial Services division provides physical damage, property and flood insurance and related tracking services to protect the commercial or retail lender's interest in collateral which is not otherwise insured against these risks. The principal product is collateral protection for automobile lenders, which is sold to financial institutions and/or their customers. Commercial banks are Financial Services' largest customer group for these services. This division also serves savings and loans, finance companies and credit unions. Based on the Company's analysis of this market, numerous companies offer these products, and none of them has a dominant market share. Risk Management Services' principal customers are community banks. Its principal products are liability insurance for directors and officers and employee dishonesty insurance. Progressive shares the risk and premium on these coverages with a small mutual insurer controlled by its bank customers. The program is sponsored by the American Bankers Association. This program represented less than 1% of total 1993 net premiums written. The Motor Carrier division provides insurance and related services, on a heavily reinsured basis, to a few excellent regional customers retained from the defunct Transportation business, as well as a growing number of intermediate-size trucking companies. The Motor Carrier division also manages involuntary Commercial Auto Insurance Plans. See SERVICE OPERATIONS on page 5 for further discussion. COMPETITIVE FACTORS The automobile insurance and other property-casualty markets in which the Company operates are highly competitive. Property-casualty insurers generally compete on the basis of price, consumer recognition, coverages offered, claim handling, financial stability, customer service and geographic coverage. Vigorous competition is provided by large well-capitalized national companies, some of which have broad distribution networks of employed or captive agents, and by smaller regional insurers. While the Company relies heavily on technology and extensive data gathering and analysis to segment and price markets according to risk potential, some competitors merely price their coverage at rates set lower than the Company's published rates. By avoiding extensive data gathering and analysis, these competitors incur lower underwriting costs. The Company has remained competitive by closely managing expenses and achieving operating efficiencies, and by refining its risk measurement and price segmentation skills. In addition, the Company offers prices for a wide spectrum of risks and seeks to offer a wider array of payment plans, limits of liability and deductibles than its competitors. Superior customer service and claim adjustment are also important factors in its competitive strategy. LICENSES The insurance group operates under licenses issued by various state or provincial insurance authorities. Such licenses may be of perpetual duration or renewable periodically, provided the holder continues to meet applicable regulatory requirements. The licenses govern the kind of insurance coverages which may be written or the nature of the insurance-related services which may be provided in the issuing state. Such licenses are normally issued only after the filing of an appropriate application and the satisfaction of prescribed criteria. All licenses which are material to the Company's business are in good standing. INSURANCE REGULATION The insurance subsidiaries are generally subject to regulation and supervision by insurance departments of the jurisdictions in which they are domiciled or licensed to transact business. One or more of the subsidiaries are licensed and subject to regulation in each of the 50 states, in each Canadian province and by Canadian federal authorities. The nature and extent of such regulation and supervision varies from jurisdiction to jurisdiction. Generally, an insurance company is subject to a higher degree of regulation and supervision in its state of domicile. The Company's principal insurance subsidiaries are domiciled in the states of Florida, Mississippi, New York, Ohio, Pennsylvania, Texas, Washington and Wisconsin. State insurance departments have broad administrative power relating to licensing insurers and agents, regulating premium rates and policy forms, establishing reserve requirements, prescribing accounting methods and the form and content of statutory financial reports and regulating the type and amount of investments permitted. Rate regulation varies from "file and use" to prior approval to mandated rates. Most jurisdictions prohibit rates that are "excessive, inadequate or unfairly discriminatory." Insurance departments are charged with the responsibility to ensure that insurance companies maintain adequate capital and surplus and comply with a variety of operational standards. Insurance companies are generally required to file detailed annual and other reports with the insurance department of each jurisdiction in which they conduct business. Insurance departments are authorized to make periodic and other examinations of regulated insurers' financial condition, adherence to statutory accounting principles and compliance with state insurance laws and regulations. Insurance holding company laws enacted in many jurisdictions grant to insurance authorities the power to regulate acquisitions and certain other transactions involving insurers and to require periodic disclosure of certain information. These laws impose prior approval requirements for certain transactions between regulated insurers and their affiliates and generally regulate dividend and other distributions, including loans and cash advances, from regulated insurers to their affiliates. See the "Dividends" discussion in Item 5(c) for further information on such dividend limitations. Under state insolvency and guaranty laws, regulated insurers can be assessed for, or be required to contribute to state guaranty funds to cover policyholder losses resulting from insurer insolvencies. Insurers are also required by many states to provide coverage to certain risks as a condition of doing business in the state. Such programs generally specify the types of insurance and the level of coverage which must be offered to such involuntary risks, as well as the allowable premium. Many states have laws and regulations that limit a company's ability to exit a market. For example, certain states limit an automobile insurer's ability to cancel and non-renew policies. Furthermore, certain states prohibit an insurer from withdrawing one or more lines of business from the state, except pursuant to a plan that is approved by the state insurance department. The state insurance department may disapprove a plan that may lead to market disruption. Laws and regulations that limit cancellation and non-renewal and that subject program withdrawals to prior approval requirements may restrict an insurer's ability to exit unprofitable markets. Regulation of insurance constantly changes as real or perceived issues and developments arise. Some changes may be due to technical factors, such as changes in investment laws made to recognize new investment vehicles; other changes result from such general pressures as consumer resistance to price increases and concerns relating to insurer solvency. In recent years, legislation and voter initiatives have been introduced which deal with insurance rate development, rate determination and the ability of insurers to cancel or renew insurance policies, reflecting concerns about availability, prices and alleged discriminatory pricing. In some states, such as California and Georgia, the automobile insurance industry has been under pressure in recent years from regulators, legislators or special interest groups to reduce, freeze or set rates at levels that are not necessarily related to underlying costs, including initiatives to roll back automobile and other personal lines rates. This activity has adversely affected, and may in the future adversely affect, the profitability and growth of the subsidiaries' automobile insurance business in those jurisdictions, and may limit the subsidiaries' ability to increase rates to compensate for increases in costs. Adverse legislative and regulatory activity limiting the subsidiaries' ability to adequately price automobile insurance may occur in the future. The impact of these regulatory changes on the subsidiaries' businesses cannot be predicted. The state insurance regulatory framework has come under increased federal scrutiny, and certain state legislatures have considered or enacted laws that alter and, in many cases, expand state authority to regulate insurance companies and insurance holding company systems. Further, the National Association of Insurance Commissioners and state insurance regulators are re-examining existing laws and regulations, specifically focusing on insurance company investments, issues relating to the solvency of insurance companies, risk-based capital guidelines and further limitations on the ability of regulated insurers to pay dividends. In addition, the United States Congress and certain federal agencies are investigating the current condition of the insurance industry to determine whether federal regulation is necessary, and the Clinton administration is in the process of considering changes to the nation's health care system. Changes in the health care system may have an effect on the medical coverage included in auto insurance policies. It is currently not possible to predict the outcome of any of these matters, or their potential impact on the Company. STATUTORY ACCOUNTING PRINCIPLES The Insurance Group's results are reported in accordance with generally accepted accounting principles (GAAP), which differ from amounts reported under statutory accounting principles (SAP) prescribed by insurance regulatory authorities. Specifically, under GAAP: 1. Commissions, premium taxes and other costs incurred in connection with writing new and renewal business are deferred and amortized over the period in which the related premiums are earned, rather than expensed as incurred, as required by SAP. 2. Direct response advertising costs, which consist primarily of direct mail expenses, are capitalized and amortized over the estimated period of the benefits, rather than expensed as incurred, as required by SAP. 3. Estimated salvage and net subrogation recoverables are reflected in the financial statements at the time the related loss reserves are established, rather than when actually recovered, as permitted by SAP. Salvage is the amount recovered when the property against which a claim is made is recovered and sold by the insurance company. Subrogation is the amount of claim cost recovered from the party at fault. 4. Certain assets are included in the consolidated balance sheets, rather than charged against retained earnings, as required by SAP. These assets consist primarily of premium receivables over 90 days old and furniture and fixtures. 5. Amounts related to ceded reinsurance are shown gross as prepaid reinsurance premiums and reinsurance recoverables, rather than netted against unearned premium reserves and loss and loss adjustment expense reserves, as required by SAP. The differing treatment of income and expense items results in a corresponding difference in Federal income tax expense. SERVICE OPERATIONS The Motor Carrier division currently manages involuntary commercial auto insurance plans (CAIP) in 29 states. As a CAIP servicing carrier, the division processes about one third of the premiums in the involuntary commercial market, without assuming the indemnity risk. It competes with approximately 14 other providers nationwide. The Company's subsidiaries also provide claim services to fleet owners and other insurance companies. Revenues from all service businesses are derived primarily from fees and commissions. Total service revenues were $43.7 million in 1993, compared to $53.3 million and $54.0 million in 1992 and 1991, respectively. INVESTMENTS The Company's approach to investing is consistent with its need to maintain capital adequate to support the insurance premiums written. The Company's portfolio is invested primarily in short-term and intermediate-term, investment-grade fixed-income securities. The Company's investment portfolio, at market value, was $2,805.2 million at December 31, 1993, compared to $2,407.4 million at December 31, 1992. Investment income is affected by shifts in the types of investments in the portfolio, changes in interest rates and other factors. Investment income, including net realized gains (losses) on security sales, before expenses and taxes was $242.4 million in 1993, compared to $153.5 million in 1992 and $152.2 million in 1991. See MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, beginning on page 12 herein for additional discussion. EMPLOYEES The number of employees, excluding temporaries, at December 31, 1993, was 6,101. LIABILITY FOR PROPERTY-CASUALTY LOSSES AND LOSS ADJUSTMENT EXPENSES The consolidated financial statements include the estimated liability for unpaid losses and loss adjustment expenses ("LAE") of the Company's property-casualty and life insurance subsidiaries. The life insurance operations are in run-off. In order to assure safety of capital and conservatism of the balance sheet, total loss reserves are set at a level that is intended to provide confidence that they are adequate. The liabilities for losses and LAE are determined using actuarial and statistical procedures and represent undiscounted estimates of the ultimate net cost of all unpaid losses and LAE incurred through December 31 of each year. These estimates are subject to the effect of future trends on claim settlement. These estimates are continually reviewed and adjusted as experience develops and new information becomes known. Such adjustments, if any, are reflected in the current results of operations. The accompanying tables present an analysis of property-casualty losses and LAE. The following table: (1) provides a reconciliation of beginning and ending estimated liability balances for 1993, 1992 and 1991, and (2) shows the difference between the estimated liability in accordance with GAAP and that reported in accordance with SAP. RECONCILIATION OF NET RESERVES FOR LOSSES AND LOSS ADJUSTMENT EXPENSES The reconciliation above shows a $98.5 million redundancy, which emerged during 1993, in the 1993 liability and a $51.5 million redundancy in the 1992 liability, based on information known as of December 31, 1993 and December 31, 1992, respectively. Current reserves reflect conservatism of the liability established for potential adverse development. The anticipated effect of inflation is explicitly considered when estimating liabilities for losses and LAE. While anticipated increases due to inflation are considered in estimating the ultimate claim costs, the increase in average severities of claims is caused by a number of factors that vary with the individual type of policy written. Future average severities are projected based on historical trends adjusted for anticipated changes in underwriting standards, inflation, policy provisions and general economic trends. These anticipated trends are monitored based on actual development and are modified if necessary. The Company has not entered into any loss reserve transfers or similar transactions having a material effect on earnings or reserves. ANALYSIS OF LOSS AND LOSS ADJUSTMENT EXPENSES DEVELOPMENT (millions) The above table presents the development of balance sheet liabilities for 1983 through 1992. The top line of the table shows the estimated liability for unpaid losses and LAE recorded at the balance sheet date for each of the indicated years for the property-casualty insurance subsidiaries only. Similar reserves for the life insurance subsidiary, which are immaterial, are excluded. This liability represents the estimated amount of losses and LAE for claims arising in all prior years that are unpaid at the balance sheet date, including losses that had been incurred but not reported. The upper section of the table shows the cumulative amount paid with respect to the previously recorded liability as of the end of each succeeding year. The lower portion of the table shows the re-estimated amount of the previously recorded liability based on experience as of the end of each succeeding year. The estimate is increased or decreased as more information becomes known about the frequency and severity of claims for individual years. For example, as of December 31, 1993, the companies had paid $139.1 million of the currently estimated $144.5 million of losses and LAE that had been incurred through the end of 1984; thus an estimated $5.4 million of losses incurred through 1984 remain unpaid as of the current financial statement date. The "Cumulative Redundancy (Deficiency)" represents the aggregate change in the estimates over all prior years. For example, the 1983 liability has developed a $2.9 million deficiency over ten years. That amount has been reflected in income over the ten years and did not have a significant effect on the income of any one year. The effects on income during the past three years due to changes in estimates of the liabilities for losses and LAE is shown in the reconciliation table on page 7 as the "prior years" provision for incurred losses and LAE. In evaluating this information, note that each cumulative redundancy (deficiency) amount includes the effects of all changes in amounts during the current year for prior periods. For example, the amount of the redundancy related to losses settled in 1986, but incurred in 1983, will be included in the cumulative deficiency or redundancy amount for years 1983, 1984 and 1985. Conditions and trends that have affected development of the liability in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on this table. The data in the Analysis of Loss and Loss Adjustment Expenses Development table on page 8 are constructed slightly differently than the data in the Current Estimate of Total Redundancy column in the chart on page 54 of the Company's Annual Report. The data in the former table are based on Schedule P from the 1993, 1992, 1991 and 1990 Consolidated Annual Statement, as filed with state insurance departments, and Schedules O and P filed for years prior to 1989. The reserve accuracy percentages reported in this table differ from the percentages reported in the Annual Report. The primary reason for the difference is the method of apportioning loss adjustment expenses to accident years. The Consolidated Annual Statement, Schedule P, Part-1, specifies how to distribute unallocated loss adjustment expenses to accident years. The Company disagrees with this arbitrary approach and, therefore, uses a different approach for the Annual Report. It believes that both apportionment methods give the same result when viewed over several years. A second reason is that the data reported in the Annual Report includes results for life insurance products sold by the Company's life insurance subsidiary. Life insurance reserves are less than 1% of total reserves. Given the uncertainty inherent in establishing insurance loss reserves, its reserves have proven to be quite accurate. The Company's Consolidated Annual Statement Schedule P for 1993, 1992 and 1991 includes $14.5 million, $27.2 million, and $17.2 million, respectively, of paid LAE for non-indemnity business which is excluded for GAAP and, therefore, not included in the reconciliation shown on page 7. There are two significant differences between the development table on page 8 and The Company's Consolidated Annual Statement, Schedule P. Schedule P includes cumulative payments from a company purchased in September 1990 and an affiliate consolidated in March 1991, which are not included for GAAP reporting for periods prior to the dates of acquisition. Also, the development displayed in Schedule P, Part-2, excludes unallocated loss adjustment expenses which are included in the preceding development table. (d) Financial Information about Foreign and Domestic Operations The Company operates throughout the United States and in Canada. The amount of Canadian revenues and assets are approximately two percent of the Company's consolidated revenues and assets. The amount of operating income (loss) generated by its Canadian operations is immaterial with respect to the Company's consolidated operating income (loss). ITEM 2.

ITEM 2. PROPERTIES OWNED PROPERTIES The Company's central data processing facility occupies a modern, three-story brick building containing approximately 107,000 square feet of office space, on an approximately 40-acre parcel in Mayfield Village, Ohio, owned by a subsidiary. In spring 1992, construction began on the Company's new corporate office complex on this parcel, and in December 1993, the Company began occupying a portion of this complex. Construction is expected to be completed in 1994. The new facility will consist of approximately 520,000 square feet of space and will replace office space held under leases in a number of locations in the Cleveland, Ohio area. The cost of the project is currently estimated at $74.8 million and is being funded through operating cashflows. As of December 31, 1993, $50.5 million of the project's costs had been paid. The Company owns a modern three-story building containing approximately 96,700 square feet of office space in Mayfield Heights, Ohio. The property was purchased in December 1993, for approximately $6.5 million, and is occupied by the Company's Northeast Division. The Company's Florida Division is headquartered in a modern, two-story building containing approximately 60,000 square feet of office space in Tampa, Florida. The property was financed with, and is held subject to a mortgage granted in connection with, industrial development revenue bonds bearing interest equal to 79.45% of a specified prime commercial lending rate. The remaining annual principal amounts payable are $368,000 in each of 1994 through 1997 and $92,000 in 1998. The Company owns a modern, two-story building containing approximately 39,000 square feet of office space in Tampa, Florida; this building is leased to a non-affiliated tenant. The Company also owns a one-story brick building containing approximately 92,000 square feet of training facilities, office and warehouse space in Mayfield Village, Ohio. LEASED PROPERTIES The Company leases approximately 681,000 square feet of modern office space at various locations throughout the United States for its other business units and staff functions. In addition, the Company leases approximately 225 processing and claim offices at various locations throughout the United States. Two offices are leased in Canada. These leases are generally short-term to medium-term leases of standard commercial office space. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS Incorporated by reference from Note 6, LITIGATION, on page 43 of the Company's Annual Report. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SHAREHOLDERS None. EXECUTIVE OFFICERS OF THE REGISTRANT Incorporated by reference from information with respect to executive officers of The Progressive Corporation and its subsidiaries set forth in Item 10 of this Annual Report on Form 10-K. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS (a) Market Information The Company's Common Shares are traded on the New York Stock Exchange under the symbol PGR. The high and low prices set forth below are as reported on the New York Stock Exchange. All stock prices and dividends per share have been adjusted to reflect the December 8, 1992 3-for-1 stock split. The closing price of the Company's Common Shares on February 24, 1994 was $34 5/8. (b) Holders There were 4,849 shareholders of record on February 24, 1994. (c) Dividends Statutory policyholders' surplus was $703.6 million and $658.3 million at December 31, 1993 and 1992, respectively. Generally, under state insurance laws, the net admitted assets of insurance subsidiaries available for transfer to a corporate parent are limited to those net admitted assets, as determined in accordance with SAP, which exceed minimum statutory capital requirements. At December 31, 1993, $91.5 million of statutory policyholders' surplus represents net admitted assets of the insurance subsidiaries that are not transferable in the form of dividends, loans or advances to the parent. Furthermore, state insurance laws limit the amount that can be paid as a dividend or other distribution in any given year without prior regulatory approval and adequate policyholders' surplus must be maintained to support premiums written. Under current regulations, subsidiary dividends of $117.1 million in the aggregate may be paid in 1994 out of statutory policyholders' surplus, without such approval by regulatory authorities. The regulations may change during 1994, which could affect the dividends permitted to be paid by a regulated subsidiary without prior approval. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FINANCIAL CONDITION The Progressive Corporation is a holding company and does not have any revenue producing operations of its own. It receives cash through borrowings, equity sales, subsidiary dividends and other transactions, and may use the proceeds to contribute to the capital of its insurance subsidiaries in order to support premium growth, to repurchase its Common Shares and other outstanding securities, to redeem debt, and for other business purposes. In 1993, the Company sold 4,950,000 Common Shares for net proceeds of $177.0 million, $150.0 million of its 7% Notes due 2013 and filed a shelf registration for $200.0 million of its debt securities (in January 1994, the Company sold $200.0 million of its 6.60% Notes due 2004 under the shelf registration statement). During 1993, the Company repurchased .4 million of its Serial Preferred Shares, Series A, at a cost of $9.8 million, repaid $170.0 million borrowed under its credit facilities and redeemed the entire $70.0 million of its 8 3/4% Debentures. During the three-year period ended December 31, 1993, the Company also sold 4,000,000 Serial Preferred Shares, Series A, for net proceeds of $96.4 million, of which .4 million were repurchased as discussed above, repurchased 4.0 million Common Shares (not adjusted for the December 1992 three-for-one stock split) at a total cost of $215.6 million, and decreased its aggregate borrowings $167.3 million. During the same period, The Progressive Corporation received $393.3 million from its insurance subsidiaries, net of capital contributions made to these subsidiaries. The regulatory restrictions on subsidiary dividends are described in Item 5(c) DIVIDENDS, on page 11. The Company has substantial capital resources and is unaware of any trends, events or circumstances that are reasonably likely to affect its capital resources in a material way. The Company also has available a $20.0 million revolving credit agreement. The Company believes it has sufficient borrowing capacity and other capital resources to support current and anticipated growth. The Company's insurance operations create liquidity by collecting and investing premiums written from new and renewal business in advance of paying claims. For the three years ended December 31, 1993, operations generated a positive cash flow of $664.7 million, and cash flow is expected to be positive in both the short-term and reasonably foreseeable future. The Company's substantial investment portfolio is highly liquid, consisting almost entirely of readily marketable securities. The Company does not expect any material changes in its cash requirements and is not aware of any trends, events or uncertainties that are reasonably likely to have a material effect on its liquidity. Total capital expenditures for the three years ended December 31, 1993, aggregated $122.6 million. In spring 1992, construction began on the Company's new corporate office complex in Mayfield Village, Ohio, and in December 1993, the Company began occupying a portion of this complex. Construction is expected to be completed in 1994. The new facility will consist of approximately 520,000 square feet of space and will replace office space held under leases in a number of locations in the Cleveland, Ohio area. The cost of the project is currently estimated at $74.8 million, and is being funded through operating cash flows. As of December 31, 1993, $50.5 million of the project's cost had been paid. In June 1992, the Company reached an agreement with the California Department of Insurance to refund approximately $50 million of premiums (including interest) on business written between November 8, 1988 and November 7, 1989 to approximately 260,000 policyholders, thereby settling all rollback and refund exposure since Proposition 103 was adopted in November 1988. As a result, the Proposition 103 premium refund and rollback reserve was reduced by $106.0 million. During the second quarter 1992, the Company changed its financial arrangement with Progressive Partners Limited Partnership (Progressive Partners), its investment manager, as part of its strategy to compete more effectively for private passenger auto insurance by lowering costs. Under the new arrangement, Progressive Partners' people, now employed by a wholly-owned Progressive subsidiary, continue to provide the Company with investment and capital management. The transaction involved paying Progressive Partners a one-time fee for terminating the investment management contract, and an additional incentive fee for the period ended June 30, 1992, in the aggregate amount of $54.6 million. This transaction reduced the Company's costs for investment and capital management. In December 1992, Mr. Alfred Lerner, then Chairman of the Company, converted his $75.0 million Floating Rate Convertible Subordinated Debenture due 2008 into 9,000,000 Common Shares and sold 5,175,000 of those Common Shares in an underwritten public offering. The public offering was completed pursuant to the registration rights provisions of the convertible debenture, under which the Company paid $5.1 million in underwriting and other expenses of the offering. These expenses were charged directly to shareholders' equity in accordance with generally accepted accounting principles. On the same date, Mr. Lerner agreed to a termination of his employment agreement with the Company, and, in connection with these transactions, the Company paid Mr. Lerner $10.0 million. RESULTS OF OPERATIONS Direct premiums written increased 20 percent to $1,966.4 million in 1993, compared to $1,636.8 million in 1992 and $1,536.8 million in 1991. These amounts include premiums written under state-mandated involuntary Commercial Auto Insurance Plans (CAIP), for which the Company retains no indemnity risk, of $98.0 million in 1993, $142.2 million in 1992 and $180.0 million in 1991. In 1993, the Company provided policy and claim processing services to 28 state CAIPs, compared to 26 in 1992 and 25 in 1991; the size of the CAIP market continues to decrease. Net premiums written increased 25 percent to $1,819.2 million, compared to $1,451.2 million in 1992 and $1,324.6 million in 1991. Premiums earned, which are a function of the amount of premiums written in the current and prior periods, increased 17 percent in 1993, compared to 11 percent in 1992 and 8 percent in 1991. In 1989, the Company established a reserve for potential premium rollbacks and refunds under provisions of California Proposition 103 and added to the reserve in subsequent years; the reserve reduced premiums written and earned $10.2 million and $49.7 million in 1992 and 1991, respectively. In 1992, the Company settled its financial responsibility under Proposition 103 and reduced its reserve as described above. In 1993, the Company's Core business' net premiums written grew 25 percent, driven by an increase in unit sales. The Company anticipates continued growth in its Core business in 1994; however, the Company prices business to achieve a four percent underwriting margin. As a result, in the short run, operating earnings may not increase in proportion to volume growth. Claim costs, the Company's most significant expense, represent actual payments made and changes in estimated future payments to be made to or on behalf of its policyholders, including expenses required to settle claims and losses. These costs include a loss estimate for future assignments and assessments, based on current business, under state-mandated involuntary automobile programs. Claims costs are influenced by inflation and loss severity and frequency, the impact of which is mitigated by adequate pricing. Increases in the rate of inflation increase loss payments, which are made after premiums are collected. Accordingly, anticipated rates of inflation are taken into account when the Company establishes premium rates and loss reserves. Claim costs, expressed as a percentage of premiums earned, were 62 percent in 1993, compared to 65 percent in 1992 and 67 percent in 1991. The personnel reductions in late 1991 and early 1992, along with other cost-cutting measures and the favorable run-off of the Transportation business, reduced the Company's losses and loss adjustment expenses. Policy acquisition and other underwriting expenses as a percentage of premiums earned were 28 percent in 1993, compared to 31 percent in 1992 and 37 percent in 1991. The decrease reflects the cost-cutting measures discussed above, as well as process improvements, changed workflows and lower commission programs. Service revenues were $43.7 million in 1993, compared to $53.3 million in 1992 and $54.0 million in 1991; the decrease in revenues reflects the decrease in CAIP premiums written. Service businesses generated a pretax operating profit of $6.8 million in 1993, compared to a pretax loss of $4.3 million in 1992 and a pretax loss of $2.1 million in 1991. During 1992, loss adjustment expense reserves were increased $6.2 million. Recurring investment income (interest and dividends) decreased 3 percent to $134.5 million in 1993, 4 percent to $139.0 million in 1992 and 5 percent to $144.8 million in 1991, primarily due to lower prevailing interest rates. Net realized gains on security sales were $107.9 million in 1993, $14.5 million in 1992 and $7.4 million in 1991. A significant portion of the 1993 realized gains resulted from the sale of certain equity securities held in the Company's investment portfolio. President Clinton signed the Omnibus Budget Reconciliation Act of 1993, which, among other items, increased the statutory tax rate to 35 percent. Effective January 1, 1992, the Company adopted SFAS 109 and was able to demonstrate that the benefit of deferred tax assets was fully realizable. The cumulative effect of adopting SFAS 109 increased net income $14.2 million, or $.20 per share. In 1991, the deferred tax asset write-down, as required under SFAS 96, was included in the Federal income tax provision. INVESTMENTS The Company invests in fixed maturity, short-term and equity securities. The Company's investment strategy recognizes its need to maintain capital adequate to support its insurance operations. Therefore, the Company evaluates the risk/reward trade-offs of investment opportunities, measuring their effects on stability, diversity, overall quality and liquidity of the investment portfolio. The majority ($2,135.1 million, or 76.6%, in 1993 and $1,779.4 million, or 74.6%, in 1992) of the portfolio at December 31, 1993 and 1992, was in short-term and intermediate- term, investment-grade fixed-income securities. A relatively small portion ($453.9 million, or 16.3% in 1993 and $398.6 million, or 16.7% in 1992) of the investment portfolio was invested in preferred and common equity securities providing risk/reward balance and diversification. The remainder of the portfolio was invested in long-term investment-grade fixed-income securities ($77.6 million, or 2.8% in 1993 and $122.7 million, or 5.1% in 1992) and non-investment-grade fixed-income securities ($119.8 million, or 4.3% in 1993 and $85.4 million, or 3.6% in 1992). The non-investment-grade fixed-income securities, although constituting only a small portion of the portfolio, offer the Company high returns and added diversification without a significant adverse effect on the stability and quality of the investment portfolio as a whole. These securities may involve greater risks often related to creditworthiness, solvency and relative liquidity of the secondary trading market. The weighted average fully taxable equivalent yield of the portfolio was 8.7%, 8.6% and 9.4% as of December 31, 1993, 1992 and 1991, respectively. As of December 31, 1993, the Company elected to early adopt Statement of Financial Accounting Standards (SFAS) 115 "Accounting for Certain Investments in Debt and Equity Securities." For 1993, the adoption of SFAS 115 did not have any effect on the Company's results of operations or financial position. Fixed maturity securities which are held-to-maturity and short-term securities are reported at amortized cost; amortized cost of short-term securities approximates market. Available-for-sale securities are held for indefinite periods of time and include fixed maturities and equity securities. The available-for-sale securities are reported at market value with the changes in market value, net of deferred income taxes, reported directly in shareholders' equity as unrealized appreciation or depreciation. The quality distribution of the fixed-income portfolio is as follows: As of December 31, 1993, the Company held $122.5 million of Collateralized Mortgage Obligations ("CMOs"), which represented 4.4% of the total investment portfolio. There are four types of securities held in the CMO Portfolio. As of December 31, 1993, sequential bonds represented 51.0% of the portfolio ($62.5 million) and had an average life of 1.5 years. Planned Amortization Class ("P.A.C.") bonds represented 25.9% of the portfolio ($31.7 million) and had an average life of 1.6 years. P.A.C. Principal Only and Interest Only bonds represented the remaining 23.1% of the portfolio ($28.3 million) and had an average life of 1.8 years. The portfolio contains no residual interests. CMOs held by the Company are highly liquid with readily available quotes and, at December 31, 1993, had an average life of 1.6 years. Eighty- nine percent of the CMOs held by the Company are rated AAA by Moody's or Standard & Poor's. As of December 31, 1993, the Company's total CMO portfolio had an unrealized loss of $3.7 million. The single largest unrealized loss in any CMO security was $1.3 million, or only 1.1% of such position. Investments in the Company's portfolio have varying degrees of risk. Equity securities generally have greater risks than the non-equity portion of the portfolio since these securities are subordinate to rights of debt holders and other creditors of the issuer. As of December 31, 1993, the mark-to-market net gains in the Company's equity portfolio were $20.7 million ($13.5 million, net of taxes), as compared to $88.3 million ($58.3 million, net of taxes) in 1992. As of December 31, 1993 and 1992, the marketable equity portfolio of the Company was $453.9 million, or 16.3% and $398.6 million, or 16.7%, respectively, of the total investment portfolio. The 1993 marketable equity portfolio consisted of three principal components: (i) $73.0 million, or 16.1%, of standard adjustable rate preferreds (ARPS), (ii) $283.4 million, or 62.4%, of perpetual preferreds with mechanisms that may provide an opportunity to liquidate at par, and (iii) $97.5 million, or 21.5%, of common stocks. The 1992 marketable equity portfolio consisted of three principal components; (i) $138.9 million, or 34.8%, of standard adjustable rate preferred (ARPS), (ii) $64.1 million, or 16.1% of perpetual preferreds with mechanisms that may provide an opportunity to liquidate at par, and (iii) $195.6 million, or 49.1%, of common stocks. The Company continually evaluates the creditworthiness of each issuer for all securities held in its portfolio. Changes in market value are evaluated to determine the extent to which such changes are attributable to: (i) interest rates, (ii) market-related factors other than interest rates and (iii) financial conditions, business prospects and other fundamental factors specific to the issuer. Declines attributable to issuer fundamentals are reviewed in further detail. Available evidence is considered to estimate the realizable value of the investment. Evidence reviewed may include the recent operating results and financial position of the issuer, information about its industry, recent announcements and other information. The Company retains a staff of experienced security analysts to compile, review and evaluate such information. When a security in the Company's investment portfolio has a decline in market value which is other than temporary, the Company is required by GAAP to reduce the carrying value of such security to its net realizable value. It is the Company's general policy to dispose of securities when the Company determines that the issuer is unable to reverse its deteriorating financial condition and the prospects for its business within a reasonable period of time. In less severe circumstances, the Company may decide to dispose of a portion of its holdings in a specific issuer when the risk profile of the investment becomes greater than its tolerance for such risk. ENVIRONMENTAL AND PRODUCT LIABILITY EXPOSURES Because the Company has been primarily an insurer of motor vehicles, it has limited exposure for environmental, product and general liability claims. The Company has established reserves for these exposures, in amounts which it believes to be adequate based on information currently known by it and, in addition, has a supplemental reserve that is in an amount substantially in excess of the potential exposure for such claims. The Company does not believe that these claims will have a material impact on the Company's liquidity, results of operations or financial condition. However, the ultimate costs of the environmental and product liability claims are inherently difficult to project due to numerous uncertainties, including causation and policy coverage issues, the possible uncollectability of related reinsurance and third-party indemnity arrangements, unsettled and sometimes conflicting case law, difficulties in determining the scope of any contamination or injury and the nature and cost of the appropriate remedial action and the number and financial condition of responsible parties and their insurers, among other factors. Most of the Company's exposure for such claims results from Progressive's acquisition in 1985 of American Star Insurance Company, since renamed National Continental Insurance Company. When American Star was acquired, the seller agreed to administer all claims asserted under policies previously written by American Star and to pay all losses incurred under such policies, including those covered by reinsurance then in place on some of the policies. The seller encountered major financial difficulties as a result of losses in Hurricane Andrew and, despite having paid all losses and adjusted all claims on the old business since 1985, has contested its obligation to administer these claims and to pay the losses not being paid by some of the reinsurers. The dispute has been submitted to arbitration and is scheduled to be heard by an arbitration panel during the second quarter. If it is determined that the seller is responsible for all of these losses, the amounts could be material to it. According to a recent study by independent actuaries for the seller, aggregate reserves on this business are about $19.2 million. Of that amount, about $6.3 million is being contested in the arbitration, $7.8 million is the admitted obligation of the seller and the balance is the responsibility of reinsurance sources that are paying their obligations. The Company will continue to monitor these exposures, adjust the related reserves appropriately as additional information becomes known and disclose any material developments. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Consolidated Financial Statements of the Company, along with the related notes, supplementary data and report of independent accountants, are incorporated by reference from the Company's 1993 Annual Report, pages 33 through 46 and pages 50 through 55. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT A description of the directors, including those nominated for election as directors at the 1994 Annual Meeting of Shareholders of the Registrant, is incorporated herein by reference from the section entitled "Election of Directors" in the Proxy Statement, pages 1 through 3. A description of the executive officers of the Registrant and its subsidiaries follows. These descriptions reflect the Company's termination of its officership program and consequent elimination of many officer positions, effective December 31, 1993. SECTION 16(A) REPORTING Under the Federal securities laws, the directors and certain officers of the Company, and holders of 10% or more of the Company's Common Shares, are required to report their ownership of the Company's Common Shares, and any changes in such ownership, to the Securities and Exchange Commission and New York Stock Exchange within specified time frames. The Company is required to report in this Form 10-K any failure on the part of any such individual to timely file any such report. The Form 5 filed for Daniel R. Lewis for 1992 inadvertently omitted to disclose two gifts totalling 100 of the Company's Common Shares received by his two minor children in January 1992. A supplemental filing was made with the Securities and Exchange Commission and the New York Stock Exchange promptly after this oversight was discovered. Norman S. Matthews' Form 5 for 1993, reporting charitable gifts totalling 250 Common Shares, was filed 29 days late. The total of all charitable gifts reported for David M. Schneider on his December 1993 Form 4 inadvertently omitted 4 Common Shares. An amended Form 4 was filed promptly after this omission was discovered. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION Incorporated by reference from the section of the Proxy Statement entitled "Executive Compensation," pages 7 through 15. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Incorporated by reference from the section of the Proxy Statement entitled "Security Ownership of Certain Beneficial Owners and Management," pages 4 through 6. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Incorporated by reference from the section of the Proxy Statement entitled "Election of Directors - Certain Related Transactions," page 3. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a)(1) Listing of Financial Statements The following consolidated financial statements of the Registrant and its subsidiaries, included in the Registrant's Annual Report, are incorporated by reference in Item 8: Report of Independent Accountants Consolidated Statements of Income - December 31, 1993, 1992 and 1991 Consolidated Balance Sheets - December 31, 1993 and 1992 Consolidated Statements of Changes in Shareholders' Equity - December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows - December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Supplemental Information* *Not covered by Report of Independent Accountants. (a)(2) Listing of Financial Statement Schedules The following financial statement schedules of the Registrant and its subsidiaries, Report of Independent Accountants and Consent of Independent Accountants are included in Item 14(d): Schedules Report of Independent Accountants Consent of Independent Accountants Schedule I - Summary of Investments - Other than Investments in Related Parties Schedule II - Amounts Receivable from Related Parties and Underwriters, Promoters, and Employees other than Related Parties Schedule III - Condensed Financial Information of Registrant Schedule V - Supplementary Insurance Information Schedule VI - Reinsurance Schedule X - Supplemental Information Concerning Property-Casualty Insurance Operations No other schedules are required to be filed herewith pursuant to Article 7 of Regulation S-X. (a)(3) Listing of Exhibits See exhibit index contained herein at pages 37 through 40. Management contracts and compensatory plans and arrangements are identified in the Exhibit Index as Exhibit Nos. (10)(B) through (10)(K). (b) Reports on Form 8-K On November 12, 1993, the Company filed a Form 8-K to report the call for redemption on December 17, 1993, of the entire $70 million aggregate principal amount of its outstanding 8 3/4% Debentures due 2017. The redemption was made at 105.425% of the principal amount, plus accrued interest to the date fixed for redemption. These debentures were issued pursuant to an Indenture dated October 15, 1986 between the Company and Morgan Guaranty Trust Company of New York, as trustee. (c) Exhibits The exhibits in response to this portion of Item 14 are submitted concurrently with this report. (d) Financial Statement Schedules The response to this portion of Item 14 is located at pages 23 through 36. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities and on the dates indicated. ANNUAL REPORT ON FORM 10-K ITEM 14(D) FINANCIAL STATEMENT SCHEDULES YEAR ENDED DECEMBER 31, 1993 THE PROGRESSIVE CORPORATION MAYFIELD VILLAGE, OHIO REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders, The Progressive Corporation: Our report on the consolidated financial statements of The Progressive Corporation and subsidiaries has been incorporated by reference in this Form 10-K from page 33 of the 1993 Annual Report to Shareholders of The Progressive Corporation. In connection with our audits of such financial statements, we have also audited the related financial statement schedules listed in the index on page 20 of this Form 10-K. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. COOPERS & LYBRAND Cleveland, Ohio January 26, 1994 CONSENT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders, The Progressive Corporation: We consent to the incorporation by reference in the Registration Statement of The Progressive Corporation on Form S-8 (File No. 33-64210) filed June 10, 1993, the Registration Statement of The Progressive Corporation on Form S-8 (File No. 33-51034) filed August 20, 1992, the Registration Statement on Form S-8 (File No. 33-46944) filed April 3, 1992, the Registration Statement on Form S-8 (File No. 33-38793) filed February 4, 1991, the Registration Statement on Form S-8 (File No. 33-38464) filed December 28, 1990, the Registration Statement on Form S-8 (File No. 33-38107) filed December 6, 1990, the Registration Statement on Form S-8 (File No. 33-37707) filed November 9, 1990, the Registration Statement on Form S-8 (File No. 33-33240) filed January 31, 1990, the Registration Statement on Form S-8 (File No. 33-23203) filed August 3, 1988 and the Registration Statement on Form S-8 (File No. 33-16509) filed August 14, 1987 of our report dated January 26, 1994, on our audits of the consolidated financial statements and financial statement schedules of The Progressive Corporation and subsidiaries as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993, which report is included in this Annual Report on Form 10-K. COOPERS & LYBRAND Cleveland, Ohio March 29, 1994 SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED) NOTES TO CONDENSED FINANCIAL STATEMENTS The accompanying condensed financial statements of The Progressive Corporation (the "Registrant") should be read in conjunction with the consolidated financial statements and notes thereto of The Progressive Corporation and subsidiaries included in the Registrant's 1993 Annual Report. STATEMENTS OF CASH FLOWS -- For the purpose of the Statements of Cash Flows, cash includes only bank demand deposits. The Registrant paid Federal income taxes of $91.0 million, $4.0 million and $30.4 million in 1993, 1992 and 1991, respectively. Total interest paid was $40.9 million for 1993, $44.3 million for 1992 and $47.0 million for 1991. During 1992, the $75.0 million Floating Rate Convertible Subordinated Debenture due 2008 was converted into 9.0 million Common Shares. The Registrant effected a 3-for-1 stock split in the form of a dividend to shareholders on December 8, 1992. The Registrant issued its Common Shares by transferring $38.5 million from retained earnings to the common stock account. All per share and share amounts and stock prices were adjusted to give effect to the split. Treasury shares were not split. DEBT -- Funded debt at December 31 consisted of: Funded debt is the amount the Registrant has borrowed and contributed to the capital of its insurance subsidiaries or borrowed for other long- term purposes. In May 1990, the Registrant entered into a revolving credit arrangement with National City Bank, which is reviewed by the bank annually. Under this agreement, the Registrant had the right to borrow up to $50.0 million. In February 1994, the Registrant reduced this revolving credit arrangement to $20.0 million. See Note 12, SUBSEQUENT EVENTS, on page 46 of the Registrant's 1993 Annual Report. By selecting from available credit options, the Registrant may elect to pay interest at rates related to the London interbank offered rate, the bank's base rate or at a money market rate. A commitment fee is payable on any unused portion of the committed amount at the rate of .125% per annum. At December 31, 1993, the Registrant had no borrowings under this arrangement; at December 31, 1992, $50.0 million was outstanding. In May 1990, the Registrant also entered into a four-year credit facility with Morgan Guaranty Trust Company of New York under which the Registrant had the right to borrow up to $75.0 million. By selecting from available credit options, the Registrant could have elected to pay interest at rates related to the London interbank offered rate, the bank's CD rate, a base lending rate or a quoted rate. A commitment fee was payable on any unused portion of the committed facility at the rate of .15% per annum. At December 31, 1993 and 1992, the Registrant had no borrowings under this agreement. In February 1994, the Registrant terminated this credit facility. See Note 12, SUBSEQUENT EVENTS, on page 46 of the Registrant's 1993 Annual Report. SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT (Continued) NOTES TO CONDENSED FINANCIAL STATEMENTS In October 1989, the Registrant entered into a five-year credit facility agreement with a group of banks under which the Registrant secured the right to borrow up to $235.0 million and request an additional $235.0 million. By selecting from available credit options, the Registrant could have elected to pay interest at rates related to the London interbank offered rate or the greater of the agent bank's base lending rate or a rate based on the Federal funds' rate. A commitment fee was payable on any unused portion of the committed facility at the rate of .125% per annum. The agreement provides for a utilization fee not to exceed .10% on the average amount of outstanding borrowings. At December 31, 1993, no borrowings were outstanding under this arrangement; at December 31, 1992, $120.0 million was outstanding. In February 1994, the Registrant terminated this agreement. See Note 12, SUBSEQUENT EVENTS, on page 46 of the Registrant's 1993 Annual Report. In October 1993, the Registrant sold $150.0 million of noncallable 7% Notes due 2013 with interest payable semiannually. The fair value of these Notes was $145.3 million at December 31, 1993. In February 1987, the Registrant sold $100.0 million, ($70.0 million after a May 1989 debt exchange), of 8 3/4% Debentures due 2017 with interest payable semiannually. In December 1993, the Registrant redeemed the entire $70.0 million principal amount of these Debentures. The Registrant redeemed the Debentures at 105.425% of the principal amount, plus accrued interest, with the proceeds of the sale of certain securities in its investment portfolio. A $4.0 million charge on debt extinguishment was recorded as a "non-recurring item." The fair value of this debt was $69.2 million at December 31, 1992. In May 1989, the Registrant issued $30.0 million of 8 3/4% Notes due 1999 in exchange for $30.0 million of the 8 3/4% Debentures due 2017. These Notes are noncallable, and interest is payable semiannually. The fair value of these Notes was $33.7 million and $31.8 million at December 31, 1993 and 1992, respectively. In December 1988, the Registrant sold $150.0 million of 10% Notes due 2000, and $150.0 million of 10 1/8% Subordinated Notes due 2000. All the Notes are noncallable. Interest is payable semiannually on both issues. The fair value of the 10% Notes and 10 1/8% Subordinated Notes were $180.6 million and $181.2 million, respectively, at December 31, 1993, and $170.4 million and $169.1 million, respectively, at December 31, 1992. As of December 31, 1993, the Registrant is in compliance with its financial debt covenants. The most restrictive covenant, which appeared under the recently terminated credit facilities, provided that senior indebtedness could not exceed 200% of long-term capital. In January 1994, the Registrant sold $200.0 million of its 6.60% Notes due 2004. See Note 12, SUBSEQUENT EVENTS, on page 46 of this Registrant's 1993 Annual Report. Aggregate principal payments on funded debt outstanding at December 31, 1993 are $0 for 1994 through 1998 and $480.0 million thereafter. FEDERAL INCOME TAXES -- The Registrant files a consolidated Federal income tax return with all subsidiaries. The Federal income taxes in the accompanying Condensed Balance Sheets represent amounts recoverable from the Internal Revenue Service by the Registrant as agent for the consolidated tax group. The Registrant and its subsidiaries have adopted, pursuant to a written agreement, a method of allocating consolidated Federal income taxes. Amounts allocated to the subsidiaries under the written agreement are included in Payable to Subsidiaries in the accompanying Condensed Balance Sheets. SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT (Continued) NOTES TO CONDENSED FINANCIAL STATEMENTS Effective January 1, 1992, the Registrant adopted Statement of Financial Accounting Standards (SFAS 109) "Accounting for Income Taxes", which changes the method of accounting for income taxes. Under SFAS 109, the Registrant was able to demonstrate that the benefit of deferred tax assets were fully realizable. The cumulative effect of adopting SFAS 109 was to restore the deferred tax assets and increase net income $14.2 million, or $.20 per share, in 1992. INVESTMENTS IN CONSOLIDATED SUBSIDIARIES -- The Registrant, through its investment in consolidated subsidiaries, recognizes the changes in unrealized gains (losses) on equity securities of the subsidiaries. These amounts were: OTHER MATTERS -- The information relating to incentive compensation plans and related party transactions is incorporated by reference from Note 9, Employee Benefit Plans, "Incentive Compensation Plans" and Note 10, RELATED PARTIES, on pages 44 and 45 of the Registrant's 1993 Annual Report.

711404_1993.txt

711404

1993

ITEM 1. BUSINESS. INTRODUCTION The Cooper Companies, Inc. ('TCC' or the 'Company'), through its subsidiaries, develops, manufactures and markets healthcare products, including a range of contact lenses, ophthalmic pharmaceutical products and diagnostic and surgical instruments and accessories, and provides healthcare services through the ownership and operation of certain psychiatric facilities and the management of other such facilities. TCC is a Delaware corporation which was organized on March 4, 1980. BUSINESS EXPANSION TCC disposed of a number of businesses during the 1980s, and by 1989 all of its revenues were derived from the sale of contact lenses. Since that time, the Company has pursued a strategy of diversification into other businesses. As a result, total operating revenues have grown significantly and for fiscal 1993 can be allocated among the Company's businesses as follows: Hospital Group of America, Inc. (including PSG Management, Inc.) -- $45,283,000, CooperVision, Inc. -- $32,120,000, CooperSurgical, Inc. -- $14,679,000 and CooperVision Pharmaceuticals, Inc. -- $570,000. During fiscal 1990, TCC, through various subsidiaries, acquired rights to (i) certain materials used to manufacture contact lenses, (ii) cryosurgical instruments and diagnostic devices, (iii) manufacture, distribute and sell a hard and soft intraocular lens and the injector used to insert the soft intraocular lens (which rights were subsequently sold), and (iv) two ophthalmic products. Early in fiscal 1991, a newly-formed subsidiary, CooperVision Pharmaceuticals, Inc., obtained an exclusive license for the ophthalmic use of Verapamil, a Class I calcium channel blocker being developed as a topical therapeutic to treat ocular hypertension, or glaucoma, which could lead to damaged eye tissue and loss of vision. At about the same time, CooperSurgical, Inc., another newly-formed subsidiary, purchased a company whose primary product is an office hysteroscopy system. Shortly thereafter, CooperSurgical, Inc. acquired another company, which develops and markets surgical instruments principally used for performing gynecologic procedures. In May 1992, another newly-formed subsidiary of TCC acquired all of the issued and outstanding capital stock of Hospital Group of America, Inc. ('Original HGA'), a corporation indirectly owned by Nu-Med, Inc. ('Nu-Med'). In June 1992, Original HGA was merged with and into TCC's subsidiary, with that subsidiary surviving such merger and changing its name to Hospital Group of America, Inc. ('HGA'). Pursuant to the acquisition, HGA acquired facilities providing both psychiatric and substance abuse treatment for children, adolescents and adults. In addition, PSG Management, Inc., another newly-formed subsidiary of TCC ('PSG Management'), entered into a three-year management services agreement (the 'Management Services Agreement') in May 1992, pursuant to which it provides management and administrative services to three facilities still owned by Nu-Med subsidiaries. Those facilities provide a range of specialized treatments for children, adolescents and adults, including programs for women, older adults, survivors of psychological trauma and alcohol and drug abusers. Treatments at both the owned and managed facilities are provided on an inpatient, outpatient and partial hospitalization basis. In April 1993, CooperVision, Inc. acquired all of the stock of CoastVision, Inc., which manufactures and markets soft toric contact lenses designed to correct astigmatism. INVESTMENT COMPANY ACT The Investment Company Act of 1940, as amended (the 'Investment Company Act'), places restrictions on the capital structure of, and the business activities that may be undertaken by, investment companies. The Investment Company Act defines an investment company as, among other things and subject to certain exceptions, an issuer that is engaged in the business of investing or trading in securities and which owns 'investment securities' (as such term is defined in the Investment Company Act) having a value exceeding 40% of the 'value' (as such term is defined in the Investment Company Act) of such company's total assets (exclusive of government securities and cash items) on an unconsolidated basis. Following the completion in 1989 of the Company's divestiture program, a substantial percentage of the Company's assets consisted of cash, cash equivalents and marketable securities, which the Company used or intended to be used primarily for working capital purposes, to reduce further the Company's debt and to fund acquisitions. The Division of Investment Management of the Securities and Exchange Commission (the 'SEC') has raised an issue as to whether the Company may be an investment company under the above definition. The Company has advised the SEC that its consolidated balance sheets at July 31, 1992 and at the last day of each fiscal quarter thereafter demonstrate that less than 40% of the value of the Company's total assets (exclusive of government securities and cash items) consists of investment securities, and that, if such balance sheets had been presented on an unconsolidated basis, the value (for purposes of the Investment Company Act) of the Company's investments in and advances to its subsidiaries that are actively engaged in various aspects of the healthcare business would have been significantly in excess of the carrying value of the underlying assets of those subsidiaries that was included in the consolidated balance sheets. The Company has provided the SEC with information regarding the Company's unconsolidated balance sheets at April 30 and July 31, 1993. The Company believes that this information also demonstrates that the Company is not an investment company within the meaning of the Investment Company Act. As of the date hereof, the Company is continuing to work with the SEC to clarify the Company's status under the Investment Company Act. If the Company were found to be an investment company, the Company believes that such status would have a materially adverse effect upon the Company due to the restrictions which would be placed on its capital structure and business activities. COOPERVISION The Company, through its CooperVision, Inc. subsidiary ('CooperVision'), develops, manufactures and markets a range of hard and soft contact lenses in the United States and Canada. Sales of soft contact lenses represent 98% of CooperVision's total lens sales. Of CooperVision's line of soft contact lenses, approximately 75% of the lenses sold are conventional daily or flexible wear lenses and approximately 25% constitute frequent replacement lenses. CooperVision's major brand name lenses are Preference'r', Vantage'r', Permaflex'r', Permalens'r', Cooper Clear'tm' and Hydrasoft'r'. These and other products enable CooperVision to fit the needs of a diverse group of wearers by offering lenses formulated from a variety of polymers containing varying amounts of water, having different design parameters, diameters, base curves and lens edges and different degrees of oxygen permeability. Certain lenses offer special features such as protection against ultraviolet light, color tint or aphakic correction. Lenses are also available in a wide range of prices. Preference'r' is a frequent replacement product developed using the Tetrafilcon A polymer. When Preference'r' was compared to other leading planned replacement contact lenses, in two studies conducted at an aggregate of 22 investigative sites using 505 patients, Tetrafilcon A demonstrated superior resistance to the formation of deposits on lens surfaces. Preference'r' was test marketed during the fourth quarter of fiscal 1991 and introduced in fiscal 1992. CooperVision acquired CoastVision, Inc. ('CoastVision'), a contact lens company which designs, manufactures and markets high quality soft toric lenses (the majority of which are custom made) designed to correct astigmatism. The acquisition enables CooperVision to expand into an additional niche in the contact lens market and to enlarge its customer base. CooperVision is continuing to explore opportunities to expand and diversify its business into additional niche markets. COOPERVISION PHARMACEUTICALS CooperVision Pharmaceuticals, Inc. ('CVP'), a development stage business, develops and markets ophthalmic pharmaceuticals. In February 1993, CVP sold its EYEscrub'tm' product line while retaining the right to market two medical product kits which include EYEscrub'tm'. Several other products discussed below are in various stages of clinical development. In 1993, CVP continued the clinical development of Verapamil, a Class I calcium channel blocker, as a potential anti-glaucoma compound. CVP received U.S. Food and Drug Administration ('FDA') clearance to begin human clinical trials in June 1991. Phase I clinical trials were initiated in 1991 and completed in 1992. Phase II clinical trials were initiated in 1992 and have been completed. Phase III clinical trials commenced during 1993. Rose Bengal, Phenyltrope'r' and other products are being developed as diagnostic aids for use by eye-care professionals. During 1993, a filing was made with the FDA seeking clearance to begin marketing Rose Bengal. A New Drug Application for Phenyltrope'r' will be submitted to the FDA in fiscal 1994. In 1993, CVP began to market a line of prescription and over-the-counter ophthalmic pharmaceuticals. The prescription line consists of antibacterial products, anti-inflammatory products, glaucoma treatment products and diagnostic dilating agents. The non-prescription offerings are intended to be used as tear replacements. COOPERSURGICAL CooperSurgical, Inc. ('CooperSurgical') was established in November 1990 to compete in niche segments of the rapidly expanding worldwide market for diagnostic and surgical instruments and accessories. Its business is developing, manufacturing and distributing electrosurgical, cryosurgical and general application diagnostic and surgical instruments and equipment used selectively in both traditional and minimally invasive surgical procedures. Unlike traditional surgical instruments, electrosurgical instruments, which operate by means of high radio frequency, dissect and cause coagulation, making them useful in surgical procedures to minimize blood loss. Cryosurgical equipment is differentiated by its ability to apply cold or sub-zero temperatures to the body in order to cause adhesion, provoke an inflammatory response or destroy diseased tissue. CooperSurgical's loop electrosurgical excision procedure products, marketed under the LEEP'tm' brand name, are viewed as an improvement over existing laser treatments for primary use in the removal of cervical and vaginal pre-cancerous tissue and benign external lesions. Unlike laser ablation which tends to destroy tissue, the electrosurgery procedure removes affected tissue with minimal charring, thereby improving the opportunity to obtain an accurate histological analysis of the patient's condition by producing a viable tissue specimen for biopsy purposes. In addition, the loop electrosurgical excision procedure is less painful than laser ablation and is easily learned by practitioners. Because this procedure enables a gynecologist to both diagnose and treat a patient in one office visit, patients incur lower costs. CooperSurgical's LEEP System 6000'tm' branded products include an electrosurgical generator, sterile single application LEEP Electrodes'tm', the CooperSurgical Smoke Evacuation System 6080, a single application LEEP RediKit'r', a series of educational video tapes and a line of coated LEEP'tm' surgical instruments. CooperSurgical's Euro-Med mail order business offers over 400 products for use in gynecologic and general surgical procedures. Over 60% of these products are exclusive to Euro-Med, including its 'signature' instrument series, cervical biopsy punches, clear plastic instruments used for unobstructed viewing, titanium instruments used in laser surgeries, colposcopy procedure kits and instrument care and sterilization systems. Euro-Med recently introduced its FNA 21'tm' for fine needle aspiration from the breast, thyroid and salivary glands of lymphoma and other tumors. The CooperSurgical Diagnostic Office Hysteroscopy System 3000'tm' is designed for in-office use by gynecologists. The system includes a hysteroscope, light source, monitor, solid state video camera and the Diagnostic Hysteroscopy RediKit'r', a prepackaged, disposable procedure kit. CooperSurgical's Frigitronics'r' instruments for cryosurgery are used primarily in dermatologic procedures to treat skin cancers, in ophthalmic procedures to treat retinal detachments and remove cataracts, and in certain gynecologic, cardiovascular and general surgical procedures. The primary products bearing the Frigitronics brand name are the Model 310 Zoom Colposcope, the CCS-200 Cardiac Cryosurgical System, the Model 2000 Ophthalmic Cryosurgical System and the Cryo-Plus System. Since October 1992, CooperSurgical has also offered its CooperEndoscopy line of endoscopic instruments which enable physicians to conduct abdominal and thoracic exploration using minimally invasive procedures. Included in that line are the LSS'tm' 500 Electronic Laparoscopic Insufflator, the LSS'tm' 600 Electronic Auto Shutter Endoscopic Camera System and the LSS'tm' 700 High Intensity Xenon Light Source. HOSPITAL GROUP OF AMERICA On May 29, 1992, HGA acquired three psychiatric facilities through the acquisition of Original HGA: Hartgrove Hospital in Chicago, Illinois (119 licensed beds), Hampton Hospital in Rancocas, New Jersey (100 licensed beds), and MeadowWood Hospital in New Castle, Delaware (50 licensed beds). In addition, the Company, through its subsidiary, PSG Management, entered into the Management Services Agreement with three indirectly owned subsidiaries of Nu-Med under which it assumed the management of three psychiatric facilities owned by such subsidiaries: Northwestern Institute of Psychiatry in Fort Washington, Pennsylvania (146 licensed beds), Malvern Institute for Psychiatric and Alcohol Studies in Malvern, Pennsylvania (36 licensed beds), and Pinelands Hospital in Nacogdoches, Texas (40 licensed beds). The HGA facilities provide intensive and structured treatment for children, adolescents and adults suffering from a variety of mental illnesses and/or chemical dependencies. Services include comprehensive psychiatric and chemical dependency evaluations, inpatient and outpatient treatment and partial hospitalization. In response to market demands for an expanded continuum of care, HGA is in the process of expanding its outpatient and partial hospitalization programs. The following is a comparison of certain statistical data relating to inpatient treatment for fiscal years 1991, 1992 and 1993 for the psychiatric facilities owned by HGA: - ------------ (1) Reflects operations of HGA when owned by Nu-Med and, after May 29, 1992, by TCC. Each psychiatric facility is accredited by the Joint Commission of Accreditation of Healthcare Organizations (JCAHO), a voluntary national organization which periodically undertakes a comprehensive review of a facility's staff, programs, physical plant and policies and procedures for purposes of accreditation of such healthcare facility. Accreditation generally is required for patients to receive insurance company reimbursement and for participation by the facility in government sponsored provider programs. HGA periodically conducts audits of the facilities of its subsidiaries to ensure compliance with applicable practices, procedures and regulations. In the course of an ongoing audit that was recently commenced, HGA has learned that there may be certain irregularities at Hampton Hospital (the primary facility operated by HGA's subsidiary, Hospital Group of New Jersey, Inc.) with respect to certain billings for clinical services. The provision of clinical services at Hampton Hospital, as well as the billing for such services, are the responsibility of an independent medical group under contract to Hampton Hospital. Consequently, HGA has not yet been able to determine if any billing irregularities have occurred. It is, however, currently investigating this matter and has requested the production of the billing records. To date, the independent medical group has refused to cooperate. HGA considers this refusal to be a breach of the contract between the parties and is in the process of evaluating its options. The Management Services Agreement provides for the contracting subsidiaries to pay to PSG Management a $6,000,000 fee (the 'Management Fee') in equal monthly installments over the three- year term (subject to prior termination in accordance with its terms, upon which termination all or a portion of such Management Fee becomes immediately due and payable). Payments of the Management Fee are jointly and severally guaranteed by Nu-Med and its subsidiary PsychGroup, Inc., the parent of the contracting subsidiaries. On January 6, 1993, Nu-Med (but not any of its direct or indirect subsidiaries) filed a voluntary petition under Chapter 11 of the United States Bankruptcy Code. Neither the Company nor any of its subsidiaries filed a proof of claim in the Nu-Med Chapter 11 proceeding, and the bar date (the time for filing proofs of claim) has past. None of the Nu-Med subsidiaries have filed under Chapter 11 and, to date, they have paid the Management Fee on a timely basis, although representatives of Nu-Med and its subsidiaries have alleged in writing that PSG Management has breached the Management Services Agreement (which contention PSG Management vigorously disputes). Moreover, Nu-Med's Proposed Disclosure Statement to accompany its Second Amended Plan of Reorganization, filed with the United States Bankruptcy Court for the Central District of California, indicates that PsychGroup, Inc. is commencing performance of certain administrative functions performed by PSG Management on a parallel basis. On October 9, 1992, HGA filed a complaint against Nu-Med and several of its subsidiaries asserting claims in excess of $4 million and asserted additional claims against the same defendants in excess of an additional $6 million that are to be resolved by an independent auditor. In both instances, HGA's claims arose from the defendants' alleged breaches of certain provisions in the acquisition agreement pursuant to which the HGA facilities were acquired. As indicated, the Company and its subsidiaries did not file a proof of claim against Nu-Med, and the bar date has passed. Since Nu-Med's subsidiaries have not filed under Chapter 11, the bar date is not applicable with respect to the Company's claims against Nu-Med's subsidiaries and those claims are still pending. Patient and Third Party Payments. HGA receives payment for its psychiatric services either from patients, from their health insurers or through the Medicare, Medicaid and Civilian Health and Medical Program of Uniformed Services ('CHAMPUS') governmental programs. Medicare is a federal program which entitles persons 65 and over to a lifetime benefit of up to 190 days as an inpatient in an acute psychiatric facility. Persons defined as disabled, regardless of age, also receive this benefit. Medicaid is a joint federal and state program available to persons with limited financial resources. CHAMPUS is a federal program which provides health insurance for active and retired military personnel and their dependents. While other programs may exist or be adopted in different jurisdictions, the following four categories include all methods by which HGA's three owned facilities receive payment for services: (a) Standard reimbursement, consisting of payment by patients and their health insurers, is based on a facility's schedule of rates and is not subject to negotiation with insurance companies, competitive bidding or governmental limitation. (b) Negotiated rate reimbursement is at prices established in advance by negotiation or competitive bidding for contracts with insurers and other payors such as managed care companies, health maintenance organizations ('HMO'), preferred provider organizations ('PPO') and similar organizations which can provide a reasonable number of referrals. (c) Cost-based reimbursement is predicated on the allowable cost of services, plus, in certain cases, an incentive payment where costs fall below a target rate. It is used by Medicare, Medicaid and certain Blue Cross insurance programs to provide reimbursement in amounts lower than the schedule of rates in effect at an HGA facility. (d) CHAMPUS reimbursement is at either (1) regionally set rates, (2) a national rate adjusted upward periodically on the basis of the Medicare Market Basket Index or (3) a fixed discount rate per day at certain facilities where CHAMPUS contracts with a benefit administration group. The approximate percentages of HGA's net patient revenue by payment source are as follows: - ------------ (1) Reflects operations of HGA when owned by Nu-Med and, after May 29, 1992, by TCC. (2) Consists of self-payors and other miscellaneous payors. The Medicare, Medicaid and CHAMPUS programs are subject to statutory and regulatory changes and interpretations, utilization reviews and governmental funding restrictions, all of which may materially increase or decrease program payments and the cost of providing services, as well as the timing of payments to the facilities. Existing and Proposed Legislation. In recent years, forms of prospective reimbursement legislation have been proposed in various states but have not been enacted into law. If legislation based on the budgeted costs of individual hospitals were to be enacted in the future in one or more of the states in which HGA operates psychiatric facilities, it could have an adverse effect on HGA's business and earnings. In addition, the enactment of such legislation in states where HGA does not now operate could have a deterrent effect on the decision to acquire or establish facilities in such states. RESEARCH AND DEVELOPMENT During the fiscal years ended October 31, 1993, 1992 and 1991, expenditures for Company-sponsored research and development were $3,209,000, $3,267,000 and $2,268,000, respectively. During fiscal 1993, approximately 51% of those expenditures was incurred by CVP, 24% was incurred by CooperVision and the balance was incurred by CooperSurgical. No customer-sponsored research and development has been conducted. The Company employs 14 people in its research and development and manufacturing engineering departments. Product development and clinical research for CooperVision products are supported by outside specialists in lens design, formulation science, polymer chemistry, microbiology and biochemistry. At CooperVision, experienced employees work with outside consultants. Product research and development for CooperSurgical is conducted in-house and by outside surgical specialists, including members of both the CooperSurgical and Euro-Med surgical advisory boards. GOVERNMENT REGULATION Healthcare Products. The development, testing, production and marketing of the Company's healthcare products is subject to the authority of the FDA and other federal agencies as well as foreign ministries of health. The Federal Food, Drug and Cosmetic Act and other statutes and regulations govern the testing, manufacturing, labeling, storage, advertising and promotion of such products. Noncompliance with applicable regulations can result in fines, product recall or seizure, suspension of production and criminal prosecution. The Company is currently developing and marketing both medical devices and drug products. Medical devices are subject to different levels of FDA regulation depending upon the classification of the device. Class III devices, such as contact lenses, require extensive premarket testing and approval procedures, while Class I and II devices are subject to substantially lower levels of regulation. A multi-step procedure must be completed before a new contact lens can be sold commercially. Data must be compiled on the chemistry and toxicology of the lens, its microbiological profile and the proposed manufacturing process. All data generated must be submitted to the FDA in support of an application for an Investigational Device Exemption. Once granted, clinical trials may be initiated subject to the review and approval of an Institutional Review Board and, where a lens is determined to be a significant risk device, the FDA. Upon completion of clinical trials, a Premarket Approval Application must be submitted and approved by the FDA before commercialization may begin. The ophthalmic pharmaceutical products under development by the Company require extensive testing before marketing approval may be obtained. Preclinical laboratory studies are conducted to determine the safety and efficacy of a new drug. The results of these studies are submitted to the FDA in an Investigational New Drug Application under which the Company seeks clearance to commence human clinical trials. The initial clinical evaluation, Phase I, consists of administering the drug and evaluating its safety and tolerance levels. Phase II involves studies to evaluate the effectiveness of the drug for a particular indication, to determine optimal dosage and to identify possible side effects. If the new drug is found to be potentially effective, Phase III studies, which consist of additional testing for safety and efficacy with an expanded patient group, are undertaken. If results of the studies demonstrate safety and efficacy, marketing approval is sought from the FDA by means of filing a New Drug Application. The Company, in connection with some of its new surgical products, can submit premarket notification to the FDA under an expedited procedure known as a 510(k) application, which is available for any product that is substantially equivalent to a device marketed prior to May 28, 1976. If the new product is not substantially equivalent to a pre-existing device or if the FDA were to reject a claim of substantial equivalence, extensive preclinical and clinical testing would be required, additional costs would be incurred and a substantial delay would occur before the product could be brought to market. FDA and state regulations also require adherence to applicable 'good manufacturing practices' ('GMP'), which mandate detailed quality assurance and record-keeping procedures. In conjunction therewith, the Company is subject to unscheduled periodic regulatory inspections. The Company believes it is in substantial compliance with GMP regulations. The Company also is subject to foreign regulatory authorities governing human clinical trials and pharmaceutical/medical device sales that vary widely from country to country. Whether or not FDA approval has been obtained, approval of a product by comparable regulatory authorities of foreign countries must be obtained before products may be marketed in those countries. The approval process varies from country to country, and the time required may be longer or shorter than that required for FDA approval. The procedures described above involve expenditures of considerable resources and usually result in a substantial time lag between the development of a new product and its introduction into the marketplace. There can be no assurance that all necessary approvals will be obtained, or that they will be obtained in a time frame that allows the product to be introduced for commercial sale in a timely manner. Furthermore, product approvals may be withdrawn if compliance with regulatory standards is not maintained or if problems occur after marketing has begun. Healthcare Facilities. The healthcare services industry is subject to substantial federal, state and local regulation. Government regulation affects the Company's business by controlling the use of its properties and controlling reimbursement for services provided. Licensing, certification and other applicable governmental regulations vary from jurisdiction to jurisdiction and are revised periodically. The Company's facilities must comply with the licensing requirements of federal, state and local health agencies and with the requirements of municipal building codes, health codes and local fire department codes. In granting and renewing a facility's license, a state health agency considers, among other things, the condition of the physical buildings and equipment, the qualifications of the administrative personnel and professional staff, the quality of professional and other services and the continuing compliance of such facility with applicable laws and regulations. Most states in which the Company operates or manages facilities have in effect certificate of need statutes. State certificate of need statutes provide, generally, that prior to the construction of new healthcare facilities, the addition of new beds or the introduction of a new service, a state agency must determine that a need exists for those facilities, beds or services. A certificate of need is generally issued for a specific maximum amount of expenditures or number of beds or types of services to be provided, and the holder is generally required to implement the approved project within a specific time period. Certificate of need issuances for new facilities are extremely competitive, often with several applicants for a single certificate of need. Each Company owned or managed facility that is eligible (five of the six) is certified or approved as a provider under one or more of the Medicaid or Medicare programs. In order to receive Medicare reimbursement, each facility must meet the applicable conditions promulgated by the United States Department of Health and Human Services relating to the type of facility, its equipment, its personnel and its standards of patient care. The Social Security Act contains a number of provisions designed to ensure that services rendered to Medicare and Medicaid patients are medically necessary and meet professionally recognized standards. Those provisions include a requirement that admissions of Medicare and Medicaid patients to healthcare facilities must be reviewed in a timely manner to determine the medical necessity of the admissions. In addition, the Peer Review Improvement Act of 1982 provides that a healthcare facility may be required by the federal government to reimburse the government for the cost of Medicare-paid services determined by a peer review organization to have been medically unnecessary. Various state and federal laws regulate the relationships between providers of healthcare services and physicians. Among these laws are the Medicare and Medicaid Anti-Fraud and Abuse Amendments to the Social Security Act, which prohibit individuals or entities participating in the Medicare or Medicaid programs from knowingly and willfully offering, paying, soliciting or receiving remuneration in order to induce referrals for items or services reimbursed under those programs. In addition, specific laws exist that regulate certain aspects of the Company's business, such as the commitment of patients to psychiatric hospitals and disclosure of information regarding patients being treated for chemical dependency. Many states have adopted a 'patient's bill of rights' which sets forth standards for dealing with issues such as use of the least restrictive treatment, patient confidentiality, patient access to telephones, mail and legal counsel and requiring the patient to be treated with dignity. Healthcare Reform. On October 27, 1993, President Clinton delivered his Administration's proposal for national health care reform to Congress. This complex proposal contains provisions designed to control and reduce growth in public and private spending on health care and to reform the payment methodology for health care goods and services by both the public (Medicare and Medicaid) and private sectors, including overall limitations on future growth in spending for health care benefits and the provision of universal access to health care. Currently, there are pending before Congress several competing health care reform proposals which, through varying mechanisms and methodologies, are also intended to control or reduce public and private spending on health care. It is uncertain which, if any, of these proposals will be adopted by Congress or what actions federal, state or private payors for health care goods and services may take in response thereto. The Company cannot yet predict the effect such reforms or the prospect of their enactment may have on the business of the Company and its subsidiaries. Accordingly, no assurance can be given that the same will not have a material adverse effect on the Company's revenues, earnings or cash flows. RAW MATERIALS In general, raw materials required by CooperVision consist of various polymers as well as packaging materials. Alternative sources of all of these materials are available. Raw materials used by CooperSurgical or its suppliers are generally available from a variety of sources. Products manufactured for CooperSurgical are generally available from more than one source. However, because some products require specialized manufacturing procedures, CooperSurgical could experience inventory shortages if an alternative manufacturer had to be secured on short notice. MANUFACTURING CooperVision manufactures products in the United States and Canada. CooperSurgical manufactures products in the United States and Europe. Pursuant to a supply agreement entered into in May 1989 and subsequently amended between the Company and Pilkington plc, the buyer of the Company's contact lens business outside of the United States and Canada, CooperVision purchases certain of its product lines from Pilkington plc (see Note 14)(1). These purchased lenses represented approximately 28%, 31% and 40% of the total number of lenses sold by the Company in fiscal 1993, 1992 and 1991, respectively. MARKETING AND DISTRIBUTION Healthcare Products. In the United States and Canada, CooperVision markets its products through its field sales representatives, who call on ophthalmologists, optometrists, opticians and optical chains. In the United States, field sales representatives also call on distributors. CVP's line of generic pharmaceuticals is sold directly to wholesalers and distributors through an independent contract sales force and by the sales forces of CooperVision and CoastVision. CooperSurgical's LEEP'tm', Frigitronics'r', hysteroscopy and endoscopy products are marketed worldwide by a network of independent sales representatives and distributors. In the United States, CooperSurgical, as a principal method of increasing physician awareness of its products, conducted teaching seminars in fiscal 1993. Euro-Med instruments and systems, as well as certain LEEP'tm' disposable products, are marketed through direct mail catalog programs. Healthcare Facilities. HGA's marketing concept aims to position each psychiatric facility as the provider of the highest quality mental health services in its marketplace. HGA employs a combination of general advertising, toll-free 'help lines', community education programs and facility-based continuing education programs to underscore the facility's value as a mental health resource center. HGA's marketing emphasizes discrete programs for select illnesses or disorders because of its belief that marketing a generic product without program differentiation will not generate the interest of, or be of value to, a referral source seeking treatment for specific disorders. Referral sources include psychiatrists, other physicians, psychologists, social workers, school guidance counselors and the police, courts, clergy, care-provider organizations and former patients. PATENTS, TRADEMARKS AND LICENSING AGREEMENTS TCC owns or licenses a variety of domestic and foreign patents which, in the aggregate, are material to its businesses. CooperVision is a party to a licensing agreement under which it holds a perpetual, royalty free, nonexclusive right to make, have made and sell contact lenses utilizing a polymer owned by a third party. CooperVision's ability to utilize that polymer is material to its business. Unexpired terms of TCC's United States patents range from less than one year to a maximum of 17 years. CVP has the exclusive license to the U.S. patent for the use of Class I calcium channel blockers as agents to reduce intraocular pressure in ocular hypertensive conditions including glaucoma. In addition, CVP has filed and/or is in the process of filing additional U.S. and international patent applications. As indicated in the references to such products in this Item 1, the names of certain of TCC's products are protected by trademark registration in the United States Patent and Trademark Office and, in some instances, in foreign trademark offices as well. Applications are pending for additional trademark registrations. TCC considers these trademarks to be valuable because of their contribution to the market identification of its various products. DEPENDENCE UPON CUSTOMERS At this time, no material portion of TCC's businesses is dependent upon any one customer or upon any one affiliated group of customers. - ------------ (1) All references to Note numbers shall constitute the incorporation by reference of the text of the specific Note contained in the Notes to Consolidated Financial Statements of the Company located in Item 8 into the Item number in which it appears. GOVERNMENT CONTRACTS No material portion of TCC's businesses is subject to renegotiation of profits or termination of contracts or subcontracts at the election of the United States government. COMPETITION No single company competes with the Company in all of its industry segments; however, each of TCC's business segments operates within a highly competitive environment. Competition in the healthcare industry revolves around the search for technological and therapeutic innovations in the prevention, diagnosis and treatment of illness or disease. TCC competes primarily on the basis of product quality, technological benefit, service and reliability, as perceived by medical professionals. Healthcare Products. Numerous companies are engaged in the development and manufacture of contact lenses and ophthalmic pharmaceuticals. CooperVision competes primarily on the basis of product quality, service and reputation among medical professionals and by its participation in specialty niche markets. It has been, and continues to be, the sponsor of clinical lens studies intended to generate information leading to the improvement of CooperVision's lenses from a medical point of view. Major competitors have greater financial resources and larger research and development and sales forces than CooperVision. Furthermore, many of these competitors offer a greater range of contact lenses, plus a variety of other eye care products, which gives them a competitive advantage in marketing their lenses. In the surgical segment, competitive factors are technological and scientific advances, product quality, price and effective communication of product information to physicians and hospitals. CooperSurgical believes that it benefits, in part, from the technological advantages of certain of its products and from the ongoing development of new medical procedures, which creates a market for equipment and instruments specifically tailored for use in such new procedures. CooperSurgical competes by focusing on distinct niche markets and supplying medical personnel working in those markets with equipment, instruments and disposable products that are high in quality and that, with respect to certain procedures, enable a medical practitioner to obtain from one source all of the equipment, instruments and disposable products required to perform such procedure. As CooperSurgical develops products to be used in the performance of new medical procedures, it offers training to medical professionals in the performance of such procedures. CooperSurgical competes with a number of manufacturers in each of its niche markets, including larger manufacturers that have greater financial and personnel resources and sell a substantially larger number of product lines. Healthcare Facilities. In most areas in which HGA operates, there are other psychiatric facilities that provide services comparable to those offered by HGA's facilities. Some of those facilities are owned by governmental organizations, not-for-profit organizations or investor-owned companies having substantially greater resources than HGA and, in some cases, tax-exempt status. Psychiatric facilities frequently draw patients from areas outside their immediate locale, therefore, HGA's psychiatric facilities compete with both local and distant facilities. In addition, psychiatric facilities also compete with psychiatric units in acute care hospitals. HGA's strategy is to develop high quality programs designed to target specific disorders and to retain a highly qualified professional staff. BACKLOG TCC does not consider backlog to be a material factor in its businesses. SEASONALITY HGA's psychiatric facilities experience a decline in occupancy rates during the summer months when school is not in session and during the year-end holiday season. No other material portion of TCC's businesses is seasonal. COMPLIANCE WITH ENVIRONMENTAL LAWS Federal, state and local provisions regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, do not currently have a material effect upon TCC's capital expenditures, earnings or competitive position. WORKING CAPITAL TCC's businesses have not required any material working capital arrangements in the past five years. In light of the substantial reduction in TCC's cash items and temporary investments and the net cash outflow still anticipated by the Company, the Company is considering a variety of alternatives to obtain funds through borrowings or other financings or sales of assets. See Item 7 'Management's Discussion and Analysis of Financial Condition and Results of Operations -- Capital Resources and Liquidity.' FINANCIAL INFORMATION ABOUT BUSINESS SEGMENTS, GEOGRAPHIC AREAS, FOREIGN OPERATIONS AND EXPORT SALES Note 16 sets forth financial information with respect to TCC's business segments and sales in different geographic areas. EMPLOYEES On October 31, 1993, TCC and its subsidiaries employed approximately 970 persons. In addition, HGA's psychiatric facilities are staffed by licensed physicians who have been admitted to the medical staff of an individual facility. Certain of those physicians are not employees of HGA. TCC believes that its relations with its employees are good. ITEM 2.

ITEM 2. PROPERTIES. The following are TCC's principal facilities as of December 31, 1993: (table continued on next page) (table continued from previous page) - ------------ (1) Outstanding loans totaling $13,718,000 as of October 31, 1993, were secured by these properties. (2) Does not include optional renewal periods. The Company believes its properties are suitable and adequate for its businesses. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. The Company is a defendant in a number of legal actions relating to its past or present businesses in which plaintiffs are seeking damages. On November 10, 1992, the Company was charged in an indictment (the 'Indictment'), filed in the United States District Court for the Southern District of New York, with violating federal criminal laws relating to a 'trading scheme' by Gary A. Singer, a former Co-Chairman of the Company (who went on a leave of absence on May 28, 1992, begun at the Company's request, and who subsequently resigned on January 20, 1994), and others, including G. Albert Griggs, Jr., a former analyst with The Keystone Group, Inc., and John D. Collins II, to 'frontrun' high yield bond purchases by the Keystone Custodian Funds, Inc., a group of mutual funds. The Company was named as a defendant in 10 counts. Gary Singer was named as a defendant in 24 counts, including violations of the Racketeer Influenced and Corrupt Organizations Act and the mail and wire fraud statutes (including defrauding the Company by virtue of the 'trading scheme,' by, among other things, transferring profits on trades of DR Holdings, Inc. 15.5% bonds (the 'DR Holdings Bonds') from the Company to members of his family during fiscal 1991), money laundering, conspiracy, and aiding and abetting violations of the Investment Advisers Act of 1940, as amended (the 'Investment Advisers Act'), by an investment advisor. On January 13, 1994, the Company was found guilty on six counts of mail fraud and one count of wire fraud based upon Mr. Singer's conduct, but acquitted of charges of conspiracy and aiding and abetting violations of the Investment Advisers Act. Mr. Singer was found guilty on 21 counts. One count against Mr. Singer and the Company was dismissed at trial and two counts against Mr. Singer relating to forfeiture penalties were resolved by stipulation between the government and Mr. Singer. Sentencing is scheduled for March 25, 1994. The maximum penalty which could be imposed on the Company is the greater of (i) $500,000 per count, (ii) twice the gross gain derived from the offense or (iii) twice the gross loss suffered by the victim of the offense, and a $200 special assessment. In addition to the penalties described in (i), (ii) or (iii), the Court could order the Company to make restitution. The Company is considering its options, including filing an appeal of its conviction. Mr. Singer's attorney has advised the Company that Mr. Singer intends to appeal his conviction. Although the Company may be obligated under its Certificate of Incorporation to advance the costs of such appeal, the Company and Mr. Singer have agreed that Mr. Singer will not request such advances, but that he will reserve his rights to indemnification in the event of a successful appeal. Also on November 10, 1992, the SEC filed a civil Complaint for Permanent Injunction and Other Equitable Relief (the 'SEC Complaint') in the United States District Court for the Southern District of New York against the Company, Gary A. Singer, Steven G. Singer (the Company's Executive Vice President and Chief Operating Officer and Gary Singer's brother), and, as relief defendants, certain persons related to Gary and Steven Singer and certain entities in which they and/or those related persons have an interest. The SEC Complaint alleges that the Company and Gary and Steven Singer violated various provisions of the Securities Exchange Act of 1934, as amended (the 'Securities Exchange Act'), including certain of its antifraud and periodic reporting provisions, and aided and abetted violations of the Investment Company Act, and the Investment Advisors Act, in connection with the 'trading scheme' described in the preceding paragraphs. The SEC Complaint further alleges, among other things, federal securities law violations (i) by the Company and Gary Singer in connection with an alleged manipulation of the trading price of the Company's 10 5/8% Convertible Subordinated Reset Debentures due 2005 (the 'Debentures') to avoid an interest rate reset allegedly required on June 15, 1991 under the terms of the Indenture governing the Debentures, (ii) by Gary Singer in allegedly transferring profits on trades of high yield bonds (including those trades in the DR Holdings Bonds which were the subject of certain counts of the Indictment of which Mr. Singer was found guilty) from the Company to members of his family and failing to disclose such transactions to the Company and (iii) by the Company in failing to disclose publicly on a timely basis such transactions by Gary Singer. The SEC Complaint asks that the Company and Gary and Steven Singer be enjoined permanently from violating the antifraud, periodic reporting and other provisions of the federal securities laws, that they disgorge the amounts of the alleged profits received by them pursuant to the alleged frauds (stated in the SEC's Litigation Release No. 13432 announcing the filing of the SEC Complaint as being $1,296,406, $2,323,180 and $174,705, respectively), plus interest, and that they each pay appropriate civil monetary penalties. The SEC Complaint also seeks orders permanently prohibiting Gary and Steven Singer from serving as officers or directors of any public company and disgorgement from certain Singer family members and entities of amounts representing the alleged profits received by such defendants pursuant to the alleged frauds. In February 1993, the court granted a motion staying all proceedings in connection with this matter pending completion of the criminal case. On January 24, 1994, the Court lifted the stay and directed the defendants to file answers to the SEC Complaint within 30 days. The Company is currently involved in settlement negotiations with the SEC. At this time, there can be no assurances these negotiations will be successfully concluded. The imposition of monetary penalties upon the Company as a result of the criminal convictions or in connection with the matters alleged in the SEC Complaint, as well as the incurrence of any additional defense costs, could exacerbate, possibly materially, the Company's liquidity problems and its need to raise funds. See Item 7 -- 'Management's Discussion and Analysis of Financial Condition and Results of Operations.' Copies of the Indictment and the SEC Complaint were attached as exhibits to the Company's Current Report on Form 8-K, dated November 16, 1992, filed with the SEC. The Company is named as a nominal defendant in a shareholder derivative action entitled Harry Lewis and Gary Goldberg v. Gary A. Singer, Steven G. Singer, Arthur C. Bass, Joseph C. Feghali, Warren J. Keegan, Robert S. Holcombe and Robert S. Weiss, which was filed on May 27, 1992 in the Court of Chancery, State of Delaware, New Castle County. On May 29, 1992, another plaintiff, Alfred Schecter, separately filed a derivative complaint in Delaware Chancery Court that was essentially identical to the Lewis and Goldberg complaint. Lewis and Goldberg later amended their complaint, and the Delaware Chancery Court thereafter consolidated the Lewis and Goldberg and Schecter actions as In re The Cooper Companies, Inc. Litigation, Consolidated C.A. 12584, and designated Lewis and Goldberg's amended complaint as the operative complaint (the 'First Amended Derivative Complaint'). The First Amended Derivative Complaint alleges that certain directors of the Company and Gary A. Singer, as Co-Chairman of the Board of Directors, caused or allowed the Company to be a party to the 'trading scheme' that was the subject of the Indictment. The First Amended Derivative Complaint also alleges that the defendants violated their fiduciary duties to the Company by not vigorously investigating the allegations of securities fraud. The First Amended Derivative Complaint requests that the Court order the defendants (other than the Company) to pay damages and expenses to the Company and certain of the defendants to disgorge their profits to the Company. On October 16, 1992, the defendants moved to dismiss the First Amended Derivative Complaint on grounds that such Complaint fails to comply with Delaware Chancery Court Rule 23.1 and that Count III of the First Amended Derivative Complaint fails to state a claim. The Company has been advised by the individual directors named as defendants that they believe they have meritorious defenses to this lawsuit and intend vigorously to defend against the allegations in the First Amended Derivative Complaint. The Company was named as a nominal defendant in a purported shareholder derivative action entitled Bruce D. Sturman v. Gary A. Singer, Steven G. Singer, Brad C. Singer, Martin Singer, John D. Collins II, Back Bay Capital, Inc., G. Albert Griggs, Jr., John and Jane Does 1-10 and The Cooper Companies, Inc., which was filed on May 26, 1992 in the Supreme Court of the State of New York, County of New York. The plaintiff, Bruce D. Sturman, a former officer and director of the Company, alleged that Gary A. Singer, as Co-Chairman of the Board of Directors, and various members of the Singer family caused the Company to make improper payments to alleged third-party co-conspirators, Messrs. Griggs and Collins, as part of the 'trading scheme' that was the subject of the Indictment. The complaint requested that the Court order the defendants (other than the Company) to pay damages and expenses to the Company, including reimbursement of payments made by the Company to Messrs. Collins and Griggs, and to disgorge their profits to the Company. Pursuant to its decision and order, filed August 17, 1993, the Court dismissed this action under New York Civil Practice Rule 327(a). On September 22, 1993, the plaintiff filed a Notice of Appeal. The Company was named in an action entitled Bruce D. Sturman v. The Cooper Companies, Inc. and Does 1-100, Inclusive, first brought on July 24, 1992 in the Superior Court of the State of California, Los Angeles, County. Mr. Sturman alleged that his suspension from his position as Co-Chairman of the Board of Directors constituted, among other things, an anticipatory breach of his employment agreement. On May 14, 1993, Mr. Sturman filed a First Amended Complaint in the Superior Court of the State of California, County of Alameda, Eastern Division, the jurisdiction to which the original case had been transferred. In the Amended Complaint, Mr. Sturman alleged that by first suspending and then terminating him from his position as Co-Chairman, the Company breached his employment agreement, violated provisions of the California Labor Code, wrongfully terminated him in violation of public policy, breached its implied covenant of good faith and fair dealing, defamed him, invaded his privacy and intentionally inflicted emotional distress, and was otherwise fraudulent, deceitful and negligent. The Amended Complaint seeks declaratory relief, damages in the amount of $5,000, treble and punitive damages in an unspecified amount, and general, special and consequential damages in the amount of at least $5,000,000. In March 1993, the Court ordered a stay of all discovery in this action until further order of the Court and thereafter scheduled a conference for January 14, 1994 to review the status of the stay. The Court subsequently modified the stay to permit the taking of the deposition of one witness who will not be available to testify at trial. On September 24, 1993, Mr. Sturman filed a Second Amended Complaint, setting forth the same material allegations and seeking the same relief and damages as set forth in the First Amended Complaint. On January 7, 1994, the Company filed an Answer, generally denying all of the allegations in the Second Amended Complaint, and also filed a Cross-Complaint against Mr. Sturman. In the Cross-Complaint, the Company alleges that Mr. Sturman's conduct constituted a breach of his employment agreement with the Company as well as a breach of his fiduciary duty to the Company, that Mr. Sturman misrepresented and failed to disclose certain material facts to the Company and converted certain assets of the Company to his personal use and benefit. The Cross-Complaint seeks compensatory and punitive damages in an unspecified amount. On January 14, 1994, the Court continued in place the stay on all discovery and scheduled a case management conference for February 10, 1994 to review the status of the stay. Based on management's current knowledge of the facts and circumstances surrounding Mr. Sturman's termination, the Company believes that it has meritorious defenses to this lawsuit and intends to defend vigorously against the allegations in the Second Amended Complaint. In two virtually identical actions, Frank H. Cobb, Inc. v. The Cooper Companies, Inc., et al., and Arthur J. Korf v. The Cooper Companies, Inc., et al., class action complaints were filed in the United States District Court for the Southern District of New York in August 1989, against the Company and certain individuals who served as officers and/or directors of the Company after June 1987. In their Fourth Amended Complaint filed in September 1992, the plaintiffs allege that they are bringing the actions on their own behalf and as class actions on behalf of a class consisting of all persons who purchased or otherwise acquired shares of the Company's common stock during the period May 26, 1988 through February 13, 1989. The amended complaints seek an undetermined amount of compensatory damages jointly and severally against all defendants. The complaints, as amended, allege that the defendants knew or recklessly disregarded and failed to disclose to the investing public material adverse information about the Company. Defendants are accused of having allegedly failed to disclose, or delayed in disclosing, among other things: (a) that the allegedly real reason the Company announced on May 26, 1988 that it was dropping a proposed merger with Cooper Development Company, Inc. was because the Company's banks were opposed to the merger; (b) that the proposed sale of Cooper Technicon, Inc., a former subsidiary of the Company, was not pursuant to a definitive sales agreement but merely an option; (c) that such option required the approval of the Company's debentureholders and preferred stockholders; (d) that the approval of such sale by the Company's debentureholders and preferred stockholders would not have been forthcoming absent extraordinary expenditures by the Company; and (e) that the purchase agreement between the Company and Miles, Inc. for the sale of Cooper Technicon, Inc. included substantial penalties to be paid by the Company if the sale was not consummated within certain time limits and that the sale could not be consummated within those time limits. The amended complaints further allege that the defendants are liable for having violated Section 10(b) of the Securities Exchange Act and Rule 10(b)-5 thereunder and having engaged in common law fraud. Based on management's current knowledge of the facts and circumstances surrounding the events alleged by plaintiffs as giving rise to their claims, the Company believes that it has meritorious defenses to these lawsuits and intends vigorously to defend against the allegations in the amended complaints. The parties have engaged in preliminary settlement negotiations; however, there can be no assurances that these discussions will be successfully concluded. On September 2, 1993, a patent infringement complaint was filed against the Company in the United States District Court for the District of Nevada captioned Steven P. Shearing v. The Cooper Companies, Inc. On or about that same day, the plaintiff filed twelve additional complaints, accusing at least fourteen other defendants of infringing the same patent. The patent in these suits covers a specific method of implanting an intraocular lens into the eye. Until February 1989, the Company manufactured intraocular lenses and ophthalmic instruments, but did not engage in the implantation of such lenses. Subsequent to February 1989, the Company was not involved in the manufacture, marketing or sale of intraocular lenses. The Company denies the material allegations of Shearing's complaint and will vigorously defend itself. The Company is a defendant in more than 2,600 breast implant lawsuits pending in federal district courts and state courts, some of which purport to be class actions, relating to the mammary prosthesis (breast implant) business of its former wholly-owned subsidiaries, Aesthetech Corporation ('Aesthetech'), the manufacturer, and Natural Y Surgical Specialities, Inc. ('Natural Y'), the distributor, of polyurethane foam covered, silicone gel-filled breast implants, which subsidiaries were sold to Medical Engineering Corporation ('MEC'), a wholly-owned subsidiary of Bristol-Myers Squibb Company ('BMS') on December 14, 1988. The plaintiffs in the breast implant lawsuits generally claim to have been injured by breast implants allegedly manufactured and/or sold by Aesthetech, Natural Y or MEC. The ailments typically alleged include autoimmune disorders, scleroderma, chronic fatigue syndrome and vascular and neurological complications, as well as, in some cases, a fear of cancer. A small percentage of lawsuits allege that plaintiffs are suffering from cancer, allegedly caused by the component parts of the implants, including the alleged breakdown of polyurethane foam used to cover the implants. In most cases, other defendants are named in addition to the Company, Aesthetech, Natural Y, MEC and BMS, including, in many cases, implanting surgeons and the suppliers of the silicone and polyurethane products used in the manufacture of the breast implants. On October 29, 1992, the Delaware Chancery Court in Medical Engineering Corporation and Bristol-Myers Squibb Company v. The Cooper Companies, Inc. ruled that, as between BMS and MEC, on the one hand, and the Company, on the other, the Company is responsible for product liability claims and obligations relating to breast implants sold by Natural Y before December 14, 1988, irrespective of when the claims are brought. On September 28, 1993, the Company entered into an agreement with MEC (the 'MEC Agreement') settling this litigation between the Company and BMS and MEC. Pursuant to the MEC Agreement, MEC has agreed, subject to limited exceptions, to take responsibility for all legal fees and other costs, and to pay all judgments and settlements, resulting from all pending and future claims in respect of breast implants sold by Aesthetech and Natural Y prior to their acquisition by MEC (including the above-mentioned lawsuits), and the Company has withdrawn its appeal of the Delaware Chancery Court decision and agreed, among other things, to make certain payments to MEC. Pursuant to the terms of the MEC Agreement, MEC could have terminated the agreement if the exchange offer and consent solicitation (the 'Exchange Offer and Solicitation') relating to its Debentures (or an alternative restructuring of the Debentures or other amendment, forebearance or waiver with respect to the Debentures) was not completed on terms satisfactory to the Company by February 1, 1994. The Exchange Offer and Solicitation was completed on January 6, 1994. See Item 7 -- 'Management's Discussion and Analysis of Financial Condition and Results of Operations, Capital Resources and Liquidity' and Notes 14 and 19. The Company was named as a defendant in a civil action entitled Site Microsurgical Systems v. The Cooper Companies, Inc. filed in the United States District Court of Delaware on November 13, 1990. The plaintiff alleged that the Company infringed one of its U.S. patents through sales by the CooperVision Surgical Division ('CVS') of certain cassettes and systems utilizing such cassettes prior to the sale of CVS in February, 1989. The Company denied the plaintiff's allegations and counterclaimed for a Declaratory Judgment of non-infringement and invalidity of the plaintiff's patent-in-suit. This lawsuit was settled in October 1993. Pursuant to the settlement, the Company made a cash payment to the plaintiff and the parties terminated a generic ophthalmic pharmaceutical supply agreement. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. The 1993 Annual Meeting of Stockholders was held on September 14, 1993. Eight individuals were nominated to serve as directors of the Company. Information with respect to votes cast for or against such nominees is set forth below: On June 14, 1993, the Company acquired from Cooper Life Sciences, Inc. ('CLS') 160,600 shares of its Senior Exchangeable Redeemable Restricted Voting Preferred Stock ('SERPS'), constituting all of the Company's then outstanding SERPS, together with all rights to any dividends thereon, in exchange for 345 shares of a newly created series of preferred stock of the Company, designated Series B Preferred Stock (the 'Series B Preferred Stock'), having a par value of $.10 per share and a liquidation preference of $10,000 per share. The stockholders of the Company were asked to approve conversion rights on such Series B Preferred Stock, whereby such shares would be convertible, at the option of CLS, into an aggregate of 3,450,000 shares of common stock of the Company (subject to customary antidilution adjustments). The proposal to approve conversion rights of the Series B Preferred Stock was approved by a vote of 17,741,096 shares in favor, with 600,364 shares voted against and 409,155 shares abstaining. 9,315,119 shares present at the meeting for the purpose of establishing a quorum were ineligible to vote on the proposal. The shares of Series B Preferred Stock, if any, issued in payment of dividends on the Series B Preferred Stock will be convertible into one share of common stock for each $1.00 of liquidation preference of such Series B Preferred Stock (subject to customary antidilution adjustments). The Company also has the right to compel conversion of Series B Preferred Stock at any time after (i) the average of the closing sale prices for the common stock on its principal trading market on the trading days during any period of 90 consecutive calendar days is at least $1.375 and (ii) on at least 80% of the trading days during such period, the closing sale price is at least $1.375. Stockholders were also asked to ratify the appointment of KPMG Peat Marwick as independent certified public accountants for the Company for the fiscal year which ended October 31, 1993. A total of 27,694,165 shares were voted in favor of the ratification, 291,596 shares were voted against it and 79,973 shares abstained. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company's common stock is traded on The New York Stock Exchange, Inc. and the Pacific Stock Exchange Incorporated. No cash dividends were paid with respect to the common stock in fiscal 1993 or 1992. The Certificate of Designations, Preferences and Relative Rights, Qualifications, Limitations and Restrictions of the Company's SERPS, which were retired in exchange for the Series B Preferred Stock on June 14, 1993, as indicated in Item 4 above, prohibited the payment of cash dividends on the Company's common stock unless certain conditions, which the Company did not meet, were met. The Certificate of Designations, Preferences and Relative Rights, Qualifications, Limitations and Restrictions of the Series B Preferred Stock prohibits the payment of cash dividends on the Company's common stock unless the full amount of cumulative dividends on the Series B Preferred Stock have been declared and paid in full or contemporaneously are paid through the most recent dividend payment date. Dividends on the Series B Preferred Stock do not begin to accrue until June 14, 1994. The Indenture, dated as of March 1, 1985, governing the Company's Debentures, as amended by the First Supplemental Indenture dated as of June 29, 1989 and the Second Supplemental Indenture dated as of January 6, 1994, and the Indenture dated as of January 6, 1994 governing the Company's 10% Senior Subordinated Secured Notes due 2003 (collectively, the 'Indentures'), permit the payment of cash dividends on the Series B Preferred Stock but prohibit the payment of cash dividends on the Company's common stock unless (i) no defaults exist or would exist under the Indentures, (ii) the Company's Cash Flow Coverage Ratio (as defined in the Indentures) for the most recently ended four full fiscal quarters has been at least 1.5 to 1, and (iii) such cash dividend, together with the aggregate of all other Restricted Payments (as defined in the Indentures), is less than the sum of 50% of the Company's cumulative net income plus the proceeds of certain sales of the Company's or its subsidiaries' capital stock subsequent to February 1, 1994. The Company does not anticipate, in the foreseeable future, being able to satisfy the foregoing test and, therefore, does not anticipate being able to pay cash dividends on its common stock in the foreseeable future. The ability of the Company to declare and pay dividends is also subject to restrictions set forth in the Delaware General Corporation Law (the 'Delaware GCL'). As a general rule, a Delaware corporation may pay dividends under the Delaware GCL either out of its 'surplus,' as defined in the Delaware GCL, or, subject to certain exceptions, out of its net profits for the fiscal year in which the dividend is declared and/or the preceding fiscal year. Even if the Company were to satisfy the requirements in the Indentures for the payment of cash dividends on the Company's common stock, the Company's ability to pay cash dividends will depend upon whether the Company satisfies the requirements of the Delaware GCL at the time any such proposed dividend is declared. CLS filed Amendment No. 2 to its Schedule 13D stating that it owns and has sole voting and dispositive power with respect to 4,850,000 shares of the Company's common stock as of June 12, 1992. On June 14, 1993, CLS acquired 345 shares of Series B Preferred Stock which are convertible into 3,450,000 shares of common stock. In addition, the Company had been advised that, as of December 15, 1993, Moses Marx, the beneficial owner of approximately 22% of the outstanding stock of CLS, beneficially owned 1,126,000 shares (or approximately 3.7%) of the Company's common stock and $4,500,000 principal amount of Debentures, or approximately 11.4% of the aggregate principal amount thereof, and that United Equities Company ('United Equities'), a brokerage firm owned by Mr. Marx, held approximately $3,706,000 principal amount of Debentures or approximately 9.4% of the aggregate principal amount of Debentures outstanding, in its trading account. Mr. Marx and United Equities tendered all of their Debentures in the Exchange Offer and Solicitation (although not all of their Debentures were accepted, due to proration), and the Company is not aware of either Mr. Marx's or United Equities' current holdings of the Company's securities. Although the Company takes no position as to whether Mr. Marx and United Equities are 'affiliates' of the Company, the Company has not treated Mr. Marx or United Equities as affiliates for purposes of the Company's Form 10-K. Other information called for by this Item is set forth in Note 17. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA THE COOPER COMPANIES, INC. AND SUBSIDIARIES FIVE YEAR FINANCIAL HIGHLIGHTS THE COOPER COMPANIES, INC. AND SUBSIDIARIES FIVE YEAR FINANCIAL HIGHLIGHTS ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. References to Note numbers herein are references to 'Notes to Consolidated Financial Statements' of the Company located in Item 8

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA THE COOPER COMPANIES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET See accompanying notes to financial statements. THE COOPER COMPANIES, INC. AND SUBSIDIARIES STATEMENT OF CONSOLIDATED OPERATIONS See accompanying notes to financial statements. THE COOPER COMPANIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS See accompanying notes to financial statements. THE COOPER COMPANIES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS -- (CONTINUED) During the three years ended October 31, 1993, the Company acquired businesses and entered into certain licensing and distribution agreements. In connection with these acquisitions and agreements were assumed liabilities as follows: On June 12, 1992, the Company consummated a transaction with Cooper Life Sciences, Inc. ('CLS') which eliminated approximately 80% of the Company's $100 per share liquidation preference Senior Exchangeable Redeemable Restricted Voting Preferred Stock ('SERPS') and resulted in the issuance of 4,850,000 shares of the Company's common stock. On June 14, 1993, the Company acquired from CLS all of the remaining outstanding SERPS of the Company in exchange for a newly created series of preferred stock of the Company ('Series B Preferred Stock'). See Note 15, 'Agreements with CLS,' for a further discussion of these transactions. See accompanying notes to financial statements. THE COOPER COMPANIES, INC. AND SUBSIDIARIES STATEMENT OF CONSOLIDATED STOCKHOLDERS' EQUITY YEARS ENDED OCTOBER 31, 1993, 1992, AND 1991 (IN THOUSANDS) See accompanying notes to financial statements. THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL The Cooper Companies, Inc. and its subsidiaries (the 'Company') develop, manufacture and market healthcare products, including a range of hard and soft contact lenses, ophthalmic pharmaceutical products and diagnostic and surgical instruments. On May 29, 1992, with the acquisition of Hospital Group of America, Inc. ('HGA')(see Note 2), the Company began to provide healthcare services through the ownership and operation of certain psychiatric facilities and management of other such facilities. With the acquisition of HGA, the Company has adopted certain financial accounting and reporting practices which are specific to the healthcare service industry. PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of the Company. Intercompany transactions and accounts are eliminated in consolidation. Also, certain reclassifications have been applied to prior years' financial statements to conform such statements to the current year's presentation. None of these reclassifications had any impact on net loss. FOREIGN CURRENCY TRANSLATION Assets and liabilities of the Company's operations located outside the United States (primarily Canada) are translated at prevailing year-end rates of exchange. Related income and expense accounts are translated at weighted average rates for each year. Gains and losses resulting from the translation of financial statements in foreign currencies into U. S. dollars are recorded in the equity section of the consolidated balance sheet. Gains and losses resulting from the impact of changes in exchange rates on transactions denominated in foreign currencies are included in the determination of net loss for each period. Foreign exchange losses included in the Company's consolidated statement of operations for each of the years ended October 31, 1993, 1992 and 1991 were ($550,000), ($769,000) and ($49,000), respectively. NET SERVICE REVENUE Net service revenue consists primarily of net patient service revenue, which is based on the HGA hospitals' established billing rates less allowances and discounts principally for patients covered by Medicare, Medicaid, Blue Cross and other contractual programs. Payments under these programs are based on either predetermined rates or the cost of services. Settlements for retrospectively determined rates are estimated in the period the related services are rendered and are adjusted in future periods as final settlements are determined. Management believes that adequate provision has been made for adjustments that may result from final determination of amounts earned under these programs. Approximately 38% and 41%, respectively, of 1993 and 1992 net service revenues are from participation of hospitals in Medicare and Medicaid programs and Blue Cross. With respect to net service revenue, receivables from government programs and Blue Cross represent the only concentrated group of credit risk for the Company, and management does not believe that there are any credit risks associated with these governmental agencies or Blue Cross. Negotiated and private receivables consist of receivables from various payors, including individuals involved in diverse activities, subject to differing economic conditions, and do not represent any concentrated credit risks to the Company. Furthermore, management continually monitors and adjusts its reserves and allowances associated with these receivables. THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NET SALES OF PRODUCTS Net sales of products consists of sales from the Company's CooperVision and CooperSurgical businesses. The Company recognizes product revenue when risk of ownership has transferred to the buyer, with appropriate provisions for sales returns and uncollectible accounts. With respect to net sales of products, management believes trade receivables do not include any concentrated groups of credit risk. CASH AND CASH EQUIVALENTS Cash and cash equivalents includes commercial paper and other short-term income producing securities with a maturity date at purchase of three months or less. These investments are readily convertible to cash, and are carried at cost which approximates market. RESTRICTED CASH Restricted cash represents collateral for expiring insurance policies for a discontinued contact lens insurance program. TEMPORARY INVESTMENTS Temporary investments are primarily current marketable equity and debt securities. Current marketable debt and equity securities are carried at the lower of aggregate cost or market at the balance sheet date with unrealized losses included in investment income, net in the statement of consolidated operations. Other securities and investments are carried at cost. Gains or losses realized upon sale (based on the first-in, first-out method) and write-downs necessitated by other than temporary declines in value for all securities and investments are also reflected in investment income, net. As of October 31, 1993 and October 31, 1992, aggregate cost and market value, and gross unrealized gains and losses for current marketable securities are as follows: In addition, the Company carried certain non-marketable equity and debt securities at October 31, 1992, at cost in the amounts of $4,068,000 and $2,100,000, respectively, in its temporary investments. Unrealized gains and losses on marketable securities included in the table above compare the market value of the Company's investment in securities as of October 31, 1993 and 1992 versus the cost of such securities. The unrealized gains and losses do not indicate the actual gains or losses that will be realized by the Company upon the disposition of such marketable securities. The net unrealized loss on the current marketable securities portfolio was increased from approximately $1,150,000 at October 31, 1993, to approximately $1,842,000 at December 31, 1993. For the two months ended December 31, 1993, the Company had net realized gains on investments of $191,000. Included in the Company's marketable debt securities portfolio at October 31, 1993 and 1992 are debt securities whose issuers are currently in default of interest payments and/or in bankruptcy reorganization. Total debt securities in default of interest payments and in bankruptcy at October 31, 1993 have an adjusted carrying amount of approximately $2,651,000 on which the Company has recorded an aggregate unrealized loss of $641,000. The maximum additional accounting loss the THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Company would incur if these securities become worthless would be an additional $2,010,000 (i.e. $2,651,000 less $641,000) because the Company does not accrue interest income on such issues. Included in the statement of consolidated operations in investment income, net for each of the years ended October 31, 1993, 1992 and 1991 are unrealized gains (losses) of $6,532,000, ($6,244,000) and $2,797,000, respectively, on current marketable securities. Also included in investment income, net for the years ended October 31, 1993, 1992, and 1991 are net realized gains (losses) of ($7,356,000), $13,538,000 and ($2,586,000), respectively, on marketable equities, debt securities and option contracts. The combined impact of the aforementioned net unrealized and realized gains (losses) for each of the years ended October 31, 1993, 1992 and 1991 was a net gain (loss) of ($824,000), $7,294,000 and $211,000, respectively. Interest income for each of the years ended October 31, 1993, 1992 and 1991 was $2,439,000, $6,960,000 and $12,057,000, respectively, and is included in investment income, net. Dividend income in any reported year was de minimis. A former Co-Chairman of the Company and, by reason of his actions, the Company, have been convicted of violations of federal criminal laws, and the Securities and Exchange Commission (the 'SEC') has initiated an action with respect to, among other things, trading in certain marketable debt securities previously owned by the Company. For a further discussion, see Note 18. LOANS AND ADVANCES Loans and advances were made by the Company to certain of its officers and employees at interest rates ranging from 9.0% to 9.5% per annum. The principal amount of loans and advances outstanding at October 31, 1993 and 1992 was $65,000 and $902,000, respectively. INVENTORIES Inventories are stated at the lower of cost, determined on a first-in, first-out or average cost basis, or market. UNAMORTIZED BOND DISCOUNT The difference between the carrying amount and the principal amount of the Company's 10 5/8% Convertible Subordinated Reset Debentures due 2005 (the 'Debentures') represents unamortized discount which is being charged to expense over the life of the issue. As of October 31, 1993, the amount of unamortized discount was $387,000. DEPRECIATION AND LEASEHOLD AMORTIZATION Depreciation is computed on the straight-line method in amounts sufficient to write-off the cost or carrying amount of depreciable assets over their estimated useful lives. Leasehold improvements are amortized over the shorter of their estimated useful lives or the period of the related lease. EXPENDITURES FOR MAINTENANCE AND REPAIRS Expenditures for maintenance and repairs are expensed; major replacements, renewals and betterments are capitalized. The cost and accumulated depreciation of assets retired or otherwise disposed of are eliminated from the asset and accumulated depreciation accounts, and any gains or losses are reflected in operations for the period. THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) AMORTIZATION OF INTANGIBLES Amortization is currently provided for on all intangible assets (primarily goodwill, which represents the excess of purchase price over fair value of net assets acquired) on a straight-line basis over periods of up to thirty years. Accumulated amortization at October 31, 1993 and 1992 was approximately $3,059,000 and $2,155,000, respectively. The Company assesses the recoverability of goodwill by determining whether the amortization of goodwill balance over its remaining life can be recovered through reasonably expected future results. RESTRICTED STOCK AND COMPENSATION EXPENSE Under the Company's 1988 Long Term Incentive Plan, its 1990 Non-Employee Directors' Restricted Stock Plan and its predecessor Restricted Stock Plans (see Note 12), certain officers and key employees designated by the Board of Directors or a committee thereof have purchased, for par value, shares of the Company's common stock restricted as to resale ('Restricted Shares') unless or until certain prescribed objectives are met or certain events occur. The difference between market value and par value of the Restricted Shares on the date of grant is recorded as unamortized restricted stock award compensation and shown as a component of stockholders' equity. This compensation is charged to operations as earned. INCOME TAXES Income taxes are provided for in the period in which the related transactions enter into the determination of net income. No provisions have been made for taxes which may become payable should income of subsidiaries outside the United States be remitted to the Company (see Note 9). Investment tax credits and other credits are applied as a reduction of the provision for United States federal income taxes on the flow-through method. EARNINGS PER COMMON SHARE Net income (loss) per common share is determined by using the weighted average number of common shares and common share equivalents (stock warrants) outstanding during each year. Stock options have not been included in the determination of earnings per common share for any period as they are anti-dilutive or resulted in dilution of less than 3%. NOTE 2. ACQUISITIONS AND DISPOSITIONS ACQUISITIONS On April 1, 1993, CooperVision, Inc., a subsidiary of the Company, acquired via a purchase transaction the stock of CoastVision for approximately $9,800,000 cash. CoastVision manufactures and markets a range of contact lens products, primarily custom soft toric contact lenses, which are designed to correct astigmatism. The purchase of CoastVision expands CooperVision's customer base for its existing product lines. CoastVision had net sales of $9,600,000 in its fiscal year ended October 31, 1992. Excess cost over net assets acquired recorded on the purchase was $7,500,000, which is being amortized over 30 years. On May 29, 1992, the Company acquired all of the common stock of Hospital Group of America, Inc. ('HGA') from its ultimate parent, Nu-Med Inc. ('NuMed') for a total consideration of approximately $50,000,000 including $15,898,000 in cash, the assumption of approximately $22,000,000 of third party debt of HGA and the delivery of $21,685,000 principal amount of Nu-Med debentures owned by the Company (including $3,525,000 principal amount of 'Affiliate debentures,' defined and described below), in which the Company had a cost basis of approximately $12,322,000. The Company THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) used available cash to purchase the Nu-Med debentures and to make the $15,898,000 payment at closing. Except for the 'Affiliate debentures' defined and described below, the Company acquired the Nu-Med debentures in open market transactions for a total cost of approximately $10,374,000. On April 13, 1992, the Company acquired, for a total cost of approximately $1,948,000, an additional $3,525,000 principal amount of Nu-Med debentures (the 'Affiliate debentures') from an individual and a corporation (together, the 'Affiliates') related to or affiliated with Messrs. Gary, Steven and Brad Singer. The Affiliate debentures were tendered to Nu-Med at the same price paid by the Company. At the time of the transaction, Gary and Steven Singer were each officers and directors of the Company, and Brad Singer was a director of the Company. The Affiliate debentures were purchased by the Company at the cost paid by the Affiliates plus accrued interest thereon, following the approval of the majority of the disinterested members of the Board of Directors of the Company. To protect the Company against any potential loss, it acquired the Affiliate debentures pursuant to an agreement that would have allowed the Company to 'put' the Affiliate debentures back to the Affiliates at the Company's cost if the acquisition of HGA had not occurred. HGA provides psychiatric and substance abuse treatment through three hospitals with a total of 259 beds at the time of the acquisition, which was subsequently increased to 269. Concurrently, PSG Management, Inc. ('PSG Management'), a subsidiary of the Company, entered into a management agreement with three indirect subsidiaries of Nu-Med under which PSG Management is managing three additional hospitals owned by such subsidiaries which have a total of 220 licensed beds. Under the management agreement, PSG Management is entitled to receive a management fee of $6,000,000 payable in equal monthly installments over the three year term of the agreement. The management agreement is jointly and severally guaranteed by Nu-Med and its wholly-owned subsidiary, PsychGroup, Inc. the parent of the contracting subsidiaries which own the managed facilities. On January 6, 1993, Nu-Med (but not any of its direct or indirect subsidiaries) filed a voluntary petition under Chapter 11 of the United States Bankruptcy Code. Neither the Company nor any of its affiliates filed a proof of claim in the Nu-Med Chapter 11 proceeding, and the bar date (the time for filing proofs of claims) has past. However, none of the Nu-Med subsidiaries has filed under Chapter 11, and the Nu-Med subsidiaries have paid the management fee on a timely basis, although representatives of Nu-Med and its subsidiaries have alleged in writing that PSG Management has breached the Management Services Agreement (which contention PSG Management vigorously disputes). Moreover, Nu-Med's Proposed Disclosure Statement to accompany its Second Amended Plan of Reorganization, filed with the United States Bankruptcy Court for the Central District of California, indicates that PsychGroup, Inc. is commencing performance of certain administrative functions performed by PSG Management on a parallel basis. The acquisition of HGA was accounted for as a purchase. Accordingly, the results of HGA's operations were included in the Company's consolidated results from acquisition date. Excess of cost over net assets acquired has initially been estimated to be $6,155,000, subject to purchase price adjustments per the sales agreement, and is being amortized over 30 years. Had the acquisition of HGA occurred on November 1, 1991, the Company's unaudited pro forma combined net revenue, loss from continuing operations and loss from continuing operations per share would have been $95,320,000, ($15,586,000) and ($.56), respectively, for the twelve months ended October 31, 1992. Had such acquisition occurred on November 1, 1990, the comparable unaudited pro forma combined figures for the twelve months ended October 31, 1991 would have been $82,951,000, ($19,394,000) and ($.84), respectively. During 1992, the Company acquired two parcels of land having an aggregate cost of $3,149,000. The land is carried at cost in property, plant and equipment. Concurrently, the Company entered into two lease agreements under which the Company is entitled to receive rental payments amounting to THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) approximately $22,000,000 over the next 48 years. The subject parcels of land were sold in fiscal 1994 for cash and notes aggregating the approximate original purchase price. In December 1990 and January 1991, the Company acquired Euro-Med Endoscope and Euro-Med, Inc., for cash and notes in the aggregate amount of $3,250,000. The two companies offer a line of surgical instruments and diagnostic hysteroscopy equipment for use in gynecologic and minimally invasive surgical procedures. Excess cost over net assets acquired for these two businesses was $2,082,000. In November 1990, the Company entered into a license agreement under which the Company will support the licensor's efforts to obtain FDA approvals so that the Company may manufacture, market and sell Verapamil for ophthalmic applications. DISPOSITIONS On February 12, 1993, the Company sold its EYEscrub'tm' product line for $1,400,000 cash which resulted in a $620,000 gain. The Company retains the right to market certain ophthalmic pharmaceutical surgical kits containing EYEscrub'tm' once certain regulatory requirements are met. On January 31, 1992, the Company assigned its license to manufacture, have manufactured, sell, distribute and market certain intraocular lens products and disposed of certain other related rights and assets. Total cash consideration received by the Company for such assignment was approximately $5,200,000, which resulted in a pretax gain of $1,030,000. On June 29, 1989, the Company completed the sale of Cooper Technicon, Inc. ('CTI'), the Company's former automated medical diagnostic and industrial analytical systems business, to Miles Inc. ('Miles'), a subsidiary of Bayer USA Inc., a subsidiary of Bayer A G, West Germany, in a transaction involving approximately $477,000,000, consisting of cash and the elimination of CTI's debt of approximately $290,000,000 from the Company's consolidated financial statements. Pursuant to the terms of the sale, the Company sold all of CTI's capital stock for approximately $191,000,000 reduced by $4,000,000 for certain adjustments, resulting in a net cash receipt of approximately $187,000,000, of which $10,000,000 was placed in escrow to secure certain post-closing indemnity obligations of the Company. During 1990, $150,000 of the escrow principal was released to Miles. As of October 31, 1992, $9,850,000 of the escrow was included in 'Other receivables' in the Company's consolidated balance sheet. During 1993 $7,550,000 of such funds were collected by the Company, with the balance being released to Miles. The funds released to Miles were charged against an accrual for such purpose. NOTE 3. DISCONTINUED OPERATIONS In 1993, the Company recorded a charge of $14,000,000 to increase the Company's accrual (the 'Breast Implant Accrual') for contingent liabilities associated with breast implant litigation involving the plastic and reconstructive surgical division of the Company's former Cooper Surgical business segment which was sold in fiscal 1989. See Note 18 for a discussion of breast implant litigation. The Breast Implant Accrual will be charged for payments made and to be made to MEC under the MEC Agreement (see Note 14 for a discussion of the schedule of payments) as well as certain related charges. In October 1993 the Company made the initial payment of $3,000,000 to MEC. At October 31, 1993 the Company is carrying $9,000,000 of the Breast Implant Accrual in 'Deferred income taxes and other non current liabilities' on the Company's Consolidated Balance Sheet for future payments to MEC, none of which is due for repayment in one year or less from October 31, 1993. The Company also recorded a reversal of $343,000 of accruals no longer necessary related to another discontinued business. In 1992, the Company recorded a charge of $9,300,000 to discontinued operations. A charge of $7,000,000 represents an increase to the Company's Breast Implant Accrual. See Note 18 for a discussion of breast implant litigation. The balance of the charge reflects a $2,000,000 settlement of a THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) dispute involving the Company's former Surgical business segment, and a $300,000 adjustment to the loss on the sale of the Company's former Cooper Technicon business segment. No tax benefit has been applied against the above figures, as the Company was not profitable in either year. NOTE 4. EXTRAORDINARY ITEMS The extraordinary gain of $924,000, or $.03 per share, in 1993 represents gains on the Company's purchases of $4,846,000 principal amount of its Debentures. The purchases were privately negotiated and executed at prevailing market prices. The extraordinary gain of $640,000, or $.02 per share, in 1992 represents gains on the Company's purchases of $5,031,000 principal amount of its Debentures. Substantially all of the purchases were privately negotiated and executed at prevailing market prices. The extraordinary gain of $5,428,000, or $.21 per share, in 1991 represents gains on the Company's purchases of $23,166,000 principal amount of its Debentures, including $8,518,000 owned by Brad, Gary and Steven Singer (each of whom was an officer and/or director of the Company at the time of the transaction) or their relatives, $7,656,000 owned by Moses Marx (a former director of the Company) and $2,115,000 owned by Mel Schnell, currently a director of the Company and a director and President and Chief Executive Officer of Cooper Life Sciences, Inc. ('CLS'). See Note 7. Substantially all of the purchases were privately negotiated and executed at or slightly below prevailing market prices. NOTE 5. STOCKHOLDERS RIGHTS PLAN On October 29, 1987, the Board of Directors of the Company declared a dividend distribution of one right for each outstanding share of the Company's common stock, par value $.10 per share (a 'Right'). Each Right entitles the registered holder of an outstanding share of the Company's common stock to initially purchase from the Company a unit consisting of one one-hundredth of a share of Series A Junior Participating Preferred Stock (a 'Unit'), par value $.10 per share, at a purchase price of $60.00 per Unit, subject to adjustment. The Rights are exercisable only if a person or group acquires (an 'Acquiring Person'), or generally obtains the right to acquire beneficial ownership of 20% or more of the Company's common stock, or commences a tender or exchange offer which would result in such person or group beneficially owning 30% or more of the Company's common stock. If, following the acquisition of 20% or more of the Company's common stock, (i) the Company is the surviving corporation in a merger with an Acquiring Person and its common stock is not changed, (ii) a person or entity becomes the beneficial owner of more than 30% of the Company's common stock, except in certain circumstances such as through a tender or exchange offer for all the Company's common stock which the Board of Directors determines to be fair and otherwise in the best interests of the Company and its stockholders, (iii) an Acquiring Person engages in certain self-dealing transactions or (iv) an event occurs which results in such Acquiring Person's ownership interest being increased by more than 1%, each holder of a Right, other than an Acquiring Person, will thereafter have the right to receive, upon exercise, the Company's common stock (or, in certain circumstances, cash, property or other securities of the Company) having a value equal to two times the exercise price of the Right. The Board of Directors amended the Rights Agreement dated as of October 29, 1987, between the Company and The First National Bank of Boston, as Rights Agent, so that Cooper Life Sciences, Inc. ('CLS') and its affiliates and associates would not be Acquiring Persons thereunder as a result of CLS's beneficial ownership of more than 20% of the outstanding common stock of the Company by reason of its ownership of Series B Preferred Stock or common stock issued upon conversion thereof. See Note 15 under 'Agreements With CLS.' Under certain circumstances, if (i) the Company is acquired in a merger or other business combination transaction in which the Company is not the surviving corporation, unless (a) the THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) transaction occurs pursuant to a transaction which the Board of Directors determines to be fair and in the best interests of the Company and its stockholders (b) the price per share of Common Stock offered in the transaction is not less than the price per share of common stock paid to all holders pursuant to the tender or exchange offer, and (c) the consideration used in the transaction is the same as that paid pursuant to the offer, or (ii) 50% or more of the Company's assets or earning power is sold or transferred, each holder of a Right, other than an Acquiring Person, shall thereafter have the right to receive, upon exercise, common stock of the acquiring company having a value equal to two times the exercise price of the Right. At any time until the close of business on the tenth day following a public announcement that an Acquiring Person has acquired, or generally obtained the right to acquire beneficial ownership of 20% or more of the Company's common stock, the Company will generally be entitled to redeem the Rights in whole, but not in part, at a price of $.05 per Right. After the redemption period has expired, the Company's right of redemption may be reinstated if an Acquiring Person reduces his beneficial ownership to 10% or less of the outstanding shares of common stock in a transaction or series of transactions not involving the Company. Until a Right is exercised, the holder thereof, as such, will have no rights as a stockholder of the Company, including, without limitation, the right to vote or to receive dividends. The Rights expire on October 29, 1997. NOTE 6. COSTS ASSOCIATED WITH RESTRUCTURING OPERATIONS In the second quarter of 1993, the Company recorded a restructuring charge of $451,000 for consolidation of CooperSurgical facilities and related reorganization and relocation costs. NOTE 7. SETTLEMENT OF DISPUTES The Company and CLS entered into a settlement agreement, dated July 14, 1993, pursuant to which CLS delivered a general release of claims against the Company, subject to exceptions for specified on-going contractual obligations, and agreed to certain restrictions on its acquisitions, voting and transfer of securities of the Company, in exchange for the Company's payment of $4,000,000 in cash and delivery of 200,000 shares of common stock of CLS owned by the Company and a general release of claims against CLS, subject to similar exceptions. See Note 15 for a discussion of the settlement terms. The cash paid and fair value of CLS shares returned to CLS were charged to the Company's statement of operations for 1993 as settlement of disputes. In addition, the Company charged $1,500,000 to the statement of operations for certain other disputes. Included in fiscal 1992 is a charge for settlement of disputes which includes 1) a $650,000 charge related to a transaction with CLS, 2) a payment to Mr. Frederick R. Adler and 3) provisions for several ongoing litigations and disputes including the tentative settlement of Guenther v. Cooper Life Sciences, Inc. et. al. In April 1992, Frederick R. Adler, a former director of the Company at that time, notified the Company that he would solicit proxies to elect his own slate of nominees at the 1992 Annual Meeting of Shareholders (the 'Annual Meeting'), in opposition to the Board's nominees to the Board of Directors (the 'Proxy Contest'). On June 15, 1992, Mr. Adler and the Company entered into a settlement agreement with respect to the Proxy Contest pursuant to which the Board of Directors set the size of the Board at nine members, effective as of the Annual Meeting, and nominated Mr. Adler and Louis A. Craco, a partner in the law firm of Willkie, Farr & Gallagher, for election to the Board together with the Board's seven other nominees, Arthur C. Bass, Allen H. Collins, M.D., Joseph C. Feghali, Mark A. Filler, Michael H. Kalkstein, Allan E. Rubenstein, M.D., and Robert S. Weiss. The settlement agreement provided for the replacement of Mr. Adler by one of three designated persons if he was unable or unwilling to serve as a director following his election at the Annual Meeting. In December THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 1992, Mr. Adler resigned from the Company's Board of Directors and designated Michael R. Golding, M.D., as his replacement. As part of the settlement, in which the parties exchanged mutual releases of claims arising out of the Proxy Contest and litigation brought in connection therewith, Mr. Adler agreed, among other things, not to solicit proxies in opposition to the election of the Board's nine nominees at the Annual Meeting and not to take any action to call a special meeting of stockholders or solicit stockholder consents with respect to the election or removal of directors prior to the 1993 annual meeting of stockholders of the Company. The Company also reimbursed Mr. Adler for $348,000 of expenses actually incurred by him in connection with the Proxy Contest and negotiation of the settlement agreement. In 1992 the Company reached an agreement involving the settlement of Guenther v. Cooper Life Sciences, et. al., a class and shareholder derivative action filed against CLS, the Company, Cooper Development Company, a Delaware corporation ('CDC'), Parker G. Montgomery, A. Kenneth Nilsson, Charles Crocker, Robert W. Jamplis, Barbara Foster as executrix of the Estate of Hugh K. Foster, Michael Mitzmacher, Joseph A. Dornig, Martin M. Koffel, Richard W. Turner, John Vuko, Randolph Stockwell, Hambrecht & Quist, Incorporated, Peat Marwick Main & Co., Gryphon Associates, L.P. and The Gryphon Management Group, Ltd. in June 1988 in the United States District Court for the District of Minnesota and transferred in December 1988 to the District Court for the Northern District of California. As amended, the action alleged various securities law violations and shareholder derivative claims in connection with the public disclosures by, and management of, CLS from 1985 to 1988. The Company formerly shared certain officers and directors with CLS and is alleged to have controlled CLS. The settlement resolved all claims asserted against the Company and its former officers and directors. On April 30, 1993, the court approved the settlement after notice to the plaintiff class and a court hearing. In accordance with the settlement, the case has been dismissed as to the Company and all other defendants. The settlement provided for a payment by Optics Cayman Islands Insurance Ltd., a subsidiary of the Company (which provided directors' and officers' liability insurance to some of the above-named individuals), in the amount of $2,200,000 on behalf of the directors and officers of CLS, as well as a payment of $1,800,000 by the Company. The settlement amount was fully reserved in the books of the Company at July 31, 1992 and paid into escrow by October 31, 1992. NOTE 8. PREFERRED STOCK On June 14, 1993, the Company acquired from CLS all of the remaining outstanding shares of the Company's SERPS, having an aggregate liquidation preference of $16,060,000, together with all rights to any dividends or distributions thereon, in exchange for shares of Series B Preferred Stock having an aggregate liquidation preference of $3,450,000 and a par value of $.10 per share. The 345 shares of Series B Preferred Stock, and any shares of Series B Preferred Stock issued as dividends, are convertible into one share of common stock of the Company for each $1.00 of liquidation preference, subject to customary antidilution adjustments. The Company also has the right to compel conversion of Series B Preferred Stock at any time after the market price of the common stock on its principal trading market averages at least $1.375 for 90 consecutive calendar days and closes at not less than $1.375 on at least 80% of the trading days during such period. CLS currently owns 4,850,000 shares of common stock, or approximately 16.2% of the Company's outstanding common stock. See Note 15. Dividends will accrue on the Series B Preferred Stock commencing June 14, 1994, and will be payable quarterly in cash at the rate of 9% (of liquidation preference) per annum or, if the Company is restricted by applicable law or certain debt agreements from paying cash dividends, in additional shares of Series B Preferred Stock at the rate of 12% (of liquidation preference) per annum. The Series B Preferred Stock is redeemable, in whole or in part, at the option of the Company, at any time at a redemption price equal to its then applicable liquidation preference, plus accrued and unpaid dividends. THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 9. INCOME TAXES The components of income (loss) from continuing operations before income taxes and extraordinary items and the provision for income taxes are as follows: A reconciliation of the provision for (benefit of) income taxes included in the Company's statement of consolidated operations and the amount computed by applying the United States statutory federal income tax rate to income (loss) from continuing operations before extraordinary items and income taxes follows: At October 31, 1993, the Company had net operating loss carryforwards of approximately $224,000,000 for financial statement purposes and approximately $243,000,000 for income tax purposes, and investment tax, research and development and job tax credit carryforwards of approximately $2,455,000 all of which will expire in varying amounts beginning in the year ending October 31, 1999. Income taxes have not been provided for the undistributed earnings of subsidiaries operating outside the United States. There were no such earnings of the Company at October 31, 1993. During 1992 and 1991, the Company repatriated $3,655,000 and $1,713,000, respectively, of earnings of the Company's selected subsidiaries. Such repatriations did not result in a material increase in income taxes. Statement of Financial Accounting Standards No. 109, 'Accounting for Income Taxes' ('FAS 109') was issued by the Financial Accounting Standards Board in February 1992. FAS 109 requires a THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) change from the deferred method under APB Opinion 11 to the asset and liability method of accounting for income taxes. Under the asset and liability method of FAS 109, deferred income taxes are recognized for the future tax consequences attributable to differences between bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under FAS 109, the effect on deferred taxes of a change in tax rates is recognized in income in the period that includes the enactment date. FAS 109 must be adopted for years beginning after December 15, 1992. Upon adoption, the provisions of FAS 109 may be applied without restating prior years' financial statements or may be applied retroactively by restating any number of consecutive prior years' financial statements. Upon adoption in the 1994 fiscal year, the Company plans to apply the provisions of FAS 109 without restating prior years' financial statements. The Company anticipates that the adoption of FAS 109 will not have a material impact on the financial statements. No benefit will be recognized for operating loss and tax credit carryforwards since the deferred tax asset will be offset by a valuation reserve. NOTE 10. PROPERTY, PLANT AND EQUIPMENT A summary of property, plant and equipment follows: - ------------ * Includes approximately $3,000,000 for two parcels of land sold in fiscal 1994. See Note 2. Depreciation and leasehold amortization expense amounted to $2,624,000, $1,537,000 and $1,039,000 for the years ended October 31, 1993, 1992 and 1991, respectively. NOTE 11. LONG-TERM DEBT, NOTES PAYABLE AND WARRANTS LONG-TERM DEBT As used herein, the term 'Indenture' means the indenture governing the Company's Debentures. The Indenture has been amended twice (and unless specified herein or the context requires otherwise, references to the Indenture are to the Indenture as so amended): first, pursuant to a First Supplemental Indenture dated as of June 29, 1989, and second, pursuant to a Second Supplemental Indenture dated as of January 6, 1994. During the year ended October 31, 1989, in order to consummate the sale of CTI (see Note 2), the Company was required to obtain the approval of the sale by the holders of a majority of the Company's Debentures which were then 8 5/8% Convertible Subordinated Debentures due 2005 (the '8 5/8% Debentures'). The Company's Consent Solicitation and Offer to Purchase sought consents for: the sale of CTI the sale of the Optometrics business the adoption of the First Supplemental Indenture. THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The Company received the requisite consents and, in connection therewith, upon consummating the CTI sale, purchased approximately $70,000,000 principal amount of the 8 5/8% Debentures, and entered into the First Supplemental Indenture, which amended certain terms of the Indenture. Under these amended terms, the interest rate on the 8 5/8% Debentures was increased from 8 5/8% to 10 5/8% per annum, effective June 29, 1989. Reflecting this change, the 8 5/8% Debentures were retitled the '10 5/8% Convertible Subordinated Reset Debentures due 2005'. In addition, under the terms of the Indenture as then amended, the Company was required to reset the interest rate on the Debentures on June 15, 1991, to a rate per annum, as determined by two nationally recognized investment banking firms selected by the Company, such that the Debentures would have a market value equal to 75% of their principal amount on such date. The market value of the Debentures was 75% of principal value as of June 15, 1991; therefore, no interest rate reset was necessary. The SEC has filed a complaint for Permanent Injunction and Other Equitable Relief (the 'SEC Complaint') alleging, among other things, federal securities laws violations by the Company and Gary Singer, a former Co-Chairman of the Company, in connection with an alleged manipulation of the price and demand of the Debentures to avoid an allegedly required reset. The SEC Complaint alleges that Gary Singer and the Company manipulated the trading price of the Debentures, and that Gary Singer obtained allegedly false opinion letters from two firms, which letters failed to meet the Indenture requirements to avoid such reset. See Note 18. As a result of the losses experienced by the Company, the Company's Adjusted Net Worth, as defined in the Indenture (as in effect after adoption of the First Supplemental Indenture but prior to consummation of the Exchange Offer and Solicitation more fully discussed in Note 19), was $24,580,000 at April 30, 1993, $10,965,000 at July 31, 1993 and $452,000 at October 31, 1993. As a result of the Company's Adjusted Net Worth remaining below $41,500,000 for two consecutive fiscal quarters, the Company was required, pursuant to Section 4.09 of the Indenture (as then in effect), to purchase $15,000,000 principal amount of Debentures in the open market or through private transactions or to make an offer to all holders to purchase $15,000,000 principal amount of Debentures (less the principal amount of any Debentures purchased after July 31, 1993 through market or private purchases) at the optional redemption price then in effect, plus accrued and unpaid interest. The maximum purchases that the Company was required to make to comply with the covenant would have been $15,000,000 principal amount of Debentures every six months, beginning October 25, 1993. In addition, pursuant to Section 4.14 of the Indenture (as in effect after adoption of the First Supplemental Indenture but prior to consummation of the Exchange Offer and Solicitation), if all of the outstanding Debentures were not repurchased in connection with the covenant described above and if the Company had an Adjusted Net Worth of less than $350,000,000 at January 31, 1995 or a Cash Flow Coverage Ratio of less than 5 to 1 for the fiscal quarter then ended, the Company would have been required to purchase, in June of 1995, all Debentures then outstanding at 100% of principal amount plus accrued and unpaid interest. In its Annual Report on Form 10-K for the fiscal year ended October 31, 1991, as amended, the Company disclosed the following transactions: On July 11, 1991, the Company purchased $450,000 principal amount of Bally's Grand Inc. 11 1/2% bonds (the 'Bally's Grand Bonds') for $301,500. On July 16, 1991, Gary Singer purchased $500,000 principal amount of Bally's Grand Bonds for his wife's account for $340,000. On August 7, 1991, the Company purchased the Bally's Grand Bonds held in his wife's account for $345,000. The Company has been advised by counsel for Mr. Singer that in transactions such as this transaction and the transactions described below, because prices for these bonds are not widely quoted, it was Mr. Singer's practice to confirm the market price by requesting market price information from brokers. Mr. Singer's wife received net proceeds on such sale of $344,470.50. On September 5, 1992, the Company sold its entire position of Bally's Grand Bonds for $656,687.50. On July 23, July 26 and August 5, 1991, the Company purchased an aggregate of $9,500,000 principal amount of Petrolane Gas 13 1/4% bonds (the 'Petrolane Bonds') for an aggregate of $3,361,875. On September 17, 1991, the Company sold $6,000,000 principal amount of its Petrolane THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Bonds, for an aggregate of $2,520,000. On September 19, 1991, it sold its remaining $3,500,000 principal amount of bonds to a relative of Mr. Singer for $1,400,000. Mr. Singer's relative purchased such bonds for $1,404,375 (including broker mark-up) and sold a portion of them on September 30, and the balance on October 2, 1991, receiving aggregate proceeds of $1,469,375. On September 24 and 26, 1991, the Company purchased an aggregate of $4,887,000 principal amount of DR Holdings Bonds for an aggregate of $2,385,195. On October 1, 1991, the Company sold its DR Holdings Bonds to the same relative of Mr. Singer for $2,565,675. Mr. Singer's relative purchased such bonds for $2,571,783.75 (including broker mark-up) and sold them on October 2, 1991, for $2,907,765. On or about September 27, 1991, the Company purchased $2,213,000 principal amount of DR Holdings Bonds for $1,156,292.50. On or about October 4, 1991, the DR Holdings Bonds were transferred to a securities brokerage account in the name of the wife of Gary Singer, and, on or about October 7, 1991, a payment of $1,156,292.50 was made by Mr. Singer's wife to the Company. Counsel for Mr. Singer has advised the Company that Mr. Singer intended to purchase the DR Holdings Bonds for his wife's account, that the transaction was executed in a Company account as the result of a broker's error, and that the subsequent transfer of the DR Holdings Bonds from a Company account to his wife's account and payment by his wife to the Company, as described above, were undertaken to correct the broker's error. Counsel for Mr. Singer has further advised the Company that, on October 2, 1991, Mr. Singer's wife sold the $2,213,000 principal amount of DR Holdings Bonds for $1,316,735. Gary Singer was convicted of violations of federal criminal laws in connection with certain of the foregoing transactions, and certain of such transactions are also the subject of allegations in the SEC Complaint that, among other things, Gary Singer entered into such trades for the purpose of diverting profits from the Company to such relatives. See Note 18. Section 4.12 of the Indenture (as in effect prior to consummation of the Exchange Offer and Solicitation) contained a covenant limiting the Company's ability to, among other things, sell any of its property or assets to, or purchase any property or assets from, any Affiliate of the Company (as defined in the Indenture as then in effect). Section 4.18 of the Indenture (as in effect after adoption of the First Supplemental Indenture but prior to consummation of the Exchange Offer and Solicitation) contained a covenant prohibiting the Company from maintaining an equity interest for more than eighteen months in, and making any direct or indirect advances, loans or other extensions of credit to, any person that is not consolidated with the Company. From time to time, the Company has maintained an equity interest in unconsolidated persons for more than the permitted period and may have engaged in transactions that could be construed to be a direct or indirect advance, loan or other extension of credit in violation of the Indenture as then in effect. Breach of the covenants contained in Section 4.09, 4.12 or 4.18 of the Indenture or the reset obligation contained in the Debentures (in each case, as in effect after adoption of the First Supplemental Indenture but prior to consummation of the Exchange Offer and Solicitation) was a Default under the Indenture, which would have led to an Event of Default under the Indenture (providing grounds for the Trustee or the holders ('Holders') of at least 25% in principal amount of the Debentures then outstanding to declare the principal and accrued interest on the outstanding Debentures immediately due and payable) if such Default was not cured within 60 days of the Company's receipt of notice of the Default from the Trustee or such Holders. The Company did not have the necessary cash resources to pay the principal and accrued interest on the outstanding Debentures (totalling approximately $40,000,000 at October 31, 1993) in the event that the Debentures were successfully accelerated and such acceleration were not rescinded. Consummation of the Exchange Offer and Solicitation in January 1994 and the execution of the Second Supplemental Indenture pursuant thereto eliminated the requirement that the Company purchase Debentures by reason of Section 4.09 of the Indenture and eliminated the risk that the Company would be required to purchase Debentures by reason of Section 4.14 of the Indenture. In addition, the Company obtained, pursuant to the Exchange Offer and Solicitation, the waiver (the 'Waiver') of any and all Defaults and Events of Default and their consequences under the Debentures THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) and the Indenture arising out of any actions, omissions or events occurring on or prior to 5:00 p.m. New York City time, January 6, 1994, the expiration date of the Exchange Offer and Solicitation (the 'Expiration Date'), including any Defaults or Events of Default arising out of the matters described above. The Debentures mature on March 1, 2005 and, as a result of amendments approved by the holders of the Debentures in connection with the Exchange Offer and Solicitation and set forth in the Second Supplemental Indenture, are convertible into common stock at a conversion price of $5.00 per share, subject to adjustment under certain conditions to prevent dilution to the holders. On October 31, 1993, the aggregate principal amount of Debentures then outstanding were convertible into an aggregate of 1,434,754 shares of common stock at a conversion price of $27.45. Interest is payable semiannually on March 1st and September 1st of each year. As of October 31, 1993, $39,384,000 principal amount of the Debentures remained outstanding, the market value of which was approximately $26,584,000. The difference between the principal amount and carrying value on the Company's consolidated balance sheet of $387,000 represents unamortized discount which is being charged to expense. Following consummation of the Exchange Offer and Solicitation approximately $9,400,000 principal amount of the Debentures remain outstanding, convertible into shares of common stock at a conversion price of $5.00, and approximately $22,000,000 principal amount of Notes (as defined in Note 19) were outstanding. During 1993, 1992 and 1991, the Company purchased $4,846,000, $5,031,000 and $23,166,000, respectively, principal amount of its Debentures, all of which have been retired. See Note 4 for a discussion of extraordinary gains which resulted from these purchases. Other long-term debt consists of the following: The HGA Term Loan and HGA IRB contain several covenants, including the maintenance of certain ratios and levels of net worth (as defined), restrictions with respect to the payments of cash dividends on common stock and on the levels of capital expenditures, interest and debt payments. In addition, the holders of the HGA IRB have the right to accelerate all outstanding principal at December 31, 1995 upon notification one year prior to that date. Substantially all of the property and equipment and accounts receivable of HGA collateralize its outstanding debt. Aggregate annual maturities of other long-term debt, including the current installments thereof, during the five years subsequent to October 31, 1993, are as follows: THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTES PAYABLE AND WARRANTS In connection with agreements to extend the due date on certain of the Company's outstanding debt in 1988, the Company issued warrants to a group of its lenders. Warrants to purchase 658,950 shares of the Company's common stock vested in December 1988 and currently have an expiration date of December 29, 1995. All other warrants related to the agreements expired. The terms of the warrants provide that the exercise price is to be reset every six months to the lower of the then current exercise price or 80% of the market value as defined in the warrant agreement. As of January 12, 1994, the most recent reset date, the exercise price was $.37 per share. NOTE 12. STOCK OPTIONS, STOCK APPRECIATION RIGHTS, RESTRICTED STOCK, DEFERRED STOCK, STOCK PURCHASE RIGHTS AND LONG TERM PERFORMANCE AWARDS 1988 Long-Term Incentive Plan The 1988 Long Term Incentive Plan, as amended (the 'LTIP') provides the Company with opportunities to attract, retain and motivate key employees and consultants to the Company and its subsidiaries and affiliates, and enables the Company to provide incentives to key employees and consultants who are directly linked to the profitability of the Company and to increasing stockholder value. The LTIP authorizes a committee consisting of three or more individuals not eligible to participate in the LTIP or, if no committee is appointed, the Company's Board of Directors, to grant to eligible individuals during a period of ten years from September 15, 1988, stock options, stock appreciation rights, restricted stock, deferred stock, stock purchase rights, phantom stock units and long term performance awards for up to 6,376,710 shares of common stock, subject to adjustment for future stock splits, stock dividends and similar events. As of October 31, 1993, 4,008,943 shares remained available under the LTIP for future grants. Since the approval of the LTIP by the Company's stockholders, no further grants have been, and none will be, made under predecessor stock option and restricted stock plans. However, grants made under the prior plans before approval of the LTIP remain in effect. In February 1989, Gary Singer, Steven Singer, Bruce Sturman, Howard Sturman, Wayne Sturman, Kenneth Nilsson, Peter Riepenhausen and Martin Singer were granted the right to purchase 25,000, 25,000, 25,000, 25,000, 25,000, 5,000, 5,000 and 25,000 shares of restricted stock, respectively, pursuant to the LTIP. At the same time, options to purchase 313,170 shares were granted to each of Gary Singer, Steven Singer, Bruce Sturman, Howard Sturman, Wayne Sturman and Martin Singer, and options to purchase 25,000 shares were granted to each of Kenneth Nilsson and Peter Riepenhausen. The exercise price of such options was $3.75 per share. In March 1989, Arthur Bass, the former President and Chief Executive Officer of the Company at that time, was granted the right to purchase 50,000 shares of restricted stock pursuant to the LTIP. The purchase price for all such restricted stock awards was $.10 per share. Restrictions were removed from 10% of all of the aforementioned restricted shares in 1989 according to the restricted share release formula and 90% of the grants of Howard Sturman, Wayne Sturman, Kenneth Nilsson and Peter Riepenhausen were forfeited by each of the foregoing upon the termination of his employment. Martin Singer's restricted shares as to which restrictions had not been removed (22,500 shares) were relinquished as described more fully below. In April 1990 and April 1991, in accordance with the revised vesting schedule described below, the first two Price Levels (i.e. $4.43 THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) and $5.22, respectively) were achieved and, accordingly, restrictions were removed from 40% of the restricted shares still outstanding on each of such dates from which restrictions had not been removed previously. In March 1989, Arthur Bass also received an option to purchase 737,690 shares of the Company's common stock at an exercise price of $3.75 per share. In accordance with a renegotiation of his compensation, Mr. Bass waived that option in return for 150,000 shares of restricted stock, of which 31,317 shares were immediately free of restrictions. Restrictions were removed from another 23,736 of those shares in April 1990 upon satisfaction of the first Price Level. When Mr. Bass resigned as President and Chief Executive Officer of the Company in September 1990, he forfeited his remaining restricted shares. Pursuant to employment agreements between the Company and each of Gary Singer, Steven Singer and Bruce Sturman, which became effective as of March 9, 1990, each of the aforementioned individuals received a grant of the right to purchase 313,170 shares of restricted stock (the 'March Restricted Shares'), of which 31,317 shares were immediately free of restrictions. Restrictions on the remainder of the March Restricted Shares were to be removed in 20% increments when the average closing price of the Company's common stock on the New York Stock Exchange (composite quotations) over any consecutive period of 30 days (the 'Average Price') next equals or exceeds $4.43, $5.22, $6.16, $7.27 and $8.58 (individually, a 'Price Level') or, if not previously removed, at the end of ten years. Pursuant to other provisions in the aforementioned employment agreements, the formula for removing restrictions from the restricted shares granted in February and March 1989 was amended to conform to that of the March Restricted Shares and each of Gary Singer, Steven Singer and Bruce Sturman relinquished their 313,170 options. The issuance of the March Restricted Shares was effected pursuant to Board authorization given in connection with the adoption of a series of proposals designed to reduce the cash compensation of senior management. Bruce Sturman, Gary Singer and Steven Singer each relinquished their rights to cash severance in exchange for the March Restricted Shares. That compensation adjustment reflects some of the terms contained in a subsequently approved stipulation of settlement (the 'Settlement Agreement') in a derivative suit entitled In Re The Cooper Companies, Inc. Shareholders' Litigation in which Bruce Sturman, Gary Singer and Steven Singer and certain former officers of the Company were named defendants. Also pursuant to the aforementioned Board authorization and in contemplation of the effectiveness of the Settlement Agreement, 281,853 stock options of Martin Singer which had not yet become exercisable and 22,500 restricted shares as to which the restrictions had not yet been removed were relinquished in exchange for the right to purchase for par value 272,500 restricted shares as to which all restrictions were to be removed 18 months following the date of issuance (the 'Special Restricted Shares'). On March 9, 1990, the Executive Committee of the Board of Directors authorized additional grants totalling 457,500 restricted shares to various other employees and consultants of the Company, with restrictions to be removed in 20% increments or at the end of ten years as described above. All of the aforementioned grants were also ratified and approved by the Compensation Committee and by the full Board of Directors. When the first and second Price Levels were achieved in April 1990 and April 1991, restrictions were removed from 40% of the aforementioned restricted shares, other than the Special Restricted Shares of Martin Singer. In July 1990, the Compensation Committee of the Board of Directors authorized several grants covering an aggregate of 383,000 restricted shares (the 'July Restricted Shares') to be issued pursuant to the LTIP. Restrictions on 20% of the July Restricted Shares were removed pursuant to the terms of individual restricted share agreements upon issuance of those shares. Restrictions on the remaining 80% of the July Restricted Shares were to be removed in 25% increments when the Average Price of the Company's common stock next equals or exceeds for the first time $5.22, $6.16, $7.27 and $8.58, or, if THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) not previously removed, at the end of ten years. In April 1991, the $5.22 Price Level was achieved and, accordingly, restrictions were removed from 25% of the restricted shares. All remaining restrictions on the aforementioned restricted shares, except for restricted shares of Steven Singer as a result of a modification to his employment agreement, were removed in September 1993 as a result of a 'Change in Control' as defined by the LTIP in connection with the issuance by the Company of Series B Preferred Stock. In January and June 1991, the Administrative Committee of the LTIP authorized grants to employees and consultants of the Company covering an aggregate of 101,500 restricted shares. Those restricted shares were to have restrictions removed in 20% increments at the various Price Levels or at the end of ten years, as described above. As of October 31, 1992, restrictions on 13,450 of these shares were removed, and during 1993 the remainder of restrictions were removed as a result of a 'Change in Control' as defined by the LTIP in connection with the issuance by the Company of Series B Preferred Stock. In October 1991, the Administrative Committee of the LTIP made a grant to Bruce Sturman of 100,000 restricted shares. Of those 100,000 shares, 46,000 shares had restrictions removed upon purchase and the remaining restricted shares would have been released in 33.33% increments at Price Levels of $6.16, $7.27 and $8.58. With the termination of Bruce Sturman's employment with the Company on July 27, 1992, the remaining restricted shares granted in October 1991 (54,000 shares) and his remaining restricted shares granted in March 1990 (182,611 shares) were purchased by the Company for $.10 per share. In October 1991, the Administrative Committee of the LTIP made grants of 25,000 phantom stock units ('PSUs') to each of Gary Singer, Steven Singer and Bruce Sturman which were immediately vested to the individuals. Gary and Steven Singer each surrendered their 25,000 PSUs to the Company in October 1991, whereupon they received an amount of cash ($98,450 each) equal to the fair market value of 25,000 shares of common stock as specified by the grant. Bruce Sturman's PSUs expired with his termination of employment with the Company on July 27, 1992. In February and June 1992, the Administrative Committee of the LTIP authorized grants to employees and consultants covering an aggregate of 223,250 restricted shares. These restricted shares were to have restrictions removed in 20% increments at the various Price Levels (as described above), or have restrictions removed based on performance criteria or at the end of ten years. Of these grants, restrictions were removed from a total of 12,300 shares in 1992, and the remainder, not otherwise forfeited, had restrictions removed during 1993 as a result of a 'Change in Control' as defined by the LTIP in connection with the issuance by the Company of Series B Preferred Stock. (See Note 8.) In June 1993, the Administrative Committee of the LTIP authorized a grant to a consultant covering an aggregate of 125,000 restricted shares. These restricted shares had all restrictions removed in 1993. As of August 1, 1993, there were options to purchase an aggregate of 1,102,500 shares of common stock granted to, and not subsequently forfeited by, optionholders at exercise prices ranging from $.69 to $4.25 per share. The Company offered each employee who held options granted under the LTIP an opportunity to exchange those options for a smaller number of substitute options. Each new option is exercisable at $.56 per share. The number of shares each employee was entitled to purchase pursuant to such option was computed by the Company's independent nationally recognized compensation consulting firm using an option exchange ratio derived under the Black-Scholes option pricing model which takes into account the number of shares which could be acquired pursuant to outstanding options, the exercise price of the options, the current market of the Company's common stock and the option expiration date. Each person who elected to participate received an option to purchase an individually calculated percentage of the shares covered by his outstanding option, ranging from 21% to 70% of the shares such person was entitled to purchase. A percentage of the new option, equal to the percentage of the outstanding option that was already exercisable, was immediately exercisable. The remainder of the new option will vest and become exercisable in 25% tranches if and when the trading THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) price of the Company's common stock over 30 days averages, $1.00, $1.50, $2.00 and $2.50 per share, respectively. The option exchange program provided optionholders the opportunity to exchange options with exercise prices well in excess of the current market price of the Company's common stock with a lesser number of options that are exercisable at a price that, while still above current market price, is lower than the exercise price on the surrendered options. Under the terms of the option exchange offer, each person who elected to participate waived the vesting of options that otherwise would have resulted from the Change in Control (as such term is defined in the LTIP) that occurred when stockholders approved the conversion rights of the Series B Preferred Stock on September 14, 1993. 1990 Non-Employee Directors Restricted Stock Plan On April 26, 1990, the Company's Board of Directors adopted the 1990 Non-Employee Directors Restricted Stock Plan (the 'NEDRSP'), subject to the approval of such plan by the stockholders of the Company. Such approval was received July 12, 1990, at the Annual Meeting of Stockholders. The NEDRSP, by its terms, grants to each current and future director of the Company who is not also an employee or a consultant to the Company or any subsidiary of the Company ('Non-Employee Director') the right to purchase for $.10 per share, shares of the Company's common stock, subject to certain restrictions. One hundred thousand shares of such common stock were authorized and reserved for issuance under the NEDRSP. Shares which are forfeited become available for new awards under such plan. On July 12, 1990, upon approval of the NEDRSP by the stockholders of the Company, three Non-Employee Directors received grants for 10,000 restricted shares each. Each grant provided that the restrictions will be removed from 20% of such shares upon issuance. Restrictions shall lapse in 25% increments for the remaining 8,000 shares each time the Average Price next equals or exceeds $5.22, $6.16, $7.27 and $8.58. Restricted shares acquired under any award made after July 12, 1990 shall be in awards of 5,000 shares and shall have restrictions lapse with respect to 20% of such shares, and the shares subject thereto shall become nonforfeitable and freely transferable, each time, after the date of grant of the award, the Average Price equals or exceeds for the first time each of the following percentages of increase over the Average Price on the date of grant of the award: 18%, 36%, 54%, 72% and 90%. Transactions involving options to purchase the Company's common stock in connection with the LTIP and NEDRSP during each of the three years ended October 31, 1993 are summarized below: Options issued and outstanding have option prices ranging from $.56 to $2.625 per share. THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The excess of market value over $.10 per share of LTIP and NEDRSP restricted shares on respective dates of grant is recorded as unamortized restricted stock award compensation and shown as a separate component of stockholders' equity. Restricted shares and other stock compensation charged (credited) to selling, general and administrative expense for the twelve months ended October 31, 1993, 1992 and 1991 was approximately $1,084,000, ($33,000) and $1,734,000, respectively. Prior Stock Option Plans Prior to the implementation of the LTIP, the Company had two stock option plans, the 1982 Stock Option Plan and the 1985 Stock Option Plan (collectively referred to as the 'Stock Option Plans'). With the adoption of the LTIP, effective September 15, 1988, all authorized but unallocated options of the Stock Option Plans (approximately 430,500 options) were transferred to the LTIP and no further grants were allowed from the Stock Option Plans. Previously existing grants, however, remained in effect. THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Options granted under the Stock Option Plans could not be granted at less than 85% of the market value on the date of grant, could not have terms exceeding ten years and were generally exercisable in four equal annual installments commencing on the first anniversary of the date of the grant. The maximum number of shares authorized to be granted under the Stock Option Plans was 2,150,000 shares. Transactions in the Company's common stock during each of the three years ended October 31, 1993 in connection with the Company's Stock Option Plans are summarized below: NOTE 13. EMPLOYEE BENEFITS THE COMPANY'S RETIREMENT INCOME PLAN The Company adopted The Cooper Companies, Inc. Retirement Income Plan (the 'Retirement Plan') in December 1983. The Retirement Plan is a non-contributory pension plan covering substantially all full-time United States employees of CVI, CVP and the Company's Corporate Headquarters. The Company's customary contributions are designed to fund normal cost on a current basis and to fund over thirty years the estimated prior service cost of benefit improvements (fifteen years for annual gains and losses). The unit credit actuarial cost method is used to determine the annual cost. The Company pays the entire cost of the Retirement Plan and funds such costs as they accrue. Retirement costs applicable to continuing and discontinued operations of the Company for the years ended October 31, 1993, 1992 and 1991 were approximately $181,000, $265,000 and $351,000, respectively. Virtually all of the assets of the Retirement Plan are comprised of participations in equity and fixed income funds. Based on the latest actuarial information available, the following tables set forth the net periodic pension costs, funded status and amounts recognized in the Company's consolidated financial statements for the Retirement Plan: THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NET PERIODIC PENSION COST SCHEDULE RECONCILING THE FUNDED STATUS OF THE PLAN WITH PROJECTED AMOUNTS FOR THE FINANCIAL STATEMENTS ACTUARIAL PRESENT VALUE OF BENEFIT OBLIGATIONS THE COMPANY'S 401(K) SAVINGS PLAN The Company adopted its Stock Purchase Savings Plan (the 'Stock Plan') on December 1, 1983. Effective July 1, 1990, the Company froze the Stock Plan and implemented The Cooper Companies, Inc. 401(k) Savings Plan (the '401(k) Plan'), a revision of the Stock Plan. Both plans provide for a deferred compensation arrangement as described in section 401(k) of the Internal Revenue Code. The 401(k) Plan is a contributory plan and is available to substantially all full-time United States employees of the Company. United States resident employees of the Company who participate in the 401(k) Plan may elect to have from 2% to 10% of their pre-tax salary or wages (but not more than $8,994 for the calendar year ended December 31, 1993) deferred and contributed to the trust established under the 401(k) Plan. The Company's contributions to the Stock Plan or the 401(k) Plan on account of the THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Company's participating employees, net of forfeiture credits, were $90,000, $72,000 and $54,000 for the years ended October 31, 1993, 1992 and 1991, respectively. THE COMPANY'S BONUS PLAN The Company adopted its Incentive Payment Plan (the 'IPP') available to key executives and certain other personnel on November 1, 1982 pursuant to which such persons may in certain years receive cash bonuses based on Company and subsidiary performance. Total payments earned under the IPP for the years ended October 31, 1993, 1992 and 1991, were approximately $439,000, $456,000 and $125,000, respectively. The Board of Directors of the Company also approved discretionary bonuses outside of the IPP for the years ended October 31, 1993 and October 31, 1992 of approximately $124,000 and $343,000, respectively. THE COMPANY'S TURN-AROUND INCENTIVE PLAN The Company adopted its Turn-Around Incentive Plan (the 'TIP') on May 18, 1993 pursuant to which certain designated employees are eligible to receive awards, payable over time in a combination of cash and restricted stock issued if the Company achieves a global resolution acceptable to the Board of Directors of all breast implant matters and if the price of the Company's common stock reaches certain designated price levels. No payments have been made under the TIP to date. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS In December 1990, the Financial Accounting Standards Board issued Statement No. 106, Employer's Accounting for Postretirement Benefits Other Than Pensions ('FAS 106'), which required adoption of a new method of accounting for postretirement benefits. FAS 106 establishes standards for providing an obligation for future postretirement benefits due employees over the service period of such employees. FAS 106 is effective for fiscal years beginning after December 15, 1992. The Company will adopt FAS 106 as required and believes the adoption will have no material impact on its consolidated financial statements. NOTE 14. LEASE AND OTHER COMMITMENTS Total minimum annual rental obligations under noncancelable operating leases (substantially all real property and equipment) in force at October 31, 1993 are payable in subsequent years as follows: Aggregate rental expense for both cancelable and noncancelable contracts amounted to $2,105,000, $2,828,000 and $2,869,000 in 1993, 1992 and 1991, respectively. Commitments under capitalized leases are not significant. Under the terms of a supply agreement most recently modified in 1993, the Company agreed to purchase by December 31, 1997, certain contact lenses from a British manufacturer with an aggregate cost of approximately `L'4,063,000. As of December 31, 1993, there remained a commitment of `L'3,835,116. THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The $9,000,000 liability recorded for payments to be made to MEC under the MEC Agreement described in Notes 3, 18 and 19 will become due as follows: Additional payments to be made to MEC beginning December 31, 1999 are contingent upon the Company's earning net income before taxes in each fiscal year, and are, therefore, not recorded in the Company's financial statements. Such payments are limited to the smaller of 50% of the Company's net income before taxes in each such fiscal year on a noncumulative basis or the amounts shown below: NOTE 15. RELATIONSHIPS AND TRANSACTIONS BETWEEN THE COMPANY CLS, COOPER DEVELOPMENT COMPANY ('CDC') AND THE COOPER LABORATORIES, INC. STOCKHOLDERS' LIQUIDATING TRUST (THE 'TRUST') ADMINISTRATIVE SERVICES Pursuant to separate agreements between the Company and CDC, CLS and the Trust, which was formed in connection with the liquidation of the Company's former parent, Cooper Laboratories, Inc., the Company provided certain administrative services to CDC, CLS and the Trust, including the services of the Company's treasury, legal, tax, data processing, corporate development, investor relations and accounting staff. Expenses are charged on the basis of specific utilization or allocated based on personnel, space, percent of assets used or other appropriate bases. The agreements relating to the provision of administrative services to CDC and CLS terminated on September 17, 1988. The Company has not performed any services for CDC and CLS since September 17, 1988, other than historic tax services pursuant to the Trust. Combined corporate administrative expenses charged to the Trust by the Company were $213,000 in 1992 and $560,000 in 1991. On July 9, 1992, the Trust filed a petition in Bankruptcy under Chapter 7 of the Bankruptcy Code; and, effective July 31, 1992, the Company ceased providing services to the Trust. The Company has asserted a claim for approximately $740,000 in the Trust's bankruptcy proceedings, primarily representing unpaid administrative service fees and expenses and legal fees advanced by the Company on behalf of the Trust. AGREEMENTS WITH CLS On October 21, 1988, the Company and CLS entered into a settlement agreement (the '1988 CLS Settlement Agreement') pursuant to which certain claims between the two corporations were settled. Among other things, the 1988 CLS Settlement Agreement provided that (a) the discovery period under the directors and officers liability insurance policy issued by the Company covering directors and officers of CLS would be extended pursuant to an option contained in the insurance policy (see 'Liability Insurance', below), (b) CLS would indemnify the Company for certain claims made by a former consultant to the Company (c) CLS would have no further liability to the Company with respect to the termination of the contract pursuant to which the Company had agreed to purchase ophthalmic THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) laser systems from CLS, (d) CLS would pay the Company $2,750,000 and (e) CLS, in its capacity as a holder of the SERPS, would consent to the Company's proposed sales of its CTI business and its Cooper Surgical business and to the proposed deletion of the mandatory redemption provision of the Senior Preferred Stock. The 1988 CLS Settlement Agreement did not allocate the $2,750,000 settlement amount among the various items contained therein. The $2,750,000 was paid in full by CLS in December 1988. On November 27, 1989, the Company and CLS entered into another separate settlement agreement (the '1989 CLS Settlement Agreement'). Pursuant to the 1989 CLS Settlement Agreement, among other things, the Company and CLS (i) entered into a mutual standstill arrangement precluding each party from acquiring each other's common stock and precluding CLS from acquiring additional shares of the SERPS, (ii) dismissed most of the outstanding litigations among the Company and CLS, (iii) reaffirmed the Company's obligation to register the SERPS, and (iv) obtained the consent of CLS, as a holder of outstanding SERPS, to any future sale of all or any portion of the Company's remaining contact lens business, subject to the receipt of a fairness opinion and following a 90-day period (since expired) in which the Company would negotiate the sale of the business exclusively with CLS and CDC. On June 12, 1992, the Company consummated a transaction with CLS, which eliminated approximately 80% of the SERPS (the '1992 CLS Transaction'). Pursuant to an Exchange Agreement between the Company and CLS dated as of June 12, 1992 (the '1992 Exchange Agreement'), the Company acquired from CLS 488,004 shares of SERPS owned by CLS, and all of CLS's right to receive, by way of dividends pursuant to the terms of SERPS, an additional 11,996 shares of SERPS (such 11,996 shares together with the 488,004 shares being referred to collectively as the 'Exchanged SERPS') in exchange for 4,850,000 newly issued shares of the Company common stock (the 'Company Shares'). In addition, the Company purchased 200,000 unregistered shares of CLS common stock (the 'CLS Shares'), for a purchase price of $1,500,000 in cash (carried at October 31, 1992, at cost in 'Other assets' of the Company's consolidated balance sheet) and entered into a settlement agreement with CLS dated as of June 12, 1992 (the '1992 CLS Settlement Agreement'), with respect to certain litigation and administrative proceedings in which the Company and CLS were involved. Pursuant to the 1992 Settlement Agreement, CLS, among other things, released its claim against the Company for unliquidated damages arising from the Company's failure to register the SERPS, in return for the Company's payment of $500,000, the reimbursement of certain legal fees and expenses in the amount of $650,000 incurred by CLS in connection with certain litigation and administrative proceedings, and the payment of $709,000 owed by the Company to CLS pursuant to tax sharing agreements between them. The Company also agreed to reimburse CLS for up to $250,000 of legal and other fees and expenses incurred by CLS in connection with the 1992 CLS Transaction and, if requested by CLS, to use its reasonable best efforts to cause the election to the Company's Board of Directors of one or two designees of CLS, reasonably acceptable to the Company (the number of designees depending, respectively, on whether CLS owns more than 1,000,000 but less than 2,400,000 shares, or more than 2,400,000 shares of the Company's common stock). As part of the 1992 CLS Transaction, pursuant to Registration Rights Agreements, dated as of June 12, 1992, each between the Company and CLS (the 'Registration Rights Agreements'), the Company and CLS each agreed to use its reasonable best efforts to register, respectively, the Company Shares and the CLS Shares. On July 27, 1992, the Company filed with the SEC a registration statement for the Company Shares which became effective November 20, 1992. If a registration statement covering the Company Shares had not been declared effective within 180 days following June 12, 1992, the Company had agreed to pay $1,250,000 in cash (an amount equal to the value of 'pay-in-kind' dividends it would have accrued on the Exchanged SERPS but for the exchange). CLS agreed that if CLS had not registered the CLS Shares within 17 months from the closing date, the Company could require CLS to repurchase the CLS Shares, at the Company's cost of $1,500,000, by either, at CLS's option, (a) payment of cash, (b) delivery of shares of Senior Preferred Stock, valued at $39 per share, or (c) delivery of THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) shares of the Company's common stock, valued at $3 per share The CLS Shares were delivered to CLS as part of 1993 CLS Settlement Agreement (as defined and described below). On June 14, 1993, the Company acquired from CLS, all of the remaining outstanding SERPS of the Company, having an aggregate liquidation preference of $16,060,000, together with all rights to any dividends or distributions thereon, in exchange for shares of Series B Preferred Stock having an aggregate liquidation preference of $3,450,000 and a par value of $.10 per share (the '1993 CLS Exchange Agreement'). Such shares, and any shares of Series B Preferred Stock issued as dividends, are convertible into one share of common stock of the Company for each $1.00 of liquidation preference, subject to customary antidilution adjustments. The Company also has the right to compel conversion of Series B Preferred Stock at any time after the market price of the common stock on its principal trading market averages at least $1.375 for 90 consecutive calendar days and closes at not less than $1.375 on at least 80% of the trading days during such period. CLS currently owns 4,850,000 shares of Common Stock, or approximately 16.2% of the outstanding common stock. Dividends will accrue on the Series B Preferred Stock commencing June 14, 1994, and will be payable quarterly in cash at the rate of 9% (of liquidation preference) per annum or, if the Company is restricted by applicable law or certain debt agreements from paying cash dividends, in additional shares of Series B Preferred Stock at the rate of 12% (of liquidation preference) per annum. The Series B Preferred Stock is redeemable, in whole or in part, at the option of the Company, at any time at a redemption price equal to its then applicable liquidation preference, plus accrued and unpaid dividends. The Company and CLS also entered into a Registration Rights Agreement, dated June 14, 1993, providing for the registration under the Securities Act of the shares of common stock issued upon such conversion of any of the Series B Preferred Stock and any of the 4,850,000 shares of common stock currently owned by CLS which have not been sold prior thereto. The Board of Directors amended the Rights Agreement dated as of October 29, 1987, between the Company and The First National Bank of Boston, as Rights Agent, so that CLS and its affiliates and associates would not be Acquiring Persons thereunder as a result of CLS's beneficial ownership of more than 20% of the outstanding Common Stock of the Company by reason of its ownership of Series B Preferred Stock or Common Stock issued upon conversion thereof. See Note 5. CLS obtained the 4,850,000 shares of Common Stock it currently owns pursuant to the 1992 CLS Exchange Agreement described above. In Amendment No. 1 to its Schedule 13D, filed with the SEC on November 12, 1992, CLS disclosed that 'in light of the recent public disclosures relating to the Company and the recent significant decline in the public trading price of the Common Stock, CLS is presently considering various courses of action which it may determine to be necessary or appropriate in order to maintain and restore the value of the Common Stock. Included among the actions which CLS is considering pursuing are the initiation of litigation against the Company and the replacement of management and at least a majority of the members of the Board of Directors of the Company.' On June 14, 1993, in order to resolve all disputes with CLS, the Company and CLS entered into a Settlement Agreement (the '1993 CLS Settlement Agreement'), pursuant to which CLS delivered a general release of claims against the Company, subject to exceptions for specified on-going contractual obligations, and agreed to certain restrictions on its voting and transfer of securities of the Company, in exchange for the Company's payment of $4,000,000 in cash and delivery of 200,000 shares of common stock of CLS owned by the Company and a general release of claims against CLS, subject to similar exceptions. The cash paid and fair value of CLS shares returned have been charged to the Company's statement of operations as settlement of disputes. See Note 7. Pursuant to the 1993 CLS Settlement Agreement, the Company agreed to nominate, and CLS agreed to vote all of its shares of common stock of the Company in favor of the election of, a Board of Directors of the Company consisting of eight members, up to three of whom will, at CLS's request, be THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) designated by CLS (such designees to be officers or more than 5% stockholders of CLS as of June 14, 1993 or otherwise be reasonably acceptable to the Company). The number of CLS designees will decline as CLS's ownership of common stock (including shares of common stock into which the shares of Series B Preferred Stock owned by CLS are or may become convertible) declines. A majority of the Board members (other than CLS designees) will be individuals who are not officers or employees of the Company. Pursuant to the 1993 CLS Settlement Agreement, CLS designated, and on August 10, 1993 the Board of Directors elected, one person to serve as a director of the Company until the 1993 Annual Meeting. CLS also designated that individual along with two other people as its three designees to the eight-member Board of Directors that was elected at the 1993 Annual Meeting. CLS also agreed in the 1993 Settlement Agreement not to acquire any additional securities of the Company (except shares of Series B Preferred Stock issued as dividends or common stock issued upon conversion, if any, of Series B Preferred Stock) and to certain limitations on its transfer of securities of the Company. In addition, CLS agreed, among other things, not to seek control of the Company or the Board or otherwise take any action contrary to the 1993 CLS Settlement Agreement. CLS is free, however, to vote all voting securities owned by it as it deems appropriate on any matter before the Company's stockholders. The agreements with respect to Board representation and voting, and the restrictions on CLS's acquisition and transfer of securities of the Company, will terminate on June 14, 1995, or earlier if CLS beneficially owns less than 1,000,000 shares of common stock (including as owned any common stock into which shares of Series B Preferred Stock owned by CLS are convertible). The agreements will be extended if the market price of the common stock increases to specified levels prior to each of June 12, 1995, and June 12, 1996, or the Company agrees to nominate one CLS designee, who is independent of CLS and reasonably acceptable to the Company, in addition to that number of designees to which CLS is then entitled on each such date, which could result in such agreements continuing through October 31, 1996, and CLS having up to five designees on the Board (which would then have a total of ten members, or eleven members if a new chairman or chief executive officer is then serving on the Board). Following termination of such agreements and through June 12, 2002, CLS will continue to have the contractual right that it had pursuant to the 1992 CLS Settlement Agreement to designate two directors of the Company, so long as CLS continues to own at least 2,400,000 shares of common stock, or one director, so long as it continues to own at least 1,000,000 shares of common stock. LIABILITY INSURANCE Prior to fiscal 1988, a subsidiary of the Company that is engaged in the insurance underwriting business issued a directors and officers liability policy to CLS and a former affiliate of the Company covering its directors and officers for certain liabilities. Each policy had a maximum aggregate coverage of $5,000,000. On September 2, 1988, the Company terminated the insurance policies. As described above, the discovery periods for claims under such policies were extended pursuant to the terms of such policies. The Company had pledged $7,750,000 of cash (included in restricted cash at October 31, 1991 in the Company's consolidated balance sheet) to collateralize the contingent obligation. On April 30, 1993, the civil action entitled Guenther v. Cooper Life Sciences, Inc. et. al. filed in 1988 was settled. With such settlement, the Company was released from any future potential director and officer liability relating to coverage under the aforementioned policies and, therefore, the restricted cash which collateralized contingent liabilities was released. For a further discussion of the action see Note 7 'Settlement of Disputes.' OTHER CLS was formerly an 89.5% owned subsidiary of the Company's former parent, Cooper Laboratories, Inc. ('Labs'). THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) CLS filed Amendment No. 2 to its Schedule 13D stating that it owns and has sole voting and dispositive power with respect to 4,850,000 shares of the Company's common stock as of June 12, 1992. On June 14, 1993, CLS acquired 345 shares of Series B Preferred Stock which are convertible into 3,450,000 shares of common stock. In addition, the Company had been advised that, as of December 15, 1993, Moses Marx, the beneficial owner of approximately 22% of the outstanding stock of CLS, beneficially owned 1,126,000 shares (or approximately 3.7%) of the Company's common stock and $4,500,000 principal amount of Debentures, or approximately 11.4% of the aggregate principal amount thereof, and that United Equities Company ('United Equities'), a brokerage firm owned by Mr. Marx, held approximately $3,706,000 principal amount of Debentures or approximately 9.4% of the aggregate principal amount of Debentures outstanding, in its trading account. Mr. Marx and United Equities tendered all of their Debentures in the Exchange Offer and Solicitation (although not all of their Debentures were accepted due to proration), and the Company is not aware of Mr. Marx's or United Equities' current holdings of the Company's securities. NOTE 16. BUSINESS AND GEOGRAPHIC SEGMENT INFORMATION The Company's operations are attributable to four business segments: HGA (including PSG Management) which provides psychiatric healthcare services, and CooperVision, CooperVision Pharmaceuticals and CooperSurgical which develop, manufacture and market healthcare products. Total revenues by business segment represent service and sales revenue as reported in the Company's statement of consolidated operations. Total net sales revenue by geographic area include intercompany sales which are priced at terms that allow for a reasonable profit for the seller. Operating income (loss) is total revenue less cost of products sold, research and development expenses, selling, general and administrative expenses, costs of restructuring and amortization of intangible assets. Corporate operating loss is principally corporate headquarters expense. Investment income, net, settlement of disputes, debt restructuring costs, gain on sales of assets and businesses, net, other income (expense), net, and interest expense were not allocated to individual businesses and geographic segments. Identifiable assets are those assets used in continuing operations (exclusive of cash and cash equivalents) or which are allocated thereto when used jointly. Corporate assets are principally cash and cash equivalents, restricted cash and temporary investments. THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Information by business segment for each of the years in the three year period ended October 31, 1993 follows: - ------------ (1) Results from May 29, 1992. (2) Includes $3,149,000 for two real estate investments made by Cooper Real Estate Group. THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Information by geographic area for each of the years in the three year period ended October 31, 1993 follows: THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 17. QUARTERLY FINANCIAL DATA (UNAUDITED) - ------------ * The sum of income (loss) per common share for the four quarters is different from the full year net income (loss) per common share as a result of computing the quarterly and full year amounts on the weighted average number of common shares outstanding in the respective periods. THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) - ------------ At December 31, 1993 and 1992 there were 4,550 and 4,902 common stockholders of record, respectively. ITEM 18. LEGAL PROCEEDINGS. The Company is a defendant in a number of legal actions relating to its past or present businesses in which plaintiffs are seeking damages. On November 10, 1992, the Company was charged in an indictment (the 'Indictment'), filed in the United States District Court for the Southern District of New York, with violating federal criminal laws relating to a 'trading scheme' by Gary A. Singer, a former Co-Chairman of the Company (who went on a leave of absence on May 28, 1992, begun at the Company's request, and who subsequently resigned on January 20, 1994), and others, including G. Albert Griggs, Jr., a former analyst with The Keystone Group, Inc., and John D. Collins II, to 'frontrun' high yield bond purchases by the Keystone Custodian Funds, Inc., a group of mutual funds. The Company was named as a defendant in 10 counts. Gary Singer was named as a defendant in 24 counts, including violations of the Racketeer Influenced and Corrupt Organizations Act and the mail and wire fraud statutes (including defrauding the Company by virtue of the 'trading scheme', by, among other things, transferring profits on trades of DR Holdings, Inc. 15.5% bonds (the 'DR Holdings Bonds') from the Company to members of his family during fiscal 1991), money laundering, conspiracy, and aiding and abetting violations of the Investment Advisers Act of 1940, as amended (the 'Investment Advisers Act'), by an investment advisor. On January 13, 1994, the Company was found guilty on six counts of mail fraud and one count of wire fraud based upon Mr. Singer's conduct, but acquitted of charges of conspiracy and aiding and abetting violations of the Investment Advisers Act. Mr. Singer was found guilty on 21 counts. One count THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) against Mr. Singer and the Company was dismissed at trial and two counts against Mr. Singer relating to forfeiture penalties were resolved by stipulation between the government and Mr. Singer. Sentencing is scheduled for March 25, 1994. The maximum penalty which could be imposed on the Company is the greater of (i) $500,000 per count, (ii) twice the gross gain derived from the offense or (iii) twice the gross loss suffered by the victim of the offense, and a $200 special assessment. In addition to the penalties described in (i), (ii) or (iii), the Court could order the Company to make restitution. The Company is considering its options, including filing an appeal of its conviction. Mr. Singer's attorney has advised the Company that Mr. Singer intends to appeal his conviction. Although the Company may be obligated under its Certificate of Incorporation to advance the costs of such appeal, the Company and Mr. Singer have agreed that Mr. Singer will not request such advances, but that he will reserve his rights to indemnification in the event of a successful appeal. Also on November 10, 1992, the SEC filed a civil Complaint for Permanent Injunction and Other Equitable Relief (the 'SEC Complaint') in the United States District Court for the Southern District of New York against the Company, Gary A. Singer, Steven G. Singer (the Company's Executive Vice President and Chief Operating Officer and Gary Singer's brother), and, as relief defendants, certain persons related to Gary and Steven Singer and certain entities in which they and/or those related persons have an interest. The SEC Complaint alleges that the Company and Gary and Steven Singer violated various provisions of the Securities Exchange Act of 1934, as amended (the 'Securities Exchange Act'), including certain of its antifraud and periodic reporting provisions, and aided and abetted violations of the Investment Company Act, and the Investment Advisors Act , in connection with the 'trading scheme' described in the preceding paragraphs. The SEC Complaint further alleges, among other things, federal securities law violations (i) by the Company and Gary Singer in connection with an alleged manipulation of the trading price of the Company's 10 5/8% Convertible Subordinated Reset Debentures due 2005 (the 'Debentures') to avoid an interest rate reset allegedly required on June 15, 1991 under the terms of the Indenture governing the Debentures, (ii) by Gary Singer in allegedly transferring profits on trades of high yield bonds (including those trades in the DR Holdings Bonds which were the subject of certain counts of the Indictment of which Mr. Singer was found guilty) from the Company to members of his family and failing to disclose such transactions to the Company and (iii) by the Company in failing to disclose publicly on a timely basis such transactions by Gary Singer. The SEC Complaint asks that the Company and Gary and Steven Singer be enjoined permanently from violating the antifraud, periodic reporting and other provisions of the federal securities laws, that they disgorge the amounts of the alleged profits received by them pursuant to the alleged frauds (stated in the SEC's Litigation Release No. 13432 announcing the filing of the SEC Complaint as being $1,296,406, $2,323,180 and $174,705, respectively), plus interest, and that they each pay appropriate civil monetary penalties. The SEC Complaint also seeks orders permanently prohibiting Gary and Steven Singer from serving as officers or directors of any public company and disgorgement from certain Singer family members and entities of amounts representing the alleged profits received by such defendants pursuant to the alleged frauds. In February 1993, the court granted a motion staying all proceedings in connection with this matter pending completion of the criminal case. On January 24, 1994, the Court lifted the stay and directed the defendants to file answers to the SEC Complaint within 30 days. The Company is currently involved in settlement negotiations with the SEC. At this time, there can be no assurance these negotiations will be successfully concluded. The imposition of monetary penalties upon the Company as a result of the criminal convictions or in connection with the matters alleged in the SEC Complaint, as well as the incurrence of any additional defense costs, could exacerbate, possibly materially, the Company's liquidity problems and its need to raise funds. Copies of the Indictment and the SEC Complaint were attached as exhibits to the Company's Current Report on Form 8-K, dated November 16, 1992, filed with the SEC. The Company is named as a nominal defendant in a shareholder derivative action entitled Harry Lewis and Gary Goldberg v. Gary A. Singer, Steven G. Singer, Arthur C. Bass, Joseph C. Feghali, Warren THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) J. Keegan, Robert S. Holcombe and Robert S. Weiss, which was filed on May 27, 1992 in the Court of Chancery, State of Delaware, New Castle County. On May 29, 1992, another plaintiff, Alfred Schecter, separately filed a derivative complaint in Delaware Chancery Court that was essentially identical to the Lewis and Goldberg complaint. Lewis and Goldberg later amended their complaint, and the Delaware Chancery Court thereafter consolidated the Lewis and Goldberg and Schecter actions as In re The Cooper Companies, Inc. Litigation, Consolidated C.A. 12584, and designated Lewis and Goldberg's amended complaint as the operative complaint (the 'First Amended Derivative Complaint'). The First Amended Derivative Complaint alleges that certain directors of the Company and Gary A. Singer, as Co-Chairman of the Board of Directors, caused or allowed the Company to be a party to the 'trading scheme' that was the subject of the Indictment. The First Amended Derivative Complaint also alleges that the defendants violated their fiduciary duties to the Company by not vigorously investigating the allegations of securities fraud. The First Amended Derivative Complaint requests that the Court order the defendants (other than the Company) to pay damages and expenses to the Company and certain of the defendants to disgorge their profits to the Company. On October 16, 1992, the defendants moved to dismiss the First Amended Derivative Complaint on grounds that such Complaint fails to comply with Delaware Chancery Court Rule 23.1 and that Count III of the First Amended Derivative Complaint fails to state a claim. The Company has been advised by the individual directors named as defendants that they believe they have meritorious defenses to this lawsuit and intend vigorously to defend against the allegations in the First Amended Derivative complaint. The Company was named as a nominal defendant in a purported shareholder derivative action entitled Bruce D. Sturman v. Gary A. Singer, Steven G. Singer, Brad C. Singer, Martin Singer, John D. Collins II, Back Bay Capital, Inc., G. Albert Griggs, Jr., John and Jane Does 1-10 and The Cooper Companies, Inc., which was filed on May 26, 1992 in the Supreme Court of the State of New York, County of New York. The plaintiff, Bruce D. Sturman, a former officer and director of the Company, alleged that Gary A. Singer, as Co-Chairman of the Board of Directors, and various members of the Singer family caused the Company to make improper payments to alleged third-party co-conspirators, Messrs. Griggs and Collins, as part of the 'trading scheme' that was the subject of the Indictment. The complaint requested that the Court order the defendants (other than the Company) to pay damages and expenses to the Company, including reimbursement of payments made by the Company to Messrs. Collins and Griggs, and to disgorge their profits to the Company. Pursuant to its decision and order, filed August 17, 1993, the Court dismissed this action under New York Civil Practice Rule 327(a). On September 22, 1993, the plaintiff filed a Notice of Appeal. The Company was named in an action entitled Bruce D. Sturman v. The Cooper Companies, Inc. and Does 1-100, Inclusive, first brought on July 24, 1992 in the Superior Court of the State of California, Los Angeles, County. Mr. Sturman alleged that his suspension from his position as Co-Chairman of the Board of Directors constituted, among other things, an anticipatory breach of his employment agreement. On May 14, 1993, Mr. Sturman filed a First Amended Complaint in the Superior Court of the State of California, County of Alameda, Eastern Division, the jurisdiction to which the original case had been transferred. In the Amended Complaint, Mr. Sturman alleged that by first suspending and then terminating him from his position as Co-Chairman, the Company breached his employment agreement, violated provisions of the California Labor Code, wrongfully terminated him in violation of public policy, breached its implied covenant of good faith and fair dealing, defamed him, invaded his privacy and intentionally inflicted emotional distress, and was otherwise fraudulent, deceitful and negligent. The Amended Complaint seeks declaratory relief, damages in the amount of $5,000, treble and punitive damages in an unspecified amount, and general, special and consequential damages in the amount of at least $5,000,000. In March 1993, the Court ordered a stay of all discovery in this action until further order of the Court and thereafter scheduled a conference for January 14, 1994 to review the status of the stay. The Court subsequently modified the stay to permit the taking of the deposition of one witness who will not be available to testify at trial. On September 24, 1993, Mr. Sturman filed a Second Amended Complaint, setting forth the same material allegations and seeking the same relief THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) and damages as set forth in the First Amended Complaint. On January 7, 1994, the Company filed an Answer, generally denying all of the allegations in the Second Amended Complaint, and also filed a Cross-Complaint against Mr. Sturman. In the Cross-Complaint, the Company alleges that Mr. Sturman's conduct constituted a breach of his employment agreement with the Company as well as a breach of his fiduciary duty to the Company, that Mr. Sturman misrepresented and failed to disclose certain material facts to the Company and converted certain assets of the Company to his personal use and benefit. The Cross-Complaint seeks compensatory and punitive damages in an unspecified amount. On January 14, 1994, the Court continued in place the stay on all discovery and scheduled a case management conference for February 10, 1994 to review the status of the stay. Based on management's current knowledge of the facts and circumstances surrounding Mr. Sturman's termination, the Company believes that it has meritorious defenses to this lawsuit and intends to defend vigorously against the allegations in the Second Amended Complaint. In two virtually identical actions, Frank H. Cobb, Inc. v. The Cooper Companies, Inc., et al., and Arthur J. Korf v. The Cooper Companies, Inc., et al., class action complaints were filed in the United States District Court for the Southern District of New York in August 1989, against the Company and certain individuals who served as officers and/or directors of the Company after June 1987. In their Fourth Amended Complaint filed in September 1992, the plaintiffs allege that they are bringing the actions on their own behalf and as class actions on behalf of a class consisting of all persons who purchased or otherwise acquired shares of the Company's common stock during the period May 26, 1988 through February 13, 1989. The amended complaints seek an undetermined amount of compensatory damages jointly and severally against all defendants. The complaints, as amended, allege that the defendants knew or recklessly disregarded and failed to disclose to the investing public material adverse information about the Company. Defendants are accused of having allegedly failed to disclose, or delayed in disclosing, among other things: (a) that the allegedly real reason the Company announced on May 26, 1988 that it was dropping a proposed merger with Cooper Development Company, Inc. was because the Company's banks were opposed to the merger; (b) that the proposed sale of Cooper Technicon, Inc., a former subsidiary of the Company, was not pursuant to a definitive sales agreement but merely an option; (c) that such option required the approval of the Company's debentureholders and preferred stockholders; (d) that the approval of such sale by the Company's debentureholders and preferred stockholders would not have been forthcoming absent extraordinary expenditures by the Company; and (e) that the purchase agreement between the Company and Miles, Inc. for the sale of Cooper Technicon, Inc. included substantial penalties to be paid by the Company if the sale was not consummated within certain time limits and that the sale could not be consummated within those time limits. The amended complaints further allege that the defendants are liable for having violated Section 10(b) of the Securities Exchange Act and Rule 10(b)-5 thereunder and having engaged in common law fraud. Based on management's current knowledge of the facts and circumstances surrounding the events alleged by plaintiffs as giving rise to their claims, the Company believes that it has meritorious defenses to these lawsuits and intends vigorously to defend against the allegations in the amended complaints. The parties have engaged in preliminary settlement negotiations; however, there can be no assurances that these discussions will be successfully concluded. On September 2, 1993, a patent infringement complaint was filed against the Company in the United States District Court for the District of Nevada captioned Steven P. Shearing v. The Cooper Companies, Inc. On or about that same day, the plaintiff filed twelve additional complaints, accusing at least fourteen other defendants of infringing the same patent. The patent in these suits covers a specific method of implanting an intraocular lens into the eye. Until February 1989, the Company manufactured intraocular lenses and ophthalmic instruments, but did not engage in the implantation of such lenses. Subsequent to February 1989, the Company was not involved in the manufacture, marketing or sale of intraocular lenses. The Company denies the material allegations of Shearing's complaint and will vigorously defend itself. THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The Company is a defendant in more than 2,600 breast implant lawsuits pending in federal district courts and state courts, some of which purport to be class actions, relating to the mammary prosthesis (breast implant) business of its former wholly-owned subsidiaries, Aesthetech Corporation ('Aesthetech'), the manufacturer, and Natural Y Surgical Specialities, Inc. ('Natural Y'), the distributor, of polyurethane foam covered, silicone gel-filled breast implants, which subsidiaries were sold to Medical Engineering Corporation ('MEC'), a wholly-owned subsidiary of Bristol-Myers Squibb Company ('BMS') on December 14, 1988. The plaintiffs in the breast implant lawsuits generally claim to have been injured by breast implants allegedly manufactured and/or sold by Aesthetech, Natural Y or MEC. The ailments typically alleged include autoimmune disorders, scleroderma, chronic fatigue syndrome and vascular and neurological complications, as well as, in some cases, a fear of cancer. A small percentage of lawsuits allege that plaintiffs are suffering from cancer, allegedly caused by the component parts of the implants, including the alleged breakdown of polyurethane foam used to cover the implants. In most cases, other defendants are named in addition to the Company, Aesthetech, Natural Y, MEC and BMS, including, in many cases, implanting surgeons and the suppliers of the silicone and polyurethane products used in the manufacture of the breast implants. On October 29, 1992, the Delaware Chancery Court in Medical Engineering Corporation and Bristol-Myers Squibb Company v. The Cooper Companies, Inc. ruled that, as between BMS and MEC, on the one hand, and the Company, on the other, the Company is responsible for product liability claims and obligations relating to breast implants sold by Natural Y before December 14, 1988, irrespective of when the claims are brought. On September 28, 1993, the Company announced that it had entered into an agreement with MEC (the 'MEC Agreement') settling this litigation between the Company and BMS and MEC. Pursuant to the MEC Agreement, MEC has agreed, subject to limited exceptions, to take responsibility for all legal fees and other costs, and to pay all judgments and settlements, resulting from all pending and future claims in respect of breast implants sold by Aesthetech and Natural Y prior to their acquisition by MEC (including the above-mentioned lawsuits), and the Company has withdrawn its appeal of the Delaware Chancery Court decision and agreed, among other things, to make certain payments to MEC. Pursuant to the terms of the MEC Agreement, MEC could have terminated the agreement if the Exchange Offer and Solicitation relating to its Debentures (or an alternative restructuring of the Debentures or other amendment, forebearance or waiver with respect to the Debentures) was not completed on terms satisfactory to the Company by February 1, 1994. The Exchange Offer and Solicitation was completed on January 6, 1994. See Notes 14 and 19. The Company was named as a defendant in a civil action entitled Site Microsurgical Systems v. The Cooper Companies, Inc. filed in the United States District Court of Delaware on November 13, 1990. The plaintiff alleged that the Company infringed one of its U.S. patents through sales by the CooperVision Surgical Division ('CVS') of certain cassettes and systems utilizing such cassettes prior to the sale of CVS in February, 1989. The Company denied the plaintiff's allegations and counterclaimed for a Declaratory Judgment of non-infringement and invalidity of the plaintiff's patent-in-suit. This lawsuit was settled in October 1993. Pursuant to the settlement, the Company made a cash payment to the plaintiff and the parties terminated a generic ophthalmic pharmaceutical supply agreement. NOTE 19. SUBSEQUENT EVENT On January 6, 1994, the Company consummated the Exchange Offer and Solicitation in which it issued approximately $22,000,000 of 10% Senior Subordinated Secured Notes due 2003 (the 'Notes') and paid approximately $4,350,000 in cash ($725 principal amount of Notes and $145 in cash for each $1,000 principal amount of Debentures) in exchange for approximately $30,000,000 aggregate principal amount of Debentures (out of $39,384,000 aggregate principal amount then outstanding). The Company also obtained, pursuant to the Exchange Offer and Solicitation, consents of the holders of Debentures THE COOPER COMPANIES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) to (i) certain proposed amendments to the Indenture and (ii) the Waiver. See Note 11. Following the exchange, approximately $9,400,000 aggregate principal amount of Debentures remain outstanding. On January 6, 1994, after receiving consents from holders of a majority of the outstanding principal amount of Debentures not owned by the Company or its affiliates, the Waiver was effected and the Company and the Trustee under the Indenture executed the Second Supplemental Indenture effecting the proposed amendments, which eliminated or modified various covenants in the Indenture. The consummation of the Exchange Offer and Solicitation also satisfied a condition of the MEC Agreement, described in Note 18, limiting the Company's liability with respect to breast implant litigation. The Notes bear interest from September 1, 1993 at a rate equal to 10% per annum. (Interest accrued from September 1, 1993 will not be paid on Debentures tendered and accepted pursuant to the Exchange Offer and Solicitation.) Interest on the Notes is payable quarterly on each March 1, June 1, September 1 and December 1, commencing March 1, 1994. The Notes are redeemable solely at the option of the Company, in whole or in part, at any time, at a redemption price equal to 100% of their principal amount, together with accrued and unpaid interest thereon to the redemption date. The Company will not be required to effect any mandatory redemptions or make any sinking fund payments with respect to the Notes, except in connection with certain sales or other dispositions of, or certain financings secured by, the collateral securing the Notes. Pursuant to a pledge agreement dated as of January 6, 1994, between the Company and the trustee for the holders of the Notes, the Company has pledged a first priority security interest in all of its right, title and interest in stock of HGA and CooperSurgical, all additional shares of stock of, or other equity interests in HGA and CooperSurgical from time to time acquired by the Company, all intercompany indebtedness of HGA and CooperSurgical from time to time held by the Company and, except as set forth in the indenture governing the Notes, the proceeds received from the sale or disposition of any or all of the foregoing. A full description of the pledge agreement and terms of the indenture governing the Notes is included in the Company's Amended and Restated Offer to Exchange and Consent Solicitation filed with SEC on December 15, 1993. The Exchange Offer and Solicitation has been accounted for in accordance with Statement of Financial Accounting Standards No. 15 'Accounting by Debtors and Creditors for Troubled Debt Restructurings.' Consequently, the difference between the carrying value of the Debentures exchanged less the face value of the Notes issued and the aggregate cash payment for the Debentures is recorded as a deferred premium. The Company will recognize the benefit of the deferred premium prospectively as a reduction to the effective interest rate on the Notes over the life of the issue. In addition, the Company recorded a charge of $2,131,000 in 1993 for the estimated debt restructuring costs related to the Exchange Offer and Solicitation. SCHEDULE II THE COOPER COMPANIES, INC. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES THREE YEARS ENDED OCTOBER 31, 1993 All outstanding loans are due on demand under certain conditions. The following footnotes address original loan amounts and do not reflect interest accrued or collected. - ------------ (A) Represents a 9% term loan of $900,000 granted pursuant to an employment agreement dated October 31, 1989, secured by a lien on real estate. (B) Represents a 9.5% temporary housing loan of $200,000 secured by a lien on real estate. SCHEDULE V THE COOPER COMPANIES, INC. AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT THREE YEARS ENDED OCTOBER 31, 1993 - ------------ (A) Represents reclassification of an addition in 1992. (B) Represents acquired assets of CoastVision, Inc. and other items. (C) Represents write-off of leaseholds upon relocation of executive office. (D) Represents acquired assets of Hospital Group of America, Inc. (E) Represents write-off of machinery and equipment resulting from a fire. (F) Represents acquired assets of Euro-Med, Inc. and other items. SCHEDULE VI THE COOPER COMPANIES, INC. AND SUBSIDIARIES ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT THREE YEARS ENDED OCTOBER 31, 1993 - ------------ (A) Represents write-off of leaseholds upon relocation of executive office. (B) Represents write-off of machinery and equipment resulting from a fire. SCHEDULE VIII THE COOPER COMPANIES, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS THREE YEARS ENDED OCTOBER 31, 1993 - ------------ (A) Represents acquired reserve of CoastVision, Inc. (B) Represents acquired reserve of Hospital Group of America, Inc. (C) Uncollectible accounts written off, recovered accounts receivable previously written off and other items. (D) Recorded in Stockholders' Equity. SCHEDULE X THE COOPER COMPANIES, INC. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION THREE YEARS ENDED OCTOBER 31, 1993 Royalties, maintenance and repairs and taxes other than payroll and income taxes are omitted as each item does not exceed 1% of net operating revenue as reported in the Statement of Consolidated Operations. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) Documents filed as part of this report: 1. Financial Statements of the Company. The Consolidated Financial Statements and the Notes thereto, the Financial Statement Schedules identified in (2) below and the Accountants' Report on the foregoing are included in Part II, Item 8 of this report. 2. Financial Statement Schedules of the Company. All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are not applicable and, therefore, have been omitted. Also included herein are separate company Financial Statements and the Notes thereto, the Accountants' Report thereon and required Financial Statement Schedules of: Hospital Group of America, Inc. and Subsidiaries CooperSurgical, Inc. INDEPENDENT AUDITORS' REPORT Board of Directors HOSPITAL GROUP OF AMERICA, INC.: We have audited the accompanying consolidated balance sheets of Hospital Group of America, Inc. and subsidiaries as of October 31, 1993, October 31, 1992, May 29, 1992 and April 30, 1991 and the related consolidated statements of operations, stockholder's equity and cash flows for the year ended October 31, 1993, for the period from May 30, 1992 to October 31, 1992, for the period from June 1, 1991 to May 29, 1992, for the period from May 1, 1991 to May 31, 1991 and for the year ended April 30, 1991. In connection with our audits of the consolidated financial statements, we also have audited financial statement schedules V, VI, VIII and X. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Hospital Group of America, Inc. and subsidiaries at October 31, 1993, October 31, 1992, May 29, 1992 and April 30, 1991 and the results of their operations and their cash flows for the year ended October 31, 1993, for the period from May 30, 1992 to October 31, 1992, for the period from June 1, 1991 to May 29, 1992, for the period from May 1, 1991 to May 31, 1991, and for the year ended April 30, 1991 in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. The accompanying financial statements have been prepared assuming Hospital Group of America, Inc. will continue as a going concern. As discussed in Note H to the consolidated financial statements, the Company's losses, negative cash flows, working capital deficiency, and dependence upon the Parent raise substantial doubt about the Company's ability to continue as a going concern. Additionally, the independent auditors' report dated January 24, 1994 on the Parent's financial statements as of October 31, 1993 includes an explanatory paragraph describing a substantial doubt about the Parent's ability to continue as a going concern. The accompanying financial statements and financial statement schedules do not include any adjustments that might result from the outcome of these uncertainties. KPMG PEAT MARWICK Philadelphia, Pennsylvania January 24, 1994 HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES (A WHOLLY OWNED SUBSIDIARY OF THE COOPER COMPANIES, INC.) CONSOLIDATED BALANCE SHEETS OCTOBER 31, 1993 AND 1992 See accompanying notes to consolidated financial statements. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES (A WHOLLY OWNED SUBSIDIARY OF THE COOPER COMPANIES, INC.) CONSOLIDATED STATEMENTS OF OPERATIONS YEAR ENDED OCTOBER 31, 1993 AND PERIOD FROM MAY 30, 1992 TO OCTOBER 31, 1992 See accompanying notes to consolidated financial statements. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES (A WHOLLY OWNED SUBSIDIARY OF THE COOPER COMPANIES, INC.) CONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY YEAR ENDED OCTOBER 31, 1993 AND PERIOD FROM MAY 30, 1992 TO OCTOBER 31, 1992 See accompanying notes to consolidated financial statements. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES (A WHOLLY OWNED SUBSIDIARY OF THE COOPER COMPANIES, INC.) CONSOLIDATED STATEMENTS OF CASH FLOWS YEAR ENDED OCTOBER 31, 1993 AND PERIOD FROM MAY 30, 1992 TO OCTOBER 31, 1992 See accompanying notes to consolidated financial statements. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES (A WHOLLY OWNED SUBSIDIARY OF THE COOPER COMPANIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEAR ENDED OCTOBER 31, 1993 AND PERIOD FROM MAY 30, 1992 TO OCTOBER 31, 1992 A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Accounting -- On May 29, 1992, The Cooper Companies, Inc. ('Cooper' or 'Parent') acquired all of the common stock of Hospital Group of America, Inc. (HGA) from its ultimate parent, Nu-Med, Inc. (Nu-Med). The acquisition of HGA was accounted for as a purchase and the purchase adjustments were 'pushed-down' to the separate financial statements of HGA resulting in a new basis of accounting as of May 30, 1992. The Parent's cost of the acquisition was approximately $50 million, including the assumption of approximately $22 million of third-party debt of HGA. The purchase price was allocated to assets and liabilities based on their estimated fair values as of the acquisition date. The purchase price exceeded the estimated fair value of the identifiable net assets acquired resulting in goodwill. The estimated goodwill amount of $6,155,000 was recorded as of May 30, 1992 and is being amortized over 30 years on a straight-line basis. Business -- The accompanying consolidated financial statements include the accounts of HGA and its wholly owned subsidiaries (the 'Company'). All intercompany balances and transactions have been eliminated. The Company owns and operates the following psychiatric facilities: Effective May 30, 1992, PSG Management, Inc. (PSG), a sister company to HGA and a wholly-owned subsidiary of Cooper, entered into a three year agreement with the following subsidiaries to manage the two psychiatric hospitals and the substance abuse treatment center owned by the subsidiaries of Nu-Med, Inc. The management fee earned by PSG from the subsidiaries of Nu-Med, Inc. related to this agreement is $2,000,000 annually, payable in equal monthly installments. The management agreement is jointly and severally guaranteed by Nu-Med and a wholly owned subsidiary of Nu-Med, Inc. HGA is not a party to this agreement and therefore the management fee earned by PSG from the subsidiaries of Nu-Med, Inc. is not recognized in the accompanying financial statements. However, in connection with this agreement, HGA performs services on behalf of PSG for which it earns a fee of 25% of certain of its corporate headquarters' cost plus a 20% mark-up. Such fees earned by HGA from PSG amounted to $691,000 for the year ended October 31, 1993 and $260,000 for the period from May 30, 1992 to October 31, 1992. On January 6, 1993, Nu-Med (but not any of its direct or indirect subsidiaries) filed a voluntary petition under Chapter 11 of the United States Bankruptcy Code. Neither Cooper nor any of its subsidiaries filed a Proof of Claim in the Nu-Med Chapter 11 proceeding, and the bar date (the time for filing proofs of claim) has past. However, none of the Nu-Med subsidiaries have filed under Chapter 11, and the Nu-Med subsidiaries have paid the management fee on a timely basis, although representatives of Nu-Med and its subsidiaries have alleged in writing that PSG Management has breached the management services agreement (which contention PSG Management vigorously disputes). Moreover, Nu-Med's Proposed Disclosure Statement to accompany its Second Amended Plan of Reorganization, filed with the United States Bankruptcy Court for the Central District of California, indicates that PsychGroup is commencing, performance of certain administrative functions performed by PSG Management on a parallel basis. The following are subsidiaries of Nu-Med which own the facilities managed by PSG: HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES (A WHOLLY OWNED SUBSIDIARY OF THE COOPER COMPANIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEAR ENDED OCTOBER 31, 1993 AND PERIOD FROM MAY 30, 1992 TO OCTOBER 31, 1992 Net Patient Service Revenue -- Net patient service revenue is recorded at the estimated net realizable amounts from patients, third-party payors, and others for services rendered, including estimated retroactive adjustments under reimbursement agreements with third-party payors. Retroactive adjustments are accrued on an estimated basis in the period the related services are rendered and adjusted in the period as final settlements are determined. Charity Care -- The Company provides care to indigent patients who meet certain criteria under its charity care policy without charge or at amounts less than its established rates. Because the Company does not pursue collection of amounts determined to qualify as charity care, they are not reported as revenue. The Company maintains records to identify and monitor the level of charity care it provides. These records include the amount of charges foregone for services and supplies furnished under its charity care policy. Charges at the Company's established rates forgone for charity care provided by the Company amounted to $3,220,000 during the year ended October 31, 1993 and $1,597,000 during the period May 30, 1992 to October 31, 1992. Hampton Hospital is required by its Certificate of Need to incur not less than 10% of total patient days as free care. Health Insurance Coverage -- The Company is self-insured for the health insurance coverage offered to its employees. The provision for estimated self-insured health insurance costs includes management's estimates of the ultimate costs for both reported claims and claims incurred but not reported. Supplies -- Supplies consist principally of medical supplies and are stated at the lower of cost (first-in, first-out method) or market. Property and Equipment -- Property and equipment are stated at fair value as of May 29, 1992, the date of the acquisition of HGA by Cooper. Depreciation is computed on the straight-line method over the estimated useful lives of the respective assets, which range from 20 to 40 years for buildings and improvements, and 5 to 10 years for equipment, furniture and fixtures. Other Assets -- Loan fees incurred in obtaining long-term financing are deferred and recorded as other assets. Loan fees are amortized over the terms of the related loans. The balance of unamortized loan fees amounted to $540,000 and $727,000, respectively, at October 31, 1993 and 1992. Income Taxes -- The Company is included in the consolidated tax returns of Cooper. The Company computes a tax provision as if it were a stand alone entity. Cash and Cash Equivalents -- Cash and cash equivalents include investments in highly liquid debt instruments with a maturity of three months or less. B. NET PATIENT SERVICE REVENUE The Company has agreements with third-party payors that provide for payments to the Company at amounts different from its established rates. A summary of the payment arrangements with major third-party payors follows: Commercial Insurance -- Most commercial insurance carriers reimburse the Company on the basis of the hospitals' charges, subject to the rates and limits specified in their policies. Patients covered by commercial insurance generally remain responsible for any differences between insurance proceeds and total charges. Blue Cross -- Reimbursement under Blue Cross plans varies depending on the areas in which the Company presently operates facilities. Benefits paid to the Company can be charge-based, cost-based, negotiated per diem rates or approved through a state rate setting process. Medicare -- Services rendered to Medicare program beneficiaries are reimbursed under a retrospectively determined reasonable cost system with final settlement determined after HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES (A WHOLLY OWNED SUBSIDIARY OF THE COOPER COMPANIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEAR ENDED OCTOBER 31, 1993 AND PERIOD FROM MAY 30, 1992 TO OCTOBER 31, 1992 submission of annual cost reports by the Company and audits thereof by the Medicare fiscal intermediary. Managed Care -- Services rendered to subscribers of health maintenance organizations, preferred provider organizations and similar organizations are reimbursed based on prospective negotiated rates. The Company's business activities are primarily with large insurance companies and federal and state agencies or their intermediaries. Other than adjustments arising from audits by certain of these agencies, the risk of loss arising from the failure of these entities to perform according to the terms of their respective contracts is considered remote. During the period ended October 31, 1992, the Company received and recognized as net patient service revenue, approximately $465,000 related to the settlement of prior year cost reports. C. RELATED PARTY TRANSACTIONS The current portion of Due to Parent at October 31, 1993 consists of amounts due under a demand note ('Demand Note') for costs incurred or paid by the Parent in connection with the acquisition, cash advances from the Parent, interest payable on the Subordinated Promissory Note (as defined below) in the amount of $2,680,000, and an allocation of Cooper corporate services amounting to $623,000, net of payments to the Parent. All current and future borrowings under the terms of the Demand Note bear interest, payable monthly, commencing on December 1, 1993 at the rate of 15% per annum (17% in the event principal and interest is not paid when due), and all principal and all accrued and unpaid interest under the Demand Note shall be completely due and payable on demand. Prior to December 1, 1993, the Parent did not charge the Company for amounts due to it except for amounts due under the Subordinated Promissory Note. The non-current portion of Due to Parent consists of a $16,000,000 subordinated promissory note (the 'Subordinated Promissory Note'). The annual interest rate on the Subordinated Promissory Note is 12%. The principal amount of this Subordinated Promissory Note shall be due and payable on May 29, 2002 unless payable sooner pursuant to its terms. HGA allocates interest expense to PSG to reflect an estimate of the interest cost on debt incurred by HGA in connection with the May 29, 1992 acquisition which relates to the PSG management agreement with Nu-Med. Such allocations amounted to $194,000 and 106,000 for the year ended October 31, 1993 and the period from May 30, 1992 to October 31, 1992, respectively and are recorded as reductions of interest on long-term debt and interest on due to Parent note. D. EMPLOYEE BENEFITS The Company participates in Cooper's 401(k) plan (the 'Plan'), which covers substantially all full-time employees with more than 60 days of service. The Company matches employee contributions up to certain limits. These costs were $40,000 for the year ended October 31, 1993 and $26,000 for the period from May 30, 1992 to October 31, 1992. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES (A WHOLLY OWNED SUBSIDIARY OF THE COOPER COMPANIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEAR ENDED OCTOBER 31, 1993 AND PERIOD FROM MAY 30, 1992 TO OCTOBER 31, 1992 E. LONG TERM DEBT Long-term debt at October 31, 1993 and 1992 consists of the following: Annual maturities of long-term debt are as follows: The long-term debt agreements contain several covenants, including the maintenance of certain ratios and levels of net worth (as defined), restrictions with respect to the payments of cash dividends on common stock and on the levels of capital expenditures, interest and debt payments. In addition, the Industrial Revenue Bonds give the holders the right to accelerate all outstanding principal at December 31, 1995 upon notification one year prior to that date. Substantially all of the property and equipment and accounts receivable of the Company collateralize the debt outstanding. F. COMMITMENTS AND CONTINGENCIES In the normal course of business, the Company is involved in various litigation cases. In the opinion of management, the disposition of such litigation will not have a material adverse effect on the Company's consolidated financial position. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES (A WHOLLY OWNED SUBSIDIARY OF THE COOPER COMPANIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEAR ENDED OCTOBER 31, 1993 AND PERIOD FROM MAY 30, 1992 TO OCTOBER 31, 1992 The Company leases certain space and equipment under operating lease agreements. The following is a schedule of estimated minimum payments due under such leases with an initial term of more than one year as of October 31, 1993: Some of the operating leases contain provisions for renewal or increased rental (based upon increases in the Consumer Price Index), none of which are taken into account in the above table. Rental expense under all operating leases amounted to $736,000 and $340,000, respectively, for the year ended October 31, 1993, and the period from May 30, 1992 to October 31, 1992. G. INCOME TAXES The Company is included in the consolidated tax returns of Cooper. The Company and Cooper have incurred operating losses and accordingly the Company has not recognized any income tax benefit in the accompanying financial statements. In February 1992, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 109, 'Accounting for Income Taxes.' Cooper and the Company are required to adopt the new method of accounting for income taxes no later than the fiscal year ending October 31, 1994. Neither the Company nor Cooper has completed an analysis to estimate the impact of the statement on the Company's consolidated financial statements. H. DEPENDENCE UPON COOPER The Company has incurred losses and negative cash flows since May 30, 1992, and has a working capital deficiency at October 31, 1993 which includes a liability to the Parent of $6,082,000. The Parent has provided the Company with cash advances to meet its cash needs. The independent auditors' report dated January 24, 1994 on the Parent's October 31, 1993 consolidated financial statements includes the following explanatory paragraph: The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. During the past three fiscal years, the Company has suffered significant losses and negative cash flows. In addition, as discussed in Note 18 to the financial statements the Company is exposed to contingent liabilities related to a criminal conviction and a Securities and Exchange Commission action. Such losses, negative cash flows, and contingent liabilities raise substantial doubt about the Company's ability to continue as a going concern. The consolidated financial statements and financial statement schedules do not include any adjustments that might result from the outcome of these uncertainties. The Company is unable to predict the effect, if any, of the uncertainty concerning the Parent's ability to continue as a going concern on its financial condition or results of operations. The aforementioned factors raise substantial doubt about the Company's ability to continue as a going concern. The financial statements do not include any adjustments that might be necessary if the Company or its Parent is unable to continue as a going concern. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES (A WHOLLY OWNED SUBSIDIARY OF THE COOPER COMPANIES, INC.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEAR ENDED OCTOBER 31, 1993 AND PERIOD FROM MAY 30, 1992 TO OCTOBER 31, 1992 I. Subsequent Event Pursuant to a pledge agreement dated as of January 6, 1994, between the Parent and the trustee for the holders of a new class of debt issued by the Parent (the 'Notes'), the Parent has pledged a first priority security interest in all of its right, title and interest in stock of the Company, all additional shares of stock of, or other equity interest in, the Company from time to time acquired by the Parent, all intercompany indebtedness of the Company from time to time held by the Parent and except as set forth in the indenture governing the Notes, the proceeds received from the sale or disposition of any or all of the foregoing. A full description of the pledge agreement and terms of the indenture governing the Notes is included in the Parent's Amended and Restated Offer to Exchange and Consent Solicitation filed with the Securities and Exchange Commission on December 15, 1993. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET MAY 29, 1992 (IN THOUSANDS OF DOLLARS) See accompanying notes to consolidated financial statements. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF EARNINGS PERIODS FROM MAY 1, 1991 TO MAY 31, 1991 AND JUNE 1, 1991 TO MAY 29, 1992 (IN THOUSANDS OF DOLLARS) See accompanying notes to consolidated financial statements. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF STOCKHOLDER'S EQUITY PERIOD FROM MAY 1, 1991 TO MAY 31 1991 AND JUNE 1, 1991 TO MAY 29, 1992 (IN THOUSANDS OF DOLLARS) See accompanying notes to consolidated financial statements. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS PERIODS FROM MAY 1, 1991 TO MAY 31, 1991 AND JUNE 1, 1991 TO MAY 29, 1992 (IN THOUSANDS OF DOLLARS) See accompanying notes to consolidated financial statements. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS PERIODS FROM MAY 1, 1991 TO MAY 31, 1991 AND JUNE 1, 1991 TO MAY 29, 1992 A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BUSINESS The accompanying consolidated financial statements include the accounts of Hospital Group of America (HGA) and its wholly owned subsidiaries (the 'Company') and certain other assets and operations owned by an entity affiliated through common ownership. HGA was a wholly owned subsidiary of PsychGroup, Inc. which in turn is wholly owned by Nu-Med, Inc. The financial position and results of operations of Hospital Group of America and its subsidiaries may not necessarily be indicative of conditions that may have existed or the results of operations if the Company had been operated as an unaffiliated entity. All intercompany balances and transactions have been eliminated. The Company owns and operates the following psychiatric facilities: BASIS OF PRESENTATION On May 29, 1992, PSG Acquisition, Inc., a wholly owned subsidiary of The Cooper Companies, Inc. ('Cooper'), acquired all of the issued and outstanding capital stock of HGA from PsychGroup, Inc. Concurrent with the acquisition, all due from related parties balances as of May 29, 1992 were forgiven. The accompanying financial statements represent the financial position and results of operations of the Company as of May 29, 1992 immediately prior to the acquisition and the periods from May 1, 1991 to May 31, 1991 and June 1, 1991 to May 29, 1992 just prior to the acquisition and reflect the elimination of the due from related parties balances as of May 29, 1992 with a corresponding charge to retained earnings in the amount of $20,595,000. NET PATIENT SERVICE REVENUE Net patient service revenue is recorded at the estimated net realizable amounts from patients, third-party payors, and others for services rendered, including estimated retroactive adjustments under reimbursement agreements with third-party payors. Retroactive adjustments are accrued on an estimated basis in the period the related services are rendered and adjusted in the period as final settlements are determined. CHARITY CARE The Company provides care to indigent patient who meet certain criteria under its charity care policy without charge or at amounts less than its established rates. Because the Company does not pursue collection of amount determined to qualify as charity care, they are not reported as revenue. The HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) PERIODS FROM MAY 1, 1991 TO MAY 31, 1991 AND JUNE 1, 1991 TO MAY 29, 1992 Company maintains records to identify and monitor the level of charity care it provides. These records include the amount of charges foregone for services and supplies furnished under its charity care policy. Charges at the Company's established rates foregone for charity care provided by the Company amounted to $326,000 during the month of May 1991 and $4,768,000 for the period from June 1, 1991 to May 29, 1992. Hampton Hospital is required by its Certificate of Need to incur not less than 10% of total patient days as free care. HEALTH INSURANCE COVERAGE Effective October 1, 1991, the Company is self-insured for the health insurance coverage offered to its employees. The provision for estimated self-insured health insurance costs includes management's estimates of the ultimate costs for both reported claims and claims incurred but not reported. SUPPLIES Supplies consist principally of medical supplies and are stated at the lower of cost (first-in, first-out method) or market. PROPERTY AND EQUIPMENT Property and equipment are stated at cost. Depreciation is computed on the straight-line method over the estimated useful lives of the respective assets, which range from 20 to 40 years for buildings and improvements, and 5 to 10 years for equipment, furniture and fixtures. OTHER ASSETS Pre-opening costs incurred in new facilities and loan fees incurred in obtaining long-term financing are deferred and recorded as other assets. Pre-opening costs are amortized on a straight-line basis over five years. The unamortized portion of pre-opening costs was $21,000 at May 29, 1992. Loan fees are amortized over the terms of the related loans. The balance of unamortized loan fees amounted to $802,000 at May 29, 1992. INCOME TAXES The Company was included in the consolidated tax returns of Nu-Med. The Company computes a tax provision as if it were a stand-alone entity. The corresponding liability for such taxes is included in the net amount Due from Related Parties. CASH AND CASH EQUIVALENTS Cash and cash equivalents include investments in highly liquid debt instruments with a maturity of three months or less. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) PERIODS FROM MAY 1, 1991 TO MAY 31, 1991 AND JUNE 1, 1991 TO MAY 29, 1992 B. NET PATIENT SERVICE REVENUE The Company has agreements with third-party payors that provide for payments to the Company at amounts different from its established rates. A summary of the payment arrangements with major third-party payors follows: Commercial Insurance -- Most commercial insurance carriers reimburse the Company on the basis of the hospitals' charges, subject to the rates and limits specified in their policies. Patients covered by commercial insurance generally remain responsible for any differences between insurance proceeds and total charges. Blue Cross -- Reimbursement under Blue Cross plans varies depending on the areas in which the Company presently operates facilities. Benefits paid to the Company can be charge-based, cost-based, negotiated per diem rates or approved through a state rate setting process. Medicare -- Services rendered to Medicare program beneficiaries are reimbursed under a retrospectively determined reasonable cost system with final settlement determined after submission of annual cost reports by the Company and audits thereof by the Medicare fiscal intermediary. Managed Care -- Services rendered to subscribers of health maintenance organizations, preferred provider organizations and similar organizations are reimbursed based on prospective negotiated rates. The Company's business activities are primarily with large insurance companies and federal and state agencies or their intermediaries. Other than adjustments arising from audits by certain of these agencies, the risk of loss arising from the failure of these entities to perform according to the terms of their respective contracts is considered remote. C. RELATED PARTY TRANSACTIONS Due from related parties consisted primarily of cash advances to Nu-Med and income tax obligations. Included in the Other Operating Revenue are management fees of $320,000 for the month of May 1991 and $3,557,000 for the period from June 1, 1991 to May 29, 1992 charged to other affiliated entities which are under common ownership. In connection with the acquisition of HGA, all due from related parties balances as of May 29, 1992 were forgiven and the balance of $20,595,000 as of that date was eliminated with a corresponding charge to retained earnings. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) PERIODS FROM MAY 1, 1991 TO MAY 31, 1991 AND JUNE 1, 1991 TO MAY 29, 1992 D. EMPLOYEE BENEFITS The Company participated in the Nu-Med Combined Savings Plan, (the 'Plan'), which covers substantially all full-time employees with more than one year of service. Nu-Med may make annual contributions to the Plan based upon earnings, which the Plan may utilize to acquire Nu-Med common stock. In addition, Nu-Med may make contributions to the Plan in the form of Nu-Med common stock. No such contributions were made during the periods ended May 31, 1991 and May 29, 1992. The Company does not provide post-retirement benefits to its employees. Hartgrove had a defined benefit pension plan, which was terminated during the period ended May 29, 1992, at which time all benefits became fully vested. The excess of plan assets over vested benefits amounted to approximately $94,000. Such amount has been recorded as other operating revenue in the accompanying statement of earnings. E. LONG TERM DEBT Long-term debt at May 29, 1992 consists of the following: HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) PERIODS FROM MAY 1, 1991 TO MAY 31, 1991 AND JUNE 1, 1991 TO MAY 29, 1992 Annual maturities of long-term debt are as follows: The long-term debt agreements contain several covenants, including the maintenance of certain ratios and levels of net worth (as defined), restrictions with respect to the payments of cash dividends on common stock and on the levels of capital expenditures, interest and debt payments. In addition, the Industrial Revenue Bonds give the holders the right to accelerate all outstanding principal at December 31, 1995 upon notification one year prior to that date. Substantially all of the property and equipment and accounts receivable of the Company collateralize the debt outstanding. F. COMMITMENTS AND CONTINGENCIES In the normal course of business, the Company is involved in various litigation cases. In the opinion of management, the disposition of such litigation will not have a material adverse effect on the Company's consolidated financial position. The Company leases certain space and equipment under operating lease agreements. The following is a schedule of estimated minimum payments due under such leases with an initial term of more than one year as of May 29, 1992: Some of the operating leases contain provisions for renewal or increased rental (based upon increases in the Consumer Price Index), none of which are taken into account in the above table. Rental expense under all operating leases amounted to $37,000 and HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) PERIODS FROM MAY 1, 1991 TO MAY 31, 1991 AND JUNE 1, 1991 TO MAY 29, 1992 $619,000 for the periods from May 1, 1991 to May 31, 1991 and June 1, 1991 to May 29, 1992. G. INCOME TAXES The provision for income taxes for the following periods are composed of the following: The provision for income taxes included in the consolidated statements of earnings differs from the amount computed by applying the statutory federal income tax rate of 34% to earnings before taxes due to the effect of the state franchise taxes, net of federal benefit. This amounted to 6% for the periods presented. In February 1992, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 109, 'Accounting for Income Taxes.' Cooper and the Company are required to adopt the new method of accounting for income taxes no later than the fiscal year ending October 31, 1994. Neither the Company nor Cooper has completed an analysis to estimate the impact of the statement on the Company's consolidated financial statements. H. DEPENDENCE UPON COOPER The Company has incurred losses and negative cash flows since May 30, 1992, and has a working capital deficiency at October 31, 1993 which includes a liability to Cooper of $6,082,000. Cooper has provided the Company with cash advances to meet its cash needs. The independent auditors, report dated January 24, 1994 on Cooper's October 31, 1993 consolidated financial statements includes the following explanatory paragraph: 'The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. During the past three fiscal years, the Company has suffered significant losses and negative cash flows. In addition, as discussed in Note 18 to the financial statements the Company is exposed to contingent liabilities relatated to a criminal conviction and a Securities and Exchange Commission action. Such losses, negative cash flows and contingent liabilities raise substantial doubt about the Company's ability to continue as a going concern. The consolidated financial statements and financial statement schedules do not include any adjustments that might result from the outcome of these uncertainties.' HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) PERIODS FROM MAY 1, 1991 TO MAY 31, 1991 AND JUNE 1, 1991 TO MAY 29, 1992 The Company is unable to predict the effect, if any, of the uncertainty concerning Cooper's ability to continue as a going concern on its financial condition or results of operations. The aforementioned factors raise substantial doubt about the Company's ability to continue as a going concern. The financial statements do not include any adjustments that might be necessary if the Company or Cooper is unable to continue as a going concern. I. Subsequent Event Pursuant to a pledge agreement dated as of January 6, 1994, between the Parent and the trustee for the holders of a new class of debt issued by the Parent (the 'Notes'), the Parent has pledged a first priority security interest in all of its right, title and interest in stock of the Company, all additional shares of stock of, or other equity interest in, the Company from time to time acquired by the Parent, all intercompany indebtedness of the Company from time to time held by the Parent and except as set forth in the indenture to the Notes, the proceeds received from the sale or disposition of any or all of the foregoing. A full description of the pledge agreement and terms of the indenture to the Notes is included in the Parent's Amended and Restated Offer to Exchange and Consent Solicitation filed with the Securities and Exchange Commission on December 15, 1993. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET APRIL 30, 1991 See accompanying notes to consolidated financial statements. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF EARNINGS YEAR ENDED APRIL 30, 1991 See accompanying notes to consolidated financial statements. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF STOCKHOLDER'S EQUITY YEAR ENDED APRIL 30, 1991 See accompanying notes to consolidated financial statements. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS YEAR ENDED APRIL 30, 1991 See accompanying notes to consolidated financial statements. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEAR ENDED APRIL 30, 1991 A. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Business -- The accompanying consolidated financial statements include the accounts of Hospital Group of America, Inc., (HGA) and its wholly owned subsidiaries (the 'Company') and certain other assets and operations owned by an entity affiliated through common ownership. HGA was a wholly owned subsidiary of PsychGroup, Inc. which in turn is wholly-owned by Nu-Med, Inc. ('Nu-Med'). The financial position and results of operations of HGA and its subsidiaries may not necessarily be indicative of conditions that may have existed or the results of operations if the Company had been operated as an unaffiliated entity. All intercompany balances and transactions have been eliminated. The Company owns and operates the following psychiatric facilities: Basis of Presentation -- On May 29, 1992, PSG Acquisition, Inc., a wholly owned subsidiary of The Cooper Companies, Inc. ('Cooper'), acquired all of the issued and outstanding capital stock of HGA from PsychGroup, Inc. Concurrent with the acquisition, all due from related parties balances as of May 29, 1992 were forgiven. The accompanying financial statements represent the historical position and results of operations of the Company as of April 30, 1991 and for the year then ended. The accompanying financial statements do not reflect the elimination of the due from related parties balances with a corresponding charge to retained earnings which as of May 29, 1992 amounted to $20,595,000. Net Patient Service Revenue -- Net patient service revenue is recorded at the estimated net realizable amounts from patients, third-party payors, and others for services rendered, including estimated retroactive adjustments under reimbursement agreements with third-party payors. Retroactive adjustments are accrued on an estimated basis in the period the related services are rendered and adjusted in the period as final settlements are determined. Charity Care -- The Company provides care to indigent patients who meet certain criteria under its charity care policy without charge or at amounts less than its established rates. Because the Company does not pursue collection of amounts determined to qualify as charity care, they are not reported as revenue. The Company maintains records to identify and monitor the level of charity care it provides. These records include the amount of charges foregone for services and supplies furnished under its charity care policy. Charges at the Company's established rates foregone for charity care provided by the Company amounted to $3,457,000 for the year ended April 30, 1991. Hampton Hospital is required by its Certificate of Need to incur not less than 10% of total patient days as free care. Supplies -- Supplies consist principally of medical supplies and are stated at the lower of cost (first-in, first-out method) or market. Property and Equipment -- Property and equipment are stated at cost. Depreciation is computed on the straight-line method over the estimated useful lives of the respective assets, which range from 20 to 40 years for buildings and improvements, and 5 to 10 years for equipment, furniture and fixtures. Other Assets -- Pre-opening costs incurred in new facilities and loan fees incurred in obtaining long-term financing are deferred and recorded as other assets. Pre-opening costs are amortized on a straight-line basis over five years. Loan fees are amortized over the terms of the related loans. The balance of unamortized loan fees was $896,000 as of April 30, 1991. Income Taxes -- The Company was included in the consolidated tax returns of Nu-Med. The Company computes a tax provision as if it were a stand alone entity. The corresponding liability for such taxes is included in the net amount Due from Related Parties. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEAR ENDED APRIL 30, 1991 Malpractice Insurance Coverage -- Medical malpractice claims were covered by an occurrence-basis medical malpractice insurance policy. In the opinion of management, sufficient reserves have been established for any potential deductible to be paid by the Company. These reserves are maintained upon Nu-Med's financial statements and are not allocated to individual subsidiaries. The costs and deductibles associated with the policy are allocated to the Company and are included in operating expenses. Subsequent to October 1, 1991, the Company became directly responsible for its own malpractice insurance, with Nu-Med being responsible for any tail coverage through May 29, 1992. B. NET PATIENT SERVICE REVENUE The Company has agreements with third-party payors that provide for payments to the Company at amounts different from its established rates. A summary of the payment arrangements with major third-party payors follows: Commercial Insurance -- Most commercial insurance carriers reimburse the Company on the basis of the hospitals' charges, subject to the rates and limits specified in their policies. Patients covered by commercial insurance generally remain responsible for any differences between insurance proceeds and total charges. Blue Cross -- Reimbursement under Blue Cross plans varies depending on the areas in which the Company presently operates facilities. Benefits paid to the Company can be charge-based, cost-based, negotiated per diem rates or approved through a state rate setting process. Medicare -- Services rendered to Medicare program beneficiaries are reimbursed under a retrospectively determined reasonable cost system with final settlement determined after submission of annual cost reports by the Company and audits thereof by the Medicare fiscal intermediary. Managed Care -- Services rendered to subscribers of health maintenance organizations, preferred provider organizations and similar organizations are reimbursed based on prospective negotiated rates. The Company's business activities are primarily with large insurance companies and federal and state agencies or their intermediaries. Other than adjustments arising from audits by certain of these agencies, the risk of loss arising from the failure of these entities to perform according to the terms of their respective contracts is considered remote. C. RELATED PARTY TRANSACTIONS Amounts due from (to) related parties at April 30, 1991 were composed of the following (in thousands of dollars): Due from Nu-Med, Inc. consists primarily of cash advances, transfers of certain assets and income tax obligations. The repayment of this obligation was not expected to commence within 12 months and was to be repaid over a period of years. Therefore, this amount was classified as a long-term receivable at April 30, 1991. In connection with the acquisition of HGA, all due from related parties balances as of May 29, 1992 were forgiven and the balance of $20,595,000 as of that date was eliminated with a corresponding charge to retained earnings. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEAR ENDED APRIL 30, 1991 Included in Other Operating Revenue are management fees charged to other affiliated entities which are under common ownership. Such fees amounted to $3,172,000 for 1991. D. LONG TERM DEBT Long-term debt consists of the following: Scheduled annual maturities of long-term debt as of April 30, 1991 are as follows: The long-term debt agreements contain several covenants, including the maintenance of certain ratios and levels of net worth (as defined), restrictions with respect to the payments of cash dividends on common stock and on the levels of capital expenditures, interest and debt payments. In addition, the Industrial Revenue Bonds give the holders the right to accelerate all outstanding principal at December 31, 1995 upon notification one year prior to that date. Substantially all of the property and equipment and accounts receivable of the Company collateralize the debt outstanding. E. EMPLOYEE BENEFITS The Company participated in the Nu-Med Combined Savings Plan, (the 'Plan'), which covers substantially all full-time employees with more than one year of service. Nu-Med may make annual contributions to the Plan based upon earnings, which the Plan may utilize to acquire Nu-Med common stock. In addition, Nu-Med may make contributions to the Plan in the form of Nu-Med common stock. No such contributions were made during the year ended April 30, 1991. The Company does not provide postretirement benefits to its employees. F. COMMITMENTS AND CONTINGENCIES In the normal course of business, the Company is involved in various litigation. In the opinion of management, the disposition of such litigation will not have a material adverse effect on the Company's consolidated financial position. HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEAR ENDED APRIL 30, 1991 The Company leases certain space and equipment under operating lease agreements. The following is a schedule of estimated minimum payments due under such leases with an initial term of more than one year as of April 30, 1991 (in thousands of dollars): Some of the operating leases contain provisions for renewal or increased rental (based upon increases in the Consumer Price Index), none of which are taken into account in the above table. Rental expense under all operating leases amounted to $357,000 in 1991. G. INCOME TAXES The provision for income taxes is composed of the following (in thousands of dollars): The provision for income taxes included in the consolidated statements of earnings differs from the amount computed by applying the statutory federal income tax rate of 34% to earnings before taxes due to the effect of the state franchise taxes, net of federal benefit. This amounted to 5% for the year ended April 30, 1991. In February 1992, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 109. 'Accounting for Income Taxes'. Cooper and the Company are required to adopt the new method of accounting for income taxes no later than the fiscal year ending October 31, 1994. Neither the Company nor Cooper has completed an analysis to estimate the impact of the statement on the Company's consolidated financial statements. H. DEPENDENCE UPON COOPER The Company has incurred losses and negative cash flows since May 30, 1992, and has a working capital deficiency at October 31, 1993 which includes a liability to Cooper of $6,082,000. Cooper has provided the Company with cash advances to meet its cash needs. The independent auditors' report dated January 24, 1994 on Cooper's October 31, 1993 consolidated financial statements includes the following explanatory paragraph: 'The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. During the past three fiscal years, the Company has suffered significant losses and negative cash flows. In addition, as discussed in Note 18 to the financial statements the Company is exposed to contingent liabilities related to a criminal conviction and a Securities and Exchange Commission motion. Such losses, negative cash flows, and contingent liabilities raise substantial doubt about the Company's ability to continue as a going concern. The consolidated financial statements and financial statement schedules do not include any adjustments that might result from the outcome of these uncertainties.' HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) YEAR ENDED APRIL 30, 1991 The Company is unable to predict the effect, if any, of the uncertainty concerning Cooper's ability to continue as a going concern on its financial condition or results of operations. The aforementioned factors raise substantial doubt about the Company's ability to continue as a going concern. The financial statements do not include any adjustments that might be necessary if the Company or Cooper is unable to continue as a going concern. I. SUBSEQUENT EVENT Pursuant to a pledge agreement dated as of January 6, 1994, between the Parent and the trustee for the holders of a new class of debt issued by the Parent (the 'Notes'), the Parent has pledged a first priority security interest in all of its right, title and interest in stock of the Company, all additional shares of stock of, or other equity interest in, the Company from time to time acquired by the Parent, all intercompany indebtedness of the Company from time to time held by the Parent and except as set forth in the indenture to the Notes, the proceeds received from the sale or disposition of any or all of the foregoing. A full description of the pledge agreement and terms of the indenture governing the Notes is included in the Parent's Amended and Restated Offer to Exchange and Consent Solicitation filed with the Securities and Exchange Commission on December 15, 1993. SCHEDULE V HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES PROPERTY AND EQUIPMENT YEAR ENDED OCTOBER 31, 1993 PERIOD FROM MAY 30, 1992 TO OCTOBER 31, 1992 PERIOD FROM JUNE 1, 1991 TO MAY 29, 1992 PERIOD FROM MAY 1, 1991 TO MAY 31, 1991 YEAR ENDED APRIL 30, 1991 - ------------ (A) Includes adjustment of accounts to fair value pursuant to the implementation of purchase accounting. SCHEDULE VI HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES ACCUMULATED DEPRECIATION OF PROPERTY AND EQUIPMENT YEAR ENDED OCTOBER 31, 1993 PERIOD FROM MAY 30, 1992 TO OCTOBER 31, 1992 PERIOD FROM JUNE 1, 1991 TO MAY 29, 1992 PERIOD FROM MAY 1, 1991 TO MAY 31, 1991 YEAR ENDED APRIL 30, 1991 - ------------ (A) Write-off of accumulated depreciation pursuant to the implementation of purchase accounting. SCHEDULE VIII HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS YEAR ENDED OCTOBER 31, 1993 PERIOD FROM MAY 30, 1992 TO OCTOBER 31, 1992 PERIOD FROM JUNE 1, 1991 TO MAY 29, 1992 PERIOD FROM MAY 1, 1991 TO MAY 31, 1991 YEAR ENDED APRIL 30, 1991 SCHEDULE X HOSPITAL GROUP OF AMERICA, INC. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION YEAR ENDED OCTOBER 31, 1993 PERIOD FROM MAY 30, 1992 TO OCTOBER 31, 1992 PERIOD FROM JUNE 1, 1991 TO MAY 29, 1992 PERIOD FROM MAY 1, 1991 TO MAY 31, 1991 YEAR ENDED APRIL 30, 1991 - ------------ Royalties, maintenance and repairs and taxes other than payroll and income taxes are omitted as each item does not exceed 1% of net operating revenue as reported in the statement of consolidated operations. INDEPENDENT AUDITORS' REPORT The Board of Directors and Stockholders COOPERSURGICAL, INC. We have audited the accompanying balance sheets of CooperSurgical, Inc. as of October 31, 1993 and 1992, and the related statements of operations, stockholders' deficit, and cash flows for each of the years in the three-year period ended October 31, 1993. In connection with our audits of the financial statements, we also have audited financial statement schedules IV, VIII and X. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of CooperSurgical, Inc. as of October 31, 1993 and 1992, and the results of its operations and its cash flows for each of the years in the three-year period ended October 31,1993 in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. The accompanying financial statements have been prepared assuming CooperSurgical, Inc. will continue as a going concern. As discussed in Note 1 to the financial statements, the Company's recurring losses and negative cash flows from operations raise substantial doubt about the Company's ability to continue as a going concern. Additionally, the independent auditors' report dated January 24, 1994 on the parent's financial statements as of October 31, 1993 included an explanatory paragraph describing a substantial doubt about the parent's ability to continue as a going concern. The accompanying financial statements and financial statement schedules do not include any adjustments that might result from the outcome of these uncertainties. KPMG PEAT MARWICK Stamford, Connecticut January 24, 1994 COOPERSURGICAL, INC. BALANCE SHEET See accompanying notes to financial statements. COOPERSURGICAL, INC. STATEMENTS OF OPERATIONS See accompanying notes to financial statements. COOPERSURGICAL, INC. STATEMENT OF STOCKHOLDERS' DEFICIT YEARS ENDED OCTOBER 31, 1993, 1992, 1991 AND 1990 See accompanying notes to financial statements. COOPERSURGICAL, INC. STATEMENTS OF CASH FLOWS During Fiscal 1993, furniture and equipment with a net book value of $56 were transferred to CooperSurgical from the Parent. This non-cash transaction was recorded as an increase to Parent advances. During Fiscal 1991, CooperSurgical assumed notes payable of $1,525 with the acquisition of Euro-Med Endoscope and Euro-Med, Inc., see Note 2. Also during fiscal 1991, CooperSurgical assumed promissory notes, due to its Parent, as a result of a $450 non-cash equity transfer to its Parent. See accompanying notes to financial statements. COOPERSURGICAL, INC. NOTES TO FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES GENERAL CooperSurgical, Inc. ('CooperSurgical' or the 'Company'), a Delaware corporation, develops, manufactures and distributes electrosurgical, cryosurgical and general application diagnostic surgical instruments and equipment. The Cooper Companies, Inc. ('Parent'), a Delaware corporation, owns 100% of CooperSurgical's Series A preferred stock. CooperSurgical's outstanding common stock is 100% owned by individuals on the CooperSurgical Advisory Board which provides counsel and management of clinical trials in the area of minimally invasive surgery. The accompanying financial statements have been prepared from the separate records of CooperSurgical and may not be indicative of conditions which would have existed or the results of its operations if CooperSurgical operated autonomously (see Note 4). Foreign exchange translation and transactions are immaterial. DEPENDENCE UPON PARENT CooperSurgical has incurred substantial losses and has not generated positive cash flows from operations. The Company is, therefore, dependent upon its Parent for financing to meet its cash obligations. The Company's Parent issued its October 31, 1993 consolidated financial statements on or about January 24, 1994. The independent accountants' report thereon included the following explanatory paragraph: The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. During the past three fiscal years, the Company has suffered significant losses and negative cash flows. In addition, as discussed in Note 18 to the financial statements the Company is exposed to contingent liabilities related to a criminal conviction and a Securities and Exchange Commission action. Such losses, negative cash flows, and contingent liabilities raise substantial doubt about the Company's ability to continue as a going concern. The consolidated financial statements and financial statement schedules do not include any adjustments that might result from the outcome of these uncertainties. The Company is unable to predict the effect, if any, of this uncertainty on its financial condition or results of operations. These factors raise substantial doubt about CooperSurgical's ability to continue as a going concern. The financial statements do not include any adjustments that might be necessary if CooperSurgical or its Parent is unable to continue as a going concern. REVENUE RECOGNITION CooperSurgical recognizes product revenue when risk of ownership has transferred to the buyer, net of appropriate provisions for sales returns and bad debts. PROVISION FOR INCOME TAXES CooperSurgical is included in the consolidated federal income tax return of the Parent pursuant to a tax-sharing agreement. CooperSurgical state and franchise taxes are de minimis. In February 1992, the Financial Accounting Standards Board ('FASB') issued Statement of Financial Accounting Standards No. 109, 'Accounting for Income Taxes.' The Parent and CooperSurgical are required to adopt this method of accounting for income taxes no later than the fiscal year ending October 31, 1994. The Parent anticipates that the adoption of the statement will not have a material impact on CooperSurgical's balance sheet. COOPERSURGICAL, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) INVENTORIES Inventories are carried at the lower of cost, determined on an average cost basis, or market. FURNITURE AND EQUIPMENT Furniture and equipment are carried at cost. Depreciation is computed on the straight line method over the estimated useful lives of depreciable assets. AMORTIZATION OF INTANGIBLES Amortization is currently provided on all intangible assets on a straight line basis over periods up to 20 years. Accumulated amortization at October 31, 1993 and 1992 was $831,000 and $541,000, respectively. NOTE 2. ACQUISITIONS In December 1990 and January 1991, CooperSurgical acquired Euro-Med Endoscope and Euro-Med, Inc. for cash and notes in the amount of $3,250,000. The acquisitions were recorded using the purchase method of accounting. The two companies offer a line of surgical instruments and diagnostic hysteroscopy equipment for use in gynecologic and minimally invasive surgical procedures. Goodwill for these two businesses was $2,082,000 and is being amortized over 20 years. On a pro forma basis, if Euro-Med, Inc. results had been included in CooperSurgical's results beginning November 1, 1990, the pro forma net sales would have been approximately $8,460,000 and loss before provision of income taxes would have been approximately $3,406,000. In a separate transaction, CooperSurgical purchased distribution rights associated with the aforementioned surgical instruments and diagnostic hysteroscopy equipment from the previous owners of Euro-Med Endoscope and Euro-Med, Inc. for $256,000. NOTE 3. ACCOUNTS PAYABLE CooperSurgical utilized a cash concentration account with the Parent whereby approximately $131,000 and $293,000 of checks issued and outstanding at October 31, 1993 and 1992, respectively, in excess of related bank cash balances were reclassified to accounts payable. Sufficient funds were available from the Parent to cover these checks. NOTE 4. RELATED PARTY TRANSACTIONS Included in CooperSurgical's selling, general and administrative expense are Parent allocations for technical service fees of $1,312,000, $341,000 and $279,000 for the three years ended October 31, 1993, 1992 and 1991 respectively. 1993 technical service fees include $134,000 relating to redetermination of appropriate amount for the year ended October 31, 1992. These costs are charges from the Parent for accounting, legal, tax and other services provided to CooperSurgical. COOPERSURGICAL, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) Amounts due to the parent at October 31, 1993 and 1992 were composed of the following: NOTE 5. LONG TERM DEBT Long term debt consists of the following: Annual maturities of long-term debt, including current installments thereof, are as follows: NOTE 6. COMMITMENTS AND CONTINGENCIES In the normal course of its business, CooperSurgical is involved in various litigation cases. In the opinion of management, the disposition of such litigation will not have a materially adverse effect on CooperSurgical's financial condition. CooperSurgical leases certain property and equipment under operating lease agreements. The following is a schedule of the estimated minimum payment due under such leases with an initial term of more than one year as of October 31, 1993: Rental expense for all leases amounted to approximately $340,000 and $322,000 for the years ended October 31, 1993 and 1992, respectively. NOTE 7. EMPLOYEE BENEFITS CooperSurgical employees are eligible to participate in the Parent's 401(k) Savings Plan, a defined contribution plan and the Parent's Retirement Income Plan, a defined benefit plan. As of October 31, COOPERSURGICAL, INC. NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) 1993, CooperSurgical has not elected to participate in the Parent's Retirement Income Plan. Costs and expenses of administration of the Parent's 401(k) Savings Plan are allocated to CooperSurgical as appropriate. These costs were not significant for the years ended October 31, 1993, 1992 and 1991. NOTE 8. SERIES A CONVERTIBLE PREFERRED STOCK The Series A Convertible Preferred Stock is convertible into Common Stock on a one-to-one basis, subject to adjustment for stock splits, dividends and certain other distributions of Common Stock and has voting rights equal to the number of shares of Common Stock into which it is convertible. The Preferred Stock has a liquidation preference of $1.940625 per share and accrues cumulative dividends of $0.1940625 per share per annum. The aggregate liquidation preference of the Preferred Stock at October 31, 1993 is $1,242,000, plus cumulative dividends of $248,000. The Preferred Stock participates ratably with the Common Stock in any additional dividends declared beyond the cumulative dividends and in any remaining assets beyond the liquidation preference. The Series A Convertible Preferred Stock represents 96.5% of the total voting rights of all outstanding CooperSurgical stock. NOTE 9. INCOME TAXES As of October 31, 1993, CooperSurgical, Inc. had federal tax net operating loss carryforwards of $12,611,000 expiring as follows: 2006 -- $3,260,000, 2007 -- $3,083,000, and 2008 -- $6,268,000. The tax benefits attributable to the net operating loss carryforwards have not been recognized in the statements of operations for each of the years in the three year period ended October 31, 1993 due to the uncertainty of future taxable income. NOTE 10. SUBSEQUENT EVENT Pursuant to a pledge agreement dated as of January 6, 1994, between the Parent and the trustee for the holders of a new class of debt issued by the Parent (the 'Notes'), the Parent has pledged a first priority security interest in all of its right, title and interest in stock of CooperSurgical, all additional shares of stock of, or other equity interests in, CooperSurgical from time to time acquired by the Parent, all intercompany indebtedness of CooperSurgical from time to time held by the Parent and, except as set forth in the indenture governing the Notes, the proceeds received from the sale or disposition of any or all of the foregoing. A full description of the pledge agreement and terms of the indenture governing the Notes is included in the Parent's Amended and Restated Offer to Exchange and Consent Solicitation filed with The Securities and Exchange Commission on December 15, 1993. On January 24, 1994, the Company's Parent converted $19,012,000 of outstanding Parent advances into 9,796,660 shares of the Company's Series A preferred stock and converted the remaining $3,313,000 balance of CooperSurgical's liability to its Parent into a promissory note due January 24, 1996. As a result of this transaction, advances due to Parent have been classified as long-term. SCHEDULE IV COOPERSURGICAL, INC. INDEBTEDNESS OF AND TO RELATED PARTIES -- NOT CURRENT THREE YEARS ENDED OCTOBER 31, 1993 SCHEDULE VIII COOPERSURGICAL, INC. VALUATION AND QUALIFYING ACCOUNTS THREE YEARS ENDED OCTOBER 31, 1993 SCHEDULE X COOPERSURGICAL, INC. SUPPLEMENTARY INCOME STATEMENT INFORMATION THREE YEARS ENDED OCTOBER 31, 1993 - ------------ * Royalties, maintenance and repairs, and taxes other than payroll are omitted as each item does not exceed 1% of net operating revenue as reported in the statement of operations. 3. Exhibits. (b) Reports on Form 8-K. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on January 26, 1994. THE COOPER COMPANIES, INC. By: /s/ ALLAN E. RUBENSTEIN ... ALLAN E. RUBENSTEIN ACTING CHAIRMAN OF THE BOARD OF DIRECTORS Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on January 26, 1994. STATEMENT OF DIFFERENCES

75042_1993.txt

75042

1993

ITEM 1. BUSINESS (a) General Development of Business Oshkosh B'Gosh, Inc. (together with its subsidiaries, the "Company") was founded in 1895 and was incorporated in the state of Delaware in 1929. The Company designs, manufactures, sources and sells apparel for the children's wear, youth wear, and men's wear markets. While its heritage is in the men's workwear market, the Company is currently best known for its line of high quality children's wear. The children's wear business represented approximately 89% of consolidated Company revenues for 1993. The success of the children's wear business can be attributed to the Company's core themes: quality, durability, style, trust and Americana. These themes have propelled the Company to the position of market leader in the branded children's wear industry. The Company also leverages the economic value of the OshKosh B'Gosh name via both domestic and international licensing agreements. The Company's long-term strategy is to provide high quality, high value clothing for the entire family. Toward this end the Company continues to expand its business lines and avenues for marketing its products. Essex Outfitters, Inc. ("Essex"), a wholly owned subsidiary the Company acquired in 1990, is a vertically integrated children's wear retailer. Essex sources its apparel from third party manufacturers, primarily offshore, imports these goods and sells them primarily through its own chain of 52 retail stores. OshKosh B'Gosh International Sales, Inc. was created in 1985 for the sale of Oshkosh B'Gosh products to foreign distributors. In 1990, the Company formed OshKosh B'Gosh Europe, S.A. in conjunction with a joint venture with Poron Diffusion, S.A. to provide further access to European markets. In 1992 the Company acquired Poron's 49% interest in OshKosh B'Gosh Europe, S.A. During 1993 OshKosh B'Gosh made moves to strategically position itself for international expansion. OshKosh B'Gosh Asia/Pacific Ltd. was created in Hong Kong to oversee licensees and distributors in the Pacific Rim, to assist international licensees with the sourcing of product, and to expand the Company's presence in that region. OshKosh B'Gosh U.K. Ltd. and OshKosh B'Gosh Deutschland GmbH, incorporated in the United Kingdom and Germany respectively, were established to increase sales emphasis in those countries. The Company's chain of 40 OshKosh B'Gosh factory outlet stores sell irregular and first quality OshKosh B'Gosh merchandise throughout the United States. In 1993, the Company distributed its first children's wear mail order catalog, further expanding its channels of distribution. The Company has been expanding its utilization of off-shore sourcing as a cost-effective means to produce its products and to this end leased a production facility in Honduras in 1990 under its wholly owned subsidiary Manufacturera International Apparel S.A. (b) Financial Information About Industry Segments The Company is engaged in only one line of business, namely, the apparel industry. (c) Narrative Description of Business Products The Company designs, manufactures, sources and markets a broad range of children's clothing as well as lines of youth wear and men's casual and work wear clothing under the OshKosh, OshKosh B'Gosh, Baby B'Gosh or Boston Trader labels. The products are distributed primarily through better quality department and specialty stores, 92 of the Company's own stores, direct mail catalogs and foreign retailers. The children's wear business, which is the largest segment of the business, accounted for approximately 89% of 1993 sales compared to approximately 96% and 93% of such sales in 1992 and 1991 respectively. The children's wear and youth wear business is targeted to reach the middle to upper middle segment of the sportswear market. Children's wear is in size ranges from newborn/infant to girls 6X and boys 7. Youth wear is in size ranges girls 7 to 14 and boys 8 to 20. The Company's children's wear and youth wear businesses include a broad range of product categories organized primarily in a collection format whereby the products in that collection share a primary design theme which is carried out through fabric design, screenprint, embroidery, and trim applications. The Company also offers basic denim products with multiple wash treatments. The product offerings for each season will typically consist of a variety of clothing items including bib overalls, pants, jeans, shorts, and shortalls (overalls with short pant legs), shirts, blouses and knit tops, skirts, jumpers, sweaters, dresses, playwear and fleece. The men's wear line is the original business that started the Company back in 1895. The current line comprises the traditional bib overalls, several styles of waistband work, carpenter, and painters pants, five and six pocket jeans, work shirts and flannel shirts as well as a coats and jackets. The line is designed with a full array of sizes up to and including size 60 inch waists and 5x size shirts. Most products are designed by an in-house staff. Product design requires long lead times, with products generally being designed a year in advance of the time they actually reach the retail market. In general, the Company's products are traditional in nature and not intended to be "designer" items. In designing new products and styles, the Company attempts to incorporate current trends and consumer preferences in their traditional product offerings. In selecting fabrics and prints for its products, the Company seeks, where possible, to obtain exclusive rights to the fabric design from its suppliers in order to provide the Company with some protection from imitation by competitors for a limited period of time. Raw Materials, Manufacturing and Sourcing All raw materials used in the manufacture of Company products are purchased from unaffiliated suppliers. In 1993, approximately 65% of the Company's direct expenditures for raw materials were from its five largest suppliers, with the largest such supplier accounting for approximately 25% of total raw material expenditures. Fabric and various non-fabric items, such as thread, zippers, rivets, buckles and snaps are purchased from a variety of independent suppliers. The fabric and accessory market in which OshKosh B'Gosh purchases its raw materials is composed of a substantial number of suppliers with similar products and capabilities, and is characterized by a high degree of competition. As is customary in its industry, the Company has no long-term contracts with its suppliers. To date, the Company has experienced little difficulty in satisfying its requirements for raw materials, considers its sources of supply to be adequate, and believes that it would be able to obtain sufficient raw materials should any one of its product suppliers become unavailable. In 1993, approximately 79% of the Company products were manufactured in the United States using American-made textiles. Production administration is primarily coordinated from the Company's headquarters facility in Oshkosh with most production taking place in its eleven Tennessee and five Kentucky plants. Overseas labor is also accessed through a leased sewing plant in Honduras, where cut apparel pieces are received from the United States and are reimported by OshKosh B'Gosh as finished goods. In addition, product is produced by contractors in 14 countries and imported. The majority of the product engineering and sample making, allocation of production among plants and independent suppliers, material purchases and invoice payments are done through the Company's Oshkosh headquarters. All designs and specifications utilized by independent manufacturers are provided by the Company. While no long-term, formal arrangements exist with these manufacturers, the Company considers these relationships to be satisfactory. The Company believes it could obtain adequate alternative production capacity if any of its independent manufacturers become unavailable. Because higher quality apparel manufacturing is generally labor intensive (sewing, pressing, finishing and quality control) the Company has continually sought to upgrade its manufacturing and distribution facilities. Economies are therefore realized by technical advances in areas like computer-assisted design, computer-controlled fabric cutting, computer evaluation and matching of fabric colors, automated sewing processes, and computer-assisted inventory control and shipping. In order to realize economies of operation within the domestic production facilities, cutting operations are located in 5 of the Company's 18 plants, with all product washing, pressing and finishing done in one facility in Tennessee and all screenprint and embroidery done in one facility in Kentucky. Quality control inspections of both semi-finished and finished products are required at each plant, including those of independent manufacturers, to assure compliance. Customer orders for fashion products are booked from three to six months in advance of shipping. Because most Company production of styled products is scheduled to fill orders already booked, the Company believes that it is better able to plan its production and delivery schedules than would be the case if production were in advance of actual orders. In order to secure necessary fabrics on a timely basis and to obtain manufacturing capacity from independent suppliers, the Company must make substantial advance commitments, often as much as five to seven months prior to receipt of customer orders. Inventory levels therefore depend on Company judgment of market demand. Trademarks The Company utilizes the OshKosh, OshKosh B'Gosh or Baby B'Gosh trademarks on most of its products, either alone or in conjunction with a white triangular background. In addition, "The Genuine Article" is embroidered on the small OshKosh B'Gosh patch to signify apparel that is classic in design and all-but- indestructible in quality construction. The Company currently uses approximately 21 registered and unregistered trademarks in the United States. These trademarks and universal awareness of the OshKosh B'Gosh name are significant in marketing the products. In addition the Company licenses the Boston Trader and Trader Kids trademarks for use on its youth wear and some children's wear. The Company has recently decided to replace its Boston Trader line of children's apparel with a new brand called Genuine Kids. Seasonality Products are designed and marketed primarily for three principal selling seasons: RETAIL SALES SEASON PRIMARY BOOKING PERIOD SHIPPING PERIOD Spring/Summer August-September January-April Fall/Back-to-School January-February May-August Winter/Holiday May-June September-December Spring/Summer and Fall/Back-to-School are the Company's primary selling seasons and together accounted for approximately 65% of the Company's 1993 wholesale sales. The Company has historically experienced and expects to continue to experience seasonal fluctuations in its sales and net income from its OshKosh B'Gosh factory stores and Trader Kids outlet stores. Historically, a disproportionately high amount of the Company's retail sales and a majority of its net income have been realized during the months of August and November. Working Capital Working capital needs are affected primarily by inventory levels, outstanding accounts receivables and trades payables. The Company has unsecured credit arrangements, negotiated annually, which provide for maximum borrowings and letters of credit totalling $60 million at December 31, 1993 including $45 million under commercial paper borrowing arrangements. These credit arrangements are used to support working capital needs as well a support letters of credit issued for product being imported and other corporate needs. As of December 31, 1993 there were no outstanding obligations against these credit arrangements. Letters of credit of approximately $15 million were outstanding at December 31, 1993. Inventory levels are affected by order backlog and anticipated sales, accounts receivables are affected by payment terms offered. It is general practice in the apparel industry to offer payment terms of ten to sixty days from date of shipment. The Company offers net 30 days terms only. The Company believes that its working capital requirements and financing resources are comparable with those of other major, financially sound apparel manufacturers. Sales and Marketing Company products are sold primarily through better quality department and specialty stores, although sales are also made through direct mail catalog companies, foreign retailers and other outlets, including 91 Company operated retail factory stores and one retail showcase store. One customer, J. C. Penney Company, Inc., accounted for approximately 10.2% of the Company's 1993 sales, and its largest ten and largest 100 customers accounted for approximately 47% and 67% of sales, respectively. In 1993, the Company's products were sold to approximately 4,200 customers (14,000 to 15,000 stores) throughout the United States, and a sizeable number of international accounts. Products are sold primarily by a direct employee sales force with the balance of sales made through manufacturer's representatives, to in-house accounts or through outlet stores. In addition to the central sales office in Oshkosh, the Company maintains regional sales offices and product showrooms in Dallas and New York. Most members of the Company's sales force are assigned to defined geographic territories, with some assigned to specific large national accounts. In sparsely populated areas and new markets, a manufacturer's representative represents the Company on a non-exclusive basis. Direct advertising in consumer and trade publications is the primary method of advertising used. The Company also offers a cooperative advertising program, paying half of its customers' advertising expenditures for their products, generally up to two percent of the higher of the customer's prior or current year's gross purchases from the Company. Backlog The dollar amount of backlog of orders believed to be firm as of the end of the Company's fiscal year and as of the preceding fiscal year is not material for an understanding of the business of the Company taken as a whole. Competitive Conditions The apparel industry is highly competitive and consists of a number of domestic and foreign companies. Some competitors have assets and sales greater than those of the Company. In addition, the Company competes with a number of firms that produce and distribute only a limited number of products similar to those sold by the Company or sell only in certain geographic areas being supplied by the Company. A characteristic of the apparel industry is the requirement that a manufacturer recognize fashion trends and adequately provide products to meet such trends. Competition within the apparel industry is generally in terms of quality, price, service, style and, with respect to branded product lines, consumer recognition and preference. The Company believes that it competes primarily on the basis of quality, style, and consumer recognition and to a lesser extent on the basis of service and price. The Company is focusing attention on the issue of price and service and has taken and will continue to take steps to reduce prices, become more competitive in the eyes of value conscious consumers and deliver the service expected by its customers. The Company's share of the overall children's wear market is quite small. This is due to the diverse structure of the market where there is no truly dominant producer of children's garments across all size ranges and garment types. In the Company's channel of distribution, department and speciality stores, it holds the largest share of the children's wear market. Environmental Matters The Company's compliance with Federal, State, and local environmental laws and regulations had no material effect upon its capital expenditures, earnings, or competitive position. The Company does not anticipate any material capital expenditures for environmental control in either the current or succeeding fiscal years. Employees At December 31, 1993, the Company employed approximately 6,400 persons. Approximately 43% of the Company's personnel are covered by collective bargaining agreements with the United Garment Workers of America. The Company considers its relations with its personnel to be good. ITEM 2.

ITEM 2. PROPERTIES The Company's principal executive and administrative offices are located in Oshkosh, Wisconsin. Its principal office, manufacturing and distribution operations are conducted at the following locations: Approximate Floor Area in Principal Location Square Feet Use Albany, KY 20,000 Manufacturing Byrdstown, TN 32,000 Manufacturing Celina, TN 100,000 Manufacturing Celina, TN 90,000 Laundering/Pressing Columbia, KY 78,000 Manufacturing Columbia, KY 23,000 Manufacturing Dallas, TX (1) 1,995 Sales Offices/Showroom Dover, TN 87,000 Manufacturing Gainesboro, TN 61,000 Manufacturing Gainesboro, TN 29,000 Warehousing Hermitage Springs, TN 52,000 Manufacturing Jamestown, TN 43,000 Manufacturing Liberty, KY 218,000 Manufacturing/Warehousing Liberty, KY 32,000 Warehousing Los Angeles, CA (2) 1,145 Sales Offices/Showroom Marrowbone, KY 27,000 Manufacturing McEwen, TN (3) 29,000 Manufacturing New York City, NY (4) 18,255 Sales Offices/Showrooms Oshkosh, WI 99,000 Exec. & Operating Co. Offices Oshkosh, WI 88,000 Manufacturing Oshkosh, WI 86,000 Wholesale Distribution /Warehousing Oshkosh, WI 42,000 Retail Distribution /Warehousing Red Boiling Springs,TN 41,000 Manufacturing White House, TN 284,000 Distribution/Warehousing All properties are owned by the Registrant with the exception of: (1) Lease expiration date - 1994, (2) Lease expiration date - 1993, (3) Lease expiration date - 1997, (4) Lease expiration date - 2007. The Company believes that its properties are well maintained and its manufacturing equipment is in good operating condition and sufficient for current production. Substantially all of the Company's retail stores occupy leased premises. For information regarding the terms of the leases and rental payments thereunder, refer to the "Leases" note to the consolidated financial statements on page 26 of this Form 10-K. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS The Company and its subsidiaries are not parties to any material pending legal proceedings. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS. The Company's Class A Common Stock and Class B Common Stock is traded in the over-the-counter market on the NASDAQ National Market System under the symbols GOSHA and GOSHB, respectively. The table reflects the "last" price quotation on the NASDAQ National Market System and does not reflect mark-ups, mark-downs, or commissions and may not represent actual transactions. The Company has paid cash dividends on its common stock each year since 1936. The Company's Certificate of Incorporation requires that when any dividend (other than a dividend payable solely in shares of the Company's stock) is paid on the Company's Class B Common Stock, a dividend equal to 115% of such amount per share must concurrently be paid on each outstanding share of Class A Common Stock. As of March 11, 1994, there were 2,081 holders of record of Class A Common Stock and 203 holders of record of Class B Common Stock. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION YEAR ENDED DECEMBER 31, 1993 COMPARED TO YEAR ENDED DECEMBER 31, 1992 Net sales in 1993 were $340.2 million, down 1.7% from 1992 sales of $346.2 million. The Company's domestic wholesale business of approximately $257 million in 1993 was 9.3% less than 1992 sales, due primarily to a decline in unit shipments of approximately 10% in 1993 from 1992. The decrease in domestic wholesale unit shipments related primarily to the effects of the competitive pricing environment in the children's wear business, the Company's difficulty in meeting the delivery requirements of its wholesale customers as well as the Company's expanding focus on its retail operations. The Company currently anticipates further reduction in its domestic wholesale unit shipments in 1994. In an effort to improve customer delivery requirements, the Company is currently undertaking a significant reengineering process. The Company anticipates continued improvement in its delivery performance in 1994. Company retail sales at its Oshkosh B'Gosh branded outlet stores and its wholly-owned subsidiary Essex Outfitters Trader Kids stores expanded to approximately $65.0 million in 1993, a 49.4% increase over 1992 retail sales of approximately $43.5 million. Retail sales increases resulted primarily from the opening of an additional 38 retail stores during 1993. The Company anticipates continued expansion in its retail business through the opening of an additional 35 to 45 retail stores in 1994, which should offset the reduction in the domestic wholesale business. Gross margin as a percent of sales improved to 28.0% in 1993, compared with 25.1% in 1992. During 1993, the Company experienced a slight improvement in its domestic wholesale gross margins. Increased retail store sales, at higher gross profit margins, had a significant impact on improved overall gross margin performance. Gross margins for 1992 were unfavorably impacted by manufacturing inefficiencies resulting from the restructuring of production lines and increasing workers' compensation insurance and employee health care costs. The Company currently anticipates further modest improvement in its gross margins in the second half of 1994. Selling, general and administrative expenses increased $12.1 million in 1993 from 1992. As a percent of net sales, selling, general and administrative expenses were 23.1% in 1993, up from 19.2% in 1992. The primary reason for increasing selling, general and administrative expenses is the Company's increasing focus on its retail business. In addition, the Company initiated a catalog division in the second half of 1993 which added approximately $1.2 million to its selling, general and administrative expense. Increasing emphasis on foreign sales opportunities, including the start-up costs associated with the opening of sales offices, have also added to the Company's selling, general and administrative expense structure. In 1994, the Company's continued expansion in its retail business, along with further development of its foreign business and catalog division will result in higher selling, general and administrative expenses in relation to its net sales. During the fourth quarter of 1993, the Company recorded a pretax restructuring charge of $10.8 million. Restructuring costs (net of income tax benefit) reduced net income by $7.1 million ($.49 per share) in 1993. After review of the Company's manufacturing capacity, operational effectiveness, sales volume and alternative sourcing opportunities, the Company decided to sell its Camden, Tennessee and McKenzie, Tennessee manufacturing plants as well as evaluate other capacity reduction alternatives. During 1993 the Company reduced its total workforce by over 1,200 employees. Sale of the McKenzie plant in 1994 will reduce the Company's workforce by approximately 230 employees. The Company's $10.8 million restructuring charge includes approximately $3.3 million for facility closings, write-down of the related assets and severance costs pertaining to workforce reductions. The restructuring charge also reflects the Company's decision to market its Boston Trader line of children's apparel under the new trade name Genuine Kids and the resulting costs of the Company's decision not to renew the Boston Trader license arrangement beyond 1994, as well as expenses to consolidate its retail operations. Accordingly, the restructuring charge includes approximately $7.5 million for write-off of previously capitalized trademark rights and expenses related to consolidating the Company's retail operations. The Company anticipates that these restructuring actions, net of income tax benefit, will require expenditures of approximately $2.5 million of cash over the next year, which will be funded entirely by internally generated cash. Company management believes that while these restructuring actions will not result in material short term earnings improvement, the restructuring will better position the Company competitively over a longer term period of time. In 1991, the Company recorded the impact of its decision to discontinue the manufacturing and sale of its Absorba line of infant's apparel. A pretax restructuring charge of $5.6 million represented provisions for facility closing and lease termination costs, severance pay, write-down of the related assets and estimated operating losses until closing. These restructuring costs (net of income tax benefit) reduced 1991's net income by $3.6 million ($.25 per share). During 1992, the Company reduced its estimate of the Absorba line restructuring costs by $2.8 million due to the efficient and orderly wind down of operations and favorable settlement of lease obligations. This adjustment to restructuring costs (net of income taxes) increased 1992 net income by $1.8 million ($.12 per share). Royalty income, net of expenses, was $3.4 million in 1993, as compared to $2.6 million in 1992. The increase in net royalty income resulted primarily from additional foreign license agreements. The effective tax rate for 1993 was 51.3% compared to 39.8% in 1992. The higher 1993 effective tax rate is the result of the Company's foreign operating losses, which provide no tax benefit, combined with the Company's substantially lower income before income taxes in 1993 (which resulted in part from the restructuring charge). The Company's early adoption of Statement of Financial Accounting Standards No. 109 on accounting for income taxes in 1992 had no material impact on 1992's results of operations. Company management believes that the $10.7 million deferred tax asset at December 31, 1993 can be fully realized through reversals of existing taxable temporary differences and the Company's history of substantial taxable income which allows the opportunity for carrybacks of current or future losses. The Company elected early adoption of the of the Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," in 1992. The Company elected to record the entire transition obligation in 1992, which resulted in a net $.6 million after tax ($.04 per share) reduction in net income. In November of 1992, the Financial Accounting Standards Board issued its Statement No. 112 entitled "Employers' Accounting for Postemployment Benefits." The Statement must be applied in the preparation of the Company's consolidated financial statements for the year ending December 31, 1994. The Company has determined that this standard will not have a significant effect on its consolidated financial statements. In September 1993, the Company signed a letter of intent to purchase Rio Sportswear, Inc. and affiliated companies (collectively "Rio"). In March, 1994, the Company announced that negotiations with Rio had terminated. YEAR ENDED DECEMBER 31, 1992 COMPARED TO YEAR ENDED DECEMBER 31, 1991 Net sales for 1992 were $346.2 million, a 5.2% decrease from 1991 sales of $365.2 million. The decrease in net sales was due primarily to a 3.9% dollar decrease (1.2% in units) in the Oshkosh B'Gosh domestic wholesale business. The Company's decision to discontinue the sale of United States licensed Absorba products in 1992 also had a negative impact on reported 1992 sales, as 1991 sales of Absorba products amounted to $10.3 million. Sales by the Company's remaining subsidiaries totaled $23.2 million, a 44.2% increase over their 1991 sales. Gross margins as a percent of sales declined from 29.7% in 1991 to 25.1% in 1992. The decline resulted primarily from a 6.2% reduction in gross margins of the domestic wholesale children's wear business. Gross margins for 1992 were also unfavorably impacted by manufacturing inefficiencies resulting from the restructuring of production lines to meet the demands of product complexity and delivery schedules. Rapidly escalating workers' compensation insurance costs, employee health care costs, and other employee fringe benefit costs adversely impacted gross margins. In addition, in 1992 the Company initiated a volume discount program which placed added pressure on Company gross margins. Variations in gross margins of subsidiaries had no material effect on consolidated results. Selling, general and administrative expenses decreased $1.3 million from 1991. As a percent of net sales, selling, general and administrative expenses were 19.2% and 18.6% for 1992 and 1991 respectively. The primary reason for the decline in the dollar amount of selling, general and administrative expenses was the discontinuance of the Absorba operations, offset in part by increased advertising and factory store expenses. The increased factory store expenses were primarily the result of opening 7 additional Oshkosh B'Gosh retail stores. Subsidiary marketing and administrative expenses increased primarily from the addition of 16 retail stores at the Company's Essex Outfitters, Inc. subsidiary. During 1991 the Company decided to discontinue the manufacture and sale of its United States licensed Absorba products. An estimated pretax restructuring cost of $5.6 million was recorded in 1991 for facility closings, severance pay, loss on disposal of assets and estimated operating losses until closing. Favorable settlements of lease obligations, efficient and orderly wind down of operations, and disposition of remaining assets and inventories at favorable amounts resulted in a reduction in the Company's provision for restructuring costs by $2.8 million ($1.8 million net of income taxes). The net effect of this reduction in provision for restructuring costs increased 1992's income by $.12 per share. As of December 31, 1992, substantially all assets of Absorba, Inc. were sold and all operations were ceased. Results of operations of the Company's three remaining subsidiaries decreased 1992 income before tax by approximately $.4 million. Results of operations of the remaining subsidiaries (excluding Absorba) decreased 1991 income by approximately $.9 million. Losses were experienced in operations of Oshkosh B'Gosh Europe, S.A. and Manufacturera International Apparel, S.A. (our Honduras manufacturing subsidiary), while Essex Outfitters net income was approximately equal to that realized in 1991. The effective tax rate for 1992 and 1991 was 39.8%. The Company's early adoption of the Financial Accounting Standards Board Statement No. 109 on accounting for income taxes in 1992 had no material impact on 1992's results of operations. FINANCIAL CONDITION During 1993 total assets increased by $2.9 million or 1.3% over 1992. Accounts receivable at December 31, 1993 were $19.5 million compared to $24.4 million at December 31, 1992. Inventories at the end of 1993 were $100 million, up $7.2 million from 1992. This increase in inventories relates primarily to the Company's expanding retail business. Management believes that year end 1993 inventory levels are generally appropriate for anticipated 1994 business activity. Accrued liabilities at the end of 1993 were $29.8 million, up $13.6 million from 1992. This increase is due primarily to the Company's provision for restructuring costs recorded in the fourth quarter of 1993. On February 20, 1992, the Company finalized a $7 million Industrial Development Revenue Bond issue to finance construction of the Celina, Tennessee finishing plant. As a result of additional capital expenditures associated with the project and the possible restrictions to future expansion because of limits imposed by existing Industrial Development Revenue Bond regulations, the bonds were called on December 18, 1992 and paid off on January 19, 1993. LIQUIDITY AND CASH FLOW The Corporation maintains a relatively liquid financial position. Net working capital at the end of 1993 was $111.8 million, approximately the same as at the end of 1992. The current ratio was 3.8 to 1 at 1993 year end, compared to 4.2 to 1 at year end 1992. Cash provided by operations was approximately $21.6 million in 1993, compared to $22.9 million in 1992. Capital expenditures were approximately $9 million in 1993 and $12.6 million in 1992. Capital expenditures for 1994 are currently budgeted at approximately $12 million. Liquidity is also provided by short-term borrowings that fund seasonal working capital needs. The Company has unsecured credit arrangements, negotiated annually, which provide for maximum borrowings and letters of credit totaling $60 million at December 31, 1993 including $45 million under commercial paper borrowing arrangements. The Company believes its present liquidity, in combination with cash flow from future operations and its available credit facilities, is sufficient to meet its continuing operating and capital requirements in the foreseeable future. Dividends on the Company's Class A and Class B Common Stock totaled $.5125 per share and $.45 per share, respectively, in 1993, the same as in 1992. The dividend payout rate was 163% in 1993 and 49% in 1992. The Company's lower earnings from operations in 1993 combined with the fourth quarter 1993 restructuring charge resulted in the unusually high 1993 payout rate. INFLATION The effects of inflation on the Company's operating results and financial condition were not significant. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Page Financial Statements: Reports of Independent Auditors 15 Consolidated Balance Sheets - December 31, 1993 and 1992 17 Consolidated Statements of Income - years ended December 31, 1993, 1992 and 1991 18 Consolidated Statements of Changes in Shareholders' Equity - - - years ended December 31, 1993, 1992, and 1991 19 Consolidated Statements of Cash Flows - years ended December 31, 1993, 1992 and 1991 20 Notes to Consolidated Financial Statements 22 REPORT OF ERNST & YOUNG, INDEPENDENT AUDITORS The Board of Directors Oshkosh B'Gosh, Inc. and Subsidiaries We have audited the accompanying consolidated balance sheet of Oshkosh B'Gosh, Inc. and Subsidiaries as of December 31, 1993, and the related consolidated statements of income, changes in shareholders' equity and cash flows for the year then ended. Our audit also included the 1993 financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Oshkosh B'Gosh, Inc. and Subsidiaries at December 31, 1993, and the consolidated results of their operations and their cash flows for the year then ended in conformity with generally accepted accounting principles. Also, in our opinion, the related 1993 financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. Milwaukee, Wisconsin ERNST & YOUNG February 11, 1994 REPORT OF SCHUMAKER, ROMENESKO & ASSOCIATES, S.C., INDEPENDENT AUDITORS The Board of Directors Oshkosh B'Gosh, Inc. and Subsidiaries We have audited the accompanying consolidated balance sheet of Oshkosh B'Gosh, Inc. and Subsidiaries as of December 31, 1992, and the related consolidated statements of income, changes in shareholders' equity and cash flows for the years ended December 31, 1992 and 1991. Our audits also included the 1992 and 1991 financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Oshkosh B'Gosh, Inc. and Subsidiaries at December 31, 1992, and the consolidated results of their operations and their cash flows for the years ended December 31, 1992 and 1991 in conformity with generally accepted accounting principles. Also, in our opinion, the related 1992 and 1991 financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Notes 9 and 10 to the consolidated financial statements, effective January 1, 1992, the Company changed its method of accounting for income taxes and nonpension postretirement benefits. Oshkosh, Wisconsin SCHUMAKER, ROMENESKO & ASSOCIATES, S.C. February 15, 1993 OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Consolidated Balance Sheets (Dollars in thousands, except share and per share amounts) December 31, 1993 1992 Assets Current assets Cash and cash equivalents $ 17,853 $ 21,129 Accounts receivable, less allowances of $3,310 in 1993 and $2,265 in 1992 19,477 24,425 Inventories 99,999 92,752 Prepaid expenses and other current assets 3,810 2,185 Deferred income taxes 10,716 5,819 Total current assets 151,855 146,310 Property, plant and equipment, net 71,755 72,312 Other assets 5,521 7,573 Total assets $229,131 $226,195 Liabilities and Shareholders' Equity Current liabilities Current maturities of long-term debt $ 536 $ 7,896 Accounts payable 9,720 11,096 Accrued liabilities 29,805 16,243 Total current liabilities 40,061 35,235 Long-term debt 757 1,293 Deferred income taxes 3,040 3,680 Employee benefit plan liabilities 13,275 10,834 Commitments - - Shareholders' equity Preferred stock, par value $.01 per share: Authorized - 1,000,000 shares; Issued and outstanding - None - - Common stock, par value $.01 per share: Class A, authorized - 30,000,000 shares; Issued and outstanding - 13,280,572 shares in 1993, 12,776,860 shares in 1992 133 128 Class B, authorized - 3,750,000 shares; Issued and outstanding - 1,305,228 shares in 1993, 1,808,940 shares in 1992 13 18 Additional paid-in capital 2,971 2,971 Retained earnings 169,182 172,036 Cumulative foreign currency translation adjustments (301) - Total shareholders' equity 171,998 175,153 Total liabilities and shareholders'equity $229,131 $226,195 See notes to consolidated financial statements. OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Consolidated Statements of Income (Dollars in thousands, except per share amounts) Year Ended December 31, 1993 1992 1991 Net sales $340,186 $346,206 $365,173 Cost of products sold 244,926 259,344 256,755 Gross profit 95,260 86,862 108,418 Selling, general and administrative expenses 78,492 66,414 67,726 Restructuring 10,836 (2,800) 5,600 Operating income 5,932 23,248 35,092 Other income (expense): Interest expense (626) (797) (897) Interest income 1,114 1,022 1,134 Royalty income, net of expenses 3,417 2,562 3,047 Minority interest in loss of consolidated subsidiary - 108 602 Miscellaneous (545) (17) 174 Other income - net 3,360 2,878 4,060 Income before income taxes and cumulative effect of accounting change 9,292 26,126 39,152 Income taxes 4,769 10,390 15,576 Income before cumulative effect of accounting change 4,523 15,736 23,576 Cumulative effect of change in accounting for nonpension postretirement benefits - (601) - Net income $ 4,523 $ 15,135 $ 23,576 Income per share before cumulative effect of accounting change $.31 $1.08 $1.62 Change in accounting for nonpension postretirement benefits - (.04) - Net income per common share $.31 $1.04 $1.62 See notes to consolidated financial statements. See notes to consolidated financial statements OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows (Dollars in thousands) Year Ended December 31, 1993 1992 1991 Cash flows from operating activities Net income $ 4,523 $15,135 $23,576 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 9,233 8,375 6,568 (Gain) loss on disposal of assets 63 85 (14) Minority interest in loss of consolidated subsidiary - (108) (602) Provision for deferred income taxes (5,537) 35 (2,832) Pension expense, net of contributions 1,852 1,753 2,304 Cumulative effect of accounting change - 1,001 - Restructuring 10,836 (2,800) 5,600 Changes in operating assets and liabilities, net of effects of acquisitions: Accounts receivable 4,948 (643) 6,149 Inventories (7,247) 1,478 (3,096) Prepaid expenses and other current assets (1,624) (252) (1,336) Accounts payable (1,376) (2,522) 3,925 Accrued liabilities 5,940 1,313 (339) Net cash provided by operating activities 21,611 22,850 39,903 Cash flows from investing activities Additions to property, plant and equipment (8,990)(12,563) (19,569) Proceeds from disposal of assets 1,159 625 256 Investments in subsidiaries - (900) - Additions to other assets (1,783) (1,602) (580) Net cash used in investing activities (9,614)(14,440) (19,893) See notes to consolidated financial statements. OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows (continued) (Dollars in thousands) Year Ended December 31, 1993 1992 1991 Cash flows from financing activities Net decrease in short-term borrowings $ - $ - $(4,706) Proceeds from long-term borrowings - 7,000 - Payments of long-term debt (7,896) (1,270) (1,071) Dividends paid (7,377) (7,362) (7,362) Proceeds from issuance of subsidiary stock - - 642 Net cash used in financing activities (15,273) (1,632) (12,497) Net increase (decrease) in cash and cash equivalents (3,276) 6,778 7,513 Cash and cash equivalents at beginning of year 21,129 14,351 6,838 Cash and cash equivalents at end of year $17,853 $21,129 $14,351 Supplementary disclosures Cash paid for interest $ 1,030 $ 823 $ 946 Cash paid for income taxes $12,194 $ 9,877 $21,895 See notes to consolidated financial statements. OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Dollars in thousands, except share and per share amounts) Note 1. Significant accounting policies Business - Oshkosh B'Gosh, Inc. and its majority-owned subsidiaries (the Company) is engaged primarily in the design, manufacture and marketing of apparel to wholesale customers and through Company owned retail stores. Principles of consolidation - The consolidated financial statements include the accounts of all majority-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. Minority interest represents the minority shareholder's proportionate share of the net loss of Oshkosh B'Gosh Europe, S.A. until the Company acquired the remaining interest in July, 1992. Cash equivalents - Cash equivalents consist of highly liquid debt instruments such as money market accounts with original maturities of three months or less. The Company's policy is to invest cash in conservative instruments as part of its cash management program and to evaluate the credit exposure of any investment. Cash and cash equivalents are stated at cost, which approximates market value. Inventories - Inventories are stated at the lower of cost or market. Inventories stated on the last-in, first-out (LIFO) basis represent 90.6% of total 1993 and 96.3% of total 1992 inventories. Remaining inventories are valued using the first- in, first-out method. Property, plant and equipment - Property, plant and equipment are carried at cost. Depreciation and amortization for financial reporting purposes is calculated using the straight line method based on the following useful lives: Years Land improvements 10 to 15 Buildings 10 to 40 Leasehold improvements 5 to 10 Machinery and equipment 5 to 10 Income taxes - Effective January 1, 1992, the Company accounts for income taxes under the provisions of Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes". This Statement requires recognition of deferred tax assets and liabilities for all temporary differences between the financial reporting and income tax basis of Company assets and liabilities. In 1991, deferred income taxes were accounted for under APB Opinion No. 11. The effect of this accounting change at January 1, 1992 was not material. OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Dollars in thousands, except share and per share amounts) Note 1. Significant accounting policies (continued) Foreign currency translation - The functional currency for certain foreign subsidiaries is the local currency. Accordingly, assets and liabilities are translated at year end exchange rates, and income statement items are translated at average exchange rates prevailing during the year. Such translation adjustments are recorded as a separate component of shareholders' equity. Revenue recognition - Revenue within wholesale operations is recognized at the time merchandise is shipped to customers. Retail store revenues are recognized at the time of sale. Income per common share - Income per common share amounts are computed by dividing income by the number of shares of common stock outstanding (14,585,800 in each year). There are no common stock equivalents. Reclassifications - Certain reclassifications of financial information for the years ended December 31, 1991 and 1992 have been made to conform with the 1993 presentation. Note 2. Restructuring During the fourth quarter of 1993, the Company recorded a pretax restructuring charge of $10,836. The restructuring charge includes approximately $3,300 for facility closings, write-down of the related assets and severance costs pertaining to work force reductions. The restructuring charge also reflects the Company's decision to market its Trader Kids line of children's apparel under the new name Genuine Kids and the resulting costs of the Company's decision not to renew its Boston Trader license arrangement beyond 1994, as well as expenses to consolidate its retail operations. Accordingly, the restructuring charge includes approximately $7,500 for write-off of unamortized trademark rights and expenses related to consolidating the Company's retail operations. Restructuring costs (net of income tax benefit) reduced net income by $7,100 ($.49 per share) in 1993. The Company recorded the impact of its decision to discontinue the manufacturing and sales of its Absorba line of infant's apparel in 1991. Restructuring costs of $5,600 represented provisions for facility closing and lease termination costs, severance pay, write-down of the related assets and estimated operating losses until closing. Restructuring costs (net of income tax benefit) reduced net income by $3,600 ($.25 per share) in 1991. During 1992, the Company reduced its estimate of the Absorba line restructuring costs by $2,800 due to the efficient and orderly wind down of operations and favorable settlement of lease obli- gations. This adjustment to restructuring costs (net of income taxes) increased 1992 net income by $1,800 ($.12 per share). OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Dollars in thousands, except share and per share amounts) Note 3. Inventories A summary of inventories follows: December 31, 1993 1992 Finished goods $82,737 $71,290 Work in process 5,008 6,695 Raw materials 12,254 14,767 $99,999 $92,752 The replacement cost of inventory exceeds the above LIFO costs by $14,716 and $17,462 at December 31, 1993 and 1992, respectively. Note 4. Property, plant and equipment A summary of property, plant and equipment follows: December 31, 1993 1992 Land and improvements $ 4,172 $ 3,896 Buildings 37,640 38,107 Leasehold improvements 5,268 2,953 Machinery and equipment 67,026 62,357 Construction in progress 291 537 114,397 107,850 Less: accumulated depreciation and amortization 42,642 35,538 Property, plant and equipment, net $ 71,755 $ 72,312 Depreciation and amortization expense on property, plant and equipment for the years ended December 31, 1993, 1992, and 1991 amounted to approximately $8,425, $7,909, and $6,136, respectively. Note 5. Short-term borrowings The Company has unsecured credit arrangements, negotiated annually, which provide for maximum borrowings and letters of credit totaling $60,000 at December 31, 1993 including $45,000 under commercial paper borrowing arrangements. Bank credit lines are maintained in full support of outstanding commercial paper. Interest under the lines is at or below the lenders' prime rate. There were no outstanding obligations against these credit arrangements at December 31, 1993 or 1992. Letters of credit of approximately $15,000 were outstanding at December 31, 1993, with $41,000 of the unused line of credit available for borrowing. OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Dollars in thousands, except share and per share amounts) Note 6. Accrued liabilities A summary of accrued liabilities follows: December 31, 1993 1992 Compensation $ 4,701 $ 4,181 Group health insurance 1,700 1,900 Worker's compensation 8,600 5,705 Income taxes 640 753 Restructuring costs 8,186 422 Other 5,978 3,282 $29,805 $16,243 Note 7. Long-term debt The Company's long-term debt is summarized as follows: December 31, 1993 1992 Obligations under industrial development revenue bonds: Fixed rate $ - $ 80 Floating rate 666 8,372 Other mortgage notes and loans with interest at varying rates 627 737 Total 1,293 9,189 Less current maturities 536 7,896 Total long-term debt $ 757 $1,293 The industrial development revenue bonds are due in varying installments through 1995. The floating interest rates on the bonds range from 65% to approximately 80% of prime rate (prime rate was 6.0% at December 31, 1993). Annual total maturities of principal on long-term debt are as follows: Year ending December 31, 1994 $ 536 1995 240 1996 42 1997 43 1998 45 Thereafter 387 1,293 OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Dollars in thousands, except share and per share amounts) Note 8. Leases The Company leases certain property and equipment including retail sales facilities and regional sales offices under operating leases. Certain leases provide the Company with renewal options. Leases for retail sales facilities provide for minimum rentals plus contingent rentals based on sales volume. Minimum future rental payments under noncancellable operating leases are as follows: Year ending December 31, 1994 $ 7,346 1995 6,668 1996 5,639 1997 4,662 1998 3,858 Thereafter 13,587 Total minimum lease payments $41,760 Total rent expense charged to operations for all operating leases is as follows: Year Ended December 31, 1993 1992 1991 Minimum rentals $7,718 $5,921 $4,873 Contingent rentals 167 179 201 Total rent expense $7,885 $6,100 $5,074 Note 9. Income taxes Income tax expense (credit) is comprised of the following: Year Ended December 31, 1993 1992 1991 Current: Federal $ 8,571 $ 8,155 $15,370 State and local 1,735 1,800 3,038 10,306 9,955 18,408 Deferred (5,537) 435 (2,832) Totals $ 4,769 $10,390 $15,576 OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Dollars in thousands, except share and per share amounts) Note 9. Income taxes (continued) The components of the Company's deferred tax asset and deferred tax liability include: December 31, 1993 1992 [Assets (Liabilities)] Current deferred taxes Accounts receivable allowances $ 1,272 $ 844 Inventory valuation 2,129 1,403 Accrued liabilities 3,714 3,304 Restructuring costs 3,204 160 Other 397 108 Total net current deferred tax assets$10,716 $ 5,819 Non-current deferred taxes Depreciation $(8,266) $(7,304) Deferred employee benefits 4,419 3,496 Trademark 807 128 Foreign losses 1,807 979 Valuation allowance (1,807) (979) Total net long-term deferred tax liabilities $(3,040) $(3,680) The sources of deferred income taxes for the year ended December 31, 1991 and the tax effect of each are as follows: Depreciation $1,047 Accounts receivable allowances (90) Deferred employee benefits (498) Inventory valuation (837) Restructuring costs (2,000) Other (454) Totals $(2,832) For financial reporting purposes, income before income taxes and cumulative effect of accounting change includes the following components: Year Ended December 31, 1993 1992 1991 Pretax income (loss): United States $11,704 $27,574 $41,272 Foreign (2,412) (1,448) (2,120) $ 9,292 $26,126 $39,152 OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Dollars in thousands, except share and per share amounts) Note 9. Income taxes (continued) A reconciliation of the federal statutory income tax rate to the effective tax rates reflected in the consolidated statements of income follows: Year Ended December 31, 1993 1992 1991 Federal statutory tax rate 35.0% 34.0% 34.0% Differences resulting from: State and local income taxes, net of federal income tax benefit 4.1 4.2 4.1 Foreign losses with no tax benefit 9.1 1.9 1.8 Other 3.1 (.3) (.1) 51.3% 39.8% 39.8% Note 10. Retirement plans The Company has defined contribution and defined benefit pension plans covering substantially all employees. Charges to operations by the Company for these pension plans totaled $4,621, $4,477, and $4,615 for 1993, 1992 and 1991, respectively. Defined benefit pension plans - The Company sponsors several qualified defined benefit pension plans covering certain hourly and salaried employees. In addition, the Company maintains a supplemental unfunded salaried pension plan to provide those benefits otherwise due employees under the salaried plan's benefit formulas, but which are in excess of benefits permitted by the Internal Revenue Service. The benefits provided are based primarily on years of service and average compensation. The pension plans' assets are comprised primarily of listed securities, bonds, treasury securities, commingled equity and fixed income investment funds and cash equipvalents. Plan assets included 7,000 and 10,000 shares of Oshkosh B'Gosh, Inc. Class A common stock at December 31, 1993 and 1992, respectively, and 5,000 shares of Oshkosh B'Gosh, Inc. Class B common stock in both years, with a total market value of approximately $236 and $307 at December 31, 1993 and 1992, respectively. The Company's funding policy for qualified plans is to contribute amounts which are actuarially determined to provide the plans with sufficient assets to meet future benefit payment requirements consistent with the funding requirements of federal laws and regulations. OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Dollars in thousands, except share and per share amounts) Note 10. Retirement Plans (continued) The actuarial computations utilized the following assumptions. December 31, 1993 1992 1991 Discount rate 7.0% 7.0-7.5% 6.5-7.0% Expected long-term rate of return on assets 7.0% 7.5-8.0% 7.0-7.5% Rates of increase in compensation levels 0-4.5% 0-5.5% 0-6.0% Net periodic pension cost was comprised of: December 31, 1993 1992 1991 Service cost - benefits earned during the period $2,318 $2,309 $2,077 Interest cost on projected benefit obligations 1,808 1,601 1,409 Actual return on plan assets (1,708) (1,037) (2,351) Net amortization and deferral 1,259 636 2,213 Net periodic pension cost $3,677 $3,509 $3,348 OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Dollars in thousands, except share and per share amounts) Note 10. Retirement plans (continued) The following table sets forth the funded status of the Company's defined benefit plans and the amount recognized in the Company's consolidated balance sheets. The funded status of plans with assets exceeding the accumulated benefit obligation (ABO) is segregated by column from that of plans with the ABO exceeding assets. December 31, 1993 1992 Assets ABO Assets ABO Exceed Exceeds ExceedExceeds ABO Assets ABO Assets Actuarial present value of benefit obligations: Vested benefits $ 9,051 $ 6,308 $ 6,423$ 5,118 Nonvested benefits 1,604 449 1,119 449 Total accumulated benefit obligation $10,655 $ 6,757 $ 7,542$ 5,567 Projected benefit obligation $22,299 $ 6,835 $18,026$ 6,076 Plan net assets at fair value 12,070 2,777 10,363 2,456 Projected benefit obligation in excess of plan net assets (10,229) (4,058) (7,663)(3,620) Unamortized transition (asset) obligation (1,535) (23) (1,689) 175 Unrecognized prior service cost 2,821 2,867 3,055 2,589 Unrecognized net (gain) loss 3,546 (592) 2,950 (539) Adjustment to recognize minimum liability - (2,200) - (1,716) Accrued pension liability at December 31 $(5,397)$(4,006)$(3,347)$(3,111) Defined contribution plan - The Company maintains a defined contribution retirement plan covering certain salaried employees. Annual contributions are discretionary and are determined by the Company's Executive Committee. Charges to operations by the Company for contributions under this plan totaled $565, $658 and $853 for 1993, 1992 and 1991, respectively. The Company also has a supplemental retirement program for designated employees. Annual provisions to this unfunded plan are discretionary and are determined by the Company's Executive Committee. Charges to operations by the Company for additions to this plan totaled $379, $310 and $414 for 1993, 1992 and 1991, respectively. Deferred employee benefit plans - The Company has deferred compensation and supplemental retirement arrangements with certain key officers. OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Dollars in thousands, except share and per share amounts) Note 10. Retirement plans (continued) Postretirement health and life insurance plan - The Company sponsors an unfunded defined benefit postretirement health insurance plan that covers eligible salaried employees. Life insurance benefits are provided under the plan to qualifying retired employees. The postretirement health insurance plan is offered, on a shared cost basis, only to employees electing early retirement. This coverage ceases when the employee reaches age 65 and becomes eligible for Medicare. Retiree contributions are adjusted periodically. In 1992, the Company adopted the provisions of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." In applying this pronouncement, the Company elected to immediately recognize the accumulated postretirement benefit obligation as of the beginning of 1992 of approximately $1 million in the first quarter of 1992 as a change in accounting principle. The charge, net of an income tax benefit of $400, was $601 or $.04 per share. The following table sets forth the funded status of the plan and the postretirement benefit cost recognized in the Company's consolidated balance sheets: December 31, 1993 1992 Accumulated postretirement benefit obligation: Retirees $ 119 $ 140 Fully eligible active plan participants 216 231 Other active plan participants 670 795 1,005 1,166 Plan assets - - Unrecognized net gain 281 - Accrued postretirement benefit cost $1,286 $1,166 Net periodic postretirement benefit cost was comprised of: Year Ended December 31, 1993 1992 Service cost - benefits attributed to employee service during the year $ 98 $119 Interest cost on accumulated postretirement benefit obligation 61 75 Net amortization and deferral (18) - Net periodic postretirement benefit cost $141 $194 The discount rate used in determining the accumulated postretirement benefit obligation was 7.0% in 1993 and 7.5% in 1992. The assumed health care cost trend rate used in measuring the accumulated postretirement benefit obligation was 15%, declining gradually to 6% by 2012 and then declining further to an ultimate rate of 4% by 2022. OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Dollars in thousands, except share and per share amounts) Note 10. Retirement Plans (continued) The health care cost trend rate assumption has a significant impact on the amounts reported. Increasing the assumed health care cost trend rate by one percentage point would increase the accumulated postretirement benefit obligation at December 31, 1993 by approximately $121 and the aggregate of the service and interest cost components of net periodic postretirement benefit cost for 1993 by approximately $26. The charge for retiree health care benefits prior to the adoption of SFAS No. 106 was immaterial. Note 11. Common stock In May, 1993 shareholders of the Company approved a stock conversion plan whereby shares of Class B common stock may be converted to an equal number of Class A common shares. The Company's common stock authorization provides that dividends be paid on both the Class A and Class B common stock at any time that dividends are paid on either. Whenever dividends (other than dividends of Company stock) are paid on the common stock, each share of Class A common stock is entitled to receive 115% of the dividend paid on each share of Class B common stock. The Class A common stock shareholders are entitled to receive a liquidation preference of $7.50 per share before any payment or distribution to holders of the Class B common stock. Thereafter, holders of the Class B common stock are entitled to receive $7.50 per share before any further payment or distribution to holders of the Class A common stock. Thereafter, holders of the Class A common stock and Class B common stock share on a pro-rata basis in all payments or distributions upon liquidation, dissolution or winding up of the Company. Note 12. Business and credit concentrations The Company provides credit, in the normal course of business, to department and specialty stores. The Company performs ongoing credit evaluations of its customers and maintains allowances for potential credit losses. The Company's customers are not concentrated in any specific geographic region. Sales to a customer, as a percentage of total sales, amounted to approximately 10% in 1993. In 1992, sales to two customers, as a percentage of total sales, amounted to approximately 12% each. In 1991, sales to a single customer, as a percentage of total sales, amounted to approximately 12%. ITEM 9.

ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III. ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this item is incorporated by reference to the definitive Proxy Statement of Oshkosh B'Gosh, Inc. for its annual meeting to be held on May 6, 1994. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information required by this item is incorporated by reference to the definitive Proxy Statement of Oshkosh B'Gosh, Inc. for its annual meeting to be held on May 6, 1994. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item is incorporated by reference to the definitive Proxy Statement of Oshkosh B'Gosh, Inc. for its annual meeting to be held on May 6, 1994. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item is incorporated by reference to the definitive Proxy Statement of Oshkosh B'Gosh, Inc. for its annual meeting to be held on May 6, 1994. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) (1) Financial Statements Financial statements for Oshkosh B'Gosh, Inc. listed in the Index to Financial Statements and Supplementary Data on page 14 are filed as part of this Annual Report. (2) Financial Statement Schedules Schedule V - Property, Plant and Equipment Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment Schedule VIII - Valuation and Qualifying Accounts Schedule IX - Short-Term Borrowings Schedule X - Supplementary Income Statement InformationF-5 Schedules and notes not included have been omitted because they are not applicable or the required information is included in the consolidated financial statements and notes thereto. (3) Index to Exhibits (b) Reports on Form 8-K The registrant filed a Form 8-K, Item 4 Change of Independent Auditors, on December 13, 1993. 3) Exhibits 3.1 Certificate of Incorporation of Oshkosh B'Gosh, Inc., as restated, October 20, 1988, previously filed as Exhibit 3.1 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1988, Commission File Number 0-13365, is incorporated herein by reference. 3.2 By-laws of Oshkosh B'Gosh, Inc., as adopted through May 1, 1992, previously filed as Exhibit 3.2 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File Number 0- 13365, is incorporated herein by reference. *10.1 Employment Agreement dated July 7, 1980, between Oshkosh B'Gosh, Inc. and Charles F. Hyde as extended by "Request For Later Retirement" dated April 15, 1986 and accepted by Board of Directors' resolution on May 2, 1986, previously filed as Exhibit 10.1 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1986, Commission File Number 0-13365, is incorporated herein by reference. *10.2 Employment Agreement dated July 7, 1980, between Oshkosh B'Gosh, Inc. and Thomas R. Wyman, previously filed as Exhibit 10.2 to the Registrant's Registration Statement No. 2-96586 on Form S-1, is incorporated herein by reference. *10.3 Oshkosh B'Gosh, Inc. Pension Plan as amended, previously filed as Exhibit 10.3 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File Number 0-13365, is incorporated herein by reference. *10.4 Oshkosh B'Gosh, Inc. Profit Sharing Plan, as amended on August 5, 1985, previously filed as Exhibit 10.4 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1985, Commission File Number 0- 13365, is incorporated herein by reference. *10.5 Oshkosh B'Gosh, Inc. Restated Excess Benefit Plan as amended, previously filed as Exhibit 10.5 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File Number 0- 13365, is incorporated herein by reference. *10.6 Oshkosh B'Gosh, Inc. Executive Deferred Compensation Plan as amended, previously filed as Exhibit 10.6 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1992, Commission File Number 0- 13365, is incorporated herein by reference. *Represents a plan that covers compensation, benefits and/or related arrangements for executive management. *10.7 Oshkosh B'Gosh, Inc. Officers Medical and Dental Reimbursement Plan, previously filed as Exhibit 10.7 to the Registrant's Registration Statement No. 2-96586 on Form S-1, is incorporated herein by reference. 10.8 Loan Agreement between Oshkosh B'Gosh, Inc. and the Industrial Development Board of the Town of Dover, Tennessee, dated as of May 1, 1984 (Series 1984A), previously filed as Exhibit 10.8 to the Registrant's Registration Statement No. 2-96586 on Form S-1, is incorporated herein by reference. 10.9 Loan Agreement between Oshkosh B'Gosh, Inc. and the Industrial Development Board of the Town of Dover, Tennessee, dated as of May 1, 1984 (Series 1984B), previously filed as Exhibit 10.9 to the Registrant's Registration Statement No. 2-96586 on Form S-1, is incorporated herein by reference. 10.10 Loan Agreement between Oshkosh B'Gosh, Inc. and the Industrial Development Board of Clay County, Tennessee, dated as of December 1, 1983 (Series 1983A), previously filed as Exhibit 10.10 to the Registrant's Registration Statement No. 2-96586 on Form S-1, is incorporated herein by reference. 10.11 Loan Agreement between Oshkosh B'Gosh, Inc. and the Industrial Development Board of Clay County, Tennessee, dated as of December 1, 1983 (Series 1983B), previously filed as Exhibit 10.11 to the Registrant's Registration Statement No. 2-96586 on Form S-1, is incorporated herein by reference. 10.12 Loan Agreement between Oshkosh B'Gosh, Inc. and City of Oshkosh, Wisconsin, dated as of November 1, 1983, previously filed as Exhibit 10.12 to the Registrant's Registration Statement No. 2-96586 on Form S-1, is incorporated herein by reference. 10.13 Lease Agreement between Oshkosh B'Gosh, Inc. and City of Oshkosh, Wisconsin, dated as of March 1, 1975, previously filed as Exhibit 10.13 to the Registrant's Registration Statement No. 2-96586 on Form S-1, is incorporated herein by reference. 10.14 Acknowledgement and Guaranty Agreement between City of Liberty, Casey County, Kentucky and Oshkosh B'Gosh, Inc., dated October 4, 1984, and related Contract of Lease and Rent dated as of November 26, 1968, previously filed as Exhibit 10.14 to the Registrant's Registration Statement No. 2-96586 on Form S-1, is incorporated herein by reference. *Represents a plan that covers compensation, benefits and/or related arrangements for executive management. 10.15 Loan Agreement between Oshkosh B'Gosh, Inc. and City of Oshkosh, Wisconsin, dated as of October 1, 1985, previously filed as Exhibit 10.15 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1985, Commission File Number 0-13365, is incorporated herein by reference. 10.16 Indemnity Agreement between Oshkosh B'Gosh, Inc. and William P. Jacobsen (Vice President and Treasurer of Oshkosh B'Gosh, Inc.) dated as of June 8, 1987, previously filed as Exhibit 10.16 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1987, Commission File Number 0-13365, is incorporated herein by reference. (Note: Identical agreements have been entered into by the Company with each of the following officers: Charles F. Hyde, Thomas R. Wyman, John F. Beckman, Anthony S. Giordano, Douglas W. Hyde, Michael D. Wachtel, and Kenneth H. Masters). *10.17 Employment agreement dated December 14, 1989 and effective February 1, 1990, between Oshkosh B'Gosh, Inc. and Harry M. Krogh, previously filed as Exhibit 10.17 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1989, Commission File Number 0-13365, is incorporated herein by reference. *10.18 Oshkosh B'Gosh, Inc. Executive Non-Qualified Profit Sharing Plan effective as of January 1, 1989, previously filed as Exhibit 10.18 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1990, Commission File Number 0-13365, is incorporated herein by reference. 10.19 Loan Agreement between Oshkosh B'Gosh, Inc. and the Industrial Development Board of Clay County, Tennessee, dated as of February 1, 1992. *Represents a plan that covers compensation, benefits and/or related arrangements for executive management. 21 The following is a list of the subsidiaries of the Company as of December 31, 1993. The consolidated financial statements reflect the operations of all subsidiaries as they existed on December 31, 1993. State or Other Jurisdiction of Name of Incorporation or Subsidiary Organization Term Co. (formerly Absorba, Inc.) Delaware Essex Outfitters, Inc. Delaware Grove Industries, Inc. Delaware Manufacturera International Apparel, S.A. Honduras Oshkosh B'Gosh Europe, S.A. France Oshkosh B'Gosh International Sales, Inc. Virgin Islands Oshkosh B'Gosh Asia/Pacific Ltd. Hong Kong Oshkosh B'Gosh U.K. Ltd. United Kingdom Oshkosh B'Gosh Deutschland GmbH Germany OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Schedule V Property, Plant and Equipment Years Ended December 31, 1993, 1992 and 1991 (Dollars in Thousands) Balance at Balance Beginning Additions at End Classification of Year at Cost Retirements of Year Year Ended December 31, 1993: Construction in Progress $ 537 $ (246) $ - $ 291 Land 1,647 287 59 1,875 Land Improvements 2,249 70 22 2,297 Buildings 38,107 555 1,022 37,640 Machinery and Equipment 62,357 5,909 1,240 67,026 Leasehold Improvements 2,953 2,415 100 5,268 Total $107,850 $ 8,990 $ 2,443 $114,397 Year Ended December 31, 1992: Construction in Progress $ 7,380 $(6,843) $ - $ 537 Land 1,264 383 - 1,647 Land Improvements 1,981 268 - 2,249 Buildings 30,122 8,005 20 38,107 Machinery and Equipment 55,096 11,163 3,902 62,357 Leasehold Improvements 1,805 1,431 283 2,953 Total $97,648 $14,407 $ 4,205 $107,850 Year Ended December 31, 1991: Construction in Progress $ 3,917 $ 3,463 $ - $ 7,380 Land 1,264 - - 1,264 Land Improvements 1,849 132 - 1,981 Buildings 26,409 3,713 - 30,122 Machinery and Equipment 43,802 11,995 701 55,096 Leasehold Improvements 1,533 272 - 1,805 Total $78,774 $19,575 $ 701 $97,648 Depreciation and Amortization Depreciation and amortization for financial reporting purposes is calculated using straight-line methods based on the following useful lives: Years Land Improvements 10 to 15 Buildings 10 to 40 Equipment 5 to 10 Leasehold Improvements 5 to 10 OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Schedule VI Accumulated Depreciation and Amortization of Property, Plant and Equipment Years Ended December 31, 1993, 1992 and 1991 (Dollars in Thousands) Additions Balance atCharged to Balance BeginningCosts and at End Classification of Year Expenses Retirements of Year Year Ended December 31, 1993: Land Improvements $ 877 $ 211 $ 3 $ 1,085 Buildings 7,577 1,520 267 8,830 Machinery and Equipment 26,070 6,208 879 31,399 Leasehold Improvements 1,014 486 172 1,328 Total $35,538 $8,425* $1,321 $42,642 Year Ended December 31, 1992: Land Improvements $ 674 $ 203 $ - $ 877 Buildings 6,101 1,480 4 7,577 Machinery and Equipment 21,567 5,994 1,491 26,070 Leasehold Improvements 914 232 132 1,014 Total $29,256 $7,909* $1,627 $35,538 Year Ended December 31, 1991: Land Improvements $ 497 $ 177 $ - $ 674 Buildings 5,135 966 - 6,101 Machinery and Equipment 17,237 4,783 453 21,567 Leasehold Improvements 704 210 - 914 Total $23,573 $6,136* $ 453 $29,256 * Excludes amortization of other assets of $808 in 1993, $466 in 1992, and $432 in 1991. OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Schedule VIII Valuation and Qualifying Accounts (Dollars in Thousands) Years Ended December 31, 1993 1992 1991 Accounts Receivable - Allowances: Balance at Beginning of Period $2,265 $2,335 $2,075 Charged to Costs and Expenses 5,979 4,500 4,513 Deductions - Bad Debts Written off, Net of Recoveries and Other Allowances (4,934) (4,570) (4,253) Balance at End of Period $3,310 $2,265 $2,335 Years Ended December 31, 1993 1992 1991 Restructuring Costs - Allowances: Balance at Beginning of Period $ 422 $ 5,600 $ - Charged to Cost and Expenses 10,836 (2,800) 5,600 Actual Restructuring Costs Incurred(3,072) (2,378) - Balance at End of Period $ 8,186 $ 422 $5,600 OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Schedule IX Short-Term Borrowings Years Ended December 31, 1993, 1992 and 1991 (Dollars in Thousands) Weighted Maximum Average Average Weighted Amount Amount Interest Category of Balance Average OutstandingOutstanding Rate Aggregate at End Interest During During During Borrowings of Year Rate the Period the Year the Year Notes Payable to Banks: 1993 $ -0- -0-% $ 798 $ 2 3.60% 1992 $ -0- -0-% $ 4,990 $ 602 6.39% 1991 $ -0- -0-% $ 5,945 $ 1,047 8.94% Commercial Paper: 1993 $ -0- -0-% $23,223 $ 4,269 3.59% 1992 $ -0- -0-% $17,231 $ 2,237 4.29% 1991 $ -0- -0-% $25,854 $ 7,048 6.77% Notes payable to banks represent short-term borrowings payable under credit arrangements with lending banks. Borrowings are arranged on an as needed basis at various terms. The average amount outstanding during the year represents the average daily principal balances outstanding during the year. The weighted average interest rates were computed by dividing the actual interest incurred on short-term borrowings by the average short-term borrowings. OSHKOSH B'GOSH, INC. AND SUBSIDIARIES Schedule X Supplementary Income Statement Information Years Ended December 31, 1993, 1992 and 1991 (Dollars in Thousands) 1993 1992 1991 Advertising $11,209 $10,180 $8,917 Maintenance and Repairs $ 4,609 $4,277 Amounts for taxes other than payroll and income taxes, royalties and amortization of intangible assets for the years ended December 31, 1993, 1992 and 1991 and maintenance and repairs for the year ended December 31, 1993 are not presented as each such amount does not exceed 1% of net sales as shown in the related statements of income. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly cause this report to be signed on its behalf by the undersigned, thereunto duly authorized. OSHKOSH B'GOSH, INC. BY: DOUGLAS W. HYDE President and Chief Executive Officer BY: DAVID L. OMACHINSKI Vice President, Treasurer and Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, tis report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. CHARLES F. HYDE Chairman of the Board 3/31/94 STEVEN R. DUBACK Secretary and Director 3/29/94 DOUGLAS W. HYDE President, Chief Executive Officer 3/28/94 and Director WILLIAM P. JACOBSEN Senior Vice President and Director 3/30/94 MICHAEL D. WACHTEL Executive Vice President, Chief 3/27/94 Operating Officer and Director

18497_1993.txt

18497

1993

ITEM 1. BUSINESS GENERAL CenCor, Inc. was incorporated under the laws of Delaware on May 27, 1968. As used herein, the term "CenCor" refers to CenCor, Inc. and the term "Century" refers to CenCor's sole operating subsidiary, Century Acceptance Corporation. The term "the Company" as used herein refers to CenCor collectively with Century and, as indicated by the context, its prior subsidiaries. CenCor, through its wholly-owned subsidiary, Century, is primarily engaged in the consumer finance business. Century makes consumer and home equity loans to individuals, generally secured by personal property and real estate. Century also sells various insurance products, including credit life, accident and health, and property insurance in conjunction with its consumer loan business. In addition, Century purchases consumer retail installment sales obligations. On July 19, 1993, CenCor filed a Voluntary Petition with the United States Bankruptcy Court for the Western District of Missouri, seeking protection under Chapter 11 of the United States Bankruptcy Code. At the same time, CenCor filed an Application with the Bankruptcy Court seeking expeditious confirmation of its previously creditor approved prepackaged plan of reorganization. The plan was confirmed by the bankruptcy court on August 30, 1993. On November 1, 1993, CenCor issued new notes and stock to its subordinated noteholders pursuant to the provisions of the plan. The filing did not involve Century. CONSUMER FINANCE OPERATIONS The percentages of gross revenue from consumer financing and insurance commissions during each of the last five years were as follows: Since the consumer finance business involves the carrying of receivables, a relatively high ratio of borrowings to invested capital is customary. Net income of the Company and Century is materially dependent on the cost of borrowed funds, and because the maximum rates charged for Century's lending operations are limited by statute, any increase or decrease in interest costs tend to have an adverse or favorable effect on the Company's and Century's net income. The following tables set forth certain information concerning Century's consumer finance business: CONSUMER LOANS AND REAL ESTATE LOANS Consumer loan operations are generally confined to two types of loans, as authorized by the laws of the respective states in which business is conducted: (a) loans on which the interest is reflected in the face amount of the note (precompute loans) and (b) loans on which the interest is computed on monthly unpaid balances (interest bearing loans). As of December 31, 1993, 85% of Century's consumer loans receivable were precompute loans. Permitted relevant effective rates for loans vary from 18% per annum to approximately 36% per annum with maximum allowable loans ranging from $2,500 to an unspecified amount. In general, Century charges the maximum rate permitted. During 1993, home equity loan receivables increased by 112% from $6,382,000 to $13,560,000. The average per loan net balance outstanding at December 31, 1993 was $15,327. Home equity loans consist primarily of loans made to individuals which are secured by first or second mortgages on single family homes. If a borrower needs additional money before repaying his loan in full, Century's policy is to extend additional monies if the borrower's credit circumstances warrant. This is done by making a new loan in an amount sufficient to pay off the balance of the old loan and to supply the needed new money. The following table sets forth certain information regarding new and present borrowers: INSURANCE OPERATIONS In conjunction with its consumer lending operations and where applicable laws permit, Century also makes credit life, accident and health, property, and specialty insurance products available to its customers. The insurance is carried through American Bankers Life Assurance Co. of Florida and American Bankers Life Insurance Co. of Florida. The following table sets forth the percentage of revenues from insurance operations attributable to accident and health, property, and credit life policies for the periods indicated. LENDING POLICIES In conducting lending activities, it is the policy of Century to require a satisfactory credit history. Loans are made to individuals primarily on the basis of the borrower's income and are limited to amounts which the customer appears able to repay without hardship. Investigation of the credit worthiness of obligors is made by Century's personnel. When security is taken in connection with a loan, the net realizable value of the property on which liens are taken as security (except for real estate in which case the loan amount is limited to a maximum of 75% of the appraised market value) is in many cases less than the amount of the related receivable. Subject to governmental restrictions, Century makes loans secured by consumer goods for varying periods, with original contractual terms up to 36 months and not exceeding 48 months. Home equity loans secured by real estate generally do not exceed 180 months. Century purchases retail installment contracts with original contractual terms generally not exceeding 36 months. CREDIT LOSS EXPERIENCE Past due finance receivables are charged off in accordance with the policies set forth below and when management deems them to be uncollectible, although in most instances collection efforts do not cease. Provisions for credit losses are charged to income in amounts sufficient to maintain the allowance for credit losses at a level considered adequate to cover losses in the existing portfolio (see Note 1 "Credit Losses" to the financial statements). Prior to December 31, 1991, unpaid balances were charged off if no installments had been received for 180 days. At December 31, 1991 Century charged off all non-asset receivables such as bankruptcies, deficiency balances, settlements and the unsecured portions of Chapter XIII bankruptcy accounts. The year end effect of this policy change was to increase 1991 charge offs by $3,000,000. In August 1992, Century implemented a policy of charging off accounts when six (6) or more monthly contractual installments are past due and aggregate collections of principal and interest for a six (6) month period are less than a contractual payment. However, when an account is considered uncollectible, it is charged off immediately. Uncollectible accounts are handled as follows: BANKRUPTCY - CHAPTER 7 - The balance of the account will be charged off in the month following the date of discharge. BANKRUPTCY - CHAPTER 13 - The unsecured portion of the balance will be charged off in the month following the confirmation hearing. SETTLEMENT - The remaining balance will be charged off in the month following the final payment. REPOSSESSION DEFICIENCY - The deficiency balance will be charged off after the appropriate proceeds of the sale of security have been posted. The appropriate supervisor must warrant that there is limited potential for additional collection. The allowance for credit losses in the opinion of management is adequate to cover losses and expenses known through the end of the year. The credit loss experience of Century for each of the five years ended December 31, is set forth below: The following is a table of net receivables outstanding (gross receivables less unearned finance charges), percent of allowance for credit losses to net receivables at year-end and net charge offs at the dates indicated: A summary of delinquent consumer loan receivables (excluding sales contracts) as of December 31, 1989 through 1993 is set forth on the following page. The table includes accounts which have had no collections of principal, interest or charges for 60 days or more, classified as to the period during which the last collection was received. Thus, if any payment has been made on an account within 60 days, even though such payment was more than 60 days delinquent, the account is not included in the amounts shown in the table. REGULATION Century operates under various state laws which regulate the direct consumer loan business, although the degree and nature of such regulation varies from state to state and depends on the laws involved. In general, the laws under which a substantial amount of Century's business is conducted provide for state licensing of lenders (which licenses may be revoked for cause), impose limitations on the maximum duration and amount of individual loans and the maximum rate of interest and charges and prohibit the taking of assignments of wages. In addition, certain of these laws prohibit the taking of liens on real estate except liens resulting from judgments. In accordance with the Federal Consumer Credit Protection Act, Century discloses to its customers various charges and expenses, including the total finance charge and the annual percentage rate of charges applicable to each transaction. Century also discloses either monthly interest rates or total dollar credit charges as required by the states in which it operates. Century also is subject to the provisions of the Fair Credit Reporting Act ("FCRA") and makes the disclosures to consumers required by the FCRA. Consumers are advised when adverse action, such as the denial of credit or insurance or an increase in charges for credit or insurance, is taken based in whole or in part on information contained in consumer reports received from consumer reporting agencies, such as credit bureaus, or other sources. A rule of the Federal Trade Commission permits a debtor to assert against a purchaser of a consumer credit contract, such as the installment contracts purchased by Century, all claims and defenses which the debtor could assert against the seller of the goods or services obtained by the debtor pursuant to the contract. Although Century has no direct recourse against the seller of such installment contracts, if problems with purchased contracts arise, it is common business practice and Century's history has demonstrated that the seller will exchange a more satisfactory installment contract for the problem one. Therefore, there has been no material impact on operations as a result of the rule. At December 31, 1993, approximately 22% of Century's receivables are from the purchase of installment contracts. Century is subject to the Equal Credit Opportunity Act, Title VII, prohibiting discrimination on the basis of sex or marital status, race, color, religion, national origin, age, receipt of income under public aid or good faith exercise of rights under the Consumer Credit Protection Act. The federal bankruptcy law affects the business of Century in the following principal respects: (A) Rights of the creditor and debtor to reaffirm obligations are limited by necessity of court approval, and then the debtor has 30 days to change his mind; (B) Contact between creditor and debtor must be limited once a bankruptcy case is filed; (C) Debtor next has choice of federal exemptions or state exemptions and in many instances federal exemptions are more liberal so that creditor's rights are limited; (D) Payments made by a debtor to a creditor 90 days before bankruptcy may have to be returned because of presumption of insolvency; (E) The value of secured property can be determined by the court rather than by the balance of the loan, thus making it possible for the debtor to retain property free and clear through payoff of the debt, at an amount which is less than the outstanding balance of the loan. Century continuously modifies its finance forms in order to conform with new interpretations of the various laws and regulations to which it is subject. However, it is virtually impossible, because of numerous new court decisions with retroactive application, to avoid technical violations, especially with respect to the truth-in-lending laws, which may subject Century to substantial liabilities including penalties and attorney's fees payable to its customers. To date, there has not been a significant number of such claims asserted against Century. The sale of insurance is subject to various insurance regulations in each state where Century sells such insurance. EMPLOYEES As of March 7, 1994, the Company had 257 employees. The Company has no contract with any labor union representing its employees and there have been no organizing efforts of employees. ITEM 2.

ITEM 2. PROPERTIES LOCATION OF OFFICES Century's business requires a relatively small investment in fixed assets. All offices occupied by Century are leased with terms of five years or less. The geographic distribution of Century's business on December 31, 1993 was as follows: Item 3.

Item 3. Legal Proceedings Because the business of Century involves the collection of numerous accounts, the validity of liens, accident and other damage or loss claims under many types of insurance, and compliance with state and federal consumer laws, Century and its subsidiaries are from time to time plaintiffs and defendants in numerous legal proceedings. Other than the cases listed below, CenCor, nor any of its subsidiaries is a party to, nor is the property thereof the subject of, any pending legal proceedings which depart from the ordinary routine litigation incident to the kinds of business conducted by Century and its subsidiaries or, if such proceedings constitute other than routine litigation, in which there is a reasonable possibility of an adverse decision which could have any material adverse effect upon the financial condition of CenCor. There are no proceedings pending or, to the Company's knowledge, threatened by or on behalf of any administrative board or regulatory body which would materially affect or impair the right of Century to carry on any of its respective business. For information on legal proceedings involving the Estate of Robert F. Brozman and the CIKC Lenders (as later defined) see Note 4 to the financial statements. A subsidiary of Century commenced litigation on February 19, 1992 in the Circuit Court of the Thirteenth Judicial Circuit of Hillsborough County, Florida, against JoAnn's Instant Finance Cars, Inc. (JoAnn's) and certain of its affiliates from whom Century had purchased automobile financing contracts. The Company alleged a variety of fraudulent and criminal activities by the defendants and was seeking substantial monetary damages as well as various forms of equitable relief. Century was successful in having a receiver appointed to oversee the assets of JoAnn's and the contracts created by JoAnn's that were held by Century. The receiver was subsequently discharged upon a determination that the cost of continuing the receivership would exceed the amount of recovery to Century. On May 7, 1992, the suit filed by JoAnn's against CenCor, Century and two of their officers was dismissed with prejudice. On January 6, 1993, Century's subsidiary was awarded a summary judgment of $6,000,000 against JoAnn's; however, this amount is not necessarily indicative of the actual damages incurred by Century in the fraudulent scheme. Because JoAnn's does not own significant assets, the ability of Century to recover substantial monetary amounts from JoAnn's and/or its affiliates is doubtful, despite the summary judgment granted in Century's favor. On May 13, 1993, George C. Evans, Century's former President and CEO, filed suit against Century in the Circuit Court of Jackson County, Missouri at Kansas City, Sixteenth Judicial Circuit, State of Missouri, Case No. CV93-10201, alleging that he was terminated without cause and should be entitled to compensation for wages and bonuses. On May 13, 1993, Century filed suit against Evans, in the Circuit Court of Jackson County, Missouri at Kansas City, Case No. CV 93-10198, seeking Declaratory and Injunctive Relief. Both actions were dismissed pursuant to a Release and Settlement Agreement between Evans, Century and CenCor dated June 4, 1993. The Agreement requires that the parties keep the terms confidential with certain limited exceptions. Under the Agreement, Evans will receive periodic cash payments and may receive other contingent payments discussed in Note 13 to the financial statements. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of security holders during the fourth quarter of the registrant's fiscal year ended December 31, 1993. (The remainder of this page is intentionally blank.) PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS Until December 7, 1992, the Company's Common Stock was quoted on the NASDAQ National Market System (Symbol-CNCRE). Effective that date, the Common Stock was delisted from the NASDAQ National Market System because of CenCor's failure to meet the NASDAQ capital and surplus requirements. On December 4, 1992, the last date the Common Stock was quoted, the closing price was $ .50 per share. Since that time, CenCor's stock has been quoted on an inter-dealer basis in the over-the-counter market on the so-called "broker's pink sheets." The range of high and low sales price as quoted on broker's pink sheets for each quarter of 1993 and the range of high and low sales price as reported on the National Market system for each quarter of 1992 are as follows: The quotations from the broker's pink sheets reflect inter-dealer prices without retail mark-up, mark-down, or commission and may not represent actual transactions. On March 10, 1994, the quoted bid price of the Common Stock on broker's pink sheets was $0.50. At March 10, 1994, CenCor had approximately 1,197 shareholders of record. No dividends have been paid on the common stock and the Company does not presently intend to pay dividends. Due to the current financial status of the Company it is unlikely that dividends will be declared or paid. In addition, the terms of Century's restructuring agreements eliminate Century's ability to pay dividends on its common stock other than in shares of Century. Accordingly, CenCor will not be entitled to receive cash dividends from Century until Century's restructured debt obligations have been paid in full. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA ITEM 6. SELECTED FINANCIAL DATA (CONTINUED) (The remainder of this page is intentionally blank.) Item 7.

Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS The Company was significantly and adversely affected by certain events in 1991 and 1992. Among other consequences, these events have affected the Company's results of operations, its financial position, its liquidity, and resulted in certain defaults under the loan agreements. As a result of these adverse developments, the Company has, since mid-1991, experienced severe liquidity problems. In July 1992, the Board of Directors began reviewing various financial alternatives that the Company might pursue, including restructuring its outstanding debt by means of an exchange offer or by means of a Chapter 11 bankruptcy filing, with the goal of maximizing its investment in Century and implementing a long-term solution to the Company's financial situation. The review process resulted in the development of a proposed restructuring plan and a prepackaged bankruptcy plan of reorganization, which was circulated to noteholders and other creditors on May 13, 1993. Following creditor approval, CenCor filed for Chapter 11 bankruptcy reorganization on July 19, 1993. The prepackaged bankruptcy plan was confirmed by the bankruptcy court on August 30, 1993. On January 28, 1993, Century completed a restructuring of its debt obligations with its principal creditors (NOTE 5). Subsequent to the restructuring, Century sold or closed twelve non-strategic branches to obtain operating efficiencies. Century has also modernized many of its offices and has converted to an on-line computer system. According to its business plan, Century intends to achieve financial stability and profitability through internal growth with a program to grow its current branches and expand the branch network in states with strong operations. In addition, the business plan calls for the acquisition of compatible receivables and/or companies to achieve growth of receivables of $100 million in the next four years. The plan assumes that Century will be able to retain a substantial portion of acquired accounts as active customers and that acquisitions can be negotiated with acceptable yields and levels of credit risk. Century's acquisition program is also dependent on its ability to obtain additional financing. On August 22, 1992, the Century Board hired George C. Evans as President and CEO to direct the operations of Century. Mr. Evans' employment was terminated effective April 12, 1993 (see Note 13 to the financial statements). Dennis C. Berglund, who had 24 years of experience with Avco Financial Services, was then appointed to fulfill these duties. Effective June 15, 1993, Mr. Berglund was appointed to the positions of President and CEO. During 1993, Century also completed the installation of a modern management information and data processing system which is operated under contract with Norwest Financial Information Services Group ("Norwest"). Norwest provides similar services for the consumer loan operations of its own affiliate and for a large section of the consumer finance industry, which includes approximately 4,000 branch offices throughout the country. The system provides Century headquarter personnel on-line access to branch data and enables Century to provide more timely and informative reports to improve management decision making, supervision and control. CURRENT OVERALL TRENDS During the year ended December 31, 1993, the Company incurred a net loss from continuing operations of $7,256,000 as compared to a net loss of $12,352,000 for 1992. As discussed in further detail below, the loss resulted primarily from a decrease in total revenue of $2,768,000 (11%) and an increase in operating expenses of $4,687,000 (32%). Offsetting these was a decrease in provision for credit losses of $11,052,000 (84%). Century has shifted its emphasis away from sales finance contracts acquired from automobile dealers, and is focusing on more desirable and profitable direct loans, including home equity loans, which typically have lower yields but generally have lower charge-off and servicing costs. In addition, during 1993 Century sold four of its branches and sold an additional six branch offices during January and February of 1994. Management determined that these locations were outside of its focused market area and the cost of operating the offices was not providing adequate benefits. The sale of these branches will enable Century to focus on its more profitable and geographically desirable offices. Century also merged two of its branch offices into other nearby branches during 1993 in order to consolidate resources, improve efficiency, and eliminate overhead costs. Management feels that the above mentioned changes and the completion of the installation of the new data processing system will serve to reduce the amount of operating expenses in 1994. Management intends to closely evaluate and monitor operating expenses throughout the year. 1993 COMPARED TO 1992 Interest on finance receivables decreased by $2,131,000 (9%) in the year ended December 31, 1993. The decrease resulted primarily from the change in the concentration of high yielding assets, such as automobile sales finance contracts, to an increase in the level of lower yielding home equity loans. The provision for credit losses decreased by $11,052,000 to $2,104,000 for the year ended December 31, 1993. The decrease in the provision for credit losses is primarily attributable to the significant decrease in the auto paper portfolio, the increased recoveries of previously charged off receivables and the strengthening of management and controls. Operating expenses increased by $4,687,000 (31%) to $19,339,000 for the year ended December 31, 1993. The increase was mostly due to additional costs incurred to improve the quality and effectiveness of Century's operations. Most of the increase in operating expenses occurred in the following categories: salary and employment expenses (44%), rent expense (30%), computer system conversion (100%), incentives toward the growth of Century's portfolio (68%), settlement with a former employee (100%), and relocation expenses (78%). Interest expense decreased slightly in the year ended December 31, 1993 from $10,685,000 at December 31, 1992 to $9,263,000 at December 31, 1993. The decrease in the interest expense resulted from the restructuring of the outstanding long term debt (see Notes 2 and 5 to the financial statements). In addition, Century, in connection with its debt restructure on January 28, 1993, issued warrants to its noteholders in order to acquire 300,000 shares of Century common stock (see Note 5 to the financial statements). The value of the warrants in excess of the exercise price is being accrued as interest expense. As previously mentioned, Century sold four of its branch offices during 1993. The resulting gain from the sale of the branch receivables ($944,000) and the loss from the sale of the branch fixed assets ($18,000) was recorded as other income (loss) in the accompanying consolidated statement of operations. As a result of CenCor's reorganization plan (see Note 2 to the financial statements), CenCor issued New Notes, Convertible Notes, and stock to its noteholders. The New Notes and Convertible Notes were recorded at their net present value using an estimated market discount rate of 16%. As a result of these transactions, an extraordinary gain of $18,033,000 was recorded. No provision for income tax was recorded in 1993. See Note 10 to the financial statements. 1992 COMPARED TO 1991 Interest on finance receivables decreased in the year ended December 31, 1992 compared to 1991. Although yields were comparable between the two years, average earning balances for the period were lower in 1992 as compared to 1991. This resulted from Century's decision to significantly curtail the purchase of bulk automobile sales contracts subsequent to the discovery of the JoAnn's fraud in late 1991. As a result, net finance receivables were $74,777,000 at December 31, 1992 as compared to $100,905,000 at December 31, 1991. Because principal pay downs were not reinvested in bulk sales contracts, cash and cash equivalents increased $19,976,000 during 1992 to $23,401,000. Insurance commissions were down $306,000 or 15% from 1991. The decrease also reflected the lower consumer loan origination activity in 1992 compared to 1991. The provision for credit losses increased $1,023,000 to $13,156,000 for the year ended December 31, 1992. Net charge offs for 1992 included approximately $2,700,000 of JoAnn's notes of which $2,100,000 had been previously reserved. As a result of significant credit losses in Century's automobile sales contract portfolio, management has increased the related allowance for credit losses to approximately 22% of net outstanding balances. The allowance for credit losses on all other finance receivables is approximately 5% of net outstanding balances. Operating expenses for 1992 decreased to $14,652,000 from $18,169,000 in 1991. The 1991 results included $3,120,000 of service fees paid to JoAnn's and a $3,707,00 loss on fraudulent contracts which did not reoccur in 1992. The 1992 results reflect higher professional expenses incurred in connection with the JoAnn's fraud and dealing with defaults on CenCor's and Century's debt. The loss from discontinued operations for 1992 was $9,623,000 as compared to a loss from discontinued operations of $229,000 for the same period in 1991. The increase is primarily due to the $5,422,000 provision for credit losses related to the Junior Secured Debenture issued by Concorde Career Colleges ("Concorde") and the net loss on disposal of discontinued operations' assets of $3,699,000 (see Note 3 to the financial statements). An income tax benefit of $336,000 was recorded for the 1992 loss. A reconciliation of income tax benefit to the amount computed using the statutory federal income tax rate is included in Note 10 to the financial statements. LIQUIDITY AND CAPITAL RESOURCES DEBT AVAILABILITY On January 29, 1993, after extensive negotiations with its major creditors, Century successfully completed its debt restructuring. Prior to that date, Century had been in default on all its debt due to various covenant violations (see Note 5 to the financial statements for details of Century's debt restructure). The terms of Century's restructuring agreements limit Century's ability to incur additional indebtedness, within certain limits. On October 15, 1993 Century entered into a letter of intent with Congress Financial Corporation ("Congress") that provided for a revolving line of credit up to $25,000,000. The loan will be used to provide future working capital for Century in order to achieve its plan of portfolio growth. The facility is fully secured by a first lien on all of Century's assets. The interest rate on the proposed Congress loan is two percent (2%) above the prime commercial interest rate, adjusted monthly. The revolving credit line is provided for a minimum of two years with automatic year to year renewals unless terminated by either party. Management expects to complete the Congress agreement and have funds available by April 1, 1994. As previously mentioned, CenCor successfully restructured its debt on August 30, 1993. For a further discussion of CenCor's debt restructure, refer to Note 2 of the financial statements. CAPITAL OBLIGATIONS The Company has no significant obligations for capital purchases. DEFAULTS ON LONG-TERM DEBT At December 31, 1992, Century was in default of certain covenants in its long-term debt agreements. On January 29, 1993, Century entered into amendment and exchange agreements with the holders of its long-term debt (the Agreements), whereby the holders agreed to defer all principal payments until April 30, 1997. Additionally, many covenants of the debt agreements were amended. The covenants include, in part, maintaining net worth at certain minimum levels and limitations on indebtedness and payment of dividends. Century is in compliance with the amended covenants of the long-term debt agreements. Pursuant to the Agreements, all of Century's long-term debt will mature on April 30, 1997. However, certain scheduled principal installments as provided for in the original debt agreements are due prior to this date. In lieu of cash payment of the scheduled principal installments, Century will deliver Secured Deferred Payment Notes for the related senior debt and a combination of Secured Deferred Payment Notes and Secured Compound PIK Notes for the related subordinated and junior subordinated debt. These notes will bear interest at a fixed rate equal to the rate on 4.5 year Treasury notes as of the installment due date, plus 2.25% (senior notes), 3.75% (subordinated notes) and 5% (junior subordinated notes). Interest is payable monthly under all of the notes, except for the Secured Compound PIK Notes, for which interest compounds monthly and is payable on April 30, 1997. Prior to the restructuring of its debt, CenCor was in default on both its public and private debt. As part of the Restructuring, which was consummated on August 30, 1993, the old debt was exchanged for New Notes, Convertible Notes, and stock (see Note 2 to the financial statements). The Company is in compliance with all covenants and terms under the new indenture. INTERNAL REVENUE SERVICE EXAMINATION The Company's income tax returns for 1988 and 1989 were examined by the Internal Revenue Service (IRS), which has proposed certain adjustments, a portion of which have been protested by the Company. The Company has also claimed additional deductions in these years. Management believes that the ultimate disposition of the IRS examination will not have a material effect on the financial position of the Company. As a result of the unresolved IRS examination, management cannot precisely estimate the amount of the Company's net operating loss carryforward for financial statement or federal income tax purposes. CONTINUING OPERATIONS As noted earlier, CenCor successfully restructured its long-term debt pursuant to a plan confirmed by the U.S. Bankruptcy Court and approved by the majority of its creditors. Management believes that CenCor's financial condition will not have a material adverse impact on Century's financial condition, operations, or its ability to fund its operations. Funds that are available to CenCor, including cash on hand, investment income and the collection of certain receivables, are expected to be sufficient to support CenCor's limited activities through at least 1996. In addition, with the potential availability of the line of credit provided by Congress, Century intends to pursue its business plans of expansion through acquisitions of consumer finance businesses and portfolios of consumer loans and also through expansion of business with its existing and former customers. INFLATION AND GENERAL ECONOMIC CONDITIONS The cost of Century's operating expenses has increased due to normal inflationary increases. Century foresees no detrimental effects from inflation as long as inflation remains at or near current levels. Changes in interest rates can affect Century. Its liabilities are more sensitive to interest rate changes than its assets. While economic conditions affecting the country have an impact on Century's business, primarily with its cost of funds, the business is such, that specific local economies have a much greater financial impact. For example, a major employer either adding or reducing employees will have a ripple effect in a community which will impact Century's ability to make and collect loans. Century, as it is now structured, does not anticipate any major economic effect on its business. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT AUDITORS The Board of Directors and Stockholders CenCor, Inc. We have audited the accompanying consolidated balance sheets of CenCor. Inc. (the Company) as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholders' equity (deficit) and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion of these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of CenCor, Inc. at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. ERNST & YOUNG Kansas City, Missouri March 4, 1994 CenCor, Inc. Consolidated Balance Sheets SEE ACCOMPANYING NOTES. CenCor Inc. Consolidated Statements of Operations SEE ACCOMPANYING NOTES. CenCor Inc. Consolidated Statements of Operations (continued) SEE ACCOMPANYING NOTES. CenCor, Inc. Consolidated Statements of Stockholders' Equity (Deficit) SEE ACCOMPANYING NOTES. CenCor, Inc. Consolidated Statements of Cash Flows See Accompanying Notes. CenCor, Inc. Consolidated Statements of Cash Flows (continued) SEE ACCOMPANYING NOTES CenCor, Inc. Notes to Consolidated Financial Statements December 31, 1993, 1992, and 1991 1. SUMMARY OF SIGNIGICANT ACCOUNTING POLICIES BASIS OF PRESENTATION CenCor, Inc. is essentially a holding company for its wholly-owned subsidiary, Century Acceptance Corporation ("Century"). On January 29, 1993, Century completed a restructuring of its debt obligations with its principal creditors (NOTE 5). On July 19, 1993, CenCor filed a Voluntary Petition with the United States Bankruptcy Court for the Western District of Missouri seeking protection under Chapter 11 of the United States Bankruptcy Court. At the same time, CenCor filed an Application with the Bankruptcy Court seeking expeditious confirmation of its previously creditor approved prepackaged plan of reorganization. The plan was confirmed by the bankruptcy court on August 30, 1993. As discussed further in Note 2, on November 1, 1993, CenCor issued new notes and stock to its subordinated noteholders pursuant to the provisions of the plan. The filing did not involve Century. ACCOUNTING PRINCIPLES The consolidated financial statements have been prepared in accordance with generally accepted accounting principles. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the year. Because of changing economic conditions and the economic prospects of borrowers, it is often necessary to make frequent changes in estimates and assumptions. Accordingly, actual results could differ from such estimates. Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of the allowance for credit losses. Management believes that the allowance for credit losses is adequate. While management uses currently available information to recognize losses on finance receivables, future additions to the allowances may be necessary based on changes in economic conditions in the Company's market areas. PRINCIPLES OF CONSOLIDATION The accompanying consolidated financial statements include the accounts of CenCor, Inc., and its subsidiaries, (together, the "Company") all of which are wholly owned. At December 31, 1993, Century was the Company's only subsidiary. The Company, through its subsidiary Century, is engaged in the consumer finance industry. Century provides consumer loans and real estate loans to individuals and purchases installment sales contracts. The Company also sells various insurance products including property, credit life, accident and health insurance in conjunction with its consumer loan business. All significant intercompany accounts and transactions have been eliminated in consolidation. REVENUE RECOGNITION Finance charges on receivables are recognized as revenue using the interest (actuarial) method. Finance charge accruals are suspended on accounts more than two months contractually past due. Once an account is suspended, finance charges are recognized on a collection basis. Insurance commissions are generally recognized as revenue over the term of the loan. 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) CREDIT LOSSES Provisions for credit losses are charged to income in amounts sufficient to maintain the allowance for credit losses at a level considered adequate to cover the losses in the existing portfolio. The allowance is determined using estimated loss percentages established by management for each major category of receivables. Additions to the allowance are charged to the provision for credit losses. Management evaluates allowance requirements by examining current delinquencies, the characteristics of the accounts, the value of the underlying collateral and general economic conditions and trends. Management also evaluates the availability of dealer reserves to absorb finance receivables losses. Finance receivables are charged to the allowance for credit losses when they are deemed to be uncollectible but, in any event, all accounts (except for real estate secured loans) for which an amount aggregating a full contractual payment has not been received for six consecutive months are written off. Real estate secured loans are charged to the allowance for credit losses when a full contractual payment has not been received for twelve months unless the property has been foreclosed. DEALER RESERVES At the time of the acquisition of certain automobile and sales finance contracts, arrangements are entered into with dealers whereby reserves are established and are available to the Company to charge credit losses associated with such contracts. The balance of the reserve may be refunded to the dealer should the actual loss experience of the contracts be less than the negotiated amount. DEPRECIATION AND AMORTIZATION Furniture and equipment are depreciated over the estimated useful lives of the assets using the straight-line method. Leasehold improvements are amortized ratably over the terms of the related leases. OTHER ASSETS Included in other assets at December 31, 1993 and 1992, is a $1,000,000 receivable from an insurance company in connection with a fidelity bond claim arising from the loss on fraudulent automobile contracts (NOTE 6). Other assets at December 31, 1993 and 1992, also include a $750,000 note receivable related to the sale of Charter Equipment Leasing (Charter) (NOTE 3). GOODWILL AND OTHER INTANGIBLE ASSETS In connection with the sale of The Christine England Corporation (dba Writer's) in 1991, $1,936,000 of goodwill and non-compete agreements were netted against the sale proceeds. In connection with sale of the Company's Temporary Services division and Charter in 1992, all remaining unamortized goodwill and other intangibles of $3,097,000 were netted against the sale proceeds. Amortization expense was $145,000 in 1992, and $427,000 in 1991. 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) TRANSACTIONS WITH AFFILIATES Prior to 1993, certain corporate, general and administrative expenses had been allocated from the Company to two former subsidiaries, Concorde Career Colleges, Inc. (Concorde) and LaPetite Academy, Inc. (LaPetite), which were spun off in 1988 and 1983, respectively. These allocations were made in accordance with agreements between the Company, Concorde, and LaPetite based on the estimated amounts attributable to each. The expense allocations from the Company to Concorde were $328,000 in 1992 and $611,000 in 1991. The expense allocations from the Company to LaPetite were $689,000 in 1992 and $1,193,000 in 1991. Management believes the allocations were reasonable and approximate the costs of services had they been obtained from unaffiliated parties. Included in accounts receivable are amounts due from LaPetite which total $36,000 at December 31, 1992. This amount was paid in full in 1993. CASH EQUIVALENTS Cash equivalents consisted of money market funds and are stated at cost, which approximates market. RECLASSIFICATIONS Certain 1991 and 1992 amounts have been reclassified to conform to the 1993 presentation. DIVIDEND RESTRICTION CenCor has limited sources of funds from continuing operations, except from Century. The terms of Century's debt restructuring (NOTE 5) eliminate Century's ability to pay dividends on its common stock other than in the stock of Century. Accordingly, CenCor will not be entitled to receive cash dividends from Century until Century's restructured debt obligations have been paid in full. 2. REORGANIZATION AND EXTRAORDINARY ITEM On July 19, 1993, CenCor filed a Voluntary Petition with the United States Bankruptcy Court. At the same time, CenCor filed an Application with the Bankruptcy Court seeking expeditious confirmation of its previously creditor approved prepackaged plan of reorganization. The plan was confirmed by the Bankruptcy Court on August 30, 1993. Pursuant to the plan, the noteholders received the following securities for each $1,000 aggregate amount of principal and accrued but unpaid interest at December 31, 1992: (i) $600 principal amount of non-interest bearing New Notes (ii) $400 principal amount of non-interest bearing Convertible Notes (iii) 5.2817 shares of CenCor common stock, par value $1 per share The New Notes and Convertible Notes are non-interest bearing and will mature on July 1, 1999. The Convertible Notes may be converted at the option of the holder, at any time, into shares of common stock at 2. REORGANIZATION AND EXTRAORDINARY ITEM (CONTINUED) a ratio of one share of common stock for each $20 principal amount of Convertible Notes. The reorganization resulted in the issuance of $17,230,589 of New Notes, $11,487,060 of Convertible Notes, and 151,679 shares of $1 par value common stock on November 1, 1993. Simultaneously the Company cancelled 271,410 shares of treasury stock. The New Notes and Convertible Notes were recorded at their net present value using an estimated market discount rate of 16%. A market value of $0.125 was assigned to the issuance of the common stock. As a result of these transactions, an extraordinary gain of $18,033,000 was recorded. 3. DISCONTINUED OPERATIONS Effective November 6, 1992, the Company sold substantially all the net assets of Charter in exchange for cash of $2,396,000, net of selling expenses of approximately $144,000, a promissory note in the amount of $750,000 and the buyer's assumption of certain liabilities. The promissory note is payable in full on November 5, 1995, including all accrued interest compounded monthly at a rate of 12% per annum. Net assets sold were approximately $6,969,000. The Company recorded a loss on disposal (net of income taxes) of $4,090,000. Effective February 29, 1992, the Company sold seven Temporary Services offices located in Ohio. The gross cash proceeds of the sale was $2,842,000 which was received May 1, 1992. In July 1992, the remainder of the Temporary Services offices were sold. The gross cash proceeds to the Company of the sale was approximately $1,660,000 which was received July 29, 1992. Total net assets of all the offices sold was approximately $4,111,000. The Company recorded a gain of $391,000 (net of income taxes) from the sale of these Temporary Services offices which is classified as discontinued operations in the accompanying consolidated statements of operations. Effective December 11, 1991, the Company sold Writers to Christine England from whom the Company had acquired the business in 1989. The sales price for Writers was $2,560,000, of which $1,110,000 was paid to the Company in cash and the balance eliminated indebtedness, including accrued interest, due from CenCor to Ms. England for the deferred portion of the purchase price payable to her when CenCor acquired Writer's, or amounts due to her as consideration for her agreement not to compete with CenCor. The Company recorded a loss of $369,000 (net of income taxes) related to this sale. Concorde, which was spun off to the stockholders of the Company in 1988, had previously agreed to assume certain obligations of the Company relating to the Company's Series H 10% notes. Concorde notified the Company on October 1, 1992, that it was unable to continue making payments on the assumed debt. On October 30, 1992, Concorde executed a restructuring agreement with the Company, which terminated Concorde's obligations regarding these notes. In consideration, the Company accepted Concorde's Junior Secured Debenture ("Junior Secured Debenture") for $5,422,000. As a result of Concorde's precarious financial condition, the Company established a reserve for the full amount due from Concorde. The loss provision related to the allowance is classified in the accompanying 1992 consolidated statement of operations as discontinued operations. On December 30, 1993, Concorde and Century amended the Restructuring Agreement (as later defined) to provide that CenCor would receive $8,390,000 of Concorde's previously charged-off receivables in full payment of the accrued interest on the Junior Secured Debenture through December 31, 1993 in the amount of $559,353. The receivables, which consist of accounts and notes receivable from students who attended schools operated by Concorde or its subsidiaries, were assigned to CenCor without recourse with CenCor assuming all risk of non-payment of the receivables. The amendment grants CenCor limited rights of substitution until such time as it collects $559,353 from the receivables, exclusive of out-of-pocket collection 3. DISCONTINUED OPERATIONS (CONTINUED) fees and expenses paid to third-parties. The Company has engaged a collection agent to pursue recovery of such receivables. The $559,353 accrued but unpaid interest is fully reserved in the accompanying consolidated balance sheet. The income (loss) from operations, net of applicable income taxes, for the Temporary Services division, Writer's and Charter is classified as discontinued operations in the accompanying consolidated statements of operations. The net income (loss) from discontinued operations is as follows: 4. CIKC LOANS Robert F. Brozman, who had been the President and Chairman of the Board of CenCor since its incorporation in 1968, died on June 10, 1991. Shortly thereafter, the directors who were serving on CenCor's Board of Directors at the time of Robert F. Brozman's death, including his son, Jack L. Brozman, learned for the first time of the "CIKC Loans" described below. Prior to Robert F. Brozman's death, various banks and other lenders had made loans, purportedly to CenCor, the proceeds of which were never received by, or used for the benefit of, CenCor, but rather were credited to the account of and used by CenCor, Inc. of Kansas City ("CIKC"). CIKC is a wholly-owned subsidiary of Cor, Inc. ("Cor") which was wholly-owned and controlled by Robert F. Brozman. CIKC recorded these loans on its financial statements as its obligations. The lenders whose loan proceeds were received by and used for the benefit of CIKC ("CIKC Lenders") apparently believed, based upon actions taken by or at the direction of Robert F. Brozman, that the loans were being made to CenCor. The principal amount due to the CIKC Lenders was $23,117,820 at the time of Robert F. Brozman's death. The CIKC Lenders have asserted that CenCor (among other parties) is obligated to repay the CIKC Loans. The Estate of Robert F. Brozman (the "Estate"), CIKC and Cor (collectively, the "Indemnitors") entered into an indemnity agreement dated July 26, 1991, with the Company (the "Indemnity Agreement") in which the Estate, CIKC and Cor acknowledged that they are jointly and severally liable to repay the amounts due to the CIKC Lenders. The Indemnitors also agreed to indemnify the Company against certain other injury or loss that the Company might incur as a result of certain unauthorized actions or omissions of the late president. Although CenCor has not admitted liability with respect to these claims, it has executed a Continuing Guarantee of Collection with respect to liabilities flowing from the CIKC Loans as well as a Continuing Guarantee of Collection for Certain Creditors Previously Unsecured of up to $3 million for the benefit of certain unsecured creditors of the Estate of Robert F. Brozman. 4. CIKC LOANS (continued) The Company's potential exposure to the CIKC Lenders and to the unsecured creditors of the Estate has been significantly reduced as a result of the sale of the Estate's assets, including the common stock of LaPetite Academy, Inc. owned by the Estate. CenCor has been informed by the Estate that the outstanding balance of the CIKC Loans was $2,142,000 as of March 1, 1994 and that the current balance of the unsecured obligations of the Brozman Estate is approximately $860,000. The Estate has also informed CenCor that it has contracted to sell its last remaining significant asset, which sale may generate sales proceeds, after provision for administrative expenses and taxes, sufficient to satisfy all of its outstanding liabilities. Because the closing contingencies of the sales contract have yet to be satisfied and because the amount of taxes and administrative expenses to be paid by the Estate have not been determined, there can be no assurance that the claims of the CIKC Lenders and the others against CenCor pursuant to the guarantees will not exceed the Estate's ability to satisfy such claims and to indemnify CenCor. CenCor has recorded no provision for loss relating to the contingencies associated with the CIKC loans. (THE REMAINDER OF THIS PAGE IS INTENTIONALLY BLANK.) 5. LONG-TERM DEBT Long-term debt at December 31, 1993 and 1992, consisted of: 5. LONG-TERM DEBT (continued) On January 29, 1993, Century entered into amendment and exchange agreements with the holders of its long-term debt (the Agreements), whereby the holders exchanged their prior notes for new notes and the terms and covenants of the debt agreements were amended. The covenants include in part, maintaining net worth at certain minimum levels and limitations on indebtedness and payment of dividends. Century is in compliance with the amended covenants of the long-term debt agreements at December 31, 1993. Pursuant to the Agreements, all of Century's long-term debt will mature on April 30, 1997. However, scheduled principal installments as provided for in the original debt agreements are due prior to this date (except for past-due installments as of January 28, 1993, aggregating approximately $18.7 million, for which a combination of Secured Deferred Payment Notes and Secured Compound PIK Notes were issued but are not due prior to April 30, 1997). In lieu of cash payment of the scheduled principal installments, Century has delivered Secured Deferred Payment Notes for the related senior debt and a combination of Secured Deferred Payment Notes and Secured Compound PIK Notes for the related subordinated and junior subordinated debt. These notes will bear interest at the rate of 4.5 year Treasury Notes as of the installment due date, plus 2.25% (senior notes), 3.75% (subordinated notes) and 5% (junior subordinated notes). Interest is payable monthly under all of the notes, except for the Secured Compound PIK Notes, for which interest compounds monthly and is payable on April 30, 1997. All of the notes issued are secured by a security interest in the assets of Century. The noteholders have agreed to subordinate their lien to providers of new secured lending, provided that Century is in compliance with the conditions specified in the Agreements. Century is required under the debt agreements to pay a prepayment penalty if Century pays off the notes in full prior to the April 30, 1997 maturity date. The amount of the prepayment penalty is dependent upon the rates at which the noteholders can reinvest the principal. Century is prohibited from making partial principal payments and from redeeming less than all of the notes. 5. LONG-TERM DEBT (continued) Prior to the execution of the Agreements, Century had scheduled principal installment payments due subsequent to April 30, 1997 of approximately $16,547,000. Pursuant to the Agreements, the notes issued in exchange for these scheduled payments mature on April 30, 1997, at which time Century may be required to pay a premium based upon the rates at which the noteholders are able to reinvest the principal. In consideration for the noteholders entering into the Agreements, Century issued warrants to the noteholders to acquire 300,000 shares of Century's common stock which constitutes 25% of Century's common stock on a fully diluted basis. The warrants vested on April 30, 1993 and expire on January 1, 2003. The exercise price of the warrants is $.01 per share. Century has the right to call the warrants in May 1997 if the notes have been paid in full. The noteholders can require Century to purchase (at a per share price based upon the greater of the fair value of the shares or equity value, equal to the book value of Century plus a 5% premium on net finance receivables) their warrants and the shares obtained from the exercise of the warrants [at the greater of their then current market value if an offer exists, or equity value (as defined)] after the notes are paid in full or upon the occurrence of certain events including the sale of substantially all of the assets of Century. The value of the warrants in excess of the exercise price (the put adjustment) is accrued as interest expense over the period from the date of issuance to the earliest date the creditors may force Century to buy the warrants (the put date). Changes in the highest redemption price after the date of issuance and before the earliest put date, including changes in interim periods, will be considered changes in accounting estimates and will affect the put adjustment on a prospective basis. Changes in the highest redemption price after the earliest put date will be recognized as interest expense in the current year. The term and provisions of the long-term debt of CenCor, Inc. are described in Note 2 to the financial statements. 6. LOSS ON PURCHASE OF FRAUDULENT AUTOMOBILE CONTRACTS During 1991, Century was the victim of a fraudulent scheme involving the purchase of automobile financing contracts which the Company determined were fictitious or missing vehicle titles. The receivables were acquired in 1991 from JoAnn's Instant Finance Cars, Inc. (JoAnn's), a used car dealer. Century had an agreement with JoAnn's for JoAnn's to sell vehicles repossessed by certain of Century's subsidiaries. When the vehicles were purportedly sold by JoAnn's, Century acquired the purchasers' installment contracts. A service fee (representing repossession and automobile restoration costs) was paid to JoAnn's at the time the new contract was acquired. When those receivables became delinquent, JoAnn's exchanged other installment contracts for the delinquent accounts. Century had approximately $11,200,000 of finance receivables purchased from JoAnn's, of which $8,500,000 were charged off in 1991. During 1992, all remaining JoAnn's finance receivables were charged off, with a resulting charge to the provision for credit losses of $600,000. Century does not have any other such agreements for the sale of repossessed vehicles. These transactions were classified in the 1991 consolidated statement of operations as follows: 6. LOSS ON PURCHASE OF FRAUDULENT AUTOMOBILE CONTRACTS (continued) A subsidiary of Century commenced litigation February 19, 1992, against JoAnn's Instant Finance Cars, Inc. (JoAnn's) in the Circuit Court of the Thirteenth Judicial Circuit of Hillsborough County, Florida. The Company alleged a variety of fraudulent and criminal activities by the defendants and was seeking monetary damages, as well as various forms of equitable relief. On January 19, 1993, the Court of Florida issued a final judgement for $6,000,000 in favor of Century. Management believes it is unlikely any portion of the judgement will be recovered, and accordingly, the Company has not recorded any related amounts in the consolidated financial statements. 7. CREDIT LOSS EXPERIENCE An analysis of the allowance for credit losses on finance receivables is as follows: 8. FINANCE RECEIVABLES Finance receivables at December 31, 1993 and 1992, consisted of: Finance receivables may be originated at any one of Century's 53 branch offices or may be purchased. Century's branches are located in 16 states, primarily in the Midwest and the South. As of December 31, 1993, the five states with the largest concentration of net finance receivables are as follows: The maximum term of finance receivables, other than real estate secured accounts, is 48 months, although Century generally restricts maturities to 36 months. The maximum term over which real estate loans are written is 180 months. Contractual maturities at December 31, 1993, were estimated to be as follows: 8. FINANCE RECEIVABLES (continued) Experience of the finance industry indicates a substantial portion of finance receivables will be paid off or renewed prior to contractual maturity dates. Accordingly, the preceding table cannot be regarded as a forecast of future cash collections. Although Century may require borrowers to pledge collateral on precompute and interest-bearing loans, such collateral is generally not pursued in the event of default. Sales finance and automobile contracts are generally collateralized, although the fair value of the collateral in the event of repossession has historically been significantly less than the book value of the contract. 9. EARNINGS PER SHARE As of December 31, 1993, 1992 and 1991, earnings per common share and common equivalent shares were computed by dividing net income by the weighted average number of shares of common stock and common stock equivalents outstanding during the period. For the period ended December 31, 1993, the number of weighted average common share equivalents was increased under the assumption that all of the Convertible Notes were converted to common stock. As indicated in Note 2, the Convertible Notes may be converted, at the option of the holder at any time, into shares of common stock at a ratio of one share of common stock for each $20 principal amount of Convertible Notes. 10. INCOME TAXES On January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS109). The adoption of SFAS 109 had no impact on the Company's consolidated financial statements. The Company and its subsidiaries file a consolidated federal income tax return. The benefit for income taxes allocated to continuing operations for each of the three years in the periods ended December 31, consisted of the following: 10. INCOME TAXES (CONTINUED) A reconciliation of income tax benefit allocated to continuing operations to the amount computed using the statutory federal income tax rate is as follows: The Company's income tax returns for 1988 and 1989 were examined by the Internal Revenue Service (IRS), which has proposed certain adjustments, a portion of which have been protested by the Company. The Company has also claimed additional deductions in these years as a result of the prior period adjustments. Management believes that the ultimate disposition of the IRS examination will not have a material effect on the financial position of the Company. As a result of the matters described above, management cannot precisely estimate the amount of the Company's net operating loss carryforward for financial reporting and income tax purposes and thus, the deferred tax assets which may exist. However, a valuation allowance would be required during 1993 to fully offset the amount of any such assets. Accordingly, the present inability to estimate the net operating loss carryforward for income tax purposes has no impact on the consolidated financial statements. 11. STOCK OPTION PLAN In March 1993, the Company's stock option plan was terminated and participants were paid $0.50 for each of the 5,380 options previously outstanding in exchange for a waiver of rights with respect to acquiring shares of CenCor common stock under the plan. 12. EMPLOYEE BENEFIT PLAN The Company has a Profit-Sharing and 401(k) Retirement Savings Plan (the Plan) which covers all employees, age 21 or older, with one year of service. Participants may contribute from 1% to 20% of their annual compensation, with certain exclusions. The Company may make discretionary contributions. No contributions were made by the Company to the Plan in 1993, 1992, or 1991. 13. COMMITMENTS AND CONTINGENCIES The Company has agreed not to compete with Charter in the equipment leasing business through November 1995. Additionally, the Company has agreed not to engage in the business of temporary services for various terms, the longest of which extends through July, 1997. The Company rents substantially all office space under leases expiring at various dates through 1998. Certain of the leases contain renewal options and/or obligations or occupancy expenses allocated to tenants. Total rent expense was $946,000, $980,000 and $1,158,000 in 1993, 1992 and 1991, respectively. Aggregate minimum future rentals under these noncancelable operating leases at December 31, 1993, were as follows: On April 12, 1993, Century terminated the employment of its President and Chief Executive Officer (CEO). Century and the CEO entered into a settlement agreement which details the economic terms of severance benefits to the CEO. The amounts related to these benefits have been recorded in the accompanying consolidated financial statements. The agreement also provides for a bonus that may be payable in the event a majority of Century's assets or stock is sold prior to April 13, 1996. (THE REMAINDER OF THIS PAGE IS INTENTIONALLY BLANK.) Item 9.

Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. (THE REMAINDER OF THIS PAGE IS INTENTIONALLY BLANK.) PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The following tables sets for the names of the directors of the registrant and certain related information as of December 31, 1993. Each of the directors has been elected to serve until the next annual meeting of stockholders or until his successor is duly elected and qualified. The Board of Directors of the Company held thirteen meetings and acted by unanimous written consent on seven occasions during the last fiscal year. Standing committees, consisting of the Special Committee and the Audit Committee, held five meetings during the last fiscal year. The Executive Compensation Committee, which did not become active until early 1993, makes salary and bonus recommendations for certain executive officers. The Audit Committee oversees the work of CenCor's independent auditors. The Company's Board of Directors does not have a nominating committee. The Special Committee has the final authority to thoroughly investigate and report to the Board of Directors on certain matters concerning the misappropriation of CenCor's assets by CenCor's previous chairman of the board, Robert F. Brozman, or certain of his affiliated privately held companies. The Special Committee also has the power and authority to consider the adequacy of CenCor's internal controls and procedures and to explore strategic steps to maximize value for all relevant constituencies of CenCor and to investigate and report upon such other matters as the Special Committee considers appropriate. The Special Committee, the Executive Compensation Committee, and the Audit Committee are composed of Messrs. Bauer, Bernstein and Riesenbach. In addition to Jack L. Brozman, the following persons also serve as executive officers of CenCor or Century. NAME AGE PRINCIPAL OCCUPATION FOR LAST FIVE YEARS - ---- --- ---------------------------------------- Dennis C. Berglund 56 Chief Executive Officer and President of Century since June 1993. Acting Chief Executive Officer and President of Century from April 1993 until June 1993. Chief Financial Officer, Executive Vice President and Chief Administrative Officer of Imperial Thrift and Loan Association, Burbank, California, from March 1988 through November 1992. Experience includes 24 years with Avco Financial Services, an international consumer finance company. Patrick F. Healy 41 Vice President-Finance, Treasurer and Chief Financial Officer of CenCor and Century since July 1991. General partner in Equity Analysts, a Kansas City, Missouri based real estate investment group, for more than the prior five years. Vice President, Treasurer and Director of TSI Holdings, Inc., a parent company of a manufacturing enterprise, from November 1989 through June 1991. Randall J. Opliger 36 Controller of CenCor and Vice President and Controller of Century since July 1992. Controller and member of Executive Committee of Garsite/TSR, Inc., a Kansas City, Kansas manufacturing enterprise, from April 1990 to December 1991. Director of Finance of R.F.D. Travel Corp., Overland Park, Kansas from July 1984 to March 1990. William J. Turner 58 Executive Vice President-Acquisitions and Administration of Century since January 1993. Employed by Century in various management positions for approximately 29 years. DISCLOSURE OF DELINQUENT FILERS Except as described below, the Company believes, based on information filed with the Company, that all reports required to be filed for the past two years with the Securities and Exchange Commission under Section 16 by the Company's executive officers, directors, and ten percent stockholders have been filed in compliance with applicable rules: Randall J. Opliger failed to file an initial report on Form 3 with respect to his appointment as an executive officer of the Company in July 1992. A report on Form 5 disclosing the information required by Form 3 (and reporting no common stock ownership or transactions) was subsequently filed, on an untimely basis, with the Securities and Exchange Commission. Dennis C. Berglund failed to file an initial report on Form 3 with respect to his appointment as an executive officer of the Company in June 1993. A report on Form 5 disclosing the information required by Form 3 (and reporting no common stock ownership or transactions) was subsequently filed, on an untimely basis, with the Securities and Exchange Commission. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. SUMMARY COMPENSATION TABLE The following table sets forth information as to the compensation of the Chief Executive Officer and each of the other executive officers of CenCor and Century, whose total annual salary and bonus exceeded $100,000, during the year ended December 31, 1993 for services in all capacities to CenCor and its subsidiaries in 1991, 1992, and 1993. OPTION/SAR GRANTS IN LAST FISCAL YEAR The following table sets forth information as to stock appreciation rights granted by CenCor during 1993 to executive officers named in the Summary Compensation Table. OPTION/SAR EXERCISE AND FISCAL YEAR-END OPTION/SAR VALUE TABLE No option on stock appreciation rights were exercised by any of the named executive officers during 1993. The following table provides information with respect to the named executive officers concerning unexercised options held as of December 31, 1993. COMPENSATION OF DIRECTORS Each non-officer/director of CenCor is paid an annual retainer of $5,000 plus a fee (based on time spent on corporate matters, including attendance at board and committee meetings) and expenses. EMPLOYMENT CONTRACTS, TERMINATION OF EMPLOYMENT AND CHANGE-IN-CONTROL ARRANGE- MENTS On February 10, 1993, CenCor entered into a two-year employment agreement with Mr. Healy. Under the terms of the agreement, Mr. Healy will continue to serve as CenCor's Chief Financial Officer at an annual salary of $155,000. Mr. Healy has also agreed that he will not, during the term of the employment agreement and without the express written consent of CenCor's Board of Directors, directly or indirectly have any interest in any business which is a supplier to CenCor. On June 28, 1993, Century entered into a three-year employment agreement with Mr. Berglund. Under the terms of the agreement, Mr. Berglund will serve as Century's President and Chief Executive Officer at annual salaries of $140,000, $160,000 and $180,000 for the first, second and third years respectively of the agreement. Mr. Berglund may also receive an annual bonus based on annual pre- tax profits. Mr. Berglund has also agreed that he will not, during the term of the employment agreement and without the expressed written consent of Century's Board of Directors, directly or indirectly have any interest in any business which is a supplier to Century. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth, with respect to the Company's common stock (the only class of voting securities), the only person known to be a beneficial owner of more than five percent (5%) of any class of the Company's voting securities as of March 1, 1994. The following table sets forth, with respect to the Company's common stock (the only class of voting securities), (i) shares beneficially owned by all directors of the Company and nominees for director, and (ii) total shares beneficially owned by directors and officers as a group, as of March 1, 1994. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS TRANSACTIONS WITH CONCORDE AND LAPETITE Concorde, a former CenCor subsidiary, continues to be indebted to CenCor as a result of a 1992 restructuring agreement between Concorde and CenCor (the "Restructuring Agreement"). Under the Restructuring Agreement, Concorde, which is in the business of operating proprietary vocational training schools, was released from an earlier agreement by which it assumed the obligations of CenCor to make principal and interest payments on CenCor's outstanding Series H 10% Notes. In consideration for releasing Concorde from this obligation, CenCor received from Concorde a Junior Secured Debenture in the principal amount of $5,422,000 (the amount of the principal and accrued interest on the Series H 10% Notes immediately prior to the execution of the Restructuring Agreement) and received Concorde's promise to pay an additional contingent payment to CenCor on July 31, 1997 in an amount equal to 25% of the market value of Concorde's outstanding common stock in excess of $3,500,000. The Junior Secured Debenture is secured by a lien on substantially all of Concorde's assets, which lien is junior to the lien of Concorde's secured bank lender. The Junior Secured Debenture bears interest ranging from prime plus 1% to prime plus 1-1/2% per annum, and provides for principal and interest payments commencing September 30, 1995 based on a ten-year amortization schedule. The Junior Secured Debenture initially provided that interest would accrue and compound quarterly through September 30, 1995, when the first interest payment would be due. Interest will be payable quarterly thereafter. In addition, the Junior Secured Debenture provides that Concorde shall make annual prepayments equal to 50% of Concorde's Excess Cash Flow, as defined in the debt restructuring agreement between CenCor and Concorde. On February 9, 1993, Concorde's secured bank lender and CenCor executed an intercreditor agreement. Under the terms of the intercreditor agreement, CenCor has agreed not to assert its rights against collateral pledged to it by Concorde until the earlier to occur of (i) payment in full of Concorde's secured bank debt or (ii) July 31, 1997. In addition, CenCor agreed that any amount due to CenCor under the terms of the Restructuring Agreement or the Junior Secured Debenture would be subordinate to the indebtedness evidenced by Concorde's secured bank debt. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (CONTINUED) On December 30, 1993, Concorde and Century amended the Restructuring Agreement to provide that CenCor would receive $8,390,000 of Concorde's previously charged-off receivables in full payment of the accrued interest on the Junior Secured Debenture through December 31, 1993 in the amount of $559,353. The receivables, which consist of accounts and notes receivable from students who attended schools operated by Concorde or its subsidiaries, were assigned to CenCor without recourse with CenCor assuming all risk of non-payment of the receivables. The amendment grants CenCor limited rights of substitution until such time as it collects $559,353 from the receivables, exclusive of out- of-pocket collection fees and expenses paid to third-parties. Concorde has reported that it has an ongoing dispute with the United States Department of Education ("DOE") concerning Concorde's compliance with DOE factors of financial responsibility and, therefore, its eligibility to participate in various student financial assistance programs. Concorde has also reported that it is contesting DOE findings that certain of its proprietary schools have violated DOE regulations concerning administration of Title IV federal student financial assistance programs. CenCor has acknowledged that if its schools are not allowed to participate in these student financial assistance programs, the viability of Concorde's continuing operations would be in doubt. Because the outcome of Concorde's regulatory disputes cannot be predicted, there can be no assurance that Concorde will be able to perform its obligations under the Junior Secured Debenture or that CenCor will receive any additional payment based on the market value of Concorde's stock. Accordingly, CenCor has established a reserve in its consolidated financial statements in the full amount of the Junior Secured Debenture plus the receivables received in payment of the accrued but unpaid interest of $559,353. Jack L. Brozman, who is Chairman of the Board of CenCor and Century, is Chairman of the Board of Concorde. Mr. Brozman owns 171,724 shares of Concorde (2.5% of the outstanding). As sole fiduciary for the Estate of Robert F. Brozman (the "Brozman Estate") and the Robert F. Brozman Trust (he is one of the beneficiaries of the estate and the trust), he owns 2,985,324 shares of Concorde (42.9% of the outstanding). Prior to April 1993, CenCor shared leased office space with LaPetite, another former CenCor subsidiary, and Concorde in Kansas City, Missouri in space leased by LaPetite. Until October 1993, CenCor also shared certain office services with both LaPetite and Concorde, and there were several common officers and employees who divided their time between the three companies. Effective January 11, 1993, CenCor entered into an agreement with LaPetite and Concorde that provided for the allocation of certain costs as long as the corporations continue to share employees/officers. Under the January 11, 1993 agreement and a replacement transition agreement dated July 23, 1993, CenCor, LaPetite and Concorde each paid their own direct expenses plus an allocated portion of certain common expenses and each paid an allocated portion of salary and payroll costs of the common employees. This sharing agreement between the three companies terminated September 30, 1993. The three companies now maintain separate office leases and office services and all intercompany accounts have been settled. Prior to July 23, 1993, Jack L. Brozman was the Chairman of the Board of LaPetite and owned directly 2.1% of LaPetite's outstanding common stock. In addition, the Brozman Estate and Robert E. Brozman Trust owned 11.8% of the outstanding common stock of LaPetite prior to July 23, 1993. Management believes that these transactions with LaPetite and Concorde have been made on no less favorable terms than could be obtained from unaffiliated third parties. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS (CONTINUED) OTHER TRANSACTIONS Prior to Robert F. Brozman's death on June 10, 1991, loans were made by outside institutions, purportedly to CenCor, whose proceeds were never received by or used for the benefit of CenCor, but rather were credited to the account of and used by CenCor, Inc. of Kansas City ("CIKC"). CIKC is a wholly-owned subsidiary of Cor, Inc., which was, at the time of the loans, wholly-owned and controlled by Robert F. Brozman. CIKC recorded such loans (the "CIKC Loans") on its financial statements as its obligations. Shortly following the death of Robert F. Brozman, the Board of Directors of CenCor learned for the first time of the CIKC Loans, which had at that time a principal balance of $23,117,820. Certain creditors, including the institutions referred to above (the "CIKC Lenders"), have asserted claims against CenCor, among others, for actions taken by the late Robert F. Brozman, CenCor's former chairman, including the CIKC Loans. Although CenCor has not admitted liability with respect to these claims, it has executed a Continuing Guarantee of Collection with respect to liabilities flowing from the CIKC Loans as well as a Continuing Guarantee of Collection for Certain Creditors Previously Unsecured of up to $3 million for the benefit of certain unsecured creditors of the Estate of Robert F. Brozman. The Estate of Robert F. Brozman and the related Trust of Robert F. Brozman (collectively the "Brozman Estate"), Cor, and CIKC (collectively the "Indemnitors") have executed an Indemnity Agreement (the "Indemnity Agreement") with CenCor in which the Indemnitors acknowledge that they are jointly and severally liable to repay the amounts due to the CIKC Lenders. The Indemnitors also agree that they are jointly and severally liable to CenCor to the extent CenCor is obligated to pay any of the CIKC Loans or Cor any loss, damages or expense in connection with the CIKC Loans. The Brozman Estate has been liquidating its assets in order to satisfy the claims against it, including the claims to which the CenCor guarantees apply. CenCor has been informed by the Brozman Estate that the outstanding balance of the CIKC Loans was $2,142,000 as of March 1, 1994 and that the current balance of the unsecured obligations of the Brozman Estate is approximately $860,000. The Brozman Estate has also informed CenCor that it has contracted to sell its last remaining significant asset, which sale may generate sales proceeds, after provision for administrative expenses and taxes, sufficient to satisfy all of its outstanding liabilities. Because the closing contingencies of the sales contract have yet to be satisfied and because the amount of taxes and administrative expenses to be paid by the Brozman Estate have not been determined, there can be no assurance that the claims of the CIKC Lenders and the others against CenCor pursuant to the guarantees will not exceed the Brozman Estate's ability to satisfy such claims and to indemnify CenCor. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K. (a) The following documents are filed as part of this Annual Report on Form 10-K. 1. The following Consolidated Financial Statements of CenCor, Inc. and Subsidiaries are included in Item 8: Consolidated Balance Sheets--At December 31, 1993 and 1992. Consolidated Statements of Operations--For the years ended December 31, 1993, 1992, and 1991. Consolidated Statements of Stockholders' Equity (Deficit)--For the years ended December 31, 1993, 1992, and 1991. Consolidated Statements of Cash Flows--For the years ended December 31, 1993, 1992, and 1991. Notes to Consolidated Financial Statements. 2. The following Consolidated Financial Statement Schedules of CenCor, Inc. and Subsidiaries are included in Item 14(d): Schedule II--Amounts Receivable From Related Parties, Underwrit- ers, Promoters and Employees Other Than Related Parties. Schedule III--Condensed Financial Information of Registrant (Parent Company Only). Schedule VIII--Valuation and Qualifying Accounts and Allowances. Schedules other than those referred to above have been omitted as not applicable or not required under the instructions contained in Regulations S-X, or the information is included elsewhere in the financial statements or notes thereto. 3. Exhibits. Exhibit Number Description ------ ----------- 2(a) Plan of Reorganization (Incorporated by reference--Exhibit 2(b) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992). 3(a) Certificate of Incorporation and all Amendments thereto through August 31, 1990. (Incorporated by reference--Exhibit 3(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990.) 3(b) Bylaws amended through July 29, 1991. (Incorporated by reference--Exhibit 3(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) 4(a) Specimen common stock certificate. (Incorporated by reference-- Exhibit 4(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990.) 4(b) Certificate of Incorporation and all Amendments and Amended and Restated Bylaws. (Incorporated by reference--Exhibit 3(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990 and included as Exhibit 3(b) hereto.) 4(c) Composite Conform Copy Relating To: Century Acceptance Corpora- tion Amendment and Exchange Agreement dated as of January 28, 1993 and Composite Conformed Copy of Amendment and Exchange Agreement Regarding Century Acceptance Corporation Amendment and Exchange Agreement dated as of January 28, 1993 relating to the restructuring of Century Acceptance Corporation's outstanding indebtedness to All State Life Insurance Company, Inc., American Banker's Life Insurance Company of Florida, American Mutual Life Insurance Company, Continental American Life Insurance Company, The Lincoln National Life Insurance Company, Mutual Services Casualty Insurance Company, New England Mutual Life Insurance Company, Principal Mutual Life Insurance Company, Provident Mutual Life Annuity Company of America, Provident Mutual Life Insurance Company of Philadelphia, and Standard Insurance Company. (Incorporated by reference -- Exhibit 4(d) to Company's Annual Report on Form 10-K for the year ended December 31, 1992.) 4(d) Indentures between CenCor, Inc. and Commercial National Bank of Kansas City, N.A. dated April 27, 1993 with respect to notes due 1999. (Incorporated by reference--Exhibit T3C to Company's Application of Form T-3; SEC file #22-24246. 4(e) Indenture between CenCor, Inc. and Commercial National Bank of Kansas City, N.A. dated April 27, 1993, with respect to convertible notes due 1999; SEC file #22-24248. 10(a) Indemnity Agreement dated July 26, 1991 between the Company and the Indemnitors. (Incorporated by reference--Exhibit 2 to Report on Form 8-K dated July 29, 1991.) 10(b) First Amendment to Indemnity Agreement dated August 20, 1991 between the Company and the Indemnitors. (Incorporated by reference--Exhibit 1 to Report on Form 8-K dated September 3, 1991.) 10(c) Modification and Exchange Agreement and Lender Consent Stipulation dated August 1, 1991 between the Company, the Indemnitors, and certain CIKC Lenders. (Incorporated by reference--Exhibit 2 to Report on the Company's Form 8-K dated September 3, 1991.) 10(d) Standstill Agreement dated August 14, 1991 between the Company and College Boulevard National Bank. (Incorporated by reference- -Exhibit 4 to Report on the Company's Form 8-K dated September 3, 1991.) 10(e) Expense Sharing Agreement dated January 1, 1993 between CenCor, Inc., Century Acceptance Corporation, LaPetite Academy, Inc., and Concorde Career Colleges, Inc. (Incorporated by reference -- Exhibit 10(h) to Company's Annual Report on Form 10-K for the year ended December 31, 1992.) 10(f) Restructuring, Security and Guaranty Agreement dated October 30, 1992 between CenCor, Inc. and Concorde Career Colleges, Inc., Minnesota Institute of Medical and Dental Assistants, Inc., United Health Careers Institute, Inc., Southern California College of Medical and Dental Assistants, Inc., Concorde Careers--Florida, Inc., Colleges of Dental and Medical Assistants, Inc. and Computer Career Institute, Inc. (Incorporated by reference -- Exhibit 10(j) to Company's Annual Report on Form 10-K for the year ended December 31, 1992.) 10(g) Amendment to Agreement for Transfer of Assets and Assumption of Liabilities dated October 30, 1992 between CenCor, Inc. and Concorde Career Colleges, Inc. (Incorporated by reference -- Exhibit 10(k) to Company's Annual Report on Form 10-K for the year ended December 31, 1992.) 10(h) Employement Agreement with Dennis C. Berglund dated June 28, 1993. 10(i) First Amendment to Restructuring, Security and Guarantee Agreement between CenCor, Concorde, Minnesota Institute of Medical and Dental Assistance, Texas College of Medical and Dental Assistants, Texas College of Medical and Dental Assistants, Inc., United Health Careers Institute, Inc., Southern California College of Medical and Dental Assistants, Inc., Concorde Careers--Florida, Inc., College of Dental and Medical Assistants, Inc. and Computer Career Institute, Inc. dated December 30, 1993. 10(j) Transition Service Agreement between CenCor, Century, LaPetite, and Concorde dated July 23, 1993. 10(k) Termination of Transition Services Agreement dated August 30, 1993 between LaPetite, CenCor, and Concorde. 21 Subsidiaries of the Registrant. 27 Financial Data Schedule. (b) Reports on Form 8-K: No reports on Form 8-K were filed during the quarter ending December 31, 1993. CENCOR, INC. AND SUBSIDIARIES ---------- SCHEDULE II--AMOUNTS RECEIVABLE FROM RELATED PARTIES, UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES CENCOR, INC. (PARENT COMPANY ONLY) ---------- SCHEDULE III--CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED BALANCE SHEETS DECEMBER 31, 1993 and 1992 ASSETS See Notes to Consolidated Financial Statements of CenCor, Inc. included elsewhere in this report. CENCOR, INC. (PARENT COMPANY ONLY) ---------- SCHEDULE III--CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31 See Notes to Consolidated Financial Statements of CenCor, Inc. included elsewhere in this report. CENCOR, INC. (PARENT COMPANY ONLY) ---------- SCHEDULE III--CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENTS OF CASH FLOWS FOR THE THREE YEARS ENDED DECEMBER 31 See Notes to Consolidated Financial Statements of CenCor, Inc. included elsewhere in this report. CENCOR, INC. SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS AND ALLOWANCES SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. CENCOR, INC. By /s/ JACK L. BROZMAN ----------------------- Jack L. Brozman Chairman of the Board Date: March 31, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. SIGNATURE DATE By:/s/ JACK L. BROZMAN March 31, 1994 ---------------------------------------------------------------------- Jack L. Brozman (Chairman of the Board, Chief Executive Officer and Director) By:/s/ PATRICK F. HEALY March 31, 1994 ---------------------------------------------------------------------- Patrick F. Healy (Vice President-Finance and Treasurer, Principal Financial Officer) By:/s/ EDWARD G. BAUER, JR. March 31, 1994 ---------------------------------------------------------------------- Edward G. Bauer, Jr. (Director) By:/s/ GEORGE L. BERNSTEIN March 31, 1994 ---------------------------------------------------------------------- George L. Bernstein (Director) By:/s/ MARVIN S. RIESENBACH March 31, 1994 ---------------------------------------------------------------------- Marvin S. Riesenbach (Director) EXHIBIT INDEX Exhibit Number Description ------------------ 2(a) Plan or Reorganization (Incorporated by reference--Exhibit 2(b) to the Company's Annual Report on Form 10-K for the year ended December 31, 1992.) 3(a) Certificate of Incorporation and all Amendments thereto through August 31, 1990. (Incorporated by reference--Exhibit 3(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990.) 3(b) Bylaws amended through July 29, 1991. (Incorporated by reference-- Exhibit 3(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1991.) 4(a) Specimen common stock certificate. (Incorporated by reference--Exhibit 4(a) to the Company's Annual Report on Form 10-K for the year ended De- cember 31, 1990.) 4(b) Certificate of Incorporation and all Amendments and Amended and Restated Bylaws. (Incorporated by reference--Exhibit 3(a) to the Company's Annual Report on Form 10-K for the year ended December 31, 1990 and included as Exhibit 3(b) hereto.) 4(c) Composite Conform Copy Relating To: Century Acceptance Corporation Amendment and Exchange Agreement dated as of January 28, 1993 and Composite Conformed Copy of Amendment and Exchange Agreement Regarding Century Acceptance Corporation Amendment and Exchange Agreement dated as of January 28, 1993 relating to the restructuring of Century Acceptance Corporation's outstanding indebtedness to All State Life Insurance Company, Inc., American Banker's Life Insurance Company of Florida, American Mutual Life Insurance Company, Continental American Life Insurance Company, The Lincoln National Life Insurance Company, Mutual Services Casualty Insurance Company, New England Mutual Life Insurance Company, Principal Mutual Life Insurance Company, Provident Mutual Life Annuity Company of America, Provident Mutual Life Insurance Company of Philadelphia, and Standard Insurance Company. (Incorporated by reference -- Exhibit 4(d) to Company's Annual Report on Form 10-K for the year ended December 31, 1992.) 4(d) Indentures between CenCor, Inc. and Commercial National Bank of Kansas City, N.A. dated April 27, 1993 with respect to notes due 1999. (Incorporated by reference--Exhibit T3C to Company's application on Form T-3; SEC file #22-24246 4(e) Indenture between CenCor, Inc. and Commercial National Bank of Kansas City, N.A. dated April 27, 1993 with respect to convertible notes due 1999; (Incorporated by reference--Exhibit T3C to Company's application on Form T-3; SEC file #22-24248 10(a) Indemnity Agreement dated July 26, 1991 between the Company and the Indemnitors. (Incorporated by reference--Exhibit 2 to Report on Form 8-K dated July 29, 1991.) 10(b) First Amendment to Indemnity Agreement dated August 20, 1991 between the Company and the Indemnitors. (Incorporated by reference--Exhibit 1 to Report on Form 8-K dated September 3, 1991.) 10(c) Modification and Exchange Agreement and Lender Consent Stipulation dated August 1, 1991 between the Company, the Indemnitors, and certain CIKC Lenders. (Incorporated by reference--Exhibit 2 to Report on the Company's Form 8-K dated September 3, 1991.) 10(d) Standstill Agreement dated August 14, 1991 between the Company and College Boulevard National Bank. (Incorporated by reference--Exhibit 4 to Report on the Company's Form 8-K dated September 3, 1991.) 10(e) Expense Sharing Agreement dated January 1, 1993 between CenCor, Inc., Century Acceptance Corporation, La Petite Academy, Inc., and ConCorde Career Colleges, Inc. (Incorporated by reference -- Exhibit 10(h) to Company's Annual Report on Form 10-K for the year ended December 31, 1992.) 10(f) Restructuring, Security and Guaranty Agreement dated October 30, 1992 between CenCor, Inc. and Concorde Career Colleges, Inc., Minnesota Institute of Medical and Dental Assistants, Inc., United Health Careers Institute, Inc., Southern California College of Medical and Dental Assis- tants, Inc., Concorde Careers--Florida, Inc., Colleges of Dental and Medical Assistants, Inc. and Computer Career Institute, Inc. (Incor- porated by reference -- Exhibit 10(j) to Company's Annual Report on Form 10-K for the year ended December 31, 1992.) 10(g) Amendment to Agreement for Transfer of Assets and Assumption of Liabili- ties dated October 30, 1992 between CenCor, Inc. and Concorde Career Colleges, Inc. (Incorporated by reference -- Exhibit 10(k) to Company's Annual Report on Form 10-K for the year ended December 31, 1992.) 10(h) Employment Agreement with Dennis C. Berglund dated June 28, 1993. 10(i) First Amendment to Restructuring, Security and Guarantee Agreement between CenCor, ConCorde, Minnesota Institute of Medical and Dental As- sistance, Texas College of Medical and Dental Assistants, Texas College of Medical and Dental Assistants, Inc., United Health Careers Institute, Inc., Southern California College of Medical and Dental Assistants, Inc., ConCorde Careers--Florida, Inc., College of Dental and Medical Assistants, Inc. and Computer Career Institute, Inc. dated December 30, 1993. 10(j) Transition Service Agreement between CenCor, Century, LaPetite, and Concorde dated July 23, 1993. 10(k) Termination of Transition Services Agreement dated August 30, 1993 be- tween LaPetite, CenCor, and ConCorde. 21 Subsidiaries of the Registrant. 27 Financial Data Schedule.

33565_1993.txt

33565

1993

Item 1. Business General Essex Group, Inc. (the "Company") develops, manufactures and markets electrical wire and cable and electrical insulation products. Among the Company's products are magnet wire for electromechanical devices such as motors, transformers and electrical controls; building wire for the construction industry; telephone cable for the telecommunications industry; wire for automotive and industrial applications; and insulation products for the electrical industry. The Company's operations at December 31, 1993 included 26 domestic manufacturing facilities and employed approximately 3,755 persons. The Company was founded in Detroit, Michigan in 1930 to manufacture electrical wire harnesses for automobiles exclusively for the Ford Motor Company. United Technologies Corporation ("UTC") acquired the Company in 1974 and operated it as a wholly-owned subsidiary. On February 29, 1988, MS/Essex Holdings Inc. ("Holdings"), acquired the Company from UTC (the "1988 Acquisition"). After the 1988 Acquisition, the outstanding common stock of Holdings was beneficially owned by the Morgan Stanley Leveraged Equity Fund II, L.P., certain directors and members of management of Holdings and the Company, and others. On October 9, 1992, Holdings was acquired (the "Acquisition") by merger (the "Merger") of B E Acquisition Corporation ("BE") with and into Holdings with Holdings surviving under the name BCP/Essex Holdings Inc. BE was a newly organized Delaware corporation formed for the purpose of effecting the Acquisition. The shareholders of BE included Bessemer Capital Partners, L.P. ("BCP"), affiliates of Goldman, Sachs & Co. ("Goldman Sachs"), affiliates of Donaldson, Lufkin & Jenrette, Inc., Chemical Equity Associates, A California Limited Partnership ("CEA"), and members of management and other employees of the Company. As a result of the Merger, the stockholders of BE became stockholders of Holdings. During 1993, BCP transferred its ownership interest in Holdings to Bessemer Holdings, L.P. ("BHLP"), an affiliate of BCP. See note 2 to the table included herein setting forth information regarding beneficial ownership of Holdings common stock under the caption "Item 12. Security Ownership of Certain Beneficial Owners and Management" for information regarding BHLP. Product Lines The Company's wire products include magnet wire for electromechanical devices such as motors, transformers and electrical controls; building wire; telecommunication cable; and various types of automotive and industrial wires for applications in automobiles, trucks, appliances and construction. Insulation products include mica paper and mica-based composites laminated with glass, fabric and synthetic films, in combination with various proprietary or purchased polymers. The following table sets forth for each of the three years in the period ended December 31, 1993 the dollar amounts and percentages of sales of each of the Company's major product lines and identifies the division (defined below) with which each line is associated: (a) Includes $32.6 million in sales of an industrial wire product line transferred to EPD effective January 1992. (b) Includes $32.7 million in sales of an industrial wire product line; sales of that product line were reported as WCD sales in prior years. (c) Less than 1.0%. Division Operations The Company classifies its operations into four major divisions based on the markets served: Wire and Cable Division ("WCD"); Magnet Wire and Insulation Division ("MWI"); Telecommunication Products Division ("TPD") and Engineered Products Division ("EPD"). A summary of the business of each major division is set forth below. Wire and Cable Division Products. WCD develops, manufactures and markets a complete line of building wire and other related wire products. Specific examples include service entrance cable, underground feeder wire and nonmetallic wire and cable for the residential market and a variety of insulated wires for the nonresidential market. The ultimate end users are electrical contractors and "do-it-yourself" consumers. Sales and Marketing. WCD has produced building wire and cable in the United States since 1933. WCD has developed and maintained a large and diverse customer base, selling primarily to electrical distributors, hardware wholesalers and consumer product retailers. WCD's products are marketed nationally through manufacturers representatives and a Company sales force. WCD has distribution facilities throughout the United States and one in Canada. Historically, approximately 65% of the Company's building wire market is attributable to remodeling and repair activity while the remaining 35% is attributable to new residential and nonresidential construction. Magnet Wire and Insulation Division Products. MWI develops and manufactures magnet wire and insulation products for the electrical equipment and electronics industries in the United States. MWI offers a comprehensive line of insulation and magnet wire products, including over 500 types of magnet wire used in a wide variety of motors, coils, relays, generators, solenoids and transformers. Sales and Marketing. Historically, 66% of MWI sales have been made directly to end users and 34% of sales have been to distributors. The Company distributes electrical insulating materials and certain appliance and magnet wire products through its IWI distribution chain ("IWI"). IWI is a national distributor providing the Company access to small original equipment manufacturers and motor repair markets. In response to a growing number of Japanese transplant businesses that supply products to Japanese automobile companies with United States manufacturing operations, the Company established a joint venture with The Furukawa Electric Company, LTD., Tokyo, Japan ("Femco") in 1988. In the second quarter of 1993, the Company completed construction of a new manufacturing facility that is occupied by both the Company and Femco. Femco manufactures and markets magnet wire with special emphasis on products required by Japanese manufacturers for their production facilities in the United States. Telecommunication Products Division Products. TPD develops, manufactures and markets a broad line of plastic insulated conductor and plastic jacketed telephone cables primarily for use in the United States telephone network, although it is expanding its capability to manufacture products for overseas markets. TPD manufactures polyolefin, PVC, and fluoropolymer insulated cable of various types as well as specialized cables adapted to customer requirements. New product design and materials development activities are supported by TPD's Product Development and Materials Engineering Laboratory. Sales and Marketing. TPD sells products to regional Bell operating companies, many smaller domestic telephone companies and to telephone companies and private contractors overseas. Competition is based primarily on price, with service and product quality important, but secondary, considerations. Engineered Products Division Products. EPD develops, manufactures and distributes automotive primary wire, ignition wire, battery cable, flexible cordage, motor lead wire, submersible pump cables and welding cable. Automotive products are sold primarily to suppliers of automotive original equipment, while industrial wire and cable products are sold to appliance and power tool manufacturers. A recent acquisition has expanded EPD's product offering with the addition of specialty wiring assemblies including heavy truck harnesses and automotive ignition wire assemblies. See "Business-- Business Development." Sales and Marketing. EPD has one principal customer. See Significant Customer below. Considerable progress has been made, however, to broaden its automotive customer base. To this end, the Company has retained an independent sales organization, located in the Detroit, MI area that provides EPD with the local presence necessary to attract and service new customers in the automotive wire market. Sales representatives from MWI and WCD also call on and service many of the division's other original equipment manufacturer customers. EPD has been recognized as a technology leader in the automotive wire and cable industry by two major customers. This has led to increased business with these customers and has helped EPD obtain significant new business from other customers. The principal customer of EPD continues to be serviced by a dedicated sales representative who is a Company employee. Significant Customer. UTC's Automotive Group is the principal customer for EPD's automotive wire, generating approximately 40% of EPD's revenues in 1993. This percent has declined from previous years, when the proportion was as high as 60%, principally through developing a broader customer base; a strategy which is expected to continue. In the event this customer were to cease buying the Company's products, the Company believes EPD could be adversely impacted. However, the Company further believes that if this event were to occur it would market to other customers and any underutilized equipment could be altered to produce other wire products at a reasonable cost and in a reasonable period of time. Business Development The Company has established plans to increase sales across many of its product lines by expanding product offerings within compatible markets, targeting new global markets for existing products and expanding penetration in those overseas markets where a presence has already been established. To accomplish this objective, the Company expects to make business acquisitions and capital investments in new plant and equipment as necessary in the United States and intends to pursue select investments in strategic partners and participate in joint ventures off-shore. A senior executive has been appointed to direct new business development and international activities for the Company. In the second quarter of 1993 the Company completed construction of a new magnet wire manufacturing facility, a portion of which is leased to Femco. Femco manufactures and markets magnet wire with special emphasis on products required by Japanese manufacturers for their production facilities in the United States. In addition to an expanded presence in Japanese transplant markets, the Company also expects to benefit from the Femco joint venture through application of new production methods, product improvement and production efficiencies which, in turn, should have application to other Company Magnet Wire and Insulation Division production facilities. See "Division Operations--Magnet Wire and Insulation." In the fourth quarter of 1993 the Company completed the acquisition of a Mississippi based company which provides an entry into specialty wiring assemblies including heavy truck harnesses and automotive ignition wire assemblies. See "Management's Discussion and Analysis of Results of Operations and Financial Condition -- Liquidity, Capital Resources and Financial Condition." Also during 1993, the Company made an equity investment in a major Mexican wire producer to establish an investment presence in the Latin American wire markets. Manufacturing Strategy The Company's manufacturing strategy is primarily focused on maximizing product quality and optimizing production efficiencies. The Company has achieved a high level of vertical integration through internal production of its principal raw materials: copper rod, enamels and resin compounds. The Company believes one of its primary cost advantages in the magnet wire business is its ability to produce most of its enamel requirements internally. Similarly, the Company believes its ability to develop and produce PVC and rubber compounds, which are used as insulation and jacketing materials for many of its building wire, telecommunication, automotive and industrial wire products, provides cost advantages because the process achieves greater control over the cost and quality of essential components used in production. These operations are supported by the Company's metallurgical, chemical and polymer development laboratories. To further optimize production efficiencies, the Company invests in new plants and equipment, pursues plant rationalizations, and participates in joint venture opportunities. In the period 1988 through 1991, the Company spent an average of $13.4 million per year for capital projects. In 1992 and 1993, the Company made capital expenditures of approximately $31.2 million and $26.2 million, respectively. Company management has continued to identify opportunities to improve the efficiency of its manufacturing facilities and has employed rationalization efforts to accomplish those improvements. Manufacturing Process Copper rod is the base component for most of the Company's wire products. The Company buys copper cathode from a variety of producers and dealers and also reclaims and reprocesses scrap copper from its own and other operations. See "Metals Operations." After the rod is manufactured at the Company's rod mills, it is shipped to other manufacturing facilities where it is processed into the wire and cable products produced by the Company. See "Copper Rod Production." The manufacturing processes for all of the Company's wire and cable products require that the copper rod be drawn and insulated. Certain products also require that the wire be "bunched" or "cabled". Wire Drawing. Wire drawing is the process of reducing the metal conductor diameter by pulling it through a converging die until the specified product size is attained. Since the reduction is limited by the breaking strength of the metal conductor, this operation is repeated several times internally within the machine. As the wire becomes smaller, less pulling force is required. Therefore, machines operating in specific size ranges are required. Take-up containers or spools are generally large, allowing one person to operate several machines. Bunching. Bunching is the process of twisting together single wire strands to form a concentric construction ranging from seven to over 200 strands. The major purpose of bunching is to provide improved flexibility while maintaining current carrying capacity. For some applications (for example, automotive uses), the final wire must be concentric, requiring accurate control of the bare wire's mechanical properties, tension, and diameter. In other applications, such as building wire, different diameters are used within the single conductors to produce a round wire. Insulating. The magnet wire insulating materials (enamels) manufactured by the Company's chemical processing facility are polymeric materials produced by one of two methods. One method involves the blending of commercial resins which are dissolved in various solvents and then modified with catalysts, pigments, cross-linking agents and dyes. The other method involves building polymer resins to desired molecular weights in reactor systems. The enamelling process used in the manufacture of some magnet wire involves applying several thin coats of liquid enamel and evaporating the solvent in baking chambers. Some enamels require a specific chemical reaction in the baking chamber to fully cure the film. Enamels are generally applied to the wires in excess, which is then metered off with dies or rollers; however, some applications apply only the required amount of liquid enamel. Most other wire products are insulated with plastic or rubber compounds through an extrusion process. Extrusion involves the feeding, melting and pumping of a compound through a die to shape it into final form as it is applied to the wire. The Company has the capability to manufacture both rubber and PVC jacketing and insulating compounds, which are then extruded onto wire. In order to enhance the insulation properties of certain products, the polymers can be cross-linked chemically or by radiation after the extrusion process. Extensive chemical cross-linking capability exists within certain of the Company's facilities. In addition, an electron beam radiation facility is utilized at the Lafayette, Indiana plant. Once the wire is fabricated, it is packaged and shipped to regional warehouses, distributors or directly to customers. Metals Operations Although the Company classifies its business into four principal divisions (see "Division Operations" above) the metals operations, due to cost efficiencies, are centrally organized. Copper is the critical component of the Company's overall cost structure, comprising approximately 50% of the Company's 1993 total production cost of sales. Through centralization, the Company carefully manages its copper procurement, internal distribution, manufacturing and scrap recycling processes. The Company's operations are vertically integrated in the production of copper rod; the Company believes that only a few of its larger competitors are able to match this capability. The Company manufactures most of its copper rod requirements and purchases the remainder from various suppliers. Copper Procurement The Company centralizes its copper purchases. In 1993 the Company bought approximately 225,000 tons of copper. North American copper producers and metals merchants accounted for approximately 98% of such purchases. Under producer contracts, the Company commits to take a specified tonnage per month. Most producer contracts have a one-year term. Pricing provisions vary, but they are based on the New York Commodity Exchange, Inc. ("COMEX") price plus a premium. Under merchant contracts, prices are also based on the COMEX price plus a premium. Payment terms are negotiated. Historically, the Company has had adequate supplies of raw materials available to it from producers and dealers, both foreign and domestic. Competition from other users of copper has not affected the Company's ability to meet its copper procurement requirements. However, no assurance can be given that the Company will be able to procure adequate supplies of copper to meet its future needs. Copper Rod Production The production of copper rod is an essential part of the Company's manufacturing process. Through vertical integration, the Company's ability to manufacture rod provides greater control over the cost and quality of an essential component used in producing most of the Company's products. Approximately 80% of the Company's rod requirements are provided internally, with the balance purchased from external sources. External rod purchases are used to cover rod requirements beyond the Company's capacity to produce and for rod requirements at manufacturing locations where shipping Company-produced rod is not cost effective. The Company currently has four rod production facilities which are strategically located near its major wire producing plants to minimize freight costs. During the third quarter of 1994, the Company expects to commence production at a fifth continuous casting unit to further supply its rod requirements and reduce costs. Copper rod is manufactured by a continuous casting process where high quality copper cathodes are melted in a shaft furnace. The molten copper is transferred to a holding furnace and siphoned directly onto a casting wheel where it is cooled and subsequently rolled into copper rod. The rod is subjected to quality control tests to determine that it meets the high quality standards of the Company's products. Numerous other quality tests are performed throughout the process to determine rod characteristic and provide proper utilization of rod by plants requiring specific processing requirements. Finally, the rod is packaged for shipment via an automatic in-line coiling packaging device. Copper Scrap Reclamation The Company's Metals Processing Center receives scrap from a majority of the Company's plants. Copper scrap is processed in rotary furnaces, which also have refining capability to remove impurities. A casting process is employed to manufacture copper rod from scrap material. This continuous casting process is unique in the industry in the conversion of scrap directly into rod. Manufacturing cost economies, particularly in the form of energy savings, result from the Company's direct production technique. Additionally, management believes that internal reclamation of scrap copper provides greater control over the cost to recover the Company's principal manufacturing by-product. The Company also obtains scrap from other copper wire producers in exchange for cathodes and processes it along with the internal scrap. Exports Sales of exported goods approximated $70.6 million, $75.5 million, and $40.8 million for the years ended December 31, 1993, 1992, and 1991, respectively. TPD is the Company's primary exporting division. Backlog The Company has no significant order backlog in that it follows the industry practice of producing its products on an ongoing basis to meet customer demand without significant delay. The Company believes the ability to supply orders in a timely fashion is a competitive factor in the markets in which it operates. Competition In each of the Company's operating divisions, the Company experiences competition from at least one major competitor. However, due to the diversity of the Company's product lines as a whole, no single competitor competes with the Company across the entire spectrum of the Company's product lines. Many of the Company's products are made to industry specifications, and are therefore essentially fungible with those of competitors. Accordingly, the Company is subject in many markets to competition on the basis of price, delivery time, customer service and ability to meet specialty needs. The Company believes it enjoys strong customer relations resulting from its long participation in the industry, its emphasis on customer service, its commitment to quality control, reliability, and its substantial production resources. The Company's distribution networks enable it to compete effectively with respect to delivery time. From time to time the Company has experienced reduced margins in certain markets due to price cutting by competitors. Employees As of December 31, 1993, the Company employed approximately 1,280 salaried and 2,475 hourly employees in 33 states. Labor unions represent approximately 50% of the Company's work force. Collective bargaining agreements expire at various times between 1994 and 1999. Contracts covering approximately 26% of the Company's unionized work force will expire at various times during the remainder of 1994. The Company believes that it will be able to renegotiate its contracts covering such unionized employees on terms that will not be materially adverse to it, however, no assurance can be given to that effect. The Company believes its relations with both unionized and nonunionized employees have been good. Item 2.

Item 2. Properties At December 31, 1993 the Company operated 26 manufacturing facilities in 12 states. Except as indicated below, all of the facilities are owned by the Company or its subsidiaries. The Company believes its facilities and equipment are reasonably suited to its needs and are properly maintained and adequately insured. The following table sets forth certain information with respect to the manufacturing facilities of the Company at December 31, 1993: (a) Approximately 30,000 square feet of the Kosciusko, MS facility is leased. (b) The total square footage of the Franklin, IN facility is approximately 70,000 of which 35,000 square feet is leased to Femco as described in the third succeeding paragraph below. In addition to the facilities described in the table above, the Company owns or leases 26 warehouses throughout the United States, plus one in Canada to facilitate the sale and distribution of its products. The Company owns and maintains executive and administrative offices in Fort Wayne, Indiana. The Company believes its plants are generally adequate to service the requirements of its customers. Overall, the Company's plants are utilized to a substantial, but not full degree. The extent of current utilization is generally consistent with historical patterns, and, in the view of the Company, is satisfactory. The Company does not view any of its plants as being substantially underutilized. Most plants operate on schedules of no less than three eight hour shifts, five days a week. During 1993, the Company's facilities operated overall at approximately 93% of capacity, with MWI at 93%, EPD at 77%, TPD at 95% and WCD at 95% of capacity. The property in Franklin, Indiana is a magnet wire manufacturing facility occupied by both the Company and Femco. Half of the Franklin, Indiana building is leased to Femco which was established in 1988 as a joint venture between the Company and The Furukawa Electric Company, LTD., Tokyo, Japan. Femco manufactures and markets magnet wire with special emphasis on products required by Japanese manufacturers with production facilities in the United States. See Division Operations--Magnet Wire and Insulation and "Management's Discussion and Analysis of Results of Operations and Financial Condition Liquidity, Capital Resources and Financial Condition." Item 3.

Item 3. Legal Proceedings Legal and Environmental Matters The Company is engaged in certain routine litigation arising in the ordinary course of business. The Company does not believe that the adverse determination of any pending litigation, either singly or in the aggregate, would have a material adverse effect upon its business, financial condition or results of operations. Potential environmental liability to the Company arises from both on-site contamination by, and off-site disposal of, hazardous substances. On-site contamination at certain Company facilities is the result of historic disposal activities, including activities attributable to Company operations and those occurring prior to the use of a facility site by the Company. Off-site liability would include cleanup responsibilities at various sites to be remedied under federal or state statutes for which the Company has been identified by the United States Environmental Protection Agency (the "EPA") (or the equivalent state agency) as a Potentially Responsible Party ("PRP"). The Company has been named in government proceedings which involve environmental matters with potential remediation costs and, in certain instances, sanctions. Once the Company has been named as a PRP, it estimates the extent of its potential liability based upon, among other things, the number of other identified PRPs and the relative contribution of Company waste at the site. Nevertheless, the Company believes that, except as described in the next succeeding paragraph and subject to the $4.0 million "basket" described below and one other identified site, it will not bear the cost of investigation and cleanup at any of these sites because, pursuant to the Stock Purchase Agreement dated January 15, 1988 (the "1988 Acquisition Agreement") covering the 1988 Acquisition, UTC agreed to indemnify the Company against all losses, as defined in the 1988 Acquisition Agreement, incurred under any environmental protection and pollution control laws or resulting from or in connection with damage or pollution to the environment, and arising from events, operations or activities of the Company prior to February 29, 1988 or from conditions or circumstances existing at or prior to February 29, 1988. Except for certain matters relating to permit compliance, the Company believes that it is fully indemnified with respect to conditions, events and circumstances known to UTC prior to February 29, 1988, i.e., matters referred to in documents which were in UTC's possession, custody or control prior to the 1988 Acquisition or matters identified to UTC through the due diligence of Holdings. Further, the Company is indemnified, subject to a $4.0 million "basket" (the "Basket"), for losses related to any environmental events, conditions, or circumstances identified prior to February 28, 1993 to the extent such losses are not caused by activities of the Company after February 29, 1988. None of the foregoing was affected by the change in control of Holdings on October 9, 1992. The Company is not aware of any inability or refusal on the part of UTC to pay amounts which are owing under the UTC indemnity. From time to time, however, the Company and UTC have disagreed as to certain matters of fact which would be determinative as to whether a particular environmental matter is covered by the indemnity or is subject to the Basket. The matters involved have arisen seriatim over the past six years and have not been material. Each matter related to particular sites which have been remediated and the Company has expensed all amounts incurred by it in connection with such sites. Recently the Company and UTC agreed in principle to share financial responsibility for all of such matters without necessarily agreeing on all of the factual issues involved. The Company does not believe that, in light of the UTC indemnity, any of the environmental proceedings in which it is involved and for which it may be liable under the Basket or otherwise will, individually or in the aggregate, have a material adverse effect upon its business, financial condition or results of operations and none involves sanctions for amounts of $0.1 million or more. In 1967, following an investigation regarding the alleged violation of United States antitrust laws, the Company agreed that in the future it would refrain from tying the sale of magnet wire to the purchase of other products. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders None during the fourth quarter of 1993. PART II Item 5.

Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters There is no established public trading market for the common stock of the Company or of its parent, Holdings. The common stock of the Company and its parent has not been traded or sold publicly and accordingly no information with respect to sales prices or quotations is available. Item 6.

Item 6. Selected Financial Data The following table sets forth (i) selected historical consolidated financial data of the Company prior to the Acquisition ("Predecessor") as of and for the nine month period ended September 30, 1992, and each of the years in the three year period ended December 31, 1991, (ii) selected historical consolidated financial data of the Company after the Acquisition ("Successor") as of and for the year ended December 31, 1993 and the three month period ended December 31, 1992, and, (iii) combined historical consolidated financial data of Successor for the three month period ended December 31, 1992 and Predecessor for the nine month period ended September 30, 1992. This data should be read in conjunction with "Management's Discussion and Analysis of Results of Operations and Financial Condition" and the consolidated financial statements and related notes included elsewhere herein. The selected historical consolidated financial data presented below as of and for each of the years in the two year period ended December 31, 1990, were derived from the audited consolidated financial statements of Predecessor (not presented herein). The selected historical consolidated financial data presented below, as of and for the year ended December 31, 1993, the three month period ended December 31, 1992, the nine month period ended September 30, 1992, and the year ended December 31, 1991, were derived from the consolidated financial statements of Successor and Predecessor, which were audited by Ernst & Young, independent auditors, whose report with respect thereto, together with such financial statements, appears elsewhere herein. (Footnotes on following page) (Footnotes continued from previous page) (a) Represents a combination of Successor's three month period ended December 31, 1992 and Predecessor's nine month period ended September 30, 1992. Such combined results are not directly comparable to the consolidated results of operations of the Predecessor for each of the three years ended December 31, 1991, nor are they necessarily indicative of the results for the full year due to the effects of the Acquisition and Merger and related refinancings and the concurrent adoption of Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes," ("FAS 109"). See Notes to Consolidated Financial Statements. Financial data of the Company as of October 1, 1992 and thereafter reflect the Acquisition using the purchase method of accounting, and accordingly, the purchase price has been allocated to assets and liabilities based upon their estimated fair values. However, to the extent that Holdings management had a continuing investment interest in Holdings' common stock, such fair values (and contributed stockholder's equity) were reduced proportionately to reflect the continuing interest (approximately 10%) at the prior historical cost basis. (b) In connection with the Acquisition and Merger, debt issuance costs of $1.5 million and $1.8 million associated with debt retired were included in interest expense for the year ended December 31, 1993 and the three month period ended December 31, 1992, respectively. (c) In connection with the Acquisition and Merger, the Predecessor recorded certain merger related expenses of $18.1 million consisting primarily of bonus and option payments to certain employees and certain merger fees and expenses, which have been charged to the Predecessor's operations in the nine month period ended September 30, 1992. In May 1989, the Predecessor paid cash bonuses to certain members of its management from the proceeds of the debentures issued by Holdings. (d) Holdings and the Company file a consolidated U.S. federal income tax return. Through December 31, 1990 the deductible expenses of Holdings (primarily interest) were included in the calculation of the Company's income taxes under a tax sharing agreement with Holdings. The tax sharing agreement was amended, effective January 1, 1991, to provide that the Company's aggregate income tax liability be calculated as if it were to file a separate return with its subsidiaries. The tax benefits recorded in 1990 and 1989 for the deductible expenses of Holdings were $8.7 million and $4.8 million, respectively. The pro forma net income reflecting income taxes on a separate return basis is presented for 1990 and 1989 as if such benefits had not been recorded. (e) During 1993, Successor recognized extraordinary charges of $3.1 million, net of applicable tax benefit, representing the write off of unamortized debt costs associated with the repayment of the outstanding balance of the Company's term loans, and $0.3 million, net of applicable tax benefit, representing the net loss resulting from the redemption of the Company's 12 3/8% Senior Subordinated Debentures ("Debenture Repurchases"). During 1992 and 1991, Predecessor made Debenture Repurchases which had a carrying value of $13.8 million and $42.0 million, respectively. The net loss resulting from these repurchases, which includes the write off of a portion of unamortized debt costs, was reflected as an extraordinary charge of $0.1 million and $1.5 million, net of applicable income tax benefit for Predecessor during 1992 and 1991, respectively. (f) For purposes of this computation, earnings consist of income before income taxes plus fixed charges (excluding capitalized interest). Fixed charges consist of interest on indebtedness (including capitalized interest and amortization of deferred financing fees) plus that portion of lease rental expense representative of the interest factor (deemed to be one-third of lease rental expense). Earnings of the Successor were insufficient to cover fixed charges by the amount of $7.1 million for the three month period ended December 31, 1992. Item 7.

Item 7. Management's Discussion and Analysis of Results of Operations and Financial Condition Introduction The Company is engaged in one principal line of business, the production of electrical wire and cable. The Company classifies its operations into four major divisions based on the markets served: Wire and Cable Division, Magnet Wire and Insulation Division, Telecommunication Products Division and Engineered Products Division. See "Business" for a description of the principal products offered by each division and the total sales for each major product line for the years ended 1993, 1992 and 1991. For financial statement purposes, the Acquisition and Merger was accounted for by Holdings as a purchase acquisition effective October 1, 1992. Because the Company is a wholly-owned subsidiary of Holdings, the effects of the Acquisition and Merger have been reflected in the Company's financial statements, resulting in a new basis of accounting reflecting estimated fair values for Successor's assets and liabilities at that date. However, to the extent that Holdings' management had a continuing investment interest in Holdings' common stock, such fair values (and contributed stockholder's equity) were reduced proportionately to reflect the continuing interest (approximately 10%) at the prior historical cost basis. As a result, the Company's financial statements for the periods subsequent to September 30, 1992 are presented on the Successor's new basis of accounting, while the financial statements for September 30, 1992 and prior periods are presented on the Predecessor's historical cost basis of accounting. The consolidated results of operations of the Company for the twelve month period ended December 31, 1992 are not directly comparable to the consolidated results of operations of the Predecessor due to the effects of the Acquisition and Merger and related refinancings and the concurrent adoption of FAS 109. See Notes 1 and 7 of Notes to Consolidated Financial Statements. In connection with the Acquisition and Merger and the concurrent adoption of FAS 109, the Successor recognized $142.2 million of excess of cost over net assets acquired that is being amortized over 35 years on the straight line method. Results of Operations The Year Ended December 31, 1993 Compared With The Twelve Months Ended December 31, 1992 Net sales for 1993 were $868.8 million or 4.5% lower than 1992. Record sales volume in 1993 exceeded the previous record-level volume of 1992 by approximately 5.1% but was more than offset by reduced product prices reflecting lower copper costs, the Company's principal raw material, and competitive pricing pressures. Copper costs are generally passed on to customers through product pricing. The average price for copper on the New York Commodity Exchange, Inc. (the "COMEX") declined 17.0% from 1992. The Company believes the improved sales volume resulted from increased demand for wire products within the served markets and was attributable to an improving economy, especially as it affected the markets served by the Magnet Wire and Insulation and Engineered Products Divisions. For a discussion of the Company's practices with respect to the purchase, internal distribution and processing of copper, see "Business-Metals Operations." Also see "General Economic Conditions and Inflation" under this caption. Sales for the Magnet Wire and Insulation Division were up 5.3% compared to 1992. Sales volume increased 12.5% over 1992 resulting from increased demand for magnet wire products in the automotive, electric motor and transformer markets in addition to increased sales to distributors. Product pricing was down approximately 6.9% due primarily to lower copper prices in 1993 compared to 1992. The Engineered Products Division experienced a 5.3% increase in sales over 1992 attributable primarily to increased demand for the division's automotive wire products. Automotive wire volumes increased approximately 21% from 1992 due in part to improved demand from its primary customer and to several new accounts. See "Business-Division Operations-Engineered Products Division". Of the increased automotive sales volume, 27% resulted from new customers. Sales of non-automotive products also experienced volume improvements despite decreased demand for pump and welding cable products resulting from flooding in the midwest during 1993. The Wire and Cable, and Telecommunication Products Divisions experienced sales declines in 1993 compared with 1992. The Wire and Cable Division's sales were off 11.3% from 1992 due principally to lower copper prices and reduced product pricing. Volume was down slightly compared with 1992 due mainly to selective market participation during part of the year. Sales by the Telecommunication Products Division were down approximately 11.8% compared with 1992. In addition to reduced product pricing, unit sales volume to the domestic telephone markets was down 22.0% partially offset by a 19.3% increase in export unit volume. Product demand within the domestic markets was down due primarily to general uncertainty about the economy as well as the ongoing restructuring of the U.S. telephone cable industry. Cost of goods sold decreased 4.4% in 1993 compared with 1992 due primarily to lower copper prices partially offset by higher sales volume and additional depreciation expense resulting from the application of purchase accounting in connection with the Acquisition and Merger and the concurrent adoption of FAS 109 (See Notes 1 and 7 of Notes to Consolidated Financial Statements). The Company's cost of goods sold as a percentage of net sales was 85.8% in each of 1993 and 1992. The cost of goods sold percentage in 1993 was adversely impacted by generally lower selling prices and additional depreciation expense resulting from the application of purchase accounting in connection with the Acquisition and Merger and the concurrent adoption of FAS 109 partially offset by lower manufacturing costs resulting from increased capacity utilization. Cost of goods sold in 1992 includes a charge of $2.6 million relating to planned plant consolidations, primarily costs to move equipment and personnel related expenses. Raw material costs in 1993, excluding copper, were generally unchanged from 1992. Selling and administrative expenses in 1993 were 7.9% lower than 1992 due primarily to the expiration of a non-compete agreement with UTC in the first quarter 1993 resulting in the elimination of the related amortization charge, a $2.1 million reduction in the Company's health insurance expense and a $1.5 million accrual in 1992 for the relocation of a business unit in 1993. In connection with the 1988 Acquisition, UTC agreed that until March 1, 1993, it would not engage in any business directly competing with any business carried on by the Company on February 29, 1988. The $34.0 million purchase price allocated to the covenant not to compete was amortized over five years on the straight line method. The reduction in health insurance expense was attributable to favorable experience in health related expenditures. Partially offsetting these expense reductions was a $4.0 million amortization charge recorded in 1993 for excess of cost over net assets acquired compared to a $1.0 million charge recorded in the last quarter of 1992 and a $2.5 million reduction in the Company's allowance for doubtful accounts recorded in the third quarter of 1992. In connection with the Acquisition and Merger and concurrent adoption of FAS 109, the Successor recognized $142.2 million of excess of cost over net assets acquired that is being amortized over 35 years on the straight line method. The Company's allowance for doubtful accounts was reduced on the basis of the collection of a substantial receivable which had been considered doubtful as well as management's assessment of collection risk in the primary markets served. Interest expense in 1993 was $25.2 million as compared to $22.6 million in 1992. The increase was principally caused by $19.0 million in additional weighted average debt outstanding and an increase in the Company's average interest rate incurred (from 8.9% to 9.7%). The additional debt outstanding was primarily attributable to Acquisition- related borrowings and the May 1993 sale by the Company of its 10% Senior Notes due 2003 (the "Senior Notes"). Average interest rates increased reflecting the higher interest rate on the Senior Notes compared with the rate of interest on the Term Credit which was repaid from the sale of the Senior Notes, partially offset by the redemption of all outstanding 12 3/8% Senior Subordinated Debentures due 2000 (the "Debentures") which were also repaid in connection with the issuance of the Senior Notes. See also "Liquidity, Capital Resources and Financial Condition". In connection with the Acquisition and Merger, the Company incurred certain merger related expenses in the amount of $18.1 million consisting primarily of bonus and option payments to certain employees, and certain merger fees and expenses which were charged to operations of the Predecessor in the quarter ended September 30, 1992. These Acquisition and Merger expenses had the effect of reducing 1992 net income by $12.5 million (after applicable tax benefit of $5.6 million). See Note 1 of Notes to Consolidated Financial Statements. Income tax expense was $13.1 million, or 58.2% of pretax income in 1993 compared with $7.4 million, or 95.2%, of pretax income in 1992. The Company elected not to step up its tax bases in the assets acquired in either the Acquisition or the 1988 Acquisition. Accordingly, the Company's income tax bases in the assets acquired have not been changed from those prior to the 1988 Acquisition. Depreciation and amortization of the higher allocated financial statement bases are not deductible for income tax purposes, thus causing the effective income tax rate of the Predecessor to be generally higher than the combined federal and state statutory rate. Because of the adoption of FAS 109 by the Successor, concurrent with the Acquisition, deferred income taxes have been provided for bases differences in all assets and liabilities other than excess of cost over net assets acquired. In compliance with the Omnibus Budget Reconciliation Act of 1993, the Company's tax balances were adjusted in the third quarter of 1993 to reflect the new federal statutory tax rate of 35%. The adjustment had the effect of increasing income tax expense by $2.3 million for 1993 or 10.0% of pretax income. See Note 7 of Notes to Consolidated Financial Statements. The Company recorded net income of $6.0 million in 1993 as compared to net income of $0.3 million in 1992. The 1993 results include extraordinary charges of $3.4 million ($5.5 million before applicable tax benefits) associated with the repayment of the Term Credit and redemption of the Debentures. See also "Liquidity, Capital Resources and Financial Condition". The 1992 results include $18.1 million of Acquisition and Merger related expenses, $12.5 million net of applicable tax benefit, and a $0.1 million extraordinary charge ($0.2 million before applicable tax benefit) resulting from the partial repurchase of a portion of the outstanding Debentures. Twelve Months Ended December 31, 1992 Compared With The Year Ended December 31, 1991 Net sales for 1992 were $909.4 million or 2.7% greater than 1991 due principally to a record volume year with an 8.0% increase in sales volume over 1991. The Company attributes the increase in sales volume at least in part to the strengthening U.S. economy during the period. The positive effects of an increase in sales volumes were partially offset, however, by lower copper prices, the Company's principal raw material, and competitive product pricing. Copper costs are generally passed on to customers through product pricing and the average price for copper on the COMEX declined 2.1% from 1991. Due to increased competitive pressures, primarily in the building wire and telecommunication cable product lines, overall product pricing was below 1991 levels. For a discussion of the Company's practices with respect to the purchase, internal distribution and processing of copper, see "Business Metals Operations." Also see "General Economic Conditions and Inflation" under this caption. The Wire and Cable Division's sales, after reflecting the transfer to the Engineered Products Division of an industrial wire product line representing $32.7 million in sales in 1992, declined 3.1% from 1991 sales levels. Despite such product line transfer, Wire and Cable Division sales volume was nearly 4.7% ahead of 1991 due to improved demand for building wire products. Sales for the division would have increased 5.8% and sales volume would have increased 10.9% in 1992 over 1991 had the industrial wire product line transfer occurred on January 1, 1991. Increased competitive pressures in the fourth quarter of 1992, however, caused an overall deterioration in product pricing for the year. Sales volume during the fourth quarter was essentially unchanged from the same period in 1991. The Magnet Wire and Insulation Division's sales increased 2.7% over 1991 due primarily to a 7.5% improvement in sales volume. Increased automobile and truck production coupled with an upturn in housing starts contributed to the higher volumes. Magnet Wire and Insulation Division product pricing declined marginally from 1991. Telecommunication Products Division sales were off 5.5% from 1991 levels. During 1992, the Telecommunication Products Division experienced more severe pricing pressures in its domestic markets and therefore, diverted a larger portion of its manufacturing capacity to serve export markets. Consequently, export sales for the division were up 111.4% from 1991. Due to the change in product mix and continued pricing pressures, average Telecommunication Products Division product pricing declined moderately from 1991. Engineered Products Division's sales were up $37.1 million from 1991 although $32.7 million of that increase was attributable to the transfer from the Wire and Cable Division of the industrial wire product line. Without giving effect to that transfer, sales were up 6.2% due to an increase in automotive and industrial wire sales volumes. A generally improved economy coupled with an approximate 8.9% rise in domestic automobile and truck production were the primary contributors to this improvement. Cost of goods sold in 1992 increased 3.6% from 1991 due primarily to higher sales volume partially offset by lower copper costs and generally lower other material costs. The Company's cost of goods sold as a percent of net sales was 85.8% and 85.0% in 1992 and 1991, respectively. The cost of goods sold percentage in 1992 was higher than in 1991 because the Company's major business units experienced greater competitive pricing pressure resulting in generally lower selling prices. The higher sales volume, however, lead to increased capacity utilization resulting in generally lower manufacturing costs. Cost of goods sold in 1992 was also impacted by a charge of approximately $2.6 million to reflect anticipated plant consolidations and approximately $1.6 million in additional depreciation expense resulting from the October 1, 1992 application of purchase accounting in connection with the Acquisition and Merger and the concurrent adoption of FAS 109 on a prospective basis. Selling and administrative expenses for 1992 were up 2.2% from 1991 but remained at approximately 9.0% of sales. Contributing to this increase was a $1.5 million accrual in 1992 for the anticipated relocation of a business unit in 1993 and a $1.0 million amortization charge for the excess cost over net assets acquired associated with the Acquisition and Merger and adoption of FAS 109. A reduction of $2.5 million in the Company's allowance for doubtful accounts and a $1.0 million reduction in its health insurance accrual in 1992 offset the foregoing charges. The Company's allowance for doubtful accounts was reduced by $2.5 million (net $1.8 million after approximately $0.7 million current provision) on the basis of the collection of a substantial receivable which had been considered doubtful as well as management's assessment of risk of collection in the primary markets served. In addition, actual health related expenditures did not increase to the levels previously anticipated. The 1991 results include a charge for a warranty claim settlement of approximately $1.7 million. Interest expense in 1992 was $22.6 million as compared to $25.0 million in 1991. This 9.5% decrease was due principally to a $17.5 million reduction in the Company's weighted average total debt outstanding during 1992 and generally lower interest rates on the Company's bank credit facilities. During 1992, Debenture Repurchases totalled $13.8 million while the Company's weighted average interest rate on debt outstanding declined from 10.4% to 8.7%. Partially offsetting these favorable outcomes was an amortization charge related to the deferred debt costs incurred to place the new credit agreement and amortization of deferred debt costs on debt retired and to be retired in connection with the Acquisition. See "Liquidity, Capital Resources and Financial Condition." In connection with the Acquisition and Merger, the Company incurred certain merger related expenses in the amount of $18.1 million consisting primarily of bonus and option payments to certain employees, and certain merger fees and expenses which were charged to operations of the Predecessor in the quarter ended September 30, 1992. These Acquisition and Merger expenses had the effect of reducing net income by $12.5 million (after applicable tax benefit of $5.6 million). See Note 1 of Notes to Consolidated Financial Statements. Income tax expense was $7.4 million, or 95.2% of pretax income in 1992 compared with $13.2 million, or 47.7%, of pretax income in 1991. The Company elected not to step up its tax bases in the assets acquired in either the Acquisition or the 1988 Acquisition. Accordingly, the Company's income tax bases in the assets acquired have not been changed from those prior to the 1988 Acquisition. Depreciation and amortization of the higher allocated financial statement bases are not deductible for income tax purposes, thus causing the effective income tax rate of the Predecessor Company to be generally higher than the approximate statutory rate of 39%. Because of the adoption of FAS 109 by the Successor Company concurrent with the Acquisition, deferred income taxes have been provided for bases differences in all assets and liabilities other than excess of cost over net assets acquired. See Notes 2 and 7 of Notes to Consolidated Financial Statements. The Company's net income for the twelve month period ended December 31, 1992 (after giving effect to $18.1 million of Acquisition and Merger related expenses, $12.5 million net of applicable tax benefit) was $0.3 million which included a $0.1 million ($0.2 million before applicable tax benefit) extraordinary charge resulting from Debenture Repurchases. Liquidity, Capital Resources and Financial Condition The Company had a ratio of debt (consisting of current and non-current portions of long-term debt) to stockholder's equity of approximately 0.7 to 1 at December 31, 1993 and 1992. In connection with the Acquisition and Merger, the Company entered into a credit agreement in September 1992, among BE, the Company, Holdings, the lenders named therein and Chemical Bank, as agent (the "Credit Agreement"). Under the Credit Agreement, the Company borrowed $130.0 million in term loans (the "Term Credit") of which $94.0 million was used to repay all indebtedness outstanding under the Company's previous credit agreement and the balance was used to pay a portion of the consideration payable to Holdings' shareholders and option holders in the Merger and certain fees and expenses of the Company and Holdings related to the Acquisition and Merger and for other general corporate purposes. The Credit Agreement also provided for $155.0 million in revolving credit expiring April 9, 1998. In May 1993, the Company issued $200.0 million aggregate principal amount of its Senior Notes. The net proceeds to the Company from the sale of the Senior Notes, after underwriting discounts, commissions and other offering expenses, were approximately $193.5 million. The Company applied approximately $111.0 million of such proceeds to the repayment of the Term Credit and in June 1993 applied the balance of such proceeds together with new borrowings of approximately $7.5 million under the revolving credit facility of the amended and restated credit agreement (see immediately following paragraph), to redeem all of its outstanding Debentures. The Company recognized extraordinary charges in the second quarter of 1993 of approximately $3.4 million ($5.5 million before applicable tax benefit) associated with the repayment of the Term Credit and redemption of the Debentures. Upon application of the net proceeds received from the Senior Notes to repay the Term Credit, as discussed above, an amendment and restatement of the Credit Agreement became effective (the "Restated Credit Agreement"). The Restated Credit Agreement provides for $175.0 million in revolving credit, subject to specified percentages of eligible assets, reduced by outstanding letters of credit (the "Revolving Credit"). The Revolving Credit expires in 1998. Revolving Credit loans bear interest at floating rates at bank prime rate plus 1.25% or a reserve adjusted Eurodollar rate (LIBOR) plus 2.25%. The effective interest rate can be reduced by 0.25% to 0.75% if certain specified financial conditions are achieved. The Company has purchased interest rate cap protection through 1994 covering up to $100.0 million of Revolving Credit borrowings. No term facility is available under the Restated Credit Agreement. Through December 31, 1993, the Company fully complied with all of the financial ratios and covenants contained in the Restated Credit Agreement and the indenture under which the Senior Notes were issued (the "Indenture"). The Restated Credit Agreement and the Indenture contain provisions which may restrict the liquidity of the Company. These include restrictions on the incurrence of additional indebtedness and, in the case of the Restated Credit Agreement, mandatory principal repayment requirements for all indebtedness that exceeds the Borrowing Base as defined in the Restated Credit Agreement. Net cash provided by operating activities in 1993 was $60.7 million, an increase of $27.2 million over 1992. Cash flow provided by operating activities in 1993, together with borrowings under the revolving credit facility of the Credit Agreement and the Restated Credit Agreement were sufficient to meet the Company's cash interest requirements, working capital and capital expenditure needs and to pay mandatory principal payments on the Term Credit portion of the Credit Agreement. As previously discussed, the Term Credit was repaid in full in May 1993 out of proceeds from the issuance and sale of the Senior Notes. Capital expenditures in 1993 were $26.2 million or $5.0 million less than in 1992. Such expenditures included $2.6 and $9.2 million for a new magnet wire manufacturing facility in Franklin, Indiana in 1993 and 1992, respectively. This new facility is occupied by both the Company and Femco. Femco was established in 1988 as a joint venture between the Company and The Furukawa Electric Company, Ltd., Tokyo, Japan. At December 31, 1993, approximately $8.6 million was committed to outside vendors for capital projects to expand capacity, complete modernization projects, reduce costs and ensure continued compliance with regulatory provisions. Capital expenditures in 1994 are expected to approximate 1993 spending levels. In November 1993, the Company acquired a majority interest in Interstate Industries, Inc. for cash of $4.3 million, subject to final purchase price adjustments and the minority interest ownership percentage. See "Business--Business Development." The Restated Credit Agreement imposes annual limits on the Company's capital expenditures and business acquisitions. The Company anticipates that its working capital, capital expenditure and cash interest requirements for 1994 will be satisfied through a combination of funds generated from operating activities together with funds available under the Revolving Credit. Management bases such belief on historical experience and the substantial availability of funds under the Revolving Credit. Increased working capital needs occur whenever the Company experiences strong incremental demand in its business as well as a significant rise in copper prices. Average quarterly cash flow generated from operations for the three year period ended December 31, 1993 was $13.7 million; at December 31, 1993 the entire $175.0 million of Revolving Credit was available, subject to specified percentages of eligible assets, (less $13.9 million in outstanding letters of credit). During 1993, average borrowings under the Company's revolving credit facilities were $10.1 million compared to $66.8 million during 1992. In 1993 certain pension actuarial assumptions were revised to reflect changes in their underlying economic fundamentals. The effect of such revisions on the Company's results of operations and cash flows for 1994 is not expected to be material. The Company expects that it may also make certain cash payments to Holdings or other affiliates from time to time to the extent cash is available and to the extent it is permitted to do so under the terms of the Restated Credit Agreement and the Indenture. Such payments may include (i) an amount necessary under the tax sharing agreement between the Company and Holdings to enable Holdings to pay the Company's taxes as if computed on an unconsolidated basis; (ii) a management fee to an affiliate of BHLP of up to $1.0 million; (iii) amounts to repurchase outstanding Senior Discount Debentures due 2004 of Holdings (the "Holdings Debentures") to the extent they may become available for repurchase in the open market at prices which Holdings and the Company find attractive and to the extent such repurchases are permitted under the terms of the instruments governing Holdings and the Company's indebtedness; and (iv) other amounts to meet ongoing expenses of Holdings (such amounts are considered to be immaterial both individually and in the aggregate). To the extent the Company makes any such payments, it will do so out of operating cash flow or borrowings under the Restated Credit Agreement and only to the extent such payments are permitted under the terms of the Restated Credit Agreement and the Indenture. Each of the foregoing payments is either completely discretionary on the part of the Company or may be waived by an affiliate of the Company. Notwithstanding any of the foregoing payments which the Company may make to Holdings, Holdings' actual liquidity requirements are expected to be insubstantial in 1994 on an unconsolidated basis because Holdings has no operations (other than those conducted through the Company) or employees and is not expected to have any tax liability on an unconsolidated basis. Holdings' Series A Cumulative Redeemable Exchangeable Preferred Stock, Liquidation Preference $25 Per Share (the "Series A Preferred Stock"), which was issued in connection with the Acquisition and Merger, provides that dividends may be paid in kind at the option of Holdings until 1998 and is not subject to mandatory redemption until 2004 (except upon the occurrence of certain specified events). The redemption price is $25 per share plus accrued and unpaid dividends to the date of redemption. For the year ended December 31, 1993 Holdings recorded dividends in kind of $5.2 million. The Restated Credit Agreement permits Holdings to pay dividends in cash on the Series A Preferred Stock subject to certain limitations. However, in the near term, Holdings expects to pay dividends on the Series A Preferred Stock in additional shares of such stock. The Holdings Debentures are not expected to have an impact on the Company's liquidity prior to November 15, 1995 (unless they are repurchased or refinanced prior to that date) when cash interest at 16.0% first becomes payable semi-annually. The Holdings Debentures were issued in May 1989. As of December 31, 1993, Holdings had a liability, net of repurchases, of $228.9 million in respect of the Holdings Debentures ($277.8 million aggregate principal amount). Through December 31, 1993 Holdings had repurchased $64.2 million aggregate principal amount of its Holdings Debentures in the open market using cash dividends, management fees and income taxes paid to Holdings by the Company together with available cash. Such payments were made pursuant to the Company's prior credit agreement which was terminated October 9, 1992. There have been no repurchases of Holdings Debentures since 1991 and further repurchases, if any, may be made at the discretion of Holdings and will depend upon market conditions, and, in particular, the prices at which the Holdings Debentures are trading as well as Holdings' available cash. The Holdings Debentures are unsecured debt of Holdings and are effectively subordinated to all outstanding indebtedness of the Company, including the Senior Notes, and will be effectively subordinated to other indebtedness incurred by direct and indirect subsidiaries of Holdings, if issued. Because Holdings is a holding company with no operations and has virtually no assets other than the outstanding capital stock of the Company (all of which is pledged to the lenders under the Restated Credit Agreement), Holdings' ability to meet its cash obligations will be dependent upon the Company's ability to pay dividends, loan or to otherwise advance or transfer funds to Holdings in sufficient amounts. The Company believes that the Restated Credit Agreement and the Indenture permit the Company to dividend or otherwise provide funds to Holdings to enable Holdings to meet its known cash obligations provided that the Company meets certain conditions. Among such conditions, however, are that the Company meet various financial maintenance tests. There can be no assurance that such tests will be met, in which case the Company would not be able to pay dividends to Holdings without the consent of the percentage of the lenders specified in the Restated Credit Agreement and/or the holders of the percentage of the Senior Notes specified in the Indenture. There can be no assurance that the Company would be able to obtain such consents, or meet the terms on which such consents might be granted if they were obtainable. Moreover, a violation of the Restated Credit Agreement and/or the Indenture could lead to an event of default and acceleration of outstanding indebtedness under the Restated Credit Agreement and to acceleration of the indebtedness represented by the Senior Notes and the Holdings Debentures. Because the capital stock of the Company and its subsidiaries, as well as virtually all of the assets of the Company and its subsidiaries, are pledged to the lenders under the Restated Credit Agreement, such lenders would have a claim over such assets prior to holders of the Senior Notes and the Holdings Debentures. In the event Holdings were unable to meet its cash obligations, a sequence of events similar to that described above could ultimately occur. General Economic Conditions and Inflation The Company faces various economic risks ranging from an economic downturn adversely impacting the Company's primary markets to marked fluctuations in copper prices. In the short-term, pronounced changes in the price of copper tend to affect the Wire and Cable Division's gross profits because such changes affect raw material costs more quickly than those changes can be reflected in the pricing of the Wire and Cable Division's products. In the long-term, however, copper price changes have not had a material adverse effect on gross profits because cost changes generally have been passed through to customers over time. In addition, the Company believes that its sensitivity to downturns in its primary markets is less significant than it might otherwise be due to its diverse customer base and its strategy of attempting to match its copper purchases with its needs. During 1993, the Company experienced general improvement in most of its markets served coinciding with general economic conditions. The Company cannot predict either the continuation of current economic conditions or future results of its operations in light thereof. The Company believes that it is not particularly affected by inflation except to the extent that the economy in general is thereby affected. Should inflationary pressures drive costs higher, the Company believes that general industry competitive price increases would sustain operating results, although there can be no assurance that this will be the case. Item 8.

Item 8. Financial Statements and Supplementary Data Report of Independent Auditors . . . . . . . . . . . . . . Consolidated Balance Sheets: Successor as of December 31, 1993 and 1992 . . . . . . Consolidated Statements of Operations: Successor for the year ended December 31, 1993, and the three month period ended December 31, 1992 . . . . . . . . . . . . . . . . . . . Predecessor for the nine month period ended September 30, 1992 and the year ended December 31, 1991 . . . . . . . . . . . . . . . . . . Consolidated Statements of Cash Flows: Successor for the year ended December 31, 1993, and the three month period ended December 31, 1992 . . . . . . . . . . . . . . . . . . . Predecessor for the nine month period ended September 30, 1992 and the year ended December 31, 1991 . . . . . . . . . . . . . . . . . . Notes to Consolidated Financial Statements . . . . . . . . INDEX TO FINANCIAL STATEMENT SCHEDULES V. Property, Plant and Equipment . . . . . . . . . . . . . . . S-1 VI. Accumulated Depreciation of Property, Plant and Equipment . S-2 VIII. Valuation and Qualifying Accounts . . . . . . . . . . . . . S-3 X. Supplementary Income Statement Information . . . . . . . . S-4 All other schedules have been omitted because they are not applicable or not required or because the required information is included in the consolidated financial statements or notes thereto. Item 9.

Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure Not applicable. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant The following table sets forth information concerning the Directors and Executive Officers of the Company. Name Age Position ____ ___ ________ Stanley C. Craft 55 President and Chief Executive Officer; Director Steven R. Abbott 46 President - Wire and Cable Division; Director John L. Cox 50 President - Telecommunication Products Division; Director Robert J. Faucher 49 President - Engineered Products Division; Director Robert D. Lindsay 39 Director Charles W. McGregor 52 President - Magnet Wire and Insulation Division David A. Owen 48 Vice President - Finance, Treasurer, and Chief Financial Officer; Director Thomas A. Twehues 61 Executive Vice President; Director Ward W. Woods 51 Director Frederick M. Zinser 65 Executive Vice President Messrs. Craft, Abbott and Twehues have been directors since 1988. Messrs. Lindsay and Woods became directors of the Company in 1992. Mr. Owen has been a director since March 1993 and Messrs. Cox and Faucher were elected directors in April 1993. Directors of the Company are elected annually to serve until the next annual meeting of stockholders of the Company or until their successors have been elected or appointed and qualified. Executive officers are appointed by, and serve at the discretion of, the Board of Directors of the Company. Mr. Craft has served as President and Chief Executive Officer of the Company since March 1992 and as President since September 1991 . He was Vice President - Finance, Treasurer and Chief Financial Officer of the Company from March 1988 to August 1991. He was Executive Vice President of the European operations of the Company from November 1986 to February 1988. Mr. Craft is also a Director of Holdings. Mr. Abbott was appointed President of the Wire and Cable Division in September 1993. He was President of the Magnet Wire and Insulation Division from 1987 to 1993. Mr. Abbott has been employed by the Company since 1967. Mr. Cox was appointed President of the Telecommunication Products Division in June 1992 when he joined the Company. He had been with American Telephone and Telegraph for twenty five years the last three of which were as Director of Sales for Distributor Networks. Prior to that Mr. Cox was Manager of Product Planning for distributor network exchange cable. Mr. Faucher was appointed President of the Engineered Products Division in January 1992. He was Vice President, Operations in the Industrial Products Division from June 1988 to January 1992. He joined the Company in 1985 as Vice President, Planning. Mr. Lindsay is the sole shareholder of corporations that are the general partners of the partnerships which are the general partners of BHLP and BCP. He is also the sole shareholder of corporations which are the general partners of the two partnerships affiliated with BHLP and BCP to which the Company and Holdings paid the fees described under Item 13 below. Mr. Lindsay was Managing Director of Bessemer Securities Corporation ("BSC"), the principal limited partner of BHLP and BCP, from January 1991 to June 1993. Prior to joining BSC, Mr. Lindsay was a Managing Director in the Merchant Banking Division of Morgan Stanley & Co., Incorporated. He is a Director of Stant Corporation and private companies. Mr. Lindsay is also a Director of Holdings. Mr. McGregor was appointed President of the Magnet Wire and Insulation Division in September 1993. He was Director of Manufacturing for the Division from 1987 to 1993. Mr. McGregor has been employed by the Company in various technical assignments since January 1970. Mr. Owen was appointed Vice President Finance and Chief Financial Officer of the Company in March 1993. He was appointed Treasurer of the Company in April 1992. Prior to that time, Mr. Owen was Director, Treasury and Financial Services for the Company. Mr. Owen has been employed in various capacities by the Company since 1976. Mr. Twehues has been Executive Vice President since September 1993. He had been President of the Wire and Cable Division since 1981. Mr. Twehues started his career in sales with the Wire and Cable Division in 1960. Mr. Woods is the sole shareholder of corporations that are the general partners of the partnerships which are the general partners of BHLP and BCP. He is also the sole shareholder of corporations which are the general partners of the two partnerships affiliated with BHLP and BCP to which the Company and Holdings paid the fees described under Item 13 below. Mr. Woods is President and Chief Executive Officer of BSC, the principal limited partner of BHLP and BCP. Mr. Woods joined BSC in 1989. For ten years prior to joining BSC, Mr. Woods was a senior partner of Lazard Freres & Co., an investment banking firm. He is a director of Boise Cascade Corporation, Freeport-McMoran Inc., Overhead Door Corporation, Stant Corporation and several private companies. Mr. Woods is also a Director of Holdings. Mr. Zinser had been an Executive Vice President since June 1992 and the President of the Telecommunication Products Division from 1979 to June 1992. Mr. Zinser retired from the Company effective January 1, 1994. Item 11.

Item 11. Executive Compensation Compensation of Directors and Executive Officers The directors of the Company receive no compensation for their service as directors except for reimbursement of expenses incidental to attendance at meetings of the Board of Directors. The following table sets forth the cash compensation paid by or incurred on behalf of the Company to its Chief Executive Officer and four other most highly compensated executive officers of the Company for each of the three years ended December 31, 1993. SUMMARY COMPENSATION TABLE (1) All awards are for options to purchase the number of shares of common stock of Holdings indicated, provided, however, that the number of shares for which all options are exercisable and the exercise price therefor may be reduced by the Board of Directors of Holdings in accordance with a specified formula. See "Security Ownership of Certain Beneficial Owners and Management." (2) All Other Compensation in 1993 consists of Company contributions to the defined contribution plan on behalf of the executive officer and imputed income on excess Company-paid life insurance premiums. The following table identifies and quantifies these amounts for the named executive officers: (3) All Other Compensation in 1992 includes principally divestiture and retention bonuses paid in connection with the Acquisition and Merger. OPTIONS/SAR GRANTS IN LAST FISCAL YEAR (1) In February 1994 options to purchase 225,000 shares of Holdings common stock were granted in respect of performance for the year ended December 31, 1993. All such options become exercisable on February 1, 1997. (2) The potential realizable value assumes a per-share market price at the time of the grant to be approximately $2.86 with an assumed rate of appreciation of 5% and 10%, respectively, compounded annually for 10 years. The following table details the December 31, 1993 year end estimated value of each named executive officer's unexercised stock options. All unexercised options are to purchase the number of shares of common stock of Holdings indicated, provided, however, that the Board of Directors of Holdings may require that, in lieu of the exercise of any options, such options be surrendered without payment of the exercise price, in which case the number of shares issuable upon exercise of such options shall be reduced by the quotient of (i) the aggregate exercise price that would have been otherwise payable divided by (ii) the amount paid for each share of Holdings common stock in the Merger (approximately $2.86 per share). See "Security Ownership of Certain Beneficial Owners and Management." AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR AND YEAR-END OPTION/SAR VALUES (E) Exercisable (U) Unexercisable (1) The estimated value of unexercised stock options held at the end of 1993 assumes a per-share fair market value of approximately $2.86 and per-share exercise prices of $1.00 and $1.25 as applicable. (2) The options to purchase Holdings common stock granted in 1994 in respect of performance for the year ended December 31, 1993, were issued with an exercise price of $2.86 per share. Such options are not considered in-the-money since the assumed per-share fair market value at December 31, 1993 approximated $2.86. Pension Plans. The Company provides benefits under a defined benefit pension plan (the "Pension Plan") and a supplemental executive retirement plan (the "SERP"). The following table illustrates the estimated annual normal retirement benefits at age 65 that will be payable under the Pension Plan and SERP. The remuneration utilized in calculating the benefits payable under the plans is the compensation reported in the Summary Compensation Table under the captions Salary and Bonus. The formula utilizes the remuneration for the five consecutive plan years within the ten completed calendar years preceding the participant's retirement date that produces the highest final average earnings. As of December 31, 1993, the years of credited service under the Pension Plan for each of the executive officers named in the Summary Compensation Table were as follows: Mr. Craft, twenty-four years and nine months; Mr. Abbott, twenty-four years and seven months; Mr. Twehues, thirty-three years and four months; Mr. Faucher, twenty-one years and six months; and Mr. Zinser, twenty-eight years and five months. The benefits listed in the Pension Plan Table are based on the formula in the Pension Plan using a straight-life annuity and are subject to an offset of 50% of the participant's annual unreduced Primary Insurance Amount under Social Security. In addition, benefits for credited service for years prior to 1974 are calculated using the formula in effect at that time and would reflect a lesser benefit than outlined in the Pension Plan Table for those years. Benefits under the Pension Plan are also offset by benefits to which the participant is entitled under any defined benefit plan of UTC (other than accrued benefits transferred to the Pension Plan). Compensation Committee Interlocks and Insider Participation Messrs. Stanley C. Craft and Robert Lindsay constitute the Compensation Committee of the Board of Directors of the Company. See footnote (2) under the caption "Security Ownership of Certain Beneficial Owners and Management" for a description of the relationship between Mr. Lindsay and BHLP and the information set forth under the caption "Certain Relationships and Related Transactions" for a description of certain transactions between the Company and BCP or BHLP and between Holdings and BCP or BHLP. Mr. Lindsay is also a member of the Compensation Committee of the Holdings Board of Directors. The other members of such committee are Messrs. Joseph H. Gleberman and Karl R. Wyss. Mr. Gleberman is a Partner of Goldman Sachs and Mr. Wyss is a Managing Director of DLJ. The Holdings Compensation Committee fixes the compensation paid to the Company's executive officers, based in part on the recommendation of Mr. Craft. See the information set forth under the caption "Certain Relationships and Related Transactions" for a description of certain transactions between the Company and DLJ and Goldman Sachs and their respective affiliates. The Holdings Compensation Committee considers compensation of executive officers of the Company to the extent it is paid by or affects Holdings, as is the case when options to purchase Holdings stock are granted to executive officers of Holdings. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management All of the issued and outstanding common stock of the Company is owned beneficially and of record by Holdings. Holdings has pledged such stock to the lenders under the Restated Credit Agreement in support of its guarantee of the Company's obligations thereunder. In the event of a default by Holdings of its obligations under such guarantee, the lenders under the Restated Credit Agreement could exercise their powers under such pledge and thereby obtain control of the Company. The following table sets forth certain information regarding the beneficial ownership of the common stock of Holdings as of February 28, 1994 by (i) each beneficial owner of more than 5% of the outstanding common stock of Holdings, (ii) each director of Holdings, (iii) all directors and officers of Holdings as a group, (iv) all directors and officers of the Company as a group, and (v) all directors, officers and management of the Company as a group. (1) Percentages have been calculated assuming, in the case of each person or group listed, the exercise of all warrants and options owned (which are exercisable within sixty days following February 28, 1994) by each such person or group, respectively, but not the exercise of any warrants or options owned by any other person or group listed. (2) BHLP is a limited partnership the only activity of which is to make private structured investments. The primary limited partner of BHLP is Bessemer Securities Corporation ("BSC"), a corporation owned by trusts whose beneficiaries are descendants of Henry Phipps and charitable trusts established by such descendants. Each of Messrs. Ward W. Woods and Robert D. Lindsay, directors of Holdings, and Mr. Michael B. Rothfeld, is a sole shareholder of a corporation which is a general partner of the limited partnership which is the sole general partner of BHLP. In addition, each of Messrs. Woods, Lindsay and Rothfeld are the sole shareholders of corporations which are the general partners of each of the partnerships affiliated with BHLP and BCP, respectively, to which the Company and Holdings paid the fees described under Item 13

Item 13. Certain Relationships and Related Transactions The Company incurred advisory fees of approximately $1.0 million and $0.2 million payable to affiliates of BHLP and BCP in 1993 and 1992, respectively. Pursuant to an advisory services agreement among Holdings, the Company and an affiliate of BHLP, the Company agreed to pay such affiliate an annual advisory fee of $1.0 million. The Company also incurred advisory fees of $0.2 million and $0.3 million in 1992 and 1991, respectively payable to Morgan Stanley & Co., Incorporated, an affiliate of the former controlling shareholder of Holdings. In addition, the Company incurred management fees to Holdings of $1.9 million and $3.5 million in 1992 and 1991, respectively. No such fee was incurred in 1993. In connection with the Acquisition, the Company paid to an affiliate of BCP a financial advisory fee of approximately $1.9 million and to Morgan Stanley & Co. Incorporated a financial services fee of approximately $3.6 million and Holdings paid to an affiliate of BCP an acquisition advisory fee of approximately $1.9 million. See footnote (2) under Item 12 above for a description of the relationship of Messrs. Woods and Lindsay, directors of the Company, with such BCP affiliate. Pursuant to an engagement letter dated July 22, 1992 among BCP, BE and DLJ, as amended by a letter agreement dated October 9, 1992 among BCP, BE, DLJ and Goldman Sachs (collectively, the "Engagement Letter"), Holdings paid DLJ a financial advisory fee of $1.0 million upon consummation of the Acquisition. In addition, Holdings paid an affiliate of DLJ a $1.0 million commitment fee in connection with its commitment to purchase Series A Preferred Stock of BE. The Engagement Letter also gives DLJ and Goldman Sachs the right, but not the obligation, subject to certain conditions, to act as financial advisor to the Company and Holdings until the fifth anniversary of the Acquisition on a co-exclusive basis in connection with all acquisition, divestiture and other financial advisory assignments relating to Holdings or the Company and to act as co-exclusive managing placement agents or co- exclusive managing underwriters in connection with any debt or equity financing which is either privately placed or publicly offered (excluding commercial bank debt or other senior debt which is privately placed other than any private placement which contemplates a registration of, registered exchange offer for, or similar registration with respect to such securities). In connection with any other senior debt financing which is privately placed (excluding any private placement of senior debt which contemplates a registration, registered exchange offer for, or similar registration with respect to such securities), DLJ has the right, but not the obligation, to act as co-managing placement agent or co- managing underwriter, together only with Chemical Bank. Holdings has retained the right to designate DLJ or Chemical Bank as lead placement agent or lead managing underwriter. Pursuant to such engagement, DLJ and Goldman Sachs acted as underwriters in the offerings of the Senior Notes, and in such capacity received aggregate underwriting discounts and commissions of $5.3 million. For any further services performed by DLJ or Goldman Sachs pursuant to the Engagement Letters, DLJ and Goldman Sachs are entitled to fees competitive with those customarily charged by DLJ, Goldman Sachs and other major investment banks in similar transactions and to customary out of pocket fee and expense reimbursement and indemnification and contribution agreements. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) 1. Financial Statements The financial statements listed under Item 8 are filed as a part of this report. 2. Financial Statement Schedules The financial statement schedules listed under Item 8 are filed as a part of this report. 3. Exhibits The exhibits listed on the accompanying Index to Exhibits are filed as a part of this report. (b) No reports on Form 8-K were filed by the Company during the fourth quarter of 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ESSEX GROUP, INC. Date (Registrant) March 29, 1994 By /s/ David A. Owen ______________ _____________________________________ David A. Owen Vice President Finance, Treasurer and Chief Financial Officer; Director (Principal Financial Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Date March 29, 1994 /s/ Stanley C. Craft ______________ _______________________________________ Stanley C. Craft President and Chief Executive Officer; Director (Principal Executive Officer) March 29, 1994 /s/ David A. Owen ______________ _______________________________________ David A. Owen Vice President Finance, Treasurer and Chief Financial Officer; Director (Principal Financial Officer) March 29, 1994 /s/ Steven R. Abbott ______________ _______________________________________ Steven R. Abbott Director March 29, 1994 /s/ John L. Cox ______________ _______________________________________ John L. Cox Director March 29, 1994 /s/ Robert J. Faucher ______________ _______________________________________ Robert J. Faucher Director March 29, 1994 /s/ Thomas A. Twehues ______________ _______________________________________ Thomas A. Twehues Director March 29, 1994 /s/ Robert D. Lindsay ______________ _______________________________________ Robert D. Lindsay Director March 29, 1994 /s/ Ward W. Woods, Jr. ______________ _______________________________________ Ward W. Woods, Jr. Director March 29, 1994 /s/ James D. Rice ______________ _______________________________________ James D. Rice Vice President and Corporate Controller (Principal Accounting Officer) ESSEX GROUP, INC. INDEX OF EXHIBITS (Item 14(a)(3)) Exhibit No. Description -------------------------------------------------------------------------- 2.01 Agreement and Plan of Merger, dated as of July 24, 1992 (the "Merger Agreement"), between B E Acquisition Corporation and BCP/Essex Holdings Inc. (then known as MS/Essex Holdings Inc.), incorporated by reference to Exhibit 2.1 to BCP/Essex Holdings Inc.'s (then known as MS/Essex Holdings Inc.) Current Report on Form 8-K, filed with the Securities and Exchange Commission on August 10, 1992 (Commission File No. 1-10211). 2.02 Amendment dated as of October 1, 1992, to the Agreement and Plan of Merger between B E Acquisition Corporation and BCP/Essex Holdings Inc. (then known as MS/Essex Holdings Inc.), incorporated by reference to Exhibit 2.2 to BCP/Essex Holdings Inc.'s Current Report on Form 8-K, filed with the Securities and Exchange Commission on October 26, 1992 (Commission File No. 1-10211). 3.01 Certificate of Incorporation of the registrant (Incorporated by reference to Exhibit 3.01 to the Company's Registration Statement on Form S-1, File No. 33-20825). 3.02 By-Laws of the registrant, as amended. (Incorporated by reference to Exhibit 3.02 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1991). 4.01 Indenture under which the 10% Senior Notes Due 2003 are outstanding, incorporated by reference to Exhibit 4.1 to the Company's Registration Statement on Pre-Effective Amendment No. 1 to Form S-2 (Commission File No. 33-59488). 9.01 Investors Shareholders Agreement dated as of October 9, 1992, among B E Acquisition Corporation, Bessemer Capital Partners, L.P., certain affiliates of Donaldson, Lufkin & Jenrette, Inc., certain affiliates of Goldman, Sachs & Co., and Chemical Equity Associates, a California Limited Partnership, incorporated by reference to Exhibit 28.1 to BCP/Essex Holdings Inc.'s Current Report on Form 8-K, filed with the Securities and Exchange Commission on October 26, 1992 (Commission File No. 1-10211). 9.02 Management Stockholders and Registration Rights Agreement dated as of October 9, 1992, among B E Acquisition Corporation, Bessemer Capital Partners, L.P. and certain employees of the registrant and its subsidiaries, incorporated by reference to Exhibit 28.3 to BCP/Essex Holdings Inc.'s Current Report on Form 8-K, filed with the Securities and Exchange Commission on October 26, 1992 (Commission File No. 1-10211). 9.03 Form of Irrevocable Proxy dated as of October 9, 1992, granted to Bessemer Capital Partners, L.P. by certain employees of the registrant and its subsidiaries, incorporated by reference to Exhibit 28.4 to BCP/Essex Holdings Inc.'s Current Report on Form 8-K, filed with the Securities and Exchange Commission on October 26, 1992 (Commission File No. 1-10211). 10.01 Amendment and Restatement of Credit Agreement dated May 7, 1993, incorporated by reference to Exhibit 28.7 to the Company's Registration Statement on Pre-Effective Amendment No. 3 to Form S-2 (Commission File No. 33-59488). Exhibit No. Description -------------------------------------------------------------------------- 10.02 Credit Agreement dated as of September 25, 1992, among B E Acquisition Corporation, BCP/Essex Holdings Inc., the registrant, the lenders named therein and Chemical Bank, as agent, incorporated by reference to Exhibit 4.6 to BCP/Essex Holdings Inc.'s Current Report on Form 8-K, filed with the Securities and Exchange Commission on October 26, 1992 (Commission File No. 1-10211). 10.03 Engagement Letter dated July 22, 1992 among Bessemer Capital Partners, L.P., B E Acquisition Corporation, and Donaldson, Lufkin & Jenrette, Inc., incorporated by reference to Exhibit 10.10 to registrant's Annual Report on Form 10-K for the year ended December 31, 1992 (Commission File No. 1-7418). 10.04 Amendment dated October 9, 1992 among Bessemer Capital Partners, L.P., B E Acquisition Corporation, Donaldson, Lufkin & Jenrette, Inc. and Goldman, Sachs and Co., to Engagement Letter dated July 22, 1992 among Bessemer Capital Partners, L.P., B E Acquisition Corporation and Donaldson, Lufkin & Jenrette, Inc., incorporated by reference to Exhibit 10.11 to registrant's Annual Report on Form 10-K for the year ended December 31, 1992 (Commission File No. 1-7418). 12.01 Computation of Ratio of Earnings to Fixed Charges. 22.01 Subsidiaries of the registrant. 99.01 Registration Rights Agreement dated as of October 9, 1992, among B E Acquisition Corporation, certain affiliates of Donaldson, Lufkin & Jenrette, Inc., certain affiliates of Goldman, Sachs & Co., and Chemical Equity Associates, A California Limited Partnership, incorporated by reference to Exhibit 28.2 to BCP/Essex Holdings Inc.'s Current Report on Form 8-K, filed with the Securities and Exchange Commission on October 26, 1992 (Commission File No. 1-10211). 99.02 Amended and Restated Stock Option Plan of BCP/Essex Holdings Inc., incorporated by reference to Exhibit 4.7 to BCP/Essex Holdings Inc.'s Current Report on Form 8-K, filed with the Securities and Exchange Commission on October 26, 1992 (Commission File No. 1- 10211). REPORT OF INDEPENDENT AUDITORS The Board of Directors and Stockholder Essex Group, Inc. We have audited the accompanying consolidated balance sheets of Essex Group, Inc. Successor as of December 31, 1993 and 1992 and the related consolidated statements of operations and cash flows of Essex Group, Inc. Successor for the year ended December 31, 1993 and the three month period ended December 31, 1992, and the consolidated statements of operations and cash flows of Essex Group, Inc. Predecessor for the nine month period ended September 30, 1992 and the year ended December 31, 1991. Our audits also included the financial statement schedules listed in the Index at Item 14 (a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Essex Group, Inc. Successor at December 31, 1993 and 1992 and the consolidated results of operations and cash flows of Essex Group, Inc. Successor for the year ended December 31, 1993, and the three month period ended December 31, 1992, and of Essex Group, Inc. Predecessor for the nine month period ended September 30, 1992 and the year ended December 31, 1991, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. ERNST & YOUNG Indianapolis, Indiana January 28, 1994 ESSEX GROUP, INC. CONSOLIDATED BALANCE SHEETS See Notes to Consolidated Financial Statements ESSEX GROUP, INC. CONSOLIDATED STATEMENTS OF OPERATIONS See Notes to Consolidated Financial Statements ESSEX GROUP, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS See Notes to Consolidated Financial Statements ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS In Thousands of Dollars ----------------------- NOTE 1 ORGANIZATION AND ACQUISITION Acquisition of the Company On February 29, 1988, MS/Essex Holdings Inc. ("Holdings"), acquired Essex Group, Inc. (the "Company") from United Technologies Corporation ("UTC") (the "1988 Acquisition") and operated it as a wholly-owned subsidiary ("Predecessor"). The outstanding common stock of Holdings was beneficially owned by the Morgan Stanley Leveraged Equity Fund II, L.P. ("MSLEF II"), certain directors and members of management of Holdings and the Company, and others. On October 9, 1992, Holdings was acquired (the "Acquisition") by merger (the "Merger") of B E Acquisition Corporation ("BE") with and into Holdings with Holdings surviving under the name BCP/Essex Holdings Inc. ("Successor"). BE was a newly organized Delaware corporation formed for the purpose of effecting the Acquisition. Shareholders of BE include affiliates of Bessemer Capital Partners, L.P. ("BCP"), Goldman, Sachs & Co. ("Goldman Sachs"), Donaldson, Lufkin & Jenrette, Inc. ("DLJ"), Chemical Equity Associates, A California Limited Partnership and members of management and other employees of the Company. Pursuant to the Acquisition and Merger, (i) stockholders of Holdings, prior to the Acquisition and Merger, became entitled to receive approximately $2.86 for each outstanding share of common stock of Holdings held by them, (ii) holders of options to purchase Holdings common stock, other than those persons entering into an option continuation agreement, became entitled to receive the difference between approximately $2.86 per share and the per share exercise price of such options and (iii) the capital stock of BE was converted into capital stock of Holdings. The Acquisition and Merger resulted in a change in control of Holdings. Further, the Acquisition and Merger occurred at the Holdings level and, therefore, did not directly affect the Company's status as a wholly-owned subsidiary of Holdings. In December 1993, BCP transferred its ownership interest in Holdings to Bessemer Holdings, L.P. ("BHLP") an affiliate of BCP. In connection with the Acquisition and Merger, the Company recorded certain merger related expenses of $18,139 consisting primarily of bonus and option payments to certain employees, and certain merger fees and expenses, which were charged to operations as of September 30, 1992. For financial statement purposes, the Acquisition and Merger was accounted for by Holdings as a purchase acquisition effective October 1, 1992. Because the Company is a wholly-owned subsidiary of Holdings, the effects of the Acquisition and Merger have been reflected in the Company's financial statements, resulting in a new basis of accounting reflecting estimated fair values for the Successor's assets and liabilities at that date. However, to the extent that Holdings' management had a continuing investment interest in Holdings' common stock, such fair values (and contributed stockholder's equity) were reduced proportionately to reflect the continuing interest (approximately 10%) at the prior historical cost basis. As a result, the Company's financial statements for the periods ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- subsequent to September 30, 1992 are presented on the Successor's new basis of accounting, while the financial statements for September 30, 1992 and prior periods are presented on the Predecessor's historical cost basis of accounting. The aggregate purchase price of Holdings and a reconciliation to the initial capitalization of Successor are as follows: Purchase price, including related fees: Purchase price, excluding Seller's expenses . . . . $138,445 Related fees and expenses . . . . . . . . . . . . . 6,168 -------- 144,613 Less reduction to reflect proportionate historical cost basis for management's continuing common stock interest . . . . . . . . . . . . . . . . . . . . . (15,259) -------- 129,354 Holdings debt ($191,645) and deferred debt issuance costs, deferred and refundable income taxes and other minor Holdings amounts not reflected in Successor financial statements (See Note 9) . . . . . . . . . . . . . . . . . . . 173,430 -------- Initial capitalization of Successor . . . . . . . . $302,784 ======== The allocation of the purchase price to historical assets and liabilities of the Company was as follows: ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- The following unaudited pro forma consolidated results of operations for the twelve month periods ended December 31, 1992 and 1991 are presented assuming the Acquisition and Merger had occurred on January 1, 1991 (no affect on revenues): The primary pro forma effects are revised depreciation and amortization charges, interest expense and income taxes. The pro forma information does not purport to present what the Company's consolidated results of operations would actually have been if the Acquisition and Merger had occurred on January 1, 1991 and is not intended to project future results of operations. NOTE 2 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Consolidation and business segment The consolidated financial statements include the accounts of the Company and all majority-owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation. The Company operates in one industry segment. The Company develops, manufactures and markets electrical wire and cable and insulation products. Among the Company's products are magnet wire for electromechanical devices such as motors, transformers and electrical controls; building wire for the construction industry; telephone cable for the telecommunications industry; wire for automotive and appliance applications; and insulation products for the electrical industry. The Company's customers are principally located throughout the United States, without significant concentration in any one region or any one customer. The Company performs periodic credit evaluations of its customers' financial condition and generally does not require collateral. Fair value of financial instruments The Company's financial instruments consist of cash and cash equivalents, investment securities and the Company's long-term debt. The carrying amounts of the Company's financial instruments approximate fair value at December 31, 1993. ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- Cash and cash equivalents All highly liquid financial instruments with a maturity of three months or less at the date of purchase are considered to be cash equivalents. Inventories Inventories are stated at cost, determined principally on the last-in, first-out ("LIFO") method, which is not in excess of market. Property, plant and equipment Property, plant and equipment are recorded at cost and depreciated over estimated useful lives using the straight-line method. Investment in joint venture An investment in a joint venture is stated at cost adjusted for the Company's share of undistributed earnings or losses. Investment in subsidiary In late 1993, the Company acquired a majority interest in Interstate Industries, Inc. for cash of $4,300, subject to final purchase price adjustments and the minority interest ownership percentage. At December 31, 1993, the acquisition is included in other assets; consolidation of this subsidiary would not have a significant effect on the 1993 consolidated financial statements. Income taxes Effective October 1, 1992, concurrent with the new basis of accounting, the Successor adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," ("FAS 109"). FAS 109 requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Using this method, deferred tax liabilities and assets are determined based on the difference between the financial statement and tax bases of assets and liabilities. These deferred taxes are measured by applying current tax laws. Through September 30, 1992, deferred income taxes were provided by Predecessor for significant timing differences in the recognition of revenue and expense for tax and financial statement purposes. Holdings and the Company file a consolidated U.S. federal income tax return. The Company operates under a tax sharing agreement with Holdings whereby the Company's aggregate income tax liability is calculated as if it filed a separate tax return with its subsidiaries. ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- Excess of cost over net assets acquired Excess of cost over net assets acquired represents the excess of the Holdings contribution to capital, based on its purchase price over the fair value of the net assets acquired in the Acquisition, and is being amortized by the straight-line method over 35 years. Other intangible assets In connection with the 1988 Acquisition, a covenant not to compete agreement was entered into whereby, in general, UTC agreed that until March 1, 1993, it would not engage in or carry on any business directly competing with any business carried on by the Company on February 29, 1988. The $34,000 purchase price allocated by the Predecessor to the covenant not to compete was classified as an intangible asset and was amortized over five years through February 1993. Recognition of revenue Substantially all of the Company's revenue is recognized at the time the product is shipped. Postretirement and postemployment benefits In 1993, the Company adopted Statement of Financial Accounting Standards No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions" and Statement of Financial Accounting Standards No. 112 "Employers' Accounting for Postemployment Benefits". The effect of adopting the new rules was not material to the Company's 1993 consolidated results of operations or financial condition. Unusual items Included in Successor's cost of goods sold for the three month period ended December 31, 1992 is a charge of approximately $2,600 to reflect the estimated cost of anticipated plant consolidations, primarily costs to move equipment and personnel related expenses. In the nine month period ended September 30, 1992, Predecessor recorded a charge of approximately $1,500 to selling and administrative expenses for the relocation of a business unit which was completed in 1993. During 1991, Predecessor settled a warranty claim resulting in a charge of approximately $1,700 to selling and administrative expenses. ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- NOTE 3 INVENTORIES The components of inventories are as follows: Principal elements of cost included in the Company's inventories are copper, purchased materials, direct labor and manufacturing overhead. Inventories valued using the LIFO method amounted to $136,980 and $131,481 at December 31, 1993 and 1992, respectively. NOTE 4 PROPERTY, PLANT AND EQUIPMENT The components of property, plant and equipment are as follows: ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- NOTE 5 ACCRUED LIABILITIES Accrued liabilities include the following: NOTE 6 LONG-TERM DEBT Long-term debt consists of the following: Bank Financing In connection with the Acquisition and Merger, the Company entered into a credit agreement dated September 25, 1992, among BE, Holdings, the lenders named therein and Chemical Bank, as agent (the "Credit Agreement"). Under the Credit Agreement, the Company borrowed $130,000 in term loans (the "Term Credit") of which $94,000 was used to repay all indebtedness ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- outstanding under the previous credit agreement and the balance was used to pay a portion of the consideration payable to Holdings' shareholders and option holders in the Merger and certain fees and expenses in connection with the Acquisition and Merger and for other general corporate purposes. In May 1993, the Company applied $111,000 of the proceeds from the sale of its 10% Senior Notes due 2003 (the "Senior Notes") to repay the outstanding balance under the Term Credit. See Senior Notes below. The Company recognized an extraordinary charge of $3,055, net of applicable tax benefit of $1,953, in the second quarter of 1993 representing the write-off of unamortized debt costs associated with the outstanding Term Credit. On May 7, 1993 an amendment and restatement of the Credit Agreement (the "Restated Credit Agreement") became effective. The Restated Credit Agreement provides for $175,000 in revolving credit, subject to specified percentages of eligible assets, reduced by outstanding letters of credit ($13,924 at December 31, 1993) (the "Revolving Credit"). The Revolving Credit expires in 1998. Revolving Credit loans bear interest at floating rates at bank prime rate plus 1.25% or a reserve adjusted Eurodollar rate (LIBOR) plus 2.25%. The effective interest rate can be reduced by 0.25% to 0.75% if certain specified financial conditions are achieved. Commitment fees during the revolving loan period are 0.5% of the average daily unused portion of the available credit. The Company has purchased interest rate cap protection through 1994 with respect to $100,000 of debt. Such interest rate protection was purchased at a cost of $685 and carries a strike rate of 6% (three month LIBOR). At December 31, 1993 and 1992, the Company's incremental borrowing rate, including applicable margins, approximated 7.3% and 7.8%, respectively, relating to borrowings under the Restated Credit Agreement and the Credit Agreement. The Restated Credit Agreement contains various covenants which include, among other things: (a) the maintenance of certain financial ratios and compliance with certain financial tests and limitations; (b) limitations on investments and capital expenditures; (c) limitations on cash dividends paid; and (d) limitations on leases and the sale of assets. Through December 31, 1993, the Company fully complied with all of the financial ratios and covenants contained in the Restated Credit Agreement. The indebtedness under the Restated Credit Agreement is guaranteed by Holdings and all of the Company's subsidiaries, and is secured by a pledge of the capital stock of the Company and its subsidiaries and by a first lien on substantially all assets. Senior Notes On May 7, 1993 the Company issued $200,000 aggregate principal amount of its Senior Notes which bear interest at 10% and are due in May, 2003. The net proceeds to the Company from the sale of the Senior Notes, after underwriting discounts, commissions and other offering expenses, were $193,450. The Company applied $111,000 of such proceeds to the repayment of the Term Credit and on June 2, 1993 applied the balance of such ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- proceeds, together with new borrowings of $7,450 under the Revolving Credit, to redeem all of its outstanding 12 3/8% Senior Subordinated Debentures due 2000 (the "Debentures"). The Senior Notes rank pari passu in right of payment with all other senior indebtedness of the Company. To the extent that any other senior indebtedness of the Company is secured by liens on the assets of the Company, the holders of such secured senior indebtedness will have a claim prior to any claim of the holders of the Senior Notes as to those assets. At the option of the Company, the Senior Notes may be redeemed, commencing in May 1998 in whole, or in part, at redemption prices ranging from 103.75% in 1998 to 100% in 2001, or at 109% for up to $67,000 with the proceeds from any public equity offering prior to June 30, 1996. Upon a Change in Control, as defined in the indenture covering the Senior Notes (the "Indenture"), each holder of Senior Notes will have the right to require the Company to repurchase all or any part of such holder's Senior Notes at a repurchase price equal to 101% of the principal amount thereof. The Indenture contains various covenants which include, among other things, limitations on debt, on the sale of assets, and on cash dividends paid. Through December 31, 1993, the Company fully complied with all of the financial ratios and covenants contained in the Indenture. Debentures The Debentures were due in 2000 and bore interest at 12 3/8% per annum payable semi-annually. However, the Restated Credit Agreement required the Debentures, which were callable at 106% commencing May 15, 1993, to be retired no later than June 30, 1993. Because of the mandatory retirement, the Debentures were valued by the Successor at the expected retirement cost, discounted at 11.5%. On June 2, 1993, the Company redeemed all of the outstanding Debentures at 106% of their principal amount, resulting in a net loss of $312, net of applicable tax benefit of $199, which has been reported as an extraordinary charge. During 1992 the Company repurchased outstanding Debentures which had a carrying value of $13,843. The net loss resulting from this repurchase, which includes the write-off of a portion of unamortized debt costs, totalled $122, net of applicable income tax benefit of $78, for Predecessor, which has been reported as an extraordinary charge. During 1991, the Company repurchased outstanding Debentures which had a carrying value of $41,960. The net loss resulting from this repurchase, including unamortized debt costs, was reflected as an extraordinary charge of $1,471, net of applicable income tax benefit of $941. ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- Other The Company capitalized interest costs of $1,599, $116, $220 and $0 for Successor in 1993, Successor and Predecessor in 1992, and for Predecessor in 1991, respectively, with respect to qualifying assets. Total interest paid was $20,961, $7,344, $10,076 and $24,308, for Successor in 1993, Successor and Predecessor in 1992, and for Predecessor in 1991, respectively. There are no maturities of long-term debt within the next five years. NOTE 7 INCOME TAXES Effective October 1, 1992, concurrent with the new basis of accounting, the Successor adopted FAS 109. The Predecessor's financial statements for all periods through September 30, 1992 reflect the historical accounting method for income taxes and have not been restated to reflect FAS 109. Under FAS 109 assets and liabilities acquired, and the resulting charges or credits reflected in future statements of operations, are stated at the gross fair value at the date of acquisition, whereas under the previous historical method, assets and liabilities and the resulting charges or credits were recorded at amounts net of the related tax differences between fair value and the tax basis. Deferred income taxes at December 31, 1993 and December 31, 1992 reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Successor's deferred tax liabilities and assets are as follows: ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- The components of income tax expense (benefit) are: In compliance with the Omnibus Budget Reconciliation Act of 1993, enacted in August of 1993 retroactive to January 1, 1993, the Company's tax balances were adjusted in the third quarter of 1993 to reflect the increase in the federal statutory tax rate from 34% to 35%. The adjustment had the effect of increasing income tax expense by $2,250 for the year ended December 31, 1993. Total income taxes paid were $1,131, $8,608, $6,604 and $6,411 for Successor in 1993, Successor and Predecessor in 1992, and for Predecessor in 1991, respectively. The Predecessor's deferred tax provision results from timing differences in the recognition of revenue and expense for tax and financial reporting purposes. Sources of these differences were primarily related to depreciation and accruals deductible in different periods for tax purposes. Principal differences between the effective income tax rate and the statutory federal income tax rate are: ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- The Company elected not to step up its tax bases in the assets acquired. Accordingly, the income tax bases in the assets acquired have not been changed from pre-1988 Acquisition values. Depreciation and amortization of the higher allocated financial statement bases are not deductible for income tax purposes, thus increasing the effective income tax rate reflected in the Predecessor's consolidated financial statements. Under FAS 109, the Successor has recorded deferred income taxes for such differences. ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- NOTE 8 RETIREMENT BENEFITS The Company participates in two defined benefit retirement plans for substantially all salaried and hourly employees. In 1992, the Company adopted a supplemental executive retirement plan and related agreements, which provides benefits based on the same formula as in effect under the salaried employees' plan, but which only takes into account compensation in excess of amounts that can be recognized under the salaried employees' plan. Salaried plan benefits are generally based on years of service and the employee's compensation during the last several years of employment. Hourly plan benefits are based on hours worked and years of service with a fixed dollar benefit level. The Company's funding policy is based on an actuarially determined cost method allowable under Internal Revenue Service regulations, the projected unit credit method. Pension plan assets consist principally of fixed income and equity securities and cash and cash equivalents. The components of net periodic pension cost for the plans are as follows: The following table summarizes the funded status of these pension plans and the related amounts that are recognized in the consolidated balance sheets: ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- Certain actuarial assumptions were revised in 1993 resulting in an increase of $3,448 in the projected benefit obligation. Actuarial assumptions were revised at October 1, 1992 concurrent with the new basis of accounting. The revised assumptions resulted in a $7,328 reduction in the projected benefit obligation as of October 1, 1992. ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- Following is a summary of significant actuarial assumptions used: The Company contributed $194, $48, $136 and $165 to multi-employer pension plans for Successor in 1993, Successor and Predecessor in 1992 and for Predecessor in 1991, respectively. The Company has no further obligation, other than recurring contributions, to these plans as long as the applicable operations continue. The Company has established a defined contribution savings plan which allows both 401(a) and 401(k) contributions covering substantially all of the salaried employees of the Company. The purpose of this savings plan is generally to provide additional financial security during retirement by providing salaried employees with an incentive to make regular savings. The Company's contributions to the plan, which approximates expense, are based on employee contributions and totalled $1,030, $276, $733 and $946 for Successor in 1993, Successor and Predecessor in 1992, and Predecessor in 1991, respectively. ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- NOTE 9 STOCKHOLDER'S EQUITY The following is an analysis of the changes to the Company's stockholder's equity: ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars, Except Per Copper Pound Data ----------------------------------------------------- NOTE 10 RELATED PARTY TRANSACTIONS Advisory services fees of $1,000 and $229 were paid to affiliates of BHLP and BCP for 1993 and the three month period ended December 31, 1992, respectively, and to MSLEF II in the amount of $210 and $280 during the nine month period ended September 30, 1992, and for 1991, respectively. It is expected that financial advisory fees to an affiliate of BHLP will continue to be paid for such services in the future. Also, in connection with the Acquisition and Merger, an affiliate of BCP received financial advisory fees of $1,900 associated with the financing plus certain out of pocket expenses. DLJ and Goldman Sachs acted as underwriters in the offerings of the Senior Notes, and in such capacity received aggregate underwriting discounts and commissions of $5,300. In addition, during the nine month period ended September 30, 1992, and for the year 1991, management fees to Holdings of $1,875 and $3,500 respectively, were incurred. In May 1989, Holdings issued $342,000 aggregate principal amount ($135,117 aggregate proceeds amount) of Holdings Debentures, the proceeds of which were used to pay a dividend to Holdings shareholders, cash bonuses to certain members of its management, and related expenses. During 1991, the Company paid cash dividends to Holdings of $5,000, which amounts were used to repurchase Holdings Debentures. Additionally, during 1992, the Company paid cash dividends of $7,500 which were used to finance a portion of the Acquisition. As of December 31, 1993, Holdings had a liability of $228,942 related to the Holdings Debentures. The Holdings Debentures are unsecured debt of Holdings and are effectively subordinated to all outstanding indebtedness of the Company, including the Senior Notes, and will be effectively subordinated to other indebtedness incurred by direct and indirect subsidiaries of Holdings if issued. No periodic cash payment of interest is required to be made by Holdings prior to November 15, 1995 on the Holdings Debentures and interest is payable in cash at 16.0% thereafter. Holdings is a holding company with no operations and has virtually no assets other than its ownership of the outstanding common stock of the Company. All of such stock is pledged, however, to the lenders under the Restated Credit Agreement. Accordingly, Holdings' ability to meet its obligations when due under the terms of its indebtedness will be dependent on the Company's ability to pay dividends, to loan, or otherwise advance or transfer funds to Holdings in amounts sufficient to service Holdings' debt obligations. NOTE 11 CONTINGENT LIABILITIES AND COMMITMENTS There are various claims and pending legal proceedings against the Company including environmental matters and other matters arising out of the ordinary conduct of its business. Pursuant to the 1988 Acquisition, UTC agreed to indemnify the Company against all losses (as defined) resulting from or in connection with damage or pollution to the environment and arising from events, operations, or activities of the ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- Company prior to February 29, 1988 or from conditions or circumstances existing at February 29, 1988. Except for certain matters relating to permit compliance, the Company is fully indemnified with respect to conditions, events or circumstances known to UTC prior to February 29, 1988. Further, the Company is indemnified, subject to a $4,000 "basket" for losses related to any environmental events, conditions or circumstances identified in the five year period ended February 1993, to the extent such losses are not caused by activities of the Company after February 29, 1988. After consultation with counsel, in the opinion of management, the ultimate cost to the Company, exceeding amounts provided, will not materially affect the consolidated financial position or results of operations. At December 31, 1993, the Company had purchase commitments of 444.5 million pounds of copper. This is not expected to be either a quantity in excess of needs or at prices in excess of amounts that can be recovered upon sale of the copper products. The commitments are to be priced based on the COMEX price in the contractual month of shipment except for 60.1 million pounds priced at fixed amounts, of which 36.6 million pounds are covered by customer sales agreements at copper prices at least equal to the Company's commitment. The remaining 23.5 million pounds that are not covered by customer sales agreements are priced at an average of $.81 per pound. At December 31, 1993, the Company had committed $8,644 to outside vendors for certain capital projects. The Company occupies space and uses certain equipment under lease arrangements. Rent expense was $6,224, $1,949, $4,138 and $5,684 under such arrangements for the year ended December 31, 1993, the three month period ended December 31, 1992, the nine month period ended September 30, 1992 and the year 1991, respectively. Rental commitments at December 31, 1993 under long-term noncancellable operating leases were as follows: Real Estate Equipment Total ----------- --------- ----- 1994 $ 2,230 $2,284 $ 4,514 1995 1,883 2,067 3,950 1996 1,391 1,185 2,576 1997 1,132 701 1,833 1998 1,015 652 1,667 After 1998 13,988 1,421 15,409 ------- ------ ------- $21,639 $8,310 $29,949 ======= ====== ======= ESSEX GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued In Thousands of Dollars ----------------------- NOTE 12 QUARTERLY FINANCIAL DATA (UNAUDITED) (a) In the second quarter of 1993, the Company recognized an extraordinary charge of $3,055 net of applicable income tax benefit of $1,953, representing the write-off of unamortized debt costs associated with retirement of the outstanding Term Credit. During 1993 and the nine month period ended September 30, 1992 the Successor and Predecessor repurchased outstanding Debentures resulting in extraordinary charges of $312 and $122 net of applicable income tax benefits of $199 and $78, respectively (See Note 6). (b) In connection with the Acquisition and Merger, the Company incurred certain merger related expenses of $18,139 consisting primarily of bonus and option payments to certain employees and certain merger fees and expenses, which were charged to the Predecessor's operations in the third quarter 1992. SCHEDULE V ESSEX GROUP, INC. PROPERTY, PLANT AND EQUIPMENT In Thousands of Dollars ----------------------- (a) Balances reflect the allocation of the purchase price as described in Note 1 of Notes to Consolidated Financial Statements. S-2 SCHEDULE VI ESSEX GROUP, INC. ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT In Thousands of Dollars ----------------------- The estimated useful lives currently used in the computation of depreciation for the consolidated financial statements are as follows: Buildings and improvements 10 to 40 years Machinery and equipment 3 to 15 years S-4 SCHEDULE VIII ESSEX GROUP, INC. VALUATION AND QUALIFYING ACCOUNTS S-5 SCHEDULE X ESSEX GROUP, INC. SUPPLEMENTARY INCOME STATEMENT INFORMATION Royalties, advertising costs and taxes, other than payroll and income taxes, were either less than one percent of total sales and revenues or were disclosed in the consolidated financial statements. S-6 EXHIBIT INDEX Location of Exhibit Exhibit in Sequential Number Description of Document Numbering System -------------------------------------------------------------------------- 2.01 Agreement and Plan of Merger, dated as of July 24, 1992 (the "Merger Agreement"), between B E Acquisition Corporation and BCP/Essex Holdings Inc. (then known as MS/Essex Holdings Inc.), incorporated by reference to Exhibit 2.1 to BCP/Essex Holdings Inc.'s (then known as MS/Essex Holdings Inc.) Current Report on Form 8-K, filed with the Securities and Exchange Commission on August 10, 1992 (Commission File No. 1-10211). 2.02 Amendment dated as of October 1, 1992, to the Agreement and Plan of Merger between B E Acquisition Corporation and BCP/Essex Holdings Inc. (then known as MS/Essex Holdings Inc.), incorporated by reference to Exhibit 2.2 to BCP/Essex Holdings Inc.'s Current Report on Form 8-K, filed with the Securities and Exchange Commission on October 26, 1992 (Commission File No. 1-10211). 3.01 Certificate of Incorporation of the registrant (Incorporated by reference to Exhibit 3.01 to the Company's Registration Statement on Form S-1, File No. 33-20825). 3.02 By-Laws of the registrant, as amended. (Incorporated by reference to Exhibit 3.02 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1991). 4.01 Indenture under which the 10% Senior Notes Due 2003 are outstanding, incorporated by reference to Exhibit 4.1 to the Company's Registration Statement on Pre-Effective Amendment No. 1 to Form S-2 (Commission File No. 33-59488). 9.01 Investors Shareholders Agreement dated as of October 9, 1992, among B E Acquisition Corporation, Bessemer Capital Partners, L.P., certain affiliates of Donaldson, Lufkin & Jenrette, Inc., certain affiliates of Goldman, Sachs & Co., and Chemical Equity Associates, a California Limited Partnership, incorporated by reference to Exhibit 28.1 to BCP/Essex Holdings Inc.'s Current Report on Form 8-K, filed with the Securities and Exchange Commission on October 26, 1992 (Commission File No. 1-10211). 9.02 Management Stockholders and Registration Rights Agreement dated as of October 9, 1992, among B E Acquisition Corporation, Bessemer Capital Partners, L.P. and certain employees of the registrant and its subsidiaries, incorporated by reference to Exhibit 28.3 to BCP/Essex Holdings Inc.'s Current Report on Form 8-K, filed with the Securities and Exchange Commission on October 26, 1992 (Commission File No. 1-10211). 9.03 Form of Irrevocable Proxy dated as of October 9, 1992, granted to Bessemer Capital Partners, L.P. by certain employees of the registrant and its subsidiaries, incorporated by reference to Exhibit 28.4 to BCP/Essex Holdings Inc.'s Current Report on Form 8-K, filed with the Securities and Exchange Commission on October 26, 1992 (Commission File No. 1-10211). 10.01 Amendment and Restatement of Credit Agreement dated May 7, 1993, incorporated by reference to Exhibit 28.7 to the Company's Registration Statement on Pre-Effective Amendment No. 3 to Form S- 2 (Commission File No. 33-59488). EXHIBIT INDEX Location of Exhibit Exhibit in Sequential Number Description of Document Numbering System -------------------------------------------------------------------------- 10.02 Credit Agreement dated as of September 25, 1992, among B E Acquisition Corporation, BCP/Essex Holdings Inc., the registrant, the lenders named therein and Chemical Bank, as agent, incorporated by reference to Exhibit 4.6 to BCP/Essex Holdings Inc.'s Current Report on Form 8-K, filed with the Securities and Exchange Commission on October 26, 1992 (Commission File No. 1- 10211). 10.03 Engagement Letter dated July 22, 1992 among Bessemer Capital Partners, L.P., B E Acquisition Corporation, and Donaldson, Lufkin & Jenrette, Inc., incorporated by reference to Exhibit 10.10 to registrant's Annual Report on Form 10-K for the year ended December 31, 1992 (Commission File No. 1-7418). 10.04 Amendment dated October 9, 1992 among Bessemer Capital Partners, L.P., B E Acquisition Corporation, Donaldson, Lufkin & Jenrette, Inc. and Goldman, Sachs and Co., to Engagement Letter dated July 22, 1992 among Bessemer Capital Partners, L.P., B E Acquisition Corporation and Donaldson, Lufkin & Jenrette, Inc., incorporated by reference to Exhibit 10.11 to registrant's Annual Report on Form 10-K for the year ended December 31, 1992 (Commission File No. 1-7418).Agreement and Plan of Merger, dated as of July 24, 1992 (the "Merger Agreement"), between B E Acquisition Corporation and BCP/Essex Holdings Inc. (then known as MS/Essex Holdings Inc.), incorporated by reference to Exhibit 2.1 to BCP/Essex Holdings Inc.'s (then known as MS/Essex Holdings Inc.) Current Report on Form 8-K, filed with the Securities and Exchange Commission on August 10, 1992 (Commission File No. 1-10211). 12.01 Computation of Ratio of Earnings to Fixed Charges. 22.01 Subsidiaries of the registrant. 99.01 Registration Rights Agreement dated as of October 9, 1992, among B E Acquisition Corporation, certain affiliates of Donaldson, Lufkin & Jenrette, Inc., certain affiliates of Goldman, Sachs & Co., and Chemical Equity Associates, A California Limited Partnership, incorporated by reference to Exhibit 28.2 to BCP/Essex Holdings Inc.'s Current Report on Form 8-K, filed with the Securities and Exchange Commission on October 26, 1992 (Commission File No. 1-10211). 99.02 Amended and Restated Stock Option Plan of BCP/Essex Holdings Inc., incorporated by reference to Exhibit 4.7 to BCP/Essex Holdings Inc.'s Current Report on Form 8-K, filed with the Securities and Exchange Commission on October 26, 1992 (Commission File No. 1- 10211). EXHIBIT 12.01 ESSEX GROUP, INC. COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES (a) Earnings of the Successor were insufficient to cover fixed charges by the amount of $7,078 for the three month period ended December 31, 1992. EXHIBIT 12.01 ESSEX GROUP, INC. COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES - Continued EXHIBIT 22.01 ESSEX GROUP, INC. (MICHIGAN) SUBSIDIARIES OF THE REGISTRANT Essex Group, Inc. . . . . . . . . . . . . . . . . . . Delaware Essex International, Inc. . . . . . . . . . . . . . . Delaware Essex Wire Corporation . . . . . . . . . . . . . . . Michigan Diamond Wire & Cable Co. . . . . . . . . . . . . . . Illinois ExCel Wire and Cable Co. . . . . . . . . . . . . . . Illinois US Samica Corporation . . . . . . . . . . . . . . . . Vermont Bristol Wire Company . . . . . . . . . . . . . . . . Delaware Femco Magnet Wire Corporation . . . . . . . . . . . . Indiana Essex Group Export Inc. . . . . . . . . . . . . . . . U.S. Virgin Islands Interstate Industries Holdings Inc. . . . . . . . . . Delaware Interstate Industries, Inc. . . . . . . . . . . . . . Mississippi Essex Group Mexico Inc. . . . . . . . . . . . . . . . Delaware Essex Group Mexico S.A. de C.V. . . . . . . . . . . . Mexico

745287_1993.txt

745287

1993

ITEM 1. BUSINESS GENERAL The Registrant is a leading independent manufacturer of precision ductile and gray iron castings, with production facilities in North America and Germany. The Registrant's castings are used primarily in automobiles and light trucks, as well as in heavy trucks, construction and farm equipment, air conditioning and refrigeration equipment and internal combustion engines. The Registrant specializes in safety-related parts critical to vehicle control that meet its customers' exacting metallurgical, dimensional and quality control standards. Products manufactured for the automotive, light truck and heavy truck industries include brake parts, steering components, differential cases, camshafts and crankshafts. The Registrant provides castings used by over 20 automobile manufacturers throughout the world, including Ford, Chrysler, General Motors, Volkswagen, BMW and Mercedes-Benz. As used herein, the term "Registrant" refers collectively to Intermet Corporation and its subsidiaries, and their respective predecessors, except where otherwise indicated by context. RECENT DEVELOPMENTS On August 30, 1993 the Registrant announced plans to permanently close its Lower Basin foundry in Lynchburg, Virginia. The Lower Basin foundry had been operating well below its capacity of 70,000 tons in recent years. The foundry stopped pouring iron in December 1993 and is expected to close completely in 1994. The foundry employed approximately 660 people at the time the closing was announced. Primarily as a result of the decision to close this foundry, the Registrant recorded a restructuring charge of $24 million in the third quarter of 1994. The Board of Directors of the Registrant suspended the regular quarterly dividend in October 1993 pending an improvement in the Registrant's operating performance. PRODUCTS, MARKETS AND SALES The Registrant specializes in safety-related parts critical to vehicle control, including brake parts and steering system components, as well as differential cases, camshafts and crankshafts. The Registrant produces housings, wheels, brake parts and brackets for the construction and earthmoving equipment industries. Products for other industries include compressor parts for refrigeration and air conditioning units, cylinder heads, manifolds, valves and gears. The Registrant is seeking to expand its products to include aluminum castings. The Registrant has had a longstanding quality assurance program and is committed to maintaining its reputation for high quality products and timely delivery. For example, the Archer Creek, Radford Shell, New River and Columbus foundries and the PBM machining facility hold Ford's Q-1 quality award. The Archer Creek, Radford Shell and Ironton foundries and the Columbus machining facility hold Chrysler's Pentastar award. Radford Shell also holds the Caterpillar Certified Supplier award. The Registrant markets its products exclusively through its own sales and customer service staff, except in Europe where it also uses independent sales representatives. The Registrant currently maintains sales offices in Michigan, Ohio, Virginia and Germany. The Registrant produces principally to customer order and does not maintain any significant inventory of finished goods not on order. The Registrant provides extensive production and technical training to its sales staff. This technical background enables the sales staff to act as an effective liaison between customers and the Registrant's production personnel and permits the Registrant to offer customer assistance at the design stage of major casting programs. The Registrant also employs quality assurance representatives and engineers who work with customers' manufacturing personnel to detect and avoid potential problems and to develop new product opportunities for the Registrant. In addition to working with customer purchasing personnel, the Registrant's sales engineers confer with design engineers and other technical staff. During 1991, 1992 and 1993, direct sales to Ford accounted for 20%, 20% and 23%, respectively, direct sales to Chrysler accounted for 23%, 22% and 23%, respectively, and direct sales to General Motors Corporation accounted for 6%, 10% and 10%, respectively, of the Registrant's consolidated net sales. The loss of any of these customers or a substantial reduction in their purchases from the Registrant would have a material adverse effect on the Registrant. The Registrant's six largest customers accounted for approximately 71%, 73% and 76% of the Registrant's consolidated net sales during 1991, 1992 and 1993, respectively. The following table sets forth information regarding sales by the Registrant to customers in these markets during 1991, 1992 and 1993. In 1993 reported sales included 381,000 tons of casting shipments. The Registrant's foundries operated at 82% of average annual capacity during 1993. MANUFACTURING, MACHINING AND DESIGN The Registrant produces both ductile and gray iron castings. Gray iron, the oldest and most widely used cast iron, is readily cast into intricate shapes that are easily machinable and wear resistant. Ductile iron, which is produced by removing sulphur from the molten iron and adding magnesium and other alloys, has greater strength and elasticity than gray iron, and its use as a higher strength substitute for gray iron and a lower-cost substitute for steel has grown steadily. For the years ended December 31, 1991, 1992 and 1993, sales of ductile iron castings represented 82%, 85% and 87%, respectively, of the Registrant's total sales of castings, the balance being gray iron. The Registrant's castings range in size from small pieces weighing less than one pound to castings weighing up to 100 pounds. The manufacturing process involves melting steel scrap and pig iron in cupola or electric furnaces, adding various alloys and pouring the molten metal into molds made primarily of sand. The molten metal solidifies and cools in the molds, and the molds are broken and removed. Customers usually specify the properties their castings are to embody, such as hardness and strength, and the Registrant determines how best to meet those specifications. Constant testing and monitoring of the manufacturing process is necessary to maintain the quality and performance consistency of the castings. Electronic testing and monitoring equipment, including x-ray, cobalt x-ray, ultrasonic and magnetic-particle testing equipment, is used extensively in grading scrap metal, analyzing molten metal and testing castings. The Registrant also uses its testing equipment and procedures to provide particular tests requested by a customer for its castings. Many castings require machining (which may include drilling, threading or cutting operations) before they can be put to their ultimate use. Most customers machine their own castings or have them machined by third parties. The Registrant operates facilities in Columbus, Georgia and Chesterfield, Michigan, where it machines castings produced by it or by others. The Registrant also contracts with other companies to machine castings it produces before shipment to customers. The Registrant's design and engineering teams assist the customer, when requested, in the initial stages of product creation and modification. Among other computer-aided design techniques, the Registrant uses three-dimensional solid modeling software in conjunction with rapid prototype equipment. This equipment greatly enhances the Registrant's design flexibility and, depending on the complexity of the product, can reduce the time required to produce sample castings for customers by several weeks. RESEARCH AND DEVELOPMENT The Registrant conducts process and product development programs, principally at its separate research and development foundry located adjacent to the Archer Creek facility in Lynchburg, Virginia, and to a lesser extent at the laboratories in its other facilities. Current research and testing projects encompass both new manufacturing processes and product development. The research foundry has a self-contained melting and molding facility with complete metallurgical, physical and chemical testing capabilities. The work on new manufacturing processes is focused on ways to lower costs and improve quality. Product development work includes projects to enhance existing iron castings, such as austempering, which enhances the strength and elasticity of iron, as well as projects to develop new products, such as the conversion of forgings to castings. COMPETITION The Registrant competes with many other foundries, both in the United States and Europe. Some of these foundries are owned by major users of iron castings, and a number of foundry operators have, or are subsidiaries of companies which have, greater financial resources than the Registrant. For example, the three largest domestic automobile manufacturers, which are among the Registrant's largest customers, operate their own foundries. However, they also purchase a significant amount of castings from the Registrant and others, and there is a trend toward increased outsourcing by the domestic original equipment manufacturers. Castings produced by the Registrant also compete to some degree with malleable iron castings, other metal castings and steel forgings. The machining industry is highly fragmented and competitive. As in the foundry industry, large purchasers of machined components often have significant in-house capabilities to perform their own machining work. The Registrant competes primarily on the basis of product quality, engineering, service and price. The Registrant emphasizes its ability to produce complex, precision-engineered products in order to compete for value-added castings that generally provide a higher profit margin. RAW MATERIALS The primary raw material used by the Registrant to manufacture iron castings is steel scrap. The Registrant is not dependent on any single supplier of scrap. The Registrant has no long-term contractual commitments with any scrap supplier and does not anticipate any difficulties in obtaining scrap because of the large number of suppliers and because of the Registrant's position as a major purchaser. The cost of steel scrap is subject to fluctuations, but the Registrant has implemented arrangements with most of its customers for adjusting its castings prices to reflect those fluctuations. The Registrant has contractual arrangements, which expire at various times through 1998, for the purchase of various materials, other than steel scrap, used in or during the manufacturing process. While these contracts and the Registrant's overall level of purchases provide some protection against price increases, in most cases the Registrant does not have specific arrangements in place to adjust its casting prices for fluctuations in the prices of alloys and other materials. CYCLICALITY AND SEASONALITY Most of the Registrant's products are generally not affected by year-to-year automotive style changes. However, the inherent cyclicality of the automotive industry has affected the Registrant's sales and earnings during periods of slow economic growth or recession. For example, North American automotive production in 1991 was at its lowest level in almost ten years, but by 1993 had risen more than 20% over the 1991 level. On the other hand, much of Europe was in a recession during 1993, and automotive production fell significantly from the previous year. The Registrant's third and fourth quarter sales are usually lower than first and second quarter sales due to plant closings by automakers for vacations and model changeovers. BACKLOG Most of the Registrant's business involves supplying all or a stated portion of the customer's annual requirements, generally flexible in amount, for a particular casting against blanket purchase orders. The lead time and cost of commencing production of a particular casting tend to inhibit transfers of production from one foundry to another. Customers typically issue firm releases and shipping schedules on a monthly basis. The Registrant's backlog at any given time therefore consists only of the orders which have been released for shipment. The backlog at December 31, 1993 was approximately $50 million, compared to approximately $44 million at December 31, 1992. EMPLOYEES At February 6, 1994, the Registrant employed 4,151 persons, including 3,686 in the United States. Of the persons employed in the United States, 2,885 were hourly manufacturing personnel, and the remainder were clerical, sales and management personnel. The Registrant employed 465 persons in Germany, 384 of whom were hourly manufacturing personnel. Most of the manufacturing personnel are represented by unions under collective bargaining agreements expiring at various times through 1997. Three domestic bargaining agreements covering approximately 989 hourly employees expire in 1994. The Registrant entered into a replacement agreement for one facility, covering 363 employees, in February 1994, and expects to enter into replacement agreements for the other expiring agreements, as well. The Registrant from time to time adjusts the size of its work force to meet fluctuations in production demands at various facilities. During the past ten years the Registrant has not experienced any strike or work stoppage, other than a five-week strike by the 69 covered employees at the Hibbing, Minnesota plant during 1992. The Registrant believes that its relationship with its employees is satisfactory. ENVIRONMENTAL MATTERS The Registrant's operations are subject to various federal, state and local laws and regulations relating to the protection of the environment. These regulations, which are implemented principally by the EPA and corresponding state agencies, govern the management of solid and hazardous waste, the discharge of pollutants into the air and into surface and underground waters, and the manufacture and disposal of chemical substances. The Registrant believes that current operations of its facilities are in substantial compliance with applicable environmental laws, regulations and government orders. In February 1992 the Registrant's Board of Directors established an Environmental Compliance Committee to oversee the Registrant's environmental program. The Registrant has completed internal environmental reviews of all of its facilities and intends to remedy all non-complying situations. In addition, the Registrant has increased its environmental compliance staff and has expanded its training programs to emphasize environmental matters. The Registrant is currently in the process of attempting to resolve certain environmental matters with various governmental agencies and third parties. In addition to the administrative complaint filed by the EPA and the issue raised by the Ohio Attorney General's Office described in "Item 3 -- Legal Proceedings", these matters include the closure of five former hazardous waste treatment units at the Archer Creek and Radford Shell facilities, the remediation of soil and groundwater contamination at the Lower Basin foundries, and certain other soil remediation and clean-up projects. The Registrant believes that expenses to be incurred in resolving these matters will not materially exceed reserves established for such purposes or cause the Registrant to exceed its level of anticipated capital expenditures. However, it is not possible to accurately predict such costs. The recent amendments to the federal Clean Air Act are expected to have a major impact on the compliance costs of many U.S. companies, including foundries of the type owned by the Registrant. Until regulations implementing those amendments are adopted by the federal and state governments, it is not possible to estimate such costs. Over the years, the Registrant has landfilled wastes, such as baghouse dust and foundry sand, on or near its foundry properties. The Registrant believes its landfills and its other waste management units comply with all existing regulations. However, it is not possible to predict whether, or to what extent, future federal, state or local regulations will require the Registrant to incur additional costs to monitor, close, remediate or otherwise manage those units in ways not currently contemplated. FOREIGN OPERATIONS Information as to revenues, operating profits and identifiable assets for its foreign operations for 1993, 1992 and 1991 is contained in Note 11 of the consolidated financial statements included in the Registrant's 1993 Annual Report to Shareholders included as Exhibit 13 to this Report and is incorporated herein by reference. EXECUTIVE OFFICERS OF THE REGISTRANT Executive officers are elected by the Board of Directors annually at its meeting immediately following the Annual Meeting of Shareholders, and hold office until the next Annual Meeting unless they sooner resign or are removed from office by the Board of Directors. The executive officers of the Registrant as of February 10, 1994 and their ages and principal positions with the Registrant as of that date are as follows: Mr. Mathews has occupied the positions of Chairman and Chief Executive Officer of the Registrant since its organization. He became President of the Registrant in 1991. Mr. Tarr has served as a director of the Registrant since 1984, Vice Chairman of the Board of the Registrant since 1992, President of Intermet International, Inc. since 1991, and a consultant to the Registrant from late 1989 through 1990. He was employed as Dean and professor of the Johnson Graduate School of Management at Cornell University from 1984 through 1989 and remained as professor through June 1990. Mr. Bodnar was Vice President - Foundry Sales of the Registrant from 1987 to 1991, when he became President of Intermet Foundries, Inc. Mr. Bodnar joined Lynchburg Foundry Company in 1951, and he has held management positions in Intermet Foundries, Inc. and the Registrant since 1984. Mr. Trezek has served as Executive Vice President of the Registrant since February 10, 1994. From 1991 to 1993 he was President of Knight Facilities Management, a division of Lester B. Knight. He was director of training and retraining resources at Delta College from 1988 to 1991. From 1987 to 1988 he served as an instructor of management courses at Saginaw Valley State University and Delta College. Prior to that time he held various management positions with the Central Foundry Division of General Motors Corporation. Mr. Ernst became Treasurer in 1984 and Secretary of the Registrant in 1986. He was named Vice President - Finance and Chief Financial Officer in 1991. Mr. Rydel has served as Vice President - Human Resources of the Registrant since 1991. He served as Director of Compensation and Benefits of the Registrant from 1986 until 1990, when he became Director of Human Resources of the Registrant. Mr. Bouxsein became Controller of the Registrant in 1991. From 1987 until 1991 he was Corporate Director - Financial Reporting of the Registrant. Mr. Marsh became Vice President of the Registrant in August 1993. From 1969 through 1993, Mr. Marsh was employed by Simpson Industries, Inc., most recently as Group Vice President, Transmission and Chassis Group. ITEM 2.

ITEM 2. PROPERTIES The Registrant currently owns or operates or has an ownership interest in 10 ductile and gray iron foundries, one aluminum test foundry and one research foundry. Most castings can be produced at more than one of the Registrant's foundries. The following provides information about the location and capacity of the iron foundries, all of which are wholly-owned by the Registrant: The Registrant continually reviews the operation of its foundries and may from time to time close one or more foundries on a permanent or temporary basis due to its production needs and general business and economic conditions. The Pennsylvania foundry is currently idled, and the Lower Basin foundries will be closed in 1994. The aluminum test foundry is located in Lewisport, Kentucky and is jointly owned by the Registrant and Comalco Aluminum, Ltd. The research foundry is located in Virginia and is wholly-owned by the Registrant. The Registrant owns or leases several machining and design facilities. The Registrant owns a 100,000 square foot machining facility in Columbus, Georgia. The Registrant also has a machining operation housed in a leased facility containing approximately 200,000 square feet in Chesterfield, Michigan. InterMotive Technologies, Inc., a subsidiary providing engineering and design services, operates from a 38,000 square foot leased facility in Van Buren Township, Michigan. In addition, the Registrant owns or leases certain executive, sales, and other management offices, located in Georgia, Michigan, Ohio and Virginia. The Registrant believes that all of its facilities are well maintained. The only property of the Registrant which secures long-term indebtedness is the German foundry, which secures indebtedness with an aggregate outstanding principal balance at December 31, 1993 of $4,802,000. See Note 6 to the consolidated financial statements of the Registrant included in the Registrant's 1993 Annual Report to Shareholders included as Exhibit 13 to this Report for additional information on secured debt. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS Except as set forth below, the Registrant is not aware of any material pending or threatened legal proceedings to which the Registrant or any of its subsidiaries is a party or of which any of their property is the subject. On August 5, 1991 Lynchburg Foundry Company ("Lynchburg"), a wholly-owned subsidiary of the Registrant, was served with a complaint (the "Complaint") dated July 31, 1991 by the United States Environmental Protection Agency (the "EPA"). The Complaint alleges certain violations by Lynchburg of the Resource Conservation and Recovery Act ("RCRA"), the most significant of which relates to the treatment of certain hazardous waste at two of Lynchburg's foundry sites. The EPA initially proposed a civil penalty of $1,514,000, which Lynchburg appealed. Lynchburg and the EPA have reached an agreement in principle calling for a penalty of $330,000. The Registrant has made certain provisions in its consolidated financial statements for the penalty and remediation costs. Management does not expect this matter to have a material adverse effect on the Registrant's results of operations or financial position. The Registrant has entered into negotiations with the Office of the Ohio Attorney General with respect to certain past violations by the Registrant's Ironton, Ohio foundry of Ohio water pollution laws and regulations. In a letter dated March 15, 1994, the Attorney General's Office advised the Registrant that the Registrant could avoid litigation with respect to such violations by entering into a consent order. The Registrant will fully respond to the Attorney General's letter by mid April 1994 and expects to enter into a consent order providing for monetary penalties. Management does not expect this matter to have a material adverse effect on the Registrant's operations or financial position. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders of the Registrant during the fourth quarter of the fiscal year covered by this Report. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS MARKET INFORMATION AND DIVIDENDS The information contained in Note 12 to the consolidated financial statements of the Registrant included in the Registrant's Annual Report to Shareholders for the fiscal year ended December 31, 1993, furnished to the Commission as Exhibit 13 to this Report, is hereby incorporated herein by reference. The Registrant's Common Stock, $0.10 par value, is traded in the over-the-counter market under the Nasdaq symbol "INMT." As of March 1, 1994, there were approximately 881 holders of record of the Registrant's Common Stock. The Board of Directors of the Registrant suspended payment of the regular quarterly dividend in October 1993 pending improvement in the Registrant's operating performance. Even if payment of dividends resumes, the payment is subject to the discretion of the Board of Directors and will depend upon the results of operations and financial condition of the Registrant and other factors the Board of Directors deems relevant. The Registrant is also subject to restrictions on the payment of dividends under certain loan agreements. As of December 31, 1993, all of the Registrant's retained earnings were restricted and unavailable for the payment of dividends under those agreements. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA Selected financial data included in the Registrant's 1993 Annual Report to Shareholders, portions of which are furnished to the Commission as Exhibit 13 to this Report, under the headings "Statement of Operations Data," "Share Data" and "Balance Sheet Data," are hereby incorporated herein by reference. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION The information included under the heading "Discussion of Financial Information" in the Registrant's 1993 Annual Report to Shareholders, portions of which are furnished to the Commission as Exhibit 13 to this Report, is hereby incorporated herein by reference. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements and related notes of the Registrant and the report of the independent auditors thereon included in the Registrant's 1993 Annual Report to Shareholders, portions of which are furnished to the Commission as Exhibit 13 to this Report, are hereby incorporated herein by reference. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Within the 24-month period prior to the date of the Registrant's financial statements for the fiscal year ended December 31, 1993, the Registrant did not change auditors and had no disagreement with its auditors on any matter of accounting principles or practices or financial statement disclosure. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information contained under the heading "INFORMATION ABOUT NOMINEES FOR DIRECTORS" in the definitive Proxy Statement used in connection with the solicitation of proxies for the Registrant's Annual Meeting of Shareholders to be held April 28, 1994, filed with the Commission, is hereby incorporated herein by reference. Pursuant to Instruction 3 to Paragraph (b) of Item 401 of Regulation S-K, information relating to the executive officers of the Registrant is included in Item 1 of this Report. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information contained under the heading "EXECUTIVE COMPENSATION" in the definitive Proxy Statement used in connection with the solicitation of proxies for the Registrant's Annual Meeting of Shareholders to be held April 28, 1994, filed with the Commission, is hereby incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information contained under the heading "VOTING SECURITIES AND PRINCIPAL HOLDERS" in the definitive Proxy Statement used in connection with the solicitation of proxies for the Registrant's Annual Meeting of Shareholders to be held April 28, 1994, filed with the Commission, is hereby incorporated herein by reference. For purposes of determining the aggregate market value of the Registrant's voting stock held by nonaffiliates, shares held by all current directors and executive officers of the Registrant have been excluded. The exclusion of such shares is not intended to, and shall not, constitute a determination as to which persons or entities may be "affiliates" of the Registrant as defined by the Securities and Exchange Commission. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information contained under the headings "CERTAIN TRANSACTIONS" and the second paragraph of "COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION" in the definitive Proxy Statement used in connection with the solicitation of proxies for the Registrant's Annual Meeting of Shareholders to be held April 28, 1994, filed with the Commission, is hereby incorporated herein by reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. Financial Statements The following consolidated financial statements and notes thereto of the Registrant and its subsidiaries contained in the Registrant's 1993 Annual Report to Shareholders are incorporated by reference in Item 8 of this Report: Consolidated Balance Sheets at December 31, 1993 and 1992 Consolidated Statements of Operations for the Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Shareholders' Equity for the Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Report of Independent Auditors 2. Financial Statement Schedules The following consolidated financial statement schedules for the Registrant are filed as Item 14(d) hereof, beginning on page. Consent of Independent Auditors Schedule II - Amounts Receivable from Related Parties and Underwriters, Promoters and Employees Other than Related Parties Schedule V - Property, Plant and Equipment Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment Schedule VIII - Valuation and Qualifying Accounts Schedule X - Supplementary Income Statement Information 3. Exhibits The following exhibits are required to be filed with this Report by Item 601 of Regulation S-K: (b) No current reports on Form 8-K were filed during the fourth quarter of the Registrant's 1993 fiscal year. (c) The Registrant hereby files as exhibits to this Report the exhibits set forth in Item 14(a)3 hereof. (d) The Registrant hereby files as financial statement schedules to this Report the financial statement schedules set forth in Item 14(a)2 hereof. INDEX TO FINANCIAL STATEMENT SCHEDULES Consent of Independent Auditors We consent to the incorporation by reference in this Annual Report (Form 10-K) of Intermet Corporation of our report dated February 9, 1994, included in the 1993 Annual Report to Shareholders of Intermet Corporation. Our audits also included the financial statement schedules on Intermet Corporation listed in Item 14(a). These schedules are the responsiblity of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. We also consent to the incorporation by reference in the Registration Statements (Form S-8 Nos. 33-58354 and 33-58352) pertaining to the Intermet Corporation Directors Stock Option Plan and the Intermet Corporation Key Individual Stock Option Plan of our report dated February 9, 1994, with respect to the consolidated financial statements incorporated herein by reference, and our report included in the preceding paragraph with respect to the financial statement schedules included in this Annual Report (Form 10-K) of Intermet Corporation. /s/ Ernst and Young Atlanta, Georgia March 29, 1994 Intermet Corporation (Consolidated) Schedule II Amounts Receivable From Related Parties and Underwriters, Promoters and Employees Other Than Related Parties Intermet Corporation (Consolidated) Schedule V Property, Plant and Equipment (Including Foreign Industrial Development Grants, Net of Amortization) Intermet Corporation (Consolidated) Schedule VI Accumulated Depreciation and Amortization of Property, Plant and Equipment Intermet Corporation (Consolidated) Schedule VIII Valuation and Qualifying Accounts Intermet Corporation (Consolidated) Schedule X Supplementary Income Statement Information SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. INTERMET CORPORATION -------------------- (Registrant) By: /s/ George W. Mathews, Jr. -------------------------- George W. Mathews, Jr., Chairman of the Board of Directors, Chief Executive Officer and President Date: March 28, 1994 POWER OF ATTORNEY AND SIGNATURES Know all men by these presents, that each person whose signature appears below constitutes and appoints George W. Mathews, Jr. and John D. Ernst, or either of them, as attorney-in-fact, either with power of substitution, for him in any and all capacities, to sign any amendments to this Report on Form 10-K, and to file the same, with exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below as of March 28, 1994 by the following persons on behalf of the Registrant in the capacities indicated. Signature Capacity - --------- -------- /s/ George W. Mathews, Jr. Chairman of the Board of - --------------------------- Directors, Chief Executive George W. Mathews, Jr. Officer and President (Principal Executive Officer) /s/ Vernon R. Alden Director - ----------------------------- Vernon R. Alden Director - ----------------------------- J. Frank Broyles /s/ John P. Crecine Director - ----------------------------- John P. Crecine Director - ----------------------------- Anton Dorfmueller, Jr. /s/ John B. Ellis Director - -------------------------------- John B. Ellis /s/ Wilfred E. Gross, Jr. Director - ------------------------------ Wilfred E. Gross, Jr. Director - ---------------------------- A. Wayne Hardy /s/ Harold C. McKenzie, Jr. Director - --------------------------- Harold C. McKenzie, Jr. /s/ J. Mason Reynolds Director - ----------------------------- J. Mason Reynolds /s/ Curtis W. Tarr Director - ------------------------------ Curtis W. Tarr /s/ John D. Ernst Vice President - Finance, - ------------------------------ Chief Financial Officer, John D. Ernst Secretary and Treasurer (Principal Financial Officer) /s/ Peter C. Bouxsein Controller (Principal - ------------------------------ Accounting Officer) Peter C. Bouxsein EXHIBIT INDEX

93469_1993.txt

93469

1993

Item 1. Business (a) General Development of Business Standard Shares, Inc. ("Standard") was incorporated under Delaware law in 1925. On December 28, 1989, Pittway Corporation ("Old Pittway"), a Pennsylvania corporation incorporated in 1950, merged into Standard through an exchange of stock and Standard changed its name to Pittway Corporation ("Pittway" or "Registrant"). Prior to the merger Standard owned 50.1% of Old Pittway. The merger was accounted for in a manner similar to a pooling of interests, using historical book values. Pittway and its subsidiaries are referred to herein collectively as the "Company." The Company operates in two reportable industry segments: alarm and other security products, and publish-ing. In April 1993, the Company distributed its investment in the AptarGroup, Inc. (formerly known as the Seaquist Division packaging group) to stockholders in a tax-free spinoff. AptarGroup, Inc. is a manufacturer of aerosol valves, dispensing pumps and closures which are sold to packagers and marketers in the personal care, fragrance/cosmetics, pharmaceutical, household products and food industries. In October 1992, the Company sold its Barr Company, a contract packager for marketers of aerosol and liquid fill (non- aerosol) personal and household products, to a Canadian packaging company. In July 1992, the Company sold its First Alert/BRK Electronics business to a new company formed by BRK management and an investment firm. Financial information relating to these transactions is set forth in Note 1 ("Discontinued Operations") to the Consolidated Financial Statements contained in the 1993 Annual Report to Stockholders, page 25, which is incorporated herein by reference. In 1991, the Company sold its expedited ground transportation service business to its local management. (b) Financial Information about Industry Segments Financial information relating to industry segments for each of the three years ended December 31, 1993 is set forth in Note 13 ("Segment Information") to the Consolidated Financial Statements contained in the 1993 Annual Report to Stockholders, pages 29-30, which is incorporated herein by reference. (c) Narrative Description of Business The principal operations, products and services rendered by the Company: Alarm and Other Security Products Segment This segment involves the design, manufacture and sale of an extensive line of burglar alarm and commercial fire detection and alarm components and systems and the distribution of alarm and other security products manufactured by other companies. By offering a broad line of alarm products needed for security systems, the Company provides a full range of services to independent alarm installers, which range in size from one-man operations to the largest national alarm service companies. In every major domestic market area, quick delivery is provided through the Company's computerized regional warehouses and convenience center outlets, authorized distributors and dealers. Various products sold through the alarm system distribution group are purchased from non-affiliated suppliers and manufacturers to offer a broad range of products. Some of the products purchased are resold under the Company's Ademco brand name, others are resold under brand names owned by its suppliers. In the Canadian and overseas markets, alarm and other security products are sold through the Company's distribution centers, authorized dealers and sales agents. Commercial fire detectors, fire controls and control communicators are sold through the Company's regional warehouses, electrical and building supply wholesalers and alarm and fire safety distributors. Raw materials essential to the Company's businesses are purchased worldwide in the ordinary course of business from numerous suppliers. The vast majority of these materials are generally available from more than one supplier and no serious shortages or delays have been encountered. Certain raw materials used in producing some of the Company's products can be obtained only from a small number of suppliers and could adversely impact production of alarm equipment and commercial fire detectors by the Company. The Company believes that the loss of any other single source of supply would not have a material adverse effect on its overall business. Sales and marketing methods common to this industry segment include communications through the circulation of catalogs and merchandising bulletins, direct mail campaigns, and national and local advertising in trade publications. The Company's principal advantages in marketing are its reputation, broad product line, high quality products, extensive integrated distribution network, efficient customer service, competitive prices and brand names. Within the industry there is competition from large and small manufacturers in both the domestic and foreign markets. While competitors will continue to introduce new products similar to those sold by the Company, the Company believes that its research and development efforts and expansion of its distribution network will permit it to remain competitive. Publishing Segment This segment is a publisher of 32 national business and trade magazines with other businesses in the marketing-communications field. The Company's publications serve both specific industries and broad functional markets which include specialized manufacturing, service industries, technical and professional fields and general management. Most publications are distributed on a monthly basis with several others distributed on a biweekly, annual or biennial frequency. With the exception of two magazines paid for by subscribers, the publications are distributed free through controlled circulation. The principal source of revenue is from the sale of advertising space within the magazines. Other facets of the business include: the operation of a printing plant for the printing and production of most of the Company's publications and those of other publishers; a national mail-marketing organization; a majority-owned subsidiary specializ- ing in the design and development of courses and conferences for managerial, professional and technical personnel; research and telemarketing services; direct-response card mailer service and special publications. Within the publishing and marketing communications fields, competi- tion exists in the form of other publications and media communica- tion businesses. Reductions in advertising schedules by domestic industrial companies due to economic and other competitive pressures directly impacts the display advertising levels of the Company's publishing segment. The Company competes with one or more other magazines for advertising revenue in each of its magazine titles. The Company's principal sales advantages include relevant editorial content and innovative marketing complemented by specialized multi-magazine supplements. The Company believes that its competitive position benefits from improvements in manufacturing productivity and from cost control programs. The Company places great emphasis on providing quality products and services to its customers. Real Estate and Other Ventures The Company is involved in the sale, marketing and development of land near Tampa, Florida for residential and commercial use. Fairway Village is an improved residential property being developed into single family homes situated adjacent to a major resort. Saddlebrook Village, a 2,000 acre parcel of land nearby, is approved for development as a master planned community. Saddlebrook Corporate Center, a nearby 450 acre parcel, is a master planned business park for mixed use development including light manufacturing, research and development, distribution and warehousing, retail and other businesses. Principal competition comes from other residential and commercial developments in Florida. The Company has a limited partnership interest in a real estate developer with major commercial and residential high rise properties in Chicago, Dallas, Los Angeles and Boston. See Item 7 of this Form 10-K. The Company also has invested in three rental apartment complexes located in Chicago and Washington, D.C. as a 5% limited partner that provide certain tax advantages. The Company has a 45% interest in a leading manufacturer of commercial encryption equipment and of spread spectrum radios and a 5% equity interest in a satellite broadcast company which is expected to begin operations in the Spring of 1994. The Company also has a 16 2/3% investment in a manufacturer of residential fire protection products which has filed a registration statement with the S.E.C. for an initial public offering of its stock. See Item 7 of this Form 10-K. Other Information Patents and Trademarks - While the Company owns or is licensed under a number of patents which are cumulatively important to its business, the loss of any single patent or group of patents would not have a material adverse effect on the Company's overall business. Products manufactured by the Company are sold primarily under its own trademarks and tradenames. Some products purchased and resold by the Company's alarm and security products business are sold under the Company's tradenames while others are sold under tradenames owned by its suppliers. Customers - Neither of the Company's industry segments is dependent upon a single customer or a few customers. The loss of any one or more of these customers would not have a material adverse effect on the Company's results of operations. Research and Development - The Company is engaged in programs to develop and improve products as well as develop new and improved manufacturing methods. Expenditures for Company sponsored research and development activities in the alarm and other security products segment was $10.8 million in 1993, $10.0 million in 1992 and $10.2 million in 1991. These costs were associated with a number of products in varying stages of development, none of which represents a significant item of cost or is projected to be a significant addition to the Company's line of products. Acquisitions and Dispositions - Acquisitions of businesses by the Company in each of the three years ended December 31, 1993 were not significant to the Company's sales or results of operations. Dispositions by the Company, other than the discontinued operations previously discussed in the "General Development of Business" section, in each of the three years ended December 31, 1993 were not significant to the Company's sales or results of operations. Product Liability - Due to the nature of the alarm security business, the Company has been, and continues to be, subjected to numerous claims and lawsuits alleging defects in its products. This exposure has been lessened by the sale of First Alert/BRK Electronics. It is likely, due to the present litigious atmosphere in the United States, that additional claims and lawsuits will be filed in future years. The Company believes that it maintains sufficient insurance to cover this exposure. While it believes that resolution of existing claims and lawsuits will not have a material adverse effect on the Company's financial statements, management is unable to estimate the financial impact of claims and lawsuits which may be filed in the future. Environmental Matters - The Company anticipates that compliance with various laws and regulations relating to protection of the environment will not have a material effect on its capital expenditures, earnings or competitive position. Employees - At December 31, 1993, there were approximately 4,800 persons employed by the Company, including 4,000 employed in the United States. Approximately 1,000 of these employees were represented by labor unions. The Company considers its relations with its employees to be good. (d) Financial Information About Foreign and Domestic Operations and Export Sales Financial information concerning foreign and domestic operations and export sales is set forth in Note 13 ("Segment Information") to the Consolidated Financial Statements contained in the 1993 Annual Report to Stockholders, pages 29-30, which is incorporated herein by reference. Item 2.

Item 2. Properties The Company's principal properties and their general characteristics are as follows: Principal Lease Approximate Location Use Expiration Square Feet Alarm and Other Security Products Segment- Syosset, New York (1) N/A 341,000 Syosset, New York (3) 1997 14,000 Northford, Connecticut (1) N/A 179,000 New Haven, Connecticut (2) N/A 42,000 St. Charles, Illinois (1) 2002 158,000 West Chicago, Illinois (1) 1997 10,000 San Antonio, Texas (1) 1995 14,000 Melbourne, Australia (2) 1995 5,000 Sydney, Australia (2) 1998 25,000 Montreal, Canada (2) 1995 8,000 Toronto, Canada (2) 1997 7,000 London, England (1) 1994 18,000 Milan, Italy (1) N/A 14,000 Milan, Italy (2) 1998 8,000 Trieste, Italy (1) N/A 40,000 Juarez, Mexico (4) 1999 39,000 Madrid, Spain (2) 1998 8,000 Publishing Segment- Cleveland, Ohio (3) 2000 179,000 Cleveland, Ohio (2) 1996 30,000 Berea, Ohio (5) N/A 100,000 New York, New York (3) 1997 10,000 Dunedin, Florida (3) 1995 8,000 Safety Harbor, Florida (1) 1995 19,000 General Corporate- Chicago, Illinois (3) 2001 12,000 Other properties in the alarm and other security products segment include 77 full-line convenience centers which function as retail- like sales distribution outlets to serve the North American market. The convenience centers are under leases expiring through 2002 and range in size from 1,200 to 30,000 square feet. Other properties in the publishing segment include 13 sales and/or editorial offices under leases expiring through 2003 and located in major cities throughout the United States. The Company believes the above facilities are adequate for its present needs. (1) Offices, Manufacturing and Warehousing (2) Warehousing (3) General Offices (4) Manufacturing (5) Printing N/A Not applicable - facilities are owned by the Company Item 3.

Item 3. Legal Proceedings On May 10, 1989, the Circuit Court of the Sixth Judicial Circuit in and for Pasco County, Florida, entered a judgment against Saddlebrook Resorts, Inc. ("Saddlebrook"), a former subsidiary of the Company, in a lawsuit which arose out of the development of Saddlebrook's resort and a portion of the adjoining residential properties owned and currently under development by the Company. The lawsuit (James H. Porter and Martha Porter, Trustees, et al. vs. Saddlebrook Resorts, Inc. and The County of Pasco, Florida; Case No. CA83-1860), alleges damage to plaintiffs' adjoining property caused by surface water effects from improvements to the properties. Damages of approximately $8 million were awarded to the plaintiffs and an injunction was entered requiring, among other things, that Saddlebrook work with local regulatory authorities to take corrective actions. Saddlebrook made two motions for a new trial, based on separate grounds. One such motion was granted on December 18, 1990. Such grant was appealed by the plaintiffs. The other such motion was denied on February 28, 1991. Saddlebrook appealed such denial. The appeals were consolidated, fully briefed and heard in February 1992. Saddlebrook received a favorable ruling on March 18, 1992, dismissing the judgment and remanding the case to the Circuit Court for a new trial. An agreed order has been entered by the Court preserving the substance of the injunction pending final disposition of this matter. As part of its plan to comply with the agreed order, Saddlebrook filed applications with the regulatory agency to undertake various remediation efforts. Plaintiffs, however, filed petitions for administrative review of the applications, which administrative hearing was concluded in February 1992. On March 31, 1992, the hearing officer issued a recommended order accepting Saddlebrook's expert's testimony. The agency's governing board was scheduled to consider this recommended order on April 28, 1992, however, shortly before the hearing, the plaintiffs voluntarily dismissed their petitions and withdrew their challenges to the staff's proposal to issue a permit. At the April 28, 1992 hearing the governing board closed its file on the matter and issued the permits. Saddlebrook appealed the board's refusal to issue a final order. On July 9, 1993 a decision was rendered for Saddlebrook remanding jurisdiction to the governing board for further proceedings, including entry of a final order which was issued on October 25, 1993. The plaintiffs have appealed the Appellate Court decision to the Florida Supreme Court and appealed the issuance of the final order to the Second District Court of Appeals. Both appeals are presently being briefed and expected to be heard in spring 1994. Saddlebrook has moved for summary judgment on December 22, 1993 on the ground that plaintiffs' claims were fully litigated and decided in administrative action. The trial court ordered that, in the event plaintiffs' appeals are resolved by July 1994, Saddlebrook's motion for summary judgment will be heard in August 1994 and, in the event that such motion is denied, retrial will begin in October 1994. Until October 14, 1989, Saddlebrook disputed responsibility for ultimate liability and costs (including costs of corrective action). On that date, the Company and Saddlebrook entered into an agreement to split equally the costs of the defense of the litigation, the costs of any ultimate judgment and the costs of mandated remedial work. The agreement provides for the Company to make subordinated loans to Saddlebrook to enable Saddlebrook to pay its half of the costs of the latter two items. No loans have been made to date. The Company believes that the ultimate outcome of the aforementioned lawsuit will not have a material adverse effect on its financial statements. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders None. PART II Item 5.

Item 5. Market For Registrant's Common Equity and Related Stockholder Matters The information set forth under the heading "Market Prices, Security Holders and Dividend Information" appearing on page 33 of the Company's 1993 Annual Report to Stockholders is incorporated herein by reference. Item 6.

Item 6. Selected Financial Data The information set forth under the heading "Supplemental Information - Five Year Summary of Selected Financial Data" appearing on page 33 of the Company's 1993 Annual Report to Stockholders is incorporated herein by reference. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The information set forth under the heading "Management's Discussion and Analysis of Consolidated Results of Operations and Financial Condition" appearing on pages 34-35 of the Company's 1993 Annual Report to Stockholders is incorporated herein by reference. Item 8.

Item 8. Financial Statements and Supplementary Data The Company's Consolidated Financial Statements and Summary of Accounting Policies and Notes thereto, together with the report thereon of Price Waterhouse dated February 23, 1994, appearing on pages 19-32 of the Company's 1993 Annual Report to Stockholders are incorporated herein by reference. Item 9.

Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure None. PART III Information required to be furnished in this part of the Form 10-K has been omitted because the Registrant will file with the Securities and Exchange Commission a definitive proxy statement pursuant to Regulation 14A under the Securities Exchange Act of 1934 not later than April 30, 1994. Item 10.

Item 10. Directors and Executive Officers of the Registrant The information set forth under the headings "Nominees for Election by the Holders of Class A Stock", "Nominees for Election by the Holders of Common Stock", "Executive Officers" and "Section 16(a) Reports" in the Registrant's Proxy Statement for the annual meeting of stockholders to be held on May 19, 1994 is incorporated herein by reference. Item 11.

Item 11. Executive Compensation The information set forth under the headings "Compensation Committee Interlocks and Insider Participation", "Compensation", "Compensation Committee Report on Executive Compensation" and "Performance Graph" in the Registrant's Proxy Statement for the annual meeting of stockholders to be held on May 19, 1994 is incorporated herein by reference. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management The information set forth under the heading "Security Ownership of Certain Beneficial Owners and Management" in the Registrant's Proxy Statement for the annual meeting of stockholders to be held on May 19, 1994 is incorporated herein by reference. Item 13.

Item 13. Certain Relationships and Related Transactions The information set forth under the headings "Certain Transactions" and "Compensation Committee Interlocks and Insider Participation" (which is cross-referenced under the heading "Certain Transactions") in the Registrant's Proxy Statement for the annual meeting of stockholders to be held on May 19, 1994 is incorporated herein by reference. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) Financial statements and financial statement schedules filed as a part of this report are listed in the Index to Consolidated Financial Statements and Financial Statement Schedules on pages 14-15 of this Form 10-K and are incorporated herein by reference. Exhibits required by Item 601 of Regulation S-K are listed in the Index to Exhibits on pages 24-25 of this Form 10-K, which is incorporated herein by reference. Each management contract or compensatory plan or arrangement required to be filed as an Exhibit to this report pursuant to Item 14 (c) of Form 10-K is so identified on the Index to Exhibits. (b) No reports on Form 8-K have been filed during the quarter for which this report is filed. SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. PITTWAY CORPORATION (Registrant) BY /s/ Paul R. Gauvreau Paul R. Gauvrea Financial Vice President and Treasurer Date: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on March 25, 1994. /s/ Neison Harris /s/ Anthony Downs Neison Harris, Director and Anthony Downs, Director Chairman of the Board /s/ King Harris /s/ Leo A. Guthart King Harris, Director, President and Leo A. Guthart, Director Chief Executive Officer /s/ Paul R. Gauvreau /s/ Irving B. Harris Paul R. Gauvreau, Principal Irving B. Harris, Director Financial and Accounting Officer /s/ Eugene L. Barnett /s/ William H. Harris Eugene L. Barnett, Director William H. Harris, Director /s/ Sidney Barrows /s/ James H. Lorie Sidney Barrows, Director James H. Lorie, Director /s/ Fred Conforti /s/ Sal F. Marino Fred Conforti, Director Sal F. Marino, Director PITTWAY CORPORATION AND FINANCIAL STATEMENT SCHEDULES The following documents are filed as a part of this report: Page reference in Annual Report to Stockholders Financial Statements required by Item 8 of this Form: Consolidated Balance Sheet at December 31, 1993 and 1992 20-21 For each of the three years ended December 31, 1993 - Consolidated Statement of Income 19 Consolidated Statement of Cash Flows 22 Consolidated Statement of Stockholders' Equity 23 Summary of Accounting Policies and Notes to Consolidated Financial Statements 24-31 Report of Independent Accountants 32 Page reference in Form 10-K Financial Statement Schedules required by Article 12 of Regulation S-X: Report of Independent Accountants on Financial Statement Schedules 16 Consolidated Financial Statement Schedules - I. Marketable Securities - Other Investments 17 II. Amounts Receivable From Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties - Continuing Operations 18 II. Amounts Receivable From Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties - Discontinued Operations 19 VII. Guarantees of Securities of Other Issuers 20 VIII. Valuation and Qualifying Accounts 21 IX. Short-Term Borrowings 22 X. Supplementary Income Statement Information 23 PITTWAY CORPORATION AND FINANCIAL STATEMENT SCHEDULES Continued - The consolidated financial statements of Pittway Corporation, listed in the above index together with the Report of Independent Accountants, which are included in the Company's 1993 Annual Report to Stockholders, are incorporated herein by reference. All other schedules have been omitted because the required information is not present, or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements or notes thereto. With the exception of the aforementioned information and information incorporated by reference in Part I (in Item 1) and Part II (in Items 5, 6, 7 and 8) of this Form 10-K, the Company's 1993 Annual Report to Stockholders is not deemed to be filed as part of this report. The individual financial statements of the Company have been omitted because Pittway Corporation is primarily an operating company and the restricted net assets of subsidiaries together with the equity in undistributed earnings of equity investees is less than 25 percent of consolidated net assets. Summarized financial information for the limited real estate partnerships and other ventures is omitted because, when considered in the aggregate, they do not constitute a significant subsidiary. REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors of Pittway Corporation Our audits of the Consolidated Financial Statements referred to in our report dated February 23, 1994 appearing on page 32 of the 1993 Annual Report to Stockholders (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed in the index on page 14 of this Form 10-K. In our opinion, these Financial Statement Schedul- es present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. As discussed in Note 4 to the Consolidated Financial Statements contained in the 1993 Annual Report to Stockholders, pages 25-26, the Company changed its method of accounting for income taxes in 1993. /s/ Price Waterhouse PRICE WATERHOUSE Chicago, Illinois February 23, 1994 PITTWAY CORPORATION SCHEDULE I - MARKETABLE SECURITIES - OTHER INVESTMENTS FOR THE YEAR ENDED DECEMBER 31, 1993 (Dollars in Thousands) (A) The securities of no single issuer constitutes 2% or more of total assets. (B) Excludes related deferred income taxes. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated market value amounts and the estimates presented may not necessarily be indicative of the amounts that the Registrant could realize in a current market exchange. (C) Market value is not readily determinable but management believes it to be in excess of its carrying value. (D) Cost is based upon the cash price per share paid for all other shares issued by such entity at the time of the sale of First Alert/BRK Electronics by the Company. PITTWAY CORPORATION SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES CONTINUING OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Dollars in Thousands) (A) Loan bearing interest at a variable rate (approximately 13% per annum at December 31, 1993) and collateralized by marketable securities. (B) Relocation loan for new housing which was repaid when prior residence was sold. (C) Represents adjustments for the translation of local currency into U.S. dollars. PITTWAY CORPORATION SCHEDULE II - AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES DISCONTINUED OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Dollars in Thousands) (A) Housing loans which were due in 1999 and 2001 for Mr. Cheru and Mr. Siebel, respectively, were payable in quarterly installments and bore interest at 6% and 2.23% per annum for Mr. Cheru and Mr. Siebel, respectively. The residences were pledged as collateral. (B) Relocation loan for new housing which was due in 2009 and bore interest at 6% per annum. (C) Relocation loan for new housing which was repaid when prior residence was sold. The loan was interest-free. (D) Relocation loan for new housing due in 1995, bearing interest at 9% per annum and secured by a residence. (E) Represents adjustments for the translation of local currency into U.S. dollars. (F) Represents assumption of the receivable by AptarGroup, Inc. which was spunoff in April 1993. PITTWAY CORPORATION SCHEDULE VII - GUARANTEES OF SECURITIES OF OTHER ISSUERS FOR THE YEAR ENDED DECEMBER 31, 1993 (Dollars in Thousands) (A) Write-off of accounts considered uncollectible, net of recoveries, or write-off of obsolete inventory. Also includes valuation accounts of acquired or divested companies and foreign currency translation adjustments, net. (B) Balance established January 1, 1993 with the adoption of Statement of Financial Accounting Standard No. 109, "Accounting for Income Taxes". PITTWAY CORPORATION SCHEDULE IX - SHORT-TERM BORROWINGS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Dollars in Thousands) (A) Average amount outstanding during the period is computed on a month-end basis. (B) Average interest for the year is based on the weighted average of the stated month-end rates. PITTWAY CORPORATION SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Dollars in Thousands) (A)Advertising costs are charged to expense as incurred. INDEX TO EXHIBITS Sequential Number and Description of Exhibit Page Number*** 3.1 Restated Certificate of Incorporation of Registrant (incorporated by reference to Exhibit 3.1 of the Registrant's Annual Report on Form 10-K for the year ended February 29, 1988). 3.2 Certificate of Amendment to Restated Certificate of Incorporation of Registrant (incorporated by reference to Exhibit 4.2 of the Registrant's Form S-8 Registration Statement No. 33 - 33312 filed with the Commission on February 2, 1990). 3.3 Bylaws of Registrant (incorporated by reference to Exhibit 4.3 of the Registrant's Form S-8 Registration Statement No. 33 - 33312 filed with the Commission on February 2, 1990). 4. The Registrant hereby agrees to provide the Commission, upon request, copies of such instruments defining the rights of holders of long-term debt of the Registrant and its subsidiaries as are specified in Item 601(b)(4)(iii) of Regulation S-K. 10.1 Amended and Restated Merger Agreement and Plan of Reorganization (incorporated by reference to Exhibit 2 of the Registrant's Form S-4 Registration Statement No. 33 - 31519 filed with the Commission on October 11, 1989). 10.2 Combination Agreement by and among Pittway Corporation, AptarGroup, Inc. Karin Pilz, Peter Pfeiffer, Klaus Pfeiffer and Elke Miedler, without exhibits (incorporated by reference to Exhibit 2.1 to Form S-1 Registration Statement No. 33 - 58132 of AptarGroup, Inc. filed February 10, 1993). 10.3 Pittway Corporation 1990 Stock Awards Plan (incorporated by reference to the Registrant's Form S-8 Registration Statement No. 33 - 33312 filed with the Commission on February 2, 1990). 10.4 Second Extension and Amendment of Agreement of Employment with Sal F. Marino dated December 31, 1993.** 26-27 10.5 Agreement of Employment dated July 2, 1973 with Leo A. Guthart, as amended (incorporated by reference to Exhibit 10(f) of the Registrant's Form S-4 Registration Statement No. 33-31519 filed with the Commission on October 11, 1989).** INDEX TO EXHIBITS - cont'd. Sequential Number and Description of Exhibit Page Number*** 13. 1993 Annual Report to Stockholders.* 28-44 21. Subsidiaries of the Registrant. 45-46 23. Consent of Independent Accountants. 47 * Such report, except to the extent incorporated herein by reference, is being furnished for the information of the Securities and Exchange Commission only and is not to be deemed filed as a part of this Form 10-K. ** This document is a management contract or compensatory plan or arrangement required to be filed as an exhibit to this report pursuant to Item 14 (c) of Form 10-K. *** This information appears only in the manually signed original of this Form 10-K.

354869_1993.txt

354869

1993

ITEM 1. BUSINESS Registrant, First Bancorporation of Ohio ("Bancorporation"), is a bank holding company organized in 1981 under the laws of the State of Ohio and registered under the Bank Holding Company Act of 1956, as amended. Bancorporation holds all of the outstanding common stock of First National Bank of Ohio (formerly First National Bank of Akron), a national banking association, Akron, Ohio ("First National"), The Old Phoenix National Bank of Medina, a national banking association, Medina, Ohio ("Old Phoenix"), Elyria Savings & Trust National Bank, a national banking association, Elyria, Ohio ("EST"), The First National Bank in Massillon, a national banking association, Massillon, Ohio ("FNM") (collectively, the "Banks"), Peoples Federal Savings Bank, a federally-chartered stock savings bank, Wooster, Ohio ("Peoples Federal"), Peoples Savings Bank, Ashtabula, Ohio, an Ohio savings and loan association, Ashtabula, Ohio ("Peoples Savings"), Life Savings Bank, FSB, a federally-chartered stock savings bank ("Life Savings"), Bancorp Trust Company, National Association, a national trust company, Naples, Florida ("Bancorp Trust") and FBOH Credit Life Insurance Company ("FBOH Insurance") (all collectively, the "Subsidiaries"). Although principally a regional banking organization, Bancorporation through the Subsidiaries provides a wide range of banking, fiduciary, financial and investment services to corporate, institutional and individual customers throughout Northern Ohio and Southern Florida. Bancorporation's principal business consists of owning and supervising its Subsidiaries which primarily operate in Ashtabula, Cuyahoga, Erie, Geauga, Knox, Lake, Lorain, Medina, Portage, Richland, Stark, Summit and Wayne counties, Ohio. Life Savings operates in Pinellas County, Florida. Bancorporation directs the overall policies and financial resources of the Subsidiaries, but the day-to-day affairs, including lending practices, services, and interest rates, are managed by their own officers and directors, some of whom are also officers and directors of Bancorporation. Through Bancorp Trust, with its principal office in Naples, Florida, Bancorporation offers trust services to customers in the Naples and Ft. Myers areas of Florida. FBOH Insurance was formed in 1985 to engage in underwriting of credit life and credit accident and health insurance directly related to the extension of credit by the Banks to their customers. Presented in the following schedule is further specific information concerning each of the financial institution Subsidiaries: Each Bank is engaged in commercial banking in its respective geographical market. Commercial banking includes the acceptance of demand, savings and time deposits and the granting of commercial and consumer loans for the financing of both real and personal property. Other services include automated banking programs, credit cards, the rental of safe deposit boxes, letters of credit, leasing, discount brokerage and credit life insurance. The Banks also operate trust departments which offer estate and trust services. Each Bank offers its services primarily to consumers and small and medium size businesses in its respective geographical market. None of the Banks are engaged in lending outside the continental United States. None of the Banks are dependent upon any one significant customer or a specific industry. Peoples Federal, Peoples Savings and Life Savings operate as savings associations in their geographical markets. As savings associations, their business includes the acceptance of demand, savings and time deposit accounts and the granting of consumer and commercial loans primarily secured by real property. Peoples Federal and Peoples Savings offer their services principally to consumers and small businesses located in their geographical markets. They are not engaged in lending outside the continental United States and are not dependent upon any one significant customer or a specific industry. Bancorporation filed in 1993 applications with the necessary regulatory agencies to convert both Peoples Federal and Peoples Savings from federal and state savings associations, respectively, to national banks. Bancorporation believes it will receive the approvals needed to effect the conversions in early 1994. Bancorp Trust is engaged in providing personal trust services in its geographical markets. These services include acting as trustee in personal trusts, custodial and investment agency services, guardianships and service as personal representative in decedent estates. Bancorporation chartered Life Savings on March 11,1994, for the purpose of acquiring the assets and deposit liabilities of Life Federal Savings Bank, a federal savings association under the conservatorship of the Resolution Trust Corporation. Life Federal Savings Bank was the successor entity of Life Savings Bank, a failed Florida savings association. First National is the parent corporation of two wholly-owned Ohio corporations organized in 1993 -- FBOH Leasing Company ("FBOH Leasing") and FBOH Investor Services, Inc. ("Investor Services"). FBOH Leasing primarily provides equipment lease financing and related services, while Investor Services primarily provides discount brokerage services to customers of First National and the other Subsidiaries. The financial services industry is highly competitive. Bancorporation and its Subsidiaries compete with other local, regional and national providers of financial services such as other bank holding companies, commercial banks, savings associations, credit unions, consumer and commercial finance companies, equipment leasing companies, brokerage institutions, money market funds and insurance companies. The Subsidiaries' primary financial institution competitors include Bank One, National City Bank, and Society National Bank. Mergers between financial institutions within Ohio and in neighboring states have added competitive pressure. Bancorporation competes by offering quality and innovative services at competitive prices. Bancorporation and all of its Subsidiaries employ approximately 2,800 persons. Earnings for Bancorporation reached a record level as $55,205,000 was reported for 1993. The earnings reported reflect a $4,505,000 increase, or 8.9% over the prior year's earnings, which also were an all time high. During the third quarter of 1993, the Board of Directors elected to declare a two-for-one stock split as well as to increase the amount of the cash dividend to $.235 per share. The total cash dividend paid to a shareholder for the entire year was $.90 per share. The cash dividend, coupled with a market value increase from $23.00 to $26.00, created a total return of $3.90 or 16.9% for shares held the full year. All per share data is restated to reflect the stock split. Based on an average 25,219,035 shares outstanding, 1993 earnings per share was $2.19, up from the $2.02 reported for 1992. The cash dividend increased $.08 per share, or 9.8% over the previously stated annual payment of $.82. Interest income from both loans and investments continued to decline during the year due almost entirely to lower interest rates. Even though deposits increased during the year, total interest expense continued to decline, resulting in a net interest income improvement of 2%. As net interest remains vulnerable to movements in market interest rates, Bancorporation continues to look at additional sources of non-interest income. Other income increased from $50,792,000 in 1992 to $54,347,000 in 1993, an increase of 7.0%. Shareholders' equity which amounted to $391,641,000 or 9.80% of total assets, increased by 9.30% compared to one year ago. Over the years, additional measures of capital adequacy have been added including guidelines by which regulatory agencies consider a banking institution to be well capitalized. These measures are a Tier 1 capital ratio, a risk-based capital ratio, and a leverage ratio. At December 31, 1993, Bancorporation had a Tier 1 capital ratio of 15.22%, compared to the guideline of 6%; a risk-based capital ratio of 16.46% compared to the guideline of 10%; and a leverage ratio of 9.53% compared to the guideline of 5%. A favorable trend related to the decline in charge-offs and non-performing assets continued in 1993. Total charge-offs amounted to .19% of average outstanding loans, well below the .57% reported for 1992. Also reflecting an improving trend was the marked reduction in non-performing assets from 1.40% of total loans at the end of 1992 to .74% for 1993. Both improvements can be attributed to the continued emphasis on professionalism in the credit granting process and in the involvement with customers as their financial circumstances change. The improvement in asset quality can also be noted in the substantial reduction in the provision for loan losses which declined from $17,363,000 to $6,594,000 during 1993. Bancorporation executed on September 28, 1993, a definitive agreement for the acquisition of the common stock of Great Northern Financial Corporation, the holding company for Great Northern Savings Co., an Ohio savings association located in Barberton, Ohio with assets of approximately $385 million. It is anticipated the transaction will be completed early in the second quarter of 1994, following approval by the shareholders of Great Northern Financial Corporation and receipt of all necessary approvals from the regulatory agencies. At that time, Great Northern Financial Corporation will be merged into Bancorporation and Great Northern Savings Co. will be merged into First National. Another activity undertaken in 1993 by Bancorporation was a request to the Federal Reserve Bank of Cleveland to approve the creation of a Community Development Corporation ("CDC"). The establishment of a CDC is essential to Bancorporation's Subsidiaries in meeting the requirements of the Community Reinvestment Act ("CRA"). Congress enacted CRA to assure that banks and savings associations meet the deposit and credit needs of their communities. Through a CDC, financial institutions can meet these needs by non-traditional activities such as acquiring, rehabilitating, or investing in real estate in low to moderate income neighborhoods, and promoting the development of small business. Bancorporation has committed to provide through the CDC up to $2,000,000 over three years by funding individual projects that meet its standards as well as the spirit of the CRA. ITEM 2.

ITEM 2. PROPERTIES FIRST BANCORPORATION OF OHIO. Bancorporation owns no real property. Its executive offices and certain holding company operational facilities, totalling 52,305 square feet, are leased from First National. During 1993, Bancorporation acquired a leasehold interest in III Cascade, a seven-story office building located in downtown Akron, Ohio. Bancorporation intends to relocate its executive offices to III Cascade in 1994. The leasehold interest was acquired by an assignment of a long-term sublease of the property to FNR Holdings I, an Ohio general partnership (the "Partnership"), the general partners of which are Bancorporation and Asset Holdings Corporation I, a Delaware corporation and subsidiary of Banc One Capital Corporation. Bancorporation does not control the Partnership. The City of Akron is the lessor of the property. First National has subleased all of the premises of III Cascade from the Partnership, and Bancorporation intends to sublease a portion of the premises from First National for its executive offices. Neither Bancorporation nor First National presently occupy any of the premises. The facilities owned or leased by Bancorporation and its Subsidiaries are considered by management to be adequate, and neither the location nor unexpired term of any lease is deemed material to the business of Bancorporation. FIRST NATIONAL BANK OF OHIO. The principal executive offices of First National are located in its 28-story main office building located at 106 South Main Street, Akron, Ohio, which is owned by First National. First National is the principal tenant of the building occupying approximately one-half of a total of 200,000 square feet of the building, with the remaining portion leased to tenants unrelated to First National. The properties occupied by 32 of First National's branches are owned by First National, while the properties occupied by its remaining 33 branches are leased with various expiration dates. There is no mortgage debt owing on any of the above property owned by First National. First National also owns automated teller machines, on-line teller terminals and other computers and related equipment for use in its business. First National owns 19.5 acres near downtown Akron, on which is located the FBOH Operations Center. The Operations Center is occupied and operated by FBOH Services Division, an operating division of Bancorporation. The Operations Center primarily provides computer and communications technology-based services to Bancorporation and the Subsidiaries, and also markets its services to non-affiliated institutions. There is no mortgage debt owing on the Operations Center property. The Trust Department of First National relocated in 1993 from the main office building of First National to Main Place, a four- story office building located in downtown Akron. The Trust Department occupies 16,650 square feet of leased space in Main Place. THE OLD PHOENIX NATIONAL BANK OF MEDINA. The principal executive offices of Old Phoenix are located in its main office building at 39 Public Square, Medina, Ohio. The building which houses its executive offices is leased by Old Phoenix. The properties occupied by four of Old Phoenix's branches are owned by Old Phoenix, while the properties occupied by its remaining ten branches are the subject of various lease obligations having various expiration dates. These facilities are leased from IRT Properties, a publicly-held real estate investment trust. Old Phoenix also owns automated teller machines, on-line teller terminals and other related equipment. The computer operations of Old Phoenix are provided through First National. ELYRIA SAVINGS & TRUST NATIONAL BANK. The principal executive offices of EST are located in its main office building at 105 Court Street, Elyria, Ohio, which is owned by EST. EST occupies approximately one-half of the total available space in the building. EST owns the land and buildings occupied by 18 of its banking offices. The remaining five banking offices are the subject of lease obligations with various lessors and varying lease terms and expiration dates. EST also has automated teller machines and on-line teller terminals. The computer operations of EST are provided through First National. PEOPLES FEDERAL SAVINGS BANK. The principal executive offices of Peoples Federal are located in its main office building at 121 North Market Street, Wooster, Ohio, which is owned by Peoples Federal. The properties occupied by seven of Peoples Federal branches are owned by Peoples Federal, while the properties occupied by its remaining five branches are leased at various expiration dates. No mortgage debt exists on the above property owned by Peoples Federal. Peoples Federal also has automated teller machines and on-line terminals. THE FIRST NATIONAL BANK IN MASSILLON. The principal executive offices of FNM are located at One First National Plaza, Massillon, Ohio, in the center of downtown Massillon. The building was constructed in 1976, is owned by FNM and is not subject to mortgage debt. FNM owns the properties occupied by four of its other banking offices, while the properties occupied by the remaining four are leased under different leases with various expiration dates. PEOPLES SAVINGS BANK. The principal executive offices of Peoples Savings are located in its main office at 4200 Park Avenue, Ashtabula, Ohio, which is owned by Peoples Savings. Peoples Savings owns the properties occupied by seven of its branches, while the properties occupied by its remaining nine branches are leased at various expiration dates. Peoples Savings also leases the property occupied by a loan production office. No mortgage debt exists on the above property owned by Peoples Savings. Peoples Savings also has automated teller machines and on-line terminals. LIFE SAVINGS BANK, FSB. The principal executive offices of Life Savings are located at 21649 U.S. Highway 19 north, Clearwater, Florida. Life Savings presently leases the property occupied by its executive offices and its two branches. BANCORP TRUST COMPANY. Bancorp Trust has its principal executive offices at The Plaza on Third Street, Naples, Florida under a short-term lease with a renewal option at the election of Bancorp Trust. Bancorp Trust leases one additional office in Ft. Myers, Florida. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS The nature of Bancorporation's business results in a certain amount of litigation. Accordingly, Bancorporation and its subsidiaries are subject to various pending and threatened lawsuits in which claims for monetary damages are asserted. Management, after consultation with legal counsel, is of the opinion that the ultimate liability of such pending matters would not have a material effect on Bancorporation's financial condition. During 1991, a suit was filed in federal court against First National alleging conversion and negligence in the deposit of funds. The suit sought actual damages against First National plus punitive damages, interest, costs, attorneys fees and other relief. State law suits brought by other claimants based on the same deposits have been stayed. During 1993, the federal court granted First National's motion for summary judgment. As a result, that suit was dismissed. The plaintiff in that suit subsequently filed a notice of appeal. First National is vigorously seeking to have the favorable federal judgment affirmed on appeal, and Bancorporation continues to believe First National has meritorious defenses to all claims. After consultation with legal counsel, Management believes that the possibility of a multiple recovery by both the federal court and state court plaintiffs is unlikely and that the maximum exposure for damages approximates $7,300,000. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted during the fourth quarter of 1993 to a vote of security holders of Bancorporation. EXECUTIVE OFFICERS OF REGISTRANT The following persons are the executive officers of Bancorporation as of December 31, 1993. Unless otherwise designated, they are officers of Bancorporation, and unless otherwise stated, they have held their indicated positions for the past five years. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The outstanding shares of Bancorporation Common Stock are quoted on the NASDAQ National Market System. The following table contains bid and cash dividend information for Bancorporation Common Stock for the two most recent fiscal years: On December 31, 1993 there were approximately 6,673 shareholders of record of Bancorporation Common Stock. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following commentary presents Management's discussion and analysis of the Corporation's financial condition and results of operations. The review highlights the principal factors affecting earnings and the significant changes in balance sheet items for years 1993, 1992 and 1991. Financial information for prior years is presented when appropriate. The objective of this financial review is to enhance the reader's understanding of the accompanying tables and charts, the consolidated financial statements, notes to the financial statements and financial statistics appearing elsewhere in this report. Where applicable, this discussion also reflects Management's insights of known events and trends that have or may reasonably be expected to have a material effect on the Corporation's operations and financial condition. All financial data has been restated to give effect to acquisitions accounted for on a pooling of interest basis and stock splits in previous periods. The results of other bank and branch acquisitions, accounted for as purchases, have been included effective with the respective dates of acquisition. EARNINGS SUMMARY First Bancorporation of Ohio's net income for 1993 totaled $55.2 million. This represents an 8.9% increase over 1992 and a record high for the Corporation. Net income was favorably affected by a strong net-interest margin, improved asset quality and increased non-interest income. Net income for 1993 of $55.2 million compares to $50.7 million in 1992 and $39.6 million in 1991. The return on average assets for the Corporation equaled 1.39% in 1993 compared to 1.34% in 1992 and 1.07% in 1991. The Corporation's return on average equity, which is largely affected by its strong capital base, equaled 14.69% in 1993 compared to 14.80% and 12.50% in 1992 and 1991, respectively. On August 19, 1993 the Corporation's Board of Directors declared a 2-for-1 split of the Corporation's common stock, to shareholders of record as of August 30, 1993. The per share data is restated to reflect the stock split. Net income on a per share basis totaled $2.19 compared to $2.02 in 1992 and $1.58 in 1991. The following table summarizes the changes in earnings per share for 1993 and 1992. NET INTEREST INCOME Net interest income, the difference between interest and loan fee income on earning assets and the interest paid on deposits and borrowed funds, is the principal source of earnings for the Corporation. Throughout this discussion net interest income is presented on a fully taxable equivalent (FTE) basis which restates interest on tax-exempt securities and loans as if such interest was subject to federal income tax at the statutory rate. Net interest income is affected by market interest rates on both earning assets and interest bearing liabilities, the level of earning assets being funded by interest bearing liabilities, non-interest bearing liabilities and equity and the growth in earning assets. The following table shows the allocation to assets, the source of funding and their respective interest spreads. Net interest income totaled $189.7 million in 1993, an increase of $4.1 million or 2.2% compared to 1992. Net interest income in 1993 continued to be affected by market interest rates, as lower rates impacted both average earning assets as well as interest-bearing liabilities. The yield on earning assets fell 82 basis points, or 7.87% in 1993 compared to 8.69% in 1992, while the Corporation's cost of funds dropped from 4.01% in 1992 to 3.21% in 1993, or a total of 80 basis points. In addition to changes in market interest rates, the funding of earning assets with non-interest bearing liabilities and equity increased to 19.2% of earning assets in 1993 compared to 17.2% in 1992. Average earning assets grew 4.0% compared to one year ago. The table below provides an analysis of the effect of changes in interest rates and volumes on net interest income in 1993 and 1992. Total interest income decreased by $17.6 million or 5.8% in 1993 compared to 1992. Lower interest rates accounted for $28.8 million of the decrease which was offset by a $11.2 million increase due to increased volumes. Interest income from taxable investment securities increased $3.3 million due to increased volume while income from tax-exempt securities was down slightly due to maturities within the portfolio. The overall increase in interest income due to increases in the investment portfolio was offset by a combined decrease due to interest rates of $11.3 million. Interest income from loans and leases increased $8.0 million as a result of a 4.4% increase in outstandings, while lower interest rates decreased interest income $17.1 million for a net decrease of $9.0 million. Lower market interest rates not only reduced interest expense but also continued to affect the mix of interest bearing liabilities as depositors moved funds to more liquid deposits. Overall, interest expense decreased $21.7 million compared to one year ago or 18.9%. Lower interest rates accounted for virtually all of the drop as the decrease due to rate changes was $21.2 million compared to $.5 million due to volume. As noted above, lower market rates resulted in a shift to more liquid deposits as lower outstandings reduced interest expense on certificates and other time deposits. The interest expense on savings and interest bearing demand accounts increased due to higher volumes. The $4.1 million increase in net interest income in 1993 resulted from an $11.7 million increase due to changes in volume which was offset by a $7.6 million decrease due to changes in interest rates. The net interest margin is calculated by dividing net interest income FTE by average earning assets. As with net interest income, the net interest margin is affected by the level and mix of earning assets, the proportion of earning assets funded by non-interest bearing liabilities and the interest rate spread. In addition, the net interest margin is also impacted by changes in federal income tax rates and regulations as they affect the tax equivalent adjustment. The net interest margin was 5.28% in 1993 compared to 5.37% in 1992 and 4.71% in 1991. As interest rates continued their decline in 1993, the yield on earning assets ended the year at 7.87% down from 8.69% in 1992. The cost of funding the earning assets during 1993 fell 73 basis points to 2.59% compared to 3.32% in 1992. The mix of earning assets continued to be affected by economic uncertainty during 1993 as average loans outstanding increased 4.1% compared to one year ago. Average loans equalled 65.9% of average earning assets compared to 65.8% and 64.6% in 1992 and 1991, respectively. The amount of average earning assets funded by non-interest bearing liabilities and equity totaled 19.2% in 1993 compared to 17.2% in 1992 and 15.2% in 1991. NON-INTEREST INCOME Non-interest income totaled $54.3 million, an increase of 7.0% compared to 1992. This follows a 13.9% increase for 1992 compared to 1991. Service charges on deposit accounts increased 2.6% compared to 1992 and accounted for 37.5% of non-interest income compared to 39.1% and 39.7% in 1992 and 1991, respectively. Trust fees increased 8.8% compared to one year ago and represent 18.2% of non-interest income. Credit card fees accounted for 14.7% of non-interest income while increasing 9.2% compared to one year ago. Lower market interest rates continued to have a significant impact on mortgage lending activities throughout 1992 and into 1993. Mortgage sales and loan servicing fees increased from $3.8 million in 1992 to $4.7 million in 1993, an increase of 22.5%. The Corporation's policy is to sell all fixed rate thirty year residential mortgage loans originated while retaining the servicing for these loans. Non-interest income covered 35.9% of non-interest expense in 1993, compared to 36.2% in 1992 and 34.3% in 1991. The Corporation continues to pursue new business opportunities which generate fee income and are not subject to interest rate volatility. NON-INTEREST EXPENSE Non-interest expense increased 7.9% in 1993 compared to 1992 after a 7.8% increase for 1992 compared to 1991. Salaries and wages increased 5.9% in 1993 compared to 1992 and represent 38.4% of non-interest expense compared to 39.2% one year ago. Employee benefit expense increased $3.7 million or 24.7% in 1993. Approximately $3.0 million of the increased employee benefit expense was a result of a change made to the Corporation's benefit plan for postretirement medical and life insurance discussed below. During 1993 the Corporation adopted the Financial Accounting Standards Board Statement No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." SFAS No. 106 requires that the cost of all postretirement benefits expected to be provided by an employer to current and future retirees be accrued over those employees' service periods. In addition to recognizing the cost of benefits for the current service period, SFAS No. 106 also provides for the recognition of the cost for postretirement benefits earned in prior service periods as well as for employees currently retired (the transition obligation). This Statement became effective for the Corporation on January 1, 1993. The Corporation has a benefit plan which presently provides postretirement medical and life insurance for retired employees. Effective January 1, 1993 the Corporation made significant plan changes for future retired participants. For employees who retire after January 1, 1993 the Corporation's medical contribution is capped at 200% of the 1993 level while the medical portion for employees retired prior to January 1, 1993 anticipates the Corporation's contribution to continue to increase as a proportion of the cost of the plan. The Corporation reserves the right to terminate or make additional plan changes at any time. As of January 1, 1993 the Corporation's accumulated postretirement benefit obligation (APBO) totaled $19.0 million, and the annual postretirement benefit cost amounted to $2.1 million. The Corporation has elected to amortize the APBO over twenty years at an annual cost of $.9 million, bringing the total expense to $3.0 million for 1993. During 1991, Congress passed the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"). FDICIA mandated the FDIC to develop a risk-based assessment system no later than January 1, 1994. During 1993, the FDIC issued regulations that will take effect on January 1, 1994 and that will adopt, with few changes, the transitional assessment system that was in effect in 1993 as the final assessment system. Under the final system, the annual assessment rate for each insured institution is determined on the basis of both capital and supervisory measures, and can range from $.23 per $100.00 of deposits to $.31 per $100.00 of deposits, depending on the capital and supervisory strength of the institution. At December 31, 1993, all the subsidiaries of the Corporation would be assessed at the rate of $.23 per $100.00 of deposits. Total premiums paid by the Corporation during 1993 were $7.4 million compared to $7.2 million and $6.7 million in 1992 and 1991, respectively. Various legislative proposals concerning the banking industry and regulatory reform are pending in Congress. Given the uncertainty of the legislative process, Management cannot assess the impact of such legislation on the Corporation's financial condition or results of operations. In November of 1992 the Financial Accounting Standards Board issued Statement No. 112, "Employers' Accounting for Postemployment Benefits." SFAS No. 112 establishes standards of financial accounting and reporting for the estimated cost of benefits provided by an employer to former or inactive employees after employment, but before retirement. Currently the Corporation does not provide any postemployment benefits to employees which would have any material impact on the Corporation's results of operations or capital level. FEDERAL INCOME TAX On August 10, 1993 Congress enacted the Omnibus Budget Reconciliation Act of 1993 which included among its provisions an increase in the statutory rate from 34% to 35%. Other provisions which will impact the Corporation include changes in the deductibility of certain business expenses, changes in determining benefits and contributions under its qualified retirement plan, and the ability to depreciate future intangible assets. Federal income tax expense totaled $25.5 million in 1993 compared to $22.4 million in 1992 and $15.4 million in 1991. The effect of the increase in the statutory rate, which was retroactive to the beginning of the year, totaled $.5 million. The remainder of the increase for 1993 over the prior periods resulted from increased income before federal income taxes and increases in the Corporation's effective federal income tax rate. In 1993 the effective federal income tax rate for the Corporation equaled 31.6% compared to 30.6% in 1992 and 28.0% in 1991. One of the factors which continues to affect the effective tax rate was the Tax Reform Act of 1986 which raised the disallowance of interest cost on funds employed to carry most tax-exempt securities and loans acquired after August 7, 1986 from 20% to 100%. The result is that a greater proportion of pre-tax earnings are subject to federal income tax. The Corporation continues to invest in obligations of the local communities it serves. During 1993 the Corporation adopted the Financial Accounting Standards Board Statement No. 109, "Accounting for Income Taxes." The objective of SFAS No. 109 is to recognize the amount of taxes payable or refundable for the current year as well as to recognize deferred tax liabilities and assets for the future tax consequences of events that have been recognized in the financial statements or tax returns. The Corporation had accounted for income taxes in accordance with SFAS No. 96. As a result the adoption of SFAS No. 109 did not have a material impact on the Corporation's results of operations or level of capital. INVESTMENT SECURITIES The investment portfolio is maintained by the Corporation to provide liquidity, earnings, and a means of diversifying risk. Investment securities are purchased with the ability and the intent to hold them to maturity and, therefore, are carried at amortized cost. At December 31, 1993 investment securities totaled $1,209.7 million compared to $1,167.2 million one year ago, an increase of 3.6%. Investment securities totaled $1,119.3 million at December 31, 1991. During 1993 approximately $20.6 million of investment securities were sold for which a $29 thousand net gain was realized. A summary of investment securities' book value is presented below as of December 31, 1993, 1992 and 1991. Presented with the summary is a maturity distribution schedule with corresponding weighted average yields. The schedule reflects the liquidity within the investment securities portfolio as 15.6% of the total securities have maturities of one year or less. BOOK VALUE OF INVESTMENT SECURITIES MATURITIES OF THE INVESTMENT SECURITIES AT DECEMBER 31, 1993 As a result of lower market interest rates and the impact of Tax Reform Act of 1986, noted in the discussion of federal income taxes, the Corporation continued to increase its investment in U.S. Government agencies, mortgage- backed securities and other securities helping to maximize the yield of the investment portfolio while maintaining its soundness. At December 31, 1993 these securities represented 63.5% of the total portfolio compared to 59.4% and 58.3% in 1992 and 1991, respectively. At December 31, 1993 the investment portfolio had a book value of $1,209.7 million compared to a market value of $1,224.7 million for an unrealized net gain of $15.0 million. The yield on the portfolio fell to 6.67% in 1993 compared to 7.69% in 1992 and 8.52% in 1991. Continued low market interest rates in 1993 will further impair re-investment opportunities going forward. In May 1993, the Financial Accounting Standards Board issued Statement No. 115, "Accounting for Certain Investments in Debt and Equity Securities." The statement requires debt and equity securities to be classified as held- to-maturity, available-for-sale, or trading. Securities classified as held- to-maturity are measured at amortized or historical cost, securities available-for-sale and trading at current market. Adjustment to fair value of the securities available-for-sale, in the form of unrealized holding gains and losses, is excluded from earnings and reported as a net amount in a separate component of shareholders' equity. Adjustment to fair value of securities classified as trading is included in earnings. This statement becomes effective in 1994. Management is continuing to analyze the investment securities portfolio in order to determine the appropriate classification of held-to-maturity and available-for-sale. Current analysis indicates approximately 70% of the portfolio would be held-to-maturity and 30% available-for-sale. At this time the Corporation does not foresee any securities being classified as trading. While the adoption of SFAS No. 115 should not have a material impact on results of operations or level of capital, the above mentioned analysis would result in an adjustment to capital of approximately $12.0 million based upon a 300 basis point movement in current market interest rate at year end. LOANS Total loans outstanding at December 31, 1993 increased 3.2% compared to one year ago or $2,396.5 million compared to $2,321.8 million. A breakdown by category follows along with a maturity summary of commercial, financial, and agricultural loans. Real estate loans at December 31, 1993 totaled $1,311.8 million or 54.7% of total loans outstanding compared to 58.5% one year ago. Residential loans (1-4 family dwellings) totaled $726.8 million, home equity loans $87.5 million, construction loans $35.2 million and commercial real estate loans $462.3 million. Commercial real estate loans include both commercial loans where real estate has been taken as collateral as well as loans for commercial real estate. The majority of the commercial real estate loans look to the tenants' business for cash flow to service the debt and not to rents of the building itself. These loans are generally a part of an overall relationship with existing customers primarily within northeast Ohio. There are no loans outstanding which in total could be considered a concentration of lending in any particular industry or group of industries. Most of the Corporation's business activity is with customers located within the state of Ohio. ASSET QUALITY Credit risk is managed through the Corporation's loan policy which provides the Credit Risk Management Division of the Parent Company the responsibility for managing asset quality. The Division's responsibilities include the development of credit policies to ensure sound credit decisions, loan review, early identification of problem loans, and overseeing loan workouts in subsidiary banks. The Corporation's credit policies and review procedures are meant to minimize the risk and uncertainties inherent in lending. In following these policies and procedures, Management must rely upon estimates, appraisals, and evaluations of loans and the possibility that changes in such estimates, appraisals and evaluations could occur quickly because of changing economic conditions and the economic prospects of borrowers. NON-PERFORMING ASSETS Non-performing assets consist of loans on non-accrual, loans which have been restructured and other real estate, which are defined as follows: bullet Non-accrual loans are loans which are 90 days past due and with respect to which, in Management's opinion, collection of interest is doubtful. These loans no longer accrue interest and are accounted for on a cash basis. bullet Loans are classified as restructured when, due to the deterioration of a customer's financial ability, the original terms have been favorably modified or either principal or interest has been forgiven. bullet Other real estate consists of real estate acquired through foreclosure as satisfaction of debt and loans for which, in Management's opinion, in-substance foreclosure has occurred. Loans which are 90 days or more past due but continue to accrue interest are loans which, in Management's opinion, are well secured and are in the process of collection. Non-performing assets at December 31, 1993 totaled $17.7 million down, from $32.5 million in 1992 and $34.2 million in 1991. As a percent of total loans outstanding, non-performing assets were .74% in 1993 compared to 1.40% in 1992 and 1.52% in 1991. At December 31, 1993 other real estate owned included $4.3 million of loans which have been classified as in-substance foreclosures and have been charged down to their fair value. For the year ended December 31, 1993 interest income that would have been earned had these loans not been classified as non-accrual or restructured amounted to $646,000. The interest income actually earned on these loans amounted to $594,000. In addition to the loans classified as non-performing or past due 90 days or more accruing interest, there were $36.9 million at December 31, 1993 that Management believes to be potential problem loans. The loans are closely monitored by the Credit Risk Management Division to assess the borrowers' ability to comply with the terms of the loans. Management's most recent review indicates that a charge against the allowance for possible loan losses or classification as non-performing is not warranted for these loans at this time. ALLOWANCE FOR POSSIBLE LOAN LOSSES The Corporation's policy is to maintain the allowance for possible loan losses at a level considered by Management to be adequate for potential future losses. The evaluation performed by the Credit Risk Management Division of the Parent Company is based upon a continuous review of delinquency trends; the amount of non-performing loans (non-accrual, restructured, and other real estate owned); loans past due 90 days or more and classified loans; historical and present trends in loans charged-off; changes in the composition and level of various loan categories; and current economic conditions. At December 31, 1993, the allowance for possible loan losses was $31.2 million or 1.30% of loans outstanding compared to $29.2 million or 1.26% in 1992 and $24.8 million or 1.10% in 1991. The allowance for loan losses coverage of non-performing assets equalled 176.38% and 6.84 times 1993 net charge-offs. Net charge-offs for 1993 were $4.6 million, down from $13.0 million and $10.1 million in 1992 and 1991, respectively. As a percent of average loans outstanding, net charge-offs dropped from .57% and .46% in 1992 and 1991, respectively, to .19% in 1993. Management continues to believe that loans should be charged against the allowance for possible loan losses as soon as losses are identified. A six year summary of loan losses follows: Allocation of the Allowance for Loan Losses DEPOSITS Average deposits in 1993 increased 4.2% compared to 1992 as market interest rates continued at their lowest level in over 30 years. Total deposits averaged $3,394.9 million compared to $3,256.7 million and $3,192.2 million in 1992 and 1991, respectively. As market interest rates continued their downward trend throughout the year, the mix of deposits continued to shift toward the more liquid types of deposits. The average yield on certificates and other time deposits dropped from 6.76% in 1991 and 5.00% in 1992 to 4.01% in 1993 as the percent of certificates and other time deposits to total deposits fell to 35.3% in 1993 compared to 46.3% in 1991. Savings deposits increased 11.7% compared to one year ago and represent 37.3% of total deposits. Interest bearing demand deposits also increased 9.2%, totaling 8.6% of deposits as the average rate dropped to 2.35%. Non- interest bearing demand deposits totaled $639.3 million, an increase of 18.7%, and represent 18.8% of total deposits. The average cost of deposits was down 77 basis points compared to one year ago, or 2.63% compared to 3.40%. Based upon prior interest rate cycles, deposits tend to move back into certificates of deposits as interest rates rise, to obtain a premium for investing in longer term certificates. The following table summarizes the certificates and other time deposits in amounts of $100,000 or more as of December 31, 1993, by time remaining until maturity. INTEREST RATE SENSITIVITY Interest rate sensitivity measures the potential exposure of earnings and capital to changes in market interest rates. The Corporation has a policy which provides guidelines in the management of interest rate risk. This policy is reviewed periodically to ensure it complies with trends within the financial markets and within the industry. The analysis presented below divides interest bearing assets and liabilities into maturity categories and measures the "GAP" between maturing assets and liabilities in each category. The analysis shows that liabilities maturing within one year exceed assets maturing within the same period by a moderate amount. The Corporation uses the GAP analysis and other tools to monitor rate risk. At December 31, 1993 the Corporation was in a moderate liability- sensitive position as illustrated in the following table: CAPITAL RESOURCES Shareholders' equity at December 31, 1993 totaled $391.6 million compared to $358.3 million at December 31, 1992, an increase of 9.3%. The following table reflects the various measures of capital: The risk-based capital guidelines issued by the Federal Reserve Bank in 1988 require banks to maintain capital equal to 8% of risk-adjusted assets effective December 31, 1992. At December 31, 1993 the Corporation's risk- based capital equalled 16.46% of risk-adjusted assets, far exceeding the minimum guidelines. As noted earlier, the Corporation's Board of Directors declared a 2-for-1 split of the Corporation's common stock on August 19, 1993. The split was paid to shareholders of record as of August 30, 1993. In addition to the stock split, the Directors of First Bancorporation of Ohio increased the quarterly cash dividend, marking the twelfth consecutive year of annual increases since the Corporation's formation in 1981. The cash dividend of $.235 paid has an indicated annual rate of $.94 per share. Over the past five years the dividend has increased at an annual rate of 7.4%. LIQUIDITY The Corporation's primary source of liquidity is its strong core deposit base, raised through its retail branch system, along with a strong capital base. These funds, along with investment securities, provide the ability to meet the needs of depositors while funding new loan demand and existing commitments. The banking subsidiaries individually maintain sufficient liquidity in the form of temporary investments and a short-term maturity structure within the investment portfolio, along with cash flow from loan repayment. Asset growth in the banking subsidiaries is funded by the growth of core deposits. The liquidity needs of the Parent Company, primarily cash dividends and other corporate purposes, are met through cash, short-term investments and quarterly dividends from banking subsidiaries. Management is not aware of any trend or event which will result in or that is reasonably likely to occur that would result in a material increase or decrease in the Corporation's liquidity. REGULATION AND SUPERVISION FDICIA, which was enacted on December 19, 1991, substantially revised the regulation of financial institutions, including the creation of a strict uniform system of capital-based regulation, which became effective on December 19, 1992. FDICIA established five different levels of capitalization of financial institutions, with "prompt corrective actions" and significant operational restrictions imposed on institutions that are capital deficient under the categories. The five categories are: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. To be considered well capitalized an institution must have a total risk-based capital ratio of at least 10%, a Tier 1 risk-based capital ratio of at least 6%, a leverage capital ratio of 5%, and must not be subject to any order or directive requiring the institution to improve its capital level. An institution falls within the adequately capitalized category if it has a total risk-based capital ratio of at least 8%, a Tier 1 risk-based capital ratio of at least 4% and a leverage capital ratio of at least 4%. Institutions with lower capital levels are deemed to be undercapitalized, significantly undercapitalized or critically undercapitalized, depending on their actual capital levels. The appropriate federal regulatory agency may also downgrade an institution to the next lower capital category upon a determination that the institution is in an unsafe or unsound condition or is engaged in an unsafe or unsound practice. Institutions are required under FDICIA to monitor closely their capital levels and to notify their appropriate regulatory agency of any basis for a change in capital category. On December 31, 1993, the Parent Company and its subsidiaries all exceeded the minimum capital levels of the well capitalized category. Regulatory oversight of an institution becomes more stringent with each lower capital category, with certain "prompt corrective actions" imposed depending on the level of capital deficiency. For example, under "prompt corrective action" the regulators may restrict dividends and management fees, require capital restoration plans, require parent guarantees of capital restoration plans and limit senior executive compensation. In addition to these actions, further restrictions may be applied to institutions which fail to provide a capital undercapitalized restoration plan or which are categorized as significantly or critically undercapitalized. Among these remedies are selling or liquidating the institution, dismissing directors or senior executive officers, and restricting transactions. EFFECTS OF INFLATION The assets and liabilities of the Corporation are primarily monetary in nature and are more directly affected by the fluctuation in interest rates than inflation. Movement in interest rates is a result of the perceived changes in inflation as well as monetary and fiscal policies. Interest rates and inflation do not move with the same velocity or within the same time frame; therefore, a direct relationship to the inflation rate cannot be shown. The financial information presented in this annual report, based on historical data, has a direct correlation to the influence of market levels of interest rates. Therefore, Management believes that there is no material benefit in presenting a statement of financial data adjusted for inflationary changes. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements and accompanying notes, and the reports of management and independent auditors, are set forth immediately following Item 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Bancorporation has had no disagreement with its accountants on accounting and financial disclosure matters and has not changed accountants during the two year period ending December 31, 1993. CONSOLIDATED BALANCE SHEETS FIRST BANCORPORATION OF OHIO AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME FIRST BANCORPORATION OF OHIO AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FIRST BANCORPORATION OF OHIO AND SUBSIDIARIES December 31, 1993, 1992 and 1991 (DOLLARS IN THOUSANDS) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The accounting and reporting policies of First Bancorporation of Ohio and its subsidiaries (the "Corporation") conform to generally accepted accounting principles and to general practices within the banking industry. The Corporation's activities are considered to be a single industry segment for financial reporting purposes. The following is a description of the more significant accounting policies: (a) PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of First Bancorporation of Ohio (the "Parent Company") and its wholly owned subsidiaries: First National Bank of Ohio, The Old Phoenix National Bank of Medina, Elyria Savings & Trust National Bank, The First National Bank in Massillon, Peoples Federal Savings Bank, Peoples Savings Bank, FBOH Credit Life Insurance Company and Bancorp Trust Co., N.A. All significant intercompany balances and transactions have been eliminated in consolidation. (b) INVESTMENT SECURITIES Investment securities are carried at cost adjusted for amortization of premiums and accretion of discounts as the Corporation has the ability to hold investment securities to maturity and it is Management's intention to hold such securities to maturity. In 1994 this policy will be reevaluated in connection with the required adoption of Statement of Financial Accounting Standards No. 115 which will probably result in a portion of the investment portfolio being classified as available-for-sale and accounted for at fair value. The Corporation does not maintain a trading account. Gains or losses on the sales of investment securities are recognized upon realization and are determined by the specific identification method. (c) CASH AND CASH EQUIVALENTS Cash and cash equivalents consist of cash on hand, balances on deposit with correspondent banks and checks in the process of collection. (d) PREMISES AND EQUIPMENT Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is computed on the straight-line and declining-balance methods over the estimated useful lives of the assets. Amortization of leasehold improvements is computed on the straight-line method based on lease terms or useful lives, whichever is less. (e) INTEREST AND FEES ON LOANS Interest income on loans is generally accrued on the principal balances of loans outstanding using the "simple-interest" method. Loan origination fees and certain direct origination costs are deferred and amortized, generally over the contractual life of the related loans using a level yield method. Interest is not accrued on loans for which circumstances indicate collection is questionable. (f) PROVISION FOR POSSIBLE LOAN LOSSES The provision for possible loan losses charged to operating expenses is determined based on Management's evaluation of the loan portfolios and the adequacy of the allowance for possible loan losses under current economic conditions and such other factors which, in Management's judgment, deserve current recognition. (g) LEASE FINANCING The Corporation leases equipment to customers on both a direct and leveraged lease basis. The net investment in financing leases includes the aggregate amount of lease payments to be received and the estimated residual values of the equipment, less unearned income and non-recourse debt pertaining to leveraged leases. Income from lease financing is recognized over the lives of the leases on an approximate level rate of return on the unrecovered investment. Residual values of leased assets are reviewed on an annual basis for reasonableness. Declines in residual values judged to be other than temporary are recognized in the period such determinations are made. (h) FEDERAL INCOME TAXES The Corporation follows the asset and liability method of accounting for income taxes as prescribed by Statement of Financial Accounting Standards No. 109. Deferred income taxes are recognized for the tax consequences of "temporary differences" by applying enacted statutory tax rates applicable to future years to differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities. The effect of a change in tax rates is recognized in income in the period of the enactment date. (i) VALUE ASCRIBED TO ACQUIRED INTANGIBLES The value ascribed to acquired intangibles, including core deposit premiums, results from the excess of cost over fair value of net assets acquired in acquisitions of financial institutions. Such values are being amortized over periods ranging from 10 to 25 years, which represent the estimated remaining lives of the long-term interest bearing assets acquired. Amortization is generally computed on an accelerated basis based on the expected reduction in the carrying value of such acquired assets. If no significant amount of long-term interest bearing assets is acquired, such value is amortized over the estimated life of the acquired deposit base, with amortization periods ranging from 10 to 15 years. (j) TRUST DEPARTMENT ASSETS AND INCOME Property held by the Corporation in a fiduciary or other capacity for trust customers is not included in the accompanying consolidated financial statements, since such items are not assets of the Corporation. Trust income is reported generally on a cash basis which approximates the accrual basis of accounting. (k) PER SHARE DATA The per share data is based on the weighted average number of shares of common stock and common stock equivalents outstanding during each year, adjusted to reflect the two-for-one stock split of August 30, 1993. (l) RECLASSIFICATIONS Certain previously reported amounts have been reclassified to conform to the current reporting presentation. 2. ACQUISITION On September 28,1993 First Bancorporation of Ohio signed a definitive agreement to acquire Great Northern Financial Corporation located in Barberton, Ohio. The agreement provides that all outstanding shares and stock options will be acquired in exchange for a maximum of 1,882,440 shares of First Bancorporation of Ohio common stock. The transaction is to be accounted for as a pooling of interests. The acquisition is subject to the approval of Great Northern Financial Corporation's shareholders and regulatory and governmental authorities. 3. INVESTMENT SECURITIES The book value and market value of investment securities are as follows: The book value and market value of investment securities including mortgage-backed securities and derivatives at December 31, 1993, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities based on the issuers' right to call or prepay obligations with or without call or prepayment penalties. Proceeds from sales of investment securities during the years ended December 31, 1993 and 1992 were $27,257 and $96,912, respectively. Gross gains of $109 and $1,486, and gross losses of $80 and $118 were realized on these sales, respectively. The book value of investment securities pledged as collateral for trust and public deposits and other purposes required or permitted by law amounted to $602,694 and $549,918 at December 31, 1993 and 1992, respectively. 4. LOANS Loans consist of the following: At December 31, 1993 and 1992, the Corporation serviced loans for others aggregating $388,548 and $306,459, respectively. The Corporation grants loans principally to customers located within the state of Ohio. The Corporation makes loans to officers and directors on substantially the same terms and conditions as transactions with other parties. An analysis of loan activity with related parties for the year ended December 31, 1993 is summarized as follows: 5. ALLOWANCE FOR POSSIBLE LOAN LOSSES Transactions in the allowance for possible loan losses are summarized as follows: 6. RESTRICTIONS ON CASH AND DIVIDENDS The average balance on deposit with the Federal Reserve Bank to satisfy reserve requirements amounted to $17,920 during 1993. The level of this balance is based upon amounts and types of customers' deposits held by the banking subsidiaries of the Corporation. In addition, deposits are maintained with other banks at levels determined by Management based upon the volumes of activity and prevailing interest rates to compensate for check-clearing, safekeeping, collection and other bank services performed by these banks. At December 31, 1993, cash and due from banks included $9,078 deposited with the Federal Reserve Bank and other banks for these reasons. Dividends paid by the subsidiaries are the principal source of funds to enable the payment of dividends by the Corporation to its shareholders. These payments by the subsidiaries in 1994 are restricted by the regulatory agencies principally to the total of 1994 net income plus $14,460, representing the undistributed net income of the past two calendar years. Regulatory approval must be obtained for the payment of dividends of any greater amount. 7. PREMISES AND EQUIPMENT The components of premises and equipment are as follows: Amounts included in other expenses for depreciation and amortization aggregated $6,475, $6,771 and $7,032 for the years ended December 31, 1993, 1992 and 1991, respectively. At December 31, 1993, the Corporation was obligated for rental commitments under noncancellable operating leases on branch offices and equipment as follows: Rentals paid under noncancellable operating leases amounted to $4,631, $3,632 and $3,054 in 1993, 1992 and 1991, respectively. 8. CERTIFICATES AND OTHER TIME DEPOSITS The aggregate amount of certificates and other time deposits of $100 and over at December 31, 1993 and 1992 was $117,137 and $129,011, respectively. Interest expense on these certificates and deposits amounted to $4,868 in 1993, $5,856 in 1992, and $21,862 in 1991. 9. SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE AND OTHER BORROWINGS The average balance of securities sold under agreements to repurchase and other borrowings for the years ended December 31, 1993 and 1992, amounted to $148,822 and $144,054, respectively. In 1993 the weighted average annual interest rate amounted to 2.62%, compared to 2.95% in 1992. The maximum amount of these borrowings at any month end amounted to $176,768 in 1993 and $174,102 in 1992. 10. FEDERAL INCOME TAXES Federal income taxes are comprised of the following: The effective federal income tax rate differs from the statutory federal income tax rate as shown below: For 1993, 1992 and 1991 the deferred federal income tax provision (benefit) results from temporary differences in the recognition of income and expense for federal income tax and financial reporting purposes. The sources and tax effects of these temporary differences are presented below: Principal components of the Corporation's net deferred tax asset are summarized as follows: 11. BENEFIT PLANS The Corporation has a defined benefit pension plan covering substantially all of its employees. In general, benefits are based on years of service and the employee's compensation. The Corporation's funding policy is to contribute annually the maximum amount that can be deducted for federal income tax reporting purposes. Contributions are intended to provide not only for benefits attributed to service to date but also for those expected to be earned in the future. A supplemental non-qualified, non-funded pension plan for certain officers is also maintained and is being provided for by charges to earnings sufficient to meet the projected benefit obligation. The pension cost for this plan is based on substantially the same actuarial methods and economic assumptions as those used for the defined benefit pension plan. The following table sets forth the plans' funded status and amounts recognized in the Corporation's consolidated financial statements: Net pension cost consists of the following components: The Corporation maintains a savings plan under Section 401(k) of the Internal Revenue Code, covering substantially all full-time employees after one year of continuous employment. Under the plan, employee contributions are partially matched by the Corporation. Such matching becomes vested when the employee reaches three years of credited service. Total savings plan expense was $1,684, $1,900 and $790 for 1993, 1992 and 1991, respectively. 12. POSTRETIREMENT MEDICAL AND LIFE INSURANCE PLAN The Corporation has a benefit plan which presently provides postretirement medical and life insurance for retired employees. Effective January 1,1993 the plan was changed to limit the Corporation's medical contribution to 200% of the 1993 level for employees who retire after January 1,1993. The Corporation reserves the right to terminate or amend the plan at any time. On January 1,1993, the Corporation implemented Statement of Financial Accounting Standards (SFAS) No. 106 "Employers Accounting for Postretirement Benefits Other Than Pensions". This statement requires that the cost of postretirement benefits expected to be provided to current and future retirees be accrued over those employees' service periods. In addition to recognizing the cost of benefits for the current period, SFAS No. 106 requires recognition of the cost of benefits earned in prior service periods (the transition obligation). Prior to 1993, postretirement benefits were accounted for on a cash basis. As of January 1,1993, the Corporation's accumulated postretirement benefit obligation (also its transition obligation) totalled approximately $19 million. The Corporation, as permitted by SFAS No. 106, has elected to amortize the transition obligation by charges to income over a twenty year period on a straight line basis. The following table sets forth the plan's status and amounts recognized in the Corporation's consolidated financial statements. The following actuarial assumptions affect the determination of these amounts: Shown below is the impact of a 1% increase in the medical trend rates (i.e., pre-65, 15.3% for 1993 grading down to 7.0% in 2002; post-65 grading down to 7.1% in 2007). This information is required disclosure under SFAS 106. 13. STOCK OPTIONS The 1992 Stock Option Program provides incentive and non-qualified options to certain key employees for up to 1,000,000 common shares of the Corporation. In addition, the 1992 Directors Stock Option Program provides for the granting of non-qualified stock options to certain non-employee directors of the Corporation for which 100,000 common shares of the Corporation have been reserved. Options under these 1992 Programs are not exercisable for at least six months from date of grant. Options continue to be outstanding under the 1982 Incentive Stock Options Plan as amended in 1986; and these options are all fully exercisable. Options under these plans are granted at 100% of the fair market value. Options granted as incentive stock options must be exercised within ten years, options granted as non-qualified stock options shall have terms established by a committee of the Board. Options are cancellable within defined periods of time based upon the reason for termination of employment. A summary of stock option activity for the years ended December 31, 1993, 1992 and 1991 follows: The Employee Stock Purchase Plan provides full-time employees of the Corporation the opportunity to acquire common shares on a payroll deduction basis. Of the 200,000 shares available under the Plan, there were 10,946 shares issued in 1993. 14. PARENT COMPANY Condensed financial information of First Bancorporation of Ohio (Parent Company only) is as follows: 15. FAIR VALUE DISCLOSURE OF FINANCIAL INSTRUMENTS Statement of Financial Accounting Standards No. 107, "Disclosures About Fair Value of Financial Instruments," requires disclosures of fair value information about certain financial instruments, whether or not recognized in the consolidated balance sheets. Instruments for which quoted market prices are not available are valued based on estimates using present value or other valuation techniques whose results are significantly affected by the assumptions used, including discount rates and future cash flows. Accordingly, the values so derived, in many cases, may not be indicative of amounts that could be realized in immediate settlement of the instrument. Also, certain financial instruments and all nonfinancial instruments are excluded from these disclosure requirements. For these and other reasons, the aggregate fair value amounts presented below are not intended to represent the underlying value of the Corporation. The following methods and assumptions were used to estimate the fair values of each class of financial instrument presented: Investment securities -- Fair values are based on quoted market prices, or for certain fixed maturity securities not actively traded estimated values are obtained from independent pricing services. Federal funds sold -- The carrying amount is considered a reasonable estimate of fair value. Net loans -- Fair value for loans with interest rates that fluctuate as current rates change are generally valued at carrying amounts with an appropriate discount for any credit risk. Fair values of other types of loans are estimated by discounting the future cash flows using the current rates for which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. Cash and due from banks -- The carrying amount is considered a reasonable estimate of fair value. Accrued interest receivable -- The carrying amount is considered a reasonable estimate of fair value. Deposits -- The carrying amount is considered a reasonable estimate of fair value for demand and savings deposits and other variable rate deposit accounts. The fair values for fixed maturity certificates of deposit and other time deposits are estimated using the rates currently offered for deposits of similar remaining maturities. Securities sold under agreements to repurchase and other borrowings -- Fair values are estimated using rates currently available to the Corporation for similar types of borrowing transactions. Accrued interest payable -- The carrying amount is considered a reasonable estimate of fair value. Commitments to extend credit -- The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar arrangements, taking into account the remaining terms of the agreements, the creditworthiness of the counterparties, and the difference, if any, between current interest rates and the committed rates. Standby letters of credit and financial guarantees written -- Fair values are based on fees currently charged for similar agreements or on the estimated cost to terminate or otherwise settle the obligations. Loans sold with recourse -- Fair value is estimated based on the present value of the estimated future liability in the event of default. The estimated fair values of the Corporation's financial instruments based on the assumptions described above are as follows: 16. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK The Corporation is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit, financial guarantees, and loans sold with recourse. These instruments involve, to varying degrees, elements recognized in the consolidated balance sheets. The contract or notional amount of these instruments reflect the extent of involvement the Corporation has in particular classes of financial instruments. The Corporation's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit and financial guarantees written is represented by the contractual notional amount of those instruments. The Corporation uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. Unless noted otherwise, the Corporation does not require collateral or other security to support financial instruments with credit risk. The following table sets forth financial instruments whose contract amounts represent credit risk: Commitments to extend credit are agreements to lend to a customer provided there is no violation of any condition established in the contract. Commitments generally are extended at the then prevailing interest rates, have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Corporation evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained if deemed necessary by the Corporation upon extension of credit is based on Management's credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties. Standby letters of credit and financial guarantees written are conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing and similar transactions. Except for short-term guarantees of $22,635 and $27,290 at December 31, 1993 and 1992, respectively, the remaining guarantees extend in varying amounts through 2008. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral held varies, but may include marketable securities, equipment and real estate. In recourse arrangements, the Corporation accepts 100% recourse. By accepting 100% recourse, the Corporation is assuming the entire risk of loss due to borrower default. The Corporation's exposure to credit loss, if the borrower completely failed to perform and if the collateral or other forms of credit enhancement all prove to be of no value, is represented by the notional amount less any allowance for possible loan losses. The Corporation uses the same credit policies originating loans which will be sold with recourse as it does for any other type of loan. 17. CONTINGENCIES The nature of the Corporation's business results in a certain amount of litigation. Accordingly, the Corporation and its subsidiaries are subject to various pending and threatened lawsuits in which claims for monetary damages are asserted. Management, after consultation with legal counsel, is of the opinion that the ultimate liability of such pending matters would not have a material effect on the Corporation's financial condition. During 1991, a federal suit was filed against First National Bank of Ohio (Bank), a subsidiary of the Parent Company, alleging conversion and negligence in the deposit of funds. The suit sought actual damages against the Bank plus punitive damages, interest, costs, attorneys' fees and other relief. State lawsuits brought by other claimants based on the same deposits have been stayed. Management, after consultation with legal counsel, believes that the possibility of a multiple recovery by both the federal court and state court plaintiffs is unlikely and the maximum exposure for damages approximates $7.3 million. During 1993, the court granted the Bank's motion for summary judgment in the federal lawsuit. As a result, that suit was dismissed. The plaintiff in that suit subsequently filed a notice of appeal. The Bank is vigorously seeking to have the favorable federal judgment affirmed on appeal. The Corporation continues to believe the Bank has meritorious defenses to all claims. 18. QUARTERLY FINANCIAL DATA (UNAUDITED) Quarterly financial and per share data for the years ended December 31, 1993 and 1992 are summarized as follows: 19. SHAREHOLDER RIGHTS PLAN On October 21, 1993 the Board of Directors of the Corporation adopted a shareholder rights plan ("Plan"). To implement the Plan, the Board declared a dividend of one purchase right ("Right") per share of Common Stock which dividend was distributed on November 5, 1993. The Plan provides that each share of Common Stock issued after November 1, 1993, shall also have one Right attached. Under the Plan, the Rights would be distributed on the 10th business day after either of the following events would occur: (1) a person acquires 15% or more of the outstanding shares of common stock of the Corporation, except if pursuant to a tender offer for all shares on terms determined by a majority of the "Continuing Directors" to be fair; or (2) the commencement of a tender or exchange offer that would result in a change in the ownership of 15% or more of the outstanding shares of Common Stock. After such an event, each Right would entitle the holder to purchase shares of Series A Preferred Stock of the Corporation. Any Rights held by an "acquiring person," however, would be void. If the Corporation is acquired in a merger, or there is a transfer of 50% or more of the Corporation's assets or earning power, each Right holder would be entitled to receive common shares of the acquiring company worth two times the exercise price of the Right. The Corporation may redeem the Rights for $0.01 per Right at any time prior to the 10th business day (subject to extension) following the date when a person acquires 15% of the outstanding shares of common stock. MANAGEMENT'S REPORT The management of First Bancorporation of Ohio is responsible for the preparation and accuracy of the financial information presented in this annual report. These consolidated financial statements were prepared in accordance with generally accepted accounting principles, based on the best estimates and judgment of management. The Corporation maintains a system of internal controls designed to provide reasonable assurance that assets are safeguarded, that transactions are executed in accordance with the Corporation's authorization and policies, and that transactions are properly recorded so as to permit preparation of financial statements that fairly present the financial position and results of operations in conformity with generally accepted accounting principles. These systems and controls are reviewed by our internal auditors and independent auditors. The Audit Committee of the Board of Directors is composed of only outside directors and has the responsibility for the recommendation of the independent auditors for the Corporation. The Audit Committee meets regularly with management, internal auditors and our independent auditors to review accounting, auditing and financial matters. The independent auditors and the internal auditors have free access to the Audit Committee. INDEPENDENT AUDITORS' REPORT The Shareholders and Board of Directors First Bancorporation of Ohio: We have audited the accompanying consolidated balance sheets of First Bancorporation of Ohio and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, changes in shareholders' equity and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. The consolidated statements of income, changes in shareholders' equity and cash flows of First Bancorporation of Ohio and subsidiaries for the year ended December 31, 1991 were audited by other auditors whose report dated January 19, 1992, except as to Note 16 which was as of February 13, 1992, expressed an unqualified opinion on those statements. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the 1993 and 1992 consolidated financial statements referred to above present fairly, in all material respects, the financial position of First Bancorporation of Ohio and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for the years then ended in conformity with generally accepted accounting principles. /s/ Coopers & Lybrand Akron, Ohio January 18, 1994 PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT For information about the Directors of Bancorporation, see "Election of Directors" on pages 1 through 6 of Bancorporation's Proxy Statement dated February 22, 1994 ("Proxy Statement"), which is incorporated herein by reference. Information about the Executive Officers of Bancorporation appears in Part I of this report. Disclosures by Bancorporation with respect to compliance with Section 16(a) appear on page 6 of the Proxy Statement, and are incorporated herein by reference. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION See "Executive Compensation and Other Information" on pages 7 through 16 of the Proxy Statement, which is incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT See "Principal Shareholders" and "Election of Directors" at page 16, and pages 1 through 6, respectively, of the Proxy Statement, which are incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS See "Certain Relationships and Related Transactions" at pages 15 and 16 of the Proxy Statement, which is incorporated herein by reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)(1) The following Financial Statements appear in Part II of this Report: Independent Auditors' Report Management's Report Consolidated Balance Sheets December 31, 1993 and 1992 Consolidated Statements of Income Years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Changes in Shareholders' Equity Years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows Years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Years ended December 31, 1993, 1992 and 1991 (a)(2) Financial Statement Schedules All schedules are omitted as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes which appear in Part II of this report. (a)(3) Executive Compensation Plans and Arrangements (signatures begin on next page) SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Akron, State of Ohio, on the 16th day of March, 1994. FIRST BANCORPORATION OF OHIO By: /s/ Howard L. Flood -------------------------- Howard L. Flood, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed on the 16th day of March, 1994 by the following persons (including a majority of the Board of Directors of the registrant) in the capacities indicated.

36966_1993.txt

36966

1993

ITEM 1 BUSINESS General. First Tennessee National Corporation (the "Corporation") is a Tennessee corporation incorporated in 1968 and registered as a bank holding company under the Bank Holding Company Act of 1956, as amended. At December 31, 1993, the Corporation had total assets of $9.6 billion and ranked first in terms of total assets among Tennessee-headquartered bank holding companies and ranked in the top 65 nationally. Through its principal subsidiary, First Tennessee Bank National Association (the "Bank"), and its other banking and banking-related subsidiaries, the Corporation provides a broad range of financial services. The Corporation derives substantially all of its consolidated total pre-tax operating income and consolidated revenues from the banking business. As a bank holding company, the Corporation coordinates the financial resources of the consolidated enterprise and maintains systems of financial, operational and administrative control that allows coordination of selected policies and activities. The Corporation assesses the Bank and its subsidiaries for services they receive on a formula basis it believes to be reasonable. The Bank is a national banking association with principal offices in Memphis, Tennessee. It received its charter in 1864 and operates primarily on a regional basis. During 1993 it generated gross revenue of approximately $841 million and contributed 96.1% of consolidated net income from continuing operations. At December 31, 1993, the Bank had $9.4 billion in total assets, $7.0 billion in total deposits, and $5.8 billion in net loans. Within the State of Tennessee on December 31, 1993, it ranked first among banks in terms of total assets and deposits. Nationally, it ranked in the top 100 in terms of total assets and deposits as of December 31, 1993. On December 31, 1993, the Corporation's subsidiary banks had 214 banking locations in 20 Tennessee counties, including all of the major metropolitan areas of the state, and 4 banking locations in Mississippi. An element of the Corporation's business strategy is to seek acquisitions that would enhance long-term shareholder value. The Corporation has an acquisitions department charged with this responsibility which is constantly reviewing and developing opportunities to achieve this element of the Corporation's strategy. The Corporation significantly expanded its mortgage banking operations at the end of 1993. On October 1, 1993, the Bank acquired Maryland National Mortgage Corporation, Baltimore, Maryland ("MNMC") and its wholly-owned subsidiary, Atlantic Coast Mortgage Company, in a transaction accounted for as a purchase. At the time of acquisition, MNMC had total assets of approximately $538 million and a mortgage servicing portfolio of approximately $4.0 billion. On January 4, 1994, the Corporation acquired SNMC Management Corporation, the parent of Sunbelt National Mortgage Corporation, Dallas, Texas ("SNMC") in a transaction accounted for as a pooling-of-interests. SNMC became a subsidiary of the Bank at the close of the transaction. At the time of the acquisition, SNMC had total assets of approximately $451 million and a mortgage servicing portfolio of approximately $6.0 billion. The Corporation provides the following services through its subsidiaries: . general banking services for consumers, small businesses, corporations, financial institutions, and governments . bond division-primarily sales and underwriting of bank-eligible securities and mortgage loans and advisory services to other financial institutions . mortgage banking services . trust, fiduciary, and agency services . a nationwide check clearing service . merchant credit card and automated teller machine transaction processing . discount brokerage, brokerage, venture capital, equipment finance and credit life insurance services . investment and financial advisory services . mutual fund sales as agent . check processing software and systems. All of the Corporation's subsidiaries are listed in Exhibit 21. The Bank has filed notice with the Comptroller of the Currency as a government securities broker/dealer. The bond division of the Bank is registered with the Securities and Exchange Commission ("SEC") as a municipal securities dealer with offices in Memphis and Knoxville, Tennessee; Mobile, Alabama; and Overland Park, Kansas. The subsidiary banks are supervised and regulated as described below. First Tennessee Investment Management, Inc., is registered with the SEC as an investment adviser. Hickory Venture Capital Corporation is licensed as a Small Business Investment Company. First Tennessee Brokerage, Inc. is registered with the SEC as a broker-dealer. Expenditures for research and development activities were not material for the years 1991, 1992 or 1993. Neither the Corporation nor any of its significant subsidiaries is dependent upon a single customer or very few customers. At December 31, 1993, the Corporation and its subsidiaries had approximately 5,653 full-time-equivalent employees, not including contract labor for certain services, such as guard and house-keeping. Supervision and Regulation. The Corporation is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended (the "BHCA"), and is registered with the Board of Governors of the Federal Reserve System (the "Board"). The Corporation is required to file with the Board annual and quarterly reports and such additional information as the Board may require pursuant to the Act. The Board may also make examinations of the Corporation and its subsidiaries. The following summary of the Act and of the other acts described herein is qualified in its entirety by express reference to each of the particular acts and the applicable rules and regulations thereunder. GENERAL As a bank holding company, the Corporation is subject to the regulation and supervision of the Board under the BHCA. Under the BHCA, bank holding companies may not in general directly or indirectly acquire the ownership or control of more than 5% of the voting shares or substantially all of the assets of any company, including a bank, without the prior approval of the Federal Reserve Board. The BHCA also restricts the types of activities in which a bank holding company and its subsidiaries may engage. Generally, activities are limited to banking and activities found by the Federal Reserve Board to be so closely related to banking as to be a proper incident thereto. In addition, the BHCA generally prohibits, subject to certain limited exceptions, the Federal Reserve Board from approving an application by a bank holding company to acquire shares of a bank or bank holding company located outside the acquiror's principal state of operations unless such an acquisition is specifically authorized by statute in the state in which the bank or bank holding company whose shares are to be acquired is located. Tennessee has adopted legislation that authorizes nationwide interstate bank acquisitions, subject to certain state law reciprocity requirements, including the filing of an application with and approval of the Tennessee Commissioner of Financial Institutions. The Tennessee Bank Structure Act of 1974 prohibits a bank holding company from acquiring any bank in Tennessee if the banks that it controls hold 16 1/2% or more of the total deposits in individual, partnership and corporate demand and other transaction accounts, savings accounts and time deposits in all federally insured financial institutions in Tennessee, subject to certain limitations and exclusions. As of December 31, 1993, the Corporation estimates that its subsidiary banks (the "Subsidiary Banks") held approximately 12% of such deposits. Also, under this act, no bank holding company may acquire any bank in operation for less than five years or begin a de novo bank in any county in Tennessee with a population, in 1970, of 200,000 or less, subject to certain exceptions. Under Tennessee law, branch banking is permitted in any county in the state. The Subsidiary Banks are subject to supervision and examination by applicable federal and state banking agencies. The Bank is a national banking association subject to regulation and supervision by the Comptroller of the Currency (the "Comptroller") as its primary federal regulator, as is First Tennessee Bank National Association Mississippi, which is headquartered in Southaven, Mississippi. The remaining Subsidiary Bank, Peoples and Union Bank, is a Tennessee state-chartered bank that is not a member of the Federal Reserve System, and therefore is subject to the regulations of and supervision by the Federal Deposit Insurance Corporation (the "FDIC") as its primary federal regulator, as well as state banking authorities. In addition all of the Subsidiary Banks are insured by, and subject to regulation by, the FDIC. The Subsidiary Banks are subject to various requirements and restrictions under federal and state law, including requirements to maintain reserves against deposits, restrictions on the types and amounts of loans that may be granted and the interest that may be charged thereon and limitations on the types of investments that may be made, activities that may be engaged in, and the types of services that may be offered. Various consumer laws and regulations also affect the operations of the Subsidiary Banks. In addition to the impact of such regulation, commercial banks are affected significantly by the actions of the Federal Reserve Board as it attempts to control the money supply and credit availability in order to influence the economy. PAYMENT OF DIVIDENDS The Corporation is a legal entity separate and distinct from its banking and other subsidiaries. The principal source of cash flow of the Corporation, including cash flow to pay dividends on its stock or principal (premium, if any) and interest on debt securities, is dividends from the Subsidiary Banks. There are statutory and regulatory limitations on the payment of dividends by the Subsidiary Banks to the Corporation, as well as by the Corporation to its shareholders. Each Subsidiary Bank that is a national bank is required by federal law to obtain the prior approval of the Comptroller for the payment of dividends if the total of all dividends declared by the board of directors of such Subsidiary Bank in any year will exceed the total of (i) its net profits (as defined and interpreted by regulation) for that year plus (ii) the retained net profits (as defined and interpreted by regulation) for the preceding two years, less any required transfers to surplus. A national bank also can pay dividends only to the extent that retained net profits (including the portion transferred to surplus) exceed bad debts (as defined by regulation). State-chartered banks are subject to varying restrictions on the payment of dividends under applicable state laws. With respect to Peoples and Union Bank, Tennessee law imposes dividend restrictions substantially similar to those imposed under federal law on national banks, as described above. If, in the opinion of the applicable federal bank regulatory authority, a depository institution or a holding company is engaged in or is about to engage in an unsafe or unsound practice (which, depending on the financial condition of the depository institution or holding company, could include the payment of dividends), such authority may require that such institution or holding company cease and desist from such practice. The federal banking agencies have indicated that paying dividends that deplete a depository institution's or holding company's capital base to an inadequate level would be such an unsafe and unsound banking practice. Moreover, the Federal Reserve Board, the Comptroller and the FDIC have issued policy statements which provide that bank holding companies and insured depository institutions generally should only pay dividends out of current operating earnings. In addition, under the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), a FDIC-insured depository institution may not make any capital distributions (including the payment of dividends) or pay any management fees to its holding company or pay any dividend if it is undercapitalized or if such payment would cause it to become undercapitalized. See "--FDICIA." At December 31, 1993, under dividend restrictions imposed under applicable federal and state laws, the Subsidiary Banks, without obtaining regulatory approval, could legally declare aggregate dividends of approximately $168.2 million. The payment of dividends by the Corporation and the Subsidiary Banks may also be affected or limited by other factors, such as the requirement to maintain adequate capital above regulatory guidelines. TRANSACTIONS WITH AFFILIATES There are various legal restrictions on the extent to which the Corporation and its nonbank subsidiaries can borrow or otherwise obtain credit from the Subsidiary Banks. There are also legal restrictions on the Subsidiary Banks' purchases of or investments in the securities of and purchases of assets from the Corporation and its nonbank subsidiaries, a Subsidiary Bank's loans or extensions of credit to third parties collateralized by the securities or obligations of the Corporation and its nonbank subsidiaries, the issuance of guaranties, acceptances and letters of credit on behalf of the Corporation and its nonbank subsidiaries, and certain bank transactions with the Corporation and its nonbank subsidiaries, or with respect to which the Corporation and its nonbank subsidiaries act as agent, participate or have a financial interest. Subject to certain limited exceptions, a Subsidiary Bank (including for purposes of this paragraph all subsidiaries of such Subsidiary Bank) may not extend credit to the Corporation or to any other affiliate (other than another Subsidiary Bank and certain exempted affiliates) in an amount which exceeds 10% of the Subsidiary Bank's capital stock and surplus and may not extend credit in the aggregate to all such affiliates in an amount which exceeds 20% of its capital stock and surplus. Further, there are legal requirements as to the type, amount and quality of collateral which must secure such extensions of credit by these banks to the Corporation or to such other affiliates. Also, extensions of credit and other transactions between a Subsidiary Bank and the Corporation or such other affiliates must be on terms and under circumstances, including credit standards, that are substantially the same or at least as favorable to such Subsidiary Bank as those prevailing at the time for comparable transactions with non-affiliated companies. Also, the Corporation and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of property or furnishing of services. CAPITAL ADEQUACY The Federal Reserve Board has adopted risk-based capital guidelines for bank holding companies. The minimum guideline for the ratio of total capital ("Total Capital") to risk-weighted assets (including certain off-balance-sheet items, such as standby letters of credit) is 8%. At least half of the Total Capital must be composed of common stock, minority interests in the equity accounts of consolidated subsidiaries, noncumulative perpetual preferred stock and a limited amount of cumulative perpetual preferred stock, less goodwill and other intangible assets, subject to certain exceptions ("Tier 1 Capital"). The remainder may consist of qualifying subordinated debt, certain types of mandatory convertible securities and perpetual debt, other preferred stock and a limited amount of loan loss reserves. At December 31, 1993, the Corporation's consolidated Tier 1 Capital and Total Capital ratios were 9.60% and 12.14%, respectively. In addition, the Federal Reserve Board has established minimum leverage ratio guidelines for bank holding companies. These guidelines provide for a minimum ratio of Tier 1 Capital to average assets, less goodwill and other intangible assets, subject to certain exceptions (the "Leverage Ratio"), of 3% for bank holding companies that meet certain specific criteria, including having the highest regulatory rating. All other bank holding companies generally are required to maintain a Leverage Ratio of at least 3%, plus an additional cushion of at least 100 to 200 basis points. The Corporation's Leverage Ratio at December 31, 1993 was 6.55%. The guidelines also provide that bank holding companies experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels without significant reliance on intangible assets. Furthermore, the Federal Reserve Board has indicated that it will consider a "tangible Tier 1 Capital leverage ratio" (deducting all intangibles) and other indicia of capital strength in evaluating proposals for expansion or new activities. Each of the Subsidiary Banks is subject to risk-based and leverage capital requirements similar to those described above adopted by the Comptroller or the FDIC, as the case may be. The Corporation believes that each of the Subsidiary Banks was in compliance with applicable minimum capital requirements as of December 31, 1993. Neither the Corporation nor any of the Subsidiary Banks has been advised by any federal banking agency of any specific minimum Leverage Ratio requirement applicable to it. Failure to meet capital guidelines could subject a bank to a variety of enforcement remedies, including the termination of deposit insurance by the FDIC, to certain restrictions on its business and, in certain situations, the appointment of a conservator or receiver. See "--FDICIA." All of the federal banking agencies have proposed regulations that would add an additional risk-based capital requirement based upon the amount of an institution's exposure to interest rate risk. HOLDING COMPANY STRUCTURE AND SUPPORT OF SUBSIDIARY BANKS Because the Corporation is a holding company, its right to participate in the assets of any subsidiary upon the latter's liquidation or reorganization will be subject to the prior claims of the subsidiary's creditors (including depositors in the case of the Subsidiary Banks) except to the extent that the Corporation may itself be a creditor with recognized claims against the subsidiary. In addition, depositors of a bank, and the FDIC as their subrogee, would be entitled to priority over other creditors in the event of liquidation of a bank subsidiary. Under Federal Reserve Board policy, the Corporation is expected to act as a source of financial strength to, and commit resources to support, each of the Subsidiary Banks. This support may be required at times when, absent such Federal Reserve Board policy, the Corporation may not be inclined to provide it. In addition, any capital loans by a bank holding company to any of its subsidiary banks are subordinate in right of payment to deposits and to certain other indebtedness of such subsidiary bank. In the event of a bank holding company's bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to a priority of payment. CROSS-GUARANTEE LIABILITY Under the Federal Deposit Insurance Act (the "FDIA"), a depository institution insured by the FDIC can be held liable for any loss incurred by, or reasonably expected to be incurred by, the FDIC after August 9, 1989 in connection with (i) the default of a commonly controlled FDIC-insured depository institution or (ii) any assistance provided by the FDIC to any commonly controlled FDIC-insured depository institution "in danger of default." "Default" is defined generally as the appointment of a conservator or receiver and "in danger of default" is defined generally as the existence of certain conditions indicating that a default is likely to occur in the absence of regulatory assistance. The FDIC's claim for damages is superior to claims of shareholders of the insured depository institution or its holding company but is subordinate to claims of depositors, secured creditors and holders of subordinated debt (other than affiliates) of the commonly controlled insured depository institution. The Subsidiary Banks are subject to these cross-guarantee provisions. As a result, any loss suffered by the FDIC in respect of any of the Subsidiary Banks would likely result in assertion of the cross-guarantee provisions, the assessment of such estimated losses against the Corporation's other Subsidiary Banks and a potential loss of the Corporation's investment in such other Subsidiary Banks. FDICIA The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), which was enacted on December 19, 1991, substantially revised the depository institution regulatory and funding provisions of the FDIA and made revisions to several other federal banking statutes. Among other things, FDICIA requires the federal banking regulators to take "prompt corrective action" in respect of FDIC-insured depository institutions that do not meet minimum capital requirements. FDICIA establishes five capital tiers: "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized" and "critically undercapitalized." Under applicable regulations, an FDIC-insured depository institution is defined to be well capitalized if it maintains a Leverage ratio of at least 5%, a risk adjusted Tier 1 Capital Ratio of at least 6% and a Total Capital Ratio of at least 10% and is not subject to a directive, order or written agreement to meet and maintain specific capital levels. An insured depository institution is defined to be adequately capitalized if it meets all of its minimum capital requirements as described above. An insured depository institution will be considered undercapitalized if it fails to meet any minimum required measure, significantly undercapitalized if it has a Total Risk-Based Capital Ratio of less than 6%, a Tier 1 Risk-Based Capital Ratio of less than 3% or a Leverage Ratio of less than 3% and critically undercapitalized if it fails to maintain a level of tangible equity equal to at least 2% of total assets. An insured depository institution may be deemed to be in a capitalization category that is lower than is indicated by its actual capital position if it receives an unsatisfactory examination rating. The capital-based prompt corrective action provisions of FDICIA and their implementing regulations apply to FDIC-insured depository institutions and are not directly applicable to holding companies which control such institutions. However, the Federal Reserve Board has indicated that, in regulating bank holding companies, it will take appropriate action at the holding company level based on an assessment of the supervisory actions imposed upon subsidiary depository institutions pursuant to such provisions and regulations. FDICIA generally prohibits an FDIC-insured depository institution from making any capital distribution (including payment of dividends) or paying any management fee to its holding company if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions are subject to restrictions on borrowing from the Federal Reserve System. In addition, undercapitalized depository institutions are subject to growth limitations and are required to submit capital restoration plans. A depository institution's holding company must guarantee the capital plan, up to an amount equal to the lesser of 5% of the depository institution's assets at the time it becomes undercapitalized or the amount of the capital deficiency when the institution fails to comply with the plan for the plan to be accepted by the applicable federal regulatory authority. The federal banking agencies may not accept a capital plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the depository institution's capital. If a depository institution fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized. Significantly undercapitalized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets and cessation of receipt of deposits from correspondent banks. Critically undercapitalized depository institutions are subject to appointment of a receiver or conservator, generally within 90 days of the date on which they become critically undercapitalized. The Corporation believes that at December 31, 1993 all of the Subsidiary Banks were well capitalized under the criteria discussed above. Various other legislation, including proposals to revise the bank regulatory system and to limit the investments that a depository institution may make with insured funds, is from time to time introduced in Congress. See the "Effect of Governmental Policies" subsection. BROKERED DEPOSITS AND "PASS-THROUGH" INSURANCE The FDIC has adopted regulations under FDICIA governing the receipt of brokered deposits and pass-through insurance. Under the regulations, a bank cannot accept or rollover or renew brokered deposits unless (i) it is well capitalized or (ii) it is adequately capitalized and receives a waiver from the FDIC. A bank that cannot receive brokered deposits also cannot offer "pass-through" insurance on certain employee benefit accounts. Whether or not it has obtained such a waiver, an adequately capitalized bank may not pay an interest rate on any deposits in excess of 75 basis points over certain prevailing market rates specified by regulation. There are no such restrictions on a bank that is well capitalized. Because it believes that all the Subsidiary Banks were well capitalized as of December 31, 1993, the Corporation believes the brokered deposits regulation will have no present effect on the funding or liquidity of any of the Subsidiary Banks. FDIC INSURANCE PREMIUMS The Subsidiary Banks are required to pay semiannual FDIC deposit insurance assessments. As required by FDICIA, the FDIC adopted a risk-based premium schedule which has increased the assessment rates for most FDIC-insured depository institutions. Under the new schedule, the premiums initially range from $.23 to $.31 for every $100 of deposits. Each financial institution is assigned to one of three capital groups -- well capitalized, adequately capitalized or undercapitalized -- and further assigned to one of three subgroups within a capital group, on the basis of supervisory evaluations by the institution's primary federal and, if applicable, state supervisors and other information relevant to the institution's financial condition and the risk posed to the applicable FDIC deposit insurance fund. The actual assessment rate applicable to a particular institution will, therefore, depend in part upon the risk assessment classification so assigned to the institution by the FDIC. The FDIC is authorized by federal law to raise insurance premiums in certain circumstances. Any increase in premiums would have an adverse effect on the Subsidiary Banks' and the Corporation's earnings. Under the FDIA, insurance of deposits may be terminated by the FDIC upon a finding that the institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by a federal bank regulatory agency. DEPOSITOR PREFERENCE The Omnibus Budget Reconciliation Act of 1993 provides that deposits and certain claims for administrative expenses and employee compensation against an insured depository institution would be afforded a priority over other general unsecured claims against such an institution, including federal funds and letters of credit, in the "liquidation or other resolution" of such an institution by any receiver. Competition. The Corporation and its subsidiaries face substantial competition in all aspects of the businesses in which they engage from national and state banks located in Tennessee and large out- of-state banks as well as from savings and loan associations, credit unions, other financial institutions, consumer finance companies, trust companies, investment counseling firms, money market mutual funds, insurance companies, securities firms, mortgage banking companies and others. For information on the competitive position of the Corporation and the Bank, refer to page 1. Also, refer to the subsections entitled "Supervision and Regulation" and "Effect of Governmental Policies," both of which are relevant to an analysis of the Corporation's competitors. Due to the intense competition in the financial industry, the Corporation makes no representation that its competitive position has remained constant, nor can it predict whether its position will change in the future. Sources and Availability of Funds. Specific reference is made to the Consolidated Financial Review section, including the subsections entitled "Deposits" and "Liquidity," contained in the Corporation's 1993 Annual Report to Shareholders (the "1993 Annual Report"), which is specifically incorporated herein by reference, along with all of the tables and graphs in the 1993 Annual Report, which are identified separately in response to Item 7 of Part II of this Form 10-K, which are incorporated herein by reference. As permitted by SEC rules, attached to this Form 10-K as Exhibit 13 are only those sections of the 1993 Annual Report that have been incorporated by reference into this Form 10-K. Interest Ceiling. The maximum rates that can be charged by lenders are governed by specific state and federal laws. Most loans made by the Corporation's banking subsidiaries are subject to the limits contained in Tennessee's general usury law (the "Usury Law") or the Industrial Loan and Thrift Companies Act (the "Industrial Loan Act"), with certain categories of loans subject to other state and federal laws. The Usury Law provides for a maximum rate of interest which is the lesser of 4% above the average prime loan rate published by the Board of Governors of the Federal Reserve System or 24% per annum. The Industrial Loan Act generally provides for a maximum rate of 24% per annum plus certain additional loan charges. In addition, state statutory interest rate ceilings on most first mortgage loans on residential real estate are preempted by federal law. Also, Tennessee law permits interest on credit card balances not to exceed 21% per annum plus certain fees established by contract. Effect of Governmental Policies. The Bank is affected by the policies of regulatory authorities, including the Federal Reserve System and the Comptroller. An important function of the Federal Reserve System is to regulate the national money supply. Among the instruments of monetary policy used by the Federal Reserve are: purchases and sales of U.S. Government securities in the marketplace; changes in the discount rate, which is the rate any depository institution must pay to borrow from the Federal Reserve; and changes in the reserve requirements of depository institutions. These instruments are effective in influencing economic and monetary growth, interest rate levels and inflation. The monetary policies of the Federal Reserve System and other governmental policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. Because of changing conditions in the national economy and in the money market, as well as the result of actions by monetary and fiscal authorities, it is not possible to predict with certainty future changes in interest rates, deposit levels, loan demand or the business and earnings of the Corporation and the Bank or whether the changing economic conditions will have a positive or negative effect on operations and earnings. Bills are pending before the United States Congress and the Tennessee General Assembly which could affect the business of the Corporation and its subsidiaries, and there are indications that other similar bills may be introduced in the future. It cannot be predicted whether or in what form any of these proposals will be adopted or the extent to which the business of the Corporation and its subsidiaries may be affected thereby. Statistical Information Required by Guide 3. The statistical information required to be displayed under Item I pursuant to Guide 3, "Statistical Disclosure by Bank Holding Companies," of the Exchange Act Industry Guides is incorporated herein by reference to the Consolidated Financial Statements and the notes thereto and the Consolidated Financial Review Section in the 1993 Annual Report along with all of the tables and graphs identified in response to Item 7 of Part II of this Form 10-K; certain information not contained in the Annual Report, but required by Guide 3, is contained in the tables on the immediately following pages: FIRST TENNESSEE NATIONAL CORPORATION ADDITIONAL GUIDE 3 STATISTICAL INFORMATION BALANCES AT DECEMBER 31 (Thousands) (Unaudited) FOREIGN OUTSTANDINGS AT DECEMBER 31 MATURITIES OF SHORT-TERM PURCHASED FUNDS AT DECEMBER 31, 1993 ITEM 2

ITEM 2 PROPERTIES The Corporation has no properties that it considers materially important to its financial statements. ITEM 3

ITEM 3 LEGAL PROCEEDINGS The Corporation is a party to no material pending legal proceedings the nature of which are required to be disclosed pursuant to the Instructions contained in the Form of this Report. ITEM 4

ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted during the fourth quarter of this fiscal year to a vote of security holders, through the solicitation of proxies or otherwise. ITEM 4A EXECUTIVE OFFICERS OF REGISTRANT The following is a list of executive officers of the Corporation as of March 1, 1994. Officers are elected for a term of one year and until their successors are elected and qualified. Each of the executive officers has been employed by the Corporation or its subsidiaries during each of the last five years. Mr. Terry was President of the Corporation prior to August 1991. Mr. Horn was Vice Chairman of the Bank from August 1991 through January 1993. Prior to August 1991, Mr. Horn was Executive Vice President of the Bank and Manager of its Bond Division. Mr. Glass was Executive Vice President of the Bank and Tennessee Banking Group Manager prior to January 1993. Mr. Kelley was Executive Vice President of the Bank and Corporate Services Group Manager prior to January of 1993. Mr. Keen was Controller of the Bank prior to January 1993. Prior to October 1990, Mr. Johnson was a Senior Vice President of the Corporation and the Bank. Prior to October 1989, Mr. Vezina was a Senior Vice President of the Corporation and the Bank. PART II ITEM 5

ITEM 5 MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Corporation's common stock, $2.50 par value, trades over-the-counter on the National Association of Securities Dealers Automated Quotation System -- National Market System under the symbol FTEN. As of December 31, 1993, there were 7,893 shareholders of record of the Corporation's common stock. Generally, quarterly dividend payments are made on the first day of January, April, July and October. The Corporation has declared the following respective quarterly dividends per share during each quarter, commencing with first quarter 1992: $.28, $.28, $.28, $.36, $.36, $.36, $.36, and $.42. Additional information called for by this Item is incorporated herein by reference to the Summary of Quarterly Financial Information Table, the Selected Financial Data Table, Note 16 to the Consolidated Financial Statements, and the Liquidity subsection of the Consolidated Financial Review section in the 1993 Annual Report and to The Payment of Dividends subsection contained in Item 1 of Part I of this Form 10-K, which is incorporated herein by reference. ITEM 6

ITEM 6 SELECTED FINANCIAL DATA The information called for by this Item is incorporated herein by reference to Selected Financial Data Table in the 1993 Annual Report. ITEM 7

ITEM 7 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION The information called for by this Item is incorporated herein by reference to Consolidated Financial Review Section in the 1993 Annual Report and the following tables and graphs in the 1993 Annual Report: GRAPHS: - ------- Return on Average Equity Return on Average Assets Earnings Per Share Earnings Trend Net Interest Margin and Spread Profitability Per Employee Earning Asset Mix as a Percentage of Average Assets Average Loan Composition Deposits and Other Interest-Bearing Liabilities as a Percentage of Average Assets Net Charge-Offs Nonperforming Loans Nonperforming Assets to Total Loans Cumulative Changes in Nonaccrual Loans and Other Real Estate since Year-End 1988 (Quarterly) Cumulative Changes in Classified Assets Since Year-End 1988 (Quarterly) TABLES: - ------- Analysis of Changes in Net Interest Income Analysis of Noninterest Income and Noninterest Expense Summary of Quarterly Financial Information Rate Sensitivity Analysis at December 31, 1993 Maturities of Investment Securities at December 31, 1993 Maturities of Loans at December 31, 1993 Consumer Loans by Product at December 31 Regulatory Capital at December 31 Net Loans and Foreclosed Real Estate at December 31 FTBNA Loans Secured by Real Estate at December 31 Analysis of Allowance for Loan Losses Changes in Nonperforming Assets at December 31 Nonperforming Assets at December 31 Selected Financial Data Credit Ratings at December 31,1993 Net-Charge Offs as a Percentage of Average Loans, Net of Unearned Income Obligations of States and Municipalities by Quality Rating at December 31, 1993 Consolidated Average Balance Sheet and Related Yields and Rates ITEM 8

ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information called for by this Item is incorporated herein by reference to Consolidated Financial Statements and the notes there to and to the Summary of Quarterly Financial Information Table. ITEM 9

ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE The information called for by this Item is inapplicable. PART III ITEM 10

ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information called for by this Item as it relates to directors and nominees for director of the Corporation is incorporated herein by reference to the "Election of Directors" section of the Corporation's Proxy Statement to be mailed to shareholders in connection with the Corporation's Annual Meeting of Shareholders scheduled for April 19, 1994, (the "1994 Proxy Statement"), which will be filed by amendment to this Form 10-K, pursuant to General Instruction G(3) to such form. The information required by this Item as it relates to executive officers of the Corporation is incorporated herein by reference to Item 4A in Part I of this Report. The information required by this Item as it relates to compliance with Section 16(a) of the Securities Exchange Act of 1934 is incorporated herein by reference to the "Compliance with Section 16(a) of the Exchange Act" Section of the 1994 Proxy Statement. ITEM 11

ITEM 11 EXECUTIVE COMPENSATION The information called for by this Item is incorporated herein by reference to the "Executive Compensation" section of the 1994 Proxy Statement (excluding the Board Compensation Committee Report and the Total Shareholder Return Performance Graph). ITEM 12

ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information called for by this Item is incorporated herein by reference to the Stock Ownership Table and the two paragraphs preceding the table in the 1994 Proxy Statement. The Corporation is unaware of any arrangements which may result in a change in control of the Corporation. ITEM 13

ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information called for by this Item is incorporated herein by reference to the "Certain Relationships and Related Transactions" section of the 1994 Proxy Statement. PART IV ITEM 14

ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) The following documents are filed as a part of this Report: Financial Statements: The consolidated financial statements of the Corporation, and the notes thereto, for the three years ended December 31, 1993, in the 1993 Annual Report, are incorporated herein by reference. The Report of Independent Public Accountants, in the 1993 Annual Report, is incorporated herein by reference. The report of the other auditors referenced in the Report of Independent Public Accountants, attached hereto as Exhibit 99(b), is incorporated herein by reference. Financial Statement Schedules: Not applicable. Exhibits: (2) Stock Purchase Agreement dated as of August 19, 1993, by and between the Bank and MNC Financial, Inc. (3)(i) Restated Charter of the Corporation, as amended, attached as Exhibit 3(a) to Corporation's 1991 Annual Report on Form 10-K and incorporated herein by reference. (3)(ii) Bylaws of the Corporation, as amended. (4)(a) Shareholder Protection Rights Agreement, dated as of 9-7-89 between the Corporation and First Tennessee Bank National Association, as Rights Agent, including as Exhibit A the forms of Rights Certificate and of Election to Exercise and as Exhibit B the form of Charter Amendment designating a series of Participating Preferred Stock of the Corporation with terms as specified, attached as an exhibit to the Corporation's Registration Statement on Form 8-A filed 9-8-89, and incorporated herein by reference. (4)(b) Indenture, dated as of 6-1-87, between the Corporation and Security Pacific National Trust Company (New York), Trustee, attached as an exhibit to the Corporation's Annual Report on Form 10-K for the year ended 12-31-91, and incorporated herein by reference. (4)(c) The Corporation and certain of its consolidated subsidiaries have outstanding certain long-term debt. See Note 13 in the Corporation's 1993 Annual Report to Shareholders. None of such debt exceeds 10% of the total assets of the Corporation and its consolidated subsidiaries. Thus, copies of constituent instruments defining the rights of holders of such debt are not required to be included as exhibits. The Corporation agrees to furnish copies of such instruments to the Securities and Exchange Commission upon request. *(1O)(a) Management Incentive Plan, as amended.(1) *(1O)(b) 1983 Restricted Stock Incentive Plan, as amended.(1) *(1O)(c) 1989 Restricted Stock Incentive Plan, as amended.(1) *(1O)(d) 1992 Restricted Stock Incentive Plan.(1) *(10)(e) 1984 Stock Option Plan, as amended.(1) *(1O)(f) 1990 Stock Option Plan, as amended.(1) *(1O)(g) Survivor Benefits Plan, as amended.(1) *(1O)(h) Directors and Executives Deferred Compensation Plan, as amended.(1) *(1O)(i) Pension Restoration Plan.(2) *(1O)(j) Director Deferral Agreements with Schedule.(2) *(10)(k) Severance Agreements dated 12-15-92 with schedule.(2) (11) Statement re: computation of per share earnings. (13) The portions of the 1993 Annual Report to Shareholders which have been incorporated by reference into this Form 10-K. (21) Subsidiaries of the Corporation. (24) Power of Attorney (99)(a) Annual Report on Form ll-K for the Corporation's Savings Plan and Trust, for fiscal year ended 12- 31-93, as authorized by SEC Rule 15d-21 (to be filed as an amendment to Form lO-K). (99)(b) Report of other auditors. *Exhibits marked with an "*" represent management contract or compensatory plan or arrangement required to be filed as an exhibit. (1) These documents are incorporated herein by reference to the exhibit with the corresponding number contained in the Corporation's 1992 Annual Report on Form 10-K. (2) These documents are incorporated herein by reference to exhibits 10(j), 10(k), and 10(l), respectively, contained in the Corporation's 1992 Annual Report on Form 10-K. (b) A report on Form 8-K was filed on October 18, 1993 (with a date of report of October 1, 1993), disclosing under Item 2 ("Acquisition or Disposition of Assets") the closing of the acquisition of MNMC by the Bank. The report contained audited MNMC consolidated financial statements of financial condition as of 12-31-92 and 12-31-91, and statements of income, statements of changes in stockholders' equity, and statements of cash flows, each for the years ended 12-31-92 and 12-31-91 and contained FTNC pro forma combined condensed statement of condition as of 6-30-93, statements of income for the six months ended 6-30-93 and statements of income for the year ended 12-31-92. Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 7th day of March, 1994. FIRST TENNESSEE NATIONAL CORPORATION By: James F. Keen ------------------------------------- James F. Keen, Senior Vice President and Controller Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. EXHIBIT INDEX *Exhibits marked with an "*" represent management contract or compensatory plan or arrangement required to be filed as an exhibit. (1) These documents are incorporated herein by reference to the exhibit with the corresponding number contained in the Corporation's 1992 Annual Report on Form 10-K. (2) These documents are incorporated herein by reference to exhibits 10(j), 10(k), and 10(l), respectively, contained in the Corporation's 1992 Annual Report on Form 10-K.

799036_1993.txt

799036

1993

Item 1. Business GENERAL The Company, through its subsidiaries, provides health and life insurance underwriting, marketing and managed healthcare services throughout the nation. In 1993 the Company was organized into three Business Divisions: Insurance (Life & Health Units), Marketing and Managed Care. The Divisions were designed to allow management to focus on the specific needs, problems, customers and opportunities in each business area. The Health Unit of the Insurance Division underwrites small group and individual major hospital and medical policies, Medicare supplement, home health care and other specialty products. Medicare supplement insurance, which the Company began offering in 1966 at the inception of the federal Medicare program, accounted for approximately 33% of the Company's health insurance premiums written in 1993. Major hospital insurance plans designed for small business owners and self-employed individuals accounted for approximately 59% of the Company's health insurance premiums written in 1993. The Life Unit underwrites term life, interest sensitive life, universal life, and annuities. In 1990 the Company acquired Manhattan National Life Insurance Company, which has now become the Company's major life and annuity subsidiary. Manhattan National Life's products are distributed primarily through 8,000 brokers throughout the nation. In 1992 all life and annuity administration was consolidated at this subsidiary to enhance efficiency and service. The Marketing Division provides insurance and non-insurance marketing services for insurance companies, associations and financial institutions. The Division operates through four distribution channels: a nationwide network of approximately 1,500 career agents market insurance products to self-employed individuals and small business owners. Senior insurance products are marketed through nearly 15,000 independent agents. A network of 8,000 brokers sells life and annuity products. In 1993 the Company acquired Continental Marketing Corp. which provided a telemarketing system marketing products directly to 8,000 brokers throughout the nation. The Marketing Division markets the Company's insurance products as well as insurance products of other unaffiliated companies. This allows the Company to derive revenue in territories where it is not licensed and to distribute policies not otherwise offered by the Company. The Marketing Division also includes a non-insurance unit which primarily designs benefit packages and provides membership management services to associations across the nation. This unit also provides an emergency air ambulance service for members of associations it manages. The Managed Care Division provides healthcare coordination to control medical expense costs for insurance companies, government agencies, self- insured businesses, unions, HMO's and third-party administrators. Services include pre certification of care, provider networks and case management. In early 1990 the Company acquired National Health Services, Inc. to provide these types of services for its own subsidiaries as well as unaffiliated companies and organizations. In 1993 the Company acquired Healthcare Review Corporation which provides service primarily to government agencies. The Company was organized in Delaware in 1982 as a successor to an Illinois holding company formed in 1957. The Company's largest operating insurance subsidiary is Pioneer Life Insurance Company of Illinois (Pioneer Life), a successor to a company organized in 1926. Health and Life Insurance Company of America, National Group Life Insurance Company, Manhattan National Life Insurance Company and Continental Life & Accident Company were acquired in 1985, 1986, 1990 and 1993, respectively, primarily for specialized marketing purposes. In 1993 the Company relocated its corporate offices from Rockford, Illinois to Schaumburg, Illinois. The executive offices of the Company are now located at 1750 East Golf Road, Schaumburg, Illinois 60173 and its telephone number is (708) 995-0400. The term "Company" refers to Pioneer Financial Services, Inc. (PFS) and, unless the context otherwise requires, its subsidiaries. Information on revenue and income by Business Division is set forth in Note 19 of the Notes to Consolidated Financial Statements. PRODUCTS Health Insurance Unit The Company's accident and health insurance products, all of which are individually underwritten and issued, include Medicare supplement insurance, major hospital insurance plans, medical/hospital supplement insurance, long term care, home health care and various specialty health coverages. Medicare supplement insurance provides coverage for certain hospital and other medical costs not covered by the Medicare program. Major hospital insurance plans, which are offered on a group trust and association basis as well as on an individual basis, provide coverage for specified hospital costs. Medical/hospital supplemental policies provide coverage for hospital, medical and surgical costs within various prescribed policy deductible and benefit limits. Long term care policies provide coverage for nursing home expenses and other extended care situations. Home health care policies provide coverage for extended in-home medical care. The Company's specialty health products include supplemental medical/surgical plans. Product development efforts have generated new versions of these products as market needs have changed. The Company may adjust premium rates by class, policy form and state in which the policy is issued in order to maintain anticipated loss ratios. Since premium rate adjustments can have the tendency to increase policy lapses, conservation and customer service activities are emphasized. As a result, the Company successfully avoided any significant increases in policy lapses in either the small business or senior divisions. The Health Insurance unit also has a distinct department to focus solely on premium rate adjustments. This proactive approach involves strict scrutiny of all health premium rates on a monthly basis. The matching of pricing structure with actual claims experience varies by product line and state. This ongoing analysis provides the time basis necessary for orderly adjustment of premiums. The Company's loss ratios have varied over the years reflecting changes in medical claim costs and the frequency of benefit utilization by its insureds. The following table sets forth the earned premiums, losses and loss adjustment expenses incurred and loss ratios for the Company's accident and health business. Earned premiums reflect written premiums adjusted for reinsurance and changes in unearned premiums. In the Company's statement of consolidated operations, premiums represent premiums written, adjusted for reinsurance; the changes in unearned premiums are reflected in benefits, together with losses and loss adjustment expenses. Losses and loss adjustment expenses include losses incurred on insurance policies and the expenses of settling insurance claims, including legal and other related fees and expenses. Year Ended December 31, 1993 1992 1991 1990 1989 (Dollars in thousands) Medicare Supplement Earned premiums . . . . . $199,333 $211,756 $233,033 $197,771$146,707 Losses and loss adjustment expenses . . . . . . . 126,300 143,181 159,423 136,093 93,809 Loss ratio . . . . . . . 63% 68% 68% 69% 64% Medical/Hospital Supplement Earned premiums . . . . . $ 9,410 $11,706 $ 15,725 $ 9,281$ 6,796 Losses and loss adjustment expenses . . . . . . . 7,140 9,865 12,757 6,025 4,361 Loss ratio . . . . . . . 76% 84% 81% 65% 64% Major Hospital Earned premiums . . . . . $375,275 $302,881 $294,431 $234,004$124,744 Losses and loss adjustment expenses . . . . . . . 251,955 200,781 176,222 168,939 61,951 Loss ratio . . . . . . . 67% 66% 60% 72% 50% Specialty Health Earned premiums . . . . . $34,739 $41,235 $ 49,895 $ 42,357$ 30,747 Losses and loss adjustment expenses . . . . . . . 21,121 23,103 28,266 31,189 14,088 Loss ratio . . . . . . . 61% 56% 57% 74% 46% Total Accident and Health Earned premiums . . . . . $618,757 $567,578 $593,084 $483,413$308,994 Losses and loss adjustment expenses . . . . . . . $406,516 $376,930 376,668 342,246 174,209 Loss ratio . . . . . . . 66% 66% 64% 71% 56% Medicare Supplement. Since the inception of the Medicare program in 1966, the Company has offered policies designed to supplement Medicare benefits. Such policies accounted for approximately 39% of health insurance premiums in 1991, approximately 37% of health premiums in 1992, and approximately 33% of health premiums in 1993. These policies provide payment for deductibles and the excess over maximum limits of the federal Medicare program. Under these policies, annual premiums are increased if policy benefits increase as a result of changes in Medicare coverage. In 1991 the National Association of Insurance Commissioners (NAIC) defined 10 model Medicare supplement policies. In states which have adopted the NAIC model, only those 10 policies can be sold. In anticipation of state actions, the Company in 1991 developed 8 of the 10 model policies -- those which the Company believes are most applicable to the Company's market. This regulation, along with mandated changes to agent commissions, resulted in marketing changes. By July 1992 all states were required to have adopted the NAIC model or similar legislation which specifically defines policy models. It is not possible to predict the impact which any future Medicare legislation may have on the Company's Medicare supplement business. Medical/Hospital Supplement. The Company offers medical/hospital policies which provide limited supplemental benefits for hospital, surgical and medical expenses on either an individual or a family basis. Generally, these policies are automatically renewable at the option of the policyholder, but the Company has the right to adjust premium rates on a class basis. Policy benefits are limited to a specified aggregate amount for all covered expenses. These policies generally provide a fixed benefit for each day of hospitalization, a limited fee schedule for surgical benefits and a limited amount payable for miscellaneous expenses depending upon the length of hospital stay. Major Hospital. The Company offers major hospital insurance plans on an individual basis and on a group trust and association basis and has issued master policies for such plans to several trusts and associations. These plans, which are individually underwritten, are designed to cover in- hospital expenses for small business owners, self employed individuals, employees and their families. Hospital, surgical and other medical expenses are covered on an expense incurred basis with certain benefit limits after a prescribed deductible. Some plans offer a "reducing deductible" which provides for the lowering of the deductible if no claims are filed over a number of consecutive years. The Company has more recently introduced new products with benefit alternatives such as increased deductibles and different benefit structures designed to enable policyholders to maintain insurance protection without increased premium rates. In 1991 the Company introduced a new line of products called Design Benefit Plans which provide greater flexibility of benefit structure for policyholders. In December of 1991, the NAIC adopted the Small Employers Availability Act ("Act"). This act affects the rating and underwriting methodology that can be applied to insurance coverage sold to small employers, generally categorized as those employing 25 people or less. The Company does not anticipate this Act will have a material impact on its existing business. In response to the Act, the Company has modified its new products for sale in those states adopting the Act. Specialty Health. The Company offers various specialty health products which typically are sold in conjunction with the Company's principal accident and health products. Policies include hospital indemnity, cancer and short-term disability plans, as well as fixed dollar per diem payments for long-term convalescent care. The Company also offers a short-term major medical policy which provides coverage for a limited period of time. This policy is designed for recent school graduates, individuals between jobs, and others with short term needs. The policy does not cover any pre-existing conditions. The Company also offers long term care and home health care products designed principally for senior citizens. Long term care policies generally provide specified per day benefits for nursing home confinements. Home health care policies provide specified per day benefits for medically necessary health services received in the home and may include benefits for adult day care facility services. The Company also offers comprehensive long term care coverages which provide benefits for all levels of nursing home care, home health care and adult day care. Life Insurance Unit Substantially all of the Company's life insurance policies and annuities are individually and medically underwritten and issued, other than small accidental death benefit policies, which are not material to the Company. The following table sets forth the breakdown of premiums collected (including receipts not related to policy charges) among traditional life policies, interest-sensitive and universal life policies and annuities for the periods shown: Year Ended December 31, 1993 1992 1991 Amount Percent Amount Percent Amount Percent (Dollars in thousands) Traditional . . . . . $26,353 50 $20,300 45 $17,968 34 Interest-Sensitive & Universal Life. . 16,300 31 18,399 41 20,676 40 Annuities . . . . . . 10,004 19 6,212 14 13,479 26 Total . . . . . . . $52,657 100 $44,911 100 $52,123 100 For 1991, premiums collected from the Company's life insurance products were approximately 26% first year and 74% renewal, for 1992 approximately 27% were first year and 73% renewal, and for 1993 premiums collected were approximately 24% first year and 76% renewal. Traditional policy types accounted for 52%, 49% and 59% of the renewal premiums in the years 1991, 1992 and 1993, respectively. The Company's gross life insurance in force was as follows at the dates shown: December 31, 1993 1992 1991 (Dollars in millions) Traditional policies . . . . . . $10,320 $ 8,757 $ 7,507 Interest-sensitive and universal life policies . . . . . . . . 1,503 1,582 1,634 Total . . . . . . . . . . $11,823 $10,339 $ 9,141 Interest-Sensitive and Universal Life. The Company's interest- sensitive and universal life insurance provide whole life insurance with rates of return which are adjusted in relation to prevailing interest rates. The policies permit the Company to change the rate of interest credited to the policy from time to time. The Company offers single premium policies which provide for payment of the entire premium at time of issuance, and also offers multiple premium policies, including universal life. Universal life insurance products credit current interest rates to cash value accumulations, permit adjustments in benefits and premiums at the policyholder's option, and deduct mortality and expense charges monthly. Under other interest-sensitive policies, premiums are flexible, allowing the policyholders to vary the frequency and amount of premium payments, but typically death benefit changes may not be made by the policyholders. Some universal life products offer lower premiums for non- smokers in good health. For both universal life and other interest- sensitive policies, surrender charges are deducted from the policyholder's account value, if any. No surrender charges are deducted if death benefits are paid or if the policy remains in force for a specified period. Traditional Life. The traditional life insurance sold by the Company has consisted almost entirely of modified premium whole life policies, which provide permanent coverage with payments of higher premiums in early years than in subsequent years. These policies provide for cash values which are relatively insignificant in early years and gradually increase over the life of the policy. Modified premium whole life policies have frequently been sold in conjunction with annuity riders which supplement the accumulated cash values. Manhattan National Life offers a variety of non-participating individual life insurance policies, including universal, term and traditional whole life products. Manhattan National Life does not offer group life insurance. For a number of years, Manhattan National Life has offered individually underwritten insurance on the lives of persons who, to varying degrees, do not meet the requirements of standard insurability. Higher premiums are charged for these "impaired" or "substandard" lives and, where the amount of insurance is large or the risk is significant, a portion of the risk is reinsured. Annuities. The Company's single and flexible premium deferred annuities are offered to individuals. An annuity contract generally involves the accumulation of premiums at a compound interest rate until the maturity date, at which time the policyholder can choose one of the various payment options. Options include periodic payments during the annuitant's lifetime or the lifetimes of the annuitant and spouse, with or without a guaranteed minimum period; periodic payments for a fixed period regardless of the survival of the annuitant; or lump sum cash payment of the accumulated value. The Company's annuities typically provide for the crediting of interest at rates set from time to time by the Company. Marketing Division The Company's Marketing Division includes two units: insurance and non-insurance. Insurance Unit. This unit markets products to self-employed individuals and small employers through a nationwide network of over 1,500 career agents. Products include catastrophic hospital and major medical expense plans, multiple employer trusts, group and individual dental programs, managed care programs and a variety of supplemental products for tax favored (Section 125 and 401(k)) use. The division markets life and annuity products through approximately 8,000 brokers nationwide. In 1993 the Company acquired Continental Marketing Corporation, which provided a new distribution system - a telemarketing organization which markets products directly to 8,000 brokers throughout the nation. The Marketing Division also operates its own telemarketing lead generation company for both the self-employed and senior markets. An established independent brokerage network of nearly 15,000 insurance brokers throughout the nation sells health insurance products to senior Americans. Products include Medicare supplement, home health care, long term care, cancer coverage, life and annuities. Some of these products are underwritten by PFS insurance companies; others are underwritten by non-affiliated carriers. Non-Insurance Unit. This division designs benefit packages and provides membership management services to associations across the nation. Benefit packages include group discounts on eyewear, pharmaceuticals, hearing aids, travel, legal and other services. Membership services can range from recruitment campaigns to periodic billing and other administrative services. This unit also provides an emergency air ambulance service for the members of associations it manages. Marketing Subsidiaries Design Benefit Plans. The Company's group trust and association major hospital plans for small business owners are marketed through Design Benefit Plans, a subsidiary of National Benefit Plans, which contracts with approximately 1,500 agents and managers who operate exclusively on behalf of the organization through approximately 70 regional offices. The marketing organization is responsible for recruiting, training and supervising these agents. Policies issued under these plans are individually underwritten and issued by the Company at its regional service center in the Dallas, Texas metropolitan area. For 1991, 1992 and 1993, marketing efforts to small businesses produced approximately $288,040,000, $297,734,000, and $354,427,000 respectively, of the Company's written premiums, almost all attributable to accident and health products. Through this marketing organization, the Company has recently entered into agreements with several other insurance companies to market certain coverages which are designed to expand its product lines and marketing territories. These products include large group plans (up to 99 lives), disability income, and tax-deferred annuities. The Company has an established telemarketing subsidiary with facilities in Phoenix, Arizona, and Arlington, Texas. Currently, these facilities, together with the Company's direct mail activity, provide approximately 18,000 qualified leads a week to this division. The Senior Brokerage offers products to the senior market. Currently there are approximately 15,000 brokers associated with this unit. Major products include Medicare Supplement, Long Term Care and Home Health Care, as well as life and annuity products specifically designed for seniors. Continental Marketing. With the 1993 acquisition of Continental Marketing Corporation (CMC), the Marketing Division added its fourth distribution system. CMC conducts telemarketing at the brokerage-producer level by providing product and market support. In addition to taking on this new distribution system, the Company is expanding the portfolio available to this group of producers. Managed Care Division The Managed Care Division of the Company provides health care coordination to control costs for government agencies, self-insured businesses, insurance companies, unions, HMO's and third-party administrators. Major services provided include pre certification of care, utilization review, preferred or exclusive provider networks (PPOs, EPOs, and HMOs), large case management, risk management and occupational medical management. The Managed Care Division generated substantial claims savings for the Company's insurance subsidiaries in 1993. These savings primarily were passed on to policyholders in the form of lower premium rate adjustments. In 1992 the division began to expand its product line, to include additional products which meet the needs of small employers. These occupational medical programs include specific management of worker's compensation cases to lower employer medical costs and return the employee to the workplace more quickly. The division has also continued to expand its PPO (preferred provider organization) network which is available to clients on a fee dependent on savings achieved. By expanding the network, it becomes even more attractive and more marketable to additional companies and organizations. A new EPO (exclusive provider organization) was also successfully test marketed late in 1992. The EPO was attached to a major medical insurance policy underwritten by a health insurance subsidiary of the Company. The EPO was used to reduce the insurance premiums on the policy by taking advantage of lower negotiated medical expense rates with the exclusive provider. Premium Distribution The Company's insurance subsidiaries collectively are licensed to sell insurance in 49 states and the District of Columbia. The importance to the Company of particular states may vary over time as the composition of its agency network changes. The geographic distribution of collected premiums (before reinsurance) of the Company's subsidiaries in 1993 was as follows: Total Percent (Dollars in thousands) Florida $69,985 10.4 California 67,391 10.0 Texas 64,279 9.5 Illinois 51,436 7.6 North Carolina 28,925 4.3 Ohio 22,532 3.3 Georgia 21,619 3.2 Missouri 20,256 3.0 Other (1) 327,752 48.7 Total $674,175 100.0 (1) Includes 41 other states, the District of Columbia, and certain U.S. territories and foreign countries, each of which account for less than 3% of collected premiums. UNDERWRITING Substantially all of the Company's insurance coverages are individually underwritten to assure that policies are issued by the Company's insurance subsidiaries based upon the underwriting standards and practices established by the Company. Applications for insurance are reviewed to determine if any additional information is required to make an underwriting decision, which depends on the amount of insurance applied for and the applicant's age and medical history. Such additional information may include medical examinations, statements from doctors who have treated the applicant in the past and, where indicated, special medical tests. If deemed necessary, the Company uses investigative services to supplement and substantiate information. For certain coverages, the Company may verify information with the applicant by telephone. After reviewing the information collected, the Company either issues the policy as applied for, issues the policy with an extra premium charge due to unfavorable factors, issues the policy excluding benefits for certain conditions for a period of time or rejects the application. For certain of its coverages, the Company has adopted simplified policy issue procedures in which the applicant submits a simple application for coverage typically containing only a few health related questions instead of a complete medical history. In common with other life and health insurance companies, the Company may be exposed to the risk of claims based on AIDS. The Company's AIDS claims to date have been insignificant. Because of its emphasis on policies written for the senior citizen market and its underwriting procedures and selection processes, the Company believes its risk of AIDS claims is less than the risk to the industry in general. REINSURANCE The Company's insurance subsidiaries reinsure portions of the coverages provided by their insurance products with other insurance companies on both an excess of loss and co-insurance basis. Co-insurance generally transfers a fixed percentage of the Company's risk on specified coverages to the reinsurer. Excess of loss insurance generally transfers the Company's risk on coverages above a specified retained amount. Under its excess of loss reinsurance agreements, the maximum risk retained by the Company on one individual in the case of life insurance is $100,000 ($250,000 in the case of Manhattan National Life) and in the case of accident and health insurance is $250,000. Reinsurance agreements are intended to limit an insurer's maximum loss on the specified coverages. The ceding of reinsurance does not discharge the primary liability of the original insurer to the insured, but it is the practice of insurers (subject to certain limitations of state insurance statutes) to account for risks which have been reinsured with other approved companies, to the extent of the reinsurance, as though they are not risks for which the original insurer is liable. See Note 5 of Notes to Consolidated Financial Statements. The Company has occasionally used assumption reinsurance to acquire blocks of business from other insurers. In addition, the Company has from time to time entered into agreements to assume certain insurance business from companies for which it is marketing insurance products. The Company intends to continue these programs if they assist in expanding product lines and marketing territories. INVESTMENTS Investment income represents a significant portion of the Company's total revenues. Insurance company investments are subject to state insurance laws and regulations which limit the types and concentration of investments. The following table provides information on the Company's investments as of the dates indicated. December 31, 1993 1992 Amount % Amount % (Dollars in thousands) Fixed maturities to be held to maturity: U.S. Treasury $ 9,124 1% $ 15,363 3% States and political subdivisions 5,200 1 199 - Corporate securities 119,276 18 98,836 17 Mortgage-backed securities 192,912 29 320,328 56 Total fixed maturities to be held to maturity 326,512 49 434,726 76 Fixed maturities available for sale: U.S. Treasury 26,894 4 1,425 - States and political subdivisions 21,571 3 - - Foreign governments 4,056 1 - - Corporate securities 73,981 11 6,343 2 Mortgage-backed securities 131,215 19 30,983 6 Total fixed maturities available for sale 257,717 38 38,751 8 Equity securities........... 17,436 3 19,537 3 Mortgage and policy loans... 27,189 4 21,969 4 Short-term investments...... 45,352 6 53,366 9 Total Investments...... $674,206 100% $568,349 100% At December 31, 1993, the average expected term of the Company's fixed maturity investments was approximately six years. The results of the investment portfolio for the periods shown were as follows: Year Ended December 31, 1993 1992 1991 (Dollars in thousands) Average month-end investments . $592,546 $549,643 $532,336 Net investment income . . . . . 40,242 43,555 47,974 Average annualized yield on investments (1) . . . . . . . 6.8% 7.9% 9.0% Realized investment gains/ (losses) (2) . . . . . . . . . $(1,336) $ (47) $ 7,189 (1) Not computed on a taxable equivalent basis. Includes interest income paid or accrued on debt securities and loans and dividends on equity securities. (2) See Note 3 of Notes to Consolidated Financial Statements for information on unrealized appreciation on investments. The Company's investment policy is to balance its portfolio between long-term and short-term investments so as to achieve investment returns consistent with preservation of capital and maintenance of liquidity adequate to meet payment of policy benefits and claims. Current policy is to invest primarily in fixed income securities of the U.S. government and its agencies and authorities, and in fixed income corporate securities with investment grade ratings of Baa or better. At December 31, 1993, less than 1% of the Company's total investment portfolio was below investment grade or unrated. The Company intends to invest no more than 5% of its total invested assets in securities below investment grade. At December 31, 1993, approximately 2% of the Company's total investment portfolio were mortgage-backed derivative securities. The significant decline in interest rates during 1992 and 1993 caused the value of these securities to deteriorate. The Company has partially written-down the carrying value of these securities in 1992 and 1993. This write-down was generally offset by realized gains on the remaining portfolio. POLICY LIABILITIES The Company records reserves for future policy benefits to meet future obligations under outstanding policies. These reserves are amounts which are calculated to be sufficient to meet policy and contract obligations as they mature. The amount of reserves for insurance policies is calculated using assumptions for interest, mortality and morbidity, expenses and withdrawals. Reserves are established at the time the policy is issued and adjusted periodically based on reported and unreported claims or other information. See Note 1 of Notes to Consolidated Financial Statements. COMPETITION The insurance business is highly competitive and includes a large number of insurance companies, many of which have substantially greater financial resources and larger and more experienced staffs than the Company. The Company competes with other insurers to attract and retain the allegiance of its independent agents and marketing organizations who at this time are responsible for most of the Company's premiums. Methods of competing for agents are described under "Marketing." Methods of competition include the Company's ability to offer competitive products and to service these programs efficiently. Other competitive factors applicable to the Company's business include policy benefits, service to policyholders and premium rates. HEALTHCARE REFORM The Company expects that a federal healthcare "reform" program will be passed by Congress and will be implemented over the remainder of the decade. It is most likely to include most of the following in some form: universal access, minimum mandated benefits, coverage for pre-existing conditions and guaranteed portability. The Company's insurance subsidiaries have already adapted to state small group healthcare reform programs by making the necessary adjustments in our products and marketing structure. The Company also expects to adapt and adjust to a federal reform program in much the same way. The best-case "reform" scenario for the Company would be mandated workplace medical coverage--required either of individuals or employers-- while retaining the current free market system and wide choices for consumers. This would increase the market by over 30 million and allow the Company to continue our current distribution system. The worst-case scenario would be the elimination of current indemnity "fee-for-service" medical policies for small groups by any but a handful of insurance companies. This oligopoly would eliminate a major health insurance market and revenue source for the Company. As a result, we are now placing a major concentration on growth in supplemental and senior health insurance and life insurance and annuities. These areas are not likely to be adversely impacted by any of the reform programs currently proposed. If federal healthcare reforms are enacted that eliminate indemnity "fee-for-service" health plans or limit our ability to adjust premium rates (price controls), there could be a significant impact on our deferred policy acquisition costs (DAC) on our small group major medical business which represents approximately one-third of our DAC asset and is significantly offset by benefit reserves. The larger part of our DAC asset is in our senior health, life and annuity products, which should not be impacted by healthcare reform. With federal healthcare reform, there could be a material increase in the rate of amortization of DAC in the future for our small employer medical insurance. While the Company must consider alternative actions for worst case scenarios, we are optimistic that the final compromise reform legislation will not have this type of impact on our business. GOVERNMENT REGULATION In common with all domestic insurance companies, the Company's insurance subsidiaries are subject to regulation and supervision in the jurisdictions in which they do business under statutes which typically delegate regulatory, supervisory and administrative powers to state insurance commissions. The method of such regulation varies, but regulation relates generally to the licensing of insurers and their agents, the nature of and limitations on investments, approval of policy forms, reserve requirements, the standards of solvency which must be met and maintained, deposits of securities for the benefit of policyholders, periodic examination of insurers, and trade practices, among other things. The Company's accident and health coverages generally are subject to rate regulation by state insurance commissions which in certain cases require that certain minimum loss ratios be maintained. Certain states also have insurance holding company laws which require registration and periodic reporting by insurance companies controlled by other corporations licensed to transact business within their respective jurisdictions. The Company's insurance subsidiaries are subject to such laws and are registered as controlled insurers in those jurisdictions in which such registration is required. Such laws vary from state to state but typically require periodic disclosure concerning the corporation which controls the registered insurers and all subsidiaries of such corporation, and prior notice to, or approval by, the state insurance commission of intercorporate transfers of assets and other transactions (including payments of dividends in excess of specified amounts by the insurance subsidiary) within the holding company system. EMPLOYEES As of December 31, 1993, the Company employed approximately 1,900 persons on a full-time basis. The Company considers its employee relations to be good. EXECUTIVE OFFICERS OF THE REGISTRANT Information concerning the executive officers and directors of the Company is set forth below: Peter W. Nauert............... 50 Chairman, Chief Executive Officer, President and Director William B. Van Vleet.......... 69 Executive Vice President, General Counsel and Director Charles R. Scheper............ 41 Executive Vice President Anthony J. Pino............... 46 Executive Vice President Joan F. Boyle.................. 46 Senior Vice President Philip J. Fiskow.............. 37 Senior Vice President Ernest T. Giambra, Jr.......... 46 Senior Vice President Thomas J. Brophy.............. 58 Senior Vice President David I. Vickers.............. 33 Treasurer and Chief Financial Officer Michael A. Cavataio.......... 49 Director Richard R. Haldeman.......... 50 Director Nolanda S. Hill.............. 48 Director Karl-Heinz Klaeser........... 61 Director Michael K. Keefe............. 49 Director Robert F. Nauert............. 69 Director All executive officers are elected annually and serve at the pleasure of the Board of Directors. Peter W. Nauert has been Chief Executive Officer and a director of the Company since its incorporation in 1982. He was President of the Company from 1982 to 1988 and became Chairman of the Company in 1988. On September 1, 1991, he was again elected President. Since 1968, Mr. Nauert has been employed in an executive capacity by one or more of the Company's insurance subsidiaries. William B. Van Vleet has been Executive Vice President of the Company since 1986 and a director of the Company since 1982. He was General Counsel of the Company from 1982 to 1988. In June 1991, he was again elected General Counsel. Mr. Van Vleet has served Pioneer Life since 1948 as General Counsel and a Director. Mr. Van Vleet also serves as an Officer and Director of other subsidiaries of the Company. Charles R. Scheper has been Vice President of the Company since 1991 and was Chief Financial Officer from May 1993 to December 1993. In March 1992, he was elected Executive Vice President. Since February 14, 1992, he has been President and Vice Chairman of the Board of Manhattan National Life. Prior to the Company's acquisition of Manhattan National Life, Mr. Scheper was Manhattan's Senior Vice President and Chief Financial Officer, a position which he held from May 1987. Prior to joining Manhattan National Life, Mr. Scheper was with Union Central Life from 1979, having served as Vice President and Controller since 1985. Anthony J. Pino was elected Executive Vice President of the Company in May 1993. He was Senior Vice President of the Company from March 1992 to May 1993 and was President of National Group Life Insurance Company from July 1991 to June 1992. Mr. Pino has served as President of National Health Services since 1992. Prior to joining the Company, Mr. Pino was Chief Operating Manager of American Postal Workers' Union Health Plan, a position which he held from October 1982. Joan F. Boyle has been Senior Vice President since joining the Company in September of 1992. She is also an Officer of other subsidiaries of the Company. Prior to joining the Company, Ms. Boyle was Vice President of Sales of Empire Blue Cross/Blue Shield from October 1991 to August 1992. From 1969 to 1991, she was Executive Vice President and Chief Financial Officer with New Jersey Blue Cross/Blue Shield. Philip J. Fiskow has been Senior Vice President since May 1993 and the Chief Investment Officer since joining the Company in 1991. He was Vice President of the Company from June 1991 until May 1992. He is also an officer of other subsidiaries of the Company. Mr. Fiskow was with Asset Allocation and Management as an Investment Advisory Portfolio Manager from January 1989 to June 1991. From May 1987 to December 1988 he was an Investment Advisor with Van Kampen Merritt and a Portfolio Manager with Aon Corporation from May 1981 to May 1987. Ernest T. Giambra, Jr. was elected Senior Vice President of the Company in June 1993. Prior to joining the Company, Mr. Giambra had been with Bankers Life Holding Corporation since 1969 where he had served as Vice President of Sales since 1988. Thomas J. Brophy has been Senior Vice President since joining the Company in November 1993. Prior to joining the Company, Mr. Brophy was President and Chief Operating Officer of Southwestern Life Insurance Company from June 1990 to September 1993. Mr. Brophy also held various senior executive positions with various I.C.H. Corporation subsidiaries from March 1974 to his joining of the Company in November 1993. David I. Vickers has been with the Company since June 1992 and has been a Vice President of the Company since December 1992, Treasurer since May 1993 and Chief Financial Officer since January 1994. He is also an Officer and Director of several subsidiaries of the Company. Prior to joining the Company he was with the public accounting firm of Ernst & Young since 1983 where he was a Senior Manager in the Insurance Division. Mr. Vickers also serves as Treasurer for certain of the Company's insurance subsidiaries. Michael A. Cavataio has been a Director of the Company since 1986. Mr. Cavataio has also been President of Lillians, a chain of retail clothing stores, since 1980. Richard R. Haldeman has been a Director of the Company since 1986 and was Secretary from 1988 to June 1990. Mr. Haldeman has been a partner of Haldeman & Associates, a law firm, since June 1990. He was a partner of Williams & McCarthy, P.C., a law firm, from 1975 to May 1990. Nolanda S. Hill has been a Director of the Company since May 1992. Ms. Hill has been Chairman and Chief Executive Officer of Corridor Broadcasting Corporation since 1984. From 1976 to 1984, Ms. Hill served as Chief Executive Officer and Chief Financial Officer of National Business Network, a television station. Karl-Heinz Klaeser has been a Director of the Company since 1986. Mr. Klaeser has also been a Director of LSW Holding Corporation and Insurance Investors Life Insurance Company and the Chairman of the Board of Life Insurance Company of the Southwest since 1989 and a Director of Personal Assurance Company PLC (United Kingdom) since 1991. Michael K. Keefe has been a Director of the Company since March 1994. Mr. Keefe has been Chief Executive Officer and Chairman of the Board of Keefe Real Estate, Inc., a family owned real estate brokerage operation since 1982. Mr. Keefe has also been Chairman of the Board of Southern Wisconsin Bankshares, Inc. since 1988. Robert F. Nauert has been a Director of the Company since November 1991. Mr. Nauert has also been a Director and President of Pioneer Life since 1988 and is a Director and Officer of various subsidiaries of the Company. Mr. Nauert is the brother of Peter W. Nauert. Item 2.

Item 2. Properties The principal executive offices of the Company are located in Schaumburg, Illinois in a building purchased by the Company in January 1994. The Company, through a subsidiary, owns three buildings in Rockford, Illinois. The Company believes these facilities will adequately serve its needs for the foreseeable future and could accommodate expansion of the Company's business. The Company, through another subsidiary, also owns a building in the Dallas, Texas metropolitan area which currently serves as the main administrative office for the Company's small business market of the Health Insurance unit. The Company leases the office of its other regional service centers. The executive and administrative offices of Manhattan National Life are located in Cincinnati, Ohio in leased space. Item 3.

Item 3. Legal Proceedings The Company and its subsidiaries are named as defendants in various legal actions, some claiming significant damages, arising primarily from claims under insurance policies, disputes with agents, and other matters. The Company's management and its legal counsel are of the opinion that the disposition of these actions will not have a material adverse effect on the Company's financial position. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders NONE PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholders Matters The Company's Common Stock is traded on the New York Stock Exchange and Chicago Stock Exchange. The following table sets forth, for the periods indicated, the high and low last reported sale prices for the Common Stock on the New York Stock Exchange as reported on the consolidated transaction reporting system. High Low Quarter ended: March 31, 1992.............. 9 1/8 6 1/4 June 30, 1992............... 8 5/8 6 1/4 September 30, 1992.......... 6 3/4 4 7/8 December 31, 1992........... 6 4 March 31, 1993.............. 5 1/2 4 3/4 June 30, 1993............... 9 1/8 5 1/4 September 30, 1993.......... 10 7/8 8 3/8 December 31, 1993........... 14 10 1/2 As of December 31, 1993, there were approximately 600 holders of record of the Company's Common Stock. On March 18, 1994, the PFS Board of Directors announced a quarterly common stock dividend of 3.75 cents per share with an expectation of a total of 15 cents per share to be paid for 1994. Item 6.

Item 6. Selected Consolidated Financial Data The following selected consolidated financial data for the five years ended December 31, 1993; are derived from the consolidated financial statements of the Company. The data should be read in conjunction with the consolidated financial statements, related notes, and other financial information included herein. The comparability of the results for the periods presented is affected by certain transactions as described in Note 18 of Notes to the Consolidated Financial Statements. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations RESULTS OF OPERATIONS 1993 Compared to 1992 Division Overview The income (loss) before income taxes by Division for 1993 and 1992 are as follows (in thousands): 1993 1992 Insurance: Health Unit $ 8,578 $(26,613) Life Unit 7,623 340 Marketing 10,205 3,345 Managed Care (1,211) 335 Corporate (6,431) (2,843) Total $18,764 $(25,436) Health The significant increase in pre tax income for 1993 is due principally to the $30 million pre tax write-down of deferred policy acquisition costs in 1992. The remaining increase is due to the improved loss ratios on the Medicare supplement business and stabilized loss ratios on major hospital products. The improved loss ratios on Medicare supplement (63.4% in 1993 versus 67.6% in 1992) allowed the Company to freeze 1994 premiums for certain of these products in many states. The Company has received positive customer response to this action and expects that will increase retention on this business. Cost reduction programs have reduced the general insurance expense ratios (excludes commissions) down to 9.8% in 1993 from 10.2% in 1992 despite one-time consolidation costs of certain operations. Life The consolidation of all life insurance administration to one location on December 31, 1992, contributed to reduced general expenses in 1993 and the resulting increase in pre tax income. The unit cost per policy in- force decreased from $150 in 1992 to approximately $80 in 1993. In addition, interest spreads on life and annuity business improved despite the decline in investment yields in 1993. The mortality on the existing block of life business continued to improve in 1993 from the levels experienced in 1992. The Company is placing more emphasis on increasing life and annuity business during the next five years to mitigate any adverse effects due to healthcare reform. Marketing The increase in pre tax income was due to a 14% increase in revenue over a relatively fixed expense base. The division continued to lower lead generation costs and development costs associated with a new commission payment system during 1993. The 1992 results were negatively affected by approximately $2 million due to the settlement of certain disputes with former agents. The Marketing Division currently receives the commission overrides previously due these agents pursuant to the settlement. Managed Care The division experienced a pre tax loss of $1.2 million primarily due to start-up costs associated with a new third-party administrator and occupational medical management company formed in 1993, as well as costs of a complete rewrite of the medical criteria. The division discontinued the operation of the third-party administrator in the fourth quarter of 1993. The core business of the division increased over 100% during 1993. The significant increase in revenue was offset by sales development costs and personnel additions to support a foundation for future growth. Corporate Interest expense increased from $2,189,000 in 1992 to $3,276,000 in 1993 due to the issuance of convertible debentures. Corporate expenses also increased due to costs associated with new investor relations programs, expenses related to the public offering, and reallocation of certain senior management personnel who monitor and control division profitability at the corporate level. Consolidated Financial Condition and Results of Operations The Company reported net income of $12,145,000 for the twelve months ended December 31, 1993, compared to a net loss of $16,959,000 for the comparable period in 1992. The net loss for 1992 was primarily attributable to a $30,000,000 pre-tax write-down of deferred policy acquisition costs. The remaining increase was due to improved loss ratios on the Medicare supplement business, expense reductions in the Life Insurance Unit and increased revenue and margins in the Marketing Division. Total revenues increased $47,751,000 or 7% for the twelve month period in 1993 as compared to 1992. The increase in revenue is due to the increase in premiums and policy charges of $50,449,000 which was partially offset by reduced levels of net investment income. Accident and health insurance premiums increased $41,790,000, or 7%, in 1993 as compared to 1992. Premiums from major hospital plans increased $56,694,000 in 1993 as compared to 1992 due to rate increases implemented in 1993, and approximately $11,000,000 from the acquisition of Continental Life & Accident Company. Offsetting the increase was a decline in Medicare supplement premiums of $9,176,000 due to lower than anticipated new sales and a $3,496,000 decrease in premiums of specialty health care plans. Life and annuity premiums and policy charges increased $8,659,000 due to an increase in new life sales during 1993. Net investment income decreased $3,313,000 or 8% in 1993 compared to 1992. Annualized investment yields decreased from 7.9% in 1992 to 6.8% in 1993. The decrease in investment yield was due to the general decline in current interest rates and a higher quality portfolio with a shortened duration. Other income and realized investment gains and losses increased $615,000, or 4% in 1993 as compared to 1992. Other income increased $1,904,000 in 1993 due to increased sales to unaffiliated customers in both the Marketing and Managed Care Divisions. Realized investment losses increased $1,289,000 due to write-downs on certain mortgage-backed derivative securities. As disclosed in Note 3 to the Consolidated Financial Statements, the Company has established an allowance for losses on investments held in the amount of $4,200,000, which the Company believes is adequate to provide for other-than-temporary market declines. Total benefits increased $26,310,000 or 6% in 1993 as compared to 1992. Life and annuity benefits decreased $3,607,000 or 8% due to the general decline in credited rates during 1993 and improved mortality over the higher levels experienced during 1992. Accident and health benefits, which includes the change in unearned premiums, increased $29,917,000 or 8% in 1993 as compared to 1992. The change was primarily due to the 7% increase in accident and health premiums. The Company's accident and health loss ratios were unchanged over 1992 at 66%. The improved loss ratios on the Medicare supplement business were offset by the fourth quarter loss ratio on Continental Life & Accident business of 79%. The Company is attempting to control claim costs on this block of business by implementing additional managed healthcare efforts. In 1993 and 1992, managed healthcare efforts resulted in estimated net savings to the Company's Health Insurance Unit of $41 million and $27 million, respectively. These savings were primarily used to lower the amount of premium increases for policyholders, which the Company believes generally has the effect of decreasing lapse rates of these policies. The principal efforts and their approximate relative contributions to these estimated savings were as follows: 1993* 1992* 1991* PPOs (preferred provider organization) networks 49% 64% 72% Precertification 5 17 16 Large case management 32 11 2 Other 14 8 10 100% 100% 100% * Percent of total estimated savings from managed healthcare efforts. The Company expects to continue to emphasize managed care procedures to control claim costs. Although the Company cannot accurately determine the amount savings which may be realized from such efforts in the future, the Company believes that it will be increasingly difficult to maintain this level of growth in cost savings due to the efficiencies that have already been achieved. Amortization of deferred policy acquisition costs (DAC) decreased $23,840,000, or 24%, in 1993 as compared to 1992. The decrease was due to the $30 million pre tax write-down of DAC in the fourth quarter of 1992 primarily on major medical policies sold in the self-employed and small business owner market. The 1993 amortization rate on Medicare supplement is higher than 1992 because of the accelerated rate increase implementation which occurred in 1993. As discussed previously, the Company expects the Medicare supplement persistency to improve in 1994 with the modest rate action required. The Company continues to monitor persistency closely since future rate increases and regulatory reforms could adversly impact lapses in the future. Increased lapses resulting in an increase in the amortization rate of DAC could adversely impact future earnings. The Company's effective tax rate was approximately 35% in 1993. The Company recorded a tax benefit for 1992 due to the operating loss incurred. The effective federal income tax rate increased in 1993 due to the Revenue Reconciliation Act of 1993. Effective January 1, 1993 the Company adopted Financial Accounting Standards Board (FASB) Statement No. 113 "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts." FASB Statement No. 113 requires that reinsurance receivables, including amounts related to claims incurred but not reported, and prepaid insurance premiums, be reported as assets as opposed to reductions in the related liabilities. As a result of the adoption of FASB Statement No. 113, amounts on deposit and due from reinsurers and policy liabilities each increased $19,453,000 at December 31, 1993. Effective January 1, 1993, the Company also changed its method of accounting for income taxes from the deferred method to the liability method required by FASB Statement No. 109 "Accounting For Income Taxes." The cumulative effect of adopting FASB Statement No. 109 was not significant. President Clinton presented his health care reform policy in September of 1993. Numerous proposals have been introduced to Congress and the state legislatures to reform the current healthcare system. Proposals have included, among other things, modifications to the existing employer-based insurance system, a quasi-regulated system of "managed competition" among health plans and a single payer, public program which would replace some of the Company's current major hospital products. Changes in healthcare policy could significantly affect the Company's Health Unit. The Company is unable to accurately predict what effects these reforms may have on its future operations and is unable to evaluate what impact the expectations of such reforms may have had on past consumer behavior. The Company expects the final package approved by Congress will differ significantly from the program presented by President Clinton. (See Healthcare Reform Section) Investments, equipment, policy liabilities, and general expenses and other liabilities increased due to the acquisition of Continental Life & Accident. Other assets increased primarily due to expenses capitalized in conjunction with the public offering of the convertible subordinated debentures. RESULTS OF OPERATIONS 1992 Compared to 1991 The Company reported a net loss of $16,959,000 for the twelve months ended December 31, 1992, compared to net income of $8,872,000 for the comparable period in 1991. The net loss for 1992 was primarily attributable to a $30,000,000 write-down of deferred policy acquisition costs. The remaining decrease was primarily due to reduced levels of new production of senior health insurance, the continued impact of medical inflation, increased utilization of medical services in the health insurance small business market, and lower other income and realized investment gains. Total revenues decreased $52,649,000 or 7% in 1992 as compared to 1991. The decrease was primarily due to reduced writings of accident and health insurance policies principally in the senior market and lower other income and realized gains. Total premiums and policy charges decreased $31,444,000, or 5%, in 1992 as compared to 1991. During 1992 and 1991, in an effort to control the volume and quality of the business produced, the Company reduced the number of brokers and agents selling its products and restructured certain of its agency relationships. These changes resulted in reduced levels of new business being written. Accident and health insurance premiums decreased $33,342,000, or 6%, in 1992 as compared to 1991. Premiums from the Company's Medicare supplement plans decreased approximately $35,203,000. In addition, $7,135,000 of the decrease was attributable to a decrease in premium in specialty health care plans. Somewhat offsetting the decrease were premiums from major hospital plans which increased $9,694,000 in 1992 as compared to 1991. Life and annuity premium and policy charges were relatively unchanged for the twelve month period in 1992 as compared to 1991. Net investment income decreased $4,303,000, or 9%, in 1992 compared to 1991. Annualized investment yields decreased from 9.0% in 1991 to 7.9% in 1992. The decrease in net investment income was primarily due to the general decline in interest rates, and also the sale of a subsidiary, Union Benefit Life Insurance Company on September 1, 1991. Other income and realized investment gains and losses decreased $16,902,000, or 49%, in 1992 as compared to 1991. Other income decreased $8,957,000 in 1992 as compared to 1991. The decrease is principally due to reduced revenues from the Company's non-insurance marketing subsidiaries. The Company's Marketing Division experienced a $6,287,000, or 32%, decrease in revenues, which reflected the discontinuation of certain agent programs. The Company does not expect further declines in revenue from the discontinuation of these agent programs. The Company's Managed Care Division contributed revenues comparable to those in 1991. Realized investment gains, excluding the sale of a subsidiary, decreased $7,236,000 in 1992 as compared to 1991. This is primarily due to the write-down of $5,700,000 on mortgage-backed derivative securities in 1992. As disclosed in Note 3 to the Consolidated Financial Statements, the Company has established an allowance for losses on investments held in the amount of $1,900,000, which the Company believes is adequate to provide for any other-than-temporary market declines. Total benefits decreased $7,280,000, or 2%, in 1992 as compared to 1991 due to the reduced writings of accident and health insurance policies. Life and annuity benefits were relatively unchanged in 1992 as compared to 1991. Accident and health benefits, which include the increase in unearned premiums, decreased $8,774,000, or 2%, in 1992 as compared to 1991. In 1992 the Company's accident and health loss ratio increased to 66% as compared to 64% in 1991. The increase was due to the continued impact of medical inflation and increased utilization of medical services in the small business market. The Company is attempting to minimize the effect of medical inflation and control claim costs by implementing certain managed healthcare efforts. In 1992 and 1991, managed healthcare efforts resulted in estimated net savings to the Company's Health Insurance Unit of $27 million and $13 million, respectively. These savings were primarily used to lower the amount of premium increases for policyholders, which the Company believes generally has the effect of decreasing lapse rates of these policies. The principal efforts and their approximate relative contributions to these estimated savings were as follows: 1992* 1991* PPOs (preferred provider organization) networks 64% 72% Precertification 17 16 Large case management 11 2 Other 8 10 100% 100% * Percent of total estimated savings from managed healthcare efforts. The Company expects to continue to emphasize managed care procedures to control claim costs. Although the Company cannot accurately determine the amount of any savings which may be realized from such efforts in the future, the Company believes that it will be increasingly difficult to maintain this level of cost savings due to the efficiencies that have already been achieved. The Company initiated group medical premium rate adjustments in September 1992. These adjustments were intended to offset the impact of increased benefits and to improve loss ratios. These adjustments helped stabilize loss ratios in the fourth quarter. Policy lapses increased only modestly in the fourth quarter due to the Company's aggressive conservation activities. Insurance and general expenses decreased $10,853,000, or 6%, in 1992 as compared to 1991. The reduction in these expenses is primarily due to the reduced level of new business being written and the corresponding cost reduction programs in the insurance units, which was partially offset by an increase in the level of expenses incurred by the Company's non-insurance subsidiaries. Interest expense decreased $727,000, or 25%, in 1992 as compared to 1991 due to a decrease in the weighted average notes payable outstanding and a decrease in interest rates. However, notes payable increased from December 31, 1991, as Pioneer Life Insurance Company of Illinois entered into a loan agreement in March of 1992. Amortization of deferred policy acquisition costs increased $4,967,000, or 5%, in 1992 as compared to 1991. In the fourth quarter of 1992 the Company wrote off approximately $30,000,000 of deferred policy acquisition costs. The adjustment was primarily the result of certain policies sold in the self-employed and small business owner market. These were policies issued without managed care and cost containment features (including scheduled benefits) which are part of all of the Company's policies now issued. The adjustment included primarily individual policy contracts issued in certain states where strict regulatory approval requirements have delayed implementation of necessary premium adjustments. In all other states, the Company sells group medical plans to the small business owner market. While these group policies are individually underwritten, they provide more latitude for expedient rate adjustments that correspond with actual claims experience. Recently, the Company has experienced improved persistency, primarily on the policies issued in 1991 and 1992, which has resulted in decreased amortization of deferred acquisition costs in 1992 as compared to 1991 on this block of business. The Company continues to monitor persistency closely since general economic conditions and future premium rate adjustments could adversely impact lapses in the future. Increased lapses resulting in an increase in the amortization rate of deferred policy acquisition costs could adversely impact future earnings. The Company recorded a net tax benefit for 1992 due to the operating loss incurred. Investments increased during 1992 as a result of the investment of loan proceeds received in March of 1992 and a reduced level of ceded reinsurance. Premiums and other receivables, accrued investment income, and general expenses and other liabilities decreased due to reduced levels of new business. Deferred policy acquisition costs decreased as a result of the fourth quarter write-down and the decrease in 1992 new business issues. Other assets increased due to federal income tax recoverables and the prepayment of certain agent compensation. Federal legislation required all states to adopt certain standardized benefit provisions for the sale of Medicare supplement policies. The Company has introduced new Medicare supplement plans in response to this legislation. In addition, in 1991, the National Association of Insurance Commissioners adopted the Small Employers Availability Act (Act). The Act affects the rating and underwriting methodology that can be applied to insurance coverage sold to small employers, generally categorized as those employing 25 people or less. The Company believes the Act will not have a material impact on its existing business. In response to the Act, the Company has modified its products, and will continue to modify products (if required) for sale in those states adopting the Act. Deferred Policy Acquisition Costs Under generally accepted accounting principles, a deferred acquisition cost asset (DAC) is established to properly spread the acquisition costs for a block of policies against the expected future revenues from the policies. The acquisition costs which are capitalized and amortized consist of first year commissions in excess of renewal commissions and certain home office expenses related to selling, policy issue, and underwriting. The deferred acquisition costs for accident and health policies and traditional life policies are amortized over future revenues of the business to which the costs are related. The rate of amortization depends on the expected pattern of future revenues for the block of policies. The scheduled amortization for a block of policies is established when the policies are issued. The amortization schedule is based on the expected persistency of the policies. The actual amortization of DAC reflects the actual persistency of the business. For example, if actual policy terminations are higher than expected, DAC will be amortized more rapidly than originally scheduled. Effect of Inflation In pricing its insurance products, the Company gives effect to anticipated levels of inflation; however, the Company believes that the high rate of medical cost inflation during the last three years had an adverse impact on its major hospital accident and health claims experience. The Company has implemented rate increases in response to this experience. Liquidity and Capital Resources The Company's consolidated liquidity requirements are created and met primarily by operations of its insurance subsidiaries. The primary sources of cash are premiums, investment income, proceeds from public offerings and investment sales and maturities. The primary uses of cash are operating costs, repayment of notes payable, policy acquisition costs, payments to policyholders and investment purchases. In addition, liquidity requirements of the Company are created by dividend requirements of the $2.125 Preferred Stock and debt service requirements. The Company's liquidity requirements are met primarily by dividends declared by its non-insurance subsidiaries. As disclosed in Note 9 of Notes to Consolidated Financial Statements, payment of dividends by the insurance subsidiaries to the Company is subject to certain regulatory restrictions. The Company's life and health insurance subsidiaries require capital to fund acquisition costs incurred in the initial year of policy issuance and to maintain adequate surplus levels for regulatory purposes. These capital requirements have been met principally from internally generated funds, including premiums and investment income, and capital provided from reinsurance and the financing or sale of agent debit balances. The Company has terminated existing financial reinsurance agreements with respect to policies issued subsequent to July 1991. The current reinsurance agreements in force have been approved by the appropriate regulatory authorities and the Company believes they meet the current NAIC model regulations. If circumstances arose that would affect the Company's continued ability to include capital provided from reinsurance in the insurance subsidiaries' statutory capital and surplus, it could have an adverse impact on the Company's business. The Company is not aware of any circumstances that would have such an effect. Certain subsidiaries of the Company have entered into agreements for the sale of agent debit balances. Proceeds from such sales during 1993 and 1992 were $25.4 million and $20.3 million, respectively. The Company's agent debit balance program has been reviewed without objection by applicable regulatory authorities. If restrictions are imposed on including in capital the proceeds from this type of financing in the future, the Company would consider alternative financing arrangements or discontinue its agent advancing program. In the past, the Company has obtained funds from public stock and debt offerings and bank borrowings and contributed a portion of the proceeds to the insurance subsidiaries to support the growth of its insurance business. The level of premium volume of the Company's insurance subsidiaries will depend on the amount of their statutory capital and surplus. The statutory basis premium to surplus ratio for 1993 for the Company's major insurance subsidiaries were as follows: Manhattan National Life: 1.5 times; Pioneer Life Insurance Company of Illinois: 4.4 times; Continental Life & Accident Company 6.8 times; and National Group Life Insurance Company: 3.3 times. The concept of risk-based capital has been adopted for regulatory monitoring of the life and health insurance industry. The risk-based capital rules for life and health insurance companies were effective for 1993 annual statement filings. Risk based capital standards will be used by regulators to set in motion appropriate regulatory actions relating to insurers which show signs of weak or deteriorating conditions. The Company's insurance subsidiaries total adjusted capital, authorized control risk based capital, and related ratio by company as disclosed in the 1993 annual statement are as follows: Authorized Adjusted Control Company Capital Level RBC RBC Ratio (Dollars in thousands) Pioneer Life Insurance Company of Illinois $77,460 $23,080 336% Manhattan National Life Insurance Company 24,424 4,316 566% National Group Life Insurance Company 34,756 9,016 385% Continental Life & Accident Company 11,791 4,996 236% Health & Life Insurance Company of America 3,803 240 1,585% The Company has offered agent commission financing to certain of its agents and marketing organizations which consists primarily of annualization of first year commissions. This means that when the first year premium is paid in installments, the Company will advance a percentage of the commissions that the agent would otherwise receive over the course of the first policy year. On October 31, 1990, the Company through a subsidiary entered into an agreement with an unaffiliated corporation to provide financing for its agent commission financing program through the sale of agent receivables. This financing program was replaced with an amended agreement which was executed on October 1, 1992, to provide such subsidiary with the same type of financing. Pursuant to this amended agreement the termination date of the program is December 31, 1994, subject to extension or termination as provided therein. In April 1992, the Company settled certain disputes with several former agents and in addition to certain cash payments issued promissory notes representing future commission. The remaining total of $1,490,000 at December 31, 1993 was repaid in January 1994. In July 1993 the Company issued $57.5 million of 8% convertible subordinated debentures due 2000. Interest on the debentures is payable in January and July of each year. Net proceeds from the offering totaled approximately $54 million. The debentures are convertible into the Company's common stock at any time prior to maturity, unless previously redeemed, at a conversion price of $11.75 per share. The proceeds were used in part to repay the $15,000,000 and $10,000,000 term loans outstanding. In August 1993 the Company borrowed $1,500,000 to finance the acquisition of Healthcare Review Corporation. Interest on the note is payable quarterly at six percent. The note requires principal repayments of $75,000 per quarter through July 31, 1998. Interest paid amounted to $1,023,000, $2,274,000 and $2,416,000 for 1993, 1992, and 1991, respectively. Management believes that the diversity of the Company's investment portfolio and the liquidity attributable to the large concentration of investments in highly liquid United States government agency securities provide sufficient liquidity to meet foreseeable cash requirements. In the fourth quarter of 1992 the Company segregated the fixed maturity portfolio into two components: fixed maturities held to maturity and fixed maturities available for sale. Because the Company's insurance subsidiaries experience strong positive cash flows, including sizeable monthly cash flows from mortgage-backed securities, the Company does not expect its insurance subsidiaries to be forced to sell the held to maturity investments prior to their maturities and realize material losses or gains. However, if the Company experiences changes in credit risk, it may be required to sell assets whose fair value is less than carrying value and incur losses. Life insurance and annuity liabilities are generally long term in nature although subject to earlier surrender as a result of the policyholder's ability to withdraw funds or surrender the policy, subject to surrender and withdrawal penalties. The Company believes its policyholder liabilities should be backed by an investment portfolio that generates predictable investment returns. The Company seeks to limit exposure to risks associated with interest rate fluctuations by concentrating its invested assets principally in high quality, readily marketable debt securities of intermediate duration and by attempting to balance the duration of its invested assets with the estimated duration of benefit payments arising from contract liabilities. The Company has no material commitments for capital expenditures at the present time. The Company acquired its corporate headquarters in Schaumburg, Illinois in January 1994 which will be primarily used for investment real estate. Investment Portfolio At December 31, 1993, the Company had invested assets of $674 million, compared to $568 million at December 31, 1992. The Company manages all of its investments internally with resource and evaluation assistance provided by independent investment consultants. Government and mortgage-backed obligations and corporate fixed maturity securities collectively comprised approximately 87% and 84% of the Company's investment portfolio at December 31, 1993 and 1992, respectively. The remainder of the invested assets were in short-term investments, equity securities, policy loans and mortgage loans. Fixed Maturity Investments. With the adoption of risk based capital rules and consumer concerns over insurance company solvency and financial stability, the asset quality of insurance companies' investment portfolios has become of greater concern to policyholders and has come under closer scrutiny by insurance regulators and investors. In response, the Company reduced its investments in below-investment grade fixed maturity securities to less than 1% of its invested assets at December 31, 1993, and 3.4% at December 31, 1992, down from 4.5% at December 31, 1991, and 5.0% at December 31, 1990. These reductions resulted from sales and write-downs of the carrying value of such securities in each of these periods, and the elimination of new purchases. The Company has a policy not to invest more than 5% of its total invested assets in securities below investment grade. Investments in below-investment grade fixed maturity securities generally have greater risks (and potentially greater returns) than other corporate fixed maturity investments. Risk of loss upon default by the issuer is significantly greater for these securities because they are generally unsecured and are often subordinated to other creditors of the issuer, and because these issuers usually have high levels of indebtedness and are more sensitive to adverse economic conditions, such as recession or increasing interest rates, than are investment grade issuers. Also, the market for below-investment grade securities is less liquid and not as actively traded as the market for investment grade securities. The investment objectives of the Company are to maximize investment yield without sacrificing high investment quality and matched liquidity. The Company continually evaluates the creditworthiness of each issuer of securities held in its portfolio. When the fair value of an individual security declines materially, or when the Company's ongoing evaluation indicates that it may be likely that the Company will be unable to realize the carrying value of its investment, significant review and analytical procedures are performed to determine the extent to which such declines are attributable to changing market expectations regarding general interest rates and inflation and other factors, such as a perceived increase in the credit risk of the issuer, a general decrease in a particular industry sector or an overall economic decline. Declines in fair value attributable to factors other than market expectations regarding general interest rates and inflation are reviewed and analyzed in further detail to determine if the decline in value is other than temporary, and the carrying amount of the investment is reduced to its net realizable value based upon estimated non-discounted cash flows. The amount of the reduction is reported as a realized loss on investments and the net realizable value becomes the new cost basis of the investment. In addition, the Company reverses any accrued interest income previously recorded for the investment and records future interest income only when cash is received. The Company's use of non-discounted cash flows to evaluate net realizable value may result in lower realized losses in the current period than if the Company had elected to use discounting in its evaluation process. Also, yields recognized in future periods on such investments may be less than yields recognized on other investments and will be less than the yield expected when the fixed maturity security was originally purchased. The affect on net income from declines in interest income and portfolio yield from impaired securities in future periods will depend on many factors, including, in life insurance business, the level of interest rates credited to policyholder account balances. Inasmuch as interest rates credited to the Company's policyholders are typically only guaranteed for one year, the Company does not expect any material adverse affect on net income in future periods from declines in yields from impaired securities. Mortgage-Related Securities. At December 31, 1993, the Company had $324 million, or 55%, of its fixed maturities portfolio in mortgage-related securities ($351 million at December 31, 1992). The yield characteristics of mortgage-related securities differ from those of traditional fixed income securities. The major differences typically include more frequent interest and principal payments, usually monthly, and the possiblity that prepayments of principal may be made at any time. Prepayment rates are influenced by changes in current interest rates and a variety of economic, geographic, social and other factors and cannot be predicted with certainty. The yields to maturity of the mortgage-related securities will be affected by the actual rate of payment (including prepayments) of principal of the underlying mortgage loans. In general, prepayments on the underlying mortgage loans, and subsequently the mortgage-related securities backed by these loans, increases when the level of prevailing interest rates declines significantly below the interest rates on such loans. When declines in interest rates occur, the proceeds from the prepayment of such securities are likely to be reinvested at lower rates than the Company was earning on such securities. Prior to 1991, the Company's investments in mortgage-related securities consisted primarily of pass-through certificates which provide for regular monthly principal and interest payments. During 1991 and 1992, the Company restructured its portfolio by investing in principal only and inverse floaters/interest only tranches of collateralized mortgage obligations (CMOs) and accrual bonds (derivative securities) and other CMOs by selling pass-through certificates. The Company also purchased additional CMO investments with cash flows generated by policyholder premium collections, reinvestment of investment income and scheduled principal payments or maturities of investments and proceeds from the sales of fixed maturity investments, including significant sales of higher-coupon mortgage-related securities in 1991 and 1992. The Company's mortgage-related securities portfolio is well diversified as to collateral, maturity/duration and other characteristics. The majority of the mortgage-related securities portfolio has the guarantee or backing of agencies of the United States government. Generally, the mortgage-related securities consist of pools of single-family, residential mortgages. The derivative securities were acquired to protect the Company in the event of adverse interest rate fluctuations. The yields and fair values of the derivative securities are generally more sensitive to changes in interest rates and prepayments than other mortgage-related securities. Accrual bonds are CMOs structured such that the payments of coupon interest is deferred until principal payments begin on the bonds. On each accrual date, the principal balance is increased by the amount of the interest (based upon the stated coupon rate) that otherwise would have been payable. As such, these securities act much the same as zero coupon bonds until cash payments begin. Cash payments typically do not commence until earlier classes in the CMO structure have been retired, which can be significantly influenced by the prepayment experience of the underlying mortgage loan collateral in the CMO structure. Because of the zero coupon element of these securities and the potential uncertainty as to the timing of cash payments, their fair values and yields are more sensitive to changing interest rates than pass-through securities and coupon bonds. The Company's mortgage-related securities portfolio at December 31, 1993, also included $37 million of CMOs and pass-through certificates issued by non-government agencies ($57 million at December 31, 1992). The Company's holdings consist solely of senior securities in the CMO structures which are collateralized by first mortgage liens on single family residences. These securities are rated AAA or AA by Standard & Poor's, or the comparable equivalent rating by another independent nationally recognized rating agency. The credit worthiness of these securities is based solely on the underlying mortgage loan collateral and credit enhancements in the form of senior/subordinated structures, letters of credit, mortgage insurance or surety bonds. The underlying mortgage loan collateral principally consists of whole loan mortgages that exceed the $202,000 maximum imposed by both the Federal National Mortgage Associaton and the Federal Home Loan Mortgage Corporation and, as such, the collateral tends to be concentrated in states with the greatest number of higher priced single family residences, including California, New York, New Jersey, Maryland, Virginia and Illinois. The maximum average loan-to-value ratio for the collateral is 80%. The following table summarizes the components of the Company's mortgage-related securities portfolio at December 31, 1993, and December 31, 1992 (in thousands): December 31, 1993 December 31, 1992 Estimated Estimated Carrying Fair Carrying Market Value Value (1) Value Value (1) Inverse floaters and interest only CMO tranches $ 18,954 $ 16,003 $ 30,810 $ 24,632 Accrual bonds: U.S. government agency 6,968 7,386 7,852 8,215 Other CMOs: U.S. government agency 187,871 190,141 200,860 204,161 Non-government agency 21,154 21,919 40,635 41,772 Total other CMOs 209,025 212,060 241,495 245,933 U.S. government agency pass-through73,285 74,004 54,902 56,104 Non-government agency pass-through 15,895 16,041 16,252 16,584 Total mortgage-backed securities $324,127 $325,494 $351,311 $351,468 (1) Fair values are generally derived from independent pricing services. Fair values for principal only and inverse floater/interest only tranches of CMOs at December 31, 1993, and 1992 reflect a discounted cash flow due to a lack of a liquid market for these securities. Recently Issued Accounting Standards For a discussion of a new income tax accounting standard and a new reinsurance accounting standard and the impact these standards had on the financial statements of the Company, see Note 2 of Notes to Consolidated Financial Statements. Item 8.

Item 8. Financial Statements and Supplementary Data Consolidated Financial Statements are included in Part IV, Item 14 of this report. Item 9.

Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure Not applicable. Part III Item 10.

Item 10. Directors and Executive Officers of the Registrant The section of the definitive proxy statement to be filed with the Securities and Exchange Commission and mailed to stockholders before April 1, 1994, in connection with the Company's 1994 annual meeting of stockholders entitled "Election of Directors" is incorporated herein by this reference. For information on executive officers of the registrant, reference is made to the item entitled "Executive Officers of the Registrant" in Part I of this report. Item 11.

Item 11. Executive Compensation The section of the definitive proxy statement to be filed with the Securities and Exchange Commission and mailed to stockholders before April 1, 1994, in connection with the Company's 1994 annual meeting of stockholders entitled "Executive Compensation" is incorporated herein by this reference. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management The section of the definitive proxy statement to be filed with the Securities and Exchange Commission and mailed to stockholders before April 1, 1994, in connection with the Company's 1994 annual meeting of stockholders entitled "Principal Holders of Securities" is incorporated herein by this reference. Item 13.

Item 13. Certain Relationships and Related Transactions The section of the definitive proxy statement to be filed with the Securities and Exchange Commission and mailed to stockholders before April 1, 1994, in connection with the Company's 1994 annual meeting of stockholders entitled "Certain Transactions" is incorporated herein by this reference. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) Documents filed as a part of this report: PIONEER FINANCIAL SERVICES, INC. 1. Financial Statements Report of Independent Auditors . . . . . . . . . . . . Consolidated Financial Statements . . . . . . . . . . . Statements of Consolidated Operations . . . . . . Consolidated Balance Sheets . . . . . . . . . . . Statements of Consolidated Stockholders' Equity. . Statements of Consolidated Cash Flows . . . . . . Notes to Consolidated Financial Statements . . . . 2. Financial Statement Schedules Schedule I - Consolidated Summary of Investments - Other Than Investments in Related Parties . . . . . . Schedule II - Amounts Receivable From Related Parties and Underwriters, Promoters, and Employees Other Than Related Parties . . . . . . Schedule III - Condensed Financial Information of Registrant - Condensed Balance Sheets . . . . . . Schedule III - Condensed Financial Information of Registrant - Condensed Statements of Operations . . . Schedule III - Condensed Financial Information of Registrant - Condensed Statements of Cash Flows. . . . . . . . . . . . . . . . . . . . . . Schedule III - Note to Condensed Financial Statements Schedule V - Supplementary Insurance Information. . . Schedule VI - Reinsurance . . . . . . . . . . . . . . Schedule VIII - Valuation and Qualifying Accounts . . Schedule IX - Short-Term Borrowings . . . . . . . . . All other schedules are omitted because they are not applicable, or not required, or because the required information is included in the financial statements or notes thereto. 3. Exhibits See Exhibit Index below. (b) Reports on Form 8-K The Company filed no reports on Form 8-K during the fourth quarter of 1993. (c) Index to Exhibits Exhibit Sequentially Number Description of Document Numbered Page 3 (a) Certificate of Incorporation of the Company (filed as Exhibit 3(a) to the Company's Registration Statement on Form S-1 [No. 33-7759] and incorporated herein by reference) 3 (b) Amended Bylaws of the Company (filed as Exhibit 3(b) to Amendment No. 1 to the Company's Registration Statement on Form S-1 [No. 33-30017] and incorporated herein by reference) 4 (a) Certificate of Designations with respect to the Company's $2.125 Cumulative Convertible Exchangeable Preferred Stock ("Preferred Stock") (filed as Exhibit 4(a) to Post-Effective Amendment No. 1 to the Company's Registration Statement on Form S-1 [No. 33-30017] and incorporated herein by reference) 4 (b) Proposed form of Indenture with respect to the Company's 8 1/2% Convertible Subordinated Debentures due 2014 into which the Preferred Stock is exchangeable (filed as Exhibit 4(b) to Post-Effective Amendment No. 1 to the Company's Registration Statement on Form S-1 [No. 33-30017] and incorporated herein by reference) 4 (c) Rights Agreement dated as of December 12, 1990 between the Company and First Chicago Trust Company of New York as Rights Agent (including exhibits thereto) (filed as Exhibit 1 to the Company's registration statement on Form 8-A dated December 14, 1990 and incorporated herein by reference) 10 (a) Form of contract with independent agents (filed as Exhibit 10(f) to the Company's Registration Statement on Form S-1 [No. 33-7759] and incorporated herein by reference) 10 (b) Nonqualified Stock Option Plan (filed as Exhibit 10(g) to the Company's Registration Statement on Form S-1 [No. 33-7759] and incorporated herein by reference) 10 (c) Amendment to the Nonqualified Stock Option Plan of the Company (filed as Exhibit 10(d) to the Company's Registration Statement on Form S-8 [No. 33-26455] and incorporated herein by reference) 10 (d) Amendment to the Nonqualified Stock Option Plan of the Company (filed as Exhibit 10(c) to the Company's Registration Statement on Form S-1 [No. 33-17011] and incorporated herein by reference) 10 (e) Amendment to the Nonqualified Stock Option Plan of the Company (filed as Exhibit 10(e) to the Company's registration statement on Form S-8 [No. 33-37305] and incorporated herein by reference) 10 (f) Amended and Restated Receivables purchase agreement dated as of October 1, 1992 by and between Design Benefit Plans, Inc. (formerly National Group Marketing Corporation) and National Funding Corporation (filed herewith) *10 (g) Employment Agreement dated December 3, 1993 by and between the Company and Peter W. Nauert (filed herewith) 10 (h) Administrative Service Agreement dated December 23, 1991, by and between Administrative Service Corporation and Pioneer Life Insurance Company of Illinois (filed as Exhibit 10(v) to the Company's Annual Report on Form 10-K [No. 0-14977] and incorporated herein by reference) 10 (i) Administrative Service Agreement dated December 23, 1991, by and between Administrative Service Corporation and National Group Life (filed as Exhibit 10(w) to the Company's Annual Report on Form 10-K [No. 0-14977] and incorporated herein by reference) *10 (j) Employment Agreement dated December 31, 1991 by and between National Benefit Plans, Inc. and Peter W. Nauert (filed as Exhibit 10(x) to the Company's Annual Report on Form 10-K [No. 0-14977] and incorporated herein by reference) *10 (k) Amendment to Employment Agreement dated March 26, 1993 by and between National Benefit Plans, Inc. and Peter W. Nauert (filed herewith) *10 (l) Employment Agreement dated December 31, 1991 by and between Direct Financial Services, Inc. and Peter W. Nauert (filed as Exhibit 10(y) to the Company's Annual Report on Form 10-K [No. 0-14977] and incorporated herein by reference) *10 (m) Amendment to Employment Agreement dated March 26, 1993 by and between Direct Financial Services, Inc. and Peter W. Nauert (filed herewith) 10 (n) Credit Agreement dated as of December 22, 1993 by and among the Company and American National Bank and Trust Company of Chicago, as Agent and American National Bank and Trust Company of Chicago, Firstar Bank Milwaukee, N.A. and Bank One, Rockford, NA, as Banks (filed herewith) 11 Statement of Computation of per share net income or loss (filed herewith) __ 21 List of subsidiaries (filed herewith) __ 23 Consent of Ernst & Young (filed herewith) __ ____________________ * Indicates management employment contracts or compensatory plans or arrangements. Pioneer Financial Services, Inc. and Subsidiaries Financial Statements Year ended December 31, 1993 Contents Report of Independent Auditors . . . . . . . . . . . . . . . Financial Statements Statements of Consolidated Operations . . . . . . . . . . . . Consolidated Balance Sheets . . . . . . . . . . . . . . . . . Statements of Consolidated Stockholders Equity . . . . . . . Statements of Consolidated Cash Flows . . . . . . . . . . . . Notes to Consolidated Financial Statements . . . . . . . . . Report of Independent Auditors Board of Directors Pioneer Financial Services, Inc. We have audited the accompanying consolidated balance sheets of Pioneer Financial Services, Inc. and subsidiaries as of December 31, 1993 and 1992, and the related statements of consolidated operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Pioneer Financial Services, Inc. and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. ERNST & YOUNG Chicago, Illinois March 2, 1994 Pioneer Financial Services, Inc. and Subsidiaries Statements of Consolidated Operations (In Thousands, Except Per Share Amounts) Year ended December 31 1993 1992 1991 Revenues Premiums and policy charges (Note 5): Accident and health $ 601,684 $ 559,894 $ 593,236 Life and annuity 43,878 35,219 33,321 645,562 595,113 626,557 Net investment income (Note 3) 40,242 43,555 47,974 Other income and realized investment gains and losses (Note 3) 17,920 17,305 34,207 703,724 655,973 708,738 Benefits and expenses Benefits: Accident and health 397,963 368,046 376,820 Life and annuity 44,015 47,622 46,128 441,978 415,668 422,948 Insurance and general expenses 162,831 162,837 173,806 Interest expense (Note 7 and 10) 3,276 2,189 2,916 Amortization of deferred policy acquisition costs (Notes 3 and 8) 76,875 100,715 95,748 684,960 681,409 695,418 Income (loss) before income taxes 18,764 (25,436) 13,320 Income taxes (benefit) (Note 4): Current 10,858 2,878 7,228 Deferred (4,239) (11,355) (7,780) 6,619 (8,477) 4,448 Net income (loss) 12,145 (16,959) 8,872 Preferred stock dividends (Note 11) 2,021 2,039 2,039 Income (loss) applicable to common stockholders $ 10,124 $ (18,998) $ 6,833 Net income (loss) per common share: Primary $ 1.51 $ (2.85) $ 1.02 Fully diluted 1.26 (2.85) 1.02 Average common and common equivalent shares outstanding: Primary 6,724 6,660 6,699 Fully diluted 10,731 8,195 8,234 See notes to consolidated financial statements. Pioneer Financial Services, Inc. and Subsidiaries Consolidated Balance Sheets (In Thousands, Except Share and Per Share Amounts) December 31 1993 1992 Assets Investments (Note 3): Fixed maturities: Held to maturity - principally at amortized cost (fair value: 1993 $325,540; 1992 - $434,195) $326,512 $434,726 Available for sale - at lower of aggregate amortized cost or fair value (fair value: 1993 - $ 263,263; 1992 - $39,992) 257,717 38,751 Equity securities at fair value (cost: 1993 - $12,382; 1992 $14,925) 17,436 19,537 Mortgage loans at unpaid balance 3,201 583 Policy loans at unpaid balance 23,988 21,386 Short-term investments at cost, which approximates fair value 45,352 53,366 Total investments 674,206 568,349 Cash 23,379 18,686 Premiums and other receivables, less allowance for doubtful accounts (Notes 6 and 17) 20,734 22,056 Reinsurance receivables and amounts on deposit with reinsurers (Note 2 and 5) 74,366 56,931 Accrued investment income 8,482 7,164 Deferred policy acquisition costs (Note 8) 260,432 269,674 Land, building, and equipment at cost, less accumulated depreciation (Note 17) 22,248 18,210 Deferred federal income taxes (Note 4) 3,922 - Other 20,502 17,619 $1,108,271 $978,689 December 31 1993 1992 Liabilities, redeemable preferred stock, and stockholders equity Policy liabilities (Note 2): Future policy benefits: Life $244,249 $232,940 Annuity 208,155 180,553 Accident and health 158,330 144,922 Unearned premiums 87,945 90,880 Policy and contract claims 189,389 148,141 Other 15,037 8,260 903,105 805,696 General liabilities: General expenses and other liabilities 48,442 48,011 Deferred federal income taxes (Note 4) - 159 Short-term notes payable (Note 7) 5,575 12,931 Long-term notes payable (Note 7) 1,125 25,170 Convertible subordinated debentures (Note 10) 57,477 - Total liabilities 1,015,724 891,967 Commitments and contingencies (Notes 4 to 9 and 14) Redeemable Preferred Stock, no par value (Note 11): $2.125 cumulative convertible exchangeable preferred stock: Authorized: 5,000,000 shares Issued and outstanding: (1993 - 947,000 shares; 1992 - 959,600 shares) 23,675 23,900 Stockholders equity (Notes 4 and 9 to 13): Common Stock, $1 par value: Authorized: 20,000,000 shares Issued, including shares in treasury (1993 - 6,900,000; 1992 - 6,820,000) 6,900 6,820 Additional paid-in capital 28,814 28,399 Unrealized appreciation of equity securities (Note 3) 3,285 3,044 Retained earnings 34,645 24,521 Less treasury stock at cost (1993 - 556,800 shares; 1992 - 10,600 shares) (4,772) (52) Total stockholders equity 68,872 62,732 $1,108,271 $978,689 See notes to consolidated financial statements. See notes to consolidated financial statements. Pioneer Financial Services, Inc. and Subsidiaries Statements of Consolidated Cash Flows (In Thousands) Year ended December 31 1993 1992 1991 Operating activities Net income (loss) $ 12,145 $ (16,959)$ 8,872 Adjustments to reconcile net income or loss to net cash provided by operating activities: Decrease (increase) in premiums receivable(3,912) 5,673 6,782 Increase in policy liabilities 31,132 12,734 51,280 Deferral of policy acquisition costs (67,633) (56,936) (102,824) Amortization of deferred policy acquisition costs (Note 8) 76,875 100,715 95,748 Deferred income tax benefit (4,239) (11,355) (2,780) Change in other assets and liabilities (13,423) (10,597) (4,107) Depreciation, amortization, and accretion 9,795 10,303 2,761 Realized losses (gains) (Note 3) 1,336 47 (7,897) Net cash provided by operating activities 42,076 33,625 47,835 Investing activities Net decrease (increase) in short-term investments 28,792 (21,403) 57,883 Purchases of investments and loans made (382,339) (621,017) (400,871) Sales of investments 192,697 451,422 294,333 Maturities of investments and receipts from repayment of loans 118,620 151,042 32,734 Net purchases of property and equipment (3,956) (4,434) (3,470) Sale of subsidiary, net of cash sold of $166 - - 8,386 (Note 18) Purchase of subsidiaries including a cash overdraft of $1,019 (Note 18) (9,685) - - Net cash used by investing activities (55,871) (44,390) (11,005) Financing activities Net proceeds from issuance of convertible subordinated debentures (Note 10) 54,055 - - Increase in notes payable - 14,030 - Repayment of notes payable (31,401) (3,900) (15,247) Proceeds from sale of agent receivables (Note 6) 25,376 20,347 36,950 Transfer of collections on previously sold agent receivables (Note 6) (22,981) (22,437) (43,539) Dividends paid (2,021) (2,039) (2,039) Stock options exercised 451 165 - Purchase of treasury stock (4,720) (52) - Retirement of preferred stock (315) - - Other 44 717 - Net cash provided (used) by financing activities 18,488 6,831 (23,875) Increase (decrease) in cash 4,693 (3,934) 12,955 Cash at beginning of year 18,686 22,620 9,665 Cash at end of year $ 23,379 $ 18,686 $ 22,620 See notes to consolidated financial statements. Pioneer Financial Services, Inc. and Subsidiaries Notes to Consolidated Financial Statements 1. Accounting Policies Principles of Consolidation The accompanying consolidated financial statements have been prepared in conformity with generally accepted accounting principles (GAAP) and include the accounts and operations, after intercompany eliminations, of Pioneer Financial Services, Inc. (PFS) and its subsidiaries. Investments PFS's fixed maturity portfolio is segregated into two components: fixed maturities held to maturity and fixed maturities available for sale. Fixed maturities, where the intent is to hold to maturity, are carried at amortized cost, adjusted for other-than-temporary impairments. In cases where there are changes in credit risk, fixed maturities that are carried at amortized cost may be liquidated prior to maturity. Fixed maturities that are available for sale are carried, on an aggregate basis, at the lower of amortized cost or fair value. Changes in aggregate unrealized depreciation on fixed maturities available for sale are reported directly in stockholders' equity, net of applicable deferred income taxes. The amortized cost of fixed maturities classified as held to maturity or available for sale is adjusted for amortization of premiums and accretion of discounts to maturity, or, for mortgage-backed securities, over the estimated life of the security. Such amortization is included in net investment income. To the extent that the estimated lives of mortgage- backed securities change as a result of changes in prepayment rates, the accumulated amortization of premiums and the accretion of discounts is adjusted retrospectively with a charge or credit to current operations. As regards equity securities, changes in unrealized appreciation or temporary depreciation, after deferred income tax effects, are reported directly in stockholders equity. Realized gains and losses on the sale of investments are determined on the specific identification basis and are included in other income in the statements of operations. Revenues Revenues for interest-sensitive life insurance and annuities consist of charges assessed against policy account values. For accident and health and other life insurance, premiums are recognized as revenue when due. Accident and health group association dues and fees, included in other revenues, are recognized as revenue when received. Pioneer Financial Services, Inc. and Subsidiaries Notes to Consolidated Financial Statements (consolidated) 1. Accounting Policies (continued) Future Policy Benefits The liabilities for future policy benefits related to the annuity and interest-sensitive life insurance policies are calculated based on accumulated fund values. As of December 31, 1993, interest credited during the contract accumulation period ranged from 5.0% to 8.0%. Investment spreads and mortality gains are recognized as profits when realized, based on the difference between actual experience and amounts credited or charged to policies. The carrying amounts of PFS's liabilities for investment-type insurance contracts were $200,894,000 and $173,930,000 at December 31, 1993 and 1992, respectively. The fair values of these liabilities at December 31, 1993 and 1992 were $191,816,000 and $165,739,000, respectively. The liabilities for future policy benefits on other life and accident and health insurance policies have been computed by a net level method based on estimated future investment yield, mortality or morbidity, and withdrawals, including provisions for adverse deviation. Interest rate assumptions range from 3.5% to 8.5% depending on the year of issue. The provisions for future policy benefits and the deferral and amortization of policy acquisition costs are intended to result in benefits and expenses being associated with premiums proportionately over the policy periods. Unearned Premiums Unearned premiums are calculated using the monthly pro-rata basis. Deferred Policy Acquisition Costs Costs that vary with, and are primarily related to, the production of new business are deferred. Such costs are primarily related to accident and health business and principally include the excess of new business commissions over renewal commissions and underwriting and sales expenses. For annuities and interest-sensitive life insurance policies, deferred costs are amortized generally in proportion to expected gross profits arising from the difference between investment and mortality experience and amounts credited or charged to policies. That amortization is adjusted retrospectively when estimates of current or future gross profits (including the impact of realized investment gains and losses) to be realized from a group of products are revised. For other life and accident and health policies, costs are amortized over the premium-paying period of the policies, using the same mortality or morbidity, interest, and withdrawal assumptions that are used in calculating the liabilities for future policy benefits. 1. Accounting Policies (continued) The unamortized cost of purchased insurance in force is included in deferred policy acquisition costs ($23,078,000 and $20,200,000 at December 31, 1993 and 1992, respectively). Amortization of these amounts is in relation to the present value of estimated gross profits over the estimated remaining life of the related insurance in force. Policy and Contract Claims The liabilities for policy and contract claims, principally accident and health, are determined using case-basis evaluations and statistical analyses based on past experience and represent estimates of the ultimate net cost of incurred claims and the related claim adjustment expenses. Although considerable variability is inherent in such estimates, management believes that these liabilities are adequate. The estimates are continually reviewed and adjusted as necessary; such adjustments are included in current operations. Reinsurance Reinsurance premiums, commissions, expense reimbursements, and receivables related to reinsured business are accounted for on bases consistent with those used in accounting for the original policies issued and the terms of the reinsurance contracts. Premiums reinsured to other companies have been reported as reductions of premium revenues. Amounts recoverable for reinsurance related to future policy benefits, unearned premium reserves, and claim liabilities have been reported as reinsurance receivables; expense allowances received in connection with reinsurance have been accounted for as a reduction of the related deferred policy acquisition costs and are deferred and amortized accordingly. Acquisition costs relating to the production of new business result in a reduction of statutory-basis net income. PFS had entered into certain financial reinsurance agreements that have the effect of deferring this statutory-basis reduction and amortizing costs over future periods. The remaining effect of such reinsurance has been eliminated from the accompanying consolidated financial statements. 1. Accounting Policies (continued) Federal Income Taxes Federal income tax provisions are based on income or loss reported for financial statement purposes and tax laws and rates in effect for the years presented. For 1992 and 1991, deferred federal income taxes were provided for the differences between the recognition of income and loss determined for financial reporting purposes and income tax purposes. Effective January 1, 1993, deferred federal income taxes have been provided using the liability method an accordance with Financial Accounting Standards Board (FASB) Statement No. 109 "Accounting for Income Taxes" (See Note 2). Under this method deferred tax assets and liabilities are determined based on the differences between their financial reporting and their tax bases and are measured using enacted tax rates. Depreciation Building and equipment are recorded at cost and are depreciated using principally the straight-line method. Net Income or Loss Per Common Share Primary net income or loss per share of Common Stock is determined by dividing net income or loss, less dividends on Preferred Stock, by the weighted-average number of Common Stock and Common Stock equivalents (dilutive stock options) outstanding. Where the effect of Common Stock equivalents on net income or loss per share would be antidilutive, they are excluded from the average shares outstanding. Fully diluted net income or loss per share is computed as if the Preferred Stock and Convertible Subordinated Debentures had been converted to Common Stock. Where the effect of the assumed conversion on net income or loss per share would be antidilutive, fully diluted net income or loss per share represents the primary amount. 1. Accounting Policies (continued) Cost in Excess of Net Assets of Companies Acquired The cost in excess of net assets of companies acquired (goodwill) ($5,449,000 and $3,776,000 at December 31, 1993 and 1992, respectively) is included in other assets and is being amortized principally on a straight- line basis over periods from seven to forty years. Treasury Stock The board of directors has authorized PFS to buy back shares of its own common and preferred stock on the open market from time to time. During 1993 and 1992, PFS repurchased 546,200 and 10,600 shares, respectively, of their common stock. During 1993, PFS repurchased 12,600 shares of their preferred stock. Treasury stock is accounted for using the cost method. Cash Flow Information Cash includes cash on hand and demand deposits. Fair Values of Financial Instruments The following methods and assumptions were used by PFS in estimating its fair values for financial instruments: Cash, short-term investments, short-term notes payable, and accrued investment income: The carrying amounts reported in the balance sheets for these instruments approximate their fair values. Investment securities: Fair values for fixed maturity securities (including redeemable preferred stocks) are based on quoted market prices, where available. For fixed maturity securities not actively traded, fair values are estimated using values obtained from independent pricing services, or, in the case of private placements, are estimated by discounting expected future cash flows using a current market rate applicable to the yield,quality, and maturity of the investments. The fair values for equity securities are based on quoted market prices and are recognized in the balance sheets. Mortgage loans and policy loans: The carrying amount of PFS's mortgage loans approximates their fair values. The fair values for policy loans are estimated using capitalization of earnings methods, using interest rates currently being offered for similar loans to borrowers with similar credit ratings. Investment contracts: Fair values for PFS's liabilities under investment- type insurance contracts are based on current cash surrender values. Fair values for PFS's insurance policies other than investment contracts are not required to be disclosed. However, the fair values of liabilities under all insurance policies are taken into consideration in PFS's overall management of interest rate risk, which minimizes exposure to changing interest rates through the matching of investment maturities with amounts due under insurance policies. Long-term notes payable: The fair value of PFS's long-term notes payable approximates the carrying value. Convertible subordinated debentures: The fair value of PFS's convertible subordinated debentures is based on quoted market prices. New Accounting Standard In 1993 the FASB issued Statement No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which PFS must adopt prospectively effective January 1, 1994. Under the new rules, fixed maturities that PFS has both the positive intent and ability to hold to maturity will be carried at amortized cost. Fixed maturities that PFS does not have the positive intent and ability to hold to maturity and all marketable equity securities will be classified as available-for-sale or trading and carried at fair value. Unrealized holding gains and losses on securities classified as available-for-sale will be included as a separate component of stockholders' equity. Unrealized holding gains and losses on securities classified as trading will be reported in earnings. PFS does not anticipate categorizing any fixed maturities as trading. In connection with the adoption of the Statement No. 115, PFS may reclassify certain investments in fixed maturities between the available for sale and held to maturity categories. Accordingly, as of January 1, 1994, although the carrying value of investments in fixed maturities is expected to increase based on the December 31, 1993 fair values, the net effect on stockholders' equity has not been determined. Previously reported financial statements are not permitted to be restated for this Statement. Reclassifications Certain amounts in the 1991 and 1992 financial statements have been reclassified to conform to the 1993 presentation. 2. Changes in Accounting Principles Federal Income Taxes Effective January 1, 1993, PFS changed its method of accounting for income taxes from the deferred method to the liability method required by FASB Statement No. 109, "Accounting for Income Taxes". As permitted under the new rules, prior years' financial statements have not been restated. The cumulative effect of adopting Statement No. 109 as of January 1, 1993 was not significant and has not been separately disclosed (See Note 4 for further income tax disclosures). Reinsurance Effective January 1, 1993, PFS changed its method of accounting for reinsurance contracts in accordance with FASB Statement No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long- Duration Contracts". Under Statement No. 113, all assets and liabilities related to reinsured insurance contracts are reported on a gross basis rather than the previous practice of reporting such assets and liabilities net of reinsurance. The effect of adopting Statement No. 113 was to increase both assets and liabilities by $19,453,000 and $16,391,000 at December 31, 1993 and 1992, respectively. The amounts recoverable from reinsurers are now classified as reinsurance receivables on the balance sheets. As permitted under Statement No. 113, the accompanying December 31, 1992 balance sheet has been reclassified to the gross basis. The adoption of Statement No. 113 had no effect on net income. 3. Investments Realized investment gains (losses), including provisions for losses on investments held, and unrealized appreciation (depreciation) on equity securities, fixed maturities, and other investments are summarized as follows: Fixed Equity Maturities Securities Other Total (In Thousands) Realized $ (1,638) $ 293 $ 9 $(1,336) Unrealized 3,864 442 - 4,306 $ 2,226 $ 735 $ 9 2,970 Realized $ (91) $ 44 $ - $ (47) Unrealized (11,144) 6,998 - (4,146) $(11,235) $ 7,042 $ - $(4,193) Realized $ 7,280 $ (244) $ 861 $ 7,897 Unrealized 15,379 3,899 - 19,278 $ 22,659 $ 3,655 $ 861 $ 27,175 For annuities and interest-sensitive life insurance policies, GAAP requires that deferred policy acquisition costs be amortized in proportion to the estimated profits, including realized investment gains, expected to be realized over the life of the policies. In 1991, PFS sold investments related to this life and annuity business and realized a substantial amount of gains. As required by GAAP, realizing these higher-than-expected gains caused additional deferred policy acquisition cost amortization totaling $3,800,000 in 1991. At December 31, 1993 and 1992, the allowance for losses on investments held amounted to $4,200,000 and $1,900,000, respectively. At December 31, 1993, gross unrealized appreciation pertaining to equity securities was $5,067,000 and gross unrealized depreciation was $13,000. Deferred taxes of $1,769,000 and $1,568,000 have been provided on the net unrealized appreciation at December 31, 1993 and 1992, respectively. A comparison of amortized cost to fair value of fixed maturity investments by category is as follows: Gross Gross Amortized UnrealizedUnrealized Fair Cost Gains Losses Value (In Thousands) At December 31, 1993: Held to Maturity U.S. Treasury $ 9,124 $ 100 $ (61) $ 9,163 States and political subdivisions 5,200 - - 5,200 Corporate securities 119,276 2,653 (312) 121,617 Mortgage-backed securities 192,912 1,908 (5,260) 189,560 $326,512 $4,661 $(5,633) $325,540 Available for Sale U.S. Treasury $ 26,894 $ 570 $ (26) $ 27,438 States and political subdivisions 21,571 121 - 21,692 Foreign governments 4,056 2 (119) 3,939 Corporate securities 73,981 744 (465) 74,260 Mortgage-backed securities 131,215 5,029 (310) 135,934 $257,717 $6,466 $ (920) $263,263 Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Value (In Thousands) At December 31, 1992: Held to Maturity U.S. Treasury $ 15,363 $ 406 $ (71) $ 15,698 States and political subdivisions 199 12 - 211 Corporate securities 98,836 1,344 (1,366) 98,814 Mortgage-backed securities 320,328 7,140 (7,996) 319,472 $434,726 $8,902 $(9,433) $434,195 Available for Sale U.S. Treasury $ 1,425 $ 109 $ - $ 1,534 Corporate securities 6,343 181 (62) 6,462 Mortgage-backed securities 30,983 1,263 (250) 31,996 $ 38,751 $1,553 $(312) $ 39,992 The amortized cost and fair value of fixed maturities at December 31, 1993, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without prepayment penalties. Amortized Fair Cost Value Held to Maturity: (In Thousands) Due in 1994 $ 657 $ 673 Due 1995-1998 16,707 17,254 Due 1999-2003 67,455 68,611 Due after 2003 48,781 49,442 Mortgage-backed securities 192,912 189,560 $326,512 $325,540 Available for Sale: Due in 1994 $ 2,308 $ 2,378 Due 1995-1998 36,109 36,544 Due 1999-2003 61,750 62,036 Due after 2003 26,335 26,371 Mortgage-backed securities 131,215 135,934 $257,717 $263,263 The fair value of PFS's investment in policy loans was estimated to be $21,011,000 and $18,037,000 at December 31, 1993 and 1992, respectively. Proceeds from sales of investments (principally fixed maturities) during 1993, 1992 and 1991 were $192,697,000, $451,422,000 and $294,333,000, respectively. Gross gains of $10,834,000, $8,073,000 and $7,808,000 and gross losses of $12,472,000, $8,164,000 and $528,000 were realized on fixed maturity sales in 1993, 1992 and 1991, respectively. Major categories of net investment income are summarized as follows: 1993 1992 1991 (In Thousands) Fixed maturities $34,529 $39,384 $38,687 Short-term investments 2,691 2,083 6,311 Other 4,069 3,733 4,079 Total investment income 41,289 45,200 49,077 Investment expenses (1,047) (1,645) (1,103) Net investment income $40,242 $43,555 $47,974 At December 31, 1993, securities with a carrying value of $92,624,000 were on deposit with various government authorities to meet regulatory requirements. At December 31, 1993, the carrying value of investments in any one entity and/or in their affiliates which exceeded 10% of PFS s consolidated stockholders equity were as follows: Fixed Maturities Ford Capital $18,684,000 GMAC 17,472,000 State of Washington 10,023,000 Associates Corporation 7,242,000 At December 31, 1993, PFS held unrated or less-than-investment-grade securities of $803,000, net of reserves for losses, with an aggregate fair value of $824,000. Those holdings amounted to less than 1% of PFS s total investments at December 31, 1993. At December 31, 1993, fixed maturities with a carrying value of $18,129,000 had been non-income producing for the preceding 12-month period. 4. Federal Income Taxes As discussed in Note 2, PFS adopted FASB Statement No. 109 as of January 1, 1993. The cumulative effect of the change in accounting for income taxes was not significant. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of PFS's deferred tax liabilities and assets as of December 31, 1993 are as follows (in thousands): Deferred tax liabilities Deferred policy acquisition costs $86,545 Net unrealized appreciaton on marketable equity securities 1,769 Other 1,367 Total deferred tax liabilities 89,681 Deferred tax assets Policy liabilities 77,493 Financial reinsurance 11,150 Other 8,833 Total deferred tax assets 97,476 Valuation allowance for deferred tax assets (3,873) Deferred tax assets net of valuation allowance allowance 93,603 Net deferred tax asset $ 3,922 The nature of PFS's deferred tax assets and liabilities are such that the reversal pattern for these temporary differences should generally result in realization of PFS's deferred tax assets. PFS establishes a valuation allowance for any portion of the deferred tax asset that management believes may not be realized. In 1993, the valuation allowance was increased by $1,221,000 principally due to the acquisition of Continental Life & Accident Company (See Note 18). The deferred tax benefit for 1992 and 1991 includes the effects of the following items: 1992 1991 (Dollars in thousands) Deferred policy acquisition costs $(16,232) $ (440) Policy liabilities 2,966 (5,967) Decrease in operating loss carryforward 143 2,050 General expenses 1,537 522 Financial statement capital gains greater than tax capital gains 148 743 Other 83 312 Deferred federal income tax benefit $(11,355) $(2,780) PFS s effective federal income tax rate varied from the statutory federal income tax rate as follows: Deferred Method Liability Method 1993 1992 1991 Amount % Amount % Amount % (Dollars in Thousands) Statutory federal income tax rate applied to income or loss before income taxes $6,567 35.0% $(8,648) 34.0% $ 4,529 34.0% Nondeductible goodwill amortization 319 1.7 192 (.8) 212 1.6 Realized gain on sale of subsidiary in excess of tax-basis gain (Note 18) - - - - (247) (1.9) Tax exempt interest (99) (.5) - - - - Other (168) (.9) (21) .1 (46) (.3) Income taxes (benefit) and effective rate $ 6,619 35.3% $(8,477) 33.3% $ 4,448 33.4% Taxes paid amounted to $5,735,000, $8,828,000, and $2,566,000 for 1993, 1992, and 1991, respectively. Under pre-1984 life insurance company income tax laws, a portion of a life insurance company s gain from operations was not subjected to current income taxation but was accumulated, for tax purposes, in a memorandum account designated as the policyholders surplus account. The balance in this account at December 31, 1993 for PFS s life insurance subsidiaries was $10,040,000. Should the policyholders surplus accounts of PFS s life insurance subsidiaries exceed their respective maximums, or should distributions in excess of their tax-basis shareholders surplus account be made by the life insurance subsidiaries, such excess or distribution would be subject to federal income taxes at rates then in effect. Deferred taxes of $3,500,000 have not been provided on amounts included in the policyholders surplus accounts, since PFS contemplates no such taxable events in the foreseeable future. As of December 31, 1993, PFS s life insurance subsidiaries had combined tax-basis shareholders surplus accounts of $36,100,000. Distributions up to that amount would result in no income tax liability. 5. Reinsurance PFS s insurance subsidiaries reinsure risks with other companies to permit the recovery of a portion of the direct losses. These reinsured risks are treated as though, to the extent of the reinsurance, they are risks for which the subsidiaries are not liable. PFS remains liable to the extent that the reinsuring companies do not meet their obligations under these reinsurance treaties. PFS's premiums were reduced for reinsurance premiums by $40,592,000, $30,469,000, and $33,789,000 in 1993, 1992, and 1991, respectively. Under various reinsurance arrangements, PFS's premiums were increased by $19,338,000, $15,403,000, and $13,933,000 in 1993, 1992, and 1991, respectively. PFS's policy benefits have been reduced for reinsurance recoveries of $21,871,000 in 1993, $22,171,000 in 1992, and $28,714,000 in 1991. At December 31, 1993, approximately 67% of PFS's reinsurance receivables and amounts on deposit with reinsurers were due from Employers Reinsurance Corporation. 6. Sale of Agent Receivables In 1993, 1992, and 1991 a subsidiary of PFS sold agent receivables to an unaffiliated company for proceeds of $25,376,000, $20,347,000, and $36,950,000, respectively. The outstanding balances of such agent receivables sold that remained uncollected at December 31, 1993 and 1992 were $9,815,000 and $6,339,000, respectively. PFS remains subject to a maximum credit exposure under this agreement amounting to 10% of agent receivables at December 31, 1993. 7. Notes Payable In 1992, PFS settled certain disputes with several former agents and in addition to certain cash payments issued promissory notes representing future commissions. A final payment of $1,490,000 is payable for these notes in 1994. At December 31, 1993, PFS had $3,785,000 of short-term debt liability for which a PFS agency subsidiary s future renewal commissions were pledged as collateral. At December 31, 1993, a PFS subsidiary had an unsecured loan of $1,425,000. The portion of the loan due in 1994 of $300,000 is included in short-term notes payable. The remainder of the note is included in long-term notes payable. The note bears interest currently at 6% per annum and is payable quarterly with the final payment due July 1998. Interest paid amounted to $1,023,000, $2,274,000, and $2,416,000 for 1993, 1992, and 1991, respectively. 8. Accident and Health Business In making the determination that policy liabilities, future premiums, and anticipated investment income will be adequate to provide for future claims and expenses (including the amortization of deferred policy acquisition costs), PFS has made assumptions with regard to each of these items. Although there is significant variability inherent in these estimates, management believes that these assumptions are reasonable. Pursuant to an actuarial study performed in the fourth quarter of 1992, PFS revised certain of these assumptions to reflect present and anticipated future experience. This study resulted in increased amortization of deferred policy acquisition costs of approximately $30,000,000 in the fourth quarter of 1992. 9. Statutory-Basis Financial Information The following tables compare combined net income and stockholders' equity for PFS's insurance subsidiaries determined on the basis as prescribed or permitted by regulatory authorities (statutory basis) with consolidated net income (loss) and stockholders' equity reported in accordance with GAAP. Statutory basis accounting emphasizes solvency rather than matching revenues and expenses during an accounting period. The significant differences between statutory basis accounting and GAAP are as follows: Deferred Policy Acquisition Costs. Costs of acquiring new policies are expensed when incurred (statutory basis) rather than capitalized and amortized over the term of the related polices (GAAP). Policy Liabilities. Certain policy liabilities are calculated based on statutorily required methods and assumptions (statutory basis) rather than on estimated expected experience or, for annuity and interest-sensitive life insurance, actual account balances (GAAP). Financial Reinsurance. The effects of certain financial reinsurance transactions are included in the statutory basis financial statements but are eliminated from the GAAP financial statements. Deferred Federal Income Taxes. Deferred federal income taxes are not provided on a statutory basis for differences between financial statement and tax return amounts. Surplus Notes. Surplus notes are reported in capital and surplus (statutory basis) rather than as liabilities (GAAP). Non-insurance Companies' Equity. Contributions by PFS to the capital and surplus of its insurance subsidiaries increases the stockholders' equity of those insurance subsidiaries on a statutory basis but does not effect the consolidated stockholders' equity on a GAAP basis. 1993 1992 1991 (in thousands) Combined net income on a statutory basis $10,155 $ 3,629 $15,150 Adjustments for: Deferred policy acquisition costs (12,842) (43,779) 7,076 Policy liabilities (18,494) (19,957) (28,530) Financial reinsurance 34,017 33,118 3,862 Deferred federal income taxes 4,239 11,355 2,780 Non-insurance companies, eliminations, and other adjustments (4,930) (1,325) 8,534 Consolidated net income (loss) in accordance with GAAP $12,145 $(16,959) $ 8,872 December 31 1993 1992 (in thousands) Combined stockholders' equity on a statutory basis $ 106,567 $ 82,432 Adjustments for: Deferred policy acquisition costs 260,432 269,674 Policy liabilities (206,966) (184,862) Financial reinsurance (30,292) (64,309) Deferred federal income taxes 3,922 (159) Non-admitted assets 11,743 19,160 Surplus - (29,128) Non-insurance companies' equity, eliminations, and other adjustments (76,534) (30,076) Consolidated stockholders' equity in accordance with GAAP $ 68,872 $ 62,732 Dividends from PFS's insurance subsidiaries are limited to the greater of the prior-year statutory-basis net gain from operations or 10% of statutory-basis surplus. The total amount of dividends that could be paid without regulatory approval was $10,117,000 at December 31, 1993. At December 31, 1993, PFS's retained earnings is $20,861,000 in excess of the combined statutory-basis unassigned surplus of the insurance subsidiaries. PFS is required to maintain adequate amounts of statutory-basis capital and surplus to satisfy regulatory requirements and provide capacity for production of new business. Acquisition costs relating to the production of new business result in a reduction of statutory-basis net income and capital and surplus. 10. Convertible Subordinated Debentures In July 1993 PFS issued $57,477,000 of 8% convertible subordinated debentures due in 2000. Interest on the debentures is payable in January and July of each year. Net proceeds from the offering totaled approximately $54,000,000 and were used, in part, to repay the long-term notes payable. The debentures are convertible into PFS's Common Stock at any time prior to maturity, unless previously redeemed, at a conversion price of $11.75 per share. The fair value of the debentures was $70,122,000 at December 31, 1993. The debentures are redeemable by PFS under certain conditions after July 1996. At December 31, 1993, 4,891,660 shares of PFS's Common Stock were reserved for conversion of the outstanding convertible subordinated debentures. 11. Redeemable Preferred Stock In 1989, PFS issued 1,000,000 shares of $2.125 Cumulative Convertible Exchangeable Preferred Stock. The proceeds of the public offering were $23,337,000 after reduction for expenses of $1,663,000, which expenses were charged to additional paid-in capital. The Preferred Stock is carried on PFS s balance sheet at the redemption and liquidation value of $25 per share. Each share of Preferred Stock is convertible by the holders at any time into 1.6 shares of PFS Common Stock. Annual cumulative dividends of $2.125 per share are payable quarterly. The preferred stock is nonvoting unless dividends are in arrears. At December 31, 1993, 1,515,200 shares of PFS's Common Stock were reserved for conversion of the outstanding preferred stock. The Preferred Stock is redeemable at the option of the holders upon certain acquisitions or other business combinations involving PFS Common Stock. The Preferred Stock is redeemable by PFS at redemption prices of $26.275 per share in 1993, declining to $25 in 1999. The Preferred Stock is exchangeable in whole at PFS s option on any dividend payment date for PFS s 8 1/2% Convertible Subordinated Debentures due in 2014 at the rate of $25 principal amount of Subordinated Debentures for each share of Preferred Stock. 12. Shareholder Rights Agreement In 1990, PFS distributed one preferred share purchase right for each outstanding share of Common Stock. The rights are intended to cause substantial dilution to a person or group that attempts to acquire PFS on terms not approved by PFS s directors. The rights expire in 2000 or PFS may redeem the rights prior to exercise for $.01 per right. The rights are not exercisable unless a person or group acquires, or offers to acquire, 20% or more of PFS s Common Stock under certain circumstances. The rights, when exercisable, entitle the holder to purchase one-tenth of a share of a new series of PFS Series A Junior Preferred Stock at a purchase price of $45. Such preferred shares, of which 2,000,000 are authorized, would be voting and would be entitled to distributions that are ten times the distributions to common shareholders. Subsequent to exercise of the rights, in the event of certain business combinations involving PFS, a holder of rights would have the right to receive PFS Common Stock with a value of two times the exercise price of the rights. 13. Stock Options and Rights PFS has a nonqualified stock option plan principally for directors and key employees of PFS and its subsidiaries. PFS s Board of Directors grants the options and specifies the conditions of the options. Options expire ten years after grant. Information with respect to these options is as follows: 1993 1992 Number Number of Exercise of Exercise Shares Price Shares Price Options outstanding at beginning of year 594,250 $5.50-$12.00 799,750 $5.50- $12.00 Granted 225,000 5.50 35,000 7.25 Exercised 72,000 5.50- 12.00 30,000 5.50 Canceled/repurchased 14,000 5.50 210,000 5.50-12.00 Options outstanding at end of year 733,250 $5.50-$12.00 594,250 $5.50-$12.00 Options exercisable at end of year 573,250 471,750 Unoptioned shares available for granting of options 22,900 233,900 14. Commitments and Contingencies PFS and its subsidiaries are named as defendants in various legal actions, some claiming significant damages, arising primarily from claims under insurance policies, disputes with agents, and other matters. PFS s management and its legal counsel are of the opinion that the disposition of these actions will not have a material adverse effect on PFS s financial position. PFS leases various office facilities and computer equipment under noncancelable operating leases on an annual basis. Rent expense was $4,516,000, $3,700,000, and $3,653,000 in 1993, 1992, and 1991, respectively. Minimum future rental commitments in connection with noncancelable operating leases are as follows: 1994 $2,075,000 1995 1,637,000 1996 969,000 1997 619,000 1998 130,000 PFS has entered into employment agreements with certain officers. 15. Benefit Plan PFS has a defined-contribution employee benefit plan that covers substantially all home office employees who have attained age 21 and completed one year of service. Plan participants may contribute from 1% to 10% of their total compensation subject to an annual maximum. The plan also provides for PFS to match participants contributions up to $1,000 per year and 50% of participants contributions above $1,000 up to the annual Internal Revenue Service limit ($8,994 in 1993). PFS makes employer contributions to the plan in cash or in PFS Common Stock at the discretion of PFS s Board of Directors. At December 31, 1993 the Plan's assets included PFS Common Stock of $3,478,000, at fair value. PFS's contibutions charged to operations were $1,073,000 in 1993, $852,000 in 1992, and $831,000 in 1991. A PFS subsidiary, which owns insurance and agency companies, had a stock purchase plan that allowed certain eligible agents to purchase common stock in the subsidiary at the subsidiary s per share book value. The plan was terminated in November 1992. In accordance with the plan's provisions, agents became fully vested. Eligible agents were given the option to participate in a new agent stock purchase plan. This new plan allows agents to purchase PFS Common Stock. Stock purchases are limited to a specific percentage of the agent's commission as determined by PFS but in no event to be less than 3%. Under the plan the agents are also credited with additional shares of PFS Common Stock as determined by PFS. In 1993 and 1992, 8,057 shares and 163,566 shares, respectively, of PFS Common Stock were issued under this plan. The subsidiary received proceeds of $499,000 in 1991 relating to the minority stock sales and paid $353,000 in 1992, and $1,862,000 in 1991 relating to repurchases of these shares from the agents at book value. In addition, in 1991, in connection with stock option agreements, the subsidiary issued shares to agents. Proceeds on these sales amounted to $559,000 and a charge to operations of $47,000 was recognized. The subsidiary subsequently repurchased the shares in 1991 at book value in the amount of $606,000. 16. Related Party Transactions PFS paid, on a per use basis, a transportation company owned by an officer, a total of $81,000, $127,000, and $130,000 in 1993, 1992, and 1991, respectively, for transportation of employees and agents. In 1993, certain of PFS's marketing subsidiaries paid rent of approximately $107,000 and parking fees of approximately $12,000 to a partnership in which an officer owns a 50% interest. PFS believes that the rates charged to PFS's subsidiaries were the same as those charged to unaffiliated third parties. In 1991, PFS paid commissions of $2,135,000 to an agent training company. That company s expenses included distributions to the agents, the cost of marketing leads purchased from PFS of $774,000 in 1991, and training and other expenses. Certain officers had interests in the agent training company. In 1991 PFS paid a company in which certain officers had interests, $2,450,000 for telecommunication, printing, and mailing services. 17. Allowances and Accumulated Depreciation Allowances for doubtful accounts related to other receivables amounted to $1,271,000 at December 31, 1993 and $1,504,000 at December 31, 1992. Accumulated depreciation related to building and equipment amounted to $16,891,000 at December 31, 1993 and $11,646,000 at December 31, 1992. 18. Purchase and Sale of Subsidiaries In August 1993, PFS purchased 80% of the outstanding common stock of Continental Life & Accident Company and 100% of the outstanding common stock of Continental Marketing Corporation for $7,100,000 in cash. The total assets acquired at the purchase date were approximately $80,000,000. Also in August 1993, PFS purchased Healthcare Review Corporation, a managed care company for $1,566,000 in cash. The total assets acquired at the purchase date were approximately $2,000,000. Revenues included in PFS's 1993 consolidated statements of operations relating to these acquired entities were $25,671,000. The operations of the entities did not have a material effect on PFS's 1993 net income. In September 1991, PFS sold a subsidiary for proceeds of $8,552,000 and recorded a gain of $708,000. Revenues included in PFS's consolidated statements of operations relating to the subsidiary's operations were $4,689,000 in 1991. The subsidiary represented a portion of the life and annuity segment. 19. Segment Information PFS has three business segments: insurance, managed care and marketing. The segments are based on PFS's strategic business units. Allocations of investment income and certain general expenses are based on various assumptions and estimates, and reported operating results by segment would change if different methods were applied. Assets are not individually identifiable by segment and have been allocated based on the amount of policy liabilities by segment and by other formulas. Depreciation expense and capital expenditures are not considered material. Realized investment gains and losses are allocated to the appropriate segment. General corporate expenses are not allocated to the individual segments. Revenues, income or loss before income taxes, and identifiable assets by business segment are as follows: Revenues 1993 1992 1991 (in thousands) Insurance: Accident and health $ 611,822 $ 572,280 $ 612,215 Life and annuity 72,376 68,411 80,059 Marketing: Unaffiliated 15,020 13,361 14,630 Inter-segment 30,439 26,500 35,054 Managed care: Unaffiliated 4,506 1,921 1,834 Inter-segment 4,358 2,041 409 738,521 684,514 744,201 Eliminations 34,797 28,541 35,463 Total $ 703,724 $ 655,973 $ 708,738 Income (loss) before income taxes Insurance: Accident and health $ 8,578 $ (26,613) $ 1,886 Life and annuity 7,623 340 5,838 Marketing 10,205 3,345 8,556 Managed care (1,211) 335 62 Corporate expenses (6,431) (2,843) (3,022) Total $ 18,764 $ (25,436) $ 13,320 Identifiable assets at year-end Insurance: Accident and health $ 571,169 $ 489,053 $ 496,493 Life and annuity 514,154 478,529 460,752 Marketing 18,244 9,590 10,585 Managed care 4,704 1,517 1,360 Total $1,108,271 $ 978,689 $ 969,190 20. Credit Arrangements PFS has a line of credit arrangement for short-term borrowings with three banks amounting to $20,000,000 through April 1996, all of which all was unused at December 31, 1993. The line of credit arrangement can be terminated, in accordance with the agreement, at PFS's option. 21. Quarterly Financial Data (Unaudited) A summary of unaudited quarterly results of operations for 1993 and 1992 is as follows: 1st 2nd 3rd 4th Premiums and policy charges $155,343 $154,189 $154,132 $181,898 Net investment income and other 14,369 13,928 15,802 14,063 Net income 2,295 2,627 3,128 4,095 Net income per share: Primary .26 .31 .40 .54 Fully diluted .26 .31 .31 .37 1st 2nd 3rd 4th Premiums and policy charges $144,054 $149,969 $143,973 $157,117 Net investment income and other 17,131 17,286 14,876 11,567 Net income (loss) 1,495 357 710 (19,521) Net income (loss) per share: Primary .15 (.02) .03 (2.98) Fully diluted .15 (.02) .03 (2.98) See Note 8 for a discussion of a 1992 fourth quarter adjustment. SCHEDULE I PIONEER FINANCIAL SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED SUMMARY OF INVESTMENTS--OTHER THAN INVESTMENTS IN RELATED PARTIES December 31, 1993 Amount Shown in the Consolidated Amortized Fair Balance Type of Investment Cost Value Sheet (in thousands) Fixed maturities to be held to maturity: U.S. Treasury $ 9,124 $ 9,163 $ 9,124 States and political subdivisions 5,200 5,200 5,200 Corporate securities 119,276 121,617 119,276 Mortgage-backed securities 192,912 189,560 192,912 TOTAL FIXED MATURITIES TO BE HELD TO MATURITY 326,512 $325,540 326,512 Fixed maturities available for sale: U.S. Treasury 26,894 $ 27,438 26,894 States and political subdivisions 21,571 21,692 21,571 Foreign governments 4,056 3,939 4,056 Corporate securities 73,981 74,260 73,981 Mortgage-backed securities 131,215 135,934 131,215 TOTAL FIXED MATURITIES AVAILABLE FOR SALE 257,717 $263,263 257,717 Equity securities: Common stocks: Banks, trusts, and insurance companies 6,632 $ 11,536 11,536 Nonredeemable preferred stocks 5,750 5,900 5,900 TOTAL EQUITY SECURITIES 12,382 $ 17,436 17,436 Mortgage loans on real estate 3,201 3,201 Policy loans 23,988 23,988 Short-term investments 45,352 45,352 TOTAL INVESTMENTS $669,152 $674,206 SCHEDULE II PIONEER FINANCIAL SERVICES, INC. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES Balance at Balance Beginning of at End of Year Additions Collected Year (in thousands) Year Ended December 31, 1993 Tim O'Keefe mortgage loan from Pioneer Life Insurance Co. due October, 1997 $ - $140 $ 2 $138 Year Ended December 31, 1992: None Year Ended December 31, 1991: William McRee note payable to Design Benefit Plans, Inc. (formerly National Group Marketing)-- 5% due on demand $125 $ - $125 $ - SCHEDULE III PIONEER FINANCIAL SERVICES, INC. (Parent Company) CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED BALANCE SHEETS (In thousands, except share and per share amounts) December 31 1993 1992 ASSETS Investments in subsidiaries* $107,620 $ 83,606 Cash 1,711 543 Note receivable and accrued interest from Pioneer Life Insurance Company of Illinois (PLIC)* - 29,128 Notes receivable from United Group Holdings, Inc. (UGH)* 37,495 - Other notes receivable from subsidiaries* 403 3,994 Due from affiliates* 1,014 1,190 Prepaid expenses 573 454 Deferred debenture offering expenses 3,799 - Other assets 363 181 $152,978 $119,096 LIABILITIES, REDEEMABLE PREFERRED STOCK AND, STOCKHOLDERS' EQUITY Liabilities: General expenses and other liabilities $ 2,444 $ 264 Preferred stock dividends payable 510 510 Short-term notes payable - 7,850 Long-term notes payable - 23,750 Convertible subordinated debentures 57,477 - 60,431 32,374 Redeemable Preferred Stock, no par value: $2.125 cumulative convertible exchangeable preferred stock Authorized: 5,000,000 shares Issued and outstanding: (1993 - 947,000 shares;23,675 23,990 1992 - 959,600 shares) Stockholders' equity: Common Stock, $1 par value: Authorized: 20,000,000 shares Issued, including shares in treasury (1993 - 6,900,000 shares; 1992 - 6,820,000 shares) 6,900 6,820 Additional paid-in capital 28,814 28,399 Unrealized appreciation of equity securities 3,285 3,044 Retained earnings 34,645 24,521 Less treasury stock at cost (1993 - 556,800 shares; 1992 - 10,600 shares) (4,772) (52) Total stockholders' equity 68,872 62,732 $152,978 $119,096 See note to condensed financial statements. *Eliminated in consolidation. SCHEDULE III PIONEER FINANCIAL SERVICES, INC. (Parent Company) CONDENSED FINANCIAL INFORMATION OF REGISTRANT--Continued CONDENSED STATEMENTS OF OPERATIONS (In thousands) Year Ended December 31 1993 1992 1991 Revenues: Interest income from subsidiaries* $ 1,090 $ 1,835 $ 1,209 Other investment income 62 15 243 Dividends from consolidated subsidiaries* 10,345 10,482 15,672 11,497 12,332 17,124 Expenses: Operating and administrative expenses 4,702 2,154 1,681 Interest expense 3,204 2,206 2,893 7,906 4,360 4,574 Income before equity in undistributed net income or loss of subsidiaries 3,591 7,972 12,550 Equity in undistributed net income (loss) of subsidiaries* 8,554 (24,931) (3,678) Net income (loss) 12,145 (16,959) 8,872 Preferred stock dividends 2,021 2,039 2,039 Income (loss) applicable to common stockholders $ 10,124 $(18,998) $ 6,833 See note to condensed financial statements. *Eliminated in consolidation. SCHEDULE III PIONEER FINANCIAL SERVICES, INC. (Parent Company) CONDENSED FINANCIAL INFORMATION OF REGISTRANT--Continued CONDENSED STATEMENTS OF CASH FLOWS (In thousands) Year Ended December 31 1993 1992 1991 OPERATING ACTIVITIES Net income (loss) $ 12,145 $(16,959) $ 8,872 Adjustments to reconcile net income or loss to net cash provided by operating activities: Change in other assets and liabilities 1,678 (929) 4,289 Equity in undistributed net (income) loss of subsidiaries* (8,554) 24,931 3,678 NET CASH PROVIDED BY OPERATING ACTIVITIES 5,269 7,043 16,839 INVESTING ACTIVITIES Additional investment in consolidated subsidiaries* (15,219) (13) (83) FINANCING ACTIVITIES Decrease (increase) in notes receivable from PLIC 29,128 (11,597) (1,012) Increase in notes receivable from UGH (37,495) - - Net proceeds from issuance of convertible subordinated debentures 54,055 - - Increase in notes payable - 10,000 - Repayment of notes payable (31,600) (3,900) (13,000) Decrease (increase) in other notes receivable from subsidiaries* 3,591 (447) (218) Stock options exercised 451 165 - Dividends paid (2,021) (2,039) (2,039) Purchase of treasury stock (4,720) (52) - Retirement of preferred stock (315) - - Other 44 717 - NET CASH PROVIDED (USED) BY FINANCING ACTIVITIES 11,118 (7,153) (16,269) INCREASE (DECREASE) IN CASH 1,168 (123) 487 CASH AT BEGINNING OF YEAR 543 666 179 CASH AT END OF YEAR $ 1,711 $ 543 $ 666 See note to condensed financial statements. *Eliminated in consolidation. SCHEDULE III PIONEER FINANCIAL SERVICES, INC. (Parent Company) NOTE TO CONDENSED FINANCIAL STATEMENTS The accompanying condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto of Pioneer Financial Services, Inc. At December 31, 1992, the notes receivable from Pioneer Life Insurance Company of Illinois ("PLIC") represented $15,000,000 and $10,000,000 in surplus debentures and $4,128,000 of accrued interest. The interest rate on the $15,000,000 surplus debenture was 6.75% through June 30, 1992 and was 7% thereafter. The interest rate on the $10,000,000 surplus debenture was 7%. The payment of principal and interest to the parent company from PLIC requires regulatory approval. The surplus debentures were repaid in the third quarter of 1993. At December 31, 1993, the notes receivable from United Group Holdings of Delaware (UGH) represents the purchase of National Group Life Insurance Company from the parent company. The note bears interest at the rate of 8% and matures on December 31, 1998. SCHEDULE V PIONEER FINANCIAL SERVICES, INC. AND SUBSIDIARIES SUPPLEMENTARY INSURANCE INFORMATION (In thousands) December 31 Deferred Future Policy Policy Benefits and Acquisition Policy and Unearned Other Policy Segment Costs Contract Claims Premiums Liabilities 1993: Insurance: Accident and health $203,861 $341,916 $ 87,945 $ 8,066 Life and annuity 56,571 458,207 - 6,971 Marketing - - - - Managed care - - - - $260,432 $800,123 $ 87,945 $ 15,037 1992: Insurance: Accident and health $215,157 $288,966 $ 90,880 $ 2,832 Life and annuity 54,517 417,590 - 5,428 Marketing - - - - Managed care - - - - $269,674 $706,556 $ 90,880 $ 8,260 1991: Insurance: Accident and health $257,695 $266,430 $ 99,748 $ 2,075 Life and annuity 55,758 404,189 - 4,129 Marketing - - - - Managed care - - - - $313,453 $670,619 $ 99,748 $ 6,204 SCHEDULE V (continued) PIONEER FINANCIAL SERVICES, INC. AND SUBSIDIARIES SUPPLEMENTARY INSURANCE INFORMATION (In thousands) SCHEDULE VI PIONEER FINANCIAL SERVICES, INC. AND SUBSIDIARIES REINSURANCE (In thousands) Assumed Percentage Ceded to from of Amount Gross Other Other Net Assumed Amount Companies Companies Amount to net Year Ended December 31, 1993: Life insurance in force* $11,823,127$3,859,945 $ - $7,963,182 - Premiums and Policy Charges: Insurance: Accident and health $ 606,788$ 24,154 $ 19,050$ 601,684 3.2% Life and annuity 60,028 16,438 288 43,878 .7 Marketing - - - - - Managed care - - - - - $ 666,816$ 40,592 $ 19,338$ 645,562 3.9% Year Ended December 31, 1992: Life insurance in force* $10,338,557$3,929,621 $ - $6,408,936 - Premiums and Policy Charges: Insurance: Accident and health $ 558,847$ 14,328 $ 15,375$ 559,894 2.7% Life and annuity 51,332 16,141 28 35,219 .1 Marketing - - - - - Managed care - - - - - $ 610,179$ 30,469 $ 15,403$ 595,113 2.8% Year Ended December 31, 1991: Life insurance in force* $ 9,140,882$4,579,278 $ - $4,561,604 - Premiums and Policy Charges: Insurance: Accident and health $ 597,046$ 17,726 $ 13,916$ 593,236 2.3% Life and annuity 49,367 16,063 17 33,321 .1 Marketing - - - - - Managed care - - - - - $ 646,413$ 33,789 $ 13,933$ 626,557 2.4% *At end of year SCHEDULE VIII PIONEER FINANCIAL SERVICES, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS (In thousands) Deductions- Doubtful Accounts Written Balance at Additions- off During Balance Beginning Charged to the Year at End of Year Expense /Disposals of Year Description Year Ended December 31, 1993: Allowance for doubtful accounts $1,504 $1,171 $1,404 $1,271 Accumulated depreciation on building and equipment 11,646 5,515 270 16,891 Year Ended December 31, 1992: Allowance for doubtful accounts 147 1,475 118 1,504 Accumulated depreciation on building and equipment 9,122 3,245 721 11,646 Year Ended December 31, 1991: Allowance for doubtful accounts 40 147 40 147 Accumulated depreciation on building and equipment 6,488 2,844 210 9,122 SCHEDULE IX PIONEER FINANCIAL SERVICES, INC. AND SUBSIDIARIES SHORT-TERM BORROWINGS (Dollars in thousands) * Bank borrowing represents short term arrangements generally at prime rates. These amounts exclude current portion of long-term notes payable. ** The average amounts outstanding during the year were computed based on the month-end principal balances. *** The weighted average interest rates during the year were computed by dividing the actual interest expense by average short-term debt outstanding. Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. PIONEER FINANCIAL SERVICES, INC. BY: /S/ Peter W. Nauert Peter W. Nauert, Chairman/President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Date: March 30, 1993 /S/ Peter W. Nauert /S/ Michael A. Cavataio Peter W. Nauert, Chairman, Michael A. Cavataio Chief Executive Officer, and Director Director /S/ William B. Van Vleet /S/ Nolanda S. Hill William B. Van Vleet, Executive Nolanda S. Hill Vice President and Director Director /S/ David I. Vickers /S/ Karl-Heinz Klaeser David I. Vickers, Treasurer Karl-Heinz Klaeser and Chief Financial Officer Director /S/ Robert F. Nauert /S/ Richard R. Haldeman Robert F. Nauert Richard R. Haldeman Director Director /S/ Michael K. Keefe Michael K. Keefe Director Index to Exhibits Exhibit Sequentially Number Description of Document Numbered Page 3 (a) Certificate of Incorporation of the Company (filed as Exhibit 3(a) to the Company's Registration Statement on Form S-1 [No. 33-7759] and incorporated herein by reference) 3 (b) Amended Bylaws of the Company (filed as Exhibit 3(b) to Amendment No. 1 to the Company's Registration Statement on Form S-1 [No. 33-30017] and incorporated herein by reference) 4 (a) Certificate of Designations with respect to the Company's $2.125 Cumulative Convertible Exchangeable Preferred Stock ("Preferred Stock") (filed as Exhibit 4(a) to Post-Effective Amendment No. 1 to the Company's Registration Statement on Form S-1 [No. 33-30017] and incorporated herein by reference) 4 (b) Proposed form of Indenture with respect to the Company's 8 1/2% Convertible Subordinated Debentures due 2014 into which the Preferred Stock is exchangeable (filed as Exhibit 4(b) to Post-Effective Amendment No. 1 to the Company's Registration Statement on Form S-1 [No. 33-30017] and incorporated herein by reference) 4 (c) Rights Agreement dated as of December 12, 1990 between the Company and First Chicago Trust Company of New York as Rights Agent (including exhibits thereto) (filed as Exhibit 1 to the Company's registration statement on Form 8-A dated December 14, 1990 and incorporated herein by reference) 10 (a) Form of contract with independent agents (filed as Exhibit 10(f) to the Company's Registration Statement on Form S-1 [No. 33-7759] and incorporated herein by reference) 10 (b) Nonqualified Stock Option Plan (filed as Exhibit 10(g) to the Company's Registration Statement on Form S-1 [No. 33-7759] and incorporated herein by reference) 10 (c) Amendment to the Nonqualified Stock Option Plan of the Company (filed as Exhibit 10(d) to the Company's Registration Statement on Form S-8 [No. 33-26455] and incorporated herein by reference) 10 (d) Amendment to the Nonqualified Stock Option Plan of the Company (filed as Exhibit 10(c) to the Company's Registration Statement on Form S-1 [No. 33-17011] and incorporated herein by reference) 10 (e) Amendment to the Nonqualified Stock Option Plan of the Company (filed as Exhibit 10(e) to the Company's registration statement on Form S-8 [No. 33-37305] and incorporated herein by reference) 10 (f) Amended and Restated Receivables purchase agreement dated as of October 1, 1992 by and between Design Benefit Plans, Inc. (formerly National Group Marketing Corporation) and National Funding Corporation (filed herewith) *10 (g) Employment Agreement dated December 3, 1993 by and between the Company and Peter W. Nauert 10 (h) Administrative Service Agreement dated December 23, 1991, by and between Administrative Service Corporation and Pioneer Life Insurance Company of Illinois (filed as Exhibit 10(v) to the Company's Annual Report on Form 10-K [No. 0-14977] and incorporated herein by reference) 10 (i) Administrative Service Agreement dated December 23, 1991, by and between Administrative Service Corporation and National Group Life (filed as Exhibit 10(w) to the Company's Annual Report on Form 10-K [No. 0-14977] and incorporated herein by reference) *10 (j) Employment Agreement dated December 31, 1991 by and between National Benefit Plans, Inc. and Peter W. Nauert (filed as Exhibit 10(x) to the Company's Annual Report on Form 10-K [No. 0-14977] and incorporated herein by reference) *10 (k) Amendment to Employment Agreement dated March 26, 1993 by and between National Benefit Plans, Inc. and Peter W. Nauert (filed herewith) *10 (l) Employment Agreement dated December 31, 1991 by and between Direct Financial Services, Inc. and Peter W. Nauert (filed as Exhibit 10(y) to the Company's Annual Report on Form 10-K [No. 0-14977] and incorporated herein by reference) *10 (m) Amendment to Employment Agreement dated March 26, 1993 by and between Direct Financial Services, Inc. and Peter W. Nauert (filed herewith) 10 (n) Credit Agreement dated as of December 22, 1993 by and among the Company and American National Bank and Trust Company of Chicago, as Agent and American National Bank and Trust Company of Chicago, Firstar Bank Milwaukee, N.A. and Bank One, Rockford, NA, as Banks 11 Statement of Computation of per share net income or loss . . . . . . . . . . . . . . . . . __ 21 List of subsidiaries . . . . . . . . . . . __ 23 Consent of Ernst & Young . . . . . . . . . __ Exhibit 10(g) EMPLOYMENT AGREEMENT This Agreement is made this December 3, 1993, by and between PIONEER FINANCIAL SERVICES, INC., a Delaware corporation, having its principal place of business at 304 N. Main Street, Rockford, Illinois, 61101 (hereinafter "Pioneer Financial"); and PETER W. NAUERT, an individual residing at 5019 Parliament Place, Rockford, Illinois 61107. W I T N E S S E T H: WHEREAS, Pioneer Financial is an insurance holding company which has life insurance subsidiaries and affiliated administrative service and marketing companies; and WHEREAS, Nauert is current Chairman and Chief Executive Officer of Pioneer Financial and Nauert possesses valuable skills, expertise and abilities in the life and accident and health insurance business; and WHEREAS, Pioneer Financial is desirous of retaining the services of Nauert as a key managerial employee; and WHEREAS, Nauert desires to be employed by Pioneer Financial on the terms set forth herein: NOW, THEREFORE, for and in consideration of the covenants contained herein, Pioneer Financial hereby employs Nauert and Nauert accepts such employment with Pioneer Financial upon the terms and conditions hereinafter set forth. 1. Employment. Pioneer Financial hereby employs Nauert and Nauert hereby agrees to be employed by Pioneer Financial for a term of three (3) calendar years commencing on the first day of January, 1994, and continuing through the 31st day of December, 1996 and for successive three- year periods thereafter until terminated as provided herein, to perform the duties set forth herein. 2. Duties. Subject to the control of the Board of Directors of Pioneer Financial, Nauert shall serve during the Term as Chairman and Chief Executive Officer of Pioneer Financial and in such capacity shall render such services as the Board of Directors of Pioneer Financial shall direct. In addition, Nauert shall serve in such other offices or capacities as the Board of Directors of Pioneer Financial may from time to time determine. Nauert shall have such executive powers and authority as may reasonably be required by him in order to discharge such duties in an efficient and proper manner. 3. Compensation. Pioneer Financial shall in the aggregate pay to Nauert for all services to be rendered hereunder: (a) an annual salary in the amount of $600,000; provided that the Board of Directors of Pioneer Financial shall annually make a review of Nauert's salary and increase such annual salary as it deems appropriate; and (b) an annual bonus, as determined by the compensation committee of the Board of Directors of Pioneer Financial, based upon achieving the Pioneer Financial's company-wide performance standards as established by such committee. 4. Loan. As further compensation to Nauert for his employment hereunder, Pioneer Financial agrees to make available to Nauert at any time prior to June 30, 1994, a three-year term loan not in excess of $1,300,000 of principal indebtedness at an annual rate of interest of 3.71% payable annually, said loan to provide Nauert forgiveness not in excess of 50% of the initial principal indebtedness dependent on PFSI's attaining, as of 12/31/96, either of the following specified performance goals of PFSI's compensation committee: Specified 12/31/96 Amount of Loan PFSI Performance Goals Forgiveness at 12/31/96 Cumulative, fully diluted $325,000, loan PFSI GAAP net income per forgiveness common share ("Cumulative EPS") from 1/1/94 through 12/31/96, inclusive, of $4.50 Cumulative EPS from From Cumulative EPS (but 1/1/94 through 12/31/96, not to exceed $7.50) inclusive, greater than subtract $4.50, divide $4.50 the result by $3.00 and multiply the resulting quotient by $975,000. Add the amount so produced to $325,000 to arrive at loan forgiveness. Said loan shall be evidenced by a Note in a form substantially similar to Exhibit "A" hereto. 5. Benefits. During his employment hereunder, Nauert shall be entitled to participate in all employee benefits made available to management personnel of Pioneer Financial and its subsidiaries. 6. Death. Nauert's employment by Pioneer Financial will terminate immediately upon his death. No compensation for any period after Nauert's death will be payable to Nauert's estate. 7. Disability. If during Nauert's employment hereunder, Nauert becomes totally or partially disabled, Pioneer Financial shall continue to pay to Nauert as long as such disability continues during the Term (or until Nauert's employment is terminated by Pioneer Financial in accordance with Section 8 (if earlier)) the level of annual salary payable to Nauert at the date his disability is determined, reduced dollar-for-dollar to the extent of any disability insurance payments paid to Nauert through insurance programs, the premiums for which were paid by Pioneer Financial or its Subsidiaries or affiliates. For purposes of this Agreement, the term "total disability" shall mean Nauert's inability due to illness, accident or other physical or mental incapacity to engage in the full time performance of his duties under this Agreement as reasonably determined by the Board of Directors of Pioneer Financial based on such evidence as such Board shall deem appropriate. For purposes of this Agreement, "partial disability" shall mean Nauert's ability due to illness, accident or other physical or mental incapacity to engage in only the partial performance of his duties under this Agreement, as reasonably determined by the Board of Directors of Pioneer Financial based on such evidence as such Board shall deem appropriate. 8. Termination. (a) For Cause. Pioneer Financial shall have the right to terminate Nauert's employment hereunder at any time during the Term "for cause". For purposes of this Agreement, "for cause" shall mean any of the following actions (or inactions) by Nauert: illegal conduct of a severity greater than a misdemeanor, gross neglect of, and the continued failure to perform substantially, Nauert's duties under this Agreement. Notwithstanding anything herein to the contrary, Nauert's inability to perform the duties of his position due to his total or partial disability (as defined herein) shall not be deemed to constitute cause. If, in the opinion of the Board of Directors of Pioneer Financial, Nauert's employment shall become subject to termination for cause, such Board of Directors shall give Nauert notice to that effect, which notice shall describe the matter or matters constituting such cause. Thereafter, for a period of thirty (30) days from the receipt of such notice, Nauert shall have the opportunity to eliminate or cure the matter or matters constituting such cause. If at the end of such thirty (30) day period, Nauert has not substantially eliminated or cured each such matter or matters, then Pioneer Financial shall have the right to give Nauert notice of the termination of his employment. Nauert's employment hereunder shall be considered terminated for cause as of the date specified in such notice of termination unless and until there is a final determination by a court of competent jurisdiction that the cause of termination of Nauert's employment did not exist at the time of giving said notice of termination. Upon termination of Nauert's employment "for cause," this Agreement shall terminate without further obligations to Nauert other than Pioneer Financial's obligation (a) to pay to Nauert in a lump sum in cash within 30 days after the date of termination Nauert's base salary through the date of termination to the extent not theretofore paid and (b) to the extent not theretofore paid or provided, to pay or provide, to Nauert on a timely basis any other amounts or benefits required to be paid or provided or which Nauert is eligible to receive under any plan, program, policy or practice or contract or agreement of Pioneer Financial. (b) Without Cause. Pioneer Financial shall have the right to terminate Nauert's employment hereunder without cause at any time during the Term. If the Board of Directors determines to terminate Nauert's employment without cause, Pioneer Financial shall give notice of the termination to Nauert and Nauert's employment hereunder shall be considered terminated without cause as of the date specified in such notice of termination. Upon the date of the termination of Nauert's employment without cause, Nauert shall be paid an amount equal to the present value, discounted to the present at an annual rate of 8%, of the salary which would have been payable during a period of twenty-four (24) months commencing on the date of termination at the level of annual salary payable to Nauert at the date of termination. (c) By Nauert. Nauert may terminate his employment hereunder at any time by retirement or resignation, upon notice to Pioneer Financial. Upon such termination by Nauert, no compensation for any period after the date of such termination shall be payable to Nauert; provided, however, that if such termination by Nauert is for "good reason" (as defined in Section 9(c)), then Nauert shall be entitled to the payment described in the last sentence of Section 8(b). (d) Change in Control Effect. No payments shall be made to Nauert pursuant to this Section 8 in the event that Nauert is entitled to Change in Control Compensation pursuant to Section 9. 9. Change in Control. (a) Change in Control Severance Compensation. If, within two years following a "change in control", Nauert's employment is terminated by Pioneer Financial other than "for cause" (as defined in Section 8(a)) or is terminated by Nauert for "good reason" (as defined in Section 9(c)), Nauert shall be entitled to receive from Pioneer Financial a lump sum cash payment in an amount equal to three times his annual salary for the year in which such termination occurs ("Change in Control Compensation"). Pioneer Financial shall pay such amount to Nauert within ten (10) days of the date of termination. If Nauert's employment is terminated by Pioneer Financial for cause, by reason of Nauert's death or retirement, or by Nauert without good reason, the Change in Control Compensation will not be paid. If Nauert was totally or partially disabled as of the Change in Control, the Change in Control Compensation will not be paid. (b) Change in Control. For purposes of this Agreement, "Change in Control" shall mean the occurrence of any of the following events: (i) any person or persons acting as a group, other than a person which as of the date of this Agreement is the beneficial owner of voting securities of Pioneer Financial and other than Nauert or a group including Nauert, shall become the beneficial owner of securities of Pioneer Financial representing at least twenty percent (20%) of the combined voting power of Pioneer Financial's then outstanding securities; or (ii) any consolidation or merger to which Pioneer Financial is a party, if following such consolidation or merger, stockholders of Pioneer Financial immediately prior to such consolidation or merger shall not beneficially own securities representing at least eighty-one percent (81%) of the combined voting power of the outstanding voting securities of the surviving or continuing corporation; or (iii) any sale, lease, exchange or other transfer (in one transaction or in a series of related transactions) of all, or substantially all, of the assets of Pioneer Financial, other than to an entity (or entities) of which Pioneer Financial or the stockholders of Pioneer Financial immediately prior to such transactions beneficially own securities representing at least eighty-one percent (81%) of the combined voting power of the outstanding voting securities. (c) Good Reason. For purposes of this Agreement, "good reason" shall mean any of the following: (i) the assignment to Nauert of any duties or responsibilities which are inconsistent with Nauert's status and position in effect immediately prior to the Change in Control, or a reduction in the duties and responsibilities exercised by Nauert immediately prior to the Change in Control; (ii) any action by Pioneer Financial which renders Nauert unable to effectively discharge the duties and responsibilities exercised by Nauert immediately prior to the Change in Control; (iii) a reduction in Nauert's level of annual salary as in effect immediately prior to the Change in Control or failure to maintain Nauert's minimum annual salary in accordance with Section 3(a); (iv) a failure by Pioneer Financial to continue in effect, without material change, any benefit or incentive plan or arrangement in which Nauert participated immediately prior to the Change in Control, or the taking of any action by Pioneer Financial which would materially and adversely affect Nauert's participation in or materially reduce Nauert's benefits under any such plan or arrangement; (v) a relocation of Nauert's workplace by Pioneer Financial to any place more than twenty-five (25) miles from the location at which Nauert performed his duties immediately prior to the Change in Control, except for required travel by Nauert on Pioneer Financial's business to an extent substantially consistent with Nauert's business travel obligations immediately prior to the Change in Control; (vi) a failure by Pioneer Financial to provide to Nauert paid vacation benefits on the basis and to extent provided immediately prior to the Change in Control; or (vii) any failure by Pioneer Financial to obtain the assumption of this Agreement by any successor or assignee thereto. (d) Gross-Up. In the event that any payment received or to be received by Nauert in connection with a Change in Control of Pioneer Financial or the termination of Nauert's employment (whether payable pursuant to the terms of this Agreement or any other plan, arrangement or agreement with Pioneer Financial or any person whose actions result in a Change in Control of Pioneer Financial or any person affiliated with Pioneer Financial or such person (the "Change in Control Payments") will be subject to the tax (the "Excise Tax") imposed by Section 4999 of the Internal Revenue Code, as amended (the "Code"), Pioneer Financial shall pay to Nauert, upon payment of the Change in Control Compensation, an additional amount (the "Gross-Up Payment") such that the net amount retained by Nauert, after deduction of any Excise Tax on the Change in Control Payments and any federal and state and local income tax and Excise Tax upon the Gross-Up Payment, shall be equal to the Change in Control Payments. For purposes of determining whether any of the Change in Control Payments will be subject to the Excise Tax and the amount of such Excise Tax, any Change in Control Payments shall be treated as a "parachute payment" within the meaning of Section 280G(b)(2) of the Code, and all "parachute payments" in excess of the "base amount" within the meaning of Section 280G(b)(3) of the Code shall be treated as subject to the Excise Tax, unless in the opinion of tax counsel selected by Pioneer Financial and acceptable to Nauert such Change in Control Payments (in whole or in part) do not constitute parachute payments, or such parachute payments in excess of the base amount (in whole or in part) are otherwise not subject to the Excise Tax. For purposes of determining the amount of the Gross-Up Payment, Nauert shall be deemed to pay federal income taxes at the highest marginal rate of federal income taxation in the calendar year in which the Gross-Up Payment is to be made and state and local income taxes at the highest marginal rate of taxation in the state and locality of his residence on the date of termination, net of the maximum reduction in federal income taxes which could be obtained from deduction of such state and local taxes. In the event that the Excise Tax is subsequently determined to be less than the amount originally taken into account hereunder Nauert shall repay to Pioneer Financial at the time that the amount of such reduction in Excise Tax is finally determined, the portion of the Gross-Up Payment attributable to such reduction plus interest on the amount of such repayment at the rate provided in Section 1274(b)(2)(B) of the Code. In the event that the Excise Tax is determined to exceed the amount originally taken into account hereunder, Pioneer Financial shall make an additional Gross-Up Payment in respect of such excess at the time that the amount of such excess is finally determined. Nauert shall notify Pioneer Financial of any audit or review by the Internal Revenue Service of Nauert's federal income tax return for the year in which a Change in Control Payment or Gross-Up Payment under this Agreement is made within ten (10) days of Nauert's receipt of notification of such audit or review. In addition, Nauert shall also notify Pioneer Financial of the final resolution of such audit or review within ten (10) days of such resolution. 10. Confidential Information and Trade Secrets. (a) Nature. During Nauert's employment by Pioneer Financial, Nauert will enjoy access to Pioneer Financial's "confidential information" and "trade secrets". For purposes of this Agreement, "confidential information" shall mean information which is not publicly available, including without limitation, information concerning customers, material sources, suppliers, financial projections, marketing plans and operation methods, Nauert's access to which derives solely from Nauert's employment with Pioneer Financial. For purposes of this Agreement, "trade secrets" shall mean Pioneer Financial's processes, methodologies and techniques known only to those employees of Pioneer Financial who need to know such secrets in order to perform their duties on behalf of Pioneer Financial. Pioneer Financial take numerous steps, including these provisions, to protect the confidentiality of its confidential information and trade secrets, which it considers unique, valuable and special assets. (b) Restricted Use and Non-Disclosure. Nauert, recognizing Pioneer Financial's significant investment of time, efforts, and money in developing and preserving its confidential information, shall not, during his employment hereunder and for a two (2) year period after the end of Nauert's employment hereunder, use for his direct or indirect personal benefit any of Pioneer Financial's confidential information or trade secrets. For a two (2) year period after the end of Nauert's employment hereunder, Nauert shall not disclose to any person any of Pioneer Financial's confidential information or trade secrets. (c) Return of Pioneer Financial Property. Upon termination of Nauert's employment with Pioneer Financial, for whatever reason and in whatever manner Nauert shall return to Pioneer Financial all copies of all writings and records relating to Pioneer Financial's business, confidential information or trade secrets, which are in Nauert's possession at such time. 11. Non-Competition and Non-Solicitation. (a) Pioneer's Financial Investment. Pioneer Financial is spending and will spend much time, money and effort in building relationships with agents and insureds, and will pay Nauert valuable consideration pursuant hereto in exchange for Nauert's promises herein, including without limitation the covenants in Section 10 and in this Section 11. Pioneer Financial has engaged Nauert as Chairman and Chief Executive Officer of Pioneer Financial in order to, among other reasons, take advantage of Nauert's unique knowledge of, and contacts within, the life and accident and health insurance industry. Further, Pioneer Financial will invest significant time and money in the further development of Nauert's business ability, image and standing. As Nauert is Chairman and Chief Executive Officer of Pioneer Financial, the reputation and success of Nauert will be closely tied to the reputation and success of Pioneer Financial and, during the Term, Nauert will be heavily identified with Pioneer Financial's business. (b) Non-Competition. During Nauert's employment hereunder and for a twelve (12) month period after termination of such employment, unless such termination is made by Pioneer Financial without cause or unless there has been a Change in Control prior to such termination, Nauert shall not engage, directly or indirectly, whether as an owner, partner, employee, officer, director, agent, consultant or otherwise, in any location where Pioneer Financial or any of its subsidiaries is engaged in business after the date hereof and prior to the termination of Nauert's employment, in a business the same as, or similar to, any business now, or at any time after the date hereof and prior to Nauert's termination, conducted by Pioneer Financial or any of its subsidiaries, provided, however, that the mere ownership of 5% or less of the stock of a company whose shares are traded on a national securities exchange or are quoted on the National Association of Securities Dealers Automated Quotation System shall not be deemed ownership which is prohibited hereunder. (c) Non-Solicitation. During the twenty-four (24) month period following termination of Nauert's employment with Pioneer Financial, Nauert shall not, directly or indirectly induce employees of Pioneer Financial or any of its subsidiaries to leave such employment with the result that such employees would engage in business activities which are substantially similar or are closely related to the business activities such employee performed on behalf of Pioneer Financial and which compete against Pioneer Financial. Notwithstanding the above, in the event Nauert is terminated by Pioneer Financial without cause, then the twenty-four (24) month period referred to in this Section 11(c) shall be reduced to twelve (12) months. (d) Enforceability. The necessity of protection against the competition of Nauert and the nature and scope of such protection has been carefully considered by the parties hereto. The parties hereto agree and acknowledge that the duration, scope and geographic areas applicable to the non-competition covenant in this Section 11 are fair, reasonable and necessary, that adequate compensation has been received by Nauert for such obligations, and that these obligations do not prevent Nauert from earning a livelihood. If, however for any reason any court determines that the restrictions in this Agreement are not reasonable, that consideration is inadequate or that Nauert has been prevented from earning a livelihood, such restrictions shall be interpreted, modified or rewritten to include as much of the duration, scope and geographic area identified in this Section 11 as will render such restrictions valid and enforceable. 12. Retention of PFSI Stock. During the Term, Nauert shall retain, directly or indirectly, ownership of not less than 1,000,000 shares of PFSI Common Stock unless, and except to the extent, released from this obligation by a written release from Pioneer Financial. For purposes of this Agreement, "retain indirectly" shall mean and refer to any shares of PFSI Common Stock, which would be considered to be owned by Nauert under Section 267(c), or the income of which would be taxable to Nauert, his spouse or his children, or to any trust of which Nauert would be deemed the owner under any of Sections 671 through 677, inclusive, of the Internal Revenue Code of 1986. 13. Rights of First Refusal. During the Term, Nauert shall not transfer any shares of stock of Pioneer Financial for consideration to any person other than a relative of Nauert, unless Nauert has offered to transfer such shares to Pioneer Financial on the same terms, provided, however, that this provision shall not apply at any time when the average last reported sale price for Common Stock of Pioneer Financial on the New York Stock Exchange for the immediately preceding five trading days is greater than or equal to $12.00 per share. 14. Related Company Agreements and Options. Parties hereto recognize that Pioneer Financial has a number of related companies and that Nauert currently has employment agreements with two such companies, namely, Direct Financial Services, Inc. and National Benefit Plans, Inc. This agreement in no way supersedes or modifies any of the terms, undertaking, responsibilities or rights of any of the parties to said employment agreements. Notwithstanding the foregoing, and in consideration of Pioneer Financial's execution of this Agreement, Nauert agrees to forego his right to certain bonuses equal to 10% of net income under his current employment agreements with Pioneer Financial's subsidiaries National Benefit Plans, Inc. and Direct Financial Services, Inc. 15. Breach or Threatened Breach of Non-Competition Covenant. In the event of a breach or threatened breach by Nauert of any provision of Section 10 or 11 hereof, Nauert acknowledges that the remedy at law would be inadequate and that Pioneer Financial shall be entitled to an injunction restraining Nauert from such act or threatened breach. Nothing herein contained shall be construed as prohibiting Pioneer Financial from pursuing any other remedies available to it for such breach or threatened breach, including the recovery of monetary damages. 16. Business Days. Any date specified in this Agreement which is a Saturday, Sunday or legal holiday shall be extended to the first regular business day after such date which is not a Saturday, Sunday or legal holiday. 17. Choice of Law. This Agreement has been executed and made in accordance with the laws of the State of Illinois and is to be construed, enforced and governed in accordance therewith. 18. Counterparts. This Agreement may be executed in several counterparts, each of which shall be an original, but all of which together shall constitute one and the same instrument. 19. Entire Agreement Amendments. This Agreement contains the entire agreement among the parties hereto with respect to the subject matter hereof. No change or modification of this Agreement, or any waiver of the provisions hereof, shall be valid unless same is in writing and signed by the parties hereto. Waiver by any party hereto of a breach by the other party of any provisions of this Agreement shall not operate or be construed as a waiver of any subsequent breach by such party. 20. Headings. The headings used herein are for each of interpretation and shall have no effect on the interpretation of any provision of this Agreement. 21. Notices. All notices, requests, demands and other communications hereunder shall be in writing and shall, until receipt of contrary written instructions, be delivered personally to, or mailed by certified or registered mail with proper postage prepaid, to the party at the address as follows: To Pioneer Financial: Pioneer Financial Services, Inc. 304 N. Main Street Rockford, Illinois 61101 To Nauert: Mr. Peter W. Nauert 5019 Parliament Place Rockford, Illinois 61107 22. Severability. If any provision of this Agreement is held for any reason to be invalid, it will not invalidate any other provisions of this Agreement which are in themselves valid, nor will it invalidate the provisions of any other agreement between the parties hereto. Rather, such invalid provision shall be construed so as to give it the maximum effect allowed by applicable law. Any other written agreement between the parties hereto shall be conclusively deemed to be an agreement independent of this Agreement. 23. Successors and Assigns. This Agreement and all the provisions hereof shall be binding upon and inure to the benefit of the parties hereto and their respective heirs, legal representatives, successors and permitted assigns. This Agreement and the rights and obligations hereunder may not be assigned by either party without the prior written consent of the other. 24. Time of the Essence. Time is of the essence of this Agreement. IN WITNESS WHEREOF, the parties hereto have caused this Employment Agreement to be executed on the date first above written. Attest: "Pioneer Financial" PIONEER FINANCIAL SERVICES, INC. /s/ Chuck R. Scheper By: /s/ Karl-Heinz Klaeser Title: Chairman - Compensation Committee Witness: "Nauert" /s/ Philip J. Urbanek /s/ Peter W. Nauert Peter W. Nauert EXHIBIT A $1,300,000 Rockford, Illinois January 1, 1994 NON-NEGOTIABLE PROMISSORY NOTE ______________________________ For value received, PETER W. NAUERT ("Nauert") hereby promises to pay to PIONEER FINANCIAL SERVICES, INC., a Delaware corporation ("PFSI"), at its principal office at 304 N. Main Street, Rockford, Illinois or such other address as the holder hereof may designate, the sum of One Million, Three Hundred Thousand and No/One Hundredths Dollars ($1,300,000.00). Payment shall be made in a single payment on the last day of December, 1996. In addition, on the 31st day of December, 1994, 1995 and 1996, Nauert shall pay PFSI interest at the rate of 3.71 percent per annum on the principal balance outstanding from time to time computed from the date hereof until paid. This Note is the note referred to in, and is being issued to Nauert by PFSI in accordance with Paragraph 14 of that certain Employment Agreement dated __________, 1993 by and between Nauert and PFSI, and is subject thereto. Any payment due under this Note may be prepaid in whole or in part at any time and from time to time before its payments date. Any such prepayment shall be first applied against the principal amount of this Note and then against interest accrued thereon. Notwithstanding the foregoing, in the event either of the following specified performance goals of PFSI's compensation committee is achieved, the initial principal indebtedness of $1,300,000 shall be forgiven as of 12/31/96 as follow: Specified 12/31/96 Amount of Loan PFSI Performance Goals Forgiveness at 12/31/96 ______________________ _______________________ Cumulative, fully diluted $325,000, loan PFSI GAAP net income per forgiveness common share ("Cumulative EPS") from 1/1/94 through 12/31/96, inclusive, of $4.50 Specified 12/31/96 Amount of Loan PFSI Performance Goals Forgiveness at 12/31/96 ______________________ _______________________ Cumulative EPS from From Cumulative EPS (but 1/1/94 through 12/31/96, not to exceed $7.50) inclusive, greater than subtract $4.50, divide $4.50 the result by $3.00 and multiply the resulting quotient by $975,000. Add the amount so produced to $325,000 to arrive at loan forgiveness. In the event that PFSI's GAAP financial results as of 12/31/96 are not determinable with reasonable accuracy on 12/31/96, or even upon the due date of this Notice if such date is after 12/31/96, the PFSI's compensation committee may estimate the amount of forgiveness for purposes of Nauert's timely payoff of this Note, less the forgiveness. In such event, not later than June 30, 1997, PFSI's compensation committee shall obtain certified GAAP financial results for PFSI as of 12/31/96 and submit such certified financial results to Nauert. At such time, the difference between the amount of forgiveness previously estimated and allowed Nauert at the time of this Note's repayment and the amount of such forgiveness indicated by said certified financial results shall be reimbursed by PFSI to Nauert, or paid by Nauert to PFSI, as the case may be, together with interest thereon at the rate of 8% per annum from the date of this Note's repayment to the date of said reimbursement, or payment, as the case may be. The following shall be deemed events of default hereunder: (a) failure by Nauert to make any payment hereunder within five (5) business days of the due date of such payment; (b) the filing by Nauert of a voluntary petition, or the filing against Nauert of an involuntary petition which is not dismissed within sixty (60) days, under the provisions of Title 11 of the United State Code or any state insolvency law; (c) application for or appointment of a receiver for Nauert; (d) issuance of a warrant of attachment or writ of execution against Nauert or his property; (e) any assignment by Nauert for the benefit of his creditors; or (f) termination by Nauert of his employment under the above referenced Employment Agreement, except for "good reason" (as defined in Section 9(c) of said Employment Agreement). Upon the occurrence of an event of default hereunder, the holder may, at his option, declare the entire unpaid balance of the principal hereunder, together with interest thereon, immediately due and payable by delivering to Nauert written notice of such effect. Nauert hereby waives presentment for payment, notice of dishonor, protest or diligence in bringing suit hereon. In the event any payments herein provided for shall not be made at the time they shall become due, Nauert shall reimburse the holder hereof for all costs of collection and for reasonable attorneys' fees incurred to obtain such payments. This Note shall be construed in accordance with and governed in all respects by the laws and decisions of the State of Illinois. /s/ Peter W. Nauert Peter W. Nauert Exhibit 10(n) CREDIT AGREEMENT Dated as of December 22, 1993 among PIONEER FINANCIAL SERVICES, INC., AMERICAN NATIONAL BANK AND TRUST COMPANY OF CHICAGO, as Agent and AMERICAN NATIONAL BANK AND TRUST COMPANY OF CHICAGO, FIRSTAR BANK MILWAUKEE, N.A. and BANK ONE, ROCKFORD, NA Page SECTION 1 CERTAIN DEFINITIONS . . . . . . . . . . . . . . 1 SECTION 1.1 Terms Defined in this Agreement . . . . . . . . . . 1 SECTION 2 BANK'S COMMITMENT; BORROWING PROCEDURES; LCs . . . . . . . 11 SECTION 2.1 Bank's Commitment to Make Loans . . . . . . . . . . 11 SECTION 2.3 Procedure for Borrowing . . . . . . . . . . . . . . 12 SECTION 2.4 Conversion and Continuation Elections. . . . . . . 13 SECTION 2.5 LC Documentation. . . . . . . . . . . . . . . . . . 15 SECTION 2.6 Agreement to Repay LC Drawings. . . . . . . . . . . 17 SECTION 2.6A Participations. . . . . . . . . . . . . . . . . . . 17 SECTION 2.7 Mandatory Payment of LC Liability. . . . . . . . . 20 SECTION 2.8 LC Operations. . . . . . . . . . . . . . . . . . . 20 SECTION 2.9 Voluntary Termination or Reduction of Commitments. . . . . . . . . . . . . . . . . . . . . . . . . 21 SECTION 2.11 Mandatory Prepayment. . . . . . . . . . . . . . . . 21 SECTION 2.12 Repayment. . . . . . . . . . . . . . . . . . . . . 21 SECTION 3 NOTES EVIDENCING THE LOANS . . . . . . . . . . . . . 22 SECTION 3.1 Notes . . . . . . . . . . . . . . . . . . . . . . . 22 SECTION 4 INTEREST, FEES AND COSTS . . . . . . . . . . 22 SECTION 4.1 Interest . . . . . . . . . . . . . . . . . . . . . 22 SECTION 4.2 Fees. . . . . . . . . . . . . . . . . . . . . . . . 23 (a) Closing Fee. . . . . . . . . . . . . . . . . . . . . . . 23 (b) Unused Commitment Fees. . . . . . . . . . . . . . . . . 23 (c) Letter of Credit Fees. . . . . . . . . . . . . . . . . . 23 (d) Letter of Credit Issuance Fees. . . . . . . . . . . . . 23 SECTION 4.3 Computation of Fees and Interest. . . . . . . . . . 24 SECTION 4.4 Increased Costs; Capital Adequacy . . . . . . . . . 24 SECTION 4.5 Funding Losses. . . . . . . . . . . . . . . . . . . 26 SECTION 5 MAKING OF PAYMENTS . . . . . . . . . . . . . . . 26 SECTION 5.1 Payments by the Company . . . . . . . . . . . . . . 26 SECTION 5.2 Payments by the Banks to the Agent. . . . . . . . . 27 SECTION 5.3 Setoff . . . . . . . . . . . . . . . . . . . . . . 28 SECTION 5.4 Sharing of Payments. . . . . . . . . . . . . . . . 29 SECTION 6 REPRESENTATIONS AND WARRANTIES . . . . . . . . . . . . 29 SECTION 6.1 Corporate Organization . . . . . . . . . . . . . . 29 SECTION 6.2 Authorization; No Conflict . . . . . . . . . . . . 30 SECTION 6.3 Validity and Binding Nature . . . . . . . . . . . . 30 SECTION 6.4 Financial Statements . . . . . . . . . . . . . . . 30 i SECTION 6.5 Litigation and Contingent Liabilities . . . . . . . 30 SECTION 6.6 Employee Benefit Plans . . . . . . . . . . . . . . 31 SECTION 6.7 Investment Company Act . . . . . . . . . . . . . . 32 SECTION 6.8 Regulation U . . . . . . . . . . . . . . . . . . . 32 SECTION 6.9 Accuracy of Information . . . . . . . . . . . . . . 32 SECTION 6.10 Labor Controversies . . . . . . . . . . . . . . . . 32 SECTION 6.11 Tax Status . . . . . . . . . . . . . . . . . . . . 32 SECTION 6.12 No Default . . . . . . . . . . . . . . . . . . . . 33 SECTION 6.13 Compliance with Applicable Laws . . . . . . . . . . 33 SECTION 6.14 Insurance . . . . . . . . . . . . . . . . . . . . . 33 SECTION 6.15 Solvency. . . . . . . . . . . . . . . . . . . . . . 33 SECTION 6.16 Use of Proceeds. . . . . . . . . . . . . . . . . . 34 SECTION 6.17 Subsidiaries. . . . . . . . . . . . . . . . . . . . 34 SECTION 7 COVENANTS . . . . . . . . . . . . . . . . . 34 SECTION 7.1 Reports, Certificates and Other Information . . . . 34 (a) Annual Report. . . . . . . . . . . . . . . . . . . . . . 35 (b) Interim Reports. . . . . . . . . . . . . . . . . . . . . 35 (c) Statutory Statements. . . . . . . . . . . . . . . . . . 35 (d) Reports to SEC. . . . . . . . . . . . . . . . . . . . . 35 (e) Certificates . . . . . . . . . . . . . . . . . . . . . . 35 (f) Notice of Default, Litigation and ERISA Matters . . . . 35 (g) Other Information . . . . . . . . . . . . . . . . . . . 36 SECTION 7.2 Corporate Existence and Franchises . . . . . . . . 36 SECTION 7.3 Books, Records and Inspections . . . . . . . . . . 36 SECTION 7.4 Insurance . . . . . . . . . . . . . . . . . . . . . 36 SECTION 7.5 Taxes and Liabilities . . . . . . . . . . . . . . . 37 SECTION 7.6 Cash Flow Coverage . . . . . . . . . . . . . . . . 37 SECTION 7.7 Net Worth. . . . . . . . . . . . . . . . . . . 37 SECTION 7.8 Funds for Refinancing. . . . . . . . . . . . . 37 SECTION 7.9 Indebtedness. . . . . . . . . . . . . . . . . 37 SECTION 7.10 Risk-Based Capital . . . . . . . . . . . . . . . . 38 SECTION 7.11 Real Estate Concentration. . . . . . . . . . . . . 38 SECTION 7.12 Investment Quality. . . . . . . . . . . . . . . . . 38 SECTION 7.13 Intentionally Omitted. . . . . . . . . . . . . . . 38 SECTION 7.14 Insurance Company Leverage Ratio. . . . . . . . . 38 SECTION 7.15 Intentionally Omitted. . . . . . . . . . . . . . . 38 SECTION 7.17 Change in Nature of Business . . . . . . . . . . . 39 SECTION 7.18 Depository Relationship . . . . . . . . . . . . . . 39 SECTION 7.19 Employee Benefit Plans . . . . . . . . . . . . . . 40 SECTION 7.20 Use of Proceeds . . . . . . . . . . . . . . . . . . 40 SECTION 7.21 Other Agreements . . . . . . . . . . . . . . . . . 40 SECTION 7.22 Compliance with Applicable Laws . . . . . . . . . . 40 SECTION 7A UNRESTRICTED SUBSIDIARIES . . . . . . . . . . . . . 40 SECTION 7A.1 Unrestricted Subsidiaries. . . . . . . . . . . . . 40 SECTION 7A.2 Additional Unrestricted Subsidiaries. . . . . . . . 41 SECTION 7A.3 Effectiveness of Designation. . . . . . . . . . . . 42 SECTION 8 ii CONDITIONS TO MAKING LOANS AND ISSUING LCS . . . . . . . . 42 SECTION 8.1 Initial Loans. . . . . . . . . . . . . . . . . . . 42 (a) Fees and Expenses . . . . . . . . . . . . . . . . . . . 42 (b) Documents . . . . . . . . . . . . . . . . . . . . . . . 42 SECTION 8.2 All Loans and LCs. . . . . . . . . . . . . . . . . 43 (a) No Default, etc. . . . . . . . . . . . . . . . . . . . . 44 (b) Notice. . . . . . . . . . . . . . . . . . . . . . . . . 44 SECTION 9 EVENTS OF DEFAULT AND THEIR EFFECT . . . . . . . . . . . 44 SECTION 9.1 Events of Default . . . . . . . . . . . . . . . . . 44 (a) Nonpayment of the Loan . . . . . . . . . . . . . . 44 (b) Nonpayment of Other Indebtedness . . . . . . . . . . . . 44 (c) Bankruptcy or Insolvency . . . . . . . . . . . . . . . . 45 (d) Specified Noncompliance with this Agreement . . . . . . 45 (e) Other Noncompliance with this Agreement . . . . . . . . 45 (f) Representations and Warranties . . . . . . . . . . . . . 45 (g) Employee Benefit Plans . . . . . . . . . . . . . . . . . 46 (h) Judgments . . . . . . . . . . . . . . . . . . . . . . . 46 SECTION 9.2 Effect of Event of Default . . . . . . . . . . . . 46 SECTION 9A THE AGENT . . . . . . . . . . . . . . . . . 47 SECTION 9A.1 Appointment and Authorization . . . . . . . . . . . 47 SECTION 9A.2 Delegation of Duties . . . . . . . . . . . . . . . 47 SECTION 9A.3 Liability of Agent . . . . . . . . . . . . . . . . 47 SECTION 9A.4 Reliance by Agent . . . . . . . . . . . . . . . . . 47 SECTION 9A.5 Notice of Default . . . . . . . . . . . . . . . . . 48 SECTION 9A.6 Credit Decision . . . . . . . . . . . . . . . . . . 48 SECTION 9A.7 Indemnification . . . . . . . . . . . . . . . . . . 49 SECTION 9A.8 Agent in Individual Capacity . . . . . . . . . . . 50 SECTION 9A.9 Successor Agent . . . . . . . . . . . . . . . . . . 50 SECTION 10 GENERAL . . . . . . . . . . . . . . . . . 50 SECTION 10.1 Amendments and Waivers . . . . . . . . . . . . . . 50 SECTION 10.2 Notices . . . . . . . . . . . . . . . . . . . . . . 51 SECTION 10.3 Accounting Terms; Computations . . . . . . . . . . 52 SECTION 10.4 Costs, Expenses and Taxes . . . . . . . . . . . . . 52 SECTION 10.5 Indemnification . . . . . . . . . . . . . . . . . . 53 SECTION 10.6 Captions and References . . . . . . . . . . . . . . 53 SECTION 10.7 No Waiver; Cumulative Remedies. . . . . . . . . . . 53 SECTION 10.8 Governing Law; Jury Trial; Severability . . . . . . 54 SECTION 10.9 Counterparts . . . . . . . . . . . . . . . . . . . 55 SECTION 10.10 Successors and Assigns . . . . . . . . . . . . . . 55 SECTION 10.11 Prior Agreements . . . . . . . . . . . . . . . . . 55 SECTION 10.12 Assignments; Participations . . . . . . . . . . . . 55 SECTION 10.13 Confidentiality. . . . . . . . . . . . . . . . . . 56 SECTION 10.14 Notification of Addresses, Etc. . . . . . . . 57 iii EXHIBITS EXHIBIT A Form of Note EXHIBIT B Form of Notice of Borrowing EXHIBIT C Form of Notice of Conversion/Continuation iv CREDIT AGREEMENT This Credit Agreement dated as of December 22, 1993 (this "Agreement"), is among (i) PIONEER FINANCIAL SERVICES, INC., a Delaware corporation (herein, together with its successors and assigns, called the "Company"), (ii) AMERICAN NATIONAL BANK AND TRUST COMPANY OF CHICAGO, as administrative agent (in such capacity, the "Agent") and (iii) AMERICAN NATIONAL BANK AND TRUST COMPANY OF CHICAGO, a national banking association (herein, together with its successors and assigns, called the "ANB"), FIRSTAR BANK MILWAUKEE, N.A., a national banking association (herein, together with its successors and assigns, called "Firstar") and BANK ONE, ROCKFORD, NA, a national banking association (herein, together with its successors and assigns, called "Bank One") (ANB, Firstar and Bank One collectively referred to as the "Banks" and individually as a "Bank"). W I T N E S S E T H: WHEREAS, the Company has requested the Banks severally to make available to the Company a revolving credit facility for the purposes as set forth herein; and WHEREAS, the Banks are willing to make available to the Company a revolving facility in the aggregate amount of $20,000,000, under which each Bank severally shall lend funds and ANB, in its capacity as Issuing Bank, shall issue letters of credit from time to time to or for the benefit of the Company subject to the terms and conditions set forth in this Agreement; NOW, THEREFORE, in consideration of the mutual agreements contained herein, the parties hereto agree as follows: SECTION 1 CERTAIN DEFINITIONS SECTION 1.1 Terms Defined in this Agreement. When used herein the following terms shall have the following respective meanings: "Adjusted Capital and Surplus" means, with respect to each Insurance Subsidiary as of any date, the sum of (i) Capital and Surplus for such Insurance Subsidiary and (ii) the asset valuation reserve of such Insurance Subsidiary as of such date determined in accordance with Statutory Accounting Principles. "Affiliate" means, with respect to any Person, any other Person directly or indirectly controlling, controlled by, or under direct or indirect common control with, such Person. A Person shall be deemed to control another Person if such first Person possesses, directly or indirectly, the power to direct or cause the direction of the management and policies of such other Person, whether through ownership of voting securities, by contract or otherwise. "Agent's Payment Office" means the address for payments set forth on the signature page hereto in relation to the Agent or such other address as the Agent may from time to time specify in accordance with Section 10.2. "Agent-Related Persons" means the Agent and any successor Agent appointed under Section 9A.9, together with their respective Affiliates, and the officers, directors, employees, agents and attorneys-in-fact of such Persons and Affiliates. "Aggregate Commitment" means the combined Commitments of the Banks in the amount of twenty million dollars ($20,000,000), as such amount may be reduced from time to time pursuant to this Agreement. "Aggregate Stated Amount" shall mean, as of the date of determination, the aggregate Stated Amounts of all LCs. "Agreement" means this Credit Agreement as it may be amended, supplemented or otherwise modified from time to time in accordance with the terms hereof. "ANB" - see Preamble. "Applicable Margin" means (a) with respect to Base Rate Loans, -0-, (b) with respect to CD Rate Loans, two percent (2.00%) per annum, and (c) with respect to Eurodollar Rate Loans, two percent (2.00%) per annum. "Authorized Control Level RBC" shall have the same meaning as the term "Authorized Control Level RBC" as defined in the NAIC Risk-Based Capital (RBC) for Life and/or Health Insurers Model Act, as such term may be amended by the NAIC from time to time. "Authorized Officer" means the Chairman, the President, any Executive Vice President, the Treasurer or any Vice Presidents of the Company that are designated as authorized officers pursuant to a resolution of the Board of Directors of the Company (each Bank shall be entitled to rely on such resolution until revoked or amended in writing by the Company). "Available Cash Flow" means, for any accounting period, without duplication of items that may be included in more than one of the following computations, the sum of (i) the aggregate Distributable Profits from the Insurance Subsidiaries for such period, and (ii) the combined net after tax income of the Non-Insurance Operating Subsidiaries for such period, plus depreciation, amortization and other non-cash expenses of the Non-Insurance Operating Subsidiaries for such period, minus all capitalized expenditures of the Non-Insurance Operating Subsidiaries for such period, all to be determined in accordance with GAAP. "Bank" or "Banks" - see Preamble. "Bank Parties" - see Section 10.5. "Base Rate" means at any time and from time to time the rate of interest per annum which ANB most recently announced as its base rate at Chicago, Illinois, which rate shall not necessarily be the lowest rate of interest which ANB charges its customers. "Base Rate Loan" means a Loan that bears interest based on the Base Rate. "Borrowing" means a borrowing hereunder consisting of the several Loans made to the Company on the same day by each Bank pursuant to Section 2 hereof and having the same interest rate basis and Interest Period. "Business Day" means any day of the year on which each Bank is open for business in the city where such Bank's main office is located. "Capital and Surplus" means, with respect to each Insurance Subsidiary, such Insurance Subsidiary's capital and surplus as reported on such Insurance Subsidiary's Statutory Statements most recently filed with the department of insurance of such Insurance Subsidiary's state of incorporation. "CD Rate" means with respect to each Interest Period to be applicable to a CD Rate Loan, the rate of interest per annum payable on a certificate or certificates of deposit purchased by the Company from ANB concurrently in connection with the extension of a CD Rate Loan. "CD Rate Loan" means a Loan that bears interest based on the CD Rate. "Clean-up Date" shall mean the first day of any Clean-up Period. "Clean-up Period" shall mean, during such period of twelve consecutive months determined on a rolling basis, any period of sixty consecutive days in which no Loans are outstanding. "Closing Date" means the date on which all conditions precedent set forth in Section 8.1 are satisfied or waived by all the Banks. "Commitment", with respect to each Bank, has the meaning specified in Section 2.1. "Commitment Percentage" means, as to any Bank, the percentage equivalent at the time of determination of such Bank's Commitment divided by the Aggregate Commitment. "Company" - see Preamble. "Conversion Date" means any date on which the Company converts a Base Rate Loan to a Eurodollar Rate Loan or a CD Rate Loan; a CD Rate Loan to a Eurodollar Rate Loan or a Base Rate Loan; or a Eurodollar Rate Loan to a CD Rate Loan or a Base Rate Loan. "Debt Service Requirements" means, for any accounting period, the aggregate of the principal, interest and other dividends, payments or distributions made or required to be made (i) to each Bank under this Agreement, (ii) with respect to other Indebtedness and (iii) with respect to the Preferred Stock. "Distributable Profits" means, for any accounting period, (i) the greater of (A) 10% of the aggregate Capital and Surplus of all Insurance Subsidiaries, and (B) the aggregated net after-tax profits of all Insurance Subsidiaries, determined in accordance with Statutory Accounting Principles for such period minus (ii) the after-tax profits of each Principal Insurance Subsidiary that must be retained by such Principal Insurance Subsidiary to maintain the Total Adjusted Capital required by Section 7.10.y "Dollar(s)" and the sign "$" means lawful money of the United States of America. "Environmental Laws" means any and all federal, state or local environmental or health and safety-related laws, regulations, rules, ordinances, orders or directives. "ERISA" means the Employee Retirement Income Security Act of 1974, as amended, and any successor statute of similar import, together with the regulations thereunder and under the Internal Revenue Code of 1986, as amended, in each case as in effect from time to time. References to sections of ERISA shall be construed to also refer to any successor sections. "ERISA Affiliate" means any corporation, trade or business that is, along with the Company, a member of a controlled group of corporations or a controlled group of trades or businesses, as described in Sections 414(b) and 414(c), respectively, of the Internal Revenue Code of 1986, as amended, or Section 4001 of ERISA. "Eurodollar Rate Loan" means a Loan that bears interest based on LIBOR. "Event of Default" means any of the events described in Section 9.1. "FDIC" means the Federal Deposit Insurance Corporation, or any entity succeeding to any of its principal functions. "Federal Funds Rate" means, for any day, the rate set forth in the weekly statistical release designated as H.15(519), or any successor publication, published by the Federal Reserve Board (including any such successor, "H.15(519)") for such date opposite the caption "Federal Funds (Effective)". If on any relevant day such rate is not yet published in H.15(519), the rate for such day will be the rate set forth in the daily statistical release designated as the Composite 3:30 p.m. Quotations for U.S. Government Securities, or any successor publication, published by the Federal Reserve Bank of New York (including any such successor, the "Composite 3:30 p.m. Quotation") for such day under the caption "Federal Funds Effective Rate". If on any relevant day the appropriate rate is not yet published in either H.15(519) or the Composite 3:30 p.m. Quotations, the rate for such day will be the arithmetic mean as determined by the Agent of the rates for the last transaction in overnight Federal funds arranged prior to 9:00 a.m. (New York time) on that day by each of three leading brokers of Federal funds transactions in New York City selected by the Agent. "Federal Reserve Board" means the Board of Governors of the Federal Reserve System, or any entity succeeding to any of its principal functions. GAAP means the generally accepted accounting principles in the United States of America with such changes thereto as (i) shall be consistent with the then-effective principles promulgated or adopted by the Financial Accounting Standards Board and its predecessors and successors and (ii) shall be concurred in by the independent certified public accountants of recognized standing certifying any financial statements of the Company and its Subsidiaries. "Indebtedness" means, as of any date, all indebtedness, obligations or other liabilities of the Company and its Subsidiaries as of such date (i) for borrowed money, (ii) evidenced by bonds, debentures, notes or other similar instruments for borrowed money, or (iii) pursuant to any guarantee of any indebtedness, obligations or other liabilities of any other Person of the type described in clauses (i) or (ii); provided, however, that (a) the amounts set forth in clauses (i), (ii) and (iii) shall not be double counted and (b) Indebtedness shall not include indebtedness, obligations or other liabilities of the Company to any Subsidiary or indebtedness, obligations or other liabilities of any Subsidiary to the Company or another Subsidiary. "Indemnified Liabilities" - see Section 10.5. "Insurance Company Leverage Ratio" means, for each Principal Insurance Subsidiary on an individual basis as of any date and for all Principal Insurance Subsidiaries on a combined basis as of any date, the ratio of Adjusted Capital and Surplus to Total Assets. "Insurance Laws" means any and all federal or state laws, regulations, rules, ordinances, orders or directives that pertain to the regulation of insurance companies, as such. "Insurance Subsidiaries" means, as of any date, all Subsidiaries of the Company that are engaged in the insurance business and are subject to regulation by the insurance commission or department of any state or other jurisdiction. The Insurance Subsidiaries of the Company as of the date of this Agreement are set forth in Schedule 6.17 attached hereto. "Interest Payment Date" means, (a) with respect to any CD Rate Loan or Eurodollar Rate Loan, the last day of each Interest Period applicable to such Loan, provided, however, that if any Interest Period for a CD Rate Loan or Eurodollar Rate Loan exceeds 90 days or three months, respectively, the date which falls 90 days or three months (as the case may be) after the beginning of such Interest Period and after each Interest Payment Date thereafter shall also be an Interest Payment Date, and (b) with respect to any Base Rate Loan, the last Business Day of each calendar quarter and each date upon which such Loan is prepaid or converted to a Eurodollar Rate Loan or a CD Rate Loan. "Interest Period" means, (a) with respect to any Eurodollar Rate Loan, the period commencing on the Business Day the Loan is disbursed or continued or on the Conversion Date on which the Loan is converted to the Eurodollar Rate Loan and ending on the date one, two, three or six months thereafter, as selected by the Company in its Notice of Borrowing or Notice of Conversion/Continuation; and (b) with respect to any CD Rate Loan, the period commencing on the Business Day the CD Rate Loan is disbursed or continued or on the Conversion Date on which a Loan is converted to the CD Rate Loan and ending 30, 60, 90 or 180 days thereafter, as selected by the Company in its Notice of Borrowing or Notice of Conversion/Continuation; provided that: (i) if any Interest Period pertaining to a Eurodollar Rate Loan or CD Rate Loan would otherwise end on a day which is not a Business Day, that Interest Period shall be extended to the next succeeding Business Day unless, in the case of a Eurodollar Rate Loan, the result of such extension would be to carry such Interest Period into another calendar month, in which event such Interest Period shall end on the immediately preceding Business Day; (ii) any Interest Period pertaining to a Eurodollar Rate Loan that begins on the last Business Day of a calendar month (or on a day for which there is no numerically corresponding day in the calendar month at the end of such Interest Period) shall end on the last Business Day of the calendar month at the end of such Interest Period; and (iii) no Interest Period for any Loan shall extend beyond a Clean-up Date or the Termination Date. "Investment Grade Obligations" means, as of any date for each Insurance Subsidiary, investments having an NAIC investment rating of 1 or 2; or a Standard & Poor's rating within the range of ratings from AAA to BBB-; or a Moody's rating within the range of ratings from Aaa to Baa3. "Issuing Bank" means American National Bank and Trust Company of Chicago in its capacity as issuing bank with respect to LCs issued under and pursuant to the terms of this Agreement. "LC" - see Section 2.2. "LC Application" - see Section 2.5. "Liabilities" means any and all of the Company's obligations to the Banks, howsoever created, arising or evidenced, whether direct or indirect, absolute or contingent, now or hereafter existing, or due or to become due, which arise out of or in connection with this Agreement or the Related Documents. "LIBOR" means, with respect to each Interest Period to be applicable to a Eurodollar Rate Loan, the rate of interest per annum determined by the Agent obtained by dividing (a) the Telerate Screen Rate for such Interest Period or (b) if the Telerate Screen Rate is unavailable at the time the LIBOR rate is to be determined, a rate determined on the basis of the offered rates for deposits in U.S. dollars for a period approximately equal to such Interest Period which appear on the Reuters Screen LIBO Page, as of 11:00 a.m., London time, on the day that is two London banking days preceding the beginning of such Interest Period by (c) a percentage equal to 100% minus the stated maximum rate (expressed as a percentage) as prescribed by the Federal Reserve Board of all reserve requirements (including, without limitation, any marginal, emergency, supplemental, special or other reserves) applicable on the first day of such Interest Period to any member bank of the Federal Reserve System in respect of Eurodollar funding or liabilities. "Lien" means any mortgage, pledge, lien, security interest or other charge or encumbrance, including the retained security title of a conditional vendor or lessor. "Loan" means an extension of credit by a Bank to the Company pursuant to Section 2, and may be a Base Rate Loan, CD Rate Loan or a Eurodollar Rate Loan. "Majority Banks" means at any time Banks then having Commitments equal to at least 51% of the Aggregate Commitment. "Margin Stock" has the meaning given to such term in Regulation U. "Material Subsidiary" means any Subsidiary of the Company, the financial condition of which, when consolidated with the financial condition of the Company, has a material effect on such financial condition of the Company, and shall include, without limitation, each Principal Insurance Subsidiary. "Mortgage" means, as of any date, as to each Insurance Subsidiary, the amount of such Insurance Subsidiary's mortgage loans on real estate calculated in accordance with Statutory Accounting Principles. "Multiemployer Plan" means a "multiemployer plan" as defined in ERISA. "NAIC" means the National Association of Insurance Commissioners and any successor thereto. "Net Worth" means, with respect to the Company, as at the time any determination thereof is made, the consolidated shareholders' equity (including common stock, additional paid-in capital, retained earnings, and net unrealized gains and losses). "Non-Insurance Operating Subsidiaries" means, as of any date, all Subsidiaries of the Company that are not Insurance Subsidiaries. The Non- Insurance Operating Subsidiaries of the Company as of the date of this Agreement are set forth in Schedule 6.17 attached hereto. "Non-Investment Grade Obligations" means, as of any date, for each Insurance Subsidiary, any fixed maturity debt instrument investment that is not an Investment Grade Obligation. "Note" or "Notes" - see Section 3 and Exhibit A. "Notice of Borrowing" means a notice given by the Company to the Agent pursuant to Section 2.3, in substantially the form of Exhibit B. "Notice of Conversion/Continuation" means a notice given by the Company to the Agent pursuant to Section 2.4, in substantially the form of Exhibit C. "PBGC" means the Pension Benefit Guaranty Corporation and any entity succeeding to any or all of its functions under ERISA. "Permitted Liens" - see Section 7.16. "Person" means an individual or a corporation, partnership, trust, incorporated or unincorporated association, joint venture, joint stock company, government (or any agency or political subdivision thereof) or other entity of any kind. "Plan" means an "employee pension benefit plan", as such term is defined in Section 3(2) of ERISA, an "employee welfare benefit plan," as such term is defined in Section 3(1) of ERISA, or any bonus, deferred compensation, stock purchase, stock option, severance, salary continuation, vacation, sick leave, fringe benefit, incentive, insurance, welfare or similar arrangement. "Policy Liabilities" means the aggregate liabilities of a Principal Insurance Subsidiary for future policy benefits with respect to life and annuity policies issued by such Principal Insurance Subsidiary, determined in accordance with GAAP. "Preferred Stock" means the shares of the Company's Cumulative Convertible Exchangeable Preferred Stock, having a stated value of $25 per share. "Principal Insurance Subsidiaries" means, as of any date, any Insurance Subsidiary that is or becomes engaged in a material amount of insurance business and has been designated in writing by all of the Banks and the Company as a Principal Insurance Subsidiary. The following Insurance Subsidiaries shall be deemed to be Principal Insurance Subsidiaries as of the date of this Agreement and until designated otherwise by all of the Banks and the Company : Pioneer Life Insurance Company of Illinois, an Illinois corporation; National Group Life Insurance Company, an Illinois corporation; and Manhattan National Life Insurance Company, an Illinois corporation. "Real Estate Concentration Ratio" means, as of any date, as to each Insurance Subsidiary, the ratio of (a) the sum of (i) Real Estate Investments plus (ii) Mortgages to (b) Capital and Surplus. "Real Estate Investments" means, as of any date, as to each Insurance Subsidiary, the sum of (a) the book value of properties acquired in satisfaction of debt calculated in accordance with Statutory Accounting Principles plus (b) the investment in investment real estate calculated in accordance with Statutory Accounting Principles; provided, that the properties occupied by the Company or any Subsidiary shall be excluded from the calculation of Real Estate Investments for purposes of this Agreement. "Regulation U" means Regulation U of the Board of Governors of the Federal Reserve System and any successor rule or regulation of similar import as in effect from time to time. "Reimbursement Obligations" - see Section 2.6. "Related Documents" means, collectively, this Agreement, each Note issued by the Company to each Bank, and all other documents, instruments and agreements executed by the Company and delivered to the Agent or the Banks pursuant to or in connection with this Agreement or any of the foregoing. "Reportable Event" means a reportable event (as defined in Section 4043(b) of ERISA) for which notice has not been waived pursuant to applicable regulations. "Reuters Screen LIBO Page" means the display page designated "LIBO" on the Reuters Monitor Money Rates Service (or such other page that may replace that page on such service for the purpose of displaying comparable rates). "Stated Amount" shall mean, with respect to any LC and as of the date of determination, the maximum amount for which a draw or demand for payment may then be made thereunder, whether or not such maximum amount is defined in such LC as the "Stated Amount" thereof. "Statutory Accounting Principles" means the accounting principles used in the preparation of Statutory Statements in accordance with the rules and regulations prescribed by the insurance commission or department of each Insurance Subsidiary's respective state of domicile in effect as of the date of this Agreement. In the event that there is a material change in such accounting principles subsequent to the date hereof, the covenants contained herein and affected by such change shall be adjusted as necessary to preserve the force and effect of such covenants by the Company (provided that prior to any such adjustment the Company shall consult with the Agent with respect to any such adjustment) subject to the reasonable objection of the Majority Banks. "Statutory Statements" means, with respect to an Insurance Subsidiary, the annual or quarterly accounting statement for such Insurance Subsidiary prepared in accordance with Statutory Accounting Principles, as filed with the insurance commissioner or department of each jurisdiction in which such Insurance Subsidiary is subject to regulation. "Subsidiary" means a corporation, association or business entity of which the Company and/or its other Subsidiaries own, directly or indirectly, such number of outstanding shares as have more than 50% of the ordinary voting power for the election of such entity's directors. "Telerate Screen Rate" means, for any Interest Period to be applicable to a Eurodollar Rate Loan, the rate for deposits in U.S. dollars for a period approximately equal to such Interest Period which appears on Page 3750 of the Dow Jones Telerate Service (or such other page that may replace that page on such service for the purpose of displaying comparable rates) as of 11:00 a.m., London time, on the day that is two London banking days preceding the beginning of such Interest Period. "Termination Date" - means the earlier to occur of: (a) April 30, 1996; and (b) the date on which the Aggregate Commitment shall terminate in accordance with the provisions of this Agreement. "Total Adjusted Capital" shall have the same meaning as the term "Total Adjusted Capital" as defined in the NAIC Risk-Based Capital (RBC) for Life and/or Health Insurers Model Act, as such term may be amended by the NAIC from time to time. "Total Assets" means, as of any date, as to each Insurance Subsidiary, the total net admitted assets calculated as of such date in accordance with Statutory Accounting Principles. "Total Invested Assets" means, as of any date, as to each Insurance Subsidiary, the amount of such Insurance Subsidiary's cash and invested assets calculated in accordance with Statutory Accounting Principles. "Unrestricted Subsidiary" - see Section 7A.1. SECTION 2 BANK'S COMMITMENT; BORROWING PROCEDURES; LCs SECTION 2.1 Bank's Commitment to Make Loans. (a) On the terms and subject to the conditions set forth in this Agreement, each Bank severally agrees to make revolving loans (each such loan called a "Loan" and collectively called the "Loans") to the Company from time to time on any Business Day during the period from the Closing Date to the Termination Date, in an aggregate amount not to exceed at any time outstanding the amount set forth opposite such Bank's name on the signature page hereof under the heading "Commitment" (such amount as the same may be reduced pursuant to Section 2.9 or as a result of one or more assignments pursuant to Section 10.12, such Bank's "Commitment") minus the sum of (a) such Bank's Commitment Percentage of the aggregate Stated Amount of all LCs issued and outstanding and (b) such Bank's Commitment Percentage of the aggregate amount of all Reimbursement Obligations; provided, however, that after giving effect to any Borrowing of Loans, the aggregate principal amount of all outstanding Loans plus the sum of (c) the Aggregate Stated Amount of all LCs issued and outstanding and (d) the aggregate amount of all Reimbursement Obligations, shall not exceed the Aggregate Commitment. The Company and each Bank agree and acknowledge that each Bank's portion of each Borrowing of Loans shall be based pro rata on such Bank's Commitment Percentage determined at the time of such Borrowing. (b) The Company agrees that, with respect to each Bank's Commitment Percentage of each Loan that is a CD Rate Loan, the Company shall purchase from such Bank a certificate or certificates of deposit in an amount equal to such Bank's Commitment Percentage of each such Loan having a term equal to the Interest Period applicable to such Loan. SECTION 2.2 Issuing Bank's Commitment to Issue LCs. On the terms and subject to the conditions set forth in this Agreement, the Issuing Bank agrees, as the Company may from time to time request, to issue for the account of the Company letters of credit (each such letter of credit called an "LC" and collectively called the "LCs") from time to time on any Business Day during the period from the Closing Date to the Termination Date, in a Stated Amount not to exceed the Aggregate Commitment minus the sum of (a) the aggregate principal amount of all Loans then outstanding and not repaid, (b) the aggregate Stated Amount of all LCs previously issued and then outstanding and (c) the aggregate amount of all Reimbursement Obligations. SECTION 2.3 Procedure for Borrowing. (a) Each Borrowing of Loans shall be made upon the Company's irrevocable written notice delivered to the Agent in accordance with Section 10.2 in the form of a Notice of Borrowing (which notice must be received by the Agent prior to 11:00 a.m. (Chicago time) (i) two Business Days prior to the requested Borrowing date, in the case of Eurodollar Rate Loans, (ii) one Business Day prior to the requested Borrowing Date, in the case of CD Rate Loans, and (iii) on the requested Borrowing date, in the case of Base Rate Loans) specifying: (A) the amount of the Borrowing, which shall be in an aggregate minimum principal amount of one hundred thousand dollars ($100,000); (B) the requested Borrowing date, which shall be a Business Day; (C) whether the Borrowing is to be comprised of Eurodollar Rate Loans, CD Rate Loans or Base Rate Loans; (D) in the case of Eurodollar Rate Loans and CD Rate Loans, the duration of the Interest Period applicable to such Loans included in such notice. If the Notice of Borrowing shall fail to specify the duration of the Interest Period for any Borrowing comprised of CD Rate Loans or Eurodollar Rate Loans, such Interest Period shall be 30 days or one month, respectively; and (E) the account of the Company to which the proceeds of such Borrowing shall be deposited. (b) Upon receipt of the Notice of Borrowing, the Agent will promptly notify each Bank thereof and of the amount of such Bank's Commitment Percentage of the Borrowing. (c) Each Bank will make the amount of its Commitment Percentage of the Borrowing available to the Agent for the account of the Company at the Agent's Payment Office by 2:00 p.m. (Chicago time) on the Borrowing date requested by the Company in funds immediately available to the Agent. Promptly after receipt of all such amounts by the Agent, the proceeds of all such Loans will be disbursed by the Agent to such account of the Company designated in writing by the Company in the Notice of Borrowing in like funds as received by the Agent. (d) Unless the Majority Banks shall otherwise agree, during the existence of an Event of Default, the Company may not elect to have a Loan be made as, or converted into or continued as, a Eurodollar Rate Loan or a CD Rate Loan. SECTION 2.4 Conversion and Continuation Elections. (a) The Company may upon irrevocable written notice to the Agent in accordance with Section 2.4(b): (i) elect to convert on any Business Day, any Base Rate Loans (or any part thereof in an amount not less than $100,000) into Eurodollar Rate Loans or CD Rate Loans; or (ii) elect to convert on the last day of any Interst Period with respect thereto any Eurodollar Rate Loans (or any part thereof in an amount not less than $100,000) into Base Rate Loans or CD Rate Loans; or (iii) elect to convert on the last day of any Interest Period with respect thereto any CD Rate Loans (or any part thereof in an amount not less than $100,000) into Base Rate Loans or Eurodollar Rate Loans; or (iv) elect on the last day of any Interest Period with respect to any Eurodollar Rate Loans or CD Rate Loans (or any part thereof in an amount not less than $100,000) to continue such Eurodollar Rate Loans or CD Rate Loans (or such part thereof) as such; provided, that if the aggregate amount of CD Rate Loans or Eurodollar Rate Loans shall have been reduced, by payment, prepayment, or conversion of part thereof, to be less than $100,000, such CD Rate Loans or Eurodollar Rate Loans shall automatically convert into Base Rate Loans, and on and after such date until the amount of Loans shall exceed $100,000 the right of the Company to continue such Loans as, and convert such Loans into, Eurodollar Rate Loans or CD Rate Loans, as the case may be, shall terminate. (b) The Company shall deliver a Notice of Conversion/ Continuation in accordance with Section 10.2 to be received by the Agent not later than 11:00 a.m. (Chicago time) at least (i) two Business Days in advance of the Conversion Date or continuation date, if the Loans are to be converted into or continued as Eurodollar Rate Loans, (ii) one Business Day in advance of the Conversion Date or continuation date, if the Loans are to be converted into or continued as CD Rate Loans, and (ii) on the Conversion Date, if the Loans are to be converted into Base Rate Loans, specifying: (A) the proposed Conversion Date or continuation date; (B) the aggregate amount of Loans to be converted or continued; (C) the nature of the proposed conversion or continuation; and (D) the duration of the requested Interest Period. (c) If upon the expiration of any Interest Period applicable to CD Rate Loans or Eurodollar Rate Loans, the Company has failed to select timely a new Interest Period to be applicable to such CD Rate Loans or Eurodollar Rate Loans, as the case may be, or if any Event of Default shall then exist, the Company shall be deemed to have elected to convert such CD Rate Loans or Eurodollar Rate Loans into Base Rate Loans effective as of the expiration date of such current Interest Period. (d) Upon receipt of a Notice of Conversion/Continuation, the Agent will promptly notify each Bank thereof, or, if no timely notice is provided by the Company, the Agent will promptly notify each Bank of the details of any automatic conversion. (e) Unless the Majority Banks shall otherwise agree, during the existence of an Event of Default, the Company may not elect to have a Loan converted into or continued as a Eurodollar Rate Loan or a CD Rate Loan. SECTION 2.5 LC Documentation. (a) Each of the Company's requests for an LC must be received by the Agent and the Issuing Bank at least two Business Days prior to the requested issue date of such LC, and shall be accompanied by a duly completed application therefor (the "LC Application") and such other documents, in support thereof as the Issuing Bank may reasonably require, and all of such applications and documents shall be in form and substance reasonably satisfactory to the Issuing Bank. In addition, the proposed form of each LC shall be in form and substance reasonably satisfactory to the Issuing Bank, due regard being given to the customs and conventions followed by the Issuing Bank in the issuance of letters of credit generally and the advice of the Banks from time to time given to the Issuing Bank as to necessary or desirable terms and provisions in the form of any such proposed LC. Upon receipt of any request for an LC, the Agent will promptly notify each Bank thereof and deliver to each Bank a copy of the LC Application and each other document received by the Agent in connection with such request for an LC. Each LC shall have an expiry date that shall in no event be later than one year after the Termination Date. (b) Subject to the terms and conditions of this Agreement, including, without limitation, Section 2.2, Section 2.5(a) and Section 8.2 hereof, the Issuing Bank shall issue the requested LC in accordance with the Issuing Bank's usual and customary business practices on the date requested for such issuance by the Company in the request made by the Company pursuant to the terms of Section 2.5(a) hereof. Notwithstanding the foregoing, if the Issuing Bank shall have received written notice from the Agent or any Bank on or before the Business Day prior to the date of the Issuing Bank's issuance of such proposed LC that one or more of the conditions set forth in Section 8.2 is not then satisfied, then, until such condition is satisfied and the Issuing Bank receives written notice thereof, the Issuing Bank shall have no obligation to issue any LC. Each Bank agrees that it shall not unreasonably give any such notice or unreasonably fail to withdraw any such notice. (c) The Issuing Bank shall promptly give the Agent notice upon the issuance of an LC hereunder and a copy of the LC so issued by such Issuing Bank, and the Agent shall promptly thereafter give notice of such issuance and a copy of such LC to the Banks. An LC otherwise issued in accordance with the terms of this Agreement shall be an LC notwithstanding any failure by the Issuing Bank or the Agent to provide any such notice or copies in a timely manner. (d) The Company may request that an LC be extended beyond its stated expiry date or otherwise renewed by giving the Issuing Bank and the Agent written notice of any such extension or renewal not later than ten Business Days prior to the date (the "LC Extension Date") that such LC would have expired absent such extension or renewal. Each such notice (an "LC Extension Request") shall specify the LC that is being extended or renewed and the proposed new expiration date of such LC. The Agent shall promptly advise each Bank of its receipt of, and provide to each Bank a copy of, each LC Extension Request. The new expiration date proposed for any LC may not be a date that is on or after one year after the Termination Date. Following proper delivery of an LC Extension Request pursuant to this Section, the Issuing Bank shall, subject to Section 8.2, extend the expiration date of or renew any LC issued by the Issuing Bank. Notwithstanding the foregoing, if the Issuing Bank shall have received written notice from the Agent or any Bank on or before the Business Day prior to the Issuing Bank's proposed extension of the expiration date of an LC that one or more of the conditions set forth in Section 8.2 is not then satisfied, then, until such condition is satisfied and the Issuing Bank receives written notice thereof, the Issuing Bank shall have no obligation to extend the expiration date of such LC. (e) The Company may request that an LC be amended at any time by giving the Issuing Bank and the Agent written notice thereof not later than ten Business Days prior to the date proposed for such amendment. Each such notice (an "LC Amendment Request") shall specify in reasonable detail the changes that are then being requested to be made in the applicable LC and the changes, if any, in the information specified in the original request with respect to such LC delivered pursuant to Section 2.5(a). The Agent shall promptly advise the Banks of its receipt of, and provide a copy to each Bank of, each LC Amendment Request. If the Issuing Bank and the Agent, after consultation with any Bank that provides comments on any such LC Amendment Request, agree to such amendment, such amendment shall be given effect; provided, that (i) any extension of the expiration date or renewal of an LC shall be subject to the terms of Section 2.5(d), and (ii) any amendment which increases the face amount of an LC shall be deemed an issuance of a new LC with a face amount equal to the amount of such increase, and shall be subject to the provisions of this Agreement, including without limitation, Section 2.2, Section 2.5(a) and Section 8.2. SECTION 2.6 Agreement to Repay LC Drawings. (a) The Company hereby agrees to reimburse the Issuing Bank (collectively called the "Reimbursement Obligations" and individually a "Reimbursement Obligation"), for each payment or disbursement made by the Issuing Bank under any LC honoring any demand for payment made by the beneficiary thereunder immediately following the occurrence of any such payment or disbursement. Any Reimbursement Obligation not repaid on the date of the applicable payment or disbursement giving rise thereto shall bear interest on the amount so paid or disbursed by the Issuing Bank from the date of payment or disbursement made by the Issuing Bank to but not including the date the Issuing Bank is reimbursed therefor, at a rate per annum equal to the Base Rate from time to time in effect plus two percent (2.00%) per annum. Interest shall be computed for the actual number of days elapsed on the basis of a year consisting of 360 days. (b) Any action taken or omitted to be taken by the Issuing Bank under or in connection with any LC, if taken or omitted in the absence of willful misconduct or gross negligence, shall not put the Issuing Bank under any resulting liability to any Bank or, assuming that the Issuing Bank has complied with the applicable procedures specified herein and a Bank has not given a notice contemplated by Section 2.5(b) that continues in full force and effect, relieve any Bank of its obligations hereunder to the Issuing Bank. SECTION 2.6A Participations. (a) Upon the issuance by the Issuing Bank of any LC in accordance with the procedures and the terms set forth herein, each Bank shall be deemed to have irrevocably and unconditionally purchased and received from the Issuing Bank, without recourse or warranty, an undivided interest and participation to the extent of such Bank's Commitment Percentage in such LC (including, without limitation, all obligations of the Company with respect thereto other than amounts owing to the Issuing Bank under Section 4.2(d)), provided, that the participation of any Bank in any LC hereunder shall at no time exceed an amount equal to such Bank's Commitment minus the sum of (i) the aggregate principal amount of all Loans made by such Bank then outstanding and not repaid, (ii) such Bank's Commitment Percentage of the aggregate Stated Amount of all LCs previously issued and then outstanding and (iii) such Bank's Commitment Percentage of the aggregate amount of all Reimbursement Obligations. (b) (i) In the event that the Issuing Bank makes any payment or disbursement under any LC and the Company shall not have repaid such amount to the Issuing Bank pursuant to Section 2.6(a), the Issuing Bank shall promptly notify the Agent, which shall promptly notify each Bank, of such failure, and each Bank severally agrees to promptly and unconditionally pay to the Agent for the account of the Issuing Bank the amount of such Bank's Commitment Percentage of such payment or disbursement in same day funds and the Agent shall promptly pay such amount, and any other amounts received by the Agent for the Issuing Bank's account pursuant to this Section 2.6A(b), to the Issuing Bank. If the Agent so notifies such Bank prior to 11:00 A.M. (Chicago time) on any Business Day, such Bank shall make available to the Agent for the account of the Issuing Bank its Commitment Percentage of the amount of such payment or disbursement on such Business Day in same day funds (or on the next succeeding Business Day if notice is given after such time). The failure of any Bank to make available to the Agent for the account of the Issuing Bank its Commitment Percentage of any such payment or disbursement shall not relieve any other Bank of its obligation hereunder to make available to the Agent for the account of the Issuing Bank its Commitment Percentage of any payment or disbursement on the date such payment is to be made. (ii) In the event that any Bank fails to fund its Commitment Percentage of any payment or disbursement required to be made by the Banks to the Agent for the benefit of the Issuing Bank in accordance with the provisions of clause (i) above, until the earlier of such Bank's cure of such failure and the termination of the Bank's Commitment, the proceeds of all amounts thereafter paid or repaid to the Agent by the Company (or any Person on behalf of the Company) and contemplated hereunder to be disbursed to such Bank for application against amounts owing such Bank hereunder shall be disbursed instead to the Issuing Bank by the Agent on behalf of such Bank to cure, in full or in part, such failure by such Bank, and, upon such disbursement payment to such Bank shall be deemed to have been made. Notwithstanding anything in this Agreement to the contrary: (A) if the Issuing Bank has theretofore applied any portion of any cash collateral pledged to it to secure Reimbursement Obligations relating to the applicable LC as reimbursement for such Reimbursement Obligations, any amounts disbursed to the Issuing Bank by the Agent in accordance with this Section 2.6A(b)(ii) (net of any interest due the Issuing Bank) shall be used by the Issuing Bank to restore such cash collateral; and (B) a Bank shall be deemed to have cured its failure to fund its Commitment Percentage of any such required payment in respect of an LC at such time as an amount equal to such Bank's Commitment Percentage (determined as of the time of the Agent's receipt of notice of the failure by the Company to reimburse the Issuing Bank with respect to a payment or disbursement under such LC) of such required payment plus any interest accrued thereon is fully funded to the Issuing Bank, whether made by such Bank itself, by operation of the terms of this Section 2.6A(b)(ii) or by the Company directly to the Issuing Bank. Interest shall accrue on the amount that should have been paid by the defaulting Bank, for each day from the date such amount shall have been due until the date such amount is repaid to the Agent for the benefit of the Issuing Bank, at the Federal Funds Rate as in effect for each such day. The provisions of this Section 2.6A(b) shall not relieve the Company from paying interest at the applicable interest rate under Section 2.6(a). (c) Whenever the Issuing Bank receives a payment on account of a Reimbursement Obligation, including any interest thereon, as to which the Agent has received for the account of the Issuing Bank any payments from the Banks pursuant to this Section 2.6A, it shall promptly pay to the Agent and the Agent shall promptly pay to each Bank that has funded its participating interest therein, in the kind of funds so received, an amount equal to such Bank's Commitment Percentage thereof (according to the amounts so funded). Each such payment shall be made by the Issuing Bank or the Agent, as the case may be, on the Business day on which such Person receives the funds paid to it pursuant to the preceding sentence, if received prior to 11:00 a.m. (Chicago time) on such Business Day, and otherwise on the next succeeding Business Day. If the Issuing Bank or the Agent, as the case may be, shall fail to pay to any Bank the amount due such Bank pursuant to this Section when due, the Issuing Bank or the Agent, as the case may be, shall be obligated to pay to such Bank interest on the amount that should have been paid hereunder for each day from the date such amount shall have become due until the date such amount is paid, at the Federal Funds Rate as in effect for each such day. (d) The obligations of (i) a Bank to make payments to the Agent for the account of the Issuing Bank with respect to a payment or disbursement made under an LC issued pursuant to this Agreement and (ii) the Company to reimburse the Issuing Bank for payments and disbursements made by the Issuing Bank under any LC shall, in each case, be absolute and unconditional under any and all circumstances and irrespective of any setoff, counterclaim or defense to payment which the Company may have or have had against the Issuing Bank or such beneficiary, including, without limitation, any defense based on the failure of such demand for payment to conform to the material terms of such LC or any nonapplication or misapplication by such beneficiary of the proceeds of such demand for payment or the legality, validity, regularity or enforceability of such LC or any document or contract related to or required to be presented under the terms of such LC; provided, however, that neither the Company nor the Banks shall be obligated to reimburse the Issuing Bank for any wrongful payment or disbursement made by such Issuing Bank under such LC as a result of acts or omissions constituting negligence or willful misconduct on the part of the Issuing Bank. SECTION 2.7 Mandatory Payment of LC Liability. The Company agrees that, upon (i) its receipt of a written notice from the Agent acting upon the written request of the Majority Banks stating that an Event of Default has occurred or (ii) its receipt of a written notice from the Agent that the Termination Date has occurred, it will promptly pay to the Agent for the account of the Issuing Bank an amount equal to the amount of the then aggregate Stated Amount of all LCs issued and outstanding hereunder. The Agent, the Issuing Bank and the Company hereby agree that the Company's payment of such amount shall be by means of purchasing from the Issuing Bank or its designee a certificate or certificates of deposit in an amount equal to the amount of the then aggregate Stated Amount of all LCs issued and outstanding hereunder. Any amounts so received by the Issuing Bank or certificates of deposit issued by the Issuing Bank or its designee pursuant to the provisions of the foregoing sentence shall be retained by the Issuing Bank as collateral security for the Reimbursement Obligation of the Company with respect to such LCs. Subject to Section 2.6A and so long as no Event of Default has occurred and is continuing, upon the expiration of any LC, the Issuing Bank will return to the Agent, and the Agent shall return to the Company, all such funds with respect to such LC not used to pay Reimbursement Obligations. SECTION 2.8 LC Operations. The Issuing Bank shall, promptly following its receipt thereof, (i) examine all documents purporting to represent a demand for payment by the beneficiary under any LC to ascertain that the same appear on their face to be in conformity with the terms and conditions of such LC and (ii) notify the Agent and the Company in writing of each such demand for payment. If, after examination, the Issuing Bank shall have determined that a demand for payment under such LC does not conform to the terms and conditions of such LC, then the Issuing Bank shall, as soon as reasonably practicable, give notice to the beneficiary, the Agent and the Company to the effect that negotiation was not in accordance with the terms and conditions of such LC, stating the reasons therefor and that the relevant document is being held at the disposal of such beneficiary or is being returned to such beneficiary, as the Issuing Bank may elect. The beneficiary may attempt to correct any such nonconforming demand for payment under such LC if, and to the extent that, such beneficiary is entitled (without regard to the provisions of this sentence) and able to do so. If the Issuing Bank determines that a demand for payment under such LC conforms to the terms and conditions of such LC, then the Issuing Bank shall make payment to the beneficiary in accordance with the terms of such LC. The Issuing Bank shall have the right to require the beneficiary to surrender such LC to the Issuing Bank on the stated expiration date of such LC. SECTION 2.9 Voluntary Termination or Reduction of Commitments. The Company may, upon not less than one Business Days' prior written notice to the Agent, terminate the Aggregate Commitment or permanently reduce the Aggregate Commitment by an aggregate minimum amount of $100,000; provided that no such reduction or termination shall be permitted if, after giving effect thereto and to any prepayments of the Loans made on the effective date thereof, the sum of (i) the then outstanding principal amount of the Loans, (ii) the Aggregate Stated Amount of all LCs issued and outstanding and (iii) the aggregate amount of all Reimbursement Obligations, would exceed the amount of the Aggregate Commitment then in effect. Any reduction of the Aggregate Commitment shall be applied to each Bank's Commitment in accordance with such Bank's Commitment Percentage. All commitment fees with respect to the portion of the Commitments that are being reduced that have accrued to, but not including, the effective date of any reduction or termination of Commitments, shall be paid on the effective date of such reduction or termination. SECTION 2.10 Optional Prepayments. Subject to Section 4.5, the Company may, at any time or from time to time, ratably prepay Loans in whole or in part in any amount; provided that the Company's written notice of such prepayment shall be delivered to the Agent in accordance with Section 10.2 prior to 11:00 a.m. (Chicago time) (i) two Business Days prior to the requested date of prepayment, in the case of Eurodollar Rate Loans; (ii) one Business Day prior to the requested date of prepayment, in the case of CD Rate Loans, and (iii) on the requested date of prepayment, in the case of Base Rate Loans. Such notice of prepayment shall specify the date of repayment, the aggregate amount of such prepayment, and whether such prepayment is of Base Rate Loans, CD Rate Loans or Eurodollar Rate Loans, or any combination thereof. Such notice shall not thereafter be revocable by the Company. The Agent will promptly notify each Bank of such notice and of such Bank's Commitment Percentage of such prepayment. If such notice is given by the Company, the Company shall make such prepayment and the payment amount specified in such notice shall be due and payable on the date specified therein, together with accrued interest to each such date on the amount prepaid and any amounts required pursuant to Section 4.5. SECTION 2.11 Mandatory Prepayment. On each Clean-up Date, the Company shall make a mandatory prepayment to the Agent for the benefit of the Banks of the outstanding principal amount of all Loans outstanding on such Clean-up Date together with accrued interest to such Clean-up Date on such Loans and any amounts required pursuant to Section 4.5. SECTION 2.12 Repayment. The Company shall repay to the Agent for the benefit of the Banks in full on the Termination Date the aggregate principal amount of the Loans outstanding on the Termination Date. SECTION 3 NOTES EVIDENCING THE LOANS SECTION 3.1 Notes. Each Bank's Loans shall be evidenced by a promissory note (herein, as the same may be amended, modified or supplemented from time to time, and together with any renewals thereof or exchanges or substitutions therefor, individually called a "Note" and collectively called the "Notes"), substantially in the form set forth in Exhibit A, with appropriate insertions, dated the Closing Date, payable to the order of such Bank in the principal amount equal to such Bank's Commitment or the aggregate principal amount of the Loans outstanding to such Bank, whichever is less. The date and amount of the Loans made by each Bank and of each repayment of principal thereon received by such Bank shall be recorded by such Bank in its records or, at its option, on the schedule attached to its Note. The aggregate unpaid principal amount so recorded shall be rebuttable presumptive evidence of the principal amount owing and unpaid on such Note to such Bank. The failure so to record any such amount or any error in so recording any such amount, however, shall not limit or otherwise affect the Company's obligations hereunder or under such Note to repay the principal amount of the Loans evidenced by such Note together with all interest accruing thereon. Each Note shall provide for the payment of interest as provided in Section 4. SECTION 4 INTEREST, FEES AND COSTS SECTION 4.1 Interest. (a) Subject to Section 4.1(c), each Loan shall bear interest on the outstanding principal amount thereof from the date when made until it becomes due at a rate per annum equal to the CD Rate, LIBOR or the Base Rate, as the case may be, plus the Applicable Margin. (b) Interest on each Loan shall be paid in arrears on each Interest Payment Date. Interest shall also be paid on the date of any prepayment of Loans pursuant to Section 2.10 for the portion of the Loans so prepaid and upon payment (including prepayment) in full thereof, including, without limitation, on each Clean-up Date pursuant to Section 2.11 and, during the existence of any Event of Default, interest shall be paid on demand. (c) If any amount of principal of or interest on any Loan, or any other amount payable hereunder or under any of the other Loan Documents is not paid in full when due (whether at stated maturity, by acceleration, demand or otherwise), the Company agrees to pay interest on such unpaid principal or other amount, from the date such amount becomes due until the date such amount is paid in full, payable on demand, at a fluctuating rate per annum equal to the Base Rate plus two percent (2.00%) per annum. SECTION 4.2 Fees. (a) Closing Fee. On the Closing Date the Company shall pay to the Agent for the account of each Bank a one-time closing fee equal to 0.30% of each Bank's Commitment. (b) Unused Commitment Fees. The Company shall pay to the Agent for the account of each Bank an unused commitment fee at the rate of 0.30% per annum on the daily average amount of the difference between such Bank's Commitment from time to time in effect minus the sum of (i) such Bank's Commitment Percentage of the aggregate principal amount of all Loans then outstanding and not repaid, (ii) such Bank's Commitment Percentage of the aggregate Stated Amount of all LCs issued and outstanding and (iii) such Bank's Commitment Percentage of the aggregate amount of all Reimbursement Obligations. The Agent shall provide the Company with an invoice for the amount of the unused commitment fee due to each Bank for each quarterly period ending on the last day of each March, June, September and December, commencing on December 31, 1993. Such unused commitment fee shall accrue from the Closing Date to the Termination Date and shall be due and payable quarterly in arrears no later than thirty (30) days after the Company receives the invoice referred to above, with the final payment to be made on the Termination Date; provided that, in connection with any reduction or termination of Commitments pursuant to Section 2.9, the accrued, unused commitment fee calculated for the period ending on such date shall also be paid on the date of such reduction or termination, with the next succeeding quarterly payment being calculated on the basis of the period from the reduction or termination date to such quarterly payment date. The unused commitment fees provided in this subsection shall accrue at all times after the Closing Date, including during any Clean-up Period. (c) Letter of Credit Fees. The Company shall pay to the Agent for the account of each Bank a letter of credit fee at the rate of 1.00% per annum of such Bank's Commitment Percentage of the aggregate Stated Amount of all LCs issued and outstanding. Such letter of credit fee shall accrue from the date of issuance of each LC to the date of termination of such LC as set forth in such LC and shall be due and payable quarterly in advance, with the first such payment due on the date of issuance of each such LC. (d) Letter of Credit Issuance Fees. The Company shall pay to the Agent for the account of the Issuing Bank a letter of credit issuance fee on the date of issuance of each LC at a rate to be determined according to the standard fee schedules of the Issuing Bank with respect to letters of credit. SECTION 4.3 Computation of Fees and Interest. (a) All computations of interest in respect of the Base Rate and all computations of letter of credit fees pursuant to Section 4.2(c) shall be made on the basis of a year of 365 or 366 days, as the case may be, and actual days elapsed. All other computations of fees and interest under this Agreement shall be made on the basis of a 360-day year and actual days elapsed. Interest and fees shall accrue during each period during which interest or such fees are computed from and including the first day thereof to but excluding the last day thereof. (b) The Agent will, with reasonable promptness, notify the Company and the Banks of each determination of a Eurodollar Rate or CD Rate; provided, however, that any failure to do so shall not relieve the Company of any liability hereunder or provide the basis for any claim against the Agent. Each determination of an interest rate by the Agent pursuant hereto shall be conclusive and binding on the Company and the Banks in the absence of manifest error. SECTION 4.4 Increased Costs; Capital Adequacy. (a) If (i) Regulation D of the Board of Governors of the Federal Reserve System, or (ii) after the date hereof, the adoption of any applicable law, rule or regulation, or any change therein, or any change in the interpretation or administration thereof by any governmental authority, central bank or comparable agency charged with the interpretation or administration thereof, or compliance by a Bank with any request or directive (whether or not having the force of law) of any such authority, central bank or comparable agency issued after the date hereof, (i) shall subject such Bank to any tax, duty or other charge with respect to any Eurodollar Rate Loan or CD Rate Loan made by such Bank, the Note issued to such Bank, such Bank's obligation to make or maintain any such Loan, any LC issued by the Issuing Bank or the Issuing Bank's obligation to make or maintain any such LC, or shall change the basis of taxation of payments to a Bank or the Issuing Bank, as the case may be, of the principal of or interest on any such Eurodollar Rate Loan or CD Rate Loan or such LC or any other amounts due under this Agreement in respect of any such Eurodollar Rate Loan or CD Rate Loan or such LC or such Bank's or the Issuing Bank's, as the case may be, obligation to make or maintain any such Eurodollar Rate Loan or CD Rate Loan or such LC (except for changes in the rate of tax on the overall net income of such Bank imposed by the jurisdiction in which such Bank's principal executive office is located); or (ii) shall impose, modify or deem applicable any reserve (including, without limitation, any reserve imposed by the Federal Reserve Board but excluding, in the case of Eurodollar Rate Loans, any reserve prescribed by the Federal Reserve Board included in the determination of LIBOR), special deposit or similar requirement against assets of, deposits with or for the account of, or credit extended by, such Bank; and the result of any of the foregoing is to increase the cost to such Bank of making or maintaining any Loan or to the Issuing Bank of issuing or maintaining any LC, or to reduce the amount of any sum received or receivable by such Bank or the Issuing Bank, as the case may be, under this Agreement or under its Note with respect thereto, then within 30 days after demand by such Bank, with a copy of such demand to the Agent (which demand shall be accompanied by a statement setting forth in reasonable detail the basis of such demand), the Company shall pay to the Agent for the account of such Bank such additional amount or amounts as will compensate such Bank for such increased costs or such reduction, provided, however, that any such amount or amounts payable by the Company shall not exceed the increased costs or amount of reduction of such Bank or the Issuing Bank, as the case may be, in direct proportion to any such Loan or any such LC. (b) If either (i) the introduction of or any change in or in the interpretation of any law or regulation or (ii) compliance by a Bank with any new guideline or request from any central bank or other governmental authority affects or would affect the amount of capital required or expected to be maintained by such Bank or any corporation controlling such Bank and the amount of such capital is increased by or based upon the existence of such Bank's commitment to make or maintain any Loan by such Bank hereunder or in the case of the Issuing Bank, its commitment to issue any LC hereunder, then, within 30 days after demand by such Bank, with a copy to the Agent (which demand shall set forth in reasonable detail the basis of such demand), the Company shall pay to the Agent for the account of such Bank, from time to time as reasonably specified by such Bank, additional amounts sufficient to compensate such Bank in the light of such circumstances, to the extent that such Bank reasonably determines such increase in capital to be allocable to the existence of such Bank's commitment to make or maintain any Loan hereunder or in the case of the Issuing Bank, its commitment to issue any LC hereunder, provided, however, that any such amount or amounts payable by the Company shall not exceed the increased amount of capital required to be maintained by such Bank and allocable to any such Loan or any such LC, as the case may be, in direct proportion to any such Loan or any such LC. SECTION 4.5 Funding Losses. The Company agrees to reimburse each Bank and to hold each Bank harmless from any loss or expense which such Bank may sustain or incur as a consequence of: (a) the failure of the Company to make when due any payment of principal of any Eurodollar Rate Loan or CD Rate Loan (including payments made after any acceleration thereof) not resulting from any Bank's failure to act; (b) the failure of the Company to borrow, continue or convert a Loan after the Company has given (or is deemed to have given) a Notice of Borrowing or a Notice of Conversion/ Continuation; (c) the failure of the Company to make any prepayment after the Company has given a notice in accordance with Section 2.10 or Section 2.11; (d) the prepayment of a Eurodollar Rate Loan or a CD Rate Loan on a day which is not the last day of the Interest Period with respect thereto; or (e) the conversion pursuant to Section 2.4 of any Eurodollar Rate Loan or CD Rate Loan to a Loan of another type on a day that is not the last day of the Interest Period with respect thereto; including, in each case, (i) any such loss or expense arising from the liquidation or reemployment of funds obtained by it to maintain its Eurodollar Rate Loans or CD Rate Loans hereunder or from fees payable to terminate the deposits from which such funds were obtained and (ii) with respect to any certificate of deposit purchased by the Company from each Bank in connection with a CD Rate Loan, any penalty assessed by such Bank for the early withdrawal of the funds deposited under any such certificate of deposit in accordance with such Bank's usual and customary practices. SECTION 5 MAKING OF PAYMENTS SECTION 5.1 Payments by the Company. (a) All payments (including prepayments) to be made by the Company on account of principal, interest, fees and other amounts required hereunder shall, except as otherwise expressly provided herein, be made to the Agent for the ratable account of the Banks at the Agent's Payment Office without condition or reservation of right in immediately available funds, no later than 12:00 noon (Chicago time) on the date specified herein. Any payment which is received by the Agent later than 12:00 noon (Chicago time) shall be deemed to have been received on the immediately succeeding Business Day and any applicable interest or fee shall continue to accrue. The Agent will promptly distribute to each Bank its Commitment Percentage of such principal, interest, fees or other amounts, in like funds as received, but in any event shall distribute such amounts no later than the close of business on the date received by the Agent if received by the Agent no later than 12:00 noon on such date. If the Agent shall fail to pay to any Bank the amount due such Bank pursuant to this Section when due, the Agent shall be obligated to pay to such Bank interest on the amount that should have been paid hereunder for each day from the date such amount shall have become due until the date such amount is paid, at the Federal Funds Rate as in effect for each such day. (b) Whenever any payment hereunder shall be stated to be due on a day other than a Business Day, such payment shall be made on the next succeeding Business Day, and such extension of time shall in such case be included in the computation of interest or fees, as the case may be; subject to the provisions set forth in the definition of "Interest Period" herein. (c) Unless the Agent shall have received written notice from the Company prior to the date on which any payment is due to the Banks hereunder that the Company will not make such payment in full as and when required hereunder, the Agent may assume that the Company has made such payment in full to the Agent on such date in immediately available funds and the Agent may (but shall not be so required), in reliance upon such assumption, cause to be distributed to each Bank on such due date an amount equal to the amount then due such Bank. If and to the extent the Company shall not have made such payment in full to the Agent, each Bank shall repay to the Agent on demand such amount distributed to such Bank, together with interest thereon for each day from the date such amount is distributed to such Bank until the date such Bank repays such amount to the Agent, at the Federal Funds Rate as in effect for each such day. SECTION 5.2 Payments by the Banks to the Agent. (a) Unless the Agent shall have received written notice from a Bank, with respect to each Borrowing (other than a Borrowing of Base Rate Loans), at least one Business Day prior to the date of any proposed Borrowing (or, in the case of a Borrowing of Base Rate Loans, on the applicable Borrowing date), that such Bank will not make available to the Agent as and when required hereunder for the account of the Company the amount of that Bank's Commitment Percentage of the Borrowing, the Agent may assume that each Bank has made such amount available to the Agent in immediately available funds on the Borrowing date and the Agent may (but shall not be so required), in reliance upon such assumption, make available to the Company on such date a corresponding amount. If and to the extent any Bank shall not have made its full amount available to the Agent in immediately available funds and the Agent in such circumstances has made available to the Company such amount, that Bank shall on the next Business Day following the date of such Borrowing make such amount available to the Agent, together with interest at the Federal Funds Rate for and determined as of each day during such period. A notice of the Agent submitted to any Bank with respect to amounts owing under this Section 5.2(a) shall be conclusive, absent manifest error. If such amount is so made available, such payment to the Agent shall constitute such Bank's Loan on the date of Borrowing for all purposes of this Agreement. If such amount is not made available to the Agent on the next Business Day following the date of such Borrowing, the Agent shall notify the Company of such failure to fund and, upon demand by the Agent, the Company shall pay such amount to the Agent for the Agent's account, together with interest thereon for each day elapsed since the date of such Borrowing, at a rate per annum equal to the interest rate applicable at the time to the Loans comprising such Borrowing. (b) The failure of any Bank to make any Loan on any date of Borrowing shall not relieve any other Bank of any obligation hereunder to make a Loan on the date of such Borrowing, but no Bank shall be responsible for the failure of any other Bank to make the Loan to be made by such other Bank on the date of any Borrowing. SECTION 5.3 Setoff. (a) The Company agrees that, if at any time (i) any amount owing by it under this Agreement or any Related Document is then due and payable to a Bank or (ii) any Event of Default shall have occurred and be continuing, then such Bank, in its sole discretion, may apply to the payment of the Liabilities any and all balances, credits, deposits, accounts or moneys of the Company then or thereafter with such Bank. (b) Without limitation of Section 5.3(a), the Company agrees that, upon and during the continuance of any Event of Default, such Bank is hereby authorized, at any time and from time to time, without notice to the Company, (i) to set off against and to appropriate and apply to the payment of the Liabilities (whether matured or unmatured) any and all amounts which such Bank is obligated to pay over to the Company (whether matured or unmatured, and, in the case of deposits, whether general or special, time or demand and however evidenced) and (ii) pending any such action, to the extent necessary, to hold such amounts as collateral to secure such Liabilities. (c) Notwithstanding any other provision of this Agreement, the Notes or any other Related Document, the Banks shall not set off against, or appropriate or apply to the payment of any Liabilities, any of the deposits, accounts or other assets of any Insurance Subsidiary. SECTION 5.4 Sharing of Payments. If, other than as expressly provided elsewhere herein, any Bank shall obtain on account of the Liabilities held by such Bank any payment (whether voluntary, involuntary, through the exercise of any right of set-off, or otherwise) in excess of its Commitment Percentage of payments on account of the Liabilities obtained by all the Banks, such Bank shall promptly (a) notify the Agent of such fact and (b) upon demand purchase from the other Banks a portion of the Liabilities held by such other Banks as shall be necessary to cause such purchasing Bank to share the excess payment ratably with each of them based upon each Bank's Commitment Percentage; provided, however, that if all or any portion of such excess payment is thereafter recovered from the purchasing Bank, such purchase shall to that extent be rescinded and each other Bank shall repay to the purchasing Bank the purchase price paid therefor, together with an amount equal to such paying Bank's Commitment Percentage of any interest or other amount paid or payable by the purchasing Bank in respect of the total amount so recovered. The Company agrees that any Bank so purchasing a portion of another Bank's Liabilities pursuant to this Section 5.4 may, to the fullest extent permitted by law, exercise all of its rights of payment (including the right of setoff) with respect to such purchased Liabilities as fully as if such Bank were the direct creditor of the Company in the amount of such purchased Liabilities. The Agent will keep records (which shall be conclusive and binding in the absence of manifest error) of amounts purchased pursuant to this Section 5.4 and will in each case notify the Banks following any purchases or repayments. SECTION 6 REPRESENTATIONS AND WARRANTIES To induce each Bank to enter into this Agreement and to make Loans and to induce the Issuing Bank to enter into this Agreement and issue LCs hereunder, the Company represents and warrants to each Bank, the Issuing Bank and the Agent that: SECTION 6.1 Corporate Organization. The Company is a corporation duly existing and in good standing under the laws of the State of Delaware and is duly qualified and in good standing as a foreign corporation authorized to do business in Illinois, which is the only other jurisdiction in which the Company is required to be duly qualified and in good standing as a foreign corporation. The Company's failure to be so qualified in any other jurisdiction does not materially and adversely affect the Company's business, operations or financial condition or its ability to perform its obligations hereunder and under the Related Documents to which it is a party. SECTION 6.2 Authorization; No Conflict. The Company's execution, delivery and performance of this Agreement and each of the Related Documents to which it is a party and the consummation of the transactions contemplated by this Agreement and each of the Related Documents are within the Company's corporate powers, have been duly authorized by all necessary corporate action, require no governmental, regulatory or other approval, and (a) do not and will not contravene or conflict with any provision of (i) any law the failure of the Company to comply with in the Company's determination materially and adversely affects the Company's business, operations or financial condition or its ability to perform its obligations hereunder and under the Related Documents to which it is a party, (ii) any judgment, decree or order applicable to the Company, or (iii) the Company's articles of incorporation or by-laws, and (b) do not and will not contravene or conflict with any provision of any agreement or instrument binding upon the Company or upon any property of the Company that in the Company's determination materially and adversely affects the Company's business, operations or financial condition or its ability to perform its obligations hereunder or under the Related Documents to which it is a party. SECTION 6.3 Validity and Binding Nature. This Agreement and the Related Documents to which the Company is a party are (or, when duly executed and delivered, will be) the legal, valid and binding obligations of the Company enforceable against the Company in accordance with their respective terms. SECTION 6.4 Financial Statements. The annual and quarterly historical balance sheets and statements of operations that have been or shall hereafter be furnished to the Agent, the Issuing Bank or any Bank by or at the direction of the Company for the purposes of or in connection with this Agreement do and will present fairly the financial condition of the Persons involved as of the dates thereof and the results of their operations for the period(s) covered thereby, all in accordance with GAAP, consistently applied, unless otherwise noted therein. SECTION 6.5 Litigation and Contingent Liabilities. (a) No litigation (including, without limitation, derivative actions), arbitration proceedings, governmental proceedings or investigations or regulatory proceedings are pending or, to the best of its knowledge, threatened against the Company or any Material Subsidiary which in the Company's determination materially and adversely affects the Company's or such Material Subsidiary's business, operations or financial condition or the Company's ability to perform its obligations hereunder and under the Related Documents to which it is a party. In addition, to the best of the Company's knowledge, there are no inquiries, formal or informal, which give rise to such actions, proceedings or investigations. (b) The Company and, to the best of the Company's knowledge, each Material Subsidiary has obtained all licenses, permits, franchises and other governmental authorizations necessary to the ownership of its properties or to the conduct of its businesses, including without limitation all licenses, permits, franchises and other governmental authorizations required under all applicable Environmental Laws, a failure to obtain or violation of which in the Company's determination materially and adversely affects the Company's or such Material Subsidiary's business, operations or financial condition or the Company's ability to perform its obligations hereunder and under the Related Documents to which it is a party. (c) The Company does not have any material contingent liabilities required to be disclosed pursuant to GAAP that are not provided for or disclosed in the financial statements referred to in Section 6.4 hereof. SECTION 6.6 Employee Benefit Plans. To the best of the Company's knowledge, each Plan complies in all material respects with all applicable statutes and governmental rules and regulations (including, without limitation, the requirements of Section 401(a) of the Internal Revenue Code of 1986, as amended, to the extent that such Plan is intended to conform to that section) and during the 12-consecutive-month period prior to the Closing Date, (i) no Reportable Event has occurred and is continuing with respect to any Plan subject to Title IV of ERISA, (ii) neither the Company nor any ERISA Affiliate has withdrawn from any Plan subject to Title IV of ERISA or instituted steps to do so, (iii) no steps have been instituted to terminate any Plan subject to Title IV of ERISA, (iv) no contribution failure has occurred with respect to any Plan sufficient to give rise to a lien under Section 302(f) of ERISA, or (v) each Plan which is intended to be qualified pursuant to Section 401(a) of the Internal Revenue Code of 1986, as amended, has received a favorable determination letter. To the best of the Company's knowledge, no condition exists or event or transaction has occurred in connection with any Plan which would result in the incurrence by the Company or any ERISA Affiliate of any liability, fine or penalty, which in the Company's determination materially and adversely affects the Company's business, operations or financial condition, or the ability of the Company to perform its obligations hereunder and under the Related Documents to which it is a party. Neither the Company nor any ERISA Affiliate presently maintains, contributes to or, to the best of the Company's knowledge, has any liability (including current or potential withdrawal liability) with respect to any Multiemployer Plan. To the best of the Company's knowledge, neither the Company nor any ERISA Affiliate has any liability with respect to any funded or unfunded postretirement benefit for employees or former employees (including medical, health or life insurance) other than liability for continuation coverage described in Part 6 of Title I of ERISA. SECTION 6.7 Investment Company Act. The Company is not an "investment company" or a company "controlled" by an "investment company", within the meaning of the Investment Company Act of 1940, as amended. SECTION 6.8 Regulation U. The Company is not engaged principally, or as one of its important activities, in the business of extending credit for the purpose of purchasing or carrying Margin Stock. SECTION 6.9 Accuracy of Information. To the best of the Company's knowledge, all factual information heretofore or contemporaneously furnished by the Company to the Agent, the Issuing Bank or any Bank for purposes of or in connection with this Agreement or any transaction contemplated hereby is, and all other factual information hereafter furnished by the Company to the Agent, the Issuing Bank or any Bank will be, true and accurate in every material respect on the date as of which such information is dated or certified, and the Company has not knowingly omitted and will not knowingly omit any material fact it deems necessary to prevent such information from being false or misleading. SECTION 6.10 Labor Controversies. There are no labor controversies pending or threatened against the Company or any Material Subsidiary which in the Company's determination materially and adversely affect the Company's or such Material Subsidiary's business, operations or financial condition or the Company's ability to perform its obligations hereunder and under the Related Documents to which it is a party. SECTION 6.11 Tax Status. Except as set forth in Schedule 6.11 hereto, the Company and, to the best of the Company's knowledge, each Material Subsidiary, have made or filed all income and other tax returns, reports and declarations required by any jurisdiction to which it is subject, have paid all taxes, assessments and other charges shown or determined to be due on such returns, reports and declarations (other than those being diligently contested in good faith by appropriate proceedings), and have set aside adequate reserves against liability for taxes, assessments and charges applicable to periods subsequent to those covered by such returns, reports and declarations, a failure of which to file, to pay or to set aside in the Company's determination materially and adversely affects the Company's or such Material Subsidiary's business, operations or financial condition or the Company's ability to perform its obligations hereunder and under the Related Documents to which it is a party. SECTION 6.12 No Default. No event has occurred and no condition exists which, upon the execution and delivery of, or consummation of any transaction contemplated by, this Agreement or any Related Document, or upon the funding of any Loan or the issuance of any LC, will constitute an Event of Default. The Company and each Material Subsidiary have not received notice of default with respect to any other material agreement, security or contract, except those for which a default exists that is not capable of being cured with the payment of money or as to which a good faith dispute exists. SECTION 6.13 Compliance with Applicable Laws. The Company and, to the best of the Company's knowledge, each Material Subsidiary are in compliance with the requirements of all applicable laws, rules, regulations, and orders of all governmental authorities (Federal, state, local or foreign, and including, without limitation, Environmental Laws and Insurance Laws), a breach of which would in the Company's determination materially and adversely affect the Company's or such Material Subsidiary's business, operations or financial condition, or the ability of the Company to perform its obligations hereunder and under the Related Documents to which it is a party. SECTION 6.14 Insurance. The Company is in its sole determination, maintains adequate general liability, property and casualty insurance for its benefit under policies issued by insurers of recognized responsibility. SECTION 6.15 Solvency. After giving effect to the transactions contemplated hereby and by the Related Documents, the Company is not "insolvent", nor will the Company's incurrence of obligations to repay any Loan or to reimburse the Issuing Bank with respect to the Issuing Bank's honoring a draw under an LC render the Company "insolvent." For the purposes of this Section 6.15, a corporation is "insolvent" if (i) the "present fair salable value" (as defined below) of its assets is less than the amount that will be required to pay its probable liability on its existing debts and other liabilities (including contingent liabilities) as they become absolute and matured; (ii) the property of the Company constitutes unreasonably small capital for the Company to carry out its business as now conducted and as proposed to be conducted including the capital needs of the Company; (iii) the Company intends to, or believes that it will, incur debts beyond its ability to pay such debts as they mature (taking into account the timing and amounts of cash to be received by the Company and amounts to be payable on or in respect of debt of the Company), or the cash available to the Company after taking into account all other anticipated uses of the cash of the Company is anticipated to be insufficient to pay all such amounts on or in respect of debt of the Company when such amounts are required to be paid; or (iv) the Company believes that final judgments against the Company in actions for money damages will be rendered at a time when, or in an amount such that, the Company will be unable to satisfy any such judgments promptly in accordance with their terms (taking into account the maximum reasonable amount of such judgments in any such actions and the earliest reasonable time (as determined in the Company's best judgment) at which such judgments might be rendered), or the cash available to the Company after taking into account all other anticipated uses of the cash of the Company (including the payments on or in respect of debt referred to in clause (iii) of this Section 6.15), is anticipated to be insufficient to pay all such judgments promptly in accordance with their terms. For purposes of this Section 6.15, the following terms have the following meanings: (x) the term "debts" includes any legal liability, whether matured or unmatured, liquidated, absolute, fixed or contingent, (y) the term "present fair salable value" of the Company's assets means the amount which may be realized, within a reasonable time (as determined in the Company's best judgment), either through collection or sale of such assets at their regular market value and (z) the term "regular market value" means the amount which a capable and diligent businessman (as determined in the Company's best judgment) could obtain for the property in question within a reasonable time (as determined in the Company's best judgment) from an interested buyer who is willing to purchase under ordinary selling conditions (as determined in the Company's best judgment). SECTION 6.16 Use of Proceeds. The Company will use the proceeds of any Loans for general corporate purposes, including but not limited to financing future acquisitions and future working capital needs, including transactions with Affiliates. SECTION 6.17 Subsidiaries. The Company has no Subsidiaries except as listed on Schedule 6.17 hereto. SECTION 7 COVENANTS Until the expiration or termination of each Bank's Commitment and thereafter until all Liabilities of the Company are paid in full and all LCs have expired or been terminated, the Company agrees that, unless at any time the Majority Banks (except with respect to such sections that expressly require the written consent of all of the Banks) shall otherwise expressly consent in writing, it will: SECTION 7.1 Reports, Certificates and Other Information. Furnish to the Agent, the Issuing Bank and each of the Banks: (a) Annual Report. On or before the ninetieth (90th) day after each of the Company's fiscal years, a copy of an unqualified annual consolidated audit report of the Company and its Subsidiaries, prepared in conformity with GAAP, duly certified by independent certified public accountants of recognized standing selected by the Company. (b) Interim Reports. On or before the forty-fifth (45th) day after the end of each of the first three quarters of each fiscal year of the Company, a copy of the unaudited financial statements of the Company prepared in a manner consistent with the financial statements referred to in Section 7.1(a) hereof, signed by an Authorized Officer and consisting of, at least, balance sheets as at the close of such quarter and statements of earnings for such quarter and for the period from the beginning of such fiscal year to the close of such quarter. (c) Statutory Statements. Promptly upon the filing thereof, copies of all Statutory Statements required to be filed by the Company and each Principal Insurance Subsidiary with or to the insurance commission or department of such Person's respective state of domicile. (d) Reports to SEC. Promptly upon the filing or making thereof, copies of each Form 10-K and Form 10-Q made by the Company with or to the Securities and Exchange Commission. (e) Certificates. Simultaneously with the furnishing of each annual statement and each quarterly statement provided for in this Section 7.1, a certificate of an Authorized Officer stating that (i) no Event of Default has occurred and is continuing, or, if there is any such event, setting forth the details thereof and the action that the Company is taking or proposes to take with respect thereto and (ii) that the Company either has funds or investments or has the ability to promptly obtain funds from its Subsidiaries, including, without limitation, by means of inter-corporate loans or advances from such Subsidiaries, dividends or other distributions from such Subsidiaries or purchases by such Subsidiaries of stock, other securities or assets of, or fees for services that are due and payable from, other Subsidiaries of the Company, in an amount not less than the sum of (A) the amount of all principal of and interest on all Loans outstanding, (B) the Aggregate Stated Amount of all LCs issued and outstanding and (C) the aggregate amount of all Reimbursement Obligations, and that the ability of the Company to promptly obtain such funds will not violate or result in the breach of any law, rule, regulation or order of any governmental authority (federal, state, local or foreign and including, without limitation, Insurance Laws). (f) Notice of Default, Litigation and ERISA Matters. Promptly upon learning of the occurrence of any of the following, written notice thereof which describes the same and the steps being taken by the Company with respect thereto: (i) the occurrence of an Event of Default, (ii) the institution of, or any adverse determination in, any litigation, arbitration proceeding or governmental proceeding in which any injunctive relief is sought or in which money damages in excess of $5,000,000 are sought, (iii) the occurrence of a material Reportable Event with respect to any Plan subject to Title IV of ERISA, (iv) the institution of any material steps by the Company, the PBGC or any other Person to terminate any Plan subject to Title IV of ERISA, (v) the institution of any material steps by the Company or any ERISA Affiliate to withdraw from any Plan subject to Title IV of ERISA which would result in material liability to the Company, (vi) the failure to make a material required contribution to any Plan if such failure is sufficient to give rise to a lien under Section 302(f) of ERISA, (vii) the taking of any material action with respect to a Plan which could result in the requirement that the Company furnish a bond or other security to the PBGC or such Plan, (viii) the occurrence of any event with respect to any Plan which could result in the incurrence by the Company of any liability, fine or penalty, which would in the Company's determination materially and adversely affect the Company's business, operations or financial condition or the ability of the Company to perform its obligations hereunder and under the Related Documents to which it is a party, or (ix) promptly after the incurrence thereof, notice of any material increase in the contingent liability of the Company with respect to any postretirement Plan benefits. (g) Other Information. Such other material information concerning the Company as the Agent, the Issuing Bank or any Bank may reasonably request from time to time. SECTION 7.2 Corporate Existence and Franchises. Except as otherwise expressly permitted in this Agreement, maintain and cause each Material Subsidiary to maintain in full force and effect its separate existence and all rights, licenses, leases and franchises reasonably necessary in the Company's sole discretion to the conduct of its and each Material Subsidiary's business. SECTION 7.3 Books, Records and Inspections. Maintain, and cause each Material Subsidiary to maintain, books and records in accordance with GAAP in all material respects, the Agent on behalf of the Banks to have access to the Company's books and records, and permit the Agent on behalf of the Banks, upon seven (7) days notice to the Company, to inspect the Company's properties and operations during normal business hours and at reasonable intervals, but no more frequently than semi-annually if no Event of Default has occurred. SECTION 7.4 Insurance. Maintain, and cause each Material Subsidiary to maintain, such insurance as may be required by law. SECTION 7.5 Taxes and Liabilities. Promptly pay, and cause each Material Subsidiary to pay, when due all taxes, duties, assessments and other liabilities (except such taxes, duties, assessments and other liabilities as the Company or such Material Subsidiary is diligently contesting in good faith and by appropriate proceedings; provided that the Company or such Material Subsidiary has provided for and is maintaining adequate reserves with respect thereto in accordance with GAAP), a failure of which to pay in the Company's determination materially and adversely affects the Company's or such Material Subsidiary's business, operations or financial condition or the Company's ability to perform its obligations hereunder and under the Related Documents to which it is a party. SECTION 7.6 Cash Flow Coverage. Maintain a ratio of (x) Available Cash Flow to (y) Debt Service Requirements equal to or greater than 1.10 to 1 at the end of each fiscal quarter of the Company and its Subsidiaries on a consolidated basis, such ratio to be calculated for the period of the four fiscal quarters ending on the most recent fiscal quarter end prior to the date of computation. SECTION 7.7 Net Worth. Nor permit the Net Worth of the Company to be less than $60,000,000 at any time. SECTION 7.8 Funds for Refinancing. Shall, at all times, either have funds or investments or have the ability to promptly obtain funds from its Subsidiaries, including, without limitation, by means of inter- corporate loans or advances from such Subsidiaries, dividends or other distributions from such Subsidiaries or purchases by such Subsidiaries of stock, other securities or assets of, or fees for services that are due and payable from, other Subsidiaries of the Company, in an amount at all times not less than the sum of (a) the amount of all principal of and interest on all Loans outstanding, (b) the Aggregate Stated Amount of all LCs issued and outstanding and (c) the aggregate amount of all Reimbursement Obligations, and the ability of the Company to promptly obtain such funds shall not violate or result in the breach of any law, rule, regulation or order of any governmental authority (federal, state, local or foreign and including, without limitation, Insurance Laws). SECTION 7.9 Indebtedness. Not incur or permit to exist any Indebtedness that by its terms or otherwise is senior in right of payment to the Liabilities, except (i) Indebtedness hereinafter incurred in connection with the acquisition of assets or property, which Indebtedness is secured by the assets or property so acquired, (ii) Indebtedness originally incurred under this Agreement and converted into term loan Indebtedness pursuant to such terms and subject to such documentation as is satisfactory to the Agent and the Majority Banks in such Majority Banks' reasonable discretion (provided, however, that no Bank shall, without its consent, be compelled to convert any Indebtedness owed to it and originally incurred under this Agreement into term loan Indebtedness) and (iii) Indebtedness in connection with Permitted Liens pursuant to Section 7.16. SECTION 7.10 Risk-Based Capital. Shall cause each Principal Insurance Subsidiary on an individual basis to maintain at all times Total Adjusted Capital equal to or greater than 260% of Authorized Control Level RBC. SECTION 7.11 Real Estate Concentration. Shall cause each Principal Insurance Subsidiary on an individual basis to maintain at all times a Real Estate Concentration Ratio of less than 50%. SECTION 7.12 Investment Quality. Shall cause each Principal Insurance Subsidiary on an individual basis to maintain at all times a ratio of (x) Non-Investment Grade Obligations to (y) Total Invested Assets to be less that 15%. SECTION 7.13 Intentionally Omitted. SECTION 7.14 Insurance Company Leverage Ratio. Shall cause (a) all Principal Insurance Subsidiaries on a combined basis to maintain at all times an aggregate Insurance Company Leverage Ratio of greater than 8.33%, and (b) each Principal Insurance Subsidiary on an individual basis to maintain at all times an Insurance Coverage Leverage Ratio of greater than 7.50%. SECTION 7.15 Intentionally Omitted. SECTION 7.16 Negative Pledge. Shall not permit any Principal Insurance Subsidiary to (a) create or permit to exist any Lien with respect to any assets or properties now owned or hereafter acquired by such Principal Insurance Subsidiary or (b) enter into or consent to any oral or written agreement or arrangement that prohibits or in any manner restricts any such Principal Insurance Subsidiary from creating, incurring, assuming or suffering to exist any Lien upon or with respect to any of such Principal Insurance Subsidiary's assets or properties or to assign or otherwise convey any right to receive income, except the following Liens ("Permitted Liens"): (i) purchase money security interests hereinafter incurred in connection with the acquisition of assets or property; (ii) Liens incurred in connection with the conversion of Indebtedness originally incurred under this Agreement into term loan Indebtedness pursuant to such terms and subject to such documentation as is satisfactory to the Agent and the Majority Banks in such Majority Banks' reasonable discretion (provided, however, that no Bank shall, without its consent, be compelled to convert any Indebtedness owed to it and originally incurred under this Agreement into term loan Indebtedness); (iii) Liens for taxes, assessments or governmental charges or levies on property of the Company if the same shall not at the time be delinquent or thereafter can be paid without penalty, or are being contested in good faith and by appropriate proceedings and as to which the Company shall have set aside on its books such reserves as are required by GAAP with respect to any such taxes, assessments or other governmental charges; (iv) Liens imposed by law, such as carriers', warehousemen's and mechanics' liens and other similar liens, which arise in the ordinary course of business with respect to obligations not yet due or being contested in good faith by appropriate proceedings and as to which the Company shall have set aside on its books such reserves as are required by GAAP with respect to any such Liens; (v) Liens arising out of pledges or deposits under insurance laws, worker's compensation laws, unemployment insurance, old age pensions, or other Social Security or retirement benefits, or similar legislation; (vi) Liens consisting of mortgages, deeds of trust, liens or security interests on any interest of the Company as sublessor under any sublease of property which solely secure obligations of the Company as the lessee of such property and extensions or renewals thereof; and (vii) Liens consisting of mortgages, deeds of trust or similar encumbrances that may be incurred by the Company or an Insurance Subsidiary of the Company in connection with the Company's or such Insurance Subsidiary's purchase or refinancing of the building and property located at 1750 Golf Road, Schaumburg, Illinois; provided, however, that promptly after the creation of any Lien of the type referred to in this subsection (vii), the Company shall provide to the Agent written notice of the creation of such Lien, describing the amount of the obligation secured thereby and the properties and assets subject to such Lien. SECTION 7.17 Change in Nature of Business. Not, and not permit the Company and its Material Subsidiaries as a whole to, make any material change in the nature of its business carried on as of the date first stated above, provided, however, the Company or any Material Subsidiary may make changes in the nature of its business provided that any such change made is related in any way to the medical or insurance businesses. SECTION 7.18 Depository Relationship. The Company shall maintain its primary depository and remittance relationship with the Banks. Pursuant to such primary depository and remittance relationship, the Company shall maintain with each Bank average available demand deposits equal to the amount needed to cover non-credit services provided by such Bank to the Company and its Subsidiaries, such amount to be determined according to the published fee schedules of such Bank. The Company agrees that if the amount of available demand deposits maintained by the Company with such Bank are insufficient to equal the amount needed to cover non- credit services provided by such Bank, then such Bank may charge the Company a deficiency fee sufficient to cover such non-credit services, such deficiency fee to be determined according to the published fee schedules of such Bank or the fees being charged to the Company at that time, whichever are less. SECTION 7.19 Employee Benefit Plans. Not permit, and not permit any ERISA Affiliate to permit, any condition to exist in connection with any Plan which might constitute grounds for the PBGC to institute proceedings to have such Plan terminated or a trustee appointed to administer such Plan; and not engage in, or permit to exist or occur, or permit any ERISA Affiliate to engage in, or permit to exist or occur, any other condition, event or transaction with respect to any Plan which would result in the incurrence by the Company or any ERISA Affiliate of any liability, fine or penalty, which in either case would in the Company's determination materially and adversely affect the Company's business, operations or financial condition, or the ability of the Company to perform its obligations hereunder and under the Related Documents to which it is a party. SECTION 7.20 Use of Proceeds. Not, and not permit any Subsidiary to, use or permit the direct or indirect use of any proceeds of or with respect to any Loan for the purpose, whether immediate, incidental or ultimate, of "purchasing or carrying" (within the meaning of Regulation U) Margin Stock. SECTION 7.21 Other Agreements. Not, and not permit any Material Subsidiary to, enter into any agreement containing any provision which would be violated or breached by the performance of the Company's obligations hereunder, under any Related Document or under any instrument or document delivered or to be delivered by the Company hereunder or thereunder or in connection herewith or therewith or which would violate or breach any provision hereof or thereof or of any such instrument or document. SECTION 7.22 Compliance with Applicable Laws. Comply, and cause each Material Subsidiary to comply, with the requirements of all applicable laws, rules, regulations, and orders of all governmental authorities (Federal, state, local or foreign, and including, without limitation, Environmental Laws and Insurance Laws), a breach of which would in the Company's determination materially and adversely affect the Company's or such Material Subsidiary's business, operations or financial condition, or which would impair the Company's ability to perform its obligations hereunder and under the Related Documents to which it is a party. SECTION 7A UNRESTRICTED SUBSIDIARIES SECTION 7A.1 Unrestricted Subsidiaries. The Company may, from time to time, by written notice to the Agent, a copy of which the Agent shall promptly deliver to each Bank, designate a Subsidiary as an Unrestricted Subsidiary (referred to herein as an "Unrestricted Subsidiary") provided that each of the following conditions is satisfied: (a) the proposed Unrestricted Subsidiary shall not be a Material Subsidiary existing on the Closing Date; (b) the aggregate Indebtedness of all Unrestricted Subsidiaries, including the Indebtedness of the proposed Unrestricted Subsidiary, shall not exceed $40,000,000; (c) If Loans made to the Company under this Agreement were used by the Company directly or indirectly to acquire the proposed Unrestricted Subsidiary, such Loans shall have been repaid by the Company pursuant to the terms hereof; (d) the proposed Unrestricted Subsidiary shall have no financial obligations, liabilities or dealings of any kind with the Company or any Material Subsidiary of the Company, except for (i) ordinary overhead allocations, (ii) marketing agreements, administration agreements and other agreements which the Company customarily enters into with its Subsidiaries so long as the terms of such agreements are no more favorable to the Company than the terms of agreements the Company enters into with its other Subsidiaries, and (iii) other customary inter-corporate dealings so long as the terms of such dealings are no more favorable to the Company than the terms of dealings the Company enters into with its other Subsidiaries; and (e) the proposed Unrestricted Subsidiary shall not have, permit to exist or incur any undertaking, indebtedness, obligation or other liability pursuant to which recourse may be made to the Company or any Material Subsidiary of the Company, and neither the Company nor any Material Subsidiary of the Company shall be or become a guarantor or surety of, or otherwise be or become responsible in any manner (whether by support agreement or agreement to purchase any obligations, stock, assets, goods or services, or to supply or advance any funds, assets, goods or services, or otherwise) with respect to any undertaking, indebtedness, obligation or other liability of such proposed Unrestricted Subsidiary; provided, however, that the proposed Unrestricted Subsidiary shall be permitted to engage in the types of transactions prohibited by this Section 7A.1(e), and the Company shall be permitted to provide guarantees and sureties, if the Company's obligations under such transactions, guaranties and sureties (i) are expressly subordinated to the Company's obligations under this Agreement and (ii) shall not exceed $2,000,000 in the aggregate for any one Unrestricted Subsidiary. SECTION 7A.2 Additional Unrestricted Subsidiaries. In addition to the Unrestricted Subsidiaries designated pursuant to Section 7A.1 above, the Company and the Majority Banks can agree to designate any Subsidiary as an Unrestricted Subsidiary. Any Indebtedness of an Unrestricted Subsidiary designated as such pursuant to this Section 7A.2 shall be excluded from the calculation of the aggregate Indebtedness permitted pursuant to Section 7A.1. SECTION 7A.3 Effectiveness of Designation. The designation by the Company of a Subsidiary as an Unrestricted Subsidiary shall become effective five (5) Business Days after the Company delivers a written notice of such designation to the Agent, which notice shall certify that all of the conditions set forth in Section 7A.1 have been satisfied with respect to such Unrestricted Subsidiary. The Agent shall promptly deliver to each Bank a copy of such notice. SECTION 7A.4 Effect of Designation. Other than for purposes of the financial statements referenced in Section 7.1 hereof, the assets, liabilities, Indebtedness, income, losses, cash flow, net worth, liens and other relevant amounts and factors concerning any Unrestricted Subsidiary shall be excluded from the computations referenced in Sections 7.6 and 7.9 of this Agreement and, to the extent applicable, the computations referenced in Sections 7.10 through 7.16, inclusive, of this Agreement, and the Unrestricted Subsidiaries shall not be subject to any of the other limitations or restrictions contained herein. SECTION 8 CONDITIONS TO MAKING LOANS AND ISSUING LCS Each Bank's obligation to make any Loan and the Issuing Bank's obligation to issue any LC is subject to the satisfaction of each of the following conditions precedent: SECTION 8.1 Initial Loans. Each Bank's obligation to make its initial Loan and the Issuing Bank's obligation to issue its initial LC is, in addition to the conditions precedent specified in Section 8.2, subject to the satisfaction of each of the following conditions precedent: (a) Fees and Expenses. The Company shall have paid all fees owed to the Agent, the Issuing Bank and each of the Banks and reimbursed the Agent, the Issuing Bank and each of the Banks for all expenses due and payable hereunder on or before the Closing Date including, but not limited to, ANB's counsel fees provided for in Section 10.4 to the extent such counsel shall have requested payment of such fees. (b) Documents. The Agent shall have received in sufficient copies for the Issuing Bank and each of the Banks all of the following, each duly executed and delivered and dated the Closing Date, in form and substance satisfactory to the Agent, the Issuing Bank and each Bank: (i) Agreement. This Agreement, executed by the Company, the Agent and each Bank. (ii) Note. Promissory Notes, substantially in the form of Exhibit A hereto, with appropriate insertions, issued to each Bank and executed by the Company. (iii) Resolutions. Certified copies of resolutions of the Company's Board of Directors authorizing the execution, delivery and performance of this Agreement and the Related Documents to which the Company is a party and any other documents provided for herein or therein to be executed by the Company. (iv) Consents. Certified copies of all documents evidencing any necessary corporate action, consents and governmental approvals, if any, with respect to this Agreement, the Related Documents, and any other documents provided for herein or therein to be executed by the Company. (v) Incumbency and Signatures. A certificate of the Secretary or an Assistant Secretary of the Company certifying the names of the officer or officers of the Company authorized to sign this Agreement and the Related Documents to which the Company is a party and any other documents provided for herein or therein to be executed by the Company, together with a sample of the true signature of each such officer. Each Bank may conclusively rely on each such certificate until formally advised by a like certificate of any changes therein. (vi) Opinion of Counsel. Opinion of counsel to the Company in form and substance reasonably satisfactory to the Agent. (vii) Constitutive Documents. Certified copies of the Company's articles of incorporation and by-laws. (viii) Good Standing Certificates. Certificates of good standing for the Company in Delaware and Illinois and a certificate of the insurance commissioner or similar official of the jurisdiction of incorporation of each Principal Insurance Subsidiary as to the good standing of such Principal Insurance Subsidiary. (ix) Other. Such other documents as the Agent, the Issuing Bank or any Bank may reasonably request. SECTION 8.2 All Loans and LCs. Each Bank's obligation to make its initial Loan and each subsequent Loan, including the obligation of such Bank to convert or continue any Loan pursuant to Section 2.4 hereof, and the Issuing Bank's obligation to issue the initial LC and each subsequent LC, or any extension or amendment thereof, is subject to the following conditions precedent that: (a) No Default, etc. (i) No Event of Default shall have occurred and be continuing or will result from the making of such Loan or the issuance of such LC, and (ii) the Company's representations and warranties contained in Section 6 shall be true and correct as of the date of such requested Loan or LC with the same effect as though made on the date thereof (except to the extent such representations and warranties expressly refer to an earlier date, in which case they shall be true and correct as of such earlier date). (b) Notice. The Agent shall have received a Notice of Borrowing pursuant to and in accordance with the provisions of Section 2.3 hereof or a Notice of Conversion/Continuation pursuant to and in accordance with the provisions of Section 2.4 hereof, as the case may be. SECTION 9 EVENTS OF DEFAULT AND THEIR EFFECT SECTION 9.1 Events of Default. Each of the following shall constitute an Event of Default under this Agreement following the expiration of any applicable notice or cure period: (a) Nonpayment of the Loan. Default in the payment when due of the principal of or interest on any Loan, or the payment when due of any fees or any other amounts payable by the Company hereunder and continuance of such default for five (5) Business Days after the applicable due date. (b) Nonpayment of Other Indebtedness. Default in the payment when due (subject to any applicable grace period), whether by acceleration or otherwise, of any other Indebtedness of, or guaranteed by, the Company or any Material Subsidiary if the aggregate amount of any such other Indebtedness that is accelerated or due and payable, or that may be accelerated or otherwise become due and payable, by reason of such default is $5,000,000 or more, or default in the performance or observance of any obligation or condition with respect to any such other Indebtedness if the effect of such default is to accelerate the maturity of any such Indebtedness or cause any of such Indebtedness of $5,000,000 or more to be prepaid, purchased or redeemed or to permit the holder or holders thereof, or any trustee or agent for such holders, to cause such Indebtedness of $5,000,000 or more to become due and payable prior to its expressed maturity or to cause such Indebtedness of $5,000,000 or more to be prepaid, purchased or redeemed. (c) Bankruptcy or Insolvency. The Company becomes insolvent or generally fails to pay, or admits in writing its general inability to pay, debts as they become due; or the Company applies for, consents to, or acquiesces in the appointment of, a trustee, receiver or other custodian for the Company, or any property thereof, or makes a general assignment for the benefit of creditors; or, in the absence of such application, consent or acquiescence, a trustee, receiver or other custodian is appointed for the Company or for a substantial part of the property thereof and is not discharged within 60 days; or any bankruptcy, reorganization, debt arrangement, or other case or proceeding under any bankruptcy or insolvency law, or any dissolution or liquidation proceeding, is commenced in respect of the Company, and if such case or proceeding is not commenced by the Company, it is consented to or acquiesced in by the Company or remains for 60 days undismissed; or the Company takes any corporate action to authorize, or in furtherance of, any of the foregoing or the insurance commission or department of any Principal Insurance Subsidiary's state of domicile takes any action against such Principal Insurance Subsidiary or the Company in connection with any of the foregoing. (d) Specified Noncompliance with this Agreement. Failure by the Company to comply with or to perform under Section 7.2 (only with respect to the maintenance of the existence of the Company), Sections 7.6 through 7.16, inclusive, and Section 7.21 hereunder and continuance of such failure for five (5) Business Days after (i) written notice thereof to the Company from the Agent or (ii) any Authorized Officer of the Company knew or should have known of such failure to comply or perform; provided, however, that, with respect to the failure by the Company to comply with or to perform under Sections 7.10 through 7.14, inclusive, the continuance of such failure shall be extended from five (5) Business Days to thirty (30) days if the Agent receives written notice from the Company prior to the expiration of such five (5) Business Day period that such failure is curable within such thirty (30) day period. (e) Other Noncompliance with this Agreement. Failure by the Company to comply with or to perform any provision of this Agreement (and not constituting an Event of Default under any of the other provisions of this Section 9) and continuance of such failure for sixty (60) days after (i) written notice thereof to the Company from the Agent or (ii) any Authorized Officer of the Company knew of such failure to comply or perform. (f) Representations and Warranties. Any representation or warranty made by the Company herein or in any Related Document is breached in any material respect or is known by the Company to have been false or misleading in any material respect when given, or any schedule, certificate, financial statement, report, notice, or other writing furnished by the Company to the Agent, the Issuing Bank or any Bank is known by the Company to have been false or misleading in any material respect on the date as of which the facts therein set forth are stated or certified. (g) Employee Benefit Plans. (i) Institution by the PBGC, the Company or any ERISA Affiliate of steps to terminate a Plan subject to Title IV of ERISA if as a result of such termination, the Company or any ERISA Affiliate would be required to make a material contribution to such Plan, or would incur a material liability or obligation to such Plan; (ii) occurrence of a contribution failure with respect to any Plan sufficient to give rise to a lien under Section 302(f) of ERISA, or (iii) incurrence of any material liability (including current or potential withdrawal liability) by the Company or any ERISA Affiliate with respect to any Multiemployer Plan. (h) Judgments. There shall be entered against the Company one or more final unappealable judgments or decrees in excess of $5,000,000 in the aggregate at any one time outstanding for the Company, excluding those judgments or decrees (i) that shall have been stayed, vacated or bonded, (ii) that shall have been outstanding less than 30 days from the entry thereof, (iii) for and to the extent to which the Company is insured and with respect to which the insurer specifically has determined that it shall assume responsibility in writing or (iv) for and to the extent to which the Company is otherwise indemnified if the terms of such indemnification are satisfactory to the Majority Banks. SECTION 9.2 Effect of Event of Default. If any Event of Default described in Section 9.1(c) shall occur, the Commitments (if they have not theretofore terminated) shall immediately terminate and all Loans, the Notes and all other Liabilities shall become immediately due and payable, all without presentment, demand or notice of any kind, all of which, except as expressly set forth herein, are hereby expressly waived by the Company; and, in the case of any other Event of Default, the Agent shall, at the request of, or may, with the consent of, the Majority Banks, by written notice to the Company, declare the Commitments (if they have not theretofore terminated) to be terminated and all Loans, the Notes and all other Liabilities to be due and payable, whereupon such Loans, the Notes and all other Liabilities shall become immediately due and payable, all without presentment, demand or notice of any kind, all of which, except as expressly set forth herein, are hereby expressly waived by the Company. SECTION 9A THE AGENT SECTION 9A.1 Appointment and Authorization. Each Bank hereby appoints, designates and authorizes the Agent to take such action on its behalf under the provisions of this Agreement and each other Related Document and to exercise such powers and perform such duties as are expressly delegated to it by the terms of this Agreement or any other Related Document, together with such powers as are reasonably incidental thereto. Notwithstanding any provision to the contrary contained elsewhere in this Agreement or in any other Related Document, the Agent shall not have any duties or responsibilities, except those expressly set forth herein, nor shall the Agent have or be deemed to have any fiduciary relationship with any Bank, and no implied covenants, functions, responsibilities, duties, obligations or liabilities shall be read into this Agreement or any other Related Document or otherwise exist against the Agent. SECTION 9A.2 Delegation of Duties. The Agent may execute any of its duties under this Agreement or any other Related Document by or through agents, employees or attorneys-in-fact and shall be entitled to advice of counsel concerning all matters pertaining to such duties. The Agent shall not be responsible for the negligence or misconduct of any agent or attorney-in-fact that it selects with reasonable care. SECTION 9A.3 Liability of Agent. None of the Agent-Related Persons shall (i) be liable to any Bank for any action taken or omitted to be taken by any of them under or in connection with this Agreement or any other Related Document (except for its own gross negligence or willful misconduct) or (ii) be responsible in any manner to any of the Banks for any recital, statement, representation or warranty made by the Company or any officer thereof contained in this Agreement or in any other Related Document, or in any certificate, report, statement or other document referred to or provided for in, or received by the Agent under or in connection with, this Agreement or any other Related Document, or the validity, effectiveness, genuineness, enforceability or sufficiency of this Agreement or any other Related Document, or for any failure of the Company to perform its obligations hereunder or under any Related Document. No Agent-Related Person shall be under any obligation to any Bank to ascertain or to inquire as to the observance or performance of any of the agreements contained in, or conditions of, this Agreement or any other Related Document, or to inspect the properties, books or records of the Company or any of the Company's Subsidiaries or Affiliates. SECTION 9A.4 Reliance by Agent. (a) The Agent shall be entitled to rely, and shall be fully protected in relying, upon any writing, resolution, notice, consent, certificate, affidavit, letter, telegram, facsimile, telex or telephone message, statement or other document or conversation believed by it to be genuine and correct and to have been signed, sent or made by the proper Person or Persons, and upon advice and statements of legal counsel, independent accountants and other experts selected by the Agent. The Agent shall be fully justified in failing or refusing to take any action under this Agreement or any other Related Document unless it shall first receive such advice or concurrence of the Majority Banks as it deems appropriate and, if it so requests, it shall first be indemnified to its satisfaction by the Banks (to the extent not indemnified by the Company) against any and all liability and expense that may be incurred by it by reason of taking or continuing to take any such action. The Agent shall in all cases be fully protected in acting, or in refraining from acting, under this Agreement or any other Related Document in accordance with a request or consent of the Majority Banks (or, when expressly required hereby, all the Banks) and such request and any action taken or failure to act pursuant thereto shall be binding upon all of the Banks. (b) For purposes of determining compliance with the conditions specified in Section 8.1, each Bank that has executed this Agreement shall be deemed to have consented to, approved or accepted or to be satisfied with each document or other matter either sent by the Agent to such Bank for consent, approval, acceptance or satisfaction, or required thereunder to be consented to or approved by or acceptable or satisfactory to such Bank. SECTION 9A.5 Notice of Default. The Agent shall not be deemed to have knowledge or notice of the occurrence of any Event of Default, except with respect to defaults in the payment of principal, interest and fees required to be paid to the Agent for the account of the Banks, unless the Agent shall have received written notice from a Bank or the Company referring to this Agreement, describing such Event of Default and stating that such notice is a "notice of default". In the event that the Agent receives such a notice, the Agent shall promptly give notice thereof to the Banks. The Agent shall take such action with respect to such Event of Default as shall be requested by the Majority Banks in accordance with Section 9; provided, however, that unless and until the Agent shall have received any such request, the Agent may (but shall not be obligated to) take such action, or refrain from taking such action, with respect to such Event of Default as it shall deem advisable or in the best interest of the Banks. SECTION 9A.6 Credit Decision. Each Bank expressly acknowledges that none of the Agent-Related Persons has made any representation or warranty to it and that no act by the Agent hereinafter taken, including any review of the affairs of the Company and its Subsidiaries shall be deemed to constitute any representation or warranty by the Agent to any Bank. Each Bank represents to the Agent that it has, independently and without reliance upon the Agent and based on such documents and information as it has deemed appropriate, made its own appraisal of and investigation into the business, prospects, operations, property, financial and other condition and creditworthiness of the Company and its Subsidiaries, and all applicable bank regulatory laws relating to the transactions contemplated thereby, and made its own decision to enter into this Agreement and extend credit to the Company hereunder. Each Bank also represents that it will, independently and without reliance upon the Agent and based on such documents and information as it shall deem appropriate at the time, continue to make its own credit analysis, appraisals and decisions in taking or not taking action under this Agreement and the other Related Documents, and to make such investigations as it deems necessary to inform itself as to the business, prospects, operations, property, financial and other condition and creditworthiness of the Company and its Subsidiaries. Except for notices, reports and other documents expressly herein required to be furnished to the Banks by the Agent, the Agent shall not have any duty or responsibility to provide any Bank with any credit or other information concerning the business, prospects, operations, property, financial and other condition or creditworthiness of the Company and its Subsidiaries that may come into the possession of any of the Agent-Related Persons. SECTION 9A.7 Indemnification. Whether or not the transactions contemplated hereby shall be consummated, the Banks shall indemnify upon demand the Agent-Related Persons (to the extent not reimbursed by or on behalf of the Company and without limiting the obligation of the Company to do so), ratably from and against any and all liabilities, obligations, losses, damages, penalties, actions, judgments, suits, costs, expenses and disbursements of any kind whatsoever that may at any time (including at any time following the repayment of the Loans and reimbursement of the LCs and the termination or resignation of the related Agent) be imposed on, incurred by or asserted against any such Person in any way relating to or arising out of this Agreement or any document contemplated by or referred to herein or the transactions contemplated hereby or any action taken or omitted by any such Person under or in connection with any of the foregoing; provided, however, that no Bank shall be liable for the payment to any Agent-Related Person of any portion of such liabilities, obligations, losses, damages, penalties, actions, judgments, suits, costs, expenses or disbursements resulting from any Agent-Related Person's gross negligence or willful misconduct. Without limitation of the foregoing, each Bank shall reimburse the Agent upon demand for its ratable share of any costs or out-of-pocket expenses (including attorney costs) incurred by the Agent in connection with the administration, modification, amendment or enforcement (whether through negotiations, legal proceedings or otherwise) of, or legal advice in respect of rights or responsibilities under, this Agreement, any other Related Document, or any document contemplated by or referred to herein to the extent that the Agent is not reimbursed for such expenses by or on behalf of the Company. The obligation of the Banks in this Section shall survive the payment of all Obligations hereunder. SECTION 9A.8 Agent in Individual Capacity. ANB and its Affiliates may make loans to, issue letters of credit for the account of, accept deposits from, acquire equity interests in and generally engage in any kind of banking, trust, financial advisory or other business with the Company and its Subsidiaries and Affiliates as though ANB were not the Agent hereunder and without notice to or consent of the Banks. With respect to its Loans, ANB shall have the same rights and powers under this Agreement as any other Bank and may exercise the same as though it were not the Agent, and the terms "Bank" and "Banks" shall include ANB in its individual capacity. SECTION 9A.9 Successor Agent. The Agent may resign as Agent upon 30 days' notice to each of the Banks and the Company. If the Agent shall resign as Agent under this Agreement, the Majority Banks shall appoint from among the Banks a successor agent for the Banks which successor agent shall be approved by the Company, which consent shall not be unreasonably withheld. If no successor agent is appointed prior to the effective date of the resignation of the Agent, the Agent may appoint, after consulting with the Banks and the Company, a successor agent from among the Banks. Upon the acceptance of its appointment as successor agent hereunder, such successor agent shall succeed to all the rights, powers and duties of the retiring Agent and the term "Agent" shall mean such successor agent and the Agent's appointment, powers and duties as Agent shall be terminated. After any retiring Agent's resignation hereunder as Agent, the provisions of this Section 9A and Sections 10.4 and 10.5 shall inure to its benefit as to any actions taken or omitted to be taken by it while it was Agent under this Agreement. Notwithstanding the foregoing, the Agent's resignation shall not be effective until a successor agent is appointed and such successor agent accepts such appointment as successor agent hereunder. SECTION 10 GENERAL SECTION 10.1 Amendments and Waivers. No amendment or waiver of any provision of this Agreement or any other Related Document, and no consent with respect to any departure by the Company therefrom, shall be effective unless the same shall be in writing and signed by the Majority Banks, acknowledged by the Agent, and, in the case of amendments, signed by the Company, and then any such waiver shall be effective only in the specific instance and for the specific purpose for which given; provided, however, that no such waiver, amendment, or consent shall, unless in writing and signed by all the Banks, acknowledged by the Agent, and, in the case of an amendment, signed by the Company, do any of the following: (a) increase or extend the Commitment of any Bank (or reinstate any Commitment terminated pursuant to Section 2.9) or subject any Bank to any additional obligations; (b) postpone or delay any date fixed for any payment of principal, interest, fees or other amounts due to the Banks (or any of them) hereunder or under any other Related Document; (c) reduce the principal of, or the rate of interest specified herein on any Loan, or of any fees or other amounts payable hereunder or under any other Related Document; (d) change the percentage of the Commitments which shall be required for the Banks or any of them to take action hereunder; or (e) amend this Section 10.1 or any provision providing for consent or other action by all Banks; and, provided further, that no amendment, waiver or consent shall, unless in writing and signed by the Agent in addition to the Majority Banks or all the Banks, as the case may be, affect the rights or duties of the Agent under this Agreement or any other Related Document. SECTION 10.2 Notices. All notices hereunder shall be in writing. Notices given by mail shall be deemed to have been given (i) five Business Days after the date sent if sent by registered or certified mail, postage prepaid, (ii) the next Business Day if sent by overnight delivery service, (iii) the day sent if sent by telecopy or telex if sent prior to 5:00 p.m. local time on a Business Day, otherwise the following day, or (iv) the day delivered if sent by personal messenger, and: (a) if to the Company, addressed to the Company at its address shown below its signature hereto; (b) if to the Agent, addressed to the Agent at the address shown below its signature hereto; or (c) if to a Bank, addressed to such Bank at the address shown below its signature hereto; or in the case of any party, such other address as such party, by written notice received by the other parties to this Agreement, may have designated as its address for notices. SECTION 10.3 Accounting Terms; Computations. All accounting terms used herein and not expressly defined in this Agreement shall have the respective meanings given to them in accordance with GAAP as in effect on the Closing Date. Where the character or amount of any asset or liability or item of income or expense is required to be determined, or any consolidation or other accounting computation is required to be made, for purposes of this Agreement such determination or calculation shall, to the extent applicable and except as otherwise specified in this Agreement or agreed to in writing by the Majority Banks, be made in accordance with GAAP as then in effect. SECTION 10.4 Costs, Expenses and Taxes. (a) The Company agrees to pay within thirty (30) days after demand by ANB (including in its capacity as Agent) all of ANB's (including in its capacity as Agent) reasonable out-of-pocket costs and expenses (including the reasonable fees and out-of-pocket expenses of ANB's counsel) in connection with the preparation, execution and delivery of this Agreement, the Related Documents and all other instruments or documents provided for herein or delivered or to be delivered hereunder or in connection herewith (including, without limitation, all amendments, supplements and waivers executed and delivered pursuant hereto or in connection herewith). (b) The reasonable costs and expenses which the Agent (on behalf of itself, the Issuing Bank and all other Banks) incurs in any manner or way with respect to the following shall be part of the Liabilities, payable by the Company within thirty (30) days after demand if at any time after the date of this Agreement the Agent (on behalf of itself, the Issuing Bank and all other Banks): (i) reasonably employs counsel for advice or other representation (A) to represent the Agent (on behalf of itself, the Issuing Bank and all other Banks) in any litigation, contest, dispute, suit or proceeding or to commence, defend or intervene or to take any other action in or with respect to any litigation, contest, dispute, suit or proceeding (whether instituted by the Agent, the Issuing Bank, such Bank, any other Bank, the Company or any other Person) in any way or respect relating to this Agreement or the Related Documents, (B) to enforce any of the Agent's, the Issuing Bank's or any such Bank's rights with respect to the Company under this Agreement and the Related Documents; and/ or (ii) reasonably seeks to enforce or enforces any of the Agent's, the Issuing Bank's or any such Bank's rights and remedies with respect to the Company under this Agreement and the Related Documents; provided, however, that notwithstanding the foregoing, if the interests of the Issuing Bank or any Bank conflict with the interests of such other Bank as determined by the Issuing Bank or such Bank, as the case may be, then the reasonable costs and expenses incurred by the Issuing Bank or such Bank, as the case may be, in respect of the foregoing shall be payable by the Company within thirty (30) days after demand by the Issuing Bank or such Bank, as the case may be. (c) All of the Company's obligations provided for in this Section 10.4 shall be Liabilities of the Company hereunder. SECTION 10.5 Indemnification. In consideration of the Agent's, the Issuing Bank's and each Bank's execution and delivery of this Agreement and each Bank's agreement to extend its Commitment and to make and maintain Loans and the Issuing Bank's commitment to issue LCs, the Company hereby agrees to indemnify, exonerate and hold the Agent, the Issuing Bank and each Bank and each of its officers, directors, employees and agents (herein collectively called the "Bank Parties" and individually called a "Bank Party") free and harmless from and against any and all actions, causes of action, suits, losses, costs (including, without limitation, all documentary or other stamp taxes or duties), liabilities and damages, and expenses in connection therewith (irrespective of whether such Bank Party is a party to the action for which indemnification hereunder is sought) (the "Indemnified Liabilities"), including, without limitation, reasonable attorneys' fees and disbursements, incurred by such Bank Parties or any of them as a result of, or arising out of, or relating to (except for such Indemnified Liabilities arising on account of such Bank Party's gross negligence or willful misconduct): (a) any transaction financed or to be financed in whole or in part, directly or indirectly, with the proceeds of any Loan or LC; (b) the execution, delivery, performance, administration or enforcement of this Agreement and the Related Documents in accordance with their respective terms by any of such Bank Parties; (c) any misrepresentation or breach of any representation or warranty or covenant herein by the Company. If and to the extent that the foregoing agreements described in this Section 10.5 may be unenforceable for any reason, the Company hereby agrees to make the maximum contribution to the payment and satisfaction of each of the Indemnified Liabilities which is permissible under applicable law. SECTION 10.6 Captions and References. The recitals to this Agreement (except for definitions) and the section captions used in this Agreement are for convenience only, and shall not affect the construction of this Agreement. SECTION 10.7 No Waiver; Cumulative Remedies. No failure to exercise and no delay in exercising, on the part of the Agent, the Issuing Bank or any Bank, any right, remedy, power or privilege hereunder, shall operate as a waiver thereof; nor shall any single or partial exercise of any right, remedy, power or privilege hereunder preclude any other or further exercise thereof or the exercise of any other right, remedy, power or privilege. SECTION 10.8 Governing Law; Jury Trial; Severability. This Agreement and each Note shall be a contract made under and governed by the laws of the State of Illinois, without regard to conflict of laws principles. Wherever possible, each provision of this Agreement shall be interpreted in such manner as to be effective and valid under applicable law, but if any provision of this Agreement shall be prohibited by or invalid under such law, such provision shall be ineffective only to the extent of such prohibition or invalidity, without invalidating the remainder of such provision or the remaining provisions of this Agreement. All obligations of the Company and rights of the Agent, the Issuing Bank and any Bank, which obligations and rights are described herein or in the Note issued to such Bank, shall be in addition to and not in limitation of those provided by applicable law. THE COMPANY HEREBY IRREVOCABLY WAIVES ANY RIGHT TO TRIAL BY JURY IN ANY ACTION OR PROCEEDING (i) TO ENFORCE OR DEFEND ANY RIGHTS UNDER OR IN CONNECTION WITH THIS AGREEMENT, THE RELATED DOCUMENTS, ANY LOAN, ANY LC OR ANY AMENDMENT, INSTRUMENT, DOCUMENT OR AGREEMENT DELIVERED OR WHICH MAY IN THE FUTURE BE DELIVERED IN CONNECTION HEREWITH OR THEREWITH, OR (ii) ARISING FROM ANY DISPUTE OR CONTROVERSY IN CONNECTION WITH OR RELATED TO THIS AGREEMENT, THE RELATED DOCUMENTS, ANY LOAN, ANY LC, OR ANY SUCH AMENDMENT, INSTRUMENT, DOCUMENT OR AGREEMENT, AND AGREES THAT ANY SUCH ACTION OR COUNTERCLAIM SHALL BE TRIED BEFORE A COURT AND NOT BEFORE A JURY. ____________________ Agreed and Acknowledged by the Company THE COMPANY IRREVOCABLY AGREES THAT, SUBJECT TO THE AGENT'S, THE ISSUING BANK'S AND EACH BANK'S SOLE AND ABSOLUTE ELECTION, ANY ACTION OR PROCEEDING IN ANY WAY, MANNER OR RESPECT ARISING OUT OF THIS AGREEMENT, THE RELATED DOCUMENTS, ANY LOAN, ANY LC OR ANY AMENDMENT, INSTRUMENT, DOCUMENT OR AGREEMENT DELIVERED OR WHICH MAY IN THE FUTURE BE DELIVERED IN CONNECTION HEREWITH OR THEREWITH, OR ARISING FROM ANY DISPUTE OR CONTROVERSY ARISING IN CONNECTION WITH OR RELATED TO THIS AGREEMENT, THE RELATED DOCUMENTS, ANY LOAN, ANY LC OR ANY SUCH AMENDMENT, INSTRUMENT, DOCUMENT OR AGREEMENT SHALL BE LITIGATED IN THE COURTS HAVING SITUS WITHIN THE CITY OF CHICAGO, THE STATE OF ILLINOIS, AND THE COMPANY HEREBY CONSENTS AND SUBMITS TO THE JURISDICTION OF ANY LOCAL, STATE OR FEDERAL COURT LOCATED WITHIN SUCH CITY AND STATE. THE COMPANY HEREBY WAIVES ANY RIGHT IT MAY HAVE TO TRANSFER OR CHANGE THE VENUE OF ANY LITIGATION BROUGHT AGAINST THE COMPANY BY THE AGENT, THE ISSUING BANK OR ANY BANK IN ACCORDANCE WITH THIS SECTION 10.8. SECTION 10.9 Counterparts. This Agreement and any amendment or supplement hereto or any waiver or consent granted in connection herewith may be executed in any number of counterparts and by the different parties on separate counterparts and each such counterpart shall be deemed to be an original, but all such counterparts shall together constitute but one and the same Agreement. SECTION 10.10 Successors and Assigns. Subject to Section 10.12, this Agreement shall be binding upon the Company, each Bank and their respective successors and assigns, and shall inure to the benefit of the Company, each Bank and each Bank's successors and assigns. The Company shall have no right to assign its rights or delegate its duties under this Agreement. SECTION 10.11 Prior Agreements. The terms and conditions set forth in this Agreement shall supersede all prior negotiations, agreements, discussions, correspondence, memoranda and understandings (whether written or oral) of the Company and the Agent, the Issuing Bank and any Bank concerning or relating to the subject matter of this Agreement (including, without limitation, the terms set forth in the proposal letter dated October 20, 1993 issued by the Banks to Mr. Peter W. Nauert). SECTION 10.12 Assignments; Participations. (a) Each Bank shall have the right to assign, with the written consent of the Company, which shall not be unreasonably withheld, to any Affiliate of such Bank and to one or more banks or other financial institutions, all or a portion of its rights and obligations under this Agreement (including, without limitation, all or a portion of its Commitment, the Loans, the LCs and the Note issued to such Bank) and the Related Documents. For purposes of this Section, it shall not be unreasonable for the Company to withhold its consent to a proposed assignee if, as a result of such proposed assignment, any one Bank's Commitment Percentage would be in excess of fifty percent (50%) or there would be more than six (6) banks or financial institutions party to this Agreement. Upon any such assignment, (x) the assignee shall become a party hereto and, to the extent of such assignment, have all rights and obligations of such Bank hereunder and under the Related Documents and (y) such Bank shall, to the extent of such assignment, relinquish its rights and be released from its obligations hereunder and under the Related Documents. The Company hereby agrees to execute and deliver such documents, and to take such other actions, as such Bank may reasonably request to accomplish the foregoing. Upon such assignment, this Agreement shall be deemed to be amended to the extent, but only to the extent, necessary to reflect the addition of the assignee and the resulting adjustment of the Commitments arising therefrom. The Commitment allocated to each assignee shall reduce such Commitment of the assigning Bank pro tanto. (b) In addition to the assignments permitted in clause (a) of this Section 10.12, each Bank and any assignee pursuant to clause (a) above shall have the right with the written consent of the Company to grant participations to one or more banks or other financial institutions in or to its Commitment, any Loan, any LC, the Related Documents, and the Note held by such Bank or such assignee, provided that (i) each Bank's obligations under this Agreement shall remain unchanged and (ii) the Company and the Agent shall continue to deal solely and exclusively with such Bank. No holder of a participation in all or any part of a Commitment, the Loans, the LCs, the Related Documents, or any Note shall have any rights under this Agreement; provided, however, that, to the extent permitted by applicable law, each holder of a participation shall have the same rights as each Bank under Section 5.3. (c) The Company hereby consents to the disclosure of any information obtained in connection herewith (i) by each Bank, to any bank or other financial institution which is an assignee or potential assignee with respect to which the Company has given its written consent pursuant to clause (a) above, and (ii) by each Bank and any assignee pursuant to clause (a) above, to any bank or other financial institution which is a participant or potential participant with respect to which the Company has given its written consent pursuant to clause (b) above, it being understood that each Bank and each assignee shall advise any such bank or other financial institution of its obligation to keep confidential any nonpublic information disclosed to it pursuant to this Section 10.12. SECTION 10.13 Confidentiality. Each Bank agrees to take normal and reasonable precautions and exercise due care to maintain the confidentiality of all information provided to it by the Company, or by the Agent on the Company's behalf, in connection with this Agreement or any other Related Document, and neither it nor any of its Affiliates shall use any such information for any purpose or in any manner other than pursuant to the terms contemplated by this Agreement, except to the extent such information (i) was or becomes generally available to the public other than as a result of a disclosure by such Bank, or (ii) was or becomes available on a non-confidential basis from a source other than the Company, provided that such source is not bound by a confidentiality agreement with the Company known to such Bank; provided, further, however, that any Bank may disclose such information (A) at the request or pursuant to any requirement of any governmental or regulatory authority to which such Bank is subject or in connection with an examination of such Bank by any such authority; (B) pursuant to subpoena or other court process, provided that, if it is lawful to do so, such Bank shall give prompt notice to the Company of service thereof so that the Company may seek a protective order or other appropriate remedy or waive compliance with the provisions of this Section 10.13; (C) when required to do so in accordance with the provisions of any applicable requirement of law; (D) to the extent reasonably required in connection with any litigation or proceeding to which the Agent, any Bank or their respective Affiliates may be party, (E) to the extent reasonably required in connection with the exercise of any remedy hereunder or under any other Related Document, and (F) to such Bank's independent auditors and other professional advisors. SECTION 10.14 Notification of Addresses, Etc. Each Bank shall notify the Agent in writing of any changes in the address to which notices to such Bank should be directed, of payment instructions in respect of all payments to be made to it hereunder and of such other administrative information as the Agent shall reasonably request. IN WITNESS WHEREOF, the Company, the Agent, and each Bank have caused this Agreement to be executed and delivered as of the day and year first above written. THE COMPANY: PIONEER FINANCIAL SERVICES, INC. By: /s/ Val Rajic Title: Vice President 1750 Golf Road Schaumburg, Illinois 60101 Attention: David Vickers Val Rajic Telephone: (708) 995-0400 Telecopy: (708) 413-7195 THE AGENT: AMERICAN NATIONAL BANK AND TRUST COMPANY OF CHICAGO By /s/ Arthur Murray Vice President 33 North LaSalle Street Chicago, Illinois 60690 Attention: Arthur W. Murray Telephone: (312) 661-7298 Telecopy: (312) 661-6929 THE BANKS: COMMITMENT: AMERICAN NATIONAL BANK AND TRUST $9,000,000 COMPANY OF CHICAGO By /s/ Arthur Murray Vice President 33 North LaSalle Street Chicago, Illinois 60690 Attention: Arthur W. Murray Telephone: (312) 661-7298 Telecopy: (312) 661-6929 $6,000,000 FIRSTAR BANK MILWAUKEE, N.A. By /s/ Stephen Check Title: Vice President 777 East Wisconsin Avenue Milwaukee, Wisconsin 53202 Attention: Stephen E. Check Telephone: ________________________ Telecopy: _________________________ $5,000,000 BANK ONE, ROCKFORD, NA By /s/ Robert Opperman Title: Vice President East State at Mulford Road Rockford, Illinois 61110-4900 Attention: Robert Opperman Telephone: ________________________ Telecopy: _________________________ EXHIBIT 11 PIONEER FINANCIAL SERVICES, INC. STATEMENT OF COMPUTATION OF PER SHARE NET INCOME OR LOSS For the Year Ended December 31 1993 1992 1991 Net Income (loss) $ 12,145,000 $(16,959,000) $ 8,872,000 Less Dividends on Preferred Stock (2,021,000) (2,039,000) (2,039,000) Primary Basis-Net Income (loss) $ 10,124,000 $(18,998,000) $ 6,833,000 Fully Diluted Basis- Net Income (loss)** $ 13,507,000 $(16,959,000) $ 8,872,000 Average shares outstanding 6,546,719 6,659,657 6,626,447 Common Stock equivalents from dilutive stock options, based on the treasury stock method using average market price 176,883 - 72,092 TOTAL-PRIMARY BASIS 6,723,602 6,659,657 6,698,539 Additional shares assuming conversion of Preferred Stock 1,515,200 1,535,360 1,535,360 Additional shares assuming conversion of Subordinated Debentures 2,282,774 - - Additional Common Stock equivalents from dilutive stock options, based on the treasury stock method using closing market price 209,618 - - TOTAL-FULLY DILUTED 10,731,194 8,195,017 8,233,899 Net income (loss) per share- Primary $ 1.51 $(2.85) $ 1.02 Net income (loss) per share- Fully Diluted $ 1.26 $(2.85)* $ 1.02 * * In 1991 and 1992 fully diluted net income (loss) per share is equivalent to primary net income (loss) per share due to the fully diluted computation being anti-dilutive for these periods. ** In 1993 fully diluted net income per share was calculated after adding tax effected interest on Subordinated Debentures of $1,362,000. Exhibit 21 PIONEER FINANCIAL SERVICES, INC. Subsidiary Jurisdiction 1. Pioneer Life Insurance Company of Illinois Illinois 2. Health and Life Insurance Company of America Illinois 3. National Group Life Insurance Company Illinois 4. First Pioneer Equity Corporation Delaware 5. Pioneer Fire & Casualty Insurance Company Pennsylvania 6. Administrators Service Corporation Illinois 7. Association Management Corporation Illinois 8. Network Air Medical Systems, Inc. Illinois 9. National Benefit Plans, Inc. formerly National Group Holding Corporation Delaware 10. Design Benefit Plans, Inc. formerly National Group Marketing Corporation Illinois 11. Partners Health Group, Inc. formerly Union Capital Corporation Delaware 12. National Marketing Specialists Delaware 13. National Business Concepts, formerly Design Benefit Plans, Inc. formerly National Marketing Corporation Illinois 14. Target Ad Group, Inc. formerly National Benefit Finance, formerly Select Marketing Corporation Illinois 15. Response Air Ambulance Network, Inc. Illinois 16. National Training Corporation formerly NGM Training Corporation formerly Educational Communications, Inc. Texas 17. Direct Financial Services, Inc. Illinois 18. Association Specialty Corporation Illinois 19. National Health Services, Inc. Wisconsin 20. Manhattan National Life Insurance Company North Dakota 21. United Group Holdings of Delaware, Inc. Delaware 22. Advantage Financial Systems, Inc. Delaware 23. NHS Coordinated Care of Texas, Inc. formerly American Managed Care of Texas, Inc. Texas 24. NHS Coordinated Care, Inc. Nevada 25. Continental Life & Accident Company Iowa 26. Continental Marketing Corporation Idaho 27. Healthcare Review Corporation Kentucky EXHIBIT 23 CONSENT OF ERNST & YOUNG, INDEPENDENT AUDITORS We consent to the incorporation by reference in the Registration Statements pertaining to the Nonqualified Stock Option Plan of Pioneer Financial Services, Inc. (Form S-8 No. 33-37305), the Pioneer Financial Services, Inc. Employee Savings and Stock Ownership Plan (Form S-8 No. 33-45894) and the National Benefit Plans, Inc. 1992 Agent Stock Purchase Plan (Form S-8 No. 33-53686) of our report dated March 2, 1994, with respect to the consolidated financial statements and schedules of Pioneer Financial Services, Inc. and subsidiaries included in the Annual Report (Form 10-K) for the year ended December 31, 1993. ERNST & YOUNG Chicago, Illinois March 28, 1994

25890_1993.txt

25890

1993

ITEM 1. BUSINESS GENERAL Crown Cork & Seal Company, Inc. (the "Company" and the "Registrant") is a multinational manufacturer of metal and plastic packaging, including cans, bottles, crowns and closures (metal and plastic) and machinery for filling, packaging and handling. The Company is an international packaging producer and, as such, benefits from, but is also exposed to, the fluctuations of world trade. The Company recognizes that it must constantly review operations worldwide to ensure that it maintains its competitive position. To achieve better productivity, the Company closed or reorganized 24 facilities across nine countries between 1991 and 1993. The Company continues to review all operations so that it can determine the appropriate number, size and location of plants, emphasizing service to customers and rate of return to investors. Financial information about the Company's operations in its two industry segments and within geographic areas is set forth in Part II of this Report on page 38 under the Notes to Consolidated Financial Statements entitled "Segment Information by Industry and Geographic Areas". The Company has grown substantially since December 1989 when it commenced a series of acquisitions that have more than doubled its sales. The Company believes that these acquisitions have enabled it to become a leader in North American markets, to better penetrate important international markets, to enhance product quality, to realize economies of scale and to improve its technical and developmental capabilities while preserving the Company's traditional focus on customer service. To further accommodate its expanded base of operations, in 1992, the Company organized into four divisions by adding Plastics to its previously established North American, International and Machinery Divisions. The Company, with its 1992 acquisition of CONSTAR International, Inc., now conducts business in two separate industry segments within the Packaging Industry, Metal and Plastic. Information about the Company's acquisitions over the past three years appears in Part II hereof on pages 25 and 26 under Note C of the Notes to the Consolidated Financial Statements. DISTRIBUTION The Company's products are manufactured in 84 plants within the United States and 74 plants outside the U.S., spanning over 40 countries and are sold through the Company's sales organization to the food, citrus, brewing, soft drink, oil, paint, toiletry, drug, antifreeze, chemical and pet food industries. For the period ended December 31, 1993 and years prior to 1992, no one customer accounted for more than 10 percent of the Company's net sales. In 1992, one customer accounted for approximately 10.6 percent of the Company's net sales. RESEARCH AND DEVELOPMENT Pursuant to the acquisition of Continental Can International in 1991, the Company acquired an international engineering group currently based at the Company's new Alsip Technical Center near Chicago. The technical center enables the Company to enhance its technical and engineering services worldwide both within the Company and to third parties. The Company's research and development expenditures of $23.3 million, $16.7 million and $16.1 million in 1993, 1992, and 1991, respectively, are expected to make a greater contribution to improving and expanding the Company's product lines in the future. Crown Cork & Seal Company, Inc. MATERIALS The Company continues to pursue strategies which enable it to source its raw materials with increasing effectiveness, and may consider vertical integration into the production of certain raw materials, such as PET resin, used in plastic bottle production, if it is advantageous to do so. ENVIRONMENTAL MATTERS The Company has a Corporate Environmental Protection Policy. Environmental considerations are among the criteria by which the Company evaluates projects, products, processes and purchases. The Company continues to reduce the amount of metals and resins used in the manufacture of steel, aluminum and plastic containers through its "lightweighting" program. The Company currently recycles nearly 100 percent of scrap steel, aluminum, plastic and copper used in the manufacturing process, and through its Nationwide Recyclers subsidiary, is directly involved in post-consumer aluminum and steel can recycling. The Company is involved in promoting the development of recycling systems through various activities, including membership in recycling organizations and ongoing research and development programs. Further discussion of the Company's environmental matters is contained in Part II, Item 7 "Management's Discussion and Analysis", of this Report on page 15. WORKING CAPITAL Information relating to the Company's liquidity and capital resources is set forth in Part II, Item 7, "Management's Discussion and Analysis of Operations and Financial Condition", of this Report on pages 13, 14 and 15. EMPLOYEES At December 31, 1993, the Company employed 21,254 people throughout the world. CHANGE IN THE BOARD OF DIRECTORS After 37 years of service, Frank N. Piasecki has decided not to stand for re-election to the Board of Directors. Mr. Piasecki was the longest serving board member in the Company's 102 year history. APPOINTMENT OF CORPORATE OFFICERS As the Company continues to reorganize its operations to assimilate its recent acquisitions, the Board of Directors of the Company has appointed Mr. Mark W. Hartman to the newly created position of Executive Vice President, Corporate Technologies. Mr. Hartman will lead an organization charged with unifying the Company's extensive Research, Development and Engineering talents worldwide in keeping with its commitment to pursue global technological excellence in packaging. Mr. John W. Conway, formerly Senior Vice President - International Division, was appointed Executive Vice President, President - International Division, a position previously held by Mr. Hartman. Mr. Conway came to the Company in 1991 with the Company's acquisition of Continental Can International. Crown Cork & Seal Company, Inc. METAL PACKAGING The Metal Packaging segment includes the North American, International and Machinery Divisions of the Company. This segment in 1993 accounted for approximately 81 percent of net sales and operating profits. This segment manufactures and markets steel and aluminum cans as well as composite cans, crowns (also known as bottle caps) and metal closures. Within the Machinery Division, the Company manufactures filling, packaging and handling machinery. All products are sold through the Company's sales organization to the food, brewing, citrus, soft drink, oil, paint, toiletry, drug, chemical and pet food industries. The Company believes that price, quality and customer service are the principal competitive factors affecting its business. Based upon sales, the Company believes that it is a leader in the markets for metal packaging in which it competes; however, the Company encounters competition from a number of companies offering similar products. The basic raw materials for this segment's products are tinplate and aluminum. These metals are supplied by the major mills in the countries within which the Company operates plants. Some plants in less-developed countries, which do not have local mills, obtain their metal from nearby more-developed countries. Sufficient quantities have been available in the past, however, there can be no assurances that sufficient quantities will be available in the future. The Company, based on net sales, is one of two leading producers of aluminum beverage cans within the United States. This sector of its business, while important to the Company, continues to contribute a decreasing proportion of consolidated net sales (30% in 1993 versus 42% in 1991) as other sectors develop and as lower aluminum costs have been passed on to customers. Beverage can prices in the United States have declined by more than has been reflected in lower aluminum costs. The Company is addressing this situation through ongoing non-metal cost reductions and restructuring of production processes. Beverage can capacity in North America is being redeployed in emerging markets and, to a lesser extent, also is being retrofitted to produce two-piece food cans. In April 1993, the Company acquired the Van Dorn Company. Van Dorn provides the Company with two piece (drawn) aluminum cans for processed foods and adds additional manufacturing capacity for metal, plastic and composite cans for the paint, chemical, automotive, food, pharmaceutical and household product industries. On January 27, 1994, the Company announced that it had agreed in principle to acquire the Container Division of Tri Valley Growers. With this pending acquisition, the Company seeks to continue to expand the food can business. In North America, based on net sales, the Company believes that, along with beverage cans, it is a market leader in the manufacture and sale of metal packaging to the processed foods, aerosol and other industries. The Company's customers include leading producers of soft drinks, beer, juice, food and aerosol products. During 1992, the Company closed three Canadian plants and instituted other restructuring actions in Canada due to the unfavorable market conditions there. The Company remains confident that the Canadian economy will recover and become a better market for its products in the future. In 1993, the Company's Canadian operation reflected improvement. The Company intends over the next several years to continue to reduce the number of manufacturing lines used in North America to produce beverage cans in favor of fewer, but faster and more efficient lines. Additional restructuring also will be directed toward other products, particularly those involving U. S. non-beverage metal operations. Crown Cork & Seal Company, Inc. Outside North America, the Company's metal packaging products consist of metal crowns and closures as well as metal cans for food, beverage and aerosol customers. Europe is the most significant crown market for the Company with returnable bottles being a dominant form of beverage packaging in the region. In 1993, the Company commenced production of aerosol cans at a new facility near Amsterdam, the Netherlands and two-piece beverage cans at plants in Argentina and the United Arab Emirates. Construction of new two-piece beverage can lines at jointly-owned facilities is presently underway in Shanghai, China and Amman, Jordan. In addition to the Company's North American beverage can capacity, the Company had an additional 7 billion units of capacity in markets such as Hong Kong, China, Argentina, United Arab Emirates(UAE), Korea, Saudi Arabia and Venezuela. UAE, Korea, Saudi Arabia and Venezuela represent jointly-owned operations. This action continues to support the Company's current philosophy that the use of business partners in many overseas locations presents another cost-effective means of entering these new markets. International margins have been sustained as a result of actions commenced in 1992. Further restructuring occurred during 1993 with the closure of certain operations in France and the Netherlands. The Machinery division, representing approximately 2 percent of consolidated net sales, reported increased sales in 1993 but due to competitive factors, the Company has downsized its operations in Belgium and the United States. This downsizing will continue to reduce operating costs while improving efficiencies. PLASTIC PACKAGING The Plastics segment manufactures plastic containers and closures. The Company with its 1992 acquisition of CONSTAR International and the 1993 acquisition of the remaining 56 percent of CONSTAR'S affiliate in Europe, Wellstar, has enabled itself to offer a wider product range to its worldwide customers. The segment also includes plastic closure operations in Virginia and Switzerland. Metal Packaging plants in Belgium, Germany, Italy, Spain, Portugal, Argentina and the United Arab Emirates also manufacture plastic packaging, closures and bottles. With the acquisitions of CONSTAR and Wellstar, the Plastics segment has grown considerably and now represents almost 20 percent of the Company's net sales as compared to approximately 2 percent in 1991. The Company is actively integrating these operations into its organization by installing its cost systems and controls. CONSTAR and Wellstar manufacture plastic containers for the beverage, food, household, chemical and other industries. Wellstar is a leading European manufacturer of polyethylene terephthalate (P.E.T.) preforms and bottles, including P.E.T. returnable bottles. This acquisition strengthens the Company's plastics marketing base within Europe. Plastic containers continued to increase their share of the Packaging market during 1993. The principal raw materials used in the manufacture of plastic containers and closures are various types of resins which are purchased from several commercial sources. Resins, which are petrochemical derivatives, are presently available in quantities adequate for the Company's needs. Typically, the Company identifies market opportunities by working cooperatively with customers and implementing commercially successful programs. The Company will capitalize on both the conversions to plastic from other forms of packaging and the new markets through its technical expertise, quality reputation and customer service. Logistically, CONSTAR plant sites are strategically located and sized properly. Capital expenditures for Plastic Packaging was approximately 44 percent of total capital expenditures for the Company in 1993 as compared to approximately 5 percent in 1991. The Company has made a commitment to service global customers with plastic containers. Crown Cork & Seal Company, Inc. ITEM 2.

ITEM 2. PROPERTIES The Company's manufacturing and support facilities are designed according to the requirements of the products to be manufactured, and the type of construction varies from plant to plant. In the design of each facility, particular emphasis is placed on quality assurance in the finished products, safety in the operations, and avoidance or abatement of pollution. The Company maintains its own engineering staff, which aids in achieving close integration of research, design, construction and manufacturing functions and facilitates the construction of plants which will be best suited to their special purposes. Warehouse and delivery facilities are provided at each of the manufacturing locations, however, the Company does lease outside warehouses at some locations. The plants of the Company and its subsidiaries are owned, with the exception of those that have the word "leased", in brackets, after the location name. Joint Ventures are indicated by the initials JV, in brackets, after the location name. Crown Cork & Seal Company, Inc. * Plastic Packaging manufactured within Metal Packaging locations Some metal manufacturing locations are supported by locations that provide art work for cans and crowns, coil shearing, coil coating, research, product development and engineering. The support locations within the United States are located in Alsip, IL, Baltimore, MD, Fairless Hills, PA (Leased), Massilon, OH, Plymouth, FL and Toledo, OH; and outside the United States in Aracaju, Brazil, Rotterdam, Holland and Santafe de Bogata, Colombia. Crown Cork & Seal Company, Inc. The Company manufactures bottle and can filling machinery and parts at locations within the United States in Baltimore, MD and Titusville, FL; outside the United States in Londerzeel, Belgium and San Luis Potosi, Mexico. The Company also operates two machinery overhaul locations within the United States in Bartow, FL and Philadelphia, PA. The Company has three machine shop locations which manufacture tool and die parts used within its own manufacturing locations and also sells to customers in the packaging industry. The locations are within the United States, with two in Philadelphia, PA., and one in Wissota, WI. The Company is directly involved in post-consumer aluminum and steel can recycling through its subsidiary, Nationwide Recyclers, Inc., located in Polkton, NC. Commencing June 1994, this site will recycle post-consumer plastic packaging. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS In management's opinion, there are no pending claims or litigation, the adverse determination of which would have a material adverse effect on the consolidated financial position of the Company. The Company has been identified by the Environmental Protection Agency as a potentially responsible party (along with others, in most cases) at a number of sites. Information on this is presented in Part I, Item 1, entitled "Business" appearing on page 2 of this Report and in Part II Item 7, entitled "Management Discussion and Analysis of Financial Condition and Results of Operation" appearing on page 15 of this Report. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. Crown Cork & Seal Company, Inc. ITEM 4a. EXECUTIVE OFFICERS OF THE REGISTRANT The following table sets forth certain information concerning the principal executive officers of the Company, including their ages and positions as of December 31, 1993. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The Registrant's Common Stock is listed on the New York Stock Exchange. On March 18, 1994, there were 6,163 registered shareholders of the Registrant's Common Stock. The market price with respect to the Registrant's Common Stock is set forth on page 37 as Note R of the Notes to Consolidated Financial Statements entitled "Quarterly Data (unaudited)". Crown Cork & Seal Company, Inc. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA FIVE YEAR SUMMARY OF SELECTED FINANCIAL DATA Certain reclassifications of prior years' data have been made to improve comparability. Crown Cork & Seal Company, Inc. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (in millions, except per share, employee, shareholder and statistical data) Management's discussion and analysis should be read in conjunction with the financial statements and the notes thereto. Share data for prior years have been restated for the 3 for 1 common stock split declared in 1992. RESULTS OF OPERATIONS NET INCOME AND EARNINGS PER SHARE BEFORE CUMULATIVE EFFECT OF ACCOUNTING CHANGES Net income before cumulative effect of accounting changes for 1993 was a record $180.9, an increase of 16.4% compared with $155.4 for 1992. Net income for 1991 was $128.1. Net income for 1992 and 1991 represents increases of 21.3% and 19.6%, respectively, over the preceding year. Earnings per share before cumulative effect of accounting changes for 1993 was a record $2.08 per share, an increase of 16.2% compared with $1.79 per share for 1992. Earnings per share for 1991 was $1.48 per share. Earnings per share for 1992 and 1991 represents increases of 20.9% and 19.4%, respectively, over the preceding year. The sum of per share earnings by quarter does not equal earnings per share for the year ended December 31, 1993, due to the effect of shares issued during 1993. SALES Net sales during 1993 were $4,162.6, an increase of $381.9 or 10.1% versus 1992 net sales of $3,780.7. Net sales during 1991 were $3,807.4. Domestic sales increased by $430.9 or 17.9% in 1993 versus 1992, while 1992 domestic net sales decreased $53.6 or 2.2% versus 1991. Domestic net sales in 1991 increased 38.3% over 1990. The increase in 1993 domestic net sales primarily reflects (i) a full year sales of CONSTAR, $600 in 1993 versus approximately $100 in 1992 for two months from the date of acquisition, (ii) $130 from the acquisition of Van Dorn and (iii) increased sales unit volume in aerosol and composite cans; offset by (i) lower raw material costs which were passed on to customers in the form of reduced selling prices and (ii) continued competitive pricing in the North America beverage can market. The decrease in 1992 domestic net sales was primarily a result of lower material costs passed on as reduced selling prices to customers offset partially by the addition of CONSTAR sales of $100 for two months. The increase in 1991 net sales was primarily due to the Company's acquisitions as described in Note C to the Consolidated Financial Statements. International sales decreased $49 or 3.6% in 1993 versus 1992, which compares to increases of 2.0% and 4.0% in 1992 and 1991 over the respective preceding years. The decrease in international net sales reflects (i) $100 due to the continued strengthening of the U.S. dollar against most currencies in which the Company's affiliates operate and (ii) the continuing recession in Europe; offset partially by the acquisition of Wellstar Holding B.V. which contributed $85 from the date of acquisition. International sales unit volumes for plastic closures, beverage cans, food cans and aerosol cans improved in 1993, while crown volumes declined. COST OF PRODUCTS SOLD Cost of products sold, excluding depreciation and amortization for 1993 was $3,474.0, an 8.7% increase from the $3,197.4 in 1992. This increase follows a 2.8% decrease and a 24.6% increase in 1992 and 1991, respectively. The increase in 1993 cost of products sold primarily reflects increased sales levels as noted above offset by lower raw material costs and continuing company-wide cost containment programs. The 1992 decrease was primarily due to lower material costs while the 1991 increase reflects higher sales level of the Company's products. Crown Cork & Seal Company, Inc. As a percent of net sales, cost of products sold was 83.5% in 1993 as compared to 84.6% in 1992 and 86.4% in 1991. SELLING AND ADMINISTRATIVE Selling and administrative expenses for 1993 were $126.6, an increase of 12.9% over 1992. This increase compares to increases of 6.4% for 1992 and 22.3% for 1991. Selling and administrative expenses have increased in recent years as a result of businesses acquired. As a percent of net sales, selling and administrative expenses were 3.0% in 1993 and 1992, and 2.8% in 1991. OPERATING INCOME The Company views operating income as the measure of its performance before interest costs and other non-operating expenses. Operating income of $378.7 in 1993 was $58.7, or 18.3% greater than in 1992. Operating income was $320.0 in 1992, an increase of 17.6% over 1991, and $272.0 in 1991, an increase of 17.1% versus 1990. Operating income as a percent of net sales was 9.1% in 1993 as compared to 8.5% in 1992 and 7.1% in 1991. Operating profit in the Company's U.S. operations was 10.2% of net sales in 1993 versus 10.5% and 6.9% in 1992 and 1991, respectively. Productivity improvement, research and development and continuing programs to contain and reduce cost have all contributed to retain and increase domestic margins in 1993 and 1992 despite competitive pricing pressures. European operating profit increased to 5.7% of net sales in 1993 from 4.9% in 1992. The higher operating profit margins reflect the benefits associated with the Company's continuing efforts to restructure its European operations in response to the changing economic environment in the region. Operating profit in North and Central America (other than the United States) at $23.3 in 1993 was 5.0% of net sales as compared to 1.8% in 1992. These increased results are a result of (i) costs associated with closing three Canadian plants in 1992 and (ii) better market conditions and demand in 1993 compared to 1992 in Canada; offset by lower unit sales in most product lines in Mexico. The Company is pleased with the signs of improvement in its Canadian operations, a result of several restructuring actions taken in 1992 and 1991 and is poised to take the necessary steps to compete in the changing economic environment in Mexico. NET INTEREST EXPENSE/INCOME Net interest expense was $79.7 in 1993, an increase of $15.8 when compared to 1992 net interest of $63.9. Net interest expense was $66.6 in 1991. The increase in 1993 net interest expense is due primarily to bank borrowings necessary to finance the CONSTAR acquisition, offset by lower interest rates and the repayment of a $100 note in June 1993 which carried an interest rate of 9.17%. The decrease in 1992 net interest expense was due to declining interest rates and the repayment, in June 1992, of a $100 note which had an interest rate of 9.13%. The increase in 1991 net interest expense was due to bank borrowings necessary to fund 1991 and 1990 acquisitions. Specific information regarding acquisitions is found in Note C to the Consolidated Financial Statements, while information specific to company financing is presented in the Liquidity and Capital Resources section of this discussion and Notes I and L to the Consolidated Financial Statements. TAXES ON INCOME The effective tax rates on income were 34.8%, 39.7% and 40.1% in 1993, 1992 and 1991, respectively. The lower effective rate for 1993 was primarily a result of lower effective tax rates in non-U.S. operations compared to 1992. The higher effective tax rates versus the U.S. statutory rate in 1992 and 1991 are primarily due to the effect of different tax rates in non-U.S. operations and the increase in non-deductible amortization of goodwill and other intangibles, as a result of recent acquisitions. Crown Cork & Seal Company, Inc. EQUITY IN EARNINGS OF AFFILIATES, NET OF MINORITY INTERESTS Equity in earnings of affiliates was $5.0, $6.3 and $6.2 for 1993, 1992 and 1991, respectively. The decrease in equity earnings in 1993 is primarily a result of the Company selling 30% of its interest in its joint venture in Saudi Arabia. Minority interests were $6.5, $4.6 and $3.1 in 1993, 1992 and 1991, respectively. The increases in minority interests relate to (i) more favorable results in the Company's 50.1% interest in a Hong Kong joint venture, (ii) the commencement of production and sales in the Company's 50% interest in Dubai, United Arab Emirates and (iii) the late 1992 sale by the Company of 50% of its South African affiliate and 30% of certain other African businesses to form a joint venture partnership with another South African packaging company. During 1993 the Company's CONSTAR International subsidiary acquired the remaining 56% of Wellstar Holding, B.V. The Company, beginning in 1993, consolidates this wholly-owned subsidiary. With the acquisition of Continental Can International Corporation, Inc. (CCIC) in 1991, the Company acquired minority interests in joint ventures in the Middle East, Korea and South America. Additionally, the Company acquired a 50.1% ownership interest in a joint venture in Hong Kong. As a result of these ownership interests, the Company now has sources of income and cash flow from non-consolidated affiliates and additional liabilities of minority partners. Due to the acquisition of CCIC, the Company has entered many new markets. These new markets provide excellent future growth potential for the Company's products and services while at the same time introducing the Company to viable business partners. The Company believes that the use of business partners in many overseas locations presents another cost-effective means of entering new markets. The Company has presented earnings from equity affiliates, net of minority interests (the components of which can be found in Notes F and P to the Consolidated Financial Statements), as a separate component of net income. Management believes that presenting such earnings as a component of pre-tax income would distort the Company's effective tax rate, and as such, has presented equity earnings after the provision for income taxes. INDUSTRY SEGMENT PERFORMANCE This section presents individual segment results for the last three years. The after-tax charge of $81.8 or $.96 per share related to adoption of SFAS 106, SFAS 109 and SFAS 112 in 1993 is included as an after tax charge in the Metal Packaging segment of $83.7 or $.98 per share and an after-tax credit in the Plastic Packaging segment of $1.9 or $.02 per share, and is excluded in making comparisons of 1993 results with prior years. Net sales for the Metal Packaging segment in 1993 were $3,367.0, down $206.1 or 5.8% compared to 1992 net sales of $3,573.1. Net sales during 1991 were $3,733.0. Sales in the segment have declined in recent years primarily as a result of lower raw material costs which have been passed on to customers in the form of reduced selling prices. Metal Packaging 1993 operating income was $308.5 or 9.2% of net sales compared to $296.4 in 1992 which was 8.3% of net sales. Operating income in 1991 was $261.4 or 7.0% of net sales. The increase in operating income reflects the successful integration of acquisitions made since 1989. Despite competitive price pressures and costs associated with restructuring efforts in North America and Europe, the Company has streamlined its organizational structure and improved efficiency to achieve significant cost reductions and increase operating profits. Net sales for the Plastic Packaging segment in 1993 increased $588.0 or 283.2% to $795.6 in 1993 from $207.6 in 1992. Net sales for 1992 increased $133.2 or 179.0% against 1991 net sales of $74.4. The increase in 1993 is primarily a result of the Company's October 1992 acquisition of CONSTAR International Inc. ("CONSTAR") and the acquisition during 1993 of the remaining 56% interest in Wellstar Holding B.V. Crown Cork & Seal Company, Inc. ("Wellstar") by CONSTAR. The full year sales of CONSTAR contributed approximately $600 in 1993 compared to two months sales in 1992 of approximately $100. Wellstar from the date of acquisition contributed net sales of $85 in 1993. Plastic Packaging 1993 operating income was 8.8% of net sales at $70.2 compared to 11.4% or $23.6 in 1992. Operating income in 1991 was $10.6 or 14.2% of net sales. Increased competition, product sales mix and the recession in Europe have contributed to decreased margins. ACCOUNTING CHANGES The Company, as required, adopted SFAS 106 and SFAS 109 on January 1, 1993. Additionally, during the fourth quarter, the Company adopted SFAS 112 retroactive to January 1, 1993. The after-tax effect of these accounting changes was a one-time charge to 1993 earnings of $81.8 or $.96 per share, with an incremental charge to 1993 earnings of $2.5 or $.03 per share. These accounting changes are more fully described in Note B to the Consolidated Financial Statements. Adoption of the above three statements did not and will not have any cash flow impact on the Company. FINANCIAL POSITION LIQUIDITY AND CAPITAL RESOURCES The Company's financial position remains strong. Cash and cash equivalents totaled $54.2 at December 31, 1993, compared to $26.9 and $20.2 at December 31, 1992 and 1991, respectively. The Company had working capital of $43.8 at December 31, 1993. The Company's primary sources of cash in 1993 consisted of (i) funds provided from operations, $352.5; (ii) proceeds from short-term debt borrowings, $136.5; (iii) proceeds from sale of businesses, $83.6; and, (iv) proceeds from long-term debt borrowings, $548.3. The Company's primary uses of cash in 1993 consisted of (i) payments on long-term debt, $715.0; (ii) acquisition of and investments in businesses, $66.2; (iii) capital expenditures, $271.3 and (iv) repurchases of common stock, $86.5. The Company funds its working capital requirements on a short-term basis primarily through issuances of commercial paper. The commercial paper program is supported by revolving bank credit agreements with several banks with equal maturities on December 12, 1994 and December 20, 1995. Maximum borrowing capacity under the agreements is $550. There are no borrowings currently outstanding under these agreements. There was $324.0 and $154.0 in commercial paper outstanding at December 31, 1993 and 1992, respectively. In January 1993, the Company filed with the Securities and Exchange Commission a shelf registration statement for the possible offering and sale of up to $600 aggregate principal amount of debt securities of the Company. On April 7, 1993 the Company sold $500 of public debt securities in three maturity tranches through Salomon Brothers Inc. and The First Boston Corporation. The notes and debentures were issued pursuant to the shelf registration of debt securities and are rated Baa1 by Moody's Investors Service and BBB+ by Standard & Poor's Corporation. The three tranches include $100 of 5.875% notes due 1998, priced at par; $200 of 6.75% notes due 2003, priced at 99.625% to yield 6.80%; and $200 of 8% debentures due 2023, priced at 99.625% to yield 8.03%. Net proceeds from the issues were used to repay the bank facility which financed the acquisition of CONSTAR International in October 1992. The Company has $100 remaining on the shelf registration. The Company has, when considered appropriate, hedged its currency exposures on its foreign denominated debt through various agreements with lending institutions. The Company also utilizes a corporate "netting" system which enables resources and liabilities to be pooled and then netted, thereby mitigating the exposure. During 1993, the Company acquired businesses for approximately $222, following acquisitions in 1992 and 1991 of $539 and $235, respectively. The details of such acquisitions are discussed in Note C to the Crown Cork & Seal Company, Inc. Consolidated Financial Statements. The Company has established reserves to restructure acquired companies. At December 31, 1993 and 1992, these reserves totaled $105.2 and $94.9, respectively, and have been allocated to the purchase price of acquired companies. These reserves relate primarily with the costs associated with Company plans to combine acquired company operations with existing operations such as, severance costs, plant consolidations and lease terminations. The Company estimates that 1994 cash expenditures related to its restructuring efforts will approximate $54.3 and cash expenditures for the three years ended December 31, 1996, will approximate $90. Cash expenditures for restructuring efforts were $81, $30 and $18 for the years ended December 31, 1993, 1992, and 1991, respectively. The Company's ratio of total debt (net of cash and cash equivalents) to total capitalization was 50.1%, 52.1% and 40.5% at December 31, 1993, 1992 and 1991, respectively. Total capitalization is defined by the Company as total debt, minority interests and shareholders' equity. The increase in the Company's total debt in recent years is due to businesses acquired since December 29, 1989. As of December 31, 1993, $101.9 of long-term debt matures within one year. During the year the Company repaid $100 private placement debt which carried an interest rate of 9.17%. Additionally, the Company's Canadian subsidiary repaid CDN $100 private placement debt, partially with funds received from a property settlement and the balance with a capital increase from the parent Company. Management believes that, in addition to current financial resources (cash and cash equivalents and the Company's commercial paper program), adequate capital resources are available to satisfy the Company's investment programs. Such sources of capital would include, but not be limited to, bank borrowings. Management believes that the Company's cash flow is sufficient to maintain its current operations. CAPITAL EXPENDITURES Capital expenditures in 1993 amounted to $271.3 as compared with $150.6 in 1992. During the past five years capital expenditures totaled $730.7. Expenditures in the North American Division totaled $93 with major spending for beverage end conversion in Dayton, Ohio, a new technical center and aerosol plant in Alsip, Illinois and 2-piece food cans in Owatonna, Minnesota. Additional projects to convert beverage can and end lines in other plants to a smaller diameter began in 1993. Investments of $83 were made in the International Division. The Company constructed new plants and installed both beverage can and plastic cap production lines in Dubai, United Arab Emirates and Argentina. The Company is currently constructing a beverage can plant in Shanghai, China. Additionally, the Company constructed a new aerosol plant near Amsterdam, The Netherlands to service a major customer's centralized European filling plant. Expansion of existing plastic cap production in Italy and Germany, as well as the installation of single-serve PET equipment in Portugal have diversified the International Division from primarily metal packaging to include plastic products. With the acquisition of CONSTAR in October 1992, the Company made a commitment to service global customers with plastic containers. The Company continued this commitment with spending of $94 in 1993 within the Plastics Division. Major spending included capacity expansion of existing products and installation of several single-serve PET lines in the United States. New single-serve PET preform and bottle lines were also installed in CONSTAR's subsidiaries in England, Holland and Hungary. The Company expects its capital expenditures in 1994 to approximate $400. The Company plans to continue capital expenditure programs designed to take advantage of technological developments which enhance productivity and contain cost as well as those that provide growth opportunities. Capital expenditures, exclusive of potential acquisitions, during the five year period 1994 through 1998 are expected to approximate $1,500. Cash flow from operating activities will provide the principal support for Crown Cork & Seal Company, Inc. these expenditures; however, depending upon the Company's evaluation of growth opportunities and other existing market conditions, external financing may be required from time to time. ENVIRONMENTAL MATTERS The Company has adopted a Corporate Environmental Protection Policy. The implementation of this Policy is a primary management objective and the responsibility of each employee of the Company. The Company is committed to the protection of human health and the environment, and is operating within the increasingly complex laws and regulations of federal, state, and local environmental agencies or is taking action aimed at assuring compliance with such laws and regulations. Environmental considerations are among the criteria by which the Company evaluates projects, products, processes and purchases and, accordingly, does not expect compliance with these laws and regulations to have a material effect on the Company's competitive position, financial condition, results of operations or capital expenditures. The Company is dedicated to a long-term environmental protection program and has initiated and implemented many pollution prevention programs with the emphasis on source reduction. The Company continues to reduce the amount of metals and plastics used in the manufacture of steel, aluminum and plastic containers through a "lightweighting" program. The Company not only recycles nearly 100 percent of scrap aluminum, steel, plastic and copper used in the manufacturing process, but through its Nationwide Recyclers subsidiary is directly involved in post-consumer aluminum and steel can recycling. Nationwide Recyclers, in 1994, will also be directly involved in post-consumer plastics recycling. Additionally, the Company has already exceeded the Environmental Protection Agency's (EPA) 1995 goals for its 33/50 program which calls for companies, voluntarily, to reduce toxic air emissions by 33% by the end of 1992 and by 50% by the end of 1995, compared to the base year of 1988. The Company, at the end of 1993, had achieved a more than 64% reduction in the releases of such emissions for all U.S. facilities. The cost to accomplish this reduction did not materially affect operating results. Many of the Company's programs for pollution prevention lower operating costs and improve operating efficiencies. The Company has been identified by the EPA as a potentially responsible party (along with others, in most cases) at a number of sites. Estimated remedial expenses for active projects are recognized in accordance with generally accepted accounting principles governing probability and the ability to reasonably estimate future costs. Actual expenditures for remediation were $2.2 during 1993 and $1.7 in 1992. The Company's balance sheet reflects a net accrual for future expenditures to remediate known sites of $11.3 at December 31, 1993 and 1992, respectively. Gross remediation liabilities were estimated at $30.7 and $33.3 at December 31, 1993 and 1992, respectively. Indemnification received from the sellers of acquired companies and the Company's insurance carriers was estimated at $19.4 and $22.0 at December 31, 1993 and 1992, respectively. Environmental exposures are difficult to assess for numerous reasons, including the identification of new sites, advances in technology, changes in environmental laws and regulations and their application, the scarcity of reliable data pertaining to identified sites, the difficulty in assessing the involvement of the financial capability of other potentially responsible parties and the time periods (sometimes lengthy) over which site remediation occurs. It is possible that some of these matters (the outcome of which are subject to various uncertainties) may be decided unfavorably against the Company. It is, however, the opinion of Company management after consulting with counsel, that any unfavorable decision will not have a material adverse effect on the Company's financial position. COMMON STOCK AND OTHER SHAREHOLDERS' EQUITY Shareholders' equity was $1,251.8 at December 31, 1993, as compared with $1,143.6 at December 31, 1992. The increase in 1993 equity represents the retention of $99.1 of earnings in the business (net of $81.8 of accounting changes as more fully described in Note B to the Consolidated Financial Statements), the issuance of 3,631,624 common shares for the acquisition of Van Dorn Company and the issuance of 1,415,711 common shares for various stock purchase and savings plans offset by the effect of 2,580,982 common shares repurchased, $46.3 minimum pension liability adjustment as more fully described in Note Crown Cork & Seal Company, Inc. N to the Consolidated Financial Statements and equity adjustments for currency translation in non-U.S. subsidiaries of $29.3. The book value of each share of common stock at December 31, 1993, was $14.09, as compared to $13.24 at December 31, 1992. In 1993, the return on average shareholders' equity before cumulative effect of accounting changes was 14.6% as compared with 13.9% in 1992. The Company purchased 2,536,330 shares of its common stock from CCL Industries Inc. ("CCL") on January 7, 1993 for approximately $84.8. The Company and CCL had agreed to the share repurchase in August of 1992 at a then agreed purchase price of $33.00 per share, plus an adjustment computed at a rate of 3.5% per annum. The January 7, 1993 settlement was funded by cash flow from operations, borrowings and cash received from CCL of approximately $21. The cash received from CCL related to the settlement of guarantees made by CCL to the Company regarding the value of certain properties in connection with the Company's 1989 acquisition of Continental Can Canada Inc. The Company issued to CCL a total of 7,608,993 shares in the 1989 acquisition of Continental Can Canada Inc. The purchase of common stock from CCL was made pursuant to the Company's right of first refusal to purchase common stock offered for sale by CCL. After giving effect to the repurchase transaction, CCL held 2,536,331 shares or approximately 2.9% of the Company's shares then outstanding following the January 7, 1993 settlement date. In August 1992, the Company repurchased 1,500,000 shares from the Connelly Foundation for approximately $50.1 or approximately $33.38 per share. The purchase of shares from the Connelly Foundation was funded by cash flow from operations of $25 and an interest bearing note, at 3.5%, of approximately $25.1. The Company settled the note in December 1992 with cash flow from operations. At December 31, 1993, the Connelly Foundation held 8,554,700 shares of the Company's common stock which represented approximately 10% of the 88,814,533 shares then outstanding. The Board of Directors has approved resolutions authorizing the Company to repurchase shares of its common stock to meet the requirements for the Company's various stock purchase and savings plans. The Company acquired 2,580,982, 1,747,774, and 2,735,898 shares of common stock in 1993, 1992, and 1991 for $86.5, $61.4, and $69.1, respectively. These purchases included the purchases of stock held by the Connelly Foundation in 1992 and by CCL in 1993 and 1991. The Company has traditionally not paid dividends and does not anticipate paying dividends in the foreseeable future. At December 31, 1993 common shareholders of record numbered 6,168 compared with 4,193 at the end of 1992. INFLATION General inflation has not had a significant impact on the Company over the past three years due to strong cash flow from operations. The Company continues to maximize cash flow through programs designed for cost containment, productivity improvements and capital spending. Management does not expect inflation to have a significant impact on the results of operations or financial condition in the foreseeable future. Crown Cork & Seal Company, Inc. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Financial Statements Report of Independent Accountants 18 Consolidated Statements of Income 19 Consolidated Balance Sheets 20 Consolidated Statements of Cash Flows 21 Consolidated Statements of Shareholders' Equity 22 Notes to Consolidated Financial Statements 23 Financial Statement Schedules Schedule V - Property, Plant and Equipment 40 Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment 41 Schedule VIII - Valuation and Qualifying Accounts 42 Schedule X - Supplementary Income Statement Information 44 Crown Cork & Seal Company, Inc. Report of Independent Accountants To the Shareholders and Board of Directors of Crown Cork & Seal Company, Inc. In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Crown Cork & Seal Company, Inc. and its subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe our audits provide a reasonable basis for the opinion expressed above. As discussed in Note B, the Company changed its methods of accounting for income taxes, postretirement benefits and postemployment benefits in 1993. PRICE WATERHOUSE Thirty South Seventeenth Street Philadelphia, Pennsylvania 19103 March 14, 1994 Crown Cork & Seal Company, Inc. CONSOLIDATED STATEMENTS OF INCOME (in millions, except per share amounts) The accompanying notes are an integral part of these financial statements. Earnings per average common share for 1991 has been restated to reflect the 3 for 1 common stock split to shareholders of record as of May 12, 1992. Crown Cork & Seal Company, Inc. CONSOLIDATED BALANCE SHEETS (in millions, except share data) The accompanying notes are an integral part of these financial statements. Certain reclassifications of prior years' data have been made to improve comparability. Crown Cork & Seal Company, Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS (in millions) The accompanying notes are an integral part of these financial statements. Crown Cork & Seal Company, Inc. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (in millions, except share data) The accompanying notes are an integral part of these financial statements. Share data for prior years has not been restated for the 3 for 1 common stock split declared in 1992. Certain reclassifications of prior years' data have been made to improve comparability. Crown Cork & Seal Company, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (in millions, except per share, employee, shareholder and statistical data) (share data for years prior to 1992 have been restated for the 3 for 1 common stock split declared in 1992) A. Summary of Significant Accounting Policies Principles of Consolidation The consolidated financial statements include the accounts of Crown Cork & Seal Company, Inc. and its wholly-owned and majority-owned subsidiary companies. All significant intercompany accounts and transactions are eliminated in consolidation. Investments in joint ventures and other companies in which Crown does not have control, but has the ability to exercise significant influence over operating and financial policies (generally greater than 20% ownership) are accounted for by the equity method. Other investments are carried at cost. Foreign Currency Translation For non-U.S. subsidiaries which operate in a local currency environment, assets and liabilities are translated into U.S. dollars at year-end exchange rates. Income and expense items are translated at average rates prevailing during the year. Translation adjustments for these subsidiaries are accumulated in a separate component of Shareholders' Equity. For non-U.S. subsidiaries which operate in U.S. dollars (functional currency) or whose economic environment is highly-inflationary, local currency inventories and plant and other property are translated into U.S. dollars at approximate rates prevailing when acquired; all other assets and liabilities are translated at year-end exchange rates. Inventories charged to cost of sales and depreciation are remeasured at historical rates; all other income and expense items are translated at average exchange rates prevailing during the year. Gains and losses which result from remeasurement are included in earnings. Cash and Cash Equivalents Cash equivalents represent investments with maturities of three months or less from the time of purchase, and are carried at cost which approximates fair value because of the short maturity of those instruments. Inventory Valuation Inventories are carried at the lower of cost or market, with cost for all domestic metal and plastic container, crown and closure inventories determined under the last-in, first-out (LIFO) method. Machinery Division and non-U.S. inventories are principally determined under the average cost method. Goodwill Goodwill, representing the excess of the cost over the net tangible and identifiable intangible assets of acquired businesses, is stated on the basis of cost and is amortized, principally on a straight-line basis, over the estimated future periods to be benefitted (primarily 40 years). Accumulated amortization amounted to $62.7 and $35.1 at December 31, 1993 and 1992, respectively. Property, Plant and Equipment Property, plant and equipment (PP&E) is carried at cost and includes expenditures for new facilities and those costs which substantially increase the useful lives of existing PP&E. Maintenance, repairs and minor renewals are expensed as incurred. When properties are retired or otherwise disposed, the related costs and accumulated depreciation are eliminated from the respective accounts and profit or loss on disposition is reflected in income. Costs assigned to PP&E of acquired businesses are based on estimated fair value at the date of acquisition. Depreciation and amortization are provided on a straight-line basis for financial reporting and an accelerated basis for tax purposes. The useful lives range between 40 years for buildings and 5 years for vehicles. Crown Cork & Seal Company, Inc. Off-Balance Sheet Risk and Financial Instruments The Company enters into forward exchange contracts, primarily in European currencies, to hedge certain foreign currency transactions for periods consistent with the terms of the underlying transactions. At December 31, 1993, the Company had contracts to purchase approximately $37 and to sell approximately $23 in foreign currency. Based on year-end exchange rates and the maturity dates of the various contracts, the estimated aggregate contract value approximates the fair value of these items at December 31, 1993. Treasury Stock Treasury stock is reported at par value and constructively retired. The excess of fair value over par value is first charged to paid-in capital, if any, and then to retained earnings. Research and Development Research, development and engineering expenditures which amounted to $23.3, $16.7 and $16.1 in 1993, 1992 and 1991, respectively, are expensed as incurred. Earnings Per Share Earnings per share amounts are computed based on the weighted average number of shares actually outstanding during the period plus the shares that would be outstanding assuming the exercise of dilutive stock options, which are considered to be common stock equivalents. The number of equivalent shares that would be issued from the exercise of stock options is computed using the treasury stock method. Reclassifications Certain reclassifications of prior years' data have been made to improve comparability. B. Accounting Changes Effective January 1, 1993, the Company adopted, as required, SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," and SFAS No. 109, "Accounting for Income Taxes." In the fourth quarter of 1993, effective January 1, 1993, the Company adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits." The incremental after-tax effect of these accounting changes was a non-cash charge to 1993 earnings of $2.5 or $.03 per share. SFAS No. 106 requires employers to recognize the costs and obligations for postretirement benefits other than pensions over the employees' service lives. Previously, such costs were generally recognized as an expense when paid. The cumulative effect of implementing SFAS No. 106 as of January 1, 1993 resulted in a non-cash after-tax charge to net income of $89.2 or $1.03 per share. SFAS No. 109 establishes new accounting and reporting standards for income taxes and requires adopting the liability method, which replaces the deferred method required by Accounting Principles Board Opinion (APB) No. 11. The cumulative effect of implementing SFAS No. 109 as of January 1, 1993 resulted in a non-cash increase to net income of $23.5 or $.27 per share. SFAS No. 112 requires employers to accrue the costs and obligations of postemployment benefits (severance, disability, and related life insurance and health care benefits) to be paid to inactive or former employees. Prior to adoption, the Company had recognized expense for the cost of these benefits either on an accrual or on an "as paid" basis, depending on the plan. The cumulative effect of implementing SFAS No. 112 resulted in a non-cash after-tax charge to net income of $16.1 or $.18 per share as of January 1, 1993. Crown Cork & Seal Company, Inc. C. Acquisitions On April 16, 1993, the Company's acquisition of the Van Dorn Company was completed through the issuance of 3,631,624 shares of the Company's common stock valued at approximately $140, and the payment in cash of approximately $37. The cash portion was financed through cash from operations. Van Dorn's Plastic Machinery Division was then sold on April 20, 1993 for approximately $81 in cash to an affiliate of Mannesmann Demag, AG. During 1993, the Company through its affiliate, CONSTAR International, also acquired, in separate transactions, Wellman, Inc.'s 50% interest in Wellstar Acquisition, B.V., for consideration of approximately $33 in cash, and the minority interest in Wellstar Acquisition's affiliate, Wellstar Holding, B.V. The Company now owns 100% of Wellstar Holding. During 1992, the Company acquired the outstanding stock of Constar International, Inc. (CONSTAR) for approximately $519 in cash, which was financed through bank borrowings. Additionally, during 1992, the Company acquired in separate transactions with an aggregate cost of approximately $20, the stock of a tooling and machine overhaul company in Wisconsin, the assets of a coil coating facility in Ohio and the assets of a crown manufacturer in Texas. The cost of these acquisitions was financed through cash from operations. In 1991, the Company acquired all of the outstanding stock of Continental Can International Corporation, Inc. (Continental International) from Continental Can Europe, Inc. for $125 in cash of which $94 was financed through bank borrowings. Included in this acquisition were a wholly-owned subsidiary in Mexico, a majority-owned subsidiary in Hong Kong and minority interests in joint ventures in the Middle East, Asia and South America. During 1991, the Company also acquired, in separate transactions with an aggregate cost of approximately $110, the stock of machinery operations in Florida and the Philadelphia area, the stock of a can manufacturer in Orlando, Florida, the assets of a beverage closure business in Virginia and the assets of a can manufacturer in Canada. The cost of these acquisitions was funded through the issuance of 469,800 shares of the Company's common stock valued at approximately $13 and cash of approximately $97. The cash portion was financed through bank borrowings of approximately $85 and cash from operations of approximately $12. For financial reporting purposes, all of the acquisitions above were treated as purchases. An excess purchase price of approximately $632 has been determined, based upon the fair values of assets acquired and liabilities assumed in connection with the above acquisitions. A final allocation of the purchase price for 1993 acquisitions will be determined during 1994 when appraisals and other studies, particularly relating to restructuring costs, are completed. The operating results of each acquisition are included in consolidated net income from the date of acquisition. The following represents the unaudited pro forma results of operations as if the above noted business combinations had occurred at the beginning of the respective year in which the companies were acquired as well as at the beginning of the immediately preceding year: The pro forma operating results include each company's results of operations for the indicated years with increased depreciation and amortization on property, plant and equipment along with other relevant adjustments to reflect fair market value. Interest expense on the acquisition borrowings has also been included. Crown Cork & Seal Company, Inc. The pro forma information given above does not purport to be indicative of the results that actually would have been obtained if the operations were combined during the periods presented, and is not intended to be a projection of future results or trends. D. Receivables E. Inventories Approximately 57% and 53% of worldwide inventories at December 31, 1993 and 1992, respectively, were stated on the last-in, first-out (LIFO) method of inventory valuation. Had average cost (which approximates replacement cost) been applied to such inventories at December 31, 1993 and 1992, total inventories would have been $26.8 and $37.6 higher, respectively. F. Investments In January 1993, the Company sold 30% of its joint venture interest located in Saudi Arabia. During 1993, Constar International, a wholly-owned subsidiary, invested $9.9 in new joint ventures, primarily in Mexico and Turkey. In October 1992, the Company acquired all the outstanding stock of Constar International. With this acquisition the Company acquired a direct voting interest in Wellstar Acquisition, B.V. (Wellstar), a Dutch joint venture. During 1993, the Company acquired the remaining interest in Wellstar and has consolidated its results since acquiring a majority interest. Crown Cork & Seal Company, Inc. During 1992, the Company determined that it had operational and financial control over its joint venture investment located in China. Accordingly, the Company has consolidated the financial results of this joint venture in 1992. The effect on the Company's financial position is not significant. There was no effect on consolidated 1992 net income and prior periods have not been restated for this change in reporting entity. G. Property, Plant and Equipment H. Consolidated Non-U.S. Subsidiaries The condensed financial statements of the majority-owned non-U.S. subsidiaries are as follows: Net income from consolidated non-U.S. subsidiaries in 1992 reflects the Company's continuing efforts to restructure its businesses in Europe and Canada. Foreign exchange losses emanate primarily from the Company's holdings in Latin America. In 1991, the functional currency for the Company's affiliates in Mexico was changed to the local currency in accordance with the provisions of SFAS No. 52. On May 16, 1991, the Company acquired all the outstanding stock of Continental Can International Corporation. With this acquisition, the Company acquired a wholly-owned subsidiary in Mexico and a majority-owned affiliate in Hong Kong. The results of operations from the date of acquisition and the financial position are consolidated herein. Crown Cork & Seal Company, Inc. Combined net assets of non-U.S. subsidiaries reflected in the Consolidated Balance Sheets are: I. Short-Term Debt Domestic and Canadian operations' working capital requirements are funded on a short-term basis through the issuance of commercial paper. Short-term funds for certain international operations are obtained through bank overdrafts and short-term notes payable. The weighted average interest rates for the years ending December 31, 1993, 1992 and 1991 were determined using the average rate for each month. The Company has additional unused lines of credit amounting to $550 available under formal borrowing arrangements with various banks. Crown Cork & Seal Company, Inc. J. Accounts Payable and Accrued Liabilities Cash payments for interest were $82.2 in 1993, $78.4 in 1992 and $87.3 in 1991. K. Other Non-Current Liabilities Recognition of tax benefits associated with postretirement benefits resulted in a decrease of $190.4 in the deferred tax liability. Crown Cork & Seal Company, Inc. L. Long-Term Debt The aggregate maturities on all long-term debt are $101.9, $150.1, $128.5, $67.1 and $117.1 for each of the years ending December 31,1994 through 1998, respectively. Crown Cork & Seal Company, Inc. Proceeds from the shelf registration filed in January 1993 were used to repay the $525 term loan. The Company has $100 remaining on the shelf registration. The carrying value of total debt as of December 31, 1993 and 1992 does not differ materially from its estimated market value. M. Stock Options All amounts below have been adjusted to reflect the 3 for 1 stock split to shareholders of record as of May 12, 1992. In accordance with the Incentive Stock Option Plan adopted in December 1983, options to purchase 7,200,000 Common Shares have been granted to officers and key employees. Options were granted at market value on the date of grant and are exercisable beginning one year from date of grant and terminate up to ten years from date of grant. In accordance with the non-qualified Stock Option Plan for senior executives, adopted in July 1984, options to purchase 1,980,000 Common Shares have been granted. Options were granted at market value on the date of grant and are exercisable beginning two years from date of grant and terminate five years from date of grant. In accordance with the 1990 Stock-Based Incentive Compensation Plan adopted in December 1990, options to purchase 6,000,000 common shares can be granted to officers and key employees. Options were granted at market value on the date of grant and are exercisable beginning one to two years from date of grant and terminate up to ten years from date of grant. On April 25, 1991, the shareholders Crown Cork & Seal Company, Inc. approved the proposal to amend the 1990 Stock-Based Incentive Compensation Plan to increase the number of shares available for awards by 1,500,000 to an aggregate of 6,000,000 shares. N. Pensions and Other Retirement Benefits Pensions The Company sponsors various pension plans, covering substantially all U.S., Canadian and some non-U.S. and non-Canadian employees and participates in certain multi-employer pension plans. The company-sponsored plans are currently funded. The benefits for these plans are based primarily on years of service and the employees' remuneration near retirement. Contributions to multi-employer plans in which the Company and its non-U.S. and non-Canadian subsidiaries participate are determined in accordance with the provisions of negotiated labor contracts or applicable local regulations. Plan assets of company-sponsored plans of $1,253.4 consist principally of common stocks, including $241.3 of the Company's common stock. Pension income amounted to $18.6 (including expense of $5.7 for non-company sponsored plans) in 1993, income of $4.8 (including expense of $6.0 for non-company sponsored plans) in 1992 and expense of $14.8 (including expense of $3.8 for non-company sponsored plans) in 1991. Pension cost for non-U.S. and non-Canadian plans in 1993, 1992 and 1991 was determined under statutory accounting principles which are not considered materially different from U.S. generally accepted accounting principles. The 1993, 1992 and 1991 components of pension cost for company-sponsored plans were as follows: Crown Cork & Seal Company, Inc. The funded status of company-sponsored plans, including the assets and liabilities assumed in connection with acquisitions, at December 31, 1993 and 1992 was as follows: In addition to total pension (income) cost shown above, accrued pension cost includes $36.1 and $10.5 related to plan curtailments resulting from plant closings in 1992 and 1991, respectively, the effects of which were allocated to the purchase price of acquired companies. The Company recognized a minimum pension liability for underfunded plans. The minimum liability is equal to the excess of the accumulated benefit obligation over plan assets. A corresponding amount is recognized as either an intangible asset, to the extent of previously unrecognized prior service cost and previously unrecognized transition obligation, or a reduction of shareholders' equity. The Company had recorded additional liabilities of $84.8 and $12.2 as of December 31, 1993 and 1992, respectively. An intangible asset of $1.5 and a shareholders' equity reduction, net of income taxes, of $46.3 was recorded as of December 31, 1993. The additional liability recognized at December 31, 1992 was allocated to the purchase price of acquired companies. The weighted average actuarial assumptions for the Company's pension plans are as follows: Other Postretirement Benefit Plans The Company and certain subsidiaries sponsor unfunded plans to provide health care and life insurance benefits to pensioners and survivors. Generally, the medical plans pay a stated percentage of medical expenses reduced by deductibles and other coverages. Life insurance benefits are generally provided by Crown Cork & Seal Company, Inc. insurance contracts. The Company reserves the right, subject to existing agreements, to change, modify or discontinue the plans. Health care claims and life insurance benefits paid totaled $41.6 in 1993, $35.2 in 1992 and $25.1 in 1991. The health care accumulated postretirement benefit obligation was determined using a health care cost trend rate of 12.5% decreasing to 7% over fifteen years. The assumed long-term rate of compensation increase used for life insurance was 5%. The discount rate used was 7.1%. Changing the assumed health care cost trend rate by one percentage point in each year would change the accumulated postretirement benefit obligation by $50.0 and the postretirement net benefit cost by $4.1. Employee Savings Plan The Company, commencing in 1991, sponsors a Savings Investment Plan which covers all domestic salaried employees who are 21 years of age with one or more years of service. The Company matches with equivalent value of Company stock, up to 1.5% of a participant's compensation. The Company's 1993, 1992 and 1991 contributions were approximately $.9, $.9 and $.6, respectively. O. Income Taxes In August 1993, a new income tax law was enacted which increased the maximum corporate income tax rate from 34 percent to 35 percent. The impact on deferred tax assets and liabilities from this change was not significant. Pretax income before cumulative effect of accounting changes for the years ended December 31 was taxed under the following jurisdictions: Crown Cork & Seal Company, Inc. The provision for income taxes differs from the amount of income tax determined by applying the applicable U.S. statutory federal income tax rate to pretax income as a result of the following differences: The Company paid federal, state, local and foreign (net) income taxes of $11.7 for 1993, $38.7 for 1992 and $70.1 for 1991. The components of deferred tax assets and liabilities at December 31, 1993 follow: Other non-current assets includes $20.6 of deferred tax assets. Crown Cork & Seal Company, Inc. Approximately $37.2 of deferred tax assets relating to net operating losses and tax basis differences were available in various foreign tax jurisdictions at December 31, 1993, expiring in the following years: 1994 $ .1 1995 .3 1996 .2 1997 2.9 1998 4.6 1999 1.6 2000 2.2 2001 1.3 Unlimited 24.0 ----- Total 37.2 Portion applicable to minority interests (4.0) ----- Net future benefit available $ 33.2 ===== The Company believes that it is more likely than not that $3.8 of these benefits will be realized by offsetting existing taxable temporary differences that will reverse within the carryforward period. An additional $2.1 is expected to be realized by achieving future profitable operations based on actions taken by the Company. No net benefit has been recorded for the remaining items. Future recognition of these carryforwards will be made either when the benefit is realized or when it has been determined that it is more likely than not that the benefit will be realized against future earnings. No other tax operating loss or credit carryforwards exist for which the Company has recognized a net financial benefit. The cumulative amount of the Company's share of undistributed earnings of non-U.S. subsidiaries for which no deferred taxes have been provided was $401.2, $385.2 and $419.1 as of December 31, 1993, 1992 and 1991, respectively. Management has no plans to distribute such earnings in the foreseeable future. P. Minority Interests During 1993, the Company formed jointly-owned subsidiaries in China. During 1992, the Company formed jointly-owned subsidiaries in the United Arab Emirates (Dubai) and South Africa. Crown Cork & Seal Company, Inc. Q. Leases Minimum rental commitments under all noncancelable operating leases, primarily real estate, in effect at December 31,1993 are: Years ending December 31 1994 $ 21.7 1995 17.8 1996 12.7 1997 10.2 1998 9.4 Thereafter 11.7 ------ Total minimum payments 83.5 Less: Total minimum sublease rentals (6.5) ------ Net minimum rental commitments $ 77.0 Operating lease rental expense (net of sublease rental income of $1.0 in 1993, 1992 and 1991) was $21.9 in 1993, $10.2 in 1992 and $7.9 in 1991. R. Quarterly Data (unaudited) The closing price of the Company's common stock at December 31, 1993 and 1992 was $41.88 and $39.88, respectively. Crown Cork & Seal Company, Inc. Restatement of previously reported 1993 quarterly data to reflect accounting changes resulted in an increase in the net loss of $16.1 and an increase in the net loss per share of $.18 for the first quarter of 1993. The restatement does not have a material effect on net income for the second and third quarters of 1993. S. Segment Information by Industry and Geographic Area A. Industry Segment (1) Transfers between Geographic Areas are not material. (2) Within "Metal Packaging and Other" is the Company's machinery operation which along with other non-metal packaging domestic affiliates are not significant individually or in the aggregate so as to be reported as a separate segment. Crown Cork & Seal Company, Inc. (3) Operating profit for 1992 in Europe and North and Central America includes charges made during the year relating to the Company's continuing efforts to restructure its businesses in these regions. (4) The following reconciles operating profit to pre-tax income: * Includes interest income and expense along with other corporate income and expense items, such as exchange gains and losses and goodwill amortization. (5) The following reconciles identifiable assets to total assets: * Included in identifiable assets for 1993 is: (a) "United States," $96, relating to the acquisition of the Van Dorn Company. (b) "Europe," $42, relating to the acquisition of the remaining interest in CONSTAR International's affiliate, Wellstar Acquisition, B.V. and its affiliate Wellstar Holdings, B.V. ** Included in identifiable assets for 1992 is $525, relating to the acquisition of Constar International. *** Included in identifiable assets for 1991 is: (a) "United States," $150.1, relating to the acquisition of Continental Can International Corporation and other domestic companies as outlined in Note C to the financial statements. (b) "North America," $61.4, relating to the acquisition of Continental Can International's affiliate in Mexico. (c) "Other Non-U.S.," $40.1, relating to the acquisition of Continental Can International's affiliate in Hong Kong. (6) For the year ended December 31, 1993 and prior to 1992, no one customer accounted for more than 10% of the Company's net sales. For 1992, one customer accounted for approximately 10.6% of the Company's net sales. Included in "Other Non-U.S." are affiliates in South America, Africa, Asia and the Middle East. Figures for the United States are not comparable due to the late 1992 acquisition of Constar International and the April 1993 acquisition of the Van Dorn Company. Figures for Europe are not comparable due to the 1993 acquisitions of Wellman's interest in Wellstar Acquisition, B.V. and the minority interest in Wellstar Acquisition's affiliate, Wellstar Holding, B.V. Certain reclassifications of prior years' data have been made to improve comparability. Crown Cork & Seal Company, Inc. and its Consolidated Subsidiaries SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (in millions) For the Year Ended December 31, 1993 (in millions) For the Year Ended December 31, 1992 (in millions) For the Year Ended December 31, 1991 Note: The lives assigned to plant and equipment for depreciation purposes are: Buildings and Facilities 12 to 40 years Machinery and Equipment 5 to 14 years Crown Cork & Seal Company, Inc. and its Consolidated Subsidiaries SCHEDULE VI - ACCUMULATED DEPRECIATION OF PLANT AND EQUIPMENT (in millions) For the Year Ended December 31, 1993 (in millions) For the Year Ended December 31, 1992 (in millions) For the Year Ended December 31, 1991 Crown Cork & Seal Company, Inc. and its Consolidated Subsidiaries SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES 1 OF 2 (In millions) For the year Ended December 31, 1993 (In millions) For the year Ended December 31, 1992 (In millions) For the year Ended December 31, 1991 Crown Cork & Seal Company, Inc. and its Consolidated Subsidiaries SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES 2 OF 2 (In millions) For the year Ended December 31, 1993 (In millions) For the year Ended December 31, 1992 (In millions) For the year Ended December 31, 1991 Crown Cork & Seal Company, Inc. and its Consolidated Subsidiaries SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION (In millions) For the year ended December 31, 1993 COLUMN A COLUMN B Item Charged to Costs and Expenses Maintenance and repairs $170.6 Depreciation of plant and equipment $161.3 Taxes, other than income (excluding payroll taxes) $ 54.7 COLUMN A COLUMN B Item Charged to Costs and Expenses Maintenance and repairs $151.9 Depreciation of plant and equipment $124.8 Taxes, other than income (excluding payroll taxes) $ 39.2 * (In millions) For the year ended December 31, 1991 COLUMN A COLUMN B Item Charged to Costs and Expenses Maintenance and repairs $154.9 Depreciation of plant and equipment $117.8 Taxes, other than income (excluding payroll taxes) $ 33.7 * * Amounts have been restated to exclude payroll taxes so as to be consistent with the requirements of Item 601 Under Regulation S-K. Crown Cork & Seal Company, Inc. ITEM 9.

ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information called for by this Item, Directors and Executive Officers of the Registrant (except for the information regarding executive officers called for by Item 401 of Regulation S-K which is included in Part I, Item 4a of this Report on page 8 under the heading "Executive Officers of the Registrant") is set forth on pages 3, 4 and 5 of the Company's 1994 definitive Proxy Statement in the section entitled "Election of Directors" and on page 13 in the section entitled "Section 16 Requirements" and is incorporated herein by reference. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information set forth on pages 6 through 12 of the Company's 1994 definitive Proxy Statement in the section entitled "Executive Compensation" is incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this Item is set forth on pages 2 through 5 of the Company's 1994 definitive Proxy Statement in the sections entitled "Proxy Statement Meeting, April 28, 1994" and "Election of Directors" and is incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this Item is set forth on pages 3, 4 and 5 of the Company's 1994 definitive Proxy Statement in the section entitled "Election of Directors" and is incorporated herein by reference Crown Cork & Seal Company, Inc. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K a) The following documents are filed as part of this report: (1) All Financial Statements: Crown Cork & Seal Company, Inc. and Subsidiaries (see Part II pages 19 through 39 of this Report). (2) Financial Statement Schedules: Schedule Number V. - Property, Plant and Equipment (see page 40 of this Report). VI.- Accumulated Depreciation and Amortization of Property, Plant and Equipment (see page 41 of this Report). VIII.- Valuation and Qualifying Accounts and Reserves (see pages 42 and 43 of this Report). IX.- Short-term Borrowings (see page 28 of this Report). X. - Supplementary Income Statement Information (see page 44 of this Report). All other schedules have been omitted because they are not applicable or the required information is included in Financial Statements or Notes thereto. (3) Exhibits 3.1 Articles of Incorporation of the Registrant (incorporated by reference to Exhibit 4.1 of the Company's Registration Statement on Form S-4 filed with the Securities and Exchange Commission on March 9, 1993 (Registration No. 33-59286)). 3.2 By-laws of the Registrant (incorporated by reference to Exhibit 3(b) of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 (File No. 1-2227)). 4.1 Form of the Company's 5-7/8% Note Due 1998 (incorporated by reference to Exhibit 22 of Registrant's Current Report on Form 8-K dated April 12, 1993 (File No. 1-2227)). 4.2 Form of the Company's 6-3/4% Note Due 2003 (incorporated by reference to Exhibit 23 of Registrant's Current Report on Form 8-K dated April 12, 1993 (File No. 1-2227)). 4.3 Form of the Company's 8% Debenture Due 2023 (incorporated by reference to Exhibit 24 of Registrant's Current Report on Form 8-K dated April 12, 1993 (File No. 1-2227)). 4.4 Officers' Certificate of the Company (incorporated by reference to Exhibit 4.3 of the Registrant's Quarterly Report on Form 10-Q for the quarter ended March 31, 1993 (File No. 1-2227)). 4.5 Indenture dated as of April 1, 1993 between the Company and Chemical Bank, as Trustee (incorporated by reference to Exhibit 26 of the Registrant's Current Report on Form 8-K dated April 12, 1993 (File No 1-2227)). Crown Cork & Seal Company, Inc. 4.6 Terms Agreement dated March 31, 1993 (incorporated by reference to Exhibit 27 of the Registrant's Current Report on Form 8-K dated April 12, 1993 (File No. 1-2227)). Other long-term agreements of the Registrant are not filed pursuant to Item 601(b)(4)(iii)(A) of regulation S-K, and the Registrant agrees to furnish copies of such agreements to the Securities and Exchange Commission upon its request. 10.1 Crown Cork & Seal Company, Inc. Executive Deferred Compensation Plan (incorporated by reference to Exhibit 10 of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 (No. 1-2227)). 10.2 1990 Stock-Based Incentive Compensation Plan (incorporated by reference to Exhibit 10.2 of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992 (File No. 1-2227)). 10.3 Crown Cork & Seal Company, Inc. Restricted Stock Plan for Non- Employee Directors. (incorporated by the reference to Exhibit 10.3 of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1992 (File No. 1-2227)). 10.4 Crown Cork & Seal Company, Inc. 1984 Non-Qualified Stock Option Plan (incorporated by reference to Exhibit 28 of Registrant's Registration Statement on Form S-8 (No. 33-06261)). 10.5 Crown Cork & Seal Company, Inc. Retirement Thrift Plan (incorporated by reference to Exhibit 4.3 of the Registrant's Registration Statement on Form S-8 (No. 33-50369)). 10.6 Crown Cork & Seal Company, Inc. Stock Purchase Plan (incorporated by reference to Exhibit 4.3 of the Registrant's Registration Statement on Form S-8, filed March 16, 1994 (No. 33-52699)). Exhibits 10.1 through 10.6, inclusive, are management contracts or compensatory plans or arrangements required to be filed as exhibits pursuant to Item 14(c) of this Report. 21. Subsidiaries of Registrant. 23. Consent of Independent Accountants. b) Reports on Form 8-K There were no reports on Form 8-K by the Registrant during the fourth quarter of calendar year 1993. Crown Cork & Seal Company, Inc. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Crown Cork & Seal Company, Inc. ------------------------------- Registrant Date March 30, 1994 By: /s/ Timothy J. Donahue ---------------------------- Timothy J. Donahue Financial Controller Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated:

846902_1993.txt

846902

1993

ITEM 1. BUSINESS GENERAL Carlisle Plastics, Inc. (the "Company") is a global leader in the production of consumer products made from plastics. The Company's products include trash bags, garment hangers and sheeting used for home improvement, construction and agriculture. The Company's trash bag products include private label and institutional lines, as well as the Company's own national consumer brands. Other Company products include plastic bottles, containers and packaging. The Company's film products (including trash bag, sheeting and industrial film products) in 1993, 1992 and 1991 accounted for 65.4%, 67.7% and 69.6%, respectively, of the Company's consolidated net sales. The Company's molded products (including hangers, bottles and containers) in 1993, 1992 and 1991 accounted for 34.6%, 32.3% and 30.4%, respectively, of the Company's consolidated net sales. Poly-Tech, which is an additional registrant hereunder, is a wholly-owned subsidiary of the Company. HISTORY The Company was incorporated in Delaware in 1985 and adopted its present name in February, 1989. In 1989, the Company acquired 79% ownership in Poly-Tech. In 1990, the Company, through Poly-Tech, purchased 100% of the outstanding capital stock of American Western Corporation ("American Western"). In 1991, the Company completed an initial public offering (the "Class A Stock Offering"). In conjunction with the Class A Stock Offering, the Company converted all shares of the Company's outstanding common stock into shares of Class B Common Stock; acquired the 21% minority interests in its directly owned subsidiaries in exchange for shares of Class A Common Stock; and changed its tax status from a "S" corporation to a "C" corporation. In July 1991, the Company purchased a two-thirds interest in Rhino-X Industries, Inc. ("Rhino-X"). Under a put and call arrangement signed in conjunction with the acquisition of Rhino-X, the Company purchased the remaining shares on January 1, 1994. PRODUCTS The Company supplies plastic trash bags to three major markets. For mass merchandise and other retail stores, the Company provides Ruffies(R), a national brand consumer trash bag. For grocery chains nationwide, the Company provides private label consumer trash bags and food contact products, such as sandwich bags and wrap, recloseable bags and freezer bags. For institutional customers, such as food service distributors, janitorial supply houses, restaurants, hotels and hospitals, the Company provides heavy-duty trash liners. The Company's leading plastic sheeting product, Film-Gard(R), is sold to consumers and professional contractors through do-it-yourself outlets, home improvement centers and hardware stores. A wide range of Film-Gard(R) products are sold for various uses, including painting, renovation/construction, landscaping and agriculture. The Company's industrial packaging film is sold directly to manufacturers for use as shrink wrap and for other packaging requirements. The Company sells molded plastic garment hangers to four markets. The first is garment manufacturers who place their clothes on the Company's hangers before shipping to retail outlets. Another is the stores themselves, who buy standard Company hanger lines for retail display. For national retailers, the Company creates and sells customized hanger designs. The Company also supplies consumer plastic hangers directly to mass merchandise stores. The Company manufactures a line of plastic bottles marketed to the dairy, water, juice, food and industrial markets on the eastern coast of the United States. The Company operates in a competitive marketplace where success is dependent upon price, service and quality. The Company has positioned itself as a major supplier of innovative plastic products to large, rapidly growing national customers at the highest levels of value, service and quality. In the consumer trash bag market, the Company competes primarily with two highly advertised national brands, as well as other private and controlled label products. The Company has historically concentrated on mass merchandisers as the primary market for its branded trash bags, while the other major national brands are marketed primarily through food retailers. RAW MATERIALS The primary raw materials used by the Company in the manufacture of its products are various plastic resins, primarily polyethylene. Because plastic resins are commodity products, the Company selects its suppliers primarily on the basis of price. Consequently, the Company's sources for plastic resins tend to vary from year to year. Shortages of plastic resins have been infrequent. The Company uses in excess of 400 million pounds of plastic resins annually. At this level, the Company is one of the largest purchasers of plastic resin in the United States. Management believes that large volume purchases of plastic resin result in lower unit raw material costs. Natural gas and crude oil markets experience substantial cyclical price fluctuations as well as other market disturbances, including shortages of supply, the effect of OPEC policy and crises in the oil producing regions of the world. The capacity, supply and demand for plastic resins and the petrochemical intermediates from which they are produced are also subject to cyclical and other market factors. Plastic resin prices may fluctuate as a result of these factors. The Company may not always be able to pass through increases in the cost of its raw materials to its customers in the form of price increases. To the extent that increases in the cost of plastic resin cannot be passed on to its customers, such increases may have a detrimental impact on the profitability of the Company due to decreases in its profit margins. MAJOR CUSTOMERS The Company has no customer that accounts for over 10% of its consolidated net sales. EMPLOYEES As of December 31, 1993, the Company employed approximately 2,800 full-time employees, of whom approximately 2,400 are engaged in manufacturing and approximately 400 are engaged in administration and sales. CYCLICALITY AND SEASONALITY OF PORTIONS OF BUSINESS The trash bag and plastic bottle businesses, which account for approximately 50% of 1993 consolidated net sales, have been stable during the recent economic cycles. The hanger, construction film and industrial film businesses, which are sensitive to economic conditions, gained market share in the difficult market conditions of 1992 and 1993. Historically, the Company's results have been affected, in part, by the nature of its customers' purchasing trends for various seasonal and promotional programs. The first quarter is typically the least profitable quarter, and the third quarter is the strongest due to demands for hangers during the holiday season, lawn and leaf bags in the fall and strong promotional activity by major mass merchandisers. ENVIRONMENTAL AND SAFETY MATTERS The Company is currently not subject to any environmental proceedings. During 1993, the Company did not make any material capital expenditures for environmental control facilities, nor does it anticipate any in the near future. Actions by federal, state and local governments concerning environmental matters could result in laws or regulations that could increase the cost of producing the products manufactured by the Company or otherwise adversely affect the demand for its products. At present, environmental laws and regulations do not have a material adverse effect upon the demand for the Company's products. The Company is aware, however, that certain local governments have adopted ordinances prohibiting or restricting the use or disposal of certain plastic products that are among the types of products produced by the Company. If such prohibitions or restrictions were widely adopted, such regulatory and environmental measures could have a material adverse effect upon the Company. In addition, a decline in consumer preferences for plastic products due to environmental considerations could have a material adverse effect upon the Company. In addition, certain of the Company's operations are subject to federal, state and local environmental laws and regulations that impose limitations on the discharge of pollutants into the air and water and establish standards for the treatment, storage and disposal of solid and hazardous wastes. While historically the Company has not had to make significant capital expenditures for environmental compliance, the Company cannot predict with any certainty its future capital expenditures for environmental compliance because of continually changing compliance standards and technology. The Company does not currently have any insurance coverage for environmental liabilities and does not anticipate obtaining such coverage in the future. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS The Company is subject to legal proceedings and claims which arise in the ordinary course of its business. In the opinion of management, the amount of ultimate liability with respect to these actions will not materially affect the financial statements of the Company. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II The Company estimates that it had 7,000 beneficial owners of the Class A Common Stock at December 31, 1993. The Company's Class B Common Stock was held by 8 record holders at December 31, 1993. Each share of Class A Common Stock is entitled to one vote and each share of Class B Common Stock is entitled to twenty votes. As of December 31, 1993, officers and directors of the Company controlled 74.4% of the combined voting power of the two classes of stock. The indentures for the Company's senior notes generally prohibit the Company from paying dividends on its common stock (other than dividends on non-convertible capital stock or certain other securities). See Notes to Consolidated Financial Statements included herein. - --------------- (a) In April 1989, the Company acquired 79% of the stock of Poly-Tech. In March 1990, Poly-Tech acquired 100% of the stock of American Western. In May 1991, the Company acquired the remaining 21% of Poly-Tech. In July 1991, the Company acquired 66.6% of the stock of Rhino-X. Results are included from the date of each respective purchase. (b) In 1992, pretax income was reduced by $7.7 million for a new product introduction and $4.3 million for a restructuring charge. In 1991, pretax income was reduced by $3.4 million for a restructuring charge. In 1990, pretax income was net of certain non-recurring costs aggregating approximately $4.1 million, including $1.3 million settlement of a loan guarantee, $0.7 million estimated loss on property, and $2.1 million of costs associated with termination of the phantom stock plan, expenses incurred in connection with the American Western acquisition and transition of a manufacturing plant to Mexico. Net income was reduced $234, $89 and $3,576 in 1993, 1992 and 1991, respectively, for extraordinary items related to the early extinguishment of debt. Net income in 1993 was also increased by $1,586 for the cumulative effect of an accounting principle change relating to income taxes. (c) In 1991, the provision for income taxes includes a $3.0 million non-recurring deferred tax charge to recognize tax effects of timing differences on conversion of the Company from a "S" corporation to a "C" corporation. (d) Pro forma net income includes a provision for income taxes as if the entire Company had been a "C" corporation for the entire year. (e) Share amounts in 1991, 1990 and 1989 have been retroactively adjusted to reflect a 125.9-for-1 stock split in May 1991. (f) Includes junior subordinated notes due to stockholders and affiliates in the aggregate amount of $7.0 million in 1991, 1990 and 1989. 1993 as Compared with 1992 Net sales were $360.9 million in 1993 compared to $359.9 million in 1992. Unit volume for 1993 increased 4 percent from 1992. Gross profit increased 2.6 percent to $98.9 million in 1993 from $96.4 million in 1992. Gross margin as a percent of sales increased to 27.4 percent in 1993 from 26.8 percent in 1992. The increase was largely due to improved margins for the film products group due to lower costs. Operating expenses decreased 18.1 percent in 1993 to $67.4 million from $82.3 million in 1992. Operating expenses as a percent of sales decreased to 18.7 percent from 22.9 percent in 1992. Operating expenses in 1992 included $7.7 million associated with a new product introduction and $4.3 million of restructuring charges. These restructuring charges were utilized for realignment of production facilities, management reorganization, product re-engineering and reduction of product offerings. Interest expense, including amortization of deferred financing costs, increased to $22.5 million in 1993 from $22.0 million in 1992 due to the issuance of $90.0 million 10.25% Notes in June of 1992. Interest expense for 1993 was reduced $0.8 million as the result of interest rate swap agreements. The Company recorded a tax provision of $3.5 million in 1993, reflecting an effective tax rate of 37.2 percent, compared to a benefit of ($0.7) million in 1992 as a result of losses incurred. Net income increased to $7.2 million in 1993 from a net loss of ($6.3) million in 1992. Net income in 1993 and 1992 included an after-tax extraordinary charge of $0.2 and $0.1 million, respectively, relating to the early extinguishment of debt. Net income in 1993 also included a $1.6 million net benefit from the adoption of Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." 1992 Compared with 1991 Net sales increased 4.7 percent in 1992 to $359.9 million from $343.6 million in 1991. Unit volume increased 18 percent from 1991, partially offset by reductions in selling prices in the film products group. Gross profit decreased 7.3 percent in 1992 to $96.4 million from $104.0 million in 1991. Gross margin as a percent of sales decreased to 26.8 percent in 1992 from 30.3 percent in 1991. The decrease in 1992 resulted from heavy promotional activity by competitors in certain segments of the plastic trash bag market. Operating expenses increased 19.2 percent in 1992 to $82.3 million from $69.1 million in 1991. Operating expenses as a percent of net sales increased to 22.9 percent in 1992 from 20.1 percent in 1991. Operating expenses for 1992 included $7.7 million associated with a new product introduction and $4.3 million charges as a result of a restructuring plan. Interest expense, including amortization of deferred financing costs, was $22.0 million in 1992 compared to $22.6 million in 1991. The decrease resulted from repayment of long-term debt from the proceeds of the Class A Stock Offering in May 1991 and lower interest rates in 1992. The decrease was partially offset by the issuance of the 10.25% Notes in June of 1992. Interest and other income was $0.5 million in 1992 compared to $1.5 million in 1991. The 1991 amount included interest income from investment of the proceeds from the Class A Stock Offering until they were used to repay Company indebtedness. The Company recorded a benefit of ($0.7) million in 1992 for income taxes, compared to a provision of $8.3 million in 1991. The 1991 provision included $3.0 million recorded for a non-recurring deferred tax charge to recognize the tax effects of timing differences on conversion of the Company from a "S" corporation to a "C" corporation. LIQUIDITY AND CAPITAL RESOURCES Cash provided from operations increased 47.7 percent to $19.5 million in 1993 from $13.2 million in 1992 primarily due to the increase in net income. The Company's working capital of $54.3 million at December 31, 1993 decreased $7.6 million from December 31, 1992. This was primarily due to the reclassification of the $10.0 million 1994 Notes and a $2.7 million stock purchase obligation from long-term to current. The Company's $10.0 million of 1994 Notes become due in March 1994. In addition, the Company is actively pursuing refinancing alternatives for $68.5 million of the 13.75% Notes, which become callable at the option of the Company at 103.93% of the outstanding principal amount in April 1994. In September 1993, the Company received $2.0 million from the termination of an interest rate swap agreement, which it had entered into in June 1993. This gain has been deferred and is being amortized over the original term of the swap agreement. In September 1993, the Company entered into a new interest rate swap agreement on a notional principal amount of $90.0 million, terminating in June 1997, matching the principal and due date of the Company's 10.25% Notes. Under the agreement, the Company receives interest at a fixed rate and pays interest at a floating rate, which is established in arrears at six month intervals. In December 1993, the Company received $0.3 million from the first settlement period of the swap agreement. The net interest differential and amortization of the deferred gain of $0.8 million was recorded as a reduction of interest expense in 1993. The agreement is collateralized by the Company's accounts receivable. The Company is subject to interest rate risk during the term of the swap agreement. A sufficient increase in market interest rates during the term of the agreement could result in the Company having a net payment obligation under the agreement. Further, the Company is subject to credit risk exposure from nonperformance by the counterparty during periods when such party has a net payment obligation to the Company. The Company expects its cash on hand and funds from operations will be sufficient to cover future operating cash requirements. Approximately $179.7 million of the Company's outstanding indebtedness matures in 1997. Management believes that the Company will have the funds necessary to meet all of its financing requirements and obligations, based upon the Company's ability to generate funds from operations and obtain additional credit facilities. The Company plans to use cash generated from operations and other sources to retire long-term indebtedness. The Company expects to fund its 1994 capital expenditures from cash from operations approximately equal to its 1994 depreciation expense. TAX LAW CHANGE The Omnibus Budget Reconciliation Act of 1993 (the "Act") was signed into law on August 10, 1993. Under SFAS No. 109, the effect of changes in tax law or rates is reported as a component of income tax expense from continuing operations in the period of enactment. The Act has not significantly changed the income tax consequences for the Company. ACCOUNTING PRONOUNCEMENTS In May 1993, the Financial Accounting Standards Board issued SFAS No. 114, "Accounting for Impairment of a Loan," and SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." The Company has evaluated the effects of these standards and believes that they will not affect the Company's financial condition or operating results. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See Item 14 beginning on page 11. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information set forth in the Company's 1994 Proxy Statement under the caption "Election of Directors" is incorporated herein by reference. Each of the executive officers of the Company is also a director of the Company; thus, the required information regarding executive officers of the Company is included in the 1994 Proxy Statement. Information in response to this Item with respect to Poly-Tech is set forth in Appendix A under the caption "Directors and Executive Officers," which is included in this Form 10-K starting on page 43, following the Consolidated Financial Statements and Consolidated Financial Statement Schedules. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information set forth in the 1994 Proxy Statement under the caption "Executive Compensation" (except for the information under the subheadings "Compensation Committee Report on Executive Compensation" and "Stock Performance") is incorporated herein by reference and also as it relates to the directors and officers with respect to Poly-Tech (as described in Appendix A under the caption "Executive Compensation"). ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information set forth in the 1994 Proxy Statement under the caption "Security Ownership of Principal Shareholders and Management" is incorporated herein by reference. Information in response to this Item with respect to Poly-Tech is set forth in Appendix A under the caption "Security Ownership of Certain Beneficial Owners and Management." ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information set forth in the 1994 Proxy Statement under the caption "Certain Transactions" is incorporated herein by reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this report: 1. Consolidated Financial Statements CARLISLE PLASTICS, INC. AND SUBSIDIARIES Independent Auditors' Report Consolidated Balance Sheets at December 31, 1993 and 1992 Consolidated Statements of Operations for the years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Stockholders' Equity for the years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements 2. Consolidated Financial Statement Schedules of Carlisle Plastics, Inc. required to be filed by Item 8 and Paragraph (d) of this Item Schedule III -- Condensed Financial Information of Registrant Schedule V -- Property, Plant and Equipment Schedule VI -- Accumulated Depreciation and Amortization of Property, Plant and Equipment Schedule VIII -- Valuation and Qualifying Accounts Schedule X -- Supplementary Income Statement Information Such schedules and reports are at pages 36 through 42 of this report. All other schedules for Carlisle Plastics, Inc. and Subsidiaries and all schedules for Poly-Tech, Inc. have been omitted because they are inapplicable, not required, or the information is included elsewhere in the consolidated financial statements or notes thereto. 3. The Exhibits are listed in the Index of Exhibits required by Item 601 of Regulation S-K at Item (c) below. (b) No reports on Form 8-K were filed during the last quarter of the period covered by this report. (c) The Index to Exhibits and required Exhibits are included following the Consolidated Financial Statement Schedules beginning at page 44 of this report. (d) The Index to Consolidated Financial Statements and Consolidated Financial Statement Schedules are included following the signatures beginning at page 14 of this report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CARLISLE PLASTICS, INC. Dated: February 18, 1994 By /s/ WILLIAM H. BINNIE ----------------------------------- William H. Binnie Chairman of The Board and Chief Executive Officer SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. POLY-TECH, INC. Dated: February 18, 1994 By /s/WILLIAM H. BINNIE ------------------------------------ William H. Binnie Chairman of The Board INDEPENDENT AUDITORS' REPORT To the Board of Directors and Stockholders of Carlisle Plastics, Inc. Boston, Massachusetts We have audited the accompanying consolidated balance sheets of Carlisle Plastics, Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the consolidated financial statement schedules listed at Item 14(a)2. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Carlisle Plastics, Inc. and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for income taxes to conform with Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," during the year ended December 31, 1993. DELOITTE & TOUCHE Boston, Massachusetts February 9, 1994 See notes to consolidated financial statements. See notes to consolidated financial statements. See notes to consolidated financial statements. See notes to consolidated financial statements. CARLISLE PLASTICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) 1. BUSINESS ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES BUSINESS The principal business of Carlisle Plastics, Inc. (the "Company") is the manufacture, sale and distribution of plastic products. In May 1991, the Company completed an initial public offering (the "Class A Stock Offering") of 6,750,000 shares of Class A Common Stock (a newly authorized series). In conjunction with the Class A Stock Offering, the Company converted all shares of the Company's outstanding common stock into 10,810,846 shares of Class B Common Stock; the Company acquired the minority interests in its directly owned subsidiaries in exchange for shares of Class A Common Stock; and the Company changed its tax status from a "S" corporation to a "C" corporation. The Company used proceeds from the Class A Stock Offering to retire indebtedness. BASIS OF CONSOLIDATION The consolidated financial statements of the Company include the accounts of Poly-Tech, Inc. ("Poly-Tech"), American Western Corporation ("American Western"), Rhino-X Industries, Inc. ("Rhino-X"), A&E Products (Far East) Ltd. ("Far East") and Plasticos Bajacal, S. A. De C. V. ("Plasticos"). Significant intercompany transactions have been eliminated in consolidation. Certain amounts in the prior years' financial statements have been reclassified to conform to the current year's presentation. CASH EQUIVALENTS Cash equivalents include highly liquid investments with a maturity of three months or less when purchased. The recorded amount of cash equivalents approximates fair market value. INVENTORIES Inventories are stated at the lower of cost or market. Cost is principally determined using the first-in, first-out (FIFO) method. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are stated at cost. Depreciation is computed on a straight-line basis over the estimated lives of the assets ranging from two to fifty years. Amortization of property acquired under capitalized leases and leasehold improvements is computed on a straight-line basis over the shorter of the estimated useful lives of the assets or the remaining term of the lease. GOODWILL Goodwill arising from excess purchase cost over net assets acquired is amortized on the straight-line method principally over forty years. Accumulated amortization aggregated $10,352 and $8,221 for the years ended December 31, 1993 and 1992, respectively. DEFERRED FINANCING COSTS Included in other assets at December 31, 1993 and 1992 are $9,570 and $9,415, respectively, of deferred financing costs which are being amortized using the interest method over the term of the related debt. Accumulated amortization aggregated $5,355 and $3,990 at December 31, 1993 and 1992, respectively. CARLISLE PLASTICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) REVENUE RECOGNITION Revenues are generally recognized in the ordinary course when products are shipped and customers are invoiced. In 1992, the Company entered into a bartering agreement, whereby it exchanged inventory for advertising credits. The credits were valued at the $1,600 cost basis of the inventory exchanged. The difference between fair value of the advertising credits and the cost basis of the inventory is recognized as income when the credits are used. During 1993, credits of $981 were used; as a result, income of $760 and advertising expense of $1,741 were recognized. During 1992, no credits were used and no income was recognized. INCOME TAXES The Company adopted Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes," effective January 1, 1993, and recorded the cumulative effect of this change, which increased net income by $1,586. This statement requires recognition of deferred assets and liabilities for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax assets and liabilities are determined based on the differences between the financial statements and the tax basis of assets and liabilities using enacted tax rates. Previously, the Company accounted for income taxes under the provisions of SFAS No. 96, "Accounting for Income Taxes." Prior to the Class A Stock Offering, the Company was treated as a "S" corporation, although certain of its subsidiaries were "C" corporations. As a "S" corporation, the Company was generally not liable for federal and certain state income taxes where the "S" corporation status was recognized. Accordingly, such income taxes relating to earnings were the obligation of the Company's stockholders and, therefore, were not recorded in the accompanying consolidated financial statements. In conjunction with the Class A Stock Offering, the Company unified its tax status to a "C" corporation. Pro forma income taxes and net income for 1991 reflect the effect on such amounts as if the Company had been a "C" corporation for the entire period. INCOME PER COMMON SHARE Income per common share is computed on the basis of the weighted average number of common shares (retroactively adjusted to reflect a 125.9-for-1 stock split in May 1991) and common equivalent shares, consisting of the dilutive effect of stock options outstanding during each year. Pro forma income reflects the effect on income taxes in 1991 as if the Company had been a "C" corporation for the entire period. ACCOUNTING PRONOUNCEMENTS In May 1993, the Financial Accounting Standards Board issued SFAS No. 114, "Accounting for Impairment of a Loan," and SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." The Company has evaluated the effects of these standards and believes that they will not affect the Company's financial condition or operating results. Accumulated depreciation and amortization includes $1,745 and $1,689 at December 31, 1993 and 1992, respectively, relating to assets acquired under capital leases. In April 1989, the Company, in connection with the acquisition of Poly-Tech, issued $100,000 Senior Notes (the "13.75% Notes"). The 13.75% Notes may be redeemed at the option of the Company after April 1, 1994, in whole at any time or in part from time to time, on not less than 30 nor more than 60 days notice to the noteholders, at the following redemption prices (expressed as percentages of principal amount), plus accrued interest (if any) to the date of redemption. Redemption prices are 103.93%, 101.96% and 100.00% if redeemed during the 12-month period commencing April 1, 1994, 1995 and 1996, respectively. The fair value of the $68,525 principal of the 13.75% Notes at December 31, 1993 is estimated to be $72,506, based on the quoted market price for this issuance. In March 1990, the Company, in connection with the long-term financing of Poly-Tech's acquisition of American Western, issued $60,000 Senior Variable Rate Notes due 1997 (the "1997 Notes") and $10,000 Senior Variable Rate Notes due 1994 (the "1994 Notes"), (together, the "Variable Rate Notes"). The Variable Rate Notes may be redeemed at the option of the Company, in whole at any time or in part from time to time, on not less than 30 nor more than 60 days notice to the noteholders, at par plus accrued interest. CARLISLE PLASTICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Market price is not readily available; however, management believes that the carrying value of the Variable Rate Notes approximates fair value for these obligations. In June 1992, the Company issued $90,000 Senior Notes (the "10.25% Notes"). The 10.25% Notes may be redeemed at the option of the Company after June 14, 1995, in whole at any time or in part from time to time, on not less than 30 nor more than 60 days notice to the noteholders, at the following redemption prices (expressed as percentages of principal amount), plus accrued interest (if any) to the date of redemption. Redemption prices are 102.56% if redeemed during the 12-month period commencing June 15, 1995 and 100% thereafter. The fair value of the 10.25% Notes is estimated to be $96,039, based on the quoted market price for this issuance. The Company retired $5,000, $1,800, and $24,675 of its 13.75% Notes in 1993, 1992 and 1991, respectively, and $40,900 of its 1997 Notes in 1991. The Company incurred extraordinary charges of $234, $89 and $3,576 (net of taxes of $138, $52 and $2,056, respectively) related to the early retirement of debt in 1993, 1992 and 1991, respectively. The indentures relating to the 13.75% Notes, the Variable Rate Notes, and the 10.25% Notes (collectively, the "Notes") have been guaranteed by Poly-Tech and contain certain restrictive covenants affecting the Company and its subsidiaries. Such restrictive covenants limit the incurrence of additional debt by the Company, additional secured debt by the Company and its subsidiaries, sale and leaseback transactions, debt and preferred stock of the Company's subsidiaries, redemptions of capital stock of the Company and its subsidiaries, redemptions of certain subordinated obligations of the Company, sales of assets and subsidiary stock, transactions with affiliates, mergers and amendments to certain intercompany securities. In addition, the covenants generally prohibit dividends or distributions on capital stock of the Company and its subsidiaries, except for dividends or distributions payable in certain equity securities and except for dividends or distributions payable to the Company or a subsidiary and, if a subsidiary has minority stockholders, pro rata to such stockholders. Under certain circumstances the Company's subsidiaries (other than Poly-Tech) may be required to guarantee the Notes. Upon a "change of control" or "fundamental change of control" (as such terms are defined in the indentures) of the Company, each holder of the notes has the right to require the Company to repurchase its notes at 101% of the principal amount plus accrued interest. Certain property, plant and equipment are utilized as collateral to secure certain indebtedness. Cash paid for interest during the years ended December 31, 1993, 1992 and 1991 was $21,946, $20,813 and $23,537, respectively. CARLISLE PLASTICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The discount rate used in determining the projected benefit obligation was 7% in 1993 and 8% in 1992 and 1991. The assumed long-term rate of return on plan assets was 8% in 1993, 1992 and 1991. The rate of increase in future compensation levels used in determining the projected benefit obligation was 4.5 to 5.5% in 1993, 1992 and 1991. Plan assets consist of guaranteed insurance contracts, pooled fixed income, pooled equity and pooled real estate investments. Cash contributions to the pension plan were $122, $294 and $208 for the years ended December 31, 1993, 1992 and 1991, respectively. The Company also maintains a defined contribution plan (the "Plan"). Full time employees of the Company who are not members of collective bargaining units or who are not covered by another qualified retirement plan sponsored by the Company are eligible to participate in the Plan after six months of employment. Under the Plan, a participant may elect to reduce annual compensation by 1% to 16% and to have that amount contributed to the Plan by the Company on a pre-tax basis. The Company matches employee contributions at a rate of 50% of the employee's contribution up to 6% of the employee's salary up to the maximum allowable deferral per the Internal Revenue Code. Employee contributions vest immediately, whereas employer contributions vest over a period of three years. During 1993, 1992 and 1991, the Company's aggregate matching contributions were $372, $405 and $421, respectively. CARLISLE PLASTICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 6. INCOME TAXES As discussed in Note 1, the Company adopted SFAS No. 109, "Accounting for Income Taxes," effective January 1, 1993. This Statement supersedes SFAS No. 96, "Accounting for Income Taxes." The cumulative effect of adopting SFAS No. 109 on the Company's financial statements was to increase net income by $1,586 ($.09 per share). Deferred income taxes reflect the net tax effects of (a) temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes, and (b) operating loss and tax credit carryforwards. The Company provided a valuation allowance of $1,165 against deferred tax assets recorded as of January 1, 1993. The valuation reserve decreased $1,165 for the year ended December 31, 1993. The valuation allowance was reversed because the Company acquired the minority interest of its 67%-owned subsidiary on January 1, 1994 and the realization of tax loss carryforwards became more likely than not. Of the valuation allowance reversed, $675 was allocated to reduce goodwill, which primarily relates to the tax loss carryforwards acquired in a prior year business combination. The effect of applying SFAS No. 109 was to decrease pretax accounting income by $495 for the year ended December 31, 1993. The impact resulted from a requirement to adjust the assets and liabilities for prior business combinations from net-of-tax to pretax amounts. As of December 31, 1993, the Company had net operating loss carryforwards from a subsidiary which is not consolidated for the purpose of filing income tax returns. These carryforwards, totalling $9,385, expire in the years 2006 to 2008. The Company also had alternative minimum tax credits totalling $2,553, which have no expiration date. Cash paid for income taxes during the years ended December 31, 1993, 1992 and 1991 was $2,382, $1,864 and $3,497, respectively. The Omnibus Budget Reconciliation Act of 1993 (the "Act") was signed into law on August 10, 1993. The Act did not significantly change the income tax consequences for the Company. CARLISLE PLASTICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 7. RELATED PARTY TRANSACTIONS NOTES RECEIVABLE FROM AFFILIATES At December 31, 1993 and 1992, the Company had a $125 non-interest bearing note receivable from an affiliate. The Company provides purchasing, accounting, and other administrative services for the affiliate. In 1993, 1992 and 1991, the Company received $86, $130 and $203, respectively, from the affiliate as payment for the services rendered. SUBORDINATED PROMISSORY NOTES Interest expense paid to stockholders and affiliates (the notes were retired in 1992) was $263 and $564 in 1992 and 1991, respectively. MANAGEMENT FEES In May 1991, the Company entered into a three-year Management Agreement with Carlisle Plastics Management Corporation ("CPMC"), an affiliate of the Company, which receives an annual management fee of $1,500. Management fees in 1993, 1992 and 1991 include $1,500, $1,500 and $875, respectively, paid by the Company to CPMC under this agreement. In addition, prior to May, in 1991 the Company paid management fees of $1,763 to other affiliates of the Company. The indentures for the 10.25% Notes require that management fees do not exceed 2.0% of sales per year and that each affiliate execute a management fee subordination agreement. LEASES Rental expense of approximately $246, $217, and $206 was incurred during the years ended December 31, 1993, 1992 and 1991, respectively, with respect to the lease of office, manufacturing and warehouse space owned by affiliates of the Company. The Company leases an aircraft from Carlisle Air Corporation ("CAC"), an affiliate of the Company. Lease payments were paid to CAC in the amount of $303, $325 and $90 for 1993, 1992 and 1991, respectively, in connection therewith. INSURANCE PREMIUMS During a portion of 1991, the Company obtained insurance coverage from Greenhill Financial Group, Inc. ("Greenhill"), an affiliate of the Company. Greenhill consolidated the insurance coverage for various entities, including the Company. In 1991, the Company paid $2,100 in premiums to Greenhill. AFFILIATED PURCHASES Purchases from affiliates of the Company were $257, $355 and $28 for the years ended December 31, 1993, 1992 and 1991, respectively. OTHER TRANSACTIONS Distributions to stockholders of $1,744 were made during the year ended December 31, 1991. These distributions were approximately equal to income taxes owed by stockholders with respect to the Company's taxable income for a period of time during which the Company operated as a "S" corporation. In conjunction with the Class A Stock Offering, the Company made a special distribution to those stockholders who owned common stock of the Company prior to the Class A Stock Offering. The special distribution was valued at $4,493 and consisted of the Company's interest in a metals foundry in Costa Rica, CARLISLE PLASTICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) two unsecured notes payable to the Company by Carlisle Realty Holdings I Limited Partnership plus accrued interest, and certain notes receivable from stockholders plus accrued interest. Prior to the Class A Stock Offering, the Chairman of the Board and Chief Executive Officer and a former director of the Company owned an aggregate 21% interest in each of the Company's direct subsidiaries (the "Minority Interests"). Concurrent with the completion of the Class A Stock Offering, the Company acquired their Minority Interests in exchange for issuance of 48,364 shares of Class A Stock having an aggregate fair market value equal to the book value of the Minority Interests. 8. STOCKHOLDERS' EQUITY As of December 31, 1993 and 1992, the Company had authorized 10,000,000 shares of preferred stock at $.01 par value, 50,000,000 shares of Class A Common Stock at $.01 par value, and 20,000,000 shares of Class B Common Stock at $.01 par value. The Class B Common Stock is one-for-one convertible to Class A Common Stock and has restrictions on transfers other than those to entities outside the current holders of Class B Common Stock. Each share of Class A Common Stock is entitled to one vote, and each share of Class B Common Stock is entitled to twenty votes. In 1992, 355,900 options granted in 1991 were repriced to $5.00, the market price at the time of repricing. All options granted were at an option price per share greater than or equal to the market value at the date of grant. In 1992, a director and officer was granted options (which are not included in the above table) to purchase 400,000 shares of the Company's Class A Common Stock at $4.00 per share (which was the fair market value of the shares at the date of the agreement). The options vest on September 1, 1993, 1994 and 1995 in the amount of 50,000, 50,000 and 300,000, respectively. CARLISLE PLASTICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 9. COMMITMENTS AND CONTINGENCIES Amounts above include $2,573 which is payable to affiliates of the Company. Total rent expense under all operating leases was $4,476, $4,969 and $4,828 for 1993, 1992 and 1991, respectively. LETTERS OF CREDIT The Company had outstanding letters of credit amounting to approximately $1,357 and $1,455 at December 31, 1993 and 1992, respectively, relating to purchase commitments issued to suppliers and an insurance carrier. LITIGATION The Company is subject to legal proceedings and claims which arise in the ordinary course of its business. In the opinion of management, the amount of ultimate liability with respect to these actions will not materially affect the financial statements of the Company. 10. CONCENTRATION OF CREDIT RISK In September 1993, the Company received $2,000 from the termination of an interest rate swap agreement, which it had entered into in June 1993. This gain has been deferred and is being amortized over the original term of the swap agreement. On September 15, 1993, the Company entered into a new interest rate swap agreement on a notional principal amount of $90,000 terminating on June 15, 1997 (matching the principal and due date of the Company's 10.25% Notes). Under the agreement, the Company receives interest at a fixed rate and pays interest at a floating rate, which is established in arrears at six month intervals. The net interest differential and amortization of the deferred gain of $752 was recorded as a reduction of interest expense in the year ended December 31, 1993. The agreement is collateralized by the Company's accounts receivable. The Company is subject to interest rate risk during the term of the swap agreement. A sufficient increase in market interest rates during the term of the agreement could result in the Company having a net payment obligation under the agreement. Further, the Company is subject to credit risk exposure from nonperformance by the counterparty during periods when such party has a net payment obligation to the Company. CARLISLE PLASTICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The Company had accounts receivable from a single customer, Wal*Mart, of $3,200 and $4,500 at December 31, 1993 and 1992, respectively. This customer has a history of timely payments to the Company. The Company believes it had no significant exposure to credit risk at December 31, 1993. 11. RESTRUCTURING CHARGE AND NEW PRODUCT INTRODUCTION During 1992 and 1991, the Company recorded restructuring charges aggregating $4,320 and $3,431, respectively. These restructuring charges included realignment of production facilities, management reorganization, product re-engineering and reduction of product offerings. In addition, in 1992 the Company incurred costs of $7,743 associated with a new product introduction. 12. BUSINESS ACQUISITION In July 1991, the Company purchased a two-thirds interest in Rhino-X for $5,000. This acquisition was accounted for using the purchase method of accounting, and accordingly, the purchase price has been allocated to assets acquired and liabilities assumed based on their fair market value. Included in goodwill at December 31, 1993 is $6,230 relating to this acquisition. Under a put and call arrangement signed in conjunction with the acquisition of Rhino-X in July 1991, the Company purchased the minority interest shares at the minimum price of $12 per share on January 1, 1994. The Company had discounted this purchase at 10% and, accordingly, recorded an obligation of $3,500 and $3,152 at December 31, 1993 and 1992, respectively. At December 31, 1993 and 1992, this obligation was reduced by $779 and $714, respectively, for sales tax payments made by the Company and recoverable from the minority shareholders. CARLISLE PLASTICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) CARLISLE PLASTICS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 14. CONDENSED FINANCIAL INFORMATION OF CARLISLE PLASTICS, INC. AND SUBSIDIARIES Condensed consolidating financial information of the Company and subsidiaries is included in this Note. Mr. Binnie has been Chairman of the Board of Directors of Poly-Tech since 1989. Mr. Wilbur has been President of Poly-Tech since September 1992. From 1990 to 1992, Mr. Wilbur was President of Wilbur and Associates, a consulting and merger and acquisition company, and Vice Chairman of Edina Group, Inc., a merger and acquisition company. Mr. Wilbur was President and Chief Operating Officer of Poly-Tech, Inc. from 1984 to 1990. Mr. Bhatt has been Vice President, Secretary and Chief Financial Officer of Poly-Tech since 1989. EXECUTIVE COMPENSATION The compensation paid or accrued in 1993 on behalf of Messrs. Binnie, Wilbur and Bhatt was paid or accrued for services rendered to Carlisle Plastics, Inc., Poly-Tech and their respective subsidiaries. Information regarding such compensation is included in Item 11 of the Annual Report on Form 10-K, which incorporates by reference the information set forth in the 1994 Proxy Statement under the caption "Executive Compensation."

764764_1993.txt

764764

1993

Item 1. Business General Caterpillar Financial Services Corporation (the "Company") is a wholly owned finance subsidiary of Caterpillar Inc. ("Caterpillar"). The Company and its wholly owned subsidiaries in North America, Australia, and Europe are principally engaged in the business of financing sales and leases of Caterpillar products and non-competitive related equipment through Caterpillar dealers and is also engaged in extending loans to Caterpillar customers and dealers. Unless the context otherwise requires, the term "Company" includes subsidiary companies. The Company's business is largely dependent upon the ability of Caterpillar dealers to generate sales and leasing activity, the willingness of the customers and the dealers to enter into financing transactions with the Company, and the availability of funds to the Company to finance such transactions. Additionally, the Company's business is affected by changes in market interest rates, which, in turn, are related to general economic conditions, demand for credit, inflation, governmental policies, and other factors. The Company's retail financing business is highly competitive. Financing for users of Caterpillar products is available through a variety of competitive sources, principally commercial banks and finance and leasing companies. The Company emphasizes prompt and responsive service to meet customer requirements and offers various financing plans designed to increase the opportunity for sales of Caterpillar products and financing income for the Company. In addition, the Company's competitive position is improved by merchandising programs of Caterpillar, its subsidiaries, and/or Caterpillar dealers. The following types of retail financing plans are currently offered: Installment sale contracts. The Company finances retail sales of equipment under installment sale contracts with terms generally from one to five years. Such contracts may be entered into (i) by dealers with their customers and assigned to the Company, or (ii) by the Company directly with equipment users. Tax-oriented leases. Under these leases, the Company is considered to be the owner of the equipment for tax purposes during the term of the lease (generally from two to seven years, except for special engine or turbine applications which may range up to 15 years). For financial accounting purposes, these leases are classified as either financing or operating leases depending upon the specific characteristics of the lease. The Company establishes a specific residual value on each product leased based on various factors including the use and application, price, product type, and lease term. Generally, the lessee, at the end of the lease term, may continue to lease the product or purchase the product for its fair market value. The profitability of these leases is affected by the Company's ability to realize estimated residual values upon selling or re-leasing the equipment at the termination of the leases. Non-tax (financing) leases. Under these leases, the lessee is considered to be the owner of the equipment for tax and financial accounting purposes during the term of the lease (generally from one to six years). For financial accounting purposes, these leases are classified as financing leases. The lessee customarily has a fixed price purchase option exercisable upon expiration of the lease term or will be required to purchase the equipment at the end of the lease term. Customer and dealer loans. The Company offers loans for working capital and other business purposes to Caterpillar customers and dealers meeting the Company's credit requirements. The loans may be secured or unsecured and are repayable over terms generally ranging from two to five years. Governmental lease-purchase contracts. The Company finances sales of products to cities, counties, states, and other qualified governmental bodies for terms generally from two to seven years. In general, this form of financing is subject to termination if the governmental body does not appropriate funds for future payments. The reduced interest rate in these transactions reflects the fact that interest income is not subject to federal income tax. The Company also provides wholesale financing of Caterpillar dealer inventory in Germany and Caterpillar dealer rental fleets in the United States. These receivables are secured by the respective product which is fully insured against physical damage. The amount of credit extended by the Company for each machine is generally limited to the invoice price of the new equipment. Maturities in Germany generally range from one to three months and in the United States from six to twelve months. The percentages of the total value of the Company's portfolio represented by these financing plans at December 31 of the past three years were as follows: 1993 1992 Retail Financing: Installment sale contracts 25% 25% 27% Tax-oriented leases 20% 20% 21% Non-tax (financing) leases 19% 19% 22% Customer loans 19% 18% 13% Dealer loans 10% 12% 12% Governmental lease-purchase contracts 3% 4% 5% Wholesale Financing 4% 2% - The Company periodically offers below-market-rate financing to customers which is subsidized by Caterpillar, its subsidiaries, and/or Caterpillar dealers. In all such cases, the cost of such subsidies is borne totally by Caterpillar, its subsidiaries, and/or the dealer (and not by the Company) and is settled at the time each transaction is executed. Tax-oriented leases and governmental lease-purchase contracts are currently offered at fixed interest rates and fixed rental payments. Non-tax (financing) leases, installment sale contracts, and customer and dealer loans are offered at either fixed or floating interest rates. Approximately 80% of the Company's portfolio involves financing with fixed interest rates and fixed payments. In order to reduce the impact of interest rate fluctuations on its operations, the Company has a match funding policy of structuring the maturities of a substantial percentage of its borrowed funds over periods which closely correspond to the maturities of its portfolio. The Company provides financing only when acceptable credit standards and criteria are met. Decisions regarding credit applications are based upon the customer's credit history and financial strength, the intended use of the equipment being financed, and other considerations. In general, the Company obtains a security interest in the equipment being financed. Less than five percent of the total value of the Company's portfolio (excluding loans to dealers) is comprised of transactions in which the Company has recourse to a dealer. Management closely monitors past due accounts and regularly evaluates the collectibility of receivable balances. The Company maintains an allowance for credit losses which it believes is sufficient to cover uncollectible accounts. Company policy is to write off against such allowance that portion of the outstanding receivable which cannot be recovered by leasing or selling the related equipment. Management believes the allowance for credit losses at December 31, 1993, is sufficient to provide for any losses which may be sustained on outstanding receivables. For more information on receivables and the allowance for credit losses, see Note 2 of the Notes to the Consolidated Financial Statements. The following table summarizes the Company's delinquency experience showing past-due receivables as a percentage of total receivables: Delinquency Experience Decem ber 31, 1992 1991 Past due 31 to 60 days ..................... .7% 0.6% 1.6% Past due over 60 days ..................... 1.2% 1.9% 2.4% At December 31, 1993, the largest single customer/dealer account represented 3.5% of the Company's portfolio and the five largest such customer/dealer accounts represented 11.1% of the portfolio. With respect to dealer financing, at December 31, 1993, the largest single dealer account represented 3.5% of the Company's portfolio and the five largest such dealer accounts collectively represented 8.8% of the portfolio. In the opinion of the Company, the loss of the business represented by any one of these accounts would not have a material adverse effect on the Company's overall business. Relationship with Caterpillar Caterpillar provides the Company with certain operational and financial support which is integral to the conduct of the Company's business. The employees of the Company are covered by various benefit plans, including pension/post-retirement plans, administered by Caterpillar. The Company reimburses Caterpillar for certain corporate services and pays rent for space occupied on Caterpillar premises. For more information on payments for services, see Note 10 of the Notes to the Consolidated Financial Statements. The Company, in conjunction with Caterpillar and its subsidiaries, periodically offers below-market-rate financing to customers under merchandising programs. Caterpillar, at the outset of the transaction, remits to the Company an amount equal to the interest differential which is recognized as income over the term of the contracts. For more information on the interest differential payments, see Note 10 of the Notes to the Consolidated Financial Statements. The Company entered into agreements with a subsidiary of Caterpillar to purchase, at a discount, some or all of the subsidiary's receivables generated by sales of products to Caterpillar dealers in Germany, Austria, and the Czech Republic. These purchases (wholesale financing) in 1993 and 1992 totaled $210.2 million and $201.7 million, respectively. Through December 31, 1993, Caterpillar had invested a total of $250.0 million in the equity of the Company. The Company and Caterpillar have also entered into an agreement (the "Support Agreement") which provides, among other things, that Caterpillar will (i) remain, directly or indirectly, the sole owner of the Company, (ii) ensure that the Company will maintain a tangible net worth of at least $20.0 million, and (iii) permit the Company to use (and the Company is required to use) the name "Caterpillar" in the conduct of its business. The Support Agreement provides that it may be modified, amended, or terminated by either party. However, no such modification or amendment, which adversely affects the holders of any debt outstanding at the execution thereof, is binding on or in any manner becomes effective with respect to (i) any then outstanding commercial paper, or (ii) any other debt then outstanding unless such modification or amendment is approved in writing by the holders of 66-2/3% of the aggregate principal amount of such other debt. The obligations of Caterpillar under the Support Agreement are to the Company only and are not directly enforceable by any creditor of the Company, nor do such obligations constitute a guarantee by Caterpillar of the payment of any debt or obligation of the Company. To supplement external debt financing sources, the Company has variable amount lending agreements with Caterpillar (including one of its subsidiaries). Under these agreements, which may be amended from time to time, the Company may borrow up to $53.8 million from Caterpillar, and Caterpillar may borrow up to $83.8 million from the Company. All of the variable amount lending agreements are effective for indefinite terms and may be terminated by either party upon 30 days' notice. At December 31, 1993, the Company had no outstanding borrowings or loans receivable under these agreements. To hedge the U.S. dollar denominated borrowings in Australia against currency fluctuations, the Company has entered into forward exchange contracts with Caterpillar. All of these contracts generally have maturities not exceeding 90 days. At December 31, 1993, the Company had contracts with Caterpillar totaling $143.1 million. The Company has an agreement (the "Tax Sharing Agreement") with Caterpillar in which the Company consented to the filing of consolidated income tax returns with Caterpillar, and Caterpillar agreed, among other things, to collect from or pay to the Company, within 45 days of realization, its allocated share of any consolidated income tax liability or credit applicable to any period for which the Company is included in Caterpillar's consolidated federal income tax return. The Tax Sharing Agreement sets forth the method by which the Company's allocated share shall be determined and provides that Caterpillar will indemnify the Company for any related tax liability in excess of that amount. Similar agreements were executed between Caterpillar Financial Australia Limited and Caterpillar of Australia Ltd. with respect to taxes payable in Australia, and between the Company and Caterpillar with respect to taxes payable in Germany. Item 2.

Item 2. Properties The Company does not own any real estate. Its principal executive offices are comprised of approximately 49,000 square feet of office space at 3322 West End Avenue, Nashville, Tennessee. As of December 31, 1993, the Company had additional offices in or near Phoenix, Arizona; Dallas, Texas; Atlanta, Georgia; Baltimore, Maryland; Chicago, Illinois; Melbourne, Australia; Calgary, Alberta; Toronto, Ontario; Munich, Germany; Leipzig, Germany; Stockholm, Sweden; Oslo, Norway; Arhus, Denmark; Paris, France; London, England; and Madrid, Spain. For more information on leases, see Note 11 of the Notes to the Consolidated Financial Statements. Item 3.

Item 3. Legal Proceedings The Company is a party to various litigation matters and claims, and, while the results of litigation and claims cannot be predicted with certainty, management believes the final outcome of such matters and claims will not have a material adverse effect on the consolidated financial position. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders Information for this Item 4 is not required. See General Instruction J. PART II. Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters The Company's common stock is owned entirely by Caterpillar and is not publicly traded. In its three most recent fiscal years, the Company has not declared or paid cash dividends on its common stock. Item 6.

Item 6. Selected Financial Data Information on this Item 6 is not required. See General Instruction J. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Results of Operations The Company derives its earnings primarily from financing sales and leases of Caterpillar products and from loans extended to Caterpillar customers and dealers. New retail financing during 1993 totaled $1,967.4 million, a 28% increase over the $1,531.8 million financed in 1992 and a 59% increase over the 1991 new business of $1,240.0 million. New retail financing volume for 1993 exceeded 1992 and 1991 levels due to increased machine financing in the United States and Europe. New business volume for 1992 exceeded the 1991 level primarily as the result of financing activity in Germany. The Company had wholesale financing during 1993 of $228.2 million. New retail financing in 1994 is expected to remain at about 1993 levels. Wholesale financing in 1994 is expected to exceed 1993 levels due to expansion of the Caterpillar dealer rental fleet financing program in the United States. In 1994, the Company will offer financial services to the customers of the Caterpillar dealer in Spain through a new subsidiary, Alquiler de Equipos Industriales, S.A. Revenues from operations in the United States were more than 80% of total revenues in 1993, 1992, and 1991. Net income from operations in the United States was more than 90% of total net income in 1993, 1992, and 1991. For more geographic segment information, see Note 12 of the Notes to the Consolidated Financial Statements. Past due percentages decreased in 1993 primarily as a result of an improving U.S. economy and collection efforts. The allowance for credit losses will continue to be monitored to provide for an amount which, in management's judgement, will be adequate to cover uncollectible receivables. The composition of the Company's portfolio (see "Item 1. Business") by financing plans did not change significantly from 1992 to 1993. The Company's wholesale financing increased due to a higher floor planning receivable balance in Germany and the addition of receivables from dealers under the inventory rental assistance program in the United States. 1993 Compared With 1992 Total revenues for 1993 were $363.6 million, a 6% increase over 1992 revenues of $342.4 million. The increase in revenues, limited by a low interest rate environment, was primarily the result of earnings from the larger portfolio which increased to $3,522.1 million at December 31, 1993 from $2,812.7 million at December 31, 1992. The annualized interest rate on finance receivables (computed by dividing finance income by the average monthly finance receivable balances) was 9.1% for 1993 compared with 10.3% for 1992. Tax benefits associated with governmental lease- purchase contracts and a portion of tax benefits associated with long-term tax-oriented leases are not reflected in such annualized interest rates. The decrease in the annualized interest rate reflected a decrease in the interest rates charged to customers. Other income, net, of $15.7 million for 1993 included fees, gains on sales of equipment returned from lease, and other miscellaneous income. The increase of $1.3 million for 1993 was primarily due to a higher amount of fees collected and earned. Interest expense for 1993 was $173.1 million, $1.3 million less than 1992. Although there were increased borrowings to support the larger portfolio, interest expense decreased due to lower borrowing rates as the average cost of borrowed funds was 6.5% in 1993 compared with 7.8% in 1992. Depreciation expense increased from $63.1 million in 1992 to $69.6 million in 1993 due to the increase in equipment on operating leases which, computed as a monthly average balance, increased 9%. General, operating, and administrative expenses increased $8.8 million over 1992 primarily due to staff-related and other expenses required to service the larger portfolio and expansion into Europe. The Company's full-time employment increased from 324 at the end of 1992 to 361 at December 31, 1993. Provision for credit losses during 1993 increased from $20.4 million in 1992 to $20.8 million in 1993. This increase, partially offset by a higher provision taken in 1992 for the U.S., Australian, and Canadian companies, reflected increased levels of new business for 1993. Receivables, net of recoveries, of $18.8 million were written off against the allowance for credit losses during 1993 compared with $14.3 million during 1992 due to an acceleration of write-offs from point of sale to point of repossession. Receivables past due over 30 days were 1.9% of total receivables at December 31, 1993 compared with 2.5% at December 31, 1992. Past due percentages decreased primarily as a result of an improving U.S. economy and collection efforts. The allowance for credit losses is monitored to provide for an amount which, in management's judgment, will be adequate to cover uncollectible receivables. At December 31, 1993, the allowance for credit losses was $41.5 million which was 1.3% of finance receivables, net of unearned income, compared with $36.5 million and 1.4% at December 31, 1992, respectively. The effective income tax rate for 1993 was 36% compared with 34% for 1992. For information on this change, see Note 8 of the Notes to the Consolidated Financial Statements. Consolidated net income in 1993 was $37.8 million, compared with $34.0 million, excluding the cumulative effect of the change in accounting for income taxes in 1992. The increase in net income generally reflected the increased revenues from a larger portfolio and lower cost of borrowed funds, partially offset by increased costs to support the larger portfolio and European expansion. 1992 Compared With 1991 Total revenues for 1992 were $342.4 million, an 8% increase over 1991 revenues of $316.4 million. The increase in revenues, limited by a low interest rate environment, was primarily the result of earnings from the larger portfolio, which increased to $2,812.7 million at December 31, 1992 from $2,437.1 million at December 31, 1991. The annualized interest rate on finance receivables (computed by dividing finance income by the average monthly finance receivable balances) was 10.3% for 1992 compared with 11.1% for 1991. Tax benefits associated with governmental lease- purchase contracts and a portion of tax benefits associated with long-term tax-oriented leases are not reflected in such annualized interest rates. The decrease in the annualized interest rate reflected a decrease in interest rates charged to customers. Other income, net, of $14.4 million for 1992 included fees, gains on sales of equipment returned from lease, and other miscellaneous income. The increase of $3.7 million for 1992 was primarily due to larger gains on sales of equipment returned from lease, more commitment fees earned, and more late charge fees collected. Interest expense for 1992 was $174.4 million, $1.9 million less than 1991. Although there were increased borrowings to support the larger portfolio, interest expense decreased due to lower borrowing rates as the average cost of borrowed funds was 7.8% in 1992 compared with 8.9% in 1991. Depreciation expense increased from $54.4 million in 1991 to $63.1 million in 1992 due to the increase in equipment on operating leases which, computed as a monthly average balance, increased 12%. General, operating, and administrative expenses increased 11% over 1991 primarily due to staff-related and other expenses required to service the larger portfolio and expansion into Europe. The Company's full-time employment increased from 310 at the end of 1991 to 324 at December 31, 1992. Provision for credit losses during 1992 increased from $13.2 million in 1991 to $20.4 million in 1992. This increase reflected increased levels of new business and a higher provision taken for the U.S., Australian, and Canadian companies. Receivables, net of recoveries, of $14.3 million were written off against the allowance for credit losses during 1992 compared with $13.0 million during 1991. Receivables past due over 30 days were 2.5% of total receivables at December 31, 1992, compared with 4.0% at December 31, 1991. Past due percentages decreased primarily as a result of increased collection efforts. The allowance for credit losses is monitored to provide for an amount which, in management's judgement, will be adequate to cover uncollectible receivables. At December 31, 1992, the allowance for credit losses was $36.5 million which was 1.4% of finance receivables, net of unearned income, compared with $31.0 million and 1.4% at December 31, 1991, respectively. The effective income tax rate for 1992 and 1991 was 34%. In the fourth quarter of 1992, effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards (SFAS) 109, "Accounting for Income Taxes." SFAS 109 requires changing the method of accounting for income taxes from the deferred method to the liability method. The effect of adopting SFAS 109, as of January 1, 1992, was a benefit of $2.6 million and is excluded from the effective income tax rate calculation. For more information on this accounting change, see Note 8 of the Notes to the Consolidated Financial Statements. Consolidated net income in 1992, excluding the cumulative effect of the change in accounting for income taxes, was $34.0 million, compared with $28.5 million in 1991. The increase in net income generally reflected the increased revenues from a larger portfolio and lower cost of borrowed funds, partially offset by the increase in the provision for credit losses. Capital Resources and Liquidity The Company's operations were primarily funded with a combination of medium-term notes, commercial paper, bank borrowings, retained earnings, and additional equity capital of $30.0 million invested by Caterpillar. Additional short-term funding was available from Caterpillar (see Note 10 of the Notes to the Consolidated Financial Statements); however, no intercompany borrowings were outstanding at December 31, 1993. Total debt outstanding as of December 31, 1993, was $3,041.1 million, an increase of $639.7 million over that at December 31, 1992, and was primarily comprised of $1,854.8 million of medium- term notes, $797.2 million of commercial paper, and $335.7 million of notes payable to banks. Interest rate swaps were contracted in the United States, Australia, Canada, and Germany to reduce the exposure to interest rate fluctuations. See Notes 6 and 7 of the Notes to the Consolidated Financial Statements for more information on short-term and long-term debt. At December 31, 1993, the Company had available in the United States, Australia, Canada, Germany, Sweden, and the United Kingdom a total of $990.7 million of short-term credit lines, which expire at various dates in 1994, and $64.7 million of long- term credit lines, which expire at various dates from January 1996 to May 1996. These credit lines are with a number of banks and are considered support for the Company's outstanding commercial paper, commercial paper guarantees, the discounting of bank and trade bills, and bank borrowings at various interest rates. At December 31, 1993, there were $326.1 million of these lines utilized for bank borrowings in Australia, Germany, Sweden, and the United Kingdom. The Company also has a $455.0 million revolving credit agreement with a group of banks. This agreement is also considered support for the Company's outstanding commercial paper and commercial paper guarantees. The agreement terminates in 1996 and provides for borrowings at interest rates which vary according to LIBOR or money market rates. At December 31, 1993, there were no borrowings under this agreement. The above-mentioned credit agreements require the Company to maintain its consolidated ratio of profit before taxes plus fixed charges to fixed charges at no less than 1.1 to 1 for each quarter; the Company's total liabilities to total stockholder's equity may not exceed 8.0 to 1; and the Company's tangible net worth must be at least $20.0 million. The Company's funding requirements were met primarily through the sale of commercial paper and medium-term notes, discounting of bank and trade bills, and through bank borrowings. During 1993, the average outstanding commercial paper balance, net of discount, was $782.3 million at an average interest rate of 3.7%. At year-end 1993, the face value of commercial paper outstanding was $798.6 million. During 1993, $417.1 million of fixed-rate medium-term notes were sold at an average interest rate of 4.9% and $475.2 million of floating-rate medium-term notes were sold at rates indexed to LIBOR, prime, or commercial paper rates. Medium-term notes outstanding at year-end 1993 were $1,854.8 million. During the year, bank bills totaling $154.4 million and trade bills totaling $184.2 million were discounted at an average interest rate of 5.6% and 8.0%, respectivly. In connection with its match funding objectives, the Company entered into a variety of interest rate contracts including interest rate swap and cap agreements. Interest rate swap agreements totaled $2,047.3 million and interest rate cap agreements totaled $500.0 million at year-end 1993. The Company has entered into forward exchange contracts to hedge its U.S. dollar denominated obligations in Australia and Canada against currency fluctuations. At December 31, 1993, the outstanding forward exchange contracts totaled $146.6 million. On a consolidated basis, equity capital at the end of 1993 was $418.0 million, an increase of $64.0 million during the year. This increase included $30.0 million of additional equity investment made by Caterpillar and $37.8 million of retained earnings from operations. The increase in debt, the equity investment from Caterpillar, and the funds provided by operations were used to finance the increase in the portfolio. The ratio of debt to equity at December 31, 1993 was 7.3 to 1, compared with 6.8 to 1 for 1992 and 6.7 to 1 for 1991. Item 8.

Item 8. Financial Statements and Supplementary Data The information required by Item 8 is included as a part of this report on pages 16 through 29. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. PART III. Item 10.

Item 10. Directors and Executive Officers of the Registrant Information for Item 10 is not required. See General Instruction J. Item 11.

Item 11. Executive Compensation Information for Item 11 is not required. See General Instruction J. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management Information for Item 12 is not required. See General Instruction J. Item 13.

Item 13. Certain Relationships and Related Transactions Information for Item 13 is not required. See General Instruction J. PART IV. Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) The following documents are filed as part of this report: 1. Financial Statements Report of Independent Accountants Consolidated Statement of Financial Position at December 31, 1993, 1992, and 1991 Consolidated Statement of Income and Retained Earnings for the Years Ended December 31, 1993, 1992, and 1991 Consolidated Statement of Cash Flows for the Years Ended December 31, 1993, 1992, and Notes to Consolidated Financial Statements 2. Financial Statement Schedules Schedule IX - Short-term Borrowings All other schedules are omitted because they are not applicable or required information is shown in the financial statements or the notes thereto. (b) Reports on Form 8-K None (c) Exhibits 3.1 Certificate of Incorporation of the Company (incorporated by reference from Exhibit 3.1 to the Company's Form 10, as amended, Commission File No. 0-13295). 3.2 Bylaws of the Company (incorporated by reference from Exhibit 3.2 to the Company's Annual Report on Form 10-K, for the year ended December 31, 1990, Commission File No. 0-13295). 4.1 Indenture, dated as of April 15, 1985, between the Company and Morgan Guaranty Trust Company of New York, as Trustee, including form of Debt Security (see Table of Contents to Indenture)(incorporated by reference from Exhibit 4.1 to the Company's Registration Statement on Form S-3, Commission File No. 33- 2246). 4.2 First Supplemental Indenture, dated as of May 22, 1986, amending the Indenture dated as of April 15, 1985 between the Company and Morgan Guaranty Trust Company of New York, as Trustee (incorporated by reference from Exhibit 4.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 20, 1986, Commission File No. 0-13295). 4.3 Second Supplemental Indenture, dated as of March 15, 1987, amending the Indenture dated as of April 15, 1985 between the Company and Morgan Guaranty Trust Company of New York, as Trustee (incorporated by reference from Exhibit 4.3 to the Company's Current Report on Form 8-K dated April 24, 1987, Commission File No. 0-13295). 4.4 Third Supplemental Indenture, dated as of October 2, 1989, amending the Indenture dated as of April 15, 1985, between the Company and Morgan Guaranty Trust Company of New York, as Trustee (incorporated by reference from Exhibit 4.3 to the Company's Current Report on Form 8-K, dated October 16, 1989, Commission File No. 0-13295). 4.5 Fourth Supplemental Indenture, dated as of October 1, 1990, amending the Indenture dated April 15, 1985, between the Company and Morgan Guaranty Trust Company of New York, as Trustee (incorporated by reference from Exhibit 4.3 to the Company's Current Report on Form 8-K, dated October 29, 1990, Commission File No. 0-13295). 4.6 Indenture, dated as of July 15, 1991, between the Company and Continental Bank, National Association, as Trustee (incorporated by reference from Exhibit 4.1 to the Company's Current Report on Form 8-K, dated July 25, 1991, Commission File No. 0-13295). 4.7 Support Agreement, dated as of December 21, 1984, between the Company and Caterpillar (incorporated by reference from Exhibit 4.2 to the Company's Form 10, as amended, Commission File No. 0-13295). 10.1 Tax Sharing Agreement, dated as of June 21, 1984, between the Company and Caterpillar (incorporated by reference from Exhibit 10.3 to the Company's Form 10, as amended, Commission File No. 0-13295). 10.2 Revolving Credit Agreement, dated as of February 22, 1991, among the Company, as the Borrower, the several financial institutions parties thereto (the "Banks"), and The First National Bank of Chicago, as agent for the Banks (incorporated by reference from Exhibit 10.2 to the Company's Annual Report on Form 10-K, for the year ended December 31, 1990, Commission File No. 0-13295). 10.3 Amendment to the Revolving Credit Agreement, described in Exhibit 10.2 of the Company's Annual Report on Form 10-K for the year ending December 31, 1990, extending the Termination Date from February 20, 1994 to February 20, 1995 (incorporated by reference from Exhibit 10.3 to the Company's Annual Report on Form 10-K, for the year ended December 31, 1991, Commission File No. 0-13295). 10.4 Amendment to the Revolving Credit Agreement, described in Exhibit 10.2 of the Company's Annual Report on Form 10-K for the year ending December 31, 1990, extending the Termination Date from February 20, 1995 as amended by Exhibit 10.3 of the Company's Annual Report on Form 10-K for the year ending December 31, 1991, to February 20, 1996 (incorporated by reference from Exhibit 10.4 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993, Commission File No. 013295). 12 Statement Setting Forth Computation of Ratio of Profit to Fixed Charges. (The ratios of profit to fixed charges for the years ending December 31, 1993, 1992, and 1991 were 1.33, 1.28, and 1.23, respectively.) 23 Consent of Price Waterhouse Signatures Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Caterpillar Financial Services Corporation (Registrant) Dated: March 4, 1994 By: /s/ Nancy L. Snowden Nancy L. Snowden, Secretary Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities and on the dates indicated. Date Signature Title March 4, 1994 /s/ James S. Beard President, Director and (James S. Beard) Principal Executive Officer March 4, 1994 /S/ F. Lynn McPheeters Executive Vice President (F. Lynn McPheeters) and Director March 4, 1994 /s/ James W. Wogsland Director (James W. Wogsland) March 4, 1994 /s/ Kenneth C. Springer Controller and Principal (Kenneth C. Springer) Accounting Officer March 4, 1994 /s/ Frank C. Carder Treasurer and Principal (Frank C. Carder) Financial Officer REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholder of Caterpillar Financial Services Corporation In our opinion, the consolidated financial statements listed in the index appearing under Item 14(a)(1) and (2) on page 11 present fairly, in all material respects, the financial position of Caterpillar Financial Services Corporation and its subsidiaries at December 31, 1993, 1992, and 1991, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. As discussed in Note 8 to the consolidated financial statements, in 1992 the Company adopted the provisions of Statement of Financial Accounting Standards (SFAS) 109, "Accounting for Income Taxes." PRICE WATERHOUSE Peoria, Illinois January 21, 1994 CATERPILLAR FINANCIAL SERVICES CORPORATION CONSOLIDATED STATEMENT OF FINANCIAL POSITION (Millions of dollars) December 31, 1993 1992 Assets: Cash and cash equivalents $ 15.6 $ 11.5 $ 20.4 Finance receivables (Notes 2,3, and 5): Wholesale notes receivable 142.8 49.3 - Retail notes receivable 1,035.5 858.5 623.9 Investment in finance receivables 2,350.8 1,970.1 1,840.8 3,529.1 2,877.9 2,464.7 Less: Unearned income 348.2 315.8 288.7 Allowance for credit losses 41.5 36.5 31.0 3,139.4 2,525.6 2,145.0 Equipment on operating leases, less accumulated depreciation (Note 4) 364.6 276.7 283.0 Other assets 45.1 29.5 40.6 Total assets $3,564.7 $2,843.3 $2,489.0 Liabilities and stockholder's equity: Payable to dealers and customers $ 13.7 $ 11.1 $ 1.5 Payable to Caterpillar Inc. (Note 10) 3.9 2.9 3.5 Accrued interest payable 33.6 28.0 27.4 Income tax payable (Note 8) 36.0 30.0 8.8 Other liabilities 5.4 3.2 1.1 Short-term borrowings (Note 6) 1,138.2 913.1 672.5 Current maturities of long-term debt (Note 7) 492.5 492.4 562.7 Long-term debt (Note 7) 1,410.4 995.9 876.3 Deferred income taxes (Note 8) 13.0 12.7 22.3 Total liabilities 3,146.7 2,489.3 2,176.1 Commitments and contingent liabilities (Note 7) Common stock - $1 par value Authorized: 2,000 shares Issued and outstanding: one share 250.0 220.0 210.0 Profit employed in the business 175.5 137.7 101.1 Foreign currency translation adjustment (Note 1G) (7.5) (3.7) 1.8 Total stockholder's equity 418.0 354.0 312.9 Total liabilities and stockholder's equity $3,564.7 $2,843.3 $2,489.0 (See Notes to Consolidated Financial Statements) CATERPILLAR FINANCIAL SERVICES CORPORATION CONSOLIDATED STATEMENT OF INCOME AND RETAINED EARNINGS FOR THE YEARS ENDED DECEMBER 31, (Millions of dollars) 1993 1992 Revenues: Wholesale finance income $ 5.8 $ 4.1 $ - Retail finance income 246.4 235.2 227.7 Rental income 95.7 88.7 78.0 Other income, net 15.7 14.4 10.7 Total revenues 363.6 342.4 316.4 Expenses: Interest (Notes 6 & 7) 173.1 174.4 176.3 Depreciation 69.6 63.1 54.4 General, operating, and administrative 41.7 32.9 29.6 Provision for credit losses 20.8 20.4 13.2 Total expenses 305.2 290.8 273.5 Income before income taxes, minority interest, and cumulative effect of change in accounting for income taxes 58.4 51.6 42.9 Provision for income taxes (Note 8) 21.3 17.6 14.4 Minority interest in earnings (losses) of subsidiary (0.7) - - Income before cumulative effect of change in accounting for income taxes 37.8 34.0 28.5 Cumulative effect of change in accounting for income taxes - 2.6 - Net income 37.8 36.6 28.5 Retained earnings - beginning of year 137.7 101.1 72.6 Retained earnings - end of year $175.5 $137.7 $101.1 (See Notes to Consolidated Financial Statements) CATERPILLAR FINANCIAL SERVICES CORPORATION CONSOLIDATED STATEMENT OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, (Millions of dollars) 1993 1992 Cash flows from operating activities: Net income $ 37.8 $ 36.6 $ 28.5 Adjustments for noncash items: Depreciation 69.6 63.1 54.4 Provision for credit losses 20.8 20.4 13.2 Other (4.4) (6.1) (5.7) Change in assets and liabilities: Receivables from customers and others (15.3) 14.9 (14.6) Deferred and refundable income taxes - (9.5) 2.2 Payable to dealers and customers 2.8 10.1 (2.0) Payable to Caterpillar Inc. 1.0 (.6) (7.0) Accrued interest payable 5.5 .7 9.5 Income tax payable 6.0 21.4 (2.6) Other, net 2.1 2.1 (2.5) Net cash provided by operating activities 125.9 153.1 73.4 Cash flows from investing activities: Additions to equipment (204.1) (121.2) (118.7) Disposals of equipment 32.6 31.2 19.5 Additions to finance receivables (2,023.0) (1,601.5) (1,268.6) Collections of finance receivables 1,388.8 1,197.8 999.3 Other, net .2 (.3) .2 Net cash used for investing activities (805.5) (494.0) (368.3) Cash flows from financing activities: Additional paid in capital 30.0 10.0 10.0 Proceeds from long-term debt issues 918.4 617.0 691.3 Payments on long-term debt (517.4) (567.7) (410.7) Short-term borrowings, net 253.5 275.0 2.8 Net cash provided by financing activities 684.5 334.3 293.4 Effect of exchange rate changes on cash (.8) (2.3) (.4) Net change in cash and cash equivalents 4.1 (8.9) (1.9) Cash and cash equivalents at beginning of year 11.5 20.4 22.3 Cash and cash equivalents at end of year $ 15.6 $ 11.5 $ 20.4 (See Notes to Consolidated Financial Statements) CATERPILLAR FINANCIAL SERVICES CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollar amounts in millions) NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES A. Operations and basis of consolidation Caterpillar Financial Services Corporation (the "Company") is a wholly owned finance subsidiary of Caterpillar Inc. ("Caterpillar"). The Company provides financing of earthmoving, construction, and materials handling machinery and engines sold by Caterpillar dealers, and turbine engines sold by Solar Turbines Incorporated through offices located in North America, Australia, and Europe. The Company also provides customer and dealer loans for various business purposes. The accompanying financial statements include the accounts of Caterpillar Financial Services Corporation and its foreign subsidiaries. Certain amounts in the prior period financial statements have been reclassified to conform to the 1993 presentation. B. Recognition of earned income Retail finance income - Income on retail finance receivables (financing leases, installment sale contracts, and customer and dealer loans) is recognized over the term of the contract at a constant rate of return on the scheduled uncollected principal balance. Wholesale finance income - Income on wholesale finance receivables (dealer floor planning in Germany and rental fleet financing in the United States) is recognized based on the daily balance of wholesale receivables outstanding and the applicable effective interest rate. Rental income - Income on operating leases is reported over the life of the operating lease in the period earned. Fee income - Loan origination fees are amortized to finance income using the interest method over the contractual terms of the finance receivables. Commitments fees are amortized to other income using the straight-line method over the commitment period. Recognition of income is suspended when management determines that collection of future income is not probable. Accrual is resumed if the receivable becomes contractually current and collection doubts are removed; previously suspended income is recognized at that time. C. Depreciation Depreciation on operating leases is recognized using the straight-line method over the lease term. The depreciable basis is the original cost of the equipment less the estimated residual value of the equipment at the end of the lease term. Depreciation on property and equipment, other than equipment on operating leases, that the Company owns, was less than $1.3 million for 1993. D. Cash and cash equivalents Cash and cash equivalents include cash on hand or on deposit with banks and highly liquid short-term investments with maturities of three months or less at the time of purchase. E. Allowance for credit losses Management regularly evaluates factors affecting the collectibility of receivable balances and maintains an allowance for credit losses, which it believes is sufficient to cover uncollectible accounts. Uncollectible receivable balances are written off against the allowance for credit losses when the underlying collateral is repossessed. Prior to 1993, uncollectible receivable balances were written off when the underlying collateral was sold. F. Income taxes The Company has a tax sharing agreement with Caterpillar in which the Company consents to the filing of consolidated income tax returns with Caterpillar, and Caterpillar agrees, among other things, to collect from or pay to the Company its allocated share of any consolidated income tax liability or credit applicable to any period for which the Company is included as a member of the consolidated group in a manner determined as if each company in the consolidated group had computed its tax on a separate return basis. Similar agreements exist between Caterpillar Financial Australia Limited and Caterpillar of Australia Ltd. with respect to taxes payable in Australia, and between the Company and Caterpillar with respect to taxes payable in Germany. G. Foreign currency translation Assets and liabilities of foreign subsidiaries are translated at current exchange rates, and the effects of translation adjustments are reported as a separate component of stockholder's equity entitled "Foreign currency translation adjustment." NOTE 2 - RECEIVABLES AND ALLOWANCE FOR CREDIT LOSSES The contractual maturities of outstanding receivables at December 31, 1993, were: Installment Financing Amounts due in contracts leases Notes Total 1994 $ 415.9 $ 392.5 $ 362.2 $1,170.6 1995 304.1 296.6 288.1 888.8 1996 189.7 198.5 219.6 607.8 1997 70.8 116.7 115.2 302.7 1998 14.0 56.4 123.2 193.6 Thereafter 1.0 74.7 70.0 145.7 995.5 1,135.4 1,178.3 3,309.2 Residual Value - 219.9 - 219.9 Total $ 995.5 $1,355.3 $1,178.3 $3,529.1 Receivables generally may be repaid or refinanced without penalty prior to contractual maturity. Accordingly, this presentation should not be regarded as a forecast of future cash collections. At December 31, 1993, the recognition of finance income had been suspended on $20.1 million of finance receivables compared with $23.4 million at December 31, 1992, and $40.4 million at December 31, 1991. Activity relating to the allowance for credit losses is shown below: 1993 1992 Balance at beginning of year $36.5 $31.0 $30.8 Provision for credit losses 20.8 20.4 13.2 Aquisition of Spanish subsidiary 3.5 - - Less: Receivables written off, net of recoveries 18.8 14.3 13.0 Foreign currency translation adjustment .5 .6 - Balance at end of year $41.5 $36.5 $31.0 NOTE 3 - INVESTMENT IN FINANCING LEASES 1993 1992 Total minimum lease payments receivable $1,135.4 $ 982.3 $ 893.3 Estimated residual value of leased assets: Guaranteed 71.4 55.1 65.1 Unguaranteed 148.5 123.7 97.7 1,355.3 1,161.1 1,056.1 Less: Unearned income 229.5 212.2 182.0 Net investment in financing leases $1,125.8 $ 948.9 $ 874.1 NOTE 4 - EQUIPMENT ON OPERATING LEASES Components of the Company's investment in equipment on operating leases, less accumulated depreciation, at December 31 were as follows: 1993 1992 Equipment on operating leases, at cost $503.5 $402.0 $402.5 Less: Accumulated depreciation 138.9 125.2 119.2 Unearned investment tax credits - .1 .3 Equipment on operating leases, net $364.6 $276.7 $283.0 At December 31, 1993, scheduled minimum rental payments for operating leases were as follows: Amounts due in: 1994 $103.1 1995 83.2 1996 55.5 1997 29.2 1998 15.0 Thereafter 8.5 Total $294.5 NOTE 5 - CONCENTRATION OF CREDIT RISK The Company's receivables are primarily composed of receivables under installment sale contracts, receivables arising from leasing transactions, and notes receivable. The Company generally maintains a secured interest in equipment financed, and a substantial portion of its business activity is with customers located within the United States. Receivables from customers in construction-related industries made up approximately one-third of total finance receivables as of December 31, 1993, 1992 and 1991, respectively. However, no single customer or region represents a significant concentration of credit risk. NOTE 6 - SHORT-TERM BORROWINGS Total average short-term borrowings during 1993, 1992, and 1991 were $1,038.3 million, $776.9 million, and $662.8 million, respectively. Commercial paper and bank borrowings outstanding at December 31, 1993, generally had maturities not exceeding 90 days with average discount rates of 3.6% and 7.0%, respectively. The approximate weighted average interest rate on short-term borrowings was 4.8%, 5.2%, and 7.2% for 1993, 1992, and 1991, respectively. Interest paid on short-term borrowings was $58.3 million in 1993, $60.3 million in 1992, and $62.3 million in 1991. Short-term borrowings at December 31, consisted of the following: 1993 1992 Notes payable to banks, net $ 335.7 $195.5 $ 32.3 Commercial paper, net 797.2 714.0 638.8 Other 5.3 3.6 1.4 Total $1,138.2 $913.1 $672.5 At December 31, 1993, the Company had available in the United States, Australia, Canada, Germany, Sweden, and the United Kingdom, a total of $990.7 million of short-term credit lines which expire at various dates in 1994, and $64.7 million of long- term credit lines which expire at various dates from January 1996 to May 1996. These credit lines are with a number of banks and are considered support for the Company's outstanding commercial paper, commercial paper guarantees, the discounting of bank and trade bills, and bank borrowings at various interest rates. At December 31, 1993, there were $326.1 million of these lines utilized for bank borrowings in Australia, Germany, Sweden, and the United Kingdom. The Company also has a $455.0 million revolving credit agreement with a group of banks. This agreement is also considered support for the Company's outstanding commercial paper and commercial paper guarantees. The agreement terminates in 1996 and provides for borrowings at interest rates which vary according to LIBOR or money market rates. At December 31, 1993, there were no borrowings under this agreement. The above-mentioned credit agreements require the Company to maintain its consolidated ratio of profit before taxes plus fixed charges to fixed charges at no less than 1.1 to 1 for each quarter; the Company's total liabilities to total stockholder's equity may not exceed 8.0 to 1; and the Company's tangible net worth must be at least $20.0 million. In connection with its match funding objectives, the Company entered into a variety of interest rate contracts including interest rate swap and cap agreements, options, and forward rate agreements. These agreements are entered into with major financial institutions to reduce the Company's exposure to changes in interest rates by matching the maturities of interest- earning assets with comparable maturities of long-term and short-term funding. The interest differentials to be paid or received are accrued as interest rates change and are recognized over the lives of the agreements. As of December 31, 1993, there were outstanding swap and cap agreements with notional amounts totaling $2,047.3 million and $500.0 million, respectively. These agreements have terms generally ranging up to five years, which effectively changed $1,050.6 million of floating rate debt to fixed rate debt, $629.1 million of fixed rate debt to floating rate debt, and $867.6 million of floating rate debt to floating rate debt having different conditions. In connection with swap agreements having a total notional amount of $95.1 million, the Company entered into option agreements which would allow the counterparty to enter into swap agreements at some future date or alter the conditions of certain swap agreements. The Company's outstanding forward rate agreements totaled $246.0 million at year end, and the premiums paid or received on these agreements have been deferred and are being recognized over the lives of the agreements. The Company is exposed to possible credit loss in the event of nonperformance by the counterparties to these above-mentioned swap and cap agreements. The notional amounts of these agreements are significantly greater than the amount subject to credit risk. As of December 31, 1993, there was an accrued receivable of $2.8 million relating to these contracts. In addition, the Company may incur additional costs in replacing at current market rates any contracts for which a counterparty fails to perform. The Company has entered into forward exchange contracts to hedge its U.S. dollar denominated obligations in Australia and Canada against currency fluctuations. These contracts have terms generally ranging up to three months and do not subject the Company to risk due to exchange rate movements, because the gains and losses on the contracts offset the losses and gains on the liabilities being hedged. At December 31, 1993, the Company had forward exchange contracts totaling $146.6 million of which $143.1 million represent contracts with Caterpillar. NOTE 7 - LONG-TERM DEBT During 1993, the Company publicly issued $892.3 million of medium-term notes, of which $417.1 million were at fixed interest rates and $475.2 million were at floating interest rates indexed to LIBOR, prime, or commercial paper rates. Interest rates on fixed-rate medium-term notes are established by the Company as of the date of issuance. The notes are offered on a continuous basis through agents and have maturities ranging from nine months to 15 years. The weighted average interest rate on all outstanding medium-term notes was 6.1% at December 31, 1993. Interest paid on long-term debt in 1993, 1992, and 1991 was $102.1 million, $107.8 million, and $98.5 million, respectively. Long-term debt outstanding at December 31, 1993, matures as follows: 1994 $ 492.5 1995 486.8 1996 247.2 1997 240.2 1998 216.3 Thereafter 219.9 Total $1,902.9 At December 31, 1993, the Company was also contingently liable under guarantees of securities of certain Caterpillar dealers totaling $249.6 million of which $173.5 million was outstanding. These guarantees have terms ranging up to two years. At December 31, 1992, the Company was contingently liable for $48.1 million. No loss is anticipated under these guarantees. NOTE 8 - INCOME TAXES Effective January 1, 1992, the Company adopted SFAS 109, "Accounting for Income Taxes." Prior years' financial statements have not been restated. For years prior to 1992, income taxes were computed based on Accounting Principles Board Opinion (APB) 11. Net deferred tax liabilities as of January 1, 1992, were reduced by $2.6 million as a result of the adoption of SFAS 109. The 1992 tax provision was not materially different from the amount which would have resulted from applying APB 11. The components of the provision for income taxes were as follows for the years ended December 31: 1993 1992 Current tax provision (credit): U.S. federal taxes $17.4 $13.6 $ 9.4 Foreign taxes 2.9 4.8 1.6 U.S. state taxes 2.5 2.8 1.5 22.8 21.2 12.5 Deferred tax provision (credit): U.S. federal taxes (1.2) (.1) - Foreign taxes (.6) (3.8) .7 U.S. state taxes .3 .3 1.2 (1.5) (3.6) 1.9 Total provision for income taxes $21.3 $17.6 $14.4 Current tax provision (credit) is the amount of income taxes reported or expected to be reported on the Company's tax returns. Income taxes paid in 1993, 1992, and 1991 totaled $14.8 million, $2.2 million, and $14.8 million, respectively. In August 1993, the U.S. federal income tax rate for corporations was increased from 34% to 35% effective January 1, 1993. As a result of the rate increase, net U.S. deferred tax liabilities and the 1993 provision for income taxes were increased $0.9 million. Differences between accounting rules and tax laws cause differences between the bases of certain assets and liabilities for financial reporting and tax purposes. The tax effects of these differences, to the extent they are temporary, are recorded as deferred tax assets and liabilities under SFAS 109 and consisted of the following components at December 31: 1993 1992 U.S. federal, U.S. state, and foreign taxes: Deferred tax assets: Minimum tax credit carryforwards $ 22.0 $ 24.7 General business credit carryforwards - .2 22.0 24.9 Deferred tax liabilities - primarily capital assets (35.0) (37.6) Valuation allowance for deferred tax assets - - Deferred taxes - net $(13.0) $(12.7) No valuation allowance for the Company's deferred tax assets was necessary at December 31, 1993. The Company's tax credit carryforwards may be carried forward indefinitely. For 1991 under APB 11, the tax effect of timing differences, net of alternative minimum tax, represented deferred income tax provision reported in the financial statements because the following items were recognized in the results of operations in different years than in the tax returns: U.S. federal, U.S. state, and foreign taxes: Finance lease income and depreciation $ 1.5 Provision for credit losses - Other - net .4 Deferred tax provision $ 1.9 The provision for income taxes was different than would result from applying the U.S. statutory rate to income before income taxes and minority interest for the reasons set forth in the following reconciliation: 1993 1992 Taxes computed at U.S. statutory rates $20.4 $17.5 $14.6 Increases (decreases) in taxes resulting from: Finance income not subject to federal taxation (2.5) (2.7) (2.6) State income taxes - net of federal taxes 1.8 2.0 1.8 Subsidiaries' results subject to tax rates other than U.S. statutory rates .9 .8 .6 Change in U.S. federal tax rate .9 - - Other, net (.2) - - Provision for income taxes $21.3 $17.6 $14.4 The domestic and foreign components of income before income taxes and minority interest of consolidated companies were as follows: 1993 1992 Domestic $54.4 $51.0 $38.4 Foreign 4.0 .6 4.5 Total $58.4 $51.6 $42.9 The foreign component of income before taxes and minority interest is comprised of the profit of all consolidated subsidiaries located outside the United States. NOTE 9 - FAIR VALUE OF FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate the fair value of each class of financial instruments: Cash and cash equivalents, Other assets, Liabilities other than long-term debt and deferred income taxes, Forward exchange contracts, and Guarantees of securities. For these items, the carrying amount is a reasonable estimate of fair value. Finance receivables - net. Fair value of the outstanding receivables (excluding tax-oriented leases) is estimated by discounting the future cash flows using the Company's current rates for new receivables with similar remaining maturities. Historical experience of bad debts is also factored into the calculation. Long-term debt. Fair value is estimated by discounting the future cash flows using the Company's current borrowing rates for similar types and maturities of debt. Interest rate swaps and options. Fair value is estimated based upon the amount that the Company would receive or pay to terminate the agreements as of the reporting date. The estimated fair values of the Company's financial instruments are as follows: Carrying Fair Carrying Fair Amount Value Amount Value Cash and cash equivalents $ 15.6 $ 15.6 $ 11.5 $ 11.5 Finance receivables - net (excluding tax-oriented leases) 2,806.2 2,821.5 2,253.1 2,275.4 Other assets 45.1 45.1 29.5 29.5 Liabilities other than long-term debt and deferred income taxes 1,230.8 1,230.8 988.3 988.3 Long-term debt 1,902.9 1,941.6 1,488.3 1,520.3 Off-balance-sheet financial instruments: Interest rate swaps/caps/options: In a net receivable position* 2.8 7.9 1.2 2.7 In a net payable position* (7.3) (24.1) (6.6) (22.4) Forward exchange contracts* (1.5) (1.5) .1 .1 Guarantees of securities (173.5) (173.5) (48.1) (48.1) *The amounts shown under "Carrying amount" represent accruals or deferred income (fees) arising from these off-balance-sheet financial instruments. NOTE 10 - TRANSACTIONS WITH RELATED PARTIES Caterpillar has made capital contributions to the Company of $250.0 million. The Company has also entered into a support agreement with Caterpillar whereby the parent will cause the Company to have at all times a net worth of at least $20.0 million. To supplement external debt financing sources, the Company has variable amount lending agreements with Caterpillar (including one of its subsidiaries). Under these agreements, which may be amended from time to time, the Company may borrow up to $53.8 million from Caterpillar, and Caterpillar may borrow up to $83.8 million from the Company. All of the variable amount lending agreements are effective for indefinite terms and may be terminated by either party upon 30 days' notice. At December 31, 1993, 1992, and 1991, the Company had no outstanding borrowings or loans receivable under these agreements. The Company has also entered into forward exchange contracts with Caterpillar to hedge the U.S. dollar denominated borrowings in Australia against currency fluctuations. All of these contracts generally have maturities not exceeding 90 days. At December 31, 1993, 1992, and 1991, the Company had contracts with Caterpillar totaling $143.1 million, $116.4 million, and $119.9 million, respectively. The Company entered into agreements with a subsidiary of Caterpillar to purchase, at a discount, some or all of this subsidiary's receivables generated by sales of products to Caterpillar dealers in Germany, Austria, and the Czech Republic. The total purchases (dealer floor planning) in 1993 and 1992 amounted to $210.2 million and $201.7 million, respectively, and the cash discount earned was $4.4 million and $3.4 million, respectively. At December 31, 1993, wholesale notes receivable balances related to floor planning were $124.1 million compared with $49.3 million at December 31, 1992. Periodically, the Company offers below-market-rate financing to customers under merchandising programs. When such terms provide less than the Company's standard interest rates, Caterpillar and its subsidiaries remit an amount equal to the interest differential to the Company which is recognized as income over the term of the contract. During 1993, the Company received $7.9 million from Caterpillar and its subsidiaries relative to such programs, compared with $5.7 million in 1992 and $9.6 million in 1991. The Company reimburses Caterpillar and its subsidiaries for services provided. The amount of such charges was $4.2 million, $3.9 million, and $3.7 million for the years ended December 31, 1993, 1992, and 1991, respectively. NOTE 11 - LEASES The Company leases certain offices and other property through operating leases. Lease expense on these leases is charged to operations as incurred. Total rental expense for operating leases was $3.7 million, $3.1 million, and $2.4 million for 1993, 1992, and 1991, respectively. Minimum payments for operating leases having initial or remaining noncancelable terms in excess of one year are: 1994 $ 1.8 1995 1.7 1996 1.4 1997 1.4 1998 1.1 Thereafter 2.7 Total $10.1 NOTE 12 - SEGMENT INFORMATION Although the majority of its business is done in the United States, the Company also conducts its operations through foreign subsidiaries in Australia, Canada, and Europe. Total assets, revenues, and net income applicable to operations by geographic segments were as follows: 1993 1992 Assets: Domestic $2,878.1 $2,401.4 $2,186.0 Foreign 779.9 507.9 354.3 3,658.0 2,909.3 2,540.3 Less: Investment in subsidiaries 93.1 63.0 50.3 Intercompany balances .2 3.0 1.0 Total assets $3,564.7 $2,843.3 $2,489.0 Revenues: Domestic $ 293.0 $ 286.5 $ 265.0 Foreign 70.7 55.9 51.4 363.7 342.4 316.4 Less intercompany interest .1 - - Total revenues $ 363.6 $ 342.4 $ 316.4 Net income: Domestic $ 35.4 $ 36.9 $ 26.3 Foreign 2.4 (.3) 2.2 Total net income $ 37.8 $ 36.6* $ 28.5 *After restatement for the cumulative effect of $2.6 million ($2.5 million domestic) which resulted from the change in accounting for income taxes. NOTE 13 - SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) Financial data for the interim periods were as follows: QUARTERS FIRST SECOND THIRD FOURTH 1993 1992 1993 1992 1993 1992 1993 1992 Total revenues $86.4 $82.4 $90.1 $84.7 $91.5 $87.5 $95.6 $87.8 Income before income taxes, minority interest, and cumulative effect of change in accounting for income taxes 15.3 11.0 14.6 13.4 15.9 14.9 12.6 12.3 Net income 10.1 9.8* 9.4 8.8 9.0 9.9 9.3 8.1 *After restatement for the cumulative effect of $2.6 million which resulted from the change in accounting for income taxes. CATERPILLAR FINANCIAL SERVICE CORPORATION Schedule IX - Short-Term Borrowings (Dollars in millions) At Dec 31, Average for Year Weighted Maximum Amount Average Outstanding Outstanding Weighted Interest During the During the Interest Description Balance Rate Period Period Rate 1993: Notes payable to banks $336.0 7.0% $336.0 $251.8 8.1% Commercial paper 798.6 3.6 821.8 782.3 3.7 The Caterpillar Money Market Account 5.3 3.6 5.3 4.2 3.6 1992: Notes Payable to banks $195.5 8.6% $195.5 $ 97.1 9.1% Commercial paper 717.0 4.7 735.4 677.1 4.6 The Caterpillar Money Market Account 3.6 3.8 3.6 2.7 4.2 1991: Notes payable to banks $ 32.3 8.1% $ 34.0 $ 29.6 11.2% Commercial paper 642.0 6.4 691.1 633.0 7.0 The Caterpillar Money Market Account 1.4 5.6 1.4 .2 6.3 The weighted average interest rates were computed by relating interest for the year to average daily borrowings. Commercial paper and notes payable to banks balances represent the face amount. Unamortized discounts at December 31, 1993, 1992, and 1991 were $1.7 million, $3.0 million, and $3.2 million, respectively. Commercial paper balances represent proceeds (face amount less discount). The rate does not reflect issue costs of the money market account which was started in the third quarter of 1991. The rate reflecting issue costs was 8.2%, 11.8%, and 46.9% for 1993, 1992, and 1991, respectively.

717605_1993.txt

717605

1993

ITEM 1. BUSINESS. GENERAL DEVELOPMENT OF BUSINESS Hexcel Corporation (herein referred to as the "Parent Company" or the "Parent"), founded in 1946, was initially incorporated in California in 1948, and reincorporated in Delaware in 1983. Hexcel Corporation and subsidiaries (herein referred to as "Hexcel" or the "Company") is an international developer and manufacturer of honeycomb, advanced composites, reinforcement fabrics and resins. Hexcel materials are used in commercial aerospace, space and defense, general industrial and other markets. RESTRUCTURING AND BANKRUPTCY REORGANIZATION In December 1992, the Company initiated a worldwide restructuring program designed to improve facility utilization and determine the proper workforce requirements to support future business levels. The Company recorded a $23.5 million charge for this program in the fourth quarter of 1992. The restructuring was necessary due to anticipated protracted weakness in the aerospace industry and the need to make aggressive cost reductions to operate profitably at lower sales levels. Restructuring actions began in 1993 and included commencement of the closure of the Graham, Texas plant, personnel reductions at all remaining manufacturing facilities, and a worldwide reorganization of sales, marketing and administration. During the third quarter of 1993, Hexcel conducted a further evaluation of the adequacy of the restructuring program and existing reserves in light of declining business conditions in the Company's primary markets, including commercial aerospace. As a result of this evaluation and the continuing decline in aerospace sales, the Company significantly expanded the original restructuring program and recorded an additional restructuring charge of $50.0 million in the third quarter of 1993. The expanded restructuring is a response to deeper than anticipated declines in the aerospace market, and includes additional staff reductions, further consolidation of facilities and write-downs of impaired assets. The Company recorded another $2.6 million charge in the fourth quarter in connection with the expanded restructuring program. In order to fund the restructuring program and improve its capital structure, the Company needed substantial additional financing and a restructuring of its U.S. and European debt. Negotiations with existing senior U.S. lenders to obtain this financing and restructure the Company's domestic obligations were undertaken early in 1993 and continued throughout most of the year. Alternative sources of debt and equity financing were also pursued. The Company did secure the commitment of credit facilities for its Belgian subsidiary through March 16, 1994. However, the Company was unable to obtain a consensus among the senior U.S. lenders on a debt restructuring plan for its U.S. operations. With the Parent Company operating at critically low levels of cash, without any remaining credit availability, having extended payments to trade vendors, and needing additional financing to meet operating requirements and fund the restructuring program, Hexcel Corporation filed a voluntary petition for relief under the provisions of Chapter 11 of the federal bankruptcy laws on December 6, 1993. The Chapter 11 filing allows the Parent Company to prepare and present to the U.S. Bankruptcy Court (or "Bankruptcy Court") a plan to reorganize its operations and financial obligations while under bankruptcy protection. Bankruptcy proceedings are limited solely to Hexcel Corporation (a Delaware corporation, the "Parent Company" or "Parent"), which directly owns and operates substantially all of the Company's U.S. assets and operations. The Company's joint ventures and European subsidiaries are not included in the bankruptcy proceedings and, as such, are not subject to the provisions of the federal bankruptcy laws or the supervision of the Bankruptcy Court. However, the Parent Company is generally unable to provide direct financial support outside of the normal course of business to joint ventures and subsidiaries without Bankruptcy Court approval. Hexcel Corporation has obtained a debtor-in- possession revolving line of credit of up to $35.0 million to finance operations and restructuring activities during bankruptcy reorganization. This credit facility is expected to provide the Parent Company with adequate financing while it remains under bankruptcy protection. Further discussion of the restructuring program and bankruptcy reorganization is included in this Form 10-K in "Management Discussion and Analysis," which begins on page 28, and in Notes 2, 3 and 6 to the Consolidated Financial Statements, which begin on page 43. HEXCEL S.A. The downturn in the worldwide aerospace business and difficult economic conditions in Europe have resulted in poor financial performance by Hexcel S.A., the Company's wholly-owned Belgian subsidiary. This subsidiary has experienced a 40% sales decline and significant operating losses over the past two years. Sales are not expected to improve in 1994, and interest costs and restructuring actions continue to consume cash. Hexcel S.A. is also investigating alleged product claims which could require additional cash outlays. Hexcel S.A. is currently in negotiations with its existing lenders regarding the commitment of credit facilities which expired beginning on March 16, 1994. Four of the five existing lenders have agreed to a stand still until April 30, 1994, subject to the Parent Company making satisfactory progress toward obtaining authorization from the Bankruptcy Court to invest additional funds and recapitalize Hexcel S.A. Discussions with the fifth lender are continuing. There is no assurance that the Bankruptcy Court will authorize the investment of additional funds or the recapitalization of Hexcel S.A., or that the existing lenders will continue to extend their short-term credit agreements for any specified length of time. As a result, Hexcel S.A.'s ability to continue as a going concern is subject to its obtaining the needed financing, as well as resolving alleged product claims and successfully implementing required restructuring initiatives. Hexcel S.A. is an integral component of the Company's worldwide competitiveness, particularly in commercial aerospace. If Hexcel S.A. is unable to continue as a going concern, management believes that this would have a material adverse effect on the Company's U.S. and international operations. INDUSTRY SEGMENT Hexcel operates within a single industry segment, structural materials. The Company sells these materials in the United States and international markets. The net sales, income (loss) before income taxes, identifiable assets, capital expenditures, and depreciation and amortization for each geographic area for the past three years are shown in Note 17 to the Consolidated Financial Statements included in this Form 10-K. BUSINESS HONEYCOMB Hexcel has been the world leader in developing and manufacturing honeycomb for over 45 years. Honeycomb is a unique, lightweight, cellular structure composed generally of hexagonal cells nested together, similar in appearance to a cross-sectional slice of a beehive. The hexagonal shape of the cells gives honeycomb a high strength-to-weight ratio when used in "sandwich" form, and a uniform resistance to crushing under pressure. These characteristics are combined with the physical properties of the material from which the honeycomb is made to meet various engineering requirements. The Company produces honeycomb from a number of metallic and non-metallic materials. Most metallic honeycomb is made of aluminum and is available in a selection of alloys, cell sizes and thicknesses. Non-metallic honeycomb materials include fiberglass; graphite; thermoplastic; Nomex-R-, a non-flammable aramid fiber paper; Kevlar-R-, an aramid fiber; and several other specialty materials. Hexcel sells honeycomb in standard blocks and sheets of honeycomb core. The Company adds value to standard honeycomb core by contouring and machining it into complex shapes to meet customer specifications. In addition, honeycomb is fabricated into bonded panels and final bonded assemblies. In bonded sandwich panel construction, sheets of aluminum, stainless steel, resin-impregnated reinforcement fiber "skins" or other laminates are bonded with adhesives to each side of a honeycomb core. Bonded panels are many times stronger and stiffer than solid or laminated structures of equivalent weight. Use of an autoclave allows Hexcel to manufacture parts requiring the high temperature and pressure necessary to produce complex bonded assemblies. The largest markets for Hexcel honeycomb are the commercial and military aerospace markets. Advanced processing is used in the production of aircraft components such as wing flaps, ailerons and helicopter rotor blades. Specific applications include control surfaces (movable parts such as rudders, flaps, spoilers and speed brakes that control the direction or speed of an airplane); engine nacelles, cowlings, pylons and nozzles; fairings (flap track and wing-to-body); interiors (walls, floors, partitions and luggage bins); landing gear doors and access doors; wings, wing tips, wing leading edge and trailing edge panels; horizontal stabilizers; radomes; electromagnetic shielding and absorption; and satellite components. Non-aerospace general industrial honeycomb applications include high-speed trains and mass transit vehicles (doors, walls, ceilings, floors and external structures); energy absorption products; athletic shoe components; clean room facilities (walls and ceilings); automotive components (air flow controllers in fuel injection systems, protective head and knee restraints); portable military shelters and military support equipment; naval vessel compartments (bulkheads, water closets, doors, floor panels, partitions and bunks) and business machine cabinets. The Company operates seven honeycomb manufacturing and advanced processing facilities worldwide, including the Graham, Texas facility which is scheduled to be closed by the end of 1994. ADVANCED COMPOSITES Advanced composites combine high performance reinforcement fibers with resins to form a composite material with exceptional structural properties not found in the fibers or resins alone. Hexcel impregnates reinforcement fabrics, and fibers aligned into unidirectional tapes, with resins. The Company then partially cures the material under heat and pressure to produce a "prepreg." In addition to standard S-2-R- and E- type fiberglass, Hexcel produces advanced composite materials from a variety of commercially available fibers. Graphite fiber exhibits high strength and stiffness relative to weight and is sold principally for aerospace and recreational uses. Kevlar is exceptionally resistant to impact and is used extensively in new generation aircraft and in various armor and protection applications. Quartz and ceramic fibers are resistant to extremely high temperatures and are used in various aerospace and general industrial applications. Electrically and thermally conductive Thorstrand-R- is used mainly by the aerospace industry. Resin systems include epoxy, polyester, bismaleimide, phenolic, cyanates and polyimide. Advanced composites are sold to several markets including transportation (commercial and private aircraft, mass transit, freight and passenger vehicles); space and defense (military aircraft, naval vessels, space vehicles, defense systems and military support equipment); recreation (athletic shoes, fishing rods, bicycles, tennis rackets, baseball bats, golf clubs, surfboards, snow skis and racing cars); general industrial (utility surge arrestors, antennae and insulative rods for electrical repairs); and medical (orthotics and prosthetics). Net sales of honeycomb and advanced composites, sold separately and together as bonded structures, were $217.7 million in 1993, $253.9 million in 1992, and $263.2 million in 1991. The decline in 1993 was due mainly to a significant drop in commercial and military aerospace business. REINFORCEMENT FABRICS Hexcel produces woven fabrics without resin impregnation from the same fibers the Company uses to make advanced composites. These fibers include S-2 and E- type fiberglass, high strength carbon fibers, impact resistant Kevlar, electrically conductive Thorstrand, temperature resistant ceramic and quartz fibers, and a variety of other specialty fibers. The Company sells reinforcement fabrics for use in numerous applications. These include aerospace, marine (commercial and pleasure boats), printed circuit boards, metal and fume filtration systems, ballistics protection, decorative window coverings, automotive, insulation, recreation, civil engineering (architectural wraps), and other general and industrial applications. The Company entered into a strategic alliance with Owens-Corning Fiberglas Corporation in July 1993. The joint venture combined the weaving and stitchbonding technology of Hexcel Knytex with the worldwide reinforcement glass fiber manufacturing, marketing and distribution capabilities of Owens-Corning. The Knytex joint venture is a global market leader in the design and manufacture of stitchbonded, multi-layer reinforcement fabrics. The stitchbonded materials may be multiple layers of fabrics or fibers with varying orientations. The Company entered into a joint venture with Fyfe Associates Corporation in October 1992. Hexcel-Fyfe will sell and apply high-strength architectural wrap for the seismic retrofitting and strengthening of bridges and other structures. Net sales of reinforcement fabrics were $93.0 million in 1993, $99.2 million in 1992 and $92.4 million in 1991. As a result of the joint venture with Owens-Corning that started July 1, 1993, the Company's 1993 sales only reflect Hexcel Knytex sales for six months of $7.0 million. RESINS Resins consist of formulated epoxy and polyurethane products used in aerospace, electronics, automotive, medical devices and other general industrial applications. Applications for resin products include machinable tooling boards, fastcast resins, laminating resins for wet lay-up of boats, encapsulating materials for electronic circuits, adhesives and surface coatings. The Company has commenced discussions with interested parties for the sale of the Resins business, although no agreement has yet been reached. Net sales of resins were $27.9 million in 1993, $33.2 million in 1992 and $31.0 million in 1991. PRODUCTS AND PROCESSES, RESEARCH AND DEVELOPMENT Hexcel spent $8.7 million in 1993, $10.5 million in 1992 and $10.6 million in 1991 for research and development of products and markets. This represented 2.6% of net sales in 1993, and 2.7% of sales in each of 1992 and 1991. These expenditures were expensed as incurred. Hexcel materials rely primarily upon technology derived from the field of polymer chemistry. RAW MATERIALS The Company purchases all raw materials used in production. Aluminum and several other key raw materials are available from relatively few sources. If these materials were no longer available, which Hexcel does not anticipate, such an occurrence could have a material adverse effect on operations. ENVIRONMENTAL MATTERS Environmental control regulations have not had a significant adverse effect on overall operations. A discussion of environmental matters is included in "Item 3. Legal Proceedings" beginning on page 10 of this Form 10-K. MARKETS AND CUSTOMERS Hexcel materials are sold for a broad range of uses. The table on page 37 of this Form 10-K entitled "Market Summary" displays the percentage distribution of net sales by market since 1989. The Boeing Company and Boeing subcontractors accounted for approximately 19% of 1993 sales. The loss of this business, which the Company does not anticipate, could have a material adverse effect on sales and earnings. Sales to U.S. government programs, including some of the sales to The Boeing Company and Boeing subcontractors noted above, were 16% of sales in 1993. Hexcel commercial aerospace and space and defense sales are substantially dependent upon the level of activity within each industry as well as the acceptance by each industry of the Company's aerospace materials and services. Considerations of aircraft performance have led to the increased use of honeycomb and advanced composite materials in aircraft manufacture, particularly in newer models and development programs. However, the Company must continuously demonstrate the cost benefits of its products for aerospace applications. Commercial aerospace activity fluctuates in relation to two principal factors. First, the number of revenue passenger miles flown by the airlines affects the size of the airline fleets and generally follows the level of overall economic activity. The second factor, which is less sensitive to the general economy, is the replacement and retrofit rates for existing aircraft. These rates, resulting mainly from obsolescence, are determined in part by Federal Aviation Administration regulations as well as public concern regarding aircraft age, safety and noise. Also, these rates may by affected by the desire of airlines for higher payloads and more fuel efficient aircraft, which in turn is influenced by the price of fuel. Commercial aircraft build rates, based on the number of aircraft delivered, declined by more than 20% from 1992 to 1993. Major aircraft builders have announced significant personnel reductions which began in 1993 and are expected to continue through 1994 into 1995. Based on current projections of aircraft build rates, the commercial aerospace market will likely continue to decline at least until 1995. The Company believes activity within the military aerospace industry fluctuates in relation to world tensions and the attitudes of the current Administration and Congress toward defense spending. Since 1987, the aircraft procurement budget of the U.S. Department of Defense has declined by more than 40%. Political changes in Eastern Europe, the former Soviet Union, and the Middle East, combined with strong U.S. political sentiment toward reduced defense spending indicate that military procurement will continue to decline through 1994 and beyond. Company sales to space and defense markets, particularly military aerospace, continue to decline. In 1993, space and defense sales decreased to $55.8 million from $59.4 million in 1992 and $67.3 million in 1991. Hexcel believes the space and defense markets for its products will continue to shrink and is currently evaluating the Company's future involvement in these markets. Further discussion of the military aerospace business is included in this Form 10-K under "Management Discussion and Analysis." The B-2 program, which began in the mid - 1980s, has accounted for a significant portion of the Company's recent space and defense sales. Program delays and scheduling changes began in 1989, and orders stabilized in 1992 and 1993 far below the level anticipated when the program began. Production volumes under the program are expected to decline in 1994, and the outlook beyond 1994 is extremely uncertain. Originally, the Company expected to generate approximately $500 million in revenues over the life of the B-2 program. As a result of substantially lower orders, revenues are now expected to total approximately $100 million, most of which has already been earned. B-2 program reductions have resulted in substantial underutilized capacity at the Chandler, Arizona plant. For 1993, the Company negotiated to bill the current unabsorbed fixed costs to the prime contractor contingent upon government acceptance of this billing practice. In 1992 and 1991, the Company deferred unabsorbed fixed costs of $2.0 million and $2.4 million, respectively. Hexcel filed a claim for equitable relief associated with this program in connection with the underutilized capacity at the Chandler and other plants. Management believes, based upon advice of counsel, that the Company will realize at least the cumulative amount deferred. Hexcel contracts to supply materials for military and some commercial projects contain provisions for termination at the convenience of the U.S. government or the buyer. The Company is subject to U.S. government cost accounting standards, which are applicable to companies with more than $25 million (increased from $10 million in November 1993) of government contract or subcontract awards each year. The Company, as a defense subcontractor, is subject to U.S. government audits and reviews of negotiations, performance, cost classifications, accounting and general practices relating to government contracts. The Defense Contract Audit Agency reviews cost accounting and business practices of government contractors and subcontractors including Hexcel. The Company has been engaged in discussions of a number of cost accounting issues which could result in claims by the government. Some of these issues have already been resolved and management believes, based on available information and the Company's assertion of a right of offset among individual issues, that it is unlikely the remaining items in the aggregate will have a material adverse effect on the earnings or financial position of the Company. Further discussion of government contract matters is included in "Item 3. Legal Proceedings" of this Form 10-K. The Company has a facility security clearance from the United States Department of Defense. A portion of the Company's sales and other revenues in 1993 was derived from work requiring this clearance. Continuation of this clearance requires that the Company remains free from foreign ownership, control or influence (or "FOCI"). Management does not believe there is presently any substantial risk of FOCI that will cause the facility security clearance to be revoked. MARKETING A staff of salaried market managers, product managers and salespeople market Hexcel products directly to customers. The Company also uses independent distributors and/or manufacturer representatives for certain products and markets, including reinforcement fabrics and resins. BACKLOG The backlog of orders for aerospace materials to be filled within 12 months was $61.6 million at December 31, 1993, $100.5 million at December 31, 1992 and $118.8 million at December 31, 1991. A major portion of the backlog is cancelable without penalty. Aerospace backlog continued to decline for a number of reasons, primarily the shrinking commercial and military aerospace market. In addition, the aerospace industry is gradually moving toward "just-in-time" inventory delivery and shorter lead time requirements to reduce investment in inventory and the effect of order cancellations. Orders for aerospace materials generally lag behind the award of orders for new aircraft by a considerable period. Thus, the level of new aircraft procurement normally will not have an impact on aerospace orders received by Hexcel for about one to three years, depending on the nature of the product, manufacturer and delivery schedules. Backlog for non-aerospace materials amounted to $29.1 million at December 31, 1993 compared with $16.8 million at December 31, 1992 and $20.2 million at December 31, 1991. Most of the Company's backlog is expected to be filled within six months. Markets for the Company's products outside aerospace are generally highly competitive requiring stock for immediate sale or shorter lead times for delivery. The backlog for non-aerospace markets increased as the Company developed new applications for existing products and the economy in the U.S. began to recover in the second half of 1993. INTERNATIONAL OPERATIONS In addition to exporting from the United States, Hexcel serves international markets through four European operating subsidiaries located in Belgium, France and the United Kingdom. Each of these subsidiaries maintains manufacturing and marketing facilities. Hexcel also maintains sales offices in Australia, Brazil, Germany, Italy, Japan and Spain. Hexcel is a 50% partner in a joint venture formed in 1990 with Dainippon Ink and Chemicals (or "DIC") for the production and sale of Nomex honeycomb, advanced composites and decorative laminates for the Japanese market. All Hexcel materials, with the exception of classified U.S. military materials, are marketed throughout the world. The table on page 37 of this Form 10-K entitled "Market Summary" displays the amount of international net sales and the percentage of international sales to total net sales since 1989. Note 17 to the Consolidated Financial Statements included in this Form 10-K shows various financial data for international operations since 1991. JOINT VENTURES The Company has entered into three joint ventures since 1990, including the one with DIC discussed above. These joint ventures are discussed in "Management Discussion and Analysis" in this Form 10-K. DISCONTINUED OPERATIONS In November 1990, the Company announced plans to sell the fine chemicals business with operations in Zeeland, Michigan and Teesside, England. On March 31, 1992, the Company sold the Zeeland, Michigan fine chemicals business. On January 31, 1994, the Company sold its Teesside, England business. See Note 14 to the Consolidated Financial Statements included in this Form 10-K for further discussion. The fine chemicals business is accounted for as discontinued operations. Financial data, employees and properties related to the business have been segregated, and the information in this report reflects continuing operations only. COMPETITION In the production and sale of its materials, the Company competes with numerous U.S. and international companies on a worldwide basis, many of which are considerably larger than Hexcel in size and financial resources. For example, the Company competes with one major international manufacturer of honeycomb, advanced composites, reinforcement fabrics and resins, as well as several other major companies on specific products. The Company also competes with many smaller U.S. and international manufacturers. The broad markets for Hexcel products are highly competitive. The Company has focused on both specific markets and specialty products within markets to gain market share. Hexcel materials compete with substitute structural materials, including building materials such as structural foam, metal, wood and other engineered material. Depending upon the material and markets, relevant competitive factors include price, delivery, service, quality and product performance. Although the markets for Hexcel honeycomb materials are highly competitive, management knows of no other manufacturer that has produced and sold as much non-paper honeycomb as Hexcel during the last five years. While industry statistics are not available, management believes on the basis of market research that Hexcel currently produces and sells the largest share of metallic and non-metallic honeycomb used in the world. Hexcel continues to maintain this competitive edge through the development of new honeycomb materials for the markets it serves. PATENTS AND KNOW-HOW Management believes the ability to develop and manufacture materials is dependent upon the know-how and special skills within the Company. In addition, the Company has obtained and presently owns a number of patents, patent applications, and patent and technology licenses. It is Hexcel policy to enforce the proprietary rights of the Company. To that end, the Company has several patent infringement lawsuits pending. In 1992, the Company received a favorable judgment for patent infringement and misappropriation of trade secrets which resulted in a gain of $3.0 million. Management believes the patents and know-how rights currently owned are adequate for the conduct of business. In the opinion of management, however, no individual patent or license is of material importance. EMPLOYEES At February 28, 1994, Hexcel employed 2,340 full-time employees compared with 3,050 at December 31, 1992. Of these employees, 1,830 were in manufacturing and the remainder were administrative, sales, engineering, marketing, research and clerical personnel. 77 employees at one domestic plant have union affiliations. Management believes that labor relations in the Company are generally satisfactory. ITEM 2.

ITEM 2. PROPERTIES. Hexcel owns manufacturing plants and sales offices located throughout the United States and in several other countries as noted below. The corporate offices and principal corporate support activities for the Company are located in leased facilities in Pleasanton, California. The central research and development laboratories for the Company are located in Dublin, California. The following table lists the manufacturing plants by geographic location, approximate square footage and principal products. MANUFACTURING PLANTS The Company leases the land on which the Burlington, Washington plant is located; the 20,000 square foot Swindon, England plant; and 18,000 square feet of the Les Avenieres, France plant. In April 1993, the Company announced the closing of the Graham, Texas facility and the consolidation of the Graham operations into other plants. Even after the Graham closure, management believes the Company has more facilities and production capacity than required by either current or projected sales levels. See "Management Discussion and Analysis" in this Form 10-K for further discussion. The above table does not include the 145,000 square foot plant at Teesside, England, which was sold on January 31, 1994. This plant was used for the production of fine chemicals. Certain of the properties secure loans made to the Company. In addition, substantially all U.S. equipment and fixtures, along with other business property, secure the debtor-in-possession financing (see Note 6 to the Consolidated Financial Statements included in this Form 10-K). ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. On December 6, 1993, the Parent Company filed for protection under the provisions of Chapter 11 of the federal bankruptcy laws. For further discussion, see Items 1, "Business," and 7, "Management Discussion and Analysis of Financial Condition and Results of Operations," and Note 2 to the Consolidated Financial Statements included in this Form 10-K. Hexcel Corporation is involved in other court proceedings and claims incidental to Company business. As a result of the Chapter 11 filing, lawsuits in which Hexcel Corporation is named as a defendant are stayed as to the Company. In December 1988, employees of Lockheed Corporation working with epoxy resins and composites on classified programs filed suit against Lockheed and its suppliers (including Hexcel Corporation) claiming various injuries as a result of exposure to these products. Plaintiffs have filed for punitive damages which are uninsured. The first trial of the cases of 15 plaintiffs resulted in a mistrial and a retrial commenced in February 1994. However, Hexcel Corporation will not participate due to the bankruptcy stay. During December 1992, four shareholders commenced three actions against Hexcel Corporation and certain of its officers in the U.S. District Court for the Northern District of California. These three cases, MARTIN WEBER AND LEO BRANDSTATTER V. ROBERT L. WITT, DAVID M. WONG AND HEXCEL CORPORATION; GRETCHEN DOUGLAS V. ROBERT L. WITT ET AL; and ANN TAXIER V. ROBERT L. WITT, DAVID G. SCHMIDT AND HEXCEL CORPORATION, allege that the defendants violated sections 10(b) and 20(a) of the Securities and Exchange Act of 1934 and related Rule 10b- 5 by allegedly issuing false public disclosures regarding the business of the Company. These three suits purport to be class actions; two are on behalf of purchasers of Hexcel common stock between October 19 and December 11, 1992, and the third is on behalf of those who acquired stock between February 4 and December 11, 1992. The actions seek unspecified damages, rescission, unspecified injunctive relief and reimbursement of costs and attorneys fees. On February 5, 1993, the Court consolidated the three lawsuits into one action, IN RE HEXCEL CORPORATION SECURITIES LITIGATION. While management believes there are meritorious defenses to the claims, a tentative settlement was reached among all parties prior to the Chapter 11 filing which would avoid costly and unproductive litigation. This matter, including the tentative settlement, has been stayed by bankruptcy proceedings. In July 1992, Hexcel Corporation was joined in a lawsuit initiated in October 1990 in Alameda County Superior Court concerning a dispute over a real estate transaction between F&P Properties and Donald and Suzanne Smith (F&P PROPERTIES V. SMITH, ET AL). This action concerns, in part, responsibility for clean-up and investigation costs associated with an abandoned waste disposal site located near Company manufacturing facilities in Livermore, California. The Parent Company sold this property to the Smiths in 1979, and the Smiths, in turn, sold it to F&P Properties in 1985. A global settlement has been negotiated but was not signed by the Parent Company prior to the Chapter 11 filing. This matter, including the negotiated settlement, has been stayed by bankruptcy proceedings. Hexcel Corporation has been named as a potentially responsible party with respect to several disposal sites that it does not own or possess and are included on the Environmental Protection Agency's Superfund National Priority List ("NPL"). Also, pursuant to the New Jersey Environmental Responsibility and Clean-Up Act, Hexcel Corporation signed an administrative consent order to pay for clean-up of a manufacturing facility it formerly operated in Lodi, New Jersey. Hexcel Corporation is the account party on a $4.0 million letter of credit issued in relation to that facility in favor of the State of New Jersey, and believes that the ultimate allowed claim against it for such clean-up and for reimbursement with respect to the amount that may be paid under such letter of credit, should not exceed $4.0 million, however the ultimate cost of remediation at the Lodi site will depend on developing circumstances. The Livermore, California plant has been delisted from the NPL, however Hexcel must comply with a state clean-up order which will cause it to incur environmental costs. Contingent and unliquidated claims may be asserted against Hexcel Corporation for unexpended clean-up costs that may hereafter be expended by third parties. Such claims may be direct claims asserting joint and several liability against Hexcel Corporation for the entire future clean-up cost associated with certain Superfund and other sites that may hereafter be expended by others. Contingent claims for reimbursement or contribution may also be asserted against Hexcel Corporation by other potentially responsible parties for future clean-up costs for Superfund and other sites that may hereafter be expended by others. Hexcel cannot estimate, with any degree of confidence, the costs associated with these sites due to uncertainties relating to: (1) the nature and extent of the remediation necessary at these sites; (2) the allocation of liability among responsible parties associated with these sites; (3) the opportunities for cost recovery from other parties and insurance companies; and (4) whether the bankruptcy proceedings will act to limit the Company's liability associated with these sites. Further, Hexcel Corporation is unable to determine at this time the amount of these potential claims, including environmental claims, because an order entered in Hexcel Corporation's Chapter 11 case permits proofs of claim to be filed on or before April 28, 1994. Nor is Hexcel Corporation able to determine at this time the amount of claims that will be allowed for costs already expended by others including costs for clean-up work, although it believes that its liability is not material in amount. Under the federal bankruptcy laws, contingent or unliquidated clean-up claims may be estimated in Hexcel Corporation's Chapter 11 case for the purpose of confirming a plan of reorganization. The amount of liability of Hexcel Corporation with respect to a particular claim of that character, as estimated by the Bankruptcy Court, may, by virtue of the federal bankruptcy laws, be the maximum amount of the allowed claim of such a claimant even if such contingent or unliquidated claim later becomes fixed and liquidated. Contingent claims for reimbursement or contribution that may be filed against Hexcel Corporation may be disallowed under the federal bankruptcy laws if it is determined by the Bankruptcy Court that the claimant and Hexcel Corporation are both liable on the claim of a creditor. The last day for the filing of claims in Hexcel Corporation's Chapter 11 case is April 28, 1994, although it is possible that the Bankruptcy Court could permit the late filing of a proof of claim by a creditor that establishes excusable neglect for not filing a timely proof of claim. The maximum liability on all contingent and unliquidated claims, and the outcome of proceedings under the federal bankruptcy laws or estimation and disallowance of contingent or unliquidated claims, cannot be predicted at this time. In 1993, the Company became aware of an aluminum honeycomb sandwich panel delamination problem with panels produced by its wholly-owned Belgian subsidiary, Hexcel S.A., and installed in rail cars in France and Spain. Certain customers have alleged that Hexcel S.A. is responsible for the problem but the subsidiary has not been named in any lawsuits at this time. Hexcel S.A. is investigating these claims and the availability of any insurance coverage. Cost accounting issues and a voluntary disclosure regarding charging practices could result in future claims under U.S. government contracts. A discussion of U.S. government contracts is included in "Markets and Customers" on page 5 of this Form 10-K. The Company is cooperating with the U.S. government in all investigations of which the Company has knowledge; however, management is unable to predict whether legal proceedings will result. Management believes, based on available information, that it is unlikely any of these items will have a material adverse effect on the earnings or financial position of the Company. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. ITEM 4A. EXECUTIVE OFFICERS OF THE REGISTRANT. Listed below are the executive officers of the Company as of April 11, 1994, the positions held by them and a brief description of their business experience. There are no family relationships among any of the Company's executive officers: OFFICER POSITIONS WITH COMPANY AND NAME AGE SINCE BUSINESS EXPERIENCE - ---- --- ----- ------------------- John J. Lee 57 1993 Chairman of the Board of Directors and Chief Executive Officer since January 1994; Chairman and Co-Chief Executive Officer from July to December 1993; Director since May 1993. Mr. Lee has been the Chairman of the Executive Committee of XTRA Corporation, a transportation equipment leasing company, since 1990, and the Chairman of the Board, President and Chief Executive Officer of Lee Development Corporation, a merchant banking company, since 1987. Mr. Lee has also been a Trustee of Yale University since 1993. From July 1989 through April 1993, Mr. Lee served as Chairman of the Board and Chief Executive Officer of Seminole Corporation, a manufacturer and distributor of fertilizer. From April 1988 through April 1993, Mr. Lee served as a Director of Tosco Corporation, a national refiner and marketer of petroleum products. Mr. Lee also served as President and Chief Operating Officer of Tosco from 1990 through April 1993. OFFICER POSITIONS WITH COMPANY AND NAME AGE SINCE BUSINESS EXPERIENCE - ---- --- ----- ------------------- Donald J. O'Mara 56 1991 Director since January 1994; President and Chief Operating Officer since March 1993; Vice President - Honeycomb and Advanced Products from 1991 to 1993. From 1987 to 1991, Mr. O'Mara served as managing director of Sprague-Brooks Associates. He was Vice President and Chief Operating Officer of Gates Learjet Corporation from 1984 to 1987. Robert D. Krumme 56 1993 Director and Vice Chairman since January 1994; Vice President, General Counsel and Secretary from September 1993 to January 1994. Mr. Krumme has been President of The Corporate Management Group since 1989 and, prior to joining the Company in 1993, was a senior corporate executive officer and general counsel of three public companies. Mr. Krumme served as General Counsel of The Gillette Company from 1990 - 1991, as Vice President and General Counsel of Ingersoll-Rand Company from 1986 - 1988 and, prior to 1986, as Senior Vice President and General Counsel and in other executive positions of Cluett, Peabody & Co, Inc. for more than 15 years. Rodney P. Jenks, Jr. 43 1994 Vice President, General Counsel and Secretary of the Company since March 1994. Prior to joining the Company in 1994, Mr. Jenks was a partner in the law firm of Wendel, Rosen, Black, Dean & Levitan, from 1985. Thomas J. Lahey 53 1989 Vice President - Worldwide Sales since April 1993; Vice President - Advanced Composites from 1992 to 1993; General Manager of Advanced Composites from 1991 to 1992; General Manager of Advanced Products from 1989 to 1991. Prior to joining the company in 1989, Mr. Lahey held the position of Executive Assistant to the President of Kaman Aerospace Corporation in 1987 and 1988, and was a Vice President of Grumman Corporation from 1985 to 1987. OFFICER POSITIONS WITH COMPANY AND NAME AGE SINCE BUSINESS EXPERIENCE - ---- --- ----- ------------------- William P. Meehan 58 1993 Vice President - Finance and Chief Financial Officer of the Company since September 1993, and Treasurer of the Company since April, 1994. Prior to joining the Company in 1993, Mr. Meehan served as President and Chief Executive Officer of Thousands Trails and NACO, a membership campground and resort business, from 1990 through 1992. From 1986 through 1989, Mr. Meehan served as Vice President- Finance and Chief Financial Officer of Hadco Corporation. Robert A. Penezic 56 1979 Vice President - Administrative Operations since 1986; Vice President of Human Resources from 1979 to 1986. Mr. Penezic joined the Company in 1979. Robert A. Petrisko 39 1993 Vice President - Technology since September 1993. Mr. Petrisko joined the Company in 1989, after serving as a Research Specialist with Dow Corning Corporation from 1985 to 1989. Gary L. Sandercock 52 1989 Vice President - Manufacturing since April 1993; Vice President - Reinforcement Fabrics from 1989 to 1993; General Manager of the Trevarno Division from 1985 to 1989; other manufacturing and general management positions from 1967 to 1985. Mr. Sandercock joined the Company in 1967. William K. Woodrow 46 1993 Vice President - Marketing and Business Development since March 1993. Prior to joining the Company in 1993, Mr. Woodrow served as Director of Corporate Marketing of Raychem Corporation from 1990 to 1992, and was Division Manager of Chemelex- Industrial Division from 1988 to 1990. Wayne C. Pensky 38 1993 Controller since July 1993. Prior to joining the Company in 1993, Mr. Pensky served as Service Line Director at Arthur Andersen & Co., where he was employed from 1979. PART II ITEM 5.

ITEM 5. MARKET FOR COMMON STOCK OF REGISTRANT AND RELATED STOCKHOLDER MATTERS. Hexcel common stock is traded on the New York and Pacific Stock Exchanges. The range of high and low sales prices of Hexcel common stock on the New York Stock Exchange Composite Tape is contained in Note 18 to the Consolidated Financial Statements included in this Form 10-K and is incorporated herein by reference. The Company paid a quarterly dividend of 11 cents per share in 1992 and 1991. Payments of future cash dividends were suspended effective with the first quarter of 1993. The debtor-in-possession credit line prohibits any payment of dividends. On December 6, 1993, there were 2,294 holders of record of Hexcel common stock. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. The information required by Item 6 is contained on page 27 of this Form 10- K under "Selected Financial Data" and is incorporated herein by reference. ITEM 7.

ITEM 7. MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The information required by Item 7 is contained on pages 28 to 36 of this Form 10-K under "Management Discussion and Analysis" and is incorporated herein by reference. ITEM 8.

ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The information required by Item 8 is contained on pages 43 to 72 of this Form 10-K under "Consolidated Financial Statements and Supplementary Data" and is incorporated herein by reference. The reports of independent public accountants for the years ended December 31, 1993, 1992 and 1991 are contained on pages 40 to 42 of this Form 10-K under "Independent Auditors' Reports" and "Report of Independent Public Accountants" and are incorporated herein by reference. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not Applicable. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. 1. Directors Listed below are the directors of the Company as of April 11, 1994, the positions with the Company held by them and a brief description of each director's prior business experience. There are no family relationships among any of the Company's directors: DIRECTOR POSITIONS WITH COMPANY AND NAME AGE SINCE BUSINESS EXPERIENCE - ---- --- ----- ------------------- Thomas R. Brown 56 1981 Director; Chairman of the Insurance and Environmental Committee; member of the Audit Committee. Mr. Brown is Chairman of the Board and Co-Chief Executive Officer of California Casualty Management Co., Vice President and director of California Casualty & Life Insurance Co., and Chairman of the Board of the other corporations of the California Casualty Group. Mr. Brown is also a director of University National Bank & Trust Co. and CorVel Corporation. The California Casualty Group specializes in group sponsored personal lines, property/casualty insurance and workers' compensation. Gary L. Depolo 57 1990 Director; Chairman of the Executive Compensation and Organization Committee; member of the Audit Committee. Mr. Depolo is a retired Executive Vice President of Transamerica Corporation and served on the Board of Directors of several of Transamerica's subsidiary companies. Mr. Depolo is also a director of Alta Bates Corporation and California Health Systems. Transamerica Corporation is a financial services organization which engages primarily in lending, leasing, real estate services and insurance. John L. Doyle 62 1974 Director; Former Co-Chief Executive Officer and Vice Chairman (July 1993 to December 1993); Chairman of the Advanced Programs and Technology Committee; member of the Nominating Committee. Mr. Doyle is a retired Executive Vice President of Hewlett- Packard Co. Mr. Doyle is also a director of Analog Devices, Inc. and Tab Products. Hewlett-Packard Co. manufactures electronic computation equipment and measuring instruments. DIRECTOR POSITIONS WITH COMPANY AND NAME AGE SINCE BUSINESS EXPERIENCE - ---- --- ----- ------------------- Cyrus H. Holley 57 1991 Director; member of the Advanced Programs and Technology Committee; member of the Executive Compensation and Organization Committee. Mr. Holley is a retired Executive Vice President and Chief Operating Officer of Engelhard Corporation. Mr. Holley is also a director of Atlantic Energy, Inc. and UGI Corporation. Engelhard Corporation is a provider of specialty chemical products, engineered materials and precious metal management services. Mr. Holley currently operates Management Consulting Services which provides strategic planning services to the business and education communities. He also serves as a director of the National Association of Partners in Education. Robert D. Krumme 56 1994 Director and Vice Chairman since January 1994; Vice President, General Counsel and Secretary from September 1993 to January 1994. Mr. Krumme has been President of The Corporate Management Group since 1989 and, prior to joining the Company in 1993, was a senior corporate executive officer and general counsel of three public companies. Mr. Krumme served as General Counsel of The Gillette Company from 1990 - 1991, as Vice President and General Counsel of Ingersoll-Rand Company from 1986 - 1988 and, prior to 1986, as Senior Vice President and General Counsel and in other executive positions of Cluett, Peabody & Co, Inc. for more than 15 years. DIRECTOR POSITIONS WITH COMPANY AND NAME AGE SINCE BUSINESS EXPERIENCE - ---- --- ----- ------------------- John J. Lee 57 1993 Chairman of the Board of Directors and Chief Executive Officer since January 1994; Chairman and Co-Chief Executive Officer from July to December 1993; Director since May 1993. Mr. Lee has been the Chairman of the Executive Committee of XTRA Corporation, a transportation equipment leasing company, since 1990, and the Chairman of the Board, President and Chief Executive Officer of Lee Development Corporation, a merchant banking company, since 1987. Mr. Lee has also been a Trustee of Yale University since 1993. From July 1989 through April 1993, Mr. Lee served as Chairman of the Board and Chief Executive Officer of Seminole Corporation, a manufacturer and distributor of fertilizer. From April 1988 through April 1993, Mr. Lee served as a Director of Tosco Corporation, a national refiner and marketer of petroleum products. Mr. Lee also served as President and Chief Operating Officer of Tosco from 1990 through April 1993. Charles A. Lynch 66 1994 Director; Chairman of the Restructuring Committee. Chairman of Greyhound Lines, Inc., since 1991, and since 1989, Chairman of Market Value Partners Company, a firm that invests in and manages developing and underperforming companies. Mr. Lynch also serves on the board of directors of Pacific Mutual Life Insurance, Nordstrom, Inc., Syntex Corporation, Mid-Peninsula Bank and Fresh Choice, Inc. From 1988 through 1989 Mr. Lynch served as President and Chief Executive Officer of Levolor Corporation. From 1986 through 1988 Mr. Lynch served as Chairman and Chief Executive Officer of DHL Airways, Inc. From 1978 through 1986 Mr. Lynch served as Chairman and Chief Executive Officer of Saga Corporation. Donald J. O'Mara 56 1994 Director since January 1994; President and Chief Operating Officer since March 1993; Vice President - Honeycomb and Advanced Products from 1991 to 1993. From 1987 to 1991, Mr. O'Mara served as managing director of Sprague-Brooks Associates. He was Vice President and Chief Operating Officer of Gates Learjet Corporation from 1984 to 1987. DIRECTOR POSITIONS WITH COMPANY AND NAME AGE SINCE BUSINESS EXPERIENCE - ---- --- ----- ------------------- Lewis Rubin 56 1993 Director; Chairman of the Audit Committee; member of the Nominating Committee. Mr. Rubin has been President and Chief Executive Officer of XTRA Corporation, a transportation equipment leasing company, since 1990. From February 1988 to March 1990, Mr. Rubin served as President of Lewis Rubin Associates, a consulting firm advising the transportation equipment industry. Prior to February 1988, Mr. Rubin served as Chairman, President and Chief Executive Officer of Gelco CTI Container Services, a subsidiary of Gelco Corporation, a diversified international management services corporation, and as Executive Vice President of Gelco Corporation. Mr. Rubin is also a Director of Oneita Industries, Inc. George S. Springer 60 1993 Director; member of the Advanced Programs and Technology Committee; member of the Nominating Committee. Dr. Springer is Professor and Chairman of the Department of Aeronautics and Astronautics and, by courtesy, Professor of Mechanical Engineering and Professor of Civil Engineering at Stanford University. Dr. Springer joined Stanford's faculty in 1983. (a) EXECUTIVE OFFICERS Information concerning the executive officers of the registrant is contained in "Item 4A. Executive Officers of the Registrant" beginning on page 12 of this Form 10K and is incorporated herein by reference. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. The information required in Item 11 will be contained in the definitive Proxy Statement of the Company. Such information is incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information required in Item 12 will be contained in the definitive Proxy Statement of the Company. Such information is incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. On March 11, 1994, Mr. Rodney P. Jenks, Jr. became Vice President, General Counsel and Secretary of the Company. Prior to becoming an officer of the Company, Mr. Jenks was a partner in the law firm of Wendel, Rosen, Black, Dean & Levitan which, during 1993 and to date in 1994, provided legal services to the Company for which it was invoiced $92,011. Upon becoming an officer of the Company, Mr. Jenks resigned as a partner and currently serves as counsel to the law firm. Although the law firm continues to provide limited legal services to the Company (none of which are performed by Mr. Jenks), it is anticipated that these services will be less extensive during 1994 than during 1993. There are no currently proposed related transactions or any other related transactions during the prior fiscal year that require disclosure in this Form 10-K report. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. a. FINANCIAL STATEMENTS The consolidated financial statements of the Company, notes thereto, financial statement schedules, independent auditors' report, and report of independent public accountants are listed on page 38 of this Form 10-K and are incorporated herein by reference. b. REPORTS ON FORM 8-K Current Report on Form 8-K dated December 9, 1993 related to the Registrant filing a voluntary petition for relief under the provisions of Chapter 11 of the federal bankruptcy laws in the United States Bankruptcy Court for the Northern District of California, Oakland Division on December 6, 1993. c. EXHIBITS EXHIBIT NO. DESCRIPTION - ----------- ----------- 3. 1. Restated Certificate of Incorporation of Hexcel Corporation(6) 2. Certificate of Designation, Preferences and Rights of Series A Junior Participating Preferred Stock(6) 3. Certificate of Increase of Authorized Number of Shares of Series A Junior Participating Preferred Stock(7) 4. Amended and Restated Bylaws of Hexcel Corporation dated as of August 30, 1993 4. 1. Certificate of Incorporation of Hexcel Corporation, Articles 5 through 10 (See Exhibit 3-1) 2. Certificate of Designation, Preferences and Rights of Series A Junior Participating Preferred Stock (Exhibit 3-2) 3. Certificate of Increase of Authorized Number of Shares of Series A Junior Participating Preferred Stock (See Exhibit 3-3) 4. Amended and Restated Bylaws of Hexcel Corporation, Sections 3 through 11, 13 through 16, and 46 (See Exhibit 3-4) EXHIBIT NO. DESCRIPTION - ----------- ----------- 5. Amendment to Bylaws of Hexcel Corporation (See Exhibit 3-4) 6. Rights Agreement dated as of August 14, 1986, between Hexcel Corporation and Manufacturers Hanover Trust Company, as Successor Rights Agent(6) 7. Amendment No. 1 dated October 18, 1988 to Rights Agreement between Hexcel Corporation and the Bank of California, N.A. 8. Amendment No. 2 dated November 19, 1990 between Hexcel Corporation and Manufacturers Hanover Company, as successor Rights Agent(4) 9. Amendment No. 3 dated December 18, 1990 between Hexcel Corporation and Manufacturers Hanover Company, as successor Rights Agent(5) 10. Exemplar of Indenture between Hexcel Corporation and The Bank of California, N.A., Trustee, dated October 1, 1988 11. Loan Agreement and Indentures-Industrial Development Bonds. These instruments are not filed herewith; the registrant agrees to furnish a copy of such instruments to the Commission upon request 10. Material Contracts: 1. A. Note Agreement, as amended, dated December 9, 1977, $8,000,000 8-3/4% Notes B. Amendments dated April 25, 1978, April 30, 1980, January 6, 1981, April 12, 1981, May 13, 1981, August 21, 1981, March 15, 1982 and September 1, 1982, December 31, 1983, July 24, 1986 and August 25, 1986, to Note Agreement dated December 9, 1977, $8,000,000 8-3/4% Notes 2. Consent Agreement dated March 31, 1993, relating to Amended and Restated Credit Agreement dated March 31, 1993, among Hexcel Corporation and the Banks named therein and Wells Fargo Bank, N.A., as Agent(7) 3. Amended and Restated Credit Agreement dated March 31, 1993, among Hexcel Corporation and the Banks named therein and Wells Fargo Bank, N.A., as Agent(7) 4. Letter of Credit and Reimbursement Agreement dated March 1, 1988, between Hexcel Corporation and Banque Nationale de Paris(7) 5. Letter of Credit and Reimbursement Agreement dated December 1, 1989, between Hexcel Corporation and Banque Nationale de Paris(3) A. Amendment No. 1 to Letter of Credit and Reimbursement Agreement dated October 12, 1988, between Hexcel Corporation and Banque Nationale de Paris EXHIBIT NO. DESCRIPTION - ----------- ----------- B. Amendment No. 2 to Letter of Credit and Reimbursement Agreement dated July 1, 1992, between Hexcel Corporation and Banque Nationale de Paris C. Amendment No. 3 to Letter of Credit and Reimbursement Agreement dated April 15, 1993, between Hexcel Corporation and Banque Nationale de Paris 6. Note Agreement dated as of October 1, 1988, between Hexcel Corporation and Principal Mutual Life Insurance Company, $30,000,000 10.12% Senior Notes Due October 1, 1998 7. Letter of Credit Reimbursement Agreement dated as of November 1, 1991, among Hexcel Corporation and Barclays Bank PLC 8. Letter of Credit Reimbursement Agreement dated as of April 28, 1992, among Hexcel Corporation and Barclays Bank PLC as amended March 31, 1993 9. Debtor in Possession Credit Agreement dated as of December 8, 1993, and amended January 3, 1994 and March 25, 1994, and amended April 11, 1994 by and between Hexcel Corporation and The CIT Group/Business Credit, Inc. 10. Executive Compensation Plans and Arrangements A. Stock Option Plans (1) 1988 Management Stock Program(1) (2) Amendments to 1988 Management Stock Program(1) (3) 1988 Restricted Stock Agreement - Sample Agreement(1) (4) 1988 Directors' Discounted Stock Option Agreement - Sample Agreement(1) (5) 1988 Discounted Stock Option Agreement - Sample Agreement(1) (6) 1988 Employees Nonqualified Stock Option Agreement - Sample Agreement(2) (7) 1988 Officers' Nonqualified Stock Option Agreement - Sample Agreement(1) B. Exemplar of Executive Deferred Compensation Agreement C. Exemplars of Incentive Plans(6) D. Exemplars of Contingency Employment Agreement E. Directors' Retirement Plan(7) EXHIBIT NO. DESCRIPTION - ----------- ----------- F. Employment Agreement dated September 28, 1993 between Hexcel Corporation and John J. Lee G. Employment Agreement dated September 28, 1993 between Hexcel Corporation and John L. Doyle 11. Statement Regarding Computation of Per Share Earnings 18. Preferability letter regarding change in accounting for inventories - Deloitte & Touche 21. Subsidiaries of Registrant 23. Consents of Experts and Counsel 1. Independent Auditors' Consent - Deloitte & Touche 2. Consent of Independent Public Accountants - Arthur Andersen & Co. _______________ (1) Incorporated by reference to the Registration Statement of registrant on Post-Effective Amendment No. 1 to Form S-8 filed on May 11, 1988, No. 33- 17025, pursuant to the Securities Act of 1933 (2) Incorporated by reference to the Registration Statement of registrant on Form S-8 filed on May 2, 1989, No. 33-28445, pursuant to the Securities Act of 1933 (3) Incorporated by reference to the Annual Report of registrant on Form 10-K for the year ended December 31, 1989, filed pursuant to Section 13 of the Securities Exchange Act of 1934. (4) Incorporated by reference to the Current Report of registrant on Form 8-K dated November 19, 1990, filed pursuant to Section 13 of the Securities Exchange Act of 1934. (5) Incorporated by reference to the Current Report of registrant on Form 8-K dated December 18, 1990, filed pursuant to Section 13 of the Securities Exchange Act of 1934. (6) Incorporated by reference to the Annual Report of registrant on Form 10-K for the year ended December 31, 1991, filed pursuant to Section 13 of the Securities Exchange Act of 1934. (7) Incorporated by reference to the Annual Report of registrant on Form 10-K for the year ended December 31, 1992, filed pursuant to Section 13 of the Securities Exchange Act of 1934. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED, IN THE CITY OF PLEASANTON, STATE OF CALIFORNIA. HEXCEL CORPORATION APRIL 11, 1994 By: /s/ JOHN J. LEE ___________________________________ John J. Lee, Chief Executive Officer PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. SIGNATURE TITLE DATE --------- ----- ---- JOHN J. LEE Chairman of the Board of April 11, 1994 ______________________ Directors and Chief Executive (John J. Lee) Officer (PRINCIPAL EXECUTIVE OFFICER) WILLIAM P. MEEHAN Vice President and Chief Financial April 11, 1994 ______________________ Officer (William P. Meehan) (PRINCIPAL FINANCIAL OFFICER) WAYNE C. PENSKY Controller April 11, 1994 ______________________ (CONTROLLER AND PRINCIPAL (Wayne C. Pensky) ACCOUNTING OFFICER) THOMAS R. BROWN Director April 11, 1994 ______________________ (Thomas R. Brown) GARY L. DEPOLO Director April 11, 1994 ______________________ (Gary L. Depolo) JOHN L. DOYLE Director April 11, 1994 ______________________ (John L. Doyle) CYRUS H. HOLLEY Director April 11, 1994 ______________________ (Cyrus H. Holley) ROBERT D. KRUMME Director April 11, 1994 ______________________ (Robert D. Krumme) CHARLES A. LYNCH Director April 11, 1994 ______________________ (Charles A. Lynch) SIGNATURE TITLE DATE --------- ----- ---- DONALD J. O'MARA Director April 11, 1994 ______________________ (Donald J. O'Mara) LEWIS RUBIN Director April 11, 1994 ______________________ (Lewis Rubin) GEORGE S. SPRINGER Director April 11, 1994 ______________________ (George S. Springer) Exhibit 23.1 INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference of our report dated April 11, 1994 (which report contains explanatory paragraphs regarding the uncertainties of Hexcel Corporation's bankruptcy proceedings, substantial doubt about Hexcel Corporation's ability to continue as a going concern, uncertainties regarding the future operations of Hexcel Corporation's wholly-owned Belgian subsidiary, Hexcel S.A., a change in accounting for postretirement benefits other than pensions, a change in accounting for income taxes and a change in accounting for domestic honeycomb and fabric inventories) appearing in this Annual Report on Form 10-K for the year ended December 31, 1993, in the following Registration Statements of Hexcel Corporation: - - No. 33-9763 on Form S-3 for the Dividend Reinvestment Plan, - - No. 33-49478 on Form S-8 for the 1988 Management Stock Program. DELOITTE & TOUCHE Oakland, California April 11, 1994 ______________________________ Exhibit 23.2 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the inclusion of our report dated February 4, 1992, in this Annual Report on Form 10-K for the year ended December 31, 1993 of Hexcel Corporation and the incorporation by reference of our report in the Registration Statement on Form S-3 for the Dividend Reinvestment Plan, filed on October 28, 1986, No. 33-9763 and in the Registration Statement on Form S-8 for the 1988 Management Stock Program, filed on July 10, 1992, No. 33-49478. ARTHUR ANDERSEN & CO. San Francisco, California April 11, 1994 SELECTED FINANCIAL DATA The following table summarizes selected financial data for continuing operations(a) as of, and for, the five years ended December 31. MANAGEMENT DISCUSSION AND ANALYSIS RESTRUCTURING AND BANKRUPTCY REORGANIZATION The Company initiated a worldwide restructuring program in December 1992 and, accordingly, recorded a restructuring charge of $23.5 million. The restructuring was necessary due to several factors including a precipitous drop in aerospace build rates during the fourth quarter of 1992, anticipation of protracted weakness in the aerospace industry and the need to make aggressive cost reductions to operate profitably at lower sales levels. The initial restructuring program included reductions in excess manufacturing capacity and personnel, and a worldwide reorganization of sales, marketing and administration. In addition to the realignment and reduction of personnel in the U.S. and Europe, this program provided for the closure of the Graham, Texas honeycomb plant, which was announced in April 1993. The Company began moving manufacturing processes shortly thereafter, and expects the Graham facility to be closed completely during the second half of 1994. During the third quarter of 1993, Hexcel conducted a further evaluation of the adequacy of the restructuring program and existing reserves in light of declining business conditions in the Company's primary markets, including commercial aerospace. As a result of this evaluation and the continuing decline in aerospace sales, the Company significantly expanded the original restructuring program and recorded an additional restructuring charge of $50.0 million in the third quarter of 1993. The expanded restructuring is a response to deeper than anticipated declines in the aerospace market, and includes additional staff reductions, further consolidation of facilities in the U.S. and Europe, and write-downs of impaired assets. During the fourth quarter of 1993, an additional charge of $2.6 million was recorded in connection with the expanded restructuring program. Even after the Graham closure is complete, the Company has more production capacity than required for either current or projected sales levels, and needs to close additional facilities. The 1993 restructuring charges include the estimated costs of such closures, and the Company is currently evaluating which facilities to close. This process is complicated by the uncertain outlook for several product lines as well as aerospace industry requirements to "qualify" specific equipment and locations for the manufacture of certain products. These qualification procedures increase the complexity, cost and time of moving equipment while continuing to serve existing customers. Of the total of $76.1 million in 1993 and 1992 restructuring charges, approximately $40 million relates to noncash asset write-downs. These write- downs reflect expected losses on the disposition of facilities as well as the impairment of assets caused by the changed business environment. Based on current restructuring plans, estimated cash outlays for remaining restructuring activities as of December 31, 1993 are approximately $18 million. See Note 3 to the Consolidated Financial Statements for additional discussion. In order to fund the restructuring program and improve its capital structure, the Company needed substantial additional financing and a restructuring of its U.S. and European debt. Negotiations with existing senior U.S. lenders to obtain this financing and restructure the Company's domestic obligations were undertaken early in 1993 and continued throughout most of the year. Alternative sources of debt and equity financing were also pursued. The Company did secure commitments of credit facilities for its Belgian subsidiary through March 16, 1994, but was unable to obtain a consensus among the senior U.S. lenders on a debt restructuring plan for U.S. operations. The failure of these negotiations left the Company with insufficient cash availability to meet operating requirements and continue the restructuring program, as discussed further under "Financial Condition and Liquidity" below. As a result, on December 6, 1993, Hexcel Corporation filed a voluntary petition for relief under the provisions of Chapter 11 of the federal bankruptcy laws. The bankruptcy proceedings are limited to the U.S. parent company, Hexcel Corporation, which directly owns and operates substantially all U.S. assets and operations. The bankruptcy proceedings limit Hexcel Corporation's ability to provide direct financial support outside of the normal course of business to its joint ventures and international subsidiaries without the approval of the U.S. Bankruptcy Court. Furthermore, certain actions, including actions outside of the normal course of business, must be approved by the Bankruptcy Court. For a further discussion of the effect of bankruptcy on the Company and its rights and obligations under Chapter 11, see Note 2 to the Consolidated Financial Statements included in this Form 10-K. The Company incurred $0.6 million in costs associated with bankruptcy proceedings in December of 1993. Legal and professional fees to be incurred as a result of bankruptcy proceedings are expected to be significant. RESULTS OF OPERATIONS The 1993 loss from continuing operations was $86.5 million or $11.79 per share. This compares with a loss from continuing operations of $17.7 million in 1992 and income from continuing operations of $4.8 million in 1991. The net loss for 1993, including discontinued operations and the cumulative effects of accounting changes, was $86.0 million or $11.73 per share. The net loss was $29.3 million in 1992 and net income was $4.3 million in 1991. The 1993 loss from continuing operations includes additional restructuring charges of $52.6 million for a major expansion of the restructuring program begun in December 1992. The loss also includes other expenses of $12.8 million for the write-down of certain assets and increases in reserves for warranties and environmental matters on property previously owned. The impairment of assets was due primarily to the bankruptcy proceedings, continued changes in business conditions and depressed real estate prices on property held for sale. In addition, the Company recorded a $10.9 million reserve in 1993 to reflect the adverse impact of the bankruptcy proceeding of Hexcel Corporation and ongoing operating losses on the potential realization of deferred income tax benefits. The 1992 results include a $23.5 million restructuring charge and other income of $3.0 million from the settlement of a patent infringement case, as well as a $1.4 million gain from the settlement of interest rate swap agreements. During the fourth quarter of 1993, the Company changed to the first-in, first-out ("FIFO") method of accounting for substantially all inventories. The FIFO method provides a more meaningful presentation of the Company's financial position by reflecting inventories at more recent costs, which provides more relevant information about the Company's business condition. The effect of this change on domestic honeycomb and fabric inventories, which were previously valued using the last-in, first-out method, has been applied to prior years by retroactively restating the consolidated financial statements as required by generally accepted accounting principles. In 1993, the Company recorded a one- time, cumulative benefit of $4.5 million from the adoption of a new accounting standard for income taxes. In 1992, the Company recorded a one-time charge of $8.1 million to reflect the adoption of a new accounting standard for postretirement benefits. 1992 results also include an extraordinary gain of $1.0 million on the redemption of $7.3 million of convertible subordinated debentures at a discount. Losses from discontinued operations, which have now been sold, totaled $4.0 million, $4.5 million and $0.5 million in 1993, 1992 and 1991, respectively. The downturn in the worldwide commercial aerospace business, which accelerated in the fourth quarter of 1992, continued throughout 1993. This downturn, which is not expected to reverse in 1994, has been a major factor in the declining sales and substantial operating losses experienced by the Company since the end of 1992. The ongoing decline in military procurement, including military aerospace orders, has also contributed to the deterioration in the Company's operating results. Furthermore, while non-aerospace markets in the U.S. stabilized during 1993, general economic conditions in Europe did not improve. Many of the markets the Company serves within Europe remain depressed, although some markets such as electrical products strengthened during the year. Headcount reductions from December 31, 1992 to February 28, 1994, have totaled 710 people, to 2,340 employees at February 28, 1994. SALES Sales from continuing operations were $338.6 million in 1993, compared with $386.3 million in 1992 and $386.6 million in 1991. The 12% decline from 1992 to 1993 is primarily attributable to the downturn in the worldwide commercial aerospace market, which accelerated during the fourth quarter of 1992. Sales in the fourth quarter of 1993 of $80.3 million were down 9% from the fourth quarter of 1992, and were 17% less than fourth quarter sales two years ago. Customers within the aerospace market have responded to lower build rates for commercial aircraft by canceling orders, delaying shipments and reducing inventories to match future operating levels. The military aerospace market has also been in decline, reflecting Administration and Congressional pressure to reduce military spending. The Company continued to pursue other markets for its products during the year. Sales in the U.S. were $193.6 million in 1993, down 10% from $216.2 million in 1992. The decline in U.S. sales was attributable to the decline in the commercial and military aerospace markets. Sales to the U.S. recreation market increased, but fabrics sales were lower due to the transfer of the Company's Knytex operations to a corporate joint venture with Owens-Corning on June 30, 1993. Knytex sales of $7.0 million during the first half of the year are included in the consolidated sales total, while second half sales are not. International sales were $144.9 million for 1993 compared with $170.1 million in 1992. Decreased aerospace sales were only partially offset by improved sales to the recreation and electrical markets. In addition, sales to the European architectural market were weak as the construction industry, especially in Germany, remained in a deep recession. Part of the international sales decline is due to currency exchange rates. The Belgian and French francs declined approximately 7% against the dollar from 1992 to 1993; accordingly, sales from the Company's primary international subsidiaries were reduced when translated into U.S. dollars. Sales in 1992 were essentially unchanged from 1991. U.S. sales increased by $5.7 million which neutralized a corresponding international sales decrease. The U.S. sales increase was due mainly to graphite honeycomb shipments in early 1992. The international sales decline was attributable to depressed aerospace sales in Europe. COMMERCIAL AEROSPACE SALES Worldwide sales of $132.6 million in 1993 were down 20% from sales of $166.4 million in 1992. The commercial aerospace market began to deteriorate in 1992 and the slow-down continued throughout 1993. Reacting to order cancellations from many airlines, major aircraft manufacturers announced a series of build rate reductions worldwide. Additionally, most of these manufacturers announced significant personnel reductions and initiated ongoing efforts to reduce inventories and shorten production lead times. These actions indicate that this is not a temporary decline in the commercial aerospace market. Declining build rates and associated inventory reductions have resulted in the cancellation and delay of orders for several of the Company's aerospace products. While sales of individual products, such as graphite honeycomb and certain composites products, have increased in response to the production of new wide-bodied aircraft, the majority of products sold to the commercial aerospace market declined. The shrinking commercial aerospace market has intensified competition among suppliers for remaining business. This has resulted in price pressure and margin declines on competitive products which the Company provides to this market. SPACE AND DEFENSE SALES Worldwide sales in 1993 decreased to $55.8 million from $59.4 million in 1992. This decline continues a trend which began in 1988 when sales to the space and defense market exceeded $100.0 million. The Company expects this trend to continue and is currently evaluating its future involvement in these markets. The disposition of the current Administration and Congress is toward a general reduction in military spending, and several of the military aerospace programs in which the Company has participated in the past, including the B-2 program, are being reduced or eliminated. For further discussion of the Company's space and defense business, see "Markets and Customers" in this Form 10-K. GENERAL INDUSTRIAL AND OTHER SALES Worldwide sales were $150.1 million in 1993 compared with $160.5 million in 1992. For the first time in recent Company history, sales to general industrial markets exceeded sales to the commercial aerospace market. Products provided to non-aerospace customers included honeycomb, advanced composites, reinforcement fabrics and resins. Sales of new products introduced within the last three years continued to grow, as did sales to Reebok for use in athletic shoes. The sale of honeycomb panels for trains built for the Channel Tunnel peaked in 1993 following project delays in 1992. Demand for graphite composite tape used in golf club shafts rose as manufacturers pursued improved performance, and fabric sales to the electrical market increased as demand for circuit boards grew. Sales of material for ballistic purposes, such as bulletproof vests, increased as a result of the receipt of three large contracts. The formation of the corporate joint venture with Owens-Corning reduced sales of stitchbonded fabrics in the U.S. as sales during the second half of the year went to the joint venture. Decorative fabric sales declined, primarily in Europe, because of the slump in the construction industry. Hexcel's penetration of the U.S. decorative market is still in the embryonic stage. Resin product sales declined nearly 16% to $27.9 million in 1993. Approximately two-thirds of resin product sales are in Europe, and most of the sales decline was due to currency exchange rates. U.S. resin sales also declined due to general aerospace and other industry trends. The Company has commenced discussions with interested parties for the sale of the Resins business, although no agreement has yet been reached. The Company continues to focus on the development of products for the general industrial, recreation, transportation, and other non-aerospace markets. Increased sales to these markets are needed to lessen the Company's dependence on commercial aerospace and space and defense markets. GROSS MARGIN Gross margin for 1993 declined to 16.7% from 19.9% in 1992 and 21.0% in 1991. The gross margin decline resulted primarily from lower sales volumes and continued pricing pressures due to industry overcapacity in aerospace markets. The 12% sales decline in 1993 created additional excess capacity for the Company. Although the closure of the Company's Graham, Texas plant began in April 1993, the impact of reduced manufacturing overhead costs did not begin to materialize until the fourth quarter. The Graham closure will not be completed until the second half of 1994. For a period of time, the Company was required to maintain overlapping overhead while manufacturing processes were being transferred to other plants. In addition, many of the new products developed for non-aerospace markets have not commanded premium prices due to strong competition. At the same time, shrinking aerospace markets have generated increased competition for remaining business which has created pricing pressures on competitive products. MARKETING, GENERAL AND ADMINISTRATIVE (M,G&A) EXPENSES M,G&A expenses decreased $10.3 million from 1992 to 1993, a decline of 14%. M,G&A expenses were 18.2% of sales in 1993, 18.6% in 1992 and 16.9% in 1991. The decrease in 1993 was a result of significant headcount reductions made during the year in an effort to mitigate the effects of declining sales. These headcount reductions were achieved through a reorganization of sales and administrative functions to reduce redundancies and inefficiencies. In addition, the Company restricted spending due to its tight cash position, particularly in the second half of the year. M,G&A expenses increased by $6.6 million from 1991 to 1992 because of several significant expenses, including bad debt write-offs and legal and environmental reserves. M,G&A expenses include research and development expenses which were $8.7 million in 1993 or 2.6% of sales, approximately the same level as in 1992 and 1991. Successful research and development activities are critical to the Company's future, and the need to invest in effective research and development must be balanced against the need to reduce expenditures. INTEREST 1993 interest expenses were $9.1 million, 5% higher than in 1992. Excluding a $1.4 million gain in 1992 from the settlement of interest rate swap agreements, interest expenses actually declined by 9% from 1992 to 1993. This decline is attributable to lower average interest rates on variable rate debt, as well as the full-year benefit from the repurchase of $7.3 million of convertible subordinated debentures during the second quarter of 1992. In addition, borrowings under the U.S. revolving credit agreement were limited to $12.0 million throughout the year. Interest reductions were partially offset by additional borrowings by Hexcel S.A., the Company's Belgian subsidiary, to finance losses and restructuring activities. 1992 interest expenses of $8.7 million were 24% lower than in 1991. In addition to the $1.4 million gain noted above, 1992 expenses benefited from declining interest rates and the reduction of $19.3 million in debt from the cash proceeds from the sale of the U.S. fine chemicals business in 1991. Capitalized interest was $0.2 million in 1993, $0.3 million in 1992, and $1.1 million in 1991. The decline in interest capitalization reflects the reduction in long-term capital projects undertaken by the Company. INCOME TAXES Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109 ("SFAS 109"), "Accounting for Income Taxes." The cumulative effect of adopting this standard was the recognition of a deferred income tax benefit of $4.5 million, which was recorded in the first quarter of 1993. During 1993, substantial uncertainty developed as to the realization of the deferred income tax benefits recognized in connection with SFAS 109. As a result, the Company recorded a $10.9 million adjustment to the valuation allowance to reduce the recorded value of these benefits to zero as of December 31, 1993. The adjusted valuation allowance reflects the Company's assessment that the bankruptcy proceedings of Hexcel Corporation and ongoing operating losses have impaired the realization of deferred income tax benefits. See Note 13 to the Consolidated Financial Statements for additional discussion. The 1993 tax provision was computed in accordance with SFAS 109. The recognition of a $6.2 million provision on an $80.3 million loss from continuing operations before taxes reflects the valuation allowance noted above. The 1992 and 1991 tax benefits of $6.3 million and $0.2 million, respectively, were computed in accordance with Accounting Principles Board Opinion No. 11 ("APB 11"), which was superseded by SFAS 109. The effective rate of these tax benefits were 26% and 4%, respectively, and reflect the impact of 1992 operating losses and international tax incentives and credits, to the extent allowable by APB 11. HEXCEL S.A. (BELGIUM) The restructuring program initiated by the Company in 1992 and expanded in 1993 includes certain actions at Hexcel S.A., a wholly-owned Belgian subsidiary. Due to depressed European business conditions, particularly in the aerospace industry, Hexcel S.A. has been operating at a loss. Furthermore, interest costs are consuming cash as are the restructuring activities necessary to return the subsidiary to profitability. Hexcel S.A. is also investigating alleged product claims which could require additional cash outlays. Hexcel S.A. is currently in negotiations with its existing lenders regarding the commitment of credit facilities which expired beginning on March 16, 1994. Four of the five existing lenders have agreed to a stand still until April 30, 1994, subject to the Parent Company making satisfactory progress toward obtaining authorization from the Bankruptcy Court to invest additional funds and recapitalize Hexcel S.A. Discussions with the fifth lender are continuing. There is no assurance that the Bankruptcy Court will authorize the investment of additional funds or the recapitalization of Hexcel S.A., or that the existing lenders will continue to extend their short-term credit agreements for any specified length of time. As a result, Hexcel S.A.'s ability to continue as a going concern is subject to its obtaining needed financing, as well as resolving alleged product claims and successfully implementing required restructuring initiatives. Hexcel S.A. is an integral component of the Company's worldwide competitiveness, particularly in commercial aerospace. If Hexcel S.A. is unable to continue as a going concern, management believes that this would have a material adverse effect on the Company's U.S. and international operations. JOINT VENTURES AND DIVESTITURES The Company entered into a joint venture with Owens-Corning in June 1993. The venture is a strategic alliance which combines the stitchbonding capability of Hexcel with the reinforcement glass manufacturing, marketing and distribution expertise of Owens-Corning to produce and market stitchbonded fabrics worldwide. The venture began operations in July 1993 after the Company sold 50% of the Knytex business to Owens-Corning and contributed the remaining 50% to the venture. The Company received proceeds of $4.5 million and recorded a gain of approximately $1.5 million related to the sale. The Company owns 50% of the Knytex venture, which had revenues during the six months ended December 31, 1993 of $6.8 million. The Company entered into a joint venture with Fyfe Associates in October 1992. Hexcel-Fyfe will sell and apply high strength architectural wrap for the seismic retrofitting and strengthening of bridges and other structures. The major January 17, 1994 earthquake in Los Angeles demonstrated the capability of the product, as certain test sites near the epicenter survived with no damage. The Company owns 40% of the venture, and Fyfe Associates owns the remainder. Revenues of the venture were not significant in 1993 or 1992. In 1990, the Company entered into a joint venture with Dainippon Ink and Chemicals for the production and sale of Nomex honeycomb, advanced composites and decorative laminates for the Japanese market. Construction of a manufacturing facility in Komatsu, Japan began in 1992. The facility began production of material for qualification in 1993 with the qualification process expected to run through 1994. The Company owns 50% of this venture. In March 1992, the Company sold the fine chemicals business located in Zeeland, Michigan. In January 1994, the Company sold the fine chemicals business located in Teesside, England, which completes the divestiture of discontinued operations. See Note 14 to the Consolidated Financial Statements for additional discussion. FINANCIAL CONDITION AND LIQUIDITY EVENTS LEADING TO BANKRUPTCY REORGANIZATION As a result of the $30.6 million loss from continuing operations before income taxes in the fourth quarter of 1992, which included a $23.5 million restructuring charge, the Company was not in compliance with certain financial covenants of its U.S. revolving bank credit and other U.S. financing agreements. In March 1993, the Company entered into a new revolving credit agreement which reduced the amount available for borrowing from $35.0 million to the amount then borrowed of $12.0 million; shortened the maturity of the facility by two years to March 15, 1994; required the Company to provide by July 31, 1993 collateral consisting of substantially all U.S. assets; and revised certain financial covenants. Due to operating losses incurred during the first half of 1993, and the inability to proceed with a planned acquisition, the Company was not in compliance as of June 30, 1993 with the revised financial covenants which had included the benefits of this acquisition. Waivers for noncompliance of a financial covenant and the covenant to provide collateral were obtained from the U.S. lenders through September 15, 1993. Operating losses continued during the third quarter of 1993 and, as a result of no additional borrowing capacity under existing U.S. credit agreements, the Company was required to extend U.S. trade payables from $9.5 million at December 31, 1992 to $23.9 million as of August 31, 1993. Ongoing negotiations with the existing senior U.S. lenders failed to produce an agreement, and the September 15, 1993 waiver deadline expired with the Company in noncompliance. No additional waivers were granted although negotiations continued. The Company was able to finance its activities during September and October primarily as a result of receiving approximately $9.6 million from the accelerated collection of amounts due under long-term contracts and the settlement of a terminated contract. Restructuring costs and operating losses continued in the fourth quarter and the Company was required to reduce its accounts payable as a result of more restrictive credit terms imposed by many suppliers. The resulting consumption of cash was partially offset by efforts to control spending, reduce accounts receivable and inventory levels, limit restructuring actions to those items already in progress and limit capital expenditures to minimum levels. The Company's trade vendors were becoming increasingly concerned over the protracted extension of their payments and reports of the Company's financial distress, as well as the lack of an agreement with the senior U.S. lenders to restructure outstanding debt and obtain additional financing. By mid-November, the Parent Company was operating at critically low levels of cash without any remaining credit availability, having extended payments to trade vendors. As discussed on page 28, negotiations with existing senior U.S. lenders and other potential investors ultimately failed, and the Parent Company filed a voluntary petition for relief under the provisions of Chapter 11 of the federal bankruptcy laws on December 6, 1993. Federal bankruptcy laws prohibit Hexcel Corporation from paying almost all prepetition liabilities without the approval of the Bankruptcy Court. The effect of this prohibition was to increase the amount of available cash between December 6 and the end of the year, as Hexcel Corporation continued to generate cash proceeds from product sales without satisfying prepetition debts. This was partially offset by many vendors requiring cash in advance for purchases. As of December 31, 1993, the Company had cash and equivalents of approximately $12.9 million, including $7.9 million in the U.S. Prior to the Chapter 11 filing, Hexcel Corporation arranged for a debtor- in-possession revolving credit line from The CIT Group / Business Credit, Inc. On January 28, 1994, the Bankruptcy Court granted final approval for the use of this credit facility. The amount available for borrowing is based on the outstanding balance of eligible U.S. receivables and inventories, up to a maximum of $35.0 million. This credit line is secured by substantially all of the Company's U.S. assets, enjoys superpriority over virtually all other claims, and is subject to a number of financial covenants and restrictions. As of December 31, 1993, the Company had not borrowed against this credit line. The Company believes it will begin to borrow against this facility during the second quarter of 1994. The Company expects that the debtor-in-possession revolving line of credit will be sufficient to finance the Parent Company's operations and restructuring activities while it remains under bankruptcy protection. This credit facility expires in two years or upon confirmation of a plan of reorganization, at which time all outstanding borrowings become immediately due and payable. Consequently, the Company must secure long-term postconfirmation financing in connection with the reorganization of Hexcel Corporation. HEXCEL S.A.. As noted under "Hexcel S.A. (Belgium)" above, the Company's Belgian subsidiary is currently in negotiations with existing lenders regarding the commitment of credit facilities which expired beginning on March 16, 1994. If Hexcel S.A. is unable to obtain needed financing, it may be unable to continue as a going concern for a reasonable period of time. CURRENT FINANCIAL CONDITION AND LIQUIDITY Total credit lines, excluding U.S. credit lines subject to bankruptcy reorganization, were approximately $63.8 million at December 31, 1993. $35.0 million of this total was the debtor-in-possession revolving line of credit, and the remaining $28.8 million was comprised of various credit lines extended to the Company's European subsidiaries, including Hexcel S.A., of which $7.2 million was available for borrowing by those subsidiaries for their activities. The debtor-in-possession credit line cannot be used to provide direct financial support outside of the normal course of business to joint ventures or European subsidiaries without the prior consent of the Bankruptcy Court. Operating activities including capital expenditures and restructuring charges, but before working capital changes, consumed $23.5 million of cash in 1993, $11.0 million in 1992, and $1.7 million in 1991. The consumption of cash in 1993 and 1992 was offset by working capital improvements of $28.1 million in 1993 and $25.0 million in 1992. Much of the net increase in cash in 1993 occurred shortly after the bankruptcy filing, as prepetition obligations were stayed by the Bankruptcy Court, while December 1993 accounts receivable collections were strong. The working capital improvements in 1993 were due to lower accounts receivable and inventory levels from declining sales and improved working capital controls, as well as the deferral of payments on U.S. accounts payable during the year. The Company also obtained cash from additional borrowings on European credit lines and from the proceeds from the sale of 50% of the Knytex operation to Owens-Corning. In 1992, the Company used the proceeds from the sale of the U.S. fine chemicals business of $19.3 million to pay down debt. Working capital from continuing operations decreased to $54.7 million at the end of 1993 from $69.3 million at the end of 1992 and $105.7 million at the end of 1991. The 1993 reduction is primarily attributable to continuing sales declines, working capital controls and asset write-downs, partially offset by the increase in cash and the reclassification of short-term prepetition obligations to non-current liabilities subject to disposition in bankruptcy reorganization. The 1992 working capital reduction was largely due to the sudden sales decline in the fourth quarter and the implementation of working capital controls throughout the year. Most of the reduction occurred in accounts receivable and inventory. Capital expenditures were $6.5 million in 1993 compared with $17.1 million in 1992 and $14.7 million in 1991. The substantial decline in capital spending during 1993 reflects the ongoing effort to conserve cash which began early in the year. The Company has limited capital spending to outlays required by regulatory requirements and the replacement and upgrade of essential existing equipment. Until Hexcel Corporation emerges from bankruptcy proceedings and adequate long-term financing is in place, the Company does not expect capital expenditures to significantly increase above 1993 spending levels. Cash requirements to complete the current restructuring program are expected to total approximately $18 million. Funding for these costs will come from the debtor-in-possession revolving line of credit while in bankruptcy proceedings, and funding after bankruptcy proceedings will be provided as part of the reorganization plan. MARKET SUMMARY The following tables summarize net sales by market and by international operations for continuing operations(a) for the five years ended December 31. Net Sales by Market CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Description Page - -------------------------------------------------------------------------------- Management Responsibility for Financial Statements 39 Independent Auditors' Report 40 - 41 Report of Independent Public Accountants 42 Consolidated Financial Statements: Consolidated Statements of Operations: Three years ended December 31, 1993 43 Consolidated Balance Sheets: December 31, 1993 and 1992 44 Consolidated Statements of Shareholders' Equity: Three years ended December 31, 1993 45 Consolidated Statements of Cash Flows: Three years ended December 31, 1993 46 Notes to the Consolidated Financial Statements 47 - 68 Financial Statement Schedules for the three years ended December 31, 1993: V. Property, Plant and Equipment 69 VI. Accumulated Depreciation and Amortization of Property, Plant and Equipment 70 IX. Short-Term Borrowings 71 X. Supplementary Income Statement Information 72 Exhibit 11. Statement Regarding Computation of Per Share Earnings (Unaudited) 73 Financial statement schedules other than those listed above have been omitted because they are not applicable, not required, or the required information is included in the consolidated financial statements or notes thereto. MANAGEMENT RESPONSIBILITY FOR FINANCIAL STATEMENTS Hexcel management has prepared and is responsible for the consolidated financial statements and the related financial data contained in this report. These financial statements were prepared in accordance with generally accepted accounting principles. Management uses its best judgment to ensure that such statements reflect fairly the consolidated financial position, results of operations and cash flows of the Company. The Company maintains accounting and other control systems which management believes provide reasonable assurance that financial records are reliable for purposes of preparing financial statements and that assets are safeguarded and accounted for properly. Underlying this concept of reasonable assurance is the premise that the cost of control should not exceed benefits derived from control. The Audit Committee of the Board of Directors reviews and monitors the financial reports and accounting practices of the Company. These reports and practices are reviewed regularly by management and by the independent auditors, Deloitte & Touche, in connection with the audit of the Company's financial statements. The Audit Committee, composed solely of outside directors, meets periodically, separately and jointly, with management and the independent auditors. JOHN J. LEE - ------------------------------- (John J. Lee) CHIEF EXECUTIVE OFFICER WILLIAM P. MEEHAN - ------------------------------- (William P. Meehan) CHIEF FINANCIAL OFFICER INDEPENDENT AUDITORS' REPORT To the Board of Directors and Shareholders of Hexcel Corporation: We have audited the accompanying consolidated balance sheets of Hexcel Corporation (Debtor-in-Possession) and subsidiaries (collectively the "Company") as of December 31, 1993 and 1992, and the related consolidated statements of operations, shareholders' equity and cash flows for the years then ended. Our audits also included the financial statement schedules for the years ended December 31, 1993 and 1992 listed in the index on page 38. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such 1993 and 1992 consolidated financial statements present fairly, in all material respects, the financial position of Hexcel Corporation and subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for the years then ended in conformity with generally accepted accounting principles. Also, in our opinion, such 1993 and 1992 financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information shown therein. We also audited the adjustments described in Note 4 that were applied to restate the 1991 financial statements to give retroactive effect to the change in the method of accounting for domestic honeycomb and fabric inventories to the first-in, first-out method from the last-in, first-out method. In our opinion, such adjustments are appropriate and have been properly applied. As discussed in Notes 1 and 2, Hexcel Corporation has filed for reorganization under Chapter 11 of the Federal Bankruptcy Code. The accompanying consolidated financial statements do not purport to reflect or provide for the consequences of the bankruptcy proceedings. In particular, such consolidated financial statements do not purport to show (a) as to assets, their realizable value on a liquidation basis or their availability to satisfy liabilities; (b) as to prepetition liabilities, the amounts that may be allowed for claims or contingencies, or the status and priority thereof; (c) as to shareholder accounts, the effect of any changes that may be made in the capitalization of the Company; or (d) as to operations, the effect of any changes that may be made in its business. The outcome of these matters is not presently determinable. Accordingly, the consolidated financial statements do not include adjustments that might result from the ultimate outcome of these uncertainties. The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Notes 1,2,3 and 6, the Company's recurring losses from operations and future need for new financing raise substantial doubt about its ability to continue as a going concern. The Company's ability to continue as a going concern is dependent upon its ability to (a) return to profitability based on a successful implementation of its plan for restructuring operations and (b) obtain new financing when needed to repay anticipated borrowings against the U.S. debtor-in-possession line of credit, which are necessary to pay for restructuring activities. Any borrowings against the U.S. debtor-in-possession line of credit are due upon the earlier of December 1995 or confirmation by the U.S. Bankruptcy Court of a plan of reorganization. Management's plans concerning these matters are also discussed in Note 1. The consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should the Company be unable to continue as a going concern. As discussed in Note 16 to the consolidated financial statements, Hexcel S.A. (a Belgium company), a wholly-owned subsidiary of Hexcel Corporation, is experiencing substantial operating and financial difficulties. Additionally, Hexcel Corporation is unable to provide direct financial support outside of the normal course of business to this subsidiary without U.S. Bankruptcy Court approval, which raises substantial doubt about Hexcel S.A.'s ability to continue as a going concern. The ultimate outcome of these uncertainties is not presently determinable. Accordingly, the consolidated financial statements do not include adjustments that might result from the ultimate outcome of these uncertainties. As discussed in Note 1 to the consolidated financial statements, the Company (1) in 1992 changed its method of accounting for postretirement benefits other than pensions to conform with Statement of Financial Accounting Standards No. 106, (2) in 1993 changed its method of accounting for domestic honeycomb and fabric inventories from the last-in, first-out method to the first-in, first-out method, and (3) changed its method of accounting for income taxes effective January 1, 1993 to conform with Statement of Financial Accounting Standards No. 109. The 1992 and 1991 consolidated financial statements have been retroactively restated for the change in accounting for domestic honeycomb and fabric inventories. DELOITTE & TOUCHE Oakland, California April 11, 1994 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholders and Board of Directors of Hexcel Corporation: We have audited the consolidated statement of operations, shareholders' equity, and cash flows of Hexcel Corporation and subsidiaries for the year ended December 31, 1991 prior to the restatement (and, therefore, are not presented herein) for the change in accounting for certain inventories from the last-in, first-out ("LIFO") to the first-in, first-out ("FIFO") method as described in Note 4 to the restated consolidated financial statements. These consolidated financial statements and the schedules referred to below are the responsibility of Hexcel's management. Our responsibility is to express an opinion on these consolidated financial statements and schedules based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the results of operations and cash flows of Hexcel Corporation and subsidiaries for the year ended December 31, 1991 in conformity with generally accepted accounting principles. Our audit was made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index on page 38 are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. The schedules for the year ended December 31, 1991 have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. San Francisco, California February 4, 1992 THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. HEXCEL CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. HEXCEL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) NOTE 1 - SIGNIFICANT ACCOUNTING POLICIES BASIS OF ACCOUNTING The consolidated financial statements include the accounts of Hexcel Corporation and subsidiaries (the "Company"), after elimination of intercompany transactions and accounts. On December 6, 1993, Hexcel Corporation (a Delaware corporation, the "Parent Company" or "Parent") filed a voluntary petition for relief under the provisions of Chapter 11 of the federal bankruptcy laws (see Note 2). Consequently, the consolidated financial statements have been prepared in accordance with Statement of Position 90-7, "Financial Reporting by Entities in Reorganization Under the Bankruptcy Code," issued by the American Institute of Certified Public Accountants in November 1990. The consolidated financial statements do not purport to reflect or provide for the potential consequences of the bankruptcy proceedings of Hexcel Corporation. In particular, the consolidated financial statements do not purport to show (a) as to assets, their realizable value on a liquidation basis or their availability to satisfy liabilities; (b) as to prepetition liabilities, the amounts that may be allowed for claims or contingencies or the status and priority thereof; (c) as to shareholder accounts, the effect of any changes that may be made to the capitalization of Hexcel Corporation; or (d) as to operations, the effect of any changes that may be made in its business. The outcome of these matters is not presently determinable. Accordingly, the consolidated financial statements do not include adjustments that might result from the ultimate outcome of these uncertainties. The consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. As shown in the consolidated financial statements, during the years ended December 31, 1993 and 1992, the Company incurred losses from continuing operations of $86,456 and $17,706, respectively. These losses include accrued expenses of $52,600 and $23,500, respectively, for a major restructuring of the Company's operations, which has not yet been completed (see Note 3). In addition, Hexcel Corporation filed a voluntary petition for relief under the provisions of Chapter 11 of the federal bankruptcy laws on December 6, 1993, and has been operating as a debtor-in- possession since that date. While the Company believes it has adequate financing to operate in bankruptcy for a reasonable period of time (see Note 6), its ability to successfully continue operations is dependent upon, among other things, confirmation of a plan of reorganization that will enable Hexcel Corporation to emerge from bankruptcy proceedings, obtaining adequate postconfirmation financing to fund restructuring and working capital requirements, successfully implementing the restructuring program, and generating sufficient cash from operations and financing sources to meet obligations. Management believes that the Company should be able to restructure its existing debt and obtain adequate postconfirmation financing in connection with the confirmation of a plan of reorganization, but there is no assurance that such restructuring or financing will occur. These factors among others may indicate that the Company will be unable to continue as a going concern for a reasonable period of time. The consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should the Company be unable to continue as a going concern. CASH AND EQUIVALENTS The Company invests excess cash in investments with original maturities of less than three months. The investments consist of Eurodollar time deposits and are stated at cost, which approximates market value. The Company considers such investments to be cash equivalents for purposes of the statements of cash flows. ACCOUNTS RECEIVABLE Accounts receivable were net of reserves for doubtful accounts of $1,490 at December 31, 1993 and 1992. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are recorded at cost. Repairs and maintenance are charged to expense as incurred; replacements and betterments are capitalized. Interest expense associated with major long-term construction projects is capitalized. Capitalized interest was $227 in 1993, $298 in 1992 and $1,083 in 1991. The Company depreciates property, plant and equipment over estimated useful lives. Accelerated and straight-line methods are used for financial statement purposes. The estimated useful lives range from 10 to 40 years for buildings and improvements and 3 to 20 years for machinery and equipment. RESEARCH AND DEVELOPMENT COSTS Research and development costs of $8,745 in 1993, $10,457 in 1992 and $10,614 in 1991 were expensed as incurred, and are included in marketing, general and administrative ("M,G&A") expenses in the consolidated statements of operations. CURRENCY TRANSLATION The assets and liabilities of European subsidiaries are translated into U.S. dollars at year-end exchange rates, and revenues and expenses are translated at average exchange rates during the year. Cumulative currency translation adjustments are included in shareholders' equity. Realized gains and losses are reflected in net income. EARNINGS PER SHARE Net income (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares and dilutive common share equivalents (stock options) outstanding during each year. The computation on the fully diluted basis, which considers the exercise of stock options and the conversion of the convertible subordinated debentures, was antidilutive in 1993, 1992 and 1991. ACCOUNTING CHANGES During the fourth quarter of 1993, the Company changed to the first-in, first-out ("FIFO") method of accounting for substantially all inventories (see Note 4). The effect of this change on domestic honeycomb and fabric inventories, which were previously valued using the last-in, first-out ("LIFO") method, has been applied to prior years by retroactively restating the consolidated financial statements as required by generally accepted accounting principles. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109 ("SFAS 109"), "Accounting for Income Taxes" (see Note 13). The cumulative effect of this accounting change has been reflected in the consolidated statement of operations for the year ended December 31, 1993. Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 106 ("SFAS 106"), "Employers' Accounting for Postretirement Benefits Other than Pensions" (see Note 12). The cumulative effect of this accounting change has been reflected in the consolidated statement of operations for the year ended December 31, 1992. RECLASSIFICATIONS Certain prior year amounts in the consolidated financial statements and notes have been reclassified to conform to the 1993 presentation. NOTE 2 - BANKRUPTCY REORGANIZATION On December 6, 1993, Hexcel Corporation filed a voluntary petition for relief under the provisions of Chapter 11 of the federal bankruptcy laws in the United States Bankruptcy Court for the Northern District of California (the "Bankruptcy Court"). Since that date, Hexcel Corporation has continued business operations as debtor-in-possession under the supervision of the Bankruptcy Court. Substantially all of the U.S. assets and operations of the Company are directly owned and operated by the Parent, and are subject to bankruptcy protection. The joint ventures and European subsidiaries of Hexcel Corporation are not included in the bankruptcy proceedings and, as such, are not subject to the provisions of the federal bankruptcy laws or the supervision of the Bankruptcy Court. However, the Parent Company is generally unable to provide direct financial support outside of the normal course of business to its joint ventures and subsidiaries without Bankruptcy Court approval. All transactions outside of the Parent Company's ordinary course of business are subject to the approval of the Bankruptcy Court. A committee of unsecured creditors and a committee of equity security holders have been appointed and these committees will participate in the bankruptcy process, including the confirmation of a plan of reorganization. Federal bankruptcy laws prohibit Hexcel Corporation from paying almost all prepetition liabilities without the approval of the Bankruptcy Court. The Parent Company has received approval to pay or otherwise honor certain prepetition obligations, including employee wages and benefits. Accordingly, these obligations have been included in the appropriate liability captions of the consolidated balance sheet as of December 31, 1993. Most other prepetition liabilities, including trade accounts and notes payable, have been reflected as "liabilities subject to disposition in bankruptcy reorganization" on the basis of the expected amount of allowed claims. Additional prepetition claims may arise from the rejection of executory contracts, including leases, and from the determination by the Bankruptcy Court (or agreed to by parties in interest) of allowed claims for contingencies and other disputed amounts. Under Chapter 11, the Parent Company is prohibited from paying interest on most prepetition debt. However, the Parent Company continues to record interest expense on all interest-bearing obligations, and the resulting liability is included in liabilities subject to disposition in bankruptcy reorganization. Professional fees and other costs directly related to bankruptcy proceedings are expensed as incurred, and reflected in the consolidated statement of operations for the year ended December 31, 1993 as "bankruptcy reorganization expenses." Interest income earned by the Parent Company subsequent to the Chapter 11 filing is reported as a reduction of bankruptcy reorganization expenses. Liabilities incurred in the normal course of business after the petition date are not subject to bankruptcy protection or disposition and have been reflected accordingly in the consolidated financial statements. These postpetition liabilities are generally paid in accordance with contract terms, and the Parent Company has obtained debtor-in-possession financing to facilitate such payments (see Note 6). Substantially all of the Parent Company's liabilities as of the petition date are subject to settlement under a plan of reorganization to be voted upon by creditors and equity security holders and confirmed by the Bankruptcy Court. In the event a plan of reorganization is approved by the Bankruptcy Court, continuation of the business after reorganization is dependent upon the success of future operations and the ability to meet obligations as they become due. As a result of the reorganization proceedings, the Parent Company may have to sell or otherwise dispose of assets and liquidate or settle liabilities for amounts other than those reflected in the consolidated financial statements. Further, a plan of reorganization could materially change the amounts currently recorded in the consolidated financial statements. The consolidated financial statements do not give effect to all adjustments to the carrying value of assets, or amounts and classification of liabilities, that might be necessary as a consequence of these bankruptcy proceedings. The following condensed financial statements for Hexcel Corporation, the debtor-in-possession, as of December 31, 1993 and 1992 and for the years ended December 31, 1993, 1992 and 1991, have been prepared using the equity method to account for investments in subsidiaries: Investments in and advances to subsidiaries includes intercompany investments, loans, and trade balances. As of December 31, 1993, $1,828 of the total represents investments in and advances to Hexcel S.A., the Company's wholly-owned Belgian subsidiary (see Note 16). Liabilities subject to disposition in bankruptcy reorganization includes $2,500 payable to a European subsidiary. Net sales include sales to subsidiaries for the years ended December 31, 1993, 1992 and 1991 of $10,061, $12,359 and $19,601, respectively. Equity in earnings (losses) of subsidiaries include restructuring charges and other expenses of $16,256 and $5,530 in 1993 and 1992, respectively. NOTE 3 - RESTRUCTURING AND OTHER EXPENSES RESTRUCTURING In December 1992, the Company initiated a worldwide restructuring program designed to improve facility utilization and determine the proper workforce requirements to support projected reduced levels of business in 1993 and beyond. The Company recorded a charge for this program of $23,500 in the fourth quarter of 1992. In April 1993, the Company announced the closing of the Graham, Texas facility and the consolidation of Graham operations into other plants. The estimated costs of this closure were included in the 1992 restructuring charge. The Graham closure is expected to be completed in the second half of 1994. In September 1993, the Company announced plans to significantly expand the restructuring program in response to the expected further decline in the Company's principal markets, commercial and military aerospace. Accordingly, the Company recorded a charge of $50,000 in the third quarter of 1993. This expansion includes deeper cuts in overhead and further consolidation of facilities in the United States and Europe. During the fourth quarter of 1993, an additional charge of $2.6 million was recorded in connection with the expanded restructuring program. The 1993 and 1992 restructuring charges included approximately $40,000 of non-cash write-downs related to facility closures and the impairment of certain assets due to declining sales and the changed business environment. Even after the Graham closure is complete, the Company has more production capacity than required for either current or projected sales levels, and needs to close additional facilities. The 1993 restructuring charges include the estimated costs of such closures, and the Company is currently evaluating which facilities to close. This process is complicated by the uncertain outlook for several product lines as well as aerospace industry requirements to "qualify" specific equipment and locations for the manufacture of certain products. These qualification procedures increase the complexity, cost and time of moving equipment while continuing to serve existing customers. The total of $76,100 in restructuring charges taken in 1992 and 1993 and the remaining balance of accrued restructuring charges at December 31, 1993 consist of: Accrued restructuring liabilities include $20,910 and $14,835 in accrued liabilities at December 31, 1993 and 1992, respectively, and $22,690 and $8,000 in deferred liabilities at December 31, 1993 and 1992, respectively. OTHER EXPENSES In addition to the above restructuring charges, the Company recorded $12,780 ($12,638 in the fourth quarter) of other expenses in 1993. The $12,638 includes write-downs of certain assets and increases in reserves for warranties and environmental matters on property previously owned. The impairment of assets was due primarily to bankruptcy proceedings, continued changes in business conditions and depressed real estate prices on property held for sale. Other expenses in 1993 also include approximately $4,000 of costs in the first nine months of 1993 offset by a similar amount of gains. The costs were associated primarily with the terminated negotiations for the acquisition of a business, securities litigation costs, the settlement of a threatened proxy contest, and a reserve for anticipated loss on the disposition of property. The mitigating gains include a $1,541 gain from the sale of 50% of the Knytex stitchbonded business to Owens-Corning to form a new joint venture, and approximately $2,000 in gains from the settlement of insurance claims and a terminated contract. Other income in 1992 consisted of $2,992 from the final settlement of a patent infringement lawsuit. NOTE 4 - INVENTORIES Inventories at December 31, 1993 and 1992 were: Inventories are valued at the lower of cost or market. During the fourth quarter of 1993, the Company changed to the first-in, first-out method of accounting for substantially all inventories. Previously, domestic honeycomb and fabric inventories were valued using the last-in, first-out method and all other inventories were valued at the lower of average cost or market. The FIFO method provides a more meaningful presentation of the Company's financial position by reflecting inventories at more recent costs. The Company believes that the disclosure of inventories at recent costs provides more relevant information about the Company's current business condition. The change to the FIFO method conforms substantially all inventories of the Company to the same accounting method. The effect of the change in accounting method from LIFO to FIFO was to increase the loss from continuing operations and net loss for the year ended December 31, 1993 by $233 or $0.03 per share. This change has been applied to prior years by retroactively restating the consolidated financial statements as required by generally accepted accounting principles. The effect of this restatement was to increase retained earnings as of January 1, 1991 by $3,526. The restatement increased the 1992 loss from continuing operations and net loss by $440 or $0.06 per share, and increased the 1991 income from continuing operations and net income by $130 or $0.02 per share. The cumulative and current-year effects of changing from the average cost method to the FIFO method are not material and are included in the 1993 results. NOTE 5 - INVESTMENTS AND OTHER ASSETS Investments and other assets as of December 31, 1993 and 1992 were: Investments in joint ventures consist of a 50% interest in Knytex Company, L.L.C., which is jointly owned and operated with Owens-Corning Fiberglas Corporation; a 50% interest in DIC-Hexcel Limited, which is jointly owned and operated with Dainippon Ink and Chemicals, Inc.; and a 40% interest in Hexcel- Fyfe, L.L.C., which is jointly owned and operated with Fyfe Associates Corporation. These investments are accounted for by the equity method. Equity in earnings for the years ended December 31, 1993 and 1992 were not material to the consolidated financial statements. Knytex Company, L.L.C. was formed on June 30, 1993 when the Company sold 50% of the Hexcel Knytex business to Owens-Corning and contributed the remaining 50% to the joint venture. The Company received proceeds of $4,500 and recognized a gain of $1,541 from the sale. Reserves for long-term notes receivable totaled $3,400 as of December 31, 1993. There were no reserves as of December 31, 1992. NOTE 6 - DEBTOR-IN-POSSESSION FINANCING Prior to the Chapter 11 filing, Hexcel Corporation arranged for a debtor- in-possession revolving line of credit of up to $35,000 from The CIT Group / Business Credit, Inc. On January 28, 1994, the Bankruptcy Court granted final approval for use of this credit facility. As of December 31, 1993, Hexcel Corporation had not borrowed under this revolving line of credit. The debtor-in-possession credit line is available to finance the normal business operations and restructuring activities of Hexcel Corporation. This credit facility cannot be used to finance joint ventures, European subsidiaries, or any transaction outside of the ordinary course of business without the prior consent of the Bankruptcy Court. The amount available for borrowing is based on the outstanding balance of eligible U.S. receivables and inventories, as defined in the credit agreement, up to a maximum of $35,000. Any borrowings against the U.S. debtor-in-possession line of credit are due upon the earlier of December 1995 or confirmation by the Bankruptcy Court of a plan of reorganization. Interest on outstanding borrowings is computed at an annual rate of 1% in excess of the prime rate of the Bank of America. In addition, a commitment fee of 0.5% per annum is charged on the unused portion of the facility. The debtor-in-possession credit line is secured by substantially all of the U.S. assets of Hexcel Corporation, as well as 65% of the shares of stock of substantially all European subsidiaries. Under the terms of the facility and the provisions of federal bankruptcy laws, the security interest of The CIT Group / Business Credit, Inc. has superpriority over virtually all prepetition claims and most Chapter 11 administrative expense claims. The revolving line of credit is subject to a number of financial covenants and other restrictions. Hexcel Corporation must maintain minimum levels of cumulative earnings before interest, taxes, depreciation, and amortization. In addition, the Parent Company is subject to limitations in permitting the creation of liens, incurring lease obligations, extending trade credit to European subsidiaries, and incurring capital expenditures. Certain business activities, investments and guarantees are also restricted, and the payment of dividends is prohibited. NOTE 7 - NOTES PAYABLE Since September 15, 1993, Hexcel Corporation has been out of compliance with substantially all of its prepetition debt obligations. Payment and enforcement of most of these obligations is stayed by federal bankruptcy laws for the duration of bankruptcy proceedings. Furthermore, the ultimate disposition of these debts is subject to confirmation of a plan of reorganization by the Bankruptcy Court. Accordingly, the outstanding principal and accrued interest on all prepetition debt obligations has been included in liabilities subject to disposition in bankruptcy reorganization in the consolidated balance sheet as of December 31, 1993. The debt obligations of Hexcel Corporation's European subsidiaries are not subject to the provisions of the federal bankruptcy laws and have not been stayed. However, $15,574 of the outstanding debt of Hexcel S.A., a Belgian subsidiary, as of December 31, 1993 is pursuant to credit facilities with European banks, commitments for which expired on March 16, 1994. Hexcel S.A. is currently in negotiations with these banks to extend these credit facilities (see Note 16). The debt of Hexcel S.A. is secured by substantially all of that subsidiary's assets, which totaled $32,340 at December 31, 1993. Total credit lines, excluding U.S. credit lines subject to disposition in bankruptcy reorganization, were $63,792 at December 31, 1993. $35,000 of this total was a debtor-in-possession revolving line of credit from The CIT Group / Business Credit, Inc. (see Note 6). The remaining $28,792 was comprised of various credit lines extended to the Parent Company's European subsidiaries, $7,168 of which was available for borrowing by those subsidiaries. The debtor- in-possession credit line cannot be used to provide direct financial support outside of the normal course of business to joint ventures or European subsidiaries without the prior consent of the Bankruptcy Court, and the credit lines of European subsidiaries are unavailable to finance the activities of the Parent Company. Notes payable and capital lease obligations at December 31, 1993 and 1992 were: The 7% convertible subordinated debentures are subject to disposition in bankruptcy reorganization (see Note 9). Prior to the commencement of bankruptcy proceedings, these debentures were redeemable by the Company under certain provisions, with mandatory redemption scheduled to begin August 1, 1997 through annual sinking fund requirements. The debentures were convertible prior to maturity into common stock of the Company at $31.87 per share, subject to adjustment under certain conditions. During the second quarter of 1992, the Company repurchased $7,315 of the subordinated debentures on the open market. The repurchase resulted in an extraordinary gain of $956 after taxes. The Company has various industrial development bonds ("IDB") outstanding, guaranteed by bank letters of credit for fees of 0.375% to 0.50%. These obligations are subject to disposition in bankruptcy reorganization (see Note 9). The interest rates on the bonds are variable and averaged 2.5% in 1993, 2.9% in 1992 and 4.8% in 1991. Excluding obligations subject to disposition in bankruptcy reorganization, installments due on long-term notes payable for the years 1994 through 1997 are $2,774, $2,337, $962 and $223, respectively. There are no installments due after 1997. Interest payments were $9,529 in 1993, $11,689 in 1992 and $12,449 in 1991. The fair value of the Company's long-term debt is not presently determinable due to Hexcel Corporation's bankruptcy proceedings (see Note 2) and the uncertainties surrounding Hexcel S.A., a wholly-owned subsidiary (see Note 16). NOTE 8 - LEASING ARRANGEMENTS Assets, accumulated depreciation and related liability balances under capital leasing arrangements as of December 31, 1993 and 1992 were: Certain sales and administrative offices, data processing equipment and manufacturing facilities are leased under operating leases. Federal bankruptcy laws allow Hexcel Corporation to affirm or reject prepetition leases on a lease- by-lease basis. The Parent Company is currently evaluating prepetition lease obligations to determine which obligations to affirm and which to reject. The rejection of one or more leases may give rise to additional claims against the Parent Company which are not currently reflected in the accompanying consolidated financial statements. Rental expenses under operating leases were $3,541 in 1993, $5,053 in 1992 and $4,410 in 1991. Future minimum lease payments as of December 31, 1993 were: Total minimum capital lease payments include $823 of imputed interest. NOTE 9 - LIABILITIES SUBJECT TO DISPOSITION IN BANKRUPTCY REORGANIZATION Liabilities subject to disposition in bankruptcy reorganization as of December 31, 1993 were: Liabilities subject to disposition in bankruptcy reorganization consisted of the estimated prepetition claims of Hexcel Corporation creditors as of December 31, 1993. The Parent Company is in the process of confirming the nature and amount of existing claims, and the bar date for the filing of additional claims is April 28, 1994. Until the Parent Company receives and completes a reconciliation of all proofs of claim submitted by creditors, the recorded liability is subject to revision. Furthermore, the recorded liability does not include any amounts for claims that may arise from the rejection of executory contracts, including leases. The industrial development bonds are guaranteed by irrevocable bank letters of credit (see Note 7). The bondholders have the right to draw upon the letters of credit, at which time the issuing bank would then become an unsecured creditor of the Parent Company. The satisfaction of liabilities subject to disposition in bankruptcy reorganization is subject to confirmation of a plan of reorganization by the Bankruptcy Court. Such liabilities may be settled for amounts other than those reflected in the consolidated financial statements. NOTE 10 - SHAREHOLDERS' EQUITY AND STOCK OPTION AND PURCHASE PLANS SHAREHOLDERS' EQUITY A shareholder rights plan was adopted, effective September 1986 and amended in October 1988, November 1990 and December 1990, that provides for the issuance of two-thirds of one right for each outstanding share of common stock and equivalent. The rights become exercisable if a person or a group acquires 25% or more of the outstanding shares of the Company. The rights also become exercisable, at the option of the Board of Directors, if a person or group acquires 10% or more of the outstanding shares and is designated as an "adverse party" by the Board of Directors. The rights expire on September 19, 1996. Each right allows the purchase, for $180 (adjustable), of one one-hundredth of a share of Series A Junior Participating Preferred Stock or, in certain events involving an acquisition or change in control of the Company, stock or assets worth twice the exercise price. The Company reserves 200,000 preferred shares for the plan. The Company has authorized preferred stock of 450,000 shares. None was outstanding as of December 31, 1993 and 1992. Cash dividends declared and paid per common share were $0.44 in 1992 and 1991. The Board of Directors suspended dividend payments beginning in 1993. Dividend payments are currently precluded by bankruptcy proceedings and the debtor-in-possession credit line. STOCK OPTION AND PURCHASE PLANS Stock option data for the two years ended December 31, 1993 were: At December 31, 1993 and 1992, the total number of shares reserved for issuance under stock option plans including shares granted and shares available for grant was 955,662 and 908,771, respectively. Options vest one year from the date of grant and expire 10 years after such grant date. Prior to the Chapter 11 filing, employees meeting certain criteria could purchase common stock of the Company under a non-qualified employee stock purchase plan. The subscription price of the stock was 83.33% of the average of the high and low sales prices on the New York Stock Exchange on the quarterly purchase dates. The Board of Directors canceled this plan effective December 5, 1993. Under a restricted stock plan implemented in 1988, the Company may grant shares of restricted common stock to senior executives in amounts and with restrictions as the Company may determine. The restricted shares vest in three to seven years from date of grant. Holders of the restricted stock are entitled to vote and receive all dividends. Effective December 5, 1993, the Board of Directors suspended future grants under this plan indefinitely. As of December 31, 1993 and 1992, the Company had outstanding a total of 44,939 and 65,494 shares of restricted stock, respectively. Under a discounted stock option plan implemented in 1988, officers may exchange all or a portion of incentive bonuses for common stock options. The Company granted no discounted stock options in 1993 and 1992. NOTE 11 - RETIREMENT PLANS The Company has various retirement and profit sharing plans covering substantially all employees. The net cost of these plans was $2,330 in 1993, $2,880 in 1992, and $2,481 in 1991. In the United States, the Company maintains a defined contribution plan comprised of a 401(k) plan covering essentially all domestic employees and a profit sharing plan covering all domestic salaried employees. The Company also has defined benefit pension plans for substantially all U.S. hourly employees and U.K. employees, which have not been affected by the bankruptcy proceedings of the Parent Company. The Company also has defined benefit retirement plans for senior executives and directors. The European subsidiaries, except for those in the United Kingdom, participate in government retirement plans which cover all employees of those subsidiaries. Under the 401(k) plan, the Company makes matching contributions equal to 50% of the contributions of the employees, not to exceed 3% of base wages. Contributions to the salaried profit sharing plan are based on a formula which approximates 12% of consolidated income before provision for income taxes less certain adjustments as defined. Contributions to the 401(k) plan were $1,130 for 1993, $1,593 for 1992, and $1,637 for 1991. There were no contributions to the salaried profit sharing plan for 1993, 1992 and 1991. The defined benefit pension plans are career average pension plans. Benefits are based on years of service and the annual compensation of the employee. The funding policy for the pension plans is to contribute the minimum amount required by applicable regulations. Benefits for the executive and director retirement plans are based on years of service and annual compensation, and the Company does not fund these plans. Net cost for the defined benefit pension and retirement plans for the years ended December 31, 1993, 1992 and 1991 consisted of: Assumptions used in the accounting were: The funded status and amounts recognized for the defined benefit pension and retirement plans at December 31, 1993 and 1992 were: Statement of Financial Accounting Standards No. 87, "Employers' Accounting for Pensions," requires the recognition of a minimum pension obligation on the balance sheet. The minimum pension obligation adjustment of $646 included in shareholders' equity at December 31, 1993 is necessary to reflect the minimum obligation for the Company's pensions plans and results primarily from lowering the assumed discount rates to 7% in 1993. NOTE 12 - POSTRETIREMENT BENEFITS OTHER THAN PENSIONS The Company has various postretirement benefit plans covering substantially all U.S. employees retiring on or after age 58 who have rendered at least 15 years of service. The plans include health care and life insurance coverage for retirees and their dependents. The Company continues to fund benefit costs on a pay-as-you-go basis and, for 1993, 1992 and 1991, made benefit payments of $576, $352 and $604, respectively. On an interim basis, the Bankruptcy Court has approved the continued funding of postretirement benefits up to approximately $50 per month. Accordingly, the liability for accrued postretirement benefits other than pensions has been included in deferred liabilities in the consolidated balance sheet as of December 31, 1993. Under the health care plan, annual coverage is provided up to a maximum of 50% of plan costs for each retiree and covered dependent. Under the life insurance plan, annual coverage is provided equal to 65% of the final base pay of the retiree until the age of 70. Upon reaching 70 years of age, life insurance coverage is reduced. Effective January 1, 1992, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." This statement requires the Company to accrue the expected cost of postretirement benefits as employees render service. This is a significant change from prior policy of recognizing these costs on the cash basis. The cumulative effect, as of January 1, 1992, of changing to the accrual basis was a noncash charge of $8,052 after taxes. In addition, the Company recorded noncash expenses of $924 and $997 in 1993 and 1992, respectively. The defined postretirement benefit obligations included in deferred liabilities at December 31, 1993 and 1992 were: Net defined postretirement benefit costs for the years ended December 31, 1993 and 1992 were: Two health care cost trend rates were used in measuring the accumulated postretirement benefit obligation. The assumed indemnity health care cost trend in 1994 was 13.0% for participants less than 65 years of age and 9.0% for participants 65 years of age and older, gradually declining to 6.0% for both age groups in the year 2001. The assumed HMO health care cost trend in 1994 was 10.0% for participants less than 65 years of age and 7.0% for participants 65 years of age and older, gradually declining to 6.0% and 5.0%, respectively, in the year 2001. The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7% in 1993 and 8.25% in 1992. If the health care cost trend rate assumptions were increased by 1%, the accumulated postretirement benefit obligation as of December 31, 1993 would be increased by 6.3%. The effect of this change on the sum of the service cost and interest cost would be an increase of 4.9%. NOTE 13 - INCOME TAXES The Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," effective January 1, 1993. The cumulative effect of adopting SFAS 109 was the recognition of $4,500 of income, which was recorded in the first quarter of 1993. In connection with the adoption of SFAS 109, the Company established a valuation allowance of $4,693 against its deferred income tax assets. During 1993, substantial uncertainty developed as to the realization of the Company's deferred income tax assets. As a result, the Company increased the valuation allowance against those assets to $41,313 as of December 31, 1993, which reduced the net deferred income tax assets to zero. The increase to the valuation allowance reflects the Company's assessment that the bankruptcy proceedings of Hexcel Corporation and ongoing operating losses have jeopardized the realization of deferred income tax assets. Income (loss) before income taxes and the tax benefit (provision) for income taxes from continuing operations for the years ended December 31, 1993, 1992 and 1991 were: A reconciliation of the tax benefit (provision) to the U.S. federal statutory income tax rate of 34% for the years ended December 31, 1993, 1992 and 1991 was: The Company paid income taxes of $203 in 1993, $468 in 1992, and $434 in 1991. The Company has made no U.S. income tax provision for $12,390 of undistributed earnings of international subsidiaries as of December 31, 1993. Such earnings are considered to be permanently reinvested. The additional U.S. income tax on these earnings, if repatriated, would be offset in part by foreign tax credits. Deferred income taxes result from temporary differences between the recognition of items for income tax purposes and financial reporting purposes. Principal temporary differences as of December 31, 1993 and January 1, 1993 were: As of December 31, 1993, the Company had net operating loss carryforwards for federal income tax purposes of approximately $20,000 and net operating loss carryforwards for international income tax purposes of approximately $8,000. The federal tax carryforwards, which are available to offset future taxable income, expire at various dates through the year 2008. However, the Company's net operating loss carryforwards may be reduced or subject to annual limitations if Hexcel Corporation experiences an "ownership change" as defined by federal income tax laws. Such a change might occur as a result of market activity in the Parent Company's equity securities or in connection with a plan of reorganization involving the issuance or exchange of equity securities. NOTE 14 - DISCONTINUED OPERATIONS In November 1990, the Company announced plans to sell the fine chemicals business. On March 31, 1992, the Company sold the U.S. fine chemicals business located in Zeeland, Michigan. The divestiture resulted in a loss of $798 after taxes. The Company used the proceeds of $19,262 from the sale to repay debt. On January 31, 1994, the Company sold the European fine chemicals business located in Teesside, England, completing the divestiture of discontinued operations. The sale generated net cash proceeds of approximately $500, which was received in 1993. The 1993 loss from discontinued operations included a $2,800 write-down of European assets recorded in the third quarter, while the 1992 loss included an accrual of $2,300 for estimated future losses. NOTE 15 - SIGNIFICANT CUSTOMERS The Boeing Company and Boeing subcontractors accounted for approximately 19% of 1993 sales, 15% of 1992 sales and 18% of 1991 sales. Sales to U.S. government programs, including some of the sales to The Boeing Company and Boeing subcontractors noted above, were 16% of sales in 1993, 15% of sales in 1992 and 17% of sales in 1991. NOTE 16 - CONTINGENCIES HEXCEL S.A. (BELGIUM) The consolidated financial statements include the accounts of Hexcel S.A., the Company's wholly-owned Belgian subsidiary, after elimination of intercompany transactions and accounts. As of December 31, 1993, Hexcel S.A. had total assets of $32,340 and total liabilities of $38,711. For the year ended December 31, 1993, Hexcel S.A. generated net sales of approximately $38,000 and a net loss of approximately $13,000. Due to depressed European business conditions, particularly in the aerospace industry, Hexcel S.A. has been operating at a loss. Furthermore, interest costs and restructuring activities are consuming cash, and Hexcel S.A. is investigating alleged product claims which could require additional cash outlays. The subsidiary is currently in negotiations with it lenders regarding the commitment of credit facilities which expired beginning on March 16, 1994. Four of the five existing lenders have agreed to a stand still until April 30, 1994, subject to the Parent Company making satisfactory progress toward obtaining authorization from the Bankruptcy Court to invest additional funds and recapitalize Hexcel S.A. Discussions with the fifth lender are continuing. There is no assurance that the Bankruptcy Court will authorize the investment of additional funds or the recapitalization of Hexcel S.A., or that the existing lenders will continue to extend their short-term credit agreements for any specified length of time. Without such additional investment, Hexcel S.A. may be in violation of statutory minimum capital requirements. Hexcel S.A.'s ability to continue as a going concern is subject to its obtaining needed financing, as well as resolving alleged product claims and successfully implementing required restructuring initiatives. The above factors among others may indicate that Hexcel S.A. will be unable to continue as a going concern for a reasonable period of time. The consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should Hexcel S.A. be unable to continue as a going concern. LITIGATION AND OTHER CONTINGENCIES The Company is involved in litigation arising from business activities. In addition, the Company is subject to certain Government inquiries, including reviews of business practices and cost classifications and a civil suit. The Company is cooperating with the Government in all such inquiries of which the Company has knowledge. However, management is unable to predict the legal proceedings that could result from these inquiries. During December 1992, three lawsuits alleging violations of federal securities laws by the Company and certain officers were filed. The Court consolidated the three lawsuits into one action. Although management believes there were meritorious defenses to the claims, Hexcel Corporation negotiated a tentative settlement with the plaintiffs prior to the Chapter 11 filing to avoid costly and unproductive litigation. This matter, including the tentative settlement, has been stayed by bankruptcy proceedings. In July 1992, the Company was joined in a lawsuit concerning a dispute over a real estate transaction. This action concerned, in part, cleanup and costs associated with an abandoned waste disposal site which the Company sold in 1979. Hexcel Corporation negotiated a global settlement, which was not signed prior to the Chapter 11 filing. This matter, including the negotiated settlement, has been stayed by bankruptcy proceedings. Hexcel Corporation has provided a $4,000 back-up letter of credit in connection with environmental claims on property previously owned. As a result of the Chapter 11 filing, this letter of credit may be invoked, in which case the issuing bank would become an unsecured creditor of Hexcel Corporation pending resolution of the dispute. The Company is self-insured against claims associated with sudden and accidental environmental damage and environmental impairment damage. Certain current and former facilities are the subjects of environmental investigations or claims. In addition, the Company has been named as a potentially responsible party in several superfund sites. Management believes, based on available information, that it is unlikely any of these items will have a material adverse effect on the earnings or financial position of the Company. The Company has filed a claim for equitable relief with a major military customer in connection with underutilized capacity at the Chandler, Arizona plant. A deferral of unabsorbed fixed costs increased profits before taxes by $2,000 in 1992 and $2,428 in 1991 and was recorded as a long-term asset at December 31, 1993 and 1992. Management believes, based upon the advice of counsel, the Company ultimately will realize the cumulative amount deferred. In 1993, the customer agreed to pay for a portion of the unabsorbed fixed costs incurred during the year, contingent upon government acceptance of this billing practice. Accordingly, no additional costs were deferred in 1993. NOTE 17 - BUSINESS SEGMENT REPORTING The Company operates within a single business segment, structural materials. The following table summarizes certain financial data for continuing operations by geographic area as of December 31, 1993, 1992, and 1991 and for the years then ended: The above data exclude discontinued operations, the extraordinary gain and the cumulative effects of accounting changes. International net sales consist of the net sales of international subsidiaries, sold primarily in Europe, and U.S. exports. To compute income (loss) before income taxes, the Company allocated administrative expenses to International of $2,899 in 1993, $3,436 in 1992 and $3,380 in 1991. NOTE 18 - QUARTERLY DATA (UNAUDITED) Quarterly financial data for the years ended December 31, 1993 and 1992 were: Results for each quarter of 1993 and 1992 were restated to reflect the change in accounting for domestic honeycomb and fabric inventories from the last-in, first-out method to the first-in, first-out method. The retroactive application of this accounting change to prior periods is required by generally accepted accounting principles. The Company adopted SFAS 109, "Accounting for Income Taxes," effective January 1, 1993 (see Note 13). The cumulative effect of adopting SFAS 109 was the recognition of income of $4,500 in the first quarter of 1993. Results for the second quarter of 1993 include approximately $4,000 of other expenses offset by a similar amount of gains (see Note 3). In the third quarter of 1993, the Company recorded a $50,000 restructuring charge for the additional costs of the expanded restructuring program (see Note 3). During the fourth quarter of 1993, the Company recorded an additional restructuring charge of $2,600 and other expenses of $12,638 (see Note 3). The Company adopted SFAS 106, "Employers' Accounting for Postretirement Benefits Other than Pensions," effective January 1, 1992 (see Note 12). The cumulative effect of adopting SFAS 106 was a noncash charge of $8,052 after taxes in the first quarter of 1992. Results for the first quarter of 1992 also include a litigation gain of $2,288. The Company recognized an additional gain of $704 in the second quarter of 1992 from this suit. In the second quarter of 1992, the Company repurchased convertible subordinated debentures which resulted in an extraordinary gain of $956 after taxes (see Note 7). In the third quarter of 1992, the Company agreed to terminate interest rate swap contracts which resulted in a gain of $1,361. In December 1992, the Company initiated a restructuring program which resulted in a charge of $23,500 (see Note 3). Quarterly data for 1993 and 1992 reflect certain reclassifications made in 1993. HEXCEL CORPORATION AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (In thousands) HEXCEL CORPORATION AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (In thousands) HEXCEL CORPORATION AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION (In thousands) EXHIBIT 11 STATEMENT REGARDING COMPUTATION OF PER SHARE EARNINGS - UNAUDITED The Company reports net income (loss) per share data on primary and fully diluted bases. Primary net income (loss) per share is based upon the weighted average number of outstanding common shares and common equivalent shares from stock options. Fully diluted net income (loss) per share is based upon (a) the weighted average number of outstanding common shares and common equivalent shares from stock options and adjusted for the assumed conversion of the 7% convertible subordinated debentures and (b) net income (loss) increased by the expenses on the debentures. Computations of net income (loss) per share on the primary and fully diluted bases for 1993, 1992, and 1991 were: C. EXHIBITS EXHIBIT NO. DESCRIPTION 3. 1. Restated Certificate of Incorporation of Hexcel Corporation(6) 2. Certificate of Designation, Preferences and Rights of Series A Junior Participating Preferred Stock(6) 3. Certificate of Increase of Authorized Number of Shares of Series A Junior Participating Preferred Stock(7) 4. Amended and Restated Bylaws of Hexcel Corporation dated as of August 30, 1993 4. 1. Certificate of Incorporation of Hexcel Corporation, Articles 5 through 10 (See Exhibit 3-1) 2. Certificate of Designation, Preferences and Rights of Series A Junior Participating Preferred Stock (Exhibit 3-2) 3. Certificate of Increase of Authorized Number of Shares of Series A Junior Participating Preferred Stock (See Exhibit 3-3) 4. Amended and Restated Bylaws of Hexcel Corporation, Sections 3 through 11, 13 through 16, and 46 (See Exhibit 3-4) 5. Amendment to Bylaws of Hexcel Corporation (See Exhibit 3-4) 6. Rights Agreement dated as of August 14, 1986, between Hexcel Corporation and Manufacturers Hanover Trust Company, as Successor Rights Agent(6) 7. Amendment No. 1 dated October 18, 1988 to Rights Agreement between Hexcel Corporation and the Bank of California, N.A. 8. Amendment No. 2 dated November 19, 1990 between Hexcel Corporation and Manufacturers Hanover Company, as successor Rights Agent(4) 9. Amendment No. 3 dated December 18, 1990 between Hexcel Corporation and Manufacturers Hanover Company, as successor Rights Agent(5) 10. Exemplar of Indenture between Hexcel Corporation and The Bank of California, N.A., Trustee, dated October 1, 1988 11. Loan Agreement and Indentures-Industrial Development Bonds. These instruments are not filed herewith; the registrant agrees to furnish a copy of such instruments to the Commission upon request 10. Material Contracts: 1. A. Note Agreement, as amended, dated December 9, 1977, $8,000,000 8-3/4% Notes B. Amendments dated April 25, 1978, April 30, 1980, January 6, 1981, April 12, 1981, May 13, 1981, August 21, 1981, March 15, 1982 and September 1, 1982, December 31, 1983, July 24, 1986 and August 25, 1986, to Note Agreement dated December 9, 1977, $8,000,000 8-3/4% Notes 2. Consent Agreement dated March 31, 1993, relating to Amended and Restated Credit Agreement dated March 31, 1993, among Hexcel Corporation and the Banks named therein and Wells Fargo Bank, N.A., as Agent(7) 3. Amended and Restated Credit Agreement dated March 31, 1993, among Hexcel Corporation and the Banks named therein and Wells Fargo Bank, N.A., as Agent(7) 4. Letter of Credit and Reimbursement Agreement dated March 1, 1988, between Hexcel Corporation and Banque Nationale de Paris(7) 5. Letter of Credit and Reimbursement Agreement dated December 1, 1989, between Hexcel Corporation and Banque Nationale de Paris(3) A. Amendment No. 1 to Letter of Credit and Reimbursement Agreement dated October 12, 1988, between Hexcel Corporation and Banque Nationale de Paris B. Amendment No. 2 to Letter of Credit and Reimbursement Agreement dated July 1, 1992, between Hexcel Corporation and Banque Nationale de Paris C. Amendment No. 3 to Letter of Credit and Reimbursement Agreement dated April 15, 1993, between Hexcel Corporation and Banque Nationale de Paris 6. Note Agreement dated as of October 1, 1988, between Hexcel Corporation and Principal Mutual Life Insurance Company, $30,000,000 10.12% Senior Notes Due October 1, 1998 7. Letter of Credit Reimbursement Agreement dated as of November 1, 1991, among Hexcel Corporation and Barclays Bank PLC 8. Letter of Credit Reimbursement Agreement dated as of April 28, 1992, among Hexcel Corporation and Barclays Bank PLC as amended March 31, 1993 9. Debtor in Possession Credit Agreement dated as of December 8, 1993, and amended January 3, 1994 and March 25, 1994, and amended April 11, 1994 by and between Hexcel Corporation and The CIT Group/Business Credit, Inc. 10. Executive Compensation Plans and Arrangements A. Stock Option Plans (1) 1988 Management Stock Program(1) (2) Amendments to 1988 Management Stock Program(1) (3) 1988 Restricted Stock Agreement - Sample Agreement(1) (4) 1988 Directors' Discounted Stock Option Agreement - Sample Agreement(1) (5) 1988 Discounted Stock Option Agreement - Sample Agreement(1) (6) 1988 Employees Nonqualified Stock Option Agreement - Sample Agreement(2) (7) 1988 Officers' Nonqualified Stock Option Agreement - Sample Agreement(1) B. Exemplar of Executive Deferred Compensation Agreement C. Exemplars of Incentive Plans(6) D. Exemplars of Contingency Employment Agreement E. Directors' Retirement Plan(7) F. Employment Agreement dated September 28, 1993 between Hexcel Corporation and John J. Lee G. Employment Agreement dated September 28, 1993 between Hexcel Corporation and John L. Doyle 11. Statement Regarding Computation of Per Share Earnings 18. Preferability letter regarding change in accounting for inventories - Deloitte & Touche 21. Subsidiaries of Registrant 23. Consents of Experts and Counsel 1. Independent Auditors' Consent - Deloitte & Touche 2. Consent of Independent Public Accountants - Arthur Andersen & Co. - --------------- (1) Incorporated by reference to the Registration Statement of registrant on Post-Effective Amendment No. 1 to Form S-8 filed on May 11, 1988, No. 33- 17025, pursuant to the Securities Act of 1933 (2) Incorporated by reference to the Registration Statement of registrant on Form S-8 filed on May 2, 1989, No. 33-28445, pursuant to the Securities Act of 1933 (3) Incorporated by reference to the Annual Report of registrant on Form 10-K for the year ended December 31, 1989, filed pursuant to Section 13 of the Securities Exchange Act of 1934. (4) Incorporated by reference to the Current Report of registrant on Form 8-K dated November 19, 1990, filed pursuant to Section 13 of the Securities Exchange Act of 1934. (5) Incorporated by reference to the Current Report of registrant on Form 8-K dated December 18, 1990, filed pursuant to Section 13 of the Securities Exchange Act of 1934. (6) Incorporated by reference to the Annual Report of registrant on Form 10-K for the year ended December 31, 1991, filed pursuant to Section 13 of the Securities Exchange Act of 1934. (7) Incorporated by reference to the Annual Report of registrant on Form 10-K for the year ended December 31, 1992, filed pursuant to Section 13 o

92487_1993.txt

92487

1993

ITEM 1. BUSINESS GENERAL The Company. The Company, a Delaware corporation, is a public utility engaged in generating, purchasing, transmitting, distributing and selling electricity in portions of northeastern Texas, northwestern Louisiana and western Arkansas. It is a wholly owned subsidiary of CSW, a registered holding company under the Holding Company Act. At December 31, 1993, the Company supplied electric service to approximately 396,000 retail customers in a 25,000 square mile area with an estimated population of 899,000. It supplied at wholesale all or a portion of the electric energy requirements of two municipalities, nine rural electric cooperatives and ten other electric utilities. For the year ended December 31, 1993, the Company derived 45% of its electric operating revenues, exclusive of revenues from sales to other utilities, from customers in Texas, 34% from customers in Louisiana and 21% from customers in Arkansas. The three largest metropolitan areas served by the Company are the metropolitan areas which include the adjoining cities of Shreveport and Bossier City, Louisiana; Texarkana, Arkansas and Texas; and the city of Longview, Texas, which have estimated populations of 278,000, 62,000 and 79,000, respectively. The Company owns certain transmission facilities in Oklahoma but serves no customers there. During 1993, Southwestern Electric Power Company completed its purchase of Bossier Rural Electric Membership Corporation (BREMCO), which was adjacent to the Company's southern division in Louisiana. BREMCO customers' cost of electricity declined from 9.7 cents to the Company's 6.7 cents per kilowatt-hour. The Company's service territory is industrially diversified with the chemical processing and petroleum refining industries accounting for 22.9% of the Company's industrial revenue during 1993. The oil and gas extraction industry remains a significant sector in the economy and contributed 11.3% of the Company's industrial revenue during the year. The primary metals and paper processing industries add balance to the Company's industrial base. Competition. The Company generally has the exclusive right to sell electric power at retail within its service area. The Company competes in its service area, however, with suppliers of alternative forms of energy, such as natural gas, fuel oil and coal, some of which may be cheaper than electricity. The Company believes that its rates, the quality and reliability of its service and the relatively inelastic demand for electricity for certain end uses places it in a favorable competitive position in current retail markets. Wholesale energy markets, including the market for wholesale electric power, are extremely competitive, even more so after enactment of the Energy Policy Act. See "National Energy Policy Act of 1992," below. The Company competes with other public utilities, cogenerators and qualified facilities in other forms, exempt wholesale generators and others for sales of electric power at wholesale. Many competitive forces currently are at work in the electric utility industry. Various legislative and regulatory bodies are considering many issues, including the extent of any deregulation of the electric utility industry or of any access to an electric utility's transmission system to make retail sales of power, the pricing of transmission service on an electric utility's transmission system, and the role of utilities, independents and competitive bidding in the construction and operation of new generation capacity. The Company is unable to predict the ultimate outcome or impact of these issues or the impact of further changes in the electric utility industry on the Company. To the extent that consumers of electric power approach electric power as a fungible commodity and are accorded more choices in the future for their power supplies, the principal factor determining success in retail and wholesale markets probably would be price, and to a lesser extent, reliability, availability of capacity, and customer service. Compared to other electric utilities on a national and a regional scale, the Company believes it is a relatively low-cost producer of electric power. Moreover, the Company is taking steps to enhance its marketing and customer service, reduce costs, and improve and standardize business practices in line with the best practices in the CSW System, in order to position itself for increased competition in the future. See ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, for a discussion of the restructuring of the CSW System and certain industry and other challenges. REGULATION AND RATES Regulation. The Company, as a subsidiary of CSW, is subject to the jurisdiction of the SEC under the Holding Company Act with respect to the issuance, acquisition and sale of securities, acquisition and sale of certain assets or any interest in any business, including certain aspects of fuel exploration and development programs, accounting practices and other matters. The Company is itself a holding company by virtue of its 32% ownership of The Arklahoma Corporation, a corporation owned with Arkansas Power and Light Company and Oklahoma Gas and Electric Company. The Arklahoma Corporation owns and maintains a transmission line running from Boudinot, Oklahoma to Lake Catherine, Arkansas. The FERC has jurisdiction under the Federal Power Act over certain of the Company's electric utility facilities and operations, wholesale rates, and in certain other matters. National Energy Policy Act of 1992. The Energy Policy Act, adopted in October 1992, significantly changed U. S. energy policy, including that governing the electric utility industry. The Energy Policy Act allows the FERC, on a case- by-case basis and with certain restrictions, to order wholesale transmission access and to order electric utilities to enlarge their transmission systems. The Energy Policy Act does, however, prohibit FERC-ordered retail wheeling, including "sham" wholesale transactions. Further, under the Energy Policy Act a FERC transmission order requiring a transmitting utility to provide wholesale transmission services must include provisions generally that permit the utility to recover from the FERC applicant all of the costs incurred in connection with the transmission services, any enlargement of the transmission system and associated services. In addition, the Energy Policy Act revised the Holding Company Act to permit utilities, including registered holding companies, and non-utilities to form "exempt wholesale generators" without the principal restrictions of the Holding Company Act. Under prior law, independent power producers were generally required to adopt inefficient and complex ownership structures to avoid pervasive regulation under the Holding Company Act. Management believes that this Act will make wholesale markets more competitive. However, the Company is unable to predict the extent to which the Energy Policy Act will affect its operations. Rates. The Company is subject to the jurisdiction in Arkansas of the Arkansas Commission as to rates, accounts, standards of service, sale or acquisition of certain utility property and issuance of securities secured by liens on property located in that state. In Louisiana, the Company is subject to the jurisdiction of the Louisiana Commission as to rates, accounts and standards of service, but not as to the issuance of securities. In Oklahoma, it is subject to the jurisdiction of the Oklahoma Commission only as to the issuance of evidences of indebtedness secured by liens on property located in that state. In Texas, the Texas Commission has jurisdiction with respect to accounts, certification of utility service territories, sale or acquisition of certain utility property, mergers and certain other matters. The Texas Commission has original jurisdiction over retail rates in the unincorporated areas of Texas. The governing bodies of incorporated municipalities in Texas have such jurisdiction over rates within their incorporated limits. Municipalities may elect, and some have elected, to surrender this jurisdiction to the Texas Commission. The Texas Commission has appellate jurisdiction over rates set by incorporated municipalities. Neither the Texas Commission nor the governing bodies of incorporated municipalities have such jurisdiction over the issuance of securities. The Company's retail rates currently in effect in Louisiana are adjusted based on the Company's cost of fuel in accordance with a fuel-cost adjustment which is applied to each billing month based on the second previous month's average cost of fuel. Provision for any over- or under- recovery of fuel costs is allowed under an automatic fuel clause. Under the Company's fuel adjustment rider currently in effect in Arkansas, the fuel cost adjustment is applied for each billing month on a basis which permits the Company to recover the level of fuel cost experienced two months earlier. Electric utilities in Texas are not allowed to make automatic adjustments to recover changes in fuel costs from retail customers. A utility is allowed to recover its known or reasonably predictable fuel costs through a fixed fuel factor. The Texas Commission established procedures which became effective on May 1, 1993, subject to certain transition rules, whereby each utility under its jurisdiction may petition to revise its fuel factors every six months according to a specified schedule. Fuel factors may also be revised in the case of emergencies or in a general rate proceeding. Under the revised procedures a utility will remain subject to the prior rules until after its first fuel reconciliation, or in some instances a general rate proceeding including a fuel reconciliation, subject to the new rules. Management does not believe that the new rules substantially change the manner in which the Company will recover retail fuel costs in Texas. Fuel factors are in the nature of temporary rates and the utility's collection of revenues by such is subject to adjustments at the time of a fuel reconciliation proceeding. At the utility's semi-annual adjustment date, a utility must petition the Texas Commission for a surcharge or to make a refund when it has materially over- or under-collected its fuel costs and projects that it will continue to materially over- or under-collect. Material over- or under-collections including interest are defined as four percent of the most recent Texas Commission adopted annual estimated fuel cost for the utility, which is approximately $5.2 million for the Company. A utility does not have to revise its fuel factor when requesting a surcharge or refund. An interim emergency fuel factor order must be issued by the Texas Commission within 30 days after such petition is filed by the utility. Final reconciliation of fuel costs are made through a reconciliation proceeding, which may contain a maximum of three years and a minimum of one year of reconcilable data, and must be filed with the Texas Commission no later than six months after the end of the period to be reconciled. In addition, a utility must include a reconciliation of fuel costs in any general rate proceeding regardless of the time since its last fuel reconciliation proceeding. Any fuel costs which are determined unreasonably incurred in a reconciliation proceeding must be refunded to customers. The Company has agreements, which have been approved by the FERC, with all of its wholesale customers under which rates are based upon an agreed cost of service formula. These rates are adjusted periodically to reflect the actual cost of providing service. All of the Company's contracts with its wholesale customers contain FERC approved fuel- adjustment provisions that permit it to pass actual fuel costs through to its customers. In the event that the Company does not recover all of its fuel costs under the above procedures, such event could have an adverse impact on its results of operations. See ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA, Note 9, Litigation and Regulatory Proceedings, for further information with respect to fuel recovery. OPERATIONS Peak Loads and System Capabilities. The following table sets forth for the last three years the net system capability of the Company (including the net amounts of contracted purchases and contracted sales) at the time of peak demand, the maximum coincident system demand on a one- hour integrated basis (exclusive of sales to other electric utilities) and the respective amounts and percentages of peak demand generated by the Company and net purchases and sales: Percent Net System Maximum Increase Capability Coincident (Decrease) Net Purchases at Time of System In Peak Generation at (Sales) at Peak Demand(1) Demand Time of Peak Time of Peak Over Prior Year MW MW Period MW % MW % 1993 4,436 3,651 12.8 3,559 97.5 92 2.5 1992 3,959 3,237 1.2 3,292 101.7 (55) (1.7) 1991 4,094 3,200 (1.6) 3,008 94.0 192 6.0 (1) Maximum system demand occurred on August 18, August 10, and August 5, in the years 1993, 1992 and 1991, respectively. The Company exchanges power on an emergency or economy basis with various neighboring systems and engages in economy interchanges with the other Electric Operating Companies in the CSW System. In addition, it has contracts with certain systems for the purchase and sale of power on a system basis. As part of the negotiations to acquire BREMCO, the Company entered into a long-term purchased power contract with Cajun, BREMCO's previous full-requirements wholesale supplier. The contract covers the purchase of energy at a fixed price for 1993 and 1994, and the purchase of capacity and energy in subsequent years. The Company is a member of the Southwest Power Pool and the Western Systems Power Pool. The Company furnishes energy at wholesale to two municipalities and also supplies electric energy at wholesale to seven electric cooperatives operating in its territory through NTEC, Tex-LA and Rayburn Country. The Company also sells power to AECC and Cajun on an as- available basis. The CSW System operates on an interstate basis to facilitate exchanges of power. PSO and WTU are interconnected through the 200,000 Kw North HVDC Tie. In August 1992, the Company entered into an agreement with CPL, HLP and Texas Utilities Electric Company to construct and operate an East Texas HVDC transmission interconnection which will facilitate exchanges of power for the CSW System. The Company has a 25% ownership interest in the project. This interconnection will consist of a back-to-back HVDC converter station and 16 miles of 345 kilovolt transmission line connecting transmission substations at the Company's Welsh Power Plant and Texas Utilities Electric Company's Monticello Power Plant. In March, 1993, an application for a Certificate of Convenience and Necessity for the transmission interconnection was approved by the Texas Commission. This 600,000 Kw project is scheduled to be completed in 1995. Seasonality. Sales of electricity by the Company tend to increase during warmer summer months and, to a lesser extent, cooler winter months, because of higher demand for cooling and heating power. Employees. At December 31, 1993, the Company had 2,033 employees. Of such employees, approximately 800 are covered under a collective bargaining agreement with IBEW. CSW has announced an early retirement program to be implemented throughout the CSW System in 1994. The early retirement program was offered to 181 eligible employees of the Company and 726 employees on a systemwide basis of which approximately 78% of the eligible employees of the Company and 85% of the total systemwide eligible employees elected the early retirement program. See ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Restructuring, for a discussion of the recently announced restructuring of the CSW System and associated early retirement program and work force reduction. SOUTHWESTERN ELECTRIC POWER COMPANY OPERATING STATISTICS Year Ended December 31 1993 1992 1991 KILOWATT-HOUR SALES (MILLIONS): Residential 4,114 3,702 3,841 Commercial 3,249 3,039 3,056 Industrial 6,122 5,862 5,779 Other Retail 390 373 370 ------ ------ ------ Sales to retail customers 13,875 12,976 13,046 Sales for resale 4,508 3,854 3,195 ------ ------ ------ Total 18,383 16,830 16,241 ====== ====== ====== NUMBER OF ELECTRIC CUSTOMERS AT END OF PERIOD: Residential 340,379 325,301 321,248 Commercial 46,728 45,185 44,573 Industrial 5,809 5,687 5,657 Other 2,605 2,636 2,641 ------- ------- ------- Total 395,521 378,809 374,119 ======= ======= ======= RESIDENTIAL SALES AVERAGES: Kwh per customer 12,357 11,445 12,005 Revenue per customer $822 $770 $791 Revenue per Kwh (cents) 6.65 6.73 6.59 REVENUES PER KWH ON TOTAL SALES (cents) 4.60 4.62 4.68 FUEL COST DATA: Average Btu per net Kwh 10,582 10,717 10,797 Cost per million Btu $1.94 $1.93 $1.87 Cost per Kwh generated (cents) 2.05 2.07 2.02 Cost as a percentage of revenue 42.5 43.0 42.4 CONSTRUCTION AND FINANCING Construction. The estimated total capital expenditures (including AFUDC) for the years 1994-1996 are as follows: 1994 1995 1996 Total (Millions) Production $ 8 $ 14 $ 12 $ 34 Transmission 43 33 38 114 Distribution 39 41 43 123 Other 35 43 34 112 ---- ---- ---- ---- Total $125 $131 $127 $383 ==== ==== ==== ==== Information in the foregoing table is subject to change due to numerous factors, including the rate of load growth, escalation of construction costs, changes in lead times in manufacturing, inflation, the availability and pricing of alternatives to construction or environmental regulation, delays from regulatory hearings, the adequacy of rate relief and the availability of necessary external capital. Changes in these and other factors could cause the Company to defer or accelerate construction or to sell or buy more power, which would affect its cash position, revenues and income to an extent that cannot now be reliably predicted. See ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Construction Program, for additional information relating to construction. The Company continues to study alternatives to reduce or meet future increases in customer demand, including without limitation demand-side management programs, new and efficient electric technologies, various architectures for new and existing generation facilities, and methods to reduce transmission and distribution losses. The CSW System facilities plan currently indicates that the Company will not require additional substantial additions to its generating capacity until the year 2002 or beyond. Financing. See ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Financing and Capital Resources, for information relating to financing and capital resources. FUEL SUPPLY General. The Company's present electric generating plants showing the type of fuel used are set forth under ITEM 2.

ITEM 2. PROPERTIES. During 1993, approximately 55% of Kwh generation was from coal, 29% from lignite and 16% from gas. Coal and lignite requirements were 10.3 million tons and natural gas consumption was 29.7 million Mcf. Coal and Lignite. The long-term fuel supply for the Company's Welsh plant and its 50 percent-owned Flint Creek plant is provided under a contract with AMAX. The new contract, executed in December 1993, replaces a prior contract between the parties as part of a settlement of litigation concerning the prior contract. The settlement is expected to result in lower fuel costs now and in the future to the Welsh and Flint Creek plants. Approximately 86 percent of the total 1993 Flint Creek coal requirements and 100 percent of the total 1993 Welsh coal requirements were supplied under the AMAX contracts with the balance purchased on the spot market. Coal under the AMAX contract is mined near Gillette, Wyoming, a distance of about 1,500 and 1,100 miles, respectively, from the Welsh and Flint Creek plants. This coal is delivered to the plants under a rail carrier contract with the Company. The Company owns or leases sufficient cars and spares for operation of twelve unit trains. At December 31, 1993, the Company had coal inventories of 922,000 tons at Welsh and 365,000 tons at Flint Creek. The Company has acquired lignite leases covering an aggregate of about 27,000 acres near the Pirkey plant. Sabine Mining Company is the contract miner of these reserves. At December 31, 1993, 308,000 tons of lignite were in inventory at the plant. Another 25,000 acres are jointly leased in equal portions by the Company and CLECO in the Dolet Hills area of Louisiana near the Dolet Hills Power Plant. The Dolet Hills Mining Venture is the contract miner of these reserves. At December 31, 1993, the Company had 150,000 tons of lignite in inventory at the plant. In the Company's opinion, the acreage under lease in these areas contains sufficient reserves to cover the anticipated lignite requirements for the estimated useful lives of the lignite-fired plants. Natural Gas. In 1993, the Company purchased approximately 87% of its gas requirements pursuant to spot purchase contracts with no take-or-pay obligations. The remainder of the Company's 1993 gas requirements, approximately 13%, came from a long-term take-or-pay contract which was terminated in January 1994. The Company plans to continue to enter into short-term contracts with various suppliers to provide gas for peaking purposes. Governmental Regulation. The price and availability of each of the foregoing fuel types are significantly affected by governmental regulation. Any inability in the future to obtain adequate fuel supplies, or adoption of additional regulatory measures restricting the use of such fuels for the generation of electricity, might affect the Company's ability to meet economically the needs of its customers and could require it to supplement or replace, prior to normal retirement, existing generating capability with units using other fuels. This would be impossible to accomplish quickly, would require substantial expenditures for construction and could have a significant adverse effect on the Company's financial position and results of operations. Fuel Costs. Additional fuel cost data for the Company appears under "OPERATING STATISTICS." For 1993, total average cost of fuel per million Btu was $1.94. Average costs per million Btu by major fuel type were $2.03 for coal, $1.27 for lignite and $2.89 for natural gas. Fuel costs often fluctuate due to various factors and, as a result, the Company is unable to precisely predict the future cost of fuel. ENVIRONMENTAL MATTERS The Company is subject to regulation with respect to air and water quality and solid waste standards, along with other environmental matters, by various federal, state and local authorities. These authorities have continuing jurisdiction in most cases to require modifications in the Company's facilities and operations. Changes in environmental statutes and regulations could require substantial additional expenditures to modify the Company's facilities and operations and could have a significant adverse effect on the Company's results of operations. Violations of environmental statutes or regulations can result in fines and other costs. Air Quality. Air quality standards and emission limitations are subject to the jurisdiction of the ADPCE in Arkansas, the LDEQ in Louisiana and the TNRCC in Texas, with oversight by the EPA. In accordance with regulations of the ADPCE, LDEQ and TNRCC, permits are required for all generating units on which construction is commenced or which are substantially modified after the effective date of the applicable regulations. The EPA has approved and may enforce the air quality standards and limitations adopted by the ADPCE, LDEQ and TNRCC and has adopted ambient air quality standards applicable nationally, as well as new source performance standards for all new or substantially modified generating units. The Company has not received notice from any federal or state government agency alleging that it currently is subject to an enforcement action for a material violation of existing federal or state air quality and emission regulations. In November 1990, the United States Congress passed the Clean Air Act Amendments of 1990, which place restrictions on the emission of sulfur dioxide (SO2) and nitrogen oxides from gas, coal and lignite fired generating plants. Under the Clean Air Act Amendment, beginning in the year 2000, the Company will be required to hold allowances in order to emit SO2. The right to emit SO2 from existing generating plants has been established on historical operating conditions. These rights will be controlled through an allowance program. The Company, based on the CSW System facilities plan, believes its allowances are adequate to meet its needs at least through 2008. Public and private markets are developing for trading of excess allowances. The Company is not currently engaging in sales or purchases of allowances, but may seek to do so in the future if market conditions warrant. The facilities plan presently includes projected coal and lignite fired generating plants for which the Company has invested approximately $37.7 million in prior years for plant sites, engineering studies and lignite reserves. During 1993, the Company abandoned certain lignite leases with a value of $4.2 million. As conditions change, the Company will continue to evaluate its plans for these plants as well as the probability of recovery of these investments, and adjust the balance of the investment appropriately. In accordance with Clean Air Act requirements, the Company anticipates spending $5 million for continuous emissions monitoring equipment through 1995. Water Quality. The ADPCE, the LDEQ and the TNRCC in their respective states, and the EPA generally, have jurisdiction over all waste water discharges into state waters. These authorities have jurisdiction for establishing water quality standards and issuing waste control permits covering discharges which might affect the quality of state waters. The EPA has jurisdiction over "point source" discharges through the National Pollutant Discharge Elimination System provisions of the Clean Water Act. The Company has not received notice from any federal or state government agency alleging that it currently is subject to an enforcement action for a material violation of existing federal or state wastewater discharge regulations. Solid Waste Disposal. The RCRA and the Arkansas, Louisiana and Texas solid waste rules provide for comprehensive control of all solid wastes from generation to final disposal. The ADPCE, LDEQ and TNRCC have received authorization from the EPA to administer the RCRA solid waste control program for their respective states. The Company has not received notice from any federal or state government agency alleging that it currently is subject to an enforcement action for a material violation of existing federal or state solid waste regulations. CERCLA and Related Matters. Under CERCLA, owners or operators of contaminated sites and transporters and/or generators of hazardous substances can be held liable for the cleanup of hazardous substance disposal sites. Similar liabilities for hazardous substance disposal can arise under applicable state law. The Company, like other electric utilities, incurs significant costs for the handling, transportation, storage and disposal of hazardous, toxic and non-hazardous waste materials. Unit costs for waste classified as hazardous or toxic exceed by a substantial margin unit costs for waste classified as non-hazardous. The Company produces combustion and other generation by- products, such as sludge, ash and slag. The Company owns distribution poles treated with creosote or related substances. The EPA currently exempts coal combustion by- products from regulation as hazardous wastes. Distribution poles treated with creosote or similar substances are not expected to exhibit characteristics that would cause them to be hazardous waste. In connection with its operations, the Company also has used asbestos, PCBs and other materials classified as hazardous or toxic waste. If additional by- products or other materials generated or used by the Company were reclassified as hazardous or toxic wastes, or other new laws or regulations concerning hazardous or toxic wastes or other materials were put in effect, the Company's disposal and remedial costs could increase materially. In 1993, the EPA made an administrative determination that coal combustion by- products are non-hazardous. The EPA is expected in the near- term to issue new regulations stating whether certain other non-combustion by-products will be classified as hazardous waste. In late 1987, the Company signed an administrative order with the EPA in coordination with several other companies, for removal of PCB articles and materials stored at the now defunct EPA-permitted Rose Chemical PCB disposal site in Missouri. EPA issued an administrative order for site remediation in 1992 and the Company, along with the other parties, is complying with the order. The Company's share of cleaning up the Rose Chemical site is not expected to have a material adverse effect on the Company's results of operations. The Company was named as a PRP at the B&B Salvage site. This site, located in Missouri, received scrap metal from the Rose Chemical firm. This site has been remediated and the Company has settled its liability with other PRPs. The settlement did not have a material adverse effect on the Company's results of operations. See ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA, Note 10, Commitments and Contingent Liabilities, for information with respect to former MGP sites for which the Company has potential liability for clean up costs. From time to time the Company is made aware of various other environmental issues or is a party to various other legal claims, actions, complaints and other proceedings related to environmental matters. Management does not expect disposition of any such environmental proceedings to have a material adverse effect on the Company's results of operations. See ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS - Environmental, for certain other information relating to environmental matters. ITEM 2. PROPERTIES. Facilities. At December 31, 1993, the Company owned the following electric generating plants (or portions thereof in the cases of the jointly owned plants). See ITEM 1. FUEL SUPPLY. Net Dependable Type of Fuel Capability Plant Name and Location Primary/Secondary MW Arsenal Hill gas 113 Shreveport, Louisiana Lieberman gas 56 Mooringsport, Louisiana gas/oil (a) 220 Knox Lee gas 157 Longview, Texas gas/oil (a) 344 Lone Star gas/oil 50 Lone Star, Texas Wilkes gas/oil (a) 177 Jefferson, Texas gas 702 Welsh coal 1,584 Cason, Texas Flint Creek (b) coal 240 Gentry, Arkansas Henry W. Pirkey (b) lignite 559 Hallsville, Texas Dolet Hills (b) lignite 262 Mansfield, Louisiana ----- Total 4,464 ____________________ ===== (a) For extended periods of operation, oil can be used only in combination with gas. Sustained use of oil in facilities primarily designed to burn gas results in increased maintenance expense and a reduction of 5% to 10% in capability. (b) Data reflects only the Company's portion of plants which are jointly owned with non-affiliated parties. All of the generating plants described above are located on land owned by the Company or jointly with the other participants in jointly owned plants. The Company's electric transmission and distribution facilities are for the most part located over or under highways, streets and other public places or property owned by others, for which permits, grants, easements or licenses (which the Company believes to be satisfactory, but without examination of underlying land titles) have been obtained. The principal plants and properties of the Company are subject to the lien of the first mortgage indenture under which the Company's first mortgage bonds are issued. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. See ITEM 1. REGULATION AND RATES and ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA, Note 9, Litigation and Regulatory Proceedings, for information relating to regulatory proceedings. See ITEM 1. ENVIRONMENTAL MATTERS and ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Other Matters, for information relating to environmental proceedings. The Company is party to various other legal claims, actions and complaints arising in the normal course of business. Management does not expect disposition of these matters to have a material adverse effect on the Company's results of operations. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. All of the outstanding shares of Common Stock of the Company are owned by its parent company, CSW. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. The following selected financial data for each of the five years ended December 31 are provided to highlight significant trends in the financial condition and results of operations for the Company. 1993 1992 1991 1990 1989 (dollars in thousands) Electric Operating Revenues $ 837,192 $ 778,303 $ 760,694 $ 735,217 $ 729,861 Net Income 81,876 94,883 96,624 89,713 97,217 Preferred Stock Dividends 3,362 3,445 3,465 3,528 3,528 Net Income for Common Stock 78,514 91,438 93,159 86,185 93,689 Total Assets 1,968,285 1,927,320 1,851,108 1,869,340 1,880,100 Common Stock Equity 645,731 647,217 645,780 641,554 640,169 Preferred Stock Subject to Mandatory Redemption 36,028 37,228 38,416 36,422 36,095 Preferred Stock Not Subject to Mandatory Redemption 16,032 16,032 16,033 14,358 14,309 Long-Term Debt $ 602,065 $ 532,860 $ 573,626 $ 576,095 $ 595,988 Ratio of Earnings to Fixed Charges (SEC Method) 3.34 3.39 3.51 3.03 3.19 Capitalization Ratios: Common Stock Equity 49.7% 52.5% 50.7% 50.6% 49.8% Preferred Stock 4.0 4.3 4.3 4.0 3.9 Long-Term Debt 46.3 43.2 45.0 45.4 46.3 ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Reference is made to the Financial Statements and related Notes to Financial Statements and Selected Financial Data. The information contained therein should be read in conjunction with, and is essential in understanding, the following discussion and analysis. OVERVIEW The Company's return on average common stock equity decreased 2.4% in 1993 to 12.0% as compared to 14.4% in 1992. A return to normal temperatures in the Company's service territory contributed to a 6.2% increase in revenues from sales to retail customers. However, significant charges associated with restructuring and the adoption of Statement of Financial Accounting Standard (SFAS) No. 112 more than offset the positive effects of the weather and a change in accounting for unbilled revenues. RESTRUCTURING CSW recently announced a management restructuring and early retirement program designed to consolidate and restructure its operations in order to meet the challenges of the changing electric utility industry and to compete effectively in the years ahead. The underlying goal of the restructuring is to enable the Electric Operating Companies to focus on and be accountable for serving customers. The initial phase of the restructuring will involve certain changes at CSWS, the mutual service company that serves the CSW System. CSWS will be realigned into two primary units -- Operation Services and Production Services. Operation Services will provide administrative services that can be performed centrally to benefit the CSW System, including the Company. Production Services will focus on consolidated fuel and generation planning for the Electric Operating Companies as well as certain other activities. Certain aspects of the restructuring may be subject to SEC approval. To implement the restructuring program, the CSW System will consolidate and centralize its operation services and production services. The Company, the other Electric Operating Companies and CSW are expected to reduce the size of their work forces and incur costs associated with an early retirement program, severance packages and relocation. The early retirement program has been offered to 181 eligible employees of the Company and 726 employees on a systemwide basis, of which approximately 78% of the eligible employees of the Company and 85% of the total systemwide eligible employees elected the early retirement program. Since the restructuring is not expected to be completed until the end of 1994, it is not possible at this time for the Company to predict the number of its employees who will take the early retirement program, be granted severance packages or be relocated. The Company's share of the total cost of the restructuring was estimated to be $25.2 million before taxes, and was expensed in 1993. The Company's share of the severance and relocation costs will be paid from general corporate funds in 1994 and its share of early retirement costs primarily from pension and postretirement benefit plan trusts. Savings from the restructuring are expected to begin in the second half of 1994. By the end of 1995, initial costs should be fully recovered through operations and maintenance cost savings. CSW established a Business Improvement Plan in 1991 to identify, analyze and implement the best business practices as part of its efforts to align the CSW System strategically to meet competitive forces. The BIP program will be incorporated as part of the restructuring. Any additional costs to the Company are expected to be offset by future savings from the benefits provided through the implementation of BIP recommendations. CONSTRUCTION AND CAPITAL EXPENDITURES The Company's construction and capital expenditures increased 70% in 1993, 30.3% in 1992, and 20.9% in 1991. Included in the expenditures for 1993 was approximately $35 million for the acquisition of BREMCO, a rural electric cooperative with service territory adjacent to the Company's service territory in Louisiana. Construction expenditures during the period 1994-1996 are estimated at $383 million. These expenditures will consist primarily of expansion and improvements to transmission and distribution facilities. The construction program will continue to be reviewed and adjusted for changes affecting the Company's service area. FINANCING AND CAPITAL RESOURCES Internal Generation. Internal sources of funds, consisting of cash flows from operating activities less dividends paid, have provided $148.7 million, $75.4 million, and $104.8 million during 1993, 1992, and 1991. These amounts represented 85%, 78%, and 142% of the total construction expenditures during these periods. Sale of Accounts Receivable. The Company sells its billed and unbilled accounts receivable to CSW Credit, Inc., a wholly owned subsidiary of CSW. These sales provide the Company with cash immediately and reduce working capital and revenue requirements. The monthly average and year end amounts of accounts receivable sold were $64.4 million and $57.1 million in 1993 as compared to $59.4 million and $54.2 million in 1992. Short-Term Financing. The Company traditionally uses short-term debt for interim financing until a marketable amount can be refinanced with first mortgage bonds or preferred stock. The Company, together with other members of the CSW System, has established a System money pool to coordinate short-term borrowings and to make borrowings outside the money pool through the issuance of commercial paper and from bank borrowings. These borrowings are unsecured demand obligations at rates approximating the CSW System's commercial paper borrowing costs. The maximum and minimum amounts of borrowings outstanding at month end during 1993 were $53.5 million and zero, and the average amount of borrowings outstanding during the year was $10 million. The weighted average interest rate paid during the year was 3.2%. The maximum borrowing limit through the System money pool authorized by the SEC is $150 million. Long-Term Financing. Long-term financing by the Company involves the sale of first mortgage bonds and preferred stock and the receipt of capital contributions from its parent company or other financing alternatives. The goal of the Company is to maintain a strong capital structure. At December 31, 1993, the capitalization ratios were 50% common stock equity, 4% preferred stock, and 46% long-term debt. External financing will be required in the 1994-1996 time period; however, the timing, nature and extent thereof have not been determined. External financings will be made with capital structure goals and cost of funds in mind. Regulatory Matters. Reference is made to Note 9 of the Notes to Financial Statements for a discussion of regulatory matters. New Accounting Standards. Reference is made to Note 1 of the Notes to Financial Statements-New Accounting Standards for a discussion of SFAS No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, SFAS No. 109, Accounting for Income Taxes, SFAS No. 112, Employers' Accounting for Postemployment Benefits, and the Company's change in accounting for Unbilled Revenues. RESULTS OF OPERATIONS Net income for common stockholders decreased 14.1% during 1993 to $78.5 million from $91.4 million in 1992, due primarily to restructuring reserves and the adoption of SFAS 112, offset in part by a change in its accounting method of accounting for unbilled revenues. In 1992, net income decreased 1.8% from $93.2 million in 1991. Electric Operating Revenues. Total electric operating revenues increased 7.6% during 1993, due primarily to higher energy sales which resulted from favorable weather in the Company's service territory, and to a gain in the number of customers served. Approximately 9,400 retail customers were added with the acquisition of BREMCO, a neighboring electric cooperative. Also contributing to the higher total revenues were increased sales of energy for resale, which resulted, in part, from sales to CPL, an affiliate, during an outage at their South Texas Project generating facility. The decline in retail energy sales in 1992 was due to milder temperatures, offset in part by an increase in the number of customers served. Industrial kilowatt-hour sales increased 4.5% in 1993, and 5.9% in 1992. Fuel and Purchased Power. Fuel expense is influenced primarily by two factors, the average unit cost of fuel (price) and the quantity of fuel burned (generation). Fuel expense increased 7.3% in 1993, after increases of 3.9% in 1992 and 6.7% in 1991. The average cost of fuel per million BTU was $1.94, $1.93, and $1.87 during 1993, 1992, and 1991, which amounts to an increase of 0.5% during 1993, 3.2% during 1992, and 2.7% in 1991. The fuel expense increase in 1993 was primarily the result of an 8% increase in generation. Purchased power costs increased $6.5 million in 1993, after an increase of $4.4 million in 1992 and a decrease of $2.2 million in 1991. The increase in 1993 was largely due to scheduled and unscheduled maintenance at the Company's generating facilities and a purchased power contract negotiated as part of the purchase of BREMCO. The increase in 1992 was due largely to a higher amount of energy purchased for resale to neighboring utilities, and the decrease in 1991 resulted primarily from a lower amount of energy purchased for resale. During December 1993 and January 1994, the Company settled two major disputes involving litigation with fuel suppliers. One dispute related to a coal supply contract between the Company and AMAX. The prior contract was replaced in December 1993 with a new coal supply agreement with AMAX as part of the settlement. In January 1994, the Company entered into a settlement of litigation with DELHI regarding a gas supply contract. The settlement provided for termination of the existing gas supply contract, which otherwise would have expired in March 1995, and a new four- year gas supply contract between the parties. Both settlements are expected to result in reduced fuel costs now and in the future, the benefits of which will revert to the Company's customers through fuel cost adjustment mechanisms. Expenses and Taxes. Operation and maintenance expenses increased 41.1% during 1993, primarily the result of restructuring charges and $4.2 million in reserves for certain lignite properties. Also contributing to the increase were higher expenses for outside and legal services, and higher employee benefit expenses. Significantly higher than average maintenance expenditures on the Company's distribution and general facilities resulted in an increase of 19% in maintenance expense for 1993 compared to 1992. Federal income taxes decreased 12% or $3.9 million as a result of lower pre-tax income, which more than offset the increase in the federal income tax rate from 34% to 35%. Taxes other than federal income were 10.4% higher during 1993, primarily due to a Texas tax refund recognized in 1992. The decrease in 1992 was due in part to this refund, and to lower state income taxes. Effects of Inflation. Annual inflation rates, as measured by the national Consumer Price Index, have averaged approximately 3.3% for the three-year period ending December 31, 1993. Inflation at these levels does not materially affect the Company's results of operations or financial condition. Under existing regulatory practice, however, only the historical cost of plant is recoverable from customers. As a result, cash flows designed to provide recovery of historical plant costs may not be adequate to replace plant in future years. Interest and Preferred Stock Dividends. Interest on long-term debt decreased in each of the past three years as a result of reacquisitions and refinancings of long-term debt. OTHER MATTERS Competition and Industry Challenges. The Company's business has been, and will continue to be affected by various challenges that confront the electric utility industry generally. The Company currently faces competition for power sales in the wholesale market. In the future, the Company may face similar competition for retail sales from other utilities, independent power producers or alternative sources of electricity or other energy. To date, the Company has been successful in meeting the competition. In 1993, the Company and PSO filed with the FERC tariffs under which they make generally available firm and non-firm transmission services for other electric utilities on the combined PSO and SWEPCO transmission systems in the Southwest Power Pool. The FERC accepted the tariffs for filing on November 4, 1993. The tariffs will expose the CSW System to some additional risk of loss of load or reduced revenue resulting from competition with alternative suppliers of electric power. Other industry-wide issues confronting the Company include current and proposed stringent environmental and other regulation and deregulation. In addition, the Company is continuing to manage costs and rates and focus on new initiatives in order to maintain its financial strength and reach its financial targets. Environmental. The operations of the Company, like those of other electric utilities, generally involve the use or disposal of substances subject to environmental laws. CERCLA, the federal "Superfund" law, addresses the cleanup of sites contaminated by hazardous substances. Superfund requires that PRPs fund remedial actions regardless of fault or the legality of past disposal activities. Many states have similar laws. Theoretically, any one PRP can be held responsible for the entire cost of a cleanup. Typically, however, cleanup costs are allocated among PRPs. The Company has been named as a responsible party under federal or state remedial laws four times, and has resolved three of those claims without a material adverse effect on the Company. The Company does not anticipate that resolution of the remaining claim will have a material adverse effect on it. Factors that are the basis for the expectation are the volume and/or type of waste allegedly contributed by the Company, the estimated amount of costs allocated to the Company and the participation of other parties. Contaminated former MGPs are a type of site which utilities, and others, may have to remediate in the future under Superfund or other federal or state remedial programs. Gas was manufactured at MGPs from the mid-1800's to the mid- 1900's. In some cases, utilities and others have faced potential liability for MGPs because they, or their alleged predecessors, owned or operated the plants. In other cases, utilities or others may have been subjected to such liability for MGPs because they acquired MGP sites after gas production ceases. The Company is investigating contamination at a suspected MGP in Marshall, Texas. Although it has not been determined whether a cleanup will be required at the site, preliminary estimates of potential responses indicate that such costs would not be material to the Company. As more information is obtained about the site, and the Company discusses the site with the TNRCC, the preliminary estimates may change. If a cleanup is required, the Company intends to seek contribution from other PRPs. See ITEM 1. ENVIRONMENTAL MATTERS, for further discussion of certain Superfund and MGP sites. The Clean Air Amendments of 1990 direct the EPA to issue regulations governing nitrogen oxide emissions. In addition, these amendments require government studies to determine what controls, if any, should be imposed on utilities to control air toxic emissions. The impact that the nitrogen oxide emission regulations, and the air toxics study, will have on the Company cannot be determined at this time. Research is ongoing whether exposure to EMFs may result in adverse health effects or damage to the environment. Although a few of the studies to date have suggested certain associations between EMFs and some types of adverse health effects, the research to date has not established a cause- and-effect relationship between EMFs and adverse health effects. The Company cannot predict the impact on the CSW System or the electric utility industry if further investigations or proceedings were to establish that the present electricity delivery system is contributing to increased risk or incidence of health problems. Cumulative Effect of Changes in Accounting Principles. In 1993, the Company implemented SFAS No. 112, Employers' Accounting for Post Employment Benefits, SFAS No. 109, Accounting for Income Taxes and changed the method of accounting for unbilled revenues. These changes are presented as a net $3.4 million cumulative effect of changes in accounting principles. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. Statements Of Income for the years ended December 31 1993 1992 1991 (thousands) ELECTRIC OPERATING REVENUE Residential $273 707 $249 182 $253 053 Commercial 175 059 165 836 163 261 Industrial 250 912 243 508 235 299 Sales for resale 65 670 57 619 57 180 Sales for resale affiliated 27 667 21 195 10 980 Other 44 177 40 963 40 921 ------- ------- ------- 837 192 778 303 760 694 ======= ======= ======= OPERATING EXPENSES AND TAXES Fuel 359 306 334 972 322 272 Purchased power 10 623 5 231 1 050 Purchased power from affiliates 2 522 1 389 1 131 Other operating 122 986 101 220 96 023 Restructuring charges 25 203 - - Maintenance 50 164 42 191 45 520 Depreciation and amortization 74 385 72 300 68 686 Taxes, other than Federal income 46 942 42 502 44 968 Federal income taxes 27 004 32 771 37 727 ------- ------- ------- 719 135 632 576 617 377 ------- ------- ------- OPERATING INCOME 118 057 145 727 143 317 ------- ------- ------- OTHER INCOME AND DEDUCTIONS Allowance for equity funds used during construction 1 560 132 550 Other 3 658 537 3 883 ------- ------- ------- 5 218 669 4 433 ------- ------- ------- INCOME BEFORE INTEREST CHARGES 123 275 146 396 147 750 ------- ------- ------- INTEREST CHARGES Interest on long-term debt 40 958 47 490 48 382 Interest on short-term debt and other 4 866 4 073 3 172 Allowance for borrowed funds used during construction (1 020) (50) (428) ------- ------- ------- 44 804 51 513 51 126 ------- ------- ------- Income before Cumulative Effect of Changes in Accounting Principles 78 471 94 883 96 624 Cumulative Effect of Changes in Accounting Principles 3 405 - - ------- ------- ------- NET INCOME 81 876 94 883 96 624 Preferred stock dividends 3 362 3 445 3 465 ------- ------- ------- NET INCOME FOR COMMON STOCK $ 78 514 $ 91 438 $ 93 159 ======= ======= ======= The accompanying notes to financial statements are an integral part of these statements. Statements Of Retained Earnings for the years ended December 31 1993 1992 1991 (thousands) RETAINED EARNINGS AT BEGINNING OF YEAR $266 557 $265 120 $260 894 NET INCOME FOR COMMON STOCK 78 514 91 438 93 159 Deduct: Common stock dividends 80 000 90 000 83 000 Preferred stock redemption costs - 1 5 933 ------- ------- ------- RETAINED EARNINGS AT END OF YEAR $265 071 $266 557 $265 120 ======= ======= ======= The accompanying notes to financial statements are an integral part of these statements. Balance Sheets as of December 31 1993 1992 (thousands) ASSETS ELECTRIC UTILITY Production $1 392 058 $1 393 961 Transmission 350 625 345 183 Distribution 678 788 595 679 General 188 193 170 474 Construction work in progress 126 258 73 421 --------- --------- 2 735 922 2 578 718 Less - Accumulated depreciation 947 792 875 888 --------- --------- 1 788 130 1 702 830 --------- --------- CURRENT ASSETS Cash and temporary cash investments 6 723 1 059 Special deposits for reacquisition of long-term debt - 53 500 Accounts receivable 24 363 20 811 Materials and supplies, at average cost 25 218 24 311 Fuel inventory, at average cost 49 487 70 588 Deferred income taxes 3 912 - Prepayments and other 14 965 14 251 --------- --------- 124 668 184 520 --------- --------- DEFERRED CHARGES AND OTHER ASSETS 55 487 39 970 --------- --------- $1 968 285 $1 927 320 ========= ========= CAPITALIZATION AND LIABILITIES CAPITALIZATION Common stock, $18 par value, authorized 7,600,000 shares, issued and outstanding 7,536,640 shares $ 135 660 $ 135 660 Paid-in capital 245 000 245 000 Retained earnings 265 071 266 557 --------- --------- Total Common Stock Equity 645 731 647 217 Preferred stock Not subject to mandatory redemption 16 032 16 032 Subject to mandatory redemption 36 028 37 228 Long-term debt 602 065 532 860 --------- --------- Total Capitalization 1 299 856 1 233 337 --------- --------- CURRENT LIABILITIES Long-term debt/preferred stock due within twelve months 5 028 86 618 Advances from affiliates 27 864 28 149 Accounts payable 41 598 33 477 Fuel refund due customers 2 358 - Customers deposits 14 244 13 265 Accrued taxes 27 340 12 879 Accrued interest 17 354 17 123 Accrued restructuring charges 25 203 - Other 30 499 14 135 --------- --------- 191 488 205 646 --------- --------- DEFERRED CREDITS Income taxes 332 522 382 085 Investment tax credits 85 301 90 494 Income tax related regulatory liabilities - net 52 828 - Other 6 290 15 758 --------- --------- 476 941 488 337 --------- --------- $1 968 285 $1 927 320 ========= ========= The accompanying notes to financial statements are an integral part of these statements. Statements Of Cash Flows for the years ended December 31 1993 1992 1991 (thousands) OPERATING ACTIVITIES Net income $ 81 876 $ 94 883 $ 96 624 Non-cash items included in net income Depreciation and Amortization 93 120 79 051 75 128 Deferred income taxes and investment tax credits (4 775) 3 393 628 Restructuring Charges 25 203 - - Cumulative Effect of Changes in Accounting Principles (3 405) - - Allowance for equity funds used during construction (1 560) (132) (550) Changes in assets and liabilities Accounts receivable (3 632) (8 067) 20 230 Fuel inventory 21 101 12 722 14 220 Accounts payable 8 612 5 313 5 506 Accrued taxes 11 561 (5 817) (6 294) Accrued interest 231 (453) (1 507) Other 3 766 (12 040) (12 698) ------- ------- ------- 232 098 168 853 191 287 ------- ------- ------- INVESTING ACTIVITIES Construction expenditure (138 510) (96 676) (73 313) Acquisition expenditures (35 333) - - Allowance for borrowed funds used during construction (1 020) (50) (428) Sale of electric utility plant and other (4 113) (2 339) (2 828) ------- ------- ------- (178 976) (99 065) (76 569) ------- ------- ------- FINANCING ACTIVITIES Proceeds from sale of long-term debt 221 511 221 067 29 415 Redemption of preferred stock - (1 190) (1 080) Reacquisition of long-term debt (198 962) (176 474) (29 929) Retirement of long-term debt (39 835) (3 488) (2 830) Change in short-term debt (286) 28 149 (14 320) Special deposits for reacquisition of long-term debt 53 500 (53 500) - Payment of dividends (83 386) (93 443) (86 485) ------- ------- ------- (47 458) (78 879) (105 229) NET CHANGE IN CASH AND CASH ------- ------- ------- EQUIVALENTS 5 664 (9 091) 9 489 Cash and Cash Equivalents at Beginning of Year 1 059 10 150 661 ------- ------- ------- CASH AND CASH EQUIVALENTS AT END OF YEAR $ 6 723 $ 1 059 $ 10 150 ======= ======= ======= SUPPLEMENTARY INFORMATION Interest paid net of amount capitalized $ 42 271 $ 53 129 $ 53 221 ======= ======= ======= Income taxes paid $ 21 112 $ 37 181 $ 46 777 ======= ======= ======= The accompanying notes to financial statements are an integral part of these statements. Statements Of Capitalization as of December 31 1993 1992 (thousands) COMMON STOCK EQUITY $ 645 731 $ 647 217 PREFERRED STOCK Cumulative, $100 par value, authorized 1,860,000 shares Number Current Series Shares Outstanding Redemption Price Not subject to mandatory redemption 5.00% 75,000 $109.00 7 500 7 500 4.65% 25,000 102.75 2 500 2 500 4.28% 60,000 103.90 6 000 6 000 Premium 32 32 -------- --------- 16 032 16 032 -------- --------- Subject to mandatory redemption 6.95% 376,000 104.64 36 400 37 600 Issuance expense (372) (372) -------- --------- 36 028 37 228 -------- --------- LONG-TERM DEBT First mortgage bonds Series J, 7%, due December 1, 1997 - 20 000 Series L, 7-1/2%, due October 1, 2001 - 23 350 Series T, 8.85%, due May 1, 2016 - 55 500 Series U, 9-1/8%, due November 1, 2019 5 330 50 000 Series V, 7-3/4%, due June 1, 2004 40 000 40 000 Series W, 6-1/8%, due September 1, 1999 40 000 40 000 Series X, 7%, due September 1, 2007 90 000 90 000 Series Y, 6-5/8%, due February 1, 2003 55 000 - Series Z, 7-1/4%, due July 1, 2023 45 000 - Series AA, 5-1/4%, due April 1, 2000 45 000 - Series BB, 6-7/8%, due October 1, 2025 80 000 - 1976 Series A, 6.20%, due November 1, 2006 6 665 6 955 1976 Series B, 6.20%, due November 1, 2006 1 000 1 000 Installment sales agreements - Pollution control bonds 1978 Series A, 6%, due January 1, 2008 14 420 14 420 Series 1986, 8.2%, due July 1, 2014 81 700 81 700 1991 Series A, 8.2%, due August 1, 2011 17 125 17 125 1991 Series B, 6.9%, due November 1, 2004 12 290 12 290 Series 1992, 7.6%, due January 1, 2019 53 500 53 500 Bank Loan, Variable Rate, due June 15, 1997 50 000 50 000 Railcar lease obligations 17 452 20 657 Unamortized discount and premium (4 034) (6 099) Unamortized costs of reacquired debt (48 383) (37 538) -------- -------- 602 065 532 860 --------- --------- TOTAL CAPITALIZATION $1 299 856 $1 233 337 ========= ========= The accompanying notes to financial statements are an integral part of these statements. Notes to Financial Statements (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Southwestern Electric Power Company is subject to regulation by the SEC, under the Public Utility Holding Company Act of 1935, and by the FERC, under the Federal Power Act, and follows the Uniform System of Accounts prescribed by the FERC. The Company is subject to further regulation for rates and other matters by the Arkansas Public Service Commission, Louisiana Public Service Commission and Public Utility Commission of Texas. For its regulated activities, the Company follows SFAS No. 71, Accounting for the Effects of Certain Types of Regulation. The Company, as a member of the Central and South West System, engages in transactions and coordinates its activities and operations with other members of the CSW System. Central and South West Services, Inc., performs at cost certain accounting, engineering, tax, legal, financial, electronic data processing, centralized economic dispatching of electric power and other services for the Company. The most significant accounting policies are summarized below. Electric Utility Plant. Electric utility plant is stated at the original cost of construction, which includes the cost of contracted services, direct labor, materials, overhead items and allowances for borrowed and equity funds used during construction. Depreciation. Provisions for depreciation of utility plant are computed using the straight-line method, generally at individual rates applied to the various classes of depreciable property. The annual composite rates averaged 3.2% for each of the years 1993, 1992 and 1991. Electric Revenues and Fuel. Prior to January 1, 1993, electric revenues were recorded at the time billings were made to customers on a cycle-billing basis. Electric service provided subsequent to billing dates through the end of each calendar month became part of operating revenues of the next month. To more closely match revenues with expenses and to conform with industry practice, the Company changed its method of accounting to accrue for estimated unbilled revenues. The effect of this change on 1993 income was $5.4 million, net of taxes of $2.9 million. The Company recovers fuel costs in Texas as a fixed component of rates. The difference between fuel revenues billed and fuel expense incurred is recorded as an addition to or a reduction of revenues, with a corresponding entry to accounts receivable or other current liabilities, as appropriate. Over-recoveries of fuel are payable to customers, and under-recoveries may be billed to customers after Texas Commission approval. In Louisiana, Arkansas and its wholesale jurisdiction, the Company passes increases in unit fuel costs on to customers through the application of fuel adjustment clauses, which are generally based on fuel costs from prior months. The Company sells its accounts receivable, without recourse, to CSW Credit, Inc., a wholly owned subsidiary of CSW. Statements of Cash Flows. Cash equivalents are considered to be highly liquid debt instruments purchased with a maturity of three months or less. Accordingly, temporary cash investments and advances to affiliates are considered cash equivalents. Accounting Changes. The Company adopted in 1993 SFAS No. 106, Employers' Accounting for Postemployment Benefits and SFAS No. 112, Employers' Accounting for Postemployment Benefits (See Note 8, Benefit Plans). The Company also adopted in 1993 SFAS No. 109, Accounting for Income Taxes (See Note 2, Federal Income Taxes). In addition, the Company changed its method of accounting for revenues in 1993 (See Electric Revenues and Fuel). Reclassification. Certain financial statement items for prior years have been reclassified to conform to the 1993 presentation. (2) FEDERAL INCOME TAXES The Company adopted the provisions of SFAS No. 109, Accounting for Income Taxes, effective January 1, 1993. The net effect of this change in accounting principle on the Company's earnings was not significant. For utility operations, there is no effect of SFAS No. 109 on the Company's earnings. As a result of this change, the Company recognized additional accumulated deferred income taxes, and corresponding regulatory assets and liabilities to ratepayers in amounts equal to future revenues or the reduction in future revenues required when the income tax temporary differences reverse and are recovered or settled in rates. As a result of a favorable earnings history, the Company did not record any valuation allowance against deferred tax assets at December 31, 1993. The Company, together with other members of the CSW System, files a consolidated Federal income tax return and participates in a tax sharing agreement. Components of Federal income taxes are as follows: 1993 1992 1991 (thousands) Included in Operating Expenses and Taxes Current $31,779 $29,377 $37,099 Deferred Depreciation differences 6,115 3,695 7,523 Deferred fuel 21 (1,506) (4,300) Other (5,718) 8,069 2,343 ------ ------ ------ 418 10,258 5,566 ------ ------ ------ Deferred investment tax credits Provision - (1,480) - Amortization (5,193) (5,384) (4,938) ------ ------ ------ (5,193) (6,864) (4,938) ------ ------ ------ 27,004 32,771 37,727 ------ ------ ------ Included in Other Income and Deductions Current (1,916) 278 (1,086) ------ ------ ------ Tax Effects of Cumulative Effect of Changes in Accounting Principles 1,834 - - ------ ------ ------ $26,922 $33,049 $36,641 ====== ====== ====== Total income taxes differ from the amounts computed by applying the statutory Federal income tax rates to income before taxes. The reasons for the differences are as follows: 1993 % 1992 % 1991 % (dollars in thousands) Tax at statutory rates $38,079 35.0 $43,497 34.0 $45,310 34.0 Differences Amortization of ITC (5,193) (4.8) (5,384) (4.2) (4,938) (3.7) Tax benefit of current year tax settlements - - (3,218) (2.5) - - Consolidated savings (2,572) (2.4) - - (1,635) (1.2) Other (3,392) (3.1) (1,846) (1.6) (2,096) (1.6) ------ ---- ------ ---- ------ ---- $26,922 24.7 $33,049 25.7 $36,641 27.5 ====== ==== ====== ==== ====== ==== Investment tax credits (ITC) deferred in prior years are included in income over the lives of the related properties. The significant components of the net deferred income tax liability are as follows: December 31, January 1, 1993 1993 (thousands) DEFERRED TAX LIABILITIES: Property related book/tax basis differences $321 590 $299 074 Income Tax related regulatory asset 33 028 32 102 Pension expense 4 615 4 133 Other 34 790 30 104 ------- ------- Total Deferred Tax Liabilities 394 023 365 413 ------- ------- DEFERRED TAX ASSETS: Income tax related regulatory liability (52 250) (58 886) Other (13 163) - ------- ------- Total Deferred Tax Assets (65 413) (58 886) ------- ------- Net accumulated deferred income taxes - total $328 610 $306 527 ======= ======= Net accumulated deferred income taxes - noncurrent $332 522 $312 699 Net accumulated deferred income taxes - current (3 912) (6 172) ------- ------- Net accumulated deferred income taxes - total $328 610 $306 527 ======= ======= (3) LONG-TERM DEBT AND PREFERRED STOCK The mortgage indenture, as amended and supplemented, securing first mortgage bonds issued by the Company, constitutes a direct first mortgage lien on substantially all electric utility plant. Annual Requirements. Certain series of the Company's outstanding first mortgage bonds have annual sinking fund requirements which are generally 1% of first mortgage bonds of each series issued. These requirements may be, and have historically been, satisfied by the application of net expenditures for bondable property in an amount equal to 166- 2/3% of the annual requirements. At December 31, 1993, the annual sinking fund requirements, exclusive of maturities, and the annual aggregate maturities including sinking fund requirements of long-term debt are as follows: Annual Annual Sinking Fund Aggregate Requirements Maturities (thousands) 1994 $645 $ 3,828 1995 145 3,600 1996 145 3,900 1997 145 52,561 1998 145 2,374 Reacquired Long-term Debt. The Company entered into agreements with DeSoto Parish, Louisiana and certain investors which provided that the Company incur obligations in connection with the issuance, in November 1992, of $53.5 million of 7.6% Pollution Control Revenue Bonds, Series 1992. The Company used the proceeds from the sale to refund a like amount of 10% Series 1983, Pollution Control Revenue Bonds on January 1, 1993. In August 1992, the Company filed with the SEC a registration statement for the sale of first mortgage bonds in an aggregate amount up to $320 million. In January 1993, the Company redeemed $4.55 million of Series T, 8.85% First Mortgage Bonds due May 1, 2016 and $2 million of Series U, 9-1/8% First Mortgage Bonds due November 1, 2019. The redemptions were made under terms of the Company's bond indenture. In February 1993, the Company issued $55 million of Series Y, 6 5/8% First Mortgage Bonds due February 1, 2003. The proceeds of this issue were used to redeem $50.95 million of Series T, 8.85% First Mortgage Bonds due May 1, 2016 at 106.11% of the principal amount. On July 15, 1993, the Company issued $45 million of Series Z, 7-1/4% First Mortgage Bonds due July 1, 2023. The proceeds of this issue were used to redeem $42.17 million of Series U, 9-1/8% First Mortgage Bonds due November 1, 2019 which were acquired through a tender offer as follows: $12.18 million at 112.49% of the principal amount on July 29, 1993; $7.68 million at 112.41% of the principal amount on July 30, 1993; $3.28 million at 112.36% of the principal amount on August 2, 1993; $3.5 million at 112.34% of the principal amount on August 3, 1993; and $15.53 million at 112.33% of the principal amount on August 4, 1993. On September 16, 1993, the Company filed with the SEC an amendment to the 1992 registration statement for the sale of first mortgage bonds in an aggregate amount up to $125 million inclusive of then remaining $90 million first mortgage bonds covered by the 1992 shelf registration. On October 13, 1993, the Company issued $45 million of Series AA, 5-1/4% First Mortgage Bonds due April 1, 2000 and $80 million of Series BB, 6-7/8% First Mortgage Bonds due October 1, 2025. The proceeds of Series AA and BB were used to repay the Company's short-term borrowings, for other corporate purposes and to redeem on November 5, 1993, $20 million of Series J, 7% First Mortgage Bonds due December 1, 1997 at 101.14% of the principal amount and $23.35 million of Series L, 7-1/2% First Mortgage Bonds due October 1, 2001 at 101.82% of the principal amount. The premium and related redemption costs will be recorded as a reduction to long-term debt on the balance sheet and will be amortized over the life of the new issue. The Company may offer additional securities subject to market conditions and other factors. In January 1994, the Company redeemed $500 thousand of Series U, 9-1/8% First Mortgage Bonds due November 1, 2019. The redemption was made under the terms of the Company's bond indenture. Also during January, an additional $1.1 million of Series U bonds was reacquired at a premium. The premium and related redemption costs associated with these transactions will be recorded as a reduction to long-term debt on the balance sheet and will be amortized over the life of the respective new issues. (4) SHORT-TERM FINANCING The Company, together with other members of the CSW System, has established a money pool to coordinate short-term borrowings through the issuance of commercial paper. Money pool balances are shown on the Company's balance sheets as advances from affiliates. At December 31, 1993, the CSW System had bank lines of credit aggregating $796.5 million, including the Company's lines of credit. Short-term cash surpluses transferred to the money pool receive interest income in accordance with the money pool arrangement. (5) FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate fair value: Cash and temporary cash investments. The carrying amount approximates fair value because of the short maturity of these instruments. Short-term debt. The carrying amount approximates fair value because of the short maturity of these instruments. Long-term debt. The fair value of the Company's long-term debt is estimated based on the quoted market prices for the same or similar issues or on the current rates offered to the Company for the debt of the same remaining maturities. Preferred stock subject to mandatory redemption. The fair value of the Company's preferred stock subject to mandatory redemption is estimated based on the quoted market prices for the same or similar issues or on the current rates offered to the Company for debt on the same remaining maturities. The estimated fair values of the Company's financial instruments are as follows: (thousands) Carrying Amount Fair Value Cash and temporary cash investments $ 6,723 $ 6,723 Short-term debt 32,892 32,892 Long-term debt 602,065 631,153 Preferred stock 36,028 38,038 (6) BENEFIT PLANS Defined Benefit Pension Plan. The Company, together with other members of the CSW System, maintains a tax qualified, non-contributory defined benefit pension plan covering substantially all of its employees. Participants in the plan during 1993 included approximately 1900 active employees, 700 retirees and beneficiaries, and 125 terminated employees with vested benefits. Benefits are based on employees' years of service, age at retirement, and final average annual earnings with an offset for the participant's primary Social Security benefit. The CSW System's funding policy is based on actuarially determined contributions, taking into account amounts which are deductible for income tax purposes and minimum contributions required by the Employee Retirement Income Security Act of 1974, as amended. Contributions to the plan for the years ended December 31, 1993, 1992, and 1991 were $6.1 million, $5.2 million, and $3.8 million, respectively. Pension plan assets consist primarily of common stocks and short-term and intermediate-term fixed income investments. The components of net periodic pension cost and the assumptions used in accounting for pensions are as follows: 1993 1992 1991 (dollars in thousands) Net Periodic Pension Cost Service cost $ 4,239 $ 3,857 $ 3,442 Interest cost on projected benefit obligation 12,063 10,920 9,610 Actual return on plan assets (14,658) (9,375) (21,322) Net amortization and deferral 55 (4,253) 9,766 ------ ------ ------ $ 1,699 $ 1,149 $ 1,496 ====== ====== ====== Assumptions Discount rate 7.8% 8.5% 8.5% Long-term compensation increase 5.5 6.0 6.0 Return on plan assets 9.5 9.5 9.5 As of December 31, 1993, 1992, and 1991, the plan's net assets exceeded the total actuarial present value of accumulated benefit obligations. Postretirement Benefits Other Than Pensions. The Company adopted SFAS No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, on January 1, 1993. The adoption resulted in an increase in operating expenses of $3 million for 1993. The Company's accumulated postretirement benefit obligation was $45 million. The transition obligation was $39 million and is being amortized over twenty years. In prior years, the Company accounted for these benefits on a pay-as-you-go basis. Expenses for 1992 and 1991 were $1.9 million and $1.4 million, respectively. The CSW System's funding policy is based on actuarially determined contributions taking into account amounts which are deductible for income tax purposes. The Company contributed approximately $8.2 million in 1993. Of this amount, approximately $4.1 million was placed in a Voluntary Employee Benefits Association (VEBA) Plan for union members. The Texas Commission approved a rule allowing full recovery of costs related to SFAS No. 106 with the amortization of the transition obligation over a period of twenty years, provided the costs are funded and recovery is allowed in rate base. The rule requires all amounts received in rates to be held in an external trust. The Arkansas Commission approved a rule allowing full recovery of costs related to SFAS No. 106 with amortization of the transition obligation over a period of twenty years. The Louisiana Commission voted to remain on a pay-as-you-go basis. The components of net periodic postretirement benefit cost and the assumptions used in accounting for postretirement benefits are as follows: December 31, 1993 (dollars in thousands) Service cost $1,813 Interest cost on accumulated postretirement benefit 3,782 Actual return on plan assets (230) Amortization of transition obligation 1,967 Net amortization and deferral (474) ----- $6,858 Assumptions ===== Discount rate 7.8% Return on plan assets 9.0% Health care cost trend rate: Pre-65 Participants: 1993 Rate of 12.5% grading down .75% per year to an ultimate rate of 6.5% in 2001. Post-65 Participants: 1993 Rate of 12.0% grading down .75% per year to an ultimate rate of 6.0% in 2001. Increasing the assumed health care cost trend rates by one percentage point in each year would increase the APBO as of December 31, 1993 by $1 million and increase the aggregate of the service and interest cost components of net postretirement benefits by $6.3 million. Postemployment Benefits. The Company adopted SFAS No. 112, Employers' Accounting for Postemployment Benefits, which establishes accounting and reporting standards for postemployment benefits paid to former or inactive employees after employment but before retirement. Postemployment benefits are all types of benefits provided to these parties, their beneficiaries, and covered dependents. This new standard requires that the expected costs of these benefits be accrued during the period employees render service to qualify for benefits. In 1993 the Company accrued $3 million of expense associated with adoption of SFAS No. 112, reflected in cumulative effect of changes in accounting principles. Continuing application of SFAS No. 112 is not expected to have a material effect on the Company's results of operations. Restructuring Charges. The Company recently announced an early retirement program as a part of the Company's restructuring efforts in order to streamline operations and reduce future costs. It is anticipated that this restructuring will affect employee benefit costs incurred by the Company in future periods. Due to the timing of the implementation of the program, many variables regarding specific costs cannot be identified until mid-1994. As a result, no adjustments have been made to the employee benefit cost data presented above. (7) JOINTLY OWNED ELECTRIC UTILITY PLANT The Company is party to various joint ownership arrangements with other nonaffiliated entities. Such agreements provide for the joint ownership and operation of generating stations and related facilities, whereby each participant bears its share of the project costs. The statements of income reflect the Company's portion of operating costs associated with plant in service. At December 31, 1993, the Company had undivided interest in the generating stations and related facilities as shown below. Flint Creek Pirkey Dolet Hills Coal Plant Lignite Plant Lignite Plant (dollars in thousands) Plant in Service $77,581 $428,695 $225,449 Accumulated depreciation $36,838 $120,899 $ 54,922 Plant Capacity - MW 480 650 650 Participation 50.0% 85.9% 40.2% Share of capacity - MW 240 559 262 (8) RENTAL AND LEASE COMMITMENTS The Company has entered into various financing arrangements primarily with respect to coal transportation and related equipment, which are treated as operating leases for rate- making purposes. At December 31, 1993, leased assets of $46.0 million, net of accumulated amortization of $26.8 million, were included in electric plant on the balance sheet and at December 31, 1992, leased assets were $46.3 million, net of accumulated amortization of $23.5 million. Total charges to operating expenses for leases were $7.1 million, $6.9 million, and $6.7 million for the years 1993, 1992, and 1991. As of December 31, 1993, the future minimum rental commitments of the Company for all non-cancelable leases are as follows: Financing Other Leases Leases Total (thousands) 1994 $5,163 $ 125 $5,288 1995 5,131 75 5,206 1996 4,421 77 4,498 1997 3,374 79 3,453 1998 3,033 81 3,114 Thereafter 5,907 1,235 7,142 (9) LITIGATION AND REGULATORY PROCEEDINGS On April 15, 1991, Texas Industrial Energy Consumers (TIEC) filed suit in the Travis County District Court (District Court) challenging a Texas Commission's final order on the Company's fuel reconciliation proceeding. In the Texas Commission's order, the Company was allowed to recover $12 million of a claimed $14 million fuel cost under-recovery and related interest. TIEC asserted that aggressive renegotiation of certain fuel contracts would have reduced the cost of fuel to the Texas consumer and that the Texas Commission erred in its order approving the Company's claimed under-recovery. The Texas Commission determined that these fuel contracts had been prudently managed by the Company. This appeal was heard before the District Court in June 1992, and the Texas Commission final order was upheld. On October 1, 1992, TIEC made a filing with the Third District of the Texas Court of Appeals in Austin, Texas indicating its intent to appeal the decision of the District Court to the next judicial level. On January 5, 1994, the Texas Supreme Court rejected TIEC's subsequent request for an appeal, and that decision is now final. On March 17, 1994, the Company filed a petition with the Texas Commission to reconcile fuel costs for the period November 1989 through December 1993. Total Texas jurisdictional fuel expenses subject to reconciliation for this 50-month period were approximately $559 million. The Company's net under-recovery for the reconciliation period was approximately $900 thousand. This is the Company's first reconciliation proceeding under the Texas Commission's current fuel rule. The Company is party to various other legal claims, actions and complaints arising in the normal course of business. Management does not expect disposition of these matters to have a material adverse effect on the Company's results of operations. See ITEM 6. SELECTED FINANCIAL DATA, Note 10, Commitments and Contingent Liabilities, for a discussion of certain environmental matters- regulatory proceedings. (10) COMMITMENTS AND CONTINGENT LIABILITIES It is estimated that the Company will spend approximately $125 million for construction purposes in 1994. Substantial commitments have been made in connection with the construction program. To supply a portion of the fuel requirements of its generating plants, the Company has entered into various commitments for the procurement of fuel. In connection with the lignite mining contract for its Henry W. Pirkey Power Plant, the Company has agreed, under certain conditions, to assume the obligations of the mining contractor. As of December 31, 1993, the maximum amount the Company would have to assume is $76.3 million. The maximum amount may vary as the mining contractor's needs for funds fluctuates. The contractor's actual obligation outstanding at year-end 1993 is $66.3 million. The Company owns a suspected former MGP site in Marshall, Texas. The Company has notified the TNRCC that evidence of contamination has been found at the site. As a result of sampling conducted at the end of 1993 and early in 1994, the Company is evaluating the extent, if any, to which contamination has impacted soil, groundwater and other conditions in the area. A final range of clean-up costs has not yet been determined, but, based on a preliminary estimate, the Company has accrued approximately $2 million as a liability for this site on the Company's books as of December 31, 1993. As more information is obtained about the site, and SWEPCO discusses the site with the TNRCC, the preliminary estimate may change. The Company also owns a suspected former MGP site in Texarkana, Arkansas. The EPA ordered an initial investigation of this site, as well as one in Shreveport, Louisiana, which is no longer owned by the Company. The contractor who performed the investigations of these two sites recommended to the EPA that no further action be taken at this time. Management does not expect these matters to have a material effect on the Company's results of operations or financial position. (11) QUARTERLY INFORMATION (UNAUDITED) The following unaudited quarterly information includes, in the opinion of management, all adjustments necessary for a fair presentation of such amounts. Operating Operating Net Revenues Income Income (thousands) Quarter Ended March 31- Reported $176,486 $ 24,528 13,439 Adjustment (885) (575) 2,830 ------- ------- ------ March 31 - Restated 175,601 23,953 16,269 ------- ------- ------ June 30 - Reported 190,202 29,989 19,398 Adjustment 3,023 1,965 1,965 ------- ------- ------ June 30 - Restated 193,225 31,954 21,363 ------- ------- ------ September 30 - Reported 272,825 56,189 45,903 Adjustment 3,769 2,450 2,450 ------- ------- ------ September 30 - Restated 276,594 58,639 48,353 ------- ------- ------ December 31 - Reported 197,679 7,351 3,136 Adjustment (5,907) (3,840) (7,245) ------- ------- ------ December 31 - Restated 191,772 3,511 (4,109) ------- ------- ------ Total $837,192 $118,057 $ 81,876 ======= ======= ====== March 31 $167,633 $ 25,496 $ 13,187 June 30 189,919 32,514 20,125 September 30 234,791 52,588 40,656 December 31 185,960 35,129 20,915 ------- ------- ------- $778,303 $145,727 $ 94,883 ======= ======= ======= Quarterly information has been restated to reflect the change in accounting for unbilled revenues and the adoption of SFAS No. 112, Employers' Accounting For Postemployment Benefits. These changes were made in December 1993, but are effective January 1, 1993. Information for quarterly periods is affected by seasonal variations in sales, rate changes, timing of fuel expense recovery and other factors. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. Report Of Management Management is responsible for the preparation, integrity and objectivity of the financial statements of Southwestern Electric Power Company as well as all other information contained in this Annual Report. The financial statements have been prepared in conformity with generally accepted accounting principles applied on a consistent basis and, in some cases, reflect amounts based on the best estimates and judgments of management, giving due consideration to materiality. Financial information contained elsewhere in this Annual Report is consistent with that in the financial statements. The Company maintains an adequate system of internal controls to provide reasonable assurance that transactions are executed in accordance with management's authorization, that financial statements are prepared in accordance with generally accepted accounting principles and that the assets of the Company are properly safeguarded. The system of internal controls is documented, evaluated and tested by the Company's internal auditors on a continuing basis. Due to the inherent limitations of the effectiveness of internal controls, no internal control system can provide absolute assurance that errors and irregularities will not occur. However, management strives to maintain a balance recognizing that the cost of such a system should not exceed the benefits derived. No material internal control weaknesses were reported to management in 1993. Arthur Andersen & Co. was engaged to audit the financial statements of the Company and issue its report thereon. Their audit was conducted in accordance with generally accepted auditing standards. Such standards require an examination of selected transactions and other procedures sufficient to provide reasonable assurance that the financial statements are not misleading and do not contain material errors. The Report of Independent Public Accountants does not limit the responsibility of management for information contained in the financial statements and elsewhere in the Annual Report. Richard H. Bremer W. J. Googe, Jr. Rox E. Colvin President and Chief Vice President Administration Controller Executive Officer Report Of Audit Committee The Audit Committee of the Board of Directors is composed of five outside directors. The members of the Audit Committee are: James Davision, Al P. Eason, Jr., Chairman, Dr. Frederick E. Joyce, William C. Peatross and Jack L. Phillips. The Committee held two meetings during 1993. The Committee oversees the Company's financial reporting process on behalf of the Board of Directors. The Committee discusses with the internal auditors and the independent public accountants the overall scope and specific plans for their respective audits. The Committee also discusses the Company's financial statements and the adequacy of the Company's internal controls. The Committee meets with the Company's internal auditors and independent public accountants to discuss the results of their audits, their evaluations of the Company's internal controls, and the overall quality of the Company's financial reporting. The meetings also are designed to facilitate any private communication with the Committee desired by the internal auditors or independent public accountants. Al P. Eason, Jr. Chairman, Audit Committee Report Of Independent Public Accountants To the Stockholders and Board of Directors of Southwestern Electric Power Company: We have audited the accompanying balance sheets and statements of capitalization of Southwestern Electric Power Company (a Delaware corporation and wholly owned subsidiary of Central and South West Corporation) as of December 31, 1993 and 1992, and the related statements of income, retained earnings and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Southwestern Electric Power Company as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. In 1993, as discussed in Note 1, Southwestern Electric Power Company changed its methods of accounting for unbilled revenues, postretirement benefits other than pensions, income taxes and postemployment benefits. ARTHUR ANDERSEN & CO. Dallas, Texas February 25, 1994 PART III CSW common stock amounts in Item 11 and Item 12 have been adjusted to reflect the two-for-one common stock split, effected by a 100% common stock dividend paid March 6, 1992 to shareholders of record on February 10, 1992. ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. (a) The following is a list of directors of the Company, together with certain information with respect to each of them: Name, Age, Principal Year First Occupation, Business Experience Became and Other Directorships Director RICHARD H. BREMER AGE - 45 1989 President and CEO of the Company since September 1990. Vice President of the Company from August 1989 to September 1990. Regional General Manager of CPL from 1988 to 1989. Vice President of CPL from 1980 to 1988. Director of Commercial National Bank, Shreveport, Louisiana. E. R. BROOKS AGE - 56 1991 Chairman, President and CEO of CSW since February 1991. President of CSW from September 1990 to February 1991. President and Chief Operating Officer of CSW from January 1990 to September 1990. Executive Vice President of CSW from June 1987 to December 1989. Director of each of CSW's subsidiaries. Director of Hubbell Electric, Inc. Director of Baylor University Medical Center, Dallas, Texas. JAMES E. DAVISON AGE - 56 1993 Sole Proprietor of Paul M. Davison Petroleum Products. President and Chief Executive of Davison Transport, Inc.; Davison Motor Company, Inc.; Sunshine Oil & Storage, Inc.; Davison Terminal Services, Inc.; Davison Insurance Agency, Inc. Name, Age, Principal Year First Occupation, Business Experience Became and Other Directorships Director AL P. EASON, JR. AGE - 68 1975 Retired as Chairman and CEO of the First Federal Savings and Loan Association of Fayetteville in August 1990. President, Eason and Company, Fayetteville, Arkansas. W. J. GOOGE, JR. AGE - 51 1990 Vice President of the Company since 1984. DR. FREDERICK E. JOYCE AGE - 59 1990 Physician. President of Chappell- Joyce Pathology Association, P.A. Texarkana, Texas. President of Doctors Diagnostic Laboratory, Inc., Texarkana, Texas. Director of State First National Bank and State First Financial Corporation, Texarkana, Arkansas. MICHAEL E. MADISON AGE - 45 1992 Vice President of the Company since August 1992. Vice President of Corporate Services of WTU from 1990 to 1992. Eastern Division Manager of PSO in 1990. HARRY D. MATTISON AGE - 57 1994 Executive Vice President of CSW since September 1990 and Chief Executive Officer of CSWS since December 1993. Chief Operating Officer of CSW from September 1990 to December 1993. President and Chief Executive Officer of SWEPCO from September 1988 to September 1990. Director of CSW since 1991. Director of each of CSW's wholly owned subsidiaries. MARVIN R. McGREGOR AGE - 47 1990 Vice President of the Company since September 1990. Director of Marketing and Economic Development from 1987 to 1990. Manager of Industrial Marketing and Technical Services from 1978 to 1987. Name, Age, Principal Year First Occupation, Business Experience Became and Other Directorships Director WILLIAM C. PEATROSS AGE - 50 1990 President of Caddo Abstract and Title Co., Inc.; Partner-Baucum, Hamilton and Peatross; Partner- Kernmass-X Oil Company; Partner- Coastal Land Association; Director of Commercial National Bank, Shreveport, Louisiana. JACK L. PHILLIPS AGE - 69 1986 Owner of Jack L. Phillips Oil & Gas Exploration and Production, Gladewater, Texas. Director of Longview National Bank, Longview, Texas. JOHN W. TURK, JR. AGE - 69 1976 Mr. Turk retired as Chairman of the Company in May 1989. President and CEO of the Company from 1983 to 1988. Director of Longview National Bank, Longview, Texas. All Directors presently serving as executive officers of the Company have been employed in a managerial or executive capacity with a member or members of the CSW System for at least the past five years, and all outside directors have engaged in their respective principal occupations listed above for a period of more than five years, unless otherwise indicated. (b) The following is a list of the executive officers who are not directors of the Company, together with certain information with respect to each of them. Year First Elected to Present Name Age Present Position Position A. G. Hammett, III 61 Treasurer 1973 Rox E. Colvin 32 Controller 1993 Elizabeth D. Stephens 38 Secretary 1988 The directors of the Company are elected at the Company's Annual Meeting held on the second Wednesday in April of each year, if not a legal holiday, and if a legal holiday, then on the day following. Executive officers are elected to hold office until the first meeting of the Company's Board of Directors following the annual election of directors. The Annual Meeting will be held on April 13, 1994. Each of the executive officers listed in the table above has been employed by the Company or an affiliate in the CSW System in an executive or managerial capacity for at least the last five years. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. Cash and Other Forms of Compensation. The following table sets forth the aggregate cash and other compensation for services rendered for the fiscal years of 1993, 1992 and 1991 paid or awarded by the Company to the Named Executive Officers. Option/SAR Grants. No grants of CSW stock options or CSW stock appreciation rights (SARs) were made in 1993. Option/SAR Exercises and Year-End Value Table. Shown below is information regarding CSW Common Stock option/SAR exercises during 1993 and unexercised CSW Common Stock options/SARs at December 31, 1993 for the Named Executive Officers. Aggregated Option/SAR Exercises in 1993 and Year-End CSW Option/SAR Value Number of CSW Securities Value of Unexercised Underlying Unexercised in the money Options/SARs at Fiscal Options/SARs at Year-End Year-End (#) ($) Shares Acquired Value on Exercise Realized Exercisable/ Exercisable/ Name (#) ($) Unexercisable Unexercisable(1) Richard H. Bremer - - 4,143/ 8,288 2,589/ 5,180 Dennis M. Sharkey - - 7,371/ 1,945 4,607/ 1,216 Marvin R. McGregor - - 1,045/ 2,090 653/ 1,306 Michael L. Heard - - 1,045/ 2,090 653/ 1,306 Michael H. Madison - - 1,045/ 2,090 653/ 1,306 (1) Based on the New York Stock Exchange December 31, 1993 closing price of CSW's Common Stock of $30.25 per share and an exercise price of $29.625 per share. Long-Term Incentive Plan Awards Table. The following table shows information concerning awards made to the Named Executive Officers during 1993 under the Central and South West Corporation 1992 Long-Term Incentive Plan (LTIP). LTIP Awards Made in 1993 Estimated Future Payouts under Non-Stock Price Based Plans Performance or Other Number of CSW Shares Period Until Units or Other Rights Maturation Threshold Target Maximum Name (#) or Payout ($) ($) ($) Richard H. Bremer 1 2 years 0 137,238 205,857 Dennis M. Sharkey 1 2 years 0 26,137 39,206 Marvin R. McGregor 1 2 years 0 28,105 42,158 Michael L. Heard 1 2 years 0 28,105 42,158 Michael H. Madison 1 2 years 0 28,105 42,158 Payouts of the awards are contingent upon CSW's achieving a specified level of total shareholder return, relative to a peer group of utility companies, for the three- year period ended December 1995. Such return must also exceed the average six-month treasury bill rate for the same period in order for any payout to be made. If the Named Executive Officer's employment is terminated during the performance period for any reason other than death, total and permanent disability or retirement, then the award is generally canceled. The LTIP contains a provision accelerating awards upon a change in control of CSW. If a change in control of CSW occurs, (a) all options and SARs become fully exercisable, (b) all restrictions, terms and conditions applicable to all restricted stock are deemed lapsed and satisfied and, (c) all performance units are deemed to have been fully earned, as of the date of the change in control. Awards which have been granted and outstanding for less than six months as of the date of change in control are not then exercisable, vested or earned on an accelerated basis. The LTIP also contains provisions designed to prevent circumvention of the above acceleration provisions generally through coerced termination of an employee prior to the change in control of CSW. PENSION PLAN TABLE Annual Benefits After Specified Years of Credited Service Average Compensation 15 20 25 30 or more $100,000 . . . . $ 25,050 $ 33,333 $ 41,667 $ 50,000 150,000 . . . . 37,575 50,000 62,500 75,000 200,000 . . . . 50,100 66,667 83,333 100,000 250,000 . . . . 62,625 83,333 104,167 125,000 300,000 . . . . 75,150 100,000 125,000 150,000 350,000 . . . . 87,675 116,667 146,833 175,000 Retirement Plans. Executive officers are eligible to participate in the tax qualified Central and South West System Pension Plan like other employees of the Company. Certain executive officers, including the Named Executive Officers, are also eligible to participate in the Special Executive Retirement Plan (SERP), a non-qualified ERISA excess benefit plan. Such Pension benefits depend upon years of credited service, age at retirement and amount of covered compensation earned by a participant. The annual normal retirement benefits payable under the pension and the SERP are based on 1.67% of "average compensation" times the number of years of credited service (reduced by (i) no more than 50% of a participant's age 62 or later Social Security benefit and (ii) certain other offset benefits). "Average compensation" is the covered compensation for the plans and equals the average annual compensation (salary as reported in the Summary Compensation Table) during the 36 consecutive months of highest pay during the 120 months prior to retirement. The combined benefit levels in the table on the following page, which include both pension and SERP benefits, are based on retirement at age 65, the years of credited service shown, continued existence of the plans without substantial change, and payment in the form of a single life annuity. Respective years of credited service and ages, as of December 31, 1993, for the Named Executive Officers are as follows: Mr. Bremer, 16 and 45; Mr. Sharkey, 15 and 49; Mr. McGregor, 24 and 47; Mr. Heard, 23 and 47; and Mr. Madison, 22 and 45. Meetings and Compensation. The Board of Directors held four meetings during 1993. Directors who are not also executive officers and employees of the Company or its affiliates receive annual directors' fees of $6,600 for serving on the Board, and a fee of $300 plus expenses for each meeting of the Board or committee attended. Directors who are not also officers and employees of the Company may participate in a deferred compensation plan. Under this plan, directors may elect to defer payment of annual directors' and meeting fees until they retire from the Board or as they otherwise direct. Compensation Committee Interlocks and Insider Participation. No person serving during 1993 as a member of the Executive Compensation Committee of the Board of Directors of CSW served as an officer or employee of the Company during or prior to 1993. No person serving during 1993 as an executive officer of the Company serves or has served on the compensation committee or as a director of another company, one of whose executive officers serves as a member of the Executive Compensation Committee of CSW or as a director of the Company. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. All 7,536,640 shares of the Company's outstanding Common Stock, $8 par value per share, are owned beneficially and of record by CSW, 1616 Woodall Rodgers Freeway, Dallas, Texas 75202. Securities Ownership of Certain Beneficial Owners and Management. The following table shows securities beneficially owned as of December 31, 1993 by each director and nominee, the Named Executive Officers and, as a group, all directors and executive officers of the Company. CSW Common Stock share amounts shown in this table include restricted stock, options exercisable within 60 days after year-end, shares of CSW common stock credited to Central and South West Corporation Thrift Plus plan accounts, and all other shares of CSW common stock beneficially owned by the listed persons. Each person has sole voting and investment power with respect to all shares listed in the table below unless otherwise indicated. Beneficial Ownership as of December 31, 1993 Name CSW Common Stock SWEPCO Preferred Stock (1) (1)(2) Richard H. Bremer 19,267 - E. R. Brooks 60,959 - James E. Davison - - Al P. Eason, Jr. 2,000 22 W. J. Googe, Jr. 7,103 - Michael L. Heard 3,527 - Dr. Frederick E. Joyce 2,000 - Michael E. Madison 2,956 - Harry D. Mattison 24,675 - Marvin R. McGregor 3,489 - William C. Peatross - - Jack L. Phillips - - Dennis M. Sharkey 13,988 - John W. Turk, Jr. 18,506 41 All of the above and other executive officers as a group 170,787 78 (1) Included in these amounts for Mr. Brooks, Mr. Bremer, Mr. Sharkey, Mr. McGregor, Mr. Heard, Mr. Madison, Mr. Mattison, and the directors and other executive officers as a group include restricted stock of 7,172; 3,464; 892; 681; 707; 636; 4,708; and 19,068, respectively. These individuals currently have voting power, but not investment power with respect to these shares. The above shares also include 9,531; 4,143; 7,371; 1,045; 1,045; 1,045; 6,176; and 31,795 shares underlying immediately exercisable options held by Mr. Brooks, Mr. Bremer, Mr. Sharkey, Mr. McGregor, Mr. Heard, Mr. Madison, Mr. Mattison, and the directors and executive officers as a group, respectively. (2) All directors' and executive officers' shares owned as of December 31, 1993 as indicated aggregate less than 1% of the outstanding shares of such class. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. None. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. Page Reference (a) Financial Statements (Included under 20 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA): Report of Independent Public Accountants. 36 Statements of Income for the years ended 20 December 31, 1993, 1992 and 1991. Statements of Retained Earnings for the 21 years ended December 31, 1993, 1992 and 1991. Balance Sheets as of December 31, 1993 22 and 1992. Statements of Cash Flows for the years ended 23 December 31, 1993, 1992 and 1991. Statements of Capitalization as of 24 December 31, 1993 and 1992. Notes to Financial Statements. 25 (b) Reports on Form 8-K: - No reports were filed on Form 8-K by the Company during the quarter ended December 31, 1993. (c) Exhibits: 3. (a) Restated Certificate of - Incorporation, as amended, of the Company (incorporated herein by reference to Exhibit 3 to the Company's 1980 Form 10-K File No. 1-3146, Exhibit 2 to Form U-l File No. 70-6819, Exhibit 3 to Form U-l File No. 70-6924 and Exhibit 4 to Form U-l File No. 70-7360). Page Reference (b) Bylaws, as amended of the Company. - (Incorporated herein by reference to Exhibit 3(b) to the Company's 1988 Form 10-K File No. 1-3146). 4. Indenture dated February 1, 1940, as amended through November 1, 1976, of the Company (incorporated herein by reference to Exhibit 5.04 in Registration No. 2-60712), the Supplemental Indenture dated August 1, 1978 incorporated herein by reference to Exhibit 2.02 in Registration No. 2-61943), the Supplemental Indenture dated January 1, 1980 (incorporated herein by reference to Exhibit 2.02 in Registration No. 2-66033), the Supplemental Indenture dated April 1, 1981 (incorporated herein by reference to Exhibit 2.02 in Registration No. 2-71126), the Supplemental Indenture dated May 1, 1982 (incorporated herein by reference to Exhibit 2.02 in Registration No. 2-77165), the Supplemental Indenture dated August 1, 1985 (incorporated herein by reference to Exhibit 4 to Form U-l File No. 70-7121), the Supplemental Indenture dated May 1, 1986 (incorporated herein by reference to Exhibit 3 to Form U-l File No. 70-7233), the Supplemental Indenture dated November 1, 1989 (incorporated herein by reference to Exhibit 3 to Form U-l File No. 70-7676), the Supplemental Indenture dated June 1, 1992 (incorporated herein by reference to Exhibit 10 to Form U-l File No. 70-7934), the Supplemental Indenture dated September 1, 1992 (incorporated herein by reference to Exhibit 10(a) to Form U-l File No. 70-8041), the Supplemental Indenture dated February 1, 1993 (incorporated herein by reference to Exhibit 10(b) to Form U-l File No. 72-8041), the Supplemental Indenture dated July 1, 1993 (incorporated herein by reference to Exhibit 10(c) to Form U- 1 File No. 70-8041) and the Supplemental Indenture dated October 1, 1993 (incorporated herein by reference to Exhibit 10(a) to Form U-1 File No. 70-8239). Page Reference 12. Statement re computation of Ratio of 53 Earnings to Fixed Charges for the five years ended December 31, 1993. 18. Independent Public Accountant's letter 55 on changes in accounting practices. (d) Schedules: V. Property, Plant and Equipment for the years 49 ended December 31, 1993, 1992 and 1991. VI. Accumulated Depreciation, Depletion and 50 Amortization of Property, Plant and Equipment for the years ended December 31, 1993, 1992 and 1991. IX. Short-Term Borrowings for the years ended 51 December 31, 1993, 1992 and 1991. X. Supplementary Income Statement Information 52 for the years ended December 31, 1993, 1992 and 1991. All other schedules and exhibits are omitted because of the absence of the conditions under which they are required or because the required information is included in the financial statements and related notes to financial statements. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on March 25, 1994. SOUTHWESTERN ELECTRIC POWER COMPANY By Rox E. Colvin Controller Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on March 25, 1994. Richard H. Bremer Dr. Frederick E. Joyce President and Chief Executive Director Officer and Director (Principal executive officer) Rox E. Colvin Michael H. Madison Controller Director (Principal financial and accounting officer) E. R. Brooks Marvin R. McGregor Director Director James E. Davison William C. Peatross Director Director Al P. Eason, Jr. Jack L. Phillips Director Director W. J. Googe, Jr. John W. Turk, Jr. Director Director Harry D. Mattison Director SCHEDULE V SOUTHWESTERN ELECTRIC POWER COMPANY PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31 Column A Column B Column C Column D Column E Column F Balance Other Beginning Additions Retirements Changes Balance Classification of Year at Cost at Cost Add/(Deduct) End of Year (Thousands) Year 1993 Electric Utility Plant Production $1,393,961 $ 6,708 $ 8,611 $ - $1,392,058 Transmission 345,183 6,323 1,244 363 350,625 Distribution 595,679 73,625 6,094 15,578 678,788 General 170,474 24,865 3,271 (3,875) 188,193 Construction Work in progress 73,421 52,837 - - 126,258 --------- ------ ------ --------- --------- $2,578,718 $164,358 $19,220 $ 12,066 $2,735,922 ========= ======= ====== ========= ========= Year 1992 Electric Utility Plant Production $1,387,806 $ 8,250 $ 2,095 $ - $1,393,961 Transmission 333,565 12,754 1,038 (98) 345,183 Distribution 571,635 29,196 5,243 91 595,679 General 157,471 16,143 3,140 - 170,474 Construction Work in progress 42,900 30,521 - - 73,421 --------- ------ ------ --------- --------- $2,493,377 $96,864 $11,516 $ (7) $2,578,718 ========= ====== ====== ========= ========= Year 1991 Electric Utility Plant Production $1,382,758 $ 5,077 $ 29 $ - $1,387,806 Transmission 325,310 9,669 1,460 46 333,565 Distribution 542,840 34,852 6,011 (46) 571,635 General 147,321 12,059 1,909 - 157,471 Construction Work in progress 30,218 12,682 - - 42,900 --------- ------ ------ --------- --------- $2,428,447 $74,339 $ 9,409 $ - $2,493,377 ========= ====== ====== ========= ========= SCHEDULE VI SOUTHWESTERN ELECTRIC POWER COMPANY ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31 Column A Column B Column C Column D Column E Column F Additions Charged to Cost and Expenses Other Balance Changes Balance Beginning Other Retire- Add/ End of Classification of Year Depreciation Accounts ments(*) (Deduct) Year (Thousands) Year 1993 Electric Utility Plant Production $513,683 $ 41,874 $ 3,810 $ 7,334 $ (1,418) $550,615 Transmission 109,771 8,751 - 2,357 376 116,541 Distribution 212,830 22,559 - 9,372 8,358 234,375 General 39,604 2,991 5,154 3,943 2,455 46,261 ------- ------- ------- ------- ------- ------- $875,888 $ 76,175 $ 8,964 $ 23,006 $ 9,771 $947,792 ======= ======= ======= ======= ======= ======= Year 1992 Electric Utility Plant Production $468,898 $ 41,845 $ 4,581 $ 1,641 $ - $513,683 Transmission 102,923 8,510 - 1,662 - 109,771 Distribution 198,906 21,195 - 7,271 - 212,830 General 37,748 2,483 2,145 2,797 25 39,604 ------- ------- ------- ------- -------- ------- $808,475 $ 74,033 $ 6,726 $ 13,371 $ 25 $875,888 ======= ======= ======= ======= ======== ======= Year 1991 Electric Utility Plant Production $423,799 $ 41,668 $ 3,462 $ 31 $ - $468,898 Transmission 97,216 8,233 - 2,526 - 102,923 Distribution 186,585 20,126 - 7,854 49 198,906 General 34,256 2,327 2,980 1,816 1 37,748 ------- ------- ------- ------- ------- ------- $741,856 $ 72,354 $ 6,442 $ 12,227 $ 50 $808,475 ======= ======= ======= ======= ======= ======= (*) Retirements are at original cost, net of removal costs and salvage. SCHEDULE IX SOUTHWESTERN ELECTRIC POWER COMPANY SHORT-TERM BORROWING FOR THE YEARS ENDED DECEMBER 31 Column A Column B Column C Column D Column E Column F Maximum Average Weighted Category of Balance Weighted amount amount average aggregate at end average outstanding outstanding interest short-term of interest at any during rate during Year Ended borrowings period rate month-end the period the period (Thousands) 1993 Advances from Affiliates $27,864 3.2% $53,477 $ 9,985 3.2% 1992 Advances from Affiliates $28,149 3.7% $28,149 $13,700 3.7% 1991 Advances from Affiliates - - $30,483 $13,742 6.1% SCHEDULE X SOUTHWESTERN ELECTRIC POWER COMPANY SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE YEAR ENDED DECEMBER 31 1993 1992 1991 Real estate and personal property taxes $23,839 $23,590 $23,153 Municipal gross receipts taxes 7,483 7,114 7,227 Payroll taxes 4,718 4,108 3,969 State income taxes 2,556 1,792 3,714 State gross receipts taxes 3,490 3,040 3,078 Franchise taxes 3,497 1,278 2,393 State utility commission assessments 913 994 902 Other taxes 446 586 532 ------ ------ ------ $46,942 $42,502 $44,968 ====== ====== ====== The amounts of taxes, depreciation and maintenance charged to accounts other than income and expense accounts were not significant. Rents, royalties, advertising, and research and development costs during these years were not significant. INDEX TO EXHIBITS Exhibit Transmission Number Exhibit Method 12 Ratio of Earnings to Fixed Charges. Electronic 18 Letter re: Change in Accounting Principles. Electronic

79166_1993.txt

79166

1993

Item 1. Business -------- The Registrant is and for many years has been engaged in the business of publishing and distributing advanced scientific and technical material. The Registrant publishes and distributes books and journals and creates and maintains databases for which it receives royalties from unrelated organizations providing access to such materials throughout the world under the imprints of Plenum Press, Consultants Bureau, DaCapo Press, IFI/Plenum Data, J.S. Canner & Company, and Human Sciences Press. The Registrant and its subsidiaries maintain offices in New York, New York; Wilmington, Delaware; Boston, Massachusetts; Wilmington, North Carolina; London, England; and Moscow, Russia; and warehouse facilities in Edison, New Jersey. The Registrant's principal markets are public and private libraries, technically oriented corporations, research organizations and individual scientists, engineers, research workers, other professionals and graduate students throughout the world. Except as to the sale of reprints and trade books, the Registrant does not generally sell to book stores. The Registrant's principal methods of marketing are by direct mail and by advertising in scientific publications, including its own journals. The Registrant makes a wide distribution of its catalogs of published material, as well as plans for new publications. In certain foreign markets, the Registrant utilizes the services of independent distributors and agents. The Registrant generally secures copyrights on its publications in its own name or in the name of its subsidiaries. In some cases, pursuant to written agreement, the copyright is secured in the name of the author of the publication or a learned society or other organization. Copyrights on translations of foreign journals are limited to English language translations and do not cover the original foreign language works. Those translations of Russian journals as to which the Registrant is the distributor but not the publisher are copyrighted in the name of the publisher. Most publications printed by the Registrant's DaCapo Press subsidiary are reprints of works in the public domain which are not subject to copyright protection or are works published by others who have sold to the Registrant certain rights for publication, either for a fixed payment or under a royalty agreement. The Registrant does not perform any printing operations. It uses outside printing and binding services, with much of the material being prepared by the Registrant for printing. Preparations by the Registrant include editing, creation of a suitable design and typesetting. The following table sets forth the total revenues contributed by each class of similar products and services, and the income (loss) generated from securities owned by the Registrant. Subscription Journals - --------------------- During 1993, the Registrant published a total of 243 journals, of which 97 were translations of Russian language scientific journals which represented a substantial portion of the Registrant's subscription income. The Russian journals are in the fields of physical sciences, mathematics, engineering and life sciences. In December 1993, the Registrant entered into a Journal Production and Distribution Agreement (the "Distribution Agreement") with the Russian Academy of Sciences (the "Academy") and other interested parties pursuant to which the litigation then pending, relating to the translation of Russian scientific journals, was ended, and Registrant's role as publisher and distributor of certain of such journals was altered. The Distri- bution Agreement extends from 1994 through 2006. In the lawsuit, the Registrant had alleged a conspiracy by certain competing entities to procure the breach of its translation contract with the Copyright Agency of the former Soviet government ("VAAP") by entering into agreements to obtain translation rights to certain journals. Pursuant to the Distribution Agreement, in 1994 the Registrant will distribute for MAIK Nauka ("MN"), an entity owned in part by Pleiades Publishing, Inc. and the Academy, 21 Russian scientific journals in English. MN will become the exclusive publisher of such journals. Prior thereto, the Registrant had translated, published and distributed these journals under a con- tract with VAAP, and under contracts with the individual insti- tutes publishing the journals, and had paid royalties based in part upon the number of subscribers. Under the Distribution Agreement, the Registrant will continue to promote and distribute these journals throughout the world, and will continue to deal with and collect from subscribers to the journals, retaining a portion of such revenues for performing its function. In 1994, the Registrant will retain 35% of the revenue, with the amount gradually being reduced to 30% in 1999 and remaining at that level for the balance of the term of the Distribution Agreement. Revenue from such 21 journals in the 1993 journal year constituted 6.7% of the Registrant's overall journal revenue and 16.2% of its Russian journal revenue. Nine of such journals were being published by both the Registrant and the predecessor of MN under conflicting contracts and were the subject of the above-mentioned litigation. Under the Distribution Agreement, in 1995 and 1996 MN will undertake the publication of the English translations of 11 additional Russian journals, to be promoted and distributed by the Registrant, representing a total of an additional 13.7% of the Registrant's 1993 Russian journal revenue and 5.6% of its total journal revenue. Commencing in such years, MN may elect to publish the English translations of up to 23 additional Russian journals, to be promoted and distributed by the Regis- trant. The total revenue to the Registrant from these 23 jour- nals equals 29.2% of Registrant's 1993 Russian journal revenue and 11.9% of its total journal revenue. As to each additional journal which is published by MN and distributed by the Registrant under the Distribution Agreement, the Registrant will retain 35% of the revenue in the initial year of distribution, with the amount gradually being reduced to 30% over a six-year period. MN intends to cause the above-mentioned journals to be translated and published in the former Soviet Union. The Regis- trant will continue its activities in translating, publishing and distributing both the journals subject to the Distribution Agreement until they are published by MN and the approximately 40 English Translation Russian Journals not subject to the Agreement. These activities will be undertaken pursuant to the Registrant's existing English translation and publication contracts with the individual entities publishing the Russian language journals which generally extend through 2001. The translation journals published by MN will be distributed by the Registrant under the MAIK Nauka/Interperiodica imprint, and it will be indicated that they are distributed worldwide by Plenum/Consultants Bureau. Those translation journals translated and published by the Registrant will continue to be published under the Registrant's "Consultant's Bureau" imprint. Management expects that in 1994 and thereafter, reve- nues and net income from subscription journals will decrease as a result of the Registrant's modified relationship to the transla- tion journals covered by the Distribution Agreement, and also as a result of the political and economic situation in Russia and in the other republics of the former Soviet Union. The translation work required for the publication of the Registrant's Russian language material is done primarily by scientists and technical persons in the United States and else- where who have other principal occupations. The Registrant maintains relationships with approximately 130 such persons, most of whom have been rendering translation services to the Regis- trant for several years. The Registrant has been able to obtain the required translators to enable it to meet its needs. The number of translators reflects a reduction from previous years since the Registrant, under the Distribution Agreement, will be translating fewer journals. In addition to the Russian Language Translation Jour- nals, the Registrant published 96 journals in its English Lan- guage Journal Program in 1993. The journals are published under the Registrant's "Plenum Press" imprint, and include titles in chemistry, physics, mathematics, computer science, engineering, biology, medicine, psychiatry, social sciences and law. Each journal is published under the direction of an editorial board composed of professionals specializing in the fields of research covered by the journal. The Registrant's subsidiary, Human Sciences Press, Inc., publishes 50 journals, under the "Human Sciences Press" imprint. These journals are primarily in the health, behavioral and social science fields. Outside Journals - ---------------- In April 1993, an American learned society with which the Registrant had a contract to produce English translations of 11 Russian language journals for publication by that society gave notice that it would not exercise the option of renewing the contract beyond the term ending with the 1993 volume year. For 1993, the amount of revenue generated from the production of these 11 journals was approximately $1,261,000; however, such revenue will cease during 1994. The Registrant, through its Boston-based J.S. Canner & Company, Inc. subsidiary, engages in the purchase and sale of backissue periodicals to libraries, colleges, universities and other users. Books - ----- The Registrant's Plenum Press division publishes scientific, technical and medical books for use by scientists, engineers, research workers, other professionals and graduate students, and their supporting libraries, research laboratories and institutions. During 1993, the division published 288 new titles as part of this program, and had an active backlist of approximately 3,800 titles as of December 31, 1993. During 1992, 305 new titles were published. Titles include comprehensive treatises, monographs and other advanced text-reference works, as well as proceedings of meetings reporting original scientific research, works surveying the state of the art in various scientific fields and specialized bibliographies and data compilations. In recent years, a number of books treating scientific topics of interest to the general reader have also been published. The Registrant's DaCapo Press, Inc. subsidiary publishes reprints of books in music, dance, visual arts and the social sciences. These books are sold mainly to libraries and specialists in these fields. DaCapo also publishes a line of academic/trade paperbacks in the arts, biography and history. During 1993, this subsidiary published 40 titles compared to 43 titles in the prior year. As of December 31, 1993, this subsidiary had an active backlist of approximately 1,500 titles. The Registrant's Human Sciences Press, Inc. subsidiary had an active backlist of approximately 400 titles as of December 31, 1993. The Registrant has no immediate plans to publish new titles under the Human Sciences imprint, but will continue to publish the backlist under such imprint. The Human Sciences books are primarily in the health, behavioral and social science fields, and are sold mainly to libraries and professionals in these fields. Database Products - ----------------- The Registrant's IFI/Plenum Data Corporation subsidiary ("IFI") is primarily involved in providing to major industrial users on-line access to the IFI Comprehensive Data Base of Patents, a computerized index file containing references to all United States chemical and chemical related patents issued since January 1950. The Registrant's customers generally use terminals at their own facilities to obtain the information through several international database networks. The file is further utilized by IFI in its performance of patent searches for law firms and other customers. IFI produces other on-line databases for searching chemical, general, electrical and mechanical United States patents, and publishes in book format the Patent Intelligence and Technology Report and The Assignee Index, all of which are patent information publications. IFI also offers other online database products including Mental Health Abstracts and Information Science Abstracts. The Registrant through its subsidiary, Career Placement Registry, Inc. ("CPR"), has developed a database system of infor- mation concerning college graduates and experienced personnel who are seeking employment opportunities. The information had been made available to the approximately 150,000 subscribers to the Dialog Information Services of Knight-Ridder, Inc. Effective March 1, 1994, Dialog discontinued carrying the database due to insufficient use. CPR is currently seeking another carrier. Since its creation in 1981, the operations of CPR have not had a significant impact on the Registrant's earnings. Other Publishing Activities - --------------------------- Plenum Publishing Company Limited, the Registrant's English subsidiary, provides sales representation for the Registrant in the United Kingdom and European markets. Plenum Publishing Company Limited also performs editorial procurement services for the scientific book and journal publishing programs of the Registrant. Competition - ----------- The market in which the Registrant operates both for the procurement of manuscripts and the sale of its products is highly competitive. The Registrant is one of the leading publishers and distributors of English translations of Russian scientific journals. However, several other companies with English translation capabilities have relationships with individuals and entities responsible for the publication of scientific and technical material in the former Soviet Union. In addition, other publishers in the United States and abroad with greater financial resources than the Registrant are engaged in the publication of original English language scientific materials and database products, as well as the reprint of out-of-print books and other books generally not available. Export Sales - ------------ The Registrant's sales derived from customers outside the United States aggregated approximately $23,217,000 in 1993 (approximately 43% of consolidated sales). Sales derived from customers outside the United States were approximately $21,214,000 in 1992 and $21,453,000 in 1991 (approximately 39% and 40%, respectively, of consolidated sales). The Registrant generally prices its products sold abroad in U.S. dollars. Investments in Securities - ------------------------- In 1993, the Registrant's dividends, interest income, net realized and unrealized gains/losses on marketable securities, and equity in the net income (loss) of Gradco Systems, Inc. (the foregoing items net of interest expense and other investment-related expenses) represented 3.2% of the Registrant's pre-tax income. In 1992, such items (net of interest expense and other investment-related expenses) represented 18.4% of pre-tax income. The Registrant's excess cash is invested principally in a portfolio of marketable securities. Market conditions and the nature of the investments have an impact on the performance of the portfolio. Excess cash is also invested in part, from time to time, in short-term investments such as time deposits, money market funds and commercial paper, and in the past has been invested in U.S. Government securities. The investments of ex- cess cash are available for corporate purposes, and have been so used periodically. On April 30, 1993 the Registrant's outstand- ing 6-1/2% convertible subordinated debentures due 2007 were re- deemed, requiring an expenditure of $40,734,793 which was funded principally from liquidation of a portion of such investments. The Registrant owns 913,000 shares of Common Stock of Gradco Systems, Inc. ("Gradco"), an office automation company, which were acquired by the Registrant during the period October, 1989 through August, 1991. The acquisitions by the Registrant have been reported in a Statement on Schedule 13D and amendments thereto filed jointly with the Securities and Exchange Commission by the Registrant and by its Chairman, Martin E. Tash, and his wife, who as of the date hereof had acquired a total of 250,672 shares. Mr. Tash also has currently exercisable options to purchase 50,000 additional shares. The filings are required because the Registrant and Mr. and Mrs. Tash as a group (the "Group") beneficially own more than 5% of the outstanding shares of Gradco (11.7% by the Company and 3.8% by Mr. and Mrs. Tash, inclusive of his currently exercisable options, as of the date hereof, for a total of 15.5%). In October 1990, in a proxy contest, a five-person slate of directors was nominated by the Group in opposition to the nominees of Gradco's then current management. The slate consisted of Martin E. Tash (Registrant's Chairman of the Board and Chief Executive Officer), Bernard Bressler (Secretary and a director of Registrant) and three other individuals not affiliated with Registrant. Three nominees of the Group (including Messrs. Tash and Bressler) were elected to directorships, constituting a majority of the Board. The newly named Board named Mr. Tash as Gradco's Chairman and Chief Executive Officer. The Group may be deemed to have obtained control of Gradco in October 1990, as a result of the fact that its nominees were elected as a majority of Gradco's Board of Directors. Gradco's current five-person Board, elected without any opposing nominees at its October 1993 Annual Meeting, consists of Messrs. Tash and Bressler, and three other persons. All of the nominees were designated as such at the request of the Group, which there- fore may be deemed to continue to have control of Gradco. Registrant has not undertaken any obligations in connection with Gradco's operations or advanced any funds to it and does not otherwise engage in business through Gradco. The Registrant's investment in Gradco is reflected in the Financial Statements included herein using the equity method of accounting. Gradco, the Registrant and Mr. Tash are defendants in a lawsuit which has been brought by certain former management employees of Gradco. See Item 3, Legal Proceedings. ----------------- In view of the securities investments described above, the Registrant evaluates its status under the Investment Company Act of 1940, as amended (the "Company Act"), on an annual basis. (Prior to the redemption of the Debentures, such evaluation had been performed on a quarterly basis, but in view of the signifi- cant reduction of investments resulting from the redemption, the Registrant now considers an annual analysis to be sufficient.) The Company Act requires the registration with the Securities and Exchange Commission of, and imposes various substantive restric- tions on, any "investment company." The Company Act defines the term "investment company" to include a company that engages primarily, or proposes to engage primarily, in the business of investing, reinvesting or trading in securities. An "investment company" may also include a company which engages or proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities and which owns or proposes to acquire investment securities (which for this purpose excludes U.S. Government securities) having a value that exceeds 40% of the value of such company's total assets (excluding cash items and U.S. Government securities), unless the company is primarily engaged in a business or businesses other than that of investing, reinvesting, owning, holding or trading in securities. The Registrant's principal business continues to be publishing and distributing advanced scientific and technical material, and the Registrant is not primarily engaged in invest- ing, reinvesting or trading in securities. As of December 31, 1993, investment securities represented less than 40% of the value of the Registrant's total assets (exclusive of U.S. Govern- ment securities and cash items), and in any event the Registrant continued to be exempt from status as an investment company pursuant to Rule 3a-1 under the Company Act because less than 45% of the value of its total assets (exclusive of U.S. Government securities and cash items) consisted of, and less than 45% of its net income after taxes for the last four fiscal quarters combined was derived from, securities (other than U.S. Government securi- ties). Miscellaneous Information - ------------------------- The Registrant currently employs approximately 300 full time employees. Backlog is not significant in the Registrant's business because orders are filled on a current basis. The Registrant does receive payments and on occasion records receivables from journal subscribers in advance of the issuance of journals, and the amounts appearing on the Registrant's Consolidated Balance Sheets as "Deferred Subscription Income" represent these items. See Note 1 of Notes to Consolidated Financial Statements. The business of the Registrant is not seasonal. No material portion of the business of the Registrant is subject to renegotiation of profits or termination of contracts at the election of the Government. Compliance with the provisions enacted regulating the discharge of materials into the environ- ment or otherwise relating to the protection of the environment does not have an effect upon the Registrant. Item 2.

Item 2. Properties ---------- As of December 31, 1993, the Registrant had leases at the following principal locations: Various of the leases referred to above provide for additional payments or increases in rent over the base rental specified above under different circumstances. In addition to the leases referred to above, the Registrant or its subsidiaries have leases on space at various locations with a total annual rental of approximately $22,450. The Registrant's warehouse operations are conducted at a 69,000 square foot warehouse in Edison, New Jersey which is owned by Registrant. Item 3.

Item 3. Legal Proceedings ----------------- (a) Plenum Publishing Corporation v. Interperiodica, ----------------------------------------------- et al. - ------ This litigation, which was previously reported in the Registrant's Report on Form 10-K for the fiscal year ended Decem- ber 31, 1992, was discontinued with prejudice and without costs in December 1993, pursuant to the Journal Production and Distrib- ution Agreement described in Item 1, Business, under "Subscrip- -------- tion Journals." (b) Stewart, et al. v. Gradco Systems, Inc., --------------------------------------- Plenum Publishing Corporation, et al. - ------------------------------------ As the result of the proxy contest in October 1990, described above in Item 1, Business, under "Investments in Securities", the composition of the Board of Directors of Gradco Systems, Inc. ("Gradco") was changed. Among such changes were the election of Martin E. Tash, the Registrant's Chief Executive Officer, to the Gradco Board, and the non-renewal of Keith Stewart as a member of the Gradco Board. Mr. Tash succeeded Mr. Stewart as Chief Executive Officer of Gradco. In December 1990, Gradco asserted claims in the Superi- or Court of California against Mr. Stewart and others, alleging a conspiracy on their part to defraud Gradco of a substantial part of its assets. Mr. Stewart was charged with converting Gradco funds to satisfy his personal obligations and other wrongful actions, including defaulting on a promissory note in Gradco's favor. The aggregate of the allegedly converted funds exceeds $1,000,000. The complaint, among other things, also seeks a declaration that no payments are due under "golden parachute" agreements which are claimed to have been wrongfully obtained. Certain of Gradco's former employees, including Mr. Stewart, have instituted actions in the Superior Court of Cali- fornia against Gradco, Mr. Tash and the Registrant, claiming, among other things, the breach of the above-referenced "golden parachute" agreements. The stated aggregate claims for compensa- tory damages by said former employees exceeds $20,000,000. Of that sum, approximately $2,500,000 is attributable to the afore- said alleged breach of the "golden parachute" agreements. The balance is principally attributed to various causes of action arising from the same set of facts, including such claims as bad faith denial of contract existence, conspiracy to induce breach of contract, and intentional infliction of emotional distress. Gradco, the Registrant and Mr. Tash have denied all liability and have interposed various affirmative defenses. The claims by one of the former employees have been settled, with Gradco being responsible for the settlement payments. Pre-trial discovery is being conducted with respect to the aforesaid matters in dispute, and the discovery cutoff date is June 30, 1994. A trial date has not yet been set. Management of the Registrant, after consultation with counsel, believes that the action will not result in a material loss to the Registrant and intends to vigorously defend against it. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders --------------------------------------------------- Not applicable. PART II Item 5.

Item 5. Market for the Registrant's Common Equity and Related ----------------------------------------------------- Stockholder Matters ------------------- The Common Stock of the Registrant is traded on the NASDAQ National Market System. The following table sets forth, for the calendar quarters indicated, information furnished by the NASD, Inc. as to the high and low sale prices for the Registrant's Common Stock as reported on the NASDAQ National Market System under the symbol PLEN. The table also sets forth dividends declared during such periods. There were approximately 638 record holders of the Registrant's Common Stock on March 14, 1994. The number of holders as so stated does not include individual participants in security position listings. Dividends Calendar Year Ended December 31, High Low Per Share - -------------------------------- ---- --- --------- - ---- First Quarter.................... 30-1/2 25-3/4 $ .27 Second Quarter................... 30 25-1/2 .27 Third Quarter.................... 27-3/4 22-3/4 .27 Fourth Quarter................... 26-1/4 22-1/2 .27 Dividends Calendar Year Ended December 31, High Low Per Share - -------------------------------- ---- --- --------- - ---- First Quarter.................... 22-7/8 19-1/2 $ .26 Second Quarter................... 21-3/4 20-1/2 .26 Third Quarter.................... 23-1/2 20-3/4 .26 Fourth Quarter................... 26-3/8 22-3/4 .26 The Registrant has paid cash dividends on its Common Stock in each year since 1974. The payment and amount of future dividends are dependent upon the Registrant's earnings, general financial condition and the requirements of the business and upon declaration of the dividend from time to time by the Board of Directors. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations -------------------------------------------------- Results of Operations - --------------------- 1993 Compared to 1992 - --------------------- Revenues from the Company's publishing operations in- creased by 0.7% to $54,098,246. Revenues from subscriptions and outside journals increased by 2.4%, primarily attributable to more journal issues being published and higher selling prices, offset by non-renewals of subscriptions partially due to the reduced buying power of libraries. Revenues from book sales decreased by 6.2% primarily due to fewer book titles being published. In December 1993, the Company entered into a Journal Production and Distribution Agreement (the "Distribution Agree- ment") with the Russian Academy of Sciences (the "Academy") and other interested parties pursuant to which the litigation then pending, relating to the translation of Russian scientific journals, was ended, and the Company's role as publisher and distributor of certain of such journals was altered. The Distri- bution Agreement extends from 1994 through 2006. Pursuant to the Distribution Agreement, in 1994 the Company will distribute for MAIK Nauka ("MN"), an entity owned in part by Pleiades Publishing, Inc. and the Academy, 21 Russian scientific journals in English. MN will become the exclusive publisher of such journals. Prior thereto, the Company had translated, published and distributed these journals under a con- tract with the Copyright Agency of the former Soviet government, and under contracts with the individual institutes publishing the journals, and had paid royalties based in part upon the number of subscribers. Under the Distribution Agreement, the Company will continue to promote and distribute these journals throughout the world, and will continue to deal with and collect from subscribers to the journals, retaining a portion of such revenues for performing its function. In 1994, the Company will retain 35% of the revenue, with the amount gradually being reduced to 30% in 1999 and remaining at that level for the balance of the term of the Distribution Agreement. Revenue from such 21 journals in the 1993 journal year constituted 6.7% of the Company's overall journal revenue and 16.2% of its Russian journal revenue. Nine of such journals were being published by both the Company and the predecessor of MN under conflicting contracts and were the subject of the above-mentioned litigation. Under the Distribution Agreement, in 1995 and 1996 MN will undertake the publication of the English translations of 11 additional Russian journals, to be promoted and distributed by the Company, representing a total of an additional 13.7% of the Company's 1993 Russian journal revenue and 5.6% of its total journal revenue. Commencing in such years, MN may elect to publish the English translations of up to 23 additional Russian journals, to be promoted and distributed by the Company. The total revenue from these 23 journals equals 29.2% of the Comp- any's 1993 Russian journal revenue and 11.9% of its total journal revenue. As to each additional journal which is published by MN and distributed by the Company under the Distribution Agreement, the Company will retain 35% of the revenue in the initial year of distribution, with the amount gradually being reduced to 30% over a six-year period. MN intends to cause the above-mentioned journals to be translated and published in the former Soviet Union. The Company will continue its activities in translating, publishing and distributing both the journals subject to the Distribution Agreement until they are published by MN and the approximately 40 English Translation Russian Journals not subject to the Agreement. These activities will be undertaken pursuant to the Company's existing English translation and publication contracts with the individual entities publishing the Russian language journals which generally extend through 2001. Management expects that in 1994 and thereafter, revenues and net income from subscription journals will decrease as a result of the Company's modified relationship to the translation journals covered by the Distribution Agreement, and also as a result of the political and economic situation in Russia and in the other republics of the former Soviet Union. In April 1993, an American learned society with whom the Company had a contract to produce English translations of 11 Russian language journals for publication by that society gave formal notice that they would not exercise the option of renewing the contract beyond the term ending with the 1993 volume year. For fiscal 1993, the amount of revenue generated from the produc- tion of these 11 journals was approximately $1,261,000; however, such revenue will cease during fiscal 1994. The cost of sales as a percentage of revenues increased from 39.82% to 40.08%, primarily due to higher salaries and employee benefit costs, offset by a more favorable mix of reve- nues from subscriptions and outside journals and book sales. The increase in royalty expenses was principally due to increased royalty rates. The decrease in selling, general and administra- tive expenses was primarily attributable to decreased profession- al fees and bad debt expense, offset by higher salaries, employee benefit costs and sales commissions. The decrease in interest income was principally due to lower interest rates and decreased investments in Government securities, time deposits and money market funds, arising in large part because of the decrease in investment assets utilized for redemption of the Company's 6-1/2% Convertible Subordinated Debentures on April 30, 1993. The increase in dividend income resulted from the increase in average investment in marketable securities in 1993. The Company had a net realized gain of $801,387 on marketable securities and recorded a provision of $1,713,197 for net unrealized losses on marketable securities for 1993, as compared to a net realized gain of $2,476,916 on marketable securities for 1992. The decrease in interest expense was primarily due to the redemption of the Debentures. The decrease in net income was principally attributable to the decrease in investment income as discussed in the preceding paragraph and the extraordinary loss from early retirement of 6-1/2% Convertible Subordinated Debentures. The provision for income taxes as a percentage of income decreased in 1993 as compared to 1992 because in 1992 the Company recorded an additional provision for state and local income taxes for assessments of such taxes expected with respect to prior years. In May 1993, the Financial Accounting Standards Board issued statement of Financial Accounting Standards No.115, "Accounting for Certain Investments in Debt and Equity Securities," effective for fiscal years beginning after December 15, 1993. Under the new rules, which the Company will adopt effective January 1, 1994, the Company will classify its marketable equity securities held as trading securities on the basis of its intent to trade such securities. Accordingly, all marketable equity securities classified as trading securities will be carried at fair market value. Unrealized gains and losses applicable to these securities will be reported as a component of current earnings. Presently, the Company values marketable equity securities as trading securities and reports such securities at the lower of aggregate cost or market, with unrealized losses reported as a component of current earnings. 1992 Compared to 1991 - --------------------- Revenues from the Company's publishing operations increased by 0.7% to $53,725,999. Revenues from subscriptions and outside journals increased by 2.3%, primarily attributable to higher selling prices, offset by non-renewals of subscriptions partially due to the impact of the recession on the buying power of libraries and individuals, and fewer journal issues being published. Revenues from book sales decreased by 5.3% primarily due to fewer book titles being published. Revenues from database products increased by 9.7%, primarily due to increased prices. The cost of sales as a percentage of revenues increased from 39.56% to 39.82%, primarily due to higher salaries and employee benefit costs, offset by a more favorable mix of revenues from subscriptions and outside journals and book sales, and increased prices of database products. The increase in royalty expense was principally due to increased royalty rates and higher costs associated with extended English translation and publication agreements with Institutes publishing scientific journals in Russia. The insignificant decrease in selling, general and administrative expenses was primarily attributable to lower sales commissions, advertising expenditures, computer expenses and mailing expenses, offset by higher salaries and employee benefit costs and increased professional fees. The decrease in interest income was principally due to lower interest rates. The increase in dividend income was due to increased investment in marketable securities. The Company had a net realized gain of $2,476,916 on marketable securities for 1992, as compared to a net realized gain of $19,714 and a reversal of the provision of $6,544,417 for net unrealized loss on marketable securities for 1991. The decrease in interest expense resulted from the repurchase of $6,808,000 of 6 1/2% Convertible Subordinated Debentures due April 15, 2007. The decrease in net income was principally due to the decrease in investment income discussed in the preceding paragraph, decreased income from publishing operations and an increase in the provision for income taxes as a percentage of income, offset by the cumulative effect on prior years of accounting change for deferred income taxes and extraordinary credit arising from the repurchase of 6 1/2% Convertible Subordinated Debentures. The provision for income taxes as a percentage of income increased because the reversal of net unrealized losses on marketable securities in 1991 was exempt from income taxes to the extent that said losses, when incurred in 1990, had no deferred tax benefits recognized, and in 1992 the Company recorded an additional provision for state and local income taxes for assessments of such taxes expected with respect to prior years. Liquidity and Sources of Capital - -------------------------------- The ratio of current assets to current liabilities is 6.3 to 1 at December 31, 1993 compared to 2.1 to 1 at December 31, 1992. Management anticipates that internally generated funds will exceed requirements of the operations of the business. The Company also has funds of approximately $53,855,000 at December 31, 1993 invested in marketable securities and in cash, which are available for corporate purposes. On April 30, 1993 (the "Redemption Date"), pursuant to a notice of election to redeem which had been given to the holders on March 24, 1993, the Company redeemed the Debentures which were outstanding on the Redemption Date. In accordance with the terms of the Debentures and the applicable Trust Indenture, the redemp- tion required a total payment of $40,734,793 (representing the redemption price of 102.60% of the principal amount of outstanding Debentures and accrued interest from April 15 to April 30, 1993). This amount was funded by liquidating a portion of the Company's investments of its excess cash, and from short-term borrowing on the Company's margin account with a broker. Item 8.

Item 8. Financial Statements and Supplementary Data --------------------------------------------------- Response to this Item is contained in Item 14(a). Item 9.

Item 9. Changes in and Disagreements with Accountants on Ac- counting and Financial Disclosure ---------------------------------------------------- Not applicable. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant --------------------------------------------------- (a) The following table sets forth the name of each director and executive officer of the Registrant, the date on which his present term as a director will expire, and the nature of all positions and offices with the Registrant held by him at present. The term of office of all executive officers expires at the next annual meeting of stockholders of the Registrant, which is to be held in June 1994. Present Term as Director Name Expires Position - ---- ------------- -------- Martin E. Tash 1994 President and Chairman of the Board of Directors Mark Shaw 1994 Executive Vice President and Director Bernard Bressler 1994 Secretary and Director Earl Ubell 1995 Director N. Bruce Hannay 1995 Director Howard F. Mathiasen 1995 Director Ghanshyam A. Patel ---- Treasurer and Chief Financial Officer; Assistant Secretary (b) The following is a brief account of the recent business experience of each director and executive officer, and directorships held with other companies which file reports with the Securities and Exchange Commission. Name Business Experience - ---- ------------------- Martin E. Tash, Mr. Tash has been actively engaged in the age 53 the Registrant's business since 1971. He has been Chairman of the Board and President since July 15, 1977, and served as Treasurer and Chief Financial Officer from 1971 until September 29, 1986. Mr. Tash is also Chairman of the Board and Chief Executive Officer of Gradco Systems, Inc. Mark Shaw, Mr. Shaw has been actively engaged in the age 55 Registrant's business since 1963. He has been Executive Vice President since July 15, 1977, and manages the Registrant's book and journal publication program. Bernard Bressler, Mr. Bressler has been a practicing age 66 attorney since 1952, and is presently a member of the firm of Bressler, Amery & Ross, counsel to the Registrant. Mr. Bressler is also a director of Gradco Systems, Inc. Earl Ubell, Mr. Ubell has been the Health and Science age 67 Editor of WCBS-TV since September 11, 1978. Between August 1976 and September 1978, Mr. Ubell was the Producer of Special Events and Documentaries for NBC News. For more than three years prior to that time, Mr. Ubell was the Director of News of WNBC-TV. N. Bruce Hannay, Dr. Hannay has been a business and age 73 technical consultant since his retire- ment, as of April 10, 1982, from Bell Telephone Laboratories, Incorporated where he had held the position of Vice President - Research and Patents for the preceding ten years. Dr. Hannay had been employed by Bell Laboratories since 1944 and had been engaged in a variety of re- search programs. Dr. Hannay performs consulting services for several comp- anies, and is a director of General Sig- nal Corp., and of a group of mutual funds sponsored by Alex. Brown & Sons, Inc. Howard F. Mathiasen, Mr. Mathiasen is retired. From age 56 July 1982 to June 1987 Mr. Mathiasen was Senior Vice President of National West- minster Bank U.S.A. (formerly known as The National Bank of North America). Between June 1979 and July 1982 he was Vice President of that Bank. Between May 1, 1978 and April 1979, Mr. Mathiasen was Senior Vice President of Nassau Trust Company. Between January 1975 and May 1978, Mr. Mathiasen was Vice President of Chemical Bank. Ghanshyam A. Patel, Mr. Patel has been Treasurer and age 57 Chief Financial Officer of the Registrant since September 29, 1986. Prior to that he was with the accounting firm of Ernst & Whinney (predecessor to Ernst & Young) from April 1970 and served in the capacity of Senior Manager commencing June 1977. Item 11.

Item 11. Executive Compensation ---------------------- (a) Summary Compensation Table. The following table sets forth all compensation awarded to, earned by or paid to the following persons through March 14, 1994 for services rendered in all capacities to the Registrant and its subsidiaries during each of the fiscal years ended December 31, 1993, 1992 and 1991: (1) the Registrant's Chief Executive Officer, and (2) each of the other executive officers whose total compensation for the fiscal year ended December 31, 1993 required to be disclosed in column (c) and (d) below exceeded $100,000. SUMMARY COMPENSATION TABLE -------------------------- (a) (b) (c) (d)1 (e)2 Name and All Other Principal Position Year Salary ($) Bonus ($) Compensation ($) - ------------------ ---- ---------- --------- ---------------- Martin E. Tash 1993 290,000 295,400 30,000 Chairman of the 1992 275,000 335,650 30,000 Board and President 1991 250,000 287,350 30,000 (Chief Executive Officer) Mark Shaw 1993 290,000 211,000 30,000 Executive Vice 1992 275,000 239,750 30,000 President 1991 250,000 205,250 30,000 Ghanshyam A. Patel 1993 136,000 33,000 22,868 Treasurer and Chief 1992 130,000 37,500 20,839 Financial Officer 1991 120,000 32,000 18,196 Footnotes to Summary Compensation Table - --------------------------------------- (1)Represents amounts paid to the named executive officer, for the applicable fiscal year, under the Registrant's Incentive Compensation Plan. For each fiscal year an amount equal to 5% of the Registrant's Income from Operations as reported in the Registrant's year-end financial statements (together with, when applicable, 5% of the excess of cumulative Investment Profit over cumulative Investment Loss) is distributed to key employees. Thirty-five percent of such amount is distributed to the chief executive officer and 25% is distributed to the next senior officer. The balance of such amount is distributed as determined by the chief executive officer. Since cumulative Investment Profit (as defined) earned after 1990, through December 31, 1992, exceeded Investment Loss (as defined) incurred in 1990, the excess was added to Income from Operations for the purpose of calculating incentive compensation for 1992. Since there was Investment Profit (as defined) in 1993, the amount of such Profit was added to Income from Operations for the purpose of calculating incentive compensation for 1993. (2)Represents amount of contribution made to or accrued for the account of the named executive officer, in respect of the applicable fiscal year, in the Registrant's Profit Sharing Plan (a defined contribution plan qualified under the Internal Revenue Code). The Plan is maintained for all full-time employees who have completed certain minimum periods of service. The Registrant contributes to the Plan specified amounts based upon its after tax income as a percentage of gross revenue. The Registrant's contribution to the Plan for each employee is determined by his salary level and length of service. Contributions are invested by the Plan Trustee in stock of the Registrant and/or in a variety of other investment options, depending upon the employee's election. Interests in the Plan become vested to the extent of 20% after three years of service and vest at the rate of an additional 20% for each year of service thereafter and in any event become 100% vested at death or at the "normal retirement age" of 55 as specified in the Plan. Each employee (or his beneficiary) is entitled to receive the value of his vested interest upon his death or retirement. He may also receive the value of such interest upon prior termination of his services with the Registrant, or if he elects at any time to withdraw his interest. The interests of Messrs. Tash, Shaw, and Patel are fully vested. The aggregate contributions made or accrued by the Registrant through the end of fiscal 1993 for Messrs. Tash, Shaw and Patel under this Plan are $405,650, $425,525 and $109,694, respectively; these contributions have been invested in the manner set forth above, and (as to Mr. Shaw) a portion of the investments was transferred from the Plan into a private profit sharing plan of which Mr. Shaw is the beneficiary. (b) Compensation of Directors. ------------------------- Directors fees for Dr. N. Bruce Hannay and Messrs. Earl Ubell and Howard F. Mathiasen are currently at the rate of $9,500 per annum each. Directors of the Registrant who are also officers of the Registrant receive no additional compensation for their services as directors. (c) Termination of Employment and Change of Control Arrangements Regarding Named Executive Officers. ------------------------------------------------ (i) See footnote (2) to table in Item 11(a) for information as to entitlement of Messrs. Tash, Shaw and Patel to receive certain distributions under the Registrant's Profit Sharing Plan upon termination of their employment. (ii) On September 22, 1989, the Registrant adopted Amended Contingent Compensation Agreements with Martin Tash and Mark Shaw (executive officers of the Registrant named in the table in item 11(a)) and with Harry Allcock and Marshall Lebowitz (officers of subsidiaries of the Registrant). The Amended Agreements supersede the Contingent Compensation Agreements, adopted on October 8, 1986, and provide that if (a) during the officer's employment or within six months after his employment terminates, there is a sale of 75% of the book value of the Registrant's operating assets (as defined), or if any person or group becomes the owner of over 25% of the Registrant's outstanding stock, and (b) the officer's employment is terminated at or prior to the end of the sixth month after such event, then the Registrant shall pay the terminated officer cash equal to 290% of the officer's average annual taxable compensation over the preceding five calendar years. The Amended Agreements add a provision specifying that a successor in interest to the Registrant would remain liable thereunder. They are otherwise substantially identical to the original Agreements. On December 14 1993, the Registrant entered into Contingent Compensation Agreements with Ghanshyam Patel (an executive officer of the Registrant named in the table in item 11(a)) and Ken Derham (an officer of a subsidiary of the Registrant) on the same terms as the Amended Agreements described above. (d) Indemnification Agreements. -------------------------- In September 1987, the Registrant's liability insurance for its directors and officers expired and was not renewed due to the significantly increased cost. In light of this development, and to provide increased protection, the Registrant's By-Laws were amended on November 18, 1987 to require the Registrant to advance expenses of directors or officers in defending a civil or criminal action as such expenses are incurred, subject to certain conditions. Furthermore, on that date the Registrant entered into a contract with each of its directors and executive officers, requiring indemnification for expenses, judgments, fines and amounts paid in settlement, in accordance with the By-Laws as ameded, or any future By-Laws which provide greater indemnification. (On December 14, 1993, the Registrant entered into a substantially identical contract with an officer of one of its subsidiaries.) The present By-Laws provide for such indemnification, in connection with claims arising from service to the Registrant, or to another entity at Registrant's request, except where it would be prohibited under applicable law. (e) Compensation Committee Interlocks and Insider Participation --------------------------------------------- The Registrant's Board of Directors has no compensation committee (or other Board committee performing equivalent functions); compensation policies applicable to executive officers are determined by the Board. During the fiscal year ended December 31, 1993, the officers of the Registrant participating in the Board's deliberations concerning executive compensation were Martin E. Tash, Mark Shaw and Bernard Bressler (who are members of the Board). During the fiscal year ended December 31, 1993, Martin E. Tash (an executive officer of the Registrant) served as a member of the Board of Directors of Gradco Systems, Inc. ("Gradco"). Gradco has no compensation committee (or other Board committee performing equivalent functions); compensation policies applicable to executive officers are determined by its Board. Mr. Tash is an executive officer of Gradco and is the only such executive officer who also served on Registrant's Board. Bernard Bressler (Secretary and a director of Registrant) is an officer and director of Gradco, but he is not an executive director of either entity. During the period since January 1, 1993, there were no transactions between the Registrant and Gradco of the type required to be disclosed under Item 13, Certain Relationships and Related Transactions. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management ---------------------------------------------------- (a) The following table sets forth information regarding persons known to the Registrant to be the beneficial owners of more than 5% of the Registrant's voting securities as of March 14, 1994, based on 4,498,940 shares of Common Stock, $.10 par value, outstanding as of such date. Amount and Nature of Name and Address of Beneficial Percentage Title of Class Beneficial Owner Ownership of Class - -------------- ------------------- ---------- ---------- Common Stock Martin E. Tash 423,402 $.10 par value 233 Spring Street shares(1) 9.41% New York, NY 10013 Arlene S. Tash 298,229 17049 Northway Circle shares(2) 6.63% Boca Raton, FL 33496 Southeastern Asset 328,000 Management, Inc. shares(3) 7.29% 860 Ridgelake Boulevard Memphis, TN 38120 Quest Advisory Corp. 456,150 and Quest Management shares(4) 10.14% Company as a Group 1414 Avenue of the Americas New York, NY 10019 Footnotes - --------- (1) Includes 112,253 shares held by the Registrant's Profit Sharing Plan, as to which Mr. Tash has voting and investment power. Of the aggregate of 423,402 shares shown, Mr. Tash has sole voting and investment power as to 125,173, and shared voting and investment power with his wife as to 298,229. (2) Shares are owned jointly by Mrs. Tash with her husband, Martin E. Tash, and she shares voting and investment power with him. Shares are included in the 423,402 shares shown as owned by Mr. Tash. (3) Number of shares as shown in beneficial owner's Amendment No. 2 to Schedule 13G dated February 11, 1994, filed with the Securities and Exchange Commission, reporting ownership as of December 31, 1993. According to such Schedule 13G, Southeastern Asset Management, Inc. is an Investment Adviser registered under the Investment Advisers Act of 1940. It has sole voting power and no dispositive power as to 218,000 of the shares shown, and shared voting and dispositive power as to 110,000 of said shares. According to the Schedule 13G, all of the aforesaid securities "are owned legally by Southeastern's investment advisory clients and none are owned directly or indirectly by Southeastern. As permitted by Rule 13d-4, the filing of this statement shall not be construed as an admission that Southeastern is the beneficial owner of any of [such] securities." The Schedule 13G was also filed by O. Mason Hawkins, Chairman of the Board and President of Southeastern "in the event he could be deemed to be a controlling person of that firm as the result of his official position with or ownership of voting securities. The existence of such control is expressly disclaimed. Mr. Hawkins does not own directly or indirectly any securities covered by this statement for his own account. As permitted by Rule 13d-4, the filing of this statement shall not be construed as an admission that Mr. Hawkins is the beneficial owner of any of the securities covered by this statement." The Schedule 13G reflects that Mr. Hawkins has voting or dispositive power as to none of the Registrant's shares. (4) Number of shares as shown in beneficial owner's Amendment No. 1 to Schedule 13G dated February 8, 1994, reporting ownership as of December 31, 1993. According to such Schedule 13G, each of Quest Advisory Corp. ("Quest") and Quest Management Company ("QMC") is an Investment Adviser registered under the Investment Advisers Act of 1940. Quest has sole voting and dispositive power as to 418,650 of the shares shown above, representing 9.31% of the outstanding Common Stock, and QMC has sole voting and dispositive power as to 37,500 of the shares shown above, representing 0.83% of the outstanding Common Stock. The Schedule 13G also includes Charles M. Royce as part of the Group and indicates that he may be deemed to be a controlling person of Quest and QMC, and as such may be deemed to beneficially own the shares of the Registrant beneficially owned by Quest and QMC. Mr. Royce owns no shares of the Registrant outside of Quest and QMC and has disclaimed beneficial ownership of the shares reported above. (b) The following table sets forth information regarding the voting securities of the Registrant beneficially owned by each director of the Registrant, each of the executive officers named in the Summary Compensation table in item 11, Executive Compensation, and all executive officers and directors as a group, without naming them (7 persons), as of March 14, 1994. Amount and Nature of Name and Address of Beneficial Percentage Title of Class Beneficial Owner Ownership of Class - -------------- ------------------- ---------- ---------- Common Stock Martin E. Tash 423,402 $.10 par value 233 Spring Street shares (1) 9.41% New York, NY 10013 Mark Shaw 80,667 233 Spring Street shares (2) 1.79% New York, NY 10013 Earl Ubell 1,000 WCBS-TV shares * 524 West 57th Street New York, NY 10019 Howard F. Mathiasen 28,125 10276 Totem Run shares * Littleton, CO 80125 Bernard Bressler 12,809 Bressler, Amery & shares (3) * Ross 90 Broad Street New York, NY 10004 N. Bruce Hannay 1,000 201 Condon Lane shares(4) * Port Ludlow, WA 98365 Ghanshyam A. Patel 9,801 * 233 Spring Street shares(5) New York, NY 10013 All Executive 556,804 12.38% Officers and Directors shares as a Group (7 persons, comprising all those shown above) * Less than 1%. (1) See footnote (1) to table in Item 12(a). (2) Includes 50,625 shares held in trust for adult children. Of the aggregate of 80,667 shares shown, Mr. Shaw has sole voting and dispositive power as to 67,085 and shared voting and dispositive power with his wife as to 13,582. (3) Includes 572 shares held by a trustee for Mr. Bressler under an Individual Retirement Account. Does not include 12,497 shares held by Mr. Bressler's wife as to which he disclaims beneficial ownership. (4) Shares are held in the name of Dr. Hannay's wife and comprise community property. Dr. Hannay therefore has a direct beneficial ownership interest in the shares. He and his wife have shared voting and dispositive power. (5) Includes 4,451 shares held by the Registrant's Profit Sharing Plan, as to which Mr. Patel has sole voting and dispositive power. As to the balance of 5,350 shares, Mr. Patel shares voting and dispositive power with his wife. Item 13.

Item 13. Certain Relationships and Related Transactions ---------------------------------------------- Bernard Bressler, Secretary and a director of the Registrant, is a member of the law firm of Bressler, Amery & Ross, counsel to the Registrant. During the 1993 fiscal year, the Registrant paid legal fees of $192,899, to such firm. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K -------------------------------------------- (a) See index to financial statements and financial statement schedules. See list of exhibits in paragraph (c) below. (b) 8-K reports - During the quarter ended December 31, 1993 (the last quarter of the period covered by this Report), the Registrant filed a Report on Form 8-K to report the completion on December 13, 1993 of the execution of the Journal Production and Distribution Agreement dated November 29, 1993 with the Russian Academy of Sciences and other interested parties. (c) Exhibits - 3.1 Certificate of Incorporation of the Registrant has been filed as part of Exhibit 3 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1986.(1) 3.2 By-Laws of the Registrant, as amended November 18, 1987, have been filed as Exhibit 3.2 to the Registrant's Annual Report on Form 10-k for the fiscal year ended December 31, 1987.(1) 10.1 Journal Production and Distribution Agreement dated November 29, 1993 among the Registrant, MAIK Nauka, Interperiodica, Pleiades Publishing, Inc., the Russian Academy of Sciences and Vo Nauka, has been filed as Exhibit 99 to the Registrant's Report on Form 8-K dated December 13, 1993.(1) 10.2 Incentive Compensation Plan for Executive Officers and Key Employees of Registrant as amended on June 18, 1985 has been filed as part of Exhibit 10 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1985.(1) 10.3 Amendment adopted on December 5, 1990 to Plan referred to in Item 10.3 has been filed as exhibit 10.4 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1990.(1) 10.4 Amended Contingent Compensation Agreements dated September 22, 1989 between the Registrant and Martin Tash, Mark Shaw, Harry Allcock and Marshall Lebowitz have been filed as Exhibit 10.4 to the Registrant's Annual Report on form 10-K for the fiscal year ended December 31, 1989.(1) The Registrant has entered into identical agreements as of December 14, 1993, with Ghanshyam Patel and Ken Derham. To avoid unnecessary duplication, such additional agreements have been omitted from the exhibit filing. 10.5 Indemnification Agreement dated as of November 18, 1987 between the Registrant and Martin E. Tash has been filed as Exhibit 10.6 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1987.(1) The Registrant has entered into identical agreements as of the same date with each of the following persons: Howard F. Mathiasen, Mark Shaw, Earl Ubell, Dr. N. Bruce Hannay, and Bernard Bressler. The Registrant entered into a substantially identical agreement dated March 9, 1988 with Ghanshyam A. Patel and dated December 14, 1993 with Ken Derham. To avoid unnecessary duplication, such additional agreements have been omitted from the exhibit filing. 10.6 Amendment dated March 9, 1988 to Indemnification Agreements referred to in Item 10.6 between the Registrant and Martin E. Tash has been filed as Exhibit 10.7 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1987.(1) The Registrant has entered into identical amendments of the same date with Mark Shaw and Bernard Bressler. To avoid unnecessary duplication, such identical amendments were omitted from the exhibit filing. 11 Statement re: computation of per share earnings - filed herewith. 21 Subsidiaries of Registrant (i) Plenum Publishing Co., Ltd. (United Kingdom) (ii) Da Capo Press, Incorporated (New York) (iii) Career Placement Registry, Inc. (Delaware) (iv) J.S. Canner & Company, Inc. (Massachusetts) (v) Plenum International Sales Corporation (Virgin Islands) (vi) IFI/Plenum Data Corporation (Delaware) (vii) Human Sciences Press, Inc. (Delaware) (1) Not filed with this report but incorporated by reference herein. Signatures ---------- Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. PLENUM PUBLISHING CORPORATION (Registrant) By:s/Martin E. Tash ---------------- Martin E. Tash Chairman of the Board of Directors and President Dated: March 28, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated: By:s/Martin E. Tash ---------------- Martin E. Tash Chairman of the Board of Directors and President (Principal Executive Officer) Dated: March 28, 1994 By:s/Mark Shaw --------------------- Mark Shaw Executive Vice President and a Director Dated: March 28, 1994 By:s/Ghanshyam A. Patel --------------------- Ghanshyam A. Patel Treasurer and Chief Financial Officer (Principal Financial and Accounting Officer) Dated: March 28, 1994 By:s/Bernard Bressler --------------------- Bernard Bressler Secretary and a Director Dated: March 28, 1994 By:s/Earl Ubell --------------------- Earl Ubell Director Dated: March 28, 1994 By:s/N. Bruce Hannay --------------------- N. Bruce Hannay Director Dated: March 28, 1994 By:s/Howard F. Mathiasen --------------------- Howard F. Mathiasen Director Dated: March 28, 1994 Plenum Publishing Corporation and Subsidiary Companies Form 10-K Item 14(a)(1) and (2) and Financial Statement Schedules The following consolidated financial statements of Plenum Publishing Corporation and subsidiary companies are included in Item 8: Report of Independent Auditors S- 1 Consolidated Balance Sheets - December 31, 1993 and 1992 S- 2 Consolidated Statements of Income - Years ended December 31, 1993, 1992 and 1991 S- 4 Consolidated Statements of Stockholders' Equity - Years ended December 31, 1993, 1992 and 1991 S- 6 Consolidated Statements of Cash Flows - Years ended December 31, 1993, 1992 and 1991 S- 7 Notes to Consolidated Financial Statements S- 9 The following consolidated financial statement schedules of Plenum Publishing Corporation and subsidiary companies are included in Item 14(d): Schedules: I Marketable Securities - Other Investments S-22 VIII Valuation and Qualifying Accounts S-23 IX Short-Term Borrowings S-24 X Supplementary Income Statement Information S-25 All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore, have been omitted. Report of Independent Auditors Stockholders and Board of Directors Plenum Publishing Corporation We have audited the accompanying consolidated balance sheets of Plenum Publishing Corporation and subsidiary companies as of December 31, 1993 and 1992, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Plenum Publishing Corporation and subsidiary companies at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. ERNST & YOUNG New York, New York March 14, 1994 Plenum Publishing Corporation and Subsidiary Companies Notes to Consolidated Financial Statements December 31, 1993 1. Summary of Significant Accounting Policies - --------------------------------------------- Basis of Presentation - --------------------- The accompanying financial statements include the accounts of the Plenum Publishing Corporation (the "Company") and its domestic and foreign subsidiaries, which are wholly-owned. The accounts of the foreign subsidiaries are not material. Intercompany items and transactions are eliminated in consolidation. The Company accounts for its investment in Gradco Systems, Inc. under the equity method (see Note 5). The Company and its subsidiaries are engaged in the publishing and distri- bution of advanced scientific and technical materials in the United States and in foreign countries. Export sales aggregated approximately $23,217,000 (1993), $21,214,000 (1992) and $21,453,000 (1991). Inventories - ----------- Inventories are stated at the lower of cost (principally average cost or specific invoice cost) or market (based on selling market). Depreciation and Amortization - ----------------------------- Depreciation is provided for by the straight-line method or by the declining- balance method over estimated useful lives ranging from 3 to 35 years. Amortization of leasehold improvements is provided for by the straight-line method generally over the terms of the related leases or the estimated useful lives of the improvements, whichever period is shorter. The excess of cost of assets acquired over book amount thereof (which arose in connection with various acquisitions by the Company in prior years, other than Gradco Systems, Inc.) is being amortized by the straight-line method principally over forty years. Deferred expenses relating to issuance of long-term debt are being amortized by the straight-line method over the term of the related debt (see Note 6). The cost of the subscription lists of Human Sciences Press and Agathon journals is being amortized by the straight-line method over estimated useful lives ranging from 12 to 20 years. Other assets include the cost of rights to produce and distribute certain journals, which is being amortized by the straight-line method, primarily over a period of fifteen years. Deferred Subscription Income - ---------------------------- The Company bills subscribers to certain publications and patent information services in advance of issuance thereof. The publications are generally issued over a one-year period and subscription revenues are taken into income by the straight-line method based on the relationship of the number of publications issued to the number ordered by subscribers. Patent information service revenues are taken into income when published. The portion of advance billings which will require use of financial resources within one year is not practicable to determine and, accordingly, no portion thereof is included in current liabilities; expenditures at balance sheet dates in respect of such advance billings have similarly been excluded from current assets. Marketable Securities - --------------------- Marketable securities are valued at the lower of aggregate cost or market. Gains and losses on marketable securities are determined based on specific identification. See Note 2. Cash Equivalents and Supplemental Cash Flow Information - ------------------------------------------------------- The Company considers all highly liquid financial instruments with a maturity of three months or less when purchased to be cash equivalents. As of December 31, 1993, the Company had time deposits and money market accounts totalling approximately $1,442,000 on deposit with five financial institutions. As of December 31, 1992, the Company had time deposits and money market accounts of approximately $10,057,000 on deposit with four financial institutions. The Company paid income taxes in 1993, 1992 and 1991 of approximately $6,029,000, $5,962,000 and $6,915,000 (net of income tax refunds received of approximately $1,218,000 in 1991), respectively. In addition, the Company paid interest in 1993, 1992 and 1991 of approximately $1,565,000, $3,023,000 and $3,200,000, respectively. 2. Accounting Change - -------------------- In February 1992, the Financial Accounting Standards Board issued Statement No. 109, "Accounting for Income Taxes" (the "Statement"). The Company adopted the provisions of the new standard in its financial statements for the year ended December 31, 1992. As permitted by the Statement, prior year financial statements have not been restated to reflect the change in accounting method. The cumulative effect as of January 1, 1992 of adopting the Statement increased net income by $1,179,950 or $.25 per share ($.19 per share on a fully diluted basis). Under the Statement, the liability method is used in accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Prior to the adoption of the Statement, income tax expense was determined using the liability method prescribed by Financial Accounting Standards Board Statement No. 96 ("Statement 96"), which is superseded by the Statement. Among other matters, the Statement changes the recognition and measurement criteria for deferred tax assets included in Statement 96. In accordance with the Statement, all of the income tax benefits on the excess of book over tax deductions (for example, depreciation, allowance for doubtful accounts, etc.) are deferred (see Note 7). The cumulative effect on prior years of the change has been shown in the income statement for 1992. In May 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities," effective for fiscal years beginning after December 15, 1993. Under the new rules, which the Company will adopt effective January 1, 1994, the Company will classify its marketable equity securities held as trading securities on the basis of its intent to trade such securities. Accordingly, all marketable equity securities classified as trading securities will be carried at fair market value. Unrealized gains and losses applicable to these securities will be reported as a component of current earnings. Presently, the Company values marketable equity securities as trading securities and reports such securities at the lower of aggregate cost or market, with unrealized losses reported as a component of current earnings. 3. U.S. Government Securities - ----------------------------- The cost and market value of U.S. Government securities at December 31, 1992 are as follows: Cost $31,896,181 =========== Market Value $33,255,846 =========== 4. Inventories - -------------- Inventories at December 31 are comprised of: 1993 1992 -------------------------------- Finished publications $3,612,257 $3,841,520 Work in process 566,928 644,175 -------------------------------- $4,179,185 $4,485,695 ================================ 5. Investment in Gradco Systems, Inc. - ------------------------------------- As of December 31, 1993 and 1992, the Company owned 913,000 common shares of Gradco Systems, Inc. ("Gradco"), a company engaged in the development and marketing of photocopier machine technology, representing approximately 11.7% of its outstanding common stock. Gradco stock is publicly traded on the NASDAQ National Market System. The aggregate market value of this investment as of December 31, 1993 and 1992 amounted to approximately $2,739,000 and $1,480,000, respectively. Selected financial data of Gradco as of and for the 12 months ended December 31, 1993, 1992 and 1991 is as follows and has been extracted from unaudited financial information as filed by Gradco with the Securities and Exchange Commission (in thousands): 1993 1992 1991 ---------------------------------- Balance sheet data Total assets $38,863 $44,019 $40,962 Working capital 9,147 7,198 6,721 Noncurrent liabilities, including minority interest and excluding current installments 15,669 12,387 12,275 Shareholders' equity 9,767 10,914 11,825 Statement of operations data Net revenues 55,773 55,635 58,719 Net income (loss) 43 (863) (753) The President and Chairman of the Board of the Company, Mr. Martin E. Tash, is also the President and Chairman of the Board of Gradco. 6. Long-Term Debt - ----------------- Long-term debt at December 31, 1992 consisted of 6-1/2% Convertible Subordinated Debentures (the "Debentures") due April 15, 2007. The Debentures were issued in April and May 1987. In 1993, 1992 and 1991, the Company purchased Debentures in the principal amount of $1,149,000, $6,808,000 and $1,300,000, respectively, for an aggregate cost (including the write-off of related deferred issuance costs of approximately $28,000, $173,000 and $34,000, respectively) of approximately $1,143,000, $6,149,000 and $1,134,000, respectively. On April 30, 1993 (the "Redemption Date"), pursuant to a notice of election to redeem which had been given to the holders on March 24, 1993, the Company redeemed the Debentures which were outstanding on the Redemption Date. In accordance with the terms of the Debentures and the applicable Trust Indenture, the redemption price was equal to 102.60% of the principal amount of outstanding Debentures, and the holders were also paid accrued interest for the period from April 15, 1993 (the date on which the last semiannual installment of interest was paid) to the Redemption Date. Prior to the Redemption Date, Debentures in the aggregate principal amount of $80,000 were converted into 2,560 shares of Common Stock at the applicable conversion rate of $31.25 per $1,000 of principal amount. On the Redemption Date, Debentures in the aggregate principal amount of $39,598,000 were outstanding, requiring a total payment to the holders of approximately $40,735,000 (including accrued interest). This amount was funded by liquidating a portion of the Company's investments of its excess cash, and from short-term borrowing on the Company's margin account with a broker. The premium paid for the Debentures, and the write-off of related deferred issuance costs of approximately $956,000, net of applicable income tax benefit of $675,000 totalled approximately $1,310,000, which has been accounted for as an extraordinary loss. 7. Income Taxes - --------------- Effective January 1, 1992, the Company changed its method of accounting for income taxes to the liability method required by FASB Statement No. 109, "Accounting for Income Taxes" (see Note 2-"Accounting Change"). Income taxes for the years ended December 31 consist of the following: -------------------------------------- Current Deferred Total -------------------------------------- Federal $5,424,809 $ (874,809) $4,550,000 State and local 1,652,470 (266,470) 1,386,000 -------------------------------------- $7,077,279 $(1,141,279) $5,936,000 ====================================== -------------------------------------- Current Deferred Total -------------------------------------- Federal $5,084,206 $ (84,206) $5,000,000 State and local 2,871,540 (21,540) 2,850,000 -------------------------------------- $7,955,746 $ (105,746) $7,850,000 ====================================== -------------------------------------- Current Deferred Total -------------------------------------- Federal $5,117,300 $ 642,700 $5,760,000 State and local 1,419,158 109,842 1,529,000 -------------------------------------- $6,536,458 $ 752,542 $7,289,000 ====================================== Deferred income taxes result from the recognition of the income tax effect of timing differences in reporting transactions for financial and tax purposes. A description of the differences and the related tax effect follow: 1993 1992 1991 --------------------------------------------- Valuation of inventories $ (337,711) $ (95,457) $154,305 Depreciation ( 77,000) (102,600) 4,600 Allowance for doubtful accounts, etc. ( 26,768) 92,311 - Adjustments applicable to net unrealized losses (699,800) - 593,637 --------------------------------------------- $(1,141,279) $(105,746) $752,542 ============================================= Significant components of the Company's deferred tax assets as of December 31 are as follows: 1993 1992 ----------- ----------- Valuation of inventories $ 2,117,711 $ 1,780,000 Depreciation 1,047,721 970,721 Allowance for doubtful accounts, etc. 135,768 109,000 Allowance for net unrealized losses 699,800 - Equity in losses of Gradco 1,998,400 2,000,000 ----------- ----------- Total deferred tax assets 5,999,400 4,859,721 Valuation allowance (1,998,400) (2,000,000) ----------- ----------- Net deferred tax assets $ 4,001,000 $ 2,859,721 =========== =========== The Company has recorded a valuation allowance for the entire value of the deferred tax asset attributable to the equity in losses of Gradco, since management believes the realization of such asset is not reasonably assured. 8. Leases - --------- The Company leases certain real properties. Certain leases provide for the payment of real estate taxes and escalation of rentals based on increases in real estate taxes. Rental expense for the years ended December 31 is as follows: 1993 $758,226 1992 804,728 1991 823,848 Approximate future minimum rentals under all noncancelable operating leases for real property at December 31, 1993 are as follows: 1994 $ 506,000 1995 512,000 1996 459,000 1997 301,000 1998 289,000 Subsequent to 1998 2,648,000 --------------- $4,715,000 =============== 9. Profit Sharing and Incentive Compensation Plans - -------------------------------------------------- The Company has a profit sharing plan for its employees which provides for annual contributions based upon the Company's net income as a percentage of gross revenue and the employees' salary level and length of service. Such contributions, which are placed in a trust fund, are invested at the employees' discretion. Contributions under the plan aggregated approximately $1,121,000 (1993), $1,126,000 (1992) and $1,006,000 (1991). Other accrued expenses and sundry liabilities include accrued contributions under the plan of $1,121,000 (1993) and $1,126,000 (1992). The Company has an incentive compensation plan for executive officers and key employees of the Company providing for 5% of the Company's income from operations to be distributed (as provided) to participants of the plan. In addition to the amounts payable as set forth above, since cumulative investment income (as defined) earned after 1990 through December 31, 1992 exceeded investment loss (as defined) incurred in 1990, the excess was added to income from operations for the purpose of calculating incentive compen- sation for 1992. Since there was investment income (as defined) in 1993, the amount of such income was added to income from operations for the purpose of calculating incentive compensation for 1993. Distributions under the plan aggregated $844,000 (1993), $959,000 (1992) and $821,000 (1991). Other accrued expenses and sundry liabilities include accrued incentive compensation of $339,000 (1993) and $464,200 (1992). The Company has the right to change, modify or terminate the above plans at any time. 10. Per Share Amounts - --------------------- Primary net income per share of Common Stock is computed on the basis of weighted average number of common shares outstanding (4,607,458 (1993), 4,727,714 (1992) and 5,030,844 (1991)). Amounts per share of Common Stock assuming full dilution are computed on the basis of the weighted average number of shares set forth in the preceding paragraph adjusted for shares issuable upon conversion of the Convertible Subordinated Debentures, after elimination from net income of related debt expense thereon, less applicable income taxes. The number of shares used in this computation is 5,003,791 (1993), 6,166,436 (1992) and 6,592,579 (1991). Fully diluted net income per share is not presented for the periods where the result of the computation is antidilutive. 11. Marketable Securities - ------------------------- December 31 1993 1992 ------------------------------ Aggregate market value $ 48,825,213 $54,502,745 Cost 50,538,410 51,636,161 ------------------------------ Net unrealized (loss) gain $ (1,713,197) $ 2,866,584 ============================== The net unrealized gain at December 31, 1992 has not been recognized in the accompanying consolidated financial statements; such amount consisted of unrealized gains of $5,885,284 and unrealized losses of $3,018,700. The net unrealized loss at December 31, 1993 has been provided for in the accompanying consolidated financial statements; such amount consisted of unrealized gains of $796,126 and unrealized losses of $2,509,323. The Company's portfolio of marketable securities is substantially invested in a limited number of issuers, operating principally in the pharmaceutical industry at December 31, 1993 and in the pharmaceutical and electric utility industries at December 31, 1992. At December 31, 1993, the cost and market value of the Company's largest holding (invested in a company operating in the pharmaceutical industry) were $21,000,000 and $21,749,000, respectively ($18,422,000 and $23,154,000, respectively, at December 31, 1992). Subsequent to December 31, 1993 and through March 14, 1994, the Company realized net losses aggregating approximately $904,000 on sales of marketable securities. At March 14, 1994, the market value of marketable securities aggregated approximately $39,844,000 (cost $41,635,000). 12. Quarterly Financial Information (Unaudited) - ----------------------------------------------- 13. Distribution Agreement - -------------------------- In December 1993, the Company entered into a Journal Production and Distribution Agreement (the "Distribution Agreement") with the Russian Academy of Sciences (the "Academy") and other interested parties pursuant to which the litigation then pending, relating to the translation of Russian scientific journals, was ended, and the Company's role as publisher and distributor of certain of such journals was altered. The Distribution Agreement extends from 1994 through 2006. Pursuant to the Distribution Agreement, in 1994 the Company will distribute for MAIK Nauka ("MN"), an entity owned in part by Pleiades Publishing, Inc. and the Academy, 21 Russian scientific journals in English. MN will become the exclusive publisher of such journals. Prior thereto, the Company had translated, published and distributed these journals under a contract with the Copyright Agency of the former Soviet government, and under contracts with the individual institutes publishing the journals, and had paid royalties based in part upon the number of subscribers. Under the Distribution Agreement, the Company will continue to promote and distribute these journals throughout the world, and will continue to deal with and collect from subscribers to the journals, retaining a portion of such revenues for performing these functions. In 1994, the Company will retain 35% of the revenue, with the amount gradually being reduced to 30% in 1999 and remaining at that level for the balance of the term of the Distribution Agreement. Pursuant to the Distribution Agreement, the Company advanced the Academy $1,000,000 during 1993, of which, $750,000 was outstanding at December 31, 1993. Under the Distribution Agreement, in 1995 and 1996 MN will undertake the publication of the English translations of 11 additional Russian journals, to be promoted and distributed by the Company. Commencing in such years, MN may elect to publish the English translations of up to 23 additional Russian journals, to be promoted and distributed by the Company. As to each additional journal which is published by MN and distributed by the Company under the Distribution Agreement, the Company will retain 35% of the revenue in the initial year of distribution, with the amount gradually being reduced to 30% over a six-year period. MN intends to cause the above-mentioned journals to be translated and published in the former Soviet Union. The Company will continue its activities in translating, publishing and distributing both the journals subject to the Distribution Agreement until they are published by MN and the approximately 40 English Translation Russian Journals not subject to the Agreement. These activities will be undertaken pursuant to the Company's existing English translation and publication contracts with the individual entities publishing the Russian language journals which generally extend through 2001. 14. Contingencies - ----------------- The Company has contingent compensation agreements with certain key personnel. Each agreement provides for the cash payment of an amount equal to 290% of average annual compensation (as defined), in the event of termination of employment, under certain conditions which include, among other matters, (a) the sale of 75% of the book value of the Company's operating assets (as defined) or (b) any person (as defined) becoming the owner of more than 25% of the issued and outstanding shares of the Company's voting stock. In 1991, the Company was named as a co-defendant in an action brought by former executives of Gradco, seeking compensatory and other damages of a material amount. Management of the Company, after consultation with counsel, believes the action will not result in a material loss to the Company and intends to vigorously defend against it. S-22 S-23 S-24 Plenum Publishing Corporation and Subsidiary Companies Schedule X-Supplementary Income Statement Information Column A Column B - ----------------------------------------------------------------------- Charged to Costs Item and Expenses - ----------------------------------------------------------------------- Year ended December 31, 1993 Advertising Costs $2,069,627 Year ended December 31, 1992 Advertising Costs $2,081,552 Year ended December 31, 1991 Advertising Costs $2,071,546 Note: Items not shown above are omitted because the amounts charged to costs and expenses for such items are less than one percent of total revenues, except for royalties which are shown in the consolidated statements of income. S-25

355883_1993.txt

355883

1993

ITEM 1. BUSINESS. The information required in response to this Item is incorporated by reference from the disclosure contained under the caption "Description of Business" on page 41 of the Annual Report to Stockholders, which is included as Exhibit 13 hereto. ITEM 2.

ITEM 2. PROPERTIES. The information required in response to this Item is incorporated by reference from the disclosure contained under the caption "Properties" on page 42 of the Annual Report to Stockholders, which is included as Exhibit 13 hereto. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. The information required in response to this Item is incorporated by reference from the disclosure contained under the caption "Legal Proceedings" on page 42 of the Annual Report to Stockholders, which is included as Exhibit 13 hereto. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY AND RELATED STOCKHOLDERS MATTERS. The information required in response to this Item is incorporated by reference from the disclosure contained under the caption "Common Stock and Dividends" on page 14 of the Annual Report to Stockholders, which is included as Exhibit 13 hereto. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. The information required in response to this Item is incorporated by reference from the disclosure contained under the caption "Selected Financial Data" on page 20 of the Annual Report to Stockholders, which is included as Exhibit 13 hereto. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The information required in response to this Item is incorporated by reference from the disclosure contained under the caption "Financial Analysis" on pages 4-19 of the Annual Report to Stockholders, which is included as Exhibit 13 hereto. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The information required in response to this Item is incorporated by reference from the disclosure contained under the caption "Financial Statements and Notes" on pages 22-38 of the Annual Report to Stockholders, which is included as Exhibit 13 hereto. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not applicable. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT. The information required in response to this Item is incorporated by reference from the disclosure contained under the caption "Executive Officers of the Registrant" on page 42 and "Officers and Directors" on pages 43-46 of the Annual Report to Stockholders, which is included as Exhibit 13 hereto and is incorporated by reference from the Definitive Proxy Statement which will be filed with the Securities and Exchange Commission no later than 120 days after the end of the 1993 fiscal year covered by this Annual Report on 10-K. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. The information required in response to this Item is incorporated by reference from the Definitive Proxy Statement which will be filed with the Securities and Exchange Commission no later than 120 days after the end of the 1993 fiscal year covered by this Annual Report on 10-K. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information required in response to this Item is incorporated by reference from the Definitive Proxy Statement which will be filed with the Securities and Exchange Commission no later than 120 days after the end of the 1993 fiscal year covered by this Annual Report on 10-K. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information required in response to this Item is incorporated by reference from the Definitive Proxy Statement which will be filed with the Securities and Exchange Commission no later than 120 days after the end of the 1993 fiscal year covered by this Annual Report on 10-K. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORT ON FORM 8K. ITEM 14(a)(1) FINANCIAL STATEMENTS. The following consolidated financial statements and the report of independent auditors of First United Bancshares, Inc. and subsidiaries for the year ended December 31, 1993 as required by Item 8, are: ITEM 14(a)(2) FINANCIAL STATEMENT SCHEDULES. Not applicable. ITEM 14(a)(3) FINANCIAL STATEMENT SCHEDULES. The Exhibits required by Item 601 of Regulation S-K which are required to be filed in response to this Item 14(a)(3) are submitted as a separate section of this Annual Report on Form 10-K under the caption "Exhibit Index". ITEM 14(b) REPORTS ON FORM 8-K. First United Bancshares, Inc. filed a Current Report on Form 8-K dated on September 8, 1993, describing under Item 5 that First United Bancshares, Inc. had entered into an Agreement and Plan of Reorganization with Commerce Financial Corporation, whereby First United Bancshares, Inc. would acquire ownership of Commercial Bank at Alma, Arkansas. First United Bancshares, Inc. filed a Current Report on Form 8-K dated December 10, 1993, describing under Item 5 that First United Bancshares, Inc. had consummated an Agreement and Plan of Reorganization with Commerce Financial Corporation, whereby First United Bancshares, Inc. acquired ownership of Commercial Bank at Alma, Arkansas. ITEM 14(c) EXHIBITS. The exhibits required by Item 601 of Regulation S-K which are required to be filed in response to this Item 14(c) are submitted as a separate section of this Annual Report on Form 10-K under the caption "Exhibit Index". ITEM 14(d) FINANCIAL STATEMENT SCHEDULES. Not applicable. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 21st day of March, 1994. FIRST UNITED BANCSHARES, INC. By:/s/ JOHN E. BURNS ------------------------------- John E. Burns, Chief Financial Officer POWER OF ATTORNEY Each person whose signature appears below hereby authorizes James V. Kelley and/or John E. Burns, to file one or more amendments to this Annual Report on Form 10-K, which amendments may make such changes to the Annual Report on Form 10-K as he deems appropriate, and each such person hereby appoints James V. Kelley and/or John E. Burns as his lawful attorney-in-fact to execute in the name and on behalf of each such person individually, and in each capacity stated below, any such amendments to the Annual Report on Form 10-K. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. FIRST UNITED BANCSHARES, INC. ANNUAL REPORT ON FORM 10-K December 31, 1993 EXHIBIT INDEX

865227_1993.txt

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1993

Item 1. Business The Sears Credit Account Trust 1990 C (the "Trust") was formed pursuant to the Pooling and Servicing Agreement dated as of July 31, 1990 (the "Pooling and Servicing Agreement") among Sears, Roebuck and Co. ("Sears") as Servicer, its wholly-owned subsidiary, Sears Receivables Financing Group, Inc. ("SRFG") as Seller, and Continental Bank, National Association as trustee (the "Trustee"). The Trust's only business is to act as a passive conduit to permit investment in a pool of retail consumer receivables. Item 2.

Item 2. Properties The property of the Trust includes a portfolio of receivables (the "Receivables") arising in selected accounts under open-end credit plans of Sears (the "Accounts") and all monies received in payment of the Receivables. At the time of the Trust's formation, Sears sold and contributed to SRFG, which in turn conveyed to the Trust, all Receivables existing under the Accounts as of the end of certain of Sears regular billing cycles ending in July, 1990 and all Receivables arising under the Accounts from time to time thereafter until the termination of the Trust. Information related to the performance of the Receivables during 1993 is set forth in the ANNUAL STATEMENT filed as Exhibit 21 to this Annual Report on Form 10-K. Item 3.

Item 3. Legal Proceedings None Item 4.

Item 4. Submission of Matters to a Vote of Security Holders None PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters Investor Certificates are held and delivered in book-entry form through the facilities of The Depository Trust Company ("DTC"), a "clearing agency" registered pursuant to the provisions of Section 17A of the Securities Exchange Act of 1934, as amended. All outstanding definitive Investor Certificates are held by CEDE and Co., the nominee of DTC. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None PART III Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management As of March 15, 1994, 100% of the Investor Certificates were held in the nominee name of CEDE and Co. for beneficial owners. SRFG, as of March 15, 1994, owned 100% of the Seller Certificate, which represented beneficial ownership of a residual interest in the assets of the Trust as provided in the Pooling and Servicing Agreement. Item 13.

Item 13. Certain Relationships and Related Transactions None PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) Exhibits: 21. 1993 ANNUAL STATEMENT prepared by the Servicer. 28. ANNUAL INDEPENDENT AUDITOR'S REPORTS pursuant to Section 3.06 of the Pooling and Servicing Agreement. (a) Review of servicing procedures. (b) Annual Servicing Letter. (b) Reports on Form 8-K: Current reports on Form 8-K are filed on or before the Distribution Date each month (on, or the first business day after, the 25th of the month). The reports include as an exhibit, the MONTHLY INVESTOR CERTIFICATEHOLDERS' STATEMENT. Current Reports on Form 8-K were filed on October 15, 1993, November 15, 1993, and December 15, 1993. SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Sears Credit Account Trust 1990 C (Registrant) By: Sears Receivables Financing Group, Inc. (Originator of the Trust) By: /S/ALICE M. PETERSON _____________________________________ Alice M. Peterson President and Chief Executive Officer Dated: March 30, 1994 EXHIBIT INDEX Page number in sequential Exhibit No. number system 21. 1993 ANNUAL STATEMENT prepared by the Servicer. 28. ANNUAL INDEPENDENT AUDITOR'S REPORTS pursuant to Section 3.06 of the Pooling and Servicing Agreement. (a) Review of servicing procedures. (b) Annual Servicing Letter. Exhibit 21 SEARS CREDIT ACCOUNT TRUST 1990 C 8.70% CREDIT ACCOUNT PASS-THROUGH CERTIFICATES 1993 ANNUAL STATEMENT Pursuant to the terms of the letter issued by the Securities and Exchange Commission dated October 24, 1990 (granting relief to the Trust from certain reporting requirements of the Securities Exchange Act of 1934, as amended), aggregated information regarding the performance of Accounts and payments to Investor Certificateholders in respect of the Due Periods related to the twelve Distribution Dates which occurred in 1993 is set forth below. 1) The total amount of the distribution to Investor Certificateholders during 1993, per $1,000 interest..$87.00 2) The amount of the distribution set forth in paragraph 1 above in respect of interest on the Investor Certificates, per $1,000 interest....................$87.00 3) The amount of the distribution set forth in paragraph 1 above in respect of principal on the Investor Certificates, per $1,000 interest.................... $0.00 4) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods.................................$395,620,881.91 5) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods.................................$110,137,484.98 6) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods which were allocated in respect of the Investor Certificates................................$160,654,222.48 7) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods which were allocated in respect of the Investor Certificates.................................$30,483,437.56 8) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods which were allocated in respect of the Seller Certificate.................................$234,966,659.43 9) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods which were allocated in respect of the Seller Certificate..................................$79,654,047.42 10) The excess of the Investor Charged-Off Amount over the sum of (i) payments in respect of the Available Subordinated Amount and (ii) Excess Servicing, if any (an "Investor Loss"), per $1,000 interest............ $0.00 11) The aggregate amount of Investor Losses in the Trust as of the end of the day on December 27, 1993, per $1,000 interest...................................... $0.00 12) The total reimbursed to the Trust from the sum of the Available subordinated Amount and Excess Servicing, if any, in respect of Investor Losses, per $1,000 interest............................................. $0.00 13) The amount of the Investor Monthly Servicing Fee payable by the Trust to the Servicer..........$3,240,740.74 14) The aggregate amount which was deposited in the Principal Funding Account in respect of Collections of Principal Receivables during the related Due Periods.................................$111,111,111.12 15) The aggregate amount of Investment Income during the related Due Periods...........................$7,652,777.80 16) The total amount on deposit in the Principal Funding Account in respect of Collections of Principal Receivables, as of the end of the reportable year........................................$148,148,148.16 17) The Deficit Accumulation Amount, as of the end of the reportable year.......................................$0.00 Exhibit 28(a) February 11, 1994 Ms. Alice M. Peterson Ms. Cynthia K. Duncan Vice President and Treasurer Trust Officer Sears, Roebuck and Co. as Servicer Continental Bank, National Sears Tower Association as Trustee Chicago, Illinois 60684 231 South La Salle Street Chicago, Illinois 60697 We have applied the procedures listed below to the accounting records of Sears, Roebuck and Co. ("Sears") relating to the servicing procedures performed by Sears as Servicer under Section 3.06(b) of the Pooling and Servicing Agreement (the "Agreement") for the following Trusts: Date of Pooling and Trust Servicing Agreement Sears Credit Account Trust 1989E November 13, 1989 Sears Credit Account Trust 1990A January 12, 1990 Sears Credit Account Trust 1990B February 22, 1990 Sears Credit Account Trust 1990C July 31, 1990 Sears Credit Account Trust 1990D October 15, 1990 Sears Credit Account Trust 1990E December 1, 1990 It is understood that this report is solely for your information and is not to be referred to or distributed for any purpose to anyone other than Continental Bank, National Association as Trustee, Investor Certificateholders or the management of Sears. The procedures we performed are as follows: Compared the mathematical calculations of each amount set forth in each monthly certificate forwarded by the Servicer, pursuant to Section 3.04(b) of the Agreement, during the calendar year 1993 to the Servicer's computer-generated Portfolio Monitoring and Monthly Cash Flow Allocations Report. We found such amounts to be in agreement. February 11, 1994 Ms. Alice M. Peterson Ms. Cynthia K. Duncan Vice President and Treasurer Trust Officer Sears, Roebuck and Co. as Servicer Continental Bank, National Association as Trustee Because the above procedures do not constitute an audit conducted in accordance with generally accepted auditing standards, we do not express an opinion on any of the items referred to above. As a result of the procedures performed, no matters came to our attention that caused us to believe that the amounts in the monthly certificates require adjustment. Had we performed additional procedures or had we conducted an audit of the monthly certificates in accordance with generally accepted auditing standards, matters might have come to our attention that would have been reported to you. This report relates only to the items specified above and does not extend to any financial statements of Sears taken as a whole.

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101320

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ITEM 1. BUSINESS. (A) GENERAL DEVELOPMENT OF BUSINESS. UJB Financial Corp. ("UJB" or the "company"), registrant, commenced operations on October 1, 1970 as a New Jersey corporation and as a bank holding company registered under the Bank Holding Company Act of 1956. The company owns four banks (bank subsidiaries) and nine active non-bank subsidiaries. At December 31, 1993 the company had total consolidated deposits of $11,456,354,000 on the basis of which it ranked as the fourth largest New Jersey based bank holding company. The bank subsidiaries engage in a general banking business. United Jersey Bank is UJB's largest bank subsidiary, accounting for approximately 46% of UJB's total consolidated assets of $13,410,549,000 at December 31, 1993. The non-bank subsidiaries engage primarily in securities brokerage, venture capital investment, commercial finance lending, lease financing, and reinsuring credit life and disability insurance policies related to consumer loans made by the bank subsidiaries. UJB Financial Corp. has its corporate office at 301 Carnegie Center, P.O. Box 2066, Princeton, New Jersey 08543-2066. On December 16, 1993, the company announced a definitive agreement to acquire VSB Bancorp, Inc., headquartered in Closter, New Jersey, with total assets of approximately $379,000,000. The merger is expected to occur in the second or third quarter of 1994. On September 22, 1993, the company announced a comprehensive restructuring program. The restructuring will focus on four fronts: 1.) a new management structure centered on four primary lines of business, 2.) New Jersey and Pennsylvania statewide consolidations of existing member banks, 3.) enhanced customer service, and 4.) establishment of new financial goals. The Pennsylvania banks were consolidated into First Valley Bank on March 18, 1994, and the New Jersey banks are expected to be consolidated into United Jersey Bank in third quarter of 1994. The following table lists as of December 31, 1993 each bank subsidiary, the location in New Jersey or Pennsylvania of its principal office, the number of its banking offices and, in thousands of dollars, its total assets and deposits: - --------------- (1) Not adjusted to exclude interbank deposits or other transactions among the subsidiaries. (2) State bank, a member of the Federal Reserve System. (3) State bank, not a member of the Federal Reserve System. (4) National bank. (5) Restated to reflect the merger of The Hazleton National Bank and Hanover Bank on March 18, 1994, accounted for as a pooling-of-interests. (B) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS. UJB is engaged in the business of managing or controlling banks and such other businesses related to banking as may be authorized under the Bank Holding Company Act of 1956, as amended. The registrant is also engaged in furnishing services to, or performing services for its present operating subsidiaries. The major line of business is banking. UJB owns and operates four bank subsidiaries. UJB also owns and operates nine active non-bank subsidiaries -- two stock brokerage firms, a venture capital company, a commercial finance company, two leasing companies, two credit life reinsurance companies and a data processing company. Total revenues (excluding intercompany revenues) for the non-bank subsidiaries as a group during the last three years did not account for 10% or more of consolidated revenues of UJB and subsidiaries. (C)(1) NARRATIVE DESCRIPTION OF BUSINESS. Bank Subsidiaries United Jersey Bank was organized in 1903 and is the company's largest bank subsidiary. The bank had total assets of $6,164,317,000 at December 31, 1993. Based on the latest available data, it ranked as the fourth largest commercial bank in New Jersey. United Jersey Bank operates 37 offices to serve most of the 70 communities in Bergen County, the second most populous county in New Jersey. It also operates 38 banking offices in nearby counties. The company's bank subsidiaries are engaged in a general banking business. They accept demand deposits and various types of interest bearing transaction accounts and time deposits, make business, real estate, personal and instalment loans and provide lease financing for businesses. Most of the company's bank subsidiaries serve only the general area in which they are located. The smaller bank subsidiaries are engaged primarily in retail and community commercial banking. Certain banks may also administer individual estates and trusts, corporate trusts, employee benefit trusts, and provide investment services, mutual funds, and insurance and annuity products. Some also provide cash management, international, and correspondent banking services. Through participations with other bank subsidiaries, each bank subsidiary has the means of satisfying the credit needs of its customers beyond its own legal lending limit. Non-Bank Subsidiaries The company, through its wholly-owned subsidiary, UJB Credit Corporation, owns and operates Gibraltar Corporation of America. The company directly owns and operates UJB Investor Services Company (formerly known as Richard Blackman & Co., Inc.), Trico Mortgage Company, Inc., United Jersey Credit Life Insurance Company and United Jersey Venture Capital, Inc. The company indirectly owns UJB Leasing Corporation, Lehigh Securities Corporation, First Valley Leasing, Inc., First Valley Life Insurance Company and UJB Financial Service Corporation. Gibraltar Corporation of America is a commercial finance company operating in the New York and New Jersey metropolitan areas, which specializes in making loans secured by accounts receivable, inventory, and equipment, as well as financing sales and leases of equipment. UJB Investor Services Company and Lehigh Securities Corporation are engaged in the stock brokerage business. United Jersey Credit Life Insurance Company and First Valley Life Insurance Company reinsure credit life and disability insurance policies related to the bank subsidiaries' consumer loans. United Jersey Venture Capital, Inc. makes venture capital investments. UJB Leasing Corporation and First Valley Leasing, Inc. were established for the purpose of making equipment leases. UJB Financial Service Corporation provides data processing services to banking subsidiaries. Trico Mortgage Company, Inc. services existing mortgage and home improvement loans on residential property. Trico Mortgage Company, Inc. is currently in the process of winding down operations, as resolved by the Trico Board of Directors during 1991. Supervision and Regulation The banking industry is highly regulated. Statutory and regulatory controls increase a bank holding company's cost of doing business and limit the options of its management to deploy assets and maximize income. Areas subject to regulation and supervision by the bank regulatory agencies include: nature of business activities; minimum capital levels; dividends; affiliate transactions; expansion of locations; acquisitions and mergers; interest rates paid on certain types of deposits; reserves against deposits; terms, amounts and interest rates charged to various types of borrowers; and investments. BANK HOLDING COMPANY REGULATION UJB is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended (the "Holding Company Act"). As a bank holding company, UJB is supervised by the Board of Governors of the Federal Reserve System (the "FRB") and is required to file reports with the FRB and provide such additional information as the FRB may require. UJB is also regulated by the New Jersey and Pennsylvania Departments of Banking. The Holding Company Act prohibits UJB, with certain exceptions, from acquiring direct or indirect ownership or control of more than five percent of the voting shares of any company which is not a bank and from engaging in any business other than that of banking, managing and controlling banks or furnishing services to subsidiary banks, except that it may, upon application, engage in, and may own shares of companies engaged in, certain businesses found by the FRB to be so closely related to banking "as to be a proper incident thereto" if the FRB determines that such acquisitions will be, on balance, beneficial to the public. The Holding Company Act requires prior approval by the FRB of the acquisition by UJB of more than five percent of the voting stock of any additional bank and in effect permits only the acquisition of banks located in New Jersey and in states (including Pennsylvania) where laws specifically permit acquisitions of banks by out-of-state bank holding companies having the largest proportion of their deposits in New Jersey. In recent years the number of states permitting out-of-state bank holding companies to make acquisitions within their borders has grown rapidly and now includes New Jersey and Pennsylvania, which have in effect laws which permit interstate banking with any state in the United States which enacts reciprocal interstate banking legislation. Satisfactory financial condition, particularly with regard to capital adequacy, and satisfactory Community Reinvestment Act ratings are generally prerequisites to obtaining federal regulatory approval to make acquisitions. All of UJB's subsidiary banks are currently rated "satisfactory" or better. In addition, UJB is subject to various requirements under both New Jersey and Pennsylvania laws concerning future acquisitions. Such laws require the prior approval of the relevant Department of Banking to acquire any bank chartered by that State. Acquisitions through federally chartered subsidiaries require approval of the Comptroller of the Currency of the United States ("OCC"). Statewide branching is permitted in New Jersey and Pennsylvania. Branch approvals are subject to statutory standards relating to safety and soundness, competition, and public convenience. The Holding Company Act does not place territorial restrictions on the activities of non-bank subsidiaries of bank holding companies. The policy of the FRB provides that UJB is expected to act as a source of financial strength to each of its subsidiary banks and to commit resources to support such subsidiary banks in circumstances in which it might not do so absent such policy. In addition, any capital loans by UJB to any subsidiary bank would be subordinate in right of payment to deposits and certain other indebtedness of such subsidiary bank. UJB is required by the Holding Company Act to file annual reports of its operations with the FRB and is subject to examination by the FRB. Under Section 106 of the 1970 amendments to the Holding Company Act and the regulations of the FRB, bank holding companies and their subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit or provision of any property or services. Regulations of the FRB under the Federal Reserve Act require that reserves be maintained by a UJB bank subsidiary to the extent that the proceeds of any UJB promissory note, acknowledgement of advance, due bill or similar obligation, with a maturity of less than four years, are used to supply or to maintain the availability of funds (other than capital) to the bank subsidiary, except any such obligation that, had it been issued directly by the bank subsidiary, would not constitute a deposit. They also place limits upon the amount of UJB's equity securities which may be repurchased or redeemed by UJB. Bank regulatory authorities in the United States have issued risk-based capital standards by which all bank holding companies and banks are evaluated in terms of capital adequacy. These guidelines relate a company's capital to the risk profile of its assets. The standards require all banks to have Tier I capital of at least 4 percent and total capital, including Tier I capital, of at least 8 percent of risk-adjusted assets. Tier I capital includes common shareholders' equity and qualifying perpetual preferred stock together with related surpluses and retained earnings less certain disallowed intangible and tax assets. Total capital is comprised of Tier I capital and limited life preferred stock, qualifying debt instruments, and a portion of the allowance for loan losses. As of December 31, 1993, UJB's Tier I capital was 9.37% and total risk-based capital was 12.43%. Bank regulators have also issued leverage ratio requirements. The leverage ratio requirement is measured as the ratio of Tier I capital to adjusted average assets. The risk-based capital and leverage ratio requirements replaced the primary capital and total capital guidelines used previously. FRB guidelines provide that all bank holding companies (other than those that meet certain criteria) maintain a minimum leverage ratio of 3 percent, plus an additional cushion of 100 to 200 basis points. The guidelines also state that banking organizations experiencing internal growth or making acquisitions will be expected to maintain "strong capital positions" substantially above the minimum supervisory levels without significant reliance on intangible assets. As of December 31, 1993, UJB's ratio of Tier I capital to adjusted average assets (leverage ratio) was 7.07%. FDICIA The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA"), which became law in December 1991, in addition to authorizing increased funding for the Bank Insurance Fund ("BIF") by raising the FDIC's borrowing limits and eliminating the cap on deposit insurance premiums, imposes extensive additional statutory requirements regarding the roles, responsibilities, and liabilities of a bank's senior management, directors, independent auditors, and regulators in compliance, management and financial affairs of a bank. This Act has required additional time, effort and resources to be devoted to compliance and internal controls. FDICIA requires each insured depository institution with $500 million or more in total assets to have an annual audit of its financial statements by an independent public accountant and to have an audit committee consisting of independent outside directors. There are more stringent criteria for audit committees of institutions with $3 billion or more in total assets. It also requires that management report on and assess their responsibility for internal controls over financial reporting and compliance with designated laws and regulations. Independent public accountants must attest to management's report on internal controls over financial reporting. They must also report on management's compliance with designated laws and regulations. FDICIA requires each federal banking agency to ensure that its risk-based capital standards take adequate account of interest rate risk, concentration of credit risk and the risks of non-traditional activities, as well as reflect the actual performance and expected risk of loss on multi-family mortgages. In addition, pursuant to FDICIA, each federal banking agency has promulgated regulations specifying the levels at which a financial institution would be considered "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," or "critically undercapitalized," and to take certain mandatory and discretionary supervisory actions based on the capital level of the institution. The FDIC's regulations implementing these provisions of FDICIA provide that an institution will be classified as "well capitalized" if it (i) has a total risk-based capital ratio of at least 10.0 percent, (ii) has a Tier I risk-based capital ratio of at least 6.0 percent, (iii) has a Tier I leverage ratio of at least 5.0 percent, and (iv) meets certain other requirements. An institution will be classified as "adequately capitalized" if it (i) has a total risk-based capital ratio of at least 8.0 percent, (ii) has a Tier I risk-based capital ratio of at least 4.0 percent, (iii) has a Tier I leverage ratio of (a) at least 4.0 percent or (b) at least 3.0 percent if the institution was rated 1 in its most recent examination, and (iv) does not meet the definition of "well capitalized." An institution will be classified as "undercapitalized" if it (i) has a total risk-based capital ratio of less than 8.0 percent, (ii) has a Tier I risk-based capital ratio of less than 4.0 percent, or (iii) has a Tier I leverage ratio of (a) less than 4.0 percent or (b) less than 3.0 percent if the institution was rated 1 in its most recent examination. An institution will be classified as "significantly undercapitalized" if it (i) has a total risk-based capital ratio of less than 6.0 percent, (ii) has a Tier I risk-based capital ratio of less than 3.0 percent, or (iii) has a Tier I leverage ratio of less than 3.0 percent. An institution will be classified as "critically undercapitalized" if it has a tangible equity to total assets ratio that is equal to or less than 2.0 percent. An insured depository institution may be deemed to be in a lower capitalization category if it receives an unsatisfactory examination. Insured institutions are generally prohibited from paying dividends or management fees if after making such payments, the institution would be "undercapitalized." An "undercapitalized" institution also is required to develop and submit to the appropriate federal banking agency a capital restoration plan, and each company controlling such institution must guarantee the institution's compliance with such plan. The liability of a holding company under any such guarantee is limited to the lesser of five percent of the institution's total assets at the time it became undercapitalized or the amount needed to comply with all applicable capital standards. The FDIC is accorded a priority over the claims of unsecured creditors in any bankruptcy proceeding of a holding company that has guaranteed an institution's compliance with a capital restoration plan. Further, "undercapitalized," "significantly undercapitalized," and "critically undercapitalized" institutions are subject to increasingly extensive requirements and limitations, including mandatory sale of stock, forced mergers, and ultimately receivership or conservatorship. A "critically undercapitalized" institution, beginning 60 days after it becomes "critically undercapitalized," generally is prohibited from making any payment of principal or interest on the institution's subordinated debt. Under FDICIA, only "well capitalized" banks, and those "adequately capitalized" banks which have obtained a waiver from the FDIC, may accept brokered deposits. Those "adequately capitalized" banks that are permitted to accept brokered deposits may not pay rates that significantly exceed the rates paid on deposits of similar maturity from the bank's normal market area or, for deposits from outside the bank's normal market area, the national rate on deposits of comparable maturity, as determined by the FDIC. In addition, the FDIC will not insure accounts established under certain qualified employee benefit plans, if, at the time such deposits are accepted, the institution could not accept brokered deposits. FDICIA also provides that the FDIC insurance assessments are to move from flat-rate premiums to a new system of risk-based premium assessments, which must take effect by January 1, 1994, in order to recapitalize the BIF at a reserve ratio specified in FDICIA. The risk-based insurance assessment will evaluate an institution's potential for causing a loss to the insurance fund and base deposit insurance premiums upon individual bank profiles. A transitional risk-based assessment system is currently in place pursuant to which BIF members pay an annual assessment rate of between 23 and 31 cents per $100 of domestic deposits, depending on the risk classification assigned by the FDIC to the BIF member. Currently the annual assessment rates for the company's bank subsidiaries range from 23 to 26 cents per $100 of domestic deposits. These rates are applicable through June 30, 1994 at which time they will be reevaluated based upon more current risk classifications. The FDIC was also granted authority under FDICIA to impose special assessments on insured depositary institutions to repay FDIC borrowings from the United States Treasury or other sources should such borrowings occur. FDICIA also contains the Truth in Savings Act, which requires certain disclosures to be made in connection with deposit accounts offered to consumers. The FRB has adopted regulations implementing the provisions of the Truth in Savings Act. In addition, significant provisions of FDICIA require federal banking regulators to draft standards in a number of other areas to assure bank safety and soundness, including internal controls, information systems and internal audit systems, credit underwriting, asset growth, compensation, loan documentation and interest rate exposure. The bank regulators have proposed substantially similar regulations that impose on banks which fail to meet the safety and soundness standards of FDICIA substantially the same requirements respecting the formulation and implementation of a corrective plan of action as apply in the case of banks failing to meet the capital adequacy standards. FDICIA require the regulators to establish maximum ratios of classified assets to capital, and minimum earnings sufficient to absorb losses without impairing capital. The legislation also contains provisions which tighten independent auditing requirements, restrict the activities and investments of state-chartered banks to those permitted for national banks, amend various consumer banking laws, limit the ability of "undercapitalized" banks to borrow from the FRB discount window, and require federal banking regulators to perform annual on-site bank examinations and set standards for real estate lending. FDICIA has significantly increased costs for the banking industry due to higher FDIC assessments, additional layers of reporting and compliance requirements and more limitations on the activities of all but the most well capitalized banks. FIRREA Although the most significant purpose of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 ("FIRREA") was to restructure the savings and loan industry, many of its provisions have importance for the commercial banking industry, including the provision which authorized bank holding companies to acquire healthy as well as troubled thrift institutions, generally without limitations on interstate acquisitions, while retaining thrift branching powers. Under FIRREA, a depository institution insured by the FDIC can be held liable for any loss incurred by, or reasonably expected to be incurred by, the FDIC in connection with (i) the default of a commonly controlled FDIC-insured depository institution or (ii) any assistance provided by the FDIC to a commonly controlled FDIC-insured depository institution in danger of default. "Default" is defined generally as the appointment of a conservator or receiver and "in danger of default" is defined generally as the existence of certain conditions, including a failure to meet minimum capital requirements, indicating that a "default" is likely to occur in the absence of regulatory assistance. These provisions have commonly been referred to as FIRREA's "cross guarantee" provisions. Liability under the "cross guarantee" provisions is subordinate to claims (other than claims by shareholders, including bank holding companies, in their capacity as shareholders, and affiliates of the institution) of depositors, secured creditors, other general or senior creditors, and holders of obligations subordinated to depositors or other creditors. The FDIC may waive its rights under limited circumstances generally applicable to acquisitions of troubled institutions. FIRREA gives the FDIC as conservator or receiver of a failed depository institution express authority to repudiate contracts with such institution which it determines to be burdensome or if such repudiation will promote the orderly administration of the institution's affairs. Certain "qualified financial contracts", defined to include securities contracts, commodity contracts, forward contracts, repurchase agreements, and swap agreements, are generally excluded from the repudiation powers of the FDIC. The FDIC is also given authority to enforce contracts made by a depository institution, notwithstanding any contractual provision providing for termination, default, acceleration, or exercise of rights upon, or solely by reason of, insolvency or the appointment of a conservator or receiver. Insured depository institutions are also prohibited from entering into contracts for goods, products or services which would adversely affect the safety and soundness of the institution. The bank regulatory agencies have broad discretion to issue cease and desist orders if they determine that the company or its subsidiaries are engaging in "unsafe or unsound banking practices." In addition, the federal bank regulatory authorities are empowered to impose substantial civil money penalties for violations of certain federal banking statutes and regulations. Financial institutions, and directors, officers, employees, controlling shareholders, agents, consultants, attorneys, accountants, appraisers and others associated with a financial institution could now be subject to increased fines, penalties, and other enforcement actions as a result of provisions of FIRREA. Further, under FIRREA the failure to meet capital guidelines could subject a banking institution to a variety of enforcement remedies available to federal regulatory authorities, including the termination of deposit insurance by the FDIC. REGULATION OF SUBSIDIARIES Various laws and the regulations thereunder applicable to the company and its bank subsidiaries impose restrictions and requirements in many areas, including capital requirements, the maintenance of reserves, establishment of new offices, the making of loans and investments, consumer protection, employment practices and other matters. There are various legal limitations, including Sections 23A and 23B of the Federal Reserve Act, on the extent to which a bank subsidiary may finance or otherwise supply funds to UJB or its non-bank subsidiaries. Under federal law, no bank subsidiary may, subject to certain limited exceptions, make loans or extensions of credit to, or investments in the securities of, its parent or non-bank subsidiaries of its parent or take their securities as collateral for loans to any borrower. Each bank subsidiary is also subject to collateral security requirements for any loans or extensions of credit permitted by such exceptions. Further, a subsidiary bank may only engage in most transactions with other subsidiaries if terms and conditions are at least as favorable to the bank as those prevailing for transactions with unaffiliated companies. UJB and its banking and other subsidiaries are also subject to certain restrictions with respect to engaging in the business of issuing, underwriting, public sale, flotation or distribution of securities. The two state-chartered subsidiary banks are subject to the supervision of, and to regular examination by, the New Jersey or Pennsylvania Department of Banking. The two subsidiary banks which are national banks are subject to the supervision of, and to regular examination by, the OCC. In addition, the subsidiary banks are subject to examination by the FDIC, and by the U.S Department of Education with respect to student loan activity. United Jersey Bank is also subject to examination by the FRB. The Municipal Bond Department of United Jersey Bank, as a registered municipal securities dealer, is subject to the supervision of the Municipal Securities Rulemaking Board. None of the stocks of the subsidiary banks or other subsidiaries owned or controlled by UJB carry statutory double liability. However, Section 55 of Title 12 of the United States Code and Article XIV, Section 11 of the Constitution of the State of Arizona provide that the stock of, respectively, UJB's national bank subsidiaries and UJB's credit life insurance subsidiaries, may be subject to assessment to restore impaired capital under certain circumstances as and to the extent provided therein. There is no such provision in New Jersey or Pennsylvania law governing UJB's state-chartered banks. Certain statutory restrictions may affect the declaration and payment of dividends by the subsidiary banks to UJB. For additional information see Note 14 on page 47 of the 1993 Annual Report incorporated herein by reference as Exhibit 13. UJB and its non-bank subsidiaries are subject to examination by the New Jersey and Pennsylvania state and the three federal bank regulatory agencies at their discretion. As a mortgagee approved by Department of Housing and Urban Development and a seller-servicer of mortgages approved by the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, and the New Jersey Housing and Mortgage Finance Agency, United Jersey Bank is subject to regulation or supervision by these government agencies. First Valley Bank is a participant in the mortgage program conducted by the Pennsylvania Housing Finance Agency and is subject to the supervision of that agency. UJB Investor Services Company and Lehigh Securities Corporation are subject to regulation and examination by the Securities and Exchange Commission, the National Association of Securities Dealers, Inc. and the New Jersey Bureau of Securities. UJB Investor Services Company is also subject to regulation and examination by the New York Bureau of Investor Protection and Securities and the Florida Department of Banking and Finance. Lehigh Securities Corporation is also subject to regulation and examination by the Pennsylvania Securities Commission and, as a registered municipal securities dealer, is subject to the supervision of the Municipal Securities Rulemaking Board. Trico Mortgage Company, Inc. is subject to regulation and supervision as a mortgage banking company by the New Jersey Department of Banking. United Jersey Credit Life Insurance Company and First Valley Life Insurance Company are subject to regulation and examination by the Department of Insurance of the State of Arizona. UJB and its subsidiaries are also subject to various reporting requirements of Federal and state securities laws and regulations of the Securities and Exchange Commission and the New York Stock Exchange. From time to time, various bills are introduced in the United States Congress and the New Jersey or Pennsylvania Legislature which could result in additional regulation of the business of UJB and its subsidiaries, or further increase competition. There is a continuing trend toward regulating every aspect of retail banking through consumer protection laws, at significant expense to financial institutions. At the same time, securities brokers, insurance companies, retailers and other non-bank entities are being allowed to offer a variety of traditional bank services without being subject to the same degree of regulation as banks and bank holding companies. If these trends continue without providing parity to the commercial banks in matters such as permissible services, taxation and interest rates chargeable on loans, adverse effects on commercial banks could ensue. In its operations in other countries, United Jersey Bank is also subject to restrictions imposed by the laws and banking authorities of such countries. References under this caption, Supervision and Regulation, to applicable statutes are brief summaries of portions thereof which do not purport to be complete and which are qualified in their entirety by reference to such statutes. Monetary Policy and Economic Conditions The earnings and business of UJB and its subsidiaries are affected by the policies of regulatory authorities, including the FRB. The monetary policies of the FRB have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. Because of the changing conditions in the national and international economy and in the money markets, as a result of actions by monetary and fiscal authorities, interest rates, credit availability and deposit levels may change due to circumstances beyond the control of UJB or its subsidiaries. Effects of Inflation A bank's asset and liability structure differs from that of an industrial company, since its assets and liabilities fluctuate over time based upon monetary policies and changes in interest rates. The growth in the bank's earning assets, regardless of the effects of inflation, will increase net interest income if the bank is able to maintain a consistent interest spread between earning assets and supporting liabilities. A purchasing power gain or loss from holding net monetary assets during the year represents the effect of general inflation on monetary assets and liabilities. Almost all of the assets and liabilities of UJB are considered monetary because they are fixed in terms of dollars and therefore, are not materially affected by inflation. (C)(1)(I) PRINCIPAL PRODUCTS AND SERVICES RENDERED BY INDUSTRY SEGMENTS. Not applicable. See response to Item 1(b) contained elsewhere in this report. (C)(1)(II) DESCRIPTION OF NEW PRODUCTS OR SEGMENTS. Not applicable. (C)(1)(III) SOURCES AND AVAILABILITY OF RAW MATERIALS. Not applicable. (C)(1)(IV) IMPORTANCE OF PATENTS, TRADEMARKS, LICENSES, FRANCHISES AND CONCESSIONS HELD. Patents and licenses, as such, are not of importance to UJB or its subsidiaries, but operating charters (similar to licenses) -- approved banking location authorizations granted by the New Jersey and Pennsylvania Departments of Banking, for state-chartered bank subsidiaries, and by the OCC, for nationally-chartered bank subsidiaries -- are vital to the operation and expansion of the bank subsidiaries. Such charters are perpetual unless revoked by the granting authorities. Various licenses and approvals to do business are also required by the other regulatory agencies referred to under Supervision and Regulation above. Most of these licenses and approvals require periodic renewal. UJB has several registered service marks, none of which is considered material to its business. The duration of each registration is perpetual so long as the registrant continues to use the mark. (C)(1)(V) SEASONALITY OF BUSINESS. Not applicable. (C)(1)(VI) WORKING CAPITAL REQUIREMENTS RELATED TO INVENTORY. Not applicable. (C)(1)(VII) CONCENTRATION OF CUSTOMERS. The business of the registrant and its subsidiaries is not dependent on a single customer, nor on a small group of customers. (C)(1)(VIII) BACKLOG OF ORDERS. Not applicable. (C)(1)(IX) GOVERNMENT CONTRACTS. No material portion of the business of UJB and its subsidiaries is subject to renegotiation of profits or termination of contracts or subcontracts at the election of the Government. (C)(1)(X) COMPETITION. Each bank subsidiary faces strong competition for local business in the communities it serves from other banking institutions as well as from other financial institutions. United Jersey Bank and First Valley Bank compete in the national market with other major banking and financial institutions in the New York and Philadelphia areas, many of which are substantially larger and may have greater financial resources. A number of these institutions offer their services throughout New Jersey and Pennsylvania through bank and non-bank subsidiaries, loan production offices and solicitations through broadcast and print media and direct mail. For international business, United Jersey Bank competes not only with a substantial number of United States banks having foreign departments, but also with agencies and branches of foreign banks located in the United States and with other major banks throughout the world. The effect of liberalized branching and acquisition laws, especially after FIRREA, has been to lower barriers to entry into the banking business and to increase competition for banking business, as well as to increase both competition for and opportunities to acquire other financial institutions. Present proposals in Congress for nationwide interstate banking would accelerate these trends. For most of the services which the subsidiaries perform, there is increasing competition from financial institutions other than commercial banks due to the relaxation of regulatory restrictions. Money market funds actively compete with banks for deposits. Savings banks, savings and loan associations and credit unions also actively compete for deposits and for various types of loans; such institutions, as well as securities brokers, consumer finance companies, mortgage companies, factors, insurance companies and pension trusts, are important competitors. Financial institutions such as these, as well as retailers and other non-bank entities, have acquired so-called "non-bank banks" permitting them to offer traditional banking services without being subject to the same degree of regulation. Insurance companies, mutual fund investment counseling firms and other business firms and individuals offer competition for personal and corporate trust services and investment advisory services. Each of UJB's non-bank subsidiaries competes with a very large number of competitors, many of which are substantially larger and have greater financial resources. Competition for banking and permitted non-bank services is based on price, nature of product, quality of service, and in the case of retail activities, convenience of location. (C)(1)(XI) RESEARCH AND DEVELOPMENT. UJB and its subsidiaries conduct research activities, from time to time, relating to the development of new services. Expenditures for these activities are not considered material to the financial condition of UJB and its subsidiaries. Research expenditures during 1993 were charged directly to expense as incurred. (C)(1)(XII) COST OF COMPLIANCE WITH ENVIRONMENTAL REGULATIONS. It is not expected that compliance with Federal, State and local provisions relating to the protection of the environment will have any material effect on UJB or its subsidiaries. (C)(1)(XIII) NUMBER OF PERSONS EMPLOYED. At December 31, 1993, there were 6,219 persons, on a full-time equivalent basis, employed by UJB and its subsidiaries. (D) FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES. United Jersey Bank operates an International Banking Department principally for the benefit of its domestic customers and, in January 1974, opened its first offshore banking facility on the island of Grand Cayman in the British West Indies. Business at the offshore facility constituted less than one-half of one percent of the total assets and income of United Jersey Bank in 1993. (E) STATISTICAL INFORMATION. The following tables set forth, on a consolidated basis, certain statistical information concerning UJB and its subsidiaries. The tables should be read in conjunction with the consolidated financial statements contained in the 1993 Annual Report to Shareholders, included herein as Exhibit 13. Average data have been derived from daily balances except in the case of certain smaller subsidiaries where month-end balances were used. Distribution of Assets, Liabilities and Shareholders' Equity; Interest Rates and Interest Differential. For information on average balances, interest and average rates earned and paid see "Comparative Average Balance Sheets With Resultant Interest and Rates" on pages 36 and 37 in the 1993 Annual Report to Shareholders incorporated herein by reference as Exhibit 13. The amount by which interest income exceeds interest expense is called net interest income. The amount of net interest income in any given period is affected by the average volume of earning assets and the yield earned on such assets, the average volume of interest bearing sources of funds and the average rate paid on such liabilities, and the average volume of interest-free sources of funds. The following table shows the approximate effect on the effective interest differential of volume and rate changes for the years 1993 and 1992 on a tax-equivalent basis. For purposes of this table, the change in interest due to both volume and rate has been allocated to change due to volume and change due to rate in proportion to the relationship of the absolute dollar amounts of the change in each. Investment Securities Available for Sale The following table shows the carrying value of investment securities available for sale at December 31 for each of the following years: The following table shows the maturity distribution and weighted average yields to maturity on a tax-equivalent basis for investment securities available for sale, by type and in total, of Federal agencies, and other securities at December 31, 1993. The carrying value and market value of securities at December 31, 1993 are distributed by contractual maturity. However, mortgage-backed securities and other securities which may have prepayment provisions are distributed to a maturity category based on estimated average lives. These principal prepayments are not scheduled over the life of the investment, but are reflected as adjustments to the final maturity distribution. The distribution follows: - --------------- (1) Excludes corporate stock with a carrying value of $14,193,000 and a market value of $18,745,000. (2) Weighted average yields have been computed on a tax-equivalent basis using the statutory federal income tax rate of 35%. Investment Securities The following table shows the carrying value of investment securities at December 31 for each of the past three years: The following table shows the maturity distribution and weighted average yields to maturity on a tax-equivalent basis for investment securities, by type and in total, of U.S. Government, Federal agencies, states and political subdivisions and other securities at December 31, 1993. The carrying value and market value of securities at December 31, 1993 are distributed by contractual maturity. However, mortgage-backed securities and other securities which may have prepayment provisions are distributed to a maturity category based on estimated average lives. These principal prepayments are not scheduled over the life of the investment, but are reflected as adjustments to the final maturity distribution. the distribution follows: - --------------- (1) Excludes Federal Reserve Bank stock with a carrying value and a market value of $8,570,000. (2) Weighted average yields have been computed on a tax-equivalent basis using the statutory Federal income tax rate of 35%. Loan Portfolio The following table shows the classification of consolidated loans (before deduction of unearned discount and the allowance for loan losses) by major category at December 31 for each of the past five years: At December 31, 1993 commercial mortgage loans represented 17.9% of total loans. Home equity loans represented 16.0% of the total loan portfolio at year end. As of December 31, 1993 there are no other concentrations of loans which exceed 10% of total loans. The following table shows the approximate maturities of selected loans at December 31, 1993. The loans are segregated between those which are at predetermined interest rates and those at floating or adjustable interest rates. The table includes non-performing loans which are discussed on pages 17 and 18 of this report: The loan portfolio is reviewed regularly to determine whether specific loans should be placed in a non-performing status. Non-performing loans consist of commercial non-accrual and renegotiated loans. Non-accrual loans include loans that are past due 90 days or more as to principal or interest, or where reasonable doubt exists as to timely collectibility. At the time a loan is placed on non-accrual status, previously accrued and uncollected interest is reversed against interest income. Interest collections on non-accrual loans are generally credited to interest income when received. However, if ultimate collectibility of principal is in doubt, interest collections are applied as principal reductions. After principal and interest payments are brought current and future collectibility is reasonably assured, loans are returned to accrual status. Renegotiated loans are loans whose contractual interest rates have been reduced to below market rates or other significant concessions made due to a borrower's financial difficulties. Interest income on renegotiated loans is generally credited to interest income as received. Non-performing loans do not include past due retail loans 90 days or more as to principal or interest, but which are well collateralized and in the process of collection. At December 31, 1993 and 1992 these loans amounted to $29,513,000 and $37,917,000, respectively. The following table shows, in thousands of dollars, the principal amount of commercial non-accruing loans, renegotiated loans, and loans 90-days or more past due and accruing at December 31 for each of the past five years, and their resultant impact on earnings before taxes for the years then ended. All loans in the following table represent domestic loans. There are no foreign loans included in any of the categories. Potential problem loans are those which management believes conditions indicate that the collection of principal and interest may be doubtful in accordance with the original contract terms. They are not included in non-performing loans as these loans are still performing. Potential problem loans were $39,187,000 and $48,062,000 at December 31, 1993 and 1992 respectively. Potential problem loans at December 31, 1993 comprised commercial and industrial loans of $19,774,000, construction and development loans of $7,872,000, and real estate related loans of $11,541,000. Such risk associated with these loans have been factored into the company's allowance for loan losses. Summary of Loan Loss Experience The relationship for the past five years among loans, loans charged off and loan recoveries, the provision for loan losses and the allowance for loan losses is shown below: For additional information, see Financial Review on pages 25 through 35 of the 1993 Annual Report incorporated herein by reference as Exhibit 13. Implicit in the lending function is the fact that loan losses will be experienced and that the risk of loss will vary with the type of loan being made, the credit worthiness of the borrower and prevailing economic conditions. A standardized process has been established throughout the company to provide for loan losses through a reasonable and prudent methodology. This methodology includes a review to assess the risks inherent in the loan portfolio. It incorporates a credit review and gives consideration to areas of exposure such as concentrations of credit, economic and industry conditions, and negative trends in delinquencies and collections. Consideration is also given to collateral levels and the composition of the portfolio. Specific allocations as well as a need for general reserves are identified by loan type and allocated according to the following categories of loans at December 31 for each of the past five years. The percentage of loans to total loans is based upon the classification of loans shown as follows: - --------------- (1) Includes mortgage and construction and development loans. Deposits For information on classification of average balances for deposits, see "Comparative Average Balance Sheets With Resultant Interest and Rates" on pages 36 and 37 in the 1993 Annual Report to Shareholders incorporated herein by reference as Exhibit 13. The following table shows, by time remaining to maturity, all commercial certificates of deposit $100,000 and over at December 31, 1993 (in thousands): Return on Equity and Assets For information on consolidated ratios, see "Summary of Selected Financial Data" on page 2 in the 1993 Annual Report to Shareholders incorporated herein by reference as Exhibit 13. Short-Term Borrowings The following table summarizes information relating to certain short-term borrowings for each of the past three years: ITEM 2.

ITEM 2. PROPERTIES. UJB owns the building, constructed in 1984, in West Windsor Township, New Jersey where it maintains its corporate headquarters. Additionally, UJB occupies offices in Hackensack, New Jersey in space provided by United Jersey Bank and also occupies offices in Hackensack as well as at other locations in New Jersey, including an office and warehouse facility in Fair Lawn, which it leases from third-party lessors. During 1978, UJB sold a six-story office building that it owned in Hackensack, adjacent to the administrative and principal banking office of United Jersey Bank. United Jersey Bank leases space in the building. The principal banking office and administrative offices of United Jersey Bank are located in Hackensack in a nine-story building owned by the bank which was constructed in 1927. The bank occupies substantially the entire building. In addition to its principal office, United Jersey Bank owns 36 of its branch offices buildings; office space in certain of these buildings is leased to others. United Jersey Bank leases the buildings and property for 39 of its branch offices. It leases a multi-level parking garage accommodating 250 cars located near the principal office. UJB leases real property located in Ridgefield Park, New Jersey and a multi-story building containing approximately 300,000 square feet of space for use by UJB Financial Service Corporation as a data processing facility which was completed in 1991. The tenant improvements and furniture, fixtures and equipment for the new facility was initially funded by UJB. On August 31, 1992, the Company consummated the sale of certain assets and simultaneously negotiated the leaseback of these assets. The previous computer center in Hackensack, owned by United Jersey Bank, has been utilized to centralize certain banking activities. Of the 183 banking buildings of the other bank subsidiaries, 87 are owned in fee and 96 are leased. The principal banking and administrative offices of First Valley Bank are located in an eleven-story building built in 1974 in Bethlehem, Pennsylvania. First Valley leases the building for an initial term ending in the year 2000, with renewal options extending for an additional 38 years. First Valley occupies approximately three-quarters of the building. All properties owned by the various bank subsidiaries are unencumbered by mortgages or similar liens. The bank subsidiaries at December 31, 1993 operated banking offices in 17 of the 21 counties in New Jersey (Atlantic, Bergen, Burlington, Camden, Cumberland, Essex, Gloucester, Hudson, Mercer, Middlesex, Monmouth, Morris, Ocean, Passaic, Somerset, Union and Warren), and 12 of the 67 counties in Pennsylvania (Berks, Bucks, Carbon, Chester, Delaware, Lancaster, Lehigh, Luzerne, Montgomery, Northampton, Philadelphia and Schuylkill). Gibraltar Corporation of America occupies leased offices in New York City, New York. UJB Investor Services Company occupies leased offices in Fort Lee, Matawan, Morristown, Paramus, Princeton and West Caldwell, New Jersey. Trico Mortgage Company, Inc. occupies leased offices in Somerset, New Jersey. First Valley Leasing, Inc. occupies leased offices in Bethlehem, Pennsylvania. Lehigh Securities Corporation occupies leased offices in Whitehall, Pennsylvania. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. Management does not believe that the ultimate disposition of the litigation discussed below will have a material adverse effect on the financial position and results of operation of the company and its subsidiaries, taken as a whole. POSEIDON POOLS, INC. SUITS Poseidon Pools, Inc., a dissolved subsidiary of Gibraltar Corporation of America (Gibraltar) (a subsidiary of UJB Credit Corporation which, in turn, is a subsidiary of UJB Financial Corp.), was incorporated to take over certain assets of Atreo Manufacturing Co. on April 19, 1975 when Atreo defaulted on a substantial indebtedness to Gibraltar. A substantial portion of the assets and certain liabilities of Poseidon Pools, Inc. along with the right to the name Poseidon Pools were sold to S & V Pools, Inc., an unaffiliated entity, on September 5, 1978. Poseidon Pools, Inc. was subsequently dissolved and the Certificate of Dissolution was filed with the Secretary of State of the State of New York on January 10, 1983. The cases below involve claims of negligence, tort liability, product liability or successor product liability. No opinion has been reached as to liability in any of these cases which have not been concluded. UJB and its subsidiaries maintained insurance coverage against the claims related to its ownership of Poseidon Pools, Inc. which are discussed below, and counsel has been assigned by the insurance carriers. However, if any of the plaintiffs prevail and damages are awarded in excess of the applicable insurance coverages, such excess would be payable by subsidiaries of UJB. Richard Fleck and Diane Fleck v. KDI Sylvan Pools, Inc. a/k/a Sylvan Pools, Nichols Swim Pools, Inc. and James Hubert v. Atreo Manufacturing Co., Inc., Poseidon Pools, Inc., Poseidon Pools of America, Inc., Gibraltar Factors Corp., The Gibraltar Corporation, S & V Pools, Inc., Esther Williams Swimming Pool Company, Esther Williams Pools, Inc. and Esther Williams All Aluminum Swimming Pool Company, United States District Court, Eastern District of Pennsylvania, Civil Action No. 89-1348, Third Party Complaint filed October 23, 1989. The Plaintiffs allege that Richard Fleck suffered injuries resulting in quadriplegia when he dove into an above-ground swimming pool in August 1987. The Plaintiffs claim that the injuries were the result of a defect in the above-ground swimming pool sold by the defendant KDI Sylvan Pools, Inc. ("KDI Sylvan") (a retailer) and a defect in the liner installed in the pool by the defendant James Hubert (the homeowner). In turn, KDI Sylvan filed a Third Party Complaint against Gibraltar and its dissolved subsidiary Poseidon Pools, Inc. and other alleged manufacturers of the pool seeking to impose liability on a variety of negligence and product liability theories. The pool was purchased in 1971. The trial commenced on October 2, 1990 with the court dismissing the claims against Poseidon Pools, Inc. prior to the start of the trial. At the conclusion of the Plaintiffs' case, Gibraltar successfully moved for a directed verdict in its favor. The trial continued and the jury awarded $10.2 million in favor of the Plaintiffs as against the remaining Defendants. The Plaintiffs and another party (the replacement pool liner manufacturer) filed various post-trial motions which were all denied by the trial court. These parties then filed appeals from the directed verdict in favor of Gibraltar with the United States Circuit Court of Appeals for the Third Circuit. In addition, the replacement pool liner manufacturer also appealed from the trial court's pre-trial dismissal of the claims against Poseidon Pool, Inc. The appeals resulted in an order affirming the judgments with respect to the claims against Gibraltar and Poseidon Pools, Inc. The replacement pool liner manufacturer then filed a petition for a re-hearing en banc which was denied on December 31, 1992. The petition for a writ of certiorari filed by the replacement pool liner manufacturer was denied by the Supreme Court of the United States on March 29, 1993. All subsequent motions were denied and the matter is now concluded. A companion suit. Richard Fleck and Diane Fleck v. Atreo Manufacturing Co., Inc., Poseidon Pools, Inc., Poseidon Pools of America, Inc., Gibraltor Factors Corp., The Gibraltar Corporation and S & V Pools, Inc., Commonwealth of Pennsylvania, Court of Common Pleas, Civil Division, July Term, 1989, No. 6755, Summons filed August 4, 1989, is pending in the state court of Pennsylvania. Gibraltar received informal notice of the state court action on August 18, 1989. Based on informal inquiry, the state court action remains dormant. SHAREHOLDER SUIT In Re UJB Financial Corp. Shareholder Litigation, United States District Court for the District of New Jersey, Trenton, Civil Action No. 90-1569. Suit filed April 5, 1990. Three suits, UJB Financial Corporation, derivatively by Chappaqua Family Trust and Robert Bassman v. UJB Financial Corporation et al; Irwin Shapiro v. UJB Financial Corp. et al; Lester Associates and Jerome Katz v. UJB Financial Corp, et al were filed in April and May of 1990. These suits were consolidated and a Consolidated Amended Complaint and Derivative Complaint was filed on September 4, 1990. This purported derivative and class action securities law suit against UJB Financial Corp. ("UJB") and certain officers and directors is brought by Plaintiffs who are alleged to have owned or purchased securities of UJB from approximately February 1, 1988 through July 1990. Violations are alleged of Sections 10(b), 14(a) and 20 of the Exchange Act, Sections 11, 12 and 15 of the Securities Act of 1933 and New Jersey common law. The suit alleges that UJB's reserves for loan losses were inadequate, resulting in inaccurate financial statements, and that the defendants made misleading positive statements about UJB's financial condition and failed to disclose negative information about UJB's lending policies, operations and finances, thus artificially inflating UJB's earnings and the prices of UJB's securities. The suit further alleges that UJB's internal credit review and controls were inadequate. In addition, plaintiffs assert that the 1990 Proxy Statement was false and misleading because it did not disclose that defendants had engaged in the conduct described in the preceding paragraph or that entrenchment allegedly was defendants' true motive behind the adoption of a shareholder rights plan and a provision amending UJB's certificate of incorporation to require 80% approval by the shareholders to increase the authorized number of directors (and 80% approval to amend or repeal any provision of the proposed amendments). The plaintiffs demand judgment including unspecified money damages, a declaration that all action taken at the 1990 Annual Meeting is null and void, a declaration that the shareholder rights plan is void, and attorneys' fees. Discovery and determination of class issues were stayed by District Court order. UJB and the defendant directors and officers moved to dismiss the complaint and each claim for relief on various grounds, including, among others: failure to state a claim; failure to plead with particularity; and failure to make the required demand. The District Court granted the motion in part and allowed plaintiffs thirty days to replead or amend their complaint with respect to other alleged wrongdoing. The plaintiffs determined not to replead or amend and appealed the District Court ruling to the U.S. Circuit Court of Appeals. Plaintiffs did not appeal dismissal of the derivative claims and voluntarily withdrew, with prejudice, the claim challenging UJB's 1990 Proxy Statement. On May 22, 1992 the Court of Appeals reversed in part the District Court's decision insofar as it dismissed certain claims in the complaint and remanded same to the District Court for further proceedings, including repleading by the plaintiffs. By orders dated July 7, 1992, the Court of Appeals denied the defendants' petition for rehearing en banc but stayed entry of its mandate until August 13, 1992 to permit defendants to seek review by the United States Supreme Court. All proceedings in the District Court were stayed pending entry of the mandate; the mandate issued upon denial of review by the Supreme Court. On October 13, 1992, the Supreme Court declined to accept the case for review. On March 22, 1993, the Plaintiffs served the Second Consolidated Amended Class Action Complaint which contained substantially the same claims (except for those that had been dismissed) as set forth in the prior Amended Complaint. UJB and the defendant directors and officers then moved to dismiss the Second Consolidated Amended Class Action Complaint and each claim for relief contained therein on various grounds. On September 13, 1993, the District Court denied the defendants' motion to dismiss the plaintiffs' claims under the Securities Exchange Act of 1934 and New Jersey common law and reserved decision on the motion with regard to plaintiffs' claims under the Securities Act of 1933. The plaintiffs subsequently stipulated to the dismissal with prejudice of their claims under the Securities Act of 1933 on October 14, 1993. The defendants filed a motion requesting certification of an appeal from the District Court order to the United States Court of Appeals for the Third Circuit pursuant to 12 U.S.C. 1292(b) on October 29, 1993. The defendants also filed an Answer denying the allegations of the Second Consolidated Amended Class Action Complaint on October 28, 1993. The District Court by order dated December 3, 1993 denied the defendants' motion requesting certification of an appeal. Discovery commenced in January 1994. As permitted by New Jersey law, the expenses of the individual defendants are being advanced by UJB. The Board and management of UJB believe the allegations contained in the lawsuit to be lacking in merit and intend to defend this lawsuit vigorously. OTHER LITIGATION 1. McAdoo CERCLA Matter. First Valley Bank ("FVB") foreclosed on property in McAdoo, Pennsylvania, taking title by a sheriff's deed in 1980. The property was later designated by the United States Environmental Protection Agency ("EPA") as a part of a site (the "McAdoo Site") listed on the National Priorities List of sites to be remediated pursuant to the federal Comprehensive Environmental Response Compensation and Liability Act ("CERCLA"). On June 3, 1988, the United States District Court for the Eastern District of Pennsylvania entered a Consent Decree in United States v. Air Products and Chemicals, Inc., Civil Action No. 87-7352 (the "Air Products litigation"), in which sixty-five potentially responsible parties ("PRPs"), not including FVB, agreed to undertake remediation of the McAdoo Site and the United States agreed to pay 25% of the settling PRPs (the "Initial PRPs") cost of remediation. On June 11, 1988, after having made a demand upon FVB and a number of other non-settling PRPs, the United States sued a number of the PRPs other than FVB who did not enter into the Consent Decree in a matter entitled United States of America v. Alcan Aluminum et al, United States District Court, Eastern District of Pennsylvania, Civil Action No. 88-4970 (the "Alcan litigation"). Although the United States did not sue FVB, on April 16, 1990, one defendant in the Alcan Litigation, Kalama Chemical, Inc., filed a motion for leave to file a third party complaint against FVB seeking contribution. The motion was denied without prejudice. FVB then participated in settlement discussions in the Alcan litigation. Pursuant to those negotiations, FVB and certain defendants, third-party defendants and other potential third-party defendants deposited, in a Court registry, a sum which the United States agreed will satisfy all of its claims against FVB. The parties also executed a Consent Decree which was approved by the District Court by Order dated June 24, 1993. The Consent Decree gives FVB a broad covenant not to sue and contribution protection to the extent available under 42 U.S.C. sec. 9622(d)(2). The Consent Decree was the subject of public notice and comment, pursuant to 42 U.S.C. sec. 9622(d)(2). The Initial PRPs submitted comments to the United States objecting to the Consent Decree, including inter alia, the broad release provided to FVB. The Initial PRPs also filed a motion to intervene in the Alcan litigation, which was denied by the District Court. The Initial PRPs then appealed that denial to the United States Court of Appeals for the Third Circuit in a matter captioned United States v. Alcan Aluminum, Inc., et al., Action No. 93-1099 (3rd Cir.). Briefs have been submitted in the appeal, the Court heard oral argument on December 2, 1993, and the parties are awaiting the decision. 2. In re Payroll Express Corporation of New York and Payroll Express Corporation, United States Bankruptcy Court for the Southern District of New York, Case Nos. 92-B-43149 (CB) and 92-B-43150 (CB). United Jersey Bank (the "Bank") is involved in six Chapter 11 cases venued in the United States Bankruptcy Court for the Southern District of New York (the "Bankruptcy Cases") involving a former customer of the Bank, Payroll Express Corp. ("Payroll"), and several related entities. Payroll was primarily in the business of providing on-site check cashing services. Customers of Payroll deposited funds into a general deposit account ("Account") at the Bank to cover their payrolls. The Account was given credit for deposits received by Payroll and cash was obtained by debiting the Account. Payroll perpetrated a substantial check kiting scheme using the Account and another account at National Westminster Bank, NJ ("NatWest"). NatWest apparently discovered this scheme in late May of 1992. Due to this discovery, NatWest ceased honoring checks drawn by Payroll on its account. UJB was ultimately left with a loan of approximately $4 million in the Account. On June 5, 1992, Robert Falzenberg, the President of Payroll, was charged in a federal court located in Manhattan with embezzlement and wire fraud. He has pled guilty to among other things, wire and tax fraud, and was sentenced to 6 1/2 years imprisonment in March 1994. A trustee (the "Trustee") has been appointed by the Bankruptcy Court, and he is currently conducting an investigation of Payroll. The Trustee has also retained special counsel to pursue potential claims against the fidelity insurers of Payroll Express Corp. and possibly Payroll's insurance agent. Several parties concerned with the Bankruptcy Cases have undertaken an extensive discovery process pursuant to a Discovery Order under Bankruptcy Rule 2004. Several depositions have been taken and numerous documents exchanged. Payroll customers deposited a total of $11.8 million dollars into the Account during this period of time. Several of these customers have asserted claims against the Bank, although only two lawsuits by sixteen customers, are currently pending against the Bank: Beth Israel Medical Center, et al. v. United Jersey Bank and National Westminster Bank NJ, United States District Court for the District of New Jersey, Civ. No. CV-93-4348 (WGB), and Towers Financial Corp. v. United Jersey Bank, United States District for the Court District of New Jersey, Civ. No. CV-92-2175 (WGB). The two lawsuits allege various causes of action, including unjust enrichment, restitution, conversion, fraud, negligence and/or breach of fiduciary duty. The two lawsuits allege a total of approximately $7.2 million in damages. Towers has filed for protection under the bankruptcy laws and the above case has been inactive for several months. The bank has recently filed a motion in the Beth Israel case to stay that litigation pending future developments in the Bankruptcy Cases. Other customers may also claim that money credited to the Account should be returned by the Bank. The Trustee appointed in the Bankruptcy Cases described above has filed an adversary proceeding entitled John E. Pereira, as Chapter 11 Trustee v. UJB, Adversary Proceeding No. 93-1086A in the bankruptcy court for the Southern District of New York, which claims that these deposits should be recovered by the Payroll Express estate as an avoidable preference. The Bank believes it has acted within its rights and that it possesses substantial meritorious defenses with regard to all of the cases described above. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No applicable. EXECUTIVE OFFICERS OF THE REGISTRANT. The following data is supplied as of March 11, 1994: The term of each of the above officers is until the next organization meeting of the Board of Directors, which occurs immediately following the annual meeting of shareholders, and until a successor is appointed by the Board of Directors. Each officer may be removed at any time by the Board of Directors without cause. Management of UJB is not aware of any family relationship between any director or executive officer or person nominated or chosen to become a director or executive officer. All of the executive officers named above have been employed in executive positions by UJB, a subsidiary of UJB or a bank holding company merged into UJB for more than the last five years, except Mr. Betsinger. Mr. Betsinger was previously employed by Meritor Financial Corp. (diversified financial services holding company), Philadelphia, PA, as senior vice president and chief information officer (1986-1989). PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. This item has been omitted pursuant to paragraph (2) of General Instruction "G" -- Information to be Incorporated by Reference. See the Shareholders' Equity and Dividends section in the Financial Review on pages 32 and 33, Notes 12 and 13 to the Consolidated Financial Statements on pages 46 and 47 and Unaudited Quarterly Financial Data on page 53 of the 1993 Annual Report incorporated herein by reference as Exhibit 13. At February 28 , 1994 there were 20,636 record holders of UJB Common Stock. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. This item is omitted pursuant to paragraph (2) of General Instruction "G" -- Information to be Incorporated by Reference. See Summary of Selected Financial Data on Page 2 of the 1993 Annual Report incorporated herein by reference as Exhibit 13. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. This item is omitted pursuant to paragraph (2) of General Instruction "G" -- Information to be Incorporated by Reference. See Financial Review on pages 25 through 35 of the 1993 Annual Report incorporated herein by reference as Exhibit 13. Reference is made to page 10 of this report for a discussion of the effects of inflation. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. This item is omitted pursuant to paragraph (2) of General Instruction "G" -- Information to be Incorporated by Reference. See Consolidated Financial Statements and Notes to Consolidated Financial Statements on pages 38 through 51 of the 1993 Annual Report incorporated herein by reference as Exhibit 13. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. This item is omitted pursuant to paragraph (3) of General Instruction "G" -- Information to be Incorporated by Reference, except that certain information on Executive Officers of the Registrant is included in Part I of this report. A definitive proxy statement, dated March 11, 1994 (the "Proxy Statement"), was filed with the Securities and Exchange Commission. Information required by Item 401 of Regulation S-K is provided at page 25 of this Annual Report on Form 10-K and at pages 2-5 of the Proxy Statement under the caption "Election of Directors", which is hereby incorporated herein by reference. Information required by Item 405 of Regulation S-K is provided at pages 17-18 of the Proxy Statement in the material appearing under the caption "Additional Information Regarding Directors and Officers" and is hereby incorporated herein by reference. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. This item is omitted pursuant to paragraph (3) of General Instruction "G" -- Information to be Incorporated by Reference. Information required by Item 402 of Regulation S-K is provided at page 9 of the Proxy Statement under the caption "Corporate Governance of UJB -- Remuneration of Directors", at pages 9-10 and 12-15 of the Proxy Statement under the caption "Compensation Committee Report on Executive Compensation", at pages 11 and 14 of the Proxy Statement under the captions "Summary Compensation Table", "Options/SAR Grants in Last Fiscal Year" and "Aggregated Option/SAR Exercises in Last Fiscal Year and Fiscal Year-End Option/SAR Values", at page 16 of the Proxy Statement under the caption "Stock Performance Graph" and at pages 18-21 of the Proxy Statement under the caption "Certain Information As To Executive Officers", all of which information is hereby incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. This item has been omitted pursuant to paragraph (3) of General Instruction "G" -- "Information to be Incorporated by Reference". Information required by Item 403 of Regulation S-K is provided at page 1 of the Proxy Statement in the introductory information to the Proxy Statement and at pages 6-7 of the Proxy Statement under the caption "Beneficial Ownership of UJB Equity Securities by Directors and Executive Officers", all of which is hereby incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. This item is omitted pursuant to paragraph (3) of Instruction "G" -- "Information to be Incorporated by Reference". Information required by Item 404 of Regulation S-K is provided at pages 17-18 of the Proxy Statement in the material appearing under the caption "Additional Information Regarding Directors and Officers", which is hereby incorporated herein by reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. a)(1) Financial statements, UJB Financial Corp. and Subsidiaries: Financial statement schedules are omitted as the required information is not applicable or the information is presented in the financial statements or related notes thereto. (3) Other Exhibits (all references to Forms 8-K, 10-K and 10-Q refer to Securities and Exchange Commission File No. 1-6451. Other Exhibits are numbered in accordance with Item 601 of Regulation S-K): (2) Plan of acquisition, reorganization, arrangement, liquidation or succession. A. Agreement and Plan of Merger, dated December 16, 1993, between UJB Financial Corp. and VSB Bancorp, Inc., as amended (incorporated by reference without exhibits to Exhibits 2(a) and 2(b) to Registration Statement No. 33-52769 on Form S-4, filed March 21, 1994). (3) Articles of incorporation; By-laws. (8) A. Restated Certificate of Incorporation of UJB Financial Corp., as restated July 1, 1988, as amended through August 20, 1993 (incorporated by reference to Exhibit (3)A.(i) on Form 10-Q for the quarter ended September 30, 1993). B. By-Laws of UJB Financial Corp. as amended through December 16, 1992 (incorporated by reference to Exhibit (3)B.(i) on Form 8-K, dated December 16, 1992). (4) Instruments defining the rights of security holders, including indentures. A. Rights Agreement, dated as of August 16, 1989, by and between UJB Financial Corp. and First Chicago Trust Company of New York, as Rights Agent (incorporated by reference to Exhibit 2 to the Registration Statement on Form 8-A, filed August 28, 1989). B. Indenture, dated as of November 1, 1972, between UJB Financial Corp. (under former name of United Jersey Banks) and The Bank of New York, as Trustee, for $20,000,000 of 7 3/4% Sinking Fund Debentures due November 1, 1997 (incorporated by reference to Exhibit 4(a) to Amendment No. 2 to Registration Statement No. 2-45397 on Form S-1, filed October 25, 1972). C. Purchase Agreement, dated October 25, 1972, between UJB Financial Corp. (under former name of United Jersey Banks) and Merrill Lynch, Pierce, Fenner & Smith Incorporated and Salomon Brothers, for 7 3/4% Sinking Fund Debentures (incor- - --------------- *Refers to the respective page numbers of UJB Financial Corp. 1993 Annual Report to Shareholders included as Exhibit 13. Such pages are incorporated herein by reference. porated by reference to Exhibit 1(b) to Amendment No. 2 to Registration Statement No. 2-45397 on Form S-1, filed October 25, 1972). D. Note Agreement, dated as of August 19, 1993, between UJB Financial Corp. and The Northwestern Mutual Life Insurance Company relating to $20,000,000 of 7.95% Senior Notes Due August 25, 2003 (incorporated by reference to Exhibit (4)D. on Form 10-Q for the quarter ended September 30, 1993). E. (deleted) F. (deleted) G. (i) Subordinated Indenture, dated as of December 1, 1992, between UJB Financial Corp. and Citibank, N.A., Trustee, relating to $175,000,000 of 8 5/8% Subordinated Notes Due December 10, 2002 of UJB Financial Corp. (incorporated by reference to Exhibit (4)G. on Form 10-K for the year ended December 31, 1992), and (ii) Specimen of UJB Financial Corp.'s 8 5/8% Subordinated Notes Due December 10, 2002 (incorporated by reference to Exhibit 4 on Form 8-K, dated December 10, 1992). H. (deleted) I. (deleted) J. (deleted) K. (i) Indenture, dated as of August 1, 1983, between Commercial Bancshares, Inc. and Midlantic National Bank, Trustee, relating to the 13% Subordinated Debentures of UJB Financial Corp. (incorporated by reference to Exhibit (4)K.(i) to Registration Statement No. 33-10170 on Form S-3, filed November 14, 1986). (ii) First Supplemental Indenture, dated as of December 1, 1986, between Commercial Bancshares, Inc., UJB Financial Corp. (under former name of United Jersey Banks) and Midlantic National Bank, Trustee, relating to the 13% Subordinated Debentures of UJB Financial Corp. (incorporated by reference to Exhibit (4)K.(ii) on Form 10-K for the year ended December 31, 1992). L. (deleted) M. (deleted) N. (deleted) O. (deleted) P. (deleted) Q. (deleted) R. (i) Note Agreement, dated as of November 10, 1985, between First Valley Corporation and the Northwestern Mutual Life Insurance Company relating to $20,000,000 of 11 1/2% Senior Notes Due December 15, 1995 of First Valley Corporation (incorporated by reference to Exhibit (4)R.(i) on Form 10-K for the year ended December 31, 1992), (ii) Guarantee, dated February 28, 1989, of UJB Financial Corp. (under former name of United Jersey Banks) guaranteeing full and timely payment of principal and interest due from First Valley Corporation under the Note Agreement, (iii) Letter Amendment, dated April 6, 1989, to the Note Agreement (incorporated by reference to Exhibit (4)R.(iii) on Form 10-Q for the quarter ended March 31, 1989), (iv) Second Amendment, dated August 18, 1989, to the Note Agreement (incorporated by reference to Exhibit (4)R.(iv) on Form 10-Q for the quarter ended June 30, 1993), and (v) Third Amendment, dated September 1, 1993, to the Note Agreement (incorporated by referenced to Exhibit (4)R.(v) on Form 10-Q for the quarter ended September 30, 1993). (10) Material Contracts A. Ten year real estate lease executed and dated July 27, 1989 from Polevoy Associates for real property and improvements located thereon in Fair Lawn, New Jersey for use as purchasing department offices and warehouse facility (incorporated by reference to Exhibit (10)A. on Form 10-K for the year ended December 31, 1989). B. (i) Master Agreement of Lease, dated January 26, 1982, between United Jersey Banks (former name of UJB Financial Corp.) and Sha-Li Leasing Associates, Inc. relating to equipment leases in excess of $10,000,000 in aggregate lease obligations, including form of Equipment Schedule (incorporated by referenced to Exhibit (10)B.(i) on Form 10-Q for the quarter ended September 30, 1993), (ii) Assignment and Assumption of Equipment Lease, effective December 31, 1991, between UJB Financial Corp. and UJB Financial Service Corporation (relating to assignment of Master Agreement of Lease) (incorporated by reference to Exhibit (10)B.(ii) on Form 10-Q for the quarter ended September 30, 1993), and (iii) Form of Guaranty Agreement between UJB Financial Corp. and various lenders under the Master Agreement of Lease relating to certain equipment leases in excess of $10,000,000 in aggregate lease obligations (incorporated by reference to Exhibit (10)B.(iii) on Form 10-Q for the quarter ended September 30, 1993). *C. (i) UJB Financial Corp. 1993 Incentive Stock and Option Plan (incorporated by reference to Exhibit 10(C) to Registration Statement No. 33-62972 on Form S-8, filed May 19, 1993), and (ii) Compensation Committee Regulations for the Grant and Exercise of Stock Options and Restricted Stock (adopted July 19, 1993) (incorporated by reference to Exhibit (10)C.(ii) on Form 10-Q for the quarter ended June 30, 1993). *D. (i) UJB Financial Corp. 1990 Stock Option Plan (incorporated by reference to Exhibit (10)D. on Form 10-Q for the quarter ended June 30, 1990), and (ii) Compensation Committee Regulations for the Grant and Exercise of Stock Options and Restricted Stock (adopted July 19, 1993) (incorporated by reference to Exhibit (10)C.(ii) on Form 10-Q for the Quarter ended June 30, 1993). *E. (i) UJB Financial Corp. 1989 Long-Term Performance Stock Plan (incorporated by reference to Exhibit (10)E. on Form 10-K for the year ended December 31, 1990), and (ii) Compensation Committee Regulations for the Grant and Exercise of Stock Options and Restricted Stock (adopted July 19, 1993) (incorporated by reference to Exhibit (10)C.(ii) on Form 10-Q for the Quarter ended June 30, 1993). *F. Description of Incentive Plan approved January 20, 1982 (incorporated by reference to Exhibit (10)F. on Form 10-K for the year ended December 31, 1989). G. Deferred Compensation Plan for Directors, as revised October 17, 1979 (incorporated by reference to Exhibit (10)G. on Form 10-K for the year ended December 31, 1989). *H. (i) Agreement dated April 2, 1981 between UJB Financial Corp. (under former name of United Jersey Banks) and T. Joseph Semrod (incorporated by reference to Exhibit (10)H.(i) on Form 10-K for the year ended December 31, 1989), with (ii) Amendment No. 1 dated May 5, 1981 (incorporated by reference to Ex- - --------------- * Management contract or compensatory plan or arrangement. hibit (10)H.(ii) on Form 10-K for the year ended December 31, 1989), (iii) Amendment No. 2 dated December 15, 1982 (incorporated by reference to Exhibit (10)H.(iii) on Form 10-K for the year ended December 31, 1989), and (iv) Amendment No. 3 dated August 20, 1986 (incorporated by reference to Exhibit (10)H.(iv) on Form 10-K for the year ended December 31, 1989). I. (deleted) J. (deleted) K. (i) Guaranty Agreement, dated August 7, 1991, by and between UJB Financial Corp. and Security Pacific National Bank, as Trustee (incorporated by reference to Exhibit (10)K.(i) on Form 10-Q for the quarter ended June 30, 1991), (ii) Warranty Bill of Sale, dated August 7, 1991, of Trico Mortgage Company (incorporated by reference to Exhibit (10)K.(ii) on Form 10-Q for the quarter ended June 30, 1991), and (iii) Pooling and Servicing Agreement, dated as of June 30, 1991, by and among Trico Mortgage Company, Inc., Securitization Subsidiary I, Inc. and Security Pacific National Bank, as Trustee (incorporated by reference to Exhibit (10)K.(iii) on Form 10-Q for the quarter ended June 30, 1991). *L. (i) United Jersey Banks (former name of UJB Financial Corp.) 1982 Stock Option Plan (incorporated by reference to Exhibit 4 to Registration Statement No. 2-78500 on Form S-8, filed July 21, 1982) with (ii) Amendment No. 1, dated June 16, 1984 (incorporated by reference to Exhibit (10)L.(ii) on Form 10-K for the year ended December 31, 1989), (iii) Amendment No. 2, dated December 19, 1990 (incorporated by reference to Exhibit (10)L.(iii) on Form 10-K for the year ended December 31, 1990.), and (iv) Compensation Committee Regulations for the Grant and Exercise of Stock Options and Restricted Stock (adopted July 19, 1993) (incorporated by reference to Exhibit (10)C.(ii) on Form 10-Q for the Quarter ended June 30, 1993). . *M. (i) Retirement Restoration Plan, adopted April 19, 1993 (incorporated by reference to Exhibit (10)M.(i) on Form 10-K for the year ended December 31, 1989), (ii) Supplemental Retirement Plan, adopted August 16, 1989 (incorporated by reference to Exhibit (10)M.(ii) on Form 10-Q for the quarter ended September 30, 1989), and (iii) Written Consent of UJB Financial Corp. Benefits Committee interpreting the Retirement Restoration Plan, adopted August 30, 1989 (incorporated by reference to Exhibit (10)M.(iii) on Form 10-Q for the quarter ended September 30, 1989). N. (i) Equipment Lease Guaranty dated as of August 31, 1992 by UJB Financial Corp. to Sanwa General Equipment Leasing, Inc. (incorporated by reference to Exhibit (10)N.(i) on Form 10-Q for the quarter ended March 31, 1993), and (ii) Equipment Lease Agreement dated as of August 31, 1992 and Equipment Schedule Nos. A-1 and A-2 dated as of August 31, 1992 between Sanwa General Equipment Leasing, Inc. and UJB Financial Service Corporation, United Jersey Bank, United Jersey Bank/Central, N.A. and United Jersey Bank/South, N.A., pursuant to Equipment Lease Agreement dated as of August 31, 1992, for five year lease of furniture, fixtures and equipment (incorporated by reference to Exhibit (10)N.(ii) on Form 10-Q for the quarter ended March 31, 1993). - --------------- * Management contract or compensatory plan or arrangement. O. (i) Equipment Lease Guaranty dated as of August 31, 1992 by UJB Financial Corp. to MetLife Capital Corporation (incorporated by reference to Exhibit (10)O.(i) on Form 10-Q for the quarter ended March 31, 1993), and (ii) Equipment Schedule Nos. B-1 and B-2 dated as of August 31, 1992 between MetLife Capital Corporation and UJB Financial Service Corporation, United Jersey Bank, United Jersey Bank/Central, N.A. and United Jersey Bank/South, N.A. pursuant to Equipment Lease Agreement dated as of August 31, 1992 between Sanwa General Equipment Leasing, Inc. and United Jersey Bank, United Jersey Bank/Central, N.A. and United Jersey Bank/South, N.A., for five year lease of furniture, fixtures and equipment (incorporated by reference to Exhibit (10)O.(ii) on Form 10-Q for the quarter ended March 31, 1993). P. Twenty-year real estate lease executed and dated December 12, 1988 from Hartz Mountain Industries, Inc. for real property located in Ridgefield Park, New Jersey and improvements to be constructed by Hartz thereon for use as new data processing facility for the company. Q. (deleted) R. (i) UJB Financial Corp. Savings Incentive Plan, amended and restated as of July 1, 1993 (incorporated by reference to Exhibit (10)R. on Form 10-Q for the quarter ended June 30, 1993), with (ii) amendments adopted November 29, 1993, and (iii) amendments adopted January 24, 1994. S. (i) Trust Agreement for the United Jersey Banks Profit Sharing Plan (now UJB Financial Corp. Savings Incentive Plan) made as of January 1976 (incorporated by reference to Exhibit (10)M. to Registration Statement No. 1-82789 on Form S-8, filed March 31, 1988), with (ii) Amendment No. 1, dated June 21, 1983 (incorporated by reference to Exhibit (10)S.(ii) on Form 10-K for the year ended December 31, 1989), and (iii) Amendment No. 2, dated August 15, 1984 (incorporated by reference to Exhibit (10)S.(iii) to Post-Effective Amendment No. 1 to Registration Statement No. 2-82789 on Form S-8, filed August 1, 1984). T. (deleted) U. (deleted) V. (deleted) W. (i) Retirement Plan for Outside Directors of UJB Financial Corp., as amended and restated February 20, 1990 (incorporated by reference to Exhibit (10)W. on Form 10-K for the year ended December 31, 1990), and (ii) Interpretation, dated March 15, 1993, of the Retirement Plan for Outside Directors of UJB Financial Corp. (incorporated by reference to Exhibit (10)W.(ii) on Form 10-K for the year ended December 31, 1992). X. (deleted) Y. (deleted) Z. Stock Option Agreement, dated December 16, 1993, issued by VSB Bancorp, Inc. to UJB Financial Corp. (incorporated by reference to Exhibit (10)Z. on Form 8-K, dated December 15, 1993). AA. (deleted) BB. (deleted) CC. (deleted) DD. (deleted) *EE. (i) Form of Termination Agreement between UJB Financial Corp. and each of T. Joseph Semrod, John G. Collins, John R. Howell, John R. Haggerty, Stephen H. Paneyko, Larry L. Betsinger, Alfred M. D'Augusta, William J. Healy, James J. Holzinger, William F. Flyge, Sabry J. Mackoul, Richard F. Ober, Jr., Dennis Porterfield, Alan N. Posencheg and Edmund C. Weiss, Jr. (incorporated by reference to Exhibit (10)EE.(i) on Form 10-K for the year ended December 31, 1991) with (ii) Amendment No. 1, dated December 20, 1989 (incorporated by reference to Exhibit (10)EE.(ii) on Form 10-K for the year ended December 31, 1991), (iii) Amendment No. 2, dated October 16, 1991 (incorporated by reference to Exhibit (10)EE.(iii) on Form 10-K for the year ended December 31, 1991), and (iv) Amendment No. 3, dated December 16, 1992 (incorporated by reference to Exhibit (10)EE.(iv) on Form 8-K, dated January 19, 1993). *FF. UJB Financial Corp. Executive Severance Plan, as amended through December 16, 1992 (incorporated by reference to Exhibit (10)FF. on Form 8-K, dated January 19, 1993). GG. (deleted) HH. Retirement Program for Outside Directors of Franklin State Bank (incorporated by reference to Exhibit (10)HH. on Form 10-K for the year ended December 31, 1991). II. Franklin State Bank Deferred Compensation Plan adopted January 10, 1984 (incorporated by reference to Exhibit (10)II. on Form 10-K for the year ended December 31, 1991). JJ. (i) Retirement Plan for Outside Directors of Commercial Bancshares, Inc. adopted May 1, 1986 (incorporated by reference to Exhibit (10)JJ. on Form 10-K for the year ended December 31, 1991), and (ii) Compensation Committee Interpretation, dated July 19, 1993 (incorporated by reference to Exhibit (10)JJ.(ii) on Form 10-Q for the quarter ended June 30, 1993). KK. (i) Commercial Bancshares, Inc. Directors Deferred Compensation Plan adopted May 20, 1986 (substantially identical plans were adopted by former subsidiaries of Commercial Bancshares, Inc.) (incorporated by reference to Exhibit (10)KK.(i) on Form 10-K for the year ended December 31, 1991) and (ii) related Master Trust Agreement (incorporated by reference to Exhibit (10)KK.(ii) on Form 10-K for the year ended December 31, 1991). *LL. (i) United Jersey Banks (former name of UJB Financial Corp.) 1987 Stock Option Plan (incorporated by reference to Exhibit (10)LL.(i) on Form 10-K for the year ended December 31, 1991) with (ii) Amendment dated April 25, 1989 (incorporated by reference to Exhibit (10)LL.(ii) on Form 10-Q for the quarter ended March 31, 1989), (iii) amendment dated June 30, 1990 (incorporated by reference to Exhibit (10)LL.(ii) on Form 10-Q for the quarter ended June 30, 1990), and (iv) Compensation Committee Regulations for the Grant and Exercise of Stock Options and Restricted Stock (adopted July 19, 1993) (incorporated by reference to Exhibit (10)C.(ii) on Form 10-Q for the Quarter ended June 30, 1993). MM. (deleted) - --------------- * Management contract or compensatory plan or arrangement. *NN. First Valley Bank Executive Management Incentive Bonus Plan (incorporated by reference to Exhibit (10)NN. on Form 10-K for the year ended December 31, 1992). (13) UJB Financial Corp. 1993 Annual Report to Shareholders (21) Subsidiaries of the registrant. (23) Consents of Experts and Counsel A. Independent Auditor's Consent -- KPMG Peat Marwick - --------------- * Management contract or compensatory plan or arrangement. None of the Exhibits listed above other than the UJB Financial Corp. 1993 Annual Report to Shareholders are furnished herewith (other than certain copies filed with the Securities and Exchange Commission). Any of such Exhibits will be furnished to any requesting securityholder upon payment of a fee of 15c per page. Contact Lori A. Wierzbinsky, Assistant Corporate Secretary, UJB Financial Corp., P.O. Box 2066, Princeton, NJ 08543-2066 for a determination of the fee necessary to fulfill any request. b) Reports on Form 8-K. In a Current Report on Form 8-K, dated December 15, 1993, the Company, under Item 5 -- Other Events and Item 7 -- Financial Statements and Exhibits, reported the following: On December 15, 1993, the Board of Directors of the Company approved a 31.3% increase in the Company's quarterly Common Stock dividend to $.21 per share, up from the previous rate of $.16 per share. This represented an increase in the annual dividend rate on the Company's Common Stock to $.84 from $.64. On December 16, 1993, the Company and VSB Bancorp Inc., a Delaware business corporation and bank holding company registered under the federal Bank Holding Company Act of 1956 ("VSB"), entered into an Agreement and Plan of Merger (the "Agreement") providing for the merger of VSB with and into the Company and the issuance, in accordance with the exchange ratio provided for in the Agreement, of shares of the Common Stock of Registrant to shareholders of VSB in exchange for outstanding shares of the Common Stock of VSB held by such shareholders, all upon the satisfaction of the terms and conditions set forth in the Agreement, including the receipt of approval from the Board of Governors of the Federal Reserve System (the "Merger"). Simultaneously with the execution of the Agreement, the Company and VSB entered into a stock option agreement, dated December 16, 1993 (the "Stock Option Agreement"), pursuant to which Registrant acquired from VSB and VSB granted to the Company the option to purchase 841,704 shares of the Common Stock of VSB at $18.125 per share (the "Option"). The Option is exercisable upon the occurrence of a Purchase Event (as defined in the Stock Option Agreement). The Option terminates upon the occurrence of an Exercise Termination Event (as defined in the Stock Option Agreement). SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. UJB FINANCIAL CORP. Dated: March 18, 1994 By: /s/ J. R. HAGGERTY John R. Haggerty Senior Executive Vice President/Finance Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. EXHIBIT INDEX

64605_1993.txt

64605

1993

Item 1. The Business General Medical Monitors, Inc. (the "Registrant"), is a corporation organized under Delaware law in February, 1975. The Registrant previously developed an automated electronic blood pressure measuring device that can be used by individuals to measure their own blood pressure without training or assistance. The Registrant has experienced significant operating losses since inception, and at February 28, 1993 had an accumulated deficit of $1,960,211. The Registrant has been without any material funds to develop and expand its business since the Fall of 1981 when management determined that the Registrant should remain in an inactive status pending the development of an improved AES Unit. No such improve of the AES Unit was undertaken by the Registrant and the has been no active business operations. Since that time, Harry Shuster, the sole officer and director of the Registrant has personally financed the maintenance of the Registrant by making non-interest bearing loans to the Registrant. There can be no assurance that Mr. Shuster will be willing or able to continue personally finance the Registrant's operations or maintenance of the Registrant in the future. At present, the Registrant has no active business. The Registrant proposes to combine with an existing, privately-held Registrant which is profitable and, in management's view, has growth potential (irrespective of the industry in which it is engaged). A combination may be structured as a merger, consolidation, exchange of the Registrant's Common Stock for stock or assets or any other form which will result in the combined enterprise's being a publicly-held corporation. The Registrant will pursue a combination with a Registrant or business enterprise that satisfies its combination suitability standards by advertising in one or more newspapers or magazines to establish contact with, or by otherwise contacting, selected privately-held companies which are profitable and are believed to have growth potential. There are no assurances that management of the Registrant will be able to locate a suitable combination partner or that a combination can be structured on terms acceptable to the Registrant. Pending negotiation and consummation of a combination, the Registrant anticipates that it will have limited business activities, will have no significant sources of revenue and will incur no significant expenses or liabilities. If expenses are incurred and funds are necessary the Registrant may undertake a private placement of its common stock or borrow the necessary capital from its officers and directors. Should necessary funds be available, the Registrant will engage attorneys, accountants and/or other consultants to evaluate and assist in completing a potential combination. Capital Expenditures The Registrant plans no significant expenditures. Employees The Company currently has one employee, Harry Shuster, who is the sole officer and director of the Company. The Company is not a party to any collective bargaining agreement. Item 2.

Item 2. Properties The Company owns no real property or other materially important physical facilities. The Company uses offices maintained personally by Harry Shuster, the sole officer and director of the Company, at no cost to the Company. Item 3.

Item 3. Legal Proceedings There are no material pending legal proceedings to which the Company is a party or of which any of its property is subject. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders. No matter was submitted to a vote of security holders of the Company during the fourth quarter of the fiscal year ended February 28, 1993 through the solicitation of proxies, or otherwise. PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. The Common Stock, $.01 par value, or the Company is very thinly traded in over-the-counter market with the bid and ask ranging between $.01 and $.02. There were approximately 1,746 holders of record of the Common Stock, $.0l par value, of the Company as of February 28, 1993. The Company has paid no cash dividends on its Common Stock, $.001 par value, in the past and does not contemplate paying dividend in the foreseeable future. Future declaration of dividends, if any, will be determined by the Board of Directors in its discretion and will depend upon conditions then existing, including the availability of funds, requirements for working capital expenditures and debt retirement, general business condition and prospects, and other factors. The General Corporation Law of the State of Delaware provides that dividends may be declared and paid only out of surplus, as defined in such statute, or it there is no such surplus, only out of net profits for the fiscal year in which the dividend is paid and/or the preceding fiscal year. The Company has no surplus, as defined in the statute, and has not had any net profits in either of its last two fiscal years. Accordingly, any future dividends can only be declared and paid out of current earnings, if any. Item 6.

Item 6. Selected Financial Data See the Financial Statements of the Registrant in Item 8. Item 7.

Item 7. Management's Discussion And Analysis Of Financial Condition and Results Of Operations. General The Company has experienced severe working capital shortages during most of the period since 1976, primarily because of its prolonged experience in its research and development stage and its subsequent inability to obtain delivery of product from its manufactured. The Registrant had been primarily a one product company, engaged in the development of its automated electronic blood pressure measuring device known as the AES Unit. Since February 28, 1985, the Company has had no active business operations of any kind. All risk inherent in new and inexperienced enterprises are inherent the Company's business. The Company has not made a formal study of the economic potential of any business. At the present, the Company has not identified any assets or business opportunities for acquisition. As of February 28, 1993 the Company has no liquidity and no presently available capital resources, such as credit lines, guarantees, etc. and should a merger or acquisition prove unsuccessful, it is possible that the Company may be dissolved by the State of Delaware for failing to file reports, at which point the Company would no longer be a viable corporation under Delaware law and would be unable to function as a legal entity. Should management decide not to further pursue its acquisition activities, management may abandon its activities asked the shares of the Company would become worthless. However, the Company's officers, directors and majority shareholder, have made an oral undertaking to make loans to the Company in amounts sufficient to enable it to satisfy its reporting requirements and other obligations incumbent on it as a public company, and to commence, on a limited basis, the process of investigating possible merger and acquisition candidates. The Company's status as a publicly-held corporation may enhance its ability to locate potential business ventures. The loans will be interest free and are intended to be repaid at a future date, or when the Company shall have received sufficient funds through any business acquisition. The loans are intended to provide for the payment of filing fees, professional fees, printing and copying fees and other miscellaneous fees. Based on current economic and regulatory conditions, Management believes that it is possible. if not probable, for a company like the Company, without assets or liabilities, to negotiate a merger or acquisition with a viable private company. The opportunity arises principally because of the high legal and accounting fees and the length of time associated with the registration process of "going public". However, should any of these conditions change, it is very possible that there would be little or no economic value for anyone taking over control of the Company. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Page Balance Sheets - for the Years ended February 28, 1993 and 1992.......... 6 Statement of Operations and Accumulated Deficit.......................... 7 Statement of Cash Flows.................................................. 8 Notes to Financial Statements............................................ 9-10 All other schedules are not submitted because they are not applicable or not required or because the information is included in the financial statements or notes thereto. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. MEDICAL MONITORS BALANCE SHEETS FEBRUARY 28, 1993 AND 1992 See accompanying Notes to Financial Statements. MEDICAL MONITORS STATEMENTS OF OPERATIONS AND ACCUMULATED DEFICIT FOR THE YEARS ENDED FEBRUARY 28, 1993 AND 1992 See accompanying Notes to Financial Statements. MEDICAL MONITORS STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED FEBRUARY 28, 1993 AND 1992 See accompanying Notes to Financial Statements. MEDICAL MONITORS NOTES TO FINANCIAL STATEMENTS FEBRUARY 28, 1993 AND 1992 (UNAUDITED) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES. Description of Business - Medical Monitors, Inc. (the "Company") was incorporated in Delaware in February 1975. Initially, its purpose was to develop and market blood pressure measuring devices. In April 1980, the Company raised $884,000 from the initial public offering of its common stock. Because the Company was unable to raised additional capital to continue developing and marketing its product, in the Fall of 1981, it ceased its operations. In 1986, the Company ceased making the required public filings under the Securities and exchange Act of 1934, as amended. The Board of Directors of the Company is currently investigating the possibility of a new business direction and searching for viable acquisition or merger candidates which would enable the Company to maximize value to its shareholders. Use of Estimates - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Income Taxes - Income taxes are provided using the liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis (i.e., temporary differences). Net Income (Loss) Per Share - Net Income (loss) per share is calculated using the weighted average number of common shares outstanding. Common share equivalents are included to the extent they are dilutive. 2. GOING CONCERN. The Company ceased its operations in the Fall of 1981. The Company's ability to continue as a going concern will be dependent upon obtaining a viable business through merger or acquisition. There can be no assurance that the Company will be able to find a business to acquire or merge with. 3. NOTES PAYABLE. Notes payable consisted of the following at February 28, 1993 and 1992: 1993 1992 ----------- ---------- Non-interest bearing advances payable To H. Shuster $ 84,865 $ 84,865 Non-interest bearing notes payable to Loma Vista, Ltd. 379,833 379,833 Non-interest bearing note payable to European Diamond trading Corporation 20,750 20,750 ----------- --------- $ 485,448 $485,448 =========== ========= A portion of the notes payable to Loma Vista, Ltd. In the amount of $304,000 is secured by all assets of the Company. Harry Shuster, the President of the Company, is the sole general partner of Loma Vista, Ltd. Harry Shuster is an officer and majority shareholder of European Diamond Trading Corporation. All of the above notes are in default. 4. ACCRUED OFFICER'S SALARIES. Accrued officer's salaries consisted of amounts due Harry Shuster under his employment agreement which expired in December 1981. PART III Item 10.

Item 10. Directors and Executive officers of the Registrant. The following table sets forth certain information concerning the Directors and executive officers of the Company. A Age Principal Occupation and all Director Name Positions With the Company Since - ------------------------------------------------------------------------------- Harry Shuster Director and Chief Executive Officer 1975 President, Secretary and Chief Financial Officer 1986 Harry Shuster is a founder of the Company and has been its Chairman of the Bard, President and a Director since its inception in February, 1975. Mr. Shuster was also Treasurer of the Company until August, 1981. In 1967, Mr. Shuster founded Lion Country Safari, Inc. a publicly-held corporation whose Common Stock is registered under Section 12(g) of the Securities Exchange Act of 1934, which operates an African wildlife preserve and theme amusement park in Irvine, California. Mr. Shuster has served as Lion Country Safari, Inc.'s chief executive officer and a director since 1967, in which capacity he has directed the marketing and promotional efforts relating to the Lion Country Safari operations. Since March, 1976, Mr. Shuster has served under a consulting agreement which does not require his full-time services in such capacities for Lion Country Safari, Inc. It is estimated that approximately 20% of Mr. Shuster's business working hours were devoted to his position as Chief Executive Officer of the Company during the fiscal year ended February 28, 1985. Since the Company moved into an inactive status in late 1981, Mr. Shuster has only spent so much of his time on the business and affairs of the Company as his duties as Chief Executive Officer have required. Accordingly, Mr.. Shuster's services to Lion Country Safari Inc. have occupied more and more of his working time and, from time-to-time will likely continue to restrict the amount of time which Mr. Shuster can make available to the Company's business. See "Management Compensations" and "Certain Relationships and Related Transactions" in items 11 and 13, respectively, of this Annual Report on Form 10-K. Mr. Shuster is an attorney admitted to the Supreme Court of South Africa. The present term of each Director will expire at the time of the next Annual Meeting of Stockholders of the Company. Executive officers are elected each year at the Annual Meeting of the Board of Directors held immediately following the Annual Meeting of Stockholders and hold office until the next Annual Meeting of the Board of Directors or until their successors are duly elected and qualified. The Company has held no Annual Meeting of Shareholders since August 26, 1980. There are no arrangements or understandings known to the Company between any of the Directors or executive officers of the Company and any other person pursuant to which any of such persons was or is to be selected as a Director or an executive officer. There are no family relationships between any Director or executive officer and any other Director or executive officer of the Company. The Board of Directors has held no formal meetings since 1983. The Company has no standing audit, nominating or compensation committees of the Board of Directors. Item 11.

Item 11. Management Compensation Management Compensation No officer or Director of the Company either received or had accrued on the books of the Company any remuneration with respect to the fisca1 year ended February 28, 1993. There was no health or life insurance provided to officers or Directors by the Company which discriminates in favor of officers or Directors and which is not available generally to all salaried employees of the Company. The Company has no employee incentive, bonus or benefit plans, profit sharing plans, retirement plans, deferred compensation plans or similar arrangements. No fees are paid Directors for attendance at meetings of the Board of Directors, although out-of-pocket expenses incurred in connection therewith are reimbursed. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management The following table sets forth certain information with respect to all persons, or groups of persons, known by the Company to own beneficially more than five percent of the Common Stock, $.01 par value, of the Company, its only outstanding class of voting securities, and as to the beneficial ownership thereof of the Directors of the Company, individually, and all Directors and officers as a group, all as at February 28, 1993. Name and Address of Amount and Nature or Beneficial Owner (a) Beneficial Ownership Percentages(b) - -------------------- -------------------- -------------- Harry Shuster 1900 Westwood Blvd. Los Angeles, California 90025 16,082,088 32.16% Loma Vista, Ltd. c/o Harry Shuster 1900 Westwood Blvd. Los Angeles, California 90025 3,318,985 (c) 6.64%(c) Richard Weisman 16200 Ventura Blvd. Suite 201 Encino, California 91436 2,631,745 (d) 5.26%(d) All officers and Directors as A Group (One person) 19,401,073 (e) 38.80%(e) - ---------------- (a) Addresses are shown only for the beneficial owners of at least five-percent of the Common Stock of the Company. (b) Percentages are determined on the basis of 50,000,000 shares of outstanding Common Stock. (c) Loma Vista Ltd. is a limited partnership of which Harry Shuster, Chairman of the Board, President and Chief Executive Officer of the Company, is the general partner and through which Mr. Shuster has an interest in shares of the Company's Common Stock. A portion of the shares originally issued to Loma Vista, Ltd. were subsequently distributed to several of its limited partners. All of the shares now owned by Loma Vista, Ltd. are allocated to Mr. Shuster's general partner's interest in such limited partnership. (d) Mr. Weisman, a former Director of the Company, holds 545,106 of these shares directly, 86,000 as executor of his father's estate, and a total of 800,151 shares as trustee for his adult sons. As to all of these shares, Mr. Weisman can be said to have sole investment and voting power. The remaining shares are owned by Mr. Weisman's wife, sister and mother and Mr. Weisman disclaims any beneficial ownership thereof. (e) Includes shares owned by Loma Vista, Ltd. PART IV. Item 13.

Item 13. Certain Relationship and Related Transactions. The following table outlines certain information with respect to obligations of the Company to its present principal stockholders and their affiliates as of February 28, 1993. Accrued Purchase Loans for Total Due AES to the Services At End of Obligee Rights Company Rendered year - ------------------------------------------------------------------------------ Loma Vista, Ltd. $ 75,833(1) $304,000 (1) $ - $379,833 European Diamond Trading Corporation (2) 20,750 20,750 Harry Shuster 84,865 - 84,865 - ------------------------------------------------------------------------------ $ 75,833 $409,615 $283,464 $ 768,912 ======== ======== ======== ========== (1) This note is secured by a pledge of all assets of the Company. These notes are presently in default, but payment "thereof has not been demanded by Loma Vista, Ltd. See Note 3 of "Notes to Financial Statements". (2) These demand notes are payable to European Diamond Trading Corporation, a corporation controlled by Harry Shuster, Chairman of the Board, President and Chief Executive Officer of the Company. All of the above notes are in default. PART IV Item 14.

Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Documents filed as a part of this report: (1) Financial Statements of the Registrant. set forth under Item 8 are filed as part of this report. (2) The Financial Statement Schedules other than those listed above have been omitted because they are either not required, not applicable, or the information is otherwise included. (b) Information filed as part of this report from Form 8-K: (1) No reports on Form 8-K were filed during the last quarter of the period covered by this report. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. MEDICAL MONITORS, INC. (Registrant) Date: March 12, 1998 /S/ Harry Shuster ------------------------------ By: Harry Shuster Its: President, Secretary and Chief Financial Officer

884033_1993.txt

884033

1993

ITEM 1. Business. The trust fund relating to Pooling and Servicing Agreement dated as of January 1, 1992 (the "Pooling and Servicing Agreement") among First Boston Mortgage Securities Corp., as Depositor (the "Depositor"), and Security Pacific National Bank, as trustee (the "Trustee"). The Conduit Mortgage Pass-Through Certificates, Series 1992-1 will be comprised of ten classes of publicly offered certificates (the "Certificates"). The Certificates consist of the Class 1-R, Class 1-A, Class 1-B, Class 1-C, Class 1-D, Class 1-E and Class 1-M Certificates (collectively, the "Fixed Rate Certificates") and the Class 1-F, Class 1-G and Class 1-H Certificates. The Certificates evidence beneficial ownership interests in a trust fund (the "Trust Fund") to be created by First Boston Mortgage Securities Corp. (the "Depositor"), which will hold interests in a pool of conventional, level-payment, fixed-rate, fully-amortizing mortgage loans (the "Mortgage Loans") secured by deeds of trust on residential properties and certain other property held in trust for the benefit of the Certificateholders. The Mortgage Loans will be purchased by the Depositor from an affiliate and transferred by the Depositor to the Trust Fund pursuant to a Pooling and Servicing Agreement, dated as of January 1, 1992, in exchange for the Certificates and certain other consideration. The Mortgage Loans are more fully described in the Prospectus Supplement. Information with respect to the business of the Trust would not be meaningful because the only "business" of the Trust is the collection on the Mortgage Loans and distribution of payments on the Certificates to Certificateholders. This information is accurately summarized in the Monthly Reports to Certificateholders, which are filed on Form 8-K. There is no additional relevant information to report in response to Item 101 of Regulation S-K. ITEM 2.

ITEM 2. Properties. The Depositor owns no property. The First Boston Mortgage Securities Corp., Conduit Mortgage Pass-Through Certificates, Series 1992-1, in the aggregate, represent the beneficial ownership in a Trust consisting primarily of the Mortgage Loans. The Trust will acquire title to real estate only upon default of the mortgagors under the Mortgage Loan. Therefore, this item is inapplicable. ITEM 3.

ITEM 3. Legal Proceedings. None. ITEM 4.

ITEM 4. Submission of Matters to a Vote of Security Holders. No matters were submitted to a vote of Certificateholders during the fiscal year covered by this report. PART II ITEM 5.

ITEM 5. Market for Depositor's Common Equity and Related Stockholder Matters. The First Boston Mortgage Securities Corp., Conduit Mortgage Pass-Through Certificates, Series 1992-1 represent, in the aggregate, the beneficial ownership in a trust fund consisting primarily of the Mortgage Loans. The Certificates are owned by Certificateholders as trust beneficiaries. Strictly speaking, Depositor has no "common equity," but for purposes of this Item only, Depositor's Conduit Mortgage Pass-Through Certificates are treated as "common equity." (a) Market Information. There is no established public trading market for Depositor's Notes. Depositor believes the Notes are traded primarily in intra-dealer markets and non-centralized inter-dealer markets. (b) Holders. The number of registered holders of all classes of Certificates on (see item 12(a)for dates) was 7. (c) Dividends. Not applicable. The information regarding dividend required by sub-paragraph (c) of Item 201 of Regulation S-K is inapplicable because the Trust does not pay dividends. However, information as to distribution to Certificateholders is provided in the Monthly Reports to Certificateholders for each month of the fiscal year in which a distribution to Certificateholders was made. ITEM 6.

ITEM 6. Selected Financial Data. Not Applicable. Because of the limited activities of the Trust, the Selected Financial Data required by Item 301 of Regulation S-K does not add relevant information to that provided by the Monthly Reports to Certificateholders, which are filed on a monthly basis on Form 8-K. ITEM 7.

ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Not Applicable. The information required by Item 303 of Regulation S-K is inapplicable because the Trust does not have management per se, but rather the Trust has a Trustee who causes the preparation of the Monthly Reports to Certificateholders. The information provided by the Monthly Reports to Certificateholders, which are filed on a monthly basis on Form 8-K, does provide the relevant financial information regarding the financial status of the Trust. ITEM 8.

ITEM 8. Financial Statements and Supplementary Data. Monthly Remittance Statement to the Certificateholders as to distributions made on February 25, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on March 25, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on April 27, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on May 26, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on July 27, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on September 25, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on October 26, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on November 25, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on December 28, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Annual Statement of Compliance by the Master Servicer is not currently available and will be subsequently filed on Form 8. Independent Accountant's Report on Servicer's will be subsequently filed on Form 8. ITEM 9.

ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. PART III ITEM 10.

ITEM 10. Directors and Executive Officers of Depositor. Not Applicable. The Trust does not have officers or directors. Therefore, the information required by items 401 and 405 of Regulation S-K are inapplicable. ITEM 11.

ITEM 11. Executive Compensation. Not Applicable. The Trust does not have officers or directors to whom compensation needs to be paid. Therefore, the information required by item 402 of regulation S-K is inapplicable. ITEM 12.

ITEM 12. Security Ownership of Certain Beneficial Owners and Management. (a) Security ownership of certain beneficial owners. Under the Pooling and Servicing Agreement governing the Trust, the holders of the Certificates generally do not have the right to vote and are prohibited from taking part in management of the Trust. For purposes of this Item and Item 13

ITEM 13. Certain Relationships and Related Transactions. (a) Transactions with management and others. Depositor knows of no transaction or series of transactions during the fiscal year ended December 31, 1992, or any currently proposed transaction or series of transactions, in an amount exceeding $60,000 involving the Depositor in which the Certificateholders identified in Item 12(a) had or will have a direct or indirect material interest. There are no persons of the types described in Item 404(a)(1),(2) and (4) of Regulation S-K, however, the information required by Item 404(a)(3) of Regulation S-K is hereby incorporated by reference in Item 12 herein. (b) Certain business relationships. None. (c) Indebtedness of management. Not Applicable. The Trust does not have management consisting of any officers or directors. Therefore, the information required by item 404 of Regulation S-K is inapplicable. (d) Transactions with promoters. Not Applicable. The Trust does not use promoters. Therefore, the information required by item 404 of Regulation S-K is inapplicable. PART IV ITEM 14.

ITEM 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) The following is a list of documents filed as part of this report: EXHIBITS Monthly Remittance Statement to the Certificateholders as to distributions made on February 25, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on March 25, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on April 27, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on May 26, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on July 27, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on September 25, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on October 26, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on November 25, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. Monthly Remittance Statement to the Certificateholders as to distributions made on December 28, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 9, 1999. (c) The exhibits required to be filed by Depositor pursuant to Item 601 of Regulation S-K are listed above and in the Exhibit Index that immediately follows the signature page hereof. (d) Not Applicable. The Trust does not have any subsidiaries or affiliates. Therefore, no financial statements are filed with respect to subsidiaries or affiliates. Supplemental information to be furnished with reports filed pursuant to Section 15(d) by Depositors which have not registered securities pursuant to Section 12 of the Act. No annual report, proxy statement, form of proxy or other soliciting material has been sent to Certificateholders, and the Depositor does not contemplate sending any such materials subsequent to the filing of this report. SIGNATURE Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Depositor has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. By: Bankers Trust Company of California, N.A. not in its individual capacity but solely as a duly authorized agent of the Registrant pursuant to the Pooling and Servicing Agreement, dated as of January 1, 1992. By: /s/Judy L. Gomez Judy L. Gomez Assistant Vice President Date: March 3, 1999 EXHIBIT INDEX Exhibit Document 1.1 Monthly Remittance Statement to the Certificateholders as to distributions made on February 25, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. 1.2 Monthly Remittance Statement to the Certificateholders as to distributions made on March 25, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. 1.3 Monthly Remittance Statement to the Certificateholders as to distributions made on April 27, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. 1.4 Monthly Remittance Statement to the Certificateholders as to distributions made on May 26, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. 1.5 Monthly Remittance Statement to the Certificateholders as to distributions made on July 27, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. 1.6 Monthly Remittance Statement to the Certificateholders as to distributions made on September 25, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. 1.7 Monthly Remittance Statement to the Certificateholders as to distributions made on October 26, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. 1.8 Monthly Remittance Statement to the Certificateholders as to distributions made on November 25, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. 1.9 Monthly Remittance Statement to the Certificateholders as to distributions made on December 28, 1992, and filed with the Securities and Exchange Commission on Form 8-K on February 10, 1999. 1.10 The Pooling and Servicing Agreement of the Registrant dated as of January 1, 1992 (hereby incorporated herein by reference and filed as part of the Registrant's Current Report on Form 8-K filed with Securities and Exchange Commission on February , 1999.

17797_1993.txt

17797

1993

ITEM 1. BUSINESS _________________ GENERAL _______ 1. COMPANY. Carolina Power & Light Company (Company) is a public service corporation formed under the laws of North Carolina in 1926, and is engaged in the generation, transmission, distribution and sale of electricity in portions of North Carolina and South Carolina. The Company had 8,027 employees at December 31, 1993. The principal executive offices of the Company are located at 411 Fayetteville Street, Raleigh, North Carolina 27601, telephone number: 919-546-6111. 2. SERVICE. a. The territory served, an area of approximately 30,000 square miles, includes a substantial portion of the coastal plain in North Carolina extending to the Atlantic coast between the Pamlico River and the South Carolina border, the lower Piedmont section in North Carolina, an area in northeastern South Carolina, and an area in western North Carolina in and around the City of Asheville. The estimated total population of the territory served is approximately 3.5 million. b. The Company provides electricity at retail in 219 communities, each having an estimated population of 500 or more, and at wholesale to one joint municipal power agency, 4 municipalities and 18 electric membership corporations. At December 31, 1993, the Company was furnishing electric service to approximately 1,032,000 customers. 3. SALES. During 1993, 32.6% of operating revenues was derived from residential sales, 20.5% from commercial sales, 25.7% from industrial sales, 17.2% from resale sales and 4.0% from other sources. Of such operating revenues, approximately 85% was derived from North Carolina and approximately 15% from South Carolina. For the twelve months ended December 31, 1993, average revenues per kilowatt-hour (kWh) sold to residential, commercial and industrial customers were 8.28 cents, 6.94 cents and 5.49 cents, respectively. Sales to residential customers for the past five years are listed below. Average Average Annual Annual Revenue Year kWh Use Bill per kWh ____ _______ _______ _______ 1989 12,419 $ 987.19 7.95 cents 1990 11,957 995.01 8.32 1991 12,472 1,040.70 8.34 1992 12,396 1,029.82 8.31 1993 13,167 1,090.16 8.28 4. PEAK DEMAND. a. A 60-minute system peak demand record of 10,144 megawatts (MW) was reached on January 19, 1994. At the time of this peak demand, the Company's capacity margin based on installed capacity (less unavailable capacity) and scheduled firm purchases and sales was approximately 0.22%. b. Total system peak demand for 1991 increased by 3.2%, for 1992 increased by 3.1%, and for 1993 increased by 3.8%, as compared with the preceding year. The Company currently projects a 2.3% average annual growth in system peak demand over the next ten years. The year-to-year change in actual peak demand is influenced by the specific weather conditions during those years and may not exhibit a consistent pattern. Total system load factors, expressed as the ratio of the average load supplied to the peak load demand, for the years 1991-1993 were 57.8%, 57.4% and 59.0%, respectively. The Company forecasts capacity margins of 15.2% and 13.4% over anticipated system peak load for 1994 and 1995. This forecast assumes normal weather conditions in each year consistent with long-term experience, and is based upon the rated Maximum Dependable Capacity of generating units in commercial operation and scheduled firm purchases of power. See ITEM 1, "Generating Capability" and "Interconnections With Other Systems." However, some of the generating units included in arriving at these capacity margins may be unavailable as a result of scheduled outages, environmental modifications or unplanned outages. See ITEM 1, "Environmental Matters" and "Nuclear Matters." The data contained in this paragraph includes North Carolina Eastern Municipal Power Agency's (Power Agency) load requirements and capability from its ownership interests in certain of the Company's generating facilities. See ITEM 1, "Generating Capability," paragraph 1. GENERATING CAPABILITY _____________________ 1. FACILITIES. The Company has a total system installed generating capability of 9,613 MW, with generating capacity provided primarily from the installed generating facilities listed in the table below. The remainder of the Company's generating capacity is composed of 53 coal, hydro and combustion turbine units ranging in size from a 2.5 MW hydro unit to a 78 MW coal-fired unit. Pursuant to certain agreements with Power Agency, which is comprised of former North Carolina municipal wholesale customers of the Company and Virginia Electric and Power Company (Virginia Power), Power Agency has acquired undivided ownership interests of 18.33% in Brunswick Unit Nos. 1 and 2, 12.94% in Roxboro Unit No. 4 and 16.17% in Harris Unit No. 1 and Mayo Unit No. 1 (collectively, the Joint Facilities). Of the total system installed generating capability of 9,613 MW (including Power Agency's share), 55% is coal, 32% is nuclear, 2% is hydro and 11% is fired by other fuels including No. 2 oil, natural gas and propane. MAJOR INSTALLED GENERATING FACILITIES Year Maximum Plant Unit Commercial Primary Dependable Location No. Operation Fuel Capacity ________ ____ __________ _______ __________ Asheville 1 1964 Coal 198 MW (Skyland, N.C.) 2 1971 Coal 194 MW Cape Fear 5 1956 Coal 143 MW (Moncure, N.C.) 6 1958 Coal 173 MW H. F. Lee 1 1952 Coal 79 MW (Goldsboro, N.C.) 2 1951 Coal 76 MW 3 1962 Coal 252 MW H. B. Robinson 1 1960 Coal 174 MW (Hartsville, S.C.) 2 1971 Nuclear 683 MW Roxboro 1 1966 Coal 385 MW (Roxboro, N.C.) 2 1968 Coal 670 MW 3 1973 Coal 707 MW 4 1980 Coal 700 MW* L. V. Sutton 1 1954 Coal 97 MW (Wilmington, N.C.) 2 1955 Coal 106 MW 3 1972 Coal 410 MW Brunswick 1 1977 Nuclear 767 MW* (Southport, N.C.) 2 1975 Nuclear 754 MW* Mayo 1 1983 Coal 745 MW* (Roxboro, N.C.) Harris 1 1987 Nuclear 860 MW* (New Hill, N.C.) ____________ *Facilities are jointly owned by the Company and Power Agency, and the capacity shown includes Power Agency's share. 2. MAINTENANCE OF PROPERTIES. The Company maintains all of its properties in good operating condition in accordance with sound management practices. The average life expectancy for ratemaking and accounting purposes of the Company's generating facilities (excluding combustion turbine units and hydro units) is approximately 40 years from the date of commercial operation. 3. GENERATION ADDITIONS SCHEDULE. The Company's energy and load forecasts were revised in December 1993. Over the next ten years, system sales growth is forecasted to average 2.3% per year and annual growth in system peak demand is projected to average 2.3%. The Company's generation additions schedule reflects no additions until 1996, when three new combustion turbine generating units are currently scheduled to commence commercial operation. These units, having a total generating capacity of approximately 225 MW, will be located at the Company's Darlington County Electric Plant near Hartsville, South Carolina and are expected to cost an aggregate of approximately $93 million. The generation additions schedule, which is updated annually, also includes generation additions of 3,600 MW in combustion turbine generating units to be added over the period 1997 to 2007 at undesignated sites and a 500 MW baseload coal unit in 2008 at an undesignated site. 4. RELICENSING OF HYDROELECTRIC PLANT. In 1973, the Company filed an application with the Federal Power Commission, now the Federal Energy Regulatory Commission (FERC), for a new long-term license for its 105 MW Walters Hydroelectric Plant (Project No. 432-004). North Carolina Electric Membership Corporation (NCEMC), doing business as Carolina Electric Cooperatives, filed a competing application in August 1974 (Project No. 2748-000). Since the initial license expired in 1976, the Company has continued to operate the Walters Hydroelectric Plant under an annual license issued by the FERC. Loss of the license would result in significant additional costs to the Company; however, the financial impact would be dependent on future ratemaking treatment. The FERC issued orders staying the relicensing proceedings until February 1990. Thereafter, the FERC set the matter for hearing, and the North Carolina Department of Environment, Health and Natural Resources and the Tennessee Wildlife Resources Agency intervened in this proceeding. A two- phase evidentiary hearing was concluded in October 1991, but the FERC has not yet rendered its decision. On September 17, 1993, the Company and NCEMC filed a settlement agreement (Settlement Agreement) with the FERC. Under the terms of the Settlement Agreement, NCEMC will withdraw its competing request for a license for the Walters Hydroelectric Plant. The Settlement Agreement also resolves, as between the parties, issues related to NCEMC's objections to the Company's purchase power contract with Duke Power Company (Duke) and NCEMC's interest in transferring base load capacity from its ownership in Duke's Catawba Nuclear Station (Docket Nos. ER 89-106-000, EL 91-55-000 and ER 92-199-000). See ITEM 1, "Interconnections with Other Systems," paragraph 3.a. for further discussion of the purchase power contract. Also on September 17, 1993, the parties filed with the FERC a Power Coordination Agreement (PCA) and an Interchange Agreement (IA), both dated August 27, 1993. The PCA and IA set forth explicitly the future relationship between the parties and establish a framework under which they will operate. The PCA provides NCEMC the option to gradually assume responsibility for a portion of its load, subject to agreed upon limits, thereby enabling the Company to further enhance its planning for generation and transmission property. Additionally, the Company will sell electricity and provide necessary transmission and coordinating services to NCEMC subject to rates that will benefit the Company and its customers. On October 7, 1993, the FERC Staff filed comments partially opposing the settlement on technical grounds, but recommending that it be certified to the FERC. The Company filed its response to those comments with the FERC on October 18, 1993. On October 26, 1993, the Administrative Law Judge (ALJ) certified the case to the FERC for its decision. In his certification the ALJ noted that the settlement is a good one and will greatly benefit the people of North Carolina. On February 28, 1994, the Company and NCEMC agreed to extend the time for obtaining FERC approval of the PCA and the IA from February 28, 1994 to April 29, 1994. Another settlement agreement regarding various environmental issues has been signed by all the parties and was filed with the FERC for approval on February 16, 1994. On March 8, 1994, the FERC Staff filed comments supporting this settlement agreement. Approval of the settlement agreements and issuance of the license by the FERC will conclude this matter. The Company cannot predict the outcome of these matters. INTERCONNECTIONS WITH OTHER SYSTEMS ___________________________________ 1. INTERCONNECTIONS. The Company's facilities in Asheville and vicinity are integrated into the total system through the facilities of Duke via interconnection agreements that permit transfer of power to and from the Asheville area. The Company also has major interconnections with the Tennessee Valley Authority (TVA), Appalachian Power Company (APCO), Virginia Power, South Carolina Electric and Gas Company (SCE&G), South Carolina Public Service Authority (SCPSA) and Yadkin, Inc. (Yadkin). Major interconnections include 115 kV and 230 kV ties with SCE&G and SCPSA; 115 kV, 230 kV and 500 kV ties with Duke and Virginia Power; a 115 kV tie with Yadkin; a 161 kV tie with TVA; and three 138 kV ties and one 230 kV tie with APCO. See paragraph 3.b. below. 2. INTERCHANGE AGREEMENTS. a. The Company has interchange agreements with APCO, Duke, SCE&G, SCPSA, TVA, Virginia Power and Yadkin which provide for the purchase and sale of power for hourly, daily, weekly, monthly or longer periods. Purchases and sales under these agreements may be made due to changes in the in-service dates of new generating units, outages at existing units, economic considerations or for other reasons. b. The Virginia-Carolinas Subregion of the Southeastern Electric Reliability Council is made up of the Company, Duke, Nantahala Power & Light Company, SCE&G, SCPSA and Virginia Power, plus the Southeastern Power Administration and Yadkin. Electric service reliability is promoted by contractual arrangements among the members of electric reliability organizations at the area, regional and national levels, including the Southeastern Electric Reliability Council and the North American Electric Reliability Council. 3. PURCHASE POWER CONTRACTS. a. In March 1987, the Company entered into a purchase power contract with Duke, whereby Duke would provide 400 MW of firm capacity to the Company's system over the period January 1, 1992, through December 31, 1997. The contract was filed with the FERC in December 1988 (Docket No. ER89-106). NCEMC, Power Agency, Nucor Steel, the South Carolina Consumer Advocate and others moved to intervene in the proceeding, objecting to various aspects of the contract. A hearing was held in January 1990, but the FERC has not yet rendered its decision. Pursuant to an amendment of the contract, commencement of the purchase of power by the Company was delayed until July 1993 and termination was extended through June 1999. This amendment was filed with the FERC and accepted for filing, subject to refund, pursuant to an Order dated January 21, 1992. The docket was consolidated with Docket No. ER89-106 and a settlement agreement resolving issues related to the purchase power contract and other matters was filed with the FERC for approval on September 17, 1993. See ITEM 1, "Generating Capability," paragraph 4 for further discussion of the settlement agreement and other agreements between the Company and NCEMC. Pending the FERC's approval of the settlement, the Company began purchasing 400 MW of generating capacity from Duke in July 1993. The estimated minimum annual payment for power under the six-year agreement is $43 million, which represents capital-related capacity costs. Other costs associated with the agreement include fuel, energy-related operation and maintenance expenses and transmission use charges. The Company cannot predict the outcome of this matter. b. The Company has entered into an agreement, which has been approved by the FERC, with APCO and Indiana Michigan Power Company (Indiana Michigan), operating subsidiaries of American Electric Power Company, to upgrade a transmission interconnection with APCO in the Company's western service area, establish a new interconnection in the Company's eastern service area, and purchase 250 MW of generating capacity from Indiana Michigan's Rockport Unit No. 2. The transmission interconnection upgrade in the Company's western service area was completed in 1992. The purchase of generating capacity began on January 1, 1990, and will continue for a period of 20 years. The estimated minimum annual payment for power purchased under the terms of the agreement is approximately $30 million, which represents capital-related capacity costs. Other costs associated with the agreement include demand-related production expenses, fuel, energy-related operation and maintenance expenses and transmission use charges. 4. FAYETTEVILLE. The Company has an agreement with the City of Fayetteville's Public Works Commission (City) to exchange capacity and energy. The City has a 70 MW heat recovery unit and eight 27.5 MW dual fuel (gas or oil) fired combustion turbine units. The heat recovery unit and five of the combustion turbine units are being used by the City to satisfy energy requirements during periods of peak demand. The agreement makes provisions for the purchase and sale of capacity and/or energy for economic and reliability reasons to the mutual benefit of both parties. On March 10, 1994, the City and the Company entered into a new ten-year agreement under which the Company will continue to be the City's wholesale supplier of electricity. See ITEM 1, "Wholesale Rate Matters," paragraph 3.c. for further discussion of the new agreement. COMPETITION AND FRANCHISES __________________________ 1. COMPETITION. a. Generally, in municipalities and other areas where the Company provides retail electric service, no other utility directly renders such service. In recent years, however, customers interested in building their own generation facilities, competition from unregulated energy suppliers and changing government regulations have fostered the development of alternative sources of electricity for certain of the Company's wholesale and industrial customers. The Public Utility Regulatory Policies Act (PURPA) has facilitated the entry of non-utility companies into the electric generation business. Under PURPA, non-utility companies are allowed to construct "qualifying facilities" for the production of electricity in connection with industrial steam supplies and, under certain circumstances, to compel a utility to purchase the electricity generated at prices reflecting the utility's avoided cost as set by state regulatory bodies. Over the near term, the purchase of power from qualifying facilities has increased the Company's total cost of generation. b. In 1992, the Energy Policy Act of 1992 (Energy Act) was signed into law. The Energy Act addresses a wide range of energy issues, including several matters affecting bulk power competition in the electric utility industry. It creates exemptions from regulation under the Public Utility Holding Company Act of 1935 for persons or corporations that own and/or operate in the United States certain generating and interconnecting transmission facilities dedicated exclusively to wholesale sales, thereby encouraging the participation of utility affiliates, independent power producers and other non-utility participants in the development of wholesale power generation. In addition, the Energy Act confers expanded authority upon the FERC to issue orders requiring public utilities, such as the Company, to transmit power and energy to or for wholesale purchasers and sellers, and to require public utilities to enlarge or construct additional transmission capacity to provide these services. The Energy Act also requires or facilitates numerous initiatives to increase energy efficiency at federal and other facilities. Implementation of portions of this legislation through rulemaking is in progress at the FERC. The Company is unable to predict the ultimate impact the Energy Act will have on its operations. When fully implemented, the Energy Act could impact the Company's load forecasts and plans for power supply to the extent additional generation is facilitated by the Energy Act, current wholesale customers elect to purchase from other suppliers, or new opportunities are created for the Company to expand its wholesale load. The possible migration of some of the Company's load has created greater planning uncertainty and risks for the Company. The Company has been addressing these risks by negotiating long-term contracts with its customers, which allow the Company flexibility in managing its load and efficiently planning its future resource requirements. In this regard, in 1993 the Company signed a significant long-term agreement with NCEMC, which represents 17 of the Company's wholesale customers, and restructured its agreement with Power Agency. Also in 1993, the Company signed power supply agreements with the City of Camden, South Carolina and French Broad Electric Membership Corporation. In 1994, the City of Fayetteville's Public Works Commission entered into a new contract with the Company. In the industrial sector, the Company continues its efforts on a number of programs designed to retain and expand existing load and to attract new business to its service territory. 2. FRANCHISES. The Company is a regulated public utility and holds franchises to the extent necessary to operate in the municipalities and other areas it serves. CONSTRUCTION PROGRAM ____________________ 1. CAPITAL REQUIREMENTS. During 1993 the Company expended approximately $613 million for capital requirements. The Company revised its capital program in 1993 as part of its annual business planning process. Capital requirements, including anticipated construction expenditures for plant modifications, for the years 1994 through 1996 are set forth below. These estimates include Clean Air Act compliance expenditures of approximately $79 million, and generating facility addition expenditures of approximately $248 million. See ITEM 1, "Environmental Matters," paragraph 2 for further discussion of the impact of the Clean Air Act on the Company. Estimated Capital Requirements ______________________________ (In Millions) 1994 1995 1996 TOTAL ____ ____ ____ _____ Construction Expenditures $386 $476 $540 $1,402 Nuclear Fuel Expenditures 25 79 94 198 AFUDC (18) (29) (40) (87) ____ ____ ____ ______ Net expenditures (a) 393 526 594 1,513 Long-Term Debt Maturities 50 275 55 380 ____ ____ ____ ______ TOTAL $443 $801 $649 $1,893 ==== ==== ==== ====== _______________ (a) Reflects reductions of approximately $25 million, $25 million and $27 million for 1994, 1995 and 1996, respectively, in net capital requirements resulting from Power Agency's projected payment of its ownership share of capital expenditures related to the Joint Facilities. FINANCING PROGRAM _________________ 1. CAPITAL REQUIREMENTS. Based on the Company's most recent estimate of capital requirements, the Company does not expect to have external funding requirements in 1994 or 1996 due to the low level of long-term debt maturities in those years. External funding requirements, which do not include early redemptions of long-term debt or redemptions of preferred stock, are expected to approximate $300 million in 1995. These funds will be required for construction, long-term debt maturities and general corporate purposes, including the repayment of short-term debt. The Company may from time to time sell additional securities beyond the amount needed to meet capital requirements to allow for the early redemption of outstanding issues of long-term debt, the redemption of preferred stock, the reduction of short-term debt or for other corporate purposes. The amounts and timing of the sales of securities will depend upon market conditions and the specific needs of the Company. See ITEM 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," for further analysis and discussion of the Company's financing plans and capital resources and liquidity. 2. SEC FILINGS. a. The Company has on file with the Securities and Exchange Commission (SEC) a shelf registration statement (File No. 33-50597), enabling the Company to issue an aggregate of $600 million principal amount of First Mortgage Bonds, $450 million of which remain available for issuance. Additionally, the Company has entered into a distribution agreement with respect to the possible future sale of an aggregate amount of $200 million principal amount of First Mortgage Bonds, designated as Secured Medium-Term Notes, Series C, $110 million of which remain available for issuance. b. The Company has on file with the SEC a shelf registration statement (File No. 33-5134) enabling the Company to issue up to $180 million of Serial Preferred Stock. 3. FINANCINGS. External financings during 1993 and early 1994 included: - The issuance on February 17, 1993, of $150 million principal amount of First Mortgage Bonds, 6 1/8% Series due February 1, 2000, for net proceeds of approximately $147.8 million. - The issuance on March 3, 1993, of $150 million principal amount of First Mortgage Bonds, 7 1/2% Series due March 1, 2023, for net proceeds of approximately $147.4 million. - The issuance on July 7, 1993, of $100 million principal amount of First Mortgage Bonds, 5 3/8% Series due July 1, 1998, for net proceeds of approximately $99.1 million. - The issuance on August 26, 1993, of $100 million principal amount of First Mortgage Bonds, 6 7/8% Series due August 15, 2023, for net proceeds of approximately $98.2 million. - During the period from September through December 1993, the Company issued an aggregate of $90 million principal amount of First Mortgage Bonds, Secured Medium-Term Notes, Series C, with interest rates ranging from 4.85% to 5.06% and maturity dates ranging from 1996 to 1998. Net proceeds from the issuances of these First Mortgage Bonds aggregated $89.4 million. - The issuance on January 19, 1994, of $150 million principal amount of First Mortgage Bonds, 5 7/8% Series due January 15, 2004, for net proceeds of approximately $148 million. The proceeds from the issuances listed above were used to reduce the outstanding balance of commercial paper and other short-term debt, to redeem outstanding long-term debt and for other general corporate purposes. 4. REDEMPTIONS/RETIREMENTS. Redemptions and retirements during 1993 included: - The redemption on March 25, 1993, of $82.549 million principal amount of First Mortgage Bonds, 8 1/2% Series due October 1, 2007, at 100.26% of the principal amount of such bonds plus accrued interest to the date of redemption. - The redemption on April 1, 1993, of $70 million aggregate principal amount of First Mortgage Bonds, 7 3/4% Series due October 1, 2001, at 102.30% of the principal amount of such bonds plus accrued interest to the date of redemption. - The purchase and cancellation on April 14, 1993, of $1.8 million aggregate principal amount of The Wake County Industrial Facilities and Pollution Control Financing Authority Pollution Control Revenue Bonds (Carolina Power & Light Company Project) Series 1987 due March 1, 2017, at 100.00% of the principal amount of such bonds plus accrued interest to the date of purchase, pursuant to provisions of the related trust indenture. - The redemption on April 16, 1993, of $100 million aggregate principal amount of First Mortgage Bonds, 8 7/8% Series due March 1, 2016, at 105.77% of the principal amount of such bonds plus accrued interest to the date of redemption. - The retirement on June 22, 1993, of $25 million aggregate principal amount of First Mortgage Bonds, 8.75% Secured Medium-Term Notes, Series A, which matured on that date. - The redemption on August 18, 1993, of $100 million principal amount of First Mortgage Bonds, 8 1/2% Series due January 1, 2017, at 104.64% of the principal amount of such bonds plus accrued interest to the date of redemption. - The retirement on September 1, 1993, of $100 million principal amount of First Mortgage Bonds, 9% Series, which matured on that date. - The redemption on September 16, 1993, of $30 million principal amount of First Mortgage Bonds, 4 1/2% Series due July 1, 1994, at 100% of the principal amount of such bonds plus accrued interest to the date of redemption. - The redemption on October 1, 1993, of $65 million principal amount of First Mortgage Bonds, 7 3/8% Series due January 1, 2001, at 101.91% of the principal amount of such bonds plus accrued interest to the date of redemption. - The redemption on October 1, 1993, of $100 million principal amount of First Mortgage Bonds, 7 3/4% Series due May 1, 2002, at 102.21% of the principal amount of such bonds plus accrued interest to the date of redemption. - The retirement on November 15, 1993, of $100 million principal amount of First Mortgage Bonds, 8 1/8 % Series, which matured on that date. 5. CREDIT FACILITIES. The Company's credit facilities presently total $208.1 million, consisting of a $115 million Revolving Credit Agreement with nine domestic money centers and major regional banks, a $70 million long-term Revolving Credit Agreement with eight foreign banks and a Revolving Credit Agreement of $23.1 million with fifteen regional banks. RETAIL RATE MATTERS ___________________ 1. GENERAL. The Company is subject to regulation in North Carolina by the North Carolina Utilities Commission (NCUC) and in South Carolina by the South Carolina Public Service Commission (SCPSC) with respect to, among other things, rates for electric energy sold at retail, retail service territory and issuances of securities. 2. CURRENT RETAIL RATES. The rates of return granted to the Company in its most recent general rate cases are as follows: 1988 North Carolina Utilities Commission Order (test year ended March 31, 1987) ______________________________________________ Capital Weighted Weighted Capital Structure Ratio Cost Rate Cost _________________ _______ _________ ________ Long-Term Debt 48.57% 8.62% 4.19% Preferred Stock 7.43 8.75 .65 Common Equity 44.00 12.75 5.61 _____ Rate of Return 10.45% ===== 1988 South Carolina Public Service Commission Order (test year ended September 30, 1987) ___________________________________________________ Capital Weighted Weighted Capital Structure Ratio Cost Rate Cost _________________ _______ _________ ________ Long-Term Debt 47.82% 8.62% 4.12% Preferred Stock 7.46 8.75 .65 Common Equity 44.72 12.75 5.71 _____ Rate of Return 10.48% ===== 3. INTEGRATED RESOURCE PLANNING. Integrated Resource Planning is a process that systematically compares all reasonably available resources, both demand-side and supply-side, in order to develop that mix of resources that allows a utility to meet customer demand in a most cost effective manner, giving due regard to system reliability and safety. The Company is required to file its IRP with the NCUC and the SCPSC once every three years. The Company filed its 1992 Integrated Resource Plan (IRP) with the NCUC on April 24, 1992, and by order dated June 29, 1993, the NCUC approved the Company's 1992 IRP. The Company filed its 1992 IRP with the SCPSC on April 30, 1992, and by order dated April 8, 1993, the SCPSC found that the Company's 1992 IRP complied with the SCPSC's integrated resource planning rules. The Company regularly reviews its IRP in light of changing conditions and evaluates the impact these changes have on its resource plans, including purchases and other resource options. 4. DEMAND SIDE MANAGEMENT. The Company's Demand Side Management (DSM) programs are an integral part of its IRP. The Company offers a variety of conservation, load management, and strategic sales programs to its residential, commercial and industrial customers. The objectives of the DSM programs are to improve system operating efficiencies, meet customer needs in a growing service area, defer the need for future generating units and delay the need for future rate increases. Currently, the Company offers time-of-use rates to all its retail customers, low interest loans to its residential customers for the installation of additional insulation and high efficiency heat pumps in existing homes, financial incentives and an energy conservation discount for all-electric homes that meet enhanced thermal integrity and appliance efficiency standards, financial incentives for Company control of residential water heaters and air conditioners in most of the major metropolitan areas served by the Company, incentives for the curtailment of large industrial loads, and energy audits for large commercial and industrial customers, as well as many other programs. Additional programs are in various stages of investigation and development. The Company had achieved a summer peak load reduction capability of 1,559 MW as of December 31, 1993, through its conservation and load management programs. The Company also has rates available for the purchase of power from cogeneration and small power production facilities, as well as standby service rates for customers using their own generation equipment. At the end of 1993, the Company had 43 cogenerators and small power producers on-line with facilities capable of generating a total of approximately 471 MW, of which 283 MW is used internally by customers and 188 MW is sold to the Company. In addition to this cogeneration and small power production, which is associated with the Company's Conservation and Load Management Programs, other cogeneration projects have been installed and used as planned generation resources. This additional capacity includes approximately 266 MW that was fully operational at the end of 1993. The Company has a Hydroelectric Generation Program designed to provide technical assistance to entrepreneurs who are reactivating abandoned hydroelectric generating sites in the Company's service territory. Presently, Hydroelectric Generation Program capability on the Company's system totals approximately 15 MW. Other proposals for generation are received and evaluated by the Company from time to time. See ITEM 1, "Competition and Franchises." 5. FUEL COST RECOVERY. In the North Carolina retail jurisdiction, the NCUC establishes base fuel costs in general rate cases and holds hearings annually to determine whether a rider should be added to base fuel rates to reflect increases or decreases in the cost of fuel and the fuel cost component of purchased power as well as changes in the fuel cost component of sales to other utilities. The NCUC considers the changes in the Company's cost of fuel during a historic test period ending March 31 of each year and corrects any past over-or under-recovery. The Company's 1994 North Carolina fuel case hearing is scheduled to begin on August 2, 1994. In the South Carolina retail jurisdiction, fuel rates are set by the SCPSC based on projected costs for a future six-month test period. At the semi-annual hearings, any past over-or under-recovery of fuel costs is taken into account in establishing the new projected rate for the subsequent six-month billing period. The Company's spring 1994 South Carolina fuel case hearing was scheduled to begin on March 15, 1994; however, on February 1, 1994, the SCPSC approved a settlement agreement that resolved all issues between all parties to the spring fuel proceeding. Pursuant to the settlement, the Company's current fuel factor of 1.425 cents/kWh will continue in effect for the six month period April 1 through September 30, 1994. Issues related to outages at Brunswick Unit No. 1 and the Robinson Nuclear Plant during the period July 1, 1993 through June 30, 1994 will be considered in the fall 1994 South Carolina fuel case hearing. See ITEM 1, "Nuclear Matters," paragraph 7.d., for considerations by the NCUC and the SCPSC regarding costs related to the Brunswick Plant outage, and for a discussion of the settlement agreements, reached in 1993, that resolved issues related to a period of the Brunswick Unit No. 1 outage, and settled the annual North Carolina and semi-annual South Carolina fuel adjustment proceedings. On December 14, 1992, the South Carolina Supreme Court rendered its decision in Nucor Steel's (Nucor) appeal (Opinion No. 23761) of the SCPSC's decision in the Company's fall 1990 South Carolina fuel case. In that fuel case the SCPSC considered the three week operator training outage experienced by the Brunswick Nuclear Plant in the spring of 1990, and also considered a refueling outage experienced by Brunswick Unit No. 2 during the test period. The South Carolina Supreme Court affirmed in part and reversed in part the SCPSC's decision. As a result of the court's decision, approximately $422,000 must be refunded to the Company's customers. As part of the settlement of the spring 1994 South Carolina fuel case, the Company agreed to reduce its fuel cost under-recovery account by this amount. Nucor's appeal of the Company's fall 1990 South Carolina fuel case also challenged the SCPSC's decision to exclude certain testimony offered by Nucor regarding a partial outage experienced by the Company's Robinson Unit No. 2 during the spring and summer of 1990. When this issue was presented to the Court of Common Pleas of Richland County, South Carolina, the court found that the SCPSC should have considered Nucor's testimony, and remanded the matter to the SCPSC. The SCPSC considered the testimony, but found it unpersuasive and reaffirmed its earlier orders on this issue. On September 8, 1993, Nucor appealed the SCPSC's decision to reaffirm its earlier orders to the Court of Common Pleas of Richland County, South Carolina. The Company cannot predict the outcome of this matter. 6. IMPACT OF ENERGY ACT. Section 111 of the Energy Act requires all state commissions to consider whether the adoption of certain standards would further the purposes of the PURPA. These standards relate to the use of integrated resource planning by electric utilities, investments in conservation and demand side management, and energy efficiency investments in power generation and supply. Both the NCUC and the SCPSC have opened dockets to consider these standards. With regard to the NCUC proceeding, direct testimony was filed by the Company on February 8, 1994. A hearing was held on March 8, 1994, but the NCUC has not yet issued its ruling. With regard to the SCPSC proceeding, the Company filed initial written comments on March 1, 1994, and reply comments are due on April 15, 1994. The SCPSC will issue its decision based upon the written comments. The Company cannot predict the outcome of these matters. WHOLESALE RATE MATTERS ______________________ 1. GENERAL. The Company is subject to regulation by the FERC with respect to rates for transmission and sale of electric energy at wholesale, the interconnection of facilities in interstate commerce (other than interconnections for use in the event of certain emergency situations), the licensing and operation of hydroelectric projects and, to the extent the FERC determines, accounting policies and practices. The Company and its wholesale customers last agreed to a general increase in wholesale rates in 1988. 2. FERC MATTERS. a. On April 12, 1991, NCEMC and one of its members, Brunswick Electric Membership Corporation, filed a Complaint and Motion for a Refund (Complaint) with the FERC, Docket No. EL91-28-000, alleging that the Company's wholesale rates and fuel clause billings were excessive and requesting that the Company provide its real-time load signal to NCEMC. All of the Company's remaining wholesale customers intervened in this proceeding. On December 6, 1991, the FERC issued an order which denied the Company's request to dismiss this Complaint, set certain matters for hearing and initiated an investigation on behalf of the intervenors (Docket No. EL91-54-000) to determine if the Company's wholesale rates are excessive. On January 10, 1992, a FERC Administrative Law Judge ordered that NCEMC's case be severed from the FERC-initiated investigation so that the proceedings could continue independently of each other. With regard to the FERC-initiated investigation, on November 12, 1992, the FERC approved the settlement agreement that was filed by the Company and all of the intervenors. With regard to NCEMC's case, the Company has settled with NCEMC on all issues, and on September 15, 1993, the FERC approved the settlement agreement between the parties. The agreement provides for the continuation of existing wholesale rate levels and resolves the wholesale fuel clause billing issue through June 30, 1993. The impact of the settlement totaled approximately $8 million, net of tax, and decreased the Company's 1993 earnings by $.05 per common share. On January 11, 1994, the Company and the intervenor that remained a party to the proceeding initiated by NCEMC filed a settlement agreement with the FERC for approval. On January 31, 1994, the FERC staff filed comments partially opposing the settlement, but recommending that it be certified to the FERC. On February 10, 1994, the Company and the intervenor filed comments supporting the settlement, and rebutting the FERC staff's contrary position. The settlement was certified to the FERC on February 17, 1994. Although the Company cannot predict the outcome of this matter, it does not believe that amounts associated with the settlement will be material to the results of operations of the Company. b. In 1989, Power Agency delivered to the Company a Notice of Intention to Arbitrate certain disputed matters related to Power Agency's use of capacity and energy from the South Carolina Public Service Authority (Santee Cooper), which matters Power Agency originally raised in a complaint before the FERC in 1988 (FERC Docket No. EL88-27-000). In June 1990, the arbitrator issued an order in favor of the Company on the most significant issues of contention between the Company and Power Agency. In addition, the arbitrator ordered the Company and Power Agency to meet for at least 120 days to negotiate a power coordination agreement relating to Power Agency's use of capacity and energy from Santee Cooper. On October 2, 1991, Power Agency filed a complaint at the FERC (Docket No. EL92-1-000) alleging that the Company had refused to agree to just and reasonable terms and conditions for power coordination agreements for Power Agency's purchase of firm capacity and energy from Santee Cooper for the period beginning January 1, 1994, and for Power Agency's use of a combustion turbine electric generating project it planned at that time to place in service on June 1, 1995. In 1993, Power Agency agreed to delay the commercial operation date of its turbine generating project for three years, until June 1, 1998. Power Agency's delay of the project was part of the agreement the Company and Power Agency entered into on April 7, 1993 to restructure portions of their contracts covering power supplies and jointly-owned interests in several of the Company's generating units. See ITEM 1, "Wholesale Rate Matters," paragraph 2.c. for further discussion of the April 7, 1993 agreement between the Company and Power Agency. On September 23, 1993, Power Agency and the Company entered into an agreement in principle that resolves all remaining issues relating to the Santee Cooper and turbine generator transactions. The parties continue to negotiate the details of a final settlement. Because the Santee Cooper transaction with Power Agency commenced on January 1, 1994, the Company and Power Agency have entered into an interim agreement covering the Santee Cooper transaction until a final agreement can be developed. The interim agreement between the parties was approved by the FERC on December 30, 1993. The Company cannot predict the outcome of these matters. c. On April 7, 1993, the Company and Power Agency entered into an agreement to restructure portions of their contracts covering power supplies and jointly-owned interests in several of the Company's generating units. Under the terms of the agreement, the Company is increasing the amount of capacity and energy purchased from Power Agency's ownership interest in the Harris Plant. Additionally, the buyback period has been extended six years through 2007. Also, pursuant to the agreement, a portion of the Harris Plant will not be recoverable through sales of supplemental power to Power Agency. As a result, the Company recorded a write-off in 1993 of approximately $14.7 million, net of tax, or $.09 per common share. Pursuant to that agreement, Power Agency also agreed to the dismissal with prejudice of the Complaint it filed against the Company on July 14, 1988 in the Superior Court of Wake County, North Carolina (Docket No. 88 CVS 6512) alleging that the Company failed to disclose alleged design, management and other problems at the Harris Plant in connection with the sale of capacity to Power Agency. The agreement also provides that Power Agency will delay the commercial operation date of its combustion turbine generating project for three years, until June 1, 1998, and will withdraw the demand of its letter dated January 20, 1993 regarding the costs incurred at the Brunswick Plant during the outage that began in 1992. See ITEM 1, "Wholesale Rate Matters," paragraph 2.b. for further discussion of the agreement. The agreement was filed with the FERC on May 19, 1993 for approval of the provisions that are subject to the FERC's jurisdiction. The Company cannot predict the outcome of this matter. 3. OTHER WHOLESALE MATTERS. a. By letter dated September 23, 1991, the City of Bennettsville, South Carolina (City) notified the Company that it was terminating service as a wholesale customer effective September 30, 1994, and that it intended to enter into a contract to purchase power at wholesale from Marlboro Electric Cooperative, Inc. On December 31, 1991, the Company filed a Declaratory Judgment Complaint in the Court of Common Pleas of Marlboro County, South Carolina (Docket No. 91-CP-34-316) seeking a determination as to the appropriate termination date and as to whether a cooperative can serve the City. On February 13, 1992, the Company filed a Motion for Summary Judgment in this proceeding. By order filed September 21, 1992, the Court of Common Pleas of Marlboro County, South Carolina denied the Company's Motion for Summary Judgment regarding the Marlboro Electric Cooperative, Inc.'s authority to serve the City and granted the Motions for Summary Judgment of Marlboro Electric Cooperative, Inc. and the City. On October 21, 1992, the Company filed a Notice of Appeal in the South Carolina Supreme Court. By order dated March 7, 1994, the South Carolina Supreme Court ruled that the City of Bennettsville can purchase power from Marlboro Electric Cooperative, Inc. beginning in 1995. The Company plans no further appeals. In 1993, the City's average peak load was approximately 16 MW. b. In March 1990, the City of Camden, South Carolina (City) notified the Company that it would terminate its purchase of wholesale power from the Company as of March 31, 1993. The Company responded that the appropriate termination date was May 1, 1995. A petition filed with the FERC by the City relating to this issue was dismissed in July 1991. On December 3, 1991, the City filed a Declaratory Judgment Complaint in the Court of Common Pleas of Kershaw County, South Carolina (Docket No. 91-CP-28-613) seeking a determination as to the proper termination date. In 1992, Motions for Summary Judgment were filed by both parties in this action. On November 9, 1992, the Court granted the Company's Motion for Summary Judgment. The City filed a Notice of Appeal to the Supreme Court of South Carolina. In 1993, both parties filed briefs in the Supreme Court of South Carolina. On January 10, 1994, the parties filed with the FERC for approval a contract amendment that will extend their contractual relationship at least through 1998. By letter dated March 9, 1994, the FERC approved the contract amendment, effective March 11, 1994. Consequently, the parties will seek a dismissal of the State court litigation. In 1993, the City's average peak load was approximately 30 MW. c. On March 10, 1994, the City of Fayetteville's Public Works Commission and the Company entered into a new power supply and coordination agreement under which the Company will continue to provide bulk power to the City. The agreement provides for the sale of a minimum of 140 to 160 MW of base load service and other services for a minimum of ten years, and at the parties' option, for up to fifteen years. The agreement also resolves all wholesale fuel clause billing issues between the City and the Company through December 31, 1993. The agreement will enable the Company to effectively and efficiently meet the growing needs of the City of Fayetteville for years to come. On March 16, 1994, the agreement was filed with the FERC for approval. The Company cannot predict the outcome of this matter. ENVIRONMENTAL MATTERS _____________________ 1. GENERAL. In the areas of air quality, water quality, control of toxic substances and hazardous and solid wastes and other environmental matters, the Company is subject to regulation by various federal, state and local authorities. The Company considers itself to be in substantial compliance with those environmental regulations currently applicable to its business and operations and believes it has all necessary permits to conduct such operations. Except as noted below in paragraph 2, the Company does not currently anticipate that its potential capital expenditures for environmental pollution control purposes will be material. Environmental laws and regulations, however, are constantly evolving and the character, scope and ultimate costs for compliance with such evolving laws and regulations cannot now be accurately estimated. Costs associated with compliance with pollution control laws and regulations at the Company's existing facilities, which are expected to be incurred from 1994 through 1996, are included in the estimates of capital requirements under ITEM 1, "Construction Program." 2. CLEAN AIR LEGISLATION. The 1990 amendments to the Clean Air Act (Act) require substantial reductions in sulfur dioxide and nitrogen oxides emissions from fossil-fueled electric generating plants. The Company is not required to take action to comply with the Act's Phase I requirements, which must be met by January 1, 1995. Phase II of the Act, which contains more stringent provisions, will become effective January 1, 2000. To reduce sulfur dioxide emissions, as required by Phase II, the Company will modify equipment to allow certain of the Company's plants to burn lower sulfur coal, and is planning for the installation of scrubbers. Installation of additional equipment will also be necessary to reduce nitrogen oxides emissions. The Company anticipates that it will be able to delay the installation and operation of scrubbers until 2005 by purchasing sulfur dioxide emission allowances. Each sulfur dioxide emission allowance, issued by the Environmental Protection Agency (EPA), will allow a utility to emit one ton of sulfur dioxide. In 1993, the Company purchased emission allowances under the EPA's emission allowance trading program. The Company estimates that the total capital cost to comply with the requirements of Phase II of the Act may approximate $340 million during the period 1994 through 1999, and an additional $460 million during the period 2000 through 2005. These estimates, for installation or modification of equipment, are in nominal dollars (undiscounted future amounts expected to be expended). The required modifications and additions are expected to increase operating and maintenance costs by a total of $20 million for the period 1994 through 1999, $48 million for the period 2000 through 2004, and by $42 million annually, beginning in 2005. Actual plans for compliance with the Act's requirements have not been finalized, and the amount required for capital expenditures and for increased operating and maintenance expenditures cannot be determined with certainty at this time. The financial impact of the additional expenditures will be dependent on future ratemaking treatment. The NCUC and the SCPSC are currently allowing the Company to accrue carrying charges on its investment in emission allowances. A plan for compliance with Phase II of the Act must be submitted to the EPA by January 1, 1996. The Company cannot predict the outcome of this matter. 3. SUPERFUND. The provisions of the Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended (CERCLA), authorize the EPA and, indirectly, the states, to require generators and certain transporters of certain hazardous substances released from or at a site, and the owners and operators of such site, to clean up the site or reimburse the costs therefor. This statute has been interpreted to impose joint and several liability on responsible parties. There are presently several sites with respect to which the Company has been notified by the EPA or the State of North Carolina of its potential liability, as described below in greater detail. a. On December 2, 1986, the EPA notified the Company of its potential liability pursuant to CERCLA for the investigation and cleanup activities associated with the Maxey Flats Nuclear Disposal Site in Fleming County, Kentucky. The EPA indicated that the site was operated from 1963 to 1977 under the management of Nuclear Engineering Company (now U. S. Ecology). The EPA estimated that the Company sent 304,459 cubic feet of waste to the disposal site. In response to the EPA's notice, the Company and several other potentially responsible parties (PRPs) formed a steering committee (the Maxey Flats Steering Committee) to undertake a remedial investigation/feasibility study pursuant to CERCLA. As a result of this study, the EPA has selected a remedial action which is currently estimated to have a present value cost of between $57 million and $78 million. Subsequent analysis of waste volume sent to the site performed by the Maxey Flats Steering Committee established that the Company contributed only approximately 1% of the total waste volume. It is expected that the Company's share of remediation costs will be based on the ratio of the Company's waste volume to that of other participating PRPs. The Company is currently ranked twenty-fourth on the waste-in list. On June 30, 1992, the EPA sent the Company, along with a number of other companies, agencies and organizations, a notice demanding reimbursement of response costs of approximately $5.8 million that have been incurred at the site and seeking to initiate formal negotiations regarding performance of the remedial design and remedial action for the site. On July 20, 1992, the Company responded that it would negotiate these matters through the Maxey Flats Steering Committee. In December 1992, the EPA rejected the offer the Maxey Flats Steering Committee filed regarding the performance of the remedial design and remedial action for this site. The Maxey Flats Steering Committee submitted amended offers to the EPA in 1993. The EPA has engaged in settlement negotiations with the Maxey Flats Steering Committee. Although the Company cannot predict the outcome of these matters, it does not anticipate that costs associated with this site will be material to the results of operations of the Company. b. On December 2, 1986, the EPA notified the Company that it is a PRP with respect to the disposal, treatment or transportation for disposal or treatment of polychlorinated biphenyls (PCBs) at the Martha C. Rose Chemicals, Inc. (Rose) facility located in Holden, Missouri. Roughly 190,000 pounds of PCB wastes (approximately .8% of the total waste volume) are alleged to have been sent to the site by the Company. By volume, the Company ranks twenty-third on the waste-in list. Site stabilization was completed by Clean Sites, Inc., the third party hired to negotiate a cleanup between the waste generators and the EPA. By letter dated November 12, 1993, the EPA approved the final remediation design for the Rose site. Final site cleanup is expected to begin in 1994. There is currently over 90% participation by the PRPs in the site cleanup. It is estimated that cleanup will cost approximately $30 million. The Company has contributed approximately $293,000 to the waste generators' group and does not expect that it will be required to contribute additional funds to complete remediation of this site. Although the Company cannot predict the outcome of this matter, it does not anticipate that the costs associated with this site will be material to the results of operations of the Company. c. In May 1989, the EPA notified the Company that it is a PRP with respect to the disposal of PCB transformers allegedly sent through Saline County Salvage to Elliot's Auto Parts Site in Benton, Arkansas. In its responses to the EPA, the Company stated its belief that no Company electrical equipment went to the site. Additionally, the Company declined to enter into an Administrative Order of Consent. In December 1992, the Elliot's Auto Parts PRP Committee requested that the Company pay a share of the estimated $2.65 million cost of cleaning up the site, and threatened to initiate litigation should the Company not contribute to the cleanup cost. The Company responded that it would be willing to participate in cleanup activities at the site if documentation was produced showing that the Company contributed any hazardous substances to the site. On January 21, 1993, the Elliot's Auto Parts PRP Committee produced documents alleging that the Company contributed hazardous substances to the site. Although the documentation provided does not clearly establish that the Company disposed of transformers at the Elliot's site, the Company is currently negotiating with the Elliot's Auto Parts PRP Committee to avoid protracted litigation. The Elliot's Auto Parts PRP Committee has completed remedial activities at the site at a cost of approximately $2.7 million and will soon submit a final report to the EPA. Although the Company cannot predict the outcome of this matter, it does not anticipate that costs associated with this site will be material to the results of operations of the Company. d. By letter dated May 21, 1991, the EPA notified the Company that it is a PRP with respect to the disposal of hazardous substances at the Benton Salvage site in Benton, Arkansas. The Company has been unable to identify any records of shipments by the Company to that site. Until any such documentation can be produced, the Company does not intend to participate in cleanup activities at the site. The Company cannot predict the outcome of this matter. e. On April 15, 1991, the North Carolina Department of Environment, Health, and Natural Resources (DEHNR) notified the Company that it is a PRP with respect to the disposal of hazardous waste at the Seaboard Chemical Corporation (Seaboard) site in Jamestown, North Carolina. DEHNR has indicated that it is offering PRPs the opportunity to perform voluntary site cleanup. Seaboard records indicate that there are over 1,300 PRPs for the site and that the Company's contribution to waste disposal is less than 1% of the total waste disposed. On May 29, 1992, the Company entered into an Administrative Order on Consent with DEHNR, Division of Solid Waste Management, to undertake and perform a Work Plan for Surface Removal (Removal Work Plan). On July 28, 1993, DEHNR determined that the Removal Work Plan had been substantially completed. DEHNR further recommended that the Seaboard Group (a group of PRPs with respect to the Seaboard site) undertake additional remedial activities at the Seaboard site. The Seaboard Group is currently considering its response to DEHNR's recommendation. The Company estimates that to date its costs associated with completion of the Removal Work Plan total approximately $12,000. Although the Company cannot predict the outcome of this matter, it does not anticipate that costs associated with this site will be material to the results of operations of the Company. f. On January 9, 1992, the EPA sent notice to the Company, along with a number of other companies and persons, stating that the Company is a PRP with respect to the additional remediation of hazardous wastes at the Macon-Dockery site located near Cordova, North Carolina. The Company made arrangements in the past for the transportation and sale of waste and residual oil to C&M Oil Distributors, a company that operated an oil reprocessing facility at the Macon-Dockery site for a period of several months. However, the information available to the Company indicates that no hazardous wastes from Company facilities were sent to the site. Previously, in 1987, the EPA sent notice to the Company that the EPA believed the Company was a PRP with respect to costs incurred by the EPA for initial site cleanup of the Macon-Dockery site. The Company was also a third-party defendant in a lawsuit brought in federal district court to recover the cleanup costs incurred by the EPA. That lawsuit was subsequently settled. Unless the EPA produces evidence which establishes that hazardous wastes from Company facilities were sent to the site, the Company does not intend to participate in these new cleanup activities. The Company cannot predict the outcome of this matter. 4. OTHER ENVIRONMENTAL MATTERS. a. On April 21, 1989, the North Carolina Division of Environmental Management (DEM) requested that the Company install a groundwater compliance monitoring system at the Company's Wilmington Oil Terminal located in New Hanover County, North Carolina. The request was prompted by the discovery of petroleum contamination beneath a neighboring oil transportation facility. DEM requested the installation of the monitoring system in order to determine if groundwater quality standards have been violated at the Wilmington Oil Terminal and if any such violations have contributed to the contamination underneath the neighboring facility. During the second half of 1989, six groundwater monitoring wells were installed and samples were collected and analyzed for the presence of petroleum hydrocarbons. Samples from one of the six wells indicated gasoline contamination and samples from a second well indicated No. 2 fuel oil contamination. The Company provided information on these monitoring wells to the DEM and in February 1993, DEM granted the Company permission to install a remediation system to collect and treat contaminated groundwater. This system conveys the groundwater to the neighboring facility for co-treatment of the contaminated water. Although the Company cannot predict the outcome of this matter, it believes that any remediation expense would not exceed $100,000 annually. b. Various organic materials associated with the production of manufactured gas, generally referred to as coal tar, are regulated under various federal and state laws, and a contingent liability may exist for their remediation. The production of manufactured gas was commonplace from the late 1800s until the 1950s. The Company has learned of the existence of several manufactured gas plant (MGP) sites to which the Company and certain entities which were later merged into the Company may have had some connection. In 1992, the State of North Carolina, through DEHNR's Division of Solid Waste Management (DSWM), launched an initiative to encourage former owners and operators of MGP sites to voluntarily assess those sites and to undertake remedial action where necessary. In this regard, the Company is participating in the North Carolina MGP Group (Group), a group of entities alleged to be former owners or operators of MGP sites, that was formed in response to DSWM's initiative. In December 1993, the Group and DSWM entered into a Memorandum of Understanding relative to the establishment of a uniform program and framework for addressing MGP sites for which DSWM has contended that members of the Group have potential responsibility. It is anticipated that the investigation and remediation of specific MGP sites will be addressed pursuant to one or more Administrative Orders on Consent between DSWM and individual potentially responsible parties. Additionally, a current owner of one such site formerly owned by Tidewater Power Co., which merged into the Company in 1952, made an informal claim against the Company for the cost of investigation and possible remediation, if necessary, of hazardous materials at this site. The Company and the current owner have entered into an agreement to share the cost of investigation and remediation of the site. Due to the lack of information with respect to the operation of MGP sites and the uncertainty concerning questions of liability and potential environmental harm, the extent and cost of required remedial action, if any, and the extent to which liability may be asserted against the Company or against others are not currently determinable. The Company cannot predict the outcome of these matters or the extent to which other former MGP sites may become the subject of inquiry. NUCLEAR MATTERS _______________ 1. GENERAL. Under the Atomic Energy Act of 1954 and the Energy Reorganization Act of 1974, as amended, operation of nuclear plants is intensively regulated by the NRC, which has broad power to impose nuclear safety and security requirements. In the event of non-compliance, the NRC has the authority to impose fines, set license conditions, or shut down a nuclear unit, or some combination of these, depending upon its assessment of the severity of the situation, until compliance is achieved. The electric utility industry in general has experienced challenges in a number of areas relating to the operation of nuclear plants, including substantially increased capital outlays for modifications; the effects of inflation upon the cost of operations; increased costs related to compliance with changing regulatory requirements; renewed emphasis on achieving excellence in all phases of operations; unscheduled outages; outage durations; and uncertainties regarding storage facilities for spent nuclear fuel. See paragraph 7.c. below. The Company experiences these challenges to varying degrees. Capital expenditures for modifications at the Company's nuclear units, excluding Power Agency's ownership interests, during 1994, 1995 and 1996 are expected to total approximately $108 million, $78 million and $55 million, respectively (including AFUDC). 2. SPENT FUEL AND OTHER HIGH-LEVEL RADIOACTIVE WASTE. The Nuclear Waste Policy Act of 1982 (Act) provides the framework for development by the federal government of interim storage and permanent disposal facilities for high-level radioactive waste materials. The Act promotes increased usage of interim storage of spent nuclear fuel at existing nuclear plants. The Company will continue to maximize the usage of spent fuel storage capability within its own facilities for as long as feasible. Pursuant to the Act, the Company, through a joint agreement with the U. S. Department of Energy (DOE) and the Electric Power Research Institute, has built a demonstration facility at the Robinson Plant that allows for the dry storage of 56 spent nuclear fuel assemblies. As of December 31, 1993, sufficient on-site spent nuclear fuel storage capability is available for the full-core discharge of Brunswick Unit No. 1 through 1994, Brunswick Unit No. 2 through 1996, and Robinson Unit No. 2 through 1998, assuming normal operating and refueling schedules. The Harris Plant spent fuel storage facilities, with certain modifications together with the spent fuel storage facilities at the Brunswick and Robinson Units, are sufficient to provide storage space for spent fuel generated on the Company's system through the expiration of the current operating licenses for all of the Company's nuclear generating units. Subsequent to the expiration of the licenses, as part of decommissioning of the units, dry storage may be necessary. The Company is maintaining full-core discharge capability for the Brunswick Units and Robinson Unit No. 2 by transferring spent nuclear fuel by rail to the Harris Plant. As a contingency to the shipment by rail of spent nuclear fuel, on April 27, 1989, the Company filed an application with the NRC for the issuance of a license to construct and operate an independent spent fuel storage facility for the dry storage of spent nuclear fuel at the Brunswick Plant. The Company cannot predict whether or not a license will ultimately be issued by the NRC. As required by the Act, the Company entered into a contract with the DOE under which the DOE will dispose of the Company's spent nuclear fuel. The contract includes a provision requiring the Company to pay the DOE for disposal costs. Disposal costs of fuel burned are based upon actual nuclear generation and are paid on a quarterly basis. Effective January 31, 1992, the DOE revised the method for calculating the nuclear waste disposal cost which will reduce the Company's quarterly payment. Existing overpayments, with interest, will be refunded in the form of credits over the next two fiscal years. Disposal costs, excluding waste disposal credits, are approximately $20 million annually based on the expected level of operations and the present disposal fee per kWh of nuclear generation, and are currently recovered through the Company's fuel adjustment clauses. See ITEM 1, "Retail Rate Matters," paragraph 5. Disposal fees may be reviewed annually by the DOE and adjusted, if necessary. The Company cannot predict at this time whether the DOE will be able to perform its contract and provide interim storage or permanent disposal repositories for spent fuel and/or high-level radioactive waste materials on a timely basis. 3. LOW-LEVEL RADIOACTIVE WASTE. Disposal costs for low-level radioactive waste that results from normal operation of nuclear units have increased significantly in recent years and are expected to continue to rise. Pursuant to the Low-Level Radioactive Waste Policy Act of 1980, as amended in 1985, each state is responsible for disposal of low-level waste generated in that state. States that do not have existing sites may join in regional compacts. The States of North Carolina and South Carolina are participants in the Southeast regional compact and, currently, dispose of waste at an existing disposal site in South Carolina along with other members of the compact. The North Carolina Low-Level Radioactive Waste Management Authority, which is responsible for siting and operating a new low-level radioactive waste disposal facility for the Southeast regional compact, recently selected a preferred site in Wake County, North Carolina. Although the Company does not control the future availability of low-level waste disposal facilities, the cost of waste disposal or the development process, it is actively supporting the development of new facilities and is committed to a timely and cost-effective solution to low-level waste disposal. Should shipments to the existing regional compact site cease, present projections indicate that existing on-site storage facilities at the Company's nuclear plants are sufficient to provide approximately eight months of storage capacity. The Company cannot predict the outcome of this matter. 4. DECOMMISSIONING. a. Pursuant to a NRC rule, licensees of nuclear facilities are required to submit decommissioning funding plans to the NRC for approval to provide reasonable assurance that the licensee will have the financial ability to implement its decommissioning plan for each facility. The rule requires licensees to do one of the following: prepay at least a NRC-prescribed minimum amount immediately; set up an external sinking fund for accumulation of at least that minimum amount over the operating life of the facility; or provide a surety to guarantee financial performance in the event of the licensee's financial inability to perform actual decommissioning. On July 26, 1990, the Company submitted its decommissioning funding plans to the NRC. In this regard, the Company entered into a Master Decommissioning Trust Agreement dated July 19, 1990 (Trust), with Wachovia Bank of North Carolina, N.A., as Trustee, as a vehicle to achieve such decommissioning funding. In June 1991, the Company began depositing amounts currently collected in rates into the Trust. At the currently approved jurisdictional funding levels, contributions to the Trust will be approximately $19 million on an annualized basis. Through December 31, 1993, the Company had collected through rates an aggregate of $221.6 million for decommissioning, which includes amounts funded internally and externally. b. The Company is required to increase external funding to the NRC-prescribed minimum no later than January 1, 1996. This NRC-prescribed minimum exceeds amounts currently collected in rates. In future rate filings, the Company will request rate recovery based on site-specific estimates for prompt dismantlement decommissioning. The requested rate recovery will also include funding plans that assume external funding of, at least, the NRC-prescribed minimum. The financial impact on the Company will depend on future ratemaking treatment. The NCUC and SCPSC have allowed other utilities to recover costs based on site-specific estimates for prompt dismantlement decommissioning and funding plans similar to those the Company intends to use. c. The Company's most recent site-specific estimates of decommissioning costs were developed in 1993, and are based on prompt dismantlement decommissioning, which reflects the cost of removal of all radioactive and other structures currently at the site. These estimates, in 1993 dollars, are as follows: $257.7 million for Robinson Unit No. 2; $284.3 million for the Harris Plant; $235.4 million for Brunswick Unit No. 1; and $221.4 million for Brunswick Unit No. 2. These estimates are subject to change based on a variety of factors, including, but not limited to, inflation, changes in technology applicable to nuclear decommissioning, and changes in federal, state or local regulations. The cost estimates exclude the portion attributable to Power Agency, which holds an undivided ownership interest in certain of the Company's generating facilities. To the extent of its ownership interests, Power Agency is responsible for satisfying the NRC's financial assurance requirements for decommissioning costs. See ITEM 1, "Generating Capabilities," paragraph 1. 5. OPERATING LICENSES. Facility Operating Licenses, issued by the NRC, may be amended by the NRC to extend the expiration dates of an operating license of a nuclear facility to allow for up to 40 years of commercial operation. The current expiration dates for the Company's nuclear facilities allow for the entire 40 years of commercial operation and are set forth in the following table. Facility Operating License Facility Expiration Date ________ __________________________ Robinson Unit No. 2 July 31, 2010 Brunswick Unit No. 1 September 8, 2016 Brunswick Unit No. 2 December 27, 2014 Harris Plant October 24, 2026 6. DESIGN BASIS RECONSTITUTION EFFORTS. The Company has been in the process of reviewing the design basis documentation for Robinson Unit No. 2 since 1988 and for the Brunswick Plant since 1990. Significantly more design detail has been required by the NRC for recently constructed plants than was needed when Robinson Unit No. 2 and the Brunswick Plant were built. In order to operate effectively in the current regulatory environment, the Company must be able to provide documentary evidence of compliance with regulations and design documents. The design basis reconstitution effort involves research, compilation and verification of documents that set forth the key design requirements of the various safety systems. The Company's review of the design basis documentation for Robinson Unit No. 2 was completed in 1993, and the Brunswick Plant effort is still in progress. The baseline effort for the two Brunswick Units is scheduled for completion by the end of 1996, and is projected to have a total cost of approximately $40 million. The Company cannot predict the outcome of this matter. 7. OTHER NUCLEAR MATTERS. a. Large diameter reactor recirculation system piping in boiling water reactor (BWR) units, such as the Brunswick Units, has the potential to crack as a result of intergranular stress corrosion (IGSCC) and the NRC required an ultrasonic inspection of such piping at BWR units. As a result of these inspections, certain portions of the large diameter reactor recirculation piping were replaced at both of the Brunswick Units. Subsequently, ultrasonic testing for IGSCC was performed on Brunswick Unit No. 1 during an outage in 1991 and identified a feedwater nozzle weld which required further study. The NRC authorized restart of Unit No. 1 and, based upon additional information provided by the Company, approved full-cycle operation of Unit No. 1. The feedwater nozzle in question is being evaluated for possible replacement as part of modifications scheduled for Brunswick during the next refueling outage. b. In 1991, the NRC issued a final rule on nuclear plant maintenance that will become effective on July 10, 1996. In general terms, the new maintenance rule prescribes the establishment of performance criteria for each safety system based on the significance of that system. The rule also requires monitoring of safety system performance against the established acceptance criteria, and provides that remedial action be taken when performance falls below the established criteria. The Company has been working closely with the Nuclear Management and Resources Council and with other utilities to develop its compliance approach and to minimize the financial and operational impacts of the new rule. The Company anticipates its compliance will be on schedule and is evaluating the magnitude of the financial and operational impacts of this new rule. The Company cannot predict the outcome of this matter. c. On November 23, 1988, the NRC requested in Generic Letter 88-20 that utilities perform Individual Plant Examinations (IPEs) to determine potential vulnerabilities to severe accidents beyond the design basis accidents for which the plants are designed. These are considered to be very low probability events. The Company submitted the results of the first phase (for internally initiated events) in August 1992 for the Brunswick and Robinson Plants. Potential enhancements for the Robinson Plant are currently being evaluated, and the Company cannot predict at this time the exact magnitude of financial and operational impacts which may result from these evaluations. For the Brunswick Plant, no modifications were required to meet the guidelines of the IPE. On August 20, 1993, the Company submitted the results of the Harris Plant IPE. While some Harris Plant procedural changes were made due to the IPE results, the IPE did not reveal any significant financial or operational impacts or identify any need for plant modifications. The Company cannot predict at this time the exact magnitude of the financial and operational impact of the second phase of the IPE (for externally initiated events) to be completed for all three plants during 1994-1995. d. In April 1992, both units at the Company's Brunswick Plant were taken out of service in order for the Company to address anchor bolt deficiencies and related wall construction issues in the diesel generator building. During the outage, in addition to resolving the anchor bolt deficiencies and related diesel generator building wall construction issues, the Company conducted detailed inspections and engineering evaluations of the plant's miscellaneous steel, performed necessary corrective and preventive maintenance and made certain modifications. An intensive on-site review of Brunswick Unit No. 2 was conducted by a NRC operational readiness assessment team from March 29 through April 9, 1993. The team concluded that the depth and capability of the Brunswick staff, the organizational structure and in-place programs were adequate to support Unit No. 2 restart and operation. On April 27, 1993, the NRC issued its determination that Unit No. 2 was ready for restart. The Company promptly began a detailed startup process at Unit No. 2 to ensure a safe, controlled and deliberate return to service. The Company returned Unit No. 2 to service in May 1993. In late December 1993, Unit No. 2 set a new continuous run record for that unit of more than 219 days. In July 1993, cracks were discovered in the Brunswick Unit No. 1 reactor vessel shroud during inspections made as part of refueling activities performed during the outage. The Company conducted intensive ultrasonic testing and physical sampling inspections of the cracks. The results of this investigation provided data used to develop new stiffening braces to ensure that the shroud will continue to perform its design function. Shroud modifications were completed in late December 1993. Costs associated with the shroud repairs were not material to the results of operations of the Company. The Company commenced startup of Unit No. 1 on February 1, 1994 under a gradual power ascension startup plan. This power ascension plan was completed 27 days ahead of schedule when Unit No. 1 was returned to normal operation on February 23, 1994, after successfully completing extensive startup testing. Additional shroud inspections may be conducted during future refueling outages to identify and monitor other minor cracking in the shroud. The Company cannot predict the outcome of this matter. In July 1993, the Company also determined that the Brunswick Unit No. 2 shroud has minor crack indications which do not compromise the safety or operation of the Unit. Shroud modifications, similar to those performed on Unit No. 1, will be undertaken on Unit No. 2 during the spring 1994 refueling outage. The Company does not expect that costs associated with the shroud modifications will be material to the results of operations of the Company. On October 14, 1993, two private organizations, the National Whistleblower Center and the Coastal Alliance for a Safe Environment, and an individual filed a petition with the NRC under 10 C.F.R. Section 2.206 alleging that the Company was aware of the shroud cracks as early as 1984 and engaged in criminal activities to conceal its knowledge of the cracks. The petitioners requested that the NRC require the Company to state whether it knew about the cracks in 1984 and determine whether the Company has engaged in criminal wrongdoing. To date, the petitioners have failed to provide the Company with any evidence substantiating their claims. Additionally, the Company conducted an internal technical review of this matter which did not reveal any evidence that substantiates the petitioners' claims. The results of this technical review were submitted to the NRC in November 1993. Although the Company cannot predict the outcome of this matter, it believes the allegations contained in the petition are without merit. In December 1993, the NRC issued its latest Systematic Assessment of Licensee Performance (SALP) report for the Brunswick Plant. The report rated Brunswick's plant operations and plant support as "superior," and the Plant's maintenance and engineering as "good." The NRC, in both the report and at a public meeting, recognized significant improvements made at the plant. On July 28, 1993, the Company, the Public Staff, the Attorney General of the State of North Carolina, and Carolina Industrial Group for Fair Utility Rates II entered into an agreement that resolved as between them all issues related to the Brunswick Plant outage on or before the date of the agreement, avoided higher fuel charges to the Company's customers and settled the Company's 1993 North Carolina fuel adjustment proceeding. The Company had $31.2 million in fuel expenses for the twelve-month period ended March 31, 1993 that had not been recovered from North Carolina customers through the Company's rates. As a part of the agreement, the Company agreed to forgo recovering $25.5 million of these fuel expenses, and to recover the remaining $5.7 million through rates over a twelve-month period beginning in September 1993. That $5.7 million is subject to refund at the end of three years if the Brunswick Plant does not achieve a specified operating performance level. Additionally, the Company agreed that if the Brunswick Plant's performance for the three-year period ending March 31, 1996 does not achieve a specified operating performance level, the Company could lose up to $10 million in additional fuel expenses. By order dated September 14, 1993, the NCUC approved the agreement. The forgone fuel expense recovery of $25.5 million reduced the Company's 1993 earnings by approximately $.10 per common share. On September 7, 1993, the Company, the Staff of the SCPSC, Nucor Steel, and the Consumer Advocate for the State of South Carolina, which represents the using and consuming public in matters before the SCPSC, entered into an agreement to settle the fall 1993 SCPSC fuel proceeding. The settlement resolved all issues related to fuel costs incurred by the Brunswick Plant through June 30, 1993, avoided higher fuel charges to the Company's customers and settled the fall 1993 semi-annual South Carolina fuel adjustment proceedings. The SCPSC approved the agreement by order dated September 14, 1993. Pursuant to the terms of the settlement, the Company agreed to forgo recovery of a total of $15.6 million in fuel expenses. The forgone fuel expense recovery of $15.6 million reduced the Company's 1993 earnings by approximately $.06 per common share. The NRC, the NCUC and the SCPSC will continue to review the Company's activities at the Brunswick Plant. Except as noted, the Company cannot predict the extent to which these and other actions may impact its ability to recover costs associated with this outage. e. On November 17, 1993, during startup from a scheduled refueling outage at the Company's H. B. Robinson Plant Unit No. 2, the Company discovered problems with the fuel supplier's fabrication of certain fuel assemblies which had been loaded during the outage. A problem relating to the calibration of the power level instrumentation was also identified. The Company elected to interrupt and delay the startup process pending analysis and correction of the problems, and notified the NRC of its decision. The NRC issued a Confirmatory Action Letter, dated November 19, 1993, in which it confirmed, among other things, that the Company would conduct detailed root cause analyses of the fuel assembly and power level instrumentation issues and would take appropriate corrective actions. On November 20, 1993, an NRC Augmented Inspection Team (AIT) began its investigation of the fuel assembly and power level instrumentation issues. In investigating the fuel assembly issue, the AIT visited both the Robinson Plant and the fuel supplier's facilities. Results of the AIT's investigation were initially released in a public meeting on December 6, 1993 and the AIT's report was issued on January 5, 1994. An enforcement conference was conducted on March 14, 1994 for the purpose of discussing apparent violations identified in the AIT's report in the areas of management control of refueling and restart activities. The NRC will determine whether or not to issue violations and what, if any, resulting penalty should be imposed upon the Company. The Company cannot predict the outcome of this matter. In a separate action, on March 14, 1994, the NRC issued a Notice of Violation and Proposed Imposition of Civil Penalty in the amount of $37,500 relating to the degradation of both Robinson Unit No. 2 emergency diesel generators and failure to correct conditions which affected operation of one of the diesel generators in mid-November, 1993. The base civil penalty for this type of violation is $50,000, but the propsoed penalty was reduced to $37,500 due to the Company's comprehensive performance in analyzing the root cause of the diesel generator problem. The Company has thirty days from the date of the Notice to pay or protest the civil penalty, in whole or in part. The Company intends to pay the civil penalty. The Company cannot predict the outcome of this matter. On February 8, 1994, the NRC issued its SALP report for Robinson Unit No. 2 for the period June 1992 through December 1993. While the NRC noted that overall performance of Robinson Unit No. 2 was reasonably good, it indicated that performance declined in several areas, primarily due to the matters discussed above. The NRC rated Robinson Unit No. 2's performance as "good" in operations, engineering and plant support and "acceptable" in maintenance. In early February 1994, the Company satisfied the conditions of the NRC's confirmatory action letter, and returned Robinson Unit No. 2 to service on March 21, 1994 under a power ascension plan. f. The Company is insured against public liability for a nuclear incident up to $9.4 billion per occurrence, which is the maximum limit on public liability claims pursuant to the Price-Anderson Act. The $9.4 billion coverage includes $200 million primary coverage and $9.2 billion secondary financial protection through assessments on nuclear reactor owners. In the event that public liability claims from an insured nuclear incident exceed $200 million, the Company would be subject to a pro rata assessment, for each reactor it owns, of up to $75.5 million, plus a 5% surcharge, for each incident. Payment of such assessment would be made over time as necessary to limit the payment in any one year to no more than $10 million per reactor owned. Power Agency would be responsible for its ownership share of the assessment on jointly-owned units. FUEL ____ 1. SOURCES OF GENERATION. Total system generation (including Power Agency's share) by primary energy source, along with purchased power, for the years 1990 through 1994 is set forth below: 1990 1991 1992 1993 1994 _______________________________________________ (estimated) Fossil 47% 47% 56% 54% 47% Nuclear 41 41 27 31 40 Purchased Power 10 10 15 13 11 Hydro 2 2 2 2 2 2. COAL. The Company has intermediate and long-term agreements from which it expects to receive approximately 88% of its coal burn requirements in 1994. During 1992 and 1993, the Company obtained approximately 79% (8,185,000 tons) and 73% (7,198,000 tons), respectively, of its coal burn requirements from intermediate and long-term agreements. Over the next ten years, the Company expects to receive approximately 75% of its coal burn requirements from intermediate and long-term agreements. Existing agreements have expiration dates ranging from 1994 to 2006. During 1993, the Company maintained from 48 to 99 days' supply of coal, based on anticipated burn rate. All of the coal that the Company is currently purchasing under intermediate and long-term agreements is considered to be low sulfur coal by industry standards. Recent amendments to the Clean Air Act may result in increases in the price of low sulfur coal prior to the effective date of the first phase of the Act, with such impact to continue beyond the effective date of the second phase of the Act. See ITEM 1, "Environmental Matters," paragraph 2. The Company purchased approximately 2,250,000 tons of coal in the spot market during 1992 and 2,650,000 tons in 1993. No spot coal was purchased in 1991. The Company's contract coal purchase prices during 1993 ranged from approximately $23.19 to $39.38 per ton (F.O.B. mine). The average cost to the Company of coal delivered for the past five years is as follows: Year $/Ton Cents/Million BTU ____ _____ _________________ 1989 45.01 179 1990 45.88 183 1991 47.40 190 1992 43.25 174 1993 43.10 172 3. OIL. The Company uses No. 2 oil primarily for its combustion turbine units, which are used for emergency backup and peaking purposes. The Company burned approximately 8.4 million and 9.1 million gallons of No. 2 oil during 1992 and 1993, respectively. The Company has a No. 2 oil supply contract for its normal requirements. In the event base-load capacity is unavailable during periods of high demand, the Company may increase the use of its combustion turbine units, thereby increasing No. 2 oil consumption. The Company intends to meet any additional requirements for No. 2 oil through additional contract purchases or purchases in the spot market. There can be no assurance that adequate supplies of No. 2 oil will be available to meet the Company's requirements. To reduce the Company's vulnerability to dislocations in the oil market, seven combustion turbine units with a total generating capacity of 364 MW have been converted to burn either propane or No. 2 oil. In addition, twelve combustion turbine units with a total generating capacity of 425 MW can burn natural gas when available. Over the last five years, No. 2 oil, natural gas and propane accounted for 1.7% of the Company's total burned fuel cost. In 1993, No. 2 oil, natural gas and propane accounted for 1.5% of total burned fuel cost. The availability and cost of fuel oil could be adversely affected by energy legislation enacted by Congress, disruption of oil or gas supplies, labor unrest and the production, pricing and embargo policies of foreign countries. 4. NUCLEAR. The nuclear fuel cycle requires the mining and milling of uranium ore to provide uranium oxide concentrate (U3O8), the conversion of U3O8 to uranium hexafluoride (UF6), the enrichment of the UF6 and the fabrication of the enriched uranium into fuel assemblies. The Company has on hand or has contracted for raw materials and services for its nuclear units through the years shown below: Raw Materials and Service _______________________________________________ Unit Uranium Conversion Enrichment Fabrication ____ _______ __________ __________ ___________ Robinson No. 2 1996 1995 1994 1999 Brunswick No. 1 1996 1995 1994 1998 Brunswick No. 2 1996 1995 1994 1998 Harris Plant 1996 1995 1994 1998 These contracts are expected to supply the necessary nuclear fuel to operate Robinson Unit No. 2 through 1995, Brunswick Unit No. 1 through 1995, Brunswick Unit No. 2 through 1996, and the Harris Plant through 1996. The Company expects to meet its U3O8 requirements through the years shown above from inventory on hand and amounts received under contract. Although the Company cannot predict the future availability of uranium and nuclear fuel services, the Company does not currently expect to have difficulty obtaining U3O8 and the services necessary for its conversion, enrichment and fabrication into nuclear fuel for years later than those shown above. For a discussion of the Company's plans with respect to spent fuel storage, see ITEM 1, "Nuclear Matters," paragraph 2. 5. DOE ENRICHMENT FACILITIES DECONTAMINATION AND DECOMMISSIONING FUND. Under Title XI of the Energy Policy Act of 1992, Public Law 102-486, Congress established a decontamination and decommissioning fund for the DOE's gaseous diffusion enrichment plants. Contributions to this fund will be made by U.S. domestic utilities who have purchased enrichment services from DOE since it began sales to non-Department of Defense customers. Each utility's share of the contributions will be based on that utility's past purchases of services as a percentage of all purchases of services by U.S. utilities, with total annual contributions capped at $150 million per year, indexed to inflation, and an overall cap of $2.25 billion over 15 years, also indexed to inflation. The Company made its first payment, totaling approximately $5.2 million, to the fund on September 30, 1993. At December 31, 1993, the Company had recorded a liability of $77.7 million representing its estimated share of the contributions and expects to recover these amounts as a component of fuel cost. 6. PURCHASED POWER. In 1993 the Company purchased 6,375,907 MWh or approximately 13% of its energy requirements and had available 1,649 MW of firm purchased capacity under contract at the time of peak load. The Company also had a 100 MW firm capacity commitment to SCE&G during the peak due to a limited-term sale agreement for the summers of 1993 and 1994. See ITEM 1, "Interconnections with Other Systems," paragraph 3. The Company may acquire purchased power capacity in the future to accommodate a portion of its system load needs. OTHER MATTERS _____________ 1. SAFETY INSPECTION REPORTS. On April 3, 1990, the FERC sent a letter to the Company providing comments on its review of the Company's Fifth (1987) Independent Consultant's Safety Inspection Report (required every five years under FERC Regulation 18 CFR Part 12) for the Walters Hydroelectric Project and requesting the Company to undertake certain supplemental analyses and investigations regarding the stability of the dam under extreme and improbable loading conditions. Similar letters were sent by the FERC on May 30, 1990, with respect to the Company's Blewett and Tillery Hydroelectric Plants. With the independent consultant, the Company has begun addressing the issues raised by the FERC and is working with the FERC to complete investigations and analyses with respect to each of these matters. While both the FERC and the Company do not believe that there are any stability concerns that would be cause for any imminent safety concerns, the outcome of the analyses and investigations is currently unknown. Depending on the outcome of the analyses and the FERC's interpretations, the Company could be required to undertake efforts to enhance the stability of the dams. The cost and need for such efforts have not been determined. The Company cannot predict the outcome of this matter. 2. MARSHALL HYDROELECTRIC PROJECT. On November 21, 1991, the FERC notified the Company that the 5 MW Marshall Hydroelectric Project is no longer exempt from 18 CFR Part 12, Subparts C and D, dam safety regulations and that the plant's regulatory jurisdiction was being transferred from the NCUC to the FERC. This change resulted from updated dambreak flood studies which identified the potential impact on new downstream development, thus indicating the need to reclassify the project from a "low" to a "high" hazard classification. In accordance with the change in regulatory jurisdiction, the Company developed an emergency action plan which meets FERC regulations and guidelines and engaged its independent consultant to perform a safety inspection. On April 6, 1992, the consultant's safety inspection report was submitted to the FERC for approval. Depending on the outcome of FERC's review of the safety inspection report, the Company could be required to undertake efforts to enhance the stability of the Marshall dam and/or powerhouse. The cost and need for such efforts have not been determined. The Company cannot predict the outcome of this matter. [TEXT] ITEM 2.

ITEM 2. PROPERTIES _______ __________ In addition to the major generating facilities listed in ITEM 1, "Generating Capability," the Company also operates the following plants: Plant Location _____ ________ 1. Walters North Carolina 2. Marshall North Carolina 3. Tillery North Carolina 4. Blewett North Carolina 5. Darlington South Carolina 6. Weatherspoon North Carolina 7. Morehead City North Carolina The Company's sixteen power plants represent a flexible mix of fossil, nuclear and hydroelectric resources, with a total generating capacity of 9,613 MW. The Company's strategic geographic location facilitates purchases and sales of power with many other electric utilities, allowing the Company to serve its customers more economically and reliably. Major industries in the Company's service area include textiles, chemicals, metals, paper, automotive components and electronic machinery and equipment. At December 31, 1993, the Company had 5,830 pole miles of transmission lines including 292 miles of 500 kV and 2,789 miles of 230 kV lines, and distribution lines of approximately 38,560 pole miles of overhead lines and approximately 7,234 miles of underground lines. Distribution and transmission substations in service had a transformer capacity of approximately 34,794 kVA in 2,263 transformers. Distribution line transformers numbered 383,314 with an aggregate 15,264,600 kVA capacity. Power Agency has acquired undivided ownership interests of 18.33% in Brunswick Unit Nos. 1 and 2, 12.94% in Roxboro Unit No. 4 and 16.17% in Harris Unit No. 1 and Mayo Unit No. 1. Otherwise, the Company has good and marketable title, subject to the lien of its Mortgage and Deed of Trust, with minor exceptions, restrictions and reservations in conveyances and defects, which are of the nature ordinarily found in properties of similar character and magnitude, to its principal plants and important units, except certain rights-of-way over private property on which are located transmission and distribution lines, title to which can be perfected by condemnation proceedings. Plant Accounts (including nuclear fuel) - _______________________________________ During the period January 1, 1989 through December 31, 1993, there was added to the Company's utility plant accounts $1,827,147,000, there was retired $469,275,000 of property and there were transfers to other accounts and adjustments for a net decrease of $290,311,000 resulting in net additions during the period of $1,067,561,000 or an increase of approximately 12.6%. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS ______ _________________ Legal and regulatory proceedings are included in the discussion of the Company's business in ITEM 1 and incorporated by reference herein. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS _______ ___________________________________________________ No matters were submitted to a vote of security holders in the fourth quarter of 1993. EXECUTIVE OFFICERS OF THE REGISTRANT Name Age Recent Business Experience ____ ___ __________________________ Sherwood H. Smith, Jr. 59 Chairman and Chief Executive Officer, September 1992 to present; Chairman/President and Chief Executive Officer, May 1980 to September 1992. Member of the Board of Directors of the Company since 1971. William Cavanaugh III 55 President and Chief Operating Officer, September 1992 to present; Group President - Energy Supply, Entergy Corporation, July 1992; Chairman, Chief Executive Officer and Director, System Energy Resources, Inc., April 1992; Chairman and Chief Executive Officer, Entergy Operations, Inc., April 1992; Senior Vice President, System Executive - Nuclear, Entergy Corporation and Entergy Services, Inc., 1987-August 1992; Executive Vice President and Chief Nuclear Officer, Arkansas Power & Light Company and Louisiana Power & Light Company, 1990-August 1992; President and Chief Executive Officer, System Energy Resources, Inc., 1986-April 1992; President and Chief Executive Officer, Entergy Operations, Inc., 1990-April 1992. Member of Board of Directors of Arkansas Power & Light Company and Louisiana Power & Light Company, 1990-August 1992; Member of Board of Directors of System Fuels, Inc., 1992-August 1992; Member of Board of Directors of System Energy Resources, Inc., 1986-August 1992; Member of Board of Directors of Entergy Operations, Inc., 1990-August 1992; Member of Board of Directors of Entergy Services, Inc., 1987-August 1992. Before joining the Company, Mr. Cavanaugh held various senior management and executive positions during a 23-year career with Entergy Corporation, an electric utility holding company with operations in Arkansas, Louisiana and Mississippi. Member of the Board of Directors of the Company since 1993. Charles D. Barham, Jr. 63 Executive Vice President and Chief Financial Officer - Finance and Administration, November 1990 to present; Senior Vice President - Legal, Planning and Regulatory Group, July 1987; Senior Vice President and General Counsel - Legal and Regulatory Group, May 1982. Member of the Board of Directors of the Company since 1990. Lynn W. Eury 57 Executive Vice President - Power Supply, April 1989 to present; Senior Vice President - Operations Support, June 1986; Senior Vice President - Fossil Generation and Power Transmission Group, August 1983. William S. Orser 49 Executive Vice President - Nuclear Generation, April 1993 to present; Executive Vice President - Nuclear Generation, Detroit Edison Company, 1992-April 1993; Senior Vice President - Nuclear Generation, Detroit Edison Company, 1990-1992; Vice President - Nuclear Operations, Detroit Edison Company, 1988-1990. Prior to 1988, Mr. Orser held various other positions with Detroit Edison, and with Portland General Electric Company, Southern California Edison, and the U. S. Navy. James M. Davis, Jr. 57 Senior Vice President, Group Executive - Fossil Generation and Power Transmission, June 1986 to present; Senior Vice President - Operations Support Group, August 1983. Norris L. Edge 62 Senior Vice President, Group Executive - Customer and Operating Services, May 1990 to present; Vice President - Rates and Energy Services, September 1989; Vice President - Rates and Service Practices, December 1980. Richard E. Jones 56 Senior Vice President, General Counsel and Secretary, Group Executive - Legal, Rates, Communications and Public Affairs, January 1993 to present; Group Executive - Legal and Regulatory Services, November 1990 to January 1993; Vice President, General Counsel and Secretary, November 1989; Vice President and General Counsel, July 1987; Vice President, Senior Counsel and Manager - Legal Department, May 1982. Paul S. Bradshaw 56 Vice President and Controller, March 1980 to present. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS ______ ______________________________________________________ The Company's Common Stock is listed on the New York and Pacific Stock Exchanges. The high and low sales prices per share, adjusted for the two-for-one Common Stock split described below, for the periods indicated, as reported as composite transactions in The Wall Street Journal, and dividends paid are as follows: 1992 High Low Dividends Paid _________________________________________________________________ First Quarter $ 26 15/16 $ 24 9/16 $.395 Second Quarter 27 1/16 24 3/4 .395 Third Quarter 26 5/8 25 .395 Fourth Quarter 28 1/16 25 7/16 .395 1993 High Low Dividends Paid _________________________________________________________________ First Quarter $ 32 7/8 $ 27 1/16 $.410 Second Quarter 34 31 1/4 .410 Third Quarter 34 1/2 32 1/8 .410 Fourth Quarter 33 3/8 28 1/8 .410 The December 31 closing price of the Company's Common Stock was $27 3/4 in 1992 and $30 1/8 in 1993. As of February 28, 1994, the Company had 72,863 holders of record of Common Stock. In December 1992, the Board of Directors of the Company authorized a two-for-one split of the Company's Common Stock. On February 1, 1993, one additional share was issued for each share outstanding to shareholders of record on January 11, 1993. The number of common shares and average common share data for all periods reflect the two-for-one stock split. [TEXT] ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS _______ _________________________________________________ The Company's financial condition and results of operations are affected by numerous factors, including the timing and amount of rate relief, the extent of sales growth and the level of operating costs. The following discussion and analysis should be considered in conjunction with the relevant Sections of ITEM 1, "Selected Financial Data" in ITEM 6, and the Company's financial statements appearing in ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA _______ ___________________________________________ The following financial statements, supplementary data and financial statement schedules are included herein: Independent Auditors' Report Financial Statements: Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 Balance Sheets as of December 31, 1993 and 1992 Statements of Retained Earnings for the Years Ended December 31, 1993, 1992 and 1991 Schedules of Capitalization as of December 31, 1993 and 1992 Notes to Financial Statements Quarterly Financial Data Financial Statement Schedules for the Years Ended December 31, 1993, 1992 and 1991: V - Utility Plant VI - Accumulated Provision for Depreciation and Amortization of Electric Utility Plant VIII - Reserves IX - Short-term Borrowings X - Supplementary Income Statement Information All other schedules have been omitted as not applicable or not required or because the information required to be shown is included in the Financial Statements or the accompanying Notes to Financial Statements. INDEPENDENT AUDITORS' REPORT To the Board of Directors and Shareholders of Carolina Power & Light Company: We have audited the accompanying balance sheets and schedules of capitalization of Carolina Power & Light Company as of December 31, 1993 and 1992, and the related statements of income, retained earnings, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 8. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the financial position of the Company at December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. Also, in our opinion, such financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. We have also previously audited, in accordance with generally accepted auditing standards, the balance sheets and schedules of capitalization as of December 31, 1991, 1990, and 1989, and the related statements of income, retained earnings and cash flows for the years ended December 31, 1990 and 1989 (none of which are presented herein); and we expressed unqualified opinions on those financial statements. In our opinion, the information set forth in the selected financial data for each of the five years in the period ended December 31, 1993, appearing at Item 6, is fairly presented in all material respects in relation to the financial statements from which it has been derived. As discussed in Note 6 to the financial statements, in 1993 the Company changed its method of accounting for income taxes to conform with Statement of Financial Accounting Standards No. 109. /s/ DELOITTE & TOUCHE Raleigh, North Carolina February 14, 1994 [TEXT] NOTES TO FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES A. System of Accounts The accounting records of the Company are maintained in accordance with uniform systems of accounts prescribed by the Federal Energy Regulatory Commission (FERC), the North Carolina Utilities Commission (NCUC) and the South Carolina Public Service Commission (SCPSC). Certain amounts for 1992 and 1991 have been reclassified to conform to the 1993 presentation. B. Electric Utility Plant The cost of additions, including replacements of units of property, and betterments is charged to utility plant. Maintenance and repairs of property, and replacements and renewals of items determined to be less than units of property, are charged to maintenance expense. The cost of units of property replaced, renewed or retired, plus removal or disposal costs, less salvage, is charged to accumulated depreciation. Electric utility plant other than nuclear fuel is subject to the lien of the Company's mortgage. As prescribed in regulatory uniform systems of accounts, an allowance for the cost of borrowed and equity funds (AFUDC) used to finance electric utility plant construction is charged to the cost of plant. Regulatory authorities consider AFUDC an appropriate charge for inclusion in the Company's utility rates to customers over the service life of the property. The equity funds portion of AFUDC is credited to other income, the borrowed funds portion is credited to interest charges and, in years prior to 1993, a deferred income tax provision was reflected as a reduction in the borrowed funds portion. The composite, net-of-tax AFUDC rate was 7.3% in 1992 and 6.3% in 1991. Due to the implementation of Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes," in 1993, AFUDC-borrowed funds is no longer recorded on a net-of-tax basis (see Note 6). The composite AFUDC rate in 1993, which reflects the implementation of SFAS No. 109, was 8.8%. Pursuant to the provisions of SFAS No. 109, the deferred income taxes related to AFUDC in undepreciated plant in service at January 1, 1993, were recorded to an accumulated deferred income tax liability with an offsetting adjustment to a regulatory asset. C. Depreciation and Amortization For financial reporting purposes, depreciation of utility plant other than nuclear fuel is computed on the straight-line method based on the estimated remaining useful life of the property, adjusted for estimated net salvage. Depreciation provisions, including decommissioning costs (see Note 1D), as a percent of average depreciable property other than nuclear fuel, were approximately 3.7% in each of the years 1993, 1992 and 1991. Depreciation and amortization expense also includes amortization of plant abandonment costs (see Note 7) and intangible plant, which primarily includes software development costs. Amortization of nuclear fuel costs, including disposal costs associated with obligations to the U.S. Department of Energy (DOE), is computed primarily on the unit-of-production method and charged to fuel for generation. Costs related to obligations to the DOE for the decommissioning and decontamination of enrichment facilities are also charged to fuel for generation. The disposal and the decommissioning and decontamination costs are components of fuel costs for the purpose of deferred fuel accounting (see Note 1E). D. Nuclear Decommissioning Depreciation and amortization expense includes provisions for nuclear decommissioning costs. In the Company's retail jurisdictions, provisions for nuclear decommissioning costs are approved by the NCUC and the SCPSC and are based on site-specific estimates that included the costs for removal of all radioactive and other structures at the site. Cost recovery is based on an internal modified sinking fund methodology assuming 30-year delayed dismantlement decommissioning. In the wholesale jurisdiction, the provisions for nuclear decommissioning costs are based on amounts agreed upon in applicable rate settlements. Accumulated nuclear decommissioning cost provisions included in accumulated depreciation were $221.6 million at December 31, 1993, and $186.4 million at December 31, 1992. Pursuant to regulations of the Nuclear Regulatory Commission (NRC), the Company is required to provide financial assurance that funds will be available for decommissioning. In this regard, the Company filed decommissioning plans with the NRC and, in 1991, began depositing amounts currently collected in rates in an external decommissioning trust. The Company is required to increase external funding to the NRC-prescribed minimum no later than January 1, 1996. This NRC-prescribed minimum exceeds amounts currently collected in rates. In future rate filings, the Company will request rate recovery based on site-specific estimates for prompt dismantlement decommissioning. The requested rate recovery will also include funding plans that assume external funding of, at least, the NRC-prescribed minimum. The financial impact on the Company will depend on future ratemaking treatment. The NCUC and SCPSC have allowed other utilities to recover costs based on site-specific estimates for prompt dismantlement decommissioning and funding plans similar to those the Company intends to use. The Company's most recent site-specific estimates of decommissioning costs were developed in 1993 and are based on prompt dismantlement decommissioning, which reflects the cost of removal of all radioactive and other structures currently at the site. These estimates, in 1993 dollars, are $257.7 million for Robinson Unit No. 2, $284.3 million for the Harris Plant, $235.4 million for Brunswick Unit No. 1 and $221.4 million for Brunswick Unit No. 2. These estimates are subject to change based on a variety of factors, including, but not limited to, inflation, changes in technology applicable to nuclear decommissioning, and changes in federal, state or local regulations. The cost estimates exclude the portion attributable to North Carolina Eastern Municipal Power Agency (Power Agency), which holds an undivided ownership interest in certain of the Company's generating facilities (see Note 8). To the extent of its ownership interests, Power Agency is responsible for satisfying the NRC's financial assurance requirements for decommissioning costs. E. Other Policies Customers' meters are read and bills are rendered on a cycle basis. Revenues are recorded as services are rendered. Regulators of all three jurisdictions require deferred fuel accounting in which the Company defers the difference between fuel costs incurred and the fuel component of customer rates. Customer rates are adjusted periodically to incorporate the approved deferrals. Other property and investments are stated principally at cost, less accumulated depreciation where applicable. The Company maintains an allowance for doubtful accounts receivable, which totaled $2.3 million at December 31, 1993, and $2.1 million at December 31, 1992. Fuel inventory and inventory of materials and supplies are carried on a first-in, first-out or average cost basis. Long-term debt premiums, discounts and issuance expenses are amortized over the life of the related debt using the straight-line method. Any expenses or call premiums associated with the reacquisition of debt obligations are amortized over the remaining life of the original debt using the straight-line method. For purposes of the Statements of Cash Flows, the Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents. 2. FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying amounts of cash, cash equivalents and notes payable approximate fair value because of the short maturities of these instruments. The estimated fair value of long-term debt was obtained from an independent pricing service. Investments in trusts, presented in the table below, primarily includes external decommissioning trust assets and funds invested pursuant to a voluntary employee beneficiary association. The estimated fair values of the Company's trust investments were obtained from quoted market prices. These estimated fair values are as follows (in thousands). 1993 1992 Carrying Fair Carrying Fair Amount Value Amount Value Long-term debt....$2,799,761 $2,877,300 $2,958,588 $2,978,276 Investments in trusts..........$ 117,022 $ 119,277 $ 91,119 $ 91,844 There are inherent limitations in any estimation technique, and the estimates presented herein are not necessarily indicative of the amounts the Company could realize in current transactions. 3. CAPITALIZATION A. Common Stock Equity In December 1992, the Board of Directors authorized a two-for-one split of the Company's common stock. On February 1, 1993, one additional share was issued for each share outstanding to shareholders of record on January 11, 1993. The number of common shares, average common shares and per common share data for all periods reflect the two-for-one stock split. In 1989, the Company issued common stock shares to the Trustee of the Company's Stock Purchase-Savings Plan (SPSP) in conjunction with a qualified employee stock ownership plan (ESOP) loan. At December 31, 1993, the Trustee was indebted to the Company for $216.2 million. The note receivable from the Trustee is treated as a reduction in common stock equity. At December 31, 1993, the Company had 14,767,052 shares of authorized but unissued common stock reserved and available for issuance to satisfy the requirements of the Company's stock plans. The Company intends, however, to meet the requirements of these stock plans with issued and outstanding shares presently held by the Trustee of the SPSP or with open market purchases of common stock shares, as appropriate. The Company's mortgage, as supplemented, and charter contain provisions limiting the use of retained earnings for the payment of dividends under certain circumstances. At December 31, 1993, there were no significant restrictions on the use of retained earnings. B. Long-Term Debt As of December 31, 1993, long-term debt maturities for the years 1994 through 1998 were $50 million, $275 million, $55 million, $40 million and $205 million, respectively. Person County Pollution Control Revenue Refunding Bonds-Series 1992A totaling $56 million have interest rates that must be renegotiated on a weekly basis. First Mortgage Bonds-Pollution Control Series G, J and K, totaling $127 million have three-year interest rate periods that expire in 1994 and 1997. At the time, of interest rate renegotiation, holders of these bonds may require the Company to repurchase their bonds. These obligations are excluded in total from long-term debt maturities in the preceding paragraph. A portion of these bonds is classified as long-term debt in the Balance Sheets, consistent with the Company's intention to maintain the debt as long-term and to the extent that this intention is supported by a $70 million long-term revolving credit agreement (see Note 4). The amount of these obligations not covered by the long-term revolving credit agreement is included in current portion of long-term debt in the Balance Sheets. 4. REVOLVING CREDIT FACILITIES At December 31, 1993, the Company's unused and readily available revolving credit facilities totaled $208.1 million, consisting of a $115 million revolving credit agreement with nine domestic money centers and major regional banks, a $23.1 million revolving credit agreement with fifteen regional banks and a $70 million long-term revolving credit agreement with eight foreign banks. 5. POSTRETIREMENT BENEFIT PLANS The Company has a noncontributory defined benefit retirement plan (Plan) for all full-time employees and funds the Plan in amounts that comply with contribution limits imposed by law. Plan benefits reflect an employee's recent compensation, years of service and age at retirement. [TEXT] The expected long-term rate of return on plan assets used in determining the net periodic pension cost was 9% for each of the three years. In addition to pension benefits, the Company provides contributory postretirement benefits, including certain health care and life insurance benefits, for substantially all retired employees. In January 1993, the Company implemented SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." SFAS No. 106 requires the recognition of the costs associated with these other postretirement benefits (OPEB) on an accrual basis. Previously, the cost of OPEB was generally recognized as claims were incurred and premiums were paid. These costs totaled $2.7 million in 1992 and $3.0 million in 1991. The components of the net periodic cost of OPEB for 1993 are as follows (in thousands). Actual return on plan assets....................$ (497) Variance from expected return, deferred......... 9 ---------- Expected return on plan assets.................. (488) Service cost.................................... 6,797 Interest cost on accumulated benefit obligation. 9,662 Net amortization................................ 5,966 ---------- Net cost......................................$ 21,937 ========== A reconciliation of the funded status of the OPEB plans to the amount recognized in the Balance Sheet at December 31, 1993, is presented below (in thousands). Actuarial present value of benfits for services rendered to date: Current retirees................................$ (62,727) Active employees eligible to retire............. (14,800) Active employees not eligible to retire......... (62,225) ---------- Accumulated postretirement benefit obligation. (139,752) Fair market value of plan assets, invested primarily in equity and fixed-income securities......... 7,584 ---------- Funded status.......................... (132,168) Unrecognized actuarial loss..................... 6,288 Unrecognized transition obligation, being amortized over 20 years beginning January 1, 1993....... 113,345 ---------- Accrued OPEB costs recognized in the Balance Sheet ........................$ (12,535) ========== The accumulated postretirement benefit obligation (APBO) was determined using a 7.5% weighted-average discount rate. The expected long-term rate of return on plan assets used in determining the net periodic cost of OPEB (NPC) was 9%. The medical cost trend rates used in determining the APBO were assumed to be 10.7% and 9.5% in 1994 for pre-medicare and post-medicare benefits, respectively. These rates were assumed to gradually decline to 5% in 2005, and remain at that level thereafter. Assuming a one percent increase in the medical cost trend rates, the aggregate of the service and interest cost components of the NPC for 1993 would increase by $1.6 million, and the APBO as of December 31, 1993, would increase by $15.1 million. In general, OPEB costs are paid as claims are incurred and premiums are paid; however, the Company is partially funding future health care benefits for retirees in a trust created pursuant to Section 401(h) of the Internal Revenue Code of 1986. In future rate filings, the Company will request rate recovery based on the provisions of SFAS No. 106. The NCUC and the SCPSC have allowed other utilities to recover costs based on these provisions. 6. INCOME TAXES Income taxes are allocated between operating income and other income based on the source of the income that generated the tax. Investment tax credits related to operating income are amortized over the service life of the related property. On January 1, 1993, the Company implemented SFAS No. 109, which required the Company to establish additional deferred income tax assets and liabilities for certain temporary differences and to adjust deferred income tax accounts for changes in income tax rates. It also prohibits net-of-tax accounting for income statement and balance sheet items. Prior to the implementation of SFAS No. 109, deferred income taxes were not recorded for certain timing differences. At December 31, 1992, deferred income taxes were not provided for cumulative timing differences of approximately $311 million as a result of a rate moderation plan and pre-1976 flow-through. Substantially all of the adjustments required by SFAS No. 109 were recorded to deferred income tax balance sheet accounts, with offsetting adjustments to certain assets and liabilities. As a result, the cumulative effect on net income was not material. The Company's total assets and liabilities increased by approximately $450 million as a result of the implementation of SFAS No. 109. As a result of the implementation of SFAS No. 109, the Company no longer records the following income statement items on a net-of-tax basis: Harris Plant deferred costs, Harris Plant carrying costs and allowance for borrowed funds used during construction. In addition, a portion of the tax benefit of ESOP dividends is now recorded to non-operating income tax expense. The remaining portion continues to be recorded directly to retained earnings, but is no longer included in the determination of earnings per common share. Prior period financial statement amounts were not restated. [TEXT] A reconciliation of the Company's effective income tax rate to the statutory federal income tax rate follows. 1993 1992 1991 Effective income tax rate............... 35.4% 36.7% 36.3% State income taxes, net of federal income tax benefit.................... (5.1) (5.1) (5.3) Investment tax credit amortization...... 2.3 1.9 2.0 Other differences, net.................. 2.4 .5 1.0 ----- ----- ----- Statutory federal income tax rate.. 35.0% 34.0% 34.0% ===== ===== ===== At December 31, 1993, deferred income tax assets and liabilities were $260.8 million and $1.9 billion, respectively. At December 31, 1992, prior to the implementation of SFAS No. 109, deferred income tax assets and liabilities were $253.5 million and $1.3 billion, respectively. The net accumulated deferred income tax liability was comprised of the following at December 31 (in thousands). 1993 1992 Accelerated depreciation and property cost differences............... $ 1,449,796 $ 1,053,706 Deferred costs, net....................... 168,311 35,984 Miscellaneous other temporary differences, net........................ (12,443) (14,288) ---------- ---------- Net accumulated deferred income tax liability............... $ 1,605,664 $ 1,075,402 ========== ========== [TEXT] 7. DEFERRED COSTS The Company eliminated from its construction program and abandoned further efforts to complete Harris Unit Nos. 3 and 4 in December 1981, Harris Unit No. 2 in December 1983 and Mayo Unit No. 2 in March 1987. The NCUC and SCPSC each allowed the Company to recover the cost of these abandoned units over a ten-year period without a return on the unamortized balances. The amortization of Harris Unit Nos. 3 and 4 was completed in 1992. In 1988 rate orders and a 1990 NCUC Order on Remand, the Company was ordered to remove from rate base and treat as abandoned plant certain costs related to the Harris Plant. Amortization of plant abandonment costs is included in depreciation and amortization expense and totaled $100.7 million in 1993, $92.5 million in 1992 and $95.9 million in 1991. The 1993 amortization of plant abandonment costs reflects increased amortization due to the implementation of the SFAS No. 109 provision that prohibits net-of-tax accounting (see Note 6). The unamortized balances of plant abandonment costs are reported at the present value of future recoveries of these costs. The associated accretion of present value was $13.2 million in 1993, $18.2 million in 1992 and $24.6 million in 1991 and is reported in other income, net. In 1988, the Company began recovering certain Harris Plant deferred costs over ten years from the date of deferral, with carrying costs accruing on the unamortized balance. Excluding deferred purchased capacity costs (see Note 9A), the unamortized balance of Harris Plant deferred costs was $81.4 million at December 31, 1993, and $64.7 million, net of tax, at December 31, 1992. Due to the implementation of SFAS No. 109 in 1993, Harris Plant deferred costs are no longer recorded on a net-of-tax basis (see Note 6). Harris Plant deferred costs are reported net of amortization on the Statements of Income. 8. JOINT OWNERSHIP OF GENERATING FACILITIES Power Agency, which includes a majority of the Company's previous municipal wholesale customers, holds undivided ownership interests in certain generating facilities of the Company. The Company and Power Agency are entitled to shares of the generating capability and output of each unit equal to their respective ownership interests. Each also pays its ownership share of additional construction costs, fuel inventory purchases and operating expenses. The Company's share of expenses for the jointly-owned units is included in the appropriate expense category in the Statements of Income. Power Agency's payment obligation with respect to abandonment costs for Harris Unit Nos. 2, 3 and 4 and Mayo Unit No. 2 is 12.94% of such costs. The Company's share of the jointly-owned generating facilities is listed below with related information as of December 31, 1993 (dollars in millions). [TEXT] ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE ______ _____________________________________________ None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ________ __________________________________________________ a) Information on the Company's directors is set forth in the Company's 1994 definitive proxy statement dated March 31, 1994, and incorporated by reference herein. b) Information on the Company's executive officers is set forth in Part I and incorporated by reference herein. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION _______ ______________________ Information on executive compensation is set forth in the Company's 1994 definitive proxy statement dated March 31, 1994, and incorporated by reference herein. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ________ _______________________________________________ a) The Company knows of no person who is a beneficial owner of more than five (5%) percent of any class of the Company's voting securities except for Wachovia Bank of North Carolina, N.A., Post Office Box 3099, Winston-Salem, North Carolina 27102 which as of December 31, 1993, owned 24,380,381 shares of Common Stock (15.2% of Class) as Trustee of the Company's Stock Purchase-Savings Plan. b) Information on security ownership of the Company's management is set forth in the Company's 1994 definitive proxy statement dated March 31, 1994, and incorporated by reference herein. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ________ ______________________________________________ Information on certain relationships and transactions is set forth in the Company's 1994 definitive proxy statement dated March 31, 1994, and incorporated by reference herein. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. _______ ____________________________________________ a) 1. Financial Statements Filed: See ITEM 8 - Financial Statements and Supplementary Data. 2. Financial Statement Schedules Filed: See ITEM 8 - Financial Statements and Supplementary Data. 3. Exhibits Filed: Exhibit No. *3a(1) Restated Charter of Carolina Power & Light Company, dated May 22, 1980 (filed as Exhibit 2(a)(1), File No. 2-64193). Exhibit No. *3a(2) Amendment, dated May 10, 1989, to Restated Charter of the Company (filed as Exhibit 3(b), File No. 33-33431). Exhibit No. *3a(3) Amendment, dated May 27, 1992 to Restated Charter of the Company (filed as Exhibit 4(b)(2), File No. 33-55060). Exhibit No. *3a(4) By-laws of the Company as amended December 12, 1990 (filed as Exhibit 3(c), File No. 33-38298). Exhibit No. *4a(1) Resolution of Board of Directors, dated December 8, 1954, authorizing the issuance of, and establishing the series designation, dividend rate and redemption prices for the Company's Serial Preferred Stock, $4.20 Series (filed as Exhibit 3(c), File No. 33-25560). Exhibit No. *4a(2) Resolution of Board of Directors, dated January 17, 1967, authorizing the issuance of, and establishing the series designation, dividend rate and redemption prices for the Company's Serial Preferred Stock, $5.44 Series (filed as Exhibit 3(d), File No. 33-25560). Exhibit No. *4a(3) Statement of Classification of Shares dated January 13, 1971, relating to the authorization of, and establishing the series designation, dividend rate and redemption prices for the Company's Serial Preferred Stock, $7.95 Series (filed as Exhibit 3(f), File No. 33-25560). Exhibit No. *4a(4) Statement of Classification of Shares dated September 7, 1972, relating to the authorization of, and establishing the series designation, dividend rate and redemption prices for the Company's Serial Preferred Stock, $7.72 Series (filed as Exhibit 3(g), File No. 33-25560). Exhibit No. *4b Mortgage and Deed of Trust dated as of May 1, 1940 between the Company and The Bank of New York (formerly, Irving Trust Company) and Frederick G. Herbst (W.T. Cunningham, Successor), Trustees and the First through Fifth Supplemental Indentures thereto (Exhibit 2(b), File No. 2- 64189); and the Sixth through Sixty-second Supplemental Indentures (Exhibit 2(b)-5, File No. 2-16210; Exhibit 2(b)-6, File No. 2-16210; Exhibit 4(b)-8, File No. 2-19118; Exhibit 4(b)-2, File No. 2-22439; Exhibit 4(b)-2, File No. 2-24624; Exhibit 2(c), File No. 2-27297; Exhibit 2(c), File No. 2-30172; Exhibit 2(c), File No. 2-35694; Exhibit 2(c), File No. 2-37505; Exhibit 2(c), File No. 2-39002; Exhibit 2(c), File No. 2-41738; Exhibit 2(c), File No. 2-43439; Exhibit 2(c), File No. 2-47751; Exhibit 2(c), File No. 2-49347; Exhibit 2(c), File No. 2-53113; Exhibit 2(d), File No. 2-53113; Exhibit 2(c), File No. 2-59511; Exhibit 2(c), File No. 2-61611; Exhibit 2(d), File No. 2-64189; Exhibit 2(c), File No. 2-65514; Exhibits 2(c) and 2(d), File No. 2-66851; Exhibits 4(b)-1, 4(b)-2, and 4(b)-3, File No. 2-81299; Exhibits 4(c)-1 through 4(c)-8, File No. 2-95505; Exhibits 4(b) through 4(h), File No. 33-25560; Exhibits 4(b) and 4(c), File No. 33-33431; Exhibits 4(b) and 4(c), File No. 33-38298; Exhibits 4(h) and 4(i), File No. 33-42869; Exhibits 4(e)-(g), File No. 33-48607; Exhibits 4(e) and 4(f), File No. 33-55060; Exhibits 4(e) and 4(f), File No. 33-60014; Exhibits 4(a) and 4(b), File No. 33-38349; Exhibit 4(e), File No. 33-50597; and Item 7(c) of the Company's Current Report on Form 8-K dated January 19, 1994). Exhibit No. *10a(1) Purchase, Construction and Ownership Agreement dated July 30, 1981 between Carolina Power & Light Company and North Carolina Municipal Power Agency Number 3 and Exhibits, together with resolution dated December 16, 1981 changing name to North Carolina Eastern Municipal Power Agency, amending letter dated February 18, 1982, and amendment dated February 24, 1982 (filed as Exhibit 10(a), File No. 33-25560). Exhibit No. *10a(2) Operating and Fuel Agreement dated July 30, 1981 between Carolina Power & Light Company and North Carolina Municipal Power Agency Number 3 and Exhibits, together with resolution dated December 16, 1981 changing name to North Carolina Eastern Municipal Power Agency, amending letters dated August 21, 1981 and December 15, 1981, and amendment dated February 24, 1982 (filed as Exhibit 10(b), File No. 33-25560). Exhibit No. *10a(3) Power Coordination Agreement dated July 30, 1981 between Carolina Power & Light Company and North Carolina Municipal Power Agency Number 3 and Exhibits, together with resolution dated December 16, 1981 changing name to North Carolina Eastern Municipal Power Agency and amending letter dated January 29, 1982 (filed as Exhibit 10(c), File No. 33-25560). Exhibit No. *10a(4) Amendment dated December 16, 1982 to Purchase, Construction and Ownership Agreement dated July 30, 1981 between Carolina Power & Light Company and North Carolina Eastern Municipal Power Agency (filed as Exhibit 10(d), File No. 33-25560). Exhibit No. *10a(5) Agreement Regarding New Resources and Interim Capacity between Carolina Power & Light Company and North Carolina Eastern Municipal Power Agency dated October 13, 1987 (filed as Exhibit 10(e), File No. 33-25560). Exhibit No. *10a(6) Power Coordination Agreement - 1987A between North Carolina Eastern Municipal Power Agency and Carolina Power & Light Company for Contract Power From New Resources Period 1987-1993 dated October 13, 1987 (filed as Exhibit 10(f), File No. 33-25560). +Exhibit No. *10c(1) Directors Deferred Compensation Plan effective January 1, 1982 as amended (filed as Exhibit 10(g), File No. 33-25560). +Exhibit No. *10c(2) Supplemental Executive Retirement Plan effective January 1, 1984 (filed as Exhibit 10(h), File No. 33-25560). +Exhibit No. *10c(3) Retirement Plan for Outside Directors (filed as Exhibit 10(i), File No. 33- 25560). +Exhibit No. *10c(4) Executive Deferred Compensation Plan effective May 1, 1982 as amended (filed as Exhibit 10(j), File No. 33-25560). +Exhibit No. *10c(5) Key Management Deferred Compensation Plan (filed as Exhibit 10(k), File No. 33-25560). +Exhibit No. *10c(6) Resolutions of the Board of Directors, dated March 15, 1989, amending the Key Management Deferred Compensation Plan (filed as Exhibit 10(a), File No. 33-48607). +Exhibit No. *10c(7) Resolutions of the Board of Directors dated May 8, 1991, amending the Directors Deferred Compensation Plan (filed as Exhibit 10(b), File No. 33- 48607). +Exhibit No. *10c(8) Resolutions of the Board of Directors dated May 8, 1991, amending the Executive Deferred Compensation Plan (filed as Exhibit 10(c), File No. 33- 48607). Exhibit No. 12 Computation of Ratio of Earnings to Fixed Charges and Preferred Dividends Combined and Ratio of Earnings to Fixed Charges. Exhibit No. 23(a) Consent of Deloitte & Touche. Exhibit No. 23(b) Consent of Richard E. Jones. *Incorporated herein by reference as indicated. +Management contract or compensation plan or arrangment required to be filed as an exhibit to this report pursuant to Item 14(c) of Form 10-K. b) Reports on Form 8-K filed during or with respect to the last quarter of 1993 and the first quarter of 1994: Date of Report Item Reported ______________ _____________ December 1, 1993 Item 5. Other Events January 19, 1994 Item 7. Financial Statements, Pro Forma Financial Information and Exhibits SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 25th day of March, 1994. CAROLINA POWER & LIGHT COMPANY (Registrant) By: /s/ Paul S. Bradshaw Vice President and Controller Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. Signature Title Date _________ _____ ____ /s/ Sherwood H. Smith, Jr. Principal Executive (Chairman and Chief Executive Officer and Director Officer) /s/ Charles D. Barham, Jr. Principal Financial (Executive Vice President and Officer and Director Chief Financial Officer) /s/ Paul S. Bradshaw Principal Accounting (Vice President and Controller) Officer /s/ Edwin B. Borden Director March 25, 1994 /s/ Felton J. Capel Director /s/ William Cavanaugh III Director (President and Chief Operating Officer) /s/ George H. V. Cecil Director /s/ Charles W. Coker Director /s/ Richard L. Daugherty Director /s/ William E. Graham, Jr. Director /s/ Gordon C. Hurlbert Director /s/ J. R. Bryan Jackson Director /s/ Robert L. Jones Director /s/ Estell C. Lee Director /s/ J. Tylee Wilson Director

216228_1993.txt

216228

1993

ITEM 1. BUSINESS OF ITT ITT Corporation is a Delaware corporation, with World Headquarters at 1330 Avenue of the Americas, New York, NY 10019-5490. Until December 31, 1983, the corporation was known as International Telephone and Telegraph Corporation. It is the successor (since 1968) to a Maryland corporation incorporated in 1920. Unless the context otherwise indicates, references herein to ITT Corporation ("ITT") include its subsidiaries. ITT is a diversified global enterprise engaged, either directly or through subsidiaries, in manufacturing and selling automotive, defense and electronics, and fluid technology products, in providing and selling insurance, financial and communications and information services, and in hotel operations. In addition, ITT owns approximately 6% of the outstanding capital shares of Alcatel Alsthom, a French company which owns, among other things, Alcatel N.V., the largest telecommunications equipment manufacturer in the world. ITT has approximately 98,000 employees. BUSINESS SEGMENTS* - --------------- * Reference is made to Management's Discussion and Analysis of Financial Condition and Results of Operations and the Business Segment Information, included in the Notes to Financial Statements, which include descriptions of Business Segments. + Total sales and revenues of the Hotels segment, including 100% of unconsolidated revenues generated by franchised hotels, were $4.8, $4.8 and $4.4 billion in 1993, 1992 and 1991, respectively. FINANCIAL AND BUSINESS SERVICES Insurance. ITT companies write commercial property and casualty insurance, personal automobile and homeowners coverages and a variety of life and health insurance plans. The businesses in the Insurance segment may be generally categorized as (i) property and casualty insurance operations and (ii) life and health insurance operations and, in both instances, their related investment activities. ITT companies service the United States, Canada and Western Europe and participate in the worldwide reinsurance market. Companies include Hartford Fire Insurance Company and its subsidiaries (referred to collectively as "ITT Hartford"). ITT Hartford is one of the United States' oldest and largest international insurance organizations. ITT Hartford is serviced in North America through its home office and 40 regional offices, and it is represented by approximately 6,000 independent agents in North America. ITT Hartford operates in Western Europe through independent brokers. It assumes reinsurance from other insurers and also cedes reinsurance to other insurers or reinsurers in the world reinsurance market. ITT's insurance operations are subject to regulation and supervision in the states and other jurisdictions in which they are conducted, which may relate to, among other things, the standards of solvency which must be met and maintained; the licensing of insurers and their agents; the nature of and limitations on investments; premium rates; restrictions on the size of risks which may be insured under a single policy; approval of policy forms; periodic examinations of the affairs of companies; and annual and other reports required to be filed on the financial condition of companies or for other purposes. Additional information with respect to ITT's property and casualty insurance operations is set forth below under "Property and Casualty Insurance--Liabilities for Unpaid Claims and Claim Adjustment Expenses." Finance. This segment is comprised of ITT Financial Corporation, one of the largest independent finance companies in the United States, with commercial and consumer finance, related insurance and other financial services conducted from offices located throughout the United States and in Puerto Rico, the U.S. Virgin Islands, the Netherlands Antilles, Aruba and Panama. Commercial finance operations are also conducted in Canada and the United Kingdom through subsidiaries of ITT. Consumer finance operations include the buying, selling and originating of residential mortgages, home equity lending and, to a limited extent, the purchase from retail dealers of installment obligations arising from sales of consumer goods and services. Commercial finance operations include inventory financing, installment lending, real estate financing and loans. Property insurance is made available to certain retail dealers on the inventory financed. A mortgage banking operation which includes a federally chartered savings bank originates, buys, sells and services mortgages. Communications and Information Services. ITT subsidiaries are engaged in the publication of telephone directories, including classified directory services for telephone subscribers in numerous countries outside the United States, as well as in Puerto Rico and the U.S. Virgin Islands. Subsidiaries in the United States also operate post-secondary career education and technical schools and facilities. On March 14, 1994, ITT announced plans for an underwritten public offering of up to 19.9% of the common stock of ITT Educational Services Inc. MANUFACTURED PRODUCTS Automotive. With approximately twenty-six thousand employees in seventy-one facilities located in twelve countries, ITT supplies braking, electrical, suspension and mechanical systems and components to automotive original equipment manufacturers worldwide. This segment, one of the world's largest independent suppliers of such products, has expanded its customer base by introducing sophisticated, high-technology products such as anti-lock brakes, traction control systems, vehicle electrical components, fluid handling systems and aftermarket products. More than half of the sales of this segment were made in Europe in 1993, compared with almost three quarters in 1990. Defense & Electronics. ITT companies in the defense sector of this segment design, produce and operate numerous types of tactical communications equipment for the military, navigation and air traffic control systems for civilian and military aircraft, air and battlefield surveillance radar and night vision equipment. Some of these subsidiaries also provide upgrading, maintenance and training services for the military and other customers. A substantial portion of the work in the defense sector is performed for the United States government under prime contracts and subcontracts, some of which by statute are subject to profit limitations and all of which are subject to termination by the government. ITT companies in the electronics sector of this segment operate in several European countries, Japan and North America and produce a wide variety of electronic connectors, switches, components and semiconductor devices which are used in industrial, professional and telecommunications equipment as well as in consumer appliances and automobiles. Night vision equipment, power supplies, molded plastic components and electrical instruments are also produced for the commercial and consumer markets. Fluid Technology. This segment covers fluid handling products, which include a wide range of pumps and heat exchangers; controls and instrumentation products, including high-technology instruments for control and monitoring of fluids and energy conservation; and a broad range of valves. ITT is one of the largest pump manufacturers in the world. Most of these operations are carried on in North America and Western Europe. Principal customers are commercial and industrial users, construction contractors, process industries, water and wastewater utilities, and original equipment manufacturers. Sales are made directly and through independent distributors and representatives. HOTELS ITT Sheraton Corporation is a worldwide hospitality network of more than 400 owned, leased, managed and franchised properties in 61 countries, including hotels, casinos and inns owned and operated, or operated under lease or management agreements, by ITT subsidiaries, or operated by independent owners under license agreements with ITT subsidiaries. Approximately 89% of the rooms in the ITT Sheraton network are either managed or franchised. ITT Sheraton entered the U.S. gaming industry during 1993 with the acquisition of the Desert Inn Properties in Las Vegas, Nevada (reference is made to Governmental Regulation and Related Matters -- Nevada Gaming Laws, below). ALCATEL N.V. In July 1992, ITT sold its 30% equity interest in Alcatel N.V., a Netherlands company which is the largest telecommunications equipment manufacturer in the world, to Alcatel Alsthom, a major French company which owned the other 70% of Alcatel N.V. At the closing of the sale ITT received $1 billion in cash and 9.1 million capital shares of Alcatel Alsthom, recorded at $806 million, which, at December 31, 1993, represented approximately 6% of the outstanding capital shares of Alcatel Alsthom. In addition, ITT received a cash payment of approximately $767 million in July 1993 and will receive a cash payment of approximately $817 million in July 1994. ITT will retain its equity interest in Alcatel Alsthom until at least July 1997, unless Alcatel Alsthom and ITT agree otherwise. Mr. Rand V. Araskog, Chairman, President and Chief Executive of ITT, is a member of the board of directors of Alcatel Alsthom. Alcatel N.V. was formed in 1986, when ITT and Alcatel Alsthom, then known as Compagnie Generale d'Electricite, transferred their respective telecommunications operations to the joint venture company. DISCONTINUED OPERATIONS Effective on February 28, 1994, ITT completed the spin off of all the outstanding common shares of its former forest products subsidiary, Rayonier Inc. (formerly ITT Rayonier Incorporated) to the holders of record on February 24, 1994 of ITT common stock and ITT cumulative preferred stock, $2.25 convertible series N. OPERATIONS OUTSIDE THE UNITED STATES In 1993, approximately one-third of the Corporation's consolidated sales and revenues were made outside the United States. Of these, Western Europe comprised 75%, the Asia Pacific region 9%, Canada 6% with the balance made elsewhere. COMPETITION Substantially all of ITT's operations are in highly competitive businesses, although the nature of the competition varies among the business segments. A number of large companies engaged in the manufacture and sale of similar lines or products and the provision of similar services in most of the geographical areas in which ITT companies sell their products or render services are included in the competition, as are many small enterprises with only a few products or services and operating in limited areas. Technological innovation, quality and reliability are primary factors influencing competition in the markets of the Manufactured Products group, where the competition frequently includes smaller companies with considerable technological capabilities. In addition, pricing is a significant factor. Pricing and service are very important considerations for the ITT subsidiaries in the Financial and Business Services group, which are highly competitive areas. Numerous factors influence competitive positions in the consumer-oriented hotels segment, where advertising and pricing are important. ITT's hotel operations face heavy competition from other large hotel companies, particularly in North America. RESEARCH, DEVELOPMENT AND ENGINEERING, AND INTELLECTUAL PROPERTIES Research, development and engineering activities of ITT are conducted in laboratory and engineering facilities at most of its major manufacturing divisions and subsidiaries. ITT believes that continued leadership in technology is essential to its future, and most ITT funds dedicated to research and development are applied to areas of high technology, such as aerospace, automotive braking and suspension systems, semiconductors and electronic components. ITT's research, development and engineering expenditures amounted to $460 million in 1993, $502 million in 1992, and $530 million in 1991, of which approximately 53% was pursuant to customer contracts. While ITT owns and controls a number of patents, trade secrets, confidential information, trademarks, trade names, copyrights and other intellectual property rights which, in the aggregate, are of material importance to its business, it is believed that ITT's business, as a whole, is not materially dependent upon any one intellectual property or related group of such properties. ITT is licensed to use certain patents, technology and other intellectual property rights owned and controlled by others, and, similarly, other companies are licensed to use certain patents, technology and other intellectual property rights owned and controlled by ITT. SERVICE CONTRACTS ITT has contracts with certain of its operating subsidiaries under which it furnishes them technical, engineering, traffic, insurance, administrative, personnel, financial, accounting, purchasing and operating advice and assistance, as well as other services. Where requested, specialized employees are engaged for the account of the companies served. As compensation, such subsidiaries pay ITT a percentage of their gross operating revenues. In addition, reimbursement is sometimes made for the actual salaries and expenses of specialized employees furnished. Contracts are also in effect between ITT Industries, Inc. ("ITTI"), a wholly-owned subsidiary of ITT, and certain subsidiaries and associate companies of ITT under which ITTI, as part of ITT World Headquarters, undertakes to cause to be furnished to such entities manufacturing, sales, accounting, technical, intellectual property and personnel advice and assistance; the results of research and development work, including rights under patents; information with regard to sales and business methods and technical, engineering and manufacturing matters; and other services. The companies served pay an amount calculated as a percentage of their sales (less intercompany purchases) for the manufacturing, sales, accounting and other business advice and services furnished, and/or as a pooling of funds for performing research and development. ITTI is reimbursed for the cost of any special services rendered. The companies served also agree to grant ITTI certain patent rights and technical information with regard thereto. GOVERNMENTAL REGULATION AND RELATED MATTERS General. Ownership of ITT shares by "aliens" (to the United States) is subject to limitation under the United States Communications Act of 1934, as more fully described under "Restrictions on Alien Ownership" below, due to the licenses of the United States Federal Communications Commission held by certain of ITT's subsidiaries. In addition, a number of ITT's businesses are subject to governmental regulation by law or through contractual arrangements. ITT companies in the defense segment perform work under contracts with the United States Department of Defense and similar agencies in certain other countries. These contracts are subject to security and facility clearances under applicable governmental regulations, including regulations (requiring background investigations for high-level security clearances) applicable to ITT executive officers, and most of such contracts are subject to termination by the respective governmental parties on various grounds. Sheraton hotels in the United States are liquor retailers where permitted, licensed in each state where they do such business, and in certain states are subject to statutes which prohibit ITT Sheraton Corporation or its owner from being both a wholesaler and retailer of alcoholic beverages. The post-secondary career education and technical schools operations are extensively regulated by federal and state agencies. The numerous regulations to which ITT's insurance operations are subject include licensing requirements and, in certain states, requirements for governmental approval of changes of direct or indirect ownership of such operations or solicitations of proxies for a specified percentage of the voting power of such insurance operations or their controlling parent. In the financial services area, ITT's consumer finance operations are regulated at both the federal and state levels, and its commercial financing is also subject to regulation by state laws. ITT's bank subsidiaries are subject to both federal and state laws and regulations governing depository institutions. In addition, ITT, as a parent company of a federally chartered savings bank, is subject to federal and state laws and regulations governing unitary savings and loan holding companies. Nevada Gaming Laws. During 1993 ITT entered the casino gaming business in the United States with its acquisition of the Desert Inn hotel and casino in Las Vegas, Nevada. The casino is operated by Sheraton Desert Inn Corporation ("SDI"), which is a wholly-owned subsidiary of Sheraton Gaming Corporation ("SGC"), which is a wholly-owned subsidiary of ITT Sheraton Corporation ("Sheraton"). The ownership and operation of casino gaming facilities in the State of Nevada are subject to extensive state and local regulations. ITT's gaming operation is subject to the licensing and regulatory control of the Nevada Gaming Commission (the "Gaming Commission"), the Nevada State Gaming Control Board (the "Control Board"), and the Clark County Liquor and Gaming Licensing Board (the "CCB"). The Gaming Commission, the Control Board, and the CCB are collectively referred to as the "Nevada Gaming Authorities." The laws, regulations and supervisory procedures of the Nevada Gaming Authorities are extensive and reflect certain broad declarations of public policy. Changes in such laws, regulations and procedures could have an adverse effect on Sheraton's gaming operation. SDI, as the operator of the Desert Inn casino, is required to be licensed by the Nevada Gaming Authorities. The gaming license is not transferable and must be renewed periodically by the payment of gaming license fees and taxes. SGC and Sheraton are required to be registered as intermediary companies by the Gaming Commission and ITT is required to be registered as a publicly traded corporation. No person may become a stockholder of, or receive any percentage of profits from, SDI without first obtaining licenses and approvals from the Nevada Gaming Authorities. The Nevada Gaming Authorities may investigate any individual who has a material relationship to, or material involvement with, ITT, Sheraton, SGC or SDI in order to determine whether such individual is suitable or should be licensed as a business associate of SDI. Officers, directors and key employees of SDI must be individually licensed by, and changes in corporate positions must be reported to, the Nevada Gaming Authorities. The Nevada Gaming Authorities may disapprove a change in corporate position. Certain officers, directors and key employees of ITT, Sheraton and SGC who are actively and directly involved in the gaming activities of SDI may be required to be licensed or found suitable by the Nevada Gaming Authorities. The Nevada Gaming Authorities may deny an application for licensing for any cause which they deem reasonable. A finding of suitability is comparable to licensing, and both require submission of detailed personal and financial information followed by a thorough investigation. The applicant for licensing or finding of suitability must pay all the costs of the investigation. If the Nevada Gaming Authorities were to find an officer, director or key employee unsuitable for licensing or unsuitable to continue having a relationship with ITT, Sheraton, SGC or SDI, the companies involved would have to sever all relationships with such person. In addition, the Nevada Gaming Authorities may require a registered company or licensee to terminate the employment of any person who refuses to file appropriate applications. ITT, Sheraton, SGC and SDI are required to submit detailed financial and operating reports to the Gaming Commission. Substantially all loans, leases, sales of securities and similar financing transactions by SDI must be reported to or approved by the Gaming Commission. Nevada law prohibits a corporation registered by the Gaming Commission from making a public offering of its securities without the prior approval of the Commission if any part of the proceeds of the offering or the securities themselves are to be used to finance the construction, acquisition or operation of gaming facilities in Nevada, or to retire or extend obligations incurred for one or more such purposes. If it were determined that gaming laws were violated by SDI, the gaming license it holds could be limited, conditioned, suspended or revoked. In addition ITT, Sheraton, SGC, SDI and the persons involved could be subject to substantial fines for each separate violation of the gaming laws at the discretion of the Gaming Commission. Further, a supervisor could be appointed by the Gaming Commission to operate SDI's gaming property and, under certain circumstances, earnings generated during the supervisor's appointment (except for the reasonable rental value of SDI's gaming property) could be forfeited to the State of Nevada. Any suspension or revocation of SDI's license would have a materially adverse effect on SDI. The Nevada Gaming Authorities may investigate and require a finding of suitability of any holder of any class of ITT's voting securities at any time. Nevada law requires any person who acquires more than 5% of any class of ITT's voting securities to report the acquisition to the Gaming Commission and such person may be required to be investigated and found suitable. Any person who becomes a beneficial owner of more than 10% of any class of ITT's voting securities must apply for a finding of suitability by the Gaming Commission within thirty days after the Control Board Chairman mails the written notice requiring such filing, and must pay the costs and fees incurred by the Control Board in connection with the investigation. Under certain circumstances, an "Institutional Investor," as such term is defined in the Nevada gaming regulations, which acquires more than 10% but not more than 15% of ITT's voting securities, may apply to the Gaming Commission for a waiver of such finding of suitability requirements. If the stockholder who must be found suitable is a corporation, partnership or trust, it must submit detailed business and financial information including a list of beneficial owners. Any person who fails or refuses to apply for a finding of suitability or a license within 30 days after being ordered to do so by the Gaming Commission or by the Chairman of the Control Board, may be found unsuitable. Any stockholder found unsuitable and who holds, directly or indirectly, any beneficial ownership of ITT voting securities beyond such period of times as may be prescribed by the Gaming Commission may be guilty of a gross misdemeanor. ITT could be subject to disciplinary action if, after it receives notice that a person is unsuitable to be a stockholder or to have any other relationship with ITT, SDI, SGC, Sheraton or ITT: (i) pays that person any dividend or interest on voting securities of ITT, (ii) allows that person to exercise, directly or indirectly, any voting right conferred through securities held by that person, or (iii) gives remuneration in any form to that person. If a security holder is found unsuitable, ITT may itself be found unsuitable if it fails to pursue all lawful efforts to require such unsuitable person to relinquish the voting securities for cash at fair market value. Additionally, the CCB has taken the position that it has the authority to approve all persons owning or controlling the stock of any corporation controlling a gaming license. ITT is required to maintain a current stock ledger in Nevada which may be examined by the Nevada Gaming Authorities at any time. If any securities are held in trust by an agent or by a nominee, the record holder may be required to disclose the identity of the beneficial owner to the Nevada Gaming Authorities. A failure to make such disclosure may be grounds for finding both the record and beneficial holders unsuitable. ITT is also required to render maximum assistance in determining the identity of the beneficial owner. The Gaming Commission has the power to require ITT's stock certificates to bear a legend indicating that the securities are subject to the Nevada Act and the regulations of the Gaming Commission. However, ITT has been granted an exemption from this requirement by the Gaming Commission. ITT has been advised that the Gaming Commission may also require the holder of any debt security of a corporation registered under the Nevada Act to file applications, be investigated and be found suitable to own the debt security of such corporation. If the Gaming Commission determines that a person is unsuitable to own such security, then pursuant to the regulations of the Gaming Commission, the registered corporation can be sanctioned, including the loss of its approvals, if without the prior approval of the Gaming Commission, it (i) pays to the unsuitable person any dividend, interest or any distribution whatsoever, (ii) recognizes any voting right by such unsuitable person in connection with such securities, (iii) pays the unsuitable person remuneration in any form or, (iv) makes any payment to the unsuitable person by way of principal, redemption, conversion, exchange, liquidation or similar transaction. Regulations of the Gaming Commission provide that control of a registered publicly traded corporation cannot be changed through merger, consolidation, acquisition of assets, management or consulting agreements of any form of takeover without the prior approval of the Gaming Commission. Persons seeking approval to control a registered publicly traded corporation must satisfy the Gaming Commission as to a variety of stringent standards prior to assuming control of such corporation. The failure of a person to obtain such approval prior to assuming control over the registered publicly traded corporation may constitute grounds for finding such person unsuitable. Regulations of the Gaming Commission prohibit certain repurchases of securities by registered publicly traded corporations without the prior approval of the Gaming Commission. Transactions covered by these regulations are generally aimed at discouraging repurchases of securities at a premium over market price from certain holders of greater than 3% of the outstanding securities of the registered publicly traded corporation. The regulations of the Gaming Commission also require prior approval for a "plan of recapitalization" as defined by the regulations. Generally, a plan of recapitalization is a plan proposed by the management of a registered publicly traded corporation that contains recommended action in response to a proposed corporate acquisition opposed by management of the corporation which acquisition itself would require the prior approval of the Gaming Commission. Related Provisions of Certificate of Incorporation. ITT's restated certificate of incorporation provides that (i) all securities of ITT are subject to redemption by ITT to the extent necessary to prevent the loss or to secure the reinstatement of any gaming license held by ITT or any of its subsidiaries in any jurisdiction within or outside the United States of America, (ii) all securities of ITT are held subject to the condition that if a holder thereof is found by a gaming authority in any such jurisdiction to be disqualified or unsuitable pursuant to any gaming law, such holder will be required to dispose of all ITT securities held by such holder, and (iii) it will be unlawful for any such disqualified person to (a) receive payments of interest or dividends on any ITT securities, (b) exercise, directly or indirectly, any rights conferred by any ITT securities, or (c) receive any remuneration in any form, for services rendered or otherwise, from the subsidiary that holds the gaming license in such jurisdiction. Nevada Foreign Gaming Disclosure. Any person who is licensed, required to be licensed, registered, required to be registered, or is under common control with such persons (collectively, "Licensees"), and who proposes to become involved in a gaming operation outside of Nevada is required to deposit with the Gaming Board, and thereafter maintain, a revolving fund in the amount of $10,000 to pay the expenses of investigation of the Gaming Board of their participation in such foreign gaming. The revolving fund is subject to increase or decrease in the discretion of the Gaming Commission. Thereafter, Licensees are required to comply with certain reporting requirements imposed by the Nevada Act. Licensees are also subject to disciplinary action by the Gaming Commission if it knowingly violates any laws of the foreign jurisdiction pertaining to the foreign gaming operation, fails to conduct the foreign gaming operation in accordance with the standards of honesty and integrity required of Nevada gaming operations, engages in activities that are harmful to the State of Nevada or its ability to collect gaming taxes and fees, or employs a person in the foreign operation who has been denied a license or finding of suitability in Nevada on the ground of personal unsuitability. PROPERTY AND CASUALTY INSURANCE--LIABILITIES FOR UNPAID CLAIMS AND CLAIM ADJUSTMENT EXPENSES Liabilities for unpaid claims and claim adjustment expenses as of December 31, 1993 and 1992 were $11.9 billion and $11.8 billion. These amounts differ from those reflected on the balance sheet by $5.3 billion and $5.6 billion, respectively, reflecting liabilities on ceded reinsurance contracts as required by Statement of Financial Accounting Standards ("SFAS") No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts". Liabilities for unpaid claims and claim adjustment expenses are based upon individual case estimates for known claims, estimates of unreported claims and estimates of future expenses to be incurred in the settlement of these liabilities. Estimated loss and loss adjustment expense reserves are continually reviewed as additional experience and other relevant data become available, and reserve levels are adjusted accordingly. The natural uncertainties involved with the reserving process have become increasingly unpredictable due to a number of complex factors including social and economic trends and changes in the concept of legal liability and damage awards. Accordingly, final claim settlements may vary from the present estimates, particularly when those payments may not occur until well into the future. Any adjustments to previously established reserves would be reflected in net income for the period in which they are made. In the judgment of management, all information currently available has been properly considered and the reserves currently established for losses and loss adjustment expenses, except for the asbestos-related and environmental claims, as discussed below, are adequate to cover their eventual costs. Claims asserting injuries from asbestos and asbestos-related products and damages from environmental pollution and related clean-up costs continue to be received. With regard to these claims, deviations from past experience significantly impact the ability of insurance companies to estimate the ultimate reserves for unpaid losses and related settlement expenses. ITT finds that conventional reserving techniques cannot estimate the ultimate cost of these claims because of inadequate development patterns and inconsistent emerging legal doctrine. For asbestos and environmental pollution claims, unlike any other type of contractual claim, there is almost no agreement or consistent precedent to determine what, if any, coverage exists or which, if any, policy years and insurers may be liable. Further uncertainty arises with environmental claims because claims are often made under policies, the existence of which may be in dispute, the terms of which may have changed over many years, which may or may not provide for legal defense costs, and which may or may not contain pollution exclusion clauses that may be absolute or allow for fortuitous events. Courts in different jurisdictions have reached disparate conclusions on similar issues and in certain situations have broadened the interpretation of policy coverage and liability issues. If future social, economic or legal developments continue to expand the original intent of policies and the scope of coverage as they have in the past, the need for additional reserves may arise and that requirement cannot be reasonably estimated. Based on current evaluation, ITT believes the ultimate resolution of all its claims, including reinsurance effects, will not have a material adverse impact on its overall financial condition. Certain liabilities for unpaid claims, principally for permanently disabled claimants, terminated reinsurance treaties and certain contracts that fund loss run-offs for unrelated parties have been discounted to present value. The amount of discount was approximately $362 million and $325 million as of December 31, 1993 and 1992 and the amortization of the discount had no material effect on net income during 1993, 1992 and 1991. A reconciliation of liabilities for unpaid claims and claim adjustment expenses for the last three years and a table depicting the historical development of the liabilities for unpaid claims and claim adjustment expenses follows: Note: The liabilities for unpaid claims and claim adjustment expenses shown above are greater than those reported in the domestic insurance subsidiaries statutory filings by $1.8 billion in 1993 reflecting amounts related to non-U.S. subsidiaries and $1.7 billion in 1992 reflecting amounts related to non-U.S. subsidiaries and the exclusion of anticipated salvage and subrogation. The liabilities for claim and claim adjustment expenses shown above differ from those reflected on the balance sheet by $5.3 billion and $5.6 billion for 1993 and 1992, respectively. These amounts, which reflect liabilities on ceded reinsurance contracts as required by SFAS No. 113 do not lend themselves to practicable presentation in the above table. * Does not include the effects of foreign exchange adjustments which are included in the table on the following page. PROPERTY AND CASUALTY CLAIMS AND CLAIM ADJUSTMENT EXPENSES LIABILITY DEVELOPMENT (IN MILLIONS OF DOLLARS) NOTES: (1) The above table excludes the liabilities and claim developments for reinsurance coverage written for unrelated parties that fund ultimate net aggregate loss run-offs since changes to those reserves do not illustrate the manner in which those reserve estimates changed. Liabilities for unpaid claims and claim adjustment expenses excluded were $688 million, $629 million, $762 million, $682 million and $504 million as of December 31, 1989, 1990, 1991, 1992 and 1993. The liability for unpaid claims and claim adjustment expenses excludes the impact of the adoption of SFAS No. 113 of $5.3 billion and $5.6 billion for 1993 and 1992, respectively. Presentation of the above table to reflect liabilities on ceded reinsurance contracts is not practicable. Liabilities on all lines of insurance are monitored regularly and corrective action is taken as required. ITEM 2.

ITEM 2. PROPERTIES Reference is made to "Business of ITT." ITEM 3.

ITEM 3. LEGAL PROCEEDINGS Hartford Fire Insurance Company, a subsidiary of ITT, together with other companies, associations and organizations involved in the business of property and casualty insurance and reinsurance, was named as a defendant in a group of lawsuits filed by Attorneys General of 20 states and by various private parties in the United States District Court for the Northern District of California. All of the suits, which were filed in 1988, 1990 and 1991, were based upon allegations that the defendants violated federal and/or state antitrust laws by reason of their activities in connection with the development of new standard commercial general liability policy forms by the Insurance Services Office, an industry organization. The state suits seek civil penalties and fines, unspecified damages and various forms of injunctive relief. The private suits seek unspecified treble damages and various forms of injunctive relief. In June 1991, the Ninth Circuit U.S. Court of Appeals reversed the United States District Court for the Northern District of California which had granted summary judgment in September 1989 in favor of the defendants. The defendants filed a petition for certiorari to the United States Supreme Court which was granted by the Court in October 1992. Oral argument was held on February 23, 1993. On June 28, 1993, the Supreme Court reversed the Ninth Circuit U.S. Court of Appeals, holding that the domestic insurers, including ITT Hartford, had not lost their McCarran-Ferguson Act exemption from the antitrust laws generally, as a result of activities alleged in the complaints, but remanded the case for further proceedings to determine if certain of those activities came within the "boycott" exception to the McCarran-Ferguson Act exemption. ITT and its former subsidiaries, Rayonier Inc. ("Rayonier") and Southern Wood Piedmont Company ("SWP"), are named defendants in a lawsuit filed in 1991 in the U.S. District Court for the Southern District of Georgia, Ernest L. Jordan, Sr. et al. v. Southern Wood Piedmont Company, et al., in which plaintiffs allege property damage and personal injury based on alleged exposure to toxic chemicals used by SWP in its former wood preserving operations, seek certification as a class action, and ask for compensatory and punitive damages in the amount of $700 million. Under an agreement entered into by ITT and Rayonier in connection with the distribution of Rayonier stock to ITT stockholders in February 1994, ITT is entitled to be indemnified by Rayonier for any expenses or losses incurred by ITT in connection with this suit as well as in other legal proceedings arising out of Rayonier or SWP operations. In approximately 40 current "Superfund Site" proceedings instituted by the U.S. Environmental Protection Agency or similar state agencies a subsidiary or division of ITT has been named a "potentially responsible party." In most (approximately two-thirds) of these the ITT company is considered a "de minimis contributor." Other activities in the environmental area in which ITT and its subsidiaries are participants (approximately another 40 items) involve air, ground and/or water contamination issues which are the subject of ongoing or prospective (usually voluntary) remedial measures with any required approvals of federal or local authorities (approximately three-fourths of such items), or in connection with which other private parties seek to impose upon an ITT company the financial responsibility for costs or damages which allegedly have been or may be incurred by such other parties. Asbestos-related and environmental pollution claims received by ITT's property and casualty insurance operations are discussed above under "Business of ITT -- Property and Casualty Insurance -- Liabilities for Unpaid Claims and Claim Adjustment Expenses." There are various other lawsuits pending against ITT and its subsidiaries, some of which involve claims for substantial amounts. However, the ultimate liability with respect to the actions pending against ITT and its subsidiaries, including those proceedings and other matters specifically referred to above, is not considered material in relation to the consolidated financial condition of ITT and its subsidiaries. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of security holders of ITT during the fourth quarter of the fiscal year covered by this report. EXECUTIVE OFFICERS OF ITT The following information is provided as to the executive officers of ITT. Each of the above-named officers was elected to his or her present position to serve at the pleasure of the Board of Directors. Throughout the past five years, all of the above-named officers have held executive positions with ITT bearing at least substantially the same responsibilities as those borne in their present offices, except that (i) Mr. Aibel, prior to his election as Executive Vice President and Chief Legal Officer, was Executive Vice President and General Counsel of ITT; (ii) Mr. Bowman, prior to his election as Executive Vice President and Chief Financial Officer, was Executive Vice President and Chief Financial Officer of ITT Sheraton Corporation (1991) and Treasurer of the State of Michigan; (iii) Mr. Comey, prior to his election as Executive Vice President, was the President and Chief Operating Officer of Hartford Fire Insurance Company and Executive Vice President of ITT Hartford; (iv) Mr. Danski, prior to his election as Senior Vice President and Controller, was Vice President and General Auditor of RJR Nabisco; (v) Mr. Engen, prior to his election as Executive Vice President, was Senior Vice President of ITT and the Chief Executive Officer of ITT Defense, Inc.; (vi) Mr. Giuliano, prior to his election as Senior Vice President, was Vice President of ITT and Vice President and Director--Defense Operations of ITT Defense, Inc.; (vii) Mr. Leuliette, prior to his election as Senior Vice President, was President and Chief Executive of Siemens Automotive and Vice President of Siemens A.G.; (viii) Mr. Nilsson, prior to his election as Senior Vice President, was Vice President of ITT (1987) and President and Chief Operating Officer of ITT Fluid Technology Corporation (1991) and Managing Director of ITT Flygt AB; (ix) Mrs. Reese, prior to her election as Senior Vice President and Treasurer, was Vice President of ITT (1989) and Assistant Treasurer; (x) Mr. Schultz, prior to his election as Senior Vice President, was Executive Vice President of Bank America Corp.; and (xi) Mr. Ward, prior to his election as Senior Vice President and General Counsel, was Vice President and Associate General Counsel of ITT. PART II ITEM 5.

ITEM 5. MARKET FOR ITT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS ITT COMMON STOCK -- MARKET PRICES AND DIVIDENDS (UNAUDITED) The above table reflects the range of market prices of ITT Common Stock as reported in the consolidated transaction reporting system of the New York Stock Exchange, the principal market in which this security is traded, under the trading symbol "ITT". During the period from January 1, 1994 through February 28, 1994, the high and low reported market prices of ITT Common Stock were $104.25 and $90.00. The dividend declared in the first quarter of 1994 was $.495 per common share. The dividends declared in each of the four quarters of 1993 were also $.495 per common share. The dividends declared in each of the four quarters of 1992 were $.46 per common share. As noted above in Item 1 under "Discontinued Operations," ITT also paid a special dividend on its common stock and cumulative preferred stock, convertible series N, during the first quarter of 1994 in the form of a distribution of all the outstanding common shares of its former forest products subsidiary. See "Notes to Financial Statements -- Capital Stock" for descriptions of restrictions on dividend payments. There were approximately 60,000 holders of record of ITT Common Stock on February 28, 1994. ITT Common Stock is listed on the following exchanges: Amsterdam, Antwerp, Basel, Bern, Brussels, Frankfurt, Geneva, Lausanne, London, New York, Pacific, Paris, Tokyo, Vienna and Zurich. RESTRICTIONS ON ALIEN OWNERSHIP Pursuant to the requirements of United States statutes, ITT limits stock ownership by aliens (as used herein, the term "alien" includes the following and their representatives: individuals who are not nationals of the United States, partnerships unless a majority of the partners are such nationals and share in a majority of its profits, foreign governments, entities created under the laws of foreign governments, and entities controlled directly or indirectly by one or more of such individuals, partnerships, governments or entities). The ITT By-Laws provide that under no circumstances shall the amount of ITT stock owned of record by aliens exceed 25% of the total outstanding. If and so long as the stock records of ITT shall at any time disclose 25% alien ownership (i) no transfers of shares of domestic record to aliens may be made and (ii) if it shall be found that stock of domestic record is in fact held by or for the account of an alien, the holder of such stock shall not be entitled to vote, to receive dividends, or to have any other rights except the right to transfer the stock to a citizen of the United States. At the close of business on January 31, 1994, approximately 6.5% of the outstanding stock of ITT was owned of record by aliens. Assuming that all of the shares of ITT Common Stock issuable upon conversion of securities initially issued to aliens, or issuable pursuant to other existing commitments to aliens, had been issued at that date to aliens, and that at that date all other securities then convertible into ITT stock were owned by nationals of the United States and had also been converted in accordance with their terms, such percentage would not have been significantly different. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA - --------------- * As restated (see Notes to Financial Statements). ** Before the cumulative effect of accounting changes in 1992. *** Excludes effects of Discontinued Operations. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (DOLLAR AMOUNTS ARE IN MILLIONS UNLESS OTHERWISE STATED) The task of repositioning the Corporation's businesses which began in 1992 was intensified in 1993 with a number of strategic transactions expected to further the Corporation's goals of improved shareholder value, cash generation and return on equity. A major study designed to improve the effectiveness and productivity of the Corporation's Headquarters functions was completed last fall and will result in reduced overhead costs in 1994 and future years. At ITT Hartford, both revenues and operating income reached record levels in 1993 as the life insurance operations continued to grow through internal expansion and through the assumption of policies from other insurers. Improved underwriting results in the property and casualty business were also a significant contributor to ITT Hartford's performance as the worldwide combined ratio improved to 107.3 percent. ITT Automotive's sales of four-wheel anti-lock brake and traction control systems exceeded $1 billion for the first time in 1993, making it the first automotive parts supplier in the world to reach that level. In June, the sale of ITT Consumer Financial Corporation's domestic unsecured consumer small loan portfolio was completed resulting in a pretax gain of $95 ($63 after tax). Proceeds from the sale allowed ITT Financial to retire higher cost fixed-rate debt, and return capital to the Corporation. An extraordinary pretax loss of $75 ($50 after tax) was recorded on the debt retirement. In September, the Corporation announced the signing of a preliminary agreement to acquire the Motors and Actuators Business Unit of General Motors Automotive Components Group. This acquisition is expected to contribute annual revenues of $900 and add strength to ITT's position as a global leader in the automotive components and systems market. The transaction is expected to close in the first half of 1994. In November, the Corporation entered the U.S. gaming industry with the acquisition of the Desert Inn Properties in Las Vegas which is expected to be developed into a major gaming resort. The acquisition of a full-service resort in Las Vegas, the country's number one destination resort and one of the largest convention cities in the U.S., afforded the Corporation the opportunity to immediately enter the North American land-based gaming industry. ITT Sheraton also plans to open a dockside casino near Memphis by the summer of 1994. The spin-off of ITT Rayonier to the Corporation's shareholders was announced in December and was completed in February, 1994. The spin-off allows Rayonier to better fulfill its long-term strategies and objectives while furthering the Corporation's strategic goals. Rayonier expects to pay a dividend of $.72 per share in 1994, the equivalent of $.18 per share to the Corporation's shareholders. Rayonier has been reflected as a "Discontinued Operation" for all periods presented. These important actions further the Corporation's commitment to improving returns and shareholder value. To that end, additional steps will be taken in 1994, including strategic acquisitions and the continuation of the repurchase of the Corporation's common shares. SALES, REVENUES AND INCOME Worldwide sales and revenues were $22.8 billion in 1993 compared with a restated $23.0 billion and $21.5 billion in 1992 and 1991, respectively. The sales and revenues decrease in 1993 primarily reflects the sale of ITT Financial's domestic unsecured consumer small loan business in June as well as reduced Defense business as several major programs were completed. Excluding the sales of companies included in "Dispositions and Other", sales and revenues increased 2% in 1993 and 8% in 1992. Sales and revenues in all periods have been modified to include 100 percent of the revenues of partially-owned hotel properties and hotel properties under long-term management agreements. The Corporation believes that this presentation better reflects the breadth and control of hotel operations and increased sales and revenues (with no impact on operating income) by $2.4, $2.3 and $2.1 billion in 1993, 1992 and 1991, respectively. Net income for 1993 was $913 or $6.90 per fully diluted share compared with a net loss of $885 or $6.90 per fully diluted share in 1992, which was due primarily to several significant nonrecurring items and accounting changes during 1992. This was compared with net income in 1991 of $749 or $5.49 per fully diluted share. Primary earnings (loss) per share were $7.32 in 1993, $(7.93) in 1992 and $5.84 in 1991. 1993: A number of one-time items are included in net income in 1993 including the gain on the sale of the domestic unsecured consumer small loan portfolio at ITT Financial of $63 after tax, or $.48 per fully diluted share and the related retirement of fixed-rate debt at a premium of $50 after tax, or $.38 per fully diluted share. In addition, results included a $33 after tax or $.25 per fully diluted share provision relating to a program aimed at increasing the effectiveness and productivity at ITT Headquarters and the headquarters of the business segments and a $22 or $.17 per fully diluted share favorable impact of the changes in the United States tax law. Income in future periods will be negatively impacted by the 1% increase in the U.S. Federal tax rate. Further, the year was impacted by $19 after tax or $.15 per fully diluted share for the accelerated write-off of capitalized development expenses at ITT Sheraton; $7 or $.06 per fully diluted share for an after tax gain at ITT Sheraton on its investment in Bally's Las Vegas and $10 after tax or $.08 per fully diluted share for an after tax gain on the sale of ITT Components Distribution. The year also included prior period tax and associated interest charges related to separate decisions by Canadian and California state taxing authorities of $16 after tax or $.12 per fully diluted share and $10 or $.08 per fully diluted share. Extraordinary catastrophe losses at ITT Hartford early in the year negatively impacted earnings by $41 after tax or $.32 per fully diluted share. The catastrophes included the World Trade Center bombing in New York and excessive damage from storms in the Northeastern United States. Portfolio gains at ITT Hartford and ITT Financial in 1993 totalled $98 after tax or $.76 per fully diluted share. Excluding these gains along with the one-time items, net income was $882 or $6.65 per fully diluted share. 1992: The net loss in 1992 included the effects of the Corporation's adoption of Statement of Financial Accounting Standards ("SFAS") No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions", and SFAS No. 112, "Employers' Accounting for Postemployment Benefits," which were recorded effective January 1, 1992 using the immediate recognition method. These accounting changes resulted in a cumulative catch-up adjustment of $625 after tax, or $4.71 per fully diluted share. These standards required accrual of postretirement and postemployment health care and life insurance benefit costs during the years that an employee provides services to the Corporation rather than on the pay-as-you-go basis previously in effect. There is no cash flow impact of these accounting changes. In July 1992, the Corporation completed the sale of its 30% stake in Alcatel N.V. to its joint venture partner, Alcatel Alsthom, resulting in an after tax gain of $622 or $4.71 per fully diluted share -- see "Alcatel N.V." in Notes to Financial Statements. The Corporation also recorded several one-time items during the year to realign and restructure certain businesses including: -- A $594 after tax charge at ITT Hartford to fund expected loss developments in surplus lines and reinsurance business at its Cameron & Colby unit and $165 after tax for expected legal defense costs associated with environmental-related claims. The total result was a charge of $759 or $5.75 per fully diluted share. Extraordinary catastrophe losses at ITT Hartford in 1992 negatively impacted earnings by $131 after tax or $.99 per fully diluted share. The catastrophes included Hurricanes Andrew and Iniki along with the Los Angeles riots and the Chicago flood. -- A $612 after tax charge or $4.66 per fully diluted share at ITT Financial primarily to strategically transform the consumer finance business by significantly reducing its domestic unsecured consumer small loan business. As a result, ITT Financial established reserves of $693 to cover future unsecured loan losses from the run-off of its existing portfolio, $103 for restructuring, including consolidation of loan offices, and $132 for anticipated losses in the commercial real estate portfolio. The domestic unsecured consumer small loan business has been reflected in "Dispositions and Other" and, as discussed previously, was sold in June 1993. -- Other provisions and reserves of $115 after tax or $.87 per fully diluted share, to cover the loss on the disposal of assets and for closure expenses of ITT Rayonier's Grays Harbor pulp and paper complex. In addition, a $34 after tax, or $.25 per fully diluted share provision to write down hotel investments at ITT Sheraton, and a $33 after tax or $.25 per fully diluted share charge for restructuring in the Components operations of ITT Defense & Electronics were recorded. Portfolio gains at ITT Hartford and ITT Financial in 1992 totalled $337 after tax or $2.56 per fully diluted share. Excluding these gains as well as the one-time items and accounting changes, net income was $465 or $3.31 per fully diluted share. 1991: There were no significant items of an unusual or nonrecurring nature during 1991. Net income was $749 or $5.49 per fully diluted share. Portfolio gains at ITT Hartford and ITT Financial in 1991 totalled $137 or $1.04 per fully diluted share. Excluding these gains, net income was $612 or $4.45 per fully diluted share. CASH FLOW The Corporation generated $1.7 billion of cash from operating activities during 1993, $1.7 billion in 1992 and $2.1 billion in 1991. Additional funds of $2.4 billion were also raised in 1993 from the sale of companies including ITT Financial's domestic unsecured consumer small loan business for $1.5 billion and the collection on a note of $.8 billion from the 1992 sale of Alcatel N.V. Proceeds in 1992 from the Alcatel N.V. sale totalled $1.0 billion. Growth in investment life contracts provided $1.7 billion, compared with $1.6 billion and $1.8 billion in the prior two years. Cash generated was used to fund internal growth, pay dividends, repay debt in 1993 and to repurchase and redeem ITT common and preferred shares in 1993 and 1992. Cash was also reinvested in securities at ITT Hartford and ITT Financial. Additional information on the investment portfolio is included in "Insurance and Finance Investments" in Notes to Financial Statements. Pursuant to the Corporation's share repurchase program announced in May 1992, 3.6 million common shares were repurchased in 1993 at an average price of $86.52 per share for a total of $310 at December 31, 1993. At December 31, 1992, approximately 1.7 million common shares had been repurchased at an average price of $65.63 per share for a total of $109. In addition, the Corporation called for the redemption of all outstanding $4.00 Convertible Series K and $5.00 Convertible Series O Cumulative Preferred Stock at $100 per share plus accrued dividends in June 1992. Redemptions totalled $106, which reduced common equivalent shares by an additional 1.6 million, with the balance converted to 5.8 million shares of common stock. Since the Corporation's stock repurchase programs began in 1987, nearly 40 million equivalent shares have been repurchased and redeemed for approximately $2.3 billion. Dividend payments were $277, $270 and $267 during 1993, 1992 and 1991, including $48 in both 1993 and 1992 and $49 in 1991 related to the ESOP preferred stock. Cash expenditures for plant, property and equipment were $505 in 1993, $549 in 1992 and $658 in 1991 and are expected to approximate $800 in 1994. Acquisitions in 1993 included the Desert Inn Properties in Las Vegas for $160. The planned acquisitions in 1994 in the Automotive and Hotels segments are expected to total approximately $1.0 billion. The Corporation has sufficient cash available, along with debt and equity financing alternatives, to fulfill these and other commitments that may be undertaken during the year. Depreciation in 1993 was $463 compared with $483 in 1992 and $426 in 1991. Accumulated depreciation amounted to 47% of gross plant, property and equipment at year-end 1993 and 1992. Expenditures for research, development and engineering totalled $460 in 1993, $502 in 1992 and $530 in 1991, of which approximately 53% was pursuant to customer contracts. These expenditures have funded numerous product developments such as anti-lock brake systems, and integrated circuits for multimedia applications and digital television, as well as electronic countermeasures and tactical radio communications technology. The Corporation remains financially strong and flexible given the level of cash generated from operations as well as the proceeds received (and expected to be received in 1994) from the sale of investments. Cash at December 31, 1993 totalled $1.1 billion and debt as a percentage of total capital was 33 percent with the Insurance and Finance subsidiaries carried on an equity basis and excluding Discontinued Operations. BUSINESS SEGMENTS Following is a discussion of important factors affecting the sales, revenues and operating income of each Business Segment. INSURANCE Revenues and operating income achieved record levels in 1993. Revenues increased 5 percent despite portfolio gains which were $288 lower than 1992. Portfolio gains included in revenues totalled $155, $443 and $144 in 1993, 1992 and 1991, respectively. Life operations provided much of the revenue growth and contributed 29 percent of the segment revenues in 1993 compared with 24 percent and 21 percent in 1992 and 1991. This increase, 25 percent in 1993, reflects dramatic improvement in account charge revenues from corporate owned life insurance contracts (COLI) combined with continued growth in individual life and annuity lines of business. The assumption and reinsurance of both COLI and annuity policies from Mutual Benefit and Fidelity Bankers were instrumental in the continued growth. Operating income in the life operations contributed 31 percent to the insurance segment in 1993 and increased 30 percent compared with 1992 which, in turn, increased 26 percent over 1991. As with revenues, the effects of the Mutual Benefit and Fidelity Bankers transactions were the largest contributors to the improvement. North American property and casualty underwriting revenues also increased modestly while revenues of the international property and casualty operations were flat compared with 1992. Dramatically improved income performance reflects improved property and casualty underwriting results as reflected in the worldwide combined ratio of 107.3 percent in 1993. Worldwide combined ratios were 133.7 percent in 1992 and 111.3 percent in 1991. Reserves were established in 1992 for expected loss developments in surplus lines and reinsurance at Cameron & Colby ($900) as well as projected legal defense costs associated with environmental-related claims ($250). Excluding the effects of the Cameron & Colby loss developments in surplus lines and reinsurance, the worldwide combined ratios were 105.9 percent in 1993, 114.8 percent in 1992 and 109.1 percent in 1991. In addition, catastrophe losses in 1993 were significantly below the record setting levels of 1992. Adjusted for these unusual items and portfolio gains, 1993 operating income increased significantly. These improvements were partially offset by reduced investment income, the result of lower interest rates and lower portfolio gains in 1993. On the same adjusted basis, 1992 operating income approximated 1991, reflecting a similar trend in domestic property and casualty results, offset by difficult market conditions in the international property and casualty business. Operating results are projected to continue to improve in 1994 due to improvements in worldwide property and casualty underwriting results combined with the effect of the growing life insurance operations. These projections include the benefits of recent restructuring actions designed to increase ITT Hartford's efficiency and competitiveness. FINANCE During 1993, ITT Financial completed a strategic repositioning of the company aimed toward emphasizing the origination and servicing of secured lending assets. Actions during 1993 included the sale of its domestic unsecured consumer small loan portfolio, the start up of ITT Residential Capital Corp. (a fully integrated residential mortgage company) and the repositioning of the domestic home equity business. At year-end 1993, secured funded receivables constituted 88% of total funded receivables as compared to 69% at year-end 1992. Revenues and operating income data have been restated to exclude the results of the domestic unsecured consumer small loan business which is reported in "Dispositions and Other". The benefits of this strategic shift will be reduced operating expenses, dramatically improved credit quality, and improved asset liquidity. ITT Financial plans to leverage these benefits through improved capital efficiency, primarily securitization. During 1993, ITT Financial completed the securitization of $2.4 billion of assets. Finance revenues from ongoing businesses increased in 1993 and 1992 due to increased finance charges and servicing income on higher levels of owned and serviced receivables. The operating income improvement in 1993 reflects the absence of last year's provision of $132 for anticipated losses in the commercial real estate portfolio. When adjusting for that provision, along with the portfolio gains which were significantly lower in 1993 compared with prior years, operating income in 1993 improved over 1992 and approximated 1991 levels. Emphasis on secured lending and asset securitization will remain the focus in 1994. The nature of this strategy is to enhance the Company's risk profile and improve asset quality, although operating income will be somewhat lower. COMMUNICATIONS & INFORMATION SERVICES Both sales and revenues and operating income rose 5 percent in 1993 over 1992 when adjusting for the impact of unfavorable foreign exchange. The increase in all periods reflected improvements in the telephone directory operations in Western Europe as well as an increase in the number of ITT Technical Institutes and student enrollment at those institutes at ITT Educational Services. At ITT World Directories, operating margins are under pressure due to lower advertising volume in a number of units. Modest price increases, coupled with reduced operating costs, have resulted in margins that generally meet or exceed prior year levels. ITT World Directories' operations in the United Kingdom were sold to British Telecom in 1993 prior to the expiration of a directory sales contract. Operations in Turkey were shut down in December 1992 as a result of continuing losses in a difficult economic environment. The operating results of these units are reported in "Dispositions and Other" for all years presented. A shift in the regulatory and competitive structures in the European Community may limit growth of existing operations during 1994. The Company continues to pursue a program of product diversification and geographic expansion. At ITT Educational Services, 20,000 students are enrolled at 48 schools. Five new schools opened during 1993. Operating results at ITT Educational Services are projected to continue to improve in 1994 due to additional school openings and a continuing expansion of curricula and degree offerings. A period of strong growth is expected as a result of ongoing demand for increased technical education of the U.S. work force. AUTOMOTIVE Sales continued to increase in 1993 as in 1992 as a result of increased market penetration of ITT Anti-lock Brake Systems ("ABS"), higher light vehicle production in North America and the continued shift in consumer preference toward light trucks for which ITT Automotive maintains a strong product offering. Tempering the growth in 1993 was the deepening recession in Western Europe which resulted in a decline in Western European car production. Western European sales comprised 57 percent of the total in 1993 compared with 68 percent in 1992 and 70 percent in 1991. Higher operating income in 1993 is largely the result of continued cost reduction efforts partially offset by lower sales prices and higher labor costs. Compared with 1991, the increased operating income was largely attributable to sales growth in addition to cost reduction efforts partially offset by higher labor costs and restructuring actions. ITT Automotive will continue to benefit in 1994 from an anticipated increase in North American light vehicle production, particularly light trucks, as well as continued cost reduction efforts. Additionally, Western European passenger car production is anticipated to stabilize. Anti-lock brake systems remains the largest product line offered by ITT Automotive, comprising 30, 27 and 22 percent of total sales in 1993, 1992 and 1991, respectively. The acquisition of General Motors' motors and actuators business unit is expected to strengthen ITT Automotive's position in a number of product lines, particularly motors and wiper systems for the North American market. DEFENSE & ELECTRONICS The 13 percent sales reduction in 1993 was anticipated and related primarily to the Defense units as the impact of the completion of several major programs and reduced U.S. government defense spending resulted in lower shipments and a decline in operations and maintenance contracts. The sales decrease in 1992 related primarily to the Electronics units due to a worldwide decline in the television market and softness in the connector product line, especially due to lower military related demand. Sales and operating income have been restated in all periods to reflect the December 1993 sale of ITT Components Distribution. The gain on the sale of $13 pretax and the operating results are reflected in "Dispositions and Other." Operating income improved substantially in 1993 reflecting current year cost improvements at several units and favorable margin adjustments on mature military programs along with the absence of a 1992 restructuring charge. The operating loss in 1992 resulted from the $53 million restructuring charge, reduced volume and downward pricing pressures for commercial products. Order backlog was $2.2, $2.3 and $2.2 billion at December 31, 1993, 1992 and 1991, respectively. Sales and operating income in 1994 are expected to approximate 1993 levels. New product development, expanded markets (including international defense opportunities) and the benefits of ongoing restructuring activities provide a basis for future growth. FLUID TECHNOLOGY Sales have remained relatively level in the past several years with the decrease in 1993 due primarily to a stronger U.S. dollar versus many of the European currencies in which Fluid Technology operates. In the past two years, growth in markets including water and wastewater treatment, power generation and exports as well as new products have been largely offset by weak market conditions in such industries as construction, industrial process, oil and gas, mining and leisure marine. Operating income in 1993 benefited from the impact of cost improvement actions taken in 1992, including the consolidation of facilities to reduce excess capacity. In 1992, provisions for restructuring along with the devaluation of the Swedish krona adversely impacted operating income. Slow but steady economic improvement is expected in served markets in 1994. ITT Fluid Technology's position of market leadership, customer-oriented marketing programs, and new products, together with its lower cost structure, should allow the company to resume its profitable growth. HOTELS Sales and revenues have been modified in all periods to include 100 percent of the revenues of the hotels under Sheraton's management. The Corporation believes that such a presentation better reflects the breadth and control of hotel operations and increased sales and revenues (with no impact on operating income) by $2.4, $2.3 and $2.1 billion in 1993, 1992 and 1991, respectively. Sales and revenues increased in 1993 largely due to improvements in the North American region along with the contribution of the Desert Inn which was acquired in late 1993. The increase in 1992 over 1991 was also attributable to the North American region, where room inventory levels were fully restored as renovations were completed at several owned hotels and to higher revenues among Sheraton's managed properties. In 1993, ITT Sheraton continued its focus on upgrading properties and enhancing its image through the completion of renovation work and elimination of properties which do not meet required standards. More than 30.2 million room nights were sold in 1993, an increase of 1.7 million room nights from 1992 for comparable hotels. Operating income in 1993 reflected the accelerated write-off of capitalized development expenses totalling $29 along with an $11 gain on the sale of an investment in Bally's Las Vegas operations. In 1992, a provision of $45 to write down hotel investments resulted in a reported operating loss. When excluding the impacts of these one-time items, operating income rose dramatically in 1993. Total sales and revenues of the Hotels segment, including 100% of unconsolidated revenue generated by franchised hotels, were (in billions) $4.8 in 1993 and 1992 and $4.4 in 1991. Room rates of owned, managed and leased properties averaged $105.48, $107.14 and $104.19 for 1993, 1992 and 1991, respectively, while occupancy rates were 68.5% , 66.4% and 64.9%. The 1993 room rate reduction reflects the stronger U.S. dollar against numerous foreign currencies, particularly in Europe. Total properties numbered 407 in 1993 compared with 426 and 423 in 1992 and 1991, respectively, including franchised properties of 230, 252 and 259 in those years. Operating income is expected to continue to improve in 1994 both from existing hotels as well as from acquisitions. The Gaming division, which will include a full year's results from the Desert Inn and the anticipated contribution from a casino near Memphis opening mid-year, will be a significant focal point. Other anticipated acquisitions are expected to provide Sheraton with an enhanced presence in markets not previously represented. ALCATEL N.V. The Corporation sold its 30 percent interest in Alcatel N.V. to its joint venture partner, Alcatel Alsthom in July, 1992. Proceeds from the sale included $1 billion in cash, two notes payable in 1993 and 1994 totalling $1.6 billion (including interest) and 9.1 million shares in Alcatel Alsthom. The shares, which have a net book value of $.8 billion, have a fair market value of $1.1 billion as of February 28, 1994. The Corporation recognized a pretax gain of $942 ($622 after tax) in 1992 on the transaction. DISPOSITIONS AND OTHER Dispositions and Other includes the sales, operating results and the gain or loss from sale or closedown of units other than "Discontinued Operations," along with the sales and operating results of other non-core businesses. Results for all years presented include sales and operating results of the Corporation's Community Development subsidiary. The domestic unsecured consumer small loan portfolio previously included in the Finance segment is the largest business included in "Dispositions and Other". The operating losses are included in all years presented along with the provision in 1992 to cover future domestic unsecured consumer small loan losses and to restructure the business, including consolidation of consumer loan offices. A $95 pretax gain ($63 after tax) on the sale of this portfolio is included in 1993. Operating results for all periods and associated gains on sale in 1993 as they relate to ITT Components Distribution and World Directories United Kingdom operations are also included. 1992 included provisions for the closedown of World Directories' unit in Turkey ($41 pretax offset with tax benefits of a similar amount included in "Income Taxes") along with respective operating losses in 1992 and 1991. Sales and operating results for 1991 included certain Italian automotive operations sold in 1991. DISCONTINUED OPERATIONS During December, 1993, the Corporation announced its plans to spin-off ITT Rayonier, the Corporation's Forest Products segment to its common and preferred shareholders. The spin-off was completed in February, 1994. Accordingly, the results of ITT Rayonier are reported as "Discontinued Operations" on a one-lined after tax basis. The income (loss) from "Discontinued Operations", net of taxes, were $53, $(72) and $54 in 1993, 1992 and 1991, respectively. The 1992 results included an after tax provision of $115 for the loss on disposal and the estimated closure costs of ITT Rayonier's Grays Harbor pulp and paper complex. INTEREST, TAXES AND OTHER Net interest expense in 1993 decreased due to lower average debt levels and higher average cash invested. Net interest expense in 1992 approximated 1991 levels as interest income earned in the second half of the year from the proceeds of the Alcatel sale offset higher expense from higher average debt levels incurred to support investments, capital programs and working capital requirements. Income taxes of $345 in 1993 were provided on pretax income of $1.3 billion representing a 27 percent effective tax rate. Tax exempt interest earned on invested assets at Insurance and Finance caused the effective rate to be lower than the U.S. statutory rate. Additionally, in 1993, the changes in the United States tax law resulted in a one-time benefit of $32 representing an increase in the Corporation's deferred tax assets at the beginning of the year necessitated by the 1 percent increase in the statutory rate. Partly offsetting this benefit was a $10 increase to the current year tax provision. "Discontinued Operations", "Extraordinary Item" and "Cumulative Effect of Accounting Changes" are all presented on a net of tax basis and accordingly, the associated tax benefits are not included in the provision above. The increase in income taxes over 1992 and 1991 related primarily to the increase in pretax income. In 1992, large provisions in the Insurance and Finance segments resulted in a pretax loss and a corresponding tax benefit. Income taxes paid in 1993, 1992 and 1991 were $337, $202 and $157, respectively. "Other" consists primarily of corporate expenses, minority equity and non-operating income (expense). In 1993, a provision of $50 pretax is included for estimated severance and other costs associated with a program aimed at increasing the effectiveness and productivity at the Corporation's headquarters locations. "Other" expenses increased in 1992 primarily due to higher corporate provisions for divested company exposures and environmental issues. DEBT AND LIQUIDITY Outstanding debt, including Insurance and Finance debt, was $13.9 billion at December 31, 1993. This was a $2.0 billion decrease from 1992, and was primarily due to the application of the proceeds from the sale of ITT Financial's domestic unsecured consumer small loan portfolio and from ITT Financial's receivable securitization. At December 31, 1993 and 1992, debt was 64% and 68% of total capitalization, including finance and insurance subsidiaries debt of $10.4 billion and $12.1 billion, respectively. With insurance and finance subsidiaries carried on an equity basis and excluding Discontinued Operations, debt was 33% of total capitalization at the end of 1993 compared with 37% at the end of 1992. The Corporation remains strong, flexible and well positioned. Future debt needs can be met as required by traditional and emerging channels. Certain subsidiaries are subject to restrictions on transfer of funds to the Corporation, but the restrictions have not affected the Corporation's ability to meet its cash obligations. No change in this condition is anticipated. Stockholders equity increased $403 during 1993 to $7.7 billion mainly as a result of earnings, partly offset by dividends, share repurchases and redemptions and a reduction in the cumulative translation account. The Corporation had cash of $1.1 billion at December 31, 1993, compared with $882 at the end of 1992. The increase is largely the result of cash generated from operations and proceeds from the collection of the Alcatel note, partly offset by share repurchases and acquisitions. Collection of the remaining note received in the Alcatel sale will supplement the Corporation's available cash by $817 in 1994. This cash, along with debt and equity financing alternatives, is available for share repurchases, acquisitions or debt repayment in 1994 and future periods. In February, 1994, the Corporation entered into a new revolving credit agreement with terms ranging from one to five years with 65 domestic and foreign banks providing credit commitments of $7 billion. These commitments were made to the ITT parent company and certain of its subsidiaries for $3 billion and to ITT Financial totalling $4 billion. The credit commitments of the ITT parent company are used to assure working capital needs and to support commercial paper. Commercial paper borrowings totalled $268 at December 31, 1993. ITT's insurance and finance subsidiaries, foreign units and certain other major domestic subsidiaries usually meet their funding requirements on a direct basis and, from time to time, are supplemented through Corporate-established financing vehicles. ITT Financial is a direct issuer of commercial paper. At December 31, 1993, $2.0 billion of commercial paper was outstanding. The Corporation operates in a multinational environment with minimal exposures in hyper-inflationary countries. Thus, inflation has not had a significant impact on the financial position of the Corporation or results of its operations in recent periods, nor is it expected to do so in the near future. The multinational operations of the Corporation also create exposure to foreign currency fluctuation. The Corporation enters into foreign exchange contracts with major financial institutions to reduce such exposure. These agreements are meant to either hedge exchange exposure on the Corporation's net investment in a foreign country or on the Corporation's foreign denominated debt or are meant to hedge a specific transaction. During 1993, consolidated net assets decreased by $114 reflecting the effect of translated local currencies on the Corporation's net foreign investments and was primarily the result of the strengthening of the U.S. dollar against most European currencies. Foreign currency transaction gains or losses were not significant. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA See Index to Financial Statements and Schedules elsewhere herein. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF ITT The information called for by Item 10 with respect to directors is incorporated herein by reference to the definitive proxy statement involving the election of directors filed or to be filed by ITT with the Securities and Exchange Commission pursuant to Regulation 14A within 120 days after the end of the fiscal year covered by this Form 10-K. The information called for by Item 10 with respect to executive officers is set forth above in Part I under the caption "Executive Officers of ITT." ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information called for by Item 11 is incorporated herein by reference to the definitive proxy statement referred to above in Item 10. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information called for by Item 12 is incorporated herein by reference to the definitive proxy statement referred to above in Item 10. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information called for by Item 13 is incorporated herein by reference to the definitive proxy statement referred to above in Item 10. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Documents filed as a part of this report: 1. See Index to Financial Statements and Schedules appearing on page for a list of the financial statements and schedules filed as a part of this report. 2. See Exhibit Index appearing on pages II-2 and II-3 for a list of the exhibits filed or incorporated herein as a part of this report. (b) There were no Form 8-K Current Reports filed by ITT during the quarter ended December 31, 1993. AND SCHEDULES REPORT OF MANAGEMENT The management of ITT Corporation is responsible for the preparation and integrity of the information contained in the financial statements and other sections of the Annual Report. The financial statements are prepared in accordance with generally accepted accounting principles and, where necessary, include amounts that are based on management's informed judgments and estimates. Other information in the Annual Report is consistent with the financial statements. ITT's financial statements are audited by Arthur Andersen & Co., independent public accountants, elected by the shareholders. Management has made ITT's financial records and related data available to Arthur Andersen & Co., and believes that the representations made to the independent public accountants are valid and complete. ITT's system of internal controls is a major element in management's responsibility to provide a fair presentation of the financial statements. The system includes both accounting controls and the internal auditing program, which are designed to provide reasonable assurance that the Corporation's assets are safeguarded, that transactions are properly recorded and executed in accordance with management's authorization, and that fraudulent financial reporting is prevented or detected. ITT's internal controls provide for the careful selection and training of personnel and for appropriate divisions of responsibility. The controls are documented in written codes of conduct, policies and procedures that are communicated to ITT's employees. Management continually monitors the system of internal controls for compliance. ITT's internal auditors independently assess the effectiveness of internal controls and make recommendations for improvement on a regular basis. The independent public accountants also evaluate internal controls and perform tests of procedures and accounting records to enable them to express their opinion on ITT's financial statements. They also make recommendations for improving internal controls, policies and practices. Management takes appropriate action in response to each recommendation from the internal auditors and the independent public accountants. The Audit Committee of the Board of Directors, composed of nonemployee directors, meets periodically with management and with the independent public accountants and internal auditors to evaluate the effectiveness of the work performed by them in discharging their respective responsibilities and to assure their independent and free access to the Committee. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS TO THE STOCKHOLDERS OF ITT CORPORATION: We have audited the financial statements of ITT Corporation (a Delaware corporation) and subsidiaries as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993, as described in the accompanying Index to Financial Statements and Schedules. These financial statements and the schedules referred to below are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of ITT Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in the accompanying notes to financial statements, the Corporation adopted new accounting standards promulgated by the Financial Accounting Standards Board, changing its methods of accounting, in 1993, for reinsurance of short-duration and long-duration contracts, and, effective January 1, 1992, for postretirement benefits other than pensions and postemployment benefits. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the Index to Financial Statements and Schedules are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. Arthur Andersen & Co. New York, New York February 3, 1994 ITT CORPORATION AND SUBSIDIARIES CONSOLIDATED INCOME IN MILLIONS EXCEPT PER SHARE - --------------- * The reported net loss in 1992 causes the calculation of the fully diluted loss per share in 1992 to be anti-dilutive. In such a case, generally accepted accounting principles suggest the fully diluted loss per share to be the same as the primary loss per share; however, the Corporation has presented the actual calculated amount in order that all calculations and comparisons with previously reported and future amounts be on a consistent basis. The accompanying notes to financial statements are an integral part of the above statement. ITT CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET IN MILLIONS EXCEPT FOR SHARES AND PER SHARE The accompanying notes to financial statements are an integral part of the above statement. ITT CORPORATION AND SUBSIDIARIES CONSOLIDATED CASH FLOW IN MILLIONS The accompanying notes to financial statements are an integral part of the above statement. ITT CORPORATION AND SUBSIDIARIES CONSOLIDATED RETAINED EARNINGS IN MILLIONS EXCEPT PER SHARE CONSOLIDATED CAPITAL STOCK AND SURPLUS IN MILLIONS EXCEPT FOR SHARES CUMULATIVE PREFERRED STOCK STATED VALUE IN MILLIONS The Corporation has authorized 50,000,000 shares of cumulative preferred stock, without par value, which are issuable in series. The ESOP Series shares are redeemable after July 1, 1994 at $77.20 per share reduced annually through June 30, 1999 to $74.59 per share. Liquidation preference on shares outstanding is $34 per share for the Series N and $77.72 per share for the ESOP Series. The accompanying notes to financial statements are an integral part of the above statements. NOTES TO FINANCIAL STATEMENTS (DOLLAR AMOUNTS ARE IN MILLIONS UNLESS OTHERWISE STATED) ACCOUNTING POLICIES Consolidation Principles: The financial statements include the accounts of all majority-owned subsidiaries. All significant intercompany transactions have been eliminated. Insurance Operations: Policy acquisition costs, representing commissions, premium taxes and certain other underwriting costs of developing and implementing new insurance programs, are deferred and amortized over the periods benefited. Estimates of future revenues, including investment income, are compared with estimates of future costs, including amortization of policy acquisition costs, to determine if policies currently in force are expected to result in a net loss. No revenue deficiencies have been determined in the periods presented. The liability for property and casualty claims includes amounts determined by claim adjusters on individual cases and estimates for unreported claims based on past experience. While asbestos and pollution liabilities are established for claims and legal defense costs, the ultimate liabilities cannot be reasonably estimated due to the unpredictability of notification and resolution, and therefore the liabilities established may have to be adjusted as additional information becomes available. However, based on current evaluation, the Corporation believes the ultimate resolution of all its claims, including reinsurance effects, will not have a material adverse impact on its overall financial condition. Certain liabilities for unpaid claims are discounted at interest rates between 3% and 3.5%, for permanently disabled claimants, and between 3% and 14% for terminated reinsurance treaties and certain reinsurance contracts that fund loss runoffs for unrelated parties. The discount amounted to $362 and $325 as of December 31, 1993 and 1992. Unearned premiums are calculated principally by the application of monthly pro rata fractions for the unexpired terms of policies in force. The liability for future life insurance payments, excluding investment and universal life-type contracts, is computed by the net level premium method, based on estimated future investment yields, withdrawals, mortality and other assumptions made at the time the policies are issued. The liability for investment and universal life-type contracts is stated at policyholder account values before surrender charges. Revenue on these contracts represents policyholder charges. The cost of acquiring new business is recognized over the term of the contracts in proportion to estimated gross profits. Separate account assets and corresponding liabilities totalling $16.6 billion and $8.8 billion at December 31, 1993 and 1992, respectively, have been netted in the accompanying Balance Sheet. Finance Operations: Revenues from finance receivables are recognized using the interest method, whereby finance charges, loan origination fees and direct loan origination costs are recognized over the life of the related loan to provide a constant effective yield. Because the insurance subsidiaries of the finance companies are integral parts of the finance operations, the accounts of those subsidiaries are included in finance revenues, operating costs and expenses, assets and liabilities. The reserve for credit losses is based on analysis of historical loss experience and other factors, and is considered adequate to cover incurred losses in the finance receivables portfolio. In May 1993, the Financial Accounting Standards Board issued a new standard related to the accounting by creditors for the impairment of a loan (SFAS No. 114). The standard, which must be adopted by 1995, requires that impaired loans, as defined, be measured based on the present value of expected future cash flows. The Corporation is reviewing the requirements and the timing of the adoption of the standard, however, the impacts are not expected to be material to the Corporation's financial position or results of operations. Hotel Operations: During 1993, the Corporation changed its presentation of the operations of partially-owned hotel properties and hotel properties under long-term management agreements to include their revenues and expenses in the consolidated results of operations. The change was made because the operating control and responsibilities associated with these properties are substantially the NOTES TO FINANCIAL STATEMENTS (CONTINUED) same as those for owned or leased hotel properties. The inclusion of revenues and expenses of these properties more clearly reflects the results of operations of all of the properties that are actively managed and controlled by the Corporation. Prior year amounts have been reclassified to conform to the 1993 presentation. Sales and expenses have been increased by $2.4 billion, $2.3 billion and $2.1 billion (with no impact on operating income) in 1993, 1992 and 1991, respectively. Inventories: Inventories are generally valued at the lower of cost (first-in, first-out) or market. In manufacturing operations, a full absorption procedure is employed using standard cost techniques. Revenue from long-term contracts is recognized on the percentage-of-completion method. Expected losses on long-term contracts and potential losses from obsolete and slow-moving inventories are provided for in the current period. Plant, Property and Equipment: Plant, property and equipment, including capitalized interest applicable to major project expenditures, are recorded at cost. The Corporation normally claims the maximum depreciation deduction allowable for tax purposes. In general, for financial reporting purposes, depreciation is provided on a straight-line basis over the useful economic lives of the assets involved. Accumulated depreciation was $3,054 and $2,916 at December 31, 1993 and 1992. Earnings Per Share: Fully diluted earnings per share is based on the weighted average of common stock equivalents and assumes conversion of the ESOP Series convertible preferred stock and in 1992 and 1991 assumes conversion of the then outstanding Series O convertible preferred stock. Net income applicable to fully diluted earnings per share consists of reported net income or loss adjusted for the amount, net of tax, the Corporation would be required to contribute to the ESOP if the ESOP Series preferred shares were converted into common stock. Primary earnings per share is based, in 1993, on the weighted average of common and common equivalent shares outstanding, which include Series N convertible preferred stock and stock options. In 1992, common equivalent shares, which include Series K and N convertible preferred stock and stock options, have not been considered since their effect is anti-dilutive. These common equivalent shares are, however, included in the primary earnings per share calculation in 1991. With respect to options, it is assumed that proceeds received upon exercise will be used to acquire common stock of the Corporation. In 1993 and 1991, net income applicable to primary earnings per share consists of the reported net income adjusted for dividend requirements on preferred stock not considered common stock equivalents, net of the related tax benefits. In 1992, net income applicable to primary earnings per share consists of reported net loss adjusted for dividend requirements on all preferred stock series, net of the related tax benefits. CHANGES IN ACCOUNTING PRINCIPLES Change Adopted in 1993: During the first quarter of 1993, the Corporation adopted Statement of Financial Accounting Standards ("SFAS") No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts", by restating the balance sheet of the prior period. This new standard requires reinsurance recoverables and prepaid reinsurance premiums to be reported as assets. As a result of the restatement, reinsurance recoverables increased $10.2 billion, prepaid insurance premiums (included in "Other Assets") increased $.3 billion and policy liabilities and accruals increased $10.5 billion at December 31, 1992. The income statement impact of the adoption is not significant. Changes Adopted in 1992: Effective January 1, 1992, the Corporation adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" and SFAS No. 112, "Employers' Accounting for Postemployment Benefits", using the immediate recognition method. Accordingly, cumulative adjustments (through December 31, 1991) of $580 after tax ($4.37 per fully diluted share) and $45 after tax ($.34 per fully diluted share), respectively, have been recognized at January 1, 1992. The Corporation's cash flows were not impacted by these changes in accounting principles. NOTES TO FINANCIAL STATEMENTS (CONTINUED) SPECIAL CHARGES AND EXTRAORDINARY ITEM In 1992, as a result of adverse loss developments in certain surplus lines and reinsurance business, the Corporation's insurance operations recorded a $900 pretax charge to fund expected loss developments in surplus lines and reinsurance business and $250 pretax for expected legal defense costs associated with environmental-related claims. The effect of these two charges was $759 after tax or $5.75 per fully diluted share. The Corporation also announced in 1992 a strategic transformation of its consumer finance operations to considerably reduce its business in the domestic unsecured consumer small loan area and to pursue growth opportunities in other portions of the finance business. The domestic unsecured consumer small loan portfolio totalled $2.4 billion at December 31, 1992. In conjunction with this decision, reserves were established in the fourth quarter totalling $928 pretax or $612 after tax ($4.66 per fully diluted share), including a $693 pretax provision to cover future unsecured consumer small loan losses from the run-off of its existing portfolio; $103 pretax for restructuring and consolidation of loan offices; and $132 pretax for anticipated losses in the commercial real estate portfolio. In June 1993, the domestic unsecured consumer small loan portfolio was sold to a group of investors resulting in a $95 pretax gain ($63 after tax or $.48 per fully diluted share). Proceeds from the sale were used to retire fixed-rate debt resulting in an extraordinary loss of $50 after tax or $.38 per fully diluted share. ALCATEL N.V. In July 1992, the Corporation sold its 30% equity interest in Alcatel N.V. (Alcatel) to its joint venture partner, Alcatel Alsthom, resulting in a pretax gain of $942 or $622 after tax ($4.71 per fully diluted share). The Corporation received cash at the closing of $1 billion, two notes payable in 1993 and 1994 valued at $1.4 billion and 9.1 million shares of Alcatel Alsthom stock recorded at $806. The Alcatel Alsthom stock, which is carried at cost, is included in "Other Assets" in the accompanying Balance Sheet and has a value of $1.3 billion and $1.1 billion based on the quoted market prices at December 31, 1993 and 1992. Equity in earnings of Alcatel in 1992 and 1991 represents the Corporation's 30% equity in after tax income of Alcatel, adjusted for amortization of the amount by which the Corporation's investment exceeded its equity in the joint venture, over periods not longer than 40 years. RECEIVABLES Finance Receivables of $7,556 and $9,280 at December 31, 1993 and 1992 are net of unearned income of $567 and $917 and reserves for credit losses of $222 and $1,119. The estimated fair value of Finance Receivables, net, at December 31, 1993 and 1992, approximates the recorded value and was computed by discounting the projected cash flows at a rate at which similar loans would be made to borrowers with similar credit ratings and for the same maturities. Consumer receivables were $3,647 and $5,932 and commercial receivables were $4,698 and $5,384 at December 31, 1993 and 1992. These receivables are generally written with maximum original terms of 60 months for consumer small loans, 84 months for commercial loans, 180 months for consumer mortgages and 120 months for commercial mortgages. Net charge-offs as a percentage of average net finance receivables were 3.22%, 4.85% and 4.58% in 1993, 1992 and 1991. Other Receivables were $5,163 and $5,403 at December 31, 1993 and 1992, net of allowances for doubtful accounts of $127 and $133. Included in the balances are notes receivable from the sale of Alcatel totalling $785 and $1,461 at December 31, 1993 and 1992, respectively, which approximate fair value. Also included are insurance premiums receivable and agents' balances of $1,842 and $1,791, trade receivables of $2,395 and $1,989 and other receivables of $268 and $295. NOTES TO FINANCIAL STATEMENTS (CONTINUED) INCOME TAX Income tax data from continuing operations is as follows: No provision was made for U.S. taxes payable on undistributed foreign earnings amounting to approximately $800 since these amounts are permanently reinvested. Deferred income taxes represent the tax effect related to recording revenues and expenses in different periods for financial reporting and tax purposes. The December 31, 1993 and 1992 Balance Sheets include net U.S. Federal deferred tax assets of $1,044 and $1,037, respectively (included in "Other Assets"), and net foreign and other deferred tax liabilities of $196 and $244, respectively (included in "Other Liabilities"). Deferred tax assets (liabilities) include the following: A reconciliation of the tax provision (benefit) at the U.S. statutory rate to the provision (benefit) for income tax as reported is as follows: NOTES TO FINANCIAL STATEMENTS (CONTINUED) DEBT As of December 31, debt consisted of: The fair value of the Corporation's commercial paper and bank loans and other short-term loans approximates carrying value. The estimated fair value of long-term debt at December 31, 1993 and, 1992 is $6,590 and $6,135 for Finance and $3,071 and $2,935 for Other, based on discounted cash flows using the Corporation's incremental borrowing rates for similar arrangements. Long-term debt maturities and interest rates at December 31 were: The balances as of December 31, 1993 and 1992 exclude amortizable debt discounts of $111 and $110 for Finance and $158 and $174 for Other operations. Bank loans and other short-term debt are drawn down under lines of credit, some of which extend for a fixed term of several years. As of December 31, 1993, the Corporation had unused credit lines of $3.3 billion for Finance, the majority of which supports outstanding commercial paper, and $2.0 billion for Other operations. The Corporation enters into interest rate swap agreements with major financial institutions to manage exposure from fluctuations in interest rates. Interest expense is adjusted with changes of the interest rate and any credit risk is considered remote. At December 31, 1993 and 1992, interest rates were effectively converted on the following notional principal amounts: The estimated fair value of these interest rate swap agreements at December 31, 1993 and 1992 amount to net payable of $25 and $32 over recorded amounts. The fair value of interest rate swaps is the estimated amount that the Corporation would receive or pay to terminate the swap agreements at December 31, 1993 and 1992, taking into account current interest rates. NOTES TO FINANCIAL STATEMENTS (CONTINUED) CAPITAL STOCK During 1993, 3,588,008 common shares were repurchased for $310. The excess over par value was charged to Capital Surplus to the extent available and then to Retained Earnings. In 1992, 1,664,518 common shares were repurchased for $109 with the excess over par value charged to Capital Surplus. Also in 1992, the Corporation called for the redemption of all outstanding $4.00 Convertible Series K and $5.00 Convertible Series O Cumulative Preferred Stock at $100 per share plus accrued dividends. Redemptions totalled $106, which reduced common equivalent shares by an additional 1,562,559 shares with the balance converted to 5,822,118 shares of common stock. There were no share repurchases in 1991. As of December 31, 1993, reserved shares of authorized and unissued common stock totalled 13,344,783, in connection with convertible preferred stock and incentive stock plans and shares held in treasury totalled 27,587,131. Certain subsidiaries were subject to various restrictions such as transfers of funds in the form of dividends and advances without prior regulatory approval. The net assets of subsidiaries subject to such restrictions were approximately $1.2 billion at December 31, 1993. FOREIGN CURRENCY Balance sheet accounts are translated at the exchange rates in effect at each year end and income accounts are translated at the average rates of exchange prevailing during the year. The national currencies of foreign operations are generally the functional currencies. The Corporation enters into foreign exchange contracts with major financial institutions (currency swaps and forward exchange contracts) to reduce its exposure to fluctuations in foreign currencies. These agreements are meant to either hedge exchange exposure on the Corporation's net investment in a foreign country or on the Corporation's foreign denominated debt and are, therefore, of a long-term duration, or are meant to hedge a specific transaction. The contractual amounts of these foreign exchange contracts at December 31, 1993 and 1992 totalled $966 and $1,122, respectively, and mature at varying dates through 1997. The estimated fair value at December 31, 1993 and 1992 approximates the recorded amounts. The estimated fair value is the present value of the change in cash flows that would result from the agreements being replaced at the year-end market rate for the remaining term of the agreements. Cumulative translation adjustments are adjusted for contracts that hedge the Corporation's foreign investments, when the differential to be paid or received fluctuates with the foreign exchange rate. Any credit risk is considered remote. Translation adjustments recorded in a separate component of Stockholders Equity were: EMPLOYEE BENEFIT PLANS Pension Plans -- The Corporation and its subsidiaries sponsor numerous pension plans. The plans are funded with trustees, except in some countries outside the U.S. where funding is not required. NOTES TO FINANCIAL STATEMENTS (CONTINUED) Total pension expenses were: U.S. pension expenses included in the net periodic pension costs in the table above were $85, $100 and $86 for 1993, 1992 and 1991. The following table sets forth the funded status of the pension plans, amounts recognized in the Corporation's Balance Sheet at December 31, 1993 and 1992, and the principal weighted average assumptions inherent in their determination. For substantially all domestic plans, assets exceed accumulated benefits and, for substantially all foreign plans, accumulated benefits exceed the related assets. Investment and Savings Plan -- The ITT Investment and Savings Plan for Salaried Employees includes an Employee Stock Ownership Plan (ESOP) feature. In 1989, ITT sold to the ESOP 9,384,951 shares of a new series of Cumulative preferred stock at a price of $74.5875 per share, which was financed through borrowings by the ESOP guaranteed by ITT. Shares are allocated to participants as a percent of each covered employee's salary and respective contribution. At December 31, 1993, 1,968,237 shares were allocated to participants. The ESOP debt of $603 is included in the Balance Sheet due to the Corporation's guarantee of its repayment by the ESOP and is offset by a reduction in Stockholders Equity as deferred compensation. The debt is at fixed rates ranging between 8.4% and 8.8% and matures in varying amounts through 2004. The fair value of ESOP debt at December 31, 1993 is $686 based on discounted cash flows using incremental borrowing rates for similar arrangements. Interest and principal repayments are funded by dividends on the ESOP Series preferred stock and Plan contributions from the Corporation. NOTES TO FINANCIAL STATEMENTS (CONTINUED) Postretirement Health and Life -- The Corporation and its subsidiaries provide health care and life insurance benefits for certain eligible retired employees. Effective January 1, 1992, the Corporation adopted SFAS No. 106, using the immediate recognition method for all benefits accumulated to date. The Corporation adopted certain changes to a number of its postretirement benefit plans during 1992. The effect of these changes has been reflected in the determination of the expense recorded for 1993 and 1992 as reported below. The Corporation has prefunded a portion of the health care and life insurance obligations through trust funds where such prefunding can be accomplished on a tax effective basis. Postretirement health care and life insurance benefits expense (excluding the cumulative catch-up adjustment in 1992) was comprised of the following in 1993 and 1992: For 1991, the aggregate costs amounted to $27 under the prior accounting method. The following table sets forth the funded status of the postretirement benefit plans other than pensions, amounts recognized in the Corporation's Balance Sheet at December 31, 1993 and 1992 and the principal weighted average assumptions inherent in their determination: The assumed rate of future increases in the per capita cost of health care (the health care trend rate) was 12.1% for 1993, decreasing ratably to 6.0% in the year 2001. Increasing the table of health care trend rates by one percent per year would have the effect of increasing the accumulated postretirement benefit obligation by $40 and the annual expense by $3. To the extent that the actual experience differs from the inherent assumptions, the effect will be amortized over the average future service of the covered active employees. STOCK INCENTIVE PLANS The Corporation's stock option incentive plans provide common shares for options to employees, exercisable over ten-year periods. Some options become exercisable upon the attainment of a specified and sustained market price appreciation of the Corporation's common shares, while other options become exercisable over a three-year period commencing with the date of grant. The exercise price per share is the fair market value on the date each option is granted. NOTES TO FINANCIAL STATEMENTS (CONTINUED) As of December 31, 1993, options for 1,684,000 shares were exercisable under the Corporation's incentive plans. Common shares subject to options during 1993 were (in thousands of shares): As of December 31, 1993, 94,498 shares were available for future grants under the Corporation's various incentive plans. Grants contingent on the acceptance of a new incentive plan by the Corporation's shareholders total 307,300 and are not included. The number of options outstanding as well as the exercise price of all outstanding options will be adjusted in 1994 to recognize the effect of the Rayonier spin-off. INSURANCE AND FINANCE INVESTMENTS Fixed maturity investments of Insurance and Finance subsidiaries, substantially all of which are carried at amortized cost, consisted of the following at December 31, 1993 and 1992: The Corporation considers its fixed maturity portfolio to be held primarily for investment although, at times, changing interest rates, tax position and other factors result in portfolio activity. Other insurance and finance investments are primarily equity securities, real estate and policy loans. Equity securities are carried at market and were $1,367 and $1,045 at December 31, 1993 and 1992. Gross unrealized gains and losses on equity securities were $183 and $61, respectively, in 1993 and $91 and $46, respectively, in 1992. The after tax difference from cost for equity securities is reflected in Stockholders Equity. Real estate, policy loans and other are carried at cost which approximates fair value. NOTES TO FINANCIAL STATEMENTS (CONTINUED) Excluding U.S. government and government agency investments, the Corporation is not exposed to any significant credit concentration risk. Net investment income including realized gains is reflected in insurance and finance revenues and totalled $2,375, $2,692 and $2,287 for 1993, 1992 and 1991, net of investment expenses of $104, $98 and $96. Total realized investment gains (pretax) for 1993, 1992 and 1991 were $161, $511 and $208. Net pretax changes in unrealized gains (losses) for fixed maturity and equity securities were $218 for 1993, $(685) for 1992 and $1,096 for 1991. The amortized cost and estimated market value of fixed maturity investments at December 31, 1993 by estimated maturity are shown below. Maturities are reflected by contract date except for asset-backed securities which are distributed to maturity year based on the Corporation's estimate of the rate of future prepayments of principal over the remaining life of the securities. Actual maturities will differ from contractual and estimated maturities reflecting borrowers' rights to call or prepay their obligations. The Corporation manages its exposure to market price and/or interest rate fluctuations on certain of its planned investment purchases or existing investments by entering into interest rate cap or swap agreements as well as exchange-traded financial futures and other contracts with major financial institutions. At December 31, 1993 and 1992, respectively, the notional amounts of investments under interest rate swap agreements were $4,120 and $4,200, interest rate cap agreements were $1,685 and $1,357 and futures and other contracts were $3,302 and $1,237. The fair value of these instruments, together with other similar financial instruments, at December 31, 1993 and 1992 approximates the recorded amounts. The estimated fair value is the present value of the cash flows that would result from the agreements being replaced at the year-end market rate for the remaining term of the agreements. These agreements mature at varying dates through 2003. Any credit risk is considered remote. In May 1993, the Financial Accounting Standards Board issued a new standard of accounting and reporting for certain investments in debt and equity securities (SFAS No. 115). The new standard must be implemented by the 1994 first quarter and requires, among other things, that securities be classified as held-to-maturity, available for sale or trading based on the Corporation's intentions with respect to the ultimate disposition of the security and its ability to effect those intentions. The classification determines the appropriate accounting carrying value (cost basis or fair value) and, in the case of fair value, whether the adjustment impacts Stockholders Equity directly or is reflected in the Statement of Income. The Corporation is reviewing the standard which will primarily impact the investment portfolios in the Insurance and Finance segments. It is anticipated that generally, portfolios will be classified as available for sale and accordingly, most investments will be reflected at fair value with the corresponding impact included in Stockholders Equity. At December 31, 1993, the estimated impact of the standard is an increase to Stockholders Equity of approximately $250 after tax. Implementation under generally accepted accounting principles has not been finalized with respect to certain investments and accordingly, a charge, which is not expected to be significant, may be recorded through the income statement as a "Cumulative Effect of an Accounting Change" when the standard is adopted. NOTES TO FINANCIAL STATEMENTS (CONTINUED) REINSURANCE The Corporation's insurance operations cede insurance to other insurers to limit its maximum loss. Such transfers do not relieve the originating insurers of their primary liabilities. These operations also assume insurance from other insurers. Failure of reinsurers to honor their obligation could result in losses to the Corporation. The Corporation evaluates the financial condition of its reinsurers and monitors concentrations of credit risk. The effect of reinsurance on property and casualty premiums written and earned is as follows: Reinsurance recoveries, which reduced loss and loss expenses incurred, were $1.2 billion, $1.2 billion and $1.7 billion for the years ended December 31, 1993, 1992 and 1991. Life insurance net retained premiums were comprised of the following: Life insurance recoveries, which reduced death and other benefits, approximated $19 for each of the years ended December 31, 1993, 1992 and 1991. During 1992, ITT Hartford entered into an agreement with Mutual Benefit Life Insurance Company in Rehabilitation ("Mutual Benefit") whereby it assumed a block of contract obligations of Mutual Benefit individual corporate owned life insurance (COLI) contracts. As part of this agreement, ITT Hartford received $5.6 billion in cash and invested assets, $5.3 billion of which were COLI policy loans. ITT Hartford coinsured approximately 84% of these contract obligations back to Mutual Benefit and two other insurers. At December 31, 1993, ITT Hartford has a reinsurance receivable from Mutual Benefit of $4.5 billion. The risk of Mutual Benefit becoming insolvent is mitigated by the reinsurance agreement's requirement that assets be kept in a security trust, with ITT Hartford as the sole beneficiary. ITT Hartford has no other significant reinsurance-related concentrations of credit risk. POLICY LIABILITIES AND ACCRUALS Policy liabilities and accruals at December 31 were: At December 31, 1993 and 1992, the estimated fair value of Other Policy Claims and Benefits Payable approximates the recorded amount and is based on the present value of estimated future cash flows using current market rates for similar arrangements. NOTES TO FINANCIAL STATEMENTS (CONTINUED) INSURANCE OPERATING COSTS AND EXPENSES Insurance operating costs and expenses were: DISCONTINUED OPERATIONS In December 1993, the Corporation announced plans to spin-off ITT Rayonier, the Corporation's wholly-owned forest products subsidiary, to ITT shareholders. On February 28, 1994, all of the shares of common stock of ITT Rayonier (approximately 29.6 million shares) will be distributed to holders of ITT Common Stock and holders of ITT Cumulative Preferred Stock, $2.25 Convertible Series N, on the basis of one share of Rayonier Common Stock for every four shares of ITT Common Stock held and one share of Rayonier Common Stock for every 3.1595 shares of ITT Series N held. ITT Rayonier has been reflected as a "Discontinued Operation" in the accompanying financial statements. The net assets of Discontinued Operations are included in Other Assets. Summarized information is as follows: ITT Rayonier's results of operations in 1992 include a charge of $180 pretax or $115 after tax recorded in connection with the closedown of its Grays Harbor pulp and paper complex. LEASES AND RENTALS As of December 31, 1993, minimum rental commitments under operating leases were $237, $186, $149, $123 and $103 for 1994, 1995, 1996, 1997 and 1998. For the remaining years, such commitments amounted to $742, aggregating total minimum lease payments of $1,540. Rental expenses for operating leases were $322, $341 and $328 for 1993, 1992 and 1991, respectively. COMMITMENTS AND CONTINGENCIES The Corporation and its subsidiaries are involved in various legal matters including those related to antitrust issues, government contracts and environmental matters. Some of these actions include claims for substantial sums. Reserves have been established when the outcome is probable and can be reasonably estimated. While the ultimate result of claims and litigation cannot be determined, the Corporation does not expect that these matters will have a material adverse effect on its results of operations or its consolidated financial position. SUPPLEMENTARY CONDENSED FINANCIAL STATEMENTS ITT CORPORATION AND SUBSIDIARIES (WITH INSURANCE AND FINANCE SUBSIDIARIES ON AN EQUITY BASIS) The following condensed balance sheets, statements of income and cash flows reflect the insurance and finance subsidiaries on an equity basis. This presentation does not affect consolidated income or stockholders equity. CONDENSED BALANCE SHEETS SUPPLEMENTARY CONDENSED FINANCIAL STATEMENTS -- (CONTINUED) ITT CORPORATION AND SUBSIDIARIES (WITH INSURANCE AND FINANCE SUBSIDIARIES ON AN EQUITY BASIS) CONDENSED STATEMENTS OF INCOME CONDENSED STATEMENTS OF CASH FLOWS BUSINESS SEGMENT INFORMATION* FINANCIAL AND BUSINESS SERVICES. The Insurance segment writes a broad range of life and property and casualty insurance while Finance makes consumer and commercial loans and services mortgages. Communications & Information Services primarily publishes telephone directories and provides educational services. MANUFACTURED PRODUCTS. Automotive, Defense & Electronics and Fluid Technology units are engaged in the manufacture and sale of equipment for commercial, military and process industries. Products include automotive equipment, accessories and parts for the OEM and aftermarket, pumps, valves, electrical connectors, components, integrated circuits and other semiconductors. Defense activities include the development, manufacture, sale, installation, maintenance and operation of military electronic and communications equipment, primarily for the U.S. Government. HOTELS operates a worldwide network of hotels, resorts and casinos under the Sheraton name. "Dispositions and Other" include the operating results and the gain or loss from sale or closedown of units other than "Discontinued Operations," including the Domestic Unsecured Consumer Small Loan business, ITT Components Distribution and World Directories, U.K. and Turkey operations, along with sales and operating income of other non-core businesses. "Income (Loss)" consists of the gross profit on sales and revenues less operating expenses incurred. "Other" includes nonoperating income, corporate assets and expenses and minority equity. Intercompany sales, which are priced on an arm's-length basis and eliminated in consolidation, are not material. GEOGRAPHICAL INFORMATION -- TOTAL SEGMENTS - --------------- * Refer to page 2 where Business Segment sales, revenues and income information are provided. QUARTERLY RESULTS* FOR 1993 AND 1992 (UNAUDITED) - --------------- * As restated (see Notes to Financial Statements). ** The reported net loss in 1992 causes the calculation of the fully diluted loss per share in 1992 to be anti-dilutive. In such a case, generally accepted accounting principles suggest the fully diluted loss per share to be the same as the primary loss per share; however, the Corporation has presented the actual calculated amount in order that all calculations and comparisons with previously reported and future amounts be on a consistent basis. EXPORT SALES (UNAUDITED) In serving its global markets, ITT generates significant export sales, which benefit local economies. Sales of products (including intercompany) manufactured in various countries for shipment to other countries consisted of the following: ITT CORPORATION AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS (MILLIONS OF DOLLARS) - --------------- NOTE: (1) Principally retirements as well as companies sold during the year. (2) Principally related to the sale of receivables during the year. S-1 ITT CORPORATION AND SUBSIDIARIES SHORT-TERM BORROWINGS (MILLIONS OF DOLLARS) - --------------- NOTE: (1) Finance calculations are based primarily on daily balances, and include commitment fees and the impact of interest rate exchange agreements. Other calculations are based primarily on month-end balances. ITT CORPORATION AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION (MILLIONS OF DOLLARS) - --------------- NOTE:Items totalling less than 1% of sales and revenues, or shown elsewhere herein, have been omitted from this schedule. S-2 ITT CORPORATION AND SUBSIDIARIES SUMMARY OF INSURANCE INVESTMENTS (MILLIONS OF DOLLARS) - --------------- Note: (1) Market values for stocks and bonds approximate those quotations published by the applicable stock exchanges or are received from other reliable sources. S-3 ITT CORPORATION AND SUBSIDIARIES SUPPLEMENTARY INSURANCE INFORMATION (MILLIONS OF DOLLARS) - --------------- (1) Net investment income is allocated based on property and casualty and life and health's share of investable funds. (2) Restated 1992 and 1991 for the adoption of Statement of Financial Accounting Standards No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts". --------------- SUPPLEMENTAL INFORMATION CONCERNING PROPERTY AND CASUALTY INSURANCE OPERATIONS (MILLIONS OF DOLLARS) - --------------- (1) Reserves for permanently disabled claimants have been discounted to present value at rates of interest ranging from 3.0% to 3.5% for the three years ended December 31, 1993. Reserves for terminated reinsurance treaties and certain reinsurance contracts that fund loss run-offs for unrelated parties have been discounted to present value at rates of interest ranging from 3% to 6% for 1993, 6% to 14% for 1992 and from 7% to 13% in 1991. S-4 ITT CORPORATION AND SUBSIDIARIES REINSURANCE (MILLIONS OF DOLLARS) S-5 SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED, AND BY THE UNDERSIGNED IN THE CAPACITY INDICATED. ITT Corporation By JON F. DANSKI ----------------------------------- JON F. DANSKI SENIOR VICE PRESIDENT AND CONTROLLER (PRINCIPAL ACCOUNTING OFFICER) March 24, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. II-1 EXHIBIT INDEX II-2 II-3

791445_1993.txt

791445

1993

ITEM 1. BUSINESS. (a) General Development of Business Trump Plaza Associates (the "Partnership") owns and operates the Trump Plaza Hotel and Casino ("Trump Plaza"), a luxury casino hotel located on The Boardwalk in Atlantic City, New Jersey. The Partnership was organized in June 1982 as a general partnership under the laws of the State of New Jersey. Trump Plaza Funding, Inc. (the "Company") was incorporated on March 14, 1986 as a New Jersey corporation and was originally formed solely to raise funds through the issuance and sale of its debt securities for the benefit of the Partnership. The partners in the Partnership are Trump Plaza Holding Associates ("Holding"), which has a 99% interest in the Partnership, and the Company, which has a 1% interest in the Partnership. Donald J. Trump ("Trump"), by virtue of his ownership of the Company, Holding and Trump Plaza Holding Inc. ("Holding Inc."), which owns a 1% partnership interest in Holding, is the beneficial owner of 100% of the equity interest in the Partnership. In 1993, the Partnership, the Company and certain affiliated entities completed a refinancing (the "Refinancing") of their debt and equity interests. The purpose of the Refinancing was (i) to repay, in full, the mortgage indebtedness and certain other indebtedness issued as part of the restructuring (the "Restructuring") of the indebtedness of the Partnership and the Company pursuant to a prepackaged plan of reorganization (the "Plan") under chapter 11 of the Bankruptcy Code of 1978, as amended, effective as of May 29, 1992, (ii) to repurchase the preferred stock interest in Trump Plaza not owned by Trump and (iii) to repay certain personal indebtedness of Trump. The Refinancing On June 25, 1993, the Company consummated the Refinancing, which included (i) the offering (the "Mortgage Note Offering") by the Company of $330 million in aggregate principal amount of its 10-7/8% Mortgage Notes due 2001 (the "Mortgage Notes") and (ii) the offering (the "Units Offering" and, together with the Mortgage Note Offering, the "Offerings") by Holding of 12,000 Units (the "Units") consisting of an aggregate of $60 million in principal amount of 12-1/2% Pay-in-Kind Notes due 2003 (the "PIK Notes") and 12,000 Warrants to acquire an aggregate of $12 million in principal amount of PIK Notes. Each of the Warrants entitles the holder to acquire $1,000 principal amount of PIK Notes for no additional consideration. The partnership agreement of the Partnership was amended and restated to alter certain procedures and to effectuate the consummation of the Offerings. The proceeds of the Units Offering were distributed to Trump. Trump used $35 million of such proceeds to purchase stock of the Company, which used such funds, together with a portion of the proceeds of the Mortgage Note Offering, to redeem the Company's outstanding stock units (the "Stock Units"), each consisting of (i) one share of the Company's 9.34% Participating Cumulative Redeemable Preferred Stock (the "Preferred Stock"), liquidation preference $25 per share, par value $1 per share, and (ii) one share of the Company's common stock (the "Common Stock"), par value $.00001 per share. The remaining $25 million of the proceeds of the Units Offering were distributed to Trump as part of a special distribution (the "Special Distribution"). Trump used the Special Distribution primarily to reduce his personal indebtedness and to satisfy certain property tax obligations with respect to real estate owned by him. Out of the proceeds of the Mortgage Note Offering, $225 million was used to redeem all of the Bonds (as defined below). In connection with the Offerings, the Company formed Holding, a New Jersey general partnership, for the purpose of offering the Units. Trump contributed to Holding his equity ownership interest in the Partnership and became the sole beneficial owner of Holding. The two partners in Holding are Trump and Holding Inc. Holding Inc. acts as the managing general partner of Holding. Holding has no assets other than its equity interest in the Partnership. Also in connection with the Offerings, the Company became the managing general partner of the Partnership as of June 18, 1993 upon its merger with TP/GP Corp., a New Jersey corporation ("TP/GP"), which had been the managing general partner of the Partnership until such date. Holding and the Company, both of which became wholly-owned by Trump upon such merger, became the sole partners of the Partnership. The Mortgage Notes are senior indebtedness of the Company. The Company and the Partnership are subject to restrictions on the incurrence of additional indebtedness. The Mortgage Notes are unconditionally guaranteed by the Partnership. The Guarantee ranks pari passu in right of payment with all existing and future senior indebtedness of the Partnership. The PIK Notes are secured by Holding's equity interest in the Partnership. Holders of the PIK Notes and the Warrants are not creditors of the Partnership and, consequently, have no recourse to the assets of the Partnership if an event of default should occur thereunder. Accordingly, the PIK Notes are structurally subordinated to the indebtedness of the Partnership, including the Mortgage Notes. In the event of a sale of equity interests in Holding or an affiliate thereof which owns any direct or indirect equity interest in Trump Plaza, Holding is required to, or is required to cause such affiliate to, use 35% of the net proceeds of such sale, within 90 days after receipt thereof, to redeem PIK Notes at 100% of the principal amount thereof, if such redemption occurs prior to June 15, 1995. After such date, the redemption price is 108% of the principal amount of the PIK Notes until June 15, 1998, with the redemption price decreasing annually thereafter. The PIK Notes are redeemable at the option of Holding, in whole or in part, at any time on or after June 15, 1998 at the redemption prices set forth therein, together with accrued and unpaid interest to the date of redemption. Upon consummation of the Refinancing (i) Trump became the sole owner record of the Company's outstanding Common Stock, as well as the sole owner of the equity interest of Holding and the Partnership and (ii) the Company redeemed its Stock Units, including the Preferred Stock, and the Bonds (as defined below). As of December 31, 1993, the Company's debt consisted of approximately $330 million principal amount outstanding of its Mortgage Notes and $325,859,000 (net of discount) of mortgage indebtedness. As of December 31, 1993, Holding's debt consisted of approximately $64,252,000 of PIK Notes and $12 million of deferred warrant obligations. As of December 31, 1993, the Partnership's debt consisted of a non-recourse promissory note to the Company in the amount of $325,859,000 (net of discount) and approximately $7.5 million of other indebtedness. The Partnership has unconditionally guaranteed the Mortgage Notes. The Restructuring In 1991, the Partnership began to experience a liquidity problem. Management believes that the Partnership's liquidity problem was attributable, in part, to an overall deterioration in the Atlantic City gaming market, as indicated by reduced rates of casino revenue growth for the industry for the two prior years, aggravated by an economic recession in the Northeast and the Persian Gulf War. Comparatively excessive casino gaming capacity in Atlantic City, due in part to the opening of the Trump Taj Mahal Casino Resort (the "Taj Mahal") in April 1990, may also have contributed to the Partnership's liquidity problem. In order to alleviate its liquidity problem, on May 29, 1992 (the "Effective Date"), the Partnership and the Company restructured their indebtedness pursuant to the Plan. The purpose of the Restructuring was to improve the amortization schedule and extend the maturity of the Partnership's indebtedness by (i) eliminating the sinking fund requirement on the Company's 12-7/8% First Mortgage Bonds, due 1998 (the "Original Bonds"), (ii) extending the maturity and lowering the interest rate on the Original Bonds, (iii) reducing the aggregate principal amount of such indebtedness from $250 million to $225 million, and (iv) eliminating certain other indebtedness by reconstituting such debt in part as Bonds (defined below) and in part as Stock Units. The Restructuring was necessitated by the Partnership's inability to either generate cash flow or obtain additional financing sufficient to make the scheduled sinking fund payment on the Original Bonds. On the Effective Date, the Company, which theretofore had no interest in the Partnership, received a 50% beneficial interest in TP/GP, and the Company and TP/GP were admitted as partners of the Partnership. The Company issued $225 million principal amount of the Company's 12% Mortgage Bonds due 2002 (the "Bonds") and approximately three million Stock Units to certain creditors. Pursuant to the terms of the partnership agreement, the Company was issued the Preferred Stock. TP/GP became the managing general partner of the Partnership, and through its Board of Directors, managed the affairs of the Partnership until its merger into the Company on June 24, 1993. Upon consummation of the Plan, each holder of $1,000 principal amount of Original Bonds and such other indebtedness received (i) $900 principal amount of Bonds, (ii) 12 Stock Units and (iii) certain cash payments. As a result of the Refinancing, the Company redeemed the Stock Units, consisting of the Company's Common Stock and Preferred Stock and Trump became the sole beneficial owner of the Company's Common Stock. The Company also retired the outstanding principal amount and interest on the Bonds. In addition, TP/GP was merged into the Company and the Company became the managing general partner of the Partnership. (b) Financial Information about Industry Segments The Partnership operates in only one industry segment. See the Financial Statements of the Company and the Partnership included elsewhere herein. (c) Narrative Description of Business General The Partnership owns and operates Trump Plaza, a luxury casino hotel located in Atlantic City, New Jersey. Trump Plaza, with its 60,000 square foot casino (presently being expanded to 75,000 square feet by June 1994), first class guest rooms and other luxury amenities, is the only casino hotel in Atlantic City with both a "Four Star" Mobil Travel Guide rating and a "Four Diamond" AAA rating. Management believes that these ratings reflect the high quality amenities and services that Trump Plaza provides to its casino patrons and hotel guests. Trump Plaza is conveniently located on The Boardwalk, at the end of the main highway into Atlantic City and is one of the first casino hotels visible from that approach. Management believes that the central location of Trump Plaza, with its accessibility to "drive in" and "walk in" patrons, is highly advantageous to Trump Plaza. In addition, the Casino Reinvestment Development Authority ("CRDA") is currently overseeing the development of a "tourist corridor" which will link The Boardwalk with downtown Atlantic City and, when completed, will feature an entertainment and retail complex of up to 800,000 square feet. Trump Plaza will be located at the end of the tourist corridor by The Boardwalk. Trump Plaza seeks to attract casino patrons who tend to wager more frequently and in larger denominations than the typical Atlantic City gaming patron (a "high-end" patron). This strategy is accomplished, in part, through the attractiveness of the facility, which is enhanced by routinely attending to the aesthetics of the casino and other public areas in Trump Plaza. In addition, Trump Plaza provides a consistency in the conduct of play of its table games that serious gaming patrons seek. Finally, Trump Plaza offers a broad selection of dining choices (including four gourmet restaurants), headline entertainment, deluxe accommodations and other amenities and services. Facilities and Amenities The casino in Trump Plaza currently offers 86 table games and 1,836 slot machines. After the planned expansion of Trump Plaza, the casino will offer approximately 2,244 slot machines, 86 table games and a keno lounge. In addition to the casino, Trump Plaza consists of a 31-story tower with 557 guest rooms, including 62 suites. The facility also offers 10 restaurants, a 750-seat cabaret theatre, four cocktail lounges, 28,000 square feet of convention, ballroom and meeting room space, a swimming pool, tennis courts and a health spa. A 10-story parking garage, which can accommodate 2,650 cars, is connected to Trump Plaza via an enclosed pedestrian walkway. The entry level of Trump Plaza includes a cocktail lounge, three gift shops, a deli, a coffee shop, an ice cream parlor and a buffet. The casino level houses the casino, a fast food restaurant, an exclusive slot lounge for high-end patrons and a gift shop. There is also an enclosed skywalk which connects Trump Plaza at the casino level with the Atlantic City Convention Center. Trump Plaza's guest rooms are located in a tower which affords most guest rooms a view of the ocean. While rooms are of varying size, a typical guest room consists of approximately 400 square feet. Trump Plaza also features 23 one-bedroom suites, 21 two-bedroom suites and 18 "Super Suites." The Super Suites are located on the top two floors of the tower and offer luxurious accommodations and 24-hour butler and maid service. The Super Suites and certain other suites are located on the "Club Level" which requires guests to use a special elevator key for access, and contains a lounge area (the "Club Level Lounge") that offers 24-hour food and bar facilities. Trump Plaza is connected by an enclosed pedestrian walkway to a 10-story parking garage, which can accommodate approximately 2,650 cars, and contains 13 bus bays, a comfortable lounge, a gift shop and waiting area (the "Transportation Facility"). The Transportation Facility provides patrons with immediate access to the casino, and is located directly off of the main highway into Atlantic City. Business Strategy General. In 1990, the Atlantic City casino industry experienced a significant increase in room capacity and in available casino floor space, due primarily to opening the Taj Mahal, which at the time was wholly-owned by Trump. Management believes that the opening of Taj Mahal had a disproportionately adverse effect on Trump Plaza due to the common use to the "Trump" name. Management believes that results in 1991 were adversely affected by the weakness in the economy throughout the Northeast and the adverse impact on tourism and consumer spending caused by the war in the Middle East. In 1991, the Partnership retained the services of Nicholas L. Ribis as Chief Executive Officer, and Kevin DeSanctis as President and Chief Operating Officer. Mr. DeSanctis resigned from his positions on March 7, 1994. See "Management." Mr. Trump and this new management team implemented a new business strategy, designed to capitalize on Trump Plaza's first-class facilities and improve operating results. Key elements of this strategy consist of redirecting marketing efforts to more profitable patron segments and continually monitoring operations to adapt to, and anticipate, industry trends. A primary element of the new business strategy is to seek to attract patrons who tend to wager more frequently and in larger denominations than the typical Atlantic City gaming customer. Such high-end players typically wager $5 or more per play in slots and $25 or more per play in table games. In order to attract more high-end gaming patrons to Trump Plaza in a cost-effective manner, the Partnership has refocused its marketing efforts. Commencing in 1991, the Partnership substantially curtailed costly "junket" marketing operations which involved attracting groups of patrons to the facility on an entirely complimentary basis (e.g., by providing free air fare, gifts and room accommodations). In the fall of 1992, the Partnership decided to de-emphasize marketing efforts directed at "high roller" patrons from the Far East, who tend to wager $50,000 or more per play in table games. In each case the Partnership determined that the potential benefit derived from these patrons did not outweigh the high costs associated with attracting such players and the resultant volatility in the results of operations of Trump Plaza. This shift in marketing strategy has allowed the Partnership to focus its efforts on attracting the high-end players. Gaming Environment. Trump Plaza also pursues a continuous preventative maintenance program that emphasizes the casino, hotel rooms and public areas in Trump Plaza. These programs are designed to maintain the attractiveness of Trump Plaza to its gaming patrons. Trump Plaza continuously monitors the configuration of the casino floor and the games it offers to patrons with a view towards making changes and improvements. Trump Plaza's casino floor has clear, large signs for the convenience of patrons. As new games have been approved by the Casino Control Commission ("CCC"), the Partnership has integrated such games into its casino operations to the extent it deems appropriate. In recent years, there has been an industry trend towards fewer table games and more slot machines. For the Atlantic City casino industry, revenue from slot machines increased from 54.6% of the industry gaming revenue in 1988 to 67.1% of the industry gaming revenue in 1993. Trump Plaza experienced a similar increase, with slot revenue increasing from 51.2% of gaming revenue in 1988 to 70.2% of the industry gaming revenue in 1993. In response to this trend, Trump Plaza has devoted more of its casino floor space to slot machines. In April 1993, Trump Plaza removed 12 table games from the casino floor and replaced them with 75 slot machines. Moreover, as part of its program to attract high-end slot players, the Partnership created "Fifth Avenue Slots," a partitioned portion of the casino floor that includes approximately 70 slot machines (most of which provide for $5 or more per play), an exclusive lounge for high-end patrons and other amenities. "Comping" Strategy. In order to compete effectively with other Atlantic City casino hotels, the Partnership offers complimentary drinks, meals, room accommodations and/or travel arrangements to its patrons ("complimentaries" or "comps"). Trump Plaza's policy on complimentaries is to provide comps primarily to patrons with a demonstrated propensity to wager at Trump Plaza. Entertainment. Trump Plaza offers headline entertainment, as well as other entertainment and revue shows as part of its strategy to attract high-end and other patrons. In 1993, Trump Plaza entered into Atlantic City exclusive contracts with Kenny Rogers, Anne Murray, Jay Black, Jimmy Roselli, Paul Anka, Regis Philbin & Kathie Lee Gifford, Engelbert and Jerry Vale. Trump Plaza offers headline entertainment weekly during the summer and monthly during the off-season, and also features other entertainment and revue shows. Player Development/Casino Hosts. The Partnership currently employs approximately 24 gaming representatives in New Jersey, New York and other states, as well as several international representatives, to promote Trump Plaza to prospective gaming patrons. Player development personnel host special events, offer incentives and contact patrons directly in an effort to attract high-end table game patrons from the United States, Canada and South America. Trump Plaza's casino hosts assist patrons on the casino floor, make room and dinner reservations and provide general assistance. They also solicit Trump Card (the frequent player slot card) sign-ups in order to increase the Partnership's marketing base. Promotional Activities. The Trump Card, a player identification card, constitutes a key element in Trump Plaza's direct marketing program. Slot machine players are encouraged to register for and utilize their personalized Trump Card to earn various complimentaries based upon their level of play. The Trump Card is inserted during play into a card reader attached to the slot machine for use in computerized rating systems. These computer systems record data about the cardholder, including playing preferences, frequency and denomination of play and the amount of gaming revenues produced. Trump Plaza designs promotional offers, conveyed via direct mail and telemarketing, to patrons expected to provide revenues based upon their historical gaming patterns. Such information is gathered on slot wagering by the Trump Card and on table game wagering by the casino game supervisors. Promotional activities include the mailing of vouchers for complimentary slot play. Trump Plaza also utilizes a special events calendar (e.g., birthday parties, sweepstakes and special competitions) to promote its gaming operations. The Partnership conducts slot machine and table game tournaments in which cash prizes are offered to a select group of players invited to participate in the tournament based upon their tendency to play. Such players tend to play at their own expense during "off-hours" of the tournament. At times, tournament players are also offered special dining and entertainment privileges that encourage them to remain at Trump Plaza. Bus Program. Trump Plaza has a bus program, which transports approximately 2,400 gaming patrons per day during the week and 3,500 per day on the weekends. The Partnership's bus program offers incentives and discounts to certain scheduled and chartered bus customers. Trump Plaza's Transportation Facility contains 13 bus bays and is connected by an enclosed pedestrian walkway to Trump Plaza. The Transportation Facility provides patrons with immediate access to the casino, and contains a comfortable lounge area for patrons waiting for return buses. Credit Policy. Historically, Trump Plaza has extended credit to certain qualified patrons. For the years ended December 31, 1991, 1992 and 1993, credit play as a percentage of total dollars wagered was approximately 29%, 28% and 18%, respectively. As part of the Partnership's new business strategy and in response to the general economic downturn in the Northeast and recent credit experience, Trump Plaza has imposed stricter standards on applications for new or additional credit and has reduced credit to international patrons. Atlantic City Market Gaming in Atlantic City started in May 1978 when the first casino hotel opened for business. Since 1978, gaming in Atlantic City has grown from one casino to 12 casinos as of December 31, 1993, with approximately $3.3 billion of casino industry revenue generated in 1993. Gaming revenue for all Atlantic City casino hotels has increased approximately 2.6%, 5.2%, 1.3%, 7.5% and 2.7% during 1989, 1990, 1991, 1992 and 1993, respectively (in each case as compared to the prior year). See "Competition" below. Atlantic City is near many densely populated metropolitan areas. The primary area served by Atlantic City casino hotels is the corridor that extends from Washington, D.C. to Boston and includes New York City and Philadelphia. Within this primary area, Atlantic City may be reached by automobile or bus. Principal arteries lead into Atlantic City from the metropolitan New York area and from the Baltimore/Washington, D.C. area, both of which are approximately three hours away by automobile. Atlantic City can also be reached by air and rail transportation, although most patrons arrive by automobile or bus. Historically, Atlantic City has suffered from inadequate rail and air transportation. As a result, a majority of Atlantic City gaming patrons travel from the mid-atlantic and northeast regions of the United States by automobile or bus. Rail service to Atlantic City has recently been improved with the introduction of Amtrak express service to and from Philadelphia and New York City. An expansion of the Atlantic City International Airport (located approximately 12 miles from Atlantic City) to handle large airline carriers and large passenger jets was recently completed. Despite the expansion of the Atlantic City International Airport, however, access to Atlantic City by air is still limited by a lack of regularly scheduled flights and by inadequate terminal facilities. The lack of adequate transportation infrastructure has limited the expansion of the Atlantic City gaming industry's geographic patron base and the attractiveness of Atlantic City to major conventions. In February 1993, the State of New Jersey broke ground for a new $250,000,000 Convention Center on a 30.5-acre site adjacent to the Atlantic City Expressway. Targeted for completion in 1996, the new Convention Center will house approximately 500,000 square feet of exhibit space along with 45 meeting rooms totalling nearly 110,000 square feet. The building will include a 1,600-car underground garage and an indoor street linking the Convention Center to the existing Rail Terminal. The new Convention Center has been designed to serve as the centerpiece of Atlantic City's renaissance as a favorable meeting destination. Possible Expansion Sites Management has determined to expand the Partnership's facilities. The purpose of such an expansion is to increase the casino floor space and to add additional gaming units. Any such expansion will require various regulatory approvals, including the approval of the CCC. Furthermore, the Casino Control Act requires that additional guest rooms be put in service within a specified time period after any such casino expansion. As discussed below, the Partnership has planned expansion of its hotel facilities. If the Partnership completed any casino expansion and subsequently did not complete the requisite number of additional guest rooms within the specified time period, the Partnership might have to close all or a portion of the expanded casino in order to comply with regulatory requirements, which could have a material adverse effect on the results of operations and financial condition of the Partnership. Boardwalk Expansion Site. In 1993, the Partnership received the approval of CCC, subject to certain conditions, for the expansion of the Trump Plaza hotel facilities on a 2.0-acre parcel of land located directly across the street from Trump Plaza on the Boardwalk upon which there is located an approximately 361-room hotel, which is closed to the public and is in need of substantial renovation and repair (the "Boardwalk Expansion Site"). In June 1993, Trump and the lender holding mortgage liens on the Boardwalk Expansion Site negotiated the terms of a restructuring of loans of approximately $52.0 million of principal and accrued interest secured by the liens on the Boardwalk Expansion Site. On June 25, 1993, the date the Offerings were consummated, Trump transferred title to the Boardwalk Expansion Site to the lender in exchange for a reduction in Trump's indebtedness to such lender, with a further reduction of Trump's indebtedness if the Partnership assumed the Boardwalk Expansion Site Lease (as defined below). On such date, the lender leased the Boardwalk Expansion Site to Trump (the "Boardwalk Expansion Site Lease") for a term of five years, which expires on June 30, 1998, during which time Trump is obligated to pay the lender $260,000 per month in lease payments. In connection with the Offerings, the Partnership acquired a five- year option (the "Option") to acquire the Boardwalk Expansion Site. In October 1993, the Partnership assumed the Boardwalk Expansion Site Lease and related expenses. See "Management's Discussion and Analysis of Financial Condition and Results of Operation -- Liquidity and Capital Resources." The Partnership's ability to acquire the Boardwalk Expansion Site pursuant to the Option is dependent upon its ability to obtain financing to acquire the property. The ability to incur such indebtedness is restricted by the Mortgage Note Indenture and the PIK Note Indenture and would require the consent of certain of Trump's personal creditors. The Partnership's ability to develop the Boardwalk Expansion Site is dependent upon its ability to use existing cash on hand and generate cash flow from operations sufficient to fund development costs. No assurance can be given that such cash on hand will be available to the Partnership for such purposes or that it will be able to generate sufficient cash flow from operations. In addition, exercise of the Option requires the consent of certain of Trump's personal creditors, and there can be no assurance that such consent will be obtained at the time the Partnership desires to exercise the Option. The CCC has required that the Partnership exercise the Option by no later than July 1, 1995. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidation and Capital Resources." Management has determined to build or refurbish rooms at the Boardwalk Expansion Site. When completed, the hotel will have approximately 361 rooms, including a retail space, located on two stories, fronting The Boardwalk. In September 1993, Trump entered into a sublease agreement (the "Time Warner Sublease") with Time Warner Entertainment Company, L.P. ("Time Warner") for a period of ten years with the sublessee's option to renew the sublease for a ten-year period. Under this agreement, Time Warner agreed to sublease the entire first floor of the retail space (approximately 17,000 square feet) located at the Boardwalk Expansion Site for a new Warner Brothers Studio Store. In October 1993, the Partnership assumed Trump's duties and obligations under the Time Warner Sublease. The Time Warner Sublease is subject to certain conditions subsequent; the Partnership believes that it will satisfy all conditions subsequent to that agreement in 1994. Management believes that the store will be a major attraction on The Boardwalk and will increase the flow of patrons through the casino. The remaining portion of the Boardwalk Expansion Site will be used for a new entranceway to Trump Plaza, directly off the Atlantic City Expressway, as well as a public park and parking facilities for Trump Plaza patrons. As a result of such expansion, the Partnership, upon approval by the CCC, will be able to increase Trump Plaza's casino floor space by 30,000 square feet. The Partnership has begun construction at such site (pursuant to rights granted to the Partnership by the lender and the lessee under the Boardwalk Expansion Site Lease) prior to acquiring title thereto pursuant to the Option. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources." The Partnership is obligated to either pay a tax to the CRDA of 2.5% of its gross casino revenues or to obtain investment tax credits in an amount equal to 1.25% of its gross casino revenues. In connection with the assumption of the Boardwalk Expansion Site Lease, the Partnership obtained from the CRDA $10.3 million of investment tax credits with respect to the demolition of certain structures on the Boardwalk Expansion Site and the construction of certain improvements on the site. There can be no assurance, however, that such credits would be sufficient to defray a significant portion of the total project costs. Regency Expansion Site. In December 1993, Trump entered into an option agreement to acquire the Trump Regency Hotel ("Trump Regency"). In consideration for the Partnership's making certain payments in connection with the option, Trump agreed that, if the Trump Regency is acquired pursuant to such option, he would make the Trump Regency available for the sole benefit of the Partnership on a basis consistent with the Partnership's contractual obligations and requirements. See "Certain Relationships and Related Transactions -- Trump Regency." Competition Competition in the Atlantic City casino hotel market is intense. Trump Plaza competes primarily with other casinos located in Atlantic City, New Jersey, as well as gaming establishments located on Native American reservations in New York and Connecticut, and also would compete with any other facilities in the northeastern and mid-atlantic regions of the United States at which casino gaming or other forms of wagering may be authorized in the future. To a lesser extent, Trump Plaza faces competition from cruise lines, riverboat gambling, casinos located in Mississippi, Nevada, New Orleans, Puerto Rico, the Bahamas and other locations inside and outside the United States and from other forms of legalized gaming in New Jersey and in its surrounding states such as lotteries, horse racing (including off-track betting), jai alai and dog racing and from illegal wagering of various types. To the extent that legalized gaming becomes more prevalent in New Jersey or other nearby jurisdictions, competition from Native Americans or others would intensify. At present, there are 12 casino hotels located in Atlantic City, including Trump Plaza, all of which compete for patrons. In addition, there are several sites on The Boardwalk and in the Atlantic City Marina area on which casino hotels could be built in the future, although Management is not aware of any present plans to develop such sites. Total Atlantic City gaming revenue has increased over the past four years, although at varying rates. In 1991, six Atlantic City casino hotels reported increases in gaming revenues as compared to 1990, and five reported decreases in gaming revenues (including Trump Plaza). Management believes that the reduced rate of growth in aggregate gaming revenues in Atlantic City since 1987 as compared to prior years was principally due to the weakness in the economy throughout the Northeast and the adverse impact in 1991 of the war in the Middle East on tourism and consumer spending. Although all 12 Atlantic City casinos reported increases in gaming revenues in 1992 as compared to 1991, the Partnership believes that this was due, in part, to the depressed industry conditions in 1991. In 1993, nine casinos experienced increased casino revenues, as compared to 1992, while three casinos (including Trump Plaza) reported decreases. In 1990, the Atlantic City casino industry experienced a significant increase in room capacity and in available casino floor space, including the rooms and floor space made available by the opening of the Taj Mahal, which at the time was wholly-owned by Trump. The effects of such expansion were to increase competition and to contribute to a 1990 decline in gaming revenues per square foot. In 1990, the Atlantic City casino industry experienced a decline in gaming revenues per square foot of 5.0% which trend continued in 1991, although at the reduced rate of 2.9%. However, in 1992 and 1993, the Atlantic City casino industry experienced an increase of 6.9% and 1.4%, respectively in gaming revenues per square foot each as compared to the prior year. Casinos in Atlantic City must be located in approved hotel facilities which offer dining, entertainment and other guest facilities. Competition among casino hotels is based primarily upon promotional allowances, advertising, the attractiveness of the casino area, service, quality and price of rooms, food and beverages, restaurant, convention and parking facilities and entertainment. In order to compete effectively with all other Atlantic City casino hotels, the Partnership offers complimentary drinks, meals, room accommodations and/or travel arrangements to patrons with a demonstrated propensity to wager at Trump Plaza, as well as cash bonuses and other incentives pursuant to approved coupon programs. In 1988, Congress passed the Indian Gaming Regulatory Act ("IGRA"), which requires any state in which casino-style gaming is permitted (even if only for limited charity purposes) to negotiate compacts with federally recognized Native American tribes at the request of such tribes. Under IGRA, Native American tribes enjoy comparative freedom from regulation and taxation of gaming operations, which provides such tribes with an advantage over their competitors, including the Partnership. In 1991, the Mashantucket Pequot Nation opened a casino facility in Ledyard, Connecticut, located in the far eastern portion of such state, an approximately three-hour drive from New York City. In February 1992, the Mashantucket Pequot Nation initiated 24 hour gaming. In January 1993, slot machines were added at such facility, and the facility currently contains over 3,100 slot machines. The Mashantucket Pequot Nation has announced various expansion plans, including its intention to build another casino in Ledyard together with hotels, restaurants and a theme park. Trump, the Partnership and the Other Trump Casinos have recently filed a lawsuit seeking, among other things, a declaration that IGRA is unconstitutional and seeking an injunction against the enforcement of certain provisions of IGRA. The complaint states, among other things, that the Mashantucket Pequot Nation's casino has caused the Partnership substantial economic injury. The complaint states further that any future expansions of existing Native American gaming facilities or new ventures by such persons or others in the northeastern or mid-Atlantic region of the United States would have a further adverse impact on Atlantic City in general and could cause the Partnership further substantial economic injury. A group in New Jersey terming itself the "Ramapough Indians" has applied to the U.S. Department of the Interior to be recognized formally as a Native American tribe, which recognition would permit it to require the State of New Jersey to negotiate a gaming compact under IGRA. On December 3, 1993, however, the Interior Department proposed that such Federal recognition to the Ramapough Indians be denied. Similarly, a group in Cumberland County, New Jersey calling itself the "Nanticoke Lenni Lenape" tribe has filed a notice of intent with the Federal Bureau of Indian Affairs seeking formal recognition as a Native American tribe. Also, it has been reported that a Sussex County, New Jersey businessman has offered to donate land he owns there to the Oklahoma-based Lenape/Delaware Indian Nation which originated in New Jersey and already has Federal tribal status but does not have a reservation in the state. In addition, in July 1993, the Oneida Nation opened a casino featuring 24-hour table gaming, but without slot machines, near Syracuse, New York. Representatives of the St. Regis Mohawk Nation signed a gaming compact with New York State officials for the opening of a casino, without slot machines, in the northern portion of the state close to the Canadian border. The St. Regis Mohawk Nation has announced that it intends to open their casino in the summer of 1994. The Narragansett Native American Nation of Rhode Island has recently won a federal court case, which will require the Governor of Rhode Island to negotiate a casino gaming compact with the Nation. The Mohegan Nation, which is located in Connecticut, received federal recognition in March 1994. Other Native American Nations are seeking federal recognition, land, and negotiation of gaming compacts in New York, Pennsylvania, Connecticut and other nearby states. Legislation permitting other forms of casino gaming has been proposed, from time to time, in various states, including those bordering New Jersey. The Partnership's operations would be adversely affected by such competition, particularly if casino gaming were permitted in jurisdictions near or in New Jersey or other states in the Northeast. In December 1993, the Rhode Island Lottery Commission approved the addition of slot machine games on video terminals at Lincoln Greyhound Park and Newport Jai Alai, where poker and blackjack have been offered for over two years. Currently, casino gaming, other than Native American gaming, is not allowed in other areas of New Jersey or in New York or Pennsylvania. However, the Partnership expects that proposals may be introduced to legalize riverboat or other forms of gaming in Philadelphia and one or more other locations in Pennsylvania. The State of Louisiana recently approved casino gaming in the City of New Orleans, and a developer has been selected. To the extent that legalized gaming becomes more prevalent in New Jersey or other jurisdictions, competition would intensify. In addition, legislation has from time to time been introduced in the New Jersey State Legislature relating to types of state-wide legalized gaming, such as video games with small wagers. To date, no such legislation, which may require a state constitutional amendment, has been enacted. Management is unable to predict whether any such legislation, if enacted, would have a material adverse impact on the business, operations or financial condition of the Partnership. Conflicts of Interest Trump is a 100% beneficial owner of Trump's Castle Casino Resort ("Trump's Castle") subject to certain litigation warrants and a 50% beneficial owner of the Taj Mahal (collectively, the "Other Trump Casinos"), and is the sole beneficial owner of TC/GP, Inc., an entity that as of December 31, 1993 has provided certain services to Trump's Castle; prior thereto, Trump's Castle Management Corp., an entity solely owned by Trump, provided management services to Trump's Castle. Under certain circumstances, Trump could increase his beneficial interest in Taj Mahal to 100%. In addition, Trump has a personal services agreement with the partnership that owns the Taj Mahal pursuant to which he receives substantial compensation based, in part, on the financial results of the Taj Mahal. The Other Trump Casinos compete directly with each other and with other Atlantic City casino hotels, including Trump Plaza. Nicholas L. Ribis, the Chief Executive Officer of the Partnership, is also the chief executive officer of the partnerships that own the Other Trump Casinos. In addition, Messrs. Ribis and Trump serve on the governing bodies of the partnerships that own the Other Trump Casinos. As a result of Trump's interests in three competing Atlantic City casinos and the common chief executive officer, a conflict of interest may be deemed to exist by reason of such persons' access to information and business opportunities possibly useful to any or all of such casinos. No specific procedures have been devised for resolving conflicts of interest confronting, or which may confront, Trump, such persons and the Other Trump Casinos. See "Certain Relationships and Related Transactions." Employees and Labor Relations The Partnership has approximately 3,800 employees of whom approximately 1,100 are covered by collective bargaining agreements. Management believes that its relationships with its employees are satisfactory. All of the Partnership's employees must be licensed or registered under the Casino Control Act. See "Gaming Regulations -- Employees." The Company has no employees. In April 1993, the National Labor Relations board found that the Partnership had violated the National Labor Relations Act (the "NLRA") in the context of a union organizing campaign by table game dealers of the Partnership in association with the Sports Arena and Casino Employees Union Local 137, a/w Laborers' International Union of North America, AFL-CIO ("Local 137"). In connection with such finding, the Partnership was ordered to refrain from interfering with, restraining, or coercing employees in the exercise of the rights guaranteed them by Section 7 of the NLRA, to notify its employees of such rights and to hold an election by secret ballot among its employees, which is anticipated to be held in May 1994, regarding whether they desire to be represented for collective bargaining by Local 137. Seasonality The gaming industry in Atlantic City traditionally has been seasonal, with its strongest performance occurring from May through September, and with December and January showing substantial decreases in activity. Revenues have been significantly higher on Fridays, Saturdays, Sundays and holidays than on other days. Gaming and Other Laws and Regulations The following is only a summary of the applicable provisions of the Casino Control Act and certain other laws and regulations. It does not purport to be a full description thereof and is qualified in its entirety by reference to the Casino Control Act and such other laws and regulations. In general, the Casino Control Act contains detailed provisions concerning, among other things: the granting of casino licenses; the suitability of the approved hotel facility, and the amount of authorized casino space and gaming units permitted therein; the qualification of natural persons and entities related to the casino licensee; the licensing and registration of employees and vendors of casino licensees; rules of the games; the selling and redeeming of gaming chips; the granting and duration of credit and the enforceability of gaming debts; management control procedures, accounting and cash control methods and reports to gaming agencies; security standards; the manufacture and distribution of gaming equipment; equal employment opportunity for employees of casino operators, contractors of casino facilities and others; and advertising, entertainment and alcoholic beverages. Casino Control Commission. The ownership and operation of casino/hotel facilities in Atlantic City are the subject of strict state regulation under the Casino Control Act. The CCC is empowered to regulate a wide spectrum of gaming and non-gaming related activities and to approve the form of ownership and financial structure of not only a casino licensee, but also its entity qualifiers and intermediary and holding companies. Operating Licenses. The Partnership was issued its initial casino license on May 14, 1984. On April 19, 1993, the CCC renewed the Partnership's casino license through March 31, 1995, and on March 15, 1993 approved Trump as a natural person qualifier through May 1995. No assurance can be given that the CCC will renew the casino license or, if it does so, as to the conditions it may impose, if any, with respect thereto. Casino Licensee. No casino hotel facility may operate unless the appropriate license and approvals are obtained from the CCC, which has broad discretion with regard to the issuance, renewal, revocation and suspension of such licenses and approvals, which are non-transferable. The qualification criteria with respect to the holder of a casino license include its financial stability, integrity and responsibility; the integrity and adequacy of its financial resources which bear any relation to the casino project; its good character, honesty and integrity; and the sufficiency of its business ability and casino experience to establish the likelihood of a successful, efficient casino operation. The casino license held by the Partnership is renewable for periods of up to two years. The CCC may reopen licensing hearings at any time, and must reopen a licensing hearing at the request of the New Jersey Division of Gaming Enforcement (the "Division"). To be considered financially stable, a licensee must demonstrate the following ability: to pay winning wagers when due, to achieve a gross operating profit; to pay all local, state and federal taxes when due, to make necessary capital and maintenance expenditures to insure that it has a superior first-class facility, and to pay, exchange, refinance or extend debts which will mature or become due and payable during the license term. In the event a licensee fails to demonstrate financial stability, the CCC may take such action as it deems necessary to fulfill the purposes of the Casino Control Act and protect the public interest, including: issuing conditional licenses, approvals or determinations; establishing an appropriate cure period, imposing reporting requirements; placing restrictions on the transfer of cash or the assumption of liability; requiring reasonable reserves or trust accounts; denying licensure; or appointing a conservator. See "Conservatorship" below. The partnership believes that it has adequate financial resources to meet the financial stability requirements of the CCC for the foreseeable future. Pursuant to the Casino Control Act, CCC Regulations and precedent, no entity may hold a casino license unless each officer, director, principal employee, person who directly or indirectly holds any beneficial interest or ownership in the licensee, each person who in the opinion of the CCC has the ability to control or elect a majority of the board of directors of the licensee (other than a banking or other licensed lending institution which makes a loan or holds a mortgage or other lien acquired in the ordinary course of business) and any lender, underwriter, agent or employee of the licensee or other person whom the CCC may consider appropriate, obtains and maintains qualification approval from the CCC. Qualification approval means that such person must, but for residence, individually meet the qualification requirements as a casino key employee. See "Narrative Description of Business -- Gaming and Other Laws and Regulations -- Employees." Pursuant to a condition of its casino license, payments by the Partnership to or for the benefit of any related entity or partner are subject to prior CCC approval; and, if the Partnership's cash position falls below $5.0 million for three consecutive business days, the Partnership must present to the CCC and the Division evidence as to why it should not obtain a working capital facility in an appropriate amount. Control Persons. An entity qualifier or intermediary or holding company, such as Holding, Holding Inc. and the Company, is required to register with the CCC and meet the same basic standards for approval as a casino licensee; provided, however, that the CCC, with the concurrence of the Director of the Division, may waive compliance by a publicly-traded corporate holding company with the requirement that an officer, director, lender, underwriter, agent or employee thereof, or person directly or indirectly holding a beneficial interest or ownership of the securities thereof individually qualify for approval under casino key employee standards so long as the CCC and the Director are, and remain, satisfied that such officer, director, lender, underwriter, agent or employee is not significantly involved in the activities of the casino licensee, or that such security holder does not have the ability to control the publicly-traded corporate holding company or elect one or more of its directors. Persons holding five percent or more of the equity securities of such holding company are presumed to have the ability to control the company or elect one or more of its directors and will, unless this presumption is rebutted, be required to individually qualify. Equity securities are defined as any voting stock or any security similar to or convertible into or carrying a right to acquire any security having a direct or indirect participation in the profits of the issuer. Financial Sources. The CCC may require all financial backers, investors, mortgagees, bond holders and holders of notes or other evidence of indebtedness, either in effect or proposed, which bears any relation to the casino project, publicly traded securities of an entity which holds a casino license or is an entity qualifier, subsidiary or holding company of a casino licensee (a "Regulated Company"), to qualify as financial sources. In the past, the CCC has waived the qualification requirement for holders of less than 15% of a series of publicly traded mortgage bonds so long as the bonds remained widely distributed and freely traded in the public market and the holder had no ability to control the casino licensee. The CCC may require holders of less than 15% of a series of debt to qualify as financial sources even if not active in the management of the issuer or the casino licensee. Institutional Investors. An institutional investor ("Institutional Investor") is defined by the Casino Control Act as any retirement fund administered by a public agency for the exclusive benefit of federal, state or local public employees; investment company registered under the Investment Company Act of 1940; collective investment trust organized by banks under Part Nine of the Rules of the Comptroller of the Currency; closed end investment trust; chartered or licensed life insurance company or property and casualty insurance company; banking and other chartered or licensed lending institution; investment advisor registered under the Investment Advisers Act of 1940; and such other persons as the CCC may determine for reasons consistent with the policies of the Casino Control Act. An Institutional Investor may be granted a waiver by the CCC from financial source or other qualification requirements applicable to a holder of publicly-traded securities, in the absence of a prima facie showing by the Division that there is any cause to believe that the holder may be found unqualified, on the basis of CCC findings that: (i) its holdings were purchased for investment purposes only and, upon request by the CCC, it files a certified statement to the effect that it has no intention of influencing or affecting the affairs of the issuer, the casino licensee or its holding or intermediary companies; provided, however, that the Institutional Investor will be permitted to vote on matters put to the vote of the outstanding security holders; and (ii) if (x) the securities are debt securities of a casino licensee's holding or intermediary companies or another subsidiary company of the casino licensee's holding or intermediary companies which is related in any way to the financing of the casino licensee and represent either (A) 20% or less of the total outstanding debt of the company, or (B) 50% or less of any issue of outstanding debt of the company, (y) the securities are equity securities and represent less than 10% of the equity securities of a casino licensee's holding or intermediary companies, or (z) the securities so held exceed such percentages, upon a showing of good cause. There can be no assurance, however, that the CCC will make such findings or grant such waiver and, in any event, an Institutional Investor may be required to produce for the CCC or the Division upon request, any document or information which bears any relation to such debt or equity securities. Generally, the CCC requires each institutional holder seeking waiver of qualification to execute a certification to the effect that (i) the holder has received the definition of Institutional Investor under the Casino Control Act and believes that it meets the definition of Institutional Investor; (ii) the holder purchased the securities for investment purposes only and holds them in the ordinary course of business; (iii) the holder has no involvement in the business activities of, and no intention of influencing or affecting the affairs of the issuer, the casino licensee or any affiliate; and (iv) if the holder subsequently determines to influence or affect the affairs of the issuer, the casino licensee or any affiliate, it shall provide not less than 30 days' prior notice of such intent and shall file with the CCC an application for qualification before taking any such action. If an Institutional Investor changes its investment intent, or if the CCC finds reasonable cause to believe that it may be found unqualified, the Institutional Investor may take no action with respect to the security holdings, other than to divest itself of such holdings, until it has applied for interim casino authorization (see "Interim Casino Authorization" below) and has executed a trust agreement pursuant to such an application. Ownership and Transfer of Securities. The Casino Control Act imposes certain restrictions upon the issuance, ownership and transfer of securities of a Regulated Company and defines the term "security" to include instruments which evidence a direct or indirect beneficial ownership or creditor interest in a Regulated Company including, but not limited to, mortgages, debentures, security agreements, notes and warrants. Each of the Company and the Partnership are deemed to be a Regulated Company, and instruments evidencing a beneficial ownership or creditor interest therein, including partnership interest, are deemed to be the securities of a Regulated Company. If the CCC finds that a holder of such securities is not qualified under the Casino Control Act, it has the right to take any remedial action it may deem appropriate including the right to force divestiture by such disqualified holder of such securities. In the event that certain disqualified holders fail to divest themselves of such securities, the CCC has the power to revoke or suspend the casino license affiliated with the Regulated Company which issued the securities. If a holder is found unqualified, it is unlawful for the holder (i) to exercise, directly or through any trustee or nominee, any right conferred by such securities, or (ii) to receive any dividends or interest upon such securities or any remuneration, in any form, from its affiliated casino licensee for services rendered or otherwise. With respect to non-publicly-traded securities, the Casino Control Act and CCC regulations require that the corporate charter or partnership agreement of a Regulated Company establish a right in the CCC of prior approval with regard to transfers of securities, shares and other interests and an absolute right in the Regulated Company to repurchase at the market price or the purchase price, whichever is the lesser, any such security, share or other interest in the event that the CCC disapproves a transfer. With respect to publicly-traded securities, such corporate charter or partnership agreement is required to establish that any such securities of the entity are held subject to the condition that, if a holder thereof is found to be disqualified by the CCC, such holder shall dispose of such securities. Interim Casino Authorization. Interim casino authorization is a process which permits a person who enters into a contract to obtain property relating to a casino operation or who obtains publicly-traded securities relating to a casino licensee to close on the contract or own the securities until plenary licensure or qualification. During the period of interim authorization, the property relating to the casino operation or the securities are held in trust. Whenever any person enters into a contract to transfer any property which relates to an ongoing casino operation, including a security of the casino licensee or a holding or intermediary company or entity qualifier, under circumstances which would require that the transferee obtain licensure or be qualified under the Casino Control Act, and that person is not already licensed or qualified, the transferee is required to apply for interim authorization. Furthermore, the closing or settlement date in the contract may not be earlier than the 121st day after the submission of a complete application for licensure or qualification together with a fully executed trust agreement in a form approved by the CCC. If, after the report of the Division and a hearing by the CCC, the CCC grants interim authorization, the property will be subject to a trust. If the CCC denies interim authorization, the contract may not close or settle until the CCC makes a determination on the qualifications of the applicant. If the CCC denies qualification, the contract will be terminated for all purposes and there will be no liability on the part of the transferor. If, as the result of a transfer of publicly traded securities of a licensee, a holding or intermediary company or entity qualifier of a licensee or a financing entity of a licensee, any person is required to qualify under the Casino Control Act, that person is required to file an application for licensure or qualification within 30 days after the CCC determines that qualification is required or declines to waive qualification. The application must include a fully executed trust agreement in a form approved by the CCC or, in the alternative, within 120 days after the CCC determines that qualification is required, the person whose qualification is required must divest such securities as the CCC may require in order to remove the need to qualify. The CCC may grant interim casino authorization where it finds by clear and convincing evidence that: (i) statements of compliance have been issued pursuant to the Casino Control Act; (ii) the casino hotel is an approved hotel in accordance with the Casino Control Act; (iii) the trustee satisfies qualification criteria applicable to key casino employees, except for residency and casino experience; and (iv) interim operation will best serve the interests of the public. When the CCC finds the applicant qualified, the trust will terminate. If the CCC denies qualification to a person who has received interim casino authorization, the trustee is required to endeavor, and is authorized, to sell, assign, convey or otherwise dispose of the property subject to the trust to such persons who are licensed or qualified or shall themselves obtain interim casino authorization. Where a holder of publicly traded securities is required, in applying for qualification as a financial source or qualifier, to transfer such securities to a trust in application for interim casino authorization and the CCC thereafter orders that the trust become operative: (i) during the time the trust is operative, the holder may not participate in the earnings of the casino hotel or receive any return on its investment or debt security holdings; and (ii) after disposition, if any, of the securities by the trustee, proceeds distributed to the unqualified holder may not exceed the lower of their actual cost to the unqualified holder or their value calculated as if the investment had been made on the date the trust became operative. Approved Hotel Facilities. The CCC may permit a licensee, such as the Partnership, to increase its casino space if the licensee agrees to add a prescribed number of qualifying sleeping units within two years after the commencement of gaming operations in the additional casino space. However, if the casino licensee does not fulfill such agreement due to conditions within its control, the licensee will be required to close the additional casino space, or any portion thereof that the CCC determines should be closed. License Fees. The CCC is authorized to establish annual fees for the renewal of casino licenses. The renewal fee is based upon the cost of maintaining control and regulatory activities prescribed by the Casino Control Act, and may not be less than $200,000 for a two-year casino license. Additionally, casino licensees are subject to potential assessments to fund any annual operating deficits incurred by the CCC or the Division. There is also an annual license fee of $500 for each slot machine maintained for use or in use in any casino. Gross Revenue Tax. Each casino licensee is also required to pay an annual tax of 8% on its gross casino revenues. For the years ended December 31, 1992 and 1993, the Partnership's gross revenue tax was approximately $21.0 million and $21.3 million respectively, and its license, investigations, and other fees and assessments totalled approximately $4.7 million and $4.0 million respectively. Investment Alternative Tax Obligations. An investment alternative tax imposed on the gross casino revenues of each licensee in the amount of 2.5% is due and payable on the last day of April following the end of the calendar year. A licensee is obligated to pay the investment alternative tax for a period of 25 years. Estimated payments of the investment alternative tax obligation must be made quarterly in an amount equal to 1.25% of estimated gross revenues for the preceding three-month period. Investment tax credits may be obtained by making qualified investments or by the purchase of bonds issued by the CRDA. CRDA bonds may have terms as long as fifty years and bear interest at below market rates, resulting in a value lower than the face value of such CRDA bonds. For the first ten years of its obligation, the licensee is entitled to an investment tax credit against the investment alternative tax in an amount equal to twice the purchase price of bonds issued to the licensee by the CRDA. Thereafter, the licensee is (i) entitled to an investment tax credit in an amount equal to twice the purchase price of such bonds or twice the amount of its investments authorized in lieu of such bond investments or made in projects designated as eligible by the CRDA and (ii) has the option of entering into a contract with the CRDA to have its tax credit comprised of direct investments in approved eligible projects which may not comprise more than 50% of its eligible tax credit in any one year. From the moneys made available to the CRDA, the CRDA set aside $100,000,000 for investment in hotel development projects in Atlantic City undertaken by a licensee which result in the construction or rehabilitation of at least 200 hotel rooms by December 31, 1996. The CRDA is required to determine the amount each casino licensee may be eligible to receive out of the moneys set aside. Minimum Casino Parking Charges. As of July 1, 1993, each casino licensee was required to impose on and collect from patrons a standard minimum parking charge of at least $2.00 for the use of parking, space for the purpose of parking, garaging or storing motor vehicles in a parking facility owned or leased by a casino licensee or by any person on behalf of a casino licensee. Of the amount collected by the casino licensee, $1.50 will be paid to the New Jersey State Treasurer and paid by the New Jersey State Treasurer into a special fund established and held by the New Jersey State Treasurer for the exclusive use of the CRDA. Amounts in the special fund will be expended by the CRDA for (i) eligible projects in the corridor region of Atlantic City, which projects are related to the improvement of roads, infrastructure, traffic regulation and public safety, and (ii) funding up to 35% of the cost to casino licensee of expanding their hotel facilities to provide additional hotel rooms, which hotel rooms are required to be available upon the opening of the Atlantic City Convention Center and dedicated to convention events. Conservatorship. If, at any time, it is determined that the Partnership, the Company, Holding, Inc. or Holding has violated the Casino Control Act or that any of such entities cannot meet the qualification requirements of the Casino Control Act, such entity could be subject to fines or the suspension or revocation of its license or qualification. If the Partnership's license is suspended for a period in excess of 120 days or revoked or if the CCC fails or refuses to renew such casino license, the CCC could appoint a conservator to operate and dispose of the Partnership's casino hotel facilities. A conservator would be vested with title to all property of the Partnership relating to the casino and the approved hotel subject to valid liens and/or encumbrances. The conservator would be required to act under the direct supervision of the CCC and would be charged with the duty of conserving, preserving and, if permitted, continuing the operation of the casino hotel. During the period of the conservatorship, a former or suspended casino licensee is entitled to a fair rate of return out of net earnings, if any, on the property retained by the conservator. The CCC may also discontinue any conservatorship action and direct the conservator to take such steps as are necessary to effect an orderly transfer of the property of a former or suspended casino licensee. Employees. All employees of the Partnership must be licensed by or registered with the CCC, depending on the nature of the position held. Casino employees are subject to more stringent requirements than non-casino employees and must meet applicable standards pertaining to financial stability, integrity and responsibility, good character, honesty and integrity, business ability and casino experience and New Jersey residency. These requirements have resulted in significant competition among Atlantic City casino operators for the services of qualified employees. Gaming Credit. The Partnership's casino games are conducted on a credit as well as cash basis. Gaming debts arising in Atlantic City in accordance with applicable regulations are enforceable in the courts of the State of New Jersey. The extension of gaming credit is subject to regulations that detail procedures which casinos must follow when granting gaming credit and recording counter checks which have been exchanged, redeemed or consolidated. Control Procedures. Gaming at Trump Plaza is conducted by trained and supervised personnel. The Partnership employs extensive security and internal controls. Security checks are made to determine, among other matters, that job applicants for key positions have had no criminal history or associations. Security controls utilized by the surveillance department include closed circuit video camera to monitor the casino floor and money counting areas. The count of moneys from gaming also is observed daily by representatives of the CCC. Other Laws and Regulations. The United States Department of the Treasury has adopted regulations pursuant to which a casino is required to file a report of each deposit, withdrawal, exchange of currency, gambling tokens or chips, or other payments or transfers by, through, or to such casino which involves a transaction in currency of more than $10,000 per patron per gaming day. Such reports are required to be made on forms prescribed by the Secretary of the Treasury and are filed with the Commissioner of the Internal Revenue Service (the "IRS"). In addition, the Partnership is required to maintain detailed records (including the names, addresses, social security numbers and other information with respect to its gaming customers) dealing with, among other items, the deposit and withdrawal of funds and the maintenance of a line of credit. The Department of the Treasury has recently adopted regulations, scheduled to become effective in December 1994, which will require the Partnership, among other things, to keep records of the name, permanent address and taxpayer identification number (or in the case of a non-resident alien, such person's passport number) of any person engaging in a currency transaction in excess of $3,000. The Partnership is unable to predict what effect, if any, these new reporting obligations will have on gaming practices of certain of its patrons. In the past, the IRS had taken the position that gaming winnings from table games by non-resident aliens was subject to a 30% withholding tax. The IRS, however, subsequently adopted a practice of not collecting such tax. Recently enacted legislation exempts from tax withholding table game winnings by non-resident aliens, unless the Secretary of the Treasury determines by regulation that such collections have become administratively feasible. As the result of an audit conducted by the U.S. Department of Treasury, Office of Financial Enforcement, the Partnership was alleged to have failed to timely file the "Currency Transaction Report by Casino" in connection with 65 individual currency transactions in excess of $10,000 during the period from October 31, 1986 to December 10, 1988. The Partnership paid a fine of $292,500 in connection with these violations. The Partnership has revised its internal control procedures to ensure continued compliance with these regulations. The Partnership is subject to other federal, state and local regulations and, on a periodic basis, must obtain various licenses and permits, including those required to sell alcoholic beverages. Management believes that it has obtained all required licenses and permits to conduct its business. (d) Financial Information About Foreign and Domestic Operations and Export Sales Not applicable. ITEM 2.

ITEM 2. PROPERTIES. The Partnership owns and leases several parcels of land in and around Atlantic City, New Jersey, each of which is used in connection with the operation of Trump Plaza and each of which is subject to the liens of the Note Mortgage and Guarantee Mortgage (collectively, the "Mortgages") and certain other liens. The "Note Mortgage" is the mortgage on and related assignments of the assets constituting the real property owned and leased by the Partnership and substantially all of the Partnership's other assets, all of which constitute Trump Plaza and its related properties, which secures the non-recourse promissory note (the"Partnership Note") of the Partnership issued to the Company in exchange for the Company's lending to the Partnership the proceeds of the Mortgage Note Offering. In exchange for the use of such proceeds, the Company has assigned the Note Mortgage and the Partnership Note to the Trustee. The "Guarantee Mortgage" is the mortgage on and related assignments of the assets of the Partnership described above, senior to the lien of the Note Mortgage, which secures the Partnership's non-recourse guarantee (the "Guarantee") of the Mortgage Notes. The Mortgage Note Indenture, the Note Mortgage and the Guarantee Mortgage are herein collectively referred to as the "Mortgage Note Agreements." Casino Parcel. Trump Plaza is located on The Boardwalk in Atlantic City, New Jersey, next to the Atlantic City Convention Center. It occupies the entire city block (approximately 2.38 acres) bounded by The Boardwalk, Mississippi Avenue, Pacific Avenue and Columbia Place (the "Casino Parcel"). The Casino Parcel consists of four tracts of land, one of which is owned by the Partnership and three of which are leased to the Partnership pursuant to three non-renewable Ground Leases, each of which expires on December 31, 2078 (each, a "Ground Lease"). Trump Seashore Associates, Seashore Four Associates and Plaza Hotel Management Company (each, a "Ground Lessor") are the owners/lessors under such Ground Leases (respectively, the "TSA Lease," "SFA Lease" and "PHMC Lease"; the land which is subject to the Ground Leases (which includes Additional Parcel 1, as hereinafter defined) is referred to collectively as the "Leasehold Tracts" and individually as a "Leasehold Tract"). Trump Seashore Associates and Seashore Four Associates are beneficially owned by Trump and are, therefore, affiliates of the Company and the Partnership. On August 1, 1991, as security for indebtedness owed to a third party, Trump Seashore Associates transferred its interest in the TSA Lease to United States Trust Company of New York ("UST"), as trustee for the benefit of such third party creditor. The trust agreement among UST, Trump Seashore Associates and such creditor provides that the trust shall terminate on the earlier of (i) August 1, 2012 or (ii) the date on which such third party creditor certifies to UST that all principal, interest and other sums due and owing from Trump Seashore Associates to such third party creditor have been paid. Trump Seashore Associates is currently negotiating with its third party lender for the extension or refinancing of the indebtedness described above, which debt matured on October 28, 1993. The lender has agreed to forebear from pursuing remedies under such loan through May 28, 1994, while such refinancing negotiations are taking place. The Mortgage Note Agreements provide that, upon such refinancing, the refinancing lender shall consent to the execution of an agreement between TSA and the Partnership providing, among other matters, for certain protections for holders of Mortgage Notes in the event of a default arising under the TSA Lease. While the transfer to UST of Trump Seashore Associates' interest in the TSA Lease was primarily a financing transaction to provide the third-party creditor with a potentially enhanced security interest, because of the transfer of such interest to UST, it is not certain that the TSA Lease would be deemed to be held by an affiliate of the Partnership and, therefore, even if the agreement described above is executed by TSA, the holders of the Mortgage Notes and the PIK Notes may not have the benefit of any such agreement regarding the TSA Lease. The SFA Lease and the PHMC Lease each contain options pursuant to which the Partnership may purchase the Leasehold Tract covered by such Ground Lease at certain times during the term of such Ground Lease under certain circumstances. Upon any refinancing of the mortgage indebtedness which currently encumbers the fee interest in the TSA Lease Leasehold Tract, including any refinancing resulting from the on-going negotiations described above, the TSA Lease will be amended to confirm the existence thereunder of the purchase options, or provide for an additional option grant, in each case substantially similar to those currently set forth in the other Ground Leases. The purchase price pursuant to each option is specified in the applicable Ground Lease. The Ground Leases are "net leases" pursuant to which the Partnership, in addition to the payment of fixed rent, is responsible for all costs and expenses with respect to the use, operation and ownership of the Leasehold Tracts and the improvements now, or which may in the future be, located thereon, including, but not limited to, all maintenance and repair costs, insurance premiums, real estate taxes, assessments and utility charges. The improvements located on the Leasehold Tracts are owned by the Partnership during the terms of the respective Ground Leases and upon the expiration of the term of each Ground Lease (for whatever reason), ownership of such improvements will vest in the Ground Lessor. Subject to the provisions of the Mortgage Note Agreements, the Partnership has the right to improve the Leasehold Tracts, alter, demolish and/or rebuild the improvements constructed thereon, and remove any personal property and movable trade fixtures therefrom. The Ground Leases provide that each Ground Lessor may encumber its fee estate with mortgage liens, but any such fee mortgage will not increase the rent under the applicable Ground Lease and must be subordinate to such Ground Lease. Accordingly, any default by a Ground Lessor under any such fee mortgage (including that mortgage encumbering the TSA Lease parcel, for which refinancing negotiations are on-going) will not result in a termination of the applicable Ground Lease but would permit the fee mortgagee to bring a foreclosure action and succeed to the interests of the Ground Lessor in the fee estate, subject to the Partnership's leasehold estate under such Ground Lease. Each Ground Lease also specifically provides that the Lessor may sell its interest in the applicable Leasehold Tract, but any such sale would be made subject to the Partnership's interest in the applicable Ground Lease. The Mortgages are subject and subordinate to each of the Ground Leases. Accordingly, if a Ground Lease were to be terminated while such Mortgages were outstanding, the lien of the Mortgages would be extinguished as to the applicable Leasehold Tract. The Ground Leases, however, contain certain provisions to protect the Mortgage Note Trustee and the holders of the Mortgage Notes from such an occurrence, including the following: (i) no cancellation, surrender, acceptance of surrender or modification of a Ground Lease is binding on the Mortgage Note Trustee or affects the lien of the Mortgages without the Mortgage Note Trustee's prior written consent, (ii) the Mortgage Note Trustee is entitled to a copy of any notices (including notices of default) sent by a Ground Lessor to the Partnership, has the right to perform any term or condition of the Ground Lease to be performed by the Partnership and can cure any defaults, (iii) if any default is not remedied within the applicable grace period specified in the Ground Lease, then before the Ground Lessor exercises its rights under the Ground Lease or any statute, the Mortgage Note Trustee has an additional period of time within which to cure, or commence the curing of, the default and (iv) upon any termination of a Ground Lease, the Ground Lessor must enter into a new lease, on substantially the same terms as the applicable Ground Lease, with the Mortgage Note Trustee. In the event of a default by the Partnership under a Ground Lease, however, notwithstanding any additional cure period granted to the Mortgage Note Trustee, there can be no assurance that the Mortgage Note Trustee will take action to cure the default, will have sufficient time to cure the default or will otherwise be able to take advantage of such provisions. If the Ground Lease were then terminated and a new lease entered into, the Mortgage Note Trustee would nevertheless remain obligated to cure all pre- existing defaults. If a bankruptcy case is filed by or commenced against a lessor under applicable bankruptcy law, the trustee in bankruptcy in a liquidation or reorganization case under the applicable bankruptcy law, or a debtor-in-possession in a reorganization case under the applicable bankruptcy law, has the right, at its option, to assume or reject the lease of the debtor-lessor (subject, in each case, to court approval). If the lease is assumed, the rights and obligations of the Partnership thereunder, and the rights of the Mortgage Note Trustee as leasehold mortgagee under the Mortgage Note Agreements, would continue in full force and effect. If the lease is rejected, the Partnership would have the right, at its election, either (i) to treat the lease as terminated, in which event the lien of the Mortgages on the leasehold estate created thereby would be extinguished, or (ii) to continue in possession of the land and improvements under the lease for the balance of the term thereof and at the rental set forth therein (with a right to offset against such rent any damages caused by the lessor's failure to thereafter perform its obligations under such lease). The Mortgage Note Agreements provide that if a lease is rejected, the Partnership assigns to the Trustee its rights to elect whether to treat the lease as terminated or to remain in possession of the leased premises. In the case of the Ground Leases, the rejection of a Ground Lease by a trustee in bankruptcy or debtor-lessor (as debtor-in-possession) may result in termination of any options to purchase the fee estate of the debtor-lessor and the Mortgage Note Trustee's option (as leasehold mortgagee), in certain circumstances, to enter into a new lease directly with the lessor. In addition, under an interpretation of New Jersey law, it is possible that a court would regard such options as separate contracts and, therefore, severable from the Ground Lease. In such event, the trustee in bankruptcy or debtor-lessor (as debtor-in-possession) could assume the Ground Lease, while rejecting some or all of such options under the Ground Lease. Parking Parcels. The Partnership owns a parcel of land (the "Garage Parcel") located across the street from the Casino Parcel and along Pacific Avenue in a portion of the block bounded by Pacific Avenue, Mississippi Avenue, Atlantic Avenue and Missouri Avenue. The Partnership has constructed on the Garage Parcel a 10-story parking garage capable of accommodating approximately 2,650 cars and which includes offices and a bus transportation center with bays accommodating up to 13 buses at one time. An enclosed pedestrian walkway from the parking garage accesses Trump Plaza at the casino level. Parking at the parking garage is available to Trump Plaza's guests, as well as to the general public. Two of the tracts comprising a portion of the Garage Parcel are subject to first mortgages on the Partnership's fee interest in such tracts. As of December 31, 1993, such mortgages had approximate outstanding principal balances of $2.7 million and $2.0 million. The Partnership leases, pursuant to the PHMC Lease, a parcel of unimproved land located on the northwest corner of the intersection of Mississippi and Pacific Avenues consisting of approximately 11,800 square feet ("Additional Parcel 1") and owns another unimproved parcel on Mississippi Avenue adjacent to Additional Parcel 1 consisting of approximately 5,750 square feet (the "Bordonaro Parcel"). The Bordonaro Parcel is encumbered by a first mortgage having an outstanding principal balance, as of December 31, 1993, of approximately $150,000. Additionally Parcel 1 and the Bordonaro Parcel are presently paved and used for surface parking. The Partnership also owns five unimproved parcels of land, aggregating approximately 43,300 square feet, and sub leases on an unimproved parcel consisting of approximately 3,125 square feet. All of such parcels are contiguous and are located along Atlantic Avenue, in the same block as the Garage Parcel. They are used for surface parking for employees of Trump Plaza and are not encumbered by any mortgage liens other than those of the Mortgages. Warehouse Parcel. The Partnership owns a warehouse and office facility located in Egg Harbor Township, New Jersey containing approximately 64,000 square feet of space (the "Egg Harbor Parcel"). The Egg Harbor Parcel is encumbered by a first mortgage having an outstanding principal balance, as of December 31, 1993, of approximately $1.6 million. Boardwalk Expansion Site. See "Certain Relationships and Related Transactions -- Boardwalk Expansion Site." Superior Mortgages. The lien securing the indebtedness on the Garage Parcel, the Bordonaro Parcel and the Egg Harbor Parcel (all of such liens are collectively called the "Existing Senior Mortgages") are all senior to the liens of the Mortgages. The principal amount currently secured by such Existing Senior Mortgages as of December 31, 1993 is in the aggregate, $6.4 million. If the Partnership were to default in the payment of the indebtedness secured by any of the Existing Senior Mortgages or default in the performance of any of the other obligations thereunder, and the holder of an Existing Senior Mortgage were to commence a foreclosure action, the debt owed to the holder of such Existing Senior Mortgage, together with the debt owed to the holder of any other Existing Senior Mortgage which is also then being foreclosed, would have to be satisfied before the holders of the Mortgage Notes would realize any proceeds from the sale of the portion of the property encumbered thereby. If the Company and the Partnership default in the payment of the Mortgage Notes or any other obligation under the Mortgages, and the Mortgage Note Trustee elects to foreclose under the Mortgages, the Mortgage Note Trustee will receive the proceeds of the sale of the collateral under the Mortgage Note Indenture (the "Collateral") subject to the rights of the holders of any Existing Senior Mortgages. The purchaser of the Collateral at any such foreclosure sale would take title to the Collateral subject to the extent not foreclosed upon the Existing Senior Mortgages. In addition to the Existing Senior Mortgages, the Partnership may, under certain circumstances, borrow up to $25 million to pay for certain expansion site costs which may be secured by a lien on the expansion site superior to the lien of the Mortgages thereon. The Partnership has financed or leased and from time to time will finance or lease its acquisition of furniture, fixtures and equipment. The lien in favor of any such lender or lessor will be superior to the liens of the Mortgages. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. The Partnership, its partners, certain members of its former Executive Committee, and certain of its employees, have been involved in various legal proceedings. In general, the Partnership has agreed to indemnify such persons against any and all losses, claims, damages, expenses (including reasonable costs, disbursements and counsel fees) and liabilities (including amounts paid or incurred in satisfaction of settlements, judgments, fines and penalties) incurred by them in said legal proceedings. Such persons and entities are vigorously defending the allegations against them and intend to vigorously contest any future proceedings. Penthouse Litigation On April 3, 1989, BPHC Acquisition, Inc. and BPHC Parking Corp. (collectively, "BPHC") filed a third-party complaint (the "Complaint") against the Partnership and Trump. The Complaint arose in connection with the action entitled Boardwalk Properties, Inc. and Penthouse International Ltd. v. BPHC Acquisition, Inc. and BPHC Parking Corp., which was instituted on March 20, 1989 in the New Jersey Superior Court, Chancery Division, Atlantic County. The suit arose in connection with the conditional sale by Boardwalk Properties, Inc. ("BPI") (or, with respect to certain of the property, BPI's agreement to sell) to Trump of BPI's fee and leasehold interests in (i) an approximately 2.0-acre parcel of land located directly across the street from Trump Plaza upon which there is located an approximately 500 room hotel, which is closed to the public and is in need of substantial renovation (the "Penthouse Site"), (ii) an approximately 4.2-acre parcel of land located on Atlantic Avenue, diagonally across from Trump Plaza's parking garage (the "Columbus Plaza Site") which was then owned by an entity in which 50% of the interests were each owned by BPHC and BPI and (iii) an additional 1,462-square foot parcel of land located within the area of the Penthouse Site (the "Bongiovanni Site"). Prior to BPI entering into its agreement with Trump, BPI had entered into agreements with BPHC which provided, among other things, for the sale to BPHC of the Penthouse Site, as well as BPI's interest in the Columbus Plaza Site, assuming that certain contingencies were satisfied by a certain date. Additionally, by agreement between BPHC and BPI, in the event BPHC failed to close on the Penthouse Site, BPHC would convey to BPI the Bongiovanni Site. Upon BPHC's failure to close on the Penthouse Site, BPI entered into its agreement with Trump pursuant to which it sold the Penthouse Site to Trump and instituted a lawsuit against BPHC for specific performance to compel BPHC to transfer to BPI, BPHC's interest in the Columbus Plaza and Bongiovanni Sites, as provided for in the various agreements between BPHC and BPI and in the agreement between BPI and Trump. The Complaint alleges that the Partnership and/or Trump engaged in the following activities: civil conspiracy, violations of the New Jersey Antitrust Act, violations of the New Jersey RICO statute, malicious interference with contractual relations, malicious interference with prospective economic advantage, inducement to breach a fiduciary duty and malicious abuse of process. The relief sought in the Complaint included, among other things, compensatory damages, punitive damages, treble damages, injunctive relief, the revocation of all of the Partnership's and Trump's casino licenses, the revocation of the Partnership's current Certificate of Partnership, the revocation of any other licenses or permits issued to the Partnership and Trump by the State of New Jersey, and a declaration voiding the conveyance by BPI to Trump of BPI's interest in the Penthouse Site, as well as BPI's and/or Trump's rights to obtain title to the Columbus Plaza Site. The Partnership and Trump filed an answer denying all liability and alleging that all of BPHC's claims are without merit. On November 9, 1990, BPHC filed an application to amend its counterclaims against BPI and the Complaint, which amendment sought to withdraw all of BPHC's affirmative claims for equitable relief and thereby limit such claims to monetary damages. On December 20, 1990, the Superior Court entered an Order permitting BPHC to withdraw its affirmative demands for equitable relief. Trial of the Penthouse litigation was bifurcated into issues of liability and damages, with liability issues to be tried first. On March 25, 1993, after trial on issues of liability, the Superior Court rendered a decision rejecting all of BPHC's claims in the Complaint. On October 13, 1993, the court entered a judgment dismissing with prejudice all claims against Trump and the Partnership. On November 5, 1993 BPHC filed a motion seeking to have this judgment declared interlocutory in nature, rather than final. The Partnership successfully opposed this motion which was denied on November 19, 1993. On November 30, 1993, BPHC filed a notice of appeal to the Appellate Division. On January 19, 1994, BPHC filed a motion in the Appellate Division seeking a determination that the Superior Court had erred in ruling that the judgment as to the Partnership and Trump was final. The Partnership and Trump successfully opposed that motion, which was denied on March 3, 1994. A briefing schedule for the appeal from the final judgment has been set. If that schedule is not subsequently modified, BPHC's brief is due on April 18, 1994, the brief of the Partnership and Trump is due on May 18, 1994 and BPHC's reply brief is due on May 31, 1994. On January 9, 1991, BPHC instituted suit against Trump, the Partnership, BPI, Penthouse International Ltd. and Robert C. Guccione in the United States District Court for the District of New Jersey. This action is virtually identical to the state court action described above. The Partnership and Trump filed an answer denying all liability and alleging that all of BPHC's claims are without merit. In April 1993, the Partnership filed a motion to dismiss certain claims based on the favorable decision in the state court action. In May 1993, the court issued an order to show cause, scheduling a hearing for June 1993 to determine whether certain claims of the plaintiff's amended complaint should be dismissed with prejudice. On July 15, 1993, the court acted favorably on the Partnership's motion and dismissed the action in its entirety. The order of dismissal was appealed to the United States Court of Appeals for the Third Circuit. All briefs have been filed and the appeal is presently scheduled for disposition in April 1994. Other Litigation Various other legal proceedings are now pending against the Partnership. The Partnership considers all such other proceedings to be ordinary litigation incident to the character of its business and not material to its business or financial condition. The majority of such claims are covered by liability insurance (subject to a $250,000 deductible per claim), and the Partnership believes that the resolution of these claims, to the extent not covered by insurance, together with uninsured claims will not, individually or in the aggregate, have a material adverse effect on the financial condition and results of operations of the partnership. The Partnership is also a party to various administrative proceedings involving allegations that it has violated certain provisions of the Casino Control Act. The Partnership believes that the final outcome of these proceedings will not, either individually or in the aggregate, have a material adverse effect on the Partnership or on the ability of the Partnership to otherwise retain or renew any casino or other licenses required under the Casino Control Act for the operation of Trump Plaza. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. No matters were submitted by the Registrant to its security holders for a vote during the fourth quarter of 1993. ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. (a) There is no established public trading market for the Company's outstanding Common Stock. (b) As of December 31, 1993, Trump was the sole holder of record of the Company's Common Stock. (c) The Company has not paid any cash dividends on its Common Stock. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. SELECTED FINANCIAL INFORMATION The following table sets forth historical financial information of the Partnership for each of the five years ended December 31, 1993. This information should be read in conjunction with the financial statements of the Partnership and related notes included elsewhere in this Report and "Management's Discussion and Analysis of Financial Condition and Results of Operations." Year Ended December 31, ----------------------- 1989 1990 1991 1992 1993 ---- ---- ---- ---- ---- Statements of Operations Data: (dollars in thousands) Revenues: Gaming . . . . . . . . . . . . $306,009 $276,932 $233,265 $265,448 $264,081 Other. . . . . . . . . . . . . 90,680 87,286 66,411 73,270 69,203 Trump Regency. . . . . . . . . - - 11,547 9,465 - -------- ------- -------- -------- ------- Gross revenues . . . . . . . 396,689 364,218 311,223 348,183 333,284 Promotional allowances 42,551 44,281 31,539 34,865 32,793 -------- ------- -------- -------- ------- Net revenues . . . . . . . . . 354,138 319,937 279,684 313,318 300,491 Costs and expenses: Gaming . . . . . . . . . . . . 177,401 178,356 133,547 146,328 136,895 Other . . . . . . . . . . . . 29,158 26,331 23,404 23,670 24,778 General and administrative 71,533 76,057 69,631 75,459 71,624 Depreciation and amortization. 16,906 16,725 16,193 15,842 17,554 Restructuring costs. . . . . . - - 943 5,177 - Trump Regency . . . . . . . . - 3,359 19,879 11,839 - -------- ------- ------- -------- -------- 294,998 300,828 263,597 278,315 250,851 -------- ------- ------- -------- -------- Income from operations 59,140 19,109 16,087 35,003 49,640 -------- ------- ------- -------- -------- Net interest expense . . . . . . 31,988 33,128 33,363 31,356 39,889 Extraordinary (loss) gain - - - (38,205) 4,120 Net income (loss) (1). . . . . . 24,564 (10,591) (29,230) (35,787) 9,338 Balance Sheet Data: Cash and cash equivalents. . . . $11,627 $10,005 $10,474 $18,802 14,393 Property and equipment - net . . 321,391 316,595 306,834 300,266 293,141 Total assets . . . . . . . . . . 406,950 395,775 378,398 370,349 374,498 Total long-term debt - net (2) 273,411 247,048 33,326 249,723 395,948 Preferred Partnership Interest - - - 58,092 - Total capital. . . . . . . . . . 88,481 83,273 54,043 11,362 (54,710) - -------------- (1) Net loss for the year ended December 31, 1990 includes income of $2.4 million resulting from the settlement of a lawsuit relating to a boxing match. Net loss for the year ended December 31, 1991 includes a $10.9 million charge associated with rejection of the Regency Lease and $4.0 million of costs associated with certain litigation. Net income for 1992 includes $1.5 million of costs associated with certain litigation. Net income for 1993 includes $3.9 million of costs associated with the Boardwalk Expansion Site. (2) Long-term debt of $225 million at December 31, 1991 had been classified as a current liability. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. General The Company was incorporated on March 14, 1986 as a New Jersey Corporation, and was originally formed solely to raise funds through the issuance and sale of its debt securities for the benefit of the Partnership. As part of a prepackaged plan of reorganization under chapter 11 of the U.S. Bankruptcy Code consummated on May 29, 1992, the Company became a partner of the Partnership and issued approximately three million Stock Units, each comprised of one share of Preferred Stock and one share of Common Stock. On June 25, 1993 the Company issued and the Partnership guaranteed $330,000,000 of Mortgage Notes (for net proceeds of $325,687,000) and Holding, issued 12,000 Units consisting of an aggregate of $60,000,000 of PIK Notes, together with Warrants to acquire an additional $12,000,000 of PIK Notes at no additional cost. Holding has no other assets or business other than its 99% equity interest in the Partnership. The Company owns the remaining 1% interest in the Partnership. The combined proceeds of the Offerings, together with cash on hand, were used substantially as follows: (i) $225.0 million of such proceeds were used to repay the Partnership's Promissory Note to the Company in the principal amount of $225.0 million, which proceeds were then used by the Company to redeem the Bonds; (ii) $12.0 million was used to repay the Regency Note (see "Item 13. Certain Relationships and Related Transactions -- Trump Regency"); (iii) $40.0 million was distributed to the Company (which used such funds, together with $35.0 million from the Units Offering distributed to Trump and paid to the Company, to redeem its Stock Units); (iv) approximately $17.3 million was used to pay the expenses incurred in connection with the Offerings; and (v) approximately $52.5 million was used to make the Special Distribution to Trump, which was used by Trump primarily to pay certain personal indebtedness. No portion of the net proceeds was retained by Holding, the Company or the Partnership for working capital purposes. The financial information presented below reflects the results of operations of the Partnership. Since the Company and Holding have no business operations other than their interest in the Partnership, their results of operations are not discussed below. Results Of Operations For The Years Ended December 31, 1993 and Gaming revenues were $264.1 million for the year ended December 31, 1993, a decrease of $1.4 million or 0.5% from gaming revenues of $265.4 million in 1992. This decrease in gaming revenues consisted of a reduction in table games revenues, which was partially offset by an increase in slot revenues. These results were impacted by major snow storms during February and March, which severely restricted travel in the region. The decrease in revenues was also attributable, in part, to the revenues derived from "high roller" patrons from the Far East during 1992, which did not recur in 1993, due in part to the decision to de-emphasize marketing efforts directed at "high roller" patrons from the Far East and also to the effects of the adverse economic conditions in that region. Slot revenues were $170.5 million for the year ended December 31, 1993, an increase of $1.0 million or 0.6%, from slot revenues of $169.5 million in 1992. The Partnership elected to discontinue certain progressive slot jackpot programs thereby reversing certain accruals into revenues which had the effect of improving slot revenue by $4.1 million for the year ended December 31, 1992. Excluding the aforementioned adjustment, slot revenues would have resulted in a $5.0 million or 3.0% improvement over 1992. The Partnership believes that its improvement in slot revenues reflects its intensified slot marketing efforts directed towards patrons who tend to wager more per slot play and general growth in the industry. See "Business - -- Business Strategy." Table games revenues were $93.6 million for the year ended December 31, 1993, a decrease of $2.3 million or 2.4% from table games revenues of $95.9 million in 1992. This decrease was primarily due to a reduction in table games drop (i.e., the dollar value of chips purchased) by 9.2% for the year ended December 31, 1993 from 1992, offset by an increase in the table games hold percentage to 14.9% (the percentage of table drop retained by the Partnership) for the year ended December 31, 1993 from 13.9% in 1992. The reduction in table game drop was due to the large dollar amounts wagered during 1992 by certain foreign customers. During the year ended December 31, 1993, gaming credit extended to customers was approximately 18.0% of overall table play. At December 31, 1993, gaming receivables amounted to approximately $16.0 million, with allowances for doubtful gaming receivables of approximately $10.4 million. Other revenues were $69.2 million for the year ended December 31, 1993, a decrease of $4.1 million or 5.6%, from other revenues (excluding revenues from Trump Regency) of $73.3 million in 1992. Other revenues include revenues from rooms, food and beverage and miscellaneous items. The decrease in other revenues primarily reflects a $2.1 million adjustment to the outstanding gaming chip liability in 1992, (this amount had been offset in gaming cost and expenses with a specific reserve provision for casino uncollectible accounts receivable) as well as decreases in food and beverage revenues attendant to reduced levels of gaming activity, and reduced promotional allowances. Promotional allowances were $32.8 million for the year ended December 31, 1993, a decrease of $2.1 million or 5.9%, from promotional allowances of $34.9 million in 1992. This decrease is primarily attributable to a reduction in table gaming activity as well as the Partnership's focusing its marketing efforts during the period towards patrons who tend to wager more frequently and in larger denominations. Gaming costs and expenses were $136.9 million for the year ended December 31, 1993, a decrease of $9.4 million, or 6.4%, from gaming costs and expenses of $146.3 million in 1992. This decrease was primarily due to a $4.8 million decrease in gaming bad debt expense as well as decreased promotional and operating expenses and taxes associated with decreased levels of gaming activity and revenues from 1992. Other costs and expenses were $24.8 million for the year ended December 31, 1993 an increase of $1.1 million or 4.7%, from other costs and expenses of $23.7 million in 1992. General and administrative expenses were $71.6 million for the year ended December 31, 1993, a decrease of $3.8 million, or 5.1%, from general and administrative expenses of $75.5 million in 1992. This decrease resulted primarily from a $2.4 million real estate tax charge resulting from a reassessment by local authorities of prior years' property values incurred during 1992 and overall cost reductions related to cost containment efforts. Income from operations was $49.6 million for the year ended December 31, 1993, an increase of $7.0 million or 16.4% from income from operations (excluding the operations of Trump Regency and before restructuring costs) of $42.6 million for 1992. In addition to the items described above, 1993 costs and expenses were lower as a result of the absence of the Restructuring costs and the expenses associated with the Trump Regency which were incurred in 1992. Net interest expense was $39.9 million for the year ended December 31, 1993, an increase of $8.5 million, or 27.2% from net interest expense of $31.4 million in 1992. This is attributable to the interest expense associated with the Offerings. Other non-operating expenses were $3.9 million for the year ended December 31, 1993, an increase of $2.4 million or 164.9% from non-operating expense of $1.5 million in 1992. This increase is directly attributable to costs associated with the Boardwalk Expansion Site. See "Note 7 to the Financials -- Commitments and Contingent Future Expansions." The Offerings resulted in an extraordinary gain of $4.1 million for the year ended December 31, 1993, which reflects the excess of carrying value of the Regency Hotel obligation over the amount of the settlement payment, net of related prepaid expenses. The Restructuring resulted in an extraordinary loss of $38.2 million for the year ended December 31, 1992 consisting of the effects of stating the Bonds and Preferred Stock issued at fair value and the write off of certain deferred financing charges and costs. Results Of Operations For The Year Ended December 31, 1992 and Gaming revenues were $265.4 million for the year ended December 31, 1992, an increase of $32.1 million, or 13.8%, from gaming revenues of $233.3 million in 1991. This increase in gaming revenues was primarily attributable to an increase in slot revenues which was partially offset by a decline in table game revenues. Slot revenues were $169.5 million for the year ended December 31, 1992, an increase of $35.1 million, or 26.1%, from slot revenues of $134.4 million in 1991. The Partnership believes that its improvement in slot revenues reflects its intensified slot marketing efforts directed towards patrons who tend to wager more per slot play and general growth in the industry. See "Business - Business Strategy". In addition, the Partnership elected to discontinue certain progressive slot jackpot programs, thereby reversing certain accruals into revenues which had the effect of improving slot revenue by $4.1 million for the year ended December 31, 1992. Table game revenues were $95.9 million for the year ended December 31, 1992, a decrease of $3.0 million, or 3.0%, from table game revenues of $98.9 million in 1991. While table game drop (i.e., the dollar value of chips purchased) increased 6.7% for the year ended December 31, 1992 from 1991, the decline in table game revenues was due to a decrease in the table game hold percentage (i.e., the percentage of table game drop retained by the Partnership) to 13.9% for the year ended December 31, 1992 from 15.3% in 1991. The reduction in table game hold percentage was due, in part, to the large dollar amounts wagered by a few patrons, whose individual success at the gaming tables had an impact on the overall table game hold percentage. During the year ended December 31, 1992, gaming credit extended to customers was approximately 27.8% of overall table play. At December 31, 1992, gaming receivables amounted to approximately $20.5 million, with allowances for doubtful gaming receivables of approximately $14.0 million. Other revenues (excluding revenues from Trump Regency) were $73.3 million for the year ended December 31, 1992, an increase of $6.9 million, or 10.4%, from other revenues of $66.4 million in 1991. Other revenues include revenues from rooms, food and beverage and miscellaneous items. This increase in other revenues primarily reflects increases in food and beverage revenues attendant to increased levels of gaming activity. In addition, the Partnership recognized $2.1 million in other revenues during the year ended December 31, 1992 as the result of the cancellation of outstanding chips to offset the debt of a patron who owed in excess of such amounts to the Partnership. The revenue derived from such cancellation, however, was offset by an associated increase in bad debt expense in 1992. Promotional allowances were $34.9 million for the year ended December 31, 1992, an increase of $3.4 million, or 10.8%, from promotional allowances of $31.5 million in 1991. This increase is primarily attributable to the increase in gaming activity during the period. Gaming costs and expenses were $146.3 million for the year ended December 31, 1992, an increase of $12.8 million, or 9.6%, from gaming costs and expenses of $133.5 million in 1991. This increase was primarily due to increased promotional and operating expenses associated with increased slot revenues, increased taxes and increased regulatory expenses. Gaming costs and expenses also increased due to the $2.1 million increase in bad debt expense referred to above. Other costs and expenses were $23.7 million for the year ended December 31, 1992, an increase of $0.3 million, or 1.3%, from other costs and expenses of $23.4 million in 1991. General and administrative expenses were $75.5 million for the year ended December 31, 1992, an increase of $5.9 million, or 8.5%, from general and administrative expenses of $69.6 million in 1991. This increase resulted primarily from a $2.4 million increase in real estate taxes arising from a reassessment by local authorities of prior years property values, as well as increased property insurance and other costs associated with maintaining Trump Plaza. In connection with the Restructuring, the Partnership incurred $5.2 million of non-recurring costs for the year ended December 31, 1992, comprised of professional fees and other costs and expenses of the Restructuring. Pursuant to the terms of the Restructuring, the Partnership ceased operating Trump Regency as of September 30, 1992. For the year ended December 31, 1992, the Partnership realized a net loss of $2.4 million from the operation of Trump Regency, compared to the net loss of $8.3 million in 1991. See "Certain Relationships and Related Transactions." Income from operations (excluding the operations of Trump Regency and before restructuring costs) was $42.6 million for the year ended December 31, 1992, an increase of $17.2 million, or 67.7%, from income from operations of $25.4 million in 1991. Net interest expense was $31.4 million for the year ended December 31, 1992, a decrease of $2.0 million, or 6.0%, from net interest expense of $33.4 million in 1991. The Restructuring resulted in an extraordinary loss of $38.2 million for the year ended December 31, 1992, which reflects a $32.8 million accounting adjustment to carry the Bonds and Preferred Stock issued in the Restructuring on the Partnership's balance sheet at fair market value based upon then current rates of interest. The Partnership also wrote-off certain deferred financing charges and costs of $5.4 million. Net loss was $35.8 million for the year ended December 31, 1992, and increase of $6.6 million, or 22.6%, from the net loss of $29.2 million in 1991. Liquidity and Capital Resources The Partnership. Cash flow from operating activities is the Partnership's principal source of liquidity. For the year ended December 31, 1993, net cash from operating activities was $18.5 million. On June 25, 1993, the date of consummation of the Offerings, the Partnership paid accrued interest on the Bonds. Interest on the Bonds was payable semi-annually on March 15 and September 15, while interest on the Mortgage Notes is payable semi-annually on each June 15 and December 15, commencing December 15, 1993. The decrease of $7.7 million in net cash provided by operating activities as compared to 1992 reflects the aforementioned changes in payments of accrued interest on the Bonds. Capital expenditures of $10.1 million for the year ended December 31, 1993 increased approximately $1.4 million from 1992, and was primarily due to the refurbishment of the casino floor (including new carpeting), the purchase of additional slot machines, the construction of an electronic graphic sign adjacent to the transportation facility and demolition and refurbishing costs associated with the Boardwalk Expansion Site. These expenditures were financed from funds generated from operations. The Boardwalk Expansion (as described below), may require additional borrowings. Capital expenditures for 1992, and 1991 were $8.6 million and $5.5 million, respectively. Previously, the Partnership provided for significant capital expenditures which concentrated on the construction of the Transportation Facility and the renovation of certain restaurants, hotel rooms and the hotel lobby. See "Business -- Facilities and Amenities." At December 31, 1993, the Partnership had a combined working capital deficit totalling $1.5 million, compared to a working capital deficit of $18.2 million at December 31, 1992. In 1993, the Partnership received the approval of the CCC, subject to certain conditions, for the Expansion of its hotel facilities on the Boardwalk Expansion Site upon which there is located an approximately 361-room hotel, which is closed to the public and in need of substantial renovation and repair. On June 25, 1993, the date the Offerings were consummated, Trump transferred title to the Boardwalk Expansion Site to a lender in exchange for a reduction in Trump's indebtedness to such lender in an amount equal to the sum of fair market value of the Boardwalk Expansion Site and all rent payments made to such lender by Trump under the Boardwalk Expansion Site Lease (as defined below). On the date the Offerings were consummated, the lender leased the Boardwalk Expansion Site to Trump for a term of five years, which expires on June 30, 1998, during which time Trump will be obligated to pay the lender $260,000 per month in lease payments. In October 1993, the Partnership assumed the Boardwalk Expansion Site Lease and related expenses. In connection with the Offerings, the Partnership acquired a five-year option to purchase the Boardwalk Expansion Site. Until such time as the Option is exercised or expires, the Partnership will be obligated, from and after the date it entered into the Option, to pay the net expenses associated with the Boardwalk Expansion Site, including, without limitation, current real estate taxes (approximately $1.2 million per year based upon current assessed valuation), $66,000 per month until January 1, 1995 in respect of past due taxes and annual lease payments for the portion of the Boardwalk Expansion Site currently leased by the Partnership from a third party, which lease payments were $86,058 for 1993 and $83,500 for 1992, and increase annually based on the consumer price index. In addition, net expenses include the costs of demolishing certain structures situated on the Boardwalk Expansion Site at a cost of approximately $1.5 million, the redemption in November 1993 of $496,000 in tax sale certificates issued to third parties and $100,000 in annual insurance expense. Under the Option, the Partnership has the right to acquire the Boardwalk Expansion Site for a purchase price of $26.0 million through 1994, increasing by $1.0 million annually thereafter until expiration on June 30, 1998. In addition, the Partnership has a right of first refusal upon any proposed sale of all or any portion of the Boardwalk Expansion Site during the term of the Option. Trump, individually, also has been granted by such lender a right of first refusal upon a proposed sale of all or any portion of the Boardwalk Expansion Site. Trump, has agreed with the Partnership that his right of first refusal will be subject to the Partnership's prior exercise of its right of first refusal (with any decision of the Partnership requiring the approval of the Independent Directors of the Company, acting as the managing general partner of the Partnership). Acquisition of the Boardwalk Expansion Site by the Partnership would under certain circumstances (provided there are no events of default under the Boardwalk Expansion Site Lease or the Option and provided that certain other events had not theretofore or do not thereafter occur) discharge Trump's obligation to such lender in full. Under the terms of the Option, if the Partnership defaults in making payments due under the Option, the Partnership would be liable to the lender for the sum of (a) the present value of all remaining payments to be made by the Partnership pursuant to the Option during the term thereof and (b) the cost of demolition of all improvements then located on the Boardwalk Expansion Site. The Partnership's ability to acquire the Boardwalk Expansion Site pursuant to the Option would be dependent upon its ability to obtain financing to acquire the property. The ability to incur such indebtedness is restricted by the Mortgage Note Indenture and the PIK Note Indenture and requires the consent of certain of Trump's personal creditors. The Partnership's ability to develop the Boardwalk Expansion Site would be dependent upon its ability to use existing cash on hand and generate cash flow from operations sufficient to fund development costs. No assurance can be given that such cash on hand will be available to the Partnership for such purposes or that it will be able to generate sufficient cash flow from operations. In addition, exercise of the Option or the right of first refusal requires the consent of certain of Trump's personal creditors, and there can be no assurance that such consent will be obtained at the time the Partnership desires to exercise the Option or such right. The CCC has required that the Partnership exercise the Option or its right of first refusal therein no later than July 1, 1995. Management has determined to build or refurbish rooms at the Boardwalk Expansion Site. As a result of such expansion, the Partnership will be permitted to increase Trump Plaza's casino floor space by 30,000 square feet. The Partnership plans to add approximately 10,000 square feet in April, 1994 with an additional 5,000 square feet in June, 1994 and 10,000 square feet planned to open in April, 1995. The 5,000 remaining allowable square feet will be added as patron demand warrants. The Partnership has begun construction at such site pursuant to rights granted to the Partnership by the lender under the Boardwalk Expansion Site Lease. Pursuant to the terms of certain personal indebtedness of Trump, the Partnership is restricted from expending more than $15.0 million less any CRDA tax credits for improvements at the Boardwalk Expansion Site prior to such time as it exercises the Option. The Partnership has received approximately $294,000 in CRDA credit as of December 31, 1993. The Partnership's ability to exercise the Option will be restricted by, among other things, the Mortgage Note Indenture, the PIK Note Indenture and the terms of certain indebtedness of Trump, and would require the approval of the CCC. Management does not currently anticipate that it will be in a position to exercise the Option to acquire such site prior to 1995 due, in part, to limitations on its ability to incur additional indebtedness. If the Partnership is unable to finance the purchase price of the Boardwalk Expansion Site pursuant to the Option, any amounts expended with respect to the Boardwalk Expansion Site, including payments under the Option and the Boardwalk Expansion Site lease, if assumed, and any improvements thereon would inure to the benefit of the owner of the Boardwalk Expansion Site and not to the Partnership. In such event, the Partnership might have to close all or a portion of the expanded casino in order to comply with regulatory requirements, which could have a material adverse effect on the results of operations and financial condition of the Partnership. As of December 31, 1993, the Partnership had expended approximately $2.7 million in construction costs related to the Boardwalk Expansion Site. Pursuant to the terms of the Partnership Agreement, prior to amendment on June 25, 1993, the date of the consummation of the Offerings, which eliminated such distribution requirements, the Partnership was required to make certain periodic distributions to the Company and Trump sufficient to pay taxes attributable to distributions received from the Partnership, any amounts required to be paid to directors as fees or pursuant to indemnification obligations, premiums on directors' and officers' liability insurance and other reasonable general and administrative expenses. The Partnership was also required to distribute to the Company, to the extent of cash available therefrom, funds sufficient to enable the Company to pay dividends on, and the redemption price of its Stock Units. For the year ended December 31, 1993, such distributions were approximately $6.3 million. Pursuant to the terms of a Services Agreement with Trump Plaza Management Corp. ("TPM"), a corporation beneficially owned by Trump, in consideration for services provided, the Partnership pays TPM each year an annual fee of $1.0 million in equal monthly installments, and reimburses TPM on a monthly basis for all reasonable out-of-pocket expenses incurred by TPM in performing its obligations under the Services Agreement, up to certain amounts. Under this Agreement, approximately $1.2 million was charged to expense for the year ended December 31, 1993. The Mortgage Note Indenture and the PIK Note Indenture restrict the ability of the Partnership to make distributions to its partners, including restrictions relating to the achievement of certain financial ratios. Subject to the satisfaction of these restrictions, the Partnership may make distributions to its partners with respect to their partnership interests. The Company. The Company's sole source of liquidity is, and will be, payments made by the Partnership in respect of the Partnership Note securing the Company's indebtedness, and distributions from the Partnership, if any, in respect of its Partnership interest. Holding. Holding has no business operations other than that associated with holding its partnership interest in the Partnership and as issuer of the PIK Notes and Warrants. Holding's sole source of liquidity is from distributions in respect of its interest in the Partnership. Prior to the Units Offering, Holding did not have any long-term or short-term indebtedness; upon consummation of the Units Offering on June 25, 1993, Holding issued $72.0 million of indebtedness comprised of $60.0 million of PIK Notes and $12.0 million of deferred warrant obligations. Holding's indebtedness will increase upon exercise of the Warrants and upon the issuance of additional PIK Notes in lieu of cash interest paid on the PIK Notes. On December 15, 1993, the Partnership elected to issue in lieu of cash, an additional $3.6 million in PIK Notes to satisfy its semi-annual PIK Note interest obligation. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. An index to the financial statements and required financial statement schedules is set forth at Item 14. ITEM 9.

ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS. Management Prior to the merger of TP/GP into the Company, management of the affairs of the Partnership was vested in TP/GP. As of June 18, 1993, the date of such merger, the Company became the managing partner of the Partnership. As of such date, the Company was granted full authority to do all things deemed necessary or desirable of the operations, business and affairs of the Partnership. As currently constituted, the Board of Directors of the Company consists of Messrs. Trump, Nicholas L. Ribis, Jay Kramer and Don M. Thomas. As currently constituted, the board of directors of Holding Inc. consists of Messrs. Trump, Ribis, Ernest E. East, Kramer and Thomas. In addition, Holding Inc. acts as the managing partner of Holding. Trump is currently the sole beneficial owner of the Partnership, the Company, Holding and Holding Inc. Pursuant to the PIK Notes Indenture and the Mortgage Notes Indenture, the Company and Holding Inc. are each required to have at least two Independent Directors (as such term is defined by the American Stock Exchange, Inc.). The prior approval of the majority of the Company's Independent Directors will be required before the Partnership can engage in certain affiliate transactions. Set forth below, are the names, ages, positions and offices held with the Company, Holding and the Partnership and a brief account of the business experience during the past five years of each member of the Board of Directors and the executive officers of the Company, Holding and the Partnership. Donald J. Trump - Mr. Trump, 47 years old, has been a general partner of the Partnership and a 100% shareholder, director, Chairman of the Board of Directors, President and Treasurer of the Company, the managing general partner of the Partnership. Prior to the consummation of the Offerings, Trump was a 50% shareholder, director, Chairman of the Board of Directors, President and Treasurer of TP/GP. Trump was President and sole director of the Company from May 1986 to May 1992; and Chairman of the executive committee and President of the Partnership from May 1986 to May 1992. Trump has been Chairman of the Board of Partner Representatives of Trump's Castle Associates, the partnership that owns Trump's Castle ("TCA"), since May 1992; and was Chairman of the executive committee of TCA, from June 1985 to May 1992. Trump was Chairman of the executive committee of Trump Taj Mahal Associates, the partnership that owns the Taj Mahal ("TTMA"), from June 1988 to October 1991; and has been Chairman of the board of directors of the managing general partner of TTMA since October 1991; President and sole director of Trump Boardwalk since May 1986; and President of the Trump Organization, which has been in the business, through its affiliates and subsidiaries, of acquiring, developing and managing real estate properties for more than the past five years. Trump was a member of the board of directors of Alexander's Inc. from 1987 to March 1992. Nicholas L. Ribis - Mr. Ribis, 49 years old, has been the Chief Executive Officer of the Partnership since February 1991 and a member of the Executive Committee of the Partnership from April 1991 to May 29, 1992 and was a director and Vice President of TP/GP from May 1992 until its merger into the Company in June 1993. Mr. Ribis serves as the Chairman of the Atlantic City Casino Association. He has also been Chief Executive Officer of TCA and TTMA since March 1991; member of the executive committee of TCA from April 1991 to May 1992; member of the Board of Partner Representatives of TCA since May 1992; member of the executive committee of TTMA from April 1991 to October 1991; and member of the board of directors of the managing general partner of TTMA since October 1991. From January 1980 to January 1991, Mr. Ribis was Senior Partner in, and since February 1991, is Counsel to, the law firm of Ribis, Graham & Curtin, which serves as New Jersey legal counsel to all of the above-named companies, and certain of their affiliated entities, including the Company. Kevin DeSanctis - Mr. DeSanctis, 41 years old, was President of the Company from March 1991 until March 7, 1994 and was Chief Financial Officer of the Company from May to July 1992. Mr. DeSanctis was a director of TP/GP from May 29, 1992 until TP/GP's merger into the Company in June 1993 and has been President and Chief Operating Officer of the Partnership since March 1991. From August 1989 to February 1991, Mr. DeSanctis served as Vice President of Casino Operations of the Mirage Hotel and Casino in Las Vegas, Nevada. Mr. DeSanctis previously served as Vice President of Casino Operations of the Golden Nugget Hotel and Casino from April 1989 to August 1989; Senior Vice President of Casino Operations of Clark Management Company (d/b/a Dunes Hotel/Casino) from January 1988 to April 1989; Senior Vice President/Director of Casino Operations of the Aladdin Hotel & Casino from March 1987 to November 1987; Vice President/Director of Casino Operations of the Flamingo Hilton from January 1986 to February 1987 and in various other positions within the Las Vegas gaming industry prior thereto. William Velardo - Mr. Velardo, 39 years old, has been the acting Chief Operating Officer of the Company since March 7, 1994 and, prior thereto, was Vice President of Casino Operations of the Partnership since May 1991. Mr. Velardo served as an Administrative Assistant of the Partnership from March 1991 until receiving licensure in the position of Vice President of Casino Operations. From November 1989 to March 1991, Mr. Velardo served as Casino Manager at the Mirage Hotel and Casino in Las Vegas. Prior to his position at the Mirage, Mr. Velardo served in a variety of casino management positions for over 13 years, 11 of which were with Caesars Palace and Caesars Tahoe. Ernest E. East - Mr. East, 51 years old, was Secretary of TP/GP from May 1992 until its merger into the Company in June 1993 and has been Secretary of the Company since July 1992; Senior Vice President-Administrative and Corporate Affairs of the Partnership since July 1991; and Senior Vice President- Administrative and Corporate Affairs of TCA and TTMA since July 1991; member of the Board of Partner Representatives of TCA since May 1992; member of the board of directors of the managing general partner of TTMA since October 1991. Mr. East was formerly the Vice President-General Counsel of the Del Webb Corporation from January 1984 through June 1991. Jay Kramer - Mr. Kramer, 76 years old, is an attorney and labor relations specialist. Mr. Kramer was a Commissioner and Chairman of the New York Sate Labor Relations Board from 1954 through 1976, under five governors. Mr. Kramer was a director of TP/GP until its merger into the Company in June 1993 and has been a director of the Company since June 1993. Mr. Kramer served as a member of the Audit Committee of TTMA from July 1990 through October 1991, and as a member of the Audit Committee of TCA and the Partnership from August 1986 through May 1992. In 1981 and 1982, Mr. Kramer served as director, audit committee member and sole stockholder of Claridge Management Corporation, an entity formed to act as the managing general partner of Claridge Casino pending the licensing of the owner of such casino by the CCC. Mr. Kramer has been the impartial chairman (the automatic arbitrator of all disputes) in many industries, including the National Building Trade Congress, the fur industry, the pharmaceuticals industry, the deep sea tanker industry, Three Mile Island and numerous others. Don M. Thomas - Mr. Thomas, 62 years old, has been the Senior Vice President of Corporate Affairs of the Pepsi-Cola Bottling Co. of New York since January 1985. Mr. Thomas was the Acting Chairman, and a Commissioner, of the CRDA from 1985 through 1987, and a Commissioner of the CCC from 1980 through 1984. From 1974 through 1980, Mr. Thomas served as Vice President, General Counsel of the National Urban League. From 1966 through 1974, Mr. Thomas served in various capacities with Chrysler Corporation rising to the level of President-Auto Dealerships. Mr. Thomas was an attorney with American Airlines from 1957 through 1966. Mr. Thomas was a director of TP/GP until its merger into the Company in June 1993 and has been a director of the Company since June 1993. Mr. Thomas is an attorney licensed to practice law in the State of New York. Mitchell G. Etess - Mr. Etess, 36 years old, has been Senior Vice President of Marketing of the Partnership since December 1991 and Advertising Manager and Public Relations Manager of the Partnership's predecessor from December 1988 to December 1991. From January 1988 to December 1988, Mr. Etess was a vice president of the advertising agency of Gordon, Etess & Associates in Pinehurst, North Carolina. Mr. Etess was General Manager of the Holly Inn in Pinehurst, North Carolina from November 1986 to November 1987; Associate Manager of Club Corp. of America in Traverse City, Michigan from May 1986 to November 1986, and Manager of Grossinger's Hotel in New York from February 1985 to November 1985. Francis X. McCarthy, Jr. - Mr. McCarthy, 41 years old, was Vice President of Finance and Accounting of TP/GP from October 1992 until June 1993, the date of TP/GP's merger into the Company, and has been Senior Vice President of Finance and Administration of the Partnership since August 1990; Chief Accounting Officer of the Company since May 1992; Vice President and Chief Financial Officer of the Company since July 1992 and Assistant Treasurer of the Company since March 1991. Mr. McCarthy previously served in a variety of financial positions for Greater-Bay Hotel and Casino, Inc. from June 1980 through August 1990. John P. Burke - Mr. Burke, 46 years old, has been corporate treasurer of the Partnership since October 1991; corporate treasurer of TCA since October 1991; Vice President of The Trump Organization since September 1990; and member of the board of directors of TTMA since October 1991. Mr. Burke was an Executive Vice President and Chief Administrative Officer of Imperial Corporation of America from April 1989 through September 1990. From May 1980 through April 1989, Mr. Burke was Executive Vice President and Chief Financial Officer of Tamco Enterprises, Inc. Robert M. Pickus - Mr. Pickus, 38 years old, has been Vice President and General Counsel of the Partnership since December 1993 and was Senior Vice President and General Counsel of TCA, Secretary of Trump's Castle Funding, Inc. from June 1988 until December 1993 and General Counsel of TCA from June 1985 to June 1988. Mr. Pickus was also Secretary of Trump's Castle Hotel & Casino, Inc., an entity beneficially owned by Trump, from October 1991 until December 1993. Patricia M. Wild - Ms. Wild, 41 years old, was Assistant Secretary of the Company and Vice President and General Counsel of the Partnership from February 1991 until December 1993; Vice President and General Counsel of the Company from July 1992 until December 1993; and Associate General Counsel of the Partnership from May 1989 through January 1991. From December 1986 to April 1989, Ms. Wild served as a Deputy Attorney General on the Environmental Prosecutions Task Force of the New Jersey Department of Law and Public Safety, Division of Criminal Justice. From April 1983 to December 1986, Ms. Wild served as Deputy Attorney General with the New Jersey Division of Gaming Enforcement. All of the persons listed above have been qualified or licensed by the CCC. The employees of the Partnership serve at the pleasure of the Company, the managing general partner of the Partnership, subject to any contractual rights contained in any employment agreement. The officers of the Company serve at the pleasure of the Board of Directors of the Company. The officers of Holding Inc. serve at the pleasure of the board of directors of that company. Donald J. Trump, Nicholas L. Ribis and Ernest E. East served as either executive officers and/or directors of TTMA and its affiliated entities when such parties filed their petition for reorganization under chapter 11 of the Bankruptcy Code on July 17, 1991. The Second Amended Joint Plan of Reorganization of such parties was confirmed on August 28, 1991, and was declared effective on October 4, 1991. Donald J. Trump, Nicholas L. Ribis, Ernest E. East and John P. Burke also served as executive committee members, officers, and/or directors of TCA and its affiliated entities, at the time such parties filed a petition for reorganization under chapter 11 of the Bankruptcy Code on March 9, 1992. The First Amended Joint Plan of Reorganization of such parties was confirmed on May 5, 1992, and declared effective on May 29, 1992. Donald J. Trump, Nicholas L. Ribis, Ernest E. East and John P. Burke served as either executive officers and/or directors of the Partnership and its affiliated entities when such parties filed their petition for reorganization under chapter 11 of the Bankruptcy Code in March 1992. The First Amended Joint Plan of Reorganization of such parties was confirmed on April 30, 1992, and was declared effective on May 29, 1992. Trump was a partner of Plaza Operating Partners Ltd. when it filed a petition for reorganization under chapter 11 of the Bankruptcy Code on November 2, 1992. The plan of reorganization for Plaza Operating Partners Ltd. was confirmed on December 11, 1992 and declared effective in January 1993. John P. Burke was Executive Vice President and Chief Administrative Officer of Imperial Corporation of America ("Imperial"), a thrift holding company whose major subsidiary, Imperial Savings, was seized by the Resolution Trust Corporation in February 1990. Subsequently, in February 1990, Imperial filed a petition for reorganization under chapter 11 of the Bankruptcy Code. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. Compensation Holding, the Company and the Partnership do not offer their executive officers stock option or stock appreciation right plans, long-term incentive plans or defined benefit pension plans. The following table sets forth compensation paid or accrued during the years ended December 31, 1993, 1992 and 1991 to the Chief Executive Officer and each of the four most highly compensated executive officers of the Partnership whose cash compensation, including bonuses and deferred compensation, exceeded $100,000 for the year ended December 31, 1993. Executive Officers of the Company do not receive any additional compensation for serving in such capacity. Compensation accrued during one year and paid in another is recorded under the year of accrual. Information relating to long-term compensation is inapplicable and has therefore been omitted from the table. - ----------- (1) Represents the dollar value of annual compensation not properly categorized as salary or bonus, including amounts reimbursed for income taxes and director's fees. Following SEC rules, perquisites and other personal benefits are not included in this table if the aggregate amount of that compensation is the lesser of either $50,000 or 10% of the total of salary and bonus for that officer. (2) Represents vested and unvested contributions made by the Partnership under the Trump Plaza Hotel and Casino Retirement Savings Plan. Funds accumulated for an employee, which consist of a certain percentage of the employee's compensation plus Partnership contributions equalling 50% of the participant's contributions, are retained until termination of employment, attainment of age 59 1/2 or financial hardship, at which time the employee may withdraw his or her vested funds. (3) Mr. Ribis devotes approximately one-third of his professional time to the affairs of the Partnership. Mr. Ribis is also employed as the chief executive officer of the Other Trump Casinos; his compensation from the Other Trump Casinos is not included in the table. (4) Mr. DeSanctis resigned from all of his positions with the Company on March 7, 1994. (5) Mr. Velardo has been serving as acting Chief Operating Officer since March 7, 1994. Employment Agreements The Partnership has an employment agreement with Nicholas L. Ribis pursuant to which Mr. Ribis acts as Chief Executive Officer of the Partnership. The agreement, which expires in September 1996, provides for an annual salary of $550,000. The salary increases by ten percent for each of the second and third years of the agreement. Upon execution of the employment agreement, Mr. Ribis received a $250,000 signing bonus. In the event the Partnership, or any entity which acquires substantially all of the equity interests or assets of the Partnership, proposes to engage in an offering of common shares to the public, the Partnership and Mr. Ribis have agreed to negotiate new compensation arrangements which shall include equity participation for Mr. Ribis. Mr. Ribis is also chief executive officer of TTMA and TCA, the partnerships that own the Other Trump Casinos, and receives compensation from such entities for such services. Mr. Ribis devotes approximately one-third of his professional time to the affairs of the Partnership. All other executive officers of the Partnership, except Messrs. East and Burke, devote substantially all of their time to the business of the Partnership. The Partnership had an employment agreement with Kevin DeSanctis, former President and Chief Operating Officer of Trump Plaza. The agreement was terminated upon the resignation of Mr. DeSanctis. Mr. DeSanctis received $205,000 of salary in 1994. The Partnership has an employment agreement with Ernest E. East, Esq., who is Senior Vice President of Administration and Corporate Affairs of the Partnership. The agreement, which expires in June 1995, provides for an annual salary of $100,000. Mr. East also has similar employment agreements with each of TTMA and TCA. Mr. East devotes approximately one-third of his professional time to the affairs of the Partnership. The Partnership had an employment agreement with William Velardo, who until March 7, 1994 was the Vice President of Casino Operations of the Partnership. That agreement expired on March 12, 1994. The Partnership has not yet negotiated a separate employment agreement with Mr. Velardo, who, as of March 7, 1994, has been the acting Chief Operating Officer of the Company. The Partnership has a severance agreement with Robert M. Pickus, Esq., who is the Vice President/General Counsel of the Partnership. The agreement provides that upon Mr. Pickus' termination other than for cause (as defined in the agreement) or loss of his casino key employee license from CCC, the Partnership will pay Mr. Pickus a severance payment equal to the amount of his salary at its then current rate for a period of one year, which is anticipated to be in excess of $150,000. All of the above agreements provide for discretionary bonuses and/or signing bonuses. Compensation of Directors Each director of the Company, receives an annual fee of $50,000 and $2,000 per meeting attended, plus reasonable out-of-pocket expenses incurred in attending any meeting of the Board of Directors of the Company. Each director of TP/GP, other than Trump, received an annual fee of $50,000 and $2,000 per meeting attended, plus reasonable out-of-pocket expenses incurred in attending any meeting of the board of directors of TP/GP. In addition, each member of the TP/GP Audit Committee received a fee of $1,500 for each meeting attended. Upon consummation of the PIK Notes Offerings, all members of the board of directors of Holding Inc., other than Trump, received an annual fee of $50,000 and a fee of $2,000 per meeting attended, plus reasonable out-of-pocket expenses incurred in attending any meeting of the Board. Such fees were paid to persons who also act as officers or employees of the Partnership. Compensation Committee Interlocks and Insider Participation Holding does not have a compensation committee and its officers serve without separate compensation. In general, the compensation of executive officers of the Partnership is determined by the Board of Directors of the Company, composed of Donald J. Trump, Nicholas L. Ribis, Jay Kramer and Don M. Thomas. The compensation of Nicholas L. Ribis and Kevin DeSanctis is set forth in their employment agreements with the Partnership, pursuant to which the Partnership has delegated the responsibility over certain matters, such as bonuses, to Trump. See "Employment Agreements" above. No officer or employee of Trump Plaza, other than Messrs. Ribis and DeSanctis, who serve on the Board of Directors of the Company, participated in the deliberations of the Board of Directors of the Company concerning executive compensation. Executive officers of the Company do not receive any additional compensation for serving in such capacity. The SEC requires issuers to disclose the existence of any other corporation in which both (i) an executive officer of the registrant serves on the board of directors and/or compensation committee, and (ii) a director of the registrant serves as an executive officer. Messrs. Ribis, East and Burke, executive officers of the Partnership, have served on the board of directors of other entities in which members of the Board of Directors of the Company and TP/GP (namely, Messrs. Trump and Ribis) served and continue to serve as executive officers. Management believes that such relationships have not affected the compensation decisions made by the Board of Directors of the Company and TP/GP in the last fiscal year. Messrs. Ribis, East and Burke serve on the board of directors of Taj Mahal Holding Corp., which holds an indirect equity interest in TTMA, the partnership that owns the Taj Mahal, of which Messrs. Trump and Ribis are executive officers. Such persons also serve on the board of directors of TM/GP Corporation (a subsidiary of Taj Mahal Holding Corp.), the managing general partner of TTMA, of which Messrs. Trump and Ribis are executive officers. Mr. Ribis is compensated by TTMA for his services as its chief executive officer; Mr. East is compensated by TTMA for his services as its vice president. Mr. Ribis also serves on the board of directors of Trump Taj Mahal Realty Corp. ("Taj Realty Corp."), which leases certain real property to TTMA, of which Trump is an executive officer. Trump, however, does not receive any compensation for serving as an executive officer of Taj Realty Corp. Mr. East also serves on the Board of Partner Representatives of TCA, the partnership that owns Trump's Castle, of which Messrs. Trump and Ribis are executive officers. Mr. Ribis receives compensation from TCA for acting as its chief executive officer. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Trump has owned 100% of the Common Stock since June 25, 1993. Trump has sole voting and investment power regarding the Common Stock owned by him. In connection with the PIK Note Offering which was consummated on June 25, 1993, TP/GP was merged with and into the Company, and the Company became the managing general partner of the Partnership. Trump contributed his interest in the Partnership to Holding, which is beneficially-owned by Trump. Since such date, the Company and Holding have been the sole partners in the Partnership. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Although the Partnership has not fully considered all of the areas in which it intends to engage in transactions with affiliates of the partners, it is free to do so, subject to certain restrictions. Payments to affiliates in connection with any such transactions are governed by the provisions of the Mortgage Note Indenture and the PIK Note Indenture which generally require that such transactions be on terms as favorable to the Partnership as would be obtainable from an unaffiliated party, and requires the approval of a majority of the Independent Directors of the Company for certain affiliated transactions. The Partnership has engaged in some limited intercompany transactions with TCA and TTMA. The Partnership utilized TCA's print shop operations (until it closed in February 1991) and utilized its fleet maintenance and limousine services until April 1991. The Partnership paid TCA approximately $317,000 in 1991 and paid to TTMA approximately $1,000, $242,000 and $0 in 1993, 1992 and 1991, respectively, for fleet maintenance and limousine services. In the future the Partnership may be required to make payments to TTMA for the continued use of its limousine bays. Payments made by the Partnership to TCA for services provided by its print shop approximated $4,000 in 1991. The Partnership also has joint property insurance coverage with TCA and TTMA for which the annual premium paid by the Partnership was $251,000 for the twelve months ended May 1993. The Partnership also leases from TTMA certain office facilities located in Pleasantville, New Jersey. In 1993, 1992 and 1991, lease payments by the Partnership to TTMA totalled approximately $30,000, $138,000 and $98,000, respectively, and to TCA (the former owner of such facility) totalled approximately $42,000 in 1991. In 1990, lease payments for such leases to TCA totalled approximately $135,000. Such lease terminated on March 19, 1993, and the Partnership vacated the premises. Through February 1, 1993, the Partnership also leased from Trump approximately 120 parking spaces at the Penthouse Site for approximately $5.50 per parking space per day, with payments under such arrangement for the year ended December 31, 1993 and December 31, 1992 totalling $21,000 and $227,000 respectively. The Partnership also leased portions of its warehouse facility located in Egg Harbor Township, New Jersey to TTMA until 1991. Lease payments by TTMA to the Partnership totalled $46,000 and $23,000 in 1991 and 1990, respectively. The Partnership also leased such warehouse to TCA until January 31, 1994; lease payments by TCA to the Partnership totalled $15,000, $14,000, and $18,000 in 1993, 1992 and 1991, respectively. Until January 1991, Helicopter Air Services, Inc. (d/b/a Trump Air) ("Trump Air"), a Delaware corporation wholly-owned by Trump, provided regularly scheduled helicopter services to the public between New York City and Atlantic City. In addition, the Partnership provided complimentary carriage to certain patrons of Trump Plaza on an Aerospatiale Super Puma helicopter that was operated by Trump Air and owned by another corporation that is wholly-owned by Trump. Trump Air was reimbursed by the Partnership for its actual costs and expenses incurred in rendering helicopter services provided by the Super Puma. All other helicopter services provided by Trump Air to patrons of Trump Plaza were paid for by the Partnership at Trump Air's prevailing ticket rates. In 1990, the Partnership paid Trump Air approximately $231,000 for air services provided to patrons of Trump Plaza. Trump and Trump Boardwalk collectively own 100% of the interests in Seashore Four. Seashore Four is the fee owner of a parcel of land constituting a portion of the Casino Parcel, which it leases to the Partnership pursuant to the SFA Lease, a long-term, triple-net lease. Seashore Four was assigned the lessor's interest in the existing SFA Lease in connection with its acquisition of fee title to such parcel from a non-affiliated third party in November 1983. The SFA Lease was entered into by the Partnership with such third party on an arm's-length basis. The Partnership recorded rental expenses of approximately $900,000, $900,000 and $900,000 in 1993, 1992 and 1991, respectively, concerning rent owed to Seashore Four. Trump and Trump Seashore Associates, Inc. collectively own 100% of the interests in Trump Seashore Associates ("Trump Seashore"). Trump Seashore is the fee owner of a parcel of land constituting a portion of the Casino Parcel, which it leases to the Partnership pursuant to the Trump Seashore Lease, a long-term, triple-net lease. In July 1988, Trump Seashore exercised a $10 million option to purchase the fee title to such parcel from a non-affiliated third party. In connection therewith, Trump Seashore was assigned the lessors' interest in the Trump Seashore Lease, which interest has, however, been transferred to UST. See "Properties." The Partnership paid rental payments to Trump Seashore of approximately $1.0 million, $1.0 million and $1.1 million in 1993, 1992 and 1991, respectively. The Partnership has separately agreed to reimburse Trump for any payments which he may make under (i) a note (the "Harrah's Note") for which Trump and the Partnership are co-makers and which constitutes part of the redemption price for Harrah's Atlantic City, Inc.'s ("HAC") prior interests in the Partnership and Seashore Four, which were redeemed in 1986, pursuant to a Redemption Agreement dated as of March 11, 1986; and (ii) his or Trump Boardwalk's indemnity of HAC under the Redemption Agreement, insofar as it relates to the Partnership. Trump and Trump Boardwalk have agreed to assign to the Partnership any payment either receives pursuant to HAC's and The Promus Companies Incorporated's (HAC's parent corporation) indemnity, insofar as it relates to the Partnership. The Harrah's Note was repaid on May 16, 1993. Prior to the consummation of the Offerings, the board of directors of TP/GP authorized the Partnership to lease, on a per diem basis, certain real property in Florida owned by Trump, known as "Mar-a-lago," to entertain certain patrons of Trump Plaza. To date, the Partnership has not leased Mar-a-lago, and the Partnership currently has no specific plans to lease Mar-a-lago in the future; nevertheless, the Partnership may enter into such arrangements in the future. In May of 1991, the Partnership entered into a lease with Atlantic City Explorers Club of which Hugh B. McCluskey, a former partner of the law firm of Ribis, Graham & Curtin, is President, whereby the Partnership leased certain property in Atlantic City for $60,000.00 per annum. Nicholas L. Ribis, the Chief Executive Officer of the Partnership, is Of Counsel to such law firm. The lease was terminated in January 1993. Trump Regency. In June 1989, Trump Crystal Tower Associates Limited Partnership, a New Jersey limited partnership wholly-owned by Trump, acquired from Elsinore Shore Associates all of the assets constituting the former Atlantis casino hotel, which is located on The Boardwalk adjacent to the Atlantic City Convention Center on the opposite side from Trump Plaza. Prior to such acquisition, all of the Atlantis' gaming operations were discontinued. The facility was renamed the Trump Regency Hotel and leased to the Partnership, which operated it solely as a non-casino hotel. As part of the Restructuring, the lease was terminated and the Partnership issued to Chemical Bank ("Chemical"), the assignee of rents payable under such lease, a promissory note in the original principal amount of $17.5 million (the "Regency Note"). At such time, title to the Trump Regency was transferred by Trump to ACFH Inc. ("ACFH"), a wholly owned subsidiary of Chemical. Since that time, the Trump Regency has been operated by ACFH as a non-casino hotel. The Partnership repaid the Regency Note with a portion of the proceeds of the Offerings. In December 1993, Trump entered into an option agreement (the "Chemical Option Agreement") with Chemical and ACFH. The Chemical Option Agreement grants to Trump an option to purchase (i) the Trump Regency (including the land, improvements and personal property used in the operation of the hotel) and (ii) certain promissory notes made by Trump and/or certain of his affiliates and payable to Chemical (the "Chemical Notes") which are secured by certain real estate assets located in New York, unrelated to Trump Plaza. As of December 31, 1993, the aggregate amount owed by Trump and his affiliates under the Chemical Notes (none of which constitutes an obligation of Plaza Associates) was approximately $65 million. The aggregate purchase price payable for the assets subject to the Chemical Option Agreement is $80 million. Under the terms of the Chemical Option Agreement, $1 million was required to be paid for the option by January 5, 1994. The option expires on May 6, 1994, provided that the option may be extended until June 30, 1994 by the payment of an additional $250,000 on or before that date. The $1 million payment (and the $250,000 payment, if made) may be credited against the $80 million purchase price. The Chemical Option Agreement does not allocate the purchase price among the assets subject to the option or permit the option to be exercised for some, but not all, of such assets. In connection with the execution of the Chemical Option Agreement, Trump agreed with the Partnership that, if Trump is able to acquire the Trump Regency pursuant to the exercise of the option, he would make the Trump Regency available for the sole benefit of the Partnership on a basis consistent with the Partnership's contractual obligations and requirements. Trump further agreed that Trump Plaza would not be required to pay any additional consideration to Trump in connection with any assignment of the option to purchase the Trump Regency to the Partnership. In consideration of the foregoing agreements, the Partnership agreed to make the $1 million option payment to Chemical (subject to refund by Trump if the option is terminated as a result of certain specified events). On January 5, 1994, the Partnership obtained the approval of the CCC to make the $1 million payment, and the payment was made on that date. Boardwalk Expansion Site. On February 2, 1993, the Partnership acquired the Option from Trump to enter into a long-term lease of the Boardwalk Expansion Site, on which the partially constructed Penthouse Hotel is located. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources." The portion of the Boardwalk Expansion Site owned by Trump (which constitutes substantially all of the Boardwalk Expansion Site) is encumbered by a mortgage securing a loan with a balance of approximately $52.0 million of principal and accrued interest. In June 1993 Trump and the lender which holds such mortgage negotiated the terms of a restructuring of such loan. In connection with such restructuring Trump transferred title to the property to such lender, on the date the Offerings are consummated, entered into the Boardwalk Expansion Site Lease. The Boardwalk Expansion Site Lease has a term of five years during which time Trump will be obligated to pay the lender $260,000 per month in lease payments. In October 1993, the Partnership assumed the Boardwalk Expansion Site Lease and the obligation to make some or all of the payments thereunder subject to certain limitations, including regulatory approval and the satisfaction of the conditions set forth in the Mortgage Note Indenture and the PIK Note Indenture. See "Management's Discussion and Analysis of Financial Condition and Results of Operation -- Liquidity and Capital Resources." In connection with the Offerings, the Partnership acquired the Option to purchase the Boardwalk Expansion Site. Until such time as the Option is exercised or expires, the Partnership will be obligated to pay the net expenses associated with the Boardwalk Expansion Site. See "Management's Discussion and Analysis of Financial Condition and Results of Operation -- Liquidity and Capital Resources." Under the Option, the Partnership has the right to purchase the Boardwalk Expansion Site for a purchase price of $26.0 million through 1994, increasing by $1.0 million annually thereafter until 1998, in consideration of which the Partnership will pay certain expenses of the Boardwalk Expansion Site, including annual lease payments for the portion of the Boardwalk Expansion Site currently leased by Trump from a third party, which lease payments were $86,058 for 1993 and $83,500 for 1992 and increase annually based on the consumer price index, as well as current real estate taxes (approximately $1.2 million per year based upon current assessed valuation). See "Management's Discussion and Analysis of Financial Condition and Results of Operation -- Liquidity and Capital Resources." Acquisition of the Boardwalk Expansion Site by the Partnership would under certain circumstances (provided there are no events of default under the Boardwalk Expansion Site Lease or the Option and provided that certain other events had not theretofore or do not thereafter occur) discharge Trump's obligation to such lender in full. Management believes that the Boardwalk Expansion Site will be useful to the operation of Trump Plaza as the site of the future expansion of the Partnership's hotel operations. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources" and "Business -- Possible Expansion Sites." Services Agreement On June 24, 1993, The Partnership and Trump Plaza Management Corp. ("TPM") entered into an Amended and Restated Services agreement (the "Services Agreement") pursuant to which TPM is required to provide to the Partnership, from time to time when reasonably requested, consulting services on a non-exclusive basis, relating to marketing, advertising, promotional and other similar and related services (the "Services") with respect to the business and operations of the Partnership. In addition, the Services Agreement contains a non-exclusive "license" of the "Trump" name. TPM is not required to devote any prescribed amount of time to the performance of its duties. In consideration for the Services, the Partnership pays TPM an annual fee of $1.0 million in equal monthly installments. In addition to such annual fee, the Partnership reimburses TPM on a monthly basis for all reasonable out-of-pocket expenses incurred by TPM in performing its obligations under the Services Agreement. The Partnership paid TPM $1,247,000 and $708,000 in 1993 and 1992, respectively, for the Services. Pursuant to the Services Agreement, the Partnership will agree to hold TPM, its officers, directors and employees harmless from and against any loss arising out of or in connection with the performance of the Services and to hold Trump harmless from and against any loss arising out of the license of the "Trump" name. Indemnification Agreements The directors of the Company and the directors of TP/GP (other than Trump) serving prior to the Offerings have entered into separate indemnification agreements with the Partnership pursuant to which such persons are afforded the full benefits of the indemnification provisions of the Partnership Agreement. The Partnership has also entered into an Indemnification Trust Agreement with an Indemnification Trustee (the "Trust Agreement") pursuant to which the sum $100,000 has been deposited by the Partnership with the Indemnification Trustee for the benefit of the directors of the Company and the Class B Directors of TP/GP serving prior to the Offerings to provide a source for indemnification for such persons if the Partnership, the Company or TP/GP, as the case may be, fails to immediately honor a demand for indemnification by such persons. The Trust Agreement also provides that the directors of the Company and TP/GP (other than Trump) serving prior to the Offerings, under certain circumstances, are entitled to request that the lender under the Working Capital Facility deposit funds with the Indemnification Trustee for distribution to such persons in the event that they are entitled to indemnification for the Company, the Partnership or TP/GP and such indemnity is not provided. Not more than $200,000 per director (or an aggregate of $1.0 million) may be drawn down for such purpose; the Partnership is obligated to repay all such amounts. In connection with the Offerings, the Indemnification Agreements with the directors of the Company and the Class B Directors of TP/GP were amended to provide that (i) the Working Capital Facility would not be terminated or amended in a manner adverse to such directors unless prior thereto there is deposited an additional aggregate amount of $600,000 in the Indemnification Trust Fund for the benefit of such directors, and (ii) the Partnership would maintain directors' and officers' insurance covering such persons during the term of the Indemnification Agreements; provided, however, that if such insurance would not be available on a commercially practicable basis, the Partnership could, in lieu of obtaining such insurance, annually deposit an amount in the Indemnification Trust Fund equal to $500,000 for the benefit of such directors; provided, further, that deposits relating to the failure to obtain such insurance shall not exceed $2.5 million. Since the Working Capital Facility was terminated upon consummation of the Offerings, the Partnership deposited $600,000 in the Indemnification Trust Fund in June 1993. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) Financial Statements. See the Index immediately following the signature page. (b) Reports on Form 8-K. The Registrant did not file any reports on Form 8-K during the last quarter of the year ended December 31, 1993. (c) Exhibits. Exhibit No. Exhibit - ----------- ------- 3.1 Amended and Restated Certificate of Incorporation of the Company. (1) 3.1.1 Form of Second Amended and Restated Certificate of Incorporation of the Company. (8) 3.2 Amended and Restated By-Laws of the Company. (1) 3.3 Amended and Restated Certificate of Incorporation of TP/GP. (1) 3.4 Amended and Restated By-Laws of TP/GP. (1) 3.5 Certificate of Incorporation of Holding Inc. (8) 3.6 By-Laws of Holding. (8) 3.7 Second Amended and Restated Partnership Agreement of the Partnership. (9) 3.8 Partnership Agreement of Holding. (8) 3.8.1 Amendment No. 1 to the Partnership Agreement of Holding. (8) 3.9 Agreement and Plan of Merger between TP/GP and the Company. (8) 4.1 Mortgage Note Indenture, among the Company, as issuer, the Partnership, as guarantor, and the Mortgage Note Trustee, as trustee. (9) 4.2 Indenture of Mortgage, between the Partnership, as Mortgagor, and the Company, as Mortgagee. (9) 4.3 Assignment Agreement between the Company and the Mortgage Note Trustee. (9) 4.4 Assignment of Operating Assets from the Partnership to the Company. (9) 4.5 Assignment of Leases and Rents from the Partnership to the Company. (9) 4.6 Indenture of Mortgage between the Partnership and the Mortgage Note Trustee (the Guarantee Mortgage). (9) 4.7 Assignment of Leases and Rents from the Partnership to the Mortgage Note Trustee. (9) 4.8 Assignment of Operating Assets from the Partnership to the Mortgage Note Trustee. (9) 4.9 Partnership Note. (9) 4.10 Mortgage Note (included in Exhibit 4.1). (9) 4.11 Pledge Agreement of the Company in favor and for the benefit of the Trustee. (9) 4.12 Indenture between Holding, as Issuer, and the PIK Note Trustee, as trustee. (9) 4.13 PIK Note (included in Exhibit 4.12). (9) 4.14 Warrant Agreement. (8) 4.15 Warrant (included in Exhibit 4.14). (8) 4.16 Pledge Agreement of Holding in favor and for the benefit of the PIK Note Trustee. (8) 10.10 Agreement of Lease, dated as of July 1, 1980, by and between SSG Enterprises, as Lessor and Atlantic City Seashore 2, Inc., as Lessee, as SSG Enterprises' interest has been assigned to Seashore Four, and as Atlantic City Seashore 2, Inc.'s interest has been, through various assignments, assigned to the Partnership (with schedules). (4) 10.11 Agreement of Lease, dated July 11, 1980, by and between Plaza Hotel Management Company, as Lessor, and Atlantic City Seashore 3, Inc., as Lessee, as Atlantic City Seashore 3, Inc.'s interest has been, through various assignments, assigned to the Partnership (with schedules). (4) 10.12 Agreement of Lease, dated as of July 1, 1980, by and between Magnum Associates and Magnum Associates II, as Lessor and Atlantic City Seashore 1, Inc., as Lessee, as Atlantic City Seashore 1, Inc.'s interest has been, through various assignments, assigned to the Partnership (with schedules). (4) 10.13-10.15 Intentionally omitted. 10.16 Trump Plaza Hotel and Casino Retirement Savings Plan effective as of November 1, 1986. (2) 10.17-10.20 Intentionally omitted. 10.21 Assignment of Lease, dated as of July 28, 1988, by and between Magnum Associates and Magnum Associates II, as assignor, Trump Seashore Associates, as assignee, and Trump Plaza Associates, as lessee. (5) 10.22-10.23 Intentionally omitted. 10.24 Employment Agreement, dated January 28, 1991, between the Partnership and Kevin DeSanctis. (5) 10.24.1 Amendment to Employment Agreement, dated August 6, 1992, between the Partnership and Kevin DeSanctis. (7) 10.25 Intentionally omitted. 10.26 Employment Agreement, dated as of June 1, 1992 between the Partnership and Ernest E. East. (1) 10.27 Employment Agreement, dated as of March 13, 1991 between the Partnership and William Velardo. (3) 10.28 Option Agreement, dated as of February 2, 1993 between Trump and the Partnership. (3) 10.29 Appraisal of Trump Plaza by Appraisal Group International, dated March 5, 1993. (8) 10.30 Amended and Restated Services Agreement between the Partnership and Trump. (6) 10.31 Working Capital Facility between the Partnership and Belmont Fund, L.P. (1) 10.31.1 Mortgage and Security Agreement of the Partnership in favor of Belmont Fund, L.P. (8) 10.31.2 Assignment of Rents and Leases: by the Partnership to Belmont Fund L.P., dated May 29, 1992. (8) 10.31.3 Assignment of Operating Assets: by the Partnership to Belmont Fund L.P., dated May 29, 1992. (8) 10.32.1 Mortgage: from Donald J. Trump, Nominee to Emil F. Aysseh, Trustee dated January 12, 1983. (8) 10.32.2 Mortgage: from Donald J. Trump, Nominee to Emil F. Aysseh, Trustee dated June 23, 1983. (8) 10.32.3 Mortgage Consolidation, Modification, and Extension Agreement: dated June 23, 1983. (8) 10.32.4 Partial Assignment of Mortgage: (1/3 interest) by Alfred Aysseh to New Canaan Bank Trust Company. (8) 10.32.5 Partial Assignment of Mortgage: (1/3 interest) by New Canaan Bank and Trust Company to Alfred Aysseh. (8) 10.32.6 Assignment of Mortgage: Emil F. Aysseh, Trustee to Community National Bank and Trust Company of New York. (8) 10.32.7 Mortgage Note and Mortgage Modification Agreement: by and between Emil F. Aysseh, Trustee and Donald J. Trump, Nominee dated January 10, 1992. (8) 10.33 Mortgage: from Donald J. Trump, Nominee to Albert Rothenberg and Robert Rothenberg, dated October 3, 1983. (8) 10.34 Mortgage: made by Harrah's Associates to Adeline Bordonaro, dated January 28, 1986. (8) 10.35 Mortgage: made by the Partnership to The Mutual Benefit Life Insurance Company, dated October 5, 1990. (8) 10.35.1 Collateral Assignment of Leases: made by the Partnership to The Mutual Benefit Life Insurance Company, dated October 5, 1990. (8) 10.36 Form of Option between the Partnership and Midlantic Bank. (9) 10.37 Form of Lease between Trump and Midlantic Bank. (8) 10.38 Employment Agreement between the Partnership and Nicholas L. Ribis. 10.39 Severance Agreement between the Parnership and Robert M. Pickus. 25 Power of Attorney of directors and certain officers of the Company (included in signature page). (8) - ------------ (1) Incorporated herein by reference to the Exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992. (2) Incorporated herein by reference to the identically numbered Exhibit in the Company's Annual Report on Form 10-K for the year ended December 31, 1986. (3) Incorporated herein by reference to the identically numbered Exhibit in the Company's Annual Report on Form 10-K for the year ended December 31, 1992. (4) Incorporated herein by reference to the identically numbered Exhibit in the Company's Registration Statement on Form S-1, Registration No. 33-4604, declared effective on May 9, 1986. (5) Incorporated herein by reference to the identically numbered Exhibit in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1990. (6) Previously filed in Holding's Registration Statement on Form S-1, Registration No. 33-58608. (7) Incorporated herein by reference to the Exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992. (8) Incorporated herein by reference to the identically numbered Exhibit in the Company's and the Partnership's Registration Statement on Form S-1, Registration No. 33-58602. (9) Incorporated herein by reference to the identically numbered Exhibit in Holding's Registration Statement on Form S-1, Registration No. 33-58608. (d) Financial Statement Schedules. See the Index immediately following the signature page. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the Company and registrants have duly caused this report to be signed on their behalf by the undersigned, thereunto duly authorized, in the City of New York, State of New York, on the 30th day of March, 1994. TRUMP PLAZA HOLDING ASSOCIATES By: Trump Plaza Holding, Inc. Its Managing General Partner ----------------------- By: Donald J. Trump Title: President TRUMP PLAZA FUNDING, INC. ------------------------ By: Donald J. Trump Title: President Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this Report has been signed below by the following persons on behalf of the registrants and in the capacities and on the dates indicated. Signature Title Date --------- ----- ---- TRUMP PLAZA FUNDING, INC. By: - ------------------------ Donald J. Trump Principal Executive March 30, 1994 Officer By: - ------------------------ Francis X. McCarthy Jr. Principal Financial March 30, 1994 and Accounting Officer By: - ------------------------ Donald J. Trump Director March 30, 1994 By: - ------------------------ Nicholas L. Ribis Director March 30, 1994 By: - ------------------------ Jay Kramer Director March 30, 1994 By: - ------------------------ Don M. Thomas Director March 30, 1994 TRUMP PLAZA HOLDING ASSOCIATES By: Trump Plaza Holding, Inc. its Managing General Partner By: - ------------------------ Donald J. Trump Chief Executive Officer March 30, 1994 By: - ------------------------ Francis X. McCarthy Jr. Principal Financial March 30, 1994 and Accounting Officer By: - ------------------------ Donald J. Trump Director March 30, 1994 By: - ------------------------ Nicholas L. Ribis Director March 30, 1994 By: - ------------------------ Ernest E. East Director March 30, 1994 By: - ------------------------ Jay Kramer Director March 30, 1994 By: - ------------------------ Don M. Thomas Director March 30, 1994 Reports of Independent Public Accountants......... Balance Sheets of Trump Plaza Funding, Inc. as of December 31, 1993 and 1992................ Statements of Income of Trump Plaza Funding, Inc. for the years ended December 31, 1993, 1992 and 1991................................... Statements of Capital of Trump Plaza Funding, Inc. for the Years Ended December 31, 1993, 1992 and 1991................................... Statements of Cash Flows of Trump Plaza Funding, Inc. for the Years Ended December 31, 1993, 1992 and 1991................................... Report of Independent Public Accountants. Consolidated Balance Sheets of Trump Plaza Holding Associates and Trump Plaza Associates as of December 31, 1993 and 1992...................... Consolidated Statements of Operations of Trump Plaza Holding Associates and Trump Plaza Associates for the Years Ended December 31, 1993, 1992 and 1991. Consolidated Statements of Capital (Deficit) of Trump Plaza Holding Associates and Trump Plaza Associates for the Years Ended December 31, 1993, 1992 and 1991........................................ Consolidated Statements of Cash Flows of Trump Plaza Holding Associates and Trump Plaza Associates for the Years Ended December 31, 1993, 1992 and 1991. Notes to Financial Statements of Trump Plaza Funding, Inc., Trump Plaza Holding Associates and Trump Plaza Associates.......................... Schedule II Amounts Receivable (Payable) From (To) Related Parties, Underwriters, Promoters, and Employees other than Related Parties.......... V Property and Equipment............................ VI Accumulated Depreciation and Amortization of Property and Equipment.......... VIII Valuation and Qualifying Accounts............... X Supplementary Income Statement Information...... Other Schedules are omitted for the reason that they are not required or are not applicable, or the required information is shown in the consolidated financial statements or notes thereto REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Trump Plaza Funding, Inc.: We have audited the accompanying balance sheets of Trump Plaza Funding, Inc. (a New Jersey corporation) as of December 31, 1993 and 1992, and the related statements of income and retained earnings and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Trump Plaza Funding, Inc. as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. ARTHUR ANDERSEN & CO. Roseland, New Jersey February 18, 1994 TRUMP PLAZA FUNDING, INC. BALANCE SHEETS DECEMBER 31, 1993 AND 1992 ASSETS DECEMBER 31, DECEMBER 31, 1993 1992 ----------- ----------- CURRENT ASSETS: Cash $ 2,000 $ 2,000 Mortgage Interest Receivable 1,495,000 7,950,000 Receivable From Partnership 974,000 4,228,000 ----------- ----------- Total current assets 2,471,000 12,180,000 Mortgage Note Receivable 325,859,000 225,000,000 Receivable From Partnership 2,949,000 - Investment in Preferred Partnership Interest - 58,092,000 ----------- ----------- Total assets $331,279,000 $295,272,000 =========== =========== LIABILITIES AND CAPITAL CURRENT LIABILITIES: Accrued Interest Payable $ 1,495,000 $ 7,950,000 Income Taxes Payable 974,000 2,086,000 Dividends Payable - 2,026,000 ----------- ---------- Total current liabilities 2,469,000 12,062,000 10 7/8% Mortgage Bonds, net of discount due 2001 (Notes 1, 2 and 4) 325,859,000 - 12% Mortgage Bonds, due 2002 (Notes 1, 2 and 4) - 225,000,000 Deferred Income Taxes Payable 2,949,000 116,000 ----------- ----------- Total liabilities 331,277,000 237,178,000 ----------- ----------- Commitments and Contingencies (Note 7) Preferred Stock, 3,600,893 authorized, 2,999,580 issued and outstanding in 1992 - 58,092,000 Common Stock, $.00001 par value 3,600,893 authorized, 2,999,580 issued and outstanding in 1992 - - Common Stock, $.01 par value, 1,000 shares authorized, 100 shares issued and outstanding, at December 31, 1993 and none in 1992 - - Additional Paid in Capital 2,000 2,000 Retained Earnings - - ----------- ----------- Total liabilities and capital $331,279,000 $295,272,000 =========== =========== The accompanying notes to financial statements are an integral part of these balance sheets. TRUMP PLAZA FUNDING, INC. STATEMENTS OF INCOME FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 1993 1992 1991 ----------- ---------- ----------- Interest Income From Partnership $ 32,642,000 $ 27,720,000 $ 30,444,000 Preferred Partnership Investment Income 3,993,000 4,468,000 - Reimbursement for Income Taxes 1,802,000 2,202,000 - Interest Expense (32,642,000) (27,720,000) (30,444,000) Directors' Fees and Related Expenses (497,000) (224,000) - ----------- ----------- ------------ Income Before Provision for Taxes 5,298,000 6,446,000 - Provision for Income Taxes 1,802,000 2,202,000 - ----------- ----------- ------------ Net Income $ 3,496,000 $ 4,244,000 $ - =========== =========== =========== The accompanying notes to financial statements are an integral part of these statements. TRUMP PLAZA FUNDING, INC. STATEMENTS OF CAPITAL FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Common Stock ------------ Additional Number of Paid In Retained Shares Amount Capital Earnings Total --------- -------- ---------- ------------ ---------- Balance, December 31, 1993 200 $ 2,000 $ - $ - $ 2,000 Net Income - - - - - --------- -------- --------- ----------- --------- Balance, December 31, 1991 200 2,000 - - 2,000 Net Income - - - 4,244,000 4,244,000 Accrued dividends on preferred stock - - - (4,126,000) (4,126,000) Preferred Stock Accretion - - - (342,000) (342,000) Capital contribution from Partnership - - - 224,000 224,000 Redemption of stock units upon consummation of offering, effective May 29, 1992 (200) (2,000) - - (2,000) Issuance of stock upon consummation of offering effective May 29, 1992 2,999,580 - 2,000 - 2,000 --------- ------- ---------- --------- ---------- Balance, December 31, 1992 2,999,580 - 2,000 - 2,000 Net Income - - - 3,496,000 3,496,000 Accrued dividends on preferred stock - - - (3,678,000) (3,678,000) Preferred stock accretion - - - (315,000) (315,000) Capital contribution from Partnership - - 40,000,000 497,000 40,497,000 Capital contribution from Donald J. Trump - - 35,000,000 - 35,000,000 Redemption of Preferred Stock - - (75,000,000) - 75,000,000) Redemption of Stock Units upon consummation of offering, effective June 25, 1993 (2,999,580) - - - - Issuance of stock upon consummation of offering, effective June 25, 1993 100 - - - - -------- ------- ----------- -------- --------- Balance, December 31, 1993 100 $ - $ 2,000 $ - $ 2,000 ========= ======== =========== ========= ========== The accompanying notes to financial statements are an integral part of these statements. The accompanying notes to financial statements are an integral part of these statements. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Trump Plaza Holding Associates and Trump Plaza Associates: We have audited the accompanying consolidated balance sheets of Trump Plaza Holding Associates (a New Jersey general partnership) and Trump Plaza Associates ( a New Jersey general partnership) as of December 31, 1993 and 1992, and the related statements of operations, capital and cash flows for each of the three years in the period ended December 31, 1993. These consolidated financial statements and the schedules referred to below are the responsibility of the management of Trump Plaza Holding Associates and Trump Plaza Associates. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Trump Plaza Holding Associates and Trump Plaza Associates as of December 31, 1993 and 1992,and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index to the financial statements and schedules are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basis financial statements taken as a whole. ARTHUR ANDERSEN & CO. Roseland, New Jersey February 18, 1994 TRUMP PLAZA HOLDING ASSOCIATES AND TRUMP PLAZA ASSOCIATES CONSOLIDATED BALANCE SHEETS December 31, 1993 and 1992 ASSETS 1993 1992 -------- -------- Current Assets: Cash and cash equivalents...................... $14,393,000 $18,802,000 Trade receivables, net of allowance for doubtful accounts of $10,616,000 and $14,402,000, respectively..................... 6,759,000 7,675,000 Accounts receivable, other..................... 198,000 195,000 Due from affiliates, net (Note 9).............. - 91,000 Iventories..................................... 3,566,000 3,068,000 Prepaid expenses and other current assets...... 2,701,000 2,502,000 ------------ ------------ Total current assets...................... 27,617,000 32,333,000 ------------ ------------ Property and Equipment (Note 5): Land and land improvements................... 35,613,000 34,907,000 Buildings and building improvements.......... 295,617,000 293,908,000 Furniture, fixtures and equipment............ 78,173,000 74,622,000 Leasehold improvements....................... 2,404,000 2,378,000 Construction in progress..................... 3,784,000 3,924,000 ------------ ------------ 415,591,000 409,739,000 Less--Accumulated depreciation and amortization................................ (122,450,000) (109,473,000) ------------ ------------ Net property and equipment............... 293,141,000 300,266,000 ------------ ------------ Land Rights, net of accumulated amortization of $3,410,000 and $3,041,000, respectively... 30,058,000 30,428,000 ------------ ------------ Other Assets: Deferred bond issuance costs, net of accumulated amortization of $1,088,000 in 1993 (Note 2)............................ 16,254,000 - Other (Note 8)............................... 7,428,000 7,322,000 ------------ ------------ Total other assets........................ 23,682,000 7,322,000 ------------ ------------ Total assets.............................. $374,498,000 $370,349,000 ============ ============ LIABILITIES AND CAPITAL Current Liabilities: Current maturities of long-term debt (Note 4) $1,633,000 $9,980,000 Accounts payable............................. 6,309,000 7,767,000 Accrued payroll.............................. 5,806,000 4,978,000 Accrued interest payable (Note 4)............ 1,829,000 8,028,000 Due to affiliates, net (Note 9).............. 97,000 - Other accrued expenses....................... 7,109,000 10,475,000 Other current liabilities.................... 5,330,000 5,221,000 Distribution payable to Trump Plaza Funding, Inc................................ 974,000 4,112,000 ------------ ------------ Total current liabilities................. 29,087,000 50,561,000 ------------ ------------ Non-Current Liabilities: Long-term debt, net of current maturities (Notes 2 and 4)............................. 395,948,000 249,723,000 Distribution payable to Trump Plaza Funding, Inc................................ 2,949,000 116,000 Deferred state income taxes.................. 1,224,000 495,000 ------------ ------------ Total noncurrent liabilities.............. 400,121,000 250,334,000 ------------ ------------ Total liabilities......................... 429,208,000 300,895,000 ------------ ------------ Commitments and Contingencies (Notes 5 and 7) Preferred Partnership Interest................. - 58,092,000 ------------ ------------ Capital: Partners' Deficit............................ (78,772,000) (3,362,000) Retained Earnings............................ 24,062,000 14,724,000 ------------ ------------ Total Capital (Deficit)........................ (54,710,000) 11,362,000 ------------ ------------ Total liabilities and capital............. $374,498,000 $370,349,000 ============ ============ The accompanying notes to financial statements are an integral part of these consolidated balance sheets. The accompanying notes to financial statements are an integral part of these consolidated statements. The accompanying notes to financial statements are an integral part of these consolidated statements. The accompanying notes to financial statements are an integral part of these consolidated statements. TRUMP PLAZA FUNDING, INC. AND TRUMP PLAZA HOLDING ASSOCIATES AND TRUMP PLAZA ASSOCIATES NOTES TO FINANCIAL STATEMENTS (1) Organization: ------------- The accompanying financial statements include those of Trump Plaza Funding, Inc. (the "Company"), a New Jersey General Corporation as well as those of Trump Plaza Holding Associates ("Holding"), a New Jersey General Partnership, and its 99% owned subsidiary, Trump Plaza Associates (the "Partnership"), a New Jersey General Partnership, which owns and operates Trump Plaza Hotel and Casino located in Atlantic City, New Jersey. The Company owns the remaining 1% interest in the Partnership. Holding's sole source of liquidity is distributions in respect of its interest in the Partnership. All significant intercompany balances and transactions have been eliminated in the consolidated financial statements of Holding. The minority interest in the Partnership has not been separately reflected in the consolidated financial statements of Holding since it is not material. The Company was incorporated on March 14, 1986 as a New Jersey corporation, and was originally formed solely to raise funds through the issuance and sale of its debt securities for the benefit of the Partnership. As part of a Prepackaged Plan of Reorganization under Chapter 11 of the U.S. Bankruptcy code consummated on May 29, 1992, the Company became a partner of the Partnership and issued approximately three million Stock Units, each comprised of one share of Preferred Stock and one share of Common Stock of the Company. On June 25, 1993, the Stock Units were redeemed with a portion of the proceeds of the Company's 10 7/8% Mortgage Notes due 2001 (the "Mortgage Notes") as well as Holding's Units. See Note 2-Offering of Mortgage Notes and Units. Holding was formed in February, 1993 as a New Jersey general partnership for the purpose of raising funds for the Partnership. On June 25, 1993, Holding completed the sale of 12,000 Units (the "Units"), each Unit consisting of $5,000 principal amount of 12 1/2% Pay-In-Kind Notes, due 2003 (the "PIK Notes"), and one Warrant to acquire $1,000 principal amount of PIK Notes (collectively with the Mortgage Note Offering, the "Offerings"). The PIK Notes and the Warrants are separately transferable. Holding has no other assets or business other than its 99% equity interest in the Partnership. See Note 2-Offering of Mortgage Notes and Units. The Partnership was organized in June 1982 as a New Jersey general partnership. Prior to the date of the consummation of the Offerings, the Partnership's three partners were TP/GP, the managing general partner of the Partnership, the Company and Donald J. Trump ("Trump"). On June 25, 1993, Trump contributed his interest in TP/GP to the Company and TP/GP merged with and into the Company. The Company then became the managing general partner of the Partnership. In addition, Trump contributed his interest in the Partnership to Holding, and the Company and Holding, each of which are wholly owned by Trump, became the sole partners of the Partnership. (2) Offering of Mortgage Notes and Units: ------------------------------------- On June 25, 1993 the Company issued, and the Partnership guaranteed $330,000,000 of Mortgage Notes (for net proceeds of $325,687,000) and Holding issued an aggregate of $60,000,000 of PIK Notes, together with Warrants to acquire an additional $12,000,000 of PIK Notes at no additional cost (the "Offerings"). The combined proceeds, together with cash on hand were used substantially as follows: (i) $225.0 million of such proceeds were used to repay the Partnership's promissory note to the Company in the principal amount of $225.0 million, which proceeds were then used by the Company to redeem the 12% Mortgage Bonds, due 2002; (ii) $12.0 million was used to repay the Regency Note (see Note 4); (iii) $40.0 million was distributed to the Company (which used such funds, together with $35.0 million from the Units Offering distributed to Trump and paid to the Company, to redeem its Stock Units); (iv) approximately $17.3 million was used to pay the expenses incurred in connection with the Offerings; (v) approximately $52.5 million was used to make the Special Distribution to Trump which was used by Trump to repay certain personal indebtedness and (vi) to pay accrued interest on the Bonds and accrued dividends on the Preferred Stock. (3) Summary of significant accounting policies: ------------------------------------------- Gaming Revenues and Promotional Allowances - ------------------------------------------ Gaming revenues represent the net win from gaming activities which is the difference between amounts wagered and amounts won by patrons. The retail value of accommodations, food, beverage and other services provided to customers without charge is included in gross revenue and deducted as promotional allowances. The estimated departmental costs of providing such promotional allowance are included in gaming costs and expenses as follows: YEARS ENDED DECEMBER 31, ------------------------ (in thousands) 1993 1992 1991 ---- ---- ---- ROOMS $ 4,190 $ 4,804 $ 4,307 FOOD AND BEVERAGE 14,726 14,982 13,572 OTHER 3,688 3,884 2,802 ------- ------- ------- $22,604 $23,670 $20,681 ====== ====== ====== During 1992, certain Progressive Slot Jackpot Programs were discontinued which resulted in $4,100,000 of related accruals being taken into income. Inventories - ----------- Inventories of provisions and supplies are carried at the lower of cost (weighted average) or market. Property and Equipment - ---------------------- Property and equipment is carried at cost and is depreciated on the straight-line method using rates based on the following estimated useful lives: Buildings and building improvements 40 years Furniture, fixtures and equipment 3-10 years Leasehold improvements 10-40 years Interest associated with borrowings used to finance construction projects has been capitalized and is being amortized over the estimated useful lives of the assets. Land Rights - ----------- Land rights represent the fair value of such rights, at the time of contribution to the Partnership by the Trump Plaza Corporation, an affiliate of the Partnership. These rights are being amortized over the period of the underlying operating leases which extend through 2078. Income Taxes - ------------ The Company, Holding and the Partnership adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS No. 109"), effective January 1, 1993. Adoption of this new standard did not have a significant impact on the respective statements of financial condition or results of operations. SFAS No. 109 requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method deferred tax liabilities and assets are determined based on the difference between the financial statement and the tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The accompanying financial statements of the Company include a provision for Federal income taxes, based on distributions from the Partnership relating to the Company's Preferred Stock which was redeemed on June 25, 1993. The Company will be reimbursed for such income taxes by the Partnership. The accompanying consolidated financial statements of Holding and the Partnership do not include a provision for Federal income taxes since any income or losses allocated to its partners are reportable for Federal income tax purposes by the partners. Income Taxes cont. - ------------------ Under the New Jersey Casino Control Commission regulations, the Partnership is required to file a New Jersey corporation business tax return. Accordingly, a provision (benefit) for state income taxes has been reflected in the accompanying consolidated financial statements of Holding and the Partnership. The Partnership's deferred state income taxes result primarily from differences in the timing of reporting depreciation for tax and financial statement purposes. Statements of Cash Flows - ------------------------ For purposes of the statements of cash flows, the Company, Holding and the Partnership consider all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents. The following supplemental disclosures are made to the statements of cash flows. 1993 1992 1991 ---------- ---------- ---------- Cash paid during the year for interest $41,118,000 $25,310,000 $34,533,000 ========== ========== ========== Cash paid for state and Federal income taxes $ 81,000 $ - $ - ========== ========== ========== Reclassifications - ----------------- Certain reclassifications were made to the 1991 and 1992 consolidated financial statements to present them on a basis consistent with the 1993 classification. (4) Long-Term debt: --------------- Long term debt consists of the following: December 31, December 31, 1993 1992 ------------ ------------ Company: 10 7/8% Mortgage Notes, due 2001 net of unamortized discount of $4,141,000 in 1993 (A) $325,859,000 $ - 12% First Mortgage bonds, due 2002 (A) - 225,000,000 ----------- ----------- $325,859,000 $225,000,000 =========== =========== Holding and the Partnership: Partnership Partnership Note (10 7/8% Mortgage Notes, due 2001 net of unamortized discount of $4,141,000 in 1993) (A) $325,859,000 $ - Partnership Note (12% First Mortgage bonds, due 2002) (A) - 225,000,000 10% note payable to Harrah's Atlantic City, Inc. (C) - 8,471,000 Mortgage notes payable (D) 6,410,000 7,284,000 Regency Hotel Obligation (A) - 17,500,000 Other notes payable 1,060,000 1,448,000 ----------- ----------- 333,329,000 259,703,000 Less - Current maturities 1,633,000 9,980,000 ----------- ----------- 331,696,000 249,723,000 Holding PIK Notes (12 1/2% Notes due 2003 net of discount of $11,310,000 in 1993) (B) 64,252,000 - ----------- ----------- $395,948,000 249,723,000 =========== =========== (4) Long-Term debt cont.: --------------------- (A) On June 25, 1993 the Company issued $330,000,000 principal amount of 10 7/8% Mortgage Notes, due 2001, net of discount of $4,313,000. Net proceeds of the Offering were used to redeem all of the Company's outstanding $225,000,000 principal amount 12% Mortgage Bonds, due 2002 and together with other funds (see (B) Pay-In-Kind Notes) all of the Company's Stock Units, comprised of $75,000,000 liquidation preference participating cumulative redeemable Preferred Stock with associated shares of Common Stock, to repay $17,500,000 principal amount 9.14% Regency Note due 2003 (see Note 6), to make a portion of the Special Distribution and to pay transaction expenses. See Note 2- Offering of Mortgage Notes and Units. The Mortgage Notes mature on June 15, 2001 and are redeemable at any time on or after June 15, 1998, at the option of the Company or the Partnership, in whole or in part, at the principal amount plus a premium which declines ratably each year to zero in the year of maturity. The Mortgage Notes bear interest at the stated rate of 10 7/8% per annum from the date of issuance, payable semi-annually on each June 15 and December 15, commencing December 15, 1993 and are secured by substantially all of the Partnership's assets. The accompanying consolidated financial statements reflect interest expense at the effective interest rate of 11.12% per annum. The Mortgage Note Indenture contains certain covenants limiting the ability of the Partnership to incur indebtedness, including indebtedness secured by liens on Trump Plaza. In addition, the Partnership may, under certain circumstances, incur up to $25.0 million of indebtedness to finance the expansion of its facilities, which indebtedness may be secured by a lien on the Boardwalk Expansion Site (see Note 8 Commitments And Contingencies) senior to the liens of the Note Mortgage and Guarantee Mortgage thereon. The Mortgage Notes represent the senior indebtedness of the Company. The Partnership Note and the Guarantee rank pari passu in right of payment with all existing and future senior indebtedness of the Partnership. The Mortgage Notes, the Partnership Note, the Note Mortgage, the Guarantee and the Guarantee Mortgage are non-recourse to the partners of the Partnership, to the shareholders of the Company and to all other persons and entities (other than the Company and the Partnership), including Trump. Upon an event of default, holders of the Mortgage Notes would have recourse only to the assets of the Company and the Partnership. (B) On June 25, 1993 Holding issued $60,000,000 principal amount of 12 1/2% PIK Notes, due 2003, together with Warrants to acquire an additional $12,000,000 of PIK Notes at no additional cost. The Warrants are exercisable following the earlier of certain triggering events or June 15, 1996. The PIK Notes mature on June 15, 2003 and bear interest at the rate of 12 1/2% per annum from the date of issuance, payable semi-annually on each June 15 and December 15, commencing December 15, 1993. At the option of Holding, interest is payable in whole or in part, in cash or, in lieu of cash, through the issuance of additional PIK Notes valued at 100% of their principal amount. The ability of Holding to pay interest in cash on the PIK Notes is entirely dependent on the ability of the Partnership to distribute available cash, as defined, to Holding for such purpose. On December 15, 1993 the Partnership elected to issue, in lieu of cash, an additional $3,562,000 in PIK Notes to satisfy its semi-annual PIK Note interest obligation. The PIK Notes are subordinate to the Company's Mortgage Notes and any other indebtedness of the Partnership and are secured by a pledge of Holding's 99% equity interest in the Partnership. The indenture to which the PIK Notes were issued (the "PIK Note Indenture") contains covenants prohibiting Holding from incurring additional indebtedness and engaging in other activities, and other covenants restricting the activities of the Partnership substantially similar to those set forth in the Mortgage Note Indenture. The PIK Notes and the Warrants are non-recourse to the Partners of Holding, including Trump, and to all other persons and entities (other than Holding). Upon an event of default, holders of PIK Notes or Warrants will have recourse only to the assets of Holding which consist solely of its equity interest in the Partnership. (4) Long-Term debt cont.: --------------------- (C) The entire $8,471,000 principal amount of the 10% note payable was repaid on May 16, 1993. (D) Interest on these notes are payable with interest rates ranging from 10.0% to 11.0%. The notes are due at various dates between 1994 and 1998 and are secured by real property. The aggregate maturities of long-term debt in each of the years subsequent to 1993 are: 1994 $ 1,633,000 1995 2,850,000 1996 542,000 1997 2,012,000 1998 433,000 Thereafter 390,111,000 ------------ $397,581,000 ============ (5) Leases: ------- The Partnership leases property (primarily land), certain parking space, and various equipment under operating leases. Rent expense for the years ended December 31, 1993, 1992, and 1991 was $4,338,000, $4,361,000 and $11,219,000 respectively, of which $2,513,000, $2,127,000 and $8,478,000, respectively, relates to affiliates of the Partnership. Future minimum lease payments under the noncancelable operating leases are as follows: Amounts Relating to Total Affiliates ------------ ------------ 1994 $ 6,220,000 $ 1,900,000 1995 6,445,000 2,125,000 1996 6,670,000 2,350,000 1997 6,670,000 2,350,000 1998 5,110,000 2,350,000 Thereafter 274,183,000 193,600,000 ------------ ------------ $305,298,000 $204,675,000 ============ ============ Certain of these leases contain options to purchase the leased properties at various prices throughout the leased terms. At December 31, 1993, the aggregate option price for these leases was approximately $58,000,000. In October 1993, the Partnership assumed the Boardwalk Expansion Site Lease and related expenses which are included in the above lease commitment amounts. In connection with the Offerings, the Partnership acquired a five-year option to purchase the Boardwalk Expansion Site. Management intends to exercise this option by June 30, 1995. See Note 7-"Commitments and Contingencies Future Expansion." (6) Extraordinary Gain (Loss) and Non-Operating Expense: ---------------------------------------------------- The $4,120,000 excess of the carrying value of the Regency Hotel obligation over the amount of the settlement payment net of related prepaid expenses, has been reported as an extraordinary gain for the year ended December 31, 1993. The extraordinary loss for the year ended December 31, 1992 consists of the effect of stating the Bonds and Preferred Stock issued at fair value as compared to the carrying value of these securities and the write off of certain deferred financing charges and costs. Non-operating expense in 1993 includes $3,873,000 in costs associated with the Boardwalk Expansion Site (see Note 7-Commitments and Contingencies Future Expansion), net of miscellaneous non- operating credits. In 1992 these costs included $1,462,000 of legal expenses relating to the Penthouse litigation, and in 1991 these costs included $3,968,000 of legal expenses incurred in connection with the Penthouse litigation and $10,850,000 for the settlement of the Regency lease. (7) Commitments and Contingencies: ------------------------------ Casino License Renewal - ---------------------- The operation of an Atlantic City hotel and casino is subject to significant regulatory controls which affect virtually all of its operations. Under the New Jersey Casino Control Act (the "Act"), the Partnership is required to maintain certain licenses. In April, 1993, the New Jersey Casino Control Commission ("CCC") renewed the Partnership's license to operate Trump Plaza. This license must be renewed in June, 1995, is not transferable and will include a review of the financial stability of the Partnership. Upon revocation, suspension for more than 120 days, or failure to renew the casino license, the Act provides for the mandatory appointment of a conservator to take possession of the hotel and casino's business and property, subject to all valid liens, claims and encumbrances. Legal Proceedings - ----------------- The Partnership, its Partners, certain members of its former Executive Committee, and certain of its employees, have been involved in various legal proceedings. In general, the Partnership has agreed to indemnify such persons against any and all losses, claims, damages, expenses (including reasonable costs, disbursements and counsel fees) and liabilities (including amounts paid or incurred in satisfaction of settlements, judgements, fines and penalties ) incurred by them in said legal proceedings. Such persons and entities are vigorously defending the allegations against them and intend to vigorously contest any future proceedings. Various other legal proceedings are now pending against the Partnership. The Partnership considers all such other proceedings to be ordinary litigation incident to the character of its business and not material to its business or financial condition. The Partnership believes that the resolution of these claims will not, individually or in the aggregate, have a material adverse effect on its financial condition or results of operations. The Partnership is also a party to various administrative proceedings involving allegations that it has violated certain provisions of the Act. The Partnership believes that the final outcome of these proceedings will not, either individually or in the aggregate, have a material adverse effect on its financial condition, results of operations or on the ability of the Partnership to otherwise retain or renew any casino or other licenses required under the Act for the operation of Trump Plaza. Casino Reinvestment Development - ------------------------------- Authority Obligations --------------------- Pursuant to the provisions of the Act, the Partnership, commencing twelve months after the date of opening of Trump Plaza in May 1984, and continuing for a period of twenty-five years thereafter, must either obtain investment tax credits (as defined in the Casino Control Act), in an amount equivalent to 1.25% of its gross casino revenues, or pay an alternative tax of 2.5% of its gross casino revenues, (as defined in the Casino Control Act). Investment tax credits may be obtained by making qualified investments or by the purchase of bonds at below market interest rates from the Casino Reinvestment Development Authority ("CRDA"). The Partnership is required to make quarterly deposits with the CRDA. In April 1990, the Partnership modified its agreement with the CRDA under which it was required to purchase bonds to satisfy the investment alternative tax. Under the terms of the agreement, the Partnership donated $11,971,000 in deposits previously made to the CRDA for the purchase of CRDA bonds through December 31, 1989, in exchange for satisfaction of an equivalent amount of its prior bond purchase commitments, as well as receiving future tax credits, to be utilized to satisfy substantial portions of the Partnership's future investment alternative tax obligations. The Partnership charged $1,358,000 and $2,493,000 to operations in 1992 and 1991, respectively, which represents amortization of the tax credits discussed above. As of December 31, 1993, no tax credits were available. For the years ended December 31, 1993, 1992 and 1991, the Partnership charged to operations $1,047,000, $645,000 and $219,000, respectively, to give effect to the below market interest rates associated with the CRDA bonds. Concentrations of Credit Risks - ------------------------------ In accordance with casino industry practice, the Partnership extends credit to a limited number of casino patrons, after extensive background checks and investigations of credit worthiness. At December 31, 1993 approximately 31% of the Partnership's casino receivables were from customers whose primary residence is outside the United States with no significant concentration in any one foreign country. Future Expansion - ---------------- In 1993, the Partnership received the approval of the CCC, subject to certain conditions, for the expansion of its hotel facilities (the "Boardwalk Expansion Site"). On June 25, 1993, Trump transferred title to the Boardwalk Expansion Site to a lender in exchange for a reduction in Trump's indebtedness to such lender in an amount equal to the sum of fair market value of the Boardwalk Expansion Site and all rent payments made to such lender by Trump under the Boardwalk Expansion Site Lease. On the date the Offerings were consummated, the lender leased the Boardwalk Expansion Site to Trump ("the Boardwalk Expansion Site Lease") for a term of five years, which expires on June 30, 1998, during which time Donald J. Trump was obligated to pay the lender $260,000 per month in lease payments. See Note 6-"Extraordinary Gain (Loss) and Non-Operating Expense." In October 1993, the Partnership assumed the Boardwalk Expansion Site Lease and related expenses. In connection with the Offerings, the Partnership acquired a five- year option to purchase the Boardwalk Expansion Site (the "Option"). Until such time as the Option is exercised or expires, the Partnership will be obligated, from and after the date it entered into the Option, to pay the net expenses associated with the Boardwalk Expansion Site. During the year ended December 31, 1993 the Partnership incurred $4.4 million of such expenses. Under the Option, the Partnership has the right to acquire the Boardwalk Expansion Site for a purchase price of $26.0 million through 1994, increasing by $1.0 million annually thereafter until expiration on June 30, 1998. The CCC has required that the Partnership exercise the Option for its right of first refusal therein no later than July 1, 1995. If the Partnership defaults in making payments due under the Option, the Partnership would be liable to the lender for the sum of (a) the present value of all remaining payments to be made by the Partnership pursuant to the Option during the term thereof and (b) the cost of demolition of all improvements then located on the Boardwalk Expansion Site. As of December 31, 1993, the Partnership had capitalized approximately $2.7 million in construction costs related to the Boardwalk Expansion Site. The Partnership's ability to acquire the Boardwalk Expansion Site pursuant to the Option would be dependent upon its ability to obtain financing to acquire the property. The ability to incur such indebtedness is restricted by the Mortgage Note Indenture and the PIK Note Indenture and requires the consent of certain of Trump's personal creditors. The Partnership's ability to develop the Boardwalk Expansion Site is dependent upon its ability to use existing cash on hand and generate cash flow from operations sufficient to fund development costs. No assurance can be given that such cash on hand will be available to the Partnership for such purposes or that it will be able to generate sufficient cash flow from operations. In addition, exercise of the Option requires the consent of certain of Trump's personal creditors, and there can be no assurance that such consent will be obtained at the time the Partnership desires to exercise the Option or such right. The accompanying financial statements do not include any adjustments that may be necessary should the Partnership be unable to exercise the Option. (8) Employee Benefit Plans: ----------------------- The Partnership has a retirement savings plan for its nonunion employees under Section 401(K) of the Internal Revenue Code. Employees are eligible to contribute up to 15% of their earnings to the plan and the Partnership will match 50% of an eligible employee's contributions up to a maximum of 4% of the employee's earnings. The Partnership recorded charges of $765,000, $699,000 and $571,000 for matching contributions for the years ended December 31, 1993, 1992 and 1991, respectively. (9) Transactions with Affiliates: ----------------------------- Due to/from Affiliates - ---------------------- Amounts due to affiliates was $97,000, as of December 31, 1993 and due from affiliates was $91,000 as of December 31,1992. The Partnership leases warehouse facility space to Trump Castle Associates and had formerly leased space to Trump Taj Mahal Associates. Lease payments of $15,000, $14,000 and $18,000 were received from Trump Castle Associates in 1993, 1992 and 1991, respectively, and $46,000 from Trump Taj Mahal Associates in 1991. The Partnership leases office space from Trump Taj Mahal Associates, which terminated on March 19, 1993. Lease payments of $30,000, $138,000 and $98,000 were paid to Trump Taj Mahal Associates in 1993, 1992 and 1991 respectively. Prior to April 1991, the Partnership leased office space from Trump Castle Associates. Lease payments to Trump Castle Associates amounted to $42,000 in 1991. The Partnership paid Trump Castle Associates $317,000 in 1991, and Trump Taj Mahal Associates $1,000 and $242,000 in 1992 and 1991, respectively, for fleet maintenance and limousine services. Additionally, the Partnership paid Trump Castle Associates $4,000 in 1991 for printing services. The Partnership leases two parcels of land under long-term ground leases from Seashore Four Associates and Trump Seashore Associates. In 1993, 1992 and 1991, the Partnership paid $900,000, $900,000 and $900,000, respectively, to Seashore Four Associates, and paid $1,000,000, $1,000,000 and $1,100,000 in 1993, 1992 and 1991, respectively, to Trump Seashore Associates. Services Agreement - ------------------ Pursuant to the terms of a Services Agreement with Trump Plaza Management Corp. ("TPM"), a corporation beneficially owned by Donald J. Trump, in consideration for services provided, the Partnership pays TPM each year an annual fee of $1.0 million in equal monthly installments, and reimburses TPM on a monthly basis for all reasonable out-of-pocket expenses incurred by TPM in performing its obligations under the Services Agreement, up to certain amounts. Under this Agreement, approximately $1.2 million and $0.7 million was charged to expense for the years ended December 31, 1993 and 1992, respectively. Advances to Donald J. Trump - --------------------------- In December 1993, Trump entered into an option agreement (the "Chemical Option Agreement") with Chemical Bank ("Chemical") and ACFH Inc. ("ACFH") a wholly owned subsidiary of Chemical. The Chemical Option Agreement grants to Trump an option to purchase (i) the Trump Regency (including the land, improvements and personal property used in the operation of the hotel) and (ii) certain promissory notes made by Trump and/or certain of his affiliates and payable to Chemical (the "Chemical Notes") which are secured by certain real estate assets located in New York, unrelated to the Partnership. The aggregate purchase price payable for the assets subject to the Chemical Option Agreement is $80 million. Under the terms of the Chemical Option Agreement, $1 million was required to be paid for the option by January 5, 1994. The option expires on May 6, 1994, provided that the option may be extended until June 30, 1994 by the payment of an additional $250,000 on or before that date. The $1 million payment (and the $250,000 payment, if made) may be credited against the $80 million purchase price. The Chemical Option Agreement does not allocate the purchase price among the assets subject to the option or permit the option to be exercised for some, but not all, of such assets. In connection with the execution of the Chemical Option Agreement, Trump agreed with the Partnership that, if Trump is able to acquire the Trump Regency pursuant to the exercise of the option, he would make the Trump Regency available for the sole benefit of the Partnership on a basis consistent with the Partnership's contractual obligations and requirements. Trump further agreed that the Partnership would not be required to pay any additional consideration to Trump in connection with any assignment of the option to purchase the Trump Regency. On January 5, 1994, the Partnership obtained the approval of the CCC to make the $1 million payment, and the payment was made on that date. (10) Fair Value of Financial Instruments: ------------------------------------ The carrying amount of the following financial instruments of the Company, Holding and the Partnership approximates fair value, as follows: (a) cash and cash equivalents, accrued interest receivables and payables are based on the short term nature of these financial instruments. (b) CRDA bonds and deposits are based on the allowances to give effect to the below market interest rates. The estimated fair values of other financial instruments are as follows: December 31, 1993 ----------------- Carrying Amount Fair Value --------------- --------------- 12 1/2% PIK Notes $ 64,252,000 $ 68,784,000 10 7/8% Mortgage Notes $325,859,000 $313,500,000 The fair values of the PIK and Mortgage Notes are based on quoted market prices obtained by the Partnership from its investment advisor. There are no quoted market prices for other notes payable and a reasonable estimate could not be made without incurring excessive costs. (A) Represents reclassification of completed capital projects to in-service classifications. SCHEDULE VI (A) Represents reclassification of certain capital projects to appropriate classifications. (B) Includes retirements of $811,000, and $163,000 in 1992, and 1991 respectively. SCHEDULE VIII (A) Write-off of uncollectible accounts. (B) Write-off of allowance applicable to contribution of CRDA deposits.

719264_1993.txt

719264

1993

ITEM 1. BUSINESS GENERAL First Citizens Bancshares, Inc. ("Bancshares") was organized December, 1982 as a Tennessee Corporation and commenced operations in September, 1983, with the acquisition of all Capital Stock of First Citizens National Bank of Dyersburg ("First Citizens"). First Citizens was chartered as a national bank in 1900 and presently operates a general retail banking business in Dyersburg and Dyer County, Tennessee providing customary banking services. First Citizens operates under the supervision of the Comptroller of the Currency, is insured up to applicable limits by the Federal Deposit Insurance Corporation and is a member of the Federal Reserve System. First Citizens operates under the day-to-day management of its own officers and directors; and formulates its own policies with respect to lending practices, interest rates, service charges and other banking matters. Bancshares' primary source of income is dividends received from First Citizens. Dividend payments are determined in relation to First Citizens' earnings, deposit growth and capital position in compliance with regulatory guidelines. Management anticipates that future increases in the capital of First Citizens will be accomplished through earnings retention or capital injection. The following table sets forth a comparative analysis of Assets, Deposits, Net Loans, and Equity Capital of Bancshares as of December 31, for the years indicated: December 31 (in thousands) 1993 1992 1991 Total Assets $234,892 $239,897 $227,017 Total Deposits 193,823 193,459 193,064 Total Net Loans 147,646 133,957 131,131 Total Equity Capital 21,700 19,309 17,576 Individual bank performance is compared to industry standards through utilization of the Uniform Bank Performance Report (UBPR), published quarterly by the Federal Financial Institution's Examination Council. This report provides comparisons of significant operating ratios of First Citizens with peer group banks. Presented in the following chart are comparisons of First Citizens with peer group banks for the periods indicated: 12/31/93* 12/31/92 12/31/91 FCNB PEER GRP FCNB PEER GRP FCNB PEER GRP Average Assets/ Net Interest Income 4.49% 4.47% 4.51% 4.45% 4.22% 4.21% Average Assets/ Net Operating Income 1.15% 1.34% .91% 1.29% .83% 1.08% Net loan losses/ Average total loans .29% .15% .47% .25% .40% .30% Primary Capital/ Average Assets 8.32% 8.83% 7.29% 8.48% 7.05% 8.13% Cash Dividends/ Net Income 20.20% 38.00% 32.73% 30.49% 64.61% 44.88% *Performance as of 12/31/93 is compared to peer group totals as of 09/30/93 (Most recent UBPR available) EXPANSION Bancshares may, subject to regulatory approval, acquire existing banks or organize new banks. The Federal Reserve Board permits bank holding companies to engage in non-banking activities closely related to banking or managing or controlling banks, subject to Board approval. In making such determination, the Federal Reserve Board considers whether the performance of such activities by a bank holding company would offer advantages to the public which outweigh possible adverse effects. Approval by the Federal Reserve Bank of a Bank Holding Company's application to participate in a proposed activity is not a determination that the activity is a permitted non-bank activity for all bank holding companies. Approval applies only to the applicant, although it suggests the likelihood of approval in a similar case. First Citizens National Bank through its strategic planning process has stated its intention to acquire other financial institutions within the West Tennessee Area. The Bank's objective in acquiring other banking institutions would be for asset growth and diversification into other market areas. Acquisitions would afford the bank increased economies of scale within the data processing function and better utilization of human resources. Any acquisition approved by the Board of Bancshares, Inc. would provide a profitable investment for shareholders. In January, 1994, a Letter of Intent to purchase was issued to a bank located in the West Tennessee Area. Consummation of the purchase transaction is pending based on acceptance of the offer and necessary regulatory approval. During 1985, the Tennessee Legislature passed the Regional Reciprocal Interstate Banking Act. This law provided for banks located within 13 states named therein to purchase banks located in Tennessee. Tennessee banks, in turn, could purchase financial institutions located in any of the states identified by the law. The Comptroller of the Currency ruled in 1987 that Banks may branch within any state to the extent permitted state-chartered thrifts also engaged in the business of banking. As a result of this ruling, the state legislature amended the 1985 Regional Reciprocal Interstate Banking Act effective January 1, 1991 to remove regional limitations on interstate banking. This will allow branching within any state which allows reciprocal branching. The issue of interstate branching is one which even bankers are unable to agree upon. Smaller banking organizations vigorously oppose the concept while the regionals and super-regionals continue to lobby for legislation which will allow them access to all markets. SUPERVISION AND REGULATION Bancshares is a one-bank holding company under the Bank Holding Company Act of 1956, as amended, and is subject to supervision and examination by the Board of Governors of the Federal Reserve System. As a bank holding company, Bancshares is required to file with the Federal Reserve Board annual reports and other information regarding the business obligations of itself and its subsidiaries. Board approval must be obtained before Bancshares may: (1) Acquire ownership or control of any voting securities of a bank or Bank Holding Company where the acquisition results in the BHC owning or controlling more than 5 percent of a class of voting securities of that bank or BHC; (2) Acquire substantially all assets of a bank or BHC or merge with another BHC. Federal Reserve Board approval is not required for a bank subsidiary of a BHC to merge with or acquire substantially all assets of another bank if prior approval of a federal supervisory agency, such as the Comptroller of the Currency is required under the Bank Merger Act. Relocation of a subsidiary bank of a BHC from one state to another requires prior approval of the Federal Reserve Board and is subject to the prohibitions of the Douglas Amendment. The Bank Holding Company Act provides that the Federal Reserve Board shall not approve any acquisition, merger or consolidation which would result in a monopoly or which would be in furtherance of any combination or conspiracy to monopolize or attempt to monopolize the business of banking in any part of the United States. Further, the Federal Reserve Board may not approve any other proposed acquisition, merger, or consolidation, the effect of which might be to substantially lessen competition or tend to create a monopoly in any section of the country, or which in any manner would be in restraint of trade, unless the anti-competitive effect of the proposed transaction is clearly outweighed in favor of public interest by the probable effect of the transaction in meeting the convenience and needs of the community to be served. An amendment effective February 4, 1993 further provides that an application may be denied if the applicant has failed to provide the Federal Reserve Board with adequate assurances that it will make available such information on its operations and activities, and the operations and activities of any affiliate, deemed appropriate to determine and enforce compliance with the Bank Holding Company Act and any other applicable federal banking statutes and regulations. In addition, consideration is given to the competence, experience and integrity of the officers, directors and principal shareholders of the applicant and any subsidiaries as well as the banks and bank holding companies concerned. The Board also considers the record of the applicant and its affiliates in fulfilling commitments to conditions imposed by the Board in connection with prior applications. A bank holding company is prohibited with limited exceptions from engaging directly or indirectly through its subsidiaries in activities unrelated to banking or managing or controlling banks. One exception to this limitation permits ownership of a company engaged solely in furnishing services to banks; another permits ownership of shares of the company, all of the activities of which the Federal Reserve Board has determined after due notice and opportunity for hearing, to be so closely related to banking or managing or controlling banks, as to be a proper incident thereto. Moreover, under the 1970 amendments to the Act and to the Board's regulations, a bank holding company and its subsidiaries are prohibited from engaging in certain "tie-in" arrangements in connection with any extension of credit or provision of any property or service. Subsidiary banks of a bank holding company are subject to certain restrictions imposed by the Federal Reserve Act on any extension of credit to the bank holding company or to any of its other subsidiaries, or investments in the stock or other securities thereof, and on the taking of such stock or securities as collateral for loans to any borrower. Bank holding companies are required to file an annual report of their operations with the Federal Reserve Board, and they and their subsidiaries are subject to examination by the Board. EXECUTIVE OFFICERS OF THE REGISTRANT The following information relates to the principal executive officers of Bancshares and its principal subsidiary, First Citizens National Bank as of December 31, 1993. Name Age Position and Office Stallings Lipford 63 Chairman of the Board and CEO of First Citizens and Bancshares. Mr. Lipford joined First Citizens in 1950. He became a member of the Board of Directors in 1960 and President in 1970. He was made Vice-Chairman of the Board in 1982. He served as Vice Chairman of the Board of Bancshares from September, 1983 to February, 1984. The Board elected Mr. Lipford Chairman of both First Citizens and Bancshares on February 14, 1984. He served as President of First Citizens and Bancshares from 1983 to 1992. Katie Winchester 53 President of First Citizens and Bancshares; employed by First Citizens National Bank in 1961; served as Executive Vice President and Secretary of the Board from 1986 to 1992. She was made President of Bancshares and First Citizens in 1992. Ms. Winchester was elected to the Board of both First Citizens and Bancshares in 1990. H. Hughes Clardy 51 Vice President of First Citizens Bancshares, Inc.; Senior Vice President and Senior Trust Officer of First Citizens National Bank. Employed by First Citizens National Bank in 1993. Mr. Clardy was employed as Vice President and Senior Trust Officer at Crestar Bank from January, 1987 to January, 1991 and as a Vice President of Dominion Trust Company of Tennessee from 1991 to 1993. Ralph Henson 52 Vice President of First Citizens Bancshares, Inc.; Executive Vice President of Loan Administration of First Citizens National Bank. Employed by First Citizens National Bank in 1964. Mr. Henson served the Bank as Senior Vice President and Senior Lending Officer until his appointment as Executive Vice President of Loan Administration in February, 1993. BANKING BUSINESS First Citizens operates a general retail banking business in Dyer County, Tennessee. All persons who live in the community or who work in or have a business or economic interest in the community are considered as forming a part of the area serviced by the Bank. First Citizens provides customary banking services, such as checking and savings accounts, funds transfers, various types of time deposits, and safe deposit facilities. It also finances commercial transactions and makes and services both secured and unsecured loans to individuals, firms and corporations. Commercial lending operations include various types of credit services for its customers. The installment lending department makes direct loans to individuals for personal, automobile, real estate, home improvement, business and collateral needs. Mortgage lending makes available long term fixed and variable rate loans to finance the purchase of residential real estate. These loans are sold in the secondary market without retaining servicing rights. Credit cards and open-ended credit lines are available to both commercial customers and consumers. First Citizens Financial Plus, Inc., a Bank Service Corporation wholly owned by First Citizens National Bank is a licensed Brokerage Service. This allows the bank to compete on a limited basis with numerous non-bank entities who pose a continuing threat to our customer base, and are free to operate outside regulatory control. First Citizens was granted trust powers in 1925 and has maintained an active Trust Department since that time. Assets as of December 31, 1993 were in excess of $121,000,000. Services offered by the Trust Department include but are not limited to estate settlement, trustee of living trusts, testamentary trustee, court appointed conservator and guardian, agent for investment accounts, and trustee of pension and profit sharing trusts. During 1991, the Board approved a name change for the Trust Department to "Investment Management and Trust Services Division". The purpose of this change was to more accurately reflect actual services provided. The business of providing financial services is highly competitive. The competition involves not only other banks but non-financial enterprises as well. In addition to competing with other commercial banks in the service area, First Citizens competes with savings and loan associations, insurance companies, savings banks, small loan companies, finance companies, mortgage companies, real estate investment trusts, certain governmental agencies, credit card organizations, and other enterprises. The following tabular analysis sets forth the competitive position of First Citizens when compared with other financial institutions in the service area for the period ending June 30, 1992. Information for the period ending 6/30/93 will be made available by the Federal Financial Institutions Examination Council in April, 1994. Dyer County Market (All Financial Institutions) (in thousands) Total Deposits % of Market Share Bank Name 06/30/92 06/30/92 First Citizens National Bank $191,818 49.99% First Tennessee Bank 89,149 23.23% Security Bank 52,449 13.67% Save-Trust Federal Savings Bank 32,664 8.51% First Exchange Bank 7,391 1.93% Merchants State Bank 7,903 2.06% Dyersburg City Employees Credit Union 2,345 .61% At December 31, 1993 Bancshares and its subsidiary, First Citizens National Bank, employed a total of 149 full time equivalent employees. Having been a part of the local community in excess of 100 years, First Citizens has been privileged to enjoy a major share of the financial services market. Dyersburg and Dyer County are growing and with this growth come demands for more sophisticated financial products and services. Strategic planning has afforded the Company both the physical resources and data processing technology necessary to meet the financial needs generated by this growth. USURY, RECENT LEGISLATION AND ECONOMIC ENVIRONMENT Tennessee usury laws limit the rate of interest that may be charged by banks. Certain Federal laws provide for preemption of state usury laws. Legislation enacted in 1983 amends Tennessee usury laws to permit interest at an annual rate of interest four (4) percentage points above the average prime loan rate for the most recent week for which such an average rate has been published by the Board of Governors of the Federal Reserve System, or twenty-four percent (24%), whichever is less (TCA 47-14-102(3)). The "Most Favored Lender Doctrine" permits national banks to charge the highest rate permitted by any state lender. Specific usury laws may apply to certain categories of loans, such as the limitation placed on interest rates on single pay loans of $1,000.00 or less for one year or less. Rates charged on installment loans, including credit cards, are governed by the Industrial Loan and Thrift Companies Act. Monetary policies of regulatory authorities, including the Federal Reserve Board, have a significant effect on the operating results of bank holding companies and their subsidiary banks. The Federal Reserve Board regulates the national supply of bank credit by open market operations in United States Government securities, changes in the discount rate on bank borrowings, and changes in reserve requirements against bank deposits. A tool once extensively used by the Federal Reserve Board to control growth and distribution of bank loans, investments and deposits has been eliminated through deregulation. Competition, not regulation, dictates rates which must be paid and/or charged in order to attract and retain customers. Federal Reserve Board monetary policies have materially affected the operating results of commercial banks in the past and are expected to do so in the future. The nature of future monetary policies and the effect of such policies on the business and earnings of the company and its subsidiaries cannot be accurately predicted. ITEM 2.

ITEM 2. PROPERTIES First Citizens owns and occupies a six-story building in Dyersburg, Tennessee containing approximately 50,453 square feet of office space, bearing the municipal address of First Citizens Place (formerly 200 West Court). An expansion program completed during 1988 doubled the available floor space of the existing facility. The space was utilized to combine all lending and loan related functions. First Citizens owns the Banking Annex containing total square footage of 12,989, of which approximately 3,508 square feet is rented to various tenants. The municipal address of the bank occupied portion of the Annex is 213-219 Masonic Street. The land and building occupied by the Downtown Drive-In Branch located at 113 South Church Street, Dyersburg, Tennessee is owned by First Citizens. The building, containing approximately 1,250 square feet, is located on a lot which measures 120 feet square. Also located at this address is a separate ATM facility wholly owned by the Bank. The Midtown Branch of First Citizens is located at 620 U.S. 51 By-Pass adjacent to the Green Village Shopping Center. The building contains 1,920 square feet and has been owned by First Citizens since construction. The land on which this Branch is located, having previously been leased, was purchased during 1987. In June of 1992 an additional 1.747 acres adjoining the Midtown Branch property was purchased to accomodate future growth and expansion. Also located on this property is an ATM. In addition, the Midtown Branch Motor Bank is located on .9 acres adjoining the Midtown Branch. This property consists of a servicing facility and six remote teller stations and is owned in its entirety by the Bank. A drive-through ATM will be located at this facility during 1994. The Newbern Branch, also owned by First Citizens, is located on North Monroe Street, Newbern, Tennessee. The building contains approximately 4,284 square feet and occupies land which measures approximately 1.5 acres. A separate facility located in Newbern on the corner of Highway 51 and RoEllen Road houses an ATM. Both land and building are owned by the Bank. The Super Money Market Branch in the Kroger Supermarket on Highway 78 is operated under a franchise obtained through National Bank of Commerce, Memphis, Tennessee. While the fixtures are owned by First Citizens, space is made available from the Kroger Company through the franchise agreement. 1.12 acres of land located at 2211 St. John was purchased in 1993 to locate a full service banking facility and a drive through ATM. Architectural plans for construction of the building are currently being studied by Bank Management. In November, 1993, First Citizens National Bank leased space in the Wal-Mart store #677 located at 2650 Lake Road in Dyersburg, Tennessee to locate an Automatic Teller Machine (ATM). The ATM was installed in December, 1993. There are no liens or encumbrances against any of the properties owned by First Citizens. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS During December, 1989 a lawsuit was brought against First Citizens Bancshares, Inc. and three other co-defendants claiming that certain individuals are entitled to a real estate commission of $138,285 on property sold by the Bank Holding Company. The plaintiffs were seeking prejudgement interest and punitive damages of $638,285. The lawsuit was settled in 1993 with the Bank paying settlement costs of $5,000 to the plaintiffs. The Bank was also a defendant in a suit filed September 20, 1991 by a bankruptcy trustee alleging that First Citizens was the recipient of a preferential transfer under the bankruptcy code in the amount of $689,702 and a preferential transfer in the amount of $1,551,889. The suit sought recovery of both transfers plus prejudgment interest. The allegations were being contested by the Bank. The lawsuit was settled in 1993 with no payments being made by First Citizens National Bank. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the fourth quarter of the year ending December 31, 1993, there were no meetings, annual or special, of the shareholders of Bancshares. No matters were submitted to a vote of the shareholders nor were proxies solicited by management or any other person. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS As of December 31, 1993 there were 617 active holders of Bancshares' stock. Bancshares common stock is not actively traded on any market. Per share prices reflected in the following table are based on records of actual sales during stated time periods. These records may not include all sales during these time periods if sales were not reported to First Citizens for transfer. Quarter Ended High Low March 31, 1993 $57.65 $52.50 June 30, 1993 $68.00 $61.00 September 30, 1993 $69.10 $68.00 December 31, 1993 $30.00 $27.64** March 31, 1992 $55.00 $43.00 June 30, 1992 $55.00 $48.00 September 30, 1992 $55.00 $50.00 December 31, 1992 $55.00 $48.00* *Declared 10% stock dividend. **Declared 2.5 for 1 stock split. Dividends paid each quarter of 1993 were .60 cents (first two quarters) .65 cents (third quarter); and .25 cents for the fourth quarter. Fourth quarter dividend also included a 2.5 for 1 stock split in the Common Capital Stock of First Citizens Bancshares, Inc. The 2.5 for 1 stock split provided for the issuance of an additional 1.5 shares for each share owned of record as of October 15, 1993. Annual per share dividends paid in 1993 were $2.10. The adjusted dividend per share in 1993 is referenced in Item 6

ITEM 6. SELECTED FINANCIAL DATA The following table presents information for Bancshares effective December 31 for the years indicated. (in thousands) (except per share data) 1993 1992 1991 1990 1989 Net Interest & Fee Income $ 10,895 $ 10,389 $ 9,882 $ 9,991 $ 8,901 Gross Interest Income $ 18,156 $ 18,893 $ 21,074 $ 22,261 $ 21,720 Income From Continuing Operations $ 2,638 $ 2,175 $ 1,961 $ 1,314 $ 1,270 Long Term Obligations $ 0 $ 0 $ 0 $ 0 $ 555 Income Per Share from Continuing Operations* $ 3.76 $ 3.39 $ 3.06 $ 2.05 $ 1.98 Net Income per Common Share** $ 3.94 $ 3.39 $ 3.06 $ 2.05 $ 1.98 Cash Dividends Declared per Common Share** $ .99 $ .94 $ .89 $ .88 $ .84 Total Assets at Year End $234,892 $239,897 $227,017 $218,378 $222,296 * Restated to reflect 10% stock dividend on December 15, 1992. ** Restated to reflect 2.5 for 1 Stock Split on October 15, 1993. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS To understand the following analysis, reference should be made to the consolidated financial statements and other selected financial data presented elsewhere in this report. For purposes of the following discussion, net interest income and net interest margins are presented on a fully taxable equivalent basis. Per share data is adjusted to reflect all stock dividends declared through December 31, 1993. The combination of a favorable interest rate environment reduced operating expense and improved asset quality resulted in record earnings for Bancshares for the year just ended. Operating results for 12/31/93 reflect significant improvement when compared to previous years. Net Income for 1993, 1992 and 1991 was $2,638,459, $2,174,710 and $1,961,203 respectively. Earnings per share were $3.94 in 1993 compared to $3.39 in 1992 and $3.06 in 1991. Earnings per share were adjusted in 1993 to reflect a 2.5 for 1 stock split approved by the Board of Directors in September, 1993. Return on average assets for the years ending 12/31/93, 92 and 91 respectively were 1.17%, .95% and .89%. Return on Average Equity was 8.71% in 1993 compared to 8.07% in 1992 and 7.60% in 1991. Improvement reflected in the Return on Average Assets and equity comparisons for the years indicated is due to strategic planning effort to shift the focus from asset growth to improved profitability. Total Assets declined approximately $5 million or 2.13% when comparing 1993 to 1992. This decline is reflective of a run-off in consumer dollars previously invested in CD's into alternative investment sources providing a higher rate of return. In the present low rate environment, customers are willing to sacrifice security in exchange for higher returns. Net Interest Income after the provision for loan losses increased 5.16% and 7.40% in 1993 and 1992. Net Income improved each year under comparison due to (1) a decrease in non-earning assets (Non-Accrual Loans and Other Real Estate Owned), (2) improved income from the Broker Dealer Subsidiary, (3) sale of annuities (a new product offered in 1993), (4) insurance commissions, and (5) increased volume in the loan portfolio. The provision for Loan Losses reflect a continuous decrease for the years under comparison. Net charge-offs at 12/31/93 was $428,000 compared to $644,000 for the same period in 1992. The ratio of net charge-offs to average net loans outstanding was .30%, .48% and .43% for 12/31/93, 92 and 91. Other expenses decreased in 1993 when comparing YTD 1993 to YTD 1992. The decrease is attributed to a reduction of approximately $600,000 in Data Processing expenses. In 1992, a decision was made to terminate the existing Facilities Management Contract with Systematics, Inc. for data processing services. On September 25, 1992, First Citizens converted to an in-house IBM AS/400 and Horizon Software. The change enhanced income significantly in 1993. Salaries and employee benefits increased 5.31% and 6.38% respectively in 1993 and 1992. A further discussion of Salaries and Benefits is included in the discussion of Non-Interest Expense. Purchases of investment securities were limited to those having maturities within guidelines previously established by policy. While longer maturities would afford an immediate increase in investment income, it was determined that the long term risk was unacceptable. Competition in the local market for quality loans led some financial institutions to extend credit at fixed rates for fifteen years and longer. It was determined that transactions of this nature violated sound asset liability management policy and would be entered into on a limited basis, if at all. On March 4, 1993, the Bank entered into an agreement with Southern Data Systems, Roswell, Georgia, to install a platform automation system, "Bank Pro", for deposit and loan document processing. Bank Pro is completely integrated with the central information file of the Bank's host system, as well as deposit and loan accounting systems. Installation is expected to improve customer service as well as stream line loan and deposit operations. "Bank Pro" was successfully installed September 27, 1993. Two changes were made in the composition of the management team during the first quarter of 1993. Until this time the lending function operated under the quidance of both a Loan Administrator and a Senior Commercial Lending Officer. Based on the significant reduction in problem loans, non-accrual loans, and other real estate owned, coupled with the improved quality of new loans placed into the portfolio for the past several years, it was determined that dual leadership was no longer needed. After careful deliberation of the facts, the responsibilities of Loan Administrator were assigned to the Senior Lending Officer. Lending duties once assumed by this individual were delegated to others within the Commercial Lending area. In addition, an analysis of earnings and other factors within the Trust Department led management to recommend a change in leadership of this function. This was also accomplished during the first quarter. In September, 1993, Bank's management accepted the resignation of the Mortgage Loan Department Manager and two other bank officers responsible for originating long term mortgage loans. The position of manager was filled with a qualified individual with extensive experience in mortgage lending. The individuals hired as loan originators are equally qualified. Changes in Financial Accounting Standards Implementation of FASB No. 109 (Accounting for Income Taxes) has been accomplished for years beginning after 12/15/92. A major change in the new statement is the shift to the liability method from the deferred method of accounting for income taxes. Under the liability method, deferred taxes are adjusted for tax rate changes, whereas they are not under the deferred method. Bancshares carries deferred tax assets on its general ledger as of 12/31/93 of $60,000. This asset is primarily the result of a difference in book and tax deductions for loan losses during the year just ended. FASB No. 107 entitled "Disclosures about Fair Value of Financial Instruments" is effective for fiscal years ending after December 15, 1992. This pronouncement requires disclosure of the "fair value" of all financial instruments. The definition of "financial instruments" includes contractual obligations, such as loans and deposits, on which disclosure of fair value has not previously been required. Disclosure of the methods and significant assumptions utilized in determining fair values must also be disclosed. "Fair Value" is defined as "the amount at which the instrument could be exchanged in a current transaction between willing parties. FASB No. 115 (Accounting for certain investments in Debts and Equity Securities) is scheduled to take effect 1/1/94. Subsequent to the effective date, only those securities contained within either the Trading or Held for Sale Accounts will be available for sale. This limitation will alter investment strategy by forcing banks into shorter maturities. Interim purchases intended for resale within a twelve month period will be placed in either the Trading or Held for Sale Account. FASB No. 106 entitled "Employees' Accounting for Postretirement Benefits other than Pensions" is effective for fiscal years ending after December 15, 1992. This standard applies primarily to health care benefits and requires accrual, during the years that the employee renders service, of the expected cost of providing those benefits to an employee and the employee's beneficiaries and covered dependents. FASB No. 106 will have no effect on Bancshares or the Bank since health care benefits are not provided for its employees after retirement. Other changes presently proposed in Financial Accounting Standards will have no direct material effect on the bank. NON-INTEREST INCOME The following table reflects non-interest income for the years ending December 31, 1993, 1992 and 1991: First Citizens consistently outperforms peer group banks in the area of non-interest income. Total Non-Interest Income reflects an increase of 16.03% and 4.10% when reviewing the years under comparison. Non-Interest Income for 1992 includes Securities Gains of $159,820. Without the gains from sale of securities, Non-Interest Income would have increased $116,000 or 7% above the 1991 total. Other income increased due to increased sales in Mortgage Loans, Brokerage Services, Accounts Receivable Factoring and the sale of annuities. Fiduciary income decreased approximately $50,127 when comparing 1992 to 1991. The decrease was due to the loss of a large corporate account. Service charges on Deposit Accounts decreased $35,000 or 7.46% from 1991 to 1992 because of decreased collections of overdraft and business account analysis income. Non- interest income is projected to be more in line with peer banks in 1994 due to a slow down in refinancing of mortgage loans and management's decision to transfer the sale of annuities from the bank's product listing to Financial Plus, Inc., a subsidiary of the bank that offers brokerage services. Offering a new overdraft line of credit product in 1994 is currently being considered to meet customer needs. A decision to add this product to the bank's credit product listing could have a slight impact on fee income. However, Trust Department income is projected to improve over the next three years. Under new management, the potential for increased profits is significant. NON-INTEREST EXPENSE Total Non-Interest Expense increased 7.47% when comparing 1992 to 1991, then leveled off in 1993. Salaries and benefits increased 5.30% in 1993 and 6.39% in 1992. Increases can be attributed to budget based incentive payments totaling approximately $300,000 in 1993, $151,000 in 1992, and $83,000 in 1991. Excluding bonus payments, salaries would have decreased 9.98% in 1993 when compared to 1992. The decrease is reflective not only of the bank's strategic efforts to maintain staffing levels comparable to peer banks, but of efforts made to encourage quality performance rewarded with an annual bonus payment directly related to bank's profitability. In 1993, the budget based incentive program was enhanced to include all employees of the bank. Under the new plan, bonuses are paid based on the bank's ROA ranging from .85% (minimum payment) to 1.15% (maximum payment) and the employees classification level. The prebonus ROA in 1993 was 1.24%. Also included in salaries and benefits for the two current years are retirement benefits totaling $337,500 in 1993 and $318,000 in 1992. Net Occupancy Expense decreased 13.65% in 1992 due to decreased data processing cost. Other Operating Expense increased $386,000 or 10.90% when comparing 1992 to 1991. This can be partially attributed to a $167,000 (74%) increase in FDIC insurance premiums. Total Non-Interest Expense is closely monitored and tightly controlled by management. One measure of efficient staffing in the banking industry is the dollar amount of assets per employee. Peer group banks average $1,900,000. The following table reflects progress made by First Citizens in attempting to achieve this level: (in thousands) December 31 Assets Per Employee 1993 $1,563 1992 $1,643 1991 $1,393 1990 $1,380 1989 $1,408 It is conceivable that our ratios will remain higher than peer group banks because of increased staff necessary to support extended banking hours and non-banking services to our customers. Management's decision to provide customers with more convenient banking hours by opening drive-in windows at 7AM, and certain of our branches on Saturdays, mandates additional staff which would not be necessary for banks operating only during traditional banking hours. Likewise, the Super Money Market Branch located in the Kroger Supermarket allows banking until 8PM on weekdays and 6PM on Saturday. Non-banking services include Trust and Brokerage services. Full time equivalent employees was 149, 146, 163 respectively as of 12/31/93, 92 and 91. The bank's management is making every effort to monitor and control staffing levels. The slight increase in 1993 was a result of management's decision to construct a full service branch bank located at 2211 St. John near the Industrial Park. Two additional staff members were employed as replacement for employees selected to transfer to the branch. COMPOSITION OF DEPOSITS The average daily amounts of deposits and rates paid on such deposits are summarized for the periods indicated: December 31 (in thousands) 1993 1992 1991 Average Average Average Average Average Average Balance Rate Balance Rate Balance Rate Non-Interest Bearing Demand Deposits $ 21,922 - $ 18,695 - $ 17,382 - Savings Deposits $ 65,612 2.58% $ 60,006 2.98% $ 52,916 4.37% Time Deposits $104,166 4.70% $111,771 5.42% $117,864 6.90% TOTAL DEPOSITS $191,700 3.44% $190,472 4.12% $188,162 5.55% The preceding table is reflective of customer response to the current low interest rate environment. The reluctance to recommit funds into certificates of deposits had the ultimate effect of reducing time deposits by $13,698,000 or 13.15% since 1991, while increasing savings and time balances by $12,696,000 or 23.99%. One factor which is not evident when reviewing information contained within the table is the growth in "Sweep Account Funds". Large balance customers are offered a service which provides for funds to be automatically swept daily from a demand deposit account into an overnight repurchase agreement. This affords commercial customers the opportunity to earn interest on excess collected funds while providing availability of adequate funds to clear large denomination checks when presented for payment. The sweep balances at December 31, 1993, 1992, and 1991 were $10,022,000, $19,049,000, $7,847,000 respectively. During 1993, approximately $5 million was converted from sweep funds to the bank's Investment Management and Trust Services Division. The Bank's management is continuously monitoring and enhancing the bank's product line to retain funds belonging to its existing customers and to attract new customer relationships. In July, 1993, Generations Gold, a new checking club program was offered that included discounts on travel, food, health services, and other major products, as well as savings on bank services. This account replaced all package accounts previously offered and should serve to ultimately strengthen deposit totals. A time deposit product enhanced to attract funds was the "Sweet Sixteen" Certificate of Deposit offering a 16 month maturity and two rate change options. The average rate paid on deposits in 1993, 1992 and 1991 was 3.44%, 4.12% and 5.55%. A slightly higher rate was paid on deposits when compared to average rates paid in other areas of Tennessee because of competitive pricing in the bank's market place. Pricing of deposit products is based on local market and Treasury Bill rates. MATURITY DISTRIBUTION OF TIME DEPOSITS IN AMOUNTS OF $100,000 AND OVER December 31 (in thousands) 1993 1992 Amount Percent Amount Percent Maturing in: 3 months or less $ 6,770 39.48% $ 8,204 46.20% Over 3 through 6 months $ 5,200 30.32% $ 2,641 14.87% Over 6 through 12 months $ 2,388 13.92% $ 1,737 9.78% Over 12 months $ 2,792 16.28% $ 5,176 29.15% TOTAL $17,150 100.00% $17,758 100.00% SOURCES AND USES OF FUNDS (in thousands) 1993 1992 1991 FUNDING USES Average Increase Average Increase Average Balance (Decrease) % Balance (Decrease) % Balance Amount Amount Amount INTEREST-EARNING ASSETS: Loans (Net of Unearned Discounts & Reserve) $141,664 $ 7,150 5.32% $134,514 $ 284 .21% $134,230 Taxable Investment Securities $ 59,124 $ 614 1.05% $ 58,510 $ 6,590 12.69% $ 51,920 Non-Taxable Investment Securities $ 9,800 $ 3,385 52.77% $ 6,415 $ 637 11.02% $ 5,778 Federal Funds Sold $ 2,387 $(4,632)(65.99%)$ 7,019 $ 74 1.07% $ 6,945 Interest Earning Deposits In Banks $ 198 $ 198 100% $ 0 $ (112) (100%) $ 112 TOTAL INTEREST- EARNING ASSETS $213,173 $ 6,715 3.25% $206,458 $ 7,473 3.76% $198,985 Other Uses $ 20,105 $ (17) (.08%)$ 20,122 $ 105 .52% $ 20,017 TOTAL FUNDING USES $233,278 $ 6,698 2.96% $226,580 $ 7,578 3.34% $219,002 1993 1992 1991 FUNDING SOURCES Average Increase Average Increase Average Balance (Decrease) % Balance (Decrease) % Balance Amount Amount Amount INTEREST-BEARING LIABILITIES: Savings Deposits $ 65,612 $ 5,606 9.34% $ 60,006 $ 7,090 13.40% $ 52,916 Time Deposits $104,166 $ (7,605)(6.80%)$111,771 $ (6,093)(5.17%) $117,864 Federal Funds Purchased and Other Interest Bearing Liabilities $ 21,204 $ 3,418 19.22% $ 17,786 $ 5,097 40.17% $ 12,689 TOTAL INTEREST- BEARING LIABILITIES $190,982 $ 1,419 .75% $189,563 $ 6,094 3.32% $183,469 Demand Deposits $ 21,922 $ 3,227 17.26% $ 18,695 $ 1,313 7.55% $ 17,382 Other Sources $ 20,374 $ 2,052 11.20% $ 18,322 $ 171 .94% $ 18,151 TOTAL FUNDING SOURCES: $233,278 $ 6,698 2.96% $226,580 $ 7,578 3.34% $219,002 SUMMARY - AVERAGE BALANCE SHEET AND NET INTEREST INCOME ANALYSIS (1) Loan totals are shown net of interest collected, not earned and loan loss reserves. (2) Fee Income is included in interest income and the computations of the yield on loans. Overdraft Fee Income is excluded from the totals. (3) Includes loans on nonaccrual status. (4) Interest and rates on securities which are non-taxable for Federal Income Tax purposes are presented on a taxable equivalent basis. (5) Includes Insured Money Fund, NOW, club accounts, and other savings. The preceding table summarizes average interest earning assets and interest bearing liabilities including average yields for each category. Total Interest Earning Assets increased $6,715,000 or 3.25% and $7,473,000 or 3.76% and $4,574,000 or 2.36% when comparing 1993, 1992 and 1991 respectively. Total Interest Bearing Liabilities increased $1,419,000 or .75% and $6,094,000 or 3.32% when analyzing the same time periods. Total Interest Earning Assets averaged $213,173,000 at an average rate of 8.31% in 1993 while Total Interest Bearing Liabilities averaged $190,982,000 at an average rate of 3.80%. Net Yield on Average Earning Assets was 4.91% in 1993, 4.74% in 1992, and 4.67% in 1991. LOAN PORTFOLIO ANALYSIS COMPOSITION OF LOANS December 31 (in thousands) 1993 1992 1991 1990 1989 Real Estate Loans: Construction $ 7,675 $ 5,272 $ 4,879 $ 5,526 $ 6,096 Mortgage $ 84,801 $ 79,376 $76,500 $74,039 $66,696 Commercial, Financial and Agricultural Loans $ 34,547 $ 33,931 $33,089 $29,786 $30,140 Installment Loans to Individuals $ 15,901 $ 15,077 $15,901 $17,130 $16,507 Other Loans $ 6,398 $ 2,005 $ 2,697 $ 3,835 $ 4,060 TOTAL LOANS $149,322 $135,661 $133,066 $130,316 $123,499 CHANGES IN LOAN CATEGORIES December 31, 1993 as compared to December 31, 1992 (in thousands) % of Increase Amount of Increase Loan Category (Decrease) (Decrease) Real Estate 9.25% $ 7,828 Commercial, Financial and Agricultural 1.82% $ 616 Installment Loans to Individuals 5.47% $ 824 Other Loans 219.10% $ 4,393 TOTAL LOANS 10.07% $13,661 Improved earnings resulted from several factors, one of which was the ability to increase loan portfolio totals in excess of $13 million from 1992 to 1993. Low interest rates prompted consumer refinancing of existing mortgages, adding significantly to the mortgage loan portfolio. In addition, commercial customers secured outstanding debt with real estate to take advantage of the lower rates and to provide longer repayment terms. Growth in the loan portfolio exceeded budget projections for 1993. The bank's strategic plan calls for loan officers to aggressively seek quality new loan business. The local economy continues to perform better than other areas in Tennessee as a result of diversification. Several unrelated industries and an excellent agricultural base provide stability not present in less diversified economies. The loan portfolio consists of quality diversified assets with real estate loans comprising 62%, commercial, financial and agricultural 23%, and installment and all others 15%. Total real estate loans outstanding as of 12/31/92 were $84,801,000. Approximately 55% of this total are residential in nature and the remaining 45% are commercial and agricultural property. The average yield on loans of First Citizens National Bank for the years indicated are as follows: 1993 - 9.46% 1992 - 10.05% 1991 - 11.34% 1990 - 12.82% 1989 - 12.76% LOAN MATURITIES AND SENSITIVITY TO CHANGES IN INTEREST RATES Due after Due in one one year but Due after year or less within five years five years (in thousands) Real Estate $12,820 $69,110 $10,546 Commercial, Financial and Agricultural $16,324 $16,692 $ 1,531 All Other Loans $ 5,357 $13,331 $ 3,611 TOTALS $34,501 $99,133 $15,688 Loans with Maturities After One Year for which: (in thousands) Interest Rates are Fixed or Predetermined $86,778 Interest Rates are Floating or Adjustable $28,043 Managing interest rate risk is a primary objective of asset-liability management. One tool utilized by First Citizens to ensure market rate return is variable rate loans. Loans totaling $62,544,000 (42% of total portfolio) are subject to repricing within one year or carry a variable interest rate. This total is down approximately $10 million from year end, 1992. Loan maturities in the one to five year category increased from $75,426,000 at 12/31/92 to $99,133,000 at 12/31/93 due to customers demand to lock in fixed interest rates for a longer period of time. While growth in the portfolio is an objective, our first priority is ensuring credit quality. Management considers the portfolio composition to be diversified, with no concentrations in any one industry. NON-PERFORMING LOANS Nonaccrual, Restructured and Past Due Loans and Foreclosed Properties (First Citizens National Bank) December 31 (in thousands) 1993 1992 1991 1990 1989 Nonaccrual Loans $1,079 $1,743 $2,058 $1,958 $ 444 Restructured Loans 0 0 0 0 0 Foreclosed Property Other Real Estate, 98 550 884 1,247 1,597 Other Repossessed Assets 0 0 0 13 24 Total Nonperforming Assets $1,177 $2,293 $2,942 $3,218 $2,065 Loans and leases 90 days Past due and still accruing interest $ 322 $ 176 $1,029 $ 877 $ 673 Nonperforming assets as a percent of loans and leases plus foreclosed property at end of year* .79% 1.71% 2.20% 2.45% 1.65% Allowance as a percent of: Nonperforming assets 142.40% 74.27% 65.81% 59.48% 66.39% Nonperforming assets and loans 90 days past due 111.81% 68.98% 48.76% 46.74% 50.07% Gross Loans 1.12% 1.27% 1.46% 1.47% 1.11% Addition to Reserve as a percent of Net Charge-Offs 93.69% 63.82% 103.86% 142.49% 82.10% Loans and leases 90 days past due as a percent of loans and leases at year end* .22% .13% .78% .67% .54% Recoveries as a percent of Gross Charge-Offs 28.79% 36.17% 26.64% 10.75% 44.01% *Net of unearned income Interest income on loans is recorded on an accrual basis. The accrual of interest is discontinued on all loans, except consumer loans, which become 90 days past due, unless the loan is well secured and in the process of collection. Consumer loans which become past due 90 to 120 days are charged to the allowance for loan losses. The gross interest income that would have been recorded for the twelve months ending 12/31/92 if all loans reported as non-accrual had been current in accordance with their original terms and had been outstanding throughout the period is $102,000. Interest income on loans reported as ninety days past due and on interest accrual status was $30,000 for 1993. Loans on which terms have been modified to provide for a reduction of either principal or interest as a result of deterioration in the financial position of the borrower are considered to be "Restructured Loans". First Citizens has no Restructured Loans for the period being reported. Total Non-Performing Assets have consistently decreased since 1991. As of December, 1993, non-performing loans are at the lowest level since 1985. Total assets in this category as a percent of loans and leases plus foreclosed property was .79% in 1993, 1.71% in 1992, and 2.20% in 1991. Certain loans contained on the bank's Internal Problem Loan List are not included in the listing of non-accrual, past due or restructured loans. Management is confident that, although certain of these loans may pose credit problems, any potential for loss has been provided for by specific allocations to the Loan Loss Reserve Account. Loan officers are required to develop a "Plan of Action" for each problem loan within their portfolio. Adherence to each established plan is monitored by Loan Administration and re-evaluated at regular intervals for effectiveness. LOAN LOSS EXPERIENCE & RESERVE FOR LOAN LOSSES (in thousands) 1993 1992 1991 1990 1989 Average Net Loans Outstanding $141,664 $134,514 $134,230 $126,083 $118,139 Balance of Reserve for Loan Losses at Beginning of Period $ 1,703 $ 1,936 $ 1,914 $ 1,371 $ 1,412 Loan Charge-Offs $ (601) $ (1,009) $ (777) $ (1,432) $ (409) Recovery of Loans Previously Charged Off $ 173 $ 365 $ 207 $ 154 $ 180 Net Loans Charged Off $ (428) $ (644) $ (570) $ (1,278) $ (229) Additions to Reserve Charged to Operating Expense $ 401 $ 411 $ 592 $ 1,821 $ 188 Balance at End of Period $ 1,676 $ 1,703 $ 1,936 $ 1,914 $ 1,371 Ratio of Net Charge- Offs to Average Net Loans Outstanding .30% .48% .43% 1.01% .19% The allowance for possible loan losses is determined by management and approved by the Board based on previous loan loss experience, existing and anticipated economic conditions, composition and volume of the loan portfolio and the level of non-performing assets. A quarterly analysis is presented to the Board in order that a determination may be made concerning the sufficiency of the reserves. The balance of the Loan Loss Reserve account at 12/31/93 was $1,676,000 representing 1.12% of total loans outstanding and a 15.00% decrease from the 1991 account balance. Additions to reserve charged against earnings have reduced significantly since 1990 and are below peer group levels. Management has adequately provided for potential loan losses and risk within the bank's loan portfolio. Internal Loan Review performs an analysis on an annual basis of approximately 75% of the portfolio. Based on this review, each loan is classified as Pass, Substandard, Doubtful or Loss. Loans classified as loss are charged monthly against the Loan Loss Reserve account. Those considered by Loan Review to be Substandard or Doubtful are included on the bank's internal Problem Loan List. Problem Loans, as a percentage of total portfolio were 2.92% at 1993, 4.10% at 12/31/92, and 6.57% at 12/31/91. Quarterly Reports are provided directly to the Board of Directors by the Loan Review Officer which summarize results of the reviews. New classifications are analyzed and discussed in detail. Management estimates the approximate amount of charge-offs for the 12 month period ending 12/31/94 to be as follows: Domestic Amount Commercial, Financial & Agricultural $300,000 Real Estate-Construction 0 Real Estate-Mortgage 50,000 Installment Loans to individuals & credit cards 150,000 Lease financing 0 01/01/94 through 12/31/94 Total $500,000 The following table will identify charge-offs by category for the periods ending December 31 as indicated: Year Ending December 31 (in thousands) 1993 1992 1991 Charge-offs: Domestic: Commercial, Financial & Agricultural $ 415 $ 649 $ 293 Real Estate-Construction 0 0 0 Real Estate-Mortgage 27 115 88 Installment Loans to individuals & credit cards 159 245 396 Lease financing 0 0 0 Total $ 601 $1,009 $ 777 Recoveries: Domestic: Commercial, Financial & Agricultural $ 53 $ 66 $ 97 Real Estate-Construction 0 0 0 Real Estate-Mortgage 11 148 4 Installment Loans to individuals & credit cards 109 151 106 Lease financing 0 0 0 Total $ 173 $ 365 $ 207 Net Charge-offs $ 428 $ 644 $ 570 COMPOSITION OF INVESTMENT SECURITIES December 31 (in thousands) 1993 1992 1991 1990 1989 U. S. Treasury & Government Agencies $42,502 $59,019 $50,919 $43,337 $54,147 State & Political Subdivisions $12,774 $ 9,300 $ 3,239 $ 7,484 $ 7,522 All Others $ 5,471 $ 6,129 $ 4,944 $ 5,251 $ 5,439 TOTALS $60,747 $74,448 $59,102 $56,072 $67,108 MATURITY AND YIELD ON SECURITIES - DECEMBER 31, 1993 (in thousands) Maturing Maturing Maturing Maturing After One Year After Five Years After Within One Year Within Five Years Within Ten Years Ten Years Amount Yield Amount Yield Amount Yield Amount Yield U. S. Treasury and Government Agencies $15,400 6.05% $19,532 5.82% $ 3,135 6.48% $ 4,435 6.08% State and Political Subdivisions* $ 1,653 6.72% $ 9,050 6.73% $ 1,971 6.85% $ 100 6.59% All Others $ 1,900 7.57% $ 3,571 5.31% $ 0 .00% $ 0 .00% TOTALS $18,953 6.26% $32,153 6.02% $ 5,106 6.62% $ 4,535 6.10% *Yields on tax free investments are stated herein on a taxable equivalent basis. The investment securities portfolio is a major component of First Citizens' earning assets. It provides a stable long term income stream and is managed in such a way as to enhance the Company's asset/liability management program. Investment Securities also serve as collateral for government and other public funds deposits. Securities contained within the portfolio consist primarily of U.S. Treasury and other U.S. Government Agency securities and tax-exempt obligations of states and political subdivisions. All other investment securities contained therein comprise approximately 10% of the portfolio. The investment portfolio, when comparing 1993 to 1992 decreased approximately $10 million. Since 1989, deposit and capital growth as well as maturing investments were utilized to fund loan growth. Purchases of Investments during the third quarter consisted primarily of Tax Free Municipal Bonds. A 21% increase in tax free investments from 1992 to 1993 is a conscious effort to reduce tax liability in light of increased earnings. Maturities within the portfolio are made up of 31.19% within one year and 52.92% after one year and within five years. Policy provides for 20% maturities on an annual basis. Management has made a conscious effort to shorten maturities based on the current interest rate environment and mark to market rules scheduled to take effect 1/1/94. Beginning in 1994, the portfolio will be structured to insure that future sales of securities prior to maturity will be accomplished from either the Trading or Held for Sale accounts. During the third quarter of 1993, taxable securities totaling $4,150,000 bearing maturity or call dates in the calendar year 1993 were sold. The sale resulted in gross profits of approximately $22,233. Also sold from the investment portfolio in February, 1993 was a CMO PAC with a par value of $1,022,500 sold with a net loss of $3,280.32. These securities were sold due to interest rate risk in a rising rate environment if held to maturity and to fund loan growth in 1993. For years ending December 31, 1993, 1992 and 1991 there was no activity within the trading account. Interest and dividend income was non- existant for this three year period, with ending balances being zero for all years under comparison. Securities in the Held for Sale Account consisted of 24,000 shares of FHLMC Preferred Stock having a book value of $600,000. Reported in Held for Sale at 6/30/93 was 12,000 shares of FHLMC Preferred stock valued at $300,000. An additional 12,000 shares were purchased and placed in this account during the third quarter 1993. The average and ending balances in the Held for Sale Account for 12/31/93 were $500,000 and $600,000 respectively. During the fourth quarter, 1993, there were no transfers between the Trading, Held for Sale, and Investment Accounts. Gains/Losses reflected in year-end income statements attributable to trading account securities: Year Ended 12/31 Gains Losses Net 1993 $ 0.00 $ 0.00 $ 0.00 1992 $ 0.00 $ 0.00 $ 0.00 1991 $ 3,125.00 $ 0.00 $ 3,125.00 The following table allocates by category unrealized Gains/Losses within the portfolio as of December 31, 1993 (in thousands): UNREALIZED NET GAINS LOSSES GAINS/LOSSES U.S. TREASURY SECURITIES $ 227 $ 0 $ 227 OBLIGATIONS OF U.S. GOVERNMENT AGENCIES AND CORPORATIONS $ 516 $ 35 $ 481 OBLIGATIONS OF STATES AND POLITICAL SUBDIVISIONS $ 205 $ 27 $ 178 FEDERAL RESERVE AND CORPORATE STOCK $ 156 $ 0 $ 156 TOTALS $ 1,104 $ 62 $ 1,042 LIQUIDITY AND INTEREST RATE SENSITIVITY Liquidity is the ability to meet the needs of our customer base for loans and deposit withdrawals by maintaining assets which are convertible to cash equivalents with minimal exposure to interest rate risks. The liquidity ratio which is determined by a comparison of net liquid assets to net liabilities remains between 10% and 15%. The stability of our deposit base, sound asset/liability management, a strong capital base and quality assets assure adequate liquidity. The low interest rate environment has placed pressure on the ability to retain funds in maturing certificates of deposit. Many of our customers are, for the first time, looking outside the traditional bank investment options and investing in annuities, mutual funds and stocks. Deposits of $100,000 and over tend to be much more volatile and interest sensitive than smaller consumer deposits which make up the major portion of our deposit base. Another factor which must be addressed in the current interest rate situation is the inclination of our customers to lock in rates for longer periods of time. In excess of $24,000,000 in loans shifted from less than one year maturity to the one to five year category. Sound asset/liability management principals would dictate that investments should and do follow this trend. To address liquidity concerns, First Citizens became a member of the Federal Home Loan Bank, thereby opening up an additional liquidity source should the need arise. Interest rate sensitivity varies with different types of interest- earning assets and interest-bearing liabilities. Overnight federal funds, on which rates change daily, and loans which are tied to the prime rate are much more sensitive than long-term investment securities and fixed rate loans. The shorter term interest sensitive assets and liabilities are the key to measurement of the interest sensitivity gap. Minimizing this gap is a continual challenge in the present interest rate environment. This is the primary objective of the asset/liability management program. The following condensed gap report provides an analysis of interest rate sensitivity of earning assets and interest bearing liabilities. First Citizens Asset/Liability Management Policy provides that the cumulative gap as a percent of assets shall not exceed 10% for the three to six months, six to twelve months. The Cumulative Gap position in the one to five year category shall not exceed 20%. As evidenced by the following table, our current position is significantly below this level, with annual income exposure determined to be less than $100,000. CONDENSED GAP REPORT 12/31/93 CURRENT BALANCES (in thousands) 1-2 2+ YEARS YEARS CASH AND DUE FROM: CURRENCY AND COIN - 1,880 DUE FROM BANKS - 1,838 CASH ITEMS - 4,724 TOTAL CASH & DUE FROM - 8,442 INVESTMENTS: US TREASURIES 2,000 4,613 US AGENCIES 1,993 14,550 MUNICIPALS 2,305 8,816 HELD FOR SALE - - CORP & OTHERS 1,006 1,341 FEDERAL HOME LOAN BANK - 1,224 TOTAL INVESTMENTS 7,304 30,544 LOANS: COMMERCIAL FIXED 1,593 9,040 COMMERCIAL VARIABLE - - REAL ESTATE-VARIABLE - - REAL ESTATE FIXED 6,204 53,009 HOME EQUITY LOANS - - SEC MORTGAGE - - INSTALLMENT LOANS 3,844 9,497 INSTALLMENT VARIABLE - - FLOOR PLAN - - CREDIT CARDS - - OVERDRAFTS - - NON-ACCRUAL LOANS - 1,079 FHLB LOANS - 2,513 TOTAL LOANS 11,641 75,138 LOAN LOSS RESERVE - 1,676 NET LOANS 11,641 73,462 FED FUNDS SOLD - - TOTAL FED FUNDS SOLD - - TOTAL EARNING ASSETS 18,945 104,006 OTHER ASSETS: BUILDING, F&F & LAND - 7,627 OTHER REAL ESTATE - 98 OTHER ASSETS - 3,062 TOTAL OTHER ASSETS - 10,787 TOTAL ASSETS 18,945 123,235 DEMAND DEPOSITS: BANKS - 39 DEMAND DEPOSITS - 22,392 OFFICIAL CHECKS - 1 TOTAL DEMAND - 22,432 SAVINGS ACCOUNTS: REGULAR SAVINGS - 18,007 NOW ACCOUNT - 27,154 IMF-MMDA - 12,239 HIGH YIELD ACCOUNT - - GENERATIONS GOLD - 5,722 TOTAL SAVINGS - 63,122 CONDENSED GAP REPORT 12/31/93 CURRENT BALANCES (in thousands) 1-2 2+ YEARS YEARS TIME DEPOSITS: FLEX-CD 7,304 6,148 LARGE CD-FLEX 1,342 1,450 IRA-FLOATING - - IRA-FIXED 2,431 6,211 CHRISTMAS CLUB - - TOTAL TIME 11,077 13,809 TOTAL DEPOSITS 11,077 99,363 SHORT TERM BORROWINGS: TT&L - - SECURITIES SOLD-SWEEP - - SECURITIES SOLD-FIXED 600 281 TOTAL SHORT TERM BORR. 600 281 OTHER LIABILITIES: ACCRUED INT. PAYABLE - 1,369 OTHER LIABILITIES - 404 TOTAL OTHER LIABILITIES - 1,773 TOTAL LIABILITIES 11,677 101,417 CAPITAL: COMMON STOCK - 2,000 SURPLUS - 4,000 UNDIVIDED PROFITS - 13,506 TOTAL CAPITAL - 19,506 TOTAL LIAB'S & CAPITAL 11,677 120,923 GAP (SPREAD) 7,268 2,312 GAP % TOTAL ASSETS 3.12 0.99 CUMULATIVE GAP -2,312 - CUM. GAP % TOTAL ASSETS -0.99 - SENSITIVITY RATIO 0.98 1.00 CONDENSED GAP REPORT 12/31/93 CURRENT BALANCES (in thousands) 1-2 2+ YEARS YEARS CASH AND DUE FROM: CURRENCY AND COIN - - DUE FROM BANKS - - CASH ITEMS - - TOTAL CASH & DUE FROM - - INVESTMENTS: US TREASURIES 5.10 5.40 US AGENCIES 5.10 6.12 MUNICIPALS 6.89 6.72 HELD FOR SALE - - CORP & OTHERS 5.16 5.39 FEDERAL HOME LOAN BANK - 5.35 TOTAL INVESTMENTS 5.67 6.12 LOANS: COMMERCIAL FIXED 8.23 7.70 COMMERCIAL VARIABLE - - REAL ESTATE-VARIABLE - - REAL ESTATE FIXED 9.55 8.13 HOME EQUITY LOANS - - SEC MORTGAGE - - INSTALLMENT LOANS 11.57 9.55 INSTALLMENT VARIABLE - - FLOOR PLAN - - CREDIT CARDS - - OVERDRAFTS - - NON-ACCRUAL LOANS - - FHLB LOANS - 7.50 TOTAL LOANS 10.03 8.12 LOAN LOSS RESERVE - - NET LOANS 10.03 8.31 FED FUNDS SOLD - - TOTAL FED FUNDS SOLD - - TOTAL EARNING ASSETS 8.35 7.66 OTHER ASSETS: BUILDING, F&F & LAND - - OTHER REAL ESTATE - - OTHER ASSETS - - TOTAL OTHER ASSETS - - TOTAL ASSETS 8.35 6.47 DEMAND DEPOSITS: BANKS - - DEMAND DEPOSITS - - OFFICIAL CHECKS - - TOTAL DEMAND - - SAVINGS ACCOUNTS: REGULAR SAVINGS - 2.76 NOW ACCOUNT - 2.46 IMF-MMDA - 2.73 HIGH YIELD ACCOUNT - - GENERATIONS GOLD - 2.16 TOTAL SAVINGS - 2.57 CONDENSED GAP REPORT 12/31/93 CURRENT BALANCES (in thousands) 1-2 2+ YEARS YEARS TIME DEPOSITS: FLEX-CD 5.26 5.90 LARGE CD-FLEX 5.35 6.44 IRA-FLOATING - - IRA-FIXED 5.23 5.81 CHRISTMAS CLUB - - TOTAL TIME 5.26 5.92 TOTAL DEPOSITS 5.26 2.45 SHORT TERM BORROWINGS: TT&L - - SECURITIES SOLD-SWEEP - - SECURITIES SOLD-FIXED 5.08 5.80 TOTAL SHORT TERM BORR. 5.08 5.80 OTHER LIABILITIES: ACCRUED INT. PAYABLE - - OTHER LIABILITIES - - TOTAL OTHER LIABILITIES - - TOTAL LIABILITIES 5.25 2.42 CAPITAL: COMMON STOCK - - SURPLUS - - UNDIVIDED PROFITS - - TOTAL CAPITAL - - TOTAL LIAB'S & CAPITAL 5.25 2.03 GAP (SPREAD) 3.10 4.44 GAP % TOTAL ASSETS CUMULATIVE GAP CUM. GAP % TOTAL ASSETS SENSITIVITY RATIO RETURN ON EQUITY AND ASSETS FIRST CITIZENS BANCSHARES, INC. 1993 1992 1991 1990 1989 Percentage of Net Income to: Average Total Assets 1.17% .95% .89% .60% .59% Average Shareholders Equity 13.48% 11.79% 11.65% 8.43% 8.40% Percentage of Dividends Declared Per Common Share to Net Income Per Common Share 25.62% 27.67% 28.86% 42.57% 43.04% Percentage of Average Shareholders' Equity to Average Total Assets 8.71% 8.07% 7.60% 7.27% 7.00% Improved earnings performance is evident when reviewing the following table. The "domino effect" is seen in return on assets and equity, and in improved capital ratios. The company's Strategic Plan addresses objectives to sustain improved earnings, maintain a quality loan portfolio, and to maintain market share by providing quality customer service. Management of the Bank is committed to improving and maintaining earnings that are comparable to peer banks. Ratios comparing net income to average total assets and average shareholders equity indicate improvement from prior years. Return on Assets at 12/31/93 was 1.17%. Total Shareholders' equity (including Loan Loss Reserve) of First Citizens Bancshares as of 12/31/93 was $21,700,477 compared to $19,308,975 at 12/31/92. Total Capital (excluding Reserve for Loan Losses) as a percentage of total assets is presented in the following table for years indicated. CAPITAL RESOURCES/TOTAL ASSETS - YEAR-END TOTALS FIRST CITIZENS BANCSHARES, INC. 1993 1992 1991 1990 1989 9.24% 8.05% 7.75% 7.34% 6.80% Cash Dividends to Shareholders for 1993 and 1992 were $2.10 and $2.30 per share. This compares to dividends of $2.225 in 1990 and $2.10 per share paid each year from 1987 thru 1989. In September, 1993 a 2.5 for 1 stock split on the Common Capital Stock of Bancshares was declared to holders of record as October 15, 1993. The number of shares outstanding increased proportionately with changes to the capital account. In addition, a 10% stock dividend was declared payable December 15, 1992 which provided for the issuance of one share of stock for each 10 shares owned; with payment for fractional shares being made in cash. 25,158 shares were issued as a result of this dividend. In 1989, a stock dividend was declared payable December 15, 1989 which provided for the issuance of one share of stock for each twenty shares owned. Fractional shares were also paid in cash. 11,826 shares were issued as a result. Total shares outstanding were 706,656 at 12/31/93 and 279,247 at 12/31/92. An amendment to the Articles of Association ratified by the Shareholders in April, 1989 approved an increase in the number of shares authorized from 410,000 to 750,000. Risk-based capital focuses primarily on broad categories of credit risk and incorporates elements of transfer, interest rate and market risks. The calculation of risk-based capital ratio is accomplished by dividing qualifying capital by weighted risk assets. Effective January 1, 1993, the minimum risk-based capital ratio increased to 8.00%. At least one-half or 4.00% must consist of core capital (Tier 1), and the remaining 4.00% may be in the form of core (Tier 1) or supplemental capital (Tier 2). Tier 1 capital/core capital consists of common stockholders equity, qualified perpetual stock and minority interests in consolidated subsidiaries. Tier 2 Capital/Supplementary capital consists of the allowance for loan and lease losses, perpetual preferred stock, term subordinated debt, and other debt and stock instruments. Bancshares has historically maintained capital in excess of minimum levels established by the Federal Reserve Board. The risk-based capital ratio for Bancshares and First Citizens National Bank as of 12/31/93 was 13.88 percent and 12.73 percent respectively, significantly above the 8.0 percent level as required by regulation. With the exception of the Reserve for Loan and Lease Losses, all capital is Tier 1 level. Growth in capital will be maintained through retained earnings. There is no reason to assume that income levels will not be sufficient to maintain an adequate capital ratio. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA Board of Directors First Citizens Bancshares, Inc. Dyersburg, Tennessee 38024 We have audited the accompanying consolidated balance sheets of First Citizens Bancshares, Inc., and subsidiary as of December 31, 1993 and 1992, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the three years ended December 31, 1993. These financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of First Citizens Bancshares, Inc. and Subsidiary as of December 31, 1993 and 1992, and their results of operations and cash flows for the three years ended December 31, 1993 in conformity with generally accepted accounting principles. Dyersburg, Tennessee CARMICHAEL, ENOCH & ASSOCIATES January 25, 1994 FIRST CITIZENS BANCSHARES, INC., AND SUBSIDIARY CONSOLIDATED BALANCE SHEETS December 31, 1993 and 1992 ASSETS December 31 1993 1992 Cash and due from banks - Note 12 $ 8,407,663 $ 10,591,316 Federal funds sold 5,200,000 6,700,000 Investment securities - Notes 1 and 2 (market value $61,789,052 at December 31, 1993, and $75,285,031 at December 31, 1992) 60,747,040 74,447,690 Loans - Notes 1 and 3 (net of unearned income of $1,065,608 in 1993 and $1,149,319 in 1992) 149,322,178 135,660,731 Less: Allowance for loan losses - Notes 1 and 4 1,676,133 1,703,349 Net Loans 147,646,045 133,957,382 Premises and equipment - Notes 1 and 5 7,778,246 8,214,425 Accrued interest receivable 2,572,669 2,857,664 Other assets - Notes 1 and 6 2,540,369 3,128,812 TOTAL ASSETS $234,892,032 $239,897,289 LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities: Deposits: Note 7 Demand $ 22,324,092 $ 21,302,536 Time 105,189,285 105,759,874 Savings 66,309,872 66,396,924 Total Deposits 193,823,249 193,459,334 Securities sold under agreement to repurchase 16,914,142 25,133,919 Long-term debt - Note 15 30,021 162,964 Notes payable of Employee Stock Ownership Plan - Note 18 160,000 Other liabilities 2,424,143 1,672,097 Total Liabilities 213,191,555 220,588,314 Stockholders' Equity: Common stock, $10 Par Value: Authorized - 750,000 shares: Issued and Outstanding - 706,656 shares in 1993 279,247 shares in 1992 7,066,560 2,792,470 Surplus 2,356,082 6,394,048 Retained earnings 12,338,242 10,282,457 Less treasury stock, at cost 2,024 shares (60,407) Obligation of Employee Stock Ownership Plan (160,000) Total Stockholders' Equity 21,700,477 19,308,975 TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $234,892,032 $239,897,289 See accompanying notes and accountants' report. FIRST CITIZENS BANCSHARES, INC., AND SUBSIDIARY CONSOLIDATED STATEMENTS OF INCOME Years Ended December 31, 1993, 1992, and 1991 1993 1992 1991 Interest Income Interest and fees on loans $14,029,313 $14,289,129 $16,064,641 Interest and dividends on investment securities: Taxable 3,499,964 3,994,589 4,170,801 Tax-exempt 447,114 321,501 345,467 Dividends 91,738 19,245 75,961 Other interest income 81,203 257,470 400,039 Lease financing income 6,426 11,182 16,693 Total Interest Income 18,155,758 18,893,116 21,073,602 Interest Expense Interest on deposits 6,588,376 7,846,697 10,423,725 Interest on long-term debt 26,557 27,836 26,576 Other interest expense 646,021 629,606 741,213 Total Interest Expense 7,260,954 8,504,139 11,191,514 Net Interest Income 10,894,804 10,388,977 9,882,088 Provision for loan losses - Note 4 401,273 411,001 592,110 Net interest income after provision for loan losses 10,493,531 9,977,976 9,289,978 Other Income Income from fiduciary activities 521,284 522,540 572,667 Service charges on deposit accounts 439,756 434,058 469,287 Other service charges, commissions, and fees 771,024 559,284 458,104 Securities gains (losses) - Net - Note 2 31,758 159,820 2,077 Other income 316,496 322,311 220,254 Total Other Income 2,080,318 1,998,013 1,722,389 Other Expenses Salaries and employee benefits - Note 8 4,750,184 4,510,654 4,239,795 Net occupancy expenses 348,702 309,921 358,585 Furniture and equipment expense 135,895 148,616 123,157 Depreciation 798,220 596,221 482,645 Data processing expense 154,670 802,398 990,572 Legal and professional fees 128,574 116,959 94,605 Stationary and office supplies 161,796 172,542 185,730 Other expenses 2,254,641 2,089,716 1,664,046 Total Other Expenses 8,732,682 8,747,027 8,139,135 Net income before income taxes 3,841,167 3,228,962 2,873,232 Provision for income tax expense - Note 9 1,202,708 1,054,252 912,029 Net income for operations 2,638,459 2,174,710 1,961,203 Cumulative change in accounting principle - Note 9 125,278 Net Income $ 2,763,737 $ 2,174,710 $1,961,203 Earnings Per Common Share - Note 10: Net income from operations $ 3.76 $ 3.39 $ 3.08 Net income $ 3.94 $ 3.39 $ 3.08 Weighted average shares outstanding 700,958 640,363 635,121 See accompanying notes and accountants' report. FIRST CITIZENS BANCSHARES, INC., AND SUBSIDIARY CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY Years Ended December 31, 1993, 1992, and 1991 Common Retained Stock Surplus Earnings Balance, January 1, 1991 $2,540,890 $5,324,833 $ 8,635,612 Net income, year ended December 31, 1991 1,961,203 Cash dividends paid - $2.225 per share (566,395) Balance, December 31, 1991 2,540,890 5,324,833 10,030,420 Net income, year ended December 31, 1992 2,174,710 Cash dividends paid - $2.30 per share (601,878) Ten percent stock dividend - December, 1992 - Note 10 251,580 1,069,215 (1,320,795) Balance, December 31, 1992 $2,792,470 6,394,048 10,282,457 Net income, year ended December 31, 1993 2,763,737 Cash dividends paid-$2.10 per share (707,952) Sale of Common Stock 47,110 189,014 Stock Split - Note 10 4,226,980 (4,226,980) Balance, December 31, 1993 $7,066,560 $2,356,082 $12,338,242 See accompanying notes and accountants' report. FIRST CITIZENS BANCSHARES, INC., AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOW Years Ended December 31, 1993, 1992, and 1991 1993 1992 1991 Operating Activities Net income $ 2,763,737 $ 2,174,710 $1,961,203 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 401,273 411,001 592,110 Provision for losses on other real estate 3,000 7,600 40,339 Provision for depreciation and amortization 798,220 596,221 508,319 Amortization of investment security discounts (25,919) (31,849) (60,702) Deferred income taxes (175,989) 98,684 (Gains) losses on sales of other real estate (4,289) (13,903) (60,910) Realized and unrealized investment security (gains) losses (31,758) (159,820) (2,077) (Increase) decrease in accrued interest receivable 284,995 469,832 (46,297) Increase (decrease) in accrued interest payable 29,159 (471,601) (291,991) (Increase) decrease in other assets 765,721 669,033 (723,182) Increase (decrease) in other liabilities 722,887 (757,368) 34,225_ NET CASH PROVIDED BY OPERATING ACTIVITIES 5,531,037 2,893,856 2,049,721 Investing Activities Proceeds of maturities of securities 10,826,000 17,618,000 15,010,397 Proceeds from sales of trading and investment securities 5,300,252 10,096,833 14,009,395 Purchase of trading and investment securities (2,367,925) (42,868,559) (31,537,312) Increase in loans - net (14,089,936) (3,237,807) (3,446,209) Purchases of premises and equipment (362,041) (1,545,185) (551,690) NET CASH PROVIDED (USED) BY INVESTING ACTIVITIES $ (693,650) $(19,936,718) $(6,515,419) See accompanying notes and accountants' report. FIRST CITIZENS BANCSHARES, INC., AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOW (CONTINUED) Years Ended December 31, 1993, 1992, and 1991 1993 1992 1991 Financing Activities Net increase (decrease) in demand deposits, NOW Accounts and savings accounts $ 450,967 $ 12,169,387 $ 1,120,594 Increase (decrease) in time deposits - net (87,052) (11,773,657) 2,003,393 Payment of principal on long-term debt (132,943) (130,906) (131,647) Proceeds from sale of common stock 236,124 Cash dividends paid (707,952) (601,878) (566,395) Net increase (decrease) in short-term borrowings (8,219,777) 12,271,124 4,509,753 Treasury stock transactions - net (60,407) NET CASH PROVIDED (USED) BY FINANCING ACTIVITIES (8,521,040) 11,934,070 6,935,698 INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (3,683,653) (5,108,792) 2,470,000 Cash and cash equivalents at beginning of year 17,291,316 22,400,108 19,930,108 CASH AND CASH EQUIVALENTS AT END OF YEAR $13,607,663 $ 17,291,316 $ 22,400,108 Cash payments made for interest and income taxes during the years presented are as follows: 1993 1992 1991 Interest $7,231,795 $8,975,740 $11,483,505 Income taxes 1,131,310 912,156 1,143,750 See accompanying notes and accountants' report. FIRST CITIZENS BANCSHARES, INC., AND SUBSIDIARY NOTES TO FINANCIAL STATEMENTS December 31, 1993 Note 1 - Summary of Significant Accounting and Reporting Policies The accounting and reporting policies of First Citizens Bancshares, Inc. and subsidiary conform to generally accepted accounting principles. The significant policies are described as follows: BASIS OF PRESENTATION The consolidated financial statements include all accounts of First Citizens Bancshares, Inc. and First Citizens National Bank. First Citizens Bancshares, Inc.'s investment in its subsidiary shown on the Parent Company Balance Sheet is stated at equity in the underlying assets. All inter-company items are eliminated in consolidation. BASIS OF ACCOUNTING The consolidated financial statements are presented using the accrual basis of accounting. CASH EQUIVALENTS Cash equivalents include amounts due from banks which do not bear interest and federal funds sold. Generally, federal funds are purchased and sold for one day periods. SECURITIES Investment securities are carried at cost, adjusted for amortization of premiums and accretion of discounts, computed using the straight-line method, which approximates the interest method. The adjusted cost of the specific security sold is used to compute gains or losses on the sale of securities. Trading account securities are carried at market value. Gains and losses on sales of trading account securities and market value adjustments to trading account securities are included in net securities gains and losses on the consolidated statement of income. Debt securities are classified, when purchased, as an investment security or a trading account asset based on management's intent. Securities which are purchased for resale in the foreseeable future are categorized as trading account assets while those which management intends to hold for an extended time or until maturity are classified as investment securities. ALLOWANCE FOR LOAN LOSSES The provision for loan losses which is charged to operations is based on management's assessment of the quality of the loan portfolio, current economic conditions and other relevant factors. In management's judgment, the provision for loan losses will maintain the allowance for loan losses at an adequate level to absorb potential loan losses which may exist in the portfolio. PREMISES AND EQUIPMENT Bank premises and equipment are stated at cost less accumulated depreciation. The provision for depreciation is computed using straight-line and accelerated methods for both financial reporting and income tax purposes. Expenditures for maintenance and repairs are charged against income as incurred. Cost of major additions and improvements are capitalized and depreciated over their estimated useful lives. FIRST CITIZENS BANCSHARES, INC., AND SUBSIDIARY NOTES TO FINANCIAL STATEMENTS (CONTINUED) December 31, 1992 Note 1 - Summary of Significant Accounting and Reporting Policies (Continued) REAL ESTATE ACQUIRED BY FORECLOSURE Real estate acquired through foreclosure is reflected in other assets and is recorded at the lower of the related outstanding loan amount or estimated net realizable value at the date of acquisition. Adjustments made at the date of foreclosure are charged to the allowance for loan losses. Expenses incurred in connection with ownership, subsequent adjustments to book value, and gains and losses upon disposition are included in other non-interest expenses. Adjustments to net realizable value are made annually subsequent to acquisition based on appraisal. INCOME TAXES First Citizens Bancshares, Inc. uses the accrual method of accounting for federal income tax reporting. Deferred tax assets or liabilities are computed for significant differences in financial statement and tax bases of assets and liabilities which result from temporary differences in financial statement and tax accounting. LOANS AND INTEREST INCOME ON LOANS Interest income on commercial and real estate loans is computed on the basis of the daily principal balance outstanding using the accrual method. Interest on installment loans is credited to operations by the rule of 78th method, which does not represent a significant financial deviation from the interest method. NET INCOME PER SHARE OF COMMON STOCK Net income per share of common stock is computed by dividing net income by the weighted average number of shares of common stock outstanding during the period, after giving retroactive effect to stock dividends and stock splits. INCOME FROM FIDUCIARY ACTIVITIES Income from fiduciary activities is recorded on the accrual basis. Note 2 - Investment Securities The following tables reflect amortized cost, unrealized gains and losses, and approximate market value for investment securities for each balance sheet date presented: December 31, 1993 Gross Gross Estimated Amortized Unrealized Unrealized Market Cost Gains Losses Value U.S. Treasury securities and obligations of U.S. government corporations and agencies $38,515,709 $ 718,878 $ 24,379 $39,210,208 Obligations of states and political subdivisions 12,773,676 203,304 25,273 12,951,707 Other debt securities 7,442,655 148,426 10,444 7,580,637 Total debt securities 58,732,040 1,070,608 60,096 59,742,552 Other securities investments 2,015,000 31,500 2,046,500 Total Investment Securities $60,747,040 $1,102,108 $ 60,096 $61,789,052 FIRST CITIZENS BANCSHARES, INC., AND SUBSIDIARY NOTES TO FINANCIAL STATEMENTS (CONTINUED) December 31, 1993 Note 2 - Investment Securities (Continued) December 31, 1992 Gross Gross Estimated Amortized Unrealized Unrealized Market Cost Gains Losses Value U.S. Treasury securities and obligations of U.S. government corporations and agencies $59,019,011 $ 861,186 $138,798 $59,741,399 Obligations of states and political subdivisions 9,300,427 58,948 81,108 9,278,267 Other debt securities 4,952,252 137,113 5,089,365 Total debt securities 73,271,690 1,057,247 219,906 74,109,031 Other Securities Investments 1,176,000 1,176,000 Total Investment Securities $74,447,690 $1,057,247 $219,906 $75,285,031 The differences between book values of investment securities and market values at December 31, 1993 and December 31, 1992, total $1,042,012 and $837,341, respectively. These differences are deemed to be temporary market fluctuations and the securities are expected to mature at par value. The Corporation has both the intent and ability to hold these investments to maturity. The amortized cost and estimated market value of debt securities at December 31, 1993 and 1992, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. 1993 1992 Estimated Estimated Amortized Market Amortized Market Cost Value Cost Value Due in one year or less $18,386,816 $18,630,689 $19,562,889 $19,726,509 Due after one year through five years 26,669,724 27,298,941 43,850,937 44,462,497 Due after five years through ten years 8,540,010 8,725,285 6,676,589 6,733,668 Due after ten years 5,135,490 5,087,637 3,181,275 3,186,457 $58,732,040 $59,742,552 $73,271,690 $74,109,131 At December 31, 1993 and 1992, investment securities were pledged to secure government, public and trust deposits as follows: December 31 Book Value Market Value 1993 $35,310,879 $36,010,041 1992 44,811,189 45,332,386 Securities gains (losses) presented in the consolidated statements of income consist of the following: Gross Sales of Investment Year Ended December 31 Securities Gains Losses Net 1993 $ 5,300,252 $ 35,038 $ 3,280 $ 31,758 1992 10,096,833 182,301 22,481 159,820 1991 11,799,817 148,178 146,101 2,077 FIRST CITIZENS BANCSHARES, INC., AND SUBSIDIARY NOTES TO FINANCIAL STATEMENTS (CONTINUED) December 31, 1993 Note 2 - Investment Securities (Continued) During the years presented First Citizens Bancshares, Inc., experienced the following trading account securities gains and losses which are included in the caption "Securities gains (losses)" on the consolidated statements of income: Year Ended December 31 Gains Losses Net 1993 $ -0- $ -0- $ -0- 1992 -0- -0- -0- 1991 3,125 -0- 3,125 At December 31, 1993 and 1992, no trading account securities were held as assets. The Bank classifies certain securities as "held for resale" and during the year ended December 31, 1992, sales of these securities resulted in losses of $10,176, which is also included in the caption "securities gains (losses)." No transactions occurred in securities "held for resale" during the year ended December 31, 1993. Note 3 - Loans Loans outstanding at December 31, 1993 and 1992, were comprised of the following: 1993 1992 (In Thousands) Commercial, Financial and Agricultural $ 34,547 $ 33,930 Real Estate - Construction 7,675 5,272 Real Estate - Mortgage 84,801 79,376 Installment 15,901 15,077 Other Loans 6,398 2,005 149,322 135,660 Less: Allowance for possible loan losses 1,676 1,703 $147,646 $133,957 Note 4 - Allowance for Possible Loan Losses An analysis of the allowance for possible loan losses during the three years ended December 31, 1993 is as follows: 1993 1992 1991 Balance, beginning of period $1,703,349 $1,935,544 $1,913,972 Provision for loan losses charged to operations 401,273 411,001 592,110 Loans charged to allowance, net of loan loss recoveries of $173,875, $365,677, and $206,979 (428,489) (643,196) (570,538) Balance, end of period $1,676,133 $1,703,349 $1,935,544 For tax purposes, the Corporation deducts the maximum amount allowable. During the year ended December 31, 1993, the deduction taken was $418,577. The deductions for tax purposes in 1992 and 1991 were $448,003 and $712,334, respectively. FIRST CITIZENS BANCSHARES, INC., AND SUBSIDIARY NOTES TO FINANCIAL STATEMENTS (CONTINUED) December 31, 1993 Note 5 - Premises and Equipment The fixed assets used in the ordinary course of business are summarized as follows: Useful Lives in Years 1993 1992 Land $ 670,743 $ 670,743 Buildings 5 to 50 7,051,184 7,051,378 Furniture and equipment 3 to 20 5,369,850 5,647,600 13,091,777 13,369,721 Less: Accumulated depreciation 5,313,531 5,155,296 $ 7,778,246 $ 8,214,425 Note 6 - Repossessed Real Property The book value of repossessed real property on the balance sheet is $1,942,305 at December 31, 1993 and $2,379,525 at December 31, 1992. Both balances include unimproved commercial property valued at $1,161,627 which was acquired through foreclosure by First Citizens Bancshares, Inc. in 1987. In addition, as of December 31, 1991, First Citizens National Bank sold to First Citizens Bancshares, Inc., a local shopping center which had been acquired through foreclosure and which is carried on the books of the holding company at $650,000. The property is occupied and during the years ended December 31, 1993 and 1992, the Company recognized rental income from its tenants in the amount of $128,272 and $136,443 respectively. Subsequent to December 31, 1993, the Corporation was notified that buyers had exercised their option to purchase the real estate mentioned previously which is carried at a book value of $1,161,627. The property will be sold at a price which will result in a profit of $287,284. The remaining balance of repossessed real property is reflected on the balance sheet of First Citizens National Bank and is carried in "other assets." Note 7 - Deposits Included in the deposits shown on the balance sheet are the following time deposits and savings deposits in denominations of $100,000 or more: 1993 1992 (In Thousands) Time Deposits $17,150 $24,916 Savings Deposits 21,710 14,164 NOW accounts, included in savings deposits on the balance sheet, totaled $27,153,922 at 12/31/93 and $26,896,000 at 12/31/92. Note 8 - Employee Stock Ownership Plan First Citizens National Bank maintains the First Citizens National Bank of Dyersburg Employee Stock Ownership Plan as an employee benefit. The plan provides for a contribution annually not to exceed twenty-five percent of the total compensation of all participants and affords eligibility for participation to all full-time employees who have completed at least one year of service. Contributions to the Employee Stock Ownership Plan totaled $337,541 in 1993, $333,159 in 1992, and $229,024 in 1991. FIRST CITIZENS BANCSHARES, INC., AND SUBSIDIARY NOTES TO FINANCIAL STATEMENTS (CONTINUED) December 31, 1993 Note 9 - Income Taxes Provision for income taxes is comprised of the following: 1993 1992 1991 Federal income tax expense (benefit) Current $1,015,549 $ 760,234 $ 660,220 Deferred (174,849) 108,529 83,882 State income tax expense (benefit) Current 230,470 166,337 153,125 Deferred 6,260 19,152 14,802 $1,077,430 $1,054,252 $ 912,029 The ratio of applicable income taxes to net income before income taxes differed from the statutory rates of 34%. The reasons for these differences are as follows: 1993 1992 1991 Tax expense at statutory rate $1,305,997 $1,097,847 $ 976,899 Increase (decrease) resulting from: State income taxes, net of federal income tax benefit 155,932 122,423 110,830 Tax exempt interest (159,408) (110,136) (132,316) Other differences (49,102) (55,882) (43,384) 1,253,419 1,054,252 912,029 Cumulative effect of adoption of SFAS No. 109, "Accounting for Income Taxes" (175,989) $1,077,430 $1,054,252 $ 912,029 Deferred tax liabilities have been provided for taxable temporary differences related to depreciation, accretion of securities discounts and other minor items. Deferred tax assets have been provided for deductible temporary differences related primarily to the allowance for loan losses and adjustments for loss on repossessed real estate. The net deferred tax assets in the accompanying consolidated balance sheets include the following components: December 31 1993 1992 Deferred tax liabilities $(398,383) $(402,115) Deferred tax assets 458,496 411,517 Net deferred tax assets $ 60,113 $ 9,402 Effective January 1, 1993, First Citizens Bancshares, Inc. and its subsidiary adopted SFAS No. 109, "Accounting for Income Taxes", which requires an asset and liability approach to financial accounting and reporting for income taxes. Accordingly, the difference between the financial statement and tax bases of assets and liabilities is determined periodically. Deferred income tax assets and liabilities are then computed for those differences that have future tax consequences using the currently enacted tax laws and rates that apply to the periods in which they are expected to affect taxable income. Valuation allowances are established, if appropriate, to reduce the deferred tax asset to the amount which is actually expected to be realized. Income tax expense is the current tax payable or refundable for the period plus or minus the net change in the deferred tax assets or liabilities. The effect of adopting SFAS No. 109 on 1993 net income from operations was an increase of $50,711. The cumulative effect of the accounting change on years prior to January 1, 1993, of $125,278 is included in 1993 income. FIRST CITIZENS BANCSHARES, INC., AND SUBSIDIARY NOTES TO FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 Note 10 - Stock Dividends In December, 1992, First Citizens Bancshares, Inc., declared a ten percent stock dividend. The transaction was recorded by transferring par value ($10 per share) from retained earnings to the capital stock account and the balance of market value per share ($52.50) from retained earnings to surplus. On October 20, 1993, the Board of Directors declared a 2.5 for 1 stock split, which was paid on November 15, 1993, in the form of a dividend of one and one-half additional shares of the Company's common stock for each share owned by the Stockholders of record on October 15, 1993. Par value remained at $10 per share. The split resulted in the issuance of 422,698 additional shares of common stock from authorized but unissued shares and in the transfer of $4,226,980 from surplus to common stock, representing the par value of the shares issued. All references to earnings per share and to weighted average shares outstanding have been restated to give retroactive recognition to an equivalent change in capital structure in those periods. Note 11 - Regulatory Capital Requirements First Citizens Bancshares, Inc., is subject to minimum capital requirements imposed by the Federal Reserve Bank and which are designed to measure capital adequacy in terms of credit risk. The regulations require that total capital equal at least 8.0% of weighted risk assets as of December 31, 1993. In the case of First Citizens Bancshares, Inc., capital consists of common stockholders' equity and the allowance for loan losses of which in excess of 90% is stockholders' equity or Tier I capital. At December 31, 1993, the Corporation's risk-based capital ratio is 12.89%. Note 12 - Restrictions on Cash and Due From Bank Accounts The Corporation's bank subsidiary maintains cash reserve balances as required by the Federal Reserve Bank. Average required reserve balances during 1993 and 1992 were $362,000 and $268,000 respectively. Note 13 - Restrictions on Capital and Payment of Dividends The Corporation is subject to capital adequacy requirements imposed by the Federal Reserve Bank. In addition, the Corporation's National Bank Subsidiary is restricted by the Office of the Comptroller of the Currency from paying dividends in any years which exceed the net earnings of the current year plus retained profits of the preceding two years. As of December 31, 1993, approximately $5.7 million of retained earnings was available for future dividends from the subsidiary to the parent corporation. The 1993 cash dividends reflected $2.10 per share ($.60, $.60, $.65, $.25). The 4th quarter dividend of $.25 was subsequent to the 2.5 for 1 stock split. The adjusted cash dividends per share for those years affected are as follows: 1993 1992 1991 1990 1989 $.99 $.92 $.89 $.88 $.84 FIRST CITIZENS BANCSHARES, INC., AND SUBSIDIARY NOTES TO FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 Note 14 - Condensed Financial Information First Citizens Bancshares, Inc. (Parent Company Only) BALANCE SHEETS December 31 1993 1992 ASSETS Cash $ 109,175 $ 42,891 Investment in subsidiary 19,506,591 17,349,341 Real estate owned 1,995,500 1,980,540 Other assets 161,552 104,869 TOTAL ASSETS $21,772,818 $19,477,641 LIABILITIES AND STOCKHOLDERS' EQUITY LIABILITIES Note Payable of ESOP $ $ 160,000 Accrued Expenses 12,341 8,666 Option Deposit 60,000 TOTAL LIABILITIES 72,341 168,666 STOCKHOLDERS' EQUITY 21,700,477 19,308,975 TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $21,772,818 $19,477,641 STATEMENTS OF INCOME December 31 1993 1992 INCOME Dividends from bank subsidiary $ 546,000 $ 690,000 Other income 159,923 155,688 TOTAL INCOME 705,923 845,688 EXPENSES Other expenses 153,978 124,472 TOTAL EXPENSES 153,978 124,472 Income before income taxes and equity in undistributed net income of bank subsidiary 551,945 721,216 Income tax expense (benefit) (54,542) (34,225) 606,487 755,441 Equity in undistributed net income of bank subsidiary 2,157,250 1,419,269 NET INCOME $ 2,763,737 $ 2,174,710 FIRST CITIZENS BANCSHARES, INC., AND SUBSIDIARY NOTES TO FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1993 Note 14 - Condensed Financial Information (continued) (Parent Company Only) STATEMENTS OF CASH FLOW Years Ended December 31 1993 1992 Operating Activities Net income $ 2,763,737 $ 2,174,710 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation 23,443 21,236 Undistributed income of subsidiary (2,157,250) (1,419,269) (Increase) decrease in other assets (56,683) (20,853) Increase (decrease) in other liabilities 63,675 8,666 NET CASH PROVIDED BY OPERATING ACTIVITIES 636,922 764,490 Investing Activities Purchase of other real estate (38,403) (152,650) NET CASH PROVIDED (USED) BY INVESTING ACTIVITIES (38,403) (152,650) Financing Activities Payment of dividends and payments in lieu of fractional shares (707,952) (601,878) Sale of Common Stock 236,124 Treasury Stock transactions - net (60,407) NET CASH PROVIDED (USED) BY FINANCING ACTIVITIES (532,235) (601,878) INCREASE (DECREASE) IN CASH 66,284 9,962 Cash at beginning of year 42,891 32,929 CASH AT END OF YEAR $ 109,175 $ 42,891 Note 15 - Capital Leases During the year ended December 31, 1989, First Citizens National Bank placed in service furniture, fixtures, and equipment with a total cost of $520,964 which were acquired through capital leases. These leases became effective at various dates ranging from January, 1989 through October, 1989, and each lease extends for a term of sixty months. The total liability on these leases as originated was $655,232 with $30,021 remaining to be paid as of December 31, 1993. Future minimum lease payments according to these leases are as follows: Years Ending December 31, 1994 $ 30,021 Less: amount representing interest 7,014 Present value of net minimum lease payments $ 23,007 FIRST CITIZENS BANCSHARES, INC., AND SUBSIDIARY NOTES TO FINANCIAL STATEMENTS (CONTINUED) December 31, 1993 Note 16 - Subsequent Events During the year ended December 31, 1993, the Corporation executed an agreement to purchase certain real estate in Dyersburg, Tennessee, as a site for a proposed branch location. On January 5, 1994, the land was acquired by First Citizens National Bank at a total cost of $336,219. Note 17 - Noncash Investing and Financing Activities During the periods presented, the Corporation engaged in the following non-cash investing and financing activities: Investing 1993 1992 1991 Other real estate acquired in satisfaction of loans $ 61,729 $542,510 $591,415 Note 18 - Notes Payable of Employee Stock Ownership Plan On March 21, 1988, First Citizens National Bank Employee Stock Ownership Plan and Trust borrowed the sum of $800,000 from another financial institution to acquire additional stock of First Citizens Bancshares, Inc. At December 31, 1992, the outstanding principal balance was $160,000 which was due in one installment on June 15, 1993. The note was retired during 1993. Note 19 - Financial Instruments with Off-Balance Sheet Risk First Citizens National Bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit risk which are not recognized in the statement of financial position. The Bank's exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The same policies are utilized in making commitments and conditional obligations as are used for creating on-balance sheet instruments. Ordinarily, collateral or other security is not required to support financial instruments with off-balance sheet risk. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Loan commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Each customer's credit-worthiness is evaluated on a case-by-case basis and collateral required, if deemed necessary by the bank upon extension of credit, is based on management's credit evaluation of the counter party. At December 31, 1993, First Citizens National Bank had outstanding loan commitments of $46,655,000. Of these commitments, none had an original maturity in excess of one year. Standby letters of credit and financial guarantees are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are issued primarily to support public and private borrowing arrangements, and the credit risk involved is essentially the same as that involved in extending loans to customers. The bank requires collateral to secure these commitments when it is deemed necessary. At December 31, 1993, outstanding standby letters of credit totaled $2,144,000. FIRST CITIZENS BANCSHARES, INC., AND SUBSIDIARY NOTES TO FINANCIAL STATEMENTS (CONTINUED) December 31, 1993 Note 19 - Financial Instruments with Off-Balance Sheet Risk (Continued) In the normal course of business, First Citizens National Bank extends loans which are subsequently sold to other lenders, including agencies of the U.S. Government. Certain of these loans are conveyed with recourse creating off-balance sheet risk with regard to the collectibility of the loan. At December 31, 1993, the Bank had loans sold totaling $2,144,124. Note 20 - Significant Concentrations of Credit Risk First Citizens National Bank grants agribusiness, commercial, residential and personal loans to customers throughout a wide area of the mid-southern United States. A large majority of the Bank's loans, however, are concentrated in the immediate vicinity of the Bank or northwest Tennessee. Although the Bank has a diversified loan portfolio, a substantial portion of its debtors' ability to honor their obligations is dependent upon the agribusiness and industrial economic sectors of that geographic area. Note 21 - Disclosure of Fair Value of Financial Instruments The following assumptions were made and methods applied to estimate the fair value of each class of financial instruments reflected on the balance sheet of the Corporation: CASH AND CASH EQUIVALENTS For instruments which qualify as cash equivalents, as described in Note 1 of Notes to Financial Statements, the carrying amount is assumed to be fair value. INVESTMENT SECURITIES Fair value for investment securities is based on quoted market price, if available. If quoted market price is not available, fair value is estimated using quoted market prices for similar securities. LOANS RECEIVABLE Fair value of variable-rate loans with no significant change in credit risk subsequent to loan origination is based on carrying amounts. For other loans, such as fixed rate loans, fair values are estimated utilizing discounted cash flow analyses, applying interest rates currently offered for new loans with similar terms to borrowers of similar credit quality. Fair values of loans which have experienced significant changes in credit risk have been adjusted to reflect such changes. The fair value of accrued interest receivable is assumed to be its carrying value. DEPOSIT LIABILITIES DEMAND DEPOSITS The fair values of deposits which are payable on demand, such as interest-bearing and non-interest bearing checking accounts, passbook savings and certain money market accounts are equal to the carrying amount of the deposits. VARIABLE-RATE DEPOSITS The fair value of variable-rate money market accounts and certificates of deposit approximate their carrying value at the balance sheet date. FIRST CITIZENS BANCSHARES, INC., AND SUBSIDIARY NOTES TO FINANCIAL STATEMENTS (CONTINUED) December 31, 1992 Note 21 - Disclosure of Fair Value of Financial Instruments (Continued) FIXED-RATE DEPOSITS For fixed-rate certificates of deposit, fair values are estimated using discounted cash flow analyses which apply interest rates currently being offered on certificates to a schedule of aggregated monthly maturities on time deposits. SHORT-TERM BORROWINGS Carrying amounts of short-term borrowings, which include securities sold under agreement to repurchase and notes payable of the employee stock ownership plan which matures June 15, 1993, approximate their fair values at December 31, 1992. LONG-TERM DEBT The fair value of the Corporation's long-term debt is estimated using the discounted cash flow approach, based on the institution's current incremental borrowing rates for similar types of borrowing arrangements. At December 31, 1993, the long-term debt interest rate equals the fair market rate and, as a result, the carrying value of long-term debt approximates its fair value. OTHER LIABILITIES Other liabilities consist primarily of accounts payable, accrued interest payable and accrued taxes. These liabilities are short-term and their carrying values approximate their fair values. The estimated fair values of the Corporation's financial instruments are as follows: 1993 1992 Carrying Fair Carrying Fair Amount Value Amount Value Financial Assets: Cash and cash equivalents $ 13,607,663 $ 13,607,663 $ 17,291,316 $ 17,291,316 Investment securities 60,747,040 61,789,052 74,447,690 75,285,031 Loans 149,322,178 135,660,731 Less: Allowance for loan losses (1,676,133) (1,703,349) Loans, net of allowance $147,646,045 $143,637,321 $133,957,382 $129,943,000 Accrued interest receivable 2,572,669 2,572,669 2,857,664 2,857,664 Financial Liabilities: Deposits $193,823,249 $184,104,215 $193,459,334 $187,727,210 Short-term borrowings 16,914,142 16,620,133 25,293,919 25,293,919 Long-term debt 30,021 30,021 162,964 162,964 Other liabilities 2,424,143 2,424,143 1,672,097 1,672,097 Unrecognized financial instruments: Commitments to extend credit 46,655,000 46,655,000 16,622,000 16,622,000 Standby letters of credit 2,144,000 2,144,000 2,441,000 2,441,000 FIRST CITIZENS BANCSHARES, INC., AND SUBSIDIARY NOTES TO FINANCIAL STATEMENTS (CONTINUED) December 31, 1993 FIRST CITIZENS BANCSHARES, INC., AND SUBSIDIARY NOTES TO FINANCIAL STATEMENTS (CONTINUED) December 31, 1993 Note 22 - Amounts Receivable From Certain Persons (Continued) Indebtedness shown represents amounts owed by directors and executive officers of First Citizens Bancshares, Inc., and First Citizens National Bank and by businesses in which such persons are general partners or have at least 10% or greater interest and trust and estates in which they have a substantial beneficial interest. All loans have been made on substantially the same terms, including interest rates and collateral as those prevailing at the time for comparable transactions with others and do not involve other than normal risks of collectibility. ITEM 9.

ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Bancshares had no disagreements regarding accounting procedures. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information appearing in Bancshares' definitive 1991 Proxy Statement regarding directors and officers is incorporated herein by reference in response to this Item (See pages 3 through 6 of the Proxy Statement). ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information required under this Item is set forth in the 1991 definitive Proxy Statement, and is incorporated by reference. (See page 6 of the Proxy Statement). ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Ownership of Bancshares' common stock by certain beneficial owners and by management is set forth in Bancshares' definitive 1991 Proxy Statement for the Annual Meeting of Shareholders to be held April 15, 1991, in the sections entitled Voting Securities and Election of Directors and is incorporated herein by reference. (See pages 1 through 4 of the Proxy Statement). ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Officers, Directors and principal shareholders of the holding company (and their associates) have deposit accounts and other transactions with First Citizens National Bank. These relationships are covered in detail on page 7 of the Proxy Statement under "Certain Relationships and Related Transactions" and incorporated herein by reference. Additional information concerning indebtedness to Bancshares and First Citizens by Directors and/or their affiliates is included herein under Part III, Page 43 "Amounts Receivable from Certain Persons." SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, hereunto duly authorized. FIRST CITIZENS BANCSHARES, INC. By /s/Stallings Lipford Stallings Lipford, Chairman & CEO By /s/Jeff Agee Jeff Agee Vice President & Principal Financial Officer Dated: 02/24/94 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on the 22nd of February, 1991: /s/Stallings Lipford /s/Mary Frances McCauley Stallings Lipford Mary Frances McCauley Director Director /s/Eddie Anderson /s/L. D. Pennington Eddie Anderson L. D. Pennington Director Director /s/Sam Bradshaw /s/G. W. Smitheal, Jr. Sam Bradshaw, Jr. G. W. Smitheal, Jr. Director Director /s/James H. Carver /s/H. P. Tigrett, Jr. James H. Carver H. P. Tigrett, Jr. Director Director /s/William C. Cloar /s/P. H. White, Jr. William C. Cloar P. H. White, Jr. Director Director /s/Richard Donner /s/Dwight Steven Williams Richard W. Donner Dwight Steven Williams Director Director /s/J. E. Heckethorn /s/Katie Winchester John E. Heckethorn Katie Winchester Director Director /s/E. H. Lannom, Jr. /s/Billy S. Yates E. H. Lannom, Jr. Billy S. Yates Director Director /s/M. Eugene Magee M. Eugene Magee Director

92050_1993.txt

92050

1993

Item 1. Business. Introduction Southeastern Public Service Company ("SEPSCO"), directly and through its subsidiaries, is currently engaged in three primary businesses: refrigeration, liquefied petroleum gas and natural gas and oil. In addition, SEPSCO also currently holds minority interests in several subsidiaries of Triarc Companies, Inc. ("Triarc"), a public corporation formerly known as DWG Corporation which, as a result of a recent merger, owns 100% of SEPSCO's voting securities. See "Item 1. Business -- Introduction -- Other Investments" and "Item 1. Business -- Introduction -- Recent Merger" below. As a result of a merger with a wholly-owned subsidiary of Triarc (the "Merger") which was consummated on April 14, 1994, (i) all of SEPSCO's voting securities are owned by Triarc and (ii) in the near future, SEPSCO's common stock will be delisted from the Pacific Stock Exchange, the principal market for such stock ("PSE"), and the registration of such stock under the Securities Exchange Act of 1934, as amended (the "1934 Act"), will be terminated. Triarc's Class A Common Stock (the only class of Triarc's voting securities) is traded on the New York Stock Exchange and the PSE. On April 23, 1993, approximately 28.6% of Triarc's then outstanding Class A Common Stock was acquired by DWG Acquisition Group, L.P. ("DWG Acquisition"), a Delaware limited partnership the sole general partners of which are Nelson Peltz and Peter W. May. See "Item 1. Business -- Introduction -- New Ownership and Executive Management" below. SEPSCO was incorporated in Delaware in 1947. SEPSCO's principal executive offices are located at 777 South Flagler Drive, Suite 1000E, West Palm Beach, Florida 33401, and its telephone number is (407) 653-4000. Reference herein to the Company includes collectively SEPSCO and its subsidiaries unless the context indicates otherwise. Other Investments In addition to its three primary businesses, SEPSCO also holds minority interests in several Triarc subsidiaries, including a 49% interest in Graniteville Company ("Graniteville"), which manufacturers, dyes and finishes cotton, synthetic and blended apparel fabrics, and a 5.4% interest in CFC Holdings Corp. ("CFC Holdings"), the indirect parent of Royal Crown Company, Inc. (the name of which was formerly Royal Crown Cola Co. and which produces and sells soft drink concentrates used in the production and distribution of soft drinks under such brand names as RC COLA and DIET RITE COLA) and Arby's, Inc. (the world's largest franchise restaurant system specializing in roast beef sandwiches). In July 1993, the Board of Directors of SEPSCO adopted a resolution (the "July Resolution") calling for the sale or discontinuance of substantially all of its operating businesses and assets, other than its minority equity interests in other Triarc subsidiaries. The actions contemplated by the July Resolution are referred to herein as the "Discontinued Operations Plan." See "Item 1. -- Business - - - Discontinued Operations." Discontinued Operations In October 1993, pursuant to the Discontinued Operations Plan, SEPSCO completed three transactions in which it disposed of businesses which provided a variety of services to electrical and telephone utilities and municipalities, which businesses formerly constituted SEPSCO's utilities and municipal services business segment. In April 1994, SEPSCO sold to Southwestern Ice, Inc. ("Southwestern") substantially all of the operating assets of the ice manufacturing and distribution portion of SEPSCO's refrigeration services and products business segment (the "Ice Business") for $5.0 million in cash and approximately $4.3 million principal amount of subordinated secured notes due on the fifth anniversary of the sale (the "Ice Sale") and the assumption by Southwestern of certain current liabilities and of certain environmental liabilities. For additional information regarding actions taken pursuant to the July Resolution, see "Item 1. Business -- Recent Transactions." In addition, in connection with the Discontinued Operations Plan, it is expected that in the near future SEPSCO will (a) sell to Triarc the stock of SEPSCO's subsidiaries that hold SEPSCO's natural gas and oil working and royalty interests for a net cash purchase price of $8.5 million and (b) transfer the liquefied petroleum gas business currently conducted by Public Gas Company, a 99.7% owned subsidiary of SEPSCO ("Public Gas"), to National Propane Corporation, a wholly-owned subsidiary of Triarc ("National Propane"). Once the sale and the transfer described in the immediately preceding sentence are completed, the only SEPSCO business remaining to be sold to an independent third party pursuant to the Discontinued Operations Plan will be the nationwide cold storage and warehouse facilities portion of SEPSCO's refrigeration products and services business segment (the "Cold Storage Business"). No agreements have been entered into as of the date hereof with respect to the Cold Storage Business, and the precise timetable for the disposition of such business will depend upon SEPSCO's ability to identify an appropriate purchaser and to negotiate acceptable terms of sale. Although SEPSCO currently anticipates completing the sale of that business by July 31, 1994, there can be no assurance that SEPSCO will be successful in this regard. Some or all of the net proceeds from the sale by SEPSCO of any such business or assets may be used to repurchase, redeem or prepay SEPSCO's outstanding indebtedness, including the indebtedness evidenced by SEPSCO's 11-7/8% Senior Subordinated Debentures due February 1, 1998 (the "Debentures"). Recent Merger On April 14, 1994, a wholly-owned subsidiary of Triarc was merged into SEPSCO and, as a result, SEPSCO became a wholly-owned subsidiary of Triarc. In the Merger, holders of outstanding shares of SEPSCO common stock, other than Triarc and its subsidiaries, received 0.8 of a share of Triarc's Class A Common Stock for each of their shares of SEPSCO common stock. The Merger was structured to satisfy Triarc's obligations under the terms of a Stipulation of Settlement (the "Settlement Agreement") relating to the settlement of a purported derivative action (the "Action") brought by William A. Ehrman, a SEPSCO stockholder, on behalf of SEPSCO against Triarc, certain of its affiliates and certain individuals. For more information regarding the Action and the Settlement Agreement, see SEPSCO's Definitive Proxy filed with the Securities and Exchange Commission pursuant to Regulation 14A on March 11, 1994 (the "SEPSCO Proxy"). New Ownership and Executive Management On April 23, 1993, DWG Acquisition acquired shares of Triarc Class A Common Stock from Victor Posner ("Posner") and certain entities controlled by him (together with Posner, the "Posner Entities"), representing approximately 28.6% of Triarc's then outstanding common stock. As a result of such acquisition and a series of related transactions which were also consummated on April 23, 1993 (collectively, the "Equity Transactions"), the Posner Entities no longer hold any shares of voting stock of Triarc or any of its subsidiaries. Concurrently with the consummation of the Equity Transactions, Triarc refinanced a significant portion of its high cost debt in order to reduce interest costs and to provide additional funds for working capital and liquidity purposes (the "Refinancing"). Following the consummation of the Equity Transactions and the Refinancing, the Board of Directors of each of Triarc and SEPSCO installed a new corporate management team, headed by Nelson Peltz and Peter W. May, who were elected Chairman and Chief Executive Officer and President and Chief Operating Officer of each of Triarc and SEPSCO, respectively. In addition, Leon Kalvaria was elected Vice Chairman of each of Triarc and SEPSCO. The Triarc Board of Directors also approved a plan to decentralize and restructure Triarc's management (the "Restructuring"). The Equity Transactions, the Refinancing and the Restructuring are collectively referred to herein as the "Reorganization". Change in Fiscal Year On October 27, 1993, Triarc announced that it was changing its fiscal year end from April 30 of each year to December 31 of each year effective with the transition period ended December 31, 1993, and that each of its subsidiaries that did not currently have a December 31 fiscal year end (including SEPSCO) would also change its fiscal year end to December 31 effective for the transition period ended December 31, 1993. Accordingly, this Form 10-K report relates to the ten month transition period from March 1, 1993 through December 31, 1993 ("Transition 1993"). References in this Form 10-K to a year preceded by the word "Fiscal" refer to the twelve months ended February 28 or 29 of such year. Business Overview As a result of the actions taken by the Board of Directors of SEPSCO in October 1993 pursuant to the Discontinued Operations Plan (see "Item 1. Business -- Introduction -- Discontinued Operations"), all of the businesses historically engaged in by SEPSCO other than the liquefied petroleum gas business have been reclassified as discontinued operations, and SEPSCO's consolidated financial statements have been restated to reflect such reclassification. See Note [3] to the Consolidated Financial Statements (the "Consolidated Financial Statements") of Southeastern Public Service Company and Subsidiaries included in "Item 8. Financial Statements and Supplementary Data" below. Set forth below is a brief description of the businesses which SEPSCO continues to operate pending the transfer, sale or discontinuance thereof, as well as a brief description of SEPSCO's other investments. Refrigeration Services SEPSCO's refrigeration business provides cold storage warehousing facilities. The principal customers of the warehousing activities are food distributors and supermarket chains. SEPSCO's refrigeration services are provided to domestic customers on a national basis. SEPSCO also enters into processing and storage agreements with certain customers. The availability of raw materials is not material to the operation of this business segment. SEPSCO's refrigeration business is seasonal. Operating revenues are lower during cold weather when demand declines for cold storage. The services provided by this business segment are marketed nationally in competition with three large national companies as well as many local concerns. No competitor is dominant in the industry, although several larger firms have greater resources than SEPSCO. The principal competitive factors in the refrigeration business are price and service. As a result of certain environmental audits in 1991, SEPSCO became aware of possible contamination by hydrocarbons and metals at certain sites of SEPSCO's refrigeration operations and has filed appropriate notifications with state environmental authorities and has begun a study of remediation at such sites. SEPSCO removed certain underground storage and other tanks at certain facilities of its refrigeration operations and has engaged in certain remediation in connection therewith. Such removal and environmental remediation involved a variety of remediation actions at various facilities of SEPSCO located in a number of jurisdictions. Such remediation varied from site to site, ranging from testing of soil and groundwater for contamination, development of remediation plans and removal in certain instances of certain contaminated soils. Remediation has recently been completed or is on-going at two sites in Miami, Florida, one site in Marathon, Florida, one site in Willard, Ohio, and one site in Provo, Utah. In addition, remediation will be required at thirteen sites at various locations which were sold or leased to Southwestern as part of the Ice Sale, and such remediation will be made in conjunction with Southwestern. See "Item 1. Business -- Recent Transactions." Based on preliminary information and consultations with, and certain reports of, environmental consultants and others, SEPSCO presently estimates SEPSCO's cost of all such remediation and/or removal will approximate $3.7 million, in respect of which charges of $1.3 million, $0.2 million and $2.2 million were made against earnings in SEPSCO's Fiscal 1991, 1992 and 1993, respectively. In connection therewith, through December 31, 1993, SEPSCO had incurred actual costs of $1.2 million and had a remaining accrual of approximately $2.5 million. In addition to the environmental costs borne by SEPSCO, in connection with the Ice Sale, Southwestern assumed liability for up to $1.0 million of remediation expenses relating to the Ice Business assets that were sold, with SEPSCO remaining liable for remediation expenses not so assumed. See "Item 1. Business -- Recent Transactions." SEPSCO believes that after such accrual and assumption of liability, the ultimate outcome of this matter will not have a material adverse effect on SEPSCO's consolidated results of operations or financial condition. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources." Liquefied Petroleum Gas Business SEPSCO, through Public Gas, distributes and sells liquefied petroleum gas ("LP gas") and related appliances and equipment throughout the state of Florida, for residential, agricultural, commercial and industrial uses, including, space heating, water heating, cooking and engine fuel. Following the Reorganization, management of SEPSCO's LP gas business was transferred to Triarc's National Propane subsidiary. In connection with the Discontinued Operations Plan, it is expected that in the near future, SEPSCO will transfer Public Gas' business to National Propane. The precise method by which such business will be transferred, however, has not yet been determined. Triarc has informed SEPSCO that prior to or in connection with transferring such business, it intends to cause Public Gas, which is currently 99.7% owned by SEPSCO, to become a wholly-owned subsidiary of SEPSCO. For a more complete description of SEPSCO's LP gas business, see "Business of Triarc Companies -- Business Segments -- Liquefied Petroleum Gas (National Propane and Public Gas)" in SEPSCO's Proxy. Natural Gas and Oil Interests SEPSCO has working and royalty interests in natural gas and oil producing properties located almost entirely in the states of Alabama, Kansas, Kentucky, Louisiana, Mississippi, North Dakota, West Virginia and Texas. SEPSCO produces most of the natural gas and all of the oil that it sells. Natural gas produced by SEPSCO is sold to major marketers and pipeline systems, under short and long-term contracts. Oil production is sold to crude oil refiners. The business is not dependent upon a single customer. SEPSCO has a very minor position in the natural gas and oil industry and competes with many larger independent natural gas and oil producers as well as with the major oil companies. This industry is not subject to seasonal factors. In the near future, SEPSCO expects to sell to Triarc the stock of SEPSCO's subsidiaries that hold SEPSCO's natural gas and oil working and royalty interests for a purchase price of $8.5 million. The sale will be consummated on or before July 22, 1994. Other Investments Graniteville SEPSCO owns 49% of the outstanding common stock of Graniteville, the remaining 51% of which is held by a wholly-owned subsidiary of Triarc. SEPSCO accounts for its investment in Graniteville on the equity method. Graniteville manufactures, dyes, and finishes cotton, synthetic and blended (cotton and polyester) apparel fabrics. Graniteville produces fabrics for utility wear including uniforms and other occupational apparel, piece-dyed fabrics for sportswear, casual wear and outerwear, indigo-dyed fabrics for jeans, sportswear and outerwear and specialty fabrics for recreational, industrial and military end-uses. Through its wholly-owned subsidiary, C.H. Patrick & Co., Inc., Graniteville also produces and markets dyes and specialty chemicals primarily to the textile industry. For additional information regarding the business of Graniteville, see "Business of Triarc Companies -- Business Segments -- Textiles (Graniteville)" in SEPSCO's Proxy. As a result of the discontinuance of substantially all of SEPSCO's other businesses, SEPSCO's investment in Graniteville will constitute its largest asset. Because of Graniteville's significance to SEPSCO, financial statements of Graniteville are included in this Form 10-K. See "Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K" below. CFC Holdings SEPSCO also has an investment in CFC Holdings. SEPSCO owns approximately 5.4% of the outstanding common stock of CFC Holdings, the remaining 94.6% of which is owned by Triarc. SEPSCO accounts for its investment in CFC Holdings on the equity method. CFC Holdings owns 100% of the outstanding common stock of RC/Arby's Corporation, formerly known as Royal Crown Corporation, whose principal subsidiaries are Royal Crown Company, Inc. ("Royal Crown") and Arby's, Inc. ("Arby's"). Royal Crown produces and sells soft drink concentrates used in the production and distribution of soft drinks by independent bottlers under the brand names RC COLA, DIET RC COLA, DIET RITE COLA, DIET RITE flavors, NEHI, UPPER 10 and KICK. RC COLA is the third largest national brand cola and is the only national brand cola alternative available to non-Coca-Cola and non-Pepsi-Cola bottlers. Royal Crown is also the exclusive supplier of proprietary cola concentrate to Cott Corporation, which sells private label soft drinks to major retailers such as Wal-Mart, A&P and Safeway. Arby's is the world's largest franchise restaurant system specializing in roast beef sandwiches with an estimated market share in 1993 of 65.1% of the roast beef sandwich segment of the quick-service restaurant category. In addition, SEPSCO believes that Arby's is the 14th largest restaurant chain in the United States, based on domestic system-wide sales. Worldwide sales for the Arby's system were approximately $1.6 billion in 1993. Arby's acts both as a franchisor and as an owner and operator in a system that included 2,682 restaurants as of December 31, 1993, of which 259 were company-owned. For a more detailed description of the business of Royal Crown and Arby's, see, respectively, "Business of Triarc Companies -- Business Segments -- Soft Drinks (RC Cola)" and "Business of Triarc Companies -- Business Segments -- Fast Food (Arby's)" in SEPSCO's Proxy. In addition, CFC Holdings also owns all of the outstanding common stock of Chesapeake Insurance Company Limited ("Chesapeake Insurance"), which historically provided certain property insurance coverage for Triarc, its subsidiaries (including SEPSCO) and certain of Triarc's former affiliates and reinsured a portion of certain insurance coverage which Triarc, its subsidiaries (including SEPSCO) and such former affiliates maintained with unaffiliated insurance companies. Chesapeake Insurance ceased writing insurance or reinsurance of any kind for periods commencing on or after October 1, 1993. SEPSCO also owns 15,000 shares of convertible redeemable preferred stock of Chesapeake Insurance which it purchased in 1992 for $1.5 million. Because the loss reserves of Chesapeake Insurance for insurance already written are approximately equal to its assets, Chesapeake Insurance's equity has been permanently impaired, and no dividends or liquidating distributions are expected to be made to Chesapeake Insurance's equity holders. Both SEPSCO and CFC Holdings have, therefore, reduced the value of the assets represented by their respective equity interests in Chesapeake Insurance to zero. For further information regarding Chesapeake Insurance, see "Business of Triarc Companies -- Discontinued and Other Operations" in SEPSCO's Proxy. Recent Transactions In October 1993, SEPSCO sold the businesses that formerly constituted its utilities and municipal services segment in three separate transactions. The first two of these transactions involved the sale by SEPSCO to Perkerson, Patton Management Corp. ("PPM Corp.") of the stock of each of Wright & Lopez, Inc. ("Wright & Lopez"), through which SEPSCO conducted its underground cable and conduit business, and Pressure Concrete Construction Co., through which SEPSCO conducted its concrete refurbishment business. These corporations were sold to PPM Corp. for a nominal amount subject to the adjustments described below. PPM Corp. has agreed to pay, as deferred purchase price, 75% of the net proceeds received from the sale or liquidation of these corporations' assets (cash of approximately $1.8 million had been received as of December 31, 1993) plus, in the case of Wright & Lopez, an amount equal to 1.25 times its adjusted book value as of the second anniversary of such sale. At the time Wright & Lopez was sold to PPM Corp., its adjusted book value was approximately $1.6 million. In addition, SEPSCO paid an aggregate of $2.0 million during October and November 1993 to cover the buyer's short-term operating losses and working capital requirements for the construction related operations. SEPSCO currently expects to break even on such sales, excluding any consideration of the potential book value adjustment. The other transaction involved the sale of substantially all of the assets of SEPSCO's tree maintenance subsidiaries to Asplundh Tree Expert Co. ("Asplundh") for a purchase price of approximately $69.6 million in cash and the assumption by Asplundh of certain liabilities aggregating $5.0 million resulting in a loss of approximately $4.8 million. The terms of each of these transactions was the result of arms'-length negotiations between SEPSCO and PPM Corp. and Asplundh, as the case may be. Neither PPM Corp. nor Asplundh is an affiliate of SEPSCO. In April 1994, SEPSCO sold to Southwestern substantially all of the operating assets of SEPSCO's Ice Business for $5.0 million in cash and approximately $4.3 million principal amount of subordinated secured notes due on the fifth anniversary of the Ice Sale and the assumption by Southwestern of certain current liabilities and certain environmental liabilities. SEPSCO, however, retained certain real estate assets associated with the Ice Business. An environmental remediation plan (the "Remediation Plan") was prepared in connection with the Ice Sale. The Remediation Plan indicated that remediation will be required at thirteen sites which were sold or leased to Southwestern as part of the Ice Sale, and such remediation will be made in conjunction with Southwestern, which is responsible for payment of the first and third $500,000 of expenses incurred in connection with the Remediation Plan, while SEPSCO remains liable for the second $500,000 of expenses and any expenses in excess of $1.5 million. Environmental Matters Although SEPSCO has not performed any environmental audits on any of the operations which it continues to own, other than with respect to the properties sold or leased in connection with the Ice Sale and certain inactive properties set forth below, SEPSCO currently does not anticipate that present environmental regulations will materially affect the capital expenditures, earnings or competitive position of any segment of SEPSCO's businesses, except for expenditures for environmental remediation required to be made in the remainder of its current fiscal year and thereafter in connection with its refrigeration business. See "Item 1. Business -- Business Overview -- Refrigeration Services" above. Working Capital SEPSCO's working capital requirements have generally been fulfilled from cash flow from operations, although from January 1991 through April 1993 SEPSCO had a credit facility with a commercial lender, secured by substantially all of the accounts receivable of the tree maintenance activities and the construction-related activities of the utility and municipal services segment and certain other receivables. In connection with the Reorganization, Triarc made certain payments on account of indebtedness owed by it to SEPSCO, and SEPSCO used a portion of the proceeds thereof to pay in full all amounts due under such credit facility, at which time such facility was terminated. Intellectual Property; Research and Development; Backlog Patents, trademarks, licenses, franchises and concessions are not material to any segment of SEPSCO's business. During Fiscal 1992, Fiscal 1993 and Transition 1993, SEPSCO had no material expenditures for research and development activities. The existence of a forward order backlog is not material to any segment of SEPSCO's businesses. Employees As of December 31, 1993, SEPSCO employed 624 employees, including approximately 169 salaried employees. Approximately 187 of such employees were covered by 13 collective bargaining agreements expiring from time to time through 1996. SEPSCO believes that relationships with employees are satisfactory. Item 2.

Item 2. Properties. Certain information about the materially important physical properties of SEPSCO's operations as of December 31, 1993 is set forth in the following table: Sq. Ft. of Business Facilities-Location Land Title Floor Space Refrigeration Cold storage: Topeka, KS 1 owned 266,000 Bonner Springs, KS 1 owned 919,000 Denver, CO 1 owned 202,000 San Martin, CA 1 owned 131,000 Santa Maria, CA 1 owned 318,000 Portland, OR 1 owned 200,000 American Falls, ID 1 owned 169,000 Other locations 3 owned 166,000 throughout the United States Liquefied Petroleum Gas 27 Bulk Plants 18 owned * (including retail 9 leased depots) Natural Gas Office/warehouse 2 leased 8,000 and Oil various locations 4 owned 6,000 throughout the 6 leased 10,000 United States Other Facilities (inactive) Refrigeration Ice mfg. and cold storage 3 owned 189,000 Ice mfg. 11 owned 69,000 _______________ *Liquefied petroleum gas facilities have approximately 2,579,000 gallons of storage capacity. The natural gas and oil operations have net working interests in approximately 61,000 acres and net royalty interests in approximately 4,000 acres, located almost entirely in the states of Alabama, Kentucky, Louisiana, Mississippi, North Dakota, Texas and West Virginia. The Ice Business operations, which were sold in April 1994, consisted of 12 facilities with approximately 450,000 total square feet. The Company's management believes that the properties of the operations that the Company continues to own, taken as a whole, are generally well maintained and are adequate for current and foreseeable business needs. The majority of the properties are owned by the Company. All of the properties owned in fee by the Company are without encumbrances, except minor ones which do not affect the use thereof in the Company's business. Except as set forth in the table above with respect to properties listed as inactive, substantially all of the Company's materially important physical properties were being fully utilized as of December 31, 1993. Item 3.

Item 3. Legal Proceedings. In December 1990, the Action was brought against Triarc and other defendants on behalf of SEPSCO. As a result of the Merger, the court in which the Action is pending will permanently bar and enjoin the institution or prosecution of all claims arising out of or in any way relating to the Action against Triarc and certain of its affiliates. For a detailed description of such legal proceedings, see "Special Factors -- Background to the Merger; Reasons for the Merger -- Legal Proceedings Related to SEPSCO and Triarc" in SEPSCO's Proxy. In addition to the Action and the matters referred to or described under "Item 1. Business -- Environmental Matters," the Company is involved in claims, litigation and administrative proceedings and investigations of various types in several jurisdictions. Such matters arise in the ordinary course of the Company's business, and it is the opinion of the Company's management that the outcome of any such matter, or all of them combined, will not have a material adverse effect on the Company's business or consolidated financial condition. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders. Not Applicable. PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. As a result of the Merger, (a) SEPSCO became a wholly-owned subsidiary of Triarc and (b) in the near future, SEPSCO's common stock will be delisted from the PSE and the registration of such stock under the 1934 Act will be terminated. Historically, however, the principal market for the SEPSCO Common Stock has been the PSE (symbol: SPV). The high and low closing prices of the SEPSCO Common Stock as reported in the consolidated transaction reporting system are as follows: Market Prices -------------- Calendar Quarters High Low ----------------- -------------- First Quarter............................. $ 3-3/8 $ 1-7/8 Second Quarter............................ 2-3/8 1-3/8 Third Quarter............................. 1-7/8 7/8 Fourth Quarter............................ 2-1/4 13/16 First Quarter............................. $ 6-5/8 $ 1-1/2 Second Quarter............................ 7-1/8 4-3/4 Third Quarter............................. 9-1/4 5-5/8 Fourth Quarter............................ 14 8-5/8 First Quarter............................. $14-1/2 $12-5/8 Second Quarter............................ 16-1/2 14-1/8 Third Quarter............................. 24-7/8 15-1/8 Fourth Quarter............................ 24-1/4 18-7/8 First Quarter............................. $20-1/8 $14-5/8 No dividends have been paid or declared on the SEPSCO Common Stock in the three most recent fiscal years, during Transition 1993, or in the current year to date. Under the provisions of the Debentures, the payment of cash dividends and the acquisition of shares of SEPSCO's capital stock by SEPSCO are limited to the sum of (i) 50% of the aggregate consolidated net income after November 30, 1982 (exclusive of equity in the net income (loss) of affiliates), (ii) the aggregate net proceeds received from the sale of capital stock and (iii) $7.5 million. Under such provisions, at December 31, 1993 SEPSCO was not permitted to pay cash dividends or acquire shares of SEPSCO's capital stock. The payment of cash dividends is also dependent upon, among other things, the availability of current and retained earnings. SEPSCO does not presently anticipate the declaration of cash dividends on the SEPSCO Common Stock in the near future. As a result of the Merger, on April 14, 1994, all of the outstanding shares of SEPSCO's voting securities were held by Triarc. PAGE Item 6.

Item 6. Selected Financial Data PAGE Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Results of Operations TEN MONTHS ENDED DECEMBER 31, 1993 COMPARED WITH THE TEN MONTHS ENDED DECEMBER 31, 1992 (UNAUDITED) Net sales increased from $22.4 million in the ten months ended December 31, 1992 ("Comparable 1992") to $23.4 million in the ten months ended December 31, 1993 ("Transition 1993") principally as a result of higher volumes of LP gas due to colder weather in the regions serviced by such business in Transition 1993, partially offset by slightly lower average selling prices which resulted from lower product costs. Operating profit decreased from $2.5 million in Comparable 1992 to $1.7 million in Transition 1993 principally due to an increase in selling, general and administrative expenses which resulted from a facilities relocation and corporate restructuring charge of $0.8 million relating to continuing operations (see Note 14 to the consolidated financial statements), partially offset by a slight increase in gross profit. Interest expense was favorably impacted due primarily to the lower debt outstanding and, to a much lesser extent, lower interest rates during Transition 1993. Equity in earnings of affiliates before cumulative effect of changes in accounting principles and extraordinary items of affiliate was unfavorably impacted in Transition 1993 primarily due to the following equity in significant charges of affiliates: (i) a $1.9 million charge recorded in Transition 1993 related to facilities relocation and corporate restructuring, (ii) $0.9 million of estimated cost allocated to the affiliates by Triarc for compensation paid to a special committee relating to the change in control of Triarc and affiliates which took place April 23, 1993, (iii) $1.2 million from the write-off of Graniteville Company's ("Graniteville") investment in Chesapeake Insurance Company Limited ("Chesapeake Insurance") and (iv) $0.5 million from insurance loss reserves recorded by Chesapeake Insurance. Interest income from Triarc was unfavorably impacted due to lower debt outstanding in Transition 1993. SEPSCO also wrote off its $1.5 million investment in Chesapeake Insurance since such investment is no longer deemed recoverable as a result of Chesapeake Insurance reducing its stockholders' equity to a minimal amount following additional provisions for insurance losses of $10.0 million during Transition 1993 and the decision by Triarc effective October 1993 to cease writing new insurance or reinsurance of any kind through Chesapeake Insurance. The benefit from income taxes increased from $0.3 million during Comparable 1992 to $1.2 million in Transition 1993. The Transition 1993 benefit resulted primarily from the equity in earnings of affiliates. Loss from discontinued operations, net of income taxes increased $22.7 million from $0.7 million in Comparable 1992 to $23.4 million in Transition 1993 primarily due to the following reasons: In connection with the consummation of the sales of the tree maintenance services operations and the construction related operations and the letter of intent to sell (and subsequent sale) of the ice operations, SEPSCO reevaluated the estimated gain or loss from the sale of its discontinued operations and provided $13.9 million for the estimated loss on the sale of the discontinued operations during Transition 1993. The revised estimate principally reflects (i) $4.6 million of losses from the sales of the operations comprising the utility and municipal services business segment previously estimated to be approximately break-even, (ii) $6.7 million of losses from the sale of operations comprising the refrigeration business segment previously estimated to be a gain of $1.6 million, (iii) $2.5 million of estimated losses from operations from July 22, 1993 to the actual or estimated disposal dates and (iv) less previously estimated losses of $1.5 million from the sale of the natural gas and oil business segment which now will be sold to Triarc and accounted for as a transfer between entities under common control at net book value. The net loss from the sale of the utility and municipal services business segment reflects a reduction of $1.8 million in the estimated sales price for the construction related operations from previous estimates, a $2.0 million reduction in anticipated proceeds from asset sales by July 22, 1994, and other adjustments in finalizing the loss on the sale of the tree maintenance services operations. The reduction in proceeds from asset sales results from the buyer of such businesses successfully negotiating extensions of certain major contracts with respect to the larger of such businesses and as a result no longer intending to immediately dispose of the major portion of the assets. Should the buyer hold such assets through October 5, 1995, the $2.0 million reduction in proceeds would be effectively realized through the Book Value Adjustment (see subsequent discussion). The $8.2 million change relating to the sales of the refrigeration business segment principally results from (i) a $4.0 million reduction in the sales price for the ice operations and (ii) a $4.0 million reduction in the estimated sales price of the cold storage operations based on preliminary sales discussions and experience with respect to negotiating the sale of the other operations. SEPSCO recorded an $8.0 million write-down relating to the impairment of certain unprofitable properties in Transition 1993. During Transition 1993 SEPSCO was allocated by Triarc as well as directly incurred certain facilities relocation and corporate restructuring charges totaling $4.7 million, of which $3.9 million was allocated to discontinued operations (see Note 14 to the consolidated financial statements for a further discussion). Operating profits of certain business segments through July 22, 1993, exclusive of the above charges, also declined. The tree maintenance activities experienced a decline in earnings due to higher insurance costs, losses on certain contracts and start-up costs on new crews. The flooding conditions experienced during the second quarter of Transition 1993 prevented the generation of revenues by crews added in anticipation of increased workload, whereas the Comparable 1992 period was favorably affected by the additional work in connection with Hurricane Andrew. The construction related activities experienced a decline due to a lower number of contracts in progress and losses experienced on existing contracts. Refrigeration operations had lower margins due to lower revenues from cold storage due to lower occupancy rates and lower margins in the ice operations due to competitive conditions. The above charges were partially offset by the effect of deferring the $3.8 million net loss from discontinued operations subsequent to July 22, 1993, the measurement date, through December 31, 1993 which was considered in the loss on disposal of discontinued operations. SEPSCO expects that such net losses will be offset by seasonal net income of the natural gas and oil operations through its disposal date. Effective March 1, 1993, SEPSCO changed its method of accounting for income taxes when it adopted the provisions of Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes" ("SFAS 109"). The cumulative effect on prior years of the change in accounting principles decreased the net loss for Transition 1993 by $7.6 million or $.64 per share. Effective March 1, 1992 Graniteville adopted SFAS 109 and Statement of Financial Accounting Standards No. 106 "Employers' Accounting for Postretirement Benefits Other than Pensions". The change in accounting principles resulted in charges amounting to $6.0 million, (net of taxes of $0.4 million), or $.51 per share, which was reflected in the consolidated statement of operations in Fiscal 1993. FISCAL 1993 COMPARED WITH FISCAL 1992 Net sales decreased from $29.2 million in Fiscal 1992 to $28.5 million in Fiscal 1993 due to a decrease in the average selling prices, coupled with a slight decrease in volume due to unseasonably warmer weather and increased competitive conditions. Operating profit decreased from $4.6 million in Fiscal 1992 to $3.6 million in Fiscal 1993 principally due to the decrease in sales as explained above, and to a lesser extent higher cost of product. Equity in earnings of affiliates before extraordinary items and cumulative effect of changes in accounting principles increased from $5.2 million in Fiscal 1992 to $12.2 million in Fiscal 1993 due to increased earnings of Graniteville. The gain on sale of marketable security of $6.0 million resulted from the recognition of a gain previously deferred on the sale of the common stock of an unaffiliated company to Triarc which had been previously deferred until collection of a note was assured. As such note was collected in April 1993 prior to the issuance of the Fiscal 1993 consolidated financial statements, the gain was recorded in Fiscal 1993. Gains on repurchase of debentures for sinking fund requirement decreased from $4.0 million in Fiscal 1992 to $0.1 million in Fiscal 1993 due to the market price of the Debentures which increased to above par, and accordingly, since the repurchase of the Debentures was no longer beneficial, the sinking fund requirement was principally made in cash. Other, net decreased from income of $0.4 million in Fiscal 1992 to expense of $1.1 million in Fiscal 1993 principally due to a $1.3 million accrual for the proposed settlement of the Ehrman Litigation in Fiscal 1993. Provision for income taxes as a percentage of income from continuing operations before income taxes for Fiscal 1993 was lower than the statutory rate due to the equity in earnings of affiliates on which income taxes were provided only on the portion remaining after an 80% dividend exclusion. Loss from discontinued operations, net of income taxes, increased from $0.2 million in Fiscal 1992 to $5.5 million in Fiscal 1993 principally due to a $4.7 million reduction in gross profit in the utility and municipal services segment due to competitive conditions experienced principally in the construction related activities and the tree maintenance operations due to intensely competitive bidding in the first quarter of Fiscal 1993 which resulted in losses of certain contracts, most of which were replaced by ones with lower margins and the adjustment of prices to retain certain other existing contracts. Also, the refrigeration operations recorded a $2.1 million accrual before income taxes for potential environmental remediation in Fiscal 1993, whereas Fiscal 1992 included a credit of $1.4 million as proceeds from settlement of certain litigation of the construction operations. These factors were partially offset by a benefit from income taxes of $2.4 million in Fiscal 1993 compared to a benefit from income taxes of $0.3 million in Fiscal 1992. Equity in cumulative effect of changes in accounting principles of affiliate of $6.0 million resulted from Graniteville's adoption of SFAS 109 and SFAS 106 during Fiscal 1993. Equity in extraordinary items of affiliate of $0.3 million in Fiscal 1993 resulted from the early extinguishment of debt by CFC Holdings. LIQUIDITY AND CAPITAL RESOURCES At February 28, 1993 and December 31, 1993 cash and equivalents, excluding restricted cash, amounted to $0.2 million and $33.6 million (including ($10.8 million of marketable securities), respectively. The $22.6 million increase in cash is principally a result of the remaining excess proceeds from the sale of the tree maintenance services operations (see subsequent discussion). Total debt, excluding the debt of the discontinued operations, amounted to $58.3 million and $59.3 million at February 28, 1993 and December 31, 1993, respectively. As previously reported, a change in control of Triarc occurred on April 23, 1993 (the "Closing Date"), which as a result of Triarc's ownership of SEPSCO's voting securities constituted a change in control of SEPSCO. In connection therewith SEPSCO received from Triarc $27.1 million in cash and $3.5 million in the form of an offset of amounts due to Triarc as of April 23, 1993 in connection with the providing by Triarc of certain management services to SEPSCO. The aggregate $30.6 million of payments by Triarc included full payment of $6.8 million (including $0.3 million of accrued interest) on an unsecured promissory note issued to SEPSCO by Triarc in connection with the 1988 sale of an investment and partial payment of $23.8 million (including $1.4 million of accrued interest) on a $49.0 million promissory note due to SEPSCO resulting from the 1986 sale of approximately 51% of Graniteville's common stock to Triarc, as described below. SEPSCO used the $27.1 million of cash proceeds to pay $12.7 million due under its accounts receivable financing arrangement which was then terminated and to pay $14.4 million (including $0.4 million of accrued interest) owed to Chesapeake Insurance Company Limited ("Chesapeake Insurance"). At December 31, 1993 SEPSCO holds a promissory note (the "Note") of $28.0 million (including $1.4 million of accrued interest) from Triarc, which is included in "Due from Triarc Companies, Inc." in the consolidated balance sheet, which had an original face amount of approximately $49.0 million, bearing interest at the annual rate of 13% payable semi-annually. As described above, on the Closing Date, SEPSCO received partial payment of the Note of approximately $23.8 million including $1.4 million of accrued interest from Triarc. The Note, after giving effect to such prepayment, is due in August 1998 and resulted from the 1986 sale of approximately 51% of the outstanding common shares of Graniteville to Triarc and is secured by such shares. The Note is subordinated to senior indebtedness of Triarc to the extent, if any, that the payment of principal and interest thereon is not satisfied out of proceeds of the pledged Graniteville shares. SEPSCO has not received any cash dividends from its investment in Graniteville during Transition 1993 compared with $3.0 million in Fiscal 1993. Under its present credit agreement, Graniteville is permitted to pay dividends or make loans or advances to its stockholders, including SEPSCO in an amount equal to 50% of the net income of Graniteville accumulated from the beginning of the first fiscal year commencing on or after December 20, 1994, provided that the outstanding principal balance of Graniteville's term loan is less than $50.0 million at the time of the payment (the outstanding principal balance was $72.5 million as of December 31, 1993) and certain other conditions are met. Accordingly, Graniteville is unable to pay any dividends or make any loans or advances to SEPSCO prior to December 31, 1995. SEPSCO is required to pay interest on its 11 7/8% Senior Subordinated Debentures due February 1, 1998 (the "Debentures") semi-annually on February 1 and August 1 of each year. Interest payments due February 1, 1994 and August 1, 1994 aggregate $6.9 million. SEPSCO is also required to retire annually, through the operation of a mandatory sinking fund, $9.0 million principal amount of the Debentures on February 1 of each year. The indenture pursuant to which the Debentures were issued (the "Indenture") provides that, in lieu of making such payment in cash, SEPSCO may credit against the mandatory sinking fund requirement the principal amount of Debentures acquired by SEPSCO other than through the sinking fund. On February 1, 1994, SEPSCO satisfied such sinking fund requirement by payment of $9.0 million in cash through cash received from the sale of the tree maintenance services operations rather than through the delivery of Debentures. The indenture contains a provision which limits to $100.0 million the aggregate amount of specified kinds of indebtedness that SEPSCO and its consolidated subsidiaries can incur. At December 31, 1993 such indebtedness was $59.3 million resulting in allowable additional indebtedness, if SEPSCO desired to make such borrowings and if such financing could be obtained, of $40.7 million. On October 18, 1993, Triarc entered into a Settlement Agreement (the "Settlement Agreement") with the plaintiff (the "Plaintiff") in the Ehrman Litigation. The Settlement Agreement provides, among other things, that SEPSCO would be merged into, or otherwise acquired by, Triarc or an affiliate thereof, in a transaction in which each holder of SEPSCO's Common Stock other than Triarc will receive in exchange for each share of SEPSCO's Common Stock, 0.8 shares of Triarc's Class A Common Stock. On November 22, 1993 Triarc and SEPSCO entered into a merger agreement (the"Merger"). The Settlement Agreement was approved by the United States District Court For the Southern District of Florida on January 11, 1994 and the Merger was approved on April 14, 1994 by SEPSCO's stockholders other than Triarc. The Merger was consummated on April 14, 1994 pursuant to which a subsidiary of Triarc was merged into SEPSCO in the manner described in the Settlement Agreement. Following the Merger, Triarc owns 100% of the SEPSCO Common Stock. On July 22, 1993, SEPSCO's Board of Directors authorized the sale or liquidation of the utility and municipal services, refrigeration and natural gas and oil businesses. Accordingly, SEPSCO has retroactively restated the consolidated financial statements for each of the periods shown to reflect all of such businesses as discontinued operations through July 22, 1993. The operating results of the discontinued operations subsequent to July 22, 1993 have been deferred which was anticipated in the loss on disposal of discontinued operations and are included in "Net current liabilities of discontinued operations" in the consolidated balance sheets. In addition, on July 22, 1993 SEPSCO Board of Directors authorized the sale or liquidation of the liquefied petroleum gas business. Sepsco intends to transfer the liquified petroleum gas business to a subsidiary of Triarc and the transfer would be accounted for at net book value. The precise nature of such transfer has not been determined and is expected to occur by July 22, 1994. Based on these facts SEPSCO has continued to reflect the liquified petroleum gas business as a continuing operation. On December 9, 1993 SEPSCO's Board of Directors decided to sell the natural gas and oil business to Triarc following the Merger and the resulting minority interest in SEPSCO rather than selling such business to an independent third party. Such sale will be in the form of a sale of the stock of the entities comprising the natural gas and oil business for cash of $8.5 million which is equal to their fair value and approximately $4.0 million higher than their net book value. On October 15, 1993 SEPSCO sold the assets of its tree maintenance services operations previously included in its utility and municipal services business segment for $69.6 million in cash plus the assumption by the purchaser of $5.0 million in current liabilities resulting in a loss of $4.8 million. The $22.8 million cash balance as of December 31, 1993 is principally a result of such cash proceeds, less the repayment of $24.1 million of capitalized lease obligations relating to the tree maintenance services operations, repayment of $1.1 million of amounts due to Triarc, payment of $2.0 million to the purchasers of the construction related operations (see below) and general operating requirements since October 15, 1993. On October 7, 1993 SEPSCO sold the stock of its two construction related operations previously included in its utility and municipal services business segment for a nominal amount subject to adjustments described below. As the related assets are sold or liquidated the purchasers have agreed to pay, as deferred purchase price, 75% of the net proceeds received therefrom (cash of $1.8 million had been received as of December 31, 1993) plus, in the case of one of the two entities, an amount equal to 1.25 times the adjusted book value of such entity as of October 5, 1995 (the "Book Value Adjustment"). As of October 7, 1993, the adjusted book value of the assets of that entity aggregated approximately $1.6 million. In addition, SEPSCO paid $2.0 million in October and November 1993 to cover the buyer's short-term operating losses and working capital requirements for the construction related operations. SEPSCO currently expects to break-even the sales of the construction related operations excluding any consideration of the potential Book Value Adjustment. On April 8, 1994 SEPSCO sold substantially all of the operating assets of the ice operations of its refrigeration business segment for $5.0 million in cash, a $4.3 million note (discounted value $3.3 million) and the assumption by the buyer of certain current liabilities of up to $1.0 million. While the loss on the sale has not been finalized, SEPSCO currently estimates it will approximate $2,500,000. The note, which bears no interest during the first year and 5% thereafter, would be payable in installments of $120.0 thousand in 1995 through 1998 with the balance of approximately $3.8 million due in 1999. The only remaining discontinued operation to be sold to an independent third party is the cold storage operation of the refrigeration business. The precise timetable for the sale and liquidation of the cold storage operation will depend upon SEPSCO's ability to identify appropriate potential purchasers and to negotiate acceptable terms for the sale of such operation. SEPSCO currently anticipates completion of such sales by July 22, 1994. SEPSCO has $5.3 million of restricted cash and equivalents which support letters of credit which collateralize certain performance and other bonds relating to the utility and municipal services business segment. SEPSCO anticipates that buyers of the segment will provide the collateral for such bonds or that the performance secured by the bond will be completed and the restricted cash will revert to SEPSCO free of restrictions and at that time be used for general corporate purposes. SEPSCO had cash provided by operations of $4.1 million during Transition 1993. Such cash requirements, excluding cash flows from operations, for 1994 will include $3.9 million of capital expenditures, of which SEPSCO intends to seek financing from banks and other sources for $3.2 million, as well as a $9.0 million sinking fund payment on the Debentures (paid February 1, 1994). SEPSCO expects to meet all of its cash requirements during 1994 with the aforementioned financing for capital expenditures and its existing cash balances principally derived from the sale of the tree maintenance services operations. In 1987, Graniteville was notified by the South Carolina Department of Health and Environmental Control ("DHEC") that it discovered certain contamination of Langley Pond near Graniteville, South Carolina and DHEC asserted that Graniteville may be one of the parties responsible for such contamination. Graniteville entered into a consent decree providing for the study and investigation of the alleged pollution and its sources. The study report prepared by Graniteville's environmental consulting firm and filed with DHEC in April 1990, recommended that pond sediments be left undisturbed and in place. DHEC responded by requesting that Graniteville submit additional information concerning potential passive and active remedial alternatives, with accompanying supportive information. In May 1991 Graniteville provided this information to DHEC in a report of Graniteville's environmental consulting firm. The 1990 and 1991 reports concluded that pond sediments should be left undisturbed and in place and that other less passive remediation alternatives either provided no significant additional benefits or themselves involved adverse effects on human health, to existing recreational uses or to the existing biological communities. SEPSCO is unable to predict at this time what further actions, if any, may be required in connection with Langley Pond or what the cost thereof may be. However, given the passage of time since the submission of the two reports by DHEC and the absence of desirable remediation alternatives, other than continuing to leave the Langley Pond sediments in place and undisturbed as described in the reports, SEPSCO believes the ultimate outcome of this matter will not have a material adverse effect on SEPSCO's consolidated results of operations or financial position. As a result of certain environmental audits in 1991, SEPSCO became aware of possible contamination by hydrocarbons and metals at certain sites of SEPSCO's refrigeration operations and has filed appropriate notifications with state environmental authorities and has begun a study of remediation at such sites. SEPSCO has removed certain underground storage and other tanks at certain facilities of its refrigeration operations and has engaged in certain remediation in connection therewith. Such removal and environmental remediation involved a variety of remediation actions at various facilities of SEPSCO located in a number of jurisdictions. Such remediation varied from site to site, ranging from testing of soil and groundwater for contamination, development of remediation plans and removal in certain instances of certain contaminated soils. Based on preliminary information and consultations with, and certain reports of, environmental consultants and others, SEPSCO presently estimates the cost of such remediation and/or removal will approximate $3.7 million, all of which was provided in prior years. In connection therewith, SEPSCO has incurred actual costs through December 31, 1993 of $1.2 million and has a remaining accrual of $2.5 million. SEPSCO believes that after such accrual the ultimate outcome of this matter will not have a material adverse effect on SEPSCO's consolidated results of operations or financial position. PAGE Item 8.

Item 8. Financial Statements and Supplementary Data Index: Report of Independent Certified Public Accountants Consolidated Balance Sheets - February 28, 1993 and December 31, 1993 Consolidated Statements of Operations and Retained Earnings (Deficit) - Two years ended February 28, 1993 and ten months ended December 31, 1993 Consolidated Statements of Cash Flows - Two years ended February 28, 1993 and ten months ended December 31, 1993 Notes to Consolidated Financial Statements REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS To the Board of Directors and Stockholders, SOUTHEASTERN PUBLIC SERVICE COMPANY: We have audited the accompanying consolidated balance sheets of Southeastern Public Service Company (a Delaware corporation and a 71.1% owned subsidiary of Triarc Companies, Inc., formerly DWG Corporation, prior to April 14, 1994 and a wholly-owned subsidiary thereafter) and subsidiaries as of February 28, 1993 and December 31, 1993 and the related consolidated statements of operations and retained earnings (deficit) and cash flows for each of the two years in the period ended February 28, 1993 and the ten months ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Southeastern Public Service Company and subsidiaries as of February 28, 1993 and December 31, 1993, and the results of their operations and their cash flows for each of the two years in the period ended February 28, 1993 and for the ten months ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Notes 7 and 1 to the consolidated financial statements, the Company's 49% owned affiliate accounted for under the equity method and the Company changed their methods of accounting for income taxes and postretirement benefits other than pensions, effective March 2, 1992 and March 1, 1993, respectively. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in Item 14.(A) 2. are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Miami, Florida, April 14, 1994. PAGE See accompanying notes to consolidated financial statements. PAGE See accompanying notes to consolidated financial statements. PAGE Other: During the years ended February 29, 1992 and February 28, 1993 and ten months ended December 31, 1993, Southeastern Public Service Company ("SEPSCO"), a 71.1% owned subsidiary of Triarc Companies, Inc. ("Triarc", formerly DWG Corporation) prior to April 14, 1994 and a 100% owned subsidiary of Triarc thereafter, received interest payments from Triarc of $7,209, $6,026 and $3,308, respectively, in the form of offsets against amounts due from SEPSCO to Triarc. During the year ended February 28, 1993, amounts payable to Triarc were netted against a $6,500 promissory note receivable form Triarc (see Note 5). See accompanying notes to consolidated financial statements. PAGE SOUTHEASTERN PUBLIC SERVICE COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements (1) Summary of Significant Accounting Policies Principles of Consolidation The consolidated financial statements include the accounts of Southeastern Public Service Company ("SEPSCO"), a 71.1% owned subsidiary of Triarc Companies, Inc. ("Triarc", formerly DWG Corporation) prior to April 14, 1994 and a 100% owned subsidiary of Triarc thereafter (see Note 15), and its subsidiaries. Due to their planned sale or liquidation (see Note 3), all subsidiaries, except for the liquefied petroleum gas business, have been reflected as discontinued operations. All significant intercompany balances and transactions have been eliminated in consolidation. Certain amounts in the prior years have been reclassified to conform to the current year presentation. On October 27, 1993 SEPSCO's Board of Directors approved a change in the fiscal year of SEPSCO from a fiscal year ending February 28 to a calendar year ending December 31, effective for the transition period ending December 31, 1993. Graniteville Company ("Graniteville"), a 49% owned investment, also changed its fiscal year to a calendar year ending December 31. As used herein, "Fiscal 1992" and "Fiscal 1993" refer to the years ended February 28, 1992 and 1993, respectively, and "Transition 1993" refers to the ten months ended December 31, 1993. SEPSCO's consolidated financial statements for each of the periods in Fiscal 1992, Fiscal 1993 and Transition 1993 include the results of Graniteville as a 49% owned affiliate and CFC Holdings Corp. ("CFC Holdings") as a 5.4% owned affiliate. Both investments are accounted for on the equity method. Also, as used herein February 28 shall mean the last day of SEPSCO's fiscal year for Fiscal 1992 and Fiscal 1993. Cash Equivalents SEPSCO considers all highly liquid instruments with an original maturity of three months or less when purchased to be cash equivalents. At December 31, 1993, SEPSCO had $20,646,000 invested in short-term commercial paper. Marketable Securities At December 31, 1993, marketable securities, which are stated at cost which approximates fair market value, consisted of the following (in thousands): Marketable equity securities $ 1,005 Marketable debt securities 9,790 -------- $ 10,795 ======== Inventories Inventories are determined under the lower of cost (first-in, first-out basis) or market. Depreciation, Depletion and Amortization Assets acquired prior to March 1, 1980 are depreciated on the straight- line basis using composite annual rates on the majority of properties of 5.2% to 7.2% for refrigeration properties; and 5% for liquefied petroleum gas properties. The development of these composite rates was based on the estimated useful lives of the related asset groups. Under the composite method of depreciation, upon normal retirement or replacement, the cost of property, less any salvage proceeds, is charged to accumulated depreciation. Gains and losses arising from abnormal retirements or disposal are included in current operations. Assets acquired on or after March 1, 1980 are depreciated on the straight-line basis using the estimated useful lives of the related major classes of properties; 3 to 9 years for automotive equipment; 5 to 20 years for machinery and equipment; and 20 to 30 years for buildings and improvements. Under this method, gains and losses arising from disposal are included in current operations. Depreciation and depletion on natural gas and oil properties are computed using the units of production method based on proven reserves estimated from engineering data. Financing costs incurred in connection with the issuance of SEPSCO's 11 7/8% Senior Subordinated Debentures (the "Debentures") are being amortized as interest expense over the term of the Debentures using the interest rate method. At February 28, 1993 and December 31, 1993, $1,063,000 and $846,000, respectively, of such unamortized deferred financing costs are included in "Other assets" in the accompanying consolidated balance sheets. The original issue debt discount on the Debentures is being amortized as interest expense over the term of the Debentures using the interest rate method. Such unamortized debt discount is reported as a reduction of related long-term debt in the accompanying consolidated balance sheets. Income Taxes Federal income tax returns for SEPSCO and its consolidated subsidiaries are filed on a consolidated basis. SEPSCO adopted Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes" ("SFAS 109") effective March 1, 1993. This accounting change resulted in a benefit of $7,617,000, $.64 per share, which is reflected as the cumulative effect of changes in accounting principles for "The Company" in the accompanying consolidated statement of operations for Transition 1993. SEPSCO recognizes deferred income taxes for the tax consequences of temporary differences by applying the enacted statutory tax rates to the differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities. Postretirement Benefits Other than Pensions Effective March 1, 1993, SEPSCO adopted the provisions of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions" ("SFAS 106"). This new standard requires the expected cost of these benefits be charged to expense during the years that employees render service. The effect of the adoption of SFAS 106 was immaterial. Oil and Gas The successful efforts method of accounting is followed for costs incurred in oil and gas exploration and development activities. Property acquisition costs for oil and gas properties are initially capitalized. When a property is determined to contain proven reserves, its property acquisition costs are transferred to proven properties and amortized using the units-of-production method. Exploration costs other than drilling, including geological and geophysical costs are expensed as incurred. Exploratory drilling costs are initially capitalized. If and when a property is determined to be nonproductive, property acquisition and exploratory drilling costs are expensed. Income (Loss) Per Share Income (loss) per share has been computed by dividing net income (loss), after the reduction for an insignificant amount of preferred stock dividends, by the 11,655,067 weighted average common shares outstanding during Fiscal 1992, Fiscal 1993 and Transition 1993. (2) Change in Fiscal Year The following sets forth unaudited condensed financial information for the ten months ended December 31, 1992, the comparable prior ten month period to Transition 1993 (in thousands, except per share amounts): (3) Discontinued Operations On July 22, 1993 SEPSCO's Board of Directors authorized the sale or liquidation of all of its operating businesses, consisting of its utility and municipal services, refrigeration and natural gas and oil businesses. Accordingly, SEPSCO has retroactively restated the accompanying consolidated financial statements for each of the periods shown to reflect all of such businesses as discontinued operations through July 22, 1993. The operating results of the discontinued operations subsequent to July 22, 1993 have been deferred and considered in the loss on disposal of discontinued operations and are included in "Net current liabilities of discontinued operations". In addition, on July 22, 1993 SEPSCO's Board of Directors authorized the sale or liquidation of the liquefied petroleum gas business. SEPSCO intends to transfer the liquefied petroleum gas business to a subsidiary of Triarc and the transfer would be accounted for at net book value. The precise nature of such transfer has not been determined and is expected to occur by July 22, 1994. Based on these facts SEPSCO has continued to reflect the liquefied petroleum gas business as a continuing operation. On December 9, 1993 SEPSCO's Board of Directors decided to sell the natural gas and oil business to Triarc following the Merger and the resulting elimination of the minority interest in SEPSCO (see Note 15) rather than selling such business to an independent third party. Such sale will be in the form of a sale of the stock of the entities comprising the natural gas and oil business for a net cash purchase price of $8,500,000, which Triarc and SEPSCO believe is equal to their fair value and which is approximately $4,000,000 higher than their net book value. On October 15, 1993 SEPSCO sold the assets of its tree maintenance services operations previously included in its utility and municipal services business segment for $69,600,000 in cash plus the assumption by the purchaser of $5,000,000 in current liabilities resulting in a loss of $4,571,000. On October 7, 1993 SEPSCO sold the stock of its two construction related operations previously included in its utility and municipal services business segment for a nominal amount subject to adjustments described below. As the related assets are sold or liquidated the purchasers have agreed to pay, as deferred purchase price, 75% of the net proceeds received therefrom (cash of $1,815,000 has been received as of December 31, 1993) plus, in the case of the larger of the two entities, an amount equal to 1.25 times the adjusted book value of such entity as of October 5, 1995 (the "Book Value Adjustment"). As of October 7, 1993, the adjusted book value of the assets of that entity aggregated approximately $1,600,000. In addition, SEPSCO paid $2,000,000 in October and November 1993 to cover the buyer's short-term operating losses and working capital requirements for the construction related operations. SEPSCO currently expects to break-even on the sales of the construction related operations, excluding any consideration of the potential Book Value Adjustment. On April 8, 1994 SEPSCO sold substantially all of the operating assets of the ice operations of its refrigeration business segment for $5,000,000 in cash, a $4,295,000 note (discounted value $3,327,000) and the assumption by the buyer of certain current liabilities of up to $1,000,000. The note, which bears no interest during the first year and 5% thereafter is payable in installments of $120,000 in 1995 through 1998 with the balance of $3,815,000 due 1999. The only remaining discontinued operations are the cold storage operation of the refrigeration business and the natural gas and oil business. The precise timetable for the sale and liquidation of the cold storage operations will depend upon SEPSCO's ability to identify appropriate potential purchasers and to negotiate acceptable terms for the sale of such operation. SEPSCO currently anticipates completion of such sales by July 22, 1994. In connection with the dispositions referred to above, SEPSCO reevaluated the estimated gain or loss from the sale of its discontinued operations and provided $13,910,000 for the revised estimated loss on the sale of the discontinued operations from an estimated break-even position as of August 31, 1993. The revised estimate principally reflects (i) approximately $4,600,000 of losses from the sales of the operations comprising the utility and municipal services business segment previously estimated to be approximately break-even, (ii) approximately $6,700,000 of losses from the sale of operations comprising SEPSCO's refrigeration business segment previously estimated to be a gain of $1,600,000, (iii) approximately $2,500,000 of estimated losses from operations from July 22, 1993 to the actual or estimated disposal of the discontinued operations and (iv) less previously estimated losses of $1,500,000 from the sale of SEPSCO's natural gas and oil business segment which will now be sold to Triarc and accounted for as a transfer between entities under common control at net book value. The net loss from the sale of the utility and municipal services business segment reflects a reduction of $1,800,000 in the estimated sales price for the construction related operations from previous estimates, a $2,000,000 reduction in anticipated proceeds from asset sales by July 22, 1994 and other adjustments in finalizing the loss on the sale of the tree maintenance services operations. The reduction in proceeds from asset sales result from the buyer of such business successfully negotiating extensions of certain major contracts with respect to the larger of such businesses and as a result no longer intending to immediately dispose of the major portion of the assets. Should the buyer hold such assets through October 5, 1995, the $2,000,000 reduction in proceeds would be effectively realized through the Book Value Adjustment. The $8,200,000 change relating to the sales of the refrigeration business segment principally results from (i) a $4,000,000 reduction in the sales price for the ice operations and (ii) a $4,000,000 reduction in the estimated sales price of the cold storage operations based on preliminary sales discussions and experience with respect to negotiating the sale of the other operations. SEPSCO expects that all remaining dispositions, including the results of their operations through the actual or anticipated disposal dates, will not in the aggregate result in any additional material loss to SEPSCO. The loss from discontinued operations consisted of the following (in thousands): PAGE Net current assets (liabilities) and non-current assets of discontinued operations consist of the following (for the purpose of the following tables, Natural Gas and Oil will be referred to as "NG&O" and Utility and Municipal Services and Refrigeration will be referred to as "Services and Refrig."): PAGE PAGE (4) Restricted Cash SEPSCO has an arrangement with a bank providing for the issuance of letters of credit for the purposes of securing certain performance and other bonds associated with the discontinued operations. These letters of credit are collateralized by cash deposited in restricted interest-bearing accounts not associated with the discontinued operations. (5) Change in Control As previously reported, a change in control of SEPSCO's parent, Triarc, occurred on April 23, 1993, which as a result of Triarc's ownership of SEPSCO's voting securities constituted a change in control of SEPSCO (the "Change in Control"). In connection with the Change in Control, the Board of Directors of SEPSCO was reconstituted and new senior executive officers were elected. In connection therewith, SEPSCO received from Triarc $27,115,000 in cash and $3,535,000 in the form of an offset of amounts due to Triarc as of April 23, 1993 in connection with the providing by Triarc of certain management services to SEPSCO. The aggregate $30,650,000 of payments by Triarc included full payment of $6,806,000 (including $306,000 of accrued interest) on an unsecured promissory note (the "Promissory Note") issued to SEPSCO by Triarc in connection with the 1988 sale of an investment and partial payment of $23,844,000 (including $1,430,000 of accrued interest) on a $48,952,000 promissory note (the "Note") due to SEPSCO. The remaining $26,538,000 principal balance of the Note is due on August 1, 1998. SEPSCO estimates that the carrying value of the Note at February 28, 1993 and December 31, 1993 approximates fair value based upon estimated market prices for a security with a comparable maturity, interest rate and security of principal. The Note resulted from the 1986 sale of approximately 51% of the outstanding common shares of Graniteville to Triarc and is secured by such shares. The Note is subordinated to senior indebtedness of Triarc to the extent, if any, that the payment of principal and interest thereon is not satisfied out of proceeds of the pledged Graniteville shares. SEPSCO used the $27,115,000 of cash proceeds to pay $12,689,000 due under its accounts receivable financing arrangement, which bore interest at the prime rate plus 1%, which was then terminated and to pay $14,426,000 (including $383,000 of accrued interest) owed to Chesapeake Insurance Company Limited ("Chesapeake Insurance"), a subsidiary of CFC Holdings. In connection with the collection of the Promissory Note, in Fiscal 1993 SEPSCO recognized a $6,000,000 gain on the sale of the common stock of an unaffiliated company to Triarc which had been previously deferred until collection of the Promissory Note was assured. As such note was collected in April 1993 prior to the issuance of the Fiscal 1993 consolidated financial statements, the $6,000,000 gain was recognized in Fiscal 1993. (6) Properties The following is a summary of properties, at cost: (7) Investment in Affiliates SEPSCO had a $1,500,000 investment in the preferred stock of Chesapeake Insurance and Graniteville had a $2,500,000 investment in such preferred stock. During its quarter ended September 30, 1993 Chesapeake Insurance increased its reserve for insurance and reinsurance losses by $10,000,000 and as a result reduced the stockholders' equity of Chesapeake Insurance to a minimal amount. Chesapeake Insurance ceased writing insurance or reinsurance of any kind for periods commencing on or after October 1, 1993. As a result Chesapeake Insurance will not have any future operating cash flows and its remaining liabilities, including payment of claims on insurance previously written, will be liquidated with assets on hand. Accordingly, the preferred stock investment is not recoverable and SEPSCO and Graniteville wrote off their investment in such stock since the decline in value was deemed to be other than temporary. This reduced equity in earnings of affiliates in Transition 1993 by $1,225,000 and $540,000 relating to Graniteville and CFC Holdings, respectively. Investments in affiliates consisted of the following: Equity in earnings of affiliates before income taxes on the ultimate distribution of earnings of affiliates of SEPSCO, cumulative effect of changes in accounting principles and extraordinary items consisted of the following: Graniteville Summary consolidated balance sheet information at February 28, 1993 and December 31, 1993 and summary consolidated income statement information for Fiscal 1992, Fiscal 1993 and Transition 1993 for Graniteville are as follows: In Fiscal 1993 Graniteville adopted SFAS 109 and SFAS 106 with the cumulative effect of changes in accounting principles resulting in charges to Graniteville's consolidated statement of earnings amounting to $12,314,000 for SFAS 109 and $722,000, net of Graniteville's taxes of $429,000 for SFAS 106. SEPSCO's equity, net of taxes of $434,000, in such cumulative effect, amounted to a charge of $5,954,000 or $.51 per share. Under its new credit facility, Graniteville is permitted to pay dividends or make loans or advances to its stockholders, including SEPSCO, in an amount equal to 50% of the net income of Graniteville accumulated from the beginning of the first fiscal year commencing on or after December 20, 1994, provided that the outstanding principal balance of Graniteville's term loan is less than $50,000,000 at the time of the payment (the outstanding principal balance was $72,500,000 as of December 31, 1993) and certain other conditions are met. Accordingly, Graniteville is unable to pay any dividends to or make any loans or advances to SEPSCO prior to December 31, 1995. Cash dividends received by SEPSCO from its investments in Graniteville under its previous credit facility were $1,038,000 and $3,004,000, in the years ended February 29, 1992 and February 28, 1993, respectively. CFC Holdings SEPSCO presently owns 5.4% of the outstanding common stock of CFC Holdings. The remaining 94.6% of such common stock is currently owned by Triarc. CFC Holdings owns 100% of RC/Arby's Corporation ("RCAC", formerly Royal Crown Corporation, the principal subsidiaries of which are Arby's, Inc. ("Arby's") and Royal Crown Company, Inc. ("Royal Crown", formerly Royal Crown Cola Co.) and Chesapeake Insurance). SEPSCO received its 5.4% in CFC Holdings in July 1991 in exchange for its then 5.4% interest in the common stock of RCAC which at that time owned 100% of Arby's, Royal Crown and Chesapeake Insurance. In connection with a capital restructuring in July 1991, all of the RCAC preferred stock which was owned by Triarc was converted into common stock of RCAC reducing SEPSCO's ownership percentage from its then 48% to 5.4%. The reduction in SEPSCO's ownership in connection with such restructuring resulted in SEPSCO reclassifying as of August 31, 1991, to "Additional paid-in capital", the cumulative equity in net losses of CFC Holdings amounting to $15,210,000 which was previously recorded in "Other liabilities". SEPSCO's equity in extraordinary items relates to CFC Holdings and consisted of a charge in Fiscal 1993 of $348,000 due to the early extinguishment of debt. (8) Income Taxes The benefit from (provision for) income taxes consisted of the following components: The difference between the reported tax benefit (provision) and a computed tax benefit (provision) at the Federal statutory rate (34% for Fiscal 1992, 34.2% for Fiscal 1993 and 35% for Transition 1993) is reconciled as follows: The current deferred tax assets and the non-current deferred tax assets (liabilities) consisted of the following components: The net change in the current deferred tax asset and non-current deferred tax liability from March 1, 1993 to December 31, 1993 of $5,307,000 is comprised of a deferred tax benefit from continuing operations of $1,195,000 and a deferred tax benefit from discontinued operations of $4,112,000. As of December 31, 1993 SEPSCO had net operating loss carryforwards for federal income tax reporting purposes of approximately $6,400,000. Such carryforwards will expire in the amount of approximately $2,200,000 in the year 2004 and approximately $4,200,000 in the year 2006. In addition SEPSCO has depletion carryforwards of $5,000,000 and alternative minimum tax credit carryforwards of approximately, $3,400,000 both of which have an unlimited carryforward period. Deferred income tax (provision) benefit results from timing differences in the recognition of income and expenses for tax and financial reporting purposes. The tax effect of the principal timing differences are as follows (such disclosure is not presented for Transition 1993 as it is not required under SFAS 109): Federal income tax returns of SEPSCO have been examined by the Internal Revenue Service ("IRS") for the tax years 1985 through 1988. Such audit has been substantially resolved at no material cost to SEPSCO. The IRS has recently commenced the examination of SEPSCO's Federal income tax returns for the tax years from 1989 through 1992. The amount and timing of any payments required as a result of the 1989 through 1992 audit cannot presently be determined. However, SEPSCO believes that it has adequate aggregate reserves for any tax liabilities, including interest, that may result from all such examinations. (9) Long-term Debt Long-term debt consists of the following (in thousands): Aggregate annual maturities, including required sinking fund payments, of long-term debt are as follows as of December 31, 1993 (in thousands): SEPSCO is required to retire annually, through a mandatory sinking fund, $9,000,000 principal amount of the Debentures through 1997 with a final payment of $27,000,000 due in 1998. On February 1, 1993 SEPSCO satisfied its mandatory sinking fund requirement due on such date by payment of $8,734,000 in cash and $266,000 of principal amount of the Debentures. The amortization of the discount on the Debentures purchased is reported as a separate line item in the accompanying consolidated statements of operations. Under provisions of the indenture (the "Indenture") pursuant to which the Debentures were issued, SEPSCO is not permitted to pay cash dividends and acquire shares of SEPSCO's capital stock as of December 31, 1993. The fair value of the Debentures was approximately $4,700,000 and $5,500,000 higher than the carrying values at February 28, 1993 and December 31, 1993, respectively, based on quoted market prices. The indenture contains a provision which limits to $100,000,000 the aggregate amount of specified kinds of indebtedness that SEPSCO and its consolidated subsidiaries can incur. At December 31, 1993 such indebtedness was $59,321,000 resulting in allowable indebtedness of $40,679,000. (10) Stockholders' Equity At December 31, 1993 71.1% of SEPSCO's outstanding common stock, $1.00 par value per share, (the "SEPSCO Common Stock") and all of the convertible preferred stock, Series B, was owned by Triarc. On April 14, 1994, Triarc increased its ownership of SEPSCO's Common Stock to 100% (see Note 15). The convertible preferred stock bears a dividend of 5 1/2% and is convertible into 8,167 shares of common stock at a rate of $3.00 per share. Included in "Retained earnings (deficit)" at February 28, 1993 and December 31, 1993 are $3,309,000 and $7,696,000 of net undistributed earnings of unconsolidated affiliates, respectively. (11) Lease Commitments SEPSCO leases certain machinery, automotive and other equipment primarily from an indirect, wholly-owned subsidiary of Triarc under long-term lease obligations which are accounted for as capital leases in the accompanying consolidated balance sheets. The cost of properties under capital leases amounted to $1,264,000 and $1,029,000 at February 28, 1993 and December 31, 1993, respectively, and the cost of properties under capital leases of discontinued operations (included in "Net non-current assets of discontinued operations") amounted to $54,698,000 and $1,246,000, respectively. The decrease in the cost of properties under capital leases of discontinued operations is the result of the sale of certain businesses (see Note 3). The future minimum lease payments (net of sublease rentals which are not significant) under capital leases and operating leases with an initial noncancelable term in excess of one year are as follows as of December 31, 1993: Rental expense under operating leases, which is primarily for the rental of office space, was $2,330,000 in Fiscal 1992, $2,012,000 in Fiscal 1993 and $1,470,000 in Transition 1993, of which $537,000, $485,000 and $370,000 related to continuing operations and $1,793,000, $1,527,000 and $1,100,000 related to discontinued operations. (12) Retirement and Incentive Compensation Plans Substantially all of the employees of the continuing and discontinued businesses are covered under SEPSCO's 401(k) defined contribution plan or one of the multi-employer union plans to which SEPSCO contributes. The defined contribution plan allows eligible employees to contribute up to 15% of their total earnings, subject to certain limitations. SEPSCO makes a matching contribution for eligible employees of 25% of the employee's contributions but limited to the first 5% of an employee's compensation and an additional contribution equal to 1/4 of 1% of such employee's total earnings. Total contributions were $368,000 in Fiscal 1992, and $394,000 in Fiscal 1993 and $133,000 in Transition 1993. SEPSCO had several defined benefit pension plans, all of which were frozen prior to February 28, 1990. SEPSCO's applications with the Pension Benefit Guaranty Corporation and the Internal Revenue Service for the termination and distribution of surplus pension assets of SEPSCO's defined benefit pension plans were approved during Fiscal 1992. After the purchase of annuities for plan participants, SEPSCO received the net surplus pension assets of $3,226,000 in Fiscal 1992 and $206,000 in Fiscal 1993. Substantially all of the gain on such reversions had previously been reflected through February 28, 1992 in accordance with SFAS 87, including $863,000 in Fiscal 1992. During Fiscal 1993 all remaining prepaid and accrued pension costs existing as of February 28, 1992 were eliminated resulting in a termination gain of $431,000. The components of the Fiscal 1992 net periodic pension benefits are as follows (in thousands): An assumed discount rate of 7.0% in Fiscal 1992 and an expected long- term rate on assets of 9%, were used in developing this data. Plan assets were invested in a managed portfolio consisting primarily of money market investments, corporate bonds and common stock of unaffiliated issuers. Under certain union contracts, SEPSCO is required to make payments to the union pension funds based upon hours worked by the eligible employees. Payments to the funds amounted to $819,000 in Fiscal 1992, $784,000 in Fiscal 1993 and $536,000 in Transition 1993. Information from the plan administrators of the funds is not available to permit SEPSCO to determine its share of unfunded vested benefits, if any. During Transition 1993 Triarc granted stock options to certain key employees of SEPSCO under Triarc's Amended and Restated 1993 Equity Participation Plan. Of such options 10,000 were granted at an option price of $20.00 that was lower than the fair market value of Triarc's Class A Common Stock at the date of grant of $31.75. The aggregate difference of $118,000 between the option price and the fair market value at the date of grant is being amortized to compensation expense over the applicable vesting period through 1998. Compensation expense resulting from the grants was $8,000 during Transition 1993 and is included in "Selling, general and administrative expenses" in the accompanying consolidated statement of operations. (13) Transactions with Affiliates In Fiscal 1993, SEPSCO increased its borrowings from Chesapeake Insurance by $8,400,000 to $14,043,000. The additional borrowings were used to provide the necessary funds to meet SEPSCO's mandatory sinking fund requirements due February 1, 1993. The loans from Chesapeake Insurance were payable on demand and bore interest at an annual rate of 11 7/8%. In addition such loans were secured by a pledge of approximately 100% of the stock of SEPSCO's Public Gas subsidiary. On April 23 1993 SEPSCO paid in full such loans amounting to $14,426,000 including $383,000 of accrued interest to Chesapeake Insurance (see Note 5). In Fiscal 1992 SEPSCO purchased 15,000 convertible redeemable preferred shares of Chesapeake Insurance for $1,500,000 (see Note 7). Prior to the Change in Control, SEPSCO received from Triarc certain management services including legal, accounting, tax, insurance, financial and other management services. The portion of these costs allocated to SEPSCO under a management services agreement (the "Former Management Services Agreement") was $2,063,000 in Fiscal 1992, $2,033,000 in Fiscal 1993 and $557,000 in Transition 1993 (of which $268,000, $264,000 and $92,000, respectively, was allocated to continuing operations and $1,795,000, $1,769,000 and $465,000, respectively, was allocated to discontinued operations). Such costs were allocated to SEPSCO by Triarc based first directly on the cost of the service provided and then, for those costs which could not be directly allocated, based upon the relative revenues and tangible assets of the affiliated companies. Management of SEPSCO believes the cost of such services would have been higher if SEPSCO had operated as an entity unaffiliated with Triarc. Effective April 23, 1993, SEPSCO entered into a new management services agreement (the "New Management Services Agreement") with Triarc which revised the allocation method of these costs which can not be directly allocated. As revised, such costs are allocated based upon the relative sum of the greater of earnings before income taxes, depreciation and amortization and 10% of revenues. The portion of these costs allocated to SEPSCO under the New Management Services Agreement was $2,699,000 in Transition 1993 (of which $447,000 was allocated to continuing operations and $2,252,000 was allocated to discontinued operations). Management of SEPSCO believes that such allocation method approximates the costs that would have been incurred if SEPSCO had operated as an entity unaffiliated with Triarc. Additionally, SEPSCO was allocated certain uncollectible amounts owed to Triarc for similar management services to certain former affiliates of SEPSCO amounting to $849,000 in Fiscal 1992, $1,781,000 in Fiscal 1993 and $150,000 in Transition 1993 (of which $110,000, $232,000 and $25,000, respectively, was allocated to continuing operations and $739,000, $1,549,000 and $125,000, respectively, was allocated to discontinued operations). These amounts were allocated principally on the same basis as the costs of the management services, an allocation method the management of SEPSCO believes is reasonable. Such costs to SEPSCO would have been lower if SEPSCO had operated as an unaffiliated entity of Triarc to the extent the cost of such services would not have been incurred had services not been provided to the entities unable to pay. Such amounts are included in "Selling, general and administrative expenses" and "Loss from discontinued operations, net of income taxes" in the accompanying consolidated statements of operations. Until January 31, 1994 SEPSCO, through Triarc, leased office space from a trust for the benefit of Victor Posner and his children (the "Posner Lease"). Rent allocated by Triarc to SEPSCO amounted to $1,467,000 in Fiscal 1992, $1,055,000 in Fiscal 1993 and $163,000 (which is net of a credit relating to prior years resulting from the decrease in rent noted below) in Transition 1993 (of which $191,000, $137,000 and $27,000, respectively, was allocated to continuing operations and $1,276,000, $918,000 and $136,000, respectively, was allocated to discontinued operations). The Posner Lease, which would have expired in 1993, was renewed by Triarc and in accordance therewith in January 1993 rental expense was reduced by approximately 50%. Such amounts are included in "Selling, general and administrative expenses" and "Income (loss) from discontinued operations, net of income taxes" in the accompanying consolidated statements of operations. During Transition 1993, SEPSCO also recorded a provision of $2,840,000 (of which $471,000 was allocated to continuing operations and $2,369,000 was allocated to discontinued operations) for its share of the remaining payments on the Posner Lease due to its cancellation effective January 31, 1994. Such amounts are included in "Selling, general and administrative expenses" and "Income (loss) from discontinued operations, net of income taxes" in the accompanying consolidated statements of operations. During Fiscal 1992, Fiscal 1993 and Transition 1993 until April 23, 1993, the rent was allocated based on direct square footage utilized and the relative net revenues and tangible assets of SEPSCO. Effective with the Change in Control the rent allocation method was changed and is now based solely on direct square footage utilized and the relative net revenues of SEPSCO, a method management of SEPSCO believes is reasonable. Had SEPSCO not occupied space under Triarc's long-term lease obligation or been allocated rent for indirect usage, given the competitive rental market during the relevant periods, management of SEPSCO believes that its rent costs on a stand alone basis would have been substantially lower through December 31, 1992. In addition, SEPSCO incurred interest expense at 18% on unpaid balances due to Triarc for management services and rent under the Former Management Services Agreement of $737,000 in Fiscal 1992, $652,000 in Fiscal 1993 and $(68,000) (which is net of a credit relating to prior years) in Transition 1993 (of which $96,000, $85,000 and $(11,000), respectively, was allocated to continuing operations and $641,000, $567,000 and $(57,000), respectively, was allocated to discontinued operations). Chesapeake Insurance provided certain insurance and reinsurance of certain risks to SEPSCO until October 1993 at which time Chesapeake Insurance ceased writing all insurance and reinsurance. The net premium expense incurred was $9,416,000 in Fiscal 1992, $10,688,000 in Fiscal 1993 and $9,791,000 in Transition 1993 (of which $997,000, $1,064,000 and $969,000 respectively, was allocated to continuing operations and $8,419,000, $9,624,000 and $8,822,000, respectively, was allocated to discontinued operations). In addition, Insurance and Risk Management, Inc., an affiliated company until April 23, 1993, acted as agent or broker in connection with insurance coverage obtained by SEPSCO and also provided claims processing services. The commissions and payments incurred for such services were $528,000 in Fiscal 1992, $488,000 in Fiscal 1993 and $50,000 in Transition 1993 (of which $56,000, $49,000 and $8,000, respectively, was allocated to continuing operations and $472,000, $439,000 and $42,000, respectively, was allocated to discontinued operations). SEPSCO's machinery and automotive equipment under capital lease for the continuing and discontinued operations are leased from an indirect, wholly- owned subsidiary of Triarc. Interest charges on these lease obligations amounted to $3,629,000 in Fiscal 1992, $3,156,000 in Fiscal 1993 and $1,885,000 in Transition 1993 (of which $76,000, $72,000 and $56,000, respectively, was allocated to continuing operations and $3,553,000, $3,084,000 and $1,829,000, respectively, was allocated to discontinued operations). (14) Significant Transition 1993 Charges The accompanying condensed consolidated statements of operations include the following significant charges recorded in Transition 1993 (in thousands): (1) $782,000 included in "Selling, general and administrative expenses" of continuing operations and $3,932,000 included in "Loss from discontinued operations." (2) $104,000 included in "Selling, general and administrative expenses" of continuing operations and $521,000 included in "Loss from discontinued operations." (3) $(301,000) included in "Benefit from income taxes" of continuing operations and $(4,222,000) included in "Loss from discontinued operations." (4) Included in "Loss from discontinued operations." (5) $100,000 included in "Benefit from income taxes" of continuing operations and $500,000 included in "Loss from discontinued operations." (a) During Transition 1993 results of operations were significantly impacted by facilities relocation and corporate restructuring charges aggregating $4,714,000 consisting of $4,214,000 of charges allocated to SEPSCO by Triarc: (i) estimated allocated cost of $2,840,000 to terminate the lease on Triarc's existing corporate facilities; (ii) total allocated costs of $1,374,000 relating to a five-year consulting agreement (the "Consulting Agreement") extending through April 1998 between Triarc and Steven Posner, the former Vice Chairman of Triarc and $500,000 of estimated direct costs to be incurred by SEPSCO to relocate SEPSCO's corporate office. All of such charges are related to the Change in Control described in Note 5. In connection with the Change in Control, Victor Posner and Steven Posner resigned as officers and directors of Triarc. In order to induce Steven Posner to resign, Triarc entered into the Consulting Agreement with him. The allocated cost related to the Consulting Agreement was recorded as a charge in Transition 1993 because the Consulting Agreement does not require any substantial services and SEPSCO and Triarc do not expect to receive any services that will have substantial value to them. As a part the Change in Control, the Triarc Board of Directors was reconstituted. The first meeting of the reconstituted Triarc Board of Directors was held on April 24, 1993. At that meeting, based on a report and recommendations from a management consulting firm that had conducted an extensive review of Triarc and its subsidiaries operations and management structure, the Triarc Board of Directors approved a plan of decentralization and restructuring which entailed, among other things, the following features: (i) the strategic decision to manage Triarc in the future on a decentralized rather than on a centralized basis; (ii) the hiring of new executive officers for Triarc; (iii) the termination of a significant number of employees as a result of both the new management philosophy and the hiring of an almost entirely new management team and (iv) the relocation of Triarc and certain subsidiaries, including SEPSCO's corporate headquarters. SEPSCO's allocated cost to terminate the lease on Triarc's existing corporate facilities ($2,840,000) and the cost to relocate SEPSCO's headquarters ($500,000) all stemmed from the decentralization and restructuring plan formally adopted at the April 24, 1993 meeting of the reconstituted Triarc Board of Directors and accordingly, were recorded in Transition 1993. (b) In accordance with certain court proceedings and related settlements, five directors, including three court-appointed directors, were appointed in 1991 to serve on a special committee (the "Special Committee") of Triarc's Board of Directors. Such committee was empowered to review and pass on transactions between Triarc and Victor Posner, the then largest shareholder of Triarc, and his affiliates. SEPSCO has been charged $625,000 as an allocation of the cash portion of a success fee payable to the Special Committee attributable to the closing of the Triarc reorganization and the resulting Change in Control. (c) Represents write-downs in the carrying value of certain unprofitable properties reflecting their estimated impairment as a result of management's re-valuation of such assets. (d) SEPSCO's equity in significant charges recorded in Transition 1993, which consisted of both direct charges and charges allocated by Triarc to Graniteville and CFC Holdings is summarized as follows (in thousands): (15) Legal Matters In December 1990, a purported shareholder derivative suit (the "Ehrman Litigation") was brought against SEPSCO's directors at that time and certain corporations, including Triarc, in the United States District Court for the Southern District of Florida(the "District Court"). On October 18, 1993, Triarc entered into a settlement agreement (the "Settlement Agreement") with the plaintiff (the "Plaintiff") in the Ehrman Litigation. The Settlement Agreement provides, among other things, that SEPSCO would be merged into, or otherwise acquired by, Triarc or an affiliate thereof, in a transaction in which each holder of SEPSCO's common stock other than Triarc will receive in exchange for each share of SEPSCO's common stock, 0.8 shares of Triarc's common stock. On November 22, 1993 Triarc and SEPSCO entered into a merger agreement which provided for a subsidiary of Triarc to be merged into SEPSCO in the manner described in the Settlement Agreement(the "Merger"). On January 11, 1994 the District Court approved the Settlement Agreement, and the Merger was approved on April 14, 1994 by SEPSCO's stockholders other than Triarc. As a result of the Merger, Triarc owns 100% of SEPSCO's Common Stock. The Settlement Agreement also provides that Plaintiff's counsel and financial advisor will be paid by Triarc, subject to court approval, cash not to exceed $1,250,000 and $50,000, respectively and that Triarc would be responsible for other expenses relating to the issuance of Triarc common shares pursuant to the Merger. SEPSCO had previously accrued such $1,300,000 in the fourth quarter of Fiscal 1993 and accrued additional expenses related to the settlement of the Ehrman Litigation of $400,000 and $1,200,000 in the first and second quarters of Transition 1993, respectively, since SEPSCO originally anticipated it would be responsible for such fees and expenses. However, as previously indicated, the Settlement Agreement established that Triarc and not SEPSCO was responsible for certain of these expenditures and, accordingly, SEPSCO reversed $1,900,000 of previously accrued expenses in the third quarter of Transition 1993 which is included in "Other, net" in the consolidated statement of operations. The Merger will be accounted for by Triarc in accordance with the purchase method of accounting. Accordingly, Triarc's additional 28.87% interest in SEPSCO's assets and liabilities will be recorded at their fair values and Triarc's minority interest in SEPSCO will be eliminated. This excess of purchase price over the fair value of the additional interest in the net assets acquired will be amortized on a straight-line basis over 30 years. Triarc has not yet performed a final evaluation of purchase accounting, and accordingly, cannot presently determine the amount of costs in excess of net assets of acquired companies ("Goodwill") that will result from the Triarc Merger. However, assuming that the fair value of the additional interest acquired approximates its book value and based on the market price per share of Triarc's Class A Common Stock on April 14, 1994, Goodwill would increase by approximately $25,000,000 which Triarc will push down to SEPSCO. Such increase in goodwill is net of the portion of the merger consideration which represents the settlement of the Ehrman Litigation (see above). Pro forma unaudited condensed summary operating results of SEPSCO for Transition 1993 giving effect to the Merger as if it had been consummated on March 1, 1993, are as follows (in thousands except per share amount): SEPSCO and its subsidiaries are defendants in certain other legal proceedings arising out of the conduct of SEPSCO's business. In the opinion of management and counsel, the ultimate outcome of these legal proceedings will not have material adverse effect on the consolidated financial position or results of operations of SEPSCO. As a result of certain environmental audits, SEPSCO became aware of possible contamination by hydrocarbons and metals at certain sites of SEPSCO's refrigeration operations and has filed appropriate notifications with state environmental authorities and began a study of remediation at such sites. SEPSCO has removed certain underground storage and other tanks at certain facilities of its refrigeration operations and has engaged in certain remediation in connection therewith. Such removal and environmental remediation involved a variety of remediation actions at various facilities of SEPSCO located in a number of jurisdictions. Such remediation varied from site to site, ranging from testing of soil and groundwater for contamination, development of remediation plans and removal, in certain instances, of certain contaminated soils. Based on preliminary information and consultations with, and certain reports of, environmental consultants and others, SEPSCO presently estimates their cost of such remediation and/or removal described above will approximate $3,661,000 of which $1,300,000 was provided in Fiscal 1991, $200,000 in Fiscal 1992 and $2,161,000 in Fiscal 1993 included in "Other, net" in the results of discontinued operations. In connection therewith SEPSCO has incurred actual costs of $1,224,000 through December 31, 1993 and has a remaining accrual of $2,437,000 included in "Net non-current assets of discontinued operations" in the balance sheet above as of December 31, 1993. SEPSCO believes that its current reserves for remediation costs are adequate. (16) Quarterly Information (Unaudited) - ------------ (a) Quarterly information has been retroactively restated to reflect the discontinuance of utility and municipal services, refrigeration and natural gas and oil operations in Transition 1993. (b) Includes a gain from sale of marketable security of $6,000,000 and a $1,300,000 provision for the settlement of certain litigation. (c) Includes a provision for anticipated losses on construction contracts in progress of $1,608,000 and other fourth quarter adjustments of $820,000 related to net realizable value of oil and gas properties and plugging and abandonment of wells. Includes a $375,000 provision for settlements of certain litigation and a $2,100,000 provision for environmental costs. (d) For discussion see Note 3 - Discontinued Operations. (e) For discussion see Note 1 - Summary of Significant Accounting Policies. (f) For discussion see Note 7 - Investment in Affiliates. Item 9.

Item 9. Change in and Disagreements with Accountants on Accounting and Financial Disclosure. Not Applicable. PART III The information required by Part III of this Form 10-K is incorporated herein by reference from SEPSCO's Proxy. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (A) 1. Financial Statements See Index to Financial Statements (Item 8) 2. Financial Statement Schedules: II. Amounts Receivable From Related Parties -- Two Years Ended February 28, 1993 and Ten Months Ended December 31, 1993 IX. Short-term Borrowings -- Two Years Ended February 28, 1993 and Ten Months Ended December 31, 1993 X. Supplementary Income Statement Information -- Two Years Ended February 28, 1993 and Ten Months Ended December 31, 1993 All other schedules are omitted because they are not applicable or the required information in the Consolidated Financial Statements or notes thereto. 3. Exhibits: Copies of the following exhibits are available at a charge of $.25 per page upon written request to the Secretary of the Company at 777 South Flagler Drive, Suite 1000E, West Palm Beach, Florida 33401. 2.1 Agreement and Plan of Merger dated as of November 22, 1993 among Southeastern Public Service Company ("SEPSCO"), Triarc Companies, Inc. ("Triarc") and SEPSCO Merger Corporation, incorporated herein by reference to Exhibit 2.1 to SEPSCO's Definitive Proxy Statement (the "SEPSCO Proxy"), filed pursuant to Regulation 14A on March 11, 1994 (SEC file #1-4351). 3.1 Certificate of Incorporation of SEPSCO, incorporated herein by reference to Exhibit 3.1 to SEPSCO's Annual Report on Form 10-K for the fiscal year ended February 28, 1981 (SEC file #1-4351). 3.2 Certificate of Amendment dated September 24, 1984 to the Certificate of Incorporation of SEPSCO, incorporated herein by reference to Exhibit 3.2 to SEPSCO's Annual Report on Form 10-K for the fiscal year ended February 28, 1985 (SEC file #1-4351). 3.3 By-Laws of SEPSCO, incorporated herein by reference Exhibit 3.2 to SEPSCO's Annual Report on Form 10-K for the fiscal year ended February 28, 1981 (SEC file #1-4351). 4.1 SEPSCO Indenture dated as of February 1, 1983, incorporated herein by reference to Exhibit 4(a) to SEPSCO's Registration Statement on Form S-2 dated January 18, 1983 (SEC file #2-81393). 10.1 Memorandum of Understanding dated as of September 13, 1993 between Triarc and William Ehrman, individually and derivatively on behalf of SEPSCO, incorporated herein by reference to Exhibit 10.1 to Triarc's Current Report on Form 8-K dated September 13, 1993 (SEC file #1-2207). 10.2 Stipulation of Settlement of the Ehrman Litigation dated as of October 18, 1993, incorporated herein by reference to Exhibit 1 to Triarc's Current Report on Form 8-K dated October 15, 1993 (SEC file #1-2207). 10.3 Form of Former Management Services Agreement between Triarc and certain other corporations, including SEPSCO, incorporated herein by reference to Exhibit 10.10 to Triarc's Annual Report on Form 10- K for the fiscal year ended April 30, 1993 (SEC file #1-2207). 10.4 Form of New Management Services Agreement between Triarc and certain of its subsidiaries, including SEPSCO, incorporated herein by reference to Exhibit 10.10 to Triarc's Annual Report on Form 10- K for the fiscal year ended April 30, 1993 (SEC file #1-2207). 21.1 Subsidiaries of the Registrant* ____________ *being filed herewith (B) Reports on Form 8-K: During December 1993, the registrant filed reports on Form 8-K on the following dates with respect to the following matters: Date Subject Matter ---- -------------- December 22, 1993 Completion of the sale of SEPSCO's utility and municipal services business segment and reevaluation by SEPSCO of its estimated gain or loss from the role of its discontinued operations. (D) Financial Statements: Consolidated financial statements of Graniteville Company for each of the two years in the period ended February 28, 1993 and the ten month period from March 1, 1993 to January 2, 1994. Financial statements, financial statement schedules and report of independent certified public accountants with respect to Graniteville Company are included immediately following Exhibit 21.1. PAGE SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. SOUTHEASTERN PUBLIC SERVICE COMPANY (Registrant) NELSON PELTZ By:--------------------------------- Nelson Peltz Dated: April 15, 1994 Chairman and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on the 15th day of April, 1994 by the following persons on behalf of the registrant in the capacities indicated. Signature Titles --------- ------ NELSON PELTZ Chairman and Chief Executive - --------------------------- Officer, and Director (Nelson Peltz) (Principal Executive Officer) PETER W. MAY President and Chief Operating - --------------------------- Officer, and Director (Peter W. May) (Principal Operating Officer) LEON KALVARIA Vice Chairman and Director - --------------------------- (Leon Kalvaria) JOSEPH A. LEVATO Executive Vice President and - -----------------------------Chief Financial Officer (Joseph A. Levato) (Principal Financial Officer) FRED H.SCHAEFER Vice President and Chief - ----------------------------- Accounting Officer (Fred H. Schaefer) (Principal Accounting Officer) PAGE PAGE PAGE PAGE Exhibit 21.1 SOUTHEASTERN PUBLIC SERVICE COMPANY AND SUBSIDIARIES Subsidiaries of the Registrant April 15, 1994 The subsidiaries of Southeastern Public Service Company, their respective states or jurisdictions of organization and the names under which such subsidiaries do business are as follows: State or Jurisdiction Under which Organized --------------------- Crystal Ice & Cold Storage, Inc. Delaware Houston Oil & Gas Company, Inc. Delaware Northwestern Ice & Cold Storage Company Oregon Public Gas Company (formerly Southeastern Propane Gas Company) Florida Royal Palm Ice Company Florida SEPSCO Merger Corporation Delaware Southeastern Gas Company Delaware Geotec Engineers, Inc. West Virginia Western Refrigeration & Cold Storage Company California PAGE GRANITEVILLE COMPANY AND SUBSIDIARIES CONSOLIDATED FINANCIAL STATEMENTS JANUARY 2, 1994 TOGETHER WITH REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS PAGE REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS To the Board of Directors and Stockholders, Graniteville Company: We have audited the accompanying consolidated balance sheets of Graniteville Company (a South Carolina corporation and 49% owned by Southeastern Public Service Company and 51% owned by Triarc Companies, Inc., formerly DWG Corporation) and Subsidiaries as of January 2, 1994 and February 28, 1993, and the related consolidated statements of income and retained earnings and cash flows for the ten month period ended January 2, 1994 and for each of the two years in the period ended February 28, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Graniteville Company and Subsidiaries as of January 2, 1994 and February 28, 1993, and the results of their operations and their cash flows for the ten month period ended January 2, 1994 and for each of the two years in the period ended February 28, 1993, in conformity with generally accepted accounting principles. As discussed in Note 4 to the consolidated financial statements, the Company changed its method of accounting for income taxes and postretirement benefits other than pensions effective March 2, 1992. Our audits were made for the purpose of forming an opinion on the basic consolidated financial statements taken as a whole. The schedules V, VI, VIII and IX for the ten month period ended January 2, 1994, and for each of the two years in the period ended February 28, 1993 are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic consolidated financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic consolidated financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole. Arthur Andersen & Co. Columbia, South Carolina February 25, 1994. (Except with respect to the matter discussed in Note 7, as to which the date is March 10, 1994). See accompanying notes to consolidated financial statements. See accompanying notes to consolidated financial statements. PAGE See accompanying notes to consolidated financial statements. PAGE GRANITEVILLE COMPANY AND SUBSIDIARIES Notes to Consolidated Financial Statements January 2, 1994 (1) Summary of Significant Accounting Policies Basis of Presentation Graniteville Company ("the Company") is a 51% owned subsidiary of Triarc Companies, Inc. (formerly DWG Corporation and referred to herein as "Triarc" and, collectively with its subsidiaries, "Triarc Companies") and 49% owned by Southeastern Public Service Company ("SEPSCO"). At January 2, 1994, SEPSCO was 71% owned by Triarc. Principles of Consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, C. H. Patrick & Co., Inc. ("C. H. Patrick") and Graniteville International Sales, Inc. ("Graniteville International"), an inactive corporation. All significant intercompany balances and transactions have been eliminated in consolidation. Fiscal Year/Change in Fiscal Year On October 27, 1993, the Board of Directors of Triarc approved a change in Triarc's fiscal year from a fiscal year ending April 30 to a calendar year ending December 31 effective for the transition period ending December 31, 1993. The fiscal years of all of Triarc's subsidiaries which did not end on December 31 were also so changed. Accordingly, the Company has adopted a 52-53 week period ending on the Sunday nearest the last day of December. As used herein, "Transition 1993" refers to the ten month period (44 weeks) ended January 2, 1994, "Fiscal 1993" refers to the year (52 weeks) ended February 28, 1993 and "Fiscal 1992" refers to the year (52 weeks) ended March 1, 1992. Inventories The Company's inventories, consisting of materials, labor and overhead, are valued at the lower of cost or market. Cost for substantially all inventories is determined on the last-in, first-out ("LIFO") basis. Depreciation Depreciation is computed principally on the straight-line basis using the estimated useful lives of the related major classes of properties: 3 to 6 years for automotive and transportation equipment; 12 to 14 years for machinery and equipment; and 15 to 60 years for buildings and improvements. Gains and losses arising from disposals are included in current operations. Amortization of Deferred Financing Costs Deferred financing costs are being amortized as interest expense over the life of the respective debt using the interest rate method. Unamortized deferred financing costs are included in "Other assets" in the accompanying consolidated balance sheets. Research and Development Research and development costs are expensed during the year in which the costs are incurred and amounted to $691,000 in Fiscal 1992, $744,000 in Fiscal 1993, and $640,000 in Transition 1993. Income Taxes The Company files a consolidated Federal income tax return with its wholly-owned subsidiaries. The Company recognizes deferred tax liabilities and assets for the expected future tax consequences of temporary differences between the carrying amounts and the tax basis of assets and liabilities. Revenue Recognition The Company records revenues principally when inventory is shipped. The Company also records revenues to a lesser extent on a bill and hold basis under which the goods are complete, packaged and ready for shipment; such goods are effectively segregated from inventory which is available for sale; the risks of ownership of the goods have passed to the customer; and such underlying customer orders are supported by written confirmation. Concentration of Credit Risk Financial instruments which potentially subject the Company to concentration of credit risk consist primarily of trade accounts receivable. The Company's customers consist of domestic and foreign apparel producers and other users of textile products. The Company performs ongoing credit evaluations of its customers' financial condition and establishes an allowance for doubtful accounts based upon factors surrounding the credit risk of specific customers, historical trends and other information. In addition, the Company factors, on a non-recourse basis, a significant volume of accounts receivable, thereby reducing its exposure to credit risk. Historically, the Company has not incurred material credit-related losses. Major Customer Sales to a group of customers under common control totaled approximately 11%, 14%, and 11%, of the Company's sales in Fiscal 1992, Fiscal 1993, and Transition 1993, respectively. No other customer or similar group accounted for more than 10% of the Company's sales in such periods. Reclassifications Certain amounts included in the prior years' consolidated financial statements have been reclassified to conform with the current year's presentation. (2) Change in Control and the Triarc Reorganization On April 23, 1993, DWG Acquisition Group, LP ("DWG Acquisition"), a newly formed limited partnership controlled by Nelson Peltz and Peter W. May, acquired control of Triarc from Victor Posner, the former Chairman and Chief Executive Officer of Triarc, and certain entities controlled by him (collectively, "Posner") through a series of related transactions (the "Reorganization"). Immediately prior to the Reorganization, Posner owned approximately 46% of the outstanding common stock of Triarc. The principal elements comprising the equity portion of the Reorganization included the following components: DWG Acquisition purchased from Posner 5,982,867 shares of Triarc's Class A common stock, par value $.10 per share (the "Triarc Class A Common Stock"), representing approximately 28.6% of Triarc's common equity outstanding immediately after the Reorganization, for $12.00 per share, or an aggregate purchase price of $71,794,000. All of the remaining shares of the Class A Common Stock owned by Posner were exchanged for shares of newly-created, non-voting, convertible redeemable preferred stock of Triarc. Victor Posner and his son, Steven Posner, the former Vice Chairman of Triarc Companies, resigned as directors, officers and employees of Triarc Companies and all of its subsidiaries. In connection with such resignations, Victor Posner did not receive any severance payments. However, in order to induce Steven Posner to resign, Triarc entered into a five year consulting agreement (the "Consulting Agreement") with Steven Posner which provides for an initial payment of $1,000,000 at the commencement of the term of such agreement and an annual consulting fee of $1,000,000. The Consulting Agreement does not require Steven Posner to provide any substantial services to Triarc and Triarc presently does not expect that it will receive any such services from him. As a result, the $6,000,000 aggregate amount of payments required under the Consulting Agreement was expensed in Triarc's fiscal year ended April 30, 1993, of which $229,000 has been allocated to the Company and is included in "Facilities Relocation and Corporate Restructuring Charges" (see Note 14). Affiliates of Donaldson, Lufkin & Jenrette Securities Corporation ("DLJ") and of Merrill Lynch & Co. ("Merrill Lynch" and together with DLJ, the "DLJ/Merrill Lynch Investors") purchased from Triarc an aggregate of 833,332 newly issued shares of Triarc Class A Common Stock, representing approximately 4.0% of the Triarc Class A Common Stock outstanding immediately after the Reorganization, for $12.00 per share, the same price at which DWG Acquisition purchased its Triarc Class A Common Stock. The aggregate price approximated $10,000,000 (the "Equity Financing"). Concurrently with the consummation of the Reorganization (the "Closing"), certain debt of Triarc and its subsidiaries, including the Company, was refinanced in order to reduce borrowing costs and to make available additional funds for general working capital and liquidity purposes. The principal refinancing transactions consummated in connection with the Reorganization included the establishment of a new $180,000,000 credit facility for Graniteville (the "Graniteville Credit Facility") providing for $80,000,000 of term loans and $100,000,000 of revolving credit loans (see Note 7). The following table summarizes the intended aggregate sources and uses of funds by the Company in connection with the Triarc Reorganization (in thousands): The advance to Triarc is evidenced by a note receivable which bears interest at the rate of 9.5% per annum and is due on April 15, 2003. Interest only is payable semi-annually either in cash or by the issuance of additional notes identical to the original note, at the option of Triarc. However, at least 20% of each interest payment due through and including April 15, 1995 must be in cash and at least 40% of each interest payment thereafter must be in cash. As of January 2, 1994, the note receivable from Triarc consists of the following (in thousands): (3) Inventories The following is a summary of the major classifications of inventories: Had the first-in, first-out method been used, inventories would have been approximately $2,500,000 higher at February 28, 1993 and January 2, 1994. (4) Changes in Accounting Principles Effective March 2, 1992, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes" ("SFAS 109") and SFAS No. 106, "Accounting for Postretirement Benefits Other than Pensions" ("SFAS 106"). The Company's adoption of such standards resulted in a charge of $13,036,000 to the Company's results of operations for Fiscal 1993. Such charge consisted of $12,314,000 and $722,000, net of applicable income taxes of $429,000, related to SFAS 109 and SFAS 106, respectively, and is reported in the "Cumulative effect of changes in accounting principles". (5) Properties The following is a summary of the major classifications of properties: (6) Income Taxes The current deferred tax liability and the non-current deferred tax liability consists of the following components (in thousands): Deferred income tax expense results from temporary differences in recognition of revenue and expense for income tax and financial statement purposes. The tax effects of the principal temporary differences are as follows (such disclosure is not presented for Transition 1993 as it is not required under SFAS 109): Notes to Consolidated Financial Statements The difference between the reported provision for income taxes and a computed tax based on income before income taxes and cumulative effect of changes in accounting principles at the statutory rate of 34% in Fiscal 1992 and Fiscal 1993 and 35% in Transition 1993 is reconciled as follows: Federal income tax returns of the Company have been examined by the Internal Revenue Service ("IRS") for the tax years 1986 through 1988. Such audit has been substantially resolved at no material cost to the Company. The IRS has recently commenced the examination of the Company's Federal income tax returns for the tax years from 1989 through 1992. The amount and timing of any payments required as a result of the 1989 through 1992 audit cannot presently be determined. However, the Company believes that it has adequate reserves for any tax liabilities, including interest, that may result from all such examinations. (7) Long-term Debt Long-term debt consists of the following: Aggregate annual maturities of the long-term debt as of January 2, 1994 are as follows (in thousands): In connection with the Reorganization, on April 23, 1993 the Company and C. H. Patrick entered into a $180,000,000 senior secured credit facility with the Company's commercial lender as agent for itself and various lenders, repaid its prior term loan and repurchased all receivables that had been sold to such commercial lender under the Company's non-notification factoring arrangement. The Graniteville Credit Facility consists of a senior secured revolving credit facility of up to $100,000,000 (the "Revolving Loan") with a $7,500,000 sublimit for letters of credit and an $80,000,000 senior secured term loan (the "Term Loan") and expires in 1998. As part of the Graniteville Credit Facility, Graniteville's commercial lender will continue to factor the Company's and C. H. Patrick's receivables, with credit balances assigned to secure the Graniteville Credit Facility (the "Factoring Arrangement"). The Company incurred approximately $6,500,000 of fees and expenses, including $500,000 of such fees and expenses incurred in Fiscal 1993, in connection with the Graniteville Credit Facility which are recorded as deferred financing costs. Borrowings under the Revolving Loan bear interest, at the Company's option, at either the prime rate plus 1.25% per annum or the 90-day London Interbank Offered Rate (the "LIBOR rate") plus 3.00% per annum (weighted average interest rate of 7.15% at January 2, 1994). When the unpaid principal balance of the Term Loan is less than $55,000,000, the interest rate on the Revolving Loan will be reduced to the prime rate plus 1.00% or the 90-day LIBOR rate plus 2.75%. All LIBOR rate loans have a 90-day interest period and are limited to the lesser of $90,000,000 or 50% of the outstanding balance in multiples of $10,000,000 under the Graniteville Credit Facility. The borrowing base for the Revolving Loan is the sum of 90% of accounts receivable which are credit-approved by the factor ("Credit Approved Receivables"), plus 85% of all other eligible accounts receivable, plus 65% of eligible inventory, provided that advances against eligible inventory shall not exceed $35,000,000 at any one time. At January 2, 1994, the Company had approximately $11,000,000 of unused availability under the Revolving Loan. The Company, in addition to the aforementioned interest, pays a commission of 0.45% on all Credit-Approved Receivables, including a 0.20% bad debt reserve which will be shared equally by Graniteville's commercial lender and the Company after deducting customer credit losses. On March 10, 1994, the Company amended the Graniteville Credit Facility to provide for an increase in the maximum Revolving Loan to $107,000,000 during the period March 10, 1994 through September 1, 1994 with a corresponding increase in eligible inventory to $42,000,000. The Term Loan is repayable $11,500,000 in 1994, $12,000,000 in 1995 through 1997 and $25,000,000 in 1998. Until the unpaid principal of the Term Loan is equal to or less than $60,000,000 at the end of any year, the Company must make mandatory prepayments in an amount equal to 50% of Excess Cash Flow, as defined, for such year. The Term Loan bears interest at the prime rate plus 1.75% per annum or the 90-day LIBOR rate plus 3.5% per annum (weighted average interest rate of 7.39% at January 2, 1994). When the unpaid principal balance of the Term Loan is less than $55,000,000, the interest rate thereon will be reduced to the prime rate plus 1.375% or the 90-day LIBOR rate plus 3.125%. In each case, the LIBOR rate is limited to the lesser of $90,000,000 or 50% of the outstanding balance in multiples of $10,000,000 under the Graniteville Credit Facility. In the event that the Company prepays the Term Loan, in whole or in part, prior to the end of the third year, then a prepayment fee shall be payable as follows: 2% of the amount prepaid if the prepayment occurs in the first year, 1% of the prepayment during the second year and 1/2 of 1% in the third year. The Graniteville Credit Facility is secured by all of the assets of the Company and C. H. Patrick, including all accounts receivable, notes (including the $66,600,000 note the Company received from Triarc as an intercompany advance), inventory, machinery and equipment, trademarks, patents and other intangible assets, and all real estate. The Company has also pledged as collateral the stock of C. H. Patrick. Additionally, Triarc and Graniteville International have unconditionally guaranteed all obligations under the Graniteville Credit Facility. As collateral for such guarantee, Triarc pledged (i) 51% of the issued and outstanding stock of the Company (subject to pre- existing pledge of such stock in connection with Triarc's intercompany note payable to SEPSCO in the principal amount of $26,538,000), and (ii) the issued and outstanding common stock of SEPSCO owned by Triarc. The Graniteville Credit Facility contains various covenants which (a) require meeting certain financial amount and ratio tests; (b) limit, among other items (i) the incurrence of indebtedness, (ii) investments, (iii) asset dispositions, (iv) capital expenditures and (v) affiliate transactions other than in the normal course of business; and (c) restrict the payment of dividends (see below). If the Company becomes eligible to join in Triarc's consolidated Federal income tax return, the Company will be permitted to pay to Triarc an amount equal to the Federal income tax liability that the Company and its subsidiaries would have paid if they had filed a separate consolidated Federal income tax return. Additionally, the Company will be permitted to pay dividends or make loans or advances to its affiliates in an amount equal to 50% of the net income of the Company accumulated from the beginning of the first year commencing on or after December 20, 1994, provided that the outstanding principal balance of the Term Loan is less than $50 million at the time of the payments and certain other conditions are met. Accordingly, the Company in unable to pay any dividends or make any loans or advances to its stockholders, including Triarc, prior to December 31, 1995. (8) Lease Commitments The Company leases certain machinery and automotive and transportation equipment from an affiliate and from unrelated third parties under long-term lease obligations which are accounted for as capital leases and are included in "Properties, at cost" in the accompanying consolidated balance sheets at February 28, 1993 and January 2, 1994 in the amount of $4,392,000 and $987,000, respectively. The future minimum lease payments (net of sublease rentals which are not significant) under capital leases and operating leases with an initial noncancelable term in excess of one year are as follows: Rental expense under operating leases which is primarily for the rental of real estate and equipment, was $1,032,000 in Fiscal 1992, $1,794,000 in Fiscal 1993, and $1,911,000 in Transition 1993. (9) Postretirement Benefits Other than Pensions Postretirement benefits other than pensions consist of health care and life insurance benefits provided to a group of former employees who retired prior to January 1, 1990, and a limited health care benefit program provided to early retirees. With the exception of a group of retirees who retired prior to January 1, 1982, a portion of the cost of these benefits is paid by the retiree. Effective March 2, 1992, Graniteville adopted SFAS 106 and accordingly, provided for the unfunded accumulated postretirement obligation as of that date. Prior thereto, the Company accounted for postretirement obligation payments on a pay-as-you-go basis. In Fiscal 1992, such payments were immaterial. Net other postretirement benefit expense consists of the following: The accumulated postretirement benefit obligation consists of the following: For purposes of measuring the expected postretirement obligation, a 12% annual rate of increase in the per capita claims cost was assumed for 1994. This rate is assumed to decrease by 1% per year to 6% in the year 2000 and remain level thereafter. The discount rate used in determining the net other postretirement benefit expense for Fiscal 1993 and Transition 1993 and the accumulated postretirement benefit obligation as of February 28, 1993 was 8%. The discount rate used in determining the accumulated postretirement benefit obligation as of January 2, 1994 was 7%. If the health care cost trend rate were increased by 1%, the accumulated postretirement benefit obligation as of January 2, 1994 would have been increased by approximately $90,000. The effect of this change on the aggregate ot the service cost and interest cost components of the net other postretirement benefit expense for Transition 1993 would be an increase of approximately $8,300. (10) Transactions with Affiliates By agreement, Triarc provides certain management services including, among others, legal, insurance and financial services and incurs certain costs on behalf of the Company. In Fiscal 1992, Fiscal 1993 and Transition 1993 such costs aggregated $1,792,000, $2,441,000, and $7,904,000, respectively. Such amounts include approximately $640,000, $1,299,000, and $105,000 in Fiscal 1992, Fiscal 1993, and Transition 1993, respectively, representing allocations to the Company in accordance with the applicable management services agreement of certain reserves established by Triarc for amounts owed by certain former affiliates of the Company in connection with the providing by Triarc of such management services. The Company, through Triarc, also leased space from an affiliate for approximately $864,000, $824,000, and $612,000 in Fiscal 1992, Fiscal 1993, and Transition 1993, respectively. In July 1993, Triarc Companies gave notice to terminate the lease effective January 31, 1994 and the Company has recorded a charge of $1,614,000 in Transition 1993 representing the allocated cost of such lease termination (see Note 14). Prior to December 1993, the Company maintained certain property insurance coverage with Chesapeake Insurance Company Limited ("Chesapeake Insurance"), an affiliated company registered in Bermuda. Premiums attributable to such insurance coverage amounted to $203,000 in Fiscal 1992, $212,000 in Fiscal 1993 and $84,000 in Transition 1993. The Company also maintained certain insurance coverage with an unaffiliated insurance company for which Chesapeake Insurance reinsured a portion of the risk. Net premiums attributable to such reinsurance were approximately $3,047,000 in Fiscal 1992, $2,619,000 in Fiscal 1993 and $1,643,000 in Transition 1993. In addition, prior to July 1, 1993, Insurance and Risk Management Inc., an affiliate until April 23, 1993, acted as agent or broker in connection with insurance coverage obtained by the Company and provided claims processing services for the Company. The commissions and payments for such services paid to such company were $455,000, $459,000 and $77,000 in Fiscal 1992, Fiscal 1993 and the applicable period of Transition 1993, respectively. The Company had a $2,500,000 investment in the convertible preferred stock of Chesapeake Insurance. During its quarter ended September 30, 1993, Chesapeake Insurance increased its reserve for insurance and reinsurance losses by $10,000,000 and as a result reduced the stockholders' equity of Chesapeake Insurance to $308,000. In December 1993, Triarc decided to cease writing insurance and reinsurance of any kind through Chesapeake Insurance. As a result, Chesapeake Insurance will not have any future operating cash flows and its remaining liabilities, including payment of claims on insurance previously written, will be liquidated with assets on hand. Accordingly, the preferred stock investment is not recoverable and the Company has written off its investment in such stock since the decline in value was deemed to be other than temporary. Certain machinery and automotive equipment is leased from an affiliate (see Note 8). Interest charges on these lease obligations amounted to $97,000 in Fiscal 1992, $71,000 in Fiscal 1993, and $16,000 in Transition 1993. On October 1, 1993, Triarc began leasing corporate aircraft from Triangle Aircraft Services Corporation ("TASCO"), a company owned by Messrs. Peltz and May. Usage fees charged to the Company aggregated $17,000 during Transition 1993 (none in prior periods). (11) Legal Matters The Company participates in regional waste water treatment facilities and considers that it is in substantial compliance with water pollution regulations. In 1987, the Company was, however, notified by the South Carolina Department of Health and Environmental Control ("DHEC") that DHEC discovered certain contamination of Langley Pond near Graniteville, South Carolina and asserted that the Company may be one of the parties responsible for such contamination. The Company entered into a consent decree providing for the study and investigation of the alleged pollution and its sources. The study report prepared by the Company's environmental consulting firm and filed with DHEC in April 1990, recommended that pond sediments be left undisturbed and in place. DHEC responded by requesting that the Company submit additional information concerning potential passive and active remedial alternatives, with accompanying supportive information. In May 1991 the Company provided this information to DHEC in a report of its independent environmental consulting firm. The 1990 and 1991 reports concluded that pond sediments should be left undisturbed and in place and that other less passive remediation alternatives either provided no significant additional benefits or themselves involved adverse effects on human health, to existing recreational uses or to the existing biological communities. The Company is unable to predict at this time what further actions, if any, may be required in connection with Langley Pond or what the cost thereof may be. However, given the passage of time since the submission of the two reports by the Company's environmental consulting firm without any objection or adverse comment on such reports by DHEC and the absence of desirable remediation alternatives, other than continuing to leave the Langley Pond sediments in place and undisturbed as described in the reports, the Company believes the ultimate outcome of this matter will not have a material adverse effect on the Company's consolidated results of operations or financial position. The Company and its subsidiaries are defendants in certain other legal proceedings arising out of the ordinary conduct of the Company's business. In the opinion of management, the ultimate outcome of these legal proceedings will not have a material adverse effect on the consolidated financial position or results of operations of the Company. (12) Restructuring Costs In Fiscal 1992, the Company recorded a restructuring charge of $2,500,000 representing costs and expenses associated with plans to cease the manufacture and sale of cotton yarns and shuttle woven, industrial greige fabrics. Actual costs and expenses associated with the strategic restructuring exceeded management's original estimate and Fiscal 1993 results include an additional charge of $1,855,000. (13) Retirement and Incentive Compensation Plans The Company maintains a 401(k) defined contribution plan which covers substantially all employees. Employees may contribute from 1% to 8% of their total earnings, subject to certain limitations. In addition, the Company may make discretionary contributions to the plan. Discretionary retirement contribution expense was $1,000,000 in both Fiscal 1993 and Transition 1993 (none in Fiscal 1992). Effective with the first payroll period in March 1994, the Company made various changes to the retirement plan including an increase in allowable employee contributions. Employees may now contribute up to 15% of earnings and the Company will match up to 75% of employee contributions based on years of service but limited to the first 4%. In Fiscal 1993 and prior years, the Company maintained management incentive plans (the "Incentive Plans") which provided for incentive compensation of up to 10% of operating earnings and up to 10% of earnings from sales or other dispositions of assets. The plans were administered by the Compensation Committee of the Board of Directors of Triarc and awards for elected corporate officers were approved by the Board. In accordance with the terms of these Incentive Plans the Company provided $192,000 in Fiscal 1992 (net of reversal of $2,000,000 accrued in prior years) and $3,538,000 in Fiscal 1993 and reversed prior year accruals of $968,000 in Transition 1993 due to the termination of the plans. During Transition 1993, the Company replaced the previous Incentive Plans with annual and mid-term cash incentive plans (the "New Incentive Plans") for certain officers and key employees. The New Incentive Plans provide for discretionary cash awards depending upon the Company's financial performance as compared to target performance. The New Incentive Plans are designed to yield a target award in cash if the Company achieves an agreed-upon profit over a one-year and three-year performance cycle. An amount is accrued each year based upon the amount by which the Company's profit for such year exceeds the target performance. A new three-year performance cycle begins each year, such that after the third year the annual amount paid to participants will equal the target award if the Company's profit goals have been achieved. Amounts provided under the New Incentive Plans aggregated $1,998,000 in Transition 1993. Net incentive compensation expense under all plans was $192,000, $3,538,000 and $1,030,000 in Fiscal 1992, Fiscal 1993 and Transition 1993, respectively. During Transition 1993, Triarc granted 50,000 restricted shares of Triarc Class A common stock to the Company's chief executive officer under Triarc's Amended and Restated 1993 Equity Participation Plan (the "Triarc Equity Plan"). The value of the award at date of grant of $900,000 is being accrued as compensation expense over the applicable vesting period through December 31, 1996. In addition, during Transition 1993 Triarc granted stock options to certain key employees of the Company under the Triarc Equity Plan. Of such options, 65,000 were granted at an option price of $20.00 that was lower than the fair market value of Triarc's Class A common stock at the date of grant of $31.75. The aggregate difference of $764,000 between the option price and the fair market value at the date of grant was recorded by Triarc as unearned compensation and is being amortized to compensation expense over the applicable vesting period through September 28, 1998. Compensation expense resulting from the grants of restricted shares and below market stock options aggregated $255,000 during Transition 1993 and is included in "General and administrative expenses". (14) Significant Charges in Transition 1993 The accompanying consolidated statement of income includes the following significant charges recorded in Transition 1993 (in thousands): (15) Fair Value of Financial Instruments The estimated fair value of applicable financial instruments and related underlying assumptions are as follows as of January 2, 1994: Note receivable from Triarc - The carrying amount of $70,446,000 approximates fair value based upon scheduled cash flows discounted at an estimated current market rate of interest. Long-term debt - The Company estimates that the carrying value of $163,123,000 approximates the fair value of debt at January 2, 1994 based upon the floating rate of interest applicable to the Graniteville Credit Facility and the recent origination of such debt. (16) Prior Year Comparable Period The Company changed its year end effective January 2, 1994, as previously disclosed. The following unaudited operating results for the ten months ended December 27, 1992 are presented for comparative purposes (in thousands): PAGE PAGE PAGE PAGE

788043_1993.txt

788043

1993

ITEM 2 - PROPERTIES - ------------------- VWR Corporation owns and leases office and warehouse space throughout the United States and Canada for wholesale distribution of scientific equipment and supplies as follows: Batavia, Illinois Owned Bridgeport, New Jersey Owned Buffalo Grove, Illinois Owned Cerritos, California Leased San Francisco, California Leased Houston, Texas Leased Marietta, Georgia Leased London, Ontario, Canada Leased Catano, Puerto Rico Leased Toronto, Ontario, Canada Leased The Company leases office space in West Chester, Pennsylvania, for executive, financial, information systems, marketing, and other administrative activities. The Company also leases twenty-five smaller facilities throughout the United States and five smaller facilities in Canada which support the sales and warehouse functions. All facilities have been designed to serve the Company's purpose (generic office and warehouse functions) and are sufficient for its current operations. ITEM 3.

ITEM 3. - LEGAL PROCEEDINGS - ------ ----------------- The Corporation is involved in various contractual, warranty, public liability cases and environmental claims which are considered normal to the Corporation's business. ITEM 4.

ITEM 4. - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ------ --------------------------------------------------- No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended December 31, 1993. PART II. - -------- ITEM 5

ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS - ------------------------------------------------------------------------ VWR Corporation Common Stock, $1.00 par value, is traded on the NASDAQ/National Market System under the VWRX symbol. On February 28, 1994, there were approximately 6,000 shareholders represented by 1,837 holders of record. The market prices of the Corporation's common shares during the years ended December 31, 1993, and 1992, are set forth below. The prices reflect bid prices as reported by NASDAQ for the Company. * All share and per share data reflect a two-for-one stock split effective May 9,1992. The Corporation declared quarterly dividends of $0.10 per share for each quarter during the fiscal years ended December 31, 1993, and December 31, 1992. The Corporation's long-term debt agreements provide, among other terms, limitations on working capital, tangible net worth, the current ratio, and the debt-to-equity ratio which may restrict the Corporation's ability to declare or pay dividends. Approximately $2 million of retained earnings was available to pay dividends at December 31, 1993. ITEM 6.

ITEM 6. - SELECTED FINANCIAL DATA - ------ ----------------------- The following table of selected financial data should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere herein. ITEM 7

ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION - ----------------------------------------------------------------------- Results of Operations - --------------------- Sales 1993 Increase 1992 Increase 1991 - ---------------------------------------------------------------------- $509.2 3.9% $490.2 11.2% $441.0 Sales increased by almost 4% in 1993 due primarily to strong growth rates in our international export, high school science education (Sargent-Welch division) businesses and the effects of the acquisition of Johns Scientific and the distribution agreement with BDH Ltd. in Canada. Growth in Canada was less than expected. Combining the operations and systems of the three companies proved to be a more complex task than anticipated and we experienced higher costs. In addition, sales of our principal U.S. operating unit (VWR Scientific) lagged behind the market and we missed our internal target. In 1992 each of our areas of business activity gained market share and contributed to our growth from 1991. Sargent-Welch and our international export business sales were very strong. The acquisition of Johns Scientific in the fourth quarter of 1992 for approximately $7.4 million and a large international order in the second half of 1992 accounted for about 1% of the sales growth. Approximately 2% of the sales growth was due to price increases. Gross Margin - ------------- 1993 Increase 1992 Increase 1991 - -------------------------------------------------------------------- Margin $116.3 1.7% $114.4 9.1% $104.9 Percent of Sales 22.8% 23.3% 23.8% Over the three-year period, gross margin as a percent of sales declined primarily as a result of customer mix and competitive price pressures. Operating Expenses Before Restructuring and Other Charges - --------------------------------------------------------- 1993 Increase 1992 Increase 1991 - ---------------------------------------------------------------------- Expenses $101.9 6.7% $95.5 8.2% $88.3 Percent of Sales 20.0% 19.5% 20.0% In 1993 the increase in operating expenses before restructuring and other charges is primarily due to higher personnel costs and transition costs associated with the acquisition of Johns Scientific and the distribution agreement with BDH, Ltd., and our investment in a new direct marketing effort. Excluding the impact from Canadian acquisitions and direct marketing, operating expenses grew approximately 1.4%. Operating expenses grew at a rate slower than sales in 1992. The reasons for the slower growth rate were our continuous emphasis on cost containment and the fact that fixed costs were stable while sales increased. Restructuring and Other Charges - ------------------------------- In the fourth quarter of 1993, the Company made the decision to refocus certain information systems efforts into customer service systems and to take actions that would reduce operating expenses. As a result of this effort, the Company recorded a $3.3 million charge which included non-cash charges of $1.3 million (primarily for software development costs that do not have continuing value) and $2 million related to the consolidation of functions and facilities which consists primarily of severance and personnel-related costs. Approximately $2 million is accrued at December 31, 1993, and is reflected in current liabilities. It is anticipated that the impact of the consolidation of certain functions will result in annualized cost savings of approximately $2 million, beginning in the first half of 1994. Interest Expense - ---------------- 1993 Increase 1992 Decrease 1991 - -------------------------------------------------------------------- Interest $4.5 15.4% $3.9 (7.1)% $4.2 Percent of Sales .9% .8% 1.0% In 1993 interest expense increased due to increased borrowing levels which occurred primarily for the purchase of a new warehouse facility for the Sargent-Welch division, system enhancements, and the 1992 acquisition of Johns Scientific. Interest expense decreased in 1992 primarily as a result of reduced debt levels. Lower debt levels were achieved primarily by improvements in working capital management. Income Taxes - ------------ 1993 Decrease 1992 Increase 1991 - -------------------------------------------------------------------- Taxes $2.7 (52.6)% $5.7 23.9% $4.6 Percent of Sales .5% 1.2% 1.0% Effective tax rate 40.6% 37.5% 37.5% The income taxes footnote to the financial statements describes the difference between the statutory and effective income tax rates. The higher effective tax rate in 1993 reflects the impact of new U.S. federal tax legislation and the carryforward to future years of Canadian tax benefits not recognized currently. In 1993 the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109 "Accounting for Income Taxes," which did not have a material effect on the consolidated financial position or results of operations. Income Before Cumulative Effect of Accounting Change and Per Share Data - ----------------------------------------------------------------------- 1993 Decrease 1992 Increase 1991 - -------------------------------------------------------------------- Income $3.9 (58.5)% $9.4 22.1% $7.7 Percent of Sales .8% 1.9% 1.8% Per Share $ .35 $ .85 $ .71 In addition to the impact of the restructuring and other charges, which were $3.3 million pre-tax ($1.9 million net of tax or $.18 per share), income before cumulative effect of accounting change decreased primarily due to decreased operating income from lower than expected sales and margins, and higher operating expenses along with higher interest costs. In 1992 the improvement was the result of sales growth, improved profitability in our newer areas of business activity, expense controls, lower debt levels, and strong asset management. Financial Condition and Liquidity - --------------------------------- The ratio of debt to equity over the past four years is as follows: 1993 1992 1991 1990 - -------------------------------------------------------------- 1.5 1.1 1.3 1.8 The ratio of income before cumulative effect of accounting change, plus depreciation and amortization, to interest expense over the past four years is as follows: 1993 1992 1991 1990 - -------------------------------------------------------------- 2.9 4.6 3.7 2.6 VWR continues to maintain a liquid financial position. VWR's current ratio was 2.7 at December 31, 1993 and accounts receivable and inventory accounted for 63% of total assets. For the year ended December 31, 1993 cash flow from operations of $6.4 million and debt borrowings of $14 million were used to finance investments in property and equipment of $13.4 million and to pay dividends of $4.4 million. The significant investment in property and equipment was due to the purchase of a new warehouse facility for the Sargent- Welch division and system enhancements. Sufficient credit availability existed at December 31, 1993 to provide for the amounts of bank checks outstanding less cash in bank of $1.1 million. Cash requirements reach a low toward the end of each calendar year due to the natural business cycle. The Company has unsecured revolving credit loan agreements, expiring in 1996 which provide for committed facilities of $75 million. The Company is obligated to make available an unsecured subordinated revolving line of credit for approximately $5 million to Momentum Corporation (formerly Momentum Distribution, Inc., the company spun off in 1990) through February 1995. There have been no loans to Momentum Corporation through December 31, 1993. VWR borrows at short-term interest rates. Our credit agreements give us the option to convert up to $37.5 million to a five-year term loan. Interest rate collars effectively establish a minimum and maximum rate on up to $55 million of revolving credit debt. Collars of $25 million will expire in 1994 and are expected to be replaced with interest rate swaps of $10 million at a fixed rate. The remaining collar of $30 million will expire in 1996 and is expected to be replaced at a fixed rate into 1999. On January 1, 1994, the company formed a joint venture with E. Merck of Germany to acquire an interest in Bender & Hobein GmbH, a distributor of laboratory supplies and equipment in Germany. The investment will be accounted for using the cost method of accounting and was funded through the Company's revolving credit line. VWR has been designated by the EPA as a potentially responsible party for various sites. Management believes that any required expenditures would be immaterial to the Company's consolidated financial statements. The Company adopted SFAS No. 106 "Accounting For Postretirement Benefits Other Than Pensions," in 1993, which resulted in a one-time non-cash charge of $1.4 million (net of deferred tax benefit of $.9 million). See notes to the consolidated financial statements for further discussion. Due to declining interest and inflation rates, the Company changed certain pension and retiree medical actuarial assumptions, which included lowering the discount rate to 7.75% and rate of compensation increase to 4%. These changes will not have a material effect on the consolidated financial statements in 1994. As of December 31, 1993 the estimated cost for capital improvement projects is expected to range between $4-$5 million in 1994 related primarily to continued investments in new computer and warehouse systems. Operating Income Return on Average Invested Capital - ----------------------------------------------------- 1993 1992 1991 1990 - --------------------------------------------------------------------- 11.5% 21.8% 19.0% 19.1% 1993 before restructuring charges 14.9% Operating Income to Sales - ------------------------- 1993 1992 1991 1990 - --------------------------------------------------------------------- 2.2% 3.9% 3.8% 3.9% 1993 before restructuring charges 2.8% Average Invested Capital to Sales - --------------------------------- 1993 1992 1991 1990 - --------------------------------------------------------------------- 18.9% 17.7% 19.8% 20.7% Days Sales in Accounts Receivable - --------------------------------- 1993 1992 1991 1990 - --------------------------------------------------------------------- 42.6 41.5 42.1 43.5 Inventory Turnover (Before LIFO) - -------------------------------- 1993 1992 1991 1990 - --------------------------------------------------------------------- 6.9 6.4 6.0 5.6 VWR CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - ------------------------------------------ Principles of Consolidation - -------------------- The accompanying consolidated financial statements include the accounts of VWR Corporation (the Company) and all of its subsidiaries (including its wholly owned Canadian subsidiary). All significant intercompany accounts and transactions have been eliminated. Capitalization, Depreciation and Amortization - --------------------------------------- Land, buildings, and equipment are recorded at cost. Depreciation is computed using the straight-line method for financial reporting purposes and, generally, accelerated methods for income tax purposes. Acquisition and development costs for significant business systems and related software for internal use are capitalized on significant projects and amortized over their estimated useful lives of seven years. Interest is capitalized on major construction and development projects while in progress. The Company capitalizes the costs of developing and producing catalogs, which are used by customers for ordering products. Such costs are amortized over the period of use, generally two years. Income Taxes - ------------ In 1993, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109 "Accounting for Income Taxes," which supersedes SFAS No. 96 previously followed by the Company. The adoption of SFAS 109 did not have a material effect on the Company's financial position or results of operations. SFAS 109 uses the asset and liability method under which deferred taxes are determined based on the difference between the financial statement amounts and tax bases of assets and liabilities using enacted tax rates. Deferred tax expense is the result of changes in the asset or liability for deferred taxes. Postretirement Benefits - ----------------------- In 1993, the Company adopted SFAS No. 106 "Accounting for Postretirement Benefits Other Than Pensions." This Statement requires the Company to accrue the cost of retiree medical expenses over the period earned by the participants, which is a change from the Company's prior practice of recording these costs when incurred. Earnings Per Share and 1992 Stock Split - ---------------------------------- Earnings per share are based on the weighted average number of shares and dilutive common share equivalents outstanding during the period. On April 20, 1992, the Company's Board of Directors declared a two-for-one stock split in the form of a stock dividend payable to shareholders of record as of May 9, 1992. The aggregate par value, which did not change on a per- share basis, of $5.6 million for the additional shares was transferred from additional paid-in capital to common stock. All share and per-share data in these financial statements have been restated to give effect to the stock split. Segment and Customer Information - -------------------------------- The Company is engaged in one line of business, industrial distribution. No single customer accounts for more than 10% of sales. The majority of the Company's business activity pertains to, and accounts receivable result from, sales of laboratory equipment and supplies to businesses across a wide geographical area in various industries, mainly industrial, governmental, biomedical, and educational. At December 31, 1993, the Company had no significant concentrations of credit risk. Reclassifications - ----------------- Certain prior years' amounts have been reclassified to conform to the current year's presentation. INVENTORIES - ----------- Inventories consist primarily of purchased goods for sale and are valued at the lower of cost (substantially last-in, first-out method) or market. LIFO cost at December 31, 1993, and 1992, was approximately $26.8 million and $25.5 million, respectively, less than current cost. The effect of LIFO layer liquidations decreased the cost of sales by $.6 million in 1993, and $.4 million in 1992 and 1991. Depreciation expense for the years ended December 31, 1993, 1992, and 1991, was $5.4 million, $4.3 million, and $4.0 million, respectively. ACCRUED LIABILITIES - ------------------- Included in accrued liabilities at December 31, 1993, and 1992, is accrued compensation of approximately $4.2 million and $5.2 million respectively. FOREIGN CURRENCY TRANSACTIONS - ------------------------------ The Company has entered into forward exchange contracts to hedge foreign currency transactions with its Canadian subsidiary. As of December 31, 1993, the Company had approximately $3.4 million of forward exchange contracts outstanding. Net transaction gains and losses are not material. At December 31, 1993, the Company had unsecured revolving lines of credit of $75 million. Under the terms of these agreements, which expire in 1996, the Company may borrow U.S. dollars at various rates. In addition, the Company can elect to convert up to $37.5 million of the line into term notes which can extend into the year 2001. Principal amounts due on long-term debt, including assumed conversion in 1995 of the revolving credit agreements to term notes, in each of the five years beginning January 1, 1994, are $.1 million, $3.9 million, $32.1 million, $7.7 million and $7.6 million, respectively. A principal payment of $1.1 million due in 1994 on other debt is expected to be funded from the revolving credit facility and, accordingly, is classified as long-term. For the year ended December 31, 1993, the approximate weighted average interest rate on borrowings made under the unsecured revolving lines was 7.88%, which approximates the year-end rate. The Company has purchased interest rate collars on $55 million, of which $20 million expires on March 27, 1994, $5 million expires on May 3, 1994, and $30 million expires on March 1, 1996. The collars are based on the three-month London Interbank Offered Rate ("LIBOR") and have a floor of 6.75% and a ceiling of 9.5%. The cost of the collars is treated as a reduction of the revolving credit debt and is being amortized as revolving credit interest expense over the terms of the collars. The Company's long-term debt agreement provides for, among other terms, restrictive covenants with respect to working capital, tangible net worth, the current ratio, and the debt-to-equity ratio, which may restrict the Company's ability to declare or pay dividends. Under the most restrictive of these terms, approximately $2 million of retained earnings at December 31, 1993, is available to pay dividends. INCOME TAXES - ------------ During 1993, the Company adopted SFAS No. 109 "Accounting for Income Taxes." The cumulative effect of the accounting change was not material. The income (loss) before income taxes and cumulative effect of accounting change is as follows: The reconciliation of tax computed at the federal statutory tax rates of 35% (1993) and 34% (1992 and 1991) of income before income taxes and cumulative effect of accounting change to the actual income tax provision is as follows: Deferred tax liabilities (assets) as of December 31, 1993 and 1992 are comprised of the following: - ----------------------------------------------------------------------------- (Thousands of dollars) 1993 1992 - ----------------------------------------------------------------------------- Depreciation $6,400 $6,539 Pension 1,918 884 ----- ----- Deferred tax liabilities 8,318 7,423 ----- ----- Postretirement benefits (809) Other benefits (584) (485) Restructuring charges (720) Other-net (363) (578) ----- ----- Deferred tax assets (2,476) (1,063) ------ ------ Net deferred tax liability $5,842 $6,360 ====== ====== Included in other current assets at December 31, 1993 are refundable income taxes of approximately $2.1 Million and $.6 million of net current deferred tax assets. The Company has Canadian tax loss carryforwards of approximately $.9 million which expire at various dates through 2000. SHAREHOLDER RIGHTS AGREEMENT - ---------------------------- On May 20, 1988, the Company established a Shareholder Rights Agreement. The Agreement is designed to deter coercive or unfair takeover tactics that could deprive shareholders of an opportunity to realize the full value of their shares. Under the Agreement, the Company has distributed a dividend of one Right for each outstanding share of the Company's stock. When exercisable, each Right will entitle its holder to buy two shares of the Company's common stock at $45.00 per share. The Rights will become exercisable if a purchaser acquires or makes an offer to acquire 20 percent of the Company's common stock. In the event that a purchaser acquires 20 percent of the common stock, each Right shall entitle the holder, other than the acquirer, to purchase, at the Right's then-current full exercise price, shares of the Company's common stock having a market value of twice the then-current full exercise price of the Right. In the event that, under certain circumstances, the Company is acquired in a merger or transfers 50 percent or more of its assets or earnings to any one entity, each Right entitles the holder to purchase common stock of the surviving or purchasing company having a market value of twice the full exercise price of the Right. The Rights, which expire on May 31, 1998, may be redeemed by the Company at a price of $.005 per Right. STOCK AND INCENTIVE PROGRAMS - ---------------------------- Under the stock option and restricted stock plans, in addition to outstanding options, 235,411 shares were reserved for issuance at December 31, 1993. Restricted Stock Awards - ----------------------- The Company's restricted stock award plan, provides for grants of common stock to certain directors, officers, and managers. The vesting periods range from one to eight years. The fair market value of the stock at the date of grant establishes the compensation amount, which is amortized to operations over the vesting period. During the years ended December 31, 1993, 1992 and 1991, the Company granted 45,219, 7,580 and 15,116 shares, respectively, at fair market values of approximately $.7 million, $.1 million and $.1 million, respectively. Stock Options - ------------- Under the stock option plan, options, which vest over 3 to 10 years, have been granted to certain officers and managers to purchase common stock of the Company at its fair market value at date of grant. Changes in options outstanding were: At December 31, 1993, there were 98,871 options exercisable at an average price of $7.50. Savings Investment Plan - ----------------------- The Company has a savings investment plan whereby it matches 50% of the employee's contribution up to 3% of the employee's pay. For employee contributions between 3% and 7.5% of their pay, the Company will match 50% of the contribution within prescribed limits based on the Company's profitability for the year. All Company contributions are used to buy shares of the Company's stock. Expenses under this plan for the years ended December 31, 1993, 1992, and 1991, were $.5 million, $.6 million and $.4 million, respectively. At December 31, 1993, there were approximately 538,000 shares available for issuance under this Plan. Employee Stock Ownership Plan - ----------------------------- In September, 1990, the Company established an employee stock ownership plan (ESOP) by, in effect, contributing 400,000 shares of treasury stock ($2.9 million fair value) to the ESOP. All full-time and part-time employees, except certain union employees, are eligible to participate in the plan. The ESOP shares will be allocated equally to individual participants' accounts over a period up to ten years. Vesting occurs equally over an employment period of five years at which time the employee is 100% vested in the plan. Expenses are recognized based on shares to be allocated in the subsequent year and are reduced for dividends paid, which approximated $.1 million in 1993, and $.2 million in 1992 and 1991. The net expense for 1993, 1992, and 1991 was approximately $.1 million, $.3 million and $.2 million, respectively. POSTRETIREMENT BENEFITS - ------------------------ Pension Plans: The Company has two defined benefit pension plans covering substantially all of its domestic employees, except for employees covered by independently operated collective bargaining plans. Pension benefits are based on years of credited service and the highest five consecutive years' average compensation. Contributions to the Company plans are based on funding standards established by the Employee Retirement Income Security Act of 1974 (ERISA). The total VWR Corporation plans' funding status and the amounts recognized in the Company's Consolidated Balance Sheets at December 31, 1993, and 1992, are: The assets of the Company plans consist predominantly of undivided interests in several funds structured to duplicate the performance of various stock and bond indexes. Net pension expense under the Company plans includes the following components: The Company maintains a supplemental pension plan for certain senior officers. Expenses incurred under this plan in 1993 were approximately $.3 million. There were no expenses incurred under this plan for 1992 and 1991. Certain employees are covered under union-sponsored, collectively bargained plans. Expenses under these plans for the years ended December 31, 1993, 1992 and 1991, were $.2 million, $.2 million and $.1 million, respectively, as determined in accordance with negotiated labor contracts. Retiree Medical Benefits Program - -------------------------------- The Company provides certain medical benefits for retired employees. In 1993, the Company adopted SFAS No. 106 "Accounting for Postretirement Benefits Other Than Pensions." The Company elected to immediately recognize the calculated liability resulting in a one-time non-cash charge to income of approximately $1.4 million, net of a deferred tax benefit of approximately $.9 million. Employees retired as of December 31, 1992 and active employees who reached age 55 by December 31, 1992 are eligible to participate in the company's retiree health plan (the "plan"). There are also certain provisions for participation by spouses. The plan is contributory, with retiree contributions based on years of service and includes other co-payment and co-insurance provisions. The Company does not fund the plan. The liability of the plan at December 31, 1993 is as follows: (Thousands of dollars) Accumulated postretirement benefit obligation: Retirees $1,604 Eligible active participants 183 Other active participants 21 Unrecognized net gain 266 ----- Accrued postretirement benefit obligation $2,074 ===== The net periodic postretirement benefit cost for 1993 includes the following components: Service cost $ 7 Interest cost 174 ----- $181 ===== The assumed health care cost trend rate used in measuring the accumulated postretirement benefit obligation is 10% through 1996 and declines 1% per year to a level of 5.4% in 2001 and thereafter. The effect of a 1% annual increase in the assumed cost trend rate would increase the accumulated postretirement benefit obligation by approximately 8%; the annual service and interest cost components in the aggregate would not be materially affected. A 7.75% discount rate was used in determining the accumulated postretirement benefit obligation. Before the adoption of SFAS No. 106, the retiree health care expense was recorded as claims were incurred. The expense for 1992 and 1991 was approximately $.2 million. LEASES - ------ The Company leases office and warehouse space, computer equipment, and automobiles under operating leases with terms ranging up to 15 years, subject to renewal options. Rental expense for continuing operations for the years ended December 31, 1993, 1992, and 1991, was approximately $5.2 million, $4.8 million, and $4.4 million, respectively. Future minimum lease payments as of December 31, 1993, under noncancelable operating leases, having initial lease terms of more than one year are: CONTINGENCIES AND COMMITMENTS - ------------------------------ The Company is involved in various environmental, contractual, warranty, and public liability cases and claims, which are considered routine to the Company's business. In the opinion of management, the potential financial impact of these matters is not material to the consolidated financial statements. As a result of the March, 1990 spin-off of Momentum Corporation, VWR is obligated to make available to the spun-off company, through February 1995, an unsecured subordinated revolving line of credit of $5 million. There have been no loans to Momentum Corporation under this facility. ACQUISITION - ---------- Effective October 5, 1992, the Company, through its wholly owned Canadian subsidiary, acquired certain assets related to the laboratory supply business of Johns Scientific, Inc. of Toronto, Canada for approximately $7.4 million. This acquisition was accounted for under the purchase method of accounting and was funded through the Company's revolving credit line, and a $1.6 million, 8% note payable expected to be refinanced through the revolving line of credit. The acquisition is not material in relation to the Company's consolidated financial statements. The $2.6 million excess purchase price over net assets acquired is being amortized over a 15 year period. RESTRUCTURING AND OTHER CHARGES - ------------------------------- In the fourth quarter of 1993, the Company made the decision to refocus certain information systems efforts into customer service systems and to take actions that would reduce operating expenses. As a result of this effort, the Company recorded a $3.3 million charge which included non-cash charges of $1.3 million (primarily for software development costs that do not have continuing value) and $2 million related to the consolidation of functions and facilities which consists primarily of severance and personnel-related costs. As of December 31, 1993, approximately $2 million of these costs are accrued on the Company's consolidated balance sheet as a current liability. REPORT OF INDEPENDENT AUDITORS - ------------------------------ To The Shareholders of VWR Corporation: We have audited the consolidated balance sheets of VWR Corporation as of December 31, 1993 and 1992, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. Our audits also include the financial statement schedules listed in the index at Item 14(a). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of VWR Corporation at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in the notes to the consolidated financial statements (postretirement benefits), in 1993, the Company changed its method of accounting for postretirement benefits other than pensions. BY (SIGNATURE) ERNST & YOUNG Philadelphia, Pennsylvania February 11, 1994 ITEM 9.

ITEM 9. - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE - ------ -------------------------------------------------------------- None PART III. - -------- ITEM 10.

ITEM 10. - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - -------- --------------------------------------------------- The information required by this item is incorporated by reference from the section captioned "Election of Directors" and the last paragraph of the section captioned "Ownership of VWR Corporation Stock" contained in the Company's definitive Proxy Statement, which the Company will have filed with the Commission pursuant to Regulation 14A within 120 days after the close of the fiscal year. Information regarding executive officers of the Company is included in Part I of this Form 10-K. ITEM 11.

ITEM 11. - EXECUTIVE COMPENSATION - ------- ---------------------- The information required by this item is incorporated by reference from the Sections "Fees to Directors and Committees of the Board" and "Executive Compensation" contained in the Company's definitive Proxy Statement which the Company will have filed with the Commission pursuant to regulation 14A within 120 days after the close of the fiscal year. ITEM 12.

ITEM 12. - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - ---------- ---------------------------------------------------------- The information required by this item is incorporated by reference from the section captioned "Ownership of VWR Corporation Stock" contained in the Company's definitive Proxy Statement, which the Company will have filed with the Commission pursuant to Regulation 14A within 120 days after the close of the fiscal year. ITEM 13.

ITEM 13. - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - ------- ---------------------------------------------- None PART IV. - ------- ITEM 14.

ITEM 14. - EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K - -------- ------------------------------------------------------------ (a)(1) Financial Statements The following financial statements have been included as part of this report: Form 10-K Page --------- Consolidated Statements of Operations 17 Consolidated Balance Sheets 18 Consolidated Statements of Cash Flows 20 Consolidated Statements of Shareholders' Equity 22 Notes to Consolidated Financial Statements 25 Report of Independent Auditors 39 (2) Financial Statement Schedules (a) The following financial statement schedules are submitted herewith: -Schedule V - Property, Plant, and Equipment -Schedule VI - Accumulated Depreciation, Depletion, and Amortization of Property, Plant, and Equipment -Schedule VIII - Valuation and Qualifying Accounts All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and have therefore been omitted. (b) Reports on Form 8-K None (3) Exhibits Exhibit Number and Description ------------------------------ 2 Agreement and Plan of Distribution between VWR Corporation and Momentum Distribution, Inc.(1) 3 Restated Certificate of Incorporation dated July 9, 1987, as amended by Certificate of Ownership and Merger dated March 1, 1990(1) Bylaws as amended and restated as of February 27, 1992(1) 4 Credit Agreement by and among VWR Corporation and its Subsidiaries and CoreStates Bank, N.A. for itself and as agent, Seattle-First National Bank and PNC Bank, National Association dated December 20, 1993. 10 Change of Control Agreements between VWR Corporation and Jerrold B. Harris, Gerard W. Cooney, Walter S. Sobon, and Richard H. Serafin(1)(3) Change of Control Agreements between VWR Corporation and Joseph A. Panozzo, Paul J. Nowak and Richard W. Amstutz(2)(3) VWR Corporation Executive Bonus Plan dated January 1, 1990(1) VWR Corporation Supplemental Benefits Plan dated November 1, 1990(1) 11 Computation of Per Share Earnings 21 Parent and Subsidiaries of the Company 23 Consent of Independent Auditors 24 Power of Attorney (1) Filed as an Exhibit to the Company's Form 10-K Report for the year ended December 31, 1991 and incorporated herein by reference. (2) Filed as an Exhibit to the Company's Form 10-K Report for the year ended December 31, 1992 and incorporated herein by reference. (3) May be deemed a management contract or compensatory plan or arrangement. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. VWR CORPORATION Date March 29, 1994 BY (SIGNATURE) Jerrold B. Harris, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on the behalf of the registrant in the capacities and on the dates indicated. Date March 29, 1994 BY (SIGNATURE) Walter S. Sobon, Vice President Finance (Principal Financial Officer) DIRECTORS James W. Bernard ) Richard E. Engebrecht ) Jerrold B. Harris ) Curtis P. Lindley ) BY (SIGNATURE) Edward A. McGrath, Jr.) Donald P. Nielsen ) N. Stewart Rogers ) Jerrold B. Harris Robert S. Rogers ) Attorney-in-fact James H. Wiborg ) Power of Attorney dated February 28, 1994 Date: March 29, 1994 VWR CORPORATION -------------------------------- SCHEDULE V - PROPERTY, PLANT, AND EQUIPMENT ------------------------------------------- (thousands of dollars) (1) Construction in progress which was completed and transferred to Equipment & Computer Software. (2) Principally, new Distribution Systems and Software. (3) Principally furniture, equipment and leasehold improvements for headquarter's facility and financial software. (4) Reallocation of purchase price of Canadian subsidiary acquired in 1990. (5) Principally furniture, equipment and leasehold improvements for new warehouse facility in Buffalo Grove, Illinois and distribution systems and software. (6) The annual provisions for depreciation have been computed principally in accordance with the following lives: - Buildings 40 years - Equipment 3 - 10 years - Computer Software 7 years (1) Uncollectible accounts written off, net of recoveries. Exhibit Index - ------------- Exhibit Number and Description Page - ------------------------------ ---- 2 Agreement and Plan of Distribution between VWR Corporation and Momentum Distribution, Inc. * 3 Restated Certificate of Incorporation dated July 9, 1987, as amended by Certificate of Ownership and Merger dated March 1, 1990 * Bylaws as amended and restated as of February 27, 1992 * 4 Credit Agreement by and among VWR Corporation and its 49 Subsidiaries and CoreStates Bank, N.A. for itself and as agent, Seattle-First National Bank and PNC Bank, National Association dated December 20, 1993. 10 Change of Control agreements between VWR Corporation and Jerrold B. Harris, Gerard W. Cooney, Walter S. Sobon, and Richard H. Serafin * Change of Control agreements between VWR Corporation and Joseph A. Panozzo, Paul J. Nowak, and Richard W. Amstutz ** VWR Corporation Executive Bonus Plan dated January 1, 1990 * VWR Corporation Supplemental Benefits Plan dated November 1, 1990 * 11 Computation of Per Share Earnings 98 21 Parent and Subsidiaries of the Company 100 23 Consent of Independent Auditors 101 24 Power of Attorney 102 * Filed as an Exhibit to the Company's Form 10-K Report for the year ended December 31, 1991, and incorporated herein by reference ** Filed as an Exhibit to the Company's Form 10-K Report for the year ended December 31, 1992.

29989_1993.txt

29989

1993

Item 1. Business Omnicom Group Inc., through its wholly and partially-owned companies (hereinafter collectively referred to as the "Agency" or "Company"), operates advertising agencies which plan, create, produce and place advertising in various media such as television, radio, newspaper and magazines. The Agency offers its clients such additional services as marketing consultation, consumer market research, design and production of merchandising and sales promotion programs and materials, direct mail advertising, corporate identification, and public relations. The Agency offers these services to clients worldwide on a local, national, pan-regional or global basis. Operations cover the major regions of North America, the United Kingdom, Continental Europe, the Middle East, Africa, Latin America, the Far East and Australia. In both 1993 and 1992, 52% of the Agency's billings came from its non-U.S. operations. (See "Financial Statements and Supplementary Data") According to the unaudited industry-wide figures published in the trade journal, Advertising Age, in 1993 Omnicom Group Inc. was ranked as the third largest advertising agency group worldwide. The Agency operates three separate, independent agency networks: The BBDO Worldwide Network, the DDB Needham Worldwide Network and the TBWA International Network. The Agency also operates independent agencies, Altschiller Reitzfeld, and Goodby, Berlin and Silverstein, and certain marketing service and specialty advertising companies through Diversified Agency Services ("DAS"). The BBDO Worldwide, DDB Needham Worldwide and TBWA International Networks General BBDO Worldwide, DDB Needham Worldwide and TBWA International, by themselves and through their respective subsidiaries and affiliates, independently operate advertising agency networks worldwide. Their primary business is to create marketing communications for their clients' goods and services across the total spectrum of advertising and promotion media. Each of the agency networks has its own clients and competes with each other in the same markets. The BBDO Worldwide, DDB Needham Worldwide and TBWA International agencies typically assign to each client a group of advertising specialists which may include account managers, copywriters, art directors and research, media and production personnel. The account manager works with the client to establish an overall advertising strategy for the client based on an analysis of the client's products or services and its market. The group then creates and arranges for the production of the advertising and/or promotion and purchases time, space or access in the relevant media in accordance with the client's budget. BBDO Worldwide Network The BBDO Worldwide Network operates in the United States through BBDO Worldwide which is headquartered in New York and has full-service offices in Los Angeles and San Francisco, California; Atlanta, Georgia; Chicago, Illinois; Detroit, Michigan; and Minneapolis, Minnesota. The BBDO Worldwide Network operates internationally through subsidiaries in Austria, Belgium, Brazil, Canada, Finland, France, Germany, Greece, Hong Kong, Italy, Malaysia, Mexico, the Netherlands, Peru, Poland, Portugal, Puerto Rico, Russia, Singapore, Spain, Sweden, Switzerland, Taiwan and the United Kingdom; and through affiliates located in Argentina, Australia, Chile, Croatia, the Czech Republic, Denmark, Egypt, El Salvador, Guatemala, Honduras, Hungary, India, Lebanon, Kuwait, New Zealand, Norway, Panama, the Philippines, Romania, Saudi Arabia, the Slovak Republic, Sweden, Turkey, the United Kingdom, United Arab Emirates, Uruguay, and Venezuela; and through joint ventures in China and Japan. The BBDO Worldwide Network uses the services of associate agencies in Colombia, Ecuador, Indonesia, Korea, Pakistan and Thailand. DDB Needham Worldwide Network The DDB Needham Worldwide Network operates in the United States through DDB Needham Worldwide which is headquartered in New York and has full-service offices in Los Angeles, California; Dallas, Texas; Honolulu, Hawaii; Chicago, Illinois; and Seattle, Washington. The DDB Needham Worldwide Network operates internationally through subsidiaries in Australia, Austria, Belgium, Canada, China, the Czech Republic, Denmark, France, Germany, Greece, Hong Kong, Hungary, Italy, Japan, Mexico, the Netherlands, New Zealand, Norway, Poland, Portugal, Singapore, the Slovak Republic, Spain, Sweden, Thailand and the United Kingdom; and through affiliates located in Brazil, Estonia, Finland, Germany, India, Korea, Malaysia, the Philippines, Switzerland, Taiwan and Thailand. The DDB Needham Worldwide Network uses the services of associate agencies in Argentina, Chile, Colombia, Costa Rica, Egypt, Indonesia, Ireland, Peru, Saudi Arabia, Turkey, United Arab Emirates, Venezuela and in Denver, Colorado. TBWA International Network The TBWA International Network operates in the United States through TBWA Advertising which is headquartered in New York and through TBWA Switzer Wolfe Advertising in St. Louis, Missouri. The TBWA International Network operates internationally through subsidiaries in Belgium, France, Germany, Italy, the Netherlands, Spain, Switzerland, and the United Kingdom; and through affiliates located in Denmark, South Africa and Sweden. The TBWA International Network uses the services of associate agencies in Austria, Canada, Finland, Greece, Japan, Korea, Mexico, Norway, Portugal and Turkey. Diversified Agency Services DAS is the Company's Marketing Services and Specialty Advertising division whose agencies' mission is to provide customer driven marketing communications coordinated to the client's benefit. The division offers marketing services including sales promotion, public relations, direct and database marketing, corporate and brand identity, graphic arts, merchandising/point-of-purchase; and specialty advertising including financial, healthcare and recruitment advertising. DAS agencies headquartered in the United States include: Harrison, Star, Wiener & Beitler, Inc., The Schechter Group, Inc., Kallir, Philips, Ross, Inc., RC Communications, Inc., Merkley Newman Harty Inc. and Lavey/Wolff/Swift, Inc., in New York; Doremus & Company, Gavin Anderson & Company Worldwide, Inc., Porter Novelli, Inc., Bernard Hodes Advertising, Inc., and Rapp Collins Worldwide Inc., all in various cities and headquartered in New York; Baxter, Gurian & Mazzei, Inc., in Beverly Hills, California; Frank J. Corbett, Inc., in Chicago, Illinois; Thomas A. Schutz Co., Inc. in Morton Grove, Illinois; Rainoldi, Kerzner & Radcliffe, Inc. in San Francisco, California and Alcone Sims O'Brien, Inc., in Irvine, California and Mahwah, New Jersey. DAS operates in the United Kingdom through subsidiaries which include Countrywide Communications Group Ltd., CPM Field Marketing Ltd., Granby Marketing Services Ltd., Headway, Home and Law Publishing Group Ltd., Interbrand Ltd., Product Plus London Ltd., Specialist Publications (UK) Ltd., The Anvil Consultancy Ltd. and Colour Solutions Ltd. In addition, DAS operates internationally with subsidiaries and affiliates in Australia, Belgium, Canada, France, Germany, Hong Kong, Ireland, Italy, Japan, Mexico, Scotland, Spain, Sweden and Switzerland. Omnicom Group Inc. As the parent company of BBDO Worldwide, DDB Needham Worldwide, TBWA International, the DAS Group, Goodby, Berlin and Silverstein, Inc., and Altschiller Reitzfeld, Inc., the Company, through its wholly-owned subsidiary Omnicom Management Inc., provides a common financial and administrative base for the operating groups. The Company oversees the operations of each group through regular meetings with their respective top-level management. The Company sets operational goals for each of the groups and evaluates performance through the review of monthly operational and financial reports. The Company provides its groups with centralized services designed to coordinate financial reporting and controls, real estate planning and to focus corporate development objectives. The Company develops consolidated services for its agencies and their clients. For example, the Company participated in forming The Media Partnership, which consolidates certain media buying activities in Europe in order to obtain cost savings for clients. Clients The clients of the Agency include major industrial, financial and service industry companies as well as smaller, local clients. Among its clients are Anheuser-Busch, Apple Computer, Chrysler Corporation, Delta Airlines, General Mills, Gillette, GTE, Henkel, McDonald's, PepsiCo., Volkswagen and The Wm. Wrigley Jr. Company. The Agency's ten largest clients accounted for approximately 18% of 1993 billings. The majority of these have been clients for more than ten years. The Agency's largest client accounted for less than 5% of 1993 billings. Revenues Commissions charged on media billings are the primary source of revenues for the Agency. Commission rates are not uniform and are negotiated with the client. In accordance with industry practice, the media source typically bills the Agency for the time or space purchased and the Agency bills its client for this amount plus the commission. The Agency typically requires that payment for media charges be received from the client before the Agency makes payments to the media. In some instances a member of the Omnicom Group, like other advertising agencies, is at risk in the event that its client is unable to pay the media. The Agency's advertising networks also generate revenues in arranging for the production of advertisements and commercials. Although, as a general matter, the Agency does not itself produce the advertisements and commercials, the Agency's creative and production staff directs and supervises the production company. The Agency bills the client for production costs plus a commission. In some circumstances, certain production work is done by the Agency's personnel. In some cases, fees are generated in lieu of commissions. Several different fee arrangements are used depending on client and individual agency needs. In general, fee charges relate to the cost of providing services plus a markup. The DAS Group primarily charges fees for its various specialty services, which vary in type and scale, depending upon the service rendered and the client's requirements. Advertising agency revenues are dependent upon the marketing requirements of clients and tend to be highest in the second and fourth quarters of the fiscal year. Other Information For additional information concerning the contribution of international operations to commissions and fees and net income see Note 5 of the Notes to Consolidated Financial Statements. The Agency is continuously developing new methods of improving its research capabilities, to analyze specific client requirements and to assess the impact of advertising. In the United States, approximately 136 people on the Agency's staff were employed in research during the year and the Agency's domestic research expenses approximated $13,137,000. Substantially all such expenses were incurred in connection with contemporaneous servicing of clients. The advertising business is highly competitive and accounts may shift agencies with comparative ease, usually on 90 days' notice. Clients may also reduce advertising budgets at any time for any reason. An agency's ability to compete for new clients is affected in some instances by the policy, which many advertisers follow, of not permitting their agencies to represent competitive accounts in the same market. As a result, increasing size may limit an agency's potential for securing certain new clients. In the vast majority of cases, however, the separate, independent identities of BBDO Worldwide, DDB Needham Worldwide and TBWA International and the independent agencies within the DAS Group have enabled the Agency to represent competing clients. BBDO Worldwide, DDB Needham Worldwide, TBWA International and the DAS Group have sought, and as part of the Agency's operating segments will seek, new business by showing potential clients examples of advertising campaigns produced and by explaining the variety of related services offered. The Agency competes in the United States and abroad with a multitude of full service and special service agencies. In addition to the usual risks of the advertising agency business, international operations are subject to the risk of currency exchange fluctuations, exchange control restrictions and to actions of governmental authorities. Employees The business success of the Agency is, and will continue to be, highly dependent upon the skills and creativity of its creative, research, media and account personnel and their relationships with clients. The Agency believes its operating groups have established reputations for creativity and marketing expertise which attract, retain and stimulate talented personnel. There is substantial competition among advertising agencies for talented personnel and all agencies are vulnerable to adverse consequences from the loss of key individuals. Employees are generally not under employment contracts and are free to move to competitors of the Agency. The Company believes that its compensation arrangements for its key employees, which include stock options, restricted stock and retirement plans, are highly competitive with those of other advertising agencies. As of December 31, 1993, the Agency, excluding unconsolidated companies, employed approximately 14,400 persons, of which approximately 6,100 were employed in the United States and approximately 8,300 were employed in its international offices. Government Regulation The advertising business is subject to government regulation, both within and outside the United States. In the United States, federal, state and local governments and their agencies and various consumer groups have directly or indirectly affected or attempted to affect the scope, content and manner of presentation of advertising. The continued activity by government and by consumer groups regarding advertising may cause further change in domestic advertising practices in the coming years. While the Company is unable to estimate the effect of these developments on its U.S. business, management believes the total volume of advertising in general media in the United States will not be materially reduced due to future legislation or regulation, even though the form, content, and manner of presentation of advertising may be modified. In addition, the Company will continue to assure that its management and operating personnel are aware of and are responsive to the possible implications of such developments. Item 2.

Item 2. Properties Substantially all of the Company's offices are located in leased premises. The Company has continued a program to consolidate leased premises. Management has obtained subleases for most of the premises vacated. Where appropriate, management has established reserves for the difference between the cost of the leased premises that were vacated and anticipated sublease income. Domestic The Company's corporate office occupies approximately 25,000 sq. ft. of space at 437 Madison Avenue, New York, New York under a lease expiring in the year 2010. BBDO Worldwide occupies approximately 265,000 sq. ft. of space at 1285 Avenue of the Americas, New York, New York under a lease expiring in the year 2012, which includes options for additional growth of the agency. DDB Needham Worldwide occupies approximately 211,000 sq. ft. of space at 437 Madison Avenue, New York, New York under leases expiring in the year 2010, which include options for additional growth of the agency. TBWA International occupies approximately 51,000 sq. ft. of space at 292 Madison Avenue, New York, New York under a lease expiring in the year 2004, which includes options for additional growth of the agency. The Agency's other full-service offices in Atlanta, Beverly Hills, Chicago, Dallas, Detroit, Honolulu, Irvine, Los Angeles, Mahwah, Minneapolis, Morton Grove, New York, San Francisco, Seattle and St. Louis and service offices at various other locations occupy approximately 1,780,000 sq. ft. of space under leases with varying expiration dates. International The Company's international subsidiaries in Australia, Austria, Belgium, Brazil, Canada, China, the Czech Republic, Denmark, Finland, France, Germany, Greece, Hong Kong, Hungary, Italy, Japan, Malaysia, Mexico, the Netherlands, New Zealand, Norway, Poland, Portugal, Puerto Rico, Russia, Singapore, the Slovak Republic, Spain, Sweden, Switzerland, Taiwan, Thailand and the United Kingdom occupy premises under leases with various expiration dates. Item 3.

Item 3. Legal Proceedings The Agency has no material pending legal proceedings, other than ordinary routine litigation incidental to its business. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of security holders during the last quarter of 1993. Executive Officers of the Company The individuals named below are Executive Officers of the Company: John L. Bernbach, Martin Boase and Peter I. Jones ceased to be Executive Officers of the Company in 1993 by reason of a change in their responsibilities. Effective January 1, 1994, Keith L. Bremer resigned his position as Treasurer of the Company to become Chief Financial Officer of DDB Needham Worldwide Inc. Effective January 1, 1994, Dennis E. Hewitt was promoted to Treasurer of the Company. Mr. Hewitt joined the Company in May 1988 as Assistant Treasurer. William G. Tragos became an Executive Officer of the Company upon the Company's acquisition of TBWA International B.V. in May 1993. Mr. Tragos is one of the founding partners of TBWA International B.V. and has served as the Chairman and Chief Executive Officer since its formation. John D. Wren became an Executive Officer of the Company upon his appointment as Chief Executive Officer of Diversified Agency Services in May 1993. Mr. Wren had served as President of Diversified Agency Services since February 1992, having previously served as its Executive Vice President and General Manager from January 1991 through February 1992, and as its Senior Vice President and Chief Financial Officer from September 1986 through December 1990. Dale A. Adams was promoted to Controller of the Company in July 1992. Mr. Adams joined the Company in July 1991 after ten years with Coopers & Lybrand, where he served as a general practice manager from 1987 until joining the Company. Raymond E. McGovern has served as Secretary and General Counsel of the Company since September 1986, having previously served as Secretary and General Counsel of BBDO Worldwide Inc. (then named BBDO International, Inc.) for more than 10 years. Similar information with respect to the remaining Executive Officers of the Company will be found in the Company's definitive proxy statement expected to be filed April 8, 1994. The Executive Officers of the Company are elected annually following the Annual Meeting of the Shareholders of their respective employers. PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters Price Range of Common Stock and Dividend History The Company's Common Stock is listed on the New York Stock Exchange under the symbol "OMC". The table below shows the range of reported last sale prices on the New York Stock Exchange Composite Tape for the Company's common stock for the periods indicated and the dividends paid per share on the common stock for such periods. Dividends Paid Per Share of High Low Common Stock ---- --- ------------ First Quarter .............. $36 3/4 $31 1/4 $.275 Second Quarter ............. 36 5/8 32 .310 Third Quarter .............. 35 7/8 32 .310 Fourth Quarter ............. 41 7/8 34 3/4 .310 First Quarter .............. 47 1/2 38 3/8 .310 Second Quarter ............. 47 1/4 38 1/4 .310 Third Quarter .............. 46 1/4 37 .310 Fourth Quarter ............. 46 1/2 41 1/2 .310 The Company is not aware of any restrictions on its present or future ability to pay dividends. However, in connection with certain borrowing facilities entered into by the Company and its subsidiaries (see Note 7 of the Notes to Consolidated Financial Statements), the Company is subject to certain restrictions on its current ratio, tangible net worth, and the ratio of net cash flow to consolidated indebtedness. On January 24, 1994 the Board of Directors declared a regular quarterly dividend of $.31 per share of common stock, payable April 1, 1994 to holders of record on March 18, 1994. Approximate Number of Equity Security Holders Approximate Number of Record Holders Title of Class on March 15, 1994 -------------- --------------------- Common Stock, $.50 par value ............. 2,672 Preferred Stock, $1.00 par value ......... None Item 6.

Item 6. Selected Financial Data The following table sets forth selected financial data of the Company and should be read in conjunction with the consolidated financial statements which begin on page. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Results of Operations In 1993, domestic revenues from commissions and fees increased 9 percent. The effect of acquisitions, net of divestitures, accounted for a 4 percent increase. The remaining 5 percent increase was due to net new business gains and higher spending from existing clients. Domestic revenues increased 2 percent in both 1992 and 1991, primarily as a result of net new business gains and higher spending from existing clients. In 1993, international revenues increased 10 percent. The effect of the acquisition of TBWA International B.V. and several marketing services companies in the United Kingdom, net of divestitures, accounted for an 18 percent increase in international revenues. The strengthening of the U.S. dollar against several major international currencies relevant to the Company's non-U.S. operations decreased revenues by 12 percent. The increase in revenues, due to net new business gains and higher spending from existing clients, was 4 percent. In 1992, international revenues increased 25 percent, of which the effect of the acquisition of McKim Baker Lovick BBDO in Canada and the purchase of additional shares in several companies which were previously affiliates of the Company accounted for 14 percent. The remaining increase was due to net new business gains and higher spending from existing clients. The fourth quarter strengthening of the U.S. dollar did not significantly impact the revenues for the year. In 1991, international revenues increased 9 percent, of which the effect of the acquisition of Valin Pollen in the United Kingdom, the purchase of additional shares in several companies which were previously affiliates of the Company, offset by the merger of BBDO's agency in the United Kingdom into Abbott Mead Vickers. BBDO Ltd., accounted for 4 percent. The strengthening of the U.S. dollar decreased international revenues by 3 percent in 1991. The remaining increase was due to net new business gains and higher spending from existing clients. In 1993, worldwide operating expenses increased 9 percent. Acquisitions, net of divestitures during the year, accounted for a 12 percent increase in worldwide operating expenses. The strengthening of the U.S. dollar against several international currencies decreased worldwide operating expenses by 6 percent. The remaining increase was caused by normal salary increases and growth in out-of-pocket expenditures to service the increased revenue base. Net foreign exchange gains did not significantly impact operating expenses for the year. In 1992, worldwide operating expenses, before the special charge, increased 12 percent. Acquisitions, net of divestitures during the year, accounted for 5 percent of the increase. The remaining increase was caused by normal salary increases and growth in out-of-pocket expenditures to service the increased revenue base. Foreign exchange gains did not significantly impact total operating expenses for the year. The ratio of worldwide operating expenses, before the special charge, as a percent of commissions and fees improved slightly over 1991. In 1991, worldwide operating expenses, increased 5 percent over 1990 levels. The ratio of worldwide operating expenses, excluding non-recurring items, as a percent of commissions and fees did not change significantly in 1991. Foreign exchange gains were comparable to those reported in 1990. Gains, net of losses, from the sales of equity interests in certain companies, together with other non-recurring items did not have a significant effect on the 1991 results. Interest expense in 1993 is comparable to 1992. Interest and dividend income decreased in 1993 by $2.2 million. This decrease was primarily due to lower average amounts of cash and marketable securities invested during the year and lower average interest rates on amounts invested. Interest expense in 1992 is comparable to 1991. Interest and dividend income decreased by $1.4 million in 1992. This decrease was primarily due to lower average funds available for investment during the year and declining interest rates in certain countries. Interest expense increased in 1991 by $1.3 million. Interest and dividend income increased by $2.8 million in 1991. This increase was primarily due to an increase of funds available for investment overseas in markets where interest rates were generally above those in the United States. In 1993, the effective tax rate decreased to 42.0%. This decrease primarily reflects a lower international effective tax rate caused by fewer international operating losses with no associated tax benefit, partially offset by an increased domestic federal tax rate. In 1992, the effective tax rate of 43.6% was comparable to the 1991 effective tax rate of 44%. In 1993, consolidated net income increased 23 percent. This increase is the result of revenue growth, margin improvement, an increase in equity income and a decrease in minority interest expense. Operating margin increased to 11.2 percent in 1993 from 11.1 percent in 1992. This increase was the result of greater growth in commission and fee revenue than the growth in operating expenses. The increase in equity income is the result of improved net income at companies which are less than 50 percent owned. The decrease in minority interest expense is primarily due to the acquisition of certain minority interests in 1993 and lower earnings by companies in which minority interests exist. In 1993, the incremental impact of acquisitions, net of divestitures, accounted for 1 percent of the increase in consolidated net income, while the strengthening of the U.S. dollar against several international currencies decreased consolidated net income by 6 percent. Consolidated net income increased 21 percent in 1992. This increase is a result of revenue growth and margin improvement. Operating margin, before the first quarter special charge discussed below, increased to 11.1 percent in 1992 from 10.9 percent in 1991. This increase was the result of greater growth in commissions and fees than the growth in operating expenses. In 1992, the incremental impact of acquisitions, net of divestitures, accounted for 6 percent of the increase in consolidated net income. Consolidated net income increased 10 percent in 1991. This increase is a result of revenue growth, margin improvement, lower net interest costs and a reduction in the effective tax rate. Operating margin, which excludes net interest expense, increased to 10.9 percent in 1991 from 10.8 percent in 1990, reflecting the greater growth of commissions and fees as compared to operating expenses. The reduction in net interest expense also contributed to an increase in the Net Income Before Tax margin from 8.7 percent to 9.1 percent. The impact of net non-recurring items in 1991 did not contribute towards net income growth. In 1991, the incremental effect of acquisitions net of dispositions had an adverse effect of 5 percent on net income. At December 31, 1993, accounts payable increased by $131.3 million from December 31, 1992. This increase was primarily due to an increased volume of activity resulting from business growth and acquisitions during the year and differences in the dates on which payments to media and other suppliers became due in 1993 compared to 1992. In 1992, the Company adopted two new accounting principles which had a net favorable cumulative after tax effect of $3.8 million. At the same time, the Company recorded a special charge to provide for future losses related to certain leased property. The combination of the favorable impact of the adoption of the new accounting principles and the after tax impact of the special charge had no effect on 1992 consolidated net income. Effective January 1, 1994, the Company will adopt Statement of Financial Accounting Standards No. 112 "Employers' Accounting for Postemployment Benefits" ("SFAS No. 112"). The Company estimates that the adoption of SFAS No. 112 will result in an unfavorable after tax effect on net income of approximately $27 million. The current economic conditions in the Company's major markets would indicate varying growth rates in advertising expenditures in 1994. The Company anticipates slow growth rates in certain European economies and improved growth rates in the United States, the United Kingdom and Australia. However, the Company believes that it is properly positioned should the anticipated improved growth rates not occur. Capital Resources and Liquidity Cash and cash equivalents increased $62 million during 1993 to $175 million at December 31, 1993. The Company's positive net cash flow provided by operating activities was enhanced by an improvement in the relationship between the collection of accounts receivable and the payment of obligations to media and other suppliers. After annual cash outlays for dividends paid to shareholders and minority interests and the repurchase of the Company's common stock for employee programs, the balance of the cash flow was used to fund acquisitions, make capital expenditures, repay debt obligations and invest in marketable securities. Cash was also raised from the issuance of $144 million of 4.5%/6.25% Step-Up Convertible Subordinated Debentures due 2000, the net proceeds of which were used for general corporate purposes, including, to reduce borrowings under the Company's commercial paper program. On August 9, 1993, the Company issued a Notice of Redemption for the outstanding $85 million of its 7% Convertible Subordinated Debentures due 2013. Prior to the October 8, 1993 redemption date, debenture holders elected to convert all of their outstanding debentures into common stock of the Company at a conversion price of $25.75 per common share. The Company maintains relationships with a number of banks worldwide, which have extended unsecured committed lines of credit in amounts sufficient to meet the Company's cash needs. At December 31, 1993, the Company had $359 million in committed lines of credit, comprised of a $200 million, two and one-half year revolving credit agreement and $159 million in unsecured credit lines, principally outside of the United States. Of the $359 million in committed lines, $27 million were used at December 31, 1993. Management believes the aggregate lines of credit available to the Company are adequate to support its short-term cash requirements for dividends, capital expenditures and maintenance of working capital. The Company anticipates that the year end cash position, together with the future cash flows from operations and funds available under existing credit facilities will be adequate to meet its long-term cash requirements as presently contemplated. Item 8.

Item 8. Financial Statements and Supplementary Data The financial statements and supplementary data required by this item appear beginning on page. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant Information with respect to the directors of the Company is incorporated by reference to the Company's definitive proxy statement expected to be filed by April 8, 1994. Information regarding the Company's executive officers is set forth in Part I of this Form 10-K. Item 11.

Item 11. Executive Compensation Incorporated by reference to the Company's definitive proxy statement expected to be filed by April 8, 1994. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management Incorporated by reference to the Company's definitive proxy statement expected to be filed by April 8, 1994. Item 13.

Item 13. Certain Relationships and Related Transactions Incorporated by reference to the Company's definitive proxy statement expected to be filed by April 8, 1994. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K Page ---- (a) 1.Financial Statements: Report of Management ............................................ Report of Independent Public Accountants ........................ Consolidated Statements of Income for the three years ended December 31, 1993 ...................................... Consolidated Balance Sheets at December 31, 1993 and 1992 ....... Consolidated Statements of Shareholders' Equity for the three years ended December 31, 1993 .......................... Consolidated Statements of Cash Flows for the three years ended December 31, 1993 ...................................... Notes to Consolidated Financial Statements ...................... Quarterly Results of Operations (Unaudited) ..................... 2.Financial Statement Schedules: For the three years ended December 31, 1993: Schedule II--Amounts Receivable from Related Parties, Underwriters, Promoters, and Employees Other Than Related Parties .................................. S-1 Schedule VIII--Valuation and Qualifying Accounts ............... S-3 Schedule IX--Short-Term Borrowings ............................. S-4 Schedule X--Supplementary Income Statement Information ......... S-5 All other schedules are omitted because they are not applicable or the required information is shown in the consolidated financial statements or notes thereto. 3. Exhibits: (3)(i) Articles of Incorporation. Incorporated by reference to the 1986 Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 31, 1987. (ii) By-laws. Incorporated by reference to the 1987 Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 31, 1988. (4) Instruments Defining the Rights of Security Holders, Including Indentures. 4.1 Copy of Registrant's 6 1/2% Convertible Subordinated Debentures due 2004, including the indenture, filed as Exhibit 4.2 to Omnicom Group Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1989, is incorporated herein by reference. 4.2 Copy of Registrant's 4.5%/6.25% Step-Up Convertible Subordinated Debentures due 2000, filed as Exhibit 4.3 to Omnicom Group Inc.'s Quarterly Report on Form 10-Q for the quarter ended September 30, 1993, is incorporated herein by reference. (10) Material Contracts. Management Contracts, Compensatory Plans, Contracts or Arrangements. 10.1 Standard Form of Severance Compensation Agreement incorporated by reference to BBDO International Inc.'s Form S-1 Registration Statement filed with the Securities and Exchange Commission on September 28, 1973, is incorporated herein by reference. 10.2 Copy of Registrant's 1987 Stock Plan, filed as Exhibit 10.26 to Omnicom Group Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1987, is incorporated herein by reference. 10.3 Copy of Registrant's Profit-Sharing Retirement Plan dated May 16, 1988, filed as Exhibit 10.24 to Omnicom Group Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1988, is incorporated herein by reference. 10.4 Copy of Employment Agreement dated March 20, 1989, between Peter I. Jones and Boase Massimi Pollitt plc, filed as Exhibit 10.22 to Omnicom Group Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1989, is incorporated herein by reference. 10.5 Standard Form of the Registrant's 1988 Executive Salary Continuation Plan Agreement, filed as Exhibit 10.24 to Omnicom Group Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1989, is incorporated herein by reference. 10.6 Standard Form of the Registrant's Indemnification Agreement with members of Registrant's Board of Directors, filed as Exhibit 10.25 to Omnicom Group Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1989, is incorporated herein by reference. 10.7 Copy of DDB Needham Worldwide Joint Savings Plan, effective as of May 1, 1989, filed as Exhibit 10.26 to Omnicom Group Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1989, is incorporated herein by reference. 10.8 Amendment to Registrant's Profit-Sharing Retirement Plan, listed as Exhibit 10.3 above, adopted February 4, 1991, filed as Exhibit 10.28 to Omnicom Group Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1990, is incorporated herein by reference. 10.9 Amendment to Registrant's Profit-Sharing Retirement Plan listed as Exhibit 10.3 above, adopted on December 7, 1992, filed as Exhibit 10.13 to Omnicom Group Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1992, is incorporated herein by reference. 10.10 Amendment to Registrant's Profit-Sharing Retirement Plan listed as Exhibit 10.3 above, adopted on July 1, 1993. 10.11 Copy of Severance Agreement dated July 6, 1993, between Keith Reinhard and DDB Needham Worldwide Inc. 10.12 Copy of Severance Agreement dated July 6, 1993, between John L. Bernbach and DDB Needham Worldwide Inc. 10.13 Copy of Employment Agreement dated May 26, 1993, between William G. Tragos and TBWA International B.V. 10.14 Copy of Deferred Compensation Agreement dated October 12, 1984, between William G. Tragos and TBWA Advertising Inc. Other Material Contracts. 10.15 Copy of $200,000,000 Amended and Restated Credit Agreement, dated January 1, 1993, between Omnicom Finance Inc., Swiss Bank Corporation and the financial institutions party thereto, filed as Exhibit 10.12 to Omnicom Group Inc.'s Annual Report on Form 10-K for the fiscal year ended December 31, 1992, is incorporated herein by reference. (21) Subsidiaries of the Registrant....................... S-6 (23) Consents of Experts and Counsel. 23.1 Consent of Independent Public Accountants............ S-16 (24) Powers of Attorney from Bernard Brochand, Robert J. Callander, Leonard S. Coleman, Jr., John R. Purcell, Gary L. Roubos, Quentin I. Smith, Jr., Robin B. Smith, William G. Tragos, and Egon P. S. Zehnder. (b) Reports on Form 8-K: No reports on Form 8-K were filed during the fourth quarter of the year ended December 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Omnicom Group Inc. Date: March 28, 1994 By: /s/ Fred J. Meyer ------------------------------- Fred J. Meyer Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. REPORT OF MANAGEMENT The management of Omnicom Group Inc. is responsible for the integrity of the financial data reported by Omnicom Group and its subsidiaries. Management uses its best judgment to ensure that the financial statements present fairly, in all material respects, the consolidated financial position and results of operations of Omnicom Group. These financial statements have been prepared in accordance with generally accepted accounting principles. The system of internal controls of Omnicom Group, augmented by a program of internal audits, is designed to provide reasonable assurance that assets are safeguarded and records are maintained to substantiate the preparation of accurate financial information. Underlying this concept of reasonable assurance is the premise that the cost of control should not exceed the benefits derived therefrom. The financial statements have been audited by independent public accountants. Their report expresses an independent informed judgment as to the fairness of management's reported operating results and financial position. This judgment is based on the procedures described in the second paragraph of their report. The Audit Committee meets periodically with representatives of financial management, internal audit and the independent public accountants to assure that each is properly discharging their responsibilities. In order to ensure complete independence, the Audit Committee communicates directly with the independent public accountants, internal audit and financial management to discuss the results of their audits, the adequacy of internal accounting controls and the quality of financial reporting. /s/ Bruce Crawford /s/ Fred J. Meyer - ----------------------------------- ---------------------------------- Bruce Crawford Fred J. Meyer President and Chief Executive Officer Chief Financial Officer REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors and Shareholders of Omnicom Group Inc.: We have audited the accompanying consolidated balance sheets of Omnicom Group Inc. (a New York corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Omnicom Group Inc. and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. As discussed in Note 12 to the consolidated financial statements, effective January 1, 1992, the Company changed its methods of accounting for income taxes and postretirement benefits other than pensions. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules on pages S-1 through S-5 are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. Arthur Andersen & Co. New York, New York February 22, 1994 OMNICOM GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME The accompanying notes to consolidated financial statements are an integral part of these statements. OMNICOM GROUP INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS A S S E T S The accompanying notes to consolidated financial statements are an integral part of these balance sheets. OMNICOM GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY Three Years Ended December 31, 1993 (Dollars in Thousands) The accompanying notes to consolidated financial statements are an integral part of these statements. OMNICOM GROUP INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS The accompanying notes to consolidated financial statements are an integral part of these statements. OMNICOM GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Summary of Significant Accounting Policies Recognition of Commission and Fee Revenue. Substantially all revenues are derived from commissions for placement of advertisements in various media and from fees for manpower and for production of advertisements. Revenue is generally recognized when billed. Billings are generally rendered upon presentation date for media, when manpower is used, when costs are incurred for radio and television production and when print production is completed. Principles of Consolidation. The accompanying consolidated financial statements include the accounts of Omnicom Group Inc. and its domestic and international subsidiaries (the "Company"). All significant intercompany balances and transactions have been eliminated. Reclassifications. Certain prior year amounts have been reclassified to conform with the 1993 presentation. Billable Production. Billable production orders in process consist principally of costs incurred in producing advertisements and marketing communications for clients. Such amounts are generally billed to clients when costs are incurred for radio and television production and when print production is completed. Treasury Stock. The Company accounts for treasury share purchases at cost. The reissuance of treasury shares is accounted for at the average cost. Gains or losses on the reissuance of treasury shares are generally accounted for as additional paid-in capital. Foreign Currency Translation. The Company's financial statements were prepared in accordance with the requirements of Statement of Financial Accounting Standards No. 52, "Foreign Currency Translation." Under this method, net transaction gains of $5.0 million, $8.1 million and $5.3 million are included in 1993, 1992 and 1991 net income, respectively. Net Income Per Common Share. Primary earnings per share is based upon the weighted average number of common shares and common share equivalents outstanding during each year. Fully diluted earnings per share is based on the above adjusted for the assumed conversion of the Company's Convertible Subordinated Debentures and the assumed increase in net income for the after tax interest cost of these debentures. For the year ended December 31, 1993, the 6.5% Convertible Subordinated Debentures were assumed to be converted for the full year; the 7% Convertible Subordinated Debentures were assumed to be converted through October 8, 1993 when they were converted into common stock; and the 4.5%/6.25% Step-Up Convertible Subordinated Debentures were assumed to be converted from their September 1, 1993 issuance date. For the years ended December 31, 1992 and 1991, the 6.5% and 7% Convertible Subordinated Debentures were assumed to be converted for the full year. The number of shares used in the computations were as follows: 1993 1992 1991 ---- ---- ---- Primary EPS computation ....... 30,607,900 28,320,400 27,415,000 Fully diluted EPS computation . 37,563,500 35,332,400 34,384,400 Severance Agreements. Arrangements with certain present and former employees provide for continuing payments for periods up to 10 years after cessation of their full-time employment in consideration for agreements by the employees not to compete and to render consulting services in the post employment period. Such payments, which are determined, subject to certain conditions and limitations, by earnings in subsequent periods, are expensed in such periods. Depreciation of Furniture and Equipment and Amortization of Leasehold Improvements. Depreciation charges are computed on a straight-line basis or declining balance method over the estimated useful lives of furniture and equipment, up to 10 years. Leasehold improvements are amortized on a straight-line basis over the lesser of the terms of the related lease or the useful life of these assets. Intangibles. Intangibles represent acquisition costs in excess of the fair value of tangible net assets of purchased subsidiaries which are being amortized on a straight-line basis over periods not exceeding forty years. Deferred Taxes. Deferred tax liabilities and tax benefits relate to the recognition of certain revenues and expenses in different years for financial statement and tax purposes. OMNICOM GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Cash Flows. The Company's cash equivalents are primarily comprised of investments in overnight interest-bearing deposits and money market instruments with maturity dates of three months or less. The following supplemental schedule summarizes the fair value of assets acquired, cash paid, common shares issued and the liabilities assumed in conjunction with the acquisition of equity interests in subsidiaries and affiliates, for each of the three years ended December 31: (Dollars in thousands) 1993 1992 1991 Fair value of non-cash assets acquired .. $ 287,177 $ 173,974 $ 89,384 Cash paid, net of cash acquired ......... (80,577) (59,651) (77,129) Common shares issued .................... (21,906) 5,596 (10,610) --------- --------- --------- Liabilities assumed ..................... $ 184,694 $ 119,919 $ 1,645 ========= ========= ========= During 1993, the Company issued 3,334,079 shares of common stock upon conversion of $85.9 million of its 7% Convertible Subordinated Debentures. Concentration of Credit Risk. The Company provides advertising and marketing services to a wide range of clients who operate in many industry sectors around the world. The Company grants credit to all qualified clients, but does not believe it is exposed to any undue concentration of credit risk to any significant degree. 2. Acquisitions During 1993 the Company made several acquisitions whose aggregate cost, in cash or by issuance of the Company's common stock, totaled $132.8 million for net assets, which included intangible assets of $149.7 million. Included in both figures are contingent payments related to prior year acquisitions totaling $16.2 million. Pro forma combined results of operations of the Company as if the acquisitions had occurred on January 1, 1992 do not materially differ from the reported amounts in the consolidated statements of income for each of the two years in the period ended December 31, 1993. Certain acquisitions entered into in 1993 require payments in future years if certain results are achieved. Formulas for these contingent future payments differ from acquisition to acquisition. In May 1993, the Company completed its acquisition of a third agency network, TBWA International B.V. The acquisition was accounted for as a pooling of interests and, accordingly, the results of operations for TBWA International B.V. have been included in these consolidated financial statements since January 1, 1993. Prior year consolidated financial statements were not restated as the impact on such years was not material. 3. Bank Loans and Lines of Credit Bank loans generally resulted from bank overdrafts of international subsidiaries which are treated as loans pursuant to bank agreements. At December 31, 1993 and 1992, the Company had unsecured committed lines of credit aggregating $359 million and $266 million, respectively. The unused portion of credit lines was $332 million and $237 million at December 31, 1993 and 1992, respectively. The lines of credit are generally extended at the banks' lending rates to their most credit worthy borrowers. Material compensating balances are not required within the terms of these credit agreements. At December 31, 1992, the committed lines of credit included $125 million under a two year revolving credit agreement. Due to the long term nature of this credit agreement, borrowings under the agreement were classified as long-term debt. As of January 1, 1993, the $125 million credit agreement was replaced by a $200 million, two and one-half year revolving credit agreement. Borrowings under this credit agreement are also classified as long-term debt. There were no borrowings under these credit agreements at December 31, 1993 and 1992. 4. Employee Stock Plans Under the terms of the Company's 1987 Stock Plan, as amended (the "1987 Plan"), 4,750,000 shares of common stock of the Company are reserved for restricted stock awards and non-qualified stock options to key employees of the Company. OMNICOM GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Under the terms of the 1987 Plan, the option price may not be less than 100% of the market value of the stock at the date of the grant. Options become exercisable 30% on each of the first two anniversary dates of the grant date with the final 40% becoming exercisable three years from the grant date. Under the 1987 Plan, 285,000, 242,500 and 175,000 non-qualified options were granted in 1993, 1992 and 1991, respectively. A summary of changes in outstanding options for the three years ended December 31, 1993 is as follows: Years Ended December 31, --------------------------------- 1993 1992 1991 ---- ---- ---- Shares under option (at prices ranging from $16.50 to $35.0625) -- Beginning of year ..................... 998,000 1,043,900 1,076,416 Options granted (at prices ranging from $23.50 to $40.0625) ................... 285,000 242,500 175,000 Options exercised (at prices ranging from $16.50 to $35.0625) .............. (197,800) (274,200) (203,600) Options forfeited ....................... (12,800) (14,200) (3,916) --------- ------- --------- Shares under option (at prices ranging from $16.875 to $40.0625)-- End of year 1,072,400 998,000 1,043,900 ========= ======= ========= Shares exercisable ...................... 562,650 443,400 371,749 Shares reserved ......................... 1,502,882 589,422 1,099,902 Under the 1987 Plan, 337,200 shares, 314,775 shares and 278,250 shares of restricted stock of the Company were awarded in 1993, 1992 and 1991, respectively. All restricted shares granted under the 1987 Plan were sold at a price per share equal to their par value. The difference between par value and market value on the date of the sale is charged to shareholders' equity and then amortized to expense over the period of restriction. Under the 1987 Plan, the restricted shares become transferable to the employee in 20% annual increments provided the employee remains in the employ of the Company. Restricted shares may not be sold, transferred, pledged or otherwise encumbered until the restrictions lapse. Under most circumstances, the employee must resell the shares to the Company at par value if the employee ceases employment prior to the end of the period of restriction. A summary of changes in outstanding shares of restricted stock for the three years ended December 31, 1993 is as follows: Years Ended December 31, ----------------------------------- 1993 1992 1991 ---- ---- ---- Beginning balance ........... 629,752 619,024 765,763 Amount granted ............ 337,200 314,775 278,250 Amount vested ............. (201,712) (278,942) (394,085) Amount forfeited .......... (24,804) (25,105) (30,904) ------- ------- ------- Ending balance .............. 740,436 629,752 619,024 ======= ======= ======= The charge to operations in connection with these restricted stock awards for the years ended December 31, 1993, 1992 and 1991 amounted to $7.1 million, $6.0 million and $6.2 million, respectively. OMNICOM GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 5. Segment Reporting The Company operates advertising agencies and offers its clients additional marketing services and specialty advertising through its wholly-owned and partially-owned businesses. A summary of the Company's operations by geographic area as of December 31, 1993, 1992 and 1991, and for the years then ended is presented below: (Dollars in Thousands) United States International Consolidated ---------- ------------- ------------ Commissions and Fees ........ $ 770,611 $ 745,864 $1,516,475 Operating Profit ............ 92,095 77,104 169,199 Net Income .................. 40,814 44,531 85,345 Identifiable Assets ......... 827,032 1,462,831 2,289,863 Commissions and Fees ........ 706,902 678,259 1,385,161 Operating Profit ............ 70,558 75,816 146,374 Net Income .................. 33,223 36,075 69,298 Identifiable Assets ......... 675,508 1,276,442 1,951,950 Commissions and Fees ........ 692,642 543,516 1,236,158 Operating Profit ............ 65,981 69,136 135,117 Net Income .................. 25,078 31,974 57,052 Identifiable Assets ......... 659,583 1,226,311 1,885,894 6. Investments in Affiliates The Company has approximately 45 unconsolidated affiliates with equity ownership ranging from 20% to 50%. The following table summarizes the balance sheets and income statements of the Company's unconsolidated affiliates, primarily in Europe, Australia, Asia and Canada, as of December 31, 1993, 1992, 1991, and for the years then ended: (Dollars in Thousands) 1993 1992 1991 ---- ---- ---- Current assets ................. $308,741 $312,423 $408,376 Non-current assets ............. 73,772 64,901 54,474 Current liabilities ............ 235,389 259,508 321,777 Non-current liabilities ........ 29,596 8,302 11,456 Minority interests ............. 1,149 1,110 275 Gross revenues ................. 290,814 288,416 374,760 Costs and expenses ............. 238,039 243,661 326,076 Net income ..................... 33,574 27,752 28,933 The Company's equity in the net income of these affiliates amounted to $13.2 million, $9.6 million and $9.3 million for 1993, 1992 and 1991, respectively. The Company's equity in the net tangible assets of these affiliated companies was approximately $58.1 million, $56.2 million and $54.5 million at December 31, 1993, 1992 and 1991, respectively. Included in the Company's investments in affiliates is the excess of acquisition costs over the fair value of tangible net assets acquired. These acquisitions costs are being amortized on a straight-line basis over periods not exceeding forty years. OMNICOM GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 7. Long-Term Debt and Financial Instruments Long-term debt outstanding as of December 31, 1993 and 1992 consisted of the following: During the third quarter of 1993, the Company issued $143,750,000 of 4.5%/6.25% Step-Up Convertible Subordinated Debentures with a scheduled maturity in 2000. The average annual interest rate through the year 2000 is 5.42%. The debentures are convertible into common stock of the Company at a conversion price of $54.88 per share subject to adjustment in certain events. The debentures are not redeemable prior to September 1, 1996. Thereafter, the Company may redeem the debentures initially at 102.984% and at decreasing prices thereafter to 100% at maturity, in each case together with accrued interest. The debentures also may be repaid at the option of the holder at anytime prior to September 1, 2000 if there is a Fundamental Change, as defined in the debenture agreement, at the repayment prices set forth in the debenture agreement, subject to adjustment, together with accrued interest. On August 9, 1993, the Company issued a Notice of Redemption for its 7% Convertible Subordinated Debentures with a scheduled maturity in 2013. Prior to the October 1993 redemption date, debenture holders elected to convert all of their outstanding debentures into common stock of the Company at a conversion price of $25.75 per common share. During the third quarter of 1989, the Company issued $100,000,000 of 6.5% Convertible Subordinated Debentures with a scheduled maturity in 2004. The debentures are convertible into common stock of the Company at a conversion price of $28.00 per share subject to adjustment in certain events. Debenture holders have the right to require the Company to redeem the debentures on July 26, 1996 at a price of 123.001%, or upon the occurrence of a Fundamental Change, as defined in the debenture agreement, at the prevailing redemption price. The Company may redeem the debentures on or after July 27, 1994, initially at 118.808%, from July 27, 1995 to and including July 26, 1996 at 123.001%, and thereafter at 100%, together in each case with accrued interest. The debentures may also be redeemed in whole at any time, at par together with accrued interest, if any, in the event of certain developments regarding United States tax laws or the imposition of certain certification or identification requirements. Also in the third quarter of 1989, a wholly-owned subsidiary of the Company issued interest bearing Loan Notes in connection with the acquisition of Boase Massimi Pollitt plc. The Loan Notes are unsecured obligations guaranteed by the Company and bear interest at a yearly rate of 1/8 percent below the average of the six month London Inter-Bank Offered Rate for the three business days preceding the commencement of the relevant interest period. The Loan Notes are redeemable, at the option of the holder in whole or in part at their nominal amount, together with interest accrued to the date of redemption, on any interest payment date. Under certain conditions the Company may redeem the Loan OMNICOM GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Notes, at their nominal amount plus accrued interest, on any interest payment date on or after December 31, 1992. Unless earlier redeemed or purchased and cancelled, the Loan Notes will be repaid on December 31, 1994 at their nominal amount together with accrued interest. In January 1993, the Company amended and restated the revolving credit agreement originally entered into in 1988. This $200,000,000 revolving credit agreement is with a consortium of banks having an initial term of two and one-half years. This credit agreement includes a facility for issuing commercial paper backed by bank letters of credit. The agreement contains certain financial covenants regarding minimum tangible net worth, current ratio, ratio of net cash flow to consolidated indebtedness, limitation on foreign indebtedness, limitation on employee loans, and limitation on investments in and loans to affiliates and unconsolidated subsidiaries. At December 31, 1993 the Company was in compliance with all of these covenants. Aggregate maturities of long-term debt in the next five years are as follows: (Dollars in Thousands) ---------------------- 1994 ........................ $21,892 1995 ........................ 18,906 1996 ........................ 9,622 1997 ........................ 4,373 1998 ........................ 1,526 Periodically, the Company enters into swap agreements and other derivative financial instruments primarily to reduce the impact of changes in foreign exchange rates on net assets and liabilities denominated in foreign currencies and to reduce the impact of changes in interest rates on floating rate debt. At December 31, 1993, the Company had foreign currency and interest rate swap agreements outstanding with commercial banks having a notional principal amount of $70.6 million. These agreements effectively change a portion of the Company's foreign currency denominated debt to U.S. dollar denominated debt. The change from foreign currency denominated debt reduces the exposure to foreign currency fluctuations. The Company also has entered into U.S. dollar interest rate swap agreements which convert its floating rate debt to a fixed rate. These agreements have varying notional principal amounts, starting dates and maturity dates. The aggregate maximum notional principal amount outstanding through October 2003 is $50 million. 8. Income Taxes Income before income taxes and the provision for taxes on income consisted of the amounts shown below: Years Ended December 31, (Dollars in Thousands) ----------------------------------- 1993 1992 1991 --------- --------- --------- Income before income taxes: Domestic ......................... $ 65,571 $ 47,535 $ 44,937 International .................... 77,053 74,761 66,987 --------- --------- --------- Totals ......................... $ 142,624 $ 122,296 $ 111,924 Provision for taxes on income: Current: Federal ........................ $ 16,428 $ 17,143 $ 15,140 State and local ................ 6,531 6,215 2,765 International .................. 35,071 29,067 29,980 --------- --------- --------- 58,030 52,425 47,885 --------- --------- --------- Deferred: Federal ........................ 2,979 (3,702) 1,170 State and local ................ 139 (1,375) 239 International .................. (1,277) 5,920 (46) --------- --------- --------- 1,841 843 1,363 --------- --------- --------- Totals ......................... $ 59,871 $ 53,268 $ 49,248 ========= ========= ========= OMNICOM GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The Company's effective income tax rate varied from the statutory federal income tax rate as a result of the following factors: 1993 1992 1991 ---- ---- ---- Statutory federal income tax rate ..... 35.0% 34.0% 34.0% State and local taxes on income, net of federal income tax benefit .......... 3.0 2.6 1.8 International subsidiaries' tax rate in excess of federal statutory rate .... 0.1 1.3 2.7 Losses of international subsidiaries without tax benefit ................. 0.2 1.0 0.3 Non-deductible amortization of goodwill 3.9 3.7 3.3 Other ................................. (0.2) 1.0 1.9 ---- ---- ---- Effective rate ........................ 42.0% 43.6% 44.0% ==== ==== ==== The Company accounts for income taxes in accordance with the provisions of Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes," which was adopted effective January 1, 1992. Deferred income taxes are provided for the temporary difference between the financial reporting basis and tax basis of the Company's assets and liabilities. Deferred tax benefits result principally from recording certain expenses in the financial statements which are not currently deductible for tax purposes. Deferred tax liabilities result principally from expenses which are currently deductible for tax purposes, but have not yet been expensed in the financial statements. The Company has recorded deferred tax benefits as of December 31, 1993 and 1992 of $56.7 million and $21.9 million, respectively, related principally to leasehold amortization, restricted stock amortization, foreign exchange transactions, and accrued expenses. The Company has recorded deferred tax liabilities as of December 31, 1993 and 1992 of $29.3 million and $21.9 million, respectively, related principally to furniture and equipment depreciation and tax lease recognition. In 1993, legislation was enacted which increased the U.S. statutory tax rate from 34% to 35%. The effect of this rate change and other statutory rate changes in various state, local and international jurisdictions was not material to net income. A provision has been made for additional income and withholding taxes on the earnings of international subsidiaries and affiliates that will be distributed. 9. Employee Retirement Plans The Company's international and domestic subsidiaries provide retirement benefits for their employees primarily through profit sharing plans. Company contributions to the plans, which are determined by the boards of directors of the subsidiaries, have been in amounts up to 15% (the maximum amount deductible for federal income tax purposes) of total eligible compensation of participating employees. Profit sharing expense amounted to $25.8 million in 1993, $20.8 million in 1992 and $24.4 million in 1991. Some of the Company's international subsidiaries have pension plans. These plans are not required to report to governmental agencies pursuant to the Employee Retirement Income Security Act of 1974 (ERISA). Substantially all of these plans are funded by fixed premium payments to insurance companies who undertake legal obligations to provide specific benefits to the individuals covered. Pension expense amounted to $2.4 million in 1993, $2.7 million in 1992 and $2.5 million in 1991. Certain subsidiaries of the Company have an executive retirement program under which benefits will be paid to participants or their beneficiaries over 15 years from age 65 or death. In addition, other subsidiaries have individual deferred compensation arrangements with certain executives which provide for payments over varying terms upon retirement, cessation of employment or death. OMNICOM GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Some of the Company's domestic subsidiaries provide life insurance and medical benefits for retired employees. Eligibility requirements vary by subsidiary, but generally include attainment of a specified combined age plus years of service factor. In 1991 the cost of these benefits was expensed as paid and was not material to the consolidated results of operations. Effective January 1, 1992, the Company adopted the provisions of Statement of Financial Accounting Standards No. 106 "Employers' Accounting For Post- retirement Benefits Other Than Pensions" ("SFAS No. 106"). SFAS No. 106 requires that the expected cost of post retirement benefits be charged to expense during the years that the eligible employees render service. The after tax cumulative effect of the adoption of SFAS No. 106 was not material to the net worth of the Company and the expense for the year was not material to the 1993 and 1992 consolidated results of operations. 10. Commitments At December 31, 1993, the Company was committed under operating leases, principally for office space. Certain leases are subject to rent reviews and require payment of expenses under escalation clauses. Rent expense was $128.8 million in 1993, $117.3 million in 1992 and $101.7 million in 1991 after reduction by rents received from subleases of $10.0 million, $14.1 million and $17.9 million, respectively. Future minimum base rents under terms of noncancellable operating leases, reduced by rents to be received from existing noncancellable subleases, are as follows: (Dollars in Thousands) Gross Rent Sublease Rent Net Rent ---------- ------------- -------- 1994 .................... $103,531 $ 9,297 $ 94,234 1995 .................... 94,594 7,698 86,896 1996 .................... 85,395 6,459 78,936 1997 .................... 77,229 4,305 72,924 1998 .................... 66,330 2,927 63,403 Thereafter .............. 414,201 10,944 403,257 Where appropriate, management has established reserves for the difference between the cost of leased premises that were vacated and anticipated sublease income. 11. Fair Value of Financial Instruments SFAS No. 107 "Disclosures about Fair Value of Financial Instruments," which was adopted by the Company in 1992, requires all entities to disclose the fair value of financial instruments for which it is practicable to estimate fair value. The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value: Cash and marketable securities: Marketable securities consist principally of investments in short-term, interest bearing instruments. The carrying amount approximates fair value. Long-term investments: Included in deferred charges and other assets are long-term investments which consist principally of an investment in Aegis Group plc., a publicly traded company, carried at fair market value and related stock warrants carried at cost. The fair value of the warrants was determined using an option pricing model. The remaining amounts, carried at cost, approximate estimated fair value. Long-term debt: The fair value of the Company's convertible subordinated debenture issues was determined by reference to quotations available in markets where those issues are traded. These quotations primarily reflect the conversion value of the debentures into the Company's common stock. These debentures are redeemable OMNICOM GROUP INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) by the Company, at prices explained in Note 7, which are significantly less than the quoted market prices used in determining the fair value. The fair value of the Company's remaining long-term debt was estimated based on the current rates offered to the Company for debt with the same remaining maturities. Swap agreements and forward contracts: The fair value of interest rate swaps and forward contracts is the estimated amount that the Company would receive or pay to terminate the agreements at December 31, 1993. The estimated fair value of the Company's financial instruments at December 31, 1993 is as follows: (Dollars in Thousands) Carrying Fair Amount Value --------- --------- Cash and marketable securities ......... $ 212,836 $ 212,836 Long-term investments .................. 26,015 27,672 Long-term debt ......................... 300,204 370,941 Other financial instruments: Interest rate swaps ................. -- (2,457) Forward contracts ................... (288) (288) 12. Special Charge and Adoption of New Accounting Principles Effective January 1, 1992, the Company adopted SFAS No. 106 and SFAS No. 109. The cumulative after tax effect of the adoption of these Statements increased net income by $3.8 million, substantially all of which related to SFAS No. 109. Due to the continued weakening of the commercial real estate market in certain domestic and international locations and the reorganization of certain operations, the Company provided a special charge of $6.7 million pretax for losses related to future lease costs. Effective January 1, 1994, the Company will adopt SFAS No. 112, "Employers' Accounting for Postemployment Benefits" ("SFAS No. 112"). The Company estimates that the adoption of SFAS No. 112 will result in an unfavorable after tax effect on net income of approximately $27 million. OMNICOM GROUP INC. AND SUBSIDIARIES QUARTERLY RESULTS OF OPERATIONS (Unaudited) The following table sets forth a summary of the unaudited quarterly results of operations for the two years ended December 31, 1993 and 1992, in thousands of dollars except for per share amounts. First Second Third Fourth --------- --------- --------- --------- Commissions & Fees 1993 ....................... $ 339,139 $ 381,758 $ 339,531 $ 456,047 1992 ....................... 308,888 347,561 327,750 400,962 Income Before Special Charge and Income Taxes 1993 ....................... 24,738 49,274 19,581 49,031 1992 ....................... 24,093 39,441 23,042 42,434 Special Charge 1993 ....................... -- -- -- -- 1992 ....................... 6,714 -- -- -- Income Before Income Taxes 1993 ....................... 24,738 49,274 19,581 49,031 1992 ....................... 17,379 39,441 23,042 42,434 Income Taxes 1993 ....................... 10,390 20,678 8,228 20,575 1992 ....................... 7,678 16,993 10,633 17,964 Income After Income Taxes 1993 ....................... 14,348 28,596 11,353 28,456 1992 ....................... 9,701 22,448 12,409 24,470 Equity in Affiliates 1993 ....................... 1,692 2,674 1,769 7,045 1992 ....................... 2,103 4,081 125 3,289 Minority Interests 1993 ....................... (1,584) (4,008) (276) (4,720) 1992 ....................... (2,876) (4,172) (2,157) (3,923) Cumulative Effect of Change in Accounting Principles 1993 ....................... -- -- -- -- 1992 ....................... 3,800 -- -- -- Net Income 1993 ....................... 14,456 27,262 12,846 30,781 1992 ....................... 12,728 22,357 10,377 23,836 Primary Earnings Per Share 1993 ....................... 0.50 0.90 0.43 0.95 1992 ....................... 0.45 0.78 0.37 0.84 Fully Diluted Earnings Per Share 1993 ....................... 0.49 0.82 0.43 0.87 1992 ....................... 0.45 0.72 0.37 0.76 Schedule II OMNICOM GROUP INC. AND SUBSIDIARIES SCHEDULE II--AMOUNTS RECEIVABLE FROM RELATED PARTIES, UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES For the Three Years Ended December 31, 1993 - ----------- (1) See footnote on Page S-2 S-1 Schedule II OMNICOM GROUP INC. AND SUBSIDIARIES SCHEDULE II--AMOUNTS RECEIVABLE FROM RELATED PARTIES, UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES (Continued) For the Three Years Ended December 31, 1993 S-2 Schedule VIII OMNICOM GROUP INC. AND SUBSIDIARIES SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS For the Three Years Ended December 31, 1993 S-3 Schedule IX OMNICOM GROUP INC. AND SUBSIDIARIES SCHEDULE IX--SHORT-TERM BORROWINGS For the Three Years Ended December 31, 1993 S-4 Schedule X OMNICOM GROUP INC. AND SUBSIDIARIES SCHEDULE X--SUPPLEMENTARY INCOME STATEMENT INFORMATION For the Three Years Ended December 31, 1993 S-5

702163_1993.txt

702163

1993

Item 1 - Business As used in this Annual Report, unless the context indicates otherwise, the terms "Citizens" or "Company" refer to Citizens First Bancorp, Inc. and its subsidiary, the term "Bank" refers to Citizens First National Bank of New Jersey and its subsidiaries, the term "Investment" refers to Citizens First Investment Corp. and its subsidiary, the term "Financial" refers to C. F. Financial Corp., the term "Leasing" refers to C F Leasing Corp., and the term "Property" refers to C. F. Property, Inc. Citizens' and the Bank's principal executive offices are located at 208 Harristown Road, Glen Rock, New Jersey 07452-3306; telephone number (201) 445-3400. Citizens First Bancorp, Inc. is a bank holding company incorporated in New Jersey and registered under the Bank Holding Company Act of 1956, as amended. It commenced business in 1982 when it acquired all the outstanding capital stock of the Bank. The Bank accounts for substantially all of the consolidated assets, revenues and operating results of Citizens. The only subsidiary of Citizens is the Bank, a full service commercial bank offering a complete range of individual, commercial and trust services through 50 banking offices located in the northern New Jersey counties of Bergen, Hudson, Morris and Passaic, and in Ocean County in southern New Jersey. On the basis of total deposits at June 30, 1993, Citizens ranked 182nd of the top 300 commercial banks in the United States and eleventh in size among commercial banking organizations in New Jersey. As of December 31, 1993, Citizens and the Bank employed 878 full-time equivalent employees. On March 21, 1994, Citizens announced the execution of a definitive merger agreement among National Westminster Bank Plc ("NatWest"), NatWest Holdings Inc., a subsidiary of NatWest, and Citizens. For information relating to the merger, see "Item 8 - Financial Statements and Supplementary Data" on page 13 hereof under the heading "Subsequent Event." The Bank The Bank is a national banking association which was organized in 1920 and is a full service commercial bank providing a broad spectrum of personal, commercial and trust services, including secured and unsecured personal and business loans, real estate financing and letters of credit to consumers and local businesses. In addition, the Bank makes available to its customers checking, savings, time and retirement accounts, certificates of deposit and repurchase agreements. In response to the growing preference of customers seeking alternatives to traditional deposit products, the Bank introduced annuity and mutual fund sales programs. The trust department manages discretionary assets with a market value of $497,635,000 at year-end 1993. Financial, a wholly-owned subsidiary of Investment since 1985, was established in 1983 for the purpose of holding certain investment securities. Prior to 1985, Financial was a wholly-owned subsidiary of the Bank. Investment, a wholly-owned subsidiary of the Bank, was established in 1985 for the purpose of owning Financial. Leasing, a wholly-owned subsidiary of the Bank, was established in 1986 for the purpose of originating and servicing equipment leases. Property, a wholly-owned subsidiary of the Bank, was established in 1990 for the purpose of holding certain real estate acquired through foreclosure. Market Area Citizens' offices are located in 5 New Jersey counties with the largest representation in Bergen County. The Bank's customer base is comprised of a variety of commercial and retail clients including a high concentration of middle and above average household incomes. The average household income of the Bank's northern New Jersey market area is 18% higher than the state average.* In Citizens' Bergen, Passaic and Morris County market areas, the average household income is 27%, 14% and 39% respectively higher than the state average.* Thirty-one branch offices are concentrated in Citizens' northern Bergen County market area including such communities as Ridgewood, Hillsdale and Bergenfield. The Bank's market area also includes communities within Morris, Passaic, Ocean and Hudson counties. In Bergen County, the Bank holds approximately 7.73% of the countywide deposits.** Citizens' deposit base of $2.3 billion is supported by 50 branch facilities. Substantially all branch offices provide a full range of consumer and commercial banking services. The Bank has implemented a "relationship banking" approach to serving customers, providing attractive packages of high quality services, developing new business, and proactively serving community needs. The "relationship banking" strategy was reinforced during the year with the introduction of SMARTBanking -TM-, a value-oriented package of consumer services, and annuity and mutual fund sales programs. The Bank believes that customer relationships will be strengthened and fee income increased by expanding the product line with these financial services. * The household income data is from the 1991 Sheshunoff New Jersey Branch Deposit Book. ** The market share information is from the 1994 Sheshunoff New Jersey Branch Deposit Book. Supervision and Regulation Citizens is a holding company registered under the Bank Holding Company Act of 1956, as amended ("Act"). Under the Act, bank holding companies may engage directly, or indirectly through subsidiaries, in activities which the Board of Governors of the Federal Reserve System ("FRS") determines to be so closely related to banking, managing or controlling banks as to be a proper incident thereto. There is generally no restriction under the Act on the geographical area in which these non-banking activities may be conducted. Engaging in activities which the FRS has not determined to be incidental to banking requires specific FRS approval. Under FRS regulations, Citizens and its subsidiary are prohibited from engaging in certain tie-in arrangements in connection with extensions of credit, leases, the sale of property, or the franchising of services. The Act prohibits a bank holding company from acquiring more than five percent of the voting shares or substantially all of the assets of any bank without the prior approval of the FRS, which is prohibited from approving an application by a bank holding company to acquire voting shares of any commercial bank in another state unless such acquisition is specifically authorized by the laws of the other state. New Jersey law permits mergers with banking organizations in other states, subject to reciprocal legislation. As a national bank, the Bank is subject to regulation and supervision by federal bank regulatory agencies. Federal law imposes certain restrictions on the Bank in extending credit to Citizens, and with certain exceptions, to other affiliates of Citizens, in investing in the stock or securities of Citizens, and in taking such stock or securities as collateral for loans to any borrower. The Bank is also subject to other statutes and regulations concerning required reserves, investments, loans, interest payable on deposits, establishment of branches and other aspects of its operation. In December 1992, as a result of the Bank's improved capital position and other factors, the Office of the Comptroller of the Currency ("OCC") terminated a Cease and Desist order issued in 1990 and entered into a Memorandum of Understanding ("MOU") with the Board of Directors setting forth areas that the Bank will continue to address to further the rebuilding process, including reducing the levels of nonperforming assets. The MOU requires the Bank to maintain a Tier 1 capital ratio of 6.5% of adjusted total assets, a Tier 1 capital ratio of 7.5% of risk-weighted assets, and total capital of 10.0% of risk-weighted assets. At December 31, 1993, the Bank was in full compliance with all regulatory capital requirements. As a result of the improved financial condition of the Bank, on March 15, 1994, the MOU was terminated. In December 1990, the Board of Directors of Citizens entered into a written agreement with the Federal Reserve Bank of New York ("FRB") concerning the operations of Citizens, the purpose of which is to restore and maintain the financial health of Citizens. Included among the matters covered by the agreement with the FRB are restrictions on the payment of dividends, bonuses, benefits and expenditures of an extraordinary nature by Citizens without notice to, or the prior approval of, the FRB. In March 1993, Citizens executed an amendment to its written agreement with the FRB permitting Citizens to declare and pay regular quarterly dividends on the preferred stock without being required to obtain prior written approval. In addition, in the fourth quarter of 1993, the FRB approved Citizens' request to declare and pay a Common Stock dividend of $.0425 per share, payable on February 1, 1994, to shareholders of record on January 14, 1994. As a result of the improved financial condition of Citizens, on March 15, 1994, the written agreement was terminated. Governmental Monetary Policies The earnings of Citizens and the Bank are affected by domestic and foreign economic conditions, particularly by the monetary and fiscal policies of the United States government and its agencies. The monetary policies of the Federal Reserve Board have had, and will continue to have, an important impact on the operating results of commercial banks through its power to implement national monetary policy in order, among other things, to mitigate recessionary and inflationary pressures by regulating the national money supply. The techniques used by the Federal Reserve Board include setting the reserve requirements of member banks and establishing the discount rate on member bank borrowings. The Federal Reserve Board also conducts open market transactions in United States government securities. From time to time various proposals are made in the United States Congress and the New Jersey legislature and before various regulatory authorities which would alter the powers of, and restrictions on, different types of banking organizations and which would restructure part or all of the existing regulatory framework for financial institutions. It is impossible to predict whether any of the proposals will be adopted and the impact, if any, of such adoption on the business of Citizens and the Bank. Statistical Information and Analysis This section presents certain statistical data concerning Citizens on a consolidated basis. Average data throughout this section was calculated on a daily basis and is representative of the consolidated operations of Citizens. I. Distribution of Assets, Liabilities and Shareholders' Equity; Interest Rates and Interest Differential Citizens responds to this segment by incorporating by reference the material under the caption "Average Rates and Yields on a Taxable-Equivalent Basis" on pages 36 and 37 of Citizens' 1993 Annual Report to Shareholders, and the material under the captions "Net Interest Income" and "Rate/Volume Analysis of Net Interest Income" on pages 25 and 26 of Citizens' 1993 Annual Report to Shareholders. II. Securities Portfolio A. Book Value of Securities Portfolio Citizens responds to this segment by incorporating by reference the material under the caption "Securities Portfolio" on page 29 of Citizens' 1993 Annual Report to Shareholders. B. The following table presents the maturity distributions and weighted average interest yields on a taxable-equivalent basis of securities of Citizens at December 31, 1993: III. Loan Portfolio A. Types of Loans Citizens responds to this segment by incorporating by reference the material under the caption "Loans," "Commercial and Industrial Loans," "Real Estate Loans" and "Consumer Loans" on pages 29 and 30 of Citizens' 1993 Annual Report to Shareholders. B. Maturities and Sensitivity of Loans to Changes in Interest Rates The following table presents information on the scheduled maturity and interest sensitivity of total loans by category at the date indicated: C. Risk Elements Citizens responds to this segment by incorporating by reference the material under the caption "Asset Quality" on pages 31 through 32 of Citizens' 1993 Annual Report to Shareholders. IV. Summary of Loan Loss Experience A. The following table sets forth an analysis of changes in the allowance for loan losses at the dates indicated: The allowance for loan losses is a valuation reserve established through charges to income. Loan losses are charged against the allowance when management believes that the collectibility of all or a portion of the principal is unlikely. This evaluation is based upon identification of loss elements and known facts which are reasonably determined and quantified. If, as a result of loans charged off or an increase in the level of portfolio risk characteristics, the allowance is below the level considered by management to be sufficient to absorb future losses on outstanding loans and commitments, the provision for loan losses is increased to the level considered necessary to provide an adequate allowance. In the opinion of management, the allowance for loan losses at December 31, 1993 was adequate to absorb possible future losses on existing loans and commitments. On a monthly basis management reviews the adequacy of the allowance. That process includes a review of all delinquent, nonaccrual and other loans identified as needing additional review and analysis. The evaluation of loans in these categories involves an element of subjectivity, but the process takes into consideration the risk of loss presented by the loans and potential sources of repayment, including collateral security. The evaluation is based upon a credit rating system that conforms to regulatory classification definitions that are extensively tested by management and the internal loan review department. Consideration is also given to historical data, trends in overall delinquencies, concentration of loans by industry and current economic conditions that may result in increased delinquencies, as well as other relevant factors. At December 31, 1993, the allowance for loan losses was $63,788,000, a decrease of 15.9% over the $75,838,000 reported for 1992. The decrease was primarily attributable to a charge to the allowance of approximately $15,000,000 related to a bulk sale of loans and foreclosed real estate during 1993. The provision for loan losses was $17,000,000 and $23,000,000 in 1993 and 1992, respectively. The allowance for loan losses to total loans was 3.6%, 4.5% and 4.4% at December 31, 1993, 1992 and 1991, respectively. The allowance for loan losses to nonperforming loans was 99.4% at December 31, 1993 compared to 74.1% and 61.2% at December 31, 1992 and 1991, respectively. B. The following table presents an allocation by loan category of the allowance for loan losses at the dates indicated: Allocation of the Allowance for Loan Losses by Category The allocation of the allowance for loan losses by loan category is an estimate which involves the exercise of judgment and requires consideration of the loan loss experience of prior years. It also requires assumptions concerning economic conditions in Citizens' market areas, the value and adequacy of collateral and the growth and composition of the loan portfolio. Since these factors are subject to change, the allocation of the allowance for loan losses should not be interpreted as an indication that charge-offs in 1994 will occur in these amounts or proportions, or that the allocation indicates future trends. The following table presents the percentage of loans in each loan category to total loans at the dates indicated: Percentage of Total Loans by Category V. Deposits A. Citizens responds to this segment by incorporating by reference the material under the caption "Average Rates and Yields on a Taxable-Equivalent Basis" on pages 36 and 37 of Citizens' 1993 Annual Report to Shareholders. D. The following table sets forth, by time remaining until maturity, time deposits in amounts of $100,000 or more at December 31 in each of the past three years: VI. Return on Equity and Assets Citizens responds to this item by incorporating by reference the material under the caption "Financial Ratios" on page 35 of Citizens' 1993 Annual Report to Shareholders. VII. Short-Term Borrowings Citizens responds to this item by incorporating by reference the material under Footnote 10 to the Consolidated Financial Statements, "Short-Term Borrowings," found on page 17 of Citizens' 1993 Annual Report to Shareholders. Item 2

Item 2 - Properties The headquarters of Citizens, Investment, Leasing and Property is located at 208 Harristown Road, Glen Rock, New Jersey. The property is leased by the Bank, which also maintains its administrative headquarters and a full service banking office at that location. The main office of the Bank is located at 54 East Ridgewood Avenue, Ridgewood, New Jersey and is owned by the Bank. A full service banking office is maintained at that location. Financial is located at 1100 North Market Street, Wilmington, Delaware; the property is leased. Citizens has a total of 50 banking offices, all in New Jersey, of which 28 are owned with the remainder leased. The owned properties are free and clear of all mortgages. The leased properties required $2,280,000 in rental payments in 1993. In the opinion of management, all properties are well maintained and suitable to their respective present needs and operations. Item 3

Item 3 - Legal Proceedings In 1990, two class action lawsuits against Citizens and certain of its present and former directors and officers were filed in the United States District Court for the District of New Jersey. These actions have been consolidated since they involve common questions of law and fact. The plaintiffs allege that purchasers of Citizens' stock during a certain period were victims of knowing or reckless misrepresentations by the defendants concerning the financial condition of Citizens. The court has certified October 4, 1989 through August 31, 1990 as the class period. Specifically, the plaintiffs claim that the defendants knowingly or recklessly stated that Citizens' allowance for loan losses at December 31, 1989 was adequate; overstated Citizens' profit for 1989; and artificially inflated the value of Citizens' stock. The plaintiffs claim similar misrepresentations by the defendants with respect to the March 31, 1990 interim financial statements of Citizens. Plaintiffs claim that the misrepresentations of the defendants violate Section 10(b) of the Securities Exchange Act, Rule 10(b) of the Rules and Regulations promulgated thereunder, Section 20 of the Exchange Act, and constitute common law fraud and negligent omissions. The plaintiffs demand unspecified compensatory damages, punitive damages and costs of the suits. Citizens believes that the allegations of wrongdoing by it and its directors and officers are without merit and is vigorously defending the action. However, in consideration of the uncertainties of litigation, preliminary analyses of potential liability prepared by experts and the coverage of certain defendants under a Directors and Officers liability insurance policy, management has determined it prudent to accrue $875,000 for this matter during the year ended December 31, 1993. Based upon these and other factors and advice received from Citizens' legal counsel, management believes that the outcome of the litigation will not result in an additional liability which would be material to Citizens' consolidated results of operations or financial position. Citizens is also subject to other claims and litigation that arise primarily in the ordinary course of business. Based on information presently available and advice received from legal counsel representing Citizens, it is the opinion of management that the disposition or ultimate determination of such other claims and litigation will not have a material adverse effect on the consolidated financial position of Citizens. Item 4

Item 4 - Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of security holders during the fourth quarter of the year covered by this report, either through the solicitation of proxies or otherwise. PART II Item 5

Item 5 - Market for Citizens' Common Equity and Related Stockholder Matters The number of common shareholders of record on December 31, 1993 was 4,311. For information relating to restrictions on the ability of the Bank to pay dividends to Citizens, see Footnote 19 to the Consolidated Financial Statements, "Dividend Limitation," found on page 21 of Citizens' 1993 Annual Report to Shareholders, which is incorporated by reference herein, and the last two paragraphs on page 5 hereof under the heading "Supervision and Regulation." For information relating to stock price ranges and dividends per share, see the tables included under the caption "Common Stock and Dividend Information" found on page 33 of Citizens' 1993 Annual Report to Shareholders, which is incorporated by reference herein. Item 6

Item 6 - Selected Financial Data Citizens responds to this item by incorporating by reference the material under the caption "Comparison of Selected Data" on pages 34 and 35 of Citizens' 1993 Annual Report to Shareholders. Item 7

Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations Citizens responds to this item by incorporating by reference the material under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 24 through 33 of Citizens' 1993 Annual Report to Shareholders. Item 8

Item 8 - Financial Statements and Supplementary Data Citizens responds to this item by incorporating by reference the material on pages 9 through 37 of Citizens' 1993 Annual Report to Shareholders. Subsequent Event (unaudited) On March 21, 1994, Citizens announced the execution of a definitive merger agreement among National Westminster Bank Plc ("NatWest"), NatWest Holdings Inc., a subsidiary of NatWest, and Citizens. Under the terms of the merger, Citizens will be merged into National Westminster Bank NJ, a subsidiary of National Westminster Bancorp, Inc., which is itself a subsidiary of NatWest Holdings Inc. Shareholders of Citizens, at their option, will have the right to have their shares converted into $9.75 per share in cash or .22034 American Depository Receipts ("ADRs") of NatWest per share. Each ADR represents six ordinary shares of NatWest. After taking into account shareholder elections, no more than 60% nor less than 50% of Citizens shares will be converted into ADRs and the remaining Citizens shares will be converted into cash. The transaction is designed to be tax-free to Citizens shareholders electing to receive ADRs. The agreement is subject to approvals by the Federal Reserve Board, other regulatory authorities and the shareholders of Citizens. It is intended that the transaction will be completed as soon as possible after approvals are obtained and is expected to occur in the Fall of 1994. For further information regarding this transaction, please see Form 8-K filed by Citizens. Item 9

Item 9 - Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Not applicable. PART III Item 10

Item 10 - Directors and Executive Officers of Citizens Directors of Citizens Citizens responds to this segment by incorporating by reference the material under the caption "Election of Directors," found in Citizens' definitive proxy statement concerning its 1994 Annual Shareholders' Meeting to be filed with the Securities and Exchange Commission pursuant to Regulation 14A. Executive Officers of Citizens These officers are appointed annually by the Board of Directors of Citizens, the Bank, Investment, Financial, and Leasing, as the case may be. There are no family relationships among the officers listed. Item 11

Item 11 - Executive Compensation Citizens responds to this item by incorporating by reference the material under the captions "Meetings and Fees of Board of Directors," "Executive Compensation" and "Compensation Committee Report" found in Citizens' definitive proxy statement concerning the 1994 Annual Shareholders' Meeting to be filed with the Securities and Exchange Commission pursuant to Regulation 14A. Item 12

Item 12 - Security Ownership of Certain Beneficial Owners and Management Citizens responds to this item by incorporating by reference the material under the caption "Information Concerning Nominees for Directors of the Company" found in Citizens' definitive proxy statement concerning the 1994 Annual Shareholders' Meeting to be filed with the Securities and Exchange Commission pursuant to Regulation 14A. Item 13

Item 13 - Certain Relationships and Related Transactions Citizens responds to this item by incorporating by reference the material under the caption "Certain Transactions" found in Citizens' definitive proxy statement concerning the 1994 Annual Shareholders' Meeting to be filed with the Securities and Exchange Commission pursuant to Regulation 14A. PART IV Item 14

Item 14 - Exhibits, Financial Statement Schedules, and Reports on Form 8-K Page (a) Financial Statements and Schedules - Index (1) Financial Statements * Citizens First Bancorp, Inc. and Subsidiary - Consolidated Balance Sheets at December 31, 1993 and 1992 Consolidated Statements of Income for each of the three years in the period ended December 31, 1993 Consolidated Statements of Changes in Shareholders' Equity for each of the three years in the period ended December 31, 1993 Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 1993 Independent Auditors' Report Notes to Consolidated Financial Statements (2) Financial Statement Schedules All schedules have been omitted as inapplicable, or not required, or because the information required is included in the financial statements or the notes thereto. *Incorporated by reference to pages 9 through 23 of Citizens' 1993 Annual Report to Shareholders. (3) Exhibits included herein: 3(a) Amendment to Certificate of Incorporation of Citizens First Bancorp, Inc., increasing the number of common shares authorized from 50,000,000 to 56,393,972, incorporated by reference to Exhibit 3(a) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1988, previously filed with the Securities and Exchange Commission, File No. 1-8413. 3(b) Amendment to Certificate of Incorporation of Citizens First Bancorp, Inc., adding articles EIGHTH and NINTH regarding indemnification of officers and directors, incorporated by reference to Exhibit 3(b) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1988, previously filed with the Securities and Exchange Commission, File No. 1-8413. 3(c) Certificate of Incorporation of Citizens First Bancorp, Inc., as amended to date, incorporated by reference to Exhibit 3(c) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1988, previously filed with the Securities and Exchange Commission, File No. 1-8413. 3(d) Bylaws of Citizens First Bancorp, Inc., as amended to date, incorporated by reference to Exhibit 3(d) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(a) Citizens First National Bank of New Jersey's Annual Incentive Plan dated January 31, 1983, incorporated by reference to Exhibit 10(a) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(b) Citizens First Bancorp, Inc.'s Incentive Stock Option Plan (1983), incorporated by reference to Exhibit 10(b) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(c) Form of Citizens First Bancorp, Inc.'s Individual Incentive Stock Option Agreement, incorporated by reference to Exhibit 10(c) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(d) Change in Control Agreement, dated as of September 19, 1989, between Citizens First Bancorp, Inc. and Richard G. Kelley, incorporated by reference to Exhibit 10(g) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(e) Change in Control Agreement, dated as of September 19, 1989, between Citizens First Bancorp, Inc. and Rodney T. Verblaauw, incorporated by reference to Exhibit 10(h) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(f) Employment Agreement dated as of September 19, 1989, among Citizens First Bancorp, Inc., Citizens First National Bank of New Jersey and Richard G. Kelley, incorporated by reference to Exhibit 10(i) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(g) Employment Agreement dated as of September 19, 1989, among Citizens First Bancorp, Inc., Citizens First National Bank of New Jersey and Rodney T. Verblaauw, incorporated by reference to Exhibit 10(j) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(h) Citizens First Bancorp, Inc. Director Retirement Plan, incorporated by reference to Exhibit 10(k) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(i) Citizens First Bancorp, Inc. Restated Director Retirement Plan, incorporated by reference to Exhibit 10(i) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(j) Citizens First Bancorp, Inc.'s 1985 Incentive Stock Plan, incorporated by reference to Exhibit 10(j) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1990, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(k) Stock Option Agreement dated July 16, 1985 between Richard G. Kelley and Citizens First Bancorp, Inc., incorporated by reference to Exhibit 10(l) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1985, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(l) Stock Option Agreement dated July 16, 1985 between Rodney T. Verblaauw and Citizens First Bancorp, Inc., incorporated by reference to Exhibit 10(m) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1985, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(m) Amendment No. 2 to the Amended and Restated Retirement Plan of Citizens First National Bank of New Jersey, incorporated by reference to Exhibit 10(n) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1988, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(n) Amended and Restated Retirement Plan of Citizens First National Bank of New Jersey, incorporated by reference to Exhibit 10(o) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1988, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(o) Amendment No. 3 to the Amended and Restated Retirement Plan of Citizens First National Bank of New Jersey. 10(p) Amended and Restated Employee Stock Ownership Plan of Citizens First National Bank of New Jersey, incorporated by reference to Exhibit 10(r) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(q) Amendment No. 1 to the Amended and Restated Employee Stock Ownership Plan of Citizens First National Bank of New Jersey, incorporated by reference to Exhibit 10(s) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(r) Amendment No. 2 to the Amended and Restated Employee Stock Ownership Plan of Citizens First National Bank of New Jersey, incorporated by reference to Exhibit 10(t) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(s) Amendment No. 3 to the Amended and Restated Employee Stock Ownership Plan of Citizens First National Bank of New Jersey, incorporated by reference to Exhibit 10(u) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1989, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(t) Benefit Equalization Plan of Citizens First National Bank of New Jersey, incorporated by reference to Exhibit 10(q) to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1985, previously filed with the Securities and Exchange Commission, File No. 1-8413. 10(u) Amendment No. 1 to the Benefit Equalization Plan of Citizens First National Bank of New Jersey. 10(v) Employment Agreement dated February 26, 1992 among Citizens First Bancorp, Inc., Citizens First National Bank of New Jersey and Allan D. Nichols. 10(w) Amendment to the Employment Agreement among Citizens First Bancorp, Inc., Citizens First National Bank of New Jersey and Allan D. Nichols. 10(x) Stock Option Agreement dated February 26, 1992 between Allan D. Nichols and Citizens First Bancorp, Inc. 10(y)* Employment Agreement among Citizens First Bancorp, Inc., Citizens First National Bank of New Jersey and Rodney T. Verblaauw as of January 5, 1994. 10(z)* Form of Change in Control Agreement, dated as of January 18, 1994, between Citizens First National Bank of New Jersey on the one hand and Allan D. Nichols and Rodney T. Verblaauw. 10(aa)*Form of Change in Control Agreement, dated as of January 18, 1994, between Citizens First National Bank of New Jersey on the one hand and Frank A. DeLisi, J. Michael Feeks, Eugene V. Malinowski and Jeffrey B. Morris. 10(bb)*Form of Change in Control Agreement, dated as of January 18, 1994, between Citizens First National Bank of New Jersey on the one hand and John C. Anello, Ronald H. Barnett, Steven A. Cole, Gregg N. Gerken, Charles E. O'Neal, George J. Theiller and James R. Van Horn. 11* Computation of Per Share Income. 13* 1993 Annual Report to Shareholders. 21 For 1993 Citizens First National Bank of New Jersey constituted the only significant subsidiary. Separate financial statements are omitted for the Bank since omission criteria under Rule 3A-02(e)(1) of Regulation S-X are satisfied. 23* Independent Auditors' Consent. Copies of the foregoing Exhibits will be furnished upon request and payment of Citizens' reasonable expenses in furnishing the Exhibits. (b)Reports on Form 8-K On October 14, 1993, Citizens filed a report on Form 8-K, as referenced in the September 30, 1993 Form 10-Q. On December 21, 1993, Citizens filed a report on Form 8-K indicating that the Board of Directors of Citizens First Bancorp, Inc. announced that it had declared the first dividend on the Company's Common Stock in three and one-half years. The dividend, in the amount of $.0425 per share, was payable on February 1, 1994 to shareholders of record at the close of business on January 14, 1994. The Board also declared the regular quarterly dividend of $.625 per share on the Company's Preferred Stock, Series A $2.50 Cumulative Convertible, payable on February 1, 1994 to shareholders of record at the close of business on January 14, 1994. "The reinstatement of Common Stock dividends represents an important milestone in our rebuilding program," said Allan D. Nichols, Chairman and Chief Executive Officer. Less than two years ago the viability of the Company and the Bank were in question. Today we have the highest level of capital in our history and strong core earnings." Nichols noted that the successful recapitalization of Citizens through an oversubscribed rights offering of new stock, the restructuring of the management team, significant improvement in earnings and a marked reduction in the level of the Bank's nonperforming assets were all important factors leading to the reinstatement of Common Stock dividend payments. "While the rebuilding of Citizens is not yet complete, we have come a long way in a relatively short time," Nichols said. "The Board of Directors has been grateful for the support of our shareholders through this process and is pleased to acknowledge this support through the restoration of the Common Stock dividend." No other reports on Form 8-K were required to be filed by Citizens during the last quarter of the period covered by this report. For the purposes of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, the undersigned registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into registrant's Registration Statements on Form S-8 Nos. 33-2287 (filed December 19, 1985) and 33-2302 (filed December 20, 1985): Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the Registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CITIZENS FIRST BANCORP, INC. By:ALLAN D. NICHOLS Allan D. Nichols, Chairman of the Board and Chief Executive Officer (Principal Executive Officer) Glen Rock, New Jersey Dated: March 21, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Each person hereby appoints Eugene V. Malinowski and James R. Van Horn and each of them as his attorney-in-fact to execute and file such amendments to this report on Form 8 as such attorney-in-fact, or either of them, may deem appropriate. Signature Title Date ALLAN D. NICHOLS Chairman of the Board and March 21, 1994 (Allan D. Nichols) Chief Executive Officer RODNEY T. VERBLAAUW President and Chief Adminis- March 21, 1994 (Rodney T. Verblaauw) trative Officer, Director DANIEL AMSTER Director March 21, 1994 (Daniel Amster) DOUGLAS H. DITTRICK Director March 21, 1994 (Douglas H. Dittrick) DANIEL M. DWYER Director March 21, 1994 (Daniel M. Dwyer) ROBERT D. HUNTER Director March 21, 1994 (Robert D. Hunter) SAMUEL M. LYON, JR. Director March 21, 1994 (Samuel M. Lyon, Jr.) HARRY RANDALL, JR. Director March 21, 1994 (Harry Randall, Jr.) Signature Title Date ALFRED S. TEO Director March 21, 1994 (Alfred S. Teo) WALTER W. WEBER, JR. Director March 21, 1994 (Walter W. Weber, Jr.) EUGENE V. MALINOWSKI, CPA Treasurer (Principal March 21, 1994 (Eugene V. Malinowski, CPA) Financial Officer and Principal Accounting Officer) EXHIBIT INDEX EXHIBIT NO. (3) Exhibits included herein: 10(y)* Employment Agreement among Citizens First Bancorp, Inc., Citizens First National Bank of New Jersey and Rodney T. Verblaauw as of January 5, 1994. 10(z)* Form of Change in Control Agreement, dated as of January 18, 1994, between Citizens First National Bank of New Jersey on the one hand and Allan D. Nichols and Rodney T. Verblaauw. 10(aa)*Form of Change in Control Agreement, dated as of January 18, 1994, between Citizens First National Bank of New Jersey on the one hand and Frank A. DeLisi, J. Michael Feeks, Eugene V. Malinowski and Jeffrey B. Morris. 10(bb)*Form of Change in Control Agreement, dated as of January 18, 1994, between Citizens First National Bank of New Jersey on the one hand and John C. Anello, Ronald H. Barnett, Steven A. Cole, Gregg N. Gerken, Charles E. O'Neal, George J. Theiller and James R. Van Horn. 11* Computation of Per Share Income 13* 1993 Annual Report to Shareholders 23* Independent Auditors' Consent Copies of the foregoing Exhibits will be furnished upon request and payment of Citizens' reasonable expenses in furnishing the Exhibits.

75252_1993.txt

75252

1993

Item 1. Business Owens & Minor, Inc. (the "Company") was incorporated in Virginia on December 7, 1926 as a successor to a partnership founded in Richmond, Virginia in 1882. The Company is a wholesale distributor of medical/surgical supplies and carries over 104,000 products and operates 36 distribution centers serving hospitals, nursing homes, alternate medical care facilities and other institutions nationwide. The Company also distributes pharmaceuticals and other products to independent pharmacies and chain drug stores in south Florida. The Company's common stock is traded on the New York Stock Exchange under the symbol OMI. On December 22, 1993, the Company entered into an agreement with Stuart Medical, Inc. (Stuart) whereby the companies will combine their two businesses. Stuart, a distributor of medical/surgical supplies, has distribution centers located primarily in the West, Midwest and Northeast and had sales for the year ended December 31, 1993 of $890.5 million (unaudited). In the proposed transaction, the Company will form a holding company that will own all of the currently outstanding capital stock of the Company and Stuart. Under the terms of the agreement, the new holding company would exchange $40,200,000 in cash and $115,000,000 par value of convertible preferred stock for all of the capital stock of Stuart. The Company will also refinance Stuart's pro forma debt of $141,000,000 (unaudited). Each outstanding share of the Company's common stock would be exchanged for one share of common stock of the new holding company. The Company intends to account for this transaction as a purchase, if consummated. The Board of Directors of the Company and the requisite shareholders of Stuart have unanimously approved this transaction. The Company's shareholders will vote on the proposed transaction at the annual shareholders' meeting with expected closing of the transaction to occur in the second quarter. In 1993, the Company did not engage in any material amount of governmental business that may be subject to renegotiation of profits or termination of contract at the election of the government. The Company held no material patents, trademarks, licenses, franchises or concessions in 1993 nor is it subject to any material seasonality. At December 31, 1993, the Company had 1,674 full and part-time employees and considers its relations with them to be excellent. The Company is required to carry a significant investment in inventory to meet the rapid delivery requirements of its customers. The Company sells only finished goods purchased from approximately 1,650 different competing manufacturers that provide an adequate availability of inventory. In 1993, products purchased from Johnson & Johnson, Inc. accounted for more than 19% of the Company's net sales. The Company believes that it is not vulnerable to supply interruptions that would have a material adverse effect on its operations or profitability. Due to the immediate delivery requirements of its customers, the Company has no material backlog of orders. During 1993, hospital customers (including members of hospital buying groups) represented 90% of the Company's sales. The remaining sales were to nursing homes, physicians and other purchasers. The high percentage of sales to hospitals reflects the principal strategy to concentrate on hospital customers in the belief that hospitals will remain the primary focus of the healthcare industry. Important elements of this strategy have been to maintain the Company's status as a low cost distributor of high volume disposable, commodity products and to operate in a decentralized manner to provide customers with a high level of service on a local basis. In 1993, the majority of the Company's net sales were related to eight product groups - urological products, dressings, needles and syringes, surgical packs and gowns, sterile procedure trays, sutures, intravenous products and endoscopic products. These products are disposable and are generally used in high volume by customers. The sales of these products are supplemented by sales of a wide variety of other products including incontinence products, feeding tubes, surgical staples, blood collection devices and surgical gloves. The Company's growth has been achieved by expansion into new geographical areas through acquisitions, the opening of new distribution centers and the consolidation of existing distribution centers. In May 1989, the Company acquired National Healthcare and Hospital Supply Corporation (National Healthcare). With the addition of National Healthcare's six continuing distribution centers, the Company was able to expand its distribution area to the western portion of the United States. On December 2, 1991, the Company acquired Koley's Medical Supply, Inc. (Koley's). The acquisition of Koley's provided the Company with three distribution centers located in Iowa and Nebraska. In May 1992 and September 1992, the Company opened distribution centers in Columbus, Ohio and Memphis, Tennessee, respectively. In May 1993, the Company acquired Lyons Physician Supply Company located in Youngstown, Ohio. In June 1993, the Company acquired A. Kuhlman & Co. located in Detroit, Michigan. In June 1993, the Company opened distribution centers in Birmingham, Alabama and Detroit, Michigan, and in August 1993 and December 1993, the Company opened distribution centers in Boston, Massachusetts and Seattle, Washington, respectively. The Company intends to continue to acquire or establish facilities in new locations depending on the attractiveness of new markets, the availability of suitable acquisition candidates and the potential for additional sales or cost savings from new locations. Since 1985, the Company has been a distributor for Voluntary Hospitals of America, Inc. ("VHA"). The Company entered into a new supply agreement with VHA in November 1993. VHA is the nation's largest non-profit hospital system, representing over 960 hospitals, approximately 370 of which are in markets serviced by the Company. Under the provisions of the new VHA agreement, commencing on April 1, 1994, the Company will sell products to VHA-member hospitals and affiliates on a variable cost-plus basis that is generally dependent upon dollar volume of purchases and percentage of total products purchased from the Company. Accordingly, as the Company's sales to and penetration of VHA-member customers increase, the cost plus pricing charged to such customers decreases. Prior to April 1, 1994, products were sold on a straight cost- plus basis. During 1993, no single customer accounted for 10% or more of the Company's sales, except for sales under the VHA agreement to member hospitals, which amounted to approximately $460 million or 33% of the Company's total net sales. In February 1994, the Company was selected by Columbia/HCA Healthcare Corp. ("Columbia/HCA") as its prime distributer for medical/surgical products. Columbia/HCA operates 192 acute care and specialty hospitals throughout the United States. The Company also acts as an agent for Abbott Laboratories, warehousing and distributing intravenous solutions and related products on a fee basis at six distribution centers. CUSTOMER SERVICE AND MARKETING SYSTEMS The Company believes that its increased use of computers will continue to improve its inventory management and its ability to provide prompt delivery to customers. The use of computers has enabled the Company to handle an increasing level of sales without corresponding increases in personnel. Since 1988, the Company has utilized its Owens & Minor Network Information System (OMNI), a fully integrated on-line system that operates from a centralized data base. OMNI has improved operating controls and provided more consistent information from the distribution centers. Additionally, the OMNI system has improved the Company's ability to communicate with and service its customers. The second phase of the OMNI implementation provides for the installation of a new computer-oriented warehouse management system, which includes a state-of-the-art radio frequency control system utilizing barcodes that interface with the mainframe computer system. This system completely computerizes on-line the receiving, putaway, storage, verification, order picking and shipping of merchandise. One of the benefits of the system is that it provides for periodic recounts of merchandise, which will improve the accuracy of on-hand product inventory data. Through 1993, this new warehouse management system has been implemented in 18 of the Company's 36 distribution centers. During 1992, the Company began an investment in resources to upgrade the OMNI system in order to service its customers more effectively. Selected employees within the information systems department are utilizing the latest application development techniques including Computer Aided System Engineering (CASE). The Company offers its customers certain systems-related services which management believes contribute to its competitive position. The Company has a variety of electronic order entry systems which allow its sales representatives and customers to enter orders directly into the Company's computer. These systems can interface with existing customer materials management systems and with hand-held microcomputers carried by sales representatives to transmit orders. During 1993, approximately 63% of the Company's sales were entered through these systems. Electronic order entry systems have enabled the Company to reduce its order processing costs and improve customer service. Customers with compatible computer terminals or computerized materials management systems can enter orders directly into the mainframe computer in Richmond using their own product numbering system. The Company has also adapted its central computer system in Richmond to receive computer-to-computer order transmissions from several more comprehensive material management software systems used by certain customers. The customer has the choice of using its own product numbering system or the Company's standard numbering system. MARKETING DEVELOPMENTS Under the name of PANDAC(R) services, the Company markets wound closure inventory management and cost control programs for use in acute care hospitals. This system aids in budget forecasting and control, both in terms of balance sheet and profit and loss applications. In 1993, the Company introduced SPECTROM(TM), an instrument-scope repair service for the cost conscious healthcare provider. The SPECTROM(TM) service was designed to be a single source for both major and minor repairs, offering the customer quality repair, quick turnaround time and economy. SPECTROM(TM) can reduce the hospital's instrument-scope repair cost which offers the customer valuable quality performance at the lowest possible cost. In 1993, the Company introduced CARDIOM(TM), an inventory and cost management service for the angio Cath Lab. CARDIOM(TM) can significantly reduce the hospital's Cath Lab asset investment. As part of the service provided by CARDIOM(TM), the hospital receives quarterly reports containing data which assists the hospital in maintaining efficient inventories and controlling procedure product costs. In 1993, the Company introduced Pallet Architecture Location Services (PALS(TM)), a service designed to reduce the customers operating costs by palletizing customer orders to facilitate the receiving process and reduce put-away time. LOGISTIC SERVICES Due to changing needs in the marketplace, the Company's Logistic Support Services developed a Quality Management Process (QMP) to provide customized services and solutions. The objective of QMP is to provide hospital customers with the solutions needed to manage their business through an era of increasing costs and shrinking reimbursements, with the underlying goal of providing the lowest delivered cost to the patient. The QMP Continuum offers steps to help the customer move from a traditional to a non-traditional distribution environment, defined by the specific needs of each hospital. The QMP Continuum is comprised of four basic components: (1) Process Documentation identifies quality improvement opportunities to remove redundancies, reduce inefficiency, and introduce a continuous improvement process; (2) Asset Management Solution provides EDI transactions, continuous inventory replenishment, J-I-T/Stockless partnerships, PANDAC(R) Wound Closure Management Program and other asset management programs; (3) Cost Control Analysis provides data needed to identify asset utilization, streamline and reduce costs, including PALS(TM); and (4) Project Management and Consulting Services provide operating system design, distribution system design, facility design, space utilization, Cath Lab design, mergers and consolidations, etc. The Quality Management Process methodology is integrated into the operations of the local Owens & Minor Distribution Center which serves the hospital. COMPETITION The medical/surgical supply business in the United States consists of one nationwide distributor, Baxter International, and a number of regional and local distributors. The Company believes that, based upon sales, it is the second largest distributor of medical/surgical products to hospitals in the United States. Competition within the medical/surgical supply business exists with respect to product availability, delivery time, services provided, the ability to meet special requirements of customers and price. In recent years, there has been a consolidation of medical/surgical supply distributors through the purchase of smaller distributors by larger companies. Item 2.

Item 2. Properties The corporate headquarters of the Company are located in western Henrico County in suburban Richmond, Virginia in a leased facility. The Company owns two undeveloped parcels of land in western Henrico County, which are adjacent to the Company's corporate headquarters. The former office and production facilities of Harbor Medical, Inc., located in Sanford, Florida, which are presently leased to a tenant through May 1996, are owned by the Company. Also, with the acquisition of Lyons Physician Supply Company, the Company owns the land and building of its Youngstown, Ohio location. The Company also leases offices and warehouses for its distribution centers in 35 cities throughout the country. Excluding the Stuart transaction, the Company expects to relocate or renovate up to seven of its leased office and warehouse facilities in 1994. All other Company facilities are considered adequate for their current and projected use. Item 3.

Item 3. Legal Proceedings There are no legal proceedings pending against the Company or any of its subsidiaries other than ordinary routine litigation incidental to its business, including certain tort claims arising in the ordinary course of business which are adequately covered by insurance and are being defended either by the Company's insurance carriers or the suppliers of the merchandise involved. No legal proceeding pending against the Company is expected to have a material adverse effect upon the Company. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of security holders during the fourth quarter of 1993. EXECUTIVE AND OTHER OFFICERS OF THE REGISTRANT The Company's Executive Officers are: Name Age Office Held ---- --- ----------- G. Gilmer Minor, III 53 President and Chief Executive Officer Robert E. Anderson, III 59 Senior Vice President, Planning and Development Henry A. Berling 51 Senior Vice President, Sales and Marketing Drew St. J. Carneal 55 Senior Vice President, Corporate Counsel and Secretary Glenn J. Dozier 43 Senior Vice President, Finance, Chief Financial Officer Craig R. Smith 42 Senior Vice President, Distribution and Information Systems The Company's Other Officers are: Richard F. Bozard 47 Vice President, Treasurer Richard L. Farinholt 55 Vice President, Technology Systems Hugh F. Gouldthorpe, Jr. 55 Vice President, Quality and Communications Frederick R. Ricker 48 Vice President, Business Development and Support Michael L. Roane 39 Vice President, Human Resources F. Thomas Smiley 38 Vice President, Controller Hue Thomas, III 55 Vice President, Corporate Relations All of the Officers were elected at the annual meeting of the Board of Directors held April 27, 1993. All Officers are elected to serve until the 1994 Annual Meeting of Shareholders, or such time as their successors are elected. Mr. G. Gilmer Minor, III was first employed by the Company in 1963. Mr. Minor received his B.A. from the Virginia Military Institute in 1963. In 1966, he was awarded an MBA from the Colgate Darden School of Business Administration from the University of Virginia. He has spent his entire business career with the Company and was elected President in 1981 and Chief Executive Officer in 1984. Mr. Anderson was Vice President of Powers & Anderson from 1958 to 1966. With the Company's acquisition of Powers & Anderson in 1967, Mr. Anderson was employed in the Medical/Surgical Division in sales and marketing and was elected Vice President in 1981. In October 1987, he was elected Senior Vice President, Corporate Development. In April 1991, Mr. Anderson was elected Senior Vice President, Marketing and Planning. In 1992, Mr. Anderson assumed a new role as Senior Vice President, Planning and Development. Mr. Anderson received a B.S. in Commerce from the University of Virginia in 1955. Mr. Berling was employed by A & J Hospital Supply Company following the completion of his education in 1965. With the Company's acquisition of A & J Hospital Supply in 1966, Mr. Berling was employed by the Company in the Medical/Surgical Division and was elected Vice President in 1981 and Senior Vice President, Sales and Marketing, a newly created position, in 1987. In April 1989, he was elected Senior Vice President and Chief Operating Officer. In April 1991, Mr. Berling assumed a new role as Senior Vice President, Sales and Distribution. In 1992, Mr. Berling assumed the role of Senior Vice President, Sales and Marketing. Mr. Berling received a B.S. in Economics from Villanova University in 1965. Mr. Carneal was employed by the Company in January 1989 as Vice President and Corporate Counsel. From 1985 to 1988, he served as the Richmond City Attorney and, prior to that date, he was a partner for the law firm of Cabell, Moncure and Carneal which provided legal services to the Company. In February 1989, he was elected Secretary by the Board of Directors. In March 1990, he was elected Senior Vice President, Corporate Counsel and Secretary. Mr. Carneal received a B.A. in English from Princeton University in 1960. Mr. Carneal received his L.L.B. at the University of Virginia School of Law. Mr. Dozier was elected to the position of Senior Vice President, Chief Financial Officer, in February 1991. In April 1991, he assumed the additional responsibility of Senior Vice President, Operations and Systems. Mr. Dozier was formerly Vice President, Treasurer and Chief Financial Officer. In 1992, Mr. Dozier assumed a new role of Senior Vice President, Finance and Information Systems and Chief Financial Officer. In 1993, Mr. Dozier assumed the role of Senior Vice President, Finance, Chief Financial Officer. Prior to joining the Company in April 1990, Mr. Dozier had been Chief Financial Officer and Vice President of Administration and Control since 1987 for AMF Bowling, Inc. Previously, Mr. Dozier was with Dravo Corporation, where his last position was Vice President, Finance. Mr. Dozier received an MBA from The Colgate Darden School of Business at the University of Virginia and received a B.S. from Virginia Polytechnic Institute and State University in Industrial Engineering and Operations Research. Mr. Smith was employed by National Healthcare and Hospital Supply Corporation in June 1983 as a sales representative. With the Company's acquisition of National Healthcare and Hospital Supply Corporation in May 1989, Mr. Smith was employed by the Company as Division Vice President. From 1990 to 1992, Mr. Smith served as Group Vice President for the western region. On January 4, 1993 Mr. Smith assumed responsibilities of Senior Vice President, Distribution. In 1993, Mr. Smith assumed the new role of Senior Vice President, Distribution and Information Systems. Mr. Smith is a graduate of the University of Southern California. Mr. Bozard was employed by the Company in March 1988 and was elected Vice President, Treasurer in 1991. Prior to joining the Company, he served as an officer for CIT/Manufacturers Hanover Bank and Trust. From 1984 to 1986 he was with Williams Furniture where his last position was President. Mr. Bozard received a B.S. from Virginia Commonwealth University in Business Administration. Mr. Farinholt was employed by the Company in October 1991 as Vice President, Information Systems. In January 1994, Mr. Farinholt assumed the position of Vice President, Technology Systems. Prior to joining the Company, Mr. Farinholt was President of a consulting firm, Information Technology Group, Inc. Prior thereto, he was President of HealthNet, Inc. Previously, Mr. Farinholt was with IBM for 17 years. Mr. Farinholt received a B.S. Degree in Accounting from the University of Virginia. Mr. Gouldthorpe joined the Company in 1986 as Director of Hospital Sales for the Wholesale Drug Division. In 1987, he was promoted to Vice President and was named Vice President and General Manager of the Wholesale Drug Division in 1989. In April 1991, he was elected Vice President, Corporate Communications and in September 1993, was appointed Vice President, Quality and Communications. Prior to joining the Company, Mr. Gouldthorpe was employed by E.R. Squibb and Sons for 20 years. While at Squibb he held numerous sales and marketing positions that included Advertising Manager, Director of Training and Director of Sales. Mr. Gouldthorpe is a graduate of The Virginia Military Institute with a B.A. in Chemistry and Biology. Mr. Ricker was employed by the Company in March 1989 as Vice President and Director of Operations. In 1991, Mr. Ricker assumed the additional responsibility of Vice President, Support Services. In 1993, Mr. Ricker assumed the position of Vice President, Business Development and Support. Prior to joining the Company, he was Director of Operations with Grinnell Corporation from 1986 to 1989. Prior to 1986, Mr. Ricker served as Director and/or Vice President of Operations with John Portman and Associates and W. W. Grainger, Inc. He started his career with IBM in 1968 as a Financial Analyst. Mr. Ricker is a graduate of Youngstown State University. Mr. Roane was employed by the Company in October 1992 as Vice President, Human Resources. Prior to joining Owens & Minor, Mr. Roane was employed by Philip Morris Co. where his last position was Manager, Employee Relations Operations. Mr. Roane received his B.S. Degree in Business Management from Canisius College. Mr. Smiley was employed by the Company in September 1979 as Manager of Internal Audit. In January 1981, he became the Assistant Controller. In June 1985, he became the Controller. In April 1986 he was elected Assistant Vice President, Controller. In April 1989, he was elected Vice President, Controller. Prior to joining the Company, he was with Coopers & Lybrand, where his last position was Senior Accountant. Mr. Smiley received a B.S. in Business Administration from the University of Richmond. Mr. Thomas joined the Company in 1970. In 1984, he was promoted to Assistant General Manager of the Medical/Surgical Division. In 1985, he was made Assistant Corporate Vice President and was named Vice President in 1987. In 1989, he was named Vice President and General Manager of the Medical/Surgical Division. In 1991, he was named Vice President, Corporate Relations. Mr. Thomas received a B.S. from Georgia Institute of Technology in 1964. PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters Information regarding the market price of the Company's Common Stock and related stockholder matters is set forth in the 1993 Annual Report under the heading "Market and Dividend Information" on page 40 and is incorporated by reference herein. Item 6.

Item 6. Selected Financial Data The information required under this item is contained in the 1993 Annual Report under the heading "Selected Financial Data" on pages 18 and 19 and is incorporated by reference herein. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The information required under this item is contained in the 1993 Annual Report under the heading "Management's Discussion and Analysis of Results of Operations and Financial Condition" on pages 18 through 21 and is incorporated by reference herein. Item 8.

Item 8. Financial Statements and Supplementary Data The consolidated financial statements and notes as of December 31, 1993 and 1992 and for each of the years in the three-year period ended December 31, 1993, together with the independent auditors' report of KPMG Peat Marwick dated February 4, 1994, appearing on pages 22 through 37 of the 1993 Annual Report are incorporated by reference herein. The information required under Item 302 of Regulation S-K is set forth in the 1993 Annual Report in Note 12 - "Quarterly Financial Data (Unaudited)" in the Notes to the Consolidated Financial Statements on page 36 and is incorporated by reference herein. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure There were no changes in or disagreements with accountants on accounting and financial disclosures during the two years ended December 31, 1993. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant The information required for this item is contained in Part I of this report and in the 1994 Proxy Statement under the heading, "Proposal 2: Election of Directors." Item 11.

Item 11. Executive Compensation The information required under this item is contained in the 1994 Proxy Statement under the heading "Proposal 2: Election of Directors - Executive Compensation" and is incorporated by reference herein. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management The information required under this item is contained in the 1994 Proxy Statement under the heading "Proposal 2: Election of Directors - O&M Common Stock Owned by Principal Shareholders and Management" and is incorporated by reference herein. Item 13.

Item 13. Certain Relationships and Related Transactions The information required under this item is contained in the 1994 Proxy Statement under the heading "Proposal 2: Election of Directors - Compensation Committee Interlocks and Insider Participation" and is incorporated by reference herein. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K * Incorporated by reference from the indicated pages of the 1993 Annual Report. All other schedules are omitted because the related information is included in the consolidated financial statements or notes thereto or because they are not applicable. 3. Exhibits (2) Agreement of Exchange dated as of December 22, 1993 by and among Stuart Medical, Inc., the Company, OMI Holding, Inc. and certain shareholders of Stuart Medical, Inc.** (3) (a) Amended and Restated Articles of Incorporation of the Company (incorporated herein by reference to the Company's Annual Report on Form 10-K, Exhibit 3(a), for the year ended December 31, 1990) (b) Amendment effective March 8, 1993 to the Amended and Restated Articles of Incorporation of the Company (incorporated herein by reference to the Company's Annual Report on Form 10-K, exhibit 3(b), for the year ended December 31, 1992) (c) Bylaws of the Company as amended on February 25, 1993 (incorporated herein by reference to the Company's Annual Report on Form 10-K, Exhibit 3(c), for the year ended December 31, 1992) (4) (a) Owens & Minor, Inc. $11.5 million, 0% subordinated note dated May 31, 1989, due May 31, 1997, between the Company and Hygeia Ltd. (incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1990) (b) Owens & Minor, Inc. $3.5 million, 6.5% convertible subordinated debenture dated May 31, 1989, between the Company and Hygeia Ltd. (incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1990) (c) Owens & Minor, Inc. $40 million Credit Agreement, dated as of November 1, 1993, among the Company and Crestar Bank and NationsBank of Virginia, N.A. (10) (a) Owens & Minor, Inc. Annual Incentive Plan (incorporated herein by reference to the Company's definitive Proxy Statement dated March 25, 1991)* (b) 1985 Stock Option Plan as amended on January 27, 1987 (incorporated herein by reference to the Company's Annual Report on Form 10-K, Exhibit 10(f), for the year ended December 31, 1987)* (c) Stock Purchase Agreement dated May 1, 1989 among the Company, Hygeia N.V. and Hygeia Medical Supply B.V. (incorporated herein by reference to the Company's Current Report on Form 8-K, Exhibit 2.1, filed on May 24, 1989) (d) Owens & Minor, Inc. Pension Plan (incorporated herein by reference to the Company's Annual Report on Form 10-K, Exhibit 10(h), for the year ended December 31, 1990)* (e) Supplemental Executive Retirement Plan dated July 1, 1991 (incorporated herein by reference to the Company's Annual Report on Form 10-K, Exhibit 10(i), for the year ended December 31, 1991)* (f) Owens & Minor, Inc. Executive Severance Agreements (incorporated herein by reference to the Company's Annual Report on Form 10-K, Exhibit 10(i), for the year ended December 31, 1991)* (g) Owens & Minor, Inc. Directors' Stock Option Plan (incorporated herein by reference to the Company's Annual Report on Form 10-K, Exhibit 10(i), for the year ended December 31, 1991)* (h) Agreement dated December 31, 1985 by and between Owens & Minor, Inc. and G. Gilmer Minor, Jr. (incorporated herein by reference to the Company's Annual Report on Form 10-K, exhibit 10(k), for the year ended December 31, 1992)* (i) Agreement dated December 31, 1985 by and between Owens & Minor, Inc. and Philip M. Minor (incorporated herein by reference to the Company's Annual Report on Form 10-K, exhibit 10(l), for the year ended December 31, 1992)* (j) Agreement dated May 1, 1991 by and between Owens & Minor, Inc. and W. Frank Fife (incorporated herein by reference to the Company's Annual Report on Form 10-K, exhibit 10(m), for the year ended December 31, 1992)* (k) Owens & Minor, Inc. 1993 Stock Option Plan* (l) Owens & Minor, Inc. Directors' Compensation Plan* (m) Form of Enhanced Authorized Distribution Agency Agreement dated as of November 16, 1993 by and between Voluntary Hospitals of America, Inc. and Owens & Minor, Inc.*** (11) Calculation of Net Income Per Share (13) Owens & Minor, Inc. 1993 Annual Report to Stockholders (Note 1) (22) Subsidiaries of Registrant (24) Consent of KPMG Peat Marwick, independent auditors * A management contract or compensatory plan or arrangement required to be filed as an exhibit to this Form 10-K. ** The schedules to this Agreement have been omitted pursuant to Item 601(b)(2) of Regulation S-K. The Company hereby undertakes to file supplementally with the Commission upon request a copy of the omitted schedules. *** The Company has requested confidential treatment by the Commission of certain portions of this Agreement, which portions have been omitted and filed separately with the Commission. (b) Reports on Form 8-K There were no reports filed on Form 8-K during the fourth quarter of 1993 Note 1. With the exception of the information incorporated in this Form 10-K by reference thereto, the 1993 Annual Report shall not be deemed "filed" as a part of this Form 10-K. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. OWENS & MINOR, INC. by/s/ G. Gilmer Minor, Jr. G. Gilmer Minor, Jr. Chairman of the Board Pursuant to the requirements of the Securities Exchange Act of 1934, this report is signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated: /s/ G. Gilmer Minor, Jr. /s/ R. E. Cabell, Jr. G. Gilmer Minor, Jr. R. E. Cabell, Jr Chairman of the Board Director and Director /s/ Philip M. Minor /s/ James B. Farinholt, Jr. Philip M. Minor James B. Farinholt, Jr. Vice Chairman and Director Director /s/ G. Gilmer Minor, III /s/ Vernard W. Henley G. Gilmer Minor, III Vernard W. Henley President and Chief Director Executive officer and Director /s/ William F. Fife /s/ E. Morgan Massey William F. Fife E. Morgan Massey Retired Executive Vice Director President and Director /s/ Glenn J. Dozier /s/ James E. Rogers Glenn J. Dozier James E. Rogers Senior Vice President, Director Finance, Chief Financial Officer /s/ F. Thomas Smiley /s/ James E. Ukrop F. Thomas Smiley James E. Ukrop Vice President, Principal Director Accounting Officer and Controller /s/ Anne Marie Whittemore Anne Marie Whittemore Director Each of the above signatures is affixed as of March 7, 1994. INDEPENDENT AUDITORS REPORT ON FINANCIAL STATEMENT SCHEDULES The Board of Directors and Stockholders Owens & Minor, Inc.: Over date of February 4, 1994, we reported on the consolidated balance sheets of Owens & Minor, Inc. and subsidiaries as of December 31,1993 and 1992, and the related consolidated statements of income, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 annual report to stockholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related financial statement schedules included on pages 17 and 18 of this annual report on Form 10-K. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Note 10 to the consolidated financial statements, as of January 1, 1993, the Company changed its method of accounting for income taxes. KPMG Peat Marwick Richmond, Virginia February 4, 1994 Schedule VIII OWENS & MINOR, INC. AND SUBSIDIARIES Valuation and Qualifying Accounts (In thousands) Balance at Additions beginning charged to Balance at of costs and end of Description year expenses Deductions* year - ----------- --------- -------- --------- ---------- Allowance for doubtful accounts deducted from accounts and notes receivable in the Consolidated Balance Sheets December 31, 1993 $4,442 $ 497 $ 261 $4,678 December 31, 1992 $4,514 $1,351 $1,423 $4,442 December 31, 1991 $3,671 $1,506 $ 663 $4,514 * Uncollectible accounts written off. Schedule IX OWENS & MINOR, INC. AND SUBSIDIARIES Short-Term and Revolving Credit Borrowings (Dollars in thousands) NOTE A: Calculations are based on daily average amounts outstanding and include commitment fees on the revolving line of credit. Form 10-K Exhibit Index Exhibit # Description Page # - --------- ----------- ------ 2 Agreement of Exchange dated as of December 22, 1993 by and among Stuart Medical, Inc., the Company, OMI Holding, Inc. and certain shareholders of Stuart Medical, Inc. 4 (c) Owens & Minor, Inc. $40 million Credit Agreement, dated as of November 1, 1993, among the Company and Crestar Bank and NationsBank of Virginia, N.A. 10 (k) Owens & Minor, Inc. 1993 Stock Option Plan (l) Owens & Minor, Inc. Directors' Compensation Plan (m) Form of Enhanced Authorized Distribution Agency Agreement dated as of November 16, 1993 by and between Voluntary Hospitals of America, Inc. and Owens & Minor, Inc. 11 Calculation of Net Income Per Share 13 Owens & Minor, Inc. 1993 Annual Report to Stockholders 22 Subsidiaries of Registrant 24 Consent of KPMG Peat Marwick, independent auditors

65660_1993.txt

65660

1993

ITEM 1. BUSINESS GENERAL Michigan National Corporation (MNC), a registered bank and savings and loan association holding company, is incorporated under the laws of the State of Michigan. MNC owns 100% of the common stock of four of its bank and savings and loan subsidiaries, and its five non-bank subsidiaries. MNC owns 49% of the common stock of the holding company of an additional bank subsidiary. Effective October 1, 1993, MNC sold substantially all the assets and certain liabilities of BancA Corporation, a Dallas, Texas computer software company. The assets were previously written down during the second quarter of 1993 with a $4.6 million charge to income and no additional loss resulted from the sale transaction. MNC had acquired all the assets and assumed certain liabilities of BancA Corporation on July 29, 1992, for a cash purchase price of $3.5 million. On April 1, 1993, Peoples National Bank, Pasadena, Texas; Peoples Bank, Houston, Texas; and Community National Bank, Friendswood, Texas were acquired and merged into Lockwood Banc Group, Inc. (Lockwood). The cash purchase price for the acquisition was $16.7 million, which was equal to the estimated net fair value of those institutions. The transaction was accounted for under the purchase method and goodwill of $4.1 million was recognized in the acquisition, which is being amortized over 15 years on a straight-line basis. MNC has approximately 5,900 full-time equivalent employees. At the end of 1993, MNC was the fourth largest bank holding company in Michigan based upon total assets. Michigan National Bank (MNB), MNC's principal banking subsidiary, has 190 branch offices, operates one of the largest automated teller machine networks in Michigan and provides all services associated with a full-service commercial banking institution. INDUSTRY SEGMENTS MNC operates in two industry segments - the mortgage banking industry and the financial institutions industry. Please refer to Note W. to consolidated financial statements for industry segment information. Independence One Mortgage Corporation (IOMC) operates the mortgage banking business and has 23 offices in ten states. IOMC's principal business activities are discussed in the Mortgage Banking Activities section of Note A. to consolidated financial statements. FORM 10-K ITEM 1. BUSINESS (CONTINUED) The financial institutions primary businesses are retail banking, commercial banking and investment banking. These businesses are operated by MNB. Independence One Bank of California (IOBOC), Lockwood and First State Bank & Trust also operate retail and commercial banking businesses. COMPETITION Michigan is a highly competitive financial services market. Michigan laws that allow reciprocal interstate banking with contiguous states and nationwide interstate banking have enlarged the banking market and heightened competitive forces. MNB competes primarily with other Michigan banks for loans, deposits and trust accounts. Further competition comes from a variety of financial intermediaries including savings and loan associations, consumer finance companies, mortgage companies and credit unions. IOBOC does business in the highly competitive southern California market and MNC's Texas banks have a small presence in southeast area of the state. Financial institutions compete for deposit accounts, loans and other business on the basis of interest rates, fees, convenience and quality of service. The mortgage banking industry in which IOMC does business is highly competitive in most of the markets it serves. MNC's non-bank subsidiaries (included in the financial institutions industry segment), which are involved in leasing, insurance and investment management, face direct competition from leasing companies, brokerage houses, large retailers and commercial finance and insurance companies. SUPERVISION AND REGULATION MNC is subject to supervision and regulation by the Federal Reserve Board under the Bank Holding Company Act of 1956, as amended. Since it is a bank holding company, the services provided by the subsidiary banks and the operations of MNC are required to be closely related to the business of banking or related financial services. MNC currently operates two national banks and one state bank, all of which are members of the Federal Reserve System, thereby supervised, regulated and subject to examination by the appropriate federal regulatory agencies. MNC also operates a federally-chartered stock savings bank which is regulated by the Office of Thrift Supervision. In addition, all MNC bank subsidiaries and its savings bank subsidiary are members of the Federal Deposit Insurance Corporation. The electronic funds transfer services of these subsidiaries are governed by both state and federal laws. As previously reported in August 1993, MNB entered into a Memorandum of Understanding (MOU) with the Central Office of the Comptroller of the Currency. Under the terms of the MOU, MNB agreed to review its management structure; risk FORM 10-K ITEM 1. BUSINESS (CONTINUED) management policies; and its mortgage banking business for the purpose of determining its appropriate role in MNB's strategic plan. ITEM 2.

ITEM 2. PROPERTIES MNC's corporate headquarters is located at 27777 Inkster Road, Farmington Hills, Michigan in a building owned by MNB. MNB occupies 199 offices throughout the State of Michigan, of which 103 are owned and 96 are leased. The initial lease terms of these properties range from one year through 20 years, while the majority have terms ranging from 5 through 10 years. The expiration of most of the leases will occur in the period 1994 through 2010. GLOSSARY Definitions of terms used in the following Management's Discussion and Analysis and Consolidated Financial Statements and Notes to Consolidated Financial Statements include: ASSISTANCE AGREEMENT An agreement entered into on December 31,1988, between Michigan National Corporation, the Federal Savings and Loan Insurance Corporation (FSLIC) and Independence One Bank of California, FSB (IOBOC), formerly Beverly Hills Federal Savings Bank (BHFSB), executed in connection with the acquisition of IOBOC, whereby FSLIC agreed to provide certain assistance to IOBOC. Under the provisions of the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA), the FDIC assumed the FSLIC's responsibilities in connection with the Assistance Agreement. BASIS POINT A unit of measure used in quantifying interest rates. One basis point is equal to 0.01%. CORPORATION Michigan National Corporation and subsidiaries. COVERED ASSETS All assets of IOBOC at the acquisition date except cash, marketable securities, premises and equipment and the Note Receivable-FDIC. CAPITAL LOSS COVERAGE Guarantee to IOBOC, provided for under the terms of the Assistance Agreement, against losses incurred on the disposition or write-down of Covered Assets. ESF Excess Service Fees, an asset that represents the present value of the difference between estimated net servicing fee income retained when mortgage loans are sold and normal servicing fee income. FCSI First Collateral Services, Inc., a mortgage warehouse lending business acquired by IOBOC on April 13, 1992. FDIC Federal Deposit Insurance Corporation FHLBB COF A cost of funds index determined and published by the Eleventh District of the Federal Home Loan Bank Board (Federal Home Loan Bank of San Francisco). The index is a composite of the weighted average cost of funds of all savings institutions in the district. FULLY TAXABLE EQUIVALENT (FTE) ADJUSTMENT The basis on which tax-exempt interest income and expense is converted to its equivalent pre-tax interest income and expense, stated in fully-taxable amounts. GUARANTEED YIELD Guaranteed interest income on Covered Assets provided for under the terms of the Assistance Agreement. The Assistance Agreement guaranteed that the Covered Asset portfolio will earn interest income at the FHLBB COF plus 250 Basis Points in 1989 and at the FHLBB COF plus 150 Basis Points from 1990 through 1992. IOBOC Independence One Bank of California, FSB, formerly Beverly Hills Federal Savings Bank. IMMEDIATELY REALIZABLE VALUE An estimate of the pre-tax value realizable if an asset were to be sold immediately for cash on an "as is" basis for purposes of determining the 1992 Capital Loss Coverage settlement. LOCKWOOD Lockwood Banc Group, Inc., the holding company for Lockwood National Bank of Houston, Texas (Lockwood Bank). NET INTEREST INCOME Net Interest Income is the difference between total interest income and total interest expense. Increases or decreases in Net Interest Income are the result of changes in the volume and mix of assets and liabilities (including off-balance sheet instruments such as interest rate swaps) and their relative sensitivity to movements in determinant interest rates. NET INTEREST MARGIN Net Interest Income on a Fully Taxable Equivalent Basis expressed as a percentage of average earning assets. NET INTEREST RATE SPREAD The difference between the average rate earned on total earning assets and the average rate paid on total interest-bearing liabilities on a Fully Taxable Equivalent Basis. NON-PERFORMING LOANS Non-accrual loans plus renegotiated loans. NON-PERFORMING ASSETS Non-performing Loans plus property from defaulted loans plus other real estate owned. NOTE RECEIVABLE-FDIC A ten year note issued by the FSLIC to IOBOC in connection with the acquisition of IOBOC that bears interest at a floating rate of FHLBB COF plus a stated premium. The interest rates applicable to the note during its term are as follows: PEOPLES/COMMUNITY BANKS Peoples National Bank, Pasadena, Texas; Peoples Bank, Houston, Texas; and Community National Bank, Friendswood, Texas acquired April 1, 1993, and merged into Lockwood Bank. PMSR Purchased Mortgage Servicing Rights, an intangible asset that represents the capitalized cost of purchasing the right to service loans originated by others. WATCH CREDITS Performing loans where the borrower's operating results are showing signs of current or possible future financial difficulties. These performing loans are subjected to closer and more frequent risk assessment reviews and closer management of the credit relationship. MANAGEMENT'S DISCUSSION AND ANALYSIS FINANCIAL REVIEW Net Income for the year ended 1993 was $23.8 million, or $1.56 per share. Net income for the year 1992, which included a one-time cumulative adjustment of $6.3 million related to the adoption of Statement of Financial Accounting Standards (SFAS) No. 109, was $66.1 million, or $4.38 per share. During 1993, earnings were significantly pressured by unprecedented mortgage refinancing activity experienced by the mortgage banking industry and the resulting accelerated prepayments in mortgage servicing portfolios. Starting in the third quarter 1992, the Corporation aggressively addressed the effect of these prepayment trends through accelerated amortization of its mortgage servicing assets. Total 1993 amortization expense for PMSR and ESF of $123.9 million was twice the $62.5 million recorded in 1992. The total net book value of these assets at December 31, 1993, was $56.3 million, a 68% decrease from $177.3 million at the end of 1992. The Corporation continued to make improvements in the area of credit quality during 1993. The level of Watch Credits, Non-performing Assets and net charge-offs all declined during the year. After reaching a high of $694 million at June 30, 1992, Watch Credits decreased to $387 million at December 31, 1993; total Non-performing Assets declined from $304.2 million at year-end 1992, to $255.2 million at December 31, 1993; net charge-offs for the year ended 1993 were $25.4 million, 52% below 1992's net charge-offs of $52.8 million. These improvements prompted a $30.7 million (43%) decrease in the provision for possible loan losses to $40.0 million in 1993 from $70.7 million in 1992. At the same time, the allowance for possible loan losses strengthened to 2.86% of total loans at December 31, 1993, up from 2.61% at December 31, 1992, and the allowance to Non-performing Loans ratio improved to 121.5% from 115.4% at year-end 1992. Net Interest Income was $401.6 million and $401.1 million in 1993 and 1992, respectively. The Net Interest Margin was 4.60% in 1993 and 4.55% in 1992. Wide interest rate spreads and effective asset/liability management, which included the use of off-balance sheet hedging strategies, contributed to the strong margin in both periods. The Net Interest Margin in both periods was further enhanced by significant increases in non-interest-bearing demand deposits. Non-interest income increased $16.0 million, or 7.1%, in 1993 compared to 1992. Growth in commercial and retail banking fee income of approximately $7.7 million plus an increase in mortgage banking gains of approximately $8.0 million were primary contributors to the increase. Approximately $2.6 million of the increase was attributable to the Corporation's recent acquisitions (FCSI in 1992 and Peoples/Community banks in 1993). Non-interest income included total one-time gains of $25.6 million in 1993, compared to one-time gains of $15.0 million in 1992. These one-time gains were offset by an increase in 1993 ESF amortization expense to $18.9 million, which was twice 1992 amortization expense of $9.5 million. Non-interest expense increased in 1993 to $580.7 million from $488.8 million in 1992. A major contributor to this increase was PMSR amortization expense, which increased $52.0 million to $105.0 million in 1993 from $53.0 million in 1992. The Corporation's recent acquisitions contributed another $11.9 million to the increase. Non-interest expense in 1993 includes retiree medical expense of $6.9 million accrued in accordance with the requirements of SFAS No. 106, which the Corporation adopted effective January 1, 1993. This is approximately $5.6 million greater than cash claims cost expensed in 1992 under cash basis accounting. Salaries and other employee benefits (excluding the aforementioned retiree medical benefit expense and expenses of recent acquisitions) increased $13.1 million, or 6.3%, from 1992. Also during 1993, the Corporation recorded a $4.6 million write-down of the assets of its Texas software subsidiary, BancA Corporation. MANAGEMENT'S DISCUSSION AND ANALYSIS (1) 1989 includes a $225 million pre-tax gain from the sale of the Corporation's credit card portfolio. (2) A fourth quarter 1993 dividend of $0.50 per share was declared January 19, 1994, payable to shareholders of record as of February 1, 1994. This does not represent a change in the Corporation's dividend policy, but rather a change only in the timing of the dividend declaration. (3) Federal Reserve Board risk-based capital guidelines were first effective March 15, 1989. (4) Based on primary earnings per common share. N/A: Not applicable. Certain prior period amounts were reclassified to conform to current period presentation. MANAGEMENT'S DISCUSSION AND ANALYSIS NET INTEREST INCOME OVERVIEW An analysis of the Corporation's average balance sheet and associated interest income, expense and average rates for each of the three years ended December 31, 1993, 1992 and 1991, is presented in Tables 2 and 3. Net Interest Income was relatively flat in 1993 compared to 1992 and increased $32.1 million, or 8.7%, in 1992 compared to 1991. Net Interest Margin was also relatively flat in 1993 compared to 1992 and increased 18 Basis Points in 1992 compared to 1991. The average balance of earning assets decreased during both periods as discussed below under Balance Sheet Composition. The principal reasons for the strong margin in both years were effective asset/liability management, which includes the use of off-balance sheet financial instruments, and the wide spread between the prime interest rate and money market rates. The Net Interest Margin in both periods was also enhanced by significant increases in non-interest-bearing demand deposits. Partially offsetting these favorable conditions in 1993 and 1992 were decreases in tax-exempt interest income. Tax-exempt interest income decreased in both periods due to lower average balances in Covered Assets and the Note Receivable-FDIC and lower FHLBB COF rates throughout both periods. Interest income from the Note Receivable-FDIC is tax-exempt and a portion of the Guaranteed Yield on Covered Assets was tax-exempt. Following is a discussion regarding the Corporation's asset/liability management and balance sheet composition. ASSET/LIABILITY MANAGEMENT Asset/Liability management involves managing the positions of interest rate sensitive assets, liabilities and off-balance sheet financial instruments used in the Corporation's investing, financing and interest rate management activities with the objective of maximizing Net Interest Income within the constraints of manageable levels of interest rate risk, while maintaining prudent levels of capital and liquidity. Changes in customer demand for various forms of loans and deposits are frequent and unpredictable and the maturities or repricing of these loans and deposits rarely match, subjecting the Corporation to interest rate risk. The Corporation's Asset/Liability Management Committee (ALCO), with the review of the Board of Directors, sets policies regarding the management of the interest rate risk of the Corporation. Policies implemented by ALCO utilize both off and on-balance sheet strategies to manage interest rate risk. Off-balance sheet hedges are used to manage a significant portion of interest rate risk that is inherent in the Corporation's banking operations. The use of interest rate swap agreements enables the Corporation to offer customers the products they desire without having to restructure the balance sheet to protect earnings when movements in interest rates occur. A significant percentage of the Corporation's commercial loan portfolios are prime-based, variable-rate loans that reprice faster than longer term deposit liabilities and which, therefore, in the falling rate environment of the past few years, created an asset sensitive balance sheet. Rather than implement strategies to restructure the balance sheet, the Corporation entered into interest rate swap agreements to mitigate this asset sensitivity. At December 31, 1993, the Corporation was hedging a portion of its prime-based, variable-rate commercial loans with approximately $2.0 billion of interest rate swap agreements. The table below summarizes these interest rate swap agreements. For further discussion of off-balance sheet financial instruments, see Note I. (1) Rate paid on the notional value varies primarily with the three and six month LIBOR rate. (2) Rate received on the notional value varies with the three month LIBOR rate. (3) Rate paid on the notional value varies with the prime rate. An interest rate sensitivity/gap analysis is presented in Table 4 for informational purposes only. The analysis summarizes the Corporation's gap between repricing or maturing assets and liabilities at a point in time. However, assets and liabilities with similar contractual repricing characteristics may not reprice at the same time nor to the same degree. As a result, the gap analysis does not necessarily predict the effect on Net Interest Income of changes in general levels of interest rates. The Corporation, in practice, measures forecasted interest rate risk through the use of an income forecasting simulation model. The model facilitates the forecasting of Net Interest Income under a variety of interest rate scenarios. At December 31, 1993, the Corporation estimated that annual Net Interest Income would increase approximately $2.7 million should a 100 Basis Point increase in the prime interest rate occur. Conversely, an estimated $5.4 million of annual Net Interest Income is at risk should a 100 Basis Point decrease in the prime rate occur. INTEREST RATE ENVIRONMENT On balance, interest rates declined throughout 1992 and 1993, and the spread between the prime rate and money market rates was wider than historical spreads. This favorable spread combined with the aforementioned interest rate swap hedge positions had the effect of lowering the MANAGEMENT'S DISCUSSION AND ANALYSIS Corporation's overall funding cost without a proportionate decrease in the earnings rate on its prime-based assets, thereby contributing to the strong Net Interest Rate Spread and Net Interest Margin for these periods. Contraction of the spread between prime and money market borrowing rates could have the effect of reducing Net Interest Margin from current levels. BALANCE SHEET COMPOSITION Earning Assets Average earning assets decreased $356.9 million, or 3.7%, from 1992 to 1993. Reductions in the average balances of Covered Assets, the Note Receivable-FDIC, investment securities and the short-term commercial real estate-construction loan portfolio were the principal contributors to the decrease. The average balance of Covered Assets declined primarily as a result of sales and a formal valuation process conducted in connection with the 1992 Capital Loss Coverage settlement provision of the Assistance Agreement. Reference Note E for further information on the Assistance Agreement. According to the terms of the Assistance Agreement, any remaining Covered Assets were required to be written down to their Immediately Realizable Value by December 31, 1992, and IOBOC reimbursed for the write-down amount. After payment of the Capital Loss Coverage settlement, the assets were no longer "covered" for purposes of Guaranteed Yield and Capital Loss Coverage. This process was completed during the first quarter of 1993. Those assets which the Corporation intended to sell were transferred to the Assets Held for Sale account (included in Other Assets on the Statement of Condition). IOBOC contracted with an independent party to market these assets. During 1993 and 1992, net gains of $0.5 million and $0.3 million, respectively, were realized in connection with sales of these assets. At December 31, 1993, the balance remaining in the Assets Held for Sale account was $0.7 million. Approximately $77 million of previously Covered Assets, which the Corporation intends to hold, were transferred to the performing residential and commercial real estate-mortgage loan accounts late in 1992. Due to the discounted value of these loans, their average yield is substantially higher than the yield on Covered Assets. The decline in the average balance of the Note Receivable-FDIC was due to two FDIC principal payments made since the beginning of 1992. The FDIC made principal payments of approximately $105 million and $162 million in January, 1992, and January, 1993, respectively. The FDIC also made principal payments of approximately $81 million in May, 1991 and $114 million in January, 1994. The Corporation accepted these payments, reserving its rights under the terms of the note to challenge them as being made prematurely. According to the Corporation's interpretation of the terms of the note the prepayments could not have been made until December 31 of the respective years. Furthermore, the Corporation has recently resumed discussions with representatives of the FDIC to determine if, or on what terms, the Assistance Agreement might be terminated. A termination could involve the early pay-off of the Note Receivable-FDIC, an early settlement of the value of deposit subsidies and early settlement of the FDIC's right to receive a return on its equity capital investment. The accounting treatment of any gain or loss resulting from an early termination and settlement of the Assistance Agreement is under review at this time and is contingent upon the actual results of the negotiations. The Corporation is under no obligation to renegotiate the Assistance Agreement. Reimbursement of write-downs and proceeds from sales of Covered Assets, and Note Receivable-FDIC principal payments were used to pay down higher cost discretionary liabilities and to fund the April 13, 1992, acquisition of a mortgage warehouse lending business. The average balance of total investment securities was also lower in 1993 principally as a result of security sales in December 1992 of approximately $125 million, and in 1993 of approximately $221 million. In addition, accelerated payments on amortizing mortgage-backed securities contributed to the lower average balance of total investment securities. Cash proceeds from the December 1992 security sales were used to pay down higher cost funding sources. Cash proceeds from the 1993 security sales along with payments on amortizing mortgage-backed securities were used to purchase new securities with original average maturities ranging from 2.5 to 6.5 years. Refer to the Investment Securities section for additional information regarding these sales. The short-term commercial real estate-construction loan portfolio declined significantly since the beginning of 1991. This decrease is a result of a managed effort to reduce the Corporation's commercial real estate exposure. Partially offsetting these decreases in earning assets was an increase in the average balance of residential mortgages, the addition of earning assets from the Corporation's recent acquisitions and an increase in the average balance of consumer loans. Growth in IOMC's portfolio of prime plus mortgage loans since the latter half of 1992 contributed to the increase in residential mortgage loans. However, during September 1993, approximately $300 million of prime plus mortgage loans were sold. The loans were sold principally to prevent possible future economic loss associated with the prepayment risk inherent in the portfolio. The remaining balance in this portfolio was approximately $67 million at December 31, 1993, and the Corporation now intends to manage this portfolio as held for sale. Cash proceeds from the sale of these loans were invested temporarily in money market investments and are being used to pay down higher cost discretionary liabilities as they mature. Also contributing to the growth in the residential mortgage loan portfolio MANAGEMENT'S DISCUSSION AND ANALYSIS were purchases of Federal Housing Administration (FHA) insured loans during the third and fourth quarters of 1993 (average balance for 1993 of approximately $43 million and period end balance at December 31, 1993, of approximately $122 million). Interest income on these loans was accrued at a weighted average rate of 9.11% during 1993. (Refer to the Loans and Lease Financing Portfolio and Credit Risk Analysis section). Earning assets from the Corporation's recent acquisitions of Peoples/Community Banks and a mortgage warehouse lending business (refer to Note B) also partially offset the above decreases. Peoples/Community Banks, acquired April 1, 1993, contributed loans with an average balance of approximately $58 million. The Corporation's April 13, 1992, acquisition of a mortgage warehouse lending business (operating as FCSI) contributed earning assets with an average balance of approximately $259 million, including $257 million of commercial loans for 1993. During 1992, the business contributed approximately $129 million of earning assets, including approximately $122 million of commercial loans. The average balance of the Corporation's installment loan portfolio increased $56.1 million (excluding the installment loan portfolio of Peoples/Community Banks), or 9%, from $636.2 million for the year ended December 31, 1992, to $692.4 million for 1993. This increase was principally attributable to growth in consumer loans due to the low interest rate environment and successful marketing of the Capital Reserve line of credit product. Interest-Bearing Liabilities The Corporation's funding mix continued to shift throughout 1992 and 1993 as a result of the liquidity provided by the decreases in earning assets discussed above and the current low interest rate environment. The Corporation used some of the liquidity provided by the decrease in earning assets to reduce higher cost discretionary funding sources, primarily time deposits greater than $100,000. The average balances of lower cost savings and money market accounts grew as a percentage of total interest-bearing liabilities while higher cost time deposits greater than $100,000 decreased. Also contributing to this change in funding mix were deposit pricing strategies and customer preferences for shorter term and more liquid deposit products in the current low interest rate environment. This rate environment has also induced some customers to seek higher returns in traditional non-bank financial products, contributing to the decrease in time deposits less than $100,000. There was a significant decrease in the average balance of short-term borrowings during 1993 and 1992. Liquidity provided by increases in non-interest-bearing demand deposits along with reductions in certain earning assets discussed above reduced the Corporation's need for these discretionary borrowings. The Peoples/Community Banks acquisition contributed interest-bearing deposits with an average balance of approximately $53 million for 1993. Under the terms of the Assistance Agreement, the FDIC subsidizes interest expense on certain time deposits through the earlier of the date of their maturity or December 31, 1998. At December 31, 1993, the balance of subsidized time deposits was approximately $143 million. The subsidy limits the interest expense on those deposits to the FHLBB COF. In addition, an interest subsidy of approximately 6% was paid on a long-term debt obligation of IOBOC. This obligation was paid off during 1992. The amount of FDIC interest expense subsidy received during 1993 and 1992 was $13.3 million and $14.1 million, respectively. 1992 VS. 1991 The level of average earning assets was relatively constant from 1991 to 1992. Reductions in the average balances of Covered Assets, the Note Receivable-FDIC and the commercial real estate loan portfolios that were experienced throughout 1991 and 1992 were offset by growth in the portfolio of residential loans and by assets added through acquisitions. Lockwood, acquired October 31, 1991, contributed earning assets with an average balance of approximately $212 million during 1992, and $35 million during 1991. The addition of earning assets from FCSI during 1992 is discussed above. The decrease in the average balance of interest-bearing liabilities from 1991 to 1992 was due to the 1992 reductions discussed above. Lockwood contributed interest-bearing liabilities with an average balance of approximately $156 million in 1992 and $26 million in 1991. EFFECT OF BALANCE SHEET COMPOSITION ON NET INTEREST MARGIN The Net Interest Rate Spread and Net Interest Margin in 1993 were relatively flat compared to those of 1992. The decline in the average rate paid on interest-bearing liabilities resulting from the favorable change in funding mix was offset by a similar decline in the average rate received on earning assets due to decreases in certain higher yielding earning assets discussed above. The favorable change in the Corporation's funding mix was also the primary on-balance sheet contributor to the improvement in Net Interest Rate Spread and Net Interest Margin in 1992 compared to those of 1991. The average rate paid on the Corporation's interest-bearing funds declined more than the average rate received on earning assets, contributing to the improvement in the above ratios. Both 1993 and 1992 ratios were enhanced by significant increases in the average balance of non-interest-bearing demand deposits. The average balance of non-interest-bearing demand deposits increased approximately $263 million in 1993, and $292 million in 1992, over the balance in the respective preceding year. The increases in non-interest-bearing demand deposits resulted from higher balances in commercial and retail banking customer accounts and the collection of payoffs on loans in the Corporation's off-balance sheet mortgage servicing portfolios. The payoffs collected are temporarily held and invested before being remitted to investors. MANAGEMENT'S DISCUSSION AND ANALYSIS (1) The average balance of loans and lease financing is net of unearned income and includes Non-performing Loans. (2) The tax equivalent adjustment is computed using a federal income tax rate of 34% in 1993, 1992 and 1991, as adjusted for the loss of interest expense deductions associated with tax-exempt obligations acquired after August 7, 1986, in accordance with the Tax Reform Act of 1986. Certain prior period amounts have been reclassified to conform to current period presentation. The rate/volume variance is allocated to the rate variance and the volume variance on the basis of the percentage relationship of each to the sum of the two. MANAGEMENT'S DISCUSSION AND ANALYSIS MANAGEMENT'S DISCUSSION AND ANALYSIS (1) Excluding commercial and residential real estate-mortgage, installment and lease financing loans. Demand loans and overdrafts are classified as due within one year. MANAGEMENT'S DISCUSSION AND ANALYSIS NON-INTEREST INCOME Non-interest income, largely fee-based, remains an important supplement to Net Interest Income in the increasingly competitive financial services industry. Non-interest income increased $16.0 million, or 7.1%, in 1993 compared to 1992, and $34.8 million, or 18.3%, in 1992 compared to 1991. Refer to Table 7 for a comparative analysis of the components of non-interest income. Also, refer to the Business Review section and Table 15 for summary financial information regarding the Corporation's principal subsidiaries. Following is a discussion of the major transactions included in the comparative analysis in Table 7. 1993 VS. 1992 Activity at the Corporation's mortgage banking subsidiary, IOMC, was a significant contributor to the increase in non-interest income. During 1993, IOMC realized a $10.1 million gain from the sale of approximately $300 million of prime plus residential mortgage loans, reflected in the mortgage banking gains category. The remaining balance in this portfolio was approximately $67 million at December 31, 1993, and the Corporation now intends to manage this portfolio as held for sale. This sale is discussed in the Net Interest Income section. Excluding the gain from the sale of prime plus loans, 1993 mortgage banking gains from the sale of loan production were $19.5 million compared to mortgage banking gains (1) New businesses include: Lockwood, acquired 10/31/91; Independence One Asset Management Corporation, start-up 11/12/91; First Collateral Services, Inc., acquired 4/13/92; BancA Corp., acquired 7/29/92 and Peoples/Community Banks, acquired 4/1/93. (2) Includes inter-company eliminations. Certain prior period amounts have been reclassified to conform to current period presentation. MANAGEMENT'S DISCUSSION AND ANALYSIS in 1992 of $11.5 million. This increase is principally due to an increase in the volume of loans sold with servicing released. In addition, net gains of $9.3 million were recognized from the sales of the mortgage servicing rights for approximately $2.5 billion of loans. The gains of $9.3 million were net of approximately $15.2 million of PMSR and ESF assets written off in the sale. Net gains in 1992 were $5.8 million from sales of the mortgage servicing rights for approximately $579 million of loans. Unprecedented refinancing activity resulted in accelerated prepayments (runoff) in IOMC's off-balance sheet servicing portfolios which required the acceleration of the amortization of ESF. The 1993 amortization expense of 18.9 million was twice that of $9.5 million for 1992, reducing mortgage servicing income. In addition, the net runoff in the servicing portfolios was the principal reason for the $3.4 million decrease in mortgage servicing fees. Refer to the Business Review section for further discussion of IOMC's business activities. Approximately $2.6 million of the increase in non-interest income was attributable to the Corporation's recent acquisitions (FCSI in 1992 and Peoples/Community Bank in 1993). 1992 VS. 1991 As in 1993, IOMC was a significant contributor to the increase in non-interest income in 1992 from 1991. Mortgage servicing fees, before amortization of ESF, increased $9.4 million, or 16.5%, due to the significant net growth in the mortgage servicing portfolios in 1992. The extraordinary increase in refinancing loan production during 1992 resulted in a $6.3 million, or 120%, increase in mortgage banking gains. (1) New businesses include: Lockwood, acquired 10/31/91; Independence One Asset Management Corporation, start-up 11/12/91; First Collateral Services, Inc., acquired 4/13/92; BancA Corp., acquired 7/29/92 and Peoples/Community Banks, acquired 4/1/93. (2) Includes inter-company eliminations. Certain prior period amounts have been reclassified to conform to current period presentation. (1) New businesses include: Lockwood, acquired 10/31/91; Independence One Asset Management Corporation, start-up 11/12/91; First Collateral Services, Inc., acquired 4/13/92; BancA Corp., acquired 7/29/92 and Peoples/Community Banks, acquired 4/1/93. (2) Includes inter-company eliminations. Certain prior period amounts have been reclassified to conform to current period presentation. MANAGEMENT'S DISCUSSION AND ANALYSIS NON-INTEREST EXPENSE Non-interest expense increased $91.9 million, or 18.8%, in 1993 compared to 1992, and $77.9 million, or 19.0%, in 1992 compared to 1991. Refer to Table 8 for a comparative analysis of the components of non-interest expense for the years ended December 31, 1993, 1992, and 1991. Following is a discussion of the major transactions included in the comparative analysis in Table 8. 1993 VS. 1992-The major contributor to higher expenses in 1993 was an approximate 100% increase in PMSR amortization expense to $105.0 million for the year ended 1993 from $53.0 million during 1992. This increase is directly attributable to the accelerated prepayments in the purchased servicing portfolios resulting from the extraordinary volume of refinancing activity that continued through most of 1993. The Corporation's recent acquisitions contributed another $11.9 million to the increase in non-interest expense. Effective January 1, 1993, the Corporation's FDIC deposit insurance assessment increased from twenty-three Basis Points to twenty-six Basis Points resulting in a $2.0 million increase in FDIC insurance expense. During the second quarter 1993, the Corporation recognized a $4.6 million one-time write-down of the assets of the Corporation's Dallas, Texas software subsidiary, BancA Corporation, due to a longer than expected sales cycle for bank software products. Virtually all the assets of BancA Corporation were sold effective October 1, 1993. The sale transaction did not result in any further loss to the Corporation. Other employee benefits for the year ended December 31, 1993, include retiree medical benefit expense of $6.9 million accrued in accordance with SFAS No. 106, which was adopted January 1, 1993. This compares to retiree medical claims expense of $1.3 million recognized in 1992 under cash basis accounting. Effective December 31, 1993, the Corporation reduced the discount rate used to measure the present value of pension and post retirement health care benefit obligations from 8.5% to 7.0%. The change in discount rate will have the effect of increasing future annual expense accruals for these (1) New businesses include: Lockwood, acquired 10/31/91; Independence One Asset Mangement Corporation, start-up 11/12/91; First Collateral Services, Inc., acquired 4/13/92; BancA Corporation, acquired 7/29/92 and Peoples/Community Banks, acquired 4/1/93. 1993 activity includes the $4.6 million on-time write-down of BancA Corporation assets. (2) Includes inter-company eliminations. (3) Non-interest expense less non-interest income divided by average earning assets. (4) Non-interest expense divided by the sum of Net Interest Income (Fully Taxable Equivalent) and non-interest income. MANAGEMENT'S DISCUSSION AND ANALYSIS benefits. The Corporation's current projection of these increases is an estimated $2.5 million for pension benefit expense and an estimated $1.5 million for postretirement health care benefit expense. See Note P and Note Q for further information regarding these benefit obligations. 1992 VS. 1991-Excluding increases attributable to the Corporation's recent acquisitions and a one-time charge in 1991, non-interest expense for 1992 increased $72.7 million over 1991. The one-time charge represented a write-off of intangible assets totaling $8.1 million and is included in other expense ($6.4 million) and amortization of goodwill ($1.7 million). As in 1993, the principal contributor to the year-over-year increases in total non-interest expense was an increase in PMSR amortization expense at IOMC. Significant operating expense increases, principally salaries and wages, were also incurred to process the unusually high volume of refinancing activity. The negative effect the depressed commercial real estate industry had on certain borrowers resulted in significant increases in the Corporation's holdings of foreclosed (legal and in-substance) commercial real estate and associated defaulted loan expense during 1992 and 1991. The increase in FDIC insurance was attributable to an increase in the assessment from nineteen and one-half Basis Points to twenty-three Basis Points effective July 1, 1991. NEW ACCOUNTING STANDARDS Two new accounting standards were recently issued which affect the measurement of employee benefit costs. The Financial Accounting Standards Board has issued SFAS No. 112, Employer's Accounting for Postemployment Benefits. The Corporation will adopt this Statement in the first quarter of 1994. The American Institute of Certified Public Accountants has issued Statement of Position No. 93-6, Employer's Accounting for Employee Stock Ownership Plans. This Statement is effective for fiscal years beginning after December 31, 1993, and applies to shares acquired by employee stock ownership plans after December 31, 1992. Refer to Note A for further information on these new accounting standards. (1) New businesses include: Lockwood, acquired 10/31/91; Independence One Asset Mangement Corporation, start-up 11/12/91; First Collateral Services, Inc., acquired 4/13/92; BancA Corporation, acquired 7/29/92 and Peoples/Community Banks, acquired 4/1/93. 1993 activity includes the $4.6 million on-time write-down of BancA Corporation assets. (2) Includes inter-company eliminations. (3) Non-interest expense less non-interest income divided by average earning assets. (4) Non-interest expense divided by the sum of Net Interest Income (Fully Taxable Equivalent) and non-interest income. (1) New businesses include: Lockwood, acquired 10/31/91; Independence One Asset Mangement Corporation, start-up 11/12/91; First Collateral Services, Inc., acquired 4/13/92; BancA Corporation, acquired 7/29/92 and Peoples/Community Banks, acquired 4/1/93. 1993 activity includes the $4.6 million on-time write-down of BancA Corporation assets. (2) Includes inter-company eliminations. (3) Non-interest expense less non-interest income divided by average earning assets. (4) Non-interest expense divided by the sum of Net Interest Income (Fully Taxable Equivalent) and non-interest income. MANAGEMENT'S DISCUSSION AND ANALYSIS INCOME TAXES For the years 1993 and 1992, the Corporation determined income tax expense in accordance with SFAS No. 109, which was adopted effective January 1, 1992. A $6.3 million cumulative effect on prior years of adopting the new standard was recognized in 1992. Prior to January 1, 1992, the Corporation determined income tax expense under the provisions of SFAS No. 96. SFAS No. 109 supersedes SFAS No. 96. The difference between the effective income tax rate and the statutory rate (35% in 1993, 34% in 1992 and 1991) in each of the three years ended December 31, 1993, 1992, and 1991, is principally due to the recognition of tax benefits derived from tax-exempt assistance received by IOBOC from the FDIC, as well as tax-exempt interest income from municipal obligations. Further information regarding the assistance received from the FDIC can be found in Note E. A detailed reconciliation to the statutory income tax rate is presented in Note V. The effective tax rate was (9.2)% in 1993 compared to an effective rate of 10.0% in 1992 and 18.8% in 1991. The change in the effective tax rate from 1992 to 1993 was principally due to an increase in the percentage of tax-exempt income relative to total pre-tax income. In addition, the Omnibus Budget Reconciliation Act of 1993 increased the normal corporate statutory tax rate by 1 % to 35% for calendar year 1993. This rate change increased the value of the Corporation's net deferred tax assets, which contributed to the reduction of the effective tax rate. The decrease in the effective tax rate to 10.0% for 1992 from 18.8% for 1991 was primarily due to the recognition of deferred tax benefits under the provisions of SFAS No. 109 that the Corporation could not otherwise recognize under SFAS No. 96. For further detail regarding the Corporation's income tax provisions for each of the three years ended December 31, 1993, 1992 and 1991, refer to Note V. The U.S. Department of Treasury and the Internal Revenue Service have indicated that they will contest tax deductions for losses and expenses reimbursed by assistance from the FDIC. Refer to Note V for additional information regarding the contingencies associated with this issue. INVESTMENT SECURITIES The management of the investment portfolios is an important component of the overall management of the Corporation's balance sheet. Investment portfolio management requires diversification of risk and the ability to satisfy bank pledging requirements. The investment portfolios are structured so that sufficient marketable securities mature periodically or can be easily liquidated. Effective December 1992, the Corporation accounts for its investment securities in one of two portfolios-Investments held-to-maturity and Investments available-for-sale. The accounting policies applicable to these two portfolios are presented in Note A. Security holdings that management intends to retain until maturity are classified as Investments held-to-maturity. Investments which may be utilized for active management of interest rate risk or liquidity are classified in the available-for-sale portfolio. In December 1992 and the first quarter 1993, the Corporation transferred a total of approximately $312 million of mortgage-backed securities, and approximately $54 million of short-term U.S. Government Treasury bills to this portfolio. Prior to the transfers the Corporation had both the positive intent and ability to hold those securities for the foreseeable future. However, management considered it prudent to make the transfers because the market characteristics of those securities could make them more susceptible to more active management sometime prior to maturity. Once these securities were transferred to the available-for-sale portfolio, they were subject to "lower of cost or market" accounting with the potential for future unrealized market losses below cost creating a new risk to capital. In December, 1992, the Corporation sold approximately $125 million of these securities for a net gain of approximately $8.0 million, and during 1993, the Corporation sold approximately $221 million for net gains of approximately $6.3 million. The Financial Accounting Standards Board has issued SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. This Statement requires investment in equity and debt securities be classified in three categories and accounted for as follows: (i) debt securities that the Corporation has the positive intent and ability to hold to maturity are classified as held-to-maturity securities and reported at amortized cost; (ii) debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings; (iii) debt and equity securities not classified as either held-to-maturity securities or trading securities are classified as available-for-sale securities and reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of shareholders' equity. The Statement is effective for financial statements with fiscal years beginning after December 15, 1993. The Corporation will adopt this Statement in the first quarter of 1994 and does not expect that adoption will have a material adverse effect on its financial condition. The Corporation's investments held-to-maturity portfolio consists of four types of securities: (a) U.S. Treasury, Government agencies and corporations (b) state and municipal, (c) mortgage-backed securities and (d) other securities. Refer to Note D for further detailed disclosures regarding the investment portfolio. Declining interest rates have resulted in accelerated principal prepayment of mortgage-backed securities. The mortgage-backed securities portfolio balance at December 31, 1993, was $1.0 billion with an expected weighted average maturity of 2.36 years and an average yield of 6.62%. This compares to a balance of $1.0 billion at December 31, 1992, with an expected weighted average maturity of 3.2 years and an average yield of 7.76%. In an effort to mitigate some of the prepayment risk associated with the mortgage-backed portfolio, the Corporation sold approximately $70.2 million of pass-through certificates in a coupon roll down transaction during the first quarter 1992. That is, higher coupon rate certificates were sold and the proceeds immediately reinvested in lower coupon securities. This sale resulted in gains of $1.9 million. LOANS AND LEASE FINANCING PORTFOLIO AND CREDIT RISK ANALYSIS OVERVIEW Credit quality continued to improve during 1993 as evidenced by reductions in the level of Watch Credits, Non-performing Assets and net charge-offs. After reaching a high of $694 million at June 30, 1992, Watch Credits decreased to $387 million at December 31, 1993; total Non-performing Assets declined from $304.2 million at year-end 1992, to $255.2 million at December 31, 1993; net charge-offs for the year ended 1993 were $25.4 million, 52% below 1992's net charge-offs of $52.8 million. Further improvement in credit quality will continue to be a major focus of the Corporation in 1994. The Corporation's total loans and lease financing were relatively flat compared to year-end 1992 total outstandings. Net increases in consumer loans; commercial real estate mortgages and lease financing were offset by net decreases in residential real estate-mortgages; short-term real estate-construction; and commercial loans. A discussion of the loan portfolio composition, management of credit risk and loan quality follows. LOAN PORTFOLIO COMPOSITION Table 9 provides a five year presentation of the Corporation's loan portfolio. A breakdown of the Corporation's outstanding commercial loans secured by real estate and other commercial loans by industry and geographic concentrations at December 31, 1993 are presented in Table 9a. Table 9b presents the Corporation's outstanding short-term commercial real estate construction loans and commercial real estate-mortgage loans by collateral type and geographic concentration at December 31, 1993. The installment loan portfolio increased $132.4 million, or 20%, to $780.5 million at December 31, 1993, from $648.1 million at year-end 1992. This increase was principally attributable to growth in secured and unsecured direct consumer loans due to the low interest rate environment and successful marketing of the unsecured Capital Reserve line of credit product. Mortgage loan refinancing activity subsided in late 1993 and contributed to the reduction of the residential mortgage loan portfolio. Another major contributor to the decrease in residential mortgage loans was a sale of a $300 million prime-rate-based residential loan portfolio. This sale is further discussed in the Net Interest Income section. The remaining balance in this portfolio was approximately $67 million at December 31, 1993, and the Corporation now intends to manage this portfolio as held for sale. Partially offsetting these decreases was the purchase of approximately $122 million of FHA insured residential mortgages that are over 90 days delinquent in Government National Mortgage Association (GNMA) mortgage pools serviced by IOMC. The FHA insures 100% of the principal balance of these loans and interest is insured at an FHA debenture rate less two months interest for those loans that become foreclosure loans. These past due but still accruing loans are excluded from the Corporation's Non-performing Asset totals. The Corporation is accruing interest income on these loans at FHA debenture rates. The weighted average debenture rate for this portfolio was 9.11% at December 31, 1993. The loans' contractual interest rates in all cases exceed the FHA debenture rate and, for those loans that are brought current by the borrower, interest income received in excess of the debenture rate is recognized on a cash basis only. The purchase reduces IOMC's risk of loss associated with those loans that might become foreclosure loans. That is, IOMC will not have the expense of reimbursing GNMA for the difference between the contractual interest and the FHA debenture rate. Other costs associated with foreclosure are the obligation of IOMC regardless of whether the loans have been purchased or remain in GNMA pools. The commercial loan portfolio declined slightly during 1993 due, in part, to alternative funding opportunities which are available to customers in the private placement and syndication markets. The Corporation expects modest increases in loan volume during 1994, continuing to concentrate on middle market business. MANAGEMENT'S DISCUSSION AND ANALYSIS MANAGEMENT OF CREDIT RISK The Corporation's senior credit officer reports directly to the Chairman and Chief Executive Officer and is responsible for credit policies designed to reduce the credit risk of the Corporation. This structure provides for greater focus on general credit policies and their consistent application on a corporate wide basis. The Corporation utilizes a committee structure as the primary mechanism for credit approval. A comprehensive risk rating system is employed for commercial and commercial real estate loans in excess of $10 thousand. The risk rating of a loan is based upon the borrower's financial condition, industry analyses and other factors. If a loan is performing but the borrower's operating results are showing signs of current or possible future financial difficulties, the loan is classified as a Watch Credit. These performing loans are subjected to closer and more frequent risk assessment reviews and closer management of the credit relationship. The Corporation's Watch Credits totaled $387 million at December 31, 1993, a significant decline from $539 million at December 31, 1992. Improvement in the financial condition of certain borrowers was a significant contributing factor to this decline. If and when the current and/or projected financial condition of a borrower reaches a point where, in management's judgment, serious doubt of repayment of principal or interest exists, the loan is placed in a non-accrual or in-substance foreclosure status. Non-performing and in-substance foreclosure loans and property from defaulted loans are generally reassigned to departments that specialize in the management of such assets as well as the management and marketing of properties from defaulted loans with the objective of maximizing the Corporation's return, or minimizing any loss. (1) During 1990, the Corporation undertook a project whereby its loans were reclassified in accordance with definitions which better reflect the relative risk characteristics of those loans. Prior year data was not restated because the 1990 reclassifications did not materially change the respective categories. (2) Loans classified as Watch Credits are included in the above loan balances. N/A: Not Available. MANAGEMENT'S DISCUSSION AND ANALYSIS Table 9a. Commercial, Financial and Agricultural Loans Outstanding at DECEMBER 31, 1993 (in thousands) (1)During 1993 the Corporation redefined its industry categories from Standard Industrial Classification codes to internally developed definitions which are based on the primary market in which the borrower operates. Table 9b. Short-Term Commercial Real Estate-Construction and Commercial Real Estate-Mortgage Loans Outstanding at DECEMBER 31, 1993 (in thousands) MANAGEMENT'S DISCUSSION AND ANALYSIS NON-PERFORMING ASSETS Non-performing Assets continued to decrease in 1993 to $255.2 million, the lowest level since September 30, 1990, from a high of $348 million at March 30, 1991. The high level of Non-performing Assets in recent years was due to the weak economy's effect on individual borrowers and the deterioration in real estate values which were caused by an excess supply of commercial real estate properties in several market areas. Loans are generally placed in non-accrual status when 90 days or more past due, or sooner when there is serious doubt as to the collectability of future interest or principal. While in non-accrual, cash payments received (both principal and interest) are generally applied as a reduction of the principal balance. Property from defaulted loans includes both foreclosed and in-substance foreclosed properties, which are recorded at the lower of the investment in the related loan or the fair market value of the foreclosed property less estimated costs to sell the asset. Cash payments received on in-substance foreclosed properties are recorded based on the source of the payment. Payments sourced from the operation of the property are recorded as defaulted loan income; payments from other sources (i.e. sale of property) are recorded as reductions of the principal balance. Table 10 provides a five year presentation of the Corporation's Non-performing Assets and Table 10a presents the 1993 activity in commercial and commercial real estate Non-performing Assets. Table 10b presents a break down of commercial loans secured by real estate and other commercial Non-performing Assets by industry and geographic concentrations at December 31, 1993. A break down of the short-term commercial real estate-construction and commercial real estate-mortgage Non-performing Assets by collateral type and by geographic concentration at December 31, 1993, is presented in Table 10c. As the economy improves, a continuing decline in the level of Non-performing Assets is expected. In 1994, the Corporation will continue to focus its efforts on reducing Non-performing Assets through successful marketing of property from defaulted loans. At December 31, 1993, the Corporation had only $7 million of unfunded commitments associated with its Non-performing Assets which it may fund under certain circumstances. The following table presents the estimated interest income on Non-performing Assets held at December 31 that would have been recognized in each year during the period that such assets were in a non-performing status. PROFORMA INTEREST INCOME Actual cash interest received during 1993, 1992 and 1991 on Non-performing Assets held at December 31 of each year, while such assets were in an accruing status, was $14.7 million, $19.9 million and $10.5 million, respectively. MANAGEMENT'S DISCUSSION AND ANALYSIS Certain prior period amounts have been restated for a change in reporting classification to exclude loans that are 90 days or more past due and still accruing and to include real estate of discontinued operations. Loans 90 days or more past due and still accruing at December 31, 1993, 1992, 1991, 1990 and 1989, were $118,363, $2,087, $2,049, $4,445 and $1,564, respectively. At December 31, 1993, 97.5% of loans 90 days or more past due and still accruing were insured by the FHA. N/A: Not Available Management's Discussion and Analysis (1) Loans are returned to performing status after a reasonable period of sustained performance and the borrower's financial condition has improved to a point where doubt as to repayment of principal and interest no longer exists. (2) Represents net activity for assets with a carrying value generally less than $250 thousand. Prior period amounts have been restated for a change in reporting classification to exclude loans that are 90 days or more past due and still accruing. (1)During 1993 the Corporation redefined its industry categories from Standard Industrial Classification codes to internally developed definitions which are based on the primary market in which the borrower operates. MANAGEMENT'S DISCUSSION AND ANALYSIS ALLOWANCE FOR POSSIBLE LOAN LOSS Provisions are made to the allowance for possible loan losses in amounts necessary to maintain the allowance at a level considered by management to be sufficient to provide for risk of loss inherent in the loan portfolio. Determining the adequacy of the allowance for possible loan losses involves a disciplined quarterly analysis. The analysis ensures that all relevant factors affecting loan collectability are consistently applied. The analysis of the allowance relies mainly on historical loss ratios, current general economic and industry trends, and the current and projected financial condition of certain individual borrowers. Specific allocations of the allowance are assigned to individual loans where serious doubt of full principal repayment exists. General allocations of the allowance are assigned to the remaining portfolio primarily on the basis of historical loss factors. The historical loss factors are determined on the basis of past charge-off experience identified by portfolio type and, within each portfolio type, identified by risk rating. A migration analysis is utilized to support the calculation of the allowance and evaluate the overall reasonableness. Management believes the allowance for possible loan loss at December 31, 1993, is adequate based on the risks identified in the various loan categories. The Corporation places more emphasis on estimates of a property's net realizable value and a borrower's equity position in the collateral, and less emphasis on secondary collateral values and personal guarantees when assessing the need for charge-off. The Corporation's Appraisal Review Department is responsible for establishing and maintaining property appraisal policies in accordance with regulatory guidelines. The frequency of re-appraisal is determined based upon several factors, including the loan's risk rating. Table 11 presents a five year summary of charge-off, recovery and provision activity within the allowance. The decline in the provision and the corresponding improvement in the ratio of allowance for possible credit losses to year-end loans and in the ratio of allowance for possible credit losses to Non-performing Loans is primarily attributable to declines in the levels of Non-performing Assets over the past two years. Table 12 presents a five year summary of the allocation of the allowance among the various loan categories. NEW ACCOUNTING STANDARD The Financial Accounting Standards Board has issued SFAS No. 114, Accounting by Creditors for Impairment of a Loan. The Corporation plans to adopt this Statement in 1995. Refer to Note A for further information on this new accounting standard. MANAGEMENT'S DISCUSSION AND ANALYSIS N/A: Not Available - ------------------------------------------------------------------------------ CROSS BORDER OUTSTANDINGS At December 31, 1993, there was $76 million of deposits and interest bearing investments outstanding with banks in the United Kingdom. At December 31, 1992 and 1991 there were $118 million and $303 million, respectively, of deposits and interest bearing investments outstanding with banks in Japan. MANAGEMENT'S DISCUSSION AND ANALYSIS (1)This table represents an estimated allocation of the allowance and is provided only as an indication of the relative risk assessment of the components of the loan portfolio. The allowance for loan losses is a general allowance available to cover losses in any category of the loan portfolio. - ------------------------------------------------------------------------------ LIQUIDITY AND CAPITAL RESOURCES The Corporation's liquidity and capital positions remain strong and management believes that the strength of its liquidity and capital levels will support its various business activities. During 1993, the Corporation continued to manage the asset/liability process toward a prudent level of increased liquidity, thereby enhancing balance sheet strength. This has been achieved, in part, by maintaining high levels of short-term, liquid investments and low levels of discretionary and credit-sensitive, short-term borrowings. The capital position of the Corporation is an important factor in developing corporate strategies and achieving established goals. Management reviews the various capital measures weekly and takes appropriate action to ensure that they are within established internal and regulatory guidelines. The Corporation's capital position substantially exceeds guidelines established by the industry regulators. LIQUIDITY MANAGEMENT The purpose of liquidity management is to ensure sufficient cash flow to meet all financial commitments and enable the Corporation to capitalize on opportunities for business expansion. The parent company manages its liquidity position to provide the cash necessary to service debt, pay dividends, and satisfy other operating requirements. Its primary sources of funds are dividends and fees from subsidiaries, borrowings and, from time to time, proceeds from equity issuances. The parent company has sufficient cash resources to cover fixed charges and cash dividend payments. The common stock cash dividend coverage ratio at December 31, 1993, was 63.7% and the fixed charge coverage ratio was 272.5%. These ratios have declined over 1992 and 1993, principally due to the depressed earnings at IOMC (a subsidiary of the Corporation's principal bank subsidiary), which have had the effect of reducing the availability of subsidiary dividends as a source of cash. Consideration of regulatory capital requirements governing the subsidiary banks and the subsidiary savings and loan are employed in determining the payment of dividends by the respective subsidiaries to the parent company. Current banking laws and regulations place limitations on the ability of national banks to pay cash dividends in order to prevent capital impairment. The subsidiary banks and the subsidiary savings and loan are in compliance with the regulatory dividend limitation guidelines as of December 31, 1993. Dividends paid to the parent company in 1993 totaled $40.5 million. At December 31, 1993, the subsidiaries had retained earnings of approximately $33.0 million available to pay dividends to the parent company without regulatory approval. The subsidiary banks and subsidiary savings and loan manage liquidity to meet the needs of borrowers and to honor deposit withdrawals. Subsidiary liquidity is derived from deposit growth, short-term borrowings, short-term investments, and the sale and maturity of investment securities. Reference Table 13 for a presentation of the Corporation's funding structure. LIQUIDITY POSITION The following discussion of the Corporation's liquidity position should be read in conjunction with the Consolidated Statement of Cash Flows. The Corporation's cash and cash equivalents were $1.0 billion at December 31, 1993, and December 31, 1992, compared to $811.2 million at December 31, 1991. MANAGEMENT'S DISCUSSION AND ANALYSIS - ---------------------------------------------------------------------------- Cash provided by investing activities totaled $428.9 million, $130.5 million and $621.0 million for the year ended December 31, 1993, 1992 and 1991, respectively. The sale of securities and prime plus loans as well as the repayment and maturities of securities, loans and the Note Receivable-FDlC enhanced the liquidity position of the Corporation in 1993. Cash proceeds from these transactions were used to pay down higher cost discretionary liabilities and to purchase securities and money market instruments (refer to the Net Interest Income section for further discussion of these transactions and for discussion of the possible early settlement of the Note Receivable-FDIC). Net cash used by financing activities for the year ended December 31, 1993, was $709.5 million, compared to $23.4 million and $611.0 million for 1992 and 1991, respectively. The major contributor to this use of funds in 1993 was the pay-down of higher cost discretionary and credit-sensitive liabilities (principally time deposits greater than $100,000 and short-term borrowings), which was funded by an increase in non-interest-bearing demand deposits and the aforementioned reduction in earning assets. Discretionary liabilities provided 11.26%,17.15% and 22.77% of total asset funding at December 31, 1993, 1992 and 1991, respectively. Decreased reliance on credit-sensitive liabilities minimized the negative impact of a credit rating downgrade on the Corporation's liquidity position. In September 1993, the Corporation's Standard and Poor's (S&P) credit rating was downgraded. Other major rating agencies, however, did not change their credit ratings from those in effect at December 31, 1992. The following chart presents the Moody's and S&P credit ratings at December 31, 1993, of the parent company and its principal bank subsidiary. N/R = NOT RATED N/A = NOT APPLICABLE Reference Note M for information on the Corporation's outstanding and available short-term borrowings and Note N for outstanding and available long-term debt. Tables 4, 5, 6 and Note D provide information regarding the Corporation's short-term and long-term liquidity status as it relates to asset and liability repricing and maturities. CAPITAL POSITION Bank holding companies and national banks are required to comply with capital guidelines mandated by the Federal Reserve Board (FRB) and the Office of the Comptroller of the Currency (OCC). The purpose of these guidelines is to ensure capital adequacy which is critical to the safety and soundness of an institution. Capital adequacy is measured in terms of two ratios which are the risk-based capital ratio and the leverage ratio. Risk-based capital requirements assess the credit risk of a financial institution's balance sheet assets and off-balance sheet commitments relative to its capital structure. Under the guidelines, one of four risk weights is applied to the different balance sheet assets and off-balance sheet items, such as loan commitments, primarily based on the relative credit risk of the counter party. Capital instruments are divided into two tiers which are: core capital (Tier 1) and supplemental (Tier 2) capital. The risk-based capital ratio is obtained by dividing the capital base (Tier 1 and Tier 2) by the total risk-weighted assets. The capital guidelines establish a minimum total (Tier 1 plus Tier 2) ratio of 8%, 4% of which must be comprised of Tier 1 capital. Refer to Table 14 for the composition of Tier 1 and Tier 2 capital. The leverage ratio, which is used in tandem with the risk-based capital ratio, consists of Tier 1 capital divided by average total assets (excluding intangible assets that were deducted to arrive at Tier 1 capital). The guidelines establish a minimum leverage ratio of 3%. The capital level of a financial institution is further classified under one of five capital categories as mandated by the FDIC Improvement Act of 1992. The highest capital category is "Well Capitalized". The Corporation's December 31, 1993, capital category designation is Well Capitalized. Its excess capital under this capital category as of December 31, 1993, amounted to $290.7 million, $140.9 million and $263.9 million for Tier 1, Total Risk-Based and Leverage capital levels respectively. The Corporation's bank and thrift subsidiaries are individually in compliance with all required capital adequacy ratios and are classified as Well Capitalized at December 31, 1993. The Corporation's capital position at December 31, 1993, 1992, and 1991, is further illustrated in Table 14. The Federal Reserve Board and other federal agencies are currently addressing issues that will potentially impact future regulatory capital positions of the Corporation and its subsidiary banks and savings and loan. The issuance of SFAS No. 115, Accounting for Certain Investments in Debt & Equity Securities (reference Investment Securities section for a discussion of SFAS No. 115) has raised the question of whether unrealized gains and losses on available-for-sale securities should be included in Tier 1 capital for risk-based and leverage capital purposes. Also under consideration by federal agencies, is the measurement of the effect of interest rate exposure on risk-adjusted total assets and capital positions of institutions. Management has examined these proposals and estimates that they, as presently defined, would not have a material effect on the Corporation's current capital position. MANAGEMENT'S DISCUSSION AND ANALYSIS (1) The 1992 and 1991 common equity was adjusted to conform to regulatory accounting principals (RAP) which require a maximum 15 year amortization period for purchased mortgage servicing rights, the effect of which was a $.7 million and a $3.7 million decrease to earnings in 1992 and 1991, respectively. (2) Regulatory capital guidelines limit inclusion of PMSR in regulatory capital to the lesser of: (a) 90% of fair value or (b) 100% of unamortized book value. (3) Regulatory capital guidelines relating to the adoption of SFAS 109 limit the amount of deferred tax assets dependent on future taxable income or tax planning strategies to the lesser of: (a) the amount that can be realized within one year of the report date or (b) 10% of Tier 1 capital. (4) The allowance for possible credit losses is limited to 1.25% of the total risk-weighted assets and off-balance sheet exposure. MANAGEMENT'S DISCUSSION AND ANALYSIS BUSINESS REVIEW The Corporation's four core businesses are retail banking, commercial banking, mortgage banking, and investment banking. These businesses are operated by the Corporation's principal subsidiary, Michigan National Bank (MNB). Independence One Mortgage Corporation (IOMC), a wholly-owned subsidiary of MNB, operates the mortgage banking business. In addition, the Corporation's savings and loan subsidiary, Independence One Bank of California (IOBOC), and the Corporation's two subsidiary banks in Texas, First State Bank & Trust (FSB&T) and Lockwood National Bank, (Lockwood Bank), operate retail and commercial banking businesses. IOBOC also operates a mortgage warehouse lending subsidiary, doing business as First Collateral Services, Inc. (FCSI). A summary of financial information for the Corporation's principal subsidiaries is presented in Table 15, and a brief discussion of 1993 operating performance follows. MNB (EXCLUDING IOMC) MNB's commercial banking business performance in 1993 was favorably affected by improvements in credit quality and increases in its business deposit accounts. Over the past few years, this business has focused its efforts on managing a reduction in its commercial real estate portfolios. These efforts, along with improvements in the financial condition of certain borrowers, have resulted in a reduction in both Non-performing Assets and Watch Credits, as well as a reduction in net charge-offs. The success in the area of credit quality contributed to earnings improvement in 1993. Increased sales of commercial cash management products and services contributed to an increase in commercial deposits from $565.1 million at December 31, 1992, to $628.9 million at December 31, 1993. This increase along with the low interest rate environment in 1993 were the primary reasons for commercial fee income growth and a continued strong net interest margin. Commercial deposit account processing fee income for the year ended December 31, 1993 was $18.0 million compared to $15.4 million in 1992. Commercial loan growth was sluggish in 1993 due, in part, to alternative funding opportunities offered by the private placement and syndication markets. Modest loan growth is expected for 1994 with a continued concentration on middle market business. During 1993, MNB's retail banking business concentrated on growth in its consumer deposit base and its consumer loan portfolio. In terms of market share, core households (households with one or more personal checking or savings accounts) increased from 300,761 at December 31, 1992, to 307,686 at December 31, 1993. In addition, its anchor account (checking and savings) balances increased $0.2 billion to $2.2 billion at December 31, 1993. However, retail investment deposit account (time deposit and money market) balances decreased $0.3 billion to $3.3 billion principally due to the competitive pressures from more attractive yields offered by traditional non-bank financial products. MNB's total retail customer service fee income grew $5.4 million, or 10%, to $59.9 million for the year ended 1993. (1) Amounts include inter-company eliminations. (2) Amounts include loans serviced for MNC affiliates of $1.0 billion, $1.3 billion and $1.4 billion at December 31, 1993, 1992 and l991, respectively. Certain prior period amounts were restated to conform to current period presentation. MANAGEMENT'S DISCUSSION AND ANALYSIS MNB's consumer lending business experienced excellent growth in 1993 in its secured and unsecured direct loans. The low interest rate environment along with successful marketing of the Capital Reserve line of credit product were the primary reasons for the growth. MNB's total consumer loan outstandings increased $78.6 million, or 15%, to $596.6 million at December 31, 1993, from $518.0 million at December 31, 1992. In 1994, MNB's retail banking business will continue to focus on profitable growth in consumer deposit and consumer lending market share. A new business unit has been formed which is dedicated to the special needs of small businesses through MNB's new Business Class Banking line of products. In addition, in 1994 retail banking will continue to place emphasis on improving its financial performance by rationalizing its branch network in Michigan, re-engineering branch processes, and otherwise reducing operating costs. MNB's investment services business provides asset management, trust services, and investment products to individuals, corporations, employee benefit plans, institutions, and municipal entities. The investment services industry is highly competitive with banks, brokers, insurance companies, and investment counseling firms all competing for customers. During 1993, MNB's investment services business continued to introduce new products such as an enhanced 401k plan (Envision) and an asset allocation product (CAPITALAdvantage), which have helped to position the business for continued growth. In 1993, the investment services business contributed $6 million to the Corporation's pre-tax operating profits, a 52% increase over 1992. Total fee income of $24.8 million and fee generating assets of $6.3 billion increased 8.4% and 12.4%, respectively, from 1992 levels. IOMC IOMC originates and purchases residential mortgage loans and then sells those loans into the secondary market. Historically, substantially all the loans were sold with servicing rights retained to generate servicing fee income over the life of the underlying loans. Table 16 presents the activity in IOMC's off-balance sheet servicing portfolio for each of the three years ended December 31, 1993, 1992 and 1991. IOMC's earnings performance continued to be adversely effected by unprecedented volume of mortgage loan refinancings, which resulted in a prepayment (runoff) rate of approximately 48% in the purchased servicing portfolio and a corresponding amortization rate of PMSR assets during 1993. The runoff in the servicing portfolios also caused a decline in servicing fee income during 1993. Servicing fee income was further reduced by the sale of the servicing rights for approximately $2.5 billion of loans, for a net gain of $9.3 million, after the write-off of approximately $15.2 million of related PMSR and ESF assets. The servicing rights were sold as part of IOMC's strategy to reposition its business and reduce the earnings volatility resulting from purchased servicing. Accelerated amortization along with the aforementioned sale have resulted in significant declines in the mortgage servicing assets. The total net book value of PMSR and ESF assets at December 31, 1993, was $56.3 million, (1) Amounts include inter-company eliminations. (2) Amounts include loans serviced for MNC affiliates of $1.0 billion, $1.3 billion and $1.4 billion at December 31, 1993, 1992 and l991, respectively. Certain prior period amounts were restated to conform to current period presentation. MANAGEMENT'S DISCUSSION AND ANALYSIS a 68% decrease from $177.4 million at the end of 1992. IOMC is positioned to sell servicing rights related to 1994 loan originations, taking advantage of attractive market prices. This action along with the reduction in the servicing assets and expected reductions in servicing operating expenses will provide a solid foundation for financial improvement at IOMC. IOBOC During 1993, IOBOC concentrated on expansion of commercial lines of business through its corporate banking department and its subsidiary, FCSI. FCSI's interest income benefitted from the record home mortgage refinancing activity through its mortgage warehouse lending operations. At December 31, 1993, IOBOC's total commercial loans outstanding were $404 million with unfunded commitments of approximately $312 million, a substantial increase from loans outstanding of $300 million and unfunded commitments of $212 million at the end of 1992. In addition, IOBOC increased non-interest-bearing demand deposits from $59 million at December 31, 1992, to $135 million at December 31, 1993. This increase is primarily related to the growth in IOBOC corporate deposit customers doing business with FCSI. IOBOC's successes in 1993 are noteworthy considering the continued weakness in the California economy. From a competitive standpoint, IOBOC's strong capital base provides an advantage in relation to competitors in IOBOC's market. During 1994, IOBOC management will concentrate on continuing to expand its commercial banking activities and on increasing its retail market share through aggressive but focused marketing and sales efforts. TEXAS SUBSIDIARIES FSB&T and Lockwood Bank continue to generate strong earnings since their acquisition in mid-1989 and late 1991, respectively. On a combined basis, the return on equity and return on assets for these two subsidiaries for the year 1993 was 14.87% and 1.15%, respectively. The Corporation recently announced its intent to sell these two subsidiaries. Current aggressive acquisition pricing has made further expansion in Texas costly and more difficult for the Corporation to build its Texas affiliates to a critical mass that would justify a long-term investment. Accordingly, the Corporation has decided to redeploy the capital invested in Texas to its core businesses. The Corporation does not expect to recognize any losses associated with the intended sale(s). - ------------------------------------------------------------------------------ Table 16 Residential Mortgage Servicing Portfolio Activity - ------------------------------------------------------------------------------ CONSOLIDATED STATEMENT OF CONDITION Certain prior period amounts have been reclassified to conform to current year presentation. See notes to consolidated financial statements. CONSOLIDATED STATEMENT OF INCOME (1) A fourth quarter 1993 dividend of $0.50 per share was declared January 19, 1994, payable to shareholders of record as of February 1, 1994. This does not represent a change in the Corporation's dividend policy, but rather a change only in the timing of the dividend declaration. Certain prior period amounts have been reclassified to conform to current period presentation. See notes to consolidated financial statements. Consolidated Statement of Cash Flows CONSOLIDATED STATEMENT OF CASH FLOWS CONTINUED Certain prior period amounts have been reclassified to conform to current period presentation. See notes to consolidated financial statements. (1)A fourth-quarter 1993 dividend of $0.50 per share was declared January 19, 1994, payable to shareholders of record as of February 1, 1994. This does not represent a change in the Corporation's dividend policy, but rather a change only in the timing of the dividend declaration. See notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS A. Summary of Significant Accounting Policies GENERAL The Corporation's accounting and reporting policies conform with generally accepted accounting principles, Securities and Exchange Commission regulations and predominant practices within the banking and savings and loan industries. PRINCIPLES OF CONSOLIDATION The consolidated financial statements of the Corporation include the accounts of the parent company and its subsidiaries. All significant inter-company accounts and transactions are eliminated in the consolidated financial statements. The Corporation uses the equity method to account for its 49% investment in Bloomfield Hills Bancorp, Inc., which is not materially different than consolidation. The amount of retained earnings from this subsidiary included in consolidated retained earnings was approximately $184 thousand and $30 thousand at December 31, 1993 and 1992, respectively. INVESTMENT AND TRADING SECURITIES Management determines the appropriate classification of securities at the time of purchase. Investment securities that management has the ability and intent, at the time of purchase, to hold to maturity are classified as investments held-to-maturity and accounted for at amortized cost, adjusted for amortization of premiums and discounts using the interest method. Beginning in 1992, investment securities purchased to be held for an indefinite period of time are classified as investments available-for-sale and carried at the lower of aggregate cost or market value. These securities are intended to be used by management to respond to unforeseen circumstances or future conditions which may necessitate the sale of these securities to mitigate the effects of such events. Gains and losses from the sale of securities are computed using the specific identification method. Mortgage backed securities are subject to prepayment risk. The premium and discount accounts and, therefore, the effective annual yield of those securities, are adjusted at least annually for actual prepayment experience. Investment securities which are purchased for the purpose of selling in the short-term to generate a profit for the Corporation are classified as trading securities. Trading securities are stated at market value. Gains and losses are included in non-interest income. Net interest earned on trading securities is included in interest income. The Financial Accounting Standards Board has issued SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. This Statement requires investment in equity and debt securities be classified in three categories and accounted for as follows: (i) debt securities that the Corporation has the positive intent and ability to hold to maturity are classified as held-to-maturity securities and reported at amortized cost; (ii) debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings; (iii) debt and equity securities not classified as either held-to-maturity securities or trading securities are classified as available-for-sale securities and reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of shareholders' equity. The Statement is effective for financial statements with fiscal years beginning after December 15, 1993. The Corporation will adopt this Statement in the first quarter of 1994 and does not expect that adoption will have a material adverse effect on its financial condition. FINANCIAL FUTURES, OPTIONS, INTEREST RATE CAPS, FOREIGN EXCHANGE AND FORWARD CONTRACTS The Corporation is party to a variety of financial futures, options, interest rate caps, foreign exchange and forward contracts in its trading activities and in the management of its interest rate exposure. Financial futures, options, caps, forward contracts, and foreign exchange contracts used in trading activities are carried at market value. Realized and unrealized gains and losses are included in non-interest income. Realized and unrealized gains and losses on financial futures and forward contracts designated and effective as hedges of interest rate exposure are deferred and recognized as interest income or interest expense over the lives of the hedged assets or liabilities. INTEREST RATE SWAP AGREEMENTS The Corporation enters into interest rate swap agreements as a means of managing its interest rate exposure. The differential paid or received on interest rate swap agreements is recorded as an adjustment to interest income or interest expense on the related asset or liability being hedged. Realized gains and losses from the early termination of swap agreements are deferred and amortized through the remaining term of the original hedge period. LOANS AND LEASE FINANCING Loans are stated at the principal amount outstanding, net of any unearned discount (including deferred fees and costs), if any, except for mortgages held for sale, which are carried at the lower of cost or market value. Interest income on loans is accrued based on the principal amount outstanding. Generally, loan origination and commitment fees, certain direct loan origination costs, and purchase premiums and discounts are deferred and amortized as an adjustment to yield over the life of the loan. Fees that adjust the yield on the underlying loan are included in interest on loans and lease financing. Fees for loan related services are included in non-interest income. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Loans are placed in a non-accrual category generally when over 90 days past due, or sooner when there is serious doubt as to the collectability of future interest or principal. When loans are placed in non-accrual, the related interest receivable is reversed against interest income of the current period. Cash interest payments received on non-accrual loans are generally applied as a reduction of the principal balance. Loans are removed from non-accrual and returned to a performing loan status at their then current carrying value when they become current as to both principal and interest and when doubt no longer exists as to the collectability of principal or interest. ALLOWANCE FOR POSSIBLE CREDIT LOSSES The allowance for possible credit losses is available for future loan charge-offs. The allowance is increased by a provision in the income statement and by recoveries on items previously charged off. The allowance is decreased as loans are charged off. A charge-off, in whole or in part, occurs once a probability of loss has been determined, with consideration given to such factors as the customer's financial condition and underlying collateral. The provision for possible credit losses is based upon management's estimate of the amount necessary to maintain the allowance at a level adequate to provide for probable and estimable losses inherent in the loan and lease portfolio. Management's estimate is based upon evaluations of individual loans and concentrations of credit risk, historical charge-offs, levels of non-accrual loans, current economic conditions industry analyses, and other pertinent factors. In addition, reviews are performed by the responsible lending officers, the internal loan review staff and credit administration management who consider, among other things, the effects of current developments with respect to the borrower's financial condition, changes in economic conditions and results of examinations by bank regulatory authorities. PREMISES AND EQUIPMENT Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is recognized over the estimated useful lives of the assets. Leasehold improvements are amortized over the term of the lease or the estimated useful life of the improvements, whichever is shorter. Depreciation and amortization are calculated using the straight-line method. The Corporation and its subsidiaries lease certain premises and equipment. Capital leases are accounted for and amortized as owned property, with lease payments accounted for as interest and debt reduction. PROPERTY FROM DEFAULTED LOANS Property from defaulted loans is comprised of foreclosed properties where the bank has actually received title, or which are in-substance foreclosures. Loans are classified as in-substance foreclosures when the debtor has little or no remaining equity in the collateral considering its fair value; where repayment can only be expected to come for the operation or sale of the collateral; and where the borrower formally or informally abandoned control of the collateral to the Corporation, or retained control of the collateral but it is doubtful that the debtor will be able to rebuild equity in the collateral. In April of 1992, the American Institute of Certified Public Accountants (AICPA) issued Statement of Position (SOP) 92-3, Accounting for Foreclosed Assets. The Statement requires that foreclosed assets held for sale be carried at the lower of (a) cost or (b) fair value less estimated costs to sell. The Corporation adopted SOP 92-3 in 1992, and the effect of this change resulted in an increase in defaulted loan expense of $1.6 million and $1.2 million in 1993 and 1992, respectively. Foreclosed properties and in-substance foreclosures are recorded at the lower of the recorded investment in the related loan or the fair market value of the foreclosed property less estimated costs to sell the asset. Fair market value of such assets is determined based on current independent market appraisals and other relevant factors. At the time of foreclosure and classification as property from defaulted loans, any excess of the recorded investment in the related loan over the fair market value of the foreclosed collateral is recorded as a charge-off to the allowance for possible credit losses. Subsequent to classification as property from defaulted loans, valuation write-downs, net operating expenses (including rental or lease income, legal fees and real estate taxes), and gains or losses from sales of property from defaulted loans are charged or credited to defaulted loan expense, while costs related to improving such real estate are capitalized up to the estimated fair value of the property less estimated selling costs. Capital improvement costs in excess of the estimated fair market value less estimated selling costs are charged to defaulted loan expense. MORTGAGE BANKING ACTIVITIES The Corporation's consolidated subsidiary, Independence One Mortgage Corporation (IOMC), originates, purchases, sells and services residential mortgage loans. Residential mortgage loans held for sale are carried at the lower of cost or market, determined on a net aggregate basis. IOMC is party to forward contracts in the management of its interest rate exposure. Hedge gains and losses are deferred and recognized upon sale and delivery of the underlying mortgage loans and are included in gains from the sale of mortgage loans. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Gains or losses on sales of mortgage loans are recognized at the time of sale and are determined by the difference between net sales proceeds, adjusted for excess servicing fees (ESF), and the carrying value of loans sold, adjusted for deferred hedge gains or losses. IOMC generally sells loans with servicing rights retained. Mortgage servicing fee income is generally recorded when received. Purchased mortgage servicing rights (PMSR) represent the cost of purchasing the right to service mortgage loans originated by others. ESF represent the present value of the difference between estimated future net servicing fee income retained when mortgage loans are sold and normal servicing fee income. PMSR and ESF are recorded as assets and amortized in proportion to, and over the period of, estimated net servicing income. The expected life of the estimated net servicing income is based, in part, on the expected prepayment rate of the underlying mortgages. Periodically during the year, the Corporation reviews the carrying value of PMSR and ESF assets for impairment due to changes in prepayment and other valuation assumptions, and makes necessary adjustments to the carrying value. The impairment analyses are performed for individual mortgage pools with similar economic characteristics using a discounted cash flow method. IOMC establishes and maintains escrow and custodial funds. These funds are segregated in special bank accounts which are held on deposit with Michigan National Bank (a wholly owned subsidiary of the Corporation) and are therefore reflected in the consolidated statement of condition. INCOME TAXES In February 1992, the Financial Accounting Standards Board issued SFAS No. 109, Accounting for Income Taxes which superseded SFAS No. 96, Accounting for Income Taxes. Under the asset and liability method of SFAS No. 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. To the extent that current available evidence about the future raises doubt about the realization of a deferred tax asset, a valuation allowance must be established. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under SFAS No. 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Effective January 1, 1992, the Corporation adopted SFAS No. 109 and has reported the cumulative effect of that change in method of accounting for income taxes in the 1992 consolidated statement of income. The Corporation previously used the asset and liability method under SFAS No. 96. Under the asset and liability method of SFAS No. 96, deferred tax assets and liabilities were recognized for all events that had been recognized in the financial statements. Under SFAS No. 96, the future tax consequences of recovering assets or settling liabilities at their financial statement carrying amounts were considered in calculating deferred taxes. Generally, SFAS No. 96 prohibited consideration of any other future events in calculating deferred taxes. EARNINGS PER SHARE Primary and fully diluted earnings per common share are based on the weighted average number of common shares outstanding in each year, plus shares representing the dilutive effect of outstanding stock options and Cancelable Mandatory Stock Purchase Contracts (Equity Contracts). The dilutive effect of outstanding stock options and Equity Contracts is calculated using the Treasury Stock Method in accordance with Accounting Principles Board Opinion No. 15, Earnings Per Share. For periods prior to April, 1993, the weighted average number of common shares outstanding were further adjusted for the assumed conversion of convertible preferred shares outstanding in accordance with the preferred share conversion formula. On April 2, 1993, all of the convertible preferred shares were converted and 120,000 shares of common stock were issued in the conversion. DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS SFAS No. 107, Disclosures about Fair Value of Financial Instruments, requires disclosure of estimated fair values of financial instruments, whether or not recognized in the statements of condition, for which it is practicable to estimate such values. In cases where quoted market prices are not available, fair value estimates are based on the present value of expected future cash flows or other valuation techniques, all of which may be significantly affected by the assumptions used. Therefore, these values may not be substantiated by comparison to independent markets and are not intended to reflect proceeds that may be realized from a current exchange. Furthermore, the Corporation does not intend to dispose of a significant portion of financial instruments, and thus, any aggregate unrealized gains or losses should not be interpreted as a forecast of future earnings and cash flows. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SFAS No. 107 excludes certain financial instruments from its disclosure requirements, such as obligations for pension and other postretirement benefits, deferred compensation arrangements and leases. In addition, disclosure of fair value estimates are not required for non-financial assets and liabilities, such as fixed assets and intangibles. Fair value estimates, methods and assumptions are set forth, as applicable, throughout the following notes to financial statements. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board has issued SFAS No. 112, Employer's Accounting for Postemployment Benefits. This Statement requires accrual of the estimated cost of benefits provided by an employer to former or inactive employees after employment but before retirement (e.g., salary continuation, severance and disability benefits, job training and counseling and continuation of benefits such as health care and life insurance coverage). Postemployment benefit expense recognized under these requirements will replace the "pay-as-you-go" method of accounting currently utilized by the Corporation for short-term disability and health insurance continuation. The Statement is effective for financial statements with fiscal years beginning after December 15, 1993. The Corporation will adopt this Statement in the first quarter 1994 and the estimated effect of adoption of this new accounting standard in 1994 is an increase in personnel benefit expense of approximately $1.5 million. The Financial Accounting Standards Board has issued SFAS No. 114, Accounting by Creditors for Impairment of a Loan. This Statement addresses the accounting by creditors for impairment of certain loans. It is applicable to all impaired loans, uncollateralized as well as collateralized, except large groups of smaller-balance homogeneous loans that are collectively evaluated for impairment, loans that are measured at fair value or at the lower of cost or fair value, leases and debt securities. A loan is impaired when, based on the current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. It requires that impaired loans be measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or, as a practical expedient, at the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. This Statement applies to financial statements for fiscal years beginning after December 15, 1994. The Corporation plans to adopt this Statement in 1995. Management's initial estimates indicate that the effect of implementing the foregoing, in today's interest rate environment, will not be material to the Corporation's earnings or financial condition. The American Institute of Certified Public Accountants has issued SOP No. 93-6, Employer's Accounting for Employee Stock Ownership Plans. This Statement provides guidance on employer's accounting for employee stock ownership plans (ESOP), both leveraged and non-leveraged. The Corporation has a leveraged ESOP whereby employer debt was issued to the ESOP to purchase shares of stock of the Corporation. Specifically the Statement requires that compensation expense shall be recognized based on the fair value of the shares of stock committed to be released by the ESOP to plan participants. Additionally, this Statement changes the computation of earnings per share (EPS) for the number of shares held by the ESOP. Only shares that have been committed to be released to participants shall be considered outstanding in the calculation of EPS. This Statement is effective for fiscal years beginning after December 15, 1993, and applies to shares acquired by ESOP's after December 31, 1992, but not yet committed to be released to participants. The ESOP has not purchased any shares of stock of the Corporation subsequent to December 31, 1992. This statement will have no effect on the Corporation's net income or earnings per share until such future time as additional shares of stock are purchased by the ESOP. A discussion regarding the new SFAS No. 115 is included under the heading "Investment and Trading Securities" in Note A. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS B. Acquisitions and Sale Effective October 1, 1993, the Corporation sold substantially all the assets and certain liabilities of BancA Corporation, a Dallas, Texas computer software company. The assets were previously written down during the second quarter of 1993 with a $4.6 million charge to income and no additional loss resulted from the sale transaction. The Corporation had acquired all the assets and assumed certain liabilities of BancA Corporation on July 29, 1992, for a cash purchase price of $3.5 million. On April 1, 1993, the Corporation completed the acquisition of all of the outstanding stock of Peoples National Bank, Pasadena, Texas; Peoples Bank, Houston, Texas; and Community National Bank, Friendswood, Texas and the banks were merged into Lockwood. The cash purchase price for the acquisition was $16.7 million. The transaction was accounted for under the purchase method and goodwill of $4.1 million was recognized in the acquisition, which is being amortized over 15 years on a straight-line basis. On June 30, 1992, Michigan National Bank (MNB), the principal subsidiary of the Corporation, acquired 3,047 merchant credit card processing contracts from Central Fidelity Bank of Richmond, Virginia for a cash purchase price of $1.4 million. Under the terms of the acquisition agreement, MNB will assume all the merchant transaction processing responsibilities of Central Fidelity Bank and both Central Fidelity Bank and MNB will conduct joint marketing efforts. On April 13, 1992, a subsidiary of IOBOC purchased a mortgage warehouse lending business and other net assets having a total book value of approximately $200 million from First Collateral Services, Inc., a subsidiary of Honfed Bank, FSB. The assets were purchased for cash equal to their book value plus a $400,000 premium. Subsequent to the acquisition, IOBOC's subsidiary is doing business as First Collateral Services, Inc. (FCSI). On October 31, 1991, MNC acquired Lockwood Banc Group, Inc. for a cash purchase price of $17.3 million. The fair market value of the assets acquired and liabilities assumed totaled $225.9 million and $213.3 million, respectively. The transaction was accounted for under the purchase method. Goodwill of $4.7 million was recognized in the acquisition and is being amortized over 15 years on a straight-line basis. The Corporation recently announced its intent to sell its two Texas subsidiary banks, FSB&T and Lockwood (the holding company of Lockwood Bank), and does not expect to recognize any losses on the intended sale(s). C. Cash and Due From Banks Included in cash and due from banks are amounts required to be maintained by subsidiary banks to comply with deposit reserve requirements of bank regulatory authorities. These amounts were $216 million and $186 million at December 31, 1993 and 1992, respectively. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS D. Investment Securities The following summarizes the book value, estimated market value, and gross unrealized gains and losses of investment securities at December 31 of each year. The carrying amounts for short-term investments approximate market value because they mature in 90 days or less. The estimated market value of longer-term investments is based on quoted market prices or bid quotations received from securities dealers. Investment securities with a book value of $656 million at December 31, 1993, were pledged to collateralize deposits of public funds and for other purposes required or permitted by law; at December 31, 1992, the corresponding amount was $603 million. In addition, at December 31, 1993 and 1992, mortgage-backed investment securities with a book value of $14 million (market value of $15 million), and $153 million (market value of $160 million), respectively, were pledged under repurchase agreements. Mortgage-backed investment securities with a book value of $133 million (market value of $141 million) were collateralized under dollar repurchase agreements at December 31, 1992. Interest and dividend income from investment securities at December 31 of each year. For the years ended December 31, 1993, 1992 and 1991, the Corporation received proceeds of $227.5 million, $292.9 million and $166.0 million, respectively, from sales of investment securities. The Corporation realized gross gains of $6.6 million, $12.3 million and $2.8 million as of December 31, 1993, 1992 and 1991, respectively, from sales of investment securities. Gross realized losses from sales of investment were $600 thousand, $25 thousand and $140 thousand for the years then ended. The remaining balance of security gains (losses) for each of the three years ended December 31, 1993, consisted of non-sales related activity, including write-offs of premiums and discounts associated with early pay-offs of securities. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- D. Investment Securities (continued) - ------------------------------------------------------------------------------- The following summarizes the remaining maturity and average yield of the investment securities portfolio at December 31 of each year.(1)(2) - ------------------------------------------------------------------------------- The following summarizes the remaining maturity and average yield of securities available-for-sale at December 31.(1) - ------------------------------------------------------------------------------- (1) Weighted average yields are computed by dividing the annual income by the security balance outstanding at December 31 of each year. Such computations for states of the U.S. and political subdivisions are based on fully taxable equivalent income using a federal tax rate of 34% in each year. (2) The average maturity of the total investment securities portfolio was approximately 2.3, 3.1 and 3.8 years at December 31, 1993, 1992 and 1991, respectively. (3) The weighted average expected life was used to determine the maturity of mortgage-backed securities. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - -------------------------------------------------------------------------------- E. FDIC Assistance - -------------------------------------------------------------------------------- Relevant terms of the Assistance Agreement are as follows: - - The FDIC issued a 10 year $808 million negative net worth note, (subsequently adjusted to $811 million based on a beginning balance sheet audit completed in 1990), to bring IOBOC's equity deficit to zero. The note bears interest at a rate tied to the FHLBB COF. The interest rate is on a downward sliding scale starting at 200 Basis Points over the FHLBB COF in 1989 and finishing at 50 Basis Points over in 1998. The note agreement specifies consecutive quarterly interest payments during the term of the note. The entire remaining principal balance is due with the final interest payment on December 31, 1998. - - The terms of the note allow prepayment of the principal outstanding at the end of each respective year according to the following schedule; 10% in 1991, 23% in 1992, 43% in 1993, 57% in 1994, 68% in 1995, 76% in 1996 and 100% in both 1997 and 1998. In addition, under certain circumstances defined in the Assistance Agreement, the FDIC may elect to prepay the entire outstanding balance with 90 days prior written notice beginning on January 1, 1990. The relevant circumstances did not exist at February 15, 1994, and the FDIC has therefore, not made this election. - - The FDIC agreed to provide certain assistance for a period of ten years, except for Item 1 below which has expired. The nature and extent of assistance is as follows: 1. Capital Loss Coverage and Guaranteed Yield on Covered Assets. In addition, the Assistance Agreement requires that any remaining Covered Assets be written-down to their Immediately Realizable Value by December 31, 1992, and IOBOC reimbursed for the write-down amount. This process was completed during the first quarter of 1993. The following summarizes IOBOC's Covered Assets and FDIC assistance at December 31, 1992. 2. Cost of funds subsidies on all fixed term deposit liabilities of IOBOC at the acquisition date which mature after December 31, 1989. The subsidy will limit interest expense on those deposits to the FHLBB COF. In addition, an interest subsidy of approximately 6% is paid on a long-term debt obligation of IOBOC. This obligation was paid-off during 1992. 3. Indemnification for unreserved claims and challenges to the transaction. - - Under the Assistance Agreement, IOBOC agreed to share realized tax benefits with the FDIC. The FDIC receives 25% of these benefits until the Corporation has realized a return of its aggregate investment plus a 20% compound return on investment, thereafter, the tax benefits are shared equally. The FDIC shared tax benefits at a 25% rate each year since the acquisition. Tax benefits expected relate primarily to the tax-exempt status of all FDIC assistance and "built in tax losses" resulting from sales of Covered Assets with tax bases in excess of assigned values. Reference Note V for a discussion of contingencies related to the tax deductibility of certain of these tax benefits. - - The FDIC has the right to receive a payment at March 31, 1999, of up to 20% of the sum of IOBOC earnings through December 31, 1998, plus the Corporation's equity capital investment, as defined. At its option, IOBOC may satisfy this obligation at any time by payment of $15 million plus interest from December 31, 1988 to the date of exercise at a rate of 10% compounded annually. Currently, the Corporation expects to pay an amount less than the maximum of $15 million plus interest at March 31, 1999, and has accrued $9.7 million in connection with this right. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - -------------------------------------------------------------------------------- F. Loans and Lease Financing - -------------------------------------------------------------------------------- The following summarizes loans and lease financing (excluding Covered Assets) at December 31 of each year. The estimated fair value of the Corporation's loan portfolio (excluding lease financing) was $6.5 billion and $6.6 billion at December 31, 1993 and 1992, respectively. The fair value of performing variable rate loans was based on their carrying values adjusted by an estimate of losses inherent in the loan portfolio. The fair value of performing fixed-rate loans was segregated by loan type (e.g., commercial, commercial real estate-mortgage, commercial real estate-construction, installment, and residential mortgage held for investment) and estimated through a discounted cash flow calculation that applies interest rates currently being offered for new loans with similar terms and conditions. The fair value of performing fixed-rate residential mortgage loans held for sale was estimated on the basis of existing forward rate commitments to sell such loans. Fair value of non-accrual loans (fixed and variable) were generally estimated based on recent appraisals of the underlying collateral or carrying value adjusted for potential credit loss. - -------------------------------------------------------------------------------- G. Allowance for Possible Credit Losses - -------------------------------------------------------------------------------- The following summarizes the activity in the allowance for possible credit losses. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS H. Significant Concentrations of Credit Risk The Corporation grants commercial, residential and installment loans primarily to customers in Michigan. The Corporation has limited its credit risk by establishing guidelines limiting aggregate outstanding commitments and loans to particular borrowers, industries and geographic areas. Compliance with these guidelines is monitored by the Credit Policy Committee. Although the Corporation has a diversified loan portfolio, management has identified the following as significant concentrations of credit risk as of December 31, 1993 and 1992. I. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK The Corporation is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers, to reduce its own exposure to fluctuations in interest rates, and to realize profits. These financial instruments include: commitments to extend credit, loans sold with recourse, standby and other letters of credit, forward and futures contracts, foreign currency futures, foreign exchange contracts, options, interest rate swap contracts and interest rate caps. These financial instruments involve, to varying degrees, elements of credit and market risk in excess of the amount recognized in the statement of condition. The contract or notional amount of those instruments expresses the extend of involvement the Corporation has in particular classes of financial instruments. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS I. Financial Instruments with Off-Balance Sheet Risk The risks associated with these products include credit risk, market risk and currency rate risk. CREDIT RISK Credit risk is the risk that a counterparty may fail to meet its obligations under the contract. The Corporation manages credit risk by limiting and monitoring the amount of contracts by customer and/or broker-dealer. These limits are established through an evaluation of the customer's and/or broker-dealer's credit worthiness on a case-by-case basis, and collateral is required to support financial instruments when it is deemed necessary. MARKET AND CURRENCY RATE RISK Market and currency rate risk are caused by changes in the market value as a result of movements in interest and currency exchange rates. The contract or notional amount should not be considered a measure of the risk for futures, forwards, foreign exchange contracts, options, interest rate swaps and interest rate cap agreements because the present value of the replacement cost, at current interest rates, of the contracts generally is much smaller than the contract or notional amount. The risk as of December 31, 1993, is further discussed below for each instrument. COMMITMENTS TO EXTEND CREDIT The Corporation enters into contractual commitments to extend credit, normally with fixed expiration dates or termination clauses, at specified rates and for specific purposes. Commercial customers use credit commitments to ensure that funds will be available for working capital purposes, for capital expenditures and to ensure access to funds at specified terms and conditions. Substantially all of the Corporation's commitments to extend credit to commercial customers are contingent upon the customers maintaining specific credit standards at the time of loan funding. At December 31, 1993 and 1992, respectively, the Corporation had entered into commitments to lend to commercial customers in the amounts of approximately $2.9 billion and $2.2 billion. The Corporation does not expect all of these outstanding commitments to be drawn upon and, therefore, the total commitment amounts do not necessarily represent future cash requirements. The estimated fair value of commitments to extend credit was $29 million and $22 million at December 31, 1993 and 1992, respectively. These amounts are based on fees currently charged to enter into similar agreements. The Corporation also has contractual commitments to close and fund residential mortgage loan applications within a specified period of time at specified interest rates. Those loans that are closed and funded are then delivered to outside investors under previously contracted commitments to sell loans which are discussed below under Futures and Forward Agreements. The Corporation had contractual commitments to close and fund residential mortgage loan applications of approximately $530 million and $652 million as of December 31, 1993 and 1992, respectively. Of the total commitments at December 31, 1993 approximately $139 million are for variable-rate loans and therefore present no market value risk to the Corporation. The Corporation does not expect all of the remaining $391 million of fixed-rate commitments to close. Approximately $271 million of the fixed-rate commitments are hedged under forward commitments to sell that have an estimated fair value of $0.4 million at December 31, 1993, determined on the basis of the commitment price stated in the forward agreements adjusted for changes in interest rates or credit risk if any. At December 31, 1992, the Corporation was hedging approximately $181 million of commitments to fund fixed-rate residential loans with forward commitments to sell that had an estimated fair value of $0.3 million. STANDBY AND OTHER LETTERS OF CREDIT Standby and other letters of credit obligate the Corporation to guarantee the performance of a customer to a third party. These instruments frequently are issued in support of corporate debt issuances. The Corporation's policies generally require that standby and other letter of credit arrangements contain security and debt covenants similar to those contained in loan agreements. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loan facilities to customers. Standby letters of credit are considered in determining the adequacy of the allowance for possible credit losses. The estimated fair value of standby and other letters of credit was $3.9 million and $3.4 million at December 31, 1993 and 1992, respectively. The estimated fair value of the Corporation's standby and other letters of credit was estimated on the same basis as that discussed above for commitments to extend credit. LOANS SOLD WITH RECOURSE Prior to 1990, IOMC sold loans with recourse, either directly or indirectly, for credit or other loss exposure reasons. Approximately $116 million and $202 million of such loans were still outstanding as of December 31, 1993 and 1992, respectively. These transactions were recorded as sales with appropriate reserves established for such losses. Actual losses to date have not been significant. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOREIGN EXCHANGE CONTRACTS Foreign exchange contracts are entered into primarily for trading activities. The risk in these contracts arises from the ability of the counterparties to deliver under the terms of the contract. Also, market risk arises from inherent fluctuations in currency exchange rates. The Corporation had contract amounts of approximately $5 million and $12 million for trading purposes as of December 31, 1993 and 1992, respectively. The estimated fair value of foreign exchange contracts is determined by quoted market prices or quotes from broker dealers. The estimated fair value of foreign exchange contracts at December 31, 1993 and 1992, was $23 thousand and $57 thousand, respectively. FUTURES AND FORWARD CONTRACTS Futures and forward contracts represent future commitments to purchase or sell securities at a specified price and date. The Corporation uses futures and forward contracts in connection with its trading activities as well as to hedge its assets and liabilities. The Corporation mitigates its credit risk by entering into futures and forward contracts through organized exchanges which control who can purchase and sell such contracts. The Corporation had approximately $701 million and $709 million in forward rate agreements outstanding as of December 31, 1993 and 1992, respectively. These agreements were commitments to sell loans to another party at a specified price and specified date in the future. The risk associated with the forward rate agreements arises if the Corporation is unable to deliver according to the terms of the agreement. No losses occurred as a result of the forward rate agreements outstanding as of December 31, 1992. As of January 31, 1994, 51% of the forward rate agreements outstanding at December 31, 1993, had been delivered without a loss to the Corporation. The remaining contracts are expected to be delivered as follows: 36% in February, 9% in March and the remaining 4% before the end of 1994. The Corporation does not anticipate any material losses as a result of the forward rate agreements. The estimated fair value of these instruments is discussed under Commitments to Extend Credit above and in Note F. INTEREST RATE SWAPS Interest rate swaps obligate two parties to exchange periodic cash flows based on two different rates of interest applied to the same notional principal amount. The parties exchange cash flows of a fixed or floating rate based on specified interest rate indices. The Corporation has entered into interest rate swap agreements with third parties to hedge specific assets or liabilities and to reduce the impact of changes in interest rates on its earnings. The Corporation has entered into customer accommodation swap transactions which are also used for hedging purposes. Additionally, certain of the Corporation's interest rate swaps have a declining notional feature whereby the notional balance is amortized over the life of the swap. The credit risk associated with interest rate swap agreements revolves around the ability of the counterparty to perform its payment obligation under the agreement. Credit exposure exists at a particular point in time when an interest rate swap has a positive market value. The Corporation minimizes its credit risk by performing normal credit reviews on its swap counterparties. Additionally, this exposure is further minimized by the amount of collateral value received from the counterparty when it is deemed necessary. At December 31, 1993 and 1992, the Corporation had interest rate swap agreements hedging commercial loans with a total notional principal amount of $2.0 billion and $1.8 billion respectively. Of the 1993 amount, approximately $153 million were customer accommodation swaps. Those agreements effectively hedged the Corporation's interest rate exposure associated with its prime-based variable-rate commercial loans. At December 31, 1993 and 1992, the Corporation had credit exposure on these interest rate swaps of $23 million and $39 million respectively. Customer accommodation swaps represented approximately $1.3 million of the total credit exposure in 1993. In addition to the swap agreements hedging commercial loans, at December 31, 1993, the Corporation had swap agreements outstanding with a notional principal amount of approximately $541 million hedging its current production of originated and purchased residential mortgage servicing. The terms of these swap agreements require the Corporation to make monthly premium payments to the counterparty which are determined on the basis of the underlying outstanding unamortized notional principal of the swap agreement. The counterparty is obligated to make payment to the Corporation in the event that interest rates fall resulting in prepayment speeds that differ from anticipated prepayment speeds. The payment amount is determined on the basis of a scheduled formula and predetermined prepayment rate. The Corporation had no credit risk exposure on these swap agreements at December 31, 1993. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - --------------------------------------------------------------------------- The Corporation had interest rate swap agreements hedging its fixed-rate deposit notes having a total notional principal amount of $25 million as of December 31, 1992. These agreements effectively changed the interest rate exposure on those fixed-rate liabilities to a variable rate. It is the Corporation's policy to execute net counterparty payments on all new swap transactions. At December 31, 1993,100% of the swap portfolio was on a net payment basis. The estimated fair value of interest rate swaps is calculated on a present value basis using current interest rates, taking into consideration the credit worthiness of the counterparties. The Corporation's estimate of fair value on its total swap portfolio was $35 million and $45 million at December 31, 1993 and 1992, respectively. INTEREST RATE SWAPS OUTSTANDING (dollars in millions) - ---------------------------------------------------------------------------- The following is a presentation of the Corporation's interest rate swap activity for the years ended December 31. INTEREST RATE CAPS Interest rate caps are similar to interest rate swaps with regard to hedging interest rate risk; however, these contracts obligate the seller of the interest rate cap to make payments if an interest rate index exceeds a specified "capped" level. The Corporation was party to interest rate cap agreements at December 31, 1993 and 1992, with a notional principal of $10 million and $31 million, respectively. If the interest rate index exceeds the "capped" level, the cap will be utilized by the Corporation to hedge the commercial loan portfolio by effectively changing the Corporation's interest rate exposure on a fixed rate loan to a floating rate. As of December 31, 1993 and 1992, the estimated fair value of interest rate caps was zero. OPTIONS Options are contracts allowing, but not requiring, its holder to buy or sell a specific financial instrument at a specified price during a specified time period. An issued option obligates the seller of the contract to purchase or sell a specific financial instrument at the option of the buyer of the contract. As of December 31, 1992, the Corporation had issued options with contract amounts of $5 million in connection with its trading activities. As the issuer of options, the Corporation received a premium at the outset, and then bears the risk of an unfavorable change in the price of the financial instrument underlying the option. Options used in such trading activity are carried at market value based on market quotes. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- J. Premises and Equipment - -------------------------------------------------------------------------------- The following summarizes premises and equipment, including capital leases, at December 31 of each year. - -------------------------------------------------------------------------------- The following summarizes capital leases included in premises and equipment, at December 31 of each year. - -------------------------------------------------------------------------------- The following summarizes rent expense for operating leases, at December 31 of each year. The following summarizes future minimum lease payments under non-cancellable leases at December 31, 1993. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ---------------------------------------------------------------------------- K. Property From Defaulted Loans and Discontinued Operations - ---------------------------------------------------------------------------- The following summarizes property from defaulted loans at December 31 of each year. - ---------------------------------------------------------------------------- The following summarizes the activity in property from defaulted loans for the years ended December 31. - ---------------------------------------------------------------------------- Certain prior period amounts have been restated for a change in reporting classification to include real estate of discontinued operations. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - -------------------------------------------------------------------------------- L. Purchased Mortgage Servicing Rights and Capitalized Excess Service Fees. - -------------------------------------------------------------------------------- The following summarizes the activity in the purchased mortgage servicing and capitalized excess service fees for years ended December 31. In measuring the net book value of PMSR and ESF at December 31, 1993, concensus estimates of future prepayment rates, when applied to the Corporation's portfolio were 26% for PMSR and 22% for ESF. Weighted average discount rates of 13.46% and 10.69% were used in the December 31, 1993 valuation analysis for PMSR and ESF, respectively. PMSR and ESF are discussed in Note A. Also, reference Note W for a presentation of the originated portion of the Corporation's mortgage servicing portfolio for each of the years ended December 31, 1993, 1992 and 1991. (1) Scheduled amortization represents annual amortization determined on the basis of prepayment assumptions in effect at the beginning of the year. (2) The estimated fair value of unamortized excess service fees, determined on a discounted cash flow basis adjusted for estimated prepayments, was $7.2 million and $26.5 million at December 31, 1993 and 1992, respectively. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- M. Short-Term Borrowings - ------------------------------------------------------------------------------- The Corporation had up to $100 million of commercial paper available to issue at December 31, 1993. The actual amount of commercial paper that can be issued is dependent upon the Corporation's credit ratings and the availability of back-up lines of credit. These notes have a maturity of not more than 270 days from date of issuance. The yield is dictated by the market for similarly rated commercial paper. The Corporation had no commercial paper borrowings outstanding at December 31, 1993 and 1992. To support the commercial paper program, two lines of credit were established during the second quarter of 1992 totaling $45 million which may be used for a variety of general corporate purposes. The first facility is a $25 million, three year line of credit with a commitment period that expires April 30, 1995 and the second facility, a $20 million 364 day line of credit, which was extended to March 10, 1994. The latter facility may be renewed upon consent of the involved parties. The annual interest rate charged on advances is based on the average outstanding advances during the interest period and may be a floating rate, fixed CD rate, or a Eurodollar rate at the selection of the Corporation. Facility fees are paid on the commitment (whether used or unused) based upon the rating assigned to the Corporation by a mutually acceptable rating agency. In December 1990, IOBOC received approval from the Federal Home Loan Bank of San Francisco (FHLB) for line of credit advances under the FHLB's credit program. Advances must be fully collateralized and, based upon residential mortgage collateral pledged at December 31, 1993, IOBOC's borrowing capacity was approximately $14.0 million. Advances are available, at IOBOC's option, at a variable-rate subject to daily repricing or at a fixed rate with terms of one to six months. IOBOC did not have any advances outstanding as of December 31, 1993 or 1992. The carrying value of the Corporation's total short-term borrowings approximates fair value because of the short-term maturity of these instruments. - ------------------------------------------------------------------------------- A summary of short-term borrowings for the past two years is presented below. - ------------------------------------------------------------------------------- NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - -------------------------------------------------------------------------------- N. Long-Term Debt - -------------------------------------------------------------------------------- On November 10, 1988, the Corporation issued $55 million of 8% Redeemable Subordinated Debentures (Debentures) due November 10, 1998. The Debentures were issued with detachable Cancelable Mandatory Stock Purchase Contracts. Interest is payable quarterly on the fifteenth day of March, June, September and December. The Debentures are redeemable at the Corporation's option upon at least 60 days written notice. Redemption prices, which are expressed as a percentage of par and adjusted on November 10 of each year, are as follows: 103.56% in 1993, 102.67% in 1994,101.78% in 1995, 100.89% in 1996 and 100.00% in 1997. The Debentures are subordinate and junior in right of payment to certain present and future indebtedness of the Corporation. The following table is a summary of long-term debt at December 31, 1993 and 1992. The floating rate note due through 1997 relates to the Employee Stock Ownership Plan and Trust discussed in Note P. The $3.2 million variable rate subordinated debentures due 1997 were assumed in connection with the acquisition of Lockwood. The debentures are redeemable at the option of Lockwood in whole at any time, or in part from time to time, upon notice to holders of the debentures. Annual maturities of consolidated long-term debt (exclusive of capital lease obligations) for the five years ending December 31, 1994, through 1998, respectively, are $3.8, $3.8, $3.8, $7.1 and $54.9 million. The estimated fair value of the Corporation's Debentures was approximately $57 million and $56 million at December 31, 1993 and 1992, respectively. The amounts are based on the quoted market prices for similar issues available to the Corporation for debt of the same remaining maturities. The remainder of the Corporation's long-term debt (excluding capital leases) is estimated to approximate market value. (1) Interest rate is Marine Midland Bank prime rate. (2) Interest rate is First City National Bank of Houston prime rate with a maximum of 11% and a minimum of 7%. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - -------------------------------------------------------------------------------- O. Capital - -------------------------------------------------------------------------------- The Corporation's Tier 1 Risk-Based Capital Ratio at December 31, 1993 and 1992, was 9.57% and 9.69%, respectively. The Total Risk-Based Capital Ratio was 11.73% and 11.91% at December 31, 1993 and 1992, respectively. The leverage ratio at December 31, 1993 and 1992 was 7.56% and 7.24%, respectively. The minimum ratios for a Well Capitalized financial institution as designated by the FDIC Improvement Act of 1992 are 6.00%,10.00% and 5.00% for the Tier 1 Risk-Basked Capital Ratio, Total Risk-Based Capital Ratio and leverage ratio, respectively. Current banking laws and regulations place limitations on the ability of national banks to pay cash dividends in order to prevent capital impairment. The Corporation's subsidiary banks and subsidiary savings and loan are in compliance with the regulatory dividend limitation guidelines as of December 31, 1993. At December 31, 1993 and 1992, the subsidiaries had retained earnings of approximately $33.0 million and $51.3 million, respectively, available to pay dividends to the parent company without regulatory approval. On November 10, 1988, as part of the Subordinated Debenture (Debentures) issue discussed in Note N, the Corporation issued $55 million of Cancelable Mandatory Stock Purchase Contracts (Equity Contracts). The Equity Contract holders are required to purchase $55 million of the Corporation's common stock on May 10, 1998 at a price of $56.375 per share, but have the option to purchase all or a portion of the shares covered by the contract prior to May 10, 1998 at the same price per share. Payment for these shares may be made in cash or by surrender of the Debentures. The Equity Contract owners are not shareholders and do not have any of the rights or privileges of common stock shareholders. The number of common stock shares purchased pursuant to the Equity Contracts was 1,773, none and 443 during the years 1993, 1992 and 1991, respectively. All were purchased by the surrender of debentures. On April 19, 1988, the Corporation adopted a Rights Plan (Plan) to ensure that shareholders receive a fair price for their investment in the event of an acquisition of the Corporation. Under the Plan, shareholders were issued one Right for each of their shares which entitles them to purchase 1/100 of a share of a new series of the Corporation's Series B Junior Participating Preferred Stock. The Rights, which expire in 1998, have an exercise price of $170 (subject to adjustment) and will be exercisable only if a person or group acquires 20% or more of the Corporation's common stock, announces a tender offer for 30% or more of the common stock, or the Corporation's board of directors determines that any person or group that has acquired 15% or more of the Corporation's common stock is an "Adverse Person." The board of directors may redeem the Rights at $.05 per Right prior to the occurrence of any of the above events. If, after the occurrence of one of the above events, any entity becomes the beneficial owner of 25% or more of the Corporation's common stock, other than pursuant to certain tender or exchange offers described in the Plan or if the Board of Directors of the Corporation determines that any person or group that is the beneficial owner of 15 % or more of the Corporation's common stock is an Adverse Person, as specified in the Plan, each Right not owned by such person or any related party will entitle its holder to purchase, at the Right's then-current exercise price, shares of the Corporation's common stock having a value of twice the Right's exercise price. Following the occurrence of any such event, all Rights held by a 20% or more shareholder or an Adverse Person will be null and void. In addition, if after any person has become a 20% or more shareholder, the Corporation is involved in a merger or other business combination transaction with another person, each Right will entitle its holder to purchase, at the Right's then-current exercise price, shares of common stock of such other person having a value of twice the Right's exercise price. On March 22, 1988, the Corporation purchased from Marine Midland Banks, Inc. (Marine) warrants to acquire 1.7 million shares of the Corporation's common stock. Marine had originally acquired these warrants in 1985. In exchange for the warrants, Marine received $10 million in cash and 166,667 shares of a newly issued series of non-redeemable Cumulative Convertible Preferred Stock (Preferred Stock). The Preferred Stock paid an annual dividend equal to 6% of its stated value of $36 per share. Contractual provisions allowed Marine to convert the Preferred Stock into the Corporation's common stock before October 10, 1993. The amount of common stock issued upon conversion of the Preferred Stock was determined on the basis of a ratio of the then-current market to book value of the Corporation's common stock. In accordance with that formula, 120,000 to 660,000 shares of common stock could be issued upon conversion of the Preferred Stock. On March 31, 1993, Marine exercised their right to redeem the 166,667 shares of Preferred Stock for 120,000 shares of newly issued common stock. The Corporation is authorized, from time to time and in one or more series, to issue up to a total of six million shares of Preferred Stock, $10 par value, with terms, conditions, rights and preference to be determined by the Board of Directors prior to any such issuance. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - -------------------------------------------------------------------------------- P. Employee Benefit Plans - -------------------------------------------------------------------------------- STOCK OPTIONS In 1985, the Board of Directors granted an option to purchase 200,000 shares of the Corporation's common stock to its Chief Executive Officer. During 1992, this option was exercised in its entirety. Also in 1985, a proposal was approved by the shareholders establishing a stock option plan for certain of its employees (1985 Plan). The 1985 Plan was subsequently amended and restated in 1987 and 1991 by the shareholders and is now known as the Michigan National Corporation Stock Option and Performance Incentive Plan (the Plan). During 1991, the Plan was amended and restated to change the total number of shares authorized for issuance from 1,000,000 shares to 8% of the total number of the outstanding shares of the Corporation's common stock representing approximately 1,214,107 shares as of December 31, 1993. Of these shares, 424,611 have been granted and exercised, 636,116 are granted and outstanding, and 153,380 are available for future grant. The options granted under the Plan are not exercisable before one year or after 10 years of date of grant. Total shares immediately exercisable under stock options were 508,760; 498,153; and 680,446 at December 31, 1993, 1992 and 1991, respectively. The following is a summary of the activity with respect to stock options offered by the Corporation. (1) Includes 200,000 shares exercised under the 1985 stock option granted to the Chief Executive Officer. PENSION All eligible, salaried employees of the Corporation and its subsidiaries, are covered by a non-contributory, defined-benefit pension plan. Benefits under the plan are based on years of service and the highest average level of compensation for any five consecutive years out of the last ten years of service. The majority of plan assets are invested in fixed income U.S. Government obligations and equities, with the balance in limited partnerships and cash. The following is a summary of the components of net periodic pension costs for years ended December 31. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS The "projected credit unit" method is used in the determination of accumulated benefits and periodic pension cost. The weighted-average discount rate used in determining the actuarial present value of the projected benefit obligation was 7.0% and 8.5% at December 31, 1993 and 1992, respectively. The assumed rate of increase in future salaries was 5% at December 31, 1993 and 1992. The expected long-term rate of return on assets was 8.25% at December 31, 1993 and 1992. The net obligation at date of adoption is being recognized over 15 years on a straight-line basis. The unrecognized prior service cost is the result of plan amendments effective January 1, 1988, 1989, 1991, and 1993. This cost is being recognized on a straight-line basis over approximately 13 years, the average remaining service of employees. The Corporation's funding policy is to contribute annually within the range of tax deductible amounts after considering the minimum amount required by the Employee Retirement Income Security Act. The following table sets forth the plan's funded status and the prepaid pension cost recorded in the consolidated statement of condition. During the years ended December 31, 1993, 1992 and 1991 the Corporation recognized additional pension expense of $0.6 million, $0.4 million, and $1.0 million, respectively, for supplemental pension benefits. The unfunded recognized pension obligation for these benefits was $3.0 million and $1.7 million at December 31, 1993 and 1992, respectively. The December 31, 1993 liability balance of $3.0 million includes an "additional minimum liability" of $0.7 million recognized in accordance with the provisions of SFAS No. 87. The recognition of this liability was offset by the recognition of an "intangible asset" of $0.3 million and a reduction in stockholders' equity of $0.4 million. During 1992, the Corporation purchased individual deferred annuities to settle the December 31, 1992 accumulated benefit obligation of certain of the participants of the supplemental plans. The total cost of the annuities was $1.5 million and the settlement resulted in an approximate $0.3 million settlement gain determined in accordance with SFAS No. 88. EMPLOYEE STOCK OWNERSHIP PLAN (ESOP) In 1985, the Corporation established an Employee Stock Ownership Plan and Trust (ESOP). The ESOP purchased 1.3 million newly-issued shares of common stock and the Corporation contributed an additional 6,035 shares of common stock to the ESOP. All employees are eligible to participate in the ESOP if employed by the Corporation or a participating subsidiary, after completion of the age and service requirements. An employee will be enrolled as a participant on the first "Enrollment Date" after reaching age 18 and completing 1,000 hours of service. The Corporation, when the plan was established, loaned the ESOP approximately $37.6 million to finance its purchase of the stock in exchange for a promissory note. The note, which bears interest at the prime rate, is to be repaid over 12 years using future Corporation contributions. The Corporation's initial contribution to the ESOP of 6,035 shares was made on behalf of all regular full-time employees age 18 or over as of July 10, 1985. This was equal to one share of Michigan National Corporation common stock for each eligible employee. Thereafter, the Corporation may make contributions to the plan in an amount determined by its Board of Directors. The contribution will be in amounts which, when added to the dividends received on the Corporation's shares owned by the ESOP, are at least enough to allow the ESOP to pay principal and interest on its loan. The Corporation contributed $3.0, $3.1 and $3.5 million in 1993, 1992 and 1991, respectively, to the ESOP. The note is shown as a reduction from shareholders' equity. The repayment terms are identical to those of a related borrowing by the Corporation from Marine Midland Bank, N.A. (See Note N). The Corporation made an annual principal payment of $2.8 million and interest payments of $1.0, $1.3 and $2.1 in 1993, 1992 and 1991, respectively, to Marine Midland Bank, N.A.. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Q. Postretirement Benefits The Corporation provides certain health care and life insurance benefits for all of its retired employees who are eligible for a benefit under the pension plan, are at least age 55 and have at least 15 years of service. Effective January 1, 1993, the Corporation adopted SFAS No. 106, Employers' Accounting for Postretirement Benefits Other Than Pension. SFAS No. 106 requires the Corporation to accrue the estimated cost of retiree benefit payments during the years the employee provides services. The Corporation previously expensed the cost of these benefits as claims were incurred. For each of the years ended December 31, 1992 and 1991, the Corporation recognized expense of $1.3 million for postretirement benefit claims paid. SFAS No. 106 allows immediate recognition of the cumulative effect of the liability (transition obligation) in the year of adoption or amortization of the transition obligation over a period of up to twenty years. The Corporation has elected to recognize the January 1, 1993, accumulated benefit obligation of approximately $40.2 million over a period of twenty years. The Corporation's cash flows are not affected by implementation of this Statement, but implementation resulted in additional expense for the year ended December 31, 1993, of approximately $5.6 million. - ------------------------------------------------------------------------------ The following is a summary of the components of net periodic postretirement costs for the year ended December 31, 1993, determined under the provisions of SFAS No. 106. - ------------------------------------------------------------------------------ - ------------------------------------------------------------------------------- The following table sets forth the amount recorded in the December 31, 1993, consolidated statement of condition. - ------------------------------------------------------------------------------- For purposes of measuring the accumulated benefit obligation and periodic cost, a 14% annual rate of increase in the per capita cost of covered benefits (i.e., health care cost trend rate) was assumed for 1993; the rate was further assumed to decline linearly over the next 15 years to 5.5%. A one-percentage-point increase in the assumed health care cost trend rate for each year would increase the accumulated postretirement benefit obligation as of December 31, 1993 by an estimated $6.1 million and the annual net periodic postretirement health care cost by an estimated $0.9 million. The assumed discount rate used in determining the accumulated postretirement benefit obligation was 7.0% at December 31, 1993, and 8.5% at January 1, 1993. The Corporation has not funded its postretirement obligation. - ------------------------------------------------------------------------ R. Fair Value of Deposit Liabilities - ------------------------------------------------------------------------ The estimated fair value of deposit liabilities was $8.8 billion and $9.0 billion at December 31, 1993 and 1992, respectively. The estimated fair value of deposits with no stated maturity, such as non-interest bearing demand deposits, savings, NOW accounts, money market and checking accounts, is equal to the amount payable on demand as of December 31, 1993. The fair value of certificates of deposit is estimated by discounting their expected future cash flows using rates offered for deposits of similar remaining maturities as of the reporting date. The fair value estimates above do not include the benefit that results from the low-cost funding provided by the deposit liabilities compared to the cost of borrowing funds in the market. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS S. Transactions with Related Parties The Corporation's major subsidiaries had, and expect to have in the future, transactions with the Corporation's directors and their affiliates. Such transactions were made in the ordinary course of business on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated parties and did not involve more than the normal risk of collectability or present other unfavorable features. The aggregate amount of such loans to persons who were related parties at December 31, 1993, approximated $97 million at the beginning and $113 million at the end of 1993. During 1993, advances and new loans to related parties approximated $82 million and payments approximated $39 million. In addition, the beginning balance was reduced by approximately $27 million for individuals who were directors or officers at December 31, 1992, but not at December 31, 1993. During 1992, advances and new loans to related parties approximated $134 million and payments approximated $116 million. The aggregate amount of such loans at January 1, 1992, approximated $79 million. T. Other Expenses U. Legal Proceedings and Regulatory Matters LEGAL PROCEEDINGS The Corporation and certain of its subsidiaries are parties to routine legal proceedings arising in the normal course of their respective businesses. Management, after having consulted with legal counsel, is of the opinion that the ultimate liability, if any, resulting from these routine proceedings, will not have a material adverse effect on the consolidated financial position or results of operations of the Corporation. Also reference Note V for a discussion of certain tax contingencies. REGULATORY MATTERS As previously reported in August 1993, Michigan National Bank (MNB), the Corporation's principal banking subsidiary, entered into a Memorandum of Understanding (MOU) with the Central Office of the Comptroller of the Currency. Under the terms of the MOU, MNB agreed to review its management structure; risk management policies; and its mortgage banking business for the purpose of determining its appropriate role in MNB's strategic plan. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS As discussed in Note A, the Corporation adopted SFAS No. 109 as of January 1, 1992. The cumulative effect of this change in accounting for income taxes of $6.3 million was determined as of January 1, 1992 and was reported separately in the consolidated statement of income for the year ended December 31, 1992. Prior years' financial statements were not restated to apply the provisions of SFAS No. 109. As previously reported, the significant components of the net tax effects of changes in temporary differences reflected in the deferred tax expense for the years ended December 31, 1991 is as follows: Significant deferred tax assets and liabilities as of December 31, 1993 and 1992 arising from temporary differences and carryforwards are as follows: A valuation allowance has been provided for net operating loss carryforwards because of the uncertainty surrounding their realization. The income tax expense was different than the amount computed using the U.S. statutory income tax rate (35% for 1993, 34% for 1992 and 1991) as a result of the following: NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------ At December 31, 1993, the Corporation has NOL carryforwards for federal income tax purposes of approximately $169 million arising in the years 1989, 1990 and 1991. These carryforwards will expire in the years 2004, 2005 and 2006, respectively. As discussed below, in August 1993, the Internal Revenue Code was amended retroactively to March 4, 1991, for certain losses and deductions related to IOBOC. As a result of this retroactive change in law, the Corporation's NOL carryforwards were reduced by approximately $42 million. In addition NOL carryforwards of approximately $231 million were acquired and are available at December 31, 1993, to offset only the future taxable income of IOBOC. These carryforwards expire through 2003. The Corporation also has alternative minimum tax credit carryforwards for tax purposes of approximately $17.6 million which are available to reduce future federal regular income taxes over an indefinite period. Benefits derived from the utilization of these carryforwards are subject to sharing by the FDIC, see Note E for a discussion of tax benefit sharing under the Assistance Agreement. On March 4, 1991, the U.S. Department of Treasury (Treasury) issued a report to the United States Congress announcing for the first time that the Treasury has determined that an expense or loss of an assisted institution that is incurred on the sale or write-down of certain assets should not be deductible for federal income tax purposes to the extent the expense or loss is reimbursed through assistance payments from the federal government (covered losses). The report recognizes that certain inconsistencies exist between the position taken in the report and prior Treasury positions and acknowledges potential contrary interpretations of the law. The report urges "Congressional clarification" of these issues and further indicates that the Internal Revenue Service (IRS) is prepared to challenge and litigate, if necessary, the deductibility of these expenses and covered losses. The Internal Revenue Code (IRC) was amended as of August of 1993 to provide, among other things, that FSLIC Assistance received for losses realized on the disposition or write-down of covered assets shall be treated for tax purposes as compensation for the loss, thus reducing or eliminating any tax loss with respect to the asset. Furthermore, future assistance must be considered when determining the extent a debt is currently worthless, hence reducing the amount of any addition a taxpayer may claim to the tax bad debt reserve. This change applies to FSLIC assistance credited on or after March 4, 1991, for assets disposed of and charge-offs made in tax years ending on or after March 4, 1991. Congressional history to this provision indicates that no inference is intended as to prior law or as to the treatment of any item to which the IRC amendment does not apply. Despite these recent IRC amendments, Treasury has not expressed a change of opinion with respect to the deductibility of expenses and covered losses realized prior to the effective date of the amendments to the IRC. The Corporation has claimed deductions of this nature. It is presently impossible to determine how, if at all, such deductions will be affected. In the unlikely event that all of these deductions are disallowed, future earnings would be adversely impacted by approximately $23 million. In addition, approximately $169 million of net operating loss carryforwards would be eliminated. The Corporation continues to believe that its tax position with respect to these deductions is correct and proper and it will vigorously defend them against any challenge by the IRS. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - ------------------------------------------------------------------------------- W. Industry Segment Information - ------------------------------------------------------------------------------- The Corporation operates in two industry segments (as defined by Statement of Financial Accounting Standards (SFAS) No. 14, Financial Reporting for Segments of a Business Enterprise). The two industry segments are the mortgage banking industry and the financial institutions industry. Following is a presentation of the revenues, operating profits and identifiable assets for the years ended December 31, 1993, 1992 and 1991. The intercompany income/(expense) presented below represents interest expense incurred by the mortgage banking business on its line of credit with the Corporation's bank subsidiary less interest income paid to the mortgage banking business by the bank subsidiary for investment earnings from deposit relationships brought to the bank by the mortgage banking servicing business. In addition, intercompany income/(expense) includes operating expenses incurred by the mortgage banking business for services provided by the bank subsidiary (principally data processing services) and by the parent company (principally general administrative services). In addition, the mortgage banking business maintains escrow and custodial funds which are on deposit with the Corporation's principal banking subsidiary, MNB, and therefore are reflected in the total liabilities of the financial institution business segment. Those deposit balances were approximately $469 million and $501 million at December 31, 1993 and 1992, respectively. The off-balance sheet mortgage servicing portfolio is described in the Mortgage Banking Activities section of Note A. As presented below, the percentage of the off-balance sheet mortgage servicing portfolio that is comprised of servicing from loans originated by the mortgage banking business was significantly greater at December 31, 1993 than in prior years. Servicing from originated loans does not have a purchased mortgage servicing intangible asset associated with it. Certain prior period amounts were restated to conform to current period presentation. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTES TO CONSOLIDATED FINANCIAL STATEMENT - -------------------------------------------------------------------------------- Condensed Parent Company Only Statement of Cash Flows - -------------------------------------------------------------------------------- INDEPENDENT AUDITORS REPORT [LOGO] Shareholders and Board of Directors Michigan National Corporation We have audited the accompanying consolidated statements of financial condition of Michigan National Corporation and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, changes in shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of Michigan National Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Michigan National Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in the summary of significant accounting policies, Michigan National Corporation changed its method of accounting for postretirement benefits effective January 1, 1993 in order to conform with Statement of Financial Accounting Standard No. 106. The Corporation changed its method of accounting for income taxes effective January 1, 1992 in order to conform with Statement of Financial Accounting Standard No. 109. /s/ Deloitte & Touche Detroit, Michigan Feberuary 15, 1994 SHAREHOLDER INFORMATION The Corporation's common stock is traded on the NASDAQ over-the-counter market, and as of December 31, 1993, there were approximately 8,800 holders of record. The following table shows the high and low closing market values by quarter for the last two years. The quotations represent actual transactions and do not reflect retail markups, markdowns or commissions. (a) A fourth quarter 1993 dividend of $0.50 per share was declared January 19, 1994, payable to shareholders of record as of February 1, 1994. This does not represent a change in the Corporation's dividend policy, but rather a change only in the timing of the dividend declaration. HEADQUARTERS Michigan National Corporation 27777 Inkster Road Farmington Hills, MI 48334 (810) 473-3000 ANNUAL MEETING Tuesday, April 19, 1994 10:00 A.M. EST Auditorium of Michigan National Corporation Headquarters MICHIGAN NATIONAL CORPORATION STOCK Michigan National Corporation common stock is traded in the over-the-counter market and quoted on the National Association of Securities Dealers Automated Quotations (NASDAQ) National Market System under the symbol "MNCO." GENERAL SHAREHOLDER CORRESPONDENCE (Inquiries related to disbursement of dividends, replacement of lost certificates, and address changes): First Chicago Trust Company of New York P.O. Box 2500 Jersey City, New Jersey 07303-2500 1-(800)-628-8585 STOCK TRANSFERS First Chicago Trust Company of New York P.O. Box 2506 Jersey City, New Jersey 07303-2506 1-(800)-628-8585 DIVIDEND REINVESTMENT PLAN Automatic reinvestment of dividends and voluntary cash purchases of Michigan National Corporation common stock are available without brokerage commissions or service fees. Please direct requests for a Dividend Reinvestment Plan brochure and any inquiries related to the Plan to: First Chicago Trust Company of New York Dividend Reinvestment Plan P.O. Box 2598 Jersey City, New Jersey 07303-2598 1-(800)-628-8585 VOLUNTARY CASH PURCHASE PAYMENTS First Chicago Trust Company of New York Dividend Reinvestment Plan P.O. Box 13531 Newark, New Jersey O7188-0001 1-(800)-628-8585 ADDITIONAL SHAREHOLDER INFORMATION Please direct inquiries to: Michigan National Corporation Investor Relations Department P.O. Box 9065 Farmington Hills, MI 48333-9065 (810) 473-3076 SELECTED QUARTERLY FINANCIAL INFORMATION (1) A fourth quarter 1993 dividend of $0.50 per share was declared January 19, 1994, payable to shareholders of record as of February 1, 1994. This does not represent a change in the corporation's dividend policy, but rather a change only in the timing of the dividend declaration. N/M = not meaningful. Certain prior period amounts have been reclassified to conform to current period presentation. Previously reported amounts for the three months ended September 30, 1993 and June 30, 1993, have been restated to reflect the effects of postponing the recognition of a second quarter sale of servicing rights for accounting purposes. CONSOLIDATED SUMMARY OF INCOME Certain prior period amounts have been reclassified to conform with the current period presentation. EMPLOYMENT AGREEMENT THIS AGREEMENT, is entered into this 17th day of November, 1993, between Michigan National Corporation, ("Employer") and Douglas E. Ebert, ("Employee"). WHEREAS, Employer wishes to avail itself of Employee's experience and management skills in connection with the operation of Employer's business; and WHEREAS, the Employee desires to be employed by Employer as an executive officer. NOW, THEREFORE, for the reasons set forth above, and in consideration of the promises and conditions set forth herein, Employer and Employee agree as follows: ARTICLE ONE EMPLOYMENT 1.1 Employer hereby employs and hires Employee as its Chief Operating Officer. Employee accepts and agrees to such hiring and employment, subject to the general supervision and pursuant to the orders, advice, and direction of Employer. Employee shall perform all duties as are customarily performed by one holding such position in other, or similar, businesses or enterprises as that engaged in by Employer, and shall also additionally render such other and unrelated services and duties as may be assigned to him from time-to-time by Employer. Employee further agrees to perform such services and act in such executive capacity as the Board of Directors of Employer shall from time-to-time direct including, but not limited to, Chief Operating Officer of Michigan National Bank, its principal banking subsidiary. 1.2 Employee agrees that he will at all times and to the best of his ability, experience, and talents, perform all of the duties that may be required of him pursuant to the express and implied terms hereof, to the satisfaction of Employer. Such duties shall be rendered at the principal offices of Employer. 1.3 Employee agrees that he will at all times observe and be bound by all resolutions, policies or rules, in any form whatsoever, heretofore or hereafter adopted by Employer that are generally applicable to Employer's officers and employees including, but not limited to, those existing resolutions, policies or rules concerning conflicts of interest and transactions in the securities of Employer. ARTICLE TWO TERM; TERMINATION 2.1 The initial term of this Agreement shall be three (3) years to conclude on December 31, 1996 ("Term"), which may be extended for an additional one-year period at the discretion of the Board of Directors of Employer at the end of the first and second years of the Term of this Agreement. Upon termination of this Agreement, Employee's employment may continue on an "at will" basis. 2.2 This Agreement and Employee's employment hereunder may be terminated by resolution of the Board of Directors of Employer or by mutual written agreement between Employer and Employee at any time during the Term of this Agreement whereupon Employee shall be entitled to continue to receive his Base Salary, as defined in Section 4.1 hereof, for the remaining Term of the Agreement, which shall be paid periodically as though his employment is continued under this Agreement ("Salary Continuation"), but shall not be entitled to the continuation of any other benefit whatsoever under this Agreement. Provided, however, that Employee will continue to receive any pension benefits to which he may be entitled pursuant to Section 5.3 hereof for services rendered prior to the termination of this Agreement. Furthermore, Employee agrees that any Salary Continuation will be reduced by any earnings from Employment in any other capacity during the period of the Salary Continuation. 2.3 This Agreement may also be terminated for any reason whatsoever by Employee by giving ninety (90) days prior written notice to Employer. If Employee elects to terminate this Agreement, all compensation and benefits of any nature whatsoever shall terminate as of the effective date of the termination of this Agreement. Provided, however, that Employee will continue to receive any pension benefits to which he may be entitled pursuant to Section 5.3 hereof for services rendered prior to the termination of this Agreement. ARTICLE THREE EMPLOYMENT RESTRICTIONS 3.1 Employee shall devote substantially all of his attention, knowledge, and skills solely to the business and interests of Employer. During the Term of this Agreement, Employee shall not participate directly or indirectly, as partner, officer, director, advisor, employee or in any other capacity with any other organization or business without the express written consent of the Board of Directors of Employer. ARTICLE FOUR COMPENSATION 4.1 Employer agrees to compensate employee for services to be rendered pursuant to this Agreement in the following manner: (a) Employee shall receive an annual base salary of Four Hundred Fifty Thousand ($450,000) Dollars ("Base Salary"), which shall be adjusted annually in accordance with Employer's policy on merit salary increases. (b) Employee shall participate in any bonus program participated in generally by the Employer's executive officers. (c) At time of hire, Employee will receive a one-time lump sum payment of Seventy-Five Thousand ($75,000) Dollars. (d) Upon election to Employer's Board of Directors, Employee will be granted options to purchase One Hundred Thousand (100,000) shares of Employer's common stock which options will include, but not be limited to, the following provisions: -- The option price will be the average of the closing bid and asked prices for such stock as of the date Employee is elected to the Board of Directors; -- The options will be 100% vested as of the grant date; -- The date of expiration will be ten (10) years and one (1) day after the date of grant; -- Employee will have 365 days after the date of termination of actual employment by reason of retirement, death, or disability to exercise the options; -- In the event of termination by Employer, Employee will have six months from the date of termination to exercise the options; and -- The options are nontransferable other than by will or by the laws of descent and distribution. (e) Employer will reimburse Employee for any loss incurred upon the sale of Employee's current principal residence, including brokerage fees, up to One Hundred Thousand ($100,000) Dollars. In the alternative, Employee may elect to be covered under Employer's current Relocation Policy. (f) The Board of Directors of Employer is currently reviewing its existing Change in Control Severance Agreements with certain of its executive officers. Employee will be provided with the benefits afforded by any Change in Control Severance Agreements with any executive officers of Employer. ARTICLE FIVE EMPLOYEE BENEFITS 5.1 During the Term of this Agreement, Employer shall provide certain fringe benefits to Employee, pursuant to such general policies and procedures of Employer as adopted or amended from time-to-time in its sole discretion by the Board of Directors of Employer. Employee shall also be entitled to participate in such other plans or arrangements as the Board of Directors of Employer may hereafter, in its sole discretion, adopt and approve or change with respect to incentive compensation, deferred compensation and/or retirement benefits for any salary grade of employees, which includes Employee. 5.2 Employee will be provided with pension benefits equal to 50% of the average of the three highest years of total compensation, including base wages and corporate bonus, with benefits beginning at age sixty (60). The pension benefits will have a ten (10) year vesting cycle with 0% vesting for the first two (2) years, 30% vesting after three (3) years, and 10% vesting each year for years four (4) through ten (10). Any benefits received from Social Security or from any qualified pension plan will reduce the pension benefits payable under this Agreement. ARTICLE SIX CONFIDENTIAL INFORMATION 6.1 Employee agrees, during the Term of his employment, to treat as confidential all memoranda, notes, computer software, records, data, statistics, figures, customer information, manner of operations, plans, or other documents or information not publicly available or generally known, made or compiled or obtained by Employee, or made available or disclosed to Employee, during his employment concerning the business of Employer ("Confidential Information"). The parties hereto stipulate the Confidential Information is important, material, and confidential, and gravely affects the effective and successful conduct of the business of Employer, and Employer's goodwill. Any breach of the terms of this Section of the Agreement by Employee shall be deemed a material breach. 6.2 Employee agrees that, during the Term of his employment, he will not use such Confidential Information for his own use, advantage or benefit or for the use, advantage or benefit of any person, corporation, partnership or association whatsoever ("Persons"). Employee further agrees upon termination for any reason, that he will continue to treat as privileged any such Confidential Information, and will not release any such Confidential Information to any Persons, whether by statement, deposition or as witness, except upon written authority of Employer or as may be required by law. 6.3 Employee agrees that during the Term of his employment, Employee shall not at any time or in any manner, either directly or indirectly, divulge, disclose, duplicate, communicate or otherwise make available to any Persons in any manner whatsoever, any such Confidential Information. Employee further agrees that he will not allow any Persons to copy, reproduce or disclose, in whole or in part, in any manner, any such Confidential Information. 6.4 Notwithstanding the foregoing, Employee shall only use, disclose, communicate or duplicate any such Confidential Information in a manner consistent with or as required to fulfill the terms of his employment. ARTICLE SEVEN SURRENDER OF RECORDS ON TERMINATION 7.1 Upon termination of employment for whatever reason, Employee shall immediately return to Employer all of Employer's property, including any such Confidential Information, as defined in Section 6, used by Employee in fulfilling the terms of his employment, that is in Employee's possession or under his control. ARTICLE EIGHT MISCELLANEOUS 8.1 Employee expressly acknowledges that the limitations contained in this Agreement are reasonable and properly required for the adequate protection of the business of Employer. It is the intention of the parties hereto that the provisions of this Agreement be enforced to the fullest extent permissible under all applicable laws and public policies, but that the unenforceability or the modification to conform with such laws or public policies of any provision contained herein shall not render unenforceable or impair the remainder of this Agreement. Accordingly, if any provision of this Agreement shall be determined to be invalid, illegal or unenforceable, in any respect, this Agreement shall be deemed amended to delete or modify, as necessary, the invalid or unenforceable provisions, to alter the balance of this Agreement in order to render the same valid and enforceable and the legality, validity and enforceability of the remaining provisions contained in this Agreement shall not in any way be affected or impaired thereby. 8.2 Moreover, if any one or more of the provisions of this Agreement is for any reason held excessively broad, it shall be construed or rewritten so as to be enforceable to the extent of the greatest protection to Employer compatible with applicable law. 8.3 This Agreement is entered into in the State of Michigan and shall be construed and interpreted according to the statutes, rules of law and court decisions of such State. 8.4 This Agreement may be amended, modified or superseded only by an agreement, in writing, and signed by an authorized Executive Officer of Employer and Employee. 8.5 No waiver or any breach of any term or provision of this Agreement shall be construed to be a waiver of any preceding or succeeding breach of the same or any other term or provision. Any waiver must be in writing signed by the party waiving any such breach to be effective. 8.6 Employee expressly consents to the jurisdiction of the courts of the State of Michigan and in the event of any dispute arising under this Agreement, further expressly agrees to accept service of process by certified mail, return receipt requested, to his last known address. 8.7 The headings of Sections are inserted only for the purposes of convenient reference and shall not be deemed to govern, limit, modify, or in any other manner affect the meaning or intent of any of the provisions of this Agreement. 8.8 All notices, requests, demands and other communications provided for by this Agreement shall be in writing and shall be sufficiently given if and when mailed by registered or certified mail, return receipt requested, or personally delivered to the party entitled thereto at the address stated below or to such other address as the addressee may indicate by similar notice: To Employer: Robert J. Mylod, Chairman Michigan National Corporation 27777 Inkster Road P.O. Box 9065 Farmington Hills, MI 48333-9065 To Employee: Douglas E. Ebert 27777 Inkster Road P.O. Box 9065 Farmington Hills, MI 48333-9065 8.9 This Agreement constitutes the entire agreement between the parties and shall be binding upon and inure to the benefit of the parties hereto and their legal representatives, heirs, successors and assigns, provided that Employee shall have no right to assign, pledge or otherwise dispose of or transfer any interest in this Agreement without the prior written consent of Employer. 8.10 Nothing contained herein shall limit any other rights Employer has at law in connection with Employee's obligations to Employer, all of which are preserved. ARTICLE NINE AGREEMENTS OUTSIDE OF CONTRACT 9.1 This Agreement contains the complete agreement concerning the employment arrangement between the parties and shall, as of the effective date hereof, supersede all other agreements between the parties. The parties stipulate that neither of them has made any representation with respect to the subject matter of this Agreement or any representations including the execution and delivery hereof except such representations as are specifically set forth herein, and each of the parties hereto acknowledges that he or it has relied on its own judgment in entering into this Agreement. The parties hereto further acknowledge that any payments or representations that may have heretofore been made by either of them to the other are of no effect and that neither of them has relied thereon in connection with his or its dealings with the other. IN WITNESS WHEREOF, the undersigned have caused this Agreement to be executed as of the day and year first above written. MICHIGAN NATIONAL CORPORATION By: /s/ ROBERT J. MYLOD ------------------------- Robert J. Mylod Chairman By: /s/ DOUGLAS E. EBERT -------------------------- Douglas E. Ebert EMPLOYMENT AGREEMENT THIS AGREEMENT, is entered into this 2nd day of March, 1994, between Michigan National Bank, a national banking association, ("Employer") and Joseph J. Whiteside ("Employee"). WHEREAS, the Employee has considerable knowledge and experience relating to banking and the operations of financial institutions; WHEREAS, Employer wishes to avail itself of Employee's experience and management skills in connection with the operation of Employer's business; and WHEREAS, the Employee desires to be employed by Employer as an officer. NOW, THEREFORE, for the reasons set forth above, and in consideration of the promises and conditions set forth herein, Employer and the Employee agree as follows: ARTICLE ONE EMPLOYMENT 1.1 Employer hereby employs and hires Employee as a Executive Vice President, Chief Financial Officer and Cashier for Michigan National Bank. In addition, Employee will be appointed Executive Vice President and Chief Financial Officer of Employer's holding company, Michigan National Corporation. Employee accepts and agrees to such hiring and employment, subject to the general supervision and pursuant to the orders, advice, and direction of Employer. Employee shall perform all duties as are customarily performed by one holding such position in other, or similar, businesses or enterprises as that engaged in by Employer, and shall also additionally render such other and unrelated services and duties as may be assigned to him from time to time by Employer. Employee further agrees to perform such services and act in such executive capacity as the Board of Directors of Employer shall direct. 1.2 Employee agrees that he will at all times to the best of his ability, experience, and talents, perform all of the duties and services that may be required of him pursuant to the express and implied terms hereof, to the reasonable satisfaction of Employer. Such duties shall be rendered at the principal offices of Employer or at such other place or places as Employer and Employee may mutually agree to conduct the business of Employer. 1.3 Employee shall make available to Employer all information related to duties and services performed under this Agreement of which Employee shall have any knowledge and shall make all suggestions and recommendations that will be of mutual benefit to Employer and himself. 1.4 Employee agrees to adhere strictly to any and all rules and regulations established by Employer as may be amended from time to time, including but not limited to rules and regulations set forth in any compliance or procedures manual prepared by Employer. Employee further agrees to adhere strictly to all of the rules, regulations and reporting requirements of any applicable governmental agencies, including but not limited to, the Board of Governors of the Federal Reserve System, the Securities and Exchange Commission, the Comptroller of the Currency and the State of Michigan. ARTICLE TWO TERM; TERMINATION 2.1 The initial term of this Agreement shall be three (3) years to conclude on March 31, 1997 ("Term"), which may be extended for an additional one-year period at the discretion of the Board of Directors of Employer at the end of the first and second years of the Term of this Agreement. Upon termination of this Agreement, Employee's employment may continue on an "at will" basis. 2.2 This Agreement and Employee's employment hereunder shall terminate before the end of the Original Term upon the happening of any of the following events: (a) Mutual written agreement between Employer and Employee to terminate Employee's employment. (b) Resolution of the Board of Directors of Employer pursuant to 12 USC 24 (Fifth). 2.3 If this Agreement is terminated because of the occurrence of the events listed in sections 2.2(a) or 2.2(b), then Employee shall be entitled to receive the balance of the compensation remaining under this Agreement, or the standard corporate severance package, whichever is greater. 2.4 The provisions of Sections 2.2-2.3 notwithstanding, this Agreement may be terminated during the Original Term for any reason by either party on ninety (90) days written notice to the other. If Employee shall so terminate this Agreement, he shall not be entitled to any further compensation whatsoever, after the effective date of his resignation. If Employer shall so terminate this Agreement, Employee shall be entitled to the balance of the compensation remaining under this Agreement or the standard corporate severance package, whichever is greater. ARTICLE THREE EMPLOYMENT RESTRICTIONS 3.1 Employee shall devote substantially all of his business time, attention, knowledge, and skills solely to the business and interest of Employer. Employer shall be entitled to all of the benefits, profits or other issues arising from or incident to all work, services, and advice of Employee, and Employee shall not, during the term hereof, be interested directly or indirectly, in any manner, as partner, officer, director, advisor, employee or in any other capacity in any other financial institution (including bank holding company, commercial bank, savings bank, savings and loan association or credit union) during the term of this employment. ARTICLE FOUR COMPENSATION 4.1 Employer agrees to compensate Employee for services to be rendered pursuant to this Agreement in the following manner: (a) Employee shall receive an annual base salary of Two Hundred Seventy-Five Thousand ($275,000.00) Dollars ("Base Salary") as compensation for the performance of his duties under Section 1.1 of this Agreement. Such Base Salary shall be adjusted annually in accordance with Employer's policy on merit salary increases. (b) Employee will be eligible to receive bonus compensation under the Michigan National Corporation bonus program as adopted by the Board of Directors. The maximum bonus opportunity will be 50% of Employee's annual base salary. (c) Employee shall receive a one-time lump sum payment of $35,000.00, payable within ten (10) days after his date of hire. (d) Employee shall be provided with a Supplemental Executive Retirement Plan which will provide pension benefits equal to 40% of Employee's highest average total compensation for the three consecutive years out of the last ten calendar years of employment. The Agreement will have a ten year vesting schedule with 0% vesting for the first two years, 30% vesting after three years and 10% vesting each year for years four through ten. These benefits will be offset by any benefits available under the Michigan National Qualified Pension Plan, Social Security and any single premium annuity purchased on Employee's behalf by the Corporation under the terms of the Pension Agreement. (e) Employee shall be granted 25,000 options on Michigan National Corporation Stock with the option price based on the closing price of the stock on Employee's date of hire. The options will be 100% vested as of the date of grant. (f) Employee will also be eligible for a Country Club membership of his chose, full relocation benefits and eligibility under all of the appropriate Michigan National Welfare and Deferred benefits. ARTICLE FIVE EMPLOYEE BENEFITS 5.1 During the term of this Agreement, Employer shall provide certain fringe benefits to Employee, including vacation days, stock options, country club membership, Employee life insurance policy, pursuant to such general policies and procedures of Employer as adopted or amended from time to time in its sole discretion by the Board of Directors of Employer. Employee shall also be entitled to participate in such other plans or arrangements as the Board of Directors of Employer may hereafter, in its sole discretion, adopt and approve or change with respect to incentive compensation, deferred compensation and/or retirement benefits for Employee or any class of Employees including Employee. All such benefits shall be terminated by Employer upon the termination of this Agreement. 5.2 Employee shall be reimbursed for all reasonable business expenses incurred by him in connection with the conduct of Employer's business for which he furnishes appropriate documentation and which has been approved in accordance with Company policy. ARTICLE SIX CONFIDENTIAL INFORMATION 6.1 Employee agrees, during the term of his employment, to treat as confidential all memoranda, notes, computer software, records, data, statistics, figures, customer information, manner of operations, plans, or other documents or information not publicly available or generally known, made or compiled or obtained by Employee, or made available or disclosed to Employee, during his employment concerning the business of Employer ("Confidential Information"). The parties hereto stipulate the Confidential Information is important, material, and confidential, and gravely affects the effective and successful conduct of the business of Employer, and Employer's goodwill. Any breach of the terms of this Section of the Agreement by Employee shall be deemed a material breach. 6.2 Employee agrees that, during the term of his employment he will not use such Confidential Information for his own use, advantage or benefit or for the use, advantage or benefit of any person, corporation, partnership or association whatsoever ("Persons"). Employee further agrees upon termination for any reason, that he will continue to treat as privileged any such Confidential Information, and will not release any such Confidential Information to any Persons, whether by statement, deposition or as witness, except upon written authority of Employer or as may be required by law. 6.3 Employee agrees that during the term of his employment Employee shall not at any time or in any manner, either directly or indirectly, divulge, disclose, duplicate, communicate or otherwise make available to any Persons in any manner whatsoever, any such Confidential Information. Employee further agrees that he will not allow any Persons to copy, reproduce or disclose, in whole or in part, in any manner any such Confidential Information. 6.4 Notwithstanding the foregoing, Employee shall only use, disclose, communicate or duplicate any such Confidential Information in a manner consistent with or as required to fulfill the terms of his employment. ARTICLE SEVEN SURRENDER OF RECORDS ON TERMINATION 7.1 Upon termination of employment for whatever reason, Employee shall immediately return to Employer, all of Employer's property, including any such Confidential Information, as defined in Article Six, used by Employee in fulfilling the terms of his employment, that is in Employee's possession or under his control. ARTICLE EIGHT MISCELLANEOUS 8.1 Employee expressly acknowledges that the limitations contained in this Agreement are reasonable and properly required for the adequate protection of the business of Employer. It is the intention of the parties hereto that the provisions of this Agreement, be enforced to the fullest extent permissible under all applicable laws and public policies, but that the unenforceability or the modification to conform with such laws or public policies of any provision contained herein shall not render unenforceable or impair the remainder of this Agreement. Accordingly, if any provision of this Agreement shall be determined to be invalid, illegal or unenforceable, in any respect, this Agreement shall be deemed amended to delete or modify, as necessary, the invalid or unenforceable provisions, to alter the balance of this Agreement in order to render the same valid and enforceable and the legality, validity and enforceability of the remaining provisions contained in this Agreement shall not in any way be affected or impaired thereby. 8.2 If, moreover, any one or more of the provisions of this Agreement is for any reason held excessively broad, it shall be construed or rewritten so as to be enforceable to the extent of the greatest protection to Employer compatible with applicable law. 8.3 This Agreement is entered into in the State of Michigan and shall be construed and interpreted according to the statutes, rules of law and court decisions of such State. 8.4 This Agreement may be amended or modified or superseded only by an agreement, in writing, and signed by an authorized Executive Officer of Employer and Employee. 8.5 No waiver or any breach of any term or provision of this Agreement shall be construed to be a waiver of any preceding or succeeding breach of the same or any other term or provision. Any waiver must be in writing signed by the party waiving any such breach to be effective. 8.6 Employee expressly consents to the jurisdiction of the courts of the State of Michigan and in the event of any dispute arising under this Agreement further expressly agrees to accept service of process by certified mail, return receipt requested, to his last known address. 8.7 The headings of articles are inserted only for the purposes of convenient reference and shall not be deemed to govern, limit, modify, or in any other manner affect the meaning or intent of any of the provisions of this Agreement or the Agreement itself. 8.8 All notices, requests, demands and other communications provided for by this Agreement shall be in writing and shall be sufficiently given if and when mailed by registered or certified mail, return receipt requested, or personally delivered to the party entitled thereto at the address stated below or to such other address as the addressee may indicate by similar notice: To Employer: Robert J. Mylod Michigan National Corporation 27777 Inkster Road P. O. Box 9065 Farmington Hills, MI 48333-9065 To Employee: Joseph J. Whiteside Michigan National Corporation 27777 Inkster Road P. O. Box 9065 Farmington Hills, MI 48333-9065 8.9 This Agreement constitutes the entire agreement between the parties and shall be binding upon and inure to the benefit of the parties hereto and their legal representatives, heirs, successors and assigns, provided that Employee shall have no right to assign, pledge or otherwise dispose of or transfer any interest in this Agreement or any payments hereunder without the prior written consent of Employer. 8.10 Nothing contained herein shall limit any other rights Employer has at law in connection with Employee's obligations to Employer, all of which are preserved. ARTICLE NINE AGREEMENTS OUTSIDE OF CONTRACT 9.1 With the exception of an Executive Change in Control Agreement, Stock Option Agreement and an Executive Pension Agreement, this Agreement contains the complete agreement concerning the employment arrangement between the parties and shall, as of the effective date hereof, supersede all other agreements between the parties. The parties stipulate that neither of them has made any representation with respect to the subject matter of this Agreement or any representations including the execution and delivery hereof except such representations as are specifically set forth herein, and each of the parties hereto acknowledges that he or it has relied on its own judgment in entering into this Agreement. The parties hereto further acknowledge that any payments or representations that may have heretofore been made by either of them to the other are of no effect and that neither of them has relied thereon in connection with his or its dealings with the other. ARTICLE TEN MICHIGAN NATIONAL CORPORATION GUARANTEE 10.1 If Michigan National Bank's compensation obligations under this Agreement are rendered void by any court or regulatory agency with jurisdiction over Michigan National Bank, then the compensation obligations will be fulfilled by Michigan National Corporation, the holding company of Michigan National Bank. IN WITNESS WHEREOF, the undersigned have caused this Agreement to be executed as of the day and year first above written. MICHIGAN NATIONAL BANK a national banking association By: /s/ ROBERT J. MYLOD --------------------------- Robert J. Mylod Title: Chairman By: /s/ JOSEPH J. WHITESIDE --------------------------- Joseph J. Whiteside Date: 3/4/94 -------------------------- SCHEDULE OF DIFFERENCES IN KEY PROVISIONS OF THE REFERENCED PENSION AGREEMENTS * DOCUMENT OMITTED. This pension agreement is substantially identical in all material respects, except as indicated above, to the pension agreement between Michigan National Corporation and Richard C. Webb dated January 1, 1991, as amended March 5, 1992. The latter pension agreement was filed in Item 14 (c) (10) (p) of the December 31, 1992 Form 10-K and is incorporated herein by reference. ITEM 14(C)21. SUBSIDIARIES OF THE REGISTRANT MNC operates two national banks, Michigan National Bank and Lockwood National Bank of Houston, which are national banking associations established and organized under the laws of the United States. MNC operates one Texas banking corporation, First State Bank and Trust Company, organized under the laws of the State of Texas. MNC has one savings bank, IOBOC, a federally chartered stock savings bank. MNC's eight active non-banking subsidiaries are incorporated as follows: Lockwood Banc Group, Inc., Independence One Investment Services Corporation, Bloomfield Hills Bancorp, Inc., Independence One Asset Management Corporation, and MNC Operation And Services, Inc. under the laws of the State of Michigan; MNC Leasing Company and Independence One Holding Company under the laws of the State of Delaware; and Independence One Life Insurance Company under the laws of the State of Arizona. [LOGO] EXHIBIT 23 INDEPENDENT AUDITORS' CONSENT Michigan National Corporation: We consent to the incorporation by reference in the following Registration Statements of Michigan National Corporation (MNC) of our report dated February 15, 1994 appearing in this Annual Report on Form 10-K of MNC for the year ended December 31, 1993: DELOITTE & TOUCHE March 28, 1994 [LOGO] 93 FORM 10-K SIGNATURES February 23, 1994 Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. _____________________________ Michigan National Corporation (Registrant) /s/ ROBERT J. MYLOD _____________________________ Robert J. Mylod Chairman, President and Chief Executive Officer /s/ ERIC D. BOOTH _____________________________ Eric D. Booth Chief Financial Officer /s/ ROBERT V. PANIZZI _____________________________ Robert V. Panizzi Chief Accounting Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacity as its directors: /s/ DANIEL T. CARROLL /s/ ROBERT J. MYLOD ___________________________ ___________________________ Daniel T. Carroll Robert J. Mylod /s/ JOHN S. CARTON /s/ WILLIAM F. PICKARD ___________________________ ___________________________ John S. Carton William F. Pickard /s/ DOUGLAS E. EBERT /s/ STANTON KINNIE SMITH, JR. ___________________________ ___________________________ Douglas E. Ebert Stanton Kinnie Smith, Jr. /s/ SIDNEY E. FORBES /s/ WALTER H. TENINGA ___________________________ ___________________________ Sidney E. Forbes Walter H. Teninga /s/ SUE L. GIN /s/ RICHARD T. WALSH ___________________________ ___________________________ Sue L. Gin Richard T. Walsh /s/ MORTON E. HARRIS /s/ JAMES A. WILLIAMS ___________________________ ___________________________ Morton E. Harris James A. Williams /s/ GERALD B. MITCHELL ___________________________ Gerald B. Mitchell

108721_1993.txt

108721

1993

ITEM 1. BUSINESS Wynn's International, Inc., through its subsidiaries, is engaged primarily in the automotive parts and accessories business and the petrochemical specialties business. The Company designs, produces and sells O-rings and other seals and molded rubber and thermoplastic products and automotive air conditioning systems, components and related parts. The Company also formulates, produces and sells petrochemical specialty products and automotive service equipment and distributes, primarily in southern California, locks and hardware products manufactured by others. O-rings and other molded rubber products are marketed under the trademark "Wynn's-Precision." Air conditioning units for the automotive aftermarket are marketed by the Company under the trademark "Frostemp(R)," and wholesale parts are marketed and installation centers are operated under the trademark "Maxair(R)." Petrochemical specialty products are marketed under various trademarks, including "Wynn's(R)," "Friction Proofing(R)," "X-Tend(R)," "Spit Fire(R)," "Classic(R)," "Mark X(R)" and "Du-All(TM)." The Company's executive offices are located at 500 North State College Boulevard, Suite 700, Orange, California 92668. Its telephone number is (714) 938-3700. The terms "Wynn's International, Inc.," "Wynn's," "Company" and "Registrant" herein refer to Wynn's International, Inc. and its subsidiaries unless the context indicates otherwise. FINANCIAL INFORMATION BY BUSINESS SEGMENT AND GEOGRAPHIC DATA The Company's operations are conducted in three industry segments: Automotive Parts and Accessories; Petrochemical Specialties; and Builders Hardware. Financial information relating to the Company's business segments for the five years ended December 31, 1993 is incorporated by reference from Note 15 of "Notes to Consolidated Financial Statements" on pages 29 through 31 of the Company's Annual Report to Stockholders for the year ended December 31, 1993 (the "1993 Annual Report"). AUTOMOTIVE PARTS AND ACCESSORIES The Automotive Parts and Accessories Division consists of Wynn's-Precision, Inc. ("Precision") and Wynn's Climate Systems, Inc. ("Wynn's Climate Systems"). During 1993, sales of the Automotive Parts and Accessories Division were $181,478,000 or 64% of the Company's total net sales as compared with $185,947,000 and 64% in 1992. The operating profit of this division in 1993 was $16,643,000, or 70% of the Company's total operating profit as compared with $15,265,000 and 68% in 1992. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Business Segment and Geographical Information" on pages 14 through 17 and 29 through 31, respectively, of the 1993 Annual Report, which are hereby incorporated by reference. See also "Other Factors Affecting the Business." WYNN'S-PRECISION, INC. (O-RINGS, SEALS AND MOLDED RUBBER AND THERMOPLASTIC PRODUCTS) PRODUCTS Precision and its affiliated companies manufacture and sell a variety of static and dynamic sealing products. The principal users of the Precision products are automotive manufacturers, heavy vehicle manufacturers, industrial component manufacturers, hydraulic and pneumatic cylinder manufacturers, aerospace and defense contractors and the oil service industry. The principal products of Precision are O-rings, rack and pinion and front wheel drive seals, composite gaskets, hydraulic cylinder seals and various engineered molded rubber and plastic parts. These products are made from synthetic elastomers and thermoplastic materials. DISTRIBUTION Precision sells its products primarily through a direct sales force to original equipment manufacturer ("OEM") customers. Precision also markets its products throughout the United States through independent distributors and through Company-operated regional service centers located in Rancho Cucamonga, California; Elgin, Illinois; Grand Rapids, Michigan; Golden Valley, Minnesota; Charlotte, North Carolina; Buffalo, New York; Dayton, Ohio; Bensalem, Pennsylvania; Indianapolis, Indiana; Fort Worth, Texas; and Lenexa, Kansas. Precision's Canadian operation distributes products principally through a direct sales force to OEM customers, through independent distributors and through Precision-operated service centers in Canada and England. PRODUCTION Precision's manufacturing facilities are located in Lebanon and Livingston, Tennessee; Tempe, Arizona; Lynchburg, Virginia; Houston, Texas; and Orillia, Ontario, Canada. In 1993, Precision closed its 5,000 square-foot leased manufacturing facility located in Alexandria, Scotland due to certain start-up problems. Precision's corporate headquarters are located at the site of its main manufacturing facility in Lebanon, Tennessee. Precision also operates its own tool production facility in Lebanon, Tennessee. Over the past several years, Precision has made significant investments in modern computerized production equipment and facilities. Precision has a facility in Lebanon, Tennessee dedicated exclusively to injection molding. Using internally generated funds, Precision plans to spend approximately $10 million for capital expenditures in 1994 to increase its production capacity. The principal raw materials used by Precision are elastomeric and thermoplastic materials. These raw materials generally have been available from numerous sources in sufficient quantities to meet Precision's requirements. Adequate supplies of raw materials were available in 1993 and are expected to continue to be available in 1994. WYNN'S CLIMATE SYSTEMS, INC. (AUTOMOTIVE AIR CONDITIONING PRODUCTS) Wynn's Climate Systems sells its products to OEM customers and to independent distributors who resell units principally to car dealers. Wynn's Climate Systems also distributes wholesale parts manufactured by others and sells refrigerant recovery and recycling machines. In addition, Wynn's Climate Systems operates installation centers in the Denver, Colorado area and in Colorado Springs, Colorado, Phoenix, Arizona and Mesa, Arizona that perform installation services for car dealers and retail customers. PRODUCTS Wynn's Climate Systems designs, engineers and produces automotive air conditioning systems for the OEM market and the automotive aftermarket. Systems are manufactured for many current year models of domestic and imported automobiles, trucks and vans. Wynn's Climate Systems also manufactures and sells units for a wide range of automobiles, trucks and vans from prior model years. In addition, Wynn's Climate Systems manufactures and sells a variety of air conditioning components, including condensers, evaporator coils and adapter kits, and distributes air conditioning components and accessories manufactured by others. Wynn's Climate Systems also manufactures and sells refrigerant recovery and recycling equipment. DISTRIBUTION The products of Wynn's Climate Systems are distributed in several different ways. First, Wynn's Climate Systems manufactures air conditioners for sale to OEM customers and their distributors and dealers. Sales to Mazda, the largest customer of Wynn's Climate Systems, were approximately $35.1 million in 1993 or approximately 28% less than in 1992. In 1993, Wynn's Climate Systems supplied air conditioning kits to Mazda principally for its 323 automobile and light trucks. As previously reported, in approximately April 1993, Mazda began purchasing light trucks from Ford in lieu of importing them from Japan. Wynn's Climate Systems also supplies certain components to Mazda's Flat Rock, Michigan facility. Mazda assembles its own air conditioning kits in the United States for the MX-6, 626 and Miata model automobiles and the MPV. Mazda has informed Wynn's Climate Systems that Mazda will assemble air conditioning kits for the 323 automobile commencing in model year 1995, but Wynn's Climate Systems will continue to supply air conditioning kits for the 323 automobile through model year 1994. In 1991, Wynn's Climate Systems began supplying front units for Land and Range Rover four-wheel drive vehicles. This supply arrangement with Rover terminated in February 1994. In early 1993, Wynn's Climate Systems began supplying a newly-designed rear air conditioning unit for certain Rover models. Wynn's Climate Systems also sells its products to Chrysler Corporation, which purchases products for its Dodge vans and Jeep vehicles and for export. Wynn's Climate Systems supplies units to the General Motors Truck and Bus Division. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Other Factors Affecting the Business." Second, Wynn's Climate Systems manufactures and sells products under the trademark "Frostemp(R)" in the United States and Canada to approximately 75 active independent distributors. Sales to independent distributors decreased approximately 8% in 1993 compared to 1992 due primarily to the impact on aftermarket sales of the continuing trend of increased factory installed air conditioning systems. See "Other Factors Affecting the Business." Wynn's Climate Systems also distributes component parts and accessories purchased from other manufacturers to independent distributors. Third, Wynn's Climate Systems manufactures and sells refrigerant recovery and recycling equipment to end users and to distributors. Wynn's Climate Systems offers a line of equipment that recovers and recycles R-12 and R-134a refrigerants used in automotive air conditioning systems. Finally, Wynn's Climate Systems manufactures and distributes parts and components to OEM customers and distributors. Wynn's Climate Systems also sells "Frostemp(R)" brand air conditioning systems and products manufactured by others through five company-operated service centers which perform installation services for dealers and sell directly to retail customers. PRODUCTION The manufacturing facilities of Wynn's Climate Systems are located in Fort Worth, Texas. Air conditioning kits are assembled and produced in a 210,000 square foot facility which also serves as the corporate headquarters of Wynn's Climate Systems. In 1993, Wynn's Climate Systems consolidated three satellite manufacturing facilities into the main facility. The production facilities of Wynn's Climate Systems include an environmental test and calibration chamber used for evaluating the performance of air conditioning units. The test chamber has computer controlled environmental test conditions and data collection and can handle both front-wheel and rear-wheel drive vehicles over a variety of simulated speeds, temperatures and levels of humidity. Wynn's Climate Systems manufactures condensers and evaporator coils, injection-molded and vacuum-formed plastic parts, adapter kits, steel brackets and hose and tube assemblies. Wynn's Climate Systems uses these components in the production of its air conditioning units and sells them to outside customers. Outside vendors supply certain finished components such as accumulators, receiver/dryers and compressors. An adequate supply of these materials is available at present and is expected to continue to be available for the foreseeable future. Wynn's Climate Systems generally experienced only modest price increases for raw materials in 1993. In 1993, Wynn's Climate Systems installed a technologically advanced nitrogen brazing oven, which will be used to produce high efficiency heat exchangers. Wynn's Climate Systems also acquired in 1993 equipment to enable it to produce high quality hose assemblies in house. This equipment was purchased in connection with the efforts of Wynn's Climate Systems to enhance its production and technological capabilities. PHASE-OUT OF R-12 REFRIGERANT Most automotive air conditioning systems manufactured by Wynn's Climate Systems and others prior to 1994 utilized R-12 as a refrigerant. R-12 is a chlorofluorocarbon ("CFC") which has been linked to the destruction of ozone molecules in the Earth's upper atmosphere. Under the Montreal Protocol, CFC production in the United States is being phased out and will cease after December 31, 1995. Wynn's Climate Systems has developed air conditioning systems which use R-134a refrigerant, a hydrofluorocarbon which is a permissible alternative to CFC refrigerants. Sales of R-134a systems are expected to increase as sales of traditional CFC systems are phased out. Wynn's Climate Systems also has begun the development of retrofit kits that will permit automotive air conditioning systems designed for R-12 use to be converted to use R-134a. R-134a is not compatible with an R-12-based system without certain necessary changes. Other optional changes will enhance the performance of R-134a in an R-12-based air conditioning system. The sales volume of these retrofit kits will depend upon the future availability and price of R-12 refrigerant. PETROCHEMICAL SPECIALTIES The Petrochemical Specialties Division consists of Wynn Oil Company and its subsidiaries ("Wynn Oil"). During 1993, net sales at Wynn Oil were $98,318,000 or 34% of the Company's total net sales as compared to $99,622,000 and 34% for 1992. The operating profit of the division during 1993 was $7,046,000, or 29% of the Company's total operating profit compared with $6,636,000 and 30% for 1992. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Business Segment and Geographical Information" on pages 14 through 17 and 29 through 31, respectively, of the 1993 Annual Report, which are hereby incorporated by reference. See also "Other Factors Affecting the Business." PRODUCTS The principal business of Wynn Oil is the production and marketing of a wide variety of petrochemical specialty car care products under the "Wynn's(R)" and "X-Tend(R)" trademarks. Wynn Oil's car care products are designed to provide preventive or corrective maintenance for automotive engines, transmissions, differentials, engine cooling systems and other automotive mechanical parts. Wynn Oil also manufactures industrial specialty chemical products, including forging compounds, lubricants, cutting fluids and multipurpose coolants for precision metal forming and machining operations. In addition, the Company sells the GM-approved and patented "Mark X(R)" power-flush machine which, when combined with proprietary cooling system products, flushes a vehicle's engine cooling system, removes contaminants from the used antifreeze and returns the rejuvenated antifreeze to the engine cooling system. Wynn Oil also sells the new GM-approved "Du-All(TM)" bulk antifreeze recycling machine which, when combined with proprietary cooling system products, drains the used antifreeze, removes contaminants from the antifreeze and rejuvenates the antifreeze for reuse. Wynn Oil also sells its Emission Control product, a patented organic fuel combustion catalyst for spark ignition and diesel engines which helps reduce exhaust emissions and improve fuel economy. Wynn Oil also produces and markets a line of automotive appearance products under the "Classic(R)" and "Wynn's Classic(R)" trademarks. Wynn Oil is a principal U.S. automotive distributor of AirSept(TM) odor-removing chemical spray, used principally in automotive air conditioning systems. Wynn Oil also markets the Wynn's Product Warranty(R) program, which, in general, are kits containing a specially formulated line of automotive additive products, accompanied by a special product warranty. The warranty kits are sold, through distributors and automobile dealers, primarily to purchasers of used automobiles. The Wynn's Product Warranty(R) program provides reimbursement of certain parts and labor expenses and, in some instances, the costs of towing and a rental car incurred by vehicle owners who used the special products to treat their vehicles in accordance with the terms and conditions of the warranty and who experience certain types of damage which the special products were designed to help prevent. See "Other Factors Affecting the Business." DISTRIBUTION Wynn Oil's car care products are sold in the United States and in approximately 80 foreign countries. See "Foreign Operations." Wynn Oil distributes its products through a wide range of distribution channels. Domestically, Wynn Oil distributes its products through independent distributors, warehouse distributors, mass merchandisers and chain stores. The Company also uses an internal sales force and manufacturers' representative organizations in the sale and distribution of its products. Foreign sales are made principally through wholly-owned subsidiaries, which sell either through an internal sales force or to independent distributors. The Company also engages in direct export sales to independent distributors, primarily in Asia and Latin America. See "Other Factors Affecting the Business." PRODUCTION Wynn Oil has manufacturing facilities in Azusa, California; St. Niklaas, Belgium; and Arganda del Rey, Spain. Other foreign subsidiaries either purchase products directly from the manufacturing facilities in the United States or Belgium or have the products manufactured locally by outside suppliers according to Wynn Oil's specifications and formulae. Several years ago, Wynn Oil transferred some of its production requirements to its foreign subsidiaries due to the strength of the United States dollar at that time and its impact on prices to Wynn Oil's foreign customers. With fluctuating foreign currency rates, Wynn Oil periodically reviews its production and sourcing locations. Wynn Oil utilizes a large number of chemicals in the production of its various petrochemical specialty products. Primary raw materials necessary for the production of these products, as well as the finished products, generally have been available from several sources. An adequate supply of materials was available in 1993 and is expected to continue to be available for the foreseeable future. BUILDERS HARDWARE The Builders Hardware Division consists of Robert Skeels & Company ("Skeels"), a wholesale distributor of builders hardware products, including locksets and locksmith supplies. During 1993, Skeels' net sales were $5,161,000 or 2% of the Company's total net sales as compared with $6,219,000 and 2% for 1992. The operating profit of this division during 1993 was $193,000, or 1% of the Company's total operating profit compared with $422,000 and 2% for 1992. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Business Segment and Geographical Information" on pages 14 through 17 and 29 through 31, respectively, of the 1993 Annual Report, which are hereby incorporated by reference. Skeels' main facility is located in Compton, California. In addition, Skeels also has leased satellite facilities located in Fullerton and Los Angeles, California. Skeels supplies approximately 35,000 items to retail hardware, locksmith and lumberyard outlets in southern California, Arizona, and Nevada. Skeels also sells directly to school districts, municipalities, industrial firms and building contractors. Skeels has been a distributor of Schlage lock products since 1931. Skeels also distributes other well-known brands such as Lawrence, Kwikset and Master. All of Skeels' distributorship arrangements generally are cancelable by the manufacturers without cause. Most of Skeels' sales are derived from replacement items used by industry, institutions and in-home remodeling and repair. OTHER FACTORS AFFECTING THE BUSINESS COMPETITION All phases of the Company's business have been and remain highly competitive. The Company's products and services compete with those of numerous companies, some of which have financial resources greater than those of the Company. Sales by the Automotive Parts and Accessories Division are in part related to the sales of vehicles by its OEM customers. Precision has a large number of competitors in the market for static and dynamic sealing products, some of which competitors are substantially larger than Precision. The markets in which Precision competes are also sensitive to changes in price. Requests for price reductions are not uncommon. Precision attempts to work with its customers to identify ways to lower costs and prices. Precision focuses on high technology, high quality sealing devices and has made significant investments in advanced equipment and other means to raise productivity. Precision's major focus is to be the low cost producer of superior quality products within its industry. Precision believes it must expand into additional areas of sealing technology in order to continue to be an effective competitor. In 1993, Precision invested approximately $4.4 million in new equipment and facilities to improve overall performance to its customers. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." Historically, the largest part of Wynn's Climate Systems' sales have been to OEM customers. Following the opening of its Flat Rock, Michigan facility, Mazda has gradually taken over production of its requirements for air conditioning kits in the United States. Sales to Mazda decreased approximately 28% in 1993 compared to 1992 due to the phase-out of the air conditioning supply agreement for light trucks and a decline in sales by Mazda of its 323 cars. The Company anticipates that commencing in the third quarter of 1994, Wynn's Climate Systems will no longer furnish 323 kits to Mazda, as Mazda has elected to assemble these kits at its Flat Rock, Michigan facility. Sales of kits for Mazda 323 cars were approximately $29.9 million in 1993. In 1993, Wynn's Climate Systems' sales to the Rover Group in the U.K were approximately $14.5 million, of which approximately $12.8 million was for units for the Range Rover and Discovery vehicles, pursuant to a supply agreement in effect through the end of model year 1993. In 1994, this customer began purchasing air conditioning systems for these vehicles from a foreign competitor of Wynn's Climate Systems. Although the expiration of this supply agreement is not expected to have a material adverse effect on the Company's consolidated results of operation in 1994, it is expected to cause a decline in the operating profit of Wynn's Climate Systems in 1994. Over time there has been a gradual increase in the number of air conditioning systems installed on the factory line. An increase in the number of factory-installed units reduces the size of the market for aftermarket sales. See "Wynn's Climate Systems, Inc." Competition with respect to the Company's petrochemical specialty products consists principally of other automotive aftermarket chemical and industrial fluid companies. Some major oil companies also market their own additive products through retail service stations, independent dealers and garages. Certain national retailers market private label brands of petrochemical specialty products. The Company's "Mark X(R)" power flush system and "Du-All(TM)" antifreeze recycling equipment and chemicals compete against other antifreeze recycling processes, some of which also have been approved by General Motors. The principal methods of competition vary by geographic locale and by the relative market share held by the Company compared to other competitors. Skeels continues to face intense price competition from numerous cash-and-carry discount retailers. Skeels also has observed some manufacturers selling directly to retailers to increase volume. Skeels' revenues declined 17% in 1993 compared to 1992 in part due to this competition. KEY CUSTOMERS Sales to Mazda constituted 42% of the total net sales of Wynn's Climate Systems and 12.3% of the total net sales of the Company in 1993. As noted above, sales to Mazda related to kits for the 323 model are expected to continue until the third quarter of 1994, when Mazda will take over production of kits for the 1995 model 323 automobile. Due to the previous actions taken by the Company to restructure the business of Wynn's Climate Systems and the relatively low margins associated with the Mazda business, the loss of Mazda as a key customer of the Company is not expected to have a material adverse effect on the consolidated results of operations of the Company. See "Wynn's Climate Systems, Inc." and "Management's Discussion and Analysis of Financial Condition and Results of Operations." Sales to General Motors constituted approximately 9.2% of the total net sales of the Company in 1993. GOVERNMENT REGULATIONS The number of governmental rules and regulations affecting the Company's business and products continues to increase. Wynn Oil markets the Wynn's Product Warranty(R) program in approximately thirty-five states and two foreign countries. Questions have been raised by certain state insurance regulators as to whether the product warranty that accompanies the kit is in the nature of insurance. Wynn Oil attempts to resolve these questions to the satisfaction of each state insurance regulator. At times, it has elected to withdraw the Wynn's Product Warranty(R) from certain states. No assurance can be given that governmental regulations will not significantly affect the marketing of the Wynn's Product Warranty(R) in the United States or other countries in the future. ENVIRONMENTAL MATTERS The Company has used various substances in its past and present manufacturing operations which have been or may be deemed to be hazardous, and the extent of its potential liability, if any, under environmental statutes, rules, regulations and case law is unclear. Under the Comprehensive Environmental Response, Compensation and Liability Act, as amended ("CERCLA"), a responsible party may be jointly liable for the entire cost of remediating contaminated property even if it contributed only a small portion of the total contamination. The nature of environmental investigation and cleanup activities creates difficulties in determining the impact of such activities on the Company's financial position. The effect of resolution of environmental matters on results of operation cannot be predicted due to the uncertainty concerning both the amount and timing of future expenditures and future results of operations. See Note 12 of "Notes to Consolidated Financial Statements" on page 28 of the 1993 Annual Report, which is hereby incorporated by reference. All potentially significant environmental matters presently known to the Company are described below. In January 1984, Wynn Oil received a letter from the United States Environmental Protection Agency (the "EPA") regarding an investigation of groundwater contamination in the San Gabriel Valley, California. The letter from the EPA requested Wynn Oil to furnish certain information relating to its manufacturing facility in Azusa, California (the "Azusa Facility"). Wynn Oil complied with the request. In March 1988, Wynn Oil received a letter from the EPA requesting additional information with respect to its Azusa Facility. Wynn Oil submitted its response at the end of May 1988. In July 1990, Wynn Oil received a general notice letter from the EPA stating that it may be a potentially responsible party ("PRP") with respect to the Azusa/Irwindale Study Area in the San Gabriel Valley, California Superfund Sites (the "AISA"). The EPA letter included an information request pursuant to Section 104(e) of CERCLA. The EPA letter stated that the EPA contemplated using the Special Notice procedures of Section 122(e) of CERCLA to formally negotiate the terms of a consent agreement with PRPs to conduct a Remedial Investigation/Feasibility Study for the AISA. Wynn Oil Company responded to the EPA information request within the specified time period. In September 1990, Wynn Oil received a letter from the EPA stating that it did not expect to send a Special Notice letter to Wynn Oil for the AISA, but that it still considered Wynn Oil, as well as a large number of other companies, to be PRPs for basinwide groundwater activities in the San Gabriel Valley. In May 1993, the EPA made available for public comment its Operable Unit Feasibility Study for the Baldwin Park Operable Unit ("BPOU") of the San Gabriel Valley Superfund Sites. The Azusa Facility is located within the BPOU. In its Operable Unit Feasibility Study for the BPOU, the EPA has proposed construction of extraction and treatment facilities with an estimated initial capital cost of $47 million and estimated annual operating and maintenance costs of $4 to $5 million. Wynn Oil has been cooperating with other companies located in the BPOU, as well as state and local government and water supply officials, who are working to develop a substantially less costly alternative which would accomplish the desired remedial goals. In March 1988, a representative of the Los Angeles County Department of Health Services (the "LADHS") inspected the Azusa Facility and observed oil-stained surface soils. Based on these observations, LADHS directed Wynn Oil to conduct a site assessment and implement remedial measures if contaminated soils were identified. In February 1989, Wynn Oil received a Subsurface Investigation Report from the consulting firm retained by Wynn Oil to perform the site assessment and submitted the report to the LADHS. In April 1989, regulatory jurisdiction over this matter was transferred from the LADHS to the California Regional Water Quality Control Board-Los Angeles Region (the "RWQCB"). Since October 1989, Wynn Oil and its consultants have been working with representatives of the RWQCB to conduct a comprehensive site assessment of the Azusa Facility. In January 1992, at the request of the EPA and the RWQCB, Wynn Oil agreed to expand the scope of its investigation of the Azusa Facility to include three soil gas monitoring wells and one groundwater monitoring well. The monitoring wells were installed in 1992, and the results of ongoing sampling have been reported to the RWQCB. In the summer of 1993, RWQCB requested Wynn Oil to install an upgradient groundwater monitoring well at the Azusa Facility. The RWQCB subsequently requested two other companies located upgradient of Wynn Oil to install downgradient soil gas and groundwater monitoring wells. Wynn Oil and one of these companies have entered into an agreement to share the cost of one groundwater and one soil gas monitoring well which will operate as an upgradient monitoring well for Wynn Oil and a downgradient monitoring well for the other company. In May 1989, Wynn's Climate Systems received notice that it had been identified as a generator of hazardous waste that had been shipped to the Chemical Recycling, Inc. ("CRI") site in Wylie, Texas (the "CRI Site") for treatment. CRI was engaged in the business of recycling and reclaiming spent solvents and other hazardous wastes at the CRI Site until it ceased operations in February 1989. Wynn's Climate Systems is one of approximately 100 hazardous waste generators who have been identified as potentially responsible parties for the CRI Site. A PRP Steering Committee (the "Committee") was formed to negotiate with the EPA on behalf of its members an agreement to take remedial measures voluntarily at the CRI Site. As of March 15, 1994, approximately 88 PRPs, including Wynn's Climate Systems, have agreed to participate in the Committee for the CRI Site. PRPs who have agreed to participate in the Committee have signed Consent Agreements with the EPA with respect to the CRI Site. Remediation efforts have begun at the CRI Site under the guidance of the Committee. As of March 15, 1994, Wynn's Climate Systems' proportionate share of the total volume of waste contributed to the CRI Site by Committee members was less than one percent (1%). In January 1991, Wynn's Climate Systems received a letter from the Texas Water Commission (the "TWC") that soil adjacent to one of its leased manufacturing facilities was contaminated with hazardous substances. The TWC directed Wynn's Climate Systems to determine the extent of such contamination and then take appropriate remedial measures. Wynn's Climate Systems retained environmental consultants to conduct soil sampling and otherwise comply with the directive of the TWC. Performance of this work was completed in late 1991. Wynn's Climate Systems submitted a copy of the report of its consultants to the TWC in January 1992. In 1994, Wynn's Climate Systems received a letter from the TWC requesting additional information. Wynn's Climate Systems is cooperating with the requests of the TWC. In January 1990, Precision received a letter from the EPA regarding the Saad Site in Nashville, Tennessee. The owner of the Saad Site engaged in reclamation and recycling activities at the Site, which resulted in soil and groundwater contamination. The letter stated that Precision may be a PRP for the Saad Site. The EPA subsequently requested Precision to furnish information about its involvement with the Saad Site. Precision has provided the information requested. Precision's records indicated that a predecessor entity sent wastes to the Saad Site in the mid-1970s. Based on that information, Precision joined the Saad Site Steering Committee as a Limited Member. In February 1992, the Company received a letter stating that the Allocation Committee had concluded that Precision should become a Full Member of the Steering Committee and thus share proportionately in the liability for the cleanup. Precision responded by letter that there was no legal basis to hold it responsible for the activities of the predecessor entity. As of March 15, 1994, the Allocation Committee has not responded to Precision's letter. In 1992, Precision identified an area at its Lebanon, Tennessee facility which contained oil stained soils. Precision retained outside environmental consultants to investigate the nature and extent of the contamination. The remedial investigation is underway and Precision intends to take any necessary remedial actions. In March 1992, an inactive subsidiary of the Company received a letter from the then lessee ("Lessee") of a parcel of real property in Compton, California formerly leased by this subsidiary. The letter stated that the Lessee had discovered soil contamination at the site and asserted that the Company's subsidiary may be liable for the cost of cleanup. The letter stated that the Lessee was investigating the nature and extent of the soil contamination. In July 1993, the Company received a letter from the owner of the real property stating that the owner had asserted a claim against the Lessee to pay the cost of remediation and that the owner may assert a claim against the Company. The Company has determined that the Lessee has filed for voluntary reorganization under the federal bankruptcy laws. The Company does not know the extent of the contamination or the estimated cost of cleanup at this site. FOREIGN CURRENCY FLUCTUATIONS In 1993, the United States dollar generally appreciated in value compared to 1992 in the currencies of most countries in which the Company does business. This appreciation caused sales and operating profit to be lower than what would have been reported if exchange rates had remained constant during 1993. In 1993, the Equity Adjustment from Foreign Currency Translation account on the Consolidated Balance Sheet declined by $2.1 million, which caused a corresponding reduction in Total Stockholders' Equity. See "Foreign Operations." PATENTS, TRADEMARKS AND LICENSE AGREEMENTS The Company holds a number of patents and trademarks which are used in the operation of its businesses. There is no known challenge to the Company's rights under any material patents or material trademarks. In 1989, Wynn Oil filed a lawsuit in the federal district court in Detroit, Michigan against another company and its principal stockholder for infringement of Wynn Oil's X- Tend(R) trademark. In February 1994, the court awarded Wynn Oil $2.0 million in damages. The court also indicated it would award prejudgment interest and attorneys' fees to Wynn Oil. Following the entry of a final judgment, the defendants are expected to appeal the trial court's decision. See "Legal Proceedings." SEASONALITY OF THE BUSINESS Although sales at the Company's divisions are somewhat seasonal, the consolidated results of operations generally do not reflect seasonality. RESEARCH AND DEVELOPMENT Wynn Oil maintains research and product performance centers in Azusa, California; St. Niklaas, Belgium; Paris, France; and Edenvale, South Africa. The main activities of the research staff are the development of new specialty chemicals and other products, improvement of existing products, including finding new applications for their use, evaluation of competitive products and performance of quality control procedures. Precision maintains research and engineering facilities in Lebanon, Tennessee; Lynchburg, Virginia; and Orillia, Ontario, Canada. Research and development is an important aspect of Precision's business as Precision has developed and continues to develop numerous specialized compounds to meet the specific needs of its various customers. Precision also has technical centers at its Lebanon, Tennessee, Lynchburg, Virginia, and Orillia, Ontario, Canada facilities to construct prototype products and to perform comprehensive testing of materials and products. Precision maintains extensive research, development and engineering facilities to provide outstanding service to its customers. FOREIGN OPERATIONS The following table shows sales to foreign customers for 1993, 1992 and 1991: Consolidated operating results are reported in United States dollars. Because the Company's foreign subsidiaries conduct operations in the currencies of the countries in which they are based, all financial statements of the foreign subsidiaries must be translated into United States dollars. As the value of the United States dollar increases or decreases relative to these foreign currencies, the United States dollar value of items on the financial statements of the foreign subsidiaries is reduced or increased, respectively. Therefore, changes in dollar sales of the foreign subsidiaries from year to year are not necessarily indicative of changes in actual sales recorded in local currency. See Note 4 and Note 15 of "Notes to Consolidated Financial Statements" on pages 25 and 29 through 31, respectively, of the 1993 Annual Report, which are hereby incorporated by reference. The value of any foreign currency relative to the United States dollar is affected by a variety of factors. It is exceedingly difficult to predict what such value may be at any time in the future. Consequently, the ability of the Company to control the impact of foreign currency fluctuations is limited. A material portion of the Company's business is conducted outside the United States. Therefore, the Company's ability to continue such operations or maintain their profitability is to some extent subject to control and regulation by the United States government and foreign governments. EMPLOYEES At December 31, 1993, the Company had 1,978 employees. A majority of the production and maintenance employees at the Lebanon, Tennessee plant of Precision are represented by a local lodge of the International Association of Machinists and Aerospace Workers. The collective bargaining agreement for this facility will expire in April 1995. The production and maintenance employees at the Orillia, Ontario, Canada plant of Precision are represented by a local unit of the United Rubber, Cork, Linoleum and Plastic Workers of America. The collective bargaining agreement for the unit will expire in February 1997. A majority of the production and maintenance employees at the Lynchburg, Virginia plant of Dynamic Seals, Inc., an affiliate of Precision, are represented by a local of the International Chemical Workers Union. The collective bargaining agreement for this facility expires in February 1996. The Company considers its relations with its employees to be good. EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers of the Company, who are appointed annually, are as follows: The principal occupations of Mr. Carroll and Mr. Gibbons for the past five years have been their current respective positions with the Company. Prior to his employment with the Company in July 1989, Mr. Schlosser was Vice President-Finance of EECO Incorporated (electronic components) from August 1987 to June 1989 and Controller of Baker Hughes Incorporated and its predecessor, Baker International Corporation (oil field services and process technologies) from July 1984 to August 1987. There is no arrangement or understanding between any executive officer and any other person pursuant to which he was selected as an officer. There is no family relationship between any executive officers of the Company. ITEM 2.

ITEM 2. PROPERTIES The following is a summary description of the Company's facilities, all of which the Company believes to be of adequate construction: The Company believes that all of its operating properties are adequately maintained, fully utilized and suitable for the purposes for which they are used. With respect to those leases expiring in 1994 and 1995, the Company believes it will be able to renew such leases on acceptable terms or find suitable, alternative facilities. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS Various claims and actions, considered normal to Registrant's business, have been asserted and are pending against Registrant and its subsidiaries. Registrant believes that such claims and actions should not have any material adverse effect upon the results of operations or the financial position of Registrant based on information presently known to Registrant. In February 1994, the United States District Court for the Eastern District of Michigan, Southern Division, in the case of Wynn Oil Company v. American Way Service Corporation and Thomas A. Warmus, Case No. 89-CV-71777-DT, awarded Wynn Oil the sum of $2,023,645 in damages in an action brought by Wynn Oil in 1989 asserting trademark infringement by the defendants. The trial court also indicated that it would award prejudgment interest and attorneys' fees to Wynn Oil upon application to the court. Wynn Oil is seeking prejudgment interest and attorneys' fees in an aggregate amount of between approximately $1.2 million and $1.5 million. Following the entry of a final judgment by the trial court, the defendants are expected to appeal the trial court's decision to the United States Court of Appeals for the Sixth Circuit. No portion of this judgment has been included in the results of operations of the Company and all of Registrant's costs relating to this case have been expensed as incurred. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of security holders during the fourth quarter of 1993. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information appearing under "Common Stock Price and Cash Dividends Per Share: 1993-1992" on page 13 of the 1993 Annual Report and "Number of Stockholders" and "Stock Exchange Listing" on page 33 of the 1993 Annual Report is hereby incorporated by reference. On February 7, 1994, the Board of Directors of Registrant declared a cash dividend of $0.11 per share payable March 31, 1994 to stockholders of record on March 14, 1994. Under a long-term loan agreement with an insurance company, Registrant's ability to pay dividends may be restricted under certain circumstances. At the present time, Registrant believes that these restrictions will not have an impact on the declaration of future dividends. It is expected that Registrant will continue to pay dividends in the future. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA Incorporated by reference from page 13 of the 1993 Annual Report. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Incorporated by reference from the 1993 Annual Report, pages 14 through 17. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Consolidated financial statements of Registrant at December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993 (including unaudited supplementary data) and the report of independent auditors thereon are incorporated by reference from the 1993 Annual Report, pages 13 and 18 through 32. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information appearing under "Election of Directors" and "Compliance with Section 16(a) of the Securities Exchange Act of 1934" on pages 4, 5 and 21 of Registrant's definitive proxy statement for the Annual Meeting of Stockholders to be held on May 11, 1994 ("Registrant's 1994 Proxy Statement") is hereby incorporated by reference. A list of executive officers of Registrant is provided in Part I of this report. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information appearing under "Compensation of Directors," "Compensation Committee Interlocks and Insider Participation" and "Executive Compensation" on pages 6 through 10 of Registrant's 1994 Proxy Statement is hereby incorporated by reference. The Report of the Compensation Committee on pages 10 through 12 of Registrant's 1994 Proxy Statement shall not be deemed to be incorporated by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information appearing under "Security Ownership of Certain Beneficial Owners and Management" on pages 2 through 4 of Registrant's 1994 Proxy Statement is hereby incorporated by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information appearing under "Certain Relationships and Related Transactions" on page 21 of Registrant's 1994 Proxy Statement is hereby incorporated by reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. See Index to Financial Statements and Financial Statement Schedules Covered By Report of Independent Auditors. 2. See Index to Financial Statements and Financial Statement Schedules Covered By Report of Independent Auditors. 3. See Index to Exhibits. (b) No Reports on Form 8-K were filed by Registrant during the last quarter of 1993. WYNN'S INTERNATIONAL, INC. INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES COVERED BY REPORT OF INDEPENDENT AUDITORS (ITEM 14(A)) All other schedules are omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements, including the notes thereto. The consolidated financial statements listed in the above index, which are included in the 1993 Annual Report, are hereby incorporated by reference. With the exceptions of the pages listed in the above index and the items referred to in Items 1, 5, 6, 7 and 8, the 1993 Annual Report is not deemed to be filed as part of this report. WYNN'S INTERNATIONAL, INC. SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS THREE YEARS ENDED DECEMBER 31, 1993 ____________________ (1) Represents accounts written off against the reserve. WYNN'S INTERNATIONAL, INC. SCHEDULE IX - SHORT-TERM BORROWINGS THREE YEARS ENDED DECEMBER 31, 1993 Notes payable represent obligations payable under several credit agreements to various banks. Borrowings are arranged on an as-needed basis at various terms and at the banks' most advantageous prevailing rates (see Note 7 of "Notes to Consolidated Financial Statements" on page 26 of the 1993 Annual Report). The average amount outstanding during the year was computed by averaging the month-end balances during the year. The weighted average interest rate was computed by dividing interest expense by the average amount outstanding. In 1993, the majority of the average outstanding borrowings were incurred by foreign subsidiaries in countries with interest rates above prevailing rates in the United States. WYNN'S INTERNATIONAL, INC. SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION THREE YEARS ENDED DECEMBER 31, 1993 All other information has been omitted since the required information is not present in amounts sufficient to require inclusion in this schedule or because the information required is included in the consolidated financial statements, including the notes thereto. POWER OF ATTORNEY Each person whose signature appears below hereby authorizes each of James Carroll, Seymour A. Schlosser and Gregg M. Gibbons as attorney-in-fact to sign on his behalf, individually and in each capacity stated below, and to file all amendments and/or supplements to this Annual Report on Form 10-K. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on March 25, 1994. WYNN'S INTERNATIONAL, INC. By JAMES CARROLL ------------------------------------ James Carroll President Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Date ---- March 25, 1994 By WESLEY E. BELLWOOD ------------------------------------ Wesley E. Bellwood Chairman of the Board March 25, 1994 By JAMES CARROLL ------------------------------------ James Carroll President Chief Executive Officer Director Date ---- March 25, 1994 By SEYMOUR A. SCHLOSSER ---------------------------------- Seymour A. Schlosser Vice President-Finance (Principal Financial and Accounting Officer) March 25, 1994 By BARTON BEEK ---------------------------------- Barton Beek Director March 25, 1994 By JOHN D. BORIE ---------------------------------- John D. Borie Director March 25, 1994 By BRYAN L. HERRMANN ---------------------------------- Bryan L. Herrmann Director March 25, 1994 By ROBERT H. HOOD, JR. ---------------------------------- Robert H. Hood, Jr. Director March 25, 1994 By RICHARD L. NELSON ---------------------------------- Richard L. Nelson Director March 25, 1994 By JAMES D. WOODS ---------------------------------- James D. Woods Director WYNN'S INTERNATIONAL, INC. INDEX TO EXHIBITS (Item 14(a))

37748_1993.txt

37748

1993

ITEM 1. BUSINESS. Fluor Corporation ("Fluor" or the "Company") was incorporated in Delaware in 1978 as a successor in interest to a California corporation of the same name that was originally incorporated in 1924. Its executive offices are located at 3333 Michelson Drive, Irvine, California 92730, telephone number (714) 975- 2000. Through Fluor Daniel, Inc. and other domestic and foreign subsidiaries, the Company provides engineering, procurement, construction, maintenance and related technical services on a worldwide basis to an extensive range of industrial, commercial, utility, natural resources, energy and governmental clients. The Company maintains investments in coal-related businesses through its ownership of Massey Coal Company ("Massey"). In November of 1992, the Company announced its decision to exit its lead business and classified the business as a discontinued operation in the Company's consolidated financial statements. A summary of the Company's operations and activities by business segment and geographic area is set forth below. ENGINEERING AND CONSTRUCTION The Fluor Daniel group of domestic and foreign companies ("Fluor Daniel") provides a full range of engineering, construction and related services on a worldwide basis to clients in five broad market sectors: Hydrocarbon, Industrial, Government, Process and Power. The types of services provided by Fluor Daniel, directly or through companies or partnerships jointly owned or affiliations with other companies, include: feasibility studies, conceptual design, engineering, procurement, project and construction management, construction, maintenance, plant operations, technical, project financing, quality assurance/quality control, start-up assistance, site evaluation, licensing, consulting and environmental services. Fluor Constructors International, Inc. ("Fluor Constructors") is organized and operated separately from Fluor Daniel. Fluor Constructors provides construction management, construction and maintenance services in the United States and Canada. Fluor Constructors is the Company's union construction arm. American Equipment Company, a wholly owned Fluor subsidiary, provides construction equipment, tools and related asset management services to Fluor Daniel, Fluor Constructors and the construction/maintenance industry at large through strategically located support centers. The engineering and construction business is conducted under various types of contractual arrangements, including cost reimbursable (plus fixed or percentage fee), all-inclusive rate, unit price, fixed or maximum price and incentive fee contracts. Contracts are either competitively bid and awarded or individually negotiated. In terms of dollar amount, the majority of contracts are of the cost reimbursable type. In certain instances, the Company has guaranteed facility completion by a scheduled acceptance date and/or achievement of certain acceptance and performance testing levels. Failure to meet any such schedule or performance requirements could result in costs that exceed project profit margins. The markets served by the business are highly competitive and for the most part require substantial resources, particularly highly skilled and experienced technical personnel. There are a large number of companies competing in the markets served by the business. Competition is primarily centered on performance and the ability to provide the engineering, planning and management skills required to complete complex projects in a timely and cost efficient manner. The business derives its competitive strength from its diversity, reputation for quality, worldwide procurement capability, project management expertise, geographic coverage, ability to meet client requirements by performing construction on either a union or non- union basis, ability to execute projects of varying sizes, strong safety record and lengthy experience with a wide range of services and technologies. Design and engineering services provided by the business involve the continual development of new and improved versions of existing processes, materials or techniques, some of which are patented. However, none of the existing or pending patents held or licensed by the business are considered essential to operations. Generally, the development and improvement of processes, materials and techniques are performed as part of design and engineering services in connection with the projects undertaken for various clients. FLUOR DANIEL Fluor Daniel serves five broad market sectors: Hydrocarbon, Industrial, Government, Process and Power. Services are provided through 12 global business units that focus on specific markets within each sector. The business units rely on a network of operations centers and regional offices to provide resources and expertise in support of project execution worldwide. In the United States, services are provided primarily through Fluor Daniel, Inc. Principal offices are located in Irvine, California; Greenville, South Carolina; Houston (Sugar Land office), Texas; Chicago, Illinois; Anchorage, Alaska; Tulsa, Oklahoma; and Philadelphia, Pennsylvania (Marlton, New Jersey office). Additional North American operations are conducted through Fluor Daniel Canada, Inc. in Canada and Fluor Daniel Caribbean, Inc. in Puerto Rico. The international operations of the group are divided into regional areas. The Asia Pacific region includes the following operating subsidiaries: Fluor Daniel Australia Limited; Fluor Daniel China, Inc.; Fluor Daniel Eastern, Inc. (Indonesia); Fluor Daniel Engineers & Constructors, Ltd. (Hong Kong); Fluor Daniel (Japan) Inc.; Fluor Daniel (Malaysia) Sdn. Bhd.; Fluor Daniel Pacific, Inc. (the Philippines); and Fluor Daniel Thailand, Ltd. Operating subsidiaries for the Europe region include: Fluor Daniel B.V. (the Netherlands); Fluor Daniel Espana, S.A. (Spain); Fluor Daniel GmbH (Germany); and Fluor Daniel Limited (England). Operating subsidiaries for the Middle East region include Fluor Daniel Arabia Limited. Latin American operations are conducted in Venezuela through Tecnofluor C.A. (a company which is jointly owned with Tecnoconsult S.A., a Venezuelan engineering company), in Mexico through ICA Fluor Daniel (a joint equity company with Grupo ICA) and through Fluor Daniel Chile S.A. While the United States will remain an important market for Fluor Daniel's services, increasingly the largest share of opportunities are located outside the United States. Demand for higher living standards is driving strong economic growth in developing economies, particularly in the Asia Pacific and Latin American regions. Expansion of basic industries is increasing fundamental energy requirements and infrastructure needs. Globalization of markets and geopolitical change is also stimulating strategic investments in new production facilities in these emerging markets. Due largely to weak economies and capital spending within certain United States, European and Middle Eastern markets, the Government, Process, Industrial and Power sectors experienced declines in new awards in fiscal 1993 that were only partially offset by an increase in the Hydrocarbon sector. There continue to be a number of megaproject opportunities, particularly outside the United States. These projects develop slowly and, therefore, could create variability in the Company's incoming order and backlog pattern. The operations of Fluor Daniel are detailed below by market sector. Hydrocarbon Services provided to the Hydrocarbon sector include services for refining and processing plants, production facilities, oil and gas transmission systems and related facilities for petroleum, petrochemical and natural gas clients. These services are provided through the Petroleum and Petrochemicals, and Production and Pipelines business units. During fiscal 1993, Hydrocarbon sector domestic contract awards included: pipeline inspection and right of way services in New York; engineering for an aromatics project for a refinery in Pennsylvania and pipeline and pump stations in Alaska; engineering and procurement for a reformulated fuels program in California and an inter-refinery pipeline in Pennsylvania; engineering, procurement and construction for an ethylene debottlenecking project for a refinery in Texas and fire rehabilitation of a refinery in Mississippi; and engineering, procurement and construction management for a reformulated gasoline and a clean fuels program, both in California, and a fluid catalytic cracking unit ("FCCU") revamp in Illinois. International contract awards included: engineering for a debottlenecking project in Indonesia, a natural gas liquids recovery facility in Nigeria, fire rehabilitation of a gas plant in the United Arab Emirates and early production system equipment, oil field production facilities, pipeline development and oil field expansion, all in Colombia; engineering and procurement for a chlor- alkali/ethylene expansion of a petrochemical plant in Saudi Arabia, an effluent quality upgrade for a refinery in the United Kingdom and a liquid petroleum gas plant upgrade in the United Arab Emirates; and engineering, procurement and construction management for a refinery upgrading project in the Netherlands, a grass roots refinery in Thailand, a hydrotreater upgrade in Canada and a field gathering and oil production system in Gabon. Ongoing projects include: engineering for a tertiary-amyl methyl ether ("TAME") unit in Texas; construction in Louisiana of gas reinjection modules for erection in Alaska; engineering and procurement for a hydrocracker revamp in California and oil production facilities in Gabon; engineering, procurement and construction for modifications to a refinery in California; engineering, procurement and construction assistance for a reformulated gasoline project in California; and engineering, procurement and construction management for a refinery upgrading project in the Netherlands, a refinery revamp in Belgium, a refinery expansion in the Philippines, a pipeline from Argentina to Chile, a delayed coker in Venezuela and expansion of crude oil production facilities in Saudi Arabia. Projects completed in fiscal 1993 included: engineering studies for an oil pipeline in the Caspian Sea region and various refinery projects in Mexico; engineering for an alkylation plant revamp and propylene splitter, both in the United Kingdom, a butane upgrading project and a low sulfur diesel facility, both in Texas, and a gas injection project in the Netherlands; engineering and procurement for an offshore oil/gas production facility in the Netherlands and two naphtha hydrotreaters, one in Minnesota and one in Kentucky; engineering, procurement and construction for a vinyl acetate plant and a MTBE plant, both in Texas, a polystyrene plant in China and a diesel hydrotreater in Utah; engineering, procurement and construction assistance for fire rehabilitation of a refinery in California; and engineering, procurement and construction management for a continuous catalytic reformer ("CCR") in Kentucky and a hydrocracker and catalytic reformer in Texas. Industrial Services provided to the Industrial sector include facility maintenance and operations services as well as a broad range of services to the telecommunications, transportation, commercial and criminal justice, asbestos abatement, defense and aerospace, electronics, automotive, general manufacturing, mining, metals and pulp and paper industries. These services are provided through the Facility and Plant Services, Pulp and Paper, Mining and Metals and Industrial business units. As of January, 1993, Fluor Daniel established a partnership with the United States operations of Jaakko Poyry of Finland, a pulp and paper engineering and design firm, in an effort to improve the Pulp and Paper business unit's strategic position when this market recovers. During fiscal 1993, Industrial sector domestic contract awards included: condition assessment for facilities at 12 military installations at various locations throughout the United States; maintenance for an automotive manufacturing facility in Tennessee; construction for the modernization of a pulp mill in Ohio; construction management for a correctional facility expansion in California, a county jail expansion in Texas and renovation of a turbine facility and a weave room addition, both in South Carolina; engineering and procurement for a copper electrorefinery in Arizona; engineering and construction management for an automotive manufacturing plant expansion in Ohio; engineering, procurement and construction for a blast furnace coal injection facility in Indiana; and engineering, procurement and construction management for a grass roots paint shop in Kentucky. International contract awards during fiscal 1993 included: engineering for a nickel reverts handling project in Canada; and engineering, procurement and construction management for a building and garage upgrade in Germany. Ongoing projects include: construction for an automotive assembly plant in South Carolina and a newsprint mill in Tennessee; construction management for a newsprint recycling plant in Australia and airport expansions in Georgia and Japan; project management for rail transit for the Los Angeles County Metropolitan Transportation Authority, rail stations for the Federal Transportation Administration in New York City, a telecommunications upgrade project for the United States Agency for International Development in Egypt, a convention center in North Carolina and highway construction in Orange County, California; maintenance services for a refinery in Mississippi, a tire manufacturing facility in Tennessee, computer manufacturing plants in Florida, Texas and North Carolina and automotive facilities in Germany and Hungary; design and construction management for six embassies in Eastern Europe for the United States Department of State; engineering, procurement and construction for an emergency 911 response system for the City of Chicago, Illinois; and engineering, procurement and construction management for a paper products plant in Korea, a copper smelter modernization in Utah, a copper mine expansion in Indonesia and a copper concentrator expansion and solvent extraction electrowinning copper processing facility, both in Chile. Projects completed in fiscal 1993 included: operations and maintenance for the National Aeronautics and Space Administration ("NASA") Johnson Space Center in Texas; facility maintenance and support services for Lawrence Livermore National Laboratory in California; project management for highway construction in California Department of Transportation District 12; engineering and construction management for a pulp and paper mill in the United Kingdom and a research and development facility in Arizona; engineering, procurement and construction for an automobile air bag propellant plant in Arizona; and engineering, procurement and construction management for a zinc plant and a copper smelter in Canada, an aluminum cold rolling mill expansion in Kentucky and an aluminum smelter in Australia (a joint venture with SNC Lavalin Inc. of Canada and Crooks, Mitchell, Peacock, Stewart, Pty Limited (CMPS) of Australia). Government Services provided to the Government sector include services for projects involving nuclear and other fuel cycles, nuclear waste disposal and hazardous waste cleanup, treatment, abatement and removal. Clients include federal, state and local agencies, quasi-governmental entities and organizations in private industry and other government prime contractors. These services are provided through the Advanced Technology and Environmental Services business units. During fiscal 1993, Government sector contract awards included: environmental investigation at various military installations for the United States Army Corps of Engineers. Ongoing projects include: environmental remediation management for the United States Department of Energy ("DOE") former uranium processing plant in Ohio (the "Fernald Project"); engineering for a DOE waste vitrification plant in Washington, the DOE nuclear waste repository program and the reconfiguration of the DOE nuclear weapons program; engineering and construction management for the DOE Strategic Petroleum Reserve in Louisiana and for various radar and weather stations located throughout the United States for the National Oceanic and Atmospheric Administration; environmental investigation and remediation plan services for a toxic waste site for a private client in New York; remedial investigation and feasibility studies for the United States Army Corps of Engineers Hazardous and Toxic Waste Agency's environmental program; management and operation services for the Naval Petroleum and Oil Shale Reserves program for the DOE in Colorado, Utah and Wyoming; environmental investigation, remediation design and implementation services for a chemical waste site for a private client in Ohio; and engineering, procurement, construction management and program management for an environmental remediation program for a toxic waste site for a group of private clients in Indiana. Process Services provided to the Process sector include services to the food, beverages, consumer products, synthetic fiber, film, plastics, pharmaceutical, biotechnology and chemicals industries. These services are provided through the Chemicals and Plastics, Process and Delta business units. Delta provides work services worldwide to E.I. du Pont de Nemours and Company under an alliance agreement. During fiscal 1993, Process sector domestic contract awards (excluding Delta) included: engineering for a process and enzyme system in Missouri; construction of a chemical plant in Louisiana; construction management for a polyester fiber facility in South Carolina; engineering and procurement for a ethoxylation project in Texas; engineering, procurement and construction of a hydrochlorofluorocarbon plant in Kentucky, a plastics stretch project in Alabama and a food processing plant in Georgia; and engineering, procurement and construction management of a plastics stretch project in Indiana, a dextrose expansion project in Illinois and a growth factor fermentation plant in California. International contract awards included: construction of a grass roots wastewater facility in Puerto Rico; construction management for a dairy plant in Germany and a grass roots chemical facility in Puerto Rico; engineering, procurement and construction for a grass roots polyethylene facility in Mexico; and engineering, procurement and construction management for a sodium cromoglycate facility in the United Kingdom and a regional headquarters building in Venezuela. Ongoing projects include: construction of a spherilene and ethylene purification facility in Texas and a chemical fibers plant in North Carolina; engineering and procurement for an ethylene glycol plant in Canada; construction management for a pilot plant for pharmaceutical manufacturing in New Jersey, a tobacco processing plant expansion in North Carolina and a biotechnology clinical manufacturing facility in Colorado; engineering and construction for several consumer products facilities in Ohio and a corn processing plant in Illinois; engineering, procurement and validation for a synthetic hemoglobin manufacturing facility in Colorado; engineering and construction management for two tobacco facilities, one in Turkey and one in the Netherlands; engineering, procurement and construction for an aspartame facility expansion in the Netherlands, a filter tow facility expansion in the United Kingdom, an edible food casing facility in South Carolina, personal care and laundry detergent manufacturing facilities in Ohio and food processing plants in Texas, Wisconsin, Florida and Georgia; and engineering, procurement, and construction management for a pharmaceutical plant in Canada and an MTBE chemical complex in Saudi Arabia. Projects completed in fiscal 1993 included: engineering for two biotechnology fermentation facilities, one in Pennsylvania and one in Puerto Rico; construction of a grass roots additives facility in Alabama; construction management for a veterinary vaccines manufacturing facility in Nebraska; engineering and construction for a parenteral and solid dosage facility in Puerto Rico; engineering and construction management for laundry and dishwashing detergent manufacturing facilities in Ohio and a boiler in Illinois; engineering and construction management for a liquid chemical facility in Ohio; engineering, procurement and construction for the remodel of an existing acetone recovery facility in the United Kingdom, a cellulose acetate plant in Tennessee, a chemical plant expansion in the United Kingdom, a grass roots food additive facility in Iowa, a food processing plant in Kentucky and an ibuprofen plant in Texas; and engineering, procurement and construction management for a grass roots biochemical manufacturing facility in Washington and various cleaning solution manufacturing plants in the United States. Delta contract awards for 1993 included: engineering and procurement for a fibers expansion plant in Holland; engineering, procurement and construction for a bi-component fibers facility in North Carolina and a turbine generator in South Carolina; and engineering, procurement and construction management for a fibers line plant in Luxembourg. Delta ongoing projects include: evergreen construction and supplemental maintenance for various chemical and fibers facilities in the United States; technical services for various chemical and fibers plants in Canada; construction for a grass roots film facility in Ohio; engineering and construction management for a grass roots nylon facility in Spain, a bulk fibers facility expansion in Canada and a grass roots polymer facility in Singapore; and engineering, procurement and construction for expansion of a fibers facility in North Carolina. Delta projects completed in fiscal 1993 included: technical services for several petrochemical plant expansions in Texas; engineering, procurement and construction management for a specialty chemicals facility in France; engineering, procurement and construction for an X-ray film line facility expansion in North Carolina; and engineering, procurement and construction management for a grass roots flame retardant fiber facility in Spain. Power Services provided to the Power sector include comprehensive services for utility and non-utility clients in the power generation industry utilizing nuclear, fossil, hydroelectric, geothermal, waste and bio-fuel generating technologies. These services are provided through the Power business unit which includes the Duke/Fluor Daniel partnership concentrating on coal-fired plants. During fiscal year 1993, Power sector contract awards included: detailed engineering for a molten carbonate fuel cell demonstration project in California and a substation retrofit in Illinois; a five year general services agreement for an Ohio utility; and engineering, procurement and construction for a diesel power plant in the Philippines. In addition, a significant number of existing maintenance and plant modification contracts were renewed in fiscal 1993. Ongoing projects include: maintenance and outage support at various plant sites for a southeastern power generator in Tennessee and Kentucky; maintenance for nuclear plants in Virginia, South Carolina and Kansas; maintenance for fossil and gas generation plants in Texas, Louisiana, South Carolina, Georgia and Australia; operation and maintenance for a 130 megawatt cogeneration facility in Virginia; engineering and procurement for a 600 megawatt fossil plant repowering in New Jersey; engineering for a laboratory facility upgrade and nuclear engineering services for a utility, both in Illinois; engineering for emission monitoring equipment for various power generating sites of utilities in Texas, Louisiana, Mississippi and Arkansas; engineering, design and procurement for a 385 megawatt pulverized coal plant in South Carolina; nuclear, substation and engineering support services contract for an Illinois utility; and engineering and construction management for a transmission and distribution system for an Ohio utility. Projects completed in fiscal 1993 included: nuclear maintenance services for a utility in North Carolina; nuclear engineering services for a Minnesota utility; engineering for replacement of steam generators for a nuclear plant in Connecticut; and engineering, procurement and construction for a 105 megawatt diesel-powered facility in the Philippines. FLUOR CONSTRUCTORS Fluor Constructors is organized and operated separately from Fluor Daniel. Fluor Constructors provides unionized construction management, construction and maintenance services in the United States and Canada, both independently and as a subcontractor to Fluor Daniel. During fiscal 1993, Fluor Constructors contract awards included: construction management for an aromatics project for a refinery and an inter- refinery pipeline, both in Pennsylvania, and a blast furnace coal injection facility in Indiana; and construction and construction management for a reformulated gasoline project in California. Ongoing projects include: maintenance and outage support at various plant sites for a southeastern power generator in Tennessee and Kentucky; maintenance for nuclear power plants in Missouri, Florida and Alabama; construction management for a potable water supply system facility in Nevada, an Emergency 911 response system in Illinois and a copper smelter in Canada; and construction and construction management for an ethylene glycol plant expansion in Canada and fossil power plants in Louisiana, Mississippi and Arkansas. Projects completed in fiscal 1993 included: construction and construction management for replacement of steam generators for a nuclear plant in Connecticut and two naphtha hydrotreaters, one in Minnesota and one in Kentucky; construction management for a component test facility for the NASA Stennis Space Center in Mississippi and environmental improvements to a zinc plant in Canada; and maintenance for a nuclear power plant in Illinois. BACKLOG The following table sets forth the consolidated backlog of Fluor's engineering and construction segment at October 31, 1993 and 1992 (grouped by business sector): The dollar amount of the backlog is not necessarily indicative of the future earnings of Fluor related to the performance of such work. Although backlog represents only business which is considered to be firm, there can be no assurance that cancellations or scope adjustments will not occur. Due to additional factors outside of Fluor's control, such as changes in project schedules, Fluor cannot predict with certainty the portion of backlog not to be performed in fiscal 1994. Approximately $2.5 billion of the Hydrocarbon sector backlog is attributable to two projects for companies affiliated with Royal Dutch Shell (the Rayong Refinery project in Thailand and the Pernis Refinery in the Netherlands). Approximately $2 billion of the Government sector backlog is attributable to the DOE Fernald Project and subject to government funding determined on an annual basis. During fiscal 1993, the backlog of certain business units was reclassified to reflect an internal realignment of these units between the five market sectors. This resulted in reclassifying approximately $1 billion of business in the food and beverage products area from the Industrial sector to the Process sector. Balances at October 31, 1992 and 1993 have been restated to conform with the current business unit alignment. COAL INVESTMENT A. T. Massey Coal Company, Inc., which is headquartered in Richmond, Virginia, and its subsidiaries conduct Massey's coal-related businesses and are collectively referred to herein as the "Massey Companies." The Massey Companies produce, process and sell bituminous, low sulfur coal of steam and metallurgical grades from 15 mining complexes (11 of which include preparation plants) located in West Virginia, Kentucky and Tennessee. At October 31, 1993, two of the mining complexes were still in development and not yet producing coal. A third mining complex is idle pending negotiation of a labor agreement. Operations at certain of the facilities are conducted in part through the use of independent contract miners. The Massey Companies also purchase and resell coal produced by unrelated companies. Steam coal is used primarily by utilities as fuel for power plants. Metallurgical coal is used primarily to make coke for use in the manufacture of steel. For each of the three years in the period ended October 31, 1993, the Massey Companies' (a) production (expressed in thousands of short tons) of steam coal and metallurgical coal, respectively, was 16,048 and 5,163 for fiscal 1993, 13,832 and 3,867 for fiscal 1992, and 13,472 and 3,421 for fiscal 1991, and (b) sales (expressed in thousands of short tons) of coal produced by it and others, respectively, were 21,192 and 2,302 for fiscal 1993, 17,538 and 4,402 for fiscal 1992, and 16,982 and 6,578 for fiscal 1991. A large portion of the steam coal produced by the Massey Companies is sold to domestic utilities under long-term contracts. Metallurgical coal is sold to both foreign and domestic steel producers. Approximately 41% of the Massey Companies' fiscal 1993 coal production was sold under long-term contracts, 88% of which was steam coal and 12% of which was metallurgical coal. Approximately 11% of the coal tonnage sold by the Massey Companies in fiscal 1993 was sold on the export market. Massey is among the five largest marketers of coal in the United States. The coal market is a mature market with many strong competitors. Competition is primarily dependent upon coal price, transportation cost, producer reliability and characteristics of coal available for sale. The management of Massey considers Massey to be generally well-positioned with respect to these factors in comparison to its principal competitors. On February 22, 1993, the Massey Companies acquired certain assets in Pike County, Kentucky, from Pittston Coal Company, including an estimated 32 million tons of undeveloped coal reserves and three million tons of developed coal reserves with related preparation plant and mining facilities. Since the undeveloped coal reserves are strategically located near existing mining and coal processing facilities of the Massey Companies, development capital requirements will be modest. The economic life of the existing Massey operations in the vicinity will be significantly extended by this acquisition. On November 15, 1993, the Massey Companies acquired the assets of W-P Coal Company located in Logan County, West Virginia. Major components of the W-P Coal acquisition include approximately 40 million tons of reserves and a modern preparation plant. Simultaneously with the acquisition, the Massey Companies entered into a long-term coal supply agreement with Wheeling Pittsburgh Steel Corporation, a W-P Coal Company affiliate. Recently passed acid rain legislation is generally anticipated to benefit prices for low sulfur coal. Massey intends to continue to evaluate and pursue, in appropriate circumstances, the acquisition of additional low sulfur coal reserves. The Coal Industry Retiree Health Benefits Act of 1992 (the "Act") provides that certain retired coal miners who were members of the United Mine Workers of America, along with their spouses, are guaranteed health care benefits. The Massey Companies' obligation under the Act is currently estimated to aggregate $64 million which will be recognized as expense as payments are assessed. The management of the Massey Companies estimates that, as of October 31, 1993, the Massey Companies had total recoverable reserves (expressed in thousands of short tons) of 1,088,601; 456,810 of which are assigned recoverable reserves and 631,791 of which are unassigned recoverable reserves; and 799,287 of which are proven recoverable reserves and 289,314 of which are probable recoverable reserves. The management of the Massey Companies estimates that approximately 29% of the total reserves listed above consist of reserves that would be considered primarily metallurgical grade coal. They also estimate that approximately 63% of all reserves contain less than 1% sulfur. A portion of the steam coal reserves could be beneficiated to metallurgical grade by coal preparation plants, and a portion of the metallurgical coal reserves could be sold as high quality steam coal, if market conditions warrant. "Reserves" means that part of a coal deposit which could be economically and legally extracted or produced at the time of the reserve determination. "Recoverable reserves" means coal which is recoverable by the use of existing equipment and methods under federal and state laws now in effect. "Assigned recoverable reserves" means reserves which can reasonably be expected to be mined from existing or planned mines and processed in existing or planned plants. "Unassigned recoverable reserves" means reserves for which there are no specific plans for mining and which will require for their recovery substantial capital expenditures for mining and processing facilities. "Proven recoverable reserves" refers to deposits of coal which are substantiated by adequate information, including that derived from exploration, current and previous mining operations, outcrop data and knowledge of mining conditions. "Probable recoverable reserves" refers to deposits of coal which are based on information of a more preliminary or limited extent or character, but which are considered likely. DISCONTINUED LEAD OPERATION In November 1992, the Company announced its decision to exit its lead business, conducted primarily through The Doe Run Company ("Doe Run"). As a result, the Company's lead segment has been classified as a discontinued operation in the Company's consolidated financial statements. During 1993, the Company made substantial progress toward the disposition of the lead business. While the outcome of such disposition cannot be determined with certainty at this time, management's intent to dispose of the lead business remains unaltered and management believes that a disposal will be accomplished during fiscal 1994. OTHER MATTERS ENVIRONMENTAL, SAFETY AND HEALTH MATTERS The Company's natural resource operations are affected by federal, state and local laws and regulations regarding environmental protection and plant and mine safety and health. It is impossible to predict the full impact of future legislative or regulatory developments on such operations, because the standards to be met, as well as the technology and length of time available to meet those standards, continue to develop and change. Under the federal Clean Air Act, as amended, which is applicable to Doe Run's lead smelters, the Environmental Protection Agency ("EPA") is authorized to promulgate ambient air quality standards for certain identified pollutants. Each state is required to develop an implementation plan that is designed to achieve such ambient air quality standards through emission limitations and related requirements. Upon approval by the EPA, these state implementation plans become federally enforceable. The State of Missouri is required to develop implementation plans to control lead emissions from the two Doe Run lead smelters. An implementation plan was approved by the State for the Buick smelter on June 24, 1993, and has been submitted to EPA for approval. The Buick plan requires installation of various projects, but only if the primary smelter portion of the facility is to be operated. A supplemental implementation plan was approved for the Herculaneum smelter on June 24, 1993, and has also been submitted to EPA for approval. The Herculaneum plan requires the installation of $2.5 million in additional capital projects, with a final completion date of October, 1994. In September 1988, the EPA listed primary lead smelter surface impoundment solids as a hazardous waste under the federal Resource Conservation and Recovery Act. In anticipation of the final issuance of EPA regulations, the Company is in the process of eliminating surface impoundments (all of which are located at its Buick smelter). This corrective action was substantially completed by the end of fiscal 1993. The Company believes that with completion of this corrective action, the Company will be in compliance with final EPA regulations when issued. The Company is affected by and complies with other federal, state and local laws relating to environmental protection, safety and health applicable to all or part of its natural resource operations, including but not limited to the federal Surface Mining Control and Reclamation Act of 1977; Occupational Safety and Health Act; Mine Safety and Health Act of 1977; Water Pollution Control Act, as amended by the Clean Water Act of 1977; Toxic Substances Control Act; Black Lung Benefits Revenue Act of 1977; and Black Lung Benefits Reform Act of 1977. In fiscal 1993, Fluor made approximately $5.4 million in expenditures to comply with environmental, health and safety laws and regulations in connection with its coal investment, none of which were capital expenditures. Fluor anticipates making $11.3 million and $8.9 million in such non-capital expenditures in fiscal 1994 and 1995, respectively. Of these expenditures, $3.7 million, $9.6 million and $7.2 million for fiscal 1993, 1994 and 1995, respectively, are (in the case of fiscal 1993) or are anticipated to be (in the case of fiscal 1994 and 1995) for surface reclamation. Existing reserves are believed to be adequate to cover actual and anticipated surface reclamation expenditures. Other expenditures will be expensed as incurred. In fiscal 1993, Fluor made approximately $4.3 million in capital expenditures and $3.2 million in other expenditures to comply with environmental, health and safety laws and regulations in connection with its discontinued lead business. Other In 1986, the California North Coast Regional Water Quality Control Board for the State of California requested that the Company perform a site investigation of a property in Northern California designated as a hazardous waste site under the California Hazardous Waste Control Act. The Company formerly owned the property. The California Environmental Protection Agency has assumed lead agency status for any required remedial action at the site. The Company signed a Consent Order to perform a remedial investigation/feasibility study that will determine the extent of contamination for purposes of determining the remedial action required to remedy and/or remove the contamination. St. Joe Minerals Corporation ("St. Joe"), a wholly owned subsidiary of Fluor, is participating as a potentially responsible party at several different sites pursuant to proceedings under the Comprehensive Environmental Response, Compensation and Liability Act ("Superfund"). Other parties have also been identified as potentially responsible parties at all but one of these sites, and many of these parties have shared in the costs associated with the sites. Investigative and/or remedial activities are ongoing at each site. In 1987, St. Joe sold its zinc mining and smelting division to Zinc Corporation of America ("ZCA"). As part of the agreement, St. Joe and Fluor agreed to indemnify ZCA for certain environmental liabilities arising from operations conducted prior to the sale. During the 1993 fiscal year, ZCA has made claims under this indemnity against St. Joe for anticipated environmental expenditures at three of its major operating facilities. These claims are the subject of ongoing discussions between St. Joe, ZCA and other potentially responsible parties, including parties who have given similar contractual indemnities to St. Joe. St. Joe has initiated a proceeding against certain of its insurance carriers alleging that the investigative and remediation costs incurred by St. Joe in connection with its environmental proceedings are covered by insurance. This proceeding is in its early stages and no credit or offset for any such coverage has been taken into account by Fluor in establishing its reserves for future environmental costs. The Company does not believe that the claims or proceedings identified in the two preceding paragraphs, either individually or in the aggregate, will have a material adverse impact upon its operations or financial condition. NUMBER OF EMPLOYEES The following table sets forth the number of salaried and craft/hourly employees of Fluor and its subsidiaries engaged in Fluor's business segments as of October 31, 1993: OPERATIONS BY BUSINESS SEGMENT AND GEOGRAPHIC AREA The financial information for business segments and geographic areas is included in the Operations by Business Segment and Geographic Area section of the Notes to Consolidated Financial Statements in Fluor's 1993 Annual Report to stockholders, which section is incorporated herein by reference. ITEM 2.

ITEM 2. PROPERTIES. Major Facilities Operations of Fluor and its subsidiaries are conducted in both owned and leased properties. In addition, certain owned or leased properties of Fluor and its subsidiaries are leased or subleased to third party tenants. The following table describes the general character of the major existing facilities, exclusive of mines, coal preparation plants and their adjoining offices: Coal Properties See Item 1, Business, of this report for additional information regarding the coal operations and properties of Fluor. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. Fluor and its subsidiaries, incident to their business activities, are parties to a number of legal proceedings in various stages of development, including but not limited to those described below. The majority of these proceedings, other than environmental proceedings, involve matters as to which liability, if any, of Fluor or its subsidiaries would be adequately covered by insurance. With respect to litigation outside the scope of applicable insurance coverage and to the extent insured claims may exceed liability limits, it is the opinion of the management of Fluor, based on reports of counsel, that these matters individually and in the aggregate will not have a material adverse effect upon the consolidated financial position or results of operations of Fluor. In July 1987, four lawsuits were filed against R. T. Vanderbilt Company, Inc., Gouverneur Talc Company, Inc., St. Joe and Fluor for personal injury and wrongful death allegedly due to asbestos, talc and silicon exposure in certain New York mines. Subsequent to July 1987, 16 additional lawsuits have been filed. All of these suits (representing a total of 213 plaintiffs) have been filed with the New York Supreme Court, St. Lawrence County, New York. The total damages claimed in these cases, referred to as Bailey, Baker, Beane, et al. v. R. T. Vanderbilt Company, Inc., et al. (the claims have not been consolidated), are $287 million against all defendants. Plaintiffs also seek an unspecified amount of punitive damages against all defendants. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. Executive Officers of the Registrant(1) Leslie G. McCraw, age 59 Director since 1984; Chairman of Executive Committee and member of Nominating Committee. Chairman of the Board since 1991; Chief Executive Officer since 1990; formerly Vice Chairman of the Board from 1990; formerly President from 1988; joined the Company in 1975. Vincent L. Kontny, age 56 Director since 1988; member of Executive Committee. Chief Operating Officer since 1991; President since 1990; President of Fluor Daniel, Inc.(2) since 1988; joined the Company in 1965. Charles J. Bradley, Jr., age 58 Vice President, Human Resources and Administration since 1986; joined the Company in 1958. J. Michal Conaway, age 45 Vice President-Finance since January 4, 1993; formerly Vice President and Chief Financial Officer of National Gypsum Company and its parent, Aancor Holdings, Inc., from 1988. James O. Rollans, age 51 Senior Vice President and Chief Financial Officer since June, 1992; formerly Vice President, Corporate Communications from 1982; joined the Company in 1982. P. Joseph Trimble, age 63 Corporate Secretary since December, 1992; Senior Vice President-Law since 1984; joined the Company in 1972. Executive Operating Officers(1) Hugh K. Coble, age 59 Director since 1984; member of Executive Committee. Group President of Fluor Daniel, Inc.(2) since 1986; joined the Company in 1966. Gerald M. Glenn, age 51 Director since 1989; member of Executive Committee. Group President of Fluor Daniel, Inc.(2) since 1986; joined the Company in 1964. Don L. Blankenship, age 43 Chairman of the Board and Chief Executive Officer of A. T. Massey Coal Company, Inc.(3) since January, 1992; President of that subsidiary since 1990; formerly Chief Operating Officer of that subsidiary from 1990; formerly President of Massey Coal Services, Inc.(4) from 1989; formerly Executive Vice President of that subsidiary from 1988; joined Rawl Sales & Processing Co.(5) in 1982. Richard A. Flinton, age 63 Chairman of the Board of Fluor Constructors, Inc.(6) since 1989; formerly President of that subsidiary from 1988; joined the Company in 1957. Jeffrey L. Zelms, age 49 Chief Executive Officer of The Doe Run Company(7) since August, 1992; President of that company since 1986; joined St. Joe Minerals Corporation in 1970. - -------- (1) Except where otherwise indicated, all references are to positions held with Fluor. (2) Fluor Daniel, Inc. is a wholly owned subsidiary of Fluor which provides design, engineering, procurement, construction management and technical services to a wide range of industrial, commercial, utility, natural resources, energy and governmental clients. (3) A. T. Massey Coal Company, Inc. is an indirectly wholly-owned subsidiary of Fluor which, along with its subsidiaries, conducts Fluor's coal-related investment. (4) Massey Coal Services, Inc. is a wholly owned subsidiary of A. T. Massey Coal Company, Inc. (5) Rawl Sales & Processing Co. is a wholly owned subsidiary of A. T. Massey Coal Company, Inc. (6) Fluor Constructors, Inc., a wholly owned subsidiary of Fluor, provides construction and maintenance services to a variety of clients. (7) In November 1992, Fluor announced its decision to exit its lead business, conducted primarily through The Doe Run Company, and classified it as a discontinued operation in its consolidated financial statements. PART II Information for Items 5, 6 and 7 is contained in Fluor's 1993 Annual Report to stockholders, which information is incorporated herein by reference (and except for these sections, and sections incorporated herein by reference in Items 1 and 8 of this report, Fluor's 1993 Annual Report to stockholders is not to be deemed filed as part of this report): Information for Item 8

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not Applicable. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Information concerning Fluor's executive officers is included under the caption "Executive Officers of the Registrant" following Part I, Item 4. Other information required by this item has been omitted because Fluor will file with the Securities and Exchange Commission (the "Commission") a definitive proxy statement pursuant to Regulation 14A, involving the election of directors, not later than 120 days after the close of Fluor's fiscal year ended October 31, 1993. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. Fluor maintains certain employee benefit plans and programs in which its executive officers and directors are participants. Copies of these plans and programs are set forth or incorporated by reference as Exhibits 10.1 through 10.18 inclusive to this report. Certain of these plans and programs provide for payment of benefits or for acceleration of vesting of benefits upon the occurrence of a change of control of Fluor as that term is defined in such plans and programs. The amounts payable thereunder would represent an increased cost to be paid by Fluor (and indirectly by its stockholders) in the event of a change in control of Fluor. This increased cost would be a factor to be taken into account by a prospective purchaser in determining whether, and at what price, it would seek control of the Company and whether it would seek the removal of then existing management. If a change of control were to have occurred on October 31, 1993, the additional amounts payable by Fluor, either in cash or in stock, if each of the five most highly compensated executive officers and all executive officers as a group were thereupon involuntarily terminated without cause would be as follows: -------- (1) Payable in cash. (2) Value at October 31, 1993 of previously awarded restricted stock which would vest upon change of control. (3) Lump sum entitlement of previously awarded benefits which would vest upon change of control. Further disclosure regarding this item has been omitted because Fluor will file with the Commission a definitive proxy statement pursuant to Regulation 14A, involving the election of directors, not later than 120 days after the close of Fluor's fiscal year ended October 31, 1993. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. This item has been omitted because Fluor will file with the Commission a definitive proxy statement pursuant to Regulation 14A, involving the election of directors, not later than 120 days after the close of Fluor's fiscal year ended October 31, 1993. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. This item has been omitted because Fluor will file with the Commission a definitive proxy statement pursuant to Regulation 14A, involving the election of directors, not later than 120 days after the close of Fluor's fiscal year ended October 31, 1993. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. FLUOR CORPORATION January 27, 1994 By J.O. Rollans ___________________________________ J.O. Rollans Senior Vice President and Chief Financial Officer PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. L. N. Fisher *By ___________________________ L. N. Fisher, Attorney-in-fact Manually signed Powers of Attorney authorizing L. N. Fisher, A. M. Oldham and P. J. Trimble and each of them, to sign the annual report on Form 10-K for the fiscal year ended October 31, 1993 and any amendments thereto as attorneys-in- fact for certain directors and officers of the registrant are included herein as Exhibits 24.1 and 24.2. FLUOR CORPORATION AND FINANCIAL STATEMENT SCHEDULES ITEM 14(A) 1.Financial Statements The following financial statements are contained in Fluor's 1993 Annual Report to stockholders: Consolidated Balance Sheet at October 31, 1993 and 1992 Consolidated Statement of Earnings for year ended October 31, 1993, 1992 and 1991 Consolidated Statement of Cash Flows for year ended October 31, 1993, 1992 and 1991 Consolidated Statement of Shareholders' Equity for year ended October 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements 2.Financial Statement Schedules Form 10-K Page II Consolidated amounts receivable from related parties and underwriters, promoters and employees other than related parties--year ended October 31, 1993 and 1992...................................... V Consolidated property, plant and equipment--year ended October 31, 1993, 1992 and 1991.............. VI Consolidated accumulated depreciation, depletion and amortization of property, plant and equipment--year ended October 31, 1993, 1992 and 1991............................................... VII Consolidated guarantees of securities of other issuers as of October 31, 1993..................... All other schedules have been omitted since the required information is not present or not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and notes thereto. FLUOR CORPORATION SCHEDULE II--CONSOLIDATED AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES YEAR ENDED OCTOBER 31, 1993 AND 1992 - -------- (1) As of October 31, 1993, Fluor held a non-interest bearing note, payable in five annual installments and secured by a second deed of trust on a residence. On January 11, 1994, the balance of the note was fully repaid. FLUOR CORPORATION SCHEDULE V--CONSOLIDATED PROPERTY, PLANT AND EQUIPMENT YEAR ENDED OCTOBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) - -------- (1) Amounts in 1992 primarily include the reclassification of the lead business to net assets of discontinued operations and the purchase of certain partnership interests which owned the Company's Greenville, South Carolina engineering office. Amounts in 1991 include the purchase of certain partnership interests which owned the the Company's Sugar Land, Texas engineering office. Transfers of construction in progress were: zero, zero and $.1 million to land; $2.5 million, $37.6 million and $3.1 million to buildings and improvements; $7.7 million, $33.7 million and $40.6 million to machinery and equipment; zero, zero and $.2 million to mining properties and mineral rights in 1993, 1992 and 1991, respectively. Maintenance and repairs expense for continuing operations totaled $62.1 million in 1993, $51.7 million in 1992 and $52.9 million in 1991. FLUOR CORPORATION SCHEDULE VI--CONSOLIDATED ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT YEAR ENDED OCTOBER 31, 1993, 1992 AND 1991 (IN THOUSANDS) - -------- (1) See footnote (1) on Schedule V, Consolidated Property, Plant and Equipment on page 22 of this Form 10-K for a discussion of items included in this caption. Depreciation is provided principally using the straight line method over the following estimated useful lives: buildings and improvements 3 to 50 years; machinery and equipment 2 to 20 years. Amortization is provided principally using the units of production method for mining properties and mineral rights. FLUOR CORPORATION SCHEDULE VII--CONSOLIDATED GUARANTEES OF SECURITIES OF OTHER ISSUERS AS OF OCTOBER 31, 1993 (IN THOUSANDS) EXHIBIT INDEX

701345_1993.txt

701345

1993

Item 1. BUSINESS USAir Group, Inc. ("USAir Group" or the "Company") is a corporation organized under the laws of the State of Delaware. The Company's executive offices are located at 2345 Crystal Drive, Arlington, Virginia 22227 (telephone number (703) 418-5306). USAir Group's primary business activity is ownership of all the common stock of USAir, Inc. ("USAir"), Pennsylvania Commuter Airlines, Inc. (which is operating as Allegheny Commuter Airlines) ("Alleghe- ny"), Piedmont Airlines, Inc. ("Piedmont") (formerly Henson Aviation, Inc.), Jetstream International Airlines, Inc. ("Jet- stream"), USAir Fuel Corporation ("USAir Fuel"), USAir Leasing and Services, Inc. ("USAir Leasing and Services") and Material Services Company, Inc. In May 1987, the Company acquired Pacific Southwest Airlines ("PSA"), which merged into USAir on April 9, 1988. In November 1987 the Company completed its acquisition of Piedmont Aviation, Inc. ("Piedmont Aviation"), which merged into USAir on August 5, 1989. On July 15, 1992, the Company sold three wholly- owned subsidiaries, Piedmont Aviation Services, Inc., Air Service, Inc. and Aviation Supply Corporation. The former subsidiaries were engaged in fixed base operations and the sale and repair of aircraft and aircraft components. During the third quarter of 1992, the Company merged one wholly-owned subsidiary, Allegheny Commuter Airlines, Inc. into another, Pennsylvania Commuter Airlines, Inc. Significant Impact of Low Cost, Low Fare Competition As discussed in greater detail in "Management's Discussion and Analysis of Financial Condition and Results of Operations," the dramatic expansion of low fare competitive service in many of USAir's markets in the eastern U.S. during the first quarter of 1994 and USAir's competitive response in February 1994 by reducing its fares up to 70 percent in those markets and other affected markets in order to preserve its market share led the Company to announce that it expected to experience greater losses in 1994 than it experienced in 1993. In September 1993, Southwest Airlines, Inc. ("Southwest"), a low cost, low fare, "no frills" air carrier which had not previous- ly provided service to or in the eastern U.S., inaugurated service to Chicago and Cleveland from Baltimore/ Washington International Airport ("BWI") at fares substantially below those previously offered by USAir and other airlines in the same markets. BWI is one of USAir's hub airports. Unlike the other major U.S. air carriers, Southwest does not structure its operations around connecting hub airports, relying instead on high frequency point- to-point service. USAir responded by matching most of Southwest's fares and increasing the frequency of service in related markets. On March 22, 1994, Southwest announced that on May 26, 1994, and June 6, 1994, it will expand service between BWI and Chicago. Southwest also announced that on May 26, 1994, it will initiate its low fare service between BWI and St. Louis, and on July 8, 1994, between BWI and Birmingham, Alabama and Louisville, Kentucky. At this time, USAir has not determined its response to the Southwest announcement. In October 1993, Continental Airlines ("Continental"), which had reorganized under bankruptcy proceedings earlier in 1993, inaugurated low fare service on certain routes in the eastern U.S. USAir is a competitor in most of the markets served by these routes. While Continental initiated service to certain cities, such as Charleston, South Carolina; Greensboro, North Carolina; and Jacksonville, Florida; most of the markets included as part of its new program (for example, Baltimore) were previously served by Continental through its hubs at Newark, Cleveland, and Houston. However, under its new program, Continental linked certain of these cities independently of its hubs while continuing to provide many of the same services that are available on its hub flights, including advance seat assignment, frequent traveler mileage credits and interline connections. Under its new program, Continental served approximately 80 city pair markets, from which USAir has historically realized approximately 4% of its total passenger revenue. When Continental started the new program it was uncertain whether the program was an experiment or a beachhead from which Continental planned to expand further. USAir, therefore, made a measured response by matching most of the low fares offered by Continental. On January 31, 1994, Continental increased its competitive threat. It announced that by March 9, 1994, it would expand the low fare program to approximately 356 city pair markets, most of which USAir served and from which USAir has historically realized approximately 8% of its passenger revenue. Moreover, if secondary markets within a 90-mile radius, or a reasonable driving distance, were viewed as being included in Continental's new program, markets from which USAir has historically realized approximately 36% of its passenger revenue were affected. Contemporaneously, Continental announced that it would substantially reduce service at its Denver hub and redeploy significant aircraft and personnel resources to the eastern U.S. Although Continental's balance sheet continues to have significant leverage following its bankruptcy reorganization, its liquidity position improved substantially as a result of equity and debt infusions completed as part of that reorganization. Moreover, Continental completed a common stock offering in December 1993, which may indicate the market's receptivity to its efforts to raise additional funds. Continental has operating (including labor) costs that are substantially lower than those of USAir and the other major air carriers. On February 8, 1994, in response to the expansion of Continen- tal and to avoid loss of market share in the eastern U.S., USAir lowered in primary and secondary markets affected by the Continen- tal expansion, by as much as 50%, the fares most commonly used by business travelers on many east coast routes. In addition, USAir lowered leisure fares by as much as 70% in the same markets. In many of the markets, free companion fares are available with business fares. These reduced fares have no expiration date. However, USAir could adjust the fares at some time in the future. Increases in traffic which are stimulated by the lower fares offered by Southwest, Continental and USAir will not offset USAir's reduced revenue resulting from lower yields in these markets. USAir believes that Southwest, Continental or other low cost carriers with a significant cost advantage over USAir likely will expand their operations to additional markets. For example, in December 1993, Southwest completed its acquisition of Morris Air, a regional air carrier with operations concentrated in the western U.S. This acquisition could enable Southwest to divert resources to expand its operations in the eastern U.S. Furthermore, media reports indicate that Southwest has entered into a long-term agreement for the use of four additional gates at BWI, where it currently operates from two gates. On March 4, 1994, Continental further escalated prospective competition by announcing that it will further reduce operations at its Denver, Colorado hub and establish a flight crew base at Greensboro, North Carolina. These measures are likely to increase losses at USAir because they could enable Continental, which has significantly lower costs than USAir, to expand further its high frequency, low fare service described above in additional short-haul markets served by USAir with substantial detriment to USAir. In addition, other low cost carriers may enter other USAir markets. For example, America West Airlines ("America West") announced on February 15, 1994 that it will commence service on April 18, 1994 between Columbus, Ohio where it operates a hub and Philadelphia, where USAir has a hub operation. Other carriers, including some of the larger carriers, have also indicated their intent to develop similar low-fare short- haul service. In March 1994, USAir announced that it expected a pre-tax loss for the quarter ended March 31, 1994 of approximately $200 million and that it expected a pre-tax loss for the full year of 1994 in excess of the $350 million loss reported for 1993. USAir, whose operating costs are among the highest in the domestic airline industry, believes that it must reduce those costs significantly if it is to survive in this low fare competitive environment. The largest single component of USAir's operating costs, approximately 40 percent, relates to personnel costs. USAir also announced in March 1994 that it had initiated discussions with the leaders of its unionized employees regarding efforts to reduce these costs, including reductions in wages, improvements in productivity and other cost savings. The outcome of those discussions is uncertain. There are recent examples of companies in the airline industry which have obtained employee concessions in agreements also resulting in the recapitalization of the companies, including employee ownership stakes and employee participation in corporate governance as well as the restructuring of debt and lease obligations. In other cases, airlines have filed for bankruptcy protection under Chapter 11 of the bankruptcy code, and some airlines have ceased operation altogether when their operating costs remained excessive in relation to their revenues, and their liquidity became insufficient to sustain their operations. In addition, other factors beyond the Company's control, such as a downturn in the economy, a dramatic increase in fuel prices or intensified industry fare wars, could have a material adverse effect on the Company's and USAir's prospects and financial condition. Because the Company and USAir are highly leveraged and currently do not have access to bank credit and receivables facilities which had supplied a substantial portion of their liquidity, they could be more vulnerable to these factors than their financially stronger competitors. See "Managem- ent's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources." British Airways Announcement Regarding Additional Investment in the Company; Code Sharing As described in greater detail in "British Airways Investment Agreement" below, on January 21, 1993, the Company and British Airways Plc ("BA") entered into an Investment Agreement (as subsequently amended, the "Investment Agreement"). Pursuant to the Investment Agreement, on the same date, BA invested $300 million in certain preferred stock of the Company. In June 1993, pursuant to BA's exercise of its preemptive and optional purchase rights under the Investment Agreement which were triggered by the issuance by the Company to the public, and under certain employee benefit plans, of certain shares of common stock, BA purchased $100.7 million of additional series of preferred stock of the Company. The Company has benefitted from the additional equity provided by BA and also from the resulting enhancement of the Company's image in the marketplace and in the investment community. However, on March 7, 1994, BA announced that because of the Company's continued substantial losses it would make no additional investments in the Company until the outcome of the Company's efforts to reduce its costs is known. See "Significant Impact of Low Fare, Low Cost Competition" above and "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources." At the same time, BA indicated it would continue to cooperate with USAir on the code sharing arrangements discussed below. In addition, since January 1993, pursuant to the Investment Agreement, BA and USAir have entered into code sharing arrangements whereby certain USAir flights carry the airline designator code of both USAir and BA. Code sharing is a common practice in the airline industry whereby one carrier sells the flights of another carrier (its code sharing partner) as if it provides those flights with its own equipment and personnel. On March 17, 1994, the U.S. Department of Transportation (the "DOT") issued an order renewing for one year all of the code share authority it had previously approved for USAir and BA which includes authority to code share to 64 airports in the U.S. through 12 gateways and to Mexico City through Philadelphia. The DOT did not act on other pending applications by BA and USAir for expanded code share authority. Major Airline Operations USAir, a certificated air carrier engaged primarily in the business of transporting passengers, property and mail, is the Company's principal operating subsidiary, accounting for more than 93% of USAir Group's operating revenues in 1993. USAir is one of nine passenger carriers classified as "major" airlines (those with annual revenues greater than $1 billion) by the United States Department of Transportation (the "DOT"). USAir enplaned more than 54.0 million passengers in 1993, and is the sixth largest United States air carrier ranked by revenue passenger miles ("RPMs") flown. At January 31, 1994, USAir provided regularly scheduled jet service through 118 airports to more than 154 cities in the continental United States, Canada, the Bahamas, Bermuda, the Cayman Islands, Puerto Rico, Germany, France and the Virgin Islands. USAir ceased serving the United Kingdom in January 1994. See "British Airways Investment Agreement". USAir's executive offices are located at 2345 Crystal Drive, Arlington, Virginia 22227 (telephone number (703) 418-7000), and its primary connecting hubs are located at the Pittsburgh, Charlotte/Douglas, Philadelphia and Baltimore/Washington International ("BWI") Airports. A substantial portion of USAir's RPMs is flown within or to and from the eastern United States. USAir Group and USAir incurred substantial operating and net losses during 1991, 1992 and 1993. During the first quarter of 1992, USAir's RPMs decreased over the same period in 1991, however, yield, or passenger revenue per RPM, improved. The decline in traffic was attributable to the May 1991 Restructuring (discussed below) and the economic recession. It is not possible to estimate accurately how many business and leisure travelers decided not to travel during 1991 and 1992 as a result of the recession and perceived weak recovery. During the second quarter of 1992, American Airlines, Inc. ("American") introduced a four-tier fare structure which resulted in the proliferation of deeply discounted promotional fares in the second and third quarters of 1992. Although the promotional fares significantly stimulated traffic during the second and third quarters of 1992, yields suffered substantial declines versus comparable periods in 1991. Although yields at USAir recovered and improved significantly in the fourth quarter of 1992 and in the first three quarters of 1993, yields started to erode in the fourth quarter of 1993 and declined versus the comparable quarter of 1992 due to proliferation of discount and promotional fares which were designed to stimulate passenger traffic. Yields have continued to be weak in the first quarter of 1994 due primarily to USAir's action to reduce fares to remain competitive with low cost low fare carriers which had entered many of USAir's markets in the eastern U.S. During 1993, systemwide traffic remained relatively weak. In addition, the domestic airline industry was characterized in 1991 - 1993 by substantial losses, excess capacity, intense competition and certain carriers operating under the protection of Chapter 11 of the Bankruptcy Code. Any of these factors or other developments, including the emergence of America West from bankruptcy, the entry or potential entry of low cost carriers in USAir's markets and a resurgence in low fare competition from these and other carriers could have a material adverse effect on the Company's yields, liquidity and financial condition. See "Significant Impact of Low Fare, Low Cost Competition" above and Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations." For information on possible further effects of the recent economic recession, increased competition from low cost, low fare carriers, possible restructuring of the Company and USAir, consolidation in the domestic airline industry and globalization of the airline industry, see Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations." USAir implemented several operational changes during the period 1991 through 1993 in efforts to return to profitability and has announced plans for additional action in 1994. On May 2, 1991, USAir ceased operating its fleet of 18 British Aerospace BAe 146-200 ("BAe-146") aircraft, ceased serving eight airports in California, Oregon and Washington, and eliminated some flights at Baltimore/Washington and Cleveland Hopkins International Airports. Although other service was added to partially offset these reductions, the net effect was a decrease of approximately three percent in USAir's system available seat miles ("ASMs"), and a net reduction in scheduled departures of ten percent from January 1991 service levels. In connection with this restructuring, USAir closed four flight crew bases, two heavy maintenance facilities and one reservations office (these measures are collectively referred to as the "May 1991 Restructuring"). (In April 1993, USAir reintroduced long-haul service at John Wayne Airport in Orange County, California, one of the airports that USAir ceased serving in the May 1991 Restructuring). Effective January 7, 1992, USAir discontinued its hub operations at Dayton, Ohio due to operating losses there. Daily jet departures from Dayton were reduced from 72 to 23. The majority of USAir's jet flights between Dayton and smaller and medium-sized "spoke" cities was shifted to USAir's hub at Pitts- burgh, Pennsylvania, and there was no reduction in total systemwide capacity as a result of this action. In September 1993, USAir announced steps to reduce projected operating costs in 1994 by approximately $200 million. These measures include a workforce reduction of approximately 2,500 full time positions, revision of USAir's vacation, holiday and sick leave policy and a review of planned 1994 capital expenditures. The workforce reduction, which USAir anticipates will be completed by the end of the first quarter of 1994, will be comprised primarily of the elimination of approximately 1,800 customer service, 200 flight attendant and 200 maintenance positions. USAir recorded a non-recurring charge of approximately $68.8 million primarily in the third quarter of 1993 for severance, early retirement and other personnel-related expenses in connection with the workforce reduction. In March 1994, USAir initiated discussions with the leadership of its unionized employees regarding reductions in wages, improve- ments in productivity and other cost savings as a result of the entry of low cost low fare carriers in many of its markets and USAir's response to this low fare competition. See "Significant Impact of Low Cost, Low Fare Competition" above and Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations". In counterpoint to the reductions outlined above, USAir has also taken, or plans to take, the following steps to augment or enhance its service. In December 1991, USAir reached agreements with General Electric Capital Corporation ("GE Capital") and with The Boeing Company ("Boeing") to acquire up to 40 757-200 aircraft during 1992-1997. USAir agreed to lease ten aircraft owned by GE Capital and formerly operated by Eastern Air Lines ("Eastern"). In December 1992, USAir agreed to sublease an additional 757-200 aircraft from Boeing that was formerly operated by Eastern. USAir added these 11 aircraft to its operating fleet during 1992. USAir also agreed with Boeing to purchase 15 new 757-200 aircraft in 1993 and 1994, and took options to purchase 15 more 757-200s in 1996 and 1997. In April 1993, USAir and Boeing reached an agreement to exercise the options on 757-200 aircraft previously scheduled for delivery in 1996-1997 and accelerate their delivery to 1995-1996, and to convert a firm order for a 767-200 aircraft, originally scheduled for delivery in 1994, to a firm order for a 757-200 aircraft, also scheduled for delivery in 1994. Boeing granted USAir options to purchase 15 additional 757-200 aircraft for 1995 and beyond, three of which have expired. In addition, Boeing relieved USAir of its obligation to purchase 20 of its 60 firm orders for Boeing 737 series aircraft and agreed to reschedule delivery of the remaining 40 on order. No new firm order 737 aircraft are scheduled to be delivered to USAir between 1994-1996, while 12 new 737 aircraft will be delivered annually in the years 1997-1999 and four will be delivered in the year 2000. USAir is using the Boeing 757-200 aircraft, which seats approximately 190 passengers, on long-haul routes and in high demand markets where potential passenger traffic may not currently be accommodated on smaller aircraft at peak travel times. USAir considers the 757-200 aircraft to be more suitable for these missions than the Boeing 767-200 and Boeing 737 aircraft types. The above actions supple- ment USAir's agreements with Boeing in 1990 and 1991 to defer delivery of several 737 and 767 aircraft originally scheduled for the 1991-1994 period. Overall, the deferrals have substantially reduced USAir's capital commitments and financing needs during that time period. USAir is engaged in negotiations with Boeing regarding, among other things, the current schedule of new aircraft deliveries. See Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources" and Item 8A. Note 4 to the Company's Consolidat- ed Financial Statements. On January 17, 1992, USAir purchased 62 jet take-off and landing slots and 46 commuter slots at New York City's LaGuardia Airport ("LaGuardia") and six jet slots at Washington National Airport from Continental Airlines ("Continental") for $61 million. USAir also assumed Continental's leasehold obligations associated with the East End Terminal, which commenced operations on Septem- ber 12, 1992, and a flight kitchen at LaGuardia. USAir acquired all 46 commuter slots and 24 of the jet slots at LaGuardia on February 1, 1992; the remaining 38 jet slots at LaGuardia and all six jet slots at Washington National Airport were transferred to USAir on May 1, 1992. As a result of the acquisition, USAir expanded its operations at LaGuardia including the initiation of non-stop service to eight additional cities, four of which are in Florida. The New York-Florida markets are among the largest in the nation. USAir Express carriers used the commuter slots to expand service primarily to cities in the northeastern United States. (See "Commuter Airline Operations"). Expansion into these jet and commuter markets enhanced USAir's presence in the New York area and in the northeast. In addition, the East End Terminal permitted USAir to consolidate its mainline, commuter and USAir Shuttle operations in adjoining facilities, which USAir believes are the most comfortable and convenient at LaGuardia. USAir sold substan- tially all the assets associated with the flight kitchen operation on October 9, 1992. USAir Group reached an agreement during 1992 with the creditors of the Trump Shuttle to manage and operate the Shuttle under the name "USAir Shuttle" for a period of up to ten years. Under the agreement, USAir Group has an option to purchase the shuttle operation on or after October 10, 1996. The USAir Shuttle commenced operations in April 1992 between New York City, Boston and Washington D.C. Effective August 1, 1992, USAir leased 28 take-off and landing slots at Washington National Airport from Northwest Airlines, Inc. ("Northwest"). USAir is using the slots to offer expanded service from Washington to five Florida cities and New Orleans. In August 1993, USAir purchased eight of these slots from Northwest. USAir continues to lease the remaining slots from Northwest. On October 1, 1992, USAir moved its hub operation at Pitts- burgh, which is the largest on its system, to the new Pittsburgh International Airport terminal, where USAir leases 53 of 75 gates. USAir believes that the Pittsburgh hub, one of the largest hub airports (measured by departures) in the U.S., is one of the most efficient connecting complexes in the nation. Effective February 1, 1993, USAir and USAir Express service within the state of Florida commenced operating under the brand name "USAir Florida Shuttle". In addition, USAir started hourly service between Miami and Tampa and Miami and Orlando. On February 1, 1993 total USAir and USAir Express daily departures in the intra-Florida markets and to cities outside Florida increased approximately 27% over February 1992 levels. To enhance customer service and bolster brand loyalty within the state, USAir offered special benefits, bonus miles and upgrades to Florida residents participating in its Frequent Traveler Program. (See Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations - General Economic Conditions and Industry Capacity.") By June 1993 USAir increased capacity between key cities on the west coast of the U.S. and cities in the midwestern and eastern parts of the nation as it realigned west coast schedules and increased its emphasis on long-haul flights. Much of the increase in capacity was achieved by replacing smaller aircraft types with 757-200 aircraft. During 1993 and thus far in 1994 USAir and BA have gradually implemented code sharing arrangements pursuant to the Investment Agreement. As of March 1, 1994, USAir and BA had implemented code sharing to 34 of the 65 airports currently authorized by the DOT. See "British Airways Announcement Regarding Additional Investment in the Company; Code Sharing" above and "British Airways Investment Agreement" below. In March 1994, USAir (i) purchased from United Air Lines, Inc. ("United") certain takeoff and landing slots at Washington National Airport and New York LaGuardia Airport; (ii) purchased from United certain gates and related space at Orlando International Airport and (iii) granted to United options to purchase certain gates and related space, and a right of first refusal to purchase certain takeoff and landing slots, at Chicago O'Hare International Airport. In December 1993, USAir reached an agreement with United to negotiate a code sharing agreement with United regarding USAir's flights to and from Miami and United's flights between Miami and Latin America. Consummation of the code sharing agreement is subject to a number of conditions, including governmental approvals and definitive documentation. At this time, USAir cannot predict when the transactions contemplated by the code sharing agreement with United will be consummated. In September 1993, USAir received a civil investigative demand from the U.S. Department of Justice ("DOJ") related to an investigation of violations of Section 1 of the Sherman Act in connection with USAir's agreement with United regarding the above transactions. Although there can be no certainty, USAir does not believe the DOJ will seek to overturn the transactions described in (i), (ii) and (iii) above. In 1994, USAir has implemented and plans to implement certain changes to its service on certain short-haul routes to reduce the cost and increase the efficiency of those operations. In addition, in the second half of 1993 and early 1994, USAir experienced increased competition from low cost, low fare carriers. See "Significant Impact of Low Cost, Low Fare Competition" and Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations - Low Cost, Low Fare Competition". In response to the entry of certain low cost, low fare competitors at BWI and as part of USAir's measures to reduce the cost and increase the efficiency of its shorthaul service, USAir has substantially expanded its operations at BWI. As of March 1994, USAir had 121 daily jet departures at that airport compared to 91 daily jet departures in March 1993. See Item 7. "Manage- ment's Discussion and Analysis of Financial Condition and Results of Operations - Low Cost, Low Fare Competition." In November 1993, USAir commenced service between BWI and St. Thomas, Virgin Islands and between Charlotte and Tampa and Grand Cayman, Cayman Islands. In addition, USAir commenced nonstop service from Philadelphia to Mexico City in March 1994 and will commence non-stop service from Tampa to Mexico City in May 1994. As a result of seasonal adjustments, increased service to existing markets and service to new destinations, on May 8, 1994, USAir also plans to increase daily jet departures at its Pittsburgh hub from 327 to 355 and at its Charlotte hub from 323 to 334. In summary, in 1993, USAir continued to try to capitalize on its strong franchise in the northeastern U.S. and in Florida, based on measures it had implemented in 1991 and 1992. By the end of the third quarter of 1993, however, due to continued fare discounting, a resurgence of low fare competition from low cost carriers, persistent consumer price consciousness and, despite significant countermeasures, increased operating expenses, it became clear that for USAir to remain competitive, it needed to reduce costs and become more efficient. This realization resulted in, among other steps, the reduction in force of 2,500 full-time positions initiated in 1993, the innovations in short-haul service and the initiation of discussions with the leadership of USAir's unionized employees regarding wage reductions, improved productivity and other costs savings described in "Significant Impact of Low Cost, Low Fare Competition" above and Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations - Low Cost, Low Fare Competition." USAir is engaged in formulating additional plans to reduce its operating costs in 1994. USAir's operating statistics during the years 1989 through 1993 are set forth in the following table: * Scheduled service only. c = cents (1) Statistics for 1989 are set forth on a pro forma basis to include the jet operations of Piedmont Aviation as if it had merged into USAir effective January 1, 1989. (2) Passenger load factor is the percentage of aircraft seating capacity that is actually utilized (RPMs/ASMs). (3) Breakeven load factor represents the percentage of aircraft seating capacity that must be utilized, based on fares in effect during the period, for USAir to break even at the pre- tax income level, adjusted to exclude non-recurring and special items. (4) Adjusted to exclude non-recurring and special items. (5) Financial statistics for 1993 exclude revenue and expense generated under the BA wet lease arrangement. Commuter Airline Operations Most commuter airlines in the United States are affiliated with a major or regional jet carrier. USAir provides reservations and, at certain stations, ground support services, in return for service fees, to 10 commuter carriers (including Allegheny, Piedmont and Jetstream) which operate under the name "USAir Express." At certain other stations, the commuter carriers commenced performing ground support for their operations in 1993. These airlines share USAir's two-letter designator code and feed connecting traffic into USAir's route system at several points, including its major hub operations at Pittsburgh, Charlotte, Philadelphia and BWI. At January 5, 1994, USAir Express carriers served 181 airports in the United States, Canada and the Bahamas, including 88 also served by USAir. During 1993, USAir Express' combined operations enplaned approximately 8.7 million passengers. Piedmont's collective bargaining agreement with the Air Line Pilots Association ("ALPA"), which represents its pilot employees, became amendable on December 1, 1992. On February 22, 1994, the National Mediation Board (the "NMB"), which had assigned a mediator to the negotiations between Piedmont and ALPA on a new agreement, declared these negotiations at an impasse and commenced a thirty- day "cooling-off" period. Upon the expiration of this period at midnight on March 25, 1994, the Piedmont pilots would be free to strike and Piedmont could resort to self-help measures. As USAir's largest commuter affiliate, Piedmont provides significant passenger feed to USAir. In addition, if the Piedmont pilots commence a strike, other USAir Express or USAir employees could refuse to cross picket lines or engage in sympathy strikes. USAir would view such activity as violative of applicable contracts and the Railway Labor Act and would pursue all legal remedies to halt it. Suspension of the operations of Piedmont, other USAir Express carriers or USAir for a prolonged period due to strikes or self- help measures could have a material adverse effect on the Company's and USAir's financial condition and prospects. USAM Corp. At December 31, 1992, USAM Corp. ("USAM"), a subsidiary of USAir, owned 11% of the Covia Partnership ("Covia") which owned and operated a computerized reservation system ("CRS"). In September 1993, Covia purchased the assets of the corporation that owned and operated the Galileo CRS which provided CRS services to travel agent subscribers in Europe. Covia was then separated into three entities. As a result, at December 31, 1993, USAM owns 11% of the Galileo International Partnership, approximately 11% of the Galileo Japan Partnership and approximately 21% of the Apollo Travel Services Partnership. The Galileo International Partnership owns and operates the Galileo CRS ("Galileo"). Galileo Japan Partnership markets CRS services in Japan. Apollo Travel Services markets CRS services in the U.S. and Mexico. Galileo is the second largest of the four such systems in the U.S. based on revenues generated by travel agency subscribers. A subsidiary of United controls 38% of the partnership, and the other partners exclusive of USAir's interest are subsidiaries of BA, Swissair, KLM Royal Dutch Airlines, Alitalia, Air Canada, Olympic Airways, Austrian Airlines, Aer Lingus and TAP Air Portugal. CRSs play a significant role in the marketing and distribution of airline tickets. During 1993, travel agents issued tickets which generated the majority of USAir's passenger revenues. Most travel agencies use one or more CRSs to obtain information about airline schedules and fares and to book their clients' travel. Employees At December 31, 1993, USAir Group's various subsidiaries employed approximately 48,500 full-time equivalent employees. USAir employed approximately 5,400 pilots, 10,100 maintenance and related personnel, 12,300 station personnel, 4,100 reservations personnel, 8,600 flight attendants and 4,900 personnel in other administrative and miscellaneous job categories, while the commuter and other subsidiaries employed approximately 1,000 pilots, 800 maintenance personnel, 400 station personnel, 400 flight attendants and 500 personnel in other administrative and miscellaneous job categories. Approximately 24,400, or 50%, of the employees of USAir Group's subsidiaries are covered by collective bargaining agreements with various labor unions. As indicated in "Significant Impact of Low Cost, Low Fare Competition" above and Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations," because of the entry of low cost low fare carriers in certain of USAir's markets and USAir's response to this market penetration, in March 1994 USAir initiated discussions with the leadership of its unionized employees for wage reductions, improved productivity and other cost savings. USAir must reduce its operating costs significantly if it is to survive in this low fare competitive environment. Historically, USAir implemented a workforce reduction program in September 1990, in response to the economic recession and financial losses that caused USAir to decrease its planned capacity growth for 1991. More than 3,600 positions were eliminated through layoffs, furloughs and voluntary separations in connection with that program. A further reduction of more than 3,500 positions resulted from the May 1991 Restructuring. In September 1993, USAir announced steps to reduce projected operating costs in 1994. These measures will include a workforce reduction of approximately 2,500 full time positions and certain other cost reductions discussed under "Major Airline Operations". In addition, USAir believes that it was largely successful in implementing during 1992 and 1993 the elements of the comprehensive cost reduction program that it announced in October 1991. The cost reduction program included salary and wage reductions for a fixed time period, suspension of longevity/step increases in wages and salary, the freeze of a defined benefit pension plan applicable to non-contract employees, productivity improvements, contributions by employees for a portion of the cost of medical and dental benefits and implementation of a new managed care program intended to reduce the cost and retard the growth of these benefits. Consistent with this program, USAir sought concessionary contracts with each of its unions and stated that salary reductions for non-contract employees would take effect only when the first major union agreed to wage reductions. In the second quarter of 1992, ALPA, which represents USAir's pilot employees, reached agreement on a new contract which becomes amendable on May 1, 1996. The new contract included wage reduc- tions and suspension of longevity/step increases which resulted in savings of approximately $58 million over the twelve-month period which began June 1992. Additional savings of approximately $15 million resulted from productivity improvements over the same period. If fully implemented, USAir expects the productivity improvements will save the airline up to approximately $83 million annually. In addition, the pilots agreed to participate in contributory managed care medical and dental programs, which USAir expects will save approximately $10 million annually. In June 1993, the wages of pilot employees reverted to pre- reduction levels, and on September 1, 1993, in accordance with the terms of ALPA's agreement with USAir, pilot employees received a 2.5% increase in their wages. These employees are scheduled to receive further wage increases on (i) July 1, 1994, of approximate- ly 6.9%; (ii) July 1, 1995 of 2%; and (iii) January 1, 1996 of 1%. In accordance with its previously announced policy, when ALPA agreed to the cost reduction program, USAir imposed wage reductions and suspension of longevity/step increases on its non-contract employees for the twelve-month period commencing in June 1992. USAir estimates that it saved approximately $32 million from these measures. Earlier in 1992, USAir had implemented the contributory managed care medical and dental programs for non-contract employ- ees, which result in approximately $20 million in annual savings. Prior to January 1, 1992, USAir exclusively paid contributions to the basic defined benefit pension plan for its non-contract employees. USAir froze this pension plan at the end of 1991, which resulted in a one-time book gain of approximately $107 million in 1991. USAir implemented a defined contribution pension plan for these employees on January 1, 1993, which is composed of three components: contributions by USAir based on a percentage of salary, a partial match by USAir of employee contributions to a savings plan and a profit-sharing plan. On October 8, 1992, following a four-day strike, USAir reached agreement with the International Association of Machinists ("IAM"), which represents USAir's mechanics and related employees, on a new contract which becomes amendable on October 1, 1995. The new contract included wage reductions and suspension of longevity/step increases for the twelve-month period commencing October 1992, which USAir estimates resulted in savings of approximately $20 million. USAir also estimates that productivity improvements, which are also provided for in the new contract, resulted in savings of approximately $22 million in 1993 and will result in savings of $45 million annually if the improvements are fully implemented. In addition, IAM employees agreed to participate in contributory managed care medical and dental programs, which USAir expects will save approximately $14 million annually. In November 1993, the wages of the IAM-represented employees reverted to pre-reduction levels and on November 1, 1993, in accordance with the terms of the IAM's agreement with USAir, the wages of these employees increased by 2%. These employees are scheduled to receive further wage increases on June 1, 1994 and April 1, 1995 of approximately 3.9% and 4.7%, respectively. In February 1993, USAir announced that it had reached a tentative agreement with the Association of Flight Attendants ("AFA"), which represents its flight attendant employees, on a new contract which would become amendable on January 1, 1997. The contract, which was ratified by the AFA membership in March 1993, provides for wage reductions and suspension of longevity/step increases for a twelve-month period commencing April 1, 1993, which USAir expects will result in savings of approximately $10 million. USAir also estimates that productivity improvements, which are also provided for in the new contract, will result in savings of approximately $18 million over the twelve-month period commencing April 1, 1993 and $43 million annually if the improvements are fully implemented. In addition, AFA employees agreed to partici- pate in contributory managed care medical and dental programs, which USAir expects will save approximately $7 million annually. In March 1994, the wages of the flight attendant employees will revert to pre-reduction levels, and on April 1, 1994, in accordance with the terms of the AFA agreement with USAir, the wages of these employees will increase by 3%. These employees are scheduled to receive further wage increases on January 31, 1995 and January 31, 1996 of approximately 4% commencing on each date. On March 31, 1993 the Transport Workers Union (the "TWU"), which represents 175 flight dispatch employees, reached agreement with USAir on a contract which becomes amendable on September 1, 1996. The agreement provides for productivity improvements. These employees also participate in wage reductions, suspension of longevity/step increases and contributory managed care medical and dental programs because of their non-contract status when those measures were implemented for non-contract employees. The defined benefit plan for the flight dispatch employees was frozen on December 31, 1991 because of their non-contract status at that time. On July 29, 1993, USAir reached agreement with the TWU, which also represents approximately 60 USAir flight simulator engineers, on a new four-year contract which becomes amendable on August 1, 1997. The contract will result in savings of approximately $140,000 over the 12-month period commencing August 1, 1993, in the form of temporary salary reductions and suspension of longevi- ty/step increases. In addition, the flight simulator engineers agreed to participate in contributory managed care medical and dental programs which the Company expects will save approximately $50,000 annually. In addition, the defined benefit pension plan for these employees was frozen effective August 31, 1993, and will be replaced by a defined contribution pension plan beginning September 1, 1994. Taken together, the above measures provided for temporary wage reductions and suspension of longevity/step increases in wages that USAir estimates saved approximately $120 million during the period June 1992 through March 1994. These concessions provide for productivity improvements which are expected to save USAir approximately $55 million during the same period. If fully implemented, these productivity enhancements may save an additional $171 million annually. All employees affected by these changes have also agreed to participate in contributory managed care medical and dental program which are expected to save approximately $51 million annually. In exchange for the concessions agreed upon by its unionized employees, USAir included "no furlough" provisions in each of the new labor agreements with the ALPA, IAM, AFA and TWU, which prohibit USAir from furloughing employees hired on or before the effective date of the agreements during the term of each respective contract. USAir recorded a non-recurring charge of approximately $36.8 million in the fourth quarter of 1993 based on a projection of the repayment of the amount of the temporary wage and salary reductions discussed above in the event that the employees who sustained the pay cuts leave the employ of USAir. USAir will adjust this accounting charge in subsequent periods to reflect the change in the present value of the liability and changes in actuarial assumptions including, among other things, actual experience with the rate of attrition for these employees and whether such employees have received payments under the profit sharing program discussed in the next paragraph. In exchange for the pay reductions and pension freeze, affected employees will participate in a profit sharing program and have been, or will be, granted options to purchase USAir Group common stock. The profit sharing program is designed to recompense those employees whose pay has been reduced in an amount equal to (i) two times salary foregone plus; (ii) one times salary foregone (subject to a minimum of $1,000) for the freeze of pension plans described above. Estimated savings of approximately $23 million attributable to the suspension of longevity/step increases will not be subject to repayment through the profit sharing program. For each year the profit sharing program is in effect, pre-tax profits, as defined in the program, of USAir Group would be distributed to participating employees as follows: 25% of the first $100 million in pre-tax profits 35% of the next $100 million in pre-tax profits 40% of the pre-tax profits exceeding $200 million This profit sharing program will be in effect until USAir employees are recompensed for salary and pension benefits forgone and is independent of the profit sharing plan which is an element of the new defined contribution pension plan for non-contract employees discussed above. Under the stock option program, employees whose pay has been reduced have received or will receive options to purchase 50 shares of USAir Group common stock at $15 per share for each $1,000 of salary reduction. The options were, or become, exercisable following the twelve-month period of the salary reduction program for each group of employees. Generally, participating employees have five years from the grant date to exercise such options. As of December 31, 1993, USAir Group had granted options to purchase approximately five million shares of common stock to USAir employees under the program. At December 31, 1993, the market value of a share of USAir Group common stock was $12.875. Certain unions are engaged in efforts to unionize USAir's customer service and reservations employees. The Railway Labor Act (the "RLA") governs, and the NMB has jurisdiction over, such campaigns. Under the RLA, the NMB could order an election among a class or craft of eligible employees if a union submitted an application to the NMB supported by the authorization cards from at least 35% of the applicable class or craft of employees. If the NMB ordered an election and a majority of the eligible employees voted for representation, USAir would be required to negotiate a collective bargaining agreement with the union that wins the election. On January 28, 1994, the IAM, United Steelworkers of America ("USWA") and International Brotherhood of Teamsters filed applications with the NMB requesting that an election be held among USAir's fleet service employees, a class or craft of approximately 8,000 workers included among USAir's customer service employees. On March 1, 1994, after determining that each of the three applicant unions had submitted the required number of authorization cards, the NMB declared an election among the fleet service agents. At this time, the NMB has not determined the dates for the mailing or tabulation of ballots, however, USAir expects this process will be completed by the end of the third quarter of 1994. USAir cannot predict the outcome of the election, nor can it predict, if a union is certified, when a collective bargaining agreement would be negotiated or what its terms would be. On March 21, 1994, the USWA filed an additional application with the NMB requesting an election among USAir's passenger service employees, a class or craft of approximately 10,000 workers included among USAir's customer service employees. The NMB is in the process of determining whether this application is supported by sufficient authorization cards to warrant an election. USAir cannot predict whether an election will be held among the passenger service class or craft and if an election were held, the outcome. Nor can it predict if a union is certified when a collective bargaining agreement would be negotiated or what its terms would be. If unions are certified to represent the fleet service employees and the passenger service employees, substantially all of USAir's non-management employees would be unionized. USAir also cannot predict whether any union might submit authorization cards to the NMB sufficient to obtain an election among any other class or craft of employees. Except as noted, the following table presents the status of USAir's labor agreements as of December 31, 1993: As indicated under "Significant Impact of Low Fare, Low Cost Competition," in March 1994, USAir initiated discussions with the leadership of its unionized employees regarding wage reductions, improved productivity and other cost savings. If these discussions are successful, the terms of the above labor agreements will be renegotiated. See also "Management's Discussion and Analysis of Financial Condition and Results of Operations - Low Cost, Low Fare Competition." See"-Commuter Airline Operations" for information regarding negotiations between Piedmont and ALPA. Jet Fuel USAir and USAir Fuel have contracts with 25 different fuel suppliers to meet a large percentage of USAir's current jet fuel requirements. The contracts for these jet fuel purchases are generally for one-year terms and expire at various dates. The pricing provisions of these agreements may be based upon many factors including crude oil, heating oil or jet fuel market conditions. In some cases, USAir has the right to terminate the agreements if contract prices become unacceptable. As market conditions permit, USAir also may purchase a portion of its fuel on the spot market at day-to-day prices depending upon availability, price and purchasing strategy. The most important single factor affecting petroleum product prices, including the price of jet fuel, continues to be the actions of the OPEC countries in setting targets for the produc- tion, and pricing of crude oil. In addition, jet fuel prices are affected by the markets for heating oil, diesel fuel, automotive gasoline and natural gas. Seasonally, second and third quarter jet fuel prices are typically lower than during the first and fourth quarters as the demand for heating oil, which competes with jet fuel for refinery production, subsides and refiners switch to gasoline production which also increases the output of jet fuel. Due primarily to OPEC's unwillingness or inability to restrain crude oil production and recession-dampened demand for petroleum products by the industrialized nations, USAir benefitted during 1993 from a general downward trend in jet fuel prices. For 1993, USAir's jet fuel cost averaged approximately 58.4 cents per gallon (versus an average of 61 cents in 1992) with quarterly averages of 59.8, 59.5, 56.7, and 57.7 cents. USAir continues to adjust its jet fuel purchasing strategy to take advantage of the best available prices while attempting to ensure that supplies are secure. While USAir believes that jet fuel prices will remain relatively stable in 1994, all petroleum product prices continue to be subject to unpredictable economic, political and market factors. Also, the balance among supply, demand and price has become more reactive to world market condi- tions. Accordingly, the price and availability of jet fuel, as well as other petroleum products, continues to be unpredictable. In addition, USAir has entered into agreements to hedge the price of a portion of its jet fuel needs, which may have the net effect of increasing or decreasing USAir's fuel expense. See Note 1 to Consolidated Financial Statements of USAir. In early August 1993, the Clinton Administration's budget package was enacted. The budget package included a 4.3 cent per gallon tax on transportation fuels beginning October 1, 1993. The airline industry is exempt from the tax until October 1, 1995. Imposition of the fuel tax will increase USAir's operating expenses. If the fuel tax had been in effect on January 1, 1993, USAir's fuel expense in 1993 would have increased by approximately $50 million. The following table sets forth statistics about USAir's jet fuel consumption and cost for each of the last three years: (1) Operating expenses have been adjusted to exclude non-recurring and special items. Insurance The Company and its subsidiaries maintain insurance of the types and in amounts deemed adequate to protect them and their property. Principal coverage includes liability for bodily injury to or death of members of the public, including passengers; damage to property of the Company, its subsidiaries and others; loss of or damage to flight equipment, whether on the ground or in flight; fire and extended coverage; and workers' compensation and em- ployer's liability. Effective February 1, 1991, the Company reduced the hull insurance coverage on its narrowbody aircraft from replacement value to the higher of book value or the loss value required by applicable leases or other contractual provisions. Coverage for environmental liabilities is expressly excluded from the Company's insurance policies. Industry Conditions The airline industry has historically been cyclical, in that demand for air transportation has tended to mirror general economic conditions. Although airline traffic and operating revenues generally benefitted from the economic growth that occurred through much of the 1980s, the Company and the industry have been adversely affected by the recent economic recession. Historically, the Company's airline operations have also been subject to seasonal variations in demand. First and fourth quarter results have often been adversely affected by winter weather and, with certain exceptions, reduced travel demand, while the second and third quarters generally have been characterized by more favorable weather conditions as well as higher levels of passenger travel. The restructuring of USAir's route system in recent years to emphasize its strengths in the northeastern U.S. and to capitalize in the first, second and fourth quarters on passenger traffic to Florida may result in changes in historic seasonality. Most of USAir's operations are in competitive markets. USAir and its commuter affiliates experience competition in varying degrees with other air carriers and with all forms of surface transportation. USAir competes with at least one major airline on most of its routes between major cities. Vigorous price competi- tion exists in the airline industry, and competitors have frequent- ly offered sharply reduced discount fares in many of these markets. Airlines use discount fares and other promotions to stimulate traffic during normally slack travel periods, to generate cash flow and to increase relative market share in selected markets. Discount and promotional fares are often subject to various restrictions such as minimum stay requirements, advance ticketing, limited seating and refund penalties. USAir has often elected to match those discount or promotional fares. In 1993, Southwest Airlines, Inc. and Continental, two low cost carriers, entered several of USAir's markets in the eastern U.S. and commenced low fare service. Continental substantially expanded its low fare operations in the first quarter of 1994, and, in anticipation of that expansion, USAir substantially reduced its fares in many markets. See "Significant Impact of Low Fare, Low Cost Competi- tion" above and Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations - Low Cost, Low Fare Competition." USAir expects that it will continue to face vigorous price competition. To the extent that low fares continue and their depressive effect on revenues is not offset by stimulation of additional traffic or by reduced costs, USAir's and the Company's earnings and liquidity will continue to be materially and adversely affected. Of the eleven airlines classified as "major" carriers by the DOT in January 1991, two have ceased operations, one is currently operating under Chapter 11 of the Bankruptcy Code and two filed for bankruptcy protection, reorganized and emerged from bankruptcy in 1993. Eastern, which declared bankruptcy in March 1989, ceased operations in January 1991. Pan American World Airways filed for Chapter 11 protection from creditors in January 1991 and ceased operations in December 1991. Continental, America West and Trans World Airlines ("TWA") filed for bankruptcy in December 1990, June 1991 and January 1992, respectively. Continental and TWA reorga- nized and emerged from bankruptcy in April 1993 and November 1993, respectively. America West is seeking to emerge from bankruptcy in 1994. In addition, Midway Airlines, a smaller carrier that had been a competitor of USAir at Philadelphia, declared bankruptcy in March 1991 and ceased operations in November 1991. Airlines operating under Chapter 11 often engage in discount pricing to generate the cash flow necessary for their survival. In addition, when these airlines emerge from bankruptcy they may have substantially reduced their debt and lease obligations and other operating costs, as was the case when Continental and TWA emerged. These reduced costs may permit the reorganized carriers to enter new markets and offer discount fares, which may be intended to generate cash flow, preserve and enhance market share and rehabili- tate the carriers' image in the marketplace. Since its reorganiza- tion, Continental has entered many of USAir's markets in the eastern U.S. and offered fares that were substantially lower than those that were previously available. See "Significant Impact of Low Fare, Low Cost Competition" above and Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations - Low Cost Low Fare Competition." The availability of the assets of bankrupt carriers has enabled certain financially stronger participants in the market, including, to a lesser extent, USAir, to consolidate their position by purchasing routes, aircraft, takeoff and landing slots and other assets. While substantial capacity has been removed in certain domestic markets, these bankruptcies and failures illustrate the difficulties facing the airline industry today. Regulation All domestic airlines, including USAir and its commuter affiliates, are subject to regulation by the FAA under the Federal Aviation Act of 1958, as amended. The Federal Aviation Administra- tion ("FAA") has regulatory jurisdiction over flight operations generally, including equipment, ground facilities, security systems, maintenance and other safety matters. To assure compli- ance with its operational standards, the FAA requires air carriers to obtain operations, airworthiness and other certificates, which may be suspended or revoked for cause. The FAA also conducts safety audits and has the power to impose fines and other sanctions for violations of aviation safety and security regulations. USAir has developed extensive maintenance programs which consist of a series of phased checks for each aircraft type. These checks are performed at specified intervals measured either by time flown or by the number of takeoffs and landings ("cycles") performed. They range from daily "walkaround" inspections, to more involved overnight maintenance checks, to exhaustive and time- consuming overhauls. The "Q Check", for example, requires more than 7,000 personnel-hours of work and includes stripping the airframe, extensively testing the airframe structure and a large number of parts and components, and reassembling the overhauled airframe with new or rebuilt components. Aircraft engines are subject to phased, or continuous, maintenance programs designed to detect and remedy potential problems before they occur. The service lives of certain parts and components of both airframes and engines are time or cycle controlled. Parts and other components are replaced or overhauled prior to the expiration of their time or cycle limits. The FAA approves all airline maintenance programs, including changes to the programs. In addition, the FAA licenses the mechanics who perform the inspections and repairs, as well as the inspectors who monitor the work. The FAA frequently issues airworthiness directives, often in response to specific incidents or reports by operators or manufac- turers, requiring operators of specified equipment to perform prescribed inspections, repairs or modifications within stated time periods or number of cycles. In response to several incidents involving older aircraft, the FAA, in cooperation with airframe manufacturers and operators, has developed mandatory programs requiring extensive testing, modifica- tions and repairs to certain models of older aircraft as a condition of their continuing in service beyond specified time periods or number of cycles. USAir is modifying its Boeing 727- 200, Boeing 737-200 and Douglas DC-9-30 aircraft to comply with the first phase of the "aging aircraft" requirements, which requires that a series of structural modifications be performed. The second phase, announced in November 1990, involves intensified corrosion control and detection procedures. Many of USAir's aircraft will be brought into compliance well in advance of the FAA's time and cycle requirements, because the work is scheduled to be accomplished in conjunction with other maintenance. A continuing regulatory issue currently facing the airline industry involves air traffic delays and landing rights. While the volume of aircraft operations in domestic airspace has increased during recent years, the capacity of the national air traffic control system has not kept pace. This situation causes frequent and significant air traffic delays, especially at the nation's busiest airports. These delays have led the FAA to require monthly reporting by air carriers of on-time performance and have prompted various proposals for reform of the FAA, which oversees and regulates the air traffic control system. The National Commission to Ensure a Strong Competitive Airline Industry (the "Airline Commission") issued its report in August 1993. Among other things, the Airline Commission recommended that: (1) the air traffic control system be modernized and the FAA air traffic control functions be performed by an independent federal corporation; (2) the federal regulatory burden be reduced; (3) the airlines be granted certain tax relief; and (4) the bankruptcy process be shortened. The Airline Commission also favored raising the statutory limit on foreign ownership of voting securities in U.S. airlines to 49 percent under certain circumstances. It further urged that the current international system of bilateral agreements be replaced with multilateral arrangements. In addition, the Airline Commission recommended that the DOT review the airlines' business, capital or financial plans with the assistance of a presidentially appointed advisory committee and, if an airline repeatedly failed to heed warnings or concerns of the DOT Secretary, the DOT could "exercise its existing authority," among other things, to revoke an airline's operating certificate. In January 1994, the Clinton Administration issued a report which described its program to implement certain of the Airline Commission's recommendations. Among other things, the Administra- tion stated that it supported the recommendation described above regarding the FAA, supported increasing to 49 percent the foreign ownership restrictions provided there are reciprocal opportunities for U.S. airlines and investors abroad, and opposed the recommenda- tions regarding tax relief and the appointment of the advisory committee discussed above. At this time, it is impossible to predict whether any of the Airline Commission's recommendations will be enacted and, if enacted, their effect on USAir. It is also difficult to anticipate whether the Congress will act in the near term on any of the proposals requiring legislation. The FAA, through its High Density Traffic Airport Rule, limits the number of flight operations at Washington National Airport, Chicago's O'Hare International Airport and New York City's John F. Kennedy International and LaGuardia Airports during specified time periods. Takeoff and landing rights ("slots") are assigned to airlines serving these high density airports. The FAA has promulgated regulations governing the allocation and use of slots that permit them to be traded, leased, purchased and sold. In addition, in 1992, the FAA amended its regulations governing the use of slots to require slotholders to increase their average monthly use of their slots. In 1993, the DOT began a comprehensive examination of the High Density Rule. As part of its study, the DOT will determine whether the operating limitations imposed by the rule can be eliminated or modified to better utilize available capacity at these airports. USAir holds a substantial number of slots at LaGuardia and National Airports, including those assigned a value when the Company acquired Piedmont Aviation. Any DOT action which would eliminate those slots or compel USAir to transfer those slots could have a material adverse effect on USAir's operations and financial position. Revision of the High Density Rule at National Airport, however, would require legisla- tion by the Congress. The DOT has indicated that it expects to complete its study by late 1994. The FAA also has authority to set noise standards for civil aircraft. Three noise level categories exist under FAA regula- tions. Stage 1 aircraft, which were designed before the first FAA noise regulations were promulgated in 1969, are no longer permitted to operate in the United States unless retrofitted to meet Stage 2 requirements. Stage 2 aircraft comply with regulations limiting noise emissions to specified levels. Aircraft designed after 1977 must meet the even more stringent noise limitations of Stage 3. At December 31, 1993, 260 aircraft, or 62% of USAir's operating fleet (excluding 33 Fokker aircraft exempt from the Stage 3 require- ments because their gross takeoff weights do not exceed 75,000 pounds), were Stage 3 aircraft. The Airport Noise and Capacity Act of 1990, with minor qualifications, prohibits operation of Stage 2 aircraft after 1999. Regulations promulgated by the FAA in 1991 require operators to modify or reduce the number of Stage 2 aircraft they operated during 1990 by 25% by the end of 1994, by 50% by the end of 1996, and by 75% by the end of 1998. Alterna- tively, an operator may elect to operate a fleet that is at least 55% Stage 3 by the end of 1994, 65% Stage 3 by the end of 1996 and 75% Stage 3 by the end of 1998. Modification costs will depend on the technology that is developed in response to the need, but these costs could be substantial for some aircraft types. See Note 4 to the Company's Consolidated Financial Statements. USAir intends to convert up to 64 of its Boeing 737-200 and 31 of its Douglas DC-9- 30 aircraft from Stage 2 to Stage 3. In May 1993, USAir entered into agreements to purchase hushkits for a substantial portion of its Boeing 737-200 fleet. The installation of these hushkits will bring the aircraft into compliance with federally mandated Stage 3 noise level requirements. These agreements are in addition to a previously existing agreement to purchase hushkits for certain of USAir's DC-9-30 aircraft. Installation of the hushkits will be accomplished during 1994-1999. Certain airport operators have adopted local regulations which, among other things, impose curfews, restrict the number of aircraft operations and require aircraft to meet prescribed decibel limits. Local noise regulations affect USAir's scheduling flexibility by requiring that only certain aircraft be scheduled at certain airports and at specified times of the day. In compliance with FAA regulations, USAir has implemented a drug testing program that involves not only education and training, but also periodic drug testing of personnel performing safety and security-related work, including pilots, flight attendants, mechanics, instructors, dispatchers and security screeners, and drug testing of all newly hired employees regardless of job classification. The FAA's drug testing regulations are comprehen- sive and complex. They require, among other things, six categories of drug tests: pre-employment, probable cause, periodic, random, post-accident and return to duty. In addition, all USAir Express operators have drug testing programs in place that comply with the FAA's drug testing regulations. The DOT has recently promulgated rules requiring by January 1995 the periodic testing of airline employees in safety-related jobs for alcohol use. USAir cannot predict at this time the effect of these new rules. Several aspects of airlines' operations are subject to regulation or oversight by Federal agencies other than the FAA. The DOT has jurisdiction over certain aviation matters such as international routes and fares, consumer protection and unfair competitive practices. The antitrust laws are enforced by the DOJ. Labor relations in the air transportation industry are generally regulated under the RLA, which vests in the NMB certain regulatory powers with respect to disputes between airlines and labor unions that arise under collective bargaining agreements. USAir and other airlines certificated prior to October 24, 1978 are also subject to regulations issued by the Department of Labor which implement the statutory preferential hiring rights granted by the Airline Deregulation Act of 1978 to certain airline employees who have been furloughed or terminated (other than for cause). The Company must also comply with federal and state environ- mental laws and regulations and has developed formal policies and procedures designed to ensure its ongoing compliance. The Company expects that its operating expenses will increase in the future as a result of governmental rulemaking and more stringent enforcement of applicable existing environmental laws. The Company cannot predict the magnitude of those increased costs or when they may be incurred, but in order to conduct their operations, airlines, including USAir and the USAir Express carriers, release and discharge pollutants into the environment. For example, USAir and the other airlines operating at Pittsburgh are subject to a Pennsylvania consent decree to reduce the runoff of deicing fluid which has resulted in the construction of new deicing pads, the cost of which will be passed on to the airlines. In addition, the Clean Air Act, as amended, as it may be implemented by the various states, may require operational upgrades and tighter emissions controls not only on aircraft but also on ground equipment operated by airlines. The airlines' operations in certain states, for example, California, where air pollution is a serious problem, may be affected more significantly than in other states. Moreover, many airports were constructed before the enactment of various environmental laws. The cost of correcting environmental problems at these airports may be passed onto the airlines operating at these airports through increased rents and fees. See also the disclosure above regarding the FAA's regulations regarding noise standards for civil aircraft and noise regulation by other governmental authorities and Note 4(d) to the Company's Con- solidated Financial Statements for disclosure regarding capital commitments related to compliance with these FAA regulations. British Airways Investment Agreement The following summary of certain terms of the Investment Agreement is subject to, and is qualified in its entirety by, the Investment Agreement and the exhibits thereto, which are exhibits to this report. On March 7, 1994, BA announced it would make no additional investments in the Company until the outcome of measures by the Company to reduce costs and improve its financial results is known. As of March 1, 1994, BA owned preferred stock in the Company constituting approximately 22% of the total voting interest in the Company. See Item 12. "Security Ownership of Certain Beneficial Owners and Management." Terms of the Series F Preferred Stock On January 21, 1993, the Company sold, pursuant to the Investment Agreement, 30,000 shares of the Company's Series F Cumulative Convertible Senior Preferred Stock, without par value, ("Series F Preferred Stock") to BA for an aggregate purchase price of $300 million. The Series F Preferred Stock is convertible into shares of Common Stock at a conversion price of $19.41 and will have a liquidation preference of $10,000 per share plus an amount equal to accrued dividends. See "Miscellaneous" for a discussion of an antidilution adjustment to the conversion price of the Series F Preferred Stock. The Series F Preferred Stock may be converted at the option of USAir Group at any time after January 21, 1998 if the average composite closing market price of Common Stock during any 30-day calendar period is at least 133% of the conversion price. The Series F Preferred Stock will be entitled to cumulative quarterly dividends of 7% per annum when and if declared and to share in certain other distributions. The Series F Preferred Stock must be redeemed by USAir Group on January 15, 2008. Each share of the Series F Preferred Stock will be entitled to a number of votes equal to the number of shares of Common Stock into which it is convertible and will vote with the Common Stock and USAir Group's Series A Cumulative Convertible Preferred Stock, without par value ("Series A Preferred Stock"), and any other capital stock with general voting rights for the election of directors, as a single class. Subject to adjustment, 515.2886 shares of Common Stock are issuable on conversion per share of Series F Preferred Stock (determined by dividing the $10,000 liquidation preference per share of Series F Preferred Stock by the $19.41 conversion price), and 15,458,658 shares of Common Stock would be issuable on conversion of all Series F Preferred Stock. However, under the terms of any USAir Group preferred Stock that is or will be held by BA ("BA Preferred Stock"), conversion rights (and as a result voting rights) may not be exercised to the extent that doing so would result in a loss of USAir Group's or any of its subsidiaries' operating certificates and authorities under Foreign Ownership Restrictions, as defined under "Board Representation" below, and it is assumed for this purpose that Series F Preferred Stock will be fully converted before any other BA Preferred Stock. Under Foreign Ownership Restrictions, no more than 25% of the Company's voting interest may be held by persons other than U.S. citizens, including BA. With respect to dividend rights and rights on liquidation, dissolution and winding up, the Series F Preferred Stock ranks senior to USAir Group's $437.50 Series B Cumulative Convertible Preferred Stock, without par value, and Junior Participating Preferred Stock, Series D, no par value, and Common Stock, and pari passu with BA Preferred Stock and Series A Preferred Stock. Moreover, the Certificate of Designation for the Series F Preferred Stock provides that if on any one occasion on or prior to January 21, 1996, any court or regulatory authority issues a final order that any material part of the Investment Agreement is unenforceable (except pursuant to bankruptcy or like event), then the conversion price of Series F Preferred Stock shall be reduced by 10.2564%. In that event, if the then conversion price of the Series F Preferred Stock were $19.41, it would be reduced to $17.42. On March 15, 1993, the DOT issued an order (the "DOT Order") finding, among other things, that "BA's initial investment of $300 million does not impair USAir's citizenship" under Foreign Ownership Restrictions as defined under "Board Representation" below. However, the DOT instituted a proceeding to consider whether USAir will remain a U.S. citizen if the transactions and acts contemplated by the Investment Agreement, including the transactions discussed under "Possible Additional BA Investments" and "Certain Governance Matters" below, are consummated. The DOT has suspended indefinitely the period for comments from interested parties to the proceeding pending its resolution of requests by other airlines for production of additional documents from USAir. The DOT Order states that the DOT expects and advises USAir Group and BA not to proceed with the Second Purchase and Final Purchase, as such terms are defined under "Possible Additional BA Invest- ments," until the DOT has completed its review of USAir's citizen- ship. In any event, on March 7, 1994, BA announced that it would make no additional investments in the Company until the outcome of measures by the Company to reduce its costs and improve its financial results is known. See "Significant Impact of Low Fare, Low Cost Competition" and "British Airways Announcement Regarding Additional Investments in the Company; Code Sharing" above. The Company cannot predict the outcome of the proceeding or if the transactions contemplated under the Investment Agreement, particu- larly those discussed under "Possible Additional BA Investments" and "Certain Governance Matters", will be consummated. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" for a discussion of issues and consider- ations pertaining to globalization of the airline industry and "Miscellaneous" for information regarding BA's purchase of two additional series of preferred stock from USAir Group pursuant to its exercise of optional and preemptive purchase rights under the Investment Agreement and its decision not to exercise its optional purchase rights with respect to three additional series of preferred stock. Board Representation USAir Group increased the size of its Board of Directors by three on January 21, 1993 and the Board of Directors filled the newly created directorships with designees of BA. Under the terms of the Investment Agreement, USAir Group must use its best efforts to cause BA to be proportionally represented on the Board of Directors (on the basis of its voting interest), up to a maximum representation of 25% of the total number of autho- rized directors ("Entire Board"), assuming that such proportional representation is permitted by then applicable U.S. statutory and DOT regulatory or interpretative foreign ownership restrictions ("Foreign Ownership Restrictions"), until the later of the closing of the Second Purchase, as defined under "Possible Additional BA Investments" below, and the date on which BA may exercise under Foreign Ownership Restrictions the rights described under "Certain Governance Matters" below. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Industry Globalization" for a discussion of currently applicable Foreign Ownership Restrictions. U.S.-U.K. Routes Under the Investment Agreement, USAir Group agreed that as promptly as commercially practicable it would divest or, if divestiture were not possible, relinquish, all licenses, certificates and authorities for each of USAir's routes between the U.S. and the U.K. (the "U.K. Routes") at such time as BA and USAir implement the code-sharing arrangement contemplated by the Investment Agreement discussed below. USAir Group and BA have agreed that they should attempt to mitigate any negative impact on Company employees or communities served by the U.K. Routes and to share any losses suffered as a result of such divestiture or relinquishment with due regard to their respective interests. Accordingly, BA is operating and marketing certain routes formerly operated by USAir under a "wet lease." Under a "wet lease," an airline, in this case USAir, leases its aircraft and cockpit and cabin crews to another airline, in this case BA, for the purpose of operating certain routes or flights. The wet leases have an initial term of one year and may be extended by USAir Group and BA for a cumulative lease term not to exceed two years and eleven months. Rentals under the wet lease are based on USAir's costs. BA will retain the cumulative profits received by it in respect of these routes on the basis of its fully diluted stock ownership in USAir Group and pay the balance of the profits to USAir Group annually. See "Code Sharing" below. If the contemplated profit sharing cannot be performed, BA will reimburse USAir Group for a portion of any losses suffered by USAir Group in the divesture or relinquishment of the U.K. Routes based on a formula set forth in the Investment Agreement. The route authorities which USAir was required to sell or relinquish were the Philadelphia-London and BWI-London route authorities purchased by USAir from TWA in April 1992 for $50 million, and its route authority between Charlotte and London. Assets related to the U.K. Routes were carried on USAir's books at approximately $47 million at December 31, 1993 and USAir expects to recover such amount in full pursuant to the provisions of the Investment Agreement described above. During March and April of 1993, USAir reached agreement with two air carriers to sell the Philadelphia-London and BWI-London route authorities, provided, among other conditions, governmental authorities permitted the transfer of these route authorities to other cities. In June 1993, the DOT denied applications for such transfers on the grounds that the U.S.-U.K. bilateral air services agreement does not permit such transfers. In July 1993, the DOT awarded the Philadelphia-London route authority to American. USAir ceased operating the BWI-London route authority on October 1, 1993 as a result of the implementation of the wet leasing and code sharing arrangements with BA. See "Code Sharing" below. In April 1993, USAir agreed to sell to the Metropolitan Nashville Airport Authority, Nashville, Tennessee for $5 million its operating authority between Charlotte and London Gatwick Airport. In December 1993, the DOT issued an order which disapproved USAir's proposed sale of this route to Nashville and awarded the BWI-London and Charlotte-London route authorities to American, which will transfer the U.S. gateway cities for these route authorities to Nashville and Raleigh/Durham, North Carolina. USAir ceased serving the Charlotte-London route on January 19, 1994 and implemented the code sharing and wet leasing arrangement with BA in that market on that date. Code Sharing BA and USAir Group entered into a code share agreement on January 21, 1993 (the "Code Share Agreement") pursuant to which certain USAir flights will carry the airline designator code of both BA and USAir. Code sharing is a common practice in the airline industry whereby one carrier sells the flights of another carrier (its code sharing partner) as if it provides those flights with its own equipment and personnel. These flights are intended by USAir Group and BA eventually to include all routes provided for under the bilateral air services agreement between the U.S. and the U.K. to the extent possible, consistent with commer- cial viability and technical feasibility. The DOT Order, among other things, granted USAir for one year a statement of authorization, and BA an exemption, for certain code sharing and wet leasing arrangements contemplated by the Investment Agreement (the "Initial Code Share Authority"). USAir believes that the one-year term of the Initial Code Share Authority was consistent with DOT policy and precedents with respect to other code sharing arrangements. As contemplated in the Initial Code Share Authority, USAir can code share with BA to approximately 38 airports in the U.S. beyond the BWI, Philadelphia and Pittsburgh gateways. Since the DOT Order was issued in March 1993, the DOT also granted USAir code sharing authorization for 26 additional U.S. airports and Mexico City through nine additional U.S. gateways, including Charlotte (the "Supplemental Code Share Authority"). Although the DOT granted the Supplemental Code Share Authority for periods shorter than one year in an effort to exert pressure on the U.K. to liberalize access to the U.K., particularly London's Heathrow Airport, in negotiations on a revised U.S.-U.K. bilateral air services agreement, the DOT eventually extended the Supplemental Code Share Authority to March 17, 1994, the same date the Initial Code Share Authority expired. As of March 1, 1994, USAir and BA had implemented the code sharing arrangements for 34 U.S. cities. On March 17, 1994, the DOT issued an order renewing for one year the code share authorization granted under the Initial Code Share Authority and Supplemental Code Share Authority. In January 1994, USAir and BA filed applications to code share to 65 additional U.S., and seven additional foreign, destinations via the same and several additional U.S. gateways. The DOT did not act on these applications in its March 17, 1994 order. The Company and BA are in the process of exploring the economies and synergies that may be possible as a result of the Code Share Agreement. The Company believes that (i) the code-share cities in the U.S. will receive greater access to international markets; (ii) it will have greater access to international traffic; and (iii) BA's and its customers will benefit from better on-line connections as well as coordinated check-in and baggage checking procedures. The Company believes that the code sharing arrange- ments will generate increased revenues; however, the magnitude of any increase cannot be estimated at this time. The DOT may continue to link further renewals of the code share authorization to the U.K.'s liberalization of U.S. air carrier access to the U.K.; however, the code sharing arrangements contemplated by the Code Share Agreement are expressly permitted under the bilateral air services agreement between the U.S. and U.K. Accordingly, USAir expects that the existing code share authorization will continue to be renewed; however, there can be no assurance that this will occur. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Industry Globaliza- tion." USAir does not believe that the DOT's failure to renew further the authorization would result in a material adverse change in its financial condition; however, if the authorization is not renewed, consummation of the Second Purchase and the Final Purchase, as defined under "Possible Additional BA Investments" below, may be less likely. In any event, on March 7, 1994 BA announced that it would not make any additional investments in the Company until the outcome of measures by the Company to reduce costs and improve its financial results is known. As discussed under "Possible Additional BA Investments" below, USAir cannot predict whether or when the Second Purchase or the Final Purchase will be consummated in any event. Possible Additional BA Investments On March 7, 1994 BA announced that it would not make any additional investments in the Company until the outcome of measures by the Company to reduce costs and improve its financial results is known. Under the terms of the Investment Agreement, assuming the Series F Preferred Stock or any shares issued upon conversion thereof are outstanding and BA has not sold any shares of preferred stock issued to it by USAir Group or any common stock or other securities received upon conversion or exchange of the preferred stock, BA is entitled at its option to elect to purchase from USAir Group, on or prior to January 21, 1996, 50,000 shares of Series C Cumulative Convertible Senior Preferred Stock, without par value ("Series C Preferred Stock"), at a purchase price of $10,000 per share, to be paid by BA's surrender of the Series F Preferred Stock and a payment of $200 million (the "Second Purchase"), and, on or prior to Janu- ary 21, 1998, assuming that BA has purchased or is purchasing simultaneously Series C Preferred Stock, 25,000 (or more in certain circumstances) shares of Series E Cumulative Convertible Exchange- able Senior Preferred Stock, without par value ("Series E Preferred Stock"), at a purchase price of $10,000 per share (the "Final Purchase"). Series E Preferred Stock is exchangeable under certain circumstances at the option of USAir Group into certain USAir Group debt securities ("BA Notes"). If the DOT approves all the transactions and as contemplated by the Investment Agreement, at the election of either BA or USAir Group on or prior to January 21, 1998, BA's purchase of the Series C Preferred Stock (unless previously consummated) and BA's purchase of the Series E Preferred Stock would be consummated under certain circumstances. If BA has not elected to purchase the Series C Preferred Stock by January 21, 1996, then USAir Group may at its option redeem, in whole or in part, Series F Preferred Stock at the higher of market value or the price of $10,000 per share, plus accrued dividends. USAir cannot predict whether or when the Second Purchase and Final Purchase will be consummated. Terms of the Series C Preferred Stock and Series E Preferred Stock The Series C Preferred Stock and Series E Preferred Stock are substantially similar to Series F Preferred Stock, except as follows. Series C Preferred Stock will be convertible into shares of Class B Common Stock or Non-Voting Class C Stock (as such terms are defined under "Terms of BA Common Stock" below) at an initial conversion price of approximately $19.79, subject to Foreign Ownership Restrictions. Each share of Series C Preferred Stock will be entitled to a number of votes equal to the number of share of Class B Common Stock into which it is convertible, subject to Foreign Ownership Restrictions. If shares of Series C Preferred Stock are transferred to a third party, they convert automatically at the seller's option into either shares of Common Stock or a like number of shares of Series G Cumulative Convertible Senior Preferred Stock. Series E Preferred Stock will be convertible into shares of Common Stock or Non-Voting Class ET Stock (as defined under "Terms of BA Common Stock" below) at an initial conversion price of approximately $21.74, subject to increase if the Series E Preferred Stock is originally issued on or after January 21, 1997, subject to Foreign Ownership Restrictions. Each share of Series E Preferred Stock will be entitled to a number of votes equal to the number of shares of Common Stock into which it is convertible, subject to Foreign Ownership Restrictions. Terms of BA Common Stock To the extent permitted by Foreign Ownership Restrictions, an amendment to USAir Group's charter, which is to be filed with the Delaware Secretary of State immedi- ately prior to the Second Purchase, which BA has announced it will not complete under current circumstances, will create three new classes of common stock - Class B Common Stock, par value $1.00 per share ("Class B Common Stock"), Non-Voting Class C Common Stock, par value $1.00 per share ("Non-Voting Class C Stock"), and Non- Voting Class ET Common Stock, par value $1.00 per share ("Non- Voting Class ET Common Stock," collectively with Class B Common Stock and Non-Voting Class C Common Stock, "BA Common Stock") all of which may be held only by BA or one of its wholly-owned subsidiaries. Except with respect to voting and conversion rights, the BA Common Stock will be substantially identical to the Common Stock. Shares of BA Common Stock will convert automatically to shares of Common Stock upon their transfer to a third party. Subject to Foreign Ownership Restrictions, Class B Common Stock will be entitled to one vote per share. After the effectiveness of the above charter amendment, to the extent permitted by Foreign Ownership Restrictions, Class B Common Stock will vote as a single class with Series C Preferred Stock on the election of one-fourth of the directors and the approval of the holders of Class B Common Stock and Series C Preferred Stock voting as a single class will be required for certain matters. Certain Governance Matters Following the Second Purchase, which BA has announced it will not complete under current circum- stances, and assuming these changes are permitted under Foreign Ownership Restrictions, the above charter amendment will fix the size of USAir Group's Board of Directors at 16, one-fourth of whom would be elected by BA. In addition, the vote of 80% of the USAir or USAir Group Boards of Directors will be required for approval of the following (with certain limited exceptions): (i) any agreement with the DOT regarding citizenship and fitness matters; (ii) any annual operating or capital budgets or financing plans; (iii) incurring capital expenditure not provided for in a budget approved by the vote of 80% of the board in excess of $10 million in the aggregate during any fiscal year; (iv) declaring and paying dividends on any capital stock of USAir Group or any of its subsidiaries (other than dividends paid only to USAir Group or any wholly-owned subsidiary of USAir Group and any dividends on preferred stock); (v) making investments in other entities not provided for in approved budgets in excess of $10 million in the aggregate during any fiscal year; (vi) incurring additional debt (other than certain debt specified in the Investment Agreement) not in an approved financing plan in excess of $450 million in the aggregate during any fiscal year; (vii) incurring off-balance sheet liabilities (e.g., operating leases) not in an approved financing plan in excess of $50 million in the aggregate during any fiscal year; (viii) appointment, compensation and dismissal of certain senior executives; (ix) acquisition, sale, transfer or relinquish- ment of route authorities or operating rights; (x) entering into material commercial or marketing agreements or joint ventures; (xi) issuance of capital stock (or debt or other securities convertible into or exchangeable for capital stock), other than (A) the stock options granted to employees in return for pay reductions under the USAir Group 1992 Stock Option Plan, as described under "Employees" above, (B) to USAir Group or any direct or indirect wholly owned subsidiary of USAir Group, (C) pursuant to the terms of USAir Group securities outstanding when a certain amendment to USAir Group's charter required in connection with consummation of the Second Purchase becomes effective, or (D) pursuant to the terms of securities the issuance of which was previously approved by the vote of 80% of the board; (xii) acquisition of its own equity securities other than from USAir Group or its subsidiaries, or pursuant to sinking funds or an approved financing plan; and (xiii) establishment of a board of directors' committee with power to approve any of the foregoing. This supermajority vote requirement would allow any four directors, including those elected by BA, to withhold approval of the actions described above if they believe them to be contrary to the best interests of USAir. The super- majority vote would not be required with regard to the foregoing actions to the extent they involve the enforcement by USAir Group of its rights under the Investment Agreement. Following the Second Purchase, which BA has indicated it will not complete under current circumstances, to the extent permitted under Foreign Ownership Restrictions, USAir Group and BA will integrate certain of their respective business operations pursuant to certain "Integration Principles" included in the Investment Agreement. In addition, to the extent permitted by Foreign Ownership Restrictions or pursuant to specific DOT approval, an "Integration Committee," headed by the chief executive officers of USAir Group and BA and by an Executive Vice President-Integration of USAir Group, would oversee the integration subject to the ultimate discretion of USAir Group's board of directors. As of the Final Purchase, which BA has indicated it will not complete under current circumstances, to the extent permitted by Foreign Ownership Restrictions, the Investment Agreement provides for the establish- ment of a committee ("Appointments Committee") of the board of directors of USAir Group, composed of USAir Group's chief executive officer, BA's chief executive officer and another director serving on both USAir Group's and BA's board of directors, to handle all employment matters relating to managers at the level of vice president and above, except for certain senior executives. BA's governance rights after the Second Purchase and the Final Purchase, which BA has indicated it will not complete under current circumstances, are subject to reduction if BA reduces its holding in USAir Group under the following circumstances. If BA sells or transfers, in one or more transactions, BA Preferred Stock, Common Stock or BA Common Stock (collectively, Common Stock and BA Common Stock are hereinafter referred to as "Non-Preferred Stock") issued directly or indirectly upon the conversion thereof such that the aggregate purchase price of the BA Preferred Stock, BA Notes, Non- Preferred Stock or other equity securities of USAir Group held by BA and its directly or indirectly wholly owned subsidiaries following such sale or transfer (the "BA Holding") is less than both two-thirds of the aggregate purchase price of all BA Preferred Stock, BA Notes, Non-Preferred Stock or other equity securities of USAir Group acquired by BA and its subsidiaries following Janu- ary 21, 1993 and $750 million (or $500 million if the Final Purchase has not occurred), then (i) the number of directors elected by the Class B Common Stock and the Series C Preferred Stock, voting together as a single class, will be limited to two; (ii) the directors elected by the Common Stock, Series A Preferred Stock, Series E Preferred Stock, Series T Preferred Stock, as defined under "Miscellaneous" below, and other capital stock with voting rights will no longer be required to include two directors selected from among the outside directors on the board of directors of BA; (iii) special class voting rights applicable to the Class B Common Stock and Series C Preferred Stock will no longer apply and; (iv) BA will no longer participate in the Appointments Committee. In addition, if the BA Holding becomes less than both one-third of the aggregate purchase price of all BA Preferred Stock, BA Notes, Non-Preferred Stock or other equity securities of USAir Group acquired by BA and its subsidiaries following January 21, 1993 and $375 million (or $250 million if the Final Purchase has not occurred), then the number of directors elected by the Class B Common Stock and the Series C Preferred Stock, voting together as a single class, will be reduced to one. If the BA Holding becomes less than $100 million, then the Class B Common Stock and the Series C Preferred Stock will no longer vote together as a single class with respect to the election of any directors of USAir Group, but will vote together with the Common Stock, the Series A Preferred Stock and any other class or series of capital stock with voting rights with respect to the election of directors of USAir Group. Miscellaneous Under the terms of the Investment Agreement, BA has the right to maintain its proportionate ownership (based on the assumed consummation of the Second Purchase and the Final Purchase) of USAir Group's securities under certain circumstances by purchasing shares of certain series of Series T Cumulative Convertible Exchangeable Senior Preferred Stock, without par value ("Series T Preferred Stock"), Common Stock or BA Common Stock. Pursuant to these provisions, on June 10, 1993, BA purchased (i) 152.1 shares of Series T-1 Preferred Stock for approximately $1.5 million as a result of certain issuances during the period January 21 through March 31, 1993 of Common Stock in connection with the exercise of certain employee stock options and to certain defined contribution retirement plans; and (ii) 9,919.8 shares of Series T-2 Preferred Stock for approximately $99.2 million as a result of USAir Group's issuance on May 4, 1993 of 11,500,000 shares of Common Stock for net proceeds of approximately $231 million pursuant to a public underwritten offering. Because BA partially exercised its preemptive right in connection with the Common Stock offering and the offering price was below a certain level, the conversion price of the Series F Preferred Stock was antidilutively adjusted on June 10, 1993 from $19.50 to $19.41 per share. As a result, the Series F Preferred stock is convertible into 15,458,658 shares of Common Stock or Non-Voting Class ET Common Stock. On March 7, 1994, BA advised the Company that it would not exercise its optional purchase rights under the Invest- ment Agreement to buy three additional series of Series T Preferred Stock triggered by issuances of common stock of the Company pursuant to certain Company benefit plans during the second, third and fourth quarters of 1993. The Investment Agreement also imposes certain restrictions on BA's right to acquire additional voting securities, participate in solicitations with respect to USAir Group securities or otherwise propose or discuss extraordinary transactions concerning USAir Group. In addition, the Investment Agreement restricts BA's right to transfer certain securities and requires that prior to transfer- ring such securities, BA must, in most cases, first offer to sell the securities to USAir Group. BA has certain rights to require USAir Group to register for sale USAir Group securities sold to it pursuant to the Investment Agreement. USAir Group believes that the investments made by BA, the code sharing arrangements and consummation of the other transactions contemplated by the Investment Agreement have enabled and would further enable it to compete more effectively by (i) increasing USAir Group's equity capital and strengthening its balance sheet; (ii) improving its liquidity and access to capital markets; (iii) providing financial resources to help it withstand adverse economic conditions and fare competition; (iv) providing financial resources for the purchase of strategic assets which may be on the market from time to time; and (v) giving USAir greater access to interna- tional traffic. However, BA has announced that while it will continue to code share with USAir, it will not make additional investments in the Company under current circumstances. It is unclear whether or when any additional investments by BA will occur. Item 2.

Item 2. PROPERTIES Flight Equipment At December 31, 1993, USAir operated the following jet aircraft: (1) Of the owned aircraft, 119 were collateral for various secured financing obligations aggregating $2.0 billion at December 31, 1993, 31 were collateral under USAir Group's Credit Agreement (see Item 8A, Notes to the Consolidated Financial Statements of USAir Group). (2) The terms of the leases expire between 1994 and 2015. (3) The above table excludes one owned and one leased Boeing 767- 200ER which USAir leased to BA under a wet lease arrangement at December 31, 1993. See "British Airways Investment Agreement - U.S.-U.K. Routes." At December 31, 1993, USAir Group's three commuter airline subsidiaries operated the following propeller-driven aircraft: (1) Of the owned aircraft, four were collateral for various secured financing obligations aggregating $3.6 million at December 31, 1993, 35 were collateral under USAir Group's Credit Agreement (see Item 8A, Notes to the Consolidated Financial Statements of USAir Group), 14 were owned by USAir Leasing and Services, and 17 were owned by USAir. (2) The terms of the leases expire between 1994 and 2010. USAir is party to purchase agreements that provide for the future acquisition of new jet aircraft. See Note 4(d) to the Company's Consolidated Financial Statements for outstanding commitments and options for the purchase of flight equipment. The Company's subsidiary airlines maintain inventories of spare engines, spare parts, accessories and other maintenance supplies sufficient to meet their operating requirements. USAir owns one and leases 17 BAe 146-200 aircraft, leases 8 Boeing 727-200 and owns 12 Fokker-1000 aircraft that were parked in storage facilities and not operating at December 31, 1993. In addition, certain of the Company's subsidiaries lease five owned-1000 aircraft to outside parties. USAir is a participant in the Civil Reserve Air Fleet ("CRAF"), a voluntary program administered by the Air Mobility Command ("MAC"). USAir's commitment under CRAF is to provide two Boeing 767 aircraft in support of military operations, probably for aeromedical missions, as specified by MAC. To date, MAC has not requested USAir to activate any of its aircraft under CRAF. Ground Facilities USAir leases the majority of its ground facilities, including executive and administrative offices in Arlington, Virginia adjacent to Washington National Airport; its principal operating, overhaul and maintenance bases at the Pittsburgh and Charlotte/Douglas International Airports; major training facilities in Pittsburgh and Charlotte; central reservations offices in several cities; and line maintenance bases and local ticket, cargo and administrative offices throughout its system. USAir owns property in Fairfax, Virginia, a training facility in Winston- Salem, North Carolina, a reservations and training facility in San Diego, California, and a reservations facility in Orlando, Florida. Allegheny owns its principal ground facilities in Middletown, Pennsylvania. Jetstream leases its principal ground facilities in Dayton, Ohio. Piedmont leases its principal ground facilities in Salisbury, Maryland, Norfolk, Virginia and Jacksonville, Florida. The Company's airline subsidiaries utilize public airports for their flight operations under lease arrangements with the govern- ment entities that own or control these airports. Airport authorities frequently require airlines to execute long-term leases to assist in obtaining financing for terminal and facility construction. Future requirements for new or improved airport facilities and passenger terminals will require additional expenditures and long-term commitments. Several significant projects which affect large airports on USAir's route system are discussed below. The new terminal at Pittsburgh International Airport commenced operation in October 1992. The construction cost of the new terminal was approximately $800 million, a substantial portion of which was financed through the issuance of airport revenue bonds. As the principal tenant of the new facility, USAir will pay a portion of the cost of the new terminal through rents and other charges pursuant to a use agreement which expires in 2018. While USAir's terminal rental expense at Pittsburgh increased from approximately $14 million annually prior to relocation to the new facility, to approximately $49 million annually in 1993, the new facility has provided additional gate capacity for USAir and has enhanced the efficiency and quality of its hub services at Pittsburgh. In addition to the annual terminal rental expense, USAir is recognizing approximately $18 million annual rental expense for property and equipment typically owned by USAir at other airports. The annual terminal rental expense is subject to adjustment, depending on the actual airport operating costs, among other factors. These additional rents are reflected in Note 4(b), "Lease Commitments", to the Company's and USAir's respective Consolidated Financial Statements. The East End Terminal at New York LaGuardia Airport, which cost approximately $177 million to construct, opened in the third quarter of 1992. USAir, USAir Express and the USAir Shuttle operations at LaGuardia are conducted from this new terminal and the adjoining USAir Shuttle terminal. The East End Terminal has 12 jet gates. USAir will recognize approximately $31.6 million in annual rental expense for the new terminal and is responsible for all maintenance and operating costs. In 1993, USAir and the City of Philadelphia reached an agreement to proceed with certain capital improvements at Philadel- phia International Airport, where USAir has its third largest hub. The improvements include between $60 million and $90 million in various terminal renovations and a new $214 million commuter airline runway expansion project, exclusive of financing costs. Depending on the timing of certain federal environmental reviews, USAir expects construction will begin some time in 1994 or 1995 and will be completed in 1996 or 1997. The Washington National Airport Authority, which operates Washington National Airport ("National"), is currently undertaking a $930 million capital development project at National, which includes construction of a new terminal currently expected to commence operation in the fourth quarter of 1996. Based on current projections, the Company estimates that its annual operating expenses at Washington National Airport will increase by approxi- mately $15-$20 million. During 1990, Congress enacted legislation to permit airport authorities, with prior approval from the DOT, to impose passenger facility charges ("PFCs") as a means of funding local airport projects. These charges, which are collected by the airlines from their passengers, are limited to $3.00 per enplanement, and to no more than $12.00 per round trip. The legislation provides that the airlines will be reimbursed for the cost of collecting these charges and remitting the funds to the airport authorities. To date, approximately 200 airports, including airports at Boston, Baltimore, Washington, Newark, New York City, Philadelphia, Orlando and Tampa (which are major markets served by USAir), have imposed or are seeking approval to impose PFCs. These airports will receive more than $1 billion annually in PFCs. By the end of 1993, most major airports had imposed, or announced their intent to impose, PFCs. As a result of downward competitive pressure on fares, USAir and other airlines have been unable in many instances to pass on the cost of the PFCs to passengers through fare increases. With respect to the magnitude of airport rent and landing and other user fees generally, federal law prohibits States and their subdivisions from collecting these fees, other than reasonable rental charges, landing fees and other service charges, from aircraft operators for the use of airport facilities. In the absence of guidance from the FAA and the DOT, which are charged with enforcing such laws, regarding the "reasonableness" of fees charged at certain airports, controversies have arisen in recent years concerning the allocation of airport costs among the airlines, general aviation and concessionaires operating at the airport. Until these agencies act, governmental authorities will continue to assess fees in excess of what the airlines believe is reasonable at certain airports. In addition, during 1993, the controversy surrounding the diversion by airport and other governmental authorities of airport revenues continued to grow. Airport revenues typically consist primarily of rents and landing and other user fees paid by the airlines operating at the airport. Under federal law, federal transportation funds could be denied to certain airports that engage in diversion of these revenues. During 1993, a number of airlines operating at Los Angeles International Airport ("LAX") withheld a portion of the fees assessed by LAX on the grounds that airport revenues were being diverted to the City of Los Angeles. The LAX airport authority threatened to prohibit certain airlines, including USAir, from operating at LAX until the fees were paid. Although, following litigation, the airlines eventually paid the fees at LAX, the Company expects that the temptation to divert airport revenues will continue at certain airports because of increasing governmental budgets and a reluctance to increase taxes and other sources of revenue. Item 3.

Item 3. LEGAL PROCEEDINGS USAir has been named as party to, or may be affected by, legal proceedings brought by owners and residents of property located in the vicinity of certain commercial airports. The plaintiffs generally seek to enjoin certain aircraft operations at such airports or to obtain awards of damages on the defendant airport operators and air carriers as a result of alleged aircraft noise or air pollution. The relative rights and liabilities among property owners, airport operators, air carriers and Federal, state and local governments are unclear. Any liability imposed on airport operators or air carriers, or the granting of any injunctive relief against them, could result in higher costs to air carriers, including the Company's airline subsidiaries. The Equal Employment Opportunity Commission and various state and local fair employment practices agencies are investigating charges by certain job applicants, employees and former employees of the Company's subsidiaries involving allegations of employment discrimination in violation of Federal and state laws. The plaintiffs in these cases generally seek declaratory and injunctive relief and monetary damages, including back pay. In some instances they also seek classification adjustment and punitive damages. The above proceedings are in various stages of litigation and investigation, and the outcome of these proceedings is difficult to predict. In the Company's opinion, however, the disposition of these matters is not likely to have a material adverse effect on its financial condition. In 1989 and 1990, a number of U.S. air carriers, including USAir received two Civil Investigative Demands ("CIDs") from the DOJ (a CID is a request for information in the course of an antitrust investigation and does not constitute the institution of a civil or criminal action) related to investigations of price fixing in the domestic airline industry. The Attorney General of the State of Florida has also issued CIDs to USAir and other airlines concerning the same subject matter. The investigations by the DOJ culminated in the filing of a lawsuit against Airline Tariff Publishing Company ("ATPCo") and eight major air carriers, including USAir, alleging that the defendants had agreed to fix prices in violation of Section 1 of the Sherman Act through the methods used to disseminate fare data to ATPCo, an airline-owned fare publishing service. To avoid the costs associated with protracted litigation and an uncertain outcome, USAir and another carrier decided to settle the lawsuit by entering into a consent decree to modify their fare-filing practices in certain respects and to implement compliance programs that would include education of employees regarding the carrier's responsibilities under the consent decree. Accordingly, the consent decree and the U.S. Government's complaint were filed contemporaneously in the U.S. District Court for the District of Columbia in December 1992. Due to certain legal requirements associated with the settlement of government antitrust suits, the consent decree could not be entered until a notice and comment period had expired. On November 1, 1993, after it had reviewed the comments, the Court entered the consent decree. USAir does not believe that the fare-filing practices reflected in the consent decree will have a material adverse effect on its financial condition or on its ability to compete. In March 1994, the remaining six air carrier defendants agreed to the entry of a separate consent decree to settle the lawsuit. This consent decree cannot be entered by the Court until a notice and comment period has expired. When that consent decree is entered, USAir can petition the Court to have its consent decree amended to conform with the other settlement and the Court will enter an amended consent decree. On March 19, 1993, the U.S. District Court in Atlanta, Georgia entered a settlement involving USAir and five other U.S. air carrier defendants in the Domestic Air Transportation Antitrust Litigation class action lawsuit. The class action suit, which was filed in July 1990, alleged that the airlines used ATPCo to signal and communicate carrier pricing intentions and otherwise limit price competition for travel to and from numerous hub airports. Under the terms of the settlement, the six air carriers will pay $45 million in cash and issue $396.5 million in certificates valid for purchase of domestic air travel on any of the six airlines. USAir's share of the cash portion of the settlement, $5 million, was recorded in results of operations for the second quarter of 1992. The certificates provide a dollar-for-dollar discount against the cost of a ticket generally of up to a maximum of 10% per ticket, depending on the cost of the ticket. It is possible that this settlement could have a dilutive effect on USAir's passenger transportation revenue and associated cash flow. However, due to the interchangeability of the certificates among the six carriers involved in the settlement, the possibility that carriers not party to the settlement will honor the certificates, and the potential stimulative effect on travel created by the certificates, USAir cannot reasonably estimate the impact of this settlement on further passenger revenue and cash flows. USAir has employed the incremental cost method to estimate a range of costs attributable to the exercise of the certificates, based on the assumption that the estimated maximum number of certificates to be redeemed for travel on USAir will be related to USAir's market share relative to the total market share of the six carriers involved in the settlement. USAir's estimated percentage of such market share is less than 9%. Incremental costs include unit costs for passenger food, beverages and supplies, fuel, liability insurance, and denied boarding compensation expenses expected to be incurred on a per passenger basis. USAir has estimated that its incremental cost will not be material based on the equivalent free trips associated with the settlement. The Attorney General of the State of Florida and the Attorneys General of several other states are investigating whether several major airlines, including USAir, have engaged in price fixing and other unlawful restraints of trade. Certain of these Attorneys General have issued document requests to USAir and several other airlines requiring them to provide certain information and documents. At this time, USAir cannot predict the manner in which these investigations will be resolved and if the resolution will have an adverse effect on USAir's results of operations or financial position. Item 4.

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of 1993. PART II Item 5A. MARKET FOR USAir Group's COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Stock Exchange Listings The common stock of the Company is traded on the New York Stock Exchange (Symbol U). On February 28, 1994, there were approximately 59,265,000 shares (exclusive of approximately 1,815,000 shares held in treasury) of common stock of the Company outstanding. The stock was held by 35,763 stockholders of record. The holders reside throughout the United States and abroad. Market Prices of Common Stock Presented below are the high and low sale prices of the common stock of the Company as reported on the New York Stock Exchange Composite Tape during 1993 and 1992: Holders of the common stock are entitled to receive such dividends as may be lawfully declared by the Board of Directors of the Company. A common stock dividend of $.03 per share was paid in every quarter from the second quarter of 1980 through the second quarter of 1990. In September 1990, however, the Board of Directors suspended the payment of dividends on common stock for an indefinite period. Item 5B. MARKET FOR USAir's COMMON EQUITY AND RELATED STOCKHOLDER MATTERS There is no established public trading market for USAir's common stock, which is all owned by USAir Group. No dividends were paid in 1992 or 1993. Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDI- TION AND RESULTS OF OPERATIONS Management's Discussion and Analysis of Financial Condition and Results of Operations presented below relates to the Consoli- dated Financial Statements of USAir Group, Inc. ("USAir Group" or the "Company") presented in Item 8A. Consolidated Financial Statements for USAir, Inc. ("USAir"), the Company's principal subsidiary, are presented in Item 8B. USAir's operating revenue accounted for more than 93% of the Company's operating revenue in each of the last three years. USAir Group also owns three commuter airline subsidiaries, which accounted for more than 5% of the Company's operating revenue in each of the last three years. Therefore, the following discussion and analysis of results of operations relates principally to the operations of USAir and to the airline industry. The following general factors are among those that influence USAir's financial results and its future prospects: 1. General economic conditions and industry capacity. 2. A decline in the proportion of passengers paying higher yield "business fares" to passengers paying lower yield fares. 3. The emergence and growth of low cost, low fare airlines and USAir's high cost structure. 4. The trend toward globalization in the airline industry and related regulatory limitations. These and other factors are discussed in the following sections. General Economic Conditions and Industry Capacity Historically, demand for air transportation has tended to mirror general economic conditions. Economic conditions in the United States and fare competition in the domestic airline industry continued to be major factors affecting the financial condition of USAir and the airline industry in 1993. In recent years, the change in industry capacity has failed to mirror the reduction in demand for domestic air transportation due primarily to continued delivery of new aircraft and, secondarily, to the operation of certain major U.S. carriers under the protection of Chapter 11 of the Bankruptcy Code for extended periods. While industry capacity has leveled off and the general economy has shown signs of improvement, the Company expects that the airline industry will remain extremely competitive for the foreseeable future. See the discussion of low cost, low fare airlines below. During the recent economic recession, some observers of the travel industry speculated that the business traveler became less reliant on air transportation as teleconferencing, telecopying and other technological developments gained wider acceptance. In addition, some observers have speculated that corporate restructur- ing and furloughs in the U.S. have reduced the number of business travelers and that the leisure traveler has become conditioned to waiting for promotional fares before making travel plans. The Company is unable to determine whether these structural changes have occurred in the air transportation market or if these changes have occurred, how long-lived these trends will be. However, the Company believes that for the foreseeable future the demand for higher yield "business fares" will remain essentially flat and relatively inelastic while the lower yield "leisure" market will continue to grow with the general economy. This trend could make it more difficult for the domestic airlines, including USAir, to sustain meaningful yield increases in the future. Financial circumstances have compelled certain bankrupt or financially weakened carriers to sell assets, including foreign routes, gates and take-off and landing slots at capacity con- strained airports. Proceeds from asset sales provide cash infusions to weaker carriers, but also augment the route systems and market presence of the stronger carriers. Although USAir has completed route and other asset purchases from a number of weaker carriers, the purchases illustrate a trend of consolidation of strategic assets and financial strength within the industry which appears to benefit the three largest U.S. carriers in the long- term. In the short-term, however, these carriers have suffered from the cost of integrating these assets into their systems and from the incremental capacity which has been exacerbated by declines in passenger travel and fare wars. As a result, these carriers have taken or announced actions including reduction in workforce and salary and other employee benefits, concessions from unionized employees, deferral of new aircraft deliveries, early retirement of inefficient aircraft types, and termination of unprofitable service. USAir implemented similar measures during 1990-1993, including a workforce reduction of 2,500 full-time positions between November 1993 and the first quarter of 1994, which, along with other measures, is expected to save the Company approximately $200 million in 1994. USAir will pursue additional measures in 1994 to reduce further its operating costs. See Item 1. "Business - Significant Impact of Low Cost, Low Fare Competi- tion" and "-British Airways Announcement Regarding Additional Investment in the Company; Code Sharing." In 1993, USAir reached an agreement with the Boeing Company ("Boeing") to, among other things, exercise options to purchase additional B757-200 aircraft on an accelerated basis and to cancel and reschedule the delivery of certain Boeing 737 aircraft on order into the future. This agreement reduced USAir's capital expendi tures by more than $880 million between 1993 and 1996. USAir is currently in negotiations with Boeing regarding, among other things, the current schedule of new aircraft deliveries. Each major airline has developed a frequent traveler program that offers its passengers incentives to maximize travel on that particular carrier. Participants in such programs typically earn "mileage credits" for every trip they fly that can be redeemed for airline travel or, in some cases, for other benefits. Under USAir's Frequent Traveler Program ("FTP"), participants receive mileage credits equal to the greater of actual miles flown or 750 miles for each paid flight on USAir or USAir Express, or actual miles flown on one of USAir's FTP airline partners. Participants flying on first or business class tickets receive additional credits. Participants may also earn mileage credits by staying at participating hotels or by renting cars from participating car rental companies within 24 hours of a flight. Mileage credits can be redeemed for certificates for various travel awards, including fare discounts, first class upgrades and tickets on USAir or other airlines participating in USAir's FTP. Certain awards also include hotel and car rental awards. Award certificates may not be brokered, bartered or sold, and have no cash value. USAir and its airline partners limit the number of seats allocated per flight for award recipients. The number of seats varies depending upon flight, day, season and destination. Award travel is not permitted on blackout dates, which generally correspond to certain holiday periods in the United States or peak travel dates to foreign destinations. Hotel awards are valid at participating hotels and are subject to room availability, which is limited. Car rental awards are valid only at participating locations. The number of cars available for award usage is limited, and no cars are available for award usage on blackout dates. USAir reserves the right to terminate the FTP or portions of the program at any time, and the FTP's official rules, partners, special offers, blackout dates, awards and mileage levels are subject to change with or without prior notice. USAir accounts for its FTP under the incremental cost method, whereby travel awards are valued at the incremental cost of carrying one additional passenger. Such costs are accrued when FTP participants accumulate sufficient miles to be entitled to claim award certificates. No value is assigned to airline, hotel or car rental award certificates that are to be honored by other parties. Incremental costs include unit costs for passenger food, beverages and supplies, fuel, liability insurance and denied boarding compensation expenses expected to be incurred on a per passenger basis. No profit or overhead margin is included in the accrual for incremental costs. FTP participants had accumulated mileage credits for approxi- mately 3,896,000 awards (at the 20,000 mile level required for a free domestic flight on USAir) at December 31, 1993, compared with 3,199,000 awards at December 31, 1992. However, because USAir expects that some award certificates will be redeemed by other airlines participating in USAir's FTP, that some certificates will expire, and that some accumulated mileage credits will never be applied towards award certificates, the calculations of the accrued liability for incremental costs at December 31, 1993 and 1992 were based on approximately 88% and 86%, respectively, of the accumulat- ed credits. Mileage for FTP participants who have accumulated less than the minimum number of mileage credits necessary to claim an award is excluded from the calculation of the accrual. Most participants belong to more than one frequent traveler program and it is not possible to project when or if participants will accrue additional mileage credits required to earn an award. Incremental changes in the liability resulting from additional mileage credits are recorded as part of the regular review process. Effective January 1, 1995, USAir will increase the minimum mileage level required for a free domestic flight from 20,000 to 25,000. USAir's customers redeemed approximately 841,000, 626,000 and 654,000 awards for free travel on USAir in 1993, 1992 and 1991, respectively, representing approximately 8.0%, 4.9% and 5.3% of USAir's revenue passenger miles ("RPMs") in those years, respec- tively. During 1993, two "free ticket for segments flown" promotions were completed which increased the number of awards used for free travel on USAir. These promotions were offered in response to similar promotions offered by USAir's competitors. USAir does not believe that usage of FTP awards results in any significant displacement of revenue passengers. USAir has the ability, through its inventory management system, to identify markets and flights expected to have high load factors and, through capacity controls, to maximize use of FTP awards on flights with lower demand and available seats. Also, blackout dates forestall the usage of awards on peak travel days. Furthermore, USAir's exposure to the displacement of revenue passengers is not signifi- cant, as the number of USAir flights that depart 100% full is minimal. In the third quarter of 1993 (the third quarter being the period of the year when USAir generally experiences its highest load factor and expects the usage of FTP awards to be highest), for example, fewer than 2.2% of USAir's flights departed 100% full. During this same quarterly period, only approximately 1.9% of USAir's flights departed 100% full and also had one or more passengers on board who were traveling on FTP award tickets. Airlines often use other competitive promotions, such as offering extra credits or reduced award thresholds under certain conditions, as incentives to stimulate travel. USAir reviews these promotions to determine the proper accounting treatment for each one. To the extent these promotions are determined to be an integral part of the FTP, they are accounted for in the same manner as free travel earned through mileage credits. Low Cost, Low Fare Competition In September 1993, Southwest Airlines, Inc. ("Southwest"), a low cost, low fare, "no frills" air carrier which had not previous- ly provided service to or in the eastern U.S., inaugurated service to Chicago and Cleveland from Baltimore/ Washington International Airport ("BWI") at fares substantially below those previously offered by USAir and other airlines in the same markets. BWI is one of USAir's hub airports. Unlike the other major U.S. air carriers, Southwest does not structure its operations around connecting hub airports, relying instead on high frequency point- to-point service. USAir responded by matching most of Southwest's fares and increasing the frequency of service in related markets. On March 22, 1994, Southwest announced that on May 26, 1994, and June 6, 1994, it will expand service between BWI and Chicago. Southwest also announced that on May 26, 1994, it will initiate its low fare service between BWI and St. Louis, and on July 8, 1994, between BWI and Birmingham, Alabama and Louisville, Kentucky. At this time, USAir has not determined its response to the Southwest announcement. In October 1993, Continental Airlines ("Continental"), which had reorganized under bankruptcy proceedings earlier in 1993, inaugurated low fare service on certain routes in the eastern U.S. USAir is a competitor in most of the markets served by these routes. While Continental initiated service to certain cities, such as Charleston, South Carolina; Greensboro, North Carolina; and Jacksonville, Florida; most of the markets included as part of its new program (for example, Baltimore) were previously served by Continental through its hubs at Newark, Cleveland, and Houston. However, under its new program, Continental linked certain of these cities independently of its hubs while continuing to provide many of the same services that are available on its hub flights, including advance seat assignment, frequent traveler mileage credits and interline connections. Under its new program, Continental served approximately 80 city pair markets, from which USAir has historically realized approximately 4% of its total passenger revenue. When Continental started the new program it was uncertain whether the program was an experiment or a beachhead from which Continental planned to expand further. USAir, therefore, made a measured response by matching most of the low fares offered by Continental. On January 31, 1994, Continental increased its competitive threat. It announced that by March 9, 1994, it would expand the low fare program to approximately 356 city pair markets, most of which USAir served and from which USAir has historically realized approximately 8% of its passenger revenue. Moreover, if secondary markets within a 90-mile radius, or a reasonable driving distance, were viewed as being included in Continental's new program, markets from which USAir has historically realized approximately 36% of its passenger revenue were affected. Contemporaneously, Continental announced that it would substantially reduce service at its Denver hub and redeploy significant aircraft and personnel resources to the eastern U.S. Although Continental's balance sheet continues to have significant leverage following its bankruptcy reorganization, its liquidity position improved substantially as a result of equity and debt infusions completed as part of that reorganization. Moreover, Continental completed a common stock offering in December 1993, which may indicate the market's receptivity to its efforts to raise additional funds. Continental has operating (including labor) costs that are substantially lower than those of USAir and the other major air carriers. On February 8, 1994, in response to the expansion of Continen- tal and to avoid loss of market share in the eastern U.S., USAir lowered in primary and secondary markets affected by the Continen- tal expansion, by as much as 50%, the fares most commonly used by business travelers on many east coast routes. In addition, USAir lowered leisure fares by as much as 70% in the same markets. In many of the markets, free companion fares are available with business fares. These reduced fares have no expiration date. However, USAir could adjust the fares at some time in the future. Increases in traffic which are stimulated by the lower fares offered by Southwest, Continental and USAir will not offset USAir's reduced revenue resulting from lower yields in these markets. USAir believes that Southwest, Continental or other low cost carriers with a significant cost advantage over USAir likely will expand their operations to additional markets. For example, in December 1993, Southwest completed its acquisition of Morris Air, a regional air carrier with operations concentrated in the western U.S. This acquisition could enable Southwest to divert resources to expand its operations in the eastern U.S. Furthermore, media reports indicate that Southwest has entered into a long-term agreement for the use of four additional gates at BWI, where it currently operates from two gates. On March 4, 1994, Continental further escalated prospective competition by announcing that it will further reduce operations at its Denver, Colorado hub and establish a flight crew base at Greensboro, North Carolina. These measures are likely to increase losses at USAir because they could enable Continental, which has significantly lower costs than USAir, to expand further its high frequency, low fare service described above in additional short-haul markets served by USAir with substantial detriment to USAir. In addition, other low cost carriers may enter other USAir markets. For example, America West announced on February 15, 1994 that it will commence service on April 18, 1994 between Columbus, Ohio where it operates a hub and Philadelphia, where USAir has a hub operation. Other carriers, including some of the larger carriers, have also indicated their intent to develop similar low-fare short-haul service. Unless USAir is able to reduce its operating costs, present and increasing competition from low cost, low fare airlines in USAir's markets could have a material adverse impact on USAir's cash position and therefore, its ability to sustain operations. In March 1994, USAir announced that it had initiated discussions with the leadership of its unionized employees regarding wage reduc- tions, improved productivity and other cost savings. The outcome of these negotiations is uncertain, but if timely agreements are not reached, the Company may seek other restructuring alternatives. See Item 1. "Business - Significant Impact of Low Fare, Low Cost Competition". In 1993, Northwest Airlines, Inc. ("Northwest") and Trans World Airlines, Inc. ("TWA") sought and obtained from unionized employees substantial concessions and productivity improvements. In exchange, these employees have received ownership interests in those companies. In December 1993, United Airlines, Inc. ("Unit- ed") announced that it had reached agreement with two of its unions to trade concessions for a substantial ownership stake by all employees, subject to approval by United's stockholders. The memberships of these two unions have ratified the agreement. The stated intent and purpose of these labor concessions are to enable these carriers to lower their operating costs. At this time, it is uncertain whether the United transaction will be consummated and whether these events constitute isolated incidents or a trend of employee ownership in the airline industry. As an airline with relatively high labor costs and a route system with a significant percentage of short-haul flying, USAir is considering additional ways to reduce these costs which could involve an exchange of employee concessions for an ownership interest in the Company. USAir is currently engaged in discussions with the leaders of its unionized employees regarding efforts to reduce costs, including reductions in wages, improvements in productivity and other cost savings. The outcome of these discussions is uncertain. See Item 1. "Business - Significant Impact of Low Fare, Low Cost Competi- tion." USAir has been examining various ways to restructure its operations to increase efficiency and lower unit costs in markets of approximately 500 miles or less in distance. Certain carriers, such as Southwest and Continental, have a substantial cost advantage over USAir in these short-haul markets. In addition, consumers appear to be increasingly price conscious, particularly for short distance flights. In February 1994, USAir implemented the first phase of the introduction of a new short-haul product in 18 city-pair markets of approximately 500 miles or less, resulting in increased utilization and productivity of aircraft, personnel, and ground facilities in these markets by decreasing the amount of time that aircraft spend on the ground between flights from an average of 45 minutes to approximately 25 minutes. Initiation of the first phase of this service did not involve any immediate pricing changes or new personnel. Ultimately, USAir anticipates that enhancements to the short-haul product will be completed in summer 1994, and that long-haul and transatlantic service will be redesigned later in 1994. USAir plans to expand this higher frequency service to additional short-haul and other markets in July 1994, with a total fleet of approximately 100 aircraft. Although USAir expects this higher frequency operation will result in reduced unit costs in relevant markets, certain variable costs generally associated with providing the incremental flights, including jet fuel, landing fees and labor, will increase. There can be no assurance, therefore, that the changes will result in improved financial results for USAir. If USAir cannot find ways to compete effectively with low cost carriers by lowering its operating costs, and to generate sufficient additional passengers to offset the effect of sharply reduced fares, USAir's revenue and results of operations will continue to be materially and adversely affected. Industry Globalization and Regulation The trend toward globalization of the airline industry has accelerated in recent years as the three largest U.S. carriers have initiated foreign service and purchased the foreign routes of financially distressed or bankrupt U.S. carriers. In addition, certain foreign carriers have made substantial investments in U.S. carriers which have frequently been tied to marketing alliances or, less frequently, reciprocal investments by the U.S. carrier in its foreign partner. In August 1993, Continental announced that it had reached agreement with Air France on a joint marketing agreement. Earlier in the year, Air Canada made a substantial equity invest- ment in Continental in connection with Continental's bankruptcy reorganization. In October 1993, United and Lufthansa German Airlines announced that they had reached an agreement to implement code sharing to link some of their flights. Continuing privatiza- tion of sovereign carriers and foreign airline deregulation may encourage further foreign investment. Foreign investment in U.S. air carriers is restricted by statute and may be subject to review by the U.S. Department of Transportation ("DOT") and, on antitrust grounds, by the U.S. Department of Justice ("DOJ"). On January 21, 1993, USAir Group and British Airways Plc ("BA") entered into an Investment Agreement ("Investment Agree- ment") under which a wholly-owned subsidiary of BA has purchased certain preferred stock of the Company for $400.7 million. On March 7, 1994, BA announced that it would not make any additional investments in the Company under current circumstances. See "Liquidity and Capital Resources" and Item 1. "Business - British Airways Announcement Regarding Additional Investments in the Company; Code Sharing" and "- British Airways Investment Agreement" for additional information related to the investment. Under the Investment Agreement, USAir and BA have entered into a code sharing arrangement under which certain domestic USAir flights, connecting to certain BA transatlantic flights, may be listed on computerized reservation systems either under USAir's or BA's two letter designation code, subject to authorization by the DOT. As of March 1, 1994, USAir and BA offered code share service to and from 34 of the 65 airports authorized by the DOT. On March 17, 1994, the DOT issued an order renewing for one year the existing code sharing authority. In January 1994, USAir and BA filed applica- tions with the DOT to code share to 65 additional domestic and seven additional foreign destinations. The DOT did not act on these applications in its March 17, 1994 order. See Item 1. "Business - British Airways Announcement Regarding Additional Investments in the Company; Code Sharing" and "-British Airways Investment Agreement". USAir and BA are in the process of expanding their code sharing arrangement. USAir believes that it will have greater access to international traffic and that its and BA's customers will benefit from better on-line connections as well as coordinated check-in and baggage checking procedures. USAir also believes that the code sharing arrangement will generate increased revenues, the magnitude of which cannot be reasonably estimated at this time. The DOT may continue to link further renewals of the code share authorization to the United Kingdom's ("U.K.") liberalization of U.S. air carrier access to the U.K. markets. However, the code sharing arrangement is expressly permitted under the bilateral air services agreement between the U.S. and U.K. USAir expects that the authorization will be renewed in the future; however, there can be no assurance that this will occur. USAir does not believe that the DOT's failure to renew the code share authorization or grant the pending application would result in a material adverse change in its financial condition. However, further investment in the Company by BA, as contemplated in the Investment Agreement, may be less likely. See Item 1. "Business - British Airways Announcement Regarding Additional Investments in the Company; Code Sharing" and "-British Airways Investment Agreement." Current U.S. law provides that foreign ownership or control of the voting interest in a certificated U.S. air carrier may not exceed 25%, non-U.S. citizens may not constitute more than a third of the board of directors and managing officers of the air carrier and the president of the air carrier must be a U.S. citizen. Over the years in the context of "fitness" reviews to determine whether air carriers could be issued, or continue to hold, operating certificates, the DOT has also issued interpretations regarding whether investments by, or other arrangements with, foreign investors constitute de facto control over a U.S. air carrier. Although the Company believes the policy has no basis in law, recently and particularly during 1992 and 1993, the DOT has linked its review of foreign investment in, and foreign alliances with, U.S. air carriers to the status of the bilateral air transportation treaty between the U.S. and the country of origin of the foreign airline. The willingness of the DOT to allow proposed foreign investments, alliances and participation in corporate governance has been linked to its perception of the liberality of the relevant treaty with respect to the right of U.S. air carriers to operate to, from and beyond the foreign country. For example, the Netherlands entered into a new bilateral treaty with the U.S. in 1992 which permitted "open skies", or unrestricted access to the Netherlands by U.S. air carriers. As a result, in 1992 the DOT approved Northwest's proposal to integrate its operations with those of KLM Royal Dutch Airlines, an airline based in that nation. However, the DOT has refused to allow USAir and BA to proceed with the second and third phases of their Investment Agreement, which calls for an additional investment of $450 million by BA, unless and until the U.K. government agrees to amend its bilateral air services agreement with the U.S. to permit new services by U.S. carriers to the U.K. and particularly to London's Heathrow Airport. The U.S. and U.K. governments held several negotiating sessions during the past year and have exchanged proposals to amend the bilateral agreement, but to date the two governments have failed to resolve their differences. As a result, USAir and BA were unable to proceed with the second and third phases of the Investment Agreement in 1993. In any event, on March 7, 1994, BA announced that it would not make any additional investments in the Company under current circumstances. See Item 1. "Business - British Airways Announcement Regarding Additional Investment in the Company; Code Sharing" and "-British Airways Investment Agreement." The National Commission to Ensure a Strong Competitive Airline Industry ("Airline Commission") issued its report in August 1993. The Airline Commission was a presidentially-appointed committee with the task of analyzing the condition of the U.S. airline industry and reporting to the Clinton Administration its findings and recommendations. Among other things, the Airline Commission recommended that: (i) the air traffic control system be modernized and the Federal Aviation Administration's ("FAA") air traffic control functions be performed by an independent federal corpora- tion; (ii) the federal regulatory burden be reduced; (iii) the airlines be granted certain tax relief; and (iv) the bankruptcy process be shortened. The Airline Commission also favored raising the statutory limit on foreign ownership of voting securities in the U.S. airlines to 49 percent under certain circumstances. It further urged that the current international system of bilateral agreements be replaced with multilateral arrangements. In addition, the Airline Commission recommended that the DOT review the airlines' business, capital or financial plans with the assistance of a presidentially-appointed advisory committee and, if an airline repeatedly failed to heed warnings or concerns of the DOT Secretary, the DOT could "exercise its existing authority", among other things, to revoke an airline's operating certificate. In January 1994, the Clinton Administration issued a report which described its program to implement certain of the Airline Commission's recommendations. Among other things, the Administra- tion stated that it supported the recommendation described above regarding the FAA, supported increasing to 49 percent the foreign ownership restrictions provided there are reciprocal opportunities for U.S. airlines and investors abroad, and opposed the recommenda- tions regarding tax relief and the appointment of the advisory committee discussed above. At this time, it is impossible to predict whether any of the Airline Commission's recommendations will be enacted and, if enacted, their effect on USAir. It is also difficult to anticipate whether the Congress will act in the near term on any of the proposals requiring legislation. As part of its initiative in the transportation industry, the Clinton Administration also indicated that the DOT has begun a comprehensive examination of the "high density rule" which limits airline operations at Chicago O'Hare, New York's LaGuardia ("LaGuardia") and John F. Kennedy International, and Washington National ("National") Airports by restricting the number of takeoff and landing slots. As part of its study, the DOT will determine whether the operating limitations imposed by the rule can be eliminated or modified to better utilize available capacity at these airports. USAir holds a substantial number of slots at LaGuardia and National, including those assigned a value when the Company acquired Piedmont Aviation, Inc. Any DOT action which would eliminate those slots or compel USAir to transfer those slots could have a material adverse effect on USAir's operations and financial position. Revision of the high density rule at National, however, would require legislation by the Congress. The DOT has indicated that it expects to complete its study by late 1994. RESULTS OF OPERATIONS 1993 Compared with 1992 The Company recorded a net loss of $393.1 million on revenue of $7.1 billion, in 1993 compared with the 1992 net loss of $1.2 billion on revenue of $6.7 billion. Several non-recurring items, which include the cumulative effect of accounting changes, make it difficult to compare these results. After excluding the effect of certain non-recurring items discussed below, which amount to $153.2 million and $759.3 million in 1993 and 1992, respectively, the net loss would have been $239.9 million in 1993 ($5.69 per common share after preferred dividend requirement) compared with a loss of $469.6 million in 1992 ($11.09 per common share after preferred dividend requirement). The Company's 1993 financial results contain $153.2 million of non-recurring items, including (i) $68.8 million for severance, early retirement and other personnel-related expenses recorded in connection with a workforce reduction of approximately 2,500 full- time positions between November 1993 and the first half of 1994; (ii) $43.7 million for the cumulative effect of an accounting change, as required by Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("FAS 112"), which was adopted during the third quarter of 1993, retroactive to January 1, 1993; (iii) $36.8 million based on a projection of the repayment of certain employee pay reductions; (iv) $13.5 million for certain airport facilities at locations where USAir has, among other things, discontinued or reduced its service; (v) $8.8 million for a loss on USAir's investment in the Galileo International Partnership, which operates a computerized reservations system; and (vi) an $18.4 million credit related to non-operating aircraft. The Company's 1992 financial results contain $759.3 million of non-recurring items, including (i) $628.1 million for the cumula- tive effect of an accounting change, as required by Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("FAS 106"); (ii) $107.4 million related to aircraft which have been withdrawn from service; (iii) $34.1 million loss related to the sale of ten McDonnell Douglas 82 ("MD-82") aircraft which USAir had on order but eliminated from its fleet plan; and (iv) $10.3 million gain resulting from the sale of three of the Company's subsidiaries during 1992. Operating Revenue - The Company's Passenger Transportation Revenue increased by $356.5 million (5.8%) in 1993 compared with 1992, primarily due to the $296.0 million (5.1%) increase at USAir. USAir's capacity, as measured by available seat miles ("ASM" - one ASM is equal to one seat flown one mile), decreased by 0.3% in 1993 compared with 1992, its passenger revenue per ASM increased by 5.4% to 10.22 cents and its passenger load factor, a measure of capacity utilization, increased by 0.4 points to 59.2%. The increase in passenger revenue per ASM is largely attributed to the lower level of discounting in 1993 versus 1992. The Company expects that it will experience a 1 - 2% increase in ASMs (including the effect of weather-related cancellations) in 1994 compared with 1993. Continued fare discounting and low fares offered by USAir to compete with low cost, low fare carriers discussed above, are expected to have a negative impact on the Company's passenger revenue. It is not expected that the resulting decrease in revenue per ASM will be totally offset by additional passengers. The severe winter weather conditions in the U.S. during the early part of 1994 have caused a reduction in revenue which the Company estimates at approximately $50 million. In March 1993, USAir and five other U.S. air carriers entered into a settlement in the Domestic Air Transportation Antitrust Litigation class action lawsuit, which alleged that the airlines used the Airline Tariff Publishing Company to signal and communi- cate carrier pricing intentions and otherwise limit price competi- tion for travel to and from numerous hub airports. It is possible that this settlement could have a dilutive effect on USAir's passenger transportation revenue and associated cash flow. However, due to the interchangeability of the certificates among the six carriers involved in the settlement, the possibility that carriers not party to the settlement will honor the certificates, and the potential stimulative effect on travel created by the certificates, USAir cannot reasonably estimate the impact of this settlement on future passenger revenue and cash flows. USAir has estimated that any incremental cost associated with the settlement will not be material based on the nominal equivalent free trips associated with the settlement. See Note 4 to the Company's Consolidated Financial Statements for additional information. The Company's Other Revenue increased by $38.8 million (12.3%) in 1993. USAir's increase of $90.5 million (32.3%) was partially offset at the Company level by a decrease in non-airline subsidiary revenue resulting from the sale of three wholly-owned subsidiaries in July 1992. USAir's 32.3% improvement resulted from increased passenger cancellation and rebooking fees, frequent traveler participation fees, and various other sources. Expense - The Company's total operating expenses increased $141.7 million (2.0%) in 1993 compared with 1992. The Company's Personnel Costs increased by $217.7 million (8.3%), $205.6 million of which is attributable to USAir. USAir's increase includes (i) $65.6 million of the $68.8 million non-recurring charge related to a workforce reduction of 2,500 full-time positions; and (ii) the $36.8 million charge based on an estimate of the repayment of certain employee pay reductions, both discussed above. Without the effect of these non-recurring charges, USAir experienced an increase in employee salaries of $91.4 million (4.7%) and an increase in employee benefits of $11.8 million (2.1%). The increase in employee salaries is generally due to contractual and general salary increases which occurred during 1993. The amount saved as a result of the 12-month salary reduction program was approximately the same in 1993 and 1992. USAir expects that due to scheduled contractual increases and the effect of the expiration of the 12-month salary reduction program, employee salaries will increase in 1994 to the extent that the reduction of 2,500 full- time positions and any other possible measures do not offset the increases. See Item 1. "Business - Significant Impact of Low Fare, Low Cost Competition" and "- Employees" for information related to the possible unionization of additional employee groups. The $11.8 million increase in employee benefits is the result of increased pension expense, offset partially by a decrease in other postretir- ement benefit expense. The increased pension expense in 1993 resulted from the establishment of a defined contribution pension plan for USAir's non-contract employees on January 1, 1993. The defined benefit plan for these employees was frozen at December 31, 1991. Because of the interest rates on long-term, high quality corporate bonds which prevailed at December 31, 1993, the Company has lowered its discount rate used to calculate the actuarial present value of its pension and postretirement obligations. This action will cause an increase in the Company's pension and other postretirement benefits expense in 1994 of approximately $70 million over 1993. See Note 11 to the Company's Consolidated Financial Statements. The Company's Aviation Fuel Expense decreased $43.2 million (5.7%) as a result of a lower cost per gallon and decreased consumption. In early August 1993, the Clinton Administration's budget package was enacted. The budget package included a 4.3 cent per gallon tax on transportation fuels beginning October 1, 1993. The airline industry is exempt from the tax until October 1, 1995. See Item 1. "Business - Jet Fuel" and Note 1 to the Company's Consolidated Financial Statements. Commissions increased by $27.2 million (4.8%) as a result of the 5.8% increase in Passenger Transportation Revenue. The Company's Other Rent and Landing Fees increased $64.3 million (15.8%) primarily due to an increase in USAir's facility rental expense following the opening of the new terminal at Pittsburgh in October 1992, and the $8.9 million of non-recurring expense recorded for certain airport facilities, discussed above. The Company's Aircraft Rent Expense included a $72.4 million non- recurring charge in 1992 (part of the $107.4 million discussed above). Without this charge, aircraft rent expense increased $15.0 million (3.3%) due to the addition of new leased aircraft in 1993. Excluding the effect of non-recurring items in 1992 and 1993, Aircraft Maintenance Expense increased by $37.6 million (10.6%) resulting from the timing of aircraft maintenance cycles. Other Operating Expense decreased by $58.0 million (4.0%), reflecting a $25.0 million (1.8%) decrease at USAir and a $58.4 million decrease which resulted from the sale of three wholly-owned subsidiaries in July 1992, offset by increases at the Company's other wholly-owned subsidiaries. The Company's Interest Capitalized decreased $10.0 million (36.1%) as the level of outstanding purchase deposits decreased with the delivery of new aircraft and changes in delivery sched- ules. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes", ("FAS 109"). The adoption of FAS 109 resulted in no cumulative adjustment. Results for 1993 do not include any income tax credit due to the FAS 109 limitations in recognizing a current benefit for net operating losses. See Note 6 to the Company's Consolidated Financial Statements for additional information. 1992 Compared With 1991 The Company recorded a net loss of $1.2 billion on revenue of $6.7 billion in 1992, compared with the 1991 net loss of $305.3 million on revenue of $6.5 billion. Several non-recurring items, which include the cumulative effect of an accounting change, make it difficult to compare these results. In addition, the Company recorded no tax credit in 1992. After excluding the effect of certain non-recurring items which amount to a net charge of $759.3 million and a net gain of $45.9 million in 1992 and 1991, respec- tively, the pre-tax loss would have been $469.6 million in 1992 ($11.09 per common share after preferred dividend requirement) compared with a pre-tax loss of $460.7 million in 1991 ($11.01 per common share after preferred dividend requirement). This compari- son does not consider the ongoing effect to the Company's operating expenses which result from the adoption of FAS 106, the freezing of the pension plan for non-contract employees, or other changes. The Company's 1992 financial results contained $759.3 million of non-recurring items, detailed above. Operating results for 1991 included (i) $107 million pre-tax gain related to the freeze of the fully funded pension plan for USAir's non-contract employees; (ii) a $21 million pre-tax charge related to USAir's parked British Aerospace BAe-146 ("BAe-146") fleet; (iii) $21.6 million pre-tax expense related to early retirement incentives; and (iv) $18.5 million, net, in miscellaneous non-recurring charges. On October 5, 1992, the International Association of Machin- ists ("IAM"), which represents USAir's mechanics and related employees, commenced a strike against USAir. At that time, USAir implemented a reduced flight schedule equal to approximately 60% of the normal flight schedule. On October 8, 1992, USAir reached agreement with the IAM on a new collective bargaining agreement which becomes amendable in October 1995. Following ratification of the agreement by the IAM-represented employees, USAir resumed full service on October 12, 1992. USAir immediately offered various incentives including bonus frequent traveler miles and relaxed advance purchase restrictions in an effort to attract passengers following the disruption of service. The Company estimates that the IAM strike had a negative effect on results of approximately $45 million for the year. Operating Revenue - The Company's Passenger Transportation Revenue increased $164.6 million (2.7%) in 1992, reflecting a $97.9 million increase in USAir passenger transportation revenue and a $66.7 million increase in commuter airline passenger revenue. USAir's ASMs increased by 2.4% in 1992, its passenger revenue per ASM decreased by 0.7% to 9.7 cents, and its passenger load factor increased by 0.2 points to 58.8%. USAir's average 1992 passenger revenue per ASM was adversely affected by widespread fare promo- tions. The improvement in commuter airline passenger revenue is attributed to increased traffic made possible by 20.1% increase in capacity during 1992 over 1991, as measured by ASMs, at the Company's commuter airline subsidiaries. USAir's Other Revenue increased $81.3 million (40.9%) in 1992 as compared with 1991, due to increases in revenue generated by passenger cancellation and re-booking fees, fees received from commuter affiliates for handling certain of their flights, and other miscellaneous sources. Operating Expenses - The Company's Personnel Costs increased $102.5 million (4.1%) in 1992 compared with 1991, driven by USAir's increase in personnel costs of $99.7 million (4.2%). Personnel Costs are comprised of two components: (i) employee wages and salaries; and (ii) employee benefits. USAir's wage and salary expense decreased $21.9 million (1.1%) during 1992 as a result of partial-year wage concessions on the part of pilots, non-contract employees and mechanics, all of which ended in 1993. USAir's employee benefit expense increased $121.6 million (27.8%) in 1992 resulting from the adoption of FAS 106 in 1992, and the 1991 freeze of the fully-funded pension plan for non-contract employees. The 1991 pension freeze resulted in a $107 million gain. The Company estimates that USAir's pension expense was approximately $40 million lower in 1992 than would have been the case if the freeze had not occurred. Expense for postretirement medical and death benefits, calculated in accordance with FAS 106, was $114.7 million in 1992, compared with approximately $8 million cash-basis expense in 1991. USAir's medical and dental benefit expense for active employees decreased $26.7 million (14.2%) in 1992 compared with 1991 as a result of a contributory managed care program that was implemented during 1992 for most employee groups. Excluding the effects of FAS 106 and the pension freeze, USAir employee benefit expense decreased approximately $48 million, or 8.8%, in 1992 compared with 1991. The Company's Aviation Fuel Expense decreased $45.8 million (5.7%) during 1992 compared with 1991 as a result of lower cost per gallon, partially offset by an increase in consumption. The price of fuel was inflated during early 1991 as a result of the Iraqi invasion of Kuwait and ensuing Desert Storm operation in August 1990 - January 1991, and did not return to pre-invasion levels until the second quarter of 1991. Commissions increased $29.6 million (5.5%) as a result of the 2.7% increase in passenger transportation revenue and the mix of travel agency sales versus total sales. Other Rent and Landing Fees Expense for the Company increased $56.6 million (16.2%) during 1992. This increase was largely due to increased expense at LaGuardia which resulted from USAir's assumption of Continental's leasehold obligations associated with the East End Terminal there in January, 1992 and the increased operation at LaGuardia during the year using the take-off and landing slots acquired from Continental. Also contributing to the increase was the October 1992 opening of the new terminal at the Pittsburgh International Airport, USAir's largest hub. The Company's Aircraft Rent Expense increased $152.3 million (40.3%) during 1992. A charge related to USAir's grounded BAe-146 fleet accounted for $81 million of the increase. The remainder of the increase was caused by additional leased aircraft both at USAir and the commuter airline subsidiar- ies. The Company's Aircraft Maintenance Expense decreased $33.9 million (8.2%) during 1992. This decrease reflects USAir's decrease in aircraft maintenance of $43.4 million, or 12.0%, and an increase of $9.5 million at the Company's commuter airline subsidiaries during the same period. The improvement in USAir's aircraft maintenance expense is largely attributable to the grounding of its BAe-146 fleet in May 1991, the shifting of certain aircraft engine repairs in-house from outside vendors and the negotiation of a new vendor repair contract in 1991 for certain aircraft engines. The increase in maintenance expense at the commuter airline subsidiaries is due primarily to an increased fleet size in 1992. Maintenance expense for 1992 and 1991 includes charges of $25.0 million and $25.5 million, respectively, related to grounded aircraft. The Company's Other Operating Expense, Net increased $63.6 million (4.6%) in 1992 compared with 1991. Expense for 1992 includes $25 million related to an employee suggestion program which netted estimated savings of $22 million in 1992 and $110 million in 1993. The remainder of the increase is attributable to changes in various smaller expense categories. USAir Group's Interest Income decreased $8.7 million (46.9%) during 1992 due to a lower average level of short-term investments during 1992 coupled with lower interest rates in 1992. Both USAir's interest income and expense include intercompany amounts which have been eliminated in the USAir Group consolidation process. The Company's Interest Expense decreased $10.4 million (4.0%) in 1992 due to a lower average level of debt outstanding related to USAir Group's revolving bank credit agreement, partially offset by additional interest associated with higher levels of aircraft-related debt in 1992. Interest Capitalized decreased $7.8 million (21.8%) as a result of a lower level of outstanding equipment deposits coupled with a lower capitalized interest rate. The Company's Other Non-Operating Expense, Net increased $17.0 million, or 40.2%, during 1992. In 1992, this category included a gain of $10.3 million from the sale of three wholly-owned subsid- iaries and a $34.1 million loss related to the sale of ten MD-82 aircraft discussed above. In 1991, this category included a $12.5 million loss incurred in conjunction with the sale of nine Boeing B727-200 aircraft which had been previously retired from service. All of the Company's remaining available tax credit, or $117.6 million, was recognized upon the adoption of FAS 106 on January 1, 1992. The Company could not recognize any tax credit associated with the 1992 results due to limitations under Accounting Princi- ples Board Opinion No. 11. Inflation and Changing Prices Inflation and changing prices do not have a significant effect on the Company's operating revenues, operating expenses, and operating income because such revenues and expenses, other than depreciation and amortization, generally reflect current price levels. Depreciation and amortization expense is based on historical cost. For assets acquired through the purchase of Pacific Southwest Airlines, USAir's historical cost is based on fair market value of the assets on May 29, 1987. In the case of Piedmont Aviation, Inc., USAir's historical cost is based on the fair market value of the assets on November 5, 1987, reduced by the tax effect of that portion of fair market value not deductible for tax purposes in the form of depreciation and amortization. Therefore, aggregate depreciation and amortization is lower than if this expense reflected today's replacement costs for existing productive assets. In evaluating how inflation would increase depreciation expense, however, consideration should also be given to the reduction in other operating expenses, such as aircraft maintenance and aviation fuel, that would be achieved from the operating efficiencies of newer, more technologically advanced productive assets. LIQUIDITY AND CAPITAL RESOURCES Cash used by operations was $21.3 million during 1993, including a $220.0 million payment under USAir's revolving accounts receivable sale program ("Receivables Agreement"). At December 31, 1993, cash and cash equivalents totaled approximately $368.3 million, excluding $163.7 million which was deposited in trust accounts to collateralize letters of credit or workers compensation policies and classified as "Other Assets" on the Company's balance sheet. Although not currently available (see below), at Decem- ber 31, 1993, USAir Group had $300 million in commitments available for borrowing under its revolving credit agreement with a group of banks ("Credit Agreement") and no outstanding loans thereunder, and USAir had approximately $141 million of available funds under its Receivables Agreement. At February 28, 1994, cash and cash equivalents totaled approximately $363.5 million. Funds under the Credit Agreement and Receivables Agreement are not available to the Company and USAir because of violations of minimum net worth covenants in those agreements. On March 14, 1994, the Company and USAir announced that they are seeking waivers of compliance with the minimum net worth covenant and other anticipated covenant violations. There can be no assurance that the Company or USAir will be able to obtain the waivers or arrange replacement facilities. The Company and USAir are highly leveraged. In order to meet debt service, lease and other obligations and to finance daily operations, the Company and USAir require substantial liquidity and working capital. In addition, developments may occur which are beyond the control of the Company and USAir, including intensified fare wars or substantial increases in jet fuel prices, which could have a material adverse effect on the Company's prospects and financial condition. The Company and USAir have unencumbered assets, particularly if the Credit Agreement is terminated and the mortgage of aircraft equipment related thereto is released. The Company expects that it could use these unencumbered assets to raise funds to provide an infusion of liquidity. In addition, the second and third quarters of the year historically have been characterized by higher revenues and working capital than in the first and fourth quarters. Moreover, USAir is seeking in discus- sions with the leadership of its unionized employees substantial wage reductions, improved productivity and other cost savings. However, if unforeseen adverse developments occur, if the Company and USAir are unable to finance unencumbered assets, or if timely agreements with the employees are not reached, the Company and USAir may pursue other restructuring alternatives. See Item 1. "Business - Significant Impact of Low Fare, Low Cost Competition" and Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations - Low Cost, Low Fare Competi- tion." During 1993, the Company's investment in new aircraft acquisitions and purchase deposits totaled $545.3 million. USAir took delivery of 11 Boeing 757-200, one Boeing 767-200, and six MD- 82 aircraft during the year. The MD-82s were immediately sold to a third party. In addition, USAir sold two other MD-82 aircraft which had been delivered in the fourth quarter of 1992. Proceeds from the sale of the MD-82s approximated $168 million. The Company has completed financing arrangements for, including the $337.7 million issue of Pass Through Certificates ("Certificates") which USAir sold through an underwritten public offering on November 1, 1993, or internally funded, all of its 1993 aircraft expenditures. See Note 4(d) to the Company's Consolidated Financial Statements for the projected cash flows associated with aircraft orders and other contractual capital commitments. The Company has arranged committed financing for 100% of its 1994 and 1995 aircraft deliveries. On January 21, 1993, a wholly-owned subsidiary of BA purchased 30,000 shares of the 7% Series F Cumulative Convertible Senior Preferred Stock ("Series F Preferred Stock"), for $300 million. Substantially all of the $300 million received by the Company from the sale of the Series F Preferred Stock was used to pay down debt under the Company's Credit Agreement. The Series F Preferred Stock is subject to mandatory redemption on January 15, 2008. On May 4, 1993, the Company sold 11.5 million shares of $1 par value Common Stock at $20.75 per share which netted proceeds of approximately $231 million. BA partially exercised its preemptive right to maintain its proportionate ownership percentage by purchasing, on June 10, 1993, 9,919.8 shares of redeemable Series T-2 Cumulative Exchangeable Senior Preferred Stock ("Series T-2 Preferred Stock") for approximately $99.2 million. For additional information, see Note 8 to the Company's Consolidated Financial Statements. On March 7, 1994, BA announced that it would not make any additional investments in the Company until the outcome of measures by the Company to reduce costs and improve financial results is known. On July 8, 1993, USAir sold $300 million principal amount of 10% Senior Notes due 2003 (the "10% Notes") through an underwritten public offering. The offering netted proceeds of approximately $294 million. The 10% Notes are unconditionally guaranteed by the Company. On February 2, 1994, USAir sold $175 million principal amount of 9 5/8% Senior Notes due 2001 (the "9 5/8% Notes") through an underwritten public offering. The offering netted proceeds of approximately $172 million. The 9 5/8% Notes are unconditionally guaranteed by the Company. The 9 5/8% Notes are not reflected in the Company's December 31, 1993 balance sheet because they were issued after that time. All net proceeds received by USAir or the Company from the Common Stock offering, the sale to BA of the Series T-2 Preferred Stock, the sale of the 10% Notes and 9 5/8% Notes were added to the working capital of the Company for general corporate purposes, including the possible early repayment of certain outstanding debt with high interest rates. USAir and the Company have filed with the Securities and Exchange Commission ("SEC") a shelf registration for $700 million of various debt and equity securities. Approximately $187 million of securities remain available for sale on the shelf registration following the sale of the 9 5/8% Notes and may be sold from time- to-time depending on market conditions. The Company will continue to evaluate opportunities in the financial markets. On September 29, 1993, the maximum commitment available under the Credit Agreement decreased to $300 million from $600 million in accordance with the terms of the agreement. The Credit Agreement is due to expire on September 30, 1994. In September 1993, USAir Group obtained a waiver of compliance with the coverage ratio test required to be maintained as part of the Credit Agreement, for the period July 1 through September 30, 1993. Without this waiver, USAir Group would have violated this test on September 30, 1993. As of September 30, 1993, USAir Group was in compliance with the other financial covenants required to be maintained as part of the Credit Agreement. Moreover, in December 1993, USAir Group obtained an additional waiver under the Credit Agreement of compliance during the period October 1 through December 31, 1993 with the coverage ratio test. Without this waiver, USAir Group would have violated this test on December 31, 1993. The Company is currently unable to borrow under the Credit Agreement because it is in violation of a minimum net worth covenant thereunder. In addition, based on current projections of its results for 1994, USAir Group expects that it will not be in compliance with the coverage ratio test and possibly other financial covenants at March 31, 1994 and during the remainder of the year. There can be no assurance that USAir Group will be able to obtain a waiver of compliance with these covenants or to arrange a replacement facility. In September 1993 and December 1993, USAir obtained waivers of the coverage ratio test under the Receivables Agreement on the same terms as described above with respect to the Credit Agreement. At December 31, 1993, USAir was in compliance with the other financial covenants and had no amounts outstanding under the Receivables Agreement. The maximum amount of receivables which USAir may sell under the Receivables Agreement was $240 million at December 31, 1993 and will be adjusted downward to $190 million on June 30, 1994 if the Company's consolidated net worth does not exceed $1.5 billion. For purposes of this net worth comparison, the Company's actual net worth is adjusted to add back the initial and ongoing impact of adopting FAS 106 and certain other accounting pronounce- ments. USAir is currently unable to sell receivables under the Receivables Agreement because it is in violation of a minimum net worth covenant thereunder. In addition, based on current projec- tions of its results for 1994, USAir expects that it will not be in compliance with the coverage ratio test and possibly other financial covenants at March 31, 1994 and during the remainder of the year. There can be no assurance that USAir will be able to obtain a waiver of compliance with these covenants or to arrange a replacement facility. The Company's and USAir's debt and equity securities are presently rated below investment grade by Standard and Poor's Corporation ("S&P") and Moody's Investors Service, Inc. ("Moo- dy's"). Following the January 21, 1993 transaction in which a subsidiary of BA purchased $300 million of the Company's Series F Preferred Stock, Moody's placed the ratings on watch for possible upgrade. On March 19, 1993, Moody's confirmed its ratings of USAir Group and USAir securities. Following DOT approval of the purchase of the Series F Preferred Stock and the code sharing and wet lease relationship between USAir and BA, S&P affirmed its ratings of USAir Group and USAir securities, stating its ratings outlook was positive. In December 1993, S&P affirmed its ratings of USAir Group and USAir securities. However, the agency revised the ratings outlook to negative, citing, among other considerations, the status of the negotiations on a revised U.S.-U.K. bilateral air services agreement and the entrance and possible expansion of the operations of low fare, low cost air carriers into USAir's markets. In February 1994, as a result of USAir's low fare initiative in certain markets and its high cost structure, S&P and Moody's placed the securities of the Company and USAir on watch with negative implications. On March 24, 1994, S&P further downgraded the Company's and USAir's securities. This downgrade will make it more difficult for the Company and USAir to effect additional financing. In addition, the Company's and USAir's securities remain on watch with negative implications at S&P. In 1992, the Company's investment in new aircraft acquisitions and purchase deposits, net of deposits refunded, totaled $458.7 million. The Company purchased eight Fokker and four deHavilland Dash 8 aircraft during 1992. The acquisition of these aircraft was financed through a combination of secured debt financings and interim debt financings. In addition, USAir took delivery of four MD-82s, two of which were immediately sold to a third party. The remaining two aircraft delivered in 1992 were sold to a third party in early 1993. Cash outflows for other property during the period totaled $277.2 million, which includes $61 million paid to Continental for landing and take-off slots at LaGuardia and Washington National Airports and $50 million paid to TWA for London routes from BWI and Philadelphia International Airports. See Item 1. "Business - British Airways Investment Agreement - U.S.-U.K. Routes." Proceeds from disposition of assets of $429.5 million were realized during the year, primarily from sale-leaseback transactions, the sale of the two MD-82 aircraft, and the sale of three wholly-owned subsidiaries. During 1991, acquisition of new aircraft and purchase deposit payments amounted to $345 million. During 1991, USAir took delivery of two Boeing 767-200ER, nine Boeing 737-400, 12 Fokker 100, and five deHavilland Dash 8 aircraft. The acquisition of these aircraft was financed through a combination of sale-leaseback transactions, secured debt financings and interim debt financings. Expenditures for other property, consisting primarily of ground support equipment, leasehold improvements, and major aircraft components, totaled $97 million. Proceeds from disposition of property of $286 million were realized during 1991, primarily as a result of aircraft sale-leaseback transactions. In May 1991, USAir Group sold 4,263,050 Depositary Shares, each representing 1/100 of a share of $437.50 Series B Cumulative Convertible Preferred Stock, without par value, for net proceeds of $207.8 million. Such proceeds were used to repay indebtedness under USAir Group's Credit Agreement. At December 31, 1993, USAir Group's ratio of current assets to current liabilities was 0.53 to 1 and the debt component of USAir Group's capitalization structure was approximately 82% (100% if the redeemable Series A Cumulative Convertible Preferred Stock, the Series F Preferred Stock and the redeemable Series T Cumulative Convertible Exchangeable Senior Preferred Stock are considered to be debt). Item 8A. FINANCIAL STATEMENTS AND SUPPLEMENTARY INFORMATION USAir Group, Inc. Independent Auditors' Report The Stockholders and Board of Directors USAir Group, Inc.: We have audited the accompanying consolidated balance sheets of USAir Group, Inc. and subsidiaries ("Group") as of December 31, 1993 and 1992, and the related consolidated statements of opera- tions, cash flows, and changes in stockholders' equity (deficit) for each of the years in the three-year period ended December 31, 1993. These consolidated financial statements are the responsibil- ity of Group's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of USAir Group, Inc. and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993 in conformity with generally accepted accounting principles. As discussed in Note 11 to the consolidated financial statements, effective January 1, 1993, Group changed its method of accounting for postemployment benefits and effective January 1, 1992, Group changed its method of accounting for postretirement benefits other than pensions. KPMG PEAT MARWICK Washington, D. C. February 25, 1994 See accompanying Notes to Consolidated Financial Statements. See accompanying Notes to Consolidated Financial Statements. See accompanying Notes to Consolidated Financial Statements. USAir Group, Inc. Notes to Consolidated Financial Statements (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (a) Basis of Presentation The accompanying consolidated financial statements include the accounts of USAir Group, Inc. ("USAir Group" or the "Company") and its wholly-owned subsidiaries USAir, Inc. ("USAir"), Piedmont Airlines, Inc. ("Piedmont") (formerly Henson Aviation, Inc.), Jetstream International Airlines, Inc. ("Jetstream"), Pennsylvania Commuter Airlines, Inc. ("PCA"), USAir Leasing and Services, Inc. ("Leasing"), USAir Fuel Corporation and Material Services Company, Inc. All significant intercompany accounts and transactions have been eliminated. At December 31, 1992, USAM Corp. ("USAM"), a subsidiary of USAir, owned 11% of the Covia Partnership ("Covia") which owned and operated a computerized reservation system ("CRS"). In September 1993, Covia purchased the assets of the corporation that owned and operated the Galileo CRS which provided CRS services to travel agent subscribers in Europe. Covia was then separated into three new entities. As a result, at December 31, 1993, USAM owns 11% of the Galileo International Partnership which owns and operates the Galileo CRS, approximately 11% of the Galileo Japan Partnership which markets the Galileo CRS in Japan, and approximately 21% of the Apollo Travel Services Partnership which markets the Galileo CRS in the U.S. and Mexico. USAM accounts for these investments using the equity method. On August 1, 1992, two wholly-owned USAir Group's commuter airline subsidiaries, Allegheny Commuter Airlines, Inc. and PCA, merged. PCA, the surviving entity, operates under the name of Allegheny Commuter Airlines, with headquarters in Middletown, Pennsylvania. On July 15, 1992, USAir Group completed the sale of three of its wholly-owned subsidiaries: Piedmont Aviation Services, Inc., Air Service, Inc. and Aviation Supply Corporation. The Company realized a gain of $10.3 million as a result of the sale. The three former subsidiaries engaged in fixed base operations and the sale and repair of aircraft and aircraft components. These subsidiaries were included in the accounts until their sale. On October 9, 1991, USAir reached agreement for the sale of certain assets of its wholly-owned subsidiary Pacific Southwest Airmotive ("Airmotive"). Airmotive discontinued operations in the third quarter of 1991. USAir did not realize any material gain or loss on the sale and discontinuance of Airmotive's operations. USAir Group's principal operating subsidiary, USAir, and its three commuter airline subsidiaries, Piedmont, Jetstream and PCA, operate within one industry (air transportation); therefore, no segment information is provided. Certain 1992 and 1991 amounts have been reclassified to conform with 1993 classifications. (b) Cash and Cash Equivalents For financial statement purposes, the Company considers all highly liquid investments purchased with a maturity of three months or less to be cash equivalents. (c) Materials and Supplies Inventories of materials and supplies are valued at average cost and are charged to operations as consumed. An allowance for obsolescence is provided for flight equipment expendable parts. (d) Property and Equipment Property and equipment is stated at cost or, if acquired under capital leases, at the lower of the present value of minimum lease payments or fair market value at the inception of the lease. Maintenance and repairs, including the overhaul of aircraft components, are charged to operating expense as incurred and costs of major improvements are capitalized for both owned and leased assets. Interest related to deposits on aircraft purchase contracts and facility and equipment construction projects is capitalized as additional cost of the asset or as leasehold improvement if the asset is leased. Depreciation and amortization for principal asset classifications is provided on a straight-line basis to estimated residual values over estimated depreciable lives as follows: Property acquired under capital lease is amortized on a straight-line basis over the term of the lease and charged to depreciation expense. (e) Goodwill, Other Intangibles and Other Assets Goodwill, the cost in excess of fair value of identified net assets acquired, is being amortized on a straight-line basis over 40 years as other non-operating expense. Accumulated amortization at December 31, 1993 and 1992 was $98 million and $82 million, respectively. Intangible assets consist of purchased operating rights at various airports, purchased route authorities, and the intangible assets associated with the underfunded amounts of certain pension plans. The operating rights, valued at purchase cost or appraised value if acquired from Piedmont Aviation, Inc. ("Piedmont Avia- tion") or Pacific Southwest Airlines ("PSA"), are being amortized over periods ranging from ten to 25 years as Other Rent and Landing Fees Expense. The purchased route authorities are amortized over periods of 25 years as other operating expense. Accumulated amortization at December 31, 1993 and 1992 was $72 million and $65 million, respectively. The decrease in Other Intangibles, net in 1993 is primarily attributable to the $47 million reclassification of two London routes to Other Assets as a result of USAir's relinquishment of these routes as contemplated by the January 21, 1993 Investment Agreement ("Investment Agreement") between the Company and British Airways Plc ("BA"). USAir relinquished its Charlotte to London route authority in January 1994. In addition, takeoff and landing slots at Washington National Airport were purchased from Northwest Airlines, Inc. ("Northwest") for $10 million during 1993. (f) Restricted Cash and Investments Restricted cash and investments consist primarily of deposits in trust accounts to collateralize letters of credit or workers compensation policies and short-term investments restricted for specified construction projects. These amounts are classified as Other Assets on the accompanying balance sheets. (g) Deferred Gains on Sale and Leaseback Transactions Gains on aircraft sale and leaseback transactions are deferred and amortized over the term of the leases as a reduction of rental expense. (h) Passenger Revenue Recognition Passenger ticket sales are recognized as revenue when the transportation service is rendered. At the time of sale, a liability is established (Traffic Balances Payable and Unused Tickets) and subsequently eliminated either through carriage of the passenger, through billing from another carrier which renders the service or by refund to the passenger. (i) Frequent Traveler Awards USAir accrues the estimated incremental cost of providing outstanding travel awards earned by participants in its Frequent Traveler Program. (j) Investment Tax Credit Investment tax credit benefits are recorded using the "flow- through" method as a reduction of the Federal income tax provision. (k) Earnings Per Share Earnings per share is computed by dividing net loss, after deducting preferred stock dividend requirements, by the weighted average number of shares of Common Stock outstanding, net of treasury stock. USAir Group's outstanding redeemable Series A Cumulative Convertible Preferred Stock ("Series A Preferred Stock"), Series B Cumulative Convertible Preferred Stock ("Series B Preferred Stock"), redeemable Series F Cumulative Senior Preferred Stock ("Series F Preferred Stock"), redeemable Series T Cumulative Convertible Exchangeable Senior Preferred Stock ("Series T Preferred Stock) and common stock equivalents are anti-dilutive. (l) Swap Agreements USAir has entered into hedging arrangements to reduce its exposure to fluctuations in the price of jet fuel. Net settlements are recorded as adjustments to aviation fuel expense. USAir is party to such hedging arrangements with several entities. Under these arrangements, the Company's maximum commitments, which are offset by amounts received under the arrangements, totaled approximately $100.3 million and $158.7 million at December 31, 1993 and 1992, respectively. Although the agreements expose the Company to credit loss in the event of nonperformance by the other parties to the agreements, the Company does not anticipate such nonperformance. The Company has entered into interest rate swap transactions to manage interest rate exposure. Net settlements are recorded as an adjustment to interest expense. The Company is party to such interest rate swap agreements with banks and other financial institutions. The notional principal amounts of these agreements were $150 million and $400 million at December 31, 1993 and 1992, respectively. Under these swap agreements, the Company pays interest at fixed rates averaging 9.8% and 9.7% at December 31, 1993 and 1992, respectively, and receives floating rate interest payments based on three-month LIBOR. Although the agreements, which expire in 1995, expose the Company to credit loss in the event of non-performance by the other parties to the agreements, the Company does not anticipate such non-performance. (2) DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS Unless a quoted market price indicates otherwise, the fair values of cash and investments generally approximate carrying values because of the short maturity of these instruments. The Company has estimated the fair value of long-term debt based on quoted market prices for the same or similar issues or on the current rates offered to the Company for debt of similar remaining maturities. The estimated fair values of the Series A Preferred Stock, Series F Preferred Stock and Series T Preferred Stock are obtained by consulting with an independent external valuation source. The fair values of interest rate swap agreements, energy swap agreements and foreign currency contracts are obtained from dealer quotes whereby these values represent the estimated amount the Company would receive or pay to terminate such agreements. The estimated fair values of the Company's financial instru- ments are summarized as follows: (3) LONG-TERM DEBT Details of long-term debt are as follows: Maturities of long-term debt and debt under capital leases for the next five years are as follows: (in thousands) 1994 $ 87,833 1995 75,344 1996 73,464 1997 84,027 1998 152,180 Thereafter 2,059,002 In addition to the varying interest rate on Credit Agreement borrowings as described below, interest rates on $239 million principal amount of long-term debt at December 31, 1993 are subject to adjustment to reflect prime rate and other rate changes. The Company and a group of banks are parties to a Credit Agreement dated as of March 30, 1987, as amended (the "Credit Agreement") which makes a $300 million revolving credit facility available to the Company as of December 31, 1993. The Credit Agreement expires on September 30, 1994. At December 31, 1993, loans under the Credit Agreement, at the option of the Company, would have borne interest at a reference rate, a Eurodollar rate plus 2.50% - 2.65% per annum, determined by the Company's coverage ratio discussed below, or a bid rate if offered by a lending bank. During 1993, 1992 and 1991, the maximum amount of credit agreement borrowings outstanding at any month end was $250 million, $450 million and $733 million, respectively. All outstanding Credit Agreement borrowings were paid off in May 1993 and no other funds were borrowed during the remainder of 1993. The average amount of Credit Agreement borrowings outstanding and weighted average interest rate for 1993 were $37 million and 5.8%, respectively. The average amount of Credit Agreement borrowings outstanding and the weighted average interest rate for 1992 were $174 million and 6.2%, respectively. The average amount of Credit Agreement borrowings and the weighted average interest rate for 1991 were $510 million and 8.3%, respectively. On June 21, 1993, USAir Group entered into the Seventh Amendment to the Credit Agreement. The Seventh Amendment increased the limit of unsecured debt of subsidiaries to $300 million from $200 million. On December 21, 1993, the Company obtained a waiver under the Credit Agreement which further increased the limit of unsecured debt of subsidiaries to $620 million for the period commencing December 21, 1993 and ending on the final annual reduction date of September 30, 1994. This waiver also exempted the Company from compliance, for the quarter ended December 31, 1993, with the coverage ratio test which must be maintained as part of the Credit Agreement. The Company would not otherwise have complied with this test as of December 31, 1993 but was in compliance with the other financial covenants required to be maintained as part of the Credit Agreement. USAir Group is currently unable to borrow under the Credit Agreement because it is in violation of a minimum net worth covenant thereunder. In addition, based on current projections of its results for 1994, USAir Group expects that it will not be in compliance with the coverage ratio test and possibly other financial covenants at March 31, 1994 and during the remainder of the year. There can be no assurance that USAir Group will be able to obtain a waiver of compliance with these covenants or arrange a replacement facility. Certain USAir, Piedmont and PCA aircraft and engines with a net book value of $247 million at December 31, 1993 secure the Credit Agreement. Equipment financings totaling $2.0 billion are collateralized by aircraft and engines with a net book value of $2.2 billion at December 31, 1993. An aggregate of $32 million of future principal payments of the Equipment Financing Agreements are payable in Japanese Yen. This foreign currency exposure has been hedged to maturity. Although the Company is exposed to credit loss in the event of non- performance by the counterparty to the hedge agreement, the Company does not anticipate such non-performance. On February 2, 1994, USAir sold $175 million principal amount of 9 5/8% Senior Notes ("9 5/8% Senior Notes") which are uncondi- tionally guaranteed by the Company. The 9 5/8% Senior Notes are not reflected in the above table because they were sold after December 31, 1993. (4) COMMITMENTS AND CONTINGENCIES (a) Operating Environment The economic conditions in the United States, fare competition and the emergence and growth of lower cost, lower fare carriers in the domestic airline industry are factors affecting the financial condition of USAir Group. Industry capacity has recently failed to mirror changes in demand due primarily to the continued delivery of new aircraft and secondarily, to the prolonged operation of certain major U.S. carriers under the protection of Chapter 11 of the Bankruptcy Code. USAir competes with at least one major airline on most of its routes between major cities. Although the economy generally has shown signs of improvement, the Company expects that the competitive environment in the airline industry, the entry of low cost, low fare carriers into USAir's markets, and the excess capacity in the domestic airline industry will continue to have an adverse effect on USAir's passenger revenue for the foreseeable future. The extent or duration of these conditions cannot be reasonably determined at this time. (b) Lease Commitments The Company's airline subsidiaries lease certain aircraft, engines, computer and ground equipment, in addition to the majority of their ground facilities. Ground facilities include executive offices, overhaul and maintenance bases and ticket and administra- tive offices. Public airports are utilized for flight operations under lease arrangements with the municipalities or agencies owning or controlling such airports. Substantially all leases provide that the lessee shall pay taxes, maintenance, insurance and certain other operating expenses applicable to the leased property. Most leases also include renewal options and some aircraft leases include purchase options. The following amounts applicable to capital leases are included in property and equipment: At December 31, 1993, obligations under capital and noncancel- able operating leases for future minimum lease payments were as follows: Rental expense under operating leases for 1993, 1992 and 1991 was $781 million, $707 million and $605 million, respectively. Rental expense for 1993 excludes a charge of $9 million related to certain airport facilities where USAir has, among other things, discontinued or reduced its service. Rental expense for 1992 excludes a charge of $72 million related to USAir's grounded BAe- 146 fleet. Rental expense for 1991 excludes a credit of $9 million for the BAe-146 fleet. (c) Legal Proceedings The Company and various subsidiaries have been named as defendants in various suits and proceedings which involve, among other things, environmental concerns and employment matters. These suits and proceedings are in various stages of litigation, and the status of the law with respect to several of the issues involved is unsettled. For these reasons the outcome of these suits and proceedings is difficult to predict. In the Company's opinion, however, the disposition of these matters is not likely to have a material adverse effect on its financial condition or results of operations. In 1989 and 1990, a number of U.S. air carriers, including USAir, received two Civil Investigative Demands ("CIDs") from the U.S. Department of Justice ("DOJ") (a CID is a request for information in the course of an antitrust investigation and does not constitute the institution of a civil or criminal action) related to investigations of price fixing in the domestic airline industry. The investigations by the DOJ culminated in the filing of a lawsuit against Airline Tariff Publishing Company ("ATPCo") and eight major air carriers, including USAir, alleging that the defendants had agreed to fix prices in violation of Section 1 of the Sherman Act through the methods used to disseminate fare data to ATPCo, an airline-owned fare publishing service. To avoid the costs associated with protracted litigation and an uncertain outcome, USAir and another carrier decided to settle the lawsuit by entering into a consent decree to modify their fare-filing practices in certain respects and to implement compliance programs that would include education of employees regarding the carriers' responsibilities under the consent decree. Accordingly, the consent decree and the U.S. Government's complaint were filed contemporaneously in the U.S. District Court for the District of Columbia in December 1992. Due to certain legal requirements associated with the settlement of government antitrust suits, the consent decree could not be entered until a notice and comment period had expired. On November 1, 1993, after it had reviewed the comments, the Court entered the consent decree. USAir does not believe that the fare-filing practices reflected in the consent decree will have a material adverse effect on its financial condition or on its ability to compete. In March 1994, the remaining six air carrier defendants agreed to the entry of a separate consent decree to settle the lawsuit. This consent decree cannot be entered by the Court until a notice and comment period has expired. When that consent decree is entered, USAir can petition the Court to have its consent decree amended to conform with the other settlement and the Court will enter the amended consent decree. On March 19, 1993, the U.S. District Court in Atlanta, Georgia entered a settlement involving USAir and five other U.S. air carrier defendants in the Domestic Air Transportation Antitrust Litigation class action lawsuit. The class action suit, which was filed in July 1990, alleged that the airlines used ATPCo to signal and communicate carrier pricing intentions and otherwise limit price competition for travel to and from numerous hub airports. Under the terms of the settlement, the six air carriers will pay $45 million in cash and issue $396.5 million in certificates valid for purchase of domestic air travel on any of the six airlines. USAir's share of the cash portion of the settlement, $5 million, was recorded in results of operations for the second quarter of 1992. The certificates provide a dollar-for-dollar discount against the cost of a ticket generally of up to a maximum of 10% per ticket, depending on the cost of the ticket. It is possible that this settlement could have a dilutive effect on USAir's passenger transportation revenue and associated cash flow. However, due to the interchangeability of the certificates among the six carriers involved in the settlement, the possibility that carriers not party to the settlement will honor the certificates, and the potential stimulative effect on travel created by the certificates, USAir cannot reasonably estimate the impact of this settlement on future passenger revenue and cash flows. USAir has employed the incremental cost method to estimate a range of costs attributable to the exercise of the certificates, based on the assumption that the estimated maximum number of certificates to be redeemed for travel on USAir will be related to USAir's market share relative to the total market share of the six carriers involved in the settlement. USAir's estimated percentage of such market share is less than 9%. Incremental costs include unit costs for passenger food, beverages and supplies, fuel, liability insurance, and denied boarding compensation expenses expected to be incurred on a per passenger basis. USAir has estimated that its incremental cost will not be material based on the equivalent free trips associated with the settlement. The Attorney General of the State of Florida and the Attorneys General of several other states are investigating whether several major airlines, including USAir, have engaged in price fixing and other unlawful restraints of trade. Certain of these Attorneys General have issued document requests to USAir and several other airlines requiring them to provide certain information and documents. At this time, USAir cannot predict the manner in which these investigations will be resolved and if the resolution will have an adverse effect on USAir's results of operations or financial position. (d) Aircraft Commitments At December 31, 1993 USAir's new aircraft on firm order, options for new aircraft and scheduled payments for new aircraft orders (including progress payments, buyer furnished equipment, spares, and capitalized interest) were: USAir may elect, under certain circumstances, to convert Boeing 737 Series and Boeing 767 Series firm order or option deliveries to Boeing 757-200 deliveries. If USAir were to elect such a substitution, the payments presented in the table above would change. USAir is currently in negotiations with Boeing regarding, among other things, the above schedule of new aircraft deliveries. In addition, USAir has a commitment to purchase hushkits for certain of its McDonnell Douglas DC-9-30 aircraft and a substantial portion of its Boeing 737-200 aircraft. The installation of these hushkits will bring the aircraft into compliance with Federal Aviation Administration ("FAA") Stage 3 noise level requirements. The projected payments associated with the purchase of the hushkits are: $29.1 million - 1994; $12.0 million - 1995; $42.3 million - 1996; $43.4 million - 1997; $44.0 million - 1998; and $30.8 million thereafter. (e) Concentration of Credit Risk USAir Group does not believe it is subject to any significant concentration of credit risk. At December 31, 1993, most of the Company's receivables related to tickets sold to individual passengers through the use of major credit cards (48%) or to tickets sold by other airlines (17%) and used by passengers on USAir or the commuter subsidiaries. These receivables are short- term, generally being settled shortly after sale or in the month following usage. Bad debt losses, which have been minimal in the past, have been considered in establishing allowances for doubtful accounts. (f) Guarantees At December 31, 1993, USAir guaranteed payments of certain debt obligations of the Galileo International Partnership amounting to approximately $16 million. (5) SALE OF RECEIVABLES USAir is party to an agreement ("Receivables Agreement") to sell, on a revolving basis, undivided interest of up to $240 million in a pool of designated receivables. Approximately $141 million was available for sale at December 31, 1993 based on receivable balances at that date. The maximum amount available under the Receivables Agreement to be sold gradually reduces from $240 million at December 31, 1993, to $190 million on June 30, 1994. The Receivables Agreement expires on December 21, 1994. USAir had no outstanding amounts due under the Receivable Agreement at December 31, 1993. The net amounts sold reduce receivables in the accompanying balance sheet by $220 million and $188 million at December 31, 1992 and 1991, respectively. Included in the accounts payable balances at December 31, 1992 and 1991, are $74 million and $64 million, respectively, which represent funds held by USAir related to previously sold receivables that had been collected. USAir obtained a waiver from the purchaser of the receivables and its operating agent, exempting USAir from compliance with the coverage ratio financial covenant in the Receivables Agreement for the quarter ended December 31, 1993. USAir is currently unable to sell receivables under the Receivables Agreement because it is in violation of a minimum net worth covenant thereunder. In addition, based on current projections of its results for 1994, USAir expects that it will not be in compliance with the coverage ratio test and possibly other financial covenants at March 31, 1994 and during the remainder of the year. There can be no assurance that USAir will be able to obtain a waiver of compliance with these covenants or to arrange a replacement facility. (6) INCOME TAXES Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"). FAS 109 required a change from the deferred method under Accounting Principles Board Opinion No. 11 to the asset and liability method of accounting for income taxes. No cumulative adjustment at January 1, 1993, and no income tax credit for the year ended December 31, 1993, were recognized due to the FAS 109 limitation in recognizing benefits for net operating losses. The Company files a consolidated Federal income tax return with its wholly-owned subsidiaries. The components of the provision (credit) for income taxes are as follows: The significant components of deferred income tax expense/- (benefit) for the year ended December 31, 1993, are as follows: Deferred tax benefit (exclusive of the other components listed below) $(136,191) Adjustments to deferred tax assets and liabilities for enacted changes in tax laws and rates (8,880) Increase for the year in the valuation allowance for deferred tax assets 145,071 -------- Total $ 0 ======== For the years ended December 31, 1992 and 1991 deferred income taxes result from differences in the recognition of revenue and expenses and investment tax credits for tax and financial reporting purposes. The major items resulting in these differences and the related tax effects are shown in the following chart: A reconciliation of taxes computed at the statutory Federal tax rate on earnings before income taxes to the provision (credit) for income taxes is as follows: The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1993 are presented below: (in thousands) Deferred tax assets: Leasing transactions $ 132,551 Tax benefits purchased/sold 79,434 Gain on sale and leaseback transactions 164,613 Employee benefits 430,257 Net operating loss carryforwards 557,494 Alternative minimum tax credit carryforwards 21,146 Investment tax credit carryforwards 49,802 Other deferred tax assets 62,615 --------- Total gross deferred tax assets 1,497,912 Less valuation allowance (564,838) --------- Net deferred tax assets 933,074 Deferred tax liabilities: Equipment depreciation and amortization (874,640) Other deferred tax liabilities (58,434) --------- Net deferred tax liabilities (933,074) --------- Net deferred taxes $ 0 ========= The valuation allowance for deferred tax assets as of January 1, 1993, was $420 million. The increase in the valuation allowance during 1993 was $145 million. At December 31, 1993, the Company had unused net operating losses of $1.5 billion for Federal tax purposes, which expire in the years 2005-2008. The Company also has available, to reduce future taxes payable, $460 million alternative minimum tax net operating losses expiring in 2007 and 2008, $50 million of investment tax credits expiring in 2002 and 2003, and $21 million of minimum tax credits which do not expire. The Federal income tax returns of the Company through 1986 have been examined and settled with the Internal Revenue Service. (7) BRITISH AIRWAYS PLC INVESTMENT On January 21, 1993, USAir Group and BA entered into the Investment Agreement under which a wholly-owned subsidiary of BA purchased certain series of convertible preferred stock during 1993 (see Note 8 - Redeemable Preferred Stock) and BA entered into code sharing and wet lease arrangements with USAir contemplated by the Investment Agreement. On March 7, 1994, BA announced that it would not make any additional investments in the Company until the outcome of measures by the Company to reduce its costs and improve its financial results is known. At December 31, 1993, the preferred stock held by BA con- stituted approximately 22% of the total voting interest in the Company. To the extent permitted by foreign ownership restrictions which are applicable by statute regulations or interpretation by regulatory authorities, including the U.S. Department of Transpor- tation ("DOT") ("Foreign Ownership Restrictions"), the preferred stock owned by BA votes on all matters presented to the Company's stockholders for a vote and has voting power equal to the underly- ing shares of Common Stock. Under the Investment Agreement, on January 21, 1993, BA designated three of its officers to serve on the Company's Board of Directors. The Company has agreed to use its best efforts to place these designees on the slate of nominees for election as Directors of the Company. In addition to BA's holdings of the Company's preferred stock at December 31, 1993, BA has the option, which it has announced it will not exercise under current circumstances, to purchase, at a minimum, an additional $450 million of the Company's preferred stock. Under certain circumstances, BA is entitled, at its option, to purchase, on or prior to January 21, 1996, 50,000 shares of Series C Cumulative Convertible Senior Preferred Stock ("Series C Preferred Stock") resulting in an additional cash investment in the Company of $200 million, and, on or prior to January 21, 1998, 25,000 shares of Series E Cumulative Convertible Senior Preferred Stock ("Series E Preferred Stock") resulting in an additional cash investment in the Company of $250 million. If the DOT approves all the transactions and acts contemplated by the Investment Agreement, at the election of either BA or the Company on or prior to January 21, 1998, BA's purchase of the Series C Preferred Stock (unless previously consummated) and BA's purchase of the Series E Preferred Stock must be consummated under certain circumstances. On March 15, 1993, the DOT issued an order ("DOT Order") stating, among other things, that BA's initial investment does not impair USAir's citizenship under current U.S. Foreign Ownership Restrictions. However, the DOT instituted a proceeding to consider whether USAir will remain a U.S. citizen if the transactions and acts contemplated by the Investment Agreement, including the possible sale of Series C Preferred Stock and Series E Preferred Stock, to BA, are consummated. The DOT has indefinitely suspended the period for comments from interested parties pending its resolution of requests by other airlines for production of additional documents from USAir. The DOT Order states that the DOT expects and advises USAir and BA not to proceed with the closing of the purchase of the Series C Preferred Stock or the Series E Preferred Stock until the DOT has completed its review of USAir's citizenship. In any event, on March 7, 1994, BA announced it would not make any additional investments in the Company under current circumstances. USAir cannot predict the outcome of the proceedings or if further transactions contemplated under the Investment Agreement, including the sale of Series C and Series E Preferred Stock to BA, will be consummated. The sale of additional preferred stock to BA on June 10, 1993 (see Note 8(c)), did not result in BA's ownership of voting stock in the Company exceeding applicable foreign ownership restrictions and therefore does not affect the Company's U.S. citizenship under those restrictions. (8) REDEEMABLE PREFERRED STOCK (a) Series A Preferred Stock At December 31, 1993, the Company had 358,000 shares of its 9 1/4% Series A Cumulative Convertible Redeemable Preferred Stock ("Series A Preferred Stock"), without par value, outstanding which was convertible into 9,239,944 shares of the Company's Common Stock at a conversion price of approximately $38.74 per share. The Series A Preferred Stock ranks pari passu with the Series F Cumulative Convertible Senior Preferred Stock ("Series F Preferred Stock"), without par value, and Series T-_ Cumulative Convertible Exchangeable Senior Preferred Stock ("Series T Preferred Stock"), without par value, and senior to the Series B Cumulative Convert- ible Preferred Stock ("Series B Preferred Stock"), without par value, Junior Participating Preferred Stock, Series D ("Series D Preferred Stock"), without par value, and the Common Stock, with respect to dividend payments and the distribution of assets. At December 31, 1993, the Series A Preferred Stock is entitled to approximately 25.81 votes per share (determined by dividing the $1,000 liquidation preference per share of Series F Preferred Stock by the $38.74 conversion price), or a total of 9,239,944 votes, and votes together with the Series F Preferred Stock, the Series T Preferred Stock and the Common Stock, on all matters submitted to a vote of stockholders of the Company. The Series A Preferred Stock is redeemable on August 7, 1999 at $1,000 per share. The Company has the right to redeem the stock at a 10% premium until that time. The agreement relating to the sale of the Series A Preferred Stock imposes certain restrictions on the purchaser's ability to increase its ownership of, and to transfer, its stock in USAir Group. There have been no changes in the balance sheet value of the Series A Preferred Stock since its issuance in 1989. (b) Series F Preferred Stock At December 31, 1993, the Company had outstanding 30,000 shares of its 7% Series F Preferred Stock which was convertible into 15,458,658 shares of the Company's Common Stock at a conver- sion price of approximately $19.41 per share. The Series F Preferred Stock ranks pari passu with the Series A Preferred Stock and Series T Preferred Stock and senior to the Series B Preferred Stock, Series D Preferred Stock, and the Common Stock, with respect to dividend payments and the distribution of assets. At December 31, 1993, each share of Series F Preferred Stock was entitled to approximately 515.29 votes per share to the extent permitted by the existing Foreign Ownership Restrictions and votes with the Company's Series A Preferred Stock, the Series T Preferred Stock and the Company's Common Stock as a single class. Under Foreign Ownership Restrictions, no more than 25% of the Company's voting interest may be held by persons other than U.S. citizens. In accordance with the terms of any preferred stock held by BA, conversion rights and voting rights may not be exercised to the extent that doing so would result in a loss of the Company's or any of its subsidiaries' operating certificates and authorities under Foreign Ownership Restrictions, and it is assumed for this purpose that Series F Preferred Stock will be fully converted before any other preferred stock held by BA. The Series F Preferred Stock is convertible at any time on or after January 21, 1997 to the extent that such conversion would not violate U.S. Foreign Ownership Restrictions. Series F Preferred Stock may be converted at the option of the Company at any time after January 21, 1998 if the average composite closing market price of Common Stock during any 30-day calendar period is at least 133% of the conversion price. The Series F Preferred Stock is mandatorily redeemable on January 21, 2008. If BA has not purchased the Series C Preferred Stock by January 21, 1996, then the Company may at its option redeem, in whole or in part, Series F Preferred Stock at the higher of market value or the price of $10,000 per share, plus accrued dividends. The Series F Certifi- cate provides that if on any one occasion on or prior to Janu- ary 21, 1996, any court or regulatory authority issues a final order that any material part of the Investment Agreement is unenforceable (except pursuant to bankruptcy or like event), then the conversion price of Series F Preferred Stock shall be reduced by 10.2564%. There have been no changes in the balance sheet value of the Series F Preferred Stock since its issuance in 1993. (c) Series T Preferred Stock Under the Investment Agreement, BA has preemptive and optional purchase rights to maintain its proportionate ownership of the Company's Common Stock and convertible securities, measured in terms of the BA Percentage ("BA Percentage") which approximates BA's fully diluted ownership percentage based on BA's current and potential holdings in the Company. The BA Percentage is calculated without regard to Foreign Ownership Restrictions at the time of the calculation. BA may exercise such preemptive or optional purchase rights by purchasing, from time-to-time, a series of Series T Preferred Stock. At December 31, 1993, the Company had two series of the Series T Preferred Stock outstanding. On June 10, 1993, BA exercised its preemptive purchase right by purchasing 9,919.8 shares of a series of the Series T Preferred Stock ("Series T-2 Preferred Stock") for approximately $99.2 million and exercised its optional purchase right by purchasing 152.1 shares of a series of Series T Preferred Stock ("T-1 Preferred Stock") for approximately $1.5 million. BA's preemptive right was triggered by the issuance of Common Stock, as described in Note 8 - Stockholders' Equity, and BA's optional purchase rights were triggered by the Company's issuance of additional shares of Common Stock through the exercise of options under various employee stock option plans and through the sale of shares to certain defined contribution plans during the period from January 21, 1993 to March 31, 1993. On March 7, 1994, BA advised the Company that it would not exercise its optional purchase rights to buy three additional series of Series T Preferred Stock triggered by the Company's issuance of common stock pursuant to certain employee benefit plans during the second, third and fourth quarters of 1993. There have been no changes in the balance sheet value of the Series T-1 Preferred Stock and Series T-2 Preferred Stock since their issuance in 1993. The terms of all series of the Series T Preferred Stock are substantially similar to those of the Series F Preferred Stock except as noted. Each share of Series T-2 Preferred Stock carries a conversion price of $26.40 and is convertible into approximately 378.79 shares of Common Stock or Non-Voting Class ET stock. Each share of Series T-1 Preferred Stock has a conversion price of $20.50 and is convertible into approximately 487.80 shares of Common Stock or Non-Voting Class ET stock. With respect to the Series T Preferred Stock, dividends are payable quarterly in arrears, at 50 basis points over the three-month LIBOR rate. Any shares of the Series T Preferred Stock held by any person other than BA or its subsidiaries may be redeemed for cash at any time at the option of the Company at $10,000 plus accrued dividends plus a redemption premium equal to $700 from the date of issue until the first anniversary thereof and reduced by $46.67 on each anniversary thereafter. The Series T Preferred Stock is exchangeable, at the option of the Company, for that principal amount of floating rate convertible subordinated notes of the Company ("T Notes") equal to the liquidation preference of the shares to be exchanged and bearing interest at the dividend rate. Any accrued dividends on the Series T Preferred Stock to be exchanged will be treated as accrued interest on the T Notes. Each $10,000 aggregate principal amount of such T Notes will be entitled to a number of votes equal to the number of votes to which each share of Series T Preferred Stock was entitled at the time of its exchange for T Notes, subject to adjustment. If issued, T Notes will have terms otherwise consis- tent with the terms of the Series T Preferred Stock. (9) STOCKHOLDERS' EQUITY (a) Common Stock The Company had 150,000,000 and 100,000,000 authorized shares of Common Stock, par value $1, at December 31, 1993 and 1992, respectively. If BA purchases the Series C Preferred Stock (see Note 6 - British Airways Plc Investment), the number of authorized shares of various classes of Common Stock will increase to 300,000,000. BA has indicated, however, that it will not make any additional investments in the Company under current circumstances. At December 31, 1993, approximately 52,618,000 shares were reserved for issuance upon the conversion of preferred stock and for offerings under employee stock purchase, stock option and stock incentive plans. On May 4, 1993, the Company sold 11.5 million shares of previously unissued Common Stock at $20.75 per share through a public, underwritten offering. The offering netted proceeds of approximately $231 million. (b) Preferred Stock and Senior Preferred Stock At December 31, 1993, the Company had 5,000,000 authorized shares of preferred stock, without nominal or par value, of which 358,000 shares were issued as Series A Preferred Stock, 43,000 shares were issued as Series B Preferred Stock and 1,035,000 shares were reserved as Series D Preferred Stock. Also, at December 31, 1993, the Company had 3,000,000 authorized shares of Senior Preferred Stock, without nominal or par value, of which 30,000 shares were issued as Series F Preferred Stock and approximately 10,000 were issued as Series T Preferred Stock. (c) Series B Preferred Stock At December 31, 1993, the Company had 4,263,050 Depositary Shares, representing 42,630.5 shares of its $437.50 Series B Preferred Stock outstanding. Each Depositary Share represents 1/100 of a share of the Series B Preferred Stock. The Series B Preferred Stock is convertible at any time, at the option of the holder, at the rate of 249.25 shares of Common Stock of the Company per preferred share, or 2.4925 shares of Common Stock per De- positary Share. The Series B Preferred Stock ranks junior to the Company's Series A Preferred Stock, the Series F Preferred Stock and the Series T Preferred Stock and senior to the Series D Preferred Stock and the Common Stock with respect to dividend payments and the distribution of assets, whether upon liquidation or otherwise. Except under certain circumstances, the holders of Series B Preferred Stock have no voting rights. The Series B Preferred Stock is not redeemable prior to May 15, 1994. The Series B Preferred Stock is redeemable, at the option of the Company and with consent of the holders of Series F Preferred Stock, on or after May 15, 1994, (i) in whole but not in part, only in certain circumstances, for so long as any shares of Series A Preferred Stock are outstanding; and (ii) in whole or in part if no shares of Series A Preferred Stock are outstanding, in each case initially at a redemption price of approximately $53.06 per 1/100 of a share and thereafter at prices declining to $50 per 1/100 of a share (equivalent to $5,000 per share of Series B Preferred Stock) on or after May 15, 2001, plus dividends accrued and accumulated but unpaid to the redemption date. (d) Preferred Stock Purchase Rights Each outstanding share of Common Stock is accompanied by one Preferred Share Purchase Right ("Right") and each outstanding share of Series A Preferred Stock, Series F Preferred Stock and Series T Preferred Stock is accompanied by a Right for each share into which it is convertible. Each Right entitles the holder to buy 1/100th of a share of Series D Preferred Stock at an exercise price of $175 per Right. The Rights expire on June 29, 1996. As long as the Rights remain outstanding, the Company will issue one Right with each new share of Common Stock issued upon the conversion of any preferred stock into, or the exercise of any options for, Common Stock, as long as such preferred stock or options were outstanding prior to the Rights becoming exercisable. Generally, the Rights become exercisable only if a party other than, under certain circumstances, BA acquires 20% or more of the Company's Common Stock or announces a tender offer for 20% or more of the Common Stock. The Rights are redeemable at $.03 per Right at any time before 20% or more of the Company's Common Stock has been acquired. If at any time after the Rights become exercisable and before they have been redeemed the Company is involved in a merger or other business combination transaction, the Rights will automatically entitle a holder, other than a holder of 20% or more of the Company's Common Stock, to receive, upon exercise of each Right, a number of shares of Common Stock, or a number of common shares of the acquiring company, as the case may be, having a market value of two times the exercise price of each Right. In addition, at any time after the acquisition of 30% or more of the Common Stock by any person and prior to the acquisition by such person of 50% or more of the Common Stock, the Board of Directors of the Company may exchange the Rights (other than Rights owned by such person which have become void), in whole or in part, at an exchange ratio of one share of Common Stock, or 1/100th of a share of Series D Preferred Stock, per Right. Until the first to occur of the redemption or expiration of the Rights, the Company will issue one Right with each new share of Common Stock issued upon the conversion of any securities into, or the exercise of any options or warrants for, Common Stock if such securities, options or warrants were outstanding prior to when Rights became exercisable. (e) Treasury Stock In 1989, the Company's Board of Directors authorized the repurchase from time-to-time of up to 9.4 million shares of its Common Stock in open market transactions. In 1989, approximately 2.1 million shares were repurchased. The Company sold approximate- ly 500,000 shares and approximately 390,000 shares of its treasury stock during 1993 and 1992, respectively. The remaining shares are carried on the accompanying balance sheet at the average acquisi- tion cost. (f) Employee Stock Option and Purchase Plans During 1992, the Company's stockholders approved the 1992 Stock Option Plan ("1992 Plan") which allows for the issuance of stock options to purchase up to 8,125,000 shares of USAir Group Common Stock to USAir employees who participate in the previously announced cost reduction program. Under the stock option program, employees whose pay was or is currently being reduced receive options to purchase 50 shares of Common Stock at a price not less than $15 per share for each $1,000 of salary reduction. The Company will grant stock options under the 1992 Plan only in connection with salary reductions. Participating employees have five years from the grant date to exercise such options. Options, with an exercise price of $15, have been granted to purchase ap- proximately five million shares of Common Stock in conjunction with salary reductions. The Company plans to seek authority from its stockholders at its 1994 Annual Meeting to reduce the number of shares reserved for this plan. At December 31, 1993, 5.3 million shares of Common Stock are reserved for the granting of stock options or restricted stock under the Company's 1984 Stock Option and Stock Appreciation Rights ("SARs") Plan and 1988 Stock Incentive Plan. These plans provide that options may be granted as either nonqualified or incentive stock options. Options awarded prior to 1991, except for those that reverted, have vested. Options awarded during 1991, 1992 and 1993, except under the 1992 Plan, become exercisable generally within three years from date of grant. Optionees may also receive SARs which permit them to receive, in lieu of the right to exercise the stock option, an amount equivalent to the difference between the stock option price and the fair market value of the Common Stock on the date of exercising the right. This amount may be paid in stock, in cash, or in any combination of the two. Also, restricted stock award grants for 57,000 shares and 111,600 shares were outstanding at December 31, 1993 and 1992, respectively. Deferred compensation related to the restricted stock, which vests over periods of up to five years, amounted to $.3 million and $ .6 million at December 31, 1993 and 1992, respectively. As of December 31, 1993, options to acquire approximately 9 million shares under all three plans, including 85,000 SARs, were outstanding at a weighted average exercise price of $18.77. Of those outstanding, approximately six million options were exercis- able at December 31, 1993. Options were exercised to purchase approximately 33,500 and 6,000 shares of Common Stock at average exercise prices of $17.24 and $10.44 during 1993 and 1992, respectively. (g) Dividend Restrictions The Company's Credit Agreement does not contain specific provisions which restrict the payment of dividends by USAir Group. The amount of dividends, however, is indirectly restricted through the existence of certain covenants contained in the Credit Agreement. At December 31, 1993, under the most restrictive of these provisions, the Company's ability to pay dividends is limited to approximately $77 million. (10) EMPLOYEE STOCK OWNERSHIP PLAN In August 1989, USAir established an Employee Stock Ownership Plan ("ESOP"). The Company sold 2,200,000 shares of Common Stock to an Employee Stock Ownership Trust to hold on behalf of USAir's employees, exclusive of officers, in accordance with the terms of the Trust and the ESOP. Financing of approximately $111.4 million for the Trust's purchase of the shares was provided by USAir through a 9 3/4% loan to the Trust, and an additional $2.2 million was contributed to the Trust by USAir. The loan is being repaid with contributions made by USAir. The contributions are made in amounts equal to the periodic loan payments as they come due, less dividends available for loan payment. The amount of dividends used for debt service by the ESOP was $127,000 in 1991. As the loan is repaid over time, participating employees receive allocations of the Common Stock purchased by the Trust. The initial maturity of the loan is 30 years. However, the ESOP provides that if the Company's profitability as measured by return on sales exceeds certain goals during the life of the ESOP, USAir's contributions and the repayment of the loan will be accelerated. Contributions made by USAir and therefore loan repayments made by the Trust were $11.4 million in 1993, 1992 and 1991. The interest portion of these contributions was $10.5 million in 1993, $10.6 million in 1992 and $10.7 million in 1991. Approximately 366,000 shares of Common Stock have been allocated to employees. USAir recognized approximately $4 million of compensation expense related to the ESOP in each of 1993, 1992 and 1991 based on shares allocated to employees (the "shares allocated" method). Deferred compensation related to the ESOP amounted to approximately $95 million, $98 million and $102 million at December 31, 1993, 1992 and 1991, respectively. (11) EMPLOYEE BENEFIT PLANS (a) Pension Plans The Company's subsidiaries have several pension plans in effect covering substantially all employees. One qualified defined benefit plan covers USAir maintenance employees and provides benefits of stated amounts for specified periods of service. Qualified defined benefit plans for substantially all other employees provide benefits based on years of service and compensa- tion. The qualified defined benefit plans are funded, on a current basis, to meet requirements of the Employee Retirement Income Security Act of 1974. The defined benefit pension plan for USAir non-contract employees was frozen at the end of 1991 for all non-contract participants, resulting in a one-time book gain of approximately $107 million in 1991. All non-contract plan participants became 100% vested at the time of the freeze. As a result of this plan curtailment, the accrual of service costs related to defined benefits for USAir non-contract employees ceased at the end of 1991. USAir implemented a defined contribution pension plan for non-contract employees in January 1993. The funded status of the qualified defined benefit plans at December 31, 1993 and 1992 was as follows: Approximately 97% of the accumulated benefit obligation was vested at December 31, 1993 and 1992. Unrecognized transition assets are being amortized over periods up to 27 years. The weighted average discount rate used to determine the actuarial present value of the projected benefit obligation was 7.6% and 8.75% as of December 31, 1993 and 1992, respectively. The expected long-term rate of return on plan assets used in 1993 and 1992 was 9.5%. Rates of 3% to 6% were used to estimate future salary levels. At December 31, 1993, plan assets consisted of approxi- mately 8% in cash equivalents and short-term debt investments, 37% in equity investments, and 55% in fixed income and other invest- ments. At December 31, 1992, plan assets consisted of approximate- ly 4% in cash equivalents and short-term debt investments, 70% in equity investments, and 26% in fixed income and other investments. The following items are the components of the net pension cost for the qualified defined benefit plans: Net pension cost for 1993 and 1991 presented above excludes a settlement charge of approximately $33.9 million and $21.6 million, respectively, related to "early-out" incentive programs offered to a limited number of USAir employees during the years. No such charges were incurred in 1992. Non-qualified supplemental pension plans are established for certain employee groups, which provide incremental pension payments from the Company's funds so that total pension payments equal amounts that would have been payable from the Company's principal pension plans if it were not for limitations imposed by income tax regulations. The following table sets forth the non-qualified plans' status at December 31, 1993 and 1992: Net supplementary pension cost for the two years included the following components: The discount rate used to determine the actuarial present value of the projected benefit obligation was 7.5% and 8.75% as of December 31, 1993 and 1992, respectively. Rates of 3% to 6% were used to estimate future salary levels. In addition to the qualified and non-qualified defined benefit plans described above, USAir also contributes to certain defined contribution plans primarily for employees not covered under a collective bargaining agreement. Company contributions are based on a formula which considers the age and pre-tax earnings of each employee and the amount of employee contributions. The Company's contribution expense was $42 million for 1993. The Company recognized no such expense in 1992 or 1991. (b) Postretirement Benefits Other Than Pensions USAir offers medical and life insurance benefits to employees who retire from the Company and their eligible dependents. The medical benefits provided by USAir are coordinated with Medicare benefits. Retirees generally contribute amounts towards the cost of their medical expenses based on years of service with the Company. USAir provides uninsured death benefit payments to survivors of retired employees for stated dollar amounts, or in the case of retired pilot employees, death benefit payments determined by age and level of pension benefit. The plans for postretirement medical and death benefits are funded on the pay-as-you-go basis. USAir adopted Statement of Financial Accounting Standards No. 106 ("FAS 106") during 1992 and elected to record the January 1, 1992 Accumulated Postretirement Benefit Obligation ("APBO") using the immediate recognition approach. The cumulative effect of adopting FAS 106 was $745.7 million ($628.1 million net of tax benefit). The following table sets forth the financial status of the plans as of December 31, 1993 and 1992: The components of net periodic postretirement benefit cost are as follows: The postretirement benefit expense for 1993 presented above excludes a charge of approximately $15.5 million related to "early out" programs offered to a limited number of employees during the year. No such charges were incurred in 1992 or 1991. The discount rate used to determine the APBO was 7.75% and 8.75% at December 31, 1993 and 1992, respectively. The assumed health care cost trend rate used in measuring the APBO was 10.5% in 1993 and 1994, declining by 1% per year after 1994 to an ultimate rate of 4.5%. If the assumed health care cost trend rate were increased by one percentage point, the APBO at December 31, 1993 would be increased by 10% and 1993 periodic postretirement benefit cost would increase 13%. Prior to the adoption of FAS 106, USAir recognized expense for retiree health care at an estimated monthly rate (based on payments) and recognized expense for death benefits when paid. The expense using this methodology was approximately $8 million for 1991. (c) Postemployment Benefits USAir adopted Statement of Financial Accounting Standards No. 112, "Employer's Accounting for Postemployment Benefits" ("FAS 112"), during 1993. FAS 112 requires the use of an accrual method to recognize postemployment benefits such as disability-related benefits. The cumulative effect at January 1, 1993 of adopting FAS 112 was $43.7 million. (12) SUPPLEMENTAL BALANCE SHEET INFORMATION The components of certain accounts in the accompanying balance sheets are as follows: (13) NON-RECURRING AND UNUSUAL ITEMS (a) 1993 The Company's results for 1993 include non-recurring charges of (i) $43.7 million for the cumulative effect of an accounting change, as required by FAS 112 which was adopted during the third quarter of 1993, retroactive to January 1, 1993; (ii) $68.8 million for severance, early retirement and other personnel-related expenses recorded primarily during the third quarter of 1993 in connection with a workforce reduction of approximately 2,500 full- time positions between November 1993 and the first half of 1994; (iii) $36.8 million based on a projection of the repayment of certain employee pay reductions, recorded in the fourth quarter of 1993; (iv) $13.5 million for certain airport facilities at locations where USAir has, among other things, discontinued or reduced its service, recorded in the fourth quarter of 1993; (v) $8.8 million for a loss on USAir's investment in the Galileo International Partnership which operates a computerized reserva- tions system, recorded in the fourth quarter of 1993; and (vi) $18.4 million credit related to non-operating aircraft recorded in the second quarter of 1993. (b) 1992 The Company's results for 1992 include (i) a charge of $628.1 million for the cumulative effect of an accounting change as required by FAS 106, effective January 1, 1992; (ii) a $107.4 million charge related to certain aircraft which have been withdrawn from service, recorded in the fourth quarter of 1992; (iii) a $34.1 million non-operating loss related to the sale of ten MD-82 aircraft which USAir eliminated from its fleet plan, recorded in the fourth quarter of 1992; and (iv) a $10.3 million gain on the sale of three wholly-owned subsidiaries, recorded in the third quarter of 1992 (see Note (1)). (c) 1991 The Company's results for 1991 include (i) a $107 million pre- tax gain related to freezing of the fully funded non-contract employee pension plan; (ii) a $21.6 million pre-tax expense related to early retirement incentives offered to certain employees during 1991; (iii) a $21 million pre-tax charge to establish an additional reserve for USAir's grounded BAe-146 fleet; and (iv) $18.5 million, net, in miscellaneous non-recurring charges. (14) SELECTED QUARTERLY FINANCIAL DATA (Unaudited) The following table presents selected quarterly financial data for 1993 and 1992: Item 8B. FINANCIAL STATEMENTS AND SUPPLEMENTARY INFORMATION USAir, Inc. Independent Auditors' Report The Stockholder and Board of Directors USAir, Inc.: We have audited the accompanying consolidated balance sheets of USAir, Inc. and subsidiaries ("USAir") as of December 31, 1993 and 1992, and the related consolidated statements of operations, cash flows, and changes in stockholder's equity for each of the years in the three-year period ended December 31, 1993. These consolidated financial statements are the responsibility of USAir's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of USAir, Inc. and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993 in conformity with generally accepted accounting principles. As discussed in Note 9 to the consolidated financial state- ments, effective January 1, 1993, USAir changed its method of accounting for postemployment benefits and effective January 1, 1992, USAir changed its method of accounting for postretirement benefits other than pensions. KPMG PEAT MARWICK Washington, D. C. February 25, 1994 (PAGE> USAir, Inc. Notes to Consolidated Financial Statements (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (a) Basis of Presentation The accompanying consolidated financial statements include the accounts of USAir, Inc. ("USAir") and its wholly-owned subsidiary USAM Corp. ("USAM"). USAir is a wholly-owned subsidiary of USAir Group, Inc. ("USAir Group" or "the Company"). All significant intercompany accounts and transactions have been eliminated. At December 31, 1992, USAM owned 11% of the Covia Partnership ("Covia") which owned and operated a computerized reservation system ("CRS"). In September 1993, Covia purchased the assets of the corporation that owned and operated the Galileo CRS which provided services to travel agent subscribers in Europe. Covia was then separated into three new entities. As a result, at Decem- ber 31, 1993, USAM owns 11% of the Galileo International Partner- ship which owns and operates the Galileo CRS, approximately 11% of the Galileo Japan Partnership which markets the Galileo CRS in Japan and approximately 21% of the Apollo Travel Services Partner- ship which markets the Galileo CRS in the U.S. and Mexico. USAM accounts for these investments using the equity method. On October 9, 1991, USAir reached agreement for the sale of certain assets of its wholly-owned subsidiary Pacific Southwest Airmotive ("Airmotive"). Airmotive discontinued operations in the third quarter of 1991. USAir did not realize any material gain or loss on the sale and discontinuance of Airmotive's operations. Certain 1992 and 1991 amounts have been reclassified to conform with 1993 classifications. (b) Cash and Cash Equivalents For financial statement purposes, the Company considers all highly liquid investments purchased with a maturity of three months or less to be cash equivalents. (c) Materials and Supplies Inventories of materials and supplies are valued at average cost and are charged to operations as consumed. An allowance for obsolescence is provided for flight equipment expendable parts. (d) Property and Equipment Property and equipment is stated at cost or, if acquired under capital leases, at the lower of the present value of minimum lease payments or fair market value at the inception of the lease. Maintenance and repairs, including the overhaul of aircraft components, are charged to operating expense as incurred and costs of major improvements are capitalized for both owned and leased assets. Interest related to deposits on aircraft purchase contracts and facility and equipment construction projects is capitalized as additional cost of the asset or as leasehold improvement if the asset is leased. Depreciation and amortization for principal asset classifications is provided on a straight-line basis to estimated residual values over estimated depreciable lives as follows: Property acquired under capital lease is amortized on a straight-line basis over the term of the lease and charged to depreciation expense. (e) Goodwill, Other Intangibles and Other Assets Goodwill, the cost in excess of fair value of identified net assets acquired, is being amortized on a straight-line basis over 40 years as other non-operating expense. Accumulated amortization at December 31, 1993 and 1992 was $98 million and $82 million, respectively. Intangible assets consist of purchased operating rights at various airports, purchased route authorities, and the intangible assets associated with the underfunded amounts of certain pension plans. The operating rights, valued at purchase cost or appraised value if acquired from Piedmont Aviation, Inc. ("Piedmont Avia- tion") or Pacific Southwest Airlines ("PSA"), are being amortized over periods ranging from ten to 25 years as Other Rent and Landing Fees Expense. The purchased route authorities are amortized over periods of 25 years as other operating expense. Accumulated amortization at December 31, 1993 and 1992 was $72 million and $64 million, respectively. The decrease in Other Intangibles, net in 1993 is primarily attributable to the $47 million reclassification of two London routes to Other Assets as a result of USAir's relinquishment of these routes as contemplated by the January 21, 1993 Investment Agreement ("Investment Agreement") between the Company and British Airways Plc ("BA"). USAir relinquished its Charlotte to London route authority in January 1994. In addition, takeoff and landing slots at Washington National Airport were purchased from Northwest Airlines, Inc. ("Northwest") for $10 million during 1993. (f) Restricted Cash and Investments Restricted cash and investments consist primarily of deposits in trust accounts to collateralize letters of credit or workers compensation policies and short-term investments restricted for specified construction projects. These amounts are classified as Other Assets on the accompanying balance sheets. (g) Deferred Gains on Sale and Leaseback Transactions Gains on aircraft sale and leaseback transactions are deferred and amortized over the term of the leases as a reduction of rental expense. (h) Passenger Revenue Recognition Passenger ticket sales are recognized as revenue when the transportation service is rendered. At the time of sale, a liability is established (Traffic Balances Payable and Unused Tickets) and subsequently eliminated either through carriage of the passenger, through billing from another carrier which renders the service or by refund to the passenger. Approximately $29 million and $28 million of amounts owed to wholly-owned subsidiaries of USAir Group for passenger transportation revenue are included in Traffic Balances Payable and Unused Tickets at December 31, 1993 and 1992, respectively. (i) Frequent Traveler Awards USAir accrues the estimated incremental cost of providing outstanding travel awards earned by participants in its Frequent Traveler Program. (j) Investment Tax Credit Investment tax credit benefits are recorded using the "flow- through" method as a reduction of the Federal income tax provision. (k) Swap Agreements USAir has entered into hedging arrangements to reduce its exposure to fluctuations in the price of jet fuel. Net settlements are recorded as adjustments to aviation fuel expense. USAir is party to such hedging arrangements with several entities. Under these arrangements, the Company's maximum commitments, which are offset by amounts received under the arrangements, totaled approximately $100.3 million and $158.7 million at December 31, 1993 and 1992, respectively. Although the agreements expose the Company to credit loss in the event of nonperformance by the other parties to the agreements, the Company does not anticipate such nonperformance. (2) DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS Unless a quoted market price indicates otherwise, the fair values of cash and investments generally approximate carrying values because of the short maturity of these instruments. USAir has estimated the fair value of long-term debt based on quoted market prices for the same or similar issues or on the current rates offered to the Company for debt of similar remaining maturities. The fair values of energy swap agreements and foreign currency contracts are obtained from dealer quotes whereby these values represent the estimated amount USAir would receive or pay to terminate such agreements. The estimated fair values of USAir's financial instruments are summarized as follows: (3) LONG-TERM DEBT Details of long-term debt are as follows: Maturities of long-term debt and debt under capital leases for the next five years are as follows: (in thousands) 1994 $ 85,715 1995 75,691 1996 75,715 1997 86,496 1998 155,234 Thereafter 2,153,879 Interest rates on $239 million principal amount of long-term debt at December 31, 1993 are subject to adjustment to reflect prime rate and other rate changes. Equipment financings totaling $2.1 billion are collateralized by aircraft and engines with a net book value of $2.2 billion at December 31, 1993. In addition, certain USAir aircraft and engines with a net book value of $162 million collateralize USAir Group's Credit Agreement borrowings. An aggregate of $32 million of future principal payments of the Equipment Financing Agreements are payable in Japanese Yen. This foreign currency exposure has been hedged to maturity. Although the Company is exposed to credit loss in the event of non- performance by the counterparty to the hedge agreement, the Company does not anticipate such non-performance. On February 2, 1994, USAir sold $175 million principal amount of 9 5/8% Senior Notes ("9 5/8% Senior Notes") which are uncondi- tionally guaranteed by the Company. The 9 5/8% Senior Notes are not reflected in the above table because they were sold after December 31, 1993. (4) COMMITMENTS AND CONTINGENCIES (a) Operating Environment The economic conditions in the United States, fare competition and the emergence and growth of low cost, low fare carriers in the domestic airline industry are factors affecting the financial condition of USAir. Industry capacity has recently failed to mirror changes in demand due primarily to the continued delivery of new aircraft and secondarily, to the prolonged operation of certain major U.S. carriers under the protection of Chapter 11 of the Bankruptcy Code. USAir competes with at least one major airline on most of its routes between major cities. Although the economy generally has shown signs of improvement, the Company expects that the competitive environment in the airline industry, the entry of low cost, low fare carriers into USAir's markets, and the excess capacity in the domestic airline industry will continue to have an adverse effect on USAir's passenger revenue for the foreseeable future. The extent or duration of these conditions cannot be reasonably determined at this time. (b) Lease Commitments USAir leases certain aircraft, engines, computer and ground equipment, in addition to the majority of its ground facilities. Ground facilities include executive offices, overhaul and mainte- nance bases and ticket and administrative offices. Public airports are utilized for flight operations under lease arrangements with the municipalities or agencies owning or controlling such airports. Substantially all leases provide that the lessee shall pay taxes, maintenance, insurance and certain other operating expenses applicable to the leased property. Most leases also include renewal options and some aircraft leases include purchase options. The following amounts applicable to capital leases are included in property and equipment: At December 31, 1993, obligations under capital and noncancel- able operating leases for future minimum lease payments were as follows: Rental expense under operating leases for 1993, 1992 and 1991 was $739 million, $678 million and $576 million, respectively. Rental expense for 1993 excludes a charge of $9 million related to certain airport facilities where USAir has, among other things, discontinued or reduced its service. Rental expense for 1992 excludes a charge of $72 million related to USAir's grounded BAe- 146 fleet. Rental expense for 1991 excludes a credit of $9 million for the BAe-146 fleet. (c) Legal Proceedings USAir and various subsidiaries have been named as defendants in various suits and proceedings which involve, among other things, environmental concerns and employment matters. These suits and proceedings are in various stages of litigation, and the status of the law with respect to several of the issues involved is unset- tled. For these reasons the outcome of these suits and proceedings is difficult to predict. In the Company's opinion, however, the disposition of these matters is not likely to have a material adverse effect on its financial condition or results of operations. In 1989 and 1990, a number of U.S. air carriers, including USAir, received two Civil Investigative Demands ("CIDs") from the U.S. Department of Justice ("DOJ") (a CID is a request for information in the course of an antitrust investigation and does not constitute the institution of a civil or criminal action) related to investigations of price fixing in the domestic airline industry. The investigations by the DOJ culminated in the filing of a lawsuit against Airline Tariff Publishing Company ("ATPCo") and eight major air carriers, including USAir, alleging that the defendants had agreed to fix prices in violation of Section 1 of the Sherman Act through the methods used to disseminate fare data to ATPCo, an airline-owned fare publishing service. To avoid the costs associated with protracted litigation and an uncertain outcome, USAir and another carrier decided to settle the lawsuit by entering into a consent decree to modify their fare-filing practices in certain respects and to implement compliance programs that would include education of employees regarding the carriers' responsibilities under the consent decree. Accordingly, the consent decree and the U.S. Government's complaint were filed contemporaneously in the U.S. District Court for the District of Columbia in December 1992. Due to certain legal requirements associated with the settlement of government antitrust suits, the consent decree could not be entered until a notice and comment period had expired. On November 1, 1993, after it had reviewed the comments, the Court entered the consent decree. USAir does not believe that the fare-filing practices reflected in the consent decree will have a material adverse effect on its financial condition or on its ability to compete. In March 1994, the remaining six air carrier defendants agreed to the entry of a separate consent decree to settle the lawsuit. This consent decree cannot be entered until a notice and comment period has expired. When that consent decree is entered, USAir can petition the Court to have its consent decree amended to conform with the other settlement and the Court will enter the amended consent decree. On March 19, 1993, the U.S. District Court in Atlanta, Georgia entered a settlement involving USAir and five other U.S. air carrier defendants in the Domestic Air Transportation Antitrust Litigation class action lawsuit. The class action suit, which was filed in July 1990, alleged that the airlines used ATPCo to signal and communicate carrier pricing intentions and otherwise limit price competition for travel to and from numerous hub airports. Under the terms of the settlement, the six air carriers will pay $45 million in cash and issue $396.5 million in certificates valid for purchase of domestic air travel on any of the six airlines. USAir's share of the cash portion of the settlement, $5 million, was recorded in results of operations for the second quarter of 1992. The certificates provide a dollar-for-dollar discount against the cost of a ticket generally of up to a maximum of 10% per ticket, depending on the cost of the ticket. It is possible that this settlement could have a dilutive effect on USAir's passenger transportation revenue and associated cash flow. However, due to the interchangeability of the certificates among the six carriers involved in the settlement, the possibility that carriers not party to the settlement will honor the certificates, and the potential stimulative effect on travel created by the certificates, USAir cannot reasonably estimate the impact of this settlement on future passenger revenue and cash flows. USAir has employed the incremental cost method to estimate a range of costs attributable to the exercise of the certificates, based on the assumption that the estimated maximum number of certificates to be redeemed for travel on USAir will be related to USAir's market share relative to the total market share of the six carriers involved in the settlement. USAir's estimated percentage of such market share is less than 9%. Incremental costs include unit costs for passenger food, beverages and supplies, fuel, liability insurance, and denied boarding compensation expenses expected to be incurred on a per passenger basis. USAir has estimated that its incremental cost will not be material based on the equivalent free trips associated with the settlement. The Attorney General of the State of Florida and the Attorneys General of several other states are investigating whether several major airlines, including USAir, have engaged in price fixing and other unlawful restraints of trade. Certain of these Attorneys General have issued document requests to USAir and several other airlines requiring them to provide certain information and documents. At this time, USAir cannot predict the manner in which these investigations will be resolved and if the resolution will have an adverse effect on USAir's results of operations or financial position. (d) Aircraft Commitments At December 31, 1993, USAir's new aircraft on firm order, options for new aircraft and scheduled payments for new aircraft orders (including progress payments, buyer furnished equipment, spares, and capitalized interest) were: USAir may elect, under certain circumstances, to convert Boeing 737 Series and Boeing 767 Series firm order or option deliveries to Boeing 757-200 deliveries. If USAir were to elect such a substitution, the payments presented in the table above would change. USAir is currently in negotiations with Boeing regarding, among other things, the above schedule of new aircraft deliveries. In addition, USAir has a commitment to purchase hushkits for certain of its McDonnell Douglas DC-9-30 aircraft and a substantial portion of its Boeing 737-200 aircraft. The installation of these hushkits will bring the aircraft into compliance with Federal Aviation Administration ("FAA") Stage 3 noise level requirements. The projected payments associated with the purchase of the hushkits are: $29.1 million - 1994; $12.0 million - 1995; $42.3 million - 1996; $43.4 million - 1997; $44.0 million - 1998; and $30.8 million thereafter. (e) Concentration of Credit Risk USAir does not believe it is subject to any significant concentration of credit risk. At December 31, 1993, most of USAir's receivables related to tickets sold to individual passen- gers through the use of major credit cards (47%) or to tickets sold by other airlines (16%) and used by passengers on USAir or USAir Group's commuter subsidiaries. These receivables are short-term, generally being settled shortly after sale or in the month following usage. Bad debt losses, which have been minimal in the past, have been considered in establishing allowances for doubtful accounts. (f) Guarantees At December 31, 1993, USAir guaranteed payments of certain debt obligations of the Galileo International Partnership amounting to approximately $16 million. In addition, at December 31, 1993, USAir guaranteed payments of debt and lease obligations of USAir Group's three wholly-owned subsidiaries amounting to approximately $148 million. (5) SALE OF RECEIVABLES USAir is party to an agreement ("Receivables Agreement") to sell, on a revolving basis, undivided interest of up to $240 million in a pool of designated receivables. Approximately $141 million was available for sale at December 31, 1993 based on receivable balances at that date. The maximum amount available under the Receivable Agreement to be sold gradually reduces from $240 million at December 31, 1993, to $190 million on June 30, 1994. The Receivables Agreement expires on December 21, 1994. USAir had no outstanding amounts due under the Receivable Agreement at December 31, 1993. The net amounts sold reduce receivables in the accompanying balance sheet by $220 million and $188 million at December 31, 1992 and 1991, respectively. Included in the accounts payable balances at December 31, 1992 and 1991, are $74 million and $64 million, respectively, which represent funds held by USAir related to previously sold receivables that had been collected. USAir obtained a waiver from the purchaser of the receivables and its operating agent, exempting USAir from compliance with the coverage ratio financial covenant in the Receivables Agreement for the quarter ended December 31, 1993. USAir is currently unable to sell receivables under the Receivables Agreement because it is in violation of a minimum net worth covenant thereunder. In addition, based on current projections of its results for 1994, USAir expects that it will not be in compliance with the coverage ratio test and possibly other financial covenants at March 31, 1994 and during the remainder of the year. There can be no assurance that USAir will be able to obtain a waiver of compliance with these covenants or arrange a replacement facility. (6) INCOME TAXES Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"). FAS 109 required a change from the deferred method under Accounting Principles Board Opinion No. 11 to the asset and liability method of accounting for income taxes. No cumulative adjustment at January 1, 1993, and no income tax credit for the year ended December 31, 1993, were recognized due to the FAS 109 limitation in recognizing benefits for net operating losses. USAir files a consolidated Federal income tax return with its parent USAir Group pursuant to a tax allocation agreement. The components of the provision (credit) for income taxes are as follows: The significant components of deferred income tax ex- pense/(benefit) for the year ended December 31, 1993, are as follows: (in thousands) Deferred tax benefit (exclusive of the other components listed below) $(121,847) Adjustments to deferred tax assets and liabilities for enacted changes in tax laws and rates (9,429) Increase for the year in the valuation allowance for deferred tax assets 131,276 -------- Total $ 0 ======== For the years ended December 31, 1992 and 1991, deferred income taxes result from differences in the recognition of revenue and expenses and investment tax credits for tax and financial reporting purposes. The major items resulting in these differences and the related tax effects are shown in the following chart: A reconciliation of taxes computed at the statutory Federal tax rate on earnings before income taxes to the provision (credit) for income taxes is as follows: The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1993 are presented below: (in thousands) Deferred tax assets: Leasing transactions $ 129,276 Tax benefits purchased/sold 79,434 Gain on sale and leaseback transactions 162,400 Employee benefits 429,312 Net operating loss carryforwards 508,240 Alternative minimum tax credit carryforwards 20,881 Investment tax credit carryforwards 47,880 Other deferred tax assets 61,210 --------- Total gross deferred tax assets 1,438,633 Less valuation allowance (568,816) --------- Net deferred tax assets 869,817 Deferred tax liabilities: Equipment depreciation and amortization (840,584) Other deferred tax liabilities (29,233) --------- Net deferred tax liabilities (869,817) --------- Net deferred taxes $ 0 ========= The valuation allowance for deferred tax assets as of January 1, 1993, was $438 million. The increase in the valuation allowance for 1993 was $131 million. At December 31, 1993, the Company had unused net operating losses of $1.3 billion for Federal tax purposes, which expire in the years 2005-2008. USAir also has available, to reduce future taxes payable, $429 million alternative minimum tax net operating losses expiring in 2007 and 2008, $47 million of investment tax credits expiring in 2002 and 2003, and $20 million of minimum tax credits which do not expire. The Federal income tax returns of the Company through 1986 have been examined and settled with the Internal Revenue Service. (7) STOCKHOLDER'S EQUITY USAir Group owns all of the outstanding common stock of USAir. USAir Group's Credit Agreement includes a provision that limits USAir's ability to declare dividends to USAir Group. (8) EMPLOYEE STOCK OWNERSHIP PLAN In August 1989, USAir established an Employee Stock Ownership Plan ("ESOP"). USAir Group sold 2,200,000 shares of its Common Stock to an Employee Stock Ownership Trust to hold on behalf of USAir's employees, exclusive of officers, in accordance with the terms of the Trust and the ESOP. Financing of approximately $111.4 million for the Trust's purchase of the shares was provided by USAir through a 9 3/4% loan to the Trust, and an additional $2.2 million was contributed to the Trust by USAir. The loan is being repaid with contributions made by USAir. The contributions are made in amounts equal to the periodic loan payments as they come due, less dividends available for loan payment. The amount of dividends used for debt service by the ESOP was $127,000 in 1991. As the loan is repaid over time, participating employees receive allocations of the Common Stock purchased by the Trust. The initial maturity of the loan is 30 years. However, the ESOP provides that if the Company's profitability as measured by return on sales exceeds certain goals during the life of the ESOP, USAir's contributions and the repayment of the loan will be accelerated. Contributions made by USAir and therefore loan repayments made by the Trust were $11.4 million in 1993, 1992 and 1991. The interest portion of these contributions was $10.5 million in 1993, $10.6 million in 1992 and $10.7 million in 1991. Approximately 366,000 shares of Common Stock have been allocated to employees. USAir recognized approximately $4 million of compensation expense related to the ESOP in each of 1993, 1992 and 1991 based on shares allocated to employees (the "shares allocated" method). Deferred compensation related to the ESOP amounted to approximately $95 million, $98 million and $102 million at December 31, 1993, 1992 and 1991, respectively. (9) EMPLOYEE BENEFIT PLANS (a) Pension Plans USAir has several pension plans in effect covering substan- tially all employees. One qualified defined benefit plan covers USAir maintenance employees and provides benefits of stated amounts for specified periods of service. Qualified defined benefit plans for substantially all other employees provide benefits based on years of service and compensation. The qualified defined benefit plans are funded, on a current basis, to meet requirements of the Employee Retirement Income Security Act of 1974. The defined benefit pension plan for USAir non-contract employees was frozen at the end of 1991 for all non-contract participants, resulting in a one-time book gain of approximately $107 million in 1991. All non-contract plan participants became 100% vested at the time of the freeze. As a result of this plan curtailment, the accrual of service costs related to defined benefits for USAir non-contract employees ceased at the end of 1991. USAir implemented a defined contribution pension plan for non-contract employees in January 1993. The funded status of the qualified defined benefit plans at December 31, 1993 and 1992 was as follows: Approximately 97% of the accumulated benefit obligation was vested at December 31, 1993 and 1992. Unrecognized transition assets are being amortized over periods up to 27 years. The weighted average discount rate used to determine the actuarial present value of the projected benefit obligation was 7.6% and 8.75% as of December 31, 1993 and 1992, respectively. The expected long-term rate of return on plan assets used in 1993 and 1992 was 9.5%. Rates of 3% to 6% were used to estimate future salary levels. At December 31, 1993, plan assets consisted of approxi- mately 8% in cash equivalents and short-term debt investments, 37% in equity investments, and 55% in fixed income and other invest- ments. At December 31, 1992, plan assets consisted of approximate- ly 4% in cash equivalents and short-term debt investments, 70% in equity investments, and 26% in fixed income and other investments. The following items are the components of the net pension cost for the qualified defined benefit plans: 1993 1992 1991 ---- ---- ---- (in millions) Service cost (benefits earned during the year) $ 90 $ 79 $ 98 Interest cost on projected benefit obligation 188 171 168 Actual return on plan assets (224) (114) (353) Net amortization and deferral 40 (65) 201 ---- ---- ---- Net pension cost $ 94 $ 71 $ 114 ==== ==== ==== Net pension cost for 1993 and 1991 presented above excludes a charge of approximately $33.9 million and $21.6 million, respec- tively, related to "early-out" incentive programs offered to a limited number of USAir employees during the years. No such charges were incurred in 1992. Non-qualified supplemental pension plans are established for certain employee groups, which provide incremental pension payments from the Company's funds so that total pension payments equal amounts that would have been payable from the Company's principal pension plans if it were not for limitations imposed by income tax regulations. The following table sets forth the non-qualified plans' status at December 31, 1993 and 1992: Net supplementary pension cost for the two years included the following components: The discount rate used to determine the actuarial present value of the projected benefit obligation was 7.5% and 8.75% as of December 31, 1993 and 1992, respectively. Rates of 3% and 6% were used to estimate future salary levels. In addition to the qualified and non-qualified defined benefit plans described above, USAir also contributes to certain defined contribution plans primarily for employees not covered under a collective bargaining agreement. Company contributions are based on a formula which considers the age and pre-tax earnings of each employee and the amount of employee contributions. USAir's contribution expense was $42 million for 1993. USAir recognized no such expense in 1992 and 1991. (b) Postretirement Benefits Other Than Pensions USAir offers medical and life insurance benefits to employees who retire from the Company and their eligible dependents. The medical benefits provided by USAir are coordinated with Medicare benefits. Retirees generally contribute amounts towards the cost of their medical expenses based on years of service with the Company. USAir provides uninsured death benefit payments to survivors of retired employees for stated dollar amounts, or in the case of retired pilot employees, death benefit payments determined by age and level of pension benefit. The plans for postretirement medical and death benefits are funded on the pay-as-you-go basis. USAir adopted Statement of Financial Accounting Standards No. 106 ("FAS 106") during 1992 and elected to record the January 1, 1992 Accumulated Postretirement Benefit Obligation ("APBO") using the immediate recognition approach. The cumulative effect of adopting FAS 106 was $745.5 million ($638.8 million net of tax benefit). The following table sets forth the financial status of the plans as of December 31, 1993 and 1992: The postretirement benefit expense for 1993 presented above excludes a charge of approximately $15.5 million related to "early- out" programs offered to a limited number of employees during the year. No such charges were incurred in 1992 or 1991. The discount rate used to determine the APBO was 7.75% and 8.75% at December 31, 1993 and 1992, respectively. The assumed health care cost trend rate used in measuring the APBO was 10.5% in 1993 and 1994, declining by 1% per year after 1994 to an ultimate rate of 4.5%. If the assumed health care cost trend rate were increased by 1 percentage point, the APBO at December 31, 1993 would be increased by 10% and 1993 periodic postretirement benefit cost would increase 13%. Prior to the adoption of FAS 106, USAir recognized expense for retiree health care at an estimated monthly rate (based on payments) and recognized expense for death benefits when paid. The expense using this methodology was approximately $8 million for 1991. (c) Postemployment Benefits USAir adopted Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("FAS 112"), during 1993. FAS 112 requires the use of an accrual method to recognize postemployment benefits such as disability-related benefits. The cumulative effect at January 1, 1993 of adopting FAS 112 was $43.7 million. (10) SUPPLEMENTAL BALANCE SHEET INFORMATION The components of certain accounts in the accompanying balance sheets are as follows: (11) NON-RECURRING AND UNUSUAL ITEMS (a) 1993 USAir's results for 1993 include non-recurring charges of (i) $43.7 million for the cumulative effect of an accounting change, as required by FAS 112 which was adopted during the third quarter of 1993, retroactive to January 1, 1993; (ii) $68.8 million for severance, early retirement and other personnel-related expenses recorded primarily during the third quarter of 1993 in connection with a workforce reduction of approximately 2,500 full-time positions between November 1993 and the first half of 1994; (iii) $36.8 million based on a projection of the repayment of certain employee pay reductions, recorded in the fourth quarter of 1993; (iv) $13.5 million for certain airport facilities at locations where USAir has, among other things, discontinued or reduced its service, recorded in the fourth quarter of 1993; (v) $8.8 million for a loss on USAir's investment in the Galileo International Partnership, which operates a computerized reservation system, recorded in the fourth quarter of 1993; and (vi) $18.4 million credit related to non-operating aircraft, recorded in the second quarter of 1993. (b) 1992 USAir's results for 1992 include (i) a charge of $628.1 million for the cumulative effect of an accounting change as required by FAS 106, effective January 1, 1992; (ii) a $107.4 million charge related to certain aircraft which have been withdrawn from service, recorded in the fourth quarter of 1992; and (iii) a $34.1 million non-operating loss related to the sale of ten MD-82 aircraft which USAir eliminated from its fleet plan, recorded in the fourth quarter of 1992. (c) 1991 USAir's results for 1991 include (i) a $107 million a pre-tax gain related to freezing of the fully funded non-contract employee pension plan; (ii) a $21.6 million pre-tax expense related to early retirement incentives offered to certain employees during 1991; (iii) a $21 million pre-tax charge to establish an additional reserve for USAir's grounded BAe-146 fleet; and (iv) a $18.5 million, net, in miscellaneous pre-tax non-recurring charges. (12) SELECTED QUARTERLY FINANCIAL DATA (Unaudited) The following table presents selected quarterly financial data for 1993 and 1992: Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF USAir Group, Inc. Each of the persons listed below is currently a director of the Company and was elected in 1993 by the stockholders of the Company. Each director of the Company is also a director of USAir. Except as noted otherwise, the following biographies disclose the age and describe the business experience of each Director for at least the past five years. As required by the Investment Agreement, the Board of Directors amended the Company's By-Laws on January 21, 1993 to increase the authorized number of directors by three and immediately thereafter elected Messrs. Marshall, Maynard and Stevens to fill the new directorships. Under the Investment Agreement, the Company is required to use its best efforts to ensure that the slate of persons nominated by the Company for election as directors of the Company includes that number of persons designated by BA that is the percentage of the total then authorized number of directors, which is currently 16, of the Company that is nearest to but not greater than the percentage (but in no event greater than 25%) of the aggregate voting power of the securities that vote with the Common Stock as a single class for the election of directors of the Company then held by BA and its wholly-owned subsidiaries. Under this provision of the Investment Agreement, BA is entitled to designate three directors to the Board of Directors and has accordingly designated Messrs. Marshall, Maynard and Stevens. Served as Director since -------- Warren E. Buffett, 63.... Mr. Buffett has been Chairman 1993 and Chief Executive Officer of Berkshire Hathaway Inc. (insurance, candy, retailing, manufacturing and publishing) since 1970. He is also a Director of Capital Cities/ ABC, Inc., The Coca-Cola Company, The Gillette Comp- pany and Salomon Inc. Mr. Buffett is a member of the Finance and Planning Committee of the Board of Directors. Edwin I. Colodny, 67..... Mr. Colodny is of counsel to 1975 the law firm of Paul, Has- tings, Janofsky & Walker. He retired as Chairman of the Company and of USAir in July 1992. He served as Chief Executive Officer of USAir from 1975 until retiring as an employee of USAir in June 1991. Mr. Colodny is a Director of Martin Marietta Corporation, Comsat Corporation and Ester- line Technologies, Inc., and is a member of the Board of Trustees of the University of Rochester. He is a member of the Finance and Planning and Nominating Committees of the Board of Directors. Mathias J. DeVito, 63.... Mr. DeVito is Chairman of the 1981 Board and Chief Executive Officer of The Rouse Com- pany (real estate develop- ment and management). He also serves as a Director of First Maryland Bancorp and subsidiaries of The Rouse Company. He is a member of the Board of the Business Committee for the Arts and former Chair of the Greater Baltimore Committee. Mr. DeVito is Chairman of the Compensation and Benefits Committee and a member of the Finance and Planning Committee of the Board of Directors. George J. W. Goodman, 63.. Mr. Goodman is President of 1978 Continental Fidelity, Inc. which provides editorial and investment services. He is the author of a number of books and articles on finance and economics under the pen name "Adam Smith" and is the host of a television series of that name seen on public broadcasting stations in the U.S. and on other networks abroad. He is a Director of Cambrex Corporation. Mr. Goodman also serves as a mem- ber of the Advisory Committee of the Center for International Relations at Princeton Univer- sity, and is a Trustee of the Urban Institute. He is a mem- ber of the Compensation and Benefits and Finance and Planning Committees of the Board of Directors. John W. Harris, 47....... Mr. Harris is President of 1991 The Harris Group (real estate development). From 1972 through 1991, he was President of The Bissell Companies, Inc. (real estate development). He is a Director of Southern Bell Telephone and Telegraph Company. Mr. Harris is former Chairman of the Greater Charlotte Chamber of Commerce and a member of the Board of Trustees of the University of North Carolina and serves on the boards of several community service organiza- tions. He is a member of the Audit and Compensation and Benefits Committees of the Board of Directors. Edward A. Horrigan, Jr., 64 Mr. Horrigan is Chairman and 1987 Chief Executive Officer of Liggett Group Inc. (consumer products), a position he has held since May 1993. He is also the retired Vice Chairman of the Board of RJR Nabisco, Inc. and retired Chairman and Chief Executive Officer of R. J. Reynolds Tobacco Company, Winston -Salem, North Carolina (consumer products). He is a Director of the Haggai Foun- dation. Mr. Horrigan is a member of the Audit and Nominating Committees of the Board of Directors. Robert LeBuhn, 61......... Mr. LeBuhn is Chairman of 1966 Investor International (U.S.), Inc. (investments) and is a Director of Acceptance Insur- ance Companies, Amdura Corp., Lomas Financial Corp. and Cambrex Corporation. He is Trustee and President of the Geraldine R. Dodge Foun- dation, Morristown, New Jersey and is a member of the New York Society of Security Analysts. He is Chairman of the Finance and Planning Committee and a member of the Nominating Committee of the Board of Directors. Sir Colin Marshall, 60.... Sir Colin was elected Chairman 1993 of BA in February 1993. Prev- iously, he had been Chief Executive of BA and a member of BA's Board of Directors since 1983. Sir Colin is a Director of Grand Metropolitan plc, HSBC Holdings Plc, and IBM United Kingdom Holdings Limited. He is a member of the Finance and Planning Committee of the Board of Directors. Roger P. Maynard, 51...... Mr. Maynard has been Director 1993 of Corporate Strategy of BA since 1991. Previously, from 1987, he had held various positions at BA, including Director of Investor Relations & Marketplace Performance and Executive Vice President North America. Mr. Maynard is a member of the Nominating and Compensation and Benefits Committees of the Board of Directors. John G. Medlin, Jr, 60.... Mr. Medlin is Chairman of the 1987 Board and, until December 31, 1993, was Chief Executive Officer of Wachovia Corpor- ation (bank holding company). Mr. Medlin also serves as a Director of BellSouth Company, Media General, Inc., National Services Industries, Inc. and RJR Nabisco, Inc. He is Chair- man of the Nominating Committee and a member of the Compen- sation and Benefits Committee of the Board of Directors. Hanne M. Merriman, 52..... Mrs. Merriman is the Principal 1985 in Hanne Merriman Associates (retail business consultants). Previously, she served as President of Nan Duskin, Inc. (retailing), President and Chief Executive Officer of Honeybee, Inc., a division of Spiegel, Inc., and President of Garfinckel's, a division of Allied Stores Corporation. Mrs. Merriman is a Director of CIPSCO, Inc. Central Public Service Company, State Farm Mutual Automobile Insurance Company, The Rouse Company and Ann Taylor Stores Corporation. She is a member of the National Women's Forum and a Trustee of The American-Scandinavian Founda- tion. She was a member of the Board of Directors of the Federal Reserve Bank of Richmond, Virginia from 1984- 1990 and served as Chairman in 1989-1990. Mrs. Merriman is Chairman of the Audit Committee and is a member of the Nominating Committee of the Board of Directors. Charles T. Munger, 70..... Mr. Munger is Vice Chairman of 1993 Berkshire Hathaway Inc. (insur- ance, candy, retailing, manu- facturing and publishing) of which he has been an officer and Director since 1975. He is Chairman of Daily Journal Corporation and is a Director of Salomon Inc. and Wesco Financial Corporation. Mr. Munger is a member of the Audit Committee of the Board of Directors. Seth E. Schofield, 54..... Mr. Schofield was elected 1989 Chairman of the Board of Directors of the Company and USAir in June 1992. In June 1991 he was elected President and Chief Execu- tive Officer of the Company and of USAir. In June 1990 he was elected President and Chief Operating Officer of USAir. He had served as Executive Vice President- Operations of USAir since 1981. Mr. Schofield joined USAir in 1957 and has held various corporate staff positions. Mr. Schofield is a Director of the Erie Insurance Group, the PNC Bank, N.A., the Greater Washington Board of Trade, the Flight Safety Foundation, and the Greater Pittsburgh Council of the Boy Scouts of America. Mr. Schofield is Chairman of the Board of Directors of the Greater Pittsburgh Chamber of Commerce, and a Board Member of the Pennsylvania Business Roundtable, Penn's Southwest Association and the Virginia Business Council. He is also a member of the Allegheny Conference on Community Development and the Federal City Council. Richard P. Simmons, 62.... Mr. Simmons is Chairman of 1987 the Board and Chairman of the Executive Committee of Allegheny Ludlum Corp. and served as its President and Chief Execu- tive Officer from 1980 to 1990. Allegheny Ludlum pro- duces stainless steel and other high alloyed steels. Mr. Simmons is also a Director and Chairman of the Executive Committee of PNC Bank Corp. and Consolidated Natural Gas. He is a member of the Ameri- can Institute of Mining, Metallurgical and Petroleum Engineers and is a fellow and Distinguished Life Member of the American Society for Metals. Mr. Simmons is a member of the M.I.T. Corpor- ation and serves on the boards of several community service organizations. He is a member of the Audit and Finance and Planning Committees of the Board of Directors. Raymond W. Smith, 56..... Mr. Smith is Chairman of 1990 the Board and Chief Executive Officer of Bell Atlantic Com- pany, which is engaged princi- pally in the telecommunications business and is one of the seven regional companies formed as a result of the divestiture of the Bell System. Previously, Mr. Smith had served as Vice Chairman and President of Bell Atlantic and Chairman of The Bell Telephone Com- pany of Pennsylvania. He is a member of the Board of Directors of CoreStates Financial Company, a trustee of the University of Pittsburgh and is active in many civic and cultural organizations. He is a mem- ber of the Compensation and Benefits and Nominating Committees of the Board of Directors. Derek M. Stevens, 55...... Mr. Stevens has been Chief 1993 Financial Officer of and a Director of BA since 1989. Previously, from 1981, he was Finance Director of TSB Group plc (financial institution). Mr. Stevens is a member of the Audit Commit- tee of the Board of Directors. The law firm of Paul, Hastings, Janofsky and Walker, with which Mr. Colodny is affiliated on an Of Counsel basis, provided legal services to USAir during 1993 and is expected to provide such services during 1994. The following persons are executive officers of the Company. For purposes of Rule 405 under the Securities Act of 1933, Messrs. Lagow, Long, Schwab, Fornaro, Frestel, Harper and Ms. Risque Rohrbach are deemed to be executive officers of the Company. There are no family relationships among any of the officers listed above. No officer was selected pursuant to any arrangement between him or her and any other person. Officers are elected annually to serve for the following year or until the election and qualification of their successors. All the executive officers except Ms. Risque Rohrbach and Messrs. Lagow, Salizzoni, Aubin, Frestel, Fornaro and Harper have been actively engaged in the business and affairs of the Company and USAir during the past five years. The business experience of the officers listed above since January 1, 1989 is as follows: Mr. Schofield was elected Executive Vice President of the Company in July 1989. At that time he was also elected Vice Chairman of the Board of the Company and of USAir. Mr. Schofield served as Executive Vice President-Operations of USAir until his election as President and Chief Operating Officer of USAir in June 1990. Effective on July 1, 1991, Mr. Schofield was elected President and Chief Executive Officer of both the Company and USAir. Effective on July 1, 1992, Mr. Schofield was elected Chairman of the Board of Directors of both the Company and USAir. Mr. Lagow was Senior Vice President-Market Planning of Northwest Airlines until February 1988, when he became Senior Vice President-Planning of United Airlines. Mr. Lagow held that position until he was elected Executive Vice President-Marketing of USAir in February 1992. Mr. Lloyd engaged in the private practice of law in Washing- ton, D.C. from 1967 until election as Vice President, General Counsel and Secretary of the Company and as Senior Vice President and General Counsel of USAir in 1987. He served in those capaci- ties until his election as Executive Vice President, Secretary and General Counsel of the Company and Executive Vice President and General Counsel of USAir in January 1991. Mr. Long served as Senior Vice President-Administration of USAir until his election as Senior Vice President-Customer Operations of USAir in June 1989. He served in that capacity until his election as Senior Vice President-Customer Services in March 1991. Mr. Long served as Senior Vice President-Customer Services until his election as Executive Vice President-Customer Services in May 1992. Mr. Salizzoni was Vice Chairman and Chief Financial Officer of Trans World Airlines and Trans World Corporation until 1987, when he became Vice Chairman and Chief Financial Officer of TW Services, Inc. He was Chairman and Chief Executive Officer of TW Services from April 1987 until August 1989, just before that company went private. Mr. Salizzoni was associated with Mancusco and Co. from August 1989 until he was elected Executive Vice President-Finance of the Company and of USAir in November 1990. Mr. Schwab served as Vice President-Management Information Systems of USAir until his election as Senior Vice President- Management Information Systems of USAir in July 1989. Mr. Schwab served in that capacity until his election as Executive Vice President-Operations in April 1991. He also served as President of USAM Corp. from April 1988 through April 1991. Mr. Aubin was Executive Advisor to the Vice Chairman, President and Chief Executive Office of Air Canada and, prior to that position, Senior Vice President Technical Operations and Chief Technical Officer of Air Canada during the relevant time. He was elected Senior Vice President-Maintenance Operations of USAir in January 1994. Mr. Fornaro was Vice President-Research of Jesup & Lamont Securities until February 1988, when he became Senior Vice President-Marketing of Braniff, Inc. In August 1988, Mr. Fornaro became Senior Vice President-Market Planning of Northwest Airlines, the position he held until February 1992. He was elected Senior Vice President-Planning of USAir in March 1992. Mr. Frestel was Vice President-Personnel and Labor Relations for The Atchinson, Topeka & Santa Fe Railway during the relevant time, and was a Director of that company from June 1988, until his election as Senior Vice President-Human Resources of USAir in January 1989. Mr. Harper was Senior Vice President-Marketing and Information Systems at Axe-Houghton Management (investment management) until his election as Vice President and Controller of the Company and USAir in December 1991. He served in that position until his election as Senior Vice President-Information Systems of USAir in October 1992. Ms. Rohrbach was a public policy and communications consultant during 1993. She was Assistant Secretary of Labor for Policy at the U.S. Department of Labor during 1991-1992. Ms. Rohrbach served on the White House staff as a member of the legislative liaison team (1981-1986) and subsequently as Assistant to the President and Secretary to the Cabinet (1987-1988). In 1989 and 1990, she was a resident fellow at Harvard University's Institute of Politics, a consultant to the Department of Energy and in the private sector. From 1988-1993, she also served as a member of the National Commission on Children. She was elected Vice President-Public and Community Relations of the Company and Senior Vice President-Public and Community Relations of USAir in January 1994. Item 11. EXECUTIVE COMPENSATION Compensation of Directors Each director, except Mr. Schofield, is paid a retainer fee of $18,000 per year for service on the Board of Directors of the Company and a fee of $600 per Board meeting or committee meeting attended. Consistent with a comprehensive cost reduction program at USAir, the retainer fee was reduced by 20% to $14,400 for an eighteen-month period commencing January 1, 1992 and ending on June 30, 1993. Mr. LeBuhn, Chairman of the Finance and Planning Committee, Mr. DeVito, Chairman of the Compensation Committee, and Mrs. Merriman, Chairman of the Audit Committee each receives an additional fee of $2,000 per year for serving in those respective capacities. Mr. Medlin, Chairman of the Nominating Committee, receives an additional fee of $1,000 per year for serving in that capacity. Mr. Schofield receives a salary in his capacity as an officer of USAir and receives no additional compensation as a director of the Company and USAir. In 1987 the Company established a retirement plan for directors who are not also employees of the Company and its subsidiaries. The plan provides that such directors shall be eligible to receive retirement benefits thereunder if they have attained seventy years of age and served at least five consecutive years on the Board of Directors or, if they have not attained age seventy, have served for at least ten consecutive years on the Board of Directors. Eligible directors receive an annual retirement benefit equal to the highest annual retainer in effect for active directors during the five years prior to retirement. If the annual retainer for active directors is increased, the annual retirement benefit paid to retired directors is increased by an amount equal to 50% of the increase in retainer paid to active directors. If a director dies prior to retirement and had served for at least five consecutive years on the Board of Directors, the deceased director's surviving spouse is eligible under the plan to receive, for a period of five years following such death, an annual death benefit equal to 50% of the annual retainer paid to such director at the time of his or her death. If a retired eligible director dies, the director's surviving spouse is eligible under the plan to receive, for a period of five years following such death, 50% of the annual retirement benefit payable to the director at the time of his or her death. The plan is administered by the Compensation Committee. COMPENSATION OF EXECUTIVE OFFICERS The Summary Compensation Table below sets forth the compensation paid during the years indicated to each of the Chief Executive Officer and the four remaining most highly compensated executive officers of the Company (including its subsidiaries). SUMMARY COMPENSATION TABLE - -------- * Under the SEC's transition rules, no disclosure is required. (A) Mr. Schofield was elected Chief Executive Officer effective June 1, 1991. (B) Mr. Lagow's employment with USAir commenced on February 7, 1992. (C) Amounts disclosed reflect reductions in salary during (i) 1993 of $24,365, $14,942, $12,250, $10,904 and $10,904, and (ii) 1992 of $87,019, $49,272, $43,750, $38,942 and $38,942 for Messrs. Schofield, Lagow, Salizzoni, Lloyd and Schwab, respectively, which were implemented for all USAir officers for a fifteen-month period commencing on January 1, 1992 and ending on March 29, 1993 pursuant to a comprehensive cost reduction program at USAir. (D) Amounts disclosed include for (i) 1993, $271,288, $33,259, $73,215, and $27,621 and (ii) 1992, $171,410, $22,523, $47,974 and $16,784, received by Messrs. Schofield, Salizzoni, Lloyd and Schwab, respectively, to cover incremental tax liability resulting from income derived from the lapsing of restrictions on disposition of Restricted Stock. Any amounts disclosed in the column that are in excess of the amounts disclosed in the preceding sentence represent income derived from personal travel on USAir. (E) At December 31, 1993, Messrs. Schofield, Salizzoni, Lloyd and Schwab owned 30,000, 6,000, 4,000 and 3,200 shares of Restricted Stock, respectively. At the fair market value of the Common Stock on that date, these holdings of Restricted Stock were valued at $386,250, $77,250, $51,500, $41,200, respectively. (F) Under USAir's split dollar life insurance plan, described under "Additional Benefits" below, individual life insurance coverage is available to the named officers. During 1992, each officer paid the amount of the premium associated with the term life component of the coverage. In 1993, USAir commenced paying the premium associated with this coverage. In 1992 and 1993, USAir paid the remainder of the premium associated with the whole life component of the coverage. If all assumptions as to life expectancy and other factors occur in accordance with projections, USAir expects to recover the premiums it pays with respect to the whole life component of the coverage. The following amounts reflect the value of the benefits accrued during the years indicated, calculated on an actuarial basis, ascribed to the insurance policies purchased on the lives of the named officers (plus, with respect to 1993, the dollar value of premiums paid by USAir with respect to term life insurance): 1993--Mr. Schofield-- $29,328, Mr. Lagow--$9,716, Mr. Salizzoni--$26,010, Mr. Lloyd--$17,291 and Mr. Schwab--$11,170; 1992--Mr. Schofield--$38,495; Mr. Lagow--$12,902; Mr. Salizzoni--$34,382; Mr. Lloyd--$21,382 and Mr. Schwab--$15,555. During 1993, USAir made contributions of $34,974, $22,805, $26,212, $18,897 and $18,897 to the accounts of Messrs. Schofield, Lagow, Salizzoni, Lloyd and Schwab in certain defined contribution pension plans. (G) Upon the commencement of his employment, USAir agreed to pay Mr. Lagow $1 million over four years, which amount was intended to compensate him for restricted stock and stock options which he forfeited when he left his former employer. The amount disclosed includes the first installment, $250,000, of the total payment. (H) Amount disclosed also reflects $125,000 paid to Mr. Lagow in the form of a "sign-on bonus" and $4,715 for reimbursement of relocation expenses. (I) Amount disclosed also reflects $25,380 for reimbursement of relocation expenses. Aggregated Option/SAR Exercises in Last Fiscal Year and Fiscal Year-End Option/SAR Values The following table provides information on the number of options held by the named executive officers at fiscal year-end 1993. None of the officers exercised any options during 1993 and none of the unexercised options held by these officers were in-the-money based on the fair market value of the Common Stock on December 31, 1993 ($12.875). The values reflected in the above chart represent the application of the Retirement Plan formula to the specified amounts of compensation and years of service. The credited years of service under the Retirement Plan for each of the individuals included in the Summary Compensation Table are as follows: Mr. Schofield-32 years, Mr. Lagow-2 years, Mr. Salizzoni-3 years, Mr. Lloyd-7 years and Mr. Schwab-6 years. USAir has entered into agreements with Messrs. Lagow, Salizzoni, Lloyd and Schwab which provide for a supplement to their retirement benefits under the Retirement Plan. This supplement is designed to provide such persons with those benefits they would have received had they been employed by USAir for the minimum number of years to be entitled to full retirement benefits under the Retirement Plan. USAir adopted, effective January 1, 1993, a defined contribu- tion retirement program for its eligible non-contract employees (the "Retirement Savings Plan") as a replacement for the Retirement Plan described above. Under the Retirement Savings Plan, eligible employees may elect to contribute on a tax-deferred basis up to 13% of their pre-tax compensation, subject to a maximum annual contribution of $8,994 in 1993. USAir will also contribute to each employee's account in the Retirement Savings Plan (i) a matching contribution equal to 50% of each employee's contribution, subject to a maximum of 2% of the employee's annual pre-tax compensation, (ii) a basic contribution which ranges, depending on the employee's age, from 2% to 8% of the employee's annual pre-tax compensation and (iii) if USAir's pre-tax profit margin, as defined, exceeds certain thresholds, a profit sharing contribution up to a maximum of 7.5% of an employee's annual pre-tax compensation. USAir made no contributions under the profit sharing component of the Retirement Savings Plan in 1993. Pre-tax compensation is defined for purposes of the Retirement Savings Plan as all compensation which USAir must report as wages on an employee's Form W-2, plus an employee's tax deferred contributions under such Plan up to a maximum of $235,840 in 1993. USAir also established a non-qualified supplemental defined contribution plan (the "Supplemental Savings Plan") in 1993, which credits amounts to accounts of certain officers who participate in the Retirement Savings Plan but who are adversely affected by the maximum benefit limitations under qualified plans imposed by the Code. Amounts obligated to be paid by USAir under the Supplemental Savings Plan will be deposited in a trust established for the benefit of the participants. See the "All Other Compensation" column of the Summary Compensation Table for the amounts contributed or allocated in 1993 to Messrs. Schofield, Lagow, Salizzoni, Lloyd and Schwab under the Retirement Savings Plan and the Supplemental Savings Plan. Under the Retirement Savings Plan and the Supplemental Savings Plan, participants may direct the investment of their contributions and USAir's contributions to their accounts among certain invest- ment funds. Participants' contributions are fully vested when made. USAir's contributions vest when the participant has been employed by USAir for at least two years. Additional Benefits USAir has in effect an Officers' Supplemental Benefit Plan, which provides certain benefits to a current or retired officer's spouse and children under age 19 following the officer's death. These benefits include: (i) dependent survivors' monthly income benefit and (ii) dependent survivors' health care insurance. A dependent survivors' monthly income benefit is payable to the eligible spouse or children of a deceased officer or retired officer in an amount equal to 20% of the monthly basic rate of salary payable to the officer the day prior to death or, in the case of a deceased retired officer, the day prior to retirement. Monthly income benefits will be reduced by the amount of any spouse protection benefit payable from Retirement Plan funds, and are subject to cessation upon the occurrence of certain specified events. In no case are monthly income benefits payable for more than 19 years following the date of death. The eligible surviving spouse or children of a deceased officer or retired officer are also entitled to receive dependent survivors' health care insurance, which provides the medical, major medical and dental insurance benefits generally available to dependents of salaried employees of USAir. Eligibility for this coverage ceases upon the occurrence of certain specified events. USAir also maintains a split-dollar life insurance plan under which individual term life insurance is available to its officers in the amount of three times base salary. The plan also provides for accrual of a cash value component for each officer who holds a policy. Under the plan, during 1993, USAir paid the premiums on the term and whole life insurance components of the policy. The premium attributable to the term life insurance of the policy is treated as income to the participant. At death, prior to transfer of the policy to the participant, the beneficiary receives the amount of the coverage less any amount necessary to reimburse the employer for its investment, and the employee is entitled to any additional proceeds. Upon transfer of the policy to the partici- pant, the participant is entitled to the cash surrender value of the policy in excess of the amount payable to the employer for recovery of its investment. See the "All Other Compensation" column of the Summary Compensation Table for information concerning compensation with respect to Messrs. Schofield, Lagow, Salizzoni, Lloyd and Schwab that was attributable to the split dollar life insurance plan. Arrangements Concerning Termination of Employment and Change of Control USAir currently has employment contracts (the "Employment Contracts") with the executive officers (the "Executives") named in the Summary Compensation Table. The terms of the Employment Contracts extend until the earlier of the fourth anniversary thereof or the Executive's normal retirement date and are subject to automatic one-year annual extensions on each anniversary date (to the fourth anniversary of such anniversary date) unless advance written notice is given by USAir. In exchange for each Executive's commitment to devote his or her full business efforts to USAir, the agreements provide that each Executive will be re-elected to a responsible executive position with duties substantially similar to those in effect during the prior year and will receive (1) an annual base salary at a rate not less than that in effect during the previous year, (2) incentive compensation as provided in the contract and (3) insurance, disability, medical and other benefits generally granted to other officers. In the event of a change of control, as defined in each Employment Contract, the term of each Employment Contract is automatically extended until the earlier of the fourth anniversary of the change of control date or the Executive's normal retirement date. As a result of amendments to the Employment Contracts entered into in June 1992, the acquisition of 20% or more of the outstanding securities of the Company under circumstances in which the acquiror would obtain the power to elect 20% or more of the members of the Board of Directors was added to the definition of a change of control under the Employment Contracts. To the extent permitted by Foreign Ownership Restric- tions and assuming the consummation of the Second Purchase (the "Second Closing") results in BA's electing at least 20% of the Board of Directors, the Second Closing would be treated as a change of control and would result in extension of the term of each Employment Contract until the earlier of the fourth anniversary of the Second Closing or the Executive's normal retirement date. On March 7, 1994, BA announced that it would not make any additional investments in the Company under current circumstances. See Item 1. "Business-British Airways Announcement Regarding Additional Investments in the Company; Code Sharing." The Employment Contracts provide that, should USAir or any successor fail to re-elect the Executive to his or her position, assign the Executive to inappropriate duties which result in a diminution in the Executive's position, authority or responsibili- ties, fail to compensate the Executive as provided in the Employ- ment Contract, transfer the Executive in violation of the Employ- ment Contract, fail to require any successor to USAir to comply with the Employment Contract or otherwise terminate the Executive's employment in violation of the Employment Contract, the Executive may elect to treat such failure as a breach of the Employment Contract if the Executive then terminates employment. As liquidat- ed damages as the result of an event not following a change of control that is deemed to be a breach of the Employment Contracts, USAir or its successor would be required to pay the Executive an amount equal to his or her annual base salary for the then remaining term of the Employment Contract, and to continue granting certain employee benefits for the then remaining term of the Executive's Employment Contract. If the breach follows a change of control, the Executive would be entitled to receive (i) an amount equal to the product of three times the sum of the Executive's annual base salary plus an annual bonus, (ii) a lump sum equal to the actuarial equivalent of the pension benefits which the Executive would have received had he or she remained employed by USAir until the end of the term of the Employment Contract, (iii) medical benefits until such time as the Executive qualifies for group medical benefits from another employer, (iv) travel benefits for the Executive's life, (v) reimbursement of reductions in salary sustained by the Executive as a result of a comprehensive cost reduction program initiated by USAir in October 1991, and (vi) continuation of certain other benefits during the remainder of the term of the Employment Contract. In addition, except under the circumstances described in the immediately following paragraph, during the 30-day period immediately following the first anniversa ry of a change of control any Executive could elect to terminate his or her Employment Contract for any reason and receive the liquidated damages described in the immediately preceding sentence. Each Employment Contract provides that if USAir breaches the Employment Contract, as described above, each Executive shall be entitled to recover from USAir reasonable attorney's fees in connection with enforcement of such Executive's rights under the Employment Contract. Each Employment Contract also provides that any payments the Executive receives in the event of a termination shall be increased, if necessary, such that, after taking into account all taxes he or she would incur as a result of such payments, the Executive would receive the same after-tax amount he or she would have received had no excise tax been imposed under Section 4999 of the Code. In order to facilitate consummation of the acts and transac- tions contemplated by the Investment Agreement, the Executives agreed in January 1993 to an amendment to their Employment Contracts that will become effective upon the Second Closing (i) to eliminate their right to elect to terminate their Employment Contracts without any reason during the 30-day period immediately following the first anniversary of the Second Closing; (ii) that USAir may transfer the Executive's employment to any location that meets certain criteria in the Employment Contracts without such relocation constituting a breach of the Employment Contracts; (iii) that consummation of the Second Closing would be treated as the only change of control with respect to BA; and (iv) that following the Second Closing, USAir may make certain changes in benefit plans affecting the Executives that are not material, as that term is defined in the Employment Contracts, provided that the changes apply to all eligible officers of USAir and are approved by a majority of the directors of the Company not elected by BA. Currently, under the Company's 1984 Stock Option and Stock Appreciation Rights Plan (the "1984 Plan") and 1988 Stock Incentive Plan (the "1988 Plan," and together with the 1984 Plan, the "Plans"), pursuant to which employees of the Company and its subsidiaries have been awarded stock options and stock appreciation rights with respect to Common Stock and, in the case of the 1988 Plan, shares of Restricted Stock, occurrence of a change of control, as defined, would make all granted options immediately exercisable without regard to the vesting provisions thereof. In addition, grantees would be able, during the 60-day period immediately following a change of control (the "Cash-out Right"), to surrender all unexercised stock options not issued in tandem with stock appreciation rights under the Plans to the Company for a cash payment equal to the excess, if any, of the fair market value of the Common Stock over the exercise prices of such stock options or the positive value of any stock appreciation rights. As described above, in June 1992, the Company amended the definition of a change of control in the Plans with the result that, to the extent permitted by Foreign Ownership Restrictions and assuming the Second Closing results in BA's electing at least 20% of the Board of Directors, the Second Closing would be treated as a change of control thereunder. As of March 1, 1994, there were unexercised stock options to purchase 548,310 shares of Common Stock (of which 84,600 had tandem stock appreciation rights) under the 1984 Plan and unexercised stock options to purchase 3,625,500 shares of Common Stock (none of which had tandem stock appreciation rights) under the 1988 Plan. (As of March 1, 1994, 3,177,400 of the 3,625,500 options outstanding under the 1988 Plan and 322,910 of the 548,310 options outstanding under the 1984 Plan were exercis- able pursuant to their normal vesting schedule.) The weighted average exercise price of all the outstanding stock options was approximately $23.15. On February 28, 1994, the closing price of a share of Common Stock on the NYSE was $11.375. See the "Aggre- gated Option/SAR Exercises in Last Fiscal Year and Fiscal Year-End Option/SAR Values" table for information regarding stock options held by the Executives. Currently, 50,400 shares of Restricted Stock previously granted to the Executives may (i) become free of transfer restric- tions upon their normal vesting schedule or (ii) be subject to accelerated vesting upon a termination of employment which triggers the payment of liquidated damages under the Employment Contracts, as discussed above, regardless of whether the termination occurred following a change of control as defined in the Employment Contracts. See "Beneficial Security Ownership" for information regarding Restricted Stock owned by the Executives. With respect to Mr. Lagow, in order to induce him to accept its offer of employment in 1992, USAir agreed, among other things, to pay Mr. Lagow $1 million in four equal installments, each installment being due and payable on the first four anniversaries of the commencement of his employment by USAir, provided Mr. Lagow remains employed by USAir. This payment was intended to compensate Mr. Lagow for stock options and restricted stock which he forfeited when he left his former employer. In the event of a change of control under his Employment Contract or wrongful termination thereunder, USAir has also agreed to pay Mr. Lagow in a lump sum any unpaid balance of this obligation. Notwithstanding anything to the contrary set forth in any of the Company's or USAir's filings under the Securities Act of 1933, as amended (the "Securities Act"), or the Securities Exchange Act of 1934, as amended (the "Exchange Act"), that incorporates by reference this Proxy Statement, in whole or in part, the following Report and Performance Graph shall not be incorporated by reference into any such filings. Report of the Compensation and Benefits Committee of the Board of Directors The Compensation Committee policies with respect to compensa- tion of the Company's executive officers are to: 1. Attract and retain talented and experienced senior management by offering compensation that is competitive with respect to other major U.S. airlines and other U.S. companies of comparable size. 2. Motivate senior management to provide a high-quality product to consumers with the ultimate goal of maximizing profit- ability and stockholder returns by offering incentive and long-term compensation that is linked to return on sales and the market value of the Common Stock. The Compensation Committee has played an active role in the oversight and review of all executive compensation paid to executive officers of the Company during the last fiscal year. Ordinarily, the Compensation Committee and the full Board of Directors, in consultation with the Senior Vice President-Human Resources of USAir and, if warranted, an independent compensation consultant, annually review the total compensation package (comprised of base salary, incentive compensation, and long-term incentive compensation) of the Chairman, President and Chief Executive Officer. The Compensation Committee reviews the market rate for peer-level positions of the other major domestic passenger carriers including, but not limited to, the three other airline companies included in the S&P Airline Index, which is reflected in the "Performance Graph." Based primarily on this comparison, the Compensation Committee establishes the Chief Executive Officer's base salary. Mr. Schofield does not participate in Compensation Committee or Board of Directors deliberations or decision-making regarding any aspect of his compensation. Correspondingly, the Compensation Committee established the compensation reported for 1993 for the Company's other executive officers, including the four officers named in the Summary Compensation Table, based upon a comparison of peer positions at the other major U.S. airlines including, but not limited to, the three other airline companies included in the S&P Airline Index, which is reflected in the "Performance Graph." The principal elements of the Company's compensation paid to the executive officers in the last completed fiscal year are discussed below. Base Salary. As part of a comprehensive program to reduce costs at USAir, the Compensation Committee reduced the salaries of the executive officers and the other officers of USAir for a fifteen month period commencing on January 1, 1992 and ending on March 29, 1993. The Compensation Committee reduced each ex- ecutive's base salary in accordance with the following graduated schedule: ~ First $20,000 of salary reduced by 0% ~ Next $30,000 of salary reduced by 10% ($20,000 to $50,000) ~ Next $50,000 of salary reduced by 15% ($50,000 to $100,000) ~ Any amount of salary in excess of $100,000 reduced by 20%. Each of the executive officers agreed to the reductions in salary, which otherwise would have constituted grounds for the executives to have terminated their employment agreements with USAir. The amounts of salary not paid in 1992 and 1993 to Mr. Schofield and the other four executive officers named in the Summary Compensation Table are disclosed in footnote (C) to that table. As stated above, the Compensation Committee establishes the base salaries of the Company's executive officers primarily by reference to the salaries of officers holding comparable positions at other major U.S. airlines including, but not limited to, the three other airline companies included in the S&P Airline Index, which is reflected in the "Performance Graph." Historically, the Compensation Committee had awarded merit increases based on measuring individual performance against objectives. However, due to the Company's poor financial performance, the Compensation Committee last awarded merit increases in executive base salaries in 1989. Since 1989 the Compensation Committee had increased the salaries of executive officers solely as a result of a promotion or an increase in responsibilities. The Company commissioned an independent compensation consultant to conduct a comprehensive study of the salaries of comparable airline officers in 1992. The study disclosed that the salaries (prior to the fifteen-month reduction described above) of most officers were substantially below those of salaries for analogous positions at major competi- tors. Following the study, in July 1992, the Compensation Committee prospectively set the salaries of executive officers generally at the median of the comparative range adjusted by individual performance and experience, effective April 1993. In connection with the same review, the Compensation Committee proposed to increase Mr. Schofield's base salary (before adjustment for the fifteen-month salary reductions) from $500,000 to $590,000, effective April 1993. Because the Company has continued to sustain losses, Mr. Schofield declined to accept the increase in base salary. Annual Cash Incentive Compensation Program: The Compensation Committee adopted the Executive Incentive Compensation Plan effective on January 1, 1988. The plan is administered by the Compensation Committee. All officers, including executive officers, of the Company are eligible to participate in this plan. The Compensation Committee is authorized to grant awards under this plan only if the Company achieves for a fiscal year a two percent or greater return on sales ("ROS"). The target level of performance is four percent ROS. If the Company achieves the target performance of four percent ROS, the full target percentage (which varies depending on position) is applied against the individual's base salary for the year to determine the target bonus award (the "Target Award") for the individual. Target Awards for executive officers range between 30% and 50% of base salary. If the minimum level of performance of two percent ROS is achieved, 50% of the Target Award would be available for distribution. If the maximum level of performance of six percent ROS is achieved, 200% of the Target Award would be available for payment. The Compensation Committee may adjust awards made to executive officers based on individual performance; however, no award may exceed 250% of the Target Award for any individual. The Compensation Committee last approved payments to executive officers under this plan for the fiscal year ended December 31, 1988. The Company has not achieved the minimum two percent ROS in any fiscal year, and the Compensation Committee has not made any awards under the plan, since then. Long-Term Incentive Programs Stock Options: The executive officers of the Company partici- pate in the Company's 1984 Stock Option and Stock Appreciation Rights Plan (the "1984 Plan") and 1988 Stock Incentive Plan (the "1988 Plan", and together with the 1984 Plan, the "Plans") which are both administered by the Compensation Committee. The Compensation Committee is authorized to grant options under these Plans only at an exercise price equal to the fair market value of a share of Common Stock on the date of grant. During 1993, the Compensation Committee did not grant any options from either of the Plans to the executive officers. The Compensation Committee determines the size of any option grant under the Plans based upon (i) the Compensation Committee's perceived value of the grant to motivate and retain the individual executive, (ii) a comparison of long-term incentive practices within the commercial airline industry, (iii) a comparison of awards provided to peer executives within the Company and (iv) the number of outstanding options held by the grantee and the exercise prices of these options. Although the Compensation Committee supports and encourages stock ownership in the Company by executive officers, it has not promulgated any standards regarding levels of ownership by executive officers. Pursuant to the reductions in the executive officers' salaries discussed above, in 1992 the Compensation Committee granted these persons non-qualified stock options to purchase 50 shares of Common Stock at $15 per share for each $1,000 of salary foregone during the wage reduction program, as is the case for each USAir employee whose pay was reduced pursuant to the program. Restricted Stock The Compensation Committee did not award any Restricted Stock under the 1988 Plan during 1993. (Grants of Restricted Stock are not authorized under the 1984 Plan). From 1988-1990, the Compensation Committee granted Restricted Stock to a total of nine executive officers, some of whom are no longer employed by USAir. During 1993, restrictions on disposition expired on a total of 23,200 shares of Restricted Stock held by Mr. Schofield, which shares were originally granted between 1988 and 1990. Restrictions on disposition also lapsed during 1993 on a total of 10,900 shares of Restricted Stock held by Messrs. Salizzoni, Lloyd and Schwab, which shares were originally granted between 1988 and 1990. The Omnibus Budget Reconciliation Act of 1993 added Section 162(m) to the Internal Revenue Code. Section 162(m) provides that companies will not be entitled to a tax deduction for certain compensation paid to any executive officer to the extent that the compensation exceeds $1 million in a taxable year. The Compensa- tion Committee is studying Section 162(m) and the proposed rules thereunder and is in the process of determining whether to recommend that the Company take the necessary measures to conform its compensation to Section 162(m). The Compensation Committee will continue to review all compensation and benefit matters presented to it and will act based upon the best information available in the best interests of the Company, its stockholders and employees. Mathias J. DeVito, Chairman George J. W. Goodman John W. Harris Roger P. Maynard John G. Medlin, Jr. Raymond W. Smith PERFORMANCE GRAPH This graph compares the performance of the Company's Common Stock during the period January 1, 1989 to December 31, 1993 with the S&P 500 Index and the S&P Airline Index. The graph depicts the results of investing $100 in the Company's Common Stock, the S&P 500 Index and the S&P Airline Index at closing prices on Decem- ber 31, 1988. The stock price performance shown on the graph is not necessarily indicative of future performance. The S&P Airline Index consists of AMR Corporation, Delta Air Lines, Inc., UAL Corporation and the Company. Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following information pertains to Common Stock, Series A Preferred Stock, Series F Preferred Stock, Series T Preferred Stock and Depositary Shares ("Depositary Shares"), each representing 1/100 of a share of the Company's $437.50 Series B Cumulative Convertible Preferred Stock, without par value ("Series B Preferred Stock"), beneficially owned by all directors and executive officers of the Company as of March 1, 1994. Unless indicated otherwise, the information refers to ownership of Common Stock. Unless indicated otherwise by footnote, the owner exercises sole voting and investment power over the securities (other than unissued securities, the ownership of which has been imputed to such owner). Series F Preferred Stock and Series T Preferred Stock, Common Stock receivable upon conversion. In addition, such Rights are issuable on a one-for-one basis with respect to shares of Common Stock receivable upon exercise of stock options or conversion of Depositary Shares. (2) Percentages are shown only where they exceed one percent of the number of shares outstanding and, in the case of Common Stock holdings are based on shares of Common Stock outstanding (exclusive of treasury stock) on March 1, 1994. (3) Various affiliates of Berkshire Hathaway Inc. ("Berkshire") are recordholders of 358,000 or 100% of the outstanding shares of Series A Preferred Stock. Messrs. Buffett and Munger are Chairman and Chief Executive Officer and Vice Chairman, respectively, of Berkshire and may be deemed to control that company. Messrs. Buffett and Munger each disclaims beneficial ownership of Series A Preferred Stock. Series A Preferred Stock is currently convertible into 9,239,944 shares of Common Stock, which represents approximately 10.5% of the total voting interest represented by Common Stock, Series F Pre- ferred Stock, Series T Preferred Stock and Series A Preferred Stock at March 1, 1994. (4) The listing of Mr. Colodny's holding includes 67,000 shares of Common Stock issuable within 60 days of March 1, 1994 upon exercise of stock options. (5) Mr. Goodman's holdings of Depositary Shares is convertible into 498 shares of Common Stock. (6) A wholly-owned subsidiary of BA is recordholder of 30,000 or 100% of the outstanding shares of Series F Preferred Stock, 152.1 or 100% of the outstanding shares of the Series T-1 Preferred Stock and 9,919.8 or 100% of the outstanding shares of the Series T-2 Preferred Stock pursuant to the Investment Agreement. Messrs. Marshall, Maynard and Stevens are Chair- man, Director of Corporate Strategy and Chief Financial Offic- er, respectively, of BA and have been designated by BA to act as directors of the Company pursuant to the Investment Agreement. Messrs. Marshall, Maynard and Stevens each dis- claims beneficial ownership of Series F Preferred Stock and Series T Preferred Stock. (7) The listing of Mr. Schofield's holding includes 335,069 shares of Common Stock issuable within 60 days of March 1, 1994 upon exercise of stock options, and 30,000 shares of Common Stock subject to certain restrictions upon disposition ("Restricted Stock"). (8) The listing of Mr. Lagow's holding reflects shares of Common Stock issuable within 60 days of March 1, 1994 upon exercise of stock options. (9) The listing of Mr. Salizzoni's holding includes 152,800 shares of Common Stock issuable within 60 days of March 1, 1994 upon exercise of stock options and 6,000 shares of Restricted Stock. (10) The listing of Mr. Lloyd's holding includes 169,742 shares of Common Stock issuable within 60 days of March 1, 1994 upon exercise of stock options and 4,000 shares of Restricted Stock. (11) The listing of Mr. Schwab's holding includes 167,992 shares of Common Stock issuable within 60 days of March 1, 1994 upon exercise of stock options and 3,200 shares of Restricted Stock. (12) The listing of all directors' and officers' holdings includes 1,193,583 shares of Common Stock issuable within 60 days of March 1, 1994 upon exercise of stock options and 50,400 shares of Restricted Stock. The only persons known to the Company (from Company records and reports on Schedules 13D and 13G filed with the Securities and Exchange Commission (the "SEC")) which owned, as of March 1, 1994, more than 5% of its Common Stock, Series A Preferred Stock, Series F Preferred Stock and Series T Preferred Stock are listed below: (1) Represents percent of class of stock outstanding (exclusive of treasury stock) on March 1, 1994. (2) Number of shares as to which such person has shared voting power-358,000; shared dispositive power-358,000. (3) These shares of Series A Preferred Stock are owned directly by affiliates of Berkshire, are convertible, under certain circumstances and subject to certain antidilution adjustments, into 9,239,944 shares of Common Stock and represent approxi- mately 10.5% of the combined voting power of the outstanding Common Stock, Series A Preferred Stock, Series F Preferred Stock and Series T Preferred Stock, voting as a single class, at March 1, 1994. A number of Rights, equal to the number of shares of Common Stock into which the Series A Preferred Stock is convertible, is also owned by this person. As disclosed above, two directors of the Company, Messrs. Buffett and Munger, may be deemed to control Berkshire and disclaim beneficial ownership of Series A Preferred Stock. (4) Number of shares as to which BA has sole voting power and sole dispositive power-30,000. (5) BritAir Acquisition Corp. Inc. is a wholly-owned subsidiary of BA and owns Series F Preferred Stock and Series T Preferred Stock pursuant to the Investment Agreement. Series F Preferred Stock and Series T Preferred Stock are convertible, under certain circumstances on or after January 21, 1997 and subject to certain antidilution adjustments and Foreign Ownership Restrictions, into a total of 15,458,658 and 3,831,695 shares of Common Stock, respectively. Together, the Series F Pre- ferred Stock and Series T Preferred Stock represent approxi- mately 21.9% of the combined voting power of the outstanding Common Stock, Series A Preferred Stock, Series F Preferred Stock and Series T Preferred Stock, voting as a single class, at March 1, 1994. A number of Rights, equal to the number of shares of Common Stock into which the Series F Preferred Stock and Series T Preferred Stock are convertible, is owned by this person. As disclosed above, three directors of the Company, Messrs. Marshall, Maynard and Stevens, have been designated by BA to act as directors of the Company pursuant to the Invest- ment Agreement and disclaim beneficial ownership of Series F Preferred Stock and Series T Preferred Stock. (6) Reflects 152.1 or 100% of the outstanding shares of Series T-1 Preferred Stock and 9,919.8 or 100% of the outstanding shares of Series T-2 Preferred Stock. BA has sole voting power and sole dispositive power as to all these outstanding shares of Series T Preferred Stock. (7) The Schedule 13G dated January 6, 1994 disclosing such ownership was jointly filed by such person with five French mutual insurance companies ("Mutuelles AXA") and AXA. The Schedule 13G indicated that each of Mutuelles AXA, as a group, and AXA expressly declares that the filing of the Schedule 13G should not be construed as an admission that it is, for purposes of Section 13(d) of the Securities Exchange Act of 1934, as amended, the beneficial owner of any securities covered by the Schedule 13G. The Company is investigating whether, owing to the investment of Mutuelles AXA and AXA (collectively, "AXA") in the Equitable Companies Incorporated ("Equitable"), AXA is the beneficial owner of these shares. If it is determined that AXA is the beneficial owner, then self-effectuating provisions of the Company's restated certificate of incorporation, as amended, would provide that the subject shares would be non-voting shares. The Company does not know whether Equitable would cause such shares to be sold in the event such shares have no voting rights. See "Management's Discussion and Analysis of Financial Condition and Results of Operations-Industry Globalization and Regula- tion" for information regarding U.S. statutory limitations on foreign ownership of U.S. air carriers and Item 1. "Business- British Airways Investment Agreement" and notes (4), (5) and (6) above for information regarding BA's ownership interest in the Company. (8) Number of shares as to which person has sole voting power- 5,669,403; shared voting power-1,300; no voting power-636,800; sole dispositive power-6,305,703; shared dispositive power- none; no dispositive power-1,800. (9) The shares are owned by a direct and an indirect subsidiary of the person. Number of shares as to which such subsidiaries have sole voting power-4,832,200; sole dispositive power- 4,832,200. In connection with BA's purchase of the Series T Preferred Stock in June 1993, Messrs. Marshall, Maynard and Stevens and BA were required by Section 16 of the Securities Exchange Act of 1934, as amended, and rules thereunder to file by July 10, 1993, Form 4 reports disclosing this change of ownership. Messrs. Marshall, Maynard and Stevens and BA filed these reports on September 14, 1993. Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None PART IV Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this report: 1. FINANCIAL STATEMENTS (i) The following consolidated financial statements of USAir Group are included in Part II, Item 8A of this report: - Consolidated Statements of Operations for each of the Three Years Ended December 31, 1993 - Consolidated Balance Sheets at December 31, 1993 and - Consolidated Statements of Cash Flows for each of the Three Years Ended December 31, 1993 - Consolidated Statements of Changes in Stockholders' Equity for each of the Three Years Ended December 31, - Notes to Consolidated Financial Statements (ii) The following consolidated financial statements of USAir are included in Part II, Item 8B of this report: - Consolidated Statements of Operations for each of the Three Years Ended December 31, 1993 - Consolidated Balance Sheets at December 31, 1993 and - Consolidated Statements of Cash Flows for each of the Three Years Ended December 31, 1993 - Consolidated Statements of Changes in Stockholder's Equity for each of the Three Years Ended December 31, - Notes to Consolidated Financial Statements 2. FINANCIAL STATEMENT SCHEDULES (i) Independent Auditors' Report on Consolidated Financial Statement Schedules of USAir Group. - Consolidated Financial Statement Schedules - Three Years Ended December 31, 1993: V - Property, Equipment and Leasehold Improvements VI - Accumulated Depreciation and Amortization of Prop- erty, Equipment and Leasehold Improvements VII - Guarantees of Securities of Other Issuers VIII - Valuation and Qualifying Accounts and Reserves X - Supplementary Income Statement Information (ii) Independent Auditors' Report on Consolidated Financial Statement Schedules of USAir. - Consolidated Financial Statement Schedules - Three Years Ended December 31, 1993: IV - Indebtedness to Related Parties - Not Current V - Property, Equipment and Leasehold Improvements VI - Accumulated Depreciation and Amortization of Prop- erty, Equipment and Leasehold Improvements VII - Guarantees of Securities of Other Issuers VIII - Valuation and Qualifying Accounts and Reserves X - Supplementary Income Statement Information All other schedules are omitted because they are not appli- cable or not required, or because the required information is either incorporated herein by reference or included in the financial statements or notes thereto included in this report. (b) Reports on Form 8-K During the quarter ended December 31, 1993, the Company and USAir filed Current Reports dated September 23, October 20, and November 4, 1993, on Form 8-K regarding the Second Waiver dated September 15, 1993 to the Credit Agreement, results for the quarter ended September 30, 1993 and the sale of $337.7 million of pass through certificates, respectively. The Company and USAir filed a Current Report dated January 18, 1994 on Form 8-K regarding the Third Waiver dated as of December 21, 1993 to the Credit Agreement. In addition, the Company and USAir filed a Current Report dated January 25, 1994 on Form 8-K regarding the press release dated January 25, 1994 of USAir Group, Inc. and USAir, Inc., with consolidated statements of operations for each company. On March 9, 1994, the Company and USAir filed a Current Report on Form 8-K disclosing projected losses for the first quarter and year 1994 and the initiation of negotiations with the leadership of USAir's unions regarding pay reductions and productivity improvements. 3. EXHIBITS Designation Description 3.1 Restated Certificate of Incorporation of USAir Group (incorporated by reference to Exhibit 3.1 to USAir Group's Registration Statement on Form 8-B dated January 27, 1983), including the Certificate of Amend- ment dated May 13, 1987 (incorporated by reference to Exhibit 3.1 to USAir Group's and USAir's Quarterly Report on Form 10-Q for the quarter ended March 31, 1987), the Certificate of Increase dated June 30, 1987 (incorporated by reference to Exhibit 3 to USAir Group's and USAir's Quarterly Report on Form 10-Q for the quarter ended June 30, 1987), the Certificate of Increase dated October 16, 1987 (incorporated by reference to Exhibit 3.1 to USAir Group's and USAir's Quarterly Report on Form 10-Q for the quarter ended September 30, 1987), the Certificate of Increase dated August 7, 1989 (incorporated by reference to Exhibit 3.1 to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1989), the Certificate of Increase dated April 9, 1992, the Certificate of Increase dated January 21, 1993, and as amended by Amendment No. 1 dated May 26, 1993 (incorporated by reference to Appendix II to USAir Group's Proxy State- ment dated April 26, 1993). 3.2 By-Laws of USAir Group (incorporated by reference to Exhibit 3.2 to USAir Group's and USAir's Annual Report on Form 10-K for the year ended December 31, 1992). 3.3 Rights Agreement, dated as of July 29, 1989, as amended and restated as of January 21, 1993, between USAir Group and Chemical Bank, as Rights Agent (incorporated by reference to Exhibit 28.4 to USAir Group's Current Report on Form 8-K dated January 21, 1993). 3.4 Restated Certificate of Incorporation of USAir (in- corporated by reference to Exhibit 3.1 to USAir's Registration Statement on Form 8-B dated January 27, 1983). 3.5 By-Laws of USAir (incorporated by reference to Exhibit 3.5 to USAir Group's and USAir's Annual Report on Form 10-K for the year ended December 31, 1992). 4.1 Amended Certificate of Designation, Preferences, and Rights of the Series D of Junior Preferred Stock of USAir Group (incorporated by reference to Exhibit 4(c) to USAir Group's Current Report on Form 8-K dated August 11, 1989). 4.2 Certificate of Designation of Series A Cumulative Convertible Preferred Stock of USAir Group (incorpo- rated by reference to Exhibit 4(b) to USAir Group's Current Report on Form 8-K dated August 11, 1989). 4.3 Certificate of Designation of Series B Cumulative Convertible Preferred Stock of USAir Group (incorpo- rated by reference to Exhibit 3.3 to Amendment No. 4 to USAir Group's Registration Statement on Form S-3 (Registration No. 33-39540) dated May 17, 1991). 4.4 Agreement between USAir Group and Berkshire Hathaway Inc. dated August 7, 1989 (incorporated by reference to Exhibit 4(a) to USAir Group's Current Report on Form 8- K dated August 11, 1989). 4.5 Certificate of Designation of Series F Cumulative Convertible Senior Preferred Stock of USAir Group (incorporated by reference to Exhibit 28.2 to USAir Group's Current Report on Form 8-K dated January 21, 1993). 4.6 Form of Certificate of Designation of Series T-_ Cumulative Exchangeable Convertible Senior Preferred Stock of USAir Group (incorporated by reference to Appendix VII to USAir Group's Proxy Statement dated April 26, 1993). Neither USAir Group nor USAir is filing any instrument (with the exception of holders of exhibits 10.1(a-h)) defining the rights of holders of long-term debt because the total amount of securities authorized under each such instrument does not exceed ten percent of the total assets of USAir. Copies of such instruments will be furnished to the Securities and Exchange Commission upon request. 10.1(a) Credit Agreement dated as of March 30, 1987 and Amended and Restated as of October 21, 1988 among the Banks named therein and USAir Group (incorporated by reference to Exhibit 28.2 to Amendment No. 1 dated October 28, 1988 to Piedmont's Registration Statement on Form S-3 No. 33-24870 dated October 7, 1988). 10.1(b) First Amendment, dated as of July 28, 1989, to USAir Group's Amended and Restated Credit Agreement (incor- porated by reference to Exhibit 10.1(b) to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1989). 10.1(c) Second Amendment, dated as of February 15, 1990, to USAir Group's Amended and Restated Credit Agreement (incorporated by reference to Exhibit 10.1 to USAir Group's Current Report on Form 8-K dated October 26, 1990). 10.1(d) Third Amendment, dated as of September 30, 1990, to USAir Group's Amended and Restated Credit Agreement (incorporated by reference to Exhibit 10.2 to USAir Group's Current Report on Form 8-K dated October 26, 1990). 10.1(e) Fourth Amendment, dated as of March 29, 1991, to USAir Group's Amended and Restated Credit Agreement (incor- porated by reference to the Exhibit to USAir Group's Current Report on Form 8-K dated April 23, 1991). 10.1(f) Fifth Amendment, dated as of April 26, 1991, to USAir Group's Amended and Restated Credit Agreement (incor- porated by reference to Exhibit 28.7 to USAir Group's Registration Statement on Form S-8 No. 33-39540 dated April 26, 1991). 10.1(g) Sixth Amendment, dated as of October 14, 1992, to USAir Group's Amended and Restated Credit Agreement (incor- porated by reference to Exhibit 28.3 to USAir Group's and USAir's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992). 10.1(h) Seventh Amendment, dated as of June 21, 1993, to USAir Group's Amended and Restated Credit Agreement (incor- porated by reference to Exhibit 28 to USAir Group's Current Report on Form 8-K filed on July 1, 1993). 10.2(a) Supplemental Agreement No. 16, dated July 19, 1990, to Purchase Agreement No. 1102 between USAir and The Boeing Company (incorporated by reference to Exhibit 10.2(a) to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1990). 10.2(b) Supplemental Agreement No. 17, dated November 28, 1990, to Purchase Agreement No. 1102 between USAir and The Boeing Company (incorporated by reference to Exhibit 10.2(b) to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1990). 10.2(c) Supplemental Agreement No. 18, dated December 23, 1991, to Purchase Agreement No. 1102 between USAir and The Boeing Company (incorporated by reference to Exhibit 10.2(c) to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1991). 10.3 Purchase Agreement No. 1725 dated December 23, 1991 between USAir and The Boeing Company (incorporated by reference to Exhibit 10.3 to USAir Group's and USAir's Annual Report on Form 10-K for the year ended Decem- ber 31, 1991). 10.4 USAir, Inc. Executive Incentive Compensation Plan (incorporated by reference to Exhibit 10.3 to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1989). 10.5 USAir, Inc. Officers' Supplemental Benefit Plan (incorporated by reference to Exhibit 10.5 to USAir's Annual Report on Form 10-K for the year ended December 31, 1980). 10.6 USAir, Inc. Supplementary Retirement Benefit Plan (incorporated by reference to Exhibit 10.5 to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1989). 10.7 USAir Group's 1984 Stock Option and Stock Appreciation Rights Plan (incorporated by reference to Exhibit A to USAir Group's Proxy Statement dated March 30, 1984). 10.8 USAir Group's 1988 Stock Incentive Plan (incorporated by reference to Exhibit 10.15 to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1987). 10.9 USAir Group's 1992 Stock Option Plan (incorporated by reference to Exhibit A to USAir Group's Proxy Statement dated March 30, 1992). 10.10 Employment Agreement between USAir and its President and Chief Executive Officer (which is similar in form to the employment agreements of USAir Group's other executive officers) (incorporated by reference to Exhibit 10.9 to USAir Group's and USAir's Annual Report on Form 10-K for the year ended December 31, 1991). 10.11 Agreements providing supplemental retirement benefits for the following officers of USAir: Executive Vice President and General Counsel (incorporated by reference to Exhibit 10.14 to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1987), Executive Vice President-Operations, Senior Vice President-Corporate Communications and Senior Vice President-Human Resources (incorporated by reference to Exhibit 10.9 to USAir Group's Annual Report on Form 10- K for the year ended December 31, 1989). 10.12(a) Trust Agreement dated as of August 1, 1989 between USAir Group and Wachovia Bank and Trust Company, N.A., as Trustee (incorporated by reference to Exhibit 10.10(a) to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1989). 10.12(b) Trust Agreement dated as of August 1, 1989 between USAir and Wachovia Bank and Trust Company, N.A., as Trustee (incorporated by reference to Exhibit 10.10(b) to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1989). 10.13 Investment Agreement dated as of January 21, 1993 between USAir Group and British Airways Plc (incorporated by reference to Exhibit 28.1 to USAir Group's and USAir's Current Report on Form 8-K filed on January 28, 1993, as amended by Amendment No. 1 on Form 8 filed on April 13, 1993). 10.13(a) Amendment dated as of February 21, 1994 to the Investment Agreement dated as of January 21, 1993 between USAir Group and British Airways Plc. 11 Computation of primary and fully diluted earnings per share of USAir Group for the five years ended December 31, 1993. 21 Subsidiaries of USAir Group and USAir. 23.1 Consent of the Auditors of USAir Group to the incorporation of their report concerning certain financial statements contained in this report in certain registration statements. 23.2 Consent of the Auditors of USAir to the incorporation of their report concerning certain financial statements contained in this report in certain registration statements. 24.1 Powers of Attorney signed by the directors of USAir Group, authorizing their signatures on this report. 24.2 Powers of Attorney signed by the directors of USAir, authorizing their signatures on this report. SIGNATURES Pursuant to the requirements of Section 13 of 15(d) of the Securities Exchange Act of 1934, USAir Group, Inc. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. USAir Group, Inc. By: /s/Seth E. Schofield --------------------------------- Seth E. Schofield Chairman, President and Chief Executive Officer (Principal Executive Officer) Date: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of USAir Group, Inc. and in the capacities and on the dates indicated. March 25, 1994 By: /s/Seth E. Schofield --------------------------------- Seth E. Schofield Chairman, President and Chief Executive Officer (Principal Executive Officer) March 25, 1994 By: /s/Frank L. Salizzoni --------------------------------- Frank L. Salizzoni Executive Vice President-Finance (Principal Financial Officer) March 25, 1994 By: /s/Ann Greer-Rector --------------------------------- Ann Greer-Rector Vice President & Controller (Principal Accounting Officer) March 25, 1994 By: * -------------------------------- Warren E. Buffett Director March 25, 1994 By: * --------------------------------- Edwin I. Colodny Director March 25, 1994 By: * -------------------------------- Mathias J. DeVito Director March 25, 1994 By: * -------------------------------- George J. W. Goodman Director March 25, 1994 By: * --------------------------------- John W. Harris Director March 25, 1994 By: * --------------------------------- Edward A. Horrigan, Jr. Director March 25, 1994 By: * --------------------------------- Robert LeBuhn Director March 25, 1994 By: * --------------------------------- Sir Colin Marshall Director March 25, 1994 By: * --------------------------------- Roger P. Maynard Director March 25, 1994 By: * --------------------------------- John G. Medlin, Jr. Director March 25, 1994 By: * --------------------------------- Hanne M. Merriman Director March 25, 1994 By: * -------------------------------- Charles T. Munger Director March 25, 1994 By: * --------------------------------- Richard P. Simmons Director March 25, 1994 By: * --------------------------------- Raymond W. Smith Director March 25, 1994 By: * -------------------------------- Derek M. Stevens Director By: /s/Frank L. Salizzoni ------------------------------ Frank L. Salizzoni Attorney-In-Fact SIGNATURES Pursuant to the requirements of Section 13 of 15(d) of the Securities Exchange Act of 1934, USAir, Inc. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. USAir, Inc. By: /s/Seth E. Schofield --------------------------------- Seth E. Schofield Chairman, President and Chief Executive Officer (Principal Executive Officer) Date: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of USAir, Inc. and in the capacities and on the dates indicated. March 25, 1994 By: /s/Seth E. Schofield --------------------------------- Seth E. Schofield Chairman, President and Chief Executive Officer (Principal Executive Officer) March 25, 1994 By: /s/Frank L. Salizzoni --------------------------------- Frank L. Salizzoni Executive Vice President-Finance (Principal Financial Officer) March 25, 1994 By: /s/Ann Greer-Rector --------------------------------- Ann Greer-Rector Vice President & Controller (Principal Accounting Officer) March 25, 1994 By: * -------------------------------- Warren E. Buffett Director March 25, 1994 By: * --------------------------------- Edwin I. Colodny Director March 25, 1994 By: * -------------------------------- Mathias J. DeVito Director March 25, 1994 By: * -------------------------------- George J. W. Goodman Director March 25, 1994 By: * --------------------------------- John W. Harris Director March 25, 1994 By: * --------------------------------- Edward A. Horrigan, Jr. Director March 25, 1994 By: * --------------------------------- Robert LeBuhn Director March 25, 1994 By: * --------------------------------- Sir Colin Marshall Director March 25, 1994 By: * --------------------------------- Roger P. Maynard Director March 25, 1994 By: * --------------------------------- John G. Medlin, Jr. Director March 25, 1994 By: * --------------------------------- Hanne M. Merriman Director March 25, 1994 By: * -------------------------------- Charles T. Munger Director March 25, 1994 By: * --------------------------------- Richard P. Simmons Director March 25, 1994 By: * --------------------------------- Raymond W. Smith Director March 25, 1994 By: * -------------------------------- Derek M. Stevens Director By: /s/Frank L. Salizzoni ------------------------------ Frank L. Salizzoni Attorney-In-Fact Independent Auditors' Report On Consolidated Financial Statement Schedules - USAir Group, Inc. The Stockholders and Board of Directors USAir Group, Inc.: Under date of February 25, 1994, we reported on the consoli- dated balance sheets of USAir Group, Inc. and subsidiaries ("Group") as of December 31, 1993 and 1992, and the related consolidated statements of operations, cash flows, and changes in stockholders' equity (deficit) for each of the years in the three- year period ended December 31, 1993, as included in Item 8A in this annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related consolidated financial statement schedules as listed in Item 14(a)2(i). These consolidated financial statement schedules are the responsibility of Group's management. Our responsibility is to express an opinion on these consolidated financial statement schedules based on our audits. In our opinion, such consolidated financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG PEAT MARWICK Washington, D. C. February 25, 1994 Independent Auditors' Report On Consolidated Financial Statement Schedules - USAir, Inc. The Stockholder and Board of Directors USAir, Inc.: Under date of February 25, 1994, we reported on the consolidated balance sheets of USAir, Inc. and subsidiaries ("USAir") as of December 31, 1993 and 1992, and the related consolidated statements of operations, cash flows, and changes in stockholder's equity for each of the years in the three-year period ended December 31, 1993, as included in Item 8B in this annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related consolidated financial statement schedules as listed in Item 14(a)2(ii). These consolidated financial statement schedules are the responsibility of USAir's management. Our responsibility is to express an opinion on these consolidated financial statement schedules based on our audits. In our opinion, such consolidated financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG PEAT MARWICK Washington, D. C. February 25, 1994 Exhibit 21 SUBSIDIARIES OF USAIR GROUP, INC. AND USAIR, INC. USAir Group, Inc. - ----------------- USAir, Inc. Piedmont Airlines, Inc. (formerly Henson Airlines, Inc.) Jetstream International Airlines, Inc. Pennsylvania Commuter Airlines, Inc. (d/b/a/ Allegheny Commuter Airlines) USAir Leasing and Services, Inc. USAir Fuel Corporation Material Services Corp. USAir, Inc. (the following companies are also indirect subsidiaries - ------------------------------------------------------------------- of USAir Group, Inc.) - --------------------- USAM Corp. Pacific Southwest Airmotive (substantially all of the assets of this company were sold on October 9, 1991) Exhibit 23.1 CONSENT OF INDEPENDENT AUDITORS The Board of Directors USAir Group, Inc. We consent to the incorporation by reference in the Registration Statements on Form S-8 Nos. 2-98828, 33-26762, 33-39896, 33-44835, 33-60618 and 33-60620 and the Registration Statement on Form S-3 No. 33-41821 of USAir Group, Inc., of our reports dated February 25, 1994 relating to the consolidated balance sheets of USAir Group, Inc. and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of operations, cash flows and changes in stockholders' equity, and the related consolidated financial statement schedules for each of the years in the three- year period ended December 31, 1993 which reports appear in the December 31, 1993 annual report on Form 10-K of USAir Group, Inc. and USAir, Inc. KPMG PEAT MARWICK Washington, D.C. March 25, 1994 Exhibit 23.2 CONSENT OF INDEPENDENT AUDITORS The Board of Directors USAir, Inc. We consent to the incorporation by reference in the Registration Statement on Form S-3 No. 33-35509 of USAir, Inc., of our reports dated February 25, 1994 relating to the consolidated balance sheets of USAir, Inc. and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of operations, cash flows and changes in stockholders' equity, and the related consolidated financial statement schedules for each of the years in the three- year period ended December 31, 1993 which reports appear in the December 31, 1993 annual report on Form 10-K of USAir Group, Inc. and USAir, Inc. KPMG PEAT MARWICK Washington, D.C. March 25, 1994 Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Warren E. Buffett, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Warren E. Buffett (L.S.) --------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Edwin I. Colodny, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 25 day of January, 1994. /s/Edwin I. Colodny (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Mathias J. DeVito, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Mathias J. DeVito (L.S.) --------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, George J. W. Goodman, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 13 day of January, 1994. /s/George J. W. Goodman (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, John W. Harris, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 26 day of January, 1994. /s/J. W. Harris (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Edward A. Horrigan, Jr., Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Edward A. Horrigan, Jr. (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Robert LeBuhn, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14th day of January, 1994. /s/Robert LeBuhn (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Colin Marshall, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 15 day of January, 1994. /s/C. Marshall (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Roger P. Maynard, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 15 day of January, 1994. /s/R. Maynard (L.S.) --------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, John G. Medlin, Jr., Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 19th day of January, 1994. /s/John G. Medlin, Jr. (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Hanne M. Merriman, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Hanne M. Merriman (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Charles T. Munger, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 24th day of January, 1994. /s/Charles T. Munger (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Richard P. Simmons, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 13th day of January, 1994. /s/Richard P. Simmons (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Raymond W. Smith, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/R. W. Smith (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Derek M. Stevens, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 26 day of January, 1994. /s/Derek M. Stevens (L.S.) --------------------------------- Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Warren E. Buffett, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Warren E. Buffett (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Edwin I. Colodny, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 25 day of January, 1994. /s/Edwin I. Colodny (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Mathias J. DeVito, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Mathias J. DeVito (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, George J. W. Goodman, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 13 day of January, 1994. /s/George J. W. Goodman (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, John W. Harris, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 26 day of January, 1994. /s/J. W. Harris (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Edward A. Horrigan, Jr., Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Edward A. Horrigan, Jr. (L.S.) --------------------------------- Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Robert LeBuhn, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14th day of January, 1994. /s/Robert LeBuhn (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Colin Marshall, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 15 day of January, 1994. /s/C. Marshall (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Roger P. Maynard, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 15 day of January, 1994. /s/R. P. Maynard (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, John G. Medlin, Jr., Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 19th day of January, 1994. /s/John G. Medlin, Jr. (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Hanne M. Merriman, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Hanne M. Merriman (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Charles T. Munger, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 24th day of January, 1994. /s/Charles T. Munger (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Richard P. Simmons, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 13th day of January, 1994. /s/Richard P. Simmons (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Raymond W. Smith, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/R. W. Smith (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Derek M. Stevens, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 26 day of January, 1994. /s/Derek M. Stevens (L.S.) ------------------------------

Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDI- TION AND RESULTS OF OPERATIONS Management's Discussion and Analysis of Financial Condition and Results of Operations presented below relates to the Consoli- dated Financial Statements of USAir Group, Inc. ("USAir Group" or the "Company") presented in Item 8A. Consolidated Financial Statements for USAir, Inc. ("USAir"), the Company's principal subsidiary, are presented in Item 8B. USAir's operating revenue accounted for more than 93% of the Company's operating revenue in each of the last three years. USAir Group also owns three commuter airline subsidiaries, which accounted for more than 5% of the Company's operating revenue in each of the last three years. Therefore, the following discussion and analysis of results of operations relates principally to the operations of USAir and to the airline industry. The following general factors are among those that influence USAir's financial results and its future prospects: 1. General economic conditions and industry capacity. 2. A decline in the proportion of passengers paying higher yield "business fares" to passengers paying lower yield fares. 3. The emergence and growth of low cost, low fare airlines and USAir's high cost structure. 4. The trend toward globalization in the airline industry and related regulatory limitations. These and other factors are discussed in the following sections. General Economic Conditions and Industry Capacity Historically, demand for air transportation has tended to mirror general economic conditions. Economic conditions in the United States and fare competition in the domestic airline industry continued to be major factors affecting the financial condition of USAir and the airline industry in 1993. In recent years, the change in industry capacity has failed to mirror the reduction in demand for domestic air transportation due primarily to continued delivery of new aircraft and, secondarily, to the operation of certain major U.S. carriers under the protection of Chapter 11 of the Bankruptcy Code for extended periods. While industry capacity has leveled off and the general economy has shown signs of improvement, the Company expects that the airline industry will remain extremely competitive for the foreseeable future. See the discussion of low cost, low fare airlines below. During the recent economic recession, some observers of the travel industry speculated that the business traveler became less reliant on air transportation as teleconferencing, telecopying and other technological developments gained wider acceptance. In addition, some observers have speculated that corporate restructur- ing and furloughs in the U.S. have reduced the number of business travelers and that the leisure traveler has become conditioned to waiting for promotional fares before making travel plans. The Company is unable to determine whether these structural changes have occurred in the air transportation market or if these changes have occurred, how long-lived these trends will be. However, the Company believes that for the foreseeable future the demand for higher yield "business fares" will remain essentially flat and relatively inelastic while the lower yield "leisure" market will continue to grow with the general economy. This trend could make it more difficult for the domestic airlines, including USAir, to sustain meaningful yield increases in the future. Financial circumstances have compelled certain bankrupt or financially weakened carriers to sell assets, including foreign routes, gates and take-off and landing slots at capacity con- strained airports. Proceeds from asset sales provide cash infusions to weaker carriers, but also augment the route systems and market presence of the stronger carriers. Although USAir has completed route and other asset purchases from a number of weaker carriers, the purchases illustrate a trend of consolidation of strategic assets and financial strength within the industry which appears to benefit the three largest U.S. carriers in the long- term. In the short-term, however, these carriers have suffered from the cost of integrating these assets into their systems and from the incremental capacity which has been exacerbated by declines in passenger travel and fare wars. As a result, these carriers have taken or announced actions including reduction in workforce and salary and other employee benefits, concessions from unionized employees, deferral of new aircraft deliveries, early retirement of inefficient aircraft types, and termination of unprofitable service. USAir implemented similar measures during 1990-1993, including a workforce reduction of 2,500 full-time positions between November 1993 and the first quarter of 1994, which, along with other measures, is expected to save the Company approximately $200 million in 1994. USAir will pursue additional measures in 1994 to reduce further its operating costs. See Item 1. "Business - Significant Impact of Low Cost, Low Fare Competi- tion" and "-British Airways Announcement Regarding Additional Investment in the Company; Code Sharing." In 1993, USAir reached an agreement with the Boeing Company ("Boeing") to, among other things, exercise options to purchase additional B757-200 aircraft on an accelerated basis and to cancel and reschedule the delivery of certain Boeing 737 aircraft on order into the future. This agreement reduced USAir's capital expendi tures by more than $880 million between 1993 and 1996. USAir is currently in negotiations with Boeing regarding, among other things, the current schedule of new aircraft deliveries. Each major airline has developed a frequent traveler program that offers its passengers incentives to maximize travel on that particular carrier. Participants in such programs typically earn "mileage credits" for every trip they fly that can be redeemed for airline travel or, in some cases, for other benefits. Under USAir's Frequent Traveler Program ("FTP"), participants receive mileage credits equal to the greater of actual miles flown or 750 miles for each paid flight on USAir or USAir Express, or actual miles flown on one of USAir's FTP airline partners. Participants flying on first or business class tickets receive additional credits. Participants may also earn mileage credits by staying at participating hotels or by renting cars from participating car rental companies within 24 hours of a flight. Mileage credits can be redeemed for certificates for various travel awards, including fare discounts, first class upgrades and tickets on USAir or other airlines participating in USAir's FTP. Certain awards also include hotel and car rental awards. Award certificates may not be brokered, bartered or sold, and have no cash value. USAir and its airline partners limit the number of seats allocated per flight for award recipients. The number of seats varies depending upon flight, day, season and destination. Award travel is not permitted on blackout dates, which generally correspond to certain holiday periods in the United States or peak travel dates to foreign destinations. Hotel awards are valid at participating hotels and are subject to room availability, which is limited. Car rental awards are valid only at participating locations. The number of cars available for award usage is limited, and no cars are available for award usage on blackout dates. USAir reserves the right to terminate the FTP or portions of the program at any time, and the FTP's official rules, partners, special offers, blackout dates, awards and mileage levels are subject to change with or without prior notice. USAir accounts for its FTP under the incremental cost method, whereby travel awards are valued at the incremental cost of carrying one additional passenger. Such costs are accrued when FTP participants accumulate sufficient miles to be entitled to claim award certificates. No value is assigned to airline, hotel or car rental award certificates that are to be honored by other parties. Incremental costs include unit costs for passenger food, beverages and supplies, fuel, liability insurance and denied boarding compensation expenses expected to be incurred on a per passenger basis. No profit or overhead margin is included in the accrual for incremental costs. FTP participants had accumulated mileage credits for approxi- mately 3,896,000 awards (at the 20,000 mile level required for a free domestic flight on USAir) at December 31, 1993, compared with 3,199,000 awards at December 31, 1992. However, because USAir expects that some award certificates will be redeemed by other airlines participating in USAir's FTP, that some certificates will expire, and that some accumulated mileage credits will never be applied towards award certificates, the calculations of the accrued liability for incremental costs at December 31, 1993 and 1992 were based on approximately 88% and 86%, respectively, of the accumulat- ed credits. Mileage for FTP participants who have accumulated less than the minimum number of mileage credits necessary to claim an award is excluded from the calculation of the accrual. Most participants belong to more than one frequent traveler program and it is not possible to project when or if participants will accrue additional mileage credits required to earn an award. Incremental changes in the liability resulting from additional mileage credits are recorded as part of the regular review process. Effective January 1, 1995, USAir will increase the minimum mileage level required for a free domestic flight from 20,000 to 25,000. USAir's customers redeemed approximately 841,000, 626,000 and 654,000 awards for free travel on USAir in 1993, 1992 and 1991, respectively, representing approximately 8.0%, 4.9% and 5.3% of USAir's revenue passenger miles ("RPMs") in those years, respec- tively. During 1993, two "free ticket for segments flown" promotions were completed which increased the number of awards used for free travel on USAir. These promotions were offered in response to similar promotions offered by USAir's competitors. USAir does not believe that usage of FTP awards results in any significant displacement of revenue passengers. USAir has the ability, through its inventory management system, to identify markets and flights expected to have high load factors and, through capacity controls, to maximize use of FTP awards on flights with lower demand and available seats. Also, blackout dates forestall the usage of awards on peak travel days. Furthermore, USAir's exposure to the displacement of revenue passengers is not signifi- cant, as the number of USAir flights that depart 100% full is minimal. In the third quarter of 1993 (the third quarter being the period of the year when USAir generally experiences its highest load factor and expects the usage of FTP awards to be highest), for example, fewer than 2.2% of USAir's flights departed 100% full. During this same quarterly period, only approximately 1.9% of USAir's flights departed 100% full and also had one or more passengers on board who were traveling on FTP award tickets. Airlines often use other competitive promotions, such as offering extra credits or reduced award thresholds under certain conditions, as incentives to stimulate travel. USAir reviews these promotions to determine the proper accounting treatment for each one. To the extent these promotions are determined to be an integral part of the FTP, they are accounted for in the same manner as free travel earned through mileage credits. Low Cost, Low Fare Competition In September 1993, Southwest Airlines, Inc. ("Southwest"), a low cost, low fare, "no frills" air carrier which had not previous- ly provided service to or in the eastern U.S., inaugurated service to Chicago and Cleveland from Baltimore/ Washington International Airport ("BWI") at fares substantially below those previously offered by USAir and other airlines in the same markets. BWI is one of USAir's hub airports. Unlike the other major U.S. air carriers, Southwest does not structure its operations around connecting hub airports, relying instead on high frequency point- to-point service. USAir responded by matching most of Southwest's fares and increasing the frequency of service in related markets. On March 22, 1994, Southwest announced that on May 26, 1994, and June 6, 1994, it will expand service between BWI and Chicago. Southwest also announced that on May 26, 1994, it will initiate its low fare service between BWI and St. Louis, and on July 8, 1994, between BWI and Birmingham, Alabama and Louisville, Kentucky. At this time, USAir has not determined its response to the Southwest announcement. In October 1993, Continental Airlines ("Continental"), which had reorganized under bankruptcy proceedings earlier in 1993, inaugurated low fare service on certain routes in the eastern U.S. USAir is a competitor in most of the markets served by these routes. While Continental initiated service to certain cities, such as Charleston, South Carolina; Greensboro, North Carolina; and Jacksonville, Florida; most of the markets included as part of its new program (for example, Baltimore) were previously served by Continental through its hubs at Newark, Cleveland, and Houston. However, under its new program, Continental linked certain of these cities independently of its hubs while continuing to provide many of the same services that are available on its hub flights, including advance seat assignment, frequent traveler mileage credits and interline connections. Under its new program, Continental served approximately 80 city pair markets, from which USAir has historically realized approximately 4% of its total passenger revenue. When Continental started the new program it was uncertain whether the program was an experiment or a beachhead from which Continental planned to expand further. USAir, therefore, made a measured response by matching most of the low fares offered by Continental. On January 31, 1994, Continental increased its competitive threat. It announced that by March 9, 1994, it would expand the low fare program to approximately 356 city pair markets, most of which USAir served and from which USAir has historically realized approximately 8% of its passenger revenue. Moreover, if secondary markets within a 90-mile radius, or a reasonable driving distance, were viewed as being included in Continental's new program, markets from which USAir has historically realized approximately 36% of its passenger revenue were affected. Contemporaneously, Continental announced that it would substantially reduce service at its Denver hub and redeploy significant aircraft and personnel resources to the eastern U.S. Although Continental's balance sheet continues to have significant leverage following its bankruptcy reorganization, its liquidity position improved substantially as a result of equity and debt infusions completed as part of that reorganization. Moreover, Continental completed a common stock offering in December 1993, which may indicate the market's receptivity to its efforts to raise additional funds. Continental has operating (including labor) costs that are substantially lower than those of USAir and the other major air carriers. On February 8, 1994, in response to the expansion of Continen- tal and to avoid loss of market share in the eastern U.S., USAir lowered in primary and secondary markets affected by the Continen- tal expansion, by as much as 50%, the fares most commonly used by business travelers on many east coast routes. In addition, USAir lowered leisure fares by as much as 70% in the same markets. In many of the markets, free companion fares are available with business fares. These reduced fares have no expiration date. However, USAir could adjust the fares at some time in the future. Increases in traffic which are stimulated by the lower fares offered by Southwest, Continental and USAir will not offset USAir's reduced revenue resulting from lower yields in these markets. USAir believes that Southwest, Continental or other low cost carriers with a significant cost advantage over USAir likely will expand their operations to additional markets. For example, in December 1993, Southwest completed its acquisition of Morris Air, a regional air carrier with operations concentrated in the western U.S. This acquisition could enable Southwest to divert resources to expand its operations in the eastern U.S. Furthermore, media reports indicate that Southwest has entered into a long-term agreement for the use of four additional gates at BWI, where it currently operates from two gates. On March 4, 1994, Continental further escalated prospective competition by announcing that it will further reduce operations at its Denver, Colorado hub and establish a flight crew base at Greensboro, North Carolina. These measures are likely to increase losses at USAir because they could enable Continental, which has significantly lower costs than USAir, to expand further its high frequency, low fare service described above in additional short-haul markets served by USAir with substantial detriment to USAir. In addition, other low cost carriers may enter other USAir markets. For example, America West announced on February 15, 1994 that it will commence service on April 18, 1994 between Columbus, Ohio where it operates a hub and Philadelphia, where USAir has a hub operation. Other carriers, including some of the larger carriers, have also indicated their intent to develop similar low-fare short-haul service. Unless USAir is able to reduce its operating costs, present and increasing competition from low cost, low fare airlines in USAir's markets could have a material adverse impact on USAir's cash position and therefore, its ability to sustain operations. In March 1994, USAir announced that it had initiated discussions with the leadership of its unionized employees regarding wage reduc- tions, improved productivity and other cost savings. The outcome of these negotiations is uncertain, but if timely agreements are not reached, the Company may seek other restructuring alternatives. See Item 1. "Business - Significant Impact of Low Fare, Low Cost Competition". In 1993, Northwest Airlines, Inc. ("Northwest") and Trans World Airlines, Inc. ("TWA") sought and obtained from unionized employees substantial concessions and productivity improvements. In exchange, these employees have received ownership interests in those companies. In December 1993, United Airlines, Inc. ("Unit- ed") announced that it had reached agreement with two of its unions to trade concessions for a substantial ownership stake by all employees, subject to approval by United's stockholders. The memberships of these two unions have ratified the agreement. The stated intent and purpose of these labor concessions are to enable these carriers to lower their operating costs. At this time, it is uncertain whether the United transaction will be consummated and whether these events constitute isolated incidents or a trend of employee ownership in the airline industry. As an airline with relatively high labor costs and a route system with a significant percentage of short-haul flying, USAir is considering additional ways to reduce these costs which could involve an exchange of employee concessions for an ownership interest in the Company. USAir is currently engaged in discussions with the leaders of its unionized employees regarding efforts to reduce costs, including reductions in wages, improvements in productivity and other cost savings. The outcome of these discussions is uncertain. See Item 1. "Business - Significant Impact of Low Fare, Low Cost Competi- tion." USAir has been examining various ways to restructure its operations to increase efficiency and lower unit costs in markets of approximately 500 miles or less in distance. Certain carriers, such as Southwest and Continental, have a substantial cost advantage over USAir in these short-haul markets. In addition, consumers appear to be increasingly price conscious, particularly for short distance flights. In February 1994, USAir implemented the first phase of the introduction of a new short-haul product in 18 city-pair markets of approximately 500 miles or less, resulting in increased utilization and productivity of aircraft, personnel, and ground facilities in these markets by decreasing the amount of time that aircraft spend on the ground between flights from an average of 45 minutes to approximately 25 minutes. Initiation of the first phase of this service did not involve any immediate pricing changes or new personnel. Ultimately, USAir anticipates that enhancements to the short-haul product will be completed in summer 1994, and that long-haul and transatlantic service will be redesigned later in 1994. USAir plans to expand this higher frequency service to additional short-haul and other markets in July 1994, with a total fleet of approximately 100 aircraft. Although USAir expects this higher frequency operation will result in reduced unit costs in relevant markets, certain variable costs generally associated with providing the incremental flights, including jet fuel, landing fees and labor, will increase. There can be no assurance, therefore, that the changes will result in improved financial results for USAir. If USAir cannot find ways to compete effectively with low cost carriers by lowering its operating costs, and to generate sufficient additional passengers to offset the effect of sharply reduced fares, USAir's revenue and results of operations will continue to be materially and adversely affected. Industry Globalization and Regulation The trend toward globalization of the airline industry has accelerated in recent years as the three largest U.S. carriers have initiated foreign service and purchased the foreign routes of financially distressed or bankrupt U.S. carriers. In addition, certain foreign carriers have made substantial investments in U.S. carriers which have frequently been tied to marketing alliances or, less frequently, reciprocal investments by the U.S. carrier in its foreign partner. In August 1993, Continental announced that it had reached agreement with Air France on a joint marketing agreement. Earlier in the year, Air Canada made a substantial equity invest- ment in Continental in connection with Continental's bankruptcy reorganization. In October 1993, United and Lufthansa German Airlines announced that they had reached an agreement to implement code sharing to link some of their flights. Continuing privatiza- tion of sovereign carriers and foreign airline deregulation may encourage further foreign investment. Foreign investment in U.S. air carriers is restricted by statute and may be subject to review by the U.S. Department of Transportation ("DOT") and, on antitrust grounds, by the U.S. Department of Justice ("DOJ"). On January 21, 1993, USAir Group and British Airways Plc ("BA") entered into an Investment Agreement ("Investment Agree- ment") under which a wholly-owned subsidiary of BA has purchased certain preferred stock of the Company for $400.7 million. On March 7, 1994, BA announced that it would not make any additional investments in the Company under current circumstances. See "Liquidity and Capital Resources" and Item 1. "Business - British Airways Announcement Regarding Additional Investments in the Company; Code Sharing" and "- British Airways Investment Agreement" for additional information related to the investment. Under the Investment Agreement, USAir and BA have entered into a code sharing arrangement under which certain domestic USAir flights, connecting to certain BA transatlantic flights, may be listed on computerized reservation systems either under USAir's or BA's two letter designation code, subject to authorization by the DOT. As of March 1, 1994, USAir and BA offered code share service to and from 34 of the 65 airports authorized by the DOT. On March 17, 1994, the DOT issued an order renewing for one year the existing code sharing authority. In January 1994, USAir and BA filed applica- tions with the DOT to code share to 65 additional domestic and seven additional foreign destinations. The DOT did not act on these applications in its March 17, 1994 order. See Item 1. "Business - British Airways Announcement Regarding Additional Investments in the Company; Code Sharing" and "-British Airways Investment Agreement". USAir and BA are in the process of expanding their code sharing arrangement. USAir believes that it will have greater access to international traffic and that its and BA's customers will benefit from better on-line connections as well as coordinated check-in and baggage checking procedures. USAir also believes that the code sharing arrangement will generate increased revenues, the magnitude of which cannot be reasonably estimated at this time. The DOT may continue to link further renewals of the code share authorization to the United Kingdom's ("U.K.") liberalization of U.S. air carrier access to the U.K. markets. However, the code sharing arrangement is expressly permitted under the bilateral air services agreement between the U.S. and U.K. USAir expects that the authorization will be renewed in the future; however, there can be no assurance that this will occur. USAir does not believe that the DOT's failure to renew the code share authorization or grant the pending application would result in a material adverse change in its financial condition. However, further investment in the Company by BA, as contemplated in the Investment Agreement, may be less likely. See Item 1. "Business - British Airways Announcement Regarding Additional Investments in the Company; Code Sharing" and "-British Airways Investment Agreement." Current U.S. law provides that foreign ownership or control of the voting interest in a certificated U.S. air carrier may not exceed 25%, non-U.S. citizens may not constitute more than a third of the board of directors and managing officers of the air carrier and the president of the air carrier must be a U.S. citizen. Over the years in the context of "fitness" reviews to determine whether air carriers could be issued, or continue to hold, operating certificates, the DOT has also issued interpretations regarding whether investments by, or other arrangements with, foreign investors constitute de facto control over a U.S. air carrier. Although the Company believes the policy has no basis in law, recently and particularly during 1992 and 1993, the DOT has linked its review of foreign investment in, and foreign alliances with, U.S. air carriers to the status of the bilateral air transportation treaty between the U.S. and the country of origin of the foreign airline. The willingness of the DOT to allow proposed foreign investments, alliances and participation in corporate governance has been linked to its perception of the liberality of the relevant treaty with respect to the right of U.S. air carriers to operate to, from and beyond the foreign country. For example, the Netherlands entered into a new bilateral treaty with the U.S. in 1992 which permitted "open skies", or unrestricted access to the Netherlands by U.S. air carriers. As a result, in 1992 the DOT approved Northwest's proposal to integrate its operations with those of KLM Royal Dutch Airlines, an airline based in that nation. However, the DOT has refused to allow USAir and BA to proceed with the second and third phases of their Investment Agreement, which calls for an additional investment of $450 million by BA, unless and until the U.K. government agrees to amend its bilateral air services agreement with the U.S. to permit new services by U.S. carriers to the U.K. and particularly to London's Heathrow Airport. The U.S. and U.K. governments held several negotiating sessions during the past year and have exchanged proposals to amend the bilateral agreement, but to date the two governments have failed to resolve their differences. As a result, USAir and BA were unable to proceed with the second and third phases of the Investment Agreement in 1993. In any event, on March 7, 1994, BA announced that it would not make any additional investments in the Company under current circumstances. See Item 1. "Business - British Airways Announcement Regarding Additional Investment in the Company; Code Sharing" and "-British Airways Investment Agreement." The National Commission to Ensure a Strong Competitive Airline Industry ("Airline Commission") issued its report in August 1993. The Airline Commission was a presidentially-appointed committee with the task of analyzing the condition of the U.S. airline industry and reporting to the Clinton Administration its findings and recommendations. Among other things, the Airline Commission recommended that: (i) the air traffic control system be modernized and the Federal Aviation Administration's ("FAA") air traffic control functions be performed by an independent federal corpora- tion; (ii) the federal regulatory burden be reduced; (iii) the airlines be granted certain tax relief; and (iv) the bankruptcy process be shortened. The Airline Commission also favored raising the statutory limit on foreign ownership of voting securities in the U.S. airlines to 49 percent under certain circumstances. It further urged that the current international system of bilateral agreements be replaced with multilateral arrangements. In addition, the Airline Commission recommended that the DOT review the airlines' business, capital or financial plans with the assistance of a presidentially-appointed advisory committee and, if an airline repeatedly failed to heed warnings or concerns of the DOT Secretary, the DOT could "exercise its existing authority", among other things, to revoke an airline's operating certificate. In January 1994, the Clinton Administration issued a report which described its program to implement certain of the Airline Commission's recommendations. Among other things, the Administra- tion stated that it supported the recommendation described above regarding the FAA, supported increasing to 49 percent the foreign ownership restrictions provided there are reciprocal opportunities for U.S. airlines and investors abroad, and opposed the recommenda- tions regarding tax relief and the appointment of the advisory committee discussed above. At this time, it is impossible to predict whether any of the Airline Commission's recommendations will be enacted and, if enacted, their effect on USAir. It is also difficult to anticipate whether the Congress will act in the near term on any of the proposals requiring legislation. As part of its initiative in the transportation industry, the Clinton Administration also indicated that the DOT has begun a comprehensive examination of the "high density rule" which limits airline operations at Chicago O'Hare, New York's LaGuardia ("LaGuardia") and John F. Kennedy International, and Washington National ("National") Airports by restricting the number of takeoff and landing slots. As part of its study, the DOT will determine whether the operating limitations imposed by the rule can be eliminated or modified to better utilize available capacity at these airports. USAir holds a substantial number of slots at LaGuardia and National, including those assigned a value when the Company acquired Piedmont Aviation, Inc. Any DOT action which would eliminate those slots or compel USAir to transfer those slots could have a material adverse effect on USAir's operations and financial position. Revision of the high density rule at National, however, would require legislation by the Congress. The DOT has indicated that it expects to complete its study by late 1994. RESULTS OF OPERATIONS 1993 Compared with 1992 The Company recorded a net loss of $393.1 million on revenue of $7.1 billion, in 1993 compared with the 1992 net loss of $1.2 billion on revenue of $6.7 billion. Several non-recurring items, which include the cumulative effect of accounting changes, make it difficult to compare these results. After excluding the effect of certain non-recurring items discussed below, which amount to $153.2 million and $759.3 million in 1993 and 1992, respectively, the net loss would have been $239.9 million in 1993 ($5.69 per common share after preferred dividend requirement) compared with a loss of $469.6 million in 1992 ($11.09 per common share after preferred dividend requirement). The Company's 1993 financial results contain $153.2 million of non-recurring items, including (i) $68.8 million for severance, early retirement and other personnel-related expenses recorded in connection with a workforce reduction of approximately 2,500 full- time positions between November 1993 and the first half of 1994; (ii) $43.7 million for the cumulative effect of an accounting change, as required by Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("FAS 112"), which was adopted during the third quarter of 1993, retroactive to January 1, 1993; (iii) $36.8 million based on a projection of the repayment of certain employee pay reductions; (iv) $13.5 million for certain airport facilities at locations where USAir has, among other things, discontinued or reduced its service; (v) $8.8 million for a loss on USAir's investment in the Galileo International Partnership, which operates a computerized reservations system; and (vi) an $18.4 million credit related to non-operating aircraft. The Company's 1992 financial results contain $759.3 million of non-recurring items, including (i) $628.1 million for the cumula- tive effect of an accounting change, as required by Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" ("FAS 106"); (ii) $107.4 million related to aircraft which have been withdrawn from service; (iii) $34.1 million loss related to the sale of ten McDonnell Douglas 82 ("MD-82") aircraft which USAir had on order but eliminated from its fleet plan; and (iv) $10.3 million gain resulting from the sale of three of the Company's subsidiaries during 1992. Operating Revenue - The Company's Passenger Transportation Revenue increased by $356.5 million (5.8%) in 1993 compared with 1992, primarily due to the $296.0 million (5.1%) increase at USAir. USAir's capacity, as measured by available seat miles ("ASM" - one ASM is equal to one seat flown one mile), decreased by 0.3% in 1993 compared with 1992, its passenger revenue per ASM increased by 5.4% to 10.22 cents and its passenger load factor, a measure of capacity utilization, increased by 0.4 points to 59.2%. The increase in passenger revenue per ASM is largely attributed to the lower level of discounting in 1993 versus 1992. The Company expects that it will experience a 1 - 2% increase in ASMs (including the effect of weather-related cancellations) in 1994 compared with 1993. Continued fare discounting and low fares offered by USAir to compete with low cost, low fare carriers discussed above, are expected to have a negative impact on the Company's passenger revenue. It is not expected that the resulting decrease in revenue per ASM will be totally offset by additional passengers. The severe winter weather conditions in the U.S. during the early part of 1994 have caused a reduction in revenue which the Company estimates at approximately $50 million. In March 1993, USAir and five other U.S. air carriers entered into a settlement in the Domestic Air Transportation Antitrust Litigation class action lawsuit, which alleged that the airlines used the Airline Tariff Publishing Company to signal and communi- cate carrier pricing intentions and otherwise limit price competi- tion for travel to and from numerous hub airports. It is possible that this settlement could have a dilutive effect on USAir's passenger transportation revenue and associated cash flow. However, due to the interchangeability of the certificates among the six carriers involved in the settlement, the possibility that carriers not party to the settlement will honor the certificates, and the potential stimulative effect on travel created by the certificates, USAir cannot reasonably estimate the impact of this settlement on future passenger revenue and cash flows. USAir has estimated that any incremental cost associated with the settlement will not be material based on the nominal equivalent free trips associated with the settlement. See Note 4 to the Company's Consolidated Financial Statements for additional information. The Company's Other Revenue increased by $38.8 million (12.3%) in 1993. USAir's increase of $90.5 million (32.3%) was partially offset at the Company level by a decrease in non-airline subsidiary revenue resulting from the sale of three wholly-owned subsidiaries in July 1992. USAir's 32.3% improvement resulted from increased passenger cancellation and rebooking fees, frequent traveler participation fees, and various other sources. Expense - The Company's total operating expenses increased $141.7 million (2.0%) in 1993 compared with 1992. The Company's Personnel Costs increased by $217.7 million (8.3%), $205.6 million of which is attributable to USAir. USAir's increase includes (i) $65.6 million of the $68.8 million non-recurring charge related to a workforce reduction of 2,500 full-time positions; and (ii) the $36.8 million charge based on an estimate of the repayment of certain employee pay reductions, both discussed above. Without the effect of these non-recurring charges, USAir experienced an increase in employee salaries of $91.4 million (4.7%) and an increase in employee benefits of $11.8 million (2.1%). The increase in employee salaries is generally due to contractual and general salary increases which occurred during 1993. The amount saved as a result of the 12-month salary reduction program was approximately the same in 1993 and 1992. USAir expects that due to scheduled contractual increases and the effect of the expiration of the 12-month salary reduction program, employee salaries will increase in 1994 to the extent that the reduction of 2,500 full- time positions and any other possible measures do not offset the increases. See Item 1. "Business - Significant Impact of Low Fare, Low Cost Competition" and "- Employees" for information related to the possible unionization of additional employee groups. The $11.8 million increase in employee benefits is the result of increased pension expense, offset partially by a decrease in other postretir- ement benefit expense. The increased pension expense in 1993 resulted from the establishment of a defined contribution pension plan for USAir's non-contract employees on January 1, 1993. The defined benefit plan for these employees was frozen at December 31, 1991. Because of the interest rates on long-term, high quality corporate bonds which prevailed at December 31, 1993, the Company has lowered its discount rate used to calculate the actuarial present value of its pension and postretirement obligations. This action will cause an increase in the Company's pension and other postretirement benefits expense in 1994 of approximately $70 million over 1993. See Note 11 to the Company's Consolidated Financial Statements. The Company's Aviation Fuel Expense decreased $43.2 million (5.7%) as a result of a lower cost per gallon and decreased consumption. In early August 1993, the Clinton Administration's budget package was enacted. The budget package included a 4.3 cent per gallon tax on transportation fuels beginning October 1, 1993. The airline industry is exempt from the tax until October 1, 1995. See Item 1. "Business - Jet Fuel" and Note 1 to the Company's Consolidated Financial Statements. Commissions increased by $27.2 million (4.8%) as a result of the 5.8% increase in Passenger Transportation Revenue. The Company's Other Rent and Landing Fees increased $64.3 million (15.8%) primarily due to an increase in USAir's facility rental expense following the opening of the new terminal at Pittsburgh in October 1992, and the $8.9 million of non-recurring expense recorded for certain airport facilities, discussed above. The Company's Aircraft Rent Expense included a $72.4 million non- recurring charge in 1992 (part of the $107.4 million discussed above). Without this charge, aircraft rent expense increased $15.0 million (3.3%) due to the addition of new leased aircraft in 1993. Excluding the effect of non-recurring items in 1992 and 1993, Aircraft Maintenance Expense increased by $37.6 million (10.6%) resulting from the timing of aircraft maintenance cycles. Other Operating Expense decreased by $58.0 million (4.0%), reflecting a $25.0 million (1.8%) decrease at USAir and a $58.4 million decrease which resulted from the sale of three wholly-owned subsidiaries in July 1992, offset by increases at the Company's other wholly-owned subsidiaries. The Company's Interest Capitalized decreased $10.0 million (36.1%) as the level of outstanding purchase deposits decreased with the delivery of new aircraft and changes in delivery sched- ules. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes", ("FAS 109"). The adoption of FAS 109 resulted in no cumulative adjustment. Results for 1993 do not include any income tax credit due to the FAS 109 limitations in recognizing a current benefit for net operating losses. See Note 6 to the Company's Consolidated Financial Statements for additional information. 1992 Compared With 1991 The Company recorded a net loss of $1.2 billion on revenue of $6.7 billion in 1992, compared with the 1991 net loss of $305.3 million on revenue of $6.5 billion. Several non-recurring items, which include the cumulative effect of an accounting change, make it difficult to compare these results. In addition, the Company recorded no tax credit in 1992. After excluding the effect of certain non-recurring items which amount to a net charge of $759.3 million and a net gain of $45.9 million in 1992 and 1991, respec- tively, the pre-tax loss would have been $469.6 million in 1992 ($11.09 per common share after preferred dividend requirement) compared with a pre-tax loss of $460.7 million in 1991 ($11.01 per common share after preferred dividend requirement). This compari- son does not consider the ongoing effect to the Company's operating expenses which result from the adoption of FAS 106, the freezing of the pension plan for non-contract employees, or other changes. The Company's 1992 financial results contained $759.3 million of non-recurring items, detailed above. Operating results for 1991 included (i) $107 million pre-tax gain related to the freeze of the fully funded pension plan for USAir's non-contract employees; (ii) a $21 million pre-tax charge related to USAir's parked British Aerospace BAe-146 ("BAe-146") fleet; (iii) $21.6 million pre-tax expense related to early retirement incentives; and (iv) $18.5 million, net, in miscellaneous non-recurring charges. On October 5, 1992, the International Association of Machin- ists ("IAM"), which represents USAir's mechanics and related employees, commenced a strike against USAir. At that time, USAir implemented a reduced flight schedule equal to approximately 60% of the normal flight schedule. On October 8, 1992, USAir reached agreement with the IAM on a new collective bargaining agreement which becomes amendable in October 1995. Following ratification of the agreement by the IAM-represented employees, USAir resumed full service on October 12, 1992. USAir immediately offered various incentives including bonus frequent traveler miles and relaxed advance purchase restrictions in an effort to attract passengers following the disruption of service. The Company estimates that the IAM strike had a negative effect on results of approximately $45 million for the year. Operating Revenue - The Company's Passenger Transportation Revenue increased $164.6 million (2.7%) in 1992, reflecting a $97.9 million increase in USAir passenger transportation revenue and a $66.7 million increase in commuter airline passenger revenue. USAir's ASMs increased by 2.4% in 1992, its passenger revenue per ASM decreased by 0.7% to 9.7 cents, and its passenger load factor increased by 0.2 points to 58.8%. USAir's average 1992 passenger revenue per ASM was adversely affected by widespread fare promo- tions. The improvement in commuter airline passenger revenue is attributed to increased traffic made possible by 20.1% increase in capacity during 1992 over 1991, as measured by ASMs, at the Company's commuter airline subsidiaries. USAir's Other Revenue increased $81.3 million (40.9%) in 1992 as compared with 1991, due to increases in revenue generated by passenger cancellation and re-booking fees, fees received from commuter affiliates for handling certain of their flights, and other miscellaneous sources. Operating Expenses - The Company's Personnel Costs increased $102.5 million (4.1%) in 1992 compared with 1991, driven by USAir's increase in personnel costs of $99.7 million (4.2%). Personnel Costs are comprised of two components: (i) employee wages and salaries; and (ii) employee benefits. USAir's wage and salary expense decreased $21.9 million (1.1%) during 1992 as a result of partial-year wage concessions on the part of pilots, non-contract employees and mechanics, all of which ended in 1993. USAir's employee benefit expense increased $121.6 million (27.8%) in 1992 resulting from the adoption of FAS 106 in 1992, and the 1991 freeze of the fully-funded pension plan for non-contract employees. The 1991 pension freeze resulted in a $107 million gain. The Company estimates that USAir's pension expense was approximately $40 million lower in 1992 than would have been the case if the freeze had not occurred. Expense for postretirement medical and death benefits, calculated in accordance with FAS 106, was $114.7 million in 1992, compared with approximately $8 million cash-basis expense in 1991. USAir's medical and dental benefit expense for active employees decreased $26.7 million (14.2%) in 1992 compared with 1991 as a result of a contributory managed care program that was implemented during 1992 for most employee groups. Excluding the effects of FAS 106 and the pension freeze, USAir employee benefit expense decreased approximately $48 million, or 8.8%, in 1992 compared with 1991. The Company's Aviation Fuel Expense decreased $45.8 million (5.7%) during 1992 compared with 1991 as a result of lower cost per gallon, partially offset by an increase in consumption. The price of fuel was inflated during early 1991 as a result of the Iraqi invasion of Kuwait and ensuing Desert Storm operation in August 1990 - January 1991, and did not return to pre-invasion levels until the second quarter of 1991. Commissions increased $29.6 million (5.5%) as a result of the 2.7% increase in passenger transportation revenue and the mix of travel agency sales versus total sales. Other Rent and Landing Fees Expense for the Company increased $56.6 million (16.2%) during 1992. This increase was largely due to increased expense at LaGuardia which resulted from USAir's assumption of Continental's leasehold obligations associated with the East End Terminal there in January, 1992 and the increased operation at LaGuardia during the year using the take-off and landing slots acquired from Continental. Also contributing to the increase was the October 1992 opening of the new terminal at the Pittsburgh International Airport, USAir's largest hub. The Company's Aircraft Rent Expense increased $152.3 million (40.3%) during 1992. A charge related to USAir's grounded BAe-146 fleet accounted for $81 million of the increase. The remainder of the increase was caused by additional leased aircraft both at USAir and the commuter airline subsidiar- ies. The Company's Aircraft Maintenance Expense decreased $33.9 million (8.2%) during 1992. This decrease reflects USAir's decrease in aircraft maintenance of $43.4 million, or 12.0%, and an increase of $9.5 million at the Company's commuter airline subsidiaries during the same period. The improvement in USAir's aircraft maintenance expense is largely attributable to the grounding of its BAe-146 fleet in May 1991, the shifting of certain aircraft engine repairs in-house from outside vendors and the negotiation of a new vendor repair contract in 1991 for certain aircraft engines. The increase in maintenance expense at the commuter airline subsidiaries is due primarily to an increased fleet size in 1992. Maintenance expense for 1992 and 1991 includes charges of $25.0 million and $25.5 million, respectively, related to grounded aircraft. The Company's Other Operating Expense, Net increased $63.6 million (4.6%) in 1992 compared with 1991. Expense for 1992 includes $25 million related to an employee suggestion program which netted estimated savings of $22 million in 1992 and $110 million in 1993. The remainder of the increase is attributable to changes in various smaller expense categories. USAir Group's Interest Income decreased $8.7 million (46.9%) during 1992 due to a lower average level of short-term investments during 1992 coupled with lower interest rates in 1992. Both USAir's interest income and expense include intercompany amounts which have been eliminated in the USAir Group consolidation process. The Company's Interest Expense decreased $10.4 million (4.0%) in 1992 due to a lower average level of debt outstanding related to USAir Group's revolving bank credit agreement, partially offset by additional interest associated with higher levels of aircraft-related debt in 1992. Interest Capitalized decreased $7.8 million (21.8%) as a result of a lower level of outstanding equipment deposits coupled with a lower capitalized interest rate. The Company's Other Non-Operating Expense, Net increased $17.0 million, or 40.2%, during 1992. In 1992, this category included a gain of $10.3 million from the sale of three wholly-owned subsid- iaries and a $34.1 million loss related to the sale of ten MD-82 aircraft discussed above. In 1991, this category included a $12.5 million loss incurred in conjunction with the sale of nine Boeing B727-200 aircraft which had been previously retired from service. All of the Company's remaining available tax credit, or $117.6 million, was recognized upon the adoption of FAS 106 on January 1, 1992. The Company could not recognize any tax credit associated with the 1992 results due to limitations under Accounting Princi- ples Board Opinion No. 11. Inflation and Changing Prices Inflation and changing prices do not have a significant effect on the Company's operating revenues, operating expenses, and operating income because such revenues and expenses, other than depreciation and amortization, generally reflect current price levels. Depreciation and amortization expense is based on historical cost. For assets acquired through the purchase of Pacific Southwest Airlines, USAir's historical cost is based on fair market value of the assets on May 29, 1987. In the case of Piedmont Aviation, Inc., USAir's historical cost is based on the fair market value of the assets on November 5, 1987, reduced by the tax effect of that portion of fair market value not deductible for tax purposes in the form of depreciation and amortization. Therefore, aggregate depreciation and amortization is lower than if this expense reflected today's replacement costs for existing productive assets. In evaluating how inflation would increase depreciation expense, however, consideration should also be given to the reduction in other operating expenses, such as aircraft maintenance and aviation fuel, that would be achieved from the operating efficiencies of newer, more technologically advanced productive assets. LIQUIDITY AND CAPITAL RESOURCES Cash used by operations was $21.3 million during 1993, including a $220.0 million payment under USAir's revolving accounts receivable sale program ("Receivables Agreement"). At December 31, 1993, cash and cash equivalents totaled approximately $368.3 million, excluding $163.7 million which was deposited in trust accounts to collateralize letters of credit or workers compensation policies and classified as "Other Assets" on the Company's balance sheet. Although not currently available (see below), at Decem- ber 31, 1993, USAir Group had $300 million in commitments available for borrowing under its revolving credit agreement with a group of banks ("Credit Agreement") and no outstanding loans thereunder, and USAir had approximately $141 million of available funds under its Receivables Agreement. At February 28, 1994, cash and cash equivalents totaled approximately $363.5 million. Funds under the Credit Agreement and Receivables Agreement are not available to the Company and USAir because of violations of minimum net worth covenants in those agreements. On March 14, 1994, the Company and USAir announced that they are seeking waivers of compliance with the minimum net worth covenant and other anticipated covenant violations. There can be no assurance that the Company or USAir will be able to obtain the waivers or arrange replacement facilities. The Company and USAir are highly leveraged. In order to meet debt service, lease and other obligations and to finance daily operations, the Company and USAir require substantial liquidity and working capital. In addition, developments may occur which are beyond the control of the Company and USAir, including intensified fare wars or substantial increases in jet fuel prices, which could have a material adverse effect on the Company's prospects and financial condition. The Company and USAir have unencumbered assets, particularly if the Credit Agreement is terminated and the mortgage of aircraft equipment related thereto is released. The Company expects that it could use these unencumbered assets to raise funds to provide an infusion of liquidity. In addition, the second and third quarters of the year historically have been characterized by higher revenues and working capital than in the first and fourth quarters. Moreover, USAir is seeking in discus- sions with the leadership of its unionized employees substantial wage reductions, improved productivity and other cost savings. However, if unforeseen adverse developments occur, if the Company and USAir are unable to finance unencumbered assets, or if timely agreements with the employees are not reached, the Company and USAir may pursue other restructuring alternatives. See Item 1. "Business - Significant Impact of Low Fare, Low Cost Competition" and Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations - Low Cost, Low Fare Competi- tion." During 1993, the Company's investment in new aircraft acquisitions and purchase deposits totaled $545.3 million. USAir took delivery of 11 Boeing 757-200, one Boeing 767-200, and six MD- 82 aircraft during the year. The MD-82s were immediately sold to a third party. In addition, USAir sold two other MD-82 aircraft which had been delivered in the fourth quarter of 1992. Proceeds from the sale of the MD-82s approximated $168 million. The Company has completed financing arrangements for, including the $337.7 million issue of Pass Through Certificates ("Certificates") which USAir sold through an underwritten public offering on November 1, 1993, or internally funded, all of its 1993 aircraft expenditures. See Note 4(d) to the Company's Consolidated Financial Statements for the projected cash flows associated with aircraft orders and other contractual capital commitments. The Company has arranged committed financing for 100% of its 1994 and 1995 aircraft deliveries. On January 21, 1993, a wholly-owned subsidiary of BA purchased 30,000 shares of the 7% Series F Cumulative Convertible Senior Preferred Stock ("Series F Preferred Stock"), for $300 million. Substantially all of the $300 million received by the Company from the sale of the Series F Preferred Stock was used to pay down debt under the Company's Credit Agreement. The Series F Preferred Stock is subject to mandatory redemption on January 15, 2008. On May 4, 1993, the Company sold 11.5 million shares of $1 par value Common Stock at $20.75 per share which netted proceeds of approximately $231 million. BA partially exercised its preemptive right to maintain its proportionate ownership percentage by purchasing, on June 10, 1993, 9,919.8 shares of redeemable Series T-2 Cumulative Exchangeable Senior Preferred Stock ("Series T-2 Preferred Stock") for approximately $99.2 million. For additional information, see Note 8 to the Company's Consolidated Financial Statements. On March 7, 1994, BA announced that it would not make any additional investments in the Company until the outcome of measures by the Company to reduce costs and improve financial results is known. On July 8, 1993, USAir sold $300 million principal amount of 10% Senior Notes due 2003 (the "10% Notes") through an underwritten public offering. The offering netted proceeds of approximately $294 million. The 10% Notes are unconditionally guaranteed by the Company. On February 2, 1994, USAir sold $175 million principal amount of 9 5/8% Senior Notes due 2001 (the "9 5/8% Notes") through an underwritten public offering. The offering netted proceeds of approximately $172 million. The 9 5/8% Notes are unconditionally guaranteed by the Company. The 9 5/8% Notes are not reflected in the Company's December 31, 1993 balance sheet because they were issued after that time. All net proceeds received by USAir or the Company from the Common Stock offering, the sale to BA of the Series T-2 Preferred Stock, the sale of the 10% Notes and 9 5/8% Notes were added to the working capital of the Company for general corporate purposes, including the possible early repayment of certain outstanding debt with high interest rates. USAir and the Company have filed with the Securities and Exchange Commission ("SEC") a shelf registration for $700 million of various debt and equity securities. Approximately $187 million of securities remain available for sale on the shelf registration following the sale of the 9 5/8% Notes and may be sold from time- to-time depending on market conditions. The Company will continue to evaluate opportunities in the financial markets. On September 29, 1993, the maximum commitment available under the Credit Agreement decreased to $300 million from $600 million in accordance with the terms of the agreement. The Credit Agreement is due to expire on September 30, 1994. In September 1993, USAir Group obtained a waiver of compliance with the coverage ratio test required to be maintained as part of the Credit Agreement, for the period July 1 through September 30, 1993. Without this waiver, USAir Group would have violated this test on September 30, 1993. As of September 30, 1993, USAir Group was in compliance with the other financial covenants required to be maintained as part of the Credit Agreement. Moreover, in December 1993, USAir Group obtained an additional waiver under the Credit Agreement of compliance during the period October 1 through December 31, 1993 with the coverage ratio test. Without this waiver, USAir Group would have violated this test on December 31, 1993. The Company is currently unable to borrow under the Credit Agreement because it is in violation of a minimum net worth covenant thereunder. In addition, based on current projections of its results for 1994, USAir Group expects that it will not be in compliance with the coverage ratio test and possibly other financial covenants at March 31, 1994 and during the remainder of the year. There can be no assurance that USAir Group will be able to obtain a waiver of compliance with these covenants or to arrange a replacement facility. In September 1993 and December 1993, USAir obtained waivers of the coverage ratio test under the Receivables Agreement on the same terms as described above with respect to the Credit Agreement. At December 31, 1993, USAir was in compliance with the other financial covenants and had no amounts outstanding under the Receivables Agreement. The maximum amount of receivables which USAir may sell under the Receivables Agreement was $240 million at December 31, 1993 and will be adjusted downward to $190 million on June 30, 1994 if the Company's consolidated net worth does not exceed $1.5 billion. For purposes of this net worth comparison, the Company's actual net worth is adjusted to add back the initial and ongoing impact of adopting FAS 106 and certain other accounting pronounce- ments. USAir is currently unable to sell receivables under the Receivables Agreement because it is in violation of a minimum net worth covenant thereunder. In addition, based on current projec- tions of its results for 1994, USAir expects that it will not be in compliance with the coverage ratio test and possibly other financial covenants at March 31, 1994 and during the remainder of the year. There can be no assurance that USAir will be able to obtain a waiver of compliance with these covenants or to arrange a replacement facility. The Company's and USAir's debt and equity securities are presently rated below investment grade by Standard and Poor's Corporation ("S&P") and Moody's Investors Service, Inc. ("Moo- dy's"). Following the January 21, 1993 transaction in which a subsidiary of BA purchased $300 million of the Company's Series F Preferred Stock, Moody's placed the ratings on watch for possible upgrade. On March 19, 1993, Moody's confirmed its ratings of USAir Group and USAir securities. Following DOT approval of the purchase of the Series F Preferred Stock and the code sharing and wet lease relationship between USAir and BA, S&P affirmed its ratings of USAir Group and USAir securities, stating its ratings outlook was positive. In December 1993, S&P affirmed its ratings of USAir Group and USAir securities. However, the agency revised the ratings outlook to negative, citing, among other considerations, the status of the negotiations on a revised U.S.-U.K. bilateral air services agreement and the entrance and possible expansion of the operations of low fare, low cost air carriers into USAir's markets. In February 1994, as a result of USAir's low fare initiative in certain markets and its high cost structure, S&P and Moody's placed the securities of the Company and USAir on watch with negative implications. On March 24, 1994, S&P further downgraded the Company's and USAir's securities. This downgrade will make it more difficult for the Company and USAir to effect additional financing. In addition, the Company's and USAir's securities remain on watch with negative implications at S&P. In 1992, the Company's investment in new aircraft acquisitions and purchase deposits, net of deposits refunded, totaled $458.7 million. The Company purchased eight Fokker and four deHavilland Dash 8 aircraft during 1992. The acquisition of these aircraft was financed through a combination of secured debt financings and interim debt financings. In addition, USAir took delivery of four MD-82s, two of which were immediately sold to a third party. The remaining two aircraft delivered in 1992 were sold to a third party in early 1993. Cash outflows for other property during the period totaled $277.2 million, which includes $61 million paid to Continental for landing and take-off slots at LaGuardia and Washington National Airports and $50 million paid to TWA for London routes from BWI and Philadelphia International Airports. See Item 1. "Business - British Airways Investment Agreement - U.S.-U.K. Routes." Proceeds from disposition of assets of $429.5 million were realized during the year, primarily from sale-leaseback transactions, the sale of the two MD-82 aircraft, and the sale of three wholly-owned subsidiaries. During 1991, acquisition of new aircraft and purchase deposit payments amounted to $345 million. During 1991, USAir took delivery of two Boeing 767-200ER, nine Boeing 737-400, 12 Fokker 100, and five deHavilland Dash 8 aircraft. The acquisition of these aircraft was financed through a combination of sale-leaseback transactions, secured debt financings and interim debt financings. Expenditures for other property, consisting primarily of ground support equipment, leasehold improvements, and major aircraft components, totaled $97 million. Proceeds from disposition of property of $286 million were realized during 1991, primarily as a result of aircraft sale-leaseback transactions. In May 1991, USAir Group sold 4,263,050 Depositary Shares, each representing 1/100 of a share of $437.50 Series B Cumulative Convertible Preferred Stock, without par value, for net proceeds of $207.8 million. Such proceeds were used to repay indebtedness under USAir Group's Credit Agreement. At December 31, 1993, USAir Group's ratio of current assets to current liabilities was 0.53 to 1 and the debt component of USAir Group's capitalization structure was approximately 82% (100% if the redeemable Series A Cumulative Convertible Preferred Stock, the Series F Preferred Stock and the redeemable Series T Cumulative Convertible Exchangeable Senior Preferred Stock are considered to be debt). Item 8A. FINANCIAL STATEMENTS AND SUPPLEMENTARY INFORMATION USAir Group, Inc. Independent Auditors' Report The Stockholders and Board of Directors USAir Group, Inc.: We have audited the accompanying consolidated balance sheets of USAir Group, Inc. and subsidiaries ("Group") as of December 31, 1993 and 1992, and the related consolidated statements of opera- tions, cash flows, and changes in stockholders' equity (deficit) for each of the years in the three-year period ended December 31, 1993. These consolidated financial statements are the responsibil- ity of Group's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of USAir Group, Inc. and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993 in conformity with generally accepted accounting principles. As discussed in Note 11 to the consolidated financial statements, effective January 1, 1993, Group changed its method of accounting for postemployment benefits and effective January 1, 1992, Group changed its method of accounting for postretirement benefits other than pensions. KPMG PEAT MARWICK Washington, D. C. February 25, 1994 See accompanying Notes to Consolidated Financial Statements. See accompanying Notes to Consolidated Financial Statements. See accompanying Notes to Consolidated Financial Statements. USAir Group, Inc. Notes to Consolidated Financial Statements (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (a) Basis of Presentation The accompanying consolidated financial statements include the accounts of USAir Group, Inc. ("USAir Group" or the "Company") and its wholly-owned subsidiaries USAir, Inc. ("USAir"), Piedmont Airlines, Inc. ("Piedmont") (formerly Henson Aviation, Inc.), Jetstream International Airlines, Inc. ("Jetstream"), Pennsylvania Commuter Airlines, Inc. ("PCA"), USAir Leasing and Services, Inc. ("Leasing"), USAir Fuel Corporation and Material Services Company, Inc. All significant intercompany accounts and transactions have been eliminated. At December 31, 1992, USAM Corp. ("USAM"), a subsidiary of USAir, owned 11% of the Covia Partnership ("Covia") which owned and operated a computerized reservation system ("CRS"). In September 1993, Covia purchased the assets of the corporation that owned and operated the Galileo CRS which provided CRS services to travel agent subscribers in Europe. Covia was then separated into three new entities. As a result, at December 31, 1993, USAM owns 11% of the Galileo International Partnership which owns and operates the Galileo CRS, approximately 11% of the Galileo Japan Partnership which markets the Galileo CRS in Japan, and approximately 21% of the Apollo Travel Services Partnership which markets the Galileo CRS in the U.S. and Mexico. USAM accounts for these investments using the equity method. On August 1, 1992, two wholly-owned USAir Group's commuter airline subsidiaries, Allegheny Commuter Airlines, Inc. and PCA, merged. PCA, the surviving entity, operates under the name of Allegheny Commuter Airlines, with headquarters in Middletown, Pennsylvania. On July 15, 1992, USAir Group completed the sale of three of its wholly-owned subsidiaries: Piedmont Aviation Services, Inc., Air Service, Inc. and Aviation Supply Corporation. The Company realized a gain of $10.3 million as a result of the sale. The three former subsidiaries engaged in fixed base operations and the sale and repair of aircraft and aircraft components. These subsidiaries were included in the accounts until their sale. On October 9, 1991, USAir reached agreement for the sale of certain assets of its wholly-owned subsidiary Pacific Southwest Airmotive ("Airmotive"). Airmotive discontinued operations in the third quarter of 1991. USAir did not realize any material gain or loss on the sale and discontinuance of Airmotive's operations. USAir Group's principal operating subsidiary, USAir, and its three commuter airline subsidiaries, Piedmont, Jetstream and PCA, operate within one industry (air transportation); therefore, no segment information is provided. Certain 1992 and 1991 amounts have been reclassified to conform with 1993 classifications. (b) Cash and Cash Equivalents For financial statement purposes, the Company considers all highly liquid investments purchased with a maturity of three months or less to be cash equivalents. (c) Materials and Supplies Inventories of materials and supplies are valued at average cost and are charged to operations as consumed. An allowance for obsolescence is provided for flight equipment expendable parts. (d) Property and Equipment Property and equipment is stated at cost or, if acquired under capital leases, at the lower of the present value of minimum lease payments or fair market value at the inception of the lease. Maintenance and repairs, including the overhaul of aircraft components, are charged to operating expense as incurred and costs of major improvements are capitalized for both owned and leased assets. Interest related to deposits on aircraft purchase contracts and facility and equipment construction projects is capitalized as additional cost of the asset or as leasehold improvement if the asset is leased. Depreciation and amortization for principal asset classifications is provided on a straight-line basis to estimated residual values over estimated depreciable lives as follows: Property acquired under capital lease is amortized on a straight-line basis over the term of the lease and charged to depreciation expense. (e) Goodwill, Other Intangibles and Other Assets Goodwill, the cost in excess of fair value of identified net assets acquired, is being amortized on a straight-line basis over 40 years as other non-operating expense. Accumulated amortization at December 31, 1993 and 1992 was $98 million and $82 million, respectively. Intangible assets consist of purchased operating rights at various airports, purchased route authorities, and the intangible assets associated with the underfunded amounts of certain pension plans. The operating rights, valued at purchase cost or appraised value if acquired from Piedmont Aviation, Inc. ("Piedmont Avia- tion") or Pacific Southwest Airlines ("PSA"), are being amortized over periods ranging from ten to 25 years as Other Rent and Landing Fees Expense. The purchased route authorities are amortized over periods of 25 years as other operating expense. Accumulated amortization at December 31, 1993 and 1992 was $72 million and $65 million, respectively. The decrease in Other Intangibles, net in 1993 is primarily attributable to the $47 million reclassification of two London routes to Other Assets as a result of USAir's relinquishment of these routes as contemplated by the January 21, 1993 Investment Agreement ("Investment Agreement") between the Company and British Airways Plc ("BA"). USAir relinquished its Charlotte to London route authority in January 1994. In addition, takeoff and landing slots at Washington National Airport were purchased from Northwest Airlines, Inc. ("Northwest") for $10 million during 1993. (f) Restricted Cash and Investments Restricted cash and investments consist primarily of deposits in trust accounts to collateralize letters of credit or workers compensation policies and short-term investments restricted for specified construction projects. These amounts are classified as Other Assets on the accompanying balance sheets. (g) Deferred Gains on Sale and Leaseback Transactions Gains on aircraft sale and leaseback transactions are deferred and amortized over the term of the leases as a reduction of rental expense. (h) Passenger Revenue Recognition Passenger ticket sales are recognized as revenue when the transportation service is rendered. At the time of sale, a liability is established (Traffic Balances Payable and Unused Tickets) and subsequently eliminated either through carriage of the passenger, through billing from another carrier which renders the service or by refund to the passenger. (i) Frequent Traveler Awards USAir accrues the estimated incremental cost of providing outstanding travel awards earned by participants in its Frequent Traveler Program. (j) Investment Tax Credit Investment tax credit benefits are recorded using the "flow- through" method as a reduction of the Federal income tax provision. (k) Earnings Per Share Earnings per share is computed by dividing net loss, after deducting preferred stock dividend requirements, by the weighted average number of shares of Common Stock outstanding, net of treasury stock. USAir Group's outstanding redeemable Series A Cumulative Convertible Preferred Stock ("Series A Preferred Stock"), Series B Cumulative Convertible Preferred Stock ("Series B Preferred Stock"), redeemable Series F Cumulative Senior Preferred Stock ("Series F Preferred Stock"), redeemable Series T Cumulative Convertible Exchangeable Senior Preferred Stock ("Series T Preferred Stock) and common stock equivalents are anti-dilutive. (l) Swap Agreements USAir has entered into hedging arrangements to reduce its exposure to fluctuations in the price of jet fuel. Net settlements are recorded as adjustments to aviation fuel expense. USAir is party to such hedging arrangements with several entities. Under these arrangements, the Company's maximum commitments, which are offset by amounts received under the arrangements, totaled approximately $100.3 million and $158.7 million at December 31, 1993 and 1992, respectively. Although the agreements expose the Company to credit loss in the event of nonperformance by the other parties to the agreements, the Company does not anticipate such nonperformance. The Company has entered into interest rate swap transactions to manage interest rate exposure. Net settlements are recorded as an adjustment to interest expense. The Company is party to such interest rate swap agreements with banks and other financial institutions. The notional principal amounts of these agreements were $150 million and $400 million at December 31, 1993 and 1992, respectively. Under these swap agreements, the Company pays interest at fixed rates averaging 9.8% and 9.7% at December 31, 1993 and 1992, respectively, and receives floating rate interest payments based on three-month LIBOR. Although the agreements, which expire in 1995, expose the Company to credit loss in the event of non-performance by the other parties to the agreements, the Company does not anticipate such non-performance. (2) DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS Unless a quoted market price indicates otherwise, the fair values of cash and investments generally approximate carrying values because of the short maturity of these instruments. The Company has estimated the fair value of long-term debt based on quoted market prices for the same or similar issues or on the current rates offered to the Company for debt of similar remaining maturities. The estimated fair values of the Series A Preferred Stock, Series F Preferred Stock and Series T Preferred Stock are obtained by consulting with an independent external valuation source. The fair values of interest rate swap agreements, energy swap agreements and foreign currency contracts are obtained from dealer quotes whereby these values represent the estimated amount the Company would receive or pay to terminate such agreements. The estimated fair values of the Company's financial instru- ments are summarized as follows: (3) LONG-TERM DEBT Details of long-term debt are as follows: Maturities of long-term debt and debt under capital leases for the next five years are as follows: (in thousands) 1994 $ 87,833 1995 75,344 1996 73,464 1997 84,027 1998 152,180 Thereafter 2,059,002 In addition to the varying interest rate on Credit Agreement borrowings as described below, interest rates on $239 million principal amount of long-term debt at December 31, 1993 are subject to adjustment to reflect prime rate and other rate changes. The Company and a group of banks are parties to a Credit Agreement dated as of March 30, 1987, as amended (the "Credit Agreement") which makes a $300 million revolving credit facility available to the Company as of December 31, 1993. The Credit Agreement expires on September 30, 1994. At December 31, 1993, loans under the Credit Agreement, at the option of the Company, would have borne interest at a reference rate, a Eurodollar rate plus 2.50% - 2.65% per annum, determined by the Company's coverage ratio discussed below, or a bid rate if offered by a lending bank. During 1993, 1992 and 1991, the maximum amount of credit agreement borrowings outstanding at any month end was $250 million, $450 million and $733 million, respectively. All outstanding Credit Agreement borrowings were paid off in May 1993 and no other funds were borrowed during the remainder of 1993. The average amount of Credit Agreement borrowings outstanding and weighted average interest rate for 1993 were $37 million and 5.8%, respectively. The average amount of Credit Agreement borrowings outstanding and the weighted average interest rate for 1992 were $174 million and 6.2%, respectively. The average amount of Credit Agreement borrowings and the weighted average interest rate for 1991 were $510 million and 8.3%, respectively. On June 21, 1993, USAir Group entered into the Seventh Amendment to the Credit Agreement. The Seventh Amendment increased the limit of unsecured debt of subsidiaries to $300 million from $200 million. On December 21, 1993, the Company obtained a waiver under the Credit Agreement which further increased the limit of unsecured debt of subsidiaries to $620 million for the period commencing December 21, 1993 and ending on the final annual reduction date of September 30, 1994. This waiver also exempted the Company from compliance, for the quarter ended December 31, 1993, with the coverage ratio test which must be maintained as part of the Credit Agreement. The Company would not otherwise have complied with this test as of December 31, 1993 but was in compliance with the other financial covenants required to be maintained as part of the Credit Agreement. USAir Group is currently unable to borrow under the Credit Agreement because it is in violation of a minimum net worth covenant thereunder. In addition, based on current projections of its results for 1994, USAir Group expects that it will not be in compliance with the coverage ratio test and possibly other financial covenants at March 31, 1994 and during the remainder of the year. There can be no assurance that USAir Group will be able to obtain a waiver of compliance with these covenants or arrange a replacement facility. Certain USAir, Piedmont and PCA aircraft and engines with a net book value of $247 million at December 31, 1993 secure the Credit Agreement. Equipment financings totaling $2.0 billion are collateralized by aircraft and engines with a net book value of $2.2 billion at December 31, 1993. An aggregate of $32 million of future principal payments of the Equipment Financing Agreements are payable in Japanese Yen. This foreign currency exposure has been hedged to maturity. Although the Company is exposed to credit loss in the event of non- performance by the counterparty to the hedge agreement, the Company does not anticipate such non-performance. On February 2, 1994, USAir sold $175 million principal amount of 9 5/8% Senior Notes ("9 5/8% Senior Notes") which are uncondi- tionally guaranteed by the Company. The 9 5/8% Senior Notes are not reflected in the above table because they were sold after December 31, 1993. (4) COMMITMENTS AND CONTINGENCIES (a) Operating Environment The economic conditions in the United States, fare competition and the emergence and growth of lower cost, lower fare carriers in the domestic airline industry are factors affecting the financial condition of USAir Group. Industry capacity has recently failed to mirror changes in demand due primarily to the continued delivery of new aircraft and secondarily, to the prolonged operation of certain major U.S. carriers under the protection of Chapter 11 of the Bankruptcy Code. USAir competes with at least one major airline on most of its routes between major cities. Although the economy generally has shown signs of improvement, the Company expects that the competitive environment in the airline industry, the entry of low cost, low fare carriers into USAir's markets, and the excess capacity in the domestic airline industry will continue to have an adverse effect on USAir's passenger revenue for the foreseeable future. The extent or duration of these conditions cannot be reasonably determined at this time. (b) Lease Commitments The Company's airline subsidiaries lease certain aircraft, engines, computer and ground equipment, in addition to the majority of their ground facilities. Ground facilities include executive offices, overhaul and maintenance bases and ticket and administra- tive offices. Public airports are utilized for flight operations under lease arrangements with the municipalities or agencies owning or controlling such airports. Substantially all leases provide that the lessee shall pay taxes, maintenance, insurance and certain other operating expenses applicable to the leased property. Most leases also include renewal options and some aircraft leases include purchase options. The following amounts applicable to capital leases are included in property and equipment: At December 31, 1993, obligations under capital and noncancel- able operating leases for future minimum lease payments were as follows: Rental expense under operating leases for 1993, 1992 and 1991 was $781 million, $707 million and $605 million, respectively. Rental expense for 1993 excludes a charge of $9 million related to certain airport facilities where USAir has, among other things, discontinued or reduced its service. Rental expense for 1992 excludes a charge of $72 million related to USAir's grounded BAe- 146 fleet. Rental expense for 1991 excludes a credit of $9 million for the BAe-146 fleet. (c) Legal Proceedings The Company and various subsidiaries have been named as defendants in various suits and proceedings which involve, among other things, environmental concerns and employment matters. These suits and proceedings are in various stages of litigation, and the status of the law with respect to several of the issues involved is unsettled. For these reasons the outcome of these suits and proceedings is difficult to predict. In the Company's opinion, however, the disposition of these matters is not likely to have a material adverse effect on its financial condition or results of operations. In 1989 and 1990, a number of U.S. air carriers, including USAir, received two Civil Investigative Demands ("CIDs") from the U.S. Department of Justice ("DOJ") (a CID is a request for information in the course of an antitrust investigation and does not constitute the institution of a civil or criminal action) related to investigations of price fixing in the domestic airline industry. The investigations by the DOJ culminated in the filing of a lawsuit against Airline Tariff Publishing Company ("ATPCo") and eight major air carriers, including USAir, alleging that the defendants had agreed to fix prices in violation of Section 1 of the Sherman Act through the methods used to disseminate fare data to ATPCo, an airline-owned fare publishing service. To avoid the costs associated with protracted litigation and an uncertain outcome, USAir and another carrier decided to settle the lawsuit by entering into a consent decree to modify their fare-filing practices in certain respects and to implement compliance programs that would include education of employees regarding the carriers' responsibilities under the consent decree. Accordingly, the consent decree and the U.S. Government's complaint were filed contemporaneously in the U.S. District Court for the District of Columbia in December 1992. Due to certain legal requirements associated with the settlement of government antitrust suits, the consent decree could not be entered until a notice and comment period had expired. On November 1, 1993, after it had reviewed the comments, the Court entered the consent decree. USAir does not believe that the fare-filing practices reflected in the consent decree will have a material adverse effect on its financial condition or on its ability to compete. In March 1994, the remaining six air carrier defendants agreed to the entry of a separate consent decree to settle the lawsuit. This consent decree cannot be entered by the Court until a notice and comment period has expired. When that consent decree is entered, USAir can petition the Court to have its consent decree amended to conform with the other settlement and the Court will enter the amended consent decree. On March 19, 1993, the U.S. District Court in Atlanta, Georgia entered a settlement involving USAir and five other U.S. air carrier defendants in the Domestic Air Transportation Antitrust Litigation class action lawsuit. The class action suit, which was filed in July 1990, alleged that the airlines used ATPCo to signal and communicate carrier pricing intentions and otherwise limit price competition for travel to and from numerous hub airports. Under the terms of the settlement, the six air carriers will pay $45 million in cash and issue $396.5 million in certificates valid for purchase of domestic air travel on any of the six airlines. USAir's share of the cash portion of the settlement, $5 million, was recorded in results of operations for the second quarter of 1992. The certificates provide a dollar-for-dollar discount against the cost of a ticket generally of up to a maximum of 10% per ticket, depending on the cost of the ticket. It is possible that this settlement could have a dilutive effect on USAir's passenger transportation revenue and associated cash flow. However, due to the interchangeability of the certificates among the six carriers involved in the settlement, the possibility that carriers not party to the settlement will honor the certificates, and the potential stimulative effect on travel created by the certificates, USAir cannot reasonably estimate the impact of this settlement on future passenger revenue and cash flows. USAir has employed the incremental cost method to estimate a range of costs attributable to the exercise of the certificates, based on the assumption that the estimated maximum number of certificates to be redeemed for travel on USAir will be related to USAir's market share relative to the total market share of the six carriers involved in the settlement. USAir's estimated percentage of such market share is less than 9%. Incremental costs include unit costs for passenger food, beverages and supplies, fuel, liability insurance, and denied boarding compensation expenses expected to be incurred on a per passenger basis. USAir has estimated that its incremental cost will not be material based on the equivalent free trips associated with the settlement. The Attorney General of the State of Florida and the Attorneys General of several other states are investigating whether several major airlines, including USAir, have engaged in price fixing and other unlawful restraints of trade. Certain of these Attorneys General have issued document requests to USAir and several other airlines requiring them to provide certain information and documents. At this time, USAir cannot predict the manner in which these investigations will be resolved and if the resolution will have an adverse effect on USAir's results of operations or financial position. (d) Aircraft Commitments At December 31, 1993 USAir's new aircraft on firm order, options for new aircraft and scheduled payments for new aircraft orders (including progress payments, buyer furnished equipment, spares, and capitalized interest) were: USAir may elect, under certain circumstances, to convert Boeing 737 Series and Boeing 767 Series firm order or option deliveries to Boeing 757-200 deliveries. If USAir were to elect such a substitution, the payments presented in the table above would change. USAir is currently in negotiations with Boeing regarding, among other things, the above schedule of new aircraft deliveries. In addition, USAir has a commitment to purchase hushkits for certain of its McDonnell Douglas DC-9-30 aircraft and a substantial portion of its Boeing 737-200 aircraft. The installation of these hushkits will bring the aircraft into compliance with Federal Aviation Administration ("FAA") Stage 3 noise level requirements. The projected payments associated with the purchase of the hushkits are: $29.1 million - 1994; $12.0 million - 1995; $42.3 million - 1996; $43.4 million - 1997; $44.0 million - 1998; and $30.8 million thereafter. (e) Concentration of Credit Risk USAir Group does not believe it is subject to any significant concentration of credit risk. At December 31, 1993, most of the Company's receivables related to tickets sold to individual passengers through the use of major credit cards (48%) or to tickets sold by other airlines (17%) and used by passengers on USAir or the commuter subsidiaries. These receivables are short- term, generally being settled shortly after sale or in the month following usage. Bad debt losses, which have been minimal in the past, have been considered in establishing allowances for doubtful accounts. (f) Guarantees At December 31, 1993, USAir guaranteed payments of certain debt obligations of the Galileo International Partnership amounting to approximately $16 million. (5) SALE OF RECEIVABLES USAir is party to an agreement ("Receivables Agreement") to sell, on a revolving basis, undivided interest of up to $240 million in a pool of designated receivables. Approximately $141 million was available for sale at December 31, 1993 based on receivable balances at that date. The maximum amount available under the Receivables Agreement to be sold gradually reduces from $240 million at December 31, 1993, to $190 million on June 30, 1994. The Receivables Agreement expires on December 21, 1994. USAir had no outstanding amounts due under the Receivable Agreement at December 31, 1993. The net amounts sold reduce receivables in the accompanying balance sheet by $220 million and $188 million at December 31, 1992 and 1991, respectively. Included in the accounts payable balances at December 31, 1992 and 1991, are $74 million and $64 million, respectively, which represent funds held by USAir related to previously sold receivables that had been collected. USAir obtained a waiver from the purchaser of the receivables and its operating agent, exempting USAir from compliance with the coverage ratio financial covenant in the Receivables Agreement for the quarter ended December 31, 1993. USAir is currently unable to sell receivables under the Receivables Agreement because it is in violation of a minimum net worth covenant thereunder. In addition, based on current projections of its results for 1994, USAir expects that it will not be in compliance with the coverage ratio test and possibly other financial covenants at March 31, 1994 and during the remainder of the year. There can be no assurance that USAir will be able to obtain a waiver of compliance with these covenants or to arrange a replacement facility. (6) INCOME TAXES Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"). FAS 109 required a change from the deferred method under Accounting Principles Board Opinion No. 11 to the asset and liability method of accounting for income taxes. No cumulative adjustment at January 1, 1993, and no income tax credit for the year ended December 31, 1993, were recognized due to the FAS 109 limitation in recognizing benefits for net operating losses. The Company files a consolidated Federal income tax return with its wholly-owned subsidiaries. The components of the provision (credit) for income taxes are as follows: The significant components of deferred income tax expense/- (benefit) for the year ended December 31, 1993, are as follows: Deferred tax benefit (exclusive of the other components listed below) $(136,191) Adjustments to deferred tax assets and liabilities for enacted changes in tax laws and rates (8,880) Increase for the year in the valuation allowance for deferred tax assets 145,071 -------- Total $ 0 ======== For the years ended December 31, 1992 and 1991 deferred income taxes result from differences in the recognition of revenue and expenses and investment tax credits for tax and financial reporting purposes. The major items resulting in these differences and the related tax effects are shown in the following chart: A reconciliation of taxes computed at the statutory Federal tax rate on earnings before income taxes to the provision (credit) for income taxes is as follows: The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1993 are presented below: (in thousands) Deferred tax assets: Leasing transactions $ 132,551 Tax benefits purchased/sold 79,434 Gain on sale and leaseback transactions 164,613 Employee benefits 430,257 Net operating loss carryforwards 557,494 Alternative minimum tax credit carryforwards 21,146 Investment tax credit carryforwards 49,802 Other deferred tax assets 62,615 --------- Total gross deferred tax assets 1,497,912 Less valuation allowance (564,838) --------- Net deferred tax assets 933,074 Deferred tax liabilities: Equipment depreciation and amortization (874,640) Other deferred tax liabilities (58,434) --------- Net deferred tax liabilities (933,074) --------- Net deferred taxes $ 0 ========= The valuation allowance for deferred tax assets as of January 1, 1993, was $420 million. The increase in the valuation allowance during 1993 was $145 million. At December 31, 1993, the Company had unused net operating losses of $1.5 billion for Federal tax purposes, which expire in the years 2005-2008. The Company also has available, to reduce future taxes payable, $460 million alternative minimum tax net operating losses expiring in 2007 and 2008, $50 million of investment tax credits expiring in 2002 and 2003, and $21 million of minimum tax credits which do not expire. The Federal income tax returns of the Company through 1986 have been examined and settled with the Internal Revenue Service. (7) BRITISH AIRWAYS PLC INVESTMENT On January 21, 1993, USAir Group and BA entered into the Investment Agreement under which a wholly-owned subsidiary of BA purchased certain series of convertible preferred stock during 1993 (see Note 8 - Redeemable Preferred Stock) and BA entered into code sharing and wet lease arrangements with USAir contemplated by the Investment Agreement. On March 7, 1994, BA announced that it would not make any additional investments in the Company until the outcome of measures by the Company to reduce its costs and improve its financial results is known. At December 31, 1993, the preferred stock held by BA con- stituted approximately 22% of the total voting interest in the Company. To the extent permitted by foreign ownership restrictions which are applicable by statute regulations or interpretation by regulatory authorities, including the U.S. Department of Transpor- tation ("DOT") ("Foreign Ownership Restrictions"), the preferred stock owned by BA votes on all matters presented to the Company's stockholders for a vote and has voting power equal to the underly- ing shares of Common Stock. Under the Investment Agreement, on January 21, 1993, BA designated three of its officers to serve on the Company's Board of Directors. The Company has agreed to use its best efforts to place these designees on the slate of nominees for election as Directors of the Company. In addition to BA's holdings of the Company's preferred stock at December 31, 1993, BA has the option, which it has announced it will not exercise under current circumstances, to purchase, at a minimum, an additional $450 million of the Company's preferred stock. Under certain circumstances, BA is entitled, at its option, to purchase, on or prior to January 21, 1996, 50,000 shares of Series C Cumulative Convertible Senior Preferred Stock ("Series C Preferred Stock") resulting in an additional cash investment in the Company of $200 million, and, on or prior to January 21, 1998, 25,000 shares of Series E Cumulative Convertible Senior Preferred Stock ("Series E Preferred Stock") resulting in an additional cash investment in the Company of $250 million. If the DOT approves all the transactions and acts contemplated by the Investment Agreement, at the election of either BA or the Company on or prior to January 21, 1998, BA's purchase of the Series C Preferred Stock (unless previously consummated) and BA's purchase of the Series E Preferred Stock must be consummated under certain circumstances. On March 15, 1993, the DOT issued an order ("DOT Order") stating, among other things, that BA's initial investment does not impair USAir's citizenship under current U.S. Foreign Ownership Restrictions. However, the DOT instituted a proceeding to consider whether USAir will remain a U.S. citizen if the transactions and acts contemplated by the Investment Agreement, including the possible sale of Series C Preferred Stock and Series E Preferred Stock, to BA, are consummated. The DOT has indefinitely suspended the period for comments from interested parties pending its resolution of requests by other airlines for production of additional documents from USAir. The DOT Order states that the DOT expects and advises USAir and BA not to proceed with the closing of the purchase of the Series C Preferred Stock or the Series E Preferred Stock until the DOT has completed its review of USAir's citizenship. In any event, on March 7, 1994, BA announced it would not make any additional investments in the Company under current circumstances. USAir cannot predict the outcome of the proceedings or if further transactions contemplated under the Investment Agreement, including the sale of Series C and Series E Preferred Stock to BA, will be consummated. The sale of additional preferred stock to BA on June 10, 1993 (see Note 8(c)), did not result in BA's ownership of voting stock in the Company exceeding applicable foreign ownership restrictions and therefore does not affect the Company's U.S. citizenship under those restrictions. (8) REDEEMABLE PREFERRED STOCK (a) Series A Preferred Stock At December 31, 1993, the Company had 358,000 shares of its 9 1/4% Series A Cumulative Convertible Redeemable Preferred Stock ("Series A Preferred Stock"), without par value, outstanding which was convertible into 9,239,944 shares of the Company's Common Stock at a conversion price of approximately $38.74 per share. The Series A Preferred Stock ranks pari passu with the Series F Cumulative Convertible Senior Preferred Stock ("Series F Preferred Stock"), without par value, and Series T-_ Cumulative Convertible Exchangeable Senior Preferred Stock ("Series T Preferred Stock"), without par value, and senior to the Series B Cumulative Convert- ible Preferred Stock ("Series B Preferred Stock"), without par value, Junior Participating Preferred Stock, Series D ("Series D Preferred Stock"), without par value, and the Common Stock, with respect to dividend payments and the distribution of assets. At December 31, 1993, the Series A Preferred Stock is entitled to approximately 25.81 votes per share (determined by dividing the $1,000 liquidation preference per share of Series F Preferred Stock by the $38.74 conversion price), or a total of 9,239,944 votes, and votes together with the Series F Preferred Stock, the Series T Preferred Stock and the Common Stock, on all matters submitted to a vote of stockholders of the Company. The Series A Preferred Stock is redeemable on August 7, 1999 at $1,000 per share. The Company has the right to redeem the stock at a 10% premium until that time. The agreement relating to the sale of the Series A Preferred Stock imposes certain restrictions on the purchaser's ability to increase its ownership of, and to transfer, its stock in USAir Group. There have been no changes in the balance sheet value of the Series A Preferred Stock since its issuance in 1989. (b) Series F Preferred Stock At December 31, 1993, the Company had outstanding 30,000 shares of its 7% Series F Preferred Stock which was convertible into 15,458,658 shares of the Company's Common Stock at a conver- sion price of approximately $19.41 per share. The Series F Preferred Stock ranks pari passu with the Series A Preferred Stock and Series T Preferred Stock and senior to the Series B Preferred Stock, Series D Preferred Stock, and the Common Stock, with respect to dividend payments and the distribution of assets. At December 31, 1993, each share of Series F Preferred Stock was entitled to approximately 515.29 votes per share to the extent permitted by the existing Foreign Ownership Restrictions and votes with the Company's Series A Preferred Stock, the Series T Preferred Stock and the Company's Common Stock as a single class. Under Foreign Ownership Restrictions, no more than 25% of the Company's voting interest may be held by persons other than U.S. citizens. In accordance with the terms of any preferred stock held by BA, conversion rights and voting rights may not be exercised to the extent that doing so would result in a loss of the Company's or any of its subsidiaries' operating certificates and authorities under Foreign Ownership Restrictions, and it is assumed for this purpose that Series F Preferred Stock will be fully converted before any other preferred stock held by BA. The Series F Preferred Stock is convertible at any time on or after January 21, 1997 to the extent that such conversion would not violate U.S. Foreign Ownership Restrictions. Series F Preferred Stock may be converted at the option of the Company at any time after January 21, 1998 if the average composite closing market price of Common Stock during any 30-day calendar period is at least 133% of the conversion price. The Series F Preferred Stock is mandatorily redeemable on January 21, 2008. If BA has not purchased the Series C Preferred Stock by January 21, 1996, then the Company may at its option redeem, in whole or in part, Series F Preferred Stock at the higher of market value or the price of $10,000 per share, plus accrued dividends. The Series F Certifi- cate provides that if on any one occasion on or prior to Janu- ary 21, 1996, any court or regulatory authority issues a final order that any material part of the Investment Agreement is unenforceable (except pursuant to bankruptcy or like event), then the conversion price of Series F Preferred Stock shall be reduced by 10.2564%. There have been no changes in the balance sheet value of the Series F Preferred Stock since its issuance in 1993. (c) Series T Preferred Stock Under the Investment Agreement, BA has preemptive and optional purchase rights to maintain its proportionate ownership of the Company's Common Stock and convertible securities, measured in terms of the BA Percentage ("BA Percentage") which approximates BA's fully diluted ownership percentage based on BA's current and potential holdings in the Company. The BA Percentage is calculated without regard to Foreign Ownership Restrictions at the time of the calculation. BA may exercise such preemptive or optional purchase rights by purchasing, from time-to-time, a series of Series T Preferred Stock. At December 31, 1993, the Company had two series of the Series T Preferred Stock outstanding. On June 10, 1993, BA exercised its preemptive purchase right by purchasing 9,919.8 shares of a series of the Series T Preferred Stock ("Series T-2 Preferred Stock") for approximately $99.2 million and exercised its optional purchase right by purchasing 152.1 shares of a series of Series T Preferred Stock ("T-1 Preferred Stock") for approximately $1.5 million. BA's preemptive right was triggered by the issuance of Common Stock, as described in Note 8 - Stockholders' Equity, and BA's optional purchase rights were triggered by the Company's issuance of additional shares of Common Stock through the exercise of options under various employee stock option plans and through the sale of shares to certain defined contribution plans during the period from January 21, 1993 to March 31, 1993. On March 7, 1994, BA advised the Company that it would not exercise its optional purchase rights to buy three additional series of Series T Preferred Stock triggered by the Company's issuance of common stock pursuant to certain employee benefit plans during the second, third and fourth quarters of 1993. There have been no changes in the balance sheet value of the Series T-1 Preferred Stock and Series T-2 Preferred Stock since their issuance in 1993. The terms of all series of the Series T Preferred Stock are substantially similar to those of the Series F Preferred Stock except as noted. Each share of Series T-2 Preferred Stock carries a conversion price of $26.40 and is convertible into approximately 378.79 shares of Common Stock or Non-Voting Class ET stock. Each share of Series T-1 Preferred Stock has a conversion price of $20.50 and is convertible into approximately 487.80 shares of Common Stock or Non-Voting Class ET stock. With respect to the Series T Preferred Stock, dividends are payable quarterly in arrears, at 50 basis points over the three-month LIBOR rate. Any shares of the Series T Preferred Stock held by any person other than BA or its subsidiaries may be redeemed for cash at any time at the option of the Company at $10,000 plus accrued dividends plus a redemption premium equal to $700 from the date of issue until the first anniversary thereof and reduced by $46.67 on each anniversary thereafter. The Series T Preferred Stock is exchangeable, at the option of the Company, for that principal amount of floating rate convertible subordinated notes of the Company ("T Notes") equal to the liquidation preference of the shares to be exchanged and bearing interest at the dividend rate. Any accrued dividends on the Series T Preferred Stock to be exchanged will be treated as accrued interest on the T Notes. Each $10,000 aggregate principal amount of such T Notes will be entitled to a number of votes equal to the number of votes to which each share of Series T Preferred Stock was entitled at the time of its exchange for T Notes, subject to adjustment. If issued, T Notes will have terms otherwise consis- tent with the terms of the Series T Preferred Stock. (9) STOCKHOLDERS' EQUITY (a) Common Stock The Company had 150,000,000 and 100,000,000 authorized shares of Common Stock, par value $1, at December 31, 1993 and 1992, respectively. If BA purchases the Series C Preferred Stock (see Note 6 - British Airways Plc Investment), the number of authorized shares of various classes of Common Stock will increase to 300,000,000. BA has indicated, however, that it will not make any additional investments in the Company under current circumstances. At December 31, 1993, approximately 52,618,000 shares were reserved for issuance upon the conversion of preferred stock and for offerings under employee stock purchase, stock option and stock incentive plans. On May 4, 1993, the Company sold 11.5 million shares of previously unissued Common Stock at $20.75 per share through a public, underwritten offering. The offering netted proceeds of approximately $231 million. (b) Preferred Stock and Senior Preferred Stock At December 31, 1993, the Company had 5,000,000 authorized shares of preferred stock, without nominal or par value, of which 358,000 shares were issued as Series A Preferred Stock, 43,000 shares were issued as Series B Preferred Stock and 1,035,000 shares were reserved as Series D Preferred Stock. Also, at December 31, 1993, the Company had 3,000,000 authorized shares of Senior Preferred Stock, without nominal or par value, of which 30,000 shares were issued as Series F Preferred Stock and approximately 10,000 were issued as Series T Preferred Stock. (c) Series B Preferred Stock At December 31, 1993, the Company had 4,263,050 Depositary Shares, representing 42,630.5 shares of its $437.50 Series B Preferred Stock outstanding. Each Depositary Share represents 1/100 of a share of the Series B Preferred Stock. The Series B Preferred Stock is convertible at any time, at the option of the holder, at the rate of 249.25 shares of Common Stock of the Company per preferred share, or 2.4925 shares of Common Stock per De- positary Share. The Series B Preferred Stock ranks junior to the Company's Series A Preferred Stock, the Series F Preferred Stock and the Series T Preferred Stock and senior to the Series D Preferred Stock and the Common Stock with respect to dividend payments and the distribution of assets, whether upon liquidation or otherwise. Except under certain circumstances, the holders of Series B Preferred Stock have no voting rights. The Series B Preferred Stock is not redeemable prior to May 15, 1994. The Series B Preferred Stock is redeemable, at the option of the Company and with consent of the holders of Series F Preferred Stock, on or after May 15, 1994, (i) in whole but not in part, only in certain circumstances, for so long as any shares of Series A Preferred Stock are outstanding; and (ii) in whole or in part if no shares of Series A Preferred Stock are outstanding, in each case initially at a redemption price of approximately $53.06 per 1/100 of a share and thereafter at prices declining to $50 per 1/100 of a share (equivalent to $5,000 per share of Series B Preferred Stock) on or after May 15, 2001, plus dividends accrued and accumulated but unpaid to the redemption date. (d) Preferred Stock Purchase Rights Each outstanding share of Common Stock is accompanied by one Preferred Share Purchase Right ("Right") and each outstanding share of Series A Preferred Stock, Series F Preferred Stock and Series T Preferred Stock is accompanied by a Right for each share into which it is convertible. Each Right entitles the holder to buy 1/100th of a share of Series D Preferred Stock at an exercise price of $175 per Right. The Rights expire on June 29, 1996. As long as the Rights remain outstanding, the Company will issue one Right with each new share of Common Stock issued upon the conversion of any preferred stock into, or the exercise of any options for, Common Stock, as long as such preferred stock or options were outstanding prior to the Rights becoming exercisable. Generally, the Rights become exercisable only if a party other than, under certain circumstances, BA acquires 20% or more of the Company's Common Stock or announces a tender offer for 20% or more of the Common Stock. The Rights are redeemable at $.03 per Right at any time before 20% or more of the Company's Common Stock has been acquired. If at any time after the Rights become exercisable and before they have been redeemed the Company is involved in a merger or other business combination transaction, the Rights will automatically entitle a holder, other than a holder of 20% or more of the Company's Common Stock, to receive, upon exercise of each Right, a number of shares of Common Stock, or a number of common shares of the acquiring company, as the case may be, having a market value of two times the exercise price of each Right. In addition, at any time after the acquisition of 30% or more of the Common Stock by any person and prior to the acquisition by such person of 50% or more of the Common Stock, the Board of Directors of the Company may exchange the Rights (other than Rights owned by such person which have become void), in whole or in part, at an exchange ratio of one share of Common Stock, or 1/100th of a share of Series D Preferred Stock, per Right. Until the first to occur of the redemption or expiration of the Rights, the Company will issue one Right with each new share of Common Stock issued upon the conversion of any securities into, or the exercise of any options or warrants for, Common Stock if such securities, options or warrants were outstanding prior to when Rights became exercisable. (e) Treasury Stock In 1989, the Company's Board of Directors authorized the repurchase from time-to-time of up to 9.4 million shares of its Common Stock in open market transactions. In 1989, approximately 2.1 million shares were repurchased. The Company sold approximate- ly 500,000 shares and approximately 390,000 shares of its treasury stock during 1993 and 1992, respectively. The remaining shares are carried on the accompanying balance sheet at the average acquisi- tion cost. (f) Employee Stock Option and Purchase Plans During 1992, the Company's stockholders approved the 1992 Stock Option Plan ("1992 Plan") which allows for the issuance of stock options to purchase up to 8,125,000 shares of USAir Group Common Stock to USAir employees who participate in the previously announced cost reduction program. Under the stock option program, employees whose pay was or is currently being reduced receive options to purchase 50 shares of Common Stock at a price not less than $15 per share for each $1,000 of salary reduction. The Company will grant stock options under the 1992 Plan only in connection with salary reductions. Participating employees have five years from the grant date to exercise such options. Options, with an exercise price of $15, have been granted to purchase ap- proximately five million shares of Common Stock in conjunction with salary reductions. The Company plans to seek authority from its stockholders at its 1994 Annual Meeting to reduce the number of shares reserved for this plan. At December 31, 1993, 5.3 million shares of Common Stock are reserved for the granting of stock options or restricted stock under the Company's 1984 Stock Option and Stock Appreciation Rights ("SARs") Plan and 1988 Stock Incentive Plan. These plans provide that options may be granted as either nonqualified or incentive stock options. Options awarded prior to 1991, except for those that reverted, have vested. Options awarded during 1991, 1992 and 1993, except under the 1992 Plan, become exercisable generally within three years from date of grant. Optionees may also receive SARs which permit them to receive, in lieu of the right to exercise the stock option, an amount equivalent to the difference between the stock option price and the fair market value of the Common Stock on the date of exercising the right. This amount may be paid in stock, in cash, or in any combination of the two. Also, restricted stock award grants for 57,000 shares and 111,600 shares were outstanding at December 31, 1993 and 1992, respectively. Deferred compensation related to the restricted stock, which vests over periods of up to five years, amounted to $.3 million and $ .6 million at December 31, 1993 and 1992, respectively. As of December 31, 1993, options to acquire approximately 9 million shares under all three plans, including 85,000 SARs, were outstanding at a weighted average exercise price of $18.77. Of those outstanding, approximately six million options were exercis- able at December 31, 1993. Options were exercised to purchase approximately 33,500 and 6,000 shares of Common Stock at average exercise prices of $17.24 and $10.44 during 1993 and 1992, respectively. (g) Dividend Restrictions The Company's Credit Agreement does not contain specific provisions which restrict the payment of dividends by USAir Group. The amount of dividends, however, is indirectly restricted through the existence of certain covenants contained in the Credit Agreement. At December 31, 1993, under the most restrictive of these provisions, the Company's ability to pay dividends is limited to approximately $77 million. (10) EMPLOYEE STOCK OWNERSHIP PLAN In August 1989, USAir established an Employee Stock Ownership Plan ("ESOP"). The Company sold 2,200,000 shares of Common Stock to an Employee Stock Ownership Trust to hold on behalf of USAir's employees, exclusive of officers, in accordance with the terms of the Trust and the ESOP. Financing of approximately $111.4 million for the Trust's purchase of the shares was provided by USAir through a 9 3/4% loan to the Trust, and an additional $2.2 million was contributed to the Trust by USAir. The loan is being repaid with contributions made by USAir. The contributions are made in amounts equal to the periodic loan payments as they come due, less dividends available for loan payment. The amount of dividends used for debt service by the ESOP was $127,000 in 1991. As the loan is repaid over time, participating employees receive allocations of the Common Stock purchased by the Trust. The initial maturity of the loan is 30 years. However, the ESOP provides that if the Company's profitability as measured by return on sales exceeds certain goals during the life of the ESOP, USAir's contributions and the repayment of the loan will be accelerated. Contributions made by USAir and therefore loan repayments made by the Trust were $11.4 million in 1993, 1992 and 1991. The interest portion of these contributions was $10.5 million in 1993, $10.6 million in 1992 and $10.7 million in 1991. Approximately 366,000 shares of Common Stock have been allocated to employees. USAir recognized approximately $4 million of compensation expense related to the ESOP in each of 1993, 1992 and 1991 based on shares allocated to employees (the "shares allocated" method). Deferred compensation related to the ESOP amounted to approximately $95 million, $98 million and $102 million at December 31, 1993, 1992 and 1991, respectively. (11) EMPLOYEE BENEFIT PLANS (a) Pension Plans The Company's subsidiaries have several pension plans in effect covering substantially all employees. One qualified defined benefit plan covers USAir maintenance employees and provides benefits of stated amounts for specified periods of service. Qualified defined benefit plans for substantially all other employees provide benefits based on years of service and compensa- tion. The qualified defined benefit plans are funded, on a current basis, to meet requirements of the Employee Retirement Income Security Act of 1974. The defined benefit pension plan for USAir non-contract employees was frozen at the end of 1991 for all non-contract participants, resulting in a one-time book gain of approximately $107 million in 1991. All non-contract plan participants became 100% vested at the time of the freeze. As a result of this plan curtailment, the accrual of service costs related to defined benefits for USAir non-contract employees ceased at the end of 1991. USAir implemented a defined contribution pension plan for non-contract employees in January 1993. The funded status of the qualified defined benefit plans at December 31, 1993 and 1992 was as follows: Approximately 97% of the accumulated benefit obligation was vested at December 31, 1993 and 1992. Unrecognized transition assets are being amortized over periods up to 27 years. The weighted average discount rate used to determine the actuarial present value of the projected benefit obligation was 7.6% and 8.75% as of December 31, 1993 and 1992, respectively. The expected long-term rate of return on plan assets used in 1993 and 1992 was 9.5%. Rates of 3% to 6% were used to estimate future salary levels. At December 31, 1993, plan assets consisted of approxi- mately 8% in cash equivalents and short-term debt investments, 37% in equity investments, and 55% in fixed income and other invest- ments. At December 31, 1992, plan assets consisted of approximate- ly 4% in cash equivalents and short-term debt investments, 70% in equity investments, and 26% in fixed income and other investments. The following items are the components of the net pension cost for the qualified defined benefit plans: Net pension cost for 1993 and 1991 presented above excludes a settlement charge of approximately $33.9 million and $21.6 million, respectively, related to "early-out" incentive programs offered to a limited number of USAir employees during the years. No such charges were incurred in 1992. Non-qualified supplemental pension plans are established for certain employee groups, which provide incremental pension payments from the Company's funds so that total pension payments equal amounts that would have been payable from the Company's principal pension plans if it were not for limitations imposed by income tax regulations. The following table sets forth the non-qualified plans' status at December 31, 1993 and 1992: Net supplementary pension cost for the two years included the following components: The discount rate used to determine the actuarial present value of the projected benefit obligation was 7.5% and 8.75% as of December 31, 1993 and 1992, respectively. Rates of 3% to 6% were used to estimate future salary levels. In addition to the qualified and non-qualified defined benefit plans described above, USAir also contributes to certain defined contribution plans primarily for employees not covered under a collective bargaining agreement. Company contributions are based on a formula which considers the age and pre-tax earnings of each employee and the amount of employee contributions. The Company's contribution expense was $42 million for 1993. The Company recognized no such expense in 1992 or 1991. (b) Postretirement Benefits Other Than Pensions USAir offers medical and life insurance benefits to employees who retire from the Company and their eligible dependents. The medical benefits provided by USAir are coordinated with Medicare benefits. Retirees generally contribute amounts towards the cost of their medical expenses based on years of service with the Company. USAir provides uninsured death benefit payments to survivors of retired employees for stated dollar amounts, or in the case of retired pilot employees, death benefit payments determined by age and level of pension benefit. The plans for postretirement medical and death benefits are funded on the pay-as-you-go basis. USAir adopted Statement of Financial Accounting Standards No. 106 ("FAS 106") during 1992 and elected to record the January 1, 1992 Accumulated Postretirement Benefit Obligation ("APBO") using the immediate recognition approach. The cumulative effect of adopting FAS 106 was $745.7 million ($628.1 million net of tax benefit). The following table sets forth the financial status of the plans as of December 31, 1993 and 1992: The components of net periodic postretirement benefit cost are as follows: The postretirement benefit expense for 1993 presented above excludes a charge of approximately $15.5 million related to "early out" programs offered to a limited number of employees during the year. No such charges were incurred in 1992 or 1991. The discount rate used to determine the APBO was 7.75% and 8.75% at December 31, 1993 and 1992, respectively. The assumed health care cost trend rate used in measuring the APBO was 10.5% in 1993 and 1994, declining by 1% per year after 1994 to an ultimate rate of 4.5%. If the assumed health care cost trend rate were increased by one percentage point, the APBO at December 31, 1993 would be increased by 10% and 1993 periodic postretirement benefit cost would increase 13%. Prior to the adoption of FAS 106, USAir recognized expense for retiree health care at an estimated monthly rate (based on payments) and recognized expense for death benefits when paid. The expense using this methodology was approximately $8 million for 1991. (c) Postemployment Benefits USAir adopted Statement of Financial Accounting Standards No. 112, "Employer's Accounting for Postemployment Benefits" ("FAS 112"), during 1993. FAS 112 requires the use of an accrual method to recognize postemployment benefits such as disability-related benefits. The cumulative effect at January 1, 1993 of adopting FAS 112 was $43.7 million. (12) SUPPLEMENTAL BALANCE SHEET INFORMATION The components of certain accounts in the accompanying balance sheets are as follows: (13) NON-RECURRING AND UNUSUAL ITEMS (a) 1993 The Company's results for 1993 include non-recurring charges of (i) $43.7 million for the cumulative effect of an accounting change, as required by FAS 112 which was adopted during the third quarter of 1993, retroactive to January 1, 1993; (ii) $68.8 million for severance, early retirement and other personnel-related expenses recorded primarily during the third quarter of 1993 in connection with a workforce reduction of approximately 2,500 full- time positions between November 1993 and the first half of 1994; (iii) $36.8 million based on a projection of the repayment of certain employee pay reductions, recorded in the fourth quarter of 1993; (iv) $13.5 million for certain airport facilities at locations where USAir has, among other things, discontinued or reduced its service, recorded in the fourth quarter of 1993; (v) $8.8 million for a loss on USAir's investment in the Galileo International Partnership which operates a computerized reserva- tions system, recorded in the fourth quarter of 1993; and (vi) $18.4 million credit related to non-operating aircraft recorded in the second quarter of 1993. (b) 1992 The Company's results for 1992 include (i) a charge of $628.1 million for the cumulative effect of an accounting change as required by FAS 106, effective January 1, 1992; (ii) a $107.4 million charge related to certain aircraft which have been withdrawn from service, recorded in the fourth quarter of 1992; (iii) a $34.1 million non-operating loss related to the sale of ten MD-82 aircraft which USAir eliminated from its fleet plan, recorded in the fourth quarter of 1992; and (iv) a $10.3 million gain on the sale of three wholly-owned subsidiaries, recorded in the third quarter of 1992 (see Note (1)). (c) 1991 The Company's results for 1991 include (i) a $107 million pre- tax gain related to freezing of the fully funded non-contract employee pension plan; (ii) a $21.6 million pre-tax expense related to early retirement incentives offered to certain employees during 1991; (iii) a $21 million pre-tax charge to establish an additional reserve for USAir's grounded BAe-146 fleet; and (iv) $18.5 million, net, in miscellaneous non-recurring charges. (14) SELECTED QUARTERLY FINANCIAL DATA (Unaudited) The following table presents selected quarterly financial data for 1993 and 1992: Item 8B. FINANCIAL STATEMENTS AND SUPPLEMENTARY INFORMATION USAir, Inc. Independent Auditors' Report The Stockholder and Board of Directors USAir, Inc.: We have audited the accompanying consolidated balance sheets of USAir, Inc. and subsidiaries ("USAir") as of December 31, 1993 and 1992, and the related consolidated statements of operations, cash flows, and changes in stockholder's equity for each of the years in the three-year period ended December 31, 1993. These consolidated financial statements are the responsibility of USAir's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of USAir, Inc. and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993 in conformity with generally accepted accounting principles. As discussed in Note 9 to the consolidated financial state- ments, effective January 1, 1993, USAir changed its method of accounting for postemployment benefits and effective January 1, 1992, USAir changed its method of accounting for postretirement benefits other than pensions. KPMG PEAT MARWICK Washington, D. C. February 25, 1994 (PAGE> USAir, Inc. Notes to Consolidated Financial Statements (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (a) Basis of Presentation The accompanying consolidated financial statements include the accounts of USAir, Inc. ("USAir") and its wholly-owned subsidiary USAM Corp. ("USAM"). USAir is a wholly-owned subsidiary of USAir Group, Inc. ("USAir Group" or "the Company"). All significant intercompany accounts and transactions have been eliminated. At December 31, 1992, USAM owned 11% of the Covia Partnership ("Covia") which owned and operated a computerized reservation system ("CRS"). In September 1993, Covia purchased the assets of the corporation that owned and operated the Galileo CRS which provided services to travel agent subscribers in Europe. Covia was then separated into three new entities. As a result, at Decem- ber 31, 1993, USAM owns 11% of the Galileo International Partner- ship which owns and operates the Galileo CRS, approximately 11% of the Galileo Japan Partnership which markets the Galileo CRS in Japan and approximately 21% of the Apollo Travel Services Partner- ship which markets the Galileo CRS in the U.S. and Mexico. USAM accounts for these investments using the equity method. On October 9, 1991, USAir reached agreement for the sale of certain assets of its wholly-owned subsidiary Pacific Southwest Airmotive ("Airmotive"). Airmotive discontinued operations in the third quarter of 1991. USAir did not realize any material gain or loss on the sale and discontinuance of Airmotive's operations. Certain 1992 and 1991 amounts have been reclassified to conform with 1993 classifications. (b) Cash and Cash Equivalents For financial statement purposes, the Company considers all highly liquid investments purchased with a maturity of three months or less to be cash equivalents. (c) Materials and Supplies Inventories of materials and supplies are valued at average cost and are charged to operations as consumed. An allowance for obsolescence is provided for flight equipment expendable parts. (d) Property and Equipment Property and equipment is stated at cost or, if acquired under capital leases, at the lower of the present value of minimum lease payments or fair market value at the inception of the lease. Maintenance and repairs, including the overhaul of aircraft components, are charged to operating expense as incurred and costs of major improvements are capitalized for both owned and leased assets. Interest related to deposits on aircraft purchase contracts and facility and equipment construction projects is capitalized as additional cost of the asset or as leasehold improvement if the asset is leased. Depreciation and amortization for principal asset classifications is provided on a straight-line basis to estimated residual values over estimated depreciable lives as follows: Property acquired under capital lease is amortized on a straight-line basis over the term of the lease and charged to depreciation expense. (e) Goodwill, Other Intangibles and Other Assets Goodwill, the cost in excess of fair value of identified net assets acquired, is being amortized on a straight-line basis over 40 years as other non-operating expense. Accumulated amortization at December 31, 1993 and 1992 was $98 million and $82 million, respectively. Intangible assets consist of purchased operating rights at various airports, purchased route authorities, and the intangible assets associated with the underfunded amounts of certain pension plans. The operating rights, valued at purchase cost or appraised value if acquired from Piedmont Aviation, Inc. ("Piedmont Avia- tion") or Pacific Southwest Airlines ("PSA"), are being amortized over periods ranging from ten to 25 years as Other Rent and Landing Fees Expense. The purchased route authorities are amortized over periods of 25 years as other operating expense. Accumulated amortization at December 31, 1993 and 1992 was $72 million and $64 million, respectively. The decrease in Other Intangibles, net in 1993 is primarily attributable to the $47 million reclassification of two London routes to Other Assets as a result of USAir's relinquishment of these routes as contemplated by the January 21, 1993 Investment Agreement ("Investment Agreement") between the Company and British Airways Plc ("BA"). USAir relinquished its Charlotte to London route authority in January 1994. In addition, takeoff and landing slots at Washington National Airport were purchased from Northwest Airlines, Inc. ("Northwest") for $10 million during 1993. (f) Restricted Cash and Investments Restricted cash and investments consist primarily of deposits in trust accounts to collateralize letters of credit or workers compensation policies and short-term investments restricted for specified construction projects. These amounts are classified as Other Assets on the accompanying balance sheets. (g) Deferred Gains on Sale and Leaseback Transactions Gains on aircraft sale and leaseback transactions are deferred and amortized over the term of the leases as a reduction of rental expense. (h) Passenger Revenue Recognition Passenger ticket sales are recognized as revenue when the transportation service is rendered. At the time of sale, a liability is established (Traffic Balances Payable and Unused Tickets) and subsequently eliminated either through carriage of the passenger, through billing from another carrier which renders the service or by refund to the passenger. Approximately $29 million and $28 million of amounts owed to wholly-owned subsidiaries of USAir Group for passenger transportation revenue are included in Traffic Balances Payable and Unused Tickets at December 31, 1993 and 1992, respectively. (i) Frequent Traveler Awards USAir accrues the estimated incremental cost of providing outstanding travel awards earned by participants in its Frequent Traveler Program. (j) Investment Tax Credit Investment tax credit benefits are recorded using the "flow- through" method as a reduction of the Federal income tax provision. (k) Swap Agreements USAir has entered into hedging arrangements to reduce its exposure to fluctuations in the price of jet fuel. Net settlements are recorded as adjustments to aviation fuel expense. USAir is party to such hedging arrangements with several entities. Under these arrangements, the Company's maximum commitments, which are offset by amounts received under the arrangements, totaled approximately $100.3 million and $158.7 million at December 31, 1993 and 1992, respectively. Although the agreements expose the Company to credit loss in the event of nonperformance by the other parties to the agreements, the Company does not anticipate such nonperformance. (2) DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS Unless a quoted market price indicates otherwise, the fair values of cash and investments generally approximate carrying values because of the short maturity of these instruments. USAir has estimated the fair value of long-term debt based on quoted market prices for the same or similar issues or on the current rates offered to the Company for debt of similar remaining maturities. The fair values of energy swap agreements and foreign currency contracts are obtained from dealer quotes whereby these values represent the estimated amount USAir would receive or pay to terminate such agreements. The estimated fair values of USAir's financial instruments are summarized as follows: (3) LONG-TERM DEBT Details of long-term debt are as follows: Maturities of long-term debt and debt under capital leases for the next five years are as follows: (in thousands) 1994 $ 85,715 1995 75,691 1996 75,715 1997 86,496 1998 155,234 Thereafter 2,153,879 Interest rates on $239 million principal amount of long-term debt at December 31, 1993 are subject to adjustment to reflect prime rate and other rate changes. Equipment financings totaling $2.1 billion are collateralized by aircraft and engines with a net book value of $2.2 billion at December 31, 1993. In addition, certain USAir aircraft and engines with a net book value of $162 million collateralize USAir Group's Credit Agreement borrowings. An aggregate of $32 million of future principal payments of the Equipment Financing Agreements are payable in Japanese Yen. This foreign currency exposure has been hedged to maturity. Although the Company is exposed to credit loss in the event of non- performance by the counterparty to the hedge agreement, the Company does not anticipate such non-performance. On February 2, 1994, USAir sold $175 million principal amount of 9 5/8% Senior Notes ("9 5/8% Senior Notes") which are uncondi- tionally guaranteed by the Company. The 9 5/8% Senior Notes are not reflected in the above table because they were sold after December 31, 1993. (4) COMMITMENTS AND CONTINGENCIES (a) Operating Environment The economic conditions in the United States, fare competition and the emergence and growth of low cost, low fare carriers in the domestic airline industry are factors affecting the financial condition of USAir. Industry capacity has recently failed to mirror changes in demand due primarily to the continued delivery of new aircraft and secondarily, to the prolonged operation of certain major U.S. carriers under the protection of Chapter 11 of the Bankruptcy Code. USAir competes with at least one major airline on most of its routes between major cities. Although the economy generally has shown signs of improvement, the Company expects that the competitive environment in the airline industry, the entry of low cost, low fare carriers into USAir's markets, and the excess capacity in the domestic airline industry will continue to have an adverse effect on USAir's passenger revenue for the foreseeable future. The extent or duration of these conditions cannot be reasonably determined at this time. (b) Lease Commitments USAir leases certain aircraft, engines, computer and ground equipment, in addition to the majority of its ground facilities. Ground facilities include executive offices, overhaul and mainte- nance bases and ticket and administrative offices. Public airports are utilized for flight operations under lease arrangements with the municipalities or agencies owning or controlling such airports. Substantially all leases provide that the lessee shall pay taxes, maintenance, insurance and certain other operating expenses applicable to the leased property. Most leases also include renewal options and some aircraft leases include purchase options. The following amounts applicable to capital leases are included in property and equipment: At December 31, 1993, obligations under capital and noncancel- able operating leases for future minimum lease payments were as follows: Rental expense under operating leases for 1993, 1992 and 1991 was $739 million, $678 million and $576 million, respectively. Rental expense for 1993 excludes a charge of $9 million related to certain airport facilities where USAir has, among other things, discontinued or reduced its service. Rental expense for 1992 excludes a charge of $72 million related to USAir's grounded BAe- 146 fleet. Rental expense for 1991 excludes a credit of $9 million for the BAe-146 fleet. (c) Legal Proceedings USAir and various subsidiaries have been named as defendants in various suits and proceedings which involve, among other things, environmental concerns and employment matters. These suits and proceedings are in various stages of litigation, and the status of the law with respect to several of the issues involved is unset- tled. For these reasons the outcome of these suits and proceedings is difficult to predict. In the Company's opinion, however, the disposition of these matters is not likely to have a material adverse effect on its financial condition or results of operations. In 1989 and 1990, a number of U.S. air carriers, including USAir, received two Civil Investigative Demands ("CIDs") from the U.S. Department of Justice ("DOJ") (a CID is a request for information in the course of an antitrust investigation and does not constitute the institution of a civil or criminal action) related to investigations of price fixing in the domestic airline industry. The investigations by the DOJ culminated in the filing of a lawsuit against Airline Tariff Publishing Company ("ATPCo") and eight major air carriers, including USAir, alleging that the defendants had agreed to fix prices in violation of Section 1 of the Sherman Act through the methods used to disseminate fare data to ATPCo, an airline-owned fare publishing service. To avoid the costs associated with protracted litigation and an uncertain outcome, USAir and another carrier decided to settle the lawsuit by entering into a consent decree to modify their fare-filing practices in certain respects and to implement compliance programs that would include education of employees regarding the carriers' responsibilities under the consent decree. Accordingly, the consent decree and the U.S. Government's complaint were filed contemporaneously in the U.S. District Court for the District of Columbia in December 1992. Due to certain legal requirements associated with the settlement of government antitrust suits, the consent decree could not be entered until a notice and comment period had expired. On November 1, 1993, after it had reviewed the comments, the Court entered the consent decree. USAir does not believe that the fare-filing practices reflected in the consent decree will have a material adverse effect on its financial condition or on its ability to compete. In March 1994, the remaining six air carrier defendants agreed to the entry of a separate consent decree to settle the lawsuit. This consent decree cannot be entered until a notice and comment period has expired. When that consent decree is entered, USAir can petition the Court to have its consent decree amended to conform with the other settlement and the Court will enter the amended consent decree. On March 19, 1993, the U.S. District Court in Atlanta, Georgia entered a settlement involving USAir and five other U.S. air carrier defendants in the Domestic Air Transportation Antitrust Litigation class action lawsuit. The class action suit, which was filed in July 1990, alleged that the airlines used ATPCo to signal and communicate carrier pricing intentions and otherwise limit price competition for travel to and from numerous hub airports. Under the terms of the settlement, the six air carriers will pay $45 million in cash and issue $396.5 million in certificates valid for purchase of domestic air travel on any of the six airlines. USAir's share of the cash portion of the settlement, $5 million, was recorded in results of operations for the second quarter of 1992. The certificates provide a dollar-for-dollar discount against the cost of a ticket generally of up to a maximum of 10% per ticket, depending on the cost of the ticket. It is possible that this settlement could have a dilutive effect on USAir's passenger transportation revenue and associated cash flow. However, due to the interchangeability of the certificates among the six carriers involved in the settlement, the possibility that carriers not party to the settlement will honor the certificates, and the potential stimulative effect on travel created by the certificates, USAir cannot reasonably estimate the impact of this settlement on future passenger revenue and cash flows. USAir has employed the incremental cost method to estimate a range of costs attributable to the exercise of the certificates, based on the assumption that the estimated maximum number of certificates to be redeemed for travel on USAir will be related to USAir's market share relative to the total market share of the six carriers involved in the settlement. USAir's estimated percentage of such market share is less than 9%. Incremental costs include unit costs for passenger food, beverages and supplies, fuel, liability insurance, and denied boarding compensation expenses expected to be incurred on a per passenger basis. USAir has estimated that its incremental cost will not be material based on the equivalent free trips associated with the settlement. The Attorney General of the State of Florida and the Attorneys General of several other states are investigating whether several major airlines, including USAir, have engaged in price fixing and other unlawful restraints of trade. Certain of these Attorneys General have issued document requests to USAir and several other airlines requiring them to provide certain information and documents. At this time, USAir cannot predict the manner in which these investigations will be resolved and if the resolution will have an adverse effect on USAir's results of operations or financial position. (d) Aircraft Commitments At December 31, 1993, USAir's new aircraft on firm order, options for new aircraft and scheduled payments for new aircraft orders (including progress payments, buyer furnished equipment, spares, and capitalized interest) were: USAir may elect, under certain circumstances, to convert Boeing 737 Series and Boeing 767 Series firm order or option deliveries to Boeing 757-200 deliveries. If USAir were to elect such a substitution, the payments presented in the table above would change. USAir is currently in negotiations with Boeing regarding, among other things, the above schedule of new aircraft deliveries. In addition, USAir has a commitment to purchase hushkits for certain of its McDonnell Douglas DC-9-30 aircraft and a substantial portion of its Boeing 737-200 aircraft. The installation of these hushkits will bring the aircraft into compliance with Federal Aviation Administration ("FAA") Stage 3 noise level requirements. The projected payments associated with the purchase of the hushkits are: $29.1 million - 1994; $12.0 million - 1995; $42.3 million - 1996; $43.4 million - 1997; $44.0 million - 1998; and $30.8 million thereafter. (e) Concentration of Credit Risk USAir does not believe it is subject to any significant concentration of credit risk. At December 31, 1993, most of USAir's receivables related to tickets sold to individual passen- gers through the use of major credit cards (47%) or to tickets sold by other airlines (16%) and used by passengers on USAir or USAir Group's commuter subsidiaries. These receivables are short-term, generally being settled shortly after sale or in the month following usage. Bad debt losses, which have been minimal in the past, have been considered in establishing allowances for doubtful accounts. (f) Guarantees At December 31, 1993, USAir guaranteed payments of certain debt obligations of the Galileo International Partnership amounting to approximately $16 million. In addition, at December 31, 1993, USAir guaranteed payments of debt and lease obligations of USAir Group's three wholly-owned subsidiaries amounting to approximately $148 million. (5) SALE OF RECEIVABLES USAir is party to an agreement ("Receivables Agreement") to sell, on a revolving basis, undivided interest of up to $240 million in a pool of designated receivables. Approximately $141 million was available for sale at December 31, 1993 based on receivable balances at that date. The maximum amount available under the Receivable Agreement to be sold gradually reduces from $240 million at December 31, 1993, to $190 million on June 30, 1994. The Receivables Agreement expires on December 21, 1994. USAir had no outstanding amounts due under the Receivable Agreement at December 31, 1993. The net amounts sold reduce receivables in the accompanying balance sheet by $220 million and $188 million at December 31, 1992 and 1991, respectively. Included in the accounts payable balances at December 31, 1992 and 1991, are $74 million and $64 million, respectively, which represent funds held by USAir related to previously sold receivables that had been collected. USAir obtained a waiver from the purchaser of the receivables and its operating agent, exempting USAir from compliance with the coverage ratio financial covenant in the Receivables Agreement for the quarter ended December 31, 1993. USAir is currently unable to sell receivables under the Receivables Agreement because it is in violation of a minimum net worth covenant thereunder. In addition, based on current projections of its results for 1994, USAir expects that it will not be in compliance with the coverage ratio test and possibly other financial covenants at March 31, 1994 and during the remainder of the year. There can be no assurance that USAir will be able to obtain a waiver of compliance with these covenants or arrange a replacement facility. (6) INCOME TAXES Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("FAS 109"). FAS 109 required a change from the deferred method under Accounting Principles Board Opinion No. 11 to the asset and liability method of accounting for income taxes. No cumulative adjustment at January 1, 1993, and no income tax credit for the year ended December 31, 1993, were recognized due to the FAS 109 limitation in recognizing benefits for net operating losses. USAir files a consolidated Federal income tax return with its parent USAir Group pursuant to a tax allocation agreement. The components of the provision (credit) for income taxes are as follows: The significant components of deferred income tax ex- pense/(benefit) for the year ended December 31, 1993, are as follows: (in thousands) Deferred tax benefit (exclusive of the other components listed below) $(121,847) Adjustments to deferred tax assets and liabilities for enacted changes in tax laws and rates (9,429) Increase for the year in the valuation allowance for deferred tax assets 131,276 -------- Total $ 0 ======== For the years ended December 31, 1992 and 1991, deferred income taxes result from differences in the recognition of revenue and expenses and investment tax credits for tax and financial reporting purposes. The major items resulting in these differences and the related tax effects are shown in the following chart: A reconciliation of taxes computed at the statutory Federal tax rate on earnings before income taxes to the provision (credit) for income taxes is as follows: The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1993 are presented below: (in thousands) Deferred tax assets: Leasing transactions $ 129,276 Tax benefits purchased/sold 79,434 Gain on sale and leaseback transactions 162,400 Employee benefits 429,312 Net operating loss carryforwards 508,240 Alternative minimum tax credit carryforwards 20,881 Investment tax credit carryforwards 47,880 Other deferred tax assets 61,210 --------- Total gross deferred tax assets 1,438,633 Less valuation allowance (568,816) --------- Net deferred tax assets 869,817 Deferred tax liabilities: Equipment depreciation and amortization (840,584) Other deferred tax liabilities (29,233) --------- Net deferred tax liabilities (869,817) --------- Net deferred taxes $ 0 ========= The valuation allowance for deferred tax assets as of January 1, 1993, was $438 million. The increase in the valuation allowance for 1993 was $131 million. At December 31, 1993, the Company had unused net operating losses of $1.3 billion for Federal tax purposes, which expire in the years 2005-2008. USAir also has available, to reduce future taxes payable, $429 million alternative minimum tax net operating losses expiring in 2007 and 2008, $47 million of investment tax credits expiring in 2002 and 2003, and $20 million of minimum tax credits which do not expire. The Federal income tax returns of the Company through 1986 have been examined and settled with the Internal Revenue Service. (7) STOCKHOLDER'S EQUITY USAir Group owns all of the outstanding common stock of USAir. USAir Group's Credit Agreement includes a provision that limits USAir's ability to declare dividends to USAir Group. (8) EMPLOYEE STOCK OWNERSHIP PLAN In August 1989, USAir established an Employee Stock Ownership Plan ("ESOP"). USAir Group sold 2,200,000 shares of its Common Stock to an Employee Stock Ownership Trust to hold on behalf of USAir's employees, exclusive of officers, in accordance with the terms of the Trust and the ESOP. Financing of approximately $111.4 million for the Trust's purchase of the shares was provided by USAir through a 9 3/4% loan to the Trust, and an additional $2.2 million was contributed to the Trust by USAir. The loan is being repaid with contributions made by USAir. The contributions are made in amounts equal to the periodic loan payments as they come due, less dividends available for loan payment. The amount of dividends used for debt service by the ESOP was $127,000 in 1991. As the loan is repaid over time, participating employees receive allocations of the Common Stock purchased by the Trust. The initial maturity of the loan is 30 years. However, the ESOP provides that if the Company's profitability as measured by return on sales exceeds certain goals during the life of the ESOP, USAir's contributions and the repayment of the loan will be accelerated. Contributions made by USAir and therefore loan repayments made by the Trust were $11.4 million in 1993, 1992 and 1991. The interest portion of these contributions was $10.5 million in 1993, $10.6 million in 1992 and $10.7 million in 1991. Approximately 366,000 shares of Common Stock have been allocated to employees. USAir recognized approximately $4 million of compensation expense related to the ESOP in each of 1993, 1992 and 1991 based on shares allocated to employees (the "shares allocated" method). Deferred compensation related to the ESOP amounted to approximately $95 million, $98 million and $102 million at December 31, 1993, 1992 and 1991, respectively. (9) EMPLOYEE BENEFIT PLANS (a) Pension Plans USAir has several pension plans in effect covering substan- tially all employees. One qualified defined benefit plan covers USAir maintenance employees and provides benefits of stated amounts for specified periods of service. Qualified defined benefit plans for substantially all other employees provide benefits based on years of service and compensation. The qualified defined benefit plans are funded, on a current basis, to meet requirements of the Employee Retirement Income Security Act of 1974. The defined benefit pension plan for USAir non-contract employees was frozen at the end of 1991 for all non-contract participants, resulting in a one-time book gain of approximately $107 million in 1991. All non-contract plan participants became 100% vested at the time of the freeze. As a result of this plan curtailment, the accrual of service costs related to defined benefits for USAir non-contract employees ceased at the end of 1991. USAir implemented a defined contribution pension plan for non-contract employees in January 1993. The funded status of the qualified defined benefit plans at December 31, 1993 and 1992 was as follows: Approximately 97% of the accumulated benefit obligation was vested at December 31, 1993 and 1992. Unrecognized transition assets are being amortized over periods up to 27 years. The weighted average discount rate used to determine the actuarial present value of the projected benefit obligation was 7.6% and 8.75% as of December 31, 1993 and 1992, respectively. The expected long-term rate of return on plan assets used in 1993 and 1992 was 9.5%. Rates of 3% to 6% were used to estimate future salary levels. At December 31, 1993, plan assets consisted of approxi- mately 8% in cash equivalents and short-term debt investments, 37% in equity investments, and 55% in fixed income and other invest- ments. At December 31, 1992, plan assets consisted of approximate- ly 4% in cash equivalents and short-term debt investments, 70% in equity investments, and 26% in fixed income and other investments. The following items are the components of the net pension cost for the qualified defined benefit plans: 1993 1992 1991 ---- ---- ---- (in millions) Service cost (benefits earned during the year) $ 90 $ 79 $ 98 Interest cost on projected benefit obligation 188 171 168 Actual return on plan assets (224) (114) (353) Net amortization and deferral 40 (65) 201 ---- ---- ---- Net pension cost $ 94 $ 71 $ 114 ==== ==== ==== Net pension cost for 1993 and 1991 presented above excludes a charge of approximately $33.9 million and $21.6 million, respec- tively, related to "early-out" incentive programs offered to a limited number of USAir employees during the years. No such charges were incurred in 1992. Non-qualified supplemental pension plans are established for certain employee groups, which provide incremental pension payments from the Company's funds so that total pension payments equal amounts that would have been payable from the Company's principal pension plans if it were not for limitations imposed by income tax regulations. The following table sets forth the non-qualified plans' status at December 31, 1993 and 1992: Net supplementary pension cost for the two years included the following components: The discount rate used to determine the actuarial present value of the projected benefit obligation was 7.5% and 8.75% as of December 31, 1993 and 1992, respectively. Rates of 3% and 6% were used to estimate future salary levels. In addition to the qualified and non-qualified defined benefit plans described above, USAir also contributes to certain defined contribution plans primarily for employees not covered under a collective bargaining agreement. Company contributions are based on a formula which considers the age and pre-tax earnings of each employee and the amount of employee contributions. USAir's contribution expense was $42 million for 1993. USAir recognized no such expense in 1992 and 1991. (b) Postretirement Benefits Other Than Pensions USAir offers medical and life insurance benefits to employees who retire from the Company and their eligible dependents. The medical benefits provided by USAir are coordinated with Medicare benefits. Retirees generally contribute amounts towards the cost of their medical expenses based on years of service with the Company. USAir provides uninsured death benefit payments to survivors of retired employees for stated dollar amounts, or in the case of retired pilot employees, death benefit payments determined by age and level of pension benefit. The plans for postretirement medical and death benefits are funded on the pay-as-you-go basis. USAir adopted Statement of Financial Accounting Standards No. 106 ("FAS 106") during 1992 and elected to record the January 1, 1992 Accumulated Postretirement Benefit Obligation ("APBO") using the immediate recognition approach. The cumulative effect of adopting FAS 106 was $745.5 million ($638.8 million net of tax benefit). The following table sets forth the financial status of the plans as of December 31, 1993 and 1992: The postretirement benefit expense for 1993 presented above excludes a charge of approximately $15.5 million related to "early- out" programs offered to a limited number of employees during the year. No such charges were incurred in 1992 or 1991. The discount rate used to determine the APBO was 7.75% and 8.75% at December 31, 1993 and 1992, respectively. The assumed health care cost trend rate used in measuring the APBO was 10.5% in 1993 and 1994, declining by 1% per year after 1994 to an ultimate rate of 4.5%. If the assumed health care cost trend rate were increased by 1 percentage point, the APBO at December 31, 1993 would be increased by 10% and 1993 periodic postretirement benefit cost would increase 13%. Prior to the adoption of FAS 106, USAir recognized expense for retiree health care at an estimated monthly rate (based on payments) and recognized expense for death benefits when paid. The expense using this methodology was approximately $8 million for 1991. (c) Postemployment Benefits USAir adopted Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" ("FAS 112"), during 1993. FAS 112 requires the use of an accrual method to recognize postemployment benefits such as disability-related benefits. The cumulative effect at January 1, 1993 of adopting FAS 112 was $43.7 million. (10) SUPPLEMENTAL BALANCE SHEET INFORMATION The components of certain accounts in the accompanying balance sheets are as follows: (11) NON-RECURRING AND UNUSUAL ITEMS (a) 1993 USAir's results for 1993 include non-recurring charges of (i) $43.7 million for the cumulative effect of an accounting change, as required by FAS 112 which was adopted during the third quarter of 1993, retroactive to January 1, 1993; (ii) $68.8 million for severance, early retirement and other personnel-related expenses recorded primarily during the third quarter of 1993 in connection with a workforce reduction of approximately 2,500 full-time positions between November 1993 and the first half of 1994; (iii) $36.8 million based on a projection of the repayment of certain employee pay reductions, recorded in the fourth quarter of 1993; (iv) $13.5 million for certain airport facilities at locations where USAir has, among other things, discontinued or reduced its service, recorded in the fourth quarter of 1993; (v) $8.8 million for a loss on USAir's investment in the Galileo International Partnership, which operates a computerized reservation system, recorded in the fourth quarter of 1993; and (vi) $18.4 million credit related to non-operating aircraft, recorded in the second quarter of 1993. (b) 1992 USAir's results for 1992 include (i) a charge of $628.1 million for the cumulative effect of an accounting change as required by FAS 106, effective January 1, 1992; (ii) a $107.4 million charge related to certain aircraft which have been withdrawn from service, recorded in the fourth quarter of 1992; and (iii) a $34.1 million non-operating loss related to the sale of ten MD-82 aircraft which USAir eliminated from its fleet plan, recorded in the fourth quarter of 1992. (c) 1991 USAir's results for 1991 include (i) a $107 million a pre-tax gain related to freezing of the fully funded non-contract employee pension plan; (ii) a $21.6 million pre-tax expense related to early retirement incentives offered to certain employees during 1991; (iii) a $21 million pre-tax charge to establish an additional reserve for USAir's grounded BAe-146 fleet; and (iv) a $18.5 million, net, in miscellaneous pre-tax non-recurring charges. (12) SELECTED QUARTERLY FINANCIAL DATA (Unaudited) The following table presents selected quarterly financial data for 1993 and 1992: Item 9.

Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III Item 10.

Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF USAir Group, Inc. Each of the persons listed below is currently a director of the Company and was elected in 1993 by the stockholders of the Company. Each director of the Company is also a director of USAir. Except as noted otherwise, the following biographies disclose the age and describe the business experience of each Director for at least the past five years. As required by the Investment Agreement, the Board of Directors amended the Company's By-Laws on January 21, 1993 to increase the authorized number of directors by three and immediately thereafter elected Messrs. Marshall, Maynard and Stevens to fill the new directorships. Under the Investment Agreement, the Company is required to use its best efforts to ensure that the slate of persons nominated by the Company for election as directors of the Company includes that number of persons designated by BA that is the percentage of the total then authorized number of directors, which is currently 16, of the Company that is nearest to but not greater than the percentage (but in no event greater than 25%) of the aggregate voting power of the securities that vote with the Common Stock as a single class for the election of directors of the Company then held by BA and its wholly-owned subsidiaries. Under this provision of the Investment Agreement, BA is entitled to designate three directors to the Board of Directors and has accordingly designated Messrs. Marshall, Maynard and Stevens. Served as Director since -------- Warren E. Buffett, 63.... Mr. Buffett has been Chairman 1993 and Chief Executive Officer of Berkshire Hathaway Inc. (insurance, candy, retailing, manufacturing and publishing) since 1970. He is also a Director of Capital Cities/ ABC, Inc., The Coca-Cola Company, The Gillette Comp- pany and Salomon Inc. Mr. Buffett is a member of the Finance and Planning Committee of the Board of Directors. Edwin I. Colodny, 67..... Mr. Colodny is of counsel to 1975 the law firm of Paul, Has- tings, Janofsky & Walker. He retired as Chairman of the Company and of USAir in July 1992. He served as Chief Executive Officer of USAir from 1975 until retiring as an employee of USAir in June 1991. Mr. Colodny is a Director of Martin Marietta Corporation, Comsat Corporation and Ester- line Technologies, Inc., and is a member of the Board of Trustees of the University of Rochester. He is a member of the Finance and Planning and Nominating Committees of the Board of Directors. Mathias J. DeVito, 63.... Mr. DeVito is Chairman of the 1981 Board and Chief Executive Officer of The Rouse Com- pany (real estate develop- ment and management). He also serves as a Director of First Maryland Bancorp and subsidiaries of The Rouse Company. He is a member of the Board of the Business Committee for the Arts and former Chair of the Greater Baltimore Committee. Mr. DeVito is Chairman of the Compensation and Benefits Committee and a member of the Finance and Planning Committee of the Board of Directors. George J. W. Goodman, 63.. Mr. Goodman is President of 1978 Continental Fidelity, Inc. which provides editorial and investment services. He is the author of a number of books and articles on finance and economics under the pen name "Adam Smith" and is the host of a television series of that name seen on public broadcasting stations in the U.S. and on other networks abroad. He is a Director of Cambrex Corporation. Mr. Goodman also serves as a mem- ber of the Advisory Committee of the Center for International Relations at Princeton Univer- sity, and is a Trustee of the Urban Institute. He is a mem- ber of the Compensation and Benefits and Finance and Planning Committees of the Board of Directors. John W. Harris, 47....... Mr. Harris is President of 1991 The Harris Group (real estate development). From 1972 through 1991, he was President of The Bissell Companies, Inc. (real estate development). He is a Director of Southern Bell Telephone and Telegraph Company. Mr. Harris is former Chairman of the Greater Charlotte Chamber of Commerce and a member of the Board of Trustees of the University of North Carolina and serves on the boards of several community service organiza- tions. He is a member of the Audit and Compensation and Benefits Committees of the Board of Directors. Edward A. Horrigan, Jr., 64 Mr. Horrigan is Chairman and 1987 Chief Executive Officer of Liggett Group Inc. (consumer products), a position he has held since May 1993. He is also the retired Vice Chairman of the Board of RJR Nabisco, Inc. and retired Chairman and Chief Executive Officer of R. J. Reynolds Tobacco Company, Winston -Salem, North Carolina (consumer products). He is a Director of the Haggai Foun- dation. Mr. Horrigan is a member of the Audit and Nominating Committees of the Board of Directors. Robert LeBuhn, 61......... Mr. LeBuhn is Chairman of 1966 Investor International (U.S.), Inc. (investments) and is a Director of Acceptance Insur- ance Companies, Amdura Corp., Lomas Financial Corp. and Cambrex Corporation. He is Trustee and President of the Geraldine R. Dodge Foun- dation, Morristown, New Jersey and is a member of the New York Society of Security Analysts. He is Chairman of the Finance and Planning Committee and a member of the Nominating Committee of the Board of Directors. Sir Colin Marshall, 60.... Sir Colin was elected Chairman 1993 of BA in February 1993. Prev- iously, he had been Chief Executive of BA and a member of BA's Board of Directors since 1983. Sir Colin is a Director of Grand Metropolitan plc, HSBC Holdings Plc, and IBM United Kingdom Holdings Limited. He is a member of the Finance and Planning Committee of the Board of Directors. Roger P. Maynard, 51...... Mr. Maynard has been Director 1993 of Corporate Strategy of BA since 1991. Previously, from 1987, he had held various positions at BA, including Director of Investor Relations & Marketplace Performance and Executive Vice President North America. Mr. Maynard is a member of the Nominating and Compensation and Benefits Committees of the Board of Directors. John G. Medlin, Jr, 60.... Mr. Medlin is Chairman of the 1987 Board and, until December 31, 1993, was Chief Executive Officer of Wachovia Corpor- ation (bank holding company). Mr. Medlin also serves as a Director of BellSouth Company, Media General, Inc., National Services Industries, Inc. and RJR Nabisco, Inc. He is Chair- man of the Nominating Committee and a member of the Compen- sation and Benefits Committee of the Board of Directors. Hanne M. Merriman, 52..... Mrs. Merriman is the Principal 1985 in Hanne Merriman Associates (retail business consultants). Previously, she served as President of Nan Duskin, Inc. (retailing), President and Chief Executive Officer of Honeybee, Inc., a division of Spiegel, Inc., and President of Garfinckel's, a division of Allied Stores Corporation. Mrs. Merriman is a Director of CIPSCO, Inc. Central Public Service Company, State Farm Mutual Automobile Insurance Company, The Rouse Company and Ann Taylor Stores Corporation. She is a member of the National Women's Forum and a Trustee of The American-Scandinavian Founda- tion. She was a member of the Board of Directors of the Federal Reserve Bank of Richmond, Virginia from 1984- 1990 and served as Chairman in 1989-1990. Mrs. Merriman is Chairman of the Audit Committee and is a member of the Nominating Committee of the Board of Directors. Charles T. Munger, 70..... Mr. Munger is Vice Chairman of 1993 Berkshire Hathaway Inc. (insur- ance, candy, retailing, manu- facturing and publishing) of which he has been an officer and Director since 1975. He is Chairman of Daily Journal Corporation and is a Director of Salomon Inc. and Wesco Financial Corporation. Mr. Munger is a member of the Audit Committee of the Board of Directors. Seth E. Schofield, 54..... Mr. Schofield was elected 1989 Chairman of the Board of Directors of the Company and USAir in June 1992. In June 1991 he was elected President and Chief Execu- tive Officer of the Company and of USAir. In June 1990 he was elected President and Chief Operating Officer of USAir. He had served as Executive Vice President- Operations of USAir since 1981. Mr. Schofield joined USAir in 1957 and has held various corporate staff positions. Mr. Schofield is a Director of the Erie Insurance Group, the PNC Bank, N.A., the Greater Washington Board of Trade, the Flight Safety Foundation, and the Greater Pittsburgh Council of the Boy Scouts of America. Mr. Schofield is Chairman of the Board of Directors of the Greater Pittsburgh Chamber of Commerce, and a Board Member of the Pennsylvania Business Roundtable, Penn's Southwest Association and the Virginia Business Council. He is also a member of the Allegheny Conference on Community Development and the Federal City Council. Richard P. Simmons, 62.... Mr. Simmons is Chairman of 1987 the Board and Chairman of the Executive Committee of Allegheny Ludlum Corp. and served as its President and Chief Execu- tive Officer from 1980 to 1990. Allegheny Ludlum pro- duces stainless steel and other high alloyed steels. Mr. Simmons is also a Director and Chairman of the Executive Committee of PNC Bank Corp. and Consolidated Natural Gas. He is a member of the Ameri- can Institute of Mining, Metallurgical and Petroleum Engineers and is a fellow and Distinguished Life Member of the American Society for Metals. Mr. Simmons is a member of the M.I.T. Corpor- ation and serves on the boards of several community service organizations. He is a member of the Audit and Finance and Planning Committees of the Board of Directors. Raymond W. Smith, 56..... Mr. Smith is Chairman of 1990 the Board and Chief Executive Officer of Bell Atlantic Com- pany, which is engaged princi- pally in the telecommunications business and is one of the seven regional companies formed as a result of the divestiture of the Bell System. Previously, Mr. Smith had served as Vice Chairman and President of Bell Atlantic and Chairman of The Bell Telephone Com- pany of Pennsylvania. He is a member of the Board of Directors of CoreStates Financial Company, a trustee of the University of Pittsburgh and is active in many civic and cultural organizations. He is a mem- ber of the Compensation and Benefits and Nominating Committees of the Board of Directors. Derek M. Stevens, 55...... Mr. Stevens has been Chief 1993 Financial Officer of and a Director of BA since 1989. Previously, from 1981, he was Finance Director of TSB Group plc (financial institution). Mr. Stevens is a member of the Audit Commit- tee of the Board of Directors. The law firm of Paul, Hastings, Janofsky and Walker, with which Mr. Colodny is affiliated on an Of Counsel basis, provided legal services to USAir during 1993 and is expected to provide such services during 1994. The following persons are executive officers of the Company. For purposes of Rule 405 under the Securities Act of 1933, Messrs. Lagow, Long, Schwab, Fornaro, Frestel, Harper and Ms. Risque Rohrbach are deemed to be executive officers of the Company. There are no family relationships among any of the officers listed above. No officer was selected pursuant to any arrangement between him or her and any other person. Officers are elected annually to serve for the following year or until the election and qualification of their successors. All the executive officers except Ms. Risque Rohrbach and Messrs. Lagow, Salizzoni, Aubin, Frestel, Fornaro and Harper have been actively engaged in the business and affairs of the Company and USAir during the past five years. The business experience of the officers listed above since January 1, 1989 is as follows: Mr. Schofield was elected Executive Vice President of the Company in July 1989. At that time he was also elected Vice Chairman of the Board of the Company and of USAir. Mr. Schofield served as Executive Vice President-Operations of USAir until his election as President and Chief Operating Officer of USAir in June 1990. Effective on July 1, 1991, Mr. Schofield was elected President and Chief Executive Officer of both the Company and USAir. Effective on July 1, 1992, Mr. Schofield was elected Chairman of the Board of Directors of both the Company and USAir. Mr. Lagow was Senior Vice President-Market Planning of Northwest Airlines until February 1988, when he became Senior Vice President-Planning of United Airlines. Mr. Lagow held that position until he was elected Executive Vice President-Marketing of USAir in February 1992. Mr. Lloyd engaged in the private practice of law in Washing- ton, D.C. from 1967 until election as Vice President, General Counsel and Secretary of the Company and as Senior Vice President and General Counsel of USAir in 1987. He served in those capaci- ties until his election as Executive Vice President, Secretary and General Counsel of the Company and Executive Vice President and General Counsel of USAir in January 1991. Mr. Long served as Senior Vice President-Administration of USAir until his election as Senior Vice President-Customer Operations of USAir in June 1989. He served in that capacity until his election as Senior Vice President-Customer Services in March 1991. Mr. Long served as Senior Vice President-Customer Services until his election as Executive Vice President-Customer Services in May 1992. Mr. Salizzoni was Vice Chairman and Chief Financial Officer of Trans World Airlines and Trans World Corporation until 1987, when he became Vice Chairman and Chief Financial Officer of TW Services, Inc. He was Chairman and Chief Executive Officer of TW Services from April 1987 until August 1989, just before that company went private. Mr. Salizzoni was associated with Mancusco and Co. from August 1989 until he was elected Executive Vice President-Finance of the Company and of USAir in November 1990. Mr. Schwab served as Vice President-Management Information Systems of USAir until his election as Senior Vice President- Management Information Systems of USAir in July 1989. Mr. Schwab served in that capacity until his election as Executive Vice President-Operations in April 1991. He also served as President of USAM Corp. from April 1988 through April 1991. Mr. Aubin was Executive Advisor to the Vice Chairman, President and Chief Executive Office of Air Canada and, prior to that position, Senior Vice President Technical Operations and Chief Technical Officer of Air Canada during the relevant time. He was elected Senior Vice President-Maintenance Operations of USAir in January 1994. Mr. Fornaro was Vice President-Research of Jesup & Lamont Securities until February 1988, when he became Senior Vice President-Marketing of Braniff, Inc. In August 1988, Mr. Fornaro became Senior Vice President-Market Planning of Northwest Airlines, the position he held until February 1992. He was elected Senior Vice President-Planning of USAir in March 1992. Mr. Frestel was Vice President-Personnel and Labor Relations for The Atchinson, Topeka & Santa Fe Railway during the relevant time, and was a Director of that company from June 1988, until his election as Senior Vice President-Human Resources of USAir in January 1989. Mr. Harper was Senior Vice President-Marketing and Information Systems at Axe-Houghton Management (investment management) until his election as Vice President and Controller of the Company and USAir in December 1991. He served in that position until his election as Senior Vice President-Information Systems of USAir in October 1992. Ms. Rohrbach was a public policy and communications consultant during 1993. She was Assistant Secretary of Labor for Policy at the U.S. Department of Labor during 1991-1992. Ms. Rohrbach served on the White House staff as a member of the legislative liaison team (1981-1986) and subsequently as Assistant to the President and Secretary to the Cabinet (1987-1988). In 1989 and 1990, she was a resident fellow at Harvard University's Institute of Politics, a consultant to the Department of Energy and in the private sector. From 1988-1993, she also served as a member of the National Commission on Children. She was elected Vice President-Public and Community Relations of the Company and Senior Vice President-Public and Community Relations of USAir in January 1994. Item 11.

Item 11. EXECUTIVE COMPENSATION Compensation of Directors Each director, except Mr. Schofield, is paid a retainer fee of $18,000 per year for service on the Board of Directors of the Company and a fee of $600 per Board meeting or committee meeting attended. Consistent with a comprehensive cost reduction program at USAir, the retainer fee was reduced by 20% to $14,400 for an eighteen-month period commencing January 1, 1992 and ending on June 30, 1993. Mr. LeBuhn, Chairman of the Finance and Planning Committee, Mr. DeVito, Chairman of the Compensation Committee, and Mrs. Merriman, Chairman of the Audit Committee each receives an additional fee of $2,000 per year for serving in those respective capacities. Mr. Medlin, Chairman of the Nominating Committee, receives an additional fee of $1,000 per year for serving in that capacity. Mr. Schofield receives a salary in his capacity as an officer of USAir and receives no additional compensation as a director of the Company and USAir. In 1987 the Company established a retirement plan for directors who are not also employees of the Company and its subsidiaries. The plan provides that such directors shall be eligible to receive retirement benefits thereunder if they have attained seventy years of age and served at least five consecutive years on the Board of Directors or, if they have not attained age seventy, have served for at least ten consecutive years on the Board of Directors. Eligible directors receive an annual retirement benefit equal to the highest annual retainer in effect for active directors during the five years prior to retirement. If the annual retainer for active directors is increased, the annual retirement benefit paid to retired directors is increased by an amount equal to 50% of the increase in retainer paid to active directors. If a director dies prior to retirement and had served for at least five consecutive years on the Board of Directors, the deceased director's surviving spouse is eligible under the plan to receive, for a period of five years following such death, an annual death benefit equal to 50% of the annual retainer paid to such director at the time of his or her death. If a retired eligible director dies, the director's surviving spouse is eligible under the plan to receive, for a period of five years following such death, 50% of the annual retirement benefit payable to the director at the time of his or her death. The plan is administered by the Compensation Committee. COMPENSATION OF EXECUTIVE OFFICERS The Summary Compensation Table below sets forth the compensation paid during the years indicated to each of the Chief Executive Officer and the four remaining most highly compensated executive officers of the Company (including its subsidiaries). SUMMARY COMPENSATION TABLE - -------- * Under the SEC's transition rules, no disclosure is required. (A) Mr. Schofield was elected Chief Executive Officer effective June 1, 1991. (B) Mr. Lagow's employment with USAir commenced on February 7, 1992. (C) Amounts disclosed reflect reductions in salary during (i) 1993 of $24,365, $14,942, $12,250, $10,904 and $10,904, and (ii) 1992 of $87,019, $49,272, $43,750, $38,942 and $38,942 for Messrs. Schofield, Lagow, Salizzoni, Lloyd and Schwab, respectively, which were implemented for all USAir officers for a fifteen-month period commencing on January 1, 1992 and ending on March 29, 1993 pursuant to a comprehensive cost reduction program at USAir. (D) Amounts disclosed include for (i) 1993, $271,288, $33,259, $73,215, and $27,621 and (ii) 1992, $171,410, $22,523, $47,974 and $16,784, received by Messrs. Schofield, Salizzoni, Lloyd and Schwab, respectively, to cover incremental tax liability resulting from income derived from the lapsing of restrictions on disposition of Restricted Stock. Any amounts disclosed in the column that are in excess of the amounts disclosed in the preceding sentence represent income derived from personal travel on USAir. (E) At December 31, 1993, Messrs. Schofield, Salizzoni, Lloyd and Schwab owned 30,000, 6,000, 4,000 and 3,200 shares of Restricted Stock, respectively. At the fair market value of the Common Stock on that date, these holdings of Restricted Stock were valued at $386,250, $77,250, $51,500, $41,200, respectively. (F) Under USAir's split dollar life insurance plan, described under "Additional Benefits" below, individual life insurance coverage is available to the named officers. During 1992, each officer paid the amount of the premium associated with the term life component of the coverage. In 1993, USAir commenced paying the premium associated with this coverage. In 1992 and 1993, USAir paid the remainder of the premium associated with the whole life component of the coverage. If all assumptions as to life expectancy and other factors occur in accordance with projections, USAir expects to recover the premiums it pays with respect to the whole life component of the coverage. The following amounts reflect the value of the benefits accrued during the years indicated, calculated on an actuarial basis, ascribed to the insurance policies purchased on the lives of the named officers (plus, with respect to 1993, the dollar value of premiums paid by USAir with respect to term life insurance): 1993--Mr. Schofield-- $29,328, Mr. Lagow--$9,716, Mr. Salizzoni--$26,010, Mr. Lloyd--$17,291 and Mr. Schwab--$11,170; 1992--Mr. Schofield--$38,495; Mr. Lagow--$12,902; Mr. Salizzoni--$34,382; Mr. Lloyd--$21,382 and Mr. Schwab--$15,555. During 1993, USAir made contributions of $34,974, $22,805, $26,212, $18,897 and $18,897 to the accounts of Messrs. Schofield, Lagow, Salizzoni, Lloyd and Schwab in certain defined contribution pension plans. (G) Upon the commencement of his employment, USAir agreed to pay Mr. Lagow $1 million over four years, which amount was intended to compensate him for restricted stock and stock options which he forfeited when he left his former employer. The amount disclosed includes the first installment, $250,000, of the total payment. (H) Amount disclosed also reflects $125,000 paid to Mr. Lagow in the form of a "sign-on bonus" and $4,715 for reimbursement of relocation expenses. (I) Amount disclosed also reflects $25,380 for reimbursement of relocation expenses. Aggregated Option/SAR Exercises in Last Fiscal Year and Fiscal Year-End Option/SAR Values The following table provides information on the number of options held by the named executive officers at fiscal year-end 1993. None of the officers exercised any options during 1993 and none of the unexercised options held by these officers were in-the-money based on the fair market value of the Common Stock on December 31, 1993 ($12.875). The values reflected in the above chart represent the application of the Retirement Plan formula to the specified amounts of compensation and years of service. The credited years of service under the Retirement Plan for each of the individuals included in the Summary Compensation Table are as follows: Mr. Schofield-32 years, Mr. Lagow-2 years, Mr. Salizzoni-3 years, Mr. Lloyd-7 years and Mr. Schwab-6 years. USAir has entered into agreements with Messrs. Lagow, Salizzoni, Lloyd and Schwab which provide for a supplement to their retirement benefits under the Retirement Plan. This supplement is designed to provide such persons with those benefits they would have received had they been employed by USAir for the minimum number of years to be entitled to full retirement benefits under the Retirement Plan. USAir adopted, effective January 1, 1993, a defined contribu- tion retirement program for its eligible non-contract employees (the "Retirement Savings Plan") as a replacement for the Retirement Plan described above. Under the Retirement Savings Plan, eligible employees may elect to contribute on a tax-deferred basis up to 13% of their pre-tax compensation, subject to a maximum annual contribution of $8,994 in 1993. USAir will also contribute to each employee's account in the Retirement Savings Plan (i) a matching contribution equal to 50% of each employee's contribution, subject to a maximum of 2% of the employee's annual pre-tax compensation, (ii) a basic contribution which ranges, depending on the employee's age, from 2% to 8% of the employee's annual pre-tax compensation and (iii) if USAir's pre-tax profit margin, as defined, exceeds certain thresholds, a profit sharing contribution up to a maximum of 7.5% of an employee's annual pre-tax compensation. USAir made no contributions under the profit sharing component of the Retirement Savings Plan in 1993. Pre-tax compensation is defined for purposes of the Retirement Savings Plan as all compensation which USAir must report as wages on an employee's Form W-2, plus an employee's tax deferred contributions under such Plan up to a maximum of $235,840 in 1993. USAir also established a non-qualified supplemental defined contribution plan (the "Supplemental Savings Plan") in 1993, which credits amounts to accounts of certain officers who participate in the Retirement Savings Plan but who are adversely affected by the maximum benefit limitations under qualified plans imposed by the Code. Amounts obligated to be paid by USAir under the Supplemental Savings Plan will be deposited in a trust established for the benefit of the participants. See the "All Other Compensation" column of the Summary Compensation Table for the amounts contributed or allocated in 1993 to Messrs. Schofield, Lagow, Salizzoni, Lloyd and Schwab under the Retirement Savings Plan and the Supplemental Savings Plan. Under the Retirement Savings Plan and the Supplemental Savings Plan, participants may direct the investment of their contributions and USAir's contributions to their accounts among certain invest- ment funds. Participants' contributions are fully vested when made. USAir's contributions vest when the participant has been employed by USAir for at least two years. Additional Benefits USAir has in effect an Officers' Supplemental Benefit Plan, which provides certain benefits to a current or retired officer's spouse and children under age 19 following the officer's death. These benefits include: (i) dependent survivors' monthly income benefit and (ii) dependent survivors' health care insurance. A dependent survivors' monthly income benefit is payable to the eligible spouse or children of a deceased officer or retired officer in an amount equal to 20% of the monthly basic rate of salary payable to the officer the day prior to death or, in the case of a deceased retired officer, the day prior to retirement. Monthly income benefits will be reduced by the amount of any spouse protection benefit payable from Retirement Plan funds, and are subject to cessation upon the occurrence of certain specified events. In no case are monthly income benefits payable for more than 19 years following the date of death. The eligible surviving spouse or children of a deceased officer or retired officer are also entitled to receive dependent survivors' health care insurance, which provides the medical, major medical and dental insurance benefits generally available to dependents of salaried employees of USAir. Eligibility for this coverage ceases upon the occurrence of certain specified events. USAir also maintains a split-dollar life insurance plan under which individual term life insurance is available to its officers in the amount of three times base salary. The plan also provides for accrual of a cash value component for each officer who holds a policy. Under the plan, during 1993, USAir paid the premiums on the term and whole life insurance components of the policy. The premium attributable to the term life insurance of the policy is treated as income to the participant. At death, prior to transfer of the policy to the participant, the beneficiary receives the amount of the coverage less any amount necessary to reimburse the employer for its investment, and the employee is entitled to any additional proceeds. Upon transfer of the policy to the partici- pant, the participant is entitled to the cash surrender value of the policy in excess of the amount payable to the employer for recovery of its investment. See the "All Other Compensation" column of the Summary Compensation Table for information concerning compensation with respect to Messrs. Schofield, Lagow, Salizzoni, Lloyd and Schwab that was attributable to the split dollar life insurance plan. Arrangements Concerning Termination of Employment and Change of Control USAir currently has employment contracts (the "Employment Contracts") with the executive officers (the "Executives") named in the Summary Compensation Table. The terms of the Employment Contracts extend until the earlier of the fourth anniversary thereof or the Executive's normal retirement date and are subject to automatic one-year annual extensions on each anniversary date (to the fourth anniversary of such anniversary date) unless advance written notice is given by USAir. In exchange for each Executive's commitment to devote his or her full business efforts to USAir, the agreements provide that each Executive will be re-elected to a responsible executive position with duties substantially similar to those in effect during the prior year and will receive (1) an annual base salary at a rate not less than that in effect during the previous year, (2) incentive compensation as provided in the contract and (3) insurance, disability, medical and other benefits generally granted to other officers. In the event of a change of control, as defined in each Employment Contract, the term of each Employment Contract is automatically extended until the earlier of the fourth anniversary of the change of control date or the Executive's normal retirement date. As a result of amendments to the Employment Contracts entered into in June 1992, the acquisition of 20% or more of the outstanding securities of the Company under circumstances in which the acquiror would obtain the power to elect 20% or more of the members of the Board of Directors was added to the definition of a change of control under the Employment Contracts. To the extent permitted by Foreign Ownership Restric- tions and assuming the consummation of the Second Purchase (the "Second Closing") results in BA's electing at least 20% of the Board of Directors, the Second Closing would be treated as a change of control and would result in extension of the term of each Employment Contract until the earlier of the fourth anniversary of the Second Closing or the Executive's normal retirement date. On March 7, 1994, BA announced that it would not make any additional investments in the Company under current circumstances. See Item 1. "Business-British Airways Announcement Regarding Additional Investments in the Company; Code Sharing." The Employment Contracts provide that, should USAir or any successor fail to re-elect the Executive to his or her position, assign the Executive to inappropriate duties which result in a diminution in the Executive's position, authority or responsibili- ties, fail to compensate the Executive as provided in the Employ- ment Contract, transfer the Executive in violation of the Employ- ment Contract, fail to require any successor to USAir to comply with the Employment Contract or otherwise terminate the Executive's employment in violation of the Employment Contract, the Executive may elect to treat such failure as a breach of the Employment Contract if the Executive then terminates employment. As liquidat- ed damages as the result of an event not following a change of control that is deemed to be a breach of the Employment Contracts, USAir or its successor would be required to pay the Executive an amount equal to his or her annual base salary for the then remaining term of the Employment Contract, and to continue granting certain employee benefits for the then remaining term of the Executive's Employment Contract. If the breach follows a change of control, the Executive would be entitled to receive (i) an amount equal to the product of three times the sum of the Executive's annual base salary plus an annual bonus, (ii) a lump sum equal to the actuarial equivalent of the pension benefits which the Executive would have received had he or she remained employed by USAir until the end of the term of the Employment Contract, (iii) medical benefits until such time as the Executive qualifies for group medical benefits from another employer, (iv) travel benefits for the Executive's life, (v) reimbursement of reductions in salary sustained by the Executive as a result of a comprehensive cost reduction program initiated by USAir in October 1991, and (vi) continuation of certain other benefits during the remainder of the term of the Employment Contract. In addition, except under the circumstances described in the immediately following paragraph, during the 30-day period immediately following the first anniversa ry of a change of control any Executive could elect to terminate his or her Employment Contract for any reason and receive the liquidated damages described in the immediately preceding sentence. Each Employment Contract provides that if USAir breaches the Employment Contract, as described above, each Executive shall be entitled to recover from USAir reasonable attorney's fees in connection with enforcement of such Executive's rights under the Employment Contract. Each Employment Contract also provides that any payments the Executive receives in the event of a termination shall be increased, if necessary, such that, after taking into account all taxes he or she would incur as a result of such payments, the Executive would receive the same after-tax amount he or she would have received had no excise tax been imposed under Section 4999 of the Code. In order to facilitate consummation of the acts and transac- tions contemplated by the Investment Agreement, the Executives agreed in January 1993 to an amendment to their Employment Contracts that will become effective upon the Second Closing (i) to eliminate their right to elect to terminate their Employment Contracts without any reason during the 30-day period immediately following the first anniversary of the Second Closing; (ii) that USAir may transfer the Executive's employment to any location that meets certain criteria in the Employment Contracts without such relocation constituting a breach of the Employment Contracts; (iii) that consummation of the Second Closing would be treated as the only change of control with respect to BA; and (iv) that following the Second Closing, USAir may make certain changes in benefit plans affecting the Executives that are not material, as that term is defined in the Employment Contracts, provided that the changes apply to all eligible officers of USAir and are approved by a majority of the directors of the Company not elected by BA. Currently, under the Company's 1984 Stock Option and Stock Appreciation Rights Plan (the "1984 Plan") and 1988 Stock Incentive Plan (the "1988 Plan," and together with the 1984 Plan, the "Plans"), pursuant to which employees of the Company and its subsidiaries have been awarded stock options and stock appreciation rights with respect to Common Stock and, in the case of the 1988 Plan, shares of Restricted Stock, occurrence of a change of control, as defined, would make all granted options immediately exercisable without regard to the vesting provisions thereof. In addition, grantees would be able, during the 60-day period immediately following a change of control (the "Cash-out Right"), to surrender all unexercised stock options not issued in tandem with stock appreciation rights under the Plans to the Company for a cash payment equal to the excess, if any, of the fair market value of the Common Stock over the exercise prices of such stock options or the positive value of any stock appreciation rights. As described above, in June 1992, the Company amended the definition of a change of control in the Plans with the result that, to the extent permitted by Foreign Ownership Restrictions and assuming the Second Closing results in BA's electing at least 20% of the Board of Directors, the Second Closing would be treated as a change of control thereunder. As of March 1, 1994, there were unexercised stock options to purchase 548,310 shares of Common Stock (of which 84,600 had tandem stock appreciation rights) under the 1984 Plan and unexercised stock options to purchase 3,625,500 shares of Common Stock (none of which had tandem stock appreciation rights) under the 1988 Plan. (As of March 1, 1994, 3,177,400 of the 3,625,500 options outstanding under the 1988 Plan and 322,910 of the 548,310 options outstanding under the 1984 Plan were exercis- able pursuant to their normal vesting schedule.) The weighted average exercise price of all the outstanding stock options was approximately $23.15. On February 28, 1994, the closing price of a share of Common Stock on the NYSE was $11.375. See the "Aggre- gated Option/SAR Exercises in Last Fiscal Year and Fiscal Year-End Option/SAR Values" table for information regarding stock options held by the Executives. Currently, 50,400 shares of Restricted Stock previously granted to the Executives may (i) become free of transfer restric- tions upon their normal vesting schedule or (ii) be subject to accelerated vesting upon a termination of employment which triggers the payment of liquidated damages under the Employment Contracts, as discussed above, regardless of whether the termination occurred following a change of control as defined in the Employment Contracts. See "Beneficial Security Ownership" for information regarding Restricted Stock owned by the Executives. With respect to Mr. Lagow, in order to induce him to accept its offer of employment in 1992, USAir agreed, among other things, to pay Mr. Lagow $1 million in four equal installments, each installment being due and payable on the first four anniversaries of the commencement of his employment by USAir, provided Mr. Lagow remains employed by USAir. This payment was intended to compensate Mr. Lagow for stock options and restricted stock which he forfeited when he left his former employer. In the event of a change of control under his Employment Contract or wrongful termination thereunder, USAir has also agreed to pay Mr. Lagow in a lump sum any unpaid balance of this obligation. Notwithstanding anything to the contrary set forth in any of the Company's or USAir's filings under the Securities Act of 1933, as amended (the "Securities Act"), or the Securities Exchange Act of 1934, as amended (the "Exchange Act"), that incorporates by reference this Proxy Statement, in whole or in part, the following Report and Performance Graph shall not be incorporated by reference into any such filings. Report of the Compensation and Benefits Committee of the Board of Directors The Compensation Committee policies with respect to compensa- tion of the Company's executive officers are to: 1. Attract and retain talented and experienced senior management by offering compensation that is competitive with respect to other major U.S. airlines and other U.S. companies of comparable size. 2. Motivate senior management to provide a high-quality product to consumers with the ultimate goal of maximizing profit- ability and stockholder returns by offering incentive and long-term compensation that is linked to return on sales and the market value of the Common Stock. The Compensation Committee has played an active role in the oversight and review of all executive compensation paid to executive officers of the Company during the last fiscal year. Ordinarily, the Compensation Committee and the full Board of Directors, in consultation with the Senior Vice President-Human Resources of USAir and, if warranted, an independent compensation consultant, annually review the total compensation package (comprised of base salary, incentive compensation, and long-term incentive compensation) of the Chairman, President and Chief Executive Officer. The Compensation Committee reviews the market rate for peer-level positions of the other major domestic passenger carriers including, but not limited to, the three other airline companies included in the S&P Airline Index, which is reflected in the "Performance Graph." Based primarily on this comparison, the Compensation Committee establishes the Chief Executive Officer's base salary. Mr. Schofield does not participate in Compensation Committee or Board of Directors deliberations or decision-making regarding any aspect of his compensation. Correspondingly, the Compensation Committee established the compensation reported for 1993 for the Company's other executive officers, including the four officers named in the Summary Compensation Table, based upon a comparison of peer positions at the other major U.S. airlines including, but not limited to, the three other airline companies included in the S&P Airline Index, which is reflected in the "Performance Graph." The principal elements of the Company's compensation paid to the executive officers in the last completed fiscal year are discussed below. Base Salary. As part of a comprehensive program to reduce costs at USAir, the Compensation Committee reduced the salaries of the executive officers and the other officers of USAir for a fifteen month period commencing on January 1, 1992 and ending on March 29, 1993. The Compensation Committee reduced each ex- ecutive's base salary in accordance with the following graduated schedule: ~ First $20,000 of salary reduced by 0% ~ Next $30,000 of salary reduced by 10% ($20,000 to $50,000) ~ Next $50,000 of salary reduced by 15% ($50,000 to $100,000) ~ Any amount of salary in excess of $100,000 reduced by 20%. Each of the executive officers agreed to the reductions in salary, which otherwise would have constituted grounds for the executives to have terminated their employment agreements with USAir. The amounts of salary not paid in 1992 and 1993 to Mr. Schofield and the other four executive officers named in the Summary Compensation Table are disclosed in footnote (C) to that table. As stated above, the Compensation Committee establishes the base salaries of the Company's executive officers primarily by reference to the salaries of officers holding comparable positions at other major U.S. airlines including, but not limited to, the three other airline companies included in the S&P Airline Index, which is reflected in the "Performance Graph." Historically, the Compensation Committee had awarded merit increases based on measuring individual performance against objectives. However, due to the Company's poor financial performance, the Compensation Committee last awarded merit increases in executive base salaries in 1989. Since 1989 the Compensation Committee had increased the salaries of executive officers solely as a result of a promotion or an increase in responsibilities. The Company commissioned an independent compensation consultant to conduct a comprehensive study of the salaries of comparable airline officers in 1992. The study disclosed that the salaries (prior to the fifteen-month reduction described above) of most officers were substantially below those of salaries for analogous positions at major competi- tors. Following the study, in July 1992, the Compensation Committee prospectively set the salaries of executive officers generally at the median of the comparative range adjusted by individual performance and experience, effective April 1993. In connection with the same review, the Compensation Committee proposed to increase Mr. Schofield's base salary (before adjustment for the fifteen-month salary reductions) from $500,000 to $590,000, effective April 1993. Because the Company has continued to sustain losses, Mr. Schofield declined to accept the increase in base salary. Annual Cash Incentive Compensation Program: The Compensation Committee adopted the Executive Incentive Compensation Plan effective on January 1, 1988. The plan is administered by the Compensation Committee. All officers, including executive officers, of the Company are eligible to participate in this plan. The Compensation Committee is authorized to grant awards under this plan only if the Company achieves for a fiscal year a two percent or greater return on sales ("ROS"). The target level of performance is four percent ROS. If the Company achieves the target performance of four percent ROS, the full target percentage (which varies depending on position) is applied against the individual's base salary for the year to determine the target bonus award (the "Target Award") for the individual. Target Awards for executive officers range between 30% and 50% of base salary. If the minimum level of performance of two percent ROS is achieved, 50% of the Target Award would be available for distribution. If the maximum level of performance of six percent ROS is achieved, 200% of the Target Award would be available for payment. The Compensation Committee may adjust awards made to executive officers based on individual performance; however, no award may exceed 250% of the Target Award for any individual. The Compensation Committee last approved payments to executive officers under this plan for the fiscal year ended December 31, 1988. The Company has not achieved the minimum two percent ROS in any fiscal year, and the Compensation Committee has not made any awards under the plan, since then. Long-Term Incentive Programs Stock Options: The executive officers of the Company partici- pate in the Company's 1984 Stock Option and Stock Appreciation Rights Plan (the "1984 Plan") and 1988 Stock Incentive Plan (the "1988 Plan", and together with the 1984 Plan, the "Plans") which are both administered by the Compensation Committee. The Compensation Committee is authorized to grant options under these Plans only at an exercise price equal to the fair market value of a share of Common Stock on the date of grant. During 1993, the Compensation Committee did not grant any options from either of the Plans to the executive officers. The Compensation Committee determines the size of any option grant under the Plans based upon (i) the Compensation Committee's perceived value of the grant to motivate and retain the individual executive, (ii) a comparison of long-term incentive practices within the commercial airline industry, (iii) a comparison of awards provided to peer executives within the Company and (iv) the number of outstanding options held by the grantee and the exercise prices of these options. Although the Compensation Committee supports and encourages stock ownership in the Company by executive officers, it has not promulgated any standards regarding levels of ownership by executive officers. Pursuant to the reductions in the executive officers' salaries discussed above, in 1992 the Compensation Committee granted these persons non-qualified stock options to purchase 50 shares of Common Stock at $15 per share for each $1,000 of salary foregone during the wage reduction program, as is the case for each USAir employee whose pay was reduced pursuant to the program. Restricted Stock The Compensation Committee did not award any Restricted Stock under the 1988 Plan during 1993. (Grants of Restricted Stock are not authorized under the 1984 Plan). From 1988-1990, the Compensation Committee granted Restricted Stock to a total of nine executive officers, some of whom are no longer employed by USAir. During 1993, restrictions on disposition expired on a total of 23,200 shares of Restricted Stock held by Mr. Schofield, which shares were originally granted between 1988 and 1990. Restrictions on disposition also lapsed during 1993 on a total of 10,900 shares of Restricted Stock held by Messrs. Salizzoni, Lloyd and Schwab, which shares were originally granted between 1988 and 1990. The Omnibus Budget Reconciliation Act of 1993 added Section 162(m) to the Internal Revenue Code. Section 162(m) provides that companies will not be entitled to a tax deduction for certain compensation paid to any executive officer to the extent that the compensation exceeds $1 million in a taxable year. The Compensa- tion Committee is studying Section 162(m) and the proposed rules thereunder and is in the process of determining whether to recommend that the Company take the necessary measures to conform its compensation to Section 162(m). The Compensation Committee will continue to review all compensation and benefit matters presented to it and will act based upon the best information available in the best interests of the Company, its stockholders and employees. Mathias J. DeVito, Chairman George J. W. Goodman John W. Harris Roger P. Maynard John G. Medlin, Jr. Raymond W. Smith PERFORMANCE GRAPH This graph compares the performance of the Company's Common Stock during the period January 1, 1989 to December 31, 1993 with the S&P 500 Index and the S&P Airline Index. The graph depicts the results of investing $100 in the Company's Common Stock, the S&P 500 Index and the S&P Airline Index at closing prices on Decem- ber 31, 1988. The stock price performance shown on the graph is not necessarily indicative of future performance. The S&P Airline Index consists of AMR Corporation, Delta Air Lines, Inc., UAL Corporation and the Company. Item 12.

Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following information pertains to Common Stock, Series A Preferred Stock, Series F Preferred Stock, Series T Preferred Stock and Depositary Shares ("Depositary Shares"), each representing 1/100 of a share of the Company's $437.50 Series B Cumulative Convertible Preferred Stock, without par value ("Series B Preferred Stock"), beneficially owned by all directors and executive officers of the Company as of March 1, 1994. Unless indicated otherwise, the information refers to ownership of Common Stock. Unless indicated otherwise by footnote, the owner exercises sole voting and investment power over the securities (other than unissued securities, the ownership of which has been imputed to such owner). Series F Preferred Stock and Series T Preferred Stock, Common Stock receivable upon conversion. In addition, such Rights are issuable on a one-for-one basis with respect to shares of Common Stock receivable upon exercise of stock options or conversion of Depositary Shares. (2) Percentages are shown only where they exceed one percent of the number of shares outstanding and, in the case of Common Stock holdings are based on shares of Common Stock outstanding (exclusive of treasury stock) on March 1, 1994. (3) Various affiliates of Berkshire Hathaway Inc. ("Berkshire") are recordholders of 358,000 or 100% of the outstanding shares of Series A Preferred Stock. Messrs. Buffett and Munger are Chairman and Chief Executive Officer and Vice Chairman, respectively, of Berkshire and may be deemed to control that company. Messrs. Buffett and Munger each disclaims beneficial ownership of Series A Preferred Stock. Series A Preferred Stock is currently convertible into 9,239,944 shares of Common Stock, which represents approximately 10.5% of the total voting interest represented by Common Stock, Series F Pre- ferred Stock, Series T Preferred Stock and Series A Preferred Stock at March 1, 1994. (4) The listing of Mr. Colodny's holding includes 67,000 shares of Common Stock issuable within 60 days of March 1, 1994 upon exercise of stock options. (5) Mr. Goodman's holdings of Depositary Shares is convertible into 498 shares of Common Stock. (6) A wholly-owned subsidiary of BA is recordholder of 30,000 or 100% of the outstanding shares of Series F Preferred Stock, 152.1 or 100% of the outstanding shares of the Series T-1 Preferred Stock and 9,919.8 or 100% of the outstanding shares of the Series T-2 Preferred Stock pursuant to the Investment Agreement. Messrs. Marshall, Maynard and Stevens are Chair- man, Director of Corporate Strategy and Chief Financial Offic- er, respectively, of BA and have been designated by BA to act as directors of the Company pursuant to the Investment Agreement. Messrs. Marshall, Maynard and Stevens each dis- claims beneficial ownership of Series F Preferred Stock and Series T Preferred Stock. (7) The listing of Mr. Schofield's holding includes 335,069 shares of Common Stock issuable within 60 days of March 1, 1994 upon exercise of stock options, and 30,000 shares of Common Stock subject to certain restrictions upon disposition ("Restricted Stock"). (8) The listing of Mr. Lagow's holding reflects shares of Common Stock issuable within 60 days of March 1, 1994 upon exercise of stock options. (9) The listing of Mr. Salizzoni's holding includes 152,800 shares of Common Stock issuable within 60 days of March 1, 1994 upon exercise of stock options and 6,000 shares of Restricted Stock. (10) The listing of Mr. Lloyd's holding includes 169,742 shares of Common Stock issuable within 60 days of March 1, 1994 upon exercise of stock options and 4,000 shares of Restricted Stock. (11) The listing of Mr. Schwab's holding includes 167,992 shares of Common Stock issuable within 60 days of March 1, 1994 upon exercise of stock options and 3,200 shares of Restricted Stock. (12) The listing of all directors' and officers' holdings includes 1,193,583 shares of Common Stock issuable within 60 days of March 1, 1994 upon exercise of stock options and 50,400 shares of Restricted Stock. The only persons known to the Company (from Company records and reports on Schedules 13D and 13G filed with the Securities and Exchange Commission (the "SEC")) which owned, as of March 1, 1994, more than 5% of its Common Stock, Series A Preferred Stock, Series F Preferred Stock and Series T Preferred Stock are listed below: (1) Represents percent of class of stock outstanding (exclusive of treasury stock) on March 1, 1994. (2) Number of shares as to which such person has shared voting power-358,000; shared dispositive power-358,000. (3) These shares of Series A Preferred Stock are owned directly by affiliates of Berkshire, are convertible, under certain circumstances and subject to certain antidilution adjustments, into 9,239,944 shares of Common Stock and represent approxi- mately 10.5% of the combined voting power of the outstanding Common Stock, Series A Preferred Stock, Series F Preferred Stock and Series T Preferred Stock, voting as a single class, at March 1, 1994. A number of Rights, equal to the number of shares of Common Stock into which the Series A Preferred Stock is convertible, is also owned by this person. As disclosed above, two directors of the Company, Messrs. Buffett and Munger, may be deemed to control Berkshire and disclaim beneficial ownership of Series A Preferred Stock. (4) Number of shares as to which BA has sole voting power and sole dispositive power-30,000. (5) BritAir Acquisition Corp. Inc. is a wholly-owned subsidiary of BA and owns Series F Preferred Stock and Series T Preferred Stock pursuant to the Investment Agreement. Series F Preferred Stock and Series T Preferred Stock are convertible, under certain circumstances on or after January 21, 1997 and subject to certain antidilution adjustments and Foreign Ownership Restrictions, into a total of 15,458,658 and 3,831,695 shares of Common Stock, respectively. Together, the Series F Pre- ferred Stock and Series T Preferred Stock represent approxi- mately 21.9% of the combined voting power of the outstanding Common Stock, Series A Preferred Stock, Series F Preferred Stock and Series T Preferred Stock, voting as a single class, at March 1, 1994. A number of Rights, equal to the number of shares of Common Stock into which the Series F Preferred Stock and Series T Preferred Stock are convertible, is owned by this person. As disclosed above, three directors of the Company, Messrs. Marshall, Maynard and Stevens, have been designated by BA to act as directors of the Company pursuant to the Invest- ment Agreement and disclaim beneficial ownership of Series F Preferred Stock and Series T Preferred Stock. (6) Reflects 152.1 or 100% of the outstanding shares of Series T-1 Preferred Stock and 9,919.8 or 100% of the outstanding shares of Series T-2 Preferred Stock. BA has sole voting power and sole dispositive power as to all these outstanding shares of Series T Preferred Stock. (7) The Schedule 13G dated January 6, 1994 disclosing such ownership was jointly filed by such person with five French mutual insurance companies ("Mutuelles AXA") and AXA. The Schedule 13G indicated that each of Mutuelles AXA, as a group, and AXA expressly declares that the filing of the Schedule 13G should not be construed as an admission that it is, for purposes of Section 13(d) of the Securities Exchange Act of 1934, as amended, the beneficial owner of any securities covered by the Schedule 13G. The Company is investigating whether, owing to the investment of Mutuelles AXA and AXA (collectively, "AXA") in the Equitable Companies Incorporated ("Equitable"), AXA is the beneficial owner of these shares. If it is determined that AXA is the beneficial owner, then self-effectuating provisions of the Company's restated certificate of incorporation, as amended, would provide that the subject shares would be non-voting shares. The Company does not know whether Equitable would cause such shares to be sold in the event such shares have no voting rights. See "Management's Discussion and Analysis of Financial Condition and Results of Operations-Industry Globalization and Regula- tion" for information regarding U.S. statutory limitations on foreign ownership of U.S. air carriers and Item 1. "Business- British Airways Investment Agreement" and notes (4), (5) and (6) above for information regarding BA's ownership interest in the Company. (8) Number of shares as to which person has sole voting power- 5,669,403; shared voting power-1,300; no voting power-636,800; sole dispositive power-6,305,703; shared dispositive power- none; no dispositive power-1,800. (9) The shares are owned by a direct and an indirect subsidiary of the person. Number of shares as to which such subsidiaries have sole voting power-4,832,200; sole dispositive power- 4,832,200. In connection with BA's purchase of the Series T Preferred Stock in June 1993, Messrs. Marshall, Maynard and Stevens and BA were required by Section 16 of the Securities Exchange Act of 1934, as amended, and rules thereunder to file by July 10, 1993, Form 4 reports disclosing this change of ownership. Messrs. Marshall, Maynard and Stevens and BA filed these reports on September 14, 1993. Item 13.

Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None PART IV Item 14.

Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this report: 1. FINANCIAL STATEMENTS (i) The following consolidated financial statements of USAir Group are included in Part II, Item 8A of this report: - Consolidated Statements of Operations for each of the Three Years Ended December 31, 1993 - Consolidated Balance Sheets at December 31, 1993 and - Consolidated Statements of Cash Flows for each of the Three Years Ended December 31, 1993 - Consolidated Statements of Changes in Stockholders' Equity for each of the Three Years Ended December 31, - Notes to Consolidated Financial Statements (ii) The following consolidated financial statements of USAir are included in Part II, Item 8B of this report: - Consolidated Statements of Operations for each of the Three Years Ended December 31, 1993 - Consolidated Balance Sheets at December 31, 1993 and - Consolidated Statements of Cash Flows for each of the Three Years Ended December 31, 1993 - Consolidated Statements of Changes in Stockholder's Equity for each of the Three Years Ended December 31, - Notes to Consolidated Financial Statements 2. FINANCIAL STATEMENT SCHEDULES (i) Independent Auditors' Report on Consolidated Financial Statement Schedules of USAir Group. - Consolidated Financial Statement Schedules - Three Years Ended December 31, 1993: V - Property, Equipment and Leasehold Improvements VI - Accumulated Depreciation and Amortization of Prop- erty, Equipment and Leasehold Improvements VII - Guarantees of Securities of Other Issuers VIII - Valuation and Qualifying Accounts and Reserves X - Supplementary Income Statement Information (ii) Independent Auditors' Report on Consolidated Financial Statement Schedules of USAir. - Consolidated Financial Statement Schedules - Three Years Ended December 31, 1993: IV - Indebtedness to Related Parties - Not Current V - Property, Equipment and Leasehold Improvements VI - Accumulated Depreciation and Amortization of Prop- erty, Equipment and Leasehold Improvements VII - Guarantees of Securities of Other Issuers VIII - Valuation and Qualifying Accounts and Reserves X - Supplementary Income Statement Information All other schedules are omitted because they are not appli- cable or not required, or because the required information is either incorporated herein by reference or included in the financial statements or notes thereto included in this report. (b) Reports on Form 8-K During the quarter ended December 31, 1993, the Company and USAir filed Current Reports dated September 23, October 20, and November 4, 1993, on Form 8-K regarding the Second Waiver dated September 15, 1993 to the Credit Agreement, results for the quarter ended September 30, 1993 and the sale of $337.7 million of pass through certificates, respectively. The Company and USAir filed a Current Report dated January 18, 1994 on Form 8-K regarding the Third Waiver dated as of December 21, 1993 to the Credit Agreement. In addition, the Company and USAir filed a Current Report dated January 25, 1994 on Form 8-K regarding the press release dated January 25, 1994 of USAir Group, Inc. and USAir, Inc., with consolidated statements of operations for each company. On March 9, 1994, the Company and USAir filed a Current Report on Form 8-K disclosing projected losses for the first quarter and year 1994 and the initiation of negotiations with the leadership of USAir's unions regarding pay reductions and productivity improvements. 3. EXHIBITS Designation Description 3.1 Restated Certificate of Incorporation of USAir Group (incorporated by reference to Exhibit 3.1 to USAir Group's Registration Statement on Form 8-B dated January 27, 1983), including the Certificate of Amend- ment dated May 13, 1987 (incorporated by reference to Exhibit 3.1 to USAir Group's and USAir's Quarterly Report on Form 10-Q for the quarter ended March 31, 1987), the Certificate of Increase dated June 30, 1987 (incorporated by reference to Exhibit 3 to USAir Group's and USAir's Quarterly Report on Form 10-Q for the quarter ended June 30, 1987), the Certificate of Increase dated October 16, 1987 (incorporated by reference to Exhibit 3.1 to USAir Group's and USAir's Quarterly Report on Form 10-Q for the quarter ended September 30, 1987), the Certificate of Increase dated August 7, 1989 (incorporated by reference to Exhibit 3.1 to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1989), the Certificate of Increase dated April 9, 1992, the Certificate of Increase dated January 21, 1993, and as amended by Amendment No. 1 dated May 26, 1993 (incorporated by reference to Appendix II to USAir Group's Proxy State- ment dated April 26, 1993). 3.2 By-Laws of USAir Group (incorporated by reference to Exhibit 3.2 to USAir Group's and USAir's Annual Report on Form 10-K for the year ended December 31, 1992). 3.3 Rights Agreement, dated as of July 29, 1989, as amended and restated as of January 21, 1993, between USAir Group and Chemical Bank, as Rights Agent (incorporated by reference to Exhibit 28.4 to USAir Group's Current Report on Form 8-K dated January 21, 1993). 3.4 Restated Certificate of Incorporation of USAir (in- corporated by reference to Exhibit 3.1 to USAir's Registration Statement on Form 8-B dated January 27, 1983). 3.5 By-Laws of USAir (incorporated by reference to Exhibit 3.5 to USAir Group's and USAir's Annual Report on Form 10-K for the year ended December 31, 1992). 4.1 Amended Certificate of Designation, Preferences, and Rights of the Series D of Junior Preferred Stock of USAir Group (incorporated by reference to Exhibit 4(c) to USAir Group's Current Report on Form 8-K dated August 11, 1989). 4.2 Certificate of Designation of Series A Cumulative Convertible Preferred Stock of USAir Group (incorpo- rated by reference to Exhibit 4(b) to USAir Group's Current Report on Form 8-K dated August 11, 1989). 4.3 Certificate of Designation of Series B Cumulative Convertible Preferred Stock of USAir Group (incorpo- rated by reference to Exhibit 3.3 to Amendment No. 4 to USAir Group's Registration Statement on Form S-3 (Registration No. 33-39540) dated May 17, 1991). 4.4 Agreement between USAir Group and Berkshire Hathaway Inc. dated August 7, 1989 (incorporated by reference to Exhibit 4(a) to USAir Group's Current Report on Form 8- K dated August 11, 1989). 4.5 Certificate of Designation of Series F Cumulative Convertible Senior Preferred Stock of USAir Group (incorporated by reference to Exhibit 28.2 to USAir Group's Current Report on Form 8-K dated January 21, 1993). 4.6 Form of Certificate of Designation of Series T-_ Cumulative Exchangeable Convertible Senior Preferred Stock of USAir Group (incorporated by reference to Appendix VII to USAir Group's Proxy Statement dated April 26, 1993). Neither USAir Group nor USAir is filing any instrument (with the exception of holders of exhibits 10.1(a-h)) defining the rights of holders of long-term debt because the total amount of securities authorized under each such instrument does not exceed ten percent of the total assets of USAir. Copies of such instruments will be furnished to the Securities and Exchange Commission upon request. 10.1(a) Credit Agreement dated as of March 30, 1987 and Amended and Restated as of October 21, 1988 among the Banks named therein and USAir Group (incorporated by reference to Exhibit 28.2 to Amendment No. 1 dated October 28, 1988 to Piedmont's Registration Statement on Form S-3 No. 33-24870 dated October 7, 1988). 10.1(b) First Amendment, dated as of July 28, 1989, to USAir Group's Amended and Restated Credit Agreement (incor- porated by reference to Exhibit 10.1(b) to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1989). 10.1(c) Second Amendment, dated as of February 15, 1990, to USAir Group's Amended and Restated Credit Agreement (incorporated by reference to Exhibit 10.1 to USAir Group's Current Report on Form 8-K dated October 26, 1990). 10.1(d) Third Amendment, dated as of September 30, 1990, to USAir Group's Amended and Restated Credit Agreement (incorporated by reference to Exhibit 10.2 to USAir Group's Current Report on Form 8-K dated October 26, 1990). 10.1(e) Fourth Amendment, dated as of March 29, 1991, to USAir Group's Amended and Restated Credit Agreement (incor- porated by reference to the Exhibit to USAir Group's Current Report on Form 8-K dated April 23, 1991). 10.1(f) Fifth Amendment, dated as of April 26, 1991, to USAir Group's Amended and Restated Credit Agreement (incor- porated by reference to Exhibit 28.7 to USAir Group's Registration Statement on Form S-8 No. 33-39540 dated April 26, 1991). 10.1(g) Sixth Amendment, dated as of October 14, 1992, to USAir Group's Amended and Restated Credit Agreement (incor- porated by reference to Exhibit 28.3 to USAir Group's and USAir's Quarterly Report on Form 10-Q for the quarter ended September 30, 1992). 10.1(h) Seventh Amendment, dated as of June 21, 1993, to USAir Group's Amended and Restated Credit Agreement (incor- porated by reference to Exhibit 28 to USAir Group's Current Report on Form 8-K filed on July 1, 1993). 10.2(a) Supplemental Agreement No. 16, dated July 19, 1990, to Purchase Agreement No. 1102 between USAir and The Boeing Company (incorporated by reference to Exhibit 10.2(a) to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1990). 10.2(b) Supplemental Agreement No. 17, dated November 28, 1990, to Purchase Agreement No. 1102 between USAir and The Boeing Company (incorporated by reference to Exhibit 10.2(b) to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1990). 10.2(c) Supplemental Agreement No. 18, dated December 23, 1991, to Purchase Agreement No. 1102 between USAir and The Boeing Company (incorporated by reference to Exhibit 10.2(c) to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1991). 10.3 Purchase Agreement No. 1725 dated December 23, 1991 between USAir and The Boeing Company (incorporated by reference to Exhibit 10.3 to USAir Group's and USAir's Annual Report on Form 10-K for the year ended Decem- ber 31, 1991). 10.4 USAir, Inc. Executive Incentive Compensation Plan (incorporated by reference to Exhibit 10.3 to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1989). 10.5 USAir, Inc. Officers' Supplemental Benefit Plan (incorporated by reference to Exhibit 10.5 to USAir's Annual Report on Form 10-K for the year ended December 31, 1980). 10.6 USAir, Inc. Supplementary Retirement Benefit Plan (incorporated by reference to Exhibit 10.5 to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1989). 10.7 USAir Group's 1984 Stock Option and Stock Appreciation Rights Plan (incorporated by reference to Exhibit A to USAir Group's Proxy Statement dated March 30, 1984). 10.8 USAir Group's 1988 Stock Incentive Plan (incorporated by reference to Exhibit 10.15 to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1987). 10.9 USAir Group's 1992 Stock Option Plan (incorporated by reference to Exhibit A to USAir Group's Proxy Statement dated March 30, 1992). 10.10 Employment Agreement between USAir and its President and Chief Executive Officer (which is similar in form to the employment agreements of USAir Group's other executive officers) (incorporated by reference to Exhibit 10.9 to USAir Group's and USAir's Annual Report on Form 10-K for the year ended December 31, 1991). 10.11 Agreements providing supplemental retirement benefits for the following officers of USAir: Executive Vice President and General Counsel (incorporated by reference to Exhibit 10.14 to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1987), Executive Vice President-Operations, Senior Vice President-Corporate Communications and Senior Vice President-Human Resources (incorporated by reference to Exhibit 10.9 to USAir Group's Annual Report on Form 10- K for the year ended December 31, 1989). 10.12(a) Trust Agreement dated as of August 1, 1989 between USAir Group and Wachovia Bank and Trust Company, N.A., as Trustee (incorporated by reference to Exhibit 10.10(a) to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1989). 10.12(b) Trust Agreement dated as of August 1, 1989 between USAir and Wachovia Bank and Trust Company, N.A., as Trustee (incorporated by reference to Exhibit 10.10(b) to USAir Group's Annual Report on Form 10-K for the year ended December 31, 1989). 10.13 Investment Agreement dated as of January 21, 1993 between USAir Group and British Airways Plc (incorporated by reference to Exhibit 28.1 to USAir Group's and USAir's Current Report on Form 8-K filed on January 28, 1993, as amended by Amendment No. 1 on Form 8 filed on April 13, 1993). 10.13(a) Amendment dated as of February 21, 1994 to the Investment Agreement dated as of January 21, 1993 between USAir Group and British Airways Plc. 11 Computation of primary and fully diluted earnings per share of USAir Group for the five years ended December 31, 1993. 21 Subsidiaries of USAir Group and USAir. 23.1 Consent of the Auditors of USAir Group to the incorporation of their report concerning certain financial statements contained in this report in certain registration statements. 23.2 Consent of the Auditors of USAir to the incorporation of their report concerning certain financial statements contained in this report in certain registration statements. 24.1 Powers of Attorney signed by the directors of USAir Group, authorizing their signatures on this report. 24.2 Powers of Attorney signed by the directors of USAir, authorizing their signatures on this report. SIGNATURES Pursuant to the requirements of Section 13 of 15(d) of the Securities Exchange Act of 1934, USAir Group, Inc. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. USAir Group, Inc. By: /s/Seth E. Schofield --------------------------------- Seth E. Schofield Chairman, President and Chief Executive Officer (Principal Executive Officer) Date: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of USAir Group, Inc. and in the capacities and on the dates indicated. March 25, 1994 By: /s/Seth E. Schofield --------------------------------- Seth E. Schofield Chairman, President and Chief Executive Officer (Principal Executive Officer) March 25, 1994 By: /s/Frank L. Salizzoni --------------------------------- Frank L. Salizzoni Executive Vice President-Finance (Principal Financial Officer) March 25, 1994 By: /s/Ann Greer-Rector --------------------------------- Ann Greer-Rector Vice President & Controller (Principal Accounting Officer) March 25, 1994 By: * -------------------------------- Warren E. Buffett Director March 25, 1994 By: * --------------------------------- Edwin I. Colodny Director March 25, 1994 By: * -------------------------------- Mathias J. DeVito Director March 25, 1994 By: * -------------------------------- George J. W. Goodman Director March 25, 1994 By: * --------------------------------- John W. Harris Director March 25, 1994 By: * --------------------------------- Edward A. Horrigan, Jr. Director March 25, 1994 By: * --------------------------------- Robert LeBuhn Director March 25, 1994 By: * --------------------------------- Sir Colin Marshall Director March 25, 1994 By: * --------------------------------- Roger P. Maynard Director March 25, 1994 By: * --------------------------------- John G. Medlin, Jr. Director March 25, 1994 By: * --------------------------------- Hanne M. Merriman Director March 25, 1994 By: * -------------------------------- Charles T. Munger Director March 25, 1994 By: * --------------------------------- Richard P. Simmons Director March 25, 1994 By: * --------------------------------- Raymond W. Smith Director March 25, 1994 By: * -------------------------------- Derek M. Stevens Director By: /s/Frank L. Salizzoni ------------------------------ Frank L. Salizzoni Attorney-In-Fact SIGNATURES Pursuant to the requirements of Section 13 of 15(d) of the Securities Exchange Act of 1934, USAir, Inc. has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. USAir, Inc. By: /s/Seth E. Schofield --------------------------------- Seth E. Schofield Chairman, President and Chief Executive Officer (Principal Executive Officer) Date: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of USAir, Inc. and in the capacities and on the dates indicated. March 25, 1994 By: /s/Seth E. Schofield --------------------------------- Seth E. Schofield Chairman, President and Chief Executive Officer (Principal Executive Officer) March 25, 1994 By: /s/Frank L. Salizzoni --------------------------------- Frank L. Salizzoni Executive Vice President-Finance (Principal Financial Officer) March 25, 1994 By: /s/Ann Greer-Rector --------------------------------- Ann Greer-Rector Vice President & Controller (Principal Accounting Officer) March 25, 1994 By: * -------------------------------- Warren E. Buffett Director March 25, 1994 By: * --------------------------------- Edwin I. Colodny Director March 25, 1994 By: * -------------------------------- Mathias J. DeVito Director March 25, 1994 By: * -------------------------------- George J. W. Goodman Director March 25, 1994 By: * --------------------------------- John W. Harris Director March 25, 1994 By: * --------------------------------- Edward A. Horrigan, Jr. Director March 25, 1994 By: * --------------------------------- Robert LeBuhn Director March 25, 1994 By: * --------------------------------- Sir Colin Marshall Director March 25, 1994 By: * --------------------------------- Roger P. Maynard Director March 25, 1994 By: * --------------------------------- John G. Medlin, Jr. Director March 25, 1994 By: * --------------------------------- Hanne M. Merriman Director March 25, 1994 By: * -------------------------------- Charles T. Munger Director March 25, 1994 By: * --------------------------------- Richard P. Simmons Director March 25, 1994 By: * --------------------------------- Raymond W. Smith Director March 25, 1994 By: * -------------------------------- Derek M. Stevens Director By: /s/Frank L. Salizzoni ------------------------------ Frank L. Salizzoni Attorney-In-Fact Independent Auditors' Report On Consolidated Financial Statement Schedules - USAir Group, Inc. The Stockholders and Board of Directors USAir Group, Inc.: Under date of February 25, 1994, we reported on the consoli- dated balance sheets of USAir Group, Inc. and subsidiaries ("Group") as of December 31, 1993 and 1992, and the related consolidated statements of operations, cash flows, and changes in stockholders' equity (deficit) for each of the years in the three- year period ended December 31, 1993, as included in Item 8A in this annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related consolidated financial statement schedules as listed in Item 14(a)2(i). These consolidated financial statement schedules are the responsibility of Group's management. Our responsibility is to express an opinion on these consolidated financial statement schedules based on our audits. In our opinion, such consolidated financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG PEAT MARWICK Washington, D. C. February 25, 1994 Independent Auditors' Report On Consolidated Financial Statement Schedules - USAir, Inc. The Stockholder and Board of Directors USAir, Inc.: Under date of February 25, 1994, we reported on the consolidated balance sheets of USAir, Inc. and subsidiaries ("USAir") as of December 31, 1993 and 1992, and the related consolidated statements of operations, cash flows, and changes in stockholder's equity for each of the years in the three-year period ended December 31, 1993, as included in Item 8B in this annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also audited the related consolidated financial statement schedules as listed in Item 14(a)2(ii). These consolidated financial statement schedules are the responsibility of USAir's management. Our responsibility is to express an opinion on these consolidated financial statement schedules based on our audits. In our opinion, such consolidated financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG PEAT MARWICK Washington, D. C. February 25, 1994 Exhibit 21 SUBSIDIARIES OF USAIR GROUP, INC. AND USAIR, INC. USAir Group, Inc. - ----------------- USAir, Inc. Piedmont Airlines, Inc. (formerly Henson Airlines, Inc.) Jetstream International Airlines, Inc. Pennsylvania Commuter Airlines, Inc. (d/b/a/ Allegheny Commuter Airlines) USAir Leasing and Services, Inc. USAir Fuel Corporation Material Services Corp. USAir, Inc. (the following companies are also indirect subsidiaries - ------------------------------------------------------------------- of USAir Group, Inc.) - --------------------- USAM Corp. Pacific Southwest Airmotive (substantially all of the assets of this company were sold on October 9, 1991) Exhibit 23.1 CONSENT OF INDEPENDENT AUDITORS The Board of Directors USAir Group, Inc. We consent to the incorporation by reference in the Registration Statements on Form S-8 Nos. 2-98828, 33-26762, 33-39896, 33-44835, 33-60618 and 33-60620 and the Registration Statement on Form S-3 No. 33-41821 of USAir Group, Inc., of our reports dated February 25, 1994 relating to the consolidated balance sheets of USAir Group, Inc. and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of operations, cash flows and changes in stockholders' equity, and the related consolidated financial statement schedules for each of the years in the three- year period ended December 31, 1993 which reports appear in the December 31, 1993 annual report on Form 10-K of USAir Group, Inc. and USAir, Inc. KPMG PEAT MARWICK Washington, D.C. March 25, 1994 Exhibit 23.2 CONSENT OF INDEPENDENT AUDITORS The Board of Directors USAir, Inc. We consent to the incorporation by reference in the Registration Statement on Form S-3 No. 33-35509 of USAir, Inc., of our reports dated February 25, 1994 relating to the consolidated balance sheets of USAir, Inc. and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of operations, cash flows and changes in stockholders' equity, and the related consolidated financial statement schedules for each of the years in the three- year period ended December 31, 1993 which reports appear in the December 31, 1993 annual report on Form 10-K of USAir Group, Inc. and USAir, Inc. KPMG PEAT MARWICK Washington, D.C. March 25, 1994 Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Warren E. Buffett, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Warren E. Buffett (L.S.) --------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Edwin I. Colodny, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 25 day of January, 1994. /s/Edwin I. Colodny (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Mathias J. DeVito, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Mathias J. DeVito (L.S.) --------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, George J. W. Goodman, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 13 day of January, 1994. /s/George J. W. Goodman (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, John W. Harris, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 26 day of January, 1994. /s/J. W. Harris (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Edward A. Horrigan, Jr., Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Edward A. Horrigan, Jr. (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Robert LeBuhn, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14th day of January, 1994. /s/Robert LeBuhn (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Colin Marshall, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 15 day of January, 1994. /s/C. Marshall (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Roger P. Maynard, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 15 day of January, 1994. /s/R. Maynard (L.S.) --------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, John G. Medlin, Jr., Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 19th day of January, 1994. /s/John G. Medlin, Jr. (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Hanne M. Merriman, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Hanne M. Merriman (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Charles T. Munger, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 24th day of January, 1994. /s/Charles T. Munger (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Richard P. Simmons, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 13th day of January, 1994. /s/Richard P. Simmons (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Raymond W. Smith, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/R. W. Smith (L.S.) ---------------------------------- Exhibit 24.1 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Derek M. Stevens, Director of USAir Group, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 26 day of January, 1994. /s/Derek M. Stevens (L.S.) --------------------------------- Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Warren E. Buffett, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Warren E. Buffett (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Edwin I. Colodny, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 25 day of January, 1994. /s/Edwin I. Colodny (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Mathias J. DeVito, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Mathias J. DeVito (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, George J. W. Goodman, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 13 day of January, 1994. /s/George J. W. Goodman (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, John W. Harris, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 26 day of January, 1994. /s/J. W. Harris (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Edward A. Horrigan, Jr., Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Edward A. Horrigan, Jr. (L.S.) --------------------------------- Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Robert LeBuhn, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14th day of January, 1994. /s/Robert LeBuhn (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Colin Marshall, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 15 day of January, 1994. /s/C. Marshall (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Roger P. Maynard, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 15 day of January, 1994. /s/R. P. Maynard (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, John G. Medlin, Jr., Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 19th day of January, 1994. /s/John G. Medlin, Jr. (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Hanne M. Merriman, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/Hanne M. Merriman (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Charles T. Munger, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 24th day of January, 1994. /s/Charles T. Munger (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Richard P. Simmons, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 13th day of January, 1994. /s/Richard P. Simmons (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Raymond W. Smith, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 14 day of January, 1994. /s/R. W. Smith (L.S.) ------------------------------ Exhibit 24.2 POWER OF ATTORNEY ----------------- KNOW ALL MEN BY THESE PRESENTS, THAT I, Derek M. Stevens, Director of USAir, Inc., (the "Company"), do hereby constitute and appoint James T. Lloyd and Frank L. Salizzoni, and each of them (with full power to each of them to act alone), attorney and agent for me and in my name and on my behalf to sign any Annual Report on Form 10-K of the Company for the year ended December 31, 1993 and any amendments or supplements thereto which shall be filed with the Securities and Exchange Commission under the Securities and Exchange Act of 1934, as amended. I hereby give and grant to said attorneys and agents, and each of them, full power and authority generally to do and perform all acts and things necessary to be done in the premises as fully and effectually in all respects as I could do if personally present; and I hereby ratify and confirm all that said attorneys and agents, and each of them, shall do or cause to be done by virtue hereof. IN WITNESS WHEREOF, I have hereunto set my hand and seal this 26 day of January, 1994. /s/Derek M. Stevens (L.S.) ------------------------------

876858_1993.txt

876858

1993

Item 1. Business The Sears Credit Account Trust 1991 C (the "Trust") was formed pursuant to the Pooling and Servicing Agreement dated as of July 1, 1991 (the "Pooling and Servicing Agreement") among Sears, Roebuck and Co. ("Sears") as Servicer, its wholly-owned subsidiary, Sears Receivables Financing Group, Inc. ("SRFG") as Seller, and Continental Bank, National Association as trustee (the "Trustee"). The Trust's only business is to act as a passive conduit to permit investment in a pool of retail consumer receivables. Item 2.

Item 2. Properties The property of the Trust includes a portfolio of receivables (the "Receivables") arising in selected accounts under open-end credit plans of Sears (the "Accounts") and all monies received in payment of the Receivables. At the time of the Trust's formation, Sears sold and contributed to SRFG, which in turn conveyed to the Trust, all Receivables existing under the Accounts as of the end of certain of Sears regular billing cycles ending in June, 1991 and all Receivables arising under the Accounts from time to time thereafter until the termination of the Trust. Information related to the performance of the Receivables during 1993 is set forth in the ANNUAL STATEMENT filed as Exhibit 21 to this Annual Report on Form 10-K. Item 3.

Item 3. Legal Proceedings None Item 4.

Item 4. Submission of Matters to a Vote of Security Holders None PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters Investor Certificates are held and delivered in book-entry form through the facilities of The Depository Trust Company ("DTC"), a "clearing agency" registered pursuant to the provisions of Section 17A of the Securities Exchange Act of 1934, as amended. All outstanding definitive Investor Certificates are held by CEDE and Co., the nominee of DTC. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None PART III Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management As of March 15, 1994, 100% of the Investor Certificates were held in the nominee name of CEDE and Co. for beneficial owners. SRFG, as of March 15, 1994, owned 100% of the Seller Certificate, which represented beneficial ownership of a residual interest in the assets of the Trust as provided in the Pooling and Servicing Agreement. Item 13.

Item 13. Certain Relationships and Related Transactions None PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) Exhibits: 21. 1993 ANNUAL STATEMENT prepared by the Servicer. 28. ANNUAL INDEPENDENT AUDITOR'S REPORTS pursuant to Section 3.06 of the Pooling and Servicing Agreement. (a) Review of servicing procedures. (b) Annual Servicing Letter. (b) Reports on Form 8-K: Current reports on Form 8-K are filed on or before the Distribution Date each month (on, or the first business day after, the 25th of the month). The reports include as an exhibit, the MONTHLY INVESTOR CERTIFICATEHOLDERS' STATEMENT. Current Reports on Form 8-K were filed on October 15, 1993, November 15, 1993, and December 15, 1993. SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Sears Credit Account Trust 1991 C (Registrant) By: Sears Receivables Financing Group, Inc. (Originator of the Trust) By: /S/ALICE M. PETERSON _____________________________________ Alice M. Peterson President and Chief Executive Officer Dated: March 30, 1994 EXHIBIT INDEX Page number in sequential Exhibit No. number system 21. 1993 ANNUAL STATEMENT prepared by the Servicer. 28. ANNUAL INDEPENDENT AUDITOR'S REPORTS pursuant to Section 3.06 of the Pooling and Servicing Agreement. (a) Review of servicing procedures. (b) Annual Servicing Letter. Exhibit 21 SEARS CREDIT ACCOUNT TRUST 1991 C 8.65% CREDIT ACCOUNT PASS-THROUGH CERTIFICATES 1993 ANNUAL STATEMENT Pursuant to the terms of the letter issued by the Securities and Exchange Commission dated September 5, 1991 (granting relief to the Trust from certain reporting requirements of the Securities Exchange Act of 1934, as amended), aggregated information regarding the performance of Accounts and payments to Investor Certificateholders in respect of the Due Periods related to the twelve Distribution Dates which occurred in 1993 is set forth below. 1) The total amount of the distribution to Investor Certificateholders during 1993, per $1,000 interest..$86.50 2) The amount of the distribution set forth in paragraph 1 above in respect of interest on the Investor Certificates, per $1,000 interest....................$86.50 3) The amount of the distribution set forth in paragraph 1 above in respect of principal on the Investor Certificates, per $1,000 interest.....................$0.00 4) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods.....................................$454,076,419.73 5) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods.....................................$130,374,092.38 6) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods which were allocated in respect of the Investor Certificates................................$330,262,728.83 7) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods which were allocated in respect of the Investor Certificates.................................$94,789,916.87 8) The aggregate amount of Collections of Principal Receivables processed during the related Due Periods which were allocated in respect of the Seller Certificate.................................$123,813,690.90 9) The aggregate amount of Collections of Finance Charge Receivables processed during the related Due Periods which were allocated in respect of the Seller Certificate..................................$35,584,175.51 10) The excess of the Investor Charged-Off Amount over the sum of (i) payments in respect of the Available Subordinated Amount and (ii) Excess Servicing, if any (an "Investor Loss"), per $1,000 interest.............$0.00 11) The aggregate amount of Investor Losses in the Trust as of the end of the day on December 15, 1993, per $1,000 interest.......................................$0.00 12) The total reimbursed to the Trust from the sum of the Available subordinated Amount and Excess Servicing, if any, in respect of Investor Losses, per $1,000 interest..............................................$0.00 13) The amount of the Investor Monthly Servicing Fee payable by the Trust to the Servicer..........$9,999,999.96 14) The aggregate amount which was deposited in the Principal Funding Account in respect of Collections of Principal Receivables during the related Due Periods..$0.00 15) The aggregate amount of Investment Income during the related Due Periods...................................$0.00 16) The total amount on deposit in the Principal Funding Account in respect of Collections of Principal Receivables, as of the end of the reportable year.....$0.00 17) The Deficit Accumulation Amount, as of the end of the reportable year.......................................$0.00 18) The aggregate amount which was deposited in the Interest Funding Account in respect of Certificate Interest during the related Due Periods...............$43,250,000.04 19) The total amount on deposit in the Interest Funding Account in respect of Certificate Interest, as of the end of the reportable year....................18,020,833.35 Exhibit 28(a) February 11, 1994 Ms. Alice M. Peterson Ms. Cynthia K. Duncan Vice President and Treasurer Trust Officer Sears, Roebuck and Co. as Servicer Continental Bank National Sears Tower Association as Trustee Chicago, Illinois 60684 231 South La Salle Street Chicago, Illinois 60697 We have applied the procedures listed below to the accounting records of Sears, Roebuck and Co. ("Sears") relating to the servicing procedures performed by Sears as Servicer under Section 3.06(b) of the Pooling and Servicing Agreement (the "Agreement") for the following Trusts: Date of Pooling and Trust Servicing Agreement Sears Credit Account Trust 1991A March 1, 1991 Sears Credit Account Trust 1991B May 15, 1991 Sears Credit Account Trust 1991C July 1, 1991 Sears Credit Account Trust 1991D September 15, 1991 Sears Credit Account Master Trust I November 18, 1992 It is understood that this report is solely for your information and is not be referred to or distributed for any purpose to anyone other than Continental Bank, National Association as Trustee, Investor Certificateholders or the management of Sears. The procedures we performed are as follows: Compared the mathematical calculations of each amount set forth in each monthly certificate forwarded by the Servicer, pursuant to Section 3.04(b) of the Agreement, during the calendar year 1993 to the Servicer's computer-generated Portfolio Monitoring and Monthly Cash Flow Allocations report. We found such amounts to be in agreement. Because the above procedures do not constitute an audit conducted in accordance with generally accepted auditing standards, we do not express an opinion on any of the items referred to above. February 11, 1994 Ms. Alice M. Peterson Ms. Cynthia K. Duncan Vice President and Treasurer Trust Officer Sears, Roebuck and Co. as Servicer Continental Bank National Association as Trustee As a result of the procedures performed, no matters came to our attention that caused us to believe that the amounts in the monthly certificates require adjustment. Had we performed additional procedures or had we conducted an audit of the monthly certificates in accordance with generally accepted auditing standards, matters might have come to our attention that would have been reported to you. This report relates only to the items specified above and does not extend to any financial statements of Sears taken as a whole.

310431_1993.txt

310431

1993

Item 1. Business (a) The Registrant, CBI Industries, Inc. and its subsidiaries (CBI), classifies its operations in three major business segments: Contracting Services, Industrial Gases and Investments. CBI was incorporated in Delaware in 1979, as a holding company. CBI's Contracting Services segment is comprised of a number of separate companies, including the original Chicago Bridge & Iron Company which was founded in 1889. The Industrial Gases segment of CBI is comprised of Liquid Carbonic Industries Corporation, and its subsidiaries, which was founded in 1888 and acquired by CBI in 1984. The Investments segment of CBI includes CBI Investments, Inc. and its subsidiaries which have interests in oil and refined product storage, blending, and transport; real estate; and financial investments. (b) Financial information by business segment appears under Financial Summary in CBI's 1993 Annual Report to Shareholders and is incorporated herein by reference. (c) The percentage of revenues contributed by each business segment over the past three years was: 1993 1992 1991 ____ ____ ____ Contracting Services 44% 47% 48% Industrial Gases 49 45 43 Investments 7 8 9 ____ ____ ____ 100% 100% 100% ==== ==== ==== A description of the business done by each of CBI's industry segments follows. Items that are not considered material to an understanding of the business taken as a whole have been omitted. CBI holds patents and licenses for certain items incorporated into its products. However, none are so essential that their loss would materially affect the businesses of CBI. For information regarding working capital practices, refer to Financial Review - Financial Condition - Liquidity and Capital Resources in CBI's 1993 Annual Report to Shareholders which is incorporated herein by reference. CBI has incurred expenses during the year for the purpose of complying with environmental regulations, but their impact on the financial statements has not been material. Contracting Services Chicago Bridge & Iron Company (Chicago Bridge) is the parent company of the Contracting Services segment companies. Chicago Bridge is organized as a worldwide construction group that provides, through separate subsidiaries, a broad range of services, including design, engineering, fabrication, project management, general contracting and specialty construction services, including non-destructive inspection and post-weld heat treatment. The traditional products constructed by the Chicago Bridge companies have been a wide variety of fabricated metal plate structures including, but not limited to, elevated water tanks, penstocks and tunnel liners for hydroelectric dams, low temperature and cryogenic vessels and systems, and flat-bottom tanks, pressure vessels, and other vessels and structures utilized in the chemical, petroleum refining and petrochemical industries. In recent years, Chicago Bridge companies have broadened their capabilities so as to be in a better position to provide additional products and services to address a more diverse base of customers. Other products and services include the construction of experimental test facilities, environmental chambers, advanced energy systems and structures, power plant maintenance and repair, turnkey water and wastewater treatment facilities, turnkey woodyard facilities for the forest products industry, non-destructive testing, post-weld heat treating and refractory bakeouts, and vessels, tanks and other structures for corrosion- resistant applications. Chicago Bridge conducts these activities through various separate companies, the major of which are mentioned on the following page. CBI Na-Con, Inc. provides domestic construction-related services which include, but are not limited to, the construction of commercial and municipal water and wastewater treatment plants, defense-related facilities, industrial expansion projects, refinery turnarounds and turnkey storage terminals. CBI Na-Con, Inc. has district offices located in Norcross, Georgia; Houston, Texas; Fontana, California; and Plainfield, Illinois. It also has metal plate fabrication capabilities at its Houston and Fontana facilities. CBI Services, Inc. provides fabricated metal plate products and other specialized domestic construction services for the power generation industries, the government and other industrial customers. The product lines of CBI Services, Inc. include, but are not limited to, petroleum, petrochemical and chemical storage tanks; pressure, cryogenic and low temperature vessels; and miscellaneous metal plate structures. CBI Services has district offices located in New Castle, Delaware; Fremont, California; and Kankakee, Illinois. It also has metal plate fabrication capabilities at its Kankakee facility. Chicago Bridge & Iron Company, incorporated in Illinois, is the original company which was formed in 1889 and is the parent company for Contracting Services companies which operate outside the United States. Regional offices of international subsidiaries are located in London (England), Singapore, Fort Erie (Canada), and Houston, Texas. Other subsidiary offices and facilities are located in Caracas (Venezuela), Dammam (Saudi Arabia), Dubai (U.A.E.), Blacktown (Australia), Johannesburg (South Africa), Kuala Lumpur (Malaysia), Manila (Philippines), Jakarta (Indonesia), Bangkok (Thailand) and Tokyo (Japan). Other Chicago Bridge companies include: CBI Walker, Inc., which designs and supplies equipment used to treat municipal and industrial water and wastewater; FMP/Rauma Company (a partnership owned 50.1% by Fibre Making Processes, Inc., a wholly-owned subsidiary of Chicago Bridge) which designs, manufactures and/or supplies equipment and turnkey woodyards to the forest products industry; Chicago Bridge and Iron Technical Services Company, which provides engineering and research services for the Chicago Bridge subsidiaries and for outside parties; MQS Inspection, Inc., which provides non-destructive examination and inspection services; Cooperheat, Inc. which provides post-weld heat treating and refractory bake-outs as field services and sells associated equipment; and Ershigs, Inc. (acquired May 1993), which is an engineering, manufacturing and construction company which specializes in fiberglass reinforced plastic and dual-laminate vessels, tanks and other structures for corrosion-resistant applications. The principal raw materials used by the Contracting Services segment are metal plate and structural steel. These materials are available from various domestic and international mills. Chicago Bridge does not anticipate having difficulty in obtaining adequate amounts of raw materials. This segment is not dependent upon any single customer or group of customers and the loss of any single customer would not have any material adverse effect on the business. This segment had a backlog of work to be completed on contracts of $424,900,000 at December 31, 1993 and $325,200,000 at December 31, 1992. Approximately 86% of the backlog as of December 31, 1993 is expected to be completed in 1994. Adequate industry statistics relating to this segment of the business in which CBI competes are not available. Several large companies offer metal plate products that compete with some, but not all, of those of Chicago Bridge. Local and regional companies offer strong competition in one or more geographical areas, but not in other areas where Chicago Bridge operates. Therefore, it is impossible to state Chicago Bridge's position in the industry. Quality, reputation, delivery, and price are the principal methods of competition within the industry. Competition is based primarily on performance and the ability to provide the design, engineering, fabrication, project management and construction required to complete projects in a timely and cost-efficient manner. Chicago Bridge believes its position is among the top in the field. As of December 31, 1993, this segment employed 45 people engaged full-time in the research and development of new products and services or the improvement of existing products and services. This is comparable to 40 people employed at December 31, 1992 and 43 at December 31, 1991. This segment incurred expenses of approximately $3,078,000 in 1993, $2,961,000 in 1992 and $2,824,000 in 1991 for its research and development activities. This segment also performs certain research and development activities for customers. Approximately 7,100 people were employed by this segment at the end of 1993. Industrial Gases Liquid Carbonic Industries Corporation (Liquid Carbonic) is the parent company of the Industrial Gases segment companies. CBI believes Liquid Carbonic is the world's largest supplier of carbon dioxide in its various forms. Liquid Carbonic also produces, processes and markets a wide variety of other industrial/medical and specialty gases, including oxygen, nitrogen, argon, hydrogen, acetylene, carbon monoxide, liquified natural gas and nitrous oxide. The segment also assembles and sells industrial gas-related equipment. Liquid Carbonic conducts its business through various separate companies, each of which either generally provides different products or services or conducts business in a different geographical area than the other companies. The business of Liquid Carbonic is generally broken down into units which engage in domestic carbon dioxide processing and sales; domestic bulk air gas production and sales; domestic cylinder gas products production and sales; domestic carbon monoxide and hydrogen gas production and pipeline sales; Canadian carbon dioxide processing and industrial gas production and sales; and international business outside of the United States and Canada, which involves primarily the processing and sale of carbon dioxide and other gases and chemicals in 21 other countries. The major Liquid Carbonic business units are the following: Liquid Carbonic Carbon Dioxide is engaged in the domestic processing and sale of carbon dioxide in all its forms. Carbon dioxide is used in the refrigeration, freezing, processing and preservation of food, beverage carbonation, chemical production, water treatment and the enhancement of oil and gas production. Liquid Carbonic Carbon Dioxide operates carbon dioxide plants and receives by-product carbon dioxide from other plants operated by suppliers. It also owns and operates plants to produce dry ice. It sells carbon dioxide to its bulk customers through a network of sales offices nationwide. Liquid Carbonic Bulk Gases produces and sells industrial/medical gases domestically. It sells oxygen, nitrogen and argon to industrial customers for refrigeration, as a pressure medium and for other applications; and to medical customers for resuscitative and therapeutic purposes. This unit operates air separation plants for the production of these gases. It sells industrial gases mainly to small and medium sized "merchant" accounts near supply sources and sells medical gases primarily to group purchasing organizations and individual medical centers. Liquid Carbonic Cylinder Gas Products is engaged in the domestic production and sale of specialty gases. It sells highly purified gases, acetylene, cylinder oxygen, nitrogen, argon and nitrous oxide. The highly purified gases are produced and distributed from regional gas laboratories and sold to universities, research centers, clinics and industry. Liquid Carbonic Process Plants produce and sell gaseous and liquid carbon monoxide and gaseous hydrogen. These gases are mainly sold by pipeline to customers located in Louisiana, Ohio and West Virginia. Liquid Carbonic Corporation is the parent company for the Liquid Carbonic companies which operate outside the United States. The principal subsidiaries are in Argentina, Belize, Bolivia, Brazil, Canada, Chile, Colombia, Mexico, Peru, Poland (acquired April 1993), Spain, Thailand and Venezuela. Liquid Carbonic Corporation also owns a non-majority interest in a number of affiliated companies located in Barbados, Guyana, Haiti, Jamaica, Japan, Korea, Trinidad, Turkey and Uruguay. Most of these companies process and sell carbon dioxide and produce industrial/medical gases, chemicals (including precipitated calcium carbonate, a chemical ingredient used in the manufacture of a variety of consumer and industrial products) and other products. These companies operate by-product and combustion plants for the processing of carbon dioxide, dry ice plants and air separation plants. Liquid Carbonic's strength in the carbon dioxide market is in part due to its ability over the years to secure adequate supplies of product from diverse sources. Most carbon dioxide sold by Liquid Carbonic is purchased from by- product sources. By-product carbon dioxide is obtained from various sources, including chemical plants, refineries, and industrial processes, or from carbon dioxide wells, and is processed in Liquid Carbonic's own plants to produce commercial carbon dioxide. Liquid Carbonic also purchases commercial carbon dioxide from by-product sources having their own carbon dioxide plants. Liquid Carbonic has supply contracts which require the purchase of specified minimum quantities of carbon dioxide. Generally, these contracts do not obligate the supplier to continue to produce carbon dioxide or to supply specified minimum quantities; however, these provisions have historically had no material adverse effect on Liquid Carbonic's source of supply. This segment is not dependent upon any single customer or group of customers and the loss of any single customer would not have a material adverse effect on the business. Liquid Carbonic's principal competitors in North America are the Airco subsidiary of the BOC Group, Air Products and Chemicals, Inc., the Cardox subsidiary of L'Air Liquide, and Praxair, Inc. It also faces competition from a number of regional and local competitors. As of December 31, 1993, Liquid Carbonic employed 98 people engaged full- time in the research and development of new products and services or the improvement of existing products and services. This is comparable to 106 people employed at December 31, 1992 and 88 at December 31, 1991. This segment incurred expenses of approximately $10,616,000 in 1993, $8,765,000 in 1992 and $7,246,000 in 1991 for its research and development activities. This segment also performs certain research and development activities for customers. Approximately 6,600 people were employed by this segment at the end of 1993. Investments CBI Investments, Inc. is the parent company of the Investments segment companies. The Investments segment includes Statia Terminals (Statia), which operates fuel oil and refined petroleum products storage and blending facilities and provides bunkering services in the Caribbean, and operates a special products terminal in Brownsville, Texas. On October 20, 1993, Statia purchased the other outstanding interests in, and became 100% owner of, Point Tupper Terminals Corporation, a Canadian terminal company. The Point Tupper operation, in which Statia initially became an equity investor in August 1992, is strategically located to service global oil producing and trading customers which market their products in the northeastern part of North America. Investments are also held in Petroterminal de Panama, S.A., a crude oil pipeline and transport facility in Panama; Tankstore Pte. Ltd., a fuel oil and petroleum product storage and terminal facility and bunkering operation in Singapore; and real estate. In addition, CBI Investments, Inc. has interests in several other companies. The businesses in this segment primarily provide services and therefore do not depend heavily on raw materials. Approximately 220 people were employed by Statia at the end of 1993. (d) Financial information by geographic area of operation is shown in Notes and Reports - Note 13 - Operations by Business Segment and Geographic Area in CBI's 1993 Annual Report to Shareholders and is incorporated herein by reference. Item 2.

Item 2. Properties Contracting Services Chicago Bridge owns or leases the properties used to conduct its business. The capacities of these facilities depend upon the mix of products being manufactured. As the product mix is constantly changing, the extent of utilization of these facilities cannot be accurately stated. Chicago Bridge believes that these facilities are adequate to meet its requirements. The following list summarizes the principal owned properties: Type of Square Location Facility Footage ________ __________ _______ United States Fontana, California fabrication plant, warehouse and office 36,000 Fremont, California warehouse and office 85,000 Houston, Texas fabrication plant, warehouse and office 253,000 Kankakee, Illinois fabrication plant, warehouse and office 396,000 New Castle, Delaware warehouse and office 143,000 Norcross, Georgia warehouse and office 36,000 Plainfield, Illinois engineering and research center 176,000 warehouse and office 12,000 International Blacktown, New South Wales, Australia fabrication plant, warehouse and office 134,000 Fort Erie, Ontario, Canada fabrication plant, warehouse and office 208,000 In addition to the above, Chicago Bridge has interests in other fabrication facilities in Saudi Arabia, Thailand, Indonesia, Venezuela, South Africa and Australia. Chicago Bridge also owns or leases a number of field construction offices, warehouses and equipment maintenance centers strategically located throughout the world. In April 1993, Chicago Bridge announced a decision to close a fabrication facility located in Cordova, Alabama. Industrial Gases Liquid Carbonic owns or leases the facilities used in its business. Liquid Carbonic believes these facilities are adequately utilized and sufficient to meet its customer needs. The following list summarizes the principal properties: Type of Facility by Number of Facilities Geographic Area Owned or Leased ___________________ ____________________ United States By-product CO2 22 owned Air separation 3 owned, 3 leased Carbon monoxide/hydrogen 3 owned Research center 1 leased International By-product CO2 58 owned, 1 leased Combustion 31 owned Air separation 20 owned Research center 2 owned Investments The total storage capacity for Statia is, in millions of barrels, as follows: Caribbean (island of St. Eustatius, Netherlands Antilles) terminal 6.3 United States (Brownsville, Texas) terminal 1.6 Canada (Cape Breton Island, Nova Scotia) terminal 7.6 Approximately 30% of the total storage capacity at the Canadian terminal is currently being utilized. The remaining storage is scheduled to be reactivated by mid-1994. In November 1993, Statia Terminals entered into an agreement with an independent third-party to lease and operate five million barrels of new storage capacity, together with a related single-point mooring buoy, on the island of St. Eustatius. These additional facilities, which are scheduled to be on-line by the end of the first quarter of 1995, will permit Statia Terminals to service a new long-term contract with a major oil producer, and to discharge and re-load shipments from very large crude oil carriers. Petroterminal de Panama, S.A., in which CBI has a 21.25% interest, owns a pipeline and terminal facility in Panama. The pipeline is 81 miles in length and has a maximum capacity of 755,000 barrels of oil per day. The terminal facility occupies approximately 1,694 acres, of which 8 acres are owned by Petroterminal de Panama and the balance is owned by the Republic of Panama. Tankstore Pte. Ltd., in which CBI has a 20% interest, owns a storage and terminal facility on approximately 84 acres of land leased from the Republic of Singapore. The total storage capacity in Singapore is 5.2 million barrels. CBI currently owns approximately 2,300 acres of undeveloped real estate in Virginia, Texas and Utah. CBI also owns its corporate headquarters located in Oak Brook, Illinois. The buildings have approximately 196,000 square feet of space. Item 3.

Item 3. Legal Proceedings On October 30, 1987, CBI Na-Con, Inc. was working in the Marathon Petroleum Company (Marathon) refinery in Texas City, Texas. While a lift was being made by a crane supplied and operated by others, the crane became unstable, causing the operator to drop the load on a hydrofluoric acid tank which released part of its contents into the atmosphere. The community surrounding the refinery was evacuated after the incident, and a substantial number of persons evacuated sought medical attention. CBI Na-Con, Inc. has reached settlements with all but 15 of the 4,300 (approximate) third-party plaintiffs who brought suit as a result of the incident. CBI Na-Con, Inc. is also defending a lawsuit brought by Marathon originally seeking contractual indemnity which has been amended to seek reimbursement for Marathon's expenditures relating to the incident, including property damage, emergency response costs, third-party claim payments and legal fees. CBI filed suit against its insurers seeking insurance coverage and other recourse as a result of the denial of coverage or reservation of rights by the insurers for the incident based on certain pollution exclusions in the policies. The trial court granted summary judgment in favor of the insurers in April 1991. CBI appealed the trial court's judgment, and the Texas Appellate Court reversed and remanded the case back to the trial court in August 1993 to allow CBI to conduct discovery. The insurers are seeking review by the Texas Supreme Court. Chicago Bridge & Iron Company (Chicago Bridge) was a minority shareholder from 1934 to 1954 in a company which owned or operated at various times several wood treating facilities at sites in the United States, some of which are currently under investigation, monitoring or remediation under various environmental laws. Chicago Bridge is involved in litigation concerning environmental liabilities, which are currently undeterminable, in connection with certain of those sites. Chicago Bridge denies any liability for each site and believes that the successors to the wood treating business are responsible for any cost of remediation at the sites. Chicago Bridge has now reached settlements for environmental liabilities at most of the sites. The company believes that any remaining potential liability will not have a materially adverse effect on its operations or financial condition. A subsidiary of the company, Liquid Carbonic Industries Corporation (Liquid Carbonic), has been or is currently involved in civil litigation and governmental proceedings relating to antitrust matters. In this regard, since April 1992, several lawsuits have been filed against Liquid Carbonic and various competitors. These cases have been consolidated in the United States District Court for the Middle District of Florida, Orlando Division. The lawsuits allege generally that, beginning not later than 1968 and continuing through the present, defendants conspired to allocate customers, fix prices and rig bids for carbon dioxide in the United States in violation of the antitrust laws. On April 19, 1993, the court certified a class in the consolidated cases consisting of direct purchasers of carbon dioxide from defendants in the continental United States for the period from January 1, 1968 to and including October 26, 1992. Plaintiffs seek from defendants unspecified treble damages, civil penalties, injunctive relief, costs and attorneys' fees. In addition, a suit has been brought against Liquid Carbonic and others under the antitrust laws of the State of Alabama based upon the foregoing allegations. The company believes that the allegations made against Liquid Carbonic in these lawsuits are without merit, and Liquid Carbonic intends to defend itself vigorously. Liquid Carbonic and its subsidiaries also from time to time furnish documents and witnesses in connection with governmental investigations of alleged violations of the antitrust laws. While the outcome of any particular lawsuit or governmental investigation cannot be predicted with certainty, the company believes that these antitrust matters will not have a materially adverse effect on its operations or financial condition. In addition to the above lawsuits, CBI is a defendant in a number of lawsuits arising from the conduct of its business. While it is impossible at this time to determine with certainty the ultimate outcome of any litigation or matters referred to above, CBI's management believes that adequate provisions have been made for probable losses with respect thereto as best as can be determined at this time and that the ultimate outcome, after provisions therefor, will not have a material adverse effect on the financial position of CBI. The adequacy of reserves applicable to the potential costs of being engaged in litigation and potential liabilities resulting from litigation are reviewed as developments in the litigation warrant. Item 3. Legal Proceedings (Continued) CBI also is jointly and severally liable for some liabilities of partnerships and joint ventures and has also given certain guarantees in connection with the performance of contracts and repayment of obligations by its subsidiaries and other ventures in which CBI has a financial interest. CBI's management believes that the aggregate liability, if any, for these matters will not be material to its financial position. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of security holders during the fourth quarter ended December 31, 1993. PART II Item 5.

Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters CBI's common stock is listed on the New York Stock Exchange (symbol CBH). The approximate number of holders of record of common stock at February 16, 1994, was 7,700. Information appearing under Quarterly Financial Data - Quarterly Operating Results, Common Stock Prices and Dividends in CBI's 1993 Annual Report to Shareholders is incorporated herein by reference. Item 6.

Item 6. Selected Financial Data The summary of selected financial data appearing under Financial Summary in CBI's 1993 Annual Report to Shareholders is incorporated herein by reference. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Information appearing under Financial Review in CBI's 1993 Annual Report to Shareholders is incorporated herein by reference. Item 8.

Item 8. Financial Statements and Supplementary Data The financial statements consisting of Statements of Income, Balance Sheets, Statements of Cash Flows, Statements of Common Shareholders' Investment, Notes and Report of Independent Public Accountants in CBI's 1993 Annual Report to Shareholders is incorporated herein by reference. The supplemental financial information appearing under Quarterly Financial Data - Quarterly Operating Results, Common Stock Prices and Dividends in CBI's 1993 Annual Report to Shareholders is incorporated herein by reference. Additional financial information and schedules can be found in Part IV of this report. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures CBI has neither changed its independent accountants nor had any disagreements on accounting and financial disclosure with its independent accountants during the two most recent fiscal years. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant (a) Information appearing under Election of Directors in CBI's 1994 Proxy Statement is incorporated herein by reference. (b) The executive officers of CBI as of March 15, 1994 are as follows: Served as Executive Officer Name Age Title of CBI Since John E. Jones 59 Chairman of the Board, President and Chief Executive Officer 1980 Lewis E. Akin 56 Executive Vice President 1986 Robert J. Daniels 60 Executive Vice President 1988 George L. Schueppert 55 Executive Vice President-Finance and Chief Financial Officer 1987 Charles O. Ziemer 54 Senior Vice President and General Counsel 1984 Buel T. Adams 61 Vice President and Treasurer 1983 Stephen M. Duffy 44 Vice President-Human Resources 1993 Carl T. Haller 50 Vice President-Administration 1993 Alan J. Schneider 48 Vice President and Controller 1991 (d) There are no family relationships between any executive officers and directors. Executive officers are usually elected at the meeting of the Board of Directors immediately preceding the Annual Meeting of Shareholders and serve until successors are elected. (e) With the exceptions of Stephen M. Duffy and Carl T. Haller, all of the above named officers have been employed by CBI in an executive or management capacity for more than five years. Stephen M. Duffy was formerly a Vice President with Sunbeam Appliance Company. Carl T. Haller was formerly a Vice President with Signode Corporation, a wholly owned subsidiary of Illinois Tool Works Inc. Information with respect to compliance with Section 16(a) of the Securities Exchange Act of 1934 appears under Compliance with Section 16 of the Exchange Act in CBI's 1994 Proxy Statement and is incorporated herein by reference. Item 11.

Item 11. Executive Compensation Information appearing under Executive Compensation in CBI's 1994 Proxy Statement is incorporated herein by reference. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management Information appearing under Common Stock Ownership By Certain Persons and Management in CBI's 1994 Proxy Statement is incorporated herein by reference. Item 13.

Item 13. Certain Relationships and Related Transactions Not applicable. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) 1. Financial Statements The following financial statements and Report of Independent Public Accountants previously incorporated by reference under Item 8 of Part II of this report. Financial Statements: Statements of Income - For the years ended December 31, 1993, 1992 and 1991 Balance Sheets - For the years ended December 31, 1993, 1992 and 1991 Statements of Cash Flows - For the years ended December 31, 1993, 1992 and 1991 Statements of Common Shareholders' Investment - For the years ended December 31, 1993, 1992 and 1991 Notes Report of Independent Public Accountants 2. Financial Statement Schedules The following Supplemental Schedules to Financial Statements are included herein on pages 12 through 15 of this report: Schedule V - Property and Equipment - For the years ended December 31, 1993, 1992 and 1991 Schedule VI - Accumulated Depreciation of Property and Equipment - For the years ended December 31, 1993, 1992 and 1991 Schedule VIII - Valuation and Qualifying Accounts and Reserves - For the years ended December 31, 1993, 1992 and 1991 Report of Independent Public Accountants on Supplemental Schedules to Consolidated Financial Statements Schedules other than those listed have been omitted because the schedules are either not applicable or the required information is shown in the financial statements or notes thereto incorporated by reference under Item 8 of Part II of this report. Quarterly financial data for the years ended December 31, 1993 and 1992 is shown in the supplemental financial information incorporated by reference under Item 8 of Part II of this report. CBI's interest in 50 percent or less owned affiliates, when considered in the aggregate, constitute a significant subsidiary. Summarized financial information is shown in Notes and Reports - Note 14 - Unconsolidated Affiliates previously incorporated by reference under Item 8 of Part II of this report. 3. Exhibits The Exhibit Index on page 16 and Exhibits being filed are submitted as a separate section of this report. (b) Reports on Form 8-K There were no reports on Form 8-K filed during the fourth quarter ended December 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CBI INDUSTRIES, INC. Date: March 15, 1994 By: /s/ George L. Schueppert _____________________________ George L. Schueppert Executive Vice President-Finance, Chief Financial Officer and Director Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on March 15, 1994. Signature Title /s/ John E. Jones Chairman of the Board, President, _______________________________ Chief Executive Officer (Principal Executive Officer) and Director /s/ Lewis E. Akin Executive Vice President and Director _______________________________ Lewis E. Akin /s/ Robert J. Daniels Executive Vice President and Director _______________________________ Robert J. Daniels /s/ George L. Schueppert Executive Vice President-Finance, _______________________________ Chief Financial Officer (Principal George L. Schueppert Financial Officer) and Director /s/ Wiley N. Caldwell Director and Chairman of the Audit _______________________________ Committee Wiley N. Caldwell /s/ E.H. Clark, Jr. Director and Member of the Audit Committee _______________________________ E.H. Clark, Jr. /s/ John F. Riordan Director and Member of the Audit Committee _______________________________ John F. Riordan /s/ Robert G. Wallace Director and Member of the Audit Committee _______________________________ Robert G. Wallace /s/ Alan J. Schneider Vice President and Controller _______________________________ (Principal Accounting Officer) Alan J. Schneider REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SUPPLEMENTAL SCHEDULES TO CONSOLIDATED FINANCIAL STATEMENTS To the Shareholders and Board of Directors, CBI Industries, Inc.: We have audited in accordance with generally accepted auditing standards, the financial statements of CBI Industries, Inc. and Subsidiaries included in the company's 1993 Annual Report to Shareholders incorporated by reference in this Form 10-K, and have issued our report thereon dated February 17, 1994. Our report on these financial statements includes an explanatory paragraph with respect to the change in methods of accounting for income taxes and for postretirement benefits other than pensions in 1992 as discussed in Notes 11 and 12 to the financial statements. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The supplemental schedules to financial statements listed in the index to Item 14 on page 10 are the responsibility of the company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These supplemental schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ ARTHUR ANDERSEN & CO. _________________________ ARTHUR ANDERSEN & CO. Chicago, Illinois February 17, 1994 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS WITH RESPECT TO FORM S-8 AND FORM S-3 As independent public accountants, we hereby consent to the incorporation of our reports included and incorporated by reference in this Form 10-K, into the company's previously filed Registration Statements on Form S-8 (Nos. 33-46962, 33-14906 and 33-37246) and on Form S-3 (Nos. 33-65122 and 33-51595). /s/ ARTHUR ANDERSEN & CO. _________________________ ARTHUR ANDERSEN & CO. Chicago, Illinois March 15, 1994 1993 FORM 10-K ANNUAL REPORT EXHIBIT INDEX Item 14 (a) 3 Exhibit (3) Articles of Incorporation and By-Laws. (i) Articles of Incorporation. - Certificate of Incorporation as amended can be found in CBI's Form 10-Q dated November 13, 1992 and is incorporated herein by reference. (ii) By-Laws. - By-laws as amended can be found in CBI's Form 10-K dated March 29, 1991 and are incorporated herein by reference. (4) Instruments Defining the Rights of Security Holders, Including Indentures. - 6 1/4% Notes due June 30, 2000. The indenture can be found in CBI's Form S-3 dated June 22, 1993 and is incorporated herein by reference. - 6 5/8% Notes due March 15, 2003. The indenture can be found in CBI's Form S-3 dated February 26, 1993 and is incorporated herein by reference. - Series A Preferred Stock Purchase Rights Agreement as amended can be found in CBI's Form 8-K dated August 8, 1989 and is incorporated herein by reference. - Description of Convertible Voting Preferred Stock, Series C can be found in CBI's Form 8-K dated April 19, 1988 and is incorporated herein by reference. (10) Material Contracts. (iii) Executive Contracts and Compensation Plans. (a) Directors' Deferred Fee Plan, as amended, can be found in CBI's Form 10-K dated March 30, 1993 and is incorporated herein by reference. (b) Agreement between John E. Jones and CBI can be found in CBI's Form 10-K dated March 29, 1983 and is incorporated herein by reference. (c) A summary of the Termination Agreements can be found in CBI's Form 8-K dated October 10, 1986 and is incorporated herein by reference. (d) Agreement between George L. Schueppert and CBI can be found in CBI's Form 10-K dated March 29, 1989 and is incorporated herein by reference. (e) CBI Industries Stock Option Plan, as amended, can be found in CBI's Form S-8 dated October 10, 1990 and is incorporated herein by reference. (f) CBI Executive Life Insurance Plan can be found in CBI's Form 10-K dated March 30, 1993 and is incorporated herein by reference. (11) Computation of Per Share Earnings. (13) Portions of the 1993 Annual Report to Shareholders expressly incorporated by reference into this report. (21) Subsidiaries of the Registrant.

764037_1993.txt

764037

1993

Item 1 Business (a) General Development of Business Encore Computer Corporation ("Encore" or the "Company"), a worldwide company headquartered in Fort Lauderdale, Florida, is a supplier of open, scalable computer systems for data center and mission-critical applications. The Company was founded in 1983 as a Delaware corporation. With sales offices and distributors throughout the United States, Canada, Europe and the Far East, the Company designs, manufactures, distributes and supports mainframe class computer systems for on-line transaction processing and real-time applications. Many of the company's product lines employ Encore's patented MEMORY CHANNEL technology. Encore's alternative mainframe product, known as the Infinity 90 Series, exceeds proprietary mainframe computing requirements through cost-effective, massively scalable computer technology. The real-time product sets including the Infinity R/T and ENCORE RSX, provide optimum solutions for complex, real- time processing applications. In 1989, Encore enhanced its worldwide marketing presence when it acquired the assets and assumed the liabilities of the Gould Electronics Inc. (formerly Gould Inc.) Computer Systems Division (the "Computer Systems Business"), a business that was significantly larger than the Company itself. Since the acquisition, the Company has integrated the best of both business' technologies into a single, high performance open system architecture. However, as more fully discussed in Management's Discussion and Analysis of Financial Condition and Results of Operations and in Notes G and J of the Notes to Consolidated Financial Statements, since the acquisition of the Computer Systems Business, the Company has been unable to achieve a level of profitability and has sustained significant losses in all years since the acquisition. Japan Energy Corporation ("Japan Energy"; formerly Nikko Kyodo Co., Ltd.) and its wholly owned subsidiaries Gould Electronics Inc.("Gould") and EFI International, Ltd. ("EFI") (or collectively the "Japan Energy Group") have been the principal sources of the Company's financing since the acquisition. The Japan Energy Group has provided the Company with its revolving credit facility, provided certain loan guarantees and entered into various exchanges of indebtedness for preferred stock. The Company is and will remain dependent on the continued financial support of the Japan Energy Group until it achieves a state of continued profitability. Should Encore be unsuccessful in securing additional future financing from the Japan Energy Group as it is required, it is likely the Company will be unable to settle its liabilities on a timely basis. Approximately 37% of 1993 revenues were derived through sales to various U.S. government agencies. In certain cases, U.S. government agencies, such as the Department of Defense, are precluded from awarding contracts requiring access to classified information to foreign owned or controlled companies. As discussed above, the principal source of both debt and equity financing for the Company has been through Japan Energy (a Japanese corporation) and certain of its wholly owned subsidiaries. In light of various U.S government limitations on the ability of certain agencies to do business with foreign owned or controlled companies, Encore and Japan Energy have worked together to comply with all U.S. government requirements. In this connection, as indicated by the terms of the Series A, Series B, Series D, and Series E Preferred Stock, Japan Energy has agreed to accept certain terms and conditions relating to its equity security investments in the Company, including the limitation of voting rights of its shares, limitations on the number of seats it may have on the board of directors and restrictions with regards to converting its Preferred shares into Common Stock. Both the United States Defense Investigative Service ("DIS") and the Committee on Foreign Investment in the United States ("CFIUS") have reviewed the relationship between the Company and the Japan Energy Group under the United States Government requirements relating to foreign ownership, control or influence. Neither organization has indicated they have any objections. Encore is committed to complying with all U.S. government requirements regarding foreign ownership and control of U.S. companies. At this time, the Company is unaware of any circumstances that would adversely impact the determinations of either DIS or CFIUS. However, should either DIS or CFIUS change its opinion of the nature of the Japan Energy Group's influence or control on the Company, a significant portion of its future revenues realized through U.S. government agencies could be jeopardized. (b)(c) Industry Segments and Narrative Description of Business GENERAL The Company operates in a single industry segment, the information technology industry, which includes the design, manufacture, sale and service of computer hardware, software, and related peripheral equipment and products on a worldwide basis. Encore offers five principal families of computer systems targeted at certain niches within the information processing and real-time computing marketplaces. The product families are: (i) the Infinity 90 Series, (ii) the Infinity R/T Series, (iii) the Infinity SP (iv) the Encore 90 Series and (v) the Encore RSX line of real-time computers. Additionally, the Company continues to support its prior generation CONCEPT/32 product line. The Infinity 90 Family offers a powerful range of air-cooled, massively scalable, system solutions that exceed the performance of traditional mainframes at a fraction of their cost. Infinity 90 systems solve large or complex mainframe computing challenges by offering an array of easily expandable system and subsystem configurations for an enterprise-wide computing solution. With essentially unlimited configuration flexibility the Infinity 90 enables the connection of multiple processors and I/O subsystems, which packaged together in large or complex configurations, creates a powerful solution for demanding on-line transaction processing applications. The Infinity R/T family is a family of high-performance real-time computer systems. The term "real-time" defines an environment in which a computer interfaces with a physical occurrence in such a way that it can acquire and analyze data and then, on the basis of that data, respond to the occurrence so rapidly that virtually no time passes between acquisition of data and response to the occurrence. These systems incorporate real- time UNIX and an architecture based on second generation RISC processors in a symmetric multiprocessor design featuring deterministic performance with very large cache stores, extremely high-speed buses and a large standard base memory. The systems provide for integral multinode clustering capability and certain models support software which allows a single system view of the multiple compute and I/O elements of a large configured system. The Infinity SP leverages the Infinity 90 series of systems by combining its architectural elements with specialized software to provide a comprehensive set of storage products for solving mainframe storage requirements. Infinity SP products are designed utilizing new technologies that meet or exceed those used in existing mainframe storage solutions. These include the use of commodity microprocessors, high-performance/high-density 3 1/2 inch disk drive technologies as well as high-availability and fault-tolerant designs utilizing various levels of RAID (Redundant Arrays of Inexpensive Disks). Existing Encore Infinity SP storage subsystems are capable of delivering storage solutions with available capacities from 100 gigabytes to multiple terabytes and can provide direct attached storage devices (DASD) for IBM compatible mainframes as well as being concurrently capable of providing shared storage facilities to open systems environments. The Encore 90 Family consisting of the 91 Series and the 93 Series provides a range of computer technology with an open systems architecture for time-critical applications. These symmetric multiprocessor systems use industry-standard hardware platforms, I/O interfaces, operating systems and application software to achieve deterministic real-time capability. The Encore 91 Series provides the computing power necessary to meet the needs of applications from the low to midpoint of the performance range while the Encore 93 Series satisfies the more demanding application requirements at the high end of the performance spectrum. Encore RSX computer systems, based on the proprietary Mapped Programming Executive (MPX-32) operating system, are object code compatible throughout the product line and are designed to run time critical, real-time applications. Encore RSX systems provide capability for real-time event response, powerful computation, high volume data input/output and easy expansion. Because of its object code compatibility, the Encore RSX allows customers to easily migrate their existing applications developed on earlier generations of the Company's product offerings to today's technology. This preserves the customer's investment in its application software. - --------------------------------------------------------------------------- NOTE: The following products are trademarks of Encore Computer Corporation: Infinity R/T, MEMORY CHANNEL, Encore RSX, Infinity 90 Series, Encore 90 Series, Encore 91 Series, Encore 93 Series, MPX-32, and UMAX V R/T. CONCEPT/32 is a registered trademark of the Company. - --------------------------------------------------------------------------- MARKETS AND CUSTOMERS As discussed below, Encore participates in portions of both the information processing and real-time computing marketplaces. Information Processing The Company has introduced its massively scalable, symmetric multiprocessor-based open systems products into four new information processing markets: (i) On-Line Transaction Processing (OLTP) and Decision Support Systems (DSS), (ii) Mainframe Replacement, (iii) Interactive Information Network Servers and Switches and (iv) Data Storage. Encore's strategy is to provide a system that can continue to support a user's existing critical applications while allowing the user to re- engineer some or all of those applications to run in an open system environment at a much lower cost than traditional mainframes. During the 1960s, mainframe computers provided batch processing solutions for its information system customers. In the 1970s, minicomputers became the common computing paradigm. Then in the 1980s, the computing trend shifted towards PCs and workstations with data base management software. Due to the proliferation of data from workstations and PCs, many large commercial customers now require the immediate interactive processing of available data for enterprise-wide computing rather than the batch processing approach of traditional mainframes. Accordingly, today the market has begun to migrate to a client/server processing model served by both (i) mainframes and mainframe alternatives for on-line transaction processing and data base applications, and (ii) massively parallel systems for numerically intensive applications. The systems of the 90s will be characterized by their ability to meet the user's increasing computational power and I/O requirements as well as the ability to move customers easily from a proprietary technology environment into the open systems environment. Encore serves the Information Systems market with the Infinity 90 Series of computer systems. These systems are well suited to a wide range of applications including On-Line Transaction Processing (OLTP), client/server system management, data base management, decision support systems, and interactive information networks as these computer systems offer the high computational power, I/O bandwidth, and versatile communications required by such applications. The products are most effectively targeted at Fortune 500 and other large organizations such as U.S. government agencies with a need for cost-effective computing power to handle both existing and new centralized computing applications. Examples of successful market penetration of the Company's products include the selection of the Infinity 90 as part of a multi-million dollar contract issued to a government prime contractor for consolidating multiple mainframe data processing centers within the U.S. Air Force Materiel Command over the next five years. Additionally, Encore has signed agreements with several systems integrators in the United States, the Middle East and the Pacific Rim. Additionally, within the information processing market, Encore provides IBM mainframe system-compatible data storage products using high performance technologies leveraged from its Infinity 90 product line. Data storage demands within the information processing market are expanding due to increased requirements of capturing business data as well as storing new forms of information (e.g. document images, sound and video storage). Accordingly, the mainframe storage marketplace is undergoing changes similar to those of the information processing marketplace. These changes include the need for faster, denser and more cost effective storage solutions to reduce demands on existing facilities and shrinking mainframe data processing budgets. Today's data processing environments have developed a strong strategic requirement to leverage technology advances being applied to the open systems environment. The Company's Infinity Storage Product (Infinity SP) provides an innovative new approach to solving the storage processing requirements of today's increasingly complex mainframe environments. Many of the same technologies that Encore uses in its alternative mainframe products (Infinity 90) address these changes and are directly applicable to both the existing and emerging storage marketplace. These technologies have been optimized to provide reliable high performance I/O subsystems while being readily suited to addressing the needs of both mainframe and open systems environments. Real-Time The Company's real-time computer systems, the Infinity R/T Family, the Encore 90 Family and the Encore RSX, are used for the acquisition, processing, and interpretation of data primarily in four markets: (i) simulation, (ii) range and telemetry, (iii) energy, and (iv) transportation. Simulation is the Company's single largest real-time market segment. Encore products are widely used in simulators that duplicate complex situations in controlled environments. The Company's installed simulation systems are used to safely and economically train commercial and military personnel to operate and maintain complex systems such as space vehicles, aircraft, weapons systems, ships, ground-based vehicles, and nuclear power plants. In the range/telemetry market segment, the Company's real- time systems are used for the acquisition and processing of data by flight, space, sea, and ground ranges. These systems are used in the test and evaluation of state-of-the-art military and commercial aircraft, space vehicles, ground equipment, and instrumentation systems. Encore also competes in the power and electric utility market segments of the energy marketplace where the Company's real-time systems typically acquire, monitor and provide supervisory and can provide closed loop control in energy management, power plant monitoring and control, and power plant simulation systems. This is done at both nuclear and fossil fuel plants. The Company's systems monitor the transmission and distribution of electrical power from generation to substation to end use and facilitates the training of power plant operators by putting them in simulated environments to prepare them for emergency situations. Within the energy marketplace as a whole, Encore systems provide the same real-time capability of data acquisition and control to other market segments such as seismic, oil exploration, and off-shore oil platforms. Transportation is one of Encore's emerging markets. The Company's products are currently installed in rapid transit/metro rail and marine transportation applications. Strategically, the Company is focusing on other developing niches within this marketplace including intelligent vehicular highway systems (IVHS). The Company's real-time customers include original equipment manufacturers (OEMs) and systems integrators who combine Encore's products with other hardware and/or application software for resale to end users. The Company also sells its products to end users who require a compatible range of high performance systems which are used as the basis for major internal installations. The real-time customer base is technology and life cycle cost driven and constantly in need of increased performance at lower costs. Encore sales efforts are concentrated on "program" business where typically large contracts are awarded with multiple systems scheduled for delivery over an extended period of years, including continued demand for upgrades and spare parts as well as ongoing maintenance. Often an initial system is shipped to a systems integrator who may spend from six to eighteen months developing software and connecting other equipment to the system before final delivery to the end user. PRODUCTS AND SERVICES During 1993, net sales of the Company's Infinity 90, Infinity R/T, Encore RSX and Encore 90 product lines represented approximately 3%, 1%, 36%, and 7%, respectively of total net sales. In 1992, Infinity 90, Infinity R/T, Encore RSX and Encore 90 product lines represented 0%, 0%, 38%, and 14%, respectively of total net sales. Customer Service revenue represented 53% of 1993 net sales and 48% of 1992 net sales. Infinity 90 The Infinity 90 Family of computer systems is a highly scalable, open systems alternative mainframe computer that combines state of the art RISC technology, symmetric multiprocessing, a UNIX- based operating environment and a powerful open systems-based direct MEMORY CHANNEL bus architecture. The backbone of the architecture is Encore's patented MEMORY CHANNEL which provides direct memory to memory connections between functional nodes at bandwidths of up to 1.6 gigabytes per second. The MEMORY CHANNEL technology solves a fundamental problem associated with I/O bottlenecks by providing I/O bandwidth scaling from 26 megabytes per second to 1.6 gigabytes per second. The Infinity 90 Series can start with hundreds of users and can be expanded to thousands of users as an enterprise's compute and I/O requirements grow. This scalability can provide the user with over 100 times the compute power, 20 times the bandwidth and over 75 times the I/O capacity of today's traditional mainframes at significantly lower costs. Entry level systems offer compute power of 35 MIPS and can be scaled incrementally to 1000 MIPS. The I/O subsystems are designed to enhance overall system performance and provide unlimited capacity and throughput increases by nonintrusive upgrades as well as provide storage control, communications and data paths within the Infinity 90 architecture. The amount of CPU and I/O capacity can be balanced and intermixed as necessary to deliver significant price/performance advantages over traditional mainframes. The Infinity 90's scalability is achieved through a building block approach to system configuration which allows every aspect of the system to scale incrementally. Comprised of functionally specific standards- based computational and I/O subsystem building blocks, the Infinity 90 can be configured into many unique system configurations. The Infinity 90 provides a solution for companies with the need to downcost their data processing operations. The system saves up to 80% of the cost associated with traditional mainframes. High density packaging provides a high degree of serviceability and reduces the system's footprint significantly. Utilization of state of the art low power consumption components provide for low cost of operations. The Infinity 90 employs technologically advanced components and peripherals that deliver mainframe equivalent performance and capacity but require only one-tenth the cooling and power. This minimizes the life cycle cost of system ownership. As a file server, the Infinity 90 has overcome the low I/O bandwidth, small storage capacity and overall limited growth of other solutions by separating file processing from communications protocol processing. Intelligent storage and communication subsystems are independently scalable as are the 53 megabyte per second MEMORY CHANNEL buses that connect them. While partitioned internally, the Infinity 90 is seen by the user as one large file address space accessible from numerous communications ports. Because a user's initial storage demands may be minimal, the system is designed to provide incremental growth from gigabytes to terabytes of disk storage. All Infinity 90 systems provide a variety of communications offerings such as NetWare, LAN Manager, AppleTalk, TCP/IP, SNA and OSI which can grow incrementally with the hardware configuration. The list prices for entry level Infinity 90 systems begin at about $200,000 and can exceed $3,000,000 for very large systems. Infinity R/T The Infinity R/T Family is a symmetric multiprocessor design featuring deterministic performance, very large cache stores, extremely high speed buses, a large, tightly coupled standard base memory, as well as direct hardware connections to on-board interrupts and timers. The systems provide for integral multinode clustering capability, and optional models support Encore's Distributed Real-Time Extensions (DRTX) and Application Specific Embedded Processing. These features accommodate a single system view of multiple compute and I/O elements that can be configured specifically to the attributes of the target environment. Versions of these products are also CONCEPT/32 compatible and provide a seamless migration path for Encore legacy users. As with the Company's mainframe alternative, the Infinity 90, the Infinity R/T Family is based on the Motorola 88100 and 88110 RISC processors and is designed to grow to meet any mix of computational and I/O requirements. This protects the customer's software investment and significantly reduces the risk normally associated with system expansion or rehosting to satisfy ever- expanding requirements. The Infinity R/T Family offers UMAX V R/T as its operating system. UMAX V R/T is an enhanced symmetrical multiprocessing version of AT&T's System V UNIX with real-time extensions. The Infinity R/T architecture supports the standards of POSIX 1003.1, 1003.4 and 1003.4a, SVID and NFS as well as standard interfaces such as VME 32/64, SCSI, Ethernet and FDDI. A full complement of software including open system CASE tools, "Parasight" an exclusive graphics-based parallel development environment, parallel Fortran, C, Ada, and C++ is also available to the user. Pricing for Infinity R/T systems starts at $64,000 and increases to over $375,000 for a fully configured system. Infinity SP The Infinity SP product line leverages the technology of the Infinity 90 Series by combining its architectural elements with the specialized software necessary to provide a comprehensive set of storage products designed to meet mainframe storage requirements. The Company believes these elements result in the ability to deliver high performance storage solutions for IBM mainframe environments. It is the Company's intent to deliver performance and flexibility superior to existing mainframe disk storage systems at a price that is competitive with competitors. Infinity SP products are designed to utilize new technologies. These include the use of commodity microprocessors, high- performance/high-density 3 1/2 inch disk drive technologies as well as high-availability and fault-tolerant designs utilizing various levels of RAID (Redundant Arrays of Inexpensive Disks). The floor space required by Infinity SP to house equal levels of storage capacity is many times less than that of traditional storage suppliers resulting in savings in facility and utility costs. Additionally, while providing a lower cost solution, Encore's Infinity SP provides much greater performance which allows customers to defer their need to invest in costly mainframe upgrades and enhancements. Infinity SP storage subsystems are capable of delivering storage solutions from 100 gigabytes to multiple terabytes. These storage subsystems may be used as direct attached storage devices (DASD) for IBM compatible mainframes as well as being concurrently capable of providing shared storage facilities to open systems environments. The Company believes this innovative combination of functionality provides significant competitive differentiation within the marketplace. Encore 90 The Encore 90 Family consists of two principal classes of computer systems: (i) the Encore 91 Series and (ii) the Encore 93 Series. At the low end of the computing range, the 91 Series represents a true real-time system comprised of open system components, bus structures and I/O. The system is implemented on a symmetric RISC multiprocessor (the Motorola 88000) design with a multiple bus architecture to maintain the deterministic response to real-time applications that are both compute and I/O sensitive. Implementing the same RISC processing elements and system software architecture, Encore's second member of the Encore 90 Family is the Encore 93 Series. With a processor expandable from two (2) to thirty-two (32) symmetrical processors, the Encore 93 Series can satisfy computing needs at the higher end of the performance range. UMAX V, Encore's multiprocessing UNIX implementation, has been enhanced to accommodate real-time features and serves as the interactive environment to the Encore 90's Power Domain Management software system. In this arena, the multiprocessing, memory, and I/O resources can be dynamically tailored to become a very high speed real-time system, while maintaining the productivity of the UNIX development environment. This facilitates an extremely high speed option to very high demand real-time environments. Entry level systems begin at $59,000 and can exceed $175,000 for fully configured Encore 90 Family computer systems. Encore RSX Systems The Company's Encore RSX products provide the deterministic performance, high aggregate computational power and high system throughput required to process the demands associated with today's real-time applications. These features are achieved through a combination of a proven family of hardware products, a proprietary Mapped Programming Executive (MPX-32) operating system and innovative technology such as Encore's patented REFLECTIVE MEMORY. Replacing the Company's prior generation CONCEPT/32 Family, the Encore RSX can provide the customer with a migration path from the CONCEPT/32 Family to the open systems Encore 90 Family. The Encore RSX subscribes to the option of IEEE 754 floating point formats. This allows a seamless application mathematical interface to the UNIX-based Encore 90 Family while maintaining CONCEPT/32 object code and SelBUS compatibility. The Encore RSX can optionally run in RISC mode by converting existing object code to the RISC instruction set of the RSX. This significantly enhances system performance without the need for the user to rewrite his applications. The Encore RSX and the Encore 91 Series product offerings may be combined into a single system via REFLECTIVE MEMORY. This new combined system is a symmetric multiprocessor based on an open systems host architecture using real-time UNIX to provide a single point of control and management. All user interfaces to the system are UNIX-based and provide open systems CASE tools to increase development productivity. Because all of the Company's real-time products are object code compatible, a customer's original investment in software and specialized hardware is preserved as he migrates his installation to newer technology. The Company also continues to offer support for the large installed base of its prior generation CONCEPT/32 products. These flexible products were designed for OEM system integration, as embedded systems in customer supplied cabinets or as complete distributed processing systems for the most complex real-time tasks. Pricing for these systems starts at $50,000 and increases to over $750,000 for a fully configured system. Customer Service Service and support are critical elements in maintaining customer satisfaction. The Company offers its customers a variety of service and support programs for both hardware and software products principally through its customer service organization consisting of third party maintenance partners with locations throughout the world. The Company also offers maintenance service for selected third party equipment. Specific service and support programs include preventive maintenance, resident labor service, customer training and education, logistics support programs, data facility management and custom technical and consulting services. In addition, the Company provides a dial-in hotline as well as remote diagnostic capabilities to allow problem resolution from Encore's home office. The Company provides a standard warranty for parts and labor on its products, generally for 90 days, and maintains and services its products on a contractual basis after the initial warranty period has expired. SALES AND DISTRIBUTION Encore uses multiple channels of distribution to sell its products. The primary channel has been its direct sales force, consisting of approximately 51 salespersons in 36 sales offices located throughout the United States, Canada and Western Europe. The Company also has joint venture operations in Japan, Hong Kong and Malaysia and various arrangements with distributors throughout the world. The Company has expanded its utilization of systems integrators, value-added resellers (VARs) and independent software vendors (ISVs) in its distribution network. Strategically, the Company is committed to continued expansion of its distribution channels through the establishment of marketing alliances with other industry leaders. The Company's general policy is to sell rather than lease its products. The Company generally has a policy of no returns and does not typically extend payment terms beyond those prevalent in the computer industry. A significant portion of the Company's sales typically occur in the last month of a fiscal quarter, a pattern that is not uncommon in the computer industry. It is the Company's objective to minimize the time from receipt of a purchase order for a computer system to delivery of the system. Accordingly, the Company does not believe backlog reported at any point in time aids materially in the overall understanding of the business. Encore's business is not subject to pronounced seasonal fluctuations. The Company is not dependent upon any one customer for a material part of its business. However, in fiscal 1993, approximately 37% of its sales were derived either directly or indirectly from various United States government agencies. No single customer accounted for as much as 10% of sales in fiscal 1993. MANUFACTURING AND RAW MATERIALS The Company is primarily an assembler and integrator, thus reducing its capital requirements and increasing operating leverage. The Company's manufacturing operation, which includes the test and quality assurance of all parts, components, sub- assemblies and final systems is ISO 9002 certified and located in Melbourne, Florida. Encore assembles its printed circuit boards using surface mount technology and automatic placement equipment. Substantially all peripherals are purchased from third party vendors. Extensive testing and burn-in is performed at the board, component and sub- assembly level and at final systems integration. The Company believes that its manufacturing facilities are sufficient to meet its requirements for at least three years. Encore's manufacturing operations utilize a wide variety of electronic and mechanical components, raw materials, and other supplies and services. The Company relies heavily on external sources of supply and has developed multiple commercial sources for most components and raw materials, but it does utilize single sources for a limited number of custom components. While delays in delivery of such single-sourced components could cause delay in shipments of certain products by Encore, at this time, the Company has no reason to believe any of its single source vendors present a serious business risk to the Company. RESEARCH AND DEVELOPMENT In fiscal 1993, Encore spent $23,331,000 (24.9% of total net sales), on research and development (R&D) activities. In fiscal 1992 and 1991, research and development spending was $22,333,000 (17.1% of net sales) and $30,543,000 (19.9% of net sales), respectively. Fiscal 1993 expenses were $998,000 higher than 1992 due principally to higher spending in the fourth fiscal quarter on materials used in the new product development process. Spending in future periods are not planned to decrease below 1993 levels. Fiscal 1992 expenses were $8,210,000 lower than 1991 as efforts to accelerate the introduction of the Infinity 90 and Encore 90 Families concluded and the benefits of prior cost reduction programs were fully realized. During 1991, research and development activities were consolidated in Ft. Lauderdale, Florida and the scope of activities at the Marlborough, Massachusetts facility were greatly reduced. Additionally, R&D priorities were realigned focusing on those product offerings necessary for the future growth of the business while significantly reducing investment in areas outside the Company's strategic focus. The fiscal 1993, 1992, and 1991 amounts above do not include certain capitalized software development costs totaling $2,142,000, $2,365,000, and $2,640,000, respectively. The Company also spent approximately $1,187,000, $70,000, and $1,829,000 on customer-sponsored engineering activities in fiscal 1993, 1992, and 1991, respectively. These costs which are classified as a deferred cost at December 31, 1993 have been reimbursed by the customer in January, 1994. In 1992 and 1991 such costs are included in cost of goods sold. Because of the rapid technological change which characterizes the computer industry, the Company must continue to make substantial investments in the development of new products to enhance its competitive position. It is expected that future annual R&D expenditures will remain at or above current levels and, as a percent of sales, will remain high in relation to industry norms. Encore has established technical expertise in three critical technologies: parallel processing, real-time and shared memory distributed systems, and the UNIX environment. The Company's primary emphasis has been to build upon these established technologies and couple the best features of each into its new generation of products, the Infinity 90, Infinity RT, Infinity SP and Encore 90 Families. COMPETITION The computer industry is intensely competitive and is characterized by rapid technological advances, decreasing product life cycles, and price reductions. The principal competitive factors in the Company's markets are total system performance, product quality and reliability, price, compatibility and connectivity to other vendors' systems, and long term service and support. The primary competitors in the Company's real-time markets are established companies, such as Concurrent Computer Corporation, Digital Equipment Corporation (DEC) and Harris Corporation. Competitors in the information processing market include established companies like DEC, International Business Machines (IBM), NCR, Hewlett Packard Company (HP) and Sequent Computer Systems. Within the storage products marketplace , the Company competes with IBM, Hitachi Data Systems and EMC. Many of Encore's competitors have greater financial, technical, and marketing resources than Encore. In some cases, this places the Company at a disadvantage. However, the Company considers its level of experience and general understanding of real-time applications and its current parallel processing and UNIX technology position to be positive competitive factors. PATENTS AND LICENSES Encore owns a number of patents, copyrights and trademarks relating to its products and business. Management believes that because of the rapid technological advancements in the industry such patents, copyrights and trademarks, while valuable to Encore, are of less significance to its success than such factors as innovation, technical skills and management ability and experience. From time to time, companies in the industry have claimed that certain products and components manufactured by others are covered by patents held by such companies. It may, therefore, be necessary or desirable for Encore to obtain additional patent licenses. Management believes that such licenses could be obtained on terms which would not have a material adverse effect on the Company's financial position or the results of its operations. During 1992, the Company settled the outstanding patent infringement claim made by IBM against the Company with no financial impact to Encore. Encore has entered into licensing agreements with several third party software developers and suppliers. The licenses generally allow for use and sublicense of certain software provided as part of the computer systems marketed by the Company. Encore is licensed by UNIX Systems Laboratories Inc. to use and sublicense their UNIX operating system in the Company's computer systems. As part of a 1991 refinancing of the Company and as more fully described in Note I of the Notes to Consolidated Financial Statements, the Company granted a license to Gould for all of Encore's intellectual property. The intellectual property license is royalty free and contains certain covenants which do not allow Gould to use the Company's intellectual property unless certain sales revenue levels are not reached by the Company. Additionally, Encore has the option to extend the initial exclusivity period for up to 5 additional years by making cash payments to Gould, and the period will be automatically extended if Encore achieves certain operating income levels. Encore may also terminate the license agreement if all borrowings under its revolving credit agreement with Gould are repaid and either (i) the outstanding shares of the Series B and Series D Convertible Preferred Stock are converted or (ii) the outstanding shares of the Series B and Series D Convertible Preferred Stock are redeemed or (iii) Encore pays Gould the fair value of the license. The Company has not achieved the net sales or operating income levels necessary under the agreement to maintain its exclusive right to the use of its intellectual property and at December 31, 1993 was in default of covenants contained in the agreement. Gould has, however, extended the Encore exclusive period until December 31, 1994. In accordance with prior agreements made with the DIS, Gould must provide ninety days notice to DIS in the event it elects to take possession of the intellectual property. If Gould should take possession of the intellectual property, Encore would continue to have the right to use that property, but such action by Gould could have a material adverse effect on the Company's business. EMPLOYEES As of December 31, 1993, Encore had 952 full-time employees engaged in the following activities: Employees Customer Service 240 Manufacturing 142 Research and Development/Custom Products 270 Sales and Marketing 221 General and Administrative 79 ------ Total 952 The Company's future success will depend in large part on its ability to attract and retain highly skilled and motivated personnel, who are in great demand throughout the industry. None of the Company's domestic employees are represented by a labor union. EXECUTIVE OFFICERS OF THE REGISTRANT The names of the Company's executive officers and certain information about them are set forth below. Name Age Position with Company - ---------------- ---- --------------------- Kenneth G. Fisher 63 Chairman of the Board and Chief Executive Officer Rowland H. Thomas, Jr. 58 President and Chief Operating Officer Charles S. Anderson 64 Vice President, Corporate Relations Ziya Aral 41 Vice President, Systems Engineering and Chief Technology Officer Robert A. DiNanno 47 Vice President and General Manager, Real-Time Operations T. Mark Morley 45 Vice President, Finance and Chief Financial Officer Thomas F. Perry 50 Vice President, Worldwide Sales and Marketing Information Systems James C. Shaw 46 Vice President, Manufacturing Operations George S. Teixeira 37 Vice President, Product Development J. Thomas Zender 54 Vice President, Corporate Program Management Mr. Fisher is a founder of the Company and has served as a Director, Chairman and Chief Executive Officer of the Company since the Company's inception in May 1983. He was the Company's President from its inception until December 1985 and also served in that capacity from December 1987 to January 1991. From January 1982 until May 1983, Mr. Fisher was engaged in private venture transactions. From 1975 to 1981, Mr. Fisher was President and Chief Executive Officer of Computervision (formerly Prime Computer, Inc.). Before joining Computervision, Mr. Fisher was Vice President of Central Operations for Honeywell Information Systems, Inc. Mr. Thomas has been a member of the Board of Directors since December 1987 and Chief Operating Officer since June 1989. He presently serves as President of the Company, a position to which he was elected in January 1991. From June 1989 to January 1991, Mr. Thomas served as Executive Vice President of the Company. In February 1988, he was named President and Chief Executive Officer of Netlink Inc. Prior to joining Netlink, Mr. Thomas was Senior Executive Vice President of National Data Corporation ("NDC"), a transaction processing company, a position he held from June 1985 to February 1988. From May 1983 through June 1985, Mr. Thomas was Executive Vice President and Senior Vice President at NDC. Mr. Anderson, joined the Company in 1985. From 1984 until joining the Company, Mr. Anderson served as Director of Human Resource Operations at Data General Corporation. Before joining Data General, Mr. Anderson was with Honeywell Information Systems, Inc. serving in various management positions since 1970, most recently as Director of Employee Relations. Mr. Aral joined the Company in 1987 and was appointed to his present position of Chief Technology Officer during 1993. Since 1987, he has held various positions of increasing responsibility within the Company including Vice President of Systems Engineering and Senior Technology Consultant. While with the Company, Mr. Aral has been the key innovator and architect of much of the Company's current technology including the Infinity 90 Series. Prior to joining Encore, Mr. Aral was employed by the Reed-Prentice Division of PMCo. in a variety of software engineering positions. Robert A. DiNanno joined the Company in July 1986. Until June 1992, Mr. DiNanno served as Vice President and General Manager, Operations. At that time, he was appointed Vice President and General Manager, Real-Time Operations. Prior to joining the Company, he served as Vice President, Manufacturing at Adage, Inc. from November 1983 to June 1986. Mr. DiNanno also held domestic and international management assignments with Honeywell Information Systems, Inc. from June 1979 until November 1983. Mr. DiNanno has experience with military and commercial flight simulations acquired during his tenure at Singer Link. T. Mark Morley joined the Company in November 1986 as Chief Financial Officer and Vice President, Finance. Prior to that during 1986 he was Chief Financial Officer, Vice President, Finance and Treasurer of Iomega Corporation. From 1977 through 1985, Mr. Morley was employed by Computervision (formerly Prime Computer, Inc.), most recently as the Senior Director responsible for the Treasury department. From 1973 to 1977, Mr. Morley was associated with Deloitte and Touche and from 1971 to 1973 he was associated with the City of Boston Legal Department. He is an attorney and a C.P.A. Mr. Perry joined the Company in November 1992 as Vice President, Worldwide Sales and Marketing Information Systems. From May 1990 to October 1992, he was President of the Systems Division and a member of the Board of Directors for The Ultimate Corporation. Mr. Perry joined The Ultimate Corporation in March 1989 as Senior Vice President of Sales Operation. From March 1988 to March 1989 Mr. Perry served as Director, Alternative Channels for Stratus Computer. Prior to that, Mr. Perry held Senior Vice President positions with several high technology start-up companies responsible for various sales and marketing functions. He has also held sales management positions with Computervision (formerly Prime Computer Corporation). Mr. Shaw joined the Company in 1989 as Vice President, Manufacturing Operations. In November 1992, he was appointed an officer of the Company. From 1985 to 1989 he served as Senior Director, Manufacturing for Modicon, Inc. Prior to that time, he was Vice President, Manufacturing for Chomerics, Inc., a position he held from 1980 to 1985. Mr. Teixeira assumed his present position in August 1991. Previously he held the positions of Vice President of Marketing and Vice President of Product Management. Mr. Teixeira was Director of Product Marketing and Management for the Computer Systems Business of Gould which the Company acquired in 1989. Prior to that he held several progressively more responsible positions since joining Gould in 1981. J. Thomas Zender joined the Company in August 1989 as Vice President of Marketing. In January 1991, he was appointed Vice President Program Management and in 1992 was appointed Vice President, Corporate Program Management. From 1986 to August 1989, Mr. Zender was Vice President, Corporate Development at MAI Basic Four, Inc. Before joining MAI Basic Four, he was Vice President of Marketing of Calcomp/Terak Corporation. Mr. Zender served as Vice President of Marketing for Database Systems Corporation and Director of Marketing for Genrad, Inc. He also served as Vice President of Field Support for ITT Courier as well as holding various management positions with Honeywell Information Systems, Inc. and General Electric Company. (d) International Operations The Company maintains sales and service operations in Europe and Canada through wholly-owned subsidiaries. In the Far East, sales and service operations are performed through one or more joint ventures in Japan, Hong Kong and Malaysia and distributor agreements throughout the remainder of the Pacific Rim. In fiscal 1993, approximately 44% of consolidated net sales were derived from foreign operations. The Company believes that its overall profit margins with respect to foreign sales are not materially different from profit margins from domestic sales. In view of the locations and diversification of its foreign activities, the Company does not believe that there are any unusual risks beyond the normal business risks attendant to activities abroad. Encore uses a hedging program to reduce its exposure to foreign currency fluctuations. Additional information relating to the Company's international operations, including financial information segregated by major geographic area, is contained in Note K of the Notes to Consolidated Financial Statements. Item 2

Item 2 Properties Listed below are the Company's principal facilities as of December 31, 1993. Owned or Square Feet Location Principal Use Leased Approximately - ----------------- --------------- ------ -------------- Ft. Lauderdale, FL Administrative/ Owned 224,000 Development/ Marketing/ Ft. Lauderdale, FL Customer Service/ Leased 80,000 Development Melbourne, FL Manufacturing Owned 124,000 Paris, France Sales/Service Leased 47,000 London, England Sales/Service Leased 35,000 In addition to the facilities listed above, Encore also leases space in various other domestic and foreign locations for use as sales and service offices. The Company's owned facilities are encumbered by various mortgages, including mortgages which collateralize the Gould loan agreements (See Note G of Notes to the Consolidated Financial Statements). Item 3

Item 3 Legal Proceedings There are no material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the registrant or any of its subsidiaries are party to or of which any of their property is the subject. Item 4

Item 4 Submissions of Matters to a Vote of Security Holders No items were submitted to a vote of the security holders during the fiscal quarter ended December 31, 1993. PART II Item 5

Item 5 Market for Registrant's Common Equity and Related Stockholder Matters Prior to January 22, 1992, Encore' s common stock was quoted on Nasdaq with daily statistics found under the National Market Issues section of newspaper stock listings. Subsequent to that time, the Company was excluded from participation in the Nasdaq system because it was unable to meet the minimum capitalization requirements for its continuation in the system. As of February 22, 1992, the Company's common stock began trading on the OTC electronic bulletin board under the symbol ENCC. The high and low closing sale prices of Encore's common stock are shown for fiscal years 1993 and 1992 in the table below: Fiscal 1993 prices Fiscal 1992 prices High Low High Low -------- ------- ------ ------ 1st Quarter $ 1 15/16 $ 1 1/4 $ 2 $ 5/8 2nd Quarter 2 5/8 1 1/2 1 7/8 1 3rd Quarter 4 1/2 2 5/8 1 5/8 13/16 4th Quarter 4 1/4 2 3/4 2 1/8 1 1/4 Upon completion of its February 4, 1994 exchange of indebtedness for preferred stock discussed in Note L of the Notes to the Consolidated Financial Statements, the Company met the minimum requirements for inclusion in the Nasdaq National Market System. The Company was accepted for participation and began trading on March 18, 1994 under the symbol ENCC. Daily statistics on the Company's stock can be found in the Nasdaq National Market Issues listing of the newspaper's stock listings. The First National Bank of Boston is the stock transfer agent and registrar, and maintains shareholder records. The agent will respond to questions on change of ownership, lost stock certificates, consolidation of accounts, and change of address. Shareholder correspondence on these matters should be addressed to The First National Bank of Boston, Shareholder Services Division, P.O. Box 644, Boston, Massachusetts 02109. As of April 6, 1994, there were approximately 2,703 holders of record of the Company's common stock. The Company has never paid cash dividends on its common stock and does not anticipate the payment of cash dividends in the foreseeable future. Under the terms of the Company's current financing agreements, the Company is prohibited from paying dividends on its common stock. (1) See Notes A and J of the Notes to Consolidated Financial Statements for information on the calculation of net loss per share. During 1993 preferred stock dividends on the Series B payable in shares of Series B of $3,630,000 and dividends on the Series D payable in shares of Series D of $5,554,700 were accumulated by the Company. During 1992, preferred stock dividends on the Series B of $3,943,100 were paid with additional shares of Series B preferred stock. Additionally in 1992, preferred stock dividends of $528,300 were paid in additional shares of Series D Preferred Stock. (2) As discussed in Note L of the Notes to Consolidated Financial Statements, the Company and Gould Electronics Inc. completed a recapitalization of the Company subsequent to the Balance Sheet date. The column headed Pro Forma 1993 shows the Selected Financial Data on a Pro Forma basis as if the recapitalization had been done at December 31, 1993. (a) Quarter 4, 1993, Quarter 2, 1993, Quarter 3, 1992 and Quarter 2, 1992 include restructuring charges of $10,422,000, $12,843,000, $1,000,000 and $4,248,000, respectively. Item 7

Item 7 Management's Discussion and Analysis of Financial Condition and Results of Operations Overview Encore Computer Corporation ("Encore" or the "Company") was founded in May 1983 and was in the development stage until October 1986. During this period, the Company was primarily involved in the research, development and marketing of its UNIX- based Multimax computers and Annex terminal server. Initial sales of the Multimax and Annex products as well as revenues under certain U.S. government agency research contracts began in 1986. During 1989, Encore acquired substantially all of the assets of the Computer Systems Division of Gould Electronics Inc. (the "Computer Systems Business"). This was a significantly larger business which for over twenty-five years, provided real- time computer systems solutions to the simulation, range and telemetry, and energy marketplaces. Since the acquisition, the Company has fully integrated the businesses blending the strengths of each into next generation product offerings. This has resulted in the development of the Infinity 90 and Encore 90 Families of open systems targeted toward demanding, time critical applications in both the general purpose computing and real-time marketplaces. Based on RISC processors, a standard UNIX operating system and industry standard connectivity and networking protocols, both the Infinity 90 and Encore 90 Families offer massive I/O throughput, a broad I/O bandwidth, complete computational scalability and price/performance advantages over traditional mainframe solutions. The first members of the Encore 90 Family, the Encore 91 Series and the Encore 93 Series began shipments in 1991. The Infinity 90, an open system mainframe alternative, was available in the second half of 1992 and then during the second half of 1993, the Infinity R/T, a real-time version of the Infinity 90, was released for volume shipments. During the late 1980s, product demand in the computer marketplace began a migration away from more traditional proprietary computing technologies and towards an open systems technology. The Company anticipated this market trend and since the acquisition of the Computer Systems Business focused its research and development investments toward the development of a new generation of computer system based on a state of the art open system architecture. Since the beginning of 1991, the Company has spent approximately $76,000,000 in research and development activities with a significant portion of this directed toward programs aimed at bringing new open system technology products, such as the Infinity 90, Infinity SP and Encore 90 Families, to market. The Company must continue to invest heavily in the areas of research and development to remain competitive in the marketplace. As a percentage of net sales, research and development spending will remain high in comparison to industry averages. The Company believes that this will allow it to provide early availability of leading-edge computer technology which could position the Company favorably as the marketplace continues to migrate. During 1993 the Company's products have been favorably reviewed by certain market research firms and the Infinity 90 set a world record in performance of the industry-standard AIM-II TPC benchmarks. While the general opinion of industry analysts is that future computer solutions will be based on open systems and standards, this market is still in its infancy. Many data processing users are only now beginning to define their strategies for implementation of such technology. Accordingly, demand for the Company's open systems products has been weak. Over the three year reporting period, this has placed the Company in an extended period of product transition. Older, established products have reached the end of their competitive life cycle and are now experiencing a significant decline in revenues while the Company's newer technology product offerings have not yet generated the level of customer demand anticipated by the Company. Revenues have decreased from $153,302,000 in 1991 to $93,532,000 in 1993 and as a result the Company has incurred significant net losses. In response to the declining revenue base and resultant lower gross margin dollars, management has taken aggressive actions throughout this period to restructure the organization to levels more consistent with the declining size of the Company. These actions have included reducing the workforce to levels required to support the business, eliminating organizational redundancies and consolidating certain facilities to eliminate unneeded capacity. In connection with the restructuring activities, the Company has also recognized the non- recoverability of certain capitalized software products and the impairment in value of certain other long lived assets, including goodwill. As a result of the actions taken, the Company has recorded restructuring charges of $57,545,000 over the three year period. Because of the net losses incurred since the beginning of 1991, the Company has not generated sufficient levels of cash flow to fund its operations and cumulatively used cash in operating and investing activities of $104,998,000. While a portion of the losses incurred were funded by reductions in the working capital, the principal source of financing has been provided by Japan Energy Corporation ("Japan Energy"; formerly Nikko Kyodo Co., Ltd.) and certain of its wholly owned subsidiaries. Should the Company continue to incur significant losses, it will be difficult to operate as a going concern without the on-going financial support of Japan Energy. Until the Company returns to a sustained state of profitability, it will not be able to secure financing from other sources. Accordingly, should Japan Energy withdraw its financial support prior to the time the Company returns to profitability, the Company will experience a severe liquidity crisis and have difficulties settling its liabilities in the normal course of business. However, management believes the current availability of new technology products, such as the Infinity 90 and Infinity SP, could improve the Company's revenue stream and related profitability. Until such a time, the Company will continue to adjust spending to levels consistent with expected business conditions. Comparison of Calendar 1993, 1992 and 1991. Net sales for 1993 were $93,532,000 compared to net sales for 1992 and 1991 of $130,893,000 and $153,302,000, respectively. The 1993 revenue decline is due to both lower product and service sales. In 1993, equipment sales decreased to $43,622,000 from $67,840,000 and $81,272,000 in 1992 and 1991, respectively. Service revenues for fiscal 1993, 1992, and 1991 were $49,910,000, $63,053,000, and $72,030,000, respectively. In general as discussed below, the principal declines since 1990 are due to lower sales volumes. Despite the availability of new technology products such as the Infinity 90 and Encore 90 Families of products and continued enhancements to the Encore RSX product line, 1993 equipment sales decreased from prior years. This decline is due to a continued general softness in the computer industry as well as the fact that certain of the Company's products have reached the end of their life cycles. The computer industry is strongly influenced by changes in microchip technology. Customers tend to purchase those products offering leading-edge implementations of the most currently available technology. In recent years, product demand has begun a migration from proprietary to open system architectures. Prior to 1992, the Company's principal product offerings were proprietary architectures whose core technology was developed in the early 1980s. While product enhancements have been made, the Company's older products lost some of their technological edge. Accordingly, the Company was increasingly less competitive selling into new, long-term programs in its traditional real-time markets. This has contributed to the continuing decline in net sales. During 1992, both the Infinity 90 and Encore 90 Families based on new state of the art open systems technology, were available for sale. However, the open systems computer market place is still in its infancy and data processing users are now just beginning to adopt this technology. As a result, demand for new products based on an open systems architecture has not generated the levels of sales necessary to offset the declines realized on sales of the older, traditional product lines. It is possible that the Company will continue to experience declining revenues until such time as the overall market conditions improve and customer demand for open system products increases. Service revenues have declined from the prior year by 21% and 13% in 1993 and 1992, respectively reflecting the continued price competitiveness of the marketplace as well as the effect of the Company's declining system sales. However, as a percentage of total net sales, service revenues have increased from 47% in 1991 to 53% in 1993. Because most of the Company's installed equipment base remains in use for several years after installation and customers generally elect to purchase maintenance contracts for their system while it is in service, the rate of decline in service revenues has lagged that of equipment revenues. Accordingly, since 1991 service revenues have become an increasingly larger portion on the Company's sales mix. International sales in 1993, 1992 and 1991 were $41,371,000, $65,209,000, and $71,167,000 and 44%, 50%, and 46%, respectively of total net sales. The principal decreases in all years have occurred in Western Europe. The European markets have been adversely impacted by the same factors as the overall business, i.e. the effect of a prolonged product line transition combined with an overall general weakness in both the economy and the computer marketplace. Additionally, during 1993 a major United Kingdom distributor decided to delay the purchase of new computer systems until an enhanced version of the Infinity 90 product line becomes available for sale. This product offering is not anticipated until the middle of 1994. During 1993 sales to this distributor decreased by approximately 75% compared to 1992. In light of the downturn in international operations, management has taken actions as discussed below to reduce expenses to levels more consistent with expected future business levels. However, the decrease in international margins caused by the decline in international revenue has not been fully offset by lower international operating expenses. As displayed in Note K of the Notes to Consolidated Financial Statements, international operations have incurred operating losses in 1993 and 1992. While no single customer has accounted for as much as 10% of total net sales during the last three years, sales to various U.S. government agencies have represented approximately 37% and 29% of net sales in 1993 and 1992. The Company recognizes that reductions in current levels of U.S. government agency spending on computers and computer related services could adversely affect its traditional sources of revenue. To mitigate any potential risk, plans are in place to strategically expand into non- traditional, high growth markets with the Infinity 90 and Infinity SP Family of products. The high speed processing capabilities of these products combined with its architecture's scalability, make the product well suited for applications traditionally thought to be the sole domain of mainframe computers. Among the markets being targeted by the Company are Input-Output (I/O) intensive transaction processing data base applications and data storage applications where high speed performance is a critical factor. In certain cases, U.S. government agencies, such as the Department of Defense, are precluded from awarding contracts requiring access to classified information to foreign owned or controlled companies. The principal source of both debt and equity financing for the Company has been through Japan Energy (a Japanese corporation) and certain of its wholly owned subsidiaries. Aware of U.S. government limitations on the ability of certain agencies to do classified business with foreign owned or controlled companies, Encore and Japan Energy have proactively worked to comply with all U.S. government requirements. In this connection, Japan Energy has agreed to accept certain terms and conditions relating to its equity securities in the Company, including the limitation of voting rights of its shares, limitations on the number of seats it may have on the board of directors and certain restrictions on the conversion of its preferred shares into common stock. In connection with the recapitalizations discussed in more detail below and in Notes G, J, and L of the Notes to Consolidated Financial Statements, the Company requested the United States Defense Investigative Service ("DIS") to review the relationship between the Company, Japan Energy, and Japan Energy's wholly owned subsidiaries, Gould Electronics Inc. ("Gould") and EFI International Ltd. ("EFI"), under the United States Government requirements relating to foreign ownership, control or influence. DIS has indicated that it has no objection. Encore is committed to complying with all U.S. government requirements regarding foreign ownership and control of U.S. companies. At this time, the Company is unaware of any circumstances that would adversely affect the opinions previously issued by DIS. However, should DIS change its opinion of the nature of Japan Energy's influence or control on the Company, a significant portion of the Company's future revenues realized through U.S. government agencies could be jeopardized. Total cost of sales decreased in 1993 to $65,831,000 from $79,040,000 in 1992 and $98,163,000 in 1991. The decrease in 1993 was due generally to lower sales volumes when compared to 1992 and lower spending resulting from the restructuring of manufacturing and customer service operations during the three year period. Since the beginning of 1991, manufacturing and customer service headcount have been reduced by 54%, certain customer service field operations have been closed or scaled back, and all manufacturing operations have been consolidated in Melbourne, Florida. Gross margins on equipment sales in 1993 were $14,041,000 (32.2%) compared to 1992 gross margins of $33,557,000 (49.5%) and $30,182,000 (37.1%) in 1991. The decrease in 1993 equipment gross margins of $19,516,000 is due principally to: (i) lower margins of $12,500,000 on lower equipment sales, (ii) lower margins of $2,200,000 due to price erosion, (iii) increased obsolescence charges of $3,280,000 in connection with the Company's continued migration to its newer open systems product offerings and (iv) non-recurring engineering charges and other miscellaneous cost increases of $1,536,000. The 1992 gross margin improvement of $3,375,000 from 1991 on lower equipment sales is attributable primarily to lower manufacturing costs of $2,450,000 resulting from lower spending and improved operational efficiencies when compared to the prior year as well as lower inventory obsolescence costs of $6,437,000. These improvements more than offset the gross margin reduction from the year's lower revenue. In response to the reduced production volumes, expenditures have been reduced throughout the three year period to minimize the further deterioration of equipment gross margins. Among the actions taken since 1991 have been a 45% reduction in manufacturing personnel and the consolidation of all manufacturing activities in Melbourne, Florida. 1993 service gross margin was $13,660,000 (27.4%), a decrease of $4,636,000 from 1992. The lower margin is due to lower revenues of $13,143,000 which were only partially offset by lower operating costs achieved through restructuring actions taken during both 1992 and 1993. Among the principal cost reductions during 1993 were lower employee costs of approximately $5,500,000 due to reduced headcount, lower field office rental costs of approximately $1,200,000 as marginally profitable field locations have been consolidated or closed and other miscellaneous cost reductions of $1,807,000. Service gross margins also decreased in 1992 by $6,661,000 to $18,296,000 (29.0%) compared to prior year's gross margin of $24,957,000 (34.6%). The 1992 reduction was due to a decline of $8,977,000 in 1992 annual service revenues which were only partially offset by lower operating costs. Since 1990, the service business has been unfavorably affected by the Company's declining computer equipment sales, competitive pricing pressures, declining defense spending which has resulted in some maintenance program cancellations, and the termination of certain other service contracts as older installed systems are being decommissioned by their users. Since 1990 approximately 25% of each year's existing service contracts have not been renewed with the Company. Management will continue efforts to minimize the effect of declining service sales on the service gross margins by taking actions to maintain spending at levels consistent with expected future business levels. In the past, these actions have included reductions in workforce, the closing and consolidation of unprofitable field operations and the outsourcing of certain business functions. In the fourth quarter of 1993 the Company took further action to minimize the fixed cost associated with its domestic service business when it agreed to subcontract its equipment maintenance business to Halifax Corporation ("Halifax"). Under the terms of the agreement which takes full effect in 1994, Halifax will provide the manpower required to service equipment under maintenance contract with the Company. The agreement allows the Company to reduce the fixed cost base associated with its field maintenance operation while continuing to provide the same level of service to its customers. 1993 research and development expenses were $23,331,000 (24.9% of net sales) or an increase of $998,000 from 1992. The increase in the current year's spending is due to efforts in the fourth quarter to accelerate the availability of new products scheduled for release in the first half of 1994. For the first three quarters of 1993, spending was essentially unchanged from 1992 levels. Research and development expense increased only 4% in 1993, however, as a percentage of net sales it increased by 7.8% from 17.1% to 24.9% of net sales as a direct result of the year's net sales decline. During 1992, research and development expenses were $22,333,000 (17.1% of net sales) compared to expenses of $30,543,000 (19.9% of net sales) in 1991. In total and as a percentage of net sales, 1992 expenses decreased from 1991 levels as efforts to accelerate the introduction of the Encore 90 and Infinity 90 Family of computers concluded during 1992 and the benefit of cost reduction actions taken in 1991 were fully realized. During 1991 priorities were realigned to focus future expenditures toward those strategically aligned product offerings necessary to the future growth of the business. This significantly reduced the level of investment in areas outside the Company's strategic focus and has allowed the development organization to reduce its headcount by 30% since 1991. Activities at the Marlborough, Massachusetts facility were significantly reduced with on-going activities consolidated in Ft. Lauderdale, Florida, thereby eliminating the on-going fixed expenses associated with that facility. The reductions made in research and development spending since 1991 generally reflect operational efficiencies realized through the elimination of efforts not targeted toward the core business and are not expected to impact the Company's future competitiveness in the marketplace. To effectively compete in its market niches, the Company must continue to invest aggressively in research and development activities. Sales, general and administrative (SG&A) expenses in 1993 were $42,499,000 compared to $45,156,000 and $48,732,000 in 1992 and 1991, respectively. SG&A expenses decreased by $2,657,000 in 1993 when compared to 1992 due primarily to (i) the effect of prior restructuring actions taken by the Company, including lower labor on a reduced 1993 workforce and (ii) lower sales commissions due to lower 1993 revenues. These savings were partially offset by a non-recurring charge to compensation expense of $788,000 made in connection with the extension of the expiration date of certain stock options made during the Company's fourth fiscal quarter. A more complete discussion of this transaction is included in Note J of Notes to the Consolidated Financial Statements. The 1992 SG&A expense reduction of $3,576,000 from 1991 was due primarily to reductions in staff made in 1991 and worldwide facility consolidation programs implemented as part of earlier restructuring programs. As a percentage of net sales, sales, general and administrative expenses were 45.4%, 34.5%, and 31.8% in 1993, 1992, and 1991, respectively. The increase as a percentage of sales reflects the fact that reductions in sales, general and administrative spending have been more than offset by declines in net sales. This is partially due to the time delay in reducing certain fixed costs. In the future, sales, general and administrative costs should begin to return toward 1991 levels. The Company employs a multi-level distribution system to market its products, consisting of direct sales, OEMs, systems integrators and value added resellers (VARs). The Company is committed to expanding its distribution channels for its new products by aggressively seeking strategic alliances with other industry leaders in the marketplace. In this connection, during the first quarter of 1994, the Company and Amdahl Corporation entered into a non-exclusive multi-year agreement whereby Amdahl Corporation will remarket the Company's Infinity SP under the Amdahl brand. In each of the three years reported, the Company has taken actions to restructure its operations to levels consistent with the expected levels of future revenues. As discussed in Note F to Consolidated Financial Statements, 1993 operating expenses include restructuring charges of $23,265,000 compared to $5,248,000 and $29,032,000 for 1992 and 1991, respectively. In connection with the 1993 charges, during the second and fourth quarters management evaluated the latest financial projections of the business and based upon its evaluation concluded: (i) the rate of decline in real-time equipment and service revenues had exceeded its previous estimates, (ii) the rate of worldwide sales growth anticipated in newer product lines remained significantly below projected levels and (iii) overall business conditions in Western Europe had continued to deteriorate during the year. In light of these conclusions, management initiated the following actions to restructure its operations to levels required to meet expected future business conditions including: (i) reductions in the workforce to levels consistent with planned future sales (ii) the closure or consolidation of marginally profitable field offices and (iii) the reassessment of carrying values of certain long lived assets including property and equipment and goodwill. In June 1993, the Company reduced its workforce by approximately 10% with significant reductions made in manufacturing, customer services and international sales operations. In December 1993, plans were approved to further reduce the European workforce by 20% and U.S. headcount by approximately 8%. Because of the reduced field sales and service workforce, actions were also taken to eliminate the resulting excess field office space by closing those offices which were considered underutilized. Due to the decline in traditional real-time product line profits, the Company re-evaluated its investment in the property and equipment employed to support future real-time product sales. As a result of the analysis, management wrote down the carrying value of certain of these assets by $5,700,000 during the year. Finally, as discussed below, during June 1993 the Company wrote off the remaining carrying value of the goodwill originally recorded in connection with the 1989 acquisition of the Computer Systems Business. Of the total 1993 restructuring charges, approximately $12,000,000 reflects the write-off of long lived assets, resulting in a non-cash charge to the business. The actions taken during 1993 are intended to reduce the Company's future annual operating costs by approximately $12,000,000. Management will continue to assess its cost structure and the carrying value of its assets in light of expected future business. While there are no existing plans to take any additional actions, should future conditions necessitate it, management could approve additional plans to further reduce its cost base or recognize the additional impairment of certain long lived assets. The 1992 restructure charge includes severance and outplacement costs associated with a 9% reduction in the workforce, the write- off of certain capitalized software assets relating to the on- going transition of the Company's UNIX-based product lines, and certain costs to be incurred related to the closure of certain sales and service offices. $1,250,000 of this charge reflects non-cash charges to operation and as a result of the 1992 restructuring, annual operating expenses were reduced by approximately $6,000,000. The 1991 restructuring charge included: (i) severance and outplacement costs associated with a 24% reduction in the workforce, (ii) the write-down of goodwill related to the acquisition of the Computer Systems Business, (iii) costs incurred during the scale back of operations in Marlborough, Massachusetts, (iv) the write-off of certain capitalized software assets relating to the transition of the Company's UNIX-based product lines, and (v) costs incurred related to a facilities consolidation program including certain Ft. Lauderdale, Florida properties. $14,000,000 of the 1991 restructuring expense involved non-cash charges to operations. As a result of the 1991 restructuring actions, the Company lowered annual operating expenses by approximately $15,000,000. With regard to the write-off of goodwill, in 1989 the Company acquired the Computer Systems Business of Gould. In recording the acquisition, the Company recognized goodwill which represented the excess of acquisition cost over the fair value of assets acquired. During 1991 management determined the future earnings power associated with the certain portions of the acquired Computer Systems Business had diminished. However, the customer service business which represented in excess of 45% of the acquired Computer Systems Business revenues, continued to yield gross margins in excess of those of its direct competitors. The analysis indicated this earnings premium could result in additional future profits over the next seven years. Furthermore, at that time in management's judgment, the infrastructure acquired by the Company was still largely intact and continued to provide the potential for higher earnings in other portions of the business. In conjunction with this review, management assessed the carrying value assigned to goodwill and determined the future earnings potential of the Computer Systems Business was now less than the current carrying value of goodwill. Accordingly, in the fourth quarter of 1991, the Company wrote down the carrying value of goodwill from $12,979,000 to $4,979,000 by charging operations. The carrying value of goodwill after the write-down was equivalent to the estimated remaining earnings premium associated with the Computer Systems Business. During 1992 the Company's customer service operations came under increasing competitive pressure and some customers began to decommission installed systems canceling service contracts with the Company. In light of the declining base of acquired customer service business, management increased the rate of amortization of goodwill so that by the end of 1994 any excess value associated with the Computer Systems Business customer service base would be fully amortized. However, the continued decline in the earnings base during 1993 resulted in the write off of the remaining carrying value of goodwill ($2,628,000) by charging operations. Interest expense decreased to $6,380,000 in 1993 from $7,425,000 in 1992 and $9,175,000 in 1991 due primarily to lower average debt in 1993 when compared to the prior years. During 1992 and 1991, Encore completed a series of refinancing agreements with Japan Energy, Gould and EFI as discussed in more detail below and in Notes G and J of the Notes to Consolidated Financial Statements. As a result of the various refinancings, the Company's annual interest expense was reduced by approximately $12,000,000 through the conversion of debt with a face value of $140,000,000 into the Company's preferred stock. Interest income decreased in 1993 by $129,000 to $134,000 compared to $263,000 and $561,000 in 1992 and 1991, respectively due primarily to lower interest rates. Other expense was $780,000 in 1993, a decrease of $1,297,000 from 1992's $2,077,000, due principally to lower foreign exchange losses. In 1991, other expense was $1,259,000. Income taxes provided in 1992, 1991, and 1990 relate to taxes payable by foreign subsidiaries (see Note H of the Notes to Consolidated Financial Statements). Liquidity and Capital Resources Because of operating losses incurred for the three years ending December 31, 1993, the Company has been unable to generate cash from operating activities. In 1993, 1992, and 1991, the Company used cash in operating activities of $36,415,000, $15,307,000, and $8,817,000, respectively. During these years, losses incurred due to declining net sales were partially funded by reductions in current assets, principally accounts receivable. In 1993, 1992, and 1991 accounts receivable decreased by $11,857,000, $4,787,000, and $14,207,000, respectively. Further benefit of cash generated through the reduction in the Company's investment in accounts receivable is unlikely. During 1993 some of the benefit received from lower accounts receivable was offset as the Company used cash of $2,649,000 to increase its investment in new product inventories. The increase was due principally to acquisition of materials in the second half of 1993 to support forecasted deliveries of new products including the Infinity 90. Expenditures for property and equipment during 1993, 1992, and 1991 are $11,780,000, $10,119,000 and $17,025,000, respectively. Expenditures for capitalized software during 1993, 1992, and 1991 are $2,142,000, $2,365,000, and $2,640,000, respectively. As of December 31, 1993, there were no material commitments for capital expenditures. Total cash used in operating and investing activities during 1993, 1992 and 1991 of $50,277,000, $27,441,000 and $27,280,000, respectively. These cash outflows were principally offset by cash provided through financing activities of $49,007,000, $24,327,000, and $24,392,000 in 1993, 1992, and 1991, respectively. As discussed below, the principal source of financing has been through various agreements provided by Japan Energy and its wholly owned subsidiaries Gould and EFI (the "Japan Energy Group"). Most recently, on February 4, 1994, Gould exchanged $100,000,000 of indebtedness owed to it by the Company for Series E Convertible Preferred Stock ("Series E"). Also on April 11, 1994, the Company and Gould agreed to amend and restate its existing revolving loan agreement with the Company to increase the amount available under the agreement to $50,000,000 and extend the maturity date of the agreement to April 16, 1996. The other terms and conditions of the agreement are essentially unchanged from those of the prior agreement except certain financial covenants which were modified to more closely reflect the Company's financial position. The Company believes this credit agreement should be sufficient to meet the needs of the business through December 31, 1994. Since 1990, the Company and the Japan Energy Group have entered into the following financing transactions: On January 28, 1991, the Company exchanged Series B Convertible Preferred Stock ("Series B") and Series C Redeemable Preferred Stock ("Series C") for $60,000,000 of indebtedness owed to Gould and concurrently entered into a revolving loan agreement with Gould which, as amended, provided for borrowings of up to $50,000,000. Terms of the Series B are discussed in detail in Note J of the Notes to Consolidated Financial Statements. Effective March 31, 1992, the Company, Gould and Japan Energy completed an agreement whereby Gould converted the Company's existing revolving credit facility with a balance of $50,000,000 into a two year term loan and made available to Encore a new $10,000,000 revolving loan facility with a maturity date of March 31, 1993. Concurrently, Japan Energy through EFI agreed to refinance through its existing term an existing $80,000,000 subordinated loan the Company had with the Industrial Bank of Japan. On September 10, 1992, Gould exchanged 100,000 shares of the Series C with a liquidation preference of $10,000,000 which it held for 100,000 shares of Series D Convertible Preferred Stock ("Series D") also with a liquidation preference of $10,000,000. In connection with the transaction, the Company released Gould from any liability associated with certain outstanding claims related to or arising from the sale by Gould of its Computer System Business to the Company in 1989. Concurrently, EFI exchanged $80,000,000 ($65.5 million net of debt discount) of indebtedness owed to EFI by the Company for 800,000 shares of the Series D with an aggregate liquidation preference of $80,000,000. Completion of the exchange of Series D for the EFI subordinated loan lowered the Company's interest expense by approximately $6,000,000 per year. Terms of the Series D are discussed in detail in Note J of the Notes to Consolidated Financial Statements. On October 5, 1992, Gould agreed to increase the borrowing limit of the revolving loan agreement by $5,000,000 to $15,000,000 under essentially the same terms and conditions as the original agreement. However, as a result of fourth quarter operating losses, the Company exceeded the maximum amount available under the credit facility at December 31, 1992. Effective April 1, 1993, the Company and Gould agreed to: (i) increase the amount available under the revolving credit facility to $35,000,000 under essentially the same terms and conditions as the original agreement, (ii) extend the maturity date of the revolving credit facility to April 16, 1994, (iii) extend the maturity date of the Gould term loan to April 2, 1995 and (iv) waive the covenants contained in the revolving credit facility and the term loan through the end of the first quarter of 1994. Because of operating losses incurred during 1993, the Company reported a capital deficiency throughout the year and exceeded the maximum borrowing limit of the revolving loan agreement during its third fiscal quarter. At December 31, 1993 the Company had borrowed $61,924,000 under the agreement. During the fourth quarter, the Company initiated discussions with Gould to significantly recapitalize the Company. As discussed above and in Note G of Notes to the Consolidated Financial Statements, on February 4, 1994, the Company and Gould agreed to exchange the existing $50,000,000 term loan and $50,000,000 of borrowings under the revolving loan agreement for Series E convertible preferred stock. Terms of the Series E are discussed in detail in Note L of the Notes to Consolidated Financial Statements. On April 11, 1994, the terms of the revolving loan agreement were amended and restated to increase the amount available under the agreement to $50,000,000 and to extend the agreement's maturity date to April 16, 1996. All other terms and conditions of the agreement were essentially unchanged. The Company is dependent on the continued long-term financial support of the Japan Energy Group. Should the Japan Energy Group withdraw its financial support at any time prior to the time the Company returns to profitability by either (i) enforcement of its rights under the terms of its revolving credit agreement in the event of possible future defaults by the Company related to covenants contained therein, (ii) failing to renew existing debt agreements as they expire or (iii) failing to provide additional credit as needed, the Company anticipates it will not be able to secure financing from other sources. In such a case, the Company will suffer a severe liquidity crisis and it will have difficulties settling its liabilities in the normal course of business. The majority of the year end cash on hand of $3,751,000 was at various international subsidiaries. With minor exceptions, all cash is freely remittable to the United States. On January 22, 1992, the Company's stock was excluded from further participation in the Nasdaq National Market system because it was unable to meet minimum capitalization requirements for continuation. Effective February 22, 1992, the Company's common stock began trading on the OTC electronic bulletin board. Upon completion of the $100,000,000 exchange of preferred stock for indebtedness on February 4, 1994, the Company met the minimum requirements for participation in the Nasdaq National Market system and was accepted into the system on March 18, 1994. The Company's common stock trades under the symbol ENCC. ITEM 8

ITEM 8 Financial Statements and Supplementary Data REPORT OF INDEPENDENT ACCOUNTANTS To the Shareholders and Directors of Encore Computer Corporation We have audited the consolidated financial statements and the financial statement schedules of Encore Computer Corporation and Subsidiaries listed in Item 14 (a) of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and the financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As discussed in Note L to the consolidated financial statements, Japan Energy Corporation and Gould Electronics Inc., a wholly owned subsidiary of Japan Energy Corporation (collectively, the "Japan Energy Group") has refinanced approximately $100 million of the Company's outstanding indebtedness and has committed to provide a working capital facility amounting to $50 million. The Company is dependent upon the support of the Japan Energy Group for its financing requirements. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Encore Computer Corporation and Subsidiaries as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. COOPERS & LYBRAND Coopers & Lybrand Miami, Florida February 25, 1994, except for Note L as to which the date is April 11, 1994. ENCORE COMPUTER CORPORATION Consolidated Statements of Operations (in thousands except per share data) Year Ended: December 31 , December 31, December 31, 1993 1992 1991 ----------- ---------- -------- Net sales: Equipment $ 43,622 $ 67,840 $ 81,272 Service 49,910 63,053 72,030 ------ ------ ------ Total 93,532 130,893 153,302 Costs and expenses: Cost of equipment sales 29,581 34,283 51,090 Cost of service sales 36,250 44,757 47,073 Research and development 23,331 22,333 30,543 Sales, general and administrative 42,499 45,156 48,732 Amortization of goodwill 691 1,660 1,770 Restructuring costs 23,265 5,248 29,032 ------- ------- ------- Total 155,617 153,437 208,240 ------- ------- ------- Operating loss (62,085) (22,544) (54,938) Interest expense, principally related parties (6,380) (7,425) (9,175) Interest income 134 263 561 Other expense, net (780) (2,077) (1,259) ------- ------ ------- Loss before income taxes (69,111) (31,783) (64,811) Provision for income taxes (Note H) 454 739 577 -------- -------- -------- Net loss $ (69,565) $ (32,522) $(65,388) ========== ========== ========= Net loss per common share (Note A): Net loss attributable to common shareholders $ (78,750) $ (36,993) $(68,107) Loss per common share $ (2.01) $ (0.98) $ (1.87) ========== ========== ========= Weighted average shares of common stock 39,273 37,899 36,466 ========== ========== ========= The accompanying notes are an integral part of the consolidated financial statements. The accompanying notes are an integral part of the consolidated financial statements. The accompanying notes are an integral part of the consolidated financial statements. Supplemental schedule of non-cash investing and financing activities: A. On January 28, 1991, the Company exchanged $60,000,000 of indebtedness, for among other things, preferred stock. Refer to Note G of Notes to Consolidated Financial Statements. B. On September 10, 1992, the Company exchanged indebtedness and redeemable preferred stock for, among other things, preferred stock. Refer to Note G of Notes to Consolidated Financial Statements. C. Accretion of the discount on Series C redeemable preferred stock for the years ended December 31, 1992 and 1991 was $721,000 and $746,000, respectively. D. Effective March 31, 1992, the Company's existing $50,000,000 revolving credit facility was converted to a term loan. Refer to Note G of Notes to Consolidated Financial Statements. The accompanying notes are an integral part of the consolidated financial statements. The accompanying notes are an intergral part of the consolidated financial statements. Notes to Consolidated Financial Statements A. Summary of Significant Accounting Policies Principles of Consolidation The accompanying financial statements include the accounts of Encore Computer Corporation and its wholly owned subsidiaries ("Encore" or the "Company"). All material intercompany transactions have been eliminated. Revenue Recognition Revenue related to equipment and software sales is recognized upon shipment. Service revenue is recognized over the term of the related maintenance agreements. Revenue related to contract research under U. S. government contracts is recognized as reimbursable costs are incurred. Such reimbursable costs include engineering and development costs incurred, outside procurements related to contract performance, and general and administrative costs. Cash and Cash Equivalents Cash equivalents consist of highly liquid investments with maturities at the date of purchase of three months or less. The Company maintains its cash in bank deposit accounts which, at times, may exceed insured limits. The Company has not experienced any losses related to these accounts. Inventories Inventories are stated at the lower of cost or market. Cost is determined by the first-in, first-out method. Loaned equipment which consists primarily of finished computer systems that are loaned to customers for test and evaluation is classified as inventory only if the equipment is intended for resale and anticipated to be in service for a period of less than 12 months prior to sale. Loaned equipment in service for more than 12 months is presented as property and equipment. Property and Equipment Property and equipment is stated at cost. Property and equipment includes customer service inventory which consists principally of spare parts utilized to support repairs at customer installations and is generally not available for resale. Additions, renewals and improvements are capitalized, and repair and maintenance costs are expensed. Upon retirement or sale, the cost of the assets disposed of and the related accumulated depreciation are removed from the accounts and any resulting gain or loss is reflected in the results of operations. Depreciation is provided on a straight line basis over the estimated lives of the assets, generally three years for loaned equipment, five years for equipment and customer service inventory, ten years for furniture and fixtures, and 25 to 30 years for buildings. Leasehold improvements are amortized over their expected useful lives or the lease term, whichever is shorter. Goodwill Goodwill originated from the 1989 acquisition of the Computer Systems Business of Gould Electronics Inc. (the "Computer Systems Business") and represented the excess of the acquisition cost over the estimated fair value of the net assets acquired. From 1989 until 1991, goodwill was being amortized on a straight line basis over a 10 year period. However in 1991, based on the operating losses incurred since the acquisition of the Computer Systems Business, the Company determined goodwill had been permanently impaired. Accordingly, the Company reduced its carrying value from $12,979,000 to $4,979,000 resulting in a charge of $8,000,000. In 1992, due to continuing operating losses, the Company reduced the amortization period for the remaining carrying value of goodwill to December 31, 1994. During 1993, due to the continued inability to achieve profitability, the remaining carrying value of goodwill of $2,628,000 was charged to operations. At December 31, 1992, accumulated amortization amounted to $6,379,000. Amortization of goodwill is presented as a component of operating expense. Capitalized Software The Company capitalizes certain internal costs associated with software development after the development projects reach technological feasibility. Such costs as well as capitalized costs for purchased software, are amortized to cost of sales at the greater of straight line amortization over the expected commercial life of each product, or the proportion of the current period's product revenues to total expected product revenues. The amortization periods range from 3 to 5 years. Software development costs incurred prior to reaching the point of technological feasibility are considered research and development costs and are expensed as incurred. Income Taxes The Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes", effective January 1, 1993, which requires the use of the liability method of accounting for deferred income taxes. Under this method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The adoption of SFAS No. 109 had no cumulative effect on income for the year ended December 31, 1993. Per Share Data Per share data is calculated based upon the weighted average number of shares of common stock and common stock equivalents outstanding. In fiscal periods which report net losses, the calculation does not include the effect of common stock equivalents such as stock options since the effect on the amounts reported would be antidilutive. Series A Convertible Participating Preferred Stock has been considered common stock (on an assumed converted basis) for purposes of income (loss) per share calculations. The Series B Convertible Preferred Stock ("Series B") and Series D Convertible Preferred Stock ("Series D") have been determined to be common stock equivalents but are not included in the weighted average number of shares of common stock and equivalents because the effect would be antidilutive for the years presented. During the year ended December 31, 1993, the Company reported a capital deficiency and as such under Delaware law was precluded from paying dividends. During 1993, the Company accumulated dividends of $3,630,000 and $5,554,700 on shares of its Series B and Series D, respectively. This increased the 1993 net loss attributable to common shareholders by $9,184,700. During the years ended December 31, 1992 and 1991, dividends were paid to holders of the Series B and the then outstanding Series C Redeemable Preferred Stock with shares of Series B. In computing the loss per share, these dividends increased the 1992 and 1991 loss as reported for the per share calculation by $3,943,100 and $2,719,400, respectively. Additionally, during the year ended December 31, 1992, dividends were paid to holders of the Series D with shares of Series D. In computing the loss per share, these dividends increased the 1992 loss as reported for the per share calculation by $528,300. Foreign Currency Translation and Transactions Management has determined that the functional currency of each of the Company's subsidiaries is the United States dollar. Consequently, assets and liabilities of foreign operations are translated into U.S. dollars at period end exchange rates, except that, inventory and property and equipment are translated at historical exchange rates. Income and expenses are translated at the average rates prevailing during the year, except that cost of sales and depreciation are translated at historical exchange rates. All gains and losses arising from changes in exchange rates are included in operating results in the period incurred. The Company, at times, enters into forward exchange contracts to reduce the effect of foreign currency fluctuations on operations and the asset and liability positions of foreign subsidiaries. Resultant gains and losses on these contracts are included in operating results when the operating revenues and expenses are recognized and for assets and liabilities in the period in which the exchange rates change. At December 31, 1993 and December 31,1992, however, the Company had no forward exchange contracts. Foreign exchange losses amounted to $744,000, $1,576,000, and $732,000 in 1993, 1992, and 1991, respectively. Warranties The Company provides a standard product warranty for parts and labor which generally extends ninety days from the date of installation, but on certain contracts for up to one year. The estimated cost of providing such warranty on products sold is included in cost of sales at the time revenue is recognized. Other Certain reclassifications have been made to conform prior year data to current year presentation. B. Inventories Inventories consist of the following (in thousands): December 31, December 31, 1993 1992 ----------- ----------- Purchased parts $ 4,660 $ 2,139 Work in process 9,618 11,913 Finished goods 1,065 601 Loaned computer equipment and consignment inventory 2,421 1,160 -------- -------- $ 17,764 $ 15,813 ======== ========= C. Prepaid Expense and Other Current Assets Prepaid expense and other current assets consist of the following (in thousands): December 31, December 31, 1993 1992 ----------- ------------ Deferred customer sponsored engineering costs $ 1,187 $ - Prepaid rent 266 365 Prepaid expenses 1,477 743 Other current assets 117 407 -------- ------- $ 3,047 $ 1,515 ======== ======= D. Property and Equipment Property and equipment consists of the following (in thousands): December 31, December 31, 1993 1992 ------------ ----------- Land $ 5,100 $ 7,510 Buildings 14,874 14,849 Equipment 38,110 34,478 Customer service inventory 15,245 23,541 Furniture and fixtures 3,503 4,082 Leasehold improvements 1,872 2,100 Loaned equipment 2,735 4,488 Construction in progress 496 1,060 ----------- ----------- 81,935 92,108 Less: accumulated depreciation and amortization (44,332) (45,793) ------------ ----------- $ 37,603 $ 46,315 ============= =========== Depreciation expense in 1993, 1992 and 1991 amounted to $9,853,000, $12,297,000, and $13,683,000, respectively. E. Capitalized Software Capitalized software consists of the following (in thousands): December 31, December 31, 1993 1992 ----------- ----------- Capitalized software $ 8,878 $ 6,735 Accumulated amortization (4,475) (2,778) -------- -------- $ 4,403 $ 3,957 ======= ======= Software costs capitalized in 1993, 1992, and 1991 amounted to $2,142,000, $2,365,000, and $2,640,000, respectively. Amortization of capitalized software costs charged to expense amounted to $1,696,000, $2,043,000, and $2,870,000 in 1993, 1992, and 1991, respectively. The Company wrote down the carrying value of several of its software products by $1,248,000 and $1,271,000 in 1992 and 1991, respectively as part of its transitioning of the UNIX-based product line (See Note F). F. Accounts Payable and Accrued Liabilities; Accounts payable and accrued liabilities consist of the following (in thousands): December 31, December 31, 1993 1992 ----------- ------------ Accounts payable $ 10,805 $ 10,476 Accrued salaries and benefits 5,357 6,290 Accrued restructuring costs 10,974 6,429 Accrued interest 682 2,950 Accrued taxes 3,545 2,083 Deferred income, principally maintenance contracts 1,563 1,306 Other accrued expenses 4,495 6,959 --------- ---------- $ 37,421 $ 36,493 ========= ========= During 1993, 1992, and 1991, the Company recognized restructuring expenses of $23,265,000 $5,248,000, and $29,032,000, respectively. In 1993, restructuring expenses related to (i) the recognition of the permanent impairment in value of certain long lived assets including fixed assets and goodwill, (ii) severance and outplacement costs associated with a 12% reduction in workforce, (iii) the accrual of costs to be incurred for field offices which have been or will be abandoned due to the reduced sales and service workforce. The 1993 charge includes approximately $12,000,000 of non-cash charges related to the write down of the carrying value of assets deemed permanently impaired. It is expected a significant portion of the accrued restructuring costs at December 31, 1993 will be paid during the first half of 1994. In 1992, the Company recognized restructuring costs relating to severance and outplacement costs associated with a reduction in workforce as well as the write-off of capitalized software and certain other assets as part of the Company's continued transition of its product line. Restructuring charges in 1991 relate to severance and outplacement costs associated with a reduction in workforce, the reduction in the carrying value of goodwill, costs associated with the consolidation of operations at the Marlborough, Massachusetts facility as well as other excess facilities, and the write-off of certain capitalized software products due to the transitioning of UNIX-based product lines. Of the total 1992 and 1991 charges, approximately $1,250,000 and $14,000,000, respectively were non-cash charges to operations. G. Debt Debt consists of the following (in thousands): Unaudited (See Note L) Pro Forma December 31, December 31, December 31, 1993 1993 1992 ------------ ----------- ----------- Debt to unrelated parties: Mortgages payable and capital lease obligations $ 1,192 $ 1,192 $ 1,406 Less: Current portion 197 197 193 ----------- ----------- ------------ Total long term debt to unrelated parties $ 995 $ 995 $ 1,213 =========== =========== =========== Debt to related parties: Revolving loan agreements with Gould Electronics Inc. $ 11,924 $ 61,924 $ 15,200 Term Loan with Gould Electronics Inc. - 50,000 50,000 ----------- ----------- ------------ Total debt to related parties 11,924 111,924 65,200 Less: Current portion of debt - - - ---------- ----------- ------------ Total long term debt to related parties $ 11,924 $ 111,924 $ 65,200 ========== =========== =========== Related Party Transactions The Company, Japan Energy Corporation ("Japan Energy"; formerly Nikko Kyodo Co., Ltd.) and its subsidiaries Gould Electronics Inc. (formerly Gould Inc.; "Gould") and EFI International Limited ("EFI") are related parties due to the significant financial interests of Gould and EFI of the Company. As of December 31, 1993, assuming full conversion of their holdings in the Company's preferred stock, Gould and EFI beneficially owned 34.4% and 27.6%, respectively of the Company's common stock. As discussed in more detail in Note L of the Notes to Consolidated Financial Statements, on February 4, 1994, the Company and Gould completed an exchange of indebtedness for preferred stock. Upon completion of the transaction assuming full conversion of their holdings, Gould and EFI beneficially owned 50.2% and 20.9%, respectively. As described below, during 1993 and 1992, the Company had various debt agreements with both Gould and EFI. Total interest expense on indebtedness to Gould for 1993, 1992 and 1991 was $6,082,000, $3,040,000 and $1,299,000, respectively. Interest expense on then outstanding indebtedness to EFI during 1992 was $1,726,000. In addition to the loans described above, amounts due to Gould at December 31, 1993 and 1992, included accrued interest of $677,000 and $2,822,000, respectively. Revolving Loan Agreements Since 1989, Gould has provided the Company with its revolving credit facility. Effective March 31, 1992, Gould converted the then existing revolving loan agreement with an outstanding balance of $50,000,000 to a term loan ("Term Loan") with a maturity date of March 31, 1994. Concurrently, Gould made available to the Company a new $10,000,000 revolving loan facility with a maturity date of March 31, 1993. Borrowings under the revolving loan agreement were collateralized by substantially all of Encore's tangible and intangible assets and the agreement contains various covenants including maintenance of cash flow, leverage and tangible net worth ratios and limitations on capital expenditures, dividend payments and additional indebtedness. In connection with the conversion, compliance with financial covenants contained in the revolving loan agreement was waived through the loan's maturity. As a result of operating losses incurred during 1992, Company borrowings exceeded the maximum allowed under the loan agreement. Accordingly, the Company initiated discussions with Gould to increase the amount available under the revolving credit facility. On October 5, 1992, Gould agreed to increase the borrowing limit by $5,000,000 to $15,000,000 under essentially the same terms and conditions as the original agreement. On April 12, 1993, the Company and Gould agreed to further increase the amount available under the revolving credit facility to $35,000,000 effective April 1, 1993 and to extend its maturity until April 16, 1994, under essentially the same terms and conditions as the original agreement. Additionally, Gould provided the Company with waivers of compliance with the covenants contained in the agreement through the end of the first fiscal quarter of 1994. In light of the 1993 refinancing, the revolving credit facility was classified as a long-term obligation at December 31, 1992. Due to the operating losses incurred during 1993, as of the end of its third fiscal quarter the Company had exceeded the $35,000,000 maximum borrowing amount of its revolving line of credit by $14,415,000. Gould allowed the Company to borrow funds in excess of the agreement's maximum limit to fund its daily operations. At December 31, 1993 borrowings under the agreement were $61,924,000. Interest is equal to the prime rate plus 1% (7.0% at December 31, 1993) and is payable monthly in arrears. As discussed in more detail in Note L, on February 4, 1994, the Company and Gould agreed to exchange $100,000,000 of indebtedness owed to Gould by the Company for Series E convertible preferred stock with a liquidation preference of $100,000,000. $50,000,000 of the debt exchanged was indebtedness under the revolving credit agreement. Upon completion of the exchange, borrowings under the revolving loan agreement on February 4, 1994 were $19,134,000 or $15,866,000 below the maximum borrowing limit of the credit facility. Further, on April 11, 1994, the Company and Gould agreed to increase the amount available under the revolving credit facility to $50,000,000 and to extend its maturity date to April 16, 1996. All other terms and conditions of the revolving loan agreement were essentially unchanged except for certain financial covenants contained in the agreement which were modified to more closely reflect the Company's current financial position. Because of the 1994 refinancing, the revolving credit facility was classified as a long-term obligation at December 31, 1993. Until the Company returns to a state of continued profitability it is unlikely that it will be able to secure additional funding from unrelated parties or be able to generate the levels of cash through operations necessary to meet the on-going needs of the business. Accordingly, the Company is and will remain dependent on the continued financial support of Japan Energy and Gould. Should the Company be unsuccessful in securing additional future financing from Gould or Japan Energy as it is required, it is likely that the Company will have difficulty settling its liabilities on a timely basis. Term Loan The Term Loan due to Gould provided for interest at a rate equal to the prime lending rate plus 1% (7.0% at December 31, 1993). The terms and conditions of the loan were similar to those of the revolving loan agreement described above. The loan is collateralized by substantially all of Encore's tangible and intangible assets and contains various covenants, including maintenance of cash flow, leverage, and tangible net worth ratios and limitations on capital expenditures, dividend payments and additional indebtedness. On April 12, 1993, the Company and Gould agreed to extend the maturity date of the loan to April 2, 1995. Additionally, Gould agreed to provide the Company with waivers of compliance with the covenants contained in the agreement through the end of the first fiscal quarter of 1994. As discussed in more detail in Note L, on February 4, 1994, the Company and Gould cancelled the indebtedness owed by the Company to Gould under the Term Loan agreement in exchange for Series E convertible preferred stock. In light of the 1994 recapitalization and refinancing, the term loan was classified as a long-term obligation at December 31, 1993. 1992 Exchange of Indebtedness and Redeemable Preferred Stock for Preferred Stock On September 10, 1992, Encore and EFI entered into an agreement whereby EFI exchanged $80,000,000 ($65,451,000 net of debt discount) of indebtedness owed to EFI under the then existing subordinated loan agreement for 800,000 shares of the Company's Convertible Preferred Series D Stock ("Series D") with an aggregate liquidation preference of $80,000,000. In addition, Gould exchanged all of its outstanding 100,000 shares of Series C Redeemable Preferred Stock ("Series C") with a liquidation preference of $10,000,000 for 100,000 shares of the Series D also with a liquidation preference of $10,000,000. The Company had originally issued the 100,000 shares of Series C as part of a 1991 exchange of indebtedness for preferred stock. The Series C was redeemable at its liquidation preference plus accumulated dividends on January 28, 1996 and entitled to 6% cumulative annual dividends, payable quarterly. The Series C was recorded at its fair value at the date of issuance and the difference between the fair value and the redemption amount was recorded as a deferred credit in "Other Liabilities". The carrying amount of the Series C was increased by periodic accretions using the interest method so that the carrying amount would equal the mandatory redemption amount at the redemption date. Accretion recognized for year ended December 31, 1992 was $721,000. In connection with this transaction, the Company released Gould from any liability associated with certain outstanding claims related to or arising from the 1989 sale by Gould of its Computer Systems Business to the Company, including: (i) reimbursement to the Company of certain foreign income tax payments made by the Company on Gould's behalf and (ii) release of any liability arising from certain potential environmental clean-up matters associated with former Gould facilities acquired by the Company. The scope of the clean-up matters has been reviewed by an independent environmental engineering firm and, in their opinion, present no significant liability to the Company. Because of the related party nature of this transaction, the difference between the carrying amount of the indebtedness exchanged and the fair value of the securities issued, other considerations granted and accrued professional fees associated with the transaction, the amount of $73,230,000 was credited to additional paid-in capital as follows (in thousands): Total indebtedness exchanged (net of unamortized debt discount) $ 65,451 Total Series C exchanged at redemption value (equivalent to carrying value plus deferred credit) 10,000 Estimated value of claims against Gould forgiven by the Company (1,120) Estimated transaction costs (500) Write-off of debt issue costs related to indebtedness exchanged (592) Par value of Series D exchanged (9) -------- Addition to paid-in capital $ 73,230 ======== H. Income Taxes As discussed in Note A the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes", effective January 1, 1993. The Company has recorded a provision of $454,000, $739,000 and $577,000 for the years ended 1993, 1992 and 1991 respectively. The provision relates to the profitable operations of foreign subsidiaries. Income tax benefits have not been recorded since the Company has fully reserved the tax benefit of temporary differences, operating losses, capital losses and tax credit carryforwards due to the fact that the likelihood of realization of the tax benefits cannot be established. The significant components of the deferred tax account as of December 31, 1993 were as follows: Deferred tax assets: Net Operating Losses $ 57,775,000 Research & ExperimentaL Credits 1,750,000 Capital Losses 3,622,000 Inventory Reserves 3,535,000 Accrued Vacation 847,000 Various Reserves/Other 1,266,000 Accrued Restructuring 2,372,000 ------------ 71,167,000 Valuation Allowance 69,924,000 ---------- 1,243,000 Deferred tax liabilities: Capitalized Software $ (1,243,000) -------------- Net $ - ============== For income tax purposes the Company had a change in ownership, as defined by Internal Revenue Code Section 382, in connection with the Gould debt exchange on January 28, 1991. The change in ownership resulted in an annual limitation of approximately $2,000,000 on the amount of net operating losses incurred prior to January 28, 1991 that can be utilized to offset the Company's future taxable income. At December 31, 1993, the Company has available approximately $30,000,000 of pre change net operating losses which are allowable after application of the Section 382 limitation, as well as post change net operating losses of $132,767,000. These net operating losses expire in the years 2005 through 2008. The Company also has a net capital loss carryforward of $12,937,000 related to the Gould debt exchange on January 28, 1991, which expires in 1996. I. Commitments and Contingencies Contract Research The Company has performed services under U.S. Government contracts to develop and deliver prototype multiprocessor systems and a workstation which utilize parallel processing architecture. The contracts, issued by the Department of Navy and the Department of the Army for the Defense Advanced Research Project Agency ("DARPA"), included fixed price and cost plus fixed fee elements. While the Company retains certain commercial rights to the technology developed under the contract, the government has been granted rights to technical data developed. In 1991, the Company assigned to Worcester Polytechnic Institute ("WPI") all proposals and advance agreements proposed by the Company to DARPA related to certain potential project awards. Additionally, the Company agreed to subcontract to WPI completion of certain other contracts previously awarded to the Company by DARPA. The Government has reimbursed the Company for pre-award costs incurred in connection with the assigned proposals. WPI will make available to the Company any technological developments which may result from any of the assigned projects. While the novations and/or subcontract agreements are subject to the approval of the affected U.S. government agencies, the Company does not believe this transaction will have an adverse effect on the Company's future financial performance. There were no contract research revenues in 1993. In 1992 and 1991, contract research revenues amounted to $42,000 and $2,719,000, respectively. Leases The Company leases office, research facilities, sales offices and equipment under operating leases. Certain land and building leases have renewal options generally for periods ranging from one to five years. Rental expenses, net of sublease income, were approximately $4,127,000, $5,768,000 and, $7,923,000 for the years ended 1993, 1992, and 1991, respectively. Future minimum lease payments under capital lease obligations and minimum rental payments under operating leases for the next five years are approximately as follows: (in thousands) Capital Operating Year Leases Leases 1994 $ 62 4,180 1995 42 2,453 1996 - 1,548 1997 - 951 1998 - 792 ------- ------- Total Minimum Lease Payments 104 $ 9,924 ======= Less: Amounts representing interest 7 ------- Present value of net minimum lease payments $ 97 ====== Future minimum rental income under noncancelable subleases extending through 1998 amounts to $888,000. Litigation There are no material pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the Company or any of its subsidiaries are party to or of which any of their property is the subject. The unfavorable settlement of any existing matter would not have an adverse impact on the financial results of the Company. Employer's Postemployment Benefits The Company has provided employee's with certain Company-paid postemployment benefits including salary continuation and job counseling services. The Company recognizes such costs on a terminal accrual basis recognizing the estimated cost of postemployment benefits at the date of the event giving rise to the liability to pay those benefits. Concentrations of Credit Risk Financial instruments which subject the Company to concentrations of credit risk are limited to trade receivables. The Company grants credit terms in the normal course of business to its customers which are consistent with industry practices. Generally, the Company's customers are United States government agencies or substantial international corporations often included among the Fortune 500. Additionally, as part of its ongoing control procedures, the Company monitors the credit worthiness of its major customers and establishes individual customer credit limits accordingly. Bad debts realized by the Company have historically not been excessive and doubtful accounts are adequately reserved when identified. Because of these facts, the concentration of credit risk in trade receivables is not considered to be material. Intellectual Property License As part of the 1991 exchange of preferred stock for indebtedness described in Note G, the Company and Gould entered into an intellectual property licensing agreement whereby the Company has agreed to license substantially all of its intellectual property to Gould under certain conditions. The intellectual property license is royalty free and provided that the Company achieved certain revenue levels, would not have allowed Gould to use the intellectual property until January, 1994. The Company has the option to extend its exclusivity period for up to five additional years by making certain cash payments to Gould. However, the period will be automatically extended if certain operating income levels are achieved by the Company. The intellectual property license can be terminated by the Company if all Gould borrowings are repaid and (i) the Series B and Series D are converted into common stock or (ii) the Series B and the Series D are redeemed or (iii) the Company pays Gould the fair value of the license. The Company has not achieved the net revenue or operating income levels necessary under the agreement to maintain its exclusive right to the use of the intellectual property. However, as part of the refinancing discussed in Note L, Gould has agreed to extend the Encore exclusivity period through December 31, 1994. Should the Company be unable to negotiate further extensions to its exclusivity period, Encore will lose its exclusive right to use the intellectual property and Gould may at its option begin to exercise its rights under the agreement. Such action by Gould could have a material adverse effect on the Company's business. J. Capital Stock Series A Convertible Participating Preferred Stock Certain of the Company's operations relate to classified U.S. Government contracts. Accordingly, the government expressed concern regarding the extent of Gould's ownership of the Company's common stock, since Gould, the Company's largest shareholder, is owned and controlled by Japan Energy, a foreign corporation. In this connection, the Company has issued to Gould 73,641 shares of Series A Convertible Participating Preferred Stock ("Series A") in lieu of common stock. The Company has agreed to reserve 7,364,100 shares of common stock for issuance to Gould upon exercise of the conversion option. The holder of Series A and the Company each have the option at any time, with 30 days prior notice, to convert or require to be converted, all or any portion of the Series A preferred shares to common at a ratio of 1 to 100. Dividend rights are equal to those of the common shares (on an assumed converted basis); however, there are significant restrictions on the voting rights of the Series A. The Series A is entitled to elect two members of the Board of Directors but is not entitled to participate in the election of other members of the Board. Based upon the characteristics and rights of the Series A, the Company has deemed these shares to be common stock (on an assumed converted basis) for purposes of loss per share calculations for the fiscal periods presented herein. Cumulative Series B Convertible Preferred Stock The Cumulative Series B Convertible Preferred ("Series B") has a 6% cumulative annual dividend payable quarterly, which the Company can accumulate or pay in additional shares of Series B (valued at its liquidation preference) until the Company's shareholders' equity exceeds $50,000,000. The Series B is convertible into the Company's common stock at $3.25 per share at the holder's option at any time and at the Company's option upon satisfaction of certain conditions. The shares are non-voting, except for the right to elect one director of the Company upon certain dividend payment defaults, the right to elect a majority of the directors of the Company if certain operating income levels are not achieved by the Company and the right to approve actions adversely affecting the Series B. The Series B may be redeemed by the Company at any time for cash equal to the liquidation preference plus accumulated dividends. The Company has reserved shares of common stock sufficient for issuance upon conversion of the Series B and additional shares of Series B which may be issued as a dividend. As of December 31, 1993, the number of common shares reserved for this purpose amounts to 19,320,769. During 1993, the Company reported a capital deficiency and under Delaware law was precluded from issuing dividends. Accordingly, the Company accumulated dividends during 1993 of $3,630,000. During 1992 the Company paid dividends of $3,943,100 in additional shares of Series B. A quarterly dividend on the Series B of $941,800 is payable on January 15, 1994. The Company has elected to accumulate this dividend. As discussed in more detail in Note L of the Notes to Consolidated Financial Statements, upon completion to the exchange of preferred stock for indebtedness, the Company eliminated its capital deficiency and paid all accumulated dividends in shares of Series B. Cumulative Series D Convertible Preferred Stock The Series D has a liquidation preference of $100 per share and carries a 6% cumulative annual dividend which the Company can elect to accumulate or pay currently. The Company may (i) pay the dividend in cash or additional shares of Series D valued at its liquidation preference until shareholders' equity exceeds $50,000,000, or (ii) pay the dividend in cash when shareholders' equity exceeds $50,000,000. The Series D is convertible, at the holder's option, into the Company's common stock at $3.25 per share only (a) if the shareholder is a United States citizen or a corporation or other entity owned in the majority by United States citizens or (b) in connection with an underwritten public offering. The stock is convertible, at the Company's option, if the price of the common stock exceeds $3.90 per share for twenty consecutive days and (a) a buyer is contractually committed to purchase for at least $3.90 per share at least 50% of the shares into which all outstanding Series D would be converted or (b) a buyer is contractually committed to purchase for at least $3.50 per share at least 75% of the shares into which all outstanding Series D would be converted. The shares are non-voting, except for the right to approve actions adversely affecting the Series D. The Company has reserved shares of common stock sufficient for issuance upon conversion of the Series D and additional shares of Series D which may be used for future stock dividends. As of December 31, 1993, the number of shares reserved for this purpose was 29,564,000. During 1993, the Company reported a capital deficiency and under Delaware law was precluded from issuing dividends. Accordingly, the Company accumulated dividends during 1993 of $5,554,700. Dividends of $528,300 were paid on the Series D for the year ended December 31, 1992. A quarterly dividend on the Series D of $1,441,200 is payable on January 15, 1994. The Company has elected to accumulate this dividend. As discussed in more detail in Note L of the Notes to Consolidated Financial Statements, upon completion of the exchange of preferred stock for indebtedness, the Company eliminated its capital deficiency and paid all accumulated dividends in shares of Series D. Impact of Foreign Ownership In connection with both the 1994 exchange of indebtedness for preferred stock discussed in Note L of the Notes to Consolidated Financial Statements and the 1993 and 1992 exchanges of indebtedness for preferred stock discussed in Note G of the Notes to Consolidated Financial Statements, the United States Defense Investigative Service ("DIS") has indicated that it has no objection to the relationships under the United States government requirements relating to foreign ownership, control or influence between Japan Energy Corporation (a Japanese corporation) and its wholly owned subsidiaries (EFI and Gould) and the Company. Shareholders' Agreement In conjunction with the 1994 exchange of Series E for indebtedness discussed in Note L of the Notes to Consolidated Financial Statements and the 1992 exchange of Series D for Series C and indebtedness discussed in Note G, the Company, Kenneth G. Fisher, the Company's Chairman, and Gould amended and restated an existing stockholders agreement. The agreement provides that as long as any shares of Series A are outstanding, Gould, in all elections of directors, will vote all of its common stock pro rata in accordance with the votes of the other shareholders of the Company. In addition, so long as the revolving credit facility with Gould is in effect, should Gould request it, Mr. Fisher has agreed to vote his common shares in favor of expanding the Board of Directors and electing an additional Gould representative to the Board. Adjustment of Accrued Transaction Costs In 1991, the Company exchanged preferred stock for indebtedness owed to Gould. In recording the exchange, the Company accrued estimated transaction costs of $1,812,000 to be incurred as part of the exchange. Actual costs incurred in connection with the exchange were less than those initially estimated and accrued. Accordingly, during 1992, the Company reduced the remaining accrued liability by $900,000 and increased additional paid-in capital. Stock Option and Stock Purchase Plans The Company has had two stock option plans, the 1983 Incentive Stock Option Plan (which expired in 1993) and the 1985 Non- Qualified Stock Option Plan. Under the terms of the plans a total of 12,000,000 shares of the Company's common stock were reserved for issuance to officers, directors and employees. On September 9, 1993, the shareholders voted to increase the number of shares reserved for issuance under the plan by 12,000,000 to a total of 24,000,000 shares. Stock option activity for the 1983 Incentive Stock Option Plan is as follows: Shares Under Option Shares Price Outstanding at December 31, 1990 176,380 $1.13 Fiscal 1991: Canceled (87,500) $1.13 -------- ----- Outstanding at December 31, 1991 88,880 $1.13 Fiscal 1992: No activity - $1.13 -------- ----- Outstanding at December 31, 1992 88,880 $1.13 Fiscal 1993: Exercised (88,880) $1.13 -------- ----- Outstanding at December 31, 1993 0 ======== Options granted under the Incentive Stock Option Plan were granted at exercise prices at least equal to the then current fair market value of the Company's common stock, and were immediately exercisable. Shares issued upon exercise of such options are subject to the Company's repurchase rights which expire ratably over three to five year periods from the date of grant, or automatically upon death or disability. Shares subject to such repurchase rights at the time of termination of employment may be purchased by the Company at the optionee's exercise price. At December 31, 1993, there were no incentive stock options outstanding under the plan. Stock Option activity for the 1985 Non-Qualified Stock Option Plan ("the 1985 Plan") is as follows: Shares Under Option Shares Price Outstanding at December 31, 1990 6,962,427 $0.63 to $3.13 Fiscal 1991: Granted 4,068,366 $0.69 to $1.88 Exercised (567,253) $0.81 to $2.31 Canceled (5,230,717) $0.63 to $3.13 ----------- -------------- Outstanding at December 31, 1991 5,232,823 $0.63 to $3.13 Fiscal 1992: Granted 6,181,530 $0.94 to $1.00 Exercised (352,248) $0.63 to $1.63 Canceled (227,122) $0.63 to $3.13 ----------- -------------- Outstanding at December 31, 1992 10,834,983 $0.63 to $2.31 Fiscal 1993: Granted 592,500 $1.50 to $4.00 Exercised (927,717) $0.63 to $2.00 Canceled (473,437) $0.63 to $2.31 ----------- -------------- Outstanding at December 31, 1993 10,026,329 $0.63 to $4.00 ========== ============== Exercise rights for options granted under the 1985 Plan vest over varying periods up to four years and options to purchase 6,138,280 shares were exercisable at December 31, 1993. Options granted under the 1985 Plan may be granted at an exercise price of not less than 50% of the current fair market value of the common stock. All options granted to date have been at the then current fair market value. During 1993, options granted in 1986 to Mr. Morley, an officer of the Company, were scheduled to expire if not exercised. However, at the time the options were scheduled to expire the Company's policy on insider trading effectively prevented Mr. Morley from exercising the options. Accordingly, the Board of Directors approved an extension of the expiration date until the options could be exercised and the underlying shares sold in accordance with Company policy, which is expected to occur during 1994. The extension has been treated as a cancellation of the old options and a grant of new options in the same amount at the same exercise price. A non-cash non-recurring charge of $788,000 was incurred in connection with the extension of the expiration date of such stock options. On January 31, 1991, the Board of Directors approved a program that permitted holders of certain stock options exercisable for shares of common stock, including the options granted during 1990 at a price of $2.00 per share, to exchange said options for new options (the "Exchange"). Under the terms of the Exchange, an individual was permitted to surrender his original option in exchange for a new option to purchase a number of shares equal to 80% of the number of shares subject to the original option at a new exercise price of $0.81 per share, such exercise price being equal to the closing price per share of the Company's common stock as reported on the National Market System of Nasdaq on February 1, 1991. The effective date of any new options granted pursuant to the Exchange was February 1, 1991; however, new options could not be exercised until June 1, 1991. Except as described above, the terms of the new options were substantially the same as those of the surrendered options. The amount of shares eligible for reissue under the exchange program was 5,306,340 of which 4,101,707 were canceled in exchange for new, repriced grants. In 1990, the shareholders approved the Employee Stock Purchase Plan and reserved 4,000,000 shares for issuance pursuant to rights granted under the Plan. On September 9, 1993, the shareholders voted to increase the number of shares reserved for issuance under the plan from 4,000,000 to 8,000,000. Substantially all employees are eligible to participate in the Employee Stock Purchase Plan. The purchase price per share of common stock in any offering under the Plan is the lower of (i) 85% of the closing price per share of common stock on the commencement of the offering or (ii) 85% of the closing price of a share of common stock on the termination of the offering. Each offering is for a period of approximately six months. Under the Plan, the Company issued 477,579 shares at a weighted average price of $1.56 in 1993, 815,411 shares at a weighted average price per share of $.86 in 1992 and 1,159,504 shares at a weighted average price of $0.64 per share in 1991. K. Segment Information The Company operates in a single industry segment which includes developing, manufacturing, marketing, installing and servicing business information processing systems, principally in the United States, Europe, the Far East, and Canada. In 1993, 1992, and 1991, no single customer accounted for as much as 10% of revenues. During 1993, 1992 and 1991 approximately 37%, 29%, and 33%, respectively, of its revenues were directly or indirectly derived from U.S. Government agencies. The Company maintains operations in Europe and Canada principally through consolidated subsidiaries. Far East operations are through joint ventures in Japan, Hong Kong and Malaysia and distributors throughout the remainder of the region. Information about the Company's operations for 1993, 1992, and 1991 is presented below (in thousands). Inter-geographic net sales, operating income and assets have been eliminated to arrive at the consolidated amounts. Net Sales to Inter- Identi- Unrelated Geographic Total Operating fiable Entities Net Sales Net Sales Income (loss) Assets 1993: United States $ 56,553 $ 11,664 $ 68,217 $ (55,443) $67,928 Europe 34,769 - 34,769 (7,554) 16,409 Other 2,210 - 2,210 (724) 686 -------- ------- ------- ------- ------- Geographic Total 93,532 11,664 105,196 (63,721) 85,023 Inter-Geographic - (11,664) (11,664) 1,636 (953) ------------ --------- -------- --------- -------- Total $ 93,532 $ - $ 93,532 $ (62,085) $84,070 United States $ 69,925 $ 24,232 $ 94,157 $ (19,658) $84,931 Europe 58,311 - 58,311 (4,316) 23,186 Other 2,657 728 3,385 ( 527) 918 ------ ------ ------- -------- ------- Geographic Total 130,893 24,960 155,853 (24,501) 109,035 Inter-Geographic - (24,960) (24,960) 1,957 (3,349) ------------ --------- -------- --------- -------- Total $ 130,893 $ - $130,893 $ (22,544) $105,686 1991: United States $ 86,984 $ 27,204 $114,188 $ (56,605) $ 90,125 Europe 61,291 - 61,291 1,039 35,053 Other 5,027 435 5,462 (899) 1,959 ------- ------ ------- ------- ------- Geographic Total 153,302 27,639 180,941 (56,465) 127,137 Inter-Geographic - (27,639) (27,639) 1,527 (5,951) ------------ --------- -------- --------- ---------- Total $ 153,302 $ - $153,302 $ (54,938) $ 121,186 Inter-geographic net sales are recorded principally at 60% of list price. Identifiable assets are all assets, including corporate assets, identified with operations in each region. L. Subsequent Events On February 4, 1994, Gould exchanged its term loan and a portion of its revolving credit loan totaling $100,000,000 for 1,000,000 shares of the Company's Series E Convertible Preferred Stock ("Series E") with a liquidation preference of $100,000,000 (See Note G). The principal terms of the Series E are: (i) The Series E is senior in liquidation priority to all other classes of the Company's preferred and common stock. (ii) 6% cumulative annual dividend which the Company can elect to (a) pay in additional shares of Series E valued at its liquidation preference until shareholders' equity exceeds $50,000,000 or (b) accumulate and pay in cash when shareholders' equity exceeds $50,000,000. (iii) a liquidation preference of $100 per share. (iv) convertible, at the holder's option, into the Company's common stock at the liquidation preference divided by $3.25 per share (subject to potential adjustments for splits, etc.) only (a) if the shareholder is a United States citizen or corporation or other entity owned in the majority by United States citizens or (b) in connection with an underwritten public offering. (v) convertible, at the Company's option in accordance with the conversion methodology described in (iv) above if the price of the common stock exceeds $3.90 per share for twenty consecutive days and (a) a buyer is contractually committed to purchase for at least $3.90 per share at least 50% of the shares into which all outstanding Series E would be converted or (b) a buyer is contractually committed to purchase for at least $3.50 per share at least 75% of the shares into which all outstanding Series E would be converted. (vi) non-voting, except for the right to approve actions adversely affecting the Series E. The accompanying unaudited Pro Forma Consolidated Balance Sheet as of December 31, 1993 is presented as if the transactions described above had been consummated as of that date. Because of the related party nature of the transaction, the difference between the carrying amount of the indebtedness exchanged and the fair value of the securities issued and other consideration granted has been credited to additional paid in capital. A summary of the financial effects of the transaction are as follows (in thousands): Reduction of debt $100,000 Less: Par value of shares issued (1,000,000 shares at $.01 par value) (10) Accrued transaction costs (700) Accrued interest on the remaining indebtedness under the revolving loan agreement for the remaining term of the agreement (1,043) --------- Increase in additional paid in capital $ 98,247 ======== Upon completion of the refinancing, the Company reported a capital surplus and was able to pay all dividends accumulated since January 15, 1993 and immediately did so in additional shares of preferred stock. Prior to the transaction, Japan Energy and its wholly owned subsidiaries beneficially owned 62.0% of the Company's outstanding common stock assuming the full conversion of all outstanding shares of its preferred stock. Upon completion of the transaction, their beneficial ownership increased to 71.1%. On April 11, 1994, the Company and Gould agreed to amend and restate the existing revolving loan agreement by increasing the maximum borrowing limit of the agreement to $50,000,000 and extending its maturity date to April 16, 1996. Other terms and conditions of the agreement are essentially unchanged except certain financial covenants contained in the agreement were modified to more closely reflect the Company's current financial position. Item 9

Item 9 Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. Not Applicable. PART III Item 10

Item 10 Directors and Executive Officers of the Registrant Information regarding directors of the Company is included in the Company's Proxy Statement for the 1994 Annual Meeting of Shareholders under the caption "Election of Directors" and is incorporated herein by reference. Information regarding executive officers of the Company is included in Part I under the caption "Executive Officers of the Registrant" and is incorporated herein by reference. ITEM 11

ITEM 11 Executive Compensation Information regarding Executive Compensation is included in the Company's Proxy Statement for the 1994 Annual Meeting of Shareholders under the caption "Executive Compensation" and is incorporated herein by reference. Item 12

Item 12 Security Ownership of Certain Beneficial Owners and Management Information regarding Security Ownership of Certain Beneficial Owners and Management is included in the Company's Proxy Statement for the 1994 Annual Meeting of Shareholders under the caption "Principal Stockholders" and is incorporated herein by reference. Item 13

Item 13 Certain Relationships and Related Transactions Information regarding Certain Relationships and Related Transactions is included in the Company's Proxy Statement for the 1994 Annual Meeting of Shareholders under the caption "Certain Transactions" and is incorporated herein by reference. PART IV Item 14

Item 14 Exhibits, Financial Statement Schedules and Reports on Form 8-K (a)1. and (a)2. Index to Financial Statements and Financial Statement Schedules Form 10-K Page Number Report of independent public accountants relating to consolidated financial statements and financial statement schedules 28 Consolidated statements of operations for the years ended December 31, 1993, 1992 and 1991 29 Consolidated balance sheets at December 31, 1993 and 1992 30 Consolidated statements of cash flows for the years ended December 31, 1993, 1992 and 1991 31 Consolidated statements of shareholders' equity (capital deficiency) for the years ended December 31, 1993, 1992, and 1991 33 Notes to consolidated financial statements 34-51 The following consolidated financial statement schedules are submitted herewith: Form 10-K Page Number Schedule V Property, plant and equipment 54 Schedule VI Accumulated depreciation, depletion and amortization of property, plant and equipment 55 Schedule VIII Valuation and qualifying accounts 56 Schedule X Supplementary income statement information 57 The consolidated financial statement schedules should be read in conjunction with the consolidated financial statements included herein. All other schedules have been omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and notes thereto. (a)3. Index to Exhibits The exhibits listed on the accompanying index to exhibits immediately following the consolidated financial statement schedules are filed as part of this report. (b) Reports on Form 8-K No reports on Form 8-K were filed during the last quarter of the year ended December 31, 1993. For purposes of complying with the amendments to the rules governing Form S-8 under the Securities Act of 1933, the undersigned registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into the registrant's Registration Statements on Form S-8 Nos. 33-34171 and 33-33907. Insofar as indemnification of liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by as director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by the appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. (1) Other changes for the year ended December 31, 1991 represent obsolete inventory charged to customer service cost of sales. Other changes for the year ended December 31, 1992 represent reclassifications from and to inventory. Other changes for the year ended December 31, 1993 consist principally of assets written off as part of restructuring actions taken during 1993 (See Note F of the Notes to Consolidated Financial Statements). (1) Other changes for the year ended December 31, 1992 represent reclassifications to inventory. Other changes for the year ended December 31, 1993 consist principally of assets written off as part of restructuring actions taken during 1993 (See Note F of the Notes to Consolidated Financial Statements). (1) Includes amounts deemed uncollectible. ENCORE COMPUTER CORPORATION Schedule X Supplementary income statement information (in thousands) Year Ended Year Ended Year Ended December 31, December 31, December 31, Item 1993 1992 1991 - ---------------------- ---------- ---------- -------- Maintenance and repairs $ 2,553 $ 2,172 $ 2,705 Advertising costs 4,132 1,828 2,950 Taxes other than payroll taxes 2,011 2,076 2,256 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned as the chief accounting officer and an officer of the registrant thereunto duly authorized. ENCORE COMPUTER CORPORATION (Registrant) By: T. MARK MORLEY T. Mark Morley Vice President, Finance and Chief Financial Officer April 11, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date - ----------------- --------------------- ------------- KENNETH G. FISHER Chairman of the Board Kenneth G. Fisher Chief Executive Officer April 11, 1994 ROWLAND H. THOMAS, JR. President and Chief Rowland H. Thomas, Jr. Operating Officer and Director April 11, 1994 C. DAVID FERGUSON C. David Ferguson Director April 11, 1994 ROBERT J FEDOR Robert J. Fedor Director April 11, 1994 DANIEL 0. ANDERSON Daniel O. Anderson Director April 11, 1994 T. MARK MORLEY Vice President, Finance T. Mark Morley and Chief Financial Officer April 11, 1994 KENNETH S. SILVESTEIN Kenneth S. Silverstein Corporate Controller April 11, 1994 (a)3. Index to Exhibits. The exhibit numbers in the following index correspond to the numbers assigned to such exhibits in the Exhibit Table of Item 601 of Regulation S-K. Exhibit No. Description 3.1 Certificate of Incorporation of the Company, as amended (incorporated herein by reference to the Company's Form 10-K for the year ended December 31, 1990) 3.1a Amendment to the Certificate of Incorporation filed with the Delaware Secretary of State on March 26, 1992 (incorporated herein by reference to Exhibit 3.1a to the Company's Form 10-K for the year ended December 31, 1991). 3.2 By-laws of the Company, as amended (incorporated herein by reference to Exhibit 3.2 to the Company's Form l0-K for the year ended December 31, 1989). *3.3 Amendment to the Certificate of Incorporation dated September 30, 1993 increasing the number of authorized common shares from 120,000,000 to 150,000,000. 4.1 Articles NINTH and TENTH of the Certificate of Incorporation of the Company, as amended, and Certificates of Stock Designation relating, respectively, to the Company's Series A Convertible Participating Preferred Stock, Series B Convertible Preferred Stock and Series C Redeemable Preferred Stock (see Exhibit 3.1). Incorporated herein by reference to the Company's Form 10-K for the year ended December 31,1990. 4.2 Article 1 of the By-laws of the Company, as amended (incorporated herein by reference to Exhibit 3.2 to the Company's Form 10-K for the year ended December 31,1989). 4.3 Certificate of Stock Designation relating to the Company's Series D Convertible Preferred Stock (incorporated herein by reference to Exhibit 4.3 to the Company's Form 10-K for the year ended December 31,1992). *4.4 Certificate of Stock Designation relating to the Company's Series E Convertible Preferred Stock. 10.1 The Company's 1983 Incentive Stock Option Plan, as amended (incorporated herein by reference to Exhibit 28.1 to the Company's Form S-8/Form S-3 Registration Statement No. 33-34171). 10.2 The Company's 1985 Non-Qualified Stock Option Plan, as amended (incorporated herein by reference to Exhibit 28.2 to the Company's Form S-8/Form S-3 Registration Statement No. 33-34171). 10.3 The Company's 1990 Employee Stock Purchase Plan as amended (incorporated herein by reference to the Company's Form S-8/Form S-3 Registration Statement No. 33-72458). 10.4 Form of Promissory Note and Pledge and Escrow Agreement between the Company and Mr. DiNanno (incorporated herein by reference to Exhibit 10.9 to the Company's Form 10-K for the year ended October 25, 1986). 10.5 Form of Indemnification Agreement between the Company and its executive officers (incorporated herein by reference to Exhibit 10.4 to the Company's Form 10-K for the year ended December 31, 1989). 10.6 Purchase Agreement dated as of March 20, 1989, among the Company, Gould Inc. and certain subsidiaries of Gould Inc. (incorporated herein by reference to Exhibit 2.1 to the Company's Form 8-K filed with the Commission on May 12, 1989, as amended by Form 8-S filed July 11, 1989 and February 7, 1990), as amended by an Agreement dated August 1, 1989, among the Company, Gould Inc. and Kenneth G. Fisher (incorporated herein by reference to Exhibit 10.8b to the Company's Form 10-K for the year ended December 31, 1989). 10.7a Master Purchase Agreement dated as of September 10, 1992, between the Company, Gould Inc. and EFI International Inc. (incorporated herein by reference to Exhibit 10.7a to the Company's Form 10-K for the year ended December 31,1992). *10.7b Master Purchase Agreement dated as of February 3, 1994 between the Company and Gould Electronics Inc. 10.8 Intellectual Property License Agreement dated as of January 28, 1991, among the Company, Encore Computer U.S., Inc. ("Encore U.S.") and Gould Inc. (incorporated herein by reference to Exhibit 10.9 of the Company's Form 10-K for the year ended December 31, 1990. 10.9a First Amendment to Amended and Restated Stockholder's Agreement among the Company, Gould Inc. and Kenneth G. Fisher dated March 31, 1992 (incorporated herein by reference to the Company's Form 10-K for the year ended December 31, 1991). *10.9.b Third Amendment to Amended and Restated Stockholders Agreement among the Company, Gould Electronics Inc. as assignee of Gould Inc. and Indian Creek Capital, Ltd as assignee of Kenneth G. Fisher dated February 3, 1994. 10.9c Amended and Restated Registration Agreement dated September 10, 1992, among Kenneth G. Fisher and his permitted transferees, the Company and Gould Inc. (incorporated herein by reference to Exhibit 10.9b to the Company's Form 10-K for the year ended December 31, 1992). 10.9d Second Amendment to Amended and Restated Stockholders Agreement among the Company, Gould Inc. and Kenneth G. Fisher dated September 10, 1992 (incorporated herein by reference to Exhibit 10.9c to the Company's Form 10-K for the year ended December 31, 1992). 10.9e Amended Agreement to the Revolving Loan Agreement among the Company and Gould Inc. and the Term Loan Agreement among the company and Gould Inc. dated April 12, 1993 (incorporated herein by reference to Exhibit 10.9d to the Company's Form 10-K for the year ended December 31, 1992). *10.9f Third Amended and Restated Registration Agreement dated February 3, 1994, among the Company, Gould Electronics Inc. as assignee of Gould Inc. and Indian Creek Capital, Ltd. as assignee of Kenneth G. Fisher. 10.11 Series B Convertible Stock Purchase Agreement dated January 28, 1991, between the Company and the Purchasers named therein (incorporated herein by reference to the Company's Form 10-K Exhibit 10.12 for the year ended December 31, 1990). 10.12 Acknowledgement of Cancellantion of Debt between the Company and EFI International Inc. dated September 10, 1992 (incorporated herein by reference to Exhibit 10.12 to the Company's Form 10-K for the year ended December 31, 1992). *10.12a Acknowledgement of Cancellation of Debt between the Company and Gould Electronics Inc. dated February 3, 1994. 10.13 Revolving Loan Agreement dated as of January 28, 1991, between the Company and Gould Inc. (incorporated herein by reference to the Company's Form 10-K Exhibit 10.13 for the year ended December 31, 1990). 10.13b Agreement to amend the Loan Agreement dated March 31, 1992 between the Company and Gould Inc. (incorporated herein by reference to the Company's Form 10-K Exhibit 10.13b for the year ended December 31, 1991). 10.13c The Amended and Restated Revolving Loan Agreement dated March 31, 1992 between Encore Computer Corporation and Gould Inc. (incorporated herein by reference to the Company's Form 10-K Exhibit 10.13c for the year ended December 31, 1991). 10.13d The Second Amended and Restated Revolving Loan Note dated March 31, 1992 between Encore Computer Corporation and Gould Inc. (incorporated herein by reference to the Company's Form 10-K Exhibit 10.13d for the year ended December 31, 1991). 10.13e The Renewal Term Notes dated March 31, 1992 between Encore Computer Corporation and Gould Inc. (incorporated herein by reference to the Company's Form 10-K Exhibit 10.13e for the year ended December 31, 1991). 10.13f Agreement to amend the Loan Agreement dated October 5, 1992 between the Company and Gould Inc. (incorporated herein by reference to Exhibit 10.13f to the Company's Form 10-K for the year ended December 31, 1992). *10.13g Amended Loan Agreement and related letter agreement dated April 11, 1994 between the Company and Gould Electronics Inc. 10.14 Amended and Restated General Security Agreement dated as of January 28, 1991, among the Company, Encore U.S. and Gould Inc. (incorporated herein by reference to the Company's Form 10-K Exhibit 10.14 for the year ended December 31, 1990). 10.15a Agreement of Encore Computer Corporation to Assign The Industrial Bank of Japan, Limited subordinated loan agreement to EFI International Inc. dated March 27, 1992 (incorporated herein by reference to the Company's Form 10-K Exhibit 10.15a for the year ended December 31, 1991). 10.15b Letter Agreement between Encore Computer Corporation and EFI International Inc. concerning the subordinated loan agreement dated March 31, 1992 (incorporated herein by reference to the Company's Form 10-K Exhibit 10.15b for the year ended December 31, 1991). 10.16 Memorandum of Agreement dated November 8, 1991 between Encore Computer Corporation and Worchester Polytechnic Institute to assign certain sales proposals to Worchester Polytechnic Institute (incorporated herein by reference to the company's Form 10-K Exhibit 10.16 for the year ended December 31, 1991). *10.17 Support Services Provider Agreement dated December 9, 1993 between Encore Computer Corporation and Halifax Corporation to subcontract certain customer service field maintenance activities to Halifax Corporation. *10.18 Amendment No. 1 to Nonqualified Stock Option Agreement between Encore Computer Corporation and T. Mark Morley dated November 10, 1993. *10.19 Description of the Company's Corporate Executive Compensation Plan *11.0 Calculation of Earnings per Share *22.0 Subsidiaries of the Company. *24.1 Consent of Independent Public Accountants. *Filed herewith.

201461_1993.txt

201461

1993

ITEM 1. BUSINESS City National Corporation (the Corporation) was organized in Delaware in 1968 to acquire the outstanding capital stock of City National Bank (the Bank). Because the Bank comprises substantially all of the business of the Corporation, references to the "Company" reflect the consolidated activities of the Corporation and the Bank. The Corporation owns all the outstanding shares of the Bank. The Bank, which was founded in 1953, conducts business in Southern California and operates 19 banking offices in Los Angeles County, two in Orange County, and one in San Diego County. In November 1993, the Bank closed one office in Los Angeles County and announced a consolidation plan to improve efficiency and operational productivity in its branch network. The streamlining will involve closures of five additional branches in Los Angeles County and one branch in Orange County, while also designating four of the remaining locations as regional lending centers. The Bank expects to complete the closures in early 1994. The Bank primarily serves middle-market companies, professional and business borrowers and associated individuals with commercial banking and fiduciary needs. The Bank provides revolving lines of credit, term loans, asset based loans, real estate secured loans, trade facilities, and deposit, cash management and other business services. Real estate construction lending has been substantially curtailed since late 1990. The Bank also operates an Investment Management and Trust Services Division offering personal, employee benefit and corporate trust and estate services, and deals in money market and other investments for its own account and for its customers. The Bank offers mutual funds and residential home mortgages in association with other companies. Effective January 1, 1991, the Bank entered into an agreement to subcontract with Systematics, Inc. (now Systematics Financial Services, Inc.) for applications software, computer operations and integration services. In December 1992, the Bank entered into an agreement to sell its data processing business, City National Information Services (CNIS), to Systematics, Inc. for $12.0 million. A pretax gain of $10.8 million, which is net of certain software licensing payments and programming expenses shared with Systematics, Inc. was recognized at closing, June 1, 1993. Effective January 1, 1993, the Bank sold its merchant credit card processing business and customer contracts to NOVA Information Systems, Inc., for $1.9 million. Competition The banking business is highly competitive. The Bank competes with domestic and foreign banks for deposits, loans and other banking business. In addition, other financial intermediaries, such as savings and loans, money market mutual funds, credit unions and other financial services companies, compete with the Bank. Non-depository institutions can be expected to increase the extent to which they act as financial intermediaries. Large institutional users and sources of credit may also increase the extent to which they interact directly, meeting business credit needs outside the banking system. Furthermore, the geographic constraints on portions of the financial services industry can be expected to continue to erode. Monetary Policy The earnings of the Bank are affected not only by general economic conditions, but also by the policies of various governmental regulatory authorities in the U.S. and abroad. In particular, the Board of Governors of the Federal Reserve System (Federal Reserve Board) exerts a substantial influence on interest rates and credit conditions, primarily through open market operations in U.S. government securities, varying the discount rate on member bank borrowings and setting reserve requirements against deposits. Federal Reserve Board monetary policies have had a significant effect on the operating results of financial institutions in the past and are expected to continue to do so in the future. SUPERVISION AND REGULATION Bank holding companies, banks and their non-bank affiliates are extensively regulated under both federal and state law. The following is not intended to be an exhaustive description of the statutes and regulations applicable to the Corporation's or the Bank's business. The description of statutory and regulatory provisions is qualified in its entirety by reference to the particular statutory or regulatory provisions. Moreover, major new legislation and other regulatory changes affecting the Corporation, the Bank, banking and the financial services industry in general have occurred in the last several years and can be expected to occur in the future. The nature, timing and impact of new and amended laws and regulations cannot be accurately predicted. Bank Holding Companies Bank holding companies are regulated under the Bank Holding Company Act (BHC Act) and are supervised by the Federal Reserve Board. Under the BHC Act, the Corporation files reports of its operations with the Federal Reserve Board and is subject to examination by it. The BHC Act requires, among other things, the Federal Reserve Board's prior approval whenever a bank holding company proposes to (i) acquire all or substantially all the assets of a bank, (ii) acquire direct or indirect ownership or control of more than 5% of the voting shares of a bank, or (iii) merge or consolidate with another bank holding company. The Federal Reserve Board may not approve an acquisition, merger or consolidation that would result in or further a monopoly, or may substantially lessen competition in any section of the country, or in any other manner would be in restraint of trade, unless the anticompetitive effects of the proposed transaction are clearly outweighed by the convenience and needs of the community. The BHC Act prohibits the Federal Reserve Board from approving a bank holding company's application to acquire a bank or bank holding company located outside the state where its banking subsidiaries' operations are principally conducted, unless such acquisition is specifically authorized by statute of the state where the bank or bank holding company to be acquired is located. California law permits bank holding companies in other states to acquire California banks and bank holding companies, provided the acquiring company's home state has enacted "reciprocal" legislation that expressly authorizes California bank holding companies to acquire banks or bank holding companies in that state on terms and conditions substantially no more restrictive than those applicable to such an acquisition in California by a bank holding company from the other state. The BHC Act also prohibits a bank holding company, with certain exceptions, from acquiring more than 5% of the voting shares of any company that is not a bank and from engaging in any activities without the Federal Reserve Board's prior approval other than (1) managing or controlling banks and other subsidiaries authorized by the BHC Act, or (2) furnishing services to, or performing services for, its subsidiaries. The BHC Act authorizes the Federal Reserve Board to approve the ownership of shares in any company, the activities of which have been determined to be so closely related to banking or to managing or controlling banks as to be a proper incident thereto. The Federal Reserve Board has by regulation determined that certain activities are closely related to banking within the meaning of the BHC Act. Consistent with its "source of strength" policy (see "Capital Adequacy Requirements," below), the Federal Reserve Board has stated that, as a matter of prudent banking, a bank holding company generally should not pay cash dividends unless its net income available to common shareholders has been sufficient to fund fully the dividends, and the prospective rate of earnings retention appears consistent with the company's capital needs, asset quality and overall financial condition. The Corporation ceased paying dividends in the third quarter of 1991. Dividend payments are expected to resume, based on achieved earnings, and when the Board of Directors determines that such payments are consistent with the long-term objectives of the Corporation. A bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with the extension of credit. The Federal Reserve Board may, among other things, issue cease-and-desist orders with respect to activities of bank holding companies and nonbanking subsidiaries that represent unsafe or unsound practices or violate a law, administrative order or written agreement with a federal banking regulator. The Federal Reserve Board can also assess civil money penalties against companies or individuals who violate the BHC Act or other federal laws or regulations, order termination of nonbanking activities by nonbanking subsidiaries of bank holding companies and order termination of ownership and control of a nonbanking subsidiary by a bank holding company. National Banks The Bank is a national bank and, as such, is subject to supervision and examination by the Office of the Comptroller of the Currency (OCC) and requirements and restrictions under federal and state law, including requirements to maintain reserves against deposits, restrictions on the types and amounts of loans that may be granted and the interest that may be charged, and limitations on the types of investments that may be made and services that may be offered. Various consumer laws and regulations also affect the Bank's operations. These laws primarily protect depositors and other customers of the Bank, rather than the Corporation and its shareholders. The laws and regulations affecting the Bank were significantly altered and augmented by the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA). "Brokered deposits" are deposits obtained by a bank from a "deposit broker" or that pay above-market rates of interest. Under FDICIA, only a well capitalized depository institution may accept brokered deposits without the prior approval of the Federal Deposit Insurance Corporation (FDIC). Banks that are not at least adequately capitalized cannot obtain such approval. For purposes of this provision, the capital category definitions are similar, but not identical, to the OCC's definitions of those categories for the purpose of requiring prompt corrective action. See "Capital Adequacy Requirements," below. Although the Bank sought, and received, the permission of the FDIC to accept brokered deposits in 1993, no such deposits have in fact been accepted. The Corporation's principal asset is its investment in, and its loans and advances to, the Bank. Bank dividends are one of the Corporation's principal sources of liquidity. The Bank's ability to pay dividends is limited by certain statutes and regulations. OCC approval is required for a national bank to pay a dividend if the total of all dividends declared in any calendar year exceeds the total of the bank's net profits (as defined) for that year combined with its retained net profits for the preceding two calendar years, less any required transfer to surplus. A national bank may not pay any dividend that exceeds its net profits then on hand after deducting its loan losses and bad debts, as defined by the OCC. The OCC and the Federal Reserve Board have also issued banking circulars emphasizing that the level of cash dividends should bear a direct correlation to the level of a national bank's current and expected earnings stream, the bank's need to maintain an adequate capital base and other factors. National banks that are not in compliance with regulatory capital requirements generally are not permitted to pay dividends. The OCC also can prohibit a national bank from engaging in an unsafe or unsound practice in its business. Depending on the bank's financial condition, payment of dividends could be deemed to constitute an unsafe or unsound practice. Under FDICIA, a bank may not, except under certain circumstances and with prior regulatory approval, pay a dividend if, after so doing, it would be undercapitalized. The Bank's ability to pay dividends in the future is, and could be further, influenced by regulatory policies or agreements and by capital guidelines. The Bank ceased paying dividends in the second quarter of 1991. Dividend payments were also restricted in 1993 by the terms of the Bank's Agreement with the OCC, which was terminated on January 21, 1994. See "Regulatory Agreements," below. Dividend payments are expected to resume, based on achieved earnings, and when the Board of Directors of the Bank determine that such payments are consistent with the long-term objectives of the Bank. The Bank's ability to make funds available to the Corporation is also subject to restrictions imposed by federal law on the Bank's ability to extend credit to the Corporation to purchase assets from it, to issue a guarantee, acceptance or letter of credit on its behalf (including an endorsement or standby letter of credit), to invest in its stock or securities, or to take such stock or securities as collateral for loans to any borrower. Such extensions of credit and issuances generally must be secured and are generally limited, with respect to the Corporation, to 10% of the Bank's capital stock and surplus. The Bank is insured by the FDIC and therefore is subject to its regulations. Among other things, FDICIA provided authority for special assessments against insured deposits and required the FDIC to develop a general risk-based assessment system. The insurance assessment is set forth in a schedule issued by the FDIC that specifies, at semiannual intervals, target reserve ratios for the Bank Insurance Fund designed to increase to at least 1.25% of estimated insured deposits in 15 years. During 1992, the assessment rate for all banks was 0.23% of the average assessment base. However, in October 1992, the FDIC adopted a risk-based assessment system under which insured institutions will be assigned to one of nine categories, based on capital levels and degree of supervisory concern. Depending on its category (which may not be disclosed without the permission of the FDIC), a bank's assessment now ranges from 0.23% to 0.31% of the base, effective January 1, 1993. Due to declines in total deposits, the increases in FDIC insurance assessment rates that became effective in July 1, 1992 and January 1, 1993 did not result in an increase in FDIC insurance assessment expense. FDICIA also contains numerous other regulatory requirements. Annual examinations are required for all insured depository institutions by the appropriate federal banking agency, with some exceptions. In December 1992, the Federal Reserve Board issued regulations under FDICIA requiring institutions to adopt policies limiting their exposure to correspondent institutions in relation to the correspondent's financial condition and, in particular, to limit exposure to any correspondent that is not adequately capitalized, as defined, to not more than 25% of the exposed institution's total capital. FDICIA also requires the banking agencies to review and, under certain circumstances, prescribe more stringent accounting and reporting standards than required by generally accepted accounting principles. In addition, FDICIA contains a number of consumer banking provisions, including disclosure requirements and substantive contractual limitations with respect to deposit accounts. Under FDICIA, institutions other than small institutions must prepare a management report stating management's responsibility for preparing the institution's annual financial statements, complying with designated safety and soundness laws and regulations and other related matters. The report also must contain an assessment by management of the effectiveness of internal controls over financial reporting and of the institution's compliance with designated laws and regulations. The institution's independent public accountant must examine, attest to, and report separately on, the assertions of management concerning internal controls over financial reporting and must apply procedures agreed to by the FDIC to test compliance by the institution with designated laws and regulations concerning loans to insiders and dividend restrictions. Banks and bank holding companies are also subject to the Community Reinvestment Act of 1977, as amended (CRA). CRA requires the Bank to ascertain and meet the credit needs of the communities it serves, including low- and moderate-income neighborhoods. The Bank's compliance with CRA is reviewed and evaluated by the OCC, which assigns the Bank a publicly available CRA rating at the conclusion of the examination. Further, an assessment of CRA compliance is also required in connection with applications for OCC approval of certain activities, including establishing or relocating a branch office that accepts deposits or merging or consolidating with, or acquiring the assets or assuming the liabilities of, a federally regulated financial institution. An unfavorable rating may be the basis for OCC denial of such an application, or approval may be conditioned upon improvement of the applicant's CRA record. In the case of a bank holding company applying for approval to acquire a bank or other bank holding company, the Federal Reserve Board will assess the CRA record of each subsidiary bank of the applicant, and such records may be the basis for denying the application. In the most recent completed examination, conducted in 1993, the OCC assigned the Bank a rating of "Satisfactory," the second highest of four possible ratings. From time to time, banking legislation has been proposed that would require consideration of the Bank's CRA rating in connection with applications by the Corporation or the Bank to the Federal Reserve Board or the OCC for permission to engage in additional lines of business. The Corporation cannot predict whether such legislation will be adopted, or its effect upon the Bank and the Corporation if adopted. The federal regulatory agencies recently issued proposed revisions to the rules governing CRA compliance. The proposed rules are intended to simplify CRA compliance evaluations by establishing performance-based criteria. The regulatory agencies have extended the time for comment on, and consideration of, the proposed rules, and management is unable to predict when, or in what form, such rules will be adopted, or the effect of the rules on the Bank's CRA rating. The OCC has enforcement powers with respect to national banks for violations of federal laws or regulations that are similar to the powers of the Federal Reserve Board with respect to bank holding companies and nonbanking subsidiaries. See "Bank Holding Companies," above. On December 21, 1993, an interagency policy statement was issued on the allowance for loan and lease losses (the Policy Statement). The Policy Statement requires that federally-insured depository institutions maintain an allowance for loan and lease losses (ALLL) adequate to absorb credit losses associated with the loan and lease portfolio, including all binding commitments to lend. The Policy Statement defines an adequate ALLL as a level that is no less than the sum of the following items, given the appropriate facts and circumstances as of the evaluation date: (1) For loans and leases classified as substandard or doubtful, all credit losses over the remaining effective lives of those loans. (2) For those loans that are not classified, all estimated credit losses forecast for the upcoming twelve months. (3) Amounts for estimated losses from transfer risk on international loans. Additionally, the Policy Statement provides that an adequate level of ALLL should reflect an additional margin for imprecision inherent in most estimates of expected credit losses. The Policy Statement also provides guidance to examiners in evaluating the adequacy of a bank's ALLL. Among other things, the Policy Statement directs examiners to check the reasonableness of ALLL methodology by comparing the reported ALLL against the sum of the following amounts: (a) 50 percent of the portfolio that is classified doubtful. (b) 15 percent of the portfolio that is classified substandard; and (c) For the portions of the portfolio that have not been classified (including those loans designated special mention), estimated credit losses over the upcoming twelve months given the facts and circumstances as of the evaluation date (based on the institutions's average annual rate of net charge-offs experienced over the previous two or three years on similar loans, adjusted for current conditions and trends). The Policy Statement specifies that the amount of ALLL determined by the sum of the amounts above is neither a floor nor a "safe harbor" level for an institution's ALLL. However, it is expected that examiners will review a shortfall relative to this amount as indicating a need to more closely review management's analysis to determine whether it is reasonable, supported by the weight of reliable evidence and that all relevant factors have been appropriately considered. The Company has reviewed the Policy Statement and believes that it will not have a material impact on the level of the Company's allowances for loan losses. Capital Adequacy Requirements Both the Federal Reserve Board and the OCC have adopted similar, but not identical, "risk-based" and "leverage" capital adequacy guidelines for bank holding companies and national banks, respectively. Under the risk-based capital guidelines, different categories of assets are assigned different risk weights, ranging from zero percent for risk-free assets (e.g., cash) to 100% for relatively high-risk assets (e.g., commercial loans). These risk weights are multiplied by corresponding asset balances to determine a risk-adjusted asset base. Certain off-balance sheet items (e.g., standby letters of credit) are added to the risk-adjusted asset base. The minimum required ratio of total capital to risk-weighted assets for both bank holding companies and national banks is presently 8%. At least half of the total capital is required to be "Tier 1 capital," consisting principally of common shareholders' equity, a limited amount of perpetual preferred stock and minority interests in the equity accounts of consolidated subsidiaries, less certain goodwill items. The remainder (Tier 2 capital) may consist of a limited amount of subordinated debt, certain hybrid capital instruments and other debt securities, preferred stock and a limited amount of the general loan-loss allowance. As of December 31, 1993, the Corporation had a ratio of Tier 1 capital to risk-weighted assets (Tier 1 risk-based capital ratio) of 15.75% and a ratio of total capital to risk-weighted assets (total risk-based capital ratio) of 17.06%, while the Bank had a Tier 1 risk-based capital ratio of 14.78% and a total risk-based capital ratio of 16.09%. The minimum Tier 1 leverage ratio, consisting of Tier 1 capital to average adjusted total assets, is 3% for bank holding companies and national banks that have the highest regulatory examination rating and are not contemplating significant growth or expansion. All other bank holding companies and national banks are expected to maintain a ratio of at least 1% to 2% or more above the stated minimum. As of December 31, 1993, the Corporation had a Tier 1 leverage ratio of 9.95%, and the Bank's Tier 1 leverage ratio was 9.38%. The OCC has adopted regulations under FDICIA establishing capital categories for national banks and prompt corrective actions for undercapitalized institutions. The regulations create five capital categories: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. The following table shows the minimum total risk-based capital, Tier 1 risk- based capital and Tier 1 leverage ratios, all of which must be satisfied for a bank to be classified as well capitalized, adequately capitalized or undercapitalized, respectively, together with the Bank's ratios at December 31, 1993: (1) A bank may not be classified as well capitalized if it is subject to a specific agreement with the OCC to meet and maintain a specified level of capital. (2) 3% for institutions having a composite rating of "1" in the most recent OCC examination. If any one or more of a bank's ratios are below the minimum ratios required to be classified as undercapitalized, it will be classified as substantially undercapitalized or, if in addition its ratio of tangible equity to total assets is 2% or less, it will be classified as critically undercapitalized. A bank may be reclassified by the OCC to the next level below that determined by the criteria described above if the OCC finds that it is in an unsafe or unsound condition or if it has received a less-than-satisfactory rating for any of the categories of asset quality, management, earnings or liquidity in its most recent examination and the deficiency has not been corrected, except that a bank cannot be reclassified as critically undercapitalized for such reasons. Under FDICIA and its implementing regulations, the OCC may subject national banks to a broad range of restrictions and regulatory requirements. A national bank may not pay management fees to any person having control of the institution, nor, except under certain circumstances and with prior regulatory approval, make any capital distribution if, after doing so, it would be undercapitalized. Undercapitalized banks are subject to increased monitoring by the OCC, are restricted in their asset growth, must obtain regulatory approval for certain corporate activities, such as acquisitions, new branches and new lines of business, and, in most cases, must submit to the OCC a plan to bring their capital levels to the minimum required in order to be classified as adequately capitalized. The OCC may not approve a capital restoration plan unless the bank's holding company guarantees that the bank will comply with it. Significantly and critically undercapitalized banks are subject to additional mandatory and discretionary restrictions and, in the case of critically undercapitalized institutions, must be placed into conservatorship or receivership unless the OCC and the FDIC agree otherwise. Under Federal Reserve Board policy, a bank holding company is expected to act as a source of financial strength to its subsidiary banks and to commit resources to support each such bank. In addition, a bank holding company is required to guarantee that its subsidiary bank will comply with any capital restoration plan required under FDICIA. The amount of such a guarantee is limited to the lesser of (i) 5% of the bank's total assets at the time it became undercapitalized, or (ii) the amount which is necessary (or would have been necessary) to bring the bank into compliance with all applicable capital standards as of the time the bank fails to comply with the capital restoration plan. A guaranty by the Corporation of a capital restoration plan for the Bank would result in a priority claim to the Corporation's assets ahead of the Corporation's other unsecured creditors and shareholders that would be enforceable even in the event of the Corporation's bankruptcy or the Bank's insolvency. Regulatory Agreements On November 18, 1992, the Bank entered into a written agreement with the OCC (the Agreement) with respect to capital and other matters described below, which replaced a memorandum of understanding dated June 26, 1991, between the Bank and the OCC. The Agreement required the Bank to generate through internal and external sources a minimum of $65 million in Tier 1 capital by June 30, 1993, so as to maintain a Tier 1 risk-based capital ratio of at least 10% and a Tier 1 leverage ratio of at least 7%. In June 1993, the Corporation completed an offering and sale of 12.7 million shares of common stock (the Offering) at a price of $6.375 per share. The gross proceeds of the Offering were $81.1 million before expenses of the issuance of $4.6 million. Upon completion of the Offering, the Corporation contributed $65 million in capital to the Bank to comply with the $65 million capital - raising requirement in the Agreement with the OCC. The Agreement also required the Bank to develop a three-year capital plan and a three-year business plan and continue to improve its policies and procedures in the lending and credit administration areas. Each of these requirements was successfully met prior to December 31, 1993. As a result, on January 21, 1994, the OCC lifted the Agreement. On February 24, 1993, the Corporation entered into a memorandum of understanding with the Federal Reserve Bank of San Francisco. The memorandum of understanding required the Corporation to submit to the Federal Reserve Bank a summary of measures to improve the Bank's financial condition and ensure the Bank's compliance with the Agreement, a plan to ensure the Corporation's maintenance of adequate consolidated capital levels commensurate with its risk profile, and quarterly progress reports. Under the memorandum of understanding, the Corporation was required to give prior notice to the Federal Reserve Bank of the declaration of any cash dividends or the incurrence of debt, other than operating expenses, and the Corporation was not permitted to repurchase any of its outstanding stock without the Federal Reserve Bank's prior approval. In February 1994, the Federal Reserve Bank of San Francisco notified the Corporation that the memorandum of understanding was lifted. ITEM 2.

ITEM 2. PROPERTIES The Company has its principal offices in the City National Bank Building, 400 North Roxbury Drive, Beverly Hills, California 90210, which the Bank owns and occupies. As of December 31, 1993, the Bank and its subsidiaries actively maintained premises composed of 22 banking offices, a computer center, a regional data capture center, a warehouse, and certain other properties. Since 1967, the Bank's Pershing Square Regional Office and a number of Bank departments have been the major tenant of the office building located at 600 South Olive Street in downtown Los Angeles. The building was originally developed and built by a partnership between a wholly-owned subsidiary of the Bank, Citinational Bancorporation, and Buckeye Construction Co. and Buckeye Realty and Management Corporation (two corporations then affiliated with Mr. Bram Goldsmith, Chairman of the Board and Chief Executive Officer of the Corporation and the Bank); since its completion, the building has been owned by Citinational-Buckeye Building Co., a limited partnership of which Citinational Bancorporation and Olive-Sixth Buckeye Co. are the only general partners, each with a 29% partnership interest. Citinational Bancorporation has an additional 3% interest as a limited partner of Citinational-Buckeye Building Co.; the remainder is held by other, unaffiliated limited partners. Olive-Sixth Buckeye Co. is a limited partnership of which Mr. Goldsmith is a 49% general partner; therefore, Mr. Goldsmith has an indirect 14% ownership interest in Citinational-Buckeye Building Co. The remaining general partner and all limited partners of Olive-Sixth Buckeye Co. are not affiliated with the Corporation. Since 1990, Citinational-Buckeye Building Co. has managed the building, which is expected to require capital investment of approximately $2.2 million over the next four years, the source of which is uncertain. The major encumbrance on real properties owned directly by the Bank or its subsidiaries is a deed of trust on the 600 South Olive Street building, securing a note in favor of City National Bank on which the unpaid balance at December 31, 1993, was $16,650,842. The Bank's subsidiary, Citinational Bancorporation, also owns two buildings located on Olympic Boulevard in downtown Los Angeles, approximately 80,000 square feet of which is subject to a lease between Citinational Bancorporation and Systematics Financial Services, Inc., that expires on December 31, 2000. Twenty additional branch locations throughout Southern California are leased by the Bank at annual rentals (exclusive of operating charges and real property taxes) of approximately $4,500,000, with expiration dates ranging from 1994 to 2016, exclusive of renewal options. The Northridge earthquake of January 17, 1994, resulted in damage to several of the Bank's facilities, of which two remain closed. Of these, one will be closed permanently as part of the Bank's branch restructuring, and the Bank is negotiating for alternate facilities to replace the other. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS The Corporation and its subsidiaries are defendants in various pending lawsuits claiming substantial amounts. Based on present knowledge, management and in-house counsel are of the opinion that the final outcome of such lawsuits will not have a material adverse effect upon the financial position or the future results of its operations. The Company is not aware of any material proceedings to which any director, officer or affiliate of the Company, any owner of record or beneficially of more than 5% of the voting securities of the Company, or any associate of any such director, officer or security holder is a party adverse to the Company or any of its subsidiaries or has a material interest adverse to the Company or any of its subsidiaries. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There was no submission of matters to a vote of security holders during the fourth quarter of the year ended December 31, 1993. EXECUTIVE OFFICERS OF THE REGISTRANT Shown below are names and ages of all executive officers of the Corporation and officers of the Bank who may be deemed to be executive officers of the Corporation, with indication of all positions and offices with the Corporation and the Bank. There was no family relationship among the executive officers. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The information regarding the market for the Corporation's Common Stock and related stockholder matters appearing under the caption "Market Data on Shares of Common Stock" on page 33 of the Corporation's Annual Report to Shareholders for the year ended December 31, 1993, is incorporated by reference in this Annual Report on Form 10-K. Information regarding restrictions on the Corporation's payment of dividends appearing under "Capital" and Note 12 to the consolidated financial statements of the Company and its subsidiaries, appearing on pages 20 and 49 respectively of the Corporation's Annual Report to Shareholders for the year ended December 31, 1993, are hereby incorporated by reference. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA The selected financial data for the five years ended December 31, 1993, appearing under "Selected Financial Information" on page 7 of the Corporation's Annual Report to Shareholders for the year ended December 31, 1993, is incorporated by reference in this Annual Report on Form 10-K. The Corporation's dividend payout ratio for 1990 and 1989 was 47.4% and 31.0%, respectively. Due to the Corporation's loss in 1991, the dividend payout ratio for 1991 is not meaningful. The Corporation did not pay any dividends in 1993 or 1992. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required by this item appearing on pages 8 through 33 of the Corporation's Annual Report to Shareholders for the year ended December 31, 1993, is incorporated by reference in this Annual Report on Form 10-K. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The consolidated financial statements of the Corporation and its subsidiaries and the notes thereto, and the condensed financial statements of the registrant (the Corporation), together with the report thereon of KPMG Peat Marwick dated January 21, 1994, appearing on pages 35 through 53, and the supplementary data under "1993 Quarterly Operating Results" and "1992 Quarterly Operating Results" on page 34 of the Corporation's Annual Report to Shareholders for the year ended December 31, 1993, together with the report of Price Waterhouse dated January 13, 1993, are incorporated by reference in this Annual Report on Form 10-K. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE The information required by this item appearing in Item 4 of the Registrant's Form 8-K/A dated August 25, 1993 is incorporated by reference in this Annual Report on Form 10-K. There were no disagreements with accountants on accounting and financial disclosure matters. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT To the extent not provided above, the information required by this item appearing under the captions "Election of Directors" and "Compliance With Section 16(a) of Securities Exchange Act of 1934" on pages 4 through 6 and 22 of the Registrant's Notice of Annual Meeting and Proxy Statement dated March 18, 1994, is incorporated by reference in this Form 10-K Annual Report. See "Executive Officers of the Registrant," above. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information required by this item regarding executive compensation appearing under the caption "Compensation of Directors and Executive Officers" on pages 7 through 18 of the Registrant's Notice of Annual Meeting and Proxy Statement dated March 18, 1994, is incorporated by reference in this Form 10-K Annual Report. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item appearing under the captions "Record Date and Number of Shares Outstanding; Security Ownership of Certain Beneficial Owners" and "Security Ownership of Management" on pages 2, 3 and 19 through 21 of the Registrant's Notice of Annual Meeting and Proxy Statement dated March 18, 1994, is incorporated by reference in this Form 10-K Annual Report. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item appearing under the captions "Compensation Committee Interlocks and Insider Participation" and "Certain Transactions with Management and Others" on page 14, 21 and 22 of the Registrant's Notice of Annual Meeting and Proxy Statement dated March 18, 1994, is incorporated by reference in this Form 10-K Annual Report. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this report: 3. Exhibits (listed by numbers corresponding to Exhibit Table of Item 601 in Regulation S-K) (b) During the calendar quarter ended December 31, 1993, the registrant did not file any current reports on Form 8-K. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. City National Corporation ------------------------- (Registrant) March 23, 1994 By /s/ Bram Goldsmith ------------------------ Bram Goldsmith, Chairman of the Board and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. INDEX TO EXHIBITS

26780_1993.txt

26780

1993

ITEM 1 - BUSINESS - ----------------- Dana Corporation, founded in 1905, is a global leader in engineering, manufacturing and marketing of products and systems for the worldwide vehicular, industrial and mobile off-highway original equipment markets and is a major supplier to the related aftermarkets. Dana is also a leading provider of lease financing services in selected markets. The Company's products include: drivetrain components, such as axles, driveshafts, clutches and transmissions; engine parts, such as gaskets, piston rings, seals, pistons and filters; chassis products, such as vehicular frames and cradles and heavy duty side rails; fluid power components, such as pumps, motors and control valves; and industrial products, such as electrical and mechanical brakes and clutches, drives and motion control devices. Dana's vehicular components and parts are used on automobiles, pickup trucks, vans, minivans, sport utility vehicles, medium and heavy trucks and off-highway vehicles. In 1993, sales to this segment accounted for 82% of Dana's total sales. The Company's industrial products include mobile off-highway and stationary equipment applications. Sales to this segment amounted to 18% of the Company's 1993 total sales. "Business Segments" at pages 31 and 32 of Dana's 1993 Report to Shareholders ("1993 Annual Report") is incorporated herein by reference. GEOGRAPHICAL AREAS - ------------------ To serve its global markets, Dana has established regional operating organizations in North America, Europe, South America and Asia/Pacific, each with management responsibility for its specific geographic markets. The Company's significant international operations are located in the following countries: Argentina, Australia, Brazil, Canada, China, Columbia, France, Germany, India, Italy, Korea, Mexico, Netherlands, Singapore, Switzerland, Taiwan, Thailand, United Kingdom and Venezuela. Most of Dana's international subsidiaries and affiliates manufacture and sell vehicular and industrial products similar to those produced by Dana in the United States. Consolidated international sales were $1.3 billion, or 24% of the Company's 1993 sales. Including U.S. exports, international sales accounted for 31% of 1993 consolidated sales. International operating income was $97 million, or 21% of consolidated 1993 operating income. In addition, there was $13 million of equity in earnings from international affiliates in 1993. Dana believes the regional operating organizations have positioned the Company to profitably share in the anticipated long-term growth of the worldwide Vehicular and Industrial markets. The Company intends to increase its involvement and investment in international markets in the coming years. "Geographic Areas" at page 33 of Dana's 1993 Annual Report is incorporated herein by reference. Sales in the Financial Holdings segment consisted of real estate sales and did not exceed 1% of consolidated sales for 1991, 1992 or 1993. Financial Holdings revenues (amounting to less than 5% of Dana's consolidated 1993 total revenues) have been excluded from this market analysis. CUSTOMER DEPENDENCE - ------------------- The Company has thousands of customers and enjoys long-standing business relationships with many of these customers. The Company's attention to price, quality, delivery and service has been recognized by numerous customers who have awarded the Company supplier quality awards. Ford and Chrysler were the only customers accounting for more than 10% of the Company's net sales in 1993. The Company has been supplying product to Ford, Chrysler and their divisions for many years. Sales to Ford, as a percentage of the Company's net sales, were 15%, 17% and 18% in 1991, 1992, 1993, respectively. Sales to Chrysler, as a percentage of net sales, were 8%, 9% and 11% in 1991, 1992, and 1993, respectively. Loss of all or a substantial portion of the Company's sales to Ford, Chrysler or other large vehicle manufacturers, would have a significant adverse effect on the Company's financial results until this lost sales volume could be replaced. This event is considered unlikely in the ordinary course of business and would most likely occur only in the event of a major business interruption such as a prolonged strike at one of the Company's customers. MATERIALS - --------- The Company normally does not experience raw material shortages within its operations. Most raw materials and semi-processed or finished items are purchased within the operating regions. Temporary shortages of a particular material or part may occasionally occur, but the various Dana units basically buy from a number of capable, long-term suppliers. SEASONALITY - ----------- Dana's businesses are not considered to be seasonal. BACKLOG - ------- The majority of Dana's products are not on a backlog status. They are produced from readily available materials such as steel and have a relatively short manufacturing cycle. Each operating unit of the Company maintains its own inventories and production schedules. Nearly all products are available from more than one facility. Production capacity is either adequate to handle current requirements or will be expanded to handle anticipated growth in certain product lines. COMPETITION - ----------- In its Vehicular and Industrial products segments, the Company competes worldwide with a number of other manufacturers and distributors which produce and sell similar products. These competitors include vertically-integrated units of the Company's major vehicular OEM customers as well as a large number of independent domestic and international suppliers. The competitive environment in these segments has changed dramatically in the past few years as the Company's traditional United States OEM customers, faced with substantial international competition, have expanded their worldwide sourcing of components. In order for Dana to compete both domestically and internationally with suppliers, the Company has established operations in several regions of the world so that Dana can be a strong global supplier of its core products. In the Financial Holdings segment, the Company's primary focus is on leasing activities. The Company's competitors include national and regional leasing and finance organizations. STRATEGY - -------- In the Vehicular and Industrial products segments, the Company is actively pursuing three broad strategies. The first of these strategies is to increase the Company's involvement and investment in its international markets. The Company has developed a well-defined regional organization in support of this initiative and has competed in world markets for nearly 70 years. The Company has been in Japan for two decades and is well established throughout Europe, South America, and the Asia/Pacific region. In 1993, international sales, including exports from the United States, totaled 31% of net sales. The Company's long-term goal is to derive 50% of its net sales (including exports) from customers outside the United States. Although subject to certain risks, the Company believes broadening its international sales will enable it to offset potential adverse effects of economic downturns in specific countries, source product from the areas of the world which offer the lowest cost, and provide it access to markets which have the greatest growth potential. STRATEGY (continued) - -------- The Company's second long-term strategic objective is to increase its distribution sales to 50% of net sales. The Company believes that distribution sales are less cyclical than original equipment sales and offer long-term growth potential. To date, the Company has consistently expanded its distribution business by increasing market penetration and broadening its product offerings through internal growth and acquisition. In 1993, the Company's distribution sales were 37% of net sales. The Company's third objective is to increase its share of its OEM customers' global component purchases. To accomplish this objective, the Company is focusing on meeting OEM customers' needs in each of the local markets in which they operate, both through exports and by locating manufacturing facilities in markets where key OEM customers have assembly plants. PATENTS AND TRADEMARKS - ---------------------- Dana's proprietary drivetrain, engine parts, chassis, fluid power systems, and industrial power transmission product lines have strong identities worldwide in the Vehicular and Industrial markets which Dana serves. Throughout these product lines, Dana owns or is licensed to manufacture and/or sell its products under a number of patents and trademarks. These patents, trademarks and licenses have been obtained over a period of years and expire at various times. Dana considers each of them to be of value and aggressively protects its rights throughout the world against infringement. Because the Company is involved with many product lines, the loss of any particular patent, trademark, or license would not materially affect the sales and profits of the Company. RESEARCH AND DEVELOPMENT - ------------------------ Dana's facilities engage in engineering, research and development, and quality control activities to improve the reliability, performance and cost-effectiveness of Dana's existing Vehicular and Industrial products and to design and develop new products for both existing and anticipated applications. To promote efficiency and reduce development costs, Dana's research and engineering people work closely with original equipment manufacturing customers on special product and systems designs. Dana's consolidated worldwide expenditures for engineering, research and development, and quality control programs were $102 million in 1991, $108 million in 1992 and $120 million in 1993. EMPLOYMENT - ---------- Dana's worldwide employment (including consolidated subsidiaries and affiliates) was 36,000 at December 31, 1993. CASH FLOWS - ---------- Dana experiences increases or decreases in cash flows as sales volumes fluctuate in the Vehicular or Industrial business segments. Cash balances are utilized from time to time to purchase additional fixed assets, for acquisitions of new businesses or product lines, for investments and to retire debt. The "Statement of Cash Flows" on page 21 of Dana's 1993 Annual Report is incorporated herein by reference. ENVIRONMENTAL COMPLIANCE - ------------------------ The Company makes capital expenditures in the normal course of business, as necessary, to ensure that its facilities are in compliance with applicable federal, state and local environmental laws and regulations. Costs of environmental compliance did not have a materially adverse effect on the Company's capital expenditures, earnings or competitive position in 1993, and the Company currently does not anticipate future environmental compliance costs to be material. None of the above officers has a family relationship with any other officer or with any director of Dana. There are no arrangements or understandings between any of the above officers and any other person pursuant to which he was elected an officer of Dana. Officers are elected annually at the first meeting of the Board of Directors after the Annual Meeting of Shareholders. The first five officers and Mr. Strobel have employment agreements with the Company. ITEM 2

ITEM 2 - PROPERTIES - ------------------- Dana owns the majority of the manufacturing facilities and the larger distribution facilities for its Vehicular and Industrial products. A few manufacturing facilities and most of the Company's smaller distribution outlets, service branches, and offices are leased. The facilities, in general, are well-maintained and adapted to the operations for which they are being used, and their productive capacity is adjusted and expanded as required by market and customer growth. On a geographic basis, Dana's facilities (including those of consolidated subsidiaries and affiliates) are located as follows: ITEM 3

ITEM 3 - LEGAL PROCEEDINGS - -------------------------- The Company and its consolidated subsidiaries are parties to various pending judicial and administrative proceedings arising in the ordinary course of business, including those arising out of alleged defects in the Company's products and alleged violations of various environmental laws (including the federal "Superfund" law). Some of the environmental proceedings involve claims for damages and/or potential monetary sanctions. Management and its legal counsel periodically review the probable outcome of pending legal proceedings, the costs and expenses reasonably expected to be incurred, the availability and limits of the Company's insurance coverage, and the Company's established reserves for uninsured liabilities. While the outcome of these proceedings cannot be predicted with certainty, management believes, based on these reviews, that any liabilities that may result from these proceedings are not reasonably likely to have a material effect on the Company's liquidity, financial condition or results of operations. Included among the foregoing proceedings is the following: IN THE MATTER OF DANA CORPORATION - VICTOR PRODUCTS DIVISION AND BRC RUBBER GROUP. This administrative proceeding was brought in 1990 by the United States Environmental Protection Agency ("USEPA") in Region V, Chicago. USEPA alleges that the Company's former plant in Churubusco, Indiana (which ceased operations in 1983) violated the federal Resource Conservation and Recovery Act ("RCRA") by failing to submit a closure plan and financial assurances as a RCRA-regulated storage facility and by failing to notify the subsequent plant owner (Bluffton Rubber Company or "BRC") of the storage facility's alleged RCRA status. USEPA seeks to require a RCRA closure of the storage facility and to recover civil penalties of approximately $77,000 from the Company and $55,000 from BRC. The Company has agreed to indemnify BRC for liabilities asserted against BRC arising from alleged RCRA violations during the Company's operation of the storage facility. In June 1992, the Company submitted a settlement proposal to USEPA containing a plan to sample the soil at the storage facility site to establish that no contaminants have been released from materials that the Company stored there. In June 1993, the Indiana Department of Environmental Management ("IDEM"), on behalf of USEPA, notified the Company of its determination that the sampling plan is inadequate. IDEM also issued a Notice of Deficiency with respect to the Company's closure of the storage facility. The Company believes that the Notice of Deficiency imposes obligations which go beyond the appropriate scope of RCRA closure and has initiated discussions with IDEM about the sampling program and the Notice of Deficiency, and with USEPA about the penalty phase of the administrative hearing. ITEM 4

ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ------------------------------------------------------------ No matters were submitted to a vote by Dana's security holders during the fiscal fourth quarter. PART II ITEM 5

ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS - ------------------------------------------------------------------------------ Dana's common stock is listed on the New York, Pacific, and International (London) Stock Exchanges. On February 17, 1994, there were approximately 25,600 shareholders of record. Dividends have been paid on the common stock every year since 1936. Quarterly dividends have been paid since 1942. Management currently anticipates that dividends will continue to be paid in the future. "Additional Comments - Shareholders' Investment" at page 42 of Dana's 1993 Annual Report is incorporated herein by reference. ITEM 6

ITEM 6 - SELECTED FINANCIAL DATA - -------------------------------- "Eleven Year History - Financial Highlights" at page 43 of Dana's 1993 Annual Report is incorporated herein by reference. ITEM 7

ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND - ------------------------------------------------------------------------ RESULTS OF OPERATIONS - --------------------- "Management's Discussion and Analysis of Results" at pages 35-36 of Dana's 1993 Annual Report is incorporated herein by reference. ITEM 8

ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - ---------------------------------------------------- The financial statements, together with the report thereon of Price Waterhouse dated February 13, 1994, at pages 18-34 of Dana's 1993 Annual Report and "Unaudited Quarterly Financial Information" at page 42 of Dana's 1993 Annual Report are incorporated herein by reference. ITEM 9

ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND - ------------------------------------------------------------------------ FINANCIAL DISCLOSURE - -------------------- - None - PART III ITEM 10

ITEM 10 - DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - ------------------------------------------------------------ Information regarding Dana's directors and executive officers is set out in Part I, Item 1 of this Form 10-K and in Dana's Proxy Statement dated March 4, 1994 for the Annual Meeting of Shareholders to be held on April 6, 1994 (the "1994 Proxy Statement"). "Election of Directors" and "Compliance with Section 16(a) of the Exchange Act" from the 1994 Proxy Statement are incorporated by reference. ITEM 11

ITEM 11 - EXECUTIVE COMPENSATION - -------------------------------- "The Board and Its Committees" and "Executive Compensation" from Dana's 1994 Proxy Statement are incorporated herein by reference. ITEM 12

ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - ------------------------------------------------------------------------ "Stock Ownership" from Dana's 1994 Proxy Statement is incorporated herein by reference. ITEM 13

ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - -------------------------------------------------------- "Other Transactions" from Dana's 1994 Proxy Statement is incorporated herein by reference. Report of Independent Accountants on Financial Statement Schedules To the Board of Directors of Dana Corporation Our audits of the consolidated financial statements referred to in our report dated February 13, 1994, appearing on page 18 of the 1993 Annual Report to Shareholders of Dana Corporation (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules (Schedules V, VI, VIII and X) listed in Item 14(a) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. PRICE WATERHOUSE Toledo, Ohio February 13, 1994 DEPRECIATION: Depreciation for the more important groups of property purchased or constructed by the Company is based on the following service lives: DANA CORPORATION AND CONSOLIDATED SUBSIDIARIES ---------------------------------------------- SUPPLEMENTARY INFORMATION TO FINANCIAL STATEMENTS ------------------------------------------------- EMPLOYEE STOCK OPTION PLANS - --------------------------- The Company has in effect two stock option plans for employees which were approved by the shareholders in 1977 and 1982. The 1982 Plan was amended with shareholder approval in 1988 and 1993. These plans authorize the grant of options and/or stock appreciation rights ("SARs") to key employees to purchase 3,000,000 and 5,950,000 shares, respectively, of common stock at exercise prices no less than 85% of the market value of such stock at date of grant; the exercise periods may extend for no more than ten years from date of grant. All options and SARs granted to date under these two plans have been granted at 100% of the market value of the Company's common stock at the date of grant. The number of shares above and all references below to the number of shares and per share prices have been adjusted for all stock dividends and distributions subsequent to the dates the plans were approved by the shareholders, including the October 10, 1983 three-for-two stock split. At December 31, 1993, there were 3,291,278 shares available for future grants under the 1982 Plan, as amended. No shares have been available for grants under the 1977 Plan since 1987, and there were no SARs outstanding at December 31, 1993. The following table sets forth (1) the aggregate number of shares of the Company's common stock subject at December 31, 1993, to outstanding options, (2) the average exercise prices per share of such options, (3) the aggregate exercise prices of such options, (4) the ranges of expiration dates of such options, and (5) the aggregate market values of such shares at February 17, 1994, based on $58.38 per share, the closing sales price in the New York Stock Exchange Composite Transactions Index as reported in THE WALL STREET JOURNAL: At December 31, 1993, 1,093 employees of the Company and its subsidiaries and affiliates held exercisable options under the Company's stock option plans, consisting of 276 employees under the 1977 Plan and 817 employees (some of whom also held options under the 1977 Plan) under the 1982 Amended Plan. EMPLOYEES' STOCK PURCHASE PLAN - ----------------------------- With respect to the Company's Amended Employees' Stock Purchase Plan, as of December 31, 1993, 27,500 employees of the Company and its subsidiaries were eligible to participate. Of such employees, 6,733 were participating at December 31, 1993. NON-EMPLOYEE DIRECTORS' STOCK OPTION PLAN - ----------------------------------------- In 1993, the shareholders approved a stock option plan for non-employee Directors of the Company. The plan provides for the granting of options to purchase the Company's common stock at prices equal to the market value of the stock at the date of grant. The options are exercisable after one year for a period not to exceed ten years from the date of grant. In 1993, options were granted for 10,500 shares at an exercise price of $48.50 per share. The expiration date of the options is 4/19/03. At December 31, 1993, no stock options were exercisable and there were 54,500 shares available for future grant. At February 17, 1994, the aggregate exercise price of options outstanding under the Plan was $509,300 and the aggregate market value of those options was $613,000. DANA CORPORATION AND CONSOLIDATED SUBSIDIARIES ---------------------------------------------- SUPPLEMENTARY INFORMATION TO FINANCIAL STATEMENTS ------------------------------------------------- COMMITMENTS AND CONTINGENCIES - ----------------------------- As discussed on page 27 of the 1993 Annual Report under the comments on "Commitments and Contingencies," the Company and its consolidated subsidiaries are parties to various legal proceedings (judicial and administrative) arising in the normal course of business, including proceedings which involve environmental and products liability claims. With respect to environmental claims, the Company is involved in investigative and/or remedial efforts at a number of locations, including "on-site" activities at currently or formerly owned facilities and "off-site" activities at Superfund sites where the Company has been named as a potentially responsible party. Based on currently available facts, existing technology, and presently enacted environmental laws and regulations, the Company estimates that it will incur costs of approximately $38 million in connection with these actions, including the costs of investigation and remediation and administrative and legal expenses. This amount has been recorded in the accounts net of probable recoveries of $6 million from insurance and other sources. If circumstances change, these estimates may change. With respect to product liability claims, from time to time the Company is named in proceedings involving alleged defects in its products. Currently included in such proceedings are a large number of claims (most of which are relatively small) based on alleged asbestos-related personal injuries. At December 31, 1993, 20,000 such claims were outstanding, of which 9,600 were subject to pending settlement agreements. The Company has agreements with its insurance carriers providing for the payment of substantially all of the indemnity costs and the legal and administrative expenses for these claims. The Company is also a party to a small number of asbestos-related property damage proceedings. The Company's insurance carriers are paying the major portion of the defense costs in connection with such cases, and the Company has incurred no indemnity costs to date. The Company estimates that its total liability for product liability claims is approximately $73 million. This amount has been recorded in the accounts net of probable recoveries of $54 million from insurance and other sources. If circumstances change, these estimates may change. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. DANA CORPORATION ------------------------------------------ (Registrant) Date: March 14, 1994 By: Martin J. Strobel ------------------------- --------------------------------------- Martin J. Strobel, Vice President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated.

741612_1993.txt

741612

1993

Item 1. Business. General Development of Business The Company And Its Subsidiaries TNP Enterprises, Inc. (Company) is a Texas corporation organized in February 1983. The Company owns all of the outstanding common stock of its three subsidiaries: Texas-New Mexico Power Company (Utility), its principal operating subsidiary; Bayport Cogeneration, Inc. (Bayport); and TNP Operating Company. The Company and the Utility are holding companies as defined in the Public Utility Holding Company Act but each is exempt from regulation as a "registered holding company" as defined in said act. All financial information presented herein or incorporated by reference is on a consolidated basis and all intercompany transactions and balances have been eliminated. Texas-New Mexico Power Company Texas-New Mexico Power Company is a public utility engaged in the generation, purchase, transmission, distribution and sale of electricity to customers within the States of Texas and New Mexico. The Utility is qualified to do business as a foreign corporation in the State of Arizona. Business conducted in Arizona is limited to ownership as tenant-in-common with two other electric utility corporations in a 345-KV electric transmission line which transmits electrical energy into New Mexico for sale to customers in New Mexico. The Utility is subject to regulation by the Public Utility Commission of Texas (PUCT) and the New Mexico Public Utility Commission (NMPUC). The Utility is subject in some of its activities, including the issuance of securities, to the jurisdiction of the Federal Energy Regulatory Commission (FERC), and its accounting records are maintained in accordance with the FERC Uniform System of Accounts. The Utility has two wholly owned subsidiaries, Texas Generating Company (TGC), organized in 1988, and Texas Generating Company II (TGC II), organized in 1991. TNP One Prior to 1990, the Utility purchased virtually all of its electric requirements, primarily from other utilities. In an effort to diversify its energy and fuel sources, the Utility contracted with a consortium consisting of Westinghouse Electric Corporation, Combustion Engineering, Inc. and H. B. Zachry Company to construct TNP One. TNP One is a two-unit lignite-fueled, circulating fluidized bed generating plant in Robertson County, Texas. Unit 1 and Unit 2 of TNP One together provide, on an annualized basis, approximately 30% of the Utility's electric capacity requirements in Texas. The Utility acquired Unit 1 on July 20, 1990, and Unit 2 on July 26, 1991, through TGC and TGC II, respectively. The Utility operates the two units and sells the output of TNP One to its Texas customers. Unit 1 began commercial operation on September 12, 1990, and Unit 2 on October 16, 1991. As of December 31, 1993, the costs of Unit 1 and Unit 2 were approximately $357 million and approximately $282.9 million, respectively. Portions of the costs were funded by the Utility, with the majority of the costs borrowed by TGC and TGC II under separate financing facilities for the two units, which are guaranteed by the Utility. TNP ENTERPRISES, INC. FORM 10-K Regulatory Proceedings The Utility has received rate orders from the PUCT placing the majority of the costs of each of the two units of TNP One in rate base. The Utility and other parties to the proceedings have appealed both orders. For a review of the history of the two rate proceedings and the pending judicial proceedings, see Item 3, "Legal Proceedings" and note 5 to the consolidated financial statements contained in the Annual Report to Shareholders for the year ended December 31, 1993. See note 2 to the consolidated financial statements contained in the Annual Report to Shareholders for the year ended December 31, 1993 for a discussion of the financings of the two units including, during 1993, substantial reduction of the TNP One construction indebtedness and extension of the payment schedule for the remaining balance of the construction debt. For a discussion of the effects of the construction and financing of TNP One on the Utility's financial condition, including the detrimental regulatory treatment received to date, see "Management's Discussion and Analysis of Financial Condition and Results of Operations" contained in the Annual Report to Shareholders for the year ended December 31, 1993. Business of Other Subsidiaries TNP Operating Company and Bayport are general purpose corporations organized under the Texas Business Corporation Act. Neither company was materially involved in any business activities during 1993. Financial Information About Industry Segments This information is incorporated by reference to page 37 of the Annual Report to Shareholders for the year ended December 31, 1993. It is not possible to attribute operating profit or loss and identifiable assets to each of the classes of customers listed on the page referred to in said Annual Report. Kilowatt-hour (KWH) sales in 1993 were assisted by more typical weather experienced in 1993 as compared to 1992. KWH sales declined in 1992 from 1991 due in part to milder than normal temperatures in the Utility's service area in Texas; however, revenues were approximately the same for the two years due primarily to an increase in the Utility's Texas customers' rates in 1992. Also contributing to the sales decline was the failure of new customers and revenues to materialize as expected within the industrial class to ameliorate the loss of KWH sales to certain industrial customers. During 1993, the number of industrial customers decreased by 14, but that decrease included the consolidation of 10 customers into 2 customers for billing purposes and the reclassification of 3 customers to the commercial class of customers. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" contained in the Annual Report to Shareholders for the year ended December 31, 1993 for a discussion of the changes in operating revenues, including rate increases. Narrative Description of Business The Company is a holding company as defined in the Public Utility Holding Company Act of 1935, but is exempt from regulation as a "registered holding company" under the act except with respect to the acquisition of securities of other public utility companies. The Company's exemption is based upon the substantially intrastate character of the operations of the Utility, and the filing with the Securities and Exchange Commission (SEC) of an annual exemption statement pursuant to its Rule U-2. The Public Utility Holding Company Act authorizes the SEC to terminate an exemption which it determines to be detrimental to the public interest or to the interest of investors or consumers. Therefore, the extent to which the Company and its nonutility subsidiaries may expand or diversify and maintain the Company's exempt status is always subject to review by the SEC. The Company does not intend to take any action which will jeopardize its exempt status. TNP ENTERPRISES, INC. FORM 10-K The Company is not subject to regulation by the PUCT. The Company is not generally subject to regulation by the NMPSC; the NMPSC statutes do not regulate holding companies except under certain circumstances of consolidation, merger, or acquisition. Both of these agencies have regulatory authority under state laws over the activities of the Utility. The Utility, and not the Company, is also subject to the jurisdiction of the FERC, in certain respects, under the terms of the Federal Power Act. Narrative Description of Utility Business General The Utility purchases and generates electricity for sales to its customers wholly within the States of Texas and New Mexico. The Utility's purchases of electricity are primarily from other utilities and cogenerators (see "Sources of Energy" in this section). The Utility's current generation of electricity is from TNP One. The Utility owns and operates electric transmission and distribution facilities in 90 municipalities and adjacent rural areas in Texas and New Mexico. The areas served contain a population of approximately 616,000. The Utility's service is delivered to customers in four operating divisions in Texas and one operating division in New Mexico. The Utility's Southeast Division, on the Texas Gulf Coast, is adjacent to the Johnson Space Center and lies between the cities of Houston and Galveston. The economy is supported by the oil and petrochemical industries, agriculture and the general commercial activity of the Houston area. This division produced 49.5% of the total operating revenues in 1993. The Utility's Northern Division is based in Lewisville, just north of the Dallas-Fort Worth International Airport, and extends to include municipalities along the Red River and in the Texas Panhandle. This division serves a variety of commercial, agricultural and petroleum industry customers and produced 19.5% of the Utility's revenues in 1993. The economy of the Utility's New Mexico Division is primarily dependent upon mining and agriculture. Copper mines are the major industrial customers in the New Mexico Division. This division produced 16.8% of the total operating revenues in 1993. The Utility's Central Division includes municipalities and communities located to the south and west of Fort Worth. This area's economy is largely dependent on agriculture and to lesser degrees tourism and oil production. In far west Texas, between Midland and El Paso, the Utility's Western Division serves municipalities whose economies are primarily related to oil and gas production, agriculture and food processing. The Utility serves and intends to continue serving members of the public in all of its present service areas. The Utility will construct facilities as needed to meet increasing demand for its service. The Utility will also extend service beyond its present service territories to the extent permitted by law and the orders of regulatory commissions. For a description of the properties utilized to provide this service, see Item 2, "Properties." Operating Revenues Revenues contributed by the Utility's operating divisions in 1993, 1992 and 1991 and the corresponding percentages of total operating revenues are shown below: 1993 1992 1991 Operating Revenues Revenues Revenues Division (000's) %'s (000's) %'s (000's) %'s Central $39,460 8.3% $ 35,421 8.0% $ 34,625 7.8% Northern 92,265 19.5 83,626 18.9 84,227 19.1 Southeast 234,895 49.5 222,460 50.1 220,581 50.0 Western 28,084 5.9 27,193 6.1 27,487 6.2 New Mexico 79,538 16.8 75,127 16.9 74,423 16.9 Total $474,242 100.0% $443,827 100.0% $441,343 100.0% TNP ENTERPRISES, INC. FORM 10-K In 1993, 1992 and 1991, no single customer accounted for greater than 10% of operating revenues, although the Utility has two affiliated industrial customers in the New Mexico Division which, together, contributed between 8% and 10% of the Utility's revenues in each of these years. Sources of Energy Information on the "Sources of Energy" of the Utility is incorporated herein by reference to pages 4 and 5 of the Annual Report to Shareholders for the year ended December 31, 1993. Recovery of Purchased Power and Fuel Costs Purchased power cost recovery adjustment clauses in the Utility's rate schedules have been authorized by the regulatory authorities in Texas and New Mexico. A fixed fuel recovery factor in Texas has also been approved. Both are of substantial benefit to the Utility in efforts to recover timely and adequately these significant elements of operating expenses as described in note 1(g) to the consolidated financial statements contained in the Annual Report to Shareholders for the year ended December 31, 1993. Franchises The Utility holds franchises from each of the 90 municipalities in which it renders electric service. On December 31, 1993, these franchises had expiration dates varying from 1994 to 2039, 86 having stated terms of 25 years or more and two having stated terms of 20 years and two having stated terms of 15 years. The Utility also holds certificates of public convenience and necessity from the PUCT covering all of the territories it serves in Texas. The Utility has been issued certificates for other areas after hearings before the PUCT. These certificates include terms which are customary in the public utility industry. In New Mexico, the Utility operates generally under the grandfather clause of that state's Public Utility Act which authorizes the continuance of existing service following the date of the adoption of such act. Seasonality of Business The Utility's business is seasonal in character. Summer weather causes increased use of air-conditioning equipment which produces higher revenues during the months of June, July, August and September. For the year ended December 31, 1993, approximately 40% of annual revenues were recorded in June, July, August and September, and 60% in the other eight months. Working Capital The Utility's major demands on working capital are (1) the monthly payments for purchased power costs from the Utility's suppliers, (2) monthly and semi-annual interest payments on long-term debt and (3) semi-monthly payments for the lignite fuel source for TNP One. The purchased power and fuel costs are eventually recovered through the Utility's customers' rates and the purchased power and fuel costs recovery adjustment clauses and fixed fuel factors, more fully described in note 1(g) to the consolidated financial statements contained in the Annual Report to Shareholders for the year ended December 31, 1993. Unlike many other generating utilities, the Utility does not have the requirement of maintaining a large fuel inventory (lignite) due to the proximity of TNP One with the lignite mine site. The Utility sells customer receivables, as do many other utilities. The Utility sells its customer receivables to a nonaffiliated company on a nonrecourse basis. TNP ENTERPRISES, INC. FORM 10-K Competitive Conditions As a regulated public utility, the Utility operates with little direct competition throughout most of its service territory. Pursuant to the Texas Public Utility Regulatory Act, the PUCT has issued to all electric utilities in the State certificates of public convenience and necessity authorizing them to render elec- tric service. Rural electric cooperatives, investor-owned electric utilities and municipally owned electric utilities are all defined in such act as public utilities. In 72 of the 81 Texas municipalities served, the Utility has been the only electric utility issued a certificate to serve customers within the municipal limits. The Utility is also the only electric utility authorized to serve customers in some of the rural areas where it has electric facilities. In other rural areas served by the Utility, other electric utilities have also been authorized to serve customers; however, rural electric cooperatives may, under certain circumstances, become exempt from the PUCT's rate regulation. Where other electric utilities have also been certificated to serve customers within the same service area, the Utility may be subject to competition. From time to time, industrial customers of the Utility express interest in cogeneration as a method of reducing or eliminating reliance upon the Utility as a source of electric service, or to lower fuel costs and improve operating efficiency of process steam generation. During 1993, a major industrial customer in the Utility's Southeast Division requested proposals for a cogeneration project for evaluation by the customer. The Utility's operating revenues from this customer during 1993 were approximately $28 million. In January 1994, a potential developer for the proposed project was selected by the customer. The Utility's goal is to retain this customer and to lower overall system operating costs through coordination with the potential developer. Although the Utility cannot predict the ultimate outcome of the process, the current project as proposed by the customer, and as outlined by the potential developer, appears to present a means by which the Utility may retain electric service to this customer, at current levels. The Utility is actively pursuing the development of the necessary agreements with the potential developer to further define the degree to which electric service to this customer is retained and overall system operating costs may be lowered. In New Mexico, a utility subject to the jurisdiction of the NMPUC may not extend into territory served by another utility or into territory not contiguous to its service territory without a certificate of public convenience and necessity from the NMPUC. Investor-owned electric utilities and rural electric cooperatives are subject to the jurisdiction of the NMPUC. The Energy Policy Act of 1992, adopted in October 1992, significantly changed the U.S. energy policy, including the governing of the electric utility industry. Among the features of this act is the creation of Exempt Wholesale Generators and the authorization of the FERC to order, on a case-by-case basis, wholesale transmission access. It appears that these particular features will create competition for the generation and supply of electricity. Management continues to evaluate the effects of this act on the Utility. Although the act may not affect the Utility directly, the Utility believes that this increased competition will not have an unfavorable impact on it. Environmental Requirements Environmental requirements are not expected to materially affect capital outlays or materially affect the Utility directly. As the Utility's electric suppliers may be affected by environmental requirements and resulting costs, the rates charged by them to the Utility may be increased and thus the Utility will be affected indirectly. The Utility's facilities in Texas and New Mexico are regulated by federal and state environmental agencies. These agencies have jurisdiction over air emissions, water quality, wastewater discharges, solid wastes and hazardous substances. The Utility maintains continuous procedures to insure compliance with all applicable environmental laws, rules and regulations. Various Utility activities require permits, licenses, registrations and approvals from such agencies. The Utility has received all necessary authorizations for the construction and continued operation of its generation, transmission and distribution systems. TNP ENTERPRISES, INC. FORM 10-K TNP One's circulating fluidized bed technology produces "clean" emissions, without the addition of costly scrubbers. Unit 1 and Unit 2 meet the standards of the Clean Air Act of 1990. Under this act, an entity will be given an allotted number of allowances which permit emissions up to a specified level. The Utility believes the allowances received to be sufficient for the level of emissions to be created by TNP One. The construction costs for TNP One included approximately $89 million for environmental protection facilities. During 1993, 1992 and 1991, as an ongoing operation of air pollution abatement, including ash removal, TNP One incurred expenses of approximately $2.6 million, $2.7 million and $1.9 million, respectively. The Utility anticipates additional capital expenditures of $875,000 by 1995 for air emissions monitoring equipment for TNP One. The operations of the Utility are subject to a number of federal, state and local environmental laws and regulations, which govern the storage of motor fuels, including those regulating underground storage tanks. In September 1988, the Environmental Protection Agency (EPA) issued regulations that required all newly installed underground storage tanks be protected from corrosion, be equipped with devices to prevent spills and overfills, and have a leak detection method that meets certain minimum requirements. The effective commencement date for newly installed tanks was December 22, 1988. Underground storage tanks in place prior to December 22, 1988, must conform to the new standards by December 1998. The Utility currently estimates the cost over the next five years to bring its existing underground storage tanks into compliance with the EPA guidelines will be $100,000. The Utility also has the option of removing any existing underground storage tanks. During 1993, 1992, and 1991, the Utility incurred cleanup and testing costs on both leaking and nonleaking storage tanks of approximately $98,000, $89,000, and $84,000, respectively, in complying with these EPA regulations. A change in the regulations in the State of Texas permitted the Utility to collect in 1992 from the state environmental trust fund $65,000 of expenditures paid in prior years. Both states in which the Utility owns or operates underground storage tanks have state operated funds which reimburse the Utility for certain cleanup costs and liabilities incurred as a result of leaks in underground storage tanks. These funds, which essentially provide insurance coverage for certain environmental liabilities, are funded by taxes on underground storage tanks or on motor fuels purchased within each respective state. The funds require the Utility to pay deductibles of less than $5,000 per occurrence. During 1992, the Texas state environmental trust fund delayed reimbursement payments after September 30, 1992, of certain cleanup costs due to an increase in claims. Because the state and federal government have the right, by law, to levy additional fees on fuel purchases, the Utility believes these cleanup costs will ultimately be reimbursed. Employees The number of employees on December 31, 1993, was 1,051. TNP ENTERPRISES, INC. FORM 10-K Executive Officers of the Registrant Identification of Executive Officers Executive Officers of the Company Positions & Offices Held Period of with the Company Such Office Name Age Within the Past 5 Years1 Years Months D. R. Spurlock2 61 Interim President & Chief 0 1 Executive Officer and Director D. R. Barnard 61 Vice President & 4 8 Chief Financial Officer Vice President & 4 6 Treasurer M. D. Blanchard 43 Corporate Secretary & 6 4 General Counsel Monte W. Smith 40 Treasurer 4 8 Director - Internal Audit 2 11 Executive Officers of the Utility Positions & Offices Held Period of with the Utility Such Office Name Age Within the Past 5 Years1 Years Months D. R. Spurlock 61 Interim President & Chief 0 1 Executive Officer and Director Sector Vice President - 2 4 Operations Vice President - 11 1 Division Manager D. R. Barnard 61 Sector Vice President & 3 8 Chief Financial Officer Vice President & 1 0 Chief Financial Officer Vice President & 17 0 Treasurer J. V. Chambers, Jr. 44 Sector Vice President - 3 8 Revenue Production Vice President - Contracts 3 2 & Regulation 1, 2 See respective explanation appearing on the following page. TNP ENTERPRISES, INC. FORM 10-K Positions & Offices Held Period of with the Utility Such Office Name Age Within the Past 5 Years1 Years Months M. C. Davie 58 Vice President - Corporate 10 11 Affairs A. B. Davis 56 Vice President - Chief Engineer 1 8 Chief Engineer 1 4 Assistant Chief Engineer 0 1 Manager - Engineering 5 8 L.W. Dillon 39 Vice President - Operations 0 1 Division Manager 3 6 Division Engineering Manager 4 11 R. J. Wright 46 Vice President - 0 6 Corporate Services/Generation Vice President - Manager - Generation 4 8 M. D. Blanchard 43 Corporate Secretary & 6 4 General Counsel Monte W. Smith 40 Treasurer 4 8 Director - Internal Audit 2 11 1 All officers are elected annually by the respective Board of Directors for a one-year term until the next annual meeting of the Board of Directors or until their successors shall be elected and qualified. The term of an officer elected at any other time by the Board also will run until the next succeeding annual meeting of the Board of Directors or until a successor shall be elected and qualified. 2 Retired as Sector Vice President of the Utility effective December 31, 1992; named Interim President & Chief Executive Officer effective November 9, 1993. With the exception of D. R. Spurlock, each of the above-named officers is a full-time employee of the Utility and has been for more than five years prior to the date of the filing of this Form 10-K. TNP ENTERPRISES, INC. FORM 10-K Item 2.

Item 2. Properties. The Utility's electric properties served a total of 211,911 customers at year-end and consisted of the installations described in the following sections. (1) Electric generation, transmission and distribution facilities located in the State of Texas are as follows: (A) Central Division. Electric transmission and distribution sys- tems serving 25 municipalities and 18 unincorporated communities in 17 counties to the south and west of Fort Worth, Texas. The division is based at Clifton, Texas. (B) Northern Division. Electric transmission and distribution systems serving 36 municipalities and 19 unincorporated communities in 14 North Texas counties and 3 counties in the Texas Panhandle. The division is based at Lewisville, Texas. (C) Southeast Division. Electric transmission and distribution systems serving 14 municipalities and 2 unincorporated communities in 3 counties on the Texas Gulf Coast. The division is based at Texas City, Texas. (D) Western Division. Electric transmission and distribution sys- tems serving 6 municipalities and 1 unincorporated community in 5 counties in West Texas. The division is based at Pecos, Texas. (E) Robertson County, Texas. Two 150-megawatt lignite-fueled generating units (Unit 1 and Unit 2, collectively referred to as TNP One) using circulating fluidized bed technology. The Utility also has an 18-mile long transmission line to connect TNP One to a major transmission grid in Texas. (2) Electric generation, transmission and distribution facilities in the State of New Mexico serve 5 municipalities and 5 unincorporated communities in Grant and Hidalgo Counties, and 4 municipalities and 1 unincorporated community in Otero and Lincoln Counties. The New Mexico Division is based at Silver City, New Mexico. (3) The facilities owned by the Utility include those normally used in the electric utility business. The facilities are of sufficient capacity to adequately serve existing customers, and such facilities may be extended and expanded to serve future customer growth of the Utility in existing service areas. The Utility generally constructs its transmission and distribution facilities upon real property held pursuant to easements or public rights of way and not upon real property held in fee simple by the Utility. (4) All real and personal property of the Utility, with certain exceptions such as much of TNP One, is subject to the lien of the Indenture of Mortgage and Deed of Trust (Bond Indenture) under which the Utility's First Mortgage Bonds are issued. Certain exceptions are set forth in the Bond Indenture. The lenders in the Unit 2 financing facility and the holders of all secured debentures hold a second lien on all real and personal Texas property of the Utility. Holders of the Utility's Secured Debentures, due 1999 and Series A, Secured Debentures, due 2003 equally and ratably hold first liens on approximately 59% of Unit 1. The remaining amount of Unit 1 property is subject to a first lien under the Utility's Bond Indenture and a second lien under the secured debentures' indentures. The lenders under the Unit 2 financing facility and the Utility's Secured Debentures, due 1999, equally and ratably hold first liens on approximately 74% of Unit 2. The remaining amount of Unit 2 property is subject to a first lien under the Utility's Bond Indenture and a second lien under the secured debentures' indentures. Under certain conditions, upon repayment of portions of the loans or secured debentures under the financing facilities, the Utility may purchase undivided interests in Unit 1 or Unit 2 from TGC or TGC II, respectively, whereupon such undivided interests become subject to the first lien of the Utility's Bond Indenture. See note 2 to the consolidated financial statements contained in the Annual Report to Shareholders for the year ended December 31, 1993 for additional information. TNP ENTERPRISES, INC. FORM 10-K Item 3.

Item 3. Legal Proceedings. Appeals of Regulatory Orders The following summary discusses the Utility's most recent regulatory proceedings before the PUCT and the judicial appeals. While the ultimate outcome of these cases and of other matters discussed below cannot be predicted, the Utility is vigorously pursuing their favorable conclusion. Material adverse resolution of certain of the matters discussed below would have a material adverse impact on earnings in the period of resolution. More detailed discussions of the proceedings and related impacts are included in "Management's Discussion and Analysis of Financial Condition and Results of Operations" and note 5 to the consolidated financial statements contained in the Annual Report to Shareholders for the year ended December 31, 1993. PUCT Docket No. 9491 On April 11, 1990, the Utility filed a rate application, Docket No. 9491, with the PUCT for inclusion of the costs of Unit 1 in the Utility's rate base and for the setting of rates to recover the costs of that unit. On February 7, 1991, the Utility received a final order which allowed $298.5 million of the costs of Unit 1 in rate base; however, the PUCT disallowed from rate base $39.5 million of the requested investment costs of $338 million for that unit. The PUCT approved an increase in annualized revenues of approximately $36.7 million, or 67% of the Utility's original $54.9 million rate request. The PUCT also found that the Utility failed to prove that its decision to start construction of Unit 2 was prudent. Nevertheless, the PUCT granted rate base treatment for Unit 2 in Docket No. 10200, as discussed below. On appeal by the Utility of the PUCT's order in Docket No. 9491, a State district court in Travis County, Texas, ruled that the PUCT's disallowance of rate base treatment for certain costs of Unit 1 was in error and that the PUCT's "decision to deny $39,508,409 in capital costs for TNP One Unit 1 is not supported by substantial evidence and is arbitrary and capricious." On appeal of the State district court's order by the Utility, the PUCT and certain of the intervenor cities (the Cities), a Third District Court of Appeals in Austin, Texas, rendered a judgment partially reversing the State district court and affirming the PUCT's disallowances for $30.4 million of the total $39.5 million. The Court of Appeals remanded the cause to the district court with instructions that the cause be remanded to the PUCT for proceedings not inconsistent with the appellate opinion. On September 9, 1993, the Utility, the Cities and the PUCT filed motions for rehearing with the Court of Appeals. The Utility's opponents are seeking, among other things, lower rates and greater disallowances, and the Utility is seeking higher rates and no disallowances. The PUCT is not expected to act upon the district court's ordered remand, discussed above, until the appellate process, including appeals to the Texas Supreme Court, has been completed. Based upon the opinions of the Utility's Texas regulatory counsel, Johnson & Gibbs, a Professional Corporation, management believes that it will prevail in obtaining a remand of a significant portion of the disallowances in Docket No. 9491; however, the ultimate disposition and quantification of these items cannot presently be determined. Accordingly, no provision for any loss that may ultimately be required upon resolution of these matters has been made in the consolidated financial statements. If the Utility is not successful in obtaining a final favorable disposition in the appellate proceedings relating to the disallowances in Docket No. 9491, a write-off of some portion of the $39.5 million disallowances would be required, which could result in a significant negative impact on earnings in the period of final resolution. PUCT Docket No. 10200 On April 11, 1991, the Utility filed a rate application, Docket No. 10200, with the PUCT for inclusion of $275.2 million of capital costs of Unit 2 in the Utility's rate base and for the setting of rates to recover the costs of that unit. TNP ENTERPRISES, INC. FORM 10-K On March 18, 1993, the Utility received a final order which allowed $250.7 million of the Unit 2 costs in rate base; however, the PUCT disallowed from rate base $21.1 million associated with Unit 2 and $0.8 million additional costs requested for Unit 1. The PUCT also determined that $11.1 million of Unit 2 costs would be addressed in a future Texas rate application. The PUCT approved an increase in annualized revenues of approximately $19 million, or 53%, of the Utility's original $35.8 million rate request. The order in Docket No. 10200 also reflects application to the Utility of a new method for calculating the amount of Federal income tax expense allowed in cost of service, which significantly reduced the Utility's level of annualized revenue increase from $26 million to $19 million. The Docket No. 10200 rate order has been appealed to a Texas district court by the Utility and other parties. Because of the Court of Appeals judgment relating to the prudence of starting construction of Unit 2 (FF No. 84 in the docket No. 9491), the presiding judge in the Texas district court for the Docket No. 10200 appeal has ordered that the procedural schedule in this appeal be abated until final resolution of the FF No. 84 issue in Docket No. 9491. The Utility will vigorously pursue reversal of the PUCT's new position regarding Federal income tax expenses, in addition to seeking judicial relief from the disallowances and certain other rulings by the PUCT in Docket No. 10200. The opposing parties are seeking a variety of relief to obtain lower rates and greater disallowances, including overturning the basis of the Utility's case as presented to the PUCT and sustaining the PUCT's adverse Federal income tax position without regard to any IRS ruling on the normalization issue. Based upon the opinions of the Utility's Texas regulatory counsel, Johnson & Gibbs, a Professional Corporation, management believes that it will prevail in obtaining a remand of a significant portion of the disallowances in Docket No. 10200; however, the ultimate disposition and quantification of these items cannot presently be determined. Accordingly, no provision for any loss that may ultimately be required upon resolution of these matters has been made in the consolidated financial statements. If the Utility is not successful in obtaining a final favorable disposition in the appellate proceedings relating to the disallowances in Docket No. 10200, a write-off of some portion of the $21.9 million disallowances would be required, which could result in a significant negative impact on earnings in the period of final resolution. Other Legal Matters The Utility is involved in various claims and other legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the Utility's consolidated financial position. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders. There were no matters submitted to a vote of security holders in the fourth quarter of 1993. PART II Item 5.

Item 5. Market For The Registrant's Common Equity and Related Shareholder Matters. This information is incorporated by reference to "Common Stock Information" on page 38 of the Annual Report to Shareholders for the year ended December 31, 1993. For the years ended December 31, 1993 and 1992, the Company paid $17,344,000, and $13,780,000, respectively, in common dividends. Dividends were paid on a quarterly basis. Since most of the assets, liabilities and earnings capability of the Company are those of the Utility, the ability of the Company to pay dividends will be largely dependent upon the Utility's operations and the Utility's restrictions regarding payment of its dividends as discussed in notes 2 and 3 to the consolidated financial statements contained in the Annual Report to Shareholders for the year ended December 31, 1993. TNP ENTERPRISES 10-K Item 6.

Item 6. Selected Consolidated Financial Data. This information is incorporated by reference to "Selected Annual Consolidated Financial Data" on page 36 of the Annual Report to Shareholders for the year ended December 31, 1993. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and note 5 to the consolidated financial statements contained in the Annual Report to Shareholders for the year ended December 31, 1993 for discussion of material uncertainties which might cause the information incorporated by reference above not to be indicative of future financial condition or results of operations. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. This information is incorporated by reference to "Management's Discussion and Analysis of Financial Condition and Results of Operations" on pages 6 through 16 of the Annual Report to Shareholders for the year ended December 31, 1993. Item 8.

Item 8. Financial Statements and Supplementary Data. This information is incorporated by reference to the appropriate sections on pages 17 through 35 of the Annual Report to Shareholders for the year ended December 31, 1993. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. None. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant. Identification of Directors and Directorships The information required by this item is incorporated by reference from "The Nominees and Continuing Directors" of the definitive Proxy Statement relating to the annual meeting of holders of common stock of the Company, pursuant to Regulation 14A, filed with the SEC and mailed on or about March 28, 1994 to the holders of common stock of the Company. Identification of Executive Officers The information required by this item with respect to executive officers is set forth in Item 1 of Part I of this Form 10-K under "Executive Officers of the Registrant, " pursuant to instruction 3 of paragraph (b) of Item 401 of Regulation S-K. Item 11.

Item 11. Executive Compensation.* Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management.* Item 13.

Item 13. Certain Relationships and Related Transactions.* * The information required by Items 11, 12, and 13 is incorporated by reference from the definitive Proxy Statement relating to the Annual Meeting of holders of common stock of the Company, pursuant to Regulation 14A, filed with the SEC and mailed on or about March 28, 1994 to the holders of common stock of the Company. TNP ENTERPRISES, INC. FORM 10-K PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) Items Filed as Part of This Report Financial Statements and Supplementary Data The following information is incorporated by reference to pages 17 through 35 of the Annual Report to Shareholders for the year ended December 31, 1993: Independent Auditors' Report Consolidated Statements of Earnings, Three Years Ended December 31, Consolidated Balance Sheets, December 31, 1993 and 1992 Consolidated Statements of Common Stock Equity and Redeemable Cumulative Preferred Stocks, Three Years Ended December 31, 1993 Consolidated Statements of Cash Flows, Three Years Ended December 31, Notes to Consolidated Financial Statements, December 31, 1993, 1992 and 1991 Selected Quarterly Consolidated Financial Data (Unaudited), Quarters ended March 31, June 30, September 30, and December 31, 1993 and 1992 Financial Statement Schedules Page Independent Auditors' Report. . . . . . . . . . . . . . 17 V - Utility Plant, Three Years Ended December 31, 1993 . . . . . 18 VI - Accumulated Depreciation of Utility Plant, Three Years Ended December 31, 1993 . . . . . . . . . . . . . . 19 IX - Short-term Borrowings, Three Years Ended December 31, 1993 20 X - Supplementary Consolidated Earnings Statement Information, Three Years Ended December 31, 1993 . . . . . 21 All other schedules are omitted, as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes contained in the Annual Report to Shareholders for the year ended December 31, 1993. Exhibits. See Exhibit Index, Pages 22 through 33. (b) Reports on Form 8-K None during the last quarter covered by this report. TNP ENTERPRISES, INC. FORM 10-K SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. (Registrant) TNP ENTERPRISES, INC. By /s/ D. R. Barnard D. R. Barnard, Vice President & Chief Financial Officer Date: March 22, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Title Date By /s/ R. D. Woofter Chairman 3-22-94 R. D. Woofter By /s/ Dwight R. Spurlock Interim President & 3-22-94 D. R. Spurlock Chief Executive Officer By /s/ D. R. Barnard Vice President & 3-22-94 D. R. Barnard Chief Financial Officer By /s/ Monte W. Smith Treasurer (Principal 3-22-94 Monte W. Smith Accounting Officer) By /s/ R. Denny Alexander Director 3-22-94 R. Denny Alexander By /s/ Cass O. Edwards, II Director 3-22-94 Cass O. Edwards, II By /s/ John A. Fanning Director 3-22-94 John A. Fanning By /s/ Harris L. Kempner, Jr. Director 3-22-94 Harris L. Kempner, Jr. TNP ENTERPRISES, INC. FORM 10-K Index to Financial Statement Schedules Independent Auditors' Report Schedules: V - Utility Plant, Three Years Ended December 31, 1993 VI - Accumulated Depreciation of Utility Plant, Three Years Ended December 31, 1993 IX - Short-term Borrowings, Three Years Ended December 31, 1993 X - Supplementary Consolidated Earnings Statement Information, Three Years Ended December 31, 1993 All other schedules are omitted, as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes. The consolidated balance sheets of the Company and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, common stock equity and redeemable cumulative preferred stocks, and cash flows for each of the years in the three-year period ended December 31, 1993, together with the related notes and the report of KPMG Peat Marwick, independent certified public accountants, all contained in the Annual Report to Shareholders for the year ended December 31, 1993, are incorporated herein by reference. TNP ENTERPRISES, INC. FORM 10-K Independent Auditors' Report The Shareholders and Board of Directors TNP Enterprises, Inc.: Under date of January 28, 1994, we reported on the consolidated balance sheets of TNP Enterprises, Inc. and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of earnings, common stock equity and redeemable cumulative preferred stocks, and cash flows for each of the years in the three-year period ended December 31, 1993, as contained in the 1993 annual report to shareholders. These consolidated financial statements and our report thereon are incorporated by reference in the annual report on Form 10-K for the year 1993. In connection with our audits of the aforementioned consolidated financial statements, we also have audited the related financial statement schedules as listed in the accompanying index. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statement schedules based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. The report includes an explanatory paragraph that states that uncertainties exist with respect to the outcome of certain regulatory matters as discussed in note 5 to the consolidated financial statements. The ultimate outcome of these matters cannot presently be determined. Accordingly, no provision for any loss that may ultimately be required upon resolution of these matters has been made in the above consolidated financial statements and financial statement schedules. As discussed in note 4 to the consolidated financial statements, the Company changed its method of accounting for income taxes in 1993 to adopt the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes. As discussed in note 1(j), the Company also adopted the provisions of the Financial Accounting Standards Board's SFAS No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions in 1993. KPMG PEAT MARWICK Fort Worth, Texas January 28, 1994 TNP ENTERPRISES, INC. FORM 10-K Utility Plant Schedule V TNP ENTERPRISES, INC. FORM 10-K Accumulated Depreciation of Utility Plant Schedule VI Three Years Ended December 31, 1993 (In Thousands) TNP ENTERPRISES, INC. FORM 10-K Short-term Borrowings (1) Schedule IX Three Years Ended December 31, 1993 (Dollars in Thousands) TNP ENTERPRISES, INC. FORM 10-K Supplementary Consolidated Earnings Statement InformationSchedule X Three Years Ended December 31, 1993 (In Thousands) Charged to costs and expenses Item 1993 1992 1991 Taxes, other than payroll and income taxes: Gross receipts and street rentals $11,387 10,064 9,484 Property 14,132 14,272 10,302 Other 2,613 2,431 1,689 $28,132 26,767 21,475 TNP ENTERPRISES, INC. FORM 10-K EXHIBIT INDEX Exhibits filed herewith are denoted by "*." The other exhibits have heretofore been filed with the Commission and are incorporated herein by reference. Exhibit No. Description 3(a) - Articles of Incorporation and Amendments through March 6, 1984 (Exhibit 3(a), File No. 2-89800). 3(b) - Amendment to Articles of Incorporation filed September 25, 1984. (Exhibit 3(b) to Form 10-K for the year ended December 31, 1987, File No. 1-8847). 3(c) - Amendment to Articles of Incorporation filed August 29, 1985 (Exhibit 3(a) to Form 10-K for the year ended December 31, 1985, File No. 1-8847). 3(d) - Amendment to Articles of Incorporation filed June 2, 1986 (Exhibit 3(a) to Form 10-K for the year ended December 31, 1986, File No. 1-8847). 3(e) - Amendment to Articles of Incorporation filed May 10, 1988 (Exhibit 3(e) to Form 10-K for the year ended December 31, 1988, File No. 1-8847). 3(f) - Amendment to Articles of Incorporation filed May 10, 1988 (Exhibit 3(f) to Form 10-K for the year ended December 31, 1988, File No. 1-8847). 3(g) - Amendment to Articles of Incorporation filed December 27, 1988 (Exhibit 3(g) to Form 10-K for the year ended December 31, 1988, File No. 1-8847). 3(h) - Bylaws of the Company, as amended February 18, 1992 (Exhibit 4(h), File No. 33-53918). 4(a) - Indenture of Mortgage and Deed of Trust of the Utility dated as of November 1, 1944 (Exhibit 2(d), File No. 2-61323). 4(b) - Seventh Supplemental Indenture dated as of May 1, 1963 (Exhibit 2(k), File No. 2-61323). 4(c) - Eighth Supplemental Indenture dated as of July 1, 1963 (Exhibit 2(1), File No. 2-61323). TNP ENTERPRISES, INC. FORM 10-K Exhibit Description No. 4(d) - Ninth Supplemental Indenture dated as of August 1, 1965 (Exhibit 2(m), File No. 2-61323). 4(e) - Tenth Supplemental Indenture dated as of May 1, 1966 (Exhibit 2(n), File No. 2-61323). 4(f) - Eleventh Supplemental Indenture dated as of October 1, 1969 (Exhibit 2(o), File No. 2-61323). 4(g) - Twelfth Supplemental Indenture dated as of May 1, 1971 (Exhibit 2(p), File No. 2-61323). 4(h) - Thirteenth Supplemental Indenture dated as of July 1, 1974 (Exhibit 2(q), File No. 2-61323). 4(i) - Fourteenth Supplemental Indenture dated as of March 1, 1975 (Exhibit 2(r), File No. 2-61323). 4(j) - Fifteenth Supplemental Indenture dated as of September 1, 1976 (Exhibit 2(e), File No. 2-57034). 4(k) - Sixteenth Supplemental Indenture dated as of November 1, 1981 (Exhibit 4(x), File No. 2-74332). 4(l) - Seventeenth Supplemental Indenture dated as of December 1, 1982 (Exhibit 4(cc), File No. 2-80407). 4(m) - Eighteenth Supplemental Indenture dated as of September 1, 1983 (Exhibit (a) to Form 10-Q of Texas-New Mexico Power Company for the quarter ended September 30, 1983, File No. 1-4756). 4(n) - Nineteenth Supplemental Indenture dated as of May 1, 1985 (Exhibit 4(v), File No. 2-97230). 4(o) - Twentieth Supplemental Indenture dated as of July 1, 1987 (Exhibit 4(o) to Form 10-K of Texas-New Mexico Power Company for the year ended December 31, 1987, File No. 2-97230). 4(p) - Twenty-First Supplemental Indenture dated as of July 1, 1989 (Exhibit 4(p) to Form 10-Q of Texas-New Mexico Power Company for the quarter ended June 30, 1989, File No. 2-97230). 4(q) - Twenty-Second Supplemental Indenture dated as of January 15, 1992 (Exhibit 4(q) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). TNP ENTERPRISES, INC. FORM 10-K Exhibit No. Description 4(r) - Twenty-Third Supplemental Indenture dated as of September 15, 1993 (Exhibit 4(r) to Form 10-K of the Utility for the year ended December 31, 1993, File No. 2-97230). 4(s) - Indenture and Security Agreement for Secured Debentures dated as of January 15, 1992 (Exhibit 4(r) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). 4(t) - Indenture and Security Agreement for Secured Debentures dated as of September 15, 1993 (Exhibit 4(t) to Form 10-K of the Utility for the year ended December 31, 1993, File No. 2-97230). 4(u) - Rights Agreement and Form of Right Certificate, as amended, effective November 13, 1990 (Exhibit 2.1 to Form 8-A, File No. 1-8847). Material Contracts Relating to TNP One 10(a) - Fuel Supply Agreement, dated November 18, 1987, between Phillips Coal Company and the Utility (Exhibit 10(j) to Form 10-K of the Utility for the year ended December 31, 1987, File No. 2-97230). 10(b) - Unit 1 First Amended and Restated Project Loan and Credit Agreement, dated as of January 8, 1992 (the "Unit 1 Credit Agreement"), among the Utility, Texas Generating Company ("TGC"), the banks named therein as Banks (the "Unit 1 Banks") and The Chase Manhattan Bank (National Association), as Agent for the Unit 1 Banks (the "Unit 1 Agent"), amending and restating the Project Loan and Credit Agreement among such parties dated as of December 1, 1987 (Exhibit 10(c) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). 10(b)1 - Participation Agreement, dated as of January 8, 1992, among the banks named therein as Banks, the parties named therein as Participants and the Unit 1 Agent (Exhibit 10(c)1) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). 10(b)2 - Amendment No. 1, dated as of September 21, 1993, to the Unit 1 Credit Agreement (Exhibit 10(b)2 to Form 10-K of the Utility for the year ended December 31, 1993, File No. 2-97230). 10(c) - Assignment and Security Agreement, dated as of January 8, 1992, among TGC and the Unit 1 Agent, for the benefit of the Secured Parties, as defined in the Unit 1 Credit Agreement, amending and restating the Assignment and Security Agreement among such parties dated as of December 1, 1987 (Exhibit 10(d) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). TNP ENTERPRISES, INC. FORM 10-K Exhibit No. Description 10(d) - Assignment and Security Agreement, dated December 1, 1987, executed by the Utility in favor of the Unit 1 Agent for the benefit of the Secured Parties, as defined therein (Exhibit 10(u) to Form 10-K of the Utility for the year ended December 31, 1987, File No. 2-97230). 10(e) - Amended and Restated Subordination Agreement, dated as of October 1, 1988, among the Utility, Continental Illinois National Bank and Trust Company of Chicago and the Unit 1 Agent, amending and restating the Subordination Agreement among such parties dated as of December 1, 1987 (Exhibit 10(uu) to Form 10- K of the Utility for the year ended December 31, 1988, File No. 2-97230). 10(f) - Mortgage and Deed of Trust (With Security Agreement and UCC Financing Statement for Fixture Filing), dated to be effective as of December 1, 1987, and executed by Project Funding Corporation ("PFC"), as Mortgagor, to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(ee) to Form 10-K of the Utility for the year ended December 31, 1987, File No. 2-97230). 10(f)1 - Supplemental Mortgage and Deed of Trust (With Security Agreement and UCC Financing Statement for Fixture Filing), executed by TGC, as Mortgagor, on January 27, 1992, to be effective as of December 1, 1987, to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(g)4) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). 10(f)2 - First TGC Modification and Extension Agreement, dated as of January 24, 1992, among the Unit 1 Banks, the Unit 1 Agent, the Utility and TGC (Exhibit 10(g)1) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). 10(f)3 - Second TGC Modification and Extension Agreement, dated as of January 27, 1992, among the Unit 1 Banks, the Unit 1 Agent, the Utility and TGC (Exhibit 10(g)2) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). 10(f)4 - Third TGC Modification and Extension Agreement, dated as of January 27, 1992, among the Unit 1 Banks, the Unit 1 Agent, the Utility and TGC (Exhibit 10(g)3) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). 10(f)5 - Fourth TGC Modification and Extension Agreement, dated as of September 29, 1993, among the Unit 1 Banks, the Unit 1 Agent, the Utility and TGC (Exhibit 10(f)5 to Form 10-K of the Utility for the year ended December 31, 1993, File No. 2-97230). TNP ENTERPRISES, INC. FORM 10-K Exhibit No. Description 10(f)6 - Fifth TGC Modification and Extension Agreement, dated as of September 29, 1993, among the Unit 1 Banks, the Unit 1 Agent, the Utility and TGC (Exhibit 10(f)6 to Form 10-K of the Utility for the year ended December 31, 1993, File No. 2-97230). 10(g) - Indemnity Agreement, made as of the 1st day of December, 1987, by Westinghouse, CE and Zachry, as Indemnitors, for the benefit of the Secured Parties, as defined therein (Exhibit 10(ff) to Form 10-K of the Utility for the year ended December 31, 1987, File No. 2-97230). 10(h) - Second Lien Mortgage and Deed of Trust (With Security Agreement) executed by the Utility, as Mortgagor, to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(jj) to Form 10-K of the Utility for the year ended December 31, 1987, File No. 2-97230). 10(h)1 - Correction Second Lien Mortgage and Deed of Trust (with Security Agreement), dated as of December 1, 1987, executed by the Utility, as Mortgagor, to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(vv) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2-97230). 10(h)2 - Second Lien Mortgage and Deed of Trust (with Security Agreement) Modification, Extension and Amendment Agreement, dated as of January 8, 1992, executed by the Utility to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(i)2) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). 10(h)3 - TNP Second Lien Mortgage Modification No. 2, dated as of September 21, 1993, executed by the Utility to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(h)3 to Form 10-K of the Utility for the year ended December 31, 1993, File No. 2-97230). 10(i) - Agreement for Conveyance and Partial Release of Liens, made as of the 1st day of December, 1987, by PFC and the Unit 1 Agent for the benefit of the Utility (Exhibit 10(kk) to Form 10-K of the Utility for the year ended December 31, 1987, File No. 2-97230). 10(j) - Inducement and Consent Agreement, dated as of June 15, 1988, between Phillips Coal Company, Kiewit Texas Mining Company, the Utility, Phillips Petroleum Company and Peter Kiewit Son's, Inc. (Exhibit 10(nn) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2-97230). 10(k) - Assumption Agreement, dated as of October 1, 1988, executed by TGC, in favor of the Issuing Bank, as defined therein, the Unit 1 Banks, the Unit 1 Agent and the Depositary, as defined therein (Exhibit 10(ww) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2-97230). TNP ENTERPRISES, INC. FORM 10-K Exhibit No. Description 10(l) - Guaranty, dated as of October 1, 1988, executed by the Utility and given in respect of the TGC obligations under the Unit 1 Credit Agreement (Exhibit 10(xx) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2-97230). 10(m) - First Amended and Restated Facility Purchase Agreement, dated as of January 8, 1992, among the Utility, as the Purchaser, and TGC, as the Seller, amending and restating the Facility Purchase Agreement among such parties dated as of October 1, 1988 (Exhibit 10(n) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). 10(n) - Operating Agreement, dated as of October 1, 1988, among the Utility and TGC (Exhibit 10(zz) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2-97230). 10(o) - Unit 2 First Amended and Restated Project Loan and Credit Agreement, dated as of January 8, 1992 (the "Unit 2 Credit Agreement"), among the Utility, Texas Generating Company II ("TGCII"), the banks named therein as Banks (the "Unit 2 Banks") and The Chase Manhattan Bank (National Association), as Agent for the Unit 2 Banks (the "Unit 2 Agent"), amending and restating the Project Loan and Credit Agreement among such parties dated as of October 1, 1988 (Exhibit 10(q) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). 10(o)1 - Amendment No. 1, dated as of September 21, 1993, to the Unit 2 Credit Agreement (Exhibit 10(o)1 to Form 10-K of the Utility for the year ended December 31, 1993, File No. 2-97230). 10(p) - Assignment and Security Agreement, dated as of January 8, 1992, among TGCII and the Unit 2 Agent, for the benefit of the Secured Parties, as defined in the Unit 2 Credit Agreement, amending and restating the Assignment and Security Agreement among such parties dated as of October 1, 1988 (Exhibit 10(r) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). 10(q) - Assignment and Security Agreement, dated as of October 1, 1988, executed by the Utility in favor of the Unit 2 Agent for the benefit of the Secured Parties, as defined therein (Exhibit 10(jjj) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2-97230). 10(r) - Subordination Agreement, dated as of October 1, 1988, among the Utility, Continental Illinois National Bank and Trust Company of Chicago and the Unit 2 Agent (Exhibit 10(mmm) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2-97230). TNP ENTERPRISES, INC. FORM 10-K Exhibit No. Description 10(s) - Mortgage and Deed of Trust (With Security Agreement and UCC Financing Statement for Fixture Filing), dated to be effective as of October 1, 1988, and executed by Texas PFC, Inc., as Mortgagor, to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(uuu) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2-97230). 10(s)1 - First TGCII Modification and Extension Agreement, dated as of January 24, 1992, among the Unit 2 Banks, the Unit 2 Agent, the Utility and TGCII (Exhibit 10(u)1) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). 10(s)2 - Second TGCII Modification and Extension Agreement, dated as of January 27, 1992, among the Unit 2 Banks, the Unit 2 Agent, the Utility and TGCII (Exhibit 10(u)2) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). 10(s)3 - Third TGCII Modification and Extension Agreement, dated as of January 27, 1992, among the Unit 2 Banks, the Unit 2 Agent, the Utility and TGCII (Exhibit 10(u)3) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). 10(s)4 - Fourth TGCII Modification and Extension Agreement, dated as of September 29, 1993, among the Unit 2 Banks, the Unit 2 Agent, the Utility and TGCII (Exhibit 10(s)4 to Form 10-K of the Utility for the year ended December 31, 1993, File No. 2-97230). 10(t) - Release and Waiver of Liens and Indemnity Agreement, made effective as of the 1st day of October, 1988, by a consortium composed of Westinghouse, CE, and Zachry (Exhibit 10(vvv) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2-97230). 10(u) - Second Lien Mortgage and Deed of Trust (With Security Agreement), dated as of October 1, 1988, and executed by the Utility, as Mortgagor, to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(www) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2-97230). 10(u)1 - Second Lien Mortgage and Deed of Trust (with Security Agreement) Modification, Extension and Amendment Agreement, dated as of January 8, 1992, executed by the Utility to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(w)1) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). TNP ENTERPRISES, INC. FORM 10-K Exhibit No. Description 10(u)2 - TNP Second Lien Mortgage Modification No. 2, dated as of September 21, 1993, executed by the Utility to Donald H. Snell, as Mortgage Trustee, for the benefit of the Secured Parties, as defined therein (Exhibit 10(u)2 to Form 10-K of the Utility for the year ended December 31, 1993, File No. 2-97230). 10(v) - Intercreditor and Nondisturbance Agreement, dated as of October 1, 1988, among PFC, Texas PFC, Inc., the Utility, the Project Creditors, as defined therein, and the Collateral Agent, as defined therein (Exhibit 10(xxx) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2-97230). 10(v)1 - Amendment #1, dated as of January 8, 1992, to the Intercreditor and Nondisturbance Agreement, dated as of October 1, 1988, among TGC, TGCII, the Utility, the Unit 1 Banks, the Unit 2 Banks and The Chase Manhattan Bank (National Association) in its capacity as collateral agent for the Unit 1 Banks and the Unit 2 Banks (Exhibit 10(x)1) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2-97230). 10(v)2 - Amendment No. 2, dated as of September 21, 1993, to the Intercreditor and Nondisturbance Agreement among TGC, TGCII, the Utility, the Unit 1 Banks, the Unit 2 Banks and The Chase Manhattan Bank (National Association) in its capacity as collateral agent for the Unit 1 Banks and the Unit 2 Banks (Exhibit 10(v)2 to Form 10-K of the Utility for the year ended December 31, 1993, File No. 2-97230). 10(w) - Grant of Reciprocal Easements and Declaration of Covenants Running with the Land, dated as of the 1st day of October, 1988 between PFC and Texas PFC, Inc. (Exhibit 10(yyy) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2-97230). 10(x) - Non-Partition Agreement, dated as of May 30, 1990, among the Utility, TGC and The Chase Manhattan Bank (National Association), as Agent for the Banks which are parties to the Unit 1 Credit Agreement (Exhibit 10(ss) to Form 10-K for the year ended December 31, 1990, File No. 1-8847). 10(y) - Assumption Agreement, dated July 26, 1991, to be effective as of May 31, 1991, by TGCII in favor of the Issuing Bank, the Unit 2 Banks, the Unit 2 Agent and the Depositary, as defined therein (Exhibit 10(kkk) to Amendment No. 1 to File No. 33-41903). 10(z) - Guaranty, dated July 26, 1991, to be effective as of May 31, 1991, by the Utility and given in respect of the TGCII obligations under the Unit 2 Credit Agreement (Exhibit 10(lll) to Amendment No. 1 to File No. 33-41903). TNP ENTERPRISES, INC. FORM 10-K Exhibit No. Description 10(aa) - First Amended and Restated Facility Purchase Agreement, dated as of January 8, 1992, among the Utility, as the Purchaser, and TGCII, as the Seller, amending and restating the Facility Purchase Agreement among such parties dated July 26, 1991, to be effective as of May 31, 1991 (Exhibit 10(dd) to Form 10-K of the Utility for the year ended December 31, 1991, File No. 2- 97230). 10(aa)1 - Amendment No. 1 to the Unit 2 First Amended and Restated Facility Purchase Agreement, dated as of September 21, 1993, among the Utility, as the Purchaser, and TGCII, as the Seller (Exhibit 10(aa)1 to Form 10-K of the Utility for the year ended December 31, 1993, File No. 2-97230). 10(bb) - Operating Agreement, dated July 26, 1991, to be effective as of May 31, 1991, between the Utility and TGCII (Exhibit 10(nnn) to Amendment No. 1 to File No. 33-41903). 10(cc) - Non-Partition Agreement, executed July 26, 1991, to be effective as of May 31, 1991, among the Utility, TGCII and The Chase Manhattan Bank (National Association) (Exhibit 10(ppp) to Amendment No. 1 to File No. 33-41903). Power Supply Contracts 10(dd) - Contract dated May 12, 1976 between the Utility and Houston Lighting & Power Company (Exhibit 5(a), File No. 2-69353). 10(dd)1 - Amendment, dated January 4, 1989, to the Contract dated May 12, 1976 between the Utility and Houston Lighting & Power Company (Exhibit 10(cccc) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2-97230). 10(ee) - Contract dated May 1, 1986 between the Utility and Texas Electric Utilities Company, amended September 29, 1986, October 24, 1986 and February 21, 1987 (Exhibit 10(c) of Form 8 applicable to Form 10-K of the Utility for the year ended December 31, 1986, File No. 2-97230). 10(ff) - Amended and Restated Agreement for Electric Service dated May 14, 1990 between the Utility and Texas Utilities Electric Company (Exhibit 10(vv) to Form 10-K for the year ended December 31, 1990, File No. 1-8847). 10(ff)1 - Amendment, dated April 19, 1993, to Amended and Restated Agreement for Electric Service, dated May 14, 1990, As Amended between the Utility and Texas Utilities Electric Company (Exhibit 10(ii)1 to Form S-2 Registration Statement, filed on July 19, 1993, File No. 33-66232). 10(gg) - Contract dated June 11, 1984 between the Utility and Southwestern Public Service Company (Exhibit 10(d) of Form 8 applicable to Form 10-K of the Utility for the year ended December 31, 1986, File No. 2-97230). TNP ENTERPRISES, INC. FORM 10-K Exhibit No. Description 10(hh) - Contract dated April 27, 1977 between the Utility and West Texas Utilities Company amended April 14, 1982, April 19, 1983, May 18, 1984 and October 21, 1985 (Exhibit 10(e) of Form 8 applicable to Form 10-K of the Utility for the year ended December 31, 1986, File No. 2-97230). 10(ii) - Contract dated April 29, 1987 between the Utility and El Paso Electric Company (Exhibit 10(f) of Form 8 applicable to Form 10- K of the Utility for the year ended December 31, 1986, File No. 2-97230). 10(jj) - Contract dated February 28, 1974, amended May 13, 1974, November 26, 1975, August 26, 1976 and October 7, 1980 between the Utility and Public Service Company of New Mexico (Exhibit 10(g) of Form 8 applicable to Form 10-K of the Utility for the year ended December 31, 1986, File No. 2-97230). 10(jj)1 - Amendment, dated February 22, 1982, to the Contract dated February 28, 1974, amended May 13, 1974, November 26, 1975, August 26, 1976, and October 7, 1980 between the Utility and Public Service Company of New Mexico (Exhibit 10(iiii) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2- 97230). 10(jj)2 - Amendment, dated February 8, 1988, to the Contract dated February 28, 1974, amended May 13, 1974, November 26, 1975, August 26, 1976, and October 7, 1980 between the Utility and Public Service Company of New Mexico (Exhibit 10(jjjj) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2- 97230). 10(jj)3 - Amended and Restated Contract for Electric Service, dated April 29, 1988, between the Utility and Public Service Company of New Mexico (Exhibit 10(zz)3 to Amendment No. 1 to File No. 33-41903). 10(kk) - Contract dated December 8, 1981 between the Utility and Southwestern Public Service Company amended December 12, 1984, December 2, 1985 and December 19, 1986 (Exhibit 10(h) of Form 8 applicable to Form 10-K of the Utility for the year ended December 31, 1986, File No. 2-97230). 10(kk)1 - Amendment, dated December 12, 1988, to the Contract dated December 8, 1981 between the Utility and Southwestern Public Service Company amended December 12, 1984, December 2, 1985 and December 19, 1986 (Exhibit 10(llll) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2-97230). 10(kk)2 - Amendment, dated December 12, 1990, to the Contract dated December 8, 1981 between the Utility and Southwestern Public Service Company (Exhibit 19(t) to Form 10-K of the Utility for the year ended December 31, 1990, File No. 2-97230). TNP ENTERPRISES, INC. FORM 10-K Exhibit No. Description 10(ll) - Contract dated August 31, 1983, between the Utility and Capitol Cogeneration Company, Ltd. (including letter agreement dated August 14, 1986) (Exhibit 10(i) of Form 8 applicable to Form 10-K of the Utility for the year ended December 31, 1986, File No. 2-97230). 10(ll)1 - Agreement Substituting a Party, dated May 3, 1988, among Capitol Cogeneration Company, Ltd., Clear Lake Cogeneration Limited Partnership and the Utility (Exhibit 10(nnnn) to Form 10-K of the Utility for the year ended December 31, 1988, File No. 2-97230). 10(ll)2 - Letter Agreements, dated May 30, 1990 and August 28, 1991, between Clear Lake Cogeneration Limited Partnership and the Utility (Exhibit 10(oo)2 to Form 10-K of the Utility for the year ended December 31, 1992, File No. 2-97230). 10(ll)3 - Notice of Extension Letter, dated August 31, 1992, between Clear Lake Cogeneration Limited Partnership and the Utility (Exhibit 10(oo)3 to Form 10-K of the Utility for the year ended December 31, 1992, File No. 2-97230). 10(ll)4 - Scheduling Agreement, dated September 15, 1992, between Clear Lake Cogeneration Limited Partnership and the Utility (Exhibit 10(oo)4 to Form 10-K of the Utility for the year ended December 31, 1992, File No. 2-97230). 10(mm) - Interconnection Agreement between the Utility and Plains Electric Generation and Transmission Cooperative, Inc. dated July 19, 1984 (Exhibit 10(j) of Form 8 applicable to Form 10-K of the Utility for the year ended December 31, 1986, File No. 2-97230). 10(nn) - Interchange Agreement between the Utility and El Paso Electric Company dated April 29, 1987 (Exhibit 10(l) of Form 8 applicable to Form 10-K of the Utility for the year ended December 31, 1986, File No. 2-97230). 10(oo) - DC Terminal Participation Agreement between the Utility and El Paso Electric Company dated December 8, 1981 amended April 29, 1987 (Exhibit 10(m) of Form 8 applicable to Form 10-K of the Utility for the year ended December 31, 1986, File No. 2-97230). Employment Contracts 10(pp) - Texas-New Mexico Power Company Executive Agreement for Severance Compensation Upon Change in Control, executed November 11, 1993, between Sector Vice President and Chief Financial Officer and the Utility (Pursuant to Instruction 2 of Reg. 229.601(a), accompanying this document is a schedule: (i) identifying documents substantially identical to the document which have been omitted from the Exhibits; and (ii) setting forth the material details in which such omitted documents differ from the document) (Exhibit 10(pp) to Form 10-K of the Utility for the year ended December 31, 1993, File No. 2-97230). TNP ENTERPRISES, INC. FORM 10-K Exhibit No. Description 10(qq) - Texas-New Mexico Power Company Key Employee Agreement for Severance Compensation Upon Change in Control, executed November 11, 1993, between Assistant Treasurer and the Utility (Pursuant to Instruction 2 of Reg. 229.601(a), accompanying this document is a schedule: (i) identifying documents substantially identical to the document which have been omitted from the Exhibits; and (ii) setting forth the material details in which such omitted documents differ from the document) (Exhibit 10(qq) to Form 10-K of the Utility for the year ended December 31, 1993, File No. 2-97230). 10(rr) - Agreement between James M. Tarpley and the Company and the Utility, effective January 1, 1994 (Exhibit 10(rr) to Form 10-K of the Utility for the year ended December 31, 1993, File No. 2-97230). 10(ss) - Agreement between Dwight R. Spurlock and the Company and the Utility, effective November 9, 1993 (Exhibit 10(ss) to Form 10-K of the Utility for the year ended December 31, 1993, File No. 2-97230). *13 - Annual Report to Shareholders for the year ended December 31, 1993. *21 - Subsidiaries of the Registrant. *23 - Independent Auditors' Consent - KPMG Peat Marwick. TNP ENTERPRISES, INC. FORM 10-K

104669_1993.txt

104669

1993

ITEM 1. BUSINESS. The term 'Warner-Lambert' or 'the Company' refers to Warner-Lambert Company, a Delaware corporation organized in that state in 1920, and its consolidated subsidiaries unless otherwise indicated or unless the context otherwise requires. Industry Segments and Geographic Areas. Financial information by industry segment and geographic area for the years 1993, 1992 and 1991 is presented in the Warner-Lambert 1993 Annual Report as set forth below. The summary of Warner-Lambert's industry segments, geographic areas and related financial information, set forth in Note 20 to the consolidated financial statements on page 47 of the Warner-Lambert 1993 Annual Report, is incorporated herein by reference. All product names appearing in capitalized letters in this report on Form 10-K, with the exception of ZOVIRAX and ZANTAC, are trademarks of Warner-Lambert, its affiliates, related companies or licensors. ZOVIRAX is a registered trademark of Wellcome plc. ZANTAC is a registered trademark of Glaxo Holdings plc. BUSINESS SEGMENTS A detailed description of Warner-Lambert's industry segments is as follows: Pharmaceutical Products The principal products of Warner-Lambert in its Pharmaceutical Products segment are ethical pharmaceuticals, biologicals, specialty chemicals and capsules. Ethical Pharmaceuticals and Biologicals: Warner-Lambert manufactures and/or sells, in the United States and/or internationally, an extensive line of ethical pharmaceuticals, biologicals and specialty chemicals under trademarks and trade names such as PARKE-DAVIS and GOEDECKE. Among these products are analgesics (PONSTAN, PONSTEL, EASPRIN, VALORON, VALORON-N and VEGANIN), anesthetics (KETALAR), anthelmintics (VANQUIN), anticonvulsants (DILANTIN, ZARONTIN and NEURONTIN), anti-infectives (CHLOROMYCETIN, COLYMYCIN, DORYX, ERYC and MANDELAMINE), antihistamines (BENADRYL), antivaricosities (HEPATHROMBIN), anti-viral agents (VIRA-A), bronchodilators (CHOLEDYL and CHOLEDYL SA), cardiovascular products (NOVADRAL, DILZEM, PROCAN SR, ACCUPRIL, ACCUZIDE, ACCURETIC and NITROSTAT), cognition drugs for treatment of mild-to-moderate Alzheimer's disease (COGNEX), dermatologics (BEBEN and UTICORT), prescription hemorrhoidal preparations (ANUSOL HC), hemostatic agents (THROMBOSTAT), hormonal agents (PITRESSIN), influenza vaccines (FLUOGEN), lipid regulators (LOPID), nonsteroidal anti-inflammatories (MECLOMEN), oral contraceptives (LOESTRIN), oxytocics (PITOCIN), psychotherapeutic products (CETAL RETARD, DEMETRIN and NARDIL) and urinary analgesics (PYRIDIUM). These products are promoted for the most part directly to health care professionals through personal solicitation of doctors and other professionals by sales representatives with scientific training, direct mail contact and advertising in professional journals. They are sold either directly or through wholesalers to government agencies, chain and independent retail pharmacies, physician supply houses, hospitals, clinics, convalescent and nursing homes, mail order houses, health care professionals and health maintenance organizations. For further discussion of Warner-Lambert's ethical products, see 'Regulation' below. On September 9, 1993, Warner-Lambert received marketing approval for COGNEX (Warner-Lambert's trademark for tacrine or THA), the first effective treatment for mild-to-moderate Alzheimer's disease, in the United States and began to ship the product in late September. Warner-Lambert is attempting to obtain marketing approval for COGNEX in other major markets such as Europe and Canada. Warner-Lambert received clearance on December 30, 1993 to market NEURONTIN (gabapentin capsules) in the United States as add-on therapy in the treatment of certain types of adult epilepsy (i.e., partial seizures, with and without secondary generalization). Warner-Lambert began marketing NEURONTIN in the United Kingdom in 1993. On January 4, 1993, the U.S. patent covering LOPID, a lipid regulator, expired, subjecting LOPID to generic competition. In December 1992, Warner-Lambert began marketing gemfibrozil, the generic equivalent of LOPID, through its division, Warner Chilcott Laboratories, as described below. In the third quarter of 1993, two competitive generic versions of gemfibrozil tablets received marketing approval in the United States. Combined worldwide sales of LOPID and gemfibrozil declined in 1993 and are expected to decline further in 1994. Warner-Lambert has a separate division, Warner Chilcott Laboratories, which is dedicated solely to the generic drug business. Warner Chilcott Laboratories is a manufacturer and/or marketer of 80 generic drugs including gemfibrozil, carbamazapine chewable, hydrocodone with acetaminophen, nitroglycerin patch, potassium chloride ER, sulindac, and a line of generic antibiotics, including ampicillin, amoxicillin, penicillin, cephalexin and minocycline. These products are promoted directly to the pharmacy community and are sold principally to drug wholesalers, chain and retail pharmacies and health maintenance organizations. In January 1993, Warner-Lambert acquired a 34 percent equity interest in Jouveinal S.A., a French pharmaceutical company, and entered into a license option agreement that grants Warner-Lambert the right of first refusal as to the licensing of future Jouveinal products outside of France, Canada and French-speaking Africa. Capsules: Warner-Lambert is the leading worldwide producer of empty hard-gelatin capsules used by pharmaceutical companies for their production of encapsulated products. These capsules are used by Warner-Lambert or manufactured by Warner-Lambert according to the specifications of each of its customers and are sold under such trademarks as CAPSUGEL, CONI-SNAP and SNAP-FIT. Consumer Health Care Products The principal products of Warner-Lambert in its Consumer Health Care Products segment are over-the-counter products, shaving products and pet care products. Over-the-counter Products: Warner-Lambert manufactures and/or sells, in the United States and/or internationally, a line of over-the-counter pharmaceuticals and health care products, including antacids (ROLAIDS, SODIUM FREE ROLAIDS, EXTRA STRENGTH ROLAIDS and GELUSIL), dermatological products (LUBRIDERM, LUBRIDERM BODY BAR, LUBRIDERM LOOFA BAR, ROSKEN SKIN REPAIR, CORN HUSKERS and LISTEREX), sinus preparations (SINUTAB), antihistamines and allergy products (BENADRYL, BENADRYL-D, BENADRYL COLD, BENADRYL DAY & NIGHT and BENADRYL ALLERGY/SINUS/HEADACHE), hemorrhoidal preparations (ANUSOL, ANUSOL HC-1 and TUCKS), vaginal moisturizers (REPLENS), laxatives (AGORAL), cough syrups/suppressants (BENYLIN, BENYLIN-DM, BENYLIN DECONGESTANT, BENYLIN EXPECTORANT and BENYLIN PEDIATRIC), cough tablets (HALLS and HALLS-PLUS), throat drops (HALLS SOOTHERS), vitamin C drops (HALLS), vitamins (MYADEC), antipruritics (CALADRYL, BENADRYL spray and cream and STINGOSE), rubbing alcohol (LAVACOL), hydrogen peroxide (PROXACOL), self-diagnostic early pregnancy test kits (e.p.t'r' stick test), oral antiseptics (LISTERINE and COOL MINT LISTERINE), mouthwash/anticavity dental rinses (LISTERMINT with fluoride), effervescent denture cleaning tablets and denture cleanser pastes (EFFERDENT and FRESH 'N BRITE) and denture adhesives (EFFERGRIP). These products are promoted principally through consumer advertising and promotional programs and some are promoted directly to health care professionals. They are sold principally to drug wholesalers, chain and retail pharmacies, chain and independent food stores, mass merchandisers, physician supply houses and hospitals. In December 1993, Warner-Lambert signed separate agreements with Glaxo Holdings plc ('Glaxo') and Wellcome plc ('Wellcome') to establish joint ventures in various countries to develop and market non-prescription consumer health care products. Pursuant to the agreements with Glaxo, Warner-Lambert and Glaxo formed a joint venture in the United States named Glaxo Warner-Lambert OTC G.P. The joint venture will develop, seek approval of and market over-the-counter versions of Glaxo prescription drugs in the United States, including ZANTAC, the leading prescription ulcer treatment product. The joint venture will concentrate initially on developing ZANTAC for sale as an over-the-counter product in the United States. Additional joint ventures are expected to be formed with Glaxo in other major markets outside the United States, excluding Japan. Direction of the joint ventures will be provided by a management committee of representatives from each company. Day-to-day operations will be the responsibility of Warner-Lambert, and the joint ventures' over-the-counter products will be sold by Warner-Lambert's consumer health care products sales and marketing organization, which in most countries will be a Warner Wellcome joint venture, as described below. Warner-Lambert and Glaxo will share development costs and profits equally, with Glaxo receiving a royalty on all over-the-counter sales by the joint ventures. Pursuant to the agreements with Wellcome, Warner-Lambert and Wellcome formed a joint venture in the United States and a joint venture in Canada, each named Warner Wellcome Consumer Health Products. Joint ventures are expected to be established by Warner-Lambert and Wellcome in Europe, Australia and other countries throughout the world. The alliance calls for both companies to contribute to the joint ventures current and future over-the-counter products (excluding HALLS and ROLAIDS products). Under the agreements, after a two-year phase-in period, Warner-Lambert and Wellcome respectively will receive approximately 70 percent and 30 percent of the profits generated in the United States. A New Drug Application ('NDA') for the conversion to over-the-counter use of Wellcome's anti-viral drug ZOVIRAX as an anti-herpes medication was filed with the U.S. Food and Drug Administration ('FDA') in August 1993. Subject to such conversion, over-the-counter profits on ZOVIRAX in the United States will be shared in favor of the innovator, Wellcome. Profits on current products will be shared equally in Canada and, when joint ventures are established in such countries, in Australia and the European countries. Profits on ZOVIRAX cream outside the United States will also be shared equally, subject to a royalty to Wellcome if sales exceed a threshold amount. Other future over-the-counter switch products will be subject to a profit split favoring the innovator. Warner-Lambert will be the managing partner of the joint ventures with Wellcome (referred to herein as the 'Warner Wellcome' joint ventures or organizations), with day-to-day operating responsibility. Each partner will continue to manufacture products it contributes to the joint ventures. Glaxo Warner-Lambert OTC G.P. commenced operations in December 1993. The Warner Wellcome joint ventures in the United States and Canada commenced operations in January 1994. Warner Wellcome organizations are expected to be formed in Europe and Australia in 1994. Shaving Products: Warner-Lambert manufactures and/or sells razors and blades, both domestically and internationally. In March 1993, Warner-Lambert acquired the European, U.S. and Canadian operations of Wilkinson Sword, an international manufacturer and marketer of razors and blades. Shaving products are manufactured and/or marketed under the SCHICK, WILKINSON, WILKINSON SWORD and related trademarks. Permanent (nondisposable) products marketed under the SCHICK trademark include TRACER/FX, SUPER II, SUPER II PLUS, ULTREX PLUS, SLIM TWIN, ADVANTAGE, PERSONAL TOUCH and INJECTOR PLUS CHROMIUM. Disposable twin blade products marketed under the SCHICK trademark include SCHICK DISPOSABLE, SLIM TWIN, PERSONAL TOUCH, PERSONAL TOUCH SLIM and ULTREX DISPOSABLE. Products marketed under the WILKINSON or WILKINSON SWORD trademarks include nondisposable systems such as PROTECTOR, PROFILE, SYSTEM II and DUPLO, and disposable products that include COLOURS, PRONTO, RETRACTOR, RETRACTOR TWIN, SHAVA II and ULTRA CARESSE LADYSHAVER. These products are distributed directly to large retail outlets, as well as to wholesalers for sale to smaller retailers, drugstores and pharmacies. Retail outlets include pharmacies, food stores, department stores, variety stores, mass merchandisers and other miscellaneous outlets. Pet Care Products: Warner-Lambert manufactures and sells various products on a worldwide basis for ornamental fish and for other small pets, as well as books relating to various pets, under the trademark TETRA. In addition, in September 1993 Warner-Lambert acquired Willinger Bros., Inc., a manufacturer and distributor of aquarium products (including power filters and replacement cartridges, air pumps, plastic plants and other accessories) that are marketed largely under the WHISPER and SECONDNATURE trademarks. These pet care products are promoted to consumers through cooperative advertising and to retailers through direct promotion and advertising in trade publications. They are sold to wholesalers for sale to smaller retailers and directly to larger chain stores and retailers, in each case for ultimate sale to consumers. Confectionery Products The principal products of Warner-Lambert in its Confectionery Products segment are chewing gums and breath mints. Warner-Lambert manufactures and/or sells, in the United States and/or internationally, a broad line of chewing gums and breath mints, as well as specialty candies. Among these products are slab chewing gums (TRIDENT, DENTYNE and DENTYNE SUGARFREE), chunk bubble gums (BUBBLICIOUS, BUBBLICIOUS MONDO and TRIDENT SOFT), center-filled gums (FRESHEN-UP), candy-coated gums (CHICLETS, CHICLETS TINY SIZE and CLORETS) and stick gums (CLORETS, CINN*A*BURST and MINT*A*BURST). The breath mint line includes CERTS, SUGARFREE CERTS, SUGARFREE CERTS MINI-MINTS, CERTS EXTRA FLAVOR and CLORETS. These products are promoted directly to the consumer primarily through consumer advertising and in-store promotion programs. They are sold directly to chain and independent food stores, chain pharmacies and mass merchandisers or through candy and tobacco wholesalers and to other miscellaneous outlets which in turn sell to consumers. In the fourth quarter of 1993, Warner-Lambert sold the assets of its chocolate/caramel business, including the Junior Mints'r', Sugar Daddy'r', Sugar Babies'r', Charleston Chew!'r' and Pom Poms'r' product lines, in order to refocus its resources on its core pharmaceutical and consumer products businesses. Novon Products Group NOVON is the trademark for a family of specialty polymers based upon starch and other fully biodegradable materials. Warner-Lambert discontinued the operations of its Novon Products Group as of November 30, 1993, primarily in order to focus its resources on its core business areas. Warner-Lambert has entered into agreements with licensees and is currently in discussions with respect to the sale of substantially all of the intellectual property and certain other assets of the business. In the first quarter of 1993, Warner-Lambert recorded a one-time charge of $70 million before tax or $45 million after-tax, in connection with the disposition of the Novon Products Group. The charge included a write-down of Novon's physical assets to net realizable value, as well as a provision for additional anticipated costs to be incurred during the phase-out period. INTERNATIONAL OPERATIONS Although Warner-Lambert has globalized its organization on a segment basis, Warner-Lambert's international businesses are carried on principally through subsidiaries and branches, which are generally staffed and managed by citizens of the countries in which they operate. Approximately 23,000 of Warner-Lambert's employees are located outside the United States and only a small number of such employees are United States citizens. Certain of the products discussed above are manufactured and marketed solely in the United States and certain of such products are manufactured and marketed solely in one or more foreign countries. International sales to unaffiliated customers in 1993 amounted to approximately 53% of worldwide sales. International sales do not include United States export sales, which represent less than 1% of domestic sales. The seven largest markets with respect to the distribution of Warner-Lambert products sold outside the United States during 1993 were Japan, Germany, Canada, Mexico, France, the United Kingdom and Italy. Sales in these markets accounted for approximately 64% of Warner-Lambert's international sales, with no one country accounting for more than 17% of international sales. The international operations are subject to certain risks inherent in carrying on business abroad, including possible nationalization, expropriation and other governmental action, as well as fluctuations in currency exchange rates. RESTRUCTURING In November 1993, Warner-Lambert announced a program covering the rationalization of manufacturing facilities, principally in North America, including the eventual closing of seven plants, an organizational restructuring and related workforce reductions of approximately 2,800 positions over the next several years. The program was prompted by the combined impact of rapid and profound changes in the Company's competitive environment, including the growing impact of managed health care and other cost-containment efforts in the United States, cost regulations in Europe and changes in U.S. tax law (discussed below under the caption 'Regulation'). For further discussion of Warner-Lambert's restructuring, see 'Management's Discussion and Analysis of Financial Condition and Results of Operations -- Restructuring Actions' and Note 3 to the Company's consolidated financial statements, contained in the Warner-Lambert 1993 Annual Report and incorporated herein by reference. COMPETITION Most markets in which Warner-Lambert is engaged are highly competitive and characterized by substantial expenditures in the advertising and promotion of new and existing products. In addition, there is intense competition in research and development in all of Warner-Lambert's industry segments. No material part of the business of any of Warner-Lambert's industry segments is dependent upon one or a few customers. However, the Company cannot predict what effect, if any, the health care proposals described below under the caption 'Regulation' may have on its operations. MATERIALS AND SUPPLIES Warner-Lambert's products, in general, are produced and packaged at its own facilities. Other than certain generic drug products, relatively few items are manufactured in whole or in part by outside suppliers. Raw materials and packaging supplies are purchased from a variety of outside suppliers. The loss of any one source of supply would not have a material effect on the business of any of Warner-Lambert's industry segments. Warner-Lambert seeks to protect against fluctuating costs and to assure availability of raw materials and packaging supplies by, among other things, locating alternative sources of supply and, in some instances, making selective advance purchases. TRADEMARKS AND PATENTS Warner-Lambert's major trademarks are protected by registration in the United States and other countries where its products are marketed. Warner-Lambert believes these trademarks are important to the marketing of the related products and acts to protect them from infringement. Warner-Lambert owns many patents and has many patent applications pending in the patent offices of the United States and other countries. Although a number of products and product lines have patent protection that is significant in the marketing of such products, the management of Warner-Lambert does not consider that any single patent or related group of patents is material to Warner-Lambert's business as a whole or any of its industry segments. On January 4, 1993, the United States patent for LOPID expired, subjecting LOPID to generic competition, as discussed above under the caption 'Business Segments -- Pharmaceutical Products'. RESEARCH AND DEVELOPMENT Warner-Lambert employs over 2,000 scientific and technical personnel in research and development activities at various research facilities located in the United States and in foreign countries. Warner-Lambert invested approximately $465 million in research and development in 1993, compared with $473 million in 1992 and $423 million in 1991. Approximately eighty-two percent (82%) of Warner-Lambert's 1993 research and development spending was for research and development related to pharmaceutical products. Warner-Lambert believes research and development activities are essential to its business and intends to continue such activities. EMPLOYEES At December 31, 1993 approximately 35,000 people were employed by Warner-Lambert throughout the world. REGULATION Warner-Lambert's business is subject to varying degrees of governmental regulation in the countries in which it manufactures and distributes products, and the general trend in these countries is toward more stringent regulation. In the United States, the food, drug and cosmetic industries have been subject to regulation by various federal, state and local agencies with respect to product safety and effectiveness, manufacturing and advertising and labeling. Accordingly, from time to time, with respect to particular products under review, such agencies may require Warner-Lambert to participate in meetings, whether public or private, to address safety, efficacy, manufacturing and/or regulatory issues, to conduct additional testing or to modify its advertising and/or labeling. During the third quarter of 1993, a consent decree with the FDA was entered into by Warner-Lambert and Melvin R. Goodes, Chairman and Chief Executive Officer, and Lodewijk J. R. de Vink, President and Chief Operating Officer, covering issues related to compliance with manufacturing and quality procedures. The decree is a court-approved agreement that primarily requires Warner-Lambert to certify that laboratory and/or manufacturing procedures at its pharmaceutical manufacturing facilities in the United States and Puerto Rico meet current Good Manufacturing Practices established by the FDA. Under the terms of the decree, Warner-Lambert was permitted to ship inventory existing at the time of entry of the decree of most of its products, and has been permitted to continue to manufacture and ship prescription medications deemed medically necessary while the certification process is ongoing. The manufacture and distribution of its remaining products was suspended pending completion of certain certification procedures. Warner-Lambert's manufacturing facilities in the mainland United States quickly resumed substantially full operations. The bulk of the prescription products manufactured at the two Puerto Rico facilities were deemed medically necessary and had no significant interruption in supply, and the production of certain other products has been transferred from such facilities to mainland U.S. facilities or sourced from third parties. There are several prescription products that have not yet returned to the market or have been withdrawn. It is not possible to predict when the manufacturing facilities in Puerto Rico will be fully operational, although Warner-Lambert is actively working with outside experts and the FDA to accomplish this as soon as possible. Compliance with FDA restrictions, including the consent decree, resulted in an estimated aggregate loss of sales revenue of approximately $135 million in 1993. Pursuant to the FDA's Application Integrity Policy, Warner-Lambert, through independent experts in pharmaceutical manufacturing, is also conducting validity assessments of FDA filings made with respect to products manufactured or to be manufactured at its facilities in Vega Baja and Fajardo, Puerto Rico, due to discrepancies found in data generated at those facilities. The FDA has deferred substantive scientific reviews of pending NDA's and Abbreviated New Drug Applications ('ANDA's') for products to be manufactured at these facilities (including the oral contraceptive ESTROSTEP), and for supplements to NDA's or ANDA's for products currently manufactured at these facilities, until further assessments of Warner-Lambert filings are completed. The FDA did not suspend review of two potentially medically important drugs, COGNEX (tacrine) and NEURONTIN (gabapentin), discussed under the caption 'Business Segments -- Pharmaceutical Products' above, both of which obtained U.S. marketing approval in 1993. Warner-Lambert has pledged its full cooperation and has actively worked with the FDA in order to resolve all issues relating to this matter. Warner-Lambert expects to file shortly the expert validity assessments that have not yet been filed. The FDA will review all of these filings, as well as a Corrective Action Plan the Company is currently preparing, which outlines mechanisms in place to prevent a recurrence of the data integrity issue. The FDA will then inspect the two facilities prior to lifting the Application Integrity Policy. It is not possible to predict when the Application Integrity Policy will be lifted or whether the FDA will take additional action. Regulatory requirements concerning the research and development of drug products have increased in complexity and scope in recent years. This has resulted in a substantial increase in the time and expense required to bring new products to market. At the same time, the FDA requirements for approval of generic drugs (drugs containing the same active chemical as an innovator's product) have been decreased by the adoption of abbreviated new drug approval procedures for most generic drugs. Generic versions of many of Warner-Lambert's products in the Pharmaceutical Products segment are being marketed, and generic substitution legislation, which permits a pharmacist to substitute a generic version of a drug for the one prescribed, has been enacted in some form in all states. These factors have resulted in increased competition from generic manufacturers in the market for ethical products. For example, LOPID has been subject to this increased competition since its patent expired on January 4, 1993, as discussed above under the caption 'Business Segments -- Pharmaceutical Products'. Federal legislation enacted in late 1990 prohibits the expenditure of federal Medicaid funds for outpatient drugs of manufacturers that do not agree to pay specified rebates. Similar legislation has been enacted in several states extending rebates to state administered non-Medicaid programs. Warner-Lambert has been adhering to such rebate programs and other related rebate programs and has incurred rebate expenses of $57 million, $37 million and $15 million in 1993, 1992 and 1991, respectively. However, Warner-Lambert does not believe such rebate expenses have had, or will have, a material adverse effect upon its financial position. The Clinton Administration has identified the containment of health care costs as a major priority. The Administration's proposed health care plan, along with a number of alternative proposals, has negative implications for the pharmaceutical industry. Although Warner-Lambert cannot predict at this time which legislation, if any, will be enacted, it is likely that such legislation would result in increased pressures on the operating results of Warner-Lambert. In addition, primarily as a result of the passage by Congress of the Omnibus Budget Reconciliation Act of 1993, including changes to Section 936 of the Internal Revenue Code, Warner-Lambert estimates that its effective tax rate will increase in 1994 by approximately 1.5 to 2.5 percentage points. The regulatory agencies under whose purview Warner-Lambert operates have administrative and legal powers that may subject Warner-Lambert and its products to seizure actions, product recalls and other civil and criminal actions. They may also subject the industry to emergency regulatory requirements. Warner-Lambert's policy is to comply fully with all regulatory requirements. It is impossible to predict, however, what effect, if any, these matters or any pending or future legislation, regulations or governmental actions may have on the conduct of Warner-Lambert's business in the future. In most of the foreign countries where Warner-Lambert does business, it is subject to a regulatory and legislative climate similar to or more restrictive than that described above. Certain health care reform measures enacted in 1993 in Germany, including the imposition of price reductions on pharmaceutical products and prescribing restrictions on doctors, had a negative impact on Warner-Lambert's pharmaceutical operations in Germany in 1993 and are expected to have a negative impact on such operations in 1994. The long-term impact of such measures on Warner-Lambert's operations cannot be assessed at this time. ENVIRONMENT Warner-Lambert is responsible for compliance with a number of environmental laws and regulations. While Warner-Lambert has maintained control systems designed to assure compliance in all material respects with environmental laws and regulations, during 1993 it initiated a worldwide audit program to assure environmental compliance with a growing number of increasingly complex environmental regulations. Warner-Lambert is involved in various environmental matters, including actions initiated by the Environmental Protection Agency (the 'EPA') under the Comprehensive Environmental Response, Compensation and Liability Act, also known as Superfund, by state agencies under similar state legislation, or by other parties. The Company is presently remediating environmental problems at certain sites, including sites it previously owned. While it is not possible to predict the outcome of the proceedings described above or the ultimate costs of remediation, the management of Warner-Lambert believes it is unlikely that their ultimate disposition will have a material adverse effect on Warner-Lambert's financial position, liquidity, cash flow or results of operations for any year. Actions with respect to environmental programs and compliance result in operating expenses and capital expenditures. Warner-Lambert's capital expenditures with respect to environmental programs and compliance in 1993 were not, and in 1994 are not expected to be, material to the business of Warner-Lambert. For additional information relating to environmental matters, see Note 14 to the consolidated financial statements, 'Environmental Liabilities', on page 43 of the Warner-Lambert 1993 Annual Report, incorporated herein by reference. ITEM 2.

ITEM 2. PROPERTIES. The executive offices of Warner-Lambert are located in Morris Plains, New Jersey. In the United States, including Puerto Rico, Warner-Lambert owns facilities aggregating approximately 6,464,000 square feet and leases facilities having an aggregate of approximately 874,000 square feet. Warner-Lambert's principal U.S. manufacturing plants are located in Lititz, Pennsylvania (pharmaceuticals and consumer health care); Rockford, Illinois (confectionery and consumer health care); Rochester, Michigan (pharmaceuticals); Holland, Michigan (pharmaceuticals); Greenwood, South Carolina (capsules); and Milford, Connecticut (razors and blades). Warner-Lambert Inc., a wholly owned subsidiary of Warner-Lambert operating in Puerto Rico, has plants located in Carolina (confectionery); Fajardo (pharmaceuticals); and Vega Baja (pharmaceuticals, consumer health care and confectionery). In November 1993, in connection with the restructuring discussed above under the caption 'Business -- Restructuring', Warner-Lambert announced plans to phase out and close its Carolina, Puerto Rico confectionery manufacturing plant by the end of 1994. In the United States, Warner-Lambert currently distributes its various products through its manufacturing plants and two primary distribution centers located in Lititz, Pennsylvania and Elk Grove, Illinois. Principal U.S. research facilities are located in Ann Arbor, Michigan (pharmaceuticals) and Morris Plains, New Jersey (pharmaceuticals, consumer health care and confectionery). Internationally, Warner-Lambert owns, leases, or operates, through its subsidiaries or branches, 72 production facilities in 35 countries. Principal international manufacturing plants are located in Germany, the United Kingdom, Belgium, Italy, Canada, Mexico, Hong Kong, Japan, Ireland, Spain, France, Brazil, Venezuela and Australia. Principal international research facilities are located in Germany, Japan, the United Kingdom and Canada. In order to increase efficiency and to lower its cost of goods sold, Warner-Lambert, over a number of years and at significant cost, has consolidated many of its plants and facilities around the world. This has often resulted in the production of pharmaceutical products, consumer health care products and/or confectionery products at a single facility. Warner-Lambert's facilities are generally in good operating condition and repair and at present are adequately utilized within reasonable limits. Leases are not material to the business of Warner-Lambert taken as a whole. For information regarding the organizational restructuring and plant rationalization announced by Warner-Lambert in November 1993, see 'Business -- Restructuring' above. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. Warner-Lambert and certain present and former employees have been served with subpoenas by the U.S. Attorney's office in Maryland, which is conducting an inquiry relating to compliance with FDA regulations, to produce records and/or appear before a federal grand jury in Baltimore. Warner-Lambert is cooperating with the inquiry and cannot predict what the outcome of the investigation will be. In September 1993, Warner-Lambert received a Complaint and Compliance Order from the EPA seeking penalties of $268,000 for alleged violations of the Resource Conservation and Recovery Act, Boilers and Industrial Furnace regulations. Warner-Lambert responded to the complaint in October 1993. The Company is contesting the allegations and has entered into negotiations with the EPA. Warner-Lambert, along with numerous other pharmaceutical manufacturers and wholesalers, has been sued in a number of state and federal antitrust lawsuits by retail pharmacies seeking treble damages and injunctive relief. These actions arise from alleged price discrimination by which the defendant drug companies, acting alone or in concert, are alleged to have favored institutions, managed care entities, mail order pharmacies and other buyers with lower prices for brand name prescription drugs than those afforded to plaintiff retailers. The federal cases have been consolidated by the Judicial Panel on Multidistrict Litigation and transferred to the United States District Court for the Northern District of Illinois for pre-trial proceedings. The state cases, which are pending in California, are expected to be coordinated in the Superior Court of California, County of San Francisco. Warner-Lambert believes that these actions are without merit and will defend itself vigorously. Although it is too early to predict the outcome of these actions, Warner-Lambert does not expect this litigation to have a material adverse effect on its financial position, liquidity, cash flow or results of operations. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not Applicable. EXECUTIVE OFFICERS OF THE REGISTRANT Information with respect to the executive officers of Warner-Lambert as of March 1, 1994 is set forth below: (table continued on next page) (table continued from previous page) (table continued on next page) (table continued from previous page) (table continued on next page) (table continued from previous page) All of the above-mentioned officers, with the exception of Dr. Cuatrecasas, Mr. Fotiades, Mr. Gross and Dr. Kumar, have been employed by Warner-Lambert for the past five years. Dr. Cuatrecasas has been employed by Warner-Lambert since October 1989. Prior to that time, Dr. Cuatrecasas had been employed as Senior Vice President, Research and Development, at Glaxo, Inc. from February 1986 to August 1989. Glaxo, Inc., a multinational pharmaceutical company, had sales of approximately $3.5 billion for the year ending June 1988. Prior to his employment with Glaxo, Dr. Cuatrecasas had been employed since 1975 as Vice President, Research, Development and Medical, at Burroughs Wellcome Company. Burroughs Wellcome Company is a wholly owned subsidiary of The Wellcome Foundation Ltd., a multinational pharmaceutical company which had sales of approximately $1.5 billion in 1986. Mr. Fotiades has been employed by Warner-Lambert since November 1992. Prior to that time, Mr. Fotiades had been employed by Bristol-Myers Squibb Company. From January 1992 to November 1992, Mr. Fotiades held the position of President, Consumer Products, Japan and from January 1991 to January 1992 he served as Senior Vice President, General Manager, Clairol U.S., Bristol-Myers Squibb Company, a multinational health care and consumer products company with sales of approximately $11.0 billion in 1992. Prior to his employment with Bristol-Myers Squibb, he held the position of Senior Vice President, Marketing, Boyle-Midway, American Home Products Corporation, from August 1988 to December 1990. American Home Products Corporation, a multinational health care and food products company, had sales of approximately $6.8 billion in 1990. From September 1987 to July 1988, Mr. Fotiades held the position of General Manager, Antiperspirant/Deodorant, the Proctor & Gamble Company, a multinational consumer products company with sales of approximately $21.3 billion for the year ended June 30, 1989. Mr. Gross has been employed by Warner-Lambert since January 1990. Prior to that time, Mr. Gross had been employed since 1963 by General Electric Company in various executive positions. From January 1987 to March 1989, Mr. Gross held the position of Vice President and General Manager, GE Silicones. General Electric Company, a multinational diversified company, had sales in excess of $38.0 billion in 1988. Dr. Kumar has been employed by Warner-Lambert since October 1992. Prior to that time, Dr. Kumar had been employed since January 1986 by Pepsico, Inc. From February 1990 to October 1992 Dr. Kumar held the position of Senior Vice President, Research & Development, Pepsi Worldwide Beverage. From February 1988 to February 1990 he held the position of Vice President, Research & Development, Pepsi Worldwide Beverage, and from January 1986 to February 1988, the position of Vice President, Research & Development, Pepsi U.S.A. Pepsico, Inc. is in the beverage, snack food and restaurant business, both domestically and internationally, with sales of approximately $22 billion in 1992. None of the above officers has any family relationship with any Director or with any other officer. Officers are elected by the Board of Directors for a term of office lasting until the next annual organizational meeting of the Board of Directors or until their successors are elected and have qualified. No officer listed above was appointed pursuant to any arrangement or understanding between such officer and the Board of Directors or any member or members thereof. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The information set forth under the caption 'Management's Discussion and Analysis of Financial Condition and Results of Operations -- Shareholder Information' on page 33 of the Warner-Lambert 1993 Annual Report is incorporated herein by reference. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. The information set forth under the caption 'Five-Year Summary of Selected Financial Data' on page 34 of the Warner-Lambert 1993 Annual Report is incorporated herein by reference. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The information set forth under the caption 'Management's Discussion and Analysis of Financial Condition and Results of Operations' on pages 28 through 33 of the Warner-Lambert 1993 Annual Report is incorporated herein by reference and should be read in conjunction with the consolidated financial statements and the notes thereto contained on pages 34 through 47 of the Warner-Lambert 1993 Annual Report. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The consolidated financial statements of Warner-Lambert and its subsidiaries, together with the report thereon of Price Waterhouse dated January 24, 1994, listed in Item 14(a)1 and included in the Warner-Lambert 1993 Annual Report at pages 35 through 48, are incorporated herein by reference. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not Applicable. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The required information relating to the Warner-Lambert Directors and nominees is incorporated herein by reference to pages 2 through 7 of the Warner-Lambert Proxy Statement for the Annual Meeting of Stockholders to be held on April 26, 1994. Information relating to executive officers of Warner-Lambert is set forth in Part I of this Form 10-K on pages 9 through 13. Information relating to compliance with Section 16(a) of the Securities Exchange Act of 1934 is contained in the Proxy Statement, referred to above, at page 8 and such information is incorporated herein by reference. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. Information relating to executive compensation is contained in the Proxy Statement, referred to above in Item 10, at pages 11 through 22 and such information is incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. (a) Information relating to the beneficial ownership of more than five percent of Warner-Lambert's Common Stock is contained in the Proxy Statement, referred to above in Item 10, at page 9 and such information is incorporated herein by reference. (b) Information relating to security ownership of management is contained in the Proxy Statement, referred to above in Item 10, at page 8 and such information is incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Not Applicable. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (A) 1. ALL FINANCIAL STATEMENTS The following items are included in Part II of this report through incorporation by reference to pages 35 through 48 of the Warner-Lambert 1993 Annual Report: Consolidated Statements of Income for each of the three years in the period ended December 31, 1993. Consolidated Statements of Retained Earnings for each of the three years in the period ended December 31, 1993. Consolidated Balance Sheets at December 31, 1993 and 1992. Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 1993. Notes to Consolidated Financial Statements. Report of Independent Accountants. 2. FINANCIAL STATEMENT SCHEDULES Included in Part IV of this report: Report of Independent Accountants on Financial Statement Schedules. Schedule I -- Marketable Securities -- Other Investments Schedule II -- Amounts Receivable from Related Parties and Underwriters, Promoters and Employees other than Related Parties Schedule V -- Property, Plant and Equipment Schedule VI -- Accumulated Depreciation of Property, Plant and Equipment Schedule VIII -- Valuation and Qualifying Accounts and Reserves Schedule IX -- Short-term Borrowings Schedule X -- Supplementary Income Statement Information Schedules other than those listed above are omitted because they are either not applicable or the required information is included through incorporation by reference to pages 35 through 48 of the Warner-Lambert 1993 Annual Report. 3. EXHIBITS (3) Articles of Incorporation and by-laws (a) Restated Certificate of Incorporation of Warner-Lambert Company filed November 10, 1972, as amended to April 24, 1990 (Incorporated by reference to Warner-Lambert's Current Report on Form 8-K, dated April 24, 1990). (b) By-Laws of Warner-Lambert Company, as amended to October 25, 1988 (Incorporated by reference to Warner-Lambert's Quarterly Report on Form 10-Q for the quarter ended September 30, 1988 (File No. 1-3608)). (4) Instruments defining the rights of security holders, including indentures (a) Rights Agreement, dated as of June 28, 1988, and amended as of June 27, 1989, between Warner-Lambert Company and First Chicago Trust Company of New York, as Rights Agent (Incorporated by reference to Warner-Lambert's Registration Statement on Form 8-A, dated June 28, 1988, as amended by Form 8, dated July 5, 1989 (File No. 1-3608)). (b) Warner-Lambert agrees to furnish to the Commission, upon request, a copy of each instrument with respect to issues of long-term debt of Warner-Lambert. The principal amount of debt securities authorized under each such instrument does not exceed 10% of the total assets of Warner-Lambert. (10) Material contracts (12) Computation of Ratio of Earnings to Fixed Charges. (13) Copy of the Warner-Lambert Company Annual Report for the fiscal year ended December 31, 1993. Such report, except for those portions thereof which are expressly incorporated by reference herein, is furnished solely for the information of the Commission and is not to be deemed 'filed' as part of this filing. (21) Subsidiaries of the registrant. (23) Consent of Independent Accountants. - ------------ * Management contract or compensatory plan or arrangement required to be filed as an exhibit to this Form 10-K pursuant to Item 14(c). (B) REPORTS ON FORM 8-K A Current Report on Form 8-K, dated December 13, 1993, was filed with the Securities and Exchange Commission in connection with the announcement of Warner Lambert's signing of separate agreements establishing joint ventures with Glaxo Holdings plc and Wellcome plc. Warner-Lambert will furnish to any holder of its securities, upon request and at a reasonable cost, copies of the Exhibits listed in Item 14. WARNER-LAMBERT COMPANY AND CONSOLIDATED SUBSIDIARIES REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES To the Board of Directors and Shareholders of WARNER-LAMBERT COMPANY Our audits of the consolidated financial statements referred to in our report dated January 24, 1994 appearing on page 48 of the 1993 Annual Report to Shareholders of Warner-Lambert Company (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed in Item 14(a)2 of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. PRICE WATERHOUSE Morristown, New Jersey January 24, 1994 SCHEDULE I WARNER-LAMBERT COMPANY AND SUBSIDIARIES MARKETABLE SECURITIES -- OTHER INVESTMENTS DECEMBER 31, 1993 SCHEDULE II WARNER-LAMBERT COMPANY AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS AND EMPLOYEES OTHER THAN RELATED PARTIES YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - ------------ (1) In connection with the relocations of Mr. Joseph E. Smith and Dr. Pedro M. Cuatrecasas, interest-free loans, secured by real estate, were granted. The terms of the loans, including provisions relating to acceleration and repayment, depend on various factors. SCHEDULE V WARNER-LAMBERT COMPANY AND SUBSIDIARIES PROPERTY, PLANT AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - ------------ (a) Other Changes included reclassifications, activity related to restructuring actions and assets of companies acquired. (b) Additions in 1993 included capitalized leases of $13.6 million. SCHEDULE VI WARNER-LAMBERT COMPANY AND SUBSIDIARIES ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - ------------ (a) As a result of the restructuring actions discussed in Note 3 to the consolidated financial statements, accumulated depreciation was increased by $108.5 million and $84.9 million in 1993 and 1991, respectively, reflecting the write-down of assets to their net realizable values. Note: Depreciation is calculated using estimated useful lives of 20 to 50 years for buildings, and 3 to 15 years for machinery, furniture and fixtures. SCHEDULE VIII WARNER-LAMBERT COMPANY AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS AND RESERVES YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - ------------ (a) Primarily the write-off of accounts receivable considered uncollectible. (b) The addition to allowance for deferred tax assets of $108.9 million reflects $92.0 million for the adoption of Statement of Financial Accounting Standards (SFAS) No. 109, 'Accounting for Income Taxes,' as of January 1, 1993, and $16.9 million for 1993 additions (see Note 19 to the consolidated financial statements). SCHEDULE IX WARNER-LAMBERT COMPANY AND SUBSIDIARIES SHORT-TERM BORROWINGS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 - ------------ (a) At the end of any quarter. (b) Average of month-end balances. (c) The weighted average interest rate was calculated by relating appropriate interest expense to monthly aggregate borrowings. (d) Notes payable -- banks consist primarily of foreign currency short-term loans, terms of which vary with each agreement. (e) Commercial paper is issued in the United States with average maturities of approximately one month and is supported by lines of credit. (f) Other notes payable primarily include master notes which mature every six months and are renewable at the option of Warner-Lambert. (g) High interest rates on certain loans in South America increased the weighted average interest rates. These rates exclude the effect of foreign exchange gains attributable to the debt, which tend to offset the higher interest costs in highly inflationary economies. SCHEDULE X WARNER-LAMBERT COMPANY AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 The amounts charged to costs and expenses in the consolidated statements of income are: Taxes other than payroll and income taxes, and royalties were not significant. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. WARNER-LAMBERT COMPANY Registrant PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. STATEMENT OF DIFFERENCES The registered trademark shall be expressed as 'r'. Subscript numerics in chemistry notation shall be expressed as baseline numerics, e.g., sulfur hexaflouride would be expressed as SF6. EXHIBIT INDEX

797463_1993.txt

797463

1993

ITEM 1. BUSINESS. General Electric Capital Services, Inc. (herein together with its consolidated subsidiaries called "GE Capital Services" or the "Corporation," unless the context otherwise requires) was incorporated in 1984 in the State of Delaware. Until February 1993, the name of the Corporation was General Electric Financial Services, Inc. All outstanding capital stock of GE Capital Services is owned by General Electric Company, a New York corporation ("GE Company"). The business of GE Capital Services consists of ownership of three principal subsidiaries which, together with their subsidiaries and affiliates, constitute GE Company's principal financial services businesses. GE Capital Services is the sole owner of the common stock of General Electric Capital Corporation ("GE Capital"), Employers Reinsurance Corporation ("Employers Reinsurance") and Kidder, Peabody Group Inc. ("Kidder, Peabody"). GE Capital Services' principal executive offices are located at 260 Long Ridge Road, Stamford, Connecticut 06927 (Telephone number (203) 357-4000). GENERAL ELECTRIC CAPITAL CORPORATION GE Capital was incorporated in 1943 in the State of New York, under the provisions of the New York Banking Law relating to investment companies, as successor to General Electric Contracts Corporation, formed in 1932. The capital stock of GE Capital was contributed to GE Capital Services by GE Company in June 1984. Until November 1987, the name of the corporation was General Electric Credit Corporation. The business of GE Capital originally related principally to financing the distribution and sale of consumer and other products of GE Company. Currently, however, the type and brand of products financed and the financial services offered are significantly more diversified. Very little of the financing provided by GE Capital involves products that are manufactured by GE Company. GE Capital operates in four finance industry segments and in a specialty insurance industry segment. GE Capital's financing activities include a full range of leasing, loan, equipment management services and annuities. GE Capital's specialty insurance activities include providing private mortgage insurance, financial (primarily municipal) guarantee insurance, creditor insurance, reinsurance and, for financing customers, credit life and property and casualty insurance. GE Capital is an equity investor in a retail organization and certain other financial services organizations. GE Capital's operations are subject to a variety of regulations in their respective jurisdictions. Services of GE Capital are offered primarily throughout the United States, Canada and Europe. Computerized accounting and service centers, including those located in Connecticut, Ohio, Georgia and England, provide financing offices and other service locations with data processing, accounting, collection, reporting and other administrative support. GE Capital's principal executive offices are located at 260 Long Ridge Road, Stamford, Connecticut 06927. At December 31, 1993 GE Capital employed approximately 27,000 persons. EMPLOYERS REINSURANCE CORPORATION Employers Reinsurance Corporation (ERC), together with its subsidiaries, writes all lines of reinsurance other than title and annuities. ERC reinsures property and casualty risks written by more than 1,000 domestic and foreign insurers, and also writes certain specialty lines of insurance on a direct basis, principally excess workers' compensation for self-insurers, errors and omissions coverage for insurance and real estate agents and brokers, excess indemnity for self-insurers of medical benefits, and libel and allied torts. Domestic subsidiaries write property and casualty reinsurance through brokers, excess and surplus lines insurance, and provide reinsurance brokerage services. Subsidiaries in Denmark and the United Kingdom write property and casualty and life reinsurance, principally in Europe, Asia and the Middle East. Employers Reinsurance is licensed in all of the states of the United States, the District of Columbia, certain provinces of Canada and in certain other jurisdictions. Insurance and reinsurance operations are subject to regulation by various insurance regulatory agencies. ERC and its subsidiaries conduct business through 16 domestic offices and 9 foreign offices. Principal offices of ERC are located at 5200 Metcalf Avenue, Overland Park, Kansas 66201. At December 31, 1993 ERC employed approximately 1,000 persons. ITEM 1. BUSINESS (CONTINUED). KIDDER, PEABODY GROUP INC. Kidder, Peabody, a successor to a partnership founded in Boston in 1865, is incorporated in Delaware. Its principal subsidiary, Kidder, Peabody and Co. Incorporated ("Kidder"), is a member of the principal domestic securities and commodities exchanges and is a primary dealer in United States government securities. Kidder is a full-service international investment bank and securities broker. Its principal businesses include securities underwriting, sales and trading of equity and fixed income securities, financial futures activities, advisory services for mergers, acquisitions, and other corporate finance matters, research services and asset management. These services are provided to domestic and foreign business entities, governments, government agencies, and individual and institutional investors. Kidder is subject to the rules and regulations of various Federal and state regulatory agencies, exchanges and industry self-regulatory organizations that apply to securities broker-dealers and futures commission merchants, including the U.S. Securities and Exchange Commission, U.S. Commodity Futures Trading Commission, New York Stock Exchange, National Association of Securities Dealers, Chicago Mercantile Exchange and the Chicago Board of Trade. Kidder, Peabody conducts business in 42 domestic and 8 foreign branch offices. Principal offices of Kidder, Peabody are located at 10 Hanover Square, New York, New York 10005 and 100 Federal Street, Boston, Massachusetts 02110. At December 31, 1993 Kidder, Peabody employed approximately 5,650 persons. INDUSTRY SEGMENTS The Corporation provides a wide variety of financing, insurance, investment banking and securities brokerage products and services, which are organized into the following industry segments: o Specialty Insurance -- U.S. and international multiple-line property and casualty reinsurance and certain directly written specialty insurance (ERC), financial guaranty insurance, principally on municipal bonds and structured finance issues; private mortgage insurance; creditor insurance covering international customer loan repayments; and property, casualty and life insurance. o Consumer Services -- private label and bank credit card loans, time sales and revolving credit and inventory financing for retail merchants, auto leasing, inventory financing, mortgage servicing and annuities. o Mid-Market Financing -- loans and financing and operating leases for middle-market customers including manufacturers, distributors and end-users, for a variety of equipment, including data processing equipment, medical and diagnostic equipment, and equipment used in construction, manufacturing, office applications and telecommunications activities. o Equipment Management -- leases, loans and asset management services for portfolios of commercial and transportation equipment including aircraft, trailers, auto fleets, modular space units, railroad rolling stock, data processing equipment, ocean-going containers and satellites. o Securities Broker-Dealer -- Kidder, Peabody, a full-service international investment bank and securities broker, member of the principal stock and commodities exchanges and a primary dealer in U.S. government securities. Offers services such as underwriting, sales and trading, advisory services on acquisitions and financing, research and asset management. o Specialized Financing -- loans and leases for major capital assets including aircraft, industrial facilities and equipment and energy-related facilities; commercial and residential real estate loans and investments; and loans to and investments in corporate enterprises. Refer to Item 7 "Management's Discussion and Analysis of Results of Operations" in this Form 10-K for discussion of the Corporation's Portfolio Quality. ITEM 2.

ITEM 2. PROPERTIES. GE Capital Services and its subsidiaries conduct their businesses from various facilities, most of which are leased. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. The Corporation is not involved in any material pending legal proceedings. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Omitted PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. See Note 13 of Notes to Financial Statements. The common stock of the Corporation is owned entirely by GE Company and therefore there is no trading market in such stock. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. The following selected financial data should be read in conjunction with the financial statements of GE Capital Services and consolidated affiliates and the related Notes to Financial Statements. The Corporation adopted Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities," on December 31, 1993 resulting in the inclusion of $812 million of net unrealized gains on investment securities in equity at the end of the year. SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," was implemented in 1991 using the immediate recognition transition option. The cumulative effect to January 1 of adopting SFAS No. 106 was $19 million, net of $12 million tax credit. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS. OVERVIEW The Corporation's earnings were $1,807 million in 1993, 21% more than 1992's earnings of $1,499 million, which were 18% more than the comparable 1991 earnings of $1,275 million. The 1993 increase reflected strong performance in the Corporation's financing businesses, mainly as a result of a favorable interest rate environment, asset growth and improved asset quality. Earnings of the Corporation's Securities Broker-Dealer and Specialty Insurance segments were substantially higher in 1993. The 1992 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS (CONTINUED). increase reflected sharp improvement in the earnings of both the Specialty Insurance and Securities Broker-Dealer Segments. OPERATING RESULTS EARNED INCOME from all sources increased 20% to $22.1 billion in 1993, following a 12% increase to $18.4 billion in 1992. Asset growth in each of the Corporation's financing segments, through acquisitions of businesses and portfolios as well as origination volume, was the primary reason for increased income from time sales, loans, financing leases and operating lease rentals in both 1993 and 1992. Yields on related assets were essentially flat in 1993 compared with 1992, following a decline from 1991. Earned income in 1993 from the Corporation's annuity business, formed through two current year acquisitions, was $571 million. Specialty Insurance revenues increased 26% in 1993, compared with a 29% increase in 1992, due to higher premium and investment income as well as the impact of the creditor insurance business, which was consolidated at the end of the second quarter of 1992 when an existing equity position was converted to a controlling interest. Securities Broker-Dealer revenues increased 21% and 20% in 1993 and 1992, respectively, reflecting higher investment income and investment banking activity. INTEREST AND DISCOUNT EXPENSE on borrowings is the Corporation's principal cost. Interest and discount expense in 1993 totaled $6.5 billion, 6% higher than in 1992, which was 6% lower than in 1991. The 1993 increase was a result of funding increased security positions in the Securities Broker-Dealer segment, partially offset by substantially lower rates on higher average borrowings supporting financing operations. The 1992 decrease reflected substantially lower interest rates, which more than offset higher average borrowings and the cost of funding higher levels of security positions in the Securities Broker-Dealer segment. Composite interest rates on the Corporation's borrowings were 4.96% in 1993 compared with 5.78% in 1992 and 7.46% in 1991. OPERATING AND ADMINISTRATIVE EXPENSES increased to $7.1 billion in 1993, a 20% increase over 1992, which was 40% higher than 1991, primarily reflecting operating costs associated with businesses and portfolios acquired during the past two years. Overall, provisions for losses on investments charged to operating and administrative expense decreased in 1993, following an increase in 1992. These provisions principally related to the Commercial Real Estate and highly leveraged transaction (HLT) portfolios, and in 1993, to commercial aircraft as well. INSURANCE LOSSES AND POLICYHOLDER AND ANNUITY BENEFITS increased 62% to $3.2 billion in 1993, compared with a 21% increase to $2.0 billion in 1992. The 1993 increase principally reflected annuity benefits credited to customers following the current year annuity business acquisitions, as well as higher losses on increased volume in the property and casualty reinsurance and life reinsurance businesses. In 1992, higher losses on increased volume in the property and casualty reinsurance and the private mortgage insurance businesses, and the effects of the creditor insurance business for the second half of the year, were partially offset by lower losses in the life reinsurance business. PROVISION FOR LOSSES ON FINANCING RECEIVABLES decreased $69 million to $987 million in 1993 compared with a $46 million decrease to $1,056 million in 1992. These provisions principally related to the Consumer Services, Commercial Real Estate and HLT portfolios discussed below. DEPRECIATION AND AMORTIZATION OF BUILDINGS AND EQUIPMENT AND EQUIPMENT ON OPERATING LEASES increased to $1.6 billion in 1993, a 22% increase over 1992, which was 9% higher than 1991, primarily as a result of additions to equipment on operating leases through business and portfolio acquisitions. INCOME TAX PROVISION was $841 million in 1993 (an effective tax rate of 32%), compared with $536 million in 1992 (26%) and $382 million (23%) in 1991. The increased provision for income taxes in both 1993 and 1992 reflected the effects of additional income before taxes and, in 1993, the 1% increase in the U. S. Federal income tax rate. The higher rate in 1993, compared with 1992, primarily reflected the 1% increase in the U.S. Federal income tax rate and a lower proportion of tax-exempt income. These items were partially offset by the effects of certain unrelated financing transactions that will result in future cash savings and reduced the Corporation's obligation for previously accrued deferred taxes. The higher rate in 1992, compared with 1991, reflected a relatively lower proportion of tax-exempt income and a 1991 adjustment for tax-deductible claims reserves of the property reinsurance affiliates, for which there was no 1992 counterpart. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS (CONTINUED). OPERATING PROFIT BY INDUSTRY SEGMENT Operating profit (pre-tax income) of the Corporation, by industry segment, is summarized in Note 19 and discussed below: SPECIALTY INSURANCE operating profit of $770 million in 1993 was 20% higher than the $641 million recorded in 1992, which was 28% higher than in 1991. The 1993 increase reflected higher premium volume from bond refunding in the financial guaranty insurance business as well as reduced claims expense in the creditor insurance business. The 1992 gains primarily reflected higher premium volume and investment income at GE Capital's private mortgage and financial guaranty insurance businesses. CONSUMER SERVICES operating profit of $695 million in 1993, was 32% higher than that of 1992. This increase reflected lower provisions for receivable losses in Retailer Financial Services resulting from declines in consumer delinquency as well as strong asset growth and interest rate favorability in both Auto Financial Services and Retailer Financial Services. Operating profit of $525 million in 1992 was 53% higher than that of 1991 (excluding the impact in 1991 of the $134 million gain on the disposition of a significant portion of GE Capital's auto auction affiliate). This increase reflected higher financing spreads in Retailer Financial Services and increased asset levels in Auto Financial Services. EQUIPMENT MANAGEMENT operating profit increased $9 million to $377 million in 1993. This increase reflected higher volume in most businesses, largely the result of portfolio and business acquisitions, and improved trailer and railcar utilization, offset by lower average rental rates in Fleet Services and Computer Services, coupled with the effects of lower utilization and pricing pressures at Genstar Container. Operating profit decreased $13 million to $368 million in 1992 due to lower utilization in the Railcar Services and Genstar Container businesses, partially offset by operating profit generated as a result of Fleet Services' 1992 acquisition of the fleet leasing operations of Avis-Europe. MID-MARKET FINANCING operating profit of $454 million in 1993 was 29% higher than that of 1992 and reflected higher spreads and higher levels of invested assets, primarily as a result of business and portfolio acquisitions. Operating profit increased $104 million to $352 million in 1992 compared with 1991. Operating profit for 1992 reflected higher levels of invested assets, primarily as a result of asset portfolio acquisitions. SECURITIES BROKER-DEALER (Kidder, Peabody) operating profit was $439 million in 1993, up 46% from 1992's record $300 million, which was $181 million higher than in 1991. Strong performances in both years reflected higher investment income from trading and investment banking activities. Favorable market conditions were an important factor in both years. Higher interest expense in both years reflected costs associated with funding increased security positions. Operating and administrative expenses increased in both years, primarily because of the revenue growth and, in 1992, because of costs associated with certain litigation settlements. SPECIALIZED FINANCING operating profit was $201 million in 1993, compared with $121 million in 1992, and $220 million in 1991. The increase in 1993 principally reflected much lower provisions for losses on Corporate Finance Group HLT investments and higher gains from sales of Commercial Real Estate assets partially offset by higher loss provisions for Commercial Real Estate assets and expenses associated with redeployment and refurbishment of owned aircraft. The decline in 1992 principally reflected higher loss provisions, particularly reserves for Corporate Finance Group in-substance and owned investments, partially offset by higher gains on the sale of assets in both Commercial Real Estate and Corporate Finance Group. Further details concerning loss provisions relating to both the Commercial Real Estate portfolio and Corporate Finance Group HLT investments are discussed below. CAPITAL RESOURCES AND LIQUIDITY The Corporation's principal source of cash is financing activities that involve continuing rollover of short-term borrowings and appropriate addition of long-term borrowings, with a reasonable balance of maturities. Over the past three years, the Corporation's borrowings with maturities of 90 days or less have increased by $14.0 billion. New borrowings of $40.2 billion having maturities longer than 90 days were added during those years, while $25.6 billion of such longer-term borrowings were paid off. The Corporation has also generated significant cash from operating activities, $14.8 billion during the last three years. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS (CONTINUED). The Corporation's principal use of cash has been investing in assets to grow the business. Of $40.9 billion that the Corporation invested over the past three years, $16.1 billion was used for additions to financing receivables, $9.3 billion for new equipment, primarily for lease to others and $6.9 billion to acquire new businesses. GE Company has agreed to make payments to GE Capital, constituting additions to pre-tax income, to the extent necessary to cause GE Capital's consolidated ratio of earnings to fixed charges to be not less than 1.10 for each fiscal year commencing with fiscal year 1991. Three years advance written notice is required to terminate this agreement. No payments have been required under this agreement. GE Capital's ratios of earnings to fixed charges for the years 1993, 1992 and 1991, were 1.62, 1.44 and 1.34, respectively. The Corporation's total borrowings were $85.9 billion at December 31, 1993, of which $60.0 billion was due in 1994 and $25.9 billion was due in subsequent years. Comparable amounts at the end of 1992 were: $75.1 billion in total; $53.2 billion due within one year; and $21.9 billion due thereafter. Composite interest rates are discussed on page 4. Individual borrowings are structured within overall asset/liability interest rate and currency risk management strategies. Interest rate and currency swaps form an integral part of the Corporation's goal of achieving the lowest borrowing costs for particular funding strategies. Counterparty credit risk is closely monitored -- approximately 90% of the notional amount of swaps outstanding at December 31, 1993 was with counterparties having credit ratings of Aa/AA or better. With the financial flexibility that comes with excellent credit ratings, management believes the Corporation is well positioned to meet the global needs of its customers for capital and continue growing its diverse asset base. PORTFOLIO QUALITY THE PORTFOLIO OF FINANCING RECEIVABLES, $63.9 billion and $59.4 billion at year-ends 1993 and 1992, respectively, is the Corporation's largest asset and its primary source of revenues. Related allowances for losses aggregated $1.7 billion at the end of 1993 (2.63% of receivables -- the same level as 1992) and are, in management's judgment, appropriate given the risk profile of the portfolio. A discussion about the quality of certain elements of the portfolio of financing receivables and investments follows. Further details are included in Notes 5 and 10. CONSUMER LOANS RECEIVABLE, primarily retailer and auto receivables, were $17.3 billion and $14.8 billion at the end of 1993 and 1992, respectively. The Corporation's investment in consumer auto finance lease receivables was $5.6 billion and $4.8 billion at the end of 1993 and 1992, respectively. Non-earning receivables, 1.7% of total loans and leases (2.1% at the end of 1992), amounted to $391 million at the end of 1993. The provision for losses on retailer and auto financing receivables was $469 million in 1993, a 19% decrease from $578 million in 1992, reflecting reduced consumer delinquencies and intensified collection efforts, particularly in Europe. Most non-earning receivables were private label credit card receivables, the majority of which were subject to various loss sharing arrangements that provide full or partial recourse to the originating retailer. COMMERCIAL REAL ESTATE LOANS classified as finance receivables by the Commercial Real Estate business, a part of the Specialized Financing segment, were $10.9 billion at December 31, 1993, up $0.4 billion from the end of 1992. In addition, the investment portfolio of the Corporation's annuity business, acquired during 1993, included $1.1 billion of commercial property loans. Commercial real estate loans are generally secured by first mortgages. In addition to loans, Commercial Real Estate's portfolio also included in other assets $2.2 billion of assets that were purchased for resale from the Resolution Trust Corporation (RTC) and other institutions and $1.4 billion of investments in real estate joint ventures. In recent years, the Corporation has been one of the largest purchasers of assets from RTC and other institutions, growing its portfolio of properties acquired for resale by $1.1 billion in 1993. To date, values realized on these assets have met or exceeded expectations at the time of purchase. Investments in real estate joint ventures have been made as part of original financings and in conjunction with loan restructurings where management believes that such investments will enhance economic returns. Commercial Real Estate's foreclosed properties at the end of 1993 declined to $110 million from $187 million at the end of 1992. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS (CONTINUED). At December 31, 1993, Commercial Real Estate's portfolio included loans secured by and investments in a variety of property types that were well dispersed geographically. Property types included apartments (36%), office buildings (32%), shopping centers (14%), mixed use (8%), industrial and other (10%). These properties were located, principally across the United States, as follows: Mid-Atlantic (21%), Northeast (20%), Southwest (19%), West (15%), Southeast (12%), Central (8%), with the remainder (5%) across Canada and Europe. Reduced and non-earning receivables declined to $272 million in 1993 from $361 million in 1992, reflecting proactive management of delinquent receivables as well as write-offs. Loss provisions for Commercial Real Estate's investments were $387 million in 1993 ($248 million related to receivables and $139 million to other assets), compared with $299 million and $213 million in 1992 and 1991, respectively, as the portfolio continued to be adversely affected by the weakened commercial real estate market. HLT PORTFOLIO is included in the Specialized Financing segment and represents financing provided for highly leveraged management buyouts and corporate recapitalizations. The portion of those investments classified as financing receivables was $3.3 billion at the end of 1993 compared with $5.3 billion at the end of 1992, as substantial repayments reduced this liquidating portfolio. The year-end balance of amounts that had been written down to estimated fair value and carried in other assets as a result of restructuring or in-substance repossession aggregated $544 million at the end of 1993 and $513 million at the end of 1992 (net of allowances of $244 million and $224 million, respectively). Non-earning and reduced earning receivables declined to $139 million at the end of 1993 from $429 million the prior year. Loss provisions for HLT investments were $181 million in 1993 ($80 million related to receivables and $101 million to other assets), compared with $573 million in 1992 and $328 million in 1991. Non-earning and reduced earning receivables as well as loss provisions were favorably affected by the stronger economic climate during 1993 as well as by the successful restructurings implemented during the past few years. OTHER FINANCING RECEIVABLES, approximately $26 billion, consisted primarily of a diverse commercial, industrial and equipment loan and lease portfolio. This portfolio grew approximately $2 billion during 1993, while non-earning and reduced earning receivables decreased $46 million to $98 million at year end. The Corporation has loans and leases to commercial airlines that aggregated about $6.8 billion at the end of 1993, up from $6 billion at the end of 1992. At year-end 1993, commercial aircraft positions included conditional commitments to purchase aircraft at a cost of $865 million and financial guarantees and funding commitments amounting to $450 million. These purchase commitments are subject to the aircraft having been placed on lease under agreements, and with carriers, acceptable to the Corporation prior to delivery. Expenses associated with redeployment and refurbishment of owned aircraft totaled $112 million in 1993, compared with nominal amounts in prior years. The Corporation's increasing investment demonstrates its continued long-term commitment to the airline industry. ENTERING 1994, management believes that the diversity and strength of the Corporation's assets, along with vigilant attention to risk management, position it to deal effectively with a global and changing competitive and economic landscape. NEW ACCOUNTING STANDARDS SFAS No. 114, "Accounting by Creditors for Impairment of a Loan," modifies the accounting that applies when it is probable that all amounts due under contractual terms of a loan will not be collected. Management does not believe that this Statement, required to be adopted no later than the first quarter of 1995, will have a material effect on the Corporation's financial position or results of operations, although such effect will depend on the facts at the time of adoption. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. INDEPENDENT AUDITORS' REPORT To the Board of Directors General Electric Capital Services, Inc. We have audited the financial statements of General Electric Capital Services, Inc. and consolidated affiliates as listed in Item 14. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in Item 14. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of General Electric Capital Services, Inc. and consolidated affiliates at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993 in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. As discussed in Note 1 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities," effective December 31, 1993. /s/ KPMG PEAT MARWICK Stamford, Connecticut February 11, 1994 GENERAL ELECTRIC CAPITAL SERVICES, INC. AND CONSOLIDATED AFFILIATES STATEMENT OF CURRENT AND RETAINED EARNINGS See Notes to Consolidated Financial Statements. GENERAL ELECTRIC CAPITAL SERVICES, INC. AND CONSOLIDATED AFFILIATES STATEMENT OF FINANCIAL POSITION See Notes to Consolidated Financial Statements. GENERAL ELECTRIC CAPITAL SERVICES, INC. AND CONSOLIDATED AFFILIATES STATEMENT OF CASH FLOWS See Notes to Consolidated Financial Statements. GENERAL ELECTRIC CAPITAL SERVICES, INC. AND CONSOLIDATED AFFILIATES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES CONSOLIDATION -- The consolidated financial statements represent a consolidation of GE Capital Services and all majority-owned and controlled affiliates ("consolidated affiliates"), including General Electric Capital Corporation ("GE Capital"), Employers Reinsurance Corporation ("Employers Reinsurance") and Kidder, Peabody Group Inc. ("Kidder, Peabody"). GE Capital Services owns all of the common stock of GE Capital, Employers Reinsurance and Kidder, Peabody. All significant transactions among the parent and consolidated affiliates have been eliminated. Other affiliates in which the Corporation owns 20 percent to 50 percent of the voting rights ("nonconsolidated affiliates") are included in other assets, valued at the appropriate share of equity plus loans and advances. CASH FLOWS -- For purposes of the Statement of Cash Flows, certificates and other time deposits are treated as cash equivalents. METHODS OF RECORDING EARNED INCOME -- Income on all loans is recognized on the interest method. Accrual of interest income is suspended when collection of an account becomes doubtful, generally after the account becomes 90 days delinquent. Financing lease income, which includes related investment tax credits and residual values, is recorded on the interest method so as to produce a level yield on funds not yet recovered. Unguaranteed residual values included in lease income are based principally on independent appraisals of the values of leased assets remaining at expiration of the lease terms. Operating lease income is recognized on a straight-line basis over the term of the underlying leases. Origination, commitment and other nonrefundable fees related to fundings are deferred and recorded in earned income on the interest method. Commitment fees related to loans not expected to be funded and line-of-credit fees are deferred and recorded in earned income on a straight-line basis over the period to which the fees relate. Syndication fees are recorded in earned income at the time the related services are performed unless significant contingencies exist. Kidder, Peabody's proprietary securities and commodities transactions, unrealized gains and losses on open contractual commitments (principally financial futures), forward contracts on U.S. government and federal agency securities, and when-issued securities are recorded on a trade-date basis. Customer transactions and related revenues and expenses, investment banking revenues from management fees, sales concessions and underwriting fees are recorded on a settlement-date basis. Advisory fees are recorded as revenues when services are substantially completed and the revenue is reasonably determinable. See "Insurance and Annuity Businesses" below for information with respect to earned income of these businesses. ALLOWANCE FOR LOSSES ON FINANCING RECEIVABLES AND INVESTMENTS -- The Corporation maintains an allowance for losses on financing receivables at an amount which it believes is sufficient to provide adequate protection against future losses in the portfolio. For small-balance receivables the allowance for losses is determined principally on the basis of actual experience during the preceding three years. Further allowances are also provided to reflect management's judgment of additional loss potential. For other receivables, principally the larger loans and leases, the allowance for losses is determined primarily on the basis of management's judgment of net loss potential, including specific allowances for known troubled accounts. All accounts or portions thereof deemed to be uncollectible or to require an excessive collection cost are written off to the allowance for losses. Small-balance accounts are progressively written down (from 10% when more than three months delinquent to 100% when nine to twelve months delinquent) to record the balances at estimated realizable value. However, if at any time during that period an account is judged to be uncollectible, such as in the case of a bankruptcy, the uncollectible balance is written off. Larger-balance accounts are reviewed at least quarterly, and those accounts which are more than three months delinquent are written down, if necessary, to record the balances at estimated realizable value. When collateral is formally or substantively repossessed in satisfaction of a loan, the receivable is written down against the allowance for losses to estimated fair value and is transferred to other assets. Subsequent to such transfer, these assets are carried at the lower of cost or estimated current fair value. This accounting has been employed principally for highly leveraged transactions (HLT) and real estate loans. INCOME TAXES -- Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes," was adopted effective January 1, 1992. The effect of adopting SFAS No. 109 was not material. Deferred tax balances are stated at tax rates expected to be in effect when taxes are actually paid or recovered. INVESTMENT AND TRADING SECURITIES -- On December 31, 1993, the Corporation adopted SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which requires that investments in debt securities and marketable equity securities be designated as trading, held-to-maturity or available-for-sale. Trading securities are reported at fair value, with changes in fair value included in earnings. Investment securities include both available-for-sale and held-to-maturity securities. Available-for-sale securities are reported at fair value, with net unrealized gains and losses included in equity. Held-to-maturity debt securities are reported at amortized cost. See notes 3 and 4 for a discussion of the classification and reporting of these securities at December 31, 1992. For all investment securities, unrealized losses that are other than temporary are recognized in earnings. SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL (REVERSE REPURCHASE AGREEMENTS) AND SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE (REPURCHASE AGREEMENTS) -- Such items are treated as financing transactions and are carried at the contract amount at which the securities subsequently will be resold or reacquired. Repurchase agreements relate either to marketable securities, which are carried at market value, or to securities obtained pursuant to reverse repurchase agreements. It is the Corporation's policy to take possession of securities that are subject to reverse repurchase agreements. The Corporation monitors the market value of the underlying securities in relation to the related receivable, including accrued interest, and requests additional collateral when appropriate. EQUIPMENT ON OPERATING LEASES -- Equipment is amortized, principally on a straight-line basis, to estimated net salvage value over the lease term or the estimated economic life of the equipment. BUILDINGS AND EQUIPMENT -- The Corporation records depreciation on a sum-of-the-years' digits basis or a straight-line basis over the lives of the assets. OTHER ASSETS -- Goodwill is amortized on a straight-line basis over periods not exceeding 30 years. FOREIGN OPERATIONS -- Assets and liabilities of foreign affiliates are translated into U.S. dollars at the year-end exchange rates while operating results are translated at rates prevailing during the year. Such adjustments are accumulated and reported as a separate component of equity. INSURANCE AND ANNUITY BUSINESSES -- Premiums on short-duration insurance contracts are reported as earned income over the terms of the related reinsurance treaties or insurance policies. In general, earned premiums are calculated on a pro-rata basis or are determined based on reports received from reinsureds. Premium adjustments under retrospectively rated assumed reinsurance contracts are recorded based on estimated losses and loss expenses, including both case and incurred-but-not-reported reserves. Premiums on long-duration insurance products are recognized as earned when due. Premiums received under annuity contracts are not reported as revenues but as annuity benefits -- a liability -- and are adjusted according to the terms of the respective policies. The estimated liability for insurance losses and loss expenses consist of both case and incurred-but-not-reported reserves. Where experience is not sufficient, industry averages are used. Estimated amounts of salvage and subrogation recoverable on paid and unpaid losses are deducted from outstanding losses. The liability for future policyholder benefits of the life insurance affiliates has been computed mainly by a net-level-premium method based on assumptions for investment yields, mortality and terminations that were appropriate at date of purchase or at the time the policies were developed, including provisions for adverse deviations. Deferred insurance acquisition costs for the property and casualty businesses are amortized pro-rata over the contract periods in which the related premiums are earned. For the life insurance business, these costs are amortized over the premium-paying periods of the contracts in proportion either to anticipated premium income or to gross profit, as appropriate. For certain annuity contracts, such costs are amortized on the basis of anticipated gross profits. For other lines of business, acquisition costs are amortized over the life of the related insurance contracts. Deferred insurance acquisition costs are reviewed for recoverability; for short-duration contracts, anticipated investment income is considered in making recoverability evaluations. NOTE 2. ACQUISITIONS The Corporation has acquired two individually non-significant entities (collectively "the Acquisitions"). The acquisition of GNA Corporation ("GNA") from Weyerhaeuser Company and Weyerhaeuser Financial Services, Inc. occurred on April 1, 1993, while the acquisition of United Pacific Life Insurance Company ("UPL") from Reliance Insurance Company and its parent company, Reliance Group Holdings, Inc. occurred on July 14, 1993. The acquisitions, accounted for as purchases, have been reflected in the accompanying consolidated financial statements of the Corporation since the respective acquisition dates. The acquired companies had assets of approximately $12.8 billion, principally investment securities. The aggregate estimated purchase price was $1,113 million and is subject to certain post-closing adjustments. Unaudited pro forma condensed results of operations of the Corporation for each of the years ended December 31, 1993 and 1992 as if the Acquisitions had occurred on January 1, 1993 and January 1, 1992, respectively, are as follows: The pro forma data have been prepared based on assumptions management deems appropriate and the results are not necessarily indicative of those that might have occurred had the transactions become effective at the beginning of the respective years, primarily due to changes in investment and other business strategies of the acquired companies. The aggregate effect of several other business acquisitions completed during 1993 was not material. NOTE 3. TRADING SECURITIES AND SECURITIES SOLD BUT NOT YET PURCHASED Trading securities are shown in the following table as of December 31, 1993 and 1992: The balance of trading securities at December 31, 1992, included investments in equity securities held by insurance affiliates at a fair value of $1,505 million, with unrealized pretax gains of $94 million (net of unrealized pretax losses of $37 million) included in equity. At December 31, 1993, equity securities held by insurance affiliates were classified as investment securities (see note 4). A significant portion of the Corporation's trading securities at December 31, 1993, was pledged as collateral for bank loans and repurchase agreements in connection with securities broker-dealer operations. Market value of securities sold but not yet purchased at December 31, 1993 and 1992 are shown in the following table: NOTE 4. INVESTMENT SECURITIES At December 31, 1993, investment securities were classified as available-for-sale and reported at fair value, including net unrealized gains of $1,261 million before taxes. At December 31, 1992, investment securities of $9,033 million were classified as available-for-sale and were reported at the lower of aggregate amortized cost or fair value. The balance of the 1992 investment securities portfolio was carried at amortized cost. A summary of investment securities follows. - --------------- (a) December 31, 1992 amounts include gross unrealized gains and losses of $32 million and $5 million, respectively, on investment securities carried at amortized cost. Contractual maturities of debt securities, other than mortgage-backed securities, at December 31, 1993, are shown below. It is expected that actual maturities will differ from contractual maturities because some borrowers have the right to call or prepay obligations with or without call or prepayment penalties. Proceeds from sales of debt securities in 1993, 1992 and 1991 amounted to $6,112 million, $3,514 million and $2,814 million, respectively; gross realized gains were $173 million, $171 million and $106 million, respectively, and realized losses were $34 million, $4 million and $9 million, respectively. NOTE 5. FINANCING RECEIVABLES Financing receivables at December 31, 1993 and 1992 by principal category are shown below. Financing receivables classified as time sales and loans represent transactions with customers in a variety of forms, including time sales, revolving charge and credit, mortgages, installment loans, intermediate-term loans and revolving loans secured by business assets. The portfolio includes time sales and loans carried at the principal amount on which finance charges are billed periodically, and time sales and loans acquired on a discount basis carried at gross book value, which includes finance charges. At year-ends 1993 and 1992 commercial and industrial loans included $3,293 million and $5,262 million, respectively, for highly leveraged transactions. Note 8 contains information on commercial airline loans and leases. The financing lease operations consist of direct financing and leveraged leases of aircraft, railroad rolling stock, automobiles and other transportation equipment, data processing equipment, medical equipment, and other manufacturing, power generation, mining and commercial equipment and facilities. As the sole owner of assets under direct financing leases and as the equity participant in leveraged leases, the Corporation is taxed on total lease payments received and is entitled to tax deductions based on the cost of leased assets and tax deductions for interest paid to third-party participants. The Corporation is also entitled generally to any investment tax credit on leased equipment and to any residual value of leased assets. Investments in direct financing and leveraged leases represent unpaid rentals and estimated unguaranteed residual values of leased equipment, less related deferred income. Because the Corporation has no general obligation on notes and other instruments representing third-party participation related to leveraged leases, such notes and other instruments have not been included in liabilities but have been offset against the related rentals receivable. The Corporation's share of rentals receivable is subordinate to the share of the other participants who also have a security interest in the leased equipment. The Corporation's investment in financing leases at December 31, 1993 and 1992 is shown below. - --------------- (a) Total financing lease deferred income is net of deferred initial direct costs of $83 million and $73 million for 1993 and 1992, respectively. At December 31, 1993, contractual maturities for time sales and loans over the next five years and after are: $16,287 million in 1994; $6,286 million in 1995; $4,350 million in 1996; $4,104 million in 1997; $3,112 million in 1998; and $7,683 million in 1999 and later -- aggregating $41,822 million. At December 31, 1993, contractual maturities for finance lease rentals receivable over the next five years and after are: $6,417 million in 1994; $5,426 million in 1995; $3,919 million in 1996; $2,570 million in 1997; $1,720 million in 1998; and $9,630 million in 1999 and later -- aggregating $29,682 million. Experience of the Corporation has shown that a portion of receivables will be paid prior to contractual maturity. Accordingly, the contractual maturities of time sales and loans and of rentals receivable shown above are not to be regarded as forecasts of future cash collections. GE Capital is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include financial guarantees and letters of credit. GE Capital's exposure to credit loss in the event of nonperformance by the other party to financial guarantees is represented by the contractual amount of those instruments. GE Capital uses the same credit policies and the same collateral requirements in making commitments and conditional obligations as it does for financing transactions. In addition, GE Capital is involved with sales of receivables for which it is contingently liable for credit losses for a percentage of the initial face amount sold. At December 31, 1993 and 1992, the aggregate amount of such financial guarantees were $1,863 million and $1,693 million, respectively, excluding those related to commercial aircraft (see note 8). In connection with the sales of financing receivables, GE Capital received proceeds of $1,105 million in 1993, $1,097 million in 1992 and $2,316 million in 1991. At December 31, 1993 and 1992, $3,045 million and $3,473 million, respectively, of such receivables were outstanding. Under arrangements with customers, GE Capital had committed to lend funds of $2,131 million and $1,794 million at December 31, 1993 and 1992, respectively, excluding those related to commercial aircraft (see note 8). Additionally, at December 31, 1993 and 1992, GE Capital was conditionally obligated to advance $2,244 million and $2,236 million, respectively, principally under performance-based standby lending commitments. GE Capital also was obligated for $2,946 million and $2,147 million at year-ends 1993 and 1992, respectively, under standby liquidity facilities related to third-party commercial paper programs, although management believes that the prospects of being required to fund under such standby facilities are remote. Note 12 discusses financial guarantees of insurance affiliates. Non-earning consumer time sales and loans, primarily private-label credit card receivables, amounted to $391 million and $444 million at December 31, 1993 and 1992, respectively. A majority of these receivables was subject to various loss-sharing arrangements that provide full or partial recourse to the originating private-label entity. Non-earning and reduced earning receivables other than consumer time sales and loans were $509 million and $934 million at year-ends 1993 and 1992, respectively. Earnings of $11 million and $30 million realized in 1993 and 1992, respectively, were $41 million and $75 million lower than would have been reported had these receivables earned income in accordance with their original terms. Additional information regarding financing receivables is included in Management's Discussion of the Corporation's Portfolio Quality on Page 6. NOTE 6. ALLOWANCE FOR LOSSES ON FINANCING RECEIVABLES The allowance for losses on financing receivables represented 2.63% of total financing receivables at both year-ends 1993 and 1992. The table below shows the activity in the allowance for losses on financing receivables during 1991 through 1993: Amounts written off in 1993 were approximately 1.46% of average financing receivables outstanding during the year, compared with 1.58% and 1.87% of average financing receivables outstanding during 1992 and 1991, respectively. NOTE 7. BROKER -- DEALER POSITIONS Other receivables and accounts payable include amounts receivable from and payable to brokers and dealers in connection with Kidder, Peabody's normal trading, lending and borrowing of securities. At December 31, 1993 and 1992, amounts consisted of the following: Kidder, Peabody, in conducting its normal operations, invests in a wide variety of financial instruments in order to balance its investment positions. Management believes that the most meaningful measure of these positions for a broker-dealer is market value, the value at which the positions are presented in the Statement of Financial Position in accordance with securities industry practices. The following required supplemental disclosures are indicators of the nature and extent of broker-dealer positions and are not intended to portray the much smaller credit or economic risk. At December 31, 1993, open commitments to sell mortgage-backed securities amounted to $18,539 million ($17,191 million in 1992); open commitments to purchase mortgage-backed securities amounted to $14,637 million ($13,131 million in 1992); interest rate swap agreements were open for interest on $4,084 million ($6,038 million in 1992); commitments amounting to $10,837 million ($6,711 million in 1992) were open under options written to cover price changes in securities; the face amount of open interest rate futures and forward contracts for currencies as well as money market and other instruments amounted to $30,506 million ($10,936 million in 1992); contracts establishing limits on counterparty exposure to interest rates were outstanding for interest on $1,610 million ($2,722 million in 1992); and firm underwriting commitments for the purchase of stock or debt amounted to $3,311 million ($4,094 million in 1992). At December 31, 1993 and 1992, Kidder, Peabody had obtained irrevocable letters of credit of $592 million and $314 million, respectively, from third parties, written in favor of clearing associations to satisfy margin requirements. Kidder, Peabody seeks to control the risks associated with its customer activities by requiring customers to maintain margin collateral in compliance with various regulations and internal policies. Kidder, Peabody monitors customer credit exposure and collateral values on a daily basis and requires additional collateral to be deposited with Kidder, Peabody or returned, when deemed necessary. NOTE 8. EQUIPMENT ON OPERATING LEASES Equipment on operating leases by type of equipment and accumulated amortization at December 31, 1993 and 1992 are shown in the following table: Amortization of equipment on operating leases was $1,395 million in 1993, $1,133 million in 1992 and $1,055 million in 1991. The Corporation acts as a lender and lessor to commercial enterprises in the airline industry; at December 31, 1993 and 1992, the aggregate amount of such loans, leases and equipment leased to others were $6,776 million and $5,978 million, respectively. In addition, the Corporation had issued financial guarantees and funding commitments of $450 million at December 31, 1993 ($645 million at year-end 1992) and had conditional commitments to purchase aircraft at a cost of $865 million. These purchase commitments are subject to the aircraft having been placed on lease under agreements, and with carriers, acceptable to the Corporation prior to delivery. Included in the Corporation's equipment leased to others at year-end 1993 is $244 million of commercial aircraft off-lease ($94 million in 1992). NOTE 9. BUILDINGS AND EQUIPMENT Buildings and equipment include office buildings, satellite communications equipment, data processing equipment, vehicles, furniture and office equipment used at the Corporation's offices throughout the world. Depreciation expense was $235 million for 1993, $202 million for 1992 and $170 million for 1991. NOTE 10. OTHER ASSETS Other assets at December 31, 1993 and 1992 are shown in the table below. Accumulated amortization of goodwill and other intangibles was $496 million and $382 million, respectively, at December 31, 1993 and $415 million and $231 million, respectively, at December 31, 1992. Miscellaneous investments included $75 million and $275 million at December 31, 1993 and 1992, respectively, of in-substance repossessions at the lower of cost or estimated fair value previously included in financing receivables. Investments in and advances to nonconsolidated affiliates include advances of $1,159 million and $687 million at December 31, 1993 and 1992, respectively. The Corporation's mortgage servicing activities include the purchase and resale of mortgages. At December 31, 1993 and 1992, it had open commitments to purchase mortgages totaling $5,935 million and $2,963 million, respectively. Additionally, the Corporation had open commitments to sell mortgages totalling $6,426 million and $1,777 million, at year-ends 1993 and 1992, respectively. At December 31, 1993 and 1992, mortgages sold with full or partial recourse to the Corporation aggregated $2,526 million and $3,876 million, respectively. NOTE 11. NOTES PAYABLE Notes payable at December 31, 1993 totaled $85,888 million, consisting of $85,129 million of senior debt and $759 million of subordinated debt. The composite interest rate for the Corporation's finance activities during 1993 was 4.96% compared with 5.78% for 1992 and 7.46% for 1991. Total short-term notes payable at December 31, 1993 and 1992 consisted of the following: The average daily balance of short-term debt, excluding the current portion of long-term debt, during 1993 was $47,357 million compared with $43,817 million for 1992 and $40,513 million for 1991. The December 31, 1993 balance of $60,003 million was the maximum balance during 1993. The December 31, 1992 balance of $53,183 million was the maximum balance during 1992. The December 27, 1991 balance of $49,604 million was the maximum balance during 1991. The average short-term interest rate, excluding the current portion of long-term debt, for the year 1993 was 3.29%, representing short-term interest expense divided by the average daily balance, compared with 3.93% for 1992 and 6.36% for 1991. On December 31, 1993, 1992 and 1991, average interest rates were 3.59%, 4.20% and 5.20%, respectively, for bank borrowings, 3.39%, 3.57% and 5.12%, respectively, for commercial paper, and 3.10%, 3.54% and 4.90%, respectively, for notes with trust departments of banks. Outstanding balances in notes payable after one year at December 31, 1993 and 1992 are as follows. - --------------- (a) At December 31, 1993 and 1992, the Corporation had agreed to exchange currencies and related interest payments on principal amounts equivalent to U.S. $8,101 million and $6,499 million, respectively. At December 31, 1993 and 1992, the Corporation also had entered into interest rate swaps related to interest on $13,224 million and $8,549 million, respectively. To minimize borrowing costs, the Corporation has entered into multiple currency and interest rate agreements for certain notes. (b) At December 31, 1993 and 1992, counterparties held options under which the Corporation can be caused to execute interest rate swaps associated with interest payments through 1999 on $500 million and $625 million, respectively. (c) The Corporation will reset interest rates at the end of the initial and each subsequent interest period. At each interest rate-reset date, the Corporation may redeem notes in whole or in part at its option. Current interest periods range from March 1994 to May 1996. (d) The rate of interest payable on each note is a variable rate based on the commercial paper rate each month. Interest is payable, at the option of the Corporation, either monthly or semiannually. (e) At December 31, 1993 and 1992, subordinated notes in the amount of $700 million principal were guaranteed by GE Company. Long-term borrowing maturities during the next five years, including the current portion of notes payable after one year, are: 1994 -- $6,421 million; 1995 -- $6,204 million; 1996 -- $4,868 million; 1997 -- $2,971 million; and 1998 -- $3,566 million. At December 31, 1993 GE Capital had committed lines of credit aggregating $19,045 million with 134 banks, including $6,005 million of revolving credit agreements with 69 banks pursuant to which GE Capital has the right to borrow funds for periods exceeding one year. A total of $4,627 million of these lines were also available for use by GE Capital Services. In addition, at December 31, 1993, approximately $105 million of committed lines of credit were directly available to a foreign affiliate of GE Capital. Also, at December 31, 1993, approximately $3,045 million of GE Company's credit lines were available for use by GE Capital or the Corporation. During 1993 the Corporation did not borrow under any of these credit lines. At December 31, 1993 Kidder, Peabody had established lines of credit aggregating $6,058 million of which $3,110 million was available on an unsecured basis. Borrowings from banks were primarily unsecured demand obligations, at interest rates approximating broker call loan rates, to finance inventories of securities and to facilitate the securities settlement process. The Corporation compensates banks for credit facilities in the form of fees which were immaterial for the past three years. NOTE 12. INSURANCE RESERVES AND ANNUITY BENEFITS The Corporation adopted SFAS No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts," during 1993. The principal effect of this Statement was to report reinsurance receivables and prepaid reinsurance premiums, a total of $1,818 million at December 31, 1993, as assets. Such amounts were reported as reductions of insurance reserves at the end of 1992. Insurance reserves and annuity benefits represents policyholders' benefits, unearned premiums and provisions for policy losses and benefits relating to insurance and annuity businesses. The related balances at December 31, 1993 and 1992 are as follows: Financial guarantees, principally FGIC's guarantees on municipal bonds and structured debt issues, amounted to approximately $101.4 billion and $81.3 billion at year-end 1993 and 1992, respectively, before reinsurance of $17.3 billion and $13.7 billion, respectively. Related unearned premiums amounted to $803 million and $571 million at December 31, 1993 and 1992, respectively. As of December 31, 1993 and 1992, reserves for losses and loss adjustment expenses were $96 million and $40 million, respectively. The Corporation's mortgage insurance operations underwrite residential mortgage guarantee insurance. Total risk in force aggregated $27.0 billion and $21.3 billion at December 31, 1993 and 1992, respectively; related unearned premiums amounted to $276 million at December 31, 1993 and $236 million at December 31, 1992. Case basis loss reserves and loss adjustment expense reserves are provided in an amount sufficient to pay all estimated losses in the portfolio, including those incurred but not reported. As of December 31, 1993 and 1992, reserves for losses and loss adjustment expenses were $511 million and $372 million, respectively. Interest rates credited to annuity contracts in 1993 ranged from 3.7% to 9.7%. For most annuities, interest rates to be credited are redetermined by management on an annual basis. The Corporation's Specialty Insurance businesses are involved significantly in the reinsurance business, ceding reinsurance on both a pro-rata and an excess basis. The maximum amount of individual life insurance retained on any one life is $740,000. When the Corporation cedes business to third parties, it is not relieved of its primary obligation to policyholders and reinsureds. Consequently, the Corporation establishes allowances for amounts deemed uncollectible due to the failure of reinsurers to honor their obligations. The Corporation monitors both the financial condition of individual reinsurers and risk concentrations arising from similar geographic regions, activities and economic characteristics of reinsurers. The effects of reinsurance on premiums written and earned during 1993, 1992 and 1991 were as follows: Reinsurance recoveries recognized as a reduction of insurance losses and policyholder and annuity benefits amounted to $304 million, $525 million and $478 million for the periods ended December 31, 1993, 1992 and 1991, respectively. NOTE 13. EQUITY CAPITAL Equity capital is owned entirely by GE Company. Cash dividends paid were $610 million in 1993 and $500 million in 1992 and $350 million in 1991. In 1992, GE Company contributed to the Corporation the assets of GE Computer Services and the minority interest in Financial Insurance Group. These contributions were reflected as a $155 million ($134 million and $21 million, respectively) addition to the Corporation's additional paid-in capital. Total GE Capital Services preferred stock at both December 31, 1993 and 1992 was $510 million. In the accompanying financial statements, such preferred shares are shown as issued to and held by consolidated affiliates. At December 31, 1993 and 1992, the statutory capital and surplus of the Corporation's insurance affiliates totaled $4,829 million and $3,416 million, respectively; amounts available for the payment of dividends without the approval of the insurance regulators totaled $382 million and $322 million, respectively. As a securities broker-dealer, Kidder, Peabody is required to maintain a minimum net capital level by the Securities and Exchange Commission. At December 31, 1993, Kidder, Peabody had net capital of $625 million, $583 million in excess of the minimum net capital requirement. Other equity at December 31, 1993 and 1992 consisted of: NOTE 14. MINORITY INTEREST IN EQUITY OF CONSOLIDATED AFFILIATES Minority interest in equity of consolidated affiliates includes 8,750 shares of $100 par value variable cumulative preferred stock issued by GE Capital with a liquidation preference value of $875 million. Dividend rates on this preferred stock ranged from 2.33% to 2.79% during 1993 and from 2.44% to 3.49% during 1992. NOTE 15. EARNED INCOME Included in earned income from financing leases were gains on the sale of equipment at lease completion of $145 million in 1993, $126 million in 1992 and $147 million in 1991. Noncancelable future rentals due from customers for equipment on operating leases as of December 31, 1993 totaled $6,133 million and are due as follows: 1994, $2,036 million; 1995, $1,455 million; 1996, $879 million; 1997, $458 million; 1998, $316 million and $989 million thereafter. Amortization of deferred investment tax credit was $29 million, $26 million and $25 million in 1993, 1992 and 1991, respectively. Time sales, loan and investment and other income includes the Corporation's share of earnings from equity investees of $106 million, $72 million and $84 million for 1993, 1992 and 1991, respectively. NOTE 16. INTEREST AND DISCOUNT EXPENSES Interest and discount expenses reported in the Statement of Current and Retained Earnings are net of interest income on temporary investments of excess funds of $42 million for 1993, $48 million for 1992, and $54 million for 1991, and net of capitalized interest of $5 million for 1993, $6 million for 1992 and $8 million for 1991. For purposes of computing the ratio of earnings to fixed charges (the "ratio") in accordance with applicable Securities and Exchange Commission instructions, earnings consist of net earnings adjusted for cumulative effect of change in accounting principle, the provision for income taxes, minority interest and fixed charges. Fixed charges consist of interest on all indebtedness and one-third of annual rentals, which the Corporation believes is a reasonable approximation of the interest factor of such rentals. The ratio was 1.42 for 1993, compared with 1.33 for 1992 and 1.25 for 1991. NOTE 17. OPERATING AND ADMINISTRATIVE EXPENSES Employees and retirees of the Corporation and its affiliates are covered under a number of pension, health and life insurance plans. The principal pension plan is the GE Company pension plan, a defined benefit plan, while employees of certain affiliates, including Employers Reinsurance and Kidder, Peabody, are covered under separate plans. The Corporation provides health and life insurance benefits to certain of its retired employees, principally through GE Company's benefit program, as well as through plans sponsored by Employers Reinsurance and Kidder, Peabody and other affiliates. The annual cost to the Corporation of providing these benefits is not material and the net transition obligation arising from the 1991 adoption of the new accounting standard, SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pension," was not separately determinable, except for the Employers Reinsurance and Kidder, Peabody plans, where the charge to operations aggregated $19 million after a deferred tax benefit of $12 million. GE Company adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits," in the second quarter of 1993. The Corporation adopted this standard in conjunction with its parent. This Statement requires that employers expense the costs of postemployment benefits (as distinct from postretirement pension, medical and life insurance benefits) over the working lives of their employees. This change principally affects the Corporation's accounting for severance benefits, which previously were expensed when the severance event occurred. The net transition obligation related to the Corporation's employees covered under GE Company postemployment benefit plans is not separately determinable from the GE Company plans as a whole; accordingly, there is no financial statement impact on the Corporation. The net transition obligation for employees covered under separate plans is not material. Rental expense for 1993 aggregating $498 million, compared with $331 million for 1992 and $169 million for 1991, was principally for the rental of office space, data processing equipment and railcars. Minimum future rental commitments under noncancelable leases are: 1994, $404 million; 1995, $364 million; 1996, $340 million; 1997, $319 million; 1998, $296 million and $1,856 million thereafter. The Corporation, as a lessee, has no material lease agreements classified as capital leases. Amortization of deferred insurance acquisition costs charged to operations in 1993, 1992 and 1991 was $817 million, $624 million and $377 million, respectively. NOTE 18. INCOME TAXES Income tax provision from operations is summarized in the following table: GE Company files a consolidated Federal income tax return which includes GE Capital Services. The provisions for estimated taxes payable (recoverable) include the effect of the Corporation and its affiliates on the consolidated tax. Estimated income taxes payable were $144 million and $73 million at December 31, 1993 and 1992, respectively. A reconciliation of the Corporation's actual income tax rate to the U.S. Federal statutory rate is shown in the following table: The tax effects of principal temporary differences are shown in the following table: NOTE 19. INDUSTRY SEGMENT DATA Industry segment operating data and identifiable assets for the years 1993, 1992 and 1991 are shown below. Corporate level expenses principally include interest expense related to acquisition debt. NOTE 20. QUARTERLY FINANCIAL DATA (UNAUDITED) Summarized quarterly financial data for 1993 and 1992 are as follows: NOTE 21. RESTRICTED NET ASSETS OF AFFILIATES Various state and foreign regulations require that the Corporation's investment in certain affiliates, without regard to net unrealized after-tax gains on investment securities which were $663 million at December 31, 1993, be maintained at specified minimum levels to provide additional protection for insurance customers, investment certificate holders and passbook savings depositors. At December 31, 1993, such minimum investment levels aggregated approximately $5,700 million. NOTE 22. SUPPLEMENTAL CASH FLOW INFORMATION Cash used or provided in 1993, 1992 and 1991 included interest paid by the Corporation of $6,216 million, $5,907 million and $6,384 million, respectively and income taxes (paid) recovered by the Corporation of $(189) million, $(97) million and $99 million, respectively. NOTE 23. FAIR VALUES OF FINANCIAL INSTRUMENTS As required under generally accepted accounting principles, financial instruments are presented in the accompanying financial statements -- generally at either cost or fair value, based on both the characteristics of and management intentions regarding the instruments. Management believes that the financial statement presentation is the most useful for displaying the Corporation's results. However, SFAS No. 107, "Disclosure About Fair Value of Financial Instruments," requires disclosure of an estimate of the fair value of certain financial instruments. These disclosures disregard management intentions regarding the instruments, and therefore, management believes that this information may be of limited usefulness. Apart from the Corporation's own borrowings, certain marketable securities and financial instruments of Kidder, Peabody, relatively few of the Corporation's financial instruments are actively traded. Thus, fair values must often be determined by using one or more models that indicate value based on estimates of quantifiable characteristics as of a particular date. Because this undertaking is, by nature, difficult and highly judgmental, for a limited number of instruments, alternative valuation techniques indicate values sufficiently diverse that the only practicable disclosure is a range of values. Users of the following data are cautioned that limitations in the estimation techniques may have produced disclosed values different from those that could have been realized at December 31, 1993 or 1992. Moreover, the disclosed values are representative of fair values only as of the dates indicated, inasmuch as interest rates, performance of the economy, tax policies and other variables significantly impact fair valuations. Cash and equivalents, trading securities, reverse repurchase agreements, repurchase agreements and other receivables have been excluded as their carrying amounts and fair values are the same, or approximately the same. Values were estimated as follows: INVESTMENT SECURITIES. Based on quoted market prices or dealer quotes for actively traded securities. Value of other such securities was estimated using quoted market prices for similar securities. TIME SALES, LOANS AND RELATED PARTICIPATIONS. Based on quoted market prices, recent transactions, market comparables and/or discounted future cash flows, using rates at which similar loans would have been made to similar borrowers. INVESTMENTS IN AND ADVANCES TO NON-CONSOLIDATED AFFILIATES. Based on market comparables, recent transactions and/or discounted future cash flows. These equity interests were generally acquired in connection with financing transactions and, for purposes of this disclosure, fair values were estimated. OTHER FINANCIAL INSTRUMENTS. Based on recent comparable transactions, market comparables, discounted future cash flows, quoted market prices, and/or estimates of the cost to terminate or otherwise settle obligations to counterparties. BORROWINGS. Based on quoted market prices or market comparables. Fair values of interest rate and currency swaps on borrowings are based on quoted market prices and include the effects of counterparty creditworthiness. ANNUITY BENEFITS. Based on expected future cash flows, discounted at currently offered discount rates for immediate annuity contracts or cash surrender value for single premium deferred annuities. FINANCIAL GUARANTIES OF INSURANCE AFFILIATES. Based on future cash flows, considering expected renewal premiums, claims, refunds and servicing costs, discounted at a market rate. The carrying amounts and estimated fair values of the Corporation's financial instruments at December 31, 1993 and 1992 are as follows: - --------------- (a) Swap contracts are integral to the Corporation's goal of achieving the lowest borrowing costs for particular funding strategies. The above fair values of borrowings include fair values of associated interest rate and currency swaps. At December 31, 1993, the approximate settlement values of the Corporation's swaps were $340 million. Without such swaps, estimated fair values of the Corporation's borrowings would have been $86,680 million. Approximately 90% of the notional amount of swaps outstanding at December 31, 1993, was with counterparties having credit ratings of Aa/AA or better. (b) Proceeds from borrowings are invested in a variety of activities, including both financial instruments, shown in the preceding table, as well as leases, for which fair value disclosures are not required. When evaluating the extent to which estimated fair value of borrowings exceeds the related carrying amount, users should consider that the fair value of the fixed payment stream for long-term leases would increase as well. NOTE 24. GEOGRAPHIC SEGMENT INFORMATION Geographic segment operating data and total assets for the years 1993, 1992, and 1991 are as follows: U.S. amounts were derived from the Corporation's operations located in the U.S. The Corporation manages its exposure to currency movements by committing to future exchanges of currencies at specified prices and dates. Commitments outstanding at December 31, 1993 and 1992, were $1,833 million and $2,084 million, respectively, excluding Kidder, Peabody. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not applicable PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Omitted ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. Omitted ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Omitted ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Omitted PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) 1. FINANCIAL STATEMENTS Included in Part II of this report: Independent Auditors' Report Statement of Current and Retained Earnings for each of the years in the three-year period ended December 31, 1993 Statement of Financial Position at December 31, 1993 and 1992 Statement of Cash Flows for each of the years in the three-year period ended December 31, 1993 Notes to Financial Statements (a) 2. FINANCIAL STATEMENT SCHEDULES III. Condensed financial information of registrant. All other schedules are omitted because of the absence of conditions under which they are required or because the required information is shown in the financial statements or notes thereto. (a) 3. EXHIBIT INDEX The exhibits listed below, as part of Form 10-K, are numbered in conformity with the numbering used in Item 601 of Regulation S-K of the Securities and Exchange Commission. EXHIBIT NUMBER DESCRIPTION 3 (i) A complete copy of the Certificate of Incorporation of the Corporation as last amended on February 10, 1993 and currently in effect. 3 (ii) A complete copy of the By-Laws of the Corporation as last amended on January 4, 1994 and currently in effect. 4 (iii) Agreement to furnish to the Securities and Exchange Commission upon request a copy of instruments defining the rights of holders of certain long-term debt of the registrant and all subsidiaries for which consolidated or unconsolidated financial statements are required to be filed. 12 Computation of ratio of earnings to fixed charges. 23(ii) Consent of KPMG Peat Marwick. 24 Power of Attorney 99 Income Maintenance Agreement dated March 28, 1991 be- tween General Electric Company and General Electric Capital Corporation. (Incorporated by reference to Exhibit 28 of the Corporation's Form 10-K Report for the year ended December 31, 1992). (b) REPORTS ON FORM 8-K None. GENERAL ELECTRIC CAPITAL SERVICES, INC. AND CONSOLIDATED AFFILIATES SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT GENERAL ELECTRIC CAPITAL SERVICES, INC. CONDENSED STATEMENT OF FINANCIAL POSITION See Notes to Condensed Financial Statements. GENERAL ELECTRIC CAPITAL SERVICES, INC. AND CONSOLIDATED AFFILIATES SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT -- (CONTINUED) GENERAL ELECTRIC CAPITAL SERVICES, INC. CONDENSED STATEMENT OF CURRENT AND RETAINED EARNINGS See Notes to Condensed Financial Statements. GENERAL ELECTRIC CAPITAL SERVICES, INC. AND CONSOLIDATED AFFILIATES SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT -- (CONTINUED) GENERAL ELECTRIC CAPITAL SERVICES, INC. CONDENSED STATEMENT OF CASH FLOWS See Notes to Condensed Financial Statements. GENERAL ELECTRIC CAPITAL SERVICES, INC. AND CONSOLIDATED AFFILIATES SCHEDULE III -- CONDENSED FINANCIAL INFORMATION OF REGISTRANT -- (CONCLUDED) GENERAL ELECTRIC CAPITAL SERVICES, INC. NOTES TO CONDENSED FINANCIAL STATEMENTS INCOME TAX BENEFIT GE Company files a consolidated Federal income tax return which includes GE Capital Services. Income tax benefit includes the effect of the Corporation on the consolidated income tax. DIVIDENDS FROM AFFILIATES In 1993 and 1992, GE Capital Services received dividends of $150 million and $200 million, respectively, from Employers Reinsurance and $460 million and $300 million, respectively, from GE Capital. EXHIBIT 4(iii) March 22, 1994 Securities and Exchange Commission 450 Fifth Street, N.W. Washington, D.C. 20549 Subject: General Electric Capital Services, Inc. Annual Report on Form 10-K for the fiscal year ended December 31, 1993 -- File No. 0-14804 Dear Sirs: Neither General Electric Capital Services, Inc. (the "Corporation") nor any of its subsidiaries has outstanding any instrument with respect to its long-term debt under which the total amount of securities authorized exceeds 10% of the total assets of the registrant and its subsidiaries on a consolidated basis. In accordance with paragraph (b)(4)(iii) of Item 601 of Regulation S-K (17 CFR sec. 229.601), the Corporation hereby agrees to furnish to the Securities and Exchange Commission, upon request, a copy of each instrument which defines the rights of holders of such long-term debt. Very truly yours, GENERAL ELECTRIC CAPITAL SERVICES, INC. By: /s/ J. A. PARKE --------------------------------------- J. A. Parke, Senior Vice President, Finance EXHIBIT 12 GENERAL ELECTRIC CAPITAL SERVICES, INC. AND CONSOLIDATED AFFILIATES COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES EXHIBIT 23(ii) To the Board of Directors General Electric Capital Services, Inc. We consent to incorporation by reference in the Registration Statement on Form S-3 (No. 33-7348) of General Electric Capital Services, Inc. of our report dated February 11, 1994, relating to the statement of financial position of General Electric Capital Services, Inc. and consolidated affiliates as of December 31, 1993 and 1992 and the related statements of current and retained earnings and cash flows and related schedules for each of the years in the three-year period ended December 31, 1993, which report appears in the December 31, 1993 annual report on Form 10-K of General Electric Capital Services, Inc. Our report refers to a change in 1993 in the method of accounting for certain investments in securities. /s/ KPMG PEAT MARWICK Stamford, Connecticut March 23, 1994 EXHIBIT 24 POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that each of the undersigned, being directors and/or officers of General Electric Capital Services, Inc., a Delaware corporation (the "Corporation"), hereby constitutes and appoints Gary C. Wendt, James A. Parke, John P. Malfettone and Burton J. Kloster, Jr., and each of them, his true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution, for him and in his name, place and stead in any and all capacities, to sign one or more Annual Reports for the Corporation's fiscal year ended December 31, 1993, on Form 10-K under the Securities Exchange Act of 1934, as amended, or such other form as such attorney-in-fact may deem necessary or desirable, any amendments thereto, and all additional amendments thereto in such form as they or any one of them may approve, and to file the same with all exhibits thereto and other documents in connection therewith with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done to the end that such Annual Report or Annual Reports shall comply with the Securities Exchange Act of 1934, as amended, and the applicable Rules and Regulations of the Securities and Exchange Commission adopted or issued pursuant thereto, as fully and to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them or their or his substitute or resubstitute, may lawfully do or cause to be done by virtue hereof. IN WITNESS WHEREOF, each of the undersigned has hereunto set his hand this 23rd day of March, 1994. /s/ GARY C. WENDT /s/ JAMES A. PARKE - ---------------------------------------- --------------------------------- Gary C. Wendt, James A. Parke, Chairman of the Board, Senior Vice President, Finance President and Chief Executive Officer (Principal Financial Officer) (Principal Executive Officer) /s/ JOHN P. MALFETTONE ---------------------------------- John P. Malfettone Vice President and Comptroller (Principal Accounting Officer) A MAJORITY OF THE BOARD OF DIRECTORS SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. GENERAL ELECTRIC CAPITAL SERVICES, INC. March 23, 1994 By: /s/ GARY C. WENDT ------------------------------------------- (GARY C. WENDT) President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. A majority of the Board of Directors INDEX TO EXHIBITS

51720_1993.txt

51720

1993

ITEM 1. BUSINESS (General) Interstate Power Company, (the company), is an operating public utility incorporated in 1925 under the laws of the State of Delaware. The company is engaged in the generation, purchase, transmission, distribution and sale of electricity. It owns property in portions of twenty-five counties in the northern and northeastern parts of Iowa, in portions of twenty-two counties in the southern part of Minnesota, and in portions of four counties in northwestern Illinois. The company also engages in the distribution and sale of natural gas in Albert Lea, Minnesota; Clinton, Mason City and Clear Lake, Iowa; Fulton and Savanna, Illinois and in a number of smaller Minnesota, Iowa and Illinois communities, and in the transportation of natural gas within Iowa, Minnesota and in interstate commerce. For information pertaining to industry segments and lines of business please refer to page 27 of Exhibit EX-13 (the Annual Report to Stockholders). (Construction Program) The table below shows actual construction expenditures for 1993 and estimated expenditures for the period 1994 through 1998: (Thousands of Dollars) 1993 Actual $33,904 1994 Est. $46,510 1995 Est. $39,012 1996 Est. $31,818 1997 Est. $40,494 1998 Est. $67,166 Refer to (Environmental Regulations) on page 11 for additional information on construction expenditures related to compliance with the regulations of the Clean Air Act of 1990. (Electric Operations) Of the 234 communities served with electricity, Dubuque, Iowa, is the largest with a population of approximately 58,000. Other major cities served are Albert Lea, Minnesota and Clinton and Mason City, Iowa. The remainder of the communities served are under 15,000 population, of which 193 or 84% are less than 1,000 population. The company sells electricity at wholesale to 19 small communities which have municipal distribution systems, 13 of which are total requirements customers, and 6 of which are partial requirements customers. The territory served with electricity at retail by the company is a residential, agricultural and widely diversified industrial area with an estimated population of 338,000. There have been no significant changes since the beginning of the fiscal year in the kind of products produced, services rendered, markets or method of distribution. The facilities owned or operated by the company include facilities for the transmission of electric energy in interstate commerce or the sale of electric energy at wholesale in interstate commerce. (Sources and Availability of Raw Materials) Electricity generated by the company in 1993 was 93.5% from coal as a fuel, 0.1% from oil and 6.4% from natural gas. In 1994, the sources of such generation are estimated to be: 98.2% from coal, 0.2% from middle distillate oils, and 1.6% from natural gas. In 1993, 80.9% of the company's coal requirements came from long-term contracts. In 1994, the company anticipates that 83.8% of its coal requirements will be from long-term contracts. These contracts have expiration dates ranging from December 31, 1994 through December 31, 1998. The company in 1990 negotiated the buyout of a 300,000 ton per year contract for Montana coal. See Note 9 to the Financial Statements of the Annual Report to Stockholders (EX-13) regarding recovery of contract cancellation costs. The company has two 5 year contracts effective January 1, 1990 through December 31, 1994, for a total of 500,000 tons per year of 2% sulfur Midwestern coal for its Kapp #2, a 217 MW unit at Clinton, Iowa because of sulfur dioxide restrictions mandated by the State of Iowa. The company has a contract for 150,000 tons of coal, 50,000 tons for Lansing Units #1, #2 and #3 and 100,000 tons for Dubuque, which expires at December 31, 1994. The company has a contract for 500,000 tons per year for its 260 MW Lansing #4 unit. Lansing Unit #4 requires low sulfur coal, which is being purchased in the Powder River Basin of Wyoming. The company has this coal shipped by rail and then transloaded to barge, using facilities near Keokuk, Iowa. A contract with Orba-Johnson Transshipment Company, Inc., covers rail to barge coal transloading. Coal required for the company's generation by Neal #4 unit, located near Sioux City, Iowa is contracted for by the operator, Midwest Power Systems, under terms of the Unit Participation Agreement. Similar arrangements prevail with respect to the company's participation in Louisa #1 located near Muscatine, Iowa and operated by Iowa-Illinois Gas and Electric Company. The company owns 120 coal cars, has an undivided ownership (21.528%) in 372 coal cars in connection with Neal #4. During February 1993, 21 coal cars were damaged or destroyed beyond repair. Nine of these cars have been repaired and 12 have been replaced. The company was reimbursed by the railroad carrier for all costs of repair or replacement. The company has an undivided ownership (4%) in 136 cars in connection with Louisa #1. Coal requirements in 1994 will require using leased cars for the Louisa #1 coal supply. The company burned 665,952 gallons of No. 2 and No. 6 oil in 1993 and has 6,477,000 gallons of oil storage capacity in which to store adequate reserves during periods of high demand on refineries. The company relies on spot purchases of oil. The company presently has interruptible natural gas available for its electric generation station at Clinton, Iowa through Natural Gas Pipeline Company of America. At the Fox Lake and Dubuque plants, interruptible gas is available through Peoples Natural Gas Company. There is no assurance that interruptible gas will continue to be available as fuel for electric generating plants. (Duration and Effect of Electric Patents and Franchises) The company owns no patents. The company has, in the opinion of its legal counsel, all necessary franchises or other rights from the incorporated communities and other governmental subdivisions now served, required for the operation of its properties. With 196 electric franchises in effect in cities and villages, and with the majority of such franchises being for a term of 25 years, the renewal of such franchises is a continuing process. Thirty-two percent (62) of the franchises have been secured since January 1, 1984. (Electric Seasonal Business) The effects of air conditioning in summer and heating in winter have a seasonal impact on the business of the registrant. The air conditioning sales in the summer months are primarily related to the residential and commercial customer classes, however, the company does not meter air conditioning sales separately. During the past five years, the highest and lowest average residential consumption in the peak summer month has been 891 Kwh (July 1991) and 560 Kwh (June 1989), respectively, compared to 811 Kwh (January 1991) and 635 Kwh (February 1990) during the peak winter month. Refer to the section (Electric Governmental Regulations) for discussion of Iowa seasonal rates. (Working Capital Items) Three of the company's generating stations are located on the Mississippi River at Clinton, Dubuque and Lansing, Iowa, with their coal supply being delivered by barge during the barging season (approximately April 1st to December 1st). Coal in the stockpile at December 1st of each year has been sufficient to supply the normal requirements of these generating stations until the reopening of the Mississippi River for barge traffic. Coal shipments to the company's Neal #4 and Louisa #1 generating stations are able to continue year-round because river transportation is not involved. (Electric Governmental Regulations) The company filed an application with the IUB in September 1991 which requested an electric rate increase of $22.4 million. Interim rates of $16.2 million were placed in effect in May 1992 subject to refund. In July 1992, the IUB granted an annual revenue increase of $9.0 million (with an additional $1.4 million over the 12 months beginning November 1992 to recover costs related to a coal contract buyout). Revenue collected in excess of the IUB ordered level in the amount of $3,835,000 plus $236,000 of interest was reserved in 1992 and refunded in February 1993. On May 26, 1993, the IUB approved electric tariffs which more closely track costs incurred by the company. Individual customers experienced an increase or decrease in their electric bill, but the adoption of the new tariffs did not change the company's overall revenue. The new tariffs, which were implemented in August 1993, give greater weight to the demand component of electric usage, and include a provision for a higher rate during the summer cooling season (June - September), and a lower rate during the remainder of the year. Due to implementation of the seasonal rates, revenue for the third and fourth quarters of 1993 is not comparable to the corresponding quarters of prior years. The company filed an Iowa electric rate increase application on May 14, 1993. The IUB ruled on June 4, 1993 that the company's rate design docket approved by the IUB on May 26, 1993 constituted a change in rates. Thus, pursuant to a section of the Iowa Code which limits a utility to one rate application at a time, the rate filing was rejected. The company refiled in August 1993. The revised application requested an annual increase of $11.5 million, including a return on common equity of 12.35%. Interim rates in an annual amount of $11.0 million, which include a provision to recover SFAS 106 costs, were placed in effect on October 28, 1993, subject to refund. A decision on the rate increase is expected by the end of the second quarter of 1994. The company filed an application with the MPUC in August 1991. The application requested an electric rate increase of $8.0 million. The MPUC allowed an interim increase of $4.2 million effective October 1991. In June 1992, the MPUC issued an order granting an annual revenue increase of $4.9 million, and a return on common equity of 10.9%. The MPUC order stated that the company has 100 MW of excess capacity and disallowed recovery of $1.9 million per year applicable to the excess capacity. In instances where final rates are higher than interim rates, Minnesota law allows the utility to recover the difference. Settlement rates, including a temporary increase to recover the difference between the interim and final rates over a six month period ending May 1993, were placed into effect in December 1992. In May 1993, the Minnesota Court of Appeals affirmed the MPUC order. In June 1992, sixteen municipal wholesale customers filed a Complaint and Request for Investigation and Hearing with FERC. The complaint alleges that the company had been imprudent by entering into certain long-term coal contracts, an associated transloading agreement, and a rail transportation agreement and seeks recovery in the range of approximately $3 million to $7 million. The issue will be presented before an administrative law judge, with hearings currently scheduled to commence in August 1994. The decision by the administrative law judge is expected to be presented to the full Commission in 1995. Under this process an appeal of the FERC decision most likely would not occur until 1996 or later. The company's electric rate tariffs provide for recovery of the cost of fuel through energy adjustment clauses, which clauses are subject to revision from time to time by the regulatory authority having jurisdiction. These clauses are designed to pass on to the consumer the increases or decreases in the cost of fuel without formal rate proceedings. Purchased capacity costs are not recovered from customers through energy adjustment clauses, but rather must be addressed in base rates in a formal rate proceeding. In the company's 1991 Iowa electric rate case, the IUB required that any jurisdictional revenue from capacity sales to other utilities be returned to Iowa customers through the fuel adjustment clause. (Electric Competitive Conditions) In 1993 the Illinois Commerce Commission entered an order determining that Interstate, and not Jo-Carroll Electric Cooperative, had the right to provide electric service to a large new freezer service plant near East Dubuque, IL. The company is providing service to that plant pursuant to Commission order. Jo-Carroll filed for judicial review of the Commission's action in a proceeding now pending in the Illinois 15th Judicial Circuit. The Energy Policy Act of 1992 (Act) allows FERC to order utilities to grant access to transmission systems by third-party power producers. The Act specifically prohibits federally-mandated wheeling of power for retail customers. The company's industrial rates generally compare favorably with those of neighboring utilities. For the company's six largest industrial customers, the aggregate 1993 rate was approximately 3.4 cents per KWH. This rate also compares favorably with that of potential independent power producers and electric wholesale generators. The company's favorable rates reduce any incentive that these customers might otherwise have to relocate, self-generate or purchase electricity from other suppliers. The company has no competition from the same type of public utility service in the sale of electricity in any of the incorporated communities served by it. Interstate may be subject to competition in unincorporated areas. In the States of Iowa, Illinois and Minnesota, territorial laws govern the question of possible service to customers in such unincorporated areas, and such laws regulate competition in such areas. Laws and statutory regulations in the different states in which service is rendered provide, under varying terms and conditions, for municipal ownership of electric generating plants and distribution systems. Certain franchises under which utility service is rendered give the municipality the right to purchase the system of the company within said municipality upon certain terms and conditions. However, no such purchase option and no right of condemnation of the company's properties has been exercised and no municipal generating plant or municipal distribution system has been established in the territory now served by the company during the past twenty-five years. The Iowa Utilities Board, the Illinois Commerce Commission and the Minnesota Public Utilities Commission have each approved tariffs that allow the company to offer interruptible electric service for qualifying customers. The availability of this service provides price incentives to those customers having the ability to interrupt their connected load. The primary objective of the incentives is to reduce the system peak. The incentives also serve to retain existing customers and attract new customers. (Other Sources of Power) The company has been a participant in the Mid-Continent Area Power Pool (MAPP) Agreement since March 31, 1972. MAPP had a total coincident 1993 summer peak of 23,290 MW at which time the net capacity of the pool was 30,345 MW. Membership in the pool permits sharing of reserve capacities of the members which affects reductions in plant facilities investment for MAPP members. The minimum reserve margin for participants in MAPP has been established at 15%. Parties to the MAPP Agreement include, as participants, 29 electric power suppliers consisting of 10 investor-owned utilities, the United States Department of Interior (Western Area Power Administration), a Canadian system, public power districts and rural electric generating and transmission cooperative associations, municipal electric supply agencies and, as associate participants, 14 other electric power suppliers operating in Canada and in the North Central region of the United States. The pool coordinates planning and operation of power suppliers in Minnesota, Wisconsin, Montana, Iowa, Nebraska, North Dakota and South Dakota and provides reliability and economy for the company's bulk power supply. The MAPP Agreement was filed with the FERC and accepted as an initial rate filing effective December 1, 1972 and has been in operation since that time. In addition to MAPP, the company has interchange connections with certain Missouri and Illinois utilities through 345 KV transmission systems. Future interconnections are planned to meet transmission requirements for the next ten years. The company's total capacity includes three long-term power purchase contracts with area electric utilities. The contracts provide for the purchase of 230 to 255 megawatts of capacity over the period from May 1992 through April 2001. The company is obligated to pay the capacity charges regardless of the actual electric demand by the company's customers. Energy is available at the company's option at approximately 100% to 110% of monthly production costs for the designated units. The three power purchase contracts required capacity payments of approximately $24.1 million in 1993. Over the remaining period of the contracts, total capacity payments will be approximately $180 million. Capacity costs are not recovered from customers through energy adjustment clauses, but rather must be addressed in base rates in a formal rate proceeding. The IUB order in the company's 1991 rate case indicated that the capacity purchases were prudent and allowed recovery of the costs in rates. A 1992 rate order by the MPUC stated that the company has 100 MW of excess capacity and disallowed recovery of $1.9 million per year applicable to the excess capacity. The Minnesota Court of Appeals affirmed the MPUC disallowance in May 1993. The company has not yet filed for rate recovery in the Illinois and FERC jurisdictions. The company has contracts with several governmental power agencies whereby the company provides transmission service to their customer/members. During 1993, the company received $1,183,588 for transmission service to customers of the Western Area Power Administration (WAPA), and $1,233,863 from Cooperative Power Association (CPA) for wheeling power to nine of its member distribution cooperatives. The company's contract with CPA also provides for payment by the company for needed mutually utilized facilities constructed and owned by CPA. During 1993, these payments amounted to $330,319. The company and Southern Minnesota Municipal Power Agency (SMMPA) have agreed by contract to compensate each other if over/underinvestment in the shared transmission system occurs. During 1993, SMMPA made payments to the company in the amount of $535,342. The company's contract with Central Iowa Power Cooperative (CIPCO) provides for compensation to each other if over/underinvestment in the shared transmission system occurs. During 1993, the company owed CIPCO $63,259 for underinvestment in the Liberty Substation property. Also during 1993, CIPCO owed to the company $46,730 for underinvestment in the Dubuque-Clinton project. The net payment by the company to CIPCO totalled $16,529. (Other Electric Operations) The 1993 peak of 927,366 KW occurred on August 26, 1993 between 3:00 and 4:00 in the afternoon. At the time of its 1993 peak the company had a net effective electric capability of 1,295,600 KW. Of this net effective capability at the time of peak, 898,300 KW was in steam generation, 113,500 KW was in combustion turbine and the balance was in internal combustion units and purchases. The previous historical system net peak load for a sixty-minute period, of 919,100 KW, was reached on August 16, 1988. (Gas Operations) The company supplies retail gas service in 39 communities and serves approximately 48,000 gas customers. There have been no significant changes since the beginning of the fiscal year in the kind of products produced, markets or methods of distribution. (Gas Sources and Availability of Raw Materials) The natural gas industry was recently restructured as a result of Order 636, issued by the Federal Energy Regulatory Commission (FERC) on April 8, 1992. This Order requires the interstate pipelines to provide transportation capacity unbundled (separated) from the sales of gas supply, as well as to provide open access to their storage facilities. The company no longer purchases a bundled gas supply from Northern Natural Gas Company (NNG) and Natural Gas Pipeline Company of America (NGPL). The company purchases pipeline capacity (space) from these companies to deliver a gas supply purchased from others. As of November 1, 1993 the company purchased gas from six non-traditional suppliers, such as producers, brokers, marketers, etc., at market responsive rates. The FERC continues to approve the tariffs of NNG and NGPL, but only with regard to capacity and storage rates, subject to change as rate cases are filed. A section of the Order permits the interstate pipelines to pass on industry transition costs to their customers. Transition costs are comprised of gas supply realignment costs, unrecovered gas cost, stranded costs and new facilities costs. As a customer of NGPL and NNG, Interstate will be subject to a share of those costs. The FERC has approved the Order 636 Settlement between NNG and its customers; NGPL's Settlement is still being negotiated with its customers. Gas for the company's Mason City, Albert Lea and Savanna service areas is transported by NNG under capacity contracts for 36,533 Mcf daily, and for an additional 15,657 Mcf in the November to March time frame. The majority, 27,194 Mcf, of the above capacities is from the producing areas of New Mexico, Oklahoma and Texas, etc. These contracts expire in October, 1997. Gas is supplied by other producers, marketers and brokers as well as from storage services to meet the peak heating season requirements. The company had 20,363 Mcf/d of storage, with the necessary pipeline capacity, available for the 1993-1994 heating season. Gas for its Clinton service area is transported by NGPL under capacity contracts for 19,781 Mcf annually, with expiration dates of December 1, 1995 (6,949), February 28, 1996 (5,000), and November 30, 1996 (7,832). This gas is supplied by other producers, marketers and brokers. The company supplements this capacity with storage gas, which has the pipeline capacity embedded in its FERC approved rate. The company had 18,613 Mcf of storage available for the 1993-1994 heating season. During 1993 the company utilized approximately 42.2% of its annualized daily contract gas available from its firm suppliers. The Company's total throughput level of 34,008,768 Mcf represents a 5.6% increase for 1993 as compared to 1992. The total throughput was composed of sales gas (20.1%), spot gas (9.4%) and customer transportation gas (70.5%). During 1993 nineteen of Interstate's customers transported a total of 23,994,891 Mcf of their own gas over the company's pipeline and distribution systems. This reflects an increase over 1991 and 1992 in the number of customers exercising the transportation option. In 1991, fourteen of Interstate's customers transported a total of 16,055,921 Mcf, and in 1992 sixteen customers transported a total of 23,547,107 Mcf. The customer owned gas was delivered by interstate pipeline companies for those customers' accounts at Interstate's town border stations, under terms and conditions in tariffs approved by respective state commissions. Company policy is to assist any customer in exploring its options relative to purchasing gas directly from the producing sector. The company owns propane-air gas plants at Albert Lea, Minnesota and Clinton and Mason City, Iowa. The daily output capacities are: 5,500 Mcf, 4,000 Mcf and 9,600 Mcf of propane-air mix gas, respectively. The requirement for gas on the peak winter day of the 1992-1993 season was 139,877 Mcf, including both firm and interruptible customers. This peak consisted of 29.0% jurisdictional sales gas, 1.4% spot gas, 51.6% customer purchased gas, 6.4% firm transportation service and 11.6% storage gas. Propane-air from the company's peak- shaving plants was not needed to meet demands due to the adequate gas supply. The maximum daily firm gas sales during the 1992-1993 season were as follows: Albert Lea 10,611 Mcf; Savanna 2,338 Mcf; Clinton 20,970 Mcf; Mason City 26,494 Mcf, or 43.2% of the peak winter day throughput. The direct purchase of approximately 3,408,561 Mcf of natural gas in the spot market has resulted in a savings of $1,495,860 in the cost of natural gas during 1993. These savings have been passed on to the customers through the company's purchased gas adjustment clause. (Duration and Effect of Gas Patents and Franchises) The company owns no patents. The company has, in the opinion of its legal counsel, all necessary franchises or other rights from the incorporated communities and other governmental subdivisions now served, required for the opera- tion of its properties. With 34 gas franchises in effect in cities and villages, and with the larger majority of such franchises being for a term of 25 years, the renewal of such franchises is a continu- ing process. fifty percent (17) of the franchises have been secured since January 1, 1984. (Gas Seasonal Business) The effects of heating sales to the residential and commercial classes of customers have a significant seasonal impact on the business of the registrant. The heating sales in the winter months account for 98% of the total annual sales to these classes of custom- ers. The average consumption for a residential customer during the peak winter months is 18.5 Mcf compared to the average of 2.6 Mcf during the summer. The average consumption for a commercial customer during the peak winter months is 90.7 Mcf compared to the average of 13.4 Mcf during the summer. (Gas Governmental Regulations) In November 1992 the company filed an application with the IUB for an increase in gas rates in an annual amount of approximately $4.1 million. Interim rates were placed in effect in February 1993. Additional interim rates in an annual amount of $300,000 were placed in effect in May 1993 after the IUB approved the company's trust agreement arrangements for additional postretirement benefits expense to be recognized under SFAS 106. On August 31, 1993, the IUB issued a final order allowing an annual increase of $3.3 million. Due to customers subsequently shifting to alternate tariffs, the company estimates that it will realize an annual increase of $2.8 million. (Gas Competitive Conditions) The company has no competition from the same type of public utility service in the sale of gas in any of the incorporated communities service by it. Certain major industrial customers of the company have taken advantage of Federal and State regulations to purchase their own gas supply from producers and have that gas transported by the company as described in the "Gas Sources and Availability of Raw Materials" section. Laws and statutory regulations in the different states in which service is rendered provide, under varying terms and conditions, for municipal ownership of distribution systems. Certain franchises under which utility service is rendered give the municipality the right to purchase the system of the company within said municipality upon certain terms and conditions. However, no such purchase option and no right of condemnation of the company's properties has been exercised and no municipal distribution system has been established in the territory now serviced by the company during the past twenty-five years. (Dependence of Segment Upon a Single Customer) In 1993, 1992 and 1991, the company had no single customer or indus- try for which electric and/or gas sales accounted for 10% or more of the company's consolidated revenues. In 1993, the company's three largest industrial customers accounted for 1,288,415,514 Kwh of electric sales ($42,000,742) and 21,950,299 Mcf of gas sales and transportation ($2,905,935). (Research and Development) The company has no full-time professional employees engaged in research activities and had no company-sponsored research programs during 1993, 1992 and 1991. In the public utility industry, research is commonly and traditionally done by manufacturers of equipment, trade organizations to which the company belongs, and university research programs. In 1993 approximately $1,089,599 was paid for research activities compared with $1,012,150 in 1992 and $955,862 in 1991. (Electric and Magnetic Fields) The possibility that exposure to electric and magnetic fields emanat- ing from power lines and other electric sources may result in adverse health effects has been a subject of increased public, governmental and media attention. A considerable amount of scientific research has been conducted on this topic with no definitive results. Re- search is continuing. It is not possible to tell what, if any, impact these actions may have on the company's financial condition. (Environmental Regulations) The company is subject to environmental regulations promulgated and enforced by federal and state governments. The company believes that it presently meets existing regulations. The Federal Clean Air Act Amendments of 1990 will require reductions in sulfur dioxide and nitrogen oxide emissions from power plants. The legislation sets two deadlines for compliance, Phase 1 (January 1, 1995) and Phase 2 (January 1, 2000). The most restrictive provisions relate to sulfur dioxide emissions. During Phase 1, only one of the company's units is affected. That unit's net effective capacity is 217 MW. Present plans for the affected unit are to switch to lower sulfur coal and install low nitrogen oxide burners. Phase 2 compliance will require addition- al capital, operating and maintenance costs beyond those required for Phase 1. The Phase 2 regulations will affect approximately 87% of the company's current generating capacity. The company's long-range construction forecast (through the year 2000) contains estimated Phase 1 capital expenditures of approximate- ly $6.5 million and estimated Phase 2 capital expenditures in the range of $35.0 million. Estimated expenditures for 1994 and 1995 include $10.9 million for facilities necessary to comply with the Clean Air Act. The estimated expenditures include provisions for low nox burners, emission monitors, and flue gas conditioning systems. The company anticipates the costs of compliance with the Clean Air Act will be recovered through the ratemaking process. The United States EPA, via the Clean Water Act, and the states have promulgated discharge limits necessary to meet water quality stan- dards. A National Pollutant Discharge Elimination System (NPDES) permit is required for all discharges. The company has current NPDES permits for all discharges and meets or or falls within the required discharge limits. Early this century, various utilities including the company operated plants which used coal, coke and/or oil to produce manufactured gas for cooking and lighting. These facilities were abandoned 40 to 60 years ago when natural gas pipelines were extended into the upper Midwest. Some of the former gasification sites contain waste products which may present an environmental hazard. Waste remediation costs can vary significantly, dependent on the disposal method and type of contaminants. Current estimates range from $75 to $1,200 per ton of waste material. In 1957, the company purchased facilities in Mason City, Iowa from Kansas City Power & Light company (KCPL) which included a parcel of land previously used for coal gasification. In 1986 and again in 1991, the company entered into Consent Orders with the Environmental Protection Agency (EPA) which obligate the company to conduct a Remedial Investigation and Feasibility Study at the Mason City site. A Remedial Investigation has been completed and has been approved by the EPA. The company is continuing to perform investigative testing to determine the limits of potential groundwater contamination at the Mason City site. The remediation process will not begin until the EPA has approved the scope of the project and the appropriate process for cleaning up the site. To-date, a total of 1,200 tons of contaminated soil has been identified. To-date, all costs have been charged to expense. The company spent $300,000 on the Mason City project in 1993; it has spent $1.7 million on the site since the discovery of the tar wastes in 1984. In 1991, the company recorded estimated future expenditures of $1.4 million for groundwater monitoring, construction of an interim groundwater treatment facility and design of site remediation. In addition, the company expensed an additional $200,000 in 1992 to cover the estimated cost to remediate 1,200 tons of waste presently in a storage pile. The company is pursuing recov- ery of response costs from KCPL. The Federal District Court ruled in the third quarter of 1993 that KCPL is liable to the company regard- ing the response costs at the Mason City site. (KCPL is a strong A rated company with total assets in excess of $2 billion.) Additional court proceedings will be held in 1994 or 1995 to determine the extent of that liability. In the opinion of the company, presently accrued liabilities of $800,000 are adequate to cover the company's share of future expenses at this site. The company formerly operated a manufactured gas plant in Rochester, Minnesota. This facility was sold to another utility, which later demolished the plant. The site is currently owned by a utility and the City of Rochester. The limits of contaminated soil have been identified and are estimated to be 50,000 tons. Tentative agreements have been reached between the Minnesota PCA and all three parties noted above regarding the clean-up process. The remediation process will begin in early 1994. The total costs to clean-up this site are estimated to be $7.8 million. A verbal agreement has been reached among the parties regarding cost sharing and a written agreement is expected in the near future. The company has agreed to pay for $4.9 million of the estimated costs ($3.5 million was recorded in 1993, $1.2 million in 1992, $200,000 in 1991). To-date, all costs have been charged to expense. The company owned and operated a manufactured gas facility in Albert Lea, Minnesota and is solely responsible for the site. Testing for contaminated soil and groundwater has taken place and additional testing will take place in 1994. Based on the past testing, contami- nation is at a low level. All costs have been charged to expense. $80,000 was spent in 1993 and $243,000 has been spent to-date. Estimated investigative and remedial expenditures in the amount of $400,000 were expensed in 1991. The company anticipates that a risk assessment will be completed by late 1994. Remediation requirements will not be known until the risk assessment is completed. The company owned and operated a manufactured gas plant at Clinton, Iowa. The company believes that the coal gasification waste was removed subsequent to plant decommissioning, and therefore it is not necessary to accrue for any future liability. If hazardous wastes are found at the site, the EPA may name several potentially responsible parties in addition to the company, as other industrial operations have been conducted on or adjacent to the site. In September 1992, the company prepared a consent order (the agreement to investigate and, if necessary, remediate the site) and forwarded it to the Iowa Department of Natural Resources - Department of Environmental Quali- ty. On November 24, 1993, the company was notified that the site was referred to the Federal EPA. In addition, the company has identified four other sites in the Midwest for which the company is potentially responsible. The company has not conducted an investigation of these sites, nor has the EPA requested that any investigations be initiated. No environmental response costs have been recorded for these sites, as no evidence has been brought forth to indicate that any of these sites contain hazardous materials. In January 1994, the company was notified by an Illinois property owner of a site which contains hazardous materials which may have come from a manufactured gas plant. Investigations are underway to determine if the company has any responsibility for the site. The company has retained an outside law firm to pursue recovery from insurance carriers of environmental remediation costs applicable to the coal gasification sites. While the company's insurance carriers have stated that they are not liable, the company contends that it has coverage. Neither the company nor its legal counsel is able to predict the amount or timing of any insurance recovery, and accord- ingly, no potential recovery has been recorded. Previous actions by Iowa, Minnesota and Illinois regulators have permitted utilities to recover prudently incurred remediation and legal costs. The company anticipates that any unreimbursed costs applicable to the Iowa, Illinois and Albert Lea, Minnesota jurisdic- tions should be recovered from gas customers. It is uncertain whether the company will recover any uninsured costs applicable to the Rochester, Minnesota site, as the company no longer serves that city, and no Minnesota precedent has been established for recovery in a similar situation. Under the Federal Comprehensive Environmental Response, Compensation and Liability Act, a past waste generator can be designated by the EPA as a Potentially Responsible Party (PRP). Certain types of used transformer oil (primarily those containing polychlorinated bipheny- ls, or "PCBs") have been designated as hazardous substances by the EPA. The company has been cited as a PRP by the EPA in 3 instances which involve used transformer oil. The company was identified in 1986 by the EPA as a PRP for the clean-up of the facilities formerly operated by Martha C. Rose Chemicals, Inc. (Rose) in Holden, Missouri. Rose, pursuant to permits issued by the EPA, was engaged in decontamination of PCB fluids and processing of PCB-contaminated electrical equipment for disposal including equipment sent to them by the company. Rose ceased opera- tions in 1986, was declared bankrupt, and did not comply with EPA orders for site clean-up. Final clean-up activities at the site will not begin until 1994. The Martha Rose Chemical Steering Committee has estimated that total clean-up cost may be up to $18 million. The company, along with 14 other steering committee members, has filed suit against non-participating potentially liable entities to recover their ratable share of the costs. The company has paid clean-up costs of $317,000 to-date. The Steering Committee has indicated that it has adequate funds for clean-up, and the company anticipates that addi- tional assessments, if any, will not be material. In 1988, the EPA designated the company a PRP for the clean-up of former salvage facilities operated by B&B Salvage in Warrensburg, Missouri. The EPA pursued recovery of costs from several PRPs, although not from the company. The PRPs sued by the EPA in turn named the company as a Third Party Defendant in an attempt to recover a ratable share of the costs. In April 1993, the company paid $69,000 in full settlement of its liability for the claims asserted in that litigation. In 1988, the EPA designated the company a PRP for the clean-up of former salvage facilities operated by the Missouri Electric Works, Inc. (MEW) in Cape Girardeau, Missouri. A portion of the PCB-contami- nated equipment found at the site was formerly owned by the company. The company notified the EPA that it disclaims responsibility for the site, as the equipment was in proper operating condition when sold by the company to a third party, which subsequently made arrangements to transport this equipment to MEW. The EPA has not responded to the company's disclaimer. The company has not recorded any liability for the MEW site, and management believes that it will be able to suc- cessfully defend itself against any claims applicable to the site. (Employees) The company has 979 regular employees consisting of 941 full-time and 38 part-time employees. (Accounting Matters) The company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes" in 1993. The new standard requires a deferred tax asset or liability to be recognized for each temporary book/tax difference, including timing differences flowed through and items not previously considered timing differences (primarily Deferred Investment Tax credits and Equity AFUDC). Corresponding regulatory assets or liabilities, reflecting the expected future rate treatment, have also been recognized. For this reason, the new standard did not have a significant effect on the income statement, but did result in increased regulatory assets and deferred tax liabilities. The balance sheet as of December 31, 1993 includes additional regulatory assets and deferred tax liabilities of $27.0 million as a result of the adoption of SFAS 109. The company adopted SFAS No. 106, "Accounting for Postretirement Benefits Other Than Pensions" in 1993. Under the provisions of SFAS 106, the estimated future cost of providing these postretirement benefits is accrued during the employees' service periods. The postretirement benefit obligation at January 1, 1993 (transition obligation) was $30.9 million and is being amortized over a 20 year perod. The annual SFAS 106 cost for 1993 is $4.9 million, compared to the 1993 pay-as-you-go amount of $1.7 million. The company is deferring the difference between the SFAS 106 costs and the pay-as- you-go amount until rate cases are filed to recover the additional costs. Effective May 1993, the IUB allowed the company to recover $300,000 annually of additional SFAS 106 expense in gas rates. Effective November 1993, the IUB allowed recovery of $1.6 million annually of additional SFAS 106 expense in electric rates, subject to refund upon final determination. On the basis of generic hearings or specific rate orders issued to other utilities by the Minnesota Public Commission (MPUC), FERC and the Illinois Commerce Commission (ICC), the company believes that amounts deferred meet the criteria for deferral established by the Financial Accounting Standards Board. As of December 31, 1993 $2.6 million of SFAS 106 costs in excess of the pay-as-you-go amount have been deferred. ITEM 2.

ITEM 2. PROPERTIES The principal power plants and other materially important physical properties of the Company are maintained in accordance with sound operating practices. Their general character and location are described below: (Electric Properties) The Company has been a participant in the Mid-Continent Area Power Pool (MAPP) Agreement since March 31, 1972. As a part of this power network the Company is the owner of a 55.0 mile section of the 345 KV transmission line extending from St. Louis, Missouri to Minneapolis, Minnesota; a 15.5 mile section of the 345 KV transmission line between Minneapolis, Minnesota and Kansas City, Missouri; a 5.0 mile 345 KV transmission line from near Clinton, Iowa to near Cordova, Illinois; a 49.8 mile 345 KV transmission line from near Clinton, Iowa to a substation south of Dubuque, Iowa; and three associated 345/161 KV substations. The Company's electric generating stations at year-end consist of six steam plants, three combustion turbine stations, and five internal combustion facilities. Pertinent information regarding each electric generating station is shown on the following page: INTERSTATE POWER COMPANY GENERATING STATIONS Net Generating Units December 31, 1993 Output Nameplate Capability in KWH Unit Capacity Year KW KW (000's) Location Number KW Installed (Gross) (Net) 1993 STEAM: Dubuque, IA 2 15,000 1929 82,500 78,000 140,551 3 25,000 1952 4 33,000 1959 Clinton, IA 1 15,000 1947 254,900 235,000 1,146,141 (M.L.Kapp Plt.) 2 212,284 1967 Lansing, IA 1 15,000 1948 337,800 320,000 728,926 2 11,500 1949 3 33,000 1957 4 252,649 1977 Sherburn, MN 1 11,500 1950 113,500 108,000 167,927 (Fox Lake Plt.) 2 11,500 1951 3 75,000 1962 Sioux City, IA 4* 125,924 1979 142,000 134,300 922,780 (Neal Unit #4) Louisa County, IA 1** 27,400 1983 27,400 26,000 175,595 (Louisa Unit #1) TOTAL STEAM 958,100 901,300 3,281,920 GAS TURBINE: Montgomery, MN 1 26,535 1974 22,200 22,200 (87) Sherburn, MN 4 26,535 1974 21,300 21,300 40 (Fox Lake Plt.) Mason City, IA 1 37,520 1991 70,400 70,000 597 (Lime Creek Plt.) 2 37,520 1991 TOTAL GAS TURBINE 113,900 113,500 550 INTERNAL COMBUSTION: Dubuque, IA 1 2,000 1966 4,600 4,600 (110) 2 2,000 1966 Hills, MN 2 2,000 1960 2,000 2,000 (62) Lansing, IA 1 1,000 1970 2,000 2,000 4 2 1,000 1971 New Albin, IA 1 685 1970 700 700 (50) Rushford, MN 1 2,000 1961 2,000 2,000 (91) TOTAL INTERNAL COMBUSTION 11,300 11,300 (309) TOTAL COMPANY 1,083,300 1,026,100 3,282,161 * Interstate owns 21.528% of a 584,931 KW unit operated by Midwest Re- sources. ** Interstate owns 4.0% of a 685,000 KW unit operated by Iowa-Illinois Gas and Electric Company. (Gas Properties) The company owns and operates natural gas distributing systems in Albert Lea, Minnesota; Savanna, Illinois; Clinton, Mason City and Clear Lake, Iowa and in a number of smaller Minnesota, Illinois and Iowa communities. At Albert Lea, the company owns 14 tanks with a liquid propane storage capacity of 357,000 gallons; at Clinton there are 12 tanks with 306,000 gallons capacity and at Mason City 22 tanks with 561,000 gallons capacity. The company also owns 110 gas regulating stations and approximately 965 miles of gas distribution mains. (General Properties) The company owns numerous miscellaneous properties in various parts of its territory which are used for office, service and other purpos- es. The most important of these are three General Office buildings in Dubuque and the district office buildings at Clinton, Decorah, Dubuque, Mason City and Oelwein, Iowa and Albert Lea, and Winnebago, Minnesota and the distribution service buildings in each of those locations. The company, as lessee, leases office space at various locations. The company also leases a few small parcels of land for storage of poles and miscellaneous temporary uses. (Titles) In the opinion of legal counsel for the company, the company has satisfactory title to its properties for use in its utility business- es subject only to permitted liens as defined in the Bond Indenture and to minor defects and encumbrances customarily found in cases of like size and character and which do not materially interfere with the use of such properties. Properties such as electric transmission and electric and gas distri- bution lines are constructed principally on rights-of-way which are maintained under franchise or held by easement only. All properties of the company, other than "excepted property" as defined in the Bond Indenture, are subject to the lien of the compan- y's Bond Indenture dated as of January 1, 1948, as supplemented, securing the company's outstanding First Mortgage Bonds. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS Reference is made to "Electric Governmental Regulations", "Electric Competitive Conditions" and "Environmental Regulations" under "Item 1. Business" for certain pending legal proceedings and proceedings known to be contemplated by governmental authorities. Reference is also made to Note 9 to Financial Statements of the Annual Report to Stockholders, included herein as EX-13. Other than these items, there are no material pending legal proceedings, or proceedings known to be contemplated by governmental authorities, other than ordinary routine litigation incidental to the business, to which the company is a party or of which any of the company's property is the subject. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There was no submission of matters to a vote of security holders during the fourth quarter of the 1993 year. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS For information pertaining to common stock market data required by Item 201 of Regulation S-K please refer to page 33 of Exhibit EX-13 (the Annual Report to Stockholders). ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA On March 11, 1993, the company filed a shelf registration with the Securities and Exchange Commission for $125 million of first mortgage bonds and 745,000 shares of $50 par value preferred stock. On May 26, 1993 the company issued $94 million of 7 5/8% first mortgage bonds due in 2023. The proceeds from the sale of the bonds were used to retire higher cost bonds due in 1999, 2001, 2002 and 2008. Also, on May 26, 1993 the company issued 545,000 shares of 6.40% preferred stock. The proceeds from the issuance of the stock were used to redeem higher cost series preferred and preference stock. Below is set forth the ratio of earnings to fixed charges for each of the years in the period 1989 through 1993. December 31, 1989................. 3.69 December 31, 1990................. 3.84 December 31, 1991................. 3.77 December 31, 1992................. 2.69 December 31, 1993................. 2.68 Below is set forth the ratio of earnings to fixed charges and pre- ferred stock dividends for each of the years in the period 1989 through 1993. December 31, 1989................. 3.03 December 31, 1990................. 3.11 December 31, 1991................. 3.13 December 31, 1992................. 2.28 December 31, 1993................. 2.21 See Exhibit EX-12 for the computation of the above ratios. For information pertaining to selected financial data required by Item 301 of Regulation S-K please refer to page 32 of Exhibit EX-13 (the Annual Report to Stockholders). ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS For information pertaining to management's discussion and analysis required by Item 303 of Regulation S-K please refer to pages 1 through 11 of Exhibit EX-13 (the Annual Report to Stockholders). ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Financial statements and supplementary data incorporated by reference to Exhibit EX-13 (the Annual Report to Stockholders for 1993): Statements of Income and Retained Earnings Page 12 Balance Sheets Pages 13 & 14 Statements of Cash Flows Page 15 Statements of Capitalization Page 16 Notes to Financial Statements Pages 17 - 29 Independent Auditors' Report Page 30 ITEM 9.

ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10.

ITEM 10. EXECUTIVE OFFICERS OF THE REGISTRANT Name Age Offices Held Past 5 Years W. H. Stoppelmoor 60 1-1-87 - President and Chief Executive Officer 5-1-90 - President, Chief Executive Officer and Chairman of the Board M. R. Chase 55 1-1-91 - Vice President - Production 5-7-91 - Vice President - Power Production A. D. Cordes 62 1-1-86 - Vice President - District Adminis- tration 5-1-90 - Vice President - District Adminis- tration and Public Affairs R. R. Ewers 49 5-1-90 - Vice President - Administrative Services D. E. Hamill 57 9-1-80 - Vice President - Budgets and Regu- latory Affairs G. L. Kopischke 62 9-1-80 - Vice President - Electric Opera- tions J. C. McGowan 56 5-1-86 - Assistant Secretary and Assistant Treasurer 2-1-89 - Secretary and Treasurer R. P. Richards 57 1-1-91 - Vice President - Gas Operations W. C. Troy 55 5-1-86 - Controller All officers are elected and serve as such until the next annual meeting of directors. There are no arrangements or understandings with respect to election of any person as an officer. For information pertaining to directors, and other data required by Items 401 and 405 of Regulation S-K, refer to pages 3 through 6 of the company's Official Proxy Statement filed with the Securities and Exchange Commission on March 18, 1994. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION Refer to information on pages 8, 9, 10, 11 and 12 of the company's Official Proxy Statement filed with the Securities and Exchange Commission on March 18, 1994 for data required by Item 402 of Regulation S-K. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Refer to information on pages 6 and 7 of the company's Official Proxy Statement filed with the Securities and Exchange Commission on March 18, 1994 for data required by Item 403 of Regulation S-K. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Transactions with Management and Others: In 1993 there were no transactions and there are presently proposed no transactions with management, to which the company or its subsid- iary was or is to be a party, of the character as to which answer is called for in response to Item 404(a) of Regulation S-K. Indebtedness of Management: No director or officer, or nominee for election as a director, or any associate of any thereof, was indebted to the company or its subsid- iary during 1993, as to which answer is called for in response to Item 404(b) of Regulation S-K. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) List of documents filed as part of this report: 1. The financial statements, including supporting schedules, are listed in the Index to Financial Statements, Schedules and Exhibits filed as part of this Annual Report. 2. Exhibits which are filed herewith, including those incor- porated by reference are listed in the Index to Financial Statements, Schedules and Exhibits filed as part of this Annual Report. (b) Reports on Form 8-K: No reports on Form 8-K were filed with the Securities and Exchange Commission during the last quarter of 1993. INDEX TO FINANCIAL STATEMENTS, SCHEDULES AND EXHIBITS The 1993, 1992 and 1991 financial statements, together with the Indepen- dent Auditors' Report thereon of Deloitte & Touche dated February 3, 1994, appearing on pages 12 through 30 of Exhibit EX-13 (the 1993 Annual Report to Stockholders), are incorporated in this Form 10-K Annual Report. The following additional data, as attached on EX-23.a, EX-23.b, EX-23.c, S-1, S-2, S-3 and S-4, should be read in conjunction with the financial statements in such Exhibit EX-13. Schedules and other historical financial information not included with this additional financial data have been omitted because they are not applicable or the required information is shown in the financial state- ments or notes thereto. Page or Exhibit Reference Exhibit EX-13 Form (Annual Report to 10-K Stockholders) Report of Independent Auditors EX-23.a Consent of Independent Auditors EX-23.b Consent of Independent Auditors EX-23.c Financial Statements: Statements of Income and Retained Earnings for the years ended December 31, 1993, 1992 and 1991 12 Balance Sheets, December 31, 1993 and 1992 13 & 14 Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 15 Statements of Capitalization, December 31, 1993 and 1992 16 Notes to Financial Statements 27 - 29 Selected Financial Data 32 Common Stock Market Data 33 Management's Discussion and Analysis 1 - 11 Schedules: V. Property, Plant and Equipment S-1 VI. Accumulated Provision for Depreciation of Property, Plant and Equipment S-2 VIII. Valuation and Qualifying Accounts and Provisions S-3 X. Supplementary Profit and Loss Information S-4 INDEX TO FINANCIAL STATEMENTS, SCHEDULES AND EXHIBITS (CONT'D.) Exhibits filed as part of this report: EX-3.a Restated Certificate of Incorporation of Interstate Power Company as originally filed April 18, 1925 and as amended effective through October 21, 1993. EX-12 Statement re computation of ratios. EX-13 The Company's 1993 Annual Report to Stockholders. EX-23.a Report of Independent Auditors EX-23.b Consent of Independent Auditors EX-23.c Consent of Independent Auditors EX-99.a Listing of current material contracts, indentures and other exhibits and identified as having been previously filed with the Commission. EX-99.b Form 11-K. Interstate Power Company 401(k) Plan for the year ended December 31, 1993. EX-99.c Summary Plan Description for the Interstate Power Company 401(k) Plan dated November 30, 1993. EX-99.d Interstate Power Company Supplemental Retirement Plan dated October 8, 1990. EX-99.e Interstate Power Company Amended Deferred Compensation Plan as amended through January 30, 1990. EX-99.f Interstate Power Company Irrevocable Trust Agreement dated April 30, 1990. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. INTERSTATE POWER COMPANY Date March 17, 1994 By /s/ W. H. STOPPELMOOR (W. H. Stoppelmoor, President and Chief Executive Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. Signature Title /s/ W. H. STOPPELMOOR President and Chief Executive (W. H. Stoppelmoor) Officer (Principal Executive Officer and Principal Financial Officer) /s/ W. C. TROY Controller (Principal (W. C. Troy) Accounting Officer) /s/ A. B. ARENDS Director (A. B. Arends) /s/ J. E. BYRNS Director (J. E. Byrns) /s/ A. D. CORDES Director (A. D. Cordes) /s/ J. L. HANES Director (J. L. Hanes) /s/ G. L. KOPISCHKE Director (G. L. Kopischke) /s/ N. J. SCHRUP Director (N. J. Schrup) Date March 17, 1994 SCHEDULE V Page 1 of 3 INTERSTATE POWER COMPANY PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1993 (Thousands of Dollars) COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F OTHER BALANCE CHARGES AT ADD BALANCE BEGINNING ADDITIONS RETIRE- (DEDUCT) AT END DESCRIPTION OF YEAR AT COST MENTS(a) (b) OF YEAR YEAR ENDED DEC. 31, 1993 Utility Plant: Electric: Production $363,006 $ 4,313 $1,804 $ 1 $365,516 Transmission 167,423 7,293 1,348 2 173,370 Distribution 191,433 10,895 2,502 (52) 199,774 General 40,834 6,692 3,156 (6) 44,364 Land held for future use 587 0 0 0 587 C.W.I.P. 3,281 (117) 0 (1) 3,163 Total 766,564 29,076 8,810 (56) 786,774 Gas: Production 1,828 0 0 0 1,828 Distribution 50,378 4,896 490 0 54,784 General 2,727 399 216 (2) 2,908 C.W.I.P. 206 (207) 0 1 0 Total 55,139 5,088 706 (1) 59,520 TOTAL $821,703 $34,164 $9,516 $(57) $846,294 Property held by subsidiary $ 450 $ 297 $ 102 $ 0 $ 645 (a) Gross values of property, plant and equipment retired are summarized as follows: Charges to reserves for depreciation $9,465 Property, plant and equipment in retirement work in progress at: End of year 0 Beginning of year 0 Total (see Schedule VI) 9,465 Retirements not charged to reserve 51 TOTAL $9,516 (b) Denotes reclassifications between accounts and reduction of property due to contributions in aid of construction. S-1 SCHEDULE V Page 2 of 3 INTERSTATE POWER COMPANY PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1992 (Thousands of Dollars) COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F OTHER BALANCE CHARGES AT ADD BALANCE BEGINNING ADDITIONS RETIRE- (DEDUCT) AT END DESCRIPTION OF YEAR AT COST MENTS(a) (b) OF YEAR YEAR ENDED DEC. 31, 1992 Utility Plant: Electric: Production $358,421 $ 5,916 $1,339 $ 8 $363,006 Transmission 163,858 6,555 2,931 (59) 167,423 Distribution 182,638 11,051 2,338 82 191,433 General 38,098 3,658 927 5 40,834 Land held for future use 610 0 0 (23) 587 C.W.I.P. 4,207 (926) 0 0 3,281 Total 747,832 26,254 7,535 13 766,564 Gas: Production 1,740 197 87 (22) 1,828 Distribution 43,957 6,914 491 (2) 50,378 General 2,567 248 86 (2) 2,727 C.W.I.P. 1,341 (1,135) 0 0 206 Total 49,605 6,224 664 (26) 55,139 TOTAL $797,437 $32,478 $8,199 $(13) $821,703 Property held by subsidiary $ 317 $ 308 $ 175 $ 0 $ 450 (a) Gross values of property, plant and equipment retired are summarized as follows: Charges to reserves for depreciation $8,056 Property, plant and equipment in retirement work in progress at: End of year 0 Beginning of year 0 Total (see Schedule VI) 8,056 Retirements not charged to reserve 143 TOTAL $8,199 (b) Denotes reclassifications between accounts and reduction of property due to contributions in aid of construction. S-1 SCHEDULE V Page 3 of 3 INTERSTATE POWER COMPANY PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1991 (Thousands of Dollars) COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F OTHER BALANCE CHARGES AT ADD BALANCE BEGINNING ADDITIONS RETIRE- (DEDUCT) AT END DESCRIPTION OF YEAR AT COST MENTS(a) (b) OF YEAR YEAR ENDED DEC. 31, 1991 Utility Plant: Electric: Production $333,095 $26,226 $ 897 $ (3) $358,421 Transmission 134,357 31,548 2,047 0 163,858 Distribution 176,155 8,923 2,402 (38) 182,638 General 36,651 2,232 784 (1) 38,098 Land held for future use 610 0 0 0 610 C.W.I.P. 41,982 (37,775) 0 0 4,207 Total 722,850 31,154 6,130 (42) 747,832 Gas: Production 1,694 47 1 0 1,740 Distribution 41,575 2,846 461 (3) 43,957 General 2,433 282 148 0 2,567 C.W.I.P. 54 1,287 0 0 1,341 Total 45,756 4,462 610 (3) 49,605 TOTAL $768,606 $35,616 $6,740 $(45) $797,437 Property held by subsidiary $ 379 $ 157 $ 219 $ 0 $ 317 (a) Gross values of property, plant and equipment retired are summarized as follows: Charges to reserves for depreciation $6,672 Property, plant and equipment in retirement work in progress at: End of year 0 Beginning of year 0 Total (see Schedule VI) 6,672 Retirements not charged to reserve 68 TOTAL $6,740 (b) Denotes reclassifications between accounts and reduction of property due to contributions in aid of construction. S-1 SCHEDULE VI INTERSTATE POWER COMPANY ACCUMULATED PROVISION FOR DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E COLUMN F ADDITIONS OTHER CHARGED CHARGES BALANCE AT TO COSTS ADD BALANCE BEGINNING AND RETIRE- (DEDUCT) AT END DESCRIPTION OF YEAR EXPENSE MENTS(a) (b) OF YEAR YEAR ENDED DEC. 31, 1993 Utility Plant: Electric $320,183 $24,705 $8,759 $1,214 $337,343 Gas 19,464 2,223 706 6 20,987 TOTAL $339,647 $26,928 $9,465 $1,220 $358,330 YEAR ENDED DEC. 31, 1992 Utility Plant: Electric $301,689 $23,817 $7,392 $2,069 $320,183 Gas 18,005 2,044 664 79 19,464 TOTAL $319,694 $25,861 $8,056 $2,148 $339,647 YEAR ENDED DEC. 31, 1991 Utility Plant: Electric $283,118 $22,509 $6,062 $2,124 $301,689 Gas 16,703 1,951 610 (39) 18,005 TOTAL $299,821 $24,460 $6,672 $2,085 $319,694 (a) See note (a) to Schedule V for reconciliation of retirements with this schedule. (b) Other charges - additions (deductions) are summarized below: 1993 1992 1991 Salvage and amounts realized from sales $1,806 $2,522 $2,535 Depreciation charged to asset accounts 685 713 893 Depreciation charged to other expense accounts 624 571 528 Cost of removal (1,895) (1,658) (1,871) $1,220 $2,148 $2,085 S-2 SCHEDULE VIII INTERSTATE POWER COMPANY VALUATION AND QUALIFYING ACCOUNTS AND PROVISIONS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Thousands of Dollars) COLUMN A COLUMN B COLUMN C COLUMN D COLUMN E ADDITIONS BALANCE AT CHARGED CHARGED DEDUCTION BALANCE BEGINNING TO TO OTHER FROM AT END DESCRIPTION OF YEAR INCOME ACCOUNTS RESERVES OF YEAR YEAR ENDED DEC. 31, 1993 Valuation account deducted from caption of which it applies - accumulated provision for doubtful accounts $206 $225 $134 (a) $362 (b) $203 Provision for medical benefits, injuries and damages $1,506 $4,302 $3,521 $5,224 (c) $4,105 YEAR ENDED DEC. 31, 1992 Valuation account deducted from caption of which it applies - accumulated provision for doubtful accounts $206 $152 $115 (a) $267 (b) $206 Provision for medical benefits, injuries and damages $1,655 $4,103 $838 $5,090 (c) $1,506 YEAR ENDED DEC. 31, 1991 Valuation account deducted from caption of which it applies - accumulated provision for doubtful accounts $202 $202 $116 (a) $314 (b) $206 Provision for medical benefits, injuries and damages $783 $4,113 $946 $4,187 (c) $1,655 (a) Recoveries on accounts previously written off. (b) Accounts written off. (c) Claims and damages paid and expenses in connection therewith. S-3 SCHEDULE X INTERSTATE POWER COMPANY SUPPLEMENTARY PROFIT AND LOSS INFORMATION FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 In addition to the amounts of maintenance and depreciation shown separate- ly in the statement of income, there are insignificant amounts for such items applicable to unit train coal cars charged to the coal inventory account and vehicles charged to construction work in progress. Taxes, other than income taxes, were as follows: Year Ended December 31 1993 1992 1991 (Thousands of Dollars) Real estate and personal property taxes $14,481 $14,054 $12,853 Franchise taxes 160 160 148 Payroll taxes 2,809 2,696 2,613 Miscellaneous 201 169 195 Total $17,651 $17,079 $15,809 The above amounts were charged to accounts: Year Ended December 31 1993 1992 1991 (Thousands of Dollars) Tax expense $17,080 $16,533 $15,315 Clearing accounts 206 187 171 Construction work in progress 296 290 258 Retirement work in progress 69 69 65 Total $17,651 $17,079 $15,809 There were no royalties paid or incurred during 1993, 1992 or 1991. Rent and advertising costs were not material. S-4 INDEX OF EXHIBITS EX-3.a Restated Certificate of Incorporation of Interstate Power Company as originally filed April 18, 1925 and as amended effective through October 21, 1993. EX-12 Statement re computation of ratios. EX-13 The Company's 1993 Annual Report to Stockholders. EX-23.a Report of Independent Auditors EX-23.b Consent of Independent Auditors EX-23.c Consent of Independent Auditors EX-99.a Listing of current material contracts, indentures and other exhibits and identified as having been previously filed with the Commission. EX-99.b Form 11-K. Interstate Power Company 401(k) Plan for the year ended December 31, 1993. EX-99.c Summary Plan Description for the Interstate Power Company 401(k) Plan dated November 30, 1993. EX-99.d Interstate Power Company Supplemental Retirement Plan dated October 8, 1990. EX-99.e Interstate Power Company Amended Deferred Compensation Plan as amended through January 30, 1990. EX-99.f Interstate Power Company Irrevocable Trust Agreement dated April 30, 1990.

100826_1993.txt

100826

1993

ITEM 1. BUSINESS. GENERAL The registrant, Union Electric Company (the "Company"), incorporated in Missouri in 1922, is successor to a number of companies, the oldest of which was organized in 1881. The Company, which is the largest electric utility in the State of Missouri, supplies electric service in territories in Missouri and Illinois having an estimated population of 2,600,000 within an area of approximately 24,500 square miles, including the greater St. Louis area. Natural gas purchased from non-affiliated pipeline companies is distributed in 90 Missouri communities and in the City of Alton, Illinois and vicinity. For the year 1993, 95.2% of total operating revenues was derived from the sale of electric energy and 4.8% from the sale of natural gas. Electric operating revenues as a percentage of total operating revenues for the years 1989, 1990, 1991, and 1992 were 96%, 95.9%, 95.7%, and 95.7% respectively. The Company employed 6,417 persons at December 31, 1993. Approximately 70% of the Company's employees are represented by local unions affiliated with the AFL-CIO. Labor agreements representing approximately 4,400 employees will expire in 1996. One agreement covering 107 employees expires in 1994, and one agreement covering 21 employees will expire in 1997. CONSTRUCTION PROGRAM AND FINANCING The Company is engaged in a construction program under which expenditures averaging approximately $310 million are anticipated during each of the next five years. Capital expenditures for compliance with the Clean Air Act Amendments of 1990 are included in the construction program -- also see "Regulation", below. The Company does not anticipate a need for additional electric generating capacity before the year 2000. During the five-year period ended 1993 gross additions to the property of the Company, including allowance for funds used during construction and excluding nuclear fuel, were approximately $1.2 billion (including $266 million in 1993) and property retirements were $190 million. In addition to the funds required for construction during the 1994-1998 period, $174 million will be required to repay long-term debt and preferred stock as follows: $31 million in 1994, $38 million in 1995, $60 million in 1996, and $45 million in 1997. Amounts for years subsequent to 1994 do not include nuclear fuel lease payments since the amounts of such payments are not currently determinable. For information on the Company's external cash sources, see "Liquidity and Capital Resources" under "Management's Discussion and Analysis" on Page 18 of the 1993 Annual Report pages incorporated herein by reference. Financing Restrictions. Under the most restrictive earnings test contained in the Company's principal Indenture of Mortgage and Deed of Trust ("Mortgage") relating to its First Mortgage Bonds ("Bonds"), no Bonds may be issued (except in certain refunding operations) unless the Company's net earnings available for interest after depreciation for 12 consecutive months within the 15 months preceding such issuance are at least two times annual interest charges on all Bonds and prior lien bonds then outstanding and to be issued (all calculated as provided in the Mortgage). Such ratio for the 12 months ended December 31, 1993 was 6.3, which would permit the Company to issue an additional $2.9 billion of Bonds (7% annual interest rate assumed). Additionally, the Mortgage permits issuance of new bonds up to (a) 60% of defined property additions, or (b) the amount of previous bonds retired or to be retired, or (c) the amount of cash put up for such purpose. At December 31, 1993, the aggregate amount of Bonds issuable under (a) and (b) above was approximately $1.5 billion. The Company's Articles of Incorporation restrict the Company from selling Preferred Stock unless its net earnings for a period of 12 consecutive months within 15 months preceding such sale are at least two and one-half times the annual dividend requirements on its Preferred Stock then outstanding and to be issued. Such ratio for the 12 months ended December 31, 1993 was 22.0, which would permit the Company to issue an additional $1.5 billion stated value of Preferred Stock (7% annual dividend rate assumed). Certain other financing arrangements require the Company to obtain prior consents to various actions by the Company, including any future borrowings, except for permitted financings such as borrowings under revolving credit agreements, the nuclear fuel lease, unsecured short-term borrowings (subject to certain conditions), and the issuance of additional Bonds. RATES For the year 1993, approximately 89%, 8%, and 3% of the Company's electric operating revenues were based on rates regulated by Missouri Public Service Commission, Illinois Commerce Commission, and the Federal Energy Regulatory Commission ("FERC") of the Department of Energy, respectively. For additional information on rates, see the penultimate paragraph of Note 10 to the "Notes to Financial Statements" on Page 32 of the 1993 Annual Report pages incorporated herein by reference. FUEL SUPPLY Coal. Because of uncertainties of supply due to potential work stoppages, equipment breakdowns and other factors, the Company has a policy of maintaining a coal inventory of 75 days, based on normal annual burn practices. See "Regulation" for additional reference to the Company's coal requirements. Nuclear. The components of the nuclear fuel cycle required for nuclear generating units are as follows: (1) uranium; (2) conversion of uranium into uranium hexafluoride; (3) enrichment of uranium hexafluoride; (4) conversion of enriched uranium hexafluoride into uranium dioxide and the fabrication into nuclear fuel assemblies; and (5) disposal and/or reprocessing of spent nuclear fuel. The Company has contracts to fulfill its needs for uranium, enrichment, and fabrication services through 2002. The Company's contract for conversion services is sufficient to supply the Callaway Plant through 1995. Additional contracts will have to be entered into in order to supply nuclear fuel during the remainder of the estimated life of the Plant, at prices which cannot now be accurately predicted. The Callaway Plant normally requires re-fueling at 18- month intervals and re-fuelings are presently scheduled for the spring of 1995 and fall of 1996. Under the Nuclear Waste Policy Act of 1982, the U. S. Department of Energy (DOE) is responsible for the permanent storage and disposal of spent nuclear fuel. DOE currently charges one mill per kilowatt-hour sold for future disposal of spent fuel. Electric rates charged to customers provide for recovery of such costs. DOE is not expected to have its permanent storage facility for spent fuel available until at least 2010. The Company has sufficient storage capacity at the Callaway Plant site until 2004 and has viable storage alternatives under consideration that would provide additional storage facilities. Each alternative will likely require Nuclear Regulatory Commission approval and may require other regulatory approvals. The delayed availability of DOE's disposal facility is not expected to adversely affect the continued operation of the Callaway Plant. Oil and Gas. The actual and prospective use of such fuels is minimal, and the Company has not experienced and does not expect to experience difficulty in obtaining adequate supplies. REGULATION The Company is subject to regulation by the Missouri Commission and Illinois Commission as to rates, service, accounts, issuance of equity securities, issuance of debt having a maturity of more than twelve months, and various other matters. The Company is also subject to regulation by the FERC as to rates and charges in connection with the transmission of electric energy in interstate commerce and the sale of such energy at wholesale in interstate commerce, and certain other matters. Authorization to issue debt having a maturity of twelve months or less is obtained from the FERC. Operation of the Company's Callaway Plant is subject to regulation by the Nuclear Regulatory Commission. The Company's Facility Operating License for the Callaway Plant expires on October 18, 2024. The Company's Osage hydroelectric plant and its Taum Sauk pumped-storage hydro plant, as licensed projects under the Federal Power Act, are subject to certain federal regulations affecting, among other things, the general operation and maintenance of the projects. The Company's license for the Osage Plant expires on February 28, 2006, and its license for the Taum Sauk Plant expires on June 30, 2010. The Company's Keokuk Plant and dam located in the Mississippi River between Hamilton, Illinois and Keokuk, Iowa, are operated under authority, unlimited in time, granted by an Act of Congress in 1905. The Company is exempt from the provisions of the Public Utility Holding Company Act of 1935, except Section 9(a)(2) relating to the acquisition of securities of other public utility companies and Section 11(b)(2) with respect to concluding matters relating to the 1974 acquisition of the common stock of a former subsidiary. When the Securities and Exchange Commission approved such acquisition it reserved jurisdiction to pass upon the right of the Company to retain its gas properties. The Company is regulated, in certain of its operations, by air and water pollution and hazardous waste regulations at the city, county, state and federal levels. The Company is in substantial compliance with such existing regulations. Under the Clean Air Act Amendments of 1990, the Company is required to reduce total annual emissions of sulfur dioxide by approximately two-thirds by the year 2000. Significant reductions in nitrogen oxide will also be required. With switching to low-sulfur coal and early banking of emission credits, the Company anticipates that it can comply with the requirements of the law with no significant increase in revenue needs because the related capital costs, currently estimated at about $300 million, will be largely offset by lower fuel costs. The Company's Clean Air Act compliance program is subject to approval by regulatory authorities. As of December 31, 1993, the Company was designated a potentially responsible party (PRP) by federal and state environmental protection agencies for five hazardous waste sites. Other hazardous waste sites have been identified for which the Company may be responsible but has not been designated a PRP. The Company is presently investigating the remedial costs that will be required for all of these sites. Such costs are not expected to have a material adverse effect on the Company's financial position. Other aspects of the Company's business are subject to the jurisdiction of various regulatory authorities. INDUSTRY ISSUES The Company is facing issues common to the electric and gas utility industries which have emerged during the past several years. These issues include: changes in the structure of the industry as a result of amendments to federal laws regulating ownership of generating facilities and access to transmission systems; continually developing environmental laws, regulations and issues; public concern about the siting of new facilities; increasing public attention on the potential public health consequences of exposure to electric and magnetic fields emanating from power lines and other electric sources; proposals for demand side management programs; and public concerns about the disposal of nuclear wastes and about global climate issues. The Company is monitoring these issues and is unable to predict at this time what impact, if any, these issues will have on its operations or financial condition. OPERATING STATISTICS The information on Page 33 in the Company's 1993 Annual Report is incorporated herein by reference. OTHER STATISTICAL INFORMATION ITEM 2.

ITEM 2. PROPERTIES. The following table sets forth information with respect to the Company's generating facilities and capability at the time of the expected 1994 peak. In planning its construction program, the Company is presently utilizing a forecast of kilowatthour sales growth of approximately 1.8% and peak load growth of 1.0%, each compounded annually, and is providing for a minimum reserve margin of approximately 18% to 20% above its anticipated peak load requirements. See "Operating Statistics", incorporated by reference in Part I of this Form 10-K, for information on loads and capability during the five-year period ended 1993. See "Liquidity and Capital Resources" under "Management's Discussion and Analysis" on Pages 17 and 18 of the 1993 Annual Report pages incorporated herein by reference for information on the 1992 purchase and sale of certain properties. The Company is a member of one of the nine regional electric reliability councils organized for coordinating the planning and operation of the nation's bulk power supply - MAIN (Mid-America Interconnected Network) operating primarily in Wisconsin, Illinois and Missouri. The Company has interconnections for the exchange of power, directly and through the facilities of others, with fifteen private utilities and with Associated Electric Cooperative, Inc., the City of Columbia, Missouri, the Southwestern Power Administration and the Tennessee Valley Authority. The Company owns 40% of the capital stock of Electric Energy, Inc. ("EEI"), the balance of which is held by three other sponsoring companies -- Kentucky Utilities Company ("KU"), Central Illinois Public Service ("CIPS"), and Illinois Power Company ("IP"). EEI owns and operates a generating plant with a nominal capacity of 1,000 mW. As of January 1, 1994, 60% of the plant's output is committed to the Paducah Project of the DOE, 20% is committed to KU, 10% to the Company, and 5% each to IP and CIPS. As of December 31, 1993, the Company owned approximately 3,297 circuit miles of electric transmission lines and 731 substations with a transformer capacity of approximately 44,324,000 kVA. The Company owns four propane-air plants with an aggregate daily natural gas equivalent capacity of 31,590 million cubic feet and 2,599 miles of gas mains. Other properties of the Company include distribution lines, underground cable, steam distribution facilities in Jefferson City, Missouri and office buildings, warehouses, garages and repair shops. The Company has fee title to all principal plants and other important units of property, or to the real property on which such facilities are located (subject to mortgage liens securing outstanding indebtedness of the Company and to permitted liens and judgment liens, as defined), except that (i) a portion of the Osage Plant reservoir, certain facilities at the Sioux Plant, certain of the Company's substations and most of its transmission and distribution lines and gas mains are situated on lands occupied under leases, easements, franchises, licenses or permits; (ii) the United States and/or the State of Missouri own, or have or may have, paramount rights to certain lands lying in the bed of the Osage River or located between the inner and outer harbor lines of the Mississippi River, on which certain generating and other properties of the Company are located; and (iii) the United States and/or State of Illinois and/or State of Iowa and/or City of Keokuk, Iowa own, or have or may have, paramount rights with respect to, certain lands lying in the bed of the Mississippi River on which a portion of the Company's Keokuk Plant is located. Substantially all of the Company's property and plant is subject to the direct first lien of an Indenture of Mortgage and Deed of Trust dated June 15, 1937, as amended and supplemented. As part of the 1983 merger of the Company with its utility subsidiaries, the Company assumed the mortgage indenture of each subsidiary. Currently, the prior liens of two former subsidiary indentures extend to the property and franchises acquired by the Company from such subsidiaries. Such indentures also contain provisions subjecting to the prior lien thereof after-acquired property of the Company constituting (with certain exceptions) additions, extensions, improvements, repairs, and replacements appurtenant to property acquired in the merger. In addition, one such indenture contains a provision subjecting to the prior lien thereof after- acquired property of the Company situated in the territory served by the former subsidiary prior to the merger. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. The Company is involved in legal and administrative proceedings before various courts and agencies with respect to matters arising in the ordinary course of business, some of which involve substantial amounts. Management is of the opinion that the final disposition of these proceedings will not have a material adverse effect on the Company's financial position. INFORMATION REGARDING EXECUTIVE OFFICERS REQUIRED BY ITEM 401(b) OF REGULATION S-K: All officers are elected or appointed annually by the Board of Directors following the election of such Board at the annual meeting of stockholders held in April. There are no family relationships between the foregoing officers of the Company except that Charles J. Schukai and Robert J. Schukai are brothers. Each of the above-named executive officers has been employed by the Company for more than five years in executive or management positions. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. Information required to be reported by this item is included on page 37 of the 1993 Annual Report and is incorporated herein by reference. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. Information for the 1989-1993 period required to be reported by this item is included on pages 34 and 35 of the 1993 Annual Report and is incorporated herein by reference. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Information required to be reported by this item is included on pages 16, 17 and 18 of the 1993 Annual Report and is incorporated herein by reference. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The financial statements of the Company on pages 20 through 32, the report thereon of Price Waterhouse appearing on page 19 and the Selected Quarterly Information on page 18 of the 1993 Annual Report are incorporated herein by reference. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Any information concerning directors required to be reported by this item is included under "Item (1): Election of Directors" in the Company's 1994 definitive proxy statement filed pursuant to Regulation 14A and is incorporated herein by reference. Information concerning executive officers required by this item is reported in Part I of this Form 10-K. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. Any information required to be reported by this item is included under "Compensation" in the Company's 1994 definitive proxy statement filed pursuant to Regulation 14A and is incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. Any information required to be reported by this item is included under "Security Ownership of Management" in the Company's 1994 definitive proxy statement filed pursuant to Regulation 14A and is incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Any information required to be reported by this item is included under "Item (1): Election of Directors" in the Company's 1994 definitive proxy statement filed pursuant to Regulation 14A and is incorporated herein by reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) The following documents are filed as a part of this report: 1. Financial Statements: * *Incorporated by reference from the indicated pages of the 1993 Annual Report 2. Financial Statement Schedules: The following schedules, for the years ended December 31, 1993, 1992, and 1991, should be read in conjunction with the aforementioned financial statements (schedules not included have been omitted because they are not applicable or the required data is shown in the aforementioned financial statements). 3. Exhibits: See EXHIBITS, Page 24 (b) Reports on Form 8-K. None REPORT OF INDEPENDENT ACCOUNTANTS --------------------------------- ON FINANCIAL STATEMENT SCHEDULES -------------------------------- To the Board of Directors of Union Electric Company Our audits of the financial statements referred to in our report dated February 2, 1994 appearing on page 19 of the 1993 Annual Report to Stockholders of Union Electric Company (which report and financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed in Item 14(a) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related financial statements. /s/ PRICE WATERHOUSE PRICE WATERHOUSE One Boatmen's Plaza St. Louis, Missouri February 2, 1994 UNION ELECTRIC COMPANY SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1993 UNION ELECTRIC COMPANY SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1992 (Continued on following page) UNION ELECTRIC COMPANY SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (Continued) FOR THE YEAR ENDED DECEMBER 31, 1992 Notes: (a) Includes $58,027,040 property, plant and equipment related to Iowa and northern Illinois electric properties sold by the registrant in December, 1992. (b) Reflects Missouri retail electric properties of Arkansas Power & Light Company purchased by the registrant in March, 1992. UNION ELECTRIC COMPANY SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1991 (Continued on following page) UNION ELECTRIC COMPANY SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (Continued) FOR THE YEAR ENDED DECEMBER 31, 1991 UNION ELECTRIC COMPANY SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1993 Note: Includes $46,441,378 amortization of nuclear fuel and $9,076,951 principally reflecting depreciation of transportation and related work equipment charged to clearing accounts and amortization of electric plant acquisition adjustments. UNION ELECTRIC COMPANY SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1992 Notes: (a) Includes $47,815,755 amortization of nuclear fuel and $7,827,375 principally reflecting depreciation of transportation and related work equipment charged to clearing accounts and amortization of electric plant acquisition adjustments. (b) Includes $24,135,487 accumulated depreciation related to Iowa and northern Illinois electric properties sold by the registrant in December, 1992. (c) Reflects accumulated depreciation and amortization on Missouri retail electric properties of Arkansas Power & Light Company purchased by the registrant in March, 1992. UNION ELECTRIC COMPANY SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEAR ENDED DECEMBER 31, 1991 Note: Includes $71,964,150 amortization of nuclear fuel and $5,967,364 principally reflecting depreciation of transportation and related work equipment charged to clearing accounts. UNION ELECTRIC COMPANY SCHEDULE VIII - VALUATION AND QUALIFYING ACCOUNTS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 Note: Uncollectible accounts charged off, less recoveries. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. UNION ELECTRIC COMPANY (Registrant) CHARLES W. MUELLER President and Chief Executive Officer Date March 29, 1994 By /s/ James C. Thompson ------------------------ ------------------------------------- (James C. Thompson, Attorney-in-Fact) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. Signature Title --------- ----- CHARLES W. MUELLER President, Chief Executive Officer and Director (Principal Executive Officer) DONALD E. BRANDT Senior Vice President (Principal Financial and Accounting Officer) SAM B. COOK Director WILLIAM E. CORNELIUS Director THOMAS A. HAYS Director THOMAS H. JACOBSEN Director RICHARD A. LIDDY Director JOHN PETERS MacCARTHY Director PAUL L. MILLER, JR. Director ROBERT H. QUENON Director HARVEY SALIGMAN Director JANET MCAFEE WEAKLEY Director By /s/ James C. Thompson March 29, 1994 ---------------------------------------- (James C. Thompson, Attorney-in-Fact) EXHIBITS Exhibits Filed Herewith ----------------------- Exhibit No. Description - ----------- ----------- 3(i) - Restated Articles of Incorporation of the Company as filed with the Secretary of the State of Missouri. 4.6 - Supplemental Indenture dated May 1, 1993, creating First Mortgage Bonds, 6 3/4% Series due 2008. 4.7 - Supplemental Indenture dated August 1, 1993, creating First Mortgage Bonds, 7.15% Series due 2023. 4.8 - Supplemental Indenture dated October 1, 1993, creating First Mortgage Bonds, 5.45% Series due 2028. 4.9 - Supplemental Indenture dated January 1, 1994, creating First Mortgage Bonds, 7% Series due 2024. 12(a) - Statement re Computation of Ratios of Earnings to Fixed Charges, 12 Months Ended December 31, 1993. 12(b) - Statement re Computation of Ratio of Earnings to Fixed Charges and Preferred Stock Dividend Requirements, 12 Months Ended December 31, 1993. 13 - Those pages of the 1993 Annual Report incorporated herein by reference. 23 - Consent of Independent Accountants. 24 - Powers of Attorney. Exhibits Incorporated By Reference ---------------------------------- The following exhibits heretofore have been filed with the Securities and Exchange Commission pursuant to requirements of the Acts administered by the Commission. Such exhibits are identified by the references following the listing of each such exhibit, and they are hereby incorporated herein by reference under Rule 24 of the Commission's Rules of Practice. Exhibit No. Description - ----------- ----------- 3(ii) - By-Laws of the Company as amended to June 12, 1992. (1992 Form 10-K, Exhibit 3.4.) 4.1 - Order of the Securities and Exchange Commission dated October 16, 1945 in File No. 70-1154 permitting the issue of Preferred Stock, $3.70 Series. (Registration No. 2-27474, Exhibit 3-E.) 4.2 - Order of the Securities and Exchange Commission dated April 30, 1946 in File No. 70-1259 permitting the issue of Preferred Stock, $3.50 Series. (Registration No. 2-27474, Exhibit 3-F.) 4.3 - Order of the Securities and Exchange Commission dated October 20, 1949 in File No. 70-2227 permitting the issue of Preferred Stock, $4.00 Series. (Registration No. 2-27474, Exhibit 3-G.) 4.4 - Indenture of Mortgage and Deed of Trust of the Company dated June 15, 1937, as amended May 1, 1941, and Second Supplemental Indenture dated May 1, 1941. (Registration No. 2-4940, Exhibit B-1.) 4.5 - Supplemental Indentures to Mortgage Dated as of File Reference Exhibit No. ----------- -------------- ----------- April 1, 1965 Form 8-K, April 1965 3 May 1, 1966 2-56062 2.33 March 1, 1967 2-58274 2.9 April 1, 1971 Form 8-K, April 1971 6 February 1, 1974 Form 8-K, February 1974 3 July 7, 1980 2-69821 4.6 May 1, 1990 Form 10-K, 1990 4.6 December 1, 1991 33-45008 4.4 December 4, 1991 33-45008 4.5 January 1, 1992 Form 10-K, 1991 4.6 October 1, 1992 Form 10-K, 1992 4.6 December 1, 1992 Form 10-K, 1992 4.7 February 1, 1993 Form 10-K, 1992 4.8 Exhibit No. Description ----------- ----------- 4.10 - Indenture of Mortgage and Deed of Trust of Missouri Power & Light Company dated July 1, 1946 and Supplemental Indentures dated July 1, 1946, November 1, 1949, June 1, 1951, July 1, 1954, December 1, 1959, July 1, 1962, March 1, 1966, April 1, 1967, June 15, 1969, April 15, 1973, December 1, 1974, May 1, 1976 and July 1, 1979. (Registration No. 2-87469, Exhibit 4.1.) 4.11 - Fourteenth Supplemental Indenture dated as of December 30, 1983 to the Mortgage and Deed of Trust dated July 1, 1946, of Missouri Power & Light Company. (1983 Form 10-K, Exhibit 4.23.) 4.12 - Instrument of Substitution of Individual Trustee dated as of November 1, 1988 under the Mortgage and Deed of Trust dated July 1, 1946 of Union Electric Company (successor to Missouri Power & Light Company). (1988 Form 10-K, Exhibit 4.8.) 4.13 - Indenture of Mortgage or Deed of Trust of Missouri Edison Company dated July 1, 1945 and Supplemental Indentures dated January 1, 1952, June 1, 1961, June 1, 1965, August 1, 1975, September 1, 1976, November 1, 1977, February 1, 1981 and July 1, 1982. (Registration No. 2-87469, Exhibit 4.2.) 4.14 - Ninth Supplemental Indenture dated as of December 30, 1983 to the Indenture of Mortgage or Deed of Trust dated as of July 1, 1945 of Missouri Edison Company. (1983 Form 10-K, Exhibit 4.24.) 4.15 - Instrument of Substitution of Trustee dated as of March 1, 1985 under the Indenture of Mortgage or Deed of Trust dated July 1, 1945 of Union Electric Company (successor to Missouri Edison Company). (1984 Form 10-K, Exhibit 4.10.) 4.16 - Instrument of Substitution of Trustee dated as of October 14, 1986 under the Indenture of Mortgage or Deed of Trust dated July 1, 1945 of Union Electric Company (successor to Missouri Edison Company). (September 30, 1986 Form 10-Q, Exhibit 4.2.) 4.17 - Series A Agreement of Sale dated as of June 1, 1984 between the State Environmental Improvement and Energy Resources Authority of the State of Missouri and the Company, together with Letter of Credit and Reimbursement Agreement dated as of June 1, 1984 between Citibank, N.A. and the Company and Series A Trust Indenture dated as of June 1, 1984 between the Authority and Mercantile Trust Company National Association, as trustee. (Registration No. 2-96198, Exhibit 4.25.) 4.18 - Reimbursement Agreement dated as of April 21, 1992 among Swiss Bank Corporation, various financial institutions, and the Company, providing for an alternate letter of credit to serve as a source of payment for bonds issued under the Series A Trust Indenture dated as of June 1, 1984. (1992 Form 10-K, Exhibit 4.23.) Exhibit No. Description ----------- ----------- 4.19 - Series B Agreement of Sale dated as of June 1, 1984 between the State Environmental Improvement and Energy Resources Authority of the State of Missouri and the Company, together with Reimbursement Agreement dated as of June 1, 1984 between Chemical Bank and the Company and Series B Trust Indenture dated as of June 1, 1984 between the Authority and Mercantile Trust Company National Association, as trustee. (Registration No. 2-96198, Exhibit 4.26.) 4.20 - Reimbursement Agreement dated as of April 22, 1988 between Union Bank of Switzerland and the Company, providing for an alternate letter of credit to serve as a source of payment for bonds issued under the Series B Trust Indenture dated as of June 1, 1984. (June 30, 1988 Form 10-Q, Exhibit 4.2.) 4.21 - Amendment and Extension Agreement dated as of June 1, 1990 to the Reimbursement Agreement dated as of April 22, 1988 between Union Bank of Switzerland and the Company. (1990 Form 10-K, Exhibit 4.29.) 4.22 - Amendment and Extension Agreement dated as of June 1, 1991 to the amended Reimbursement Agreement dated as of April 22, 1988 between Union Bank of Switzerland and the Company. (1992 Form 10-K, Exhibit 4.27.) 4.23 - Amendment Agreement dated as of June 1, 1992 to the amended Reimbursement Agreement dated as of April 22, 1988 between Union Bank of Switzerland and the Company. (1992 Form 10-K, Exhibit 4.28.) 4.24 - Series 1985 A Reaffirmation Agreement and Second Supplement to Agreement of Sale dated as of June 1, 1985 between the State Environmental Improvement and Energy Resources Authority of the State of Missouri and the Company, together with Series 1985 A Reimbursement Agreement dated as of June 1, 1985 between Union Bank of Switzerland and the Company and Series 1985 A Trust Indenture dated as of June 1, 1985 between the Authority and Mercantile Trust Company National Association, as trustee and Texas Commerce Bank National Association, as co-trustee. (June 30, 1985 Form 10-Q, Exhibit 4.1.) 4.25 - Amendment and Extension Agreement dated as of June 1, 1988 revising the Reimbursement Agreement dated as of June 1, 1985 between Union Bank of Switzerland and the Company. (June 30, 1988 Form 10-Q, Exhibit 4.4.) 4.26 - Amendment and Extension Agreement dated as of June 1, 1990 revising the Reimbursement Agreement dated as of June 1, 1985, as amended, between Union Bank of Switzerland and the Company. (1990 Form 10-K, Exhibit 4.37.) 4.27 - Amendment and Extension Agreement dated as of June 1, 1991 to the amended Reimbursement Agreement dated as of June 1, 1985 between Union Bank of Switzerland and the Company. (1992 Form 10-K, Exhibit 4.32.) Exhibit No. Description ----------- ----------- 4.28 - Amendment Agreement dated as of June 1, 1992 to the amended Reimbursement Agreement dated as of June 1, 1985 between Union Bank of Switzerland and the Company. (1992 Form 10-K, Exhibit 4.33.) 4.29 - Series 1985 B Reaffirmation Agreement and Third Supplement to Agreement of Sale dated as of June 1, 1985 between the State Environmental Improvement and Energy Resources Authority of the State of Missouri and the Company, together with Series 1985 B Reimbursement Agreement dated as of June 1, 1985 between The Long- term Credit Bank of Japan, Limited and the Company and Series 1985 B Trust Indenture dated as of June 1, 1985 between the Authority and Mercantile Trust Company National Association, as trustee and Texas Commerce Bank National Association, as co-trustee. (June 30, 1985 Form 10-Q, Exhibit 4.2.) 4.30 - Reimbursement Agreement dated as of February 1, 1993 between Westdeutsche Landesbank Girozentrale and the Company, providing for an alternate letter of credit to serve as a source of payment for bonds issued under the Series 1985 B Trust Indenture dated as of June 1, 1985. (1992 Form 10-K, Exhibit 4.35.) 4.31 - Loan Agreement dated as of May 1, 1990 between the State Environmental Improvement and Energy Resources Authority of the State of Missouri and the Company, together with Indenture of Trust dated as of May 1, 1990 between the Authority and Mercantile Bank of St. Louis, N.A., as trustee. (1990 Form 10-K, Exhibit 4.40.) 4.32 - Loan Agreement dated as of December 1, 1991 between the State Environmental Improvement and Energy Resources Authority and the Company, together with Indenture of Trust dated as of December 1, 1991 between the Authority and Mercantile Bank of St. Louis, N.A., as trustee. (1992 Form 10-K, Exhibit 4.37.) 4.33 - Loan Agreement dated as of December 1, 1992, between the State Environmental Improvement and Energy Resources Authority and the Company, together with Indenture of Trust dated as of December 1, 1992 between the Authority and Mercantile Bank of St. Louis, N.A., as trustee. (1992 Form 10-K, Exhibit 4.38.) 4.34 - Fuel Lease dated as of February 24, 1981 between the Company, as lessee, and Gateway Fuel Company, as lessor, covering nuclear fuel. (1980 Form 10-K, Exhibit 10.20.) 4.35 - Amendments to Fuel Lease dated as of May 8, 1984 and October 15, 1984, respectively, between the Company, as lessee, and Gateway Fuel Company, as lessor, covering nuclear fuel. (Registration No. 2- 96198, Exhibit 4.28.) 4.36 - Amendment to Fuel Lease dated as of October 15, 1986 between the Company, as lessee, and Gateway Fuel Company, as lessor, covering nuclear fuel. (September 30, 1986 Form 10-Q, Exhibit 4.3.) Exhibit No. Description ----------- ----------- 4.37 - Credit Agreement dated as of August 15, 1989 among the Company, Certain Lenders, The First National Bank of Chicago, as Agent and Swiss Bank Corporation, Chicago Branch, as Co-Agent. (September 30, 1989 Form 10-Q, Exhibit 4.) 4.38 - Credit Agreement dated as of November 8, 1991 between the Company, Certain Banks and Chemical Bank, as Agent. (1991 Form 10-K, Exhibit 4.44.) 4.39 - Amendment dated as of October 26, 1992, to the Credit Agreement dated as of November 8, 1991 between the Company, Certain Banks and Chemical Bank, as Agent. (1992 Form 10-K, Exhibit 4.44.) 10.1 - Deferred Compensation Plan for Members of the Board of Directors. (1992 Form 10-K, Exhibit 10.1.) 10.2 - Retirement Plan for Certain Directors. (1992 Form 10-K, Exhibit 10.2.) 10.3 - Deferred Compensation Plan for Members of the General Executive Staff. (1992 Form 10-K, Exhibit 10.3.) 10.4 - Executive Incentive Plan. (1992 Form 10-K, Exhibit 10.4.) Note: Reports of the Company on Forms 8-K, 10-Q and 10-K are on file with the SEC under file number 1-2967.

40533_1993.txt

40533

1993

ITEM 1. BUSINESS INTRODUCTION General Dynamics Corporation (the Company) is a Delaware corporation formed in 1952 as successor to the Electric Boat Company, now the Company's Nuclear Submarines business. Consolidated Vultee Aircraft Corporation was merged into the Company in 1954 and from it emerged the Company's former Tactical Military Aircraft and Missile Systems businesses and the Space Launch Systems business. The Material Service Resources Company is the successor to the Material Service Corporation which was merged into the Company in 1959. Chrysler Defense, Inc., now the Company's Armored Vehicles business, was acquired in 1982. The Cessna Aircraft Company, formerly the Company's General Aviation business, was acquired in 1985. In addition, the Company operates other smaller businesses. Prior to 1992, the businesses of the Company included the following: Tactical Military Aircraft, Nuclear Submarines, Armored Vehicles, Space Launch Systems, Missile Systems and General Aviation. Over the past two years, the Company has sold its Tactical Military Aircraft, Missile Systems and General Aviation businesses, as well as certain other smaller businesses, and the sale of its Space Launch Systems business is expected to close by April 1994. The Company's remaining continuing business segments are Nuclear Submarines, Armored Vehicles and Other. The Other business segment is composed of Freeman Energy Corporation (Freeman), American Overseas Marine Corporation (AMSEA) and Patriot I, II and IV Shipping Corporations (Patriots). A general description of these businesses including products, properties and other related information follows. For financial information and further discussion of the business segments, as well as an overall discussion of the Company's business environment, reference is made to Management's Discussion and Analysis of the Results of Operations and Financial Condition, appearing on pages 12 through 17 in the Company's 1993 Shareholder Report, included in this Form 10-K-Annual Report as Exhibit 13 and incorporated herein by reference. NUCLEAR SUBMARINES The Company's Electric Boat Division (Electric Boat) is a designer and builder of nuclear submarines for the U.S. Navy. Electric Boat also performs overhaul and repair work on submarines as well as a broad range of engineering work including advanced research and technology development, systems and component design evaluation, prototype development and logistics support to the operating fleet. Certain components and subassemblies of the submarines, such as electronic equipment, are produced by other firms. Electric Boat has contracts for SSN 688-class attack submarines (SSN 688), Trident ballistic missile submarines (Trident) and Seawolf class attack submarines, all of which are currently under construction at its 96 acre shipyard on the Thames River at Groton, Connecticut. The shipyard, which contains a covered area in excess of 2.6 million square feet, is owned by the Company. Electric Boat also produces modular submarine hull sections, components and subassemblies in leased facilities at Quonset Point, Rhode Island, and in Company-owned facilities at Avenel, New Jersey and Charleston, South Carolina. Due to the winding down of the SSN 688 and Trident programs, the Company has announced that it plans to close the Charleston facility in early 1994. Approximately 45% of Electric Boat's property, plant and equipment was fully depreciated at 31 December 1993. Electric Boat competed with Newport News Shipbuilding and Drydock Company (Newport News) for construction of the SSN 688 and Seawolf submarines. Electric Boat is currently the sole-source producer of Trident and Seawolf submarines. For most engineering work, Electric Boat competes in a highly competitive environment with several smaller specialized firms in addition to Newport News. ARMORED VEHICLES The Company's Land Systems Division (Land Systems) is the sole-source producer of main battle tanks for the U.S. Government. Land Systems designs and manufactures the M1 Series Abrams Main Battle Tank for the U.S. Army and the U.S. Marine Corps. Land Systems also performs engineering and upgrade work as well as provides support for existing armored vehicles. Production of the M1A1, a version of the M1 that incorporates increased firepower, additional crew protection features, and improved armor, was initiated in 1985. Production of the M1A2, the latest version of the M1 which incorporates battlefield management systems aimed at providing improved fightability, as well as improved survivability of the tank's four crew members, was initiated in 1992. In addition to domestic sales, M1 tanks are being sold through the U.S. Government to various foreign governments. Land Systems provides training in operation and maintenance and other logistical support on international sales. - 1 - Certain components of the M1 series tank, such as the engine and the transmission and final drive, are produced by other firms. Land Systems has bid and is currently bidding on other armored vehicle and related programs for the U.S. Government in competition primarily with FMC Corporation. The current international market is characterized by intense competition for a limited number of business opportunities. The Company has been successful in competitive bids for production contracts and related logistic support with Egypt, Saudi Arabia and Kuwait, but was unsuccessful on similar bids with the United Arab Emirates and Sweden. Tank production is performed at the 1.6 million square foot plant on 370 acres in Lima, Ohio, and machining operations are performed at the 1.2 million square foot plant on 145 acres in Warren (Detroit), Michigan. Each is owned by the U.S. Government and operated by Land Systems under a facilities contract. In support of these plants, Land Systems leases property in Scranton, Pennsylvania, and owns or leases property in various locations in Michigan. The Company, teamed with Tadiran Ltd. of Israel, was selected during 1988 as the second-source producer of the Single Channel Ground and Airborne Radio System (SINCGARS). The Company is currently participating in its first competitive bid under the SINCGARS program with ITT Corporation. A decision on the competition is expected during the first half of 1994. The Company leases space in Tallahassee, Florida to support SINCGARS production. OTHER Freeman mines coal, the majority of which is sold in the spot market or under short-term contracts to a variety of customers. Freeman's remaining coal production (approximately 45%) is sold under long-term contracts to utilities and industrial users located principally in the Midwest. Several of these long-term contracts have price adjustment clauses to reflect changes in certain costs of production. Freeman operates three underground mines and one surface mine in Illinois, along with one surface mine in Kentucky. Coal preparation facilities and rail loading facilities are located at each mine sufficient for its output. Total production from Freeman's mines was approximately 5 million tons in 1993, 4.5 million tons in 1992 and 3.6 million tons in 1991. In addition, Freeman owns or leases rights to over 600 million tons of coal reserves in Illinois and Kentucky. Due to the commodity nature of the Company's coal operations, the primary factors affecting competition are price and geographic service area. Freeman's operations are not significantly affected by seasonal variations. The 1990 Clean Air Act requires, among other things, a phased reduction in sulfur dioxide emissions by coal burning facilities over the next few years. Virtually all of the coal in Freeman's Illinois basin mines has medium or high sulfur content. The impact of compliance with the Clean Air Act will be mitigated in the near-term by Freeman's long-term contracts and through installation of pollution control devices by certain of Freeman's major customers. The long-term impact of the Clean Air Act is not known. AMSEA provides ship management services for five of the U.S. Navy's Maritime Prepositioning Ships (MPS) and twelve of the U.S. Maritime Administration's Ready Reserve Force (RRF) ships. The MPS are under five year contracts which expire in 1995 and 1996 but are renewable through the year 2011. The RRF ships are in the first year of five year contracts for which the Company competed with various other ship management providers. The MPS vessels operate worldwide and the RRF vessels are located on the east, gulf and west coasts of the United States. AMSEA's home office is in Quincy, Massachusetts. Patriots are financing subsidiaries which lease liquefied natural gas tankers constructed by the Company to unrelated third parties. DISCONTINUED OPERATIONS The Company has sold or intends to sell certain businesses that are reported as discontinued operations in the Company's financial statements. The remaining businesses are as follows: The Company's Convair Division is the sole-source producer of fuselages for the McDonnell Douglas Corporation (McDonnell Douglas) MD-11 wide body tri-jet aircraft. Production work is performed in San Diego, California in facilities owned by the Company which are on land leased from the San Diego Port Authority. Material Service Corporation (Material Service) is engaged in the quarrying and direct sale of aggregates (e.g. stone, sand and gravel), and the production and direct sale of ready mix concrete and other concrete products. Material Service's aggregate and concrete facilities and operations are located primarily in Illinois. - 2 - REAL ESTATE HELD FOR DEVELOPMENT As part of the sale of businesses, certain related properties were retained by the Company. These properties have been segregated on the Consolidated Balance Sheet as real estate held for development. The Company has retained outside experts to support the development of plans which will maximize the market value of these properties. These properties include: 232 acres in Kearny Mesa and 2,420 acres in Sycamore Canyon, both of which are in the vicinity of San Diego, California; 375 acres in Rancho Cucamonga, California; and 53 acres in Camden, Arkansas. Most of this property is undeveloped. The Company owns 3.7 million square feet of building space on the aforementioned properties, as well as .6 million square feet of building space on land leased from the San Diego Port Authority. Certain of these facilities are currently being leased by the purchasers of the related sold businesses for what is expected to be a short transition period. GENERAL INFORMATION Backlog - ------- The following table shows the approximate backlog of the Company (excluding discontinued operations) as calculated at 31 December 1993 and 1992 and the portion of the 31 December 1993 backlog not reasonably expected to be filled during 1994 (dollars in millions): Backlog represents the total estimated remaining sales value of authorized work. Backlog excludes announced orders for which definitive contracts have not been executed, except for amounts funded prior to definitization. Funded backlog includes amounts that have been appropriated by the U.S. Congress, and authorized and funded by the procuring agency. Funded backlog also includes amounts which have been authorized on Foreign Military Sales and long-term coal contracts. Unfunded backlog includes amounts for which there is no assurance that congressional appropriations or agency allotments will be forthcoming. Insofar as the backlog represents orders from the U.S. Government, it is subject to cancellation and other risks associated with government contracts (see "U.S. Government Contracts"). U. S. Government Contracts - -------------------------- The Company's net sales to the U.S. Government include Foreign Military Sales (FMS). FMS are sales to foreign governments through the U.S. Government, whereby the Company contracts with and receives payment from the U.S. Government and the U.S. Government assumes the risk of collection from the customer. U.S. Government sales were as follows (excluding discontinued operations; dollars in millions): - 3 - All U.S. Government contracts are terminable at the convenience of the U.S. Government, as well as for default. Under contracts terminable at the convenience of the U.S. Government, a contractor is entitled to receive payments for its allowable costs and, in general, the proportionate share of fees or earnings for the work done. Contracts which are terminated for default generally provide that the U.S. Government only pays for the work it has accepted and may require the contractor to pay for the incremental cost of reprocurement and may hold the contractor liable for damages. In 1991, the U.S. Navy terminated the Company's A-12 aircraft contract for default. For further discussion, see Item 3 of this report. Companies engaged in supplying goods and services to the U.S. Government are dependent on congressional appropriations and administrative allotment of funds, and may be affected by changes in U.S. Government policies resulting from various military and political developments. U.S. Government contracts typically involve long lead times for design and development, and are subject to significant changes in contract scheduling. Often the contracts call for successful design and production of very complex and technologically advanced items. Foreign Sales and Operations - ---------------------------- The major portion of sales and operating earnings of the Company for the past three years was derived from operations in the United States. Although the Company purchases supplies from and subcontracts with foreign companies, it has no substantial operations in foreign countries. The majority of foreign sales are made as FMS through the U.S. Government, but certain direct foreign sales are made of components and support services. Direct foreign sales were $35 million, $42 million and $50 million in 1993, 1992 and 1991, respectively. The Company has indirect offset commitments relating to foreign contracts, whereby the Company provides economic benefits to the buying country through marketing assistance, technology transfers, direct procurement of products not related to the primary contract, and direct investments. Research and Development - ------------------------ Research and development activities in the Nuclear Submarines and Armored Vehicles segments are conducted principally under U.S. Government contracts. These research efforts are generally either concerned with developing products for large systems development programs or performing work under research and development technology contracts. In addition, the defense businesses engage in independent research and development, of which a significant portion is recovered through overhead charges to U.S. Government contracts. The table below details expenditures (excluding discontinued operations) for research and development (dollars in millions): Supplies - -------- Many items of equipment and components used in the production of the Company's products are purchased from other manufacturers. Although the Company has a broad base of suppliers and subcontractors, it is dependent upon the ability of its suppliers and subcontractors to meet performance and quality specifications and delivery schedules. In some cases it is dependent on one or a few sources, either because of the specialized nature of a particular item or because of domestic preference requirements pursuant to which it operates on a given project. All of the Company's operations are dependent upon adequate supplies of certain raw materials, such as aluminum and steel, and on adequate supplies of fuel. Fuel or raw material shortages could also have an adverse effect on the Company's suppliers, thus impairing their ability to honor their contractual commitments to the Company. The Company has not experienced serious shortages in any of the raw materials or fuel supplies that are necessary for its production programs. - 4 - Environmental Controls - ---------------------- Federal, state and local requirements relating to the discharge of materials into the environment and other factors affecting the environment have had and will continue to have an impact on the manufacturing operations of the Company. Thus far, compliance with the requirements has been accomplished without material effect on the Company's capital expenditures, earnings or competitive position. While it is expected that this will continue to be the case, the Company cannot assess the possible effect of compliance with future requirements. Patents - ------- Numerous patents and patent applications are owned by the Company and utilized in its development activities and manufacturing operations. It is also licensed under patents owned by others. While in the aggregate its patents and licenses are considered important in the operation of the Company's business, they are not considered of such importance that their loss or termination would materially affect its business. Engineering, production skills and experience are more important to the Company than its patents or licenses. Employees - --------- From the end of 1991 to the end of 1993, the Company's total employees decreased from about 80,600 to about 30,500. Approximately 70% of this decrease is due to the disposition of businesses in which the employees of the disposed businesses were transferred to the acquiring companies. At the end of 1993, approximately 40% of the Company's employees were covered by collective bargaining agreements with various unions, the most significant of which are the International Association of Machinists and Aerospace Workers, the Metal Trades Council of New London, Connecticut, the United Auto Workers Union (UAW), the Office and Professional Employees International Union and the United Mine Workers of America. During 1994, three collective bargaining agreements, which cover approximately 20% of the union represented work force, are scheduled to expire and are subject to negotiations with the respective unions, the most significant of which is the UAW at Land Systems. ITEM 2.

ITEM 2. PROPERTIES The information required for this item is included in Item 1 of this report. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS As previously reported, the Company is a defendant in U.S. vs. Davis et al, a civil action in the Federal District Court for the Southern District of New York in which the U.S. Government alleges claims under the Civil False Claims Act. A judgment in favor of the Company was entered on 2 October 1992. On 4 January 1993, the U.S. Government appealed the District Court's judgment in favor of the Company. This appeal is now pending. On 7 January 1991, the U.S. Navy terminated for default a contract with the Company and McDonnell Douglas for the full-scale development of the U.S. Navy's A-12 aircraft. The U.S. Navy has demanded repayment of unliquidated progress payments, but agreed to defer collection pending resolution of the termination dispute. The Company and McDonnell Douglas filed a complaint in the U.S. Court of Federal Claims to contest the default termination. A trial on Count XVII of the complaint, which relates to the propriety of the termination for default, was concluded in October 1993. In December 1993, the Court issued preliminary findings of fact which appear favorable to the Company and McDonnell Douglas. The Court will not issue a decision before 21 July 1994, during which time other counts in the complaint will be prepared for decision. For further discussion, see Note P to the Consolidated Financial Statements appearing on page 29 in the Company's 1993 Shareholder Report, included in this Form 10-K-Annual Report as Exhibit 13 and incorporated herein by reference. The Company believes that ultimately it will be found not to have been in default of the contract. The Company is a defendant in a shareholders' derivative action filed in the California Superior Court for San Diego County on 17 January 1991. The suit was dismissed by the court on 10 May 1993, because the plaintiffs failed to make a demand on the Board of Directors of the Company prior to bringing action. The period to amend the complaint has expired. - 5 - On 8 March 1993, a class action lawsuit, Berchin et al vs. General Dynamics Corporation and William A. Anders, was filed in the Federal District Court for the Southern District of New York. The suit alleges violations of various provisions of federal securities laws, fraud, negligent misrepresentation, and breach of fiduciary duty by the defendants with regard to disclosures made, or omitted, in the Company's tender offer completed in July 1992 and the subsequent divestiture of core businesses. The Company believes there is no liability in connection with this matter and intends to vigorously defend itself. The Company is directly or indirectly involved in seventeen Superfund sites in which the Company, along with other major U.S. corporations, has been designated a potentially responsible party (PRP) by the U.S. Environmental Protection Agency (EPA) or a state environmental agency with respect to past shipments of hazardous waste to sites now requiring environmental cleanup. Chatham Brothers Barrel Yard is a hazardous waste disposal site located near Escondido, California. The California Department of Toxic Substances Control is overseeing a cleanup of the site pursuant to California state laws and is seeking to recover its costs from a variety of PRPs, including the Company and several other major corporations in the aerospace and petroleum industries. To date, California has incurred about $8.7 million in costs, and estimates an additional $40 million to $60 million in investigation and remediation costs. Under the California equivalent of the federal Superfund law, all of the PRPs are jointly and severally liable to the State of California for these costs. The Casmalia Resources site is a former industrial waste disposal facility located near Santa Maria, California. Since March 1993, the Company and a large number of other PRPs have been negotiating with the EPA to fund and perform an environmental cleanup of this site. Site investigation studies are now just beginning, but estimates of total remediation costs have ranged from $30 million to $150 million. The Company is also involved in the cleanup and remediation of various conditions at sites it currently or formerly owned or operated, many of which were sites used in the conduct of the Company's government contracting business. The Company believes that a portion of these costs are recoverable under government contracts. The Company has defenses to liability in some cases, and in other cases the Company is acting to mitigate and minimize its potential liability. The Company is participating in steering committees and taking other actions to establish its percentage liability on an allocated and sharing basis with other PRPs. Although the Company's involvement and the extent of the remediation varies from site to site, the Company believes, based upon an analysis of each site, that its liability at the sites will not be deemed material to the financial condition or results of operations of the Company. Under the Federal Black Lung Benefits Act (the Act), a disabled coal miner with coal worker's pneumoconiosis may be entitled to monthly compensation for life. Approximately 50 claims for benefits under the Act by former employees of Freeman are pending and are in various stages of procedure, including a substantial number which are being contested by the Company. The claims are reviewed by Administrative Law Judges of the U.S. Department of Labor for determination of questions of disability and compensation. Freeman has outstanding approximately 40 claims which have been filed under the Illinois Occupational Disease Act. Many of the claims are disputed. The Company has established liabilities, on an actuarial basis, to pay for the estimated costs of any benefits that are ultimately awarded. The Company is also a defendant in other lawsuits and claims and in other investigations of varying nature. The Company believes these proceedings, in the aggregate, are not material to the Company's financial condition or results of operations. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of the Company's Security Holders during the fourth quarter of the year ended 31 December 1993. - 6 - SUPPLEMENTARY ITEM. EXECUTIVE OFFICERS OF THE COMPANY The name, age, offices and positions held for the last five years of the Company's executive officers who are not directors are as follows: - 7 - All executive officers of the Company are elected annually. There are no family relationships, as defined, between any of the above executive officers. No executive officer of the Company was selected pursuant to any arrangement or understanding between the officer and any other person. PART II ITEM 5.

ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS General Dynamics Corporation common stock is listed on the New York Stock Exchange, Chicago Stock Exchange and Pacific Stock Exchange. The high and low market price of General Dynamics Corporation common stock and the cash dividends declared for each quarterly period within the two most recent fiscal years is included in Note T to the Consolidated Financial Statements appearing on page 32 in the Company's 1993 Shareholder Report, included in this Form 10-K - Annual Report as Exhibit 13 and incorporated herein by reference. There were 24,496 common shareholders of record of General Dynamics Corporation common stock at 31 December 1993. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA The information on pages 12 through 17 and 34 of the 1993 Shareholder Report, included in this Form 10-K -- Annual Report as Exhibit 13, is incorporated herein by reference in response to this item. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION The information on pages 12 through 17 of the 1993 Shareholder Report, included in this Form 10-K -- Annual Report as Exhibit 13, is incorporated herein by reference in response to this item. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information on pages 18 through 34 of the 1993 Shareholder Report, included in this Form 10-K -- Annual Report as Exhibit 13, is incorporated herein by reference in response to this item. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. - 8 - PART III The information required to be set forth herein, Item 10, "Directors and Executive Officers of the Registrant," Item 11, "Executive Compensation," Item 12, "Security Ownership of Certain Beneficial Owners and Management," and Item 13, "Certain Relationships and Related Transactions," except for a list of the Executive Officers which is provided in Part I of this report, is included in the Company's definitive Proxy Statement pursuant to Regulation 14A, which is incorporated herein by reference, to be filed with the Securities and Exchange Commission no later than 120 days after the close of the fiscal year ended 31 December 1993. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Financial Statements--See Index on page 11. 2. Financial Statement Schedules--See Index on page 11. 3. Exhibits--See Index on pages 17 through 19. (b) Reports on Form 8-K There were no reports on Form 8-K filed during the 4th Quarter of 1993. - 9 - SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. GENERAL DYNAMICS CORPORATION By: /S/ J. Steven Keate --------------------------------- J. Steven Keate Vice President and Controller 29 March 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW ON 29 MARCH 1994 BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES INDICATED, INCLUDING A MAJORITY OF THE DIRECTORS. William A. Anders Chairman and Director Thomas G. Ayers Director Frank C. Carlucci Director Nicholas D. Chabraja Director William J. Crowe, Jr. Director James S. Crown Director Lester Crown Director Charles H. Goodman Director Harvey Kapnick Vice Chairman and Director David S. Lewis Director James R. Mellor Chief Executive Officer and Director (Principal Executive Officer) Stanley C. Pace Director Allen E. Puckett Director Bernard W. Rogers Director Elliot H. Stein Director J. Steven Keate Vice President and Controller (Principal Financial and Accounting Officer) By: /S/ E. Alan Klobasa ----------------------------------- E. Alan Klobasa Attorney-in-Fact - 10 - INDEX TO FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES ITEM 14(a) 1. AND 2. All other schedules are not submitted because they are not applicable or not required, or because the required information is included in the financial statements or the notes thereto. The Report of Independent Public Accountants and Consolidated Financial Statements listed in the above Index under Shareholder Report, are included in this Form 10-K -- Annual Report as Exhibit 13 and are incorporated herein by reference. - 11 - REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Shareholders and Board of Directors of General Dynamics Corporation: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in General Dynamics Corporation's 1993 Shareholder Report incorporated by reference in this Form 10-K, and have issued our report thereon dated 25 January 1994 (except with respect to the stock split discussed in Note K, as to which the date is 4 March 1994). Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in the accompanying index are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Washington, D.C., 25 January 1994 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our reports included and incorporated by reference into this Form 10-K for the year ended 31 December 1993 into the Company's previously filed registration statements on Form S-8 file numbers 33-23448, 2-23904, 2-23032, 2-28952, 2-50980, 2-24270 and 2-88053. ARTHUR ANDERSEN & CO. Washington, D.C., 29 March 1994 - 12 - SCHEDULE I -- MARKETABLE SECURITIES 31 DECEMBER 1993 (DOLLARS IN MILLIONS) (a) Included in Other Assets on the Consolidated Balance Sheet in the Company's 1993 Shareholder Report. - 13 - SCHEDULE VII--GUARANTEES OF SECURITIES OF OTHER ISSUERS 31 DECEMBER 1993 (DOLLARS IN MILLIONS) - 14 - SCHEDULE IX--SHORT-TERM BORROWINGS (DOLLARS IN MILLIONS) Notes: (a) Maturity ranges from overnight to six months from date of issue. No borrowings have provisions for extensions of maturity. (b) Based on the amounts outstanding at the end of each day. - 15 - SCHEDULE X--SUPPLEMENTARY INCOME STATEMENT INFORMATION--YEARS ENDED 31 DECEMBER (DOLLARS IN MILLIONS) (a) Continuing operations only. - 16 - INDEX TO EXHIBITS - 17 - - 18 - NOTES - 19 -

101830_1993.txt

101830

1993

Item 1. Business THE CORPORATION Sprint Corporation (Sprint), incorporated in 1938 under the laws of Kansas, is a holding company. Sprint's principal subsidiaries provide local exchange, cellular/wireless and domestic and international long distance telecommunications services. Other subsidiaries are engaged in the wholesale distribution of telecommunications products and the publishing and marketing of white and yellow page telephone directories. Sprint, through its subsidiaries, owns Sprint Communications Company L.P. (the Limited Partnership), the principal entity comprising the long distance division. Through December 31, 1991, GTE Corporation (GTE) owned a 19.9 percent interest in the Limited Partnership. In March 1993, Sprint's merger with Centel Corporation (Centel) was consummated, increasing Sprint's local exchange operations and greatly expanding its cellular/wireless operations. LONG DISTANCE COMMUNICATIONS SERVICES The long distance division is the nation's third largest long distance telephone company, operating a nationwide all-digital long distance communications network utilizing state-of-the-art fiber-optic and electronic technology. The division provides domestic voice and data communications services across certain specified geographical boundaries, as well as international long distance communications services. Rates charged by the division for its services sold to the public are subject to different levels of state and federal regulation, but are generally not subject to rate-base regulation. The division had net operating revenues of $6.14 billion, $5.66 billion and $5.39 billion in 1993, 1992 and 1991, respectively. The 1982 Modification of Final Judgment (MFJ) entered into by American Telephone and Telegraph Company (AT&T) and the Department of Justice significantly affected the long distance communications market. The major aspects of the MFJ were (1) the divestiture of AT&T's local telephone operating companies (the Bell Operating Companies), (2) the creation of geographical areas called Local Access and Transport Areas (LATAs) within which the Bell Operating Companies and independent local exchange companies provide basic local and intra-LATA toll service, (3) the retention of long distance services by AT&T, and (4) the prohibition against the Bell Operating Companies providing inter- LATA services and information services, and manufacturing telecommunications equipment. The Bell Operating Companies and GTE local exchange companies were required by the MFJ and the GTE Consent Decree, respectively, to provide customers with access to all inter-LATA carriers' networks in a manner "equal in type, quality, and price" to that provided to AT&T (equal access). The independent local exchange companies were required by the Federal Communications Commission (FCC) to provide equal access from many of their central offices. AT&T dominates the long distance communications market and is expected to continue to dominate the market for some years into the future. MCI Communications Corporation (MCI) is the nation's second largest long distance telephone company. Sprint's long distance division competes with AT&T and MCI in all segments of the long distance communications market. Competition is based upon price and pricing plans, the types of services offered, customer service, and communications quality, reliability and availability. The opportunities for and cost of competition and, as a result, the structure of the long distance telecommunications industry are all subject to varying degrees of change by decisions of the executive, judicial and legislative branches of the federal government. The stated objective of these changes is to open the long distance market to new entrants and eventually replace regulation with competition where it best serves the public interest. Some of the major issues being addressed by the federal government to facilitate the transition to a competitive market include the full implementation of equal access (discussed above), equal charges per unit of traffic for access transport provided to long distance carriers (discussed below), lessened regulation of AT&T (including permitting individual customer offerings), and the modification of some or all of the line-of- business restrictions imposed on the Bell Operating Companies by the MFJ (also discussed below). Many of these same competitive issues are also being considered by a number of state regulators and legislators. In 1982, the FCC distinguished between carriers and found some (AT&T and the Local Exchange Carriers, or LECs) to be dominant, and others (primarily smaller competitive long distance companies) to be nondominant. The FCC found it was in the public interest to continue to regulate dominant carriers but, because of market forces, it was appropriate to significantly lessen the amount of regulation applied to nondominant domestic carriers; thus, for instance, nondominant carriers were allowed to choose not to file interstate tariffs. This policy of "permissive detariffing" for nondominant carriers was found by the U.S. Court of Appeals for the D.C. Circuit, in November 1992, to violate the requirement in the Communications Act that all carriers "shall" file tariffs. In response to the Court's decision, the FCC adopted rules streamlining tariff filings for nondominant carriers. The U.S. Supreme Court subsequently agreed to hear an appeal of the Circuit Court decision. In February 1993, AT&T filed lawsuits in federal District Court in Washington, D.C. against the Limited Partnership, MCI and WilTel, Inc. alleging unspecified damages for providing competitive service at rates not contained in tariffs filed with the FCC. In November 1993, the court granted Sprint's motion to dismiss AT&T's lawsuit; however, AT&T has appealed the decision to the D.C. Circuit Court. Although it is impossible to predict the outcome of these proceedings with certainty, Sprint believes that the Limited Partnership has at all times complied with applicable laws and regulations and that its rates are proper and enforceable. In 1989, the FCC replaced regulation of AT&T's rate of return with a system of price caps, giving AT&T increased pricing flexibility. In 1991, the FCC adopted partial "streamlined" regulation of certain competitive business services provided by AT&T. Specifically, the FCC removed these services (primarily WATS and private line) from price caps regulation, reduced the related tariff filing requirements and permitted contracts with individual customers if the terms are generally available to other business users. The FCC subsequently extended "streamlined" regulation to most 800 services provided by AT&T. Also in 1991, the FCC extended the provision of the MFJ requiring the Bell Operating Companies (and all other LECs) to apply "equal charges per unit of traffic" for access transport to all interexchange carriers, which otherwise would have expired, and instituted a comprehensive proceeding to determine new access transport rules. In October 1992, the FCC adopted a new rate structure and new pricing rules for LEC-provided switched transport. LECs filed new access transport tariffs with the FCC in September 1993, which contain rates that will purportedly reduce the costs of the largest interexchange carrier by less than 1 percent and increase the costs of the smaller interexchange carriers (including Sprint's long distance division) by less than 2 percent. The new rates went into effect on December 30, 1993. In 1991, a series of decisions by the U.S. District Court and Circuit Court of Appeals in Washington, D.C. resulted in the MFJ's restriction against participation by the Bell Operating Companies in information services being removed. Legislation has been introduced in Congress, however, to place some safeguards on the provision of those services. Legislation also has been introduced in both Houses of Congress in 1994 to substantially modify the restrictions in the MFJ. The bill in the U.S. House would require the Justice Department, instead of the District Court, to determine whether the provision of long distance service by the Bell Operating Companies would substantially harm competition, but there are significant exceptions to this rule. The bill in the U.S. Senate would require the FCC to determine that the Bell Operating Companies can provide competitive long distance service only after local telephone competition has diminished their monopoly power. The Clinton Administration has also indicated that it favors legislation which promotes local telephone competition and the national information infrastructure. Although federal legislation to modify the MFJ has been introduced several times in recent years but has not passed, there appears to be a greater likelihood that Congress will act during the Clinton Administration. LOCAL COMMUNICATIONS SERVICES The local division is comprised of rate-regulated local exchange operating companies which serve approximately 6.1 million access lines in 19 states. In addition to furnishing local exchange services, the division provides intra-LATA toll service and access by other carriers to Sprint's local exchange facilities. The division had net operating revenues of $4.13 billion, $3.86 billion and $3.75 billion in 1993, 1992 and 1991, respectively. Florida and North Carolina were the only jurisdictions in which 10 percent or more of the division's total 1993 net operating revenues were generated. The following table reflects major revenue categories as a percentage of the division's total net operating revenues: 1993 1992 1991 Local service 39.4% 39.0% 38.3% Network access 37.1 36.9 37.2 Toll service 12.2 12.6 13.0 Other 11.3 11.5 11.5 Total 100.0% 100.0% 100.0% AT&T, as the dominant long distance telephone company, is the division's largest customer for network access services. In 1993, 17.3 percent of the division's net operating revenues (6.3 percent of Sprint's consolidated net operating revenues) was derived from services provided to AT&T, primarily network access services, compared to 18.7 percent (6.9 percent of Sprint's consolidated net operating revenues) in 1992. While AT&T is a significant customer, Sprint does not believe the division's revenues are dependent upon AT&T, as customers' demand for inter- LATA long distance telephone service is not tied to any one long distance carrier. Historically, as the market share of AT&T's long distance competitors increases, the percent of revenues derived from network access services provided to AT&T decreases. Effective January 1, 1991, the FCC adopted a price caps regulatory format for the Bell Operating Companies and the GTE local exchange companies. Other LECs could volunteer to become subject to price caps regulation. Under price caps, prices for network access service must be adjusted annually to reflect industry average productivity gains (as specified by the FCC), inflation and certain allowed cost changes. Sprint elected to be subject to price caps regulation, and under the form of the plan adopted, Sprint's LECs generally have an opportunity to earn up to a 14.25 percent rate of return on investment. Some of Sprint's LECs have committed to produce higher than industry average productivity gains, and as a result have an opportunity to earn up to a 15.25 percent rate of return on investment. The LECs owned by Centel did not originally elect price caps, but as a result of the merger, these LECs adopted price caps effective July 1, 1993. Prior to price caps, under rate of return regulation, the Centel companies' authorized rate of return on investment was 11.25 percent, with the ability to earn 0.25 percent above the authorized return. The FCC is conducting a scheduled review of all aspects of the price caps plan; changes to the plan may be proposed by interested parties and the FCC may implement changes in 1995. Without further action by the FCC, the current price caps plan would expire in 1995 and would be replaced by rate of return regulation. The potential for more direct competition with Sprint's LECs is increasing. Many states, including most of the states in which Sprint's LECs operate, allow competitive entry into the intra-LATA long distance service market. State regulators are also increasingly confronted with requests to permit resale of local exchange services, with such resale now existing in a number of states in which Sprint's LECs operate, including Pennsylvania, Kansas, Illinois and Missouri. Illinois law also allows alternative telecommunications providers to obtain certificates of local exchange service authority in direct competition with existing LECs if certain showings are made to the satisfaction of the Illinois Commerce Commission. At the interstate level, the FCC has revised its rules to permit connection of customer-owned coin telephones to the local network, exposing LECs to direct coin telephone competition. Additionally, the FCC has assisted Competitive Access Providers (CAPs) in providing access to interexchange carriers and end users by mandating that all Tier 1 (over $100 million annual operating revenues) LECs allow collocation of CAP equipment in LEC central offices. The FCC's decision regarding collocation is under appeal to the U.S. Court of Appeals for the D.C. Circuit. The extent and ultimate impact of competition for LECs will continue to depend, to a considerable degree, on FCC and state regulatory actions, court decisions and possible federal or state legislation. Legislation designed to stimulate local competition between local exchange service providers and cable programming service providers, in both markets, is presently pending in both houses of the U.S. Congress. It is uncertain if any of the bills will be enacted. CELLULAR AND WIRELESS COMMUNICATIONS SERVICES The cellular and wireless division primarily consists of Sprint Cellular Company and its subsidiaries. In addition, Sprint's LECs hold FCC licenses for Rural Service Areas. For management and financial reporting purposes, these operations have been combined with Sprint Cellular Company's operations. Approximately 50 percent of Sprint's local communications services customers are located in areas served by the cellular and wireless division of Sprint. The division has operating control of 88 markets in 15 states and a minority interest in 64 markets. The division had net operating revenues of $464 million in 1993 and served more than 652,000 customers as of year end. In 1992 and 1991, the division had revenues of $322 million and $242 million, respectively. Prior to the November 1992 decision by the U.S. Court of Appeals for the D.C. Circuit rejecting permissive detariffing discussed above under "Long Distance Communications Services", cellular carriers had not filed tariffs with the FCC. In February 1993, resale of domestic interstate toll tariffs for Sprint's cellular and wireless operations were filed. The FCC, pursuant to authority conferred by the Revenue Reconciliation Act of 1993, has adopted rules to pre-empt all state regulation of commercial mobile radio services, including cellular, and to forbear from enforcing tariffing requirements with respect to commercial mobile radio services. The FCC licenses two carriers in each cellular market area and these carriers compete directly with each other to provide cellular service to end users and resellers. Each carrier is licensed to operate on frequencies set aside for its cellular operation. Licensees also encounter retail competition from resale carriers in their market. Sprint Cellular Company also sells cellular equipment in the competitive retail market. Competition is based on quality of service, price and product quality. The FCC has announced that it will award additional radio spectrum for the provision of personal communications services (PCS). The FCC is expected to auction spectrum licenses during 1994. The FCC expects that PCS will result in additional competition for existing cellular carriers. PRODUCT DISTRIBUTION AND DIRECTORY PUBLISHING North Supply Company (North Supply), a wholesale distributor of telecommunications, security and alarm, and electrical products, distributes products of more than 900 manufacturers to approximately 12,000 customers. Products range from basics, such as wire and cable, telephones and repair parts, to complete PBX systems and security and alarm equipment. North Supply also provides material management services to several of its affiliates and to several subsidiaries of the Regional Bell Holding Companies. The nature of competition in North Supply's markets demands a high level of customer service to succeed, as a number of competitors, including other national wholesale distributors, sell the same products. North Supply sells to telephone companies and other users of telecommunications products, including Sprint's local and long distance divisions, other local and long distance telephone companies, and companies with large private networks. Other North Supply customers include original equipment manufacturers, interconnect companies, security and alarm dealers and local, state and federal governments. Sales to affiliates represented 39.3 percent of North Supply's total sales in 1993 and 1992 and 36.5 percent in 1991. North Supply's net operating revenues were $677 million, $594 million and $569 million in 1993, 1992 and 1991, respectively. Sprint Publishing & Advertising publishes and markets white and yellow page telephone directories in certain of Sprint's local exchange territories, as well as in the greater metropolitan areas of Milwaukee, Wisconsin and Chicago, Illinois. The company publishes approximately 277 directories in 19 states with a circulation of 12.6 million copies. Sprint Publishing & Advertising's net operating revenues were $268 million, $257 million, and $245 million in 1993, 1992 and 1991, respectively. In addition, Centel Directory Company, another Sprint subsidiary, publishes and markets approximately 59 directories in 5 states with a circulation of 3.5 million copies through The CenDon Partnership, a general partnership between Centel Directory Company and The Reuben H. Donnelley Corporation. Revenues of Sprint Publishing & Advertising and The CenDon Partnership are principally derived from selling directory advertisements. The companies compete with publishers of telephone directories and others for advertising revenues. ENVIRONMENT Sprint's subsidiaries are involved in the remediation of certain sites, primarily relating to leakage from tanks used for the storage of gasoline for vehicles and diesel fuel for standby power generators. Compliance with federal, state and local provisions relating to the protection of the environment has had no significant effect on the capital expenditures or earnings of Sprint or any of its subsidiaries, and future effects are not expected to be material. PATENTS, TRADEMARKS AND LICENSES Sprint and its subsidiaries own numerous patents, patent applications and trademarks in the United States and other countries. Sprint and its subsidiaries are also licensed under domestic and foreign patents owned by others. In the aggregate, these patents, patent applications, trademarks and licenses are of material importance to Sprint's businesses. EMPLOYEE RELATIONS As of December 31, 1993, Sprint and its subsidiaries had approximately 50,500 employees, of whom approximately 25 percent are members of unions. During 1993, Sprint and its subsidiaries had no material work stoppages caused by labor controversies. INFORMATION AS TO INDUSTRY SEGMENTS Sprint's net operating revenues from affiliates and non- affiliates, by segment, for the three years ended December 31, 1993, 1992 and 1991, are as follows (in millions): Net Operating Revenues 1993 1992 1991 Long Distance Communications Services Non-affiliates $ 6,088.4 $ 5,612.1 $ 5,344.2 Affiliates 50.8 46.1 43.4 6,139.2 5,658.2 5,387.6 Local Communications Services Non-affiliates 3,911.5 3,662.4 3,564.6 Affiliates 214.5 199.8 189.1 4,126.0 3,862.2 3,753.7 Cellular and Wireless Communications Services Non-affiliates 464.0 322.2 242.1 Product Distribution and Directory Publishing Non-affiliates 679.2 629.7 618.5 Affiliates 266.0 233.2 207.5 945.2 862.9 826.0 Subtotal 11,674.4 10,705.5 10,209.4 Intercompany revenues (306.6) (285.2) (276.1) Net operating revenues $ 11,367.8 $ 10,420.3 $ 9,933.3 For additional information as to industry segments of Sprint, refer to "Business Segment Information" within the Financial Statements, Financial Statement Schedules and Supplementary Data filed as part of this report. Item 2.

Item 2. Properties The aggregate cost of Sprint's property, plant and equipment was $17.72 billion as of December 31, 1993, of which $11.23 billion relates to local communications services, $5.49 billion relates to long distance communications services and $570 million relates to cellular/wireless communications services. These properties consist primarily of land, buildings, digital fiber-optic network, switching equipment, cellular radio, microwave radio and cable and wire facilities and are in good operating condition. Certain switching equipment and several general office facilities are located on leased premises. The long distance division has been granted easements, rights-of-way and rights-of-occupancy, primarily by railroads and other private landowners, for its fiber-optic network. The properties of the product distribution and directory publishing businesses consist primarily of office and warehouse facilities to support the business units in the distribution of telecommunications products and publication of telephone directories. Sprint owns its corporate headquarters building and certain other property located in the greater Kansas City metropolitan area. Property, plant and equipment with an aggregate cost of approximately $10.36 billion is either pledged as security for first mortgage bonds and certain notes or is restricted for use as mortgaged property. Item 3.

Item 3. Legal Proceedings In September 1993, a memorandum of agreement setting forth settlement terms was executed in connection with the class action lawsuit originally filed in 1990 by certain Sprint shareholders against Sprint and certain of its executive officers and directors in the United States District Court for the District of Kansas. An amended class action complaint was filed in January 1992 after dismissal without prejudice of the original complaint. The plaintiffs in the class action alleged violations of various federal securities laws and related state laws and, among other relief, sought unspecified compensatory damages. A related shareholders' derivative complaint was dismissed without prejudice by the same court in March 1993. Pursuant to the settlement, which includes settlement of the derivative claims, Sprint will pay $28.5 million. Sprint admits no wrongdoing, but settled the case to avoid the costs and uncertainties of further litigation and the disruption of business activities that would result from trial. Approximately 60 percent of the settlement will be recovered from Sprint's insurance carriers. The net settlement did not have a significant effect on Sprint's 1993 results of operations. The settlement agreement is subject to the approval of the court. Following announcement of the Sprint/Centel merger agreement in May 1992, a class action suit was filed by certain Centel shareholders against Centel and certain of its officers and directors. The suit was consolidated in the United States District Court for the Northern District of Illinois in July 1992. The complaint alleges violations of federal securities laws by failing to disclose pertinent information regarding the value of Centel common stock. The plaintiffs seek damages in an unspecified amount. Other suits arising in the ordinary course of business are pending against Sprint and its subsidiaries. Sprint cannot predict the ultimate outcome of these actions or the above- described litigation, but believes they will not result in a material effect on Sprint's consolidated financial statements. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders No matter was submitted to a vote of security holders during the fourth quarter of 1993. Item 10(b). Executive Officers of the Registrant Office Name Age Chairman and Chief Executive Officer William T. Esrey (1) 54 President - Cellular and Wireless Communications Division Dennis E. Foster (2) 53 President - Long Distance Division Ronald T. LeMay (3) 48 President - Local Telecommunications Division D. Wayne Peterson (4) 58 Executive Vice President - Law and External Affairs J. Richard Devlin (5) 43 Executive Vice President - Chief Financial Officer Arthur B. Krause (6) 52 Senior Vice President - Financial Services and Taxes Gene M. Betts (7) 41 Senior Vice President - External Affairs John R. Hoffman (8) 48 Senior Vice President and Controller John P. Meyer (9) 43 Senior Vice President - Strategic Planning and Business Development Theodore H. Schell (10) 49 Senior Vice President - Quality Development and Public Relations Richard C. Smith,Jr.(11) 53 Senior Vice President - Treasurer M. Jeannine Strandjord (12) 48 Senior Vice President - Human Resources I. Benjamin Watson (13) 45 Vice President and Secretary Don A. Jensen (14) 58 (1)Mr. Esrey was elected Chairman in 1990. He was elected Chief Executive Officer and a member of the Board of Directors in 1985. In addition, he has served as Chief Executive Officer of the Limited Partnership since 1988. (2)Mr. Foster was elected President - Cellular and Wireless Communications Division in April 1993. Mr. Foster had served as Senior Vice President - Operations of a subsidiary of Sprint since 1992. From 1991 to 1992, he served as President of GTE Mobilnet in Atlanta, Georgia. Prior to that, he had served in various positions with GTE Corporation for more than five years. (3)Mr. LeMay was elected President - Long Distance Division in 1989. He had served as Executive Vice President - Corporate Affairs of Sprint since 1987. He was elected to the Board of Directors of Sprint in 1993. (4)Mr. Peterson was elected President - Local Telecommunications Division in August 1993. From 1980 to 1993, he served as President of Carolina Telephone and Telegraph Company, a subsidiary of Sprint. (5)Mr. Devlin was elected Executive Vice President - Law and External Affairs in 1989. He had served as Vice President and General Counsel - Telephone since 1987. (6)Mr. Krause was elected Executive Vice President - Chief Financial Officer in 1988. During 1990 and 1991, he also served as Chief Information Officer. (7)Mr. Betts was elected Senior Vice President - Financial Services and Taxes in 1990. He had served as Vice President - Taxes since 1988. (8)Mr. Hoffman was elected Senior Vice President - External Affairs in 1990. He had served in the same capacity at the Limited Partnership since 1986. (9)Mr. Meyer was elected Senior Vice President and Controller in April 1993. He had served as Vice President and Controller of Centel since 1989. From 1986 to 1989, he served as Controller of Centel. (10)Mr. Schell was elected Senior Vice President - Strategic Planning and Business Development of Sprint in 1990. He joined the Long Distance Division as Vice President - Strategic Planning in 1989. From 1983 to 1989, he served as President of RealCom Communications Corporation, an IBM subsidiary, whose principal business is telecommunications services. (11)Mr. Smith was elected Senior Vice President - Quality Development and Public Relations in 1991. He had served as President of the Limited Partnership's National Markets since 1989. From 1986 to 1989, he served as President of the Limited Partnership's National Accounts Division. (12)Ms. Strandjord was elected Senior Vice President - Treasurer in 1990. She had served as Vice President and Controller since 1986. (13)Mr. Watson was elected Senior Vice President - Human Resources in April 1993. Mr. Watson headed a transition team in connection with the Centel merger following announcement of the merger. He had served as Vice President - Finance and Administration of United Telephone - Eastern Group, an operating group of subsidiaries of Sprint, since 1990. From 1983 to 1990, he served as Vice President - Administration of the Midwest Group, an operating group of subsidiaries of Sprint. (14)Mr. Jensen was elected Vice President and Secretary in 1975. There are no known family relationships between any of the persons named above or between any such persons and any outside directors of Sprint. Officers are elected annually. Part II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters Market Price Per Share 1993 1992 End of End of High Low Period High Low Period First Quarter 31 3/4 25 1/2 30 1/2 26 3/8 21 22 1/2 Second Quarter 35 3/8 29 1/2 35 1/8 25 20 3/4 21 3/4 Third Quarter 37 1/2 33 1/2 36 3/4 24 3/8 21 1/2 24 3/8 Fourth Quarter 40 1/4 31 3/8 34 3/4 26 3/4 23 3/8 25 1/2 As of March 1, 1994, there were approximately 105,000 record holders of Sprint's common stock. The principal trading market for Sprint's common stock is the New York Stock Exchange. The common stock is also traded on the Chicago and Pacific Stock Exchanges. Sprint has declared dividends of $0.25 per quarter during each of the years ended December 31, 1993 and 1992. Item 6.

Item 6. Selected Financial Data For information required by Item 6, refer to the "Selected Financial Data" section of the Financial Statements, Financial Statement Schedules and Supplementary Data filed as part of this report. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations For information required by Item 7, refer to the "Management's Discussion and Analysis of Financial Condition and Results of Operations" section of the Financial Statements, Financial Statement Schedules and Supplementary Data filed as part of this report. Item 8.

Item 8. Financial Statements and Supplementary Data For information required by Item 8, refer to the "Consolidated Financial Statements and Schedules" and "Quarterly Financial Data sections of the Financial Statements, Financial Statement Schedules and Supplementary Data filed as part of this report. Item 9.

Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure As previously reported in Sprint's Current Report on Form 8-K dated April 23, 1993, following consummation of the merger with Centel, Arthur Andersen & Co. was replaced with Ernst & Young as auditors of Centel and its subsidiaries, effective April 23, 1993. Part III Item 10.

Item 10. Directors and Executive Officers of the Registrant Pursuant to Instruction G(3) to Form 10-K, the information relating to Directors of Sprint required by Item 10 is incorporated by reference from Sprint's definitive proxy statement filed pursuant to Regulation 14A. For information pertaining to Executive Officers of Sprint, as required by Instruction 3 of Paragraph (b) of Item 401 of Regulation S-K, refer to the "Executive Officers of the Registrant" section of Part I of this report. Pursuant to Instruction G(3) to Form 10-K, the information relating to compliance with Section 16(a) required by Item 10 is incorporated by reference from Sprint's definitive proxy statement filed pursuant to Regulation 14A. Item 11.

Item 11. Executive Compensation Pursuant to Instruction G(3) to Form 10-K, the information required by Item 11 is incorporated by reference from Sprint's definitive proxy statement filed pursuant to Regulation 14A. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management Pursuant to Instruction G(3) to Form 10-K, the information required by Item 12 is incorporated by reference from Sprint's definitive proxy statement filed pursuant to Regulation 14A. Item 13.

Item 13. Certain Relationships and Related Transactions Pursuant to Instruction G(3) to Form 10-K, the information required by Item 13 is incorporated by reference from Sprint's definitive proxy statement filed pursuant to Regulation 14A. Part IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) 1. The consolidated financial statements of Sprint and supplementary financial information filed as part of this report are listed in the Index to Financial Statements, Financial Statement Schedules and Supplementary Data. 2. The consolidated financial statement schedules of Sprint filed as part of this report are listed in the Index to Financial Statements, Financial Statement Schedules and Supplementary Data. 3. The following exhibits are filed as part of this report: EXHIBITS (3) Articles of Incorporation and Bylaws: (a) Articles of Incorporation, as amended (filed as Exhibit 4 to Sprint Corporation Current Report on Form 8-K dated March 9, 1993 and incorporated herein by reference). (b) Bylaws, as amended (filed as Exhibit 3(b) to Sprint Corporation Annual Report on Form 10-K for the year ended December 31, 1991 and incorporated herein by reference). (4) Instruments defining the Rights of Sprint's Equity Security Holders: (a) The rights of Sprint's equity security holders are defined in the Fifth, Sixth, Seventh and Eighth Articles of Sprint's Articles of Incorporation. See Exhibit 3(a). (b) Rights Agreement dated as of August 8, 1989, between Sprint Corporation (formerly United Telecommunications, Inc.) and United Missouri Bank, N.A. (formerly United Missouri Bank of Kansas City, N.A.), as Rights Agent (filed as Exhibit 2(b) to Sprint Corporation Registration Statement on Form 8- A dated August 11, 1989 (File No. 1-4721), and incorporated herein by reference). (c) Amendment and supplement dated June 4, 1992 to Rights Agreement dated as of August 8, 1989 (filed as Exhibit 2(c) to Amendment No. 1 on Form 8 dated June 8, 1992 to Sprint Corporation Registration Statement on Form 8-A dated August 11, 1989 (File No. 1-4721), and incorporated herein by reference). (10) Material Agreements - Merger Agreement: (a) Agreement and Plan of Merger dated as of May 27, 1992, among Sprint Corporation, F W Sub Inc. and Centel Corporation (filed as Exhibit 2 to Sprint Corporation Current Report on Form 8-K dated May 27, 1992 and incorporated herein by reference). (b) First Amendment dated as of February 19, 1993, to the Agreement and Plan of Merger, dated as of May 27, 1992, among Sprint Corporation, F W Sub Inc. and Centel Corporation (filed as Exhibit 2b to Sprint Corporation Current Report on Form 8-K dated March 9, 1993 and incorporated herein by reference). (10) Executive Compensation Plans and Arrangements: (c) 1978 Stock Option Plan, as amended (filed as Exhibit 19(a) to United Telecommunications, Inc. Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, and incorporated herein by reference). (d) 1981 Stock Option Plan, as amended (filed as Exhibit 19(b) to United Telecommunications, Inc. Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, and incorporated herein by reference). (e) 1985 Stock Option Plan, as amended (filed as Exhibit 19(c) to United Telecommunications, Inc. Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, and incorporated herein by reference). (f) 1990 Stock Option Plan, as amended. (g) 1990 Restricted Stock Plan, as amended (filed as Exhibit 99 to Sprint Corporation Registration Statement No. 33-50421 and incorporated herein by reference). (h) Long-Term Stock Incentive Program, as amended (filed as Exhibit 19(e) to United Telecommunications, Inc. Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, and incorporated herein by reference). (i) Restated Memorandum Agreements Respecting Supplemental Pension Benefits between Sprint Corporation (formerly United Telecommunications, Inc.) and two of its current and former executive officers (filed as Exhibit 10(i) to Sprint Corporation Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference). (j) Executive Long-Term Incentive Plan. (k) Executive Management Incentive Plan. (l) Long-Term Incentive Compensation Plan (filed as Exhibit 10(j) to United Telecommunications, Inc. Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference). (m) Short-Term Incentive Compensation Plan (filed as Exhibit 10(k) to United Telecommunications, Inc. Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference). (n) Retirement Plan for Directors, as amended (filed as Exhibit 28d to Registration Statement No. 33-28237, and incorporated herein by reference). (o) Key Management Benefit Plan, as amended. (p) Executive Deferred Compensation Plan, as amended (filed as Exhibit 19(f) to United Telecommunications, Inc. Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, and incorporated herein by reference). (q) Director's Deferred Fee Plan, as amended (filed as Exhibit 19(g) to United Telecommunications, Inc. Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, and incorporated herein by reference). (r) Supplemental Executive Retirement Plan (filed as Exhibit 10(q) to Sprint Corporation Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference). (s) Form of Contingency Employment Agreements between Sprint Corporation and certain of its executive officers (filed as Exhibit 10(r) to Sprint Corporation Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference). (t) Form of Indemnification Agreements between Sprint Corporation (formerly United Telecommunications, Inc.) and its Directors and Officers (filed as Exhibit 10(s) to Sprint Corporation Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated herein by reference). (u) Summary of Executive Benefits (filed as Exhibit 10(u) to Sprint Corporation Annual Report on Form 10-K for the year ended December 31, 1991, and incorporated herein by reference). (v) Amended and Restated Centel Management Incentive Plan. (w) Amended and Restated Centel Stock Option Plan. (x) Agreements Regarding Special Compensation and Post Employment Restrictive Covenants between Sprint Corporation and three of its executive officers. (y) Amended and Restated Centel Matched Deferred Salary Plan. (z) Amended and Restated Centel Directors Deferred Compensation Plan. (aa) Amended and Restated Centel Director Stock Option Plan. (11) Computation of Earnings Per Common Share. (12) Computation of Ratio of Earnings to Fixed Charges. (21) Subsidiaries of Registrant. (23a) Consent of Ernst & Young. (23b) Consent of Arthur Andersen & Co. Sprint will furnish to the Securities and Exchange Commission, upon request, a copy of the instruments defining the rights of holders of its long-term debt and the long-term debt of its subsidiaries. The total amount of securities authorized under any of said instruments does not exceed 10 percent of the total assets of Sprint and its subsidiaries on a consolidated basis. (b) Reports on Form 8-K No reports on Form 8-K were filed during the fourth quarter of 1993. (c) Exhibits are listed in Item 14(a). SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. SPRINT CORPORATION (Registrant) By /s/ W. T. Esrey William T. Esrey Chairman and Chief Executive Officer Date: March 14, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on the 14th day of March, 1994. /s/ W. T. Esrey William T. Esrey Chairman and Chief Executive Officer /s/ Arthur B. Krause Arthur B. Krause Executive Vice President - Chief Financial Officer /s/ John P. Meyer John P. Meyer Senior Vice President and Controller Principal Accounting Officer SIGNATURES SPRINT CORPORATION (Registrant) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated on the 14th day of March, 1994. /s/ DuBose Ausley /s/ Robert E. R. Huntley DuBose Ausley, Director Robert E. R. Huntley, Director /s/ Warren L. Batts /s/ George Hutton Jr. Warren L. Batts, Director George N. Hutton Jr., Director /s/ Ruth M. Davis /s/ Ronald T. LeMay Ruth M. Davis, Director Ronald T. LeMay, Director /s/ Joseph L. Dionne /s/ Linda K. Lorimer Joseph L. Dionne, Director Linda Koch Lorimer, Director /s/ W. T. Esrey /s/ C. Price William T. Esrey, Director Charles H. Price II, Director /s/ Donald J. Hall /s/ Frank E. Reed Donald J. Hall, Director Frank E. Reed, Director /s/ P. H. Henson /s/ Charles E. Rice Paul H. Henson, Director Charles E. Rice, Director /s/ Harold S. Hook /s/ Stewart Turley Harold S. Hook, Director Stewart Turley, Director INDEX TO FINANCIAL STATEMENTS, FINANCIAL Sprint Corporation STATEMENT SCHEDULES AND SUPPLEMENTARY DATA Selected Financial Data Management's Discussion and Analysis of Financial Condition and Results of Operations Consolidated Financial Statements and Schedules: Management Report Report of Independent Auditors - Ernst & Young Report of Independent Auditors - Arthur Andersen & Co. Business Segment Information as of or for each of the three years ended December 31, 1993 Consolidated Statements of Income for each of the three years ended December 31, 1993 Consolidated Balance Sheets as of December 31, 1993 and 1992 Consolidated Statements of Cash Flows for each of the three years ended December 31, 1993 Consolidated Statements of Common Stock and Other Shareholders' Equity for each of the three years ended December 31, 1993 Notes to Consolidated Financial Statements Financial Statement Schedules for each of the three years ended December 31, 1993: V - Consolidated Property, Plant and Equipment VI - Consolidated Accumulated Depreciation VIII - Consolidated Valuation and Qualifying Accounts IX - Consolidated Short-term Borrowings X - Consolidated Supplementary Income Statement Information Certain financial statement schedules are omitted because the required information is not present, or because the information required is included in the consolidated financial statements and notes thereto. Quarterly Financial Data SELECTED FINANCIAL DATA Sprint Corporation As of or For the Years Ended December 31, 1993 1992 1991 1990 1989 (In Millions, Except Per Share Data) Results of Operations <1> Net operating revenues $ 11,367.8 $10,420.3 $9,933.3 $9,469.8 $8,557.6 Operating income <2> 1,250.6 1,213.4 1,185.6 1,045.3 1,076.7 Income from continuing operations <2>, <3>, <4> 480.6 496.1 472.7 351.1 353.0 Earnings per common share from continuing operations <2>, <3>, <4> 1.39 1.46 1.41 1.06 1.08 Dividends per common share 1.00 1.00 1.00 1.00 0.97 Financial Position <1> Total assets $14,148.9 $13,599.6 $13,929.8 $14,080.6 $13,092.7 Property, plant and equipment, net 10,314.8 10,219.9 10,310.5 10,295.2 9,700.9 Total debt (including short-term borrowings) 5,094.4 5,442.7 5,571.2 6,082.3 5,471.3 Redeemable preferred stock 38.6 40.2 56.6 60.0 63.5 Common stock and other shareholders' equity 3,918.3 3,971.6 3,671.9 3,353.5 3,151.5 <1>Effective March 9, 1993, Sprint Corporation (Sprint) consummated its merger with Centel Corporation (Centel). Because the merger has been accounted for as a pooling of interests, the accompanying data has been retroactively restated to include the results of operations and financial position of Centel. Dividends per common share for periods prior to the merger represent the amounts paid by Sprint. <2>During 1993, nonrecurring charges of $293 million were recorded related to (a) transaction costs associated with the merger with Centel and the expenses of integrating and restructuring the operations of the two companies and (b) a realignment and restructuring within the long distance division. Such charges reduced consolidated 1993 income from continuing operations by $193 million ($0.56 per share). During 1990, nonrecurring charges of $72 million were recorded related to the long distance division, which reduced consolidated 1990 income from continuing operations by $37 million ($0.11 per share). <3>During 1992 and 1991, gains were recognized related to the sales of certain local telephone and cellular properties, which increased consolidated 1992 income from continuing operations by $44 million ($0.13 per share) and consolidated 1991 income from continuing operations by $78 million ($0.23 per share). <4>During 1993, as a result of the enactment of the Revenue Reconciliation Act of 1993, Sprint was required to adjust its deferred income tax assets and liabilities to reflect the increased tax rate. Such adjustment reduced consolidated 1993 income from continuing operations by $13 million ($0.04 per share). MANAGEMENT'S DISCUSSION AND ANALYSIS OF Sprint Corporation FINANCIAL CONDITION AND RESULTS OF OPERATIONS Sprint/Centel Merger Effective March 9, 1993, Sprint Corporation (Sprint) consummated its merger with Centel Corporation (Centel), creating a diversified telecommunications enterprise with operations in long distance, local exchange and cellular/wireless communications services. The merger has been accounted for as a pooling of interests. Accordingly, the accompanying consolidated financial statements and information have been restated retroactively to include the results of operations, financial position and cash flows of Centel for all periods prior to consummation of the merger. Consolidated Results of Operations Each of Sprint's primary divisions -- long distance, local and cellular/wireless communications services -- generated record levels of net operating revenues and improved operating results in 1993. The long distance division generated a solid 8 percent growth in traffic volumes in 1993, the number of access lines served by the local division grew 5 percent, and the cellular/wireless division benefited from a strong 67 percent customer line growth rate. Cost controls and synergies resulting from the merger with Centel also contributed to the improved 1993 results. Consolidated results of operations in 1993, 1992 and 1991 were, however, affected by several nonrecurring items, as described in the next section. Highlights of consolidated results are as follows, excluding nonrecurring items as applicable: *Consolidated net operating revenues grew 9 percent in 1993 to $11.37 billion, following a 5 percent increase in 1992. *Income from continuing operations in 1993 was $687 million as compared to $452 million in 1992 and $395 million in 1991 -- which represents a compounded annual growth rate of 21 percent over the past three years. *Earnings per common share from continuing operations increased 50 percent in 1993 to $1.99 per share as compared to $1.33 per share in 1992. The following analysis of earnings per common share in 1993 and 1992 highlights the factors contributing to the improved results and the impact of nonrecurring items: 1993 1992 Prior year's earnings per common share from continuing operations (excluding nonrecurring items) $ 1.33 $ 1.18 Favorable (unfavorable) factors contributing to changes Divisional operating results 0.63 0.06 Interest expense 0.11 0.07 Other non-operating expense (0.03) 0.05 Effective income tax rate (0.02) (0.02) Change in weighted average common shares (0.03) (0.01) Current year's earnings per common share from continuing operations (excluding nonrecurring items) 1.99 1.33 Nonrecurring items Merger, integration and restructuring costs (0.56) Divestitures 0.13 1993 Tax law change (0.04) Discontinued operations (0.04) Extraordinary losses (0.08) (0.05) Accounting changes (1.12) 0.07 Total earnings per common share $ 0.15 $ 1.48 Nonrecurring Items Merger, Integration and Restructuring Costs - As a result of the merger with Centel, the operations of the merged companies continue to be integrated and restructured to achieve efficiencies which have begun to yield operational synergies and cost savings, particularly during the latter half of 1993. The transaction costs associated with the merger (consisting primarily of investment banking and legal fees) and the estimated expenses of integrating and restructuring the operations of the two companies (consisting primarily of employee severance and relocation expenses and costs of eliminating duplicative facilities) resulted in nonrecurring charges aggregating $259 million, which reduced 1993 income from continuing operations by $172 million ($0.50 per share). In addition, in 1993, Sprint initiated a realignment and restructuring of its long distance division, including the elimination of approximately 1,000 positions and the closure of two facilities. These actions are expected to improve market focus, lower costs and streamline operations within the division, and resulted in a nonrecurring charge of $34 million, which reduced 1993 income from continuing operations by $21 million ($0.06 per share). Divestitures - Divestitures of local telephone and cellular operations in 1992 and 1991 resulted in gains of $81 million and $114 million, respectively, which increased income from continuing operations by $44 million and $78 million, respectively. 1993 Tax Law Change - In August 1993, the Revenue Reconciliation Act of 1993 was enacted which, among other changes, raised the federal income tax rate to 35 percent from 34 percent. As a result, Sprint adjusted its deferred income tax assets and liabilities to reflect the revised rate. The adjustment related to Sprint's nonregulated subsidiaries increased the income tax provision for 1993 by $13 million. Discontinued Operations and Extraordinary Losses - During 1993, Sprint incurred a loss from discontinued operations of $12 million, net of related income tax benefits. In 1993, 1992 and 1991, Sprint incurred extraordinary losses related to the early extinguishments of debt of $29 million, $16 million, and $2 million, respectively, net of related income tax benefits. Accounting Changes - Effective January 1, 1993, Sprint changed its method of accounting for postretirement and postemployment benefits by adopting Statement of Financial Accounting Standards (SFAS) No. 106 and No. 112 and effected another accounting change. The cumulative effect of these changes in accounting principles reduced 1993 net income by $384 million. Effective January 1, 1992, Sprint also changed its method of accounting for income taxes by adopting SFAS No. 109. The cumulative effect of this change in accounting principle increased 1992 net income by $23 million. Non-operating Items Interest expense in 1993 and 1992 decreased $59 million and $37 million, respectively, generally related to decreases in average levels of debt outstanding and lower interest rates. The components of other expense, net are as follows (in millions): 1993 1992 1991 Equity in earnings from cellular minority partnership investments $ 20.0 $ 12.8 $ 8.8 Minority interests (9.4) (6.1) (51.6) Write-down of assets held for sale (16.0) (15.0) Other, net (16.9) 3.3 7.2 Total other expense, net $ (22.3) $ (5.0) $ (35.6) The decline in 1992 minority interests reflects Sprint's acquisition of the remaining 19.9 percent minority interest in Sprint Communications Company L.P. (the Limited Partnership) effective January 1, 1992. Sprint's income tax provisions for 1993, 1992 and 1991 resulted in effective tax rates of 38 percent, 36 percent and 34 percent, respectively. See Note 4 of "Notes to Consolidated Financial Statements" for information regarding the differences which cause the effective income tax rates to vary from the statutory federal income tax rates. As of December 31, 1993, Sprint has recorded deferred income tax assets of $316 million related to postretirement benefits and other accruals, $260 million related to alternative minimum tax credit carryforwards, and $40 million (net of a $25 million valuation allowance) related to state operating loss carryforwards. Sprint's management has determined that it is more likely than not that these deferred income tax assets, net of the valuation allowance, will be realized based on current income tax laws and expectations of future taxable income stemming from ordinary operations or the reversal of existing deferred tax liabilities. Uncertainties surrounding income tax law changes, shifts in operations between state taxing jurisdictions, and future operating income levels may, however, affect the ultimate realization of all or some portion of these deferred income tax assets. The effects of inflation on Sprint's operations were not significant during 1993, 1992, or 1991. Segmental Results of Operations Long Distance Communications Services Sprint's long distance division provides domestic and international voice and data communications services. Rates charged by the division for its services are subject to different levels of state and federal regulation, but are generally not rate-base regulated. Net operating revenues increased 9 percent in 1993, following a 5 percent increase in 1992. Such increases were generally due to traffic volume growth of 8 percent and 6 percent, respectively. Average revenue per minute received from customers was relatively constant during 1993 but declined 3 percent during 1992, primarily due to the mix of products among markets and competitive influences. The increases in net operating revenues and traffic volumes in both 1993 and 1992 reflect ongoing growth in the business and international markets, coupled with rebounding growth in the residential market during 1993. Growth in the business market in 1993 was also enhanced by the arrival of "800 portability," whereby customers who wish to change long distance carriers may now do so while retaining their advertised "800" numbers. In addition, lower revenue adjustments, reflecting improvement in the collectibility of customer accounts receivable, resulted in increased net operating revenues in 1992. Future rates of growth in both net operating revenues and traffic volumes may be influenced by both domestic and international economic conditions and the division's ability to maintain market share and current price levels in the intensely competitive long distance marketplace. Interconnection costs increased $136 million and $118 million in 1993 and 1992, respectively. International interconnection costs increased due to increased traffic volumes, partially offset by price reductions and the conversion of international traffic from resale arrangements (traffic transported by other long distance carriers) to less costly direct access arrangements. Costs of connecting to networks domestically also increased primarily as a result of traffic volume growth, partially offset by reductions in interconnection rates paid to local exchange companies and by reduced costs related to the transition from switched to special access arrangements. Interconnection costs as a percentage of net operating revenues were 44 percent in 1993 as compared to 46 percent in both 1992 and 1991. Operations expense consists of costs related to operating and maintaining the long distance network; costs of providing various services such as operator services, public payphones, telecommunications services for the hearing impaired, and video teleconferencing; and costs of data systems sales. Operations expense increased $98 million in 1993 over 1992, partially due to a change in accounting whereby circuit activity costs are now being expensed when incurred (see Note 1 of "Notes to Consolidated Financial Statements" for additional information). Exclusive of the effect of this accounting change, operations expense increased approximately $63 million in 1993 and $43 million in 1992, primarily due to expanded service offerings, increased traffic volumes and increased salaries and related benefits. Selling, general and administrative (SG&A) expense increased $120 million and $92 million in 1993 and 1992, respectively, generally as a result of intensified sales and marketing efforts. During 1993, marketing efforts primarily directed towards "800 portability," The Most calling plan and the recently introduced "Be there now" campaign resulted in increased advertising and other marketing expenses, as well as increased commissions and salaries and related expenses. During 1992, the introduction of several new calling plans and calling card features also resulted in increases in such sales and marketing expenses. Despite the increases in the amount of SG&A expense in 1993 and 1992, such expenses as a percentage of net operating revenues remained constant when compared to 1991, at 25 percent. Depreciation and amortization in 1993 decreased from 1992, primarily due to the change in accounting for circuit activity costs, as described above. Depreciation and amortization in 1992 was consistent with the 1991 amount as the increased depreciation resulting from additions to property, plant and equipment was substantially offset by a decrease in amortization expense resulting from the full amortization in June 1991 of certain intangible assets related to the 1986 formation of the Limited Partnership. Local Communications Services The local division consists principally of Sprint's rate- regulated, local exchange telephone operations. The following table summarizes, by major category, the net operating revenues of the division (in millions): 1993 1992 1991 Net operating revenues Local service $ 1,624.3 $ 1,507.4 $ 1,436.4 Network access 1,530.4 1,425.8 1,398.5 Toll service 505.3 487.5 487.2 Other 466.0 441.5 431.6 Total $ 4,126.0 $ 3,862.2 $ 3,753.7 As described in Note 9 of "Notes to Consolidated Financial Statements," certain local telephone operations were divested during 1992 and 1991. The following comparisons and discussion exclude the effects of such divested operations. Net operating revenues increased 7 percent in 1993, following a 5 percent increase in 1992. Increased local service revenues reflect continued increases in the number of access lines served and growth in add-on services, such as custom calling features. The division experienced 4.8 percent growth in access lines during 1993, compared to 4.2 percent in 1992. Network access revenues, derived from interexchange long distance carriers' use of the local network to complete calls, increased during 1993 and 1992 as a result of increased traffic volumes and additional revenues resulting from the recognition of a portion of the merger, integration and restructuring costs for regulatory purposes in certain jurisdictions, partially offset by periodic reductions in network access rates charged. Toll service revenues, related to the provision of long distance services within specified geographical areas and the reselling of interexchange long distance services, increased 4 percent and 1 percent in 1993 and 1992, respectively. Such increase in 1993 primarily reflects the election of the division's Indiana operations to serve as the primary intralata toll carrier within its serving area, rather than providing network access to another carrier. Other revenues increased in 1993 and 1992 generally due to higher equipment sales. Plant operations expense includes network operations costs; repair and maintenance costs of property, plant and equipment; and other expenses associated with the cost of providing services. The 4 percent and 2 percent increases in such costs in 1993 and 1992, respectively, were primarily related to increases in the costs of providing services resulting from access line growth. Depreciation and amortization expense increased $14 million in 1993, following a $15 million increase in 1992. Exclusive of the effects of depreciation rate changes, special short-term amortizations and nonrecurring charges approved by state regulatory commissions, such increases were $17 million and $16 million, respectively, generally due to plant additions. Other operating expense increased $99 million and $122 million in 1993 and 1992, respectively. Such increases resulted primarily from higher sales and marketing expenses to promote new products and services; increases in systems development costs incurred to enhance the efficiency and capabilities of the division's billing processes; and increases in the cost of equipment sales. The increases in both plant operations and other operating expenses also reflect the impact of the increased postretirement benefits cost of approximately $38 million being recognized in 1993 as a result of the adoption of SFAS No. 106. Consistent with most local exchange carriers, the division accounts for the economic effects of regulation pursuant to SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation." The application of SFAS No. 71 requires the accounting recognition of the rate actions of regulators where appropriate, including the recognition of depreciation and amortization based on estimated useful lives prescribed by regulatory commissions rather than those which might be utilized by non-regulated enterprises. Sprint's management believes that the division's operations meet the criteria for the continued application of the provisions of SFAS No. 71. With increasing competition and the changing nature of regulation in the telecommunications industry, the ongoing applicability of SFAS No. 71 must, however, be constantly monitored and evaluated. Should the division no longer qualify for the application of the provisions of SFAS No. 71 at some future date, the accounting impact could result in the recognition of a material, extraordinary, noncash charge. Cellular and Wireless Communications Services Sprint's cellular and wireless division consists of wholly- owned and majority-owned interests in 42 metropolitan service area (MSA) markets and 46 rural service area (RSA) markets. The company also owns minority interests in 31 MSA and 33 RSA markets. Equity in the earnings and losses of these minority investments is included in other expense, net in the consolidated statements of income. The increases in net operating revenues during 1993 and 1992 resulted principally from the growth in customer lines served, which increased 67 percent in 1993 and 52 percent in 1992. The effects of growth in customer lines served was partially offset by a decline in service revenue per customer line served, reflecting an industry-wide trend that has occurred as a result of increased general consumer market penetration. Costs of services and products declined to 33 percent of net operating revenue in 1993 from 37 percent in 1992 and 39 percent in 1991, generally reflecting economies gained from serving additional customer lines. The increases in selling, general and administrative expense for 1993 and 1992 resulted principally from increased commissions and customer service expenses, as well as increased advertising costs related to the growth in customer lines. Despite the increases in the amount of SG&A expense, such costs as a percentage of net operating revenues declined to 45 percent in 1993 from 48 percent in 1992 and 47 percent in 1991. Such improvement resulted primarily from an overall reduction in the unit cost of acquiring new customers and additional economies realized from providing service and support to a larger customer base. Depreciation and amortization increased during both 1993 and 1992 as additional investment in property, plant and equipment was required to meet the growth in customer lines. Product Distribution and Directory Publishing Sprint's product distribution and directory publishing businesses generated operating income of $64 million, $66 million and $62 million in 1993, 1992 and 1991, respectively. North Supply, a wholesale distributor of telecommunications products, had 1993 net operating revenues of $677 million, compared to $594 million in 1992 and $569 million in 1991. The increases primarily reflect additional nonaffiliated contracts and increased sales to the local division, partially as a result of sales during 1993 to the merged Centel telephone operations. Sprint Publishing & Advertising, a publisher and marketer of telephone directories, had net operating revenues of $268 million in 1993, compared with 1992 and 1991 net operating revenues of $257 million and $245 million, respectively. Liquidity and Capital Resources Cash Flows - Operating Activities Cash flows from operating activities, which are Sprint's primary source of liquidity, were $2.14 billion, $2.26 billion and $1.82 billion in 1993, 1992 and 1991, respectively. The 1992 operating cash flows include proceeds of $300 million from the sale of accounts receivable within the long distance division. Excluding these proceeds, the improvement in 1993 operating cash flows reflects better operating results, partially offset by expenditures related to merger, integration and restructuring actions of $155 million. Cash Flows - Investing Activities Sprint's investing activities used cash of $1.57 billion, $1.58 billion and $1.08 billion in 1993, 1992 and 1991, respectively. Capital expenditures, which represent Sprint's most significant investing activity, were $1.59 billion, $1.47 billion and $1.52 billion in 1993, 1992 and 1991, respectively (see "Business Segment Information" for the amounts incurred by each division). Long distance capital expenditures were incurred each year primarily to increase the network capacity and to enhance network capabilities for providing new products and services. Capital expenditures for the local division were made to accommodate access line growth, to continue the conversion to digital technologies, and to expand the division's capabilities for providing enhanced telecommunications services. The increases in 1993 and 1992 capital expenditures for the cellular and wireless division reflect the significant increases in the number of customer lines served during such years. Investing activities in 1992 also include $250 million paid in connection with Sprint's $530 million acquisition of the remaining 19.9 percent interest in the Limited Partnership and proceeds of $114 million from the sale of certain local telephone properties. Investing activities for 1991 include proceeds of $468 million from the divestitures of certain local telephone, cellular and other properties. Cash Flows - Financing Activities Sprint's financing activities used cash of $620 million, $681 million and $755 million in 1993, 1992 and 1991, respectively. Improved operating cash flows during each year, together with proceeds from the sale of additional accounts receivable in 1992 and from the various divestitures in 1992 and 1991, allowed Sprint to fund capital expenditures and dividends internally and to reduce total debt outstanding during each year. In addition, the $280 million note issued to the seller in connection with the acquisition of the remaining interest in the Limited Partnership was paid in 1992. During 1993 and 1992, a significant level of debt refinancing occurred in order to take advantage of lower interest rates. Accordingly, a majority of the proceeds from long-term borrowings in 1993 was used to finance the redemption prior to scheduled maturities of $1.24 billion of debt. During 1992, Sprint refinanced $720 million of long-term debt and borrowed $250 million to finance the payment related to the acquisition of the remaining 19.9 percent interest in the Limited Partnership. Sprint paid dividends to common and preferred shareholders of $347 million, $300 million and $296 million in 1993, 1992 and 1991, respectively. Sprint's indicated annual dividend rate on common stock is currently $1.00 per share. Financial Position, Liquidity and Capital Requirements As of December 31, 1993, Sprint's total capitalization aggregated $9.05 billion, consisting of long-term debt (including current maturities), redeemable preferred stock, and common stock and other shareholders' equity. Long-term debt (including current maturities) and short-term borrowings comprised 55 percent of total capitalization as of December 31, 1993, compared to 58 percent at year-end 1992 (as adjusted in both years on a proforma basis for the effects of changes in accounting principles). During 1994, Sprint anticipates funding estimated capital expenditures of $1.8 billion and dividends with cash flows from operating activities. Notes payable and commercial paper outstanding as of December 31, 1993 (classified as long-term debt) aggregated $756 million. During 1994, this entire balance will be replaced by the issuance of long-term debt or will continue to be refinanced under existing long-term credit facilities. Sprint expects its external cash requirements for 1994 to be approximately $800 million to $900 million, which is generally required to repay scheduled long-term debt maturities and reduce notes payable and commercial paper outstanding. A portion of such external cash requirements is expected to be generated from issuances of common stock through employee benefit plans and from the sale of certain investments. The method of financing the remaining external cash requirements will depend upon prevailing market conditions during the year. Sprint may also undertake additional debt refinancings during 1994 in order to take advantage of favorable interest rates. At year-end 1993, Sprint had the ability to borrow $803 million under a revolving credit agreement with a syndicate of domestic and international banks and other bank commitments. Other available financing sources include a Medium-Term Note program, under which Sprint may offer for sale up to $175 million of unsecured senior debt securities. Additionally, pursuant to shelf registration statements filed with the Securities and Exchange Commission, up to $1.2 billion of debt securities may be offered for sale. The aggregate amount of additional borrowings which can be incurred is ultimately limited by certain covenants contained in existing debt agreements. As of December 31, 1993, Sprint had borrowing capacity of approximately $2.8 billion under the most restrictive of its debt covenants. MANAGEMENT REPORT The management of Sprint Corporation has the responsibility for the integrity and objectivity of the information contained in this Annual Report. Management is responsible for the consistency of reporting such information and for ensuring that generally accepted accounting principles are used. In discharging this responsibility, management maintains a comprehensive system of internal controls and supports an extensive program of internal audits, has made organizational arrangements providing appropriate divisions of responsibility and has established communication programs aimed at assuring that its policies, procedures and codes of conduct are understood and practiced by its employees. The consolidated financial statements included in this Annual Report have been audited by Ernst & Young, independent auditors. Their audit was conducted in accordance with generally accepted auditing standards and their report is included herein. The responsibility of the Board of Directors for these financial statements is pursued primarily through its Audit Committee. The Audit Committee, composed entirely of directors who are not officers or employees of Sprint, meets periodically with the internal auditors and independent auditors, both with and without management present, to assure that their respective responsibilities are being fulfilled. The internal and independent auditors have full access to the Audit Committee to discuss auditing and financial reporting matters. /s/ W. T. Esrey William T. Esrey Chairman and Chief Executive Officer /s/ Arthur B. Krause Arthur B. Krause Executive Vice President - Chief Financial Officer REPORT OF INDEPENDENT AUDITORS The Board of Directors and Shareholders Sprint Corporation We have audited the accompanying consolidated balance sheets of Sprint Corporation (Sprint) as of December 31, 1993 and 1992, and the related consolidated statements of income, cash flows, and common stock and other shareholders' equity for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index To Financial Statements, Financial Statement Schedules and Supplementary Data. These financial statements and schedules are the responsibility of the management of Sprint. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We did not audit the financial statements or schedules of Centel Corporation, a wholly-owned subsidiary, as of December 31, 1992, or for each of the two years in the period ended December 31, 1992, which statements reflect total assets constituting 25% in 1992, and net income constituting approximately 9% in 1992 and 29% in 1991 of the related consolidated financial statement totals. Those statements and schedules were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to data included for Centel Corporation, is based solely on the report of the other auditors. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the report of other auditors provide a reasonable basis for our opinion. In our opinion, based on our audits and the report of other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Sprint Corporation at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 1 to the consolidated financial statements, Sprint changed its method of accounting for postretirement benefits, postemployment benefits and circuit activity costs in 1993 and income taxes in 1992. ERNST & YOUNG Kansas City, Missouri February 2, 1994 REPORT OF INDEPENDENT AUDITORS To the Shareowners of Centel Corporation: We have audited the consolidated balance sheet of CENTEL CORPORATION (a Kansas corporation) AND SUBSIDIARIES as of December 31, 1992, and the related consolidated statements of income, common shareowners' investment and cash flows for each of the two years in the period ended December 31, 1992, prior to the pooling of interests with Sprint Corporation (and, therefore, are not presented herein) described in Note 2 to the consolidated financial statements of Sprint Corporation for the year ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Centel Corporation and Subsidiaries as of December 31, 1992, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 1992, in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. In connection with our audits, certain auditing procedures were applied to the following schedules which are required for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. Such schedules are not included herein: Schedule I - Marketable Securities Schedule V - Consolidated Plant, Property and Equipment Schedule VI - Consolidated Accumulated Depreciation Schedule VIII - Consolidated Allowance for Doubtful Accounts Schedule IX - Consolidated Short-Term Borrowings Schedule X - Consolidated Supplementary Income Statement Information In our opinion, the information contained in these schedules fairly states, in all material respects, the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Chicago, Illinois February 3, 1993 BUSINESS SEGMENT INFORMATION Sprint Corporation As of or for the Years Ended December 31, 1993 1992 1991 (In Millions) Long Distance Communications Services <1> Net operating revenues $ 6,139.2 $ 5,658.2 $ 5,387.6 Operating expenses Interconnection 2,710.7 2,574.9 2,457.0 Operations 857.7 759.8 717.1 Selling, general and administrative 1,546.4 1,426.3 1,334.3 Depreciation and amortization 523.5 586.6 584.4 Total operating expenses <2>, <3> 5,638.3 5,347.6 5,092.8 Operating income $ 500.9 $ 310.6 $ 294.8 Capital expenditures $ 529.4 $ 468.1 $ 580.2 Identifiable assets as of December 31 $ 4,193.1 $ 4,232.0 $ 4,543.5 Local Communications Services <1> Net operating revenues $ 4,126.0 $ 3,862.2 $ 3,753.7 Operating expenses Plant operations 1,206.7 1,165.6 1,160.9 Depreciation and amortization 733.0 720.0 716.7 Other 1,232.5 1,137.0 1,036.5 Total operating expenses <2>, <4> 3,172.2 3,022.6 2,914.1 Operating income $ 953.8 $ 839.6 $ 839.6 Capital expenditures $ 845.3 $ 839.4 $ 802.4 Identifiable assets as of December 31 $ 7,604.0 $ 7,242.2 $ 7,099.6 Cellular and Wireless Communications Services <1> Net operating revenues $ 464.0 $ 322.2 $ 242.1 Operating expenses Cost of services and products 154.9 118.3 95.2 Selling, general and administrative 209.9 154.6 114.5 Depreciation and amortization 75.0 52.1 43.2 Total operating expenses <2> 439.8 325.0 252.9 Operating income (loss) $ 24.2 $ (2.8) $ (10.8) Capital expenditures $ 164.9 $ 123.8 $ 91.8 Identifiable assets as of December 31 $ 1,504.3 $ 1,489.4 $ 1,418.1 Product Distribution, Directory Publishing and Other <1> Net operating revenues $ 945.2 $ 862.9 $ 826.0 Operating income <2> $ 64.2 $ 66.0 $ 62.0 Depreciation and amortization $ 27.2 $ 32.8 $ 25.2 Capital expenditures $ 55.1 $ 34.9 $ 48.8 Identifiable assets as of December 31 $ 847.5 $ 636.0 $ 868.6 <1>Include net operating revenues and operating expenses eliminated in consolidation of $306.6 million, $285.2 million and $276.1 million for the years ended December 31, 1993, 1992 and 1991, respectively. <2>Exclude a nonrecurring charge of $259.0 million in 1993 related to the transaction costs associated with the merger with Centel and the estimated expenses of integrating and restructuring the operations of the two companies (see Note 2 of "Notes to Consolidated Financial Statements" for additional information). Such charge was allocable as follows: Long Distance-$12.4 million; Local-$190.1 million; Cellular and Wireless-$3.2 million; Product Distribution and Directory Publishing-$2.5 million; and Other-$50.8 million. <3>Exclude a nonrecurring charge of $33.5 million in 1993 related to the realignment and restructuring of the long distance division (see Note 9 of "Notes to Consolidated Financial Statements" for additional information). <4>Includes increased postretirement benefits cost of approximately $38 million in 1993 related to the adoption of SFAS No. 106. Such cost for the other divisions was not significant. CONSOLIDATED STATEMENTS OF INCOME Sprint Corporation For the Years Ended December 31, 1993 1992 1991 (In Millions, Except Per Share Data) Net Operating Revenues $11,367.8 $10,420.3 $ 9,933.3 Operating Expenses Costs of services and products 5,736.1 5,325.5 5,091.0 Selling, general and administrative 2,729.9 2,489.9 2,287.2 Depreciation and amortization 1,358.7 1,391.5 1,369.5 Merger, integration and restructuring costs 292.5 Total operating expenses 10,117.2 9,206.9 8,747.7 Operating Income 1,250.6 1,213.4 1,185.6 Gain on divestiture of telephone and cellular properties 81.1 113.9 Interest expense (452.4) (511.1) (548.3) Other expense, net (22.3) (5.0) (35.6) Income from continuing operations before income taxes 775.9 778.4 715.6 Income tax provision (295.3) (282.3) (242.9) Income From Continuing Operations 480.6 496.1 472.7 Discontinued operations, net (12.3) 49.4 Extraordinary losses on early extinguishments of debt, net (29.2) (16.0) (1.9) Cumulative effect of changes in accounting principles, net (384.2) 22.7 Net income 54.9 502.8 520.2 Preferred stock dividends (2.8) (3.5) (4.1) Earnings applicable to common stock $ 52.1 $ 499.3 $ 516.1 Earnings Per Common Share Continuing operations $ 1.39 $ 1.46 $ 1.41 Discontinued operations (0.04) 0.15 Extraordinary item (0.08) (0.05) (0.01) Cumulative effect of changes in accounting principles (1.12) 0.07 Total $ 0.15 $ 1.48 $ 1.55 Weighted average number of common shares 343.7 337.2 333.5 See accompanying notes to consolidated financial statements. CONSOLIDATED BALANCE SHEETS Sprint Corporation As of December 31, 1993 1992 Assets (In Millions) Current assets Cash and equivalents $ 76.8 $ 128.8 Accounts receivable, net of allowance for doubtful accounts of $121.9 million ($118.0 million in 1992) 1,230.6 1,044.8 Investment in common stock 130.2 Inventories 182.3 172.1 Deferred income taxes 81.1 46.5 Prepaid expenses 120.7 102.5 Other 156.2 169.3 Total current assets 1,977.9 1,664.0 Investments in common stocks 173.1 209.0 Property, plant and equipment Long distance communications services 5,492.7 5,355.9 Local communications services 11,226.4 10,732.2 Cellular and wireless communications services 569.6 409.9 Other 433.7 405.2 17,722.4 16,903.2 Less accumulated depreciation 7,407.6 6,683.3 10,314.8 10,219.9 Cellular minority partnership investments 287.5 271.2 Excess of cost over net assets acquired 736.8 765.3 Other assets 658.8 470.2 $14,148.9 $13,599.6 Liabilities and Shareholders' Equity Current liabilities Current maturities of long-term debt $ 523.4 $ 386.6 Short-term borrowings 362.3 Accounts payable 925.4 755.4 Accrued interconnection costs 487.5 464.3 Accrued taxes 307.2 291.9 Other 825.1 716.8 Total current liabilities 3,068.6 2,977.3 Long-term debt 4,571.0 4,693.8 Deferred credits and other liabilities Deferred income taxes and investment tax credits 1,182.9 1,308.3 Postretirement and other benefit obligations 793.1 69.0 Other 576.4 539.4 2,552.4 1,916.7 Redeemable preferred stock 38.6 40.2 Common stock and other shareholders' equity Common stock, par value $2.50 per share, authorized-500.0 million shares 858.5 847.1 Capital in excess of par or stated value 827.4 717.5 Retained earnings 2,184.2 2,451.7 Other 48.2 (44.7) 3,918.3 3,971.6 $14,148.9 $13,599.6 See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CASH FLOWS Sprint Corporation For the Years Ended December 31, 1993 1992 1991 (In Millions) Operating Activities Net income $ 54.9 $ 502.8 $ 520.2 Adjustments to reconcile net income to net cash provided by operating activities Depreciation and amortization 1,358.7 1,391.5 1,369.5 Gain on divestiture of telephone and cellular properties (81.1) (113.9) Discontinued operations (5.9) (20.6) (43.9) Extraordinary losses on early extinguishments of debt 49.5 25.1 3.1 Cumulative effect of changes in accounting principles 384.2 (22.7) Deferred income taxes and investment tax credits (34.5) 3.0 (34.7) Changes in operating assets and liabilities Accounts receivable, net (185.8) 257.8 42.4 Inventories and other current assets (42.7) (13.9) 52.3 Accounts payable and accrued interconnection costs 196.4 165.8 (130.1) Accrued expenses and other current liabilities 160.5 (39.0) 98.5 Noncurrent assets and liabilities, net 135.1 152.3 7.0 Other, net 66.0 (59.5) 50.2 Net cash provided by operating activities 2,136.4 2,261.5 1,820.6 Investing Activities Capital expenditures (1,594.7) (1,466.2) (1,523.2) Acquisition of Limited Partnership minority interest (250.0) Proceeds from divestiture of telephone and cellular properties 114.0 148.3 Proceeds from sale of discontinued operations 320.0 Other, net 26.3 24.3 (24.5) Net cash used by investing activities (1,568.4) (1,577.9) (1,079.4) Financing Activities Proceeds from long-term debt 840.4 951.2 645.0 Retirements of long-term debt (1,589.0) (1,257.4) (744.3) Net increase (decrease) in notes payable and commercial paper 393.5 147.0 (468.3) Payment of note payable to minority partner (280.0) Proceeds from common stock issued 70.8 51.6 54.1 Proceeds from employees stock purchase installments, net 28.3 13.2 13.9 Dividends paid (347.1) (300.1) (295.8) Other, net (16.9) (6.2) 40.7 Net cash used by financing activities (620.0) (680.7) (754.7) Increase (Decrease) in Cash and Equivalents (52.0) 2.9 (13.5) Cash and Equivalents at Beginning of Year 128.8 125.9 139.4 Cash and Equivalents at End of Year $ 76.8 $ 128.8 $ 125.9 See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF COMMON STOCK Sprint Corporation AND OTHER SHAREHOLDERS'EQUITY For the Years Ended December 31, 1993, 1992 and 1991 Capital in Excess of Par or Common Stated Retained Stock Value Earnings Other Total (In Millions) Balance as of January 1, 1991 (330.6 million shares issued and outstanding) $ 826.4 $ 554.0 $2,021.4 $ (48.3) $3,353.5 Net income 520.2 520.2 Common stock dividends (291.7) (291.7) Preferred stock dividends (4.1) (4.1) Employee stock purchase and other installments received, net 16.0 16.0 Common stock issued 10.0 85.6 (24.8) 70.8 Other, net 0.5 0.7 2.3 3.7 7.2 Balance as of December 31, 1991 (334.8 million shares issued and outstanding) 836.9 640.3 2,248.1 (53.4) 3,671.9 Net income 502.8 502.8 Common stock dividends (296.6) (296.6) Preferred stock dividends (3.5) (3.5) Employee stock purchase and other installments received, net 15.5 15.5 Common stock issued 9.9 73.7 (6.5) 77.1 Other, net 0.3 3.5 0.9 (0.3) 4.4 Balance as of December 31, 1992 (338.9 million shares issued and outstanding) 847.1 717.5 2,451.7 (44.7) 3,971.6 Net income 54.9 54.9 Common stock dividends (324.5) (324.5) Preferred stock dividends (2.8) (2.8) Employee stock purchase and other installments received, net 30.8 30.8 Common stock issued 11.0 98.4 (2.4) 107.0 Unrealized holding gains on investments in common stocks, net 64.8 64.8 Other, net 0.4 11.5 4.9 (0.3) 16.5 Balance as of December 31, 1993 (343.4 million shares issued and outstanding) $ 858.5 $ 827.4 $2,184.2 $ 48.2 $3,918.3 See accompanying notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Sprint Corporation 1. Accounting Policies Basis of Consolidation The accompanying consolidated financial statements include the accounts of Sprint Corporation and its wholly-owned and majority- owned subsidiaries (Sprint), including Centel Corporation (Centel) and Sprint Communications Company L.P. (the Limited Partnership). Investments in less than 50 percent-owned cellular communications partnerships are accounted for using the equity method. During 1991, GTE Corporation (GTE) owned a 19.9 percent interest in the Limited Partnership. Effective January 1, 1992, Sprint acquired GTE's interest in exchange for a $250 million cash payment and a $280 million note which was paid in June 1992. In accordance with industry practice, revenues and related net income of non-regulated operations attributable to transactions with Sprint's rate-regulated telephone companies have not been eliminated in the accompanying consolidated financial statements. Intercompany revenues of such entities amounted to $225 million, $194 million and $164 million in 1993, 1992 and 1991, respectively. All other significant intercompany transactions have been eliminated. Classification of Operations The long distance communications services division provides domestic voice and data communications services across certain specified geographical boundaries, as well as international long distance communications services. Rates charged for such services sold to the public are subject to different levels of state and federal regulation, but are generally not subject to rate-base regulation. The local communications services division consists principally of the operations of Sprint's rate-regulated telephone companies. These operations provide local exchange services, access by telephone customers and other carriers to local exchange facilities and long distance services within specified geographical areas. The cellular and wireless communications services division consists of wholly-owned and majority-owned interests in partnerships and corporations operating cellular and wireless communications properties in various metropolitan and rural service area markets. The product distribution and directory publishing businesses include the wholesale distribution of telecommunications products and the publishing and marketing of white and yellow page telephone directories. Revenue Recognition Operating revenues for the long distance, local and cellular/wireless communications services divisions are recognized as communications services are rendered. Operating revenues for the long distance communications services division are recorded net of an estimate for uncollectible accounts. Operating revenues for Sprint's product distribution business are recognized upon delivery of products to customers. Regulated Operations Sprint's rate-regulated telephone companies account for the economic effects of regulation pursuant to Statement of Financial Accounting Standards (SFAS) No. 71, "Accounting for the Effects of Certain Types of Regulation," which requires the accounting recognition of the rate actions of regulators where appropriate. Such actions can provide reasonable assurance of the existence of an asset, reduce or eliminate the value of an asset, or impose a liability on a regulated enterprise. Cash and Equivalents Cash equivalents generally include highly liquid investments with original maturities of three months or less and are stated at cost, which approximates market value. As of December 31, 1993 and 1992, outstanding checks in excess of cash balances of $166 million and $151 million, respectively, are included in accounts payable. Investments in Common Stocks Effective December 31, 1993, Sprint changed its method of accounting for its portfolio of marketable equity securities by adopting SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." Accordingly, such investments in common stocks are classified as available for sale and reported at fair value (estimated based on quoted market prices) as of December 31, 1993 and at cost as of December 31, 1992. As of December 31, 1993, the cost of such investments is $202 million, with the gross unrealized holding gains of $101 million reflected as an addition to other shareholders' equity, net of related income taxes. As of December 31, 1992, the market value of such investments was $278 million. Inventories Inventories, consisting principally of those related to Sprint's product distribution business, are stated at the lower of cost (principally first-in, first-out method) or market. Property, Plant and Equipment Property, plant and equipment are recorded at cost. Generally, ordinary asset retirements and disposals are charged against accumulated depreciation with no gain or loss recognized. Repairs and maintenance costs are expensed as incurred. Effective January 1, 1993, Sprint's long distance communications services division changed its method of accounting for certain costs related to connecting new customers to its network. The change was made to conform Sprint's accounting to the predominant industry practice for such costs. Under the new method, such costs (which were previously capitalized) are being expensed when incurred. The resulting nonrecurring, noncash charge of $32 million ($0.09 per share), net of related income tax benefits, is reflected in the 1993 consolidated statement of income as a cumulative effect of change in accounting principle. The proforma impact of retroactive application of the change would not have been material to net income or earnings per share for 1992 or 1991, and the impact of the change on Sprint's 1993 operating expenses was not significant. Depreciation The cost of property, plant and equipment is depreciated generally on a straight-line basis over the estimated useful lives (such lives related to regulated property, plant and equipment are those prescribed by regulatory commissions). Depreciation rate changes, special short-term amortizations and nonrecurring charges approved by regulatory commissions for the rate-regulated telephone companies resulted in additional depreciation totaling $7 million, $46 million and $49 million in 1993, 1992 and 1991, respectively. After the related effects on revenues and income taxes, these items reduced income from continuing operations for 1993, 1992 and 1991 by approximately $4 million, $24 million and $25 million, respectively. Cellular Minority Partnership Investments Cellular minority partnership investments include the excess of the purchase price over the underlying book value of cellular communications partnerships of $203 million and $209 million as of December 31, 1993 and 1992, respectively. Such excess is being amortized on a straight-line basis over 40 years; accumulated amortization aggregated $29 million and $23 million as of December 31, 1993 and 1992, respectively. Excess of Cost over Net Assets Acquired The excess of the purchase price over the fair value of net assets acquired, principally related to cellular communications services properties, is being amortized on a straight-line basis over 40 years. Accumulated amortization aggregated $112 million and $88 million as of December 31, 1993 and 1992, respectively. Postretirement Benefits Effective January 1, 1993, Sprint changed or modified its method of accounting for certain postretirement benefits by adopting SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." Sprint provides postretirement benefits (principally health care benefits) to certain retirees. SFAS No. 106 requires accrual of the expected cost of providing postretirement benefits to employees and their dependents or beneficiaries during the years employees earn the benefits. During 1992 and 1991, the cost of providing postretirement benefits to Sprint's retirees was expensed as such costs were paid, while for Centel's employees and retirees, an accrual basis approach was utilized to recognize such costs. Upon adoption of the new standard, Sprint elected to immediately recognize its previously unrecorded obligation for postretirement benefits already earned by current retirees and employees (the transition obligation), a substantial portion of which related to its rate-regulated telephone companies. Pursuant to SFAS No. 71, regulatory assets associated with the recognition of the transition obligation were recorded in jurisdictions where the regulators have issued orders specific to Sprint permitting recognition of net postretirement benefits costs for ratemaking purposes, and providing for recovery of the transition obligation over a period of no longer than 20 years. As of December 31, 1993, such regulatory assets aggregated $83 million. In all other jurisdictions, regulatory assets associated with the recognition of the transition obligation were not recorded due to the uncertainties as to the timing and extent of recovery. The resulting nonrecurring, noncash charge of $341 million ($1.00 per share), net of related income tax benefits, is reflected in the 1993 consolidated statement of income as a cumulative effect of change in accounting principle. Net postretirement benefits cost for 1993 increased approximately $50 million as a result of adopting SFAS No. 106. Postemployment Benefits Effective January 1, 1993, Sprint adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits." Upon adoption, Sprint recognized certain previously unrecorded obligations for benefits being provided to former or inactive employees and their dependents, after employment but before retirement. Such postemployment benefits offered by Sprint include severance, disability and workers compensation benefits, including the continuation of other benefits such as health care and life insurance coverage. The resulting nonrecurring, noncash charge of $11 million ($0.03 per share), net of related income tax benefits, is reflected in the 1993 consolidated statement of income as a cumulative effect of change in accounting principle. Adoption of SFAS No. 112 had no significant impact on operating expenses in 1993. Income Taxes Effective January 1, 1992, Sprint changed its method of accounting for income taxes by adopting SFAS No. 109, "Accounting for Income Taxes." SFAS No. 109 requires an asset and liability approach to accounting for income taxes and establishes less restrictive criteria for recognizing deferred income tax assets. Accordingly, Sprint adjusted its existing deferred income tax assets and liabilities to reflect current statutory income tax rates and previously unrecognized tax benefits related to federal and certain state net operating loss carryforwards. To the extent reductions of the rate-regulated telephone companies' deferred income tax liabilities will accrue to the benefit of its customers, such reductions were recorded as regulatory liabilities. The remaining net change in Sprint's deferred income tax assets and liabilities increased 1992 net income by $23 million ($0.07 per share) and is reflected in the consolidated statement of income as a cumulative effect of change in accounting principle. As allowed under SFAS No. 109, prior years' consolidated financial statements were not restated. During 1991, in accordance with Accounting Principles Board Opinion (APB) No. 11, deferred income taxes were provided for all differences in timing of reporting income and expenses for financial statement and income tax purposes, except for rate- regulated telephone companies' items that were not allowable by various regulatory commissions as expenses for rate-making purposes. Investment tax credits related to regulated telephone property, plant and equipment have been deferred and are being amortized over the estimated useful lives of the related assets. Interest Charged to Construction Regulatory commissions allow the rate-regulated telephone companies to capitalize an allowance for funds expended during construction. Amounts capitalized will be recovered over the service lives of the respective assets constructed as the resulting higher depreciation is recovered through increased revenues. Interest costs associated with the construction of capital assets for Sprint's other operations are capitalized in accordance with SFAS No. 34, "Capitalization of Interest Costs." Total interest amounts capitalized during 1993, 1992 and 1991, including an allowance for funds expended during construction, totaled $8 million, $11 million and $15 million, respectively. Earnings Per Share Earnings per common share amounts are based on the weighted average number of shares both outstanding and issuable assuming exercise of all dilutive options, as applicable. Reclassifications Certain amounts in the accompanying consolidated financial statements for 1992 and 1991 have been reclassified to conform to the presentation of amounts in the 1993 consolidated financial statements. Such reclassifications had no effect on the results of operations. 2. Sprint / Centel Merger Effective March 9, 1993, Sprint consummated its merger with Centel, a telecommunications company with local exchange and cellular/wireless communications services operations. Pursuant to the Agreement and Plan of Merger dated May 27, 1992, Sprint issued 1.37 shares of its common stock in exchange for each outstanding share of Centel common stock, or approximately 119 million shares. The transaction costs associated with the merger (consisting primarily of investment banking and legal fees) and the estimated expenses of integrating and restructuring the operations of the two companies (consisting primarily of employee severance and relocation expenses and costs of eliminating duplicative facilities) resulted in nonrecurring charges of $259 million, which reduced 1993 income from continuing operations by $172 million ($0.50 per share). The merger has been accounted for as a pooling of interests. Accordingly, the accompanying consolidated financial statements have been retroactively restated for all periods presented to include the results of operations, financial position and cash flows of Centel. In addition, the accompanying consolidated financial statements reflect the elimination of significant, recurring intercompany transactions and certain adjustments to conform the accounting policies of the two companies. Operating results of the separate companies for periods prior to the merger are as follows (in millions): 1992 1991 Net operating revenues Sprint $ 9,230.4 $ 8,779.7 Centel 1,191.4 1,180.5 Eliminations and reclassifications (1.5) (26.9) Total $ 10,420.3 $ 9,933.3 Income from continuing operations Sprint $ 427.2 $ 367.5 Centel 83.8 112.3 Accounting conformity adjustments (14.9) (7.1) Total 496.1 472.7 Discontinued operations, net 49.4 Extraordinary losses on early extinguishments of debt, net (1992: Sprint - $6.5 million, Centel - $9.5 million; 1991: Centel - $1.9 million) (16.0) (1.9) Cumulative effect of change in accounting for income taxes 22.7 Net income (1992: Sprint - $457.1 million, Centel - $45.7 million; 1991: Sprint - $367.5 million, Centel - $152.7 million) $ 502.8 $ 520.2 3. Employee Benefit Plans Defined Benefit Pension Plan Substantially all Sprint employees are covered by a noncontributory defined benefit pension plan. For participants of the plan represented by collective bargaining units, benefits are based upon schedules of defined amounts as negotiated by the respective parties. For participants not covered by collective bargaining agreements, the plan provides pension benefits based upon years of service and participants' compensation. Sprint's policy is to make contributions to the plan each year equal to an actuarially determined amount consistent with applicable federal tax regulations. The funding objective is to accumulate funds at a relatively stable rate over the participants' working lives so that benefits are fully funded at retirement. As of December 31, 1993, the plan's assets consisted principally of investments in corporate equity securities and U.S. government and corporate debt securities. The components of the net pension credits and related weighted average assumptions are as follows (in millions): 1993 1992 1991 Service cost -- benefits earned during the period $ 58.2 $ 50.8 $ 47.8 Interest cost on projected benefit obligation 103.9 96.1 87.2 Actual return on plan assets (241.2) (89.5) (381.7) Net amortization and deferral 62.5 (64.7) 231.4 Net pension credit $ (16.6) $ (7.3) $ (15.3) Discount rate 8.0% 8.4% 8.6% Expected long-term rate of return on plan assets 9.5% 8.5% 8.5% Anticipated composite rate of future increases in compensation 5.5% 6.2% 7.3% In addition, Sprint recognized pension curtailment losses of $3 million in 1993 as a result of integration and restructuring actions (see Notes 2 and 9). The funded status and amounts recognized in the consolidated balance sheets for the plan, as of December 31, are as follows (in millions): 1993 1992 Actuarial present value of benefit obligations Vested benefit obligation $ (1,277.0) $ (1,043.6) Accumulated benefit obligation $ (1,462.7) $ (1,183.2) Projected benefit obligation $ (1,582.9) $ (1,321.2) Plan assets at fair value 2,029.0 1,862.4 Plan assets in excess of the projected benefit obligation 446.1 541.2 Unrecognized net gains (197.3) (215.1) Unrecognized prior service cost 88.1 23.0 Unamortized portion of transition asset (221.9) (247.3) Prepaid pension cost $ 115.0 $ 101.8 The projected benefit obligations as of December 31, 1993 and 1992 were determined using discount rates of 7.5 percent and 8.0 percent, respectively, and anticipated composite rates of future increases in compensation of 4.5 percent and 5.5 percent, respectively. Defined Contribution Plans Sprint sponsors defined contribution employee savings plans covering substantially all employees. Participants may contribute portions of their compensation to the plans. Contributions of participants represented by collective bargaining units are matched by Sprint based upon defined amounts as negotiated by the respective parties. Contributions of participants not covered by collective bargaining agreements are also matched by Sprint. For these participants, Sprint provides matching contributions in common stock equal to 50 percent of participants' contributions up to 6 percent of their compensation and may, at the discretion of the Board of Directors, provide additional matching contributions based upon the performance of Sprint's common stock in comparison to other telecommunications companies. Sprint's matching contributions (including cash contributions under the former Centel savings plans) aggregated $49 million, $40 million and $36 million in 1993, 1992 and 1991, respectively. Postretirement Benefits Sprint sponsors postretirement benefits (principally health care benefits) arrangements covering substantially all employees. Employees who retired before specified dates are eligible for these benefits at no cost or a reduced cost. Employees retiring after specified dates are eligible for these benefits on a shared cost basis. Sprint funds the accrued costs as benefits are paid. The components of the 1993 net postretirement benefits cost are as follows (in millions): Service cost -- benefits earned during the period $ 22.1 Interest on accumulated benefit obligation 56.5 Net postretirement benefits cost $ 78.6 For measurement purposes, an annual health care cost trend rate of 13 percent was assumed for 1993, gradually decreasing to 6 percent by 2001 and remaining constant thereafter. The effect of a one percent increase in the assumed trend rates would have increased the 1993 net postretirement benefits cost by approximately $14 million. The weighted average discount rate for 1993 was 8.0 percent. In addition, the Company recognized postretirement benefits curtailment losses of $11 million in 1993 as a result of integration and restructuring actions (see Notes 2 and 9). The cost of providing postretirement benefits was $28 million in 1992 and $29 million in 1991. The amount recognized in the consolidated balance sheet as of December 31, 1993 is as follows (in millions): Accumulated postretirement benefits obligation Retirees $ 322.8 Active plan participants -- fully eligible 158.0 Active plan participants -- other 254.4 735.2 Unrecognized prior service benefit 6.8 Unrecognized net gains 38.9 Accrued postretirement benefits cost $ 780.9 The accumulated benefits obligation as of December 31, 1993 was determined using a discount rate of 7.5 percent. An annual health care trend rate of 12 percent was assumed for 1994, gradually decreasing to 6 percent by 2001 and remaining constant thereafter. The effect of a one percent annual increase in the assumed health care cost trend rates would have increased the accumulated benefits obligation as of December 31, 1993 by approximately $98 million. 4. Income Taxes The components of the income tax provisions allocated to continuing operations are as follows (in millions): 1993 1992 1991 Current income tax provision Federal $ 275.6 $ 242.1 $ 232.9 State 54.2 37.2 44.7 Amortization of deferred investment tax credits (24.7) (31.3) (34.6) 305.1 248.0 243.0 Deferred income tax provision (benefit) Federal 16.4 9.5 (6.4) State (26.2) 24.8 6.3 (9.8) 34.3 (0.1) Total income tax provision $ 295.3 $ 282.3 $ 242.9 On August 10, 1993, the Revenue Reconciliation Act of 1993 was enacted which, among other changes, raised the federal income tax rate for corporations to 35 percent from 34 percent, retroactive to January 1, 1993. Accordingly, Sprint adjusted its deferred income tax assets and liabilities to reflect the revised rate. The resulting adjustment related to Sprint's nonregulated subsidiaries increased the 1993 deferred income tax provision by $13 million ($0.04 per share). Adjustments to the net deferred income tax liabilities associated with the rate-regulated telephone companies were generally recorded as reductions to regulatory liabilities and, accordingly, had no immediate effect on Sprint's net income. The differences which cause the effective income tax rate to vary from the statutory federal income tax rate of 35 percent in 1993 and 34 percent in 1992 and 1991 are as follows (in millions): 1993 1992 1991 Income tax provision at the statutory rate $ 271.6 $ 264.7 $ 243.3 Less investment tax credits included in income 24.7 31.3 34.6 Expected federal income tax provision after investment tax credits 246.9 233.4 208.7 Effect of State income taxes, net of federal income tax effect 18.2 40.9 33.7 Differences required to be flowed through by regulatory commissions 6.0 5.6 5.7 Reversal of rate differentials (13.0) (16.3) (23.7) Amortization of intangibles 8.8 8.6 8.3 Merger related costs 18.0 Other, net 10.4 10.1 10.2 Income tax provision, including investment tax credits $ 295.3 $ 282.3 $ 242.9 Effective income tax rate 38% 36% 34% The income tax provisions (benefits) allocated to other items are as follows (in millions): 1993 1992 1991 Discontinued operations $ (6.6) $ 15.3 Extraordinary losses on early extinguishments of debt (20.3) $ (9.1) (1.2) Cumulative effect of changes in accounting principles Postretirement benefits (216.7) Postemployment benefits (6.7) Circuit activity costs (21.5) Unrealized holding gains on investments in common stocks (recorded directly to shareholders' equity) 36.5 Stock ownership, purchase and options arrangements (recorded directly to shareholders' equity) (10.6) (6.0) (2.7) Effective with the adoption of SFAS No. 109 in 1992, deferred income taxes are provided for the temporary differences between the carrying amounts of Sprint's assets and liabilities for financial statement purposes and their tax bases. The sources of the differences that give rise to the deferred income tax assets and liabilities as of December 31, 1993 and 1992, along with the income tax effect of each, are as follows (in millions): 1993 Deferred 1992 Deferred Income Tax Income Tax Assets Liabilities Assets Liabilities Property, plant and equipment $ 1,564.0 $ 1,522.6 Postretirement and other benefits $ 281.1 $ 25.6 Alternative minimum tax credit carryforwards 259.7 311.6 Operating loss carryforwards 64.7 70.2 Integration and restructuring costs 35.0 Other, net 9.9 10.2 Subtotal 640.5 1,573.9 417.6 1,522.6 Less valuation allowance 24.5 30.2 Total $ 616.0 $ 1,573.9 $ 387.4 $ 1,522.6 During 1993 and 1992, the valuation allowance related to deferred income tax assets decreased $6 million and $5 million, respectively. During 1991, in accordance with APB No. 11, deferred income tax provisions resulted from the differences in the timing of recognizing certain revenues and expenses for financial statement and income tax purposes. The sources of the differences, along with the income tax effect of each, are as follows (in millions): Property, plant and equipment $ 86.5 Allowance for doubtful accounts 8.9 Deferred revenue (2.9) Expense accruals (9.0) Exchangeable debentures 7.0 Alternative minimum tax credit carryforwards (90.8) Investment tax credit carryforwards 5.9 Special partnership allocations 25.3 Sale of telephone properties (32.2) Other, net 1.2 Total $ (0.1) As of December 31, 1993, Sprint has available, for income tax purposes, $260 million of alternative minimum tax credit carryforwards to offset regular income tax payable in future years, and tax benefits of $65 million associated with state operating loss carryforwards. The loss carryforwards expire in varying amounts annually from 1994 through 2008. 5. Debt Long-term debt, as of December 31, is as follows (in millions): Maturing 1993 1992 Corporate Senior notes 9.75% 1993 $ 100.0 8.60% to 9.71% 1994 $ 225.0 225.0 9.45% 1995 50.0 50.0 10.45% 1996 200.0 200.0 9.88% 1997 120.0 160.0 9.19% to 9.60% 1998 43.0 43.0 8.13% to 9.80% 2000 to 2003 632.3 632.3 Debentures 9.25% 2022 200.0 200.0 Subordinated debentures 8.00% 2006 204.8 Notes payable and commercial paper, classified as long-term debt 1996 634.4 Other 11.88% 1999 4.5 5.6 Long Distance Communications Services Vendor financing agreements 6.99% to 10.18% 1994 to 2001 423.4 538.5 Note payable to GTE 5.30% 1993 72.8 Local Communications Services First mortgage bonds 4.63% to 9.00% 1994 to 1998 167.4 260.3 2.00% to 9.37% 1999 to 2003 541.1 487.1 4.00% to 8.75% 2004 to 2008 353.0 344.3 6.88% to 9.79% 2009 to 2013 80.0 32.6 8.77% to 8.78% 2014 to 2018 80.5 216.3 7.13% to 9.89% 2019 to 2023 343.1 268.9 Debentures and notes 4.50% to 9.61% 1994 to 2017 424.4 340.1 Notes payable and commercial paper, classified as long-term debt 1996 121.4 Other 2.00% to 19.45% 1994 to 2017 17.3 20.7 Other Senior notes 9.88% to 11.70% 1998 to 2000 277.1 281.0 Debentures 9.00% 2019 150.0 229.2 Other 8.59% to 13.00% 1995 to 1998 6.5 167.9 Subtotal 5,094.4 5,080.4 Less current maturities 523.4 386.6 Long-term debt $4,571.0 $4,693.8 Long-term debt maturities during each of the next five years are as follows (in millions): Amount 1994 $ 523.4 1995 216.8 1996 1,104.2 1997 100.7 1998 385.3 Property, plant and equipment with an aggregate cost of approximately $10.36 billion is either pledged as security for first mortgage bonds and certain notes or is restricted for use as mortgaged property. Notes payable and commercial paper outstanding and related weighted average interest rates, as of December 31, are as follows (in millions): 1993 1992 Bank notes, 3.55% weighted average interest rate $ 397.5 $ 206.3 Master Trust notes, 3.71% weighted average interest rate 250.0 80.0 Commercial paper, 3.29% weighted average interest rate 108.3 76.0 Total notes payable and commercial paper $ 755.8 $ 362.3 Notes payable and commercial paper outstanding as of December 31, 1993 are classified as long-term debt due to Sprint's intent to refinance such borrowings on a long-term basis and due to its demonstrated ability to do so pursuant to the $1.1 billion revolving credit agreement described below. Such borrowings as of December 31, 1992 were classified as short-term borrowings. The bank notes are renewable at various dates throughout the year. Sprint pays a fee to certain commercial banks to support current and future credit requirements based upon loan commitments. Lines of credit may be withdrawn by the banks if there is a material adverse change in Sprint's financial condition. Sprint has a Master Trust Note Agreement with the trust division of a bank to borrow funds on demand. Interest on such borrowings is at a rate that yields interest equivalent to the most favorable discount rate paid on 180-day commercial paper. As of December 31, 1993, Sprint had a total of $1.31 billion of credit arrangements, consisting of various bank commitments and a $1.1 billion revolving credit agreement with a syndicate of domestic and international banks. At that date, Sprint had availability totaling $803 million under such arrangements. The revolving credit agreement expires in July 1996 and, subject to the approval of the lenders, may be extended for up to an additional two years. During 1993 and 1992, Sprint redeemed or called for redemption prior to scheduled maturities $1.34 billion and $720 million, respectively, of first mortgage bonds, senior notes and debentures. Excluding amounts deferred by the rate-regulated telephone companies as required by certain regulatory commissions, the prepayment penalties incurred in connection with early extinguishments of debt and the write-off of related debt issuance costs aggregated $29 million in 1993 and $16 million in 1992, net of related income tax benefits, and are reflected as extraordinary losses in the consolidated statements of income. In 1991, extraordinary losses of $2 million, net of related income tax benefits, were recorded related to the early extinguishment and defeasance of debt. 6. Redeemable Preferred Stock Sprint has 20 million authorized shares and subsidiaries have approximately 6 million authorized shares of preferred stock, including non-redeemable preferred stock. The redeemable preferred stock outstanding, as of December 31, is as follows (in millions): 1993 1992 Third series -- stated value $100 per share, shares - 208,000 in 1993 and 220,000 in 1992, non-participating, non-voting, cumulative 7.75% annual dividend rate $ 20.8 $ 22.0 Fifth series -- stated value $100,000 per share, shares - 95 in 1993 and 1992, voting, cumulative 6% annual dividend rate 9.5 9.5 Subsidiaries -- stated value ranging from $10 to $100 per share, shares - 380,055 in 1993 and 395,765 in 1992, annual dividend rates ranging from 4.7% to 5.4% 8.3 8.7 Total redeemable preferred stock $ 38.6 $ 40.2 Sprint's third series preferred stock is redeemed through a sinking fund at the rate of 12,000 shares, or $1.2 million per year, until 2008, at which time all remaining shares are to be redeemed. Sprint may redeem additional third series preferred shares at $102.55 per share during 1994, and at declining amounts in succeeding years. In the event of default, the holders of Sprint's third series redeemable preferred stock are entitled to elect a certain number of directors until all arrears in dividend and sinking fund payments have been paid. Sprint's fifth series preferred stock must be redeemed in full in 2003. If less than full dividends have been paid for four consecutive dividend periods or if the total amount of dividends in arrears exceeds an amount equal to the dividend payment for six dividend periods, the holders of the fifth series preferred stock are entitled to elect a majority of directors standing for election until all arrears in dividend payments have been paid. 7. Common Stock Common stock activity during 1993 and shares reserved for future grants under stock option plans or future issuances under various arrangements are as follows (in millions): Number of Shares 1993 Reserved as of Activity December 31, 1993 Employees Stock Purchase Plan 0.1 3.3 Employee savings plans 1.4 5.0 Automatic Dividend Reinvestment Plan 0.4 1.3 Officer and key employees' and Directors' stock options 2.2 12.2 Conversion of preferred stock and other 0.4 2.1 Total 4.5 23.9 As of December 31, 1993, elections to purchase 2.6 million of Sprint's common shares were outstanding under the 1992 offering of the Employees Stock Purchase Plan. The purchase price under the offering cannot exceed $19.66 per share, such price representing 85 percent of the average market price on the offering date, or fall below $12.00 per share. The 1992 offering terminates on June 30, 1994. Under various stock option plans, shares of common stock are reserved for issuance to officers, other key employees and outside directors. All options are granted at 100 percent of the market price at date of grant. Approximately 6 percent of all options outstanding as of December 31, 1993 provide for the granting of stock appreciation rights as an alternate method of settlement upon exercise. The stock appreciation rights feature allows the optionee to elect to receive any gain in the stock price on the underlying option directly from Sprint, either in stock or in cash or a combination of the two, in lieu of exercising the option by payment of the purchase price. A summary of stock option activity under the plans is as follows (in millions, except per share data): Per Share Number Exercise Aggregate of Price Exercise Shares Low High Amount Shares under option as of January 1, 1993 (5.5 million shares exercisable) 7.5 $ 9.44 $ 39.31 $ 170.2 Granted 1.6 27.50 38.44 50.3 Exercised Options without stock appreciation rights (2.1) 9.44 33.75 (41.0) Options with stock appreciation rights (0.3) 11.09 29.68 (5.5) Terminated and expired (0.1) 18.16 33.75 (3.2) Shares under option as of December 31, 1993 (4.5 million shares exercisable) 6.6 $ 9.44 $ 39.31 $ 170.8 During 1990, the Savings Plan Trust, an employee savings plan, acquired shares of common stock from Sprint in exchange for a $75 million promissory note payable to Sprint. The note bears an interest rate of 9 percent and is to be repaid from the common stock dividends received by the plan and the contributions made to the plan by Sprint in accordance with plan provisions. The remaining balance of the note receivable of $60 million as of December 31, 1993 is reflected as a reduction to other shareholders' equity. Under a Shareholder Rights plan, one-half of a Preferred Stock Purchase Right is attached to each share of common stock. Each Right, which is exercisable and detachable only upon the occurrence of certain takeover events, entitles shareholders to buy units consisting of one one-hundredth of a newly issued share of Preferred Stock-Fourth Series, Junior Participating at a price of $235 per unit or, in certain circumstances, common stock. Under certain circumstances, Rights beneficially owned by an acquiring person become null and void. Sprint's Preferred Stock- Fourth Series is without par value. It is voting, cumulative and accrues dividends equal generally to the greater of $10 per share or one hundred times the aggregate per share amount of all common stock dividends. No shares of Preferred Stock-Fourth Series were issued or outstanding at December 31, 1993. The Rights may be redeemed by Sprint at a price of one cent per Right and will expire on September 8, 1999. During 1993, 1992 and 1991, Sprint declared and paid annual dividends on common stock of $1.00 per share, and Centel declared pre-merger common stock dividends of $0.15, $0.90 and $0.89 per share, respectively. The most restrictive covenant applicable to dividends on common stock results from the $1.1 billion revolving credit agreement. Among other restrictions, this agreement requires Sprint to maintain specified levels of consolidated net worth, as defined. As a result of this requirement, $1.45 billion of Sprint's $2.18 billion consolidated retained earnings were effectively restricted from the payment of dividends as of December 31, 1993. The indentures and financing agreements of certain of Sprint's subsidiaries contain various provisions restricting the payment of cash dividends on subsidiary common stock held by Sprint. In connection with these restrictions, $749 million of the related subsidiaries' $1.79 billion total retained earnings is restricted as of December 31, 1993. The flow of cash in the form of advances from the subsidiaries to Sprint is generally not restricted. 8. Commitments and Contingencies Litigation, Claims and Assessments During 1993, an agreement for settlement was reached related to a class action complaint filed in January 1992 against Sprint and certain of its officers and directors, amending a complaint originally filed in 1990. The plaintiffs in the class action alleged violations of various federal securities laws and related state laws and, among other relief, sought unspecified compensatory damages. The settlement, which is subject to approval by the court, totaled $29 million, of which approximately 60 percent will be recovered from Sprint's insurance carriers. The net settlement did not have a significant effect on Sprint's 1993 results of operations. Following announcement of Sprint's merger with Centel, class action suits were filed against Centel and certain of its officers and directors in federal and state courts. The state suits have been dismissed, while the federal suits have been consolidated into a single action and seek damages for alleged violations of securities laws. These and various other suits arising in the ordinary course of business are pending against Sprint. Management cannot predict the ultimate outcome of these actions but believes they will not result in a material effect on Sprint's consolidated financial statements. Accounts Receivable Sold with Recourse Under an agreement available through January 1995, Sprint may sell on a continuous basis, with recourse, up to $600 million of undivided interests in a designated pool of its accounts receivable. Subsequent collections of receivables sold to investors are typically reinvested in the pool. On a quarterly basis, subject to the approval of the investors, Sprint may extend the agreement for an additional ninety days. During 1992, proceeds of $300 million were received under the arrangement. Receivables sold that remained uncollected as of December 31, 1993 and 1992 aggregated $600 million. Operating Leases Minimum rental commitments as of December 31, 1993 for all non- cancelable operating leases, consisting principally of leases for data processing equipment and real estate, are as follows (in millions): Amount 1994 $ 304.1 1995 251.4 1996 171.1 1997 100.6 1998 83.8 Thereafter 243.6 Gross rental expense aggregated $387 million, $385 million and $397 million in 1993, 1992 and 1991, respectively. The amount of rental commitments applicable to subleases, contingent rentals and executory costs is not significant. 9. Additional Financial Information Segment Information See "Business Segment Information." Realignment and Restructuring Charge During 1993, Sprint initiated a realignment and restructuring of its long distance communications services division, including the elimination of approximately 1,000 positions and the closure of two facilities. These actions are expected to improve market focus, lower costs and streamline operations within the division, and resulted in a nonrecurring charge of $34 million, which reduced income from continuing operations by $21 million ($0.06 per share). Divestiture of Telephone and Cellular Properties During 1992, the sale of Centel's local telephone operations in Ohio was completed, pursuant to a definitive agreement reached in November 1991. Proceeds from the sale aggregated $129 million, including $114 million of cash and $15 million of assumed debt; a gain of $44 million ($0.13 per share), net of related income taxes, was realized on the sale. During 1991, the sales of Centel's local telephone operations in Minnesota and Iowa were completed, pursuant to a definitive agreement reached in November 1990. Proceeds from the sales included $116 million in cash, 2,885,000 shares of Rochester Telephone Corporation common stock with a value of $84 million and ownership rights in various cellular franchises with a value of $28 million. Gains of $64 million ($0.19 per share), net of related income taxes, were realized on the sales. Also during 1991, 50 percent of Centel's interest in a cellular limited partnership was divested. Cash proceeds of $36 million were received, and a gain of $14 million ($0.04 per share), net of related income taxes, was realized on this divestiture. Discontinued Operations During 1991, pursuant to a definitive agreement reached in December 1990, the sale of Centel's electric operations was completed for $320 million in cash and $26 million of assumed liabilities. A gain of $37 million, net of related income taxes, was realized on the sale. Revenues related to discontinued operations were $178 million in 1991. Financial Instruments The carrying amounts and estimated fair values of Sprint's long-term debt, as of December 31, are as follows (in millions): 1993 1992 Estimated Estimated Carrying Fair Carrying Fair Amount Value Amount Value Long-term debt Corporate $ 2,109.2 $ 2,377.2 $ 1,820.7 $ 1,957.3 Long distance communications services 423.4 447.8 611.3 656.7 Local communications services 2,128.2 2,342.5 1,970.3 2,032.3 Other 433.6 534.6 678.1 705.4 The fair values of Sprint's long-term debt are estimated based on quoted market prices for publicly-traded issues, and based on the present value of estimated future cash flows using a discount rate commensurate with the risks involved for all other issues. The carrying values of Sprint's other financial instruments (principally cash equivalents, temporary investments, short-term borrowings, interest rate swap/cap agreements and foreign currency contracts) approximate fair value as of December 31, 1993 and 1992. Supplemental Cash Flows Information 1993 1992 1991 Cash paid for (in millions) Interest $ 453.6 $ 507.5 $ 568.7 Income taxes $ 292.4 $ 269.0 $ 244.8 During 1993, 1992 and 1991, Sprint contributed previously unissued shares of its common stock with market values of $39 million, $28 million and $25 million, respectively, to the employee savings plans. SPRINT CORPORATION SCHEDULE V -- CONSOLIDATED PROPERTY, PLANT AND EQUIPMENT Year Ended December 31, 1993 (In Millions) Balance Balance beginning Additions Other end of of year at cost Retirements changes year LONG DISTANCE COMMUNICATIONS SERVICES Digital fiber- optic network $ 3,976.9 $ 367.0 $ 153.0 (101.5)<1> $ 4,089.4 Data communications equipment 301.9 54.5 11.4 (64.8)<2> 280.2 Administrative assets 864.5 81.1 30.8 (31.2)<2> 883.6 Construction-in- progress 212.6 26.8 0.1 239.5 Subtotal 5,355.9 529.4 195.2 (197.4) 5,492.7 LOCAL COMMUNICATIONS SERVICES Land and buildings 636.5 29.7 6.2 660.0 Other general support assets 624.7 75.1 58.2 (0.7) 640.9 Cable and wire facility assets 5,150.8 324.9 71.5 5,404.2 Central office assets 3,855.7 387.8 163.6 3.3 4,083.2 Information origination/ termination assets 333.6 51.1 49.1 (0.2) 335.4 Telephone plant under construction 130.9 (23.3) (4.9) 102.7 Subtotal 10,732.2 845.3 348.6 (2.5) 11,226.4 CELLULAR AND WIRELESS COMMUNICATIONS SERVICES 409.9 164.9 3.3 (1.9) 569.6 PRODUCT DISTRIBUTION, DIRECTORY PUBLISHING AND OTHER 405.2 55.1 24.8 (1.8) 433.7 $ 16,903.2 $ 1,594.7 $ 571.9 $ (203.6) $ 17,722.4 Depreciation is computed on a straight-line basis. The weighted average annual composite depreciation rate for the rate-regulated local division, excluding special short-term amortizations and nonrecurring charges, was 6.7 percent in 1993. <1>Adjustment primarily represents reductions to plant due to a change in the method of accounting for certain costs related to connecting new customers to the network. See Note 1 of "Notes to Consolidated Financial Statements" for additional information. <2>Adjustments primarily represent the contribution of plant to a joint venture. SPRINT CORPORATION SCHEDULE V -- CONSOLIDATED PROPERTY, PLANT AND EQUIPMENT Year Ended December 31, 1992 (In Millions) Balance Balance beginning Additions Other end of of year at cost Retirements changes year LONG DISTANCE COMMUNICATIONS SERVICES Digital fiber- optic network $ 3,899.1 $ 356.8 $ 230.2 $ (48.8)<1><2> $ 3,976.9 Data communications equipment 243.9 51.2 3.7 10.5 <2> 301.9 Administrative assets 932.0 76.6 76.5 (67.6)<2> 864.5 Construction-in -progress 227.7 (16.5) 1.4 212.6 Subtotal 5,302.7 468.1 310.4 (104.5) 5,355.9 LOCAL COMMUNICATIONS SERVICES Land and buildings 598.7 53.5 15.3 (0.4) 636.5 Other general support assets 593.8 81.6 51.5 0.8 624.7 Cable and wire facility assets 4,959.2 292.9 101.2 (0.1) 5,150.8 Central office assets 3,688.3 377.2 210.4 0.6 3,855.7 Information origination/ termination assets 527.4 42.4 237.0 0.8 333.6 Telephone plant under construction 140.2 (8.2) (1.1) 130.9 Subtotal 10,507.6 839.4 615.4<3> 0.6 10,732.2 CELLULAR AND WIRELESS COMMUNICATIONS SERVICES 298.4 123.8 8.2 (4.1) 409.9 PRODUCT DISTRIBUTION, DIRECTORY PUBLISHING AND OTHER 398.8 34.9 29.3 0.8 405.2 $ 16,507.5 $ 1,466.2 $ 963.3 $ (107.2) $ 16,903.2 Depreciation is computed on a straight-line basis. The weighted average annual composite depreciation rate for the rate-regulated local division, excluding special short-term amortizations and nonrecurring charges, was 6.6 percent in 1992. <1>Adjustment represents an adjustment pursuant to Accounting Principles Board Opinion No. 16 related to the acquisition of the remaining 19.9% of the Limited Partnership, partially offset by reclassifications of plant among categories. <2>Adjustments represent the reclassification of plant among categories. <3>Retirements include approximately $95 million related to the divestiture of Centel's local telephone operations in Ohio. SPRINT CORPORATION SCHEDULE V -- CONSOLIDATED PROPERTY, PLANT AND EQUIPMENT Year Ended December 31, 1991 (In Millions) Balance Balance beginning Additions Other end of of year at cost Retirements changes year LONG DISTANCE COMMUNICATIONS SERVICES Digital fiber- optic network $ 3,619.1 $ 451.6 $ 137.5 $(34.1)<1> $ 3,899.1 Data communications equipment 178.4 54.0 3.3 14.8 <2> 243.9 Administrative assets 835.1 136.8 39.2 (0.7) 932.0 Construction-in -progress 289.9 (62.2) 227.7 Subtotal 4,922.5 580.2 180.0 (20.0) 5,302.7 LOCAL COMMUNICATIONS SERVICES Land and buildings 585.9 27.0 15.0 0.8 598.7 Other general support assets 564.8 75.7 49.4 2.7 593.8 Cable and wire facility assets 4,801.0 308.1 149.8 (0.1) 4,959.2 Central office assets 3,580.2 348.3 238.5 (1.7) 3,688.3 Information origination/ termination assets 708.7 33.1 215.0 0.6 527.4 Telephone plant under construction 131.4 10.2 0.1 (1.3) 140.2 Subtotal 10,372.0 802.4 667.8<3> 1.0 10,507.6 CELLULAR AND WIRELESS COMMUNICATIONS SERVICES 222.5 91.8 14.5 (1.4) 298.4 PRODUCT DISTRIBUTION, DIRECTORY PUBLISHING AND OTHER 363.9 48.8 13.8 (0.1) 398.8 $ 15,880.9 $ 1,523.2 $ 876.1 $ (20.5) $ 16,507.5 Depreciation is computed on a straight-line basis. The weighted average annual composite depreciation rate for the rate-regulated local division, excluding special short-term amortizations and nonrecurring charges, was 6.3 percent in 1991. <1>Adjustment primarily represents the reclassification of plant between categories and to inventories. <2>Adjustment represents the reclassification of plant between categories. <3>Retirements include approximately $213 million related to the divestiture of Centel's local telephone operations in Minnesota and Iowa. SPRINT CORPORATION SCHEDULE VI -- CONSOLIDATED ACCUMULATED DEPRECIATION Year Ended December 31, 1993 (In Millions) Balance Additions Balance beginning charged to Other end of of year income Retirements Changes year LONG DISTANCE COMMUNICATIONS SERVICES Digital fiber- optic network $1,258.4 $357.4 $105.4 $(62.6)<3> $1,447.8 Data communications equipment 169.5 37.7 9.2 (18.4)<4> 179.6 Administrative assets 507.2 122.7 30.7 (13.3)<4> 585.9 Subtotal 1,935.1 517.8 145.3 (94.3) 2,213.3 LOCAL COMMUNICATIONS SERVICES Buildings 180.1 22.0 6.2 (2.5) 193.4 Other general support assets 318.0 67.5 58.0 4.6 332.1 Cable and wire facility assets 2,172.8 301.1 71.5 (12.2) 2,390.2 Central office assets 1,572.9 307.6 165.1 6.5 1,721.9 Information origination/ termination assets 251.0 28.8 49.1 5.2 235.9 Subtotal 4,494.8 727.0 349.9 1.6 4,873.5 CELLULAR AND WIRELESS COMMUNICATIONS SERVICES 85.9 55.5 2.0 (1.5) 137.9 PRODUCT DISTRIBUTION, DIRECTORY PUBLISHING AND OTHER 167.5 33.3 21.1 3.2 182.9 $6,683.3 $1,333.6<1> $518.3<2> $(91.0) $7,407.6 <1> Reconciliation of additions charged to income to amount disclosed in the consolidated statement of income: Amount charged to income $ 1,333.6 Amortization of intangibles 25.1 Depreciation and amortization included in consolidated statement of income $ 1,358.7 <2> Reconciliation of retirements included in Schedule V -- Consolidated Property, Plant and Equipment: Amount charged to reserve $ 518.3 Net book value of long distance and cellular/wireless division retirements and other 53.6 Total Schedule V retirements $ 571.9 <3>Adjustment primarily represents reduction to accumulated depreciation due to a change in the method of accounting for certain costs related to connecting new customers to the network. See Note 1 of "Notes to Consolidated Financial Statements" for additional information. <4>Adjustments primarily represent the contribution of plant to a joint venture. SPRINT CORPORATION SCHEDULE VI -- CONSOLIDATED ACCUMULATED DEPRECIATION Year Ended December 31, 1992 (In Millions) Balance Additions Balance beginning charged to Other end of of year income Retirements Changes year LONG DISTANCE COMMUNICATIONS SERVICES Digital fiber- optic network $1,062.9 $385.6 $190.6 $0.5<3> $1,258.4 Data communications equipment 125.5 39.5 3.1 7.6<3> 169.5 Administrative assets 453.3 136.9 74.9 (8.1)<3> 507.2 Subtotal 1,641.7 562.0 268.6 1,935.1 LOCAL COMMUNICATIONS SERVICES Buildings 171.1 19.9 10.4 (0.5) 180.1 Other general support assets 300.9 61.8 49.3 4.6 318.0 Cable and wire facility assets 1,973.8 289.4 78.6 (11.8) 2,172.8 Central office assets 1,429.5 319.7 182.9 6.6 1,572.9 Information origination/ termination assets 458.0 26.5 236.7 3.2 251.0 Subtotal 4,333.3 717.3 557.9 2.1 4,494.8 CELLULAR AND WIRELESS COMMUNICATIONS SERVICES 60.6 32.8 2.9 (4.6) 85.9 PRODUCT DISTRIBUTION, DIRECTORY PUBLISHING AND OTHER 161.4 30.4 24.3 167.5 $6,197.0 $1,342.5<1> $853.7<2> $(2.5) $6,683.3 <1>Reconciliation of additions charged to income to amount disclosed in the consolidated statement of income: Amount charged to income $ 1,342.5 Amortization of intangibles 49.0 Depreciation and amortization included in consolidated statement of income $ 1,391.5 <2>Reconciliation of retirements included in Schedule V -- Consolidated Property, Plant and Equipment: Amount charged to reserve $ 853.7 Divestiture of local telephone operations 57.3 Net book value of long distance and cellular/wireless divisions retirements and other 52.3 Total Schedule V retirements $ 963.3 <3>Adjustments primarily represent reclassifications of plant among categories. SPRINT CORPORATION SCHEDULE VI -- CONSOLIDATED ACCUMULATED DEPRECIATION Year Ended December 31, 1991 (In Millions) Balance Additions Balance beginning charged to Other end of of year income Retirements Changes year LONG DISTANCE COMMUNICATIONS SERVICES Digital fiber- optic network $810.9 $370.8 $118.8 $1,062.9 Data communications equipment 63.4 24.1 1.1 $39.1 125.5 Administrative assets 363.6 143.5 22.6 (31.2)<3> 453.3 Subtotal 1,237.9 538.4 142.5 7.9 1,641.7 LOCAL COMMUNICATIONS SERVICES Buildings 162.0 18.9 8.5 (1.3) 171.1 Other general support assets 270.5 67.5 42.1 5.0 300.9 Cable and wire facility assets 1,802.5 271.4 89.2 (10.9) 1,973.8 Central office assets 1,295.9 320.0 192.1 5.7 1,429.5 Information origination/ termination assets 631.1 36.2 213.2 3.9 458.0 Subtotal 4,162.0 714.0 545.1 2.4 4,333.3 CELLULAR AND WIRELESS COMMUNICATIONS SERVICES 42.0 24.7 4.8 (1.3) 60.6 PRODUCT DISTRIBUTION, DIRECTORY PUBLISHING AND OTHER 143.8 27.9 12.1 1.8 161.4 $5,585.7 $1,305.0<1> $704.5<2> $10.8 $6,197.0 <1>Reconciliation of additions charged to income to amount disclosed in the consolidated statement of income: Amount charged to income $ 1,305.0 Amortization of intangibles 64.5 Depreciation and amortization included in consolidated statement of income $ 1,369.5 <2>Reconciliation of retirements included in Schedule V -- Consolidated Property, Plant and Equipment: Amount charged to reserve $ 704.5 Divestiture of local telephone operations 122.7 Net book value of long distance and cellular/wireless divisions retirements and other 48.9 Total Schedule V retirements $ 876.1 <3>Adjustments primarily represent reclassifications of plant between categories. SPRINT CORPORATION SCHEDULE VIII -- CONSOLIDATED VALUATION AND QUALIFYING ACCOUNTS Years Ended December 31, 1993, 1992 and 1991 (In Millions) Additions Balance Charged Charged Balance beginning to to other Other end of of year income accounts deductions year Allowance for doubtful accounts $118.0 $271.5 $2.6 $(270.2)<1> $121.9 Valuation allowance - deferred income tax assets $30.2 $0.7 $(6.4) $24.5 Allowance for doubtful accounts $144.8 $267.6 $2.4 $(296.8)<1> $118.0 Valuation allowance - deferred income tax assets $35.4<2> $ (5.2) $30.2 Allowance for doubtful accounts $212.6 $371.2 $2.9 $(441.9)<1> $144.8 <1> Accounts written off, net of recoveries. <2> Valuation allowance established upon adoption of SFAS No. 109, "Accounting for Income Taxes." See Notes 1 and 4 of "Notes to Consolidated Financial Statements" for additional information. SPRINT CORPORATION SCHEDULE IX -- CONSOLIDATED SHORT-TERM BORROWINGS Years Ended December 31, 1993, 1992 and 1991 (In Millions) 1993 <1> 1992 1991 <1> Bank Commercial Bank Commercial Bank Commercial Notes Paper Notes Paper Notes Paper <2> <3> <2> <3> <2> <3> Balance at end of period $ 647.5 $108.3 $ 286.3 $76.0 $ 185.3 $30.0 Weighted average interest rate 3.61% 3.29% 3.92% 4.10% 5.25% 5.31% Average amount outstanding during the year $ 456.8 $80.3 $ 398.0 $37.5 $ 401.2 $52.5 Maximum amount outstanding during the year $ 722.0 $198.0 $ 486.4 $78.5 $ 749.0 $130.2 Weighted average interest rate during the year (computed by dividing the annual interest expense by the average debt outstanding during the year) 3.70% 3.25% 4.17% 4.10% 6.73% 6.66% <1>As of December 31, 1993 and 1991, short-term borrowings were classified as long-term debt in the consolidated balance sheets due to Sprint's intent and demonstrated ability to refinance such borrowings on a long-term basis. <2>Bank notes are generally issued for terms ranging from overnight to 60 days. <3>Commercial paper is generally issued for periods ranging from overnight to 30 days. SPRINT CORPORATION SCHEDULE X -- CONSOLIDATED SUPPLEMENTARY INCOME STATEMENT INFORMATION Years Ended December 31, 1993, 1992 and 1991 (In Millions) 1993 1992 1991 Maintenance and repairs <1> $ 167.2 $ 174.1 $ 162.2 Taxes, other than payroll and income taxes: Property taxes $ 158.6 $ 148.2 $ 157.0 Gross receipts and other 77.9 76.8 60.7 $ 236.5 $ 225.0 $ 217.7 Advertising expense $ 317.2 $ 251.7 $ 192.6 <1>Amount represents maintenance and repairs for the long distance division, cellular and wireless division, and product distribution, directory publishing and other. For the local division, maintenance and repairs is the primary component of plant operations expense which totaled $1.21 billion, $1.17 billion and $1.16 billion in 1993, 1992 and 1991, respectively. QUARTERLY FINANCIAL DATA (Unaudited) First Quarter Second Quarter Third Quarter 1993 1992 1993 1992 1993 1992 (In Millions, Except Per Share Data) Net operating revenues $2,718.0 $2,501.0 $2,800.9 $2,568.2 $2,867.6 $2,631.2 Operating expenses Costs of services and products 1,381.9 1,272.5 1,408.9 1,307.2 1,435.1 1,350.8 Selling, general and administrative 641.8 594.5 675.9 625.0 690.8 609.7 Depreciation and amortization 337.2 334.3 338.0 352.4 338.5 356.8 Merger, integration and restructuring costs <1>,<2> 248.0 44.5 Total operating expenses 2,608.9 2,201.3 2,422.8 2,284.6 2,508.9 2,317.3 Operating income 109.1 299.7 378.1 283.6 358.7 313.9 Gain on divestiture of telephone properties <3> 81.1 Interest expense (117.9) (131.2) (113.0) (129.4) (114.2) (126.7) Other income (expense), net (0.7) (1.8) (8.1) 6.5 (11.4) 6.4 Income (loss) from continuing operations before income taxes (9.5) 166.7 257.0 241.8 233.1 193.6 Income tax provision <4> (1.8) (60.4) (91.9) (94.2) (96.4) (68.3) Income (loss) from continuing operations (11.3) 106.3 165.1 147.6 136.7 125.3 Discontinued operations, net (12.3) Extraordinary losses on early extinguishments of debt, net (5.2) (8.5) (14.5) (5.6) Cumulative effect of changes in accounting principles, net<5> (384.2) 22.7 Net income (loss) (413.0) 129.0 156.6 147.6 122.2 119.7 Preferred stock dividends (0.6) (1.0) (0.9) (0.9) (0.6) (0.9) Earnings (loss) applicable to common stock $(413.6) $128.0 $155.7 $146.7 $121.6 $118.8 Earnings (loss) per common share Continuing operations $(0.03) $0.31 $0.48 $0.44 $0.39 $0.37 Discontinued operations (0.04) Extraordinary item (0.02) (0.02) (0.04) (0.02) Cumulative effect of changes in accounting principles (1.12) 0.07 Total $(1.21) $0.38 $0.46 $0.44 $0.35 $0.35 QUARTERLY Sprint Corporation FINANCIAL DATA (Unaudited) Fourth Quarter Total Year 1993 1992 1993 1992 Net operating revenues $2,981.3 $2,719.9 $11,367.8 $10,420.3 Operating expenses Costs of services and products 1,510.2 1,395.0 5,736.1 5,325.5 Selling, general and administrative 721.4 660.7 2,729.9 2,489.9 Depreciation and amortization 345.0 348.0 1,358.7 1,391.5 Merger, integration and restructuring costs <1>,<2> 292.5 Total operating expenses 2,576.6 2,403.7 10,117.2 9,206.9 Operating income 404.7 316.2 1,250.6 1,213.4 Gain on divestiture of telephone properties <3> 81.1 Interest expense (107.3) (123.8) (452.4) (511.1) Other income (expense), net (2.1) (16.1) (22.3) (5.0) Income (loss) from continuing operations before income taxes 295.3 176.3 775.9 778.4 Income tax provision <4> (105.2) (59.4) (295.3) (282.3) Income (loss) from continuing operations 190.1 116.9 480.6 496.1 Discontinued operations, net (12.3) Extraordinary losses on early extinguishments of debt, net (1.0) (10.4) (29.2) (16.0) Cumulative effect of changes in accounting principles, net <5> (384.2) 22.7 Net income (loss) 189.1 106.5 54.9 502.8 Preferred stock dividends (0.7) (0.7) (2.8) (3.5) Earnings (loss) applicable to common stock $188.4 $105.8 $52.1 $499.3 Earnings (loss) per common share Continuing operations $0.55 $0.34 $1.39 $1.46 Discontinued operations (0.04) Extraordinary item (0.03) (0.08) (0.05) Cumulative effect of changes in accounting principles (1.12) 0.07 Total $0.55 $0.31 $0.15 $1.48 <1>During 1993, Sprint consummated its merger with Centel. The transaction costs associated with the merger and the expenses of integrating and restructuring the operations of the two companies resulted in nonrecurring charges in the first and third quarters of 1993. Such charges reduced net income by $165 million ($0.48 per share) and $7 million ($0.02 per share), respectively. See Note 2 of "Notes to Consolidated Financial Statements" for additional information. <2>During third quarter 1993, Sprint realigned and restructured its long distance communications services division, resulting in a nonrecurring charge which reduced net income by $21 million ($0.06 per share). See Note 9 of "Notes to Consolidated Financial Statements" for additional information. <3>During second quarter 1992, a gain of $44 million ($0.13 per share), net of related income taxes, was recognized related to the sale of certain of Centel's local telephone operations. See Note 9 of "Notes to Consolidated Financial Statements" for additional information. <4>During third quarter 1993, the Revenue Reconciliation Act of 1993 was enacted which, among other changes, raised the federal income tax rate to 35 percent from 34 percent. As a result, Sprint adjusted its deferred income tax assets and liabilities to reflect the revised rate, resulting in a nonrecurring charge which reduced net income by $13 million ($0.04 per share). See Note 4 of "Notes to Consolidated Financial Statements" for additional information. <5>Effective January 1, 1993, Sprint changed its method of accounting for postretirement and postemployment benefits by adopting SFAS No. 106 and No. 112 and effected another accounting change. Effective January 1, 1992, Sprint changed its method of accounting for income taxes by adopting SFAS No. 109. See Note 1 of "Notes to Consolidated Financial Statements" for additional information. EXHIBIT INDEX EXHIBIT NUMBER (3) Articles of Incorporation and Bylaws: (a) Articles of Incorporation, as amended (filed as Exhibit 4 to Sprint Corporation Current Report on Form 8-K dated March 9, 1993 and incorporated herein by reference). (b) Bylaws, as amended (filed as Exhibit 3(b) to Sprint Corporation Annual Report on Form 10- K for the year ended December 31, 1991 and incorporated herein by reference). (4) Instruments defining the Rights of Sprint's Equity Security Holders: (a) The rights of Sprint's equity security holders are defined in the Fifth, Sixth, Seventh and Eighth Articles of Sprint's Articles of Incorporation. See Exhibit 3(a). (b) Rights Agreement dated as of August 8, 1989, between Sprint Corporation (formerly United Telecommunications, Inc.) and United Missouri Bank, N.A. (formerly United Missouri Bank of Kansas City, N.A.), as Rights Agent (filed as Exhibit 2(b) to Sprint Corporation Registration Statement on Form 8-A dated August 11, 1989 (File No. 1-4721), and incorporated herein by reference). (c) Amendment and supplement dated June 4, 1992 to Rights Agreement dated as of August 8, 1989 (filed as Exhibit 2(c) to Amendment No. 1 on Form 8 dated June 8, 1992 to Sprint Corporation Registration Statement on Form 8-A dated August 11, 1989 (File No. 1-4721), and incorporated herein by reference). (10) Material Agreements - Merger Agreement: (a) Agreement and Plan of Merger dated as of May 27, 1992, among Sprint Corporation, F W Sub Inc. and Centel Corporation (filed as Exhibit 2 to Sprint Corporation Current Report on Form 8-K dated May 27, 1992 and incorporated herein by reference). (b) First Amendment dated as of February 19, 1993, to the Agreement and Plan of Merger, dated as of May 27, 1992, among Sprint Corporation, F W Sub Inc. and Centel Corporation (filed as Exhibit 2b to Sprint Corporation Current Report on Form 8-K dated March 9, 1993 and incorporated herein by reference). (10) Executive Compensation Plans and Arrangements: (c) 1978 Stock Option Plan, as amended (filed as Exhibit 19(a) to United Telecommunications, Inc. Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, and incorporated herein by reference). (d) 1981 Stock Option Plan, as amended (filed as Exhibit 19(b) to United Telecommunications, Inc. Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, and incorporated herein by reference). (e) 1985 Stock Option Plan, as amended (filed as Exhibit 19(c) to United Telecommunications, Inc. Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, and incorporated herein by reference). (f) 1990 Stock Option Plan, as amended. (g) 1990 Restricted Stock Plan, as amended (filed as Exhibit 99 to Sprint Corporation Registration Statement No. 33-50421 and incorporated herein by reference). (h) Long-Term Stock Incentive Program, as amended (filed as Exhibit 19(e) to United Telecommunications, Inc. Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, and incorporated herein by reference). (i) Restated Memorandum Agreements Respecting Supplemental Pension Benefits between Sprint Corporation (formerly United Telecommunications, Inc.) and two of its current and former executive officers (filed as Exhibit 10(i) to Sprint Corporation Annual Report on Form 10-K for the year ended December 31, 1992 and incorporated herein by reference). (j) Executive Long-Term Incentive Plan. (k) Executive Management Incentive Plan. (l) Long-Term Incentive Compensation Plan (filed as Exhibit 10(j) to United Telecommunications, Inc. Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference). (m) Short-Term Incentive Compensation Plan (filed as Exhibit 10(k) to United Telecommunications, Inc. Annual Report on Form 10-K for the year ended December 31, 1989, and incorporated herein by reference). (n) Retirement Plan for Directors, as amended (filed as Exhibit 28d to Registration Statement No. 33-28237, and incorporated herein by reference). (o) Key Management Benefit Plan, as amended. (p) Executive Deferred Compensation Plan, as amended (filed as Exhibit 19(f) to United Telecommunications, Inc. Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, and incorporated herein by reference). (q) Director's Deferred Fee Plan, as amended (filed as Exhibit 19(g) to United Telecommunications, Inc. Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, and incorporated herein by reference). (r) Supplemental Executive Retirement Plan (filed as Exhibit 10(q) to Sprint Corporation Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference). (s) Form of Contingency Employment Agreements between Sprint Corporation and certain of its executive officers (filed as Exhibit 10(r) to Sprint Corporation Annual Report on Form 10-K for the year ended December 31, 1992, and incorporated herein by reference). (t) Form of Indemnification Agreements between Sprint Corporation (formerly United Telecommunications, Inc.) and its Directors and Officers (filed as Exhibit 10(s) to Sprint Corporation Annual Report on Form 10-K for the year ended December 31, 1991 and incorporated herein by reference). (u) Summary of Executive Benefits (filed as Exhibit 10(u) to Sprint Corporation Annual Report on Form 10-K for the year ended December 31, 1991 and incorporated herein by reference). (v) Amended and Restated Centel Management Incentive Plan. (w) Amended and Restated Centel Stock Option Plan. (x) Agreements Regarding Special Compensation and Post Employment Restrictive Covenants between Sprint Corporation and three of its executive officers. (y) Amended and Restated Centel Matched Deferred Salary Plan. (z) Amended and Restated Centel Directors Deferred Compensation Plan. (aa) Amended and Restated Centel Director Stock Option Plan. (11) Computation of Earnings Per Common Share. (12) Computation of Ratio of Earnings to Fixed Charges. (21) Subsidiaries of Registrant. (23a) Consent of Ernst & Young. (23b) Consent of Arthur Andersen & Co.

33619_1993.txt

33619

1993

ITEM 1. BUSINESS (a) General Development of Business. Esterline Technologies Corporation (the "Company") conducts business through 14 principal domestic and foreign subsidiaries in three business segments described in sub-item (c) below. The Company was organized in August 1967. On September 27, 1989 the Company acquired six commercial aerospace and defense companies (The "Acquired Companies") from The Dyson-Kissner-Moran Corporation and certain of its affiliates together with 1,946,748 shares of common stock of Esterline (the "Shares"). The purchase price for the combined transactions was $153 million, including expenses, plus assumption of $3.2 million in debt. $27 million of the purchase price was related to the purchase of the Shares. The Acquired Companies primarily are in the commercial aerospace and defense industry and include Armtec Defense Products Co., Hytek Finishes Co., Midcon Cables Co., Republic Electronics Co. and TA Mfg. Co., which are in the Company's Aerospace and Defense Group, and Korry Electronics Co., which is in the Instrumentation Group. For additional discussion of the September 27, 1989 acquisition, see the Company's Form 8-K dated September 27, 1989 and the amendment thereto on Form 8 dated November 22, 1989. On March 30, 1992 the Company sold substantially all of the assets of Hollis Automation Co., an Esterline subsidiary which was not significant to the Company as a whole in terms of operations or financial condition. Hollis was in the Company's Automation Group. In the fourth quarter of 1993, the Company recorded a $40.6 million restructuring charge ($27.2 million net of income tax effect). It provided for the sale or shutdown of certain small operations in each of the Company's three business segments. On a pretax basis, $21.1 million of the restructuring charge related to the Aerospace and Defense Group, $8.9 million to the Instrumentation Group and $8.4 million to the Automation Group. The affected operations represented approximately 10% of the Company's fiscal 1993 sales. The charge further provides for the consolidation of plants and product lines, including employee severance, write-off of intangible assets which no longer have value and the write-down and sale of two vacant facilities. (b) Financial Information About Industry Segments. A summary of net sales to unaffiliated customers, operating earnings and identifiable assets attributable to the Company's business segments for the fiscal years ended October 31, 1993, 1992 and 1991 is incorporated herein by reference to Note 12 to the Company's Consolidated Financial Statements on pages 28 and 29 of the Annual Report to Shareholders for the fiscal year ended October 31, 1993. (c) Narrative Description of Business. The Company consists of 14 individual businesses whose results can vary widely based on a number of factors, including domestic and foreign economic conditions and developments affecting the specific industries and customers they serve. The products sold by most of these businesses represent capital investment by either the initial customer or the ultimate end user. Also, a significant portion of the sales and profitability of some Company businesses is derived from defense and other government contracts or the commercial aircraft industry. Changes in general economic conditions or conditions in specific industries, capital acquisition cycles, and government policies, collectively or individually, can have a significant effect on the Company's performance. Specific comments covering all of the Company's fiscal 1993 business segments and operating units are set forth below. AUTOMATION GROUP This Group produces and markets automated manufacturing equipment for the printed circuit board manufacturing industry (principally computer, telecommunications and automotive equipment); and automated metal fabrication equipment for transportation, heavy equipment and other related markets. Excellon Automation produces automated equipment for fabrication of printed circuit boards for the electronics industry. Its products are primarily drilling machines, driller/routers, programmers and editors, and networking systems. Excellon's products emphasize productivity and are designed to provide a highly efficient automated production system for printed circuit board manufacturers. Excellon's latest development involves autoload systems for its equipment which integrates multiple spindle microdrilling of circuit boards with automatic board loading and unloading capabilities. Excellon products are sold worldwide to the printed circuit board manufacturing industry, including both large and small electronics equipment manufacturers as well as component manufacturers, independent circuit board fabricators and custom drilling operations. In fiscal 1993, 1992 and 1991, printed circuit board drilling equipment accounted for 16%, 12% and 12%, respectively, of the Company's consolidated net sales. Tulon produces tungsten carbide drill and router bits for use in printed circuit board drilling equipment. Tulon utilizes computerized equipment which automatically inspects drill bits and provides the product consistency customers need for higher-technology drilling. W.A. Whitney produces automated equipment for the fabrication of structural steel, sheet metal and plate components and related material-handling equipment. This equipment performs such functions as punching, cutting, shearing and tapping. W.A. Whitney historically has specialized in equipment for punching and cutting heavier plate metal, utilizing plasma-arc air torch systems and hydraulic punching. Its customers consist principally of large metal fabricators, such as truck, farm implement and construction equipment manufacturers, and a wide range of independent fabricators. W.A. Whitney has also developed machines for the lighter gauge market which includes industries such as food service equipment, medical equipment and computer manufacturers. W.A. Whitney also produces a line of specialized screw machine and turret lathe tooling attachments under the Boyar-Schultz name. These products are sold to a wide range of customers primarily for use in tool room and production operations. Equipment Sales Co. acts as a sales representative principally for a manufacturer of high-speed assembly equipment for the printed circuit board industry. At October 31, 1993, the backlog of the Automation Group (of which $600,000 is expected to be filled after fiscal 1994) was $9.2 million compared with $14.8 million one year earlier. The decrease is primarily due to low incoming order levels in recent months at Excellon Automation. AEROSPACE AND DEFENSE GROUP This Group provides a broad range of measuring and sensing devices, high-performance elastomers and clamping systems, and specialized metal finishing principally for commercial aircraft and jet engine manufacturers; also combustible ammunition components and electronic warfare and radar simulation equipment for both domestic and foreign defense agencies. Armtec Defense Products manufactures molded fiber cartridge cases, mortar increments and other combustible ammunition components for the United States armed forces and domestic and foreign defense contractors. Armtec currently is the sole U.S. producer of combustible ordnance, including the 120mm combustible case used on the main armament system on the Army's M-1A1 tank and of 120mm, 81mm and 60mm combustible mortar increments for the U.S. Army. The majority of Armtec's sales are to ordnance suppliers to the U.S. Armed Forces. In fiscal 1993, 1992 and 1991, combustible ordnance components accounted for 9%, 12% and 10%, respectively, of the Company's consolidated net sales. Auxitrol, headquartered in France, manufactures aviation and industrial thermocouple-based products, liquid level measurement devices for ships and storage tanks, pneumatic accessories (including pressure gauges and regulators) and industrial alarms, as well as electrical penetration devices and alarm systems for European and other foreign nuclear power plants. This subsidiary also distributes products manufactured by others, including valves, temperature and pressure switches and flow gauges. The markets served by Auxitrol principally consist of aircraft manufacturers, shipbuilders, petroleum companies, process industries and electric utilities. During the year, Auxitrol acquired the temperature and pressure sensing product lines of a competitor increasing its market share, and added pressure sensing technology to its product line. Auxitrol has a joint venture with a Russian company to facilitate use of Auxitrol technology in retrofitting the aging nuclear plants in Eastern Europe. Exhaust gas temperature sensing equipment for a jet engine manufacturer constitute a significant portion of Auxitrol's sales. Hytek Finishes provides complete metal finishing and inspection services, including plating, anodizing, polishing, non- destructive testing and organic coatings, primarily to the commercial aircraft, aerospace and electronics markets. Hytek recently has installed an automated tin-lead plating line, employing the latest automated plating technology, to serve the semi-conductor industry. Midcon Cables manufactures electronic and electrical cable assemblies and wiring harnesses for the military, government contractors and the commercial electronics market, offering both product design services and assembly of product to customer specifications. Republic Electronics manufactures radar environmental simulators, tactical air navigation (TACAN) test equipment, identification friend or foe (IFF) interrogator test equipment, precision distance measuring equipment (PDME) test set simulators, electronic warfare simulators, and related support equipment for both U.S. and foreign commercial and military customers. TA Mfg. designs and manufactures systems installation components such as clamps, line blocks and brackets for airframe and engine manufacturers as well as military and commercial airline aftermarkets. TA's products include elastomers which are specifically formulated for various applications, including high-temperature environments. At October 31, 1993, the backlog of the Aerospace and Defense Group (of which $9.2 million is expected to be filled after fiscal 1994) was $40.8 million, compared with $58.9 million one year earlier. The decrease occurred primarily at Armtec Defense Products and Auxitrol and was due to the timing of the receipt of orders at both companies coupled with reduced levels of U.S. Army ordnance purchases. INSTRUMENTATION GROUP This Group designs and manufactures a variety of sophisticated meters, switches and indicators, panels and keyboards, gauges, control components, and measurement and analysis equipment for public utilities, industrial manufacturers, and suppliers and operators of commercial and military aircraft components. Angus Electronics manufactures recording instruments together with other analytical and process monitoring instrumentation. These include analog strip chart and digital printout recorders as well as electronic and multi-channel microprocessor-based recording equipment. Customers of Angus Electronics include industrial equipment manufacturers, electric utilities, scientific laboratories, pharmaceutical manufacturers and process industries. Korry Electronics manufactures high-reliability, lighted electromechanical components such as switches and indicators, and panels and keyboards which act as man-machine interfaces in a broad variety of control and display applications. Korry's customers include original equipment manufacturers and the aftermarkets (equipment operators and spare parts distributors), primarily in the commercial aviation, general aviation, military airborne, ground-based military equipment and shipboard military equipment markets. A significant portion of Korry's sales are to suppliers of military equipment to the U.S. Government and to a commercial aircraft manufacturer. Korry established a sales office in France during the year. Scientific Columbus (formerly Jemtec Electronics) produces analog and digital meters, electrical transducers and instruments for the monitoring, controlling and billing of electrical power. Included among these products are solid-state devices for calibration of electric utility instrumentation and a line of solid state-meters, including programmable multi-function billing meters. The latest products of Scientific Columbus are multi-function, microprocessor-based meters which offer a broad range of features on a modular basis. Scientific Columbus' products are sold to electrical utilities and industrial power users. Federal Products manufactures a broad line of analog and digital dimensional and surface measurement and inspection instruments and systems for a wide range of industrial quality control and scientific applications. Federal also distributes certain products which complement its manufactured product lines. These products constitute three major business segments: gauging, which includes dial indicators, air gauges and other precision gauges; instrumentation, which includes electronic gauges for use where ultra-precision measurement is required; and engineered products, which include custom-built and dedicated semi- automatic and automatic gauging systems. Distributed products manufactured by others include laser interferometer systems used primarily to check machine tool calibrations. Federal Products' equipment is used extensively in precision metal working. Its customers include the automotive, farm implement, construction equipment, aerospace, ordnance and bearing industries. In fiscal 1993, 1992 and 1991, gauge products manufactured by Federal Products accounted for 13%, 13% and 12%, respectively, of the Company's consolidated net sales. At October 31, 1993, the backlog of the Instrumentation Group (of which $4.6 million is expected to be filled after fiscal 1994) was $24.4 million compared with $23.9 million one year earlier. MARKETING AND DISTRIBUTION Automation Group products manufactured by Excellon are marketed domestically principally through employees and in foreign markets through employees, independent distributors, and affiliated distributors. Tulon products are marketed in the United States through employees and independent distributors and elsewhere principally through independent distributors. W.A. Whitney products are sold principally through independent distributors and representatives. Aerospace and Defense Group products manufactured by Auxitrol are marketed through employees, independent representatives, and an affiliated U.S. distributor. The products of Armtec Defense Products are marketed domestically and abroad by employees and independent representatives. Midcon Cables' products are marketed domestically by employees and independent representatives. Republic Electronics' products are marketed domestically by employees and abroad by independent representatives. Hytek's services are marketed domestically through employees. TA Mfg. products are marketed domestically and abroad by employees and independent representatives. Instrumentation Group products manufactured by Angus Electronics are marketed domestically through employees, independent representatives and distributors, and abroad through independent representatives and employees of Esterline's Auxitrol subsidiary. Scientific Columbus' products are sold through independent representatives. The products of Federal Products are marketed domestically principally through employees, and in foreign markets through both employees and independent representatives. Korry Electronics' products are marketed domestically and abroad principally through employees and independent representatives. For most of the Company's products, the maintenance of a service capability is an integral part of the marketing function. RESEARCH AND DEVELOPMENT The Company's subsidiaries conduct product development and design programs with approximately 175 professional engineers, technicians and support personnel, supplemented by independent engineering and consulting firms when needed. In fiscal 1993, approximately $14 million was expended for research, development and engineering, compared with $13.4 million in 1992 and $16.6 million in 1991. FOREIGN OPERATIONS The Company's principal foreign operations consist of manufacturing facilities of Auxitrol located in France and Spain, a manufacturing facility of Tulon located in Mexico, and sales and service operations of Excellon located in England, Germany and Japan. In addition, W.A. Whitney has a small manufacturing and distribution facility in Italy. For information as to sales, operating results and assets by geographic area and export sales, reference is made to Note 1 to the Consolidated Financial Statements on page 20, and Note 12 to the Consolidated Financial Statements on pages 28 and 29, of the Company's Annual Report to Shareholders for the fiscal year ended October 31, 1993, which is incorporated herein by reference. EMPLOYEES The Company and its subsidiaries had approximately 2,800 employees at October 31, 1993, a decrease of approximately 300 employees from October 31, 1992. COMPETITION AND PATENTS The Company's subsidiaries experience varying degrees of competition with respect to all of their products and services. Most subsidiaries are in specialized market niches with relatively few competitors. In automated drilling equipment for printed circuit board manufacturing, Excellon Automation is a leader in its field and believes it has the largest installed base in the world of automated drilling machines for the production of printed circuit boards. In molded fiber cartridge cases, mortar increments and other combustible ammunition components, Armtec currently is the sole supplier to the U.S. Army. In addition, Hytek is one of the largest metal finishers on the West Coast, and Korry Electronics, Federal Products, W.A. Whitney, and TA Mfg. are among the leaders in their respective markets. The Company's subsidiaries generally compete with many larger companies with substantially greater volume and financial resources. The Company believes the main competitive factors for the Company's products is product performance and service. Overall, the Company believes its ongoing product development and design programs, coupled with a strong customer service orientation, keep its various product groups competitive in the marketplace. The subsidiaries hold a number of patents but in general rely on technical superiority, exclusive features in their equipment and marketing and service to customers to meet competition. Patents and licenses which help maintain a significant advantage over competition include the patents covering a switch mechanism which Korry uses in its integrated panel product line, and a long-term license agreement under which Auxitrol manufactures and sells electrical penetration assemblies. SOURCES AND AVAILABILITY OF RAW MATERIALS AND COMPONENTS The Company's subsidiaries are not materially dependent for their raw materials and components upon any one source of supply except for certain components and supplies such as plasma torches, CNC controls and hydraulic components purchased by W.A. Whitney and certain other raw materials and components purchased by other subsidiaries. In such instances, ongoing efforts are conducted to develop alternative sources or designs to help avoid the possibility of any business impairment. (d) Financial Information About Foreign and Domestic Operations and Export Sales. See "Foreign Operations" above. ITEM 2.

ITEM 2. PROPERTIES The following table summarizes the principal properties owned or leased by the Company and its subsidiaries as of October 31, 1993: The Company group (business segment) operating each facility described above is indicated by the letter following the description of the facility, as follows: (A) - Automation (D) - Aerospace and Defense (I) - Instrumentation In addition to the properties listed above, a 44,000 square foot facility in Torrance, CA and a 64,000 square foot facility in Nashua, NH are owned by the Company and planned for sale. Liabilities have been accrued for environmental remediation costs expected to be incurred in the disposition of the Nashua facility. In the opinion of the management of the Company, the subsidiaries' plants and equipment are in good condition, adequate for current operations and provide sufficient capacity for up to 25% expansion at most locations. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS In late 1992, Korry Electronics received a subpoena for records from the Department of Defense, Office of the Inspector General, and became aware of a government investigation focusing on whether Korry properly certified that certain switches used in military equipment were in compliance with applicable specifications and testing standards. The Company has supplied records requested in the subpoena and is engaged in discussions with government officials. The investigation remains open, but the Company currently believes that this matter will not have a material adverse affect on its financial position or results of operations. The Company has various lawsuits, claims, investigations and contingent liabilities arising from the conduct of business, including those associated with government contracting activities, none of which, in the opinion of management, is expected to have a material effect on the Company's financial position or results of operations. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of security holders during the fourth quarter of the fiscal year ended October 31, 1993. EXECUTIVE OFFICERS OF THE REGISTRANT The names and ages of all executive officers of the Company and the positions and offices held by such persons as of January 21, 1994 are as follows: Mr. Hurlbut has been Chairman of the Board, President and Chief Executive Officer since January 1993. From February 1989 to December 1992, he was President and Chief Executive Officer. From May 1988 to February 1989, he was President and Chief Operating Officer. Mr. Stevenson has been Executive Vice President and Chief Financial Officer, Secretary and Treasurer since October 1987. Mr. Cremin has been Senior Vice President and Group Executive since December 1990. From October 1987 to December 1990, he was Group Vice President. Mr. Kring has been Group Vice President since August 1993. For more than five years prior to that date, he was President of Heath Tecna Aerospace Co., a unit of Ciba Composites Division, Anaheim, California. Mr. Larson has been Group Vice President since April 1991. For more than five years prior to that date, he held various executive positions with Korry Electronics, including President and Executive Vice President, Marketing. Mr. Zuker has been Group Vice President since March 1988. Ms. Greenberg has been Vice President, Human Relations since March 1993. For more than five years prior to that date, she was a partner in the law firm of Bogle & Gates, Seattle, Washington. Mr. Meden has been Vice President, Corporate Development since October 1987. Mr. Thompson has been Vice President and Controller since October 1987. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The following information which appears in the Company's Annual Report to Shareholders for fiscal 1993 is hereby incorporated by reference: (a) The high and low market prices of the Company's common stock for each quarterly period during the fiscal years ended October 31, 1993 and 1992, respectively (page 15 of the Annual Report to Shareholders). (b) The approximate number of holders of common stock (page 15 of the Annual Report to Shareholders). (c) Restrictions on the ability to pay future cash dividends (Note 4 to Consolidated Financial Statements, pages 21 and 22 of the Annual Report to Shareholders). No cash dividends were paid during the fiscal years ended October 31, 1993 and 1992 as the Company continued its policy of retaining all internally generated funds to support the long-term growth of the Company and to retire debt obligations. The principal market for the Company's common stock is the New York Stock Exchange. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA The Company hereby incorporates by reference the Selected Financial Data of the Company which appears on page 15 of the Company's Annual Report to Shareholders for fiscal 1993. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Company hereby incorporates by reference Management's Discussion and Analysis of Results of Operations and Financial Condition which is set forth on pages 12, 13 and 14 of the Company's Annual Report to Shareholders for fiscal 1993. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Company hereby incorporates by reference the Consolidated Financial Statements and the report thereon of Deloitte & Touche, dated December 17, 1993, which appear on pages 16 - 31 of the Company's Annual Report to Shareholders for fiscal 1993, including Note 13, page 30, which contains unaudited quarterly financial data. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT (a) Directors. The Company hereby incorporates by reference the information set forth under "Election of Directors" in the definitive form of the Company's Proxy Statement, relating to its Annual Meeting of Shareholders to be held on March 30, 1994, to be filed with the Securities and Exchange Commission and the New York Stock Exchange on or before February 10, 1994. (b) Executive Officers. Information concerning the Company's executive officers may be found in Part I of this Report following Item 4. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The Company hereby incorporates by reference the information set forth under "Executive Compensation" in the definitive form of the Company's Proxy Statement, relating to its Annual Meeting of Shareholders to be held on March 30, 1994, to be filed with the Securities and Exchange Commission and the New York Stock Exchange on or about February 10, 1994. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The Company hereby incorporates by reference the information with respect to stock ownership set forth under "Security Ownership of Certain Beneficial Owners and Management" in the definitive form of the Company's Proxy Statement, relating to its Annual Meeting of Shareholders to be held on March 30, 1994, to be filed with the Securities and Exchange Commission and the New York Stock Exchange on or about February 10, 1994. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) (1) Financial Statements. The following consolidated financial statements, together with the report thereon of Deloitte & Touche, dated December 17, 1993, appearing on pages 16 - 31 of the Company's Annual Report to Shareholders for fiscal 1993, are hereby incorporated by reference: The following additional financial data should be read in conjunction with the consolidated financial statements in the Annual Report to Shareholders for the fiscal year ended October 31, 1993: Independent Auditors' Report Schedule V -- Property, Plant and Equipment Schedule VI -- Accumulated Depreciation of Property, Plant and Equipment Schedule VIII -- Valuation and Qualifying Accounts and Reserves Schedule IX -- Short-Term Borrowings Schedule X -- Supplementary Income Statement Information (a) (3) Exhibits. (b) Reports on Form 8-K. No reports on Form 8-K were filed during the fourth quarter of fiscal 1993. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. ESTERLINE TECHNOLOGIES CORPORATION (Registrant) By /s/ Robert W. Stevenson ------------------------ Robert W. Stevenson Executive Vice President and Chief Financial Officer, Secretary and Treasurer (Principal Financial and Accounting Officer) Dated: January 31, 1994 ----------------- Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. INDEPENDENT AUDITORS' REPORT Board of Directors and Shareholders Esterline Technologies Corporation Bellevue, Washington We have audited the financial statements of Esterline Technologies Corporation as of October 31, 1993 and 1992, and for each of the three years in the period ended October 31, 1993, and have issued our report thereon dated December 17, 1993; such financial statements and report are included in your 1993 Annual Report to Shareholders and are incorporated herein by reference. Our audits also included the financial statement schedules of Esterline Technologies Corporation, listed in Item 14. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. /s/ Deloitte & Touche - ---------------------- Deloitte & Touche Seattle, Washington December 17, 1993 ESTERLINE TECHNOLOGIES CORPORATION AND SUBSIDIARIES SCHEDULE V--PROPERTY, PLANT AND EQUIPMENT (in thousands) For Years Ended October 31, 1993 and 1992 (1) Includes the related effects of the FY 1993 restructuring. ESTERLINE TECHNOLOGIES CORPORATION AND SUBSIDIARIES SCHEDULE VI--ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT (in thousands) For Years Ended October 31, 1993 and 1992 ESTERLINE TECHNOLOGIES CORPORATION AND SUBSIDIARIES SCHEDULE VIII--VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (in thousands) For Years Ended October 31, 1993, 1992 and 1991 ESTERLINE TECHNOLOGIES CORPORATION AND SUBSIDIARIES SCHEDULE IX--SHORT-TERM BORROWINGS (in thousands) (1) Borrowings are under a line of credit of $35 million. (2) Borrowings are made by foreign subsidiaries from a number of banks located in countries in which the subsidiaries have operations. (3) Determined by averaging the borrowings outstanding at each month-end during the fiscal year. (4) Determined by averaging interest rates at each month-end during the fiscal year. ESTERLINE TECHNOLOGIES CORPORATION AND SUBSIDIARIES SCHEDULE X-- SUPPLEMENTARY INCOME STATEMENT INFORMATION (in thousands) The following items have been charged to costs and expenses as stated: The following items have been charged to costs and expenses but do not individually exceed one per cent of net sales: Taxes, other than payroll and income taxes Royalties Advertising costs ESTERLINE TECHNOLOGIES CORPORATION Form 10-K Report for Fiscal Year Ended October 31, 1993 INDEX TO EXHIBITS -----------------

215419_1993.txt

215419

1993

Item 1. BUSINESS The Company is engaged in the development, production and sale of Electronic SignaturesR systems. Electronic Signatures systems are uniquely-identifiable targets which can be assigned to an object or person, and the electronic equipment that recognizes them. The recognized information can then be used immediately or stored for later review, analysis, record-keeping or other functions. Electronic Signatures systems are provided to the Company's customers as Electronic Article MerchandisingR, ("EAMR") systems, or Electronic Access Control ("EAC") systems. EAM systems alert users to the unauthorized removal of protected items such as retail merchandise and library books. EAM systems are also used for more than loss prevention. The Company's customers use these systems to bring products back into the open where consumers have access to the products, and are therefore more likely to purchase them. EAM systems make it possible for retailers and libraries to improve customer or patron service, without additional labor, through open merchandising. Open merchandising increases productivity and sales for retailers, while reducing losses caused by theft at the same time. EAC systems restrict access to buildings or areas, such as data processing centers and research and development laboratories, by unauthorized personnel. In addition, EAC systems can provide an automatic record of personnel who have entered specific areas and their time of entry and exit. The Company's EAM and EAC technologies have produced current products, and the development and convergence of these two technologies are expected to lead to future Electronic Signatures products. The Company intends to protect its leadership position in the Electronic Signatures marketplace by pursuing more sophisticated signal recognition, wider detection ranges, and integration into the customer's operation. In 1992, the Company entered into the point-of-sale ("POS") monitoring business. The primary emphasis of POS monitoring is the controlling of internal theft at the retailer's point-of-sale. The Company's POS monitoring systems record and store on video tape every transaction at each check-out, visually as well as the individual transaction data. The Company's customers can generate user defined reports and match questionable transactions to events recorded on the video tape. In 1969, the Company was incorporated in Pennsylvania as a wholly-owned subsidiary of Logistics Industries Corporation ("Logistics"). In 1977, Logistics, pursuant to the terms of its merger into Lydall, Inc. ("Lydall"), distributed the Company's Common Stock to Logistics' shareholders as a dividend. The Company is publicly held and trades on the New York Stock Exchange (NYSE:CKP). In February, 1986, the Company acquired Sielox Systems, Inc. ("Sielox"), which developed, produced and marketed EAC systems for use in commercial and institutional applications. In August, 1990, Sielox's operations were combined with the Company's. ------------------------- Electronic SignaturesR is a registered trademark of the Company. Electronic Article MerchandisingR and EAMR are registered trademarks of the Company. The Company acquired its Canadian Distributor in November of 1992 and Argentinean Distributor in March of 1993. In addition, the Company set up direct operations in Mexico during March of 1993 and Australia during June of 1993. All these subsidiaries market EAM systems for use in retail and library applications. In July of 1993, the Company purchased all the outstanding capital stock of ID Systems International B.V. and ID Systems Europe B.V., related Dutch Companies ("ID Systems Group") engaged in the manufacture, distribution and sale of EAM systems. The acquisition gave the Company direct access to six Western European countries which are The Netherlands, United Kingdom, Sweden, Germany, France and Belgium. The Company has its principal executive offices at 550 Grove Road, P.O. Box 188, Thorofare, NJ 08086, (609-848-1800). Unless the context requires otherwise, the "Company" means Checkpoint Systems, Inc. and its subsidiaries on a consolidated basis. Electronic Article Merchandising -------------------------------- EAM systems act as a deterrent to, and control the increasing problem of, theft in such establishments as retail stores and libraries. Over the past two decades, retail establishments have recognized that the most effective theft-prevention method is to monitor articles. Other means of theft prevention, (special mirrors, security guards, closed-circuit television systems and surveillance cameras) monitor people, not the articles to be protected, and this limitation among others is addressed by EAM systems. The retail industry today continues to face an overcrowded marketplace and rising costs of occupancy, labor and operations. In addition, the industry has been plagued with retail sameness and slowed consumer spending. These trends have caused aggressive price discounting, resulting in declining retail profits. With these issues facing retailers today, coupled with the growing incidences of theft, EAM clearly provides a solution to the retailer's dilemma of controlling costs and improving margins. EAM systems are generally comprised of three components: detectable and deactivatable security circuits (embedded in tags or labels), referred to as "targets", which are attached to or placed in the articles to be protected; electronic detection equipment, referred to as "sensors", which recognize the targets when they enter a detection area, usually located in the exit path; and deactivation equipment that disarms the target when patrons follow proper check-out procedures. The most versatile EAM systems use radio frequency ("RF") technology. The detection equipment consists of a transmitter and receiver, which together establish an RF field. An active target can interrupt this field and trigger an alarm. With RF technology, deactivation can occur without physically locating or touching the target to be disarmed. Currently, EAM systems are sold to two principal markets: retail establishments and libraries. The Company has three significant competitors in these markets -- Sensormatic Electronics Corporation ("Sensormatic") and Knogo Corporation("Knogo") -- principally in the retail market, and Minnesota Mining and Manufacturing Company ("3M"), principally in the library market. Electronic Access Control ------------------------- EAC systems restrict access to areas requiring protection from intrusion by unauthorized personnel by granting access only to selected individuals at specified times. Recent developments in Electronic Signatures processing and other technologies have enhanced the sophistication of EAC systems at a low cost. EAC systems use an "electronic key", such as a push-button keypad or a plastic card with a magnetic strip or magnetic code that is read by an "electronic lock". The most advanced EAC systems utilize plastic cards containing an encoded digital integrated circuit as electronic keys. These can be coded with a personal identification number ("PIN"). Once the cardholder presents the card containing a PIN, a computer, which is also part of the EAC system, determines security clearance/access levels. This data, along with time of entrance and exit, can be recorded for later analysis. Various commercial and industrial markets have applications for EAC. Systems are sold to manufacturers, banks, hospitals, prisons, airports and governmental installations, which need to protect personnel or assets. The Company's major EAC competitors are Cardkey Systems, Inc. ("Cardkey"), Software House, Inc. ("Software House") and Westinghouse Security, Inc. ("Westinghouse"). Products -------- EAM Systems ----------- The Company's principal products are the components of its EAM system, which it markets to both retail establishments and libraries. The EAM system for the retail market is designed to provide protection for a wide variety of consumer items in all types of retail environments, including apparel stores, shoe stores, drug stores, mass merchandise establishments, music, video, supermarkets and home entertainment markets. The EAM system for the library market is designed to prevent the unauthorized removal of books and other library media. EAM system components include ten styles of sensors (each including transmitter, receiver and alarm), and the customer's choice of patented disposable paper targets, reusable flexible targets and reusable hard plastic targets. The EAM system's transmitter emits an RF signal and the receiver measures the change in that signal caused by the active targets, causing the system to alarm. For 1993, 1992 and 1991, the percentage of the Company's net revenues from sensors was 30%, 34% and 31%, respectively and from targets was 42%, 40% and 45%, respectively. In 1986, the Company introduced CounterpointR, a noncontact deactivation unit which eliminated the need to search for and remove or manually detune disposable targets. Since 1989, the Company has expanded its deactivation products with electronic modules that can be installed into numerous point-of-sale ("POS") bar code scanners including those manufactured by Spectra-Physics Retail Systems, Symbol Technologies, Inc., Metrologic, Inc., National Cash Register, Inc., ICL Systems,Inc., IBM (International Business Machines) and Fujitsu Ltd. These modules allow the reading of barcode information, while deactivating targets in a single step. These deactivation units allow POS personnel to focus on the customer and minimize errors at check-out. The percentage of net revenues from deactivation units for 1993, 1992 and 1991 was 11%, 11%, and 7%, respectively. During 1993, the Company developed an improved deactivation unit, Counterpoint IVTM which provides increased deactivation height and improves the rate of product deactivation. The Company's EAM products are designed and built to comply with applicable Federal Communications Commissions ("FCC") regulations governing radio frequencies, signal strengths and other factors. The Company's present EAM products requiring FCC certification comply with applicable regulations. In addition, the Company's present EAM products meet other regulatory specifications for the countries in which they are sold. Sensors ------- The Company's sensor product lines are used principally in retail establishments and libraries. In retail establishments, EAM system sensors are usually positioned at the exits from the areas in which protected articles are displayed. In libraries, sensors are positioned at the exit paths, and gates or turnstiles control traffic. Targets are placed inside books and other materials to be protected. A target passing through the sensor triggers an alarm, which locks the gate or turnstile. The target can easily be deactivated or passed around the sensor by library personnel. Introduced in 1988, the AlphaR sensor product line represented an important step in the evolution of Electronic Signatures processing. It was the Company's first microprocessor-based sensor capable of recognizing unique radio frequency signals. Now incorporated in the QS2000R sensor this microprocessor-based technology brings the Company closer to a complete approach to merchandising, by integrating the retailers' three major control problems -- pricing, information and shoplifting. Introduced in 1990, the QS2000 is the latest evolution in the Company's proven QuicksilverTM sensor product line. With the addition of microprocessor-based radio frequency signal processing, the QS2000 has been engineered to provide excellent target detection with enhanced target-discrimination capabilities. The QS2000 analyzes RF signals in its detection zone and can discriminate between unique target signals and environmental interference. This development greatly reduces false and "phantom" alarms while increasing target detection. The QS2000 is also available in a weatherized version for outdoor use. ------------------------- CounterpointR is a registered trademark of the Company. Counterpoint IVTM is a trademark of the Company. QuicksilverTM is a trademark of the Company. AlphaR, QS2000R, and SignatureR are registered trademarks of the Company. Introduced in 1993, the CondorTM sensor, is the most technically advanced RF system on the market today. The most significant feature of this system is the combination of a receiver and transmitter in a single pedestal. Utilizing a microprocessor and two digital signal processors, the Condor has an aisle width of 12 feet using two pedestals. One sensor is capable of three feet of detection on either side of the sensor. Additional features include the ability to mount full-sized merchandising panels, a customer counter, an alarm counter and variable alarm tone. Also introduced in 1993, the QS1500TM and QS1600TM are value priced, hard tag systems designed primarily for the apparel marketplace. The QS1500 and QS1600 product lines provide a high detection rate. The QS1500 has three feet of detection on either side of a single pedestal, or it can protect up to six feet between two pedestals. For wider detection, the QS1600 with two pedestals can detect targets at distances of up to twelve feet, ideal for mall openings. This system is an inexpensive answer to wide aisle detection. As a result of the Company's acquisition of the ID Systems Group in 1993, the QX2000TM system is currently available for international installations. The QX2000 is a similar system to the microprocessor based QS2000 system with the added flexibility of modular electronics design. The modular design provides an improved service capability in addition to permitting the system to operate at three different RF frequencies. The Company also offers chrome-finished Quicksilver sensors, solid-oak SignatureR sensors, featuring an earlier generation of components, the QS3000, a wide aisle system that can span up to six feet, and the Hypermarket, which is a narrow aisle system designed specifically for hypermarkets. All of the Company's sensors can be used with the various targets available. Targets ------- Customers can choose from a wide variety of targets, depending on their merchandise mix. All targets contain an electronic circuit that unless deactivated (disposable targets) or removed (reusable targets), triggers an alarm when passed through the sensors. Disposable security targets are affixed to merchandise by pressure sensitive adhesive or other means. These range in size from 1.125" x 1.5" to 2.0" x 3.0", enabling retailers to protect smaller, frequently-pilfered items. Disposable targets must be deactivated at the point-of-sale, either manually or electronically, or passed around the sensors. Many disposable targets can be imprinted with standard price-marking equipment. When used with electronic deactivation equipment, they represent the CheklinkR concept, developed to combine pricing, merchandising, data collection and protection in a single step. Targets can be applied at the vendor level, in the distribution center or in-store. Under the Company's ImpulseR program (see Marketing Strategy) tags can be embedded in products or packaging at the point-of-manufacture or packaging. ------------------------ CondorTM is a trademark of the Company. QS1500TM, QS1600TM and QS3000TM are trademarks of the Company. QX2000TM is a trademark of the Company. CheklinkR is a registered trademark of the Company. ImpulseR is a registered trademark of the Company. In 1992, the Company was licensed to sell and provide targets for the Model 4021 label applicator (PathfinderR) printer manufactured by Monarch Marking Systems. This product is a sophisticated electronic portable bar code label printer and applicator ideal for use in high volume mass merchandise, drugstore and supermarket applications. In addition, Pathfinder has a self-contained keyboard which allows for easy entry of various types of label data including: bar code, price and size. The Pathfinder also has built-in scanning capability that can scan existing package bar codes, then print identical Checkpoint labels for application without obscuring important product information. The Company has entered into a business agreement with PMI Food Equipment Group, Hobart Corporation ("Hobart"), a manufacturer and distributor of weigh scales, label printers and meat wrappers used in supermarket meat rooms. The Company's Hobart tag, 1315 Series, is compatible with the Hobart weigh scales Model 5000 T/TE and Model 18VP. This labor saving tag is integrated with the Hobart Weigh Scale/Printer to display the weight and price of the item. In addition, the Company maintains an agreement with A&H Manufacturing ("A&H"), the dominant U.S. supplier of costume jewelry cards, which grants A&H the right to embed a Checkpoint circuit in cards during manufacturing. To assure growth in the video and mature library markets, the Company increased its product offerings and entered the electromagnetic target market. The electromagnetic targets are offered in an On Only (permanent) and an On/Off (activatable) strip. Magnetic label deactivators and activators have also been added to the Company's product offerings to aid libraries with auto circulation of materials. Reusable security targets fall into two categories. Flexible targets are plastic-laminated tags used in a variety of markets that are removed at the point-of-sale. Hard targets consist of a target and a locking mechanism within a plastic case. They are used primarily in the apparel market and present a visible psychological deterrent. Both flexible and hard targets use a nickel-plated steel pin which is pushed through the protected item into a magnetic fastener. These targets can also be attached with a lanyard using the magnetic fastener. An easy-to-use detacher unit removes reusable targets from protected articles without damage. Also obtained with the acquisition of the ID Systems Group in 1993 was the UFO hard target. The UFO hard target design combined with a superior locking device differentiates the UFO as the most difficult hard target to defeat. During 1993, the Company began manufacturing the Teardrop hard target, which is made to function only with the QS1500 and QS1600 systems, primarily used in the apparel market. During 1993, the Company introduced a line of fluid tags marketed under the name ChekInkTM which provides a cost-effective second line of defense against shoplifters. Unauthorized removal of these targets will cause sealed vials of dye to break open, rendering the garment unusable. ChekInk serves as a practical alternative to chaining down valuable merchandise. Ideal for use in department stores, mass merchandisers, and sporting goods stores, ChekInk can be removed quickly and easily at check-out in the same manner as the reusable targets. ---------------------- ChekInkTM is a trademark of the Company. PathfinderR is a registered trademark of Monarch Marking Systems. Deactivation Units ------------------ Five convenient deactivation configurations -- horizontal counter-mounted slot scanners, a vertical mounted scanner, hand-held scanners, a weigh scale scanner and a deactivation pad -- are available for a variety of POS environments. These units transmit an audible tone that alerts the user that a target has been detected. The tone stops when the target has been deactivated. With the exception of the Counterpoint deactivation pad, all of the above scanners read barcode information while deactivating hidden Cheklink targets in a single step. Ideal for high-volume environments, these scanners mount easily at POS, and can deactivate multiple targets on a single item. The Counterpoint deactivation pad is placed at the check-out counter, and targets are deactivated automatically by simply passing protected items across the low profile pad which audibly signals that targets have been deactivated. There is no need to see the targets in order to deactivate them. Two sizes of the pads are available, both of which have a very low profile on the countertop of 3/4" or less. Developed in 1993 and introduced in 1994, the CounterpointR IV provides increased deactivation height and improves the rate of product deactivation. EAC --- The EAC ThresholdR product line consists of six systems, ranging from small, relatively simple systems, to large, sophisticated systems which provide a maximum degree of control, monitoring and reporting. The ThresholdR product line features a Distributed Network ArchitectureTM which means no single point of failure can affect the entire system. These systems are capable of controlling up to 250 doors for access control and up to 100,000 cardholders. The incorporation of alarm monitoring and point control (i.e. turning lights on or off) are also integral features of all six Threshold systems. The incorporation of Threshold Remote Software Package allows the connection of controllers from anywhere in the country via telephone lines. This functionality opens major markets for communication, utilities and large scale customers with remote facilities to manage. All EAC systems can also monitor other occurrences, such as a change in the status of environmental systems, motors, safety devices or any controller with a digital output. While monitoring these controllers, any output can, by a pre-programmed decision, cause an alarm to sound or another event to occur. The Company has several proprietary proximity card/tag and reader systems for all environments. The MirageR family of readers provides the fastest card verification in the industry and the release of the Mirage SG allows these readers to be directly mounted on metal without degradation in performance. The Mirage SG provides the same read performance in a smaller more aesthetically pleasing package. --------------------------- ThresholdR and MirageR are registered trademarks of the Company. Distributed Network ArchitectureTM is a trademark of the Company. EAC (continued) -------------- The proximity cards are comprised of a custom-integrated circuit implanted in a plastic card or key tag which is powered by RF energy transmitted from a reader unit ("Mirage") located at the entrance to a controlled door. Access is gained after Mirage verifies a code transmitted by the card. The proximity card cannot be copied or duplicated due to the use of a programmed integrated circuit. In addition, Mirage can be protected from environmental damage or vandalism by installing it inside a wall or behind a glass window. Mirage is usable throughout the Threshold product line. The Company's EAC proximity cards and reader systems have been certified by the FCC to comply with applicable regulations. POS Monitoring Systems ---------------------- In December 1991, the Company licensed the worldwide rights to a POS monitoring system that is marketed under the name ViewpointTM. Viewpoint records and stores on videotape every transaction at each check-out, both the visual and the individual transaction data. Viewpoint connects directly to the point-of-sale network using a PC compatible computer and fixed closed circuit television ("CCTV") cameras usually mounted inside domes affixed to a retailer's ceiling. Because all transaction data is stored in the computer's relational data base, user-generated reports can match questionable transactions to events recorded on the tape. The system also features a remote dial-in capability that allows users to monitor multiple store locations from one site, significantly lowering personnel cost. Viewpoint can be linked to Checkpoint Electronic Article Merchandising ("EAM") systems in order to record incidents that have caused the EAM system to register an alarm. Principal Markets and Distribution ---------------------------------- EAM --- The Company sells its EAM systems principally throughout North America and Europe, and to a lesser extent, in other areas, and also rents its products. During 1993, EAM revenues from outside North America (principally Europe and Scandinavia) represented approximately 26% of the Company's net revenues. In the United States, the Company markets its EAM products through its own sales personnel, independent representatives and independent dealers. Independent dealers accounted for less than 1% of the Company's net revenues in the United States during 1993. The Company, at December 26, 1993, employed 71 salespeople who sell the Company's products to the domestic retail market and who are compensated by salary plus commissions. The Company's independent representatives sell the Company's products to the domestic library market on a commission basis. At the end of 1993, the Company had 38 such independent representatives. Three members of the Company's sales management staff are assigned to manage and assist these independent representatives. Of total EAM domestic revenues during 1993, 88% was generated by the Company's own sales personnel. ------------------------- ViewpointTM is a trademark of the Company. Principal Markets and Distribution (continued) --------------------------------------------- EAM --- Internationally, the Company markets its EAM products through various foreign subsidiaries and independent distributors. The Company's foreign subsidiaries, as of December 26, 1993, employed a total of 93 salespeople who sell the Company's products to the retail and library markets. The Company's foreign sales operations are currently located in Western Europe, Canada, Mexico, Argentina and Australia ("see Marketing Strategy"). Independent distributors accounted for 37% of the Company's foreign revenues during 1993. Foreign distributors sell the Company's products to both the retail and library markets. The Company's distribution agreements generally appoint an independent distributor for a specified term as an exclusive distributor for a specified territory. The agreements require the distributor to purchase a specified dollar amount of the Company's products over the term of the agreement. The Company sells its products to independent distributors at prices significantly below those charged to end-users because the distributors make volume purchases and assume marketing, customer training, maintenance and financing responsibilities. Marketing Strategy ------------------ The Company's strategy is to sell to retail market segments that have a well-defined need for EAM such as the mass merchandise, supermarket, apparel, drug, music, video and home entertainment markets. Retailers in these market segments have increasingly expressed an interest in expanding the usage of open merchandising in order to realize maximum sales and profits. Electronic Article Merchandising or EAM is a strategy that enables aggressive open-merchandising techniques at the store level without risk of increased inventory losses. The foundation of this strategy is built on the Company's low cost RF disposable, integrated target that can be bulk activated and then deactivated without finding or touching the target. Today, the Company's systems are starting to be viewed more as a open merchandising system rather than a article surveillance system. The Company's source tagging program, ImpulseSM, supports self-service and impulse buying. Impulse reduces tagging labor and excess packaging, because targets are placed into the products at the source through their vendors. With this strategy, any EAM-related operational burden on store managers and employees to tag products is eliminated since the Company's circuit can be embedded in the product or packaging at the point-of- manufacture or distribution. The Impulse program protects high-margin, high-volume, high-shrinkage products such as fragrances, batteries and camera film. Preventing these items from being put in protective locations such as behind the counter or in locked cases has become a critical issue for manufacturers. ------------------------- ImpulseR is a registered trademark of the Company. According to one fragrance manufacturer's study, self-service fragrance sales are 60 percent greater than sales of products kept under lock and key. A study, conducted for the Company by Management Horizons, a division of Price Waterhouse, reported that if the consumer has to wait in line or search for a salesperson to buy batteries or camera film, they are likely to forego the purchase. Other Impulse strategies are: intensify vertical market focus into key product segments where RF is the only logical choice, such as liquors; expand Impulse activities into international markets; increase staffing for Impulse efforts supporting manufacturers and suppliers to speed implementation; and, expand RF target products to accommodate more packaging schemes. In order to expand its distribution channels, the Company embarked on an acquisition strategy that began in 1992 with the acquisition of its Canadian distributor, Checkpoint Canada, Inc. In addition, the Company purchased its Argentina distributor, Checkpoint Systems, S. A. in March of 1993 and set-up operations in Mexico, Checkpoint de Mexico, S. A. de C.V. during March of 1993 and set-up operations in Australia, Checkpoint Systems Australia, PTY LTD during June of 1993. During the second quarter of 1993 the Company and Sensormatic Electronics Corporation ("Sensormatic") terminated their exclusive distribution agreement for Western Europe. To replace the distribution of the Company's products into Western Europe, the Company purchased the entire share capital of the ID Systems Group in July of 1993. The ID Systems Group was engaged in the manufacture, distribution and sale of EAM systems. This acquisition gave the Company direct access to six Western European countries which are The Netherlands, United Kingdom, Sweden, Germany, France and Belgium. EAC --- The Company's EAC sales personnel, together with manufacturers' representatives, market its EAC products to approximately 210 independent dealers. The Company employs four salespeople who are compensated by salary plus commissions. The Company's three manufacturers' representatives are compensated solely by commissions. Under the independent dealer program, the dealer takes title to the Company's products and sells them to the end-user customer. The dealer installs the systems and provides ongoing service to the end-user customer. POS Monitoring Systems ----------------------- The Company markets the POS monitoring products throughout the world through its own EAM sales personnel which currently numbers 164. Sales of the POS monitoring products are sold to the Company's existing EAM retail customers along with those retailers that currently do not have the Company's EAM products. Backlog ------- The Company's backlog of orders was approximately $6,673,000 at December 26, 1993, as compared with approximately $6,352,000 at December 27, 1992. The Company anticipates that substantially all of the backlog at the end of 1993 will be delivered during 1994. In the opinion of management, the amount of backlog is not indicative of intermediate or long-term trends in the Company's business. In addition, management believes that its business is not seasonal. License and Supply Agreements; Patent Protection ------------------------------------------------ EAM/EAC/POS Monitoring Systems ------------------------------ The Company considers its proprietary technology important. Substantially all of the Company's revenues were derived from products or technologies which are patented or licensed. EAM --- The Company is the exclusive worldwide licensee of Arthur D. Little, Inc. ("ADL") for certain patents and improvements thereon related to EAM products and manufacturing processes. The Company pays a royalty to ADL ranging from 5% to 2% of net revenues generated by the sale and lease of the licensed products, with the actual amount of the royalty depending upon revenue volume. Royalties amounted to 1.8%, 1.8% and 1.9% of EAM net revenues for 1993, 1992 and 1991, respectively. The term of the license is coterminous with the patents, the first of which expired in 1991 and the last of which will expire in 2007. In addition, the Company has other less significant licenses covering certain sensors, magnetic labels and fluid tags. These licenses arrangements have various expiration dates and royalty terms. EAC --- The Company is the worldwide licensee of certain patents and technical knowledge related to proximity card and card reader products. It pays a royalty equal to 2% of the net revenues from the licensed products. Such royalties are payable through January 29, 2000, or until all of the subject patents have been adjudicated invalid. Royalty expense for 1993, 1992 and 1991 was approximately .5%, .6% and .6% of the Company's EAC net revenues, respectively. POS Monitoring Systems ---------------------- The Company has a worldwide license to distribute a point-of-sale front- end monitoring system being marketed under the name Viewpoint. Marketing of this product began during 1992. The Company pays a one time site license fee for each site installed. Manufacturing, Raw Materials and Inventory ------------------------------------------ EAM --- The Company purchases raw materials from outside suppliers and assembles electronic components for the majority of its sensor product lines at its facilities in Puerto Rico. For its target production, the Company purchases raw materials and components from outside sources and completes the manufacturing process at its facilities in Puerto Rico (disposable targets) and the Dominican Republic (reusable targets). Certain components of sensors are manufactured at the Company's facilities in the Dominican Republic and shipped to Puerto Rico for final assembly. Although the Company generally uses single suppliers for its purchased raw materials and components, other suppliers of these items are available. The Company's general practice is to maintain a level of inventory sufficient to meet anticipated demand for its products. EAC --- The Company purchases raw materials from outside suppliers and assembles the electronic components for controllers, proximity cards and proximity readers at its facilities in the Dominican Republic and Puerto Rico. For non-proximity EAC components, the Company subcontracts manufacturing activities. All EAC final system assembly and testing is performed at the Company's facilities in Thorofare, New Jersey. POS Monitoring Systems ---------------------- The Company does not manufacture any of the components for the Viewpoint product line other than small interface circuit boards. The Company purchases all the hardware components of the Viewpoint products from major distributors. Limited inventory levels are maintained since the Company places orders with these distributors as customer orders are received. The software component of the system is added at the customer's site. Competition ----------- EAM --- To the Company's knowledge, the principal competition in the U.S. is comprised of Sensormatic and Knogo in the supply of EAM systems for retail establishments and 3M in the supply of such systems for libraries. The Company's competitors in the EAM industry are well-established businesses with comparable and in some cases greater financial resources. In the apparel market, where hard reusable targets are emphasized, Sensormatic and Knogo have enjoyed better penetration than the Company in this traditional EAM market for which the competition designed and developed their products. The Company's principal competition in Western Europe is comprised of Sensormatic, Knogo, 3M, Actron, and Esselte Meto. The Company's product line offers more diversity than its competition in protecting different kinds of merchandise with soft disposable targets and hard and flexible reusable targets, all of which operate with the same RF system. As a result, the Company believes it appeals to a wider segment of the market than does its competition and competes in marketing its products primarily on the basis of their versatility, reliability, affordability, accuracy and integration into operations. This combination provides many system solutions which allow for protection of various kinds of merchandise from theft. EAC --- The Company's EAC products compete with other manufacturers of EAC systems as well as with conventional security systems, such as manual locking mechanisms and security guard services. Major competitors are Cardkey, Software House and Westinghouse. All three competitors are subsidiaries of much larger companies that have substantially greater resources than the Company. The Company believes that its products offer more versatility than those of its competitors. POS Monitoring Systems ------------------------ The Company's POS Monitoring products compete primarily with similar products offered by Sensormatic and Knogo. The Company believes that its products represent a technological advancement over those of its competitors, particularly with respect to recording and retrieval of transaction information. Research and Development ------------------------ The Company expended approximately $5,392,000, $4,498,000 and $3,313,000 in research and development activities during 1993, 1992 and 1991, respectively. The emphasis of these activities is the improvement and development of the Electronic Signatures technology to better integrate into customers' operations. Employees --------- At December 26, 1993, the Company had 1,366 employees. Financial Information About Domestic and Foreign Operations ----------------------------------------------------------- The following table sets forth certain information concerning the Company's domestic and foreign operations for each of the last three fiscal years. Geographic Area 1993 1992 1991 =============== ==== ==== ==== (Thousands) Net revenues from From United States $71,834 $72,166 $52,943 unaffiliated and Puerto Rico customers Net revenues from Western Europe, $21,200 - - foreign subsidiaries Canada, Mexico, Argentina, and Australia Export net revenues Primarily Europe $12,163 $22,732 $15,427 and Scandinavia Domestic earnings From United States, $ 1,720 $ 4,891 $ 635 before income taxes Puerto Rico, and Dominican Republic Foreign earnings Western Europe, $ 351 $ - $ - before income taxes Canada, Mexico, Argentina and Australia Domestic identifiable In United States, $78,982 $74,333 $57,675 assets Puerto Rico, and Dominican Republic Foreign identifiable Western Europe, $26,017 $ - $ - assets Canada, Mexico, Argentina, and Australia Item 2.

Item 2. PROPERTIES The Company's headquarters and distribution center are in leased facilities located in Thorofare, New Jersey. The current leases expire in December of 1994. Of the total 67,000 square feet, approximately 48,000 square feet are used for office space and approximately 19,000 square feet are used for storage facilities. The rental for the remaining year is $435,000. Item 2. PROPERTIES (continued) To replace the current facility, the Company has entered into a twelve year lease for the construction of a 104,000 square foot facility in close proximity to the current headquarters and distribution center. Of the 104,000 square feet approximately 64,000 square feet will be used for administrative and research and development activities. The remaining 40,000 square feet will be used for storage and distribution. The annual rent during each of the first five years starting in 1995 is $692,000. The Company's principal manufacturing facility for the production of most of its products is located in Ponce, Puerto Rico. This two-story facility, which was completed in 1990, is owned by the Company and contains approximately 95,000 square feet. In addition, the Company leases a manufacturing and development facility in Puerto Rico near the manufacturing facility containing approximately 9,000 square feet. The lease expires in 1997 with an annual rent of $26,000 in 1994 and $31,000 thereafter. The Company also leases two manufacturing facilities in the Dominican Republic. One facility, located in La Vega, contains approximately 16,000 square feet. Certain components of the Company's sensors, hard targets and proximity cards are assembled at this site. The lease for this property expires in March 1998 with an annual rent of $6,000. The other facility, located in Los Alcarrizos, contains approximately 24,000 square feet. This facility performs the bending, chroming and wiring of antenna loops used in the Company's Quicksilver sensor products. This facility also performs certain injection molding production used in the assembly of the Company's reusable security targets. The lease for the Los Alcarrizos property expires in September 2000 with an annual rent of $17,500. The lease payments for both locations have been prepaid for their entire 10 year terms. The Company's foreign subsidiaries maintain various sales and distribution locations in Australia, Argentina, Belgium, Canada, France, Germany, Mexico, The Netherlands, Sweden, and United Kingdom. Item 3.

Item 3. LEGAL PROCEEDINGS On February 16, 1994, Checkpoint Systems, Inc, ("Checkpoint") and Fargklamman Svenska AB ("Fargklamman") and Colortag Inc. ("Colortag") entered into an agreement (the "Agreement") pursuant to which, inter alia, (i) Fargklamman and Colortag voluntarily dismissed with prejudice the lawsuit initiated by Fargklamman and Colortag against Checkpoint on September 10, 1993 in the United States District Court for the Southern District of New York (Civil Action No. 93 Civ. 6368 (TPG)) seeking injunctive relief and damages for alleged trade dress infringement, unfair competition and misappropriation of trade secrets in connection with Checkpoint's sales of its ink tag (ChekInkTM), (ii) Checkpoint, Fargklamman and Colortag exchanged mutual releases, and (iii) Checkpoint and Fargklamman entered into a license agreement whereby Checkpoint licensed from Fargklamman, on a non-exclusive, world-wide basis, rights to U.S. Patent No. 5,275,122 in exchange for a royalty payment based on future sales of licensed products by Checkpoint and certain payments to be made over a three year period to Fargklamman. Item 3. LEGAL PROCEEDINGS (continued) On March 10, 1993, the United States International Trade Commission ("Commission") instituted an investigation of a complaint filed by the Company under Section 337 of the Tariff Act of 1930. The complaint, as amended, alleged that six respondents imported, sold for importation, or sold in the United States after importation certain anti-theft deactivatable resonant tags and components thereof that infringed certain U.S. Letters Patents of which the Company is exclusive licensee. The Commission's notice of investigation named six respondents, each of whom was alleged to have committed one or more unfair acts in the importation or sale of components or finished tags that infringe the asserted patent claims. Those respondents are: Actron AG; Tokai Denshi Co. Ltd.; ADT, Limited; All Tag Security AG; Toyo Aluminum Ltd.; and Custom Security Industries, Inc. On March 10, 1994 the United States International Trade Commission issued a Notice of Commission Determination Not to Review An Initial Determination Finding No Violation of Section 337 of the Tariff Act of 1930. The ultimate resolution is undetermined at this time due to the various courses of action available to management, including the right of appeal which the Company currently intends to exercise. Although the Company's management ultimately expects a favorable outcome, should resolution of this matter result in less than a successful defense of the patents in question the deferred patent costs will be written off as a charge to earnings at the time of such resolution. Item 4.

Item 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS No matter was submitted during the fourth quarter of 1993 to a vote of security holders. Item A. EXECUTIVE OFFICERS OF THE REGISTRANT The following table sets forth certain information concerning the executive officers of the Company, including their ages, position and tenure as of the date hereof: OFFICER NAME AGE SINCE POSITIONS WITH THE COMPANY Albert E. Wolf 64 1969 Chairman of the Board of Directors, Chief Executive Officer, and Director Kevin P. Dowd 45 1988 President and Chief Operating Officer Luis A. Aguilera 45 1982 Senior Vice President - Manufacturing Steven G. Selfridge 38 1988 Senior Vice President - Operations, Chief Financial Officer and Treasurer Mitchell T. Codkind 34 1992 Corporate Controller and Chief Accounting Officer Muns A. Farestad 45 1990 Vice President - Research and Development William J. Reilly, Jr. 45 1989 Senior Vice President - Americas' and Pacific Rim Michael E. Smith 37 1990 Senior Vice President - Marketing and Western European Operations Neil D. Austin 47 1989 Vice President - General Counsel and Secretary Arthur Cavaliere 47 1991 Vice President - Customer Service Mr. Wolf has been Chairman of the Board of Directors since April 1986, Chief Executive Officer of the Company since April 1972, and a director since July 1969. Mr. Wolf was President from July 1977 to April 1986. Effective July 1991, Mr. Wolf resumed the position of President along with his other duties until August 1993. Mr. Wolf is a director of Lydall, Inc. Item A. EXECUTIVE OFFICERS OF THE REGISTRANT (continued) Mr. Dowd has been President and Chief Operating Officer of the Company since August 1993. He was Executive Vice President of the Company from May 1992 to August 1993. Mr. Dowd was Executive Vice President - Marketing, Sales and Service from April 1989 to May 1992 and Vice President of Sales from August 1988 to April 1989. Prior to joining the Company, Mr. Dowd was Director - Industrial Products Group, Mars Electronics from January 1987 to July 1988. Mr. Aguilera has been Senior Vice President - Manufacturing since August 1993. He was Vice President - Manufacturing of the Company from April 1982 to August 1993, and Vice President and General Manager of the Company's Puerto Rico subsidiary since February 1979. Mr. Selfridge has been Senior Vice President - Operations and Chief Financial Officer and Treasurer since August 1993. He was Chief Financial Officer and Vice President - Finance and Treasurer of the Company from December 1990 to August 1993; and Vice President - Finance and Treasurer of the Company since September 1989. Mr. Selfridge was Corporate Controller, Chief Accounting Officer and Secretary from April 1988 to September 1989 and Controller of Domestic Operations from July 1986 to April 1988. Mr. Selfridge is a Certified Public Accountant. Mr. Codkind has been Corporate Controller and Chief Accounting Officer since January 1992. Mr. Codkind was Controller of Domestic Operations from January 1990 to January 1992 and Accounting Manager of Domestic Operations from June 1986 to January of 1990. Mr. Codkind is a Certified Public Accountant. Mr. Farestad has been Vice President - Research and Development since October 1990. From July 1987 to January 1989 Mr. Farestad was Director of Manufacturing Engineering and from January 1989 to October 1990 he was Director of Process Engineering and Shared Resources. Mr. Reilly has been Senior Vice President - Americas' and Pacific Rim since August 1993. He was Vice President - Sales of the Company from April 1989 to August 1993. Mr. Reilly was Eastern Regional Sales Manager from March 1989 to April 1989. Prior to joining the Company, Mr. Reilly was U.S. Sales Manager for Multitone Electronics PLC, London, U.K. from 1982 to 1989. Mr. Smith has been Senior Vice President - Marketing and Western European Operations since August 1993. He was Vice President - Marketing from August 1990 to August 1993. Mr. Smith was Director of Marketing from April 1989 to August 1990 and Program Manager - National/Major Accounts from December 1988 to April 1989. Prior to joining the Company, Mr. Smith was Marketing Manager with Mars Electronics International from June 1987 to November 1988. Mr. Austin has been Vice President - General Counsel and Secretary since September 1990. Mr. Austin was General Counsel and Secretary from September 1989 to September 1990 and General Counsel from June 1989 to September 1989. Prior to joining the Company, Mr. Austin was a managing consultant with Mercer, Meidinger, Hansen Inc. from 1987 to 1989. Mr. Cavaliere has been Vice President - Customer Service since September 1991. Mr. Cavaliere was Director of Field Service from May 1988 to September 1991 and National Field Service Manager from June 1986 to May 1988. PART II Item 5.

Item 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS The Common Stock of the Company is traded on the New York Stock Exchange ("NYSE") under the symbol CKP. Prior to October 29, 1993, the Company's Common Stock was traded in the over-the-counter market on the National Association of Securities Dealers Automated Quotation System ("NASDAQ") National Market System, under the symbol CHEK. The following table sets forth for the indicated periods the closing price range of the Common Stock as furnished by the NYSE and NASDAQ for the respective periods. High Low ---- --- Closing Price ------------- 1992: First Quarter ............................ 13 7 3/4 Second Quarter ........................... 11 7 1/8 Third Quarter ............................ 10 7/8 8 5/8 Fourth Quarter ........................... 18 1/8 9 1/8 1993: First Quarter ............................ 20 1/8 8 3/4 Second Quarter ........................... 12 7/8 8 3/4 Third Quarter ............................ 11 3/4 8 1/8 Fourth Quarter ........................... 14 8 1/2 As of March 11, 1994, there were approximately 1,771 record holders of the Company's Common Stock. The Company has never paid a cash dividend on the Common Stock. The declaration and payment of dividends in the future, and their amounts, will be determined by the Board of Directors in light of conditions then existing, including the Company's earnings, its financial condition and requirements (including working capital needs) and other factors. Item 6.

Item 6. SELECTED ANNUAL FINANCIAL DATA 1993 1992 1991 1990 1989 ======== ======== ======== ======== ======== (Thousands, except per share data) FOR YEARS ENDED: Net revenues $ 93,034 $ 72,166 $ 52,943 $ 56,742 $ 50,750 Earnings before income taxes $ 2,071 $ 4,891 $ 635 $ 6,707 $ 6,897 Income taxes (benefit) $ 456 $ 463 $ 127 $ (225) $ 1,294 Net earnings $ 1,615 $ 4,428 $ 508 $ 6,932 $ 5,603 Earnings per common share $ .16 $ .45 $ .05 $ .72 $ .61 AT YEAR-END: Working capital $ 27,984 $ 25,792 $ 14,245 $ 17,915 $ 18,742 Long-term debt $ 24,302 $ 9,322 783 $ - $ 1,200 Shareholders' equity $ 53,779 $ 51,061 $ 42,087 $ 41,321 $ 32,610 Total assets $104,999 $ 74,333 $ 57,675 $ 53,129 $ 44,371 SELECTED QUARTERLY FINANCIAL DATA QUARTERS (unaudited) -------------------------------------------- First Second Third Fourth Year ----- ------ ----- ------ ---- (Thousands, except per share data) ---- Net revenues $20,016 $18,026 $26,604 $28,388 $93,034 Gross profit $ 8,700 $ 6,880 $11,385 $11,648 $38,613 Net earnings $ 507 $ 884 $ 112 $ 112 $ 1,615 Earnings per common share $ .05 $ .09 $ .01 $ .01 $ .16 ---- Net revenues $14,222 $16,567 $19,159 $22,218 $72,166 Gross profit $ 6,427 $ 7,570 $ 9,057 $10,462 $33,516 Net earnings $ 150 $ 943 $ 1,272 $ 2,063 $ 4,428 Earnings per common share $ .02 $ .10 $ .13 $ .20 $ .45 CHECKPOINT SYSTEMS, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Item 7.

Item 7. LIQUIDITY AND CAPITAL RESOURCES ------------------------------- Cash and cash equivalents decreased $2,320,000 during the year to a zero balance. The Company's primary sources of cash were funds provided from funding arrangements, ($14,774,000). The primary uses of cash were the acquisition of property, plant and equipment ($4,600,000), net cash used by operating activities ($6,317,000), acquisitions ($3,184,000) and other investing activities of ($3,660,000). For a detailed analysis of the Company's sources and uses of cash from operating, investing and financing activities, refer to the Consolidated Statements of Cash Flows in the financial section of this report. Below is a discussion that further enhances the Statements of Cash Flows. Depreciation and amortization increased $2,483,000 during the year compared to last year ($6,476,000 versus $3,993,000), as a result of investments principally in manufacturing equipment and management information systems. Increases in amortization resulted from software development costs and the purchase of various intangibles, including patents, licenses, trademarks and customers lists. In addition, goodwill generated from recent acquisitions have also increased amortization expense. Accounts receivable increased $2,716,000 as a result of record revenues posted in the fourth quarter. Property, plant and equipment expenditures decreased $1,543,000 during 1993 ($4,600,000 versus $6,143,000). The principal expenditures for the current year have been made in the areas of production, management information systems and lab equipment for research and development activities. Inventories increased $6,816,000 from the start of the year as a result of an expanded product offering and the Company's anticipated needs for the first half of 1994. Accounts payable increased $2,062,000 as a result of the increased inventory purchases required to meet the increased demand for the Company's products. The Company made acquisitions, net of cash acquired, of $3,184,000 relating to the capital stock purchases of the Company's Argentinean distributor and the ID Systems Group, a European manufacturer and distributor of EAM products. The $3,660,000 in other investing activities is mainly comprised of: capitalized legal expenses related to the defense of certain patents in which the Company holds exclusive rights; the purchase of a customers list from the Company's former Mexican distributor; the capitalization of software development costs; the purchase of patents and license related to two of the Company's new products, magnetics and QS1500/1600; and, deposits related to the Company's lease agreement for a new corporate facility. CHECKPOINT SYSTEMS, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) For the year, the Company borrowed a total amount of $15,000,000 under a long-term revolving credit facility. Subsequent to year end $8,000,000 outstanding under this credit facility was converted to a six year term loan at a fixed interest rate of 6.5%. Management is currently working towards finalizing a $12,000,000 private placement debt funding. Once completed, this will be used to pay down existing debt under the Company's long-term revolving credit facility. As of December 26, 1993, the current ratio was 2.0 to 1. The quick ratio was .9 to 1. The equity-debt ratio was 1.0 to 1. Management is currently contemplating other financing in order to fund its aggressive acquisition and selling strategies. CHECKPOINT SYSTEMS, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) RESULTS OF OPERATIONS --------------------- For the Year Ended December 26, 1993 ------------------------------------ Net revenues increased 29% or $20,868,000 when compared to the prior year ($93,034,000 versus $72,166,000). As a percent of net revenues, domestic and foreign net revenues were 64% and 36%, respectively compared to 69% and 31% for 1992. Domestic Electronic Article Merchandising ("EAM") net revenues increased $9,363,000 or 20% while foreign EAM net revenues increased $10,754,000 or 48% when compared to 1992. The domestic expansion is due principally to large revenue and unit increases in the Company's hardware products (sensors and deactivation) and disposable targets. These substantial gains are the result of expansion of business to large domestic retailers, particularly in the mass merchandise, drug stores, supermarkets, apparel and music segments, a broader product offering, and a record number of new customers in 1993. Foreign revenues increased by 48% as a result of the Company's recent acquisitions in Western Europe, Canada and Argentina along with setting up operations in Mexico. Revenues from the Company's subsidiaries in Canada, Mexico and Argentina represented $9.6 million of the $10.8 million increase. During the second quarter of 1993, the Company and Sensormatic Electronics Corporation ("Sensormatic") terminated their exclusive distribution agreement in Europe. During the third quarter of 1993, the Company purchased all of the outstanding capital stock of ID Systems International B.V. and ID Systems Europe B.V. ("ID Systems Group") related Dutch companies engaged in the manufacture, distribution, and sale of security products and services. Revenues from Western Europe in 1993, which combines first half sales through its former distributor and second half sales by the Company's European subsidiary, remained flat as compared to 1992 in which sales were made solely through the Company's former distributor. Management expects revenues from Western Europe in 1994 to increase over 1993 levels as result of the acquisition of the ID Systems Group. The Company is in the process of closing down the acquired manufacturing facilities in Europe and relocating this production to the Company's facilities in Puerto Rico and the Dominican Republic. Once this relocation is fully completed, sometime during the first half of 1994, the Company anticipates a reduction in the cost of manufacturing of those products previously produced overseas. (Refer to Note 14 of the Consolidated Financial Statements.) As a result of having various foreign operations, the Company is exposed to foreign exchange fluctuations. Management is evaluating various strategies in order to minimize the effect of fluctuating foreign currencies on the Company's financial statements associated with having international subsidiaries. The Company has purchased certain foreign currency forward contracts on intercompany commitments in order to hedge anticipated rate fluctuations in Europe. Electronic Access Control ("EAC") net revenues increased $751,000 or 17% over 1992. The EAC business unit first became profitable in 1991, and has remained profitable, as a result of increased revenues and integrating its operations into the New Jersey, Puerto Rico and Dominican Republic facilities in 1990. CHECKPOINT SYSTEMS, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) Net earnings were $1,615,000 or $.16 per share versus net earnings of $4,428,000 or $.45 per share for 1992. Earnings decreased due to the reduction in gross profit margins and increased selling, general, and administrative expenses resulting primarily from the recently acquired subsidiaries. The gross profit margin declined 4.9% (41.5% versus 46.4%) as a result of the significant expansion business with new and existing major domestic customers that enjoy competitive pricing and the success of several new products introduced during the year which currently carry lower margins. Although the Company obtained overall higher selling prices during the year, the gains were offset by increased service costs, a result of selling directly to nine countries in which the Company previously maintained distributors. Service costs in 1993 increased 4.3% as a percent of sales as compared to 1992. In addition, due to the termination of the Company's European distribution agreement in the second quarter, the Company reduced production volumes which resulted in slightly higher unit costs in the Company's manufacturing facility in Puerto Rico. Selling, general and administrative expenses increased $10,896,000 ($39,238,000 versus $28,342,000) when compared to last year. The higher expenses are due to increases in variable selling and marketing expenses resulting from greater domestic sales, in addition to increases in general and administrative expenses resulting from the operating expenses of the companies acquired in 1993. As a percent of net revenues, this represents an increase of 2.9% (42.2% versus 39.3%) compared to 1992. The Company's manufacturing operations in Puerto Rico are exempt from U.S. Federal income taxes under Section 936 of the Internal Revenue Code. Approximately 50% of the Company's earnings were attributed to Puerto Rico operations. The Company also enjoys local tax exemptions on Puerto Rico based earnings and benefits from the utilization of a Delaware Investment Holding company. (Refer to note 9 of the Notes to Consolidated Financial Statements.) The Company's 1993 effective tax rate was 22%. Due to the Company's foreign subsidiaries operating in countries with different statutory income tax rates, the Company anticipates a 25% tax rate for 1994. In 1993, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes." The adoption of this standard did not have a material effect on the Company's financial statements. The Company intends to continue its expansion of both product lines and distribution channels. The increased product offerings are due to internally developed products and the acquisition of products or rights to distribute those products. The Company has expanded its channels of distribution by acquisition of international distributors, acquisition of competitors, and by start-up operations. The Company intends to continue worldwide expansion based on these strategies. CHECKPOINT SYSTEMS, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) Subsequent to year end and as discussed in Item 3. Legal Proceedings, on March 10, 1993, the United States International Trade Commission instituted an investigation of a complaint filed by the Company under Section 337 of the Tariff Act of 1930. On March 10, 1994 the United States International Trade Commission issued a Notice of Commission Determination Not to Review An Initial Determination Finding No Violation of Section 337 of the Tariff Act of 1930. The Company has capitalized $2,027,000 in patent defense costs, included in "Intangibles" (see Consolidated Balance Sheet) as of December 26, 1993. The ultimate resolution is undetermined at this time due to the various courses of action available to management including the right of appeal which the Company currently intends to exercise. Although the Company's management ultimately expects a favorable outcome, should resolution of this matter result in less than a successful defense of the patents in question the deferred patent costs noted above will be written off as a charge to earnings at the time of such resolution. CHECKPOINT SYSTEMS, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) RESULTS OF OPERATIONS --------------------- For the Year Ended December 27, 1992 ------------------------------------ Net revenues increased 36% or $19,223,000 when compared to the prior year ($72,166,000 versus $52,943,000). As a percent of net revenues, domestic and export net revenues were 69% and 31%, respectively compared to 71% and 29% for the similar period last year. Domestic Electronic Article Merchandising ("EAM") net revenues increased $11,282,000 or 33% and export EAM net revenues increased $7,282,000 or 48% when compared to 1991. The increase in domestic net revenues was primarily due to aggressive sales and marketing programs initiated by the Company during the year. The primary reason for the increase in export sales was the increase in sensor and deactivation products sold to Sensormatic Electronics Corporation ("Sensormatic"), the Company's distributor for Western Europe. In addition, many of the Company's other distributors throughout the world had significant sales increases over the prior year. During 1992, the loss prevention group of the Company's former distributor, Automated Security (Holdings) PLC, ("ASH") was acquired by the Company's largest competitor, Sensormatic. An exclusive distributor agreement was reached with Sensormatic to provide distribution into 15 European countries. Electronic Access Control ("EAC") net revenues increased $659,000 or 18% over 1991's performance. As a result of having integrated this business unit into the Company's New Jersey, Puerto Rico and Dominican Republic facilities in mid 1990, this operation has become profitable in 1991 for the first time since the Company acquired it in 1986, and was again profitable in 1992. Net earnings were $4,428,000 or $.45 per share versus net earnings of $508,000 or $.05 per share for 1991. Earnings increased primarily due to a significant increase in revenues while maintaining comparable gross profit margins to 1991. The gross profit margin remained at 46% compared to 1991. Increases in volumes and manufacturing improvements were offset by price reductions to the Company's largest international distributor (Sensormatic) and aggressive sales programs within the domestic market. CHECKPOINT SYSTEMS, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (continued) Selling, general and administrative expenses increased $4,696,000 ($28,342,000 versus $23,646,000) when compared to last year. This increase was caused primarily by an increase in variable sales and marketing expenses ($3,137,000) in addition to recognition of a new Board of Directors Bonus Award Plan ($318,000), based on the value of the Company's stock as of the end of the fiscal year. The Company's manufacturing operations in Puerto Rico are exempt from U.S Federal income taxes under Section 936 of the Internal Revenue Code. Approximately 50% of the Company's earnings were attributed to Puerto Rico operations. Additionally, the Company enjoys local tax exemptions on Puerto Rico based earnings and also benefits from the utilization of a Delaware Investment Holding company (See note 9 of the Notes to Consolidated Financial Statements). The Company's effective tax rate of 1992 would have been 18% but was reduced by a $417,000 tax benefit resulting from a further refinement of a tax estimate regarding prepaid local Puerto Rico taxes. Item 8.

Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Index to Consolidated Financial Statements Report of Independent Accountants......................................28 Consolidated Balance Sheets as of December 26, 1993 and December 27, 1992...................................................29 Consolidated Earnings Statements for each of the years in the three-year period ended December 26, 1993....................30 Consolidated Statements of Shareholders' Equity for each of the years in the three-year period ended December 26, 1993..............30 Consolidated Statements of Cash Flows for each of the years in the three-year period ended December 26, 1993....................31 Notes to Consolidated Financial Statements...........................32-42 Financial Schedules Schedule V - Property, Plant and Equipment.......................46 Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment.......................47 Schedule VIII - Valuation and Qualifying Accounts...................48 Schedule IX - Short-term Borrowings...............................48 Schedule X - Supplementary Income Statement Information..........49 REPORT OF INDEPENDENT ACCOUNTANTS The Board of Directors and Shareholders Checkpoint Systems, Inc. We have audited the consolidated balance sheets of Checkpoint Systems, Inc. and subsidiaries as of December 26, 1993 and December 27, 1992, and the related consolidated earnings statements, statements of shareholders' equity and cash flows for each of the years in the three year period ended December 26, 1993. We have also audited the financial statement schedules for the years ended December 26, 1993 and December 27, 1992 listed in Item 14(a)2 of this Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above, present fairly, in all material respects, the consolidated financial position of Checkpoint Systems, Inc. and subsidiaries as of December 26, 1993 and December 27, 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 26, 1993 in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As discussed in Footnote 1, in 1993, the Company changed its method of accounting for income taxes. COOPERS & LYBRAND 2400 Eleven Penn Center Philadelphia, Pennsylvania March 22, 1994 CHECKPOINT SYSTEMS, INC. CONSOLIDATED BALANCE SHEETS December 26, December 27, 1993 1992 ------------ ------------ ASSETS (Thousands) ------ CURRENT ASSETS Cash and cash equivalents $ - $ 2,320 Accounts receivable, net of allowances of $2,237,000 and $357,000 24,239 18,562 Inventories 25,450 16,757 Other current assets 5,213 2,103 ------- ------- Total current assets 54,902 39,742 PROPERTY, PLANT AND EQUIPMENT, net of accumulated depreciation and amortization 30,862 26,982 EXCESS OF PURCHASE PRICE OVER FAIR VALUE OF NET ASSETS ACQUIRED 8,919 3,430 INTANGIBLES 5,098 2,257 DEFERRED TAXES, net of valuation allowance 479 - OTHER ASSETS 4,739 1,922 ------- ------- TOTAL ASSETS $104,999 $74,333 ======= ======= LIABILITIES AND SHAREHOLDERS' EQUITY ------------------------------------ CURRENT LIABILITIES Accounts payable $9,716 $ 4,784 Accrued compensation and related taxes 1,907 1,771 Income taxes 792 1,177 Unearned revenues 2,645 2,652 Other current liabilities 7,761 2,274 Short-term borrowings and current portion of long-term debt 4,097 1,292 ------- ------- Total current liabilities 26,918 13,950 LONG-TERM DEBT, LESS CURRENT MATURITIES 24,302 9,322 COMMITMENTS AND CONTINGENCIES SHAREHOLDERS' EQUITY Preferred stock, no par value, authorized 500,000 shares, none issued Common stock, par value $.10 per share, authorized 100,000,000 shares, issued 10,979,198 and 10,802,548 1,097 1,080 Additional capital 18,346 16,754 Retained earnings 40,506 38,891 Common stock in treasury, at cost, 799,000 shares (5,664) (5,664) Foreign currency adjustments (506) - ------- ------- TOTAL SHAREHOLDERS' EQUITY 53,779 51,061 ------- ------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $104,999 $74,333 ======= ======= See accompanying notes to consolidated financial statements. CHECKPOINT SYSTEMS, INC. CONSOLIDATED EARNINGS STATEMENTS 1993 1992 1991 ------- ------- ------- (Thousands, except per share data) Net Revenues $93,034 $72,166 $52,943 Cost of Revenues 54,421 38,650 28,479 ------- ------- ------- Gross Profit 38,613 33,516 24,464 Selling, General and Administrative Expenses 39,238 28,342 23,646 ------- ------- ------- Operating Income (loss) (625) 5,174 818 Contract Settlement Income 3,500 - - Interest Income 476 140 171 Interest Expense 953 423 354 Other Expense 327 - - ------- ------- ------- Earnings Before Income Taxes 2,071 4,891 635 Income Taxes 456 463 127 ------- ------- ------- Net Earnings $ 1,615 $ 4,428 $ 508 ======= ======= ======= Net Earnings Per Share $ .16 $ .45 $ .05 ======= ======= ======= CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY Foreign Common Additional Retained Treasury Currency Stock Capital Earnings Stock Adjust. Total ------- ------- ------- ------- ------- ------ (Thousands) Balance, December 30, 1990 $ 1,022 $12,008 $33,955 $(5,664) $ - $41,321 Net Earnings 508 508 Exercise of Stock Options 4 254 258 ------- ------- ------- ------- ------- ------- Balance, December 29, 1991 1,026 12,262 34,463 (5,664) - 42,087 Net Earnings 4,428 4,428 Exercise of Stock Options 54 4,492 4,546 ------- ------- ------- ------- ------- ------- Balance, December 27, 1992 1,080 16,754 38,891 (5,664) - 51,061 Net Earnings 1,615 1,615 Exercise of Stock Options 17 1,592 1,609 Foreign Currency Adjustments (506) (506) ------- ------- ------- ------- ------- ------- Balance, December 26, 1993 $ 1,097 $18,346 $40,506 $(5,664) $ (506) $53,779 ======= ======= ======= ======= ======= ======= See accompanying notes to consolidated financial statements. CHECKPOINT SYSTEMS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS 1993 1992 1991 ---- ---- ---- (Thousands) Cash inflow (outflow) from operating activities: Net earnings $ 1,615 $ 4,428 $ 508 Adjustments to reconcile net earnings to net cash provided by operating activities: Net book value of rented equipment sold less than cost of rented equipment (2,708) (736) (482) Long-term customer contracts 421 (1,111) - Depreciation and amortization 6,476 3,993 3,058 Deferred Taxes (479) - - Provision for losses on accounts receivable 520 88 236 (Increase) decrease in current assets: Accounts receivable (2,716) (1,445) (1,194) Inventories (6,816) (5,981) (359) Other current assets (2,024) (833) 462 Increase (decrease) in current liabilities: Accounts payable 2,062 1,284 (1,163) Accrued compensation and related taxes (269) 727 (1,018) Income taxes (385) 819 56 Unearned revenues (7) 220 268 Other current liabilities (2,007) 79 (168) ------- ------- ------- Net cash provided (used) by operating activities (6,317) 1,532 204 Cash inflow (outflow) from investing ------- ------- ------- activities: Acquisition of property, plant and equipment (4,600) (6,143) (6,121) Proceeds of investment securities - 825 650 Acquisitions, net of cash acquired (3,184) (1,030) - Other investing activities (3,660) (1,147) (765) ------- ------- ------- Net cash used by investing activities (11,444) (7,495) (6,236) Cash inflow (outflow) from financing ------- ------- ------- activities: Proceeds from stock options 1,609 4,546 258 Proceeds of debt 14,774 3,830 6,000 Payment of debt (942) (609) (1,200) ------- ------- ------- Net cash provided by financing activities 15,441 7,767 5,058 Net increase (decrease) in cash and ------- ------- ------- cash equivalents (2,320) 1,804 (974) Cash and cash equivalents: Beginning of year 2,320 516 1,490 ------- ------- ------- End of Year $ - $ 2,320 $ 516 ------- ------- ------- See accompanying notes to consolidated financial statements. CHECKPOINT SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation --------------------------- The consolidated financial statements include the accounts of Checkpoint Systems, Inc. and its wholly-owned subsidiaries ("Company"). All material intercompany transactions are eliminated in consolidation. Fiscal Year ---------- The Company's fiscal year is the 52 or 53 week period ending the last Sunday of December. References to 1993, 1992 and 1991 are for: the 52 weeks ended December 26, 1993, the 52 weeks ended December 27, 1992, and the 52 weeks ended December 29, 1991. Revenue Recognition ------------------- Revenue from the sale of equipment is recognized upon shipment of equipment or the acceptance of a customer order to purchase equipment currently rented. Equipment leased to customers under sales-type leases is accounted for as the equivalent of a sale. The present value of such lease revenues is recorded as net revenues, and the related cost of the equipment is charged to cost of revenues. The deferred finance charges applicable to these leases are recognized over the terms of the leases using the effective interest method. Rental revenue from equipment under operating leases is recognized over the term of the lease. Service revenue is recognized over the contractual period or as services are performed. Sales to third party leasing companies are recognized as the equivalent of a sale. These sales were all made on a non-recourse basis. Cash Equivalents ---------------- Cash equivalents include certificates of deposit and money market instruments with a maturity of three months or less. Inventories ----------- Inventories are stated at the lower of cost (first-in, first-out method) or market. Cost includes material, labor and applicable overhead. Property, Plant and Equipment ----------------------------- Property, plant and equipment are carried at cost. Depreciation and amortization generally are provided on a straight-line basis over the estimated useful lives of the assets; for certain manufacturing equipment, the units-of-production method is used. Maintenance, repairs and minor renewals are expensed as incurred. Additions, improvements and major renewals are capitalized. The cost and accumulated depreciation applicable to assets retired are removed from the accounts and the gain or loss on disposition is included in income. CHECKPOINT SYSTEMS, INC NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) Excess of Purchase Price Over Fair Value of Net Assets Acquired --------------------------------------------------------------- The excess of purchase price over the fair value of net assets acquired is amortized on a straight-line basis over their economic useful lives which is considered to be 20 years. Accumulated amortization approximated $1,852,000 and $1,431,000 at December 26, 1993 and December 27, 1992, respectively. Research and Development Costs ------------------------------ Research and development costs are expensed as incurred, and approximated $5,392,000, $4,498,000, and $3,313,000 in 1993, 1992 and 1991, respectively. Per Share Data -------------- Per share data is based on the weighted average number of common and common equivalent shares (stock options) outstanding during the year. The number of shares used in the per share computations were 10,386,000 (1993), 9,951,000 (1992), 9,591,000 (1991). Intangibles ----------- Intangibles consist of patents, rights, customer lists and software development costs. The costs relating to the acquisition of patents, rights and customer lists are amortized on a straight-line basis over their economic useful lives, which is considered to be ten years. Accumulated amortization approximated $473,000 and $207,000 at December 26, 1993 and December 27, 1992. The costs of internally developed software are expensed until the technological feasibility of the software has been established. Thereafter, all software development costs are capitalized and subsequently reported at the lower of unamortized cost or net realizable value. The costs of capitalized software are amortized over the products' estimated useful lives or five years, whichever is shorter. During 1993 and 1992, $575,000 and $638,000 of software development costs were capitalized. Accumulated amortization of these costs approximated $444,000 and $8,000 at December 26, 1993 and December 27, 1992. Taxes on Income --------------- In 1993, Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes" was adopted. Under this method, deferred tax liabilities and assets are determined based on the difference between financial statement and tax basis of assets and liabilities using enacted statutory tax rates in effect at the balance sheet date. The adoption of this new standard did not have a material effect on the Company's financial statements. For 1992 and 1991, taxes on income are determined under Accounting Principles Board Opinion 11 (APB 11) whereby the income tax provision is calculated under the deferred method. Generally, the deferred method recognizes income taxes on financial statement income and the tax effect of differences with taxable income are deferred at tax rates in effect during the period. CHECKPOINT SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (continued) Accounting for Foreign Currency Translation and Transactions ------------------------------------------------------------ The Company's balance sheet accounts of foreign subsidiaries are translated into U.S. dollars at the rate of exchange in effect at the balance sheet dates. Revenues, costs and expenses of the Company's foreign subsidiaries are translated into U.S. dollars at the average rate of exchange in effect during each reporting period. The resulting translation adjustment is recorded as a separate component of stockholders' equity. In addition, gains or losses on long-term intercompany transactions are excluded from the results of operations and accumulated in the aforementioned separate component of consolidated stockholders' equity. All other foreign transaction gains and losses are included in the results of operations. The Company has purchased certain foreign currency forward contracts in order to hedge anticipated rate fluctuations in Europe. Transaction gains or losses resulting from these contracts are recognized over the contract period. Aggregate foreign currency transaction losses in 1993 were $327,000 and are included in "Other Expenses" in the Consolidated Earnings Statement. 2. INVENTORIES Inventories consist of the following: 1993 1992 ---- ---- (Thousands) Raw materials $ 8,256 $ 6,340 Work-in-process 705 684 Finished goods 16,489 9,733 ------ ------ Totals $25,450 $16,757 ====== ====== 3. PROPERTY, PLANT AND EQUIPMENT The major classes are: 1993 1992 ---- ---- (Thousands) Land $ 892 $ 892 Building 9,733 9,644 Equipment rented to customers 3,736 1,380 Machinery and equipment 31,434 26,541 Leasehold improvements 1,949 1,764 Leased equipment under capital leases 15 15 ------- ------- $47,759 $40,236 Accumulated depreciation and amortization (16,897) (13,254) ------- ------- $30,862 $26,982 ======= ======= CHECKPOINT SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 4. SHORT-TERM DEBT AND CURRENT PORTION OF LONG-TERM DEBT The current portion of long-term debt at December 26, 1993 includes the following: the current portion of a $7,000,000 seven year term note, $1,050,000; the current portion of payments related to the acquisition of rights in a point-of-sale monitoring system, $261,000; the current portion of a subsidiary's three year term note, $422,000; and, various short-term loans obtained by the Company's subsidiaries totaling $2,364,000. 5. LONG-TERM DEBT The Company has a Revolving Credit Agreement with its principal lending bank which currently provides a line of credit of up to $18,000,000 through May 1, 1995 with the option to convert $8,000,000 of the outstanding borrowings to a six year term loan. At December 26, 1993 borrowings of $17,830,000 under this credit agreement were outstanding with an average interest rate of 4.11%. Subsequent to year end, the Company exercised its option to convert $8,000,000 of the outstanding borrowings to a six year term loan at a fixed rate of 6.5%. Three equal payments of $470,600 are due per year beginning July 1, 1994 with interest due monthly. The payment stream of this six year term loan is included in the aggregate maturities on long-term debt listed below. Also, subsequent to year end the Company received an increase in its line of credit to $19,000,000 through the earlier of March 31, 1994 or the completion of a $12,000,000 private placement debt funding currently being negotiated. Upon occurrence of one of these events, the Company's credit facility will be reduced to $13,000,000 through May 1, 1995. In December 1992, the Company entered into a $7,000,000 seven year loan agreement at a fixed rate of 4.9% with its principal lending bank. Three equal installments of $350,000 are due during each year for a total of $1,050,000 per year with interest due monthly. At December 26, 1993, $6,300,000 was outstanding. The loan agreement contains certain restrictive covenants which, among other things, requires maintenance of specified minimum financial ratios. Long-term debt also relates to the acquisition of rights in a point-of-sale monitoring system being marketed under the name Viewpoint. Remaining payments under this note are due each December 24 as follows: $261,000 (1994), and $280,500 (1995). Interest has been imputed using a 6.5% annual rate. The amount due on December 24, 1994 is classified as a current portion of long-term debt. In October 1993, the Company's Canadian subsidiary entered into a three year term note to finance certain sales-type leases. Payments are due monthly with a fixed interest rate of 8.00%. At December 26, 1993, $1,289,000 was outstanding, of which $422,000 was classified as current. In addition, one of the Company's European subsidiaries had $75,000 in debt outstanding. The aggregate maturities on all long-term debt are: (Thousands) 1994 $ 2,674 1995 12,994 1996 2,884 1997 2,485 1998 2,462 Thereafter 2,536 Less Current Maturities (1,733) ------- Total $24,302 ======= CHECKPOINT SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 6. STOCK OPTIONS Under a stock option plan for all employees adopted by the shareholders of the Company in 1987 ("1987 Plan"), the Company granted either incentive stock options ("ISOs") or non-incentive stock options to purchase up to 2,000,000 shares of Common Stock (amended in 1990 from a previous level of 1,000,000). The Company amended, restated and renamed the 1987 plan in 1992 ("1992 Plan") allowing the Company to grant either ISOs or non-incentive stock options to purchase up to 3,000,000 shares of Common Stock (amended in 1992 from a previous level of 2,000,000 shares). Under the 1992 Plan, only employees are eligible to receive ISOs and both employees and non- employee directors of the Company are eligible to receive non-incentive stock options. Non incentive stock options issued under the 1992 Plan through December 26, 1993 total 844,250 shares. At December 26, 1993, December 27, 1992 and December 29, 1991 a total of 364,500, 845,500 and 91,000 shares, respectively, were available for grant. All ISO's under the 1992 Plan expire not more than 10 years (plus six months in the case of non-incentive options) from the date of grant and require a purchase price of not less than 100% of the fair market value of the stock at the date of grant. The 1992 Plan is administered by the Company's Compensation and Stock Option Committee of the Board of Directors. Of the options outstanding at December 26, 1993, options for 48,364 shares were not part of any plans and did not qualify as ISOs. Options that were fully vested and exercisable totaled 1,566,464 as of December 26, 1993. The following schedule summarizes stock option activity and status: 1993 1992 1991 ---- ---- ---- Outstanding at beginning of year 1,281,114 1,639,500 1,648,850 Granted 489,000 299,000 155,000 Exercised (168,650) (548,334) (34,500) Cancelled (8,000) (109,052) (129,850) --------- --------- -------- Outstanding at end of year 1,593,464 1,281,114 1,639,500 ========= ========= ======== Price range of options outstanding $4.88 to $4.88 to $4.88 to at end of year $16.50 $13.50 $13.50 Price range of options exercised $4.88 to $4.88 to $4.88 to during the year $13.50 $13.50 $9.63 7. SUPPLEMENTAL CASH FLOW INFORMATION Cash payments in 1993, 1992 and 1991, respectively, included payments for interest of $860,000 $423,000 and $354,000 and income taxes of $638,000, $123,000 and $262,000. In March 1993, the Company purchased all of the capital stock of its Argentinean distributor for $2,000,000. Direct costs associated with this acquisition totalled $103,000. In conjunction with the acquisition, liabilities were assumed as follows: CHECKPOINT SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 7. SUPPLEMENTAL CASH FLOW INFORMATION (continued) Fair value of assets acquired ...................$3,690,000 Cash paid and direct costs incurred for the capital stock.................$2,103,000 ---------- Liabilities assumed..............................$1,587,000 ========== In July 1993, the Company purchased all of the capital stock of ID Systems International B.V. and ID Systems Europe B.V. Direct costs associated with this acquisition totalled $400,000. In conjunction with the acquisition, liabilities were assumed as follows: Fair value of assets acquired ...................$14,575,000 Cash paid and direct costs incurred for the capital stock including advances ........$ 1,690,000 ----------- Liabilities assumed..............................$12,885,000 =========== 8. SHAREHOLDERS' EQUITY In December 1988, the Company's Board of Directors approved a Shareholders' Rights Plan (the "Plan"), and declared a dividend distribution of one common share purchase right ("Right") for each outstanding share of the Company's Common Stock to shareholders of record on December 29, 1988. The Rights are designed to ensure all Company shareholders fair and equal treatment in the event of a proposed takeover of the Company, and to guard against partial tender offers and other abusive tactics to gain control of the Company without paying all shareholders a fair price. The Rights are exercisable only as a result of certain actions (defined by the Plan) of an Acquiring Person or Adverse Person, as defined. Initially, upon payment of the exercise price (currently $40), each Right will be exercisable for one share of Common Stock. Upon the occurrence of certain events as specified in the Plan, each Right will entitle its holder (other than an Acquiring Person or an Adverse Person) to purchase a number of the Company's or Acquiring Person's common shares having a market value of twice the Right's exercise price. The Rights expire on December 28, 1998. Generally, within ten days after a person becomes an Acquiring Person or is determined to be an Adverse Person, the Company can redeem the Rights. 9. INCOME TAXES The Company's net earnings generated by the operations of its Puerto Rican subsidiary are exempt from Federal income taxes under Section 936 of the Internal Revenue Code and substantially exempt from Puerto Rican income taxes. Since 1980, this subsidiary has operated under a fifteen year 100% local tax exemption on income earned from its target manufacturing operation. Under a 1983 fifteen year local tax exemption on income earned from its sensor manufacturing operation, this subsidiary had a 90% exemption through 1987, and 75% and 65% exemptions during the succeeding two five-year periods. In 1991, the Company was granted a new local tax exemption agreement which replaces the grants of 1980 and 1983 with a twenty year 90% local tax exemption retroactive to 1988 on both the target and sensor manufacturing operations. This change did not have a material impact on prior year taxes but will extend the Company's favorable local tax status in Puerto Rico. CHECKPOINT SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 9. INCOME TAXES (continued) Repatriation of the Puerto Rico subsidiary's unremitted earnings could result in the assessment of Puerto Rico "tollgate" taxes at a maximum rate of 10% of the amount repatriated. During 1993, a provision was made for tollgate taxes. During 1992 and 1991, no provision was made for tollgate taxes. The Company has not provided for tollgate taxes on $24,321,000 of its subsidiary's unremitted earnings since they are expected to be reinvested indefinitely. The domestic and foreign components of earnings before income taxes are: 1993 1992 1991 ---- ---- ---- $ 1,720 $ 4,891 $ 635 Foreign 351 - - ------- ------- ------- Total $ 2,071 $ 4,891 $ 635 ======= ======= ======= The related provision for income taxes consists of: 1993 1992 1991 ---- ---- ---- Currently Payable (Thousands) Federal $ 369 $ 632 $ 30 State 5 94 72 Puerto Rico 186 (263) 25 Foreign 375 - - Deferred Federal (509) - - State 30 - - Puerto Rico - - - Foreign - - - ------- ------- ------- Total Provision $ 456 $ 463 $ 127 ======= ======= ======= Deferred tax liabilities (assets) at December 26, 1993 consist of: (Thousands) Depreciation $ 805 Deferred maintenance 318 Unbilled receivable 138 -------- Gross deferred tax liabilities 1,261 -------- R & E credit carryforward (982) Inventory (277) Alternative minimum tax (258) Accounts receivable (100) Foreign net operating loss carryforwards (4,494) Warranty (41) Other (82) -------- Gross deferred tax assets (6,234) -------- Valuation allowance 4,494 -------- Net deferred tax asset $ (479) ======== CHECKPOINT SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 9. INCOME TAXES (continued) Included in foreign net operating loss carryforwards of $15,005,000 is $12,860,000 of foreign net operating loss carryforwards that were acquired in connection with the acquisition of the ID Systems Group. If realization of the benefit of such carryforwards occur, the Company will apply such benefit to goodwill in connection with the acquisition. The research and experimentation credit carryforwards expire beginning in January 2006 through January 2008. Of the total foreign net operating loss carryforwards available, $500,000 expire beginning January 1999 whereas the remaining portion may be carried forward indefinitely. A reconciliation of the statutory U.S. Federal income tax rate with the effective income tax rate follows: 1993 1992 1991 ---- ---- ---- Statutory federal income tax rate 34.0% 34.0% 34.0% Tax exempt earnings of subsidiary in Puerto Rico (14.0) (23.8) (29.3) Change in tax exempt earnings of subsidiary in Puerto Rico - (8.5) - Research and Experimentation tax credit (17.2) - - Foreign losses with no benefit 8.4 - - State and local income taxes, net of federal benefit 9.1 5.7 11.4 Other 1.7 2.1 3.9 ------ ------ ------ Effective tax rate 22.0% 9.5% 20.0% ====== ====== ====== During 1992, the effective tax rate was favorably impacted by a refinement of an estimate relating to tax exempt earnings of the Puerto Rico subsidiary. CHECKPOINT SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 10. EMPLOYEE BENEFIT PLANS Under the Company's defined contribution savings plans, eligible employees (see below) may make basic (up to 6% of an employee's earnings) and supplemental contributions to a trust. The Company matches 50% of participant's basic contributions. Company contributions vest to participants in increasing percentages over three to six years of service. The Company's contributions under the plans approximated $478,000, $323,000, and $285,000 in 1993, 1992 and 1991, respectively. Generally, any full-time, non-union employee of the Company (other than someone holding the position of Vice President or higher) who has completed one month of service, and any part-time non-union employee of the Company who has completed one year of service, other than employees of the Company's subsidiaries, may participate in the Company's United States Savings Plan. All full-time employees of the Puerto Rico subsidiary who have completed three months of service may participate in the Company's Puerto Rico Savings Plan. Part-time employees are not entitled to participate in the Company's Puerto Rico Savings Plan. Under the Company's non-qualified Employee Stock Purchase Plan, employees, other than employees of the Company's subsidiaries in Australia, Argentina, Europe and Mexico may contribute up to $60 per week to a trust for the purchase of Company Common Stock at fair market value. The Company matches employee contributions up to a maximum of $17 per week. The Company's contributions under this plan approximated $94,000, $76,000 and $67,000 in 1993, 1992 and 1991, respectively. Under the Company's Management Incentive Plan, bonuses are provided for certain executives based on a percentage of the amount by which consolidated net earnings exceed a specified portion of shareholders' equity at the beginning of the year. During the last three years net earnings did not exceed this criteria and, accordingly, no bonuses were provided. 11. COMMITMENTS AND CONTINGENCIES The Company leases its offices, distribution center and certain production facilities. Rental expense for all operating leases approximated $1,424,000, $811,000 and $798,000 in 1993, 1992 and 1991, respectively. Future minimum payments for operating leases having non-cancellable terms in excess of one year at December 26 1993 are: $1,733,000 (1994), $1,174,000 (1995), $843,000 (1996), $722,000 (1997), and $6,823,000 thereafter. The Company has entered into a twelve year lease agreement for a facility to be constructed in close proximity to the Company's current leased facility in Thorofare, New Jersey. When completed in 1994, this 104,000 square foot facility will be the Company's new headquarters for administrative offices, research and development and warehouse distribution. These lease payments have been included in the future minimum payments for operating leases above. 12. EXPORT SALES The Company's export sales which are principally in Europe and Scandinavia approximated $12,163,000, $22,732,000, and $15,427,000 in 1993, 1992, and 1991, respectively. Sales of the Company's foreign subsidiaries in Argentina, Australia, Canada, Europe and Mexico totalled $21,200,000 in 1993. Sales to one foreign distributor of the Company's products amounted to $5,000,000, $13,147,000 and $9,523,000 in 1993, 1992 and 1991 respectively. CHECKPOINT SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 13. CONCENTRATION OF CREDIT RISK Prior to 1993, most of the Company's export sales were to one foreign distributor. Currently, the Company's foreign subsidiaries, along with many foreign distributors, provide diversified international sales thus minimizing credit risk to one or few distributors. In addition, the Company maintains foreign credit insurance to provide coverage for potential foreign political or economic risks. Domestically, the Company's sales are well diversified among numerous retailers in the apparel, shoe, drug, mass merchandise, video, music, supermarket and home entertainment market. The Company performs ongoing credit evaluations of its customers' financial condition and generally, requires no collateral from its customers. 14. ACQUISITIONS On March 3, 1993, the Company purchased all of the capital stock of its Argentinean distributor for $2,103,000 plus a contingent amount to be determined equal to fifty percent of the Argentinean subsidiary's annual profits for the four year period ending on November 30, 1996. The total purchase price shall not exceed $5,000,000. This acquisition was accounted for under the purchase method, and, accordingly the results of operations of this business have been included with those of the Company since the date of acquisition. The purchase price resulted in an excess of acquisition cost over net assets acquired of $1,798,000. Such excess, (which will increase for any contingent cash payment) is being amortized over twenty years. On March 8, 1993, the Company purchased a customers list from the Company's former Mexican distributor for $560,000 in connection with the Company establishing direct operations in Mexico. The cost related to this customers list is included in "Intangibles" and is being amortized on a straight line basis over ten years. On July 8, 1993, the Company purchased all of the capital stock of ID Systems International B.V. and ID Systems Europe B.V. ("The ID Systems Group"), related Dutch companies engaged in the manufacture, distribution and sale of security products and services. The Company advanced the ID Systems Group $1,290,000 during the period in which the Company held an option to purchase all the outstanding capital stock. The purchase price of the capital stock, exclusive of such advances, was $60 plus direct acquisition cost of approximately $400,000. This acquisition was accounted for under the purchase method and, accordingly, the results of operations of this business have been included with those of the Company since the date of acquisition. The purchase price resulted in an excess of acquisition cost over net assets acquired of approximately $4,300,000 which is being amortized over twenty years. The Company acquired three production units in connection with the purchase of the capital stock of the ID Systems Group. The Company intends to shut down all three of these facilities by the end of second quarter of 1994. Accordingly, the estimated operating losses and shut down costs of these facilities amounting to $3,434,000 were accrued in the purchase price allocation. At December 26, 1993, $1,306,000 remains accrued for such losses and shut down costs for the first half of 1994. This amount is included in "other current liabilities." As a part of the purchase price allocation, the values assigned to these assets were based upon estimated residual values upon ulimate disposition which represents a nominal amount. CHECKPOINT SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 14. ACQUISITIONS (continued) The following unaudited pro forma summary of operations presents the consolidated results of operations as if the acquisition of the ID Systems Group had occurred at the beginning of the years presented. Other acquisitions made during the year were not material to results of operations and thus are not presented. The following results are not necessarily indicative of what would have occurred had the acquisition been consummated as of that date or of future results. 1993 1992 ---- ---- (Thousands, except per share data) Net revenues $99,426 $92,334 Earnings (loss) before income taxes ($ 4,059) ($ 2,270) Net earnings (loss) ($ 4,410) ($ 2,271) Earnings (loss) per share ($ .41) ($ .23) 15. GEOGRAPHIC SEGMENTS The following tables shows sales, operating earnings and other financial information by geographic area for the year 1993. United States and Puerto Rico Europe Other --------------- ---------- --------- (Thousands) Net Revenues from Unaffiliated Customers $71,834 $7,994 $13,206 Operating Income (loss) (1,224) (357) 956 Identifiable Assets $78,982 $15,707 $10,310 16. SUBSEQUENT EVENT On March 10, 1993, the United States International Trade Commission instituted an investigation of a complaint filed by the Company under Section 337 of the Tariff Act of 1930. On March 10, 1994 the United States International Trade Commission issued a Notice of Commission Determination Not to Review An Initial Determination Finding No Violation of Section 337 of the Tariff Act of 1930. The Company has capitalized $2,027,000 in patent defense costs, which is included in "Intangibles" as of December 26, 1993. The ultimate resolution is undetermined at this time due to the various courses of action available to management, including the right of appeal which the Company currently intends to exercise. Although the Company's management ultimately expects a favorable outcome, should resolution of this matter result in less than a successful defense of the patents in question the deferred patent costs noted above will be written off as a charge to earnings at the time of such resolution. Item 9.

Item 9. CHANGES IN AND DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III The information called for by Item 10, Directors and Executive Officers of the Registrant (except for the information regarding executive officers called for by Item 401 of Regulation S-K which is included in Part I hereof as Item A in accordance with General Instruction G(3)): Item 11, Executive Compensation: Item 12, Security Ownership of Certain Beneficial Owners and Management: Item 13, Certain Relationships and Related Transactions, is hereby incorporated by reference to the Registrant's definitive proxy statement for its Annual Meeting of Shareholders presently scheduled to be held on April 29, 1994, which management expects to file with the Securities and Exchange Commission within 90 days of the end of the Registrant's fiscal year. PART IV Item 14. EXHIBITS, FINANCIAL SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. Financial Statements PAGE ---------------------------- The following consolidated financial statements are included in Part II, Item 8: Report of Independent Accountants.........................28 Consolidated Balance Sheets as of December 26, 1993 and December 27, 1992.......................................29 Consolidated Earnings Statements for each of the years in the three-year period ended December 26, 1993........30 Consolidated Statements of Shareholders' Equity for each of the years in the three-year period ended December 26, 1993.......................................30 Consolidated Statements of Cash Flows for each of the years in the three-year period ended December 26, 1993........31 Notes to Consolidated Financial Statements...............32-42 (a) 2. Financial Schedules --------------------------- The following consolidated schedules are required to be filed by Part IV, Item, 14(a)2: Schedule V - Property, Plant and Equipment.......46 Schedule VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment.......................47 Schedule VIII - Valuation and Qualifying Accounts...48 Schedule IX - Short-term borrowings...............48 Schedule X - Supplementary Income Statement Information.........................49 All other schedules are omitted either because they are not applicable, not required, or because the required information is included in the financial statements or notes thereto: (a) 3. Exhibits required to be filed by Item 601 of Regulation S-K -------------------------------------------------------------------- Exhibit 3(a) Articles of Incorporation are hereby incorporated by reference to Item 14(a), and 3(i) of the Registrant's Form 10-K, filed with the SEC on March 14, 1991. Exhibit 10 Material Contracts, are hereby incorporated by reference to Items 14(a)(3)(v), (vi) and (viii) of the Registrant's Form 10-K, filed with the SEC on March 6, 1984; Item 14(a)(3) (v) of the Registrant's Form 10-K, filed with the SEC on February 13, 1985; Item 14(a)(3) (iv) of the Registrant's Form 10-K, filed with the SEC on March 11, 1987; Item 20(4.9) of Registrant's Post-Effective Amendment Number 1 to Form S-8, filed with the SEC on January 20, 1988; Item 2(1) of the Registrant's Form 8-A, filed with the SEC on December 21, 1988; Appendix A to the Company's Definitive Proxy Statement, filed March 23, 1992; Item 10

40454_1993.txt

40454

1993

ITEM 1. BUSINESS BOATMEN'S BANCSHARES, INC. ("CORPORATION") The Corporation was incorporated under the laws of the State of Missouri in June, 1946 and was known as General Bancshares Corporation until the time of its merger with Boatmen's Bancshares, Inc. on March 29, 1986. The Corporation's principal office is located in St. Louis, Missouri where its largest subsidiary, The Boatmen's National Bank of St. Louis ("Boatmen's Bank"), is located. The Corporation directly owns substantially all of the capital stock of 49 subsidiary banks, a trust company, a mortgage banking company, a credit life insurance company, an insurance agency and a credit card bank. The subsidiary banks operate from approximately 425 banking offices and 350 off-site automated teller machine locations in Missouri, New Mexico, Oklahoma, Iowa, Texas, Illinois, Arkansas, Tennessee and Kansas. The business of the Corporation consists primarily of the ownership, supervision and control of its subsidiaries. The Corporation provides its subsidiaries with advice, counsel and specialized services in various fields of financial and banking policy and operations. The Corporation also engages in negotiations designed to lead to the acquisition of other banks and closely related businesses. Based on total assets as of December 31, 1993, the Corporation was the largest bank holding company headquartered in the State of Missouri and among the 30 largest bank holding companies in the United States. There are numerous bank holding companies and groupings of banks located throughout the Corporation's markets which offer substantial competition in the acquisition and operation of banks and non-bank financial institutions. The Corporation's subsidiaries encounter substantial competition in all of their banking and related activities, and its banking subsidiaries face increasing competition from various non-banking financial institutions that are not subject to the same geographic and other regulatory restraints applicable to banks. On November 6, 1993, the Corporation entered into a definitive agreement to acquire Woodland Bancorp, Inc., a one bank holding company based in Tulsa, Oklahoma, which had consolidated assets of approximately $64 million at December 31, 1993. Woodland Bank, which operates from one office in Tulsa and has plans to open two additional branches, will be merged into Boatmen's First National Bank of Oklahoma upon completion of the acquisition on March 31, 1994. The information under the caption Acquisition Overview on pages 18, 19 and the top of page 20 and Table 2 on page 18 of the Corporation's Annual Report to Shareholders for the year ended December 31, 1993, is incorporated herein by reference. Banking Operations Trust Operations The Corporation provides a wide range of trust services to both individuals and institutions through Boatmen's Trust Company and the trust departments of certain of its subsidiary banks. Its trust operations rank among the 15 largest providers of trust services in the United States, with total trust assets of $71.1 billion at December 31, 1993, including $34.1 billion under management. Other Non-Bank Subsidiaries The Corporation's other non-bank subsidiaries include: (1) a mortgage banking company, whose business is the origination and servicing of real estate mortgage loans for the account of long-term investors and the servicing of real estate loans originated by its affiliate banks; (2) a credit life insurance company which insures or reinsures credit life and accident and health insurance written by the Corporation's subsidiary banks; (3) an insurance agency; and (4) a credit card bank. Regulation and Supervision As a bank holding company, the Corporation is subject to regulation pursuant to the Bank Holding Company Act of 1956 (the "Act"), which is administered by the Board of Governors of the Federal Reserve System (the "Board"). A bank holding company must obtain Board approval before acquiring, directly or indirectly, ownership or control of any voting shares of a bank or bank holding company if, after such acquisition, it would own or control more than 5% of such shares. Board approval must also be obtained before any bank holding company acquires all or substantially all of the assets of another bank or bank holding company or merges or consolidates with another bank holding company. Furthermore, any acquisition by a bank holding company of more than 5% of the voting shares, or of all or substantially all of the assets, of a bank located in another state may not be approved by the Board unless the laws of the second state specifically authorize such an acquisition. Legislation was enacted in Missouri during 1986 which authorized bank holding companies domiciled in contiguous states to acquire Missouri banks and bank holding companies provided their home states have similar laws. All of the eight contiguous states have passed similar legislation. The Act also prohibits a bank holding company, with certain limited exceptions, from acquiring or retaining direct or indirect ownership or control of more than 5% of the voting shares of any company which is not a bank or a bank holding company, or from engaging in any activities other than those of banking, managing or controlling banks, or providing services for its subsidiaries. The principal exceptions to these prohibitions involve certain activities which the Board has determined to be closely related to the business of banking or managing or controlling banks. A bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with the extension of credit, with limited exemptions. Subsidiary banks of a bank holding company are also subject to certain restrictions imposed by the Federal Reserve Act on any extensions of credit to the bank holding company or any of its subsidiaries, or investment in the stock or other securities thereof, and on the taking of such stocks or securities as collateral for loans. The Board possesses cease and desist powers over bank holding companies if their actions represent unsafe or unsound practices or violations of law. In August, 1989, the Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA") was enacted. FIRREA allows bank holding companies to acquire healthy savings institutions, removing certain restrictions on operations of such institutions. Acquired savings institutions may now be operated as separate savings subsidiaries, converted to bank charters or merged into existing bank subsidiaries, subject to certain requirements. FIRREA also contains a "cross-guarantee" provision which could result in depository institutions being assessed for losses incurred by the FDIC in the assistance provided to, or the failure of, an affiliated depository institution. On December 16, 1988, the Board adopted final risk-based capital guidelines for use in its examination and supervision of bank holding companies and banks. The guidelines have three main goals: (1) to make regulatory capital requirements more sensitive to differences in risk profiles among banking organizations; (2) to take off-balance sheet risk exposures into explicit account in assessing capital adequacy; and (3) to minimize disincentives to holding liquid, low-risk assets. A bank holding company's ability to pay dividends and expand its business through the acquisition of new banking or non-banking subsidiaries could be restricted if its capital falls below levels established by these guidelines. The risk-based capital ratios were fully implemented by the end of 1992. In 1991, the Board required bank holding companies and banks to adhere to another capital guideline referred as the Tier 1 leverage ratio. This guideline places a constraint on the degree to which a banking institution can leverage its equity capital base. The Corporation substantially exceeds the requirements of these capital guidelines. In December, 1991, the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") was enacted. FDICIA, among other things, identifies the following capital standards for depository institutions: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. A depository institution is well capitalized if it significantly exceeds the minimum level required by regulation for each relevant capital measure, adequately capitalized if it meets each such measure, undercapitalized if it fails to meet any such measure, significantly undercapitalized if it is significantly below any such measure, and critically undercapitalized if it fails to meet any critical capital level set forth in the regulations. FDICIA requires a bank that is determined to be undercapitalized to submit a capital restoration plan, and the bank's holding company must guarantee that the bank will meet its capital plan, subject to certain limitations. FDICIA also prohibits banks from making any capital distribution or paying any management fee if the bank would thereafter be undercapitalized. The Corporation's bank subsidiaries currently meet the well capitalized standards. FDICIA grants the FDIC authority to impose special assessments on insured depository institutions to repay FDIC borrowings from the United States Treasury or other sources and to establish semiannual assessment rates on Bank Insurance Fund ("BIF") member banks so as to maintain the BIF at the designated reserve ratio defined in FDICIA. FDICIA also required the FDIC to implement a risk-based insurance assessment system pursuant to which the premiums paid by a depository institution will be based on the probability that the BIF will incur a loss in respect of such institution. The FDIC has adopted a deposit insurance assessment system that places each insured institution in one of nine risk categories based on the level of its capital, evaluation of its risk by its primary state or federal supervisor, statistical analysis and other information. In 1994, deposit insurance premiums will range between 23 cents and 31 cents per $100 of domestic deposits. The Corporation's national bank subsidiaries are subject to supervision by the Comptroller of the Currency. The Arkansas federal savings bank is subject to supervision by the Office of Thrift Supervision. The FDIC has primary federal supervisory responsibility for the Corporation's state banks, with the exception of three state banks that are members of the Federal Reserve System. The Corporation's state banks and trust company are also subject to supervision by the bank supervisory authorities in their respective states. Various federal and state laws and regulations apply to many aspects of the operations of the Corporation's subsidiary banks, including interest rates paid on deposits and loans, investments, mergers and acquisitions and the establishment of branch offices and facilities. The payment of dividends by the Corporation's subsidiary banks, which is the Corporation's principal source of income, is also subject to certain statutory restrictions and to regulation by governmental agencies. Statistical Disclosure Pages 17 through 47 and footnote number 11 on page 57 of the Corporation's Annual Report to Shareholders for the year ended December 31, 1993, are incorporated herein by reference. The statistical data contained therein reflect the restatement of prior period data for the acquisition of First Amarillo Bancorporation, Inc. on November 30, 1993 using the pooling of interests accounting method. ITEM 2.

ITEM 2. PROPERTIES The Corporation's headquarters building, Boatmen's Plaza, is located in downtown St. Louis, Missouri. Through a joint venture, Boatmen's Bank owns a one-half undivided interest in two-thirds of the building. On December 31, 1981, Boatmen's Bank entered into a lease agreement for approximately 60 percent of the building for a term of 30 years. This long-term lease obligation was capitalized in accordance with Statement of Financial Accounting Standards No. 13. The principal office of Boatmen's Trust Company was purchased on January 4, 1994. The Corporation's principal banking offices in Oklahoma, Iowa and Tennessee are leased under long-term leases. The principal banking offices in New Mexico, Illinois, Arkansas and Texas are owned. The majority of the other banking offices are owned by the respective subsidiary banks. In the opinion of management, the physical properties of the Corporation and its subsidiaries are suitable and adequate and are being fully utilized. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS None. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE CORPORATION There are no family relationships between any of the named persons. Each executive officer is elected by the Board of Directors to serve until the close of the next annual meeting of the shareholders following his election and until the election of his successor. No executive officer of the Corporation was selected to his position pursuant to any arrangement or understanding with any other person. Each executive officer has held the same position or another executive position with the Corporation or Boatmen's Bank during the past five years, except as follows: Mr. Dominick was Executive Vice President of Bank One, Dallas, Texas from March 1990 until joining the Corporation on August 4, 1992. Prior to Bank One, Mr. Dominick was a partner in Dominick/Frerichs Associates Ltd. (a bank consulting firm) from February, 1989 to March 1990. Mr. Dominick was Senior Vice President of Shawmut Bank, Boston, Massachusetts from 1974 until February, 1989. PART II ITEM 5.

ITEM 5. MARKET FOR THE CORPORATION'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Footnote number 21 on page 62 and page 65 of the Corporation's Annual Report to Shareholders for the year ended December 31, 1993, are incorporated herein by reference. The last trade price for the Corporation's common stock on March 8, 1994, was $28.00. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA Page 17 of the Corporation's Annual Report to Shareholders for the year ended December 31, 1993, is incorporated herein by reference. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Pages 17 through 39 of the Corporation's Annual Report to Shareholders for the year ended December 31, 1993, are incorporated herein by reference. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements together with the report thereon of Ernst & Young on pages 48 through 63 and the supplementary quarterly information on page 39 and pages 40 through 43 of the Corporation's Annual Report to Shareholders for the year ended December 31, 1993, are incorporated herein by reference. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE CORPORATION The information under the item captioned Election of Directors and Information With Respect to Directors and Executive Officers in the Corporation's Proxy Statement filed for its Annual Meeting of Shareholders scheduled for April 26, 1994, is incorporated herein by reference. The required information regarding the Corporation's executive officers is contained in PART I in the item captioned Executive Officers of the Corporation. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information under the caption Executive Compensation on pages 10 through the graph on page 17 in the Corporation's Proxy Statement filed for its Annual Meeting of Shareholders scheduled for April 26, 1994, is incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information under the table captioned Amount and Nature of Beneficial Ownership and the caption Security Ownership of Management in the Corporation's Proxy Statement filed for its Annual Meeting of Shareholders scheduled for April 26, 1994, is incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information under the caption Certain Transactions in the Corporation's Proxy Statement filed for its Annual Meeting of Shareholders scheduled for April 26, 1994, is incorporated herein by reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K The following financial statements of the Corporation and its consolidated subsidiaries, and the accountants' report thereon, are incorporated herein by reference. Consolidated Financial Statements Balance Sheets-December 31, 1993 and 1992. Statements of Income-Years ended December 31, 1993, 1992 and 1991. Statements of Changes in Stockholders' Equity-Years ended December 31, 1993, 1992 and 1991. Statements of Cash Flows-Years Ended December 31, 1993, 1992 and 1991. Notes to Consolidated Financial Statements. Financial Statement Schedules All required schedules for the Corporation and its subsidiaries have been included in the consolidated financial statements or related notes thereto. The following exhibits are incorporated herein by reference (a): Exhibit 3(a) - Restated Articles of Incorporation of the Corporation. Exhibit 3(b) - Amended By-laws of the Corporation. Exhibit 4 - Rights Agreement dated as of August 14, 1990. Exhibit 4(a) - Amendment dated as of January 26, 1993 to Rights Agreement dated as of August 14, 1990. Note: No long-term debt instrument issued by the Corporation exceeds 10% of the consolidated total assets of the Corporation and its subsidiaries. In accordance with paragraph 4(iii) of Item 601 of Regulation S-K, the Corporation will furnish to the Commission upon request copies of long-term debt instruments and related agreements. Exhibit 10(c) - Boatmen's Bancshares, Inc. Amended 1981 Incentive Stock Option Plan, Exhibit 10(h) to Boatmen's Bancshares, Inc.'s Annual Report to the Securities and Exchange Commission on Form 10-K (File No. 1-3750) for the fiscal year ended December 31, 1986. Exhibit 10(d) - Boatmen's Bancshares, Inc. Amended 1982 Long-Term Incentive Plan, Exhibit 10(d) to Boatmen's Bancshares, Inc.'s Annual Report to the Securities and Exchange Commission on Form 10-K (File No. 1-3750) for the fiscal year ended December 31, 1992. Exhibit 10(e) - Boatmen's Bancshares, Inc. 1987 Non-Qualified Stock Option Plan, Exhibit 10(e) to Boatmen's Bancshares, Inc.'s Annual Report to the Securities and Exchange Commission on Form 10-K (File No. 1-3750) for the fiscal year ended December 31, 1992. Exhibit 10(f) - Employment Agreement dated February 1, 1992, between Boatmen's Sunwest, Inc., a subsidiary of the Corporation, and Ike Kalangis, Exhibit 10(f) to Boatmen's Bancshares, Inc.'s Annual Report to the Securities and Exchange Commission on Form 10-K (File No. 1-3750) for the fiscal year ended December 31, 1992. Exhibit 10(g) - Centerre Executive Retirement Program, Exhibit 10(c)(6) to Centerre Bancorporation's Annual Report to the Securities and Exchange Commission on Form 10-K (File No. 0-3909) for the fiscal year ended December 31, 1983. Exhibit 10(h) - Amendment dated as of January 1, 1988, to Centerre Executive Retirement Program, Exhibit 10(m) to Boatmen's Bancshares, Inc.'s Annual Report to the Securities and Exchange Commission on Form 10-K (File No. 1-3750) for the fiscal year ended December 31, 1988. Exhibit 10(i) - Second Amendment dated as of January 1, 1988, to Centerre Executive Retirement Program, Exhibit 10(n) to Boatmen's Bancshares, Inc.'s Annual Report to the Securities and Exchange Commission on Form 10-K (File No. 1-3750) for the fiscal year ended December 31, 1988. Exhibit 10(j) - Third Amendment dated March 31, 1989, effective as of December 9, 1988, to Centerre Executive Retirement Program, Exhibit 10(m) to Boatmen's Bancshares, Inc.'s Annual Report to the Securities and Exchange Commission on Form 10-K (File No. 1-3750) for the fiscal year ended December 31, 1989. Exhibit 10(k) - Centerre Bancorporation Executive Deferred Compensation Plan, Exhibit 10(c)(9) to Centerre Bancorporation's Annual Report to the Securities and Exchange Commission on Form 10-K (File No. 0-3909) for the fiscal year ended December 31, 1985. Exhibit 10(l) - Amendment dated as of January 1, 1987, to Centerre Bancorporation Executive Deferred Compensation Plan, Exhibit 10(p) to Boatmen's Bancshares, Inc.'s Annual Report to the Securities and Exchange Commission on Form 10-K (File No. 1-3750) for the fiscal year ended December 31, 1988. Exhibit 10(m) - Second Amendment dated as of January 1, 1988, to Centerre Bancorporation Executive Deferred Compensation Plan, Exhibit 10(q) to Boatmen's Bancshares, Inc.'s Annual Report to the Securities and Exchange Commission on Form 10-K (File No. 1-3750) for the fiscal year ended December 31, 1988. Exhibit 10(n) - Third Amendment dated as of January 1, 1986, to Centerre Bancorporation Executive Deferred Compensation Plan, Exhibit 10(r) to Boatmen's Bancshares, Inc.'s Annual Report to the Securities and Exchange Commission on Form 10-K (File No. 1-3750) for the fiscal year ended December 31, 1988. Exhibit 10(o) - Fourth Amendment dated December 13, 1988, to Centerre Bancorporation Executive Deferred Compensation Plan, Exhibit 10(r) to Boatmen's Bancshares, Inc.'s Annual Report to the Securities and Exchange Commission on Form 10-K (File No. 1-3750) for the fiscal year ended December 31, 1989. Exhibit 10(p) - Centerre Bancorporation Deferred Compensation Plan for Directors, Exhibit 10(c)(10) to Centerre Bancorporation's Annual Report to the Securities and Exchange Commission on Form 10-K (File No. 0-3909) for the fiscal year ended December 31, 1986. Exhibit 10(q) - Amendment dated as of January 1, 1988, to Centerre Bancorporation Deferred Compensation Plan for Directors, Exhibit 10(t) to Boatmen's Bancshares, Inc.'s Annual Report to the Securities and Exchange Commission on Form 10-K (File No. 1-3750) for the fiscal year ended December 31, 1988. Exhibit 10(r) - Amendment No. 2 dated February 14, 1989, to Centerre Bancorporation Deferred Compensation Plan for Directors, Exhibit 10(x) to Boatmen's Bancshares, Inc.'s Annual Report to the Securities and Exchange Commission on Form 10-K (File No. 1-3750) for the fiscal year ended December 31, 1989. Exhibit 10(s) - Amendment No. 3 dated August 8, 1989, to Centerre Bancorporation Deferred Compensation Plan for Directors and adoption by Boatmen's Bancshares, Inc. of Centerre Bancorporation Deferred Compensation Plan for Directors, Exhibit 10(y) to Boatmen's Bancshares, Inc.'s Annual Report to the Securities and Exchange Commission on Form 10-K (File No. 1-3750) for the fiscal year ended December 31, 1989. Exhibit 10(t) - Amendment No. 4 dated November 14, 1989, as of August 8, 1989, to Boatmen's Deferred Compensation Plan for Directors, Exhibit 10(z) to Boatmen's Bancshares, Inc.'s Annual Report to the Securities and Exchange Commission on Form 10-K (File No. 1-3750) for the fiscal year ended December 31, 1989. Exhibit 10(u) - Boatmen's Executive Deferred Compensation Plan dated August 8, 1989, effective January 1, 1990, Exhibit 10(aa) to Boatmen's Bancshares, Inc.'s Annual Report to the Securities and Exchange Commission on Form 10-K (File No. 1-3750) for the fiscal year ended December 31, 1989. Exhibit 10(x) - Boatmen's Supplemental Retirement Participation Agreement dated August 8, 1989, between the Corporation and Samuel B. Hayes, III, Exhibit 10(dd) to Boatmen's Bancshares, Inc.'s Annual Report to the Securities and Exchange Commission on Form 10-K (File No. 1-3750) for the fiscal year ended December 31, 1989. Exhibit 10(y) - Boatmen's Supplemental Retirement Participation Agreement dated August 8, 1989, between the Corporation and John Peters MacCarthy, Exhibit 10(ee) to Boatmen's Bancshares, Inc.'s Annual Report to the Securities and Exchange Commission on Form 10-K (File No. 1-3750) for the fiscal year ended December 31, 1989. Exhibit 10(bb) - Boatmen's Bancshares, Inc. 1991 Incentive Stock Option Plan, Exhibit 10(dd) to Boatmen's Bancshares, Inc.'s Annual Report to the Securities and Exchange Commission on Form 10-K (File No. 1-3750) for the fiscal year ended December 31, 1991. Exhibit 10(cc) - Boatmen's Bancshares, Inc. 1992 Annual Incentive Bonus Plan, Exhibit 10(ee) to Boatmen's Bancshares, Inc.'s Annual Report to the Securities and Exchange Commission on Form 10-K (File No. 1-3750) for the fiscal year ended December 31, 1991. Exhibit 10(dd) - Sunwest Financial Services, Inc. 1983 Incentive Stock Option Plan, Exhibit A to Boatmen's Bancshares, Inc.'s S-8 Registration Statement (No. 33-55186). Exhibit 10(ee) - Sunwest Financial Services, Inc. 1987 Incentive Stock Option Plan, Exhibit A to Boatmen's Bancshares, Inc.'s S-8 Registration Statement (No. 33-55110). Exhibit 10(ff) - Fifth Amendment dated November 10, 1992 to Centerre Bancorporation Executive Deferred Compensation Plan, Exhibit 10(ii) to Boatmen's Bancshares, Inc.'s Annual Report to the Securities and Exchange Commission on Form 10-K (File No. 1-3750) for the fiscal year ended December 31, 1992. Exhibit 10(gg) - Supplemental Executive Retirement Plan of Boatmen's Sunwest, Inc., a subsidiary of the Corporation, Exhibit (jj) to Boatmen's Bancshares, Inc.'s Annual Report to the Securities and Exchange Commission on Form 10-K (File No. 1-3750) for the fiscal year ended December 31, 1992. The following exhibits are submitted herewith: Exhibit 10(a) - Amended Employment Agreement dated November 9, 1993, between the Corporation and Andrew B. Craig, III. Exhibit 10(b) - Amended Employment Agreement dated November 9, 1993, between the Corporation and Samuel B. Hayes, III. Exhibit 10(v) - Boatmen's Supplemental Retirement Plan dated November 9, 1993. Exhibit 10(w) - Boatmen's Supplemental Retirement Participation Agreement dated August 4, 1993, between the Corporation and Andrew B. Craig, III. Exhibit 10(z) - Boatmen's Supplemental Retirement Participation Agreement dated November 9, 1993, between the Corporation and Ike Kalangis. Exhibit 10(aa) - Letter agreement dated November 9, 1993, between the Corporation and John Peters MacCarthy. Exhibit 13 - Portions of the Annual Report to Shareholders for the year ended December 31, 1993. Exhibit 21 - Subsidiaries of the Corporation. Exhibit 23 - Independent Auditors' Consent of Ernst & Young. Exhibit 23(a) - Independent Auditors' Consent of KPMG Peat Marwick. Exhibit 23(b) - Independent Auditors' Consent of KPMG Peat Marwick. Exhibit 23(c) - Independent Auditors' Consent of KPMG Peat Marwick. Exhibit 99 - Independent Auditors' Report of KPMG Peat Marwick. Exhibit 99(a) - Independent Auditors' Report of KPMG Peat Marwick. Exhibit 99(b) - Independent Auditors' Report of KPMG Peat Marwick. [FN] - ----- (a) The exhibits included under Exhibit 10 constitute all management contracts, compensatory plans and arrangements required to be filed as an exhibit to this form pursuant to Item 14(c) of this report. On December 7, 1993, the Corporation filed a Current Report on Form 8-K reporting on the November 30, 1993, acquisition of First Amarillo Bancorporation, Inc. For the purposes of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, the Corporation hereby undertakes as follows, which undertaking shall be incorporated by reference into the Corporation's Registration Statements on Form S-8 Nos. 33-15714 (filed July 10, 1987), 33-15715 (filed July 10, 1987), 33-25945 (filed December 23, 1988), 33-25946 (filed December 23, 1988), 33-37862 (filed November 16, 1990), 33-44546 (filed December 17, 1991), 33-46730 (filed April 1, 1992), 33-55186 (filed November 27, 1992), 33-55110 (filed November 27, 1992), 33-50451 (filed September 30, 1993), 33-51635 (filed December 21, 1993) and 33-51637 (filed December 21, 1993). Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the Corporation pursuant to the foregoing provisions, or otherwise, the Corporation has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the Corporation of expenses incurred or paid by a director, officer or controlling person of the Corporation in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the Corporation will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Corporation has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. BOATMEN'S BANCSHARES, INC. ........................................ (Registrant) By ANDREW B. CRAIG, III .......................................... Andrew B. Craig, III, Chairman of the Board, President and Chief Executive Officer (principal executive officer) By JAMES W. KIENKER ------------------------------------------ James W. Kienker, Executive Vice President and Chief Financial Officer (principal financial and accounting officer) Date: March 8, 1994 The above listed charts were omitted from the EDGAR version of Exhibit 13; however, the information depicted in the charts was adequately discussed and/or displayed in tabular format within the Management's Discussion and Analysis section of the Annual Report.

77227_1993.txt

77227

1993

ITEM 1. BUSINESS. Pennsylvania Electric Company (Company), a Pennsylvania corporation incorporated in 1919, is a subsidiary of General Public Utilities Corporation (GPU), a holding company registered under the Public Utility Holding Company Act of 1935 (the 1935 Act). The Company's business is the generation, transmission, distribution and sale of electricity. The Company has two minor wholly-owned subsidiaries. The Company is affiliated with Jersey Central Power & Light Company (JCP&L) and Metropolitan Edison Company (Met-Ed). The Company, JCP&L and Met-Ed are referred to herein as the "Company and its affiliates." The Company is also affiliated with GPU Service Corporation (GPUSC), a service company; GPU Nuclear Corporation (GPUN), which operates and maintains the nuclear units of the Company and its affiliates; and General Portfolios Corporation (GPC), parent of Energy Initiatives, Inc., which develops, owns and operates nonutility generating facilities. All of the Company's affiliates are wholly-owned subsidiaries of GPU. The Company and its affiliates own all of the common stock of the Saxton Nuclear Experimental Corporation which owns a small demonstration nuclear reactor that has been partially decommissioned. The Company and its affiliates, GPUSC, GPUN and GPC considered together are referred to as the "GPU System." As a subsidiary of a registered holding company, the Company is subject to regulation by the Securities and Exchange Commission (SEC) under the 1935 Act. The Company's retail rates, conditions of service, issuance of securities and other matters of the Company are subject to regulation by the Pennsylvania Public Utility Commission (PaPUC). The Nuclear Regulatory Commission (NRC) regulates the construction, ownership and operation of nuclear generating stations. The Company is also subject to wholesale rate and other regulation by the Federal Energy Regulatory Commission (FERC) under the Federal Power Act. INDUSTRY DEVELOPMENTS The Energy Policy Act of 1992 (Energy Act) has made significant changes to the 1935 Act and the Federal Power Act. As a result of this legislation, the FERC is now authorized to order utilities to provide transmission or wheeling service to third parties for wholesale power transactions provided specified reliability and pricing criteria are met. In addition, the legislation amends the 1935 Act to permit the development and ownership of a broad category of independent power production facilities by utilities and nonutilities alike without subjecting them to regulation under the 1935 Act. These and other aspects of the Energy Act are expected to accelerate the changing character of the electric utility industry. (See "Regulation.") The electric utility industry appears to be undergoing a major transition as it proceeds from a traditional rate regulated environment based on cost recovery to some combination of a competitive marketplace and modified regulation of certain market segments. The industry challenges resulting from various instances of competition, deregulation and restructuring thus far have been minor compared with the impact that is expected in the future. The Public Utility Regulatory Policies Act of 1978 (PURPA) facilitated the entry of competitors into the electric generation business. Since then, more competition has been introduced through various state actions to encourage cogeneration and, most recently, the Energy Act. The Energy Act is intended to promote competition among utility and nonutility generators in the wholesale electric generation market, accelerating the industry restructuring that has been underway since the enactment of PURPA. This legislation, coupled with increasing customer demands for lower-priced electricity, is generally expected to stimulate even greater competition in both the wholesale and retail electricity markets. These competitive pressures may create opportunities to compete for new customers and revenues, as well as increase risk which could lead to the loss of customers. Operating in a competitive environment will place added pressures on utility profit margins and credit quality. Utilities with significantly higher cost structures than supportable in the marketplace may experience reduced earnings as they attempt to meet their customers' demands for lower- priced electricity. This prospect of increasing competition in the electric utility industry has already led the major credit rating agencies to address and apply more stringent guidelines in making credit rating determinations. Among its provisions, the Energy Act allows the FERC, subject to certain criteria, to order owners of electric transmission systems, such as the Company and its affiliates, to provide third parties with transmission access for wholesale power transactions. The Energy Act did not give the FERC the authority, however, to order retail transmission access. Movement toward opening the transmission network to retail customers is currently under consideration in several states. The competitive forces have also begun to influence some retail pricing in the industry. In a few instances, industrial customers, threatening to pursue cogeneration, self-generation or relocation to other service territories, have leveraged price concessions from utilities. Recent state regulatory actions, such as in New Jersey, suggest that utilities may have limited success with attempting to shift costs associated with such discounts to other customers. Utilities may have to absorb, in whole or part, the effects of price reductions designed to retain large retail customers. State regulators may put a limit or cap on prices, especially for those customers unable to pursue alternative supply options. Insofar as the Company is concerned, unrecovered costs will most likely be related to generation investment, purchased power contracts, and "regulatory assets", which are deferred accounting transactions whose value rests on the strength of a state regulatory decision to allow future recovery from ratepayers. In markets where there is excess capacity (as there currently is in the region including Pennsylvania) and many available sources of power supply, the market price of electricity may be too low to support full recovery of capital costs of certain existing power plants, primarily the capital intensive plants such as nuclear units. Another significant exposure in the transition to a competitive market results if the prices of a utility's existing purchase power contracts, consisting primarily of contractual obligations with nonutility generators, are higher than future market prices. Utilities locked into expensive purchase power arrangements may be forced to value the contracts at market prices and recognize certain losses. A third source of exposure is regulatory assets which, if not supported by regulators, would have no value in a competitive market. Financial Accounting Standard No. 71 (FAS 71), "Accounting for the Effects of Certain Types of Regulation", applies to regulated utilities that have the ability to recover their costs through rates established by regulators and charged to customers. If a portion of the Company's operations continues to be regulated, FAS 71 accounting may only be applied to that portion. Write- offs of utility plant and regulatory assets may result for those operations that no longer meet the requirements of FAS 71. In addition, under deregulation, the uneconomical costs of certain contractual commitments for purchased power and/or fuel supplies may have to be expensed. Management believes that to the extent that the Company no longer qualifies for FAS 71 accounting treatment, a material adverse effect on its results of operations and financial position may result. At this time, it is difficult for management to project the future level of stranded assets or other unrecoverable costs, if any, without knowing what the market price of electricity will be, or if regulators will allow recovery of industry transition costs from customers. Corporate Realignment In February 1994, GPU announced a corporate realignment and related actions as a result of its ongoing strategic planning studies. GPU Generation Corporation (GPU Generation) will be formed to operate and maintain the fossil-fueled and hydroelectric generating units of the Company and its affiliates; ownership of the generating assets will remain with the Company and its affiliates. GPU Generation will also build new generation facilities as needed by the Company and its affiliates in the future. Involvement in the independent power generation market will continue through Energy Initiatives, Inc. Additionally, the management and staff of the Company and Met-Ed will be combined but the two companies will not be merged and will retain their separate corporate existence. This action is intended to increase effectiveness and lower cost. Included in this effort will be a search for parallel opportunities at GPUN and JCP&L. Completion of these realignment initiatives will be subject to various regulatory reviews and approvals from the SEC, FERC, PaPUC and the New Jersey Board of Regulatory Commissioners (NJBRC). The GPU System is also developing a performance improvement and cost reduction program to help assure ongoing competitiveness, and, among other matters, will also address workforce issues in terms of compensation, size and skill mix. The GPU System is seeking annual cost savings of approximately $80 million by the end of 1996 as a result of these organizational changes. Duquesne Transaction In September 1990, the Company and its affiliates entered into a series of interdependent agreements with Duquesne Light Company (Duquesne) for the joint construction and ownership of associated high voltage bulk transmission facilities and the purchase by JCP&L and Met-Ed of a 50% ownership interest in Duquesne's 300 MW Phillips Generating Station. The Company and its affiliates' share of the total cost of these agreements was estimated to be $500 million (of which the Company's share of its participation in the transmission line was $117 million), the major part of which was expected to be incurred after 1994. In addition, JCP&L and Met-Ed simultaneously entered into a related agreement with Duquesne to purchase 350 MW of capacity and energy from Duquesne for 20 years beginning in 1997. The Company and its affiliates and Duquesne filed several petitions with the PaPUC and the NJBRC seeking certain of the regulatory authorizations required for the transactions. In December 1993, the NJBRC denied JCP&L's request to participate in the proposed transactions. As a result of this action and other developments, the Company and its affiliates notified Duquesne that they were exercising their rights under the agreements to withdraw from and thereby terminate the agreements. Consequently, the Company wrote off the approximately $8 million it had invested in the project. GENERAL The Company provides electric service within a territory located in western, northern and south central Pennsylvania extending from the Maryland state line northerly to the New York state line, with a population of about 1.5 million, approximately 24% of which is concentrated in ten cities and twelve boroughs, all with populations over 5,000. The Company owns all of the common stock of the Waverly Electric Light & Power Company, the owner of electric distribution facilities in the village of Waverly, New York. The Company, as lessee of the property of the Waverly Electric Light and Power Company, also serves a population of about 13,700 in Waverly, New York and vicinity. The Company's other wholly-owned subsidiary is Nineveh Water Company. The electric generating and transmission facilities of the Company, Met-Ed and JCP&L are physically interconnected and are operated as a single integrated and coordinated system. The transmission facilities are physically interconnected with neighboring nonaffiliated utilities in Pennsylvania, New Jersey, Maryland, New York and Ohio. The Company and its affiliates are members of the Pennsylvania-New Jersey-Maryland Interconnection (PJM) and the Mid-Atlantic Area Council, an organization providing coordinated review of the planning by utilities in the PJM area. The interconnection facilities are used for substantial capacity and energy interchange and purchased power transactions as well as emergency assistance. During 1993, residential sales accounted for about 37% of the Company's operating revenues from customers and 30% of kilowatt-hour (KWH) sales to customers; commercial sales accounted for about 32% of operating revenues from customers and 30% of KWH sales to customers; industrial sales accounted for about 27% of operating revenues from customers and 35% of KWH sales to customers; and sales to rural electric cooperatives, municipalities (primarily for street and highway lighting) and others accounted for about 4% of operating revenues from customers and 5% of KWH sales to customers. The Company also makes interchange and spot market sales of electricity to other utilities. The revenues derived from the 25 largest customers in the aggregate accounted for approximately 12% of operating revenues from customers for the year 1993. Reference is made to "Company Statistics" on page for additional information concerning the Company's sales and revenues. The Company and its affiliates along with the other members of the PJM power pool, experienced an electric emergency due to extremely cold temperature from January 18 through January 20, 1994. In order to maintain the electric system and to avoid a total black-out, intermittent black-outs for periods of one to two hours were instituted on January 19, 1994 to control peak loads. In February 1994, the NJBRC, the PaPUC and the FERC initiated investigations of the energy emergency, and forwarded data requests to all affected utilities. In addition, the United States House of Representatives' Energy and Power Subcommittee, among others, held hearings on this matter. At this time, management is unable to estimate the impact, if any, from any conclusions that may be reached by the regulators. In May 1993, the Pennsylvania Office of Consumer Advocate (Consumer Advocate) filed a petition for review of Met-Ed's rate order with the Pennsylvania Commonwealth Court seeking to set aside a March 1993 decision which allowed Met-Ed to (a) recover in the future certain Three Mile Island Unit 2 (TMI-2) retirement costs (radiological decommissioning and nonradiological cost of removal) and (b) defer the incremental costs associated with the adoption of the Statement of Financial Accounting Standards No. 106 (FAS 106) "Employers' Accounting for Postretirement Benefits Other Than Pensions." If the 1993 Met-Ed rate order is reversed, the Company would be required to write off a total of approximately $50 million for TMI-2 retirement costs. In addition, the Consumer Advocate is contesting utility deferral of FAS 106 costs in a proceeding involving another utility. The outcome of this proceeding may affect the Company's recovery of FAS 106 costs. This matter is pending before the court. (See "Rate Proceedings.") Competition in the electric utility industry has already played a significant role in wholesale transactions, affecting the pricing of energy sales to electric cooperatives and municipal customers. During 1993, the Company successfully negotiated power supply agreements with several existing GPU System wholesale customers in response to offers made by other utilities seeking to provide electric service at rates lower than those of Met-Ed or JCP&L. The Company has made similar offers to certain wholesale customers now being served by other utilities. Although wholesale customers represent a relatively small portion of Company sales, the Company will continue its efforts to retain and add customers. NUCLEAR FACILITIES The Company has made investments in two major nuclear projects -- Three Mile Island Unit 1 (TMI-1), which is an operational generating facility, and TMI-2, which was damaged during the 1979 accident. At December 31, 1993, the Company's net investment in TMI-1, including nuclear fuel, was $165 million. TMI-1 and TMI-2 are jointly owned by the Company, JCP&L and Met-Ed in the percentages of 25%, 25% and 50%, respectively. Costs associated with the operation, maintenance and retirement of nuclear plants have continued to increase and become less predictable, in large part due to changing regulatory requirements and safety standards and experience gained in the construction and operation of nuclear facilities. The Company and its affiliates may also incur costs and experience reduced output at their nuclear plants because of the design criteria prevailing at the time of construction and the age of the plants' systems and equipment. In addition, for economic or other reasons, operation of these plants for the full term of their now assumed lives cannot be assured. Also, not all risks associated with ownership or operation of nuclear facilities may be adequately insured or insurable. Consequently, the ability of electric utilities to obtain adequate and timely recovery of costs associated with nuclear projects, including replacement power, any unamortized investment at the end of the plants' useful life (whether scheduled or premature), the carrying costs of that investment and retirement costs, is not assured. Management intends, in general, to seek recovery of any such costs described above through the ratemaking process, but recognizes that recovery is not assured. TMI-1 TMI-1, a 786-MW pressurized water reactor, was licensed by the NRC in 1974 for operation through 2008. The NRC has extended the TMI-1 operating license through April 2014, in recognition of the plant's approximate six- year construction period. During 1993, TMI-1 operated at a capacity factor of approximately 87%. A scheduled refueling outage that year lasted 36 days; the next refueling outage is scheduled for late 1995. TMI-2 The 1979 TMI-2 accident resulted in significant damage to, and contamination of, the plant and a release of radioactivity to the environment. The cleanup program was completed in 1990, and, after receiving NRC approval, TMI-2 entered into long-term monitored storage in December 1993. As a result of the accident and its aftermath, individual claims for alleged personal injury (including claims for punitive damages), which are material in amount, have been asserted against GPU and the Company and its affiliates. Approximately 2,100 of such claims are pending in the U.S. District Court for the Middle District of Pennsylvania. Some of the claims also seek recovery for injuries from alleged emissions of radioactivity before and after the accident. Questions have not yet been resolved as to whether the punitive damage claims are (a) subject to the overall limitation of liability set by the Price-Anderson Act ($560 million at the time of the accident) and (b) outside the primary insurance coverage provided pursuant to that Act (remaining primary coverage of approximately $80 million as of December 1993). If punitive damages are not covered by insurance or are not subject to the Price-Anderson liability limitation, punitive damage awards could have a material adverse effect on the financial position of the GPU System. In June 1993, the District Court agreed to permit pre-trial discovery on the punitive damage claims to proceed. A trial of twelve allegedly representative cases is scheduled to begin in October 1994. In February 1994, the Court held that the plaintiffs' claims for punitive damages are not barred by the Price-Anderson Act to the extent that the funds to pay punitive damages do not come out of the U.S. Treasury. The Court also denied the defendants' motion seeking a dismissal of all cases on the grounds that the defendants complied with applicable federal safety standards regarding permissible radiation releases from TMI-2 and that, as a matter of law, the defendants therefore did not breach any duty that they may have owed to the individual plaintiffs. The Court stated that a dispute about what radiation and emissions were released cannot be resolved on a motion for summary judgment. NUCLEAR PLANT RETIREMENT COSTS Retirement costs for nuclear plants include decommissioning the radiological portions of the plants and the cost of removal of nonradiological structures and materials. The disposal of spent nuclear fuel is covered separately by contracts with the U.S. Department of Energy. See Note 2 to consolidated financial statements for further information regarding nuclear fuel disposal costs. In 1990, the Company and its affiliates submitted a report, in compliance with NRC regulations, setting forth a funding plan (employing the external sinking fund method) for the decommissioning of their nuclear reactors. Under this plan, the Company and its affiliates intend to complete the funding for TMI-1 by the end of the plant's license term, 2014. The TMI-2 funding completion date is 2014, consistent with TMI-2 remaining in long- term storage and being decommissioned at the same time as TMI-1. Under the NRC regulations, the funding target (in 1993 dollars) for TMI-1 is $143 million, of which the Company's share is $36 million. Based on NRC studies, a comparable funding target for TMI-2 (in 1993 dollars), which takes into account the accident, is $228 million, of which the Company's share would be $57 million. The NRC is currently studying the levels of these funding targets. Management cannot predict the effect that the results of this review will have on the funding targets. NRC regulations and a regulatory guide provide mechanisms, including exemptions, to adjust the funding targets over their collection periods to reflect increases or decreases due to inflation and changes in technology and regulatory requirements. The funding targets, while not actual cost estimates, are reference levels designed to assure that licensees demonstrate adequate financial responsibility for decommissioning. While the regulations address activities related to the removal of the radiological portions of the plants, they do not establish residual radioactivity limits nor do they address costs related to the removal of nonradiological structures and materials. In 1988, a consultant to GPUN performed a site-specific study of TMI-1 that considered various decommissioning plans and estimated the cost of decommissioning the radiological portions of TMI-1 to range from approximately $205 to $285 million (adjusted to 1993 dollars), of which the Company's share would range between approximately $51 to $71 million. In addition, the study estimated the cost of removal of nonradiological structures and materials for TMI-1 at $72 million, of which the Company's share would be $18 million. The ultimate cost of retiring the Company and its affiliates' nuclear facilities may be materially different from the funding targets and the cost estimates contained in the site-specific studies and cannot now be more reasonably estimated than the level of the NRC funding target because such costs are subject to (a) the type of decommissioning plan selected, (b) the escalation of various cost elements (including, but not limited to, general inflation), (c) the further development of regulatory requirements governing decommissioning, (d) the absence to date of significant experience in decommissioning such facilities and (e) the technology available at the time of decommissioning. The Company is charging to expense and contributing to external trusts amounts collected from customers for nuclear plant decommissioning and nonradiological costs. In addition, the Company has contributed to external trusts amounts written off for nuclear plant decommissioning in 1991. TMI-1 Effective October 1993, the PaPUC approved a rate change for the Company which increased the collection of revenues for decommissioning costs for TMI-1 based on its share of the NRC funding target and nonradiological cost of removal as estimated in the site-specific study. Collections from customers for decommissioning expenditures are deposited in external trusts. These external trust funds, including the interest earned, are classified as Decommissioning Funds on the balance sheet. Provision for the future expenditure of these funds has been made in accumulated depreciation, amounting to $4 million at December 31, 1993. Management believes that TMI-1 retirement costs, in excess of those currently recognized for ratemaking purposes, should be recoverable through the ratemaking process. TMI-2 The Company has recorded a liability amounting to $57 million, as of December 31, 1993, for its share of the radiological decommissioning of TMI- 2, reflecting the NRC funding target (unadjusted for an immaterial decrease in 1993). The Company records escalations, when applicable, in the liability based upon changes in the NRC funding target. The Company has also recorded a liability in the amount of $5 million, for its share of incremental costs specifically attributable to monitored storage. Such costs are expected to be incurred between 1994 and 2014, when decommissioning is forecast to begin. In addition, the Company has recorded a liability in the amount of $18 million, for its share of nonradiological cost of removal. The above amounts for retirement costs and monitored storage are reflected as Three Mile Island Unit 2 Future Costs on the balance sheet. The Company has made a nonrecoverable contribution of $20 million to an external decommissioning trust relating to its share of the accident-related portion of the decommissioning liability. The PaPUC has granted Met-Ed decommissioning revenues for its share of the remainder of the NRC funding target and allowances for the cost of removal of nonradiological structures and materials, although the PaPUC's order has been appealed by the Consumer Advocate (see "Rate Proceedings"). The Company intends to request decommissioning revenues and an allowance for the cost of removal of nonradiological structures and materials, equivalent to its share of the amounts granted to Met-Ed, in its next retail base rate filing. Management intends to seek recovery for any increases in TMI-2 retirement costs, but recognizes that recovery cannot be assured. As a result of TMI-2's entering long-term monitored storage, the Company is incurring incremental storage costs currently estimated at $.25 million annually. The Company has deferred the $5 million, for its share of the total estimated incremental costs attributable to monitored storage through 2014, the expected retirement date of TMI-1. The Company believes these costs should be recoverable through the ratemaking process. INSURANCE The GPU System has insurance (subject to retentions and deductibles) for its operations and facilities including coverage for property damage, liability to employees and third parties, and loss of use and occupancy (primarily incremental replacement power costs). There is no assurance that the GPU System will maintain all existing insurance coverages. Losses or liabilities that are not completely insured, unless allowed to be recovered through ratemaking, could have a material adverse effect on the financial position of the Company. The decontamination liability, premature decommissioning and property damage insurance coverage for the TMI station (TMI-1 and TMI-2 are considered one site for insurance purposes) totals $2.7 billion. In accordance with NRC regulations, these insurance policies generally require that proceeds first be used for stabilization of the reactors and then to pay for decontamination and debris removal expenses. Any remaining amounts available under the policies may then be used for repair and restoration costs and decommissioning costs. Consequently, there can be no assurance that in the event of a nuclear incident, property damage insurance proceeds would be available for the repair and restoration of the stations. The Price-Anderson Act limits the of GPU System's liability to third parties for a nuclear incident at one of its sites to approximately $9.4 billion. Coverage for the first $200 million of such liability is provided by private insurance. The remaining coverage, or secondary protection, is provided by retrospective premiums payable by all nuclear reactor owners. Under secondary protection, a nuclear incident at any licensed nuclear power reactor in the country, including those owned by the GPU System, could result in assessments of up to $79 million per incident for each of the GPU System's reactors, subject to an annual maximum payment of $10 million per incident per reactor. In 1993, GPUN requested an exemption from the NRC to eliminate the secondary protection requirements for TMI-2. This matter is pending before the NRC. The Company and its affiliates have insurance coverage for incremental replacement power costs resulting from an accident-related outage at their nuclear plants. Coverage for TMI-1 commences after the first 21 weeks of the outage and continues for three years at decreasing levels beginning at a weekly amount of $2.6 million. Under its insurance policies applicable to nuclear operations and facilities, the Company is subject to retrospective premium assessments of up to $7 million in any one year, in addition to those payable under the Price-Anderson Act. NONUTILITY AND OTHER POWER PURCHASES The Company has entered into power purchase agreements with independently owned power production facilities (nonutility generators) for the purchase of energy and capacity for periods up to 25 years. The majority of these agreements are subject to penalties for nonperformance and other contract limitations. All of these facilities are must-run and generally obligate the Company to purchase all of the power produced up to the contract limits. The agreements have been approved by the PaPUC and permit the Company to recover energy and demand costs from customers through its energy clause. These agreements provide for the sale of approximately 412 MW of capacity and energy to the Company by the mid 1990s. As of December 31, 1993, facilities covered by these agreements having 293 MW of capacity were in service. Payments made pursuant to these agreements were $104 million for 1993 and are estimated to aggregate $121 million for 1994. The price of the energy and capacity to be purchased under these agreements is determined by the terms of the contracts. The rates payable under a number of these agreements are in excess of current market prices. While the Company has been granted full recovery of these costs from customers by the PaPUC, there can be no assurance that the Company will continue to be able to recover these costs throughout the term of the related contracts. The emerging competitive market has created additional uncertainty regarding the forecasting of the Company's energy supply needs which, in turn, has caused the Company to change its supply strategy to seek shorter term agreements offering more flexibility. At the same time, the Company is attempting to renegotiate higher cost long-term nonutility generation contracts where opportunities arise. The extent to which the Company may be able to do so, however, or recover associated costs through rates, is uncertain. Moreover, these efforts have led to disputes before the PaPUC, as well as to litigation, and may result in claims against the Company for substantial damages. There can be no assurance as to the outcome of these matters. In July 1993, the PaPUC acted to initiate a rulemaking proceeding which, in general, would establish a mandatory all source competitive bidding program by which utilities would meet their future capacity and energy needs. In November 1993, the Company filed an appeal with the Commonwealth Court seeking to overturn a PaPUC order which directs the Company to enter into two power purchase agreements with nonutility generators for a total of 160 MW under long-term contracts commencing in 1997 or later. The Company believes it does not need this additional capacity and believes the costs associated with these contracts are not in the economic interests of its customers. The matter is pending before the Commonwealth Court. The Company and its affiliates have entered into agreements with other utilities for the purchase of capacity and energy for various periods through 1999. These agreements provide for up to 2,130 MW in 1994, declining to 1,307 MW in 1995 and 183 MW by 1999. Payments pursuant to these agreements are estimated to aggregate $244 million in 1994. The price of the energy purchased under these agreements is determined by contracts providing generally for the recovery by the sellers of their costs. RATE PROCEEDINGS Pennsylvania In March 1993, in response to a petition filed by the Company's affiliate Met-Ed, the PaPUC modified portions of its January 1993 Met-Ed rate order to allow for the future recovery of certain TMI-2 retirement costs (radiological decommissioning and nonradiological cost of removal). (See "Nuclear Plant Retirement Costs.") In addition, the PaPUC action on the Met-Ed petition allowed the Company to defer the incremental costs associated with the adoption of FAS 106. In May 1993, the Consumer Advocate filed a petition for review with the Pennsylvania Commonwealth Court seeking to set aside the PaPUC 1993 Met-Ed rate order. The matter is pending before the court. If the 1993 rate order is reversed, the Company would be required to write off a total of approximately $50 million for TMI-2 retirement costs. The Company intends to request decommissioning revenues and an allowance for the cost of removal of nonradiological structures and materials for TMI-2, equivalent to its share of the amounts granted to Met-Ed, in its next retail base rate filing. Management intends to seek recovery for any increases in TMI-2 retirement costs, but recognizes that recovery cannot be assured. In March 1993, the PaPUC issued a generic policy statement that permitted the deferral of FAS 106 costs for review and recovery in subsequent base rate making. Consistent with the PaPUC's policy statement, the Company filed a petition with the PaPUC in July 1993 for deferral of FAS 106 costs. That petition was approved by the PaPUC in October 1993. The Consumer Advocate is contesting utility deferral of FAS 106 costs in a proceeding involving another utility. The outcome of this proceeding may affect the Company's future recovery of these costs. The PaPUC has recently completed its generic investigation into demand- side management (DSM) cost recovery mechanisms and issued a cost recovery and ratemaking order in December 1993. The Company is currently developing plans which will reflect changes since its original plan was filed in 1991. In December 1993, the Pennsylvania Industrial Energy Coalition (PIEC) appealed to the Commonwealth Court to reverse the PaPUC Order. On February 4, 1994, the Company and Met-Ed filed a petition seeking a stay of the PaPUC's Order until the PIEC's appeal is resolved (See "Construction Program - Demand-Side Management"). In March 1994, the Company made its annual filing with the PaPUC for an increase in its Energy Cost Rate of $38.3 million. The new rate is expected to become effective April 1, 1994. The PaPUC is considering generic nuclear performance standards for Pennsylvania utilities. In January 1994, the Company submitted a proposal which, along with proposals submitted by the other Pennsylvania utilities, may result in the PaPUC adopting a generic nuclear performance standard. CONSTRUCTION PROGRAM General During 1993, the Company had gross plant additions of approximately $168 million attributable principally to improvements and modifications to existing generating stations, additions to the transmission and distribution system and clean air requirements. During 1994, the Company contemplates gross plant additions of approximately $218 million. The Company's gross plant additions are expected to total approximately $242 million in 1995. The anticipated increase in construction expenditures during 1995 is principally attributable to expenditures associated with clean air requirements. The principal categories of the 1994 anticipated expenditures, which include an allowance for other funds used during construction, are as follows: (In Millions) Generation - Nuclear $ 6 Nonnuclear 111 Total Generation 117 Transmission & Distribution 86 Other 15 Total $218 In addition, expenditures for maturing debt are expected to be $70 million for 1994. The Company will have no expenditures for maturing debt in 1995. Subject to market conditions, the Company intends to redeem during these periods outstanding senior securities pursuant to optional redemption provisions thereof should it prove economical to do so. Management estimates that approximately one-half of the Company's total capital needs for 1994 and 1995 will be satisfied through internally generated funds. The Company expects to obtain the remainder of these funds principally through the sale of first mortgage bonds and preferred stock, subject to market conditions. The Company's bond indenture and articles of incorporation include provisions that limit the amount of long-term debt, preferred stock and short-term debt the Company may issue. The Company's interest and preferred stock dividend coverage ratios are currently in excess of indenture or charter restrictions. (see "Limitations on Issuing Additional Securities"). Present plans call for the Company to issue long- term debt and preferred stock during the next three years to finance construction activities and, depending on the level of interest rates, refinance outstanding senior securities. The Company's 1994 construction program includes $66 million in connection with the federal Clean Air Act Amendments of 1990 (Clean Air Act) requirements (see "Environmental Matters-Air"). The 1995 construction program currently includes approximately $62 million for Clean Air Act compliance. The Company's gross plant additions exclude nuclear fuel requirements provided under capital leases that amounted to $11 million in 1993. When consumed, the presently leased material, which amounted to $21 million at December 31, 1993, is expected to be replaced by additional leased material at an average rate of approximately $9 million annually. In the event the replacement nuclear fuel needs cannot be leased, the associated capital requirements would have to be met by other means. The Company has projected increases in peak loads of approximately 275 MW (summer rating) and 440 MW (winter rating) by the year 1998. The Company expects to experience an average growth in sales to customers during this period of about 2.3% annually. The Company expects to meet this growth through existing and contracted supply sources and the utilization of capacity of its affiliates. In response to the increasingly competitive business climate and excess capacity of nearby utilities, the Company's supply plan places an emphasis on maintaining flexibility. Supply planning focuses increasingly on short to intermediate term commitments, reliance on "spot" markets, and avoidance of long-term firm commitments. Through 1998, the Company's plan consists of the continued utilization of most existing generating facilities, power purchases and the continued promotion of economic energy conservation and load management programs. Given the future direction of the industry, the Company's present strategy includes minimizing the financial exposure associated with new long-term purchase commitments and the construction of new facilities by including projected market prices in the evaluation of these options. The Company will resist efforts to compel it to add or contract for new capacity at costs that may exceed future market prices. In addition, the Company is attempting to renegotiate higher cost long-term nonutility generation contracts where opportunities arise. Demand-Side Management The regulatory environment in Pennsylvania encourages the development of new conservation and load management programs as evidenced by recent approval of a cost recovery mechanism for DSM. DSM includes utility sponsored activities designed to improve energy efficiency in customer end-use, and includes load management programs (i.e., peak reduction) and conservation programs (i.e., energy and peak reduction). In 1990, the Company and Met-Ed jointly filed a proposal with the PaPUC on DSM issues. The proposal recommends that the PaPUC preapprove DSM programs of utilities to enable the collection of their costs and that the PaPUC issue an order on a generic basis. In December 1993, the PaPUC issued an order adopting generic guidelines for recovery of DSM expenses. Also in December 1993, the Consumer Advocate and the Pennsylvania Energy Office filed separate petitions for clarification and reconsideration of the PaPUC's order and the PIEC appealed to the Commonwealth Court to reverse the PaPUC order. On February 4, 1994, the Company and Met-Ed filed a petition seeking a stay of the PaPUC's order until the PIEC's appeal is resolved. FINANCING ARRANGEMENTS The Company expects to have short-term debt outstanding from time to time throughout the year. The peak in short-term debt outstanding is expected to occur in the spring coinciding with normal cash requirements for revenue tax payments. GPU and the Company and its affiliates have $398 million of credit facilities, which includes a Revolving Credit Agreement (Credit Agreement) with a consortium of banks that permits total borrowing of $150 million outstanding at any one time. The credit facilities generally provide for the payment of a commitment fee on the unborrowed amount of 1/8 of 1% annually. Borrowings under these credit facilities generally bear interest based on the prime rate or money market rates. Notes issued under the Credit Agreement, which expires April 1, 1995, are subject to various covenants and acceleration under certain conditions. In 1993, the Company refinanced higher cost long-term debt in the principal amount of $108 million resulting in an estimated annualized after- tax savings of $1 million. Total long-term debt issued during 1993 amounted to $120 million. In addition, the Company redeemed $25 million of high- dividend rate preferred stock. The funds for this redemption were derived from GPU through sales of its common stock. In January 1994, the Company issued an aggregate of $90 million of first mortgage bonds, of which a portion of the net proceeds were used to redeem early $38 million principal amount of 6 5/8% series bonds in late February 1994. The Company has regulatory authority to issue and sell first mortgage bonds, which may be issued as secured medium-term notes, and preferred stock for various periods through 1995. Under existing authorization, the Company may issue senior securities in the amount of $330 million, of which $100 million may consist of preferred stock. The Company also has regulatory authority to incur short-term debt, a portion of which may be through the issuance of commercial paper. Under the Company and its affiliates' nuclear fuel lease agreements with nonaffiliated fuel trusts, up to $125 million of TMI-1 nuclear fuel costs may be outstanding at any one time. It is contemplated that when consumed, portions of the presently leased material will be replaced by additional leased material. The Company and its affiliates are responsible for the disposal costs of nuclear fuel leased under these agreements. LIMITATIONS ON ISSUING ADDITIONAL SECURITIES The Company's first mortgage bond indenture and/or articles of incorporation include provisions which limit the total amount of securities evidencing secured indebtedness, and/or unsecured indebtedness which the Company may issue, the more restrictive of which are described below. The Company's first mortgage bond indenture restricts the ratio of first mortgage bonds issued to not more than 60 percent of qualified property additions. At December 31, 1993, the Company had qualified property additions sufficient to permit the Company to issue approximately $270 million of additional first mortgage bonds. In addition, the indenture generally permits the Company to issue first mortgage bonds against like principal amount of previously retired bonds, which at December 31, 1993 totalled approximately $50 million. The Company's mortgage indenture requires that for a period of any twelve consecutive months out of the fifteen calendar months preceding the issuance of additional first mortgage bonds, the Company's net earnings (before income taxes, with other income limited to 10% of operating income before income taxes) available for interest on first mortgage bonds shall have been at least twice the annual interest requirements on all first mortgage bonds to be outstanding immediately after such issuance. At December 31, 1993, these provisions would have permitted the Company to issue approximately $798 million principal amount of first mortgage bonds at an assumed rate of 8.0 percent. However, as described above, under the Company's first mortgage bond indenture the Company had qualified property additions along with previously retired bonds which would have permitted it to issue only approximately $320 million of additional first mortgage bonds at such date. Among other restrictions, the Company's articles of incorporation provide that without the consent of the holders of two-thirds of the outstanding preferred stock, no additional shares of preferred stock may be issued, unless, for a period of any twelve consecutive months out of the fifteen calendar months preceding such issuance (a) the Company's net earnings available for the payment of dividends on preferred stock shall have been at least three times the annual dividend requirements on all shares of preferred stock to be outstanding immediately after such issuance, and (b) the Company's after tax net earnings available for the payment of interest on indebtedness shall have been at least one and one-half times the aggregate of (1) the annual interest charges on indebtedness and (2) the annual dividend requirements on all shares of preferred stock to be outstanding immediately after such issuance. At December 31, 1993, these provisions would have permitted the Company to issue approximately $353 million stated value of cumulative preferred stock at an assumed dividend rate of 8.0 percent. Under the Company's articles of incorporation, without the consent of the holders of a majority of the total voting power of the Company's outstanding preferred stock, the Company may not issue or assume any securities representing unsecured indebtedness (except to refund certain outstanding unsecured securities issued or assumed by the Company or to redeem all outstanding preferred stock) if immediately thereafter the total principal amount of all outstanding unsecured debt securities having an initial maturity of less than ten years issued or assumed by the Company would exceed 10 percent of the aggregate of (a) the total principal amount of all outstanding secured indebtedness issued or assumed by the Company and (b) the capital and surplus of the Company. At December 31, 1993, these restrictions would have permitted the Company to have approximately $135 million of unsecured indebtedness outstanding. The Company has obtained authorization from the SEC to incur short-term debt (including indebtedness under the Credit Agreement and commercial paper) up to the Company's charter limitation. REGULATION As a registered holding company, GPU is subject to regulation by the SEC under the 1935 Act. The Company, as a subsidiary of GPU, is also subject to regulation under the 1935 Act with respect to accounting, the issuance of securities, the acquisition and sale of utility assets, securities or any other interest in any business, the entering into, and performance of, service, sales and construction contracts, and certain other matters. The SEC has determined that the electric facilities of the Company and its affiliates constitute a single integrated public utility system under the standards of the 1935 Act. The 1935 Act also limits the extent to which the Company may engage in nonutility businesses. The Company's retail rates for Pennsylvania customers, conditions of service, issuance of securities and other matters are subject to regulation by the PaPUC. The Company's retail rates for New York customers are subject to regulation by the New York Public Service Commission (NYPSC). Moreover, with respect to wholesale rates, the transmission of electric energy, accounting, the construction and maintenance of hydroelectric projects and certain other matters, the Company is subject to regulation by the FERC under the Federal Power Act. The NRC regulates the construction, ownership and operation of nuclear generating stations and other related matters. Although the Company does not render electric service in Maryland, the Public Service Commission of Maryland has jurisdiction over the portion of the Company's property located in that state. The Company has a levelized energy cost rate for Pennsylvania retail rates and current fuel adjustment clauses for wholesale rates and New York retail rates. The Company, as lessee, operates the facilities serving the Village of Waverly, New York, and the NYPSC has jurisdiction over such operations and property. (See "Electric Generation and the Environment - Environmental Matters" for additional regulation to which the Company is or may be subject.) The rates charged by the Company for electric service are set by regulators under statutory requirements that they be "just and reasonable." As such, they are subject to adjustment, up or down, in the event they vary from that statutory standard. In 1992, as a result of a rulemaking proceeding, the PaPUC established quarterly financial reporting requirements to monitor public utility earnings. ELECTRIC GENERATION AND THE ENVIRONMENT Fuel Of the portion of its energy requirements supplied by its own generation, the Company utilized fuels in the generation of electric energy during 1993 in approximately the following percentages: Coal--87%; Nuclear--12%; and Gas, Hydro and Oil--1%. For 1994, the Company estimates that its generation of electric energy will be supplied in approximately the same proportions. Approximately 8% of the Company's energy requirements in 1993 was supplied by purchases (including net interchange) from other utilities and nonutility generators. Approximately 13% of the Company's 1994 energy requirements are expected to be supplied by purchases (including net interchange) from other utilities and nonutility generators. Fossil: The Company has entered into long-term contracts with nonaffiliated mining companies for the purchase of coal for its Homer City generating station in which it has a fifty percent ownership interest. The contracts, which expire between 1995 and 2003, require the purchase of fixed amounts of coal. Under the contracts the price of coal is based on adjustments of indexed cost components. One contract also includes a provision for the payment of environmental and post-employment benefits. The Company's share of the cost of coal purchased under these agreements is expected to aggregate $55 million for 1994. The Company's coal-fired generating stations now in service are estimated to require an aggregate of 95 million tons of coal over the next twenty years. Of this total requirement, approximately 8 million tons are expected to be supplied by a nonaffiliated mine-mouth coal company with the balance supplied through long-term contracts and spot market purchases. At the present time, adequate supplies of fossil fuels are readily available to the Company, but this situation could change rapidly as a result of actions over which it has no control. Nuclear: Preparation of nuclear fuel for generating station use involves various manufacturing stages for which the Company and its affiliates contract separately. Stage I involves the mining and milling of uranium ores to produce natural uranium concentrates. Stage II provides for the chemical conversion of the natural uranium concentrates into uranium hexafluoride. Stage III involves the process of enrichment to produce enriched uranium hexafluoride from the natural uranium hexafluoride. Stage IV provides for the fabrication of the enriched uranium hexafluoride into nuclear fuel assemblies for use in the reactor core at the nuclear generating station. For TMI-1, under normal operating conditions, there is, with minor planned modifications, sufficient on-site storage capacity to accommodate spent nuclear fuel through the end of its licensed life while maintaining the ability to remove the entire reactor core. Environmental Matters The Company is subject to federal and state water quality, air quality, solid waste disposal and employee health and safety legislation and to environmental regulations issued by the U.S. Environmental Protection Agency (EPA), state environmental agencies and other federal agencies. In addition, the Company is subject to licensing of hydroelectric projects by the FERC and of nuclear power projects by the NRC. Such licensing and other actions by federal agencies with respect to projects of the Company are also subject to the National Environmental Policy Act. As a result of existing and proposed legislation and regulations, and ongoing legal proceedings dealing with environmental matters, including but not limited to acid rain, water quality, air quality, global warming, electromagnetic fields, and storage and disposal of hazardous and/or toxic wastes, the Company may be required to incur substantial additional costs to construct new equipment, modify or replace existing and proposed equipment, remediate or clean up waste disposal and other sites currently or formerly used by it, including formerly owned manufactured gas plants and mine refuse piles, and with regard to electromagnetic fields, postpone or cancel the installation of, or replace or modify, utility plant, the costs of which could be material. The consequences of environmental issues, which could cause the postponement or cancellation of either the installation or replacement of utility plant are unknown. Management believes the costs described above should be recoverable through the ratemaking process but recognizes that recovery cannot be assured. Water: The federal Water Pollution Control Act (Clean Water Act) generally requires, with respect to existing steam electric power plants, the application of the best conventional or practicable pollutant control technology available and compliance with state-established water quality standards. With respect to future plants, the Clean Water Act requires the application of the "best available demonstrated control technology, processes, operating methods or other alternatives" to achieve, where practicable, no discharge of pollutants. Congress may amend the Clean Water Act during 1994. The EPA has adopted regulations that establish thermal and other limitations for effluents discharged from both existing and new steam electric generating stations. Standards of performance are developed and enforcement of effluent limitations is accomplished through the issuance by the EPA, or states authorized by the EPA, of discharge permits that specify limitations to be applied. Discharge permits, which have been issued for all of the Company's generating stations, where required, have expiration dates ranging through 1996. Timely reapplications for such permits have been filed as required by regulations. The Company is also subject to environmental and water diversion requirements adopted by the Delaware River Basin Commission and the Susquehanna River Basin Commission as administered by those commissions or the Pennsylvania Department of Environmental Resources (PaDER). Nuclear: Reference is made to "Nuclear Facilities" for information regarding the TMI-2 accident, its aftermath and TMI-1. Pennsylvania has established, in conjunction with several other states, a low level radioactive waste (radwaste) compact for the construction, licensing and operation of low level radwaste disposal facilities to service their respective areas by the year 2000. Pennsylvania, Delaware, Maryland and West Virginia have established the Appalachian Compact, which will build a single facility to dispose of low level radwaste in their areas, including low level radwaste from TMI-1. The estimated cost to license and build this facility is approximately $60 million, of which the Company and its affiliates' share is $12 million. These payments are considered advance waste disposal fees and will be recovered during the facility's operation. The Company has provided for future contributions to the Decontamination and Decommissioning Fund (part of the Energy Act) for the cleanup of enrichment plants operated by the Federal government. The Company's share of the total liability at December 31, 1993 amounted to $6 million. The Company made its initial payment in 1993. The remaining amounts recoverable from ratepayers is $7 million at December 31, 1993. Air: The Company is subject to certain state environmental regulations of the PaDER. The Company is also subject to certain federal environmental regulations of the EPA. The PaDER and the EPA have adopted air quality regulations designed to implement Pennsylvania and federal statutes relating to air quality. Current Pennsylvania environmental regulations prescribe criteria that generally limit the sulfur dioxide content of stack gas emissions from generating stations constructed before 1972 and stations constructed after 1971 but before 1978, to 3.7 pounds and 1.2 pounds per million BTU of heat input, respectively. On a weighted average basis, the Company has been able to obtain coal having a sulfur content meeting these criteria. If, and to the extent that, the Company cannot continue to meet such limitations with processed coal, it may be necessary to retrofit operating stations with sulfur removal equipment that may require substantial capital expenditures as well as substantial additional operating costs. Such retrofitting, if it could be accomplished to permit continued reliable operation of the facilities concerned, would take approximately five years. As a result of the Clean Air Act, which requires substantial reductions in sulfur dioxide and nitrogen oxide (NOx) emissions by the year 2000, it may be necessary for the Company to install and operate emission control equipment as well as switch to slightly lower sulfur coal at some of the Company's coal-fired plants in order to achieve compliance. To comply with Title IV of the Clean Air Act, the Company expects to expend up to $295 million by the year 2000, of which approximately $35 million has been spent as of December 31, 1993, for the installation of scrubbers, low NOx burner technology and various precipitator upgrades. The capital costs of this equipment and the increased operating costs of the affected stations are expected to be recoverable through the ratemaking process. The Company's current strategy for Phase II compliance under the Clean Air Act is to evaluate the installation of scrubbers or fuel switching at the Homer City Unit 3 Station. Switching to lower sulfur coal is currently planned for the Seward and Warren Stations. Homer City Units 1 and 2 will use existing coal cleaning technology. The Company continues to review available options to comply with the Clean Air Act, including those which may result from the development of an emission allowance trading market. The Company's compliance strategy, especially with respect to Phase II, could change as a result of further review, discussions with co-owners of jointly-owned stations and changes in federal and state regulatory requirements. The ultimate impact of Title I of the Clean Air Act, which deals with the attainment of ambient air quality standards, is highly uncertain. In particular, this Title has established an ozone transport or emission control region that includes 11 northeast states. Pennsylvania is part of this transport region, and will be required to control NOx emissions to a level that will provide for the attainment of the ozone standard in the northeast. As an initial step, major sources of NOx will be required to implement Reasonably Available Control Technology (RACT) by May 31, 1995. This will affect the Company's steam generating stations. PaDER's RACT regulations have been approved by the Environmental Quality Board and became effective in January 1994. Large coal-fired combustion units are required to comply with a presumptive RACT emission limitation (technology) or may elect to use a case-by-case analysis to establish RACT requirements. The ultimate impact of Title III of the Clean Air Act, which deals with emissions of hazardous air pollutants, is also highly uncertain. Specifically, the EPA has not completed a Clean Air Act study to determine whether it is appropriate to regulate emissions of hazardous air pollutants from electric utility steam generating units. However, the Homer City Coal Processing Plant is being studied to determine if it is a major stationary source for air toxins. Both the EPA and PaDER are questioning the attainment of National Ambient Air Quality Standards (NAAQS) for sulfur dioxide in the vicinity of the Chestnut Ridge Energy Complex (Homer City and Seward generating stations). The Homer City generating station is jointly owned with New York State Electric and Gas Corporation (NYSEG). The EPA and the PaDER have approved the use of a nonguideline air quality model. This model is more representative and less conservative than the EPA guideline model and will be used in the development of a compliance strategy for all generating stations in the Chestnut Ridge Energy Complex. The area around the Warren generating station has been designated as nonattainment for sulfur dioxide. An air quality model evaluation study began in early 1993. The results of the study will be used to determine if a nonguideline model can be used. The study results will be available in 1994. A Consent Order and Agreement has been negotiated to allow PaDER to revise the implementation plan for Warren Station. A model evaluation study is also being conducted at Shawville Station. The results of this study will be available in 1995. Based on the results of the studies pursuant to NAAQS, significant sulfur dioxide reductions may be required at one or more of these stations which could result in material capital and additional operating expenditures. Certain other environmental regulations limit the amount of particulate matter emitted into the environment. The Company has installed equipment at its coal-fired generating stations and may find it necessary to either upgrade or install additional equipment at certain of its stations to consistently meet particulate emission requirements. In the fall of 1993, the Clinton Administration unveiled its climate change action plan which intends to reduce greenhouse gas emissions to 1990 levels by the year 2000. The climate action plan relies heavily on voluntary action by industry. The Company and its affiliates notified the Department of Energy (DOE) that they support the voluntary approach proposed by the President and expressed their intent to work with the DOE. Title IV of the Clean Air Act requires Phase I and Phase II affected units to install a continuous emission monitoring system (CEMS) and quality assure the data for sulfur dioxide, nitrogen oxides, opacity and volumetric flow. In addition, Title VIII requires all affected sources to monitor carbon dioxide emissions. Monitoring systems have been installed and certified on all of the Company's affected units as required by EPA and PaDER regulations. The PaDER has a CEMS enforcement policy to ensure consistent compliance with air quality regulations under federal and state statutes. The CEMS enforcement policy includes matters such as visible emissions, sulfur dioxide emission standards, nitrogen oxide emissions and a requirement to maintain certified continuous emission monitoring equipment. In addition, this policy provides a mechanism for the payment of certain prescribed amounts to the Pennsylvania Clean Air Fund (Clean Air Fund) for air pollutant emission excesses or monitoring failures. With respect to the operation of the Company's generating stations for 1994, it is not anticipated that payments to be made to the Clean Air Fund will be material in amount. The Clean Air Act has also expanded the enforcement options available to the EPA and the states and contains more stringent enforcement provisions and penalties. Moreover, citizen suits can seek civil penalties for violations of this act. The EPA has established Best Available Retrofit Technology (BART) sulfur dioxide emission standards to be used for the Company's Shawville and Seward generating stations under the Good Engineering Practice stack height regulation. Dependent upon the Chestnut Ridge Compliance Strategy and the results of the Shawville model evaluation study mentioned above, lower sulfur coal purchases may be necessary for compliance. Discussions with the EPA regarding this matter are continuing. In 1988, the Environmental Defense Fund (EDF), the New Jersey Conservation Foundation, the Sierra Club and Pennsylvanians for Acid Rain Control requested that the New Jersey Department of Environmental Protection and Energy (NJDEPE) and the NJBRC seek to reduce sulfur deposition in New Jersey, either by reducing emissions from both in-state and out-of-state sources, or by requiring that certain electricity imported into New Jersey be generated from facilities meeting minimum emission standards. The Company owns coal-fired generating facilities that supply electric energy to JCP&L and other New Jersey members of PJM. Hearings on the EDF petition were held during 1989 and 1990, and the matter is pending before the NJDEPE and the NJBRC. In 1993, the Company made capital expenditures of approximately $32 million in response to environmental considerations and has included approximately $73 million for this purpose in its 1994 construction program. The operating and maintenance costs, including the incremental costs of low-sulfur fuel, for such equipment were approximately $40 million in 1993 and are expected to be approximately $39 million in 1994. Electromagnetic Fields: There have been a number of scientific studies regarding the possibility of adverse health effects from electric and magnetic fields (EMF) that are found everywhere there is electricity. While some of the studies have indicated some association between exposure to EMF and cancer, other studies have indicated no such association. The studies have not shown any causal relationship between exposure to EMF and cancer, or any other adverse health effects. In 1990, the EPA issued a draft report that identifies EMF as a possible carcinogen, although it acknowledges that there is still scientific uncertainty surrounding these fields and their possible link to adverse health effects. On the other hand, a 1992 White House Office of Science and Technology policy report states that "there is no convincing evidence in the published literature to support the contention that exposures to extremely low frequency electric and magnetic fields generated by sources such as household appliances, video display terminals, and local power lines are demonstrable health hazards." Additional studies, which may foster a better understanding of the subject, are presently underway. Bills introduced in the Pennsylvania legislature could, if enacted, establish a framework under which the intensity of EMF produced by electric transmission and distribution lines would be limited or otherwise regulated. The Company cannot determine at this time what effect, if any, this matter will have on it. Residual Waste: PaDER has finalized the residual waste regulations which became effective in July 1992. These regulations impose additional restrictions on operating existing ash disposal sites and for siting future disposal sites and will increase the costs of establishing and operating these facilities. The main objective of these regulations is to prevent degradation of groundwater and to abate any existing degradation. One of the first significant compliance requirements of the regulations is conducting groundwater assessments of landfills if existing groundwater monitoring indicates the possibility of degradation. The assessments require the installation of additional monitoring wells and the evaluation of one year's worth of data. All of the Company's active landfills require assessments. If the assessments show degradation of the groundwater, then the next step is to develop abatement plans. However, there is no specific timetable on the implementation of abatement activities, if required. The Company's landfills are to have preliminary permit modification applications submitted to the PaDER by July 1994, and complete permit applications under evaluation by July 1997. In addition, the regulations can also be enforced at sites closed since 1980 at the PaDER's option. Other compliance requirements that will be implemented in the future include the lining of currently unlined disposal sites and storage impoundments. Impoundments also will eventually require groundwater monitoring systems and assessments of impact on groundwater. Groundwater abatement may be necessary at locations where pollution problems are identified. The removal of all the residual waste or "clean closed" will be done at some impoundments to eliminate the need for future monitoring and abatement requirements. Storage impoundments must have implemented groundwater monitoring plans by 2002, but PaDER can require this at any time prior to this date or defer full compliance beyond 2002 for some storage impoundments at their discretion. Also being evaluated are the exercising of beneficial use options authorized by the regulations, and source reductions. There are also a number of issues still to be resolved regarding certain waivers related to the Company's existing landfill and storage impoundment compliance requirements. These waivers could significantly reduce the cost of many of the Company's facility compliance upgrades. Another aspect of the regulations deals with the storage and disposal of polychlorinated biphenyl (PCB) wastes between 2 and 50 parts per million (ppm). Federal regulations only deal with wastes over 50 ppm. The compliance requirements for this regulation are currently being evaluated. Hazardous/Toxic Wastes: Under the Toxic Substances Control Act (TSCA), the EPA has adopted certain regulations governing the use, storage, testing, inspection and disposal of electrical equipment that contains PCBs. Such regulations permit the continued use and servicing of certain electrical equipment (including transformers and capacitors) that contain PCBs. The Company has met all requirements of the TSCA necessary to allow the continued use of equipment containing PCBs and has taken substantive voluntary actions to reduce the amount of PCB containing electrical equipment in its system. Prior to 1947, the Company owned and operated manufactured gas plants in Pennsylvania. Wastes associated with the operation and dismantlement of these gas manufacturing plants may have been disposed of both on-site and off-site. Claims may be asserted against the Company for the cost of investigation and remediation of these waste disposal sites. The amount of such remediation costs and penalties may be significant and may not be covered by insurance. The federal Resource Conservation and Recovery Act of 1976, the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA) and the Superfund Amendment and Reauthorization Act of 1986 authorize the EPA to issue an order compelling responsible parties to take cleanup action at any location that is determined to present an imminent and substantial danger to the public or to the environment because of an actual or threatened release of one or more hazardous substances. Pennsylvania has enacted legislation giving similar authority to the PaDER. Because of the nature of the Company's business, various by-products and substances are produced and/or handled that are classified as hazardous under one or more of these statutes. The Company generally provides for the treatment, disposal or recycling of such substances through licensed independent contractors, but these statutory provisions also impose potential responsibility for certain cleanup costs on the generators of the wastes. The Company has been notified by the EPA and state environmental authorities that it is among the potentially responsible parties (PRPs) who may be jointly and severally liable to pay for the costs associated with the investigation and remediation at two hazardous and/or toxic waste sites. In addition, the Company has been requested to supply information to the EPA and state environmental authorities on several other sites for which the Company has not as yet been named as a PRP. The Company has also been named in lawsuits requesting damages for hazardous and/or toxic substances allegedly released into the environment. The Company received notification in 1986 from the EPA that it is among the more than 800 PRPs under CERCLA who may be liable to pay for the cost associated with the investigation and remediation of the Maxey Flats disposal site, located in Fleming County, Kentucky. The Company is alleged to have contributed approximately .0003% of the total volume of waste shipped to the Maxey Flats site. On September 30, 1991, the EPA issued a Record of Decision (ROD) advising that a remedial alternative had been selected. The PRPs estimate the cost of the remedial alternative selected and associated activities identified in the ROD at more than $60 million, for which all responsible parties would be jointly and severally liable. The EPA has initiated a suit under CERCLA and other laws for the initial cleanup of hazardous materials deposited at a waste disposal site at Harper Drive, Millcreek Township, Pennsylvania (Millcreek site). The Company is one of over 50 PRPs at this site. The Company does not know whether its insurance carriers will assume the responsibility to defend and indemnify it in connection with this matter. Two lawsuits involving property owners at or near the Millcreek site have been filed against the Company and other PRPs. The Company's insurance carriers are defending these actions but may not provide coverage in the event compensatory damages are awarded. In addition, claims have also been made for punitive damages which may not be covered by insurance. The Company, together with 24 others, has been named as a third party defendant in an action commenced under the CERCLA by the EPA in the U.S. District Court in Ohio. The EPA is seeking to recover costs for the cleanup of hazardous and toxic materials disposed at the New Lyme landfill site in Ashtabula, Ohio. The Company, together with 22 others, has also been named as a third party defendant in an action under the CERCLA by the state of Ohio seeking to recover costs it has incurred and will incur in the future at the New Lyme landfill site. The ultimate cost of remediation of these sites will depend upon changing circumstances as site investigations continue, including (a) the technology required for site cleanup, (b) the remedial action plan chosen and (c) the extent of site contamination and the portion attributed to the Company. The Company is unable to estimate the extent of possible remediation and associated costs of additional environmental matters. Management believes the costs described above should be recoverable through the ratemaking process. FRANCHISES AND CONCESSIONS The electric franchise rights of the Company which are generally nonexclusive, consist generally of (a) charter rights to furnish electric service, and (b) certificates of public convenience and/or "grandfather rights," which allow the Company to furnish electric service in a specified city, borough, town or township or part thereof. Such electric franchises are unlimited as to time, except in a few relatively minor cases concerning the rights mentioned in clause (a) of the preceding sentence. The Company was granted a licensing exemption by the FERC for the operation of its Deep Creek hydroelectric project after its current license expired in December, 1993. Instead of reapplying for a FERC license, the Company is now able to negotiate with the Maryland Department of Natural Resources (DNR) for a permit to operate the plant. The DNR has agreed to permit the Company to continue operations at Deep Creek until an agreement is finalized. The Company also holds a license, which expires in 2002, for the continued operation and maintenance of the Piney hydroelectric project. In addition, the Company and the Cleveland Electric Illuminating Company hold a license expiring in 2015 for the Seneca pumped storage hydroelectric station, in which the Company has a 20% undivided interest. For the same station, the Company and the Cleveland Electric Illuminating Company hold a Limited Power Permit issued by the Pennsylvania Water and Power Resources Board which is unlimited as to time. For purposes of the Homer City station, the Company and NYSEG hold a Limited Power Permit issued by the Pennsylvania Water and Power Resources Board which expires in 2017, but is renewable by the permittees until they have recovered all capital invested by them in the project. The Company also holds a Limited Power Permit issued by the Pennsylvania Water and Power Resources Board for its Shawville station which expires in 2003, but is renewable by the Company until it has recovered all capital invested in the project. EMPLOYEE RELATIONS At February 28, 1994, the Company had 3,532 full-time employees. The nonsupervisory production and maintenance employees of the Company and certain of its nonsupervisory clerical employees are represented for collective bargaining purposes by local unions of the International Brotherhood of Electrical Workers (IBEW) and the Utility Workers Union of America (UWUA). The Company's five-year contracts with the IBEW and UWUA expire on May 14, 1998 and June 30, 1998, respectively. ITEM 2.

ITEM 2. PROPERTIES Generating Stations At December 31, 1993, the Company's generating stations had an aggregate effective winter capability of 2,369,000 net kilowatts (KW), as follows: Year of Name and Location of Station Installation Net KW COAL-FIRED: Homer City, Homer City, Pa. (a) 1969-1977 942,000 Shawville, Shawville, Pa. 1954-1960 618,000 Seward, Seward, Pa. 1950-1957 199,000 Warren, Warren, Pa. 1948-1949 82,000 NUCLEAR: Three Mile Island Unit No. 1, Dauphin County, Pa. (b) 1974 203,000 GAS or OIL-FIRED: Other (c) 1960-1972 191,000 HYDROELECTRIC: Piney, Clarion, Pa. 1923-1926 28,000 Deep Creek, Oakland, Md. 1925 19,000 PUMPED STORAGE: Seneca, Warren, Pa. (d) 1969 87,000 Total 2,369,000 (a) Represents the Company's 50% interest in this station. (b) Represents the Company's 25% interest in this unit. (c) Consists of combustion turbine and internal combustion units, all of which are located in Pennsylvania. (d) Represents the Company's 20% interest in this station which is a net user rather than a net producer of electric energy. Substantially all of the Company's properties are subject to the lien of its first mortgage bond indenture. The peak load of the Company, which occurred on January 18, 1994, was 2,514,000 KW. Transmission and Distribution System At December 31, 1993, the Company owned 649 transmission and distribution substations that had an aggregate installed transformer capacity of 16,008,712 kilovoltamperes (KVA), and 2,734 circuit miles of transmission lines, of which 235 miles were operated at 500 kilovolts (KV), 149 miles at 345 KV, 650 miles at 230 KV, 11 miles at 138 KV, 1,325 miles at 115 KV, and the balance of 364 miles at 46 KV. The Company's distribution system included 6,036,111 KVA of line transformer capacity, 22,145 pole miles of overhead lines and 1,704 trench miles of underground cables. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. Reference is made to "Nuclear Facilities - TMI-2", "Rate Proceedings" and "Environmental Matters" under Item 1 and to Note 1 of consolidated financial statements for a description of certain pending legal proceedings involving the Company. See page for reference to the Notes to Consolidated Financial Statements. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. PART II ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. All of the Company's outstanding common stock is owned by GPU. During 1993, the Company paid $40 million in dividends on its common stock. On February 23, 1994, the Company paid $5 million in dividends on its common stock. In accordance with the Company's mortgage indenture as supplemented, $10 million of the balance of retained earnings at December 31, 1993 is restricted as to the payment of dividends on its common stock. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. See page for reference to the Selected Financial Data required by this item. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. See page for reference to Management's Discussion and Analysis of Financial Condition and Results of Operations required by this item. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. See page for reference to Financial Statements and Supplementary Data required by this item. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. Identification of Directors The present directors of the Company, their ages, positions held and business experience during the past five years are as follows: Year First Name Age Position Elected J. R. Leva (a) 61 Chairman and Chief 1992 Executive Officer R. L. Wise (b) 50 President 1986 J. G. Graham (c) 55 Vice President and Chief 1986 Financial Officer W. R. Stinson (d) 58 Vice President and 1985 Comptroller R. C. Arnold (e) 56 Director 1989 J. G. Herbein (f) 55 Vice President 1990 G. R. Repko (g) 48 Vice President 1993 (a) Mr. Leva became Chairman of the Board and Chief Executive Officer of the Company in 1992. He became Chairman, President and Chief Executive Officer of GPU in 1992. He is also Chairman, President, Chief Executive Officer and a director of GPUSC, Chairman of the Board, Chief Executive Officer and a director of JCP&L, Met-Ed and GPC, and Chairman of the Board and a director of GPUN. Prior to assuming his present positions, Mr. Leva served as President of JCP&L since 1986. He is also a director of Utilities Mutual Insurance Company, the New Jersey Utilities Association, Chemical Bank, NJ and Princeton Bank and Trust Company. (b) Mr. Wise became President and a director in 1986. He is also a director of GPUSC and GPUN. Mr. Wise is also a director of USBANCORP, Inc. and U.S. National Bank. (c) Mr. Graham became Senior Vice President in 1989 and Chief Financial Officer of GPU in 1987. He is also Executive Vice President, Chief Financial Officer and a director of GPUSC; Vice President, Chief Financial Officer and a director of JCP&L and Met-Ed; Vice President and Chief Financial Officer of GPUN; President and a director of GPC and a director of Energy Initiatives, Inc. (d) Mr. Stinson has been Vice President and Comptroller since 1982. (e) Mr. Arnold became Executive Vice President-Power Supply of GPUSC in 1990. He was Senior Vice President-Power Supply from 1987 to 1989. He is also a director of GPUSC, JCP&L and Met-Ed. (f) Mr. Herbein became Vice President, Generation in December 1992. He was Vice President, Station Operations from 1982 to December 1992. (g) Mr. Repko became Vice President, Customer Operations in April 1993. Prior to that time he served as Vice President, Division Operations since 1986. The Company's directors are elected each year at the annual meeting of shareholders to serve until the next annual meeting of shareholders and until their respective successors are duly elected and qualified. There are no family relations among the directors and/or executive officers of the Company. Identification of Executive Officers The executive officers of the Company, their ages, positions held and business experience during the past five years are as follows: Year First Name Age Position Elected J. R. Leva (a) 61 Chairman and Chief 1992 Executive Officer R. L. Wise (b) 50 President 1980 T. N. Elston (c) 61 Vice President 1990 J. F. Furst (d) 47 Vice President 1984 J. G. Graham (e) 55 Vice President and Chief 1987 Financial Officer J. G. Herbein (f) 55 Vice President 1982 W. C. Matthews (g) 41 Secretary and Corporate 1990 Counsel D. W. Myers (h) 49 Vice President and 1993 Treasurer G. R. Repko (i) 48 Vice President 1982 W. R. Stinson (j) 58 Vice President and 1982 Comptroller (a) See footnote (a) on page 29. (b) See footnote (b) on page 29. (c) Mr. Elston has been Vice President, Human Resources since March 1990. Prior to that time he served as Personnel Services Director since 1983. (d) Mr. Furst became Vice President, Customer Services and Communication in April 1993. Prior to that time he served as Vice President, Customer Services since 1984. (e) See footnote (c) on page 29. (f) See footnote (f) above. (g) Mr. Matthews has been Secretary and Corporate Counsel since November 1990. He served as Chief Counsel to the Independent Regulatory Review Commission of the State of Pennsylvania from October 1987 to November 1990. (h) Mr. Myers became a Vice President and Treasurer of GPU in 1993. He is also Vice President and Treasurer of GPUSC, JCP&L, Met-Ed, GPUN and GPC. Prior to assuming his present positions, Mr. Myers served as Vice President and Comptroller of GPUN since 1986. (i) See footnote (g) on page 30. (j) See footnote (d) on page 29. The Company's executive officers are elected each year at the first meeting of the Board of Directors held following the annual meeting of shareholders. Executive officers hold office until the next meeting of directors following the annual meeting of shareholders and until their respective successors are duly elected and qualified. There are no family relationships among the Company's executive officers. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. (1) "Other Annual Compensation" is composed entirely of the above-market interest accrued on the pre-retirement portion of deferred compensation. (2) Number and value of aggregate restricted shares/units at the end of 1993 (dividends are paid or accrued on these restricted shares/units and reinvested): Aggregate Shares/Units Aggregate Value Robert L. Wise 6,260 $159,160 John G. Herbein 1,990 $ 51,206 Willard R. Stinson 1,770 $ 45,655 George R. Repko 1,710 $ 44,094 Thomas N. Elston 1,570 $ 40,201 (3) As noted above, Mr. Leva is Chairman and Chief Executive Officer of the Company and its affiliates, as well as Chairman and Chief Executive Officer of GPU and GPUSC. Mr. Leva is compensated by GPUSC for his overall service on behalf of the GPU System and accordingly is not compensated directly by the Company for his services. Information with respect to Mr. Leva's compensation is included on pages 13 through 15 in GPU's 1994 definitive proxy statement, which are incorporated herein by reference. (4) Consists of the Company's matching contributions under the Savings Plan ($9,434), matching contributions under the non-qualified deferred compensation plan ($1,696), the imputed interest on employer paid premiums for split-dollar life insurance ($5,286), and above-market interest accrued on the retirement portion of deferred compensation ($12,337). (5) Consists of the Company's matching contributions under the Savings Plan ($4,368) and above-market interest accrued on the retirement portion of deferred compensation ($10,970). (6) Consists of the Company's matching contributions under the Savings Plan ($5,330) and above-market interest accrued on the retirement portion of deferred compensation ($2,264). (7) Consists of the Company's matching contributions under the Savings Plan. (8) Consists of the Company's matching contributions under the Savings Plan ($4,657) and above-market interest accrued on the retirement portion of deferred compensation ($1,450). ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. All of the Company's 5,290,596 outstanding shares of common stock are owned beneficially and of record by the Company's parent, General Public Utilities Corporation, 100 Interpace Parkway, Parsippany, New Jersey 07054. The following table sets forth, as of February 1, 1994, the beneficial ownership of equity securities of the Company and other GPU System companies of each of the Company's directors, each of the named executive officers in the Summary Compensation Table and all directors and officers of the Company as a group. The shares owned by all directors and officers as a group constitute less than one percent of the total shares outstanding. Amount and Nature of Name Title of Security Beneficial Ownership R. C. Arnold GPU Common Stock 6,751 shares-Direct J. G. Graham GPU Common Stock 6,411 shares-Direct 1,780 shares-Indirect J. G. Herbein GPU Common Stock 1,071 shares-Direct J. R. Leva GPU Common Stock 3,912 shares-Direct 100 shares-Indirect G. R. Repko GPU Common Stock 897 shares-Direct W. R. Stinson GPU Common Stock 1,132 shares-Direct R. L. Wise GPU Common Stock 5,092 shares-Direct All Directors and Officers as a Group GPU Common Stock 29,174 shares-Direct 1,880 shares-Indirect ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. None. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) See page for reference to the financial statement schedules required by this item. 1. Exhibits: 10-A 1990 Stock Plan for Employees of General Public Utilities Corporation and Subsidiaries, incorporated by reference to Exhibit 10-B of the GPU Annual Report on Form 10-K for 1993 - SEC File No. 1-6047. 10-B Form of Restricted Units Agreement under the 1990 Stock Plan, incorporated by reference to Exhibit 10-C of the GPU Annual Report on Form 10-K for 1993 - SEC File No. 1-6047. 10-C Incentive Compensation Plan for Officers of GPU System Companies, incorporated by reference to Exhibit 10-E of the GPU Annual Report on Form 10-K for 1993 - SEC File No. 1-6047. 12 Statements Showing Computation of Ratio of Earnings to Combined Fixed Charges and Preferred Stock Dividends 23 Consent of Independent Accountants (b) Reports on Form 8-K: For the month of December 1993, dated December 10, 1993, under Item 5 (Other Events). For the month of February 1994, dated February 16 and February 28, 1994, under Item 5 (Other Events). SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. PENNSYLVANIA ELECTRIC COMPANY Dated: March 10, 1994 BY: /s/ R. L. Wise R. L. Wise, President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature and Title Date /s/ J. R. Leva March 10, 1994 J. R. Leva, Chairman (Principal Executive Officer) and Director /s/ R. L. Wise March 10, 1994 R. L. Wise, President and Director /s/ J. G. Graham March 10, 1994 J. G. Graham, Vice President (Principal Financial Officer) and Director /s/ W. R. Stinson March 10, 1994 W. R. Stinson, Vice President and Comptroller (Principal Accounting Officer) and Director /s/ R. C. Arnold March 10, 1994 R. C. Arnold, Director /s/ J. G. Herbein March 10, 1994 J. G. Herbein, Vice President, Generation and Director /s/ G. R. Repko March 10, 1994 G. R. Repko, Vice President, Customer Operations and Director PENNSYLVANIA ELECTRIC COMPANY AND SUBSIDIARY COMPANIES INDEX TO SUPPLEMENTARY DATA, CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES PAGE Supplementary Data Company Statistics Selected Financial Data Management's Discussion and Analysis of Financial Condition and Results of Operations Quarterly Financial Data Consolidated Financial Statements Report of Independent Accountants Consolidated Statements of Income for the years ended December 31, 1993, 1992 and 1991 Consolidated Balance Sheets as of December 31, 1993 and 1992 Consolidated Statements of Retained Earnings for the years ended December 31, 1993, 1992 and 1991 Consolidated Statement of Long-Term Debt as of December 31, 1993 Consolidated Statement of Capital Stock as of December 31, 1993 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements Financial Statement Schedules V - Property, Plant and Equipment for the Years 1991 to 1993 VI - Accumulated Depreciation and Amortization of Property, Plant and Equipment for the Years 1991 to 1993 VIII - Valuation and Qualifying Accounts for the Years 1991 to 1993 IX - Short-Term Borrowings for the Years 1991 to 1993 Schedules other than those listed above have been omitted since they are not required, are inapplicable or the required information is presented in the financial statements or notes thereto. Pennsylvania Electric Company and Subsidiary Companies MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS In 1993, earnings available for common stock decreased $3.4 million to $90.7 million. The decrease in earnings was principally the result of higher other operation and maintenance expense, the write-off of approximately $8 million of costs related to the cancellation of proposed energy-related agreements, and increased depreciation expense. These items which decreased earnings were partially offset by higher KWH revenues, the recovery of prior period transmission service revenues and lower reserve capacity expense. In 1992, earnings available for common stock decreased $6.3 million to $94.1 million. The decrease in earnings was principally because of lower kilowatt-hour revenues and decreased other income. These items which decreased earnings were offset somewhat by the effects of tax surcharge revenues for the 1991 state tax increases, lower interest charges on long- term debt and lower depreciation and amortization expenses. The earnings comparison also reflects the absence in 1992 of a nonrecurring credit with respect to a change in accounting policy resulting in the recognition of unbilled revenues in 1991 and a charge for certain TMI-2 costs in 1991. The Company's return on average common equity was 13.5% for 1993 as compared to 14.5% for 1992. REVENUES: Total revenues increased 1.3% to $908 million in 1993 after increasing 3.6% in 1992 to $896 million. The components of these changes are as follows: (In Millions) 1993 1992 Kilowatt-hour (KWH) revenues $ 6.3 $(3.4) (excluding energy portion) Energy revenues (5.2) 22.5 Other revenues 10.8 11.7 Increase in revenues $11.9 $30.8 Pennsylvania Electric Company and Subsidiary Companies Kilowatt-hour revenues KWH revenues increased in 1993 primarily from higher KWH usage by residential and commercial customers and higher capacity sales to associated companies. Revenues also increased because of new sales to the Company's principal wholesale customer. Wholesale purchases by this customer are now resold to consumers both inside and outside the Company's service territory. The 1992 federal Energy Policy Act (Energy Act) which allows transmission access and competition for wholesale customers made this possible. These out of service territory sales began during the third quarter of 1993 (See "Recent Events"). These increases were partially offset by decreased usage of industrial customers. One of the most significant reductions occurred because of the phase out of operations by the Company's largest industrial customer. KWH revenues decreased in 1992 primarily from decreased KWH sales to one principal wholesale customer and the phase out of operations of the Company's largest industrial customer. The Company's largest industrial customer accounted for approximately 5% of total KWH sales to customers in 1991, its last full year of operation. These decreases were partially offset by increased KWH sales to residential and commercial customers. Energy revenues 1993 and 1992 Changes in energy revenues do not affect earnings as they reflect corresponding changes in the energy cost rates (ECR's) billed to customers and expensed. Energy revenues decreased in 1993 as a result of decreased sales to non-associated utilities and the reclassification of certain transmission service revenues to Other revenues. The reclassification resulted from a favorable PaPUC Order allowing the Company to exclude these transmission service revenues from the Company's ECR. Partially offsetting these decreases were increased energy revenues resulting from higher energy cost rates in effect during the current periods. Energy revenues also increased in 1992 as a result of increased KWH sales to other utilities. Other revenues 1993 and 1992 Earnings were favorably affected in 1993 primarily from the reclassification of the transmission service revenues mentioned above. Earnings were also favorably affected in 1992 as a result of a timing difference in the receipt of Pennsylvania tax surcharge revenues received during 1992 for state tax increases enacted in the third quarter of 1991. For both periods other revenues reflect increased wheeling revenues. Pennsylvania Electric Company and Subsidiary Companies OPERATING EXPENSES: Power purchased and interchanged Power purchased and interchanged with affiliated companies decreased in 1993 primarily as a result of lower capacity costs. The decrease in expense favorably affected earnings because capacity costs are not recovered through energy revenues. Power purchased and interchanged with nonaffiliated companies increased in 1993 primarily from increased nonutility generation purchases. This increase was partially offset by lower purchases from other utilities. The increase in expense related to nonaffiliated purchases had little effect on earnings in 1993 because this increase was primarily comprised of energy costs which are generally recovered through energy revenues. Power purchased and interchanged increased in 1992 as a result of an increase in nonutility generation purchases and purchases from other utilities. This increase in expense had little effect on earnings in 1992 because it was comprised primarily of energy costs. Other operation and maintenance The increase in other operation and maintenance expense is due largely to higher outage activity at several of the Company's coal fired generating stations, higher payroll and higher tree trimming expenses. These increases were partially offset by the recognition of proceeds from the settlement of a property insurance claim. The decrease in other operation and maintenance expense is due largely to the absence of $9.0 million of estimated costs recognized in 1991 for preparing the TMI-2 plant for long-term monitored storage. Excluding that amount, other operation and maintenance expense remained relatively stable in 1992. Depreciation and amortization Depreciation and amortization expense increased in 1993 primarily from higher cost of removal charges and a $3.6 million charge for TMI-2 non- radiological costs not considered likely to be recovered through ratemaking. Pennsylvania Electric Company and Subsidiary Companies Depreciation and amortization expense decreased $3.9 million in 1992 primarily because of a change in depreciation rates for the year, exclusive of a $20 million charge in 1991 for the Company's share of radiological TMI-2 decommissioning costs which are not considered likely to be recovered through ratemaking. Taxes, other than income taxes 1993 and 1992 Generally, changes in taxes other than income taxes do not significantly affect earnings as they are substantially recovered in revenues. OTHER INCOME AND DEDUCTIONS: Other income, net The reduction in Other income, net is principally because of the write- off of approximately $8 million which represents the Company's share of costs related to the cancellation of proposed power supply and transmission facilities agreements between the Company and its affiliates and Duquesne Light Company (Duquesne). The decrease is mainly attributable to a reduction in interest income resulting from the 1991 collection of federal income tax refunds. INTEREST CHARGES AND PREFERRED DIVIDENDS: Interest on long-term debt increased in 1993 primarily from the issuance of additional long-term debt, offset partially by decreases associated with the refinancing of higher cost debt at lower interest rates. Other interest decreased primarily as a result of lower interest rates and lower interest on ECR overcollections resulting from the reclassification in 1993 of certain transmission service revenues (See "Energy revenues"). Interest on long-term debt decreased primarily because of the refinancing of higher cost debt at lower available interest rates in 1992. Preferred dividends decreased for both periods as a result of redemptions of preferred stock in 1993 and 1991 of $25 million and $35 million, respectively. Pennsylvania Electric Company and Subsidiary Companies LIQUIDITY AND CAPITAL RESOURCES CAPITAL NEEDS: The Company's capital needs were $150 million in 1993, consisting of cash construction expenditures. During 1993, construction funds were primarily used to continue to maintain and improve existing generating facilities, add to the transmission and distribution system and clean air act requirements. Construction expenditures are estimated to be $218 million in 1994, consisting mainly of $136 million for ongoing system development and $66 million for clean air requirements. Expenditures for maturing debt are expected to be $70 million for 1994. The Company will not have expenditures for maturing debt in 1995. In the mid 1990s, construction expenditures may include substantial amounts for clean air requirements and other system needs. Management estimates that approximately one-half of the Company's 1994 capital needs will be satisfied through internally generated funds. The Company and its affiliates' capital leases consist primarily of leases for nuclear fuel. These nuclear fuel leases are renewable annually, subject to certain conditions. An aggregate of up to $125 million of nuclear fuel costs may be outstanding at any one time for TMI-1. The Company's share of the nuclear fuel capital leases at December 31, 1993 totaled $21 million. When consumed, portions of the presently leased material will be replaced by additional leased material at a rate of approximately $9 million annually. In the event these nuclear fuel needs cannot be leased, the associated capital requirements would have to be met by other means. FINANCING: In 1993, the Company refinanced higher cost long-term debt in the principal amount of $108 million resulting in an estimated annualized after- tax savings of $1 million. Total long-term debt issued during 1993 amounted to $120 million. In addition, the Company redeemed $25 million of high- dividend rate preferred stock. In January 1994, the Company issued an aggregate of $90 million of first mortgage bonds, of which a portion of the net proceeds were used to redeem early $38 million principal amount of 6 5/8% series bonds in late February 1994. The Company has regulatory authority to issue and sell first mortgage bonds, which may be issued as secured medium-term notes, and preferred stock for various periods through 1995. Under existing authorization, the Company may issue senior securities in the amount of $330 million, of which $100 million may consist of preferred stock. The Company also has regulatory authority to incur short-term debt, a portion of which may be through the issuance of commercial paper. Pennsylvania Electric Company and Subsidiary Companies The Company's cost of capital and ability to obtain external financing is affected by its security ratings, which continue to remain well above minimum investment grade. The Company's first mortgage bonds are currently rated at an equivalent of an A rating by the three major credit rating agencies, while an equivalent of an A- rating is assigned to the preferred stock issues. In addition, the Company's commercial paper is rated as having a high credit quality. During 1993, Standard & Poor's revised its financial benchmarking standards for rating the debt of electric utilities to reflect the changing risk profiles resulting primarily from the intensifying competitive pressures in the industry. These guidelines now include an assessment of each company's business risk. Standard & Poor's new rating structure changed the business outlook for the debt ratings of approximately one-third of the industry, which moved from "A-stable" to "A-negative", meaning their credit ratings may be lowered. The Company was classified as having an "average" business risk position. Moody's announced that it expects to reduce its average credit ratings for the electric utility industry within the next three years to take into account the effects of the new competitive environment. Duff & Phelps also indicated that it intends to introduce a forecast element to its quantitative analysis to, among other things, "alert investors to the possibility of equity value reduction and credit quality deterioration." The Company's bond indenture and articles of incorporation include provisions that limit the amount of long-term debt, preferred stock and short- term debt it may issue. The Company's interest and preferred stock coverage ratios are currently in excess of indenture or charter restrictions. The ability to issue securities in the future will depend on coverages at that time. Present plans call for the Company to issue long-term debt and preferred stock during the next three years to finance construction activities and, depending on the level of interest rates, refinance outstanding senior securities. CAPITALIZATION: The Company supports its credit quality rating by maintaining capitalization ratios that permit access to capital markets at a competitive cost. Recent evaluations of the industry by credit rating agencies indicate that the Company may have to increase its equity ratio to maintain its current credit rating. The targets and actual capitalization ratios are as follows: Capitalization Target Range 1993 1992 1991 Common equity 44-47% 48% 46% 49% Preferred stock 8-10 4 7 7 Notes payable and long-term debt 48-43 48 47 44 100% 100% 100% 100% Pennsylvania Electric Company and Subsidiary Companies COMPETITIVE ENVIRONMENT: The Push Toward Competition The electric utility industry appears to be undergoing a major transition as it proceeds from a traditional rate regulated environment based on cost recovery to some combination of competitive marketplace and modified regulation of certain market segments. The industry challenges resulting from various instances of competition, deregulation and restructuring thus far have been minor compared with the impact that is expected in the future. The Public Utility Regulatory Policies Act of 1978 (PURPA) facilitated the entry of competitors into the electric generation business. Since then, more competition has been introduced through various state actions to encourage cogeneration and, most recently, the Energy Act. The Energy Act is intended to promote competition among utility and nonutility generators in the wholesale electric generation market, accelerating the industry restructuring that has been underway since the enactment of PURPA. This legislation, coupled with increasing customer demands for lower-priced electricity, is generally expected to stimulate even greater competition in both the wholesale and retail electricity markets. These competitive pressures may create opportunities to compete for new customers and revenues, as well as increase risk which could lead to the loss of customers. Operating in a competitive environment will place added pressures on utility profit margins and credit quality. Utilities with significantly higher cost structures than supportable in the marketplace may experience reduced earnings as they attempt to meet their customers' demands for lower- priced electricity. This prospect of increasing competition in the electric utility industry has already led the credit rating agencies to address and apply more stringent guidelines in making credit rating determinations. Among its provisions, the Energy Act allows the Federal Energy Regulatory Commission (FERC), subject to certain criteria, to order owners of electric transmission systems, such as the Company, to provide third parties transmission access for wholesale power transactions. The Energy Act did not give the FERC the authority, however, to order retail transmission access. That authority lies with the individual states and movement toward opening the transmission network to retail customers is currently under consideration in several states. Recent Events Competition in the electric utility industry has already played a significant role in wholesale transactions, affecting the pricing of energy sales to electric cooperatives and municipal customers. During 1993, the Company successfully negotiated power supply agreements with several existing GPU System wholesale customers in response to offers made by other utilities seeking to provide electric service at rates lower than those of Met-Ed or JCP&L. The Company has made similar offers to certain wholesale customers now being served by other utilities. Although wholesale customers represent a relatively small portion of Company's sales, the Company will continue its efforts to retain and add customers by offering competitive rates. Pennsylvania Electric Company and Subsidiary Companies The competitive forces have also begun to influence some retail pricing in the industry. In a few instances, industrial customers, threatening to pursue cogeneration, self-generation or relocation to other service territories, have leveraged price concessions from utilities. Recent state regulatory actions, such as in New Jersey, suggest that utilities may have limited success with attempting to shift costs associated with such discounts to other customers. Utilities may have to absorb, in whole or part, the effects of price reductions designed to retain large retail customers. State regulators may put a limit or cap on prices, especially for those customers unable to pursue alternative supply options. Financial Exposure In the transition from a regulated to competitive environment, there can be a significant change in the economic value of a utility's assets. Traditional utility regulation provides an opportunity for recovery of the cost of plant assets, along with a return on investment, through ratemaking. In a competitive market, the value of an asset may be determined by the market price of the services derived from that asset. If the cost of operating existing assets results in above market prices, a utility may be unable to recover all of its costs, resulting in "stranded assets" and other unrecoverable costs. This may result in write-downs to remove stranded assets from a utility's balance sheet in recognition of their reduced economic value and the recognition of other losses. Unrecovered costs will most likely be related to generation investment, purchase power contracts, and "regulatory assets", which are deferred accounting transactions whose value rests on the strength of a state regulatory decision to allow future recovery from ratepayers. In markets where there is excess capacity (as there currently is in the region including Pennsylvania) and many available sources of power supply, the market price of electricity may be too low to support full recovery of capital costs of certain existing power plants, primarily the capital intensive plants such as nuclear units. Another significant exposure in the transition to a competitive market results if the prices of a utility's existing purchase power contracts, consisting primarily of contractual obligations with nonutility generators, are higher than future market prices. Utilities locked into expensive purchase power arrangements may be forced to value the contracts at market prices and recognize certain losses. A third source of exposure is regulatory assets which if not supported by regulators would have no value in a competitive market. Financial Accounting Standard No. 71 (FAS 71), "Accounting for the Effects of Certain Types of Regulation", applies to regulated utilities that have the ability to recover their costs through rates established by regulators and charged to customers. If a portion of the Company's operations continues to be regulated, FAS 71 accounting may only be applied to that portion. Write-offs of utility plant and regulatory assets may result for those operations that no longer meet the requirements of FAS 71. In addition, under deregulation, the uneconomical costs of certain contractual commitments for purchased power and/or fuel supplies may have to be expensed. Management believes that to the extent that the Company no longer qualifies for FAS 71 accounting treatment, a material adverse effect on Pennsylvania Electric Company and Subsidiary Companies its results of operations and financial position may result. At this time, it is difficult for management to project the future level of stranded assets or other unrecoverable costs, if any, without knowing what the market price of electricity will be, or if regulators will allow recovery of industry transition costs from customers. Positioning the GPU System The typical electric utility today is vertically integrated, operating its plant assets to serve all customers within a franchised service territory. In the future, franchised service territories may be replaced by markets whose boundaries are defined by price, available capacity and transmission access. This may result in changes to the organizational structure of utilities and an emphasis on certain segments of the business among generation, transmission and distribution. In order to achieve a strong competitive position in a less regulated future, the GPU System has in place a strategic planning process. In the initial phases of the program, task forces are defining the principal challenges facing GPU, exploring opportunities and risks, and defining and evaluating strategic alternatives. Management is now analyzing issues associated with various competition and regulatory scenarios to determine how best to position the GPU System for a competitive environment. An initial outcome of the GPU System ongoing strategic planning process was a realignment proposed in February 1994, of certain system operations. Subject to necessary regulatory approval, a new subsidiary, GPU Generation Corporation, will be formed to operate and maintain the GPU System's fossil-fueled and hydroelectric generating stations, which are now owned and operated by the Company and its affiliates. It is also intended to combine the remaining operations of the Company and Met-Ed without merging the two companies. GPU is also developing a performance improvement and cost reduction program to help assure ongoing competitiveness, and, among other matters, will also address workforce issues in terms of compensation, size and skill mix. MEETING ENERGY DEMANDS: In response to the increasingly competitive business climate and excess capacity of nearby utilities, the Company's supply plan places an emphasis on maintaining flexibility. Supply planning focuses increasingly on short to intermediate term commitments, reliance on "spot" markets, and avoidance of long-term firm commitments. The Company is expected to experience an average growth rate in sales to customers through 1998 of about 1.7% annually. The Company will also have higher sales as a result of adding former JCP&L municipal customers and other load formerly serviced by JCP&L and Met-Ed, resulting in a total average growth of 2.3%. The Company also expects to experience peak load growth although at a somewhat lesser rate. Through 1998, the Company's plan consists of the continued utilization of existing Pennsylvania Electric Company and Subsidiary Companies generating facilities combined with present commitments for power purchases and the utilization of capacity of its affiliates. The plan also includes the continued promotion of economic energy conservation and load management programs. Given the future direction of the industry, the Company's present strategy includes minimizing the financial exposure associated with new long- term purchase commitments and the construction of new facilities by evaulating these options in terms of an unregulated power market. The Company will resist efforts to compel it to add new capacity at costs that may exceed future market prices. The Company is attempting to renegotiate higher cost long- term nonutility generation contracts where opportunities arise. New Energy Supplies The Company's supply plan includes the addition of 119 MW of presently contracted capacity by 1998 from nonutility generation suppliers. In July 1993, the Pennsylvania Public Utility Commission (PaPUC) acted to initiate a rulemaking proceeding which, in general, would establish a mandatory all source competitive bidding program by which utilities would meet their future capacity and energy needs. In November 1993, the Company filed an appeal with the Commonwealth Court seeking to overturn a PaPUC order which directs the Company to enter into two power purchase agreements with nonutility generators for a total of 160 MW under long-term contracts commencing in 1997 or later. The Company does not need this additional capacity and believes the costs associated with these contracts are not in the economic interests of its customers. In December 1993, the New Jersey Board of Regulatory Commissioners (NJBRC) denied JCP&L's petition to participate in the proposed power supply and transmission facilities agreements between the Company and its affiliates and Duquesne. As a result of this action and other developments, the Company and its affiliates notified Duquesne that they were exercising their rights under the agreements to withdraw from and thereby terminate the agreements. The capital costs of these transactions would have totaled approximately $500 million, of which the Company's share would have been approximately $117 million. Conservation and Load Management The regulatory environment in Pennsylvania encourages the development of new conservation and load management programs as evidenced by recent approval of a cost recovery mechanism for demand-side management (DSM) incentive regulations. DSM includes utility sponsored activities designed to improve energy efficiency in customer end-use, and includes load management programs (i.e., peak reduction) and conservation programs (i.e., energy and peak reduction). Pennsylvania Electric Company and Subsidiary Companies The PaPUC has recently completed its generic investigation into DSM cost recovery mechanisms and issued a cost recovery and ratemaking order in December 1993. The Company is currently developing plans which will reflect changes since its original plan was filed in 1991. New targets for DSM initiatives are currently being determined and will be identified when the new DSM plan is filed in the first quarter of 1994. ENVIRONMENTAL ISSUES: The Company is committed to complying with all applicable environmental regulations in a responsible manner. Compliance with the federal Clean Air Act Amendments of 1990 (Clean Air Act) and other environmental needs will present a major challenge to the Company through the late 1990s. The Clean Air Act will require substantial reductions in sulfur dioxide and nitrogen oxide emissions by the year 2000. The Company's current plan includes installing and operating emission control equipment at some of its coal-fired plants as well as switching to lower sulfur coal at other coal- fired plants. To comply with the Clean Air Act, the Company expects to expend up to $295 million by the year 2000 for air pollution control equipment. The Company reviews its plans and alternatives to comply with the Clean Air Act on a least-cost basis taking into account advances in technology and the emission allowance market and assesses the risk of recovering capital investments in a competitive environment. The Company may be able to defer substantial capital investments while attaining the required level of compliance if an alternative such as increased participation in the emission allowance market is determined to result in the least-cost plan. This and other compliance alternatives may result in the substitution of increased operating expenses for capital costs. At this time, costs associated with the capital invested in this pollution control equipment and the increased operating costs of the affected stations are expected to be recoverable through the ratemaking process, but management recognizes that recovery is not assured. For more information, see the Environmental Matters section of Note 1 to the consolidated financial statements. LEGAL MATTERS - TMI-2 ACCIDENT CLAIMS: As a result of the TMI-2 accident and its aftermath, individual claims for alleged personal injury (including claims for punitive damages), which are material in amount, have been asserted against the Company and its affiliates and GPU and are still pending. For more information, see Note 1 to the consolidated financial statements. Pennsylvania Electric Company and Subsidiary Companies EFFECTS OF INFLATION: The Company is affected by inflation since the regulatory process results in a time lag during which increased operating expenses are not fully recovered in rates. Inflation may have an even greater effect in a period of increasing competition and deregulation as the Company and the utility industry attempt to keep rates competitive. Inflation also affects the Company in the form of higher replacement costs of utility plant. In the past, the Company anticipated the recovery of these cost increases through the ratemaking process. However, as competition and deregulation accelerate throughout the industry, there can be no assurance of the recovery of these increased costs. The Company is committed to long-term cost control and is continuing to seek measures to reduce or limit the growth in operating expenses. The prudent expenditure of capital and debt refinancing programs have kept down increases in debt levels and capital costs. ACCOUNTING ISSUES: In May 1993, the Financial Accounting Standards Board issued FAS 115, "Accounting for Certain Investments in Debt and Equity Securities", which is effective for fiscal years beginning after December 15, 1993. FAS 115 requires the recording of unrealized gains and losses with a corresponding offsetting entry to earnings or shareholder's equity. The impact on the Company's financial position is expected to be immaterial and there will be no impact on the results of operations. FAS 115 will be implemented in 1994. Pennsylvania Electric Company and Subsidiary Companies QUARTERLY FINANCIAL DATA (UNAUDITED) First Quarter Second Quarter In Thousands 1993 1992 1993 1992 Operating revenues $231,148 $237,784 $219,232 $214,108 Operating income 45,279 40,832 32,357 29,356 Net income 33,212 29,832 20,246 17,870 Earnings available for common stock 31,796 28,416 18,830 16,454 Third Quarter Fourth Quarter In Thousands 1993 1992 1993 * 1992 Operating revenues $229,447 $215,750 $228,453 $228,695 Operating income 42,835 38,013 26,566 39,107 Net income 31,714 25,281 10,556 26,761 Earnings available for common stock 30,467 23,865 9,648 25,345 * Results for the fourth quarter of 1993 reflect a decrease in earnings of $4.6 million (net of income taxes of $2.7 million) for the write-off of the Duquesne transactions. REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of Pennsylvania Electric Company We have audited the accompanying consolidated financial statements and the financial statement schedules of Pennsylvania Electric Company and Subsidiary Companies listed in the Index on page and set forth on pages to, inclusive, of this Form 10-K. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. These standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining on a test basis, evidence supporting the amounts and the disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Pennsylvania Electric Company and Subsidiary Companies as of December 31, 1993 and 1992 and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As more fully discussed in Note 1 to consolidated financial statements, the Company and its affiliates are unable to determine the ultimate consequences of certain contingencies which have resulted from the accident at Unit 2 of the Three Mile Island Nuclear Generating Station (TMI-2). The matters which remain uncertain are (a) the extent to which the retirement costs of TMI-2 could exceed amounts currently recognized for ratemaking purposes or otherwise accrued, and (b) the excess, if any, of amounts which might be paid in connection with claims for damages resulting from the accident over available insurance proceeds. As discussed in Notes 5 and 7 to the consolidated financial statements, the Company was required to adopt the provisions of the Financial Accounting Standards Board's Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes," and the provisions of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" in 1993. Also, as discussed in Note 2 to the financial statements, the Company changed its method of accounting for unbilled revenues in 1991. Coopers & Lybrand 2400 Eleven Penn Center Philadelphia, Pennsylvania February 2, 1994 PENNSYLVANIA ELECTRIC COMPANY AND SUBSIDIARY COMPANIES Consolidated Statements of Retained Earnings (In Thousands) For The Years Ended December 31, 1993 1992 1991 Balance, beginning of year $278 482 $289 402 $265 358 Add, net income 95 728 99 744 106 595 Total 374 210 389 146 371 953 Deduct, cash dividends on capital stock: Cumulative preferred stock (at the annual rates indicated below): 4.40% Series B ($ 4.40 a share) 250 250 250 3.70% Series C ($ 3.70 a share) 359 359 359 4.05% Series D ($ 4.05 a share) 258 258 258 4.70% Series E ($ 4.70 a share) 135 135 135 4.50% Series F ($ 4.50 a share) 193 194 194 4.60% Series G ($ 4.60 a share) 349 348 348 8.36% Series H ($ 8.36 a share) 2 090 2 090 2 090 8.12% Series I ($ 8.12 a share) 1 353 2 030 2 030 9.00% Series L ($ 2.25 a share) - - 525 Common stock (not declared on a per share basis) 40 000 105 000 75 000 Total 44 987 110 664 81 189 Deduct, other adjustments 933 - 1 362 Balance, end of year $328 290 $278 482 $289 402 The accompanying notes are an integral part of the consolidated financial statements. PENNSYLVANIA ELECTRIC COMPANY AND SUBSIDIARY COMPANIES Consolidated Statement of Long-Term Debt December 31, 1993 (In Thousands) First Mortgage Bonds-Series as noted (a)(b): 9.35 %, due 1994 $40 000 7.92 %, due 2002 $10 000 8.50 %, due 1994 30 000 7.40 %, due 2003 10 000 7.45 %, due 1996 30 000 6.60 %, due 2003 30 000 6 1/4%, due 1996 25 000 7.48 %, due 2004 40 000 6.80 %, due 1996 20 000 6.10 %, due 2004 30 000 6 1/4%, due 1997 26 000 7 3/4%, due 2006 12 000 6 5/8%, due 1998 38 000 8.05 %, due 2006 10 000 8.72 %, due 1999 30 000 6 1/8%, due 2007 16 420 6.15 %, due 2000 30 000 8 3/8%, due 2015 20 000 (c) 8.70 %, due 2001 30 000 6 1/2%, due 2016 25 000 (c) 7.40 %, due 2002 10 000 8.33 %, due 2022 20 000 7.43 %, due 2002 30 000 7.49 %, due 2023 30 000 Subtotal $592 420 Maturities and sinking fund requirements due within one year (70 000) 522 420 Other long-term debt 3 084 Other current obligations (8) Subtotal 3 076 Unamortized net discount on long-term debt (1 005) Total long-term debt $524 491 (a) Substantially all of the properties owned by the Company are subject to the lien of the mortgage. (b) For the years 1994, 1996, 1997 and 1998, the Company has total long-term debt maturities of $70.0 million, $75.0 million, $26.0 million and $38.0 million, respectively. The Company has no long-term debt maturities in 1995. (c) Effective as of any June 1 or December 1, the interest rate may be converted, at the option of the registered holder thereof, to a variable rate. The accompanying notes are an integral part of the consolidated financial statements. PENNSYLVANIA ELECTRIC COMPANY AND SUBSIDIARY COMPANIES Consolidated Statement of Capital Stock December 31, 1993 (In Thousands) Cumulative preferred stock, without par value, 11,435,000 shares authorized, 615,000 shares issued and outstanding, without mandatory redemption (a)&(b): 56 810 shares, 4.40% Series B (callable at $108.25 per share) $ 5 681 97 054 shares, 3.70% Series C (callable at $105.00 per share) 9 705 63 696 shares, 4.05% Series D (callable at $104.53 per share) 6 370 28 739 shares, 4.70% Series E (callable at $105.25 per share) 2 874 42 969 shares, 4.50% Series F (callable at $104.27 per share) 4 297 75 732 shares, 4.60% Series G (callable at $104.25 per share) 7 573 250 000 shares, 8.36% Series H (callable at $104.09 per share) 25 000 Subtotal - Cumulative preferred stock issued 61 500 Premium on cumulative preferred stock 342 Total cumulative preferred stock $ 61 842 Common stock, par value $20 per share, 5,400,000 shares authorized, 5,290,596 shares issued and outstanding $105 812 (a) If dividends upon any shares of preferred stock are in arrears in an amount equal to the annual dividend, the holders of preferred stock, voting as a class, are entitled to elect a majority of the board of directors until all dividends in arrears have been paid. No redemptions of preferred stock may be made unless dividends on all preferred stock for all past quarterly dividend periods have been paid or declared and set aside for payment. Stated value of the Company's cumulative preferred stock is $100 per share. (b) No shares of capital stock have been sold during the three years ended December 31, 1993. All of the issued and outstanding shares of the 9% Series L (1,400,000 shares, stated value $35,000,000) and the 8.12% Series I (250,000 shares, stated value $25,000,000) cumulative preferred stock were redeemed on May 1, 1991 and September 17, 1993, respectively. The 1991 redemption of the 9% Series L and the 1993 redemption of the 8.12% Series I cumulative preferred stock resulted in charges to Retained Earnings of $1.4 million and $.9 million, respectively. No shares of capital stock were redeemed or repurchased during 1992. The accompanying notes are an integral part of the consolidated financial statements. Pennsylvania Electric Company and Subsidiary Companies NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Pennsylvania Electric Company (Company), a Pennsylvania corporation incorporated in 1919, is a wholly-owned subsidiary of General Public Utilities Corporation (GPU), a holding company registered under the Public Utility Holding Company Act of 1935. The Company has two minor wholly-owned subsidiaries. The Company is affiliated with Jersey Central Power & Light Company (JCP&L) and Metropolitan Edison Company (Met-Ed). The Company, JCP&L and Met-Ed are referred to herein as the "Company and its affiliates". The Company is also affiliated with GPU Service Corporation (GPUSC), a service company; GPU Nuclear Corporation (GPUN), which operates and maintains the nuclear units of the Company and its affiliates; and General Portfolios Corporation (GPC), parent of Energy Initiatives, Inc., which develops, owns, and operates nonutility generating facilities. The Company and its affiliates, GPUSC, GPUN and GPC considered together are referred to as the "GPU System." 1. COMMITMENTS AND CONTINGENCIES NUCLEAR FACILITIES The Company has made investments in two major nuclear projects -- Three Mile Island Unit 1 (TMI-1), which is an operational generating facility, and Three Mile Island Unit 2 (TMI-2), which was damaged during a 1979 accident. At December 31, 1993, the Company's net investment in TMI-1, including nuclear fuel, was $165 million. TMI-1 and TMI-2 are jointly owned by the Company, JCP&L and Met-Ed in the percentages of 25%, 25% and 50%, respectively. Costs associated with the operation, maintenance and retirement of nuclear plants have continued to increase and become less predictable, in large part due to changing regulatory requirements and safety standards and experience gained in the construction and operation of nuclear facilities. The Company and its affiliates may also incur costs and experience reduced output at their nuclear plants because of the design criteria prevailing at the time of construction and the age of the plants' systems and equipment. In addition, for economic or other reasons, operation of these plants for the full term of their now assumed lives cannot be assured. Also, not all risks associated with ownership or operation of nuclear facilities may be adequately insured or insurable. Consequently, the ability of electric utilities to obtain adequate and timely recovery of costs associated with nuclear projects, including replacement power, any unamortized investment at the end of the plants' useful life (whether scheduled or premature), the carrying costs of that investment and retirement costs, is not assured. Management intends, in general, to seek recovery of any such costs described above through the ratemaking process, but recognizes that recovery is not assured. Pennsylvania Electric Company and Subsidiary Companies TMI-2: The 1979 TMI-2 accident resulted in significant damage to, and contamination of, the plant and a release of radioactivity to the environment. The cleanup program was completed in 1990. After receiving Nuclear Regulatory Commission (NRC) approval, TMI-2 entered into long-term monitored storage in December 1993. As a result of the accident and its aftermath, individual claims for alleged personal injury (including claims for punitive damages), which are material in amount, have been asserted against GPU and the Company and its affiliates. Approximately 2,100 of such claims are pending in the U.S. District Court for the Middle District of Pennsylvania. Some of the claims also seek recovery for injuries from alleged emissions of radioactivity before and after the accident. Questions have not yet been resolved as to whether the punitive damage claims are (a) subject to the overall limitation of liability set by the Price-Anderson Act ($560 million at the time of the accident) and (b) outside the primary insurance coverage provided pursuant to that Act (remaining primary coverage of approximately $80 million as of December 31, 1993). If punitive damages are not covered by insurance or are not subject to the Price-Anderson liability limitation, punitive damage awards could have a material adverse effect on the financial position of the GPU System. In June 1993, the District Court agreed to permit pre-trial discovery on the punitive damage claims to proceed. A trial of twelve allegedly representative cases is scheduled to begin in October 1994. In February 1994, the Court held that the plaintiffs' claims for punitive damages are not barred by the Price-Anderson Act to the extent that the funds to pay punitive damages do not come out of the U.S. Treasury. The Court also denied the defendants' motion seeking a dismissal of all cases on the grounds that the defendants complied with applicable federal safety standards regarding permissible radiation releases from TMI-2 and that, as a matter of law, the defendants therefore did not breach any duty that they may have owed to the individual plaintiffs. The Court stated that a dispute about what radiation and emissions were released cannot be resolved on a motion for summary judgment. NUCLEAR PLANT RETIREMENT COSTS Retirement costs for nuclear plants include decommissioning the radiological portions of the plants and the cost of removal of nonradiological structures and materials. As described in the Nuclear Fuel Disposal Fee section of Note 2, the disposal of spent nuclear fuel is covered separately by contracts with the U.S. Department of Energy (DOE). In 1990, the Company and its affiliates submitted a report, in compliance with NRC regulations, setting forth a funding plan (employing the external sinking fund method) for the decommissioning of their nuclear reactors. Under this plan, the Company and its affiliates intend to complete the funding for TMI-1 by the end of the plant's license term, 2014. The TMI- 2 funding completion date is 2014, consistent with TMI-2 remaining in long- term storage and being decommissioned at the same time as TMI-1. Under Pennsylvania Electric Company and Subsidiary Companies the NRC regulations, the funding target (in 1993 dollars) for TMI-1 is $143 million, of which the Company's share is $36 million. Based on NRC studies, a comparable funding target for TMI-2 (in 1993 dollars), which takes into account the accident, is $228 million, of which the Company's share would be $57 million. The NRC is currently studying the levels of these funding targets. Management cannot predict the effect that the results of this review will have on the funding targets. NRC regulations and a regulatory guide provide mechanisms, including exemptions, to adjust the funding targets over their collection periods to reflect increases or decreases due to inflation and changes in technology and regulatory requirements. The funding targets, while not actual cost estimates, are reference levels designed to assure that licensees demonstrate adequate financial responsibility for decommissioning. While the regulations address activities related to the removal of the radiological portions of the plants, they do not establish residual radioactivity limits nor do they address costs related to the removal of nonradiological structures and materials. In 1988, a consultant to GPUN performed a site-specific study of TMI-1 that considered various decommissioning plans and estimated the cost of decommissioning the radiological portions of TMI-1 to range from approximately $205 to $285 million (adjusted to 1993 dollars), of which the Company's share would range between approximately $51 to $71 million. In addition, the study estimated the cost of removal of nonradiological structures and materials for TMI-1 at $72 million, of which the Company's share would be $18 million. The ultimate cost of retiring the Company and its affiliates' nuclear facilities may be materially different from the funding targets and the cost estimates contained in the site-specific studies and cannot now be more reasonably estimated than the level of the NRC funding target because such costs are subject to (a) the type of decommissioning plan selected, (b) the escalation of various cost elements (including, but not limited to, general inflation), (c) the further development of regulatory requirements governing decommissioning, (d) the absence to date of significant experience in decommissioning such facilities and (e) the technology available at the time of decommissioning. The Company is charging to expense and contributing to external trusts amounts collected from customers for nuclear plant decommissioning and nonradiological costs. In addition, the Company has contributed to external trusts amounts written off for nuclear plant decommissioning in 1991. TMI-1: Effective October 1993, the Pennsylvania Public Utility Commission (PaPUC) approved a rate change for the Company which increased the collection of revenues for decommissioning costs for TMI-1 based on its share of the NRC funding target and nonradiological cost of removal as estimated in the site- specific study. Collections from customers for decommissioning expenditures are deposited in external trusts and are classified as Decommissioning Funds on the balance sheet, which includes the interest earned on these funds. Provision for the future expenditure of these funds has been made in accumulated depreciation, amounting to $4 million at December 31, 1993. Pennsylvania Electric Company and Subsidiary Companies Management believes that any TMI-1 retirement costs, in excess of those currently recognized for ratemaking purposes, should be recoverable through the ratemaking process. TMI-2: The Company and its affiliates have recorded a liability amounting to $229 million (of which the Company's share was $57 million) as of December 31, 1993, for the radiological decommissioning of TMI-2, reflecting the NRC funding target (unadjusted for an immaterial decrease in 1993). The Company and its affiliates record escalations, when applicable, in the liability based upon changes in the NRC funding target. The Company and its affiliates have also recorded a liability in the amount of $20 million (of which the Company's share was $5 million) for incremental costs specifically attributable to monitored storage. Such costs are expected to be incurred between 1994 and 2014, when decommissioning is forecast to begin. In addition, the Company and its affiliates have recorded a liability in the amount of $71 million (of which the Company's share was $18 million) for nonradiological cost of removal. The above amounts for retirement costs and monitored storage are reflected as Three Mile Island Unit 2 Future Costs on the balance sheet. The Company has made a nonrecoverable contribution of $20 million to an external decommissioning trust relating to its share of the accident-related portion of the decommissioning liability. The PaPUC has granted Met-Ed decommissioning revenues for its share of the remainder of the NRC funding target and allowances for its share of the cost of removal of nonradiological structures and materials. In March 1993, a PaPUC rate order for Met-Ed allowed for the future recovery of certain TMI-2 retirement costs. In May 1993, the Pennsylvania Office of Consumer Advocate filed a petition for review with the Pennsylvania Commonwealth Court seeking to set aside the PaPUC's 1993 Met-Ed rate order. The matter is pending before the court. If the 1993 rate order is reversed, the Company would be required to write off a total of approximately $50 million for retirement costs. The Company intends to request decommissioning revenues and an allowance for the cost of removal of nonradiological structures and materials, equivalent to its share of the amounts granted to Met-Ed, in its next retail base rate filing. Management intends to seek recovery for any increases in TMI-2 retirement costs, but recognizes that recovery cannot be assured. Upon TMI-2's entering long-term monitored storage, the Company and its affiliates will incur currently estimated incremental annual storage costs of $1 million (of which the Company's share will be $.25 million). The Company and its affiliates have deferred the $20 million (of which the Company's share was $5 million) for the total estimated incremental costs attributable to monitored storage. The Company believes these costs should be recoverable through the ratemaking process. Pennsylvania Electric Company and Subsidiary Companies INSURANCE The GPU System has insurance (subject to retentions and deductibles) for its operations and facilities including coverage for property damage, liability to employees and third parties, and loss of use and occupancy (primarily incremental replacement power costs). There is no assurance that the GPU System will maintain all existing insurance coverages. Losses or liabilities that are not completely insured, unless allowed to be recovered through ratemaking, could have a material adverse effect on the financial position of the Company. The decontamination liability, premature decommissioning and property damage insurance coverage for the TMI station (TMI-1 and TMI-2 are considered one site for insurance purposes) totals $2.7 billion. In accordance with NRC regulations, these insurance policies generally require that proceeds first be used for stabilization of the reactors and then to pay for decontamination and debris removal expenses. Any remaining amounts available under the policies may then be used for repair and restoration costs and decommissioning costs. Consequently, there can be no assurance that in the event of a nuclear incident, property damage insurance proceeds would be available for the repair and restoration of the stations. The Price-Anderson Act limits the GPU System's liability to third parties for a nuclear incident at one of its sites to approximately $9.4 billion. Coverage for the first $200 million of such liability is provided by private insurance. The remaining coverage, or secondary protection, is provided by retrospective premiums payable by all nuclear reactor owners. Under secondary protection, a nuclear incident at any licensed nuclear power reactor in the country, including those owned by the GPU System, could result in assessments of up to $79 million per incident for each of the GPU System's reactors, subject to an annual maximum payment of $10 million per incident per reactor. In 1993, GPUN requested an exemption from the NRC to eliminate the secondary protection requirements for TMI-2. This matter is pending before the NRC. The Company and its affiliates have insurance coverage for incremental replacement power costs resulting from an accident-related outage at their nuclear plants. Coverage for TMI-1 commences after the first 21 weeks of the outage and continues for three years at decreasing levels beginning at a weekly amount of $2.6 million. Under its insurance policies applicable to nuclear operations and facilities, the Company and its affiliates are subject to retrospective premium assessments of up to $52 million in any one year (of which the Company's share is $7 million), in addition to those payable under the Price-Anderson Act. Pennsylvania Electric Company and Subsidiary Companies ENVIRONMENTAL MATTERS As a result of existing and proposed legislation and regulations, and ongoing legal proceedings dealing with environmental matters, including but not limited to acid rain, water quality, air quality, global warming, electromagnetic fields, and storage and disposal of hazardous and/or toxic wastes, the Company may be required to incur substantial additional costs to construct new equipment, modify or replace existing and proposed equipment, remediate or clean up waste disposal and other sites currently or formerly used by it, including formerly owned manufactured gas plants and mine refuse piles, and with regard to electromagnetic fields, postpone or cancel the installation of, or replace or modify, utility plant, the costs of which could be material. Management intends to seek recovery through the ratemaking process for any additional costs, but recognizes that recovery cannot be assured. To comply with the federal Clean Air Act Amendments of 1990, the Company expects to expend up to $295 million for air pollution control equipment by the year 2000. Costs associated with the capital invested in this equipment and the increased operating costs of the affected stations should be recoverable through the ratemaking process. The Company has been notified by the Environmental Protection Agency (EPA) and state environmental authorities that it is among the potentially responsible parties (PRPs) who may be jointly and severally liable to pay for the costs associated with the investigation and remediation at two hazardous and/or toxic waste sites. In addition, the Company has been requested to supply information to the EPA and state environmental authorities on several other sites for which it has not as yet been named a PRP. The Company has also been named in lawsuits requesting damages for hazardous and/or toxic substances allegedly released into the environment. The ultimate cost of remediation will depend upon changing circumstances as site investigations continue, including (a) the existing technology required for site cleanup, (b) the remedial action plan chosen and (c) the extent of site contamination and the portion attributed to the Company. The Company is unable to estimate the extent of possible remediation and associated costs of additional environmental matters. Also unknown are the consequences of environmental issues, which could cause the postponement or cancellation of either the installation or replacement of utility plant. Management believes the costs described above should be recoverable through the ratemaking process. OTHER COMMITMENTS AND CONTINGENCIES The PaPUC is considering generic nuclear performance standards for Pennsylvania utilities. At the request of the PaPUC, the Company, Pennsylvania Electric Company and Subsidiary Companies as well as the other Pennsylvania utilities, have supplied the PaPUC with proposals which may result in the PaPUC adopting a generic nuclear performance standard in the future. In December 1993, the NJBRC denied JCP&L's request to participate in the proposed power supply and transmission facilities agreements between the Company and its affiliates and Duquesne Light Company (Duquesne). As a result of this action and other developments, the Company and its affiliates notified Duquesne that they were exercising their rights under the agreements to withdraw from and thereby terminate the agreements. Consequently, the Company wrote off the approximately $8 million it had invested in the project. The Company's construction program, for which substantial commitments have been incurred and which extends over several years, contemplate expenditures of approximately $218 million during 1994. As a consequence of reliability, licensing, environmental and other requirements, substantial additions to utility plant may be required relatively late in their expected service lives. If such additions are made, current depreciation allowance methodology may not make adequate provision for the recovery of such investments during their remaining lives. Management intends to seek recovery of any such costs through the ratemaking process, but recognizes that recovery is not assured. As a result of the Energy Policy Act of 1992 (Energy Act) and actions of regulatory commissions, the electric utility industry appears to be moving toward a combination of competition and a modified regulatory environment. In accordance with Statement of Financial Accounting Standards No. 71, "Accounting for the Effects of Certain Types of Regulation" (FAS 71), the Company's financial statements reflect assets and costs based on current cost- based ratemaking regulations. Continued accounting under FAS 71 requires that the following criteria be met: a) A utility's rates for regulated services provided to its customers are established by, or are subject to approval by, an independent third-party regulator; b) The regulated rates are designed to recover specific costs of providing the regulated services or products; and c) In view of the demand for the regulated services and the level of competition, direct and indirect, it is reasonable to assume that rates set at levels that will recover a utility's costs can be charged to and collected from customers. This criteria requires consideration of anticipated changes in levels of demand or competition during the recovery period for any capitalized costs. Pennsylvania Electric Company and Subsidiary Companies A utility's operations can cease to meet those criteria for various reasons, including deregulation, a change in the method of regulation, or a change in the competitive environment for the utility's regulated services. Regardless of the reason, a utility whose operations cease to meet those criteria should discontinue application of FAS 71 and report that discontinuation by eliminating from its balance sheet the effects of any actions of regulators that had been recognized as assets and liabilities pursuant to FAS 71 but which would not have been recognized as assets and liabilities by enterprises in general. If a portion of the Company's operations continues to be regulated and meets the above criteria, FAS 71 accounting may only be applied to that portion. Write-offs of utility plant and regulatory assets may result for those operations that no longer meet the requirements of FAS 71. In addition, under deregulation, the uneconomical costs of certain contractual commitments for purchased power and/or fuel supplies may have to be expensed. Management believes that to the extent that the Company no longer qualifies for FAS 71 accounting treatment, a material adverse effect on its results of operations and financial position may result. The Company has entered into long-term contracts with nonaffiliated mining companies for the purchase of coal for its Homer City generating station in which it has a fifty percent ownership interest. The contracts, which expire between 1995 and 2003, require the purchase of fixed amounts of coal. Under the contracts the price of coal is based on adjustments of indexed cost components. One contract also includes a provision for the payment of environmental and post-employment benefits. The Company's share of the cost of coal purchased under these agreements is expected to aggregate $55 million for 1994. The Company and its affiliates have entered into agreements with other utilities for the purchase of capacity and energy for various periods through 1999. These agreements provide for up to 2,130 MW in 1994, declining to 1,307 MW in 1995 and 183 MW by 1999. Payments pursuant to these agreements are estimated to aggregate $244 million in 1994. The price of the energy purchased under these agreements is determined by contracts providing generally for the recovery by the sellers of their costs. The Company has also entered into power purchase agreements with independently owned power production facilities (nonutility generators) for the purchase of energy and capacity for periods up to 25 years. The majority of these agreements are subject to penalties for nonperformance and other contract limitations. All of these facilities are must-run and generally obligate the Company to purchase all of the power produced up to the contract limits. The agreements have been approved by the PaPUC and permit the Company to recover energy and demand costs from customers through its energy clause. These agreements provide for the sale of approximately 412 MW of capacity and energy to the Company by the mid 1990s. As of December 31, 1993, facilities covered by these agreements having 293 MW of capacity were in service. Pennsylvania Electric Company and Subsidiary Companies Payments made pursuant to these agreements were $104 million, $77 million and $61 million for 1993, 1992 and 1991, respectively, and are estimated to aggregate $121 million for 1994. The price of the energy and capacity to be purchased under these agreements is determined by the terms of the contracts. The rates payable under a number of these agreements are in excess of current market prices. While the Company has been granted full recovery of these costs from customers by the PaPUC, there can be no assurance that the Company will continue to be able to recover these costs throughout the term of the related contracts. The emerging competitive market has created additional uncertainty regarding the forecasting of the Company's energy supply needs which, in turn, has caused the Company to change its supply strategy to seek shorter term agreements offering more flexibility. At the same time, the Company is attempting to renegotiate presently higher cost long-term nonutility generation contracts where opportunities arise. The extent to which the Company may be able to do so, however, or recover associated costs through rates, is uncertain. Moreover, these efforts have led to disputes before the PaPUC, as well as to litigation, and may result in claims against the Company for substantial damages. There can be no assurance as to the outcome of these matters. During the normal course of the operation of its business, in addition to the matters described above, the Company is from time to time involved in disputes, claims and, in some cases, as defendants in litigation in which compensatory damages are sought by customers, contractors, vendors and other suppliers of equipment and services and by employees alleging unlawful employment practices. It is not expected that the outcome of these matters will have a material effect on the Company's financial position or results of operations. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES SYSTEM OF ACCOUNTS The consolidated financial statements include the accounts of the Company and its subsidiaries. Certain reclassifications of prior years' data have been made to conform with current presentation. The Company's accounting records are maintained in accordance with the Uniform System of Accounts prescribed by the Federal Energy Regulatory Commission (FERC) and adopted by the PaPUC. REVENUES The Company recognizes electric operating revenues for services rendered and, beginning in 1991, an estimate of unbilled revenues to record services provided to the end of the respective accounting period. DEFERRED ENERGY COSTS Energy costs are recognized in the period in which the related energy clause revenues are billed. Pennsylvania Electric Company and Subsidiary Companies UTILITY PLANT It is the policy of the Company to record additions to utility plant (material, labor, overhead and an allowance for funds used during construction) at cost. The cost of current repairs and minor replacements is charged to appropriate operating and maintenance expense and clearing accounts and the cost of renewals is capitalized. The original cost of utility plant retired or otherwise disposed of is charged to accumulated depreciation. DEPRECIATION The Company provides for depreciation at annual rates determined and revised periodically, on the basis of studies, to be sufficient to depreciate the original cost of depreciable property over estimated remaining service lives, which are generally longer than those employed for tax purposes. The Company used depreciation rates which, on an aggregate composite basis, resulted in annual rates of 2.74%, 2.86% and 3.08% for the years 1993, 1992 and 1991, respectively. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION (AFUDC) The Uniform System of Accounts defines AFUDC as "the net cost for the period of construction of borrowed funds used for construction purposes and a reasonable rate on other funds when so used." AFUDC is recorded as a charge to construction work in progress, and the equivalent credits are to interest charges for the pretax cost of borrowed funds and to other income for the allowance for other funds. While AFUDC results in an increase in utility plant and represents current earnings, it is realized in cash through depreciation or amortization allowances only when the related plant is recognized in rates. On an aggregate composite basis, the annual rates utilized were 4.91%, 4.15% and 8.50% for the years 1993, 1992 and 1991, respectively. AMORTIZATION POLICIES Accounting for TMI-2 Investment: The Company has collected all of its TMI-2 investment attributable to its retail customers. Because the Company had not been provided revenues for a return on the unamortized balance of its share of the damaged TMI-2 facility, this investment was carried at its discounted present value. The related annual accretion, which represents the carrying charges that are accrued as the asset is written up from its discounted value, is recorded in Other Income, Net. Nuclear Fuel: Nuclear fuel is amortized on a unit of production basis. Rates are determined and periodically revised to amortize the cost over the useful life. Pennsylvania Electric Company and Subsidiary Companies The Company has provided for future contributions to the Decontamination and Decommissioning Fund (part of the Energy Act) for the cleanup of enrichment plants operated by the federal government. The total liability at December 31, 1993 amounted to $6 million and is primarily reflected in Deferred Credits and Other Liabilities - Other. Utilities with nuclear plants will contribute a total of $150 million annually, based on an assessment computed on prior enrichment purchases, over a 15 year period up to a total of $2.3 billion (in 1993 dollars). The Company made its initial payment to this fund in 1993. The Company has recorded an asset for remaining amounts recoverable from ratepayers of $7 million at December 31, 1993 in Deferred Debits and Other Assets - Other. NUCLEAR OUTAGE MAINTENANCE COSTS The Company accrues its share of incremental nuclear outage maintenance costs anticipated to be incurred during scheduled nuclear plant refueling outages. NUCLEAR FUEL DISPOSAL FEE The Company is providing for its share of the estimated future disposal costs for spent nuclear fuel at TMI-1 in accordance with the Nuclear Waste Policy Act of 1982. The Company entered into a contract in 1983 with the DOE for the disposal of spent nuclear fuel. The total liability under this contract, including interest, at December 31, 1993, all of which relates to spent nuclear fuel from nuclear generation through April 1983, amounts to $12 million, and is reflected in Deferred Credits and Other Liabilities- Other. As the actual liability is in excess of the amount recovered to date from ratepayers, the Company has reflected such excess of $.5 million at December 31, 1993 in Deferred Debits and Other Assets-Other. The rates presently charged to customers provide for the collection of these costs, plus interest, over a remaining period of four years. The Company is collecting 1 mill per kilowatt-hour from its customers for spent nuclear fuel disposal costs resulting from nuclear generation subsequent to April 1983. These amounts are remitted quarterly to the DOE. INCOME TAXES The GPU System files a consolidated federal income tax return and all participants are jointly and severally liable for the full amount of any tax, including penalties and interest, which may be assessed against the group. Each subsidiary is allocated the tax reduction attributable to GPU expenses in proportion to the average common stock equity investment of GPU in such subsidiary, during the year. In addition, each subsidiary will receive in current cash payments the benefit of its own net operating loss carrybacks to the extent that the other subsidiaries can utilize such net operating loss carrybacks to offset the tax liability they would otherwise have on a separate return basis (after taking into account any investment tax credits they could utilize on a separate return basis). This method of allocation does not allow any subsidiary to pay more than its separate return liability. Pennsylvania Electric Company and Subsidiary Companies Deferred income taxes, which result primarily from liberalized depreciation methods and deferred energy costs, are provided for differences between book and taxable income. Investment tax credits (ITC) are amortized over the estimated service lives of the related facilities. Effective January 1, 1993, the Company implemented Statement of Financial Accounting Standards No. 109 (FAS 109), "Accounting for Income Taxes" which requires the use of the liability method of financial accounting and reporting for income taxes. Under FAS 109, deferred income taxes reflect the impact of temporary differences between the amount of assets and liabilities recognized for financial reporting purposes and the amounts recognized for tax purposes. STATEMENTS OF CASH FLOWS For the purpose of the consolidated statements of cash flows, temporary investments include all unrestricted liquid assets, such as cash deposits and debt securities, with maturities generally of three months or less. 3. SHORT-TERM BORROWING ARRANGEMENTS At December 31, 1993, the Company had $102 million of short-term notes outstanding, of which $37 million was commercial paper and the remainder was issued under bank lines of credit (credit facilities). GPU and the Company and its affiliates have $398 million of credit facilities, which includes a Revolving Credit Agreement (Credit Agreement) with a consortium of banks that permits total borrowing of $150 million outstanding at any one time. The credit facilities generally provide for the payment of a commitment fee on the unborrowed amount of 1/8 of 1% annually. Borrowings under these credit facilities generally bear interest based on the prime rate or money market rates. Notes issued under the Credit Agreement which expires April 1, 1995, are subject to various covenants and acceleration under certain conditions. 4. FAIR VALUE OF FINANCIAL INSTRUMENTS The estimated fair value of the Company's long-term debt, as of December 31, 1993 and 1992 is as follows: (In Thousands) Carrying Fair Amount Value 1993 $524,491 $550,751 1992 582,647 601,810 The fair value of the Company's long-term debt is estimated based on the quoted market prices for the same or similar issues or on the current rates offered to the Company for debt of the same remaining maturities. Pennsylvania Electric Company and Subsidiary Companies 5. INCOME TAXES Effective January 1, 1993, the Company implemented FAS 109 "Accounting for Income Taxes". In 1993, the cumulative effect on net income of this accounting change was immaterial. Also in 1993, the federal income tax rate changed from 34% to 35%, retroactive to January 1, 1993, resulting in an increase in the deferred tax assets of $2 million and an increase in the deferred tax liabilities of $16 million. The tax rate change did not have a material effect on net income as the changes in deferred taxes were substantially offset by the recording of regulatory assets and liabilities. The balance sheet effect as of December 31, 1993 of implementing FAS 109 resulted in a regulatory asset for income taxes recoverable through future rates of $234 million (related to liberalized depreciation), and a regulatory liability for income taxes refundable through future rates of $39 million (related to unamortized ITC), substantially due to the recognition of amounts not previously recorded. A summary of the components of deferred taxes as of December 31, 1993 follows: (In Millions) Deferred Tax Assets Deferred Tax Liabilities Current: Current: Unbilled revenue $ 1 Deferred energy $ 7 Noncurrent: Noncurrent: Unamortized ITC $39 Liberalized Decommissioning 11 depreciation: Contribution in aid previously flowed of construction 3 through $134 Other 12 future revenue Total $65 requirements 100 $234 Liberalized depreciation 205 Other 16 Total $455 Pennsylvania Electric Company and Subsidiary Companies The reconciliations from net income to book income subject to tax and from the federal statutory rate to combined federal and state effective tax rates are as follows: (In Millions) 1993 1992 1991 Net income $ 96 $ 99 $106 Income tax expense 69 71 59 Book income subject to tax $165 $170 $165 Federal statutory rate 35% 34% 34% Effect of difference between tax and book depreciation for which deferred taxes were not provided 2 3 4 Amortization of ITC (2) (2) (3) State tax, net of federal benefit 7 7 6 Other - (1) (5) Effective income tax rate 42% 41% 36% Federal and state income tax expense is comprised of the following: (In Millions) 1993 1992 1991 Provisions for taxes currently payable $ 51 $ 60 $ 59 Deferred income taxes: Liberalized depreciation 8 7 9 Decommissioning - - (8) Deferral of energy costs 11 (1) 1 Accretion income - 1 1 Unbilled revenues (1) 2 8 Nuclear outage maintenance costs 1 (1) - TMI-2 pre-monitored storage costs - 2 (4) Interest on prior years' taxes - - (4) Other 3 4 2 Deferred income taxes, net 22 14 5 Amortization of ITC, net (4) (3) (5) Income tax expense $ 69 $ 71 $ 59 The Internal Revenue Service has completed its examinations of the GPU System's federal income tax returns through 1986. The GPU System and the Internal Revenue Service have reached an agreement to settle GPU's claim that TMI-2 has been retired for tax purposes. When approved by the Joint Congressional Committee on Taxation, this settlement will provide refunds for previously paid taxes. GPU estimates that the Company would receive net refunds totaling $4 million, which would be credited to its customers. The Company would also be entitled to receive net interest estimated to total $11 million (before income taxes) through December 31, 1993, which would be credited to income. The years 1987, 1988 and 1989 are currently under audit. Pennsylvania Electric Company and Subsidiary Companies 6. SUPPLEMENTARY INCOME STATEMENT INFORMATION Maintenance expense and other taxes charged to operating expenses consisted of the following: (In Millions) 1993 1992 1991 Maintenance $81 $70 $66 Other taxes: State gross receipts $36 $35 $35 Capital stock 9 10 10 Real estate and personal property 8 8 8 Other 9 8 8 Total $62 $61 $61 For the years 1993, 1992, and 1991, the cost to the Company of services rendered to it by GPUSC amounted to approximately $37 million, $35 million and $33 million, respectively, of which approximately $25 million, $24 million and $23 million, respectively, were charged to income. For the years 1993, 1992, and 1991, the cost to the Company of services rendered to it by GPUN amounted to approximately $46 million, $40 million and $42 million, respectively, of which approximately $38 million, $31 million and $34 million, respectively, were charged to income. 7. EMPLOYEE BENEFITS Pension Plans: The Company maintains defined benefit pension plans covering substantially all employees. The Company's policy is to currently fund net pension costs within the deduction limits permitted by the Internal Revenue Code. A summary of the components of net periodic pension cost follows: (In Millions) 1993 1992 1991 Service cost-benefits earned during the period $ 8.0 $ 6.9 $ 8.7 Interest cost on projected benefit obligation 29.9 29.5 26.8 Less: Expected return on plan assets (30.4) (28.9) (27.2) Add: Amortization .1 - - Net periodic pension cost $ 7.6 $ 7.5 $ 8.3 The actual return on the plans' assets for the years 1993, 1992 and 1991 were gains of $46.1 million, $16.9 million and $61.3 million, respectively. Pennsylvania Electric Company and Subsidiary Companies The funded status of the plans and related assumptions at December 31, 1993 and 1992 were as follows: (In Millions) 1993 1992 Accumulated benefit obligation (ABO): Vested benefits $ 315.8 $ 272.0 Nonvested benefits 40.5 33.6 Total ABO 356.3 305.6 Effect of future compensation levels 63.6 57.8 Projected benefit obligation (PBO) $ 419.9 $ 363.4 PBO $ (419.9) $ (363.4) Plan assets at fair value 402.9 369.4 PBO (in excess of) less than plan assets (17.0) 6.0 Unrecognized net loss (gain) 10.7 (7.9) Unrecognized prior service credits (costs) 1.7 (4.2) Unrecognized net transition obligation 4.0 4.4 Accrued pension liability $ (.6) $ (1.7) Principal actuarial assumptions(%): Annual long-term rate of return on plan assets 8.5 8.5 Discount rate 7.5 8.5 Annual increase in compensation levels 5.0 6.0 Changes in assumptions in 1993 primarily due to reducing the discount rate assumption from 8.5% to 7.5%, resulted in a $38 million change in the PBO as of December 31, 1993. The assets of the plans are held in a Master Trust and generally invested in common stocks, fixed income securities and real estate equity investments. The unrecognized net loss represents actual experience different from that assumed, which is deferred and not included in the determination of pension cost until it exceeds certain levels. The unrecognized prior service credit or cost resulting from retroactive changes in benefits is being amortized as a charge or credit, respectively, to pension cost over the average remaining service periods for covered employees. The unrecognized net transition obligation arising out of the adoption of Statement of Financial Accounting Standards No. 87 is being amortized as a charge to pension cost over the average remaining service periods for covered employees. Savings Plans: The Company also maintains savings plans for substantially all employees. These plans provide for employee contributions up to specified limits. The Company's savings plans provide for various levels of matching contributions. The matching contributions for the Company for 1993, 1992 and 1991 were $3.0 million, $2.8 million and $2.6 million, respectively. Pennsylvania Electric Company and Subsidiary Companies Postretirement Benefits Other than Pensions: The Company provides certain retiree health care and life insurance benefits for substantially all employees who reach retirement age while working for the Company. Health care benefits are administered by various organizations. A portion of the costs are borne by the participants. For 1992 and 1991, the annual premium costs associated with providing these benefits totaled approximately $6.2 million and $5.8 million, respectively. Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106 (FAS 106), "Employers' Accounting for Postretirement Benefits Other Than Pensions." FAS 106 requires that the estimated cost of these benefits, which are primarily for health care, be accrued during the employee's active working career. The Company has elected to amortize the unfunded transition obligation existing at January 1, 1993, over a period of 20 years. A summary of the components of the net periodic postretirement benefit cost for 1993 follows: (In Millions) Service cost-benefits attributed to service during the period $ 3.6 Interest cost on the accumulated postretirement benefit obligation 12.2 Expected return on plan assets (1.2) Amortization of transition obligation 6.5 Net periodic postretirement benefit cost 21.1 Less, deferred for future recovery (10.1) Postretirement benefit cost, net of deferrals $ 11.0 The actual return on the plans' assets for the year 1993 was a gain of $1.3 million. The funded status of the plans at December 31, 1993, was as follows: (In Millions) Accumulated Postretirement Benefit Obligation: Retirees $ 83.8 Fully eligible active plan participants 23.0 Other active plan participants 75.7 Total accumulated postretirement benefit obligation (APBO) $ 182.5 APBO $(182.5) Plan assets at fair value 18.6 APBO (in excess of) plan assets (163.9) Less: Unrecognized net loss 25.3 Unrecognized prior service cost 2.9 Unrecognized transition obligation 123.7 Accrued postretirement benefit liability $ (12.0) Principal actuarial assumptions (%): Annual long-term rate of return on plan assets 8.5 Discount rate 7.5 Pennsylvania Electric Company and Subsidiary Companies The Company intends to fund amounts for postretirement benefits with an independent trustee, as deemed appropriate from time to time. The plan assets include equities and fixed income securities. The Company has begun to defer the incremental postretirement benefit costs, charged to expense, associated with the adoption of FAS 106 and in accordance with Emerging Issues Task Force (EITF) Issue Number 92-12, "Accounting for OPEB Costs by Rate-Regulated Enterprises", as authorized by the PaPUC in 1993. A portion of the increase in annual costs recognized under FAS 106 of $10.1 million is being deferred and should be recoverable through the ratemaking process. The Consumer Advocate in Pennsylvania is contesting utility deferral of FAS 106 costs in a proceeding involving another utility. The outcome of this proceeding may affect the Company's recovery of deferred FAS 106 costs. The accumulated postretirement benefits obligation was determined by application of the terms of the medical and life insurance plans, including the effects of established maximums on covered costs, together with relevant actuarial assumptions and health-care cost trend rates of 14% for those not eligible for Medicare and 11% for those eligible for Medicare for 1994, decreasing gradually to 7% in 2000 and thereafter. These costs also reflect the implementation of a cost cap of 6% for individuals who retire after December 1, 1995. The effect of a 1% annual increase in these assumed cost trend rates would increase the accumulated postretirement benefit obligation by approximately $18 million and the aggregate of the service and interest cost components of net postretirement health-care cost for 1994 by approximately $2 million. Postemployment Benefits: In November 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits" (FAS 112) which addresses accounting by employers who provide benefits to former or inactive employees after employment but before retirement, which is effective for fiscal years beginning after December 15, 1993. The Company adopted the accrual method required under FAS 112 during 1993, which did not have a material impact on the financial position or results of operations of the Company. Pennsylvania Electric Company and Subsidiary Companies 8. JOINTLY OWNED STATIONS Each participant in a jointly owned station finances its portion of the investment and charges its share of operating expenses to the appropriate expense accounts. The Company participated with affiliated and nonaffiliated utilities in the following jointly owned stations at December 31, 1993: Balance (In Millions) % Accumulated Station Ownership Investment Depreciation Homer City 50 $428.9 $151.3 Three Mile Island Unit 1 25 206.2 64.4 Seneca 20 16.5 4.4 9. LEASES The Company's capital leases consist primarily of leases for nuclear fuel. Nuclear fuel capital leases at December 31, 1993 and 1992 totaled $21 million and $17 million, respectively (net of amortization of $20 million and $15 million, respectively). The recording of capital leases has no effect on net income because all leases, for ratemaking purposes, are considered operating leases. The Company and its affiliates have nuclear fuel lease agreements with nonaffiliated fuel trusts. An aggregate of up to $125 million of nuclear fuel costs may be outstanding at any one time for TMI-1. It is contemplated that when consumed, portions of the presently leased material will be replaced by additional leased material. The Company and its affiliates are responsible for the disposal costs of nuclear fuel leased under these agreements. These nuclear fuel leases are renewable annually. Lease expense consists of an amount designed to amortize the cost of the nuclear fuel as consumed plus interest costs. For the years ended December 31, 1993, 1992 and 1991 the Company's share of these amounts were $7 million, $8 million and $8 million, respectively. The leases may be terminated at any time with at least five months notice by either party prior to the end of the current period. Subject to certain conditions of termination, the Company and its affiliates are required to purchase all nuclear fuel then under lease at a price that will allow the lessor to recover its net investment.

65358_1993.txt

65358

1993

ITEM 1. BUSINESS GENERAL United Capital Corp. (the "Registrant"), incorporated in 1980 in the State of Delaware, has four industry segments: 1. Real Estate Investment and Management. 2. Manufacture and Sale of Resilient Vinyl Flooring. 3. Manufacture and Sale of Antenna Systems. 4. Manufacture and Sale of Engineered Products. The Registrant also invests excess available cash in marketable securities and other financial instruments. DESCRIPTION OF BUSINESS REAL ESTATE INVESTMENT AND MANAGEMENT The Registrant is engaged in the business of investing in real estate properties. Most real estate properties owned by the Registrant are leased under net leases pursuant to which the tenants are responsible for all expenses relating to the leased premises, including taxes, utilities, insurance and maintenance. The Registrant also owns properties that it manages which are operated by the City of New York as day-care centers and offices and other properties leased as department stores or shopping centers around the country. In addition, the Registrant owns properties available for sale and lease with the assistance of a consultant or a realtor working in the locale of the premises. The majority of properties are leased to single tenants. Approximately 98% of the total square footage of the Registrant's properties are currently leased. RESILIENT VINYL FLOORING In March 1994 the Registrant purchased substantially all of the operating assets of Kentile Floors, Inc., a major manufacturer and supplier of resilient vinyl flooring. This acquisition was completed through a new wholly-owned subsidiary of the Registrant known as Kentile, Inc. ("Kentile"). Kentile's operations are conducted from a 315,000 square foot manufacturing facility located in Chicago, Illinois and numerous regional sales offices strategically located throughout the United States. Kentile's products include resilient vinyl tile for use in the commercial flooring industry, a line of vinyl wall base products marketed under the Kencove brandname and other supporting products which include adhesives, cleaners and waxes. These products are sold through a nationwide network of distributors which service the regional markets in which they are located. The acquisition of the operating assets of Kentile will be accounted for by the purchase method of accounting and, accordingly, the results of operations of Kentile will be included with those of the Registrant for periods subsequent to the date of acquisition. Also see Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources" and Note 17 of Notes to Consolidated Financial Statements. ANTENNA SYSTEMS The Registrant designs and manufactures antenna systems marketed internationally under the Dorne & Margolin trade name. Its products include airborne and ground-based navigation, communication and satellite communication antennas for military, commercial transport and general aviation aircraft. These products are sold internationally to military, commercial and general aviation original equipment manufacturers as well as to the end user as replacement and spare antenna systems. In April 1992, the Registrant acquired the operating assets of Chu Associates, Inc. ("Chu Associates") and affiliated companies to broaden the scope of its antenna systems segment. This addition, which is now known as D&M/Chu Technology, Inc. ("D&M/Chu"), has manufacturing facilities in Littleton, Massachusetts where it designs and manufactures communication and navigation antenna systems for land and naval based applications. D&M/Chu's product line, which is marketed internationally, complements Dorne & Margolin's speciality in airborne communication and navigation antenna systems. During 1993, the Registrant began to consolidate the operations of D&M/Chu with that of its Dorne & Margolin subsidiary in its Bohemia, New York facility. Many aspects of this consolidation have been completed to date; the remainder will occur prior to the end of the third quarter of 1994 when an expansion facility at the site is expected to be completed. Approximately 71% and 67% of the antenna systems sold by the Registrant in 1993 and 1992, respectively, were for use by the United States Government and purchased by the United States Government or its contractors. ENGINEERED PRODUCTS The Registrant's engineered products are manufactured through the Technical Products Division of Metex Corporation ("Metex") and AFP Transformers, Inc., wholly-owned subsidiaries of the Registrant. The knitted wire products and components manufactured by Metex must function in adverse environments and meet rigid performance requirements. The principal areas in which these products have application are as high temperature gaskets, seals, components for use in airbags, shock and vibration isolators, noise reduction elements and air, liquid and solid filtering devices. Metex has been an original equipment manufacturer for the automobile industry since 1974 and presently supplies several automobile manufacturers with exhaust seals and components for use in exhaust emission control devices. The Registrant's transformer products are marketed under several brandnames including Field Transformer, ISOREG and EPOXYCAST for a wide variety of industrial and research applications. AFP Transformers also provides a full line of power conditioners and uninterruptible power supplies, as well as its Spectrum line of speciality transformers for high powered ultraviolet lamps used in the printing and chemical industries. Sales by the Engineered Products segment to its two largest customers (each in excess of 10% of the segment's net sales) accounted for approximately 26% and 29% of the segment's sales for 1993 and 1992, respectively. FINANCIAL INFORMATION The following table sets forth the revenues, income from operations and identifiable assets of each business segment of the Registrant for 1993, 1992 and 1991. DISTRIBUTION The Registrant's manufactured products are distributed by a direct sales force and through distributors to dealers, contractors, industrial consumers, original equipment manufacturers and the United States Government. PRODUCT METHODS AND SOURCES OF RAW MATERIALS The Registrant's products are manufactured at its own facilities. The Registrant purchases raw materials, including resins, drawn wire, castings and electronic components from a wide range of suppliers of such materials. Most raw materials purchased by the Registrant are available from several suppliers. The Registrant has not had and does not expect to have any problems fulfilling its raw material requirements during 1994. PATENTS AND TRADEMARKS The Registrant owns several patents, patent licenses and trademarks including the Kentile trademark which is significant to the Registrant's resilient vinyl flooring operations. The loss of this trademark could have a material adverse effect on such operations. While the Registrant considers that in the aggregate its other patents and trademarks used in the resilient vinyl flooring, antenna systems and engineered products operations are significant to those businesses, it does not believe that any of these patents or trademarks are of such importance that the loss of one or more of such patents or trademarks would materially affect its business. EMPLOYEES At March 18, 1994, the Registrant employed approximately 890 persons. Certain of the Registrant's employees are represented by unions. The Registrant believes that its relationships with its employees are good. COMPETITION The Registrant competes with at least six other companies in the sale of resilient floor tile; at least 19 other companies in the sale of antenna systems; and at least 18 other companies in the sale of engineered products. The Registrant stresses product performance and service in connection with the sale of resilient floor tile, antenna systems, and engineered products. The principal competition faced by the Registrant results from the sales price of the products sold by its competitors. BACKLOG The dollar value of unfilled orders of the Registrant's antenna systems segment was approximately $10,324,000 at December 31, 1993, as compared with $10,695,000 at December 31, 1992. The Registrant anticipates that approximately 90% of the 1993 year-end backlog will be filled in 1994. The dollar value of unfilled orders of the Registrant's engineered products segment was approximately $2,141,000 at December 31, 1993, as compared with $2,119,000 at December 31, 1992. It is anticipated that substantially all such backlog will be filled in 1994. The order backlog referred to above does not include any order backlog with respect to sales of knitted wire mesh components for exhaust emission control devices or exhaust seals because of the manner in which customer orders are received. ENVIRONMENTAL REGULATIONS Federal, state and local requirements regulating the discharge of materials into the environment or otherwise relating to the protection of the environment, have had and will continue to have a significant impact upon the operations of the Registrant. It is the policy of the Registrant to manage, operate and maintain its facilities in compliance, in all material respects, with applicable standards for the prevention, control and abatement of environmental pollution to prevent damage to the quality of air, land and resources. The Registrant has undertaken the completion of environmental studies and/or remedial action at Metex' two New Jersey facilities. The process of remediation has begun at one facility pursuant to a plan filed with the New Jersey Department of Environmental Protection and Energy ("NJDEPE"). Environmental experts engaged by the Registrant currently estimate that under the most probable remediation scenario the remediation of this site is anticipated to require initial expenditures of $860,000, including the cost of capital equipment, and $86,000 in annual operating and maintenance costs over a 15-year period. Environmental studies at the second facility indicate that remediation may be necessary. Based upon the facts presently available, environmental experts have advised the Registrant that under the most probable remediation scenario, the estimated cost to remediate this site is anticipated to require $2.3 million in initial costs, including capital equipment expenditures, and $258,000 in annual operating and maintenance costs over a 10-year period. The Registrant may revise such estimates in the future due to the uncertainty regarding the nature, timing and extent of any remediation efforts that may be required at this site, should an appropriate regulatory agency deem such efforts to be necessary. The foregoing estimates may also be revised by the Registrant as new or additional information in these matters become available or should the NJDEPE or other regulatory agencies require additional or alternative remediation efforts in the future. It is not currently possible to estimate the range or amount of any such liability. Although the Registrant believes that it is entitled to full defense and indemnification with respect to environmental investigation and remediation costs under its insurance policies, the Registrant's insurers have denied such coverage. Accordingly, the Registrant has filed an action against certain insurance carriers seeking defense and indemnification with respect to all prior and future costs incurred in the investigation and remediation of these sites (see Item 3, "Legal Proceedings"). Upon the advice of counsel, the Registrant believes that based upon a present understanding of the facts and the present state of the law in New Jersey, it is probable that the Registrant will prevail in the pending litigation and thereby access all or a very substantial portion of the insurance coverage it claims; however, the ultimate outcome of litigation cannot be predicted. As a result of the foregoing, the Registrant has not recorded a charge to operations for the environmental remediation, noted above, in the consolidated financial statements, as anticipated proceeds from insurance recoveries are expected to offset such liabilities. Although the Registrant has reached a settlement with two insurance carriers, it has not recognized any significant recoveries to date. In the opinion of management, these matters will be resolved favorably and such amounts, if any, not recovered under the Registrant's insurance policies will be paid gradually over a period of years and, accordingly, should not have a material adverse effect upon the business, liquidity or financial position of the Registrant. However, adverse decisions or events, particularly as to the merits of the Registrant's factual and legal basis could cause the Registrant to change its estimate of liability with respect to such matters in the future. Effective January 1, 1994 the Registrant will reflect the provisions of Staff Accounting Bulletin 92 and will record the expected liability associated with remediation efforts and the anticipated insurance recoveries separately in the Registrant's consolidated financial statements. ITEM 2.

ITEM 2. PROPERTIES REAL PROPERTY HELD FOR RENTAL As of March 18, 1994 the Registrant owned 224 properties strategically located throughout the United States. The properties are primarily leased under long-term net leases. The Registrant's classification and gross carrying value of its properties at December 31, 1993 are as follows: SHOPPING CENTERS AND RETAIL OUTLETS Shopping centers and retail outlets include 25 department stores and other properties which are primarily leased under net leases. Taxes, maintenance of the properties and all other expenses are the responsibility of the tenants. The leases for certain shopping centers and retail outlets provide for additional rents based on sales volume and renewal options at higher rents. The department stores include 16 K-Mart stores and six Carter Hawley Hale stores with a total of approximately 1,600,000 and 1,000,000 square feet, respectively. The K-Mart stores are primarily located in the Midwest region of the United States. The Carter Hawley Hale stores are primarily located in the Pacific Coast and Southwest regions of the United States. COMMERCIAL PROPERTIES Commercial properties consist of properties leased as 105 restaurants, 32 Midas Muffler Shops, four convenience stores, six office buildings and miscellaneous other properties. Commercial properties are primarily leased under net leases which in certain cases, have renewal options at higher rents. Certain of these leases also provide for additional rents based on sales volume. The 105 restaurants, located throughout the United States, include properties leased as Roy Rogers, Pizza Huts, Hardee's, Wendy's and Kentucky Fried Chicken. DAY-CARE CENTERS AND OFFICES The 12 day-care centers and offices are located in New York City and are leased to the City of New York. The Registrant has been negotiating with the City of New York to extend, on a long-term basis, many of these leases which expired in years through 1993. To date, one such long-term lease has been signed and the remainder have received numerous short-term extensions. Although there can be no assurance that the Registrant will in fact receive such leases the Registrant believes that with continued negotiations with the City of New York, such leases should be forthcoming. HOTEL PROPERTIES The Registrant's two hotel properties are located in Georgia and California. In February 1992, upon the expiration of an existing lease, the Registrant began operating its California hotel and in May 1992 the Registrant began operating its Georgia hotel. The Registrant's hotel properties are managed through a local on-site management company which is responsible for all day-to-day operations of the hotels. The following summarizes real property held for rental by geographic area at December 31, 1993: MANUFACTURING FACILITIES The Registrant's resilient vinyl flooring operations, which were acquired in March 1994, are located on 12.4 acres in Chicago, Illinois. This facility is comprised of seven contiguous one and two story buildings totaling approximately 309,000 square feet and an adjacent building of approximately 6,000 square feet. The Registrant maintains facilities located at 2950 Veterans Memorial Highway, Bohemia, New York, on a ten-acre site approximately two miles from MacArthur Airport on Long Island for use in its antenna systems business. This site contains three one story buildings aggregating approximately 60,000 square feet of floor space, an outdoor antenna testing area, several pattern ranges and airframe mock-ups. The Registrant owns the site together with the structures. The operations of D&M/Chu are being consolidated with those of Dorne & Margolin in its Bohemia, New York facility. The Registrant intends to lease the D&M/Chu facilities at market rates, which will be sufficient to cover the carrying costs of the properties, and is exploring possibilities to develop the unused land at the Whitcomb Avenue facility. D&M/Chu has two manufacturing facilities in Littleton, Massachusetts. The Whitcomb Avenue facility is comprised of four structures encompassing 60,000 square feet and is located on 95 acres of land. The Taylor Street facility is a one-story building having approximately 35,000 square feet of floor space. The Taylor Street facility is subject to a first mortgage of approximately $1,158,000. The Registrant's engineered products are manufactured at 970 New Durham Road, Edison, New Jersey, in a one-story building having approximately 53,000 square feet of floor space and also in a second facility at 206 Talmadge Road in Edison, New Jersey which has approximately 54,500 square feet of space. The Registrant owns these facilities together with the sites. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS CARUSO VS. METEX CORP., UNITED CAPITAL CORP., ET AL. On July 29, 1993, in a unanimous jury decision, the Registrant, Metex Corporation and certain past and current directors of the Registrant and Metex, who were named in this class action civil suit, were cleared of all allegations in the matter. The action was brought by the former shareholders of Metex and alleged that certain of the defendants violated certain Federal securities laws and breached their common law fiduciary duties. METEX CORPORATION VS. AFFILIATED FM INSURANCE CO., ET AL. On June 27, 1990, Metex filed an action in the Superior Court of New Jersey, Chancery Division, Middlesex County, against several insurance companies that provided Metex with liability insurance between 1967 and 1986. These companies are: Affiliated FM Insurance Co., Atlanta International Insurance Co., The Camden Fire Insurance Association, Cigna Property and Casualty Company, Continental Casualty Company, Eric Reinsurance Company, Federal Insurance Co., General Accident Insurance Company of America, Hudson Insurance Company, Insurance Company of North America, New Jersey Manufacturers Insurance Co., The North River Insurance Company, North Star Reinsurance Corporation, and Puritan Insurance Company. During 1992 and 1993 Metex reached a settlement with Atlanta International Insurance Co. and New Jersey Manufacturers Insurance Co., respectively. The action seeks both declaratory relief and monetary damages in connection with reimbursement of the costs incurred and to be incurred by Metex in connection with the completion of environmental studies and remedial action required at its two Edison, New Jersey facilities. The declaratory relief sought is a determination that the terms of the liability insurance policies at issue obligate the defendants to defend and indemnify Metex with respect to all costs and expenses related to these environmental matters. Metex also seeks monetary damages in an unspecified amount for breach of the defendants' duty to indemnify Metex. This action is in the final stages of pretrial discovery. It is anticipated that this matter will go to trial in September, 1994. The Registrant intends to continue to vigorously pursue this action. DAVISON VS. FIRST PENNCO, ET AL. On March 24, 1991, plaintiffs, including 55 investors and limited partners in three limited partnerships, commenced a civil action in United States District Court for the Southern District of New York against 31 defendants, including the Registrant, asserting causes of action under the Racketeer Influenced and Corrupt Organizations Act. The action seeks actual, punitive and treble damages in a total unspecified amount. On July 16, 1991, plaintiffs filed an amended complaint that did not substantially alter the claims made against the Registrant or the recovery sought. In December 1991 the Registrant filed a motion to dismiss the complaint on the grounds that, among other things, the claims are the subject of a release granted in the Registrant's favor and also that the complaint was filed outside the statute of limitations. In August 1992 the Court granted the motion to dismiss on the grounds that the complaint failed to set out sufficient detail in regard to the acts alleged to have been engaged in by the defendants. The dismissal was "without prejudice" and allowed the plaintiffs to file an amended complaint setting out more detail concerning the alleged acts. In January 1993 two separate amended complaints were filed on behalf of two separate groups of the same plaintiffs. The Registrant filed motions to dismiss each of the amended complaints. In October 1993 the Court again granted the motion to dismiss these complaints on the grounds that the complaints failed to state a legal claim against the Registrant but again granted plaintiff's the right to file an amended complaint against the Registrant. In December 1993 the plaintiffs filed new amended complaints. In February 1994 the Registrant filed a motion to dismiss all claims set out in the amended complaints. The Registrant continues to believe that the material allegations in this matter are without merit and intends to vigorously defend this action. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS The Registrant's Common Stock is traded on the American Stock Exchange under the symbol AFP. The table below shows the high and low sales prices as reported in the composite transactions for the American Stock Exchange. As of March 18, 1994, there were approximately 760 record holders of the Registrant's Common Stock. The closing sales price for the Registrant's Common Stock on such date was $10.75. The Registrant has never paid any cash dividends on its Common Stock. The payment of dividends is within the discretion of the Registrant's Board of Directors, however in view of potential working capital needs and in order to finance future growth, it is unlikely that the Registrant will pay any cash dividends on its Common Stock in the near future. ITEM 6.

ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA The selected consolidated financial data presented below should be read in conjunction with, and is qualified in its entirety by reference to, the Consolidated Financial Statements and the Notes thereto. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS 1993 AND 1992 GENERAL The following discussion of the Registrant's financial condition and results of operations should be read in conjunction with the description of the Registrant's business and properties contained in Items 1 and 2 of Part I and the Consolidated Financial Statements and Notes thereto, included elsewhere in this report. Total revenues generated by the Registrant during 1993 were $69,556,000, a decrease of $1,319,000 from total 1992 revenues of $70,875,000. Net income for the current year increased to $5,069,000 or $.81 per share versus $2,866,000 or $.44 per share for 1992. REAL ESTATE OPERATIONS Rental revenues from real estate operations increased $1,272,000 or 7% during 1993 primarily as a result of additional revenues generated from two hotel properties that the Registrant began operating in February and May 1992, respectively. Of the total increase in revenues, $950,000 is from additional hotel related revenues while the remaining increase of $322,000 results from the renewal of existing leases at higher rents, increased percentage rents and additional revenues associated with mid-1992 property acquisitions. 1992 rental revenues include approximately $520,000 in percentage rents collected by the Registrant in 1992 as a result of a favorable arbitration award. These amounts were earned over a four-year period but not previously accrued. Mortgage interest expense associated with the Registrant's real estate portfolio decreased by $543,000 during 1993 versus that incurred during 1992. This decrease of 9% results from current year mortgage amortization of approximately $5,000,000 as well as the maturity of certain mortgages and is offset by a full year of interest associated with mortgages secured by properties acquired by the Registrant in mid-1992. Depreciation expense for 1993 decreased by approximately $165,000 or 3% from such expense in the preceding year. This decrease results from the reclassification of depreciation on the Registrant's hotel properties to operating expenses and from the sale of several properties in the current and prior year. Other operating expenses associated with those properties managed by the Registrant increased by approximately $1,068,000 during 1993 versus such expenses incurred in 1992. This increase primarily results from a full year of operating costs incurred in connection with the leasing of two hotel properties which accounts for $880,000 of this increase, while the timing of certain maintenance costs and additional lease renewal costs incurred in the current year account for the remaining increase of approximately $188,000. ANTENNA SYSTEMS The Registrant's antenna systems segment includes Dorne & Margolin, Inc. and D&M/Chu Technology, Inc. The operating results of D&M/Chu have been included here and in the accompanying consolidated statements of income since its acquisition by the Registrant in April 1992. See Note 2 of Notes to Consolidated Financial Statements, contained elsewhere in this report, for pro forma results of operations. The operating results of the antenna systems segment for the years ended December 31, 1993 and 1992 are as follows: Net sales of the antenna systems segment decreased by $3,415,000 or 14% during 1993 as compared to such sales of the preceding year. This decrease is the result of continued weakness in the U. S. Military and commercial aviation markets. Sales by Dorne & Margolin during 1993 were 23% lower than those of 1992. As a result of the mid-1992 acquisition of D&M/Chu by the Registrant and therefore a full year of sales in 1993, sales of D&M/Chu increased by 9% during this period. The reductions in military and commercial sales continue to seriously effect the Registrant's antenna systems segment and management is concentrating on reversing this trend. Cost of sales as a percentage of net sales of the antenna systems segment increased in 1993 by approximately 2% from 1992 levels. This increase is primarily the result of changes in the mix of product sales and differences in the gross margins of Dorne & Margolin and D&M/Chu product lines. Selling, general and administrative expenses ("SG&A") of the antenna systems segment have increased by $982,000 in the current year. This is a result of a full year of SG&A costs associated with D&M/Chu in 1993 versus only nine months of such costs in 1992 and from approximately $365,000 in costs incurred in 1993 as a result of the decision to consolidate the operations of D&M/Chu into that of Dorne & Margolin. ENGINEERED PRODUCTS The Registrant's engineered products segment includes Metex Corporation and AFP Transformers, Inc. The operating results of AFP Transformers have been included here and in the accompanying consolidated statements of income since October 1992. Pro forma results of operations have not been separately disclosed as amounts are not material. The operating results of the engineered products segment for the years ended December 31, 1993 and 1992 are as follows: Net sales generated by the engineered products segment increased by $824,000 during 1993 versus that of the previous year. Sales of Metex decreased by $1,540,000 during this period, while sales of AFP Transformers increased $2,364,000. This increase in the sales of AFP Transformers is primarily the result of the Registrant's acquisition of the operating assets of Isoreg Corporation, a manufacturer of Epoxycast transformers, in October 1992. Cost of sales as a percentage of net sales increased approximately 3% during the current year. This increase is primarily the result of lower profit margins on knitted wire sales resulting from lower automotive and European sales. Selling, general and administrative expenses of the engineered products segment increased $380,000 during 1993, as compared to such costs in the preceding year. This increase of approximately 1% as a percentage of net sales results from additional SG&A costs of AFP Transformers including the costs associated with the relocation of operations of Isoreg, which was acquired in October 1992, from Massachusetts to New Jersey. GENERAL AND ADMINISTRATIVE EXPENSES General and administrative expenses not associated with the manufacturing operations decreased $270,000 in 1993 from a year earlier. This decrease is primarily the result of lower professional fees incurred in the current year and represents a change of less than 1% of consolidated revenues. OTHER INCOME AND EXPENSE, NET Other income and expense, net for 1993 of approximately $4.1 million is comprised of $1.1 million in gains from the sale of real estate, the recovery of $744,000 in previously recorded unrealized losses on marketable securities, $578,000 in income from equity investments which represent nonrecurring cash distributions and $1.7 million in other income. The Registrant received a $2 million settlement in 1993 from Metex' insurance carrier in connection with the class action civil suit brought by the former shareholders of Metex. This settlement is included in other income in 1993, net of approximately $450,000 of current year costs incurred in the defense of this action. All defense costs incurred prior to 1993 were included in general and administrative expenses. The components of other income and expense, net in 1992 include approximately $449,000 in gains from the sale of real estate, $723,000 in unrealized losses on marketable securities, $142,000 in income from equity investments and $249,000 in other income. RESULTS OF OPERATIONS 1992 AND 1991 REAL ESTATE OPERATIONS Rental revenues from real estate operations in 1992 increased by $3,420,000 or 21% from such revenues in 1991. This increase is primarily derived from two hotel properties which the Registrant began operating in 1992 and the collection of percentage rents awarded in an arbitration settlement. Upon the termination of existing leases, the Registrant began operating its hotel properties in California and Georgia through the use of a local on-site management company. Revenues generated by these hotels since the inception of operation by the Registrant in February and May 1992, respectively, totaled $1,890,000 for 1992. Approximately $520,000 in percentage rents were collected by the Registrant in 1992 as a result of a favorable arbitration award. These amounts were earned over a four-year period and not previously accrued. The remaining increase in rental revenues over the previous year results from rents derived from property acquisitions in 1992 and 1991 and the renewal of existing leases at higher rents. Mortgage interest expense for 1992 decreased by approximately $80,000 from such expenses in 1991. This decrease results primarily from continuing mortgage amortization which accounted for approximately $8,159,000 and $6,992,000 in mortgage principal repayments during 1992 and 1991, respectively, and is offset by interest expense incurred in connection with mortgages secured by properties acquired in 1992 and 1991. Depreciation expense for 1992 decreased by approximately $319,000 or 5% from such expense in the preceding year. This decrease results from the acquisition and disposal of properties in 1992 and 1991 and from the reclassification to operating expenses of depreciation associated with the Registrant's two hotel properties which it began operating in 1992. Operating expenses associated with the management of real estate properties increased approximately $1,935,000 in 1992 when compared to such expenses incurred in the prior year. This is primarily a result of the change from the leasing of two hotel properties to the management of these facilities, as noted above. Increases in insurance costs and the need for greater repairs and maintenance on real estate properties also contributed to the increase in real estate operating costs from a year earlier. ANTENNA SYSTEMS The Registrant's antenna systems segment includes Dorne & Margolin, Inc. and D&M/Chu Technology, Inc. The operating results of D&M/Chu have been included here and in the accompanying consolidated statements of income since its acquisition by the Registrant in April 1992. See Note 2 of Notes to Consolidated Financial Statements, contained elsewhere in this report, for pro forma results of operations. The operating results of the antenna systems segment for the years ended December 31, 1992 and 1991 are as follows: Net sales generated by the antenna systems segment increased by $2,480,000 during 1992 from such sales generated in 1991. This increase is the result of revenues derived from the acquisition of the operating assets of Chu Associates, a leader in the development and manufacture of navigation and communication antenna systems for land and naval based applications, into a new wholly-owned subsidiary known as D&M/Chu Technology, Inc. Since this acquisition in April 1992, D&M/Chu has generated approximately $6,841,000 in net sales during 1992 which offset a decline in revenues of the Dorne & Margolin subsidiary caused by a continuing decline in the levels of U. S. military defense spending. Cost of sales as a percentage of net sales is virtually unchanged from that of 1991. Higher cost of sales percentages on products sold by D&M/Chu have offset cost containment measures implemented by Dorne & Margolin which reduced their cost of sales percentage by approximately 2%. Increases in the cost of sales level are the result of overall increases in the sales volume of the antenna systems segment. Selling, general and administrative expenses ("SG&A") of the antenna systems segment have increased by $1,203,000 from those of 1991. This increase is the result of additional SG&A costs due to the acquisition of D&M/Chu, offset by a decline in such expenses for Dorne & Margolin as a result of lower sales volumes, noted above. Intensified marketing efforts implemented to generate orders with the highest potential for placement have also caused the increase in SG&A spending as a percentage of net sales over that of the previous year. ENGINEERED PRODUCTS The Registrant's engineered products segment includes Metex Corporation and AFP Transformers, Inc. The operating results of AFP Transformers have been included here and in the accompanying consolidated statements of income since October 23, 1992. Pro forma results of operations have not been separately disclosed as amounts are not material. The operating results of the engineered products segment for the years ended December 31, 1992 and 1991 are as follows: Net sales of the engineered products segment increased by $2,118,000 in 1992 over such sales generated during 1991. This increase is primarily the result of $1,447,000 in additional sales generated by Metex' knitted wire business and $490,000 in sales generated from the acquisition of the operating assets of Isoreg, a manufacturer of EPOXYCAST coil transformers, power conditioners and uninterruptible power supplies. The Registrant, through a new wholly-owned subsidiary known as AFP Transformers, Inc., acquired the operating assets of Isoreg in October 1992. The Field Transformer division of Metex has been combined into AFP Transformers to provide a full line of specialty transformers. Cost of sales as a percentage of net sales for the engineered products segment decreased by 2% from that of 1991. This improvement has been brought about through cost containment programs, material cost reductions and a more favorable mix of product sales. Selling, general and administrative expenses have increased by $822,000 or 1.8% of net sales. This increase is the result of increased marketing efforts and selling costs associated with the mix of products sold and additional SG&A costs from the expanded transformer business. GENERAL AND ADMINISTRATIVE EXPENSES General and administrative expenses not associated with the manufacturing operations were $2,831,000 in 1992, a decrease of $93,000 from such expenses in 1991. This change represents a decrease of less than 1% of consolidated revenues. NET REALIZED AND UNREALIZED GAINS (LOSSES) ON MARKETABLE SECURITIES Marketable securities are stated at the lower of aggregate cost or quoted market value at the balance sheet date. At December 31, 1992 the aggregate cost of marketable securities exceeded their aggregate market value by $743,636. Accordingly, an allowance for unrealized losses has been established and is included in the results of operations for the year. LIQUIDITY AND CAPITAL RESOURCES At December 31, 1993, the Registrant's cash resources were in excess of business requirements and current assets exceeded current liabilities by approximately $3,810,000. The Registrant has an unsecured line of credit with a bank which provides for borrowings up to $7,000,000 at the bank's prime lending rate. At December 31, 1993 there were no amounts outstanding under this facility. The maximum amount outstanding under this facility during 1993 was $2,300,000. All borrowings during the year were repaid together with accrued interest. During the first quarter of 1994, the Registrant borrowed $4 million under this facility, the proceeds of which were used in the acquisition of the operating assets of Kentile Floors, Inc. ("Kentile") and also to fund the working capital requirements of the Registrant and its subsidiaries. This demand facility is reviewed by the bank annually on May 31. On March 14, 1994, the Registrant, through a new wholly-owned subsidiary known as Kentile, Inc., purchased substantially all of the operating assets of Kentile for approximately $14 million. Kentile is a major manufacturer and supplier of resilient vinyl flooring and is expected to generate approximately $40 million in revenues during 1994. The purchase price was comprised of approximately $6.1 million in new bank financing, approximately $5.4 million in cash and the assumption of approximately $2.5 million in operating liabilities. The $5.4 million cash payment includes $775,000 that was advanced to Kentile by the Registrant during 1993 and was also partially derived from a total of $4 million in short-term borrowings by the Registrant during the first quarter of 1994. The proceeds from this sale were used by Kentile to repay amounts outstanding under its asset-based lending agreement, thereby relieving the Registrant of its obligation under the letter of credit, discussed below. In November 1992, Kentile filed for protection under Chapter 11 of the United States Bankruptcy Code. Subsequent thereto, the Registrant acquired a one-third equity interest in Kentile together with an option to purchase an additional interest in the future. In consideration for this interest and option in Kentile, the Registrant provided a $2 million letter of credit to partially guarantee borrowings under Kentile's asset-based lending agreement. This letter of credit arrangement was made pursuant to Bankruptcy Court approval on a priority basis. In light of the uncertain outcome of Kentile's bankruptcy proceedings, no value was assigned to the stock acquired by the Registrant. The acquisition of the operating assets of Kentile will be accounted for by the purchase method and, accordingly, the results of operations of Kentile, Inc. will be included with that of the Registrant for periods subsequent to the date of the acquisition. The Registrant has undertaken the completion of environmental studies and remedial action at Metex' two New Jersey facilities and has filed an action against certain insurance carriers seeking recovery of costs incurred and to be incurred in these matters. Based upon the advice of counsel, management believes such recovery is probable and therefore should not have a material effect on the liquidity or capital resources of the Registrant. See Item 1, "Business-Environmental Regulations," Item 3, "Legal Proceedings" and Note 16 to Consolidated Financial Statements, "Contingencies." The cash needs of the Registrant have been satisfied from funds generated by current operations and additional borrowings. It is expected that future operational cash needs will also be satisfied from ongoing operations and additional borrowings. The primary source of capital to fund additional real estate acquisitions will come from the sale, financing and refinancing of the Registrant's properties and from third party mortgages and purchase money notes obtained in connection with specific acquisitions. In addition to the acquisition of properties for consideration consisting of cash and mortgage financing proceeds, the Registrant may acquire real properties in exchange for the issuance of the Registrant's equity securities. The Registrant may also finance acquisitions of other companies in the future with borrowings from institutional lenders and/or the public or private offerings of debt or equity securities. Funds of the Registrant in excess of that needed for working capital, purchasing real estate and arranging financing for real estate acquisitions are invested by the Registrant in corporate equity securities, corporate notes, certificates of deposit and government securities. BUSINESS TRENDS The 1993 decline in the Registrant's antenna systems revenues continues to reflect the overall weakened economy and reduced government defense spending. These factors have prompted a consolidation in the operations of the Registrant's two antenna system businesses and a reexamination of the current products produced and markets served by these companies. Management is exploring opportunities in two rapidly expanding markets that require antennas; cellular telephones and wireless cable television. Although it remains to be determined whether the Registrant can successfully develop products to compete profitably in these markets, management is committed to reversing the declining revenue trend by identifying new markets and applications, such as these, for its products rather than waiting for an improved overall economy or increased military spending. The Registrant's engineered products business has also implemented a strategy to identify new markets and new applications for its products and technologies. This is evidenced by the increasing sales of knitted wire mesh components used in automobile airbags. Sales in this area have increased to over $3 million in 1993 from virtually zero only three years ago. Metex is also developing a flex coupling device that will be used in place of existing coupling devices which require an exhaust seal manufactured by the company. This change will occur as a result of changing environmental laws and the need for tighter controls on the release of pollutants from automobile engines. The Registrant's real estate portfolio continues to perform well with an increase of $1,272,000 in revenues during the current year. Future growth is expected in the Registrant's real estate operations through opportunities to re-lease properties at higher rents or through the acquisition of similar properties that have long-term leases in place and generate positive cash flow. Since many of the properties in the Registrant's real estate portfolio are generating rents under leases that were implemented ten to twenty years earlier, they provide an excellent opportunity to increase revenues in the future. With primarily self-liquidating mortgages covering the portfolio, most of which fully amortize over the next ten years, increases in cash flow from the existing portfolio can be expected to provide opportunities to expand the current portfolio of properties or operating companies. Although there can be no assurance as to how the events discussed above, or other changes in the economy, will impact the future financial condition or results of operations of the Registrant, management continues to monitor such developments and has implemented measures to minimize any possible negative effects they may have upon these businesses. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements and supplementary information filed as part of this Item 8 are listed under Part IV, Item 14, "Exhibits, Financial Statements and Schedules and Reports on Form 8-K" and are contained in this Form 10-K at page. ITEM 9.

ITEM 9. DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT This information will be contained in the Proxy Statement of the Registrant for the 1994 Annual Meeting of Stockholders under the captions "Election of Directors" and "Executive Officers" and is incorporated herein by reference. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION This information will be contained in the Proxy Statement of the Registrant for the 1994 Annual Meeting of Stockholders under the caption "Executive Compensation and Compensation of Directors" and is incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT This information will be contained in the Proxy Statement of the Registrant for the 1994 Annual Meeting of Stockholders under the captions "Security Ownership" and "Election of Directors" and is incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS This information will be contained in the Proxy Statement of the Registrant for the 1994 Annual Meeting of Stockholders under the caption "Certain Relationships and Related Transactions" and is incorporated herein by reference. Also see Note 11, "Transactions with Related Parties," of Notes to Consolidated Financial Statements, contained elsewhere in this report. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENTS AND SCHEDULES AND REPORTS ON FORM 8-K (a) (1) CONSOLIDATED FINANCIAL STATEMENTS. The following Consolidated Financial Statements and Consolidated Financial Statement Schedules of the Registrant are included in this Form 10-K at the pages indicated: INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page ---- Report of Independent Public Accountants Consolidated Balance Sheets as of December 31, 1993 and 1992 Consolidated Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 to Consolidated Statements of Stockholders' Equity for the Years Ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 to Notes to Consolidated Financial Statements to (2) CONSOLIDATED FINANCIAL STATEMENT SCHEDULES Schedule II -- Amounts Receivable from Related Parties Schedule VIII -- Allowance for Doubtful Accounts Schedule X -- Supplementary Statement of Operations Information Schedule XI -- Real Property Held for Rental and Accumulated Depreciation to Schedule XII -- Mortgage Loans on Real Estate to (3) SUPPLEMENTARY DATA Quarterly Financial Data (Unaudited) Schedules not listed above are omitted as not applicable or the information is presented in the financial statements or related notes. (b) Reports on Form 8-K No reports on Form 8-K were filed by the Registrant during the last quarter of fiscal 1993. (c) Exhibits *3.1. Amended and restated Certificate of Incorporation of the Registrant. 3.2. By-laws of the Registrant (incorporated by reference to exhibit 3 filed with the Registrant's report on Form 10-K for the fiscal year ended December 31, 1980). 10.1. 1988 Incentive Stock Option Plan of the Registrant (incorporated by reference to Annex C to the Proxy Statement contained in the Registrant's Registration Statement on Form S-4 (File No. 33-26324)). 10.2. 1988 Joint Incentive and Non-Qualified Stock Option Plan of the Registrant (incorporated by reference to Annex D to the Proxy Statement contained in the Registrant's Registration Statement on Form S-4 (File No. 33-26324)). 10.3. Employment Agreement dated as of January 1, 1990 by and between the Registrant and A.F. Petrocelli (incorporated by reference to exhibit 10.9 filed with the Registrant's report on Form 10-K for the fiscal year ended December 31, 1989). 10.4. Amendment dated as of December 3, 1990 to Employment Agreement dated as of January 1, 1990, by and between the Registrant and A. F. Petrocelli (incorporated by reference to exhibit 10.10 filed with the Registrant's report on Form 10-K for the fiscal year ended December 31, 1990). *10.5. Amendment dated as of June 8, 1993 to Employment Agreement dated as of January 1, 1990 by and between the Registrant and A.F. Petrocelli. 10.6. Employment Agreement dated as of May 1, 1991 by and between the Registrant and Bernard Turiel (incorporated by reference to Exhibit 10.9 filed with the Registrant's report on Form 10-K for the fiscal year ended December 31, 1991). 10.7. Employment Agreement dated as of July 1, 1991 by and between the Registrant and Dennis S. Rosatelli (incorporated by reference to Exhibit 10.10 filed with the Registrant's report on Form 10-K for the fiscal year ended December 31, 1991). 10.8. Option Agreement dated May 1, 1991 between the Registrant and Bernard Turiel (incorporated by reference to Exhibit 10.11 filed with the Registrant's report on Form 10-K for the fiscal year ended December 31, 1991). 10.9. Option Agreement dated June 20, 1991 between the Registrant and A. F. Petrocelli (incorporated by reference to Exhibit 10.12 filed with the Registrant's report on Form 10-K for the fiscal year ended December 31, 1991). 10.10. Form of Option Agreements dated July 17, 1991 between the Registrant and Mason N. Carter, Robert L. Frome, Howard M. Lorber, Arnold S. Penner, Dennis S. Rosatelli and Bernard Turiel (incorporated by reference to Exhibit 10.13 filed with the Registrant's report on Form 10-K for the fiscal year ended December 31, 1991). *10.11. Amendment dated as of April 16, 1993 to Option Agreement dated as of July 17, 1991 by and between the Registrant and Robert L. Frome. 10.12. Agreement and Plan of Merger dated June 28, 1991 by and among the Registrant, BMG Transitory Corp., BMG Equities Corp. and A. F. Petrocelli, Pearl H. Hack and W. S. Hack (incorporated by reference to exhibit 28(b) filed with the Registrant's Current Report on Form 8-K dated June 28, 1991). 10.13. Amended and Restated Asset Purchase Agreement dated as of July 9, 1993 by and between the Registrant and Kentile Floors, Inc. (incorporated by reference to Exhibit 99(a) filed with the Registrant's Current Report on Form 8-K dated March 28, 1994). *21. Subsidiaries of the Registrant *23. Accountants' consent to the incorporation by reference in Registrant's Registration Statements on Form S-8 of the Report of Independent Public Accountants included herein. - - - ------------------ * Filed herewith SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. UNITED CAPITAL CORP. Dated: March 18, 1994 By: /s/A. F. Petrocelli -------------- ------------------------- A. F. Petrocelli Chairman, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated. Each of the undersigned officers and directors of United Capital Corp. hereby constitutes and appoints A. F. Petrocelli and Dennis Rosatelli and each of them singly, as true and lawful attorneys-in-fact and agents with full power of substitution and resubstitution, for him in his name in any and all capacities, to sign any and all amendments to this report and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission and to prepare any and all exhibits thereto, and other documents in connection therewith, granting unto said attorneys-in-fact and agents, full power and authority to do and perform each and every act and thing requisite or necessary to be done to enable United Capital Corp. to comply with the provisions of the Securities Exchange Act of 1934, as amended, and all requirements of the Securities and Exchange Commission, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or their substitute or substitutes, may lawfully do or cause to be done by virtue hereof. Dated: March 18, 1994 By: /s/A. F. Petrocelli -------------- ------------------------- A. F. Petrocelli Chairman, President and Chief Executive Officer Dated: March 18, 1994 By: /s/Mason N. Carter -------------- ------------------------- Mason N. Carter Director Dated: March 18, 1994 By: /s/Howard M. Lorber -------------- ------------------------- Howard M. Lorber Director Dated: March 18, 1994 By: /s/Arnold S. Penner -------------- ------------------------- Arnold S. Penner Director Dated: March 18, 1994 By: /s/Dennis S. Rosatelli -------------- ------------------------- Dennis S. Rosatelli Chief Financial Officer, Chief Accountant and Director REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors and Stockholders of United Capital Corp.: We have audited the accompanying consolidated balance sheets of United Capital Corp. (a Delaware Corp.) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of United Capital Corp. and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Note 12 to the consolidated financial statements, effective January 1, 1993, the Company changed its method of accounting for income taxes. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index of financial statements are presented for purposes of complying with the Securities and Exchange Commission's rules and are not a part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Roseland, New Jersey March 14, 1994 UNITED CAPITAL CORP. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS AS OF DECEMBER 31, 1993 AND 1992 The accompanying notes to consolidated financial statements are an integral part of these balance sheets. UNITED CAPITAL CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Continued) The accompanying notes to consolidated financial statements are an integral part of these statements. UNITED CAPITAL CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 The accompanying notes to consolidated financial statements are an integral part of these statements. UNITED CAPITAL CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (Continued) (Continued) (A) Changes in assets and liabilities, net of effects from business acquisitions for the years ended December 31, 1993, 1992 and 1991 are as follows: (B) Acquisition of Chu Associates, Inc. and Isoreg Corporation in 1992 -- See Note 2 to Consolidated Financial Statements. (C) Merger with BMG Equities Corp. -- See Note 11 to Consolidated Financial Statements. The accompanying notes to consolidated financial statements are an integral part of these statements. UNITED CAPITAL CORP. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 and 1991 (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: NATURE OF BUSINESS- United Capital Corp. (the "Registrant") and its subsidiaries are currently engaged in the investment and management of real estate and in the manufacture and sale of antenna systems, and engineered products. PRINCIPLES OF CONSOLIDATION- The consolidated financial statements include the accounts of the Registrant and its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. INCOME RECOGNITION -- REAL ESTATE OPERATIONS- The Registrant leases substantially all of its properties to tenants under net leases. Under this type of lease, the tenant is obligated to pay all operating costs of the property including real estate taxes, insurance, repairs and maintenance. Rental income is recognized based on the terms of the leases. Certain lease agreements provide for additional rent based on a percentage of tenants' sales. Such additional rents are recorded as income when they can be reasonably estimated. Gains on sales of real estate assets are recorded when the gain recognition criteria under generally accepted accounting principles have been met. MARKETABLE SECURITIES- Marketable securities are stated at the lower of aggregate cost or quoted market value. Unrealized losses resulting from fluctuations in the market value of the current securities portfolio are reflected as a component of net realized and unrealized gains (losses) on marketable securities. Unrealized gains are recognized only to the extent that previously unrealized losses have been recognized. For the purpose of calculating realized gains and losses, the cost of investments sold is determined using the first-in, first-out method. In May 1993, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"). This standard requires, among other things, that investments in debt and equity securities be classified as either held-to-maturity, trading, or available for sale. Investments in debt securities will be classified as held-to-maturity and measured at amortized cost in the consolidated balance sheet only if the Registrant has the positive intent and ability to hold those securities to maturity. Debt and equity securities that are purchased and held principally for the purpose of selling in the near term will be measured at fair value and classified as trading securities. Unrealized gains and losses on trading securities will be included in current earnings. All securities not classified as trading or held-to-maturity will be classified as available for sale and measured at fair value. Unrealized gains and losses on securities available for sale will be recorded net, as a separate component of stockholders' equity until realized. The Registrant intends to adopt SFAS 115 effective January 1, 1994. Such adoption is expected to result in an increase in the Registrant's stockholders' equity of approximately $350,000 on a net of tax basis. This change in accounting principle is not expected to have a material effect upon the consolidated financial results of the Registrant given the current market value and cost basis of securities available for sale. INVENTORIES- Inventories are stated at the lower of cost (first-in, first-out) or market and include material, labor and manufacturing overhead. The components of inventory at December 31, 1993 and 1992 are as follows- DEPRECIATION AND AMORTIZATION- Depreciation and amortization are provided on a straight-line basis over the estimated useful lives of the related assets as follows- REAL PROPERTY HELD FOR RENTAL- Real property held for rental is carried at cost less accumulated depreciation. Major renewals and betterments are capitalized. Maintenance and repairs are expensed as incurred. Certain mortgage obligations assumed by the Registrant contain provisions whereby the mortgage holder may acquire, under certain conditions, an interest in the properties securing the obligation, for a nominal amount. The Registrant considers any costs incurred as a result of these provisions to be a cost of acquisition and the basis in such properties is adjusted accordingly. RESEARCH AND DEVELOPMENT- The Registrant expenses research, development and product engineering costs as incurred. Approximately $618,000, $713,000 and $424,000 of such costs were incurred by the Registrant in 1993, 1992, and 1991, respectively. Provisions for losses are made for research and development contracts when the estimated costs under such contracts exceed the proceeds. NET INCOME (LOSS) PER COMMON SHARE- Net income (loss) per common share is computed based upon the weighted average number of common and dilutive common equivalent shares outstanding during the period. Fully diluted and primary earnings per common share are the same amounts for each of the periods presented. PRIOR YEAR FINANCIAL STATEMENTS Certain amounts have been reclassified in the December 31, 1992 and 1991 financial statements and notes thereto to present them on a basis consistent with the current year. (2) ACQUISITION OF OPERATING COMPANIES: As of April 2, 1992, the Registrant, through a wholly-owned subsidiary of Metex Corporation ("Metex"), purchased the net operating assets of Chu Associates, Inc. and affiliated companies, a manufacturer of antenna systems for naval and land-based applications, now known as D&M/Chu Technology, Inc. ("D&M/Chu"), for $3,675,000. The purchase price was satisfied by $2,475,000 in cash and a $1,200,000 note to the sellers. The $2,475,000 cash payment was derived from a total of $4,750,000 in bank borrowings by the Registrant in connection with the acquisition and the refinancing of certain of the existing debt of Chu Associates, Inc. The acquisition has been accounted for under the purchase method of accounting and, accordingly, the purchase price, including associated costs of the acquisition, was allocated to assets acquired and liabilities assumed based on their fair value at the date of acquisition as follows (in thousands)- The results of operations of D&M/Chu have been included in the accompanying consolidated statements of income from the date of acquisition. The following unaudited pro forma consolidated results of operations of the Registrant assume that the merger with D&M/Chu had occurred at the beginning of each period presented. In addition to combining historical results of operations of the two companies, the pro forma calculations include adjustments to historical assets, liabilities and results of operations which occur in a purchase. UNAUDITED PRO FORMA CONSOLIDATED RESULTS OF OPERATIONS (IN THOUSANDS EXCEPT PER SHARE AMOUNTS) The above financial information is not necessarily indicative of the actual results that would have occurred had the acquisition of D&M/Chu been consummated at the beginning of the periods presented or of future operations of the combined companies. In October 1992, AFP Transformers, Inc., a wholly-owned subsidiary of the Registrant, purchased the operating assets of Isoreg Corporation in a foreclosure sale from a bank for approximately $761,000, including all costs associated with the acquisition. The results of operations of AFP Transformers have been included in the accompanying consolidated statements of income from the date of acquisition. Pro forma results have not been separately disclosed as amounts are not material. (3) REAL ESTATE ACQUISITIONS: In January 1992, after foreclosure proceedings, the Registrant, through wholly-owned subsidiaries, acquired title to fifteen properties. The properties had served as collateral for mortgage notes due from an unrelated third party to a group of lenders including the Chairman of the Board and two directors of the Registrant. Prior to foreclosure, all interests in the mortgage notes had been acquired by the Registrant (see Note 11). (4) REAL PROPERTY HELD FOR RENTAL: The Registrant is the lessor of real estate under operating leases which expire in various years through 2057. The following is a summary of real property held for rental at December 31- As of December 31, 1993, total minimum future rentals to be received under noncancellable leases for each of the next five years and thereafter are as follows- Minimum future rentals do not include additional rentals that may be received under certain leases which provide for such rentals based upon a percentage of lessees' sales. Percentage rents included in the determination of net income in 1993, 1992 and 1991 were approximately $1,037,000, $1,271,000, and $804,000, respectively. Included in 1992 percentage rents are approximately $520,000 collected from a tenant as a result of an arbitration award. These amounts were earned over a four-year period but not previously accrued. (5) PROPERTY, PLANT AND EQUIPMENT: Property, plant and equipment is principally used in the Registrant's manufacturing operations and consists of the following at December 31- Property, plant and equipment, noted above, includes approximately $3.6 million of land and buildings used in the Registrant's D&M/Chu antenna business. These operations are being consolidated with those of the Registrant's Dorne & Margolin subsidiary. The Registrant intends to lease the D&M/Chu facilities at market rates, which will be sufficient to cover the carrying costs of the properties, and is exploring possibilities to develop the unused land at the Whitcomb Avenue facility. (6) MARKETABLE SECURITIES: At December 31, 1993 and 1991, the aggregate market value of current marketable securities exceeded their aggregate cost by $578,041 and $79,368, respectively. At December 31, 1992, the aggregate cost of current marketable securities exceeded their aggregate market value by $743,636. Realized gains and losses on the sales of marketable securities included in the determination of net income for the years ended December 31, 1993, 1992 and 1991 are as follows- (7) NOTES RECEIVABLE: Notes receivable consist of the following at December 31- (a) As partial consideration in the sale of several properties, the Registrant received mortgage notes in the aggregate amount of $2,080,000. The notes, which are secured by the properties sold, bore interest in 1992 and 1993 at various rates ranging between 8% and 14% and bear interest in future periods at rates ranging between 9% and 16%. Interest under the notes is due monthly. Principal repayment terms vary with periodic installments through December 2008. In accordance with generally accepted accounting principles, the gains from the sales of certain of these properties are being recognized under the installment method, and accordingly, the carrying value of noncurrent notes receivable has been reduced by deferred gains of approximately $991,000 and $807,000 at December 31, 1993 and 1992, respectively. The deferred gains are being recognized as income as payments are received under the note. (b) During 1993 the Registrant advanced $775,000 to Kentile Floors, Inc. ("Kentile"). Such advances were made on a priority basis pursuant to Bankruptcy Court approval granted in this matter. In 1992 the Registrant acquired a one-third interest in Kentile subsequent to Kentile's filing for protection under Chapter 11 of the U. S. Bankruptcy Code. In March 1994 the Registrant acquired the operating assets of Kentile. See Note 17, "Subsequent Events." (8) LONG-TERM DEBT AND LOANS PAYABLE TO BANKS: Long-term debt and loans payable to banks consist of the following at December 31- The approximate aggregate maturities of these obligations at December 31, 1993 are as follows- (9) REVOLVING CREDIT FACILITY: The Registrant maintains an unsecured line of credit arrangement with a bank which provides for borrowings up to $7,000,000 at the bank's prime lending rate, which was 6.0% at December 31, 1993 and 1992. This demand facility is reviewed by the bank annually on May 31. There were no borrowings outstanding under this facility at December 31, 1993 or 1992. The maximum amounts outstanding under this arrangement during 1993 and 1992 was $2,300,000 and $3,000,000, respectively. All borrowings were repaid together with accrued interest. The weighted average amount outstanding during 1993 was approximately $1,460,000. The weighted average interest rate on such borrowings was 6.0%. Borrowings under this facility are jointly and severally guaranteed by both the Registrant and its subsidiaries. Unless extended, any amounts outstanding are due and payable within 30 days of the expiration of this facility. (10) STOCKHOLDERS' EQUITY: AUTHORIZED CAPITAL AND TREASURY STOCK- The stockholders of the Registrant ratified a plan during the 1993 Annual Meeting of Stockholders to reduce the authorized capital of the Registrant to 7,500,000 shares of $.10 par value common stock. In addition, the Registrant has retired all shares of common stock previously held in treasury. STOCK OPTIONS- The Registrant has two stock option plans under which qualified and nonqualified options may be granted to key employees to purchase the Registrant's common stock at the fair market value at the date of grant. Under both plans, the options become exercisable in three equal installments, beginning one year from the date of grant. The 1988 Incentive Stock Option Plan (the "Incentive Plan") provides for the granting of incentive stock options not to exceed 125,000 options in the aggregate. The 1988 Joint Incentive and Non-Qualified Stock Option Plan (the "Joint Plan") provides for the granting of incentive or nonqualified stock options, also not to exceed 125,000 options in the aggregate. During 1993 employees of the Registrant were granted 83,000 and 43,000 options pursuant to the Joint Plan and Incentive Plan, respectively. Such options are exercisable at $11 per share subject to the vesting period noted above. Included in the 1993 grants are 70,000 and 30,000 options granted to the Chairman of the Board pursuant to the Joint Plan and Incentive Plan, respectively. Of the 70,000 options granted to the Chairman of the Board pursuant to the Joint Plan, 45,000 options are subject to shareholder approval of an increase in the number of available options under the Plans which is to be acted upon at the 1994 Annual Meeting of Stockholders. At December 31, 1993, there were 149,088 and 117,240 options outstanding under the Joint Plan and Incentive Plan, respectively, including those subject to shareholder approval, noted above. At December 31, 1992, 66,588 and 84,429 options were outstanding under the Joint Plan and Incentive Plan, respectively. In addition to options outstanding under the Joint Plan and Incentive Plan, 240,000 options were outstanding at December 31, 1993 and 1992. Such options were previously granted to Directors and certain officers of the Registrant and are presently exercisable at $5.50 per share, which price was equal to or greater than the market value per share on the date of grant. If unexercised, these options expire 30 days after the end of a Director's term. Transactions involving stock options are summarized below (11) TRANSACTIONS WITH RELATED PARTIES: In February 1993, the Registrant participated in a $7,500,000 loan transaction secured by a second mortgage covering the leasehold estate on a prime hotel property in New York City. During 1993 a total of $6,250,000 had been advanced, including approximately $1,652,000 by the Registrant, $2,532,000 by certain Directors, $200,000 by the wife of the Board Chairman, $100,000 by two adult daughters of a director, $100,000 by a trust under will in which a Director has a partial remainder interest and approximately $1,666,000 by unrelated parties. In connection with this loan, a commitment fee in the net amount of $270,000 was prorated among the participants in relation to the principal amount advanced and committed to be advanced by each participant. The note bore interest at 15% per annum, payable monthly and was fully satisfied together with accrued interest in December 1993. In June 1993 the Registrant advanced approximately $89,000 in connection with a $265,000 loan transaction secured by a first mortgage on a Brooklyn, New York property. The loan bears interest at 15% per annum, payable monthly, and matures in June 1994. A Director of the Registrant and an unrelated party also hold 1/3 interests in this loan. Until June 28, 1991, the Registrant was a majority-owned subsidiary of BMG Equities Corp. ("BMG"). BMG's primary asset was a 65% interest (6,784,559 shares) in the outstanding common stock of the Registrant. BMG was owned equally by the Registrant's Chairman of the Board and the wife of the former Board Chairman ("Shareholder"). On June 28, 1991, BMG merged with and into a wholly-owned subsidiary of the Registrant. Immediately following the merger, the subsidiary was merged with and into the Registrant. Pursuant to the merger agreement, the Registrant acquired the net assets of BMG, including the 6,784,559 shares of the Registrant's common stock. In consideration for their interests in BMG, the Chairman of the Board received 3,392,280 shares of the Registrant's common stock and the Shareholder received a $5,750,000 cash payment and a note in the amount of $6,342,112. The note was satisfied in July 1992 together with accrued interest thereon with proceeds from a bank loan (see Note 8). The acquired assets of BMG exceed the liabilities assumed on a fair value basis; however due to the related party nature of the transaction, the acquired net assets have been recorded by the Registrant at historical cost, and accordingly additional paid-in capital was reduced by approximately $4,894,000. The results of operations of BMG have been included with that of the Registrant for the period subsequent to acquisition. Pro forma results of operations have not been separately disclosed as amounts are not material. In June 1991, the Registrant entered into an agreement with the wife of the former Board Chairman ("Shareholder") which required the Registrant to purchase 91,704 shares of the Registrant's common stock owned by the Shareholder. In January 1993 the Registrant purchased these shares from the Shareholder for approximately $396,000. In January 1991, the Registrant purchased for $420,000, from an unrelated third party, a 35% participation interest in a $1,200,000 loan secured by first mortgages on seven parcels of real property, six of which are located in New York City. The borrower had defaulted on the loan which was due on August 31, 1990, and interest accrued at a default rate of 20% per annum. The Registrant's Chairman of the Board acted as agent for the lenders and held a 25% participation interest in such loan. A director and the children of another director of the Registrant also held, in the aggregate, a 22.5% participation interest in such loan. In January 1992, after foreclosure proceedings, the Registrant, through wholly-owned subsidiaries, received title to six of the seven properties, which interests in such title together with interests in the foreclosure bid were previously assigned to the Registrant by the lenders. In addition, the Registrant also received title to another nine properties as additional collateral for the loan. In February 1992, the Registrant purchased, for cash and notes, the remaining 65% interest in the loan that it did not already own for the face amount of the note together with past due interest. The purchase price was satisfied by approximately $201,000 in cash and the balance with notes in the amounts of approximately $377,000 to the Chairman of the Board, $198,000 to a director and $198,000 to an unrelated third party. The notes bear interest at 10% beginning February 1, 1992. The note to the Chairman of the Board matured and was paid in June 1992. Portions of the remaining notes were paid in November 1992 and the balance of these notes are due in February 1995. During 1993 and 1992 the Registrant advanced, in the aggregate, $3,411,833 and $230,000, respectively, to the Chairman of the Board. Such advances bore interest at varying rates of 1% and 2% over the Registrant's borrowing rate under its revolving credit facility which bore interest at 6% at December 31, 1993 and 1992. Amounts outstanding at December 31, 1993 and 1992 of $628,494 and $230,000, respectively, together with accrued interest thereon were repaid in January 1994 and 1993, respectively. (12) INCOME TAXES: Effective January 1, 1993 the Registrant adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"). In prior years, the Registrant accounted for income taxes using Accounting Principles Board Opinion No. 11 ("APB 11"). Under SFAS 109, deferred tax assets and liabilities are determined based on the difference between the tax basis of an asset or liability and its reported amount in the consolidated financial statements using enacted tax rates. Future tax benefits attributable to these differences are recognized to the extent that realization of such benefits is more likely than not. Under the provisions of SFAS 109, the Registrant has elected not to restate prior years' consolidated financial statements. The cumulative effect of this accounting change on years prior to 1993 resulted in a benefit of $702,000, or $.11 per share. In addition, the effect of this change on income before cumulative effect of an accounting change in the current year was an increase of approximately $700,000 or $.11 per share. The cumulative benefit recorded by the Registrant primarily arises from basis differences of real properties held for rental for financial statement and income tax purposes. Based upon the Registrant's historical and projected levels of pretax income, management believes it is more likely than not that the Registrant will realize such benefits in the future and accordingly no valuation reserve has been recorded. The components of the net deferred tax asset (liability) at December 31, 1993 and 1992, under SFAS 109 and APB 11, respectively, are as follows- Income tax provision (benefit) reflected in the accompanying consolidated statements of income for the years ended December 31, 1993, 1992 and 1991, is summarized as follows- A reconciliation of tax provision computed at statutory rates to the amounts shown in the accompanying consolidated statements of income for the years ended December 31, 1993, 1992 and 1991 is as follows- (13) OTHER INCOME AND EXPENSE: The components of other income and expense in the accompanying consolidated statements of income for the years ended December 31, 1993, 1992 and 1991 are as follows- (14) RETIREMENT PLAN: The Registrant's Metex subsidiary has a noncontributory pension plan that covers substantially all full-time employees of the engineered products segment. The following table sets forth the plan's funded status and amounts recognized in the Registrant's consolidated financial statements as of December 31, 1993 and 1992- Net pension expense for 1993 and 1992 includes the following components In determining the projected benefit obligation for 1993 and 1992, the weighted average assumed discount rate used was 7.5% and 8.25%, respectively, while the rate of expected increases in future salary levels was 3.5%. The expected long-term rate of return on assets used in determining net periodic pension cost was 9%. (15) BUSINESS SEGMENTS: At December 31, 1993, the Registrant had three principal business segments: real estate investment and management, the manufacture and sale of engineered products and the manufacture and sale of antenna systems. Information on the Registrant's business segments for 1993, 1992 and 1991 is as follows Through the Registrant's antenna systems segment, approximately 21%, 23% and 22% of consolidated revenues were derived from sales to the United States Government or its contractors in 1993, 1992 and 1991, respectively. Sales by the Registrant's engineered products segment to automobile original equipment manufacturers accounted for approximately 20%, 23% and 26% of 1993, 1992 and 1991 consolidated revenues, respectively. (16) CONTINGENCIES: The Registrant has undertaken the completion of environmental studies and/or remedial action at Metex' two New Jersey facilities. The process of remediation has begun at one facility pursuant to a plan filed with the New Jersey Department of Environmental Protection and Energy ("NJDEPE"). Environmental experts engaged by the Registrant currently estimate that under the most probable remediation scenario the remediation of this site is anticipated to require initial expenditures of $860,000, including the cost of capital equipment, and $86,000 in annual operating and maintenance costs over a 15-year period. Environmental studies at the second facility indicate that remediation may be necessary. Based upon the facts presently available, environmental experts have advised the Registrant that under the most probable remediation scenario, the estimated cost to remediate this site is anticipated to require $2.3 million in initial costs, including capital equipment expenditures, and $258,000 in annual operating and maintenance costs over a 10-year period. The Registrant may revise such estimates in the future due to the uncertainty regarding the nature, timing and extent of any remediation efforts that may be required at this site, should an appropriate regulatory agency deem such efforts to be necessary. The foregoing estimates may also be revised by the Registrant as new or additional information in these matters become available or should the NJDEPE or other regulatory agencies require additional or alternative remediation efforts in the future. It is not currently possible to estimate the range or amount of any such liability. Although the Registrant believes that it is entitled to full defense and indemnification with respect to environmental investigation and remediation costs under its insurance policies, the Registrant's insurers have denied such coverage. Accordingly, the Registrant has filed an action against certain insurance carriers seeking defense and indemnification with respect to all prior and future costs incurred in the investigation and remediation of these sites. Upon the advice of counsel, the Registrant believes that based upon a present understanding of the facts and the present state of the law in New Jersey, it is probable that the Registrant will prevail in the pending litigation and thereby access all or a very substantial portion of the insurance coverage it claims; however, the ultimate outcome of litigation cannot be predicted. As a result of the foregoing, the Registrant has not recorded a charge to operations for the environmental remediation, noted above, in the consolidated financial statements, as anticipated proceeds from insurance recoveries are expected to offset such liabilities. Although the Registrant has reached a settlement with two insurance carriers, it has not recognized any significant recoveries to date. In the opinion of management, these matters will be resolved favorably and such amounts, if any, not recovered under the Registrant's insurance policies will be paid gradually over a period of years and, accordingly, should not have a material adverse effect upon the business, liquidity or financial position of the Registrant. However, adverse decisions or events, particularly as to the merits of the Registrant's factual and legal basis could cause the Registrant to change its estimate of liability with respect to such matters in the future. Effective January 1, 1994 the Registrant will reflect the provisions of Staff Accounting Bulletin 92 and will record the expected liability associated with remediation efforts and the anticipated insurance recoveries separately in the Registrant's consolidated financial statements. The Registrant is involved in various other litigation and legal matters which are being defended and handled in the ordinary course of business. None of these matters are expected to result in a judgment having a material adverse effect on the Registrant's consolidated financial position or results of operations. (17) SUBSEQUENT EVENT: On March 14, 1994 the Registrant, through a new wholly-owned subsidiary known as Kentile, Inc., purchased substantially all of the operating assets of Kentile Floors, Inc. ("Kentile") for approximately $14 million. Kentile is a major manufacture and supplier of resilient vinyl flooring and is expected to generate approximately $40 million in revenues during 1994. The purchase price was comprised of approximately $6.1 million in new bank financing, approximately $5.4 million in cash and the assumption of approximately $2.5 million in operating liabilities. The $5.4 million cash payment includes $775,000 that was advanced to Kentile by the Registrant during 1993 and was also partially derived from a total of $4 million in short-term borrowings by the Registrant during the first quarter of 1994. The proceeds from this sale were used by Kentile to repay amounts outstanding under its asset-based lending agreement, thereby relieving the Registrant of its obligation under the letter of credit, discussed below. In November 1992, Kentile filed for protection under Chapter 11 of the United States Bankruptcy Code. Subsequent thereto, the Registrant acquired a one-third equity interest in Kentile together with an option to purchase an additional interest in the future. In consideration for this interest and option in Kentile, the Registrant provided a $2 million letter of credit to partially guarantee borrowings under Kentile's asset-based lending agreement. The letter of credit arrangement was made pursuant to Bankruptcy Court approval on a priority basis. In light of the uncertain outcome of Kentile's bankruptcy proceedings, no value was assigned to the stock acquired by the Registrant. The acquisition of the operating assets of Kentile will be accounted for by the purchase method and, accordingly, the results of operations of Kentile, Inc. will be included with that of the Registrant for periods subsequent to the date of the acquisition. SCHEDULE II UNITED CAPITAL CORP. AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES The accompanying notes to consolidated financial statements are an integral part of these schedules. SCHEDULE VIII UNITED CAPITAL CORP. AND SUBSIDIARIES ALLOWANCE FOR DOUBTFUL ACCOUNTS The accompanying notes to consolidated financial statements are an integral part of these schedules. SCHEDULE X UNITED CAPITAL CORP. AND SUBSIDIARIES SUPPLEMENTARY STATEMENT OF OPERATIONS INFORMATION FOR EACH OF THE THREE YEARS IN THE PERIOD ENDED DECEMBER 31, 1993 Note A -- Amounts are not presented as such amounts are less than 1% of total revenues. The accompanying notes to consolidated financial statements are an integral part of these schedules. SCHEDULE XI UNITED CAPITAL CORP. AND SUBSIDIARIES REAL PROPERTY HELD FOR RENTAL AND ACCUMULATED DEPRECIATION The accompanying notes to consolidated financial statements are an integral part of these schedules. SCHEDULE XI (Continued) NOTES: (a) Reconciliations of the carrying value of real property held for rental for the three years ended December 31, 1993 are as follows- (b) Reconciliations of accumulated depreciation for the three years ended December 31, 1993 are as follows- (c) The aggregate cost for Federal income tax purposes is approximately $178,317,000. SCHEDULE XII UNITED CAPITAL CORP. AND SUBSIDIARIES MORTGAGE LOANS ON REAL ESTATE DECEMBER 31, 1993 SCHEDULE XII (Continued) NOTES: (a) A reconciliation of mortgage loans on real estate for the year ended December 31, 1993 is as follows- (b) In accordance with generally accepted accounting principles the gains from the sale of these properties are being recognized under the installment method and, accordingly, notes receivable have been reduced by the following deferred gains at December 31, 1993: Mortgage note receivable in connection with sale of property in- (c) The carrying value for Federal income tax purposes is substantially equal to the carrying amount for book purposes. The accompanying notes to consolidated financial statements are an integral part of these schedules. UNITED CAPITAL CORP. AND SUBSIDIARIES QUARTERLY FINANCIAL DATA (UNAUDITED) (DOLLARS IN THOUSANDS EXCEPT PER SHARE DATA) - - - -------------------------------------------------------------------------------- UNITED CAPITAL CORP. EXHIBITS TO ANNUAL REPORT ON FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 31, 1993 - - - --------------------------------------------------------------------------------

54502_1993.txt

54502

1993

ITEM 1: BUSINESS _________________ As used in this report, the term "K N" means K N Energy, Inc. and the term "Company" means collectively K N Energy, Inc. and its subsidiaries, unless the context requires a different meaning. (See "Subsidiaries of the Registrant" in Exhibit 22.) (A) General Development of Business _______________________________ K N was incorporated in Kansas on May 18, 1927. The Company's principal operations are the sale, marketing, transportation, processing and gathering of natural gas and the exploration, development and production of oil and natural gas. The Company has operated as a natural gas pipeline and utility since 1937 and has been involved in oil and gas exploration and development since 1951. Since 1989, K N subsidiaries have engaged in nonregulated gas marketing and gathering activities. This segment is experiencing significant growth through acquisitions, joint ventures and the transfer of substantially all of K N's existing gathering and processing facilities to this nonregulated segment as part of its restructuring. (See "Restructuring and Reorganization" below.) On October 1, 1993, K N implemented its unbundling of pipeline services in response to the Federal Energy Regulatory Commission's Order No. 636 ("Order 636"). The Order is designed to stimulate competition in the interstate transportation and sale of natural gas. Of the many elements that make up Order 636, the central feature involves the unbundling of gas sales and transportation services. Unbundling means that traditional pipeline customers, such as wholesale customers, direct end- users and shippers, have new options when contracting for various pipeline services such as transportation and storage. In response to Order 636, K N no longer operates its interstate operations as a single entity that purchases, gathers, processes, transports, stores and sells natural gas at retail and wholesale. Instead, K N has restructured its operations and now operates its interstate transmission pipeline as a separate subsidiary business unit, K N Interstate Gas Transmission Co. ("KNI"). K N's local distribution operation is being operated as a separate business unit ("K N Retail") within the parent company. K N also provides retail natural gas services through two intrastate divisions, Rocky Mountain Natural Gas in Colorado and Northern Gas of Wyoming. Substantially all of the gathering and processing facilities that were previously part of K N's regulated transmission operation are now being operated as nonregulated facilities by K N Gas Gathering, Inc. ("KNGG"), a wholly-owned subsidiary which also operates a number of other gathering and processing facilities acquired during the past two years. On April 1, 1993, the Company completed the $48 million acquisition of the Wattenberg natural gas gathering and transportation system. The transmission segment of the system is a Federal Energy Regulatory Commission ("FERC")-regulated interstate pipeline system operated by K N Wattenberg Transmission Limited Liability Company ("KNWTLLC"), a second- tier subsidiary of K N. The nonregulated gathering portion of the system is operated by K N Front Range Gathering Company ("KNFRGC"), a wholly-owned subsidiary of KNGG. (B) Financial Information About Industry Segments _____________________________________________ The Business Segment Information in Note 13 of Notes to Consolidated Financial Statements of the 1993 Annual Report to Shareholders as shown on pages 52 and 53 provides the operating profit, identifiable assets and other information for each segment. The Consolidated Statements of Income in the 1993 Annual Report to Shareholders as shown on page 32 show sales to unaffiliated customers (operating revenues) for each segment. (C) Narrative Description of Business _________________________________ (1) Regulated Gas Services ______________________ Markets and Sales _________________ The Company's FERC-regulated interstate pipeline systems (operated by KNI and KNWTLLC) provide transportation and storage services to K N Retail and other local natural gas distribution utilities and shippers. K N Retail provides retail natural gas services to residential, commercial, agricultural and industrial customers in Kansas, Nebraska, Colorado and Wyoming. Approximately 151,000 retail customers are served by K N Retail. The interstate pipeline systems provide transportation and storage services for a portion of the system supply of Public Service Company of Colorado ("PSCo"), Western Resources, Inc. and the City of Colorado Springs, Colorado, as well as for other local utilities serving 92,000 gas consumers in Colorado, Kansas and Nebraska. As of December 31, 1993, the interstate systems provided transportation and storage services to utilities serving 293 communities, as follows: (1) Principal cities served by K N Retail include: Alliance, Chadron, Holdrege, McCook, Ogallala, Scottsbluff, Sidney and a portion of Kearney, Nebraska; Colby, Phillipsburg and Scott City, Kansas; Julesburg and Wray, Colorado; and Douglas and Torrington, Wyoming. (2) Principal cities served by other local distribution utilities include: Grand Island, Hastings, Norfolk, North Platte, and Kearney, Nebraska; Hays, Kansas; and Sterling and the metropolitan areas of Colorado Springs and Denver, Colorado. The Company operates intrastate gas pipeline systems serving industrial customers and K N's distribution divisions in Wyoming and Colorado. The Northern Gas of Wyoming Division of K N provides retail gas service to approximately 50,000 customers in 25 communities in central, south central and northeastern Wyoming. Principal cities served at retail by the Wyoming intrastate system include Casper, Gillette, Lander, Laramie, Rawlins and Riverton, Wyoming. The Rocky Mountain Natural Gas Division of K N ("RMNG") serves approximately 31,500 retail customers in 26 communities in western Colorado. Aspen, Delta, Glenwood Springs, Montrose, Snowmass Village and Telluride are the principal cities served. RMNG continues to experience significant growth in the resort areas of Colorado. During 1993, the division experienced a six percent growth in the number of residential and commercial customers. Because of the demands of this continued growth, RMNG and an affiliate, in conjunction with PSCo, have received a favorable order from the Colorado Public Utilities Commission to build a 90-mile transmission pipeline from Rifle to Avon, Colorado. The pipeline will connect natural gas production areas near Rifle to K N's Colorado intrastate pipeline system. Agriculture is the dominant factor in the economies of the Company's historical service areas. The Company supplies natural gas for irrigation, crop drying, processing of agricultural products and the manufacture of agriculture-related goods. The following table sets forth the percentage of total natural gas sales revenues for each class of customer for each of the three years in the period ended December 31, 1993, as follows: (1) Regulated sales of natural gas to other gas utilities ended on September 30, 1993, due to the Company's implementation of Order 636. Natural gas sales accounted for 51.6, 69.4 and 78.0 percent of consolidated revenues for the years ended December 31, 1993, 1992 and 1991, respectively. The transfer of substantially all of K N's gathering and processing facilities to KNGG effective January 1, 1994, will result in a significant shift in operating revenues, expenses and operating income. The cessation of the merchant function as a FERC-regulated service will substantially reduce this segment's operating revenues and gas purchase expenses; however, this will not impact operating income. Results of this business segment have historically been seasonal in nature due to fluctuating needs for natural gas for space heating and irrigation. However, Order 636 mandated the use of straight fixed-variable rate design ("SFV") for FERC-regulated services. This rate methodology will result in this business segment collecting a significant portion of its revenues from customers through demand charges collected evenly throughout the year. Accordingly, fluctuations in operating revenues resulting from seasonal variations in weather temperatures should be reduced. Transportation ______________ KNI, under its menu of services, provides not only firm and interruptible transportation, but also storage and no-notice services to its customers. Under no-notice service, customers are able to meet their peak day requirements without making specific nominations as required by firm and interruptible transportation services tariffs. Under Order 636, the local distribution companies ("LDCs") and other shippers may release their unused firm transportation capacity rights to other shippers. It is anticipated that this released capacity will, to a large extent, replace interruptible transportation on the Company's system. Interruptible transportation is charged on the basis of volumes shipped. The Company's Wyoming and Colorado intrastate systems have blanket certificates which allow them to transport gas to be delivered in interstate commerce, and both systems also provide intrastate transportation services. Marketing _________ The Company is continuing its efforts to expand its transportation business through expanded capacity and new interconnects, as well as by adding new transportation services. While there is considerable competition for this business, the Company has certain strategic advantages to enable it to be a successful competitor. These include favorable geographic pipeline locations providing access to both major gas supply areas and potential new markets. The Company will continue developing its role as an operator of transportation hubs, facilitating market-center services. A K N subsidiary is a one-third joint venture partner in the TransColorado Gas Transmission Pipeline Project. This pipeline is expected to provide increased flexibility in accessing multiple natural gas basins in the Rocky Mountain region. TransColorado is in its final preconstruction stage and regulatory work is nearing completion. To focus marketing activities, the partner companies have opened a TransColorado marketing office to secure supply and transportation commitments. Construction is anticipated to begin in 1995. Gas Supply __________ With the implementation of Order 636, gas purchasing is now the responsibility of each LDC. To meet this new responsibility, K N Retail formed a new Gas Supply Department. K N Retail has contracted with KNI and other pipelines for transportation and storage services required to serve its markets. K N Retail's gas supply requirements are being met through a combination of purchases from a wholly-owned subsidiary, K N Gas Supply Services, Inc. ("KNGSSI"), and third party suppliers. K N Retail's gas supply comes from five major geological areas, as follows: (1) Anadarko Basin, including the Hugoton, Bradshaw and Panoma fields in Kansas; (2) Barton Arch area of central Kansas; (3) Denver-Julesburg Basin in northeast Colorado, northwest Kansas and western Nebraska; (4) Wind River Basin in central Wyoming; and (5) Bowdoin area in north central Montana. The Company's intrastate system in Wyoming purchases its gas supply principally from producers in the Wind River Basin in central Wyoming. The Company's Colorado intrastate system purchases approximately 12 percent of its system supply from a K N oil and gas subsidiary and the remainder from a number of western Colorado fields. Underground storage facilities are used to provide deliverabilities for peak system demand. Four underground storage facilities are located on the interstate systems, five are on the Wyoming intrastate system and one is on the Colorado intrastate system. In connection with Order 636, K N received FERC approval to reclassify, as of October 1, 1993, 54.9 billion cubic feet ("Bcf") of working gas to cushion gas. As part of the corporate restructuring, all cushion gas (88.1 Bcf) was transferred to KNI at that time. The remaining working gas of 11.1 Bcf at October 1, 1993, was purchased in-place by K N's former wholesale customers; K N Retail retained 4.3 Bcf of this working gas. On the interstate systems, a net injection of 2.7 Bcf in 1993 increased the total year-end gas inventory owned by all parties to 95.1 Bcf. The approximate unused working gas capacity at December 31, 1993, was 9.7 Bcf. On the Wyoming intrastate system, 11.3 Bcf of working gas was available in storage at year-end after a net withdrawal of 2.5 Bcf during the year. On the Colorado intrastate system, 2.3 Bcf of working gas was available in storage at year-end after a net withdrawal of 98 million cubic feet ("MMcf") during the year. Restructuring and Reorganization ________________________________ As authorized by FERC, K N implemented Order 636 restructured services on October 1, 1993. K N requested FERC approval, as a result of Order 636, to transfer all of its interstate transmission and storage facilities to KNI, a wholly-owned jurisdictional subsidiary of K N, and substantially all of its gathering and processing facilities to KNGG, a nonjurisdictional wholly-owned subsidiary of K N. In its May 5, 1993 order, FERC approved the transfer of K N's gathering, processing, transmission and storage facilities to KNI effective October 1, 1993. On November 1, 1993, FERC authorized the transfer of substantially all gathering and processing facilities from KNI to KNGG. Through discussions with its former wholesale customers, K N was able to formulate and implement a plan which resulted in the transition to Order 636 services and which avoided the necessity of any Gas Supply Realignment ("GSR") cost recovery filings with FERC. As a part of its action on K N's restructuring proposal, on January 13, 1994, FERC approved the offer of settlement which implemented K N's GSR crediting mechanism. Regulation __________ KNI's and KNWTLLC's facilities for the transportation of natural gas in interstate commerce, and in the case of KNI, for storage services in interstate commerce, are subject to regulation by FERC. In addition, KNI is subject to the requirements of FERC Order Nos. 497, et al., the Marketing Affiliate Rules, which govern the provision of information by an interstate pipeline to its marketing affiliates. The subsidiaries of K N currently identified as marketing affiliates are K N Gas Marketing, Inc. and KNGSSI. The Company's distribution facilities and retail sales in Kansas, Colorado and Wyoming are under the regulatory authority of each state's utility commission. The Wyoming and Colorado commissions also may review the Company's issuance of securities. In Nebraska, retail gas sales rates for residential and commercial customers are regulated by each municipality served since there is no state utility commission. In the incorporated communities in which K N sells natural gas at retail, K N operates under franchises granted by the applicable municipal authorities. K N is seeking to renew its franchises in: Casper and Laramie, Wyoming; Eagle and Wellington, Colorado; and Atkinson and Gothenburg, Nebraska. Sales are currently being made during the renewal process. In Colorado, these franchises must also be approved by the state regulatory commission. The duration of franchises varies with applicable law. In unincorporated areas, K N's direct sales of natural gas are not subject to franchise, but, in all states except Nebraska, are "certificated" by the state regulatory commissions. Regulatory Matters __________________ See Note 3 of Notes to Consolidated Financial Statements of the 1993 Annual Report to Shareholders as shown on pages 39 and 40. In March 1994, RMNG filed an application for a "make whole" rate change with the Colorado Public Utilities Commission ("CPUC") proposing to increase annual revenues $2.5 million effective April 2, 1994. This matter is currently pending before the CPUC. In February and March 1994, K N filed suits for injunctive relief against 20 municipalities in Nebraska, seeking the Court to enjoin the effectiveness of ordinances which attempt to make certain gas utility rates retroactive for the period of October 1, 1990, through May 1, 1993. These lawsuits are currently pending in the District Court of Lancaster County, Nebraska. Purchased Gas Adjustment Clauses ________________________________ K N Retail has gas supply cost adjustment clauses in its Kansas, Colorado and Wyoming tariffs and in its rate ordinances for Nebraska residential and commercial customers. These gas supply cost adjustment clauses provide for the pass-on of increases or decreases in upstream delivery costs and the recovery of under- or refund of over-collected purchased gas costs (including carrying charges thereon in certain jurisdictions) from prior periods. Order 636 eliminated the gas supply cost adjustment clause in KNI's FERC tariff. K N's Wyoming and Colorado intrastate regulated utilities' tariffs also contain purchased gas adjustment clauses. Competition ___________ The Company's pipeline systems face competition from other transporters. In addition, natural gas competes with fuel oil, coal, propane and electricity in the areas served by the Company's pipeline systems and local distribution businesses. (2) Gas Marketing and Gathering ___________________________ K N Gas Marketing, Inc. ("KNGM") was formed in March 1989 to provide gas marketing and supply services to various natural gas resellers and end-users on K N pipeline systems. KNGM works with producers and end- users on the pipeline systems to arrange the purchase and transportation of producers' excess or uncommitted gas to end-users, acting as shipper or agent for the end-users, administering nominations and providing balancing assistance when needed. During 1993, KNGM continued efforts to expand its markets both on and off K N's pipelines through the reorganization of its existing staff and K N's former gas supply staff. These growth activities are expected to continue under K N's post Order 636 reorganization activities. KNGSSI began operations in September 1993 to facilitate K N's transition from a provider of bundled pipeline sales service to a provider of Order 636 restructured services. In performing this function, KNGSSI buys gas from K N's former gas suppliers, aggregates these supplies and sells gas to former wholesale customers. K N Trading, Inc. ("KNTI"), another wholly-owned subsidiary of K N, was formed in November 1991 to engage in risk management activities in the gas commodities futures market. KNTI buys and sells gas commodity futures positions on the New York Mercantile Exchange ("NYMEX") and through the use of over-the-counter gas commodity derivatives for the purpose of reducing adverse price exposure for gas supply costs or specific market margins. KNGG was formed in November 1989 to provide gathering and mainline connection services for existing and new gas supply customers. KNGG operates gathering systems whose operations and rates of return are not currently regulated by FERC. Acquisitions and Capital Expenditures _____________________________________ On April 1, 1993, the Company completed its acquisition of the Wattenberg natural gas gathering and transportation system. KNFRGC is the operator of the gathering portion of the system. This system gathers and transports gas from approximately 1,800 receipt points in northeast Colorado, and transports up to 250,000 million British thermal units ("MMBtus") of gas per day. On June 1, 1993, Wind River Gathering Company acquired approximately 110 miles of natural gas pipeline and facilities in Wyoming's Wind River Basin. Wind River Gathering Company is a joint venture between KNGG and a subsidiary of Tom Brown, Inc., a Wind River Basin producer. This system connects area producers with major markets served by K N and other interstate pipeline systems. KNGG manages the operations of the gathering system. The system gathers and transports up to 30,000 MMBtus of gas per day. KNGM and KNGG incurred 1993 capital expenditures of $7.0 million. 1994 capital expenditures are budgeted at $4.7 million. Restructuring and Reorganization ________________________________ In conjunction with its Order 636 reorganization filing, K N applied for and received FERC permission to transfer substantially all of its regulated gathering and processing assets to KNGG. This transfer was effective January 1, 1994. The assets are located in K N's traditional gas supply areas in Kansas, Wyoming, Colorado, Texas and Oklahoma. Regulation __________ To the extent the gas marketing subsidiaries make sales for resale in interstate commerce, they are subject to FERC regulations and rulemaking related to affiliated marketers. Under the Natural Gas Act, facilities used for and operations involving the production and gathering of natural gas are exempt from FERC jurisdiction, while facilities used for and operations involving interstate transmission are not. However, FERC's determination of what constitutes exempt gathering facilities as opposed to jurisdictional transmission facilities has evolved over time. Under current law, facilities which otherwise are classified as gathering may be subject to ancillary FERC rate and service jurisdiction when owned by an interstate pipeline company and used in connection with interstate transportation or jurisdictional sales. Respecting facilities owned by noninterstate pipeline companies, such as KNGG and KNFRGC's gathering facilities, FERC has historically distinguished between these types of activities on a very fact-specific basis. FERC has initiated a rulemaking to consider issues relating to gathering services performed by interstate pipelines or their affiliates. FERC intends to use information obtained to reevaluate the appropriateness of its traditional gathering criteria in light of Order 636, and to establish consistent policies for gathering rates and services for both interstate pipelines and their affiliates. It is not possible at this time to predict the outcome of this proceeding and its potential effect on KNGG and KNFRGC. As part of its corporate reorganization, K N requested and was granted authority to transfer substantially all of its gathering facilities to KNGG. The Commission determined that after the transfer, the gathering facilities would be nonjurisdictional, but FERC reserved the right to reassert jurisdiction if KNGG was found to be operating the facilities in an anti-competitive manner or contrary to open access principles. Competition ___________ The gas marketing and gathering subsidiaries operate in a competitive environment for the purchase, sale and gathering of natural gas. The general availability of competitively priced gas supplies, the availability and price of alternative fuels and the availability and price of gathering and transportation services in their market areas all have an impact on these subsidiaries' competitive position for new markets. (3) Oil and Gas Production ______________________ K N owns and participates in the development and production of oil and gas reserves through two wholly-owned subsidiaries, K N Production Company ("KNPC") and GASCO, Inc. ("Gasco"). KNPC was formed in 1983 and currently owns oil and gas properties mainly in Colorado, Oklahoma, Texas and Wyoming. All KNPC production is sold either to unaffiliated purchasers or nonjurisdictional affiliated purchasers. Gasco was formed in 1966 and acquired by K N in 1986. Gasco owns properties in Colorado and Wyoming, selling much of its production to affiliated purchasers. During 1993, KNPC participated in the drilling and completion of 16 development wells in the Denver-Julesburg Basin, and in the drilling and completion of one exploratory well in the Oklahoma panhandle. Gasco participated in working over ten wells on the Western Slope and in the drilling and completion of one development well in Colorado. At December 31, 1993, KNPC had approximately 30,000 net undeveloped acres under lease and owned interests in 84 producing wells (35 net), of which it operated 20 (14 net). Gasco had approximately 140,000 net undeveloped acres under lease and owned interests in 139 producing wells (107 net), operating 117 (105 net). In addition to oil and gas properties, Gasco owns the Wolf Creek gas storage field in Colorado, and also owns interests in three small gathering systems, all in Colorado. Acquisitions and Capital Expenditures _____________________________________ In February 1994, KNPC and Gasco finalized the acquisition of gas reserves and production from Fuel Resources Development Company, a wholly- owned subsidiary of PSCo. The properties are located near existing K N operations in western Colorado and in the Moxa Arch region of southwestern Wyoming. Total net reserves approximate 50 billion cubic feet equivalent of natural gas. The Company is discussing the possible sharing of ownership interests and non-recourse financing with other parties. The Company will continue to focus on the acquisition and development of natural gas reserves in the Mid-Continent and Rocky Mountain regions, emphasizing areas contiguous to current and future Company pipeline operations. Capital expenditures in 1993 were $4.8 million. Capital expenditures for 1994 are budgeted at $6.7 million. Regulation __________ Oil and gas operations are primarily subject to the regulation of the Minerals Management Service ("MMS") and the Bureau of Land Management on the Federal level. Each state in which the Company's oil and gas subsidiaries operate regulates the volume and manner of production of natural gas in that state under laws directed toward conservation and the prevention of waste of natural resources. Competition ___________ Oil and gas exploration and development are subject to competition from not only numerous other companies in the industry, but also from alternative fuels, including coal and nuclear energy. (4) General _______ Gas Purchases _____________ Prior to Order 636, gas was purchased by the interstate pipeline for resale to its wholesale customers. As a result of the restructuring and reorganization pursuant to Order 636, each LDC, including K N Retail, now has the responsibility for its gas purchases. Under K N's Supply Transition Program, KNGSSI administers purchases from a portfolio of gas purchase contracts that existed prior to the reorganization. Order 636 has not significantly impacted gas purchasing for K N's intrastate systems. Gas purchase prices for certain categories of gas have been deregulated over a period of time beginning January 1, 1985, pursuant to the Natural Gas Policy Act of 1978 ("NGPA"). The final total deregulation of all gas at the wellhead occurred on January 1, 1993, under terms of the Natural Gas Wellhead Decontrol Act of 1989. The deregulation of gas at the wellhead is intended to bring the prices paid for gas to a "market clearing" level. Those contracts which have a deregulation clause allow the purchaser to redetermine the price to a competitive level and the Company has exercised these rights as deregulation has occurred. The natural gas futures contract, actively traded on the NYMEX, has brought significant price discovery to the natural gas market. Various indices and regional natural gas hubs have changed the method of pricing from long-term annual redeterminations to short-term, daily or monthly, pricing of gas at current market levels. As such, gas prices now quickly react to supply and demand as any other commodity market. Gas purchase contracts also may contain a take-or-pay clause which requires that a certain purchase level be attained each contract year, or the purchaser must make a payment equal to the contract price multiplied by the deficient volume. At December 31, 1993, the level of outstanding payments was $11.7 million. All such payments are fully recoupable under the terms of the gas purchase contracts and the existing regulatory rules and regulations. To date, the Company has not made any buy-out or buy-down payments relating to take-or-pay contracts. Certain gas purchase contracts containing market-out clauses were redetermined to a competitive price for 1993, reflecting an increase in gas prices from the 1992 redetermined price. Environmental Regulation ________________________ The Company's operations and properties are subject to extensive and changing Federal, state and local laws and regulations governing the discharge of materials into the environment or otherwise relating to environmental protection. Numerous governmental departments issue rules and regulations to implement and enforce such laws which are often difficult and costly to comply with and which carry substantial penalties for failure to comply. Moreover, the recent trends toward stricter standards in environmental legislation and regulation are likely to continue. The United States Oil Pollution Act of 1990 (the "OPA") and regulations promulgated thereunder by the MMS impose a variety of requirements on persons who are or may be responsible for oil spills in waters of the United States. The term "waters of the United States" has been broadly defined to include inland waterbodies, including wetlands, playa lakes and intermittent streams. The Company has oil and gas facilities that could affect "waters of the United States." The Federal Water Pollution Control Act, also known as the Clean Water Act, and regulations promulgated thereunder, require containment of potential discharges of oil or hazardous substances and preparation of oil spill contingency plans. The Company currently is implementing programs that address containment of potential discharges and spill contingency planning. The failure to comply with ongoing requirements or inadequate cooperation during a spill event may subject a responsible party to civil or criminal enforcement actions. The Comprehensive Environmental Response, Compensation and Liability Act, as amended ("Superfund"), imposes liability, without regard to fault or the legality of the original conduct, on certain classes of persons who are considered to have contributed to the release of a "hazardous substance" into the environment. Under Superfund, such persons may be subject to joint and several liability for the costs of cleaning up the hazardous substances that have been released into the environment and for damages to natural resources. Furthermore, it is not uncommon for neighboring landowners and other third parties to file claims for personal injury and property damage allegedly caused by the hazardous substances released into the environment. Federal and state regulations have recently been changed as a result of the 1990 Amendments to the Clean Air Act. This affects the Company's operations in several ways. Natural gas compressors for both gathering and transmission activity are now required to meet stricter air emission standards. Additionally, states in which the Company operates are adopting new regulations under the authority of the "Operating Permit Program" under Title V of these 1990 Amendments. These Operating Permits will require operators of certain facilities to obtain individual site- specific air permits containing stricter operational and technological standards of operation in order to achieve compliance with this section of the 1990 Clean Air Act Amendments and associated state air regulations. Compliance with Federal, state and local provisions with respect to the protection of the environment has had no material effect upon capital expenditures, earnings, or the competitive position of the Company, except as described in Item 3 "Mystery Bridge Road Environmental Matters" and "Other Environmental Matters." Safety Regulation _________________ The operations of certain of the Company's gas pipelines are subject to regulation by the United States Department of Transportation (the "DOT") under the Natural Gas Pipeline Safety Act of 1968 (the "NGPSA"), as amended. The NGPSA establishes safety standards with respect to the design, installation, testing, construction, operation and management of natural gas pipelines, and requires entities that own or operate pipeline facilities to comply with the applicable safety standards, to establish and maintain inspection and maintenance plans and to comply with such plans. The NGPSA was amended by the Pipeline Safety Act of 1992 to require the DOT's Office of Pipeline Safety to consider, among other things, protection of the environment when developing minimum pipeline safety regulations. Management believes the Company's operations, to the extent they may be subject to the NGPSA, comply in all material respects with the NGPSA. The Company is also subject to laws and regulations concerning occupational health and safety. Although the Company is unable to predict the ultimate cost of compliance, it is not anticipated that the Company will be required in the near future to expend material amounts to comply with these laws and regulations. Other _____ Amounts spent by the Company during 1993, 1992 and 1991 on research and development activities were not material. Sales were not made to any individual customer in 1993 in an amount which equaled ten percent or more of the Company's consolidated revenues. At December 31, 1993, the Company had 1,735 employees. (D) Financial Information About Foreign and Domestic Operations and _______________________________________________________________ Export Sales ____________ All of the Company's operations are in the contiguous 48 states. ITEM 2:

ITEM 2: PROPERTIES ___________________ (A) Location and Character of Property __________________________________ The Registrant maintains its principal place of business in Lakewood, Colorado. Other major offices are in: Hastings, Nebraska; Phillipsburg, Kansas; Casper, Wyoming; and Glenwood Springs, Colorado. At December 31, 1993, the principal properties of the Company were as set forth below. Gas Service ___________ As of December 31, 1993, the Company's gas service properties included transmission, gathering and storage lines of 8,239 miles in the interstate systems, 675 miles in the Wyoming intrastate system and 766 miles in the Colorado intrastate system. (Effective January 1, 1994, 1,691 miles of gathering lines were transferred to KNGG as part of the corporate reorganization. See "Restructuring and Reorganization" on pages 9 and 10.) Distribution lines totaling 6,159 miles were in the interstate system, 1,072 miles in the Wyoming intrastate system and 1,423 miles in the Colorado intrastate system at December 31, 1993. The Company has four underground gas storage facilities in operation in the interstate systems, five in the Wyoming intrastate system and one in the Colorado intrastate system. Its major interstate facilities are the Huntsman Storage Field in Cheyenne County, Nebraska and the Big Springs Storage Field in Deuel County, Nebraska. The interstate systems also included two products extraction plants and 185 compressor units with an aggregate 175,171 rated compressor horsepower at December 31, 1993. (Effective January 1, 1994, 29 compressor units with an aggregate 5,482 rated compressor horsepower and the Scott City products extraction plant were transferred to KNGG as part of the corporate reorganization.) The Wyoming intrastate system included eight compressor units and the Colorado intrastate system included 13 compressor units with aggregate rated compressor horsepower of 3,204 and 5,995, respectively, at December 31, 1993. The Company's other gas service properties include measuring and regulating stations, garages, warehouses and other land and buildings necessary and useful in the conduct of its business. Gas Marketing and Gathering ___________________________ The Company's gas marketing and gathering properties are discussed in Item 1 (C)(2). As of December 31, 1993, KNGG and its subsidiaries operated gathering systems with 2,918 miles of gathering lines and 75 compressors with an aggregate 43,150 rated compressor horsepower. (Effective January 1, 1994, 1,691 miles of gathering lines, 29 compressor units with an aggregate 5,482 rated compressor horsepower and the Scott City products extraction plant were transferred to KNGG as part of the corporate reorganization.) For additional information relating to gas marketing and gathering properties see Notes 1(H), 2, 4 and 13 of Notes to Consolidated Financial Statements of the 1993 Annual Report to Shareholders as shown on pages 37, 39, 40-41 and 52-53. Oil and Gas Production ______________________ The Company's oil and gas producing properties are discussed in Item 1(C)(3). For additional information relating to oil and gas production properties see Notes 1(I), 4 and 13 of Notes to Consolidated Financial Statements of the 1993 Annual Report to Shareholders as shown on pages 37, 40-41 and 52-53. (B) Oil and Gas Reserves, Properties and Activities _______________________________________________ Not material. ITEM 3:

ITEM 3: LEGAL PROCEEDINGS __________________________ Mystery Bridge Road Environmental Matters _________________________________________ K N is named as one of four potentially responsible parties ("PRPs") at a U.S. Environmental Protection Agency ("EPA") Superfund site, pursuant to Superfund. The site is known as the Mystery Bridge Road/U.S. Highway 20 site located near Casper, Wyoming (the "Brookhurst Subdivision"). The EPA's remedy consists of two parts, "Operating Unit One," which addresses the groundwater cleanup and "Operating Unit Two," which addresses cleanup procedures for the soil and free-phase petroleum product. A Consent Decree between the Company, the EPA and another PRP was entered on October 2, 1991, in the Wyoming Federal District Court. Groundwater cleanup under Operating Unit One has been proceeding since 1990. On September 14, 1993, the EPA certified that the remedial action for Operating Unit One was "operational and functional." This is the last step in the Superfund process prior to remedy completion. In July 1992, the EPA approved the Company's Operating Unit Two workplan and the Company received an EPA "Statement of Work." The work required to be performed for Operating Unit Two commenced during the third quarter of 1992 and is expected to continue through 1995. (United States _____________ of America v. Dow Chemical Company, Dowell Schlumberger, Inc., and K N ______________________________________________________________________ Energy, Inc., Civil Action No. 91CV1042, United States District Court for ____________ the District of Wyoming; formerly reported as Administrative Orders for Removal Action on Consent, October 15, 1987, and Amendment to Administrative Order for Removal Order on Consent, October 10, 1989, Docket No. CERCLA VII-88-01, United States Environmental Protection Agency; Judicial Entry of Consent Decree, United States v. Dow Chemical Company, ______________________________________ et al. (D. Wyo) USDC-WY-91CV1042B, Superfund Site Number 8T83, Natrona _________________________________ County, Wyoming; EPA Docket Number CERCLA-VIII.) With regard to this same Superfund site, in 1987 the State of Wyoming filed suit against several parties (including K N) for injunctive relief, penalties and unquantified damages claimed to have resulted from alleged pollution of groundwater and soils in the Brookhurst Subdivision. On April 1, 1993, the Wyoming District Court dismissed the lawsuit, finding that K N had diligently remedied the alleged pollution. (Wyoming v. Little _________________ America Refining Co., K N Energy, Inc. and Dowell Schlumberger, Civil ______________________________________________________________ Action No. 62325, Wyoming District Court [Natrona County].) On October 20, 1989, a lawsuit was filed against the Company and 18 other defendants on behalf of a group of 268 individuals who reside or resided in the Brookhurst Subdivision, seeking damages for alleged releases of certain chemicals to the soil, groundwater and air. On February 5, 1993, the Company reached agreement to settle the above-described dispute. The settlement, which was approved by the Wyoming District Court, resolved all disputes between the parties and closed the lawsuit. A reserve for the settlement amount and related matters had been established in the Company's financial statements prior to 1993 and, accordingly, such settlement did not have any material adverse impact on the Company's financial position or results of operations. (Albertson, et al., v. Dow Chemical Co., K N ___________________________________________ Energy, Inc., et al., Civil Action No. 65212, 7th Judicial District, ____________________ Natrona County District Court, State of Wyoming.) On November 30, 1990, the Company initiated an action against a number of its insurance carriers for a declaration of the carriers' contractual obligations to provide insurance coverage for all sums associated with the alleged losses under the state, Federal and toxic tort claims related to the Brookhurst Subdivision. The Company entered into formal settlements with all of the defendants in the lawsuit in 1993, and received settlement proceeds associated therewith. (K N v. Allianz ______________ Insurance Company, et al., Civil Action No. 90CV301-J, United States ________________________ District Court for the District of Wyoming.) Other Environmental Matters ___________________________ An environmental audit performed by the Company in autumn 1991 revealed that a grease known as Rockwell 860 had been used as a valve sealant at several of the Company's locations in Nebraska. Rockwell 860 is a solid clay-like material which does not easily spill into the environment, but contains approximately ten percent polychlorinated biphenyls ("PCBs"). Based on the Company's initial studies, the PCBs are contained within the pipeline and valves at the subject locations. PCBs are regulated by the EPA under the Toxic Substances Control Act. On March 31, 1993, the Company filed suit against Rockwell International Corporation manufacturer of the valve sealant; and two other related defendants, claiming under contractual, statutory, tort and strict liability theories that the defendants share responsibility for the Company's environmental expenses and commercial losses resulting from any EPA or state required PCB cleanup or mitigation. The Company reached a settlement in principal with Rockwell, et al. in March 1994. The Company submitted a proposed PCB remediation plan to the EPA in November 1991. To date, no enforcement action or penalties have been issued or discussed by the EPA. The Company currently cannot estimate the extent of the remediation nor costs, though such costs are not expected to exceed the settlement amounts or to have any material adverse impact on the Company's financial position or results of operations. The PCB cleanup program is not expected to interrupt or diminish K N's operational ability to gather or transport natural gas. Certain used pipe reclaimed at the Company's Holdrege, Nebraska pipeyard was wrapped with asphalt-saturated asbestos felt, which was commonly removed in accordance with Company practices. The removed wrap contains friable asbestos fibers above the regulatory standard. The Nebraska Department of Environmental Control ("DEC"), the agency having jurisdiction over this matter, was notified and approved the Company's remediation plan. Remediation is effectively complete, at a total cost not to exceed $600,000. The asbestos cleanup program did not interrupt or diminish K N's operational ability to gather or transport natural gas. Grynberg v. K N et al. ______________________ On October 9, 1992, Jack J. Grynberg filed suit in the United States District Court for the District of Colorado against the Company, Rocky Mountain Natural Gas Company and Gasco (the "K N Entities") alleging that the K N Entities as well as KNPC and KNGG, have violated Federal and state antitrust laws. In essence, Grynberg asserts that the companies have engaged in an illegal exercise of monopoly power, have illegally denied him economically feasible access to essential facilities to transport and distribute gas produced from fewer than 20 wells located in northwest Colorado, and illegally have attempted to monopolize or to enhance or maintain an existing monopoly. Grynberg also asserts certain causes of action relating to a gas purchase contract. No specific monetary damages have been claimed, although Grynberg has requested that any actual damages awarded be trebled. In addition, Grynberg has requested that the K N Entities be ordered to divest all interests in natural gas exploration, development and production properties, all interests in distribution and marketing operations, and all interests in natural gas storage facilities, separating these interests from the Company's natural gas gathering and transportation system in northwest Colorado. On August 13, 1993, the United States District Court, District of Colorado, stayed this proceeding pending exhaustion of appeals in a related state court action involving the same plaintiff. (Grynberg v. K N, et al., _______________________ Civil Action No. 92-2000, United States District Court for the District of Colorado.) ITEM 4:

ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS ____________________________________________________________ None. EXECUTIVE OFFICERS OF THE REGISTRANT ____________________________________ (A) Identification and Business Experience of Executive Officers ____________________________________________________________ Name Age Position and Business Experience __________________________ _____ _________________________________ Charles W. Battey. . . . . 62 Chairman and Chief Executive Offi- cer since January 1989 and Director since 1971. Larry D. Hall. . . . . . . 51 President and Chief Operating Offi- cer since May 1988 and Director since 1984. Leland L. Hurst. . . . . . 63 Senior Vice President since May 1993. Previously Senior Vice President, Operations from June 1988 to May 1993. Judith A. Aden . . . . . . 52 Vice President and Treasurer since March 1991, Treasurer since January 1981 and Assistant Secretary since March 1989. William E. Asbury. . . . . 41 Vice President, Gas Service since 1988. Eugene B. Bade . . . . . . 47 Vice President and Controller since May 1993. Previously Vice Pres- ident K N Gas Marketing from January 1990 to May 1993, Vice President from April 1989 to January 1990 and Director of Internal Audit from November 1985 to April 1989. Richard M. Buxton. . . . . 45 Vice President, Strategic Planning and Financial Services since March 1991. Director, Financial Services from 1986 to March 1991. William S. Garner, Jr. . . 44 Vice President, General Counsel and Secretary since April 1992. Vice President and General Counsel since January 1991. Previously Vice Pres- ident and Deputy General Counsel from September 1989 through 1990 and Vice President, Law from June 1988 to September 1989. S. Wesley Haun . . . . . . 46 Vice President, Marketing and Supply since May 1993. Previously Vice President, Gas Supply from March 1990 to May 1993 and Vice President, Gas Acquisition from November 1988 to March 1990. E. Wayne Lundhagen . . . . 57 Vice President, Finance and Accounting since May 1988. Arnold R. Madigan. . . . . 55 Vice President, Interstate Transportation since May 1993. Previously Vice President, Marketing and Transportation from September 1989 to May 1993 and Vice President and General Counsel from June 1988 to September 1989. John W. Simonton . . . . . 48 Vice President, Administration and Human Resources since May 1988. H. Rickey Wells. . . . . . 37 Vice President, Operations since June 1988. These officers generally serve until March of each year. (B) Involvement in Certain Legal Proceedings ________________________________________ None. PART II ITEM 5:

ITEM 5: MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER _________________________________________________________________________ MATTERS _______ The Company's common stock is listed for trading on the New York Stock Exchange under the symbol KNE. Dividends paid and the price range of the Company's common stock by quarters for the last two years, restated for an October 1993 three-for-two stock split, are provided below. ITEM 6:

ITEM 6: SELECTED FINANCIAL DATA ________________________________ FIVE-YEAR REVIEW Selected Financial Data (Dollars in Thousands Except Per Share Amounts) (1) Restated to reflect a three-for-two common stock split in 1993. ITEM 7:

ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND ________________________________________________________________________ RESULTS OF OPERATIONS _____________________ CONSOLIDATED FINANCIAL RESULTS Continuing Operations Income from continuing operations and the applicable earnings per share and return on beginning of year common equity for the three years ended December 31, 1993, were as follows: Earnings per share for 1993 exceeded 1992 results by 23 percent, despite the negative effects of record low gas sales to irrigation customers. The impact of lower irrigation sales was more than offset by positive contributions from acquisitions of natural gas facilities, expense controls, favorable resolution of rate cases, and insurance settlements. In addition, 1993 first quarter gas sales, transportation and natural gas liquids revenues were significantly greater than those in the first quarter of 1992 due to colder weather. The decline in 1992 earnings, in comparison with 1991, reflected the impact of unfavorable weather on natural gas sales and natural gas liquids revenues, and higher interest expense which resulted, in part, from reduced operating cash flows. These negative earnings factors were partially offset by increased transportation revenues, rate increases, lower operating costs as a result of expense controls and reduced litigation expense provisions. Discontinued Operations In 1991, the Company recorded an after-tax loss of $17.3 million resulting from the sale of its coal subsidiaries and the discontinuance of this business segment. RESULTS OF CONTINUING OPERATIONS Discussion of operating results by business segment and consolidated other income and (deductions) and income taxes follows. Segment operating revenues, gas purchases, operations and maintenance expenses, and volumetric data cited here are before intersegment eliminations (dollars in millions). Revenues and expenses of the Federal Energy Regulatory Commission ("FERC")-regulated Wattenberg transmission system, acquired on April 1, 1993, are included in this segment's 1993 operating results. The decline in gas sales and transportation revenues (and related gas purchases) primarily reflects FERC Order No. 636 ("Order 636") implementation and the resultant elimination of the gas cost component from FERC-regulated service revenues. An additional cause for the decline in 1993 gas sales and transportation revenues was the record low sales to irrigation customers due to the abnormally wet summer. Irrigation sales were 3.1 Bcf below 1992 volumes. However, revenues from the Wattenberg transmission system, rate increases in essentially all K N retail jurisdictions (including resolution of the 1990 rate case in Nebraska), and increases in 1993 residential and commercial sales volumes (4.3 Bcf above 1992 due to colder weather) substantially offset the decline in irrigation sales. Greater systems throughput, costs and expenses of the Wattenberg transmission system and higher costs related to increased natural gas liquids recoveries impacted 1993 operations and maintenance expenses. These increases were partially mitigated by insurance settlements related to the Brookhurst Subdivision Superfund site near Casper, Wyoming. Gas service's 1992 operating revenues were ten percent below 1991 as a result of unfavorable weather. Most notably impacted by the adverse 1992 weather were gas sales to irrigation customers, which were 7.2 Bcf below 1991. Gas sales revenues were positively affected in 1992 by rate increases, including $3.8 million collected in prior years but reserved from earnings for the 1990 eastern and central Nebraska rate case. Transportation revenues in 1992 were $3.4 million higher than 1991 as off-system transport volumes increased by 13.3 Bcf. Natural gas liquids revenues in 1992 were $2.9 million below 1991 as the unfavorable weather affected both prices and volumes. Operating costs and expenses for 1992 were 11 percent below 1991 due principally to reduced on-system throughput and expense controls. Gas purchases declined significantly as a result of lower 1992 gas sales and processing of volumes for natural gas liquids recoveries. In addition, 1992 operations and maintenance expenses were affected by lower provisions for litigation issues. The increase in 1992 taxes, other than income taxes, primarily results from state property tax legislation in Nebraska. In addition to continued growth in nonregulated gas marketing activities, this segment's 1993 and 1992 operating results reflect the Douglas gathering and processing acquisition beginning in October 1992 and the Wattenberg gathering facilities acquisition beginning in April 1993. Additionally, with Order 636 restructuring effective October 1, 1993, this segment assumed the gas sales function previously provided by K N for its wholesale customers as part of its bundled services. The increases in 1993 and 1992 oil and gas revenues and production result from the July 1992 acquisition of producing properties in western Colorado and successful drilling in the Denver-Julesburg Basin in northeastern Colorado. The increase in interest expense primarily reflects the Company's issuance of $195 million of long-term debt during the last three years. The majority of the net proceeds from these debt issues were used to fund capital expenditures and acquisitions; however, $65 million was used to refund higher coupon debt in 1993 and 1992. As a result, the Company's year end 1993 weighted-average embedded cost of long-term debt was 8.3 percent compared with a cost of 9.6 percent at December 31, 1990. The effect of the one percent increase in the Federal tax rate, resulting from enactment of the Revenue Reconciliation Act of 1993, was more than offset by increased 1993 tax credits on gas production from wells qualifying for non-conventional fuel credit under Section 29 of the Internal Revenue Code. The 1991 effective tax rate reflects higher state income tax provisions. LIQUIDITY AND CAPITAL RESOURCES The primary sources of cash during 1993 included cash generated from operations, short-term borrowings and the issuance of long-term debt. Principal cash outflows were capital expenditures and acquisitions, redemptions of long-term debt and preferred stock, and payment of interest and dividends. Cash Flows from Operating Activities Net cash flows from continuing operations were $43.3 million, $33.2 million and $72.1 million for 1993, 1992 and 1991, respectively. In addition to the factors discussed previously, which affect cash generation as well as operating results, net cash flows have been impacted by litigation settlements (including recoupable take-or-pay payments) and environmental costs. In both 1993 and 1992, actual cash disbursements exceeded expense provisions for litigation and environmental issues. Net operating cash flows for 1993 were also reduced by repayments to gas service customers for previous years' over-recovery of gas costs. Capital Expenditures and Commitments Excluding acquisitions, 1993 capital expenditures were $63.1 million compared with expenditures of $60.1 million in 1992 and $59.4 million in 1991. (Refer to Note 13 of Notes to Consolidated Financial Statements for business segment expenditures.) The increased 1993 spending includes approximately $9.0 million of Order 636 transition costs (measurement facilities and systems) and $11.0 million for construction of a new corporate office building. The regulated portion of the Wattenberg system and the Company's portion of the Wind River gathering system primarily account for the $26.8 million of capital expenditures for acquisitions in 1993. Consolidated 1994 capital expenditures are budgeted at $54.5 million, excluding acquisitions. This includes $7.6 million for the first phase of the Rifle to Avon pipeline being jointly constructed by the Company's subsidiary, Rocky Mountain Natural Gas Company, and Public Service Company of Colorado. The second phase of this pipeline will be constructed in 1995; the Company's portion of estimated costs is approximately $5.0 million. In February 1994, K N's oil and gas subsidiaries completed the acquisition of gas reserves and production in western Colorado and southwestern Wyoming. During the first half of 1994, the Company plans to bring in one or more partners to participate in this acquisition and to assist in further development of the properties. The Company has no substantial disagreements related to take-or-pay matters. The Company monitors contractual obligations, including obligations to pay above-market prices under certain contracts, and at the end of each contract year pays those producers to whom take-or-pay amounts are payable. All amounts paid by the Company for take-or-pay are fully recoupable from future gas production. Statement of Financial Accounting Standards No. 112 ("SFAS 112"), "Employers' Accounting for Postemployment Benefits," establishes standards of financial accounting and reporting for the estimated cost of benefits provided by an employer to former or inactive employees after employment but before retirement. SFAS 112 is effective for fiscal years beginning after December 15, 1993. Implementation of SFAS 112 is not expected to have a material effect on the Company's financial position or results of operations. Capital Resources Short-term debt was $47.0 million at December 31, 1993, compared with $2.0 million of borrowings at December 31, 1992. The Company has credit agreements with eight banks to either borrow or use as commercial paper support up to $90 million. In November 1993, K N filed a shelf registration statement with the Securities and Exchange Commission for the sale of $200 million of debt securities in anticipation of long-term financing needs over the next three years. In January 1994, the Company received $41.0 million from the sale of contract demand receivables to a financial institution. The demand receivables resulted from gas sales contracts between some of K N's former wholesale customers and a K N subsidiary. Proceeds were used to reduce short-term debt. The Company expects that 1994 cash requirements for debt service, preferred stock redemptions, dividends and capital expenditures will be provided by internal cash flows, short-term borrowings, and the issuance of common stock for dividend reinvestment and employee benefit plans. OUTLOOK Restructuring and Reorganization The Company's implementation of Order 636 and the related corporate reorganization are discussed in other sections of this annual report. This discussion will focus on the expected 1994 financial implications of these events. As a result of recent acquisitions and the transfer of substantially all of K N interstate's gathering and processing facilities to a nonregulated subsidiary, the composition of 1994's operating income will differ significantly from the past. Historically, the Company's gas service segment has accounted for more than 90 percent of consolidated operating income. The expectation for 1994 is that this segment will account for approximately 65 to 70 percent of operating income. Secondly, Order 636 mandated the use of SFV rate design for FERC- regulated services. Accordingly, fluctuations in operating revenues resulting from significant variations in weather temperatures should be reduced. Revenues from the Company's important summer irrigation load will remain vulnerable to abnormal weather patterns, such as those experienced in 1993 and 1992. Finally, the effect of both of the above items is expected to change the Company's historical quarterly earnings distribution. The 1994 first and fourth quarters will account for a smaller percentage of annual earnings, while the second and third quarters will be higher. Gas Service The Company's Order 636 implementation and reorganization will significantly impact this business segment's future operating results. The transfer of substantially all of K N interstate's gathering facilities and the principal processing plant to a subsidiary within the gas marketing and gathering segment will result in a significant shift in operating revenues, expenses and operating income. Additionally, with the elimination of the merchant function from FERC-regulated services, this segment's operating revenues and gas purchases will be substantially lower than prior periods; however, this elimination should not impact operating income. Operating results for 1994 should benefit from a full year's operation of the Wattenberg transmission system and from rate increases placed into effect during 1993. As a result of the unbundling and the diverse services offered under the post-Order 636 environment, competition will increase. The Company believes that its interstate and intrastate systems are well-positioned to capitalize on opportunities resulting from future development of natural gas reserves in the Rocky Mountain region. The Company expects continued moderate growth in its retail distribution operations due, principally, to the continued customer additions being realized by its Colorado intrastate system. Gas Marketing and Gathering On January 1, 1994, substantially all of the gathering facilities and the principal processing plant, which were previously a part of the K N interstate system, were transferred to a subsidiary within the gas marketing and gathering business segment. This segment's 1993 operating results included only partial year activity of the Wattenberg nonregulated gathering system and the Wind River gas gathering joint venture. Accordingly, this segment's 1994 operating revenues, expenses and operating income are expected to be significantly higher than in 1993. Oil and Gas Production The February 1994 acquisition of producing properties and undeveloped gas reserves in western Colorado and southwestern Wyoming is expected to have a positive impact on 1994 operating results of this business segment. The Company also believes that its involvement in oil and gas development and production provides opportunities to enhance the value of its associated gas service, gathering and processing businesses. Litigation During the last three years, the Company has resolved or settled four major cases or environmental matters -- three cases related to the Brookhurst Subdivision Superfund site near Casper, Wyoming, and long-standing litigation with FM Properties Inc. and other parties. Refer to Note 5 of Notes to Consolidated Financial Statements for additional information on the Company's pending litigation. Management believes it has established adequate reserves such that resolution of pending litigation or environmental matters will not have a material adverse effect on the Company's financial position or results of operations. INFLATION Current ratemaking practices allow the Company to recover through revenues the historical cost, rather than the current replacement cost, of utility plant and equipment. In the past three years, the rate of inflation has not had a material impact on the Company's costs. ITEM 8:

ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ____________________________________________________ Report of Independent Public Accountants To K N Energy, Inc.: We have audited the accompanying consolidated balance sheets of K N Energy, Inc. (a Kansas corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, common stockholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of K N Energy, Inc. and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As explained in Notes 1(D) and 9 of Notes to Consolidated Financial Statements, the Company changed its method of accounting for income taxes effective January 1, 1992, and its method of accounting for postretirement benefits other than pensions effective January 1, 1993. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index of financial statements are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. Denver, Colorado, February 10, 1994. The accompanying notes are an integral part of these statements. The accompanying notes are an integral part of these balance sheets. The accompanying notes are an integral part of these statements. The accompanying notes are an integral part of these statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Summary of Significant Accounting Policies (A) Principles of Consolidation The consolidated financial statements include the accounts of K N Energy, Inc. ("K N") and all of its subsidiaries (the "Company"). All material intercompany items and transactions have been eliminated. (B) Basis of Accounting The accounting policies of the Company conform to generally accepted accounting principles. For the regulated public utilities in the Company, these accounting principles are applied in accordance with Statement of Financial Accounting Standards No. 71, which prescribes the circumstances in which the application of generally accepted accounting principles is affected by the economic effect of regulation. (C) Gas Service Revenues Natural gas revenues are recorded on the basis of gas delivered to customers to the end of each accounting period. This includes unbilled revenues representing the estimated amount customers will be billed for gas delivered from the time meters were last read to the end of the accounting period, net of cost of gas where applicable. Gas transportation revenues are recorded on the basis of capacity reserved on and gas transported through the pipeline systems. The Company receives a fee for its transportation services; however, there are no purchased gas expenses associated with the transportation function. (D) Income Taxes The Company implemented Statement of Financial Accounting Standards No. 109 ("SFAS 109"), "Accounting for Income Taxes," effective as of January 1, 1992. SFAS 109 requires recognition of deferred income tax assets and liabilities based on enacted tax laws for all temporary differences between financial reporting and tax bases of assets and liabilities. Deferred tax assets are reduced by a valuation allowance for the amount of any tax benefit that, more likely than not, is expected to not be realized. The adoption of SFAS 109 had an insignificant effect on the Company's financial position and results of operations, since the Company had already adopted the liability method of accounting under Statement of Financial Accounting Standards No. 96. (E) Earnings Per Share Earnings per share are computed based on the monthly weighted average number of common shares outstanding during the periods. There are no other securities or common stock equivalents which have a material dilutive effect on earnings per share. On August 10, 1993, K N's Board of Directors declared a three-for-two common stock split which was distributed on October 4, 1993, to common shareholders of record on September 15, 1993. The par value of the common stock did not change. All weighted average and per share amounts in the accompanying financial statements have been restated to reflect the stock split. The weighted average number of common shares outstanding was 14,913,000 in 1993, 14,580,000 in 1992 and 14,459,000 in 1991. (F) Nonutility Gas Marketing Subsidiaries Gas marketing subsidiaries' revenues are included in "Gas Marketing and Gathering," and their gas purchase costs are included in "Gas Purchases." (G) Prepaid Gas Prepaid gas represents payments made in lieu of taking delivery of (and purchasing) natural gas under the take-or-pay provisions of the Company's gas purchase contracts, net of any subsequent recoupments in kind from producers. All funds paid by the Company for take-or-pay are fully recoupable from future production, and are recorded as an asset (Prepaid Gas). When recoupment is made in kind in a subsequent contract year, natural gas purchase expense is recorded and the asset is reduced. (H) Property, Plant and Equipment Utility plant is stated at the original cost of construction, which includes indirect costs such as payroll taxes, fringe benefits, administrative and general costs and an allowance for funds used during construction. Expenditures which increase capacities or extend useful lives are capitalized. Routine maintenance, repairs and renewal costs are expensed as incurred. The cost of depreciable utility property, plant and equipment retired, plus the cost of removal less salvage, is deducted from accumulated depreciation with no effect on current period earnings. (I) Exploration and Development Costs K N's oil and gas subsidiaries follow the "successful efforts" method of accounting. Under this method, acquisition costs, successful exploration costs and development costs are capitalized and unsuccessful exploration costs, lease rentals and evaluation costs are expensed. (J) Depreciation, Depletion and Amortization Depreciation is computed based on the straight-line method over the estimated useful life for most utility property, plant and equipment. The unit-of-production method is used for computing depreciation, depletion and amortization for oil and gas properties. (K) Gas in Underground Storage K N's regulated interstate retail distribution business and Northern Gas Company record storage injections at the average cost of purchased gas for the year. Storage withdrawals are priced on the last-in first-out ("LIFO") method. K N Gas Supply Services, Inc., a nonjurisdictional subsidiary, prices storage injections at the average cost of purchased gas each month. Storage withdrawals are priced at the average cost of storage gas at the beginning of each month. Rocky Mountain Natural Gas Company prices storage injections at the average cost of purchased gas for the year. Storage withdrawals are priced on the first-in first-out ("FIFO") method. The Company also maintains gas in its underground storage facilities on behalf of certain third parties. The Company receives a fee for its storage services but does not reflect the value of third party gas in the accompanying financial statements. (L) Deferred Revenues In January 1994, contract demand receivables with a face amount of $41 million were sold to a financial institution. No gain or loss was recorded on the sale. The Company is deferring revenues from certain gas sales agreements associated with these receivables pending final disposition of related gas purchase contracts. (M) Reclassification of Prior Year Amounts Certain prior year amounts have been reclassified to conform with the 1993 presentation. (N) Cash Flow Information The Company considers all highly-liquid investments purchased with an original maturity of three months or less to be cash equivalents. Changes in Other Working Capital Items Summary, Supplemental Disclosures of Cash Flow Information and Supplemental Schedule of Noncash Investing and Financing Activities are as follows: (B) In connection with the exchange and lease of gathering and processing facilities described in Note 4(D), the Company exchanged its interest in the Tyrone Gas Gathering system as a portion of the consideration. 2. Restructuring and Reorganization On April 8, 1992, the Federal Energy Regulatory Commission ("FERC") issued Order No. 636 ("Order 636") which requires a fundamental restructuring of interstate natural gas pipelines. A separate restructuring docket was established for each interstate pipeline, including K N (Docket No. RS92-19-000). On November 2, 1992, K N made its compliance filing reflecting K N's proposal for its restructured services to implement Order 636. K N's proposal was revised in response to subsequent FERC orders. As authorized by FERC, K N implemented Order 636 restructured services on October 1, 1993. As a part of its action on K N's restructuring proposal, FERC approved implementation of K N's gas supply realignment ("GSR") crediting mechanism. K N requested FERC approval, as a result of Order 636, to transfer all of its interstate transmission and storage facilities to K N Interstate Gas Transmission Co. ("KNI"), a wholly-owned jurisdictional subsidiary of K N, and substantially all of its gathering and processing facilities to K N Gas Gathering, Inc. ("KNGG"), a nonjurisdictional wholly-owned subsidiary of K N. In its May 5, 1993 order, FERC approved the transfer of K N's interstate gas transmission and storage facilities to KNI effective October 1, 1993. On November 1, 1993, FERC authorized the transfer of gathering and processing facilities from KNI to KNGG. The transfer was effective January 1, 1994, and included approximately $70 million of gross property, plant and equipment. Order 636 required pipelines to unbundle sales and transportation services. KNI has complied with FERC's directive to mitigate its GSR costs caused by this restructuring. KNI's GSR process allows for the assignment of its above-market contracts. Under KNI's tariff, every shipper has a right to take assignment of these above- market contracts. Shippers may either take assignment of these above- market contracts or enter into a negotiated exit fee. This should obviate the need to make any GSR cost recovery filing with FERC. 3. Regulatory Matters On December 30, 1993, KNI made a rate filing with FERC requesting a $12.0 million annual increase in revenues. The new rates will become effective July 1, 1994, subject to refund. In February 1992, K N filed a rate restatement with FERC pursuant to FERC's purchased gas adjustment regulations. The filing proposed no change in K N's current rates. K N submitted an offer of Settlement and Stipulation ("Settlement") in August 1993. FERC approved the Settlement on November 17, 1993. Terms of the Settlement did not have a material effect on K N's financial position or results of operations. In February 1993, K N filed general rate applications in all 177 retail Nebraska communities it serves, requesting an increase in aggregate annual revenues of $2.2 million. Pursuant to Nebraska statute, the new rates became effective May 2, 1993, subject to refund. An agreement was reached in August 1993, between the Company and representatives of the 10 rate areas in Nebraska. Under the terms of the agreement, K N received a $1.4 million annual rate increase. Revenues collected above the settlement rates were refunded to the customers in December 1993. In June 1990, K N filed general rate applications in 147 central and eastern Nebraska communities requesting an increase in aggregate annual revenues of $6.7 million. Pursuant to Nebraska statute, the new rates were put into effect on October 1, 1990, subject to refund. The majority of the communities adopted a lower rate increase. K N filed for injunctions against these communities. On August 27, 1993, the Nebraska Supreme Court ruled that natural gas rates placed into effect by K N as interim rates on October 1, 1990, were properly justified and should be allowed to stand. In 1992, K N reduced the deferred portion of the increased revenues resulting from these rate applications and recorded as revenue $3.8 million of amounts previously deferred in 1990 and 1991. The remaining deferred revenues relating to this matter, totaling $1.6 million, were recorded as revenue in 1993. In June 1992, K N filed an application for a "make whole" rate increase with the Colorado Public Utilities Commission ("CPUC"). The new rates, which resulted in increased annual revenues of $0.7 million, were approved by the CPUC and became effective August 1, 1992. In December 1992, K N filed an application with the Wyoming Public Service Commission ("WPSC") for an annualized general rate increase of $1.2 million. In April 1993, the WPSC issued an order granting K N a $1.1 million annual rate increase effective May 1, 1993. In March 1993, K N filed an application with the Kansas Corporation Commission ("KCC") for an annualized general rate increase of $3.3 million. On October 28, 1993, the KCC issued an order approving a settlement agreement between K N and the interested parties which granted K N a $2.4 million annual rate increase effective October 1, 1993. 4. Acquisitions (A) Wattenberg On April 1, 1993, the Company completed the $48 million acquisition of the Wattenberg natural gas gathering and transmission system. The system has both regulated and nonregulated components. The regulated transmission segment, approximately $18 million of the acquisition, was financed with corporate funds, and the balance of the system was financed through an operating lease. The system gathers and transports gas from approximately 1,800 receipt points in northeastern Colorado. (B) Oil and Gas Reserve Acquisition On February 1, 1994, the Company's oil and gas development subsidiaries, K N Production Company and GASCO, Inc., acquired gas reserves and production properties located near existing K N operations in western Colorado and in the Moxa Arch region of southwestern Wyoming for a total purchase price of approximately $30 million. The acquired properties have total net reserves of approximately 50 billion cubic feet equivalent of natural gas. The Company is discussing the possible sharing of ownership interests and non-recourse financing with other parties. (C) Wind River Effective June 1, 1993, Wind River Gathering Company acquired approximately 110 miles of natural gas pipeline and facilities in Wyoming's Wind River Basin. Wind River Gathering Company is a joint venture between KNGG and a subsidiary of Tom Brown, Inc., a Wind River Basin producer. KNGG manages the operations of the gathering system. KNGG paid approximately $2 million for its interest in the joint venture. (D) Exchange and Lease of Gathering and Processing Facilities On October 1, 1992, K N exchanged its Tyrone gas gathering system located in the Oklahoma panhandle for a natural gas processing plant and gathering system located near Douglas, Wyoming. KNGG is operator of the Douglas system, and entered into an operating lease for the facilities with a financial institution. (E) Distribution Systems On March 31, 1992, K N acquired the stock of two corporations for $3.7 million in net cash. The acquired corporations owned two gas utility distribution systems serving approximately 7,000 customers, mainly in northeastern Wyoming. The acquisition was accounted for as a purchase, and the corporations were merged into K N effective April 1, 1992. 5. Litigation K N is named as one of four potentially responsible parties ("PRPs") at a U.S. Environmental Protection Agency ("EPA") Superfund site, pursuant to the Comprehensive Environmental Response, Compensation and Liability Act ("Superfund"). The site is known as the Mystery Bridge Road/U.S. Highway 20 site located near Casper, Wyoming (the "Brookhurst Subdivision"). The EPA's remedy consists of two parts, "Operating Unit One," which addresses the groundwater cleanup and "Operating Unit Two," which addresses cleanup procedures for the soil and free-phase petroleum product. A Consent Decree between the Company, the EPA and another PRP was entered on October 2, 1991, in the Wyoming Federal District Court. Groundwater cleanup under Operating Unit One has been proceeding since 1990. On September 14, 1993, the EPA certified that the remedial action for Operating Unit One was "operational and functional." This is the last step in the Superfund process prior to remedy completion. In July 1992, the EPA approved the Company's Operating Unit Two workplan and the Company received an EPA "Statement of Work." The work required to be performed for Operating Unit Two commenced during the third quarter of 1992 and is expected to continue through 1995 at a total cost estimated not to be more than $1.0 million. With regard to this same Superfund site, in 1987 the State of Wyoming filed suit against several parties (including K N) for injunctive relief, penalties and unquantified damages claimed to have resulted from alleged pollution of groundwater and soils in the Brookhurst Subdivision. On April 1, 1993, the Wyoming District Court dismissed the lawsuit, finding that K N had diligently remedied the alleged pollution. On October 20, 1989, a lawsuit was filed against the Company and 18 other defendants on behalf of a group of 268 individuals who reside or resided in the Brookhurst Subdivision, seeking damages for alleged releases of certain chemicals to the soil, groundwater and air. On February 5, 1993, the Company reached agreement to settle the above- described dispute. The settlement, which was approved by the Wyoming District Court, resolved all disputes between the parties and closed the lawsuit. A reserve for the settlement amount and related matters had been established in the Company's financial statements prior to 1993 and, accordingly, such settlement did not have any material adverse impact on the Company's financial position or results of operations. On November 30, 1990, the Company initiated an action against a number of its insurance carriers for a declaration of the carriers' contractual obligations to provide insurance coverage for all sums associated with the alleged losses under the state, Federal and toxic tort claims related to the Brookhurst Subdivision. The Company entered into formal settlements with all of the defendants in the lawsuit in 1993, and received settlement proceeds associated therewith. On October 9, 1992, Jack J. Grynberg filed suit in the United States District Court for the District of Colorado against the Company, Rocky Mountain Natural Gas Company and GASCO, Inc. (the "K N Entities") alleging that the K N Entities as well as K N Production Company and KNGG, have violated Federal and state antitrust laws. In essence, Grynberg asserts that the companies have engaged in an illegal exercise of monopoly power, have illegally denied him economically feasible access to essential facilities to transport and distribute gas produced from fewer than 20 wells located in northwest Colorado, and illegally have attempted to monopolize or to enhance or maintain an existing monopoly. Grynberg also asserts certain causes of action relating to a gas purchase contract. No specific monetary damages have been claimed, although Grynberg has requested that any actual damages awarded be trebled. In addition, Grynberg has requested that the K N Entities be ordered to divest all interests in natural gas exploration, development and production properties, all interests in distribution and marketing operations, and all interests in natural gas storage facilities, separating these interests from the Company's natural gas gathering and transportation system in northwest Colorado. On August 13, 1993, the United States District Court, District of Colorado, stayed this proceeding pending exhaustion of appeals in a related state court action involving the same plaintiff. The Company believes it has meritorious defenses to all lawsuits and legal proceedings in which it is a defendant and will vigorously defend against them. Based on its evaluation of the above matters, and after consideration of reserves established, management believes that the resolution of such matters will not have a material adverse effect on the Company's financial position or results of operations. 6. Income Taxes See Note 1(D) regarding the method of accounting for income taxes. Components of the income tax provision applicable to Federal and state income taxes are as follows (in thousands): The difference between the statutory Federal income tax rate and the Company's effective income tax rate is summarized as follows: The Company has recorded deferred regulatory assets of $1.5 million and $2.1 million, and deferred regulatory liabilities of $4.4 million and $7.3 million at December 31, 1993 and 1992, respectively, which are expected to result in cost-of-service adjustments. These amounts reflect the "gross of tax" presentation required under SFAS 109. T he Company reduced its deferred regulatory liability by $2.2 million as a result of the Federal tax rate increase from 34 percent to 35 percent. The deferred tax assets and liabilities and deferred regulatory assets and liabilities for rate-regulated entities computed according to SFAS 109 at December 31, 1993 and 1992 result from the following (in thousands): 7. Financing (A) Notes Payable The Company has credit agreements with eight banks to either borrow or use as commercial paper support, up to a total of $90.0 million at December 31, 1993. At December 31, 1993, $10.0 million was outstanding under the credit agreements at an interest rate of 3.27 percent. No amounts were outstanding under the credit agreements at December 31, 1992. Borrowings are made at prime or a rate less than prime negotiated on the borrowing date and for a term of not more than one year. The Company pays the banks a fee of one quarter of one percent per annum of the unused commitment. Commercial paper issued by the Company represents unsecured short-term notes with maturities up to 270 days from the date of issue. Rates at which commercial paper was issued during the year ranged from 3.2 percent to 3.7 percent. At December 31, 1993 and 1992, $37.0 million and $2.0 million of commercial paper, respectively, were outstanding. (B)Long-Term Debt Long-term debt at December 31, 1993 and 1992 was as follows (in thousands): Maturities of long-term debt for the five years ending December 31, 1998, are as follows (in thousands): (A) Class A $8.50 Preferred Stock The Class A $8.50 Preferred Stock is subject to mandatory redemption through a sinking fund (at $100 per share, plus accrued and unpaid dividends) of $500,000 in 1994. At the option of the Company, this stock is redeemable, in whole or in part, at $100.85 per share during 1994. In each of the years 1993 and 1992, the Company redeemed 10,000 shares subject to mandatory redemption. In 1991, the Company redeemed 10,000 shares subject to mandatory redemption and an additional 25,000 shares at $102.13 per share. (B) Class B $8.30 Preferred Stock The Class B $8.30 Preferred Stock is subject to mandatory redemption through a sinking fund (at $100 per share, plus accrued and unpaid dividends) of $571,400 annually from 1995 through 1998 and $572,000 in 1999. At the option of the Company, this stock is redeemable, in whole or in part, at $101.74 per share prior to January 2, 1995; such redemption price is reduced annually thereafter until January 2, 1998, when it becomes $100 per share. Also, at the option of the Company, 5,714 shares of this stock may be redeemed in each of the years 1994 through 1998, inclusive, at $100 per share. In each of the years 1993, 1992 and 1991, the Company redeemed 5,714 shares subject to mandatory redemption, and an additional 5,714 shares at $100 per share. (C) Class A $5.00 Preferred Stock The Class A $5.00 Preferred Stock is redeemable, in whole or in part, at the option of the Company at any time on 30 days' notice at $105 per share plus accrued dividends. This series has no sinking fund requirements. (D) Rights of Preferred Shareholders All outstanding series of preferred stock have voting rights. If, for any class of preferred stock, the Company (i) is in arrears on dividends, (ii) has failed to pay or set aside any amounts required to be paid or set aside for all sinking funds, or (iii) is in default on any of its redemption obligations, then no dividends shall be paid or declared on any junior stock nor shall any junior stock be purchased or redeemed by the Company. Also, if dividends on any class of preferred stock are sufficiently in arrears, the holders of that stock may elect one-third of the Company's Board of Directors. (E) Combined Aggregate Redemption Requirements The combined aggregate amount of mandatory redemption requirements for all preferred issues for the five years ending December 31, 1998, are as follows (in thousands): (F) Fair Value At December 31, 1993, both the carrying amount and the estimated fair value of K N's outstanding preferred stock subject to mandatory redemption were $3.4 million, compared with $5.5 million and $5.6 million, respectively, at December 31, 1992. The fair value of K N's preferred stock is estimated based on an evaluation made by an independent security analyst. 9. Employee Benefits (A) Retirement Plans The Company has defined benefit pension plans covering substantially all full-time employees. These plans provide pension benefits that are based on the employees' compensation during the period of employment. These plans are tax qualified subject to the minimum funding requirements of ERISA. The Company's funding policy is to contribute annually the recommended contribution using the actuarial cost method and assumptions used for determining annual funding requirements. Plan assets consist primarily of pooled fixed income and equity funds. Net pension cost for 1993, 1992 and 1991 included the following components (in thousands): The following table sets forth the plans' funded status and amounts recognized in the Company's financial statements at December 31, 1993 and 1992 (in thousands): The rate of increase in future compensation and the expected long-term rate of return on assets were 4.5 percent and 8.5 percent, respectively, for 1993, and 5.0 percent and 9.25 percent, respectively, for 1992 and 1991. The weighted average discount rate used in determining the actuarial present value of the projected benefit obligation was 7.5 percent for all three periods. The Company also contributes the lesser of ten percent of the Company's net income or ten percent of normal employee compensation to the Employees Retirement Fund Trust Profit Sharing Plan (a defined contribution plan). Contributions by the Company were $2,588,000, $2,090,000 and $464,000 for 1993, 1992 and 1991, respectively. (B) Other Postretirement Employee Benefits The Company has a defined benefit postretirement plan providing medical care benefits upon retirement for all eligible employees with at least five years of credited service as of January 1, 1993, and their eligible dependents. Retired employees are required to contribute monthly amounts which depend upon the retired employee's age, years of service upon retirement and date of retirement. This plan also provides life insurance benefits upon retirement for all employees with at least ten years of credited service who are age 55 or older when they retire. The Company pays for a portion of the life insurance benefit; employees may at their option increase the benefit by making contributions from age 55 until age 65 or retirement, whichever is earlier. In 1993, the Company began funding the future expected postretirement benefit costs under the plan by making payments to Voluntary Employee Benefit Association trusts. The Company's funding policy is to contribute amounts within the deductible limits imposed on Internal Revenue Code Sec. 501(c)(9) trusts. Plan assets consist primarily of pooled fixed income funds. Effective January 1, 1993, the Company prospectively adopted Statement of Financial Accounting Standards No. 106 ("SFAS 106") which requires the accrual of the expected costs of postretirement benefits other than pensions during the years that employees render service. The Accumulated Postretirement Benefit Obligation ("APBO") of the plan at January 1, 1993, was approximately $18.8 million. The Company has elected to amortize this transition obligation to expense over a 20- year period. Net postretirement benefit cost for the defined benefit plan in 1993 included the following components (in thousands): Prior to 1993, the cost of providing medical care benefits to retired employees was recognized as expense as claims were paid, and the cost of life insurance benefits for retirees was not accrued. Instead, life insurance claims were paid from a trust fund resulting from termination of third party coverage. The Company's net cost of medical care claims for retirees was approximately $1.2 million and $1.1 million in 1992 and 1991, respectively. In 1993, the incremental effect on postretirement cost as a result of adopting SFAS 106 was a $1.3 million increase. The following table sets forth the plan's funded status and the amounts recognized in the Company's financial statements at December 31, 1993(in thousands): The weighted average discount rate used in determining the actuarial present value of the APBO was 7.5 percent; the assumed health care cost trend rate was 11 percent for 1993, nine percent for 1994 and seven percent for 1995 and beyond. A one-percentage-point increase in the assumed health care cost trend rate for each future year would have increased the aggregate of the service and interest cost components of the 1993 net periodic postretirement benefit cost by $0.1 million and would have increased the APBO as of December 31, 1993, by $0.1 million. K N's interstate retail distribution business, in connection with rate filings described in Note 3 for Kansas, Nebraska and Wyoming, has received regulatory approval to include in the cost-of-service component of its rates the cost of postretirement benefits as measured by application of SFAS 106. In addition, KNI has requested similar regulatory treatment from FERC in connection with its rate filing, also described in Note 3. At December 31, 1993, no SFAS 106 costs were deferred as regulatory assets. (C) Other Postemployment Benefits In November 1992, FASB issued SFAS 112, which establishes standards of financial accounting and reporting for the estimated cost of benefits provided by an employer to former or inactive employees after employment but before retirement. SFAS 112 is effective for fiscal years beginning after December 15, 1993. Implementation of SFAS 112 is not expected to have a material effect on the Company's financial position or results of operations. 10. Common Stock Option and Purchase Plans The Company has incentive stock option plans for key employees and nonqualified stock option plans for its nonemployee directors. Under the plans, options are granted at not less than 100 percent of the market value of the stock at the date of grant. Pursuant to amendments to the plans' provisions, options granted after 1989 vest over three to five years and expire ten years after date of grant. Under earlier grants, all options vested immediately or within three years and are exercisable for ten years from date of grant. At December 31, 1993, 91 employees, officers and directors held options under the plans. The changes in stock options outstanding during 1993, 1992 and 1991 are as follows, restated to reflect the three-for-two common stock split described in Note 1(E): Unexercised options outstanding at December 31, 1993, expire at various dates between 1994 and 2003. Effective April 1, 1990, and for each succeeding year, the Company established an Employee Stock Purchase Plan under which eligible employees may purchase the Company's common stock through voluntary payroll deductions at a 15 percent discount from the market value of the common stock, as defined in the plan. Under the Company's Stock Option, Dividend Reinvestment, Employee Stock Purchase and Employee Benefit Plans, 2,111,299 shares were reserved for issuance at December 31, 1993. 11. Commitments and Contingent Liabilities (A) Leases In 1993, K N Front Range Gathering Company began to lease gas gathering equipment and facilities under a ten-year operating lease. Also in 1993, K N and certain subsidiaries began to lease various furniture, fixtures and vehicles under various operating leases with terms from three to seven years. In 1992, KNGG began to lease gas gathering facilities and processing equipment under a seven-year operating lease. All of these operating leases contain purchase options at the end of their lease terms. Payments made under operating leases were $5.2 million in 1993, $2.4 million in 1992 and $1.9 million in 1991. Future minimum commitments under major operating leases for the five years ending December 31, 1998 and thereafter are as follows (in thousands): (B) Capital Expenditure Budget The consolidated capital expenditure budget for 1994 is approximately $54.5 million, excluding acquisitions. Approximately $2.0 million had been committed for the purchase of plant and equipment at December 31, 1993. 12. Discontinued Operations On June 1, 1991, K N sold its wholly-owned coal mining subsidiaries, Wyoming Fuel Company and North Central Energy Company. The Company received cash proceeds of $7.2 million, and receives a royalty interest on all future coal mined and sold from the southern Colorado properties. The results of operations of the coal mining subsidiaries have been accounted for as discontinued operations in the financial statements. Following is a summary of revenues, loss from operations and loss on sale of this discontinued business (in thousands): 13. Business Segment Information The Company's principal operations are the sale and transportation of natural gas ("Gas Service"), nonregulated gas marketing and gathering ("Gas Marketing and Gathering") and exploration, development and production of oil and gas ("Oil and Gas Production"). Total revenues by segment include sales to unaffiliated customers. General corporate income and expenses, interest expense and income taxes are not included in the computation of operating income. Identifiable assets by segment are those assets used in the Company's operations in each segment. Corporate assets are principally cash and investments. (1) Restated to reflect a three-for-two common stock split in 1993. ITEM 9:

ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING _____________________________________________________________________ AND FINANCIAL DISCLOSURE ________________________ There were no such matters during 1993. PART III ITEM 10:

ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ____________________________________________________________ (A) Identification of Directors ___________________________ For information regarding the Directors, see pages 2-3 of the 1994 Proxy Statement. (B) Identification of Executive Officers ____________________________________ See Executive Officers of the Registrant under Part I. (C) Identification of Certain Significant Employees _______________________________________________ None. (D) Family Relationships ____________________ None. (E) Business Experience ___________________ See Executive Officers of the Registrant under Part I. (F) Involvement in Certain Legal Proceedings ________________________________________ See Executive Officers of the Registrant under Part I. (G) Promoters and Control Persons _____________________________ None. ITEM 11:

ITEM 11: EXECUTIVE COMPENSATION ________________________________ See "Executive Compensation", "Stock Options", "Pension Benefits" and "Director Compensation" on pages 4-5, 8-10, 12 and 13 of the 1994 Proxy Statement. ITEM 12:

ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ________________________________________________________________________ See the following pages of the 1994 Proxy Statement: (i) pages 2-3 relating to common stock owned by directors; (ii) page 11, "Executive Stock Ownership"; and (iii) pages 18-19, "Principal Shareholders". ITEM 13:

ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ________________________________________________________ (A) Transactions with Management and Others _______________________________________ See "Relationship Between Certain Directors and the Company" on page 4 of the 1994 Proxy Statement. (B) Certain Business Relationships ______________________________ See "Relationship Between Certain Directors and the Company" on page 4 of the 1994 Proxy Statement. (C) Indebtedness of Management __________________________ None. (D) Transactions with Promoters ___________________________ Not applicable. PART IV ITEM 14:

ITEM 14: EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON ________________________________________________________________ FORM 8-K ________ (a) See the index for a listing and page numbers of financial statements, financial statement schedules and exhibits included herein or incorporated by reference. Executive Compensation Plans and Arrangements _____________________________________________ Form of Key Employee Severance Agreement (Exhibit 10.2, Amendment No. 1 on Form 8 dated September 2, 1988 to the Annual Report on Form 10-K for the year ended December 31, 1987)* 1982 Stock Option Plan for Nonemployee Directors of the Company with Form of Grant Certificate (Exhibit 10.3, Amendment No. 1 on Form 8 dated September 2, 1988 to the Annual Report on Form 10-K for the year ended December 31, 1987)* 1982 Incentive Stock Option Plan for key employees of the Company (Exhibit 10.4, Amendment No. 1 on Form 8 dated September 2, 1988 to the Annual Report on Form 10-K for the year ended December 31, 1987)* 1986 Incentive Stock Option Plan for key employees of the Company (Exhibit 10.5, Amendment No. 1 on Form 8 dated September 2, 1988 to the Annual Report on Form 10-K for the year ended December 31, 1987)* 1988 Incentive Stock Option Plan for key employees of the Company (Exhibit 10.6, Amendment No. 1 on Form 8 dated September 2, 1988 to the Annual Report on Form 10-K for the year ended December 31, 1987)* Form of Grant Certificate for Employee Stock Option Plans (Exhibit 10.7, Amendment No. 1 on Form 8 dated September 2, 1988 to the Annual Report on Form 10-K for the year ended December 31, 1987)* Directors' Deferred Compensation Plan Agreement (Exhibit 10.8, Amendment No. 1 on Form 8 dated September 2, 1988 to the Annual Report on Form 10-K for the year ended December 31, 1987)* 1987 Directors' Deferred Fee Plan and Form of Participation Agreement regarding the Plan (Exhibit 10.9, Amendment No. 1 on Form 8 dated September 2, 1988 to the Annual Report on Form 10-K for the year ended December 31, 1987)* 1992 Stock Option Plan for Nonemployee Directors of the Company with Form of Grant Certificate (Exhibit 4.1, File No. 33-46999)* K N Energy, Inc. 1993 Executive Incentive Plan (Exhibit 10(k) to the Annual Report on Form 10-K for the Year Ended December 31, 1992)* K N Energy, Inc. 1994 Executive Incentive Plan (attached hereto as Exhibit 10(k))** 1994 K N Energy, Inc. Long-Term Incentive Plan (Attachment A to the K N Energy, Inc. 1994 Proxy Statement on Schedule 14-A)* (b) Reports on Form 8-K On February 3, 1994, the Company filed a Form 8-K which disclosed that on February 1, 1994, K N's gas reserves development subsidiaries, K N Production Company and GASCO, Inc., acquired gas reserves and production properties located near existing K N operations in western Colorado and in the Moxa Arch region of southwestern Wyoming from Fuel Resources Development Co., a subsidiary of Public Service Co. of Colorado.* * Incorporated herein by reference. ** Included in SEC and NYSE copies only. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. K N ENERGY, INC. (Registrant) March 23, 1994 By /s/ E. Wayne Lundhagen ______________________________________ E. Wayne Lundhagen Vice President - Finance and Accounting Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Chairman, Chief Executive Officer and Director /s/ Charles W. Battey (Principal Executive Officer) March 23, 1994 ___________________________ Charles W. Battey /s/ Stewart A. Bliss Director March 23, 1994 ___________________________ Stewart A. Bliss /s/ David W. Burkholder Director March 23, 1994 ___________________________ David W. Burkholder /s/ Robert H. Chitwood Director March 23, 1994 ___________________________ Robert H. Chitwood /s/ Howard P. Coghlan Director March 23, 1994 ___________________________ Howard P. Coghlan /s/ Robert B. Daugherty Director March 23, 1994 ___________________________ Robert B. Daugherty /s/ Jordan L. Haines Director March 23, 1994 ___________________________ Jordan L. Haines /s/ Larry D. Hall Director March 23, 1994 ___________________________ Larry D. Hall /s/ William J. Hybl Director March 23, 1994 ___________________________ William J. Hybl Vice President - Finance and Accounting (Principal Financial and Accounting /s/ E. Wayne Lundhagen Officer) March 23, 1994 ___________________________ E. Wayne Lundhagen /s/ H. A. True, III Director March 23, 1994 ___________________________ H. A. True, III SCHEDULE VI SCHEDULE IX K N ENERGY, INC. AND SUBSIDIARIES SHORT-TERM BORROWINGS THREE YEARS ENDED DECEMBER 31, 1993 The Company has credit agreements with eight banks to either borrow or use as commercial paper support, up to a total of $90.0 million at December 31, 1993. Borrowings are made at prime or a rate less than prime negotiated on the borrowing date and for a term of not more than one year. The Company pays the banks a fee of one-quarter of one percent per annum of the unused commitment. Commercial paper issued by the Company represents unsecured short-term notes with maturities up to 270 days from the date of issue. Rates at which commercial paper was issued during the year ranged from 3.2 percent to 3.7 percent. Amounts outstanding during the year and at year-end, and related interest rates, were as follows: (A) The average borrowings were determined based on the total of daily outstanding principal balances divided by the number of days in the year. (B) The weighted average interest rates during the period were computed by dividing the actual interest expense by the average short-term debt outstanding. SCHEDULE X K N ENERGY, INC. AND SUBSIDIARIES SUPPLEMENTARY INCOME STATEMENT INFORMATION THREE YEARS ENDED DECEMBER 31, 1993 The amounts of depreciation and amortization of intangible assets, preoperating costs and similar deferrals, and advertising costs are not considered to be significant. The amount of taxes, other than payroll and income taxes, maintenance and repairs, and royalties for 1993, 1992 and 1991, are as follows: EXHIBIT 12 EXHIBIT 13 K N ENERGY, INC. ________________ 1993 ANNUAL REPORT TO SHAREHOLDERS __________________________________ Interested persons may receive a copy of the Company's 1993 Annual Report to Shareholders without charge by forwarding a written request to: K N Energy, Inc., Securities Services Department, P. O. Box 281304, Lakewood, Colorado 80228-8304. EXHIBIT 22 K N ENERGY, INC. AND SUBSIDIARIES SUBSIDIARIES OF THE REGISTRANT State of Name of Company Incorporation __________________________________________________ _____________ Colorado Gasmark, Inc. (inactive). . . . . . . . . Colorado GASCO, Inc.. . . . . . . . . . . . . . . . . . . . Colorado KNE Acquisition Corporation. . . . . . . . . . . . Delaware K N Dakota Company (inactive). . . . . . . . . . . Colorado K N Front Range Operating Company. . . . . . . . . Colorado K N Gas Gathering, Inc.. . . . . . . . . . . . . . Colorado *K N Front Range Gathering Company . . . . . . . Colorado K N Gas Marketing, Inc.. . . . . . . . . . . . . . Colorado K N Gas Supply Services, Inc.. . . . . . . . . . . Colorado K N Interstate Gas Transmission Co.. . . . . . . . Colorado K N Optima Company (inactive). . . . . . . . . . . Colorado K N Production Company . . . . . . . . . . . . . . Delaware K N Trading, Inc.. . . . . . . . . . . . . . . . . Delaware K N TransColorado, Inc.. . . . . . . . . . . . . . Colorado K N Wattenberg Company . . . . . . . . . . . . . . Colorado *K N Wattenberg Transmission Limited Liability Company . . . . . . . . . . . . . . . . . . . . Colorado Midlands Transportation Company. . . . . . . . . . Kansas Northern Gas Company . . . . . . . . . . . . . . . Wyoming R M N G Gathering Co.. . . . . . . . . . . . . . . Colorado Rocky Mountain Natural Gas Company . . . . . . . . Colorado *T C P Gathering Co. . . . . . . . . . . . . . . Colorado Slurco Corporation . . . . . . . . . . . . . . . . Colorado Slurco, Inc. (inactive). . . . . . . . . . . . . . Kansas Sunflower Pipeline Company . . . . . . . . . . . . Kansas Wyoming Gasmark, Inc. (inactive) . . . . . . . . . Delaware *Second tier subsidiary of K N; subsidiary of entity listed directly above. All of the subsidiaries named above are included in the consolidated financial statements of the Registrant included herein. EXHIBIT 24 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS _________________________________________ As independent public accountants, we hereby consent to the incorporation by reference in (i) Registration Statements on Form S-16, File Nos. 2-51894, 2-55664, 2-63470 and 2-75654; (ii) Registration Statements on Form S-8, File Nos. 2-77752, 33-10747, 33-24934 and 33- 33018; and (iii) Registration Statements on Form S-3, File Nos. 2-84910, 33-26314, 33-23880, 33-42698, 33-44871, 33-45091, 33-46999 and 33-51115 of our report dated February 10, 1994, on the consolidated financial statements of K N Energy, Inc. and subsidiaries and on supplemental Schedules V, VI, IX and X included in this Form 10-K for the year ended December 31, 1993. /s/ Arthur Andersen & Co. Denver, Colorado. March 23, 1994.

37785_1993.txt

37785

1993

Item 1. Business (a) General Development of Business Annual Report to Stockholders (Exhibit 13), pages 1-18,34,35 (b) Financial Information About Industry Segments Annual Report to Stockholders, (Exhibit 13) pages 5, 18-19, 33 (c) Narrative Description of Business Annual Report to Stockholders, (Exhibit 13) pages 1-25,33,35, 45-46,50-52,54-55 (d) Financial Information About Annual Report to Stockholders, Foreign and Domestic Operations (Exhibit 13) page 45-46 and Export Sales Item 2.

Item 2. Properties Annual Report to Stockholders, (Exhibit 13) pages 15-16,54-55 Item 3.

Item 3. Legal Proceedings Annual Report to Stockholders, (Exhibit 13) pages 20-21,50-51 Item 4.

Item 4. Submission of Matters to a Vote of Security Holders (Not Applicable) EXECUTIVE OFFICERS OF THE REGISTRANT The Executive Officers of FMC Corporation, together with the offices in FMC Corporation presently held by them, their business experience since January 1, 1989, and their ages, are as follows: Age Office; year of election; Name 3/15/94 and other information for past 5 years Robert N. Burt 56 Chairman of the Board and Chief Executive Officer (91);President (90-93); Executive Vice President (88); Vice President (78); General Manager-Defense Systems Group (83); General Manager-Agricultural Chemical Group (77) Larry D. Brady 51 President (93) and a Director (89); Executive Vice President (89-93) Vice President-Corporate Development (88); Vice President and General Manager- Agricultural Chemical Group (83); Manager, Citrus Machinery Division (81-83) William F. Beck 55 Vice President (86) and General Manager-Chemical Products Group (86); President of FMC Europe (91); Director of Business Planning (84-86) Jerome D. Brady 50 Vice President (92) and General Manager-Food Machinery Group (92); Vice President, Harsco Corporation (78-92) Cheryl A. Francis 40 Treasurer (93); Adjunct Professor, University of Chicago Graduate School of Business (91-93); various financial positions with FMC (79-91); Vice President-Finance, FMC Gold Company (87-89) W. Reginald Hall 58 Vice President (91) and General Manager-Specialty Chemicals Group (92) General Manager-Food Machinery Group (90); General Manager-Food Processing Systems (86-90) Robert I. Harries 50 Vice President (92) and Deputy General Manager-Chemical Products Group (92) Patrick J. Head 61 Vice President and General Counsel (81) Robert B. Hoffman 57 Vice President (90); International Consultant (88-90); Executive Vice President, Staley Continental (85-88); Executive Vice President, Castle & Cooke, Inc. (84-85); Vice President and Chief Financial Officer, FMC (75- 84) Lawrence P. Holleran 63 Vice President-Human Resources (88); Director, Human Resources (85-88); Director, Employee Relations and Management Development (77-85) Dan W. Irwin 53 Vice President-Technology, Manufacturing and Information Services (87); Director- Information resources (84-87); Director- Business Planning (80-84) William J. Kirby 56 Vice President-Administration (85); Vice President- Personnel (76-85) Arthur D. Lyon 57 Vice President-Finance (87); Vice President (82) and Controller (77) James A. McClung 56 Vice President (91); Vice President- International (81-91) Earl M. Morgan 63 Vice President (91); General Manager- Agricultural Chemical Group (90); General Manager-International Department of Agricultural Chemical Group (76-90) Joseph Netherland 47 Vice President (87) and General Manager-Petroleum Equipment Group (86), Specialized Machinery Group (89); Manager- Wellhead Equipment Division (84); Manager-Fluid Control Division (83) Thomas W. Rabaut 45 Vice President (94), President and Chief Executive Officer, United Defense, L.P. (94); General Manager, Defense Systems Group (93); Manager, Ground Systems Division (90-93) and Director of Operations for that Division (89-90) Frank A. Riddick, III 37 Controller (93); Treasurer (90-93); previously with Merrill Lynch (87-90) most recently as Vice President, Mergers and Acquisitions; various finance-related positions with General Motors Corporation (84-87) William J. Wheeler 51 Vice President (91); President, FMC Asia-Pacific (91); General Manager, Phosphorus Chemical Division (86-91) Scott H. Williamson 42 Vice President-Corporate Development (93); Vice President, Acquisitions and Development, Itel Corporation (85-93) Each of the Company's executive officers has been employed by the Company in a managerial capacity for the past five years except for Messrs. J. Brady, Hoffman, Riddick and Williamson and Ms. Francis. No family relationships exist between any of the above-listed officers and there are no arrangements or understandings between any of them and any other person pursuant to which they were selected as an officer. All officers are elected to hold office for one year and until their successors are elected and qualify. 10-K Item No. Incorporated by Reference From: Part II. Item 5.

Item 5. Market for Registrant's Annual Report to Common Equity and Related Stockholders, (Exhibit 13) Stockholder Matters pages 23,25, 43-45, 59-60 Item 6.

Item 6. Selected Financial Data Annual Report to Stockholders, Exhibit 13) pages 34-35, 48-51, 59 Item 7.

Item 7. Management's Discussion Annual Report to Stockholders, and Analysis of Financial (Exhibit 13) pages 1-25, 28-29, 31-52, Condition and Results of 54-55 Operations Item 8.

Item 8. Financial Statements and Annual Report to Stockholders, Supplementary Data (including (Exhibit 13) pages 26-53 all Schedules required under Item 14 of Part IV) Item 9

Item 9 Changes in and disagree- ments with Accountants on Account- ing and Financial Disclosure (Not Applicable) PART III. Item 10

Item 10 Directors and Executive Part 1; Proxy Statement for Officers of the Registrant 1994 Annual Meeting of Stockholders pages 2-8,21; Item 11

Item 11 Executive Compensation Proxy Statement for 1994 Annual Meeting of Stockholders pages 9-10, 13-20 Item 12.

Item 12. Security Ownership of Proxy Statement for 1994 Annual Certain Beneficial Owners Meeting of Stockholders, pages 11-12 and Management Item 13.

Item 13. Certain Relationships Proxy Statement for 1994 Annual and Related Transactions Meeting of Stockholders, page 10 PART IV. Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) Documents filed with this Report 1. Consolidated financial statements of FMC Corporation and its subsidiaries are incorporated under Item 8 of this Form 10-K. 2. All required financial statement schedules are included in the consolidated financial statements or notes thereto as incorporated under Item 8 of this Form 10-K. 3. Exhibits: See attached exhibit index, page 6. (b) Reports on Form 8-K 1. Report filed on December 10, 1993, regarding restructuring and other charges including writedown of carrying value of certain assets. (c) Exhibits See Index of Exhibits. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. FMC CORPORATION (Registrant) Arthur D. Lyons By_________________ Arthur D. Lyons Vice President-Finance Date: March 28, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated. Signature Title Arthur D. Lyons Vice President-Finance and Principal Financial Officer Arthur D. Lyons Frank A. Riddick Controller and Principal Accounting Officer Robert N. Burt Chairman of the Board and Chief Executive Officer William W. Boeschenstein Director Larry D. Brady Director B. A. Bridgewater, Jr. Director Paul L. Davies, Jr. Director Jean A. Francois-Poncet Director Robert H. Malott Director Edward C. Meyer Director James R. Thompson Director Clayton Yeutter Director By: Robert L. Day Robert L. Day Attorney-in-fact March 28, 1994DOCUMENT HEADER DOCUMENT DESCRIPTION EXHIBIT INDEX DOCUMENT TYPE 2 COUNT 3 INDEX OF EXHIBITS FILED WITH OR INCORPORATED BY REFERENCE INTO FORM 10-K OF FMC CORPORATION FOR YEAR ENDED DECEMBER 31, 1993 Exhibit No. Exhibit Description Page No. This 10-K This 10-K 3.1 Restated Certificate of Incorporation, as filed on July 1, 1986 (incorporated by reference from Exhibit 3.1 to the Form SE filed on March 25, 1993). N/A 3.2 Amendment to Restated Certificate of Incorporation filed on April 30, 1987 (incorporated by reference from Exhibit 3.2 to the Form SE filed on March 25, 1993). N/A 3.3 By-Laws of the Company, as amended (incorporated by reference from Exhibit 3.1 to the Form SE filed on March 28, 1990). N/A 4.1 Amended and Restated Rights Agreement, dated as of February 19, 1988, between Registrant and Harris Trust and Savings Bank (incorporated by reference from Exhibit 4 to the Form SE filed on March 25, 1993). N/A 4(iii)(A) Registrant undertakes to furnish to the Commission upon request, a copy of any instrument defining the rights of holders of long-term debt of the Registrant and all of its subsidiaries for which consolidated or unconsolidated financial statements are required to be filed. N/A 4.2 Participation Agreement, dated as of January 1, 1994, by and among FMC Corporation, Harsco Corporation, Harsco Defense Holding, Inc. and United Defense, L.P.* (incorporated by reference from Exhibit 4.1 to the Form 8-K filed on February 14, 1994). N/A 4.3 Partnership Agreement, dated as of January 1, 1994, by and among FMC Corporation, Harsco Defense Holding, Inc. and United Defense, L.P.* (incorporated by reference from Exhibit 4.2 to the Form 8-K filed on February 14, 1994). N/A 4.4 Annex A-Definitions Relating to the Partnership Agreement and the Participation Agreement (incorporated by reference from Exhibit 4.3 to the Form 8-K filed on February 14, 1994) N/A 4.5 Registration Rights Agreement, dated as of January 1, 1994, by and among FMC Corporation, Harsco Defense Holding, Inc. and United Defense, L.P. (incorporated by reference from Exhibit 4.4 to the Form 8-K filed on February 14, 1994). N/A 4.6 Management Services Agreement, dated as of January 1, 1994, by and between FMC Corporation and United Defense, L.P.* (incorporated by reference from Exhibit 4.5 to the Form 8-K filed on February 14, 1994). N/A *The Registrant has omitted the schedules and certain exhibits to the Participation Agreement, the Partnership Agreement and the Management Services Agreement and agrees to furnish supplementally a copy of such schedules and exhibits to the Commission upon request. INDEX OF EXHIBITS FILED WITH OR INCORPORATED BY REFERENCE INTO FORM 10-K OF FMC CORPORATION FOR YEAR ENDED DECEMBER 31, 1993 Exhibit No. Exhibit Description Page No. This 10-K This 10-K 4.7 Form of Senior Promissory Note Agreement by and between Harsco Defense Holding, Inc. and United Defense, L.P. (incorporated by reference from Exhibit 4.6 to the Form 8-K filed on February 14, 1994). N/A 10.1 Directors' Retirement Plan (incorporated by reference from Exhibit 10.1 to the Form SE filed on March 27, 1992). N/A 10.2 FMC 1981 Incentive Share Plan, as amended, effective May 28, 1986 (incorporated by reference from Exhibit 10.1 to the Form SE filed on March 25, 1993). N/A 10.3 FMC 1990 Incentive Share Plan (incorporated by reference from Exhibit 10.1 to the Form SE filed on March 26, 1991). N/A 10.4 FMC Corporation Salaried Employees' Retirement Plan, as revised on January 1, 1985 (incorporated by reference from Exhibit 10.2 to the Form SE filed on March 27, 1992). N/A 10.5 FMC Employees' Thrift and Stock Purchase Plan, as revised and restated as of April 1, 1991 (incorporated by reference from Exhibit 10.3 to the Form SE filed on March 27, 1992). N/A 10.6 FMC Salaried Employees' Equivalent Retirement Plan (incorporated by reference from Exhibit 10.4 to the Form SE filed on March 27, 1992). N/A 10.7 FMC Deferred Compensation Equivalent Retirement and Thrift Plan (incorporated by reference from Exhibit 10.5 to the Form SE filed on March 27, 1992). N/A 10.8 FMC Management Bonus Plan (incorporated by reference from Exhibit 10.6 to the Form SE filed on March 27, 1992). N/A 10.9 FMC Corporation Amended and Restated Executive Severance Plan, (incorporated by reference from Exhibit 10.1 to the Form SE filed on March 28, 1990). N/A 10.10 FMC Employees' Thrift and Stock Purchase Trust dated April 1, 1982 (incorporated by reference from Exhibit 10.7 to the Form SE filed on March 27, 1992). N/A 10.11 Amendment to FMC Employees' Thrift and Stock Purchase Trust dated April 1, 1988 (incorporated by reference from Exhibit 10.8 to the Form SE filed on March 27, 1992). N/A INDEX OF EXHIBITS FILED WITH OR INCORPORATED BY REFERENCE INTO FORM 10-K OF FMC CORPORATION FOR YEAR ENDED DECEMBER 31, 1993 Exhibit No. Exhibit Description Page No. This 10-K This 10-K 10.12 FMC Master Trust Agreement between FMC and Bankers Trust Company (incorporated by reference from Exhibit 10.9 to the Form SE filed on March 27, 1992). N/A 10.13 Credit Agreement dated as of August 21, 1992, among the Company, the Lenders listed therein and Morgan Guaranty Trust Company of New York as Agent (incorporated by reference from Exhibit 10.1 to the Form SE filed on March 25, 1993). N/A 10.14 Fiscal Agency Agreement between FMC Corporation and Union Bank of Switzerland, Fiscal Agent, dated as of January 16, 1990 (incorporated by reference from Exhibit 10.4 to the Form SE filed on March 28, 1990). N/A 10.15 Amended and Restated FMC Deferred Stock Plan for Non-Employee Directors (incorporated by reference from Exhibit 10.2 to the Form SE filed on March 25, 1993). N/A 10.16 Consulting Agreement dated as of September 1, 1990 between the Company and Edward C. Meyer. - 13 Annual Report of FMC Corporation for the year ended December 31, 1993. 1 22 List of Significant Subsidiaries of Registrant. 56 24 Consent of Auditors. 57 25 Powers of Attorney. 58-59 DOCUMENT HEADER DOCUMENT DESCRIPTION EXHIBITS DOCUMENT TYPE 2 COUNT 59 EXHIBIT 13 MESSAGE TO SHAREHOLDERS FMC's financial results for 1993 were disappointing. Overcapacity in key chemical markets and poor economic conditions reduced operating income to $203 million from $244 million. In addition, we took a $123 million charge to cover restructuring costs and asset write-downs. Cash flow, however, remained strong as we reduced debt to $832 million by year-end 1993 from $907 million at year-end 1992. This performance, coupled with the decline of the defense market, continued weak economic conditions in Europe, and overcapacity in our key industrial chemical markets, prompts questions about how FMC will increase long-term value for our shareholders. That's what our shareholders should be and are asking me. I personally am confident that we can and will continue our tradition of providing superior shareholder returns. Even more important, the FMC management team is equally confident. Our conviction is based on the fundamental strengths and future strategies of our company, specifically:(1) The majority of our businesses have strong positions in attractive markets and are run by a superior management team with a solid track record of running our businesses well.(2) We have earned high returns and generated excellent cash flow through the economic cycles of the markets in which we operate.(3) We have a long-term strategy to increase FMC's historic growth rates by making investments that will increase growth in our major markets at returns above the cost of capital. And it's this combination of management strength, ability to earn high returns and generate strong cash flow, and commitment to our long-term growth strategy that will allow us to continue and strengthen FMC s tradition of consistently increasing shareholder value. Our management strength and our dedication to long-term strategies based on growing the company were seriously tested by business conditions we faced in 1993 and will face again in 1994. Two of our highest return businesses, defense and gold, are shrinking. Our Performance Chemicals businesses continue to perform well, with solid growth prospects, but the Industrial Chemical businesses while fundamentally strong have been hit by industry overcapacity and a weak worldwide economy. Our Energy and Transportation Equipment businesses are growing worldwide, despite the dip in petroleum prices, but the continuing slump in Europe, together with the collapse of our markets in the former Soviet Union, has hurt our food machinery businesses. To address these challenges, we must first and foremost remain dedicated to running our businesses superbly. Our approach is two-pronged paring costs and investing in solid growth opportunities. Given difficult business conditions, our lack of sales growth in constant dollars, and the need to de-layer our organization and streamline our systems to support our growth initiatives, we have initiated a thorough review of our processes that will significantly reduce overhead throughout the company. A significant portion of our $123 million write- off will cover reductions in functional staffs throughout the company, as well as downsizing and consolidating facilities. We realize that cost-cutting and lean management alone won't deliver maximum value to our shareholders, but these approaches remain an important part of running our businesses superbly. Yet even as we reduce spending at some operations, we are determined to maintain and in some cases increase the spending needed to achieve our long-term growth goals. As we pursue these dual objectives of paring costs and growing the company, we are focusing on five key strategies. These strategies are outlined briefly below and will be reviewed in more detail throughout this report.STRATEGY: CONTINUING TO RUN OUR BUSINESSES SUPERBLY.We are determined to preserve the strengths that have brought us to where we are: demanding strong operating performance, running our businesses for cash flow, rigorously analyzing investment decisions and accurately measuring our performance. And as we implement our growth strategy, we will make investments that generate returns above our cost of capital. Meeting these standards, we believe, is the way to increase shareholder value. Our new partnership with Harsco's BMY division, for example, will combine FMC's research and engineering expertise with Harsco's low-cost, flexible manufacturing capabilities, positioning us to emerge as a profitable survivor in the defense marketplace making good returns in the lean years that lie ahead for the defense industry. STRATEGY: DEVELOPING NEW PRODUCTS AND MARKETS. FMC's growth initiatives will build on a strong technological base. Our agricultural chemical researchers, for example, are aggressively developing several exciting new compounds, and we are looking for ways to expand our profitable food ingredients and bioscience businesses. Even as we restructure our food machinery businesses, we are investing more aggressively in research and development. Our subsea petroleum equipment continues to win technical kudos and new customers. STRATEGY: GLOBALIZING OUR BUSINESSES. Globalization means thinking globally about strategy, markets, competitors, product sourcing, components yet operating locally with a strong awareness of individual customer and market needs. That's nothing new. It's the standard definition of globalization, which is not so much an operating strategy as a state of mind. Last year I described the regional organizations we had created to achieve critical mass in key markets, identify more global growth opportunities and promote this global state of mind throughout the company. While these organizations are still moving up the steep part of the learning curve, they've already helped us generate new opportunities and run our businesses better. STRATEGY: ACQUIRING BUSINESSES AND TECHNOLOGIES IN MARKETS WE UNDERSTAND. Our empirical analyses of successful industrial products companies and we define success as generating share] holder returns in the top quartile of the Standard & Poor's 400 showed that almost all these companies increased value by generating both strong returns and growth. There was only one surprise only about one- quarter of them grew without acquisitions and for at least half of these premier companies, acquisitions were the primary engine of growth. We followed up on this finding and reconfirmed that most acquisitions did not earn an adequate return on investment. But we also learned that the odds of success were dramatically improved when companies pursued acquisitions of less than 10 percent of their capital employed that were related to their core businesses. As a result, we are primarily looking for smaller acquisitions investments up to $200 million that are natural extensions of our businesses in markets that we already serve and technologies that we understand. We will systematically pursue these acquisitions aggressively, but within our culture of rigorously analyzing opportunities to determine if they meet our return standards. The three acquisitions that we have made in the past two years fit our criteria. Ciba-Geigy's global flame retardant business, combined with our domestic operations, gave us a 40 percent market share world wide. Our two energy industry-related acquisitions better position us to serve the oilfield of the future. Kongsberg's subsea control and engineering systems gave us the capability to provide our worldwide petroleum customers with a total subsea engineering system. SOFEC's single-point mooring system brought us a promising oil field technology that we have the resources, expertise and market presence to turn into a major business. STRATEGY: GETTING, DEVELOPING AND KEEPING MORE THAN OUR FAIR SHARE OF THE BEST PEOPLE. If we achieve this goal, the rest will be relatively easy because it is the people of FMC who will spark innovation, identify growth opportunities and generate exciting new products. We are especially committed to valuing, and leveraging, the diversity of our worldwide work force. A global growth strategy demands that we generate new ideas and deepen our understanding of different cultures. We also need to create a workplace where people can develop their capabilities and know they have contributed to achieving our goals. 1993 RESULTS. Now to the specifics of 1993. Income from continuing operations was $164 million before restructuring and other charges, or $4.45 per share, compared with $193 million, or $5.23 per share, in 1992. Sales slipped 6 percent to $3.8 billion for the year. Performance Chemicals posted another year of record sales and profits, and Defense Systems profits remained strong due primarily to favorable cost performance. Weak worldwide economic conditions and overcapacity in some key markets affected our Industrial Chemicals businesses, while significantly weakened markets for several food machinery businesses depressed Machinery and Equipment results. Operating results are fully described in the operating review section. In December 1993, we recorded an after-tax special charge of $123 million, or $3.34 per share, related to restructuring costs and asset write-downs. After the effects of the restructuring and other charges, income from continuing operations was $41 million, or $1.11 per share, in 1993. After extraordinary charges in 1993 and 1992 related to debt refinancing, a $73 million after-tax charge in 1992 related to previously discontinued operations, as well as a $184 million charge in 1992 for adopting Statement of Financial Accounting Standards No. 106 (Postretirement Benefits Other than Pensions), net income in 1993 was $36 million, or $0.98 per share, compared with a net loss in 1992 of $76 million, or $2.06 per share. Strong cash flow in 1993 enabled us to fund the acquisitions of Kongsberg Offshore and SOFEC, invest in capital assets of $215 million, invest $149 million in research and development projects, and reduce debt by $75 million. MANAGEMENT CHANGES In 1993, our board elected Larry Brady president of the corporation. (I had previously held both this position and the chairmanship, with Larry serving as executive vice president.) This promotion confirmed Larry's leadership role in the company for the past two years. Larry's experience, enthusiasm, creativity and proven ability to get the job done are a big part of why I think we will perform as well in the 1990s as we did in the preceding decade. We were also delighted to welcome Cheryl Francis back to FMC from the University of Chicago Business School, where she had been an adjunct professor. Cheryl was elected treasurer, while former treasurer Frank Riddick was named controller. Scott Williamson, our new vice president corporate development, joined FMC from Itel Corporation, where he had been vice president acquisition and development, since 1986. We are extremely pleased to welcome Dr. Patricia Buffler to our board of directors. As the dean of the School of Public Health, University of California at Berkeley, and professor of public health and epidemiology, Pat brings us expertise that will be particularly helpful in our Agricultural Chemical and other chemical businesses, as well as in ongoing efforts in our environment, health and safety programs. Bill Boyd is retiring from our board at our 1994 annual meeting. Bill has been an enormous help in providing practical insights and direction to our strategic and global development efforts. We will miss his operations know-how and his wise counsel. OUTLOOK I don't want to underestimate the short-term challenges or the difficulty of keeping the balance between cutting costs and investing in future growth. But I believe and our management team believes that we have charted a solid course for FMC's future. We are building on our strengths, and supplementing those strengths with more growth initiatives in each of our businesses. These new initiatives will demand new resources and some trade-offs are inevitable. On the other hand, I think FMC's management team is especially well-equipped to make these decisions. We know how to make decisions that are rooted in careful financial analysis, not wishful thinking. We know how to run our businesses for solid cash flow. We have strong positions in attractive markets. We also remain committed to protecting our environment, being good citizens in our plant communities and becoming our customers' most valued supplier. And most important, we have a company full of terrific, dedicated people who are committed to achieving our ambitious goal of becoming the company we want to be by the year 2000: a growing, high- performing company that has substantially increased sales while continuing to earn returns above the cost of capital. Robert N. Burt Chairman of the Board and Chief Executive Officer February 25, 1994 REVIEW OF OPERATIONS Last year, the weak economy in certain key markets caught up to FMC. After performing well during the U.S. business downturn from 1990 to 1992, our sales and earnings declined in 1993 as market conditions worsened across a number of our industrial chemical and machinery lines. Furthermore, our Defense Systems business began to feel the effects of diminishing defense budgets, as anticipated, and we have not yet found the reserves to replace the sliding production for our Precious Metals business. In 1993, FMC's sales were down 6 percent to $3.8 billion, and income from continuing operations before taxes and restructuring and other charges decreased to $210.1 million. We recorded restructuring and other charges of $172.3 million after minority interest to cover costs related to restructuring our Machinery and Equipment and Chemicals operations and support staffs companywide, as well as the write-down of assets in our Precious Metals segment. This restructuring program will reduce expense levels in those operations where we continue to face difficult market conditions without sacrificing critical expenditures necessary for our long-term growth. The high point of our business last year was our Performance Chemicals segment, which contributed higher sales and profits. Our Agricultural Chemical business produced another year of record results. Markets for our Food Ingredients, Pharmaceutical and BioProducts businesses continue to expand, and our performance was strong. With a full year of operations, our new Process Additives business made a solid contribution to sales and earnings. Our Industrial Chemicals businesses did not fare well in 1993. Weak economic conditions and overcapacity in soda ash, phosphorus and hydrogen peroxide markets depressed demand and kept prices low. The cycle shows no signs of reversing until 1995, and in the interim, we are stepping up our efforts to reduce operating costs. The worldwide economic slump also depressed results for our Machinery and Equipment businesses. Continued weak markets in Europe and the United States, as well as political and economic instability in the former Soviet republics led to significantly decreased sales and earnings for our Food Machinery lines. Energy Equipment posted higher sales, but falling oil prices pressured margins. We continued to downsize our Defense Systems business in line with shrinking defense budgets in this post-Cold War world. Segment sales did decline in 1993, but better cost performance resulted in earnings that remained nearly even with the previous years. Finally, lower sales and earnings for Precious Metals reflected the closing of our Paradise Peak gold and silver mine in Nevada. Our challenge is to replace depleted reserves. To meet that challenge, we are refocusing our exploration on higher potential areas around the globe. Last year, we continued to make strategic moves necessary for a healthy future. Anticipating our global energy customers' needs, we made two acquisitions that will allow us to provide high-tech, turnkey services. And to secure our role in the changing defense industry, we concluded the combination of our defense business with Harsco Corporation's BMY Combat Systems Division. Our newly formed company, United Defense, L.P., will be a stronger, more diversified contender in the shrinking defense industry. In the midst of major changes in our markets and our operations, we stayed on course with one of our basic principles: assuring the health and safety of our employees and customers, and protecting the environment in the areas where we operate. Once again, in keeping with the chemical industrys Responsible Care codes of management practice, our safety and environmental programs spanned the range of our operations from enhanced environmental controls in manufacturing to comprehensive product stewardship campaigns. In one of our most unique outreach efforts to date, our agricultural chemicals business rolled out a complete product safety program expressly for our customers in developing countries in tandem with rolling out a new product. As we plan for the future, we are working hard to develop the people who will be leading our efforts. We are encouraging the development of a talented and diverse work force, and we are broadening our global perspective. Attracting and keeping the best people in business today is a critical precursor to reach our goals for the end of this decade and beyond. LARRY D. BRADY PRESIDENT INDUSTRY SEGMENT DATA (In millions) Year ended December 31 1993 1992 1991 1990 1989 SALES* Industrial Chemicals $ 979.5 $1,045.2 $1,035.4 $1,029.6$ 975.9 Performance Chemicals 857.9 790.1 648.7 594.4 565.6 Precious Metals 125.0 170.6 157.5 187.7 190.2 Defense Systems 950.2 1,111.8 1,171.6 1,067.2 900.3 Machinery and Equipment 870.9 876.7 891.5 845.5 783.0 Eliminations (29.6) (20.7) (5.3) (2.2) (0.5) Total $3,753.9 $3,973.7 $3,899.4 $3,722.2 $3,414.5 INCOME BEFORE INCOME TAXES Industrial Chemicals $ 64.3 $ 91.9 $ 102.1 $ 106.9 $ 137.7 Performance Chemicals 132.9 121.3 101.1 84.8 88.0 Precious Metals(1) 9.7 36.4 28.7 81.3 100.9 Defense Systems 161.7 167.2 160.2 96.8 47.3 Machinery and Equipment 6.7 32.1 46.2 52.0 28.3 Operating profit 375.3 448.9 438.3 421.8 402.2 Restructuring and other charges(2)(3) (172.3) - - - - Net interest expense (62.6) (82.7) (107.4) (128.1) (133.7) Corporate and other(3) (112.8) (115.9) (92.6) (101.8) (86.2) Other income and (expense), net(3) 10.2 29.3 17.6 19.5 36.0 Total $ 37.8 $ 279.6 $ 255.9 $ 211.4 $ 218.3 IDENTIFIABLE ASSETS Industrial Chemicals $ 945.4 $ 988.0 $1,032.7 $1,048.3 $ 931.5 Performance Chemicals 576.2 546.4 421.8 420.9 397.4 Precious Metals 64.8 131.8 145.1 157.4 99.3 Defense Systems 269.0 277.7 367.6 444.7 502.9 Machinery and Equipment 522.9 473.0 503.3 495.2 459.3 Subtotal 2,378.3 2,416.9 2,470.5 2,566.5 2,390.4 Corporate and other 434.8 409.7 345.1 392.7 428.6 Total $2,813.1 $2,826.6 $2,815.6 $2,959.2 $2,819.0 (1) Includes 100 percent of FMC Gold company's income of $9.0 million before income taxes and restructuring and other charges in 1993, $16.2 million in 1992, $9.2 million in 1991, $49.0 million in 1990 and $60.7 million in 1989, and the effects of the FMC Corporation hedging program. Minority shareholder interests are included in Corporate and other, except the portion related to 1993 restructuring and other charges. See (2) below. (2) Restructuring and other charges are described in Note 2 and are related to Machinery and Equipment ($66.0 million), Precious Metals ($47.9 million, net of minority interest), Industrial Chemicals ($29.7 million), Performance Chemicals ($3.2 million), and Corporate ($25.5 million). (3) See Financial Review for discussion of these items. * Certain 1992 amounts have been reclassified to conform with the current year's presentation. Industry segment mix has not changed between years. RETURN ON SALES RETURN ON ASSETS 24% 40% 18% 14.1 30% 10.4 12% 8.8 9.9 20% 10.8 15.5 9.8 6% 6.6 10% 9.1 6.7 0% 0% 93 92 91 90 89 93 92 91 90 89 INDUSTRIAL CHEMICALS FMC's Industrial Chemicals segment, producer of soda ash, phosphates, hydrogen peroxide, lithium and related chemicals, faced another difficult year. Prolonged poor global markets for chemicals and overcapacity situations in some of our major chemical lines continued to depress demand and prices. Our sales declined 6 percent to $979 million, and our profits declined to $64 million (before restructuring and other charges of $30 million). Alkali Chemicals sales and profits were down in 1993 as overcapacity persisted worldwide and prices remained under pressure. Increased production worldwide and reduced pricing of caustic soda, a substitute product for soda ash, has caused some customers to convert to caustic soda in the last half of the year. In Europe, a strengthening U.S. dollar against European currencies made it more difficult for U.S. producers to compete. To combat market pressures, FMC concentrated on cost improvements. We have streamlined our work force and operations, and temporarily stopped production of caustic soda until pricing improves. We'll continue to reduce our costs and focus on manufacturing improvements as this down cycle continues in 1994. Capacity utilization and industry pricing should increase in 1995. Our alkali lines remain a sound, attractive business for the long term. Phosphorus Chemicals sales and profits were also down last year as U.S. manufacturers of home laundry detergents rapidly phased down their use of phosphates. In an effort to reduce costs last year, we closed our phosphate production facility in Newark, Calif., and idled one of four phosphorus furnaces at our Pocatello, Idaho, facility for a portion of the year. Sales were almost even, but earnings were down for Peroxygen Chemicals. Overcapacity was an issue in the U.S. market, contributing to soft prices in spite of double-digit growth. In 1993 we worked closely with our customers on new hydrogen peroxide applications, including recycling processes for the pulp and paper industry and Caro's Acid for cyanide detoxification in the mining industry. Volume growth is projected to continue in North America and Europe for the coming years. In anticipation of the expanding hydrogen peroxide market in northern and central Europe, in 1993 we announced that FMC Foret, our European industrial chemicals operation, will open a new hydrogen peroxide facility in late 1995 in Delfzijl, an industrial port city in the Netherlands. The Delfzijl plant will augment FMC Foret's existing hydrogen peroxide plant in La Zaida, Spain, where a new cogeneration facility started up to assure a substantial reduction in energy costs. In addition to hydrogen peroxide, FMC Foret is a producer of phosphates, perborates, zeolites, silicates, sodium sulfate and sulphur derivatives for a wide range of industries, including detergents, pulp and paper and textiles. Overall, FMC Foret's sales were down in 1993 due to the effects of currency translations and general weakness in Europe, but profits were even with last year through significant cost-control efforts. In a major cost-reduction effort for our phosphate business, we closed the sulfuric acid plant at Palos, Spain, based on a favorable supply contract with a neighboring copper smelter. Meanwhile, our plant to produce zeolites, a builder used in detergents, was in its first full year of operation and met expectations for 1993. Sales and profits declined for FMC's Lithium business, reflecting increased spending on resource exploration as well as weak markets worldwide, which had an adverse effect on the lithium industry and FMC's position. Demand fell in one of lithium's key markets, aluminum processing. North American and European aluminum producers, experiencing keen competition from increased exports by Russian producers, reduced output and cut purchases of our product. Our specialized lithium products for pharmaceutical, agrochemical, polymer synthesis and energy markets performed better in 1993. We expanded our capability and flexibility to produce organolithium for pharmaceutical applications and polymerization at our two facilities in Bessemer City, N.C., and Bromborough, United Kingdom. We also expanded our research and development capabilities last year to develop new, customer-focused applications for our lithium products. To assure a supply of low-cost lithium reserves for future production, we have been actively exploring potential opportunities in South America. We're particularly encouraged by our work in Argentina, and we're developing a proprietary technology that could cut our production costs significantly. Prospects for FMC's Industrial Chemicals segment remain unchanged for 1994. The ongoing recession in Europe and continuing overcapacity in some of our product lines will continue to depress sales. We have weathered similar down cycles of the industrial chemicals industry in the past, and we see our businesses as solid performers for the long term. We are emphasizing cost reduction efforts to maintain profitability until markets improve. PERFORMANCE CHEMICALS Performance Chemicals continued to produce strong results throughout 1993. Sales were up 9 percent to $858 million, and profits increased 10 percent to $133 million (before restructuring and other charges of $3 million). A wide range of products including agricultural chemicals, pest control chemicals, food and pharmaceutical ingredients, flame retardants and water treatment chemicals contributed to the positive results. Agricultural Chemical posted another year of record results. Sales increased in 1993, and profits remained strong even as FMC substantially increased research and development spending to focus on the next generation of herbicides to be marketed later this decade. While the continued recession in Europe created a difficult market for agricultural chemicals, sales were strong in the United States and Latin America. In the United States, sales were brisk for flowable Furadan insecticide/nematicide, Command herbicide on cotton and new Fury pyrethroid on cotton. RETURN ON SALES RETURN ON ASSETS 24% 40% 18% 30% 15.5 15.4 15.6 15.6 23.7 25.0 24.0 20.7 22.3 12% 14.3 20% 6% 10% 0% 0% 93 92 91 90 89 93 92 91 90 89 Latin America showed major sales increases in 1993 as we expanded the application of Command/Gamit herbicide to rice and sugarcane in Brazil and the application of Rugby nematicide on bananas throughout the Caribbean region. Meanwhile, our specialty, or non-crop, chemical business continued to grow and produce attractive returns. In 1993, we began an aggressive international sales effort for our key specialty product, Dragnet termiticide. In January 1994, our global reach expanded as we finalized a joint venture in Indonesia, with FMC as the 51-percent owner, to formulate and distribute agricultural chemicals. Our research and development efforts in 1993 continued to focus on herbicides and insecticides, and by 1997-1998, we're anticipating the introduction of several promising new herbicide products. Our research budget for 1994 will increase to reflect the development investment needed to commercialize these products. Continuing a trend over several years, FMC's Food Ingredients, Pharmaceutical and BioProducts businesses again posted strong sales and profits in 1993. FMC's Avicel cellulose gel continues to be one of the world's leading fat-replacement products, and we remain the world's largest and most experienced producer of carrageenan products. In the pharmaceutical arena, we are the market leader in supplying tablet binders and other inactive ingredients for pharmaceutical processing. Our BioProducts business now a separate business unit is a leading supplier of specialty chemicals used in life science research and development. As consumer demand for low-fat and non-fat food products continued to rise, our Food Ingredients business produced higher sales and profits in 1993. Avicel sales were strong throughout North America and, despite a highly competitive market for carrageenan, sales improved in North America and Asia-Pacific. Regional recessionary problems contributed to slightly lower sales and earnings in Europe and Latin America. To enhance our ability to solve our customers' problems and meet their applications needs, last year we opened a new food ingredients lab at our Research and Development Center in Princeton, N.J., and increased staffing in R&D and technical sales support. In 1994, we anticipate opening new technical applications labs in Latin America and the Asia- Pacific region to concentrate on developing regional applications for existing as well as new products. In the pharmaceutical sector, FMC realigned its Pharmaceutical and BioProducts businesses an action that will help FMC move from its position as a leading worldwide supplier of specialty excipients to a broader, more strategic role as a provider of value-added technologies and services to our pharmaceutical customers. As these customers undergo profound changes in their industry and markets, FMC will be focusing on providing them with innovations for cost reduction, product design and rapid commercialization. In 1993, we further strengthened our leadership position in core specialty excipients. Despite a major slowdown in Europe, where a weak economy and health care reform tempered sales to the pharmaceutical industry, FMC continued to increase our market share and strengthen our financial performance. Last year we introduced a new product, AviSphere, for time-release applications, launched a new line of specialty excipients and entered an agreement to apply our advanced technologies to develop products for a leading pharmaceutical maker. BioProducts also contributed higher sales and profits in 1993. We succeeded in extending our reach to key segments of the life science market by improving the performance of our line of agarose products seaweed-derived gelling polymers that are indispensable in DNA research and protein analysis and introducing several new products for mapping genes and conducting DNA separations. The market for BioProducts is growing rapidly. We plan to introduce new products in 1994, and we will continue our R&D investments to meet the higher demand for DNA research reagents. Finally, in a complete year of combined operations, our new Process Additives business contributed strong sales and earnings despite a weak European economy and marketplace shifts in Eastern Europe. Process Additives combines our original flame retardants business with the flame retardants and water treatment businesses we acquired from Ciba-Geigy in 1992. The synergies of these operations have boosted FMC's market position worldwide. Our capabilities include more extensive customer sales efforts and technical service, expanded product offerings, enhanced research and development, and improved worldwide sourcing. Last year, we introduced a unique flame retardant, Reoflam PB-460, the only product on the market to combine bromine and phosphorus in the same molecule for superior flame suppression. The product is gaining acceptance worldwide and will have a positive impact on 1994 sales. Our water additives business performed extremely well in 1993, and we expect to see significant future growth. Last year we introduced new products for water desalination that will serve our customers in arid regions and other areas that need quality water. Performance Chemicals should continue at this peak performance throughout 1994. For our agricultural chemical business, we expect continued success in the United States and Latin America, as well as increased sales throughout Asia with the start-up of our Indonesian joint venture. Even with the unstable economic conditions in the former Soviet states, our opportunities for crop protection product sales should continue to expand in that area. Markets for specialty food ingredients and pharmaceutical products continue to grow, and we're encouraged by the increasing demand for our DNA research-related BioProducts. Our Process Additives product lines will continue to see significant growth with new product development and expanding market presence. DEFENSE SYSTEMS Despite shrinking defense budgets worldwide, FMC's Defense Systems segment performed better than expected in 1993. Sales decreased to $950 million and, given improved cost performance, earnings of $162 million remained relatively even with 1992 results. We completed the transaction to combine our defense business with Harsco Corporation's BMY Combat Systems Division. The BMY operation, a producer of tracked vehicles, is a strong strategic fit with FMC's business. By broadening FMC's product line and adding resources and capabilities, the new, jointly owned partnership, United Defense, L.P., will create the most diversified, low-cost company in the combat vehicle industry. FMC has a 60 percent interest and is responsible for managing the operation. Last year, sales and profits were down for our Ground Systems business. The Bradley Fighting Vehicle continued as the major product for this business, even as we reduced production rates in line with lower demand to 1.4 vehicles per day in the second quarter from 2.6 vehicles previously. Last year, Ground Systems produced 293 Bradleys for the U.S. Army and 88 Bradleys for Saudi Arabia. We also produce Bradley-derived carriers for the Multiple Launch Rocket System, and last year we delivered 68 to the U.S. Army and five to Japan. In the third quarter, the U.S. Army exercised an option to purchase an additional 54 Bradleys. This $39 million contract continues production through February 1995. FMC won a two-year, $46 million contract from the Army to provide technical support to its existing fleet of Bradleys. FMC also will upgrade six older-model Bradleys, setting the stage to upgrade as many as 100 vehicles later in 1994. RETURN ON SALES RETURN ON ASSETS 24% 60% 59.2 17.0 51.8 18% 15.0 45% 13.7 39.4 12% 9.1 30% 20.4 6% 5.3 15% 9.5 0% 0% 93 92 91 90 89 93 92 91 90 89 Meanwhile, Ground Systems is meeting the Army's aggressive schedule for the Armored Gun System, a new, light, deployable combat vehicle. Last year, Ground Systems delivered the ballistic systems structure, autoloader and armor test samples; in 1994 we will deliver the first six prototype vehicles. Last year, Ground Systems won a $317 million contract to upgrade the Paladin self-propelled howitzer. United Defense will produce 630 units of a technologically advanced model over four years, and the Army could exercise another $70 million in options. United Defense research in ground systems is focused on enhancing mobility and survivability. Our work continues on the next generation of the Bradley, the A3, which will continue the Army's cap]ability to dominate the land battle. We've also completed the first phase of work on the Composite Armored Vehicle Program and won a $54 million follow-on contract to test the viability of composite material technology. FMC's Armament Systems business, formerly Naval Systems, recorded higher sales and profits in 1993, and continued to broaden its scope beyond its established customer base of U.S. and international navies providing value-added engineering work across a number of defense systems lines and applying its expertise in armament systems on several ground systems contracts. Armament Systems had a busy production year in 1993. We delivered 57 Vertical Launching Systems modules, 206 VLS canisters and six Mk 45 gun systems to the U.S. Navy, as well as two Mk13 Pointing Launching Systems to Taiwan, two Mk 45 gun systems to Turkey and one Mk 45 gun system to Australia. Armament Systems also played a crucial role in the development of the Advanced Technology Demonstrator, a component of FMC's $67 million sole-source contract for the Advanced Field Artillery System, a self-propelled howitzer. Armament Systems will deliver the demonstrator in 1994, and we believe we're well positioned to win a contract for the next phase of the program. Sales and profits were down for our Steel Products business. Last year, the business won a $23 million contract from the U.S. Army to overhaul and convert 471 M113A2 armored personnel carriers to the newer A3 configuration. This business continues to pursue commercial opportunities outside the defense arena and is targeting the mining equipment market, among others. While international defense sales were down for 1993, profits were up, and new international business looks promising. We recently opened an office in Taipei, Taiwan, where we have strong potential to develop new business. With a new order from Kuwait, we're back in business with the M113 line of armored personnel carriers. We will also provide Singapore and Pakistan with kits to upgrade their M113 fleet, and we will deliver an additional 36 MLRS carriers to Japan over the next four years. FMC's Defense Systems continued to downsize the business in tandem with diminishing opportunities. At the end of 1993, Ground Systems' work force totaled 2,500, down from 4,200 in 1990. Armament Systems' force was down to 1,800 by the end of 1993, from 2,500 in 1990. At the end of 1993, FMC employed a total of 4,900 employees in its Defense Systems businesses. Our defense operations will remain a profitable but significantly smaller contributor to FMC in the coming years. In 1994, we'll direct much of our attention to the combination of FMC's and BMY's businesses. We're excited about the enhanced capabilities, lower cost structure and more competitive market position this partnership will enable us to achieve. And we're confident that the advanced research work we're currently conducting on several key defense projects will enhance our ability to win follow-on contracts. PRECIOUS METALS As expected, performance declined for our Precious Metals segment, which includes FMC Gold Company, our 79-percent-owned precious metals subsidiary. Sales diminished by nearly one-third to $125 million, and earnings declined substantially to $10 million (before writedowns and other charges of $61 million) due to decreased production and continuing soft gold prices. The closing of our 100-percent-owned Paradise Peak mine in western Nevada last year had a significant impact on production, sales and earnings. Reserves of mill-grade ore were depleted by mid-year, and remaining reserves were exhausted at the end of the year. In 1992, Paradise Peak had accounted for 60 percent of FMC Gold's total production. In 1993, FMC Gold's total gold production was down 23 percent to 321,000 ounces. Total silver production, at 863,000 ounces, was less than half the previous year's production. Production was up at Jerritt Canyon, also in Nevada, with improving ore grades and recovery rates. Production was down at our Royal Mountain King mine in California, and the operation will close by mid-1994. We continued to delay development of our Beartrack property in Idaho because of low gold prices. We are also awaiting the results of government environmental studies. As several of our operations shut down, we are more dependent on exploration for success. Given the declining attractiveness of exploration in the United States, we are increasingly investing in offshore exploration, but some U.S. efforts continue in selected high-potential areas. In early 1994 we also signed memoranda to participate in investigating known deposits in Russia and China. RETURN ON SALES RETURN ON ASSETS 100.0 60% 53.0 100% 43.3 45% 75% 63.3 30% 21.3 50% 18.2 26.3 15% 25% 19.0 7.8 9.9 0% 0% 93 92 91 90 89 93 92 91 90 89 MACHINERY AND EQUIPMENT FMC's Machinery and Equipment results were disappointing in 1993. Sales were down slightly to $871 million, but profits were down substantially to $7 million (before restructuring and other charges of $66 million). Food Machinery sales and earnings decreased significantly with the prolonged European recession and weakened European currencies, disruption of major markets of the former Soviet states, and continuing poor business cycles in the United States. Higher sales in our energy equipment businesses helped offset depressed Food Machinery sales, but falling oil prices pressured margins. Our best performers were a number of our Energy and Transportation Equipment businesses. With an eye toward providing the type of turnkey engineering and production services that many of our large, global energy customers now expect, FMC completed two strategic energy-related acquisitions in 1993. In June, we purchased Norway-based Kongsberg Offshore, a.s., an expert in subsea technology and a leading supplier of control systems. FMC and Kongsberg combined create the world's largest company for engineering, procurement and production on subsea projects a lucrative market that FMC has been targeting for several years. Also in June, FMC acquired SOFEC, Inc., a Houston-based engineering and construction firm that designs, fabricates and installs marine terminals and floating production systems. This capability gives our customers an economical alternative to underwater pipeline construction in remote, harsh regions of the world. In the last six months of the year, SOFEC posted nearly $45 million in inbound orders. RETURN ON SALES RETURN ON ASSETS 24% 40% 18% 30% 12% 6.2 20% 10.9 5.2 9.3 6% 3.7 3.6 10% 6.6 6.2 0.8 1.3 0% 0% 93 92 91 90 89 93 92 91 90 89 The Kongsberg acquisition boosted sales for our energy equipment businesses in 1993. But with demand for oil essentially flat, and excess OPEC production keeping oil prices low and triggering lower energy equipment pricing, our profits for this business were down. The outlook for our Wellhead Equipment business is encouraging. Following the addition of Kongsberg and SOFEC, FMC succeeded in capturing a $55 million contract from Amoco for turnkey engineering and production services on a project off the coast of China. We recently renewed our long-standing licensing agreement with Niigata Engineering of Japan to manufacture and market marine loading systems and fluid control products a relationship that continues FMC's firm foothold in the growing Asia/Pacific market. Our new joint venture to produce wellhead equipment in Russia, FMC Tyumen Petroleum Equipment, is benefiting from increased activity by Western oil companies in the Russian federation. We already are furnishing equipment for Conoco, BP/Statoil and Shell. And late last year we announced a new strategic alliance with Rockwater, a Brown & Root company, to provide turnkey subsea services. Our Fluid Control business had an excellent year in 1993. Our valves and connectors were in demand by energy service companies, and our cost control efforts and manufacturing efficiencies improved profitability. Last year we entered into alliances with several major well service customers, and in some cases, we will be the sole supplier. In 1994, we'll bring to market an advanced plug valve that should provide additional competitive advantage. Sales and earnings for our transportation equipment businesses were essentially flat. The downturn in the airline industry had a slight impact on FMC's Airline Equipment business. We were helped by our strong product portfolio, including state-of-the-art loading and deicing equipment, as well as our efforts in cost control and efficient manufacturing. We continued to retool our Automotive Service Equipment operations and succeeded in reducing fixed assets. Our Material Handling Systems operations, meanwhile, implemented a cost-control program emphasizing gains in engineering productivity and efficiencies in manufacturing. FMC's Food Machinery businesses had a difficult year, with sales and profits declining for the second consecutive year. A combination of soft domestic markets, the continuing recession in Europe, depressed agricultural commodity markets and consolidations among food producers have created uncertainty among our customers. Our citrus business was a bright spot in 1993, contributing increased sales and profits. Last year we installed processing systems for U.S. Sugar Corporation's new citrus juice facility the first new processing plant to open in Florida in many years. Europe's weak marketplace did not present opportunities for the type of large-scale food processing projects we completed in past years. Our agricultural machinery business also suffered from the poor market conditions in Europe and North America, but we believe we have reached the bottom of the business cycle in our harvester operations. Weak market conditions also depressed demand for our packaging and material handling equipment businesses. The 1994 outlook for these businesses should improve somewhat, but full recovery isn't anticipated until 1995. This past year, FMC conducted a major strategic review of our Food Machinery businesses. We concluded that we should concentrate on those core areas that allow growth opportunities, eliminate weak product positions and restructure our operations with fewer facilities and lower overhead. The coming year will mirror the successes and the challenges of 1993. A major challenge will be in managing the realignment of our businesses to improve our profit picture for the coming years. At the same time, we recognize that Food Machinery markets will continue to be depressed, as the recession continues in Europe, soft market conditions persist in the United States, and unstable economies and hard-currency shortages continue in the states of the former Soviet Union. The outlook is brighter for our Energy and Transportation Equipment business, strengthened in 1993 by acquisitions and strategic alignments, and rebounding from successful cost-control measures. Oil prices continue to be an area of concern in 1994. But our capabilities and our customer ties in these industries will provide a strong competitive edge in winning major contracts and growing profitably. FINANCIAL REVIEW Additional information highlighting FMC's operating performance and financial position is presented below. Sales and Earnings Sales in 1993 were $3.8 billion, 6 percent lower than in 1992. Income from continuing operations was $41.0 million, or $1.11 per share, compared with $192.6 million, or $5.23 per share, for 1992. Income from continuing operations for 1993 includes pretax restructuring and other charges of $172.3 million, net of minority interest ($123.3 million on an after-tax basis, or $3.34 per share). An after-tax extraordinary charge of $4.7 million was also recorded in 1993 for additional debt restructuring. After this charge, net income for 1993 was $36.3 million, or $0.98 per share. After-tax special charges recorded in 1992 included $183.7 million resulting from the adoption of Statement of Financial Accounting Standards (SFAS) No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," $73.2 million for previously discontinued operations' additional environmental and product liability requirements, and an extraordinary charge of $11.4 million related to the restructuring of debt. After these charges, the net loss for 1992 was $75.7 million, or $2.06 per share. Declining operating earnings in the Industrial Chemicals, Machinery and Equipment, and Precious Metals segments contributed to the overall decrease in 1993 earnings per share. Corporate and other expenses decreased slightly in 1993 primarily due to gains on sales of Corporate assets. A breakdown of sales, income before income taxes, and identifiable assets by industry segment appears on page 17, followed by a review of operating performance on pages 22 through 37. Segment operating profits exclude 1993 restructuring and other charges (Note 2), net interest expense, and other income and expense items. A discussion of other income and expense, order backlog, and research and development expenditures follows. OTHER INCOME AND (EXPENSE), NET Year ended December 31 (In millions) 1993 1992 1991 Industrial Chemicals $ 3.6 $ 0.6 $ 3.2 Performance Chemicals (2.8) (0.5) 0.1 Defense Systems 2.6 13.9 4.3 Machinery and Equipment (0.8) 11.5 14.8 Corporate and other 7.6 3.8 (4.8) Total $10.2 $29.3 $17.6 Other income and expense for Industrial Chemicals, Performance Chemicals, Defense Systems, and Machinery and Equipment reflect the allocation of LIFO inventory adjustments for all three years. Corporate and other includes items that are not allocated to specific business segments, primarily pension-related income. Pension-related income was $7.6 million in 1993, $3.8 million in 1992 (net of a $4.6 million curtailment charge), and $8.2 million in 1991. 1991 also included a $12.0 million charge for general environmental clean-up. ORDER BACKLOG December 31 (In millions) 1993 1992 1991 Defense Systems $1,105.0 $1,342.6 $1,939.5 Machinery and Equipment 333.1 340.9 342.9 Total $1,438.1 $1,683.5 $2,282.4 The decline in Defense Systems backlog reflects the overall downsizing of the U.S. defense industry. The slight decline in backlog for Machinery and Equipment stems from weaker demand for food machinery equipment, particularly in Europe, partially offset by increases in energy equipment due to 1993 acquisitions (Note 2). Backlogs are not reported for Industrial Chemicals, Performance Chemicals and Precious Metals due to the nature of these businesses. RESEARCH AND DEVELOPMENT EXPENDITURES Year ended December 31 (In millions) 1993 1992 1991 Industrial Chemicals $19.3 $21.3 $18.6 Performance Chemicals 79.0 67.9 57.5 Precious Metals 0.1 0.1 0.2 Defense Systems 24.0 27.8 27.8 Machinery and Equipment 26.1 26.2 28.6 Corporate 0.7 1.7 1.9 Total $149.2 $145.0 $134.6 Expenditures for research and development increased in Performance Chemicals primarily due to the development of the next generation of herbicides and insecticides, as well as product development in the Food Ingredients and BioProducts businesses. Reduced defense spending by the U.S. government on existing contracts resulted in lower research and development expense for Defense Systems in 1993. Not included in these amounts are $208.8 million, $139.2 million and $76.9 million in 1993, 1992 and 1991, respectively, for research and development projects contracted directly with the U.S. government and commercial sponsors. The increase in 1993 is attributable to the armored gun and advanced field artillery systems that are being developed by Defense Systems. EXPLORATION COSTS Mineral exploration costs were $19.9 million, $16.6 million and $13.5 million in 1993, 1992 and 1991, respectively. Approximately 85 percent of exploration spending in 1993 relates to original exploration for gold, silver, and lithium reserves, with the remainder for development of reserves near existing mines. TAXES FMC's effective tax rate was an 8 percent tax benefit on earnings compared with a 31 percent tax provision on earnings in 1992. The effective tax rate in 1993 was affected by lower domestic earnings due to restructuring and other charges (of which $61 million relates to FMC Gold Company and was not tax effected), a higher level of foreign earnings taxed as dividends in 1993, and a change in the mix of foreign and domestic earnings combined with favorable foreign effective tax rates. RESTRUCTURING AND OTHER CHARGES In 1993, FMC recorded pretax restructuring and other charges of $172.3 million, net of minority interest (after-tax $123.3 million, or $3.34 per share). These charges primarily relate to restructuring costs associated with the Machinery and Equipment segment and Chemical businesses, expenses to restructure companywide functional support staffs, as well as a write-down of the book value of the Beartrack development property in the Precious Metals segment. The company will focus on growing profitable businesses with strong market potential and intends to exit several small, unprofitable product lines in the Machinery and Equipment segment that are not projected to meet established financial criteria. Machinery and equipment operations will be streamlined by reducing staffing levels and consolidating manufacturing locations. Total pretax restructuring and other charges for this segment approximate $66.0 million. In the Chemical businesses, the company has initiated a number of restructuring activities aimed at reducing manufacturing costs and improving operating efficiencies. In addition, reserves have been provided for the shutdown of unprofitable or redundant facilities. Total pretax restructuring and other charges for the Chemical segments approximate $32.9 million. Restructuring and other charges of $47.9 million, net of minority interest, relate to the Precious Metals segment. These charges include costs for the write- down of the book value of the Beartrack development property, as well as expenses to close the Royal Mountain King and Paradise Peak mines. The long-term outlook for gold prices has changed significantly since the Beartrack property was acquired in 1990, and consequently, the book value of the property has been reduced. The company is undertaking a review of functional support staffs throughout the organization. The objective is to align resources to support the company's long-term growth initiatives and improve operating efficiencies. Related severance, relocation and other costs are expected to approximate $25.5 million on a pretax basis. The restructuring activities will result in planned, or already implemented, work force reductions of approximately 2,500 positions 12 percent of the total work force. These actions are expected to be implemented largely during 1994 and 1995. The after- tax cash outflow to fund related charges will be approximately 40 percent of the $172.3 million charge. Once completed, it is anticipated that they will result in ongoing annual cost savings and better align the company's business and support staff with its growth strategy. ENVIRONMENTAL FMC, like other industrial manufacturers, is involved with a variety of environmental matters, in the ordinary course of conducting its business, that are subject to federal, state and local environmental laws. FMC feels strongly about its responsibility to protect the environment, public health and employee safety. This includes cooperating with other parties to resolve issues created by past and present handling of wastes. When such issues arise, including notices from the Environmental Protection Agency (EPA), or other government agencies, identifying FMC as a Potentially Responsible Party (PRP), the company utilizes multifunctional advisory teams comprised of environmental, legal, financial and communications management to ensure that the companies actions are consistent with its responsibilities to the environment and public health, as well as employees and shareholders. To ensure FMC is held responsible only for its equitable share of site redemption costs, FMC has initiated, and will continue to initiate, legal proceedings for contributions from other PRPs and for a determination of coverage against insurance carriers that provided insurance coverage for the cost of clean- up at a number of waste sites. The Supreme Court of California has determined that FMC's clean-up costs are insured damages under its liability insurance policies, subject to a determination of the application of certain policy exclusions and conditions. In July 1993, in the Supreme Court of Santa Clara County, a jury verdict determined that these exclusions do not apply to several of these sites. The other sites will be the subject of future litigation. Regarding current operating sites, the company spent approximately $16 million, $20 million and $28 million for the years 1993, 1992 and 1991, respectively, on capital projects relating to environmental control facilities, and expects to spend additional capital of approximately $26 million and $28 million in 1994 and 1995, respectively. Additionally, in 1993, 1992 and 1991, FMC spent approximately $63 million, $57 million and $48 million, respectively, for environmental compliance costs for these sites. Regarding previously operated and other sites for the years 1993, 1992 and 1991, FMC charged approximately $17 million, $11 million and $5 million, respectively, against established reserves for remediation spending, and charged approximately $10 million, $11 million and $10 million, respectively, against reserves for spending on Remediation Investigation/Feasibility Studies(RI/FS). Recoveries from third parties of approximately $7 million and $3 million, respectively, were received and credited to the reserves in 1993 and 1992. No recoveries were received in 1991. FMC anticipates that the expenditures for current operating, previously operated and other sites will continue to be significant for the foreseeable future. In accordance with the company's environmental accounting policy, reserves at the end of 1993 were $133 million, net of approximately $54 million of recoveries, including recoveries from insurance companies, the federal government and other PRPs. The company cannot reasonably estimate any additional amount of loss or range of loss in excess of the recorded amounts. While the liability from potential environmental obligations that have not been reserved may or may not have a material effect on the results of operations in any one year, based on information currently available, management believes environmental- related expenditures will not likely have a material adverse effect on the company's liquidity or financial condition and will be spent over many years in the future. Additional information regarding the company's environmental accounting policies and potential environmental liability is included in Note 1 and Note 16, respectively, to the company's consolidated financial statements. LIQUIDITY AND CAPITAL RESOURCES Cash and marketable securities plus cash generated from operations provided the resources to meet 1993 operating needs, fund capital expenditures and acquisitions, and reduce debt levels. Debt levels and interest costs were reduced by $75 million and $21.3 million, respectively, in 1993. Cash requirements for capital expenditures and acquisitions approximated $245 million. During 1993, the company, with funds obtained through its revolving credit agreement, repurchased $655 million, less unamortized discount of $481 million, of 7-1/2% zero coupon senior subordinated debentures, $32 million of 7-1/2% sinking fund debentures, and $19 million of industrial revenue bonds. In August 1993, subsequent to the repurchases noted above, the company issued $200 million of 6.375% senior notes due 2003. The net proceeds of $198 million were used to repay advances under the revolving credit agreement. As of December 31, 1993, there were no borrowings under the company's revolving credit facility or uncommitted facilities. In order to secure long-term financing in the United Kingdom, the company also issued Sterling denominated debt in December 1993 due 2042 with a yield to maturity of 7.65% and a maturity value of $124 million. Cash generated from operations in 1994 and available credit facilities are expected to be sufficient to meet operating needs, fund capital expenditures and acquisitions, and meet debt service requirements for the year. Expected cash requirements for 1994 include approximately $275 million to $375 million for planned capital expenditures and acquisitions, plus approximately $40 million for net after-tax interest payments. Working capital December 31 (In millions) 1993 1992 1991 Operating working capital: Trade receivables $573.2 $543.5 $529.7 Inventories 268.1 319.3 364.8 Accounts payable (501.2) (513.9) (600.4) Accrued liabilities (449.3) (406.8) (403.9) Total operating working capital (109.2) (57.9) (109.8) Cash and marketable securities 77.5 24.3 44.2 Other current assets and liabilities, net 35.4 32.5 52.4 Total working capital $ 3.7 $ (1.1) $(13.2) Operating working capital decreased in 1993 compared with 1992. Reduced inventory levels resulted from lower business volume at Defense Systems, as well as continued inventory management initiatives and translation effects. Accrued liabilities increased due to acquisitions and timing of expenditures at year end. Operating working capital was affected by the partial liquidation of lower-cost LIFO inventories, which increased reported earnings per share by $0.04, $0.42 and $0.32 in 1993, 1992 and 1991, respectively. FMC has sustained lower inventories over the long term, producing sufficient savings in inventory carrying costs tooffset the negative cash flow effect of additional taxes paid on the increased earnings from the liquidation of lower-cost LIFO inventories. CAPITAL EXPENDITURES Year ended December 31 (In millions) 1993 1992 1991 Industrial Chemicals $ 91.0 $ 91.5 $ 94.5 Performance Chemicals 40.7 144.9 30.0 Precious Metals 18.5 19.1 19.4 Defense Systems 19.2 20.5 25.1 Machinery and Equipment 70.7 30.5 42.7 Corporate 4.4 8.0 5.1 Total $244.5 $314.5 $216.8 Capital expenditures in 1993 decreased $70 million from 1992 levels. Performance Chemicals reduced spending reflects the impact of the acquisition of Ciba-Geigy fixed assets in 1992. The increase in Machinery and Equipment spending is attributable to the acquisitions of Kongsberg Offshore a.s. (Kongsberg) and SOFEC, Inc. (SOFEC) assets in 1993. Depreciation Year ended December 31 (In millions) 1993 1992 1991 Industrial Chemicals $ 86.1 $ 96.5 $ 93.0 Performance Chemicals 41.8 40.3 31.2 Precious Metals 25.7 28.6 29.6 Defense Systems 26.0 30.4 33.1 Machinery and Equipment 28.6 26.9 26.2 Corporate 14.2 12.3 11.8 Total $222.4 $235.0 $224.9 Depreciation expense decreased $12.6 million in 1993. The decrease for Industrial Chemicals resulted from assets which became fully depreciated in 1992, and translation effects related to a Spanish operation. The decline at Defense is consistent with continued downsizing efforts. DIVIDENDS No dividends were paid in 1993, 1992 and 1991, and no dividends are expected to be paid in 1994. 1993 FOURTH QUARTER RESULTS COMPARED WITH 1992 For the fourth quarter of 1993, FMC reported sales of $946 million, a 6 percent decrease compared with the year-ago quarter. Income from continuing operations (before restructuring and other charges) of $21 million, or $0.57 per share, decreased compared with $31 million, or $0.85 per share, in last year's quarter. In December 1993, the company recorded pretax restructuring and other charges of $172.3 million, net of minority interest (after-tax $123.3 million, or $3.34 per share) related to restructuring activities and asset write- downs. After the effects of the restructuring and other charges, the company recorded a loss from continuing operations of $102 million, or $2.77 per share, in the quarter. Earnings of $33 million before interest, taxes, and restructuring and other charges decreased compared with the prior year's strong quarter. Performance Chemicals improved profits in the quarter were more than offset by decreased profits for Defense Systems and Industrial Chemicals. Net interest expense decreased 21 percent to $15 million in the quarter. Industrial Chemicals. Sales decreased 12 percent to $242.1 million from $274.1 million in 1992. Earnings for the quarter declined due to weak worldwide economic conditions and overcapacity in FMC's major product lines. Alkali sales and earnings decreased due to weak worldwide soda ash pricing and volumes, and the impact of lower caustic soda prices. Lower phosphate sales also negatively affected results of operations. Performance Chemicals. Performance Chemicals sales for the fourth quarter increased 16 percent in 1993 to $178.5 million from $154.2 million in 1992, and earnings also increased. Agricultural Chemicals sales increased primarily due to higher sales in South America. Sales of the Food Ingredients business also rose given increased global research and marketing efforts. Precious Metals. Sales declined 35 percent to $26 million in 1993 from $39.8 million in 1992, and profits also declined, primarily due to the shutdown of the Paradise Peak mine in the second quarter of 1993 and reduced gold production. Defense Systems. Sales of $246.2 million in 1993 decreased 20 percent from $306.3 million in 1992, and profits also decreased compared with fourth quarter 1992 results. Lower sales and profits primarily resulted from reduced production of the Bradley Fighting Vehicle. Machinery and Equipment. Machinery and Equipment sales of $258.9 million in 1993 increased 11 percent from $233.8 million in 1992, and profits were down between years. Fourth quarter 1993 sales benefitted from the acquisitions of Kongsberg and SOFEC. 1992 RESULTS OF OPERATIONS COMPARED WITH 1991. Sales rose 2 percent in 1992 to $4 billion, due to higher sales in the Performance Chemicals and Precious Metals segments. Income from continuing operations of $192.6 million before special charges was 11 percent higher than 1991's $173.1 million. Primary earnings per share before special charges were $5.23 compared with $4.77 for 1991. After-tax special charges recorded in 1992 included $183.7 million resulting from the adoption of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," $73.2 million related to previously discontinued operations for additional environmental and product liability requirements, and an extraordinary charge of $11.4 million related to restructuring of debt. After special charges, the net loss for 1992 was $75.7 million, or $2.06 per share, compared with net income of $163.9 million, or $4.52 per share, in 1991. The 1991 results included an after-tax extraordinary charge of $9.2 million related to the early retirement of high-coupon subordinated debt. Income from continuing operations before interest and taxes in 1992 was $362 million compared with $363 million in 1991. Industrial Chemicals. Sales were flat at $1 billion, but profits decreased 10 percent to $92 million. Stronger phosphorus chemical prices were offset by weaker European markets and higher spending to develop new, low-cost lithium reserves. Alkali sales and profits were flat in 1992, primarily due to flat demand and weaker prices for soda ash in the United States. Export sales, however, remained strong. Phosphorus profits improved in 1992 due to firm prices and the departure of two U.S. producers from this business in 1991. Peroxygen sales and earnings were down modestly as prices declined because of continued industry overcapacity. FMC Foret sales were flat, and earnings decreased due to price deterioration and manufacturing problems which have subsequently been corrected. Lithium sales improved in 1992 due to increased demand for several lithium products, but profits declined as a result of higher operating costs and spending associated with efforts to develop new, low-cost lithium reserves. Performance Chemicals. Sales rose 22 percent to $790 million, and profits increased 20 percent to $121 million. FMC's Agricultural Chemicals business posted record sales and profits, resulting from an improved product mix, cost reductions in operations and an increasing international presence. The Food Ingredients, Pharmaceuticals and BioProducts businesses showed strong sales and earnings performance. The acquisition of Ciba- Geigy's flame retardants and water treatment chemical businesses in 1992 increased sales,but marginally contributed to the profitability of the Performance Chemicals segment. Precious Metals. Sales increased 8 percent to $171 million, and profits rose 27 percent to $36 million in 1992 due to higher mill throughput and expanded heap- leaching activities. Defense Systems. Sales were down 5 percent to $1.1 billion due to slower international business, but profits increased 4 percent to $167 million because of favorable cost performance and lower discretionary spending. Machinery and Equipment. Sales decreased slightly to $877 million, and profits declined 31 percent to $32 million due to the effects of a weak economy in some markets. Food Machinery sales declined, and profits decreased by more than 50 percent. Energy and Transportation Equipment sales, however, increased due to strong international presence, and effective cost control increased earnings. *Per share amounts are antidilutive Fourth-quarter 1993 results include after-tax restructuring and other charges of $123.3 million (Note 2). The second quarter of 1993 reflects an after-tax extraordinary charge of $4.7 million related to debt restructuring. Fourth-quarter 1992 includes an after-tax special charge of $73.2 million related to previously discontinued operations. First-quarter 1992 reflects the cumulative effect of a change in accounting principleto January 1, 1992, for the change in accounting for retiree health and life insurance benefits ($183.7 million, net of taxes). The first and third quarters of 1992 also include after- tax extraordinary charges of $9.2 million and $2.2 million, respectively, related to the restructuring of debt. Quarterly earnings per common share may differ from full- year amounts due to changes in the number of shares outstanding during the year. CONSOLIDATED STATEMENTS OF INCOME (In thousands, except per share data) Year ended December 31 1993 1992 1991 REVENUE Sales $3,753,933$3,973,663$3,899,449 Equity in net earnings of affiliates (Note 6) 6,435 11,069 6,549 Other revenue 28,585 18,727 17,531 Total revenue 3,788,953 4,003,4593,923,529 COSTS AND EXPENSES Cost of sales 2,835,286 2,987,9082,943,717 Selling, general and administrative expenses 539,432 533,931 496,393 Research and development 149,244 144,990 134,644 Minority interests 2,484 3,634 3,046 Restructuring and other charges (Note 2) 172,300 - - Other (income) and expense, net (10,241) (29,294) (17,552) Total costs and expenses 3,688,505 3,641,1693,560,248 Income from continuing operations before interest and taxes 100,448 362,290 363,281 Interest income 11,015 12,275 17,334 Interest expense 73,649 94,930 124,683 Income from continuing operations before income taxes 37,814 279,635 255,932 Provision (benefit) for income taxes (Note 10) (3,153) 87,034 82,849 Income from continuing operations 40,967 192,601 173,083 Provision for discontinued operations, net of taxes (Note 2) - (73,200) - Income before extraordinary item and cumulative effect of change in accounting principle 40,967 119,401 173,083 Extraordinary items, net of taxes (Note 9) (4,683) (11,417) (9,206) Cumulative effect of change in accounting principle, net of taxes (Note 14) - (183,730) - Net income (loss) $36,284$ (75,746) $163,877 EARNINGS PER COMMON SHARE (NOTE 1) Primary: Income from continuing operations $ 1.11 $ 5.23 $ 4.77 Provision for discontinued operations - (1.99) - Income before extraordinary items and cumulative effect of change in accounting principle 1.11 3.24 4.77 Extraordinary items (0.13) (0.31) (0.25) Cumulative effect of change in accounting principle - (4.99) - Net income (loss) $ 0.98 $ (2.06) $ 4.52 Assuming full dilution: Income from continuing operations $ 1.11 $ 5.04 $ 4.68 Provision for discontinued operations - (1.84) - Income before extraordinary items and cumulative effect of change in accounting principle $ 1.11 $ 3.20 $ 4.68 Extraordinary items (0.13) * (0.24) Cumulative effect of change in accounting principle - * - Net income $ 0.98 $ * $ 4.44 See notes to consolidated financial statements. *Per share amounts are antidilutive. CONSOLIDATED BALANCE SHEETS (In thousands, except share and per share data) December 31 1993 1992 ASSETS CURRENT ASSETS Cash $20,450 $11,855 Marketable securities 57,071 12,423 Trade receivables, net (Note 3) 573,181 543,523 Inventories (Note 4) 268,107 319,280 Other current assets 111,439 100,524 Deferred income taxes (Note 10) 129,479 135,434 Total current assets 1,159,727 1,123,039 INVESTMENTS (NOTE 6) 76,197 85,819 PROPERTY, PLANT AND EQUIPMENT, NET (NOTE 7) 1,390,249 1,502,122 PATENTS, DEFERRED CHARGES AND INTANGIBLES OF ACQUIRED COMPANIES 91,741 63,168 DEFERRED INCOME TAXES (NOTE 10) 95,199 52,493 TOTAL ASSETS $2,813,113 $2,826,641 LIABILITIES AND STOCKHOLDERS ' EQUITY CURRENT LIABILITIES Short-Term Debt (Note 8) $66,904 $54,759 Accounts payable, trade and other 501,163 513,948 Accrued payroll 84,663 85,248 Accrued and other liabilities 364,694 321,576 Current portion of long-term debt (Note 9) 15,029 8,476 Current portion of accrued pension and other postretirement benefits (Notes 13 and 14) 37,119 37,302 Income taxes payable (Note 10) 86,432 102,837 Total current liabilities 1,156,004 1,124,146 LONG-TERM DEBT, LESS CURRENT PORTION (NOTE 9) 749,855 843,625 ACCRUED PENSION AND OTHER POSTRETIREMENT BENEFITS, LESS CURRENT PORTION (NOTES 13 AND 14) 302,725 327,100 RESERVE FOR DISCONTINUED OPERATIONS, RESTRUCTURING AND OTHER RESERVES (NOTE 2) 344,267 256,909 COMMITMENTS AND CONTINGENT LIABILITIES (NOTE 16) MINORITY INTERESTS IN CONSOLIDATED COMPANIES 43,379 55,860 STOCKHOLDERS' EQUITY (NOTE 11) Common stock, $0.10 par value, authorized 60,000,000 shares; issued 36,472,641 shares in 1993 and 36,158,866 shares in 1992 3,647 3,616 Capital in excess of par value of capital stock 79,582 71,955 Retained earnings 207,133 170,849 Foreign currency translation adjustment (Note 5) (64,766) (19,012) Treasury stock, common, at cost; 292,018 shares in 1993 and 285,959 shares in 1992 (8,713) (8,407) Total stockholders' equity 216,883 219,001 Total liabilities and stockholders' equity $2,813,113 $2,826,641 See notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CASH FLOWS RECONCILIATION FROM INCOME FROM CONTINUING OPERATIONS TO CASH PROVIDED BY OPERATING ACTIVITIES (In thousands) Year ended December 31 1993 1992 1991 Income from continuing operations $40,967 $192,601 $173,083 After-tax net interest expense 38,878 51,626 67,240 Restructuring and other charges (Note 2) 172,300 - - Operating income 252,145 244,227 240,323 Adjustments for non-cash components of income from continuing operations: Depreciation and amortization 226,612 236,896 227,635 Interest on zero coupon senior subordinated convertible debentures 7,419 11,852 4,500 Deferred income taxes (38,898) (3,046) (4,339) Equity in net earnings of affiliates (Note 6) (6,435) (11,069) (6,549) Amortization of accrued pension costs (Note 13) (7,631) (3,825) (8,216) Other 2,500 4,019 (362) 435,712 479,054 452,992 Tax benefit of extraordinary items 2,664 6,663 5,407 438,376 485,717 458,399 (INCREASE) DECREASE IN ASSETS: Trade receivables (40,073) (18,632) 3,866 Inventories 37,523 33,093 75,717 Other current assets (10,916) (6,589) (9,049) (Decrease) increase in liabilities: Accounts payable and accruals 24,748 (53,845) (68,056) Income taxes payable (21,165) 9,028 9,950 Accrued pension and other postretirement benefits, net (16,927) (22,009) (769) (26,810) (58,954) 11,659 Cash provided by operating activities before after-tax net interest expense $411,566 $426,763 $470,058 See notes to consolidated financial statements.* CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) Year ended December 31 1993 1992 1991 Cash provided by operating activities before after-tax net interest expense $411,566 $426,763 $470,058 After-tax net interest expense (38,878) (51,626) (67,240) CASH PROVIDED BY OPERATING ACTIVITIES 372,688 375,137 402,818 CASH PROVIDED (REQUIRED) BY DISCONTINUED OPERATIONS AND RESTRUCTURING (28,935) (29,964) 17,766 Cash provided (required) by investing activities: Capital spending (244,532) (314,480) (216,803) Disposal of property, plant and equipment 7,773 17,973 12,152 Decrease (increase) in investments 23,616 12,092 (1,501) CASH REQUIRED BY INVESTING ACTIVITIES (213,143) (284,415) (206,152) Cash provided (required) by financing activities: Net increase (decrease) in short-term debt 14,014 (4,339) (29,678) Net repayments under credit facilities (10,000) (130,000) (195,000) Increase in other long-term debt 206,363 413,214 157,815 Repayment of other long-term debt (285,138) (355,070) (200,167) Premium on early retirement of debt (3,413) (14,304) (10,011) Issuance of capital stock, net 7,352 14,725 9,568 Cash required by financing activities (70,822) (75,774) (267,473) Effect of exchange rate changes on cash and marketable securities (6,545) (4,939) 4,242 Increase (decrease) in cash and marketable securities 53,243 (19,955) (48,799) Cash and marketable securities, beginning of year 24,278 44,233 93,032 Cash and marketable securities, end of year $77,521 $24,278 $44,233 Supplemental cash flow information: The company considers all highly liquid debt instruments purchased with original maturities of three months or less to be cash equivalents. Under this definition, cash and marketable securities as shown on the balance sheet are considered cash equivalents. Cash flows from hedging contracts are reported in the statements of cash flows in the same categories as the cash flows from the transactions being hedged. Income taxes paid, net of refunds, were $41.8 million, $67.7 million and $61.5 million for 1993, 1992 and 1991, respectively. Interest payments, net of amounts capitalized, for 1993, 1992 and 1991 were $60.1 million, $99.9 million and $137.0 million, respectively. See notes to consolidated financial statements. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (In thousands) Common Capital Retained Foreign stock, $0.10 in excess earnings currency Treasury par value of par (deficit) translation stock Balance December 31, 1990 $3,502 $46,603 $ 82,718 $23,983 $(7,234) Net income 163,877 Stock options exercised (Note 11) 53 10,373 Purchase of treasury shares (858) Translation adjustment (Note 5) (13,169) Balance December 31, 1991 3,555 56,976 246,595 10,814 (8,092) Net loss (75,746) Stock options exercised (Note 11) 61 14,979 Purchase of treasury shares (315) Translation adjustment (Note 5) (29,826) Balance December 31, 1992 3,616 71,955 170,849 (19,012) (8,407) Net income 36,284 Stock options exercised (Note 11) 31 7,627 Purchase of treasury shares (306) Translation adjustment (Note 5) (45,754) Balance December 31, 1993 $3,647 $79,582 $207,133 $(64,766) $ (8,713) See notes to consolidated financial statements. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 PRINCIPAL ACCOUNTING POLICIES CONSOLIDATION. The consolidated financial statements include the accounts of the company and all significant majority- owned subsidiaries, except those excluded because control is restricted or temporary in nature. All material intercompany accounts and transactions are eliminated in consolidation. Investments. Investments in unconsolidated majority- owned subsidiaries, as well as companies in which ownership interests are 50 percent or less and FMC has significant influence over operating and financial policies, are accounted for using the equity method. All other investments are carried at their fair values or cost if appropriate. Equity in net earnings of affiliates. Equity in net earnings of affiliates has been adjusted to eliminate the effects of any material intercompany transactions. Inventories. Inventories are stated at the lower of cost or market value. Cost is determined on the last-in, first-out (LIFO) basis for all domestic inventories, except certain inventories relating to long-term contracts. Inventoried costs relating to long-term contracts not valued on the LIFO basis are stated at the actual production cost incurred to date, reduced by amounts identified with recognized revenue. The costs attributed to units delivered under such contracts are based on the estimated average cost of all units expected to be produced. The first-in, first-out (FIFO) method is used to determine the cost for all other inventories. Inventory costs include manufacturing overhead, except that domestic inventories exclude depreciation, factory administration, property taxes and certain other fixed expenses. Revenue recognition for contracts-in-progress. Sales are recorded under most production contracts as deliveries are made. Sales under cost reimbursement contracts for research, engineering, prototypes, repair and maintenance, and certain production contracts are recorded as costs are incurred and include estimated fees in the proportion that costs incurred to date bear to total estimated costs. The fees under certain government contracts may be increased or decreased in accordance with cost or performance incentive provisions. Such awards or penalties are recognized at the time the amounts can be reasonably determined. Property, plant and equipment. Property, plant and equipment, including capitalized interest, is recorded at cost. Depreciation for financial reporting purposes is provided principally on the straight-line basis over the estimated useful lives of the assets (land improvements 20 years, buildings 20 to 50 years, and machinery and equipment 3 to 18 years). Gains and losses are reflected in income upon sale or retirement of assets. Maintenance and repairs are charged to expense in the year incurred ($189.8 million, $203.0 million and $196.1 million in 1993, 1992 and 1991, respectively). Expenditures that extend the useful life of property, plant and equipment or increase its productivity are capitalized. Interest expense. Interest costs of $0.7 million ($2.1 million in 1992 and $3.5 million in 1991) associated with the construction of certain capital assets have been capitalized as part of the cost of those assets and are being amortized over their estimated useful lives. Interest expense for 1993 includes $0.3 million ($0.3 million in 1992 and $1.5 million in 1991) for amortization of fees and expenses associated with the revolving credit facility and subordinated debentures. Unamortized fees and expenses of $4.0 million, $3.7 million and $2.7 million related to debt restructuring were charged off as extraordinary items in 1993, 1992, and 1991, respectively. Patents, deferred charges and intangibles of acquired companies. Patents are capitalized and amortized over the lesser of their remaining useful or legal lives. Debt issuance costs are amortized over the term of the related debt. Intangibles represent the excess of the consideration paid for companies acquired in purchase transactions over the estimated fair value of the net assets acquired. Intangibles acquired since October 31, 1970, are amortized on a straight-line basis over periods normally not exceeding 15 years. Intangibles acquired before that date ($8.6 million at December 31, 1993 and 1992) are not being amortized, as management believes that their values have not diminished. Accounts payable. Amounts advanced by customers as deposits on orders not yet billed and progress payments on contracts-in-progress are recorded as accounts payable ($148.9 million at December 31, 1993 and $121.5 million at December 31, 1992). Income taxes. Effective January 1, 1993, the company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes." SFAS No. 109 requires an asset and liability approach, whereby deferred tax liabilities and assets are recognized for expected future tax consequences of temporary differences between the carrying amounts and tax bases of assets and liabilities. Income taxes are not provided for the equity in undistributed earnings of foreign subsidiaries or affiliates when it is management's intention that such earnings remain invested in those companies. Taxes are provided in the year the dividend payment is received or when the decision is made to repatriate the earnings. Prior to January 1, 1993, income tax provisions were based on income reported for financial statement purposes, adjusted for transactions (permanent differences) that do not enter into the computation of income taxes payable. The company deferred the tax effects of timing differences between financial reporting and taxable income. Foreign currency translation. Assets and liabilities of most foreign operations are translated at exchange rates in effect at year-end, and income statements are translated at the average exchange rates for the year. These translation gains and losses are accumulated in a separate component of stockholders' equity until the foreign entity is sold or liquidated. For operations in highly inflationary countries, inventories, property, plant and equipment, and other noncurrent assets are converted to U.S. dollars at historical exchange rates, and all gains or losses from conversion to U.S. dollars are included in income. Gains and losses resulting from foreign currency transactions are generally included in income. Hedging. FMC enters into formal contracts designated as hedges against interest rates related to floating rate financing facilities, gold, silver and other commodity prices, and certain foreign currency denominated transactions. The gains or losses on these contracts are included in the measurement of these transactions. The company has entered into commodity swap transactions to reduce the impact of changes in prices of commodities used in the manufacture of products. These agreements generally involve the cash settlement of the differential between the contract price and the average monthly spot price of the commodity. These contracts are denoted in their nominal amounts, which indicate the level of involvement the company has in these contracts and do not indicate risk of loss. At December 31, 1993 and 1992, the company had commodity swaps of $9.1 million and $11.0 million, respectively, extending through 1995. Earnings per common share. Primary earnings per common share are computed by dividing net income (loss) by the weighted average number of shares of common stock and common stock equivalents (primarily stock options) outstanding during the year (36,943,000 in 1993, 36,796,000 in 1992 and 36,267,000 in 1991). Fully diluted earnings per common share reflect the maximum dilution that would result from exercise of convertible debentures and stock options, unless such amounts are antidilutive. The average number of shares used in the fully diluted computation was 36,943,000 in 1993, 39,694,000 in 1992 and 37,566,000 in 1991. The fully diluted computation is based upon income from continuing operations after adding back after-tax interest on convertible debentures when dilutive ($7.6 million and $2.8 million in 1992 and 1991, respectively). Other income and expense items. Items not related to operating results are classified as other income and expense items in the income statements. Segment information. Segment operating profit is defined as total revenue less operating expenses. The following items have been excluded in computing operating profit: general corporate income and expenses, interest income and expense, income taxes, equity in net earnings of affiliates not directly associated with asegment, minority interests, significant gains or losses on abnormal retirements of assets, 1993 restructuring and other charges, and other income and expense items as defined above. Identifiable assets by industry segment are those assets that are used by segment operations. Corporate assets are principally cash and marketable securities, deferred income tax benefits, investments and property and equipment. Financial instruments. The fair values of financial instruments approximated their carrying values at December 31, 1993 and 1992. Fair values have been determined through information obtained from market sources and management estimates. Environmental. The company provides for environmental- related obligations, such as estimated contractor costs and fees, site study costs, reimbursements of regulatory agency costs, post-closure costs, litigation costs, and other remediation costs, when they are probable and amounts can be reasonably estimated. Estimated obligations to remediate sites that involve the Environmental Protection Agency (EPA), or equivalent government agencies, are generally accrued no later than when a Record of Decision (ROD), or equivalent, is issued, or upon completion of a Remediation Investigation/Feasibility Study (RI/FS) that is accepted by FMC and the appropriate government agency or agencies. As remediations and investigations proceed, the estimates are reviewed quarterly by the company's Environmental Health and Safety organization, as well as financial and legal management and, if necessary, adjusted as additional information becomes available. The estimates can change substantially as additional information becomes available regarding the nature or extent of site contamination, required remediation methods, and other actions by governmental agencies or private parties. Provisions for environmental costs are reflected in income, net of estimated recoveries from named Potentially Responsible Parties (PRPs) or other third parties, incorporate inflation and are not discounted to their present values. Estimated recoveries from third parties or other PRPs are recorded when probable and reasonably estimable. Accounting standards not adopted. In November 1992, the Financial Accounting Standards Board issued SFAS No. 112, "Employers' Accounting for Post-employment Benefits." Effective for fiscal year 1994, SFAS No. 112 establishes accounting standards for benefits provided to former or inactive employees after employment but before retirement. The company is continuing to evaluate the new statement's provisions, although it does not expect that implementation will have a material impact on the company's results of operations and financial position. Reclassifications. Certain prior-year amounts have been reclassified to conform with the current year's presentation. NOTE 2 RESTRUCTURING, ACQUISITIONS, DIVESTITURES AND DISCONTINUED OPERATIONS Restructuring and other charges. In the fourth quarter of 1993, the company recorded a charge of $172.3 million (after-tax $123.3 million, or $3.34 per share), net of $12.7 million of minority interest, to cover primarily restructuring costs in the Machinery and Equipment and Chemical businesses, as well as the write-down of assets in the Precious Metals operation. The restructuring program is designed to reduce costs and improve operating efficiencies in these businesses. The Machinery and Equipment restructuring program includes, among other items, costs for consolidating facilities and exiting unprofitable product lines, including relocation and severance costs. The charges for the Chemical businesses are due primarily to weak market conditions, and reflect costs for the shutdown of unproductive facilities and associated severance expenses. The Precious Metals' charges include closure costs for the shutdown of the Royal Mountain King and Paradise Peak mines, as well as a $51 million asset write-down of the Beartrack development property. This write-down was based on the long-term outlook for gold prices. The restructuring program also includes costs to reorganize functional support staff and services throughout the company to improve operating efficiencies and align these activities more closely with the company's growth initiatives. The after-tax cash outflow required to fund these charges will be approximately 40 percent of the $172.3 million charge. Acquisitions and divestitures. In April 1993, FMC Gold Company purchased the remaining 50 percent interest in the Humboldt Gold joint venture from TRE Management Company, bringing FMC Gold's owner-ship interest in all gold and precious metal-bearing ores in the related property to 100 percent. The former Humboldt Gold venture is targeting deep gold mineralization at the "Rossi Property" on the Carlin Gold Trend in Nevada. On June 30, 1993, the company acquired the assets of Kongsberg Offshore a.s. (Kongsberg), a wholly owned subsidiary of Siemens a.s. Kongsberg provides subsea and metering systems on a worldwide basis as well as turnkey subsea systems, including systems integration, project management and FMC subsea products. The company also acquired SOFEC, Inc. (SOFEC), a Houston based engineering and construction company that designs, fabricates and installs offshore mooring systems for export and import terminals and for floating storage and production facilities for offshore oil and gas. During 1993, these acquisitions were successfully integrated without significantly affecting consolidated results of operations. During 1992, the company acquired the worldwide flame retardants and fluids, and water treatment chemicals businesses of Ciba-Geigy Additives Division (Ciba-Geigy), with annual sales of approximately $150 million. The company also sold the street sweeper operation. These transactions did not significantly affect the 1992 consolidated results of operations of the company. In 1991, the company acquired the airplane wing deicer business of The Trump Companies, Inc. The 1991 consolidated results were not significantly affected by this acquisition. The aforementioned acquisitions were financed with cash, marketable securities, and long-term financing. The company has accounted for these acquisitions using the purchase method of accounting. Discontinued operations. In the fourth quarter of 1992, FMC recorded a $73.2 million charge, net of applicable tax benefits of $46.8 million, for increases in the projected costs of liquidating liabilities associated with discontinued operations. The provision included pretax charges of $75 million for environmental clean-up, and $45 million for higher projected product liability claims. In addition, a one-time, pretax adjustment of $92.5 million ($57.4 million net of tax) was recorded for retiree benefits provided to former employees of discontinued operations. The provision for retiree benefits was recorded in conjunction with the company's adoption of Statement of Financial Accounting Standards No. 106 (Note 14). The environmental provision increased reserves for Remediation Investigation/Feasibility Study (RI/FS) and remediation costs related to formerly discontinued businesses. The additions to the product liability reserve primarily represented higher-than-previously- projected product liability claims relating to equipment manufactured by the construction equipment group prior to the sale of that business to Sumitomo Heavy Industries, Ltd. Management believes that the reserve for discontinued operations of $223.5 million at December 31, 1993 is adequate to provide for the estimable costs associated with the liquidation and disposal of discontinued operations, including the possible longer-term requirements for potential product liability claims, retiree medical costs and clean-up of former manufacturing facilities and associated waste sites. NOTE 3 TRADE RECEIVABLES Trade receivables do not contain any material amounts representing receivables collectible over a period in excess of one year, receivables billed under retainage provisions of contracts or similar items whose determination or ultimate realization is uncertain. Trade receivables included approximately $29 million of unbilled receivables at December 31, 1993 for defense equipment awaiting final acceptance by the U.S. Government. There were no significant unbilled receivables at December 31, 1992. The company maintains an allowance for doubtful accounts based upon the expected collectibility of all trade receivables, including receivables discounted with recourse. A summary of activity in the allowance for doubtful accounts is shown below: (In thousands) 1993 1992 1991 Balance at beginning of year $7,358 $5,971 $6,284 Provision for doubtful accounts 2,954 7,211 3,438 Receivables written off as uncollectible, net of recoveries (3,535) (5,824) (3,751) Balance at end of year $6,777 $7,358 $5,971 NOTE 4 INVENTORIES Inventories are recorded at the lower of cost or market value. The current replacement cost of inventories exceeded their recorded values by approximately $238.0 million at December 31, 1993 and $228.0 million at December 31, 1992. During 1993, 1992 and 1991, the company reduced LIFO inventories that were carried at lower than prevailing costs. These reductions increased pretax income by $2.6 million in 1993, $25.5 million in 1992 and $19.1 million in 1991. Inventories at December 31, 1993 included approximately $40.7 million ($55.2 million at December 31, 1992) of inventoried costs relating to contracts-in-progress. Costs normally associated with general and administrative functions are expensed as incurred. There were no material amounts in inventory at December 31, 1993 and 1992 relating to the excess of production cost of delivered units over the estimated average cost of all units expected to be produced under contracts-in- progress, or other non-recurring costs for which ultimate recovery may be uncertain. Note 5 Foreign currency Net income for 1993, 1992 and 1991 included aggregate foreign currency losses of $1.0 million and $1.4 million and foreign currency gains of $3.4 million, respectively. Translation gains or losses for operations in highly inflationary economies are included in income, while substantially all other translation gains or losses are reported through a separate account in stockholders' equity. The following table presents the foreign currency adjustments to key balance sheet categories and the offsetting adjustment to stockholders' equity or income. The 1993 decrease in stockholders' equity is primarily attributable to a stronger U.S. dollar in relation to European currencies, particularly the Spanish peseta. Interest earned on foreign marketable securities and debt service costs are classified as interest income and interest expense, respectively, and are not offset in the amounts shown below. In addition, foreign currency impacts on marketable securities and debt in hyperinflationary economies are netted against interest income and expense and are not shown in the amounts below. Gains (Losses) (In thousands) 1993 1992 1991 Cash and marketable securities $ (6,545) $ (4,939) $ 4,242 Debt 7,730 20,951 3,582 Other working capital (24,065) (17,244) (8,969) Property, plant & equipment, net (33,350) (36,153) (7,175) Other 9,477 6,112 (1,482) $(46,753) (31,273) $ (9,802) Stockholders' equity $(45,754) $(29,826) $(13,169) Gain (loss) in income (999) (1,447) 3,367 $(46,753) $(31,273) $ (9,802) The company has entered into foreign currency contracts to hedge certain foreign transactions. Foreign exchange contracts mature at the anticipated cash requirement date of the hedged transaction, generally within one year, except for the sale of $104 million of foreign currencies which mature annually through the year 2000. The contract amounts reflect the extent of involvement the company has in foreign exchange transactions. At December 31, 1993 and 1992, the company had forward contracts primarily for the purchase and sale of European, Singapore and Canadian currencies. U.S. dollar-denominated contracts to purchase foreign currencies at December 31, 1993 were approximately $134 million ($192 million at December 31, 1992). U.S. dollar-denominated contracts to sell foreign currencies were approximately $277 million at December 31, 1993 ($160 million at December 31, 1992). Significant cross-currency contracts at December 31, 1993 were the exchange of 2.5 million German marks for 1.0 million British pounds, and 13 million German marks for 983 million Spanish pesetas. There were no significant cross-currency contracts outstanding at December 31, 1992. NOTE 6 INVESTMENTS For the year ended December 31, 1993, FMC's equity in net earnings of unconsolidated subsidiaries and affiliates was $6.4 million ($11.1 million in 1992 and $6.6 million in 1991). Dividends received from affiliates were $6.0 million in 1993 ($4.3 million in 1992 and $3.4 million in 1991). Dividends included in other revenue from other investments were $9.7 million, $8.2 million and $0.4 million in 1993, 1992 and 1991, respectively. Income taxes have not been provided for the company's share of the cumulative undistributed earnings of unconsolidated subsidiaries and affiliates ($50.6 million at December 31, 1993). Restrictions on the payment of dividends by these affiliates are insignificant. December 31 (In thousands) 1993 1992 Investments in, and advances to, unconsolidated subsidiaries and affiliates $64,607 $57,615 Other investments, net 11,590 28,204 Total $76,197 $85,819 NOTE 7 PROPERTY, PLANT AND EQUIPMENT A summary of changes in property, plant and equipment and related accumulated depreciation accounts follows: (In thousands) Land Machinery Construction and Buildings and in improvements equipment progress Total COST Balance December 31, 1990 $ 261,556 $ 404,268 $2,487,372 $ 126,590 $3,279,786 Additions 14,276 26,890 202,119 (26,482) 216,803 Disposals, retirements and reclassifications (43,043) (5,413) (85,896) 43,569 (90,783) Translation adjustment (117) (1,692) (14,025) (303) (16,137) Balance December 31, 1991 232,672 424,053 2,589,570 143,374 3,389,669 Additions 20,336 47,031 251,145 (4,032) 314,480 Disposals, retirements and reclassifications 36,004 (3,841) (93,817) (40,972) (102,626) Translation adjustment (1,210) (8,596) (48,666) (1,330) (59,802) Balance December 31, 1992 287,802 458,647 2,698,232 97,040 3,541,721 Additions 17,723 25,979 173,666 (2,302) 215,066 Disposals, retirements and reclassifications (51,748) (15,487) (103,035) (14,348) (184,618) Translation adjustment (965) (7,858) (62,824) (2,128) (73,775) BALANCE DECEMBER 31, 1993 $252,812 $461,281 $2,706,039 $ 78,262 $3,498,394 ACCUMULATED DEPRECIATION Balance December 31, 1990 $ 91,076 $150,707 $1,530,860 $1,772,643 Depreciation 13,165 14,779 196,980 224,924 Disposals, retirements and reclassifications (2,123) (3,410) (77,636) (83,169) Translation adjustment (28) (725) (8,209) (8,962) Balance December 31, 1991 102,090 161,351 1,641,995 1,905,436 Depreciation 17,218 16,840 200,920 234,978 Disposals, retirements and reclassifications (244) (2,425) (74,497) (77,166) Translation adjustment (90) (1,401) (22,158) (23,649) Balance December 31, 1992 118,974 174,365 1,746,260 2,039,599 Depreciation 15,005 16,449 190,935 222,389 Disposals, retirements and reclassifications (7,947) (741) (104,730) (113,418) Translation adjustment (75) 1,084 (41,434) (40,425) BALANCE DECEMBER 31, 1993 $125,957 $191,157 $1,791,031 $2,108,145 PROPERTY, PLANT AND EQUIPMENT, NET, DECEMBER 31, 1993 $126,855 $270,124 $ 915,00 $78,262 $1,390,249 NOTE 8 SHORT-TERM DEBT AND COMPENSATING BALANCE AGREEMENTS FMC maintains informal credit arrangements in many foreign countries. Foreign lines of credit, which usually include overdraft facilities, typically do not require the maintenance of compensating balances, as credit extension is not guaranteed but is subject to the availability of funds. At December 31, 1993, $67 million was extended to FMC pursuant to the above foreign credit arrangements. December 31 (In thousands) 1993 1992 1991 Balance at end of year $66,904 $54,759 $59,287 Weighted average interest rate end of year(1) 7.4% 8.4% 9.3% Maximum outstanding $66,904 $77,970 $94,899 Average outstanding $38,085 $61,580 $75,067 Weighted average interest rate during the year(1), (2) 8.8% 12.7% 13.0% (1) The average interest rates have been adjusted for currency devaluation associated withborrowings in hyperinflationary countries.(2) Weighted average interest rate is computed as related interest expense divided by the average outstanding balance during the year. NOTE 9 LONG-TERM DEBT LONG-TERM DEBT CONSISTS OF THE FOLLOWING: December 31 (In thousands) 1993 1992 Revolving credit facility, effective rate (1993 5.9%; 1992 6.9%)(1) $ - $ - Uncommitted facilities, effective rate (1993 4.2%; 1992 5.9%)(2) - 10,000 Notes payable to banks, various rates, due 1994 to 1998 39,594 198,437 Sinking fund debentures, 7-1/2%, due 2001 - 32,258 Pollution control and industrial revenue bonds, 2.9% to 7.1%, due 1995 to 2024 94,845 117,530 Senior debt, 8-3/4% due 1999, less unamortized discount (1993 $885; 1992 $1,056), effective rate 8.8% 249,115 248,944 Senior debt, 6-3/8% due 2003, less unamortized discount of $1,057, effective rate 6.4% 198,943 - Zero coupon senior subordinated convertible debentures due 2011, less unamortized discount of $488,430 in 1992, 7-1/2% yield to maturity - 166,570 Sterling denominated debt, due 2042, less unamortized discount of $18,901, 7.65% yield to maturity 104,849 - Exchangeable senior subordinated debentures, 6-3/4%, due 2005 75,000 75,000 Other 2,538 3,362 Total 764,884 852,101 Less current portion 15,029 8,476 Long-term portion $749,855 $843,625 (1) The effective rate on the revolving credit facility is based on average balances outstanding during the year and includes facility fees and expenses incurred due to interest rate swaps. (2) The effective rate on uncommitted facilities is based on average balances outstandingduring the year and includes expenses incurred due to interest rate swaps. During 1993, the company, with funds obtained through its revolving credit agreement, repurchased the remaining $655 million, less unamortized discount of $481 million, of 7-1/2% zero coupon senior subordinated convertible debentures with an original maturity date of 2011, $32 million of 7-1/2% sinking fund debentures, originally due 2001, and $19 million of industrial revenue bonds. As a result of the write-off of related unamortized debt issue costs, as well as other costs and expenses incurred, the company recognized an extraordinary charge of $4.7 million, net of tax benefits of $2.7 million. In August 1993, subsequent to the repurchases noted above, the company issued $200 million of 6-3/8% senior notes due 2003. The net proceeds of $198 million were used to repay advances under the revolving credit agreement. In order to secure long-term financing in the United Kingdom, the company also issued Sterling denominated debt in December 1993 due 2042 with a yield to maturity of 7.65% and a maturity value of $124 million. The company previously entered into an interest rate collar agreement, with a notional amount of $50 million at December 31, 1992, to reduce the impact of changes in interest rates on floating rate long-term debt. The agreement effectively capped interest rates by exchanging floating rate for fixed rate interest payment obligations. During 1993, the company terminated the interest rate collar agreement. During 1992, the company issued $250 million of 8-3/4% senior debt with a maturity date of April 1, 1999. The net proceeds of $247 million were used to repurchase the remaining $123 million of 12-1/4% senior subordinated debentures, and to reduce debt incurred in February 1992 to repurchase the remaining $99 million of 12-1/2% subordinated debentures. In October 1992, the company also repurchased the remaining $45 million of the 9-1/2% sinking fund debentures prior to their maturities. As a result of the premium paid on the above repurchases, the write-off of related unamortized debt issuance costs, and other expenses, the company incurred an extraordinary charge of $11.4 million, net of tax benefits of $6.7 million, in 1992. Net proceeds from the 1991 issuance of $146.7 million of zero coupon senior subordinated convertible debentures, repurchased in 1993, were originally used to repurchase $159 million of 12-1/2% subordinated debentures prior to their scheduled maturities. As a result of the premium paid on the repurchases, the write-off of related unamortized debt issuance costs, and other expenses, the company incurred an extraordinary charge of $9.2 million, net of tax benefits of $5.4 million, in 1991. The exchangeable senior subordinated debentures bearing interest at 6-3/4% and maturing in 2005 are exchangeable at any time into FMC Gold Company common stock held by FMC Corporation at an exchange price of $15-1/8, subject to change as defined in the offering circular. However, the company may, at its option, pay an amount equal to the market price of FMC Gold Company common stock in lieu of delivery of the shares. The debentures are subordinated in right of payment to all existing and future senior indebtedness of the company. The debentures are redeemable at the option of FMC at prices decreasing from 103-3/8% of face amount on January 16, 1995, to par on January 16, 2000. In 1992, FMC entered into a $700 million, five-year, non- amortizing revolving credit agreement that replaced the company's previous credit agreement which had a maximum credit limit of $583 million. At December 31, 1993, no amounts were outstanding under the company's revolving credit facility or uncommitted facilities. Among other restrictions, the credit agreement contains covenants relating to dividends, liens, consolidated net worth and cash flow coverage and leverage ratios (as defined in the agreement). The company is in compliance with all financial debt covenants. Aggregate maturities and sinking fund requirements over the next five years are (in millions): 1994 $15.0, 1995 $42.0, 1996 $28.1, 1997 $24.3, 1998 $19.1, and thereafter $636.4. NOTE 10 INCOME TAXES Effective January 1, 1993, the company adopted SFAS No. 109, "Accounting for Income Taxes," which changed the company's method of accounting for income taxes from the deferred method to an asset and liability approach. Previously, the company deferred the tax effects of timing differences between financial reporting and taxable income. The asset and liability approach requires the recognition of deferred tax liabilities and assets for the expected future tax consequences of temporary differences between the carrying amounts and tax bases of assets and liabilities. The company has elected not to restate the financial statements of prior years for this change in accounting. The cumulative effect of the change on pretax income and net income was not material. Domestic and foreign components of pretax income (loss) from continuing operations are shown below: Year ended December 31 (In thousands) 1993 1992 1991 Domestic $(17,165) $226,471 $205,278 Foreign 54,979 53,164 50,654 Total $ 37,814 $279,635 $255,932 The provision (benefit) for income taxes consists of: Year ended December 31 (In thousands) 1993 1992 1991 Current: Federal $23,733 $56,356 $56,353 Foreign 8,352 21,058 17,531 State and local 3,660 12,666 13,304 Total current 35,745 90,080 87,188 Deferred (38,898) (3,046) (4,339) Total income taxes $(3,153) $87,034 $82,849 Total income tax benefit for the year ended December 31, 1993 was allocated as follows: (In thousands) 1993 Income from continuing operations $(3,153) Extraordinary item (2,664) Stockholders' equity, for compensation expense for tax purposes in excess of amounts recognized for financial reporting purposes (2,388) Income tax benefit $(8,205) Significant components of the deferred income tax benefit attributable to income from continuing operations for the year ended December 31, 1993 are as follows: (In thousands) 1993 Deferred tax (exclusive of the effects of other components listed below) $(50,653) Adjustments to deferred tax assets and liabilities for enacted changes in tax laws and rates (5,083) Increase in the valuation allowance for deferred tax assets 16,838 Deferred income tax benefit $(38,898) Significant components of the company's deferred tax assets and liabilities as of December 31, 1993 are as follows: (In thousands) 1993 Accrued pension and other postretirement benefits $107,218 Reserve for discontinued operations and restructuring 149,208 Other reserves 108,561 Net operating loss carryforwards 22,737 Alternative minimum tax credit carryforwards 12,446 Capitalized research and development costs 14,660 Other 17,078 Deferred tax assets 431,908 Valuation allowance (37,281) Deferred tax assets, net of valuation allowance $394,627 Property, plant and equipment $163,797 Other 6,152 Deferred tax liabilities $169,949 Net deferred tax assets $224,678 The valuation allowance for deferred tax assets as of January 1, 1993 was $20.5 million. The total valuation allowance increased $16.8 million, primarily due to an increase in the valuation allowance for FMC Gold's deferred tax assets as a result of the write-down of the Beartrack property (Note 2), offset by a $6 million decrease in the valuation allowance due to revised estimates for realizing foreign tax net operating losses. As of December 31, 1993, the company has prepaid $12.4 million of alternative minimum tax. These prepayments represent credits that are available in future years to offset regular taxes to the extent they exceed alternative minimum tax. The effective income tax rate applicable to pretax income is less than the statutory U.S. federal income tax rate for the following reasons: Percent of pre-tax income Year ended December 31 1993 1992 1991 Statutory U.S. tax rate 35% 34% 34% Net increase (decrease): Foreign sales corporation income not subject to U.S. tax (30) (3) (3) Percentage depletion (51) (7) (8) State and local income taxes, less federal income tax benefit (6) 3 4 Foreign earnings subject to different tax rates (15) 1 (1) Tax on intercompany dividends and deemed dividends for tax purposes 54 1 3 Adjustment to deferred tax assets for enacted changes in tax rates (13) - - Equity in earnings of affiliates not taxed (9) (1) (1) Minority interest on FMC Gold restructuring charge (11) - - Change in valuation allowance 44 1 2 Other (6) 2 2 Total decrease (43) (3) (2) Effective tax rate (8)% 31% 32% The 1992 net loss included pretax special charges of $296.3 million for postretirement benefits and $120.0 million for discontinued operations. The tax benefits attributable to these special charges are included in deferred taxes and are expected to be realized over an extended period of time as the charges become deductible for tax purposes. The source and tax effect of the deferred income tax provision (benefit) were as follows: Year ended December 31 (In thousands) 1992 1991 Tax depreciation less than book $(7,215) $(11,430) Prepaid pension costs 9,040 10,390 Change in other reserves (10,475) (11,863) Research, intangible drilling, exploration and development 1,510 6,566 Tax on intercompany dividends - 4,900 Other timing differences 4,094 (2,902) Continuing operations (3,046) (4,339) Postretirement health care and life insurance benefits (112,609) - Discontinued operations (47,285) 8,013 Total deferred income tax provision (benefit) $(162,940) $3,674 FMC Corporation's federal income tax returns for years through 1986 have been examined by the Internal Revenue Service and have been settled, except for a few issues awaiting final resolution in the U.S. Tax Court for years 1978 through 1984. Management believes that adequate provision for income taxes has been made for the open issues in the U.S. Tax Court and for all other open years. Income taxes have not been provided for the equity in undistributed earnings of foreign consolidated subsidiaries ($244.9 million at December 31, 1993). Restrictions on the distribution of these earnings are not significant. Foreign earnings taxable to the company as dividends were $131.0 million, $22.2 million and $15.1 million in 1993, 1992, and 1991, respectively. NOTE 11 STOCKHOLDERS' EQUITY The company is authorized to issue 60,000,000 shares of common stock, par value $0.10 per share, and 5,000,000 shares of preferred stock, no par value. None of the preferred stock is issued or outstanding. The 1990 Incentive Share Plan is a continuation of previous plans providing certain incentives and rewards to key employees. The plan is administered by the Compensation and Organization Committee of the Board of Directors (the Committee) which, subject to the provisions of the plan, approves participants and awards, and times and conditions for payment. Awards may be made in the form of an unconditional stock option and a conditional dollar amount. Unconditional stock options are exercisable at the end of an award period, usually four years from the date of the grant, while all, part, or none of the conditional dollar amount may be paid at the end of the award period if the stock option has little or no value and, in the case of performance awards, financial targets have been met and approved by the Committee. Stock options may be incentive stock options and/or nonqualified stock options. The exercise price for options is the fair market value of the stock at the date of grant. Incentive stock options expire not more than 10 years after the grant date. Nonqualified stock options expire not more than 15 years after the grant date (10 years for grants prior to 1990), although the Committee may extend the expiration date of any nonqualified stock option. Under the plan, 2.8 million shares became available for awards and options to be granted in 1990 and later years. At December 31, 1993, awards covering approximately 1.7 million of these shares had been made in the form of stock options. The following summary shows stock option activity: Shares optioned but not Option price exercised per share December 31, 1991 2,671,826 $6.53-$31.25 Granted 681,300 $46.375 Exercised (609,979) $6.53-$24.50 Cancelled (63,789) $24.50-$46.375 December 31, 1992 2,679,358 $7.39-$46.375 Granted 199,300 $45.00 Exercised (313,775) $7.39-$24.50 Cancelled (98,700) $29.50-$46.375 December 31, 1993 2,466,183 $10.43-$46.375 At December 31, 1993, 776,683 of the optioned shares are exercisable at prices ranging from $10.43 to $31.25 per share, with expiration dates from December 12, 1994 to February 19, 1998. On January 3, 1994, an additional 704,800 shares became exercisable at prices ranging from $29.875 to $31.125 with an expiration date of April 27, 2005. The excess of proceeds over the par value of optioned shares issued is credited to capital in excess of par value of capital stock. Cancellation (through expiration, forfeiture or otherwise) of awards granted after 1989 increases the shares available for future awards. In April 1987, the stockholders approved the FMC Deferred Stock Plan for Nonemployee Directors. Under this plan, a portion of the annual retainer for these directors will be deferred and paid in the form of shares of common stock upon retirement or other termination of their directorships. At December 31, 1993, stock units representing an aggregate of 12,437 shares of stock were credited to the nonemployee directors' accounts. The following is a summary of FMC's capital stock activity over the past three years: Common Treasury (In thousands) stock stock Balance December 31, 1990 35,021 258 Stock options exercised 528 Stock repurchases 21 Balance December 31, 1991 35,549 279 Stock options exercised 610 Stock repurchases 7 Balance December 31, 1992 36,159 286 Stock options exercised 314 Stock repurchases 6 Balance December 31, 1993 36,473 292 At December 31, 1993, 3,576,683 shares of FMC common stock were reserved for stock options and awards. Covenants of the revolving credit facility agreement (Note 9) restrict aggregate payment of dividends on the company's common stock to 50 percent of consolidated net income (as defined) after December 31, 1991, plus $170 million. However, no dividends are expected to be paid on the company's common stock in 1994. The covenants also contain a minimum net worth requirement (as defined) of $300 million plus 50 percent of consolidated net income (as defined) after June 30, 1992. On February 22, 1986, the Board of Directors of the company declared a dividend distribution to each recordholder of common stock as of March 7, 1986, of one Preferred Share Purchase Right for each share of common stock outstanding on that date. Each right entitles the holder to purchase, under certain circumstances, one one- hundredth of a share of Junior Participating Preferred Stock, Series A, without par value, at a price of $75 per share (subject to adjustment), subject to the terms and conditions of a Rights Agreement dated February 22, 1986. The rights are not exercisable or transferable apart from the common stock until 10 days after a public announcement that a person or group either (1) has acquired, or has obtained the right to acquire, beneficial ownership of 20 percent or more of the company's outstanding shares of common stock, or (2) has commenced, or announced an intention to commence, a tender offer or exchange offer that would result in the person or group beneficially owning 30 percent or more of the outstanding shares of common stock. The rights expire on March 7, 1996, unless redeemed by the company at an earlier date. The redemption price of $.05 per right is subject to adjustment to reflect stock splits, stock dividends or similar transactions. The company has reserved 400,000 shares of Junior Preferred Stock for possible issuance under the plan. In February 1988, the Rights Agreement was amended, such that if an entity acquired more than 20 percent of FMC's common stock, FMC stockholders, except the acquiring stockholder, will have the right to purchase FMC common stock at a substantial discount to market value. For a period of 10 days after the date of the stock acquisition, the FMC Board of Directors may redeem the rights, permit the rights to be exercised or extend the 10-day redemption period. NOTE 12 SEGMENT INFORMATION A description and summary of the results of the company's industry segments are on pages 17 through 37 of this annual report. Sales to various agencies of the U.S. government aggregated $768.4 million, $839.5 million and $854.1million in 1993, 1992 and 1991, respectively. These sales were made primarily by the Defense Systems segment. Summarized financial information for the geographic areas in which the company operates (including export sales) is shown in the following tables. Other income and expense items are included in the profits below and are summarized and discussed on page 38. U. S. EXPORT SALES TO UNAFFILIATED CUSTOMERS BY DESTINATION OF SALE Year ended December31 (In thousands) 1993 1992 1991 Latin America and Canada $176,842 $172,171 $136,752 Europe 192,182 250,506 262,026 Asia, Africa and others 415,301 474,813 515,049 Total $784,325 $897,490 $913,827 NOTE 13 RETIREMENT PLANS FMC has retirement plans for substantially all domestic employees and certain employees in other countries. Plans covering salaried employees provide pension benefits based on years of service and an average of the highest 60 consecutive months of compensation during the last 120 months of consecutive employment. Plans covering hourly employees generally provide benefits of stated amounts for each year of service. The company's funding policy is to make contributions based on the projected unit credit actuarial cost method and to limit contributions to amounts that are currently deductible for tax reporting purposes. The following table summarizes the assumptions used and the components of the domestic net benefit: Year ended December 31 Assumptions: 1993 1992 1991 Weighted average discount rate 8.0% 8.0% 8.0% Rates of increase in future compensation levels 5.0% 5.0% 5.0% Weighted average expected long-term asset return 9.3% 9.3% 9.8% Components (in thousands): Service cost-benefits earned $22,621 $22,650 $22,283 Interest cost on projected benefit obligation 50,222 47,128 43,464 Actual return on plan assets investment (gains) losses (105,917) (43,942) (126,360) Net amortization and deferral: Net transition asset amortization (22,970) (22,970) (22,970) Prior service cost amortization 3,857 8,485 4,013 Net gain amortization (1,948) (2,270) (1,468) Net asset gain (loss) deferred 46,504 (12,906) 72,822 Net pension benefit $(7,631) $ (3,825) $(8,216) In 1992, the net pension benefit included a pension curtailment charge of $4.6 million relating to the elimination of certain employees in the company's hourly plans. The funded status of the plans and accrued pension cost recognized in the company's consolidated financial statements as of December 31 are as follows: (In thousands) 1993 1992 Actuarial present value of benefits for service rendered to date: Accumulated benefit obligation based on salaries to date, including vested benefits of $541,096 in 1993 and $492,874 in 1992 $(565,222) $(509,705) Additional benefits based on estimated future salary levels (117,110) (134,649) Projected benefit obligation (682,332) (644,354) Plan assets at fair value(1) 717,011 633,984 Projected benefit obligation (in excess of) or less than plan assets 34,679 (10,370) Unrecognized net loss 413 49,295 Unrecognized prior service cost 24,553 24,066 Unrecognized net transition asset (167,791) (190,761) Accrued pension cost $(108,146) $(127,770) (1) Primarily equities, bonds and participating annuities. The financial impact of compliance with SFAS No. 87 for non- U.S. pension plans is not materially different from the locally reported pension expense. The cost of providing those pension benefits for foreign employees was $6.7 million in 1993, $5.9 million in 1992 and $3.8 million in 1991. NOTE 14 POSTRETIREMENT HEALTH CARE AND LIFE INSURANCE BENEFITS FMC provides retiree health care and life insurance benefits for substantially all domestic employees. There are no significant plans for international employees. Employees generally become eligible for retiree benefits when they meet minimum retirement age and service requirements. The cost of providing most of these benefits is shared with retirees. The company has reserved the right to change or eliminate these benefit plans. The company funds a trust for retiree health and life benefits for the Defense Systems segment. Funding is based on amounts in negotiated government defense contracts, in conformance with Federal Cost Accounting Standards. SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," was implemented by the company effective January 1, 1992 using the immediate recognition transition option. SFAS No. 106 requires accrual of the expected cost of providing postretirement benefits, other than pensions, during the years that the employee renders the necessary service. This resulted in a one-time, pretax adjustment of $296.3 million ($183.7 million, net of tax) in 1992, of which $92.5 million ($57.4 million, net of tax) was recorded for retiree benefits provided to former employees of discontinued operations. Prior to 1992, the company recognized postretirement health care costs using the cash basis of accounting, while the estimated costs of postretirement life insurance benefits were generally accrued over the employees' active working lives. These costs were $17.2 million in 1991. For measurement purposes, the assumed rate of future increases in per capita cost of health care benefits was 13 percent in 1993 and 1992, decreasing gradually to 6 percent by the year 2001 and assumed to remain at that level thereafter. The health care cost trend rate assumption has a significant effect on amounts recorded. Increasing the health care cost trend rates by one percentage point would increase the accumulated postretirement benefit obligation by approximately $10 million and would increase annual service and interest costs by $1 million. The following table summarizes the assumptions used and the components of net periodic postretirement benefit cost: Year ended December 31 Assumptions: 1993 1992 Weighted average discount rate 8.0% 8.0% Weighted average expected long-term asset return 9.0% 9.0% Components (in thousands): Service cost of benefits earned $4,721 $6,938 Interest cost on accumulated postretirement benefit obligation 14,300 18,299 Actual return on plan assets (1,246) (707) Net amortization and deferral: Plan amendment amortization (6,132) (258) Net asset loss deferred (266) (361) Net periodic postretirement benefit cost $11,377 $23,911 The accrued postretirement benefit cost recognized in the company's consolidated financial statements and the funded status of the plan as of December 31 are as follows: (In thousands) 1993 1992 Accumulated postretirement benefit obligation (APBO): Retirees $(85,180) $(90,882) Fully eligible active participants (30,764) (61,448) Other active participants (61,395) (85,249) APBO (177,339) (237,579) Plan assets at fair value(1) 20,792 14,826 APBO obligation in excess of plan assets (156,547) (222,753) Unamortized plan amendments (70,426) (14,240) Unrecognized net (gain) or loss (4,725) 361 Accrued postretirement benefit cost $(231,698) (236,632) (1) Primarily equities and fixed income securities In 1993, the company announced plan changes to establish a service-related premium and a fixed-dollar cap on the company's medical plan contributions for its salaried and non-union hourly retiree medical plans. These changes, effective April 1, 1993, reduced the benefit obligation by $62.4 million, amortizable over the remaining years of service to full eligibility. In the fourth quarter of 1992, the company announced plan design changes to its salaried and non-union hourly retiree medical plans. These changes, effective January 1, 1993, reduced the benefit obligation by $14.5 million, amortizable over the remaining years of service to full eligibility. NOTE 15 EMPLOYEES' THRIFT AND STOCK PURCHASE PLAN The FMC Employees' Thrift and Stock Purchase Plan (Thrift Plan) is a qualified salary-reduction plan under Section 401(k) of the Internal Revenue Code in which all salaried and non-union hourly employees of the company may participate. Under the Thrift Plan, participants may elect to have up to 15 percent of their compensation contributed to the plan. An employee's contribution, up to five percent of compensation, is matched by the company anywhere from 15 percent to 100 percent (80 percent prior to April 1, 1993), depending on profits and fund elections. A participant's interest in the company's contributions vests gradually during the first five years of active service and is fully vested thereafter. The employee-elected contributions may be invested in company stock, a fixed income fund or an equity fund. All matching contributions by the company are invested in the company's stock. Charges against income for FMC's matching contributions, net of forfeitures, were $17.1 million in 1993, $13.9 million in 1992 and $12.6 million in 1991. NOTE 16 COMMITMENTS AND CONTINGENT LIABILITIES FMC leases office space, plants and facilities, and various types of manufacturing, data processing and transportation equipment. Leases of a capital nature are not significant. Total rent expense under all leases not capitalized amounted to $60.0 million, $59.8 million and $54.3 million in 1993, 1992 and 1991, respectively. Minimum future rentals under noncancellable leases aggregated approximately $321 million as of December 31, 1993 and are estimated to be payable $51 million in 1994, $42 million in 1995, $32 million in 1996, $26 million in 1997, $25 million in 1998 and $145 million thereafter. The real estate leases generally provide for payment of property taxes, insurance and repairs by FMC. The company may be obligated to recognize expenses required to comply with federal, state, and local environmental laws under which the company has been identified as a PRP by the EPA or other government agencies. The company has been named a PRP at 34 sites on the government's National Priority List (NPL). Similarly, the company also has received notice from the EPA or other regulatory agencies that the company may be a PRP, or PRP equivalent, at other sites. The company, in cooperation with appropriate government agencies, is currently participating in, or has participated in, Remediation Investigation/Feasibility Studies (RI/FS) at the identified sites, with the status of each investigation varying from site to site. RI/FS at certain sites have just begun whereby limited information, if any, is available relating to cost estimates, timing, or the involvement of other PRPs; whereas, at other sites, the studies are complete, remedial action plans have been chosen, and RODs have been issued. Reserves at the end of 1993 were provided for potential environmental obligations which management considers probable and for which a reasonable estimate of the obligation could be made. In accordance with the company's environmental accounting policy, reserves of $133 million, net of approximately $54 million of recoveries, including recoveries from insurance companies, the federal government and other PRPs that management considers probable, have been provided at the end of 1993, primarily in discontinued operations and other reserves. The liability arising from potential environmental obligations that have not been reserved for at this time because amounts cannot be reasonably determined due to uncertainties associated with remedial- related activities, relevant clean-up technologies and methods, and amounts to be recovered from third parties may or may not be material to any one year's results of operations in the future. Management, however, believes the liability arising from these potential environmental obligations is not likely to have a material adverse effect on the company's liquidity or financial condition and will be satisfied over many years. To ensure FMC is held responsible only for its equitable share of site remediation costs, FMC has initiated, and will continue to initiate, legal proceedings for contributions from other PRPs, and for a determination of coverage against insurance carriers that provided insurance coverage for the cost of clean-up at a number of waste sites. The Supreme Court of California has determined that FMC's clean-up costs are insured damages under its liability insurance policies, subject to a determination of the application of certain policy exclusions and conditions. In July 1993, in the Supreme Court of Santa Clara County, a jury verdict determined that these exclusions do not apply to several of these sites. The other sites will be the subject of future litigation. Regarding current operating sites, the company spent approximately $16 million, $20 million and $28 million for the years 1993, 1992 and 1991, respectively, on capital projects relating to environmental control facilities, and expects to spend additional capital of approximately $26 million and $28 million in 1994 and 1995, respectively. Additionally, in 1993, 1992, and 1991, FMC spent approximately $63 million, $57 million and $48 million, respectively, for environmental compliance costs for these sites. Regarding previously operated and other sites for the years 1993, 1992 and 1991, FMC charged approximately $17 million, $11 million and $5 million, respectively, against established reserves for remediation spending, and charged approximately $10 million, $11 million and $10 million, respectively, against reserves for spending on Remediation Investigation/Feasibility Studies (RI/FS). Recoveries from third parties of approximately $7 million and $3 million, respectively, were received and credited to the reserves in 1993 and 1992. No recoveries were received in 1991. FMC anticipates that the expenditures for current operating, previously operated and other sites will continue to be significant for the foreseeable future. The company also has certain other contingent liabilities resulting from litigation, claims, performance guarantees, and other commitments incident to the ordinary course of business. Management believes that the probable resolution of such contingencies will not materially affect the financial position or results of operations of FMC. NOTE 17 SUBSEQUENT EVENT On January 28, 1994, FMC Corporation and Harsco Corporation announced completion of the transaction, first announced in December 1992, to combine FMC's Defense Systems Group and Harsco's BMY Combat Systems Division. The new partnership, United Defense, L.P., is jointly owned, with FMC holding a controlling interest of 60 percent and Harsco holding 40 percent. FMC will also manage the business. United Defense, L.P. product lines include armored combat and combat support vehicles, weapons delivery systems, track and components for military vehicles, system overhaul and conversion, and logistics support services. Annual sales of approximately $1 billion are expected. The 1994 consolidated financial statements will include the combined results as if the combination had occurred on January 1, 1994. The consolidated results for the Defense Systems segment are not expected to differ significantly from those results expected prior to the combination. INDEPENDENT AUDITORS' REPORT The Board of Directors and Stockholders, FMC Corporation: We have audited the consolidated balance sheets of FMC Corporation and consolidated subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, cash flows and changes in stockholders' equity for each of the years in the three-year period ended December 31, 1993. These consolidated financial statements are the responsibility of the company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of FMC Corporation and consolidated subsidiaries at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993 in conformity with generally accepted accounting principles. As discussed in Note 14 to the consolidated financial statements, the company changed its method of accounting for post retirement benefits other than pensions in 1992. KPMG Peat Marwick Chicago, Illinois January 24, 1994 MANAGEMENT REPORT ON FINANCIAL STATEMENTS The consolidated financial statements and related information have been prepared by management, which is responsible for the integrity and objectivity of that information. Where appropriate, they reflect estimates based on judgments of management. The statements have been prepared in conformity with accounting principles generally accepted in the United States and are generally consistent with standards issued by the International Accounting Standards Committee. Financial information included elsewhere in this annual report is consistent with that contained in the consolidated financial statements. The company's system of internal accounting controls provides reasonable assurance as to the reliability of financial records and the protection of assets. Internal accounting control is maintained by the selection and training of qualified personnel, by establishing and communicating sound accounting and business policies, and by an internal auditing program which constantly evaluates the adequacy and effectiveness of such internal accounting controls, policies and procedures. The Audit Committee of the Board of Directors, composed of directors who are not officers or employees of the company, meets regularly with management, with the company's internal auditors, and with its independent auditors to discuss their evaluation of internal accounting controls and the quality of financial reporting. The independent auditors and the internal auditors have free access to the Audit Committee to discuss the results of their audits. The company's independent auditors, KPMG Peat Marwick, have been engaged to render an opinion on the consolidated financial statements. They review and make appropriate tests of the data included in the financial statements. As independent auditors, they also provide an objective, outside review of management's performance in reporting operating results and financial condition. Arthur D. Lyons Frank A. Riddick, III Vice President-Finance Controller Chicago, Illinois January 24, 1994 ADDITIONAL 10-K INFORMATION Competitive conditions. FMC competes on the basis of price and product performance and is among the market leaders in most products it manufactures. FMC is the world's largest producer of natural soda ash, the leading North American producer of hydrogen peroxide, a leading North American producer of industrial phosphorus chemicals and a world leader in the mining and processing of lithium products. FMC manufactures Furadan, one of the largest selling insecticides in the world. FMC is also the largest worldwide producer of carrageenan, microcrystalline cellulose, and phosphate ester flame retardants. FMC is a world leader in the production of tracked, armored personnel carriers. FMC also participates in many machinery businesses, including food processing, material handling and energy equipment, where FMC has a significant market share. Products are sold in highly competitive markets worldwide. Employees. The company had 20,696 employees at December 31, 1993. Contracts covering 11 percent of domestic hourly employees will expire during 1994. Management believes that these contracts will be renewed without a material effect on the company's businesses. Resources and raw materials. The company uses oil, gas, coal, coke, hydro-electric power and nuclear power to meet its energy needs. Chemical operations' natural resource requirements are purchased or provided from properties under long-term lease, which are subject to periodic royalty adjustments. Raw materials for the machinery businesses, principally steel and related products, are obtained from many foreign and domestic sources. Patents. The company's patents, trademarks and licenses are cumulatively important to its businesses. The loss of any one or group of related patents, trademarks or licenses would not have a material adverse effect on the overall businesses of the company or on any of its industry segments. Properties. FMC leases executive offices in Chicago and administrative offices in Philadelphia. The company operates 99 manufacturing facilities and mines in 21 countries. Major research facilities are in Santa Clara, Calif., and Princeton, N.J. FMC holds mining leases on shale and ore deposits in Idaho to supply its phosphorus plant in Pocatello, and owns substantial phosphatic ore deposits in Rich County, Utah. Trona ore, used for soda ash production in Green River, Wyo., is mined primarily from property held under long-term lease. FMC also owns half of a lithium mine located near Cherryville, N.C., and has long-term lease commitments for the remaining portion. FMC Gold Company owns mineral rights to gold and silver ore bodies at the Paradise Peak mine in Gabbs, Nev., the Royal Mountain King mine in Copperopolis, Calif., and 86 percent of the undeveloped Beartrack property in Idaho, as well as the right to 30 percent of the gold ore reserves at the Jerritt Canyon mine in Elko, Nev., operated by its joint- venture partner, Independence Mining Company Inc., a wholly owned subsidiary of Minorco (USA) Inc. Mining operations provide basic raw materials to many of FMC's chemical plants, without which other sources would have to be obtained. FMC's mining properties are operated under numerous long-term leases with no single lease or related group of leases material to the businesses of the company as a whole. Generally, the leases may be extended at FMC's option. Most of FMC's plant sites are owned, with an immaterial number of them being leased. FMC believes its properties and facilities meet present requirements and are in good operating condition. FMC believes that each of its significant manufacturing facilities is operating at a level consistent with the industry in which it operates. FMC's production properties for continuing operations are: United Latin America Western States and Canada Europe Other Total Industrial Chemicals 18 2 8 - 28 Performance Chemicals 8 4 5 2 19 Precious Metals 5 - - - 5 Defense Systems 10 - - - 10 Machinery and Equipment 16 4 12 5 37 FIVE YEAR FINANCIAL SUMMARY (In millions, except per share, employee and stockholder data) 1993 1992 1991 1990 1989 Summary of earnings Sales $3,753.9 3,973.7 3,899.4 3,722.2 3,414.5 Equity in earnings of affiliates 6.4 11.1 6.6 7.0 3.8 Other revenue 28.6 18.7 20.8 40.5 18.8 Total revenue 3,788.9 4,003.5 3,926.8 3,769.7 3,437.1 Cost of sales 2,825.3 2,960.2 2,930.2 2,787.8 2,497.2 Selling, general and administrative expenses 541.7 536.0 498.7 484.8 438.2 Research and development 149.2 145.0 134.6 157.6 149.7 Restructuring and other charges 172.3 - - - - Total costs and expenses 3,688.5 3,641.2 3,563.5 3,430.2 3,085.1 Income from continuing operations before interest, gain on FMC Gold Company sale of stock and taxes 100.4 362.3 363.3 339.5 352.0 Interest income 11.0 12.2 17.3 22.5 28.2 Interest expense 73.6 94.9 124.7 150.6 161.9 Gain on FMC Gold Company sale of stock - - - - - Income from continuing operations before income taxes 37.8 279.6 255.9 211.4 218.3 Provision (benefit) for income taxes (3.2) 87.0 82.8 56.1 61.5 Income from continuing operations 41.0 192.6 173.1 155.3 156.8 Discontinued operations, net of taxes - (73.2) - - - Income before extraordinary items and cumulative effect of change in accounting principle 41.0 119.4 173.1 155.3 156.8 Extraordinary items, net of taxes (4.7) (11.4) (9.2) - (20.4) Cumulative effect of change in accounting principle, net of taxes - (183.7) - - - Net income (loss) $36.3 (75.7) 163.9 155.3 136.4 Total dividends $ - - - - - Share data Average number of shares used in earnings per share computations (thousands): Primary 36,943 36,796 36,267 36,075 36,006 Fully diluted 36,943 39,694 37,566 36,094 36,106 Primary earnings (loss) per share: Continuing operations $1.11 5.23 4.77 4.30 4.35 Discontinued operations - (1.99) - - - Extraordinary items (0.13) (0.31) (0.25) - (0.56) Cumulative effect of change in accounting principle - (4.99) - - - Net income (loss) $0.98 (2.06) 4.52 4.30 3.79 Earnings (loss) per share assuming full dilution: Continuing operations $1.11 5.04 4.68 4.30 4.34 Discontinued operations - * - - - Extraordinary items (0.13) * (0.24) - (0.56) Cumulative effect of change in accounting principle - * - - - Net income $0.98 * 4.44 4.30 3.78 FINANCIAL POSITION AT YEAR-END Working capital $ 3.7 (1.1) (13.2) 40.6 117.6 Property, plant and equipment, at cost 3,498.4 3,541.7 3,389.7 3,279.8 2908.0 Accumulated depreciation 2,108.1 2,039.6 1,905.4 1,772.6 1,573.1 Total assets 2,813.1 2,826.6 2,815.6 2,959.2 2,819.0 Long-term debt 749.9 843.6 929.0 1,158.6 1,325.6 Stockholders' equity (deficit) 216.9 219.0 309.8 149.6 (70.6) OTHER DATA Income from continuing operations as a return on investment 7.8% 20.6 18.4 17.9 19.1 Capital expenditures $244.5 314.5 216.8 324.4 280.8 Provision for depreciation $222.4 235.0 224.9 211.2 197.8 Employees at year-end 20,696 22,097 23,150 23,882 24,110 Stockholders of record at year-end, common and preferred 13,180 14,487 14,959 17,451 18,151 *Per share amounts are antidilutive. FMC CORPORATION Annual Report on Form 10-K for 1993 Exhibit 22 LIST OF SIGNIFICANT SUBSIDIARIES OF REGISTRANT 12/31/93 Organized Percent of Under Laws Voting of Securities Owned (2) FMC Corporation..................... Delaware Registrant FMC of Canada Limited................... Canada 100 FMC Corporation (UK) Limited............ England 100 FMC Europe, S.A......................... France 100 FMC Gold Company........................ Delaware 79.8 FMC Paradise Peak Corporation........... Nevada 100 FMC Jerritt Canyon Corporation.......... Delaware 100 Meridian Gold Company................... Montana 100 FMC Wyoming Corporation................. Delaware 100 Food Machinery Holding Company B.V.... Netherlands 100 Foret, S.A.............................. Spain 100 Intermountain Research & Development Corporation............................. Wyoming 100 FMC Do Brasil S.A....................... Brazil 100 FMC International, A.G.................. Switzerland 100 Kongsberg Offshore, A/S................. Norway 100 Litex A/S............................... Denmark 100 Mid-Atlantic Investments Limited.... Canada 100 Mid-Atlantic Acceptance Company Limited.. Bermuda 100 (1)The names of various active and inactive subsidiaries have been omitted. Such subsidiaries, considered in the aggregate as a single subsidiary, would not constitute a significant subsidiary. (2)With respect to certain companies, qualifying shares in names of directors are included in these percentages. Percentages shown for indirect subsidiaries reflect the percentage of voting securities owned by the parent subsidiary. FMC CORPORATION Annual Report on Form 10-K for 1993 Exhibit 24 Consent of Auditors The Board of Directors FMC Corporation: We consent to incorporation by reference in Registration Statement No. 33-7749 and Registration Statement No. 33-10661 on Forms S-8 and Registration Statement No. 33-45648 on Form S- 3 of FMC Corporation and consolidated subsidiaries of our report dated January 24, 1994, relating to the consolidated balance sheets of FMC Corporation and consolidated subsidiaries as of December 31,1993 and 1992, and the related consolidated statements of income, cash flows and changes in stockholder's equity for each of the years in the three-year period ended December 31, 1993, which report appears in the December 31,1993 annual report on Form 10-K of FMC Corporation and consolidated subsidiaries. Chicago, Illinois March 28, 1994 FMC CORPORATION Annual Report on Form 10-K for 1993 Exhibit 25 POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS: WHEREAS, FMC CORPORATION, a Delaware corporation (hereinafter referred to as the "Company"), is a corporation with securities registered pursuant to Section 12(b) of the Securities and Exchange Act of 1934, as Amended, (the "Act"), and is subject to the reporting requirements of the Act including the obligation to file an annual report on Form 10-K; and WHEREAS, the undersigned holds and may hereafter from time to time hold one or more positions in the Corporation whether as an Officer, a Director, or both, such that the undersigned may be required or permitted in such capacity or capacities, or on behalf of the Corporation, to sign one or more of such documents; NOW, THEREFORE, the undersigned hereby constitutes and appoints A.D. Lyons, P.J. Head or R.L. Day, or any of them, his attorney for him and in his name, place and stead, and in his office and capacity in the Company, to sign and file the Company's Annual Report on Form 10-K for the year ended December 31, 1993, including all schedules, exhibits and amendments thereto, hereby giving and granting to said attorneys full power and authority to do and perform all and every act and thing whatsoever requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do if personally present at the doing thereof, hereby ratifying and confirming all that said attorneys may or shall lawfully do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned has hereunto set his hand this 11th day of February, 1994. Signature Title Arthur D. Lyons Vice President-Finance and Principal Financial Officer Arthur D. Lyons Frank A. Riddick Controller and Principal Accounting Officer Robert N. Burt Chairman of the Board and Chief Executive Officer William W. Boeschenstein Director Larry D. Brady Director B. A. Bridgewater, Jr. Director Paul L. Davies, Jr. Director Jean A. Francois-Poncet Director Robert H. Malott Director Edward C. Meyer Director James R. Thompson Director Clayton Yeutter Director By: Robert L. Day Robert L. Day Attorney-in-fact

893486_1993.txt

893486

1993

ITEM 1. BUSINESS DESCRIPTION OF THE TRUST The Santa Fe Energy Trust (the Trust), created under the laws of the State of Texas, maintains its offices at the office of the Trustee, Texas Commerce Bank National Association (the Trustee), 600 Travis, Suite 1150, Houston, Texas 77002. The telephone number of the Trust is (713) 216-5100. The Trust was formed pursuant to an Organizational Trust Agreement dated as of October 22, 1992. Effective November 19, 1992, the Organizational Trust Agreement was amended and restated by the Trust Agreement of Santa Fe Energy Trust between Santa Fe Energy Resources, Inc. (Santa Fe) and Texas Commerce Bank National Association (the Trust Agreement). Under the terms of the Trust Agreement, Santa Fe conveyed royalty interests in certain oil and gas properties to the Trust. In exchange for the conveyance of such royalty interests, the Trust issued 6,300,000 units of undivided beneficial interest (Trust Units). The Trust Units and the Treasury Obligations (hereinafter defined) were deposited with Texas Commerce Bank National Association, as depositary (the Depositary) in exchange for 6,300,000 Depositary Units (hereinafter defined). Each Depositary Unit consists of beneficial ownership of one Trust Unit and a $20 face amount beneficial ownership interest in a $1,000 face amount zero coupon United States Treasury obligation (Treasury Obligation) maturing on February 15, 2008 (Liquidation Date). The Depositary Units are evidenced by Secure Principal Energy Receipts (SPERs), which are issued and transferable only in denominations of 50 Depositary Units or an integral multiple thereof. The Depositary Units are traded on the New York Stock Exchange under the symbol SFF. The Trust Units and Treasury Obligations are held by the Depositary for the holders of Depositary Units (Holders). The Treasury Obligations consist of a portfolio of United States Treasury stripped interest coupons that mature on the Liquidation Date in the aggregate face amount of $126,000,000, which amount equals $20 multiplied by the aggregate number of Depositary Units issued and outstanding. Since Depositary Units may be issued or transferred only in denominations of 50 or integral multiples thereof, each holder of 50 Depositary Units owns the entire beneficial interest in a discrete Treasury Obligation, in a face amount of $1,000, the minimum denomination of such Treasury Obligations. The Treasury Obligations do not pay current interest. See 'Description of Trust Units and Depositary Units -- Federal Income Tax Matters'. The Trust is a grantor trust formed by Santa Fe to hold royalty interests in certain oil and gas properties owned by Santa Fe (the Royalty Properties). The principal asset of the Trust consists of (i) two term royalty interests (the Wasson ODC Royalty and the Wasson Willard Royalty-collectively, the Wasson Royalties) conveyed to the Trust out of Santa Fe's royalty interests in two production units (the Wasson ODC Unit and the Wasson Willard Unit) in the Wasson Field, and (ii) a net profits royalty interest (the Net Profits Royalties) conveyed to the Trust out of Santa Fe's royalty interests and working interests in a diversified portfolio of oil and gas properties (the Net Profits Properties) located in 12 states (collectively, the Royalty Interests). The terms of the Trust Agreement provide, among other things, that: (1) the Trust cannot acquire any asset other than the Royalty Interests or engage in any business or investment activity of any kind whatsoever, except that cash being held by the Trustee as a reserve for liabilities or for distribution at the next distribution date will be placed in bank accounts or certificates; (2) the Trustee can establish cash reserves and borrow funds to pay liabilities of the Trust and can pledge assets of the Trust to secure payment of the borrowing; (3) the Trustee will receive the payments attributable to the Royalty Interests and pay all expenses, liabilities and obligations of the Trust; (4) the Trustee will make quarterly distributions to Holders of cash available for distribution in February, May, August and November of each year; (5) the Trustee is not required to make business decisions affecting the Trust Units or the Trust assets, but under certain circumstances, the Trustee may be required to approve or disapprove an extraordinary transaction affecting the Trust and the Holders; and (6) the Trust will be liquidated on or prior to the Liquidation Date. The discussion of terms of the Trust Agreement contained herein is qualified in its entirety by reference to the Trust Agreement itself, which is an exhibit to this Form 10-K and is available upon request from the Trustee. The Trustee is paid an annual fee of approximately $12,500. The Trust is responsible for paying all legal, accounting, engineering and stock exchange fees, printing costs and other administrative expenses incurred by or at the direction of the Trustee. The total of all Trustee fees and Trust administrative expenses is anticipated to aggregate approximately $250,000 per year, although such costs could be greater or less depending on future events. The Trust paid Santa Fe an annual fee of $200,000 in 1993. Such fee will increase by 3.5% per year, payable quarterly, to reimburse Santa Fe for overhead expenses. The Wasson Royalties were conveyed from Santa Fe to the Trust pursuant to a single instrument of conveyance (the Wasson Conveyance). The Net Profits Royalties were conveyed from Santa Fe to the Trust pursuant to separate, substantially similar conveyances (the Net Profits Conveyances) except with respect to the Net Profits Royalties in properties located within the State of Louisiana and its related state waters. Due to the effect of certain Louisiana laws governing the transfer of properties to trusts, the Louisiana Net Profits Royalties were conveyed from Santa Fe to the Trust pursuant to a separate conveyance in the form of a secured interest in proceeds of production from such properties (the Louisiana Conveyance). The Louisiana Conveyance provides the Trust with the economic equivalent of the Net Profits Royalties determined with respect to the Net Profits Properties located in Louisiana. The Net Profits Conveyances, Wasson Conveyance and Louisiana Conveyance are referred to collectively as the Conveyances. Santa Fe owns the Royalty Properties subject to and burdened by the Royalty Interests. Santa Fe will receive all payments relating to the sale of production from the Royalty Properties and will be required, pursuant to the Conveyances, to pay to the Trust the portion thereof attributable to the Royalty Interests. Under the Conveyances, the amounts payable with respect to the Royalty Interests will be computed with respect to each calendar quarter, and such amounts will be paid by Santa Fe to the Trust not later than 60 days after the end of each calendar quarter. The amounts paid to the Trust will not include interest on any amounts payable with respect to the Royalty Interests which are held by Santa Fe prior to payment to the Trust. Santa Fe will be entitled to retain any amounts attributable to the Royalty Properties which are not required to be paid to the Trust with respect to the Royalty Interests. The following descriptions of the Wasson Royalties and the Net Profits Royalties, and the calculation of amounts payable to the Trust in respect thereof, are subject to and qualified by the more detailed provisions of the Conveyances included as exhibits to this Form 10-K and available upon request from the Trustee. THE WASSON ROYALTIES THE WASSON ODC ROYALTY. The Wasson ODC Royalty was conveyed out of Santa Fe's 12.3934% royalty interest in the Wasson ODC Unit and entitles the Trust to receive quarterly royalty payments with respect to oil production from the Wasson ODC Unit for each calendar quarter (or two-month period in the case of the initial period ended December 31, 1992) during the period ending on December 31, 2007. The royalties payable with respect to the Wasson ODC Royalty for any calendar quarter is determined by multiplying (a) the Average Per Barrel Price (as defined below) received for such quarter with respect to oil production from the Wasson ODC Unit by (b) the Royalty Production (as defined below) for such quarter related to the Wasson ODC Royalty. 'Royalty Production' for the Wasson ODC Royalty is defined as 12.3934% of the lesser of (i) the actual number of gross barrels of oil produced for such quarter from the Wasson ODC Unit and (ii) the applicable maximum quarterly gross production limitation set forth in the table below. The table also shows the maximum number of barrels of Royalty Production that may be produced per quarter in respect of the Wasson ODC Royalty (12.3934% of the quarterly gross production limitation). The Wasson ODC Royalty will terminate on December 31, 2007. Thus, the Trustee will make a final quarterly distribution from the Wasson ODC Royalty in respect of the fourth quarter of 2007 on or about the Liquidation Date. THE WASSON WILLARD ROYALTY. The Wasson Willard Royalty was conveyed out of Santa Fe's 6.8355% royalty interest in the Wasson Willard Unit and entitles the Trust to receive quarterly royalty payments with respect to oil production from the Wasson Willard Unit for each calendar quarter (or two-month period in the case of the initial period ended December 31, 1992) during the period ending on December 31, 2003. The royalty payable for any calendar quarter is determined by multiplying (a) the Average Per Barrel Price (as defined below) received for such quarter with respect to oil production from the Wasson Willard Unit by (b) the Royalty Production (as defined below) for such quarter related to the Wasson Willard Royalty. 'Royalty Production' for the Wasson Willard Royalty is defined as 6.8355% of the lesser of (i) the actual number of gross barrels of oil produced for such quarter from the Wasson Willard Unit and (ii) thc applicable maximum quarterly gross production limitation set forth in the table below. The table also shows the maximum number of barrels of Royalty Production that may be produced per quarter in respect of the Wasson Willard Royalty (6.8355% of the quarterly gross production limitation). AVERAGE PER BARREL PRICE. The 'Average Per Barrel Price' with respect to the Wasson Royalties for any calendar quarter generally means (a) the aggregate revenues received by Santa Fe for such quarter from the sale of oil production from its royalty interest in the Wasson Field production unit to which the particular Wasson Royalty relates less certain actual costs for such quarter which consist of post-production costs (including gathering, transporting, separating, processing, treatment, storing and marketing charges), costs of litigation concerning title to or operations of the Wasson Royalties, severance taxes, ad valorem taxes, excise taxes (including windfall profits taxes, if any), sales taxes and other similar taxes imposed upon the reserves or upon production, delivery or sale of such production, costs of audits, insurance premiums and amounts reserved for the foregoing, divided by (b) the aggregate number of barrels produced for such quarter from its royalty interest in the Wasson Field production unit to which the particular Wasson Royalty relates. THE NET PROFITS ROYALTIES The Net Profits Royalties entitle the Trust to receive, on a quarterly basis, 90% of the Net Proceeds (as defined in the Net Profits Conveyances) from the sale of production from the Net Profits Properties. The Net Profits Royalties are not limited in term, although under the Trust Agreement the Trustee is directed to sell the Net Profits Royalties prior to the Liquidation Date. The definitions, formulas, accounting procedures and other terms governing the computation of Net Proceeds are detailed and extensive, and reference is made to the Net Profits Conveyances and the Louisiana Conveyance for a more detailed discussion of the computation thereof. CALCULATION OF NET PROCEEDS. 'Net Proceeds' generally means, for any calendar quarter, (a) with respect to Net Profits Properties that are conveyed from working interests, the excess of Gross Proceeds (as defined below) over all costs, expenses and liabilities incurred in connection with exploring, prospecting and drilling for, operating, producing, selling and marketing oil and gas, including, without limitation, all amounts paid as royalties, overriding royalties, production payments or other burdens against production pursuant to permitted encumbrances, delay rentals, payments in connection with the drilling or deferring of drilling of any well in the vicinity, adjustment payments to others in connection with contributions upon pooling, unitization or communitization, rent for use of or damage to the surface, costs under any joint operating unit or similar agreement, costs incurred with respect to reworking, drilling, equipping, plugging back, completing and recompleting wells, making production ready or available for market, constructing production and delivery facilities, producing, transporting, compressing, dehydrating, separating, treating, storing and marketing production, secondary or tertiary recovery or other operations conducted for the purpose of enhancing production, litigation concerning title to or operation of the working interests, renewals and extensions of leases, and taxes, and (b) with respect to Net Profits Properties that are conveyed from royalty interests, the excess of Gross Proceeds over all costs, expenses and liabilities incurred in making production available or ready for market, including, without limitation, costs paid for gathering, transporting, compressing, dehydrating, separating, treating, storing and marketing oil and gas, litigation concerning title to or operation of royalty interests, taxes, costs of audits and insurance premiums. 'Gross Proceeds' generally means, for any calendar quarter, the amount of cash received by Santa Fe during such quarter from the sales of oil and gas produced from the Net Profits Properties excluding (a) all amounts attributable to nonconsent operations conducted with respect to any working interest in which Santa Fe or its assignee is a nonconsenting party and which is dedicated to the recoupment or reimbursement of penalties, costs and expenses of the consenting parties, (b) damages arising from any cause other than drainage or reservoir injury, (c) rental for reservoir use, (d) payments in connection with the drilling of any well on or in the vicinity of the Net Profits Properties and (e) all amounts set aside as reserved amounts. Gross Proceeds will not include (x) consideration for the transfer or sale of the Net Profits Properties (except as provided below under 'Description of the Trust -- Support Payments') or (y) any amount not received for oil and gas lost in the production or marketing thereof or used by the owner of the Net Profits Properties in drilling, production and plant operations. Gross Proceeds includes payments for future production to the extent they are not subject to repayment in the event of insufficient subsequent production. If a dispute arises as to the correct or lawful sales prices of any oil or gas produced from any of the Net Profits Properties, then for purposes of determining whether the amounts have been received by the owner of the Net Profits Properties and therefore constitute Gross Proceeds (a) the amounts withheld by a purchaser and deposited with an escrow agent shall not be considered to be received by the owner of the Net Profits Properties until actually collected, (b) amounts received by the owner of the Net Profits Properties and promptly deposited with a non-affiliated escrow agent will not be considered to have been received until disbursed to it by such escrow agent and (c) amounts received by the owner of the Net Profits Properties and not deposited with an escrow agent will be considered to have been received. The Trust is not liable to the owners or operators of the Net Profits Properties for any operating, capital or other costs or liabilities attributable to the Net Profits Properties or oil and gas produced therefrom, and the Trustee is not obligated to return any income received from the Net Profits Royalties. Overpayments to the Trust will reduce future amounts payable. The Net Profits Properties generally consist of mature producing properties and Santa Fe does not anticipate substantial additional development costs during the producing lives of these properties. SUPPORT PAYMENTS The Wasson Conveyance provides that the Trust is entitled to additional quarterly royalty payments (Support Payments), subject to certain limitations herein described, from an additional royalty out of Santa Fe's interests in the Wasson ODC Unit during the period ending on December 31, 2002 (the Support Period) in the event that the net cash available for distribution to Holders from the Royalty Interests for any calendar quarter during the Support Period is less than an amount sufficient to distribute to Holders a minimum supported quarterly royalty per Depositary Unit equal to $0.40 per Depositary Unit (the Minimum Quarterly Royalty). The distribution with respect to the fourth quarter of 1993 (paid in the first quarter of 1994) included a Support Payment of $362,000 (approximately $0.06 per Depositary Unit). This Support Payment was required primarily due to lower realized oil prices and capital expenditures incurred with respect to the Net Profits Properties, a substantial portion of which related to the drilling of new wells. Based on current prices, it is expected that the distribution with respect to the first quarter of 1994 (to be paid in the second quarter of 1994) will include a Support Payment, the amount of which has not been determined. CALCULATION OF AMOUNT OF SUPPORT PAYMENT. Support Payments payable to the Trust for any calendar quarter during the Support Period shall be equal to the additional amount necessary to cause the Minimum Quarterly Royalty for such quarter to be paid by the Trust in respect of all outstanding Trust Units; provided, that the aggregate amount of Support Payments, net of any amounts recouped by Santa Fe pursuant to reductions in the royalties payable with respect to the Royalty Interests as described below, will be limited to $20 million (the Aggregate Support Payment Limitation Amount), as such amount may be replenished upon recoupment of certain amounts as described in the following paragraph. REDUCTION OF ROYALTY INTERESTS. In the event Support Payments are paid to the Trust for any quarter, the royalties payable with respect to the Wasson Royalties will be reduced in future quarters (including quarters after the Support Period but prior to the Liquidation Date) after the Trust has received (or amounts are set aside for payment of) proceeds from all of the Royalty Interests in amounts sufficient to pay 112.5% of the Minimum Quarterly Royalty ($0.45 per Depositary Unit) on all Trust Units outstanding at the end of such quarter in order to permit Santa Fe to recoup the aggregate amount of the Support Payments. Any such reduction in royalties payable with respect to the Royalty Interests would be made first to the Wasson ODC Royalty and then, if additional reductions are necessary, from the Wasson Willard Royalty. The effect of such reductions in the royalties payable with respect to the Wasson Royalties would be to eliminate distributions in excess of $0.45 per Depositary Unit until the Support Payments, if any, received by the Trust have been recouped by Santa Fe through such reductions in the Wasson Royalties. PROPORTIONATE REDUCTION OF MINIMUM QUARTERLY ROYALTY AND AGGREGATE SUPPORT PAYMENT LIMITATION AMOUNT UPON CERTAIN SALES. In the event that Santa Fe causes the Trust to sell or release a portion of the Net Profits Royalties in connection with the sale by Santa Fe of underlying Net Profits Properties, the Minimum Quarterly Royalty and the Aggregate Support Payment Limitation Amount will be adjusted proportionately downward to equal the product resulting from multiplying each of the Minimum Quarterly Royalty and the Aggregate Support Payment Limitation Amount by a fraction, the numerator of which will be the Remaining Royalty Interests Amount (as defined below) and the denominator of which will be the Existing Royalty Interests Amount (as defined below). For such purposes, the 'Remaining Royalty Interests Amount' means, at any time, the Existing Royalty Interests Amount (as defined below) less the present value of the future net revenues attributable to the portion of the Net Profits Royalties sold or released by the Trust, determined by reference to the reserve report for the Royalty Properties prepared in accordance with guidelines of the Securities and Exchange Commission (Commission) as of the December 31 immediately preceding the date of the sale. The 'Existing Royalty Interests Amount' means, at any time, the then present value of the future net revenues attributable to the Royalty Interests (including the portion sold or released by the Trust), determined by reference to the reserve report for the Royalty Properties prepared in accordance with Commission guidelines as of the December 31 immediately preceding the date of the sale. Following any such sale of Net Profits Royalties, the Trustee will notify the Holders of the adjusted Minimum Quarterly Royalty and the adjusted Aggregate Support Payment Limitation Amount. OTHER MATTERS Payments to the Trust are attributable to the sale of depleting assets. Thus, the reserves attributable to the Royalty Properties are expected to decline over time. Based on the estimated production volumes in the Reserve Report (hereinafter defined), on an equivalent basis the oil and gas production from proved reserves attributable to the Royalty Interests in the year preceding the Liquidation Date is expected to be approximately 25% of the initial production rate attributable to the Royalty Properties. Under the terms of the Conveyances, neither the Trustee, the Trust nor the Holders will be able to influence or control the operation or future development of the Royalty Properties. Santa Fe operates only a small number of the Royalty Properties and is not expected to be able to significantly influence the operations or future development of the Royalty Properties that are royalty interests or that consist of relatively small working interests. Such operations will generally be controlled by persons unaffiliated with the Trustee and Santa Fe. Santa Fe, however, owns working interests in the Wasson ODC Unit and the Wasson Willard Unit and may be able to exercise some influence, though not control, over unit operations. The tertiary recovery operations in the Wasson Field have required substantial capital expenditures and will involve significant future capital expenditures for CO2 acquisition, particularly in the Wasson Willard Unit. A prolonged oil price downturn could cause the operators in the Wasson Field to reassess the economic viability of capital intensive production operations notwithstanding their substantial unrecovered investment. Such decisions will not be in the control of either Santa Fe or the Trustee and could have the effect of substantially reducing expected production from the Wasson Field. The current operators of the Royalty Properties are under no obligation to continue operating such properties, and neither the Trustee, the Holders nor Santa Fe will be able to appoint or control the appointment of replacement operators. The operators of the Net Profits Properties and any transferee have the right to abandon any well or property on a Net Profits Property that is a working interest, if, in their opinion, such well or property ceases to produce or is not capable of producing in commercially paying quantities, and upon termination of any such lease that portion of the Net Profits Royalties relating thereto will be extinguished. The Trust Agreement provides that Santa Fe may sell the Royalty Properties, subject to and burdened by the Royalty Interests, without the consent of the Holders. In addition, Santa Fe may, without the consent of the Holders, require the Trust to release up to $5 million of the Net Profit Royalties in any 12-month period (limited to $15 million in the aggregate for all sales prior to January 1, 2002) in connection with a sale of the Net Profits Properties provided that the Trust receives an amount equal to 90% of the net proceeds received by Santa Fe with respect to the Net Profits Properties so sold and such cash price represents the fair market value of such properties (which fair market value for sales in excess of $500,000 will be determined by independent appraisal). Such sales can be required of the Trust without regard to any dollar limitation on and after December 31, 2005. Any net sales proceeds paid to the Trust are distributable to Holders for the quarter in which such proceeds are received. Pursuant to the Trust Agreement, the Trust may not sell the Wasson ODC Royalty or the Wasson Willard Royalty without the consent of Santa Fe. Under the Trust Agreement, Santa Fe has a right of first refusal to purchase any of the Royalty Interests at fair market value, or if applicable the offered third-party price, prior to the Liquidation Date. The Trust has no employees. Administrative functions of the Trust are performed by the Trustee. DESCRIPTION OF THE TRUST UNITS AND DEPOSITARY UNITS The following information is subject to the detailed provisions of the Custodial Deposit Agreement entered into by Santa Fe, the Trustee, the Depositary and all holders from time to time of SPERs (the Deposit Agreement), which is an exhibit to this Form 10-K and is available upon request from the Trustee. The functions of the Depositary under the Deposit Agreement are custodial and ministerial in nature and for the benefit of Holders. The Deposit Agreement and the issuance of SPERs thereunder provide Holders an administratively convenient form of holding an investment in the Trust and a Treasury Obligation. Each Depositary Unit is evidenced by a SPER, which is issued by the Depositary and transferable only in denominations of 50 Depositary Units or an integral multiple thereof. Accordingly, each Holder of 50 Depositary Units owns a beneficial interest in 50 Trust Units and the entire beneficial interest in a discrete Treasury Obligation in a face amount of $1,000, or $20 per Depositary Unit. The deposited Trust Units and Treasury Obligations are held solely for the benefit of the Holders and do not constitute assets of the Depositary or the Trust. The Depositary has no power to assign, transfer, pledge or otherwise dispose of any of the Trust Units or Treasury Obligations, except as described under 'Possible Divestiture of Depositary Units and Trust Units'. Generally, the Depositary Units are entitled to participate in distributions with respect to the Trust Units and such distributions with respect to the Treasury Obligations and the liquidation of the remaining assets of the Trust. Upon the written request of a Holder for withdrawal of Trust Units and Treasury Obligations evidenced by SPERs in denominations of 50 Depositary Units or an integral multiple thereof from deposit and the surrender of such Holder's SPER in compliance with the terms of the Deposit Agreement, the Holder surrendering such Depositary Units will be entitled to receive the underlying Trust Units, which will be uncertificated, and whole Treasury Obligation as described herein. These withdrawn Trust Units will be evidenced on the books of the Trustee by a transfer of such Trust Units from the name of the Depositary to the name of the withdrawing Holder. Holders of withdrawn Trust Units will be entitled to receive Trust distributions and periodic Trust information (including tax information) directly from the Trustee. Due to the accreting nature of the value of the zero coupon Treasury Obligations, the withdrawal and sale of a Treasury Obligation underlying Depositary Units prior to its maturity will result in the Holder receiving less than the face value for its Treasury Obligation investment. The amount a withdrawing Holder may receive from the sale of a Treasury Obligation prior to its maturity will be affected by such factors as then current interest rates and the small size of the Treasury Obligation relative to typical trades in the secondary market for United States Treasury obligations (which may result in a discount to quoted market values). Pursuant to the Trust Agreement and the related transfer application, withdrawn Trust Units are not transferable except by operation of law. A holder of withdrawn Trust Units may, however, transfer such Trust Units in denominations of 50 (or an integral multiple thereof) to the Depositary for redeposit, together with Treasury Obligations in the face amount equal to $1,000 for each 50 Trust Units redeposited, in exchange for Depositary Units. Such redeposit may be effected by delivering written notice of such transfer jointly to the Depositary and the Trustee together with proper documentation necessary to transfer the requisite Treasury Obligations into the name of the Depositary. DISTRIBUTIONS The Trustee determines for each calendar quarter during the term of the Trust the amount of cash available for distribution to holders of Depositary Units and the Trust Units evidenced thereby. Such amount (the Quarterly Distribution Amount) is equal to the excess, if any, of the cash received by the Trust from the Royalty Interests then held by the Trust during such quarter, plus any other cash receipts of the Trust during such quarter, over the liabilities of the Trust paid during such quarter, subject to adjustments for changes made by the Trustee during such quarter in any cash reserves established for the payments of contingent or future obligations of the Trust. Based on industry practice and the payment procedures relating to the Net Profits Royalties, cash received by the Trustee in a particular quarter from the Net Profits Royalties generally represents proceeds from sales of production for the three months ending two months prior to the end of such quarter with respect to gas, and one month prior to the end of such quarter with respect to oil. For example, the royalty income received by the Trust for the third calendar quarter with respect to gas is attributable to production in the months of May, June and July (for which Santa Fe would have received payment from the purchasers in July, August and September, respectively). Since proceeds from the sale of production from the Wasson Properties are received within one month of production, payments in respect of the Wasson Royalties are made for production from the calendar quarter to which the Quarterly Distribution Amount relates. The Quarterly Distribution Amount for each quarter is payable to Holders of Depositary Units of record on the 45th day following each calendar quarter (or the next succeeding business day following such day if such day is not a business day) or such later date as the Trustee determines is required to comply with legal or stock exchange requirements (the Quarterly Record Date). The Trustee distributes cash to the Holders within two months after the end of each calendar quarter to each person who was a Holder of Depositary Units of record on a Quarterly Record Date. The net taxable income of the Trust for each calendar quarter will be reported by the Trustee for tax purposes as belonging to the Holders of record to whom the Quarterly Distribution Amount was or will be distributed. Because the Trust will be classified for tax purposes as a 'grantor trust' (see 'Federal Income Tax Matters'), the net taxable income will be realized by the Holders for tax purposes in the calendar quarter received by the Trustee, rather than in the quarter distributed by the Trustee. Taxable income of a Holder may differ from the Quarterly Distribution Amount because the Wasson Royalties and Treasury Obligations are treated as generating interest income for tax purposes. There may also be minor variances because of the possibility that, for example, a reserve will be established in one quarter that will not give rise to a tax deduction until a subsequent quarter, an expenditure paid for in one quarter will have to be amortized for tax purposes over several quarters, etc. See 'Federal Income Tax Matters.' Each Holder of Depositary Units (including the underlying Trust Units) of record as of the business day next preceding the Liquidation Date will be entitled to receive a liquidating distribution equal to a pro rata portion of the net proceeds from the sale of the Net Profits Royalties (to the extent not previously distributed) and a pro rata portion of the proceeds from the matured Treasury Obligations. POSSIBLE DIVESTITURE OF DEPOSITARY UNITS AND TRUST UNITS The Trust Agreement imposes no restrictions based on nationality or other status of holders of Trust Units. However, the Trust Agreement and the Deposit Agreement provide that in the event of certain judicial or administrative proceedings seeking the cancellation or forfeiture of any property in which the Trust has an interest because of the nationality, citizenship, or any other status, of any one or more holders of Trust Units including Holders of Depositary Units, the Trustee will give written notice thereof to each holder whose nationality, citizenship or other status is an issue in the proceeding, which notice will constitute a demand that such holder dispose of his Depositary Units or withdrawn Trust Units within 30 days. If any holder fails to dispose of his Depositary Units or withdrawn Trust Units in accordance with such notice, cash distributions on such units are subject to suspension. In the event a holder fails to dispose of Depositary Units in accordance with such notice, the Depositary may cancel such holder's Depositary Units and reissue them in the name of the Trustee, whereupon the Trustee will use its reasonable efforts to sell the Depositary Units and remit the net sale proceeds to such holder. In the case of Trust Units withdrawn from deposit with the Depositary, the Trustee shall redeem such Trust Units not divested in accordance with such notice, for a cash price equal to the then-current market price of the Depositary Units less the then-current, over-the-counter bid price of the related, withdrawn Treasury Obligations. The redemption price will be paid out in quarterly installments limited to the amount that otherwise would have been distributed in respect of such redeemed Trust Units. LIABILITY OF HOLDERS The Trust is intended to be classified as an 'express trust' under Texas law and thus subject to the Texas Trust Code. Under the Texas Trust Code, a trust beneficiary will not be held personally liable for obligations incurred by the Trust except in limited circumstances principally related to wrongful conduct by the trust beneficiary. It is unclear whether the Trust constitutes an 'express trust' under the Texas Trust Code. If the Trust were held not to be an express trust, a Holder could be jointly and severally liable for any liability of the Trust in the event that (i) the satisfaction of such liability was not by contract limited to the assets of the Trust and (ii) the assets of the Trust were insufficient to discharge such liability. Examples of such liability would include liabilities arising under environmental laws and damages arising from product liability and personal injury in connection with the Trust's business. Each Holder should weigh this potential exposure in deciding whether to retain or transfer his Trust Units. LIQUIDATION OF THE TRUST The Trust will be liquidated and the Net Profits Royalties will be sold on or prior to the Liquidation Date. Holders of record as of the business day next proceeding the Liquidation Date will be entitled to receive a terminating distribution with respect to each Depositary Unit equal to a pro rata portion of the net proceeds from the sale of the Net Profits Royalties (to the extent not previously distributed) and a pro rata portion of the proceeds from the matured Treasury Obligations. Under the Trust Agreement, Santa Fe has a right of first refusal to purchase any of the Royalty Interests at fair market value, or if applicable, the offered third-party price, prior to the Liquidation Date. FEDERAL INCOME TAX MATTERS This section is a summary of Federal income tax matters of general application which addresses all material tax consequences of the ownership and sale of Depositary Units. Except where indicated, the discussion below describes general Federal income tax considerations applicable to individuals who are citizens or residents of the United States. Accordingly, the following discussion has limited application to domestic corporations and persons subject to specialized Federal income tax treatment, such as tax-exempt entities, regulated investment companies and insurance companies. The following discussion does not address tax consequences to foreign persons. It is impractical to comment on all aspects of Federal, state, local and foreign laws that may affect the tax consequences of the transactions contemplated hereby and of an investment in Depositary Units as they relate to the particular circumstances of every prospective Holder. EACH HOLDER SHOULD CONSULT HIS OWN TAX ADVISOR WITH RESPECT TO HIS PARTICULAR CIRCUMSTANCES. This summary is based on current provisions of the Internal Revenue Code of 1986, as amended (the Code), existing and proposed regulations thereunder and current administrative rulings and court decisions, all of which are subject to changes that may or may not be retroactively applied. Some of the applicable provisions of the Code have not been interpreted by the courts or the Internal Revenue Service (IRS). No ruling has been or will be requested from the IRS with respect to any matter affecting the Trust or Holders, and thus no assurance can be provided that the statements set forth herein (which do not bind the IRS or the courts) will not be challenged by the IRS or will be sustained by a court if so challenged. TREATMENT OF DEPOSITARY UNITS A purchaser of a Depositary Unit will be treated, for Federal income tax purposes, as purchasing directly an interest in the Treasury Obligations and a Trust Unit. A purchaser will therefore be required to allocate the purchase price of his Depositary Unit between the interest in the Treasury Obligations and the Trust Unit in the proportion that the fair market value of each bears to the fair market value of the Depositary Unit. Information regarding purchase price allocations will be furnished to Holders by the Trustee. CLASSIFICATION AND TAXATION OF THE TRUST The Trust will be taxable as a grantor trust and not as an association taxable as a corporation. As a grantor trust, the Trust will not be subject to tax. For tax purposes, Holders will be considered to own and receive the Trust's income and principal as though no trust were in existence. The Trust will file an information return, reporting all items of income, credit or deduction which must be included in the tax returns of Holders. If the Trust were determined to be an association taxable as a corporation, it would be treated as a separate entity subject to corporate tax on its taxable income, Holders would be treated as shareholders, and distributions to Holders from the Trust would be treated as nondeductible corporate distributions. Such distributions would be taxable to a Holder, first, as dividends to the extent of the Holder's pro rata share of the Trust's earnings and profits, then as a tax-free return of capital to the extent of his basis in his Trust Units, and finally as capital gain to the extent of any excess. DIRECT TAXATION OF HOLDERS Because the Trust will be treated as a grantor trust for Federal income tax purposes, and a Holder will be treated, for Federal income tax purposes, as owning a direct interest in the Treasury Obligations and the assets of the Trust, each Holder will be taxed directly on his pro rata share of the income attributable to the Treasury Obligations and the assets of the Trust and will be entitled to claim his pro rata share of the deductions attributable to the Trust (subject to certain limitations discussed below). Income and expenses attributable to the assets of the Trust and the Treasury Obligations will be taken into account by Holders consistent with their method of accounting and without regard to the taxable year or accounting method employed by the Trust. The Trust will make quarterly distributions to Holders of record on each Quarterly Record Date. The terms of the Trust Agreement seek to assure to the extent practicable that taxable income attributable to such distributions will be reported by the Holder who receives such distributions, assuming that he is the owner of record on the Quarterly Record Date. In certain circumstances, however, a Holder will not receive the distribution attributable to such income. For example, if the Trustee establishes a reserve or borrows money to satisfy debts and liabilities of the Trust, income associated with the cash used to establish that reserve or to repay that loan must be reported by the Holder, even though that cash is not distributed to him. In addition, Holders will be required to recognize certain interest income attributable to the Treasury Obligations with respect to which no current cash distributions will be made. The Trust intends to allocate income and deductions to Holders based on record ownership at Quarterly Record Dates. It is unknown whether the IRS will accept that allocation or will require income and deductions of the Trust to be determined and allocated daily or require some method of daily proration, which could result in an increase in the administrative expenses of the Trust. TREATMENT OF TRUST UNITS Because the Trust is treated as a grantor trust for tax purposes, each Holder will be treated as purchasing directly an interest in the Royalty Interests. The purchaser of a Depositary Unit will be required to allocate the portion of his total purchase price allocated to the Trust Unit among the Royalty Interests in the proportion that the fair market value of each of the Royalty Interests bears to the total fair market value of all of the Royalty Interests. For purposes of making this allocation, the Royalty Interests will include the Wasson ODC Royalty, the Wasson Willard Royalty and the Net Profits Royalties. Information regarding purchase price allocations will be furnished to Holders by the Trustee. INTEREST INCOME Based on representations made by Santa Fe regarding the reserves burdened by the Wasson Royalties and the expected life of the Wasson Royalties, the Wasson Royalties will be treated as 'production payments' under Section 636(a) of the Code. Thus, each Holder will be treated as making a mortgage loan on the Wasson Properties to Santa Fe in an amount equal to the amount of the purchase price of each Depositary Unit allocated to the Wasson Royalties. Because they are treated as debt instruments for tax purposes, the Wasson Royalties will be subject to the Original Issue Discount (OID) rules of Sections 1272 through 1275 of the Code. Section 1272 generally requires the periodic inclusion of original issue discount in income of the purchaser of a debt instrument. Section 1275 provides special rules and authorizes the IRS to prescribe regulations modifying the statutory provisions where, by reason of contingent payments, the tax treatment provided under the statutory provisions does not carry out the purposes of such provisions. The IRS has not yet issued either temporary or final regulations dealing with contingent payments. Proposed regulations dealing with contingent payments were issued in 1986 and modified in 1991 (the Proposed Regulations). Under the Proposed Regulations, each payment (at the time the amount of such payment becomes fixed) made to the Trust with respect to the Wasson Royalties will be treated first as consisting of a payment of interest to the extent of interest deemed accrued under the OID rules and the excess (if any) will be treated as a payment of principal. The total amount treated as principal will be limited to the amount of the purchase price of each Depositary Unit allocated to the Wasson Royalties. For purposes of determining the amount of accrued interest, the Proposed Regulations require the use of the Applicable Federal Rate based on the due date of the final payment due under the terms of each of the production payments, which for the Wasson Willard Royalty and the Wasson ODC Royalty is December 31, 2003 and December 31, 2007, respectively. Holders will also be required to recognize and report OID interest income attributable to the Treasury Obligations. In general, the total amount of OID interest income a Holder will be required to recognize will be calculated as the difference between the amount of the purchase price of a Depositary Unit allocated to the Treasury Obligations and the pro rata portion of the face amount of such Treasury Obligations attributable to the Depositary Unit. The amount of OID interest income so calculated will be included in income by a Holder on the basis of a constant interest rate computation. ROYALTY INCOME AND DEPLETION The income from the Net Profits Royalties will be royalty income subject to an allowance for depletion. The depletion allowance must be computed separately by each Holder for each oil or gas property (within the meaning of Code Section 614). The IRS presently takes the position that a net profits interest carved out of multiple properties is a single property for depletion purposes. Accordingly, the Trust intends to take the position that the Net Profits Royalties are a single property for depletion purposes until such time as the issue is resolved in some other manner. The allowance for depletion with respect to a property is determined annually and is the greater of cost depletion or, if allowable, percentage depletion. Percentage depletion is generally available to 'independent producers' (generally persons who are not substantial refiners or retailers of oil or gas or their primary products) on the equivalent of 1,000 barrels of production per day. Percentage depletion is a statutory allowance equal to 15% of the gross income from production from a property subject to a net income limitation which is 100% of the taxable income from the property, computed without regard to depletion deductions and certain loss carrybacks. The depletion deduction attributable to percentage depletion for a taxable year is limited to 65% of the taxpayer's taxable income for the year before allowance of 'independent producers' percentage depletion and certain loss carrybacks. Unlike cost depletion, percentage depletion is not limited to the adjusted tax basis of the property, although it reduces such adjusted tax basis (but not below zero). In computing cost depletion for each property for any year, the adjusted tax basis of that property at the beginning of that year is divided by the estimated total units (Bbls of oil or Mcf of gas) recoverable from that property to determine the per-unit allowance for such property. The per-unit allowance is then multiplied by the number of units produced and sold from that property during the year. Cost depletion for a property cannot exceed the adjusted tax basis of such property. Since the Trust will be taxed as a grantor trust, each Holder will compute cost depletion using his basis in his Trust Units allocated to the Net Profits Royalties. Information will be provided to each Holder reflecting how that basis should be allocated among each property represented by his Trust Units. OTHER INCOME AND EXPENSES It is anticipated that the Trust may generate some interest income on funds held as a reserve or held until the next distribution date. Expenses of the Trust will include administrative expenses of the Trustee. Under the Code, certain miscellaneous itemized deductions of an individual taxpayer are deductible only to the extent that in the aggregate they exceed 2% of the taxpayer's adjusted gross income. Certain administrative expenses attributable to the Trust Units may have to be aggregated with an individual Holder's other miscellaneous itemized deductions to determine the excess over 2% of adjusted gross income. It is anticipated that the amount of such expenses will not be significant in relation to the Trust's income. NON-PASSIVE ACTIVITY INCOME AND LOSS The income and expenses of the Trust will not be taken into account in computing the passive activity losses and income under Code Section 469 for a Holder who acquires and holds Depositary Units as an investment. UNRELATED BUSINESS TAXABLE INCOME Certain organizations that are generally exempt from tax under Code Section 501 are subject to tax on certain types of business income defined in Code Section 512 as unrelated business income. The income of the Trust will not be unrelated business taxable income within the meaning of Code Section 512 so long as the Trust Units are not 'debt-financed property' within the meaning of Code Section 524(b). In general, a Trust Unit would be debt-financed if the Holder incurs debt to acquire a Trust Unit or otherwise incurs or maintains a debt that would not have been incurred or maintained if such Trust Unit had not been acquired. Legislative proposals have been made from time to time which, if adopted, would result in the treatment of income attributable to the Net Profits Royalties as unrelated business income. SALE OF DEPOSITARY UNITS; DEPLETABLE BASIS Generally, a Holder will realize gain or loss on the sale or exchange of his Depositary Units measured by the difference between the amount realized on the sale or exchange and his adjusted basis for such Depositary Units. Gain or loss on the sale of Depositary Units by a Holder who is not a dealer with respect to such Depositary Units and who has a holding period for the Depositary Units of more than one year will be treated as long-term capital gain or loss except to the extent of the depletion recapture amount. A Holder's basis in his Depositary Units will be equal to the amount paid for such Depositary Units. Such basis will be increased by the amount of any OID interest income recognized by the Holder attributable to the Treasury Obligations. Such basis will be reduced by deductions for depletion claimed by the Holder (but not below zero). In addition, such basis will be reduced by the amount of any payments attributable to the Wasson Royalties which are treated as payments of principal under the OID rules. For Federal income tax purposes, the sale of a Depositary Unit will be treated as a sale by the Holder of his interest in the Treasury Obligations and the assets of the Trust. Thus, upon the sale of Depositary Units, a Holder must treat as ordinary income his depletion recapture amount, which is an amount equal to the lesser of (i) the gain on that sale attributable to disposition of the Net Profits Royalties or (ii) the sum of the prior depletion deductions taken with respect to the Net Profits Royalties (but not in excess of the initial basis of such Depositary Units allocated to the Net Profits Royalties). It is possible that the IRS would take the position that a portion of the sales proceeds is ordinary income to the extent of any accrued income at the time of sale allocable to the Depositary Units sold, but which is not distributed to the selling Holder. SALE OF NET PROFITS ROYALTIES In certain circumstances, Santa Fe may cause the Trustee, without the consent of the Holders, to release a portion of the Net Profits Royalties in connection with a sale by Santa Fe of the underlying Net Profits Properties. Additionally, the assets of the Trust, including the Net Profits Royalties, will be sold by the Trustee prior to the Liquidation Date in anticipation of the termination of the Trust. A sale by the Trust of Net Profits Royalties will be treated for Federal income tax purposes as a sale of Net Profits Royalties by a Holder. Thus, a Holder will recognize gain or loss on a sale of Net Profits Royalties by the Trust. A portion of that income may be treated as ordinary income to the extent of depletion recapture. See 'Sale of Depositary Units; Depletable Basis,' above. BACKUP WITHHOLDING In general, distributions of Trust income will not be subject to 'backup withholding' unless: (i) the Holder is an individual or other noncorporate taxpayer and (ii) such Holder fails to comply with certain reporting procedures. TAX SHELTER REGISTRATION Code Section 6111 requires a tax shelter organizer to register a 'tax shelter' with the IRS by the first day on which interests in the tax shelter are offered for sale. The Trust is registered as a tax shelter with the IRS. The Trust's tax shelter registration number is 92322000636. A Holder who sells or otherwise transfers a Trust Unit in a subsequent transaction must furnish the tax shelter registration number to the transferee. The penalty for failure of the transferor of a Trust Unit to furnish such tax shelter registration number to a transferee is $100 for each such failure. Holders must disclose the tax shelter registration number of the Trust on Form 8271 to be attached to the tax return on which any deduction, loss, credit or other benefit generated by the Trust is claimed or income of the Trust is included. A Holder who fails to disclose the tax shelter registration number on his return, without reasonable cause for such failure, will be subject to a $50 penalty for each such failure. (Any penalties discussed herein are not deductible for income tax purposes.) ISSUANCE OF A TAX SHELTER REGISTRATION NUMBER DOES NOT INDICATE THAT AN INVESTMENT IN DEPOSITARY UNITS OR TRUST UNITS OR THE CLAIMED TAX BENEFITS HAVE BEEN REVIEWED, EXAMINED OR APPROVED BY THE IRS. ERISA CONSIDERATIONS The Employee Retirement Income Security Act of 1974, as amended (ERISA), imposes certain requirements on pension, profit-sharing and other employee benefit plans to which it applies (Plans), and contains standards on those persons who are fiduciaries with respect to such Plans. In addition, under the Code, there are similar requirements and standards which are applicable to certain Plans and individual retirement accounts (whether or not subject to ERISA) (collectively, together with Plans subject to ERISA, referred to herein as Qualified Plans). A fiduciary of a Qualified Plan should carefully consider fiduciary standards under ERISA regarding the Plan's particular circumstances before authorizing an investment in Trust Units. A fiduciary should first consider (i) whether the investment satisfies the prudence requirements of Section 404(a)(1)(B) of ERISA, (ii) whether the investment satisfies the diversification requirements of Section 404(a)(1)(C) of ERISA and (iii) whether the investment is in accordance with the documents and instruments governing the Plan as required by Section 404(a)(1)(D) of ERISA. In order to avoid the application of certain penalties, a fiduciary must also consider whether the acquisition of Trust Units and/or operation of the Trust might result in direct or indirect nonexempt prohibited transactions under Section 406 of ERISA and Code Section 4975. In determining whether there are such prohibited transactions, a fiduciary must determine whether there are 'plan assets' involved in the transaction. On November 13, 1986, the Department of Labor published final regulations (the DOL Regulations) concerning whether or not a Qualified Plan's assets (such as a Trust Unit) would be deemed to include an interest in the underlying assets of an entity (such as the Trust) for purposes of the reporting, disclosure and fiduciary responsibility provisions of ERISA and analogous provisions of the Code, if the Plan acquires an 'equity interest' in such entity. The DOL Regulations provide that the underlying assets of an entity will not be considered 'plan assets' if the interests in the entity are a publicly offered security. Trust Units are considered to be 'publicly offered' for this purpose if they are part of a class of securities that is (i) widely held (I.E., owned by more than 100 investors independent of the issuer and each other), (ii) freely transferable, and (iii) registered under Section 12(b) or 12(g) of the Exchange Act. Although no assurances can be given, it is believed that these requirements have been satisfied with respect to Trust Units. Fiduciaries, however, will need to determine whether the acquisition of Trust Units is a nonexempt prohibited transaction under the general requirements of ERISA Section 406 and Code Section 4975. Due to the complexity of the prohibited transaction rules and the penalties imposed upon persons involved in prohibited transactions, it is important that potential Qualified Plan investors consult with their counsel regarding the consequences under ERISA and the Code of their acquisition and ownership of Trust Units. STATE TAX CONSIDERATIONS The following is intended as a brief summary of certain information regarding state income taxes and other state tax matters affecting individuals who are Holders. Holders are urged to consult their own legal and tax advisors with respect to these matters. Prospective investors should consider state and local tax consequences of an investment in Depositary Units. The Trust owns the Royalty Interests burdening oil and gas properties located in Alabama, Arkansas, California, Colorado, Kansas, Louisiana, Mississippi, New Mexico, North Dakota, Oklahoma, Texas and Wyoming. Of these, all but Texas and Wyoming have income taxes applicable to individuals. As stated, Texas currently has no income tax and the Reserve Report reflects that more than 50% of the estimated future net cash inflows generated by the Trust will be attributable to properties located in Texas. A Holder may be required to file state income tax returns and/or to pay taxes in those states imposing income taxes and may be subject to penalties for failure to comply with such requirements. Further, in some states the Trust may be taxed as a separate entity. The Depositary will provide information prepared by the Trustee concerning the Depositary Units sufficient to identify the income from Depositary Units that is allocable to each state. Holders of Depositary Units should consult their own tax advisors to determine their income tax filing requirements with respect to their share of income of the Trust allocable to states imposing an income tax on such income. The Trust Units represented by Depositary Units may constitute real property or an interest in real property under the inheritance, estate and probate laws of some or all of the states listed above. If the Depositary Units are held to be real property or an interest in real property under the laws of a state in which the Royalty Properties are located, the holders of Depositary Units may be subject to devolution, probate and administration laws, and inheritance or estate and similar taxes under the laws of such state. DESCRIPTION OF THE TREASURY OBLIGATIONS The Treasury Obligations consist of a portfolio of interest coupons stripped from United States Treasury Bonds. All of the Treasury Obligations become due on the Liquidation Date in the aggregate face amount of $126,000,000, which amount equals $20 per outstanding Depositary Unit. The Treasury Obligations were purchased on behalf of the Depositary at a deep discount from face value at a price of $30.733 per hundred dollars, which was approximately the asked price on the over-the-counter U.S. Treasury market for such obligations on November 12, 1992 (after adjustment for five-day settlement). The Treasury Obligations were deposited with the Depositary on November 19, 1992 in connection with the initial public offering of Depositary Units. The Treasury Obligations were issued under the Separate Trading of Registered Interest and Principal of Securities program of the U.S. Treasury, which permits the trading of the Treasury Obligations in book-entry form. The Treasury Obligations are held for the benefit of Holders in the name of the Depositary in book-entry form with a Federal Reserve Bank subject to withdrawal by a Holder. The deposited Treasury Obligations are not considered assets of the Depositary or the Trust. In the unlikely event of default by the U.S. Treasury in the payment of the Treasury Obligations when due, each Holder would have the right to withdraw a deposited Treasury Obligation in a face amount of $1,000 for each 50 Depositary Units and, as a real party in interest and as the owner of the entire beneficial interest in discrete Treasury Obligations, proceed directly and individually against the United States of America in whatever manner he deems appropriate without any requirement to act in concert with the Depositary, other Holders or any other person. Santa Fe makes available quarterly to the Depositary for distribution to Holders certain information regarding the Treasury Obligations including high, low and recent asked prices quoted during each calendar quarter on the over-the-counter United States Treasury market. The Treasury Obligations pay no current interest. DESCRIPTION OF THE ROYALTY PROPERTIES THE WASSON PROPERTIES The Wasson Royalties were conveyed to the trust out of Santa Fe's 12.3934% royalty interest in the Wasson ODC Unit and its 6.8355% royalty interest in the Wasson Willard Unit, located in the Wasson Field. Santa Fe also owns significant working interests in each of these units. Santa Fe's production from the Wasson Field commenced in 1939. A secondary waterflooding phase in the Wasson Field began in the early 1960s. The Wasson Field has been significantly redeveloped for tertiary recovery operations utilizing CO2 flooding, which commenced in 1984. Gross capital expenditures in excess of $600 million have been made by all working interest owners in respect of these operations in the Wasson ODC Unit and Wasson Willard Unit. Most of the capital expenditures for plant, facilities, wells and equipment necessary for such tertiary recovery operations have been made, although significant ongoing capital expenditures for CO 2 acquisition will be required to complete the flood of the Wasson Field, particularly the Wasson Willard Unit. The Wasson Royalties are not subject to development costs or operating costs (including CO2 acquisition costs). The Wasson ODC Unit and the Wasson Willard Unit are production units formed by the various interest owners in the Wasson Field to facilitate development and production of certain geographically concentrated leases. The Wasson ODC Unit covers approximately 7,840 acres with approximately 315 producing wells and is operated by Amoco Production Company. The Wasson Willard Unit covers approximately 13,520 acres with approximately 338 producing wells and is operated by a subsidiary of Atlantic Richfield Company. Production attributable to Santa Fe's royalty interests in the Wasson ODC Unit and Wasson Willard Unit is marketed by Santa Fe and in some cases is sold at the wellhead at market responsive prices that approximate spot oil prices for West Texas Sour crude, and in other cases is sold at points within common carrier pipeline systems on terms whereby Santa Fe pays the cost of transporting same to such points. Santa Fe may sell its royalty interests in the Wasson Field subject to and burdened by the Wasson Royalties, without the consent of the Trustee of the Trust or the Holders. The Wasson Royalties may not be sold by the Trust without the consent of Santa Fe. THE NET PROFITS PROPERTIES The Royalty Properties burdened by the Net Profits Royalties consist of royalty and working interests in a diversified portfolio of producing properties located in established oil and gas producing areas in 12 states. Over 90% of the discounted present value of estimated future net revenues attributable to the Net Profits Royalties is generated from Net Profits Properties located in Texas, Oklahoma and Louisiana and related state waters. No single property or field accounts for more than 7% of the estimated future net revenues attributable to the Net Profits Royalties. The Net Profits Properties generally consist of mature producing properties and Santa Fe does not anticipate substantial additional development during the producing lives of these properties. Production attributable to the Net Profits Properties is principally sold at market responsive prices. Santa Fe owns the Net Profits Properties subject to and burdened by the Net Profits Royalties, and is entitled to proceeds attributable to its ownership interest in excess of 90% of the Net Proceeds paid to the Trust. Santa Fe is required to receive payments representing the sale of production from the Net Profits Properties, deduct the costs described above and pay 90% of the net amount to the Trust. Santa Fe may sell the Net Profits Properties subject to and burdened by the Net Profits Royalties. In addition, Santa Fe may, subject to certain limitations, cause the Trust to release portions of the Net Profits Royalties in connection with the sale of the underlying Net Profits Properties. Santa Fe estimates that as of December 31, 1993, the Net Profits Properties covered approximately 246,000 gross acres (approximately 36,000 net to Santa Fe). Productive well information generally is not made available by operators to owners of royalties and overriding royalties. Accordingly, such information is unavailable to Santa Fe for the Net Profits Properties. TITLE TO PROPERTIES The Wasson Properties have been owned by Santa Fe for over 40 years. The Conveyances contain a warranty of title, limited to claims by, through or under Santa Fe, and covering the Wasson Properties and certain of the Net Profits Properties aggregating approximately 82% of the discounted present value of the proved reserves attributable to the Royalty Interests according to the Reserve Report. The Conveyances contain no title warranty with respect to the remaining Net Profits Properties. As is customary in the oil and gas industry, Santa Fe or the operator of its properties performs only a perfunctory title examination when it acquires leases, except leases covering proved reserves. Generally, prior to drilling a well, a more thorough title examination of the drill site tract is conducted and curative work is performed with respect to significant title defects, if any, before proceeding with operations. The Royalty Properties are typically subject, to one degree or another, to one or more of the following: (i) royalties and other burdens and obligations, expressed and implied, under oil and gas leases; (ii) overriding royalties (such as the Royalty Interests) and other burdens created by Santa Fe or its predecessors in title; (iii) a variety of contractual obligations (including, in some cases, development obligations) arising under operating agreements, farmout agreements, production sales contracts and other agreements that may affect the properties or their titles; (iv) liens that arise in the normal course of operations, such as those for unpaid taxes, statutory liens securing unpaid suppliers and contractors and contractual liens under operating agreements; (v) pooling, unitization and communitization agreements, declarations and orders; and (vi) easements, restrictions, rights-of-way and other matters that commonly affect property. To the extent that such burdens and obligations affect Santa Fe's rights to production and production revenues from the Royalty Properties, they have been taken into account in calculating the Royalty Interests and in estimating the size and value of the Trust's reserves attributable to the Royalty Interests. It is not entirely clear that all of the Royalty Interests would be treated as fully conveyed real or personal property interests under the laws of each of the states in which the Royalty Properties are located. The Conveyances (other than the Louisiana Conveyance) state that the Royalty Interests constitute real property interests and Santa Fe has recorded the Conveyances (other than the Louisiana Conveyance) in the appropriate real property records of the states in which the Royalty Properties are located in accordance with local recordation provisions. If during the term of the Trust, Santa Fe becomes involved as a debtor in bankruptcy proceedings, it is not entirely clear that all of the Royalty Interests would be treated as fully conveyed property interests under the laws of each of the states in which the Royalty Properties are located. If in such a proceeding a determination were made that a Royalty Interest (or a portion thereof) did not constitute fully conveyed property interests under applicable state law, the Conveyance related to such Royalty Interest (or a portion thereof) could be subject to rejection as an executory contract (a term used in the Federal Bankruptcy Code to refer to a contract under which the obligations of both the debtor and the other party to the contract are so unsatisfied that the failure of either to complete performance would constitute a material breach excusing performance of the other) in a bankruptcy proceeding involving Santa Fe. In such event, the Trust would be treated as an unsecured creditor of Santa Fe with respect to such Royalty Interest in the pending bankruptcy. Under Louisiana law, the Louisiana Conveyance constitutes personal property that could be rejected as an executory contract in a bankruptcy proceeding involving Santa Fe, although the mortgage on the Royalty Properties that is burdened by the Louisiana Conveyance and which secures the Trust's interests in such Royalty Properties should enhance the Trust's position in the event of such a proceeding. No assurance can be given that the Royalty Interests would not be subject to rejection in a bankruptcy proceeding as executory contracts. RESERVES A study of the proved oil and gas reserves attributable to the Trust as of December 31, 1993 has been made by Ryder Scott Company, independent petroleum consultants. The following letter (Reserve Report) summarized such reserve study. The Trust has not filed reserve estimates covering the Royalty Properties with any other Federal authority or agency. (RYDER SCOTT LETTERHEAD) February 1, 1994 Santa Fe Energy Resources, Inc. 1616 South Voss Road Houston, Texas 77057-2696 Gentlemen: Pursuant to your request, we present below our estimates of the net proved reserves attributable to the interests of the Santa Fe Energy Trust (Trust) as of December 31, 1993. The Trust is a grantor trust formed to hold interests in certain domestic oil and gas properties owned by Santa Fe Energy Resources, Inc. (Santa Fe). The interests conveyed to the Trust consist of royalty interests in the Wasson Field, Texas (Wasson Royalties) and a net profits interest derived from working and royalty interests in numerous other properties (Net Profits Royalties). The properties included in the Trust are located in the states of Alabama, Arkansas, California, Colorado, Kansas, Louisiana, Mississippi, New Mexico, North Dakota, Oklahoma, Texas, Wyoming, and in state waters offshore Louisiana and Texas. The estimated reserve quantities and future income quantities presented in this report are related to a large extent to hydrocarbon prices. Hydrocarbon prices in effect as December 31, 1993 were used in the preparation of this report as required by Securities and Exchange Commission (SEC) and Financial Accounting Standards Bulletin No. 69 (FASB 69) guidelines; however, actual future prices may vary significantly from December 31, 1993 prices for reasons discussed in more detail in other sections of this report. Therefore, quantities of reserves actually recovered and quantities of income actually received may differ significantly from the estimated quantities presented in this report. The estimated proved reserves and income quantities for the Wasson Royalties presented in this report are calculated by multiplying the net revenue interest attributable to each of the Wasson Royalties by the total amount of oil estimated to be economically recoverable from the respective productive units, subject to production limitations applicable to the Wasson Royalties and an additional royalty to provide Support Payments, which have been described to us by Santa Fe. Reserve quantities are calculated differently for the Net Profits Royalties because such interests do not entitle the Trust to a specific quantity of oil or gas but to 90 percent of the Net Proceeds derived therefrom. Accordingly, there is no precise method of allocating estimates of the quantities of proved reserves attributable to the Net Profits Royalties between the interest held by the Trust and the interests to be retained by Santa Fe. For purposes of this presentation, the proved reserves attributable to the Net Profits Royalties have been proportionately reduced to reflect the future estimated costs and expenses deducted in the calculation of Net Proceeds with respect to the Net Profits Royalties. Accordingly, the reserves presented for the Net Profits Royalties reflect quantities of oil and gas that are free of future costs or expenses based on the price and cost assumptions utilized in this report. The allocation of proved reserves of the Net Profits Properties between the Trust and Santa Fe will vary in the future as relative estimates of future gross revenues and future net incomes vary. Furthermore, Santa Fe requested that for purposes of our report the Net Profits Royalties be calculated beyond the Liquidation Date of December 31, 2007, even though by the terms of the Trust Agreement the Net Profits Royalties will be sold by the Trustee on or about this date and a liquidating distribution of the sales proceeds from such sale would be made to holders of Trust Units. The 'Liquid' reserves shown above are comprised of crude oil, condensate and natural gas liquids. Natural gas liquids comprise 0.7 percent of the Trust's developed liquid reserves and 0.7 percent of the Trust's developed and undeveloped liquid reserves. All hydrocarbon liquid reserves are expressed in standard 42 gallon barrels. All gas volumes are sales gas expressed in MMCF at the pressure and temperature bases of the area where the gas reserves are located. The estimated future net cash inflows are described later in this report. Santa Fe has indicated that the conveyance of the Wasson Royalties to the Trust provides that the Trust will receive an additional royalty interest in the Wasson ODC Unit which could be available for Support Payments. Payment of this additional royalty is subject to numerous limitations which are detailed in the Conveyance. The tables shown on Pages A-1 and A-4 include 1,890,522 barrels of oil, $20,000,000 of estimated future net revenue, and $12,662,967 of discounted estimated future net revenue attributable to an additional royalty in respect of Support Payments which have been described to us by Santa Fe. In accordance with information provided by Santa Fe, proved reserves and revenues attributable to Santa Fe's remaining royalty interest in the Wasson ODC Unit available for Support Payments, which includes the above mentioned reserves and revenues, are presented below. ESTIMATED FUTURE NET PROVED OIL ESTIMATED REVENUES RESERVES FUTURE NET DISCOUNTED (BBLS) REVENUES -- $ AT 10% -- $ 3,272,552 $ 34,558,352 $ 23,815,495 The Support Payments are limited to $20,000,000 in the aggregate. As a result, even though we have calculated total estimated future net revenues of $34,558,352 available for Support Payments and $20,000,000 of such amount has been included in our estimate of the future net cash inflow for the Wasson ODC Royalty attributable to the Trust, no additional Support Payment would be allowed due to the $20,000,000 limitation. The proved reserves presented in this report comply with the Securities and Exchange Commission's Regulation S-X Part 210.4-10 Sec. (a) as clarified by subsequent Commission Staff Accounting Bulletins, and are based on the following definitions and criteria: Proved reserves of crude oil, condensate, natural gas, and natural gas liquids are estimated quantities that geological and engineering data demonstrate with reasonable certainty to be recoverable in the future from known reservoirs under existing conditions. Reservoirs are considered proved if economic producibility is supported by actual production or formation RYDER SCOTT COMPANY PETROLEUM ENGINEERS tests. In certain instances, proved reserves are assigned on the basis of a combination of core analysis and other type logs which indicate the reservoirs are analogous to reservoirs in the same field which are producing or have demonstrated the ability to produce on a formation test. The area of a reservoir considered proved includes (1) that portion delineated by drilling and defined by fluid contacts, if any, and (2) the adjoining portions not yet drilled that can be reasonably judged as economically productive on the basis of available geological and engineering data. In the absence of data on fluid contacts, the lowest known structural occurrence of hydrocarbons controls the lower proved limit of the reservoir. Proved reserves are estimates of hydrocarbons to be recovered from a given date forward. They may be revised as hydrocarbons are produced and additional data become available. Proved natural gas reserves are comprised of nonassociated, associated, and dissolved gas. An appropriate reduction in gas reserves has been made for the expected removal of natural gas liquids, for lease and plant fuel and the exclusion of non-hydrocarbon gases if they occur in significant quantities and are removed prior to sale. Reserves that can be produced economically through the application of improved recovery techniques are included in the proved classification when these qualifications are met: (1) successful testing by a pilot project or the operation of an installed program in the reservoir provides support for the engineering analysis on which the project or program was based, and (2) it is reasonably certain the project will proceed. Improved recovery includes all methods for supplementing natural reservoir forces and energy, or otherwise increasing ultimate recovery from a reservoir, including (1) pressure maintenance, (2) cycling, and (3) secondary recovery in its original sense. Improved recovery also includes the enhanced recovery methods of thermal, chemical flooding, and the use of miscible and immiscible displacement fluids. Estimates of proved reserves do not include crude oil, natural gas, or natural gas liquids being held in underground storage. Depending on the status of development, these proved reserves are further subdivided into: (i) 'developed reserves' which are those proved reserves reasonably expected to be recovered through existing wells with existing equipment and operating methods, including (a) 'developed producing reserves' which are those proved developed reserves reasonably expected to be produced from existing completion intervals now open for production in existing wells, and (b) 'developed non-producing reserves' which are those proved developed reserves which exit behind the casing of existing wells which are reasonably expected to be produced through these wells in the predictable future where the cost of making such hydrocarbons available for production should be relatively small compared to the cost of a new well; and (ii) 'undeveloped reserves' which are those proved reserves reasonably expected to be recovered from new wells on undrilled acreage, from existing wells where a relatively large expenditure is required and from acreage for which an application of fluid injection or other improved recovery technique is contemplated where the technique has been proved effective by actual tests in the area in the same reservoir. Reserves from undrilled acreage are limited to those drilling units offsetting productive units that are reasonably certain of production when drilled. Proved reserves for other undrilled units are included only where it can be demonstrated with reasonable certainty that there is continuity of production from the existing productive formation. Because of the direct relationship between quantities of proved undeveloped reserves and development plans, we include in the proved undeveloped category only reserves assigned to undeveloped locations that we have been assured will definitely be drilled and reserves assigned to the undeveloped portions of secondary or tertiary projects which we have been assured will definitely be developed. RYDER SCOTT COMPANY PETROLEUM ENGINEERS In accordance with the requirements of FASB 69, our estimates of future cash inflows, future costs and future net cash inflows before income tax, as well as our estimated reserve quantities, as of December 31, 1993 from this report presented below. In the case of the Wasson Royalties, the future cash inflows are gross revenues after gathering and transportation costs where applicable, but before any other deductions. The production costs are based on current data and include production taxes and ad valorem taxes provided by Santa Fe. In the case of the Net Profits Royalties, the future cash inflows are, as described previously, after consideration of future costs or expenses based on the price and cost assumptions utilized in this report. Therefore, the future cash inflows are the same as the future net cash inflows. Included in these future cash inflows is an estimated amount attributable to the sale of sulphur in certain Gulf Coast properties. Santa Fe furnished us gas prices in effect at December 31, 1993 and with its forecasts of future gas prices which take into account Securities and Exchange Commission guidelines, current market prices, regulations under the Natural Gas Policy Act of 1978 and the Gas Decontrol Act of 1989, contract prices and fixed and determinable price escalations where applicable. In accordance with Securities and Exchange Commission guidelines, the future gas prices used in this report make no allowances for future gas price increases which may occur as a result of inflation nor do they account for seasonal variations in gas prices which are likely to cause future yearly average gas prices to be somewhat lower than December gas prices. In those cases where contract market-out has occurred, the current market price was held constant to depletion of the reserves. In those cases where market-out has not occurred, contract gas prices including fixed and determinable escalations, exclusive of inflation adjustments, were used until the contract expires and then reduced to the current market price for similar gas in the area and held at this reduced price to depletion of the reserves. Santa Fe furnished us with liquid prices in effect at December 31, 1993 and these prices were held constant to depletion of the properties. In accordance with Securities and Exchange Commission RYDER SCOTT COMPANY PETROLEUM ENGINEERS guidelines, changes in liquid prices subsequent to December 31, 1993 were not considered in this report. Operating costs for the leases and wells in this report were provided by Santa Fe and include only those costs directly applicable to the leases or wells. When applicable, the operating costs include a portion of general and administrative costs allocated directly to the leases and wells under terms of operating agreements. Development costs were furnished to us by Santa Fe and are based on authorizations for expenditure for the proposed work or actual costs for similar projects. The current operating and development costs were held constant throughout the life of the properties. For properties located onshore, this study does not consider the salvage value of the lease equipment or the abandonment cost since both are relatively insignificant and tend to offset each other. The estimated net cost of abandonment after salvage was considered for offshore properties where abandonment costs net of salvage are significant. The estimates of the offshore net abandonment costs furnished by Santa Fe were accepted without independent verification. No deduction was made for indirect costs such as general administration and overhead expenses, loan repayments, interest expenses, and exploration and development prepayments. No attempt has been made to quantify or otherwise account for any accumulated gas production imbalances that may exist. Our reserve estimates are based upon a study of the properties in which the Trust has interests; however, we have not made any field examination of the properties. No consideration was given in this report to potential environmental liabilities which may exist nor were any costs included for potential liability to restore and clean up damages, if any, caused by past operating practices. Santa Fe informed us that it has furnished us all of the accounts, records, geological and engineering data and reports and other data required for our investigation. The ownership interests, terms of the Trust, prices, taxes, and other factual data furnished to us in connection with our investigation were accepted as represented. The estimates presented in this report are based on data available through July, 1993. The reserves included in this report are estimates only and should not be construed as being exact quantities. They may or may not be actually recovered. Estimates of proved reserves may increase or decrease as a result of future operations of Santa Fe. Moreover, due to the nature of the Net Profits Royalties, a change in the future costs, or prices, or capital expenditures different from those projected herein may result in a change in the computed reserves and the Net Proceeds to the Trust even if there are no revisions or additions to the gross reserves attributed to the property. The future production rates from properties now on production may be more or less than estimated because of changes in market demand or allowables set by regulatory bodies. In general, we estimate that gas production rates will continue to be the same as the average rate for the latest available 12 months of actual production until such time that the well or wells are incapable of producing at this rate. The well or wells are then projected to decline at their decreasing delivery capacity rate. Our general policy on estimates of future gas production rates is adjusted when necessary to reflect actual gas market conditions in specific cases. Properties which are not currently producing may start producing earlier or later than anticipated in our estimates of their future production rates. The future prices received for the sale of the production may be higher or lower than the prices used in this report as described above, and the operating costs and other costs relating to such production may also increase or decrease from existing levels; however, such possible changes in prices and costs were, in accordance with rules adopted by the Securities and Exchange Commission, omitted from consideration in preparing this report. RYDER SCOTT COMPANY PETROLEUM ENGINEERS Neither Ryder Scott Company nor any of its employees has any interest in the subject properties and neither the employment to make this study nor the compensation is contingent on our estimates of reserves and future cash inflows for the subject properties. Very truly yours, RYDER SCOTT COMPANY PETROLEUM ENGINEERS /s/ Fred W. Ziehe Fred W. Ziehe, P.E. Group Vice President FWZ/db RYDER SCOTT COMPANY PETROLEUM ENGINEERS The value of the Depositary Units and the Trust Units evidenced thereby are substantially dependent upon the proved reserves and production levels attributable to the Royalty Interests. There are many uncertainties inherent in estimating quantities and values of proved reserves and in projecting future rates of production and the timing of development expenditures. The reserve data set forth herein, although prepared by independent engineers in a manner customary in the industry, are estimates only, and actual quantities and values of oil and gas are likely to differ from the estimated amounts set forth herein. In addition, the discounted present values shown herein were prepared using guidelines established by the Commission for disclosure of reserves and should not be considered representative of the market value of such reserves or the Depositary Units or the Trust Units evidenced thereby. A market value determination would include many additional factors. Distributions to Holders could be adversely affected if any of the hazards typically associated with the development, production and transportation of oil and gas were to occur, including personal injuries, property damage, damage to productive formations or equipment and environmental damages. Uninsured costs for damages from any of the foregoing will directly reduce payments to the Trust from those Royalty Properties that are working interests, and will reduce payments to the Trust from those Royalty Properties that are royalties and overriding royalties to the extent such damages reduce the volumes of oil and gas produced. In contrast to the Net Profits Royalties, which have no contractually imposed production limitations, the Wasson Royalties have been structured with quarterly production limitations. Thus, the Trust and Holders will not receive cash distributions from oil production from the two Wasson production units burdened by the Wasson Royalties in excess of such amounts. While the Wasson ODC Unit is expected to produce at levels substantially in excess of the applicable production limitations, failure of actual production from either of the two Wasson production units to meet or exceed the applicable quarterly production limitations will reduce amounts payable in respect of the Wasson Royalties. GAS PRODUCTION At December 31, 1993, approximately 25 percent of the estimated future net revenues from proved reserves of the Royalty Interests, on an equivalent basis, was attributable to gas. Thus, the revenues of the Trust and the amount of cash distributions to Holders will be dependent upon, among other things, the volume of gas produced and the price at which such gas is sold. Since the early 1980s, the available gas production capacity nationwide has exceeded the demand by users of such gas, resulting in demand-related production curtailments. No assurances can be made that curtailments will not continue to exist. In addition, excess gas production capacity in the United States has generally resulted in downward pressure on gas prices. The effect of any excess production capacity which exists in the future cannot be predicted with certainty; however, any such excess capacity may have a material adverse effect on Trust distributions through its impact on prices and production volumes. Due to the seasonal nature of demand for gas and its effect on sales prices and production volumes, the amount of cash distributions by the Trust that is attributable to gas production may vary substantially on a seasonal basis. Generally, gas production volumes and prices tend to be higher during the first and fourth quarters of the calendar year. Because of the lag between Santa Fe's receipt of revenues related to the Net Profits Properties and the dates on which distributions are made to Holders, however, any seasonality that affects production and prices generally should be reflected in distributions to Holders in later periods. PROCEEDS, PRODUCTION AND AVERAGE PRICES Reference is made to 'Results of Operations' under Item 7 of this Form 10-K. ASSETS Reference is made to Item 6 of this Form 10-K for information relating to the assets of the Trust. DEFINITIONS As used herein, the following terms have the meanings indicated: 'Mcf' means thousand cubic feet, 'MMcf' means million cubic feet, 'Bbl' means barrel (approximately 42 U.S. gallons), and 'MBbl' means thousand barrels. COMPETITION AND MARKETS COMPETITION. The oil and gas industry is highly competitive in all of its phases. Santa Fe and the other operators of the Royalty Properties will encounter competition from major oil and gas companies, international energy organizations, independent oil and gas concerns, and individual producers and operators. Many of these competitors have greater financial and other resources than Santa Fe and the other operators of the Royalty Properties. Competition may also be presented by alternative fuel sources, including heating oil and other fossil fuels. MARKETS. Production attributable to Santa Fe's royalty interests in the Wasson ODC Unit and the Wasson Willard Unit is marketed by Santa Fe and is in some cases sold at the wellhead at market responsive prices that approximate spot oil prices for West Texas sour crude, and in other cases is sold at points within common carrier pipeline systems on terms whereby Santa Fe pays the cost of transporting same to such points. With respect to the Net Profits Properties, where such properties consist of royalty interests, the operators of the properties will make all decisions regarding the marketing and sale of oil and gas production. Although Santa Fe generally has the right to market oil and gas produced from the Royalty Properties that are working interests, Santa Fe generally relies on the operators of the properties to market the production. The ability of the operators to market the oil and gas produced from the Royalty Properties will depend upon numerous factors beyond their control, including the extent of domestic production and imports of oil and gas, the proximity of the gas production to gas pipelines, the availability of capacity in such pipelines, the demand for oil and gas by utilities and other end-users, the effects of inclement weather, state and Federal regulation of oil and gas production and Federal regulation of gas sold or transported in interstate commerce. There is no assurance that such operators will be able to market all of the oil or gas produced from the Royalty Properties or that favorable prices can be obtained for the oil and gas produced. The supply of gas capable of being produced in the United States has exceeded demand in recent years as a result of decreased demand for gas in response to economic factors, conservation, lower prices for alternative energy sources and other factors. As a result of this excess supply of gas, gas producers have experienced increased competitive pressure and significantly lower prices. Many gas pipelines have reduced their takes from producers below the amounts they were contractually obligated to take or pay at fixed prices in excess of spot prices or have renegotiated their obligations to reflect more market responsive terms. The decline in demand for gas has resulted in many pipelines reducing or ceasing altogether their purchase of new gas. Substantially all of the gas production from the Net Profits Properties is sold at market responsive prices. Demand for gas production has historically been seasonal in nature. Due to unseasonably warm weather over the last several years, the demand for gas has decreased, resulting in lower prices received by producers during the winter months than in prior years. Consequently, on an energy equivalent basis, gas has been sold at a discount to oil for the past several years. Such price fluctuations will directly impact Trust distributions, estimates of Trust reserves and estimated future net revenues from Trust reserves. In view of the many uncertainties affecting the supply and demand for oil, gas and refined petroleum products, Santa Fe is unable to make reliable predictions of future oil and gas prices and demand or the overall effect they will have on the Trust. Santa Fe does not believe that the loss of any of its purchasers would have a material adverse effect on the Trust, since substantially all of the oil and gas sales from the Royalty Properties are made on the spot market at market responsive prices. GOVERNMENTAL REGULATION OIL AND GAS REGULATION The production, transportation and sale of oil and gas from the Royalty Properties are subject to Federal and state governmental regulation, including regulations concerning maximum allowable rates of production, regulation of tariffs charged by pipelines, taxes, the prevention of waste, the conservation of oil and gas, pollution controls and various other matters. The United States has governmental power to permit increases in the amount of oil imported from other countries and to impose pollution control measures. FEDERAL REGULATION OF GAS. The Net Profits Properties are subject to the jurisdiction of the Federal Energy Regulatory Commission (FERC) and the Department of Energy with respect to various aspects of oil and gas operations including marketing and production of oil and gas. The Natural Gas Act and the Natural Gas Policy Act of 1978 (Policy Act) mandate Federal regulation of interstate transportation of gas and of wellhead pricing of certain domestic gas, depending on the category of the gas and the nature of the sale. In July 1989, however, Congress enacted the Natural Gas Wellhead Decontrol Act of 1989 that eliminated wellhead price controls on all domestic gas effective January 1, 1993. In 1992, FERC issued Orders Nos. 636 and 636-A which generally opened access to interstate pipelines by requiring the operators of such pipelines to unbundle their transportation services which historically were combined with their sales services and allow customers to choose and pay for only the services they require, regardless of whether the customer purchases gas from such pipelines or from other suppliers. The orders also require upstream pipelines to permit downstream pipelines to assign upstream capacity to their shippers, and place analogous, unbundled access requirements on the downstream pipelines. Although these regulations should generally facilitate the transportation of gas produced from the Net Profits Properties and the direct access to end user markets, the impact of FERC Order Nos. 636 and 636-A on marketing production from the Net Profits Properties cannot be predicted at this time. A number of parties which are aggrieved by the FERC's Order No. 636 program have filed petitions for review of these orders which are now pending in various U.S. Courts of Appeal. Numerous questions have been raised concerning the interpretation and implementation of several significant provisions of the Natural Gas Act and the Policy Act (collectively, Acts), and of the regulations and policies promulgated by FERC thereunder. A number of lawsuits and administrative proceedings have been instituted which challenge the validity of regulations implementing the Acts. In addition, FERC currently has under consideration various policies and proposals in addition to those discussed above that may affect the marketing of gas under new and existing contracts. Accordingly, Santa Fe is unable to estimate the full impact that the Acts and the regulations issued thereunder by FERC may have on the Net Profits Properties. LEGISLATIVE PROPOSALS. In the past, Congress has been very active in the area of gas regulation. Recently enacted legislation repeals incremental pricing requirements and gas use restraints previously applicable. There are other legislative proposals pending in the Federal and state legislatures which, if enacted, would significantly affect the petroleum industry. At the present time, it is impossible to predict what proposals, if any, might actually be enacted by Congress or the various state legislatures and what effect, if any, such proposals might have on the Royalty Properties and the Trust. STATE REGULATION. Many state jurisdictions have at times imposed limitations on the production of gas by restricting the rate of flow for gas wells below their actual capacity to produce and by imposing acreage limitations for the drilling of a well. States may also impose additional regulation of these matters. Most states regulate the production and sale of oil and gas, including requirements for obtaining drilling permits, the method of developing new fields, provisions for the unitization or pooling of oil and gas properties, the spacing, operation, plugging and abandonment of wells and the prevention of waste of oil and gas resources. The rate of production may be regulated and the maximum daily production allowable from oil and gas wells may be established on a market demand or conservation basis or both. ENVIRONMENTAL REGULATION GENERAL. Activities on the Royalty Properties are subject to existing Federal, state and local laws and regulations governing environmental quality and pollution control. It is anticipated that, absent the occurrence of an extraordinary event, compliance with existing Federal, state and local laws, rules and regulations regulating the discharge of materials into the environment or otherwise relating to the protection of the environment will not have a material effect upon the Trust. Santa Fe cannot predict what effect additional regulation or legislation, enforcement policies thereunder, and claims for damages to property, employees, other persons and the environment resulting from operations on the Royalty Properties could have on the Trust. SOLID AND HAZARDOUS WASTE. The Royalty Properties include numerous properties that have produced oil and gas for many years and that have been owned by Santa Fe for only a relatively short time. Although, to Santa Fe's knowledge, the operators have utilized operating and disposal practices that were standard in the industry at the time, hydrocarbons or other solid wastes may have been disposed or released on or under the Royalty Properties by the current or previous operator. State and Federal laws applicable to oil and gas wastes and properties have become increasingly more stringent. Under these new laws, Santa Fe or an operator of the Royalty Properties could be required to remove or remediate previously disposed wastes or property contamination (including groundwater contamination) or to perform remedial plugging operations to prevent future contamination. The operators of the Royalty Properties may generate wastes that are subject to the Federal Resource Conservation and Recovery Act and comparable state statutes. The Environmental Protection Agency (EPA) has limited the disposal options for certain hazardous wastes and is considering the adoption of more stringent disposal standards for nonhazardous wastes. Furthermore, it is anticipated that additional wastes (which could include certain wastes generated by oil and gas operations) will be designated as 'hazardous wastes', which are subject to more rigorous and costly disposal requirements. SUPERFUND. The Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), also known as the 'superfund' law, imposes liability, without regard to fault or the legality of the original conduct, on certain classes of persons that contributed to the release of a 'hazardous substance' into the environment. These persons include the owner and operator of a site and companies that disposed or arranged for the disposal of the hazardous substance found at a site. CERCLA also authorizes the EPA and, in some cases, third parties to take actions in response to threats to the public health or the environment and to seek to recover from the responsible classes of persons the costs of such action. In the course of their operations, the operators of the Royalty Properties have generated and will generate wastes that may fall within CERCLA's definition of 'hazardous substances.' Santa Fe or the operators of the Royalty Properties may be responsible under CERCLA for all or part of the costs to clean up sites at which such wastes have been disposed. AIR EMISSIONS. The operators of the Royalty Properties are subject to Federal, state and local regulations concerning the control of emissions from sources of air pollution. Administrative enforcement actions for failure to comply strictly with air regulations or permits are generally resolved by payment of a monetary penalty and correction of any identified deficiencies. Alternatively, regulatory agencies could require the operators to forego construction or operation of certain air pollution emission sources. OSHA. The operators of the Royalty Properties are subject to the requirements of the Federal Occupational Safety and Health Act (OSHA) and comparable state statutes. The OSHA hazard communication standard, the EPA community right-to-know regulations under Title III of the Federal Superfund Amendment and Reauthorization Act and similar state statutes require an operator to organize information about hazardous materials used or produced in its operations. Certain of this information must be provided to employees, state and local government authorities and local citizens. ITEM 2.

ITEM 2. PROPERTIES. Reference is made to Item 1 of this Form 10-K. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. There are no pending legal proceedings to which the Trust is a party. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. There were no matters submitted to a vote of security holders during the year ended December 31, 1993. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED HOLDER MATTERS. The Depositary Units are traded on the New York Stock Exchange -- ticker symbol SFF. The high and low closing sales prices and distributions for the quarter ended December 31, 1992 and each quarter in the year ended December 31, 1993 were as follows (in dollars): CLOSING SALES PRICES DISTRIBUTION LOW HIGH PAID Fourth Quarter (beginning November 13) 17.875 19.875 -- First Quarter---------------------- 18.00 19.75 0.30753 Second Quarter--------------------- 19.375 20.875 0.46660 Third Quarter---------------------- 19.625 22.00 0.49485 Fourth Quarter--------------------- 19.625 23.625 0.44218 At March 25, 1994, the 6,300,000 Depositary Units outstanding were held by 480 Holders of record. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. 1993 1992 (THOUSANDS OF DOLLARS, EXCEPT AS NOTED) Period Ended December 31: Distributable Cash----------------- 10,781 -- Distributable Cash per Trust Unit (in dollars)--------------------- 1.71116 -- At December 31: Investment in Royalty Interests, net------------------------------ 77,356 87,276 Trust Corpus----------------------- 77,301 87,277 ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. GENERAL; LIQUIDITY AND CAPITAL RESOURCES The Trust is a passive entity with the Trustee's primary responsibility being the collection and distribution of proceeds from the Wasson Royalties and the Net Profits Royalties and the payment of Trust liabilities and expenses (see Note 1 to the financial statements of the Trust). The Trust's results of operations are dependent upon the difference between the prices received for oil and gas and the costs of producing such resources. Since, on an equivalent basis, approximately eighty percent of the Trust's proved reserves are crude oil, even relatively modest changes in crude oil prices may significantly affect the Trust's revenues and results of operations. Crude oil prices are subject to significant changes in response to fluctuations in the world supply, economic conditions in the United States and elsewhere, the world political situation as it affects OPEC, the Middle East (including the current embargo of Iraqi crude oil from worldwide markets) and other producing countries, the actions of OPEC and governmental regulation. In addition, a substantial portion of the Trust's revenues come from properties which produce sour (i.e. high sulfur content) crude oil which sells at prices lower than sweeter (i.e. low sulfur) crude oils. The sales price of crude oil dropped significantly in the fourth quarter of 1993, as reflected in the average prices with respect to the royalty payment received in the first quarter of 1994 (see Results of Operations). For factors affecting the sale of natural gas see Item 1. Business--Gas Production. Cash proceeds from the Royalty Properties in the first quarter of 1994 included a Support Payment of $362,000, primarily due to lower realized oil prices and capital expenditures incurred with respect to certain Royalty Properties, a substantial portion of which relates to the drilling of new wells. Based on current prices, it is expected that cash proceeds from the Royalty Properties in the second quarter of 1994, which relates to operations of the Royalty Properties in the first quarter of 1994, will include a Support Payment, the amount of which has not been determined. In addition to costs and expenses related to the Royalty Properties, Trust administrative expenses are estimated to be approximately $450,000 annually, including approximately $250,000 for legal, accounting, engineering, trustee and other administrative fees and a $200,000 annual fee to Santa Fe, which will increase by 3.5 percent per year. In addition, Santa Fe paid approximately $379,000 in Trust formation costs of which $271,000 was recovered in 1993 and $108,000 was recovered in the first quarter of 1994. RESULTS OF OPERATIONS The following table reflects pertinent information with respect to the cash proceeds from the Royalty Properties and the net distributable cash of the Trust for the year 1993 and the first quarter of 1994 (in thousands of dollars, except as noted): Volumes with respect to the Wasson ODC Royalty and the Wasson Willard Royalty increased in periods subsequent to the first quarter of 1993 because (i) the first quarter of 1993 represented the initial quarter of operations of the Trust and included only two months of operations with respect to such royalties and (ii) there was an increase in the maximum net quarterly production in accordance with the royalty conveyance beginning in the second quarter of 1993. Volumes increased from the first quarter of 1993 with respect to the Net Profits Royalties generally reflecting that the first quarter of 1993 included only two months of operations with respect to such properties. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. PAGE IN THIS FORM 10-K Audited Financial Statements Report of Independent Accountants-------------------- 34 Statement of Cash Proceeds and Distributable Cash for the Year Ended December 31, 1993---------------------------- 35 Statement of Assets, Liabilities and Trust Corpus as of December 31, 1993 and 1992---------------------------------- 35 Statement of Changes in Trust Corpus for the Year Ended December 31, 1993 and the Period from Inception (October 22, 1992) to December 31, 1992--------------------- 36 Notes to Financial Statements------------------------ 37 Unaudited Financial Information Supplemental Information to the Financial Statements------------------------------- 39 ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. There are no directors or executive officers of the Registrant. The Trustee is a corporate trustee which may be removed by the affirmative vote of Holders of a majority of the Trust Units then outstanding at a meeting of the Holders of the Trust at which a quorum is present. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION. Not applicable. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. (a) Security Ownership of Certain Beneficial Owners. Not Applicable. (b) Security Ownership of Management. Not applicable. (c) Changes in Control. The Registrant knows of no arrangements, including the pledge of securities of the Registrant, the operation of which may at a subsequent date result in a change in control of the Registrant. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. Marc J. Shapiro, a director of Santa Fe, is Chairman and Chief Executive Officer of the Trustee. The Trustee is the Agent and a principal lender to Santa Fe under an Amended and Restated Revolving Credit Agreement (the Credit Agreement). As of March 31, 1994 approximately $70 million was outstanding under the Credit Agreement. In the opinion of Santa Fe, the terms of the Credit Agreement and the fees and interest rates thereunder are within the range of normal and customary bank credit transactions involving energy borrowers of similar size and credit. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (A)(1) FINANCIAL STATEMENTS The following financial statements are included in this Annual Report on Form 10-K on the pages as indicated: PAGE IN THIS FORM 10-K Report of Independent Accountants--------------------------- 34 Statement of Cash Proceeds and Distributable Cash for the Year Ended December 31, 1993----------------------------------- 35 Statement of Assets, Liabilities and Trust Corpus as of December 31, 1993 and 1992--------------------------------------------- 35 Statement of Changes in Trust Corpus for the Year Ended December 31, 1993 and the Period from Inception (October 22, 1992) to December 31, 1992------------------ 36 Notes to Financial Statements------------------------------ 37 (A)(2) SCHEDULES Schedules have been omitted because they are not required, not applicable or the information required has been included elsewhere herein. (A)(3) EXHIBITS (Asterisk indicates exhibit previously filed with the Securities and Exchange Commission and incorporated herein by reference.) SEC FILE OR REGISTRATION EXHIBIT NUMBER NUMBER 3(a)* Form of Trust Agreement of Santa Fe Energy Trust------------------------- 33-51760 3.1 4(a)* Form of Custodial Deposit Agreement---------------------------- 33-51760 4.2 4(b)* Form of Secure Principal Energy Receipt (included as Exhibit A to Exhibit 4(a))----------- 33-51760 4.1 10(a)* Form of Net Profits Conveyance (Multi-State)------------------------ 33-51760 10.1 10(b)* Form of Wasson Conveyance------------ 33-51760 10.2 10(c)* Form of Louisiana Mortgage----------- 33-51760 10.3 (B) REPORTS ON FORM 8-K No reports on Form 8-K were filed with the Securities and Exchange Commission during the year ended December 31, 1993. REPORT OF INDEPENDENT ACCOUNTANTS To the Unitholders and Trustee of the Santa Fe Energy Trust We have audited the financial statements listed in the index appearing under Item 14(a)(1) on page 33. These financial statements are the responsibility of the Trustee. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by the Trustee, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 2, these financial statements have been prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, the financial statements audited by us present fairly, in all material respects, the financial position of the Santa Fe Energy Trust at December 31, 1993 and 1992, the cash proceeds and distributable cash for the year ended December 31, 1993 and the changes in trust corpus for the year ended December 31, 1993 and the period from inception (October 22, 1992) to December 31, 1992, on the basis of accounting described in Note 2. PRICE WATERHOUSE Houston, Texas March 25, 1994 SANTA FE ENERGY TRUST STATEMENT OF CASH PROCEEDS AND DISTRIBUTABLE CASH (DOLLARS IN THOUSANDS, EXCEPT AS NOTED) YEAR ENDED DECEMBER 31, 1993 Royalty Income ODC Royalty---------------------- $ 1,802 Willard Royalty------------------ 1,881 Net Profits Royalty-------------- 7,677 Total Royalties---------------------- 11,360 Administrative Fee to Santa Fe------- (183) Trust Formation Costs---------------- (271) Advance from Santa Fe Energy Resources, Inc.-------------------- 55 Cash Withheld for Trust Expenses----- (180) Distributable Cash------------------- $ 10,781 Distributable Cash per Trust Unit (in dollars)--------------------------- $ 1.71116 Trust Units Outstanding (thousands)-------------------------- 6,300 STATEMENT OF ASSETS, LIABILITIES AND TRUST CORPUS (DOLLARS IN THOUSANDS) ASSETS DECEMBER 31, DECEMBER 31, 1993 1992 Current Assets Cash----------------------------- $ -- $ 1 Investment in Royalty Interests, at cost------------------------------- 87,276 87,276 Less: Accumulated Amortization------- (9,920) -- 77,356 87,276 $ 77,356 $ 87,277 LIABILITIES AND TRUST CORPUS Advance from Santa Fe Energy Resources, Inc.-------------------- $ 55 $ -- Trust Corpus (6,300,000 Trust Units issued and outstanding)------------ 77,301 87,277 $ 77,356 $ 87,277 The accompanying notes are an integral part of these financial statements. SANTA FE ENERGY TRUST STATEMENT OF CHANGES IN TRUST CORPUS (IN THOUSANDS OF DOLLARS) Balance at Inception (October 22, 1992)------ $ 1 Issuance of Trust Units for Royalty Interests-------------------------------- 87,276 Balance at December 31, 1992----------------- 87,277 Cash Proceeds------------------------------ 10,906 Cash Distributions------------------------- (10,781) Trust Expenses----------------------------- (181) Amortization of Royalty Interests---------- (9,920) Balance at December 31, 1993----------------- $ 77,301 The accompanying notes are an integral part of these financial statements. SANTA FE ENERGY TRUST NOTES TO FINANCIAL STATEMENTS (1) THE TRUST Santa Fe Energy Trust (the 'Trust') was formed on October 22, 1992, with Texas Commerce Bank National Association as trustee (the 'Trustee'), to acquire and hold certain royalty interests (the 'Royalty Interests') in certain properties (the 'Royalty Properties') conveyed to the Trust by Santa Fe Energy Resources, Inc. ('Santa Fe'). The Royalty Interests consist of two term royalty interests in two production units in the Wasson field in west Texas (the 'Wasson Royalties') and a net profits royalty interest in certain royalty and working interests in a diversified portfolio of properties located in twelve states (the 'Net Profits Royalties'). The Royalty Interests are passive in nature and the Trustee has no control over or responsibility relating to the operation of the Royalty Properties. The Trust will be liquidated on February 15, 2008 (the 'Liquidation Date'). In November 1992, 5,725,000 Depositary Units, each consisting of beneficial ownership of one unit of undivided beneficial interest in the Trust ('Trust Units') and a $20 face amount beneficial ownership interest in a $1,000 face amount zero coupon United States Treasury obligation maturing on or about February 15, 2008, were sold in a public offering for $20 per Depositary Unit. A total of $114.5 million was recieved from public investors, of which $38.7 million was used to purchase the Treasury obligations and $5.7 million was used to pay underwriting commissions and discounts. Santa Fe received the remaining $70.1 million and 575,000 Depositary Units. In the first quarter of 1994 Santa Fe sold in a public offering the 575,000 Depositary Units which it held. The trust agreement under which the Trust was formed (the 'Trust Agreement') provides, among other things, that: * the Trustee shall not engage in any business or commercial activity or acquire any asset other than the Royalty Interests initially conveyed to the Trust; * the Trustee may not sell all or any portion of the Wasson Royalties or substantially all of the Net Profits Royalties without the prior consent of Santa Fe; * Santa Fe may sell the Royalty Properties, subject to and burdened by the Royalty Interests, without consent of the holders of the Trust Units; following any such transfer, the Royalty Properties will continue to be burdened by the Royalty Interests and after any such transfer the royalty payment attributable to the transferred property will be calculated separately and paid by the transferee; * the Trustee may establish a cash reserve for the payment of any liability which is contingent, uncertain in amount or that is not currently due and payable; * the Trustee is authorized to borrow funds required to pay liabilities of the Trust, provided that such borrowings are repaid in full prior to further distributions to the holders of the Trust Units; * the Trustee will make quarterly cash distributions to the holders of the Trust Units. (2) BASIS OF ACCOUNTING The financial statements of the Trust are prepared on the cash basis of accounting for revenues and expenses. Royalty income is recorded when received (generally during the quarter following the end of the quarter in which the income from the Royalty Properties is received by Santa Fe) and is net of any cash basis exploration and development expenditures. Expenses of the Trust, which will include accounting, engineering, legal, and other professional fees, Trustee fees, an administrative fee paid to Santa Fe and out-of-pocket expenses, are recognized when paid. Under generally accepted accounting principles, revenues and expenses would be recognized on an accrual basis. Amortization of the Trust's investment in Royalty Interests is recorded using the unit-of-production method in the period in which the cash is received with respect to such production. No royalty income was received and no Trust expenses were paid during the period from inception (October 22, 1992) through December 31, 1992 (see Note 4). SANTA FE ENERGY TRUST NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) The conveyance of the Royalty Interests to the Trust was accounted for as a purchase transaction. The $87,276,000 reflected in the Statement of Assets and Trust Corpus as Investment in Royalty Interests represents 6,300,000 Trust Units valued at $20 per unit less the $38,724,000 paid for the Treasury obligations. The carrying value of the Trust's investment in the Royalty Interests is not necessarily indicative of the fair value of such Royalty Interests. The Trust is a grantor trust and as such is not subject to income taxes and accordingly no recognition has been given to income taxes in the Trust's financial statements. The tax consequences of owning Trust Units are included in the income tax returns of the individual Trust Unit holders. During 1993 net cash proceeds (before deducting Trust expenses) exceeded cash distributions by $125,000. In order to pay current Trust expenses Santa Fe advanced the Trust $55,000, which amount was due to Santa Fe at December 31, 1993. (3) THE ROYALTY INTERESTS The Wasson Royalties consist of interests conveyed out of Santa Fe's royalty interest in the Wasson ODC Unit (the 'ODC Royalty') and the Wasson Willard Unit (the 'Willard Royalty'). The ODC Royalty entitles the Trust to receive quarterly royalty payments with respect to 12.3934% of the actual gross oil production from the Wasson ODC Unit, subject to certain quarterly limitations set forth in the conveyance agreement, for the period from November 1, 1992 to December 31, 2007. The Willard Royalty entitles the Trust to receive quarterly royalty payments with respect to 6.8355% of the actual gross oil production from the Wasson Willard Unit, subject to certain quarterly limitations set forth in the conveyance agreement, for the period from November 1, 1992 to December 31, 2003. The Net Profits Royalties entitle the Trust to receive, on a quarterly basis, 90% of the net proceeds, as defined in the conveyance agreement, from the sale of production from the properties subject to the conveyance agreement. The Net Profits Royalties are not limited in term, although the Trustee is required to sell such royalties prior to the Liquidation Date. For any calendar quarter ending on or prior to December 31, 2002, the Trust will receive additional royalty payments ('Support Payments') to the extent it needs such payments to distribute $0.40 per Trust Unit per quarter (two-thirds of such amount for the period ended December 31, 1992). Such Support Payments are limited to Santa Fe's remaining royalty interest in the Wasson ODC Unit. If such Support Payments are received, certain proceeds otherwise payable to the Trust in subsequent quarters may be reduced to recoup the amount of such Support Payments. The aggregate of the Support Payments, net of any amounts recouped, will be limited to $20,000,000 on a revolving basis. The royalty payment received by the Trust in the first quarter of 1994 included a Support Payment of $362,000, or $0.0575 per Trust Unit. (4) DISTRIBUTIONS TO TRUST UNIT HOLDERS The Trust has received royalty payments and made distributions as follows (in thousands of dollars, except as noted): ROYALTY DISTRIBUTIONS PAYMENT PER TRUST UNIT RECEIVED AMOUNT (IN DOLLARS) First quarter-------------------- 1,937 1,937 0.30753 Second quarter------------------- 2,990 2,940 0.46660 Third quarter-------------------- 3,193 3,118 0.49485 Fourth quarter------------------- 2,786 2,786 0.44218 Total year------------------- 10,906 10,781 1.71116 First quarter (a)---------------- 2,575 2,520 0.40000 (a) Includes a Support Payment of $362,000, or $0.0575 per Trust Unit. SUPPLEMENTAL INFORMATION TO FINANCIAL STATEMENTS (UNAUDITED) OIL AND GAS RESERVES The following table sets forth the Royalty Interests' proved oil and gas reserves (all located in the United States) at December 31, 1993 and 1992 prepared by Ryder Scott Company, independent petroleum consultants. Proved reserve quantities for each of the Wasson Royalties are calculated by multiplying the net revenue interest attributable to each of the Wasson Royalties in effect for a given year by the total amount of oil estimated to be economically recoverable from the respective production units (subject to limitation by applicable maximum quarterly production amounts). Reserve quantities are calculated differently for the Net Profits Royalties because such interests do not entitle the Trust to a specific quantity of oil or gas but to the Net Proceeds derived therefrom. Proved reserves attributable to the Net Profits Royalties are calculated by deducting from estimated quantities of oil and gas reserves an amount of oil and gas sufficient, if sold at the prices used in preparing the reserve estimates for the Net Profits Royalties, to pay the future estimated costs and expenses deducted in the calculation of Net Proceeds with respect to the Net Profits Royalties. Accordingly, the reserves presented for the Net Profits Royalties reflect quantities of oil and gas that are free of future costs or expenses if the price and cost assumptions set forth in the applicable reserve report occur. CRUDE OIL AND NATURAL GAS LIQUIDS (MBBLS) (MMCF) Proved reserves at December 31, 1992------------------------------- 7,258 12,638 Revisions to previous estimates---------------------- 1,169 1,351 Extensions, discoveries and other additions 9 230 Production----------------------- (667) (3,098) Proved reserves at December 31, 1993------------------------------- 7,769 11,121 Proved developed reserves at December 31, 1992----------------------------- 7,169 12,500 1993----------------------------- 7,765 10,900 Proved reserves are estimated quantities of crude oil and natural gas which geological and engineering data indicate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions. Proved developed reserves are proved reserves which can be expected to be recovered through existing wells with existing equipment and operating methods. ESTIMATED PRESENT VALUE OF FUTURE NET CASH FLOWS Estimated future net cash flows from the Royalty Interests' proved oil and gas reserves at December 31, 1993 and 1992 are presented in the following table (in thousands of dollars): DECEMBER 31, 1993 1992 Net future cash flows---------------- 107,544 138,005 Discount at 10% for timing of cash flows-------------------------------- (42,228) (59,503) Present value of future net cash flows for proved reserves------------ 65,316 78,502 The following table sets forth the changes in the present value of estimated future net cash flows from proved reserves during the year ended December 31, 1993 (in thousands of dollars): Balance at December 31, 1992-------------------------- 78,502 Royalties, net of related property taxes (a)------ (12,123) Extensions, discoveries and other additions------- 733 Net changes in prices and costs------------------- (19,307) Changes in estimated volumes---------------------- 9,866 Interest factor -- accretion of discount---------- 7,645 (13,186) Balance at December 31, 1993-------------------------- 65,316 (a) Relates to the operations of the Royalty Properties for the year ended December 31, 1993, the proceeds from which were received by the Trust during the second, third and fourth quarters of 1993 and the first quarter of 1994. Estimated future cash flows represent an estimate of future net revenues from the production of proved reserves using estimated sales prices and estimates of the production costs, ad valorem and production taxes, and future development costs necessary to produce such reserves. No deduction has been made for depletion, depreciation or any indirect costs such as professional and administrative fees. The sales prices used in the calculation of estimated future net cash flows are based on the prices in effect at year end. Such prices have been held constant except for known and determinable escalations. Operating costs and ad valorem and production taxes are estimated based on current costs with respect to producing oil and gas properties. Future development costs are based on the best estimate of such costs assuming current economic and operating conditions. The information presented with respect to estimated future net revenues and cash flows and the present value thereof is not intended to represent the fair value of oil and gas reserves. Actual future sales prices and production and development costs may vary significantly from those in effect at December 31, 1993 and 1992 and actual future production may not occur in the periods or amounts projected. This information is presented to allow a reasonable comparison of reserve values prepared using standardized measurement criteria and should be used only for that purpose. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR L5(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED ON THIS 30TH DAY OF MARCH, 1994. SANTA FE ENERGY TRUST By TEXAS COMMERCE BANK NATIONAL ASSOCIATION, TRUSTEE By /s/ RICHARD L. MELTON RICHARD L. MELTON EXECUTIVE VICE PRESIDENT & TRUST OFFICER The Registrant, Santa Fe Energy Trust, has no principal executive officer, principal financial officer, controller or principal accounting officer, board of directors or persons performing similar functions. Accordingly, no additional signatures are available and none have been provided. THIS ANNUAL REPORT ON FORM 10-K WAS DISTRIBUTED TO HOLDERS AS AN ANNUAL REPORT. ADDITIONAL COPIES OF THIS ANNUAL REPORT WILL BE PROVIDED, WITHOUT CHARGE, AND COPIES OF EXHIBITS HERETO WILL BE PROVIDED, UPON PAYMENT OF A REASONABLE FEE, UPON WRITTEN REQUEST FROM ANY HOLDER TO: Santa Fe Energy Trust Texas Commerce Bank National Association, Trustee Attention: David Snyder, Corporate Trust Department P.O. Box 4717 Houston, Texas 77210-4717 INDEPENDENT ACCOUNTANTS COUNSEL TRANSFER AGENT AND REGISTRAR Price Waterhouse Baker & Botts, L.L.P. Texas Commerce Bank, N.A. Houston, Texas Houston, Texas Houston, Texas SANTA FE ENERGY TRUST P.O. Box 4717 Houston, Texas 77210-4717

91576_1993.txt

91576

1993

ITEM 1. BUSINESS OVERVIEW On March 1, 1994, KeyCorp ("old KeyCorp"), a financial services holding company headquartered in Albany, New York, with approximately $33 billion in assets at December 31, 1993, merged into and with Society Corporation, an Ohio corporation ("Society"), which was the surviving corporation of the merger under the name KeyCorp (See Mergers, Acquisitions and Divestitures on page 2 for a more complete description of the merger). Because the merger, which was accounted for as a pooling of interests, occurred subsequent to December 31, 1993, the information presented in this Annual Report on Form 10-K does not give effect to the impact of the merger. Consequently, unless otherwise expressly stated, the information presented relates to Society prior to its merger with old KeyCorp. However, supplemental financial statements included on pages 65 through 94 present the combined financial condition and results of operations of Society and old KeyCorp as if the merger had been in effect for all periods presented. Society, a financial services holding company organized in 1958, is headquartered in Cleveland, Ohio, is incorporated in Ohio, and is registered under the Bank Holding Company Act ("BHCA") and the Home Owners' Loan Act ("HOLA"). It is principally a regional banking organization and provides a wide range of banking, fiduciary, and other financial services to corporate, institutional, and individual customers. Based on total consolidated assets of approximately $27 billion at December 31, 1993, Society ranked as the third largest bank holding company in Ohio. The first predecessor of a subsidiary of Society was organized in 1849. At December 31, 1993, Society's subsidiary banks operated 434 full-service banking offices in the States of Ohio, Indiana, Michigan, and Florida. At December 31, 1993, Society had 12,038 full-time equivalent employees. SUBSIDIARIES Banking operations in Ohio are conducted through Society National Bank, a Federally-chartered bank headquartered in Cleveland, Ohio, which is the largest bank in Ohio and one of the nation's major regional banks. At December 31, 1993, Society National Bank had total assets of $21.8 billion and operated 291 full- service banking offices. Banking operations in Indiana are conducted through Society National Bank, Indiana, a Federally-chartered bank headquartered in South Bend, Indiana. At December 31, 1993, Society National Bank, Indiana had total assets of $3.0 billion and operated 83 full-service banking offices. Banking operations in Michigan are conducted through Society Bank, Michigan, a state-chartered bank headquartered in Ann Arbor, Michigan. At December 31, 1993, Society Bank, Michigan had assets of $1.1 billion and operated 36 full-service banking offices. Banking operations in Florida are conducted through Society First Federal Savings Bank, a Federally-chartered savings bank headquartered in Fort Myers, Florida. At December 31, 1993, Society First Federal Savings Bank had assets of $1.4 billion and operated 24 full-service banking offices. In addition to the customary banking services of accepting funds for deposit and making loans, Society's subsidiary banks provide a wide range of specialized services tailored to specific markets, including investment management, personal and corporate trust services, personal financial services, cash management services, investment banking services, and international banking services. At December 31, 1993, Society had one of the nation's largest trust departments with managed assets (excluding corporate trust assets) of approximately $29.4 billion. Society's nonbanking subsidiaries provide investment advisory services, securities brokerage services, institutional and personal trust services, mortgage banking services, reinsurance of credit life and accident and health insurance on loans made by subsidiary banks, venture capital and small business investment financing services, equipment lease financing, community development financing, stock transfer agent services and other financial services. Society is a legal entity separate and distinct from its subsidiaries. The principal source of Society's income is the earnings of subsidiary banks, and the principal source of its cash flow is dividends from its subsidiary banks. Applicable state and Federal laws impose limitations on the ability of Society's banking subsidiaries to pay dividends. In addition, the subsidiary banks are subject to the limitations contained in the Federal Reserve Act regarding extensions of credit to, investments in, and certain other transactions with Society and its other subsidiaries. See "Supervision and Regulation" on page 3 for a more complete description of the regulatory restrictions to which Society and its subsidiaries are subject. The following financial data concerning Society and its subsidiaries is incorporated herein by reference as indicated below: MERGERS, ACQUISITIONS AND DIVESTITURES On March 1, 1994, old KeyCorp, a financial services holding company headquartered in Albany, New York, with approximately $33 billion in assets as of December 31, 1993, merged into and with Society, which was the surviving corporation and assumed the name KeyCorp. Under the terms of the merger agreement, 124,351,183 KeyCorp Common Shares were exchanged for all of the outstanding shares of old KeyCorp common stock (based on an exchange ratio of 1.205 KeyCorp Common Shares for each share of old KeyCorp). The outstanding preferred stock of old KeyCorp was exchanged on a one-for-one basis for 1,280,000 shares of a comparable, new issue of 10% Cumulative Preferred Stock of KeyCorp. The merger was accounted for as a pooling of interests and, accordingly, financial results for all prior periods presented will be restated to include the financial results of old KeyCorp. The supplemental financial statements presented on pages 65 through 94 of this report present the financial condition and results of operations of Society and old KeyCorp as if the merger had been in effect for all periods presented. On October 5, 1993, Society completed the acquisition of Schaenen Wood & Associates, Inc. ("SWA"), a New York City-based investment management firm which manages approximately $1.3 billion in assets. The transaction was accounted for as a purchase. Accordingly, the results of operations of SWA have been included in the consolidated financial statements from the date of acquisition. On September 15, 1993, Society completed the sale of Ameritrust Texas Corporation ("ATC") to Texas Commerce Bank, National Association, an affiliate of Chemical Banking Corporation. ATC was based in Dallas, Texas, and provided a range of investment management and fiduciary services to institutions, businesses and individuals through 11 offices operating in Texas. For the year-to-date period through the closing date, ATC had net income of $3.2 million. The $29.4 million gain on the sale ($12.2 million after tax, $.10 per Common Share) is included in noninterest income. On January 22, 1993, Society acquired all of the outstanding shares of First Federal Savings and Loan Association of Fort Myers ("Society First Federal"), a Federal stock savings bank, for total cash consideration of $144 million. The transaction was accounted for as a purchase. Accordingly, the results of operations of Society First Federal have been included in the consolidated financial statements from the date of acquisition. Society First Federal had 24 offices in southwest and central Florida and approximately $1.1 billion in total assets at the date of acquisition. On December 4, 1992, Society and three other bank holding companies formed a joint venture in a newly-formed company, Electronic Payment Services, Inc. This company is the largest processor of automated teller machine transactions in the United States and a national leader in point-of-sale transaction processing. As part of the agreement, Society contributed its wholly-owned subsidiary, Green Machine Network Corporation, and its point-of-sale business in return for an equity interest. On September 30, 1992, Society acquired all the outstanding shares of First of America Bank-Monroe ("FAB-Monroe") from First of America Bank Corporation in a cash purchase. The transaction was accounted for as a purchase, and accordingly, the results of operations of FAB-Monroe have been included in the consolidated financial statements from the date of acquisition. FAB-Monroe operated 10 offices in southeastern Michigan and had approximately $160 million in total assets at the date of acquisition. On March 16, 1992, Ameritrust Corporation ("Ameritrust"), a financial services holding company located in Cleveland, Ohio, with approximately $10 billion in assets as of December 31, 1991, merged with and into Society. Under the terms of the merger agreement, 49,550,862 Society Common Shares were exchanged for all of the outstanding shares of Ameritrust common stock (based on an exchange ratio of .65 shares of Society for each share of Ameritrust). The outstanding preferred stock of Ameritrust was exchanged on a one-for-one basis for 1,200,000 shares of a comparable, new issue of Fixed/Adjustable Rate Cumulative Preferred Stock of Society. The merger was accounted for as a pooling of interests and, accordingly, financial results for all prior periods presented have been restated to include the financial results of Ameritrust. In connection with the merger and as part of an agreement with the United States Department of Justice, Society sold 28 Ameritrust branches located in Cuyahoga and Lake Counties in Ohio in June 1992. Deposits of $933.3 million and loans or loan participations totaling $331.8 million were sold along with the branches at a gain of $20.1 million ($13.2 million after tax, $.11 per Common Share) which is included in noninterest income. In addition, in May 1992, deposits and loans totaling $98.7 million and $45.7 million, respectively, were sold along with four branches in Ashtabula County, Ohio, in accordance with the Federal Reserve Board order that approved the merger. COMPETITION The market for banking and bank-related services is highly competitive. Society and its subsidiaries compete with other providers of financial services such as other bank holding companies, commercial banks, savings and loan associations, credit unions, mutual funds, including money market mutual funds, insurance companies, and a growing list of other local, regional and national institutions which offer financial services. Mergers between financial institutions have added competitive pressure. Competition is expected to intensify as a consequence of reciprocal interstate banking laws now in effect in a substantial number of states, and the prospect of possible Federal legislation authorizing nationwide interstate banking. Society and its subsidiaries compete by offering quality products and innovative services at competitive prices. SUPERVISION AND REGULATION GENERAL As a bank holding company, Society is subject to supervision by the Board of Governors of the Federal Reserve System ("Federal Reserve Board"). As a result of the 1993 acquisition of Society First Federal, Society is also subject to supervision by the Office of Thrift Supervision (the "OTS") as a savings and loan holding company registered under HOLA. The banking and savings association subsidiaries (collectively, "banking subsidiaries") of Society are subject to extensive supervision, examination, and regulation by applicable Federal and state banking agencies, including the Office of the Comptroller of the Currency (the "OCC") in the case of national bank subsidiaries, the Michigan Financial Institutions Bureau in the case of Society Bank, Michigan, and the OTS in the case of Society First Federal. Each of the banking subsidiaries is insured by, and therefore also subject to the regulations of, the Federal Deposit Insurance Corporation (the "FDIC"). Depository institutions such as the banking subsidiaries are affected significantly by the actions of the Federal Reserve Board as it attempts to control the money supply and credit availability in order to influence the economy. The regulatory regime applicable to bank holding companies and their subsidiaries generally is not intended for the protection of investors and is directed toward protecting the interests of depositors, the FDIC deposit insurance funds, and the U.S. banking system as a whole. Society's nonbanking subsidiaries are also subject to supervision and examination by the Federal Reserve Board, as well as other applicable regulatory agencies. For example, Society's discount brokerage and investment advisory subsidiaries are subject to supervision and regulation by the SEC, the National Association of Securities Dealers, Inc., and state securities regulators. Society's insurance subsidiary is subject to regulation by the insurance regulatory authorities of the various states. Other nonbanking subsidiaries are subject to other laws and regulations of both the Federal government and the various states in which they are authorized to do business. The following references to certain statutes and regulations are brief summaries thereof. The references are not intended to be complete and are qualified in their entirety by reference to the statutes and regulations. In addition there are other statutes and regulations that apply to and regulate the operation of banking institutions. A change in applicable law or regulation may have a material effect on the business of Society. DIVIDEND RESTRICTIONS Various Federal and state statutory provisions limit the amount of dividends that may be paid to Society by its banking subsidiaries without regulatory approval. The approval of the OCC is required for the payment of any dividend by a national bank if the total of all dividends declared by the bank in any calendar year would exceed the total of its net profits (as defined by the OCC) for that year combined with its retained net profits for the preceding two years, less any required transfers to surplus or a fund for the retirement of any preferred stock. In addition, a national bank is not permitted to pay a dividend in an amount greater than its net profits then on hand (as defined by the OCC) after deducting its losses and bad debts. For this purpose, bad debts are defined to include, generally, loans which have matured as to which interest is overdue by six months or more, other than such loans which are well secured and in the process of collection. Society's principal banking subsidiaries -- Society National Bank and Society National Bank, Indiana are national banks. In addition, OTS regulations impose limitations upon all capital distributions by savings associations. These limitations are applicable to Society First Federal, Society's only savings association subsidiary. State banks that are not members of the Federal Reserve System ("nonmember banks") are also subject to varying restrictions on the payment of dividends under state laws. Society Bank, Michigan is Society's only state nonmember bank. Under these restrictions, as of December 31, 1993, Society's banking subsidiaries could have declared dividends of approximately $76.0 million in the aggregate, without obtaining prior regulatory approval. In addition, if, in the opinion of the applicable Federal banking agency, a depository institution under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice (which, depending on the financial condition of the institution, could include the payment of dividends), the agency may require, after notice and hearing, that such institution cease and desist from such practice. In addition, the Federal Reserve Board, the OCC, the FDIC and the OTS have issued policy statements which provide that insured depository institutions and their holding companies should generally pay dividends only out of current operating earnings. HOLDING COMPANY STRUCTURE Transactions Involving Banking Subsidiaries. Transactions involving Society's banking subsidiaries are subject to Federal Reserve Act restrictions which limit the transfer of funds from such subsidiaries to Society and (with certain exceptions) to Society's nonbanking subsidiaries (together, "affiliates") in so-called "covered transactions," such as loans, extensions of credit, investments, or asset purchases. Unless an exemption applies, each such transfer by a banking subsidiary to one of its affiliates is limited in amount to 10% of that banking subsidiary's capital and surplus and, with respect to all such transfers to affiliates, in the aggregate, to 20% of that banking subsidiary's capital and surplus. Furthermore, loans and extensions of credit are required to be secured in specified amounts. "Covered transactions" also include the acceptance of securities issued by the banking subsidiary as collateral for a loan and the issuance of a guarantee, acceptance, or letter of credit for the benefit of Society or any of its affiliates. In addition, a bank holding company and its banking subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of property, or furnishing of services. Bank Holding Company Support of Banking Subsidiaries. Under Federal Reserve Board policy, a bank holding company is expected to act as a source of financial and managerial strength to each of its subsidiary banks and to commit resources to support each such subsidiary bank. This support may be required by the Federal Reserve Board at times when Society may not have the resources to provide it or, for other reasons, would not otherwise be inclined to provide it. Any capital loans by Society to any of its subsidiary banks are subordinate in right of payment to deposits and to certain other indebtedness of a subsidiary bank. In addition, the Crime Control Act of 1990 provides that in the event of a bank holding company's bankruptcy, any commitment by the bank holding company to a Federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and entitled to a priority of payment. A depository institution, the deposits of which are insured by the FDIC, can be held liable for any loss incurred by, or reasonably expected to be incurred by the FDIC in connection with (i) the default of a commonly controlled FDIC-insured depository institution or (ii) any assistance provided by the FDIC to a commonly controlled FDIC-insured depository institution in danger of default (the so-called "cross guaranty" provision). "Default" is defined under the FDIC's regulations generally as the appointment of a conservator or receiver and "in danger of default" is defined generally as the existence of certain conditions indicating that a "default" is likely to occur in the absence of regulatory assistance. CAPITAL REQUIREMENTS The minimum ratio of total capital to risk-adjusted assets (including certain off-balance sheet items, such as standby letters of credit) required by the Federal Reserve Board for bank holding companies is 8%. At least one-half of the total capital must be comprised of common equity, retained earnings, qualifying noncumulative perpetual preferred stock, a limited amount of qualifying cumulative perpetual preferred stock, and minority interests in the equity accounts of consolidated subsidiaries, less goodwill and certain other intangible assets ("Tier I capital"). The remainder may consist of hybrid capital instruments, perpetual debt, mandatory convertible debt securities, a limited amount of subordinated debt, other preferred stock, and a limited amount of loan and lease loss reserves ("Tier II capital"). The Federal Reserve Board has stated that banking organizations generally, and, in particular, those that actively make acquisitions, are expected to operate well above the minimum risk-based capital ratios. As of December 31, 1993, Society's Tier I and total capital to risk-adjusted assets ratios were 8.65% and 12.88%, respectively. In addition, Society is subject to minimum leverage ratio (Tier I capital to average total assets for the relevant period) guidelines. These guidelines provide for a minimum leverage ratio of 3% for bank holding companies that meet certain specified criteria, such as having the highest supervisory rating. All other bank holding companies are required to maintain a leverage ratio which is at least 100 to 200 basis points higher (i.e., a leverage ratio of at least 4% to 5%). Neither Society, nor any of its banking subsidiaries have been advised by its appropriate Federal regulatory agency of any specific leverage ratio applicable to it. At December 31, 1993, Society's Tier I leverage ratio was 7.18%. The guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets. Furthermore, the guidelines indicate that the Federal Reserve Board will continue to consider a "tangible Tier I leverage ratio" in evaluating proposals for expansion or new activities. The tangible Tier I leverage ratio is the ratio of a banking organization's Tier I capital less all intangibles, to total assets less all intangibles. Each of Society's banking subsidiaries is also subject to capital requirements adopted by applicable Federal regulatory agencies which are substantially similar to those imposed by the Federal Reserve Board on bank holding companies. As of December 31, 1993, each of Society's banking subsidiaries had capital in excess of all minimum regulatory requirements. All the Federal banking agencies have proposed regulations that would add an additional capital requirement based upon the amount of an institution's exposure to interest rate risk. The OTS recently adopted its final rule adding an interest rate component to its risk-based capital rule. Under the final OTS rule, savings associations with a greater than "normal" level of interest rate risk exposure will be subject to a deduction from total capital for purposes of calculating the risk-based capital ratio. The new OTS rule was effective January 1, 1994, except for limited provisions which are effective July 1, 1994. The other Federal banking agencies have yet to adopt their final rules on the interest rate risk component of risk-based capital. The OCC, the Federal Reserve, and the FDIC have proposed amendments to their respective regulatory capital rules to include in Tier I capital the net unrealized changes in the value of securities available for sale for purposes of calculating the risk-based and leverage ratios. The proposed amendments are in response to the provisions outlined in Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which takes effect for fiscal years beginning after December 15, 1993. See Note 3, Securities, on page 46 for a more complete description of SFAS No. 115. This new accounting standard establishes, among other things, net unrealized holding gains and losses on securities available for sale as a new component of stockholders' equity. If adopted as proposed, the rules could cause the Tier I capital to be subject to greater volatility. However, neither SFAS No. 115 nor the capital proposals would have any direct impact on reported earnings. SIGNIFICANT AMENDMENTS TO THE FEDERAL DEPOSIT INSURANCE ACT In 1991, Congress enacted the Federal Deposit Insurance Corporation Improvement Act of 1991, which, among other things, amended the Federal Deposit Insurance Act (the "FDIA"), and increased the FDIC's borrowing authority to resolve bank failures, mandated least-cost resolutions and prompt regulatory action with regard to undercapitalized institutions, expanded consumer protection, and mandated increased supervision of domestic depository institutions and the U.S. operations of foreign depository institutions. The amendments to the FDIA resulting from enactment of the Federal Deposit Insurance Corporation Improvement Act of 1991 require Federal banking agencies to promulgate regulations and specify standards in numerous areas of bank operations, including interest rate exposure, asset growth, internal controls, credit underwriting, executive officer and director compensation, real estate construction financing, additional review of capital standards, interbank liabilities, and other operational and managerial standards as the agencies determine appropriate. Most of these regulations have been promulgated in final form by the appropriate Federal bank regulatory agencies, although some have only been proposed. These regulations have increased and may continue to increase the cost of and the regulatory burden associated with the banking business. Prompt Corrective Action. Effective in December 1992, the FDIC, the Federal Reserve Board, the OCC and the OTS adopted new regulations to implement the prompt corrective action provisions of the FDIA. The regulations group FDIC-insured depository institutions into five broad categories based on their capital ratios. The five categories are "well capitalized," "adequately capitalized", "undercapitalized", "significantly undercapitalized," and "critically undercapitalized." An institution is "well capitalized" if it has a total risk-based capital ratio (total capital to risk-adjusted assets) of 10% or greater, a Tier I risk-based capital ratio (Tier I capital to risk-adjusted assets) of 6% or greater and a Tier I leverage capital ratio (Tier I capital to average total assets) of 5% or greater, and it is not subject to a regulatory order, agreement or directive to meet and maintain a specific capital level for any capital measure. An institution is "adequately capitalized" if it has a total risk-based capital ratio of 8% or greater, a Tier I risk-based capital ratio of 4% or greater and (generally) a Tier I leverage capital ratio of 4% or greater, and the institution does not meet the definition of a "well capitalized" institution. An institution is "undercapitalized" if the relevant capital ratios are less than those specified in the definition of an "adequately capitalized" institution. An institution is "significantly undercapitalized" if it has a total risk-based capital ratio of less than 6%, a Tier I risk-based capital ratio of less than 3%, or a Tier I leverage capital ratio of less than 3%. An institution is "critically undercapitalized" if it has a ratio of tangible equity (as defined in the regulations) to total assets of 2% or less. An institution may be downgraded to, or be deemed to be in a capital category that is lower than is indicated by its actual capital position if it is determined to be in an unsafe or unsound condition or if it receives an unsatisfactory examination rating with respect to certain matters. The capital-based prompt corrective action provisions of the FDIA and their implementing regulations apply to FDIC insured depository institutions and are not applicable to holding companies which control such institutions. However, both the Federal Reserve Board and the OTS have indicated that, in regulating holding companies, they will take appropriate action at the holding company level based on their assessment of the effectiveness of supervisory actions imposed upon subsidiary depository institutions pursuant to such provisions and regulations. Although the capital categories defined under the prompt corrective action regulations are not directly applicable to Society under existing law and regulations, based upon its ratios Society would qualify, and its subsidiary banks do qualify, as well-capitalized as of December 31, 1993. The capital category, as determined by applying the prompt corrective action provisions of the law, may not constitute an accurate representation of the overall financial condition or prospects of Society or its banking subsidiaries. The FDIA generally prohibits a depository institution from making any capital distribution (including payment of a dividend) or paying any management fee to its holding company if the institution would thereafter be undercapitalized. Undercapitalized depository institutions are also subject to restrictions on borrowing from the Federal Reserve System (effective December 19, 1993). Undercapitalized depository institutions are subject to increased monitoring by the appropriate Federal banking agency and limitations on growth, and are required to submit a capital restoration plan. The Federal banking agencies may not accept a capital plan without determining, among other things, that the plan is based on realistic assumptions and is likely to succeed in restoring the institution's capital. In addition, for a capital restoration plan to be acceptable, the depository institution's parent holding company must guarantee that the institution will comply with such capital restoration plan. The aggregate liability of the parent holding company with respect to such a guarantee is limited to the lesser of: (a) an amount equal to 5% of the depository institution's total assets at the time it became undercapitalized or (b) the amount which is necessary (or would have been necessary) to bring the institution into compliance with all capital standards applicable with respect to such institution as of the time it fails to comply with the plan. If a depository institution fails to submit an acceptable plan, it is treated as if it were significantly undercapitalized. Significantly undercapitalized depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become adequately capitalized and requirements to reduce total assets, and are prohibited from receiving deposits from correspondent banks. "Critically undercapitalized" institutions are subject to the appointment of a receiver or conservator. FDIC Insurance. Under the risk-related insurance assessment system, adopted in final form effective beginning with the January 1, 1994 assessment period, a bank or savings association is required to pay an assessment ranging from $.23 to $.31 per $100 of deposits based on the institution's risk classification. The risk classification is based on an assignment of the institution by the FDIC to one of three capital groups and to one of three supervisory subgroups. The capital groups are "well capitalized," "adequately capitalized," and "undercapitalized." The three supervisory subgroups are Group "A" (for financially solid institutions with only a few minor weaknesses), Group "B" (for those institutions with weaknesses which, if uncorrected, could cause substantial deterioration of the institution and increase the risk to the deposit insurance fund), and Group "C" (for those institutions with a substantial probability of loss to the fund absent effective corrective action). For the period commencing on July 1, 1993 through December 31, 1993, insurance assessments on all deposits of Society's banking subsidiaries were paid at the $.23 per $100 of deposits rate. DEPOSITOR PREFERENCE STATUTE In August 1993, Federal legislation was enacted which provides that insured and uninsured deposits of, and certain claims for administrative expenses and employee compensation against, an insured depository institution would be afforded a priority over other general unsecured claims against such an institution, including federal funds and letters of credit, in the "liquidation or other resolution" of such an institution by any receiver. Under this new legislation, if an insured depository institution fails, insured and uninsured depositors along with the FDIC will be placed ahead of all unsecured, nondeposit creditors in order of priority of payment. Due to its recent enactment, it is too early to determine what impact this legislation will have on the ability of financial institutions to attract junior creditors in the future or otherwise. IMPLICATIONS OF BEING A SAVINGS AND LOAN HOLDING COMPANY Society is a savings and loan holding company within the meaning of HOLA. With certain exceptions, a savings and loan holding company must obtain prior written approval from the OTS (as well as the Federal Reserve Board, or other Federal agencies whose approval may be required, depending upon the structure of the acquisition transaction) before acquiring control of a savings association or savings and loan holding company through the acquisition of stock or through a merger or some other business combination. HOLA prohibits the OTS from approving an acquisition by a savings and loan holding company which would result in the holding company's controlling savings associations in more than one state unless (a) the holding company is authorized to do so by the FDIC as an emergency acquisition, (b) the holding company controls a savings association which operated an office in the additional state or states on March 5, 1987, or (c) the statutes of the state in which the savings association to be acquired is located specifically permit a savings association chartered by such state to be acquired by an out-of-state savings association or savings and loan holding company. CONTROL ACQUISITIONS The Change in Bank Control prohibits a person or group of persons from acquiring "control" of a bank holding company unless the Federal Reserve Board has been given 60 days' prior written notice of proposed acquisition and within that time period the Federal Reserve Board has not issued a notice disapproving the proposed acquisition or extending for up to another 30 days the period during which such a disapproval may be issued. An acquisition may be made prior to the expiration of the disapproval period if the Federal Reserve Board issues written notice of its intention not to disapprove the action. Under a rebuttable presumption established by the Federal Reserve Board, the acquisition of 10% or more of a class of voting stock of a bank holding company with a class of securities registered under Section 12 of the Exchange Act, such as Society would, under the circumstances set forth in the presumption, constitute the acquisition of control. In addition, any "company" would be required to obtain the approval of the Federal Reserve Board under the BHCA before acquiring 25% (5% in the case of an acquiror that is a bank holding company) or more of the outstanding Society Common Shares, or otherwise obtaining control over Society. ITEM 2.

ITEM 2. PROPERTIES The headquarters of Society and of Society National Bank are located in Society Center at 127 Public Square, Cleveland, Ohio 44114-1306. Society currently leases approximately 625,000 square feet of the complex, encompassing the first twenty-one floors and the 55th and 56th floors of the 57-story Society Tower and all ten floors of the adjacent Society for Savings Building. Society owns a four-story office building and the Summit Center Building, a 16-story office building, both located in downtown Toledo. In addition, Society has an office center located in a one-story building containing approximately 500,000 square feet on a 55 acre site in Brooklyn, Ohio which is owned in fee by a subsidiary. Society National Bank is still under lease on the former Ameritrust offices at 2017 East Ninth Street in Cleveland in accordance with obligations assumed as part of the merger. These offices under lease consist of a portion of a 29-story office building, an attached 13-story office building and an 8-story parking garage. Society Bank, Michigan owns its seven-story main office building in Ann Arbor, Michigan, which is also the headquarters of Society Bancorp of Michigan, Inc. Society National Bank, Indiana leases its 14-story headquarters building in South Bend, Indiana. At December 31, 1993, the banking subsidiaries of Society owned 247 of their branch banking offices and leased 187 offices. The lease terms for applicable branch banking offices are not individually material, with terms ranging from month-to-month to 99-year leases from inception. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS In the ordinary course of business, Society and its subsidiaries are subject to legal actions which involve claims for substantial monetary relief. Based on information presently available to management and Society's counsel, management does not believe that any legal actions, individually or in the aggregate, will have a material adverse effect on the consolidated financial condition of Society. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS During the fourth quarter of the fiscal year covered by this Report, no matter was submitted to a vote of security holders of Society. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The discussion with respect to Common Shares and Shareholder Information appearing on page 32 and the dividend restrictions discussions included on page 4 and in Note 13, Commitments, Contingent Liabilities, and Other Disclosures, on page 56 are incorporated herein by reference. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA The Selected Financial Data included on page 11 is incorporated herein by reference. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This section provides a narrative discussion and analysis of the consolidated financial condition and results of operations of Society Corporation and its subsidiaries (the "Corporation"). The financial data included throughout the remainder of this discussion should be read in conjunction with the consolidated financial statements and notes presented on pages 39 through 61 of this report. On March 1, 1994, KeyCorp ("old KeyCorp"), a financial services holding company headquartered in Albany, New York, with approximately $33 billion in assets as of December 31, 1993, merged into and with Society Corporation ("Society"), an Ohio corporation, which was the surviving corporation of the merger under the name "KeyCorp". Because the merger, which was accounted for as a pooling of interests, occurred subsequent to December 31, 1993, the financial information and narrative discussion presented herein covers Society's financial performance prior to the merger and does not give effect to the restatement to include old KeyCorp's financial results. However, the supplemental financial statements included on pages 65 through 94 of this report present the combined financial condition and results of operations of Society and old KeyCorp as if the merger had been in effect for all periods presented. In addition to the merger of Society and old KeyCorp, the following transactions, which were completed over the past two years and have had a significant impact on the Corporation's overall growth and geographic diversification, are described in greater detail in Note 2, Mergers, Acquisitions and Divestitures, on page 45 of this report: (i) the March 16, 1992, merger of Ameritrust Corporation ("Ameritrust") with and into Society, (ii) the September 30, 1992, acquisition by Society of all the outstanding shares of First of America Bank - Monroe ("FAB-Monroe"), (iii) the December 4, 1992, formation by Society and three other bank holding companies of a joint venture in a new corporation named Electronic Payment Services, Inc., (iv) the January 22, 1993, acquisition by Society of all the outstanding shares of First Federal Savings and Loan Association of Fort Myers ("Society First Federal"), (v) the September 15, 1993, sale by Society of Ameritrust Texas Corporation ("ATC"), and (vi) the October 5, 1993, acquisition by Society of Schaenen Wood & Associates, Inc. ("SWA"). PERFORMANCE OVERVIEW Net income for 1993 reached a record level of $347.2 million, or $2.93 per Common Share, up from the previous record of $301.2 million, or $2.51 per Common Share, achieved in 1992 and $76.5 million, or $.61 per Common Share, in 1991. The return on average common equity for the current year rose to 17.87%, up from 17.52% and 4.24% in 1992 and 1991, respectively. The return on average total assets was 1.36% in 1993, 1.26% in 1992 and .30% in 1991. Record-level earnings were attained in 1993 despite fourth-quarter merger and integration charges of $53.9 million ($39.6 million after tax, $.33 per Common Share) recorded in connection with the merger with old KeyCorp. In 1992, earnings were also adversely impacted by similar charges of $50.0 million ($34.2 million after tax, $.29 per Common Share) recorded in the first quarter in connection with the merger with Ameritrust. In addition, 1992 earnings reflected a $20.1 million ($13.2 million after tax, $.11 per Common Share) gain on the sale of certain branch offices and loans. Excluding the impact of the above items, 1993 net income grew by $64.6 million, or 20%, relative to the previous year. On a pre-tax basis, this improvement reflected a $62.1 million, or 5%, increase in taxable-equivalent net interest income, a $28.3 million, or 6%, increase in noninterest income and a $75.1 million, or 51%, decrease in the provision for loan losses. These positive factors were offset in part by a $52.1 million, or 5%, increase in noninterest expense. Adjusting for the merger and integration charges in both years and the 1992 gain, the returns on average common equity and the returns on average total assets were 19.92% and 1.51%, respectively, in 1993, and 18.77% and 1.35%, respectively, in 1992. In 1991, net income was also impacted by merger and integration charges totaling $93.8 million ($68.2 million after tax, $.59 per Common Share) recorded during the fourth quarter in connection with the Ameritrust merger. Excluding the merger and integration charges in both 1992 and 1991 and the gain referred to above, net income in 1992 grew by $177.5 million, or 123%, relative to the previous year. On a pre-tax basis, this improvement reflected a $72.3 million, or 7%, increase in taxable-equivalent net interest income, a $26.4 million, or 6%, increase in noninterest income and a $132.7 million, or 47%, decrease in the provision for loan losses. Noninterest expense also decreased $22.7 million, after adjusting for the merger and integration charges in both years. On an adjusted basis, the 1991 return on average common equity and the return on average total assets were 8.36% and .57%, respectively. RESULTS OF OPERATIONS NET INTEREST INCOME Net interest income, which is comprised of interest and loan-related fee income less interest expense, is the principal source of earnings for Society's banking affiliates. Net interest income is affected by a number of factors including the level, pricing and maturity of earning assets and interest-bearing liabilities, interest rate fluctuations and asset quality. To facilitate comparisons in the following discussion, net interest income is presented on a taxable-equivalent basis, which increases reported interest income on tax-exempt loans and securities by an amount equivalent to the taxes which would be paid if the income were taxable at the statutory Federal income tax rate. The trends in various components of the balance sheet and their respective yields and rates which affect interest income and expense are illustrated in Figure 3. The table presented in Figure 4 provides an analysis of the effect of changes in yields/rates and average balances on net interest income in 1993 and 1992. A more in-depth discussion of changes in earning assets and funding sources is presented in the Financial Condition section beginning on page 23. Net interest income was $1.2 billion in 1993, up $62.1 million, or 5%, from the prior year. This followed an increase of $72.3 million, or 7%, in 1992 relative to the comparable 1991 period. In 1993, the growth in net interest income resulted from a higher level of average earning assets, which more than offset a slight decline in the net interest margin. The net interest margin is computed by dividing taxable equivalent net interest income by average earning assets. Average earning assets in 1993 totaled $23.2 billion which represented an increase of $1.5 billion, or 7%, from the prior year. This followed a decrease of $1.6 billion, or 7%, in 1992 relative to the previous year. Excluding the impact of the January 1993, acquisition of Society First Federal, average earning assets increased by $325.2 million in 1993 due to increases of $461.8 million in total securities and $69.2 million in loans and mortgage loans held for sale. These increases were partially offset by a $205.7 million decline in aggregate short-term investments. The increase in loans can be primarily attributed to growth in student loans held for sale, residential mortgage loans and lease financing, offset in part by lower levels of outstanding loans in the consumer and commercial portfolios. The $1.6 billion decrease in average earning assets in 1992 resulted primarily from a $1.3 billion decline in average loans, principally in the commercial and real estate construction portfolios. The decline also reflected a decrease of $375.4 million in Federal funds sold and security resale agreements. This latter decrease resulted from reduced short-term funding requirements for loans and the planned reduction of excess liquidity. The decrease in loans in 1992 can be attributed to a decline in demand due to weak economic conditions, strategic efforts to reduce certain types of lending, the anticipated run-off of certain Ameritrust credits and the second quarter sale of branch offices, including $331.8 million in loans, required in connection with the merger with Ameritrust. As shown in Figure 3, the net interest margin for the current year was 5.26% compared with 5.33% in 1992 and 4.65% in 1991. The slight decline in the 1993 net interest margin reflected the narrower interest rate spread contributed by Society First Federal and the lower proportion of interest free funds supporting earning assets in comparison with the prior year. The interest rate spread is computed as the difference between the taxable-equivalent yield on earning assets and the rate paid on interest-bearing liabilities. Excluding the impact of Society First Federal, the net interest margin increased to 5.35%. On an adjusted basis, the improvement in the margin over the past two years was principally the result of a wider spread. In 1993 and 1992 the spread increased by 16 basis points and 85 basis points, respectively, as the decrease in the rate paid on interest-bearing liabilities exceeded the decrease in the yield on earning assets. Several factors were responsible for the widened spreads, including an interest rate sensitivity position which has enabled the Corporation to benefit from the lower interest rate environment. This position was enhanced through the increased use of "portfolio" interest rate swaps and securities. The notional amount of such swaps increased to $5.2 billion at December 31, 1993, up from $4.8 billion at December 31, 1992, and $2.9 billion at December 31, 1991. Interest rate swaps contributed $131.1 million to net interest income and 56 basis points to the net interest margin in 1993. In 1992 interest rate swaps increased net interest income by $93.8 million and added 44 basis points to the net interest margin. The manner in which interest rate swaps are used in the Corporation's overall program of asset and liability management is described in the Asset and Liability Management section on page 16 of this report. Also contributing to the widened spread was a shift in deposits from time to lower rate savings deposits with higher liquidity and to noninterest-bearing deposits. The improved margin also reflected the effects of a lower level of nonperforming assets and the 1992 reduction in short-term investments (made by Ameritrust prior to the merger) which had narrower spreads. [PAGE INTENTIONALLY LEFT BLANK] ASSET AND LIABILITY MANAGEMENT The Corporation manages its exposure to economic loss from fluctuations in interest rates through an active program of asset and liability management within guidelines established by the Corporation's Asset/Liability Management Committee ("ALCO"). The ALCO has the responsibility for approving the asset/liability management policies of the Corporation, approving changes in the balance sheet that would result in deviations from guidelines in the policy, approving strategies to improve balance sheet positioning and/or earnings, and reviewing the interest rate sensitivity positions of the Corporation and each of the affiliate banks. The ALCO meets twice monthly to conduct this review and to approve strategies consistent with its policies. The primary tool utilized by management to measure and manage interest rate exposure is a simulation model. Use of the model to perform simulations of changes in interest rates over one-and two-year time horizons has enabled management to develop strategies for managing exposure to interest rate risk. In performing its simulations, management projects the impact on net interest income from pro forma 100 and 200 basis point changes in the overall level of interest rates. ALCO policy guidelines provide that a 200 basis point increase or decrease over a 12-month period should not result in more than a 2% negative impact on net interest income. Simulations as of December 31, 1993, indicated that a 200 basis point increase in interest rates over the next twelve months would have reduced net interest income by 2.2%. Conversely, a 200 basis point decrease in interest rates over the same time period would have increased net interest income by 1.4%. Accordingly, as of December 31, 1993, the simulation model indicated that the Corporation's liability-sensitivity position was outside of policy guidelines. ALCO determined that this interest rate sensitivity position was appropriate considering the pending merger with old KeyCorp. Simulations on a pro forma combined basis with old KeyCorp as of December 31, 1993, indicated that the combined corporation was positioned within the guidelines and was slightly liability sensitive. The simulation model is supplemented with a more traditional tool used in the banking industry for measuring interest rate risk known as interest rate sensitivity gap analysis. This tool measures the difference between assets and liabilities repricing or maturing within specified time periods. An asset-sensitive position indicates that there are more rate-sensitive assets than rate-sensitive liabilities repricing or maturing within specified time horizons, which would generally imply a favorable impact on net interest income in periods of rising interest rates. Conversely, a liability sensitive position, where rate-sensitive liabilities exceed the amount of rate-sensitive assets repricing or maturing within applicable time frames, would generally imply a favorable impact on net interest income in periods of declining interest rates. The interest rate gap analysis table shown in Figure 5 presents the gap position (including the impact of off-balance sheet items) of the Corporation at December 31, 1993. Gap analysis has several limitations. For example, it does not take into consideration the varying degrees of interest rate sensitivity pertaining to the assets and liabilities that reprice within one year. Thus at December 31, 1993, the cumulative adjusted interest rate sensitivity gap of 4.78% within the one-year time frame indicated that the Corporation was asset-sensitive, whereas the more precise simulation model, previously described, indicated the Corporation was slightly liability-sensitive. The Corporation's core lending and deposit-gathering businesses tend to generate significantly more fixed-rate deposits than fixed-rate interest-earning assets. Left unaddressed, this tendency would place the Corporation's earnings at risk to declining interest rates as interest-earning assets would reprice faster than would interest-bearing liabilities. To reduce this risk, management has utilized its securities portfolio and, for the past several years, interest rate swaps in the management of interest rate risk. The decision to use "portfolio" interest rate swaps to manage interest rate risk versus on-balance sheet securities has depended on various factors, including funding costs, liquidity, and capital requirements. The Corporation's "portfolio" swaps totaled $5.2 billion at December 31, 1993, and consisted principally of contracts wherein the Corporation receives a fixed rate of interest, while paying at a variable rate, as summarized in Figure 6. In addition to "portfolio" swaps, the Corporation has entered into interest rate swap agreements to accommodate the needs of its customers, typically commercial loan customers. The Corporation offsets the interest rate risk of customer swaps by entering into offsetting swaps, primarily with third parties. These offsetting swaps are also included in the customer swap portfolio. Where the Corporation does not have an existing loan with the customer, the swap position of the customer and any offsetting swap with a third party are carried at their respective fair values. The $1.2 billion notional value of customer swaps in Figure 6 includes $645 million of interest rate swaps that receive a fixed rate and pay a variable rate and $569 million of interest rate swaps that receive a variable rate and pay a fixed rate. The total notional value of all interest rate swap contracts outstanding was $6.5 billion and $5.5 billion as of December 31, 1993 and 1992, respectively. Figure 7 shows the current year activity for such swaps. At December 31, 1993, the aggregate notional values of interest rate swap contracts, excluding customer swaps, maturing in each of the years 1994 through 1998 were $2.5 billion, $1.0 billion, $500 million, $200 million and $650 million, respectively. The credit risk exposure to the counterparties for each interest rate swap contract is monitored by the appropriate credit committees at both the Corporate and affiliate bank levels. Based upon detailed credit reviews of the counterparties, these credit committees establish limitations on the total credit exposure the Corporation may have with each counterparty and indicate whether collateral is required. At December 31, 1993, excluding customer swaps, the Corporation had 16 counterparties to interest rate swap contracts, of which the largest credit exposure to an individual counterparty was $16.4 million on a notional amount of $900 million. The average total notional amount of swap contracts with these 16 counterparties was $328 million with an average credit exposure of $4.1 million. NONINTEREST INCOME As shown in Figure 9, noninterest income totaled $509.8 million in 1993, up $8.3 million, or 2%, from the prior year. After excluding the $29.4 million gain on the sale of ATC, the $26.1 million in net securities gains and certain other nonrecurring items, noninterest income in 1993 was $457.6 million. This represented an increase of $14.1 million, or 3%, from the amount reported in 1992, after excluding last year's $20.1 million gain on the sale of branch offices and loans, and net securities gains totaling $9.8 million. Adjusting for the 1992 gains and the securities transactions recorded in 1991, noninterest income in 1992 rose $23.9 million, or 5%, relative to the prior year. Trust fees continued to be a major source of revenue. After excluding the gains referred to above, these fees accounted for 45% of noninterest income in both 1993 and 1992, compared to 44% in 1991. The growth during the 1992 period reflected the development of new business, expanded geographic coverage and enhanced service capability. At December 31, 1993, the Corporation, through Society Asset Management, Inc. ("SAMI") and the trust departments of its affiliate banks and trust subsidiaries, managed assets (excluding corporate trust assets) of approximately $29.4 billion. SAMI, which is a wholly-owned subsidiary of Society National Bank, is registered with the Securities and Exchange Commission ("SEC") as an investment advisor and is one of the largest money managers in the Great Lakes region. The sale of ATC in September 1993 reduced managed trust assets and trust fees by approximately $4 billion and $8.0 million, respectively. Service charges on deposit accounts decreased $1.6 million, or 2%, in 1993 following an increase of $3.7 million, or 4%, in 1992. The decrease in 1993 was due, in part, to the change in the mix of the deposit base and related pricing structure resulting from acquisitions and divestitures. Factors contributing to the improvement in 1992 were pricing strategies and other corporate-wide initiatives designed to offset higher costs associated with servicing deposit accounts. In 1993, credit card fees decreased $6.8 million, or 12%, primarily due to a decline in annual membership fees relative to the prior year. This compared to an increase of $2.5 million, or 5%, in 1992. Growth in the insurance and brokerage component of other income over the past three years was due to increased broker dealer commissions at Society Investments, Inc. (SII). SII, which is a wholly-owned subsidiary of Society National Bank, is a registered broker dealer with the SEC and the National Association of Securities Dealers. The increase in commissions at SII resulted from aggressive and strategic sales initiatives, including an expanded sales force and product line. "Miscellaneous" other income in 1993 decreased $8.0 million, or 12%, from the comparable 1992 amount. Primary factors contributing to this decrease were an $8.2 million decline in ATM fees resulting from Society's contribution of the Green Machine subsidiary to the newly formed Electronic Payment Systems joint venture which Society entered into in the fourth quarter of 1992, and $10.2 million in gains resulting from the curtailment and settlement of retirement obligations recorded in 1992 in connection with merger-related staff reductions. The impact of these factors was partially offset by a $4.5 million interest rate swap trading gain recorded in 1993. NONINTEREST EXPENSE Noninterest expense, as shown in Figure 10, totaled $1.1 billion in 1993, up $55.9 million, or 5%, from the 1992 level. In both 1993 and the prior year, noninterest expense was adversely impacted by merger and integration charges of $53.9 million and $50.0 million, respectively. In addition, the current year included several nonrecurring charges totaling $34.4 million. Significant items included in these charges were $21.6 million related to various systems conversion costs, $7.0 million of facilities-related charges and $4.0 million associated with the adoption of SFAS No. 112, "Employers' Accounting for Postemployment Benefits." Excluding the merger and integration charges and the nonrecurring items, 1993 expenses rose $17.6 million, or 2%, principally due to increases in personnel expense, marketing expense and the "Miscellaneous" category, offset in part by lower fees for professional services. The overall increase in recurring noninterest expense was due, in large part, to the acquisition of Society First Federal in January 1993. The 1991 period also included merger and integration charges of $93.8 million, as well as $6.9 million of costs associated with a branch optimization program. After adjusting for these items, 1992 noninterest expense decreased $15.8 million, or 2%, relative to the prior year, reflecting the effectiveness of cost management initiatives. Personnel expense for 1993 increased $15.0 million, or 3%, over 1992. In addition to the $9.3 million impact of the Society First Federal acquisition, this increase reflected the Corporation's January 1, 1993, adoption of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," which added $4.7 million to 1993 employee benefits expense, as well as additional costs associated with a new employee incentive program. Excluding the impact of the adoption of SFAS No. 106 and SFAS No. 112, personnel expense for 1993 increased $6.3 million or 1%. SFAS No. 106 and SFAS No. 112 are more fully described below. Personnel expense for 1992 increased $4.5 million, or less than 1%, from the prior year. The 1992 increase in the salaries component was mainly due to higher costs related to temporary contracted personnel, but was substantially offset by the decrease in benefits resulting from reduced staff levels. At December 31, 1993, the number of full-time equivalent employees was 12,038, down 3% and 11% from 1992 and 1991 levels, respectively. Merger and integration charges of $53.9 million, $50.0 million and $93.8 million were recorded in 1993, 1992, and 1991, respectively. The 1993 charges were incurred in connection with the merger with old KeyCorp, while the 1992 and 1991 amounts related to the merger with Ameritrust. The merger and integration charges directly attributable to the old KeyCorp merger included accruals for merger expenses, consisting primarily of investment banking and other professional fees directly related to the merger ($12.6 million); severance payments and other employee costs ($17.6 million); systems and facilities costs ($16.7 million); and other costs incident to the merger ($7.0 million). These charges were recorded by the parent company in the fourth quarter of 1993 at which time management determined that it was probable that a liability for such charges had been incurred and could be reasonably estimated. The merger and integration charges recorded in connection with the Ameritrust merger in 1992 and 1991 were similar in nature. Although no assurance can be given, it is also expected that as a result of the old KeyCorp merger, cost savings will be achieved by the combined institution at an annual rate of approximately $100 million by the end of the first quarter of 1995. These cost savings are anticipated to result from the integration of operations and from efficiencies in certain combined lines of business. Management presently expects that approximately 50% of the annual cost savings will be achieved in 1994. One measure used in the banking industry to assess the level of noninterest expense is the efficiency ratio, which is defined in Figure 10. The efficiency ratios for 1993, 1992, and 1991 were 60.41%, 61.11%, and 66.44%, respectively. The improvement in the Corporation's efficiency ratios reflects, in large part, the success achieved in reducing overhead costs through the successful integration of banking companies, coupled with the strong growth in taxable-equivalent net interest income. SFAS No. 106, previously referred to on page 20, requires that employers recognize the cost of providing postretirement benefits over the employees' active service periods to the date they attain full eligibility for such benefits. A transition obligation, defined as the unfunded accumulated postretirement benefit obligation at the date the standard is adopted, may be recognized immediately (through a charge to earnings in the year of adoption), or on a delayed basis, generally over a transition period not to exceed 20 years. The Corporation elected to recognize the transition obligation of approximately $77 million over a 20-year transition period. As previously stated, adoption of the new standard added $4.7 million to noninterest expense in the current year. As of December 31, 1993, the discount rate used in determining the actuarial present value of both pension and other postretirement benefits was reduced from 8.5% to 7.5%. In addition, the assumed rate of increase in future compensation levels (applicable only to the determination of pension benefits) was reduced from 4.5% to 4.0%. The net effect of these assumption changes on 1994 expense levels is not expected to be material. Another assumption used in the determination of the costs of other postretirement benefits is the health care cost trend rate. Because of certain cost-sharing provisions and benefit limitations in effect, increasing the rates assumed in each future year by one percentage point would not be expected to have a material impact on the costs for other postretirement benefits. The Corporation adopted the provisions of SFAS No. 112, "Employers' Accounting for Postemployment Benefits" during 1993. This standard requires that employers who provide benefits to former and inactive employees after employment but before retirement recognize a liability for such benefits if specified conditions are met. Adoption of the standard increased third quarter and full year 1993 noninterest expense by $4.0 million. Postemployment benefits for 1992 and 1991, which were recorded on a cash basis, were not restated. INCOME TAXES The provision for income taxes for 1993 was $187.5 million, compared with $137.4 million in 1992 and $33.2 million in 1991. The increases in both 1993 and the prior year resulted from an overall increase in the level of taxable earnings. The Omnibus Budget Reconciliation Act of 1993, which was signed into law on August 10, 1993, includes a number of significant items which impacted the Corporation's Federal income tax provision. Primary among these items is a retroactive increase in the Federal statutory tax rate from 34% to 35% as of January 31, 1993. In addition, the Act places certain limitations on deductible expenses which take effect after 1993. The effective tax rate (provision for income taxes as a percentage of income before income taxes) was 35.1% in 1993, 31.3% in 1992 and 30.3% in 1991. The effective tax rate in 1993 exceeded the current Federal statutory tax rate of 35% as a higher tax-basis gain on the sale of ATC and non tax-deductible expenses, including the amortization of certain intangible assets and certain merger expenses, exceeded tax-exempt income in the current year. The non tax-deductible merger expenses incurred in 1993 were primarily due to additional costs associated with the merger with old KeyCorp. The effective tax rate in 1992 and 1991 was less than the Federal statutory tax rate of 34.0%, in effect at the time, due primarily to tax-exempt income from certain investment securities and loans. During the first quarter of 1992, the Corporation adopted the provisions of SFAS No. 109, "Accounting for Income Taxes." The adoption of this standard did not have a material effect on the Corporation's financial condition or results of operations. FINANCIAL CONDITION The financial condition of Society and its subsidiaries as of December 31 is presented in the comparative balance sheet on page 39. The following discussions address significant elements of financial condition including loans, securities, credit quality and experience, sources of funds, liquidity and capital adequacy. Unless otherwise indicated, amounts presented in the discussions are as of the appropriate period-end. LOANS At December 31, 1993, total loans outstanding were $17.9 billion, as compared with $16.0 billion at December 31, 1992, and $16.8 billion at December 31, 1991, as shown in Figure 11. The increase from the year-end 1992 level was due, in part, to the acquisition of Society First Federal in January 1993. Excluding the $836.6 million impact of this acquisition and adjusting for $200.0 million of student loans securitized or sold in 1993, loans increased by $1.3 billion since the prior year end. This reflected increases of $603.0 million in residential real estate loans, $578.5 million in student loans held for sale and $289.3 million in lease financing receivables. These increases were partially offset by decreases of $360.0 million in commercial mortgage and construction loans, $43.6 million in commercial loans, $41.5 million in credit card outstandings and $38.1 million in foreign loans. Commercial loans outstanding at December 31, 1993, were $4.4 billion, down slightly from the December 31, 1992 level, following a decrease of $747.6 million, or 14%, in the prior year. The declines in both years can be attributed to weaker loan demand as a consequence of the economic environment and to strategic efforts to reduce the level of exposure related to highly-leveraged transactions ("HLT"s), principally acquired in the Ameritrust Merger, where there has not been a long-standing relationship with the borrower. These transactions are defined and monitored based upon the criteria previously used by the banking regulators. In addition, the decline in 1992 reflected the run-off of certain other Ameritrust credits which management believed were incompatible with the Corporation's credit risk profile. At December 31, 1993, the Corporation had $247.5 million in HLT loans outstanding, down $157.7 million, or 39%, from the December 31, 1992, level. This followed a decline of $145.3 million, or 26%, in 1992. Loans secured by real estate totaled $7.3 billion at December 31, 1993, compared with $6.3 billion at December 31, 1992, and $6.4 billion at December 31, 1991. Loans secured by real estate consist of construction loans, one-to-four family residential loans (including home equity loans) and commercial mortgage loans. The increase from 1992 was mainly attributable to the acquisition of Society First Federal. The acquisition accounted for $811.9 million of the increase in total real estate loans and $767.2 million of the increase in the residential mortgage portfolio. Construction loans decreased to $623.2 million at December 31, 1993, from $737.6 million at December 31, 1992, and $839.4 million at December 31, 1991. After adjusting for the impact of the acquisition of Society First Federal, the decrease from year-end 1992 was $132.6 million. As portrayed in Figure 12, loans in the construction portfolio are concentrated in the Midwest, which has not experienced, to the same degree, the level of overbuilding and declines in real estate values as have certain other regions of the country. At December 31, 1993, 70% of the portfolio was secured by properties in Ohio, and 17% were in Indiana and Michigan, Society's principal banking markets. The commercial mortgage loan portfolio totaled $2.1 billion at December 31, 1993, compared with $2.3 billion at December 31, 1992, and $2.6 billion at December 31, 1991. In addition to efforts to downsize the portfolio, the slower economy also contributed to this decrease. As depicted in Figure 12, commercial mortgages are also geographically concentrated in the Midwest, with 64% of outstandings secured by properties in Ohio, and 21% in Indiana and Michigan. At December 31, 1993, 49% of the commercial mortgage loan portfolio was comprised of loans secured by owner-occupied properties. Those borrowers are engaged in business activities other than real estate, and the primary source of repayment is not solely dependent on the real estate market. The Corporation manages risk exposure in the construction and commercial mortgage portfolios through prudent underwriting criteria and by monitoring loan concentrations by geographic region and property type. One-to-four family residential mortgages (including home equity loans) were $4.6 billion at December 31, 1993, compared with $3.2 billion at December 31, 1992, and $2.9 billion at December 31, 1991. Excluding the SECURITIES In December 1992, the Corporation transferred its U.S. Treasury securities from the investment portfolio to the "available for sale" portfolio. At December 31, 1993, the book value of the securities portfolio, including securities available for sale, totaled $6.4 billion, up $784.7 million, or 14%, from December 31, 1992. The year-end 1992 amount was $816.1 million, or 17%, higher than the comparable amount for 1991. The growth from the 1992 year-end primarily resulted from an increase of $1.2 billion, or 35%, in mortgage-backed securities and an increase of $145.5 million, or 25%, in other securities. These increases were partially offset by decreases in securities issued by states and political subdivisions of $150.2 million, or 29%, and $384.1 million, or 34%, in securities available for sale. The increase during 1992 primarily resulted from purchases of U.S. Treasury securities, collateralized mortgage obligations ("CMOs") and other mortgage-backed securities. The securities portfolio comprised 26% of total earning assets at December 31, 1993, up from 25% at December 31, 1992, and up from 21% at December 31, 1991. The yield on the securities portfolio declined to 6.49% at December 31, 1993, from 7.61% at December 31, 1992. This reduction is attributable to prepayments on higher-yielding mortgage-backed securities and lower reinvestment yields resulting from the declining rate environment. The yield on the securities portfolio has not declined as rapidly as market yields due primarily to prior investment programs in which the portfolio was structured to benefit from the declining interest rate environment. The portfolio's market value exceeded its book value by $125.6 million at December 31, 1993, compared with an excess of $111.7 million at December 31, 1992, and $192.9 million at December 31, 1991. At December 31, 1993, the Corporation had $4.5 billion invested in mortgage-backed pass-through securities and collateralized mortgage obligations ("CMO") within the investment securities portfolio, compared with $3.4 billion at December 31, 1992. A mortgage-backed pass-through security depends on the underlying pool of mortgage loans to provide a cash flow "pass-through" of principal and interest. The Corporation had $2.9 billion invested in mortgage-backed pass-through securities at December 31, 1993. A CMO is a mortgage- backed security that is comprised of classes of bonds created by prioritizing the cash flows from the underlying mortgage pool in order to meet different objectives of investors. The Corporation had $1.6 billion invested in CMO securities at December 31, 1993. The CMO securities held by the Corporation are primarily shorter-maturity class bonds that were structured to have more predictable cash flows by being less sensitive to prepayments during periods of changing interest rates. At December 31, 1993, substantially all of the CMOs and mortgage-backed pass-through securities held by the Corporation were issued by Federal agencies or backed by Federal agency pass-through securities. ASSET QUALITY The measurement and management of asset quality is the responsibility of the Corporation's Credit Policy/Risk Management Group. This Group is responsible for both commercial and consumer lending credit policy, credit systems development and procedures, loan examination, providing additional controls in the early identification of problem loans, and the monitoring of major loan workouts in the subsidiary banks. The Group is also responsible for the determination of the adequacy of the allowance for loan losses for each of Society's bank subsidiaries. Each allowance is reviewed on the basis of three methodologies which, when combined, determine the allocated and unallocated portions of the allowance and provide management with a benchmark by which its adequacy is measured. The methodologies are: (1) a review of internal loan classifications; (2) an historical analysis of prior periods' charge-off experience; and (3) an evaluation of estimated worst-case losses on internally-classified credits. Management targets the maintenance of a minimum allowance equal to the indicated allocated requirement plus an unallocated portion, as appropriate, in light of current and expected economic conditions and trends, geographic and industry concentrations, and similar risk-related matters. The 1993 provision for loan losses was $72.2 million compared to $147.4 million for 1992 and $280.0 million for 1991. The 1991 amount included an additional provision of $93.9 million recorded by Ameritrust during the fourth quarter to conform its approach with that of the Corporation to determine the adequacy of the allowance. The significantly lower provisions in 1993 and 1992 reflect the continued corporate-wide improvement in asset quality trends, including significant declines in nonperforming loans. Net loans charged-off in 1993 decreased $76.4 million, or 45%, from the 1992 level, following a decrease of $43.4 million, or 20%, from 1991. The significant decrease in 1993 was due to lower net charge-offs in all loan categories with the largest improvement occurring in the consumer and real estate-mortgage portfolios. The 1992 decrease was largely due to a lower level of net charge-offs in the commercial loan portfolio and the consumer loan portfolio, partially offset by higher net charge-offs in the real estate portfolios. The majority of the charge-offs in both 1993 and 1992 reflected losses on problem credits for which reserves were established in previous periods. The allowance at December 31, 1993, was $480.6 million, or 2.69% of loans, as compared with $502.7 million, or 3.10% of loans, at December 31, 1992. The allowance as a percent of nonperforming loans was 295.20% at December 31, 1993, compared with 144.17% at December 31, 1992. Although used as a general indicator, the allowance to nonperforming loans ratio is not a primary factor in the determination of the adequacy of the allowance by management. As indicated in Figure 14, the unallocated portion of the allowance increased in 1993, reflecting the continued improvement in the overall quality of the loan portfolios. As shown in Figure 16, nonperforming assets totaled $224.4 million at December 31, 1993, down $272.5 million, or 55%, from the December 31, 1992, level. This followed a decrease of $130.1 million, or 21%, in the previous year. The significant improvement in 1993 resulted largely from a $185.9 million, or 53%, decrease in nonperforming loans and an $85.2 million, or 63.9%, decrease in other real estate owned. Other nonperforming assets, which are comprised primarily of nonperforming venture capital investments, decreased $1.4 million, or 9.4%, in 1993. The reduction in nonperforming loans was principally attributable to decreases in nonaccrual commercial (including HLTs), construction and commercial real estate loans. At the end of 1993, nonaccrual loans in these categories comprised 40%, 17% and 24%, respectively, of total nonperforming loans and totaled $131.9 million, down $173.8 million, or 57%, from the previous year-end. This reduction reflected progress made in working through the credit problems associated with the Ameritrust acquisition, principally through the efforts of the Special Assets Group ("SAG"). As indicated in Figure 17, the reduction in other real estate owned was primarily due to the selective sale of assets. At December 31, 1993, HLT loans classified as nonperforming amounted to $25.3 million, or 16% of total nonperforming loans. At December 31, 1992, nonperforming HLT loans aggregated $4.6 million, or 1% of total nonperforming loans. One individual nonperforming HLT loan represented $18.1 million or 72% of the total at December 31, 1993. The SAG was formed in conjunction with the acquisition of Ameritrust, and charged with the responsibility to manage and resolve primarily problem assets acquired in the merger. These assets totaled $865.3 million at March 31, 1992, and were comprised of commercial loans, commercial real estate loans and other real estate owned. At that date, the nonperforming portion of these assets was $432.6 million, and represented 69% of the Corporation's total nonperforming assets. As a result of the efforts of the SAG, total SAG assets declined $275.9 million, or 32%, to $589.4 million at December 31, 1992, and during 1993 declined $337.3 million, or 57%, to $252.1 million at December 31, 1993. The nonperforming portion of SAG assets at year-end totaled $68.4 million and represented 30% of the Corporation's total nonperforming assets, while comparable amounts at December 31, 1992, were $254.8 million and 51%, respectively. In May 1993, the Financial Accounting Standards Board ("FASB") issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan." This standard affects the definition and basis for measuring impaired loans and is more fully discussed in Note 5, Nonperforming Assets, on page 48. (FIG. 15) - SUMMARY OF LOAN LOSS EXPERIENCE (FIG. 17) - SUMMARY OF CHANGES IN NONACCRUAL LOANS AND OREO DEPOSITS AND OTHER SOURCES OF FUNDS Core deposits, defined as domestic deposits other than certificates of deposit of $100,000 or more, are the Corporation's primary source of funding. These deposits averaged $16.4 billion in both 1993 and 1992 and $17.5 billion in 1991. In 1993 average core deposits were significantly impacted by the January 1993 acquisition of Society First Federal. Excluding the impact of Society First Federal, core deposits declined $1.1 billion during the current year reflecting declining interest rates and other alternatives pursued by consumers. Over the past year, balances have also shifted significantly from the "Other time deposits" category, consisting primarily of fixed rate certificates of deposit, to demand and savings deposits (including NOW accounts) with higher liquidity, also principally as a result of declining interest rates. Based on the amounts shown in Figure 3, and after excluding the impact of Society First Federal, the $1.3 billion decline in the "Other time deposits" category and the $407.0 million decline in money market deposit accounts were partially offset by increases of $258.4 million in NOW accounts, $244.6 million in savings deposits and $72.9 million in demand deposits. The decline in core deposits in 1992 was primarily due to the sale of approximately $1.0 billion in deposits late in the second quarter (as part of the agreement reached with the United States Department of Justice and in accordance with the Federal Reserve Board order to divest certain branches in connection with the Ameritrust merger) and the pursuit of other alternatives by consumers in response to declining interest rates. Purchased funds, which are comprised of large certificates of deposit, foreign office deposits, and short-term borrowings, averaged $5.6 billion for 1993, up $1.1 billion, or 25%, from the prior year, following a decrease of $680.8 million, or 13%, in 1992. Average purchased funds were not materially impacted by the acquisition of Society First Federal. Based on the amounts shown in Figure 3, and after excluding the impact of Society First Federal, the 1993 increase was largely attributable to a $650.9 million increase in foreign office deposits, a $416.9 million increase in Federal funds purchased and securities sold under agreements to repurchase, and a $457.4 million increase in other short-term borrowings due to the issuance of Medium-Term Notes in the current year. These increases were partially offset by a $425.9 million decline in large certificates of deposits. LIQUIDITY Liquidity represents the availability of funding to meet the needs of depositors, borrowers, and creditors at a reasonable cost and without adverse consequences. The Corporation's ALCO actively analyzes and manages the Corporation's liquidity in coordination with similar committees at each bank subsidiary. The bank subsidiaries individually maintain sufficient liquidity in the form of short-term money market investments, anticipated prepayments on securities and through the maturity structure of their loan portfolios. Another source of liquidity are those securities classified as available for sale. In addition, the bank subsidiaries have access to various sources of non-core market funding for short-term liquidity requirements should the need arise. The effective management of balance sheet volumes, mix, and maturities enables the bank subsidiaries to maintain adequate levels of liquidity while enhancing profitability. During 1993, Society's lead bank, Society National Bank, issued $685 million in debt securities under a Medium-Term Bank Note program. These securities have maturities of less than one year and are included in other short-term borrowings. At December 31, 1993, the lead bank was authorized to issue up to an additional $2.3 billion of securities with maturities ranging from 9 months to 15 years under this program and an additional $1.0 billion under a separate, Medium-Term Deposit Note program. The proceeds from these programs are to be used for general corporate purposes in the ordinary course of business. During both the second quarter of 1993 and the fourth quarter of 1992, the lead bank issued $200 million in subordinated long-term debt to be used to supplement its capital base and to provide funds for loans and investments. During 1993, Society issued $111 million in debt securities under a separate Medium-Term Note program. These securities have maturities in excess of one year and are included in long-term debt. During 1993, Society redeemed $100 million in long-term debt securities due in 1996 at par plus accrued interest. In addition, Society redeemed 1,200,000 outstanding shares of Fixed/Adjustable Rate Cumulative Preferred Stock at 103% of its stated value of $60 million plus accumulated but unpaid dividends. The liquidity requirements of Society, primarily for dividends to shareholders, retirement of debt and other corporate purposes, are met principally through regular dividends from bank subsidiaries. As of December 31, 1993, $76.0 million was available in the bank subsidiaries for the payment of dividends to Society without prior regulatory approval. Excess funds are maintained in short-term investments. Society has no lines of credit with other financial institutions, but has ready access to the capital markets as a result of its favorable debt ratings. CAPITAL AND DIVIDENDS Total shareholders' equity at December 31, 1993, was $2.0 billion, up 9%, or $170.5 million, from the balance at the end of 1992. This followed an increase of $212.9 million, or 13%, in the prior year. In both years the increase was principally due to the retention of net income after dividends on Common Shares. Further information with respect to dividends is presented in the "Common Shares and Shareholder Information" section which follows and in the dividend restriction discussion included on page 56. In 1993, shareholders' equity was also impacted by the redemption of preferred stock referred to above. Capital adequacy is an important indicator of financial stability and performance. Overall, Society's capital position remains strong with a ratio of total shareholders' equity to total assets of 7.55% at December 31, 1993, up from 7.48% and 6.47% at December 31, 1992 and 1991, respectively. Banking industry regulators define minimum capital ratios for bank holding companies and their bank and savings association subsidiaries. Based on the risk-based capital rules and definitions prescribed by the banking regulators, the Corporation's Tier I and total capital to risk-adjusted assets ratios at December 31, 1993, were 8.65% and 12.88%, respectively. These compare favorably with the minimum requirements of 4.0% for Tier I and 8.0% for total capital. The Tier I leverage ratio standard prescribes a minimum ratio of 3.0%, although most banking organizations are expected to maintain ratios of at least 100 to 200 basis points above the minimum. At December 31, 1993, the Corporation's leverage ratio was 7.18%, substantially higher than the minimum requirement of 3%. Figure 19 presents the details of Society's capital position at December 31, 1993 and 1992. Effective in December 1992, Federal bank regulators adopted new regulations to implement the prompt corrective action provisions of the FDIA which group FDIC-insured institutions into five broad categories based on certain capital ratios. The five categories are "well-capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," and "critically undercapitalized." Although these provisions are not directly applicable to Society under existing law and regulations, based upon its ratios Society would qualify, and the banks do qualify, as "well capitalized" at December 31, 1993. The Corporation's capital category, as determined by applying the prompt corrective action provisions of law, may not constitute an accurate representation of the overall financial condition or prospects of Society or its banking subsidiaries. The OCC, the Federal Reserve, and the FDIC are proposing amendments to their respective regulatory capital rules to include in Tier I capital the net unrealized changes in the value of securities available for sale for purposes of calculating the risk-based and leverage ratios. The proposed amendments are in response to the provisions outlined in SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which takes effect for fiscal years beginning after December 15, 1993. See Note 3, Securities, on page 46 for a more complete description of SFAS No. 115. This new accounting standard establishes, among other things, net unrealized holding gains and losses on securities available for sale as a new component of stockholders' equity. If adopted as proposed, the rules could cause the Tier I capital to be subject to greater volatility. However, neither SFAS No. 115 nor the capital proposals would have any direct impact on reported earnings. Based upon the Corporation's securities portfolio classified as available for sale as of December 31, 1993, the estimated impact of the new standard would be an increase to shareholders' equity of approximately $28 million. The regulatory agencies are also proposing to add an additional component to the risk-based capital requirements based upon the level of an institution's exposure to interest rate risk. COMMON SHARES AND SHAREHOLDER INFORMATION On September 1, 1992, Society's Common Shares commenced trading on the New York Stock Exchange under the symbol SCY. The sales price ranges of the Common Shares and per Common Share net income and dividends by quarter for each of the last two years are presented in Figure 20. Common Shares outstanding and per Common Share data have been adjusted for a two-for-one stock split declared on January 21, 1993, which was effected by means of a 100% stock dividend paid on March 22, 1993, to Common Shareholders of record on March 2, 1993. At December 31, 1993, book value per Common Share was $17.37 based on 117,377,404 shares outstanding, compared with $15.49 based on 116,725,976 shares outstanding at December 31, 1992. At year-end 1993, the closing sales price on the New York Stock Exchange was $29.75 per share. This price was 171% of year-end book value per share and had a dividend yield of 3.76%. On January 20, 1994, the quarterly dividend on Common Shares was increased by 14% to $.32 per Common Share, up from $.28 per Common Share in 1993. The new quarterly dividend rate of $.32 per Common Share will be payable on March 15, 1994, to shareholders of record on February 28, 1994. There were 36,331 holders of record of Society Common Shares at December 31, 1993. FOURTH QUARTER RESULTS As shown in Figure 20, net income for the fourth quarter of 1993 was $57.0 million, or $.49 per Common Share, compared with $86.5 million, or $.72 per Common Share, for the same period last year. The 1993 period was impacted by merger and integration charges of $53.9 million ($39.6 million after-tax, $.33 per Common Share) recorded in connection with the merger with old KeyCorp. Excluding the impact of the merger and integration charges, net income was $96.6 million, up $10.1 million or 12%, from the prior year. This reflected a $4.8 million, or 2%, increase in taxable-equivalent net interest income and an $18.0 million, or 58%, decrease in the provision for loan losses, which were partially offset by an increase of $10.3 million, or 4%, in noninterest expense. On an annualized basis, the return on average total assets for the fourth quarter of 1993 was .87% compared with 1.40% for the fourth quarter of 1992. The annualized returns on average common equity for the fourth quarters of 1993 and 1992 were 11.09% and 19.08%, respectively. Excluding the merger and integration charges, the fourth quarter 1993 annualized return on average total assets was 1.47%, while the return on average common equity was 18.80%. The improvement in taxable-equivalent net interest income in the fourth quarter of 1993, as compared to the fourth quarter of 1992, reflected a $1.4 billion or 6% increase in the level of average earning assets, offset in part by a 23 basis point decline in the net interest margin to 5.10%. The higher level of average earning assets was primarily due to the acquisition of Society First Federal in January 1993. Excluding the impact of this acquisition, average earning assets increased by $177.1 million, mainly due to an increase of $579.3 million in average loans, principally those in the residential real estate portfolio, an increase of $732.8 million in securities available for sale and an increase of $146.2 million in mortgage loans held for sale. These increases were substantially offset by decreases of $670.9 million in interest-bearing deposits with banks and $573.0 million in investment securities. The decline in the net interest margin reflected the narrowing of spreads available on the replacement of matured and prepaid securities and interest rate swaps and the narrower spread contributed by Society First Federal. The lower provision for loan losses resulted from the overall improvement in asset quality, including a $185.9 million or 53% decline in nonperforming loans from December 31, 1992, to December 31, 1993. The increase in noninterest expense, excluding merger and integration charges, was primarily due to higher personnel expense, offset in part by lower costs associated with professional services. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF MANAGEMENT The management of Society Corporation and its subsidiaries (the "Corporation") is responsible for the preparation, content and integrity of the financial statements and other statistical data and analysis compiled for this report. The financial statements and related notes have been prepared in conformity with generally accepted accounting principles and, in the judgment of management, present fairly and consistently the Corporation's financial position, results of operations, and cash flows. Management also believes that financial information elsewhere in this report is consistent with that in the financial statements. The amounts contained in the financial statements are based on management's best estimates and judgments. The Corporation maintains a system of internal controls designed to provide reasonable assurance as to the protection of assets and the integrity of the financial statements. This corporate-wide system of controls includes written policies and procedures, proper delegation of authority and organizational division of responsibility and the careful selection and training of qualified personnel. In addition, an effective internal audit function periodically tests the system of internal controls. Management believes that the system of internal controls provides reasonable assurances that financial transactions are recorded properly to permit the preparation of reliable financial statements. The Board of Directors discharges its responsibility for the Corporation's financial statements through its Audit Committee which is composed of outside directors and has responsibility for the recommendation of the independent auditors. The Audit Committee meets regularly with the independent auditors and internal auditors to review the scope of their audits and audit reports and to discuss any action to be taken. Both the independent auditors and internal auditors have direct access to the Audit Committee. Management has made an assessment of the Corporation's internal control structure and procedures over financial reporting using established and recognized criteria. On the basis of this assessment, management believes that the Corporation maintained an effective system of internal control for financial reporting as of December 31, 1993. ROBERT W. GILLESPIE Chairman of the Board and Chief Executive Officer JAMES W. WERT Vice Chairman of the Board and Chief Financial Officer REPORT OF ERNST & YOUNG, INDEPENDENT AUDITORS The Board of Directors and Shareholders Society Corporation We have audited the accompanying consolidated balance sheets of Society Corporation and Subsidiaries as of December 31, 1993 and 1992, and the related statements of income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Society Corporation and Subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. /s/ Ernst & Young Cleveland, Ohio January 28, 1994, except for Note 2, as to which the date is March 1, 1994 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Society Corporation is an Ohio-based financial services company primarily engaged in the business of commercial banking. It provides a wide range of banking, fiduciary and financial services to corporate, institutional and individual customers. The accounting policies of Society Corporation and its subsidiaries conform with generally accepted accounting principles and with general practices within the banking industry. The following is a summary of the Corporation's significant accounting policies. BASIS OF PRESENTATION The consolidated financial statements include the accounts of Society Corporation and its subsidiaries. All significant intercompany transactions have been eliminated. Certain amounts previously reported in the financial statements have been reclassified to conform with the current presentation. As discussed in Note 2, Mergers, Acquisitions and Divestitures, the financial statements give retroactive effect to the 1992 merger of Ameritrust Corporation with and into Society, accounted for as a pooling of interests. Accordingly, all financial data are presented as if both companies had been merged for all periods presented. BUSINESS COMBINATIONS Business combinations accounted for as purchases include the results of operations of the acquired businesses from the respective dates of acquisition. The assets and liabilities are recorded at fair value at the acquisition date and related purchase premiums and discounts are amortized over the remaining average lives of the respective assets or liabilities. Goodwill, representing the excess of the cost of acquisitions over the fair value of net assets acquired, is amortized on a straight-line basis, over the estimated period to be benefited, generally not exceeding 25 years. Other intangibles are amortized using either straight-line or accelerated methods, generally over periods ranging from 4 to 15 years. In transactions accounted for as poolings of interests, the assets and liabilities of the combined companies are carried forward at their historical amounts, the companies' results of operations are combined and the consolidated financial statements and notes thereto are restated as if the companies had been merged for all periods presented. On March 1, 1994, KeyCorp, ("old KeyCorp"), merged into and with Society Corporation ("Society"), which was the surviving corporation under the name KeyCorp. Because the merger, which was accounted for as a pooling of interests, occurred subsequent to December 31, 1993, the financial statements do not give retroactive effect to the merger. However, the supplemental financial statements included on pages 65 to 94 of this report present the combined financial condition and results of operations of Society and old KeyCorp as if the merger had been in effect for all periods presented. Further details pertaining to this merger are presented in Note 2, Mergers, Acquisitions and Divestitures. STATEMENT OF CASH FLOWS The Corporation defines cash and cash equivalents as cash on hand and noninterest-bearing amounts due from banks as reported under the consolidated balance sheet caption, "Cash and due from banks." INVESTMENT SECURITIES Securities which the Corporation has the ability and positive intent to hold to maturity are carried at cost, adjusted for amortization of premiums and accretion of discounts using the level yield method. Gains and losses on sales of investment securities are computed using the specific identification method and are included in net securities gains. SECURITIES AVAILABLE FOR SALE AND TRADING ACCOUNT ACTIVITIES Securities available for sale are carried at the lower of aggregate cost or market value. Trading account assets include foreign exchange trading positions and are carried at market value. Gains and losses on sales of securities available for sale are computed using the specific identification method and are included in net securities gains. Market value adjustments for trading account assets (included in short-term investments) and securities available for sale are included in noninterest income. MORTGAGE LOANS HELD FOR SALE Mortgage loans held for sale are carried at the lower of aggregate cost or market value. LOANS Student loans held for sale are included in total loans and are carried at the lower of aggregate cost or market value. Interest income on loans is primarily accrued based on principal amounts outstanding. Accrual of interest is discontinued, and accrued but unpaid interest on a loan is reversed and charged against current earnings, when circumstances indicate that collection is questionable. Loans are returned to accrual status when management determines that the circumstances have improved to the extent that both principal and interest are deemed collectible. ALLOWANCE FOR LOAN LOSSES The allowance for loan losses is the amount which, in the opinion of management, is necessary to absorb potential losses in the loan portfolio. Management's evaluation of the adequacy of the allowance is based on the market area served, local economic conditions, the growth and composition of the loan portfolios and their related risk characteristics, and the continual review by management of the quality of the loan portfolio. PREMISES AND EQUIPMENT Premises and equipment are stated at cost less accumulated depreciation and amortization. Provisions for the depreciation of premises and equipment are determined using the straight-line method over the estimated useful lives of the respective assets. Leasehold improvements are amortized using the straight-line method over the terms of the leases. OTHER REAL ESTATE OWNED Other real estate owned includes real estate acquired through foreclosure or a similar conveyance of title and real estate considered to be in-substance foreclosed when specific criteria are met. Other real estate owned is carried at the lower of its recorded amount or fair value, less estimated cost of disposal. Write-downs of the assets at, or prior to, the dates of acquisition are charged to the allowance for loan losses. Subsequent write-downs, income and expenses incurred in connection with holding such assets, and gains and losses resulting from the sales of such assets, are included in other noninterest expense. INCOME TAXES The Corporation files a consolidated Federal income tax return. Effective January 1, 1992, the Corporation prospectively adopted SFAS No. 109, "Accounting for Income Taxes" which supersedes SFAS No. 96. The cumulative effect of adopting SFAS No. 109 was not material. INTEREST RATE SWAPS, FINANCIAL FUTURES AND OPTIONS The Corporation uses interest rate swaps, financial futures and options to manage the interest rate exposure of certain interest-sensitive assets and liabilities as part of the Corporation's overall strategy to manage interest rate risk. The net interest received or paid on interest rate swaps is recognized over the lives of the respective contracts as an adjustment to interest income or expense. Gains and losses resulting from the termination of interest rate swaps are deferred and amortized over the remaining lives of the related financial instruments. Gains and losses on futures and option contracts are recognized when the related hedged financial instruments are sold. COMMON SHARES Net income per Common Share is computed by dividing net income, less any dividend requirement on preferred stock, by the weighted average number of Common Shares and Common Share equivalents outstanding during the year as presented below. These amounts have been adjusted to reflect a two-for-one stock split in the form of a 100% stock dividend effective as of March 22, 1993. NOTE 2. MERGERS, ACQUISITIONS AND DIVESTITURES On March 1, 1994, KeyCorp ("old KeyCorp"), a financial services holding company headquartered in Albany, New York, with approximately $33 billion in assets as of December 31, 1993, merged into and with Society, which was the surviving corporation under the name KeyCorp. Under the terms of the merger agreement, 124,351,183 KeyCorp Common Shares were exchanged for all of the outstanding shares of old KeyCorp (based on an exchange ratio of 1.205 shares for each share of old KeyCorp). The outstanding preferred stock of old KeyCorp was exchanged on a one-for-one basis for 1,280,000 shares of a comparable, new issue of 10% Cumulative Preferred Stock of KeyCorp. The merger was accounted for as a pooling of interests and, accordingly financial results for all prior periods presented will be restated to include the financial results of old KeyCorp. The supplemental financial statements presented on pages 65 through 94 of this report present the financial condition and results of operations of Society and old KeyCorp as if the merger had been in effect for all periods presented. The following table presents consolidated net interest income, net income and per Common Share reported by each of the companies and on a combined basis. On October 5, 1993, Society Asset Management, Inc., an indirect wholly-owned subsidiary of Society, completed the acquisition of Schaenen Wood & Associates, Inc. ("SWA"), a New York City-based investment management firm which manages approximately $1.3 billion in assets. The transaction was accounted for as a purchase. On September 15, 1993, Society completed the sale of Ameritrust Texas Corporation ("ATC") to Texas Commerce Bank, National Association, an affiliate of Chemical Banking Corporation. ATC was based in Dallas, Texas, and provided a range of investment management and fiduciary services to institutions, businesses and individuals through 11 offices operating in Texas. For the period through the closing date, ATC had net income of $3.2 million. The $29.4 million gain on the sale ($12.2 million after tax, $.10 per Common Share) is included in noninterest income. On January 22, 1993, Society acquired all of the outstanding shares of First Federal Savings and Loan Association of Fort Myers ("Society First Federal"), a Federal stock savings bank, for total cash consideration of $144 million. The transaction was accounted for as a purchase. Society First Federal had 24 offices in southwest and central Florida and approximately $1.1 billion in total assets at the date of acquisition. On December 4, 1992, Society and three other bank holding companies formed a joint venture in a newly-formed company, Electronic Payment Services, Inc. This company is the largest processor of automated teller machine transactions in the United States and a national leader in point-of-sale transaction processing. As part of the agreement. Society contributed its wholly-owned subsidiary Green Machine Network Corporation, and its point-of-sale business in return for an equity interest. On September 30, 1992, Society acquired all the outstanding shares of First of America Bank - Monroe ("FAB - Monroe") from First of America Bank Corporation in a cash purchase. The transaction was accounted for as a purchase. FAB - Monroe operated 10 offices in southeastern Michigan and had approximately $160 million in total assets at the date of acquisition. On March 16, 1992, Ameritrust Corporation ("Ameritrust"), a financial services holding company located in Cleveland, Ohio, with approximately $10 billion in assets as of December 31, 1991, merged with and into Society. Under the terms of the merger agreement, 49,550,862 Society Common Shares were exchanged for all of the outstanding shares of Ameritrust common stock (based on an exchange ratio of .65 shares of Society for each share of Ameritrust). The outstanding preferred stock of Ameritrust was exchanged on a one-for-one basis for 1,200,000 shares of a comparable, new issue of Fixed/Adjustable Rate Cumulative Preferred Stock of Society. The merger was accounted for as a pooling of interests and, accordingly, financial results for all prior periods presented have been restated to include the financial results of Ameritrust. In connection with the merger and as part of an agreement with the United States Department of Justice, Society sold 28 Ameritrust branches located in Cuyahoga and Lake Counties in Ohio in June 1992. Deposits of $933.3 million and loans or loan participations totaling $331.8 million were sold along with the branches at a gain of $20.1 million ($13.2 million after tax, $.11 per Common Share) included in noninterest income. In addition, in May 1992, deposits and loans totaling $98.7 million and $45.7 million, respectively, were sold along with the four branches in Ashtabula County, Ohio, in accordance with the Federal Reserve Board order that approved the merger. The remaining maturities of the Corporation's securities were as follows: Mortgage-backed securities are included in the above investment securities maturity schedule based on their expected average lives. Other securities consist primarily of those collateralized by credit card and automobile installment loan receivables, corporate floating-rate notes and venture capital investments. The proceeds from sales of securities were $724.6 million, $611.0 million and $435.8 million in 1993, 1992 and 1991, respectively. Gross gains and losses related to securities were $33.4 million and $7.3 million, respectively, in 1993, $10.7 million and $.9 million, respectively, in 1992 and $8.8 million and $1.4 million, respectively, in 1991. Corporate assets, primarily securities, with a book value of approximately $4.4 billion at December 31, 1993, were pledged to secure public and trust deposits and securities sold under agreements to repurchase, and for other purposes required or permitted by law. In May 1993, the FASB issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." SFAS No. 115 requires that equity securities having readily determinable fair values and all investments in debt securities be classified and accounted for in three categories. Debt securities that management has the positive intent and ability to hold to maturity are to be classified as "held-to-maturity securities" and reported at amortized cost. Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are to be classified as "trading securities" and reported at fair value, with unrealized gains and losses included in operating results. Debt and equity securities not classified as either held-to-maturity securities or trading securities are to be classified as "available for sale securities" and reported at fair value, with unrealized gains and losses excluded from operating results and reported as a separate component of shareholders' equity. Adoption of the standard is required for fiscal years beginning after December 15, 1993, with earlier application permitted. The Corporation will adopt the new standard in 1994. Based upon the Corporation's securities portfolio classified as available for sale as of December 31, 1993, the estimated impact of the new standard would be an increase to shareholders' equity of approximately $28 million, with no impact on the results of operations. With the adoption of SFAS No. 115 in 1994, the Corporation anticipates that securities with an aggregate book value of approximately $3.2 billion will be designated as available for sale. Based upon the market values of these securities at year end 1993, the reclassification of these securities is not expected to have a material effect on shareholders' equity. NOTE 4. LOANS In 1991, Ameritrust recorded an additional $93.9 million provision for loan losses to conform its approach to determining the level of the allowance for loan losses to that used by the Corporation. In the ordinary course of business, Society's banking subsidiaries have made loans at prevailing interest rates and terms to directors and executive officers of Society and its subsidiaries and their associates (as defined by the Securities and Exchange Commission). Such loans, in management's opinion, did not present more than the normal risk of collectibility or incorporate other unfavorable features. The aggregate amount of loans outstanding to qualifying related parties at January 1, 1993, was $135.0 million. During 1993, activity with respect to these loans included new loans, repayments and a net decrease (due to changes in the status of executive officers and directors) of $30.8 million, $76.5 million and $21.5 million, respectively, resulting in an aggregate balance of loans outstanding to related parties at December 31, 1993, of $67.8 million. NOTE 5. NONPERFORMING ASSETS At December 31, 1993, there were no significant commitments outstanding to lend additional funds to borrowers with nonaccrual or restructured loans. In May 1993, the FASB issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan." SFAS No. 114 prescribes a valuation methodology for impaired loans as defined by the standard. Generally, a loan is considered impaired if management believes that it is probable that all amounts due will not be collected according to the contractual terms as scheduled in the loan agreement. An impaired loan must be valued using the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's observable market price or the fair value of the loan's underlying collateral. The Corporation expects to adopt SFAS No. 114 prospectively starting in the first quarter of 1995. It is anticipated that adoption of the new standard will not have a material effect on the Corporation's financial condition and results of operations. Depreciation and amortization expense related to premises and equipment totaled $57.1 million, $62.3 million, and $48.4 million in 1993, 1992 and 1991, respectively. At December 31, 1993, banking subsidiaries of Society were obligated under noncancellable leases for land and buildings and for other property, consisting principally of data processing equipment. Rental expense under all operating leases aggregated $53.3 million in 1993, $56.4 million in 1992, and $49.6 million in 1991. Many of the realty lease agreements contain renewal options for varying periods. In many cases, renewal terms must be negotiated at the renewal date, including annual rentals to be paid under the renewed lease. Minimum future rental payments under noncancellable leases at December 31, 1993, were as follows: 1994 -- $37.3 million; 1995 -- $30.7 million; 1996 -- $29.0 million; 1997 -- $23.8 million; 1998 -- $21.6 million; and subsequent years -- $261.3 million. NOTE 7. SHORT-TERM BORROWINGS Short-term borrowings consist primarily of Federal funds purchased and securities sold under repurchase agreements which generally represent overnight borrowing transactions. Other short-term borrowings consist of fixed rate and variable rate Medium-Term Notes with original maturities of one year or less, Treasury, tax and loan demand notes, and other borrowings with original maturities of one year or less. On November 30, 1992, Society National Bank authorized the issuance of up to $1 billion of Medium-Term Notes to be offered on a continuous basis. During 1993, $685 million in debt securities were issued under this program. These securities have original maturities of less than one year and are included in other short-term borrowings. On June 15, 1992, Society issued $200 million of 8.125% Subordinated Notes under a shelf registration. The Notes are not redeemable prior to maturity. During 1993, Society issued $110.6 million of Medium-Term Notes with maturities exceeding one year. The Notes had a weighted average annual interest rate of 5.19% at December 31, 1993, and have varying maturities through 1996. The 8.875% Notes, issued under an earlier registration, and the 11.125% Notes are not redeemable prior to maturity. In 1989, the Ameritrust Corporation Employees' Savings and Investment Plan (the "Plan") was amended to include a leveraged employee stock ownership plan ("ESOP"). To fund the ESOP, Ameritrust borrowed $71.7 million from several institutional investors through the placement of unsecured notes totaling $22.8 million (the "8.33% Notes") and $48.9 million (the "8.48% Notes"). The interest on those notes totaled $6.0 million in each of the years 1993, 1992, and 1991. The ESOP trustee used the proceeds to purchase 5,847,102 shares of Ameritrust Common Stock. These shares, as converted in the merger with Society, are held by the ESOP trustee for matching employee contributions to the Plan. The net difference between the cost of the treasury shares sold to the ESOP trustee and their market value was recorded as a reduction to retained earnings. Except for the repayment schedule, the loans to the ESOP trustee are on substantially similar terms as the borrowings from the institutional investors and, in addition, are secured by the unallocated shares held by the ESOP trustee. The ESOP trustee will repay the loans from Society using corporate contributions made by the Plan for that purpose and dividends on the Common Shares acquired with the loans. The amount of dividends on the ESOP shares used for debt service by the ESOP trustee totaled $3.9 million in 1993, $3.1 million in 1992, and $1.8 million in 1991. As contributions and dividends are received, a portion of the shares acquired with the loans will be allocated to Plan participants. Interest income recognized on loans to the ESOP trustee is netted against the interest expense incurred on the notes payable to the institutional investors. Society's receivable from the ESOP trustee, representing deferred compensation to the Corporation's employees, has been recorded as a separate reduction of shareholders' equity. Society National Bank, Society's lead bank, issued $200 million of 7.85% Subordinated Notes on November 3, 1992, and $200 million of 6.75% Subordinated Notes on June 16, 1993. The Bank issued a 10% Note in connection with the sale of branch offices and loans resulting from the merger with Ameritrust Corporation. None of these notes may be redeemed prior to maturity. Industrial revenue bonds issued by banking subsidiaries have varying maturities extending to the year 2009 and had weighted average annual interest rates of 7.14% and 7.19%, respectively, at December 31, 1993 and 1992. Other long-term debt at December 31, 1993 and 1992, consisted of capital lease obligations and various secured and unsecured obligations of corporate subsidiaries and had weighted average annual interest rates of 13.54% and 10.14%, respectively. The 8.625% Notes were redeemed at par plus accrued interest on June 30, 1993, and the 9.56% Note was assumed by the purchaser in connection with the sale of Ameritrust Texas Corporation on September 15, 1993. At December 31, 1993, the aggregate of annual maturities for all long-term debt obligations for the years 1994 through 1998 were $.5 million, $148.5 million, $147.2 million, $7.2 million, and $ 8.3 million, respectively. Long-term debt qualifying as supplemental capital for purposes of calculating Tier II Capital under Federal Reserve Board Guidelines amounted to $636.5 million and $520.9 million at December 31, 1993, and 1992, respectively. NOTE 9. SHAREHOLDERS' EQUITY PREFERRED STOCK AND COMMON SHARES In August 1989, Society's Board of Directors adopted a Shareholder Rights Plan ("Rights") under which each shareholder received one Right for each Society Common Share. Each Right represents the right to purchase a Common Share of Society at a price of $65. The Rights become exercisable 20 days after a person or group acquires 15 percent or more of the outstanding shares or commences a tender offer that could result in such an ownership interest. Until the Rights become exercisable, they will trade with the Common Shares, and any transfer of the Common Shares will also constitute a transfer of associated Rights. When the Rights become exercisable, they will begin to trade separate and apart from the Common Shares. Twenty days after the occurrence of certain "Flip-In Events," each Right will become the right to purchase a Common Share of Society for the then par value per share (now $1 per share) and the Rights held by a 15 percent or more shareholder will become void. Society may redeem these Rights at its option at $.005 per Right subject to certain limitations. Unless redeemed earlier, the Rights expire on September 12, 1999. On October 1, 1993, Society amended the Rights so that the pending merger with old KeyCorp would not activate the provisions of the Rights. On March 1, 1993, Society redeemed the 1.2 million outstanding shares of Fixed/Adjustable Rate Cumulative Preferred Stock at 103% of its stated value ($60 million), plus accumulated but unpaid dividends. Society effected a two-for-one stock split on March 22, 1993, by means of a 100% stock dividend. All relevant Common Share amounts, per Common Share amounts and related data in this report have been adjusted to reflect this split. In connection with the merger with old KeyCorp, at a special meeting held February 16, 1994, shareholders increased the authorized number of shares of Society to 926.4 million, of which 1.4 million are shares of 10% Cumulative Preferred Stock, Class A, par value $5 per share; 25.0 million are shares of Preferred Stock, par value $1 per share; and 900.0 million are Common Shares, par value $1 per share. STOCK OPTIONS AND STOCK APPRECIATION RIGHTS Society maintains various incentive compensation plans which provide for its ability to grant stock options, stock appreciation rights, limited stock appreciation rights, restricted stock and performance shares to selected employees. Generally, the terms of these plans stipulate that the exercise price of options may not be less than the fair market value of Society's Common Shares at the date the options are granted. Options granted expire not later than ten years and one month from the date of grant. Several option plans have been acquired through mergers. These plans have expired or were terminated, but unexercised options granted under the plans remain outstanding. At December 31, 1993 and 1992, options for Common Shares available for future grant totaled 1,237,965 and 1,233,958, respectively. The terms of Society's plans stipulate that stock appreciation rights may only be granted in tandem with stock options. The appreciation rights have the same terms as do the options, except that, upon exercise, the holder may receive either cash or shares for the excess of the current market value of Society's Common Shares over the option's exercise price. Upon exercise of a stock appreciation right, the related option is surrendered. During 1993, all stock appreciation rights for which exercisability was limited to a period following a change in control of the Corporation were cancelled. The following table presents a summary of pertinent information with respect to Society's stock options and stock appreciation rights. STOCK OPTIONS NOTE 10. MERGER AND INTEGRATION CHARGES Merger and integration charges of $53.9 million ($39.6 million after tax, $.33 per Common Share), $50.0 million ($34.2 million after tax, $.29 per Common Share), and $93.8 million ($68.2 million after tax, $.59 per Common Share) were recorded in 1993, 1992, and 1991, respectively. The 1993 charges were incurred in connection with the merger with old KeyCorp, while the 1992 and 1991 amounts related to the merger with Ameritrust. The merger and integration charges directly attributable to the old KeyCorp merger included accruals for merger expenses, consisting primarily of investment banking and other professional fees directly related to the merger ($12.6 million); severance payments and other employee costs ($17.6 million); systems and facilities costs ($16.7 million); and other costs incident to the merger ($7.0 million). These charges were recorded by the parent company in the fourth quarter of 1993 at which time management determined that it was probable that a liability for such charges had been incurred and could be reasonably estimated. The merger and integration charges recorded in connection with the Ameritrust merger in 1992 and 1991 were similar in nature. Although no assurance can be given, it is also expected that, as a result of the old KeyCorp merger, cost savings will be achieved by the combined institution at an annual rate of approximately $100 million by the end of the first quarter of 1995. These cost savings are anticipated to result from the integration of operations and from efficiencies in certain combined lines of business. Management presently expects that approximately 50% of the annual cost savings will be achieved in 1994. NOTE 11. EMPLOYEE BENEFIT PLANS PENSION PLANS Society and its subsidiaries have noncontributory pension plans covering substantially all employees. Benefits paid from these plans are based on age, years of service and compensation prior to retirement or termination and are determined in accordance with defined formulas. The Corporation's policy is to fund pension expense in accordance with ERISA standards. The weighted average discount rate and rate of increase in future compensation levels used in determining the actuarial present value of projected benefit obligations were 7.50% and 4.00%, respectively, at December 31, 1993, and 8.50% and 4.50%, respectively, at December 31, 1992. The weighted average expected long-term rate of return on pension assets used in determining net pension income was 9.50% for 1993, 9.00% for 1992 and 9.16% for 1991. In 1993, the Corporation recognized curtailment and settlement gains of $2.9 million resulting from the divestiture of ATC. Such amount was included in the net gain from that divestiture. In 1992, the Corporation recognized curtailment gains of $7.2 million resulting from merger-related staff reductions. A portion of the retirement obligations associated with these reductions were settled by lump-sum cash distributions which resulted in settlement gains of $1.4 million and $3.0 million in 1993 and 1992, respectively. Both the curtailment and settlement gains related to the merger-related staff reductions are included in other noninterest income. OTHER POSTRETIREMENT BENEFIT PLANS The Corporation provides postretirement health care and life insurance benefits to employees who retire at age 55 or later and have at least 10 years of service. Additionally, such benefits are provided to participants in the Corporation's long term disability plan. The postretirement health care plan is unfunded and contributory, with retirees' contributions adjusted annually to reflect certain cost-sharing provisions and benefit limitations. The postretirement life insurance plan is noncontributory. Life insurance benefits for participants who retired before 1993 are generally provided for through outside insurance carriers. Life insurance benefits for employees retiring in 1993 or later years are to be paid from the Corporation's pension plan and are, accordingly, included in the determination of the pension benefit obligation. Effective January 1, 1993, the Corporation adopted the provisions of SFAS No. 106, "Employers Accounting for Postretirement Benefits Other Than Pensions." This statement requires that employers recognize the cost of providing postretirement benefits over the employees' active service period to the date they attain full eligibility for such benefits. Postretirement benefits costs for 1992 and 1991, which were recorded on a cash basis, have not been restated. Net postretirement benefits expense was $11.9 million in 1993, including $4.7 million due to adoption of the new standard, $5.2 million in 1992 and $4.8 million in 1991. The following table sets forth the unfunded status of the postretirement benefit plans reconciled with the amount recognized in Society's consolidated balance sheet: The assumed 1994 health care cost trend rate for Medicare-eligible retirees was 11.0%, while that for non-Medicare-eligible retirees was 13.0%. Both rates are assumed to gradually decrease to 5.5% by the year 2009 and remain constant thereafter. Increasing the assumed health care cost trend rates by one percentage point in each future year would have an immaterial impact on postretirement benefits cost due to cost-sharing provisions and benefit limitations. The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 7.5% at December 31, 1993. EMPLOYEE STOCK PURCHASE AND SAVINGS PLAN Substantially all of the Corporation's employees are covered under a stock purchase and savings plan that is qualified under Section 401(k) of the Internal Revenue Code. Under provisions of this plan, the Corporation matches 100% of the employee's pre-tax contribution, up to a maximum of 6% of eligible compensation, with an equivalent amount of Society's Common Shares. Under an annual discretionary profit sharing component, employees can receive additional matching employer contributions from the Corporation based on a formula established each year by Society's Board of Directors. Total expense associated with this plan was $24.0 million, $18.1 million and $19.7 million in 1993, 1992, and 1991, respectively. POSTEMPLOYMENT BENEFITS The Corporation adopted the provisions of SFAS No. 112, "Employers' Accounting for Postemployment Benefits," during 1993. This standard requires that employers who provide benefits to former or inactive employees after employment but before retirement recognize a liability for such benefits if specified conditions are met. Adoption of this standard increased noninterest expense by $4.0 million. Postemployment benefits for 1992 and 1991, which were recorded on a cash basis, were not restated. NOTE 12. INCOME TAXES During the first quarter of 1992, the Corporation adopted the provisions of SFAS No. 109, "Accounting for Income Taxes." The adoption of this new standard did not have a material impact on Society's consolidated financial condition or results of operations. At December 31, 1993, the net deferred tax liability totaled $146.0 million compared to $80.2 million at December 31, 1992. The gross deferred tax liability was $386.0 million at December 31, 1993, and $321.8 million at the prior year-end. In both periods, deferred taxes relating to lease financing activities comprised approximately 75% of the balance. Gross deferred tax assets were $240.0 million and $241.6 million at December 31, 1993 and 1992, respectively, and amounts related to loan loss provisions comprised approximately 70% of the balance in both periods. The current and deferred components of the provision for income taxes were as follows: Income taxes on securities transactions are provided for at the statutory income tax rate and included in the current portion of the provision. The following is a reconciliation of the provision for income taxes to the amount computed by applying the Federal statutory tax rate of 35% in 1993, and 34% in 1992 and 1991 to income before income taxes. At December 31, 1993, approximately $15.4 million of alternative minimum tax credit carryovers existed for Federal income tax purposes only. These carryovers have no fixed expiration date. NOTE 13. COMMITMENTS, CONTINGENT LIABILITIES, AND OTHER DISCLOSURES LEGAL PROCEEDINGS In the ordinary course of business, Society and its subsidiaries are subject to legal actions which involve claims for substantial monetary relief. Based on information presently available to management and the Corporation's counsel, management does not believe that any legal actions, individually or in the aggregate, will have a material adverse effect on Society's consolidated financial condition. RESTRICTIONS ON CASH, DUE FROM BANKS, SUBSIDIARY DIVIDENDS AND LENDING ACTIVITIES Under the provisions of the Federal Reserve Act, depository institutions are required to maintain certain average balances in the form of cash or noninterest-bearing balances with the Federal Reserve Bank. Average reserve balances aggregating $479.5 million in 1993 were maintained in fulfillment of these requirements. The principal source of income for the parent company is dividends from its subsidiary banks. Such dividends are subject to certain restrictions as set forth in the national and state banking laws and regulations. At December 31, 1993, undistributed earnings of $76.0 million were free of such restrictions and available for the payment of dividends to the parent company. Loans and advances from banking subsidiaries to the parent company are also limited by law and are required to be collateralized. NOTE 14. FINANCIAL INSTRUMENTS FAIR VALUE DISCLOSURES The following disclosures are made in accordance with the provisions of SFAS No. 107, "Disclosures About Fair Value of Financial Instruments," which requires the disclosure of fair value information about both on-and off-balance sheet financial instruments where it is practicable to estimate that value. Fair value is defined in SFAS No. 107 as the amount at which an instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. It is not the Corporation's intent to enter into such exchanges. Financial instruments, as defined in SFAS No. 107, include the categories presented on page 58 and exclude related intangible assets such as customer relationships, mortgage servicing rights and core deposit intangibles. These intangible assets, if considered an integral part of the related financial instruments, would increase their fair values. In cases where quoted market prices were not available, fair values were based on estimates using present value or other valuation methods, as described below. The use of different assumptions (e.g., discount rates and cash flow estimates) and estimation methods could have a significant effect on fair value amounts. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Corporation could realize in a current market exchange. Because SFAS No. 107 excludes certain financial instruments and all nonfinancial instruments from its disclosure requirements, any aggregation of the fair value amounts presented would not represent the underlying value of the Corporation. The following methods and assumptions were used in estimating the fair values of financial instruments presented in the preceding table and in the following paragraphs. For financial instruments with a remaining average life to maturity of less than six months, carrying amounts were used as an approximation of fair value. The carrying amounts reported for cash and due from banks, and short-term investments are their fair values. The carrying value of mortgage loans held for sale approximates fair value. Securities available for sale and investment securities were valued based on quoted market prices. Where quoted market prices were unavailable, fair values were based on quoted market prices of similar instruments. A discounted cash flow model was used to estimate the fair values for fixed-rate commercial, installment, construction and commercial real estate loans. Carrying amounts for variable rate loans, including loans with no stated maturity (e.g., credit card loans and home equity lines of credit), were used as a reasonable approximation of their fair values. Residential real estate loans and student loans held for sale were valued based on quoted market prices of similar loans offered or sold in recent sale or securitization transactions. Lease financing receivables, although excluded from the scope of SFAS No. 107, were included in the estimated fair value for loans at their carrying amount. The fair values of certificates of deposit and of long-term debt were estimated based on discounted cash flows. Carrying amounts reported for other deposits and short-term borrowings were used as a reasonable approximation of their fair values. Interest rate swaps were valued based on discounted cash flow models and had a fair value of $67.8 million and $78.6 million at December 31, 1993 and 1992, respectively. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK The Corporation, mainly through its affiliate banks, is party to various financial instruments with off-balance sheet risk. The banks use these financial instruments in the normal course of business to meet financing needs of their customers and to effectively manage their exposure to interest rate risk. The financial instruments used include commitments to extend credit, standby letters of credit, interest rate swap agreements, forward contracts, futures and options on financial futures, and interest rate cap and floor agreements. These instruments involve, to varying degrees, credit and interest rate risks in excess of amounts recognized in Society's consolidated balance sheet. Credit risk is the possibility that a counterparty to a financial instrument will be unable to perform its contractual obligations. Interest rate risk is the possibility that, due to changes in economic conditions, the Corporation's net interest income will be adversely affected. The Corporation mitigates its exposure to credit risk through internal controls over the extension of credit. These controls include the process of credit approval and review, the establishment of credit limits, and, when deemed necessary, securing collateral. The Corporation manages its exposure to interest rate risk, in part, by using off-balance sheet instruments to offset existing interest rate risk of its assets and liabilities, and by setting variable rates of interest on contingent extensions of credit. The following is a summary of the contractual or notional amount of each significant class of off-balance sheet financial instruments outstanding. The Corporation's maximum possible accounting loss from commitments to extend credit and from standby letters of credit equals the contractual amount of these instruments. The notional amount represents the total dollar volume of transactions and is significantly greater than the amount at risk. The banks' commitments to extend credit are agreements with customers to provide financing at predetermined terms as long as the customer continues to meet specified criteria. Loan commitments serve to meet the financing needs of the banks' customers and generally carry variable rates of interest, have fixed expiration dates or other termination clauses, and may require the payment of fees. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements of the Corporation. Society evaluates each customer's creditworthiness on a case-by-case basis. Standby letters of credit are conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Society's mortgage banking subsidiary enters into forward sale agreements and option contracts to hedge against adverse movements in interest rates on mortgage loans held for sale. Forward sale agreements commit the subsidiary to deliver mortgage loans in future periods; option contracts allow the subsidiary to purchase mortgage loans at a specified price, in future periods. The banks enter into interest rate swap agreements primarily to manage interest rate risk and to accommodate the business needs of customers. Under a typical swap agreement, one party pays a fixed rate of interest based on a notional amount to a second party, which pays to the first party a variable rate of interest based on the same notional amount. The swaps have an average maturity of 2.4 years, with selected swaps having fixed maturity dates through 2003. The following is a summary of the notional amounts of outstanding interest rate swap agreements: The banks enter into interest rate cap and floor agreements in the management of their interest rate risk and to accommodate the business needs of customers. These financial instruments transfer interest rate risk at predetermined levels. The banks receive a fee as compensation for writing interest rate caps and floors. The risk from writing interest rate caps and floors is minimized by the banks through offsetting transactions. Financial futures contracts and options on financial futures provide for the delayed delivery or purchase of securities, interest rate instruments or foreign currency. The banks enter into forward contracts to manage their interest rate risk and in connection with customer transactions, as well as to minimize the interest rate risk exposure of mortgage banking activities. NOTE 15. CONDENSED FINANCIAL INFORMATION OF PARENT COMPANY Condensed financial information for Society Corporation (Parent Company only) is as follows: ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by this item is set forth in the sections captioned "ELECTION OF DIRECTORS" and "EXECUTIVE OFFICERS" contained in KeyCorp's definitive Proxy Statement for the 1994 Annual Meeting of Shareholders to be held May 19, 1994, and is incorporated herein by reference. KeyCorp expects to file its proxy statement on or about April 20, 1994. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information required by this item is set forth in the section captioned "THE BOARD OF DIRECTORS AND ITS COMMITTEES" and "COMPENSATION OF EXECUTIVE OFFICERS" contained in KeyCorp's definitive Proxy Statement for the 1994 Annual Meeting of Shareholders to be held on May 19, 1994, and is incorporated herein by reference. The information set forth in the sections captioned "COMPENSATION AND ORGANIZATION AND EXECUTIVE EQUITY COMPENSATION COMMITTEE JOINT REPORT ON EXECUTIVE COMPENSATION" and "KEYCORP STOCK PRICE PERFORMANCE" contained in KeyCorp's definitive Proxy Statement for the 1994 Annual Meeting of Shareholders to be held May 19, 1994, is not incorporated by reference in this report on Form 10-K. KeyCorp expects to file its proxy statement on or about April 20, 1994. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item is set forth in the section captioned "SHARE OWNERSHIP" contained in KeyCorp's definitive Proxy Statement for the 1994 Annual Meeting of Shareholders to be held May 19, 1994, and is incorporated herein by reference. KeyCorp expects to file its proxy statement on or about April 20, 1994. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item is set forth in the section captioned "ELECTION OF DIRECTORS" contained in KeyCorp's definitive Proxy Statement for the 1994 Annual Meeting of Shareholders to be held May 19, 1994, and is incorporated herein by reference. KeyCorp expects to file its proxy statement on or about April 20, 1994. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (A)(1) FINANCIAL STATEMENTS The following consolidated financial statements of Society Corporation and Subsidiaries, and the auditor's report thereon are included in Part II of this report:, (A)(1)(A) SUPPLEMENTAL FINANCIAL STATEMENTS On March 1, 1994, KeyCorp ("old KeyCorp") merged into and with Society Corporation, which was the surviving corporation of the merger under the name KeyCorp. Because the merger occurred subsequent to December 31, 1993, the financial statements and Management's Discussion and Analysis of Financial Condition and Results of Operations included in this Form 10-K do not give effect to the restatement to include old KeyCorp's financial results. The following Supplemental Financial Statements restate the Corporation's 1993 and prior years' financial statements, giving effect to the merger with old KeyCorp. REPORT OF ERNST & YOUNG, INDEPENDENT AUDITORS The Board of Directors and Shareholders KeyCorp We have audited the accompanying supplemental consolidated balance sheets of KeyCorp and subsidiaries as of December 31, 1993 and 1992, and the related supplemental consolidated statements of income, changes in shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. The supplemental financial statements give retroactive effect to the merger of KeyCorp and Society Corporation on March 1, 1994, which has been accounted for as a pooling of interests as described in the notes to the supplemental financial statements. These financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the supplemental financial statements referred to above present fairly, in all material respects, the consolidated financial position of KeyCorp and subsidiaries at December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, after giving retroactive effect to the merger of KeyCorp and Society Corporation as described in the notes to the supplemental financial statements in conformity with generally accepted accounting principles. /s/ ERNST & YOUNG Cleveland, Ohio March 1, 1994 NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES KeyCorp is a financial services holding company headquartered in Cleveland, Ohio, and is engaged primarily in the business of commercial and retail banking. It provides a wide range of banking, fiduciary, mortgage banking, insurance and other financial services to corporate, institutional and individual customers. The accounting policies of KeyCorp and its subsidiaries (the "Corporation") conform with generally accepted accounting principles and prevailing practices within the financial services industry. The following is a summary of significant accounting and reporting policies. KEYCORP-SOCIETY MERGER On March 1, 1994, KeyCorp ("old KeyCorp") merged into and with Society Corporation ("Society"), which was the surviving corporation under the name KeyCorp. The merger was accounted for by the pooling of interests method. These supplemental financial statements and notes have been restated to present the combined financial condition and results of operations of both companies as if the merger had been in effect for all periods presented. Further details pertaining to the merger are presented in Note 2, Mergers, Acquisitions and Divestitures, on page 71 of this report. PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of KeyCorp and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. Certain reclassifications, including adjustments to conform accounting practices, have been made to prior year amounts to agree to the current year presentation. BUSINESS COMBINATIONS In business combinations accounted for as poolings of interests, the assets, liabilities and shareholders' equity of the respective companies are carried forward at their historical amounts, the companies' results of operations are combined and the prior periods' financial statements are restated to give effect to the merger. In business combinations accounted for as purchases, the results of operations of the acquired businesses are included from the respective dates of acquisition. Net assets of the companies acquired are recorded at their cost to the Corporation at the date of acquisition and related purchase premiums and discounts are amortized over the remaining average lives of the respective assets or liabilities. STATEMENT OF CASH FLOWS Cash and due from banks are considered as cash and cash equivalents. INVESTMENT SECURITIES Securities which the Corporation has the ability and positive intent to hold to maturity are carried at cost, adjusted for amortization of premiums and accretion of discounts using the level yield method. Gains or losses from the sales of investment securities are computed using the specific identification method and included in net securities gains. SECURITIES AVAILABLE FOR SALE AND TRADING ACCOUNT ASSETS Securities available for sale are carried at the lower of aggregate cost or market value. Gains or losses from the sale of securities available for sale are computed using the specific identification method and are included in net securities gains. Market value adjustments for trading account assets (included in short-term investments) and changes in net unrealized losses on securities available for sale are included in noninterest income. MORTGAGE LOANS HELD FOR SALE Mortgage loans held for sale are carried at the lower of aggregate cost, market value, or contracted sales value when fixed price commitments to sell exist. NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED LOANS Loans are carried at the principal amount outstanding, net of unearned income, including deferred loan fees. Certain nonrefundable loan origination and commitment fees and the direct costs associated with originating or acquiring the loans are deferred. The net deferred amount is amortized as an adjustment to the related loan yield over the contractual lives of the related loans. Student loans held for sale are carried at the lower of aggregate cost or market value. Interest income on loans is primarily accrued based on principal amounts outstanding. The accrual of interest is discontinued when circumstances indicate that collection is questionable, or generally when payment is over 90 days past due. In such cases, interest accrued but not collected is charged against the allowance for loan losses. There after, payments received are first applied to the principal. Depending on management's assessment of the ultimate collectibility of the loan, interest income may be recognized on a cash basis. Loans are returned to accrual status when management determines that the circumstances have improved to the extent that both principal and interest are deemed collectible and there has been a sustained period of repayment performance. ALLOWANCE FOR LOAN LOSSES The allowance for loan losses is the amount which, in the opinion of management, is necessary to absorb potential losses in the loan portfolio. Management's evaluation of the adequacy of the allowance is based on the market area served, local economic conditions, the growth and composition of the loan portfolios and their related risk characteristics, and the continual review by management of the quality of the loan portfolio. INTEREST RATE SWAPS, FINANCIAL FUTURES AND OPTIONS The Corporation uses interest rate swaps, financial futures and options to manage the interest rate exposure of certain interest-sensitive assets and liabilities as part of the Corporation's overall strategy to manage interest rate risk. The net interest received or paid on interest rate swaps is recognized over the lives of the respective contracts as an adjustment to interest income or expense. Gains and losses resulting from the termination of interest rate swaps are deferred and amortized over the remaining lives of the related financial instruments. Gains and losses on futures and option contracts are recognized when the related hedged financial instruments are sold. PREMISES AND EQUIPMENT Premises and equipment, including leasehold improvements, are stated at cost less accumulated depreciation and amortization. Depreciation of premises and equipment is determined using the straight-line method over the estimated useful lives of the respective assets. Leasehold improvements are amortized using the straight-line method over the terms of the leases. OTHER REAL ESTATE OWNED Other real estate owned includes real estate acquired through foreclosure or a similar conveyance of title and real estate considered to be in-substance foreclosed when specific criteria are met. Other real estate owned is carried at the lower of its recorded amount or fair value less estimated cost of disposal. Writedowns of the assets at, or prior to, the dates of acquisition are charged to the allowance for loan losses. Subsequent writedowns, income and expenses incurred in connection with holding such assets, and gains and losses resulting from the sales of such assets, are included in other noninterest expense. INTANGIBLE ASSETS Goodwill, representing the excess of the cost of acquisitions over the fair value of net assets acquired, is amortized using the straight-line method over the estimated period to be benefited, generally not exceeding 25 years. Core deposit intangibles represent the net present value of the future economic benefits related to the use of deposits purchased. They are being amortized using an accelerated method over periods ranging from 7 to 15 years. Other intangibles are generally being amortized using the straight-line method over periods ranging from 4 to 15 years. NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED PURCHASED MORTGAGE SERVICING RIGHTS Purchased mortgage servicing rights represent the cost of the right to receive future servicing income. Purchased mortgage servicing rights are amortized, as a reduction to service fee income, over the estimated life of the related loans in proportion to the recognition of estimated net servicing income. An evaluation of the carrying amount of the purchased mortgage servicing rights is performed on a disaggregated basis by discounting the expected future cash flows, taking into consideration the estimated level of prepayments based upon current industry expectations. INCOME TAXES Old KeyCorp and Society each filed consolidated Federal income tax returns for the periods presented. Effective January 1, 1992, the Corporation prospectively adopted Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes," which supersedes SFAS No. 96. The cumulative effect of adopting SFAS No. 109 was not material. EARNINGS PER SHARE Earnings per Common Share is computed by dividing net income, less preferred stock dividends, by the weighted average number of Common Shares outstanding. These amounts have been adjusted to reflect stock splits. NOTE 2. MERGERS, ACQUISITIONS AND DIVESTITURES KEYCORP-SOCIETY MERGER On March 1, 1994, KeyCorp ("old KeyCorp"), a financial services holding company headquartered in Albany, New York, with approximately $33 billion in assets as of December 31, 1993, merged into and with Society Corporation ("Society"), a financial services holding company headquartered in Cleveland, Ohio, with approximately $27 billion in assets at year-end 1993, which was the surviving corporation and assumed the name KeyCorp. Under the terms of the merger agreement, 124,351,183 KeyCorp Common Shares were exchanged for all of the outstanding shares of old KeyCorp common stock (based on an exchange ratio of 1.205 shares for each share of old KeyCorp). The outstanding preferred stock of old KeyCorp was exchanged for 1,280,000 shares of a comparable, new issue of 10% Cumulative Preferred Stock of KeyCorp. The merger was accounted for as a pooling of interests and, accordingly, financial results for prior periods presented have been restated to include the combined financial results of both companies. The following table presents net interest income, net income and net income per Common Share reported by each of the companies and on a combined basis. NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED JACKSON COUNTY FEDERAL BANK On December 31, 1993, Jackson County Federal Bank of Medford, Oregon ("JCF") merged into Key Bank of Oregon, an indirect wholly-owned subsidiary of KeyCorp. A total of 1,430,813 KeyCorp Common Shares were issued to the holders of JCF common and preferred stock. The transaction qualified for accounting as a pooling of interests; however, financial statements for periods prior to the merger have not been restated to include the accounts and results of operations of JCF because the transaction was not material to KeyCorp. JCF had total assets of approximately $338 million at the date of merger. SCHAENEN WOOD & ASSOCIATES, INC. On October 5, 1993, Society Asset Management Inc., an indirect wholly-owned subsidiary of KeyCorp, completed the acquisition of Schaenen Wood & Associates, Inc. ("SWA"), a New York City-based investment management firm which manages approximately $1.3 billion in assets. The transaction was accounted for as a purchase. AMERITRUST TEXAS CORPORATION On September 15, 1993, KeyCorp completed the sale of Ameritrust Texas Corporation ("ATC"), a wholly-owned subsidiary of KeyCorp, to Texas Commerce Bank, National Association, an affiliate of Chemical Banking Corporation. ATC was based in Dallas, Texas, and provided a range of investment management and fiduciary services to institutions, businesses and individuals through 11 offices operating in Texas. For the year-to-date period through the closing date, ATC had net income of $3.2 million. A $29.4 million gain was realized on the sale ($12.2 million after tax, $.10 per Common Share) and included in noninterest income. NORTHWESTERN NATIONAL BANK On July 22, 1993, Northwestern National Bank of Port Angeles, Washington ("NNB") merged into Key Bank of Washington, an indirect wholly-owned subsidiary of KeyCorp. A total of 361,607 KeyCorp Common Shares were issued to the holders of NNB common stock. The transaction was accounted for as a purchase. NNB had total assets of approximately $49 million at the date of acquisition. EMERALD CITY BANK On July 2, 1993, Key Bank of Washington, an indirect wholly-owned subsidiary of KeyCorp, assumed $7 million of deposits of the failed Emerald City Bank of Seattle, Washington in an FDIC-assisted transaction. HOME FEDERAL SAVINGS BANK On June 30, 1993, Home Federal Savings Bank of Fort Collins, Colorado ("Home Federal") merged into Key Bank of Colorado, a wholly-owned subsidiary of KeyCorp formed for the purposes of consummating the merger. A total of 590,485 KeyCorp Common Shares were issued to the holders of Home Federal common stock. The transaction qualified for accounting as a pooling of interests; however, financial statements for periods prior to the merger have not been restated to include the accounts and results of operations of Home Federal because the transaction was not material to KeyCorp. Home Federal had total assets of approximately $230 million at the date of merger. FIRST AMERICAN BANK OF NEW YORK On March 25, 1993, Key Bank of New York, an indirect wholly-owned subsidiary of KeyCorp, acquired all of the deposits and the majority of the assets of First American Bank of New York ("First American"). Key Bank of New York acquired 40 branches and other business operations with approximately $1.0 billion in deposits and approximately $600 million in loans, in addition to branch real estate and other physical assets. The transaction was accounted for as a purchase. Key Bank of New York paid a premium of $41 million on the acquired deposits. In connection with the transaction, Key Bank of New York recorded a core deposit intangible of $33 million and goodwill of $8 million. NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED NATIONAL SAVINGS BANK OF ALBANY On February 26, 1993, National Savings Bank of Albany, New York ("National") merged into Key Bank of New York, an indirect wholly-owned subsidiary of KeyCorp. A total of 2,111,638 KeyCorp Common Shares were issued to the holders of National common stock. The transaction qualified for accounting as a pooling of interests; however, financial statements for periods prior to the merger have not been restated to include the accounts and results of operations of National because the transaction was not material to KeyCorp. National had total assets of approximately $671 million at the date of merger. FIRST FEDERAL SAVINGS AND LOAN ASSOCIATION On January 22, 1993, KeyCorp acquired all of the outstanding shares of First Federal Savings and Loan Association of Fort Myers ("Society First Federal"), a Federal stock savings bank, for total cash consideration of $144 million. The transaction was accounted for as a purchase. Society First Federal had 24 offices in southwest and central Florida and approximately $1.1 billion in total assets at the date of acquisition. PUGET SOUND BANCORP On January 15, 1993, Puget Sound Bancorp ("PSB"), a bank holding company headquartered in Tacoma, Washington, with approximately $4.7 billion in assets as of December 31, 1992, merged into Key Bancshares of Washington, Inc., a wholly-owned subsidiary of KeyCorp. A total of 31,391,544 KeyCorp Common Shares were exchanged for all of the outstanding shares of PSB common stock (based on an exchange ratio of 1.32 shares for each share of PSB). The merger was accounted for as a pooling of interests and, accordingly, financial results for prior periods presented have been restated to include the combined financial results of both companies. ELECTRONIC PAYMENT SERVICES, INC. On December 4, 1992, KeyCorp and three other bank holding companies formed a joint venture in a newly-formed company, Electronic Payment Services, Inc. This company is the largest processor of automated teller machine transactions in the United States and a national leader in point-of-sale transaction processing. As part of the agreement, the Corporation contributed its wholly-owned subsidiary, Green Machine Network Corporation, and its point-of-sale business in return for an equity interest. FIRST OF AMERICA BANK-MONROE On September 30, 1992, KeyCorp acquired all of the outstanding shares of First of America Bank-Monroe ("FAB-Monroe") from First of America Bank Corporation in a cash purchase. The transaction was accounted for as a purchase. FAB Monroe operated 10 offices in southeastern Michigan and had approximately $160 million in total assets at the date of acquisition. SECURITY PACIFIC BANK BRANCHES On September 3, 1992, Key Bank of Washington ("Key Bank"), an indirect wholly-owned subsidiary of KeyCorp, acquired 48 branches and other business and private banking operations with approximately $1.3 billion in deposits and $709 million in loans in addition to branch real estate and other physical assets in the state of Washington from BankAmerica Corporation. The transaction was accounted for as a purchase. Key Bank paid a premium of $53.6 million on the acquired deposits. OLYMPIC SAVINGS BANK On July 31, 1992, Key Savings Bank ("Key Savings"), an indirect wholly-owned subsidiary of KeyCorp, acquired Olympic Savings Bank of Washington ("Olympic"). The transaction was accounted for as a purchase. Olympic had approximately $81 million in assets at the date of acquisition. VALLEY BANCORPORATION On June 4, 1992, Valley Bancorporation ("Valley") of Idaho Falls, Idaho was merged with Key Bancshares of Idaho, a wholly-owned subsidiary of KeyCorp. A total of 838,308 KeyCorp Common Shares were issued for all of the outstanding shares of Valley common stock. The transaction qualified for accounting as a pooling of NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED interests; however, financial statements for periods prior to the merger have not been restated to include the accounts and results of operations of Valley because the transaction was not material to KeyCorp. Valley had assets of approximately $221 million at the date of merger. AMERITRUST CORPORATION On March 16, 1992, Ameritrust Corporation ("Ameritrust"), a financial services holding company located in Cleveland, Ohio, with approximately $10 billion in assets as of December 31, 1991, merged with and into the Corporation. Under the terms of the merger agreement, 49,550,862 KeyCorp Common Shares were exchanged for all of the outstanding shares of Ameritrust common stock (based on an exchange ratio of .65 shares of KeyCorp for each share of Ameritrust). The outstanding preferred stock of Ameritrust was exchanged on a one for-one basis for 1,200,000 shares of a comparable, new issue of Fixed/Adjustable Rate Cumulative Preferred Stock of KeyCorp. The merger was accounted for as a pooling of interests and, accordingly, financial results for prior periods presented have been restated to include the financial results of Ameritrust. In connection with the merger and as part of an agreement with the United States Department of Justice, the Corporation sold 28 Ameritrust branches located in Cuyahoga and Lake Counties in Ohio in June 1992. Deposits of $933.3 million and loans or loan participations totaling $331.8 million were sold along with the branches at a gain of $20.1 million ($13.2 million after tax, $.11 per Common Share) which is included in noninterest income. In addition, in May 1992, deposits and loans totaling $98.7 million and $45.7 million, respectively, were sold along with four branches in Ashtabula County, Ohio, in accordance with the Federal Reserve Board order that approved the merger. PENDING ACQUISITIONS COMMERCIAL BANCORPORATION OF COLORADO On March 24, 1994, Commercial Bancorporation of Colorado ("CBC"), a bank holding company with subsidiary banks operating in the Denver, Colorado Springs, Sterling and Fort Collins areas of Colorado, merged with Key Bank of Colorado, a wholly-owned subsidiary of KeyCorp. Holders of CBC common stock received .899 KeyCorp Common Shares for each outstanding share of CBC common stock. CBC had total assets of $390 million at December 31, 1993. The transaction qualified for accounting as a pooling of interests; however, financial statements will not be restated to include the accounts and results of operations of CBC because the transaction was not material to KeyCorp. THE BANK OF GREELEY On October 5, 1993, KeyCorp agreed to acquire the Bank of Greeley, a single branch bank headquartered in Greeley, Colorado ("Greeley Bank"). Under terms of the agreement, all shares of Greeley Bank will be exchanged for approximately 240,000 KeyCorp Common Shares. Greeley Bank had total assets of approximately $61 million at December 31, 1993. 3. SECURITIES AVAILABLE FOR SALE The book values, unrealized gains and losses and approximate market values of securities available for sale were as follows: NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED The proceeds from sales of securities available for sale during 1993 and 1992 were $630.8 million and $661.9 million, respectively. Gross gains of $35.3 million and $9.6 million were realized on those sales in 1993 and 1992, respectively, and gross losses of $24 thousand and $7.1 million were realized on those sales in 1993 and 1992, respectively. Securities available for sale by remaining maturity were as follows: Mortgage-backed securities are included in the above maturity schedule based on their expected average lives. In May 1993, the Financial Accounting Standards Board ("FASB") issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." SFAS No. 115 requires that equity securities having readily determinable fair values and all investments in debt securities be classified and accounted for in three categories. SFAS No. 115 is more fully described in Note 4, Investment Securities. 4. INVESTMENT SECURITIES The book values, unrealized gains and losses and approximate market values of investment securities were as follows: NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED Investment securities by remaining maturity were as follows: Mortgage-backed securities are included in the above maturity schedule based on their expected average lives. Other securities consist primarily of those collateralized by credit card and automobile installment loan receivables, corporate floating-rate notes and venture capital investments. The proceeds from sales of investment securities were $142.1 million, $662.2 million and $1.1 billion during 1993, 1992 and 1991, respectively. Gross gains and losses related to securities were $.8 million and $7.8 million, respectively, in 1993, $13.0 million and $.9 million, respectively, in 1992, and $26.2 million and $7.3 million, respectively, in 1991. At December 31, 1993, investment and available for sale securities with a book value of approximately $9.6 billion were pledged to secure public and trust deposits and securities sold under agreements to repurchase, and for certain other purposes required or permitted by law. In May 1993, the FASB issued SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." SFAS No. 115 requires that equity securities having readily determinable fair values and all investments in debt securities be classified and accounted for in three categories. Debt securities that management has the positive intent and ability to hold to maturity are to be classified as "held-to-maturity securities" and reported at amortized cost. Debt and equity securities that are bought and principally held for the purpose of selling them in the near term are to be classified as "trading securities" and reported at fair value, with unrealized gains and losses included in operating results. Debt and equity securities not classified as either held-to-maturity securities or trading securities are to be classified as "available for sale securities" and reported at fair value, with the unrealized gains and losses excluded from operating results and reported as a separate component of shareholders' equity. Adoption of SFAS No. 115 is required for fiscal years beginning after December 15, 1993, with earlier application permitted. The Corporation will adopt SFAS No. 115 in 1994. Based upon the Corporation's securities portfolio classified as available for sale as of December 31, 1993, the estimated impact of the new standard would be an increase to shareholders' equity of approximately $44 million, with no effect on the results of operations. With the adoption of SFAS No. 115 in 1994, the Corporation anticipates that securities with an aggregate book value ranging from $4.5 billion to $5.0 billion will be designated as available for sale. Based upon the market values of these securities at year-end 1993, the reclassification of these securities is not expected to have a material effect on shareholders' equity. NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED 5. LOANS Loans are summarized as follows: Changes in the allowance for loan losses are summarized as follows: In 1991, Ameritrust recorded an additional $93.9 million provision for loan losses to conform its approach to determining the level of the allowance to that used by the Corporation. In the ordinary course of business, KeyCorp's banking affiliates have made loans at prevailing interest rates and terms to directors and executive officers of KeyCorp and its subsidiaries and their associates (as defined by the Securities and Exchange Commission). Such loans, in management's opinion, did not present more than the normal risk of collectibility or incorporate other unfavorable features. The aggregate amount of loans outstanding to qualifying related parties at January 1, 1993, was $241.3 million. During 1993, activity with respect to these loans included new loans, repayments and a net decrease (due to changes in the status of executive officers and directors) of $149.3 million, $153.9 million and $40.3 million, respectively, resulting in an aggregate balance of loans outstanding to related parties at December 31, 1993, of $196.4 million. NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED 6. NONPERFORMING ASSETS Nonperforming assets were as follows: The effect on interest income of loans classified as nonperforming, at December 31, was as follows: At December 31, 1993, there were no significant commitments to lend additional funds to borrowers with nonaccrual or restructured loans. Changes in the allowance for OREO losses are summarized as follows: In May 1993, the FASB issued SFAS No. 114, "Accounting by Creditors for Impairment of a Loan," which takes effect for fiscal years beginning after December 15, 1994. SFAS No. 114 prescribes a valuation methodology for impaired loans as defined by the standard. Generally, a loan is considered impaired if management believes that it is probable that all amounts due will not be collected according to the contractual terms, as scheduled in the loan agreement. An impaired loan must be valued using the present value of expected future cash flows discounted at the loan's effective interest rate, the loan's observable market price or the fair value of the loan's underlying collateral. The Corporation expects to adopt SFAS No. 114 prospectively in the first quarter of 1995. It is anticipated that the adoption of SFAS No. 114 will not have a material effect on the Corporation's financial condition or results of operations. NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED 7. PREMISES AND EQUIPMENT Premises and equipment were as follows: Depreciation and amortization expense related to premises and equipment totaled $110.9 million, $104.3 million, and $84.4 million in 1993, 1992, and 1991, respectively. At December 31, 1993, KeyCorp's affiliate banks were obligated under noncancelable leases for land and buildings and for other property, consisting principally of data processing equipment. Rental expense under all operating leases totaled $123.7 million in 1993, $116.5 million in 1992 and $103.4 million in 1991. Minimum future rental payments under noncancelable leases at December 31, 1993, were as follows: 1994 -- $98.9 million; 1995 -- $89.0 million; 1996 -- $82.1 million; 1997 -- $74.2 million; 1998 -- $59.2 million; and subsequent years -- $547.5 million. 8. INTANGIBLE ASSETS AND PURCHASED MORTGAGE SERVICING RIGHTS Intangible assets, net of accumulated amortization, were as follows: The amortization expense for intangible assets was as follows: The amortization expense for purchased mortgage servicing rights totaled $56.6 million, $29.6 million and $20.4 million in 1993, 1992 and 1991, respectively. The amount of purchased mortgage servicing rights capitalized during 1993 was $77.3 million. NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED 9. SHORT-TERM BORROWINGS Short-term borrowings consist primarily of Federal funds purchased and securities sold under repurchase agreements, which generally represent overnight borrowing transactions. Other short-term borrowings consist primarily of Medium-Term Notes with original maturities of one year or less, Treasury, tax and loan demand notes and commercial paper which is issued principally in amounts of $100,000 or more with maturities of 270 days or less. On November 30, 1992, Society National Bank ("SNB"), KeyCorp's Ohio banking affiliate, authorized the issuance of up to $1 billion of Medium-Term Notes to be offered on a continuous basis. During 1993, $685 million in debt securities were issued under this program. These securities have original maturities of less than one year and are included in other short-term borrowings. The details of short-term borrowings were as follows: At December 31, 1993, the Corporation had available lines of credit for general corporate purposes aggregating $200 million, all of which were unused at December 31, 1993. Standard fees were paid for these facilities, which were cancelled subsequent to the end of the year. 10. LONG-TERM DEBT The components of long-term debt, presented net of unamortized discount where appropriate, were as follows: NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED Scheduled payments on long-term debt are as follows: During 1993 and 1992, KeyCorp issued $305.1 million and $77.0 million, respectively, of Medium-Term Notes with original maturities exceeding one year. In addition to general corporate purposes, the proceeds from the issuance of these notes were used to redeem and pay principal on notes and debentures; to fund the purchase of OREO from affiliate banks by NCB Properties, Inc., an OREO workout subsidiary; and to provide subordinated capital to affiliate banks. At December 31, 1993, KeyCorp's Medium-Term Notes as presented in the table had a weighted average interest rate of 6.61% and had varying maturities through 2003. On June 15, 1992, KeyCorp issued $200 million of 8.125% Subordinated Notes under a shelf registration. The Notes are not redeemable prior to maturity. The 8.875% Notes, issued under a separate registration statement, and the 11.125% Notes are not redeemable prior to maturity. On March 26, 1987, KeyCorp issued $75 million of 8.40% Subordinated Capital Notes due 1999 under an indenture dated March 1, 1987, between KeyCorp and Chemical Bank, as Trustee. The Notes are unsecured obligations of KeyCorp and will, at maturity, be exchanged for Capital Securities having a market value equal to the principal amount of the Notes. Proceeds of this issue were used primarily to fund the acquisition of Seattle Trust & Savings Bank in July 1987. On June 29, 1992, KeyCorp issued $125 million of 8.00% Subordinated Notes. Proceeds from these twelve-year notes were used to redeem without penalty all of its 11.25% Senior Notes prior to maturity. Proceeds were also employed to provide capital for Key Bank of Washington. This capital infusion was made in anticipation NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED of Key Bank of Washington's purchase of 48 former Security Pacific Bank branches from BankAmerica on September 3, 1992. In 1989, the Ameritrust Corporation Employees' Savings and Investment Plan (the "Plan") was amended to include a leveraged employee stock ownership plan ("ESOP"). To fund the ESOP, Ameritrust borrowed $71.7 million from several institutional investors through the placement of unsecured notes totaling $22.8 million (the "8.33% Notes") and $48.9 million (the "8.48% Notes"). The interest on those notes totaled $6.0 million in each of the years 1993, 1992 and 1991. The ESOP trustee used the proceeds to purchase 5.8 million shares of Ameritrust common stock. These shares, as converted in the merger with Society, are held by the ESOP trustee for matching employee contributions to the Plan. The net difference between the cost of the treasury shares sold to the ESOP trustee and their market value was recorded as a reduction to retained earnings. Except for the repayment schedule, the loans to the ESOP trustee are on substantially similar terms as the borrowings from the institutional investors and, in addition, are secured by the unallocated shares held by the ESOP trustee. The ESOP trustee will repay the loans from KeyCorp using corporate contributions made by the Plan for that purpose and dividends on the Common Shares acquired with the loans. The amount of dividends on the ESOP shares used for debt service by the ESOP trustee totaled $3.9 million in 1993, $3.1 million in 1992 and $1.8 million in 1991. As contributions and dividends are received, a portion of the shares acquired with the loans will be allocated to Plan participants. Interest income recognized on loans to the ESOP trustee is netted against the interest expense incurred on the notes payable to the institutional investors. KeyCorp's receivable from the ESOP trustees, representing deferred compensation to the Corporation's employees, has been recorded as a separate reduction of shareholders' equity. SNB issued $200 million of 7.85% Subordinated Notes on November 3, 1992, and $200 million of 6.75% Subordinated Notes on June 16, 1993. SNB also issued a 10% Note in connection with the sale of branch offices and loans resulting from the merger with Ameritrust. None of these notes may be redeemed prior to maturity. The 8.625% Notes due 1996 were redeemed at par plus accrued interest on June 30, 1993, and the 9.56% Note due 1995 was assumed by the purchaser in connection with the sale of Ameritrust Texas Corporation on September 15, 1993. On May 6, 1993, and May 27, 1993, KeyCorp redeemed prior to maturity, and without penalty, all of its floating rate subordinated notes due 1997 and all of its 7.75% debentures due through 2002, respectively. Industrial revenue bonds issued by affiliate banks have varying maturities extending to the year 2009 and had weighted average annual interest rates of 7.14% and 7.19%, respectively, at December 31, 1993 and 1992. Other long-term debt at December 31, 1993 and 1992, consisted of capital lease obligations and various secured and unsecured obligations of corporate subsidiaries and had weighted average annual interest rates of 13.54% and 10.14%, respectively. Long-term debt qualifying as supplemental capital for purposes of calculating Tier II capital under Federal Reserve Board Guidelines amounted to $993.4 million and $799.1 million at December 31, 1993, and 1992, respectively. 11. SHAREHOLDERS' EQUITY COMMON SHARES AND PREFERRED STOCK In August 1989, KeyCorp's Board of Directors adopted a Shareholder Rights Plan ("Rights") under which each shareholder received one Right for each Common Share of KeyCorp. Each Right represents the right to purchase a Common Share of KeyCorp at a price of $65. The Rights become exercisable 20 days after a person or group acquires 15% or more of the outstanding shares or commences a tender offer that could result in such an ownership interest. Until the Rights become exercisable, they will trade with the Common Shares, and any transfer of the Common Shares will also constitute a transfer of associated Rights. When the Rights become exercisable, they will begin to trade separate and apart from the Common Shares. Twenty days after the occurrence of certain "Flip-In Events," each Right will become the right to purchase a Common Share of NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED KeyCorp for the then par value per share (now $1 per share) and the Rights held by a 15% or more shareholder will become void. KeyCorp may redeem these Rights at its option at $.005 per Right subject to certain limitations. Unless redeemed earlier, the Rights expire on September 12, 1999. On October 1, 1993, KeyCorp amended the Rights so that the Merger would not activate the provisions of the Rights. At December 31, 1993, KeyCorp had 10.0 million shares of $5 par value, non-voting preferred stock authorized of which 1,280,000 shares of Series B were outstanding represented by 6.4 million Depositary Shares. Each Depositary Share represents a one-fifth interest in a share of 10% Cumulative Preferred Stock, Series B, $125 liquidation preference per share. Preferred stock is reported on the accompanying consolidated balance sheet at its stated value of $125 per share. In the Merger, each of the Series B shares were converted into one share of 10% Cumulative Preferred Stock, Class A. On August 2, 1993, KeyCorp redeemed the 479,394 outstanding shares of Series A Preferred Stock at its stated value ($24 million) plus accumulated but unpaid dividends. On March 1, 1993, KeyCorp redeemed the 1.2 million outstanding shares of Fixed/Adjustable Rate Cumulative Preferred Stock at 103% of its stated value ($60 million), plus accumulated but unpaid dividends. KeyCorp effected a two-for-one stock split on March 22, 1993, by means of a 100% stock dividend. All relevant Common Share amounts, per Common Share amounts and related data in this report have been adjusted to reflect this split. In connection with the Merger, at a special meeting held February 16, 1994, shareholders increased the authorized number of shares of KeyCorp to 926.4 million, of which 1.4 million are shares of 10% Cumulative Preferred Stock, Class A, par value $5 per share; 25.0 million are shares of Preferred Stock, par value $1 per share; and 900.0 million are Common Shares, par value $1 per share. STOCK OPTIONS AND STOCK APPRECIATION RIGHTS KeyCorp maintains various incentive compensation plans which provide for its ability to grant stock options, stock appreciation rights, limited stock appreciation rights, restricted stock and performance shares to selected employees and directors. Generally, the terms of these plans stipulate that the exercise price of options may not be less than the fair market value of KeyCorp's Common Shares at the date the options are granted. Options granted expire not later than ten years and one month from the date of grant. Several option plans have been acquired through mergers. These plans have expired or were terminated, but unexercised options granted under the plans remain outstanding. At December 31, 1993 and 1992, options for Common Shares available for future grant totaled 1,237,965 and 1,233,958, respectively. The terms of KeyCorp's plans stipulate that stock appreciation rights may only be granted in tandem with stock options. The appreciation rights have the same terms as do the options, except that, upon exercise, the holder may receive either cash or shares for the excess of the current market value of KeyCorp's Common Shares over the options exercise price. Upon exercise of a stock appreciation right, the related option is surrendered. During 1993, all stock appreciation rights for which exercisability was limited to a period following a change in control of the Corporation were cancelled. NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED The following table presents a summary of pertinent information with respect to KeyCorp's stock options and stock appreciation rights. STOCK OPTIONS STOCK APPRECIATION RIGHTS In 1991, KeyCorp's Board of Directors approved grants to certain officers of KeyCorp and its subsidiaries under the Career Equity Program ("Program"). The Program is designed to increase equity ownership by the participants, who make an initial investment and elect to have options automatically exercised at regular intervals when share value appreciation is present. At exercise, replacement option grants are made at the current market value. Shares received under the Program are restricted as to resale during the five-year period of the Program. 12. MERGER AND INTEGRATION CHARGES Merger and integration charges of $118.7 million ($80.6 million after tax, $.33 per Common Share), $92.7 million ($66.6 million after tax, $.29 per Common Share) and $93.8 million ($68.2 million after tax, $.29 per Common Share) were recorded in 1993, 1992 and 1991, respectively. The 1993 charges were incurred in connection with the March 1, 1994, merger of old KeyCorp into and with Society, while the 1992 charges related to the mergers with PSB and Ameritrust. The 1991 charges related to the merger with Ameritrust. The merger and integration charges included accruals for merger expenses, consisting primarily of investment banking and other professional fees directly related to the merger ($20.5 million); severance payments and other employee costs ($49.6 million); systems and facilities costs ($35.7 million); and other costs incident to the Merger ($12.9 million). These charges were recorded by the parent company in the fourth quarter of 1993 at which time management determined that it was probable that a liability for all such charges had been incurred and could be reasonably estimated. The merger and integration charges recorded in connection with the PSB and Ameritrust mergers in 1992, and the Ameritrust merger in 1991, were similar in nature. The above mergers are described in greater detail in Note 2, Mergers, Acquisitions and Divestitures, on page 71 of this report. NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED 13. EMPLOYEE BENEFITS PENSION PLANS KeyCorp and its subsidiaries sponsor noncontributory pension plans covering substantially all employees. Benefits paid from these plans are based on age, years of service and compensation prior to retirement and are determined in accordance with defined formulas. The Corporation's funding policy is to contribute amounts to the plans which meet the minimum funding requirements set forth in the Employee Retirement Income Security Act (ERISA) of 1974, plus such additional amounts as the Corporation determines to be appropriate. The following table sets forth the status of the unfunded plans and the amounts recognized in the consolidated balance sheets: (1)Including KeyCorp Common Shares valued at $27.8 million and $30.4 million at December 31, 1993 and 1992, respectively. The weighted average discount rate and rate of increase in future compensation levels used in determining the actuarial present value of projected benefit obligations were 7.37% and 4.00%, respectively, at December 31, 1993, and 8.08% and 4.78%, respectively, at December 31, 1992. The weighted average expected long-term rate of return on pension assets used in determining net pension cost was 9.91% for 1993, 9.60% for 1992 and 9.69% for 1991. The Corporation also maintains several unfunded, non-qualified, supplemental executive retirement programs that provide additional defined pension benefits for certain officers. NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED The following table sets forth the status of the unfunded plans and the amounts recognized in the consolidated balance sheets: Net pension cost (income) for the funded and unfunded plans included the following components: In 1993, the Corporation recognized curtailment and settlement gains of $2.9 million resulting from the divestiture of ATC. Such amounts were included in the net gain from that divestiture. In 1992, the Corporation recognized curtailment gains of $7.2 million resulting from merger-related staff reductions. A portion of the retirement obligations associated with these reductions was settled by lump-sum cash distributions which resulted in settlement gains of $1.4 million and $3.0 million in 1993 and 1992, respectively. Both the curtailment and settlement gains related to the merger-related staff reductions are included in other noninterest income. OTHER POSTRETIREMENT BENEFIT PLANS The Corporation sponsors postretirement health care and life insurance plans that cover substantially all employees. The postretirement health care plans are nonfunded and contributory, with retirees' contributions adjusted annually to reflect certain cost-sharing provisions and benefit limitations. The postretirement life insurance plans are noncontributory. The Corporation has adopted a funding policy for one of its life insurance plans and annually contributes the service cost of benefits earned plus one-thirtieth of the unfunded accumulated postretirement benefit obligations. Effective January 1, 1993, the Corporation adopted the provisions of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions." This statement requires that employers recognize the cost of providing postretirement benefits over the employees' active service periods to the date they attain full eligibility for such benefits. Postretirement benefits costs for 1992 and 1991, which were recorded on a cash basis, have not been restated. Net postretirement benefits cost was $16.9 million in 1993, including $8.2 million due to adoption of the new standard, $7.7 million in 1992 and $6.6 million in 1991. NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED Net post retirement benefits cost include the following components: The following table sets forth the plans' combined funded status reconciled with the amount shown in the consolidated balance sheet: The assumed 1994 health care cost trend rate for Medicare-eligible retirees was 11.0% while that for non-Medicare-eligible retirees was 13.0%. Both rates are assumed to gradually decrease to 5.5% by the year 2009 and remain constant thereafter. Increasing the assumed health care cost trend rates by one percentage point in each future year would have an immaterial impact on postretirement benefits cost due to cost-sharing provisions and benefit limitations. The weighted average discount rate used in determining the accumulated postretirement benefit obligations was 7.4% at December 31, 1993. EMPLOYEE STOCK PURCHASE AND SAVINGS PLANS Substantially all of the Corporation's employees are covered under stock purchase and savings plans that are qualified under Section 401(k) of the Internal Revenue Code. Under provisions of these plans, employees may contribute 1% to 15% of eligible compensation, with up to 6% being eligible for matching contributions from the Corporation in the form of KeyCorp Common Shares. Under an annual discretionary profit sharing component, employees can receive additional matching employer contributions from the Corporation based on a formula established each year by KeyCorp's Board of Directors. Total expense associated with these plans was $40.4 million, $30.4 million and $29.0 million in 1993, 1992 and 1991, respectively. POSTEMPLOYMENT BENEFITS The Corporation adopted the provisions of SFAS No. 112, "Employers' Accounting for Postemployment Benefits," during 1993. This standard requires that employers who provide benefits to former or inactive employees after employment but before retirement recognize a liability for such benefits if specified conditions are met. Adoption of this standard increased noninterest expense by $4.0 million. Postemployment benefits for 1992 and 1991, which were recorded on a cash basis, were not restated. NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED 14. INCOME TAXES Income taxes included in the consolidated statements of income are as follows: The reasons for the differences between income tax expense and the amount computed by applying the statutory Federal tax rate to income before taxes are as follows: The significant types of temporary differences that gave rise to net deferred income taxes include the provision for loan losses, lease income, merger and integration charges and writedown of other real estate owned. Significant components of deferred income taxes are as follows: NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED Significant components of KeyCorp's deferred tax asset (liability) are as follows: 15. COMMITMENTS, CONTINGENT LIABILITIES AND OTHER DISCLOSURES LEGAL PROCEEDINGS In the ordinary course of business, KeyCorp and its subsidiaries are subject to legal actions which involve claims for substantial monetary relief. Based on information presently available to management and the Corporation's counsel, management does not believe that any legal actions, individually or in the aggregate, will have a material adverse effect on KeyCorp's consolidated financial condition. RESTRICTIONS ON CASH, DUE FROM BANKS, SUBSIDIARY DIVIDENDS AND LENDING ACTIVITIES Under the provisions of the Federal Reserve Act, depository institutions are required to maintain certain average balances in the form of cash or noninterest-bearing balances with the Federal Reserve Bank. Average reserve balances aggregating $1.1 billion in 1993 were maintained in fulfillment of these requirements. The principal source of income for the parent company is dividends from its affiliate banks. Such dividends are subject to certain restrictions as set forth in the national and state banking laws and regulations. At December 31, 1993, undistributed earnings of $535.4 million were free of such restrictions and available for the payment of dividends to the parent company. Loans and advances from banking affiliates to the parent company are also limited by law and are required to be collateralized. 16. FINANCIAL INSTRUMENTS FAIR VALUE DISCLOSURES The following disclosures are made in accordance with the provisions of SFAS No. 107, "Disclosures About Fair Value of Financial Instruments," which requires the disclosure of fair value information about both on-and off-balance sheet financial instruments where it is practicable to estimate that value. Fair value is defined in SFAS No. 107 as the amount at which an instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. It is not the Corporation's intent to enter into such exchanges. In accordance with the provisions of SFAS No. 107, the estimated fair values of deposits, credit card loans and residential real estate mortgage loans do not take into account the fair values of long-term relationships, which are integral parts of the related financial instruments. The disclosed estimated fair values of such instruments would increase significantly if the fair values of the long-term relationships were considered. In cases where quoted market prices were not available, fair values were estimated using present value or other valuation methods, as described below. The use of different assumptions (e.g., discount rates and cash flow estimates) and estimation methods could have a significant effect on fair value amounts. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Corporation could realize in a current market exchange. Because SFAS No. 107 excludes certain financial instruments and all nonfinancial NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED instruments from its disclosure requirements, any aggregation of the fair value amounts presented would not represent the underlying value of the Corporation. The following methods and assumptions were used in estimating the fair values of financial instruments presented in the preceding table and in the following paragraphs. For financial instruments with a remaining average life to maturity of less than six months, carrying amounts were used as an approximation of fair value. The carrying amounts reported for cash and due from banks, and short-term investments are their fair values. The carrying value of mortgage loans held for sale approximates fair value. Securities available for sale and investment securities were valued based on quoted market prices. Where quoted market prices were unavailable, fair values were based on quoted market prices of similar instruments. A discounted cash flow model was used to estimate the fair values for certain loans. Certain residential real estate loans and student loans held for sale were valued based on quoted market prices of similar loans offered or sold in recent securitization transactions. Lease financing receivables, although excluded from the scope of SFAS No. 107, were included in the estimated fair value for loans at their carrying amount. In circumstances in which the fair value of loans was not estimated, the carrying amount was used as a reasonable approximation of fair value. The fair values of certificates of deposit and of long-term debt were estimated based on discounted cash flows. Carrying amounts reported for other deposits and short-term borrowings were used as a reasonable approximation of their fair values. Interest rate swaps were valued based on discounted cash flow models and had a fair value of $57.2 million and $75.8 million at December 31, 1993 and 1992, respectively. FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK The Corporation, mainly through its affiliate banks, is party to various financial instruments with off-balance sheet risk. The banks use these financial instruments in the normal course of business to meet the financing needs of their customers and to manage effectively their exposure to interest rate risk. The financial instruments used include commitments to extend credit, standby letters of credit, interest rate swap agreements, forward contracts, futures and options on financial futures, and interest rate cap and floor agreements. These instruments involve, to varying degrees, credit and interest rate risks in excess of amounts recognized in the Corporation's consolidated balance sheet. Credit risk is the possibility that a counterparty to a financial instrument will be unable to perform its contractual obligations. Market risk is the possibility that, due to changes in economic conditions, the Corporation's net interest income will be adversely affected. The Corporation mitigates its exposure to credit risk through internal controls over the extension of credit. These controls include the process of credit approval and review, the establishment of credit limits, and, when deemed necessary, securing collateral. The Corporation manages its exposure to market risk, in part, by using NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED off-balance sheet instruments to offset existing interest rate risk of its assets and liabilities, and by setting variable rates of interest on contingent extensions of credit. The following is a summary of the contractual or notional amount of each significant class of off-balance sheet financial instruments outstanding. The Corporation's maximum possible accounting loss from commitments to extend credit and from standby letters of credit equals the contractual amount of these instruments. The notional amount represents the total dollar volume of transactions and is significantly greater than the amount at risk. KeyCorp's commitments to extend credit are agreements with customers to provide financing at predetermined terms as long as the customer continues to meet specified criteria. Loan commitments serve to meet the financing needs of the banks' customers, have fixed expiration dates or other termination clauses, and may require the payment of fees. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent actual future cash requirements of the Corporation. KeyCorp evaluates each customer's creditworthiness on a case-by-case basis. Standby letters of credit are conditional commitments issued by the Corporation to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. KeyCorp's mortgage banking affiliates originate and service residential mortgage loans to be sold in the secondary market. In years prior to 1992, residential mortgages were sold with provisions for recourse by companies acquired by KeyCorp. At December 31, 1993, the amount of such loans sold with recourse was $156.1 million. KeyCorp has not and does not sell residential mortgages with provisions for recourse. NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED KeyCorp's mortgage banking affiliates enter into forward sale agreements and option contracts to hedge against adverse movements in interest rates on mortgage loans held for sale. Forward sale agreements commit the affiliates to deliver mortgage loans in future periods; option contracts allow the affiliates to sell or purchase mortgage loans at a specified price, in future periods. The banks enter into interest rate swap agreements primarily to manage interest rate risk and to accommodate the business needs of customers. Under a typical swap agreement, one party pays a fixed rate of interest based on a notional amount to a second party, which pays to the first party a variable rate of interest based on the same notional amount. The swaps have an average maturity of 1.8 years, with selected swaps having fixed maturity dates through 2003. The following is a summary of the notional amounts of outstanding interest rate swap agreements: The banks enter into interest rate cap and floor agreements in the management of their interest rate risk and to accommodate the business needs of customers. These financial instruments transfer interest rate risk at predetermined levels. The banks receive a fee as compensation for writing interest rate caps and floors. The interest rate risk from writing interest rate caps and floors is minimized by the banks through offsetting transactions. Financial futures contracts and options on financial futures provide for the delayed delivery or purchase of securities, interest rate instruments or foreign currency. The banks enter into forward contracts and options to hedge their interest rate risk and in connection with customer transactions, as well as to minimize the interest rate risk exposure of mortgage banking activities. NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED 17. CONDENSED FINANCIAL INFORMATION OF PARENT COMPANY CONDENSED BALANCE SHEETS CONDENSED STATEMENTS OF INCOME NOTES TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED CONDENSED STATEMENTS OF CASH FLOW (A)(2) FINANCIAL STATEMENT SCHEDULES All financial statement schedules for Society Corporation and subsidiaries have been included in the consolidated financial statements or the related footnotes, or they are either inapplicable or not required. (A)(3) EXHIBITS* Society hereby agrees to furnish the Securities and Exchange Commission upon request, copies of instruments outstanding, including indentures, which define the rights of long-term debt security holders. All documents listed as Exhibits 10.1 through 10.51 constitute management contracts or compensatory plans or arrangements. - --------------- * Copies of these Exhibits have been filed with Securities and Exchange Commission. Shareholders may obtain a copy of any exhibit, upon payment of reproduction costs, by writing Mr. Jay S. Gould, Investor Relations, at 127 Public Square 01-127-0406, Cleveland, Ohio 44114-1306. ** These Exhibits are incorporated by reference from old KeyCorp's Current Report on Form 8-K dated March 9, 1992. (b) Reports on Form 8-K October 13, 1993 -- Item 5. Other Events. On October 1, 1993, Society announced the signing of a definitive agreement providing for the merger of old KeyCorp into and with Society. November 19, 1993 -- Item 7. Financial Statements, Pro Forma Financial Information, and Exhibits. Society filed certain pro forma financial information that gives effect to the proposed merger of Society and old KeyCorp, and supplemental historical financial statements of old KeyCorp and its subsidiaries. No other reports on Form 8-K were filed during the three-month period ended December 31, 1993. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTIONS 13 OR 15(D) OF THE SECURITIES AND EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED, ON THE DATE INDICATED. KEYCORP CARTER B. CHASE Executive Vice President, Secretary and General Counsel March 31, 1994 PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATE INDICATED.

790603_1993.txt

790603

1993

Item 1. Business All references to "Notes" are to Notes to Consolidated Financial Statements contained in this report. The registrant, JMB Income Properties, Ltd. - XIII (the "Partnership"), is a limited partnership formed in 1986 and currently governed by the Revised Uniform Limited Partnership Act of the State of Illinois to invest in income-producing properties, primarily existing commercial real properties. On August 20, 1986, the Partnership commenced an offering to the public of $100,000,000 (subject to increase by up to $250,000,000) in Limited Partnership Interests (the "Interests") pursuant to a Registration Statement on Form S-11 under the Securities Act of 1933 (Registration No. 33-4107). A total of 126,409 Interests (at an offering price of $1,000 per Interest, before discounts) were sold to the public and were issued to investors during 1987. The offering closed on April 14, 1987. No investor has made any additional capital contribution after such date. The investors in the Partnership share in their portion of the benefits of ownership of the Partnership's real property investments according to the number of Interests held. The Partnership is engaged solely in the business of the acquisition, operation, and sale and disposition of equity real estate investments. Such equity investments are held by fee title and/or through joint venture partnership interests. The Partnership's real property investments are located throughout the nation, and it has no real estate investments located outside the United States. A presentation of information about industry segments, geographic regions, raw materials or seasonality is not applicable and would not be material to an understanding of the Partnership's business taken as a whole. Pursuant to the Partnership Agreement, the Partnership is required to terminate on or before October 31, 2036. Accordingly, the Partnership intends to hold the real properties it acquires for investment purposes until such time as a sale or other disposition appears to be advantageous. Unless otherwise described, the Partnership expects to hold its properties for long-term investment where, due to current market conditions, it is impossible to forecast the expected holding period. At the sale of a particular property, the proceeds, if any, are generally distributed or reinvested in existing properties rather than invested in acquiring additional properties. The Partnership has made the real property investments set forth in the following table: The Partnership's real property investments are subject to competition from similar types of properties (including, in certain areas, properties owned or advised by affiliates of the General Partners) in the vicinities in which they are located. Such competition is generally for the retention of existing tenants. Additionally, the Partnership is in competition for new tenants in markets where significant vacancies are present. Reference is made to Item 7 below for a discussion of competitive conditions and future renovation and capital improvement plans of the Partnership and certain of its significant investment properties. Approximate occupancy levels for the properties are set forth in Item 2

Item 2. Properties The Partnership owns directly or through joint venture partnerships the properties or interests in the properties referred to under Item 1 above to which reference is hereby made for a description of said properties. The following is a listing of principal businesses or occupations carried on in and approximate occupancy levels by quarter during fiscal years 1993 and 1992 for the Partnership's investment properties owned during 1993: ITEM 3.

ITEM 3. LEGAL PROCEEDINGS The Partnership is not subject to any material pending legal proceedings. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS There were no matters submitted to a vote of holders of Interests during fiscal years 1993 and 1992. PART II ITEM 5.

ITEM 5. MARKET FOR THE PARTNERSHIP'S LIMITED PARTNERSHIP INTERESTS AND RELATED SECURITY HOLDER MATTERS As of December 31, 1993, there were 9,335 record holders of Interests of the Partnership. There is no public market for Interests, and it is not anticipated that a public market for Interests will develop. Upon request, the Managing General Partner may provide information relating to a prospective transfer of Interests to an investor desiring to transfer his Interests. The price to be paid for the Interests, as well as any other economic aspects of the transaction, will be subject to negotiation by the investor. However, there are restrictions governing the transferability of these Interests as described in "Transferability of Partnership Interests" on pages A-31 to A-33 of the Partnership Agreement. Reference is made to Item 6

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS LIQUIDITY AND CAPITAL RESOURCES On August 20, 1986, the Partnership commenced an offering to the public of $100,000,000, subject to increase by up to $250,000,000, of Interests pursuant to a Registration Statement on Form S-11 under the Securities Act of 1933. On April 14, 1987, the offering was consummated and a total of 126,409 Interests were issued to the public by the Partnership from which the Partnership received gross proceeds of $126,409,000. After deducting selling expenses and other offering costs, the Partnership had approximately $113,741,000 with which to make investments primarily in existing commercial real property, to pay legal fees and other costs (including acquisition fees) related to such investments and to satisfy working capital requirements. A portion of such proceeds was utilized to acquire the properties described in Item 1 above. At December 31, 1993, the Partnership and its consolidated venture had cash and cash equivalents of approximately $1,300,000. Such funds and short- term investments of approximately $11,520,000 are available for future distri- butions to partners, working capital requirements, anticipated releasing costs at the Rivertree Court Shopping Center and to make additional investments in the venture which owns the First Financial Plaza Office Building as described in Note 3. As more fully described in Note 5, distributions to the General Partners have been deferred in accordance with the subordination requirements of the Partnership Agreement. The Partnership and its consolidated venture have currently budgeted in 1994 approximately $689,000 for tenant improvements and other capital expenditures. The Partnership's share of such items and its share of similar items for its unconsolidated ventures in 1994 is currently budgeted to be approximately $950,000. Actual amounts expended in 1994 may vary depending on a number of factors including actual leasing activity, results of property operations, liquidity considerations and other market conditions over the course of the year. The source of capital for such items and for both short-term and long-term future liquidity and distributions is expected to be through cash generated by the Partnership's investment properties and through the sale of such investments. The Partnership's and its ventures' mortgage obligations are all non-recourse. Therefore, the Partnership and its ventures are not obligated to pay mortgage indebtedness unless the related property produces sufficient net cash flow from operations or sale. In 1992, the Partnership paid approximately $345,000 relating to significant seismic-related improvements made to certain buildings at the Fountain Valley and Cerritos Industrial Parks in 1991. In 1993, the Partnership paid approximately $305,000 to complete significant land and building improvements at the Cerritos Industrial Park originally budgeted in 1992 as a result of a mandate from the City of Cerritos. In 1995 and 1996, leases at the Cerritos Industrial Park representing 33% and 22%, respectively, of the leasable square footage are scheduled to expire, not all of which are expected to be renewed. The Fountain Valley Industrial Park currently operates in a market with industrial vacancy rates ranging from 15% to 16%. Fountain Valley is currently 85% leased and occupied. The Partnership and the Newport Corporation, which vacated in March 1992 prior to its 1995 lease expiration and continues to pay rent pursuant to its one remaining lease obligation, entered into an agreement to terminate one of Newport's leases for approximately 77,000 square feet (representing approximately 20% of the leasable square footage at the property) in July 1993 for a $487,000 fee paid to the Partnership. The space has been leased to Fry's Electronics, an electronics retailer, for a twelve-year term effective July 1993. International Tile vacated its approximate 36,000 square feet in August 1993 prior to its lease expiration in 1997. In January 1994, International Tile filed for protection under Chapter XI of the United States Bankruptcy Code. It is unlikely that the Partnership will collect the approximate $90,000 owed by International Tile at December 31, 1993. In 1995 and 1996, leases representing 21% and 13%, respectively, of the leasable square footage at Fountain Valley are scheduled to expire, not all of which are expected to be renewed. Currently, as leases at the Fountain Valley and Cerritos Industrial Parks expire, lease renewals and new leases will likely be at rental rates less than the rates on existing leases. The supply of industrial space has caused increased competition for tenants, a corresponding decline in rental rates and a corresponding increase in time required to re-lease tenant space in these markets. This anticipated decline in rental rates and anticipated increase in re-leasing time will result in a decrease in cash flow from operations over the near term. Fountain Valley incurred minimal damage and Cerritos incurred no damage as a result of the earthquake in southern California on January 17, 1994. In February 1994, the Partnership extended and increased the first mortgage loan in the principal amount to $11,200,000, which is secured by the Fountain Valley and Cerritos Industrial Parks. The extended loan bears interest at a rate of 7.32% per annum, provides for monthly payments of principal and interest based on a twenty-year amortization period and matures March 1, 2001. After payment of costs and fees related to the re-financing, there were no distributable proceeds from the loan extension. Prior to the extension, the Partnership had entered into a forbearance agreement with the lender providing, among other things, that the lender agreed not to exercise its rights and remedies under the original loan documents from November 2, 1993, the original maturity date, until January 31, 1994. The Partnership continued to pay interest only at an annual rate of 8.83% on the original $11,000,000 principal balance through the effective date of the refinancing. As of December 31, 1993, the Partnership has made an aggregate investment of approximately $24,994,000 relating to a maximum total commitment of $25,750,000 to an existing partnership (Adams/Wabash) that constructed a parking garage and retail space structure known as the Adams/Wabash Self Park as described in Note 3(e). The Partnership is not required to increase this original aggregate investment. Pursuant to the Adams/Wabash Partnership Agreement, the Partnership's interest in the venture increased from 49.9% to 74.9% effective October 1, 1993. The Rivertree Court Shopping Center operates in a market which is experiencing significant growth in the commercial and residential sectors. The growth in the area is expected to continue in the next several years. However, in January 1994, Filene's Basement vacated their space of approximately 26,000 square feet (representing approximately 9% of the leasable square footage at the property) but continues to pay rent pursuant to its lease. The Partnership is finalizing its approval of a sub-tenant for the Filene's store. During the third quarter of 1992, Highland Superstores, Inc. and Phar-Mor, both of which then had stores at the Rivertree Court Shopping Center, filed for protection under Chapter XI of the United States Bankruptcy Code. Highland vacated its space at the end of August 1992. The Partnership has leased the Highland space to Best Buy, an appliance and home electronics retailer, which opened during February 1993. The Phar-Mor store at the center continues to operate and pay rent under its lease obligation since its bankruptcy filing. The Partnership has received no notification of Phar-Mor's intentions regarding the continued operations of this store. However, the Partnership has finalized negotiations with a replacement tenant should Phar- Mor vacate its space in the near future. On January 30, 1992, the Partnership, through JMB/Mid Rivers Mall Associates, sold its interest in the Mid Rivers Mall located in St. Peters, Missouri to the unaffiliated joint venture partner. The Partnership received in connection with the sale, after all fees, expenses and joint venture partner's participation, a net amount of cash of $13,250,000. See Note 7 for a further description of this transaction. The West Dade joint venture which owns the Miami International Mall entered into an agreement with J.C. Penney which opened a department store at the mall in October 1992 (see Note 3(d)). The addition of J.C. Penney has had a positive impact on the operations of the mall. During the third quarter of 1992, the property experienced storm damage caused by Hurricane Andrew. It has been determined that structural damage to the building was minimal; however, the landscaping surrounding the building, including the irrigation system and street curbs, was impacted more severely. All repairs necessary to continue operations have been made. The Partnership believes West Dade has adequate insurance coverage for this damage. A claim has been submitted to the property's insurance company for approximately $750,000. In January 1994, a partial settlement of approximately $710,000 of the expected insurance proceeds had been received. West Dade sold a 3.9 acre outparcel of land at the Miami International Mall in June 1993 for a net sale price of approximately $1,560,000, after certain selling costs, of which the Partnership's share was approximately $390,000. For financial reporting purposes, West Dade has recognized a gain in 1993 of approximately $1,385,000, of which the Partnership's share is approximately $346,000. West Dade is currently negotiating the sale of an additional 4 acre outparcel of land. In December 1993, West Dade obtained a new mortgage loan in the principal amount of $47,500,000 replacing the existing first mortgage loan at the property. The new mortgage loan bears interest at 6.91% per annum and matures December 21, 2003. The loan provides for monthly interest-only payments for years one through three and monthly principal and interest payments based on a twenty-year amortization period for years four through ten. The non-recourse loan is secured by a first mortgage on the Miami International Mall. After payment of costs and fees related to the refinancing, there were no distributable proceeds from the new loan. At December 31, 1993, the First Financial Plaza office building is approximately 85% occupied. In July 1993, Mitsubishi vacated its approximate 8,100 square feet prior to its lease expiration of January 1997 and continues to pay rent pursuant to its lease obligation. Including the Misubishi lease and recently executed leases, the building is 91% leased. In 1994, leases representing approximately 20% of the leasable square footage are scheduled to expire. Although renewal discussions with the majority of these tenants have been favorable, there can be no assurance that all of these tenants will renew their leases upon expiration. The Los Angeles office market in general and the Encino submarket in particular have become extremely competitive resulting in higher rental concession granted to tenants and flat or decreasing market rental rates. Furthermore, due to the recession in southern California and to concerns regarding tenants' ability to perform under current lease terms, the venture has granted rent deferrals and other forms of rent relief to several tenants including First Financial Housing, an affiliate of the unaffiliated venture partner. The property incurred minimal damage as a result of the earthquake in southern California on January 17, 1994. There are certain risks associated with the Partnership's investments made through joint ventures including the possibility that the Partnership's joint venture partners in an investment might become unable or unwilling to fulfill their financial or other obligations, or that such joint venture partners may have economic or business interest or goals that are inconsistent with those of the Partnership. In response to the weakness of the economy and the limited amount of available real estate financing in particular, the Partnership is taking steps to preserve its working capital. Therefore, the Partnership is carefully scrutinizing the appropriateness of any discretionary expenditures, particularly in relation to the amount of working capital it has available. By conserving working capital, the Partnership will be in a better position to meet future needs of its properties without having to rely on external financing sources. RESULTS OF OPERATIONS The increase in interest, rents, and other receivables as of December 31, 1993 as compared to December 31, 1992 is primarily due to the timing of the collection of tenant escalations at the Rivertree Court Shopping Center. The increase in deferred expenses as of December 31, 1993 as compared to December 31, 1992 and the related amortization expense for the year ended December 31, 1993 as compared to the year ended December 31, 1992 is primarily due to the capitalization and amortization of the lease commissions related to the 1993 commencement of the Fry's Electronics lease at the Fountain Valley Industrial Park. The decrease in amortization expense for the year ended December 31, 1992 as compared to the year ended December 31, 1991 is primarily due to the write off of deferred lease costs relating to a tenant vacating its space at the Fountain Valley Industrial Park in 1991. The decrease in current portion of long-term debt and the corresponding increase in long-term debt at December 31, 1993 as compared to December 31, 1992 is due to the extension of the $11,000,000 first mortgage loan secured by the Fountain Valley and Cerritos Industrial Parks subsequent to December 31, 1993 (see Note 4(b)). The increase in rental income for the year ended December 31, 1993 as compared to the year ended December 31, 1992 is primarily due to higher average occupancy levels at the Adams/Wabash Self Park, the Rivertree Court Shopping Center, and the Fountain Valley and Cerritos Industrial Parks. The increase in rental income is also due to the $487,000 termination fee received for the termination of one of the Newport Corporation lease obligations at the Fountain Valley Industrial Park in July 1993. In addition, parking revenue at the Adams/Wabash Self Park increased due to two monthly parking contracts which were executed during October 1992 and to increased activity from the Palmer House Hotel parking contract. The increase in leasing at the above- mentioned properties has also resulted in an increase in accrued rents receivable at December 31, 1993 as compared to December 31, 1992. The increase in rental income for the year ended December 31, 1992 as compared to the year ended December 31, 1991 is primarily due to an increase in parking revenue at the Adams/Wabash investment property due to two monthly parking contracts which were executed during October 1992 and to increased activity from the Palmer House Hotel parking contract. In addition, rental income from the retail space at the Adams/Wabash investment property increased due to higher average occupancy levels during 1992 as compared to 1991. Fountain Valley Industrial Park also received a partial bankruptcy settlement of $80,000 in 1992. The decrease in interest income for the year ended December 31, 1993 as compared to the year ended December 31, 1992 and the increase in interest income for the year ended December 31, 1992 as compared to the year ended December 31, 1991 are primarily due to the Partnership maintaining a higher average invested balance in U.S. Government obligations during 1992. The higher average invested balance resulted primarily from the receipt of cash proceeds (a portion of which were subsequently distributed to the Limited Partners in 1992) from the sale of the Partnership's interest in the Mid Rivers Mall in January 1992. The decrease in the amount of loss from Partnership's share of operations of unconsolidated ventures for the year ended December 31, 1993 as compared to the year ended December 31, 1992 is due primarily to increased operations at the Miami International Mall. The decrease in the amount of loss from Partnership's share of operations of unconsolidated ventures for the year ended December 31, 1992 as compared to the year ended December 31, 1991 is primarily due to the sale of the Partnership's interest in the Mid Rivers Mall. The decrease in Partnership's share of gain on sale of investment property and gain on sale of land from unconsolidated venture for the year ended December 31, 1993 as compared to the year ended December 31, 1992 and the increase for the year ended December 31, 1992 as compared to the year ended December 31, 1991 are primarily due to the gain recognized in connection with the sale of the Partnership's interest in the Mid Rivers Mall in January 1992, partially offset by the sale of a 3.9 acre outparcel of land at the Miami International Mall in June 1993 (see Note 3(d)). The decrease in extraordinary item from unconsolidated venture for the year ended December 31, 1993 as compared to the year ended December 31, 1992 is primarily due to a prepayment penalty to the first mortgage lender as a result of the loan refinancing at the Miami International Mall in December 1993 (see Note 3(d)). INFLATION Due to the decrease in the level of inflation in recent years, inflation generally has not had a material effect on rental income or property operating expenses. To the extent that inflation in future periods does have an adverse impact on property operating expenses, the effect will generally be offset by amounts recovered from tenants as many of the long-term leases at the Partnership's commercial properties have escalation clauses covering increases in the cost of operating and maintaining the properties as well as real estate taxes. Therefore, there should be little effect on operating earnings if the properties remain substantially occupied. In addition, substantially all of the leases at the Partnership's shopping center investment property contain provisions which entitle the Partnership to participate in gross receipts of tenants above fixed minimum amounts. Future inflation may also cause capital appreciation of the Partnership's investment properties over a period of time to the extent that rental rates and replacement costs of properties increase. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA JMB INCOME PROPERTIES, LTD. - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE INDEX Independent Auditors' Report Consolidated Balance Sheets, December 31, 1993 and 1992 Consolidated Statements of Operations, years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Partners' Capital Accounts (Deficits), years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows, years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements SCHEDULE -------- Supplementary Income Statement Information X Consolidated Real Estate and Accumulated Depreciation XI SCHEDULES NOT FILED: All schedules other than those indicated in the index have been omitted as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes. INDEPENDENT AUDITORS' REPORT The Partners JMB INCOME PROPERTIES, LTD. - XIII: We have audited the consolidated financial statements of JMB Income Properties, Ltd. - XIII (a limited partnership) and consolidated venture as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the General Partners of the Partnership. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by the General Partners of the Partnership, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of JMB Income Properties, Ltd. - XIII and consolidated venture at December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. KPMG PEAT MARWICK Chicago, Illinois March 22, 1994 JMB INCOME PROPERTIES, LTD. - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 1993, 1992 AND 1991 (1) BASIS OF ACCOUNTING The accompanying consolidated financial statements include the accounts of the Partnership and one of its ventures, Adams/Wabash Limited Partnership ("Adams/Wabash"). The effect of all transactions between the Partnership and Adams/Wabash have been eliminated in the consolidated financial statements. The equity method of accounting has been applied in the accompanying financial statements with respect to the Partnership's interests in JMB/Mid Rivers Associates ("JMB/Rivers") (see note 7), JMB First Financial Associates ("First Financial") and JMB/Miami International Associates ("JMB/Miami"). Accordingly, the accompanying financial statements do not include the accounts of JMB/Rivers, First Financial and JMB/Miami. The Partnership's records are maintained on the accrual basis of accounting as adjusted for Federal income tax reporting purposes. The accompanying financial statements have been prepared from such records after making appropriate adjustments where applicable to reflect the Partnership's accounts in accordance with generally accepted accounting principles ("GAAP"). Such adjustments are not recorded on the records of the Partnership. The net effect of these items is summarized as follows for the years ended December 31, 1993 and 1992: JMB INCOME PROPERTIES, LTD. - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The net earnings (loss) per limited partnership interest is based upon the limited partnership interests outstanding at the end of the period (126,414). Deficit capital accounts will result, through the duration of the Partnership, in net gain for financial reporting and income tax purposes. Statement of Financial Accounting Standards No. 95 requires the Partnership to present a statement which classifies receipts and payments according to whether they stem from operating, investing or financing activities. The required information has been segregated and accumulated according to the classifications specified in the pronouncement. Partnership distributions from its unconsolidated ventures are considered cash flow from operating activities only to the extent of the Partnership's cumulative share of net earnings. The Partnership records amounts held in U.S. Government obligations at cost, which approximates market. For the purposes of these statements, the Partnership's policy is to consider all such amounts held with original maturities of three months or less ($0 and $1,985,253 at December 31, 1993 and 1992, respectively) as cash equivalents with any remaining amounts reflected as short-term investments. Deferred expenses consist primarily of deferred organization costs which are amortized over a 60-month period and deferred lease commissions and loan fees which are amortized over their respective terms using the straight-line method. Although certain leases of the Partnership provide for tenant occupancy during periods for which no rent is due and/or increases in minimum lease payments over the term of the lease, the Partnership accrues rental income for the full period of occupancy on a straight-line basis. No provision for State or Federal income taxes has been made as the liability for such taxes is that of the Partners rather than the Partnership. However, in certain instances, the Partnership has been required under applicable law to remit directly to the tax authorities amounts representing withholding from distributions paid to Partners. (2) INVESTMENT PROPERTIES The Partnership has acquired, either directly or through joint ventures (note 3), three shopping centers, two multi-tenant industrial buildings, an office complex and a parking/retail structure. In January 1992, the Partnership's interest in the Mid Rivers Mall was sold (note 7). All of the properties owned at December 31, 1993 were operating. The cost of the investment properties represents the total cost to the Partnership plus miscellaneous acquisition costs. Depreciation on the properties has been provided over the estimated useful lives of the various components as follows: YEARS ----- Building and improvements -- straight-line . 30 Personal property -- straight-line . . . . . 5 == JMB INCOME PROPERTIES, LTD. - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED Maintenance and repairs are charged to operations as incurred. Significant betterments and improvements are capitalized and depreciated over their estimated useful lives. Certain investment properties are pledged as security for the long-term debt, for which there is no recourse to the Partnership (note 4). (3) VENTURE AGREEMENTS (a) General The Partnership at December 31, 1993 is a party to three operating joint venture agreements. In addition, the Partnership through a joint venture (JMB/Rivers) sold its interest in the Mid Rivers Mall on January 30, 1992 (note 7). Pursuant to such agreements, the Partnership has made capital contributions of approximately $56,757,000 through December 31, 1993. In general, the joint venture partners, who are either the sellers (or their affiliates) of the property investments being acquired, or parties which have contributed an interest in the property being developed, or were subsequently admitted to the ventures, make no cash contributions to the ventures, but their retention of an interest in the property, through the joint venture, is taken into account in determining the purchase price of the Partnership's interest, which is determined by arm's-length negotiations. Under certain circumstances, either pursuant to the venture agreements or due to the Partnership's obligations as general partner, the Partnership may be required to make additional cash contributions to the ventures. The Partnership has acquired, through the above ventures, one office building, two regional shopping malls and one parking/retail structure. The joint venture partners (who were primarily responsible for constructing the properties) contributed any excess of cost over the aggregate amount available from Partnership contributions and financing and, to the extent such funds exceeded the aggregate costs, were to retain such excesses. Two of the venture properties operating as of December 31, 1993 have been financed under various long-term debt arrangements as described in notes (c) and (d) below. There are certain risks associated with the Partnership's investments made through joint ventures including the possibility that the Partnership's joint venture partners in an investment might become unable or unwilling to fulfill their financial or other obligations, or that such joint venture partners may have economic or business interests or goals that are inconsistent with those of the Partnership. (b) JMB/Rivers In December 1986, the Partnership and JMB Income Properties, Ltd. - XII, (a partnership sponsored by an affiliate of the Managing General Partner) ("JMB-XII"), formed JMB/Rivers, which entered into a joint venture ("Mid Rivers") with an affiliate of the developer ("Venture Partner") and acquired an interest in an enclosed regional shopping center then under construction in St. Peters, Missouri, known as Mid Rivers Mall. Under the terms of the venture agreement, JMB/Rivers contributed approximately $39,400,000, of which the Partnership's share was approximately $19,700,000. During January 1992, JMB/Rivers sold its interest in Mid Rivers Mall (see note 7). JMB INCOME PROPERTIES, LTD. - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The ultimate ownership percentages for JMB/Rivers and Venture Partner were established as 80% and 20%, respectively. Operating profits and losses were generally allocated in proportion to and to the extent of distributions as described above and, to the extent profits and losses exceeded such distributions, to the Partners in accordance with their respective ownership percentages. The terms of the JMB/Rivers agreement generally provided that the Partnership was allocated or distributed, as the case may be, profits and losses, cash flow from operations and sale or refinancing proceeds in the ratio of its respective capital contributions to JMB/Rivers. The shopping center was managed by an affiliate of the Venture Partner for a fee calculated as 4% of gross receipts of the property through the date of the sale. (c) First Financial On May 20, 1987, the Partnership, through First Financial, a joint venture with JMB-XII, acquired an interest in a general partnership ("Encino") with an affiliate of the developer ("Venture Partner") which owns an office building in Encino (Los Angeles), California. First Financial is obligated to make an initial investment in the aggregate amount of $49,850,000 of which approximately $49,812,000 of such contributions have been made to Encino. The Partnership's share of the remaining amounts, approximately $14,000, will be contributed when the venture partner complies with certain requirements. In November 1987, First Financial caused Encino to obtain a third party first mortgage loan in the amount of $30,000,000. The proceeds of such loan were distributed to First Financial to reduce its contribution and to the Venture Partner who subsequently repaid a $15,500,000 loan from First Financial. Thus, the total cash investment of First Financial for its interest in the office building, after consideration of the funding of the $30,000,000 permanent financing, is approximately $20,000,000, of which the Partnership's share is approximately $7,500,000. The outstanding principal balance of the third party first mortgage loan as of December 31, 1993 is $29,394,848. The Encino partnership agreement generally provides that First Financial is entitled to receive (after any participating amounts due to Pepperdine University pursuant to its tenant lease) from cash flow from operations (as defined) an annual cumulative preferred return equal to 9.05% through April 30, 1995 (and 8.9% thereafter) of its capital contributions. Any remaining cash flow is to be split equally between First Financial and the Venture Partner. Pepperdine University, under its tenant lease, is entitled to an amount based on 6.6% of the Venture Partner's share of the office building's net operating profit and net sale profit (as defined). All of Encino's operating profits and losses before depreciation have been allocated to First Financial in 1993, 1992 and 1991. The Encino partnership agreement also generally provides that net sale proceeds and net refinancing proceeds (as defined), after any amounts due to Pepperdine University pursuant to its tenant lease, are to be distributed: first, to First Financial in an amount equal to the deficiency, if any, in its cumulative preferred return as described above; next, to First Financial in the amount of its capital contributions; next, to the Venture Partner in an amount equal to $600,000; any remaining proceeds are to be split equally between First Financial and the Venture Partner. JMB INCOME PROPERTIES, LTD. - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED The terms of the First Financial partnership agreement provide that annual cash flow, net sale or refinancing proceeds, and tax items will be distributed or allocated, as the case may be, to the Partnership in proportion to its 37.5% share of capital contributions. The office building is managed by an affiliate of the Venture Partner for a fee based upon a percentage of rental receipts (as defined) of the property. (d) JMB/Miami On January 26, 1988, the Partnership, through JMB/Miami, a joint venture with JMB/Miami Investors L.P., a partnership sponsored by an affiliate of the General Partners of the Partnership, acquired an interest in an existing partnership ("West Dade" in which JMB/Miami is a general partner), with an affiliate of the developer (the "Venture Partner"), which owns an enclosed regional shopping center in Miami, Florida known as Miami International Mall. During February 1989, IDS/JMB Balanced Income Growth, Ltd., a partnership sponsored by an affiliate of the General Partners of the Partnership made a capital contribution to JMB/Miami to acquire an interest therein. During October 1993, JMB/Miami Investors L.P. transferred its interest in JMB/Miami to Urban Shopping Centers, L.P., a partnership controlled by Urban Shopping Centers, Inc. (a corporation organized by an affiliate of the General Partners of the Partnership, which operates in a manner which it expects to enable it to qualify as a real estate investment trust). The total cash investment of JMB/Miami in West Dade is $20,805,000, of which the Partnership's share is $10,402,500. The terms of JMB/Miami partnership agreement provide that annual cash flow, net sale or refinancing proceeds, and tax items will be distributed or allocated, as the case may be, to the Partnership in proportion to its 50% share of capital contributions. At closing, JMB/Miami made a cash payment of $14,567,306 consisting of (i) $13,441,000 for a 33% interest in West Dade and options, exercised in early 1989, to acquire an additional 17% interest in West Dade and (ii) $1,126,306 as a contribution for initial working capital requirements of West Dade. JMB/Miami paid an additional $4,237,694 of purchase price representing payments under the various option agreements entered into at closing, upon exercise of these options in February 1989. The West Dade venture agreement provides that JMB/Miami and the Venture Partner generally are each entitled to receive 50% of profits and losses, net cash flow and net sale or refinancing proceeds of West Dade and are each obligated to advance 50% of any additional funds required under the terms of the West Dade venture agreement. In December 1993, West Dade obtained a new mortgage loan in the principal amount of $47,500,000 replacing the existing first mortgage loan at the property. The new mortgage loan bears interest at 6.91% per annum and matures December 21, 2003. The loan provides for monthly interest-only payments for years one through three and monthly principal and interest payments based on a twenty-year amortization period for years four through ten. The loan permits prepayment in full with 30 days prior written notice and payment of a premium calculated as the greater of (i) 1% of the principal being prepaid multiplied by the percent of months remaining to maturity or (ii) the present value of the loan less principal and accrued interest being prepaid. The non-recourse loan is secured by a first mortgage on the Miami International Mall. After payment of costs and fees related to the refinancing, there were no distributable proceeds from the new loan. JMB INCOME PROPERTIES, LTD. - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED In conjunction with the refinancing in December 1993, West Dade incurred a prepayment penalty on the early retirement of the original loan in the amount $2,015,357, of which the Partnership's share is $503,839. In addition, West Dade had written off costs associated with the original loan in the amount of $69,374, of which the Partnership's share is $17,344. In 1992, West Dade sold land to J.C. Penney to open a department store at the mall. Under the sale agreement, J.C. Penney purchased land from West Dade for approximately $1,260,000, and West Dade expended approximately $894,000 related to land preparation costs in 1990 and 1991. J.C. Penney completed construction of its own facility of 145,824 square feet and opened in late October 1992. During the third quarter of 1992, the property experienced storm damage caused by Hurricane Andrew. Although structural damage to the building was minimal, the landscaping surrounding the building, including the irrigation system and street curbs, was impacted more severely. All repairs necessary to continue operations have been made. The Partnership believes West Dade has adequate insurance coverage for this damage. A claim has been submitted to the property's insurance company for approximately $750,000. In January 1994, a partial settlement of approximately $710,000 of the expected insurance proceeds had been received. West Dade sold a 3.9 acre outparcel of land at Miami International Mall in June 1993 for a net sale price of approximately $1,560,000 after certain selling costs, of which the Partnership's share was approximately $390,000. For financial reporting purposes, West Dade has recognized a gain in 1993 of approximately $1,385,000, of which the Partnership's share is approximately $346,000. For income tax purposes, West Dade has recognized a gain in 1993 of approximately $325,000, of which the Partnership's share is a loss of approximately $37,000. West Dade is currently negotiating the sale of an additional 4 acre outparcel of land. The shopping center is managed by an affiliate of the Venture Partner. The manager is paid an annual fee equal to 4-1/2% of the net operating income of the shopping center. (e) Adams/Wabash On April 19, 1988, an affiliate of the Partnership entered into a forward commitment on behalf of the Partnership to make a total cash investment to a maximum of $25,750,000 in the Adams/Wabash Limited Partnership ("Adams/- Wabash"), which constructed a parking garage and retail space structure (the "Project") in Chicago, Illinois. The Project contains 671 parking spaces and approximately 28,800 square feet of rentable retail area. Through December 31, 1993, the Partnership has funded approximately $24,994,000 of its total cash commitment and does not anticipate increasing its original cash investment. Upon acquisition, the Partnership was admitted to an existing partnership with a 49.9% ownership interest, which increased to 74.9% effective October 1, 1993 pursuant to the terms of the Adams/Wabash Partnership Agreement. The Managing General Partner of the Partnership has a .1% interest with the remaining 25% held by the developers. The Partnership is entitled to a cumulative annual preferred return, payable from operating cash flow, of 10% of its capital contributions to the existing partnership. Payment of the preferred return was guaranteed by one of the joint venture partners through September 30, 1992, except to the extent the Partnership was required to make contributions under the joint venture agreement. Any distributable cash flow JMB INCOME PROPERTIES, LTD. - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED in excess of the Partnership's preferred return will be distributed in accordance with the ownership interests of Adams/Wabash. The Partnership also has a preferred position with respect to distributions of sales and financing proceeds. Items of profit and loss are, in general, allocated in accordance with distributions of cash flow. Accordingly, for financial reporting purposes, for the years ended December 31, 1993, 1992 and 1991, the Partnership was allocated 100% of the operating profits of Adams/Wabash. As of December 31, 1993, the Partnership has received its preferred return. (4) LONG-TERM DEBT (a) Long-term debt consisted of the following at December 31, 1993 and 1992: 1993 1992 ------------ ------------ 10.03% mortgage note; secured by the Rivertree Court Shopping Center located in Vernon Hills (Chicago), Illinois; payable monthly, interest only; due January 1, 1999 . . . . $15,700,000 15,700,000 8.83% mortgage note; secured by the Fountain Valley and Cerritos Industrial Parks located in Fountain Valley and Cerritos, (Los Angeles) California, respectively; payable monthly, interest only; due November 1, 1993 (b). . 11,000,000 11,000,000 ----------- ---------- Total debt . . . . . . . . . . 26,700,000 26,700,000 Less current portion of long-term debt (b). . . . . . -- 11,000,000 ----------- ---------- Total long-term debt . . . . . $26,700,000 15,700,000 =========== ========== (b) Long-Term Debt Refinancing In February 1994, the Partnership extended and increased the first mortgage loan to the principal amount of $11,200,000, which is secured by the Fountain Valley and Cerritos Industrial Parks. The extended loan bears interest at a rate of 7.32% per annum, provides for monthly payments of principal and interest based on a twenty-year amortization period and matures March 1, 2001. After payment of costs and fees related to the refinancing, there were no distributable proceeds from the loan extension. Prior to the extension, the Partnership had entered into a forbearance agreement with the lender providing, among other things, that the lender agreed not to exercise its rights and remedies under the original loan documents from November 2, 1993, the original maturity date, until January 31, 1994. The Partnership continued to pay interest only at an annual rate of 8.83% on the original $11,000,000 principal balance through the effective date of the refinancing. JMB INCOME PROPERTIES, LTD. - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (5) PARTNERSHIP AGREEMENT Pursuant to the terms of the Partnership Agreement, net profits or losses of the Partnership from operations generally are allocated 96% to the Limited Partners and 4% to the General Partners. Profits or losses for Federal income tax purposes from the sale or refinancing of properties generally will be allocated 99% to the Limited Partners and 1% to the General Partners. However, net profits from the sale of properties will be additionally allocated to the General Partners (i) to the extent that cash distributions to the General Partners of sale proceeds from such sale exceed the aforesaid 1% of such profits and (ii) in order to reduce deficits, if any, in the General Partners' capital accounts to a level consistent with the gain anticipated to be realized from the sale of additional properties. The General Partners have made capital contributions to the Partnership aggregating $20,000. The General Partners are not required to make any additional capital contributions except under certain limited circumstances upon dissolution and termination of the Partnership. Disburseable cash from operations, as defined in the Partnership Agreement, will be distributed 90% to the Limited Partners and 10% to the General Partners, subject to certain limitations. Sale or refinancing proceeds will be distributed 100% to the Limited Partners until the Limited Partners have received their contributed capital plus a stipulated return thereon. The General Partners will then receive 100% of the sale or refinancing proceeds until they receive amounts equal to (i) the cumulative deferral of their 10% distribution of disburseable cash and (ii) 2% of the selling prices of all properties which have been sold, subject to certain limitations. Any remaining sale or refinancing proceeds will then be distributed 85% to the Limited Partners and 15% to the General Partners. Accordingly, approximately $3,265,000 of disburseable cash and approximately $618,000 of sale proceeds from Mid Rivers Mall has been deferred by the General Partners (note 7). (6) MANAGEMENT AGREEMENTS - OTHER THAN VENTURES Rivertree Court Shopping Center, Fountain Valley Industrial Park and Cerritos Industrial Park are managed by an affiliate of the Managing General Partner of the Partnership. The fee for managing Rivertree Court is equal to 3% of minimum and percentage rents of the property. The fee for managing the Industrial Parks is equal to 3.75% of gross receipts of the properties. (7) SALE OF MID RIVERS MALL On January 30, 1992, the Partnership, through JMB/Rivers, sold its interest in the Mid Rivers Mall located in St. Peters, Missouri to the unaffiliated joint venture partner. The sale price of the interest was $26,500,000 (before closing costs and prorations) plus the outstanding balance of the mortgages of which JMB/Rivers' share was $35,318,171. The Partnership received in connection with the sale, after all fees, expenses and joint venture partner's participation, a net amount of cash of $13,250,000. For financial reporting purposes, JMB/Rivers had recognized a gain of approximately $12,022,000 in 1992, of which the Partnership's share was approximately $6,366,000. JMB INCOME PROPERTIES, LTD. - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED (8) LEASES As Property Lessor The Partnership and its consolidated venture's principal assets are two multi-tenant industrial building complexes, a shopping center and a parking/retail structure. The Partnership has determined that all leases relating to these properties are properly classified as operating leases; therefore, rental income is reported when earned and the cost of the properties, excluding the cost of the land, is depreciated over their estimated useful lives. Leases with tenants range in term from one to twenty years and provide for fixed minimum rent and partial reimbursement of operating costs. In addition, leases with shopping center tenants provide for additional rent based upon percentages of tenants' sales volumes. With respect to the Partnership's shopping center investments, a substantial portion of the ability of retail tenants to honor their leases is dependent upon the retail economic sector. Cost and accumulated depreciation of the leased assets are summarized as follows at December 31, 1993: Industrial Building Complexes: Cost. . . . . . . . . . . . . . . . . . . $36,956,309 Accumulated depreciation. . . . . . . . . (4,545,732) ----------- 32,410,577 ----------- Shopping Center: Cost. . . . . . . . . . . . . . . . . . . 39,173,543 Accumulated depreciation. . . . . . . . . (5,432,158) ----------- 33,741,385 ----------- Parking/Retail Structure: Cost. . . . . . . . . . . . . . . . . . . 22,390,562 Accumulated depreciation. . . . . . . . . (1,648,298) ----------- 20,742,264 ----------- $86,894,226 =========== Minimum lease payments, including amounts representing executory costs (e.g. taxes, maintenance, insurance) and any related profit, to be received in the future under the operating leases are as follows: 1994. . . . . . . . . . . . . . . . . . . . $ 6,130,496 1995. . . . . . . . . . . . . . . . . . . . 5,558,448 1996. . . . . . . . . . . . . . . . . . . . 4,937,843 1997. . . . . . . . . . . . . . . . . . . . 4,271,664 1998. . . . . . . . . . . . . . . . . . . . 3,414,456 Thereafter. . . . . . . . . . . . . . . . . 17,941,608 ----------- Total. . . . . . . . . . . . . . . . . $42,254,515 =========== JMB INCOME PROPERTIES, LTD. - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED In accordance with the subordination requirements of the Partnership Agreement (note 5), the General Partners have deferred payment of certain of their distributions of net cash flow from the Partnership. All amounts deferred or currently payable do not bear interest. (10) INVESTMENT IN UNCONSOLIDATED VENTURES Summary combined financial information for JMB/Rivers, First Financial and JMB/Miami (note 3) as of and for the years ended December 31, 1993 and 1992 is as follows: 1993 1992 ------------ ------------ Current assets . . . . . . . . . . $ 4,571,308 3,449,168 Other current liabilities. . . . . (975,901) (1,218,915) ------------ ------------ Working capital. . . . . . . . 3,595,407 2,230,253 Investment property, net . . . . . 87,047,194 89,900,221 Other assets, net. . . . . . . . . 2,193,963 2,035,457 Long-term debt . . . . . . . . . . (76,661,145) (74,339,146) Other liabilities. . . . . . . . . (253,238) (212,250) Venture partners' equity . . . . . (5,142,800) (7,774,113) ------------ ------------ Partnership's capital. . . . . $ 10,779,381 11,840,422 ============ ============ Represented by: Invested capital . . . . . . . . $ 32,035,179 31,980,948 Cumulative distributions . . . . (26,933,034) (26,150,584) Cumulative earnings (loss) . . . 5,677,236 6,010,058 ------------ ------------ $ 10,779,381 11,840,422 ============ ============ Total income . . . . . . . . . . . $ 18,281,016 18,104,319 ============ ============ Operating expenses . . . . . . . . $ 18,540,392 19,014,371 ============ ============ Operating loss . . . . . . . . . . $ (259,376) (910,052) ============ ============ Gain on sale of land and property. $ 1,384,831 12,022,339 ============ ============ Extraordinary item . . . . . . . . $ (2,084,731) -- ============ ============ Net income (loss). . . . . . . . . $ (959,276) 11,112,287 ============ ============ JMB INCOME PROPERTIES, LTD. - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONCLUDED Total income, operating expenses and net loss of the above-mentioned ventures for the year ended December 31, 1991 were $26,027,541, $27,409,527 and $1,381,986, respectively. (11) SUBSEQUENT EVENTS (a) Distributions In February 1994, the Partnership paid a distribution of $1,264,140 ($10.00 per interest) to the Limited Partners, $12,769 to the Special Limited Partner and $35,470 to the General Partners. (b) Re-financing In February 1994, the Partnership extended and increased the first mortgage loan to the principal amount of $11,200,000, which is secured by the Fountain Valley and Cerritos Industrial Parks. The extended loan bears interest at a rate of 7.32% per annum, provides for monthly payments of principal and interest based on a twenty-year amortization period and matures March 1, 2001. See note 4(b). Schedule X JMB INCOME PROPERTIES, LTD. - XIII (A LIMITED PARTNERSHIP) AND CONSOLIDATED VENTURE SUPPLEMENTARY INCOME STATEMENT INFORMATION Years ended December 31, 1993, 1992 and 1991 CHARGED TO COSTS AND EXPENSES --------------------------------------------- 1993 1992 1991 ---------- ---------- ---------- Maintenance and repairs. $1,010,757 1,082,912 945,276 Depreciation . . . . . . 2,476,913 2,454,001 2,415,414 Amortization of deferred expenses . . . 175,953 150,274 259,006 Real estate taxes. . . . 1,554,115 1,340,044 1,583,637 ========== ========== ========== ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE There were no changes of, or disagreements with, accountants during fiscal years 1993 and 1992. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE PARTNERSHIP The Managing General Partner of the Partnership is JMB Realty Corporation ("JMB"), a Delaware Corporation. JMB has responsibility for all aspects of the Partnership's operations, subject to the requirement that purchases and sales of real property must be approved by the Associate General Partner of the Partnership, Income Associates-XIII, L.P. an Illinois limited partnership with JMB as the sole general partner. The Associate General Partner shall be directed by a majority in interest of its limited partners (who are generally officers, directors and affiliates of JMB or its affiliates) as to whether to provide its approval of any sale of real property (or any interest therein) of the Partnership. The relationship of the Managing General Partner to its affiliates is described under the caption "Conflicts of Interest" at pages 12-18 of the Prospectus, which description is hereby incorporated herein by reference to Exhibit 3-A to the Partnership's Report on Form 10-K for December 31, 1992 (File No. 000-19496) dated March 18, 1993. The names, positions held and length of service therein of each director and executive officer and certain officers of the Managing General Partner of the Partnership are as follows: SERVED IN NAME OFFICE OFFICE SINCE - ---- ------ ------------ Judd D. Malkin Chairman 5/03/71 Director 5/03/71 Neil G. Bluhm President 5/03/71 Director 5/03/71 Jerome J. Claeys III Director 5/09/88 Burton E. Glazov Director 7/01/71 Stuart C. Nathan Executive Vice President 5/08/79 Director 3/14/73 A. Lee Sacks Director 5/09/88 John G. Schreiber Director 3/14/73 H. Rigel Barber Chief Executive Officer 8/01/93 Jeffrey R. Rosenthal Chief Financial Officer 8/01/93 Gary Nickele Executive Vice President 1/01/92 General Counsel 2/27/84 Ira J. Schulman Executive Vice President 6/01/88 Gailen J. Hull Senior Vice President 6/01/88 Howard Kogen Senior Vice President 1/02/86 Treasurer 1/01/91 There is no family relationship among any of the foregoing directors or officers. The foregoing directors have been elected to serve a one-year term until the annual meeting of the Managing General Partner to be held on June 7, 1994. All of the foregoing officers have been elected to serve one-year terms until the first meeting of the Board of Directors held after the annual meeting of the Managing General Partner to be held on June 7, 1994. There are no arrangements or understandings between or among any of said directors or officers and any other person pursuant to which any director or officer was elected as such. JMB is the corporate general partner of Carlyle Real Estate Limited Partnership-VII ("Carlyle-VII"), Carlyle Real Estate Limited Partnership-IX ("Carlyle-IX"), Carlyle Real Estate Limited Partnership-X ("Carlyle-X"), Carlyle Real Estate Limited Partnership-XI ("Carlyle-XI"), Carlyle Real Estate Limited Partnership-XII ("Carlyle-XII"), Carlyle Real Estate Limited Partnership-XIII ("Carlyle-XIII"), Carlyle Real Estate Limited Partnership-XIV ("Carlyle-XIV"), Carlyle Real Estate Limited Partnership-XV ("Carlyle-XV"), Carlyle Real Estate Limited Partnership-XVI ("Carlyle-XVI"), Carlyle Real Estate Limited Partnership-XVII ("Carlyle-XVII"), JMB Mortgage Partners, Ltd. ("Mortgage Partners"), JMB Mortgage Partners, Ltd.-II ("Mortgage Partners-II"), JMB Mortgage Partners, Ltd.-III ("Mortgage Partners-III"), JMB Mortgage Partners, Ltd.-IV ("Mortgage Partners-IV"), Carlyle Income Plus, Ltd. ("Carlyle Income Plus") and Carlyle Income Plus, Ltd.-II ("Carlyle Income Plus-II") and the managing general partner of JMB Income Properties, Ltd.-IV ("JMB Income-IV"), JMB Income Properties, Ltd.-V ("JMB Income-V"), JMB Income Properties, Ltd.-VI ("JMB Income-VI"), JMB Income Properties, Ltd.-VII ("JMB Income-VII"), JMB Income Properties, Ltd.-VIII ("JMB Income-VIII"), JMB Income Properties, Ltd.-IX ("JMB Income-IX"), JMB Income Properties, Ltd.-X ("JMB Income-X"), JMB Income Properties, Ltd.-XI ("JMB Income-XI") and JMB Income Properties, Ltd.-XII ("JMB Income-XII"). Most of the foregoing directors and officers are also officers and/or directors of various affiliated companies of JMB including Arvida/JMB Managers, Inc. (the general partner of Arvida/JMB Partners, L.P. ("Arvida")), Arvida/JMB Managers-II, Inc. (the general partner of Arvida/JMB Partners, L.P.-II ("Arvida-II") and Income Growth Managers, Inc. (the corporate general partner of IDS/JMB Balanced Income Growth, Ltd. ("IDS/BIG")). Most of such directors and officers are also partners of certain partnerships which are associate general partners in the following real estate limited partnerships: Carlyle-VII, Carlyle-IX, Carlyle-X, Carlyle-XI, Carlyle-XII, Carlyle-XIII, Carlyle-XIV, Carlyle-XV, Carlyle-XVI, Carlyle-XVII, JMB Income-VI, JMB Income-VII, JMB Income-VIII, JMB Income-IX, JMB Income-X, JMB Income-XI, JMB Income-XII, Mortgage Partners, Mortgage Partners-II, Mortgage Partners-III, Mortgage Partners-IV, Carlyle Income Plus, Carlyle Income Plus-II and IDS/BIG. The business experience during the past five years of each such director and officer of the Managing General Partner of the Partnership in addition to that described above is as follows: Judd D. Malkin (age 56) is an individual general partner of JMB Income-IV and JMB Income-V. Mr. Malkin has been associated with JMB since October, 1969. He is a Certified Public Accountant. Neil G. Bluhm (age 56) is an individual general partner of JMB Income-IV and JMB Income-V. Mr. Bluhm has been associated with JMB since August, 1970. He is a member of the Bar of the State of Illinois and a Certified Public Accountant. Jerome J. Claeys III (age 51) (Chairman and Director of JMB Institutional Realty Corporation) has been associated with JMB since September, 1977. He holds a Masters degree in Business Administration from the University of Notre Dame. Burton E. Glazov (age 55) has been associated with JMB since June, 1971 and served as an Executive Vice President of JMB until December of 1990. He is a member of the Bar of the State of Illinois and a Certified Public Accountant. Stuart C. Nathan (age 52) has been associated with JMB since July, 1972. He is a member of the Bar of the State of Illinois. A. Lee Sacks (age 60) (President and Director of JMB Insurance Agency, Inc.) has been associated with JMB since December, 1972. John G. Schreiber (age 47) has been associated with JMB since December, 1970 and served as an Executive Vice President of JMB until December 1990. He holds a Masters degree in Business Administration from Harvard University Graduate School of Business. H. Rigel Barber (age 44) has been associated with JMB since March, 1982. He holds a J.D. degree from the Northwestern Law School and is a member of the Bar of the State of Illinois. Jeffrey R. Rosenthal (age 42) has been associated with JMB since December, 1987. He is a Certified Public Accountant. Gary Nickele (age 41) has been associated with JMB since February, 1984. He holds a J.D. degree from the University of Michigan Law School and is a member of the Bar of the State of Illinois. Ira J. Schulman (age 42) has been associated with JMB since February, 1983. He holds a Masters degree in Business Administration from the University of Pittsburgh. Gailen J. Hull (age 45) has been associated with JMB since March, 1982. He holds a Masters degree in Business Administration from Northern Illinois University and is a Certified Public Accountant. Howard Kogen (age 58) has been associated with JMB since March, 1973. He is a Certified Public Accountant. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The officers and director of the Managing General Partner receive no current or proposed direct remuneration in such capacities. The General Partners of the Partnership are entitled to receive a share of cash distributions, when and as cash distributions are made to the Investors, and a share of profits or losses as described under the caption "Cash Distributions; Allocations of Profits and Losses" at pages A-9 to A-15 of the Partnership Agreement included as an exhibit to the Prospectus, which descriptions are hereby incorporated herein by reference to Exhibit 3-A to the Partnership's Report on Form 10-K for December 31, 1992 (File No. 000-19496) dated March 18, 1993. Reference is also made to Notes 5 and 9 for a description of such transactions, distributions and allocations. In 1993, 1992 and 1991, the General Partners received cash distributions in the amount of $141,879, $141,879 and $154,293, respectively. As of December 31, 1993, the General Partners have deferred payment of distributions in the aggregate amount of $3,265,057. The General Partners of the Partnership may be reimbursed for their direct expenses relating to the offering, the administration of the Partnership and the operation of the Partnership's real property investments. In 1993, an affiliate of the General Partners was due reimbursement for such out-of-pocket expenses in the amount of $11,206, of which $1,122 was unpaid at December 31, 1993. The General Partners may be reimbursed for salaries and direct expenses of officers and employees of the Managing General Partner and its affiliates while directly engaged in the administration of the Partnership and the operation of the Partnership's real property investments. In 1993, the Managing General Partner was due reimbursement for such expenses in the amount of $78,408, all of which was unpaid as of December 31, 1993. An affiliate of the General Partners provided property management services for the Fountain Valley and Cerritos Industrial Parks and the Rivertree Court Shopping Center during 1993. In 1993, such affiliate earned property management fees amounting to $231,529, of which $3,638 was unpaid as of December 31, 1993. JMB Insurance Agency, Inc., an affiliate of the Managing General Partner of the Partnership, earned and received insurance brokerage commissions in 1993 aggregating $10,861 in connection with the providing of insurance coverage for certain of the real property investments of the Partnership. Such commissions are at rates set by insurance companies for the classes of coverage provided. The Partnership is permitted to engage in various transactions involving affiliates of the Managing General Partner of the Partnership, as described under the captions "Compensation and Fees" at pages 8 to 12, and "Conflicts of Interest" at pages 12-19 of the Prospectus, which descriptions are hereby incorporated herein by reference to Exhibit 3-A to the Partnership's Report on Form 10-K for December 31, 1992 (File No. 000-19496) dated March 18, 1993, and under the caption "Rights, Powers and Duties of General Partners" at pages A-17 to A-28 of the Partnership Agreement, included as an exhibit to the Prospectus. The relationship of the Managing General Partner (and its directors and officers) to its affiliates is set forth in Item 10 above and Exhibit 21 hereto. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS There were no significant transactions or business relationships with the Managing General Partner, affiliates or their management other than those described in Items 10 and 11 above. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this report: (1) Financial Statements (See Index to Financial Statements filed with this annual report). (2) Exhibits. 3-A. The Prospectus of the Partnership dated August 20, 1986 as supplemented October 31, 1986 and January 26, 1987 as filed with the Commission pursuant to Rules 424(b) and 424(c) is hereby incorporated herein by reference. Copies of pages 8-19, 64-70, A-7 to A-16, A-34 to A-35 of the Prospectus are hereby incorporated by reference to Exhibit 3-A to the Partnership's Form 10-K dated March 18, 1993. 3-B. Amended and Restated Agreement of Limited Partnership set forth as Exhibit A to the Prospectus, which is hereby incorporated by reference to Exhibit 3-B to the Partnership's From 10-K dated March 18, 1993. 4-A. Copy of documents relating to the mortgage loan secured by the Rivertree Court Shopping Center, Vernon Hills (Chicago), Illinois dated December 30, 1988 is hereby incorporated by reference to Exhibit 4-A to the Partnership's Form 10-K dated March 18, 1993. 4-B. Copy of documents relating to the mortgage loan secured by a first mortgage on West Dade's interest in Miami International Mall, Miami, Florida dated December 21, 1993 is filed herewith. 10-A. Acquisition documents relating to the purchase by the Partnership of Rivertree Court Shopping Center in Vernon Hills (Chicago), Illinois, are hereby incorporated by reference to Exhibit 1 to the Partnership's Form 8-K dated November 4, 1988. 10-B. Acquisition documents relating to the purchase by the Partnership of Fountain Valley Industrial Buildings in Fountain Valley, California and Cerritos Industrial Buildings in Cerritos, California, are hereby incorporated by reference to Exhibits 1 and 2 to the Partnership's Form 8-K dated November 15, 1988. 10-C. Acquisition documents relating to the acquisition by the Partnership of an interest in the Adams/Wabash Parking Garage in Chicago, Illinois are hereby incorporated by reference to Exhibit 3 to the Partnership's Form 8-K dated October 15, 1990. 10-D. Sale documents and exhibits thereto relating to the sale of the Partnership's interest in Mid Rivers Mall in St. Peters (St. Louis), Missouri are hereby incorporated by reference to the Partnership's Report on Form 8-K dated February 18, 1992. 21. List of Subsidiaries. 24. Powers of Attorney Although certain long-term debt instruments of the Registrant have been excluded from Exhibit 4 above, pursuant to Rule (b)(4)(iii), the Registrants commits to provide copies of such agreements to the Securities and Exchange Commission upon request. (b) No reports on Form 8-K were required to be filed during the last quarter of the period covered by this annual report. No annual report or proxy material for the fiscal year 1993 has been sent to the Partners of the Partnership. An annual report will be sent to the Partners subsequent to this filing. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Act of 1934, the Partnership has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. JMB INCOME PROPERTIES, LTD. - XIII By: JMB Realty Corporation Managing General Partner GAILEN J. HULL By: Gailen J. Hull Senior Vice President Date:March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. By: JMB Realty Corporation Managing General Partner JUDD D. MALKIN* By: Judd D. Malkin, Chairman and Director Date:March 25, 1994 NEIL G. BLUHM* By: Neil G. Bluhm, President and Director Date:March 25, 1994 H. RIGEL BARBER* By: H. Rigel Barber, Chief Executive Officer Date:March 25, 1994 JEFFREY R. ROSENTHAL* By: Jeffrey R. Rosenthal, Chief Financial Officer Principal Financial Officer Date:March 25, 1994 GAILEN J. HULL By: Gailen J. Hull, Senior Vice President Principal Accounting Officer Date:March 25, 1994 A. LEE SACKS* By: A. Lee Sacks, Director Date:March 25, 1994 STUART C. NATHAN* By: Stuart C. Nathan, Executive Vice President and Director Date:March 25, 1994 *By: GAILEN J. HULL, Pursuant to a Power of Attorney GAILEN J. HULL By: Gailen J. Hull, Attorney-in-Fact Date:March 25, 1994 JMB INCOME PROPERTIES, LTD. - XIII EXHIBIT INDEX DOCUMENT INCORPORATED BY REFERENCE PAGE ------------ ---- 3-A. Pages 8-19, 64-70, A-7 to A-16, A-34 to A-35 of the Prospectus of the Partnership dated August 20, 1986, as supplemented on October 31, 1986, and January 26, 1987 Yes 3-B. Amended and Restated Agreement of Limited Partnership Yes 4-A. Mortgage loan agreement related to the Rivertree Court Shopping Center Yes 4-B. Mortgage loan agreement related to West Dade No 10-A. Acquisition documents relating to the Rivertree Court Shopping Center Yes 10-B. Acquisition documents relating to the Fountain Valley Industrial Buildings and Cerritos Industrial Buildings Yes 10-C. Acquisition documents relating to the Adams/Wabash Parking Garage Yes 10-D. Sale documents relating to the Mid Rivers Mall Yes 21. List of Subsidiaries No 24. Powers of Attorney No

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS There were no significant transactions or business relationships with the Managing General Partner, affiliates or their management other than those described in Items 10 and 11 above. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this report: (1) Financial Statements (See Index to Financial Statements filed with this annual report). (2) Exhibits. 3-A. The Prospectus of the Partnership dated August 20, 1986 as supplemented October 31, 1986 and January 26, 1987 as filed with the Commission pursuant to Rules 424(b) and 424(c) is hereby incorporated herein by reference. Copies of pages 8-19, 64-70, A-7 to A-16, A-34 to A-35 of the Prospectus are hereby incorporated by reference to Exhibit 3-A to the Partnership's Form 10-K dated March 18, 1993. 3-B. Amended and Restated Agreement of Limited Partnership set forth as Exhibit A to the Prospectus, which is hereby incorporated by reference to Exhibit 3-B to the Partnership's From 10-K dated March 18, 1993. 4-A. Copy of documents relating to the mortgage loan secured by the Rivertree Court Shopping Center, Vernon Hills (Chicago), Illinois dated December 30, 1988 is hereby incorporated by reference to Exhibit 4-A to the Partnership's Form 10-K dated March 18, 1993. 4-B. Copy of documents relating to the mortgage loan secured by a first mortgage on West Dade's interest in Miami International Mall, Miami, Florida dated December 21, 1993 is filed herewith. 10-A. Acquisition documents relating to the purchase by the Partnership of Rivertree Court Shopping Center in Vernon Hills (Chicago), Illinois, are hereby incorporated by reference to Exhibit 1 to the Partnership's Form 8-K dated November 4, 1988. 10-B. Acquisition documents relating to the purchase by the Partnership of Fountain Valley Industrial Buildings in Fountain Valley, California and Cerritos Industrial Buildings in Cerritos, California, are hereby incorporated by reference to Exhibits 1 and 2 to the Partnership's Form 8-K dated November 15, 1988. 10-C. Acquisition documents relating to the acquisition by the Partnership of an interest in the Adams/Wabash Parking Garage in Chicago, Illinois are hereby incorporated by reference to Exhibit 3 to the Partnership's Form 8-K dated October 15, 1990. 10-D. Sale documents and exhibits thereto relating to the sale of the Partnership's interest in Mid Rivers Mall in St. Peters (St. Louis), Missouri are hereby incorporated by reference to the Partnership's Report on Form 8-K dated February 18, 1992. 21. List of Subsidiaries. 24. Powers of Attorney Although certain long-term debt instruments of the Registrant have been excluded from Exhibit 4 above, pursuant to Rule (b)(4)(iii), the Registrants commits to provide copies of such agreements to the Securities and Exchange Commission upon request. (b) No reports on Form 8-K were required to be filed during the last quarter of the period covered by this annual report. No annual report or proxy material for the fiscal year 1993 has been sent to the Partners of the Partnership. An annual report will be sent to the Partners subsequent to this filing. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Act of 1934, the Partnership has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. JMB INCOME PROPERTIES, LTD. - XIII By: JMB Realty Corporation Managing General Partner GAILEN J. HULL By: Gailen J. Hull Senior Vice President Date:March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. By: JMB Realty Corporation Managing General Partner JUDD D. MALKIN* By: Judd D. Malkin, Chairman and Director Date:March 25, 1994 NEIL G. BLUHM* By: Neil G. Bluhm, President and Director Date:March 25, 1994 H. RIGEL BARBER* By: H. Rigel Barber, Chief Executive Officer Date:March 25, 1994 JEFFREY R. ROSENTHAL* By: Jeffrey R. Rosenthal, Chief Financial Officer Principal Financial Officer Date:March 25, 1994 GAILEN J. HULL By: Gailen J. Hull, Senior Vice President Principal Accounting Officer Date:March 25, 1994 A. LEE SACKS* By: A. Lee Sacks, Director Date:March 25, 1994 STUART C. NATHAN* By: Stuart C. Nathan, Executive Vice President and Director Date:March 25, 1994 *By: GAILEN J. HULL, Pursuant to a Power of Attorney GAILEN J. HULL By: Gailen J. Hull, Attorney-in-Fact Date:March 25, 1994 JMB INCOME PROPERTIES, LTD. - XIII EXHIBIT INDEX DOCUMENT INCORPORATED BY REFERENCE PAGE ------------ ---- 3-A. Pages 8-19, 64-70, A-7 to A-16, A-34 to A-35 of the Prospectus of the Partnership dated August 20, 1986, as supplemented on October 31, 1986, and January 26, 1987 Yes 3-B. Amended and Restated Agreement of Limited Partnership Yes 4-A. Mortgage loan agreement related to the Rivertree Court Shopping Center Yes 4-B. Mortgage loan agreement related to West Dade No 10-A. Acquisition documents relating to the Rivertree Court Shopping Center Yes 10-B. Acquisition documents relating to the Fountain Valley Industrial Buildings and Cerritos Industrial Buildings Yes 10-C. Acquisition documents relating to the Adams/Wabash Parking Garage Yes 10-D. Sale documents relating to the Mid Rivers Mall Yes 21. List of Subsidiaries No 24. Powers of Attorney No

94601_1993.txt

94601

1993

Item 1. Business. Registrant was incorporated as a Delaware corporation in 1929. Registrant, through its subsidiaries, is principally engaged in providing professional engineering, construction and consulting services. The Stone & Webster organization also owns cold storage warehousing facilities in Atlanta and Rockmart, Georgia; owns and operates the Stone & Webster office buildings in Boston, Massachusetts, Cherry Hill, New Jersey, and Houston, Texas; owns natural gas and oil production facilities in Texas, Louisiana and the Province of Alberta, Canada; explores for natural gas and oil in the United States and Canada; owns mineral interests in the United States and Canada; owns and operates natural gas gathering and transporting systems and compressor stations in the Southwest; and is developing for rental or sale a major corporate office and business center in Tampa, Florida. Services of the nature inherent in these businesses are provided to clients and customers. The information relating to the business segments of the registrant required by this Item is filed herewith under "Business Segment Information" of the Financial Information section included in Appendix A to this report. This information indicates the amounts of gross earnings from sales to unaffiliated customers, operating profit and identifiable assets attributable to the registrant's industry segments for the three years ended December 31, 1993. Engineering, Construction and Consulting Services Registrant, through its subsidiaries, provides complete engineering, design, construction and full environmental services for petrochemical, refining, power, industrial, governmental, transportation and civil works projects. It also constructs from plans developed by others, makes engineering reports and business examinations, undertakes consulting engineering work, and offers information management and computer systems expertise to clients. It also offers a full range of services in environmental engineering and sciences, including complete execution of environmental projects. It remains active in the nuclear power business, for utility and governmental clients, and continues to undertake a significant amount of modification and maintenance work on existing nuclear power plants. In addition, it offers advanced computer systems development services and products in the areas of plant scheduling, information systems, systems integration, computer-aided design, expert systems, and database management. It also develops projects in the power and other industries in which registrant or its subsidiaries may take an ownership position and for which other subsidiaries may provide engineering, construction, management and operation and maintenance services. Comprehensive management consulting and financial services are also furnished for business and industry, Form 10-K 1993 Stone & Webster, Incorporated Item 1. Business. (Cont'd.) Engineering, Construction and Consulting Services (Cont'd.) including public utility, transportation, pipeline, land development, banking, petroleum and manufacturing companies and government agencies, and appraisals are performed for industrial companies and utilities. Cold Storage Services Modern public cold storage warehousing, blast-freeze and other refrigeration and consolidation services are offered in the Atlanta, Georgia metropolitan area to food processors and others at three facilities with approximately 21.1 million cubic feet of freezer and controlled temperature storage space, including a facility in Rockmart, Georgia which has approximately 3.5 million cubic feet of freezer and controlled temperature storage space. Offices and processing areas are leased to customers. Comprehensive freezer services are offered to customers. The Rockmart site has sufficient land to allow for future expansion and to make additional space available to food processors. In addition, the facility features direct loading of product onto distribution trucks from railroad cars delivered on two railroad lines which serve the Rockmart plant. Other Building operating services are performed for office buildings at 245 Summer Street and 51 Sleeper Street, Boston, Massachusetts, and at 3 Executive Campus, Cherry Hill, New Jersey. These buildings are occupied by subsidiaries of registrant or held for rental to others. In addition, a new office building occupied by subsidiaries of registrant is located at 1430 Enclave Parkway, Houston, Texas. Building operating services are also performed at this location. Natural gas and oil production properties are owned and operated in Texas; exploration for and development of natural gas and oil properties are carried out in the United States and Canada; interest in a natural gas and oil lease offshore Texas is also owned; and working interests are held in natural gas and oil properties in Texas and in western Canada. Natural gas gathering and transporting systems are owned and operated in fee and in partnership with others, and related services are provided, in Texas, Louisiana and Oklahoma. Since the latter part of 1988, contract drilling operations which had been provided to oil and gas operators in the area around Victoria, Texas had been suspended due to unfavorable market conditions. During 1993, this operation was terminated and the drilling rigs were sold. Form 10-K 1993 Stone & Webster, Incorporated Item 1. Business. (Cont'd.) Other (Cont'd.) A large corporate office and business center is being developed in Tampa, Florida. Commercial, industrial and other properties are held for sale and for lease. Competition The principal business activities of registrant in the engineering, construction and consulting services segment are highly competitive, with competition from a large number of well- established concerns, some privately held and others publicly held. Inasmuch as registrant is primarily a service organization, it competes in its areas of interest by providing services of the highest quality. Registrant believes it occupies a strong competitive position but is unable to estimate with reasonable accuracy the number of its competitors and its competitive position in the engineering, construction and consulting services industry. The business activities of registrant in the cold storage services segment are performed in the Atlanta and northwestern areas of Georgia. Competition in this market area comes from a relatively small number of companies offering similar types of services. Registrant's subsidiary competes in this field by providing services of the highest quality, emphasizing responsiveness to the needs of its customers and to the end receiver of the customers' product. As part of that commitment, it provides modern data processing and communication equipment for its customers. Registrant believes it occupies a strong competitive position in this area. Backlog Backlog figures for the registrant's engineering, construction and consulting services segment are not considered to be indicative of any trend in these activities nor material for an understanding of its business. At any given date, the portion of engineering and construction work to be completed within one year can only be estimated subject to adjustments, which can in some instances be substantial, based on a number of factors, and the aggregate of such figures in relation to registrant's consolidated earnings would be misleading. Backlog figures in the cold storage industry are not necessarily meaningful because of the nature of the food processing, storage and distribution system which requires continual monitoring to preserve food quality. Form 10-K 1993 Stone & Webster, Incorporated Item 1. Business. (Cont'd.) Clients Although registrant's subsidiaries in the engineering, construction and consulting services segment have numerous clients and registrant historically has not had a continuing dependence on any single client, one or a few clients may contribute a substantial portion of the registrant's consolidated gross earnings in any one year or over a period of several consecutive years due to the size of major engineering and construction projects and the progress accomplished on those projects in that year or period of consecutive years. The registrant's business is not necessarily dependent upon sustaining, and the registrant does not necessarily expect to sustain, in future years the level of gross earnings contributed by a particular client in any given year or period of consecutive years. Historically the registrant has provided ongoing services to clients following completion of major projects for them. Once the registrant or one of its subsidiaries commences work on a particular project, it is unlikely that the client would terminate the involvement of the registrant or its subsidiary prior to completion of the project. Nonetheless, the registrant must obtain new engineering and construction projects, whether from existing clients or new clients, in order to generate gross earnings in future years as existing projects are completed. Consequently, the registrant does not consider the names of clients to be material to investors' understanding of the registrant's business taken as a whole. The engineering, construction and consulting services segment had one client who accounted for 17% of consolidated gross earnings in 1993 and no client who accounted for 10% or more of consolidated gross earnings in 1992 or 1991. The cold storage and related activities segment had no client who accounted for 10% or more of consolidated gross earnings in 1993, 1992, or 1991. Environmental Compliance Compliance by registrant and its subsidiaries with Federal, State and local provisions regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, has had, and is expected to have, no material adverse effect upon the capital expenditures, earnings and competitive position of registrant and its subsidiaries. The engineering, construction and consulting services segment has benefitted from the extensive amount of environmental legislation and regulatory activity now in place because the effect of such regulations on the businesses of the segment's clients has increased the demand for environmental services Form 10-K 1993 Stone & Webster, Incorporated Item 1. Business. (Cont'd.) Environmental Compliance (Cont'd.) provided by registrant's subsidiaries. This demand for such services to help clients in their own environmental compliance efforts is expected to continue. Employees The registrant and its subsidiaries had approximately 6,000 regular employees as of December 31, 1993. In addition, there are at times several thousand craft employees employed on projects by subsidiaries of registrant. The number of such employees varies in relation to the number and size of the projects actually undertaken at any particular time. Form 10-K 1993 Stone & Webster, Incorporated Item 1. Business. (Cont'd.) Executive and Other Officers of the Registrant. Name Age Position Held Held Since William F. Allen, Jr. 74 Chairman of the Board 1/1/88 Chief Executive Officer 5/21/86 Director 2/19/86 Bruce C. Coles 49 President 6/20/90 Director 6/20/90 William M. Egan 65 Executive Vice President 2/19/86 Director 10/1/91 James N. White 59 Executive Vice President 1/1/92 Kenneth F. Reinschmidt 55 Senior Vice President 7/1/93 Raymond F. Rugg 50 Vice President 1/1/93 Robert F. Gallagher 59 Treasurer 5/20/70 Vice President 5/15/91 Joel A. Skidmore 64 Secretary 9/16/81 Each of the executive and other officers listed above has held executive or administrative positions with the registrant or one or more of its subsidiaries for at least the last five years. Each officer was elected to hold office until the first meeting of the Board of Directors after the next Annual Meeting of the Stockholders and until his successor is duly elected and qualified. The next Annual Meeting of Stockholders is scheduled to be held May 12, 1994. The Board of Directors of the registrant has approved a plan to elect Bruce C. Coles Chief Executive Officer and President after the next Annual Meeting of Stockholders, and William F. Allen, Jr. will remain Chairman of the Board. Form 10-K 1993 Stone & Webster, Incorporated Item 2.

Item 2. Properties. The important physical properties of registrant and its subsidiaries are as follows: A. A 14 story office building with approximately 800,000 square feet of office space at 245 Summer Street, Boston, Massachusetts, which serves as engineering headquarters for the organization and is approximately 65% occupied by registrant's subsidiaries with the balance held for rental to others. B. An 8 story office building with approximately 140,000 square feet of office space at 51 Sleeper Street, Boston, Massachusetts which is held for rental to others. C. A 6 story office building with approximately 450,000 square feet of office space at 3 Executive Campus, Cherry Hill, New Jersey, which is approximately 50% occupied by registrant's subsidiaries with the balance held for rental to others. D. A 6 story office building with approximately 320,000 square feet of office space at 1430 Enclave Parkway, Houston, Texas is substantially occupied by subsidiaries of registrant. E. Approximately 17.6 million cubic feet of cold storage plant in two facilities in Atlanta, Georgia, and approximately 3.5 million cubic feet of cold storage space in a third facility near Rockmart, Georgia. F. Twelve facilities consisting of natural gas gathering and transporting systems and compressor stations in Texas, Louisiana and Oklahoma, including six systems the ownership of which is shared with others. G. Approximately 237 acres in or near a corporate office and business center being developed by a subsidiary of registrant in Tampa, Florida, including 10 buildings owned by subsidiaries of registrant comprising approximately 440,000 square feet of space, a 50% interest in a limited partnership owning an office building with approximately 130,000 square feet of space, and approximately 190 acres of developed and vacant land, all of which is held for sale or rental to others. Except as specified above, all of the properties listed above are owned in fee by subsidiaries of the registrant. In addition to the foregoing, registrant and its subsidiaries occupy office space in various cities, in premises leased from others for varying periods - both long and short term - the longest of which extends to 2008. Form 10-K 1993 Stone & Webster, Incorporated Item 3.

Item 3. Legal Proceedings. (a) As set forth in Part II, Item 1 of registrant's Form 10-Q for the quarter ended September 30, 1993, in 1987 Long Island Lighting Co. ("LILCO") filed an amended complaint in the action entitled "Long Island Lighting Co. v. IMO Delaval, Inc. and Stone & Webster Engineering Corporation" for the purpose of asserting additional claims against IMO Delaval, Inc. ("Delaval") and for the purpose of naming Stone & Webster Engineering Corporation ("SWEC"), a subsidiary of the registrant, as a party defendant. The claims arose out of the sale by Delaval to LILCO of certain emergency diesel generators for use at LILCO's Shoreham Nuclear Power Station ("Shoreham") and alleged that these generators were defective in a number of ways. SWEC had rendered engineering services to LILCO in connection with its purchase of these diesel generators. The claims against SWEC in this action were dismissed by the trial court based on SWEC's contractual defenses. At the conclusion of trial on the underlying action against Delaval, LILCO appealed the dismissal of SWEC to the Second Circuit Court of Appeals. On September 22, 1993, the appellate court affirmed the dismissal of LILCO's claims against SWEC. On August 5, 1991, LILCO instituted an action against SWEC in the United States District Court for the Eastern District of New York for damages arising out of SWEC's alleged deficient performance in connection with the design and construction of Shoreham which was claimed to have increased the costs of building Shoreham. The amount of damages being sought was not specified in the complaint, but LILCO estimated its damages to be approximately $725 million. On December 13, 1993, in light of the decision of the Second Circuit Court of Appeals referred to above, the District Court dismissed this complaint against SWEC. LILCO has announced that an appeal will not be taken. SWEC believes that this decision should end the litigation against SWEC with respect to Shoreham. Form 10-K 1993 Stone & Webster, Incorporated Item 3. Legal Proceedings. (Cont'd) (b) Stone & Webster Engineering Corporation has been named as a defendant, along with numerous other defendants, in a number of complaints which seek damages arising out of alleged personal injuries and/or wrongful death due to exposure to asbestos products negligently utilized by the defendants. As stated in Part I, Item 3. of registrant's Form 10-K for the year ended December 31, 1992, on March 18, 1991, SWEC was impleaded into approximately 750 asbestos- related cases pending in the United States District Court for the Eastern District of New York. SWEC has settled substantially all of these cases, as well as other cases in New York courts, for amounts which, when taken together, do not have a material impact on registrant's financial condition or results of operations. These settlements substantially reduce the number of New York State cases involving SWEC. SWEC believes that it has strong factual and legal defenses to the remaining claims and intends to defend vigorously. (c) Stone & Webster Engineering Corporation provided design engineering services to Chesapeake Paper Products Company in Virginia in connection with a plant expansion. After the completion of SWEC's services on its contract, Chesapeake made a claim against SWEC in the amount of approximately $5,000,000, claiming additional expenses due to design defects associated with the structural electrical and mechanical design of the boiler and evaporator. In April of 1993, Chesapeake brought suit against SWEC in the United States District Court for the Eastern District of Virginia. SWEC denied Chesapeake's allegations, claiming that it did not owe Chesapeake anything, and instead, by way of counterclaim, that Chesapeake owed SWEC $1,479,258 for the balance due for its services on the project. The case was tried before a jury and completed on December 8, 1993. At the close of the plaintiff's case, the Court directed a verdict on SWEC's counterclaim in favor of SWEC for approximately $1,580,000. Chesapeake's claim proceeded through trial and was submitted to the jury. The jury returned a verdict in favor of Chesapeake and against SWEC for $4,655,642. Form 10-K 1993 Stone & Webster, Incorporated Item 3. Legal Proceedings. (Cont'd) SWEC believes there are substantial grounds for setting aside the jury verdict against SWEC, and for ordering a new trial. SWEC has moved for a new trial on Chesapeake's claim and, if denied, intends to appeal to the Fourth Circuit Court of Appeals. (d) In November 1990, Stone & Webster Engineering Corporation commenced an action, now pending in the United States District Court for the District of Massachusetts, against Northbrook Insurance Company, several other insurance companies and certain other parties. The complaint sought monetary damages, attorneys' fees and costs, and a declaration that the insurance company defendants must defend and indemnify SWEC against claims asserted against it in another lawsuit. Although the underlying lawsuit was settled in March 1991, SWEC is continuing its suit seeking damages, attorneys' fees and other monetary relief relating to its defense of such underlying lawsuit. No provision has been made in the financial statements of registrant for any potential recoverable amounts. (e) Also see Note (K) to the consolidated financial statements as set forth under "Notes to Consolidated Financial Statements" of the Financial Information section filed herewith in Appendix A to this report. Item 4.

Item 4. Submission of Matters to a Vote of Security-Holders. None. PART II Item 5.

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. The information required by Item 5 is filed herewith under "Market and Dividend Information" of the Financial Information section included in Appendix A to this report. Item 6.

Item 6. Selected Financial Data. The information required by Item 6 is filed herewith under "Selected Financial Data" of the Financial Information section included in Appendix A to this report. Form 10-K 1993 Stone & Webster, Incorporated Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The information required by Item 7 is filed herewith under "Management's Discussion and Analysis of Financial Condition and Results of Operations" of the Financial Information section included in Appendix A to this report. Item 8.

Item 8. Financial Statements and Supplementary Data. The information required by Item 8 is filed herewith under the Consolidated Financial Statements of Stone & Webster, Incorporated and Subsidiaries together with the report of Coopers & Lybrand dated February 15, 1994 of the Financial Information section included in Appendix A to this report. Item 9.

Item 9. Changes In and Disagreements With Accountants on Accounting and Financial Disclosure. Not applicable. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant. In accordance with General Instruction G(3) to Form 10-K, the information called for in this Item 10 with respect to Directors is not presented here since such information is included in the definitive proxy statement which involves the election of directors which will be filed pursuant to Regulation 14A not later than 120 days after the close of the fiscal year, and such information is hereby incorporated by reference from Part I of such proxy statement. See also the section captioned "Executive and Other Officers of the Registrant" under Item 1 of Part I herein. Item 11.

Item 11. Executive Compensation. In accordance with General Instruction G(3) to Form 10-K, the information called for in this Item 11 is not presented here since such information is included in the definitive proxy statement which involves the election of directors which will be filed pursuant to Regulation 14A not later than 120 days after the close of the fiscal year, and such information is hereby incorporated by reference from Part I of such proxy statement, except that the information included therein which is not required to be "filed" in accordance with Regulation S-K, Item 402(a)(8), including the Report of the Compensation Committee and the Performance Graph, is not incorporated by reference as part of this report on Form 10-K. Form 10-K 1993 Stone & Webster, Incorporated Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management. In accordance with General Instruction G(3) to Form 10-K, the information called for in this Item 12 is not presented here since such information is included in the definitive proxy statement which involves the election of directors which will be filed pursuant to Regulation 14A not later than 120 days after the close of the fiscal year, and such information is hereby incorporated by reference from Part I of such proxy statement. Item 13.

Item 13. Certain Relationships and Related Transactions. In accordance with General Instruction G(3) to Form 10-K, the information called for in this Item 13 is not presented here since such information is included in the definitive proxy statement which involves the election of directors which will be filed pursuant to Regulation 14A not later than 120 days after the close of the fiscal year, and such information is hereby incorporated by reference from Part I of such proxy statement. Form 10-K 1993 Stone & Webster, Incorporated PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) Documents filed as part of the report: 1. Financial Statements and Financial Statement Schedules The following items appear in the Financial Information section included as Appendix A to this report: Management's Discussion and Analysis of Financial Condition and Results of Operations Financial Statements: Consolidated Statement of Income for the Three Years Ended December 31, 1993 Consolidated Balance Sheet as at December 31, 1993 and 1992 Consolidated Statement of Stockholders' Equity for the Three Years Ended December 31, 1993 Consolidated Statement of Cash Flows for the Three Years Ended December 31, 1993 Summary of Significant Accounting Policies Notes to Consolidated Financial Statements Selected Financial Data Market and Dividend Information Report of Management Business Segment Information Financial Statement Schedules: Financial Statement Schedule as at December 31, 1993: I - Marketable Securities - Other Security Investments Financial Statement Schedules for the Three Years Ended December 31, 1993: V - Property, Plant and Equipment VI - Accumulated Depreciation, Depletion and Amortization of Property, Plant and Equipment IX - Short-Term Borrowings X - Supplementary Income Statement Information Form 10-K 1993 Stone & Webster, Incorporated Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. 1. Financial Statements and Financial Statement Schedules (Cont'd.) Report of Independent Accountants 2. Exhibits: (3) Articles of Incorporation and By-laws - (i) The Restated Certificate of Incorporation of registrant which appears in Exhibit (3)(a) to registrant's Form 10-K for the fiscal year ended December 31, 1990 is hereby incorporated by reference. (ii) The By-laws of registrant, as amended, are filed herewith as Exhibit (3)(ii). (4) Instruments defining the rights of security holders, including indentures - As of December 31, 1993, registrant and its subsidiaries had outstanding long- term debt (excluding current portion) totaling approximately $47,739,000 principally in connection with mortgages relating to real property for a subsidiary's corporate office and business center in Tampa, Florida and for two other subsidiaries' office buildings, and in connection with capitalized lease commitments for the acquisition of certain computer equipment. These agreements are not filed herewith because the total amount of indebtedness authorized thereunder does not exceed 10% of the total assets of the registrant and its subsidiaries on a consolidated basis; the registrant hereby undertakes to furnish copies of such agreements to the Commission upon request. Form 10-K 1993 Stone & Webster, Incorporated Item 14. Exhibits, Financial Statement Schedules, and Report on Form 8-K. 2. Exhibits: (Cont'd.) (10) Material contracts - (a) The Restricted Stock Plan of Stone & Webster, Incorporated, approved by the Stockholders of registrant in 1976, as amended and approved by the Stockholders of registrant in 1988, and the form of grant under the Restricted Stock Plan, which appear in Exhibit (10)(a) to registrant's Form 10-K for the fiscal year ended December 31, 1988 are hereby incorporated by reference. (b) Form of letter agreement between registrant and certain officers relating to other benefits which appears in Exhibit (10)(c) to registrant's Form 10-K for the fiscal year ended December 31, 1986 (File No. 1-1228) filed with the Commission on March 5, 1987 is hereby incorporated by reference. (21) Subsidiaries of the registrant. (23) Consent of Independent Accountants. (b) Reports on Form 8-K Registrant did not file any reports on Form 8-K during the last quarter of the period covered by this report. Form 10-K 1993 Stone & Webster, Incorporated SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. STONE & WEBSTER, INCORPORATED By WILLIAM M. EGAN William M. Egan Executive Vice President Date: February 16, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. February 16, 1994 WILLIAM F. ALLEN, JR. William F. Allen, Jr. Chairman of the Board Chief Executive Officer Director " WILLIAM M. EGAN William M. Egan Executive Vice President Director (Principal Financial and Accounting Officer) " BRUCE C. COLES Bruce C. Coles President Director " WILLIAM L. BROWN William L. Brown Director Form 10-K 1993 Stone & Webster, Incorporated February 16, 1994 HOWARD L. CLARK Howard L. Clark Director " DONNA R. FITZPATRICK Donna R. Fitzpatrick Director " J. PETER GRACE J. Peter Grace Director " KENT F. HANSEN Kent F. Hansen Director " JOHN A. HOOPER John A. Hooper Director " J. ANGUS McKEE J. Angus McKee Director " KENNETH G. RYDER Kenneth G. Ryder Director " MEREDITH R. SPANGLER Meredith R. Spangler Director " FRED D. THOMPSON Fred D. Thompson Director Form 10-K 1993 Stone & Webster, Incorporated APPENDIX A STONE & WEBSTER, INCORPORATED AND SUBSIDIARIES INDEX TO FINANCIAL INFORMATION APPENDIX Schedules other than those listed above have been omitted because the required information is included in the consolidated financial statements or notes to consolidated financial statements, or is not applicable or not required. A-1 STONE & WEBSTER, INCORPORATED AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (All dollar amounts are in thousands.) RESULTS OF OPERATIONS 1993 Compared With 1992. Consolidated gross earnings were $279,792 for 1993, a slight increase over 1992, after excluding profits on investment securities of $4,398 in 1992. Consolidated operating and general expenses increased by $1,047 in 1993, before a $9,081 charge for the Incentive Retirement Program, a $4,000 charge for a judgment against a subsidiary of the Corporation and a foreign pension curtailment gain of $1,072. Gross earnings from our domestic engineering, construction and consulting services decreased by $6,550 in 1993 primarily due to the completion of a number of assignments coupled with delays in the start-up of replacement work. Many of our new assignments are executed under multiyear contracts, and there can be a long time lag between the award date and the authorization by the client to initiate start-up. Operating and general expenses of our domestic engineering, construction and consulting services increased by $4,994, before a $9,081 charge for the Incentive Retirement Program and a $4,000 charge for a judgment against a subsidiary, primarily due to higher employee carrying costs for billable staff who could not be assigned to projects and an increase in severance costs of $2,509 as a result of reduced workload. We previously reported that in excess of 200 employees elected to retire under the Incentive Retirement Program which, based on their payroll and related expenses, should have resulted in an estimated on-going annual savings of $18,000. However, this annualized savings will not necessarily result in increased net income since our workload dropped in the second half of 1993 and some staff could not be placed on billable projects as expected. Gross earnings of our foreign subsidiaries' engineering, construction and consulting services increased by $1,988 in 1993 primarily due to the favorable impact of several contract change orders and the attainment of milestones on two substantially completed foreign projects partially offset by a decrease in gross earnings from our United Kingdom subsidiary primarily due to a lack of new work. Operating and general expenses of our foreign subsidiaries' engineering, construction and consulting services decreased by $2,976 in 1993 before a pension curtailment gain of $1,072. This decrease which was primarily due to a reduction in contract staff costs in our United Kingdom subsidiary was partially offset by higher severance costs of $1,448 associated with staff reductions. There continues to be a lack of major new projects due to the slower than expected economic recovery. The intense competition for new work has resulted in lower profit margins on the projects awarded. These factors, combined with delays in the start-up of new work, adversely affected our engineering, construction and consulting operations in 1993 and will negatively impact financial results for the first half of 1994. We have placed increased emphasis on international work while adapting to the changing domestic business environment. There has been an increase in the amount of new work awarded to our engineering, construction and consulting operations during 1993, and we anticipate improved performance later in 1994 and continuing into 1995. Gross earnings from cold storage and related activities increased by $1,216 primarily due to increases in storage and handling revenue. Operating and general expenses of our cold storage and related activities increased by $107. Gross earnings from our oil and gas interests decreased by $381 in 1993 primarily due to a decline in the number of gas marketing sales by our natural gas gathering and transporting company due to competitive factors. Partially offsetting this decrease was the favorable effect on gross earnings of an increase in the average gas price received by our other oil and gas interests. Operating and general expenses of our oil and gas interests decreased in 1993 by $804 primarily due to a decline in the number of gas marketing sales and a corresponding decrease in the purchases of gas for resale. Gross earnings from dividends and interest decreased by $649 in 1993 due to reduced interest income on U.S. Government securities, reflecting lower interest rates. Gross earnings from all other activities increased by $5,469 in 1993 due principally to higher rental income on company-owned office buildings in the Northeast, previously used for engineering operations. Our real estate operations in Tampa, Florida, continued to be affected by the adverse conditions prevailing in the commercial real estate market in the United States. Operating results in 1993 showed a slight improvement over 1992. A-2 STONE & WEBSTER, INCORPORATED AND SUBSIDIARIES The effective tax rates for 1993 and 1992 are higher than the United States statutory income tax rates. Both periods reflect foreign taxes applicable to certain foreign projects which are calculated based on gross receipts, in lieu of a tax on income, prior years' federal income tax liabilities resulting from settlements with the IRS of prior years' tax returns and accruals for prior years' state and local income taxes. Also contributing to the high effective tax rate in 1993 was an increase in the Corporation's net deferred tax liabilities due to the change in the income tax rate from 34% to 35%. 1992 Compared With 1991. Consolidated gross earnings, excluding profits on investment securities of $4,398, increased by $2,280 in 1992. Gross earnings from our domestic engineering, construction and consulting services increased by $9,779 in 1992 primarily due to continued demand for our services in the power sector involving the maintenance and modification of facilities and the completion of facilities under construction as well as increases in assignments in the process and environmental sectors. Despite adverse worldwide economic conditions and the lack of major new projects from the electric utility industry, we obtained new assignments due to our successful diversification into growing areas such as environmental, process, industrial and transportation and positioned the Corporation to compete for a significant share of that anticipated new work. Gross earnings from our foreign engineering, construction and consulting services decreased by $3,761 in 1992 primarily due to losses incurred on certain projects. Gross earnings from cold storage and related activities increased by $350 in 1992 primarily due to increases in business volume. Gross earnings from our oil and gas interests decreased by $697 primarily due to the reduced volume of gas transported by our natural gas gathering company, offset in part by increased production and higher prices in our other oil and gas operations. Gross earnings from dividends and interest decreased by $2,442 in 1992 primarily due to reduced interest income on U.S. Government securities, reflecting lower interest rates, and lower dividends received on investment securities. Gross earnings from all other activities decreased by $949 in 1992 primarily due to reduced rental income on a company-owned office building in Boston, Massachusetts. Consolidated operating and general expenses increased by $9,007 in 1992. Effective January 1, 1992, the Corporation changed the method of calculating annual pension cost under Financial Accounting Standards Board Statement No. 87 which resulted in a decrease in pension cost of $2,322. This decrease was offset by higher pension cost associated with amendments to the retirement plan effective January 1, 1992 to improve generally the relationship between retirement benefits and current salary of employee members, and to increase benefit payments to retired members. Operating and general expenses of our domestic engineering, construction and consulting services increased by $9,105 in 1992 primarily due to retaining staff who were expected to be on job assignments which were cancelled, delayed or reduced in scope. Operating and general expenses of our foreign engineering, construction and consulting services increased by $539 in 1992 primarily due to an increase in business development costs. Operating and general expenses from our cold storage and related activities decreased by $247 in 1992. Operating and general expenses from our oil and gas interests decreased by $1,025 primarily due to reduced volume of gas purchased by our natural gas gathering and transporting company. Operating and general expenses from all other activities increased by $635 in 1992. Our real estate operations in Tampa, Florida continued to be affected by the slow down in the real estate market in the United States. However, there was an improvement in operating results in 1992 compared with the prior year primarily due to improved occupancy rates in company-owned buildings at our Sabal Park properties in the Tampa Bay area and lower operating and general expenses. Taxes other than income taxes increased by $1,518 in 1992 primarily due to higher payroll taxes and state unemployment tax rates. Provision for depreciation, depletion and amortization increased by $1,310 primarily due to depreciation and amortization applicable to equipment purchases, acquisition of computer equipment under capital lease and the expansion of cold storage facilities. Interest expense decreased by $638 primarily due to lower interest rates on mortgage loans. A-3 STONE & WEBSTER, INCORPORATED AND SUBSIDIARIES The provision for income taxes reflected a higher effective tax rate for 1992 compared with 1991 primarily due to higher foreign taxes applicable to certain foreign projects and an increase in prior years' federal income tax liabilities. The increase in the prior years' federal income tax liabilities was primarily due to a settlement of prior years' tax items. After excluding the profits on investment securities of $2,802, income before extraordinary item and cumulative effect of a change in accounting principle decreased by $9,879 in 1992, compared with 1991. This decrease was primarily due to lower operating results of our domestic engineering, construction and consulting operations, losses from foreign engineering, construction and consulting services and a higher effective tax rate. FINANCIAL CONDITION Cash and cash equivalents increased by $15,409 during 1993. Net cash provided by operating activities of $39,679 primarily reflects a decline in accounts receivable and an increase in advance payments by clients. Net cash used by investing activities of $34,092 represents principally property, plant and equipment expenditures primarily related to expenditures for the construction of a new office building to be occupied by an engineering subsidiary and an equity investment in a joint venture. Net cash provided by financing activities principally reflects bank loans to finance the construction of the new office building partially offset by dividends paid. The Corporation believes that the types of businesses in which it is engaged require that it maintain a strong financial condition. Except for our real estate operations and the financing for the construction of a new office building to be occupied by an engineering subsidiary, substantially all of our current and anticipated capital expenditures, dividend and working capital requirements will be met from internally generated funds. However, from time to time one or more of our subsidiaries might borrow funds on a short-term basis through lines of credit and revolving credit facilities for working capital needs. Subsidiaries of the Corporation have lines of credit, revolving credit facilities and bank overdraft facilities totaling $28,000, of which $22,323 was available at December 31, 1993. Mortgage loans scheduled to become due in 1993 and 1994 have been renewed at lower interest rates and will mature in 1998 and are classified as long-term debt. A-4 STONE & WEBSTER, INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENT OF INCOME (All dollar amounts, except per share amounts, are in thousands.) See Summary of Significant Accounting Policies and Notes to Consolidated Financial Statements. A-5 STONE & WEBSTER, INCORPORATED AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (All dollar amounts, except per share amounts, are in thousands.) See Summary of Significant Accounting Policies and Notes to Consolidated Financial Statements. A-6 STONE & WEBSTER, INCORPORATED AND SUBSIDIARIES A-7 STONE & WEBSTER, INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (All dollar amounts, except per share amounts, are in thousands.) See Summary of Significant Accounting Policies and Notes to Consolidated Financial Statements. A-8 STONE & WEBSTER, INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (All dollar amounts are in thousands.) See Summary of Significant Accounting Policies and Notes to Consolidated Financial Statements. A-9 STONE & WEBSTER, INCORPORATED AND SUBSIDIARIES SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (All dollar amounts are in thousands.) BASIS OF CONSOLIDATION. The consolidated financial statements include the accounts of the Corporation and all subsidiaries. The accounts of subsidiaries outside the United States and Canada are included in the consolidated financial statements on the basis of fiscal years ending on November 30 to facilitate timely interim and year-end financial reporting. Investments in joint ventures, where the Corporation owns 50% or less, are accounted for by the equity method. CONSOLIDATED STATEMENT OF CASH FLOWS. The Corporation considers U.S. Government securities purchased with a maturity of three months or less to be cash equivalents. FOREIGN CURRENCY TRANSLATION. Assets and liabilities of operations outside the United States are translated into U.S. dollars at current exchange rates, while income statement items are translated at average monthly exchange rates. Gains or losses on such translations are accumulated in a separate component of Stockholders' Equity and are excluded from net income. Transaction gains and losses, which were not material, resulting from the settlement of receivables or payables, or the conversion of currency, are included in the determination of net income. DEPRECIATION, DEPLETION AND AMORTIZATION. Depreciation generally is provided on a straight-line basis (accelerated methods for income taxes) over the estimated useful lives of the assets. Depreciation and depletion of oil and gas producing properties and natural gas pipeline systems are generally provided on the unit of production method. Amortization is provided for leased property and equipment on a straight-line basis over the life of the lease. Generally, the cost of depreciable property retired or otherwise disposed of is charged to the accumulated depreciation account and net salvage is credited thereto. The cost of depletable property retired or otherwise disposed of is charged to the accumulated depletion account. LONG-TERM CONTRACTS. Gross earnings from long-term engineering and construction contracts are determined on the percentage-of-completion method, based upon the ratio of costs incurred to total estimated costs. Provisions are made currently for all known or anticipated losses. The effects of changes to total estimated contract revenues and costs are recognized in the period they are determined. Certain contracts contain provisions for performance incentives. Such incentives are included in revenues when realization is assured. Contract costs attributed to claims in excess of agreed contract prices are included in revenues when realization is assured. Costs and earnings in excess of billings are classified in current assets as unbilled charges under contracts and represent revenue accrued under the percentage-of-completion method which is not yet billable under the terms of the contract but is recoverable from customers upon various measures of performance such as costs incurred, time schedules or completion of certain milestones within the contract. Amounts received from clients in excess of revenues recognized to date are classified in current liabilities as advance payments by clients. Accounts receivable includes amounts representing retainages under long-term contracts which are due within one year and are not significant. Substantially all unbilled charges under contracts reflected in the accompanying consolidated balance sheet are billed on the basis of contract terms and are usually collected in the subsequent year. There were no significant amounts included in accounts receivable or unbilled charges under contracts for claims subject to uncertainty as to their ultimate realization. INCOME TAXES. Effective January 1, 1993, the Corporation adopted Financial Accounting Standards Board Statement No. 109 - Accounting for Income Taxes, which changes the Corporation's method of accounting for income taxes from the deferred method to an asset and liability approach. Previously the Corporation deferred the past tax effects of timing differences between financial reporting and taxable income. The asset and liability approach requires the recognition of deferred tax liabilities and assets for the expected future tax consequences of temporary differences between the carrying amounts and the tax bases of other assets and liabilities. Undistributed earnings of foreign subsidiaries for which the Corporation has not provided deferred U.S. income taxes, because a taxable distribution of these earnings is not anticipated, aggregated approximately $2,976 at December 31, 1993. This amount represents the accumulated earnings of consolidated foreign subsidiaries which are being permanently reinvested in their operations. INVESTMENT SECURITIES. On December 31, 1993, the Corporation adopted Financial Accounting Standards Board Statement No. 115 - Accounting for Certain Investments in Debt and Equity Securities, which requires the Corporation's investment securities to be classified as those "available for sale" and to be carried at market value on the balance sheet with the unrealized gain or loss presented as a separate component of Stockholders' Equity net of applicable deferred taxes. INCOME PER SHARE. Per share amounts are based on the average number of shares outstanding during the year. A-10 STONE & WEBSTER, INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (All dollar amounts, except per share amounts, are in thousands.) (A) GROSS EARNINGS FROM ENGINEERING, CONSTRUCTION AND CONSULTING SERVICES Gross earnings from engineering and construction services include, generally on a percentage-of-completion basis, fees earned on agency contracts and the excess of revenues ($747,787 in 1993, $763,145 in 1992 and $660,255 in 1991) over direct construction costs ($555,561 in 1993, $564,322 in 1992 and $469,568 in 1991) on non-agency contracts. (B) DIVIDENDS AND INTEREST INCOME Dividends and interest income includes dividends from investment securities of $1,311, $1,388 and $2,477 for the years 1993, 1992 and 1991, respectively, and interest income primarily from U.S. Government securities, repurchase obligations and cash in banks of $2,935, $3,507 and $4,860 for the years 1993, 1992 and 1991, respectively. (C) INTEREST EXPENSE Interest expense for 1993 excludes $439, which was capitalized as part of the construction cost for a new office facility. (D) INCOME TAXES On January 1, 1993, the Corporation adopted Financial Accounting Standards Board Statement No. 109 - Accounting for Income Taxes. As a result of this accounting change, the cumulative effect from prior periods increased net income for 1993 by $2,322, or $.16 per share. The results for the prior years have not been restated for this change in accounting. The provision for income taxes consists of the following: * Net of reversal of prior years' income tax of $519 in 1991. ** Includes taxes, in lieu of income taxes, of $2,292 in 1993, $1,744 in 1992 and $655 in 1991 on foreign projects which are calculated based on gross receipts. In 1992 and 1991 the Corporation recognized an extraordinary item of $246 and $1,188, respectively, which represents the recognition of a tax benefit from utilization of foreign subsidiaries' tax loss carryforwards. Deferred tax liabilities (assets) comprise the following: The Corporation established a valuation allowance of $11,173 at January 1, 1993 for the deferred tax assets related to net operating loss carryforwards. The net change in the valuation allowance for 1993 was a decrease of $822 for a total valuation allowance of $10,351 at December 31, 1993. This decrease was caused by the use of net operating loss carryforwards relating to several of our foreign subsidiaries for which valuation allowances had previously been provided. The valuation allowance at December 31, 1993 comprises $6,916 relating to the carryforwards of several of the Corporation's foreign subsidiaries and $3,435 relating to state net operating loss carryforwards. Approximately $67,386 (with a tax benefit of $10,551) of the net operating loss carryforwards remains at December 31, 1993, of which $20,958 (with a tax benefit of $6,916) is applicable to foreign subsidiaries and the remaining $46,428 (with a tax benefit of $3,635) relates to state net operating loss carryforwards. Use of the foreign net operating loss carryforwards is limited to future taxable earnings of the Corporation's applicable foreign subsidiaries. Although these net operating loss carryforwards never expire, no benefit has been recognized in the consolidated financial statements. A-11 STONE & WEBSTER, INCORPORATED AND SUBSIDIARIES The state net operating loss carryforwards of $46,428 are applicable to many states and will expire as follows: $1,364 in 1994, $9,718 in 1995, $1,902 in 1996, $4,840 in 1997, $34 in 1998, $124 in 1999, $707 in 2000, $2,309 in 2001, $1,617 in 2002 and $23,813 thereafter. The Corporation has determined that it will be able to realize a tax benefit of $200 relating to these state net operating loss carryforwards and the remaining net operating loss carryforwards (with a tax benefit of $3,435, which is fully reserved for) are expected to expire unused. Deferred income taxes were provided for timing differences between book and tax income. The principal sources of these differences and the related effects for 1992 and 1991 were as follows: See Note M for deferred taxes relating to the cumulative effect of a change in accounting principle in 1992. The following is an analysis of the difference between the United States statutory income tax rate and the Corporation's effective income tax rate: Income from operations before income taxes, extraordinary item and cumulative effect of a change in accounting principle were: The Corporation accrued a $780 federal alternative minimum tax liability in 1993 and incurred a federal alternative minimum tax of $693 in 1992 and $113 in 1991, which produced a credit that can be carried forward indefinitely to reduce future federal income taxes payable. The total aggregate credit available for regular federal tax carryforward purposes was $3,221 at December 31, 1993. The Corporation has settled all issues raised in connection with the examination of the Corporation's income tax returns for the years 1985 and 1987 through 1989. The settlement of these issues resulted in an additional net charge of $2,015. The Omnibus Budget Reconciliation Act of 1993 raised the statutory federal income tax rate on corporations from 34% to 35%. The effect of this 1% increase in the tax rate on the Corporation's net deferred tax liabilities was a charge to income of $1,131, or $.08 per share. (E) INVESTMENT SECURITIES In 1993, the Corporation adopted Financial Accounting Standards Board Statement No. 115 - Accounting for Certain Investments in Debt and Equity Securities. Accordingly, investment securities are being carried at a fair market value of $40,836 and the unrealized gain of $24,975, net of deferred income taxes of $13,448, was credited to Stockholders' Equity at December 31, 1993. At December 31, 1992 investment securities were carried at a cost of $2,413 with a market value of $32,259 (no allowance was made for taxes on unrealized appreciation of $29,846). Profits on investment securities represents the sale of investment securities, which after income taxes resulted in net income of $2,802, or $.19 per share in 1992. The cost of securities sold was determined by average cost. A-12 STONE & WEBSTER, INCORPORATED AND SUBSIDIARIES (F) PROPERTY, PLANT AND EQUIPMENT Following is a summary of property, plant and equipment at December 31: Property, plant and equipment includes computer equipment under capital leases of $5,296 at December 31, 1993 and $5,340 at December 31, 1992; related amounts included in accumulated depreciation, depletion and amortization were $2,379 at December 31, 1993 and $1,386 at December 31, 1992. Depreciation expense was $18,349 for 1993, $17,718 for 1992 and $15,115 for 1991. Office buildings and other real estate includes property of a subsidiary's office and business center in Tampa, Florida of $29,209 and $28,906 at December 31, 1993 and 1992, respectively, and related accumulated depreciation of $6,354 and $5,291 at December 31, 1993 and 1992, respectively. In 1993, a subsidiary of the Corporation sold the remaining equipment in its contract drilling operations. (G) BANK LOANS In 1992, a subsidiary of the Corporation entered into a $15,000 revolving credit agreement with a bank for financing of the subsidiary's activities performed under a client's contract for engineering services. The agreement was collateralized by an assignment of the contract to the bank and payments received from the client are applied to outstanding borrowings which incur interest based on the London Interbank Offered Rate. At December 31, 1993, there was $5,677 outstanding under the revolving credit agreement. (H) OTHER ACCRUED LIABILITIES Other accrued liabilities consists of the following at December 31: (I) LONG-TERM DEBT Long-term debt consists of the following at December 31: In 1992, a subsidiary of the Corporation obtained a construction loan from a bank to finance the acquisition of land and the construction of an office building to be occupied by an engineering subsidiary of the Corporation. At December 31, 1993, the balance outstanding was $22,667. In February 1994, this construction loan was refinanced with a permanent mortgage obtained from a life insurance company. The mortgage amount is $29,000 and the loan term is 15 years. Collateral for the mortgage loan consists of the land and building. A reclassification of the loan balance from bank loans to long-term debt has been made to the December 31, 1993 balance sheet to give effect to this transaction. The Corporation and its subsidiaries have mortgage loans collateralized by office buildings and other real estate with a net book value of $57,795 at December 31, 1993. The 9 1/8% mortgage loan was incurred in connection with a subsidiary's purchase of an office building and principal and interest is payable monthly. The remaining mortgage loans were assumed in connection with a subsidiary's office and business center in Tampa, Florida and principal and interest is due monthly. The mortgage loans that were previously due in 1993 and 1994 have been renewed and will mature in 1998. The interest rate is fixed for one year and is based on U.S. Government securities rates. Principal payments required on long-term debt in the years 1994 through 1998 are $4,492, $4,480, $4,787, $1,720 and $19,382, respectively. (J) OTHER NON-CURRENT LIABILITIES Other non-current liabilities includes the accrued cost of the Employee Stock Ownership Plan of $16,031 at December 31, 1993 and $17,605 at December 31, 1992. A-13 STONE & WEBSTER, INCORPORATED AND SUBSIDIARIES (K) COMMITMENTS AND CONTINGENCIES Rental expense was $12,600 in 1993, $16,000 in 1992 and $15,300 in 1991. The Corporation and subsidiaries have leases for office space, computer equipment and other office equipment with varying lease terms. All noncancelable leases have been categorized as either capital or operating and under most leasing arrangements the Corporation and subsidiaries pay the property taxes, insurance and maintenance and expenses related to the leased properties. Future minimum lease payments, net of sublease income, under long-term leases as of December 31, 1993 are as follows: The current portion of the present value of the minimum lease obligations under capital leases as of December 31, 1993 amounted to $1,166. The Corporation and certain subsidiaries have been named as defendants, along with others, in legal actions claiming damages in connection with engineering and construction projects and other matters. Most such actions involve claims for personal injury or property damage which occur from time to time in connection with services performed by subsidiaries relating to project or construction sites, and for which coverage under appropriate insurance policies usually applies; other actions arise in the normal course of business including employment-related claims and contractual disputes for which insurance coverage or other contractual provisions may or may not apply. Such contractual disputes normally involve claims relating to the performance of equipment design or other engineering services or project construction services provided by subsidiaries of the Corporation, and often such matters may be resolved without going through a complete and lengthy litigation process. Management believes, on the basis of its examination and consideration of these matters, including consultation with counsel, that these legal actions will not result in payment of amounts, if any, which would have a material adverse effect on the consolidated financial statements. In addition, a subsidiary of the Corporation is a plaintiff in a legal action to recover damages, attorneys' fees and other monetary relief from its insurance carriers. No provision has been made in the financial statements for any potential recoverable amounts. In a contract-related lawsuit, the jury returned a verdict against a subsidiary of the Corporation. Although the subsidiary has filed a post-trial motion to set the judgment aside and intends to appeal the damage award asserted against it if this relief is not granted, the subsidiary recorded a $4,000 charge in connection with this matter. The Corporation co-signed a note for a mortgage loan collateralized by land and an office building owned by a 50%-owned joint venture. The loan will mature in 1997 and totaled $7,578 at December 31, 1993. A subsidiary of the Corporation is a partner in a joint venture in an electric cogeneration facility, which commenced operations in late 1992. An additional equity investment of $5,000 was made in 1993 resulting in a total investment of $6,000 which approximates the carrying value at December 31, 1993. The Corporation has obtained bank letters of credit amounting to $1,500 at December 31, 1993 in favor of the bank financing the project to assure that certain financial obligations with respect to the project will be met. In 1993, a subsidiary of the Corporation renewed an agreement with a bank to provide a short-term unsecured line of credit totaling $10,000, and in January 1994, that subsidiary renewed an agreement with a second bank to provide a short-term unsecured line of credit totaling $10,000. Borrowings under these agreements are to be used for general corporate purposes and incur interest based on the prime rate, money market rates, 1 1/2% above the London Interbank Offered Rate or 1% above the Eurodollar's rate. A commitment fee of 3/16% per annum is paid to the banks on the unused portion of the facility. A foreign subsidiary of the Corporation has an overdraft banking facility of $3,000, which is used for general corporate purposes and incurs interest based on 1% over the bank's published Base Rate. At December 31, 1993, no amounts were outstanding under the lines of credit or the overdraft banking facility. At December 31, 1993, subsidiaries of the Corporation have contingent liabilities arising from guarantees to banks for credit facilities extended to affiliates for general operating purposes of approximately $17,749. The Corporation and its subsidiaries place their cash and cash equivalents and U.S. Government securities with high credit quality financial institutions and, by policy, limit the amount of credit exposure to any one financial institution. (L) EMPLOYEE STOCK OWNERSHIP AND RESTRICTED STOCK PLANS Under the terms of the Employee Stock Ownership Plan, the Corporation and participating subsidiaries make contributions to a trust which can acquire from the Corporation up to 5,000,000 shares of Common Stock of the Corporation, for the exclusive benefit of participating employees. The notes receivable from the Employee Stock Ownership Trust, received as consideration by the Corporation for the 4,000,000 shares of Common Stock sold to the Trust in prior years, are payable in level payments of principal and interest over 20 years. At December 31, 1993 the balance of the notes receivable from the A-14 STONE & WEBSTER, INCORPORATED AND SUBSIDIARIES Trust was $33,549. The unamortized cost of the shares is being funded by annual contributions necessary to enable the Trust to meet its current obligations, after taking into account dividends received on the Common Stock held by the Trust. The net cost of the Plan is being amortized over 20-year periods from the dates of acquisition of shares. The charge to income was $1,562 in 1993, $1,567 in 1992 and $1,602 in 1991. Under the terms of the Restricted Stock Plan, which will terminate June 1, 1998 unless extended, the Corporation may award up to a total of 2,400,000 shares of the Common Stock of the Corporation to key employees. Restricted Stock Plan awards of 22,000 shares in 1993 and 2,000 shares in 1991, previously held in the Treasury, were granted subject to the restrictions described in the Plan. The market value of the shares awarded is being charged to income over the vesting period of five years. At December 31, 1993, 1,726,200 shares have been awarded, net of shares forfeited, and the unamortized portion of the market value was $1,011. (M) RETIREMENT PLANS The Corporation and domestic subsidiaries have a noncontributory defined benefit plan covering executive, administrative, technical and other employees. The benefits for this plan are based primarily on years of service and employees' career pay. The Corporation's policy is to make contributions which are equal to current year cost plus amortization of prior service cost, except as limited by full funding restrictions. Plan assets consist principally of common stocks, bonds and U.S. Government obligations. In 1993, the Corporation offered an Incentive Retirement Program for employees of two of its subsidiaries. In excess of two hundred employees elected to retire under this Program. Total Program costs of $9,081 ($5,460, or $.36 per share, after tax), including $89 for incentive benefits from a non-qualified Supplemental Retirement Plan, representing the actuarially determined present value of Program benefits, were charged to operating and general expenses with a corresponding offset to prepaid pension cost of $8,992 and $89 to other accrued liabilities. Effective January 1, 1992, the Corporation changed its method for determining the calculated value of the assets of its pension plan for purposes of calculating annual pension cost under Financial Accounting Standards Board Statement No. 87. This calculated value is the basis for computing the annual expected return on plan assets, which is part of the net amortization and deferral component of pension cost. This calculated value recognizes changes in fair value of assets over five years. The effect of this change before the cumulative effect of the change on prior years results was to increase income before extraordinary item and net income for the year 1992 by $1,391 (net of taxes of $931), or $.09 per share. The total cumulative effect on prior years to December 31, 1991 was $3,229 (net of taxes of $2,161), or $.21 per share, which was a one time increase in income for the year 1992. A comparison of pro forma amounts showing the effects of applying the new method retroactively is presented below: Pension cost for the domestic plan includes the following components: * Does not include Incentive Retirement Program charges of $8,992. ** Does not include the cumulative effect of a change in accounting principle on prior years of $(5,390). A reconciliation of the domestic plan's funded status to the balance sheet prepaid pension cost is as follows at December 31: The plan's funded status as of any measurement date is based on prevailing market conditions as to discount rate and plan assets, and is accordingly subject to volatility. The projected benefit obligation was determined using assumed discount rates of 7 1/2% at December 31, 1993, 8% at the June 1, 1993 interim measurement and 8 1/2% at December 31, 1992 and assumed long-term rate of compensation increases of 4 1/2%, 5% and 6% at December 31, 1993, June 1, 1993 and December 31, 1992, respectively. Pension cost was determined using an assumed long-term rate of return on plan assets of 10% for 1993, 1992 and 1991. In 1993, a foreign subsidiary of the Corporation recorded a curtailment gain of $1,072, resulting from a significant reduction in defined benefit accruals for present employees' future services. Pension expense (credit) for foreign subsidiaries was $(436) in 1993, $998 in 1992 and $349 in 1991. Assets and liabilities of foreign pension plans are not material. A-15 STONE & WEBSTER, INCORPORATED AND SUBSIDIARIES (N) FOREIGN SUBSIDIARIES The gross earnings and net assets of foreign subsidiaries amounted to $27,595 and $10,615 in 1993, $26,030 and $8,146 in 1992 and $29,627 and $12,355 in 1991. The net income (loss) of foreign subsidiaries was $2,551 in 1993, $(2,512) in 1992 and $2,845 in 1991. (O) BUSINESS SEGMENTS The Corporation, through its subsidiaries, is principally engaged in providing professional engineering, design, construction, consulting and full environmental services for petrochemical, refining, power, industrial, governmental, transportation and civil works projects. The Corporation's cold storage and related activities business offers consolidated distribution of frozen products for food processors and others throughout the Southeast. Export gross earnings were less than 10% of consolidated gross earnings. Although the Corporation has numerous clients and is not dependent on any single client, one or a few clients may contribute a substantial portion of the Corporation's consolidated gross earnings in any one year or over a period of several consecutive years due to the size of major engineering and construction projects and the progress accomplished on those projects in that year or period of years. The engineering, construction and consulting services segment had one client in 1993 who accounted for 17% of consolidated gross earnings and had no single client in 1992 or 1991 who accounted for 10% or more of consolidated gross earnings. The cold storage and related activities business segment had no single client providing 10% or more of consolidated gross earnings. Information regarding business segments is shown on page A-19 and is incorporated herein. (P) QUARTERLY FINANCIAL DATA (UNAUDITED) The following tabulation sets forth unaudited quarterly financial data for the years 1993 and 1992: * Includes cumulative effect of a change in accounting principle per share of $.16 for the first quarter; costs associated with the Incentive Retirement Program of $.36 per share for the second quarter; costs related to an increase in the statutory federal income tax rate on corporations from 34% to 35% of $.08 per share and a foreign pension curtailment gain of $.07 per share for the third quarter; a charge for a judgment against a subsidiary of the Corporation of $.16 per share and a charge for an IRS settlement of $.09 per share for the fourth quarter. * Includes gross earnings of $3,734, $290 and $374, net income of $2,364 , $191 and $247 and net income per share of $.16 , $.01 and $.02 resulting from the sale of investment securities for the second , third and fourth quarters, respectively. ** Includes extraordinary item per share of $.01 and $.01 for the first and second quarters, and cumulative effect of a change in accounting principle per share of $.21 for the first quarter. A substantial portion of the Corporation's business is derived from long-term engineering and construction contracts. Gross earnings are determined on the percentage-of-completion method. Under this method, revisions to earnings estimates recorded in any quarterly period may be adjustments to revenue recognized in prior periods and may in turn be further adjusted during subsequent quarters. Accordingly, historical results may vary from quarter to quarter. (Q) FAIR VALUE OF FINANCIAL INSTRUMENTS The estimated fair values of the Corporation's financial instruments at December 31, 1993 follows: The carrying amounts for cash and cash equivalents and U.S. Government securities approximate their fair values because of the short maturity of the instruments. Investment securities are carried at fair value based on quoted market prices. Long-term debt, excluding capital lease obligations, consists primarily of mortgage loans related to our real estate operations in Tampa, Florida, which were renewed in 1993. The fair value of these mortgage loans approximates the carrying value at December 31, 1993. The carrying value of the mortgage loan for a subsidiary's office building amounted to $6,000 compared with a fair value of $6,217 based on quoted market prices for similar issues or on current rates available to the Corporation for debt with similar terms and maturities. In addition, the Corporation and its subsidiaries have entered into other financial agreements in the normal course of business. These agreements, which by their nature contain potential risk of loss, include lines of credit, letters of credit, performance bonds and performance guarantees. The fair values of the lines of credit, letters of credit, performance bonds and performance guarantees are estimated at $340, based on the fees paid to obtain the obligations. (R) RECLASSIFICATIONS Certain reclassifications have been made in the prior years' consolidated financial statements to conform with the 1993 presentation. A-16 STONE & WEBSTER, INCORPORATED AND SUBSIDIARIES SELECTED FINANCIAL DATA (All dollar amounts, except per share amounts, are in thousands.) Notes: (1) Reflects gain on sale of investment securities, which increased net income by $2,802, or $.19 per share in 1992, as explained in Note E to the Consolidated Financial Statements, $2,853, or $.19 per share in 1990 and $2,774, or $.18 per share in 1989. (2) Includes an extraordinary item from utilization of foreign subsidiaries' net operating loss carryforwards, which increased net income by $246, or $.02 per share in 1992, $1,188, or $.09 per share in 1991 and $1,346, or $.09 per share in 1990. (3) Includes cumulative effect of a change in accounting principle, which increased net income by $2,322, or $.16 per share in 1993 and $3,229, or $.21 per share in 1992. (4) Includes a foreign pension curtailment gain which increased net income in 1993 by $1,072, or $.07 per share, and costs which decreased net income in 1993 as follows: $5,460, or $.36 per share, associated with the Incentive Retirement Program; $1,131, or $.08 per share, relating to an increase in the statutory federal income tax rate on corporations from 34% to 35%; $2,340, or $.16 per share, relating to a judgment against a subsidiary of the Corporation and $2,015, or $.13 per share, relating to an IRS settlement in connection with prior years' income tax returns. (5) Total assets at December 31, 1993 includes an increase of $38,423, as a result of carrying investment securities at a fair market value of $40,836, due to the adoption of Financial Accounting Standards Board Statement No. 115 -- Accounting for Certain Investments in Debt and Equity Securities. MARKET AND DIVIDEND INFORMATION Principal Market - New York Stock Exchange The Corporation has purchased and may continue to purchase from time to time additional shares of its Common Stock for general corporate purposes on the New York Stock Exchange, or otherwise. However, there is no assurance that the Corporation will continue to purchase shares of its Common Stock. The approximate number of record holders of Common Stock as of December 31, 1993 was 6,800. The Common Stock is also listed for trading on the Boston Stock Exchange. A-17 STONE & WEBSTER, INCORPORATED AND SUBSIDIARIES REPORT OF MANAGEMENT The management of Stone & Webster, Incorporated is responsible for the preparation of the financial statements and related notes included in this annual report to stockholders. The financial statements have been prepared in conformity with generally accepted accounting principles and accordingly include certain amounts which represent management's best estimates and judgments. Management maintains internal systems to assist it in fulfilling its responsibility for financial reporting, including careful selection of personnel, segregation of duties and the maintenance of formal accounting and reporting policies and procedures. While no system can ensure elimination of all errors and irregularities, the systems have been designed to provide reasonable assurance that assets are safeguarded, policies and procedures are followed and transactions are properly executed and reported. These systems are reviewed and modified in response to changing conditions. Management believes that the Corporation's system of internal controls is adequate to accomplish the objectives discussed herein. The system is supported by an internal auditing function that operates worldwide and reports its findings to management throughout the year. The Corporation's independent accountants are engaged to express an opinion on the year-end financial statements. The independent accountants review and test the system of internal accounting controls and the data contained in the financial statements to the extent required by generally accepted auditing standards as they deem necessary to arrive at an opinion on the fairness of the financial statements presented herein. The Audit Committee of the Board of Directors, which is comprised of outside directors, meets regularly with management, the internal auditors and the independent accountants to discuss the adequacy of internal controls, the reported financial results and the results of the auditors' examinations. The internal auditors and the independent accountants have direct access to the Audit Committee and meet privately with the Committee. William F. Allen, Jr. William M. Egan Chairman of the Board and Executive Vice President and Chief Executive Officer Chief Financial Officer Bruce C. Coles President A-18 STONE & WEBSTER, INCORPORATED AND SUBSIDIARIES BUSINESS SEGMENT INFORMATION (See Note O to Consolidated Financial Statements) (All dollar amounts are in thousands.) Notes: (1) Total segment gross earnings include gross earnings from unaffiliated customers as reported in the consolidated income statement. In computing segment gross earnings, general corporate dividends and interest and profits on investment securities have been excluded. (2) To reconcile segment gross earnings information with consolidated amounts, the following items have been included in the engineering, construction and consulting services segment: $1,060, $1,183 and $1,537 of interest income and $8,685, $3,595 and $4,718 of other gross earnings for the years 1993, 1992 and 1991, respectively; and, the following items have been included in the cold storage and related activities segment: $12, $11 and $16 of interest income for the years 1993, 1992 and 1991, respectively, and $13 of other gross earnings for the year 1993 and $5 for the years 1992 and 1991. (3) The Other segment includes oil and gas and real estate businesses that historically have never been reported as separate segments. (4) Segment operating profit comprises total segment gross earnings, as defined in Note 1, less operating expenses and before general corporate expenses, interest expense and income taxes, including taxes which are calculated based on gross receipts. (5) Identifiable assets are those assets that are used in the operations of each segment. (6) General corporate assets are principally cash, U.S. Government securities and investment securities. Corporate assets at December 31, 1993 includes an increase of $38,423 as a result of carrying investment securities at fair market value. (7) Includes export sales of $22,277, $24,171 and $16,018 for the years 1993, 1992 and 1991, respectively, primarily to Asia/Pacific Rim, Middle East and Canada. (8) Gross earnings principally to Asia/Pacific Rim, Canada, Europe and Middle East. A-19 STONE & WEBSTER, INCORPORATED AND SUBSIDIARIES SCHEDULE I - MARKETABLE SECURITIES - OTHER SECURITY INVESTMENTS as at December 31, 1993 (All dollar amounts are in thousands.) A-20 STONE & WEBSTER, INCORPORATED AND SUBSIDIARIES SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT (All dollar amounts are in thousands.) Notes: (A) Represents transfers in of $351 and miscellaneous adjustments of $14. (B) Represents transfers out of $(351) and miscellaneous adjustments of $(15). (C) Represents miscellaneous adjustments. (D) Represents reclassifications from another balance sheet account and miscellaneous adjustments. A-21 STONE & WEBSTER, INCORPORATED AND SUBSIDIARIES SCHEDULE VI - ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (All dollar amounts are in thousands.) Notes: (A) Represents net salvage of $593, transfers in of $189 and other adjustments of $19. (B) Represents net salvage of $912, transfers out of $(189) and other adjustments of $(15). (C) Represents net salvage of $13 and other adjustments of $9. (D) Represents net salvage of $259 and other adjustments of $(7). (E) Represents net salvage of $75 and other adjustments of $146. (F) Represents net salvage of $4 and other adjustments of $27. (G) Represents net salvage of $78 and other adjustments of $71. (H) Represents net salvage. (I) Represents net salvage of $285 and other adjustments of $25. See notes to Schedule VI on page A-23. A-22 STONE & WEBSTER, INCORPORATED AND SUBSIDIARIES NOTES TO SCHEDULE VI-PROPERTY, PLANT AND EQUIPMENT for the years 1993, 1992 and 1991 Depreciation and amortization are provided principally on a straight-line basis at the following annual rates: Expenditures for maintenance and repairs are charged against income; expenditures for renewals and betterments, except minor items, are capitalized. * Depreciation of lease and well equipment and pipeline properties and depletion of oil and gas properties are provided by the units of production method. A-23 STONE & WEBSTER, INCORPORATED AND SUBSIDIARIES SCHEDULE IX - SHORT-TERM BORROWINGS for the years 1993, 1992 and 1991 (All dollar amounts are in thousands.) Notes: (A) Bank loans represent borrowings under revolving lines of credit. (B) Represents loans for construction of buildings. In February 1994, the December 31, 1993 construction loan balance was refinanced with a permanent mortgage. A reclassification of this loan balance to long-term debt has been made to the December 31, 1993 Consolidated Balance Sheet to give effect to this transaction. (C) The average amount outstanding during the period was calculated using month-end outstanding principal balances during the year. (D) The weighted average interest rate during the period was computed by averaging the month-end interest rates on each borrowing, with each month-end rate being weighted in proportion to the related month-end outstanding amount. A-24 STONE & WEBSTER, INCORPORATED AND SUBSIDIARIES SCHEDULE X - SUPPLEMENTARY INCOME STATEMENT INFORMATION for the years 1993, 1992 and 1991 (All dollar amounts are in thousands.) Note - Depreciation and amortization of intangible assets, royalties and advertising costs have been omitted because each of the items does not exceed 1 percent of gross earnings in the related Consolidated Statement of Income. A-25 Form 10-K 1993 Stone & Webster, Incorporated COOPERS Certified Public Accountants & LYBRAND REPORT OF INDEPENDENT ACCOUNTANTS _______ To the Stockholders and Board of Directors of Stone & Webster, Incorporated We have audited the consolidated financial statements and the financial statement schedules of Stone & Webster, Incorporated and Subsidiaries listed in the index on page A-1 of the Form 10- K. These financial statements and financial statement schedules are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Stone & Webster, Incorporated and Subsid- iaries as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As discussed in Notes D and E to the consolidated financial statements, the Corporation changed its method of accounting for income taxes and investment securities in 1993. Additionally, as discussed in Note M to the consolidated financial statements, the Corporation changed its method for determining the calculated value of the assets of its pension plan for purposes of calculat- ing annual pension cost in 1992. COOPERS & LYBRAND New York, New York February 15, 1994 A-26 Form 10-K 1993 Stone & Webster, Incorporated EXHIBIT INDEX No. Exhibit (3) (i) Restated Certificate of Incorporation (incorporated by reference) (ii) By-Laws (filed herewith) (10) (a) Material Contracts - Restricted Stock Plan and form of grant (incorporated by reference) (b) Material Contracts - Form of letter agreement relating to other benefits (incorporated by reference) (21) Subsidiaries of the Registrant (23) Consent of Independent Accountants.

92088_1993.txt

92088

1993

ITEM 1. BUSINESS GENERAL BellSouth Telecommunications, Inc. ("BellSouth Telecommunications"), a corporation wholly-owned by BellSouth Corporation ("BellSouth"), is the surviving corporation from the merger, effective at midnight December 31, 1991 of South Central Bell Telephone Company ("South Central Bell") and Southern Bell Telephone and Telegraph Company ("Southern Bell"). BellSouth Telecommunications provides predominantly tariffed wireline telecommunications services to approximately two-thirds of the population and one-half of the territory within Alabama, Florida, Georgia, Kentucky, Louisiana, Mississippi, North Carolina, South Carolina and Tennessee. These areas were previously served by South Central Bell and Southern Bell. BellSouth Telecommunications continues to use the names South Central Bell and Southern Bell for various purposes. South Central Bell was incorporated in 1967 under the laws of the State of Delaware and Southern Bell was incorporated in 1879 under the laws of the State of New York. On December 31, 1983, pursuant to a consent decree approved by the United States District Court for the District of Columbia (the "D. C. District Court") entitled "Modification of Final Judgment" (the "MFJ") settling antitrust litigation brought by the United States Department of Justice (the "Justice Department") in 1974 and the related Plan of Reorganization (the "POR"), American Telephone and Telegraph Company ("AT&T") transferred to BellSouth its 100% ownership of South Central Bell and Southern Bell. On the same date, South Central Bell and Southern Bell were reincorporated through mergers into Georgia corporations. Effective January 1, 1984, ownership of BellSouth was divested from AT&T and BellSouth became a publicly traded company. BellSouth Telecommunications has its principal executive offices at 675 West Peachtree Street, N.E., Atlanta, Georgia 30375 (telephone number 404-529-8611). MODIFICATION OF FINAL JUDGMENT Pursuant to the MFJ, AT&T divested the 22 wholly-owned operating telephone companies (the "Operating Telephone Companies"), including South Central Bell and Southern Bell, that were included in the former Bell System. The ownership of such 22 Operating Telephone Companies was transferred by AT&T to seven holding companies (the "Holding Companies"), including BellSouth. All territory in the continental United States served by the Operating Telephone Companies was divided into geographical areas termed "Local Access and Transport Areas" ("LATAs"). These LATAs are generally centered in a city or other identifiable community of interest. The MFJ limits the telecommunications-related scope of the Operating Telephone Companies'* post-divestiture business activities, and the D. C. District Court retained jurisdiction over its construction, implementation, modification and enforcement. Under the MFJ, the Operating Telephone Companies may provide local exchange, exchange access, information access and toll telecommunications services within the LATAs. Although prohibited from providing service between LATAs, the Operating Telephone Companies provide exchange access services that link a subscriber's telephone or other equipment in one of their LATAs to the transmission facilities of carriers (the "Interexchange Carriers"), which provide toll telecommunications services between different LATAs. The Operating Telephone Companies may market, but not manufacture, customer premises equipment ("CPE"), which is defined in the MFJ as equipment used on customers' premises to originate, route or terminate telecommunications. A similar restriction applies to the manufacture or provision of "telecommunications equipment," which is defined in the MFJ as including equipment used by carriers to provide telecommunications services. The MFJ restrictions precluding the Holding Companies from providing information services and non-telecommunications related products have been judicially removed. - ------------------------ * The provisions of the MFJ are applicable to the Holding Companies. The D.C. District Court has established procedures for obtaining generic and specific waivers from the manufacturing and interLATA communications restrictions of the MFJ, although the required filings with and review by the Justice Department and the D.C. District Court usually result in lengthy and uncertain proceedings. The foregoing restrictions present significant obstacles to the provision of certain wireless, cable television and other communications services and require that such business operations, even where waivers are ultimately obtained, be conducted under burdensome arrangements or subject to elaborate structural separation or other conditions. BellSouth is advocating legislation which would remove or relax the MFJ restrictions. (See "Business Operations -- Legislation.") The MFJ requires the Operating Telephone Companies to provide, upon a bona fide request by any Interexchange Carrier or information service provider, exchange access, information access and exchange services for such access that will be equal to that provided to AT&T in quality, type and price. BellSouth Telecommunications believes it is in compliance with this requirement. BUSINESS OPERATIONS Approximately 86% of BellSouth Telecommunications' operating revenues for the years ended December 31, 1993, 1992 and 1991, respectively, were from wireline telecommunications services and the remainder of revenues was principally from directory publishing fees, CPE sales, inside wire services, billing and collection services, cellular interconnect services and rental of facilities. Certain communications services and products are provided to business customers by BellSouth Business Systems, Inc., BellSouth Communication Systems, Inc. and Dataserv, Inc., subsidiaries of BellSouth Telecommunications. Respectively, these companies provide sales, marketing, product management and customer service for BellSouth Telecommunications' large business customers within traditional telephone operating company service areas and nationwide; sell, install and maintain CPE; and maintain and provide parts and integration services for computer and data processing equipment. In the aggregate, access revenues, revenues from billing and collection activities and rental of facilities comprised approximately 30%, 30% and 31% of 1993, 1992 and 1991 operating revenues, respectively. The majority of these revenues were from services provided to AT&T, BellSouth Telecommunications' largest customer. TELEPHONE COMPANY OPERATIONS BellSouth Telecommunications provides services, which include local exchange, exchange access and intraLATA toll services, within each of the 38 LATAs in its combined nine-state operating area. (See "Local and Toll Services" and "Access Services.") The tables below set forth the following: network access lines in service at December 31 for the last five years; access lines in each state at December 31, 1993; and the annual percentage increase in access lines in each state at December 31 for the last four years. Approximately 72% of such lines were in 53 metropolitan areas, each having a population of 125,000 or more. Many localities and some sizable areas in the states in which BellSouth Telecommunications operates are served by non-affiliated telephone companies, which had approximately 29% of the network access lines in such states on December 31, 1993. BellSouth Telecommunications does not furnish local exchange, access or toll services in the areas served by such companies. The following table reflects access minutes of use and toll message volumes for the last five years. The number of intraLATA toll messages carried by BellSouth Telecommunications has declined, primarily because of the effect of expanded local area calling plans and competition by others for the - ------------------------ *Prior period operating data are revised at later dates to reflect the most current information. The above information reflects the latest data available for the periods indicated. provision of toll services. Toll message volumes are expected to decline further as additional intraLATA toll competition is authorized in many of the states served by BellSouth Telecommunications. (See "Competition" and "Management's Discussion and Analysis of Results of Operations and Financial Condition -- Operating Environment and Trends of the Business -- Volumes of Business.") LOCAL AND TOLL SERVICES Charges for local services for the years ended December 31, 1993, 1992 and 1991 accounted for approximately 48%, 47% and 46%, respectively, of BellSouth Telecommunications' operating revenues. Local services operations provide lines from telephone exchange offices to subscribers' premises for the origination and termination of telecommunications including the following: basic local telephone service provided through the regular switching network; dedicated private line facilities for voice and special services, such as transport of data, radio and video, and foreign exchange services; switching services for customers' internal communications through facilities owned by BellSouth Telecommunications; services for data transport that include managing and configuring special service networks; and dedicated low or high capacity public or private digital networks. Other local services revenue is derived from intercept and directory assistance, public telephones and various special and custom calling services. BellSouth Telecommunications has the ability to offer certain enhanced services through its network. Such offerings include various forms of data and voice transmission, voice messaging and storage services and gateway communications between customers and information services providers. The extent to which these offerings can be profitably provided will depend on the degree of market acceptance. BellSouth Telecommunications provides intraLATA toll services within, but not between, its 38 LATAs. Such toll services provided approximately 9%, 10% and 11% of BellSouth Telecommunications' operating revenues for the years ended December 31, 1993, 1992 and 1991, respectively. These services include the following: intraLATA service beyond the local calling area; Wide Area Telecommunications Service ("WATS" or "800" services) for customers with highly concentrated demand; and special services, such as transport of data, radio and video. BellSouth Telecommunications is subject to state regulatory authorities in each state in which it provides telecommunications services with respect to intrastate rates, services and other issues. Traditionally, BellSouth Telecommunications' rates were set in each state in its service areas at levels which were anticipated to generate revenues sufficient to cover its allowed expenses and to provide an opportunity to earn a fair return on its capital investment. Such a regulatory structure was satisfactory in a less competitive era; however, BellSouth Telecommunications is currently advocating changes to the regulatory processes responsive to the increasingly competitive telecommunications environment. Modified forms of state regulation are in effect in Alabama, Florida, Georgia, Kentucky, Louisiana, Mississippi and Tennessee. Under such modified form of regulation, economic incentives are provided to lower costs and increase productivity through the potential availability of "shared" earnings over a benchmark rate of return. Generally, when levels above targeted returns are reached, earnings are "shared" by providing refunds or rate reductions to customers. The amounts of any such excess which may be retained under some plans depend upon attaining mandated service standards, certain productivity improvement provisions or both. Under some plans, if earnings fall below a targeted minimum, additional earnings required to return to the bottom of the allowed range can be obtained through rate increases. Sharing plans are generally subject to renewal after two or three years, and may be subject to modification prior to renewal. Despite the potential advantages offered by sharing plans, substantial rate reductions have been incurred in connection with their adoption and operation. Of the states in which these types of plans were in place, BellSouth Telecommunications attained the earnings sharing range in Alabama, Kentucky, Louisiana and Mississippi in 1993. ALABAMA An incentive regulation plan has been in effect in Alabama since December 1988, which provides for a return on average total capital* in the range of 11.65% to 12.30%. If earnings exceed 12.30%, sharing with customers may range from 0% to 50%, depending upon whether certain service and efficiency requirements are met. In December 1993, in conjunction with approval of rate adjustments required by its incentive plans, the Alabama Public Service Commission approved a settlement of several outstanding issues. The settlement resulted in a net rate reduction to the Company of $15.72 million. FLORIDA From 1988 through 1992, the Florida incentive plan provided for a return on equity* of 11.5% to 16%, with earnings from 14% to 16% to be shared 40% by BellSouth Telecommunications and 60% by customers. The sharing level was not attained under the plan. In 1993, BellSouth Telecommunications filed a petition to extend the existing plan. In January 1994, after extensive proceedings and negotiations between BellSouth Telecommunications, Public Counsel and intervenors, the Florida Public Service Commission approved a settlement that extends incentive regulation through 1996. Among other things, the terms of the settlement provide for rate reductions of $55 million in February 1994, an additional $60 million in July 1994, $80 million in October 1995 and $84 million in October 1996. The settlement provides for other changes in service offerings and tariffs including approximately $21 million in revenue reductions or increased expenses. Basic service rates have been capped at their current levels through 1997, and BellSouth Telecommunications has agreed not to propose any local measured service on a statewide basis through the same time period. (See "Management's Discussion and Analysis of Results of Operations and Financial Condition -- Operating Environment and Trends of the Business -- Regulatory Environment -- State Regulation.") The agreement establishes a 1994 return on equity* sharing level of 12% with a cap of 14%, increasing in 1995 to a 12.5% sharing level with a cap of 14.5%. Rates of return beyond 1995 would vary based upon changes in utility bond yields but would change no more than 75 basis points from 1995 levels. GEORGIA The Georgia incentive plan adopted in 1990 provided that BellSouth Telecommunications would retain all earnings up to a 14% return on equity*. Subject to the attainment of service standards and productivity improvement provisions, BellSouth Telecommunications could retain a portion of earnings between 14% and 16%. The plan also provided for a reduction of rates if earnings exceed 14% return on equity, even if the service standards and productivity improvement provisions are met. The amount of any sharing and rate adjustments would depend upon attaining certain service standards and productivity improvements. BellSouth Telecommunications has yet to attain the sharing level under the Georgia plan. In December 1993, the Georgia Public Service Commission voted to extend the plan for six months, effective January 1, 1994. Concurrent with the extension, the Commission modified the return on equity at which sharing would occur from 14% to 13%. ------------------------- * As defined in the plan for this state. KENTUCKY Under the Kentucky incentive regulation plan, BellSouth Telecommunications may earn a return on average total capital* in the range of 10.99% to 11.61%. Earnings above 11.61% are subject to sharing. If the return on average total capital falls below 10.99%, 50% of the shortfall may be recovered from customers, and if the return falls below 9.49%, 75% of the shortfall may be recovered. BellSouth Telecommunications achieved the sharing level during 1993 and reduced rates by $6.4 million in June. This plan will be reviewed by the Kentucky Public Service Commission later in 1994. LOUISIANA In February 1992, in settlement of several years of regulatory and judicial proceedings, BellSouth Telecommunications and the Louisiana Public Service Commission agreed to a three year incentive regulation plan providing for an immediate $55.0 million refund, a rate reduction of $31.4 million and an authorized return on investment* in the range of 10.7% to 11.7%, with sharing of earnings above 11.7% and below 12.7%. Based on 1992 results, BellSouth Telecommunications reduced rates by $13.8 million in February and $7.8 million in August 1993, reflecting its sharing obligation under the new plan. In January 1994, BellSouth Telecommunications filed a petition with the Louisiana Commission requesting a price regulation plan. No hearings have been scheduled on this proposal. MISSISSIPPI In June 1990, the Mississippi Public Service Commission authorized implementation of an incentive plan that includes a return on average net investment* ranging from 10.74% to 11.74% and provides that earnings above 11.74% and shortfalls below 10.74% would be shared with customers on a 50/50 basis. Rate reductions totaling $22.8 million on an annual basis were required prior to implementation of the plan. Additional revenue reductions in the amount of $12.8 million related to intrastate access and area calling plan impacts became effective in January 1993. In June 1993, the Mississippi Commission renewed, through July 1, 1995 the incentive plan and ordered BellSouth Telecommunications to reduce rates, effective July 1993, based on a targeted 11.24% return. Legislation has recently been passed in Mississippi which would allow price regulation. NORTH CAROLINA In 1989, legislation was enacted in North Carolina authorizing the North Carolina Public Service Commission to consider alternative forms of regulation. No specific proposal has been approved or is pending. The North Carolina Commission reviews BellSouth Telecommunications' rates annually. In November 1993, the Commission approved one-time depreciation reserve deficiency amortizations of $28.5 million and $25 million in 1993 and 1994, respectively. SOUTH CAROLINA In August 1991, the South Carolina Public Service Commission authorized implementation of an incentive plan providing for a return on equity* ranging from 12.0% to 16.5%, and the sharing of earnings between 14.0% to 16.5%, on a 50/50 basis with customers. However, in August 1993, the South Carolina Supreme Court ruled that the South Carolina Commission lacked the statutory authority to approve incentive regulation plans. Legislation has been proposed in South Carolina which would permit the Commission to adopt alternative forms of regulation, including price regulation. In the interim, traditional rate of return regulation is in effect. TENNESSEE In August 1993, the Tennessee Public Service Commission approved a three year revised incentive regulation plan which lowered the sharing range as a percentage return on average net investment* from 11.0% - 12.2% to 10.65% - 11.85%. Earnings between 11.85% - 15.85% must be shared ------------------------- * As defined in the plan for this state. with ratepayers in varying degrees, depending on the quality of service. The plan also provides for rate increases to cover up to 60% of the amount by which earnings fall below 10.65%. The Tennessee Commission's decision was appealed by several intervenors to the Tennessee Court of Appeals. The appeal, which is pending, challenges the validity of the Commission's order and its rate of return finding. ------------------------ In addition to the above matters, BellSouth Telecommunications is a party to numerous proceedings pending before state regulatory bodies which involve, among other things, terms and conditions of services provided by BellSouth Telecommunications, rates charged for such services and relationships with affiliates. No assurance can be given as to the outcome of any such matters. ACCESS SERVICES BellSouth Telecommunications provides access services by connecting the communications networks of Interexchange Carriers with the equipment and facilities of subscribers. These connections are provided by linking these carriers and subscribers through the public switched network of BellSouth Telecommunications or through dedicated private lines furnished by BellSouth Telecommunications. Access charges, which are payable both by Interexchange Carriers and subscribers, provided approximately 29% of BellSouth Telecommunications' operating revenues for the years ended December 31, 1993, 1992 and 1991, respectively. These charges are designed to recover the costs of the common and dedicated facilities and switching equipment used to connect networks of Interexchange Carriers with the telephone company's local network. In addition, an interstate monthly subscriber line access charge of $3.50 per line per month applies to single-line business and residential customers. The interstate subscriber access charge for multi-line business customers varies by state but cannot exceed $6.00 per line per month. In October 1990, the FCC authorized an alternative to traditional rate of return regulation called "price caps," effective January 1, 1991, which is mandatory for certain local exchange carriers ("LECs"), including BellSouth Telecommunications and the other Operating Telephone Companies. In contrast to traditional rate of return regulation, price caps limits the prices telephone companies can charge for their services. The price cap plan limits aggregate price changes to the rate of inflation minus a productivity offset, plus or minus exogenous cost changes recognized by the FCC. The FCC expects price cap regulation to provide LECs with enhanced incentives to increase productivity and efficiency. Concurrent with the implementation of price caps, the FCC reduced the allowed rate of return on interstate operations from 12.0% to 11.25%. Those LECs which operate under price caps are allowed to elect annually by April 1 a productivity offset factor of 3.3% or 4.3%. If the lower offset is chosen, such carriers will be allowed to earn up to a 12.25% overall rate of return without sharing. If such carriers earn between 12.25% and 16.25%, half of the earnings in this range will be flowed through to customers in the form of a lower price cap index in the following year. All earnings over 16.25% would be flowed through to customers. If such carriers elect a 4.3% productivity offset, all earnings below 13.25% may be retained, earnings up to 17.25% would be shared and earnings over 17.25% would be flowed through to customers. BellSouth Telecommunications elected to operate under the 3.3% productivity offset factor for the period July 1, 1993 through June 30, 1994 and intends to elect the same factor for the ensuing annual period. In February 1994, the FCC initiated its review of the price cap plan described in the preceding paragraph. The FCC identified three broad sets of issues for examination including those related to the basic goals of price cap regulation, the operation of price caps and the transition of local exchange services to a fully competitive market. BellSouth Telecommunications believes and will advocate that a revised price cap plan should be structured to provide increased pricing flexibility for services as competition evolves in the telecommunications markets. Any changes to the current plan are expected to be effective January 1, 1995 or soon thereafter. State regulatory commissions have jurisdiction over charges related to the provision of access to the Interexchange Carriers to complete intrastate telecommunications. The state commissions have authorized BellSouth Telecommunications to collect access charges from the Interexchange Carriers and, in several states, from customers. Open Network Architecture ("ONA") plans, permitting all users of the basic network to interconnect to specific basic network functions and interfaces on an unbundled and equal access basis for the provision of enhanced services, will eliminate the FCC requirement that certain enhanced telecommunications services be offered only through a separate subsidiary. The plans may be implemented when ONA tariffs filed with the FCC become effective and are filed with the states in which ONA services will be offered and the FCC is notified by the company that it is prepared to offer the ONA services described in its plan. In November 1992, BellSouth Telecommunications filed a Notice of Initial ONA Implementation and Petition for Removal of Structural Separation Requirement (the "Notice"). The Notice informed the FCC of BellSouth Telecommunications' completion of the required steps for initial ONA implementation and asked the FCC to remove the structural separation requirements imposed on enhanced services offerings. The FCC granted the petition for structured relief in July 1993. In addition to the above matters, BellSouth Telecommunications is a party to numerous proceedings pending before the FCC which involve, among other things, terms and conditions of services provided by BellSouth Telecommunications, rates charged for such services and relationships with affiliates. No assurance can be given as to the outcome of any such matters. BILLING AND COLLECTION SERVICES BellSouth Telecommunications provides, under contract and/or tariff, billing and collection services for certain long distance services of AT&T and several other Interexchange Carriers. The agreement with AT&T has been extended through 1996, subject to the right of AT&T to assume billing and collection for certain of its services prior to the expiration of the agreement. Revenues from such services are expected to decrease as AT&T and other carriers assume more direct billing for their own services. OPERATOR SERVICES Directory assistance and local and toll operator services are provided by BellSouth Telecommunications in its service areas. Toll operator services include alternate billing arrangements, such as collect calls, third number billing, person-to-person and calling card calls; dialing instructions; pre- billed credit; and rate information. In addition, directory assistance is provided for some Interexchange Carriers which do not directly provide such services for their own customers. OTHER BUSINESS OPERATIONS Directory Publishing Fees A percentage of the billed revenues from directory advertising operations of BellSouth Advertising & Publishing Corporation, a wholly-owned subsidiary of BellSouth, are paid as publication fees to BellSouth Telecommunications for publishing rights and other services in its franchise areas. Such fees amounted to approximately $616, $598, and $580 million in 1993, 1992 and 1991, respectively. SELLING, LEASING AND MAINTAINING EQUIPMENT Through its subsidiaries, BellSouth Telecommunications sells, leases and maintains CPE, computers and related office equipment. The Holding Companies, AT&T and other substantial enterprises compete in the provision of CPE and other services and products. COMPETITION General BellSouth Telecommunications is subject to increasing competition in all areas of its business. Regulatory, legislative and judicial actions and technological developments have expanded the types of available services and products and the number of companies that may offer them. Increasingly, this competition is from large companies which have substantial capital, technological and marketing resources. Developments during 1993 indicate that a technological convergence is occurring in the telephone, cable and broadcast television, computer, entertainment and information services industries. The technologies utilized and being developed in these industries will enable companies to provide multiple forms of communications offerings. Current policies of Congress and the FCC strongly favor lowering legislative and regulatory barriers to competition in the telecommunications industry. Accordingly, the nature of competition which BellSouth Telecommunications will face will depend to a large degree on regulatory actions at the state and federal levels, decisions with respect to the MFJ and possible state and federal legislation. NETWORK AND RELATED SERVICES LOCAL SERVICE Many services traditionally provided exclusively by the LECs have been deregulated, detariffed or otherwise opened for competition. For example, some carriers and other customers with concentrated, high usage characteristics are utilizing shared tenant services, private branch exchange (PBX) systems which are owned by customers and provide internal switching functions without using BellSouth Telecommunications' central office facilities, private line services and other telecommunications links which bypass the switched networks of BellSouth Telecommunications. An increasing number of private voice and data communications networks utilizing fiber optic lines have been and are being constructed in metropolitan areas, including Atlanta, Georgia, Charlotte, North Carolina and Jacksonville, Miami and Orlando, Florida, which will offer certain high volume users a competitive alternative to the public and private line offerings of the LECs. In addition, the existing networks of cable television systems are capable of carrying two-way interactive data messages and can be configured to provide voice communications. Furthermore, wireless services, such as cellular telephone and paging services and PCS services when operational increasingly compete with wireline communications services. BellSouth Telecommunications is presently vulnerable to bypass to the extent that its access charges reflect subsidies for other services. Although BellSouth Telecommunications believes that bypass has already occurred to a significant degree in its nine-state area, it is difficult to quantify the lost revenues since customers are not required to report to the telephone companies the components of their telecommunications systems. In general, telephone company telecommunications services in highly concentrated population and business areas are more vulnerable to bypass. MCI Communications Corporation has announced long range plans to invest more than $20 billion to create and deliver a wide array of communications services. Included in these plans is an investment of $2 billion to construct local networks in major United States cities, including Atlanta, Georgia and other cities in the Southeast. MCI has stated that it would connect directly to customers and provide alternative local voice and data communications services. Local service competition from MCI could emerge in Atlanta by mid-1994. AT&T has announced an agreement to acquire McCaw Communications, Inc., the largest domestic cellular communications company, which serves customers in 10 cities in BellSouth Telecommunications local wireline territory. Furthermore, alliances are also being formed between other Holding Companies and large corporations that operate cable television systems in many localities throughout the United States, e.g., U S West, Inc./Time Warner Entertainment Co. L.P., Southwestern Bell Corp./ Cox Cable Communications and NYNEX Corporation/Viacom, Inc. As technological and regulatory developments make it more feasible for cable television to carry data and voice communications, it is increasingly likely that BellSouth Telecommunications will face competition within its region from the other Holding Companies through their cable television venture arrangements. U S West and Time Warner have announced plans to upgrade certain of their cable TV systems to full-service networks which would support new interactive and telephone services that will compete with the incumbent local exchange carriers. The first of these full-service networks is being built in Orlando, Florida and is expected to begin offering services this year. Tele-Communications, Inc. has announced plans to offer similar services in South Florida and Louisville, Kentucky. ACCESS SERVICE The FCC has adopted rules requiring local exchange carriers to offer expanded interconnection for interstate special and switched transport. BellSouth Telecommunications will be required to permit competitive carriers and customers to terminate their own transmission facilities in its central office buildings. Virtual collocation agreements may also be negotiated between carriers. Various aspects of these rules have been challenged by a number of carriers including BellSouth Telecommunications. The effects of the rules would be to increase competition for access transport. It is uncertain whether the local exchange carriers will receive the pricing flexibility necessary to compete effectively with alternative access providers. TOLL SERVICE A number of firms compete with BellSouth Telecommunications for intraLATA toll business by reselling toll services obtained at bulk rates from BellSouth Telecommunications or, subject to the approval of the applicable state public utility commission, providing toll services over their own facilities. Commissions in the states in BellSouth Telecommunications' operating territory have allowed the latter type of intraLATA toll calling, whereby the Interexchange Carriers are assigned a multiple digit access code ("10XXX") which customers may dial to place intraLATA toll calls through facilities of such Interexchange Carriers. The Kentucky Commission has concluded that competing carriers should be allowed to provide intraLATA toll presubscribed calling with a single digit access code (1+ or 0+) but is considering how and when such authorization should be implemented. PERSONAL COMMUNICATIONS SERVICES (PCS) The FCC is currently putting a licensing process in place that will allocate 160 megahertz for broadband PCS, with 120 megahertz being given to licensed operators, 20 megahertz reserved for unlicensed voice operations and 20 megahertz reserved for unlicensed data operations. The FCC is developing rules to award the licensed spectrum on an auction basis, with up to 7 licenses per geographic area. It is anticipated that the auctions could begin as early as the Fall of 1994. The federal government hopes to raise $10 billion auctioning off the PCS spectrum. BellSouth has conducted several trials of PCS-like services under experimental licenses from the FCC, but has made no final determination of the scope of its participation in the PCS licensing auctions. It is anticipated that substantial capital would be required to bid on licenses and to construct the systems should BellSouth Telecommunications elect to participate. Although the exact nature and scope of the services to be offered by PCS service providers has yet to be determined, BellSouth Telecommunications anticipates that its local wireline and telephone business may experience additional competition from PCS service providers in the future. BELLSOUTH TELECOMMUNICATIONS COMPETITIVE STRATEGY REGULATORY AND LEGISLATIVE CHANGES The states in BellSouth Telecommunications' service area currently provide for some form of regulation of earnings, a regulatory framework that BellSouth Telecommunications believes is not appropriate for the increasingly competitive telecommunications environment. Accordingly, BellSouth Telecommunications' primary regulatory focus continues to be directed toward modifying the regulatory process to one that is more closely aligned with changing market conditions and overall public policy objectives. As an alternative to the current regulatory process, BellSouth Telecommunications believes that price regulation, whereby prices of basic local exchange service are directly regulated and prices for other products and services are based on market factors, is a logical progression toward regulatory flexibility and is fair to consumers. As such, BellSouth Telecommunications intends to pursue implementation of price regulation plans through filings with state regulatory commissions or through legislative initiatives. BellSouth Telecommunications is also seeking relief in the courts and before Congress and regulatory agencies from current laws, regulations and judicial restrictions (including the MFJ) for the provision of voice, data and video communications throughout its wireline service territory and elsewhere. It is furthermore advocating legislative and regulatory initiatives which would eliminate or modify restrictions to its current and future business offerings. (See "Legislation.") Competitors and other interest groups with substantial resources oppose many of these initiatives. The ultimate outcome and timing of any relief obtained cannot be predicted with certainty. Technological changes and the effects of competition reduce the economic useful lives of BellSouth Telecommunications' fixed assets. As competition increases in both the exchange access and local exchange markets, the economic lives of related properties should continue to decrease. Therefore, BellSouth Telecommunications is examining the rates of depreciation of fixed assets authorized by the FCC and state regulatory commissions to ensure that these rates are adequate to recover fixed asset costs in a timely fashion. The FCC and the state commissions represcribe depreciation rates for BellSouth Telecommunications at three-year intervals. ENTRY INTO NEW MARKETS Notwithstanding the risks associated with increased competition, BellSouth Telecommunications will have the opportunity to benefit from entry into new business markets. BellSouth Telecommunications believes that in order to remain competitive in the future, it must aggressively pursue a corporate strategy of expanding its offerings beyond its traditional businesses. These offerings may include information services, interactive communications and cable television and other entertainment services. RESTRUCTURING BellSouth Telecommunications is restructuring its telephone operations by streamlining its fundamental processes and work activities to better respond to an increasingly competitive business environment. The restructuring is expected to improve overall responsiveness to customer needs, permit more rapid introduction of new products and services and reduce costs. A primary objective of this restructuring is the plan to downsize BellSouth Telecommunications' workforce by 10,200 by the end of 1996. LEGISLATION There are a number of bills pending in Congress that, if enacted into law, could significantly affect BellSouth Telecommunications' business operations and opportunities. The provisions of the bills set the terms, conditions, obligations and time frames under which the Operating Telephone Companies would be permitted 1) to offer interLATA services, 2) to manufacture CPE, 3) to manufacture and provide telecommunications equipment, 4) to provide video programming in their telephone service territories and 5) to offer electronic publishing services or alarm monitoring services. They also would address the need to preserve universal service in a competitive telecommunications marketplace and would preempt state laws prohibiting competition for intrastate telephone services. In the House of Representatives, these items are addressed in the provisions of two bills, H.R. 3626 and H.R. 3636. In the Senate, they are contained in S.1822. H.R. 3636 as currently drafted also specifies that a Federal/ State Joint Board should require that large carriers like BellSouth Telecommunications be subject to alternative or price regulation rather than traditional rate of return regulation. The House has held several hearings on the House bills, and the House Judiciary Committee and the House Energy and Commerce Committee have each adopted a version of H.R. 3626, and the House Energy and Commerce Committee has adopted H.R. 3636. The Rules Committee will decide how and when these bills will proceed to the floor of the House. RESEARCH AND DEVELOPMENT The services and products of BellSouth Telecommunications are in a highly technological field. BellSouth Telecommunications has expended $43.2, $46.3, and $42.0 million in 1993, 1992 and 1991, respectively, on company-sponsored research and development activities. The majority of this activity is conducted at Bell Communications Research, Inc. ("Bellcore"), one-seventh of which is owned by BellSouth, through BellSouth Telecommunications, with the remainder owned by the other Holding Companies. Bellcore provides research and development and other services for its owners and is the central point of contact for coordinating the Federal government's telecommunications requirements relating to national security and emergency preparedness. LICENSES AND FRANCHISES BellSouth Telecommunications' local exchange business is typically provided under certificates of public convenience and necessity granted pursuant to state statutes and public interest findings of the various public utility commissions of the states in which BellSouth Telecommunications does business. These certificates provide for a franchise of indefinite duration, subject to the maintenance of satisfactory service at reasonable rates. BellSouth Telecommunications owns or has licenses to use all patents, copyrights, licenses, trademarks and other intellectual property necessary for it to conduct its present business operations. It is not anticipated that any of such property will be subject to expiration or non-renewal of rights which would materially and adversely affect BellSouth Telecommunications or its subsidiaries. EMPLOYEES On December 31, 1993, 1992, and 1991 BellSouth Telecommunications employed approximately 81,400, 82,900 and 82,200 persons, respectively. About 73% of these employees at December 31, 1993 were represented by the Communications Workers of America (the "CWA"), which is affiliated with the AFL-CIO. In September 1992, the CWA ratified new three-year contracts with BellSouth Telecommunications covering about 58,000 employees. These contracts included provisions for wage increases, a cost-of-living adjustment and an increase in the team incentive award that will total an estimated 11.3% over the three year contract period. In November, 1993, BellSouth Telecommunications announced plans to reduce its work force by approximately 10,200 employees by the end of 1996 through normal attrition, transitional programs, other voluntary options and involuntary separations. ITEM 2.

ITEM 2. PROPERTIES GENERAL BellSouth Telecommunications' properties do not lend themselves to description by character and location of principal units. BellSouth Telecommunications' investment in property, plant and equipment consisted of the following at December 31: Outside plant consists of connecting lines (aerial, underground and buried cable) not on customers' premises, the majority of which are on or under public roads, highways or streets while the remainder are on or under private property. Central office equipment consists of analog switching equipment, digital electronic switching equipment and circuit equipment. Land and buildings are occupied principally by central offices. Station equipment consists of embedded intrasystem wiring, substantially all of which is on the premises of customers. Substantially all of the installations of central office equipment and administrative offices are located in buildings and on land owned by BellSouth Telecommunications. Many garages, business offices and telephone service centers are in leased quarters. BellSouth Telecommunications' customers are now served by electronic switching systems that provide a wider variety of services than their mechanical predecessors. The BellSouth Telecommunications network is in transition from an analog to a digital network, which provides capabilities for BellSouth Telecommunications to furnish advanced data transmission and information management services. PROPERTY ADDITIONS Property additions include gross additions to property, plant and equipment having an estimated service life of one year or more, plus the incidental costs of preparing the asset for its intended use. In the case of constructed assets, an amount related to the cost of debt and equity used in the construction of an asset is capitalized as part of the asset when the construction period is in excess of one year. Property additions also include assets acquired by means of entering into a capital lease agreement, gross additions to operating lease equipment and reused materials. Significant additions to property, plant and equipment will be required to meet the demand for telecommunications services and to further improve such services. The total investment in telephone plant has increased from about $32,877 million at January 1, 1989 to about $40,102 million at December 31, 1993, including the effects of retirements and property transferred at divestiture, but not including deductions of accumulated depreciation at either date. BellSouth Telecommunications' property additions since January 1, 1989, were approximately as follows: In 1993, BellSouth Telecommunications generated substantially all of its funds for property additions internally; substantially all of such property additions are expected to be financed through internally generated funds in 1994. BellSouth Telecommunications currently projects property additions to be approximately $3,000 million for 1994. The continued modernization of BellSouth Telecommunications' network is necessary to meet the needs of customers and competitive demands. (See "Competition.") Population and economic expansion is projected by BellSouth Telecommunications in certain growth centers within its nine-state area during the next five to ten years. Expansion of the network will be needed to accommodate such projected growth. ENVIRONMENTAL MATTERS BellSouth Telecommunications is subject to a number of environmental matters as a result of its operations and the shared liability provisions in the POR. As a result, BellSouth Telecommunications expects that it will be required to expend funds to remedy certain facilities, including those Superfund sites for which BST has been named as a potentially responsible party, for the remediation of sites with underground fuel storage tanks and other expenses associated with environmental compliance. At December 31, 1993, BST's recorded liability related primarily to remediation of these sites was $35.5 million. BellSouth Telecommunications continually monitors its operations with respect to potential environmental issues, including changes in legally mandated standards and remediation technologies. BellSouth Telecommunications' recorded liability reflects those specific issues where remediation activities are currently deemed to be probable and where the cost of remediation is estimable. BellSouth Telecommunications continues to believe that expenditures in connection with additional remedial actions under the current environmental protection laws or related matters will not be material. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS The MFJ and the related POR provide for the recognition and payment of liabilities by AT&T and the Operating Telephone Companies that are attributable to pre-divestiture events but that did not become certain until after divestiture. These contingent liabilities relate principally to litigation and other claims with respect to the former Bell System's rates, taxes, contracts and torts (including business torts, such as alleged violations of the antitrust laws). Contingent liabilities that are attributable to pre-divestiture events are shared by AT&T and the Operating Telephone Companies in accordance with formulae prescribed by the POR, whether or not an entity was a party to the proceeding and regardless of whether an entity was dismissed from the proceeding by virtue of settlement or otherwise. BellSouth Telecommunications' share of these liabilities to date has not been material to its financial position or results of operations for any period. BellSouth Telecommunications and its subsidiaries are subject to numerous claims and proceedings arising in the ordinary course of business involving allegations of personal injury, breach of contract, anti-competitive conduct and other matters. While complete assurance cannot be given as to the outcome of any contingent liabilities, in the opinion of BellSouth Telecommunications, any financial impact to which BellSouth Telecommunications is subject is not expected to be material in amount to BellSouth Telecommunications' operating results or its financial position. PART II ITEM 6.

ITEM 6. SELECTED FINANCIAL AND OPERATING DATA ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION (Dollars in Millions) RESULTS OF OPERATIONS -- 1993 RESULTS COMPARED TO 1992 BellSouth Telecommunications, Inc. ("BellSouth Telecommunications") reported net income of $835.0 for the year ended December 31, 1993, a decrease of $739.3 (47.0%) compared to 1992. The decrease was primarily attributable to a charge of $696.6 for the restructuring of telephone operations (see Note J). Other charges in 1993 that contributed to the decrease were $86.6 for debt refinancings (see Note E), $64.8 for the adoption of Statement of Financial Accounting Standards ("SFAS") No. 112 (see Note H), $47 for the initial impact of a regulatory settlement in Florida, approximately $24 related to the increase in the Federal statutory income tax rate for corporations, exclusive of the tax benefit associated with the restructuring charge, and approximately $25 associated with severe weather conditions during first quarter 1993. The decreases were also attributable in part to the inclusion in 1992's results of gains of $39.5 and $32.9, respectively, from the settlement of a Federal income tax matter and the settlement of prior year regulatory issues. The 1993 decreases were partially offset by overall growth of operating revenues, driven by an improvement in key business volumes, and the inclusion in 1992 of charges for debt refinancing and Hurricane Andrew. OPERATING REVENUES Operating Revenues increased $397.5 (3.0%) in 1993 compared to 1992 primarily due to a $341.3 (5.5%) increase in Local Service revenue and smaller increases in Interstate Access, Intrastate Access and Other revenues. These increases were partially offset by a $29.3 (2.3%) decrease in Toll revenues. See "Volumes of Business." Local service revenues reflect amounts billed to customers for local exchange services, which include connection to the network and secondary central office feature services, such as custom calling features and custom dialing packages. (Paging and other mobile service revenues and revenues from cellular interconnection are included in Other operating revenues for both periods presented.) The increase in 1993 revenues of $341.3 (5.5%) was primarily attributable to an increase of 683,000 access lines since December 31, 1992 and a $42.0 increase from secondary central office services. In addition, the effects of a $27.9 refund in Florida during 1992 and revenue shifts from toll to local due to expanded local area calling plans, including a plan implemented in Louisiana in 1992, contributed to the increase in 1993 (see "Toll"). The increase in revenues from local area calling plans is primarily attributable to access line growth. Interstate access revenues result from the provision of access services to interexchange carriers to provide telecommunications services between states. Interstate access revenues increased $45.6 (1.5%) in 1993. The increase for 1993 reflects increased rates effective July 1, 1993 in conjunction with the selection of a 3.3% productivity offset factor under the Federal Communications Commission's ("FCC") price cap plan, growth in minutes of use and increases in end user charges attributable to growth in the number of access lines in service. The effect of these increases was substantially offset by decreased net settlements with the National Exchange Carriers Association and revenue deferrals under the FCC's price cap plan. Since BellSouth Telecommunications' earnings are currently in the sharing range of the FCC's price cap plan and because of other factors, significant revenue growth in this category is not likely. See "Operating Environment and Trends of the Business." Intrastate access revenues result from the provision of access services to interexchange carriers which provide telecommunications services between LATAs within a state. Revenues increased $10.1 (1.2%) in 1993. The increase, due primarily to growth in minutes of use, was substantially offset by rate reductions since December 31, 1992. Toll revenues are received from the provision of long-distance services within (but not between) LATAs. These services include intraLATA service beyond the local calling area; Wide Area Telecommunications Service ("WATS" or "800" services) for customers with highly concentrated demand; and special services, such as transport of voice, data and video. Toll revenues decreased $29.3 (2.3%) in 1993. The decrease reflects rate reductions since December 31, 1992 and a decline in toll message volumes largely attributable to the expansion of local area calling plans which have the effect of shifting revenues from Toll to Local Service. The decrease was partially offset by revenue increases due to optional calling plans and independent company settlements. The overall decline in toll revenues is expected to continue over the long term. Other revenues include revenues from publishing rights fees, customer premises equipment sales and maintenance services, billing and collection services, cellular interconnect services and other nonregulated services (primarily inside wire services). Other revenues increased $29.8 (1.6%) in 1993 primarily due to an increase in publishing rights fees and revenues from nonregulated services, due in part to higher demand. Billing and collection revenues also increased due to the effect of nonrecurring adjustments; however, such revenues are expected to decline over the long term due to interexchange carriers' assuming more direct billing for their own services. The overall increase was offset by the effect of reclassifying in 1992 a $27.9 Florida refund to ratepayers from Other revenues to Local Service and the inclusion in 1992 of $52.7 for the settlement of prior year regulatory issues. OPERATING EXPENSES Operating expenses increased $1,332.0 (13.0%) during 1993 primarily due to a pre-tax charge of $1,136.4 for restructuring of the telephone operations. Adjusted for the effect of the restructuring charge, Operating expenses increased $195.6 (1.9%) due to expenses associated with improved business volumes, higher levels of salaries and wages, a regulatory settlement in Florida, and expenses attributable to severe weather conditions in the first quarter of 1993. The increase was partially offset by decreased overtime compensation and the inclusion in 1992 of expenses related to Hurricane Andrew. Cost of Services and Products includes operating expenses associated with network support and maintenance of telecommunications property, plant and equipment, material and supplies expense, cost of tangible goods sold and other expenses associated with the cost of providing services. Cost of services and products increased $118.8 (2.4%) during 1993. This increase was due to increased expenses associated with volume growth, approximately $40 of expenses related to severe weather conditions during first quarter 1993, network service improvement activities, higher levels of base salary and wage expenses resulting from annual increases for management and craft employees and an increase in employee benefits expense, including amounts reclassified from Selling, General and Administrative. The increase in employee benefits expense was driven by the higher overall cost of medical services and an increase of $26 due to the adoption of SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," partially offset by a decrease in pension expense. Pension expense is expected to decrease further in 1994 due primarily to the effect of modifying the benefit level under the recently adopted cash balance pension plan for management employees and reevaluating certain actuarial assumptions (see Note H). Other postretirement benefit expenses for 1994 are expected to increase due to the effect of changes in certain actuarial assumptions. The overall expense increase for 1993 was partially offset by reduced expenses for overtime compensation, rents, software license fees and expenses related to Hurricane Andrew reflected in 1992. Depreciation expense increased $40.1 (1.4%) during 1993. The increase was partially attributable to higher levels of property, plant and equipment since December 31, 1992 resulting from continued growth in the customer base and approximately $20 of additional depreciation expense related to extraordinary property retirements in conjunction with a regulatory settlement in Florida. Higher intrastate depreciation rates for Mississippi and higher interstate depreciation rates for Alabama, Kentucky, Louisiana, Mississippi and Tennessee, all retroactive to January 1, 1993, also contributed to the increase. The 1993 increase was partially offset by the continued expiration of inside wire and reserve deficiency amortizations and reduced depreciation expense in Florida and Alabama resulting from represcription. Selling, General and Administrative expenses include operating expenses related to sales activities such as salaries, commissions, benefits, travel, marketing and advertising expenses. Also included are the provision for uncollectibles and research and development costs. Selling, General and Administrative expenses increased $36.7 (1.6%) in 1993. The increase was primarily attributable to approximately $55 for the initial impact of a regulatory settlement in Florida, higher levels of salaries, wages and taxes other than income taxes and an increase of $11 due to the adoption of SFAS No. 112, "Employers' Accounting for Postemployment Benefits." The 1993 increase was partially offset by the effect of a reclassification of certain benefit expenses to Cost of Services and Products and a decrease in advertising expense. During 1993, BellSouth Telecommunications recognized a business restructuring charge of $1,136.4. The restructuring is being undertaken to redesign and streamline the fundamental processes and work activities of the telephone operations to better respond to an increasingly competitive business environment. The restructuring is expected to improve overall responsiveness to customer needs, permit more rapid introduction of new products and services and reduce costs. As a part of the restructuring, BellSouth Telecommunications plans to consolidate and centralize its existing operations. BellSouth Telecommunications plans to establish a single point of contact and accountability for the receipt, analysis and resolution of customer installation, repair activities and service activation. As a result, 288 existing operations centers will be consolidated into 80 locations. Data management centers used to support company operations will be reduced from 11 to 6. In addition, customer service processes and systems will be designed to provide one-number access, specific appointment times, on-line and real-time access to customer records and immediate service activation where facilities are already in place. The material components of the $1,136.4 charge relate to the downsizing of the existing workforce by 10,200 employees through 1996. These components include $368.2 for separation payments and relocations of remaining employees, $342.8 for the consolidation and elimination of certain operations facilities and $425.4 for enabling changes to information systems, primarily those used to provide services to existing customers. Substantially all of the restructuring charge is expected to require cash payments in future periods. Exclusive of capital requirements, cash payments related to restructuring for 1994, 1995 and 1996 are expected to be approximately $500, $350 and $220, respectively. In addition, future capital expenditures associated with the overall restructuring are estimated to be approximately $650. The cash requirements associated with the restructuring activities, including related capital expenditures, will be provided primarily from BellSouth Telecommunications' operations and, if necessary, from external sources. BellSouth Telecommunications reduced its overall workforce by approximately 1,300 employees in 1993 following implementation of the restructuring plan. Workforce reductions for 1994, 1995 and 1996 are expected to be approximately 3,700, 2,900 and 2,300, respectively. BellSouth Telecommunications expects that the restructuring will result in cost savings beginning in 1994 due to the workforce reductions. Once the restructuring is completed, annual cost savings are expected to be approximately $600 due primarily to reduced employee-related expenses. Interest expense includes interest on debt, certain other accrued liabilities and capital leases, offset by allowance for funds used during construction, which is capitalized as a cost of installing equipment and constructing plant. Interest expense decreased $20.7 (3.5%) in 1993. The decrease was due primarily to a decline in interest rates on borrowings, both short and long term, including the impact of refinancings of long-term debt at lower interest rates. The decrease was offset by a higher average level of short-term borrowings. (See Notes E and K.) Other income, which primarily includes interest and dividend income, decreased $54.1 (71.7%) during 1993 due to the inclusion in 1992 of $56.6 of interest income that resulted from a tax settlement with the Internal Revenue Service. Income tax expense decreased $339.3 (42.4%) in 1993 due to the impact of the restructuring charge, which reduced tax expense by $439.8. The decrease was partially offset by the impact of the Omnibus Budget Reconciliation Act of 1993, including the increase in the Federal statutory income tax rate for corporations, which, exclusive of the tax benefit associated with the restructuring charge, increased tax expense by approximately $24. BellSouth Telecommunications' effective tax rates were 31.9% and 33.1% in 1993 and 1992, respectively. A reconciliation of the statutory Federal income tax rates to these effective tax rates is provided in Note L. A discussion of the adoption of SFAS No. 109, "Accounting for Income Taxes," also is included therein. OPERATING ENVIRONMENT AND TRENDS OF THE BUSINESS REGULATORY ENVIRONMENT. In providing telecommunications services, BellSouth Telecommunications is subject to regulation by both state and federal regulators with respect to rates, services and other issues. While the states in BellSouth Telecommunications' service area currently provide for some form of regulation of earnings, as discussed below, BellSouth Telecommunications believes that the existing regulatory framework is not appropriate for the increasingly competitive telecommunications environment. Accordingly, BellSouth Telecommunications' primary regulatory focus continues to be directed toward modifying the regulatory process to one that is more closely aligned with changing market conditions and overall public policy objectives. As an alternative to the current regulatory process, BellSouth Telecommunications believes that price regulation, whereby prices of basic local exchange service are directly regulated and prices for other products and services are based on market factors, is a logical progression in regulatory flexibility and is fair to consumers. As such, BellSouth Telecommunications intends to pursue implementation of price regulation plans through filings with state regulatory commissions or through legislative initiatives. STATE REGULATION Seven of the nine states in which BellSouth Telecommunications operates are now under some alternative form of regulation other than traditional rate of return regulation. The seven states are Alabama, Florida, Georgia, Kentucky, Louisiana, Mississippi and Tennessee. These state plans are designed to provide BellSouth Telecommunications with economic incentives to improve cost controls and general efficiency in the form of shared earnings over benchmark rates of return. The plans in Georgia and Kentucky are scheduled to expire in 1994. BellSouth Telecommunications attained the earnings sharing range in Alabama, Kentucky, Louisiana and Mississippi at certain times during 1993. For a part of 1993, South Carolina also operated under a form of alternative regulation. However, in August 1993, the South Carolina Supreme Court ruled that the South Carolina Public Service Commission (the "SCPSC") lacked the statutory authority to approve incentive regulation plans of the type under which BellSouth Telecommunications had been operating since 1992. Legislation has been proposed in South Carolina which would permit the SCPSC to adopt alternative forms of regulation including price regulation. In the interim, traditional rate of return regulation is in effect in South Carolina. In January 1994, the Florida Public Service Commission approved a settlement reached by BellSouth Telecommunications and Florida's Office of Public Counsel related to pending rate proceedings initially filed by BellSouth Telecommunications in July 1992 and other consolidated matters. This settlement ended outstanding rate case and consolidated issues in Florida and extended the incentive regulation plan through at least 1996. Under the terms of the settlement, BellSouth Telecommunications was required to recognize in 1993 business all remaining deferred expenses related to Hurricane Andrew and to record expenses associated with extraordinary asset retirements, also related to Hurricane Andrew. The aggregate impact of these items was approximately $75, which reduced BellSouth Telecommunications' net income for 1993 by approximately $47. The terms of the settlement also required BellSouth Telecommunications to reduce rates by $55 in February 1994 and will require reductions of an additional $60 in July 1994, $80 in October 1995 and $84 in October 1996. The settlement provides for other changes in service offerings and tariffs including approximately $21 in revenue reductions or increased expenses. Certain other service rates have been capped at their current levels through 1997, and BellSouth Telecommunications has agreed not to propose any local measured service on a statewide basis through the same time period. FEDERAL REGULATION At the national level, BellSouth Telecommunications has been operating under price cap regulation since January 1, 1991. In contrast to regulation which limits the rate of return that can be achieved, price cap regulation limits the prices telephone companies can charge for use of their services. The current FCC plan allows for the sharing of earnings over a benchmark range of earnings. This benchmark is dependent upon the productivity offset factor chosen annually by the carrier. During the price cap plan's annual election period in 1993, BellSouth Telecommunications selected a productivity offset factor of 3.3% which increased access rates more than they would otherwise have been had the 4.3% factor been selected; however, selection of this lower productivity factor provides for a lower allowed return before sharing is required. As of December 31, 1993, BellSouth Telecommunications' recorded liability for estimated sharing was $45.6. In February 1994, the FCC initiated its review of the current price cap plan. Under a notice of proposed rulemaking, the FCC identified for examination three broad sets of issues including those related to the basic goals of price cap regulation, the operation of price caps, and the transition of local exchange services to a fully competitive market. BellSouth Telecommunications believes and will advocate that a revised price cap plan should be structured to provide increased pricing flexibility for services as competition evolves in the telecommunications markets. Any changes to the current plan are expected to be effective January 1, 1995 or soon thereafter. ECONOMY. The nine-state region served by BellSouth Telecommunications' wireline telephone business, as a whole, posted solid economic gains in 1993, while continuing economic slumps on the West Coast and in the Northeast kept the national economy sluggish for much of the year. Employment growth averaged 2.1% in the region in 1993, slower than the 4% annual rate experienced in the 1980's, but still above the national average of 1.6%. Manufacturing employment in the region grew slightly during 1993 while the nation lost approximately 180,000 manufacturing jobs. Services employment increased about 4% to lead the region's growth. Employment growth is expected to improve further in 1994. Residential construction growth moved back above pre-recession levels with housing starts in the region up 12% over the year. Housing demand is expected to remain strong in 1994. The region's relatively strong economy along with its attractive climate have kept net in-migration near 400,000 per year, boosting the demand for telecommunications services. However, increasing competition makes BellSouth Telecommunications' financial performance more susceptible to changes in the economy than previously, as its operations reflect the more competitive environment and greater elasticity in demands for its products and services. VOLUMES OF BUSINESS. Network Access Lines in Service at December 31 (Thousands): The total number of access lines in service increased by 683,000 over 1992, representing a 3.7% increase, an improvement over the 3.4% rate of increase for 1992 over 1991. The overall increase, led by growth in Florida, Georgia, North Carolina and Tennessee, was primarily attributable to continued economic improvement, including expanding employment in BellSouth Telecommunications' nine-state region and an increase in the number of second lines in residences. While the overall growth rate for residence lines remained constant at 3.0%, the growth rate for business lines continued to increase, reaching 5.9% in 1993, compared to 5.1% in 1992. Access Minutes of Use (Millions): Access minutes of use represent the volume of traffic carried by interexchange carriers between LATAs, both interstate and intrastate, using BellSouth Telecommunications' local facilities. Total access minutes of use increased by 4,065.3 million (6.3%) in 1993 compared to a 6.7% increase in 1992. The 1993 increase in access minutes of use was partially attributable to access line growth and also to intraLATA toll competition, which has the effect of increasing access minutes of use while reducing toll messages carried over BellSouth Telecommunications' facilities. The growth rate in total minutes of use continues to be negatively impacted by the effects of bypass and the migration of interexchange carriers to categories of service (e.g., special access) that have a fixed charge as opposed to a volume-driven charge and to high capacity services, which causes a decrease in minutes of use. Toll messages, comprised of Message Telecommunications Service and Wide Area Telecommunications Service, decreased 29.3 million (2.3%) compared to a 7.7% decrease in 1992. The lower rate of decrease for 1993 was attributable to the inclusion of the impact of the Louisiana area calling plan in both 1992 (beginning in March) and 1993. Competition in the intraLATA toll market and the effects of expanded local area calling plans continue to have an adverse impact on toll message volumes. These plans and the effects of competition have the effect of shifting calls from toll to local service and access, respectively, but the corresponding revenues are not generally shifted at commensurate rates. The decline in toll message volumes is expected to continue for the foreseeable future. COMPETITION. Recent developments in the telecommunications marketplace indicate that a technological convergence is occurring in the telephone, cable and broadcast television, computer, entertainment and information services industries. The technologies utilized and being developed in these industries will enable multiple communications offerings. Several large companies have recently announced proposed acquisitions or business alliances that, if consummated, could intensify and expand competition for local communications and other services currently provided over BellSouth Telecommunications' networks. Other competitors have announced plans to build local phone connections that would permit business and residential customers to bypass the facilities of local telephone companies, including those of BellSouth Telecommunications in certain cities in its service territory. In addition, legislative activities in Congress could affect BellSouth Telecommunications' business and competitive position. BellSouth Telecommunications has undertaken a plan to streamline its telephone operations and to improve its overall cost structure as a part of its competitive strategy (see "Results of Operations"). Notwithstanding the risks associated with increased competition, BellSouth and BellSouth Telecommunications will have the opportunity to benefit from entry into new business markets. BellSouth believes that in order to remain competitive in the future, it must aggressively pursue a corporate strategy of expanding its offerings beyond its traditional businesses which may include information services, interactive communications and cable television and other entertainment services. BellSouth plans to enter such businesses through acquisitions, investments and strategic alliances with established companies in such industries and through the development of such capabilities internally. Such transactions, if accomplished, could initially reduce earnings and require substantial capital. Financing for such business opportunities will be provided from funds generated through internal operations and from external sources. ACCOUNTING UNDER SFAS NO. 71. BellSouth Telecommunications continues to account for the economic effects of regulation under SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation." BellSouth Telecommunications, for strategic and business planning purposes, continuously monitors and evaluates the impacts of both existing and potential competitive factors. If, in BellSouth Telecommunications' judgment, changes in the competitive structure of the telecommunications industry dictate that it could not charge prices to customers which provide for the recovery of costs, SFAS No. 71 would no longer apply. BellSouth Telecommunications currently believes that the existing and anticipated levels of competition still permit prices based on costs to be charged to and collected from customers. However, the rapid pace of change in the industry is making it increasingly likely that BellSouth Telecommunications will be required to discontinue its accounting under SFAS No. 71 in the future. BellSouth Telecommunications believes that the existing regulatory framework is not appropriate for the increasingly competitive telecommunications environment. Accordingly, BellSouth Telecommunications intends to pursue implementation of price regulation plans in all of its jurisdictions through filings with state regulatory commissions or through legislative initiatives. Since price regulation plans do not provide for the recovery of specific costs, SFAS No. 71 would no longer apply. If BellSouth Telecommunications is successful in altering the existing regulatory framework and achieving price regulation, BellSouth Telecommunications would be required to discontinue its accounting under SFAS No. 71. If BellSouth Telecommunications were to discontinue its accounting under SFAS No. 71 due to the overall level of competition or to changes in regulatory frameworks, the effect on its financial condition and results of operations would be material. Specific financial impacts would depend on the timing and magnitude of changes, both in the marketplace and in the overall regulatory framework. OTHER MATTERS ACCOUNTING PRONOUNCEMENTS. Effective January 1, 1993, BellSouth Telecommunications adopted three new accounting standards issued by the Financial Accounting Standards Board. SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," requires employers to accrue the cost of providing postretirement benefits other than pensions during the period employees are expected to earn the benefit. BellSouth Telecommunications is recognizing the related transition benefit obligation over 15 years. As a result of the adoption of SFAS No. 106, operating expenses in 1993 were $26 higher than they would have been using the former accounting method. Accordingly, net income was reduced by approximately $16 (see Note H). SFAS No. 109, "Accounting for Income Taxes," requires companies to compute deferred income taxes using a liability approach rather than the deferred method previously required under Accounting Principles Board Opinion No. 11. The adoption of SFAS No. 109 did not materially affect tax expense or net income for 1993 (see Note L). SFAS No. 112, "Employers' Accounting for Postemployment Benefits," requires employers to accrue the cost of postemployment benefits provided to former or inactive employees after employment but before retirement. A one-time charge of $64.8, net of a deferred tax benefit of $40.8, related to the adoption of SFAS No. 112 was recognized as an accounting change (see Note H). Other pronouncements have been issued by authoritative accounting bodies but not yet adopted by BellSouth Telecommunications. The adoption of such standards in future periods, where required, is not expected to have a material impact on BellSouth Telecommunications' operating results and financial condition. DEBT REFINANCINGS. During 1993, BellSouth Telecommunications refinanced $2,760 of long-term debt at more favorable interest rates. An extraordinary loss of $86.6, net of taxes of $58.8, was recognized in connection with the early extinguishment of certain of these issues. ENVIRONMENTAL ISSUES. BellSouth Telecommunications is subject to a number of environmental matters as a result of its operations and shared liability provisions in the Plan of Reorganization, related to the Modification of Final Judgment. As a result, BellSouth Telecommunications expects that it will be required to expend funds to remedy certain facilities, including those Superfund sites for which BellSouth Telecommunications has been named as a potentially responsible party and also for the remediation of sites with underground fuel storage tanks and other expenses associated with environmental compliance. At December 31, 1993, BellSouth Telecommunications' recorded liability related primarily to remediation of these sites was $35.5. BellSouth Telecommunications continually monitors its operations with respect to potential environmental issues, including changes in legally mandated standards and remediation technologies. BellSouth Telecommunications' recorded liability reflects those specific issues where remediation activities are currently deemed to be probable and where the cost of remediation is estimable. BellSouth continues to believe that expenditures in connection with additional remedial actions under the current environmental protection laws or related matters will not have a material impact on BellSouth Telecommunications' operating results or financial condition. SUBSEQUENT EVENT. During the first quarter of 1994, BellSouth Communication Systems, Inc., a wholly-owned subsidiary, entered into an agreement to sell its customer premise equipment sales and service operations outside the nine-state region. The transaction is expected to close by the end of April 1994. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF MANAGEMENT These financial statements have been prepared in conformity with generally accepted accounting principles and have been audited by Coopers & Lybrand, independent accountants, whose report is contained herein. The integrity and objectivity of the data in these financial statements, including estimates and judgments relating to matters not concluded by the end of the year, are the responsibility of the management of BellSouth Telecommunications. Management has also prepared all other information included in this Annual Report unless indicated otherwise. Management maintains a system of internal accounting controls which is continuously reviewed and evaluated. However, there are inherent limitations that should be recognized in considering the assurances provided by any system of internal accounting controls. The concept of reasonable assurance recognizes that the cost of a system of internal accounting controls should not exceed, in management's judgment, the benefits to be derived. Management believes that BellSouth Telecommunications' system does provide reasonable assurance that the transactions are executed in accordance with management's general or specific authorizations and are recorded properly to maintain accountability for assets and to permit the preparation of financial statements in conformity with generally accepted accounting principles. Management also believes that this system provides reasonable assurance that access to assets is permitted only in accordance with management's authorizations, that the recorded accountability for assets is compared with the existing assets at reasonable intervals and that appropriate action is taken with respect to any differences. Management also seeks to assure the objectivity and integrity of its financial data by the careful selection of its managers, by organizational arrangements that provide an appropriate division of responsibility and by communications programs aimed at assuring that its policies, standards and managerial authorities are understood throughout the organization. Management is also aware that changes in operating strategy and organizational structure can give rise to disruptions in internal controls. Special attention is given to controls while the changes are being implemented. Management maintains a strong internal auditing program that independently assesses the effectiveness of the internal controls and recommends possible improvements thereto. In addition, as part of its audit of these financial statements, Coopers & Lybrand completed a review of the accounting controls to establish a basis for reliance thereon in determining the nature, timing and extent of audit tests to be applied. Management has considered the internal auditor's and Coopers & Lybrand's recommendations concerning the system of internal control and has taken actions that we believe are cost-effective in the circumstances to respond appropriately to these recommendations. Management believes that as of December 31, 1993, the system of internal controls was adequate to accomplish the objectives discussed herein. Management also recognizes its responsibility for fostering a strong ethical climate so that BellSouth Telecommunications' affairs are conducted according to the highest standards of personal and corporate conduct. This responsibility is communicated to all employees through policies and guidelines addressing such issues as conflict of interest, safeguarding of BellSouth Telecommunications' real and intellectual properties, providing equal employment opportunities and ethical relations with customers, suppliers and governmental representatives. BellSouth Telecommunications maintains a program to assess compliance with these policies. F. Duane Ackerman Patrick H. Casey PRESIDENT AND CHIEF EXECUTIVE OFFICER VICE PRESIDENT AND COMPTROLLER February 3, 1994 AUDIT COMMITTEE CHAIRMAN'S LETTER The Audit Committee of the Board of Directors consists of four independent Directors who are neither officers nor employees of BellSouth Telecommunications. The Committee is responsible for oversight of the internal controls of the Company and the objectivity of its financial reporting. The Audit Committee met four times during 1993 and reviewed with the Director -- Internal Auditing, Coopers & Lybrand and management, the various audit activities and plans, together with the results of selected internal audits. The Audit Committee also reviewed the financial reporting process and the adequacy of internal controls. The Audit Committee recommends the appointment of the independent public accountants and considers factors relating to their independence. The Director -- Internal Auditing and Coopers & Lybrand met privately with the Audit Committee on occasion to encourage confidential discussions as to any auditing matters. Lloyd C. Elam CHAIRMAN, AUDIT COMMITTEE February 3, 1994 REPORT OF INDEPENDENT ACCOUNTANTS BellSouth Telecommunications, Inc. Atlanta, Georgia We have audited the accompanying consolidated financial statements and financial statement schedules of BellSouth Telecommunications, Inc. and Subsidiaries listed in Item 14(a) of the Form 10-K. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of BellSouth Telecommunications, Inc. and Subsidiaries as of December 31, 1993 and 1992, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein. As discussed in Notes H and L to the consolidated financial statements, BellSouth Telecommunications changed its method of accounting for postretirement benefits other than pensions, postemployment benefits, and income taxes in 1993. Coopers & Lybrand Atlanta, Georgia February 3, 1994 CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference in the registration statement of BellSouth Telecommunications, Inc. on Form S-3 (File No. 33-49991) of our report dated February 3, 1994, on our audits of the consolidated financial statements and financial statement schedules of BellSouth Telecommunications, Inc. listed in Item 14(a) of this Form 10-K. Coopers & Lybrand Atlanta, Georgia March 28, 1994 BELLSOUTH TELECOMMUNICATIONS, INC. CONSOLIDATED STATEMENTS OF INCOME AND RETAINED EARNINGS (IN MILLIONS) The accompanying notes are an integral part of these financial statements. BELLSOUTH TELECOMMUNICATIONS, INC. CONSOLIDATED BALANCE SHEETS (IN MILLIONS) The accompanying notes are an integral part of these financial statements. BELLSOUTH TELECOMMUNICATIONS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (In Millions) The accompanying notes are an integral part of these financial statements. BELLSOUTH TELECOMMUNICATIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in Millions) NOTE A -- ACCOUNTING POLICIES BASIS OF PRESENTATION. BellSouth Telecommunications, Inc. ("BellSouth Telecommunications") is a wholly-owned subsidiary of BellSouth Corporation ("BellSouth"). Effective at midnight December 31, 1991, South Central Bell Telephone Company ("South Central Bell") and BellSouth Services Incorporated ("BellSouth Services") (a jointly-owned service subsidiary of South Central Bell and Southern Bell Telephone and Telegraph Company ("Southern Bell")) merged with and into Southern Bell and Southern Bell's name changed to BellSouth Telecommunications, Inc. The accompanying financial statements reflect the operations of South Central Bell, Southern Bell, BellSouth Services, and several smaller affiliated companies transferred to BellSouth Telecommunications as though the merger and such transfers had occurred on January 1, 1991. BellSouth Telecommunications maintains substantially all of its accounts and records in accordance with the Uniform System of Accounts prescribed by the Federal Communications Commission ("FCC") and makes certain adjustments necessary to present the accompanying financial statements in accordance with generally accepted accounting principles applicable to regulated entities. Such principles differ in certain respects from those used by unregulated entities, but are required to appropriately reflect the financial and economic effects of regulation and the rate-making process. Significant differences resulting from the application of these principles are disclosed elsewhere in these Notes to Consolidated Financial Statements where appropriate. BASIS OF ACCOUNTING. BellSouth Telecommunications' consolidated financial statements have been prepared in accordance with generally accepted accounting principles, including the provisions of Statement of Financial Accounting Standards ("SFAS") No. 71, "Accounting for the Effects of Certain Types of Regulation." Where appropriate, SFAS No. 71 gives accounting recognition to the actions of regulators. Such actions can provide reasonable assurance of the existence of an asset, reduce or eliminate the value of an asset or impose or eliminate a liability on a regulated entity. CASH AND CASH EQUIVALENTS. BellSouth Telecommunications considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. PROPERTY, PLANT AND EQUIPMENT. The investment in property, plant and equipment dedicated to providing telecommunications services is stated at original cost. Depreciation is based on the remaining life method of depreciation and straight-line composite rates determined on the basis of equal life groups of certain categories of telephone plant acquired in a given year. Depreciation expense also includes amortization of certain classes of telephone plant and identified depreciation reserve deficiencies over periods allowed by regulatory authorities. When depreciable plant is disposed of, the original cost less net salvage value is charged to accumulated depreciation. MATERIAL AND SUPPLIES. New and reusable material is carried in inventory, principally at average original cost, except that specific costs are used in the case of large individual items. Nonreusable material is carried at estimated salvage value. MAINTENANCE AND REPAIRS. The cost of maintenance and repairs of plant, including the cost of replacing minor items not effecting substantial betterments, is charged to operating expenses. REVENUE RECOGNITION. Revenues are recognized when earned. Certain revenues derived from local telephone services are billed monthly in advance and are recognized the following month when services are provided. Revenues derived from other telecommunications services, principally network access and toll, are recognized monthly as services are provided. Directory publishing fees are recognized over the life of the related directories, published by an affiliated company, which is generally one year. ALLOWANCE FOR FUNDS USED DURING CONSTRUCTION. Regulatory authorities allow BellSouth Telecommunications to accrue interest as a cost of constructing certain plant and as an item of income BELLSOUTH TELECOMMUNICATIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in Millions) NOTE A -- ACCOUNTING POLICIES (CONTINUED) (interest charged construction). Such income is not realized in cash currently but will be realized over the service life of the related plant as the resulting higher depreciation expense and plant investment are recovered in the form of increased revenues. INCOME TAXES. Effective January 1, 1993, BellSouth Telecommunications adopted SFAS No. 109, "Accounting for Income Taxes." In accordance with the standard, the balance sheet reflects deferred tax balances associated with the anticipated tax impact of future income or deductions implicit in the balance sheet in the form of temporary differences. Temporary differences primarily result from the use of accelerated methods and shorter lives in computing depreciation for tax purposes. Prior to 1993, BellSouth Telecommunications accounted for income taxes under the provisions of Accounting Principles Board Opinion No. 11. For financial reporting purposes, BellSouth Telecommunications is amortizing deferred investment tax credits earned prior to the 1986 repeal of the investment tax credit and also some transitional credits earned after the repeal. The credits are being amortized as a reduction to the provision for income taxes over the estimated useful lives of the assets to which the credits relate. NOTE B -- INVESTMENTS IN AND ADVANCES TO AFFILIATES Investments In and Advances to Affiliates consists primarily of 3,766,199 shares of BellSouth common stock. During 1993, grantor trusts established by BellSouth Telecommunications purchased for $199.9 the BellSouth common stock to provide partial funding for the benefits payable under certain non-qualified benefit plans. For 1993, dividend income earned from the BellSouth shares, included as a component of Other Income, net, was $7.6. NOTE C -- PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment is summarized as follows at December 31: BELLSOUTH TELECOMMUNICATIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in Millions) NOTE D -- OTHER CURRENT LIABILITIES Other current liabilities are summarized as follows at December 31: NOTE E -- DEBT DEBT MATURING WITHIN ONE YEAR: Debt maturing within one year is included as debt in BellSouth Telecommunications' computation of debt ratios and consisted of the following at December 31: BellSouth Telecommunications has committed credit lines aggregating $1,096.9 with various banks. There were no borrowings under the committed lines at December 31, 1993. BellSouth Telecommunications also maintains uncommitted lines of credit of $40.0. There are no significant commitment fees or requirements for compensating balances associated with any lines of credit. BELLSOUTH TELECOMMUNICATIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in Millions) NOTE E -- DEBT (CONTINUED) LONG-TERM: Long-term debt is summarized as follows at December 31: Maturities of long-term debt outstanding at December 31, 1993 are summarized below: During 1993 and 1992, BellSouth Telecommunications refinanced certain long-term debt issues at more favorable interest rates. As a result of the early extinguishment of these issues, charges of $86.6, net of taxes of $58.8, and $40.7, net of taxes of $30.0, were recognized as extraordinary losses in 1993 and 1992, respectively. At December 31, 1993, a shelf registration statement had been filed with the Securities and Exchange Commission by BellSouth Telecommunications under which $725.0 additional amount of debt securities could be offered. NOTE F -- OTHER LIABILITIES AND DEFERRED CREDITS Other liabilities and deferred credits is summarized as follows at December 31: NOTE G -- TRANSACTIONS WITH AFFILIATES BellSouth Telecommunications has a contractual agreement with BellSouth Advertising & Publishing Corporation ("BAPCO"), an affiliated company, wherein BAPCO publishes certain telephone directories and in return pays BellSouth Telecommunications a publishing rights fee in its franchise area. For the years ended December 31, 1993, 1992 and 1991, these fees, included in Other operating revenue, were $616.3, $598.2 and $580.1, respectively. At December 31, 1993 and 1992, amounts receivable from affiliated companies were $20.2 and $20.0, respectively. Amounts payable to affiliated companies at December 31, 1993 and 1992, both short and long-term, were $465.8 and $336.5, respectively. BELLSOUTH TELECOMMUNICATIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in Millions) NOTE H -- EMPLOYEE BENEFITS PENSION PLANS. Substantially all employees of BellSouth Telecommunications are covered by noncontributory defined benefit pension plans sponsored by BellSouth. The plan covering non-represented employees prior to July 1993, provided a benefit based on years of credited service and employees' average compensation for a specified period. Effective July 1993, BellSouth converted this plan to a cash balance plan where the pension benefit is determined by a combination of compensation-based service and additional credits, and individual account-based interest credits. The new cash balance plan is subject to a minimum benefit determined under the prior plan's formula for employees retiring through 2005. The December 31, 1993 projected benefit obligation assumes interest and additional credits greater than the minimum levels specified in the written plan. The conversion of the non-represented pension plan had no material impact on 1993 pension cost. The estimated impact on 1994 projected pension cost for BellSouth will be a reduction of $65. Pension benefits provided for represented employees are based on specified benefit amounts and years of service. Consistent with past practice, this plan includes the effect of future bargained-for improvements. BellSouth's funding policy is to make contributions to trust funds with the objective of accumulating sufficient assets to pay all pension benefits for which BellSouth is liable. Contributions are actuarially determined using the aggregate cost method, subject to ERISA and Internal Revenue Service limitations. Pension plan assets consist primarily of equity securities and fixed income investments. Pension cost allocated to BellSouth Telecommunications in 1993, 1992 and 1991 was $113.4, $155.3 and $133.4, respectively. SFAS No. 87, "Employers' Accounting for Pensions," requires certain disclosures to be made with respect to the components of net periodic pension cost for the period and a reconciliation of the funded status of the plan with amounts reported in the balance sheets. Such disclosures are not presented because the structure of the BellSouth plans does not permit disaggregation of relevant plan information on an individual company basis. The projected benefit obligation for 1993 and 1992 was determined using a discount rate of 7.5% and 7.75%, respectively, and for both years an expected long-term rate of return on plan assets of 8% and a long-term assumed weighted average rate of compensation increase of 5.7%. Other economic related benefit assumptions, for both the non-represented and the represented plans, have been changed to reflect both past experience and management's best estimate of future benefit increases. For BellSouth, the assumption changes will have the impact of reducing the projected 1994 pension cost by $20. In 1991, BellSouth Telecommunications offered an early retirement option to non-represented employees. Approximately 3,100 employees elected to retire under this option, which allowed the employee to accept the present value of their pension benefit as a lump-sum payment and to receive a special payment equivalent to 5% of base pay times full years of service (not to exceed 100% of base pay). The retirement option was accounted for in accordance with SFAS No. 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits." BellSouth Telecommunications recognized an expense of $68.1 in 1991 related to this option. POSTRETIREMENT BENEFITS OTHER THAN PENSIONS. Substantially all non-represented and represented employees of BellSouth Telecommunications participate in BellSouth's defined benefit postretirement health and life insurance plans. Effective January 1, 1993, BellSouth Telecommunications adopted SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," to account for these plans. BellSouth's transition benefit obligation of $1,486 will be amortized over 15 years, the average remaining service period of active plan participants. The accounting for the health care plan does not anticipate future adjustments to the cost-sharing arrangements provided for in the written plan. As a result of the adoption of SFAS No. 106, net income for 1993 was reduced by approximately $16. BELLSOUTH TELECOMMUNICATIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in Millions) NOTE H -- EMPLOYEE BENEFITS (CONTINUED) As of January 1993, the accumulated postretirement health benefit obligation for non-represented retirees is being funded over the average remaining service period of currently active non-represented employees. The accumulated postretirement benefit obligation for pre-January 1, 1990 represented retirees is being funded over a 10-year period while the accumulated postretirement benefit obligation for all other represented retirees is being funded over the average remaining service period of currently active represented employees. Postretirement benefit cost allocated to BellSouth Telecommunications for the twelve months ended December 31, 1993 was $243.7. Prior to 1993, BellSouth Telecommunications recognized the cost of providing postretirement benefits based on funded amounts. The cost of providing health and life benefits for both active and retired employees was $524.1 and $507.0 for 1992 and 1991, respectively. SFAS No. 106 requires certain disclosures to be made with respect to the components of postretirement benefit cost for the period and a reconciliation of the funded status of the plans with amounts reported in the balance sheet. Such disclosures are not presented because the structure of the BellSouth plans does not permit disaggregation of relevant plan information on an individual company basis. For measurement purposes, BellSouth used a 11.5% annual rate of increase in the per capita cost of covered health care benefits for 1994; the rate is assumed to decrease gradually to 5% in 2007 and remains at that level. The health care cost trend rate assumption significantly affects the amounts reported. A one-percentage-point increase in the assumed health care cost trend rates for each future year would increase BellSouth's accumulated postretirement benefit obligation by $171 and the estimated aggregate service and interest cost components of the 1993 postretirement benefit cost by $15. For purposes of valuing the postretirement life insurance obligation, a 5.7% rate of future increase in compensation at December 31, 1993 was used. The discount rate used in determining the accumulated postretirement benefit obligation was 7.5%. After a 30% tax reduction for the non-represented employees' trust, the combined expected long-term rate of return on plan assets used was 8%. The impact of reducing the discount rate from 9% to 7.5% will increase BellSouth's 1994 postretirement benefit expense by approximately $30. Most regulatory jurisdictions have accepted BellSouth Telecommunications' SFAS No. 106 implementation plan. However, one state's commission is requiring a 20-year amortization of the transition benefit obligation and in another state there are pending issues, the outcome of which are not expected to have a material impact on recovery. EFFECT OF RESTRUCTURING ON PENSIONS AND POSTRETIREMENT BENEFITS. As a result of the restructuring (see Note J), BellSouth Telecommunications recognized $88 of estimated net curtailment losses expected to impact BellSouth Telecommunications' pension and postretirement benefit plans. Of the amount recognized, $16 was realized in 1993. DEFINED CONTRIBUTION PLANS. BellSouth maintains contributory savings plans which cover substantially all employees of BellSouth Telecommunications. Employees' eligible contributions are matched with BellSouth common stock based on defined percentages determined annually by the Board of Directors. BellSouth Telecommunications' recognized compensation expense of $107.3, $112.6 and $109.8 in 1993, 1992 and 1991, respectively, related to these plans. POSTEMPLOYMENT BENEFITS. Effective January 1, 1993, BellSouth Telecommunications adopted SFAS No. 112, "Employers' Accounting for Postemployment Benefits." SFAS No. 112 requires employers to accrue the cost of postemployment benefits provided to former or inactive employees after employment but before retirement, including but not limited to workers' compensation, disability, BELLSOUTH TELECOMMUNICATIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in Millions) NOTE H -- EMPLOYEE BENEFITS (CONTINUED) and continuation of health care benefits. Previously, BellSouth Telecommunications used the cash method to account for such costs. A one-time charge related to adoption of SFAS No. 112 was recognized as a change in accounting principle, effective as of January 1, 1993. The charge was $64.8, net of a deferred tax benefit of $40.8. The effect of the change on BellSouth Telecommunications' 1993 operating results was not material. Future expense levels are dependent upon actual claim experience, but are not expected to differ materially from expense recognized under the former accounting method. NOTE I -- LEASES BellSouth Telecommunications has entered into operating leases for facilities and equipment used in operations. Rental expenses under operating leases were $228.6, $258.7 and $224.4 for 1993, 1992 and 1991, respectively. Capital leases currently in effect are not significant. The following table summarizes the approximate future minimum rentals under non-cancelable operating leases in effect at December 31, 1993: NOTE J -- RESTRUCTURING CHARGE The results of operations for the year ended December 31, 1993 include a $1,136.4 restructuring charge which reduced net income by $696.6. The restructuring is being undertaken to redesign and streamline the fundamental processes and work activities in the telephone operations to better respond to an increasingly competitive business environment. The restructuring is expected to improve overall responsiveness to customer needs, permit more rapid introduction of new products and services and reduce costs. The material components of the charge relate to the downsizing of the existing workforce by 10,200 employees through 1996. These components include provisions for separation payments and relocations of remaining employees, consolidation and elimination of certain operations facilities and for enabling changes to information systems, primarily those used to provide services to existing customers. NOTE K -- ADDITIONAL INCOME STATEMENT DATA Interest and dividend income for 1992 includes $56.6 relating to the settlement of an Internal Revenue Service summary assessment for the tax years 1979 and 1980. BELLSOUTH TELECOMMUNICATIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in Millions) NOTE K -- ADDITIONAL INCOME STATEMENT DATA (CONTINUED) Revenues from services provided to American Telephone and Telegraph Company, BellSouth Telecommunications' largest customer, were approximately 16%, 16% and 17% of consolidated operating revenues for 1993, 1992 and 1991, respectively. NOTE L -- INCOME TAXES Effective January 1, 1993, BellSouth Telecommunications adopted SFAS No. 109, "Accounting for Income Taxes," which applies a balance sheet approach to income tax accounting. In accordance with the new standard, the balance sheet reflects the anticipated tax impact of future taxable income or deductions implicit in the balance sheet in the form of temporary differences. These temporary differences reflect the difference between the basis in assets and liabilities as measured in the financial statements and as measured by tax laws using enacted tax rates. The cumulative effect of the adoption of SFAS No. 109 was not material. As permitted by the new standard, prior years' financial statements have not been restated. In accordance with the provisions of SFAS No. 71, "Accounting for the Effects of Certain Types of Regulation," BellSouth Telecommunications has, for its regulated operations, only reflected the balance sheet impact of the adoption of this statement. Specifically, BellSouth Telecommunications recorded a net regulatory liability of $538.0 coincidental with the reduction of the deferred tax reserves from higher historical to lower current tax rates. The balance of such liability at December 31, 1993, included in Other Liabilities and Deferred Credits, was $378.9. This regulatory liability will be adjusted as the related temporary differences reverse. BellSouth Telecommunications is included in the consolidated Federal income tax return filed by BellSouth Corporation and its subsidiaries. Consolidated tax expense is allocated among the separate members of the group in accordance with the applicable sections of the Internal Revenue Code. Generally, under this method each company calculates its current tax expense as if it filed a separate return. The sum of the separate company liabilities is compared to the consolidated return liability. The resulting difference, the benefit of consolidation, is allocated to companies contributing benefits (operating losses, excess credits and capital losses) in proportion to the amounts contributed. Each company calculates its deferred tax expense as if it filed a separate return. Deferred taxes are not allocated among the members of the group. The provision for income taxes is summarized as follows: BELLSOUTH TELECOMMUNICATIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in Millions) NOTE L -- INCOME TAXES (CONTINUED) Temporary differences and carryforwards which give rise to deferred tax assets and (liabilities) at December 31, 1993 are as follows: Of the Net Deferred Tax Liability at December 31, 1993, $199.6 was current and $(2,831.4) was noncurrent. Deferred tax expense for 1992 and 1991 resulting from timing differences in the recognition of revenue and expense items for tax and financial reporting purposes, were as follows: A reconciliation of the Federal statutory income tax rate to BellSouth Telecommunications' effective tax rate follows: NOTE M -- SUPPLEMENTAL CASH FLOW INFORMATION The following supplemental information is presented in accordance with the provisions of SFAS No. 95, "Statement of Cash Flows": BELLSOUTH TELECOMMUNICATIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in Millions) NOTE N -- FINANCIAL INSTRUMENTS The following disclosure of the estimated fair value of financial instruments is presented in accordance with the provisions of SFAS No. 107, "Disclosures about Fair Value of Financial Instruments." The estimated fair value amounts have been determined using available market information described below. Since judgment is required to develop the estimates, the estimated amounts presented herein may not be indicative of the amounts that BellSouth Telecommunications could realize in a current market exchange. CASH AND CASH EQUIVALENTS. At December 31, 1993 and 1992, the recorded amount for Cash and cash equivalents approximates fair value due to the short-term nature of these instruments. MARKETABLE SECURITIES. The fair value of marketable securities (representing BellSouth Common Stock), included as a component of Investments in and Advances to Affiliates, is based on the quoted market price at December 31, 1993 (see Note B). DEBT. At December 31, 1993 and 1992, the recorded amount of Debt Maturing Within One Year approximates the fair value due to the short-term nature of the liabilities. The estimates of fair value for Debentures and Notes are based on the closing market prices for each issue at December 31, 1993 and 1992, respectively (see Note E). BELLSOUTH TELECOMMUNICATIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (Dollars in Millions) NOTE O -- QUARTERLY FINANCIAL INFORMATION (UNAUDITED) In the following summary of quarterly financial information, all adjustments necessary for a fair presentation of each period were included. The results for first quarter 1993 were restated to reflect the one-time, non-cash charge for retroactive adoption of SFAS No. 112. PART IV ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE No change in accountants or disagreements on the adoption of appropriate accounting standards or financial disclosure have occurred during the periods included in this report. ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K a. Documents filed as a part of the report: Financial statement schedules other than those listed above have been omitted because the required information is contained in the financial statements and notes thereto or because such schedules are not required or applicable. (3) Exhibits: Exhibits identified in parentheses below, on file with the SEC, are incorporated herein by reference as exhibits hereto. b. Reports on Form 8-K: None. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. BELLSOUTH TELECOMMUNICATIONS, INC. /s/ PATRICK H. CASEY -------------------------------------- Patrick H. Casey VICE PRESIDENT AND COMPTROLLER March 28, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. PRINCIPAL EXECUTIVE OFFICER: F. Duane Ackerman* President and Chief Executive Officer PRINCIPAL FINANCIAL OFFICER AND PRINCIPAL ACCOUNTING OFFICER: Patrick H. Casey* Vice President and Comptroller DIRECTORS: F. Duane Ackerman* Irving W. Bailey II* Robert H. Boh* Edward E. Crutchfield, Jr.* Frank R. Day* Jere A. Drummond* Lloyd C. Elam* John W. Harris* Mark C. Hollis* Harry M. Lightsey, Jr.* Thomas H. Meeker* Joe M. Rodgers* Charles J. Zwick* *By: /s/ PATRICK H. CASEY ---------------------------------- Patrick H. Casey (INDIVIDUALLY AND AS ATTORNEY-IN-FACT) March 28, 1994 BELLSOUTH TELECOMMUNICATIONS, INC. SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT YEAR ENDED DECEMBER 31, 1993 (DOLLARS IN MILLIONS) YEAR ENDED DECEMBER 31, 1992 (DOLLARS IN MILLIONS) The notes on Page 45 are an integral part of this Schedule. BELLSOUTH TELECOMMUNICATIONS, INC. SCHEDULE V -- PROPERTY, PLANT AND EQUIPMENT YEAR ENDED DECEMBER 31, 1991 (DOLLARS IN MILLIONS) BELLSOUTH TELECOMMUNICATIONS, INC. SCHEDULE VI -- ACCUMULATED DEPRECIATION YEAR ENDED DECEMBER 31, 1993 (DOLLARS IN MILLIONS) YEAR ENDED DECEMBER 31, 1992 (DOLLARS IN MILLIONS) The notes on Page 47 are an integral part of this Schedule. BELLSOUTH TELECOMMUNICATIONS, INC. SCHEDULE VI -- ACCUMULATED DEPRECIATION YEAR ENDED DECEMBER 31, 1991 (DOLLARS IN MILLIONS) BELLSOUTH TELECOMMUNICATIONS, INC. SCHEDULE VIII -- VALUATION AND QUALIFYING ACCOUNTS ALLOWANCE FOR UNCOLLECTIBLES (DOLLARS IN MILLIONS) BELLSOUTH TELECOMMUNICATIONS, INC. SCHEDULE X -- SUPPLEMENTARY INCOME STATEMENT INFORMATION FOR THE THREE YEARS ENDED DECEMBER 31, 1993 (DOLLARS IN MILLIONS)

832427_1993.txt

832427

1993

Item 1. DESCRIPTION OF BUSINESS National Health Laboratories Incorporated (the "Company") was incorporated in Delaware on March 23, 1971 as DCL Health Laboratories Incorporated and adopted its current name on June 3, 1974. The Company's principal executive offices are located at 4225 Executive Square, Suite 800, La Jolla, California 92037, and its telephone number is (619) 550-0600. Until the initial public offering of approximately 5% of the Company's common stock in July 1988, the Company was an indirect wholly owned subsidiary of Revlon Holdings, Inc. ("Revlon"), then known as Revlon, Inc., which, in turn, is an indirect wholly owned subsidiary of Mafco Holdings Inc. ("MAFCO"), a corporation that is 100% owned by Ronald O. Perelman. Following the completion of successive secondary public offerings of the Company's common stock, a self tender offer by the Company and the purchase by the Company of outstanding shares of its common stock, MAFCO's indirect ownership has been reduced to approximately 24%. The Company is one of the leading clinical laboratory companies in the United States. Through a national network of laboratories, the Company offers a broad range of testing services used by the medical profession in the diagnosis, monitoring and treatment of disease. Office-based physicians constitute approximately 90% of the Company's clients. The remainder is comprised primarily of managed care providers, hospitals, clinics, nursing homes and other clinical laboratories. Since its founding, the Company has grown into a network of 17 major laboratories, including a national reference laboratory which performs esoteric testing and tests for the presence of drugs of abuse, 73 sales ports and 662 patient service centers and STAT laboratories, serving customers in 44 states. Recent Developments On March 14, 1994, National Health Laboratories Holdings Inc. ("NHL Holdings"), a newly formed, wholly owned subsidiary of the Company filed a Registration Statement with the Securities and Exchange Commission on Form S-4 under the Securities Act of 1933, as amended, covering the shares of NHL Holdings' common stock to be issued in connection with a proposed corporate reorganization that will create a holding company structure for the Company. Under such proposed corporate reorganization, NHL Holdings, which was specifically formed to effect the reorganization, will become the parent holding company of the Company. All outstanding shares of common stock of the Company will be converted on a share-for-share basis into shares of common stock of NHL Holdings. As a result, the owners of common stock of the Company will become the owners of common stock of NHL Holdings. The Company believes the reorganization will provide a greater ability to take advantage of future growth opportunities and will broaden the alternatives available for future financing. If the proposed corporate reorganization is approved by an affirmative vote of a majority of the outstanding shares of the Company's common stock at the Company's next annual meeting of stockholders, such reorganization is expected to be effected promptly after such approval. The Clinical Laboratory Industry Clinical laboratory tests are used by physicians to diagnose, monitor and treat diseases and other clinical states through the detection of substances in blood or tissue samples and other specimens. Clinical laboratory tests are primarily performed by hospitals in-house, by physicians in their offices or in physician-owned laboratories and by independent laboratory companies like the Company. The Company views the clinical laboratory industry as highly fragmented with many local and regional competitors, including numerous physician and hospital-owned laboratories as well as several large independent laboratory companies. The clinical laboratory industry has experienced rapid consolidation. The Company believes that this consolidation will continue due to pricing pressures, overcapacity, cost burdens on small labs as they strive to meet new regulatory requirements and restrictions on Medicare and Medicaid reimbursement for tests referred by physicians to laboratories in which they have a financial interest. Laboratory Testing Operations and Services The Company has 17 major laboratories, 73 sales ports and 662 patient service centers and STAT laboratories. A "sales port" is a central office which collects specimens in a region for shipment to one of the Company's laboratories for testing. Test results can be printed at a sales port and conveniently delivered to the client. A sales port also is used as a base for sales staff. A "patient service center" is a facility generally maintained by the Company to serve the physicians in a medical professional building. The patient service center collects the specimens as requested by the physician. The specimens are sent, principally through the Company's in-house courier system (and, to a lesser extent, through independent couriers), to one of the Company's major laboratories for testing. Some of the Company's patient service centers have "STAT labs", which are laboratories that have the ability to perform certain routine tests quickly and report results to the physician immediately. The Company processes approximately 116,000 patient specimens on an average day, representing approximately 327,000 separate laboratory tests. Patient specimens are delivered to the Company accompanied by a test request form. These forms are completed by the client, indicating the tests to be performed and providing the necessary billing information. Each specimen and related request form is checked for completeness and then given a unique identification number. The unique identification number assigned to each patient helps to assure that the results are attributed to the correct patient. The test request forms are sent to a data entry terminal where a file is established for each specimen and the necessary testing and billing information entered. Once this information is entered into the system, the tests are performed and the results are entered either manually or through computer interface, depending upon the tests and the type of equipment involved. Most of the Company's computer testing equipment is interfaced with the Company's computer system. Most routine testing is completed by early the next morning, and test results are printed and prepared for distribution by service representatives that day. Some clients have local printer capability and have reports printed out directly in their offices. Clients who request that they be called with a result are so notified in the morning. It is Company procedure to notify the client immediately if at any time in the course of the testing process a life-threatening result is found. The following discussion describes the different types of tests performed by the Company: Routine Clinical Testing. The Company believes that there are approximately 1,300 tests available in the industry today, of which the Company considers approximately 50% routine. The vast majority of the number of tests actually performed by the Company are considered by the Company to be routine. The Company performs all of such routine tests in its own laboratories. A routine test generally is a higher volume, simpler test capable of being performed and reported within 24 hours. The Company performs many routine clinical tests with sophisticated and computerized laboratory testing equipment. These tests provide information used by physicians in determining the existence or absence of disease or abnormalities. The Company performs this core group of routine tests in each of its 17 major regional laboratories for a total of approximately 81,500,000 routine tests annually. Esoteric Clinical Testing. Esoteric tests are specialized laboratory tests performed in cases where information is needed to confirm a diagnosis, or when the physician requires additional information to develop a plan of therapy for a complicated medical case. Esoteric tests are generally more complex tests, requiring more sophisticated technology and more expensive equipment and materials, as well as a higher degree of technical skill to perform. The number of esoteric tests continually increases as new medical discoveries are made. The Company presently considers approximately 650 tests to be esoteric. In March 1989, the Company opened a new, state-of-the-art national reference laboratory in Nashville, Tennessee. This laboratory provides a central location for esoteric testing for all of the Company's major laboratories and their clients. The Company performs approximately 90% of all types of tests considered by the Company to be esoteric at its own facilities, representing approximately 1,950,000 tests annually. With the opening of this facility, the Company has reduced both the types and numbers of esoteric tests that are referred to outside laboratories to be performed. Cytology. Cytology, which involves both routine and esoteric clinical testing, is the examination of cells under a microscope to detect abnormalities in composition, form or structure which are associated with disease. The PAP smear is the most common cytologic test, accounting for approximately 99% of all of the Company's testing in this area. Additional cytology tests are performed on fluid aspirations, bronchial washings and breast fluid smears. The Company performs approximately 3,800,000 PAP smears and other cytologic examinations annually. Anatomical Testing. Routine and esoteric anatomical tests require the examination of a small piece of tissue which either is cut from the body surgically or taken in a biopsy. These tissue specimens are examined by a pathologist both visually and microscopically to detect abnormalities in composition, form or structure which are associated with disease. The Company performs approximately 540,000 anatomical tests annually. Quality Assurance The Company considers the quality of its tests to be of critical importance to its growth and retention of accounts. It has established a comprehensive quality assurance program for all of its laboratories and other facilities designed to help assure accurate and timely test results. All laboratories certified by the Health Care Financing Administration ("HCFA") of the Department of Health and Human Services ("HHS") for participation in the Medicare program and licensed under the Clinical Laboratory Improvement Act of 1967, as amended by the Clinical Laboratory Improvement Amendments of 1988 ("CLIA") must participate in basic quality assurance programs. In addition to the compulsory external inspections and proficiency programs demanded by the regulatory agencies, the Company has adopted a substantial number of additional quality assurance programs. See "-- Governmental and Industry Regulation". Each laboratory is equipped with sophisticated testing equipment which is checked daily in accordance with the Company's preventive maintenance program. In addition, each laboratory is supervised by a medical director who is a physician, assisted by a technical director who meets certain regulatory requirements, and is staffed with medical professionals. The primary role of such professionals is to ensure the accuracy of the Company's tests. The Company employs inspectors with doctorate and masters degrees in biological sciences who visit and inspect each of the laboratories routinely on an unannounced basis. The Company attempts to have such inspections conducted in the same manner as the annual inspections conducted by federal and state government officials. Any deficiencies which appear must be corrected within 30 days. In late 1990, the Company completed a state-of-the-art Technology Center at its headquarters facility in La Jolla, California. The center houses the Company's Quality Assurance Group and enhances its ability to monitor the testing results of the individual laboratories. A computerized network has been established allowing virtual on-line examination of test results and monitoring of the laboratories. The Company also participates in a number of proficiency testing programs which, generally, entail submitting pretested samples to a laboratory to verify the laboratory test results against the known proficiency test value. These proficiency programs are conducted both by the Company on its own and in conjunction with groups such as the College of American Pathologists ("CAP") and state and federal government regulatory agencies. The CAP is an independent non-governmental organization of board certified pathologists which offers an accreditation program to which laboratories can voluntarily subscribe. The CAP accreditation program involves both on-site inspections of the laboratory and participation in the CAP's proficiency testing program for all categories in which the laboratory is accredited by the CAP. A laboratory's receipt of accreditation by the CAP satisfies the Medicare requirement for participation in proficiency testing programs administered by an external source. See "--Governmental and Industry Regulation". Sales, Marketing and Client Service The Company's business strategy also emphasizes sales, marketing and client service which the Company believes have been important factors in its growth. The Company's sales force was slightly reshaped during 1993 to reflect changes in the current marketplace. A new, totally dedicated sales force of 20 people was assembled to better address managed care, an emerging and increasingly important segment of the clinical laboratory customer base. At the beginning of 1993, the Company had contracts with over 300 managed care organizations and insurance companies. During the year, the managed care sales group arranged new contracts with more than 120 additional managed care providers across the country. The Company's hospital sales force was also expanded during 1993. New contracts were signed with over 100 group purchasing or individual hospital organizations which are expected to generate annualized revenues in excess of seven million dollars. The Company continued its support of the sales force's efforts with a variety of marketing and informational brochures. Patient information booklets on commonly ordered chemistry tests and the PAP test were published in both English and Spanish and given to clients for distribution to their patients. A new end stage renal dialysis marketing program was introduced; components included a marketing brochure and a sophisticated data processing program for use in dialysis centers. To support the efforts of the newly formed managed care sales force, the Company developed a unique, proprietary utilization review program geared specifically toward today's managed care client's needs. A managed care capabilities brochure was also prepared to introduce Company sales people to potential new managed care customers. The Company considers it's quality assurance program to be a leader in the industry. To convey this to new and existing clients, a quality assurance brochure was produced to give a detailed explanation of the Company's 19 clinical laboratory and 18 cytology quality assurance programs. Lastly, the Company started a quarterly newsletter called "Horizon" which is directed at the hospital marketplace. After an account is acquired, primary responsibility for the account is turned over to the Company's Client Service Program and its client service coordinators. This group expanded by approximately 20% during 1993, increasing to over 200 individuals. Through these coordinators, the Company continuously monitors and assesses service levels, maintains client relationships and attempts to identify and respond to client needs. Potential New Markets Both the hospital reference and managed care markets present tremendous opportunities for future growth. The impact of health care reform and the current industry consolidation will create many unique situations in both these market segments. The Company plans to continue to expand both sales forces that service these two groups. In addition, the Company intends to target certain niche markets for increased sales penetration during 1994: Clinical Trials, End Stage Renal Dialysis and Nursing Homes. Lastly, several of the acquisitions completed during 1993 opened new geographic markets for the Company's primary target market, office-based physicians. Sales for the Company's national reference laboratory for esoteric testing ("NRL I") increased in 1993 to approximately $65 million from approximately $60 million in 1992. The facility is located in Nashville, Tennessee, and services both the hospital reference and physician office market. Sales of the Company's national reference laboratory for testing for the presence of drugs of abuse ("NRL II") also grew from approximately $3 million in 1992 to approximately $4.3 million in 1993. The Company believes that both these organizations will exhibit continued growth in 1994 and in future years. Information Systems The Company believes the requirement for timely, clearly presented data is paramount to health care organizations' success in the 1990s. A dedicated managed care data system and an enhanced physician office system with field support were two of the many new programs developed by the information systems group in 1993. Plans for 1994 include completion of laboratory hardware/software standardization, final computerization and installation of a cytology and histology data system and developmental work on a new advanced large laboratory system. A new, enhanced billing system to handle the needs of various third party carriers and managed care clients will be installed in all the regional laboratories during the first half of 1994. Additionally, the Company will begin testing and installation of its next generation comprehensive billing system. Further, to improve customer service, a number of the laboratory telephone systems will be replaced or upgraded during 1994. Infectious Waste Certain federal and state laws govern the handling and disposal of infectious and hazardous wastes. Although the Company believes that it is currently in compliance in all material respects with such federal and state laws, failure to comply could subject the Company to fines, criminal penalties and/or other enforcement actions. Customers To date, the Company has focused its marketing efforts primarily on office-based physicians, whose orders account for approximately 90% of its net sales. The remaining 10% of net sales is derived from managed care providers, hospital reference testing, nursing homes, clinics, referrals from other clinical laboratories and other clients. The largest client of the Company accounts for approximately 1.2% of net sales. The Company believes that the loss of any one client would not have a material adverse effect on its financial condition. Payment for the Company's services is made by the patients directly, physicians who in turn bill their patients, or third party payors, including public and private parties such as Medicare, Medicaid and Blue Shield. Employees At December 31, 1993, the Company employed approximately 10,650 people. These include approximately 7,700 full-time employees and approximately 2,950 part-time employees, which represents the equivalent of approximately 8,360 persons full- time. Of the approximately 8,360 full-time equivalent employees, approximately 350 are sales personnel, approximately 7,140 are laboratory and distribution personnel and approximately 870 are administrative and data processing personnel. The Company has no collective bargaining agreements with any unions and believes that its overall relations with its employees are excellent. Governmental and Industry Regulation The clinical laboratory industry is subject to government regulation at the federal, state and local levels. The Company's major laboratories are certified under the federal Medicare program, state Medicaid programs and CLIA. Where applicable, licensure is maintained under the laws of state or local governments that have clinical laboratory regulation programs. In addition, in facilities where radioimmunoassay testing is performed, the facilities are licensed by the federal Nuclear Regulatory Commission and, where applicable, by state nuclear regulatory agencies. Sixteen of the Company's 17 major laboratories are accredited by the CAP. The Chicago regional laboratory, opened January 1, 1994, is currently applying for CAP accreditation. In addition, the Company's STAT laboratories are also certified or licensed, as necessary, under federal, state or local programs. The federal and state certification and licensure programs establish standards for the day-to-day operation of a medical laboratory, including, but not limited to, personnel and quality control. Compliance with such standards is verified by periodic inspections by inspectors employed by the appropriate federal or state regulatory agency. In addition, regulatory authorities require participation in a proficiency testing program provided by an external source which involves actual testing of specimens that have been specifically prepared by the regulatory authority for testing by the laboratory. In 1993, 1992 and 1991, approximately 41%, 42% and 42%, respectively, of the Company's revenues were derived from tests performed for beneficiaries of Medicare and Medicaid programs. Furthermore, the conduct of the Company's other business depends substantially on continued participation in these programs. Under law and regulation, for most of the tests performed for Medicare or Medicaid beneficiaries, the Company must accept reimbursement from Medicare or Medicaid as payment in full. In 1984, Congress adopted legislation establishing a fee schedule reimbursement methodology for testing for out-patients under Medicare. The 1984 legislation reduced the laboratory reimbursement rate by 40%. In 1986, Congress changed the fee schedule reimbursement mechanism by creating national limitation amounts which are the medians of the fee schedule rates for tests subject to the fee schedules. Initially, laboratories were paid 115% of the national limitation amounts. Since 1986, Congress has gradually reduced the percentage of the national limitation amounts that Medicare will pay to 84%. The latest reduction in the national limitation payment amounts (from 88% to 84% effective January 1, 1994) was made as part of the Omnibus Budget Reconciliation Act of 1993 ("OBRA '93") that was enacted into law during 1993. OBRA '93 contains provisions for a further reduction in payments to 80% of the national limitation amounts effective January 1, 1995, followed by an additional reduction to 76% on January 1, 1996. OBRA '93 also eliminated, for 1994 and 1995, the provision for annual fee schedule increases based upon the consumer price index. In addition, state Medicaid programs are prohibited from paying more than the Medicare fee schedule amount for testing for Medicaid beneficiaries. Additional future changes in federal, state or local regulations (or in the interpretation of current regulations) affecting governmental reimbursement for clinical laboratory testing or the methods for choosing laboratories eligible to perform tests could have a material adverse effect on the Company. On January 1, 1993, numerous changes in the Physicians' Current Procedural Terminology ("CPT") were published. The CPT is a coding system that is published by the American Medical Association. It lists descriptive terms and identifying codes for reporting medical and medically related services. The Medicare and Medicaid programs require suppliers, including laboratories, to use the CPT codes when they bill the programs for services performed. HCFA implemented these CPT changes for Medicare and Medicaid on August 1, 1993. The CPT changes have altered the way the Company bills Medicare and Medicaid for some of its services, thereby reducing the reimbursement the Company receives from those programs for some of its services. For example, certain codes for calculations, such as LDL cholesterol were deleted and are no longer a payable service under Medicare and Medicaid. In March 1992, HCFA published proposed regulations to implement the Medicare statute's prohibition (with certain exceptions) against compensation arrangements between physicians and laboratories. The proposed regulations would define remuneration that gives rise to a compensation arrangement as including discounts. If that definition of remuneration were to become effective, it could have an impact on the way the Company prices its services to physicians. However, in August 1993, the referenced Medicare statute was amended by OBRA '93. One of these amendments makes it clear that day-to-day transactions between laboratories and their customers, including but not limited to discounts granted by laboratories to their customers, are not affected by the compensation arrangement provisions of the Medicare statute. Thus, the Company expects the definition of remuneration in HCFA's proposed regulations will be changed to reflect this amendment to the Medicare statute. Currently, these proposed regulations have not been finalized. The Clinton Administration has announced its desire and intention to reform health care in the United States. Some of the proposals that have been discussed include managed competition, global budgeting, price controls and freezes on health care costs. Health care reform could have a material effect on the Company. The Company is unable to predict, however, whether and what type of health care reform legislation will be enacted into law. In November 1990, the Company became aware of a grand jury inquiry relating to its pricing practices being conducted by the United States Attorney for the San Diego area (the Southern District of California) with the assistance of the Office of Inspector General ("OIG") of HHS. On December 18, 1992, the Company announced that it had entered into agreements that concluded the investigation (the "Government Settlement"). The settlement revolved around the government's contention that the Company improperly included its tests for HDL cholesterol and serum ferritin (a measure of iron in the blood) in its basic Health Survey Profile, without clearly offering an alternative profile that did not include these medical tests. The government also contended that, in certain instances, physicians were told that these additional tests would be included in the Health Survey Profile at no extra charge. As a result, the government contended, the Company's marketing activities denied physicians the ability to exercise their judgment as to the medical necessity of these tests. Pursuant to the Government Settlement, the Company pleaded guilty to the charge of presenting two false claims to the Civilian Health and Medical Program of the Uniformed Services ("CHAMPUS") and paid a $1 million fine. In connection with pending and threatened civil claims, the Company also agreed to pay $100 million to the federal government, of which $73 million has been paid and $27 million will be paid in quarterly installments through September 30, 1995. Concurrently, the Company settled related Medicaid claims with states that account for over 99.5% of its Medicaid business, and has paid $10.4 million to the settling states. As a result of these settlements, the Company took a one- time pre-tax charge of $136.0 million in the fourth quarter of 1992, which reduced net earnings for the quarter and year ended December 31, 1992 by $80.3 million. Earnings per share for the fourth quarter and year were each reduced by $0.85. The charge covers all estimated costs related to the investigation and the settlement agreements. The Company will continue to receive reimbursements from all government third party reimbursement programs, including Medicare, Medicaid and CHAMPUS, under the settlement agreements. (The Company made changes to requisition forms, pricing and compendia of tests following the settlement. See "Managements' Discussion and Analysis of Financial Condition and Results of Operations".) In September 1993, the Company was served with a subpoena issued by the OIG, which required the Company to provide documents to the OIG concerning its regulatory compliance procedures. The Company has provided documents to the OIG in response to the subpoena. Compliance Program Because of evolving interpretations of regulations and the national debate over health care, compliance with all Medicare, Medicaid and other government-established rules and regulations has become a significant factor throughout the clinical laboratory industry. The Company began the implementation of a new compliance program in late 1992 and early 1993. The objective of the program is to develop aggressive and reliable compliance safeguards. Emphasis is placed on developing training programs for personnel to attempt to assure the strict implementation of all rules and regulations. Further, in-depth reviews of procedures, personnel and facilities are conducted to assure regulatory compliance throughout the Company. Such sharpened focus on regulatory standards and procedures will continue to be an absolute priority for the Company in the future. Competition The clinical laboratory testing business is characterized by intense competition. The Company believes that there are many clinical laboratory companies which provide a broad range of laboratory testing services in the same markets serviced by the Company. Among the Company's national competitors are Allied Clinical Laboratories, Inc., MetPath Inc., Nichols Institute, Roche Biomedical Laboratories, Inc. and SmithKline Beecham Clinical Laboratories, Inc. According to HCFA, there are over 157,000 federally regulated clinical laboratories, of which approximately 6,400 are independent laboratories. The number of regulated clinical laboratories has increased dramatically as a result of the enactment of the Clinical Laboratories Improvement Amendments of 1988 which expanded the definition of laboratories subject to federal regulation. Competition is based primarily on quality, price and the time required to report results. In addition to competition for customers, there is increasing competition for qualified personnel. Item 2.

Item 2. PROPERTIES The principal properties of the Company are its leased corporate headquarters located in La Jolla, California and the following major laboratory facilities: Approximate Area Nature of Location (in square feet) Occupancy ------------------- -------------- ----------------------- Phoenix, Arizona 43,024 Lease Expires 2001; 5 year renewal option San Diego, California 37,079 Lease Expires 2000 Denver, Colorado 19,982 Lease Expires 2001; two 5 year renewal options Hollywood, Florida 46,500 Lease Expires 2002; three 5 year renewal options Tampa, Florida 26,600 Lease Expires 2002; one 5 year renewal option Chicago, Illinois 40,065 Lease Expires 2003; two 5 year renewal options Louisville, Kentucky 60,000 Lease Expires 2002; three 5 year renewal options Detroit, Michigan 12,800 Lease Expires 1994 Cranford, New Jersey 36,438 Lease Expires 1995; 5 year renewal option Uniondale, New York 108,000 Lease expires 2007; two 5 year renewal options Winston-Salem, North Carolina 42,500 Lease Expires 2004; one 5 year renewal option NRL I-Nashville, Tennessee 46,313 Lease Expires 2000; two 5 year renewal options NRL II-Nashville, Tennessee 25,640 Lease Expires 2000; two 5 year renewal options Dallas, Texas 27,968 Lease Expires 1994 Houston, Texas 32,368 Lease Expires 1996 San Antonio, Texas 20,660 Lease Expires 1997; two 5 year renewal options Herndon, Virginia 64,172 Lease Expires 2004; 5 year renewal option Seattle, Washington 34,900 Lease Expires 2000; two 5 year renewal options Construction of a new major laboratory facility in Chicago, Illinois was completed in December 1993. The laboratory opened January 1, 1994. Construction of two new laboratories to replace the Company's Detroit, Michigan and Cranford, New Jersey facilities will begin in the first quarter of 1994 and be completed in the third and fourth quarters of 1994, respectively. All of the major laboratory facilities have been built or improved for the single purpose of providing clinical laboratory testing services. The Company believes that these facilities are suitable and adequate and have sufficient production capacity for its currently foreseeable level of operations. The Company believes that if it were to lose the lease on any of the facilities it presently leases, it could find alternate space at competitive market rates and readily relocate its operations to such new locations without material disruption to its operations. Item 3.

Item 3. LEGAL PROCEEDINGS The Company is involved in certain claims and legal actions arising in the ordinary course of business. In the opinion of management, based upon the advice of counsel, the ultimate disposition of these matters will not have a material adverse effect on the financial position of the Company. In December 1992, several class actions were filed against the Company and certain of its officers and directors alleging that certain public disclosures made by the Company since February 1990 were false and misleading in that they failed to disclose that a portion of the Company's income was derived from allegedly fraudulent claims and that such non-disclosures rendered the Company's financial statements misleading. These various class actions are pending in the United States District Court for the Southern District of California. The Company believes that the allegations of the complaint that claim wrong doing on behalf of the Company and its officers and directors cannot be supported by the facts or the law and that the Company's disclosures complied with all legal obligations. The Company is defending these lawsuits vigorously. In addition, certain lawsuits have been brought by purported shareholders of the Company, allegedly on the Company's behalf against the Company's directors and certain of its officers, in the Superior Court for the County of San Diego, California. These various claims allege that the Company was damaged by actions of the defendant officers and directors in connection with supervision and control of the practices that led to the guilty plea and civil settlement associated with the Government Settlement. These actions seek no damages against the Company. In November 1993, a class action was filed against the Company and certain of its officers and directors alleging that certain public disclosures made by the Company since December 1992 were false and misleading in that they stated that the Company had taken steps to insure that the Company's sales and marketing practices are compatible with the government's interpretation of current regulations and that they failed to disclose that a portion of the Company's income was derived from allegedly fraudulent claims and that such non-disclosures rendered the Company's financial statements misleading. This class action is pending in the United States District Court for the Southern District of California. The Company believes that the allegations of the complaint that claim wrongdoing on behalf of the Company and its officers and directors cannot be supported by the facts or the law and that the Company's disclosures complied with all legal obligations. On January 5, 1994, a stipulation was entered into whereby the parties have agreed to stay all further activity in this action pending the conclusion of the class actions filed in December 1992. On January 13, 1994, the individual who had commenced a previously reported, purported antitrust class action against the Company in federal district court alleging that he had been billed for unordered tests voluntarily dismissed his action. Item 4.

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report. EXECUTIVE OFFICERS OF THE REGISTRANT Pursuant to General Instruction G(3) of Form 10-K, the following is included as an unnumbered Item in Part I of this report in lieu of being included in the definitive proxy statement for the 1994 annual meeting of stockholders. The following table sets forth as of February 23, 1994 the executive officers of the Company. Name Position -------------------------- ---------------------------------- Ronald O. Perelman Chairman of the Board and Director James R. Maher President, Chief Executive Officer and Director David C. Flaugh Senior Executive Vice President and Chief Operating Officer Timothy J. Brodnik Executive Vice President Michael L. Jeub Executive Vice President, Chief Financial Officer and Treasurer Larry L. Leonard, Ph.D. Executive Vice President John F. Markus Executive Vice President and Corporate Compliance Officer James G. Richmond Executive Vice President and General Counsel W. David Slaunwhite, Ph.D. Executive Vice President Bernard E. Statland, M.D., Ph.D Executive Vice President and Chief Executive Officer of National Reference Laboratory Robert E. Whalen Executive Vice President RONALD O. PERELMAN (51) has been Chairman of the Board and Director of the Company since 1988. Mr Perelman has been Chairman of the Board and Chief Executive Officer of MacAndrews & Forbes Holdings Inc. ("M&F Holdings") and MAFCO, for more than the past five years. Mr. Perelman also is Chairman of the Board of Andrews Group Incorporated ("Andrews Group"), Consolidated Cigar Corporation ("Consolidated Cigar"), New World Communications Group, Inc. ("New World Communications"), Mafco Worldwide Corporation ("Mafco Worldwide"), Marvel Entertainment Group, Inc. ("Marvel"), Revlon Consumer Products Corporation ("Revlon Products") and SCI Television, Inc. Mr. Perelman is a director of the following corporations which file reports pursuant to the Securities Exchange Act of 1934: Andrews Group, The Coleman Company, Inc. ("Coleman"), Coleman Holdings Inc., Coleman Worldwide Corporation, Consolidated Cigar, Mafco Worldwide, Marvel, Marvel Holdings Inc. ("Marvel Holdings"), Marvel (Parent) Holdings Inc. ("Marvel Parent"), Marvel III Holdings Inc. ("Marvel III"), Revlon Products, Revlon Worldwide Corporation and SCI Television, Inc. JAMES R. MAHER (44) has been President, Chief Executive Officer and a Director of the Company since December 1992. Mr. Maher was Vice Chairman of The First Boston Corporation from 1990 to 1992 and Managing Director of The First Boston Corporation since 1982. Mr. Maher also is a director of First Brands Corporation. DAVID C. FLAUGH (46) joined the Company in 1970. In 1992 Mr. Flaugh was appointed Chief Operating Officer and Senior Executive Vice President. He was appointed Chief Financial Officer and Treasurer in 1982 and 1988, respectively. From 1991 to 1992, Mr. Flaugh was Vice President-Managing Director. TIMOTHY J. BRODNIK (46) joined the Company in 1971. He was appointed Executive Vice President of the Company in 1993 and was Senior Vice President from 1991 to 1993 and Vice President- Division Manager commencing 1979. Mr. Brodnik oversees the Company's sales operations. MICHAEL L. JEUB (51) joined the Company in 1993 as Executive Vice President, Chief Financial Officer and Treasurer. Previously, Mr. Jeub was President, Chief Operating Officer and Chief Financial Officer of Medical Imaging Centers of America from 1991 to 1993. From 1988 to 1991, Mr. Jeub was a private investor. Prior to 1988, Mr. Jeub held several positions with International Clinical Laboratories, Inc., including Chief Financial Officer and Eastern Division President. LARRY L. LEONARD (52), who holds a Ph.D. degree in microbiology, joined the Company in 1978. He was appointed Executive Vice President of the Company in 1993 and was Senior Vice President from 1991 to 1993 and Vice President-Division Manager commencing 1979. Dr. Leonard oversees major regional laboratories in Arizona, Florida, North Carolina, Texas and Virginia. JOHN F. MARKUS (42) joined the Company in 1990. He was appointed Executive Vice President and Corporate Compliance Officer in 1993 and was Vice President-Managing Director from 1990 to 1993. Previously, Mr. Markus was an attorney in the law firm of Akin, Gump, Strauss, Hauer and Feld in Washington D.C. for more than five years and was a partner in such firm since 1989. JAMES G. RICHMOND (50) joined the Company in 1992 as Executive Vice President and General Counsel. Previously, Mr. Richmond was Managing Partner of the law firm of Coffield, Ungaretti & Harris in Chicago from 1991 to 1992. Prior thereto, he was Special Counsel to the Deputy Attorney General of the United States from 1990 to 1991 and from 1985 to 1991 was United States Attorney for the Northern District of Indiana. W. DAVID SLAUNWHITE, PH.D. (48) joined the Company in 1981. He was appointed Executive Vice President in 1993, was Vice President - Managing Director from 1991 to 1993 and Vice President - Division Manager from 1989 to 1991. Prior to that he held positions of increasing importance with the Company. Dr. Slaunwhite has operational responsibilities for major regional laboratories in California, Colorado, Illinois, Kentucky, Michigan, New Jersey, New York and Washington. BERNARD E. STATLAND, M.D., PH.D. (52) joined the Company in 1990. He was appointed Executive Vice President in 1993 and was Vice President - Managing Director and Chief Executive Officer of the national reference laboratory from 1990 to 1993. Dr. Statland was named a Scientific Advisor on the Company's Board of Consultants in 1989. Prior to joining the Company, he was Director of Pathology and Laboratory Medicine at Methodist Hospital of Indiana for four years and previously held a similar position at Boston University Hospital. ROBERT E. WHALEN (51) joined the Company in 1976. He was named Executive Vice President of the Company in 1993 and was Senior Vice President from 1991 to 1993 and Vice President - Administration commencing 1985. From 1979 to 1985, he was Vice President - Division Manager of the Company. PART II Item 5.

Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS On April 24, 1991, the common stock commenced trading on the New York Stock Exchange ("NYSE") under the symbol "NH". Prior to such time, the common stock was quoted on the National Market System of the National Association of Securities Dealers, Inc. Automated Quotation System ("NASDAQ") under the symbol "NHLI". The following table sets forth for the calendar periods indicated the high and low sales prices for the common stock reported on the NYSE Composite Tape, and the cash dividends declared per share of common stock. Dividends Declared High Low Per Share --------------------------------------------------------------- First Quarter 29 1/4 24 1/4 0.07 Second Quarter 25 1/2 18 7/8 0.08 Third Quarter 24 3/8 18 0.08 Fourth Quarter 25 1/8 15 5/8 0.08 First Quarter 18 1/4 12 7/8 0.08 Second Quarter 19 1/2 16 1/8 0.08 Third Quarter 18 1/2 14 1/2 0.08 Fourth Quarter 16 3/8 12 0.08 First Quarter (through February 11, 1994) 15 1/4 13 1/4 On February 16, 1994, there were approximately 625 holders of record of the common stock. The Company has a policy pursuant to which dividends equal to approximately 30% of net earnings are paid quarterly. The declaration and payment of dividends is at the discretion of the Board of Directors of the Company and the amount thereof will be dependent upon the Company's results of operations, financial condition, cash requirements for its business, future prospects and other factors deemed relevant by the Board of Directors. In addition, the Company's five year revolving credit facility entered into in August 1993 (the "Revolving Credit Facility") contains, among other provisions, a covenant prohibiting the declaration or payment of cash dividends to stockholders if, after giving effect to such action, a default (as defined by the terms of the Revolving Credit Facility) shall occur and be continuing. Item 6.

Item 6. SELECTED FINANCIAL DATA The selected financial data presented hereinafter as of and for each of the years in the five year period ended December 31, 1993, are derived from consolidated financial statements of the Company, which financial statements have been audited by KPMG Peat Marwick, independent certified public accountants. This data should be read in conjunction with the accompanying notes, the Company's financial statements and the related notes thereto, and "Management's Discussion and Analysis of Financial Condition and Results of Operations", all included elsewhere herein. Item 7.

Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Company derives approximately 41% of its net sales from tests performed for beneficiaries of Medicare and Medicaid programs. Several changes have been made which impact the reimbursement the Company receives from such programs. On January 1, 1993, numerous changes in the Physicians' Current Procedural Terminology were published which became effective on August 1, 1993. These changes impact the reimbursement the Company receives on some of its services that are billed to the Medicare and Medicaid programs. For example, certain codes for calculations, such as LDL cholesterol were deleted and are no longer a payable service under Medicare and Medicaid. Had such changes been implemented as of January 1, 1993, the Company estimates that 1993 net sales would have been reduced by approximately $7 million. During 1993, provisions were included in OBRA '93 which reduced Medicare reimbursement schedules by lowering payments under the fee schedule methodology from 88% to 84% of the national limitation amounts, effective January 1, 1994. The Company estimates that this change would have decreased 1993 net sales by approximately $10 million had it been implemented as of January 1, 1993. A further reduction in payments to 80% of the national limitation amounts will become effective on January 1, 1995, followed by an additional reduction to 76% on January 1, 1996. OBRA '93 also eliminated, for 1994 and 1995, the provision for annual fee schedule increases based upon the consumer price index. In the latter part of 1993, the Company held discussions with HCFA concerning the reimbursement policy for serum ferritin and HDL cholesterol tests. HCFA expressed concerns that the incidence of orders of these tests by physicians remained too high despite changes in the Company's requisition forms, pricing and compendia of tests instituted after the Company's 1992 settlement. As a result of a HCFA directive to Medicare carriers, the Company began to receive denials of claims submitted in September 1993 for serum ferritin and HDL cholesterol tests ordered by physicians and performed in conjunction with automated chemistry panels. Such denials and related suspended billings reduced the Company's 1993 net sales by approximately $18.6 million. The Company continues to discuss the status of these claims with HCFA. The Company has undertaken actions with regard to HCFA's concerns. The Company has removed the HDL cholesterol and serum ferritin tests from all standard chemistry profiles offered on its test requisition form. These tests may be ordered separately or as part of a custom designed profile where specific authorization is provided by the requesting physician. The Company estimates that the annualized effect of these changes would have been a reduction in net sales of approximately $60 million. A portion of such impact aggregating approximately $18.6 million, as discussed above, was reflected in the Company's 1993 net sales. In March 1992, HCFA published proposed regulations to implement the Medicare statute's prohibition (with certain exceptions) against compensation arrangements between physicians and laboratories. The proposed regulations would define remuneration that gives rise to a compensation arrangement as including discounts. If that definition of remuneration were to become effective, it could have an impact on the way the Company prices its services to physicians. However, in August 1993, the referenced Medicare statute was amended by OBRA '93. One of these amendments makes it clear that day-to-day transactions between laboratories and their customers, including, but not limited to discounts granted by laboratories to their customers, are not affected by the compensation arrangement provisions of the Medicare statute. Thus, the Company expects the definition of remuneration in HCFA's proposed regulations will be changed to reflect this amendment to the Medicare statute. Currently, these proposed regulations have not been finalized. The Clinton Administration has announced its intention and desire to reform health care in the United States. Some of the proposals that have been discussed include managed competition, global budgeting, price controls and freezes on health care costs. Health care reform as well as additional future changes in federal, state or local regulations (or in the interpretation of current regulations) affecting governmental reimbursement for clinical laboratory testing could have a material adverse effect on the Company. The Company is unable to predict, however, whether and what type of legislation will be enacted into law. Due to the effect of numerous changes which are reshaping the clinical laboratory market, including aggressive pricing by many competitors, reduced rates of government reimbursement, pricing pressures generated by managed care providers and the demand for increased service levels, coupled with the decline in utilization of ferritin and HDL tests, the Company expects that its margins will be significantly lower in 1994 than in 1993. Year Ended December 31, 1993 compared with Year Ended December ---------------------------------------------------------------- 31, 1992 -------- Net sales increased by $39.1 million to $760.5 million in 1993, an increase of 5.4% over 1992. Revenues generated by new accounts increased net sales by approximately 12.0%. The acquisition of thirty-four small clinical laboratory companies increased the growth in net sales by approximately 3.5%. In addition, net sales for 1993 increased approximately 2.7% because of the Company's annual price increases (effective in January of 1993). Changes in Medicare's reimbursement policy for LDL tests, coupled with changes in various state Medicaid fee schedules and reimbursement methodologies partially offset the increase in net sales by approximately 1.0%. Medicare's denial of claims for ferritin and HDL tests, which began in September 1993 and continued through December 20, 1993 when the Company introduced new test forms and procedures, and related suspended billings also offset the increase in net sales by approximately 2.6%. Additionally, a decline in the utilization of laboratory services, and, to a lesser extent, severe weather in the first three months of the year further offset the increase in net sales by approximately 7.3%. The Company believes that the decline in utilization was due to fewer patient visits to physicians' offices since the number of tests ordered per patient remained relatively constant. Improved accuracy in estimating the difference between amounts billed and amounts received for services provided under third party payor programs, primarily due to the wider use of specific fee schedules for individual third party carriers, resulted in an increase in the growth in net sales of 1.6%. The aggregate of various other impacts, including discounts granted to meet competitive pressure and movement between payor mix categories, reduced the growth in net sales by approximately 3.5%. Revenues derived from tests performed for beneficiaries of Medicare and Medicaid programs were approximately 41% and 42% of net sales in 1993 and 1992, respectively. The Company actively pursued acquisitions of small clinical laboratory companies during 1993. The laboratory industry is consolidating rapidly as smaller, less efficient organizations are experiencing decreasing profitability in the current health care environment. The purchase of thirty-four small laboratories, primarily in the second half of 1993, increased net sales for the year by approximately $25 million. Had all such acquisitions occurred as of the beginning of 1993, the aggregate contribution to net sales would have been approximately $80.6 million. The Company intends to continue its acquisition program. Cost of sales primarily includes laboratory and distribution costs, a substantial portion of which varies directly with sales. Cost of sales increased to $444.5 million in 1993 from $395.1 million in 1992. As a percentage of net sales, cost of sales increased to 58.4% in 1993 from 54.8% in 1992. Labor costs increased approximately 2.7% of net sales, primarily as a result of an increase in phlebotomy staffing to improve client service and meet competitive demands. Rental of premises also grew approximately 0.3% of net sales due to expanding the number of patient service centers by 50% during 1993. Higher capital spending led to increased depreciation expenses of approximately 0.3% of net sales. Also, several expense categories increased slightly, aggregating approximately 0.3% of net sales. The Company continues to focus on cost savings as part of an ongoing program to improve its cost structure. Internal operating reviews were completed in 15 of the Company's 16 laboratories which were in operation during 1993. In 1994, operating reviews will once again be conducted in all laboratories. The Company believes that the relationship of its expense base to net sales is affected by volume growth, cost control efforts and changing emphasis in various functional areas; therefore, a decrease or increase in any cost as a percentage of net sales in a particular period is not necessarily indicative of a trend. Selling, general and administrative expenses increased to $121.4 million in 1993 from $117.9 million in 1992, an increase of $3.5 million. As a percentage of net sales, selling, general and administrative expenses decreased slightly to 16.0% in 1993 compared with 16.3% in 1992. This was primarily due to a reduction in the provision for doubtful accounts, reflecting improvements in the collection of delinquent accounts, and also a result of reduced spending for the relocation of Company employees and for legal services. These changes more than offset an increase in labor costs related to staffing added during 1993 to improve billing customer service and expand the Company's information systems group. The increase in amortization of intangibles and other assets to $9.1 million in 1993 from $8.3 million in 1992 primarily resulted from the acquisition of several small clinical laboratory companies during 1993. Other gains and expenses include expense reimbursement and termination fees of $21.6 million received in connection with the Company's attempt to purchase Damon Corporation, less related expenses and the write-off of certain bank financing costs aggregating $6.3 million, resulting in a one-time pre-tax gain of $15.3 million. Investment income decreased to $1.2 million in 1993 from $2.2 million in 1992 and interest expense increased to $10.9 million in 1993 from $4.2 million in 1992. During 1993, cash in excess of operating requirements and increased borrowings were used to finance acquisitions of numerous small clinical laboratory companies and to finance purchases by the Company of its common stock. The provision for income taxes as a percentage of earnings before income taxes increased to 41.0% in 1993 from 34.6% in 1992, primarily due to the increase in the U.S. corporate tax rates and a result of a higher effective rate for state income taxes. Year Ended December 31, 1992 compared with Year Ended December -------------------------------------------------------------- 31, 1991 -------- Net sales increased by $117.5 million to $721.4 million in 1992, an increase of 19.5% over 1991. Approximately 15.3% of the increase was due to revenues generated by new accounts. In addition, net sales for 1992 increased approximately 4.2% because of the Company's annual price increases (effective in January of 1992). A net increase in Medicare fee schedules contributed approximately 0.6% to the increase in net sales, whereas changes in various state Medicaid fee schedules and reimbursement methodologies reduced the growth in net sales by approximately 0.6%. Revenues derived from tests performed for beneficiaries of Medicare and Medicaid programs were approximately 42% of net sales in both 1992 and 1991. Cost of sales primarily includes laboratory and distribution costs, a substantial portion of which varies directly with sales. Cost of sales increased to $395.1 million in 1992 from $332.5 million in 1991, although as a percentage of net sales, cost of sales decreased slightly to 54.8% in 1992 from 55.1% in 1991. This improvement was primarily attributable to laboratory supply cost decreases of approximately 0.2% of net sales due to cost control efforts, negotiation of favorable national supply contracts and implementation of the initial phase of a new inventory control system. Distribution expenses (which are incurred to deliver specimens from the physician's office to the laboratory) decreased approximately 0.5% of net sales, primarily due to favorable automobile lease rates. Additionally, labor costs increased approximately 0.5% of net sales, mainly as a result of higher employee benefit costs. Also, cost reduction efforts and operational efficiencies resulted in a slight decrease in several expense categories aggregating approximately 0.1% of net sales. Selling, general and administrative expenses increased to $117.9 million in 1992 from $97.9 million in 1991, an increase of $20.0 million. As a percentage of net sales, selling, general and administrative expenses increased slightly to 16.3% in 1992 compared with 16.2% in 1991. This was primarily due to a moderately higher provision for doubtful accounts as a percent of net sales due to the uncertain national economy. Amortization of intangibles and other assets increased $0.6 million to $8.3 million in 1992, primarily due to amortization of debt issuance costs associated with the revolving credit facility in existence during the year. In the fourth quarter of 1992, the Company took a one-time charge of $136.0 million to cover all estimated costs related to agreements that concluded a government investigation that primarily revolved around the government's contention that the Company improperly received reimbursement for tests for HDL cholesterol and serum ferritin (a measure of iron in the blood) included in its basic Health Survey Profile. The one-time charge reduced net earnings and earnings per share for the quarter and year ended December 31, 1992 by $80.3 million and $0.85, respectively. The Company will continue to receive reimbursements from all government third party reimbursement programs, including Medicare, Medicaid and CHAMPUS, under the settlement agreements. Investment income decreased to $2.2 million in 1992 from $3.6 million in 1991 and interest expense increased to $4.2 million in 1992 from $0.1 million in 1991. Both of these changes are directly related to the purchase of 4,808,000 shares of the Company's outstanding common stock in January 1992 pursuant to a tender offer. Such purchase was financed by approximately $25.8 million in cash on hand and $100.0 million borrowed under a revolving credit facility in existence at that time. Also, in April and October 1992, the Company prepaid $15.0 million and $10.0 million, respectively, of the outstanding balance of such revolving credit facility. The provision for income taxes as a percentage of earnings before income taxes decreased to 34.6% in 1992 from 38.6% in 1991, primarily due to a lower effective rate for state income taxes. Liquidity and Capital Resources The Company has generated cash flow in excess of its operating requirements in each of the three past fiscal years. Cash from operations was $57.2 million, $102.4 million and $135.3 million for the years ended December 31, 1993, 1992 and 1991, respectively. Of these amounts, cash used for capital expenditures was $33.6 million, $34.9 million and $25.4 million for the years ended December 31, 1993, 1992 and 1991, respectively. The Company expects capital expenditures to be approximately $30.0 million to $40.0 million in 1994 to accommodate expected growth, to further automate laboratory processes and improve efficiency. During 1993, the Company acquired thirty-four clinical laboratory companies in various locations of the United States for an aggregate amount of $78.2 million in cash plus $28.7 million of liabilities, comprised primarily of future contractual and contingent payments. Such future payments are expected to be funded with cash generated from operations. These laboratories, on an annual basis, are expected to generate approximately $80.6 million in net sales. During 1992, the Company acquired five clinical laboratories for a total of $2.3 million in cash plus $0.7 million of liabilities were assumed. In 1991, three laboratory companies were purchased for $1.2 million in cash plus $5.3 million of liabilities were assumed. It is the Company's intention to continue its acquisition program, although there can be no assurance that the Company will be able to acquire additional laboratories on terms the Company believes to be competitively advantageous. On August 27, 1993, the Company entered into the unsecured Revolving Credit Facility with Citicorp USA, Inc. as agent for a group of banks. The Revolving Credit Facility provides that the Company may borrow up to $350.0 million in order to refinance existing indebtedness; to finance repurchases from time to time by the Company of its common stock; to finance certain acquisitions; and to provide for the general corporate purposes of the Company. The Revolving Credit Facility matures on September 1, 1998, with commitment reductions of $50.0 million on September 1, 1996 and September 1, 1997. The terms and conditions of the Revolving Credit Facility contain, among other provisions, requirements for maintaining a defined level of stockholders' equity, various financial ratios, certain restrictions on repurchases by the Company of its common stock and certain restrictions on acquisitions made outside the Company's ordinary course of business. Interest rates are determined at the time of borrowing and are based on London Interbank Offered Rates plus 1% per annum, or other alternative rates. On September 1, 1993, the Company borrowed $139.0 million under the Revolving Credit Facility to permanently repay all amounts outstanding under revolving credit facilities in existence on such date. Net additional borrowings during 1993 aggregated $139.0 million and were used to finance acquisitions of several clinical laboratory companies and to finance repurchases by the Company of its common stock. In March 1993 and in June 1992, the Company announced plans to purchase from time to time up to 10 million and 2 million shares of its outstanding common stock, respectively, in the open market. Pursuant to these plans, during 1993 and 1992, the Company purchased 9,485,800 and 310,000 such shares, respectively, for an aggregate amount of $154.2 million and $6.1 million, respectively. In January 1992, pursuant to a self tender offer, the Company purchased 4,808,000 of its outstanding shares of common stock for $26 per share in cash, or $125.8 million. The purchase was financed by $25.8 million of cash on hand and $100.0 million borrowed under a revolving credit facility in existence at that time. Pursuant to the Government Settlement, a total of $55.8 million was paid for settlement and other expenses during 1993, including aggregate cash payments of $38.0 million made to the federal government. The remaining amount due the federal government, $27.0 million, is being paid in quarterly installments through September 1995, which installments are expected to be paid with cash generated from operations. During 1992, the Company paid $47.1 million for settlement and related expenses, including $35.0 million to the federal government and $10.4 million to state Medicaid programs. During 1991, the Company guaranteed a $9.0 million, 5 year loan to a third party for construction of a new laboratory to replace one of the Company's existing facilities. Following its completion in November 1992, the building was leased to the Company by this third party. Under the terms of this guarantee, as modified, the Company is required to maintain 105% of the outstanding loan balance including any overdue interest as collateral in a custody account established and maintained at the lending institution. As of December 31, 1993, 1992 and 1991, the Company had placed $9.5 million, $10.3 million and $11.3 million, respectively, of investments in the custody account. Impact of Statement of Financial Accounting Standards No. 115 -- Accounting for Certain Investments in Debt and Equity Securities SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities", was issued in May 1993 and addresses the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. SFAS No. 115 requires the Company to adopt this statement in 1994. The Company does not anticipate that the adoption of SFAS No. 115 will have a material impact on its financial position or results of operations as the Company's investments in such securities are expected to be classified as trading securities, and, as such, their carrying values are considered representative of their fair values. Item 8.

Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Reference is made to the Index on Page of the Financial Report included herein. Item 9.

Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not Applicable. PART III The information required by Part III, Items 10 through 13, of Form 10-K is incorporated by reference from the registrant's definitive proxy statement for its 1994 annual meeting of stockholders, which is to be filed pursuant to Regulation 14A not later than April 30, 1994. PART IV Item 14.

Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K List of documents filed as part of this Report: (1) Consolidated Financial Statements and Independent Auditors' Report included herein: See Index on page (2) Financial Statement Schedules: See Index on page All other schedules are omitted as they are inapplicable or the required information is furnished in the Consolidated Financial Statements or notes thereto. (3) Index to and List of Exhibits (a) Exhibits:* Exhibits 10.6 through 10.43 are management contracts. 3.1 - Restated Certificate of Incorporation of the Company (incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1988 filed with the Commission on March 31, 1989, File No. 1-10740** (the "1988 10-K")). 3.2 - By-laws of the Company (incorporated herein by reference to the Company's 1988 10-K). 10.1 - Laboratory Agreement dated February 4, 1983 between the Company and Humana of Texas, Inc. d/b/a/ Medical City Dallas Hospital (incorporated herein by reference to the Company's Registration Statement on Form S-1 filed with the Commission on May 5, 1988, File No. 33-21708 (the "1988 S-1")). 10.2 - National Health Laboratories Incorporated Employees' Savings and Investment Plan (incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1991 filed with the Commission on February 13, 1992, File No. 1- 10740** (the "1991 10-K")). 10.3 - National Health Laboratories Incorporated Employees' Retirement Plan (incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1992 filed with the Commission on March 26, 1993, File No. 1-10740 (the "1992 10-K")). 10.4 - National Health Laboratories Incorporated Pension Equalization Plan (incorporated herein by reference to the 1992 10-K). 10.5 - Settlement Agreement dated December 18, 1992 be- tween the Company and the United States of America (incorporated herein by reference to the 1992 10-K). 10.6 - Employment Agreement dated December 21, 1992 be- tween the Company and James R. Maher (incorporated herein by reference to the 1992 10-K). 10.7 - Employment Agreement dated May 1, 1991 between the Company and Robert Whalen (incorporated herein by reference to the 1991 10-K). 10.8 - Amendment to Employment Agreement dated June 6, 1991 between the Company and Robert Whalen (incorporated herein by reference to the 1991 10-K). 10.9 - Amendment to Employment Agreement dated January 1, 1993 between the Company and Robert Whalen (incorporated herein by reference to the 1992 10-K). 10.10* - Amendment to Employment Agreement dated January 1, 1994 between the Company and Robert Whalen. 10.11* - Amendment to Employment Agreement dated March 1, 1994 between the Company and Robert Whalen. 10.12 - Employment Agreement dated May 1, 1991 between the Company and Larry L. Leonard (incorporated herein by reference to the 1991 10-K). 10.13 - Amendment to Employment Agreement dated June 6, 1991 between the Company and Larry L. Leonard (incorporated herein by reference to the 1991 10-K). 10.14 - Amendment to Employment Agreement dated January 1, 1993 between the Company and Larry L. Leonard (incorporated herein by reference to the 1992 10-K). 10.15* - Amendment to Employment Agreement dated January 1, 1994 between the Company and Larry L. Leonard. 10.16* - Amendment to Employment Agreement dated March 1, 1994 between the Company and Larry L. Leonard. 10.17 - Employment Agreement dated May 1, 1991 between the Company and Timothy Brodnik (incorporated herein by reference to the 1991 10-K). 10.18 - Amendment to Employment Agreement dated June 6, 1991 between the Company and Timothy Brodnik (incorporated herein by reference to the 1991 10-K). 10.19 - Amendment to Employment Agreement dated January 1, 1993 between the Company and Timothy Brodnik (incorporated herein by reference to the 1992 10-K). 10.20* - Amendment to Employment Agreement dated January 1, 1994 between the Company and Timothy Brodnik. 10.21* - Amendment to Employment Agreement dated March 1, 1994 between the Company and Timothy Brodnik. 10.22 - Employment Agreement dated December 31, 1990 between the Company and Bernard E. Statland (incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1990 filed with the Commission on March 14, 1991, File No. 1-10740** (the "1990 10-K")). 10.23 - Amendment to Employment Agreement dated April 1, 1991 between the Company and Bernard E. Statland (incorporated herein by reference to the 1991 10-K). 10.24 - Amendment to Employment Agreement dated June 6, 1991 between the Company and Bernard E. Statland (incorporated herein by reference to the 1991 10-K). 10.25 - Amendment to Employment Agreement dated January 1, 1993 between the Company and Bernard E. Statland (incorporated herein by reference to the 1992 10-K). 10.26 - Employment Agreement dated January 1, 1991 between the Company and David C. Flaugh (incorporated herein by reference to the 1990 10-K). 10.27 - Amendment to Employment Agreement dated April 1, 1991 between the Company and David C. Flaugh (incorporated herein by reference to the 1991 10-K). 10.28 - Amendment to Employment Agreement dated June 6, 1991 between the Company and David C. Flaugh (incorporated herein by reference to the 1991 10-K). 10.29 - Amendment to Employment Agreement dated January 1, 1993 between the Company and David C. Flaugh (incorporated herein by reference to the 1992 10-K). 10.30 - Employment Agreement dated January 1, 1991 between the Company and W. David Slaunwhite (incorporated herein by reference to the 1990 - 10-K). 10.31 - Amendment to Employment Agreement dated April 1, 1991 between the Company and David Slaunwhite (incorporated herein by reference to the 1991 10-K). 10.32 - Amendment to Employment Agreement dated June 6, 1991 between the Company and David Slaunwhite (incorporated herein by reference to the 1991 10-K). 10.33 - Amendment to Employment Agreement dated January 1, 1993 between the Company and W. David Slaunwhite (incorporated herein by reference to the 1992 10-K). 10.34* - Amendment to Employment Agreement dated January 1, 1994 between the Company and W. David Slaunwhite. 10.35* - Amendment to Employment Agreement dated March 1, 1994 between the Company and W. David Slaunwhite. 10.36 - Employment Agreement dated January 1, 1991 between the Company and John Markus (incorporated herein by reference to the 1990 10-K). 10.37 - Amendment to Employment Agreement dated April 1, 1991 between the Company and John Markus (incorporated herein by reference to the 1991 10-K). 10.38 - Amendment to Employment Agreement dated June 6, 1991 between the Company and John Markus (incorporated herein by reference to the 1991 10-K). 10.39 - Amendment to Employment Agreement dated January 1, 1993 between the Company and John F. Markus (incorporated herein by reference to the 1992 10-K). 10.40* - Amendment to Employment Agreement dated January 1, 1994 between the Company and John F. Markus. 10.41* - Amendment to Employment Agreement dated March 1, 1994 between the Company and John F. Markus. 10.42 - Employment Agreement dated October 1, 1992 between the Company and James G. Richmond (incorporated herein by reference to the 1992 10-K). 10.43 - Employment Agreement dated July 6, 1993 between the Company and Michael L. Jeub (incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 filed with the Commission on August 9, 1993, File No. 1-10740 (the "1993 Second Quarter 10-Q")). 10.44 - Services Agreement (incorporated herein by reference to Amendment No. 1 to the 1988 S-1). 10.45 - Tax Allocation Agreement dated as of June 26, 1990 between MacAndrews & Forbes Holdings Inc., Revlon Group Incorporated, New Revlon Holdings Inc. and the subsidiaries of Revlon set forth on Schedule A thereto (incorporated herein by reference to the Company's Registration Statement on Form S-1 (No. 33-35782) filed with the Commission on July 9, 1990 (the "1990 S- 1")). 10.46 - National Health Laboratories 1988 Stock Option Plan, as amended (incorporated herein by reference to the 1990 S-1). 10.47 - Revolving Credit Agreement dated as of August 27, 1993 among National Health Laboratories Incorporated, Citicorp USA, Inc., as agent and arranger, and the group of lenders specified therein (incorporated herein by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 filed with the Commission on November 15, 1993, File No. 1- 10740 (the "1993 Third Quarter 10-Q")). 10.48 - Loan Agreement dated August 1, 1991 among National Health Laboratories Incorporated, Frequency Property Corp. and Swiss Bank Corporation, New York Branch (incorporated herein by reference to the 1991 10-K). 24.1* - Consent of KPMG Peat Marwick. 25.1* - Power of Attorney of Ronald O. Perelman. 25.2* - Power of Attorney of James R. Maher. 25.3* - Power of Attorney of Saul J. Farber, M.D. 25.4* - Power of Attorney of Howard Gittis. 25.5* - Power of Attorney of Ann Dibble Jordan. 25.6* - Power of Attorney of David J. Mahoney. 25.7* - Power of Attorney of Paul A. Marks, M.D. 25.8* - Power of Attorney of Linda Gosden Robinson. 25.9* - Power of Attorney of Samuel O. Thier, M.D. 25.10* - Power of Attorney of David C. Flaugh. 28.1 - Form of Collateral Agency Agreement (Bank Obligations) (incorporated herein by reference to Amendment No. 1 to the 1990 S-1 filed with the Commission on July 27, 1990, File No. 33-35785). ______________ * Filed herewith. ** Previously filed under File No. 0-17031 which has been corrected to File No. 1-10740. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. NATIONAL HEALTH LABORATORIES INCORPORATED Registrant By:/s/ JAMES R. MAHER ------------------------------------ James R. Maher President and Chief Executive Officer By:/s/ MICHAEL L. JEUB ------------------------------------ Michael L. Jeub Executive Vice President, Chief Financial Officer and Treasurer (Principal Accounting Officer) Dated: March 25, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on March 25, 1994 in the capacities indicated. Signature Title ------------------------ -------- /s/ RONALD O. PERELMAN* Director ------------------------ (Ronald O. Perelman) /s/ JAMES R. MAHER* Director ------------------------ (James R. Maher) /s/ SAUL J. FARBER, M.D.* Director ------------------------ (Saul J. Farber, M.D.) /s/ HOWARD GITTIS* Director ------------------------ (Howard Gittis) /s/ ANN DIBBLE JORDAN* Director ------------------------ (Ann Dibble Jordan) /s/ DAVID J. MAHONEY* Director ------------------------ (David J. Mahoney) /s/ PAUL A. MARKS, M.D.* Director ------------------------ (Paul A. Marks, M.D.) /s/ LINDA GOSDEN ROBINSON* Director ------------------------ (Linda Gosden Robinson) /s/ SAMUEL O. THIER, M.D.* Director ------------------------- (Samuel O. Thier, M.D.) ______________________ * David C. Flaugh, by his signing his name hereto, does hereby sign this report on behalf of the directors of the Registrant after whose typed names asterisks appear, pursuant to powers of attorney duly executed by such directors and filed with the Securities and Exchange Commission. By:/s/ DAVID C. FLAUGH -------------------- David C. Flaugh Attorney-in-fact NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES AND SCHEDULES --------------------------------------------------------------- Page ---- Independent Auditors' Report . . . . . . . . . . . . . . Financial Statements: Consolidated Balance Sheets as of December 31, 1993 and 1992 . . . . . . . . . . . . . Consolidated Statements of Earnings for each of the years in the three-year period ended December 31, 1993. . . . . . . . . . . Consolidated Statements of Stockholders' Equity for each of the years in the three-year period ended December 31, 1993 . . . . . . Consolidated Statements of Cash Flows for each of the years in the three-year period ended December 31, 1993. . . . . . . . . . . . Notes to Consolidated Financial Statements . . . . . . Financial Statement Schedule: VIII - Valuation and Qualifying Accounts . . . . . . . INDEPENDENT AUDITORS' REPORT The Board of Directors and Stockholders National Health Laboratories Incorporated: We have audited the consolidated financial statements of National Health Laboratories Incorporated and subsidiaries as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we have also audited the financial statement schedule as listed in the accompanying index. These consolidated financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of National Health Laboratories Incorporated and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. KPMG PEAT MARWICK San Diego, California February 10, 1994 NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in Millions) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation: The consolidated financial statements include the accounts of National Health Laboratories Incorporated (the "Company") and its subsidiaries after elimination of all material intercompany accounts and transactions. Until May 7, 1991, the Company was a direct majority-owned subsidiary of National Health Care Group, Inc. ("NHCG") which is a wholly-owned subsidiary of Revlon Holdings, Inc. ("Revlon"), then known as Revlon, Inc., and MacAndrews & Forbes Holdings Inc. ("MacAndrews & Forbes"). MacAndrews & Forbes is wholly-owned by Mafco Holdings Inc. ("MAFCO"). As a result of an initial public offering in July 1988 (the "Public Offering") and subsequent secondary public offerings in August 1990, May 1991 and February 1992, the Company's self tender offer in January 1992 and the purchase by the Company of outstanding shares of its common stock, MAFCO's indirect ownership has been reduced to approximately 24%. Cash Equivalents: Cash equivalents (primarily investments in money market funds, time deposits and commercial paper which have maturities of three months or less at the date of purchase) are carried at cost which approximates market. Property, Plant and Equipment: Property, plant and equipment is recorded at cost. The cost of properties held under capital leases is equal to the lower of the net present value of the minimum lease payments or the fair value of the leased property at the inception of the lease. Depreciation and amortization expense is computed on all classes of assets based on their estimated useful lives, as indicated below, using principally the straight-line method. Years ----- Buildings and building improvements 40 Machinery and equipment 3-10 Furniture and fixtures 8 Leasehold improvements and assets held under capital leases are amortized over the shorter of their estimated lives or the period of the related leases. Expenditures for repairs and maintenance charged against earnings in 1993, 1992 and 1991 were $10.8, $10.7 and $10.6, respectively. NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in Millions) Intangibles: Intangibles, consisting of goodwill, net of amortization, of $203.4 and $168.9 at December 31, 1993 and 1992, respectively, and other intangibles (i.e., customer lists, non-compete agreements and rights to names), net of amortization, of $78.1 and $19.4 at December 31, 1993 and 1992, respectively, are being amortized on a straight-line basis over a period of 40 years and 3-40 years, respectively. Total accumulated amortization for goodwill and other intangibles aggregated $46.4 and $39.2 at December 31, 1993 and 1992, respectively. The Company assesses the recoverability of intangible assets by determining whether the amortization of the intangibles' balance over its remaining life can be recovered through undiscounted future operating cash flows of the acquired operations. The amount of goodwill impairment, if any, is measured based on projected undiscounted future operating cash flows. Fair Value of Financial Instruments: Statement of Financial Accounting Standards No. 107, "Disclosures About Fair Value of Financial Instruments", requires that fair values be disclosed for most of the Company's financial instruments. The carrying amount of cash and cash equivalents, accounts receivable, accounts payable, accrued expenses and the revolving credit facility are considered to be representative of their respective fair values. Concentration of Credit Risk: Concentrations of credit risk with respect to accounts receivable are limited due to the diversity of the Company's clients as well as their dispersion across many different geographic regions. Revenue Recognition: Sales are recognized on the accrual basis at the time test results are reported, which approximates when services are provided. Services are provided to certain patients covered by various third-party payor programs including the Medicare and Medicaid programs. Billings for services under third-party payor programs are included in sales net of allowances for differences between the amounts billed and estimated program payment amounts. Adjustments to the estimated payment amounts based on final settlement with the programs are recorded upon settlement. NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in Millions) Income Taxes: In conjunction with the Public Offering, the Company became a party to a tax allocation agreement with Revlon effective July 14, 1988. Pursuant thereto, the Company made payments to Revlon in amounts equal to the amounts the Company would have paid had it filed a separate federal income tax return. Effective January 1, 1990, Revlon and Revlon's domestic subsidiaries entered into a new tax allocation arrangement under which the federal income tax provision and related liability of the Company was computed as if it filed its own separate return, except that the following items were not taken into account: (i) the effect of timing differences and (ii) any gain recognized on the sale of any asset not in the ordinary course of business. As a result of the reduction of NHCG's ownership interest in the Company on May 7, 1991, the Company is no longer a member of the MAFCO consolidated tax group. For periods subsequent to May 7, 1991, the Company has filed its own separate federal, state and local income tax returns. Pursuant to the deferred method under APB Opinion 11, which was applied in 1991 and prior years, deferred income taxes are recognized for income and expense items that are reported in different years for financial reporting purposes and income tax purposes using the tax rate applicable for the year in which the item originated. Under the deferred method, deferred taxes are not adjusted for subsequent changes in tax rates. In February 1992, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("Statement 109"). Statement 109 required a change from the deferred method of accounting for income taxes of APB Opinion 11 to the asset and liability method of accounting for income taxes. Under the asset and liability method of Statement 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under Statement 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Effective January 1, 1992, the Company adopted Statement 109. The cumulative effect of the change in the method of accounting for income taxes was not material and is therefore not presented separately in the accompanying consolidated statements of earnings. NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in Millions) Earnings per Common Share: For the years ended December 31, 1993, 1992 and 1991, earnings per common share is calculated based on the weighted average number of shares outstanding during each year (89,438,764, 94,468,022 and 99,095,524 shares, respectively). Reclassifications: Certain amounts in the prior years' financial statements have been reclassified to conform with the 1993 presentation. NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in Millions) 2. ACCOUNTS RECEIVABLE, NET December 31, December 31, 1993 1992 ----------- ----------- Gross accounts receivable $ 170.0 $ 155.8 Less contractual allowances and allowance for doubtful accounts (51.0) (72.9) ------- ------- $ 119.0 $ 82.9 ======= ======= 3. PROPERTY, PLANT AND EQUIPMENT, NET December 31, December 31, 1993 1992 ----------- ----------- Land $ 0.4 $ 0.2 Buildings and building improvements 1.9 1.7 Machinery and equipment 117.9 90.8 Leasehold improvements 27.2 23.3 Furniture and fixtures 14.5 10.4 Buildings under capital leases 9.6 9.6 ------- ------- 171.5 136.0 Less accumulated depreciation and amortization (71.4) (51.5) ------- ------- $ 100.1 $ 84.5 ======= ======= 4. ACCRUED EXPENSES AND OTHER December 31, December 31, 1993 1992 ----------- ----------- Employee compensation and benefits $ 27.9 $ 29.2 Taxes other than federal taxes on income 7.5 3.0 Deferred acquisition related payments 11.4 3.0 Other 8.8 5.4 ------- ------- $ 55.6 $ 40.6 ======= ======= 5. OTHER LIABILITIES December 31, December 31, 1993 1992 ----------- ----------- Deferred acquisition related payments $ 15.4 $ 1.6 Other 6.1 3.1 ------- ------- $ 21.5 $ 4.7 ======= ======= NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in Millions) 6. GOVERNMENT SETTLEMENT In November 1990, the Company became aware of a grand jury inquiry relating to its pricing practices being conducted by the United States Attorney for the San Diego area (the Southern District of California) with the assistance of the Office of Inspector General. On December 18, 1992, the Company announced that it had entered into agreements that concluded the investigation (the "Government Settlement"). As a result of this settlement, the Company took a one-time pre-tax charge of $136.0 in the fourth quarter of 1992. The charge covered all estimated costs related to the investigation and the settlement agreements. At December 31, 1993 and 1992, the remaining liability for settlement and related expenses totalled $33.1 and $88.9, respectively, and is reflected in the accompanying consolidated balance sheets under the captions "Accrued Settlement Expenses". 7. REVOLVING CREDIT FACILITY On August 27, 1993, the Company entered into an unsecured revolving credit facility (the "Revolving Credit Facility") with Citicorp USA, Inc. as agent for a group of banks. The Revolving Credit Facility provides that the Company may borrow up to $350.0 in order to refinance existing indebtedness; to finance repurchases from time to time by the Company of its common stock; to finance certain acquisitions; and to provide for the general corporate purposes of the Company. The Revolving Credit Facility matures on September 1, 1998, with commitment reductions of $50.0 on September 1, 1996 and September 1, 1997. The terms and conditions of the Revolving Credit Facility contain, among other provisions, requirements for maintaining a defined level of stockholders' equity, various financial ratios, certain restrictions on repurchases by the Company of its common stock and certain restrictions on acquisitions made outside the Company's ordinary course of business. Interest rates are determined at the time of borrowing and are based on London Interbank Offered Rates plus 1% per annum, or other alternative rates. On September 1, 1993, the Company borrowed $139.0 under the Revolving Credit Facility to permanently repay all amounts outstanding under revolving credit facilities in existence on such date. Net additional borrowings during 1993 aggregated $139.0 and were used to finance acquisitions of several clinical laboratory companies and to finance repurchases by the Company of its common stock. NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in Millions, except per share data) 8. STOCKHOLDERS' EQUITY In March 1993 and in June 1992, the Company announced plans to purchase from time to time up to 10 million and 2 million shares of its outstanding common stock, respectively, in the open market. Pursuant to these plans, during 1993 and 1992, the Company purchased 9,485,800 and 310,000 such shares, respectively, for an aggregate amount of $154.2 million and $6.1 million, respectively. In January 1992, pursuant to a self tender offer, the Company purchased 4,808,000 of its outstanding shares of common stock for $26 per share in cash, or $125.8 million. The purchase was financed by $25.8 million of cash on hand and $100.0 million borrowed under a revolving credit facility in existence at that time. 9. INCOME TAXES As discussed in Note 1, the Company adopted Statement 109 effective January 1, 1992. The cumulative effect of the change in the method of accounting for income taxes was not material and is therefore not presented separately in the accompanying consolidated statements of earnings. The provisions for income taxes in the accompanying consolidated statements of earnings consist of the following: Years ended December 31, 1993 1992 1991 ------ ------ ------- Current: Federal $48.9 $52.3 $57.3 State and local 10.4 9.0 10.9 ------ ----- ------ 59.3 61.3 68.2 ------ ----- ------ Deferred: Federal 14.9 (32.3) (2.8) State and local 4.2 (7.5) -- ------ ------ ------ 19.1 (39.8) (2.8) ------ ------ ------ $78.4 $21.5 $65.4 ====== ====== ===== The effective tax rates on earnings before income taxes is reconciled to statutory federal income tax rates as follows: Years ended December 31, 1993 1992 1991 ----- ----- ----- Statutory federal rate 35.0% 34.0% 34.0% State and local income taxes, net of federal income tax benefit 4.9 1.5 4.3 Other 1.1 (0.9) 0.3 ----- ------ ----- Effective rate 41.0% 34.6% 38.6% ===== ====== ===== NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in Millions) The significant components of deferred income tax expense are as follows: Years ended December 31, 1993 1992 1991 ------ ------ ------ Settlement and related expense $22.2 $(34.8) $ -- Reserve for doubtful accounts 0.4 (2.1) 1.1 Other (3.5) (2.9) (3.9) ------ ------ ------ $19.1 ($39.8) ($2.8) ====== ====== ====== The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1993 and 1992 are as follows: December 31, 1993 1992 ----- ----- Deferred tax assets: Settlement and related expenses, principally due to accrual for financial reporting purposes $13.2 $34.9 Accounts receivable, principally due to allowance for doubtful accounts 5.5 5.9 Self insurance reserves, principally due to accrual for financial reporting purposes 0.9 1.7 Compensated absences, principally due to accrual for financial reporting purposes 2.0 1.4 Other 6.6 1.8 ----- ----- Total gross deferred tax assets 28.2 45.7 ----- ----- Deferred tax liabilities: Intangible assets, principally due to differences in amortization (3.7) (3.7) Property, plant and equipment, principally due to differences in depreciation (4.3) (3.9) Other (1.7) (0.6) ----- ------ Total gross deferred tax liabilities (9.7) (8.2) ----- ------ Net deferred tax asset $18.5 $37.5 ===== ====== No valuation allowance for deferred tax assets was established as of January 1, 1992; similarly, a valuation allowance was also deemed unnecessary at December 31, 1993 and 1992. NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in Millions, except per share data) 10. STOCK OPTIONS In 1988, the Company adopted the 1988 Stock Option Plan, reserving 2,000,000 shares of common stock for issuance pursuant to options and stock appreciation rights that may be granted under the plan. The Stock Option Plan was amended in 1990 to limit the number of options to be issued under the Stock Option Plan to 550,000 in the aggregate (including all options previously granted). In 1991, the number of shares authorized for issuance under the Stock Option Plan was increased to an aggregate of 2,550,000. The following table summarizes grants of non-qualified options made by the Company to officers and key employees. For each grant, the exercise price was equivalent to the fair market price per share on the date of grant. Also, for each grant, one-third of the shares of common stock subject to such options vested on the date of grant and one-third vests on each of the first and second anniversaries of such date, subject to their earlier expiration or termination. Exercise Date Options Price Date of of Grant Granted per Share Expiration ------------- ------- --------- ---------------- February 1989 240,000 $ 7.750 February 8, 1999 July 1990 100,000 13.500 July 9, 2000 October 1991 500,000 20.250 October 8, 2001 October 1992 25,000 20.000 October 2, 2002 December 1992 300,000 16.625 December 21, 2002 January 1993 775,000 16.625 January 18, 2003 July 1993 43,500 17.875 July 6, 2003 NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in Millions, except per share data) Changes during 1991, 1992 and 1993 in options outstanding under the plan were as follows: Number Exercise Price of Options per Option ---------- ----------------- Outstanding at January 1, 1991 263,400 $ 7.750 - $13.500 Granted 500,000 $20.250 Exercised (123,830) $ 7.750 - $20.250 Canceled or expired (1,670) $ 7.750 --------- Outstanding at December 31, 1991 637,900 $ 7.750 - $20.250 Granted 325,000 $16.625 - $20.000 Exercised (30,662) $ 7.750 - $20.250 Canceled or expired (39,334) $13.500 - $20.250 --------- Outstanding at December 31, 1992 892,904 $ 7.750 - $20.250 Granted 818,500 $16.625 - $17.875 Exercised (33,400) $ 7.750 Canceled or expired (111,170) $ 7.750 - $20.250 --------- Outstanding at December 31, 1993 1,566,834 $ 7.750 - $20.250 ========= Exercisable at December 31, 1993 920,501 $ 7.750 - $20.250 ========= 11. INTERCOMPANY TRANSACTIONS Pursuant to a services agreement between Revlon and the Company, Revlon provided, in years prior to 1992, the Company with certain finance, insurance, legal, employee benefit and administrative services. Revlon charged the Company $0.5 in 1991 for such services, based on the estimated actual cost incurred by Revlon in providing such services. In addition, the services agreement provided that the Company would pay Revlon all costs associated with the participation of Company employees in any pension (see Note 13), health, savings or other employee benefit plans of Revlon. These costs were $9.6 in 1991. Also, Revlon charged the Company $0.2 in 1991 for direct computer services provided to certain of the Company's laboratories. In addition, Revlon passed through to the Company certain direct costs for (i) self-insured retentions, deductibles and co-insurance under insurance policies maintained by Revlon for the Company totalling $2.6 in 1991; (ii) rental of vehicles owned by third parties used by the Company in its business totalling $4.1 in 1991; and (iii) other direct costs, such as bank service fees, totalling $0.7 for 1991. NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in Millions) From July 1990 to July 1991, Revlon invested the Company's excess cash in a segregated account in the Company's name. Commencing July 1991, the Company established a separate in-house cash management function. Interest income earned on excess cash invested for the Company by Revlon was $1.6 in 1991. 12. COMMITMENTS AND CONTINGENCIES The Company is involved in certain claims and legal actions arising in the ordinary course of business. In the opinion of management, based upon the advice of counsel, the ultimate disposition of these matters will not have a material adverse effect on the financial position of the Company. In December 1992, several class actions were filed against the Company and certain of its officers and directors alleging that certain public disclosures made by the Company since February 1990 were false and misleading in that they failed to disclose that a portion of the Company's income was derived from allegedly fraudulent claims and that such non-disclosures rendered the Company's financial statements misleading. These various class actions are pending in the United States District Court for the Southern District of California. The Company believes that the allegations of the complaint that claim wrongdoing on behalf of the Company and its officers and directors cannot be supported by the facts or the law and that the Company's disclosures complied with all legal obligations. The Company is defending these lawsuits vigorously. In addition, certain lawsuits have been brought by purported shareholders of the Company, allegedly on the Company's behalf against the Company's directors and certain of its officers, in the Superior Court for the County of San Diego, California. These various claims allege that the Company was damaged by actions of the defendant officers and directors in connection with supervision and control of the practices that led to the guilty plea and civil settlement associated with the Government Settlement. These actions seek no damages against the Company. In November 1993, a class action was filed against the Company and certain of its officers and directors alleging that certain public disclosures made by the Company since December 1992 were false and misleading in that they stated that the Company had taken steps to insure that the Company's sales and marketing practices are compatible with the government's interpretation of current regulations and that they failed to disclose that a portion of the Company's income was derived from allegedly fraudulent claims and that such non-disclosures rendered the Company's financial statements misleading. This class action is pending in the United States District Court for the Southern District of California. The Company believes that the allegations of the complaint that claim wrongdoing on behalf of the Company and its officers and directors NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in Millions) cannot be supported by the facts or the law and that the Company's disclosures complied with all legal obligations. On January 5, 1994, a stipulation was entered into whereby the parties have agreed to stay all further activity in this action pending the conclusion of the class actions filed in December 1992. During 1991, the Company guaranteed a $9.0, 5 year loan to a third party for construction of a new laboratory to replace one of the Company's existing facilities. Following its completion in November of 1992, the building was leased to the Company by this third party. Such transaction is treated as a capital lease for financial reporting purposes. The associated lease term continues for a period of 15 years, expiring in 2007. Under the terms of this guarantee, as modified, the Company is required to maintain 105% of the outstanding loan balance including any overdue interest as collateral in a custody account established and maintained at the lending institution. As of December 31, 1993 and 1992, the Company had placed $9.5 and $10.3, respectively, of investments in the custody account. Such investments are included under the caption "Other assets, net" in the accompanying consolidated balance sheets. The Company does not anticipate incurring any loss as a result of this loan guarantee due to protection provided by the terms of the lease. Accordingly, the Company, if required to repay the loan upon default of the borrower (and ultimate lessor), is entitled to a rent abatement equivalent to the amount of repayment made by the Company on the borrower's behalf, plus interest thereon at a rate equal to 2% over the prime rate. For all insurance coverages prior to May 7, 1991, the Company paid Revlon a predetermined amount each year, based upon the Company's historical loss experience and other relevant factors, in respect of the Company's share of the self-insured risks and risks insured by outside insurance carriers, in each case applicable to Revlon and its subsidiaries. Regardless of the Company's and Revlon's actual loss experience, the Company will not be required to pay Revlon amounts in excess of the Company's predetermined share of such liability for losses incurred before May 7, 1991. Under the Company's present insurance programs, coverage is obtained for catastrophic exposures as well as those risks required to be insured by law or contract. The Company is responsible for the uninsured portion of losses occurring on or after May 7, 1991 related primarily to general, product and vehicle liability and workers' compensation. The self-insured retentions are on a per occurrence basis without any aggregate annual limit. Provisions for losses expected under these programs are recorded based upon the Company's estimates of the aggregated liability of claims incurred. At December 31, 1993 and 1992, the Company had provided letters of credit aggregating approximately $3.7 and $3.3, respectively, in connection with certain insurance programs. NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in Millions) Future minimum rental commitments for leases with noncancelable terms of one year or more from December 31, 1993 are as follows: Operating Capital --------- ------- 1994 $13.7 $ 1.2 1995 10.8 1.2 1996 8.6 1.3 1997 7.2 1.4 1998 5.3 1.5 Thereafter 13.9 18.4 ----- ----- Total minimum lease payments 59.5 25.0 Less amount representing interest -- 15.3 ----- ----- Total minimum operating lease payments and present value of minimum capital lease payments $59.5 $ 9.7 ===== ===== Rental expense, which includes rent for real estate, equipment and automobiles under operating leases, amounted to $29.9, $27.0 and $25.6 for the years ended December 31, 1993, 1992 and 1991, respectively. 13. RETIREMENT PLANS Effective January 1, 1992, the Company separated its retirement plans from certain of Revlon's plans, in which the Company had been participating. The Company's plans provide benefits substantially identical to those provided under Revlon's plans. Substantially all employees of the Company are covered by a defined benefit retirement plan (the "Plan"). The benefits to be paid under the Plan are based on years of credited service and average final compensation. For the years ended December 31, 1993 and 1992, pension costs are determined actuarially. For the year ended December 31, 1991, the pension expense reflected in the accompanying consolidated statements of earnings represented an allocation by Revlon of $2.3. Such allocated amount was intended to approximate the Company's pension expense for the year. Under the requirements of Statement of Financial Accounting Standards No. 87, "Employers Accounting for Pensions", the Company has recorded an additional minimum pension liability representing the excess accumulated benefit obligation over plan assets at December 31, 1993. A corresponding amount was recognized as an intangible asset to the extent of unrecognized prior service cost, with the balance recorded as a separate reduction of stockholders' equity. The Company recorded an additional liability of $3.0, an NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in Millions) intangible asset of $0.6, and a reduction of stockholders' equity of $2.4. The components of net periodic pension cost are summarized as follows: Years ended December 31, -------------- 1993 1992 ----- ----- Service cost $ 3.7 $ 2.9 Interest cost 2.6 2.0 Actual return on plan assets (1.3) (1.0) Net amortization and deferral 0.4 0.5 ----- ----- Net periodic pension cost $ 5.4 $ 4.4 ===== ===== The status of the Plan follows: December 31, ------------- 1993 1992 ----- ----- Actuarial present value of benefit obligations: Vested benefits $25.0 $17.0 Non-vested benefits 4.0 2.7 ----- ----- Accumulated benefit obligation 29.0 19.7 Effect of projected future salary increases 13.9 9.8 ----- ----- Projected benefit obligation 42.9 29.5 Fair value of plan assets 24.2 15.8 ----- ----- Unfunded projected benefit obligation (18.7) (13.7) Unrecognized prior service cost 0.5 0.8 Unrecognized net loss 16.3 8.9 Unrecognized net transaction (asset) obligation -- -- Additional minimum liability (3.0) -- ----- ----- Accrued pension cost ($4.9) ($4.0) ===== ===== NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in Millions, except per share amounts) Assumptions used in the accounting for the Plan were: 1993 1992 ---- ---- Weighted average discount rate 7.0% 8.0% Weighted average rate of increase in future compensation levels 5.5% 5.5% Weighted average expected long-term rate of return 9.0% 9.0% 14. ACQUISITIONS During 1993, the Company acquired thirty-four clinical laboratory companies for an aggregate purchase price of $106.9. During 1992 and 1991, the Company acquired five and three laboratories, respectively, for an aggregate purchase price of $3.0 and $6.5, respectively. The acquisitions were accounted for as purchase transactions. The excess of cost over the fair value of net tangible assets acquired during 1993, 1992 and 1991 was $100.1, $3.0 and $6.4, respectively, which is included under the caption "Intangible assets, net" in the accompanying consolidated balance sheets. The consolidated statements of earnings reflect the results of operations of these purchased businesses from their dates of acquisition. 15. DIVIDENDS On December 21, 1992, the Company declared a quarterly dividend in the aggregate amount of approximately $7.6 ($0.08 per share), which was paid on January 26, 1993 to holders of record of common stock at the close of business on January 5, 1993. Such dividend was paid entirely with cash on hand. On December 15, 1993, the Company declared a quarterly dividend in the aggregate amount of approximately $6.8 ($0.08 per share), which was paid on January 25, 1994 to holders of record of common stock at the close of business on January 4, 1994. Such dividend was paid entirely with cash on hand. NATIONAL HEALTH LABORATORIES INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Dollars in Millions, except per share amounts) 16. QUARTERLY DATA (UNAUDITED) The following is a summary of unaudited quarterly data: Year ended December 31, 1993 ------------------------------------------ 1st 2nd 3rd 4th Quarter Quarter Quarter Quarter Total ------------------------------------------ Net sales $199.8 $197.0 $194.8 $168.9 $760.5 Gross profit 90.7 89.2 85.2 50.9 316.0 Net earnings 33.6 33.2 38.2 7.7 112.7 Earnings per common share 0.36 0.37 0.43 0.10 1.26 Year ended December 31, 1992 ------------------------------------------ 1st 2nd 3rd 4th Quarter Quarter Quarter Quarter Total ------------------------------------------ Net sales $176.4 $181.1 $183.6 $180.3 $721.4 Gross profit 79.9 83.5 82.6 80.3 326.3 Net earnings 29.7 31.4 30.1 (50.6) 40.6 Earnings per common share 0.31 0.33 0.32 (0.53) 0.43 Expense reimbursement and termination fees received in connection with the Company's attempt to purchase Damon Corporation, less related expenses and the write-off of certain bank financing costs, resulted in a one-time pre-tax gain of $15.3 in the third quarter of 1993. Medicare's denial of claims for ferritin and HDL tests, which began in September 1993 and continued through December 20, 1993 when the Company introduced new test forms and procedures, and related suspended billings reduced net sales and gross profit by $18.6 in the fourth quarter of 1993. The Company took a one-time pre-tax charge of $136.0 in the fourth quarter of 1992 as a result of the Government Settlement. The charge covered all estimated costs related to the investigation and the settlement agreements. INDEX TO EXHIBITS Exhibit No. ----------- Exhibits 10.6 through 10.43 are management contracts. 3.1 Restated Certificate of Incorporation of the Company (incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1988 filed with the Commission on March 31, 1989, File No. 1-10740** (the "1988 10-K")). 3.2 By-laws of the Company (incorporated herein by reference to the Company's 1988 10-K). 10.1 Laboratory Agreement dated February 4, 1983 between the Company and Humana of Texas, Inc. d/b/a/ Medical City Dallas Hospital (incorporated herein by reference to the Company's Registration Statement on Form S-1 filed with the Commission on May 5, 1988, File No. 33-21708 (the "1988 S-1")). 10.2 National Health Laboratories Incorporated Employees' Savings and Investment Plan (incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1991 filed with the Commission on February 13, 1992, File No. 1-10740** (the "1991 10-K")). 10.3 National Health Laboratories Incorporated Employees' Retirement Plan (incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1992 filed with the Commission on March 26, 1993, File No. 1-10740 (the "1992 10-K")). 10.4 National Health Laboratories Incorporated Pension Equalization Plan (incorporated herein by reference to the 1992 10-K). 10.5 Settlement Agreement dated December 18, 1992 between the Company and the United States of America (incorporated herein by reference to the 1992 10-K). 10.6 Employment Agreement dated December 21, 1992 between the Company and James R. Maher (incorporated herein by reference to the 1992 10-K). INDEX TO EXHIBITS Exhibit No. ---------- 10.7 Employment Agreement dated May 1, 1991 between the Company and Robert Whalen (incorporated herein by reference to the 1991 10-K). 10.8 Amendment to Employment Agreement dated June 6, 1991 between the Company and Robert Whalen (incorporated herein by reference to the 1991 10-K). 10.9 Amendment to Employment Agreement dated January 1, 1993 between the Company and Robert Whalen (incorporated herein by reference to the 1992 10-K). 10.10* Amendment to Employment Agreement dated January 1, 1994 between the Company and Robert Whalen. 10.11* Amendment to Employment Agreement dated March 1, 1994 between the Company and Robert Whalen. 10.12 Employment Agreement dated May 1, 1991 between the Company and Larry L. Leonard (incorporated herein by reference to the 1991 10-K). 10.13 Amendment to Employment Agreement dated June 6, 1991 between the Company and Larry L. Leonard (incorporated herein by reference to the 1991 10-K). 10.14 Amendment to Employment Agreement dated January 1, 1993 between the Company and Larry L. Leonard (incorporated herein by reference to the 1992 10-K). 10.15* Amendment to Employment Agreement dated January 1, 1994 between the Company and Larry L. Leonard. 10.16* Amendment to Employment Agreement dated March 1, 1994 between the Company and Larry L. Leonard. 10.17 Employment Agreement dated May 1, 1991 between the Company and Timothy Brodnik (incorporated herein by reference to the 1991 10-K). 10.18 Amendment to Employment Agreement dated June 6, 1991 between the Company and Timothy Brodnik (incorporated herein by reference to the 1991 10-K). INDEX TO EXHIBITS Exhibit No. ----------- 10.19 Amendment to Employment Agreement dated January 1, 1993 between the Company and Timothy Brodnik (incorporated herein by reference to the 1992 10-K). 10.20* Amendment to Employment Agreement dated January 1, 1994 between the Company and Timothy Brodnik. 10.21* Amendment to Employment Agreement dated March 1, 1994 between the Company and Timothy Brodnik. 10.22 Employment Agreement dated December 31, 1990 between the Company and Bernard E. Statland (incorporated herein by reference to the Company's Annual Report on Form 10-K for the year ended December 31, 1990 filed with the Commission on March 14, 1991, File No. 1- 10740** (the "1990 10-K")). 10.23 Amendment to Employment Agreement dated April 1, 1991 between the Company and Bernard E. Statland (incorporated herein by reference to the 1991 10-K). 10.24 Amendment to Employment Agreement dated June 6, 1991 between the Company and Bernard E. Statland (incorporated herein by reference to the 1991 10-K). 10.25 Amendment to Employment Agreement dated January 1, 1993 between the Company and Bernard E. Statland (incorporated herein by reference to the 1992 10-K). 10.26 Employment Agreement dated January 1, 1991 between the Company and David C. Flaugh (incorporated herein by reference to the 1990 10-K). 10.27 Amendment to Employment Agreement dated April 1, 1991 between the Company and David C. Flaugh (incorporated herein by reference to the 1991 10-K). 10.28 Amendment to Employment Agreement dated June 6, 1991 between the Company and David C. Flaugh (incorporated herein by reference to the 1991 10-K). 10.29 Amendment to Employment Agreement dated January 1, 1993 between the Company and David C. Flaugh (incorporated herein by reference to the 1992 10-K). INDEX TO EXHIBITS Exhibit No. ----------- 10.30 Employment Agreement dated January 1, 1991 between the Company and W. David Slaunwhite (incorporated herein by reference to the 1990 10-K). 10.31 Amendment to Employment Agreement dated April 1, 1991 between the Company and David Slaunwhite (incorporated herein by reference to the 1991 10-K). 10.32 Amendment to Employment Agreement dated June 6, 1991 between the Company and David Slaunwhite (incorporated herein by reference to the 1991 10-K). 10.33 Amendment to Employment Agreement dated January 1, 1993 between the Company and W. David Slaunwhite (incorporated herein by reference to the 1992 10-K). 10.34* Amendment to Employment Agreement dated January 1, 1994 between the Company and W. David Slaunwhite. 10.35* Amendment to Employment Agreement dated March 1, 1994 between the Company and W. David Slaunwhite. 10.36 Employment Agreement dated January 1, 1991 between the Company and John Markus (incorporated herein by reference to the 1990 10-K). 10.37 Amendment to Employment Agreement dated April 1, 1991 between the Company and John Markus (incorporated herein by reference to the 1991 10-K). 10.38 Amendment to Employment Agreement dated June 6, 1991 between the Company and John Markus (incorporated herein by reference to the 1991 10-K). 10.39 Amendment to Employment Agreement dated January 1, 1993 between the Company and John F. Markus (incorporated herein by reference to the 1992 10-K). 10.40* Amendment to Employment Agreement dated January 1, 1994 between the Company and John F. Markus. 10.41* Amendment to Employment Agreement dated March 1, 1994 between the Company and John F. Markus. INDEX TO EXHIBITS Exhibit No. ---------- 10.42 Employment Agreement dated October 1, 1992 between the Company and James G. Richmond (incorporated herein by reference to the 1992 10-K). 10.43 Employment Agreement dated July 6, 1993 between the Company and Michael L. Jeub (incorporated by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1993 filed with the Commission on August 9, 1993, File No. 1-10740 (the "1993 Second Quarter 10-Q")). 10.44 Services Agreement (incorporated herein by reference to Amendment No. 1 to the 1988 S-1). 10.45 Tax Allocation Agreement dated as of June 26, 1990 between MacAndrews & Forbes Holdings Inc., Revlon Group Incorporated, New Revlon Holdings Inc. and the subsidiaries of Revlon set forth on Schedule A thereto (incorporated herein by reference to the Company's Registration Statement on Form S-1 (No. 33- 35782) filed with the Commission on July 9, 1990 (the "1990 S-1")). 10.46 National Health Laboratories 1988 Stock Option Plan, as amended (incorporated herein by reference to the 1990 S-1). 10.47 Revolving Credit Agreement dated as of August 27, 1993 among National Health Laboratories Incorporated, Citicorp USA, Inc. as agent and arranger, and the group of lenders specified therein (incorporated herein by reference to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 filed with the Commission on November 15, 1993, File No. 1-10740 (the "1993 Third Quarter 10-Q")). 10.48 Loan Agreement dated August 1, 1991 among National Health Laboratories Incorporated, Frequency Property Corp. and Swiss Bank Corporation, New York Branch (incorporated herein by reference to the 1991 10-K). INDEX TO EXHIBITS Exhibit No. ----------- 24.1* Consent of KPMG Peat Marwick. 25.1* Power of Attorney of Ronald O. Perelman. 25.2* Power of Attorney of James R. Maher. 25.3* Power of Attorney of Saul J. Farber, M.D. 25.4* Power of Attorney of Howard Gittis. 25.5* Power of Attorney of Ann Dibble Jordan. 25.6* Power of Attorney of David J. Mahoney. 25.7* Power of Attorney of Paul A. Marks, M.D. 25.8* Power of Attorney of Linda Gosden Robinson. 25.9* Power of Attorney of Samuel O. Thier, M.D. 25.10* Power of Attorney of David C. Flaugh. 28.1 Form of Collateral Agency Agreement (Bank Obligations) (incorporated herein by reference to Amendment No. 1 to the 1990 S-1 filed with the Commission on July 27, 1990, File No. 33-35785). ______________ * Filed herewith. ** Previously filed under File No. 0-17031 which has been corrected to File No. 1-10740.

83047_1993.txt

83047

1993

ITEM 1. BUSINESS. GENERAL Reliance Financial Services Corporation ("Reliance Financial", "Company" or "Registrant") owns all of the common stock of Reliance Insurance Company ("Reliance Insurance Company"). Reliance Insurance Company and its property and casualty insurance subsidiaries (such subsidiaries, together with Reliance Insurance Company, the "Reliance Property and Casualty Companies") and its title insurance subsidiaries (collectively, the "Reliance Insurance Group") underwrite a broad range of standard commercial and specialty commercial lines of property and casualty insurance, as well as title insurance. Reliance Insurance Company has conducted business since 1817, making it one of the oldest property and casualty insurance companies in the United States. The Reliance Property and Casualty Companies consist of four principal operations: Reliance National, Reliance Insurance, Reliance Reinsurance and Reliance Surety. Reliance National was established in 1987 to provide specialty commercial insurance products and services, and innovative coverages in standard commercial lines, to selected segments of the property and casualty market which do not lend themselves to traditional insurance products and services, and which are not extensively served by competitors. In 1993, Reliance National accounted for 49% of the net premiums written by the Reliance Property and Casualty Companies. Reliance Insurance offers standard commercial lines of property and casualty insurance and is focused on the diverse needs of mid-sized companies throughout the United States. Reliance Reinsurance primarily provides property and casualty treaty reinsurance for small to medium sized regional and specialty insurance companies located in the United States. Reliance Surety is a leading writer of surety bonds and fidelity bonds in the United States. The Reliance Property and Casualty Companies accounted for $1,571.5 million (64%) of the Reliance Insurance Group's 1993 net premiums earned. The Reliance Insurance Group's title insurance business consists of Commonwealth Land Title Insurance Company ("Commonwealth") and Transamerica Title Insurance Company ("Transamerica Title", together with Commonwealth and their respective subsidiaries, "Commonwealth/Transamerica Title"). Commonwealth/Transamerica Title comprised the third largest title insurance operation in the United States, in terms of 1992 total premiums and fees. Commonwealth/Transamerica Title accounted for $893.4 million (36%) of the Reliance Insurance Group's 1993 net premiums earned. Business segment information for the years ended December 31, 1993, 1992 and 1991 is set forth in Note 17 to the Company's consolidated financial statements, which are included in the Company's 1993 Annual Report and are incorporated herein by reference. All financial information in this Annual Report on Form 10-K is presented in accordance with generally accepted accounting principles ("GAAP") unless otherwise specified. The common stock of Reliance Insurance Company, which represents approximately 98% of the combined voting power of all Reliance Insurance Company stockholders, has been pledged by the Company to secure certain indebtedness. See Note 7 to the Company's consolidated financial statements. The Company is a wholly-owned subsidiary of Reliance Group Holdings, Inc. ("Reliance Group Holdings"). Approximately 49.5% of the common stock of Reliance Group Holdings, the only class of voting securities outstanding, is owned by Saul P. Steinberg, members of his family and affiliated trusts. In November 1993, Reliance Group, Incorporated, which owned all of the Common Stock of the Company and was a wholly-owned subsidiary of Reliance Group Holdings, was merged into Reliance Group Holdings. The reason for the merger was to simplify the corporate structure of Reliance Group Holdings by eliminating an intermediate holding company. OPERATING UNITS Property and Casualty Insurance. The Reliance Property and Casualty Companies consist of four principal operations: Reliance National, Reliance Insurance, Reliance Reinsurance and Reliance Surety. The following table sets forth the amount of net premiums written in each line of business by Reliance National, Reliance Insurance, Reliance Reinsurance and Reliance Surety for the years ended December 31, 1993, 1992 and 1991. The Company has been following a strategy of changing the business mix of the Reliance Property and Casualty Companies by emphasizing specialty commercial insurance products and services and focusing its standard commercial insurance business on programs, larger accounts, and loss sensitive and retrospectively rated policies. The following table sets forth underwriting results, on a GAAP basis, for the Reliance Property and Casualty Companies' standard commercial and specialty commercial lines for the years ended December 31, 1993, 1992, 1991, 1990 and 1989. - -------- (1) Includes net premiums written in personal lines of $45.4 million, $8.8 million, $7.7 million, $178.6 million and $408.0 million for the years ended December 31, 1993, 1992, 1991, 1990 and 1989, respectively. The increase in net premiums written in personal lines for 1993 resulted from the expiration and non-renewal of a quota share treaty on June 30, 1993. The personal lines quota share treaty was not renewed in anticipation of transferring or running off the Company's personal lines business. (2) Catastrophe losses (net of reinsurance) for the Reliance Property and Casualty Companies for the years ended December 31, 1993, 1992, 1991, 1990 and 1989 were $39.3 million, $61.1 million, $28.7 million, $22.8 million and $29.2 million, respectively. Gross catastrophe losses (before reinsurance) for the Reliance Property and Casualty Companies for the years ended December 31, 1993, 1992, 1991, 1990 and 1989 were $88.5 million, $119.2 million, $29.7 million, $28.4 million and $46.3 million, respectively. For the years ended December 31, 1993, 1992, 1991, 1990 and 1989, the provision for the insured events of prior years was $40.2 million, $31.5 million, $271.7 million, $93.7 million and $78.1 million, respectively. The following table sets forth certain financial information of the Reliance Property and Casualty Companies based upon statutory accounting practices and common shareholder's equity of Reliance Insurance Company based upon GAAP, in thousands: - -------- * Includes Reliance Insurance Company's investment in title insurance operations of $176.9 million at December 31, 1993. The Reliance Property and Casualty Companies write insurance in every state of the United States, the District of Columbia and Puerto Rico and through offices located in the United Kingdom, the Netherlands and Canada, and have an affiliation with an insurer in Mexico. In 1993, California, New York, Pennsylvania and Texas accounted for approximately 19%, 12%, 7%, and 5%, respectively, of direct premiums written. No other state accounted for more than 5% of direct premiums written by the Reliance Property and Casualty Companies. The Reliance Property and Casualty Companies write insurance through independent agents and brokers. No single insurance agent or broker accounts for 10% or more of the direct premiums written by the Reliance Property and Casualty Companies. The Reliance Property and Casualty Companies ranked 31st among property and casualty insurance companies and groups in terms of net premiums written during 1992, according to Best's Insurance Management Reports. A. M. Best & Company, Inc. ("Best"), publisher of Best's Insurance Reports, Property-- Casualty, has assigned an A- (Excellent) rating to the Reliance Property and Casualty Companies. Best's ratings are based on an analysis of the financial condition and operations of an insurance company as they relate to the industry in general. An A- (Excellent) rating is assigned to those companies which have achieved excellent overall performance when compared to the norms of the property and casualty industry. Standard & Poor's ("S&P") rates the claims-paying ability of the Reliance Property and Casualty Companies A. S&P's ratings are based on quantitative and qualitative analysis including consideration of ownership and support factors, if applicable. An A rating is assigned to those companies which have good financial security, but capacity to meet policyholder obligations is somewhat susceptible to adverse economic and underwriting conditions. Best's ratings are not designed for the protection of investors and do not constitute recommendations to buy, sell or hold any security. Although the Best and S&P ratings of the Reliance Property and Casualty Companies are lower than those of many of the insurance companies with which the Reliance Property and Casualty Companies compete, management believes that the current ratings are adequate to enable the Reliance Property and Casualty Companies to compete successfully. Reliance National. Reliance National was established in 1987 to provide specialty commercial insurance products and services, and innovative coverages in standard commercial lines, to selected segments of the property and casualty market which do not lend themselves to traditional insurance products and services, and which are not extensively served by competitors. In 1993, Reliance National accounted for 49% of the net premiums written by the Reliance Property and Casualty Companies. Reliance National, which conducts business nationwide, is headquartered in New York City and has offices in eight states and in Canada, the United Kingdom and the Netherlands and has an affiliation with an insurer in Mexico. Reliance National distributes its products primarily through national insurance brokers. Reliance National maintains a strong centralized underwriting and actuarial staff and makes extensive use of third party administrators and technical consultants for certain claims and loss control services. Net premiums written by Reliance National were $872.2 million, $828.6 million and $785.8 million for the years ended December 31, 1993, 1992 and 1991, respectively. Reliance National is organized into eight divisions. Each division is comprised of individual departments, each focusing on a particular type of business, program or market segment. Each department makes use of underwriters, actuaries and other professionals to market, structure and price its products. Reliance National's eight divisions are: . Risk Management Services, Reliance National's largest division, targets Fortune 1,000 companies and multinationals with a broad array of coverages and services. Its use of risk financing techniques such as retrospectively rated policies, self-insured retentions, deductibles, captives and fronting arrangements all help clients to reduce costs and/or manage cash flow more efficiently. It also applies risk management principles to pollution exposures. In 1993, this division had net premiums written of $329.2 million. . Special Operations provides coverages for the construction and transportation industries and has started a new facility for ocean marine risks and a new facility for non-standard personal automobile coverage. In 1993, this division had net premiums written of $162.1 million. . Excess and Surplus Lines provides professional liability insurance to architects and engineers, lawyers, healthcare providers and other professions, and markets excess and umbrella coverages. It also develops and provides insurance products to certain markets requiring specialized underwriting. In 1993, this division had net premiums written of $147.2 million. . Financial Products provides directors and officers liability insurance and, for financial institutions, errors and omissions insurance. In 1993, this division had net premiums written of $67.0 million. . International writes predominantly large accounts and specialty business in the United Kingdom and Canada and provides management, insurance and reinsurance services to a Mexican insurer with which Reliance National has an affiliation. It also provides some risk management services for foreign subsidiaries of United States multinational corporations. In 1993, this division had net premiums written of $66.4 million. . Property, a recently constituted division, provides commercial property coverage focusing on excess and specialty commercial property. In 1993, the departments which were combined into this division had net premiums written of $36.5 million. . Financial Specialty Coverages provides finite risk insurance and other unusual coverages. In 1993, this division had net premiums written of $33.1 million. . Accident and Health provides high limit disability, group accident, blanket special risk and medical excess of loss programs. In 1993, this division had net premiums written of $30.7 million. In the fourth quarter of 1993, Reliance National realigned several of its departments, including those which had comprised its Specialty Lines and Programs division which provided liability and property insurance (including pollution, casualty and commercial property coverages), primarily for companies in hard to insure industries, and formed a new Property division. The 1993 net premiums written for all divisions include the premiums of the departments previously within the Specialty Lines and Programs division. Reliance National attempts to reduce its losses through the use of retrospectively rated pricing, claims-made policies and reinsurance. Approximately 21% of Reliance National's net premiums written during 1993 were written on a retrospectively rated or loss sensitive basis, whereby the insured effectively pays for a large portion or, in many cases, all of its losses. With retrospectively rated pricing, Reliance National provides insurance and loss control management services, while reducing its underwriting risk. Reliance National does, however, assume a credit risk and, therefore, accounts with retrospectively rated pricing undergo extensive credit analysis. Collateral in the form of bank letters of credit or cash collateral is generally provided by the insured to cover Reliance National's exposure. Nearly 66% of Reliance National's specialty commercial net premiums written during 1993 were written on a "claims-made" basis which provides coverage only for claims reported during the policy period or within an established reporting period as opposed to "occurrence" basis policies which provide coverage for events during the policy period without regard for when the claim is reported. Claims-made policies mitigate the "long tail" nature of the risks insured. To further limit exposures, approximately 91% of Reliance National's net premiums written during 1993 were for policies with net retentions equal to or lower than $1.5 million per risk. By reinsuring a large proportion of its business, Reliance National seeks to limit its exposure to losses on each line of business it writes. Its largest single exposure, net of reinsurance, at December 31, 1993, was $2.4 million per occurrence. Reliance Insurance. Reliance Insurance offers standard commercial lines property and casualty insurance products, focusing on the diverse needs of mid-sized companies nationwide. Reliance Insurance distributes its products primarily through approximately 2,400 independent agents, as well as through regional and national brokers. Reliance Insurance's customers are primarily closely held companies with 25 to 1,000 employees and annual sales of $5 million to $300 million. Reliance Insurance underwrites a variety of commercial insurance coverages including property, general liability, automobile and workers' compensation (written on both a guaranteed cost and a retrospectively rated basis). Reliance Insurance is headquartered in Philadelphia and operates in 50 states and the District of Columbia. Reliance Insurance provides its products and services through a decentralized network of profit centers. This organization allows it to place major responsibility and accountability for underwriting, sales, claims, and customer service close to the insured. Historically, Reliance Insurance underwrote personal lines insurance and commodity-type standard commercial lines of insurance for small accounts. Regulatory restrictions, intense competition and inadequate pricing in these lines caused Reliance Insurance to change its strategic direction in order to position itself for improved operating results. Reliance Insurance's strategy includes: . Increased emphasis on custom underwriting. Reliance Insurance's custom underwriting facility provides centralized underwriting of excess and surplus exposures (generally with lower net retentions than for other standard commercial lines written by Reliance Insurance) and provides property and liability insurance programs, targeting homogeneous groups of insureds with particular insurance needs, such as auto rental companies, day care centers, municipalities and trash haulers. These programs are administered by independent program agents, with Reliance Insurance retaining authority for all underwriting and pricing decisions. Program agents market the programs, gather the initial underwriting data and, if authorized by Reliance Insurance, issue the policies. All claims and other services are handled by Reliance Insurance. Net premiums written under the custom underwriting facility were $179.1 million in 1993. . Increased emphasis on its large accounts division. Reliance Insurance's large accounts division targets accounts with annual premiums in excess of $500,000, where it is able to offer more flexible coverages that can be quoted on a loss sensitive or experience rated basis. The large accounts division wrote $136.0 million of net premiums in 1993. . Withdrawal from personal lines. Reliance Insurance has substantially withdrawn from personal lines, where it has had unfavorable experience and it does not perceive a potential for long-term profitability. The Reliance Property and Casualty Companies derived 2.6% of their net premiums written from personal lines in 1993, compared with 22.7% in 1989. . Reductions in employees and offices. To reduce the number of its employees and offices, Reliance Insurance has merged its East and West Coast operations, implemented automated systems to process policies and related data, eliminated non-productive branch offices (resulting in a reduction in the number of branch offices from 48 in 1989 to 40 in 1993), and streamlined and downsized its home office support functions. These efforts have resulted in a reduction in head count from approximately 2,900 in 1989 to approximately 1,950 at December 31, 1993. . Reduction in guaranteed cost workers' compensation. Reliance Insurance has restructured its workers' compensation business to reduce its guaranteed cost writings in those states where Reliance Insurance believes there is limited opportunity for profit. These actions have resulted in Reliance Insurance's guaranteed cost net premiums written declining from $116.2 million in 1990 to $42.4 million in 1993. Policies written on a retrospectively priced basis increased from $36.0 million in 1990 to $103.3 million in 1993. Reliance Reinsurance. Reliance Reinsurance provides property reinsurance on a treaty basis and casualty reinsurance on both a treaty and facultative basis. All treaty business is marketed through reinsurance brokers who negotiate contracts of reinsurance on behalf of the primary insurer or ceding reinsurer, while facultative business is produced both directly and through reinsurance brokers. While Reliance Reinsurance's treaty clients include all types and sizes of insurers, Reliance Reinsurance typically targets treaty reinsurance for small to medium sized regional and specialty insurance companies, as well as captives, risk retention groups and other alternative markets, providing both pro rata and excess of loss coverage. Reliance Reinsurance believes that this market is subject to less competition and provides Reliance Reinsurance an opportunity to develop and market innovative programs where pricing is not the key competitive factor for success. Reliance Reinsurance typically avoids participating in large capacity reinsurance treaties where price is the predominant competitive factor. It generally writes reinsurance in the "lower layers," the first $1 million of primary coverage, where losses are more predictable and quantifiable. The assumed reinsurance business of the Reliance Property and Casualty Companies is conducted nationwide and is headquartered in Philadelphia. Reliance Surety. Reliance Surety is a leading writer of surety bonds and fidelity bonds in the United States. Reliance Surety concentrates on writing performance bonds for contractors of public works projects, commercial real estate and multi-family housing. It also writes financial institution and commercial fidelity bonds. Reliance Surety has established an operation targeting smaller contractors, an area traditionally less fully serviced by national surety companies and one providing potential growth for Reliance Surety. Reliance Surety is headquartered in Philadelphia and conducts business nationwide through 39 branch offices and approximately 3,200 independent agents and brokers. Surety bonds guarantee the payment or performance of one party (called the principal) to another party (called the obligee). This guarantee is typically evidenced by a written agreement by the surety (e.g., Reliance Insurance Company) to discharge the payment or performance obligations of the principal pursuant to the underlying contract between the obligee and the principal. An example of a surety bond is a performance bond posted by a contractor to guarantee the completion of his work on a construction project. Fidelity bonds insure against losses arising from employee dishonesty. Financial institution fidelity bonds insure against losses arising from employee dishonesty and other specifically named theft and fraud perils. Reliance Surety performs extensive credit analysis on its clients, and actively manages the claims function to minimize losses and maximize recoveries. Reliance Surety has enjoyed long relationships with the major contractors it has insured. Title Insurance. Through Commonwealth/Transamerica Title, the Company writes title insurance for commercial and residential real estate nationwide and provides escrow and settlement services in connection with real estate closings. The acquisition of Transamerica Title in 1990 allowed the Company to solidify its national presence and expand its National Title Service division, whereby the Company provides title services for large and multi-state commercial transactions, as well as high-volume residential title services for national lenders. Commercial business has grown to include transactions relating to the formation of real estate investment trusts (REITs), sales of troubled properties and sales of mortgage-backed securities. Commonwealth/Transamerica Title comprised the third largest title insurance operation in the United States, based on 1992 total premiums and fees. Commonwealth/Transamerica Title had premiums and fees (excluding Commonwealth Mortgage Assurance Corporation, its mortgage insurance subsidiary which was sold in the fourth quarter of 1992) of $893.4 million, $770.5 million and $613.7 million for the years 1993, 1992 and 1991, respectively. Commonwealth/Transamerica Title is organized into six regions with more than 250 branch offices covering all 50 states, as well as Puerto Rico and the Virgin Islands. In 1993, California, Texas, Florida, Pennsylvania, Washington, New York and Michigan accounted for approximately 16%, 11%, 8%, 7%, 6%, 6% and 5%, respectively, of revenues for premiums and services related to title insurance. No other state accounted for more than 5% of such revenues. Commonwealth/ Transamerica Title is committed to increasing its market share through a carefully developed plan of expanding its direct and agency operations, including selective acquisitions. Commonwealth has been consistently profitable through periods of both strong and weak economic conditions, including the recent commercial real estate downturn. The Company believes that the primary reasons for Commonwealth's consistent profitability are Commonwealth's continuous efforts to monitor and control losses and expenses, while growing the business on a selective basis. Successful efforts in loss mitigation include strict quality control procedures, as well as extensive educational programs for its agents and employees. A title insurance policy protects the insured party and certain successors in interest against losses resulting from title defects, liens and encumbrances existing as of the date of the policy and not specifically excepted from the policy's provisions. Generally, a title policy is obtained by the buyer, the mortgage lender or both at the time real property is transferred or refinanced. The policy is written for an indefinite term for a single premium which is due in full upon issuance of the policy. The face amount of the policy is usually either the purchase price of the property or the amount of the loan secured by the property. Title policies issued to lenders insure the priority position of the lender's lien. Many lenders require title insurance as a condition to making loans secured by real estate. Title insurers, unlike other types of insurers, seek to eliminate future losses through the title examination process and the closing process, and a substantial portion of the expenses of a title insurer relate to those functions. Consulting and Technical Services. RCG International, Inc. ("RCG"), a subsidiary of the Reliance Insurance Group, and its subsidiaries provide a broad range of consulting and technical services to industry, government and nonprofit organizations, principally in the United States and Europe, and also in Canada, Asia, South America, Africa and Australia. The services provided by RCG include consulting in two principal areas: information technology and energy/environmental services. RCG and its subsidiaries had revenues of $116.8 million and $109.1 million for 1993 and 1992, respectively. SALE OF NON-CORE OPERATIONS During 1992 and 1993, the Company realigned its operations in line with its strategy of emphasizing specialty commercial property and casualty insurance products and services and title insurance and focusing its standard commercial insurance business on programs, larger accounts and loss sensitive and retrospectively rated policies. In July 1993, the Company completed the sale of its life insurance subsidiary, United Pacific Life Insurance Company ("UPL"), for total consideration of $567 million. Pursuant to the terms of the sale, Reliance Insurance Company purchased $482 million of UPL's invested assets consisting principally of (a) publicly traded non-investment grade securities and (b) income-producing real estate. In the fourth quarter of 1992, the Company sold substantially all of the operating assets and insurance brokerage, employee benefits consulting and related services businesses of its insurance brokerage subsidiary, Frank B. Hall & Co. Inc. ("Hall") to Aon Corporation ("Aon") for total consideration of $457 million (consisting of $125 million in cash, $225 million of 8% cumulative perpetual preferred stock of Aon and $107 million of 6 1/4% cumulative convertible exchangeable preferred stock of Aon) plus the assumption by Aon of certain of Hall's operating liabilities. In connection with the sale of Hall, the Reliance Insurance Group agreed to place reinsurance through an Aon subsidiary, providing reinsurance brokerage commissions to Aon of $18 million per year until the year 2007. Concurrently with this sale, Hall was merged with a wholly-owned subsidiary of Reliance Group Holdings and each outstanding share of common stock of Hall, other than shares owned by the Company, was converted into .625 of a share of Reliance Group Holdings Common Stock. In the first quarter of 1994, Reliance Group Holdings agreed to increase such conversion ratio by .02 of a share of Reliance Group Holdings Common Stock. Also in the fourth quarter of 1992, the Company sold its mortgage insurance subsidiary, Commonwealth Mortgage Assurance Corporation ("CMAC"), through a public offering of 100% of the common stock of CMAC Investment Corporation ("CMAC Investment"), a newly-formed holding company for CMAC, for net proceeds of $118.5 million. In connection with this sale, the Company purchased 800,000 shares of $4.125 redeemable preferred stock of CMAC Investment for an aggregate purchase price of $40 million. In connection with the sales of UPL and Hall, customary representations, warranties and indemnities were made to the buyers. For a further description of the above transactions, see Notes 12 and 15 to the Consolidated Financial Statements. INSURANCE CEDED All of the Reliance Insurance Group's insurance operations purchase reinsurance to limit the Company's exposure to losses. Although the ceding of insurance does not discharge an insurer from its primary legal liability to a policyholder, the reinsuring company assumes a related liability and, accordingly, it is the practice of the industry, as permitted by statutory regulations, to treat properly reinsured exposures as if they were not exposures for which the primary insurer is liable. The Reliance Insurance Group enters into reinsurance arrangements that are both facultative (individual risks) and treaty (blocks of risk). Limits and retentions are based on a number of factors, including the previous loss history of the operating unit, policy limits and exposure data, industry studies as to potential severity, market terms, conditions and capacity, and may change over time. Reliance Insurance and Reliance National limit their exposure to individual risks by purchasing excess of loss and quota share reinsurance, with treaty structures and net retentions varying with the specific requirements of the line of business or program being reinsured. In many cases, Reliance Insurance and Reliance National purchase additional facultative reinsurance to further reduce their retentions below the treaty levels. During 1993, the highest net retention per occurrence for casualty risk was $2.7 million for Reliance Insurance and $2.4 million for Reliance National. In addition, both Reliance Insurance and Reliance National purchase "casualty clash" coverage to provide protection in the event of losses incurred by multiple coverages on one occurrence. During 1993, the highest net retention per occurrence for property risk was $3.2 million for Reliance Insurance and $2.3 million for Reliance National. In addition, as of December 31, 1993, Reliance Insurance and Reliance National together had reinsurance for property catastrophe losses in excess of $15 million. Between $15 million and $22 million, Reliance Insurance and Reliance National together retained up to $2.1 million of all losses attributable to a single catastrophe. Between $22 million and $107 million, Reliance Insurance and Reliance National together retained up to $10.5 million of all losses attributable to a single catastrophe. Thus, for all losses attributable to a single catastrophe of $107 million, Reliance Insurance and Reliance National together retained a maximum exposure of $27.6 million. Effective January 1, 1994, Reliance Insurance and Reliance National together retain up to $4.6 million of all losses attributable to a single catastrophe between $15 million and $107 million. Thus, for all losses attributable to a single catastrophe of $107 million, Reliance Insurance and Reliance National together retain a maximum exposure of $19.6 million. Any loss from a single catastrophe beyond $107 million is not reinsured and is retained by Reliance Insurance and Reliance National together. Renewal of catastrophe coverage during the term of the treaty is provided by a provision for one automatic reinstatement of the original coverage at a contractually determined premium. The Company believes that the limit of $107 million per occurrence is sufficient to cover its probable maximum loss in the event of a catastrophe. Additionally, Reliance National has catastrophe protection for losses in excess of a retention of $8 million, up to the $15 million attachment point of the property catastrophe cover. Catastrophe losses, including losses incurred by Reliance Reinsurance on insurance assumed, were $39.3 million in 1993 ($88.5 million before insurance ceded) compared to $61.1 million in 1992 ($119.2 million before insurance ceded), which included $45.6 million ($94.1 million before insurance ceded) arising from Hurricane Andrew. Catastrophe losses, including losses incurred by Reliance Reinsurance on insurance assumed, were $28.7 million ($29.7 million before insurance ceded) in 1991. A catastrophic event can cause losses in lines of insurance other than property. Both Reliance Insurance and Reliance National purchase workers' compensation reinsurance coverage up to $200 million to provide protection against losses under workers' compensation policies which might be caused by catastrophes. Any such losses over $200 million would be covered by the property catastrophe treaty to the extent of available capacity. Reliance Insurance and Reliance National have also purchased reinsurance to cover aggregate retained catastrophe losses in the event of multiple catastrophes in any one year. This reinsurance agreement provides coverage for up to 70% of aggregate catastrophe losses between $12.5 million and $39.0 million, after applying a deductible of $3.8 million per catastrophe. Reliance Surety retains 100% of surety bond limits up to $1 million. For surety bonds in excess of $1 million, up to $35 million, Reliance Surety obtains 50% quota share reinsurance. In addition, Reliance Surety has excess of loss protection, with a net retention of $3 million, for losses up to $25 million on any one principal insured. For fidelity business, Reliance Surety retains 100% of each loss up to $500,000. Reliance Surety has obtained reinsurance above that retention up to a maximum of $9,500,000 on each loss subject, however, to an annual aggregate deductible of $1,500,000. Reliance Reinsurance writes treaty property and casualty reinsurance and facultative casualty reinsurance with limits of $1.5 million per program. Facultative property reinsurance, which was discontinued in February 1994, was written with limits of $10 million per risk, of which the Company retained $500,000 after the purchase of reinsurance. Reliance Reinsurance purchases catastrophe protection for its property treaty and facultative insurance assumed of $5.2 million in excess of a $3 million per occurrence retention, with a contractual provision for a reinstatement. Reliance Reinsurance also writes a specific catastrophe book of business with an aggregate limit of $25 million for any one event, not subject to the above protection. In 1993, no losses were incurred under this specific catastrophe program. Commonwealth/Transamerica Title generally retains no more than $60 million on any one risk, although it often retains significantly less than this amount, with reinsurance placed with other title companies. Commonwealth/Transamerica Title also purchases reinsurance from Lloyd's of London which provides coverage for 80% of losses in excess of $20 million, up to $60 million, on any one risk. The largest net loss paid by Commonwealth or, since its acquisition, Transamerica Title on any one risk was approximately $3 million. Premiums ceded by the Reliance Insurance Group to reinsurers were $1.1 billion and $1.2 billion in 1993 and 1992, respectively. The Reliance Insurance Group is subject to credit risk with respect to its reinsurers, as the ceding of risk to reinsurers does not relieve the Reliance Insurance Group of its liability to insureds. At December 31, 1993, the Reliance Insurance Group had reinsurance recoverables of $2.6 billion, representing estimated amounts recoverable from reinsurers pertaining to paid claims, unpaid claims, claims incurred but not reported and unearned premiums. The Reliance Insurance Group holds substantial amounts of collateral, consisting of letters of credit and cash collateral, to secure recoverables from unauthorized reinsurers. In order to minimize losses from uncollectible reinsurance, the Reliance Insurance Group places its reinsurance with a number of different reinsurers, and utilizes a security committee to approve in advance the reinsurers which meet its standards of financial strength and are acceptable for use by Reliance Insurance Group. The Company had $8.2 million reserved for potentially unrecoverable reinsurance at December 31, 1993. The Company is not aware of any impairment of the creditworthiness of any of the Reliance Insurance Group's significant reinsurers. While the Company is aware of financial difficulties experienced by certain Lloyd's of London syndicates, the Company has not experienced deterioration of payments from the Lloyd's of London syndicates from which it has reinsurance. The Company has no reason to believe that the Lloyd's of London syndicates from which it has reinsurance will be unable to satisfy claims that may arise with respect to ceded losses. In 1993, the Reliance Property and Casualty Companies did not cede more than 5.4% of direct premiums to any one reinsurer and no one reinsurer accounted for more than 12.2% of total ceded premiums. The Reliance Insurance Group's ten largest reinsurers, based on 1993 ceded premiums, are as follows: - -------- (1) Assigned a Best's Rating of NA-4 (Rating Procedure Inapplicable) as the normal rating procedures for property/casualty companies do not apply to companies that retain less than 25% of gross writings. (2) An unrated captive reinsurer that is not affiliated with the Company. Obligations are fully collateralized. Reliance Insurance Company arranged with Centre Reinsurance International Company a five-year aggregate excess of loss Reinsurance Treaty effective January 1, 1994 through December 31, 1998 (the "Reinsurance Treaty"). The Reinsurance Treaty indemnifies Reliance Insurance Company for ultimate accident year losses (including loss adjustment expenses) in excess of retained accident year losses for each accident year. The retained accident year losses are determined in advance of each accident year and expressed as a planned loss ratio. The recoveries under the Reinsurance Treaty are subject to a limit of $200 million per accident year and an aggregate five-year limit of $700 million. The Reinsurance Treaty provides for an annual premium deposit of $25 million which is subject to adjustment based on loss experience and a maximum aggregate five-year premium of $400 million. Premiums in the amount of 57% of ceded losses will be paid to the reinsurer whenever losses are ceded. The Reinsurance Treaty is cancelable by Reliance Insurance Company on any December 31 during the five-year term upon thirty (30) days written notice. Reliance Insurance Company is able to commute the Reinsurance Treaty on December 31, 2003 or any December 31, thereafter subject to specific terms of the Reinsurance Treaty. The Reinsurance Treaty does not apply to the Company's title insurance subsidiaries. The Reliance Insurance Group maintains no "Funded Cover" reinsurance agreements. "Funded Cover" reinsurance agreements are multi-year retrospectively rated reinsurance agreements which do not meet relevant accounting standards for risk transfer and under which the reinsured must pay additional premiums in subsequent years if losses in the current year exceed levels specified in the reinsurance agreement. PROPERTY AND CASUALTY LOSS RESERVES As of March 15, 1994, the Reliance Insurance Group maintains a staff of 89 actuaries, of whom 15 are fellows of the Casualty Actuarial Society and one is a fellow of the Society of Actuaries. This staff regularly performs comprehensive analyses of reserves and reviews the pricing and reserving methodologies of the Reliance Insurance Group. Although the Company believes, in light of present facts and current legal interpretations, that the Reliance Insurance Group's overall property and casualty reserve levels are adequate to meet its obligations under existing policies, due to the inherent uncertainty and complexity of the reserving process, the ultimate liability may be more or less than such reserves. The following tables present information relating to the liability for unpaid claims and related expenses ("loss reserves") for the Reliance Property and Casualty Companies. The table below provides a reconciliation of beginning and ending liability balances (net of reinsurance recoverables) for the years ended December 31, 1993, 1992 and 1991. - -------- * Loss reserves exclude estimated reinsurance recoverables of $2.12 billion at December 31, 1993, $1.87 billion at December 31, 1992 and $1.31 billion at December 31, 1991 and exclude the loss reserves of title operations of $204.7 million at December 31, 1993 and $173.3 million at December 31, 1992 and the loss reserves of title and mortgage insurance operations of $177.4 million at December 31, 1991. The table below provides a reconciliation of beginning and ending liability balances (before reinsurance recoverables) for the year ended December 31, 1993. - -------- * Loss reserves at December 31, 1993 exclude the loss reserves of title operations of $204.7 million at December 31, 1993. Policy claims and related expenses include a provision for insured events of prior years of $40.2 million in 1993, compared to $31.5 million in 1992 and $271.7 million in 1991. The 1993 provision includes $21.1 million of adverse development from workers' compensation reinsurance pools and $35.2 million of adverse development related to prior-year asbestos-related and environmental pollution claims. This development was partially offset by favorable development in other lines of business, including specialty commercial general liability lines. The 1992 provision includes $55.6 million of adverse development from workers' compensation and automobile reinsurance pools. This development was partially offset by favorable development of $11.9 million from two general liability claims and favorable development of $10.7 million related to unallocated loss adjustment expenses. The 1991 provision includes $156.0 million to strengthen loss reserves principally in guaranteed cost workers' compensation business and loss adjustment expense reserves in other standard commercial lines. The 1991 provision also includes $57.3 million of adverse development from workers' compensation reinsurance pools and a $5.2 million provision in personal lines resulting from prior years' catastrophes. The table below summarizes the development of the estimated liability for loss reserves (net of reinsurance recoverables) as of December 31 of each of the prior ten years. The amounts shown on the top line of the table represent the estimated liability for loss reserves (net of reinsurance recoverables) for claims that are unpaid at the particular balance sheet date, including losses that had been incurred but not reported to the Reliance Property and Casualty Companies. The upper portion of the table indicates the loss reserves as they are reestimated in subsequent periods as a percentage of the originally recorded reserves. These estimates change as losses are paid and more accurate information becomes available about remaining loss reserves. A redundancy exists when the original loss reserve estimate is greater, and a deficiency exists when the original loss reserve estimate is less, than the reestimated loss reserve at December 31, 1993. A redundancy or deficiency indicates the cumulative percentage change, as of December 31, 1993, of originally recorded loss reserves. The lower portion of the table indicates the cumulative amounts paid as of successive periods as a percentage of the original loss reserve liability. In calculating the percentage of cumulative paid losses to the loss reserve liability in each year, unpaid losses of General Casualty at April 30, 1990 (the date of sale), relating to 1983 to 1989, were deducted from the original liability in each year. Each amount in the following table includes the effects of all changes in amounts for prior periods. The table does not present accident or policy year development data. For the years 1983 through 1992, the Company has experienced deficiencies in its estimated liability for loss reserves. Included in these deficiencies were provisions of $156.0 million in 1991 and $100.0 million in 1986 specifically made to strengthen prior-years' loss reserves. The Company's loss reserves during this period have been adversely affected by a number of factors beyond the Company's control as follows: (i) significant increases in claim settlements reflecting, among other things, inflation in medical costs; (ii) increases in the costs of settling claims, particularly legal expenses; (iii) more frequent resort to litigation in connection with claims; and (iv) a widening interpretation of what constitutes a covered claim. - ------- (1) The liability for unpaid claims and related expenses (loss reserves), before reinsurance recoverables, was $5.0 billion at December 31, 1993. The loss reserve, before reinsurance recoverables, for years 1992 and prior was redundant by $115.0 million at December 31, 1993. The difference between the property and casualty liability for loss reserves at December 31, 1993 and 1992 reported in the Company's consolidated financial statements (net of reinsurance recoverables) and the liability which would be reported in accordance with statutory accounting practices is as follows: The difference between the property and casualty liability for loss reserves at December 31, 1993 reported in the Company's consolidated financial statements (before reinsurance recoverables) and the liability which would be reported in accordance with statutory accounting practices (before reinsurance recoverables) is as follows: Property and casualty loss reserves are based on an evaluation of reported claims and statistical projections of claims incurred but not reported and loss adjustment expenses. Estimates of salvage and subrogation are deducted from the liability for unpaid claims. Also considered are other factors such as the promptness with which claims are reported, the history of the ultimate liability for such claims compared with initial and intermediate estimates, the type of insurance coverage involved, the experience of the property and casualty industry and other economic indicators when applicable. The establishment of loss reserves requires an estimate of the ultimate liability based primarily on past experience. The Reliance Property and Casualty Companies apply a variety of generally accepted actuarial techniques to determine the estimates of ultimate liability. The techniques recognize, among other factors, the Reliance Insurance Group's and the industry's experience with similar business, historical trends in reserving patterns and loss payments, pending level of unpaid claims, the cost of claim settlements, the Reliance Insurance Group's product mix, the economic environment in which property and casualty companies operate and the trend toward increasing claims and awards. Estimates are continually reviewed and adjustments of the probable ultimate liability based on subsequent developments and new data are included in operating results for the periods in which they are made. In general, reserves are initially established based upon the actuarial and underwriting data utilized to set pricing levels, and are reviewed as additional information, including claims experience, becomes available. The Reliance Property and Casualty Companies regularly analyze their reserves and review their pricing and reserving methodologies, using Reliance Insurance Group actuaries, so that future adjustments to prior year reserves can be minimized. From time to time, the Reliance Property and Casualty Companies consult with independent actuarial firms concerning reserving practices and levels. The Reliance Property and Casualty Companies are required by state insurance regulators to file, along with their statutory reports, a statement of actuarial reserve opinion setting forth an actuary's assessment of their reserve status and, in 1993, the Reliance Property and Casualty Companies used an independent actuarial firm to meet such requirements. However, given the complexity of this process, reserves will require continual updates. The process of estimating claims is a complex task and the ultimate liability may be more or less than such estimates indicate. Since 1989, the Reliance Property and Casualty Companies have increased their premium writings in specialty commercial lines of business. Estimation of loss reserves for many specialty commercial lines of business is more difficult than for certain standard commercial lines because claims may not become apparent for a number of years, and a relatively higher proportion of ultimate losses are considered incurred but not reported. As a result, variations in loss development are more likely in these lines of business. The Reliance Property and Casualty Companies attempt to reduce these variations in certain of its specialty commercial lines, primarily directors and officers liability, professional liability and general liability, by writing policies on a claims-made basis, which mitigates the long tail nature of the risks. The Reliance Property and Casualty Companies also seeks to limit the loss from a single event through the use of reinsurance. In calculating the liability for loss reserves, the Reliance Property and Casualty Companies discount workers' compensation pension claims which are expected to have regular, periodic payment patterns. These claims are discounted for mortality and for interest using statutory annual rates ranging from 3% to 6%. In addition, the reserves for claims assumed through the participation of the Reliance Property and Casualty Companies in workers' compensation reinsurance pools are discounted. In the fourth quarter of 1993, the Reliance Property and Casualty Companies commuted a treaty with a voluntary workers' compensation pool and is holding the same reserves for claims incurred but not reported and discount as was previously held by such pool before the treaty was commuted. The discounting of all claims (net of reinsurance recoverables) resulted in a $284.7 million, $289.5 million and $243.8 million decrease in the liability for loss reserves at December 31, 1993, 1992 and 1991, respectively. The discounts taken in 1993, 1992 and 1991 were $7.9 million, $54.1 million and $50.9 million, respectively. In 1993, these discounts were more than offset by discount amortization resulting in a decrease in pretax income of $4.8 million. In 1992 and 1991, these discounts were partially offset by discount amortization, resulting in an increase in pretax income of $45.7 million and $43.7 million, respectively. The liability for loss reserves includes provisions for inflation in several ways, depending on how the reserve is established. An explicit provision for inflation is used where estimates of ultimate loss are based on pricing. A provision for inflation is also included for certain discounted workers' compensation claims. In these cases, the provision for inflation is based on factors supplied by the respective workers' compensation rating bureaus which have jurisdiction for states which provide for cost-of-living increases in indemnity benefits. In other reserves, the analysis reflects the effect of inflationary trends as part of the overall effect on claim costs, as well as changes in marketing, underwriting, reporting and processing systems, claims settlement and coverages purchased. Included in the liability for loss reserves at December 31, 1993 are $152 million ($122 million net of reinsurance recoverables) of loss reserves pertaining to asbestos-related and environmental pollution claims. Included in these reserves are reserves for claims incurred but not reported and reserves for loss expenses, which include litigation expenses. The Company continues to receive claims asserting injuries from hazardous materials and alleged damages to cover various clean-up costs relating to policies written in prior years. Coverage and claim settlement issues, such as the determination that coverage exists and the definition of an occurrence, may cause the actual loss development to exhibit more variation than the remainder of the Company's book of business. The Company's net paid losses and related expenses for asbestos- related and environmental pollution claims have not been material in relation to the Company's total net paid losses and related expenses. Net paid losses and related expenses (primarily legal fees and expenses) relating to these claims were $23.0 million (including $8.6 million of related expenses), $17.3 million (including $7.7 million of related expenses) $20.3 million (including $11.5 million of related expenses), $5.6 million (including $3.6 million of related expenses) and $8.5 million (including $5.0 million of related expenses) for the years ended December 31, 1993, 1992, 1991, 1990 and 1989, respectively. Total payments for all policy claims and related expenses were $1.0 billion, $961.1 million, $910.6 million, $1.0 billion and $1.1 billion for the years ended December 31, 1993, 1992, 1991, 1990 and 1989, respectively. As of December 31, 1993, the Company had approximately 700 direct insureds for which one or more environmental or asbestos claims were open. As of December 31, 1993, the Company was involved in approximately 40 coverage disputes (where a motion for declaratory judgment had been filed, the resolution of which will require a judicial interpretation of an insurance policy) related to asbestos or environmental pollution claims. The Company is not aware of any pending litigation or pending claim which will result in significant contingent liabilities in these areas. The Company believes it has made reasonable provisions for these claims, although the ultimate liability may be more or less than such reserves. The Company believes that future losses associated with these claims will not have a material adverse effect on its financial position, although there is no assurance that such losses will not materially affect the Company's results of operations for any period. Although the Company believes, in light of present facts and current legal interpretations, that the overall loss reserves of the Reliance Property and Casualty Companies are adequate to meet their obligations under existing policies, due to the inherent uncertainty and complexity of the reserving process, the ultimate liability may be more or less than such reserves. PORTFOLIO INVESTMENTS Investment activities are an integral part of the business of the Reliance Insurance Group. The Reliance Insurance Group believes that the investment objectives of safety and liquidity, while seeking the best available return, can be achieved by active portfolio management and by the intensive monitoring of investments. Reference is made to "Reliance Financial Services Corporation and Subsidiaries Financial Review--Investment Portfolio" on page 31 of the Company's 1993 Annual Report, which section is incorporated herein by reference, and Note 2 to the Consolidated Financial Statements. The following table details the distribution of the Company's investments at December 31, 1993: - -------- (1) Does not include investment in Zenith National Insurance Corp. which is accounted for by the equity method and which, as of December 31, 1993, had a carrying value of $157.0 million. See "--Investee Company." (2) In the Company's Consolidated Financial Statements, mortgage loans are included in other accounts and notes receivable. The Company seeks to maintain a diversified and balanced fixed maturity portfolio representing a broad spectrum of industries and types of securities. The Company holds virtually no investments in commercial real estate mortgages. Purchases of fixed maturity securities are researched individually based on in-depth analysis and objective predetermined investment criteria and are managed to achieve a proper balance of safety, liquidity and investment yields. The Reliance Insurance Group primarily invests in investment grade securities (those rated "BBB" or better by S&P), and, to a lesser extent, non-investment grade and non-rated securities. Equity investments are made after in-depth analysis of individual companies' fundamentals by the Reliance Insurance Group's staff of investment professionals. They seek to identify equities that appear to be undervalued relative to the issuer's business fundamentals, such as earnings, cash flows, balance sheets and future prospects. Rather than maintaining a portfolio with large numbers of issuers weighted across a broad range of industry sectors, the Company invests in sufficiently few issuers to allow it to effectively monitor each investment. The Reliance Insurance Group has increased the liquidity of its equity portfolio by investing in issuers which have significant market capitalizations. At December 31, 1993, the Company's real estate holdings had a carrying value of $282.8 million, which includes 11 shopping centers with an aggregate carrying value of $130.3 million, office buildings and other commercial properties with an aggregate carrying value of $91.9 million, and undeveloped land with a carrying value of $60.6 million. At December 31, 1993, the Reliance Insurance Group's investment portfolio was $3.6 billion (at cost) with 87.4% in fixed maturities and short-term securities (including redeemable preferred stock) and 12.6% in equity securities, including convertible preferred stock. All publicly traded investment grade securities are priced using the Merrill Lynch Matrix Pricing model, which model is one of the standard methods of pricing such securities in the industry. All publicly traded non-investment grade securities, except as indicated below, are priced from broker-dealers who make markets in these and other similar securities. For fixed maturities not publicly traded, prices are estimated based on values obtained from independent third parties or quoted market prices of comparable instruments. Upon sale, such prices may not be realized when the size of a particular investment in an issue is significant in relation to the total size of such issue. Non-investment grade securities that are thinly traded are priced using internally developed calculations. Such securities represent less than 1% of the Reliance Insurance Group's fixed maturities portfolio. The following table presents the investment results of the Reliance Insurance Group's investment portfolio for each of the years ended December 31, 1993, 1992 and 1991: - -------- (1) The average is computed by dividing the total market value of investments at the beginning of the period plus the individual quarter-end balances by five for the years ended December 31, 1993, 1992 and 1991. (2) Consists principally of interest and dividend income, less investment expenses. (3) Does not include investment in Zenith National Insurance Corp. see "-- Investee Company." (4) The impact on the overall rate of return of a one percent increase or decrease in the December 31, 1993 fixed maturity portfolio market value would be approximately 0.78%. The carrying value and market value at December 31, 1993 of fixed maturities for which interest is payable on a deferred basis was $77.4 million. At December 31, 1993, the aggregate carrying value and market value of fixed maturities (other than short-term investments and cash) that either have been rated by S&P in the following categories or are non-rated were as follows: Substantially all of the non-investment grade fixed maturities are classified as "available for sale" and, accordingly, are carried at quoted market value. The contractual maturities of short-term and fixed maturity investments at December 31, 1993 are set forth below: As of March 15, 1994, the Reliance Insurance Group owned 3,568,634 shares of common stock of Symbol Technologies, Inc. ("Symbol"), representing 14.8% of the then outstanding common stock of Symbol. Symbol is the nation's largest manufacturer of bar code-based data capture systems. As of March 15, 1994, the market value of the Reliance Insurance Group's investment in Symbol was $72,264,839 (based upon the closing price on such date as reported by the NYSE). INVESTEE COMPANY As of March 15, 1994, the Reliance Insurance Group owned 6,574,445 shares of common stock of Zenith National Insurance Corp. ("Zenith"), representing 34.4% of the outstanding common stock of Zenith, a California-based insurance company with significant workers' compensation and standard commercial and personal lines business. As of March 15, 1994, the market value of the Reliance Insurance Group's investment in Zenith was $139,706,957 (based upon the closing price on such date as reported by the NYSE). The board of directors of Zenith includes certain executive officers of the Company. The Company's investment in Zenith is accounted for by the equity method. See Note 3 to the Consolidated Financial Statements. REGULATION The businesses of the Reliance Insurance Group, in common with those of other insurance companies, are subject to comprehensive, detailed regulation in the jurisdictions in which they do business. Such regulation is primarily for the protection of policyholders rather than for the benefit of investors. Although their scope varies from place to place, insurance laws in general grant broad powers to supervisory agencies or officials to examine companies and to enforce rules or exercise discretion touching almost every significant aspect of the conduct of the insurance business. These include the licensing of companies and agents to transact business, varying degrees of control over premium rates (particularly for property and casualty companies), the forms of policies offered to customers, financial statements, periodic reporting, permissible investments and adherence to financial standards relating to surplus, dividends and other criteria of solvency intended to assure the satisfaction of obligations to policyholders. Other legislation obliges the Reliance Property and Casualty Companies to offer policies or assume risks in various markets which they would not seek if they were acting solely in their own interest. While such regulation and legislation is sometimes burdensome, inasmuch as all insurance companies similarly situated are subject to such controls, the Company does not believe that the competitive position of the Reliance Insurance Group is adversely affected. State holding company acts also regulate changes of control in insurance holding companies and transactions and dividends between an insurance company and its parent or affiliates. Although the specific provisions vary, the holding company acts generally prohibit a person from acquiring a controlling interest in an insurer incorporated in the state promulgating the act or in any other controlling person of such insurer unless the insurance authority has approved the proposed acquisition in accordance with the applicable regulations. In many states, including Pennsylvania, where Reliance Insurance Company is domiciled, "control" is presumed to exist if 10% or more of the voting securities of the insurer are owned or controlled by a party, although the insurance authority may find that "control" in fact does or does not exist where a person owns or controls either a lesser or a greater amount of securities. The holding company acts also impose standards on certain transactions with related companies, which generally include, among other requirements, that all transactions be fair and reasonable and that certain types of transactions receive prior regulatory approval either in all instances or when certain regulatory thresholds have been exceeded. Other states, in addition to an insurance company's state of domicile, may regulate affiliated transactions and the acquisition of control of licensed insurers. The State of California, for example, presently treats certain insurance subsidiaries of the Company which are not domiciled in California as though they were domestic insurers for insurance holding company purposes and such subsidiaries are required to comply with the holding company provisions of the California Insurance Code, which provisions are more restrictive than the comparable laws of the states of domicile of such subsidiaries. The Insurance Law of Pennsylvania, where Reliance Insurance Company is domiciled, was amended in February 1994 (effective immediately) to establish a new test limiting the maximum amount of dividends which may be paid without prior approval by the Pennsylvania Insurance Department. Under such test, Reliance Insurance Company may pay dividends during the year equal to the greater of (a) 10% of the preceding year-end policyholders' surplus or (b) the preceding year's net income, but in no event to exceed the amount of "unassigned funds (surplus)", which is defined as "undistributed, accumulated surplus, including net income and unrealized gains, since the organization of the insurer." In addition, the Pennsylvania law specifies factors to be considered by the Pennsylvania Insurance Department to allow it to determine that statutory surplus after the payment of dividends is reasonable in relation to an insurance company's outstanding liabilities and adequate for its financial needs. Such factors include the size of the company, the extent to which its business is diversified among several lines of insurance, the number and size of risks insured, the nature and extent of the company's reinsurance, and the adequacy of the company's reserves. The maximum dividend permitted by law is not indicative of an insurer's actual ability to pay dividends, which may be constrained by business and regulatory considerations, such as the impact of dividends on surplus, which could affect an insurer's ratings, competitive position, the amount of premiums that can be written and the ability to pay future dividends. Furthermore, the Pennsylvania Insurance Department has broad discretion to limit the payment of dividends by insurance companies. Total common and preferred stock dividends paid by Reliance Insurance Company during 1993, 1992 and 1991 were, $133.7 million ($130.6 million for common stock), $143.7 million ($140.4 million for common stock) and $160.6 million ($156.9 million for common stock), respectively. During 1994, $126.8 million would be available for dividend payments by Reliance Insurance Company based upon the new dividend test under Pennsylvania Law. As a result of the refinancing completed on November 15, 1993, the Company believes such amount will be sufficient to meet its cash needs. There is no assurance that Reliance Insurance Company will meet the tests in effect from time to time under Pennsylvania law for the payment of dividends without prior Insurance Department approval or that any requested approval will be obtained. However, Reliance Insurance Company has been advised by the Pennsylvania Insurance Department that any required prior approval will be based upon a solvency standard and will not be unreasonably withheld. Any significant limitation of Reliance Insurance Company's dividends would adversely affect the Company's ability to service its debt and to pay dividends on its Common Stock. The NAIC has adopted a "risk-based capital" requirement for the property and casualty insurance industry which becomes effective in 1995 (based on 1994 financial results). "Risk-based capital" refers to the determination of the amount of statutory capital required for an insurer based on the risks assumed by the insurer (including, for example, investment risks, credit risks relating to reinsurance recoverables and underwriting risks) rather than just the amount of net premiums written by the insurer. A formula that applies prescribed factors to the various risk elements in an insurer's business would be used to determine the minimum statutory capital requirement for the insurer. An insurer having less statutory capital than the formula calculates would be subject to varying degrees of regulatory intervention, depending on the level of capital inadequacy. Although the regulations governing risk based capital are not effective until 1995 (based on 1994 financial results), the Company has calculated that its capital exceeds the risk based capital that would be required if the formula was currently in effect (based on 1993 financial results). However, because certain terms of the regulation have yet to be defined, management cannot predict the ultimate impact of risk-based capital requirements on the Company's capital requirements or its competitive position. Maintaining appropriate levels of statutory surplus is considered important by the Company's management, state insurance regulatory authorities, and the agencies that rate insurers' claims-paying abilities and financial strength. Failure to maintain certain levels of statutory capital and surplus could result in increased scrutiny or, in some cases, action taken by state regulatory authorities and/or downgrades in an insurers' ratings. The Company's principal property and casualty insurance subsidiary, Reliance Insurance Company, has operated outside of the NAIC financial ratio range concerning liabilities to liquid assets (the "NAIC liquidity test"). This ratio is intended only as a guideline for an insurance company to follow. The Company believes that it has sufficient marketable assets on hand to make timely payment of claims and other operating requirements. On November 8, 1988, voters in California approved Proposition 103, which requires a rollback of rates for property and casualty insurance policies issued or renewed after November 8, 1988 of 20% from November 1987 levels and freezes rates at such lower levels until November 1989. Proposition 103 also requires that subsequent rate changes be justified to, and approved by, an elected Insurance Commissioner, automobile insurance rates be determined primarily by the driver's safety record and mileage driven, and "good drivers" be given a 20% discount (in addition to the 20% rollback). In 1989, the California Department of Insurance notified United Pacific Insurance Company, one of the Company's California subsidiaries, which writes business in California, that under Proposition 103, profits generated by current rates exceeded the Department's rates for a fair and reasonable return by approximately $10.0 million. Since then, there have been several administrative hearings on rate rollback and several different regulations issued. None survived the administrative process until Emergency Regulations were approved in August and October 1991 and then readopted in February 1992. The regulations allowed the Commissioner of Insurance to order insurance companies to rollback 1988 rates and issue refunds to policyholders. In June 1992, the California Office of Administrative Law (the "OAL") disapproved the Department's Emergency Regulations. In July 1992 the OAL disapproved the Department's permanent regulations governing rate rollbacks, which were materially the same as the Department's Emergency Regulations. In February 1993, a Los Angeles Superior Court issued a decision in the consolidated case challenging the Department's Emergency Regulations and the application of these regulations. The court declared several sections of the regulations invalid and enjoined the enforcement of the regulations. In June 1993, the California Supreme Court agreed to hear the appeal from this decision. The regulations, if ultimately adopted and upheld, could result in the Company having to make a refund to policyholders possibly in excess of the amount specified in the Department's 1989 notice. In October 1991, the Commissioner announced orders to fourteen insurer groups directing specified refunds to policyholders. Insurers could comply or a departmental hearing would be scheduled. The Company was not included in the group of fourteen insurers. The amount and timing of any rate rollback or refunds by the Company remain uncertain. The Company's property and casualty insurance subsidiaries have not earned underwriting profits in California in the past five years. The Company believes that even after considering investment income, total returns in California have been less than what would be considered "fair". The Company will contest vigorously any unreasonable premium rollback determination by the California Insurance Department. Accordingly, the Company believes that it is probable that its premium revenues will not be subject to a refund which would have a material effect on the results of operations or financial condition of the Company. From time to time, other states have considered adopting legislation or regulations which could adversely affect the manner in which the Reliance Insurance Group sets rates for policies of insurance, particularly as they relate to personal lines. No assurance can be given as to what effect the adoption of any such legislation or regulation would have on the ability of the Company to raise its rates. However, since the Company has substantially withdrawn from personal lines, the Company believes that these initiatives will not have a material effect on its on-going business. COMPETITION All of the Company's businesses are highly competitive. The property and casualty insurance business is fragmented and no single company dominates any of the markets in which the Company operates. The Reliance Insurance Group competes with individual companies and with groups of affiliated companies with greater financial resources, larger sales forces and more widespread agency and broker relationships. Competition in the property and casualty insurance industry is based primarily on both price and service. In addition, because the Reliance Insurance Group sells its policies through independent agents and insurance brokers who are not obligated to choose the Reliance Insurance Group's policies over those of another insurer, the Reliance Insurance Group must compete for agents and brokers and for the business they control. Such competition is based upon price, product design, policyholder service, commissions and service to agents and brokers. Commonwealth/Transamerica Title compete with large national title insurance companies and with smaller, locally established businesses which may possess distinct competitive advantages. Competition in the title insurance business is based primarily on the quality and timeliness of service. In some market areas, abstracts and title opinions issued by attorneys are used as an alternative to title insurance and other services provided by title companies. In addition, certain jurisdictions have title registration systems which can lessen the demand for title insurance. ITEM 2.

ITEM 2. PROPERTIES. The Company and its consolidated subsidiaries own and lease offices in various locations primarily in the United States. None of these properties is material to the Company's business. At December 31, 1993, the Company and its consolidated subsidiaries employed approximately 9,600 persons in approximately 440 offices. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. The Company and its subsidiaries are involved in certain litigation arising in the course of their businesses, some of which involve claims of substantial amounts. Although the ultimate outcome of these matters cannot be ascertained at this time, and the results of legal proceedings cannot be predicted with certainty, the Company is contesting the allegations of the complaints in each pending action and believes, based on current knowledge and after consultation with counsel, that the resolution of these matters will not have a material adverse effect on the consolidated financial statements of the Company. In addition, Hall, the predecessor corporation of Prometheus Funding Corp., a subsidiary of the Company ("Prometheus"), entered into a settlement agreement, which is subject to court approval, with the Superintendent of Insurance of the State of New York (the "Superintendent"), arising out of the insolvency of Union Indemnity Insurance Company of New York, Inc. ("Union Indemnity"). The settlement agreement was submitted to the court for approval in October 1989 and objections were filed by various parties. In March 1994, the Superintendent informed Prometheus that he did not intend to pursue court approval of the settlement until the resolution of appellate proceedings in a pending litigation between the Superintendent and certain of Union Indemnity's reinsurers. Prometheus has advised the Superintendent that this position is in breach of the settlement agreement's requirement that the parties diligently make every effort to obtain court approval of the settlement, and Prometheus has reserved all of its rights with respect thereto. There is no assurance that such approval will be obtained. The settlement agreement will not become effective until final approval by the court. See Note 16 to the consolidated financial statements for additional information concerning such legal proceedings and contingencies affecting the Company and its subsidiaries. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Item 4 is not required pursuant to the reduced disclosure requirements applicable to this Form 10-K. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. As of March 15, 1994, all 1,000 outstanding shares of Reliance Financial's common stock are held of record by Reliance Group Holdings and are not publicly traded. See the information in "Market and Dividend Information for Common Stock" on page 33 of the Reliance Financial 1993 Annual Report, which information is incorporated herein by reference. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. Item 6 is not required pursuant to the reduced disclosure requirements applicable to this Form 10-K. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. See the information in "Reliance Financial Services Corporation and Subsidiaries Financial Review" on pages 26 through 33 of the Reliance Financial 1993 Annual Report, which information is incorporated herein by reference. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. See the information on pages 1 through 24 of the Reliance Financial 1993 Annual Report, which information is incorporated herein by reference. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III Items 10, 11, 12 and 13, which comprise Part III, are not required pursuant to the reduced disclosure requirements applicable to this Form 10-K. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (A) 1. FINANCIAL STATEMENTS. The consolidated financial statements of Reliance Financial Services Corporation and Subsidiaries, which appear on pages 1 through 24 of the Reliance Financial 1993 Annual Report, are incorporated herein by reference. 2. FINANCIAL STATEMENT SCHEDULES: All other schedules have been omitted because they are inapplicable, not required, or the information is included elsewhere in the financial statements or notes thereto. Pursuant to Rule 1-02(v) of Regulation S-X, Reliance Insurance Group's investment in Zenith National Insurance Corp. meets the definition of a "significant subsidiary." Zenith National Insurance Corp. files financial statements with the Securities and Exchange Commission which should be referred to for additional information. 3. EXHIBITS - -------- * Neither Reliance Financial nor its subsidiaries is a party to any instrument relating to long-term debt under which the securities authorized exceed 10% of the total consolidated assets of Reliance Financial and its subsidiaries. Copies of instruments relating to long-term debt of lesser amounts will be provided to the Securities and Exchange Commission upon request. - -------- ** Schedule P from the statutory reports of Zenith National Insurance Corp., 34.4% of the outstanding common stock of which is owned by the Reliance Insurance Group, is omitted herefrom as such Schedule P is filed directly with the Securities and Exchange Commission. (B) REPORTS ON FORM 8-K No reports on Form 8-K were filed during the three months ended December 31, 1993. SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED, ON THE 29TH DAY OF MARCH, 1994. Reliance Financial Services Corporation Saul P. Steinberg By: ___________________________________ SAUL P. STEINBERG CHAIRMAN OF THE BOARD AND CHIEF EXECUTIVE OFFICER PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED. SIGNATURE TITLE DATE Saul P. Steinberg Chairman of the Board, March 29, 1994 - ------------------------------------- Principal Executive SAUL P. STEINBERG Officer and Director George E. Bello Principal Accounting March 29, 1994 - ------------------------------------- Officer and Director GEORGE E. BELLO Lowell C. Freiberg Principal Financial March 29, 1994 - ------------------------------------- Officer and Director LOWELL C. FREIBERG George R. Baker Director March 29, 1994 - ------------------------------------- GEORGE R. BAKER Carter Burden Director March 29, 1994 - ------------------------------------- CARTER BURDEN Dennis A. Busti Director March 29, 1994 - ------------------------------------- DENNIS A. BUSTI Dean W. Case Director March 29, 1994 - ------------------------------------- DEAN W. CASE SIGNATURE TITLE DATE --------- ----- ---- Thomas P. Gerrity Director March 29, 1994 - ------------------------------------- THOMAS P. GERRITY Jewell J. McCabe Director March 29, 1994 - ------------------------------------- JEWELL J. MCCABE Irving Schneider Director March 29, 1994 - ------------------------------------- IRVING SCHNEIDER Bernard L. Schwartz Director March 29, 1994 - ------------------------------------- BERNARD L. SCHWARTZ Director - ------------------------------------- RICHARD E. SNYDER Thomas J. Stanton, Jr. Director March 29, 1994 - ------------------------------------- THOMAS J. STANTON, JR. Robert M. Steinberg Director March 29, 1994 - ------------------------------------- ROBERT M. STEINBERG James E. Yacobucci Director March 29, 1994 - ------------------------------------- JAMES E. YACOBUCCI INDEPENDENT AUDITORS' REPORT Board of Directors and Shareholder Reliance Financial Services Corporation New York, New York We have audited the consolidated financial statements of Reliance Financial Services Corporation (a subsidiary of Reliance Group Holdings, Inc.) and subsidiaries as of December 31, 1993 and 1992, and for each of the three years in the period ended December 31, 1993, and have issued our report thereon dated February 18, 1994, except for note 16, as to which the date is March 9, 1994 (which report includes an explanatory paragraph concerning the adoption of Statement of Financial Accounting Standards No. 106, 109, 113 and 115); such financial statements and report are included in your 1993 Annual Report and are incorporated herein by reference. Our audits also included the financial statement schedules of Reliance Financial Services Corporation, listed in Item 14. These financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. /s/Deloitte & Touche New York, New York February 18, 1994, except for note 16, as to which the date is March 9, 1994 A-1 SCHEDULE I ITEM 14(A)2 RELIANCE FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES SUMMARY OF INVESTMENTS--OTHER THAN INVESTMENTS IN RELATED PARTIES DECEMBER 31, 1993 - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- (1) In the consolidated financial statements, mortgage loans are included in other accounts and notes receivable. A-2 SCHEDULE II ITEM 14(A)2 RELIANCE FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- (a) Accrued interest receivable. (b) Demand note receivable bearing interest at the prime rate. A-3 SCHEDULE III ITEM 14(A)2 RELIANCE FINANCIAL SERVICES CORPORATION (PARENT COMPANY) STATEMENT OF OPERATIONS A-4 SCHEDULE III ITEM 14(A)2 RELIANCE FINANCIAL SERVICES CORPORATION (PARENT COMPANY) BALANCE SHEET A-5 SCHEDULE III ITEM 14(A)2 RELIANCE FINANCIAL SERVICES CORPORATION (PARENT COMPANY) STATEMENT OF CASH FLOWS SUPPLEMENTAL DISCLOSURE OF NON-CASH FINANCING ACTIVITIES: In 1993, non-cash dividends of $99,936,000 were recorded as a reduction in notes receivable from parent company. A-6 SCHEDULE V ITEM 14(A)2 RELIANCE FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES SUPPLEMENTARY INSURANCE INFORMATION (a) An allocation of net investment income to the individual underwriting segments is not appropriate since allocation would be arbitrary and, in management's judgment, misleading. A-7 SCHEDULE VI ITEM 14(A)2 RELIANCE FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES REINSURANCE - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- A-8 SCHEDULE IX ITEM 14(A)2 RELIANCE FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES SHORT-TERM BORROWINGS - ------------------------------------------------------------------------------- - ------------------------------------------------------------------------------- (a) Average amount outstanding during the period was computed by dividing the total of the principal outstanding at the beginning of the period plus the individual month-end principal balances by 13. (b) Weighted average interest rate during the period was computed by dividing interest expense on short-term borrowings by the average short-term borrowings outstanding. A-9 SCHEDULE X ITEM 14(A)2 RELIANCE FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES SUPPLEMENTAL INFORMATION CONCERNING PROPERTY AND CASUALTY INSURANCE OPERATIONS (a)Liabilities (net of reinsurance recoverables) for unpaid claims and related expenses for short-duration contracts which are expected to have fixed, periodic payment patterns are discounted to present values using statutory annual rates ranging from 3% to 6%. A-10 EXHIBITS TO FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF FOR THE FISCAL YEAR ENDED DECEMBER COMMISSION FILE NUMBER 1-7080 31, 1993 RELIANCE FINANCIAL SERVICES CORPORATION (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) RELIANCE FINANCIAL SERVICES CORPORATION EXHIBIT INDEX EXHIBIT NUMBER - ------- 3.1 Reliance Financial's Certificate of Incorporation, as amended (incorporated by reference to Exhibit 3.1 to Registration Statement No. 2-458933). 3.2 Amendment to Exhibit 3.1 (incorporated by reference to Exhibit 3.2 to Registration Statement No. 2-60201). 3.3 Amendment to Exhibit 3.1 (incorporated by reference to Exhibit 3.3 to Reliance Financial's Annual Report on Form 10-K for the year ended December 31, 1983). 3.4 Reliance Financial's By-Laws, as amended (incorporated by reference to Exhibit 3.4 to Reliance Financial's Annual Report on Form 10-K for the year ended December 31, 1990). *4. 10.1 Asset Purchase Agreement, dated July 24, 1992, between Frank B. Hall & Co. Inc. ("Hall") and Aon Corporation ("Aon") (incorporated by reference to Exhibit 2.1 to Reliance Group Holdings' Quarterly Report on Form 10-Q for the Quarter ended June 30, 1992). 10.2 Agreement and Plan of Merger, dated as of July 24, 1992, among Reliance Group Holdings, Hall and Prometheus Liquidating Corp. (incorporated by reference to Exhibit 2.2 to Reliance Group Holdings' Quarterly Report on Form 10-Q for the Quarter ended June 30, 1992). 10.3 Parent Undertaking Agreement, dated July 24, 1992, among Reliance Group Holdings, Inc., Reliance Insurance Company and Aon (incorporated by reference to Exhibit 28.1 to Reliance Group Holdings' Quarterly Report on Form 10-Q for the Quarter ended June 30, 1992). 10.4 Employee Benefit Agreement, dated July 24, 1992, among Reliance Group Holdings and Aon (incorporated by reference to Exhibit 28.2 to Reliance Group Holdings' Quarterly Report on Form 10-Q for the Quarter ended June 30, 1992). 10.5 Amendment, dated November 2, 1992, to Exhibit 10.1 (incorporated by reference to Exhibit 2.1 to Reliance Group Holdings' Quarterly Report on Form 10-Q for the Quarter ended September 30, 1992). 10.6 Underwriting Agreement, dated October 30, 1992, among Shearson Lehman Brothers Inc., Salomon Brothers, Inc, Commonwealth Land Title Insurance Company ("Commonwealth"), Commonwealth Mortgage Assurance Company ("CMAC") and CMAC Investment Corporation ("CIC") (incorporated by reference to Exhibit 10.1 to Reliance Group Holdings' Quarterly Report on Form 10-Q for the Quarter ended September 30, 1992). - -------- * Neither Reliance Financial nor its subsidiaries is a party to any instrument relating to long-term debt under which the securities authorized exceed 10% of the total consolidated assets of Reliance Financial and its subsidiaries. Copies of instruments relating to long-term debt of lesser amounts will be provided to the Securities and Exchange Commission upon request. EXHIBIT NUMBER - ------- 10.7 International Underwriting Agreement, dated October 30, 1992, among Lehman Brothers International Limited, Salomon Brothers International Limited, Commonwealth, CMAC and CIC (incorporated by reference to Exhibit 10.2 to Reliance Group Holdings' Quarterly Report on Form 10-Q for the Quarter ended September 30, 1992). 10.8 Settlement Agreement and Release, dated June 2, 1989, between James P. Corcoran, Superintendent of Insurance of the State of New York, as Liquidator of Union Indemnity Insurance Company of New York, Inc. and Hall (now known as Prometheus Funding Corp.) (incorporated herein by reference to Exhibit 10.01 to Frank B. Hall & Co. Inc.'s report on Form 10-Q for the Quarter ended June 30, 1989). 10.9 Stock Purchase Agreement, dated April 3, 1993, by and among Reliance Group Holdings, Inc., Reliance Insurance Company and General Electric Capital Corporation (incorporated by reference to Exhibit 10.22 to Reliance Insurance Company's Annual Report on Form 10-K for the year ended December 31, 1992). 10.10 First Amendment, dated as of May 31, 1993, to Exhibit 10.9 (incorporated by reference to Exhibit 2.2 to Reliance Insurance Company's Current Report on Form 8-K dated (date of earliest event reported) July 14, 1993). 10.11 Amendment, dated July 14, 1993, to Exhibit 10.9 (incorporated by reference to Exhibit 2.3 to Reliance Insurance Company's Current Report on Form 8-K dated (date of earliest event reported) July 14, 1993). 13.1 Reliance Financial 1993 Annual Report. **28.1 Schedule P from the statutory reports of the Reliance Property and Casualty Companies (incorporated by reference to Exhibit 28.1 to Reliance Insurance Company's Annual Report on Form 10-K for the year ended December 31, 1993). - -------- ** Schedule P from the statutory reports of Zenith National Insurance Corp., 34.4% of the outstanding common stock of which is owned by the Reliance Insurance Group, is omitted herefrom as such Schedule P is filed directly with the Securities and Exchange Commission.

893928_1993.txt

893928

1993

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

Item 2. Properties Refer to Item 1. "Business - Property," incorporated herein by reference, for information regarding the properties of the registrants. Item 3.

Item 3. Legal Proceedings Refer to Item 1. "Business - Rate Matters and Regulation," incorporated herein by reference, for details of the registrants' material rate proceedings and other regulatory proceedings and litigation that are pending or that terminated in the fourth quarter of 1993. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders A consent in lieu of a special meeting of common stockholders of Entergy-GSU Holdings, Inc. (Holdings) was executed on December 30, 1993, pursuant to a Delaware statute that permits such a procedure. The consent was signed on behalf of Entergy Corporation and GSU, which at that time owned all of the outstanding common stock of Holdings. The common stockholders acted to: (1) increase the number of directors from 2 to 18 upon the occurrence of the combination of Entergy Corporation and GSU, such expanded board to consist of Edwin Lupberger and Joseph Donnelly, who continued as directors, and the following new directors: W. Frank Blount; John A. Cooper, Jr.; Brooke H. Duncan; Lucie J. Fjeldstad; Kaneaster Hodges, Jr.; Robert v.d. Luft; Adm. Kinnaird R. McKee; Paul W. Murrill; James R. Nichols; Eugene H. Owen; John N. Palmer, Sr.; Robert D. Pugh; H. Duke Shackelford; Wm. Clifford Smith; Bismark A. Steinhagen; and Dr. Walter Washington; (2) approve the terms and provisions of certain agreements related to such combination; (3) approve the actions of the officers in connection with those agreements and the transactions contemplated thereby; (4) approve the assumption and adoption by Holdings of certain benefit plans of Entergy Corporation; and (5) approve the taking of actions to issue stock with respect to such plans, including the listing of Holdings' common stock on the New York, Pacific, and Midwest Stock Exchanges and the filing of registration statements with the Securities and Exchange Commission. After the consummation of the transactions involved in the combination, the name of Holdings was changed to Entergy Corporation. On January 22, 1994, Mr. Donnelly resigned from the position of director of Entergy Corporation. PART II Item 5.

Item 5. Market for Registrants' Common Equity and Related Stockholder Matters Entergy Corporation. The shares of Entergy Corporation's common stock are listed on the New York, Midwest, and Pacific Stock Exchanges. The high and low prices for each quarterly period in 1993 and 1992, were as follows: 1993 1992 --------------- ---------------- High Low High Low ------ ------ ------ ------ (In Dollars) First 36 1/2 32 1/2 29 5/8 27 1/8 Second 38 1/4 33 1/4 28 1/2 26 1/8 Third 39 7/8 36 1/4 31 7/8 28 1/4 Fourth 39 1/4 35 1/8 33 5/8 30 1/2 Four consecutive quarterly cash dividends on common stock were paid to stockholders of Entergy Corporation in each of 1993 and 1992. In 1993, dividends of 40 cents per share were paid in each of the first three quarters and dividends of 45 cents per share were paid in the last quarter. Dividends of 35 cents per share were paid in each of the first three quarters of 1992, and dividends of 40 cents per share were paid in the last quarter of 1992. As of February 24, 1994, there were 63,779 stockholders of record of Entergy Corporation. For information with respect to Entergy Corporation's future ability to pay dividends, refer to Note 7 of Entergy Corporation and Subsidiaries' Notes to Consolidated Financial Statements, "Dividend Restrictions," incorporated herein by reference. In addition to the restrictions described in Note 7, the Holding Company Act provides that, without approval of the SEC, the unrestricted, undistributed retained earnings of any Entergy Corporation subsidiary are not available for distribution to Entergy Corporation's common stockholders until such earnings are made available to Entergy Corporation through the declaration of dividends by such subsidiaries. AP&L, GSU, LP&L, MP&L, NOPSI, and System Energy. There is no market for the common stock of System Energy and the System operating companies, all of which is owned by Entergy Corporation. Prior to December 31, 1993, GSU's common stock was publicly held. Effective with the Merger, all shares of GSU common stock were acquired by Entergy Corporation. No cash dividends on common stock were paid by GSU to its stockholders in 1992-1993. Cash dividends on common stock paid by AP&L, LP&L, MP&L, NOPSI, and System Energy to Entergy Corporation during 1993 and 1992, were as follows: 1993 1992 ------ ------ (In Millions) AP&L $156.3 $ 75.0 LP&L 167.6 174.6 MP&L 85.8 68.4 NOPSI 43.9 32.2 System Energy 233.1 137.7 For information with respect to restrictions that limit the ability of System Energy and the System operating companies to pay dividends, and for information with respect to dividends paid to Entergy Corporation by its subsidiaries subsequent to December 31, 1993, refer respectively, to Note 6 of System Energy's and Note 7 of AP&L's, GSU's, LP&L's, MP&L's, and NOPSI's Notes to Financial Statements, "Dividend Restrictions," incorporated herein by reference. Item 6.

Item 6. Selected Financial Data Entergy Corporation. Refer to information under the heading "Entergy Corporation and Subsidiaries Selected Financial Data - Five- Year Comparison," which information is incorporated herein by reference. AP&L. Refer to information under the heading "Arkansas Power & Light Company Selected Financial Data - Five-Year Comparison," which information is incorporated herein by reference. GSU. Refer to information under the heading "Gulf States Utilities Company Selected Financial Data - Five-Year Comparison," which information is incorporated herein by reference. LP&L. Refer to information under the heading "Louisiana Power & Light Company Selected Financial Data - Five-Year Comparison," which information is incorporated herein by reference. MP&L. Refer to information under the heading "Mississippi Power & Light Company Selected Financial Data - Five-Year Comparison," which information is incorporated herein by reference. NOPSI. Refer to information under the heading "New Orleans Public Service Inc. Selected Financial Data - Five-Year Comparison," which information is incorporated herein by reference. System Energy. Refer to information under the heading "System Energy Resources, Inc. Selected Financial Data - Five-Year Comparison," which information is incorporated herein by reference. Item 7.

Item 7 "Financial Statements and Exhibits". A current report on Form 8-K, dated January 18, 1994, was filed with the SEC on January 18, 1994, reporting information under Item 5 "Other Materially Important Events". A current report on Form 8-K, dated February 1, 1994, was filed with the SEC on February 8, 1994, reporting information under Items 2 and 7. Entergy Corporation, AP&L, GSU, LP&L, MP&L and NOPSI Current Reports on Form 8-K, dated December 31, 1993, were filed by these companies on January 3, 1994 reporting the consummation of the Entergy Corporation - GSU merger under Item 5 (in the case of AP&L, LP&L, MP&L and NOPSI), Items 2 and 7 (in the case of Entergy Corporation and GSU). EXPERTS All statements in Part I of this Annual Report on Form 10-K as to matters of law and legal conclusions, based on the belief or opinion of System Energy or any System operating company or otherwise, pertaining to the titles to properties, franchises and other operating rights of certain of the registrants filing this Annual Report on Form 10-K, and their subsidiaries, the regulations to which they are subject and any legal proceedings to which they are parties are made on the authority of Friday, Eldredge & Clark, 2000 First Commercial Building, 400 West Capitol, Little Rock, Arkansas, as to AP&L and as to Entergy Services in regards to flood litigation; Monroe & Lemann (A Professional Corporation), 201 St. Charles Avenue, Suite 3300, New Orleans, Louisiana, as to LP&L and NOPSI; and Wise Carter Child & Caraway, Professional Association, Heritage Building, Jackson, Mississippi, as to MP&L and System Energy. The statements attributed to Clark, Thomas & Winters, a professional corporation, as to legal conclusions with respect to GSU's rate regulation in Texas under Item 1. "Rate Matters and Regulation - Rate Matters - Retail Rate Matters - GSU" and in Note 2 to Entergy Corporation and Subsidiaries Consolidated Financial Statements and GSU's Financial Statements, "Rate and Regulatory Matters," have been reviewed by such firm and are included herein upon the authority of such firm as experts. The statements attributed to Sandlin Associates regarding the analysis of River Bend Construction costs of GSU under Item 1. "Rate Matters and Regulation - Rate Matters - Retail Rate Matters - GSU" and in Note 2 to Entergy Corporation and Subsidiaries Consolidated Financial Statements and GSU's Financial Statements, "Rate and Regulatory Matters", have been reviewed by such firm and are included herein upon the authority of such firm as experts. ENTERGY CORPORATION SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. ENTERGY CORPORATION By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Vice President and March 14, 1994 Lee W. Randall Chief Accounting Officer (Principal Accounting Officer) Edwin Lupberger (Chairman of the Board, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); W. Frank Blount, John A. Cooper, Jr., Brooke H. Duncan, Lucie J. Fjeldstad, Kaneaster Hodges, Jr., Robert v.d. Luft, Kinnaird R. McKee, Paul W. Murrill, James R. Nichols, Eugene H. Owen, John N. Palmer, Robert D. Pugh, H. Duke Shackelford, Wm. Clifford Smith, Bismark A. Steinhagen, and Walter Washington (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) ARKANSAS POWER & LIGHT COMPANY SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. ARKANSAS POWER & LIGHT COMPANY By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Lee W. Randall Vice President and Chief March 14, 1994 Accounting Officer (Principal Accounting Officer) Edwin Lupberger (Chairman of the Board, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); Michael B. Bemis, John A. Cooper, Jr., Cathy Cunningham, Richard P. Herget, Jr., Tommy H. Hillman, Donald C. Hintz, Kaneaster Hodges, Jr., Jerry D. Jackson, R. Drake Keith, Jerry L. Maulden, Raymond P. Miller, Sr., Roy L. Murphy, William C. Nolan, Jr., Robert D. Pugh, Woodson D. Walker, Gus B. Walton, Jr., Michael E. Wilson (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) GULF STATES UTILITIES COMPANY SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. GULF STATES UTILITIES COMPANY By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Vice President and March 14, 1994 Lee W. Randall Chief Accounting Officer (Principal Accounting Officer) Edwin Lupberger (Chairman of the Board, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); Robert H. Barrow, Frank F. Gallaher, Frank W. Harrison, Jr., Donald C. Hintz, Jerry L. Maulden, Paul W. Murrill, Eugene H. Owen, M. Bookman Peters, Monroe J. Rathbone, Jr., Sam F. Segnar, Bismark A. Steinhagen, James E. Taussig, II. (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) LOUISIANA POWER & LIGHT COMPANY SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. LOUISIANA POWER & LIGHT COMPANY By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Lee W. Randall Vice President and Chief March 14, 1994 Accounting Officer (Principal Accounting Officer) Edwin Lupberger (Chairman of the Board, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); Michael B. Bemis, John J. Cordaro, Donald C. Hintz, William K. Hood, Jerry D. Jackson, Tex R. Kilpatrick, Joseph J. Krebs, Jr., Jerry L. Maulden, H. Duke Shackelford, Wm. Clifford Smith (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) MISSISSIPPI POWER & LIGHT COMPANY SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. MISSISSIPPI POWER & LIGHT COMPANY By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Lee W. Randall Vice President and Chief March 14, 1994 Accounting Officer (Principal Accounting Officer) Edwin Lupberger (Chairman of the Board, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); Michael B. Bemis, Frank R. Day, John O. Emmerich, Jr., Norman B. Gillis, Jr., Donald C. Hintz, Jerry D. Jackson, Robert E. Kennington, II, Jerry L. Maulden, Donald E. Meiners, John N. Palmer, Sr., Clyda S. Rent, Walter Washington, Robert M. Williams, Jr. (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) NEW ORLEANS PUBLIC SERVICE INC. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. NEW ORLEANS PUBLIC SERVICE INC. By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Lee W. Randall Vice President and Chief March 14, 1994 Accounting Officer (Principal Accounting Officer) Edwin Lupberger (Chairman of the Board, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); Michael B. Bemis, James M. Cain, John J. Cordaro, Brooke H. Duncan, Norman C. Francis, Donald C. Hintz, Jerry D. Jackson, Jerry L. Maulden, Anne M. Milling, John B. Smallpage, Charles C. Teamer, Sr. (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) SYSTEM ENERGY RESOURCES, INC. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. The signature of the undersigned company shall be deemed to relate only to matters having reference to such company and any subsidiaries thereof. SYSTEM ENERGY RESOURCES, INC. By /s/ Lee W. Randall Lee W. Randall, Vice President and Chief Accounting Officer Date: March 14, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. The signature of each of the undersigned shall be deemed to relate only to matters having reference to the above-named company and any subsidiaries thereof. Signature Title Date /s/ Lee W. Randall Lee W. Randall Vice President and Chief March 14, 1994 Accounting Officer (Principal Accounting Officer) Donald C. Hintz (President, Chief Executive Officer and Director; Principal Executive Officer); Gerald D. McInvale (Senior Vice President and Chief Financial Officer; Principal Financial Officer); Edwin Lupberger (Chairman of the Board), Jerry D. Jackson, Jerry L. Maulden (Directors). By: /s/ Lee W. Randall March 14, 1994 (Lee W. Randall, Attorney-in-fact) EXHIBIT 23(a) INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in Post-Effective Amendment Nos. 2, 3, 4A, and 5A on Form S-8 to Registration Statement No. 33-54298 of Entergy Corporation on Form S-4, and the related Prospectuses, of our reports dated February 11, 1994 (which express an unqualified opinion and include explanatory paragraphs as to uncertainties because of certain regulatory and litigation matters), appearing in this Annual Report on Form 10-K of Entergy Corporation for the year ended December 31, 1993. We also consent to the incorporation by reference in Registration Statements Nos. 33-36149, 33-48356 and 33-50289 of Arkansas Power & Light Company on Form S-3, and the related Prospectuses, of our reports dated February 11, 1994, appearing in this Annual Report on Form 10-K of Arkansas Power & Light Company for the year ended December 31, 1993. We also consent to the incorporation by reference in Registration Statements Nos. 33-46085, 33-39221 and 33-50937 of Louisiana Power & Light Company on Form S-3, and the related Prospectuses, of our reports dated February 11, 1994, appearing in this Annual Report on Form 10-K of Louisiana Power & Light Company for the year ended December 31, 1993. We also consent to the incorporation by reference in Registration Statements Nos. 33-53004, 33-55826 and 33-50507 of Mississippi Power & Light Company on Form S-3, and the related Prospectuses, of our reports dated February 11, 1994, appearing in this Annual Report on Form 10-K of Mississippi Power & Light Company for the year ended December 31, 1993. We also consent to the incorporation by reference in Registration Statement No. 33-57926 of New Orleans Public Service Inc. on Form S-3, and the related Prospectus, of our reports dated February 11, 1994, appearing in this Annual Report on Form 10-K of New Orleans Public Service Inc. for the year ended December 31, 1993. We also consent to the incorporation by reference in Registration Statement No. 33-47662 of System Energy Resources, Inc. on Form S-3, and the related Prospectus, of our reports dated February 11, 1994 (which express an unqualified opinion and include an explanatory paragraph as to an uncertainty resulting from a regulatory proceeding), appearing in this Annual Report on Form 10-K of System Energy Resources, Inc. for the year ended December 31, 1993. /s/ Deloitte & Touche DELOITTE & TOUCHE New Orleans, Louisiana March 14, 1994 EXHIBIT 23(b) CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference in the registration statements of Gulf States Utilities Company on Form S-3 (File Numbers 33-49739 and 33-51181) and Form S-8 (File Numbers 2-76551 and 2-98011) of our reports, dated February 11, 1994, on our audits of the financial statements and financial statement schedules of Gulf States Utilities Company as of December 31, 1993 and 1992, and for the years ended December 31, 1993, 1992 and 1991, which reports include explanatory paragraphs related to rate-related contingencies, legal proceedings and changes in accounting for income taxes, postretirement benefits, unbilled revenue and power plant materials and supplies and are included in this Annual Report on Form 10-K. /s/ Coopers & Lybrand Coopers & Lybrand Houston, Texas March 14, 1994 EXHIBIT 23(c) CONSENT OF EXPERTS We consent to the reference to our firm under the heading "Experts" in this Annual Report on Form 10-K. We further consent to the incorporation by reference of such reference to our firm into Arkansas Power & Light Company's ("AP&L") Registration Statements (Form S-3, File Nos. 33-36149, 33-48356 and 33-50289) and related Prospectuses, pertaining to AP&L's First Mortgage Bonds and Preferred Stock. Very truly yours, /s/ Friday, Eldredge & Clark FRIDAY, ELDREDGE & CLARK Date: March 14, 1994 EXHIBIT 23(d) CONSENT We consent to the reference to our firm under the heading "Experts", and to the inclusion in this Annual Report on Form 10-K of Gulf States Utilities Company ("GSU") of the statements of legal conclusions attributed to us herein (the Statements of Legal Conclusions) under Part I, Item 1. Business - "Rate Matters and Regulation" and in the discussion of Texas jurisdictional matters set forth in Note 2 to GSU's Financial Statements and Note 2 to Entergy Corporation and Subsidiaries Consolidated Financial Statements appearing as Item 8.

789292_1993.txt

789292

1993

Item 1. Regulation and Legislation. Generally, the franchising authority can decide not to renew a franchise only if it finds that the cable operator has not substantially complied with the material terms of the franchise, has not provided reasonable service in light of the community's needs, does not have the financial, legal and technical ability to provide the services being proposed for the future, or has not presented a reasonable proposal for future service. A final decision of non-renewal by the franchising authority is appealable in court. The General Partner and its affiliates recently have experienced lengthy negotiations with some franchising authorities for the granting of franchise renewals and transfers. Some of the issues involved in recent renewal negotiations include rate reregulation, customer service standards, cable plant upgrade or replacement and shorter terms of franchise agreements. The inability of a Partnership to renew a franchise, or lengthy negotiations or litigation involving the renewal process could have an adverse impact on the business of a Partnership. The inability of a Partnership to transfer a franchise could have an adverse impact on the ability of a Partnership to accomplish its investment objectives. COMPETITION. The Systems face competition from a variety of alternative entertainment media, such as: Multichannel Multipoint Distribution Service ("MMDS"), which is often called a "wireless cable service" and is a microwave service authorized to transmit television signals and other communications on a complement of channels, which when combined with instructional fixed television and other channels, is able to provide a complement of television signals potentially competitive with cable television systems; Satellite Master Antenna Television System ("SMATV"), commonly called a "private" cable television system, which is a system wherein one central antenna is used to receive signals and deliver them to, for example, an apartment complex; and Television Receive-Only Earth Stations ("TVRO"), which are satellite receiving antenna dishes that are used by "backyard users" to receive satellite delivered programming directly in their homes. Programming services sell their programming directly to owners of TVROs as well as through third parties. The competition from MMDS and TVRO potentially diminishes the pool of subscribers to the Systems because persons who subscribe to MMDS services or who own backyard satellite dishes are not likely to subscribe to all of the Systems' cable television services. In the near future, the Systems will also face competition from direct satellite to home transmission ("DBS"). DBS can provide to individuals on a wide-scale basis premium channel services and specialized programming through the use of high-powered DBS satellites that transmit such programming to a rooftop or side-mounted antenna. There are currently no DBS operators in the areas served by the Systems. DBS systems' ability to compete with the cable television industry will depend on, among other factors, the ability to obtain access to programming and the availability of reception equipment at reasonable prices. The first DBS satellite was recently launched, and it is anticipated that DBS services will become available throughout the United States during 1994. The Systems also face competition from video cassette rental outlets and movie theaters in the Systems' service areas. The General Partner believes the preponderance of video cassette recorder ("VCR") ownership in the Systems' service areas may be a positive rather than a negative factor because households that have VCRs are attracted to non-commercial programming delivered by the Systems, such as movies and sporting events on cable television, that they can tape at their convenience. Cable television franchises are not exclusive, so that more than one cable television system may be built in the same area (known as an "overbuild"), with potential loss of revenues to the operator of the original cable television system. Other than as described below, the Systems currently face no direct competition from other cable television operators. Although the Partnerships have not yet encountered competition from a telephone company entering into the cable television business, the Partnerships' Systems could potentially face competition from telephone companies doing so. Bell Atlantic, a regional Bell operating company ("RBOC"), has announced its intention, if permitted by the courts, to build a cable television system in Alexandria, Virginia, and has won a lawsuit to obtain such authority. The case is on appeal. The General Partner currently owns and manages the cable television system in Alexandria, Virginia. Another RBOC, Ameritech, has also indicated its intention to build and operate a cable television system in Naperville, Illinois, a location where the General Partner manages a system on behalf of one of its managed limited partnerships. Other RBOCs have indicated their intention to enter the cable television market, and have filed lawsuits similar to the one being pursued by Bell Atlantic and Ameritech. Widespread competition through overbuilds by RBOCs could have a negative impact on companies like the General Partner that are already established cable television system operators. COMPETITION FOR SUBSCRIBERS IN THE PARTNERSHIPS' SYSTEMS. Following is a summary of competition from MMDS, SMATV and TVRO operators in the Partnerships' franchise areas. Albuquerque System Two SMATV operators serve approximately 3,190 units in trailer parks and apartments. Augusta System Two SMATV operators serve two apartment complexes; one TVRO dealer principally operates in areas which are not serviced by cable. Ft. Myers System One MMDS operator provides negligible competition; five SMATV operators provide service to motels and an occasional apartment complex; and twelve TVRO dealers serve a customer base that is confined primarily to rural areas. Northern Illinois System The General Partner is not aware of any MMDS or TVRO satellite dish dealers in the system's service area. There are a limited number of SMATV operators in the system's service area, but they do not provide significant competition. Palmdale/Lancaster System No MMDS operators; numerous SMATV operators provide some competition in several apartment complexes, hotels, motels, trailer parks and two hospitals. There are numerous TVRO dealers in the service area. Approximately 2% of the homes in the service area have TVRO systems. Tampa System One MMDS operator provides minimal competition; ten SMATV operators provide moderate competition; thirty TVRO dealers provide minimal competition. REGULATION AND LEGISLATION. The cable television industry is regulated through a combination of the Federal Communications Commission ("FCC"), some state governments, and most local governments. In addition, the Copyright Act of 1976 imposes copyright liability on all cable television systems. Cable television operations are subject to local regulation insofar as systems operate under franchises granted by local authorities. Cable Television Consumer Protection and Competition Act of 1992. On October 5, 1992, Congress enacted the Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Cable Act"), which became effective on December 4, 1992. This legislation effected significant changes to the regulatory environment in which the cable television industry operates. The 1992 Cable Act generally allows for a greater degree of regulation of the cable television industry. Under the 1992 Cable Act's definition of effective competition, nearly all cable television systems in the United States, including those owned and managed by the General Partner, are subject to rate regulation of basic cable services. In addition, the 1992 Cable Act allows the FCC to regulate rates for non-basic service tiers other than premium services in response to complaints filed by franchising authorities and/or cable subscribers. In April 1993, the FCC adopted regulations governing rates for basic and non-basic services and ordered an interim freeze on these rates effective on April 15, 1993. The rate freeze recently was extended by the FCC until the earlier of May 15, 1994, or the date on which a cable system's basic service rate is regulated by a franchising authority. The FCC's rate regulations became effective on September 1, 1993. On February 22, 1994, the FCC announced a revision of its rate regulations which it believes will generally result in a further reduction of rates for basic and non-basic services. The 1992 Cable Act encourages competition with existing cable systems by allowing municipalities, which are otherwise legally qualified, to own and operate their own cable systems without having to obtain a franchise; prevents franchising authorities from granting exclusive franchises; or unreasonably refusing to award additional franchises covering an existing cable system's service area. The 1992 Cable Act also makes several procedural changes to the process under which a cable operator seeks to enforce renewal rights which could make it easier in some cases for a franchising authority to deny renewal. The 1992 Cable Act prohibits the common ownership of cable systems and co-located MMDS or SMATV systems, and absent certain exceptions, the sale or transfer of ownership of a cable system within 36 months after its acquisition or initial construction. The 1992 Cable Act also precludes video programmers affiliated with cable companies from favoring cable operators over competitors and requires such programmers to sell their programs to other multichannel video distributors. This provision may limit the ability of cable program suppliers to offer exclusive programming arrangements with cable companies and could affect the volume discounts that program suppliers currently offer to the General Partner in its capacity as a multiple system operator. The 1992 Cable Act has eliminated the latitude of operators to set rates for commercially leased access channels and requires that leased access rates be set according to a formula determined by the FCC. The 1992 Cable Act contains new broadcast signal carriage requirements, and the FCC has adopted regulations implementing the statutory requirements. These new rules allow a local commercial broadcast television station to elect whether to demand that a cable television system carry its signal, or to require the cable television system to negotiate with the station for "retransmission consent." A cable television system is generally required to devote up to one-third of its activated channel capacity for the mandatory carriage of local commercial broadcast television stations, and non-commercial television stations are also given mandatory carriage rights, although such stations are not given the option to negotiate retransmission consent for the carriage of their signals by cable television systems. Additionally, cable television systems also are required to obtain retransmission consent from all "distant" commercial television stations (except for commercial satellite-delivered independent "superstations"), commercial radio stations and certain low-power television stations carried by cable television systems. See Item 1. Cable Television Services. There have been several lawsuits filed by cable television operators and programmers in Federal court challenging various aspects of the 1992 Cable Act, including provisions relating to mandatory broadcast signal carriage, retransmission consent, access to cable programming, rate regulation, commercial leased channels and public access channels. On April 8, 1993, a three-judge Federal district court panel issued a decision upholding the constitutional validity of the mandatory signal carriage requirements of the 1992 Cable Act. That decision has been appealed directly to the United States Supreme Court. Appeals have been filed in the Federal appellate court challenging the validity of the FCC's retransmission consent rules. Ownership and Market Structure. The FCC rules and federal law generally prohibit the direct or indirect common ownership, operation, control or interest in a cable television system, on the one hand, and a local television broadcast station whose television signal reaches any portion of the community served by the cable television system, on the other hand. The FCC recently lifted its ban on the cross-ownership of cable television systems by broadcast networks. The FCC revised its regulations to permit broadcast networks to acquire cable television systems serving up to 10% of the homes passed in the nation, and up to 50% of the homes passed in a local market. Neither the Partnerships nor the General Partner has any direct or indirect ownership, operation, control or interest in a television broadcast station, or a telephone company, and they are thus presently unaffected by the cross-ownership rules. The Cable Communications Policy Act of 1984 (the "1984 Cable Act") and FCC regulations generally prohibit the common operation of a cable television system and a telephone company within the same service area. Until recently, a provision of a Federal court antitrust consent decree also prohibited the regional Bell operating companies ("RBOCs") from engaging in cable television operations. This prohibition was recently removed when the court retaining jurisdiction over the consent decree ruled that the RBOCs could provide information services over their facilities. This decision permits the RBOCs to acquire or construct cable television systems outside of their own service areas. The 1984 Cable Act prohibited local exchange carriers, including the RBOCs, from providing video programming directly to subscribers within their local exchange telephone service areas, except in rural areas or by specific waiver of FCC rules. This statutory provision has recently been challenged on constitutional grounds by Bell Atlantic, one of the RBOCs. The court held that the 1984 Cable Act cross-ownership provision is unconstitutional, and it issued an order enjoining the United States Justice Department from enforcing the cross-ownership ban. The National Cable Television Association, an industry group of which the General Partner is a member, has appealed this landmark decision, and the case could ultimately be reviewed by the United States Supreme Court. This federal cross-ownership rule is particularly important to the cable industry since these telephone companies already own certain facilities needed for cable television operation, such as poles, ducts and associated rights-of-way. The FCC has conducted a comprehensive proceeding examining whether and under what circumstances telephone companies should be allowed to provide cable television services, including video programming, to their customers. The FCC has concluded that under the 1984 Cable Act interexchange carriers (such as AT&T, which provide long distance services) are not subject to the restrictions which bar the provision of cable television service by local exchange carriers. In addition, the FCC concluded that neither a local exchange carrier providing a video dialtone service nor its programming suppliers leasing the dialtone service are required to obtain a cable television franchise. This determination has been appealed. If video dialtone services become widespread in the future, cable television systems could be placed at a competitive disadvantage because cable television systems are required to obtain local franchises to provide cable television service and must comply with a variety of obligations under such franchises. The FCC has tentatively concluded that construction and operation of technologically advanced, integrated broadband networks by carriers for the purpose of providing video programming and other services would constitute good cause for waiver of the cable/telephone cross-ownership prohibitions. In July 1989, the FCC granted a California telephone company a waiver of the cross- ownership restrictions based on a showing of "good cause," but the FCC's decision was reversed on appeal, and as a result of this decision, the FCC may be required to follow a stricter policy in granting such waivers in the future. As part of the same proceeding, the FCC recommended that Congress amend the 1984 Cable Act to allow Local Exchange Carriers ("LECs") to provide their own video programming services over their facilities. The FCC recently decided to loosen ownership and affiliation restrictions currently applicable to telephone companies, and has proposed to increase the numerical limit on the population of areas qualifying as "rural" and in which LECs can provide cable service without a FCC waiver. Legislation is pending in Congress which would permit the LECs to provide cable television service within their own operating areas conditioned on establishing separate video programming affiliates. The legislation would generally prohibit, however, telephone companies from acquiring cable systems within their own operating areas. The legislation would also enable cable television companies and others, subject to regulatory safeguards, to offer telephone services by eliminating state and local barriers to entry. ITEM 2.

ITEM 2. PROPERTIES The cable television systems owned at December 31, 1993 by the Partnerships are described below. The following tables set forth (i) the monthly basic plus service rates charged to subscribers, (ii) the number of basic subscribers and pay units, (iii) the number of homes passed by cable plant, (iv) the miles of cable plant and (v) the range of franchise expiration dates for the cable television systems owned and operated by the Partnerships. The monthly basic plus service rates set forth herein represent, with respect to systems with multiple headends, the basic plus service rate charged to the majority of the subscribers within the system. While the charge for basic plus service may have increased in some cases as a result of the FCC's rate regulations, overall revenues to the Partnerships may have decreased due to the elimination of charges for additional outlets and certain equipment. In cable television systems, basic subscribers can subscribe to more than one pay TV service. Thus, the total number of pay services subscribed to by basic subscribers are called pay units. Figures for numbers of subscribers, miles of cable plant and homes passed are compiled from the General Partner's records and may be subject to adjustments. As of December 31, 1993, the number of homes passed and the miles of cable plant were 21,869 and 300, respectively. Franchise expiration dates range from March 1996 to June 2001. As of December 31, 1993, the number of homes passed and the miles of cable plant were 16,751 and 262, respectively. Franchise expiration date is August 1994. The renewal of this franchise is currently being negotiated. As of December 31, 1993, the number of homes passed and the miles of cable plant were 9,182 and 81, respectively. Franchise expiration date is November 1995. As of December 31, 1993, the number of homes passed and the miles of cable plant were 64,507 and 664, respectively. Franchise expiration dates range from December 1999 to January 2002. As of December 31, 1993, the number of homes passed and the miles of cable plant were 100,100 and 1,602, respectively. Franchise expiration dates range from December 1998 to October 2003. As of December 31, 1993, the number of homes passed and the miles of cable plant were 85,768 and 937, respectively. Franchise expiration dates range from September 1994 to October 2005. Any franchises expiring in 1994 are in the process of franchise renewal negotiations. As of December 31, 1993, the number of homes passed and the miles of cable plant were 200,500 and 2,202, respectively. Franchise expiration dates range from January 1999 to August 2001. As of December 31, 1993, the number of homes passed and the miles of cable plant were 127,800 and 1,093, respectively. The Tampa franchise expires in December 1997. The City of Tampa has notified the Venture of its belief that the Venture is not in compliance with certain provisions of the franchise agreement. Specifically, the City has claimed that the Venture is not in compliance with local origination programming requirements, institutional network requirements, and other facilities, equipment and service obligations under the franchise. The Venture has responded to the claim with a detailed demonstration that many of the City's claims are erroneous and that the remaining unmet obligations should be modified. The City of Tampa and the Venture have reached an agreement in principle with respect to the settlement of the franchise dispute. A definitive settlement agreement is in the process of being negotiated. PROGRAMMING SERVICES Programming services provided by the Systems include local affiliates of the national broadcast networks, local independent broadcast channels, the traditional satellite services (e.g., American Movie Classics (AMC), Arts & Entertainment (ARTS), Black Entertainment Network (BET), C-SPAN, The Discovery Channel (DISC), Lifetime (LIFE), Entertainment Sports Network (ESPN), Home Shopping Network (HSN), Mind Extension University (MEU), Music Television (MTV), Nickelodeon (NICK), Turner Network Television (TNT), The Nashville Network (TNN), Video Hits One (VH-1), and superstations WOR, WGN and TBS. The Partnerships' Systems also provide a selection, which varies by system, of premium channel programming (e.g., Bravo (BRVO), Cinemax (CMAX), The Disney Channel (DISN), Encore (ENC), Home Box Office (HBO), Showtime (SHOW) and The Movie Channel (TMC)). ITEM 3.

ITEM 3. LEGAL PROCEEDINGS On July 15, 1992, the General Partner received a Civil Investigative Demand (the "CID") from the Department of Justice ("DOJ") in connection with an investigation to determine whether there is or has been a violation of Section 2 of the Sherman Act as a consequence of the General Partner's alleged refusal to carry a television broadcast station on cable television systems. The interrogatories and document requests included in the CID request information relating to systems owned or managed by the General Partner in Los Angeles County, and elsewhere, including the Palmdale/Lancaster System owned by the Venture. Specific reference is made in the CID to KHIZ, Channel 64. The General Partner has responded to a variety of requests for information and documents from the DOJ but has had no communication from the DOJ since March 1992. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None PART II. ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS While the Partnerships are all publicly held, there is no public market for the limited partnership interests and it is not expected that a market will develop in the future. As of March 1, 1994, the approximate number of equity security holders was: Item 6.

Item 6. Selected Financial Data ** The above financial information represents the consolidated operations of Cable TV Fund 12-BCD Venture, in which Cable TV Fund 12-D has an approximate 76 percent equity interest. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations CABLE TV FUND 12-D Results of Operations All of Cable TV Fund 12-D's ("Fund 12-D's") operations are represented by its approximate 76 percent interest in Cable TV Fund 12-BCD Venture (the " Venture"). Thus, Management's Discussion and Analysis of the Venture should be consulted for pertinent comments regarding Partnership performance. Financial Condition Fund 12-D's investment in the Venture has decreased by $8,751,100 when compared to the December 31, 1992 balance representing a deficit of $4,072,166. This deficit is due to Fund 12-D's share of Venture losses, which are principally the result of deprecation and amortization charges being greater than equity invested. These losses are expected to be recovered upon liquidation of the Venture. CABLE TV FUND 12-BCD VENTURE Results of Operations 1993 Compared to 1992 Revenues of Cable TV Fund 12-BCD Venture (the "Venture") increased $5,564,003, or approximately 7 percent, from $83,567,527 in 1992 to $89,131,530 in 1993. Between December 31, 1992 and 1993, the Venture added 7,498 basic subscribers, an increase of approximately 4 percent. This increase in basic subscribers accounted for approximately 32 percent of the increase in revenues. Basic service rate adjustments were responsible for approximately 38 percent of the increase in revenues. Advertising sales revenue accounted for approximately 12 percent of the increase in revenues. Increases in pay per view revenue accounted for approximately 14 percent of the increase. The increase in revenues would have been greater but for the reduction in basic rates due to new basic rate regulation issued by the FCC in May 1993 with which the Venture complied effective September 1, 1993. In addition, on February 22, 1994, the FCC announced a further rulemaking which, when implemented, could reduce rates further. No other single factor significantly affected the increase in revenues. Operating, general and administrative expenses in the Venture's systems increased $3,941,804, or approximately 8 percent, from $48,132,180 in 1992 to $52,073,984 in 1993. Operating, general and administrative expense represented 58 percent of revenue in 1993 and in 1992. The increase in operating, general and administrative expense was due to increases in subscriber related costs, programming fees and marketing related costs. No other single factor significantly affected the increase in operating, general and administrative expenses. Management fees and allocated overhead from Jones Intercable, Inc. increased $746,870, or approximately 8 percent, from $9,758,490 in 1992 to $10,505,360 in 1993 due to the increase in revenues, upon which such fees and allocations are based, and an increase in allocated expenses. Depreciation and amortization expense decreased $1,113,583, or approximately 4 percent, from $26,764,820 in 1992 to $25,651,237 in 1993. The decrease is due to the maturation of the Venture's asset base. The Venture recorded operating income of $900,949 for 1993 compared to an operating loss of $1,087,963 for 1992. This change is the result of increases in revenue and the decreases in depreciation and amortization expenses exceeding the increases in operating, general and administrative expenses and management fees and allocated overhead from Jones Intercable Inc. Operating income before depreciation and amortization increased $875,329, or approximately 3 percent, from $25,676,857 in 1992 to $26,552,186 in 1993. This increase is due to the increase in revenues exceeding the increase in operating, general, and administrative expenses and administrative fees and allocated overhead from Jones Intercable, Inc. Interest expense decreased $33,744, or less than 1 percent, from $12,022,874 in 1992 to $11,989,130 in 1993 due to lower interest rates on interest bearing obligations, which were offset, in part, by higher balances on such obligations. The Venture recorded other expense of $556,309 in 1993 compared to other expense of $2,708,833 in 1992. The 1992 expense primarily represented the Sunbelt litigation settlement as discussed in Note 6 of notes to financial statements of the Venture. The settlement was accrued by the Venture in 1992 and paid by the Venture in March 1993. Net loss decreased $3,299,949, or approximately 22 percent, from $14,884,365 in 1992 to $11,584,416 in 1993 due to the factors discussed above. These losses are expected to continue in the future. 1992 Compared to 1991 Revenues of the Venture increased $5,518,022, or approximately 7 percent, from $78,049,505 in 1991 to $83,567,527 in 1992. Between December 31, 1991 and 1992, the Venture added 3,670 basic subscribers, an increase of approximately 2 percent. This increase in basic subscribers accounted for approximately 17 percent of the increase in revenues. Basic service rate adjustments were responsible for approximately 46 percent of the increase in revenues. Advertising sales revenue accounted for approximately 14 percent of the increase in revenues. Increases in equipment rental revenue accounted for approximately 13 percent of the increase. No other single factor significantly affected the increase in revenues. Operating, general and administrative expenses in the Venture's systems increased $4,487,834, or approximately 10 percent, from $43,644,346 in 1991 to $48,132,180 in 1992. Operating, general and administrative expense represented 58 percent of revenue in 1992 compared to 56 percent in 1991. The increase in operating, general and administrative expense was due to increases in personnel related costs, programming fees and property taxes, which were partially offset by decreases in marketing related costs and copyright fees. No other single factor significantly affected the increase in operating, general and administrative expenses. Management fees and allocated overhead from Jones Intercable, Inc. increased $1,215,796, or approximately 14 percent, from $8,542,694 in 1991 to $9,758,490 in 1992 due to the increase in revenues, upon which such fees and allocations are based, and an increase in allocated expenses from Jones Intercable, Inc. Depreciation and amortization expense decreased $4,028,233, or approximately 13 percent, from $30,793,053 in 1991 to $26,764,820 in 1992. The decrease is due to the maturation of the Venture's asset base. Operating loss decreased $3,842,625, or approximately 78 percent, from $4,930,588 in 1991 to $1,087,963 in 1992 as a result of the increase in revenues and the decreases in depreciation and amortization exceeding the increases in operating, general and administrative expenses and management fees and allocated overhead from Jones Intercable, Inc. Interest expense decreased $898,899, or approximately 7 percent, from $12,921,773 in 1991 to $12,022,874 in 1992 due primarily to lower interest rates on interest bearing obligations, despite higher balances on such obligations. The Venture recorded other expense of $2,708,833 in 1992 compared to other income of $23,761 in 1991. This increase was due to the Sunbelt litigation settlement as discussed above. This settlement was paid by the Venture in March 1993. Net loss decreased $2,944,235, or approximately 17 percent, from $17,828,600 in 1991 to $14,884,365 in 1992 due primarily to the reductions in operating loss and interest expense which were offset, in part, by the litigation settlement discussed above. These losses are the result of the factors discussed above and are expected to continue in the future. Financial Condition Capital expenditures for the Venture totaled approximately $18,711,600 during 1993. Service drops to homes accounted for approximately 29 percent of the capital expenditures. Approximately 18 percent of these capital expenditures related to plant extensions in all of the Venture's systems. The completion of a rebuild of the Venture's Palmdale, California system accounted for approximately 17 percent of capital expenditures. Approximately 12 percent of capital expenditures was for fiber upgrades. The remaining expenditures related to various system enhancements. These capital expenditures were funded primarily from cash generated from operations and borrowings under the Venture's credit facility. Expected capital expenditures for 1994 are approximately $25,914,000. The upgrade of the Albuquerque, New Mexico system is expected to account for approximately 31 percent. Plant extensions in all of the Venture's systems are expected to account for approximately 15 percent. Service drops to homes are anticipated to account for approximately 23 percent. The remainder of the expenditures are for various system enhancements in all of the Venture's systems. Funding for these expenditures is expected to be provided by cash on hand, cash generated from operations and borrowings from the Venture's credit facility. Subject to the regulatory matters discussed below and assuming successful renegotiation of its credit facility, the Venture has sufficient sources of capital available in its ability to generate cash from operations and to borrow under its credit facility to meet its presently anticipated needs. During the first quarter of 1992, the Venture renegotiated its debt arrangements, which increased the maximum amount of debt available to $183,000,000. Such new debt arrangements consist of $93,000,000 of Senior Notes placed with a group of institutional lenders and a renegotiated $90,000,000 revolving credit agreement with a group of commercial bank lenders. The Venture used the funds from the Senior Notes to repay approximately $88,000,000 of the $155,000,000 outstanding on its previous credit facility and to repay advances from Intercable. The Venture used borrowings under its new credit facility to repay the remaining balance on its previous credit facility. The Senior Notes have a fixed interest rate of 8.64 percent and a final maturity date of March 31, 2000. The Senior Notes call for interest only payments for the first four years, with interest and accelerating amortization of principal payments for the next four years. Interest is payable semi-annually. The Senior Notes carry a "make-whole" premium, which is a prepayment penalty, if they are prepaid prior to maturity. The make-whole premium protects the lenders in the event that the funds are reinvested at a rate below 8.64 percent, and is calculated per the note agreement. The Venture's current revolving credit facility has a maximum amount available of $90,000,000. As of December 31, 1993, $73,800,000 was outstanding under the Venture's revolving credit agreement, leaving the Venture with $16,200,000 of available borrowing capacity until March 31, 1994. The revolving credit period will expire on March 31, 1994, at which time the principal balance converts to a term loan payable in quarterly installments with a final maturity date of March 31, 2000. The General Partner is negotiating to to extend the revolving credit period for one year. Interest is at the Venture's option of LIBOR plus 1.25 percent to 1.75 percent, the CD rate plus 1.375 percent to 1.875 percent or the Base Rate plus 0 percent to .50 percent. An annual commitment fee of .5 percent is required on the unused portion of the facility until it converts to a term loan. Both lending facilities are equal in standing with the other, and both are equally secured by the assets of the Venture. Regulation and Legislation On October 5, 1992, Congress enacted the Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Cable Act") which became effective on December 4, 1992. This legislation has effected significant changes to the regulatory environment in which the cable television industry operates. The 1992 Cable Act generally allows for a greater degree of regulation of the cable television industry. Under the 1992 Cable Act's definition of effective competition, nearly all cable television systems in the United States, including those owned and managed by the General Partner, are subject to rate regulation of basic cable services. In addition, the 1992 Cable Act allows the FCC to regulate rates for non-basic service tiers other than premium services in response to complaints filed by franchising authorities and/or cable subscribers. In April 1993, the FCC adopted regulations governing rates for basic and non-basic services. These regulations, with which the Venture complied, became effective on September 1, 1993. See Item 1 for further discussion of the provisions of the 1992 Cable Act. Based on Intercable's assessment of the FCC's rulemakings concerning rate regulation under the 1992 Cable Act, the Venture reduced the rates it charged for certain regulated services. On an annualized basis, such rate reductions will result in an estimated reduction in the Venture's revenue of approximately $4,500,000, or approximately 5 percent, and a decrease in operating income before depreciation and amortization of approximately $4,300,000, or approximately 10 percent. In addition, on February 22, 1994, the FCC announced a further rulemaking which, when implemented, could reduce rates further. Based on the foregoing, the General Partner believes that the new rate regulations will have a negative effect on the Venture's revenues and operating income before depreciation and amortization. The General Partner has undertaken actions to mitigate a portion of these reductions primarily through (a) new service offerings, (b) product re-marketing and re-packaging and (c)marketing efforts directed at non- subscribers. To the extent such reductions are not mitigated, the values of the Venture's cable television systems, which are calculated based on cash flow, could be adversely impacted. The 1992 Cable Act contains new broadcast signal carriage requirements, and the FCC has adopted regulations implementing the statutory requirements. These new rules allow a local commercial broadcast television station to elect whether to demand that a cable system carry its signal or to require the cable system to negotiate with the station for "retransmission consent." Additionally, cable systems also are required to obtain retransmission consent from all "distant" commercial television stations (except for commercial satellite-delivered independent "superstations"), commercial radio stations and certain low-power television stations carried by cable systems. The retransmission consent rules went into effect on October 6, 1993. In the cable television system owned by the Venture, no broadcast stations withheld their consent to retransmission of their signal. Certain broadcast signals are being carried pursuant to extensions offered to the General Partner by broadcasters, including a one-year extension for carriage of the CBS station owned and operated by the CBS network in Chicago. The General Partner expects to conclude retransmission consent negotiations with those stations whose signals are being carried pursuant to extensions, without having to terminate the distribution of any of those signals. However, there can be no assurance that such will occur. If any broadcast station currently being carried pursuant to an extension is dropped, there could be a negative effect on the system if a significant number of subscribers were to disconnect their service. Item 8.

Item 8. Financial Statements CABLE TV FUND 12 FINANCIAL STATEMENTS AS OF DECEMBER 31, 1993 AND 1992 INDEX REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Partners of Cable TV Fund 12-D: We have audited the accompanying consolidated balance sheets of CABLE TV FUND 12-D (a Colorado limited partnership) and subsidiary as of December 31, 1993 and 1992, and the related consolidated statements of operations, partners' capital (deficit) and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the General Partner's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Cable TV Fund 12-D as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index of financial statements are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ ARTHUR ANDERSEN & CO. ARTHUR ANDERSEN & CO. Denver, Colorado, March 11, 1994. CABLE TV FUND 12-D (A Limited Partnership) CONSOLIDATED BALANCE SHEETS The accompanying notes to consolidated financial statements are an integral part of these consolidated balance sheets. CABLE TV FUND 12-D (A Limited Partnership) CONSOLIDATED BALANCE SHEETS The accompanying notes to consolidated financial statements are an integral part of these consolidated balance sheets. CABLE TV FUND 12-D (A Limited Partnership) CONSOLIDATED STATEMENTS OF OPERATIONS The accompanying notes to consolidated financial statements are an integral part of these consolidated statements. CABLE TV FUND 12-D (A Limited Partnership) CONSOLIDATED STATEMENTS OF PARTNERS' CAPITAL (DEFICIT) The accompanying notes to consolidated financial statements are an integral part of these consolidated statements. CABLE TV FUND 12-D (A Limited Partnership) CONSOLIDATED STATEMENTS OF CASH FLOWS The accompanying notes to consolidated financial statements are an integral part of these consolidated statements. CABLE TV FUND 12-D (A Limited Partnership) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) ORGANIZATION AND PARTNERS' INTERESTS Formation and Business Cable TV Fund 12-D ("Fund 12-D"), a Colorado limited partnership, was formed on February 5, 1986, under a public program sponsored by Jones Intercable, Inc. Fund 12-D was formed to acquire, construct, develop and operate cable television systems. Jones Intercable, Inc., is the "General Partner" and manager of Fund 12-D. The General Partner and its subsidiaries also own and operate cable television systems. In addition, the General Partner manages cable television systems for other limited partnerships for which it is general partner and, also, for affiliated entities. Contributed Capital The capitalization of Fund 12-D is set forth in the accompanying consolidated statements of partners' capital (deficit). No limited partner is obligated to make any additional contributions to partnership capital. The General Partner purchased its interest in Fund 12-D by contributing $1,000 to partnership capital. All profits and losses of Fund 12-D are allocated 99 percent to the limited partners and 1 percent to the General Partner, except for income or gain from the sale or disposition of cable television properties, which will be allocated to the partners based upon the formula set forth in the Partnership Agreement, and interest income earned prior to the first acquisition by Fund 12-D of a cable television system, which was allocated 100 percent to the limited partners. Formation of Joint Venture and Venture Acquisitions and Sales On March 17, 1986, Funds 12-B, 12-C and 12-D formed Cable TV Fund 12-BCD Venture (the "Venture"). The Venture was formed for the purpose of acquiring certain cable television systems. The Venture owns and operates the cable television systems serving certain areas in and around Albuquerque, New Mexico; Palmdale, California; and Tampa, Florida. On September 20, 1991, the Venture entered into a purchase and sale agreement with an unaffiliated party to sell the cable television system serving the area in and around California City, California for $2,620,000. Closing on this transaction occurred on April 1, 1992. The proceeds were used to repay a portion of the amounts outstanding under the Venture's credit facility. The Venture's acquisitions were accounted for as purchases with the individual purchase prices allocated to tangible and intangible assets based upon an independent appraisal. The method of allocation of purchase price was as follows: first, to the fair value of the net tangible assets acquired; second, to the value of subscriber lists; third, to franchise costs; and fourth, to cost in excess of interests in net assets purchased. Brokerage fees paid to an affiliate of the General Partner and other system acquisition costs were capitalized and included in the cost of intangible assets. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Accounting Records The accompanying consolidated financial statements have been prepared on the accrual basis of accounting in accordance with generally accepted accounting principles. Fund 12-D's tax returns are also prepared on the accrual basis. Principles of Consolidation The accompanying consolidated financial statements include 100 percent of the accounts of Fund 12-D and those of the Venture reduced by the approximate 24 percent minority interest in the Venture. All inter-partnership accounts and transactions have been eliminated. Property, Plant and Equipment Depreciation is provided using the straight-line method over the following estimated service lives: Replacements, renewals and improvements are capitalized and maintenance and repairs are charged to expense as incurred. Intangible Assets Costs assigned to franchises and subscriber lists and cost in excess of interests in net assets purchased are amortized using the straight-line method over the following remaining estimated useful lives: Revenue Recognition Subscriber prepayments are initially deferred and recognized as revenue when earned. (3) TRANSACTIONS WITH THE GENERAL PARTNER AND AFFILIATES Brokerage Fees The Jones Group, Ltd., an affiliate of the General Partner, performs brokerage services for the Venture in connection with Venture acquisitions and sales. For brokering two acquisitions in the Tampa System for the Venture, The Jones Group, Ltd. was paid fees totaling $13,120, or 4 percent of the transaction prices, during 1992. Additionally,The Jones Group, Ltd. received $65,500, or 2 percent of the transaction price, during 1992 for brokering a sale in the Palmdale System. For brokering the acquisitions of two SMATV systems in the Tampa System for the Venture, The Jones Group, Ltd. was paid fees totaling $55,400, or 4 percent of the original purchase prices, during 1991. There were no brokerage fees paid during the year ended December 31, 1993. Management Fees, Distribution Ratios and Reimbursement The General Partner manages Fund 12-D and the Venture and receives a fee for its services equal to 5 percent of the gross revenues of the Venture, excluding revenues from the sale of cable television systems or franchises. Management fees paid to the General Partner by the Venture were $4,456,577, $4,178,376 and $3,902,475 during 1993, 1992 and 1991, respectively. Any partnership distributions made from cash flow (defined as cash receipts derived from routine operations, less debt principal and interest payments and cash expenses) are allocated 99 percent to the limited partners and 1 percent to the General Partner. Any distributions other than interest income on limited partnership subscriptions earned prior to the acquisition of Fund 12-D's first cable television or from cash flow, such as from the sale or refinancing of a system or upon dissolution of the partnership, will be made as follows: first, to the limited partners in an amount which, together with all prior distributions, will equal the amount initially contributed by the limited partners; the balance, 75 percent to the limited partners and 25 percent to the General Partner. The Venture reimburses the General Partner for certain allocated overhead and administrative expenses. These expenses represent the salaries and related benefits paid to corporate personnel, rent, data processing services and other corporate facilities costs. Such personnel provide engineering, marketing, administrative, accounting, legal and investor relations services to the Venture. Allocations of personnel costs are based primarily on actual time spent by employees of the General Partner with respect to each entity managed. Remaining overhead costs are allocated based on total revenues and/or assets managed for the partnership. Systems owned by the General Partner and all other systems owned by partnerships for which Jones Intercable, Inc. is the general partner are also allocated a proportionate share of these expenses. The General Partner believes that the methodology used in allocating overhead and administrative is reasonable. Overhead and administrative expenses allocated to the Venture by the General Partner were $6,048,783, $5,580,114 and $4,640,219 in 1993, 1992 and 1991, respectively. The Venture was charged interest during 1993 at an average interest rate of 10.61 percent on the amounts due the General Partner, which approximated the General Partner's weighted average cost of borrowing. Total interest charged the Venture by the General Partner was $15,477, $126,073 and $171,942 in 1993, 1992 and 1991, respectively. Payments to Affiliates for Programming Services The Venture receives programming from Superaudio and The Mind Extension University, affiliates of the General Partner. Payments to Superaudio totaled $134,179, $132,091 and $120,851 in 1993, 1992 and 1991, respectively. Payments to The Mind Extension University totaled $79,002, $76,676, and $72,218 in 1993, 1992 and 1991, respectively. (4) DEBT During the first quarter of 1992, the Venture renegotiated its debt arrangements, which increased the maximum amount of debt available to $183,000,000. The Venture's arrangements consist of $93,000,000 of Senior Notes placed with a group of institutional lenders and a $90,000,000 revolving credit agreement with a group of commercial bank lenders. The Senior Notes have a fixed interest rate of 8.64 percent and a final maturity date of March 31, 2000. The Senior Notes call for interest only payments for the first four years, with interest and accelerating amortization of principal payments for the next four years. Interest is payable semi-annually. The Senior Notes carry a "make-whole" premium, which is a prepayment penalty, if they are prepaid prior to maturity. The make-whole premium protects the lenders in the event that the funds are reinvested at a rate below 8.64 percent, and is calculated per the note agreement. The Venture's current revolving credit facility has a maximum amount available of $90,000,000. As of December 31, 1993, $73,800,000 was outstanding under the current revolving credit agreement, leaving the Venture with $16,200,000 of available borrowing capacity until March 31, 1994. The revolving credit period is scheduled to expire on March 31, 1994, at which time the principal balance will convert to a term loan payable in quarterly installments with a final maturity date of March 31, 2000. The General Partner is negotiating to extend the revolving credit period for one year. Interest is at the Venture's option of LIBOR plus 1.25 percent to 1.75 percent, the CD rate plus 1.375 percent to 1.875 percent or the Base Rate plus 0 percent to .50 percent. An annual commitment fee of .5 percent is required on the unused portion of the facility. The effective interest rates on amounts outstanding on the Venture's revolving credit facility as of December 31, 1993 and 1992 were 5.08 percent and 5.29 percent, respectively. Both lending facilities are equal in standing with the other, and both are equally secured by the assets of the Venture. During 1992, the Venture incurred costs associated with renegotiating its debt arrangements. These fees were capitalized and are being amortized over the life of the debt agreements. During 1988, the Venture entered into an interest rate cap agreement covering outstanding debt obligations of an additional $25,000,000. The Venture paid a fee of $957,500. The agreement protects the Venture from interest rates that exceed 10 percent for five years from the date of the agreement. The fee was charged to interest expense over the life of this agreement using the straight-line method. Installments due on debt principal for each of the five years in the period ending December 31, 1998 and thereafter, respectively, are: $2,262,209, $4,697,609, $7,945,609, $30,201,870, $36,681,000 and $85,910,400, respectively. (5) INCOME TAXES Income taxes have not been recorded in the accompanying consolidated financial statements because they accrue directly to the partners. The Federal and state income tax returns of Fund 12-D are prepared and filed by the General Partner. Fund 12-D's tax returns, the qualification of the partnership as such for tax purposes, and the amount of distributable income or loss are subject to examination by Federal and state taxing authorities. If such examinations result in changes with respect to the Fund 12-D's qualification as such, or in changes with respect to the Fund 12-D's recorded income or loss, the tax liability of the general and limited partners would likely be changed accordingly. Taxable losses reported to the partners is different from that reported in the consolidated statements of operations due to the difference in depreciation allowed under generally accepted accounting principles and the expense allowed for tax purposes under the Modified Accelerated Cost Recovery System (MACRS). There are no other significant differences between taxable income or losses and the losses reported in the consolidated statements of operations. (6) COMMITMENTS AND CONTINGENCIES On October 5, 1992, Congress enacted the Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Cable Act") which became effective on December 4, 1992. The 1992 Cable Act generally allows for a greater degree of regulation in the cable television industry. In April 1993, the FCC adopted regulations governing rates for basic and non-basic services. These regulations became effective on September 1, 1993. Such regulations caused reductions in rates for certain regulated services. On February 22, 1994, the FCC announced a further rulemaking which, when implemented, could reduce rates further. The General Partner plans to mitigate a portion of these reductions primarily through (a) new service offerings, (b) product re-marketing and re-packaging and (c) marketing efforts directed at non-subscribers. The 1992 Cable Act contains new broadcast signal carriage requirements, and the FCC has adopted regulations implementing the statutory requirements. These new rules allow a local commercial broadcast television station to elect whether to demand that a cable system carry its signal or to require the cable system to negotiate with the station for "retransmission consent." Additionally, cable systems also are required to obtain retransmission consent from all "distant" commercial television stations (except for commercial satellite-delivered independent "superstations"), commercial radio stations and certain low-power television stations carried by cable systems. The retransmission consent rules went into effect on October 6, 1993. In the cable television systems owned by the Venture, no broadcast stations withheld their consent to retransmission of their signal. Certain broadcast signals are being carried pursuant to extensions offered to the General Partner by broadcasters, including a one-year extension for carriage of the CBS station owned and operated by the CBS network in Chicago. The General Partner expects to conclude retransmission consent negotiations with those stations whose signals are being carried pursuant to extensions, without having to terminate the distribution of any of those signals. However, there can be no assurance that such will occur. If any broadcast station currently being carried pursuant to an extension is dropped, there could be a negative effect on the system if a significant number of subscribers were to disconnect their service. In February 1993, the General Partner entered into a settlement agreement related to litigation brought by Sunbelt Television, Inc. against the Venture in the amount of $2,850,000. As of December 31, 1992, the Venture had accrued $2,850,000, which was reflected as an increase in other expense in the 1992 statement of operations. This settlement was paid by the Venture in March 1993. Office and other facilities are rented under various long-term lease arrangements. Rent paid under such lease arrangements totaled $454,229, $450,295, $345,994, respectively, for the years ended December 31, 1993, 1992 and 1991. Minimum commitments under operating leases for the five years in the period ending December 31, 1998 and thereafter are as follows: 1994 $ 504,514 1995 463,103 1996 457,600 1997 460,542 1998 463,879 Thereafter 1,927,432 ----------- $ 4,277,070 =========== (7) SUPPLEMENTARY PROFIT AND LOSS INFORMATION Supplementary profit and loss information for the respective years is presented below: CABLE TV FUND 12-D SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 and 1991 1 Amount primarily represents the sale of the California City, California cable television system. CABLE TV FUND 12-D SCHEDULE VI - ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 and 1991 1 Amount primarily represents the sale of the California City, California cable television system. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Partners of Cable TV Fund 12-BCD Venture: We have audited the accompanying balance sheets of CABLE TV FUND 12-BCD VENTURE (a Colorado general partnership) as of December 31, 1993 and 1992, and the related statements of operations, partners' capital and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the General Partners' management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Cable TV Fund 12-BCD Venture as of December 31, 1993 and 1992, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index of financial statements are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. /s/ ARTHUR ANDERSEN & CO. ARTHUR ANDERSEN & CO. Denver, Colorado, March 11, 1994. CABLE TV FUND 12-BCD VENTURE (A General Partnership) BALANCE SHEETS The accompanying notes to financial statements are an integral part of these balance sheets. CABLE TV FUND 12-BCD VENTURE (A General Partnership) BALANCE SHEETS The accompanying notes to financial statements are an integral part of these balance sheets. CABLE TV FUND 12-BCD VENTURE (A General Partnership) STATEMENTS OF OPERATIONS The accompanying notes to financial statements are an integral part of these statements. CABLE TV FUND 12-BCD VENTURE (A General Partnership) STATEMENTS OF PARTNERS' CAPITAL The accompanying notes to financial statements are an integral part of these statements. CABLE TV FUND 12-BCD VENTURE (A General Partnership) STATEMENTS OF CASH FLOWS The accompanying notes to financial statements are an integral part of these statements. CABLE TV FUND 12-BCD VENTURE (A General Partnership) NOTES TO FINANCIAL STATEMENTS (1) ORGANIZATION AND PARTNERS' INTERESTS Formation and Business On March 17, 1986, Cable TV Funds 12-B, 12-C and 12-D (the "Venture Partners") formed Cable TV Fund 12-BCD Venture (the "Venture"). The Venture was formed for the purpose of acquiring certain cable television systems serving Tampa, Florida; Albuquerque, New Mexico; and Palmdale, California. Jones Intercable, Inc. ("Intercable"), the "General Partner" of each of the Venture Partners, manages the Venture. Intercable and its subsidiaries also own and operate cable television systems. In addition, Intercable manages cable television systems for other limited partnerships for which it is general partner and, also, for affiliated entities. Contributed Capital The capitalization of the Venture is set forth in the accompanying statements of partners' capital. All Venture distributions, including those made from cash flow, from the sale or refinancing of Partnership property and on dissolution of the Venture, shall be made to the Venture Partners in proportion to their approximate respective interests in the Partnership as follows: Cable TV Fund 12-B 9% Cable TV Fund 12-C 15% Cable TV Fund 12-D 76% --- 100% === Venture Acquisitions and Sales The Venture owns and operates the cable television systems serving certain areas in and around Albuquerque, New Mexico; Palmdale, California; and Tampa, Florida. On September 20, 1991, the Venture entered into a purchase and sale agreement with an unaffiliated party to sell the cable television system serving the area in and around California City, California for $2,620,000. Closing on this transaction occurred on April 1, 1992. The proceeds were used to repay a portion of the amounts outstanding under the Venture's credit facility. The Venture's acquisitions were accounted for as purchases with the individual purchase prices allocated to tangible and intangible assets based upon an independent appraisal. The method of allocation of purchase price was as follows: first, to the fair value of the net tangible assets acquired; second, to the value of subscriber lists; third, to franchise costs; and fourth, to cost in excess of interests in net assets purchased. Brokerage fees paid to an affiliate of Intercable and other system acquisition costs were capitalized and included in the cost of intangible assets. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Accounting Records The accompanying financial statements have been prepared on the accrual basis of accounting in accordance with generally accepted accounting principles. The Venture's tax returns are also prepared on the accrual basis. Property, Plant and Equipment Depreciation is provided using the straight-line method over the following estimated service lives: Distribution systems 5 - 15 years Buildings 20 years Equipment and tools 3 - 5 years Premium television service equipment 5 years Earth receive stations 5 - 15 years Vehicles 3 years Other property, plant and equipment 5 years Replacements, renewals and improvements are capitalized and maintenance and repairs are charged to expense as incurred. Intangible Assets Costs assigned to franchises and subscriber lists and cost in excess of interests in net assets purchased are amortized using the straight-line method over the following remaining estimated useful lives: Franchise costs 3 years Subscriber lists 1 year Cost in excess of interests in net assets purchased 32 years Revenue Recognition Subscriber prepayments are initially deferred and recognized as revenue when earned. (3) TRANSACTIONS WITH JONES INTERCABLE, INC. AND AFFILIATES Brokerage Fees The Jones Group, Ltd., an affiliate of the General Partner, performs brokerage services for the Venture in connection with Venture acquisitions and sales. For brokering two acquisitions in the Tampa System for the Venture, The Jones Group, Ltd. was paid fees totaling $13,120, or 4 percent of the transaction prices, during 1992. Additionally, The Jones Group, Ltd. received $65,500, or 2.5 percent of the transaction price, during 1992 for brokering a sale in the Palmdale System. For brokering the acquisitions of two SMATV systems in the Tampa System for the Venture, The Jones Group, Ltd. was paid fees totaling $55,400, or 4 percent of the original purchase prices, during 1991. There were no brokerage fees paid during the year ended December 31, 1993. Management Fees and Reimbursements Intercable manages the Venture and receives a fee for its services equal to 5 percent of the gross revenues of the Venture, excluding revenues from the sale of cable television systems or franchises. Management fees paid to Intercable for the years ended December 31, 1993, 1992 and 1991 were $4,456,577, $4,178,376 and $3,902,475, respectively. The Venture reimburses Intercable for certain allocated overhead and administrative expenses. These expenses represent the salaries and related benefits paid to corporate personnel, rent, data processing services and other corporate facilities costs. Such personnel provide engineering, marketing, administrative, accounting, legal and investor relations services to the Venture. Allocations of personnel costs are based primarily on actual time spent by employees of the General Partner with respect to each entity managed. Remaining overhead costs are allocated based on total revenues and/or the cost of assets managed for the entity. Systems owned by Intercable and all other systems owned by partnerships for which Intercable is the general partner are also allocated a proportionate share of these expenses. Intercable believes that the methodology used in allocating overhead and administrative expenses is reasonable. Overhead and administrative expenses allocated to the Venture by Intercable during the years ended December 31, 1993, 1992 and 1991 were $6,048,783, $5,580,114 and $4,640,219, respectively. The Venture was charged interest during 1993 at an average interest rate of 10.61 percent on the amounts due Intercable, which approximated Intercable's cost of borrowing. Total interest charged the Venture by Intercable was $15,477, $126,073 and $171,942 during 1993, 1992 and 1991, respectively. Payments to Affiliates for Programming Services The Venture receives programming from Superaudio and The Mind Extension University, affiliates of Intercable. Payments to Superaudio totaled $134,179, $132,091 and $120,851 in 1993, 1992, and 1991, respectively. Payments to The Mind Extension University totaled $79,002, $76,676 and $72,218 in 1993, 1992 and 1991, respectively. (4) DEBT During the first quarter of 1992, the Venture renegotiated its debt arrangements, which increased the maximum amount of debt available to $183,000,000. The Venture's debt arrangements consist of $93,000,000 of Senior Notes placed with a group of institutional lenders and a $90,000,000 revolving credit agreement with a group of commercial bank lenders. The Senior Notes have a fixed interest rate of 8.64 percent and a final maturity date of March 31, 2000. The Senior Notes call for only interest payments for the first four years, with interest and accelerating amortization of principal payments for the next four years. Interest is payable semi-annually. The Senior Notes carry a "make-whole" premium, which is a prepayment penalty, if they are prepaid prior to maturity. The make-whole premium protects the lenders in the event that the funds are reinvested at a rate below 8.64 percent, and is calculated per the note agreement. The Venture's current revolving credit facility has a maximum amount available of $90,000,000. As of December 31, 1993, $73,800,000 was outstanding under the current revolving credit agreement, leaving the Venture with $16,200,000 of available borrowing capacity until March 31, 1994. The revolving credit period is scheduled to expire on March 31, 1994, at which time the principal balance will convert to a term loan payable in quarterly installments with a final maturity date of March 31, 2000. The General Partner is negotiating to extend the revolving credit period for one year. Interest is at the Venture's option of LIBOR plus 1.25 percent to 1.75 percent, the CD rate plus 1.375 percent to 1.875 percent or the Base Rate plus 0 percent to .50 percent. An annual commitment fee of .5 percent is required on the unused portion of the facility. The effective interest rates on amounts outstanding on the Venture's revolving credit facility as of December 31, 1993 and 1992 were 4.08 percent and 5.29 percent, respectively. Both lending facilities are equal in standing with the other, and both are equally secured by the assets of the Venture. During 1992, the Venture incurred costs associated with renegotiating its debt arrangements. These fees were capitalized and are being amortized over the life of the debt agreements. During 1988, the Venture entered into an interest rate cap agreement covering outstanding debt obligations of an additional $25,000,000. The Venture paid a fee of $957,500. The agreement protects the Venture from interest rates that exceed 10 percent for five years from the date of the agreement. The fee was charged to interest expense over the life of this agreement using the straight-line method. Installments due on debt principal for each of the five years in the period ending December 31, 1998 and thereafter, respectively, are: $2,262,209, $4,697,609, $7,945,609, $30,201,870, $36,681,000 and $85,910,400, respectively. (5) INCOME TAXES Income taxes have not been recorded in the accompanying financial statements because they accrue directly to the partners of Cable TV Funds 12-B, 12-C and 12-D. The Venture's tax returns, the qualification of the Venture as such for tax purposes, and the amount of distributable income or loss, are subject to examination by Federal and state taxing authorities. If such examinations result in changes with respect to the Venture's qualification as such, or in changes with respect to the Venture's recorded loss, the tax liability of the Venture's general partners would likely be changed accordingly. Taxable losses reported to the partners is different from that reported in the statements of operations due to the difference in depreciation allowed under generally accepted accounting principles and the expense allowed for tax purposes under the Modified Accelerated Cost Recovery System (MACRS). There are no other significant differences between taxable income or losses and the net losses reported in the statements of operations. (6) COMMITMENTS AND CONTINGENCIES On October 5, 1992, Congress enacted the Cable Television Consumer Protection and Competition Act of 1992 (the "1992 Cable Act") which became effective on December 4, 1992. The 1992 Cable Act generally allows for a greater degree of regulation in the cable television industry. In April 1993, the FCC adopted regulations governing rates for basic and non-basic services. These regulations became effective on September 1, 1993. Such regulations caused reductions in rates for certain regulated services. On February 22, 1994, the FCC announced a further rulemaking which, when implemented, could reduce rates further. The General Partner plans to mitigate a portion of these reductions primarily through (a) new service offerings, (b) product re-marketing and re- packaging and (c) marketing efforts directed at non-subscribers. The 1992 Cable Act contains new broadcast signal carriage requirements, and the FCC has adopted regulations implementing the statutory requirements. These new rules allow a local commercial broadcast television station to elect whether to demand that a cable system carry its signal or to require the cable system to negotiate with the station for "retransmission consent." Additionally, cable systems also are required to obtain retransmission consent from all "distant" commercial television stations (except for commercial satellite-delivered independent "superstations"), commercial radio stations and certain low-power television stations carried by cable systems. The retransmission consent rules went into effect on October 6, 1993. In the cable television systems owned by the Venture, no broadcast stations withheld their consent to retransmission of their signal. Certain broadcast signals are being carried pursuant to extensions offered to the General Partner by broadcasters, including a one-year extension for carriage of the CBS station owned and operated by the CBS network in Chicago. The General Partner expects to conclude retransmission consent negotiations with those stations whose signals are being carried pursuant to extensions, without having to terminate the distribution of any of those signals. However, there can be no assurance that such will occur. If any broadcast station currently being carried pursuant to an extension is dropped, there could be a negative effect on the system if a significant number of subscribers were to disconnect their service. In February 1993, the General Partner entered into a settlement agreement related to litigation brought by Sunbelt Television, Inc. against the Venture in the amount of $2,850,000. As of December 31, 1992, the Venture had accrued $2,850,000, which was reflected as an increase in other expense in the 1992 statement of operations. The settlement was paid by the Venture in March 1993. Offices and other facilities are rented under various long-term lease arrangements. Rent paid under such lease arrangements totaled $454,229, $450,295 and $345,994, respectively, for the years ended December 31, 1993, 1992 and 1991. Minimum commitments under operating leases for the five years in the period ending December 31, 1998 and thereafter are as follows: (7) SUPPLEMENTARY PROFIT AND LOSS INFORMATION Supplementary profit and loss information for the respective years is presented below: CABLE TV FUND 12-BCD VENTURE SCHEDULE V - PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 and 1991 1 Amount primarily represents the sale of the California City, California cable television system. CABLE TV FUND 12-BCD VENTURE SCHEDULE VI - ACCUMULATED DEPRECIATION OF PROPERTY, PLANT AND EQUIPMENT FOR THE YEARS ENDED DECEMBER 31, 1993, 1992 and 1991 1 Amount primarily represents the sale of the California City, California cable television system. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL STATEMENTS None PART III. ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The Partnerships themselves have no officers or directors. Certain information concerning directors and executive officers of the General Partner is set forth below. Mr. Glenn R. Jones has served as Chairman of the Board of Directors and Chief Executive Officer of the General Partner since its formation in 1970, and he was President from June 1984 until April 1988. Mr. Jones was elected a member of the Executive Committee of the Board of Directors in April 1985. He is also Chairman of the Board of Directors and Chief Executive Officer of Jones Spacelink, Ltd., a publicly held cable television company that is a subsidiary of Jones International, Ltd. and the parent of the General Partner. Mr. Jones is the sole shareholder, President and Chairman of the Board of Directors of Jones International, Ltd. He is also Chairman of the Board of Directors of the subsidiaries of the General Partner and of certain other affiliates of the General Partner. Mr. Jones has been involved in the cable television business in various capacities since 1961, is a past and member of the Board of Directors of the National Cable Television Association and is a former member of its Executive Committee. Mr. Jones is a past director and member of the Executive Committee of C-Span. Mr. Jones has been the recipient of several awards including the Grand Tam Award in 1989, the highest award from the Cable Television Administration and Marketing Society, the Chairman's Award from the Investment Partnership Association, which is an association of sponsors of public syndications; the cable television industry's Public Affairs Association President's Award in 1990; the Donald G. McGannon award for the advancement of minorities and women in cable; the STAR Award from American Women in Radio and Television, Inc., for exhibition of a commitment to the issues and concerns of women in television and radio; and the Women in Cable Accolade in 1990 in recognition of support of this organization. Mr. Jones is also a founding member of the James Madison Council of the Library of Congress, is on the Board of Governors of the American Society of Training and Development and is a director of the National Alliance of Business. Mr. James B. O'Brien, the General Partner's President, joined the General Partner in January 1982 as System Manager, Brighton, Colorado, and was later promoted to the position of General Manager, Gaston County, North Carolina. Prior to being elected President and a Director of the General Partner in December 1989, Mr. O'Brien served as a Division Manager, Director of Operations Planning/Assistant to the CEO, Fund Vice President and Group Vice President/Operations. As President, he is responsible for the day-to-day operations of the cable television systems managed and owned by the General Partner. Mr. O'Brien is also President and a Director of Jones Cable Group, Ltd., Jones Global Funds, Inc., and Jones Global Management, Inc., all affiliates of the General Partner. Mr. O'Brien is a board member of Cable Labs, Inc., the research arm of the cable television industry. He also serves as a director of the Cable Television Administration and Marketing Association and as a director of the Walter Kaitz Foundation. Ms. Ruth E. Warren joined the General Partner in August 1980 and served in various capacities, including system manager and Fund Vice President, since then. Ms. Warren was elected Group Vice President/Operations of the General Partner in September 1990. Ms. Warren also serves as Vice President/Operations of Jones Spacelink, Ltd. Mr. Kevin P. Coyle joined The Jones Group, Ltd. in July 1981 as Vice President/Financial Services. In September 1985, he was appointed Senior Vice President/Financial Services. He was elected Treasurer of the General Partner in August 1987, Vice President/Treasurer in April 1988 and Group Vice President/Finance in October 1990. Mr. Christopher J. Bowick joined the General Partner in September 1991 as Group Vice President/Technology and Chief Technical Officer. Previous to joining the General Partner, Mr. Bowick worked for Scientific Atlanta's Transmission Systems Business Division in various technical management capacities since 1981, and as Vice President of Engineering since 1989. Mr. Timothy J. Burke joined the General Partner in August 1982 as corporate tax manager, was elected Vice President/Taxation in November 1986 and Group Vice President/Taxation/Administration in October 1990. He is also a member of the Board of Directors of Jones Spacelink, Ltd. Mr. Raymond L. Vigil joined the General Partner in April 1993 as Group Vice President/Human Resources and was elected a Director of the General Partner in November 1993. Previous to joining the General Partner, Mr. Vigil served as Executive Director of Learning with USWest from September 1989 to April 1993. Prior to that, Mr. Vigil worked in various human resources posts over a 14-year term with the IBM Corporation. Mr. James J. Krejci joined Jones International, Ltd. in March 1985 as Group Vice President. He was elected Group Vice President and Director of the General Partner in August 1987. He is also an officer of Jones Futurex, Inc., a subsidiary of Jones Spacelink, Ltd. engaged in manufacturing and marketing data encryption devices, Jones Information Management, Inc., a subsidiary of Jones International, Ltd. providing computer data and billing processing facilities and Jones Lightwave, Ltd., a company owned by Jones International, Ltd. and Mr. Jones, and several of its subsidiaries engaged in the provision of telecommunications services. Prior to joining Jones International, Ltd., Mr. Krejci was employed by Becton Dickinson and Company, a medical products manufacturing firm. Ms. Elizabeth M. Steele joined the General Partner in August 1987 as Vice President/General Counsel and Secretary. Ms. Steele also is an officer of Jones Spacelink, Ltd. From August 1980 until joining the General Partner, Ms. Steele was an associate and then a partner at the Denver law firm of Davis, Graham & Stubbs, which serves as counsel to the General Partner. Mr. Michael J. Bartolementi joined the General Partner in September 1984 as an accounting manager and was promoted to Assistant Controller in September 1985. He was named Controller in November 1990. Mr. George J. Feltovich was elected a Director of the General Partner in March 1993. Mr. Feltovich has been a private investor since 1978. Prior to 1978, Mr. Feltovich served as an administrative and legal consultant to various private and governmental housing programs. Mr. Feltovich was admitted to practice law in California, Pennsylvania and the District of Columbia and is a member of the California Bar Association. Mr. Patrick J. Lombardi has been a Director of the General Partner since February 1984 and has served as a member of the Audit Committee of the Board of Directors since February 1985. In September 1985, Mr. Lombardi was appointed Vice President of The Jones Group, Ltd., and in June 1989 was elected President of Jones Global Group, Inc., both affiliates of the General Partner. Mr. Lombardi is President and a director of Jones Financial Group, Ltd., an affiliate of the General Partner, and Group Vice President/Finance and a director of Jones International, Ltd. Mr. Howard O. Thrall was elected a Director of the General Partner in December 1988 and serves as a member of the Audit Committee and the special Stock Option Committee, which was established in August of 1992. From 1984 until August 1993, Mr. Thrall was associated with Douglas Aircraft Company, an aircraft manufacturing firm, most recently as Regional Vice President Marketing. In September 1993, Mr. Thrall joined World Airways, Inc. as Vice President of Sales, Asian Region. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The Partnerships have no employees; however, various personnel are required to operate the cable television systems owned by the Partnerships. Such personnel are employed by the General Partner and, pursuant to the terms of the limited partnership agreements of the Partnerships, the cost of such employment is charged by the General Partner to the Partnerships as a direct reimbursement item. See Item 13. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGERS No person or entity owns more than 5 percent of the limited partnership interests in any of the Partnerships. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The General Partner and its affiliates engage in certain transactions with the Partnerships as contemplated by the limited partnership agreements of the Partnerships and as disclosed in the prospectus for the Partnerships. The General Partner believes that the terms of such transactions, which are set forth in the Partnerships' limited partnership agreements, are generally as favorable as could be obtained by the Partnerships from unaffiliated parties. This determination has been made by the General Partner in good faith, but none of the terms were or will be negotiated at arm's-length and there can be no assurance that the terms of such transactions have been or will be as favorable as those that could have been obtained by the Partnerships from unaffiliated parties. The General Partner charges the Partnerships for management fees, and the Partnerships reimburse the General Partner for certain allocated overhead and administrative expenses in accordance with the terms of the limited partnership agreements of the Partnerships. These expenses consist primarily of salaries and benefits paid to corporate personnel, rent, data processing services and other facilities costs. Such personnel provide engineering, marketing, administrative, accounting, legal and investor relations services to the Partnerships. Allocations of personnel costs are based primarily on actual time spent by employees of the General Partner with respect to each Partnership managed. Remaining overhead costs are allocated based on revenues and/or the cost of assets managed for the Partnerships. Systems owned by the General Partner and all other systems owned by partnerships for which Jones Intercable, Inc. is the general partner are also allocated a proportionate share of these expenses. The General Partner also advances funds and charges interest on the balance payable from the Partnerships. The interest rate charged the Partnerships approximates the General Partner's weighted average cost of borrowing. Affiliates of the General Partner have received amounts from the Partnerships for performing brokerage services. The Systems receive stereo audio programming from Superaudio, a joint venture owned 50% by an affiliate of the General Partner and 50% by an unaffiliated party, for a fee based upon the number of subscribers receiving the programming. These systems also receive educational video programming from Mind Extension University, Inc., an affiliate of the General Partner, for a fee based upon the number of subscribers receiving the programming. The charges to the Partnerships for related transactions are as follows for the periods indicated: The activities of Fund 12-C and Fund 12-D are limited to their equity ownership in the Venture. See the following related party disclosure for the Venture. PART IV. ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a)1. See index to financial statements at page 21 for list of financial statements and exhibits thereto filed as a part of this report. 2. Fund 12-A: Schedule V - Property, Plant and Equipment Schedule VI - Accumulated Depreciation of Property, Plant and Equipment Fund 12-B: Schedule V - Property, Plant and Equipment Schedule VI - Accumulated Depreciation of Property, Plant and Equipment Fund 12-D: Schedule V - Property, Plant and Equipment Schedule VI - Accumulated Depreciation of Property, Plant and Equipment 12-BCD Venture Schedule V - Property, Plant and Equipment Schedule VI - Accumulated Depreciation of Property, Plant and Equipment 3. The following exhibits are filed herewith. 4.1 Limited Partnership Agreements for Cable TV Funds 12-A, 12-B and 12-C. (1) 4.2 Limited Partnership Agreement of Cable TV Fund 12-D. (3) 4.3 Joint Venture Agreement of Cable TV Fund 12-BCD Venture dated as of March 17, 1986, among Cable TV Fund 12-B, Ltd., Cable TV Fund 12-C, Ltd. and Cable TV Fund 12-D, Ltd. (3) 10.1.1 Copy of a franchise and related documents thereto granting a community antenna television system franchise for Edwards Air Force Base, California (Fund 12-BCD). (2) 10.1.2 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the City of Lancaster, California (Fund 12-BCD). (2) 10.1.3 Copy of a franchise and related documents thereto granting a community antenna television system franchise for Unincorporated portions of Los Angeles County, California (Fund 12-BCD). (2) 10.1.3.1 Copy of Los Angeles County Code regarding cable tv system franchises (Fund 12- BCD). (8) 10.1.3.2 Copy of Ordinance 90-0118F dated 10/29/90 granting a cable television franchise to Fund 12-BCD (Fund 12-BCD). (8) 10.1.4 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Green Valley/Elizabeth Lake/Leona Valley unincorporated areas of Los Angeles County, California (Fund 12-BCD). (3) 10.1.4.1 Ordinance 88-0166F dated 10/4/88 amending the franchise described in 10.1.5 (Fund 12-BCD). (8) 10.1.5 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the City of Palmdale, California (Fund 12-BCD). (8) 10.1.6 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the City of Fort Myers, Florida (Fund 12-A). (1) 10.1.7 Copy of a franchise and related documents thereto granting a community antenna television system franchise for Lee County, Florida (Fund 12-A). (1) 10.1.7.1 Renewal of Permit dated 3/4/92 (Fund 12-A). (8) 10.1.8 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the City of Tampa, Florida (Fund 12-BCD). (1) 10.1.8.1 Resolution No. 1153 dated 10/2/86 authorizing consent to transfer of the franchise and amendment to the franchise agreement (Fund 12-BCD). (8) 10.1.8.2 Amendment to franchise agreement dated 10/6/86 (Fund 12-BCD). (8) 10.1.8.3 Franchise transfer, acceptance and consent to transfer dated 10/6/86 (Fund 12- BCD). (8) 10.1.9 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the City of Augusta, Georgia (Fund 12-B). (1) 10.1.10 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the City of Blythe, Georgia (Fund 12-B). (3) 10.1.11 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the County of Burke, Georgia (Fund 12-B). (5) 10.1.12 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Unincorporated Area of Columbia County, Georgia (Fund 12-B). (8) 10.1.13 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the City of Hephzibah, Georgia (Fund 12-B). (1) 10.1.14 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Unincorporated Area of Richmond County, Georgia (Fund 12-B). (1) 10.1.15 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Unincorporated portions of Cook County, Illinois (Fund 12-A). (3) 10.1.16 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Village of Grayslake, Illinois (Fund 12-A). (1) 10.1.17 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Unincorporated Area of Lake County, Illinois (Fund 12-A). (1) 10.1.18 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Village of Libertyville, Illinois (Fund 12- A). (1) 10.1.19 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Village of Mundelein, Illinois (Fund 12-A). (1) 10.1.20 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Village of Orland Park, Illinois (Fund 12-A). (1) 10.1.21 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Village of Park Forest, Illinois (Fund 12-A). (1) 10.1.22 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Village of Wauconda, Illinois (Fund 12-A). (1) 10.1.23 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the City of Albuquerque, New Mexico (Fund 12- BCD). (2) 10.1.24 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the County of Bernalillo, New Mexico (Fund 12- BCD). (2) 10.1.25 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Town of Bernalillo, New Mexico (Fund 12-BCD). (2) 10.1.25.1 Resolution No. 12-14-87 dated 12/14/87 authorizing the assignment of the franchise to Fund 12-BCD. (8) 10.1.26 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Village of Bosque Farms, New Mexico (Fund 12- BCD). (2) 10.1.27 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Village of Corrales, New Mexico (Fund 12- BCD). (2) 10.1.28 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Kirtland Air Force Base, New Mexico (Fund 12- BCD). (8) 10.1.29 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the Village of Los Ranchos, New Mexico (Fund 12-BCD). (2) 10.1.30 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the County of Sandoval, New Mexico (Fund 12-BCD). (2) 10.1.31 Copy of a franchise and related documents thereto granting a community antenna television system franchise for the County of Valencia, New Mexico (Fund 12-BCD). (2) 10.1.31.1 Resolution No. 88-23 dated 2/14/88 authorizing assignment of the franchise to Fund 12-BCD. (8) 10.2.1 Credit Agreement, dated as of July 15, 1992, between Cable TV Fund 12-A, Ltd. and Mellon Bank, N.A, for itself and as agent for various lenders. (8) 10.2.2 Loan and Security Agreement, dated August 29, 1985, between Cable TV Fund 12-B, Ltd. and The Philadelphia National Bank, individually and as agent for various lenders. (1) 10.2.2.1 Amendment No. 1 dated as of August 14, 1986, to Loan and Security Agreement, dated August 29, 1985, between Cable TV Fund 12-B, Ltd. and The Philadelphia National Bank, individually and as agent for various lenders. (8) 10.2.2.2 Amendment No. 2 dated March 31, 1988 to Loan and Security Agreement, dated August 29, 1985, between Cable TV Fund 12-B, Ltd. and The Philadelphia National Bank, individually and as agent for various lenders. (8) 10.2.2.3 Amendment No. 3 dated March 29, 1989 to Loan and Security Agreement, dated August 29, 1985, between Cable TV Fund 12-B, Ltd. and The Philadelphia National Bank, individually and as agent for various lenders. (8) 10.2.2.4 Amendment No. 4 dated November 29, 1991 to Loan and Security Agreement dated November 1991 between Cable TV Fund 12-B, Ltd. and Corestates Bank, N.A. (formerly The Philadelphia National Bank), individually and as agent for various lenders. (6) 10.2.3 Note Purchase Agreement dated as of March 31, 1992 among Fund 12-BCD Venture and various note purchasers. (8) 10.3.1 Purchase and Sale Agreement dated as of March 29, 1988 by and between Cable TV Fund 12-BCD Venture as Buyer and Video Company as Seller. (4) 10.3.2 Purchase and Sale Agreement dated 9/20/91 and amendments thereto between Cable TV Fund 12-BCD Venture as Seller and Falcon Classic Cable Income Properties, L.P. (Fund 12-BCD). (7) __________ (1) Incorporated by reference from Registrant's Report on Form 10-K for the fiscal year ended December 31, 1985 (Commission File Nos. 0-13192, 0-13807, 0-13964 and 0-14206). (2) Incorporated by reference from Registrant's Report on Form 10-K for the fiscal year ended December 31, 1986 (Commission File Nos. 0-13192, 0-13807, 0-13964 and 0-14206). (3) Incorporated by reference from Registrant's Report on Form 10-K for the fiscal year ended December 31, 1987 (Commission File Nos. 0-13192, 0-13807, 0-13964 and 0-14206). (4) Incorporated by reference from Registrant's Report on Form 10-K for the fiscal year ended December 31, 1988 (Commission File Nos. 0-13192, 0-13807, 0-13964 and 0-14206). (5) Incorporated by reference from Registrant's Report on Form 10-K for the fiscal year ended December 31, 1990 (Commission File Nos. 0-13192, 0-13807, 0-13964 and 0-14206). (6) Incorporated by reference from Registrant's Report on Form 10-K for the fiscal year ended December 31, 1991 (Commission File Nos. 0-13192, 0-13807, 0-13964 and 0-14206). (7) Incorporated by reference from the Forms 8-K of Fund 12-B, Fund 12-C and Fund 12- D dated 4/6/92 (Commission File Nos. 0-13193, 0-13964 and 0-14206, respectively). (8) Incorporated by reference from Registrant's Report on Form 10-K for the fiscal year ended December 31, 1992 (Commission File Nos. 0-13192, 0-13807, 0-13964 and 0-14206). (b) Reports on Form 8-K. None. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CABLE TV FUND 12-A, LTD. CABLE TV FUND 12-B, LTD. CABLE TV FUND 12-C, LTD. CABLE TV FUND 12-D, LTD. Colorado limited partnerships By: Jones Intercable, Inc., their general partner By: /s/ GLENN R. JONES Glenn R. Jones Chairman of the Board and Chief Dated: March 25, 1994 Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

95301_1993.txt

95301

1993

ITEM 1. BUSINESS (a) General development of business. Sequa Corporation is a diversified industrial company that produces a broad range of products and provides a broad range of services through operating units in four industry segments: Aerospace, Machinery and Metal Coatings, Specialty Chemicals, and Professional Services and Other Products. Sequa Corporation, incorporated in 1929 and formerly known as Sun Chemical Corporation, is hereinafter sometimes referred to as the "Registrant" and, together with its consolidated subsidiaries, is hereinafter sometimes referred to as the "Company" or "Sequa." Divestitures During 1991, the Company adopted a formal plan to divest Sequa Capital's investment portfolio and to sell the Valley Line and Sabine Towing and Transportation operations in the Transportation segment, as well as the engineered services and the men's apparel units in the Professional Services and Other Products segment. During 1992, the Company completed the asset sales of Valley Line, Sabine Towing and Transportation and the Gemoco division of engineered services and in 1993, the Sturm unit of engineered services was sold. As of December 31, 1993, approximately $329,000,000 of Sequa Capital's investment portfolio has been sold, written down or otherwise disposed of since the Company adopted a formal plan to divest the portfolio. Efforts continue to divest the men's apparel unit and to liquidate the remaining Sequa Capital investment portfolio. On December 30, 1993, the Company sold the stock of ARC Professional Services for gross cash proceeds of $59.9 million, and the purchaser assumed $4.5 million of ARC Professional Services' debt. The sale resulted in a pre-tax gain of $12.4 million. Also during 1993, Northern Can Systems' two can making facilities were sold for gross cash proceeds of $15.0 million. (b) Financial information about industry segments. Segment information is included in Note 18 to the Consolidated Financial Statements on Page 55 of this Annual Report on Form 10-K and is hereby incorporated by reference. (c) Narrative description of business. The following is a narrative description of the business segments of Sequa: Aerospace The Aerospace segment includes three operating units: Gas Turbine, ARC Propulsion and the Kollsman division. Gas Turbine. The largest individual operating unit of the Company, Gas Turbine, is a leader in the development and use of advanced metallurgical and other processes to manufacture, repair and coat blades, vanes and other components of gas turbine engines. The unit serves all major jet engine models used by the global commercial airline market. The Company believes that the leadership position of its Gas Turbine operations is largely attributable to the effectiveness of its continuing development efforts on new and improved metallurgical coating, manufacturing and repair processes, and its responsiveness to customer service requirements. Gas Turbine has built on its metallurgical process technologies to develop procedures that permit the repair and reuse of turbine engine components. Management believes Gas Turbine has played a key role in the development of the repair market for certain jet engine parts. Over the years, the Company has continued to invest steadily in research and development projects that have led to ceramic coatings, vacuum plasma coatings, advanced laser drilling and welding, and diffused precious metal/aluminide coatings. Gas Turbine works in close cooperation with the manufacturers of jet engines (including Pratt & Whitney, General Electric and Rolls Royce) in connection with the design of new engines, the upgrading of old designs and the development of repair processes and procedures. Gas Turbine has introduced a series of innovative and in some cases proprietary processes that allow engines to perform at improved efficiency levels at higher operating temperatures and under severe environmental conditions. ARC Propulsion. ARC Propulsion, a supplier of solid rocket fuel propulsion systems since 1949, is a leading developer and manufacturer of advanced rocket propulsion systems, gas generators and auxiliary rockets, and engages in research and development relating to new rocket propellants and advanced materials. For the military contract market, ARC Propulsion produces propulsion systems for tactical weapons, and for space applications, ARC Propulsion produces small liquid fueled rocket engines designed to provide attitude and orbit control for a number of satellite systems worldwide. ARC Propulsion's strategy is to pursue opportunities to develop products for commercial markets in order to reduce its reliance on defense-related business. While maintaining its traditional position as a supplier of solid propellant rocket motors to the military, ARC Propulsion has initiated several commercial market ventures, including Bendix Atlantic Inflator Company (BAICO), a fifty-fifty joint venture with AlliedSignal Inc. to produce airbag inflator systems. Kollsman. Kollsman consists of three units: the military systems unit, a government contract supplier of electro-optical and electronic systems for military weapons; the avionics products unit, a designer and manufacturer of aircraft instruments and related test equipment; and Kollsman Manufacturing Company, Inc. (KMC), a separate subsidiary that produces medical diagnostic instrumentation. Machinery and Metal Coatings Segment The Company's Machinery and Metal Coatings segment is composed of Precoat Metals, Sequa Can Machinery and Materiels Equipements Graphiques. The Company recently realigned its Rutherford Machinery and Standun Canforming Systems operations into Sequa Can Machinery as part of a strategy to improve the utilization of its assets through increased efficiencies and the reduction of costs. Precoat Metals. The largest individual unit of the segment, Precoat Metals is a leader in the application of protective coatings to continuous steel and aluminum coil. Precoat's principal market is the building products industry, where coated steel is used for the construction of pre-engineered building systems, and as components in the industrial, commercial and agricultural sectors. Precoat also serves the container industry, where the division has established a position in the application of coatings to steel and aluminum stock used to fabricate two-piece metal cans and can lids. In addition, the division is establishing a presence in the truck trailer and appliance markets as a supplier of pre-painted steel for use in trailer panels and as an exterior wrap on air conditioners and for office furniture. Precoat's strategy is to expand its existing market share in building products and to further its penetration of the container industry and other growing markets. Sequa Can Machinery. Rutherford and Standun design and manufacture equipment for the two-piece can industry. Rutherford is the world's leading manufacturer of equipment to coat and decorate two-piece beverage cans. With an installed base of approximately 700 machines, Rutherford has successfully developed a retrofit business to upgrade older equipment to match the technical standards of newer lines. At the same time, the division's product development team has improved the technology of precision printing to achieve higher speeds without compromising quality. The current generation of equipment runs at a rate of 2,000 cans per minute, applying an even base coat and printing crisp, clear images in up to six colors. The Standun line of can forming equipment includes cupping presses, which punch the cup of a can from a coil of metal, and bodymakers, which form the shallow cup into the shape of a two- piece beer, soft drink or food can. The equipment operates at high speed and within close tolerances. Materiels Equipements Graphiques (MEG). MEG supplies equipment for the web offset printing industry, including dryers, chill rolls, paper guides, in-feeds and related equipment for high-speed web presses. MEG's products include a line of advanced flying pasters, devices that spin a fresh roll, or "web" of paper, to press speed and splice it to an expiring roll without interrupting press operation. Specialty Chemicals Segment The two operations that make up the Company's Specialty Chemicals segment, Warwick and Sequa Chemicals, serve distinctly different markets with performance-enhancing additives for a broad range of end products. Warwick. The larger of the two businesses in the Specialty Chemicals segment, Warwick is a leading producer and supplier of TAED, a bleach activator for powdered laundry detergent products. TAED is used in perborate- or oxygen-based bleaching systems to increase the cleaning power of detergent at low wash temperatures. These bleaching systems, as opposed to the chlorine-based bleaches traditionally used in the U.S., are used in international markets, primarily in Europe. Sequa Chemicals. Sequa Chemicals manufactures high-quality performance-enhancing chemicals used by the textile and graphic arts industries. Sequa Chemicals supplies the woven and knit fabric market with permanent press resins, softeners, water repellents, soil release agents and other chemicals to improve the look, feel and durability of clothing and other textiles. The Company also produces specialty emulsion polymers incorporated into non-woven fabrics for a variety of end uses, including medical drape, fiberfill and filters. For the paper industry, Sequa Chemicals produces three key synthetic coating additives for coated papers. In addition, Sequa Chemicals has developed and patented a unique series of specialty polymers currently marketed to the building products industry for use in roofing mat, ceiling tiles, wall board and carpet tiles. Professional Services and Other Products Segment The Professional Services and Other Products segment -- which includes the ARC Professional Services unit that was sold in December 1993 -- also includes Casco Products, which manufactures automotive cigarette lighters, power outlets and electronic sensing devices; Northern Can Systems, which manufactures easy-open steel lids for cans; and Centor, a real estate holding company which owns and operates, among other properties, the Chromalloy Plaza Building. Casco Products (Casco). Casco, which has been serving the automotive products market since 1921, is a major manufacturer of automotive cigarette lighters and the leading supplier in North America to Chrysler, Ford, General Motors and Honda. In addition, the unit has begun operating in the United Kingdom to further its penetration of the European automotive markets. Casco offers a growing line of automotive accessories, led by a series of electronic devices to monitor automotive fluid levels. These products are presently used as gauges for engine oil and engine coolant and may also be used to monitor brake, transmission and power steering fluids. Casco's other products include auxiliary power outlets and electronic control modules. Northern Can Systems (NCS). NCS supplies the domestic and international food processing market with easy-open lids for cans. Fabricated from steel, easy-open ends are gaining market share for use on packs for pet foods, snacks, fruits and vegetables. When made as pour-spout lids, which incorporate a pull-tab, easy-open ends are used for beverages, including nutritional drinks. Principal Products The percentage of Sequa's consolidated sales and revenues contributed by each class of similar products and services, which accounted for 10 percent or more of such consolidated sales and revenues during the last three fiscal years, is as follows: Markets and Methods of Distribution Sequa markets its gas turbine engine component manufacturing and repair services primarily to commercial and military aircraft customers and to users of industrial gas turbines worldwide. These and other products of Chromalloy Gas Turbine Corporation are marketed directly and through sales representatives working on a commission basis. A portion of the sales of Gas Turbine's operations is made pursuant to contracts with various agencies of the United States Government, particularly the Department of the Air Force, with which Chromalloy has had a long-term relationship. Sequa markets its electronic and electro-optical systems and its avionics products to both commercial and military customers. The electro-optical systems, and related spares and repair work, are sold primarily under government contracts to the U.S. military, and to foreign governments. KMC products are sold directly to medical equipment suppliers. Sequa markets its rocket propulsion systems generally on a subcontract basis under various defense programs of the United States Government. Programs to which the Company contributes and which are presently important to the rocket propulsion business include the Multiple Launch Rocket System, the U.S. Army Tactical Missile System, the booster rocket for the U.S. Navy's Tomahawk cruise missile and gas generators for the Trident II missile's post-boost control system. In addition, ARC Propulsion has a number of advanced programs in various stages of development and qualification, including ERINT, an anti-missile missile that is a prime candidate for the next generation Patriot mission. By their terms, government contracts are subject to termination by the government either for its convenience or for default by the contractor. Some government contracts are secured through competitive bidding. The largest single government agency contract accounted for 2% of Sequa's sales and revenues in 1993, 2% in 1992 and 4% in 1991. Prime contracts and subcontracts with all government agencies accounted for 22%, 23% and 27% of Sequa's sales and revenues in 1993, 1992 and 1991, respectively. The anticipated impact of defense spending levels on the Company's 1994 sales and revenues and operating income is set forth in the Management's discussion and analysis of financial condition and results of operations on pages 18 and 20 of this Annual Report on Form 10-K and is hereby incorporated by reference. Sequa's Machinery and Metal Coatings Segment sells its machinery products directly to the container and food industries, as well as to the web printing industry. The metal coatings business sells its coating services to regional steel and aluminum producers, building product manufacturers, merchant can makers and other participants in the food industry. The Specialty Chemicals Segment sells textile chemicals and emulsion polymers directly to manufacturers of fabric for clothing and other products. Paper chemicals are sold directly to paper mills and detergent chemicals are sold to detergent manufacturers. The automotive products subsidiary sells cigarette lighters and various electronic monitoring devices directly to the automotive industry. Competition There is significant competition in the industries in which Sequa operates, and, in several cases, it competes with larger companies having substantially greater resources than those of Sequa. Sequa believes that it is currently the world's largest manufacturer of cylindrical can-decorating equipment, one of the largest manufacturers of permanent-press textile finishing resins, a leading supplier of aircraft barometric altitude reporting instruments for military and commercial air transport aircraft, and the largest domestic supplier of automotive cigarette lighters in the United States. Sequa, through its gas turbine operations, is a leader in the development and use of advanced metallurgical and other processes to manufacture, repair and coat blades, vanes and other components of gas turbine engines used for military and commercial jet aircraft and for industrial purposes. Gas Turbine's divisions operate in highly competitive environments and compete for repair service business with a number of other major companies, including the major turbine engine manufacturers who often specify to their customers that vendors such as Gas Turbine must be approved by such manufacturers to manufacture components for their engines and/or perform repair services on their engines and components. Gas Turbine has a number of such approvals, including licensing agreements which allow it to manufacture and repair certain components of the new generation of flight engines now coming into widespread use. The impact on Gas Turbine of the government investigations of the Orangeburg, New York facility is set forth in the Management's discussion and analysis of financial condition and results of operations on pages 18, 20, 24 and 25 of this Annual Report on Form 10-K and is hereby incorporated by reference. The loss of approval by one of the major jet engine manufacturers to manufacture or repair components for such producer's engines could have an adverse effect on Gas Turbine. In such event, however, Gas Turbine would seek to replace any approvals lost by obtaining approvals with respect to the same components directly from the Federal Aviation Administration (FAA) or, alternatively, the customer. Sequa's rocket propulsion systems business competes with several other companies for defense business. In some cases, these competitors are larger than Sequa and have substantially greater resources. Government contracts in this area are generally awarded on the basis of proven engineering capability and price. The Company's ability to compete is enhanced by the needs of the U.S. Government to have alternative sources of supply under these contracts. Sequa's Kollsman unit competes in each of its markets with a number of other manufacturers, some of which are larger and have greater resources than Kollsman. This unit competes on the basis of technical competence, quality and price. Sequa's Precoat Metals operation, a leader in coating coils of steel for metal building panels, is also the most fully integrated supplier of coated metal coil stock in the United States. Sequa's cylindrical can printing and can forming equipment operations are world leaders in their markets. MEG is Europe's leading supplier of auxiliary press equipment. Sequa's automotive products manufacturer is the nation's leading producer of cigarette lighters and holds a commanding share of both the domestic original equipment market and the auto aftermarket. Sequa's easy-open can lid manufacturing business competes with a number of larger and well established entities which have substantially greater financial and other resources. Raw Materials The various segments of Sequa's business use a wide variety of raw materials and supplies. Generally, these have been available in sufficient quantities to meet requirements, although occasional shortages have occurred. Seasonal Factors Overall, Sequa's business is not considered seasonal to any significant extent. Patents and Trademarks The Company owns and is licensed to manufacture and sell under a number of patents, including patents relating to its metallurgical processes. These patents and licenses were secured over a period of years and expire at various times. The Company has also created and acquired a number of trade names and trademarks. While Sequa believes its patents, patent licenses, trade names and trademarks are valuable, it does not consider its business as a whole to be materially dependent upon any particular patent, license, trade name, trademark or any related group thereof. It regards its technical and managerial knowledge and experience as more important to its business. Backlog The businesses of Sequa for which backlogs are significant are the Kollsman division, the Turbine Airfoil, Caval Tool and Castings units of Gas Turbine, and the ARC propulsion operations of the Aerospace segment; and the Can Machinery and MEG operations of the Machinery and Metal Coatings segment. The aggregate dollar amount of backlog in these units at December 31, 1993 was $369,700,000 ($435,200,000 at December 31, 1992). The year-to-year decline is a reflection of the overall weakness in the domestic defense and the worldwide airline industries. At December 31, 1992, the professional services unit of ARC had $120,500,000 of backlog which is excluded from the above comparison. Research and Development Research and development costs, charged to expense as incurred, amounted to approximately $17,166,000 in 1993, $17,557,000 in 1992, and $19,482,000 in 1991. The reduction in research and development costs reflects a focusing of the Company's research and development effort with the objective of realizing improved returns on those projects which are undertaken and discontinuing expenditures in areas the Company believes will not be profitable due to the lack of sufficient future commercial opportunities. Reductions primarily occurred at the units serving the domestic defense markets, while expenditures increased at Sequa Can Machinery. It is not anticipated that this approach will affect the Company's ability to be competitive. Costs relating to customer-sponsored research and development activities are not material. Environmental Matters The Company has been notified that it has been named as a potentially responsible party under Federal and State Superfund laws and/or has been named as a defendant in suits by private parties (or governmental suits including private parties as co- defendants) with respect to sites currently or previously owned or operated by the Company or to which the Company may have sent hazardous wastes. The Company is not presently aware of other such lawsuits or notices contemplated or planned by any private parties or environmental enforcement agencies. The aggregate liability with respect to these matters, net of liabilities already accrued in the Consolidated Balance Sheet, will not, in the opinion of management, have a material adverse effect on the results of operations or the financial position of the Company. These environmental matters include the following: A number of claims have been filed in connection with alleged groundwater contamination in the vicinity of a predecessor corporation site which operated during the 1960s and early 1970s in Dublin, Pennsylvania. In October 1987, a tort action was filed by residents of Dublin against the Company and two other defendants. The Borough of Dublin also filed suit seeking remediation of alleged contamination of the Borough's water supply and damages in an unspecified amount. The Company expects that a trial date will be scheduled in 1994. The Pennsylvania Department of Environmental Regulation entered into a Consent Decree with the Company in 1990 providing for the performance of a remedial investigation and feasibility study with respect to the same alleged groundwater contamination in Dublin. The U.S. Environmental Protection Agency (EPA) also placed the site on the Superfund List in 1990 and, in conjunction therewith, entered into a Consent Agreement with the Company on December 31, 1990. EPA estimates that the cost of the interim remedy will be less than $4 million. The investigation for the final remedy is still in progress. The State of Florida issued an Administrative Order requiring TurboCombustor Technology, Inc. (TCT), a subsidiary of Chromalloy Gas Turbine Corporation, to investigate and to take appropriate corrective action in connection with alleged groundwater contamination in Stuart, Florida. The contamination is alleged to have arisen from a 1985 fire which occurred at TCT's former facility in Stuart. The City of Stuart has subsequently constructed and is operating a groundwater remediation system. The Company has negotiated a settlement with the City of Stuart whereby it would contribute its ratable share of the capital and operating costs for the groundwater treatment system. The Company estimates the amount to be paid in settlement plus additional groundwater sampling and analysis will be approximately $2 million to be paid over a ten year period. In September 1993, fourteen homeowners residing in West Nyack, New York served a complaint on Gas Turbine and others alleging, among other things, that contamination from a former Gas Turbine site caused the plaintiffs' alleged property damage. Gas Turbine believes it has strong defenses under New York law to the plaintiffs' complaint. Gas Turbine entered into a Consent Order with the New York Department of Environmental Conservation on February 14, 1994, to undertake the remedial investigation and feasibility study relating to the alleged contamination in the vicinity of the former Gas Turbine site. In connection with the sale of the Graphic Arts Materials Segment, now known as Sun Chemical Corporation, to Dainippon Ink and Chemicals, Inc. (DIC) in December 1986, the Company has continuing contingent liability for all off-site environmental claims which relate to activities prior to the sale. In connection therewith, the Company provided a letter of credit in the original amount of $25.0 million in favor of DIC as security for said obligation for a period of ten years from date of sale. The amount of this letter of credit is adjusted each year. It is increased by an interest factor and decreased by the amount actually paid by the Company for related off-site environmental claims. In late 1993, the agreement was amended with the amount of the letter of credit being reduced to $15.0 million, subject to annual adjustment, and the obligation to provide said letter was extended three years to December 1999. On April 3, 1989, the Company and Gas Turbine instituted a law suit in the Delaware Superior Court against forty-one of the Company's comprehensive general liability insurance carriers (the Defendants). The Company and Gas Turbine seek to enforce their rights under insurance policies sold to them by the Defendants in connection with various environmental actions that have been brought against the Company and Gas Turbine and are seeking indemnity and defense costs with respect to all Superfund actions and third-party environmental litigation. The Company has identified cost estimates for all sites it is involved with and has established reserves as required by generally accepted accounting principles. The Company anticipates that actual cash expenditures related to these sites will be in the range of $6 million to $12 million in 1994 and in the $5 million to $7 million range for each of the following several years. Anticipated expenditure levels for 1994 reflect clean-up costs on sites where work will begin earlier than previously expected. Actual cash expenditures were $7.7 million in 1993, $6.2 million in 1992, and $4.7 million in 1991. Employment At December 31, 1993, Sequa employed approximately 10,250 persons in its continuing operations of whom approximately 2,000 were covered by union contracts. The approximate number of employees attributable to each reportable business segment as of December 31, 1993 was: The Company considers its relations with employees to be generally satisfactory. Sequa maintains a number of employee benefit programs, including life, hospitalization, surgical, dental, and major medical insurance, and a number of 401(k) and pension plans. (d) Foreign Operations. Sequa's foreign operations, spread primarily throughout Europe, include Gas Turbine operations within its Aerospace Segment; detergent chemicals operations included in the Specialty Chemicals Segment; the auxiliary press equipment supplier in the Machinery and Metal Coatings Segment; and an automotive products operation in the United Kingdom in the Professional Services and Other Products Segment. These operations consist primarily of wholly-owned foreign subsidiaries. Sales and revenues, operating earnings and identifiable assets attributable to foreign operations, and export sales, are set forth in Note 18 to the Consolidated Financial Statements on page 56 of this Annual Report on Form 10-K and is incorporated herein by reference. ITEM 2.

ITEM 2. PROPERTIES Aerospace The Chromalloy Gas Turbine Corporation operates over 50 plants in fifteen states and eight foreign countries, primarily in Europe, which have aggregate floor space of approximately 4,600,000 square feet, of which approximately 2,300,000 square feet is owned and approximately 2,300,000 square feet is leased. The leases covering the leased facilities in this business have various expiration dates and some have renewal or purchase options. Rocket propulsion operations lease a 1,014-acre manufacturing facility in Camden, Arkansas. The Camden lease, which has various renewal options, expires in 1998. The Company owns 12 acres and an 89,000 square foot office and manufacturing complex in Gainsville, Virginia. An additional 189,000 square feet (of which 120,000 square feet is sublet) is leased for administrative and manufacturing purposes in Alabama, California and Virginia. The liquid propulsion division leases a 101,000 square foot facility in Niagara, New York. The Company also owns 2,430 acres of land in Orange County, Virginia, which has been developed for use in the propellant business. An additional 38,000 square feet is owned in Alexandria and is used for administrative purposes. The Kollsman operation owns two plants in New Hampshire with aggregate floor space of 405,000 square feet and leases another facility in New Hampshire with aggregate floor space of 91,000 square feet where various production, administrative, warehousing and technical services are performed. This business also owns one 23,000 square foot manufacturing facility in Wichita, Kansas and leases 6 domestic facilities aggregating approximately 55,000 square feet in which sales, repairs, and warehousing operations are conducted. Facilities in this segment are suitable and adequate for the business. Gas Turbine facilities serving the commercial repair market operate at a higher utilization rate than facilities serving either the original jet engine manufacturers or the military. Capital spending plans for the operations in this segment are primarily designed to keep up with current technology or to meet specific requirements for various government or commercial contracts. Machinery and Metal Coatings The can forming and decorating operations own two plants in the United States with aggregate floor space of 228,000 square feet and lease one small warehouse facility of approximately 5,000 square feet. In Europe, through the segment's auxiliary press equipment supplier, MEG, the Company owns a plant with aggregate floor space of approximately 57,000 square feet. MEG also leases two sales offices and owns a storage facility in Europe with a total of 20,000 square feet and leases a 1,000 square foot sales office in Singapore. The Precoat Metals operation owns four manufacturing facilities in Missouri, Illinois and Texas, with a total of 500,000 square feet of manufacturing and office space. In June 1993, the division broke ground for construction of a new 150,000 square foot facility in Mississippi designed to increase capacity in the south, to enhance customer service and to free capacity at existing locations. An additional 56,000 square feet of warehouse space is leased in Illinois and Texas. The properties in this segment are suitable and adequate for the business presently being conducted. Precoat Metals facilities are functioning at a high level of utilization and the can forming and decorating operations are functioning at a moderate level of utilization. The 1994 capital spending plans call for the finalization of the new metal coatings facility in Mississippi. Specialty Chemicals The Specialty Chemicals segment owns one plant situated on 86 acres in Chester, South Carolina with aggregate floor space of 160,000 square feet in addition to a 22,000 square foot leased warehouse also in Chester. The segment owns two plants in the United Kingdom with aggregate floor space of 223,000 square feet on approximately 43 acres of land and leases 8,000 square feet of office and warehouse space in five separate locations in France, Spain, the United Kingdom and Italy. Facilities in this segment are adequate and suitable for the business being conducted. They operate at a high utilization rate. Capital spending plans call for capacity increases and for installation of equipment required to meet or exceed environmental regulations. Professional Services and Other Products The automotive products subsidiary, Casco Products, owns a 205,000 square foot plant in Connecticut and leases a 1,600 square foot sales office in Detroit, Michigan. In June 1994, Casco will begin to relocate to a new 168,000 square foot leased facility also located in Connecticut. In addition, Casco Ltd. leases 8,700 square feet of manufacturing, warehouse and office space in the United Kingdom. NCS owns a manufacturing facility in Ohio with floor space of 90,000 square feet. The Centor Company, a wholly-owned subsidiary, owns and operates the Chromalloy Plaza Building, a modern 18-story office building in Clayton, Missouri with approximately 284,000 square feet of rentable office and commercial space. Centor also owns and rents a manufacturing facility and a warehouse in Wisconsin with aggregate floor space of 185,000 square feet as well as owning 10 smaller properties that are either leased to third parties and/or held for sale. Facilities in this segment are adequate. At NCS, utilization continues to be below 50%, but management anticipates that this will improve. Corporate The Company leases 58,000 square feet of corporate office space in New York, New York and Hackensack, New Jersey. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS Sequa is involved in a number of claims, lawsuits and proceedings (environmental and otherwise) which arose in the ordinary course of business. Additional information on environmental matters is covered in the Environmental Matters section on pages 10 through 12 of this Annual Report on Form 10-K and is hereby incorporated by reference. Other litigation is pending against the Company involving allegations that are not routine and include, in certain cases, compensatory and punitive damage claims. Included in this other class of litigation is an arbitration proceeding that was formally commenced in 1992 to resolve a dispute between the Egyptian Air Force and Chromalloy Gas Turbine. In the damage portion of the arbitration hearing in October 1993, Chromalloy Gas Turbine claimed $29.6 million in damages (which includes $17.5 million of net assets in the Company's Consolidated Balance Sheet) and the Egyptian Air Force counterclaimed for $46.5 million in damages. The ultimate legal and financial liability of the Company in respect to all claims, lawsuits and proceedings referred to above cannot be estimated with any certainty. However, in the opinion of management, based on its examination of such matters, its experience to date and discussions with counsel, the ultimate outcome of these contingencies, net of liabilities already accrued in the Company's Consolidated Balance Sheet, is not expected to have a material adverse effect on the results of operations or financial position of the Company. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. PART II (b) Holders. Shares of Sequa Class A common stock and Sequa Class B common stock are listed on the New York Stock Exchange. There were approximately 3,350 holders of record of the Sequa Class A common stock (plus 360 holders of unexchanged shares) and approximately 780 holders of record of the Sequa Class B common stock (plus 110 holders of unexchanged shares) at March 17, 1994. (c) Dividends. During the year ended December 31, 1993, Sequa declared two quarterly dividends of $.15 per share, or $.30 per share for the year, on Sequa Class A common shares and two quarterly dividends of $.125 per share, or $.25 per share for the year on Sequa Class B common shares. During the year ended December 31, 1992, Sequa declared four quarterly dividends of $ .15 per share, or $ .60 per share for the year, on the Sequa Class A common stock and four quarterly dividends of $ .125 per share, or $ .50 per share for the year, on the Sequa Class B common stock. Commencing in the third quarter of 1993, under the terms of the Company's senior subordinated notes due 1998, there was a deficiency in consolidated retained earnings available for the payment of cash dividends and the repurchase of the Company's stock. As a result, common and preferred stock dividends were not declared in the third and fourth quarters of 1993. At December 31, 1993, the deficiency in consolidated retained earnings available for payments of cash dividends was $45.8 million. In the future, net income will reduce this deficiency by seventy-five cents on the dollar while net losses will increase this deficiency on a dollar-for-dollar basis. In addition, as of December 31, 1993, the Company's earnings were not sufficient to maintain a consolidated interest coverage ratio of 2.0 to 1.0 which, pursuant to the terms of the Company's senior notes due 2001 and the senior subordinated notes due 2003, precludes the Company from paying dividends, among other restricted activities. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OPERATING RESULTS 1993-1992 SALES AND REVENUES Sales and revenues from continuing operations declined 9% in 1993, primarily as a result of decreases at the Gas Turbine and Atlantic Research (ARC) propulsion units of the Aerospace segment and the overseas unit of the Specialty Chemicals segment. Aerospace segment sales declined 16% in 1993, principally as a result of a substantial fall-off in sales of Gas Turbine, the largest individual operation in the segment and in the Company as a whole. ARC propulsion sales, which represent a smaller portion of overall revenues, declined approximately 20%, and the Kollsman division, the smallest part of the segment, posted a 9% increase in sales. Gas Turbine sales declined 18% from 1992 levels. Over half the decline occurred at the unit's largest facility in Orangeburg, New York, which was severely affected by government investigations. In addition, other Gas Turbine installations were affected by sustained weakness in the jet engine component repair and new parts market, as well as by the continuing decline in the domestic defense market. Overall market sluggishness also affected locations specializing in the overhaul and repair of both aircraft engines and industrial turbines, as well as those serving the auxiliary power equipment market. Management anticipates that the commercial airline market will improve gradually, with only a modest upturn in demand for component repair in 1994. The investigations of the Orangeburg plant are discussed in detail in the Government Investigations section of this management discussion and analysis. From the standpoint of operations, the Federal Aviation Administration's restoration of the Orangeburg facility's repair station certificate in June 1993 was a first step in restoring the facility to full operation. Since that time, each individual repair process and procedure at the facility has been subject to review. By March 1, 1994, approvals had been received for the repair of parts representing approximately 85% of the facility's ongoing repair revenues. While the approval process has taken longer than originally anticipated, management expects that all approvals will be received by July 1994. As a result, revenues at the Orangeburg facility are expected to increase gradually in 1994. The 20% reduction in sales of the ARC propulsion unit was in line with management's previous estimates and primarily resulted from reduced revenues on several major rocket motor programs including Trident D-5, Stinger and MLRS, and the completion of two other programs (MK104 Standard Missile and MK30). Barring additional Defense Department spending cuts, management anticipates that sales will decline a further 5%-10% in 1994. Kollsman's sales increased 9% in 1993 principally as a result of higher sales of military electro-optics products, including the new domestic contract with the U.S. Marine Corps to upgrade the optical system on the Cobra helicopter. Sales of avionics products also increased in 1993, but the overall advance was partially offset by a reduction in the sale of medical instrumentation. Sales of the Machinery and Metal Coatings segment increased 7% in 1993, paced by a sharp advance at the metal coatings unit. The metal coating division posted a 15% increase in sales, primarily as a result of strong demand from the building products industry and improved market penetration of this key market. At the can machinery division, sales advanced 4%, as gains in can forming equipment were largely offset by reduced shipments of can decorating equipment and lower sales of spare parts and accessories. The European auxiliary press equipment supplier posted a small sales increase measured in local currency. However, after translation into U.S. dollars, reported sales were down 5%. Sales of the Specialty Chemicals segment declined 6% in 1993 with fourth-quarter increases at both units mitigating the effect of lower sales for the the first nine months of the year. At the overseas unit, an increase in local currency sales of TAED, a bleach activator, was more than offset by an unfavorable foreign currency translation swing of 15%. At the domestic unit, sales were down marginally, as continued weakness in the paper, textile and graphic arts markets was offset by a solid advance in the specialty polymer product line, and by the sales added through a paper specialties product line acquired in late 1992. At the domestic unit, 1993 sales trends are expected to continue in the early part of 1994, and overseas sales are expected to remain at a high level. Sales and revenues of the Professional Services and Other Products segment increased 5% in 1993, as two of the four units posted increases. Revenues of the ARC professional services unit, which was sold in December 1993, increased 3% to $162.6 million. Sales of the automotive products unit advanced sharply, a reflection of the overall health of the domestic automobile market, and the resulting increase in demand for automotive cigarette lighters and power outlets. The unit also improved its penetration of the automotive lighter market in Europe. Sales of Northern Can Systems (NCS) were on a par with 1992 levels, as a doubling of can lid sales more than offset the absence of sales from two can making plants which were sold in the first half of 1993. Revenues of Centor, the real estate company, declined modestly in 1993 primarily due to a lower occupancy rate in its office building in Clayton, Missouri. OPERATING INCOME Operating income declined 87% in 1993, primarily as a result of the operating loss posted by Gas Turbine and the recording of restructuring charges amounting to $26.6 million during the year. The Aerospace segment posted a $40.9 million loss in 1993 compared to a profit of $75.5 million in 1992. This swing was primarily due to losses at Gas Turbine. Gas Turbine was adversely impacted by three major factors: the interruption of operations at the Orangeburg facility; the charge to reflect implementation of a restructuring plan; and the legal fees, payments to the government and severance costs at the Orangeburg plant. Results of all other Gas Turbine units, in total, declined modestly from a 1992 base that was already severely affected by two years of turmoil in the commercial airline market. Management anticipates that Gas Turbine will return to profitability in the first quarter of 1994. ARC propulsion profits declined 28%, a reflection of lower sales and an unfavorable sales mix shift, partially offset by reduced general and administrative, and bid and proposal costs. Management of the unit anticipates that profits will decline modestly in 1994 as the unit continues to adjust to the restrictive market conditions. Kollsman's profits increased from a modest 1992 base, primarily as a result of improvements in electro optics, and reduced selling, general and administrative expenses. Conditions in the markets Kollsman serves are not expected to strengthen in 1994, nonetheless management expects Kollsman will be able to maintain its profit level in 1994 and plans to further shrink its asset base to improve returns. Operating profit in the Machinery and Metal Coatings segment decreased 3% in 1993, as strength at the metal coatings unit and a turnaround at the auxiliary press equipment unit were more than offset by a decline in the can machinery operation. Throughout 1993, the metal coating operation benefitted from increased sales and improved capacity utilization. Although this unit will incur start-up expenses when it brings a new facility on stream in mid- 1994, profits for the full year are currently expected to remain at least on a par with 1993, due to continued strong demand from the building products market. At the can machinery operation, reduced factory utilization, competitive pricing pressures in the can decorating market, a bad debt provision, and the recording of a restructuring charge combined to cause a significant profit decline in 1993. Based on year-end backlog, this operation is expected to have a weak first quarter in 1994. The auxiliary press equipment operation returned to profitability in 1993 due to a general program of cost reduction and the absence of unusual warranty, severance and bad debt provisions that had been recorded in 1992. Based on the current level of firm backlog, losses are expected in the first half of 1994. Operating income in the Specialty Chemicals segment declined 11% in 1993, with both units down from the preceding year. At the overseas unit, strong operating results were offset by the combination of unfavorable foreign currency exchange movements and the establishment of environmental clean-up and bad debt reserves related to the non-detergent chemicals portion of the business. The decline in operating income at the domestic unit resulted from three principal factors: the start-up of a new paper specialties product line; the cost to realign and expand the European sales and marketing effort; and the reduced gross profit that resulted from lower sales and an unfavorable sales mix shift. Operating income in the Professional Services and Other Products segment more than doubled in 1993. Both ARC professional services and the automotive products units achieved solid profit advances and NCS moved from a loss in 1992 to a modest profit in 1993. Profits of the automotive products unit advanced due to the increased volume of automotive cigarette lighters. At NCS, increased sales of can ends and the benefits of cost reductions and manufacturing improvements implemented in both 1992 and 1993 fueled a turnaround. In the second half, NCS recorded a small loss, as the unit adjusted to the downsizing that resulted from the sale of the can plants. Management anticipates that this unit will return to profitability in the first quarter of 1994 and will post a profit for the full year. At Centor, profit declined from a relatively low 1992 base, primarily as a result of lower rental income. During 1993, the Company recorded restructuring charges totaling $26.6 million primarily relating to plans adopted to reduce Gas Turbine's investment in plants that are engaged in activities other than the repair of components for flight engines, and to sell excess machinery and permanently reduce the number of employees in other Gas Turbine facilities. Included in the restructuring charges are: severance costs, $7.5 million; write- down of equipment to be sold, $4.1 million; write-down of inventory to net realizable value, $3.2 million; relocation of equipment, $1.8 million; write-down of other assets, $1.5 million; operating losses through date of sale, $6.5 million; other costs, $2.0 million. As of December 31, 1993, $20.7 million of these amounts remained in Accrued expenses. INTEREST EXPENSE In 1993, interest expense declined $6.6 million due to a lower level of average borrowings related to the Company's cash generation program. OTHER, NET In 1993, Other, net included a $6.6 million loss on interest rate options sold, $3.1 million of discount expense related to the sale of accounts receivable, a $3.1 million loss incurred on a sale and leaseback transaction, a $7.6 million equity loss in the Company's unconsolidated airbag business, amortization of capitalized debt costs in the amount of $4.2 million, and $2.5 million in charges for a minority shareholder's interest in the earnings of ARC. Based upon market interest rates on March 15, 1994, adjustment of the carrying value of interest rate options sold would result in an additional loss of approximately $3.5 million to be recorded in the first quarter of 1994. In 1992, Other, net included $3.9 million of discount expense related to the sale of accounts receivable, a $4.7 million equity loss in the Company's unconsolidated airbag business, amortization of capitalized debt costs in the amount of $3.1 million, and $1.7 million in charges for a minority shareholder's interest in the earnings of ARC. ENVIRONMENTAL MATTERS The Company's engineering and environmental department, under senior management direction, manages all activities related to the Company's involvement in environmental clean-up. This department establishes the projected range of expenditures for individual sites with respect to which the Company may be considered a potentially responsible party under applicable Federal or state law. These projected expenditures, which are reviewed periodically, include: remedial investigation and feasibility studies; outside legal, consulting and remediation project management fees; the projected cost of remediation activities; site closure and post-remediation monitoring costs. The assessments take into account known conditions, probable conditions, regulatory requirements, past expenditures, and other potentially responsible parties and their probable level of involvement. Outside technical, scientific and legal consulting services are used to support management's assessments of costs at significant individual sites. The Company has identified cost estimates for all sites it is involved with and has established reserves as required by generally accepted accounting principles. The Company anticipates that actual cash expenditures related to these sites will be in the $6 million to $12 million range in 1994 and in the $5 million to $7 million range during each of the following several years. Anticipated expenditure levels for 1994 reflect clean-up costs on sites where work will begin earlier than previously expected. Actual cash expenditures were $7.7 million in 1993, $6.2 million in 1992, and $4.7 million in 1991. AUTOMOTIVE AIRBAGS In 1989, Atlantic Research and AlliedSignal formed a 50/50 joint venture, called Bendix Atlantic Inflator Company (BAICO), to develop, produce and market hybrid inflators for automotive airbag systems. The joint venture has expended substantial sums on the development and marketing of both passenger- and driver-side inflators. As a result of these efforts, the joint venture has orders from seven car companies covering 13 models beginning with the 1994 model year. The first deliveries of production units were made in 1993 with total shipments of 319,000 units. Shipments in 1994 are expected to reach nearly one million units. In 1993, Atlantic Research, AlliedSignal and Gilardini (a unit of the Fiat Group) formed an Italian company to produce and market hybrid inflators for Fiat and other European car companies. Each participant owns a one-third interest in this venture. Atlantic Research expects to spend approximately $4 million over the next 12 months for its share of the cost to equip a leased facility in Colleferro, Italy. First deliveries from this plant to fill an order from a European customer are scheduled for June 1995. The Company's equity loss in its airbag business was $7.6 million in 1993 and $4.7 million in 1992. Management currently anticipates the airbag business will achieve profitability in late 1995 or early 1996. BACKLOG The businesses of Sequa for which backlogs are significant are the Kollsman division, the Turbine Airfoil, Caval Tool and Castings units of Gas Turbine, and the ARC propulsion operations of the Aerospace segment; and the Can Machinery and MEG operations of the Machinery and Metal Coatings segment. The aggregate dollar amount of backlog in these units at December 31, 1993 was $369.7 million ($435.2 million at December 31, 1992). The year-to-year decline is a reflection of the overall weakness in the domestic defense and the worldwide airline industries. At December 31, 1992, the professional services unit of ARC had $120.5 million of backlog which is excluded from the above comparison. CAPITAL SPENDING AND OTHER INVESTMENTS Capital expenditures amounted to $76.9 million in 1993, with spending concentrated in the Gas Turbine, metal coatings and overseas chemicals operations. These funds were primarily used to upgrade existing facilities and equipment and to expand capacity. The two largest projects were the installation of an electron beam physical vapor deposition coater in a United Kingdom Gas Turbine plant and the start of construction for a new metal coatings facility in Jackson, Mississippi. Both projects are expected to be operational by the third quarter of 1994. In addition, the Company invested $2.7 million for its share of capital costs in the airbag business. The Company accounts for its airbag investment using the equity method of accounting. Accordingly, these funds were accounted for as an increase in the Company's investment and are included in Non-current receivables and other investments in the Consolidated Balance Sheet. The Company anticipates that capital spending in 1994 will be approximately $85 million and will again be concentrated in the Gas Turbine, metal coatings and chemicals operations. The Company also anticipates investing approximately $10.5 million in the airbag business. LIQUIDITY AND CAPITAL RESOURCES Management anticipates that cash flow from operations, proceeds from the divestiture of the remaining discontinued operations and other assets, the $111 million of credit available at March 15, 1994 under the new revolving credit agreement, and dividends that management expects to receive from the Company's European subsidiaries will be more than sufficient to fund the Company's operations for the foreseeable future. During 1993, the Company lengthened debt maturities by successfully restructuring its long-term debt, and dramatically improved liquidity. In addition, the Company generated $127 million from its program to trim its asset base. The largest portion of these proceeds was used to reduce debt, which declined $96 million in 1993. In 1994, the Company plans to continue its program of asset disposals and debt reduction. As part of the restructuring plan at Gas Turbine, which was announced in the third quarter, the Company currently has signed letters of intent for the sale of two Gas Turbine units which would generate approximately $50 million in cash if the transactions are successfully completed. In addition, the Company is actively pursuing additional asset disposals under the Gas Turbine restructure program; marketing the remaining discontinued business assets either through outright sale; or, in the case of Sequa Capital's leveraged leases, a transaction designed to monetize the portfolio. At December 31, 1993, under the terms of the Company's senior subordinated notes due 1998, there is a $45.8 million deficiency in consolidated retained earnings available for the payment of cash dividends and the repurchase of the Company's stock. As a result, common and preferred stock dividends were not declared in the third and fourth quarters of 1993. Under the terms of the Company's preferred stock, upon the Company's failure to make six consecutive quarterly dividend payments, the holders thereof, voting as a class, will have the right to elect two members of the Board of Directors of the Company at the next annual meeting of shareholders. These special voting rights terminate when all dividends in arrears have been paid. In addition, as of December 31, 1993, the Company's earnings were not sufficient to maintain a consolidated interest coverage ratio of 2.0 to 1.0 which, pursuant to the terms of the Company's senior notes due 2001 and the senior subordinated notes due 2003, precludes the Company from paying dividends among other restricted activities. In the short term, the Company's objective is to return to profitability, to continue to improve its capital structure and to resume dividend payments. In the longer term, the Company's objective is to regain an investment grade rating from the major rating agencies. OTHER INFORMATION Statement of Financial Accounting Standards (SFAS) No. 112, "Employer's Accounting for Postemployment Benefits," was issued in November 1992 and must be implemented by the first quarter of 1994. This statement requires benefits to former employees after employment, but before retirement, to be accrued when it is probable that a liability has been incurred and the amount can be reasonably estimated. The impact of adopting SFAS No. 112 will not have a material effect on the Company's results of operations or financial position. GOVERNMENT INVESTIGATIONS During the second quarter of 1993, the Company entered into agreements with the U.S. Attorney's Office, Southern District of New York (SDNY), and the Federal Aviation Administration (FAA) in connection with investigations by these offices and other related governmental agencies of the Company's Orangeburg facility and certain of its then employees begun in November 1992. Management believes that the investigations were in connection with allegations that the Orangeburg facility had performed repairs on certain parts in a defective manner and in violation of applicable requirements. The investigations resulted in the Orangeburg facility voluntarily surrendering its FAA repair station certification and suspending FAA authorized repair operations in April 1993. Gas Turbine's other operating facilities, as well as work done for original equipment manufacturers at the Orangeburg facility, were unaffected by the suspension. Throughout the investigations, the Company and the Orangeburg facility cooperated fully with federal authorities. In addition, the Company instituted extensive changes in the management and operations of the facility. As a result of the Company's cooperation with the government and its good faith efforts to comply with all applicable FAA standards, the FAA restored the facility's FAA repair station certificate on June 10, 1993, ending the suspension of repair operations and resolving all FAA civil matters relating to the Orangeburg facility. Subsequently, the U.S. Attorney's Office, SDNY, entered into an agreement with the Company, under which it declined to prosecute the Company in connection with its investigation. In April 1993, the Company signed a consent order with the FAA providing for a non-punitive remedial payment by the Company of $5.0 million, representing the costs incurred by the FAA to investigate the Orangeburg facility and enforce its consent decree. In addition, under the terms of the agreement with the U.S. Attorney's Office, SDNY, the Company agreed to deposit $2.5 million into a fund (with up to an additional $2.5 million to be deposited, if needed) to cover the cost of testing and analyzing jet engine parts seized by federal authorities during an early stage of the investigations. Currently, the Company is in the process of obtaining recertification on certain repair processes and procedures. By March 1, 1994, approvals had been received for the repair of parts that represent approximately 85% of the facility's ongoing repair revenues. While it has taken longer than anticipated to obtain the required approvals, the process is continuing and the Company anticipates receiving the balance of the outstanding approvals during the second quarter of 1994. As a result, revenues of the Orangeburg facility are expected to increase gradually in 1994. At the same time, overall airline industry conditions remain depressed, affecting demand for new and repaired parts. Management does not anticipate significant improvement in market conditions in the near term, but believes the Orangeburg facility's repair operations are recovering from the effects of the investigations, and operating results are continuing to improve. As a result of the investigations and the related suspension, the Company incurred direct expenses in 1993 of $12.8 million. Direct expenses included the remedial payment to the FAA, the deposit of funds described above, severance payments and related legal fees and expenses. OPERATING RESULTS 1992-1991 Sales and Revenues Sales and revenues from continuing operations declined slightly in 1992, as advances at three of the Company's four operating segments largely offset a 4% decline in the Aerospace segment. The reduction in Aerospace sales reflects declines at ARC propulsion and Kollsman. Sales of Gas Turbine were unchanged from 1991, as increased activity in landbased turbines and flight engine overhaul offset declines in the repair and manufacture of parts for aircraft engines. ARC propulsion sales declined approximately 10% in 1992, as a result of continued defense spending cuts. The impact of reductions in four solid rocket motor programs and the cancellation of a development program was partially offset by a significant increase in the Trident D-5 program. Kollsman sales declined 22% in 1992, primarily due to a substantial drop in avionics products for the general aviation market, as well as the completion of low-margin electro-optics contracts for the U.S. Government. By contrast, sales of medical instrumentation increased 12%. Sales of the Machinery and Metal Coatings segment increased 9% in 1992, with strong advances at the metal coatings and can machinery units, partially offset by a decline in sales of auxiliary press equipment. The metal coatings operation experienced strong demand and increased its penetration of the building products and container markets. The can machinery units benefitted from a high level of demand from export markets and from the successful introduction of new can forming equipment. Sales of the overseas auxiliary press equipment operation declined in 1992 with a sharp decline in the first half of the year partially offset by improved second-half results. Sales of the Specialty Chemicals segment advanced 7% in 1992 with both the overseas and domestic units contributing to the increase. At the overseas unit, TAED sales advanced modestly, with strength concentrated in the first half of the year. Softness in the second half reflected the economic recession in Europe, and a slowdown in consumer demand for laundry detergents using TAED. Other overseas sales of chemicals advanced sharply in 1992, primarily due to a mid-1991 acquisition of a chemical sales distribution company. At the domestic unit, the sales improvement was primarily the result of increased penetration of the markets for specialty polymers, with the successful introduction of new roofing and filtration products. Sales of paper chemicals increased due to overall improved demand. Sales and revenues in the Professional Services and Other Products segment increased 3%, with advances at three of the four operating units in the segment. ARC professional services registered a small revenue increase, primarily as the result of efforts to increase foreign military consulting activities. In 1992, Casco's sales increased 9%, as both the original equipment market and the aftermarket for automotive cigarette lighters improved. The NCS unit experienced a small sales decline in 1992, and the revenues of Centor, a real estate company, increased 7%. OPERATING INCOME Operating income from continuing operations improved 6% in 1992, as improvements at Kollsman, Warwick, Precoat Metals and Casco Products more than offset declines at Gas Turbine, MEG, the domestic chemicals unit and the ARC propulsion and professional services units. Operating income of the Aerospace segment was down 1%, as a turnaround at Kollsman substantially offset a sharp decline at Gas Turbine and a more modest decline at ARC propulsion. Gas Turbine's profits declined 41%, primarily due to the poor conditions and severe pricing pressures in the markets it serves. The operation also incurred significant severance costs, as it reduced its workforce in response to the restrictive market conditions. Profits were further affected for the last six weeks of the year by a government investigation at the Gas Turbine Orangeburg facility, which began on November 19, 1992. Profits at ARC propulsion declined in 1992, although less than sales. Management has been able to "manage down," aggressively cutting costs in anticipation of lower government contract revenue. Kollsman recorded a modest profit in 1992, a significant improvement from 1991, when the unit recorded a large loss. The division benefitted from a downsizing program initiated in 1991, which was designed to generate profitability at a significantly lower sales level. Operating income for the Machinery and Metal Coatings segment was on a par with 1991 results. The effect of strong improvements at the Precoat Metals division was tempered by a loss at the auxiliary press equipment unit. Can machinery results were consistent with the prior year. Profit increases at metal coatings were due to higher sales and increased capacity utilization. The 1992 loss at the overseas auxiliary press equipment operation resulted from lower sales, combined with warranty, severance and bad debt provisions. At the can machinery operations, the benefits of increased sales were largely offset by increased development costs for new can forming equipment, and higher start-up and warranty costs related to the introduction of new can decorating equipment. Operating income for the Specialty Chemicals segment increased 10% in 1992. The operating performance of both units was ahead of the prior year, although a fourth-quarter environmental clean-up provision of $2.5 million reduced the domestic unit's results below 1991. Higher profits at the overseas unit resulted from increased sales and savings derived from improved manufacturing processes. Profits at the domestic unit, before the environmental provision, increased 16%, the result of improved sales and the continuing shift to a higher value-added sales mix. Operating income for the Professional Services and Other Products segment increased $3.4 million in 1992, as three of the four units registered improvement. A change in the method of allocating self-insurance losses to other operating segments also favorably affected this segment in 1992. The results of the ARC professional services units declined primarily as a result of higher development costs for imaging software products. Casco Products profits were up, the result of increased sales, improved manufacturing efficiencies and tight cost controls. Losses at NCS narrowed in 1992, as costs were reduced and manufacturing improvements were implemented. Centor profits were up 27% in 1992, from a low 1991 base. INTEREST EXPENSE In 1992, interest expense declined $9.7 million due to both a lower level of average borrowings and a reduction in the average cost of funds. The reduction of debt was directly related to the Company's cash generation program, while the average cost of borrowings declined due to lower prevailing short-term interest rates. OTHER, NET Other, net registered a $4.7 million increase in expense in 1992, primarily due to a $4.2 million increase in the Company's share of start-up costs in the airbag joint venture and a $2.2 million increase in the amortization of capitalized debt costs. A $2.5 million reduction in expenses related to the sale of accounts receivable, which partially offset these increases, resulted primarily from lower discount rates. DISCONTINUED OPERATIONS During 1992, the Company completed the sale of Valley Line, Sabine Towing and Transportation and the Gemoco division of the engineered services group for gross cash proceeds of $197.2 million. In addition, $112.6 million of cash from asset sales and portfolio run-off was generated by Sequa Capital. In the fourth quarter of 1992, the Company recorded a $35.0 million pre-tax charge to recognize larger than expected losses from Sequa Capital, a greater than expected loss on the fourth- quarter sale of a discontinued business, higher projected litigation expenses and recent adverse developments related to contingent lease liabilities associated with an operation discontinued and sold in an earlier year. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Shareholders and the Board of Directors, Sequa Corporation: We have audited the accompanying consolidated balance sheet of Sequa Corporation (a Delaware corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Sequa Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As discussed in Note 1 to the consolidated financial statements, effective January 1, 1992, the Company changed its method of accounting for income taxes. ARTHUR ANDERSEN & CO. New York, New York March 21, 1994 SEQUA CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Summary of Significant Accounting Policies Principles of Consolidation The consolidated financial statements of Sequa Corporation (the Company) include the accounts of all majority-owned subsidiaries, including those of Sequa Receivables Corp. (SRC), a special purpose corporation formed for the sale of eligible receivables. Under the terms of the receivables purchase agreement, SRC's assets will be available to satisfy its obligations to its creditors, which have security interests in certain of SRC's assets, prior to any distribution to the Company. All material accounts and transactions between the consolidated subsidiaries have been eliminated in consolidation. CASH AND CASH EQUIVALENTS For purposes of the Consolidated Statement of Cash Flows, the Company considers time deposits, certificates of deposit and marketable securities with original maturities of three months or less to be cash equivalents. Where the right of set-off exists the Company has netted overdrafts with unrestricted cash and cash equivalents. INVENTORIES AND CONTRACT ACCOUNTING Inventories are stated at the lower of cost or market. The cost of approximately 34% of inventories in 1993 and 36% in 1992 was determined by the last-in, first-out (LIFO) method of inventory valuation. The remaining non-contract related inventories are valued principally on a first-in, first-out basis (FIFO). Inventoried costs relating to long-term contracts are stated at actual or average costs, including engineering and manufacturing labor and related overhead incurred, reduced by amounts identified with sales. The costs attributable to sales reflect the estimated costs of all items to be produced under the related contract. PROPERTY, PLANT AND EQUIPMENT For financial reporting purposes, depreciation and amortization are computed using the straight-line method to amortize the cost of assets over their estimated useful lives. Accelerated depreciation methods are used for income tax purposes. Upon sale or retirement of properties, the related cost and accumulated depreciation is removed from the accounts, and any gain or loss is reflected currently. Expenditures for maintenance and repairs of $44,362,000 in 1993, $46,393,000 in 1992 and $43,130,000 in 1991 were expensed as incurred, while betterments and replacements were capitalized. EXCESS OF COST OVER NET ASSETS OF COMPANIES ACQUIRED Excess of cost over net assets of companies acquired (goodwill) is being amortized on a straight-line basis over periods not exceeding forty years. The Company periodically reviews goodwill to assess recoverability, and impairments would be recognized in operating results if a permanent diminution in value were to occur. The amortization charged against earnings in 1993, 1992 and 1991 was $10,821,000, $10,807,000 and $10,804,000, respectively. Accumulated amortization at December 31, 1993 and 1992 was $73,562,000 and $62,741,000, respectively. FOREIGN CURRENCY TRANSLATION The financial position and results of operations of the Company's foreign subsidiaries are measured using local currency as the functional currency. Assets and liabilities of operations denominated in foreign currencies are translated into U.S. dollars at exchange rates in effect at year-end, while revenues and expenses are translated at average exchange rates prevailing during the year. The resulting translation gains and losses are charged directly to cumulative translation adjustment, a component of shareholders' equity, and are not included in net income until realized through sale or liquidation of the investment. Foreign exchange gains and losses incurred on foreign currency transactions are included in net income. POSTRETIREMENT AND POSTEMPLOYMENT BENEFITS OTHER THAN PENSIONS Statement of Financial Accounting Standards (SFAS) No. 106, "Employer's Accounting for Postretirement Benefits Other Than Pensions," was implemented by the Company in the first quarter of 1993. This statement requires the expected costs of providing postretirement benefits to be accrued during the years an employee provides services rather than the Company's past practice of recognizing these costs on the pay-as-you-go (cash) basis. At January 1, 1993, the Company's date of adoption, the actuarial present value of the accumulated benefit obligation for postretirement health care and other insurance benefits provided to certain retirees was $3,074,000. The Company is recognizing this transition obligation using the delayed recognition basis by amortizing the obligation on a straight-line basis over 20 years. The implementation of SFAS No. 106 in 1993 did not have a material impact on the Company's results of operations and had no effect on the Company's cash outlays for these retiree benefits. SFAS No. 112, "Employer's Accounting for Postemployment Benefits," was issued in November 1992 and must be implemented by the first quarter of 1994. This statement requires benefits to former employees after employment, but before retirement, to be accrued when it is probable that a liability has been incurred and the amount can be reasonably estimated. The impact of adopting SFAS No. 112 will not have a material effect on the Company's results of operations or financial position. ENVIRONMENTAL REMEDIATION AND COMPLIANCE Environmental remediation and compliance costs are accrued when environmental assessments and/or remedial efforts are probable, and the cost can be reasonably estimated. Accrued environmental remediation and compliance costs include remedial investigation and feasibility studies, outside legal, consulting and remediation project management fees, projected cost of remediation activities, site closure and postremediation monitoring costs. REVENUE RECOGNITION Generally, sales and revenues are recorded when products are shipped or services are rendered. Long-term contracts are accounted for under the percentage-of-completion method whereby sales and revenues are primarily recognized based upon costs incurred as a percentage of estimated total costs, and gross profits are recognized under a more conservative "efforts-expended method" primarily based upon direct labor costs incurred as a percentage of estimated total direct labor costs. Changes in estimates for sales and revenues, costs and gross profits are recognized in the period in which they are determinable using the cumulative catch-up method. Any anticipated losses on contracts are charged to current operations as soon as they are determinable. RESEARCH AND DEVELOPMENT Research and development costs are charged to expense as incurred and amounted to approximately $17,166,000 in 1993, $17,557,000 in 1992 and $19,482,000 in 1991. INCOME TAXES The Company adopted the provisions of SFAS No. 109, "Accounting for Income Taxes," as of January 1, 1992, and the cumulative effect of this change is reported separately in the 1992 Consolidated Statement of Income. Prior years' financial statements have not been restated to apply the provisions of SFAS No. 109. The adoption of SFAS No. 109 changed the Company's method of accounting for income taxes from the deferred method as required by Accounting Principles Board Opinion No. 11 (APB 11) to an asset and liability approach. Under the deferred method, annual income tax expense prior to 1992 was based on pre-tax financial accounting income and deferred taxes were provided at current rates for timing differences between financial accounting and taxable earnings. Under the asset and liability method, deferred taxes are established for the temporary differences between the financial reporting basis and the tax basis of the Company's assets and liabilities at enacted tax rates expected to be in effect when such amounts are realized or settled. Under SFAS No. 109, assets and liabilities acquired in purchase business combinations are assigned their fair values assuming equal tax bases, and deferred taxes are provided for lower or higher tax bases. Under APB 11, values assigned were net of tax. In adopting SFAS No. 109, the Company adjusted the carrying amounts of assets and liabilities acquired in purchase business combinations. As a result, pre-tax income from continuing operations was reduced by $1,520,000 for the year ended December 31, 1992 due to an increase in depreciation expense resulting from the higher carrying amounts of depreciable assets. The $7,337,000 charge recorded as of the beginning of 1992 for the cumulative effect on prior years of the change in the method of accounting for income taxes primarily represents the impact of adjusting deferred taxes recorded for assets and liabilities acquired in purchase business combinations. In connection with the Company's periodic reevaluation of foreign earnings estimated to be indefinitely reinvested, deferred income taxes of $14,000,000 were provided in 1993 for the estimated income tax liability that will be incurred upon the anticipated future repatriation of approximately $65,000,000 of foreign undistributed earnings in the form of dividends. Provision has not been made for U.S. or additional foreign taxes on the remaining $121,855,000 of undistributed earnings of foreign subsidiaries as those earnings are intended to be permanently reinvested. Such earnings would become taxable upon the sale or liquidation of these foreign subsidiaries or upon the remittance of dividends. It is not practicable to estimate the amount of deferred tax liability on foreign undistributed earnings which are intended to be permanently reinvested. EARNINGS PER SHARE Primary earnings per share for each of the respective years has been computed by dividing the net earnings, after deducting dividend requirements on cumulative convertible preferred stock, by the weighted average number of common and common equivalent shares outstanding during the year. The weighted average number of common and common equivalent shares for 1993, 1992 and 1991 was 9,655,000 shares, 9,620,000 shares and 9,534,000 shares, respectively. Fully diluted earnings per common share calculations for the assumed conversion of the cumulative convertible preferred stock were anti-dilutive in 1993, 1992 and 1991. NOTE 2. DISCONTINUED OPERATIONS During 1991, the Company adopted a formal plan to divest Sequa Capital's investment portfolio and to sell the Valley Line and Sabine Towing and Transportation operations in the Transportation segment, as well as the engineered services and the men's apparel units in the Professional Services and Other Products segment. During 1992, the Company completed the asset sales of Valley Line, Sabine Towing and Transportation and the Gemoco division of engineered services and in 1993, the Sturm unit of engineered services was sold. As of December 31, 1993, approximately $329,000,000 of Sequa Capital's investment portfolio had been sold, written down or otherwise disposed of since the Company adopted a formal plan to divest the portfolio. During the same period, Sequa Capital's debt was reduced from approximately $367,000,000 to zero. Efforts continue to divest the men's apparel unit and to liquidate Sales and revenues of discontinued operations prior to the measurement date were $130,429,000 in 1991. Net assets of discontinued operations approximate net realizable value and have been classified as noncurrent. A summary of the net assets of discontinued operations is as follows: Non-cash investment activities: In December 1993, the Company entered into two sale and leaseback agreements related to various Chromalloy Gas Turbine and Precoat Metals equipment. Aggregate cash proceeds from the sale of $20,845,000 have been presented as an investing activity in the accompanying Consolidated Statement of Cash Flows for the year ended December 31, 1993. The sales resulted in a loss on one transaction of $3,051,000, which is included in 1993 in Other, net in the Consolidated Statement of Income, and a gain on the other transaction of $5,738,000. The Company entered into agreements to lease back the equipment and recorded fixed assets and capital lease obligations in the amount of $20,845,000. The $5,738,000 gain on sale has been deferred and is being amortized to income over the life of the related leaseback agreement. In February 1991 and June 1991, the Company took title to several food can and lid manufacturing businesses with a fair market value of aproximately $25,400,000 from one of Sequa Capital's borrowers in settlement of debt owed to Sequa Capital. These transactions were accounted for as troubled debt restructurings, as defined by SFAS No. 15. Based upon fair values of the net assets received, Sequa Capital recorded pre-tax losses of $46,200,000 in 1991 and $45,000,000 in 1990. These losses were included in Loss from discontinued operations. Other supplemental cash flow information: NOTE 4. RESTRUCTURING CHARGE During 1993, the Company recorded restructuring charges totaling $26,640,000 primarily relating to plans adopted to reduce Gas Turbine's investment in plants that are engaged in activities other than the repair of components for flight engines, and to sell excess machinery and permanently reduce the number of employees in other Gas Turbine facilities. Included in the restructuring charges are: severance costs, $7,500,000; write-down of equipment to be sold, $4,100,000; write-down of inventory to net realizable value, $3,200,000; relocation of equipment, $1,800,000; write-down of other assets, $1,500,000; operating losses through date of sale, $6,500,000; other costs, $2,040,000. As of December 31, 1993, $20,689,000 of these amounts remained in Accrued expenses. NOTE 5. SALE OF ARC PROFESSIONAL SERVICES On December 30, 1993, the Company sold the stock of ARC Professional Services for gross cash proceeds of $59,926,000, and the purchaser assumed $4,524,000 of ARC Professional Services' debt. The sale resulted in a pre-tax gain of $12,408,000. ARC Professional Services had revenues of $162,606,000, $157,979,000 and $153,943,000 in 1993, 1992 and 1991, respectively, and operating income of $10,699,000, $9,278,000 and $10,805,000 in 1993, 1992 and 1991, respectively. The consolidated financial statements and accompanying footnotes reflect the operating results of ARC Professional Services as continuing operations. In connection with the sale of ARC Professional Services, the Company was contractually required to purchase the seven percent minority interest in Atlantic Research Corporation. In January 1994, the Company purchased the minority interest at a cost of $16,701,000. The excess of the book value of the minority interest acquired over the cost was $13,709,000. NOTE 6. OTHER, NET In 1993, Other, net included a $6,557,000 loss on interest rate options sold, $3,136,000 of discount expense related to the sale of accounts receivable, a $3,051,000 loss incurred on a sale and leaseback transaction, a $7,551,000 equity loss in the Company's unconsolidated airbag business, amortization of capitalized debt costs in the amount of $4,158,000, and $2,517,000 in charges for a minority shareholder's interest in the earnings of ARC. In 1992, Other, net included $3,912,000 of discount expense related to the sale of accounts receivable, a $4,709,000 equity loss in the Company's unconsolidated airbag business, amortization of capitalized debt costs in the amount of $3,074,000, and $1,704,000 in charges for a minority shareholder's interest in the earnings of ARC. In 1991, Other, net included several income items, offset by the following: $6,440,000 of discount expense related to the sale of accounts receivable, a $497,000 equity loss in the Company's unconsolidated airbag business, amortization of capitalized debt costs in the amount of $909,000, and $1,704,000 in charges for a minority shareholder's interest in the earnings of ARC. NOTE 7. RECEIVABLES In June 1993, Sequa Receivables Corporation (SRC), a wholly owned special purpose subsidiary of the Company, amended and restated its Receivables Purchase Agreement (the Receivables Agreement) and the receivables sales program agent thereunder assigned its interest in the Receivables Agreement to the group of banks which were party to the Company's revolving credit agreement. Under the Receivables Agreement, SRC was able to sell up to $65,000,000 of Company receivables without recourse. The Receivables Agreement, which was to expire in January 1994, was amended in December 1993 to allow SRC to sell up to $45,000,000 of receivables through March 1997. At December 31, 1993 and 1992, receivables as shown in the Consolidated Balance Sheet were net of $45,000,000 and $84,006,000, respectively, of receivable interests sold under the current and previous receivable sale agreements. Other, net, in the Consolidated Statement of Income includes discount expenses of $3,136,000 in 1993, $3,912,000 in 1992, and $6,440,000 in 1991, related to the sale of receivables under these agreements. Receivables at December 31, 1993 and 1992 have been reduced by allowances for doubtful accounts of $10,892,000 and $11,419,000, respectively. Unbilled receivables on fixed-price contracts arise as revenues are recognized under the percentage of completion method. These amounts are billable at specified dates, when deliveries are made or at contract completion, which is expected to occur within one year. All amounts included in unbilled receivables are related to long-term contracts and are reduced by appropriate progress billings. Unbilled amounts on cost-reimbursement contracts represent recoverable costs and accrued profits not yet billed. These amounts are billable upon receipt of contract funding, final settlement of indirect expense rates, or contract completion. Allowances for estimated nonrecoverable costs are primarily to provide for losses which may be sustained on contract costs awaiting funding and for the finalization of indirect expenses. Unbilled amounts at December 31, 1993 and 1992 are reduced by allowances for estimated nonrecoverable costs of $13,165,000 and $17,941,000, respectively. In December 1993, the Company entered into a new $150,000,000 revolving credit agreement with a group of banks that extends through March 1997. This agreement replaced an existing revolving credit agreement which was due to expire in January 1994. The rate of interest payable under the new agreement is, at the Company's option, a function of the prime rate or the Eurodollar rate. The agreement requires the Company to pay a facility fee at an annual rate of .5% of the maximum amount available under the credit line. Under the new credit facility, borrowings up to approximately $50,000,000 will be secured by the stock of certain of the Company's subsidiaries. At December 31, 1993, there were no borrowings outstanding under this facility; however, $18,500,000 of the available credit line was used for the issuance of letters of credit leaving $131,500,000 of unused credit available. Revolving credit debt at December 31, 1992 was classified as long-term, as the Company had the intent and the ability, supported by the terms of its existing revolving credit agreement, to maintain through January 1994 principal amounts outstanding under the agreement. In December 1993, the Company sold $125,000,000 of 8 3/4% senior unsecured notes due 2001 and $175,000,000 of 9 3/8% senior subordinated notes due 2003, pursuant to a public offering. The net proceeds from the offering together with proceeds from the sale of ARC Professional Services were used to repay $90,000,000 of indebtedness under the Company's existing revolving credit agreement, to repay $35,000,000 of the private placement due 1994 and to execute a partial in-substance defeasance of the Company's senior subordinated notes due 1998. In December 1993, the Company called $211,000,000 principal amount of the senior subordinated notes for redemption in January and February of 1994 and deposited $222,661,000 of U.S. government securities into an irrevocable trust to cover the principal amount called, the call premium of $9,847,000 and interest during the 30-day call period of $1,814,000. For financial reporting purposes, the debt has been considered extinguished; accordingly, the government securities, $211,000,000 principal amount of senior subordinated notes due 1998 and related unamortized debt issuance costs were removed from the Consolidated Balance Sheet at December 31, 1993 and the in- substance defeasance transaction resulted in an extraordinary loss of $8,524,000, net of tax benefits of $4,590,000. Based on the borrowing rates available to the Company for debt with similar terms and average maturities, the fair value of current and long-term debt at December 31, 1993 is approximately $669,000,000 compared with $648,090,000 included in the Consolidated Balance Sheet. The estimate is based on the present value of future debt and interest payments using specific discount rates which take into account the Company's credit ratings and maturity dates for each significant issue of debt. The Company has a policy aimed at managing interest rate risk associated with its current and future anticipated borrowings; accordingly, the Company has entered into various interest rate swaps, options, and similar arrangements. Any premiums paid or received in connection with these arrangements are deferred and amortized as yield adjustments over appropriate future periods. During 1993, the Company received proceeds of $9,796,000 from the early termination of interest rate swaps that were accounted for as hedges and that effectively converted $75,000,000 of fixed-rate debt into variable-rate borrowings. The resulting gains were deferred and are being amortized to income over the remaining original lives of the swaps terminated. At December 31, 1993, the Company had outstanding interest rate swaps expiring in 1996 that are accounted for as hedges and that effectively convert $50,000,000 of variable-rate borrowings under short-term financing facilities to fixed-rate borrowings with an average interest rate of 8.7%. Based upon market interest rates at the balance sheet date, the Company would have to pay approximately $5,200,000 to terminate its interest rate swaps outstanding at December 31, 1993. In addition, the Company adjusted to market value the carrying amount of interest rate options sold which gave the buyer the future right to enter into interest rate swaps. The resulting loss of $6,557,000 is included in Other, net in the Consolidated Statement of Income for 1993. The aggregate maturities of total long-term debt during the next five years are $23,998,000 in 1994, $10,874,000 in 1995, $14,620,000 in 1996, $2,176,000 in 1997 and $55,818,000 in 1998. The Company's loan agreements and indentures contain covenants which, among other matters, restrict or limit the ability of the Company to pay dividends, incur indebtedness, make capital expenditures, repurchase common and preferred stock, and repurchase the 9 3/8% senior subordinated notes due 2003. The Company must also maintain certain ratios regarding interest coverage, leverage and net worth, among other restrictions. At December 31, 1993, under the terms of the Company's senior subordinated notes due 1998, there is a $45,770,000 deficiency in consolidated retained earnings available for the payment of cash dividends and the repurchase of the Company's stock. As a result, common and preferred stock dividends were not declared in the third and fourth quarters of 1993. Under the terms of the Company's preferred stock, upon the Company's failure to make six consecutive quarterly dividend payments, the holders thereof, voting as a class, will have the right to elect two members of the Board of Directors of the Company at the next annual meeting of shareholders. These special voting rights terminate when all dividends in arrears have been paid. In addition, as of December 31, 1993, the Company's earnings were not sufficient to maintain a consolidated interest coverage ratio of 2.0 to 1.0 which, pursuant to the terms of the Company's senior notes due 2001 and the senior subordinated notes due 2003, precludes the Company from paying dividends among other restricted activities. The income tax provision (benefit) on income (loss) from continuing operations consisted of the following: As discussed in Note 1, Summary of Significant Accounting Policies, the Company adopted SFAS No. 109 as of January 1, 1992 and the cumulative effect of this change is reported separately in the 1992 Consolidated Statement of Income. Prior years' financial statements have not been restated to apply the provisions of SFAS No. 109. The 1993 and 1992 deferred tax provision represents the change in deferred tax liabilities and assets from the beginning of the year to the end of the year resulting from changes in the temporary differences between the financial reporting basis and the tax basis of the Company's assets and liabilities. These temporary differences are determined in accordance with SFAS No. 109 and are more inclusive in nature than timing differences as determined under previously applicable accounting principles. The Company has a tax net operating loss carryforward of $88,989,000 at December 31, 1993 which expires in 2006 through 2008 and will be used in the periods that net deferred tax liabilities mature. The tax capital loss carryforward of $95,565,000 at December 31, 1993 may expire unutilized in 1994 and 1995; accordingly, a valuation allowance has been established to reduce the deferred tax asset recorded for the capital loss carryforward to zero. The AMT credit carryforward can be carried forward indefinitely. During 1991, deferred taxes were provided for timing differences in the recognition of income and expense for tax and financial reporting purposes. The sources of significant timing differences generated by income from continuing operations which gave rise to deferred taxes were as follows: Note 13. Capital Stock The Company's capital stock consists of Class A and Class B common stock, and $5.00 cumulative convertible preferred stock. Holders of Class A common stock have one vote per share, holders of Class B common stock have ten votes per share and preferred stockholders have one vote per share. Holders of Class B common stock are entitled to convert their shares into Class A common stock at any time on a share-for-share basis. Each share of $5.00 cumulative convertible preferred stock is convertible into 1.322 shares of Class A common stock. The preferred stock is redeemable, at the option of the Company, at $100 per share. At December 31, 1993, 4,633,434 shares of Sequa Class A common stock were reserved for conversion of preferred and Class B common stock and stock options. NOTE 14. PENSION PLANS AND POSTRETIREMENT BENEFITS The Company sponsors various noncontributory defined benefit pension plans covering certain hourly and most salaried employees. The defined benefit plans provide benefits based primarily on the participant's years of service and compensation. It has been the Company's policy to fund domestic plans to meet the minimum funding requirements of the Employee Retirement Income Security Act (ERISA). Plan assets consist primarily of equity and fixed income securities. The status of all the Company's significant funded domestic and foreign defined benefit plans was as follows: The periodic net pension cost of all the Company's significant funded domestic and foreign defined benefit plans includes the following components: The net amortization and deferral component of pension cost includes $12,379,000 of deferred asset gains in 1993, $3,615,000 of deferred asset losses in 1992, and $9,703,000 of deferred asset gains in 1991. These unrecognized gains and losses resulted from actual returns on plan assets differing from the expected returns on plan assets. Such deferred gains and losses are subject to amortization in future periods. Pension expense includes a curtailment gain of $568,000 in 1992 and approximately $550,000 of costs in 1991 attributable to employees of discontinued operations who were participants in the Sequa Retirement Plan. Employees not covered by the defined benefit plans discussed above generally are covered by multiemployer plans as part of collective bargaining agreements or small local plans. Pension expense for these multiemployer plans and small local plans was not significant in the aggregate. The Company also has several nonfunded supplemental executive retirement plans for certain key executives. These plans provide for benefits that supplement those provided by the Company's other retirement plans. At December 31, 1993, the accumulated benefit obligation for these plans of $10,317,000 is included in Other long-term liabilities in the accompanying Consolidated Balance Sheet. The projected benefit obligation at December 31, 1993 totaled $10,904,000 and the expense for these plans was $1,919,000 in 1993, $2,221,000 in 1992, and $2,497,000 in 1991. Most of the Company's domestic non-union employees are eligible to participate in the Company's 401(k) plans. Expenses recorded for the Company's matching contributions under these plans were $7,146,000 in 1993, $8,602,000 in 1992, and $8,092,000 in 1991. SFAS No. 106, "Employer's Accounting for Postretirement Benefits Other Than Pensions," was implemented by the Company in the first quarter of 1993. This statement requires the expected costs of providing postretirement benefits to be accrued during the years an employee provides services rather than the Company's past practice of recognizing these costs on the pay-as-you-go (cash) basis. At January 1, 1993, the Company's date of adoption, the actuarial present value of the accumulated benefit obligation for postretirement health care and other insurance benefits provided to certain retirees was $3,074,000. The Company is recognizing this transition obligation using the delayed recognition basis by amortizing the obligation on a straight-line basis over 20 years. The actuarial and recorded liabilities for these post- retirement benefits, none of which have been funded, are as follows: The accumulated postretirement benefit obligation was determined using a discount rate of 7.5%, and an average health care cost trend rate of approximately 14% progressively decreasing to approximately 6% in the year 2008 and thereafter. Increasing the assumed health care cost trend rates by one percentage point in each year and holding all other assumptions constant would increase the accumulated postretirement benefit obligation as of December 31, 1993 by approximately $163,000 and increase the aggregate of the service and interest cost components of the net periodic postretirement benefit cost for 1993 by approximately $24,000. Operating income includes all costs and expenses directly related to the segment or geographic area. Identifiable assets are those used in each segment's operation. No single commercial customer accounted for more than 5% of sales and revenues in any year. The largest single contract with any one U.S. Government agency accounted for 2% of sales in 1993, 2% in 1992 and 4% in 1991. Prime and subcontracts with all government agencies accounted for 22%, 23% and 27% of sales and revenues in 1993, 1992 and 1991, respectively. NOTE 19. GOVERNMENT INVESTIGATIONS During the second quarter of 1993, the Company entered into agreements with the U.S. Attorney's Office, Southern District of New York (SDNY), and the Federal Aviation Administration (FAA) in connection with investigations by these offices and other related governmental agencies of the Company's Orangeburg facility and certain of its then employees begun in November 1992. Management believes that the investigations were in connection with allegations that the Orangeburg facility has performed repairs on certain parts in a defective manner and in violation of applicable requirements. The investigations resulted in the Orangeburg facility voluntarily surrendering its FAA repair operations in April 1993. Gas Turbine's other operating facilities, as well as work done for original equipment manufacturers at the Orangeburg facility, were unaffected by the suspension. The FAA restored the Orangeburg facility's FAA repair station certificate on June 10, 1993, ending the suspension of repair operations and resolving all FAA civil matters relating to the Orangeburg facility. Subsequently, the U.S. Attorney's Office, SDNY, entered into an agreement with the Company, under which it declined to prosecute the Company in connection with its investigation. In April 1993, the Company signed a consent order with the FAA providing for a non-punitive remedial payment by the Company of $5,000,000, representing the costs incurred by the FAA to investigate the Orangeburg facility and enforce its consent decree. In addition, under the terms of the agreement with the U.S. Attorney's Office, SDNY, the Company agreed to deposit $2,500,000 into a fund (with up to an additional $2,500,000 to be deposited, if needed) to cover the cost of testing and analyzing jet engine parts seized by federal authorities during an early stage of the investigations. As a result of the investigations and the related suspension, the Company incurred direct expenses in 1993 of $12,800,000. Direct expenses included the remedial payment to the FAA, the deposit of funds described above, severance payments and related legal fees and expenses. NOTE 20. CONTINGENCIES At December 31, 1993, the Company was contingently liable for outstanding letters of credit, not reflected in the accompanying consolidated financial statements, in the aggregate amount of approximately $66,271,000. In addition, the Company is involved in a number of claims, lawsuits and proceedings (environmental and otherwise) which arose in the ordinary course of business. Other litigation is pending against the Company involving allegations that are not routine and include, in certain cases, compensatory and punitive damage claims. Included in this other class of litigation is an arbitration proceeding that was formally commenced in 1992 to resolve a dispute between the Egyptian Air Force and Chromalloy Gas Turbine. In the damage portion of the arbitration hearing in October 1993, Chromalloy Gas Turbine claimed $29,600,000 in damages (which includes $17,500,000 of net assets in the accompanying Consolidated Balance Sheet) and the Egyptian Air Force counterclaimed for $46,500,000 in damages. The ultimate legal and financial liability of the Company in respect to all claims, lawsuits and proceedings referred to above cannot be estimated with any certainty. However, in the opinion of management, based on its examination of such matters, its experience to date and discussions with counsel, the ultimate outcome of these contingencies, net of liabilities already accrued in the Company's Consolidated Balance Sheet, is not expected to have a material adverse effect on the results of operations or financial position of the Company. (3) Senior Vice President - Atlantic Research Operations since February 1991; Vice President - Atlantic Research Operations from April 1990 to February 1991. Also serves as President and Chief Executive Officer of Atlantic Research Corporation and has held those positions since October 1989. From September 1985 to October 1989, Mr. Savoca served as a consultant to a number of companies, including Atlantic Research Corporation. From 1983 to September 1985, he was Chief Executive Officer of Transpace Carriers, Inc. From 1963 to 1983, he held planning and management positions with Thiokol Corporation, including, most recently, senior vice president and general manager of its solid rocket motor division. (4) Vice President - Gas Turbine Operations since May 1987 and Senior Vice President since February 1988. Also serves as Chairman and Chief Executive Officer of Chromalloy Gas Turbine Corporation (since January 1987) and previously was President of the CompTech Group of Chromalloy American Corporation. (5) Vice President and General Manager of Kollsman since August 1985 and Senior Vice President since February 1988. Previously, he was employed by Sperry Corporation where he served as Vice President of Sperry Defense Group from 1978 to 1983; Vice President of Operations for defense electronics products/northwest at Sperry from 1983 to July 1985. Sequa is not aware of any family relationship among any of the above-named executive officers. Each of such officers holds his office for a term expiring on the date of the annual organization meeting of the Board of Directors, subject to the provisions of Section 5 of Article IV of the Company's By-Laws relative to removal of officers. ITEMS 10 (IN PART) THROUGH 13 The Company intends to file with the Securities and Exchange Commission a definitive proxy statement pursuant to Regulation 14A involving the election of directors not later than 120 days after the end of its fiscal year ended December 31, 1993. Accordingly, the information required by Part III (Items 10 (concerning Sequa's directors and disclosure pursuant to Item 405 of Regulation S-K), 11, 12 and 13) is incorporated herein by reference to such definitive proxy statement in accordance with General Instruction G(3) to Form 10-K. 3. Exhibits Exhibit No. (Referenced to Item 601(b) of Regulation S-K) 3.1 - Restated Certificate of Incorporation of Sequa and two Certificates of Amendment of the Restated Certificate of Incorporation of Sequa (incorporated by reference to Exhibit 4(a) of Sequa's Registration Statement No. 33-12420 on Form S-8 filed on March 6, 1987). 3.2 - Certificate of Amendment of Certificate of Incorporation of Sequa, dated May 7, 1987 (incorporated by reference to Exhibit 3(b) of Sequa's Annual Report on Form 10-K for the year ended December 31, 1988, filed on March 28, 1989). 3.3 - Restated and amended (as of August 26, 1993) By-laws of Sequa, (incorporated by reference to Exhibit 3.3 of Sequa's Registration Statement No. 33-50843 on Form S- 1, filed on October 29, 1993). 4.1 - Indenture, dated as of December 15, 1993, by and between Sequa and Bankers Trust Company, as Trustee, and Form of 9 3/8% Senior Subordinated Note due December 15, 2003 (incorporated by reference to Exhibits 4.7 and 4.3, respectively, of Sequa's Registration Statement on Form 8-A, File No. 1-804, filed on January 25, 1994). 4.2 - Indenture, dated as of December 15, 1993, by and between Sequa and IBJ Schroder Bank & Trust Company, as Trustee, and Form of 8 3/4% Senior Note due December 15, 2001 (incorporated by reference to Exhibits 4.6 and 4.2, respectively, of Sequa's Registration Statement on Form 8-A, File No. 1-804, filed on January 25, 1994). 4.3 - Indenture with respect to $250,000,000 of Sequa 10-1/2% senior subordinated notes due 1998 (incorporated by reference to Amendment No. 1 to Form S-3 Registration Statement No. 33-21047 filed on April 17, 1988). 4.4 - Indenture, dated as of September 1, 1989, by and between Sequa and The First National Bank of Chicago, as Trustee, with respect to an aggregate of $250 million of senior debt (incorporated by reference to Exhibit 4.1 of Sequa's Form S-3 Registration Statement No. 33-30959, filed on September 12, 1989). 4.5 - First Supplemental Indenture, dated as of October 15, 1989, by and between Sequa and The First National Bank of Chicago, as Trustee (incorporated by reference to Exhibit 4.5 of Sequa's Registration Statement on Form 8-A, File No. 1-804, filed on January 25, 1994). 4.6 - Prospectus Supplement, dated October 19, 1989, for $150 million of senior unsecured 9 5/8% Notes due October 15, 1999 (incorporated by reference to Sequa's filing under Rule 424 (b)(2) on October 20, 1989). 4.7 - Purchase Agreement, dated October 19, 1989, by and between Sequa and certain Underwriters, and Form of Supplemental Indenture, dated as of October 15, 1989, both with respect to $150 million of senior unsecured 9 5/8% Notes due October 15, 1999 (incorporated by reference to Sequa's Report on Form 8-K, File No. 1- 804, filed on October 25, 1989) and Form of 9 5/8% Note (incorporated by reference to Exhibit 4.1 of Sequa's Registration Statement on Form 8-A, File No. 1-804, filed on January 25, 1994). 4.8 - Prospectus and Prospectus Supplement, both dated April 22, 1991, with respect to $100 million of medium-term notes (incorporated by reference to Sequa's filing under Rule 424 (b)(5) on April 23, 1991). 4.9 - Sales Agency and Distribution Agreement, executed as of April 22, 1991, by and among Sequa and Bear, Stearns & Co., Inc. and Merrill Lynch & Co., with respect to $100 million of medium-term notes, and Forms of Notes thereunder (incorporated by reference to Exhibits 4.1 and 12.1 of Sequa's Report on Form 8-K, File No. 1-804, filed on April 25, 1991). 4.10 - Instruments with respect to other long-term debt of Sequa and its consolidated subsidiaries are omitted pursuant to Item 601(b)(4)(iii) of Regulation S-K since the amount of debt authorized under each such omitted instrument does not exceed 10 percent of the total assets of Sequa and its subsidiaries on a consolidated basis. Sequa hereby agrees to furnish a copy of any such instrument to the Securities and Exchange Commission upon request. 10.1 - Amended and Restated Receivables Purchase Agreement, dated as of June 24, 1993, among Sequa, Sequa Receivables Corp., Chemical Bank, Barton Capital Corporation and Westpac Banking Corporation (incorporated by reference to Exhibit 10.1 of Sequa's Report on Form 8-K, File No. 1-804, filed on July 12, 1993) and Amendments No. 1 (dated as of September 30, 1993), No. 2 (dated as of December 1, 1993) and No. 3 (dated as of December 14, 1993) thereto (filed herewith). 10.2 - $150 Million Amended and Restated Credit Agreement, dated as of December 14, 1993, among Sequa Corporation, The Bank of New York, The Bank of Nova Scotia, Chemical Bank, Bank of America NT & SA, Chase Manhattan Bank, N.A. and The Nippon Credit Bank, Ltd. and certain other lenders (filed herewith). 10.3 Stock Purchase Agreement, dated December 30, 1993, by and among Sequa and various of its affiliates and Computer Sciences Corporation and its affiliates, in connection with the sale of ARC Professional Services Group, Inc., and certain related entities (incorporated by reference to Exhibit 10.1 of Sequa's Report on Form 8-K, File no. 1-804, filed on January 15, 1994). COMPENSATORY PLANS OR ARRANGEMENTS 10.4 - 1986 Key Employees Stock Option Plan (incorporated by reference to Annex B of Sequa's Registration Statement No. 33-12420 on Form S-8 filed March 6, 1987). 10.5 - 1988 Key Employees Stock Option Plan (incorporated by reference to Annex A of Sequa's Registration Statement No. 33-30711 on Form S-8 filed August 25, 1989). 10.6 - Sequa's Supplemental Executive Retirement Plans I, II, and III, effective as of January 1, 1990 (incorporated by reference to Exhibit 10(c) of Sequa's Annual Report on Form 10-K, File No. 1-804, for the year ended December 31, 1990, filed on April 1, 1991) and amendments thereto (incorporated by reference to Exhibit 10(c) of Sequa's Annual Report on Form 10-K, for the year ended December 31, 1991, filed on March 30, 1992). 10.7 - Management Incentive Bonus Program of Sequa for Corporate Executive Officers and Corporate Staff (filed herewith). 10.8 - Management Incentive Bonus Programs of Atlantic Research Corporation for Corporate Staff (filed herewith). 10.9 - Letter Agreements, dated May 24, 1984, by and between Norman E. Alexander and Sequa, and Stuart Z. Krinsly and Sequa (incorporated by reference to Exhibit 10(h) of Sequa's Annual Report on Form 10-K, File No. 1-804, for the year ended December 31, 1989, filed on March 30, 1990). 10.10 - Letter Agreements, dated April 30, 1990, by and between Norman E. Alexander and Sequa, and Stuart Z. Krinsly and Sequa (incorporated by reference to Exhibit 10 (h) of Sequa's Annual Report on Form 10-K, File No. 1-804, for the year ended December 31, 1990, filed on April 1, 1991). 10.11 - Employment Agreement, dated April 1, 1993, by and between John J. Quicke and Sequa, (incorporated by reference to Exhibit 10(k) of Sequa's Annual Report on Form 10-K, File No. 1-804 for the year ended December 31, 1992 filed on March 31, 1993). 10.12 - Employment Agreement, dated May 6, 1991, by and between Antonio L. Savoca and Sequa, (incorporated by reference to Exhibit 10(1) of Sequa's Annual Report on Form 10-K for the year ended December 31, 1991, filed on March 30, 1992). Amendment thereto, dated August 18, 1992 (incorporated by reference to Exhibit 10(1) of Sequa's Annual Report on Form 10-K, File No. 1-804 for the year ended December 31, 1992, filed on March 31, 1993); and Amendment thereto, dated June 10, 1993 (filed herewith). 10.13 - Employment Agreement, dated as of October 1, 1991, by and between Martin Weinstein and Chromalloy Gas Turbine Corporation, (incorporated by reference to Exhibit 10(n) of Sequa's Annual Report on Form 10-K, File No. 1-804 for the year ended December 31, 1991, filed on March 30, 1992) and Amendment thereto, dated as of June 1, 1993 by and between Chromalloy Gas Turbine Corporation and Martin Weinstein (incorporated by reference to Exhibit 10.14 of Sequa's Registration Statement No. 33-50843 on Form S-1 filed on October 29, 1993). 10.14 - Executive Life Insurance Plan of Sequa, (incorporated by reference to Exhibit 10(o) of Sequa's Annual Report on Form 10-K, File No. 1-804 for the year ended December 31, 1991, filed on March 30, 1992). 10.15 - Key Employee Medical Insurance Plan of Sequa, (incorporated by reference to Exhibit 10(p) of Sequa's Annual Report on Form 10-K, File No. 1-804 for the year ended December 31, 1991, filed on March 30, 1992). 10.16 - Exec-U-Care Medical Reimbursement Insurance Trust of Atlantic Research Corporation, (incorporated by reference to Exhibit 10(q) of Sequa's Annual Report on Form 10-K, File No. 1-804 for the year ended December 31, 1991, filed on March 30, 1992). 10.17 - Cafeteria Plan of Atlantic Research Corporation, (incorporated by reference to Exhibit 10(r) of Sequa's Annual Report on Form 10-K, File No. 1-804 for the year ended December 31, 1991, filed on March 30, 1992). 10.18 - Supplemental Retirement Program of Atlantic Research Corporation, (incorporated by reference to Exhibit 10(s) of Sequa's Annual Report on Form 10-K, File No. 1-804 for the year ended December 31, 1991, filed on March 30, 1992). 11.1 - Computation of earnings per share, filed herewith. 21.1 - List of subsidiaries of Sequa, filed herewith. 24.1 - Consent of Independent Public Accountants, filed herewith. (b) Reports on Form 8-K No Reports on Form 8-K were filed during the last quarter of 1993. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SUPPLEMENTAL SCHEDULES To Sequa Corporation: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in Sequa Corporation's Annual Report on Form 10-K, and have issued our report thereon dated March 21, 1994. Our audit was made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in Item 14(a)2 are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. New York, New York March 21, 1994

7536_1993.txt

7536

1993

Item 1. Business. Arrow Electronics, Inc. (the "company") is the world's largest distributor of electronic components and computer products to industrial and commercial customers. The company's electronics distribution networks, spanning North America, Europe, and the Pacific Rim, incorporate over 150 selling locations, ten primary distribution centers (four of which employ advanced automation), and 4,000 remote on-line terminals--all serving the needs of a diversified base of original equipment manufacturers (OEMs) and commercial customers worldwide. OEMs include manufacturers of computer and office products, industrial equipment (including machine tools, factory automation, and robotic equipment), telecommunications products, aircraft and aerospace equipment, and scientific and medical devices. Commercial customers are mainly value-added resellers (VARs) of computer systems. In 1993, the company acquired an additional 15% share in Spoerle Electronic, the largest electronics distributor in Germany, increasing its holdings to a majority interest. The company also acquired Zeus Components, Inc. a distributor of high-reliability electronic components and value-added services, Microprocessor & Memory Distribution Limited, a focused U.K. distributor of high- technology semiconductor products, and Components Agent Limited, one of the largest distributors in Hong Kong. In addition, in 1993 the company acquired Amitron S.A. and ATD Electronica S.A., distributors serving the Spanish and Portuguese markets, and CCI Electronique, a distributor serving the French marketplace. On February 28, 1992, the company acquired the electronics distribution businesses of Lex Service PLC ("Lex") in the U.K. and France (the "European businesses"), and Spoerle acquired the electronics distribution business of Lex in Germany. On September 27, 1991, the company acquired Lex Electronics Inc. and Almac Electronics Corporation, the North American electronics distribution businesses of Lex (the "North American businesses"), the third largest electronics distribution business in the United States. Early in 1994, the company acquired an additional 15% interest in Spoerle, bringing its holdings to 70%, and increased its holdings in Silverstar, the company's Italian affiliate, to a majority share. Additionally, the company acquired the electronic component distribution business of Field Oy, the largest distributor of electronic components in Finland, and TH:s Elektronik, a leading distributor in Sweden and Norway. For information with respect to these acquisitions, the company's results of operations, and other matters, see Item 6 (Selected Financial Data), Item 7 (Management's Discussion and Analysis of Financial Condition and Results of Operations), and Item 8 (Financial Statements) appearing elsewhere in this Annual Report. In North America, the company is organized into four product- specific sales and marketing groups: The Arrow/Schweber Electronics Group is the largest dedicated semiconductor distributor in the world. Zeus Electronics is the only specialist distributor serving the military and high-reliability markets. Capstone Electronics focuses exclusively on the distribution of connectors, electromechanical, and passive components. And Arrow's Commercial Systems Group distributes commercial computer products and systems. Through its wholly-owned subsidiary, Arrow Electronics Distribution Group - Europe B. V., Arrow is the largest pan-European electronics distributor. The company's European strategy stresses two key elements: strong, locally-managed distributors to satisfy widely varying customer preferences and business practices; and an electronic backbone uniting Arrow's European partners with one another and with Arrow worldwide to leverage inventory investment and better meet the needs of customers in all of Europe's leading industrial electronics markets. In most of these markets, Arrow companies hold the number one position: Arrow Electronics (UK) Ltd. in Britain; Spoerle Electronic in Central Europe; Silverstar Ltd. S.p.A. in Italy; and Amitron-Arrow and ATD Electronica S.A. in Spain and Portugal. Arrow Electronique is the fourth largest electronics distributor in France, and Arrow's Nordic companies, Field Oy and TH:s Elektronik, are among the largest distributors in the markets of Finland, Norway, and Sweden. Arrow is the first American electronics distributor to be present in the Pacific Rim market. Arrow's Components Agent Limited (C.A.L.), headquartered in Hong Kong, is the region's leading multinational distributor, maintaining seven additional facilities in key cities in Singapore, Malaysia, the People's Republic of China, and South Korea; an additional Arrow company serves India. Within these dynamic markets, Arrow is benefiting from two important growth factors: the decision by many of Arrow's traditional North American customers to locate production facilities in the region and the surging demand for electronic products resulting from rising living standards and massive investments in infrastructure. The company distributes a broad range of electronic components, computer products, and related equipment manufactured by others. About 66% of the company's consolidated sales are of semiconductor products; industrial and commercial computer products, including microcomputer boards and systems, design systems, desktop computer systems, terminals, printers, disc drives, controllers, and communication control equipment account for about 24%; and the remaining 10% of sales are of passive, electromechanical, and connector products, principally capacitors, resistors, potentiometers, power supplies, relays, switches and connectors. Worldwide, the company maintains a $435 million inventory of more than 300,000 different electronic components and computer products at the company's primary distribution centers. Most manufacturers of electronic components and computer products rely on independent authorized distributors such as the company to augment their product marketing operations. As a stocking, marketing and financial intermediary, the distributor relieves its manufacturers of a portion of the costs and personnel associated with stocking and selling their products (including otherwise sizable investments in finished goods inventories and accounts receivable), while providing geographically dispersed selling, order processing, and delivery capabilities. At the same time, the distributor offers a broad range of customers the convenience of diverse inventories and rapid or scheduled deliveries. The growth of the electronics distribution industry has been fostered by the many manufacturers who recognize their authorized distributors as essential extensions of their marketing organizations. The company and its affiliates serve approximately 125,000 industrial and commercial customers in North America, Europe, and the Pacific Rim. Industrial customers range from major original equipment manufacturers to small engineering firms, while commercial customers include value-added resellers, small systems integrators, and large end-users. Most of the company's customers require delivery of the products they have ordered on schedules that are generally not available on direct purchases from manufacturers, and frequently their orders are of insufficient size to be placed directly with manufacturers. No single customer accounted for more than 2% of the company's 1993 sales. The electronic components and other products offered by the company are sold by field sales representatives, who regularly call on customers in assigned market areas, and by telephone from the company's selling locations, from which inside sales personnel with access to pricing and stocking data provided by computer display terminals accept and process orders. Each of the company's North American selling locations, warehouses, and primary distribution centers is electronically linked to the business' central computer, which provides fully integrated, on-line, real-time data with respect to nationwide inventory levels and facilitates control of purchasing, shipping, and billing. The company's foreign operations utilize Arrow's Worldwide Stock Check System, which affords access to the company's on-line, real-time inventory system. Sales are managed and coordinated by regional sales managers and by product managers principally located at the company's headquarters in Melville, New York. Of the approximately 200 manufacturers whose products are sold by the company, the ten largest accounted for about 57% of the business' purchases during 1993. Intel Corporation accounted for approximately 18% of the business' purchases because of the market demand for microprocessors. No other supplier accounted for more than 9% of 1993 purchases. The company does not regard any one supplier of products to be essential to its operations and believes that many of the products presently sold by the company are available from other sources at competitive prices. Most of the company's purchases are pursuant to authorized distributor agreements which are typically cancelable by either party at any time or on short notice. Approximately 62% of the company's inventory consists of semiconductors. It is the policy of most manufacturers to protect authorized distributors, such as the company, against the potential write-down of such inventories due to technological change or manufacturers' price reductions. Under the terms of the related distributor agreements, and assuming the distributor complies with certain conditions, such suppliers are required to credit the distributor for inventory losses incurred through reductions in manufacturers' list prices of the items. In addition, under the terms of many such agreements, the distributor has the right to return to the manufacturer for credit a defined portion of those inventory items purchased within a designated period of time. A manufacturer who elects to terminate a distributor agreement is generally required to purchase from the distributor the total amount of its products carried in inventory. While these industry practices do not wholly protect the company from inventory losses, management believes that they currently provide substantial protection from such losses. The company's business is extremely competitive, particularly with respect to prices, franchises, and, in certain instances, product availability. The company competes with several other large multinational, national, and numerous regional and local, distributors. As the world's largest electronics distributor, the company is greater in terms of financial resources and sales than most of its competitors. The company and its affiliates employ approximately 4,600 people worldwide. Executive Officers The following table sets forth the names and ages of, and the positions and offices with the company held by, each of the executive officers of the company. Name Age Position or Office Held John C. Waddell 56 Chairman of the Board Stephen P. Kaufman 52 President and Chief Executive Officer Robert E. Klatell 48 Senior Vice President, Chief Financial Officer, General Counsel, Secretary, and Treasurer Carlo Giersch 56 President and Chief Executive Officer of Spoerle Electronic Robert J. McInerney 48 Vice President; President, Commercial Systems Group Steven W. Menefee 49 Vice President; President, Arrow/Schweber Electronics Group Wesley S. Sagawa 46 Vice President; President, Capstone Electronics Corp. Jan Salsgiver 37 Vice President; President, Zeus Electronics Set forth below is a brief account of the business experience during the past five years of each executive officer of the company. John C. Waddell has been Chairman of the Board of the company for more than five years. Stephen P. Kaufman has been President and Chief Executive Officer of the company for more than five years. Robert E. Klatell has been Senior Vice President and has served as General Counsel and Secretary of the company for more than five years. He has been Chief Financial Officer since January 1992 and Treasurer of the company since October 1990. Carlo Giersch has been President and Chief Executive Officer of Spoerle Electronic for more than five years. Robert J. McInerney has been a Vice President of the company for more than 5 years and President of the company's Commercial Systems Group since April 1989. Steven W. Menefee has been a Vice President of the company and President of the company's Arrow/Schweber Electronics Group since November 1990. For more than five years prior thereto, he was a Vice President of Avnet, Inc., principally an electronics distributor, and an executive of Avnet's Electronic Marketing Group. Wesley S. Sagawa has been a Vice President of the company for more than 5 years and President of Capstone Electronics Corp., the company's subsidiary which markets passive, electromechanical, and connector products, since January 1990. Jan Salsgiver has been a Vice President of the company since September 1993 and President of the company's Zeus Electronics since July 1993. For more than five years prior thereto, she held a variety of senior marketing positions in the company, the most recent of which was Vice President, Semiconductor Marketing of the Arrow/Schweber Electronics Group. Item 2.

Item 2. Properties. The company's executive office, located in Melville, New York, is owned by the company. The company occupies additional locations under leases due to expire on various dates to 2016. One additional facility is owned by the company, and another two facilities have been sold and leased back in connection with the financing thereof. Item 3.

Item 3. Legal Proceedings. Through a wholly-owned subsidiary, Schuylkill Metals Corporation, the company was previously engaged in the refining and selling of lead. In September 1988, the company sold its refining business. In mid-1986 the refining business ceased operations at its battery breaking facility in Plant City, Florida, which facility had been placed on the list of hazardous waste sites targeted for cleanup under the federal Super Fund Program. The Plant City site was not sold to the purchaser of the refining business, and the company remains subject to various environmental cleanup obligations at the site under federal and state law. During 1991, the company engaged in settlement negotiations with the EPA, resulting in the execution of a consent decree defining those obligations which was entered by a federal court in Florida and became effective on April 22, 1992. The consent decree requires the company to fund and implement remedial design and remedial action activity addressing environmental impacts to site soils and sediment, underlying ground water, and wetland areas. The company, through its technical contractors, has begun implementation of these requirements. Between January 1, 1993 and the date of this report, a substantial amount of the work necessary to prepare the site for the planned remediation activities was completed, the plans for the treatment and discharge of ground water contemplated by the consent decree were finalized, the plans for the remediation and mitigation of the wetland areas were finalized and approved in principle by the relevant agencies, and the company began the bid process for certain of the contracts relating to the performance of the remediation activities (including a previously-agreed upon plan for treating soils and sediment). Such activities are expected to commence in mid-1994 and the company believes that a substantial part of such activities will be completed over the next three years. The extent of such remediation activities (including the estimated cost thereof and the time necessary to complete them) is subject to change based upon conditions actually encountered during remediation, and the EPA reserves the right to seek additional action if it subsequently finds further contamination or other conditions rendering the work insufficiently protective of human health or the environment. The company believes that the amount expected to be expended in any year to fund such activities will not have a material adverse impact on the company's liquidity, capital resources or results of operations. Item 4.

Item 4. Submission of Matters to a Vote of Security Holders. None. PART II Item 5.

Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters. Market Information The company's common stock is listed on the New York Stock Exchange (trading symbol: "ARW"). The high and low sales prices during each quarter of 1993 and 1992 were as follows: Year High Low 1993: Fourth Quarter $42-1/4 $33-5/8 Third Quarter 43-1/8 34-5/8 Second Quarter 36-1/4 29-3/4 First Quarter 34-3/8 26-1/2 1992: Fourth Quarter $30-1/2 $22-1/8 Third Quarter 22-3/4 18-1/2 Second Quarter 19-1/2 15-1/8 First Quarter 18-1/2 14-3/8 Holders On March 9, 1994, there were approximately 4,000 shareholders of record of the company's common stock. Dividend History and Restrictions The company has not paid cash dividends on its common stock during the past two years. While it is the intention of the Board of Directors to consider the payment of dividends on the common stock from time to time, the declaration of future dividends will be dependent upon the company's earnings, financial condition, and other relevant factors. The terms of the company's U.S. credit agreement, senior notes, and certain foreign debt (see Note 4 of the Notes to Consolidated Financial Statements) restrict the payment of cash dividends, limit long-term debt and short-term borrowings, and require that the ratio of earnings to interest expense, ratio of operating cash flow to interest expense, working capital, and net worth be maintained at certain designated levels. Item 6.

Item 6. Selected Financial Data. The following table sets forth certain selected consolidated financial data and should be read in conjunction with the company's consolidated financial statements and related notes appearing elsewhere in this Annual Report. Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. For an understanding of the significant factors that influenced the company's performance during the past three years, the following discussion should be read in conjunction with the consolidated financial statements and other information appearing elsewhere in this report. Included in the 1993 consolidated results is Spoerle Electronic, which had been accounted for under the equity method prior to January 1993 when the company acquired an additional 15% share, increasing its holdings to a majority interest. The 1993 consolidated results also include the acquired businesses of Zeus Components, Inc., a distributor of high- reliability electronic components and value-added services, Microprocessor & Memory Distribution Limited, a focused U.K. distributor of high- technology semiconductor products, and Components Agent Limited, one of the largest distributors in Hong Kong. In addition, the 1993 results include Amitron-Arrow S.A. and ATD Electronica S.A., distributors serving the Spanish and Portuguese markets, and CCI Electronique, a distributor serving the French marketplace. On February 28, 1992, the company acquired the electronics distribution businesses of Lex Service PLC ("Lex") in the U.K. and France (the "European businesses"), and Spoerle Electronic acquired the electronics distribution business of Lex in Germany. On September 27, 1991, the company acquired Lex Electronics Inc. and Almac Electronics Corporation, the North American electronics distribution businesses of Lex (the "North American businesses"), the third largest electronics distribution business in the United States. See Note 2 of the Notes to Consolidated Financial Statements for information with respect to the 1993 and 1992 acquisitions and the pro forma effect of these transactions on the company's statement of operations. Sales In 1993, consolidated sales of $2.5 billion were 56% ahead of the 1992 sales of $1.6 billion. Excluding Spoerle, sales were $2.2 billion, an advance of 34% over the year-earlier period. This sales growth was principally due to increased activity levels in each of the company's distribution groups and, to a lesser extent, acquisitions in North America, Europe, and the Pacific Rim, offset in part by weaker currencies in Europe. Consolidated sales of $1.6 billion in 1992 were 55% higher than 1991 sales of $1 billion. This increase principally reflects the acquisitions of the North American and European businesses in September 1991 and February 1992, respectively, and increased North American sales. In 1991, consolidated sales of $1 billion were 7.5% higher than 1990 sales of $971 million. The increase in sales primarily reflects the inclusion of the North American businesses during the fourth quarter of 1991, which more than offset the 5% decrease in sales for the nine months ended September 30, 1991 principally resulting from declining sales of commercial computer products and related systems owing to soft market conditions. Operating Income In 1993, the company's consolidated operating income increased to $181.5 million, compared with 1992 operating income of $103.8 million. The significant improvement in operating income reflects the impact of increased sales and the consolidation of Spoerle, offset in part by lower gross profit margins primarily reflecting proportionately higher sales of low-margin microprocessors. Excluding Spoerle, operating income was $146.2 million in 1993, and operating expenses as a percentage of sales were 12.4%, the lowest in the company's history. The company's 1992 consolidated operating income increased to $103.8 million, compared with operating income of $34.4 million in 1991. Operating income in 1991 included the recognition of approximately $9.8 million of costs associated with the integration of the North American businesses. The significant improvement in operating income in 1992 primarily reflected the impact of the company's acquisition of the North American businesses, improved gross profit margins reflecting a product mix now more heavily weighted to semiconductor products, and improved North American sales. The rapid and successful integration of the North American businesses resulted in the realization of sizable economies of scale which, when combined with increased sales, enabled the company to reduce operating expenses as a percentage of sales from 17.6% in 1991 to 14.7% in 1992, the then lowest level in the company's history. Such economies of scale principally resulted from reductions in personnel performing duplicative functions and the elimination of duplicative administrative facilities, selling and stocking locations, and computer and telecommunications equipment. In 1991, the company's consolidated operating income increased to $34.4 million, an advance of 5% over 1990. This improvement was principally the result of increased sales and reduced operating expenses as a percentage of sales in the fourth quarter of 1991. The improved fourth quarter operating results, combined with lower operating expenses through September 1991, more than offset the special charge of $9.8 million reflecting integration expenses associated with the North American businesses, the effect of a 5% decrease in sales through September 1991, and a decrease in the company's gross profit margin as a result of competitive pricing pressures in the commercial computer products and related systems markets. Interest In 1993, interest expense decreased to $25 million from $30.1 million in 1992. The decrease principally reflects the full-year effect of the retirement during 1992 of $46 million of the company's 13-3/4% subordinated debentures and the refinancing of the company's remaining high-yield debt with securities bearing lower interest rates, offset in part by the consolidation of Spoerle and borrowings associated with acquisitions. Interest expense of $30.1 million in 1992 increased by $.9 million from the 1991 level, reflecting the company's borrowings to finance the cash portion of the purchase price of the North American and European businesses, to pay fees and expenses relating to the acquisitions, to refinance existing credit facilities of the company, and to provide the company with working capital. Such increased borrowings were partially offset by the company's redemption in May of $46 million of its 13-3/4% subordinated debentures with the proceeds from the public offering of 4.7 million shares of common stock and lower effective interest rates. In 1991, interest expense of $29.1 million increased $.1 million from 1990's level as the financing expense for the purchase of the North American businesses offset lower interest rates and reduced borrowings resulting from operating cash flow and improvements in asset management. Income Taxes In 1993, the company's effective tax rate was 40.7% compared with 37.4% in 1992. The higher effective tax rate reflects increased U.S. taxes as a result of higher statutory rates and the consolidation of Spoerle. The company recorded a provision for taxes at an effective tax rate of 37.4% in 1992 compared with 20.4% in 1991. The higher effective tax rate reflects the depletion of the company's remaining $5.8 million U.S. net operating loss carryforwards in 1991. The company's effective tax rate in 1991 was 20.4%, principally as a result of the utilization of the remaining $5.8 million of U.S. net operating loss carryforwards. Net Income Net income in 1993 was $81.6 million, an advance from $44.8 million in 1992 (after giving effect to extraordinary charges of 5.4 million reflecting the net unamortized discount and issuance expenses associated with the redemption of high-coupon subordinated debentures and other debt in 1992). The increase in net income is due principally to the increase in operating income and lower interest expense offset in part by higher taxes. The company recorded net income of $50.2 million in 1992, before extraordinary charges aggregating $5.4 million, compared with net income of $8.7 million in 1991. Including these charges, net income in 1992 was $44.8 million. Included in 1991's results was a special charge of $9.8 million ($6.5 million after taxes) associated with the integration of the acquired businesses. The improvement in net income was principally the result of the increase in operating income offset in part by the higher provision for income taxes. The company's net income in 1991 of $8.7 million decreased 14% from $10.1 million in 1990. The decrease in net income was principally the result of the $9.8 million special charge ($6.5 million after taxes) reflecting integration expenses associated with the North American businesses and the provision for income taxes. Excluding the special charge, net income was $15.2 million, an increase of 50% over 1990. Net income also included the company's equity in earnings of affiliated companies of $1.7 million in 1993, $6.6 million in 1992, and $5.7 million in 1991. The decrease in the company's equity in earnings of affiliated companies in 1993 was due to the consolidation of Spoerle. In 1993, the earnings of Silverstar, the company's Italian affiliate, advanced as a result of significant sales growth offset in part by a weaker lira. The increase in the company's equity in earnings of affiliated companies in 1992 was the result of Silverstar's profitability. The decrease in 1991 was the result of lower earnings in Germany and a loss in Italy. Liquidity and Capital Resources The company maintains a high level of current assets, primarily accounts receivable and inventories. Consolidated current assets as a percentage of total assets were 73% in 1993 and 70% in 1992. Working capital increased in 1993 by $160 million, or 43%, compared with 1992, as a result of increased sales, the consolidation of Spoerle, and acquisitions. Working capital increased by $42 million in 1992, as a result of the acquisition of the European businesses and increased sales. The net amount of cash provided by operations in 1993 was $41.7 million, the principal element of which was the cash flow resulting from higher net earnings offset by increased working capital needs to support sales growth. The net amount of cash used by the company for investing activities in 1993 amounted to $111.7 million, including $87.9 million for various acquisitions. Cash flows from financing activities were $100.3 million, principally resulting from increased borrowings to finance the 1993 acquisitions in the U.S., Europe, and the Pacific Rim (see Notes 2 and 4 of the Notes to Consolidated Financial Statements for additional information regarding these acquisitions). In September 1993, the company completed the conversion of all of its outstanding series B $19.375 convertible exchangeable preferred stock, into 1,009,086 shares of its common stock. This conversion eliminated the company's obligation to pay $1.3 million of annual dividends. The net amount of cash provided by operating activities in 1992 was $71.5 million, attributable primarily to the higher net earnings of the company. The net amount of cash used by the company for investing activi- ties in 1992 amounted to $45.8 million, including $37.2 million for the acquisition of the European businesses. The aggregate cost of the company's acquisition of the electronics distribution businesses of Lex in the U.K. and France, and Spoerle's acquisition of the Lex electronics distribution business in Germany, was $52 million, of which $32 million was paid in cash and $20 million was paid in the form of a senior subordinated note due in June 1997. The company financed the cash portion of the purchase price through the sale of 66,196 shares of newly-created series B preferred stock and U.K. bank borrowings. In addition, a portion of the proceeds from the company's public offering of common stock and the issuance of the 5-3/4% convertible subordinated debentures was used to repay the senior subordinated note. The German business was purchased by Spoerle for cash (see Notes 2, 4, and 6 of the Notes to Consolidated Financial Statements for additional information regarding these acquisitions). The net amount of cash used for financing activities in 1992 was $23.9 million, principally reflecting the redemption of high-yield subordinated debentures, repayment of long-term debt, and the payment of preferred stock dividends and financing fees, offset by the public offering of 4,703,500 shares of common stock and the 5-3/4% convertible subordinated debentures, the issuance of the senior secured notes, and U.K. bank borrowings. In September 1992, the company completed the conversion of all of its outstanding depositary shares, each representing one-tenth share of its $19.375 convertible exchangeable preferred stock, into 3,615,056 shares of its common stock. This conversion eliminated the company's obligation to pay $4.6 million of annual dividends relating to the depositary shares. Early in 1994, the company purchased an additional 15% share in Spoerle for approximately $23 million in cash. The company financed the acquisition through its U.S. credit agreement and German bank borrowings. Additionally, the company increased its holdings in Silverstar to a majority share and acquired the electronic component distribution business of Field Oy, the largest distributor of electronic components in Finland, and TH:s Elektronik, a leading distributor in Sweden and Norway. Item 8.

Item 8. Financial Statements. REPORT OF ERNST & YOUNG, INDEPENDENT AUDITORS The Board of Directors and Shareholders Arrow Electronics, Inc. We have audited the accompanying consolidated balance sheet of Arrow Electronics, Inc. as of December 31, 1993 and 1992, and the related consolidated statements of operations, cash flows, and shareholders' equity for each of the three years in the period ended December 31, 1993. Our audits also included the financial statement schedules listed in the Index at Item 14(a). These financial statements and schedules are the responsibility of the company's management. Our responsibility is to express an opinion on these financial state- ments and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Arrow Electronics, Inc. at December 31, 1993 and 1992, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting princi- ples. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. ERNST & YOUNG New York, New York February 24, 1994 See accompanying notes. See accompanying notes. See accompanying notes. See accompanying notes. ARROW ELECTRONICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992, AND 1991 1. Summary of Significant Accounting Policies Principles of Consolidation The financial statements include the accounts of the company and its consolidated subsidiaries. The company's investments in its affiliated companies which are not majority-owned are accounted for using the equity method. All significant intercompany transactions are eliminat- ed. Basis of Presentation Certain prior year amounts have been reclassified to conform to the current year's presentation. Inventories Inventories are stated at the lower of cost or market. Cost is deter- mined on the first-in, first-out (FIFO) method. Property and Depreciation Depreciation is computed on the straight-line method for financial reporting purposes and on accelerated methods for tax reporting purpos- es. Leasehold improvements are amortized over the shorter of the term of the related lease or the life of the improvement. Cost in Excess of Net Assets of Companies Acquired The cost in excess of net assets of companies acquired is being amor- tized on a straight-line basis, principally over 40 years. Foreign Currency The assets and liabilities of foreign operations are translated at the exchange rates in effect at the balance sheet date, with the related translation gains or losses reported as a separate component of share- holders' equity. The results of foreign operations are translated at the weighted average exchange rates for the year. Gains or losses resulting from foreign currency transactions, other than transactions used to hedge the value of foreign investments, are included in the statement of operations. ARROW ELECTRONICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONTINUED Income Taxes Effective January 1, 1991, the company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"), which requires that the accounting for income taxes be on the liability method. Deferred taxes reflect the tax consequences on future years of differences between the tax bases of assets and liabilities and their financial reporting amounts. Net Income Per Common Share Net income per common share is computed after deducting preferred stock dividends and is based upon the weighted average number of shares of common stock and common stock equivalents outstanding. The average number of common stock equivalents was 631,973, 885,137, and 552,128 for 1993, 1992, and 1991, respectively. Net income per common share on a fully diluted basis assumes that the convertible exchangeable preferred shares and the convertible subordi- nated debentures were converted to common stock at either the beginning of each period or the date of issuance. The dividends related to the convertible exchangeable preferred stock and the interest expense on the 5-3/4% convertible subordinated debentures, net of taxes, are eliminat- ed. The 9% convertible subordinated debentures are not assumed to be converted into common stock in 1992 as they would have been antidilutive. For 1991, the aforementioned adjustments were not required as they would have been antidilutive. Cash and Short-term Investments Short-term investments which have a maturity of ninety days or less at time of purchase are considered cash equivalents in the statement of cash flows. The carrying amount reported in the balance sheet for cash and short-term investments approximates its fair value. 2. Acquisitions of Electronics Distribution Businesses In January 1993, the company acquired an additional 15% share, for approximately $25,145,000, in Spoerle Electronic Handelsgessellschaft mbH and Co. and its general partner, Spoerle GmbH (collectively, "Spoerle") the largest distributor of electronic components in Germany, increasing its holdings to a 55% majority interest. In May 1993, the company acquired the high-reliability electronic component distribution and value-added service businesses of Zeus Components, Inc. ("Zeus"). In June 1993, the company acquired Microprocessor & Memory Distribution Limited ("MMD"), a U.K.-based electronics distributor which focuses on the distribution of high-technology semiconductor products. In August 1993, the company acquired Components Agent Limited, one of the largest electronics distributors in Hong Kong. During the third quarter of 1993 the company acquired a majority interest in Amitron S.A. and the ATD Group, electronics distributors serving the Spanish and Portuguese markets. In November 1993, the company augmented its French operations by acquiring CCI Electronique. The aggregate cost of the acquisitions was $87,875,000, including $4,757,000 for non-competition agreements. Each acquisition was accounted for as a purchase transaction beginning in the month of acquisition. ARROW ELECTRONICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONTINUED The following summarizes the allocation of the aggregate consider- ation paid for the aforementioned acquisitions, except Spoerle, to the fair market value of the assets acquired and liabilities assumed by the company (in thousands): Current assets: Accounts receivable ..................$48,010 Inventories........................... 31,726 Other................................. 2,972 $ 82,708 Property, plant and equipment........... 3,876 Cost in excess of net assets of acquired businesses................... 50,797 Other assets............................ 9,113 146,494 Current liabilities: Accounts payable.....................$(30,412) Accrued expenses..................... (35,374) Other................................ (16,789) (82,575) Net consideration paid................. $ 63,919 In February 1992, the company acquired the electronics distribution businesses of Lex Service PLC ("Lex") in the U.K. and France, and Spoerle acquired the electronics distribution business of Lex in Germany. The aggregate cost of the acquisitions was $51,983,000, of which $31,983,000 was paid in cash and $20,000,000 was paid in the form of a 12% senior subordinated note due June 1997. The company financed the cash portion of the purchase price through the sale of 66,196 shares of newly-created series B preferred stock and bank borrowings in the U.K. The German business of Lex was purchased by Spoerle for cash of $14,800,000. The acquisitions of the European businesses of Lex are being accounted for as purchase transactions effective February 28, 1992. The following summarizes the allocation of the consideration paid for the electronics distribution businesses in the U.K. and France to the fair market value of the assets acquired and liabilities assumed by the company (in thousands): Current assets: Accounts receivable.................$ 27,479 Inventories......................... 17,947 Other............................... 1,662 $ 47,088 Property, plant and equipment......... 2,975 Cost in excess of net assets of acquired businesses.................. 21,065 Other assets......................... 3,150 74,278 Current liabilities: Accounts payable.....................$(10,397) Accrued expenses..................... (26,698) (37,095) Net consideration paid............... $ 37,183 ARROW ELECTRONICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONTINUED In September 1991, the company acquired the North American electronics distribution businesses of Lex, consisting of Lex Electron- ics Inc. and Almac Electronics Corporation (collectively the "North American businesses"). The aggregate cost of the acquisition was $173,257,000, including $7,292,000 for a five-year non-competition agreement, and payment consisted of $111,706,000 of cash and 6,839,000 shares of the company's common stock valued at $61,551,000. The cash portion of the purchase price was financed under the company's U.S. credit agreement. The acquisition of the North American businesses has been accounted for as a purchase transaction effective September 27, 1991. In October 1991, the company acquired a 50% interest in Silverstar Ltd. S.p.A. ("Silverstar") in exchange for 926,000 shares of common stock valued at $8,330,000. Set forth below is the unaudited pro forma combined summary of operations for the years ended December 31, 1993 and 1992 as though each of the acquisitions had been made on January 1, 1992. 1993 1992 (In thousands except per share data) Sales..................................$2,658,000 $2,182,000 Operating income....................... 185,000 140,000 Earnings before extraordinary charges.. 83,000 51,000 Net income............................. 83,000 45,000 Per common share: Primary: Earnings before extraordinary charges............ 2.63 1.78 Net income......................... 2.63 1.57 Fully diluted: Earnings before extraordinary charges............ 2.44 1.70 Net income......................... 2.44 1.52 Average number of common shares and common share equivalents outstanding: Primary.............................. 30,994 26,109 Fully diluted........................ 35,533 30,045 The unaudited pro forma combined summary of operations has been prepared utilizing the historical financial statements of Arrow and the acquired businesses. The unaudited pro forma combined summary of operations does not reflect all sales attrition which may result from the combination of Zeus and MMD with Arrow's businesses or the sales attrition which may have resulted from the combination of the European businesses. It also does not reflect the full cost savings the company expects to achieve from the combination of the Zeus and MMD businesses with its own. ARROW ELECTRONICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONTINUED The 1992 unaudited pro forma combined summary of operations does not reflect the cost savings achieved from the combination of the U.K. business of Lex with its own or any sales attrition which may have resulted from the combination. The cost savings achieved result principally from reductions in personnel performing duplicative functions and the elimination of duplicative administrative facilities, selling and stocking locations, and computer and telecommunications equipment. The unaudited pro forma combined summary of operations does not purport to be indicative of the results which actually would have been obtained if the acquisitions had been made at the beginning of 1992. The unaudited pro forma combined summary of operations includes the effects of the purchase price allocation adjustments, the additional interest expense on debt incurred in connection with the acquisitions as if the debt had been outstanding from the beginning of the periods presented, and the issuance of additional shares of the company's preferred stock. The purchase price allocation adjustments include the adjustment of the net assets acquired to fair market value and the estimated costs associated with the integration of the businesses. Such estimated costs include professional fees as well as real estate lease termination costs, costs associated with the elimination of certain redundant franchised lines, and severance and other expenses related to personnel performing duplicative functions, all of which are associated with facilities and personnel of the acquired businesses. Early in 1994, the company acquired an additional 15% interest in Spoerle, bringing its holdings to 70%, and increased its holdings in Silverstar to a majority share. Silverstar will be consolidated into the company's results in 1994. Additionally, the company acquired the electronic component distribution business of Field Oy, the largest distributor of electronic components in Finland, and TH:s Elektronik, a leading distributor in Sweden and Norway. 3. Investments in Affiliated Companies At December 31, 1993, the company had a 50% interest in Silverstar, the largest distributor of electronic components in Italy. Prior to 1993 when it increased its holdings to a 55% majority interest, the company had a 40% interest in Spoerle. The investment in Silverstar is account- ed for using the equity method as was the investment in Spoerle prior to 1993. For the year ended December 31, 1993, Silverstar recorded net sales of $158,546,000, gross profit of $46,111,000, income before taxes of $8,959,000 and net income of $4,000,000. For the year ended December 31, 1992, Spoerle and Silverstar recorded net sales of $487,179,000, gross profit of $135,200,000, income before income taxes of $32,185,000, and net income of $26,082,000. For the year ended December 31, 1991, Spoerle recorded net sales of $226,890,000, gross profit of $66,038,000, ARROW ELECTRONICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONTINUED income before income taxes of $26,748,000, and net income of $20,466,000. Such results are exclusive of interest expense associated with financing the investment and purchase accounting adjustments (including amortization of costs assigned to identifiable assets, principally franchise agreements which are being amortized over 30 years, amortization over 40 years of costs in excess of the company's interest in net assets acquired, and related income taxes). A summary of Silverstar's balance sheet at December 31, 1993 and both affiliates' balance sheets at December 31, 1992, exclusive of the aforementioned adjustments, follows: 1993 1992 (In thousands) Current assets........................... $ 94,624 $194,232 Noncurrent assets........................ 4,854 25,946 Total assets ....................... $ 99,478 $220,178 Current liabilities..................... $ 78,836 $106,912 Noncurrent liabilities.................. 7,822 17,603 Equity.................................. 12,820 95,663 Total liabilities and equity....... $ 99,478 $220,178 The above amounts have been translated from deutsche marks and lira into U.S. dollars based on exchange rates in effect at the end of the respective year or during such year. 4. Long-Term Debt and Subordinated Debentures Long-term debt at December 31, 1993 and 1992 consisted of the following: 1993 1992 (In thousands) 8.29% senior notes due 2000.................... $ 75,000 $ 75,000 U.S. credit agreement due 1998................. 35,000 - Deutsche mark term loan due 2000............... 28,794 15,442 Pound sterling term loan due 1998.............. 18,596 7,573 Other obligations with various interest rates.. 1,634 3,131 159,024 101,146 Less installments due within one year......... 5,196 713 $ 153,828 $100,433 ARROW ELECTRONICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONTINUED The senior notes are payable in three equal annual installments commenc- ing in 1998. The senior notes restrict the payment of cash dividends, limit long-term debt and short-term borrowings, and require net worth and the ratio of operating cash flow to interest expense be maintained at certain designated levels. The company's credit agreement with a group of banks (the "U.S. credit agreement") was amended in January 1994 to release all collater- al, to increase to $175,000,000 the amount of loans available, to reduce the borrowing rate, and to extend the maturity date to January 1998. At February 24, 1994, the company had outstanding borrowings of $30,500,000 under the U.S. credit agreement and unused borrowing capacity of $144,500,000. At the company's option, the interest rate for loans under the U.S. credit agreement is at the agent bank's prevailing prime rate (6% at December 31, 1993) or the U.S. dollar London Interbank Offered Rate ("LIBOR") (3.25% at December 31, 1993) plus .75%. The company pays the banks a commitment fee of .25% per annum on the aggregate unused portion of the U.S. credit agreement. The U.S. credit agreement restricts the payment of cash dividends, limits long-term debt and short-term borrowings, and requires that working capital, net worth, and the ratio of earnings to interest expense be maintained at certain designated levels. The company's wholly-owned German subsidiary has a 50,000,000 deutsche mark term loan from a group of German banks. The loan is payable in installments and bears interest at deutsche mark LIBOR (5.9375% at December 31, 1993) plus .75%. The loan is secured by an assignment of the subsidiary's interest in profit distributions from Spoerle and is guaranteed by the company. The obligations of the company under the guarantee are subordinated to the company's obliga- tions under the U.S. credit agreement and the senior notes. In January 1994, in connection with the acquisition of an addi- tional 15% interest in Spoerle, the company borrowed 25,000,000 deutsche marks from the German banks thereby increasing the loan balance to 75,000,000 deutsche marks. The company's wholly-owned U.K. subsidiary has a loan agreement with a British bank which, as amended in June 1993, includes a L8,000,000 term loan, payable in semi-annual installments from 1994 through 1998, and a revolving credit facility which provides for loans of up to L5,000,000. Borrowings under the loan agreement bear interest at sterling LIBOR (5.5% at December 31, 1993) plus 1.5% and are secured by the assets and common stock of the subsidiary. The loan agreement also requires that operating cash flow, as defined, and the ratio of earnings to interest expense be maintained by the subsidiary at certain designated levels. ARROW ELECTRONICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONTINUED In April 1992, the company used the net proceeds of its common stock offering to redeem $46,000,000 of its 13-3/4% subordinated debentures and to repay approximately $13,000,000 of the company's 12% senior subordinated note issued to Lex in connection with the acquisi- tion of the European businesses. The redemption of the subordinated debentures resulted in an extraordinary charge of $4,039,000 ($2,424,000 after taxes), reflecting the net unamortized discount and issuance expenses of the subordinated debentures. In November 1992, the company issued $125,000,000 of 5-3/4% convertible subordinated debentures due in 2002. The debentures are convertible at any time prior to maturity, unless previously redeemed, into shares of the company's common stock, at a conversion price of $33.125. The debentures are not redeemable at the option of the company prior to October 1995. The net proceeds from the issuance of the debentures together with the proceeds from the private placement of the senior notes were used to redeem the balance of the 13-3/4% subordinated debentures, the 12% subordinated debentures, and the 9% convertible subordinated debentures, to repay the balance of the 12% senior subordi- nated note issued to Lex, to repay the then existing term loan under the U.S. credit agreement, and to provide the company with general working capital. The redemption of the subordinated debentures and repayment of the term loan resulted in an extraordinary charge of $4,925,000 ($3,000,000 after taxes). The charge resulted from the amortization of the net unamortized discount and issuance expenses. The aggregate annual maturities of long-term debt and subordinated debentures for each of the five years in the period ending December 31, 1998 are: 1994--$5,196,000; 1995--$5,053,000; 1996--$5,056,000; 1997-- $6,943,000; and 1998--$74,151,000. The carrying amounts of the company's U.S. credit agreement and foreign borrowings approximate their fair value. At December 31, 1993, the closing price of the 5-3/4% convertible subordinated debentures on the New York Stock Exchange was 140% of par. The estimated fair market value of the 8.29% senior notes at December 31, 1993 was 106% of par. 5. Income Taxes The provision for income taxes for 1993, 1992, and 1991 consisted of the following: 1993 1992 1991 (In thousands) Current Federal..................... $39,106 $14,080 $ 5,200 State....................... 9,432 3,744 1,000 Foreign..................... 9,376 - - 57,914 17,824 6,200 Deferred Federal..................... 2,760 9,869 (3,974) State....................... 552 2,333 - Foreign..................... 3,222 - - 6,534 12,202 (3,974) $64,448 $30,026 $ 2,226 ARROW ELECTRONICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONTINUED The principal causes of the difference between the U.S. statutory and effective income tax rates for 1993, 1992, and 1991 are as follows: 1993 1992 1991 (In thousands) Provision at statutory rate... $55,380 $27,292 $ 3,710 State taxes, net of federal benefit..................... 6,490 4,011 660 Minority interest............. (4,277) - - Foreign tax rate differential 3,448 - - Effect of equity income and foreign loss................ (385) (1,199) (716) Amortization of goodwill...... 1,124 775 513 Other differences............. 2,960 176 208 Tax benefit of loss and credit carryforwards............... (292) (1,029) (2,149) Income tax provision.......... $64,448 $30,026 $ 2,226 For financial reporting purposes in 1993, income before income taxes attributable to the United States and foreign operations was $120,112,000 and $38,116,000, respectively. The significant components of the company's deferred tax assets are as follows: 1993 1992 (In thousands) Inventory reserves............ $ 4,913 $ 8,082 Acquired net operating loss carryforwards............... 2,931 3,662 Other......................... 1,927 1,192 $ 9,771 $12,936 At December 31, 1993, the company had approximately $7,000,000 of acquired U.S. net operating loss carryforwards available for tax return purposes which expire in the years 2001 through 2006. Such carry- forwards are subject to certain annual restrictions on the amount that can be utilized for tax return purposes. In France, the company had approximately $9,500,000 of net operating loss carryforwards, of which approximately $8,900,000 was acquired, which expire through 1997. In accordance with SFAS 109, the cost in excess of net assets of companies acquired has been adjusted by $24,600,000 in conjunction with various acquisitions to reflect the tax benefits of these net operating loss carryforwards and other differences in the tax and book bases of the assets and liabilities acquired. Included in other liabilities are deferred tax liabilities of $11,954,000 and $11,436,000 at December 31, 1993 and 1992, respectively. The deferred tax liabilities are princi- pally the result of the differences in the bases of the German assets and liabilities for tax and financial reporting purposes. ARROW ELECTRONICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONTINUED 6. Shareholders' Equity The company has 2,000,000 authorized shares of serial preferred stock with a par value of $1. In February 1992, the company issued 66,196 shares of newly-created series B $19.375 convertible exchangeable preferred stock (the "series B preferred stock") for approximately $15,721,000 to provide partial funding for the acquisition of the European electronics distribution businesses of Lex. In September 1993, the company completed the conversion of all of its outstanding series B preferred stock into 1,009,086 shares of its common stock. This conversion eliminated $1.3 million of annual dividends. In 1988, the company paid a dividend of one preferred share purchase right on each outstanding share of common stock. Each right, as amended, entitles a shareholder to purchase one one-hundredth of a share of a new series of preferred stock at an exercise price of $50 (the "exercise price"). The rights are exercisable only if a person or group acquired 20% or more of the company's common stock or announces a tender or exchange offer that will result in such person or group acquiring 30% or more of the company's common stock. Rights owned by the person acquiring such stock or transferees thereof will automatical- ly be void. Each other right will become a right to buy, at the exercise price, that number of shares of common stock having a market value of twice the exercise price. The rights, which do not have voting rights, expire on March 2, 1998 and may be redeemed by the company at a price of $.01 per right at any time until ten days after a 20% ownership position has been acquired. In the event that the company merges with, or transfers 50% or more of its consolidated assets or earning power to, any person or group after the rights become exercisable, holders of the rights may purchase, at the exercise price, a number of shares of common stock of the acquiring entity having a market value equal to twice the exercise price. 7. Employee Stock Plans Restricted Stock Plan Under the terms of the Arrow Electronics, Inc. Restricted Stock Plan (the "Plan"), a maximum of 1,330,000 shares of common stock may be awarded at the discretion of the Board of Directors to key employees of the company. The company believes that as many as 50 employees may be considered for awards under the Plan. Shares awarded under the Plan may not be sold, assigned, trans- ferred, pledged, hypothecated, or otherwise disposed of, except as provided in the Plan. Shares awarded become free of such restrictions over a four-year period. The company awarded 40,000 shares of common stock in early 1994 to 35 key employees in respect of 1993, 49,250 shares of common stock to 35 key employees during 1993 (including 39,750 shares of common stock in early 1993 to 31 key employees in respect of ARROW ELECTRONICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONTINUED 1992), 84,000 shares of common stock to 32 key employees during 1992 (including 63,000 shares awarded in early 1992 to 30 key employees in respect of 1991), and 11,000 shares of common stock to five key employ- ees during 1991. Forfeitures of shares awarded under the Plan were 7,625, 11,875, and 2,875 during 1993, 1992, and 1991, respectively. The aggregate market value of outstanding awards under the Plan at the respective dates of award is being amortized over a four-year period and the unamortized balance is included in shareholders' equity as unamor- tized employee stock awards. Stock Option Plan Under the terms of the Arrow Electronics, Inc. Stock Option Plan (the "Option Plan"), both nonqualified and incentive stock options were authorized for grant to key employees at prices determined by the Board of Directors in its discretion or, in the case of incentive stock options, prices equal to the fair market value of the shares at the dates of grant. Options currently outstanding have terms of ten years and become exercisable in equal annual installments over two or three- year periods from date of grant. In 1993, the shareholders of the company approved an increase in the number of shares of common stock authorized for stock options to an aggregate of 4,500,000 shares. The following information relates to the Option Plan: Year ended December 31, 1993 1992 1991 Options outstanding at beginning of year...... 989,755 1,532,504 1,503,780 Granted.................. 367,250 473,900 268,550 Exercised................ (392,934) (978,446) (202,225) Forfeited................ (36,337) (38,203) (37,601) Options outstanding at end of year............ 927,734 989,755 1,532,504 Prices per share of options outstanding....$3.63-39.75 $3.63-28.25 $3.63-14.63 Average price per share of options exercised... $9.06 $5.86 $5.29 Average price per share of options outstanding. $17.02 $9.73 $6.21 Exercisable options...... 715,170 665,821 1,145,599 Options available for future grant: Beginning of year.... 748,959 1,184,656 165,605 End of year.......... 1,918,046 748,959 1,184,656 Stock Ownership Plan The company maintains a noncontributory employee stock ownership plan which enables most North American employees to acquire shares of the company's common stock. Contributions, which are determined by the Board of Directors, are in the form of company common stock or cash which is used to purchase the company's common stock for the benefit of participating employees. Contributions to the plan for 1993, 1992, and 1991 aggregated $2,525,000, $2,360,000, and $1,550,000, respectively. ARROW ELECTRONICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONTINUED 8. Retirement Plan The company has a defined contribution plan for eligible employ- ees, which qualifies under Section 401(k) of the Internal Revenue Code. The company's contribution to the plan, which is based on a specified percentage of employee contributions, amounted to $2,286,000, $2,131,000, and $1,302,000 in 1993, 1992, and 1991, respectively. 9. Lease Commitments The company leases certain office, warehouse, and other property under noncancellable operating leases expiring at various dates through 2016. Rental expenses of noncancellable operating leases amounted to $16,375,000 in 1993, $12,943,000 in 1992, and $11,588,000 in 1991. Aggregate minimum rental commitments under all noncancellable operating leases approximate $69,922,000, exclusive of real estate taxes, insur- ance, and leases related to facilities closed in connection with the integration of the acquired businesses. Such commitments on an annual basis are: 1994-$15,012,000; 1995-$12,145,000; 1996-$9,858,000; 1997- $6,859,000; 1998-$5,539,000 and $20,509,000 thereafter. The company's obligations under capitalized leases are reflected as a component of deferred income taxes and other liabilities. 10. Segment and Geographic Information The company is engaged in one business segment, the distribution of electronic components, systems, and related products. The geographic distribution of consolidated sales, operating income, and identifiable assets for 1993 and 1992 are as follows (in thousands): Sales to Identifiable Unaffiliated Operating Assets at 1993 Customers Income (Loss) December 31, North America.... $1,890,615 $156,014 $ 717,566 Europe........... 600,935 40,153 367,102 Pacific Rim...... 44,034 1,706 57,416 Eliminations and Corporate.. - (16,331) 35,849 $2,535,584 $181,542 1,177,933 Investment in affiliated company 13,371 Total assets at December 31, 1993 $1,191,304 ARROW ELECTRONICS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONTINUED Sales to Identifiable Unaffiliated Operating Assets at 1992 Customers Income (Loss) December 31, North America.... $1,504,958 $116,007 $598,017 Europe........... 116,577 1,420 94,145 Pacific Rim...... - - - Eliminations and Corporate.. - (13,646) 23,838 $1,621,535 $103,781 716,000 Investments in affiliated companies 64,893 Total assets at December 31, 1992 $780,893 11. Quarterly Financial Data (Unaudited) A summary of the company's quarterly results of operations for 1993 and 1992 follows: First Second Third Fourth Quarter Quarter Quarter Quarter (In thousands except per share data) 1993: Sales.......................$551,391 $584,069 $697,825 $702,299 Gross profit................ 120,091 120,847 136,876 135,517 Net income.................. 17,982 19,114 21,734 22,729 Per common share:........... Primary .................. .59 .62 .69 .72 Fully diluted............. .55 .58 .64 .67 First Second Third Fourth Quarter Quarter Quarter Quarter (In thousands except per share data) 1992: Sales.......................$378,679 $382,041 $407,421 $453,394 Gross profit................ 78,930 82,706 87,038 93,215 Earnings before extraordinary charges..... 9,270 11,518 13,323 16,133 Net income.................. 9,270 9,094 13,323 13,133 Per common share: Earnings before extraordinary charges.... .38 .41 .47 .53 Extraordinary charges ..... - (.10) - (.10) Net income.................... .38 .31 .47 .43 Item 9.

Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure. None. Part III Item 10.

Item 10. Directors and Executive Officers of the Registrant. See "Executive Officers" in the response to Item 1 above. In addition, the information set forth under the heading "Election of Directors" in the company's Proxy Statement filed in connection with the Annual Meeting of Shareholders scheduled to be held May 10, 1994 hereby is incorporated herein by reference. Item 11.

Item 11. Executive Compensation. The information set forth under the heading "Executive Compensation and Other Matters" in the company's Proxy Statement filed in connection with the Annual Meeting of Shareholders scheduled to be held May 10, 1994 hereby is incorporated herein by reference. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Manage- ment. The information on page 3 and under the heading "Election of Directors" in the company's Proxy Statement filed in connection with the Annual Meeting of Shareholders scheduled to be held May 10, 1994 hereby is incorporated herein by reference. Item 13.

Item 13. Certain Relationships and Related Transactions. The information set forth under the heading "Executive Compensation and Other Matters" in the company's Proxy Statement filed in connection with the Annual Meeting of Shareholders scheduled to be held May 10, 1994 hereby is incorporated herein by reference. Part IV Item 14.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a)1. Financial Statements. The financial statements listed in the accompanying index to financial statements and financial statement schedules are filed as part of this annual report. 2. Financial Statement Schedules. The financial statement schedules listed in the accompanying index to financial statements and financial statement schedules are filed as part of this annual report. All other schedules have been omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements, including the notes thereto. ARROW ELECTRONICS, INC. AND FINANCIAL STATEMENT SCHEDULES (Item 14 (a)) Page Report of Ernst & Young, independent auditors 15 Consolidated balance sheet at December 31, 1993 and 1992 16 For the years ended December 31, 1993, 1992 and 1991: Consolidated statement of operations 17 Consolidated statement of cash flows 18 Consolidated statement of shareholders' equity 19 Notes to consolidated financial statements for the years ended December 31, 1993, 1992 and 1991 20 Consolidated schedules for the three years ended December 31, 1993: II - Amounts receivable from employees 45 VIII - Valuation and qualifying accounts 46 IX - Short-term borrowings 47 3. Exhibits. (2)(a) Restated Agreement of Purchase and Sale, dated as of September 20, 1987, between Ducommun Incorporated and Arrow Electronics, Inc. (incorporated by reference to Exhibit 2(b) to the company's Registration Statement on Form S-4, Commission File No. 33-17942). (b) Letter Agreement dated January 11, 1988 between Ducommun Incorporated and Arrow Electronics, Inc. (incorporated by reference to Exhibit 2(b) to the company's Current Report on Form 8-K dated January 21, 1988, Commission File No. 1-4482). (c) Acquisition Agreement, dated July 28, 1988, between Craig, Hochreiter & Co., Incorporated and Arrow Electronics, Inc., as amended and supplemented (incorporated by reference to Exhibit 2 to the company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1988, Commission File No. 1-4482). (d)(i) Acquisition Agreement, dated July 6, 1989, between Arrow Electronics (UK) Limited and Electrocomponents plc (incorporated by reference to Exhibit 2(d)(i) to the company's Annual Report on Form 10-K for the year ended December 31, 1989, Commission File No. 1-4482). (ii) English language translation of Acquisition Agreement, dated July 6, 1989, between Spoerle Electronic Handelsgesell- schaft mbH & Co. and Retron Manger Electronic GmbH and Eldi GmbH Electronik Distributor (incorporated by reference to Exhibit 2(d)(ii) to the company's Annual Report on Form 10-K for the year ended December 31, 1989, Commission File No. 1-4482). (iii) Umbrella Agreement, dated July 6, 1989, between Electrocomponents plc; Retron Elektronische Bauteile und Gerate Handelsgesellschaft mbH, Manger Elektronik GmbH, and Eldi GmbH Elektro- nik Distributor; Arrow Electronics, Inc.; Arrow Electronics (UK) Limited; and Spoerle Electronic Handelsgesellschaft GmbH & Co. (incorpo- rated by reference to Exhibit 2(d)(iii) to the company's Annual Report on Form 10-K for the year ended December 31, 1989, Commission File No. 1-4482). (e)(i) Agreement of Purchase and Sale, as amended, by and among Lex Service PLC, Lex Burlington Inc., and Arrow Electron- ics, Inc. (incorporated by reference to Exhibit 6(a) to the company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1991, Commission File No. 1-4482). (ii) Stockholders' Agreement dated as of September 27, 1991 by and among Arrow Electronics, Inc., Lex Service PLC, and Lex Burlington Inc. (incorporated by reference to Exhibit 2(e)(ii) to the company's Annual Report on Form 10-K for the year ended December 31, 1991, Commission File No. 1-4482). (iii) Amendment No. 1 dated as of February 28, 1992 to the Stockholders' Agreement in (2)(e)(ii) above (incorporated by reference to Exhibit 2(g)(iii) to the company's Annual Report on Form 10-K for the year ended December 31, 1991, Commission File No. 1-4482). (iv) Amendment No. 2 dated as of July 30, 1992 to the Stockholders' Agreement in (2)(e)(ii) above (incorporated by reference to Exhibit 2(e)(iv) to the company's Annual Report on Form 10-K for the year ended December 31, 1992, Commission File No. 1-4482). (v) Amendment No. 3 dated as of February 1, 1993 to the Stockholders' Agreement in (2)(e)(ii) above (incorporated by reference to Exhibit 2(e)(v) to the company's Annual Report on Form 10-K for the year ended December 31, 1992, Commission File No. 1-4482). (vi) Registration Rights Agreement dated as of September 27, 1991 by and among Arrow Electronics, Inc., Lex Service PLC, and Lex Burlington Inc. (incorporated by reference to Exhibit 2(e)(iii) to the company's Annual Report on Form 10-K for the year ended December 31, 1991, Commission File No. 1-4482). (vii) Amendment No. 1 dated as of February 28, 1992 to the Registration Rights Agreement in (2)(e)(vi) above (incorporated by reference to Exhibit (2)(g)(iv) to the company's Annual Report on Form 10-K for the year ended December 31, 1991, Commission File No. 1-4482). (viii) Amendment No. 2 dated as of July 30, 1992 to the Registration Rights Agreement in (2)(e)(vi) above (incorporated by reference to Exhibit (2)(e)(viii) to the company's Annual Report on Form 10-K for the year ended December 31, 1992, Commission File No. 1-4482). (ix) Amendment No. 3 dated as of February 1, 1993 to the Registration Rights Agreement in (2)(e)(vi) above (incorporated by reference to Exhibit (2)(e)(ix) to the company's Annual Report on Form 10-K for the year ended December 31, 1992, Commission File No. 1-4482). (f)(i) Share Purchase Agreement dated as of October 10, 1991 among EDI Electronics Distribution International B.V., Aquarius Investments Ltd., Andromeda Investments Ltd., and the other persons named therein (incorporated by reference to Exhibit 2.2 to the company's Registration Statement on Form S-3, Registration No. 33-42176). (ii) Standstill Agreement dated as of October 10, 1991 among Arrow Electronics, Inc., Aquarius Investments Ltd., Andromeda Investments Ltd., and the other persons named therein (incorporated by reference to Exhibit 4.1 to the company's Registration Statement on Form S-3, Registration No. 33-42176). (iii) Shareholder's Agreement dated as of October 10, 1991 among EDI Electronics Distribution International B.V., Giorgio Ghezzi, Germano Fanelli, and Renzo Ghezzi. (g) Asset Purchase Agreement, dated as of February 12, 1993, between Zeus Components, Inc. and Arrow Electronics, Inc. (incorporated by reference to Exhibit 10(1) to the company's Annual Report on Form 10-K for the year ended December 31, 1992, Commission File No. 1-4482). (h) Agreement dated as of February 28, 1992 among Lex Service PLC, Arrow Electronics (UK) Limited, EDI Electronics Distribution International (France) SA, Arrow Electronics GmbH, and Arrow Electronics, Inc. (incorporated by reference to Exhibit 2(1) to the company's Current Report on Form 8-K, dated March 11, 1992, Commis- sion File No. 1-4482). (i) Subscription Agreement dated February 7, 1992, between Arrow Electronics, Inc. and various purchasers, pertaining to the sale of the company's Series B $19.375 Convertible Exchangeable Preferred Stock (incorporated by reference to Exhibit 2(h) to the company's Annual Report on Form 10-K for the year ended December 31, 1991, Commission File No. 1-4482). (3) (a) Amended and Restated Certificate of Incorpo- ration of the company, as amended (incorporated by reference to Exhibit 4(1) to the company's Registration Statement on Form S-3, Registration No. 33-67890). (b) Certificate of Amendment of the Amended and Restated Certificate of Incorporation of the company dated as of August 24, 1993 (incorporated by reference to Exhibit 4(2) to the company's Registration Statement on Form S-3, Registration No. 33-67890). (c) By-Laws of the company, as amended (incorpo- rated by reference to Exhibit 3(b) to the company's Annual Report on Form 10-K for the year ended December 31, 1986, Commission File No. 1-4482). (4) (a) Indenture, including Debenture, dated as of November 25, 1992 between the company and the Bank of Montreal Trust Company, as Trustee, with respect to the company's 5-3/4% Convertible Subordinated Debentures due 2004 (incorporated by reference to Exhibit 4(a) to the company's Annual Report on Form 10-K for the year ended December 31, 1992, Commission File No. 1-4482). (b)(i) Rights Agreement dated as of March 2, 1988 between Arrow Electronics, Inc. and Manufacturers Hanover Trust Company, as Rights Agent, which includes as Exhibit A a Certificate of Amendment of the Restated Certificate of Incorporation for Arrow Electronics, Inc. for the Participating Preferred Stock, as Exhibit B a letter to share- holders describing the Rights and a summary of the provisions of the Rights Agreement and as Exhibit C the forms of Rights Certificate and Election to Exercise (incorporated by reference to Exhibit 1 to the company's Current Report on Form 8-K dated March 3, 1988, Commission File No. 1-4482). (ii) First Amendment, dated June 30, 1989, to the Rights Agreement in (4)(b)(i) above (incorporated by reference to Exhibit 4(b) to the Company's Current Report on Form 8-K dated June 30, 1989, Commission File No. 1-4482). (iii) Second Amendment, dated June 8, 1991, to the Rights Agreement in (4)(b)(i) above (incorporated by reference to Exhibit 4(i)(iii) to the company's Annual Report on Form 10-K for the year ended December 31, 1991, Commission File No. 1-4482). (iv) Third Amendment, dated July 19, 1991, to the Rights Agreement in (4)(b)(i) above (incorporated by reference to Exhibit 4(i)(iv) to the company's Annual Report on Form 10-K for the year ended December 31, 1991, Commission File No. 1-4482). (v) Fourth Amendment, dated August 26, 1991, to the Rights Agreement in (4)(b)(i) above (incorporated by reference to Exhibit 4(i)(v) to the company's Annual Report on Form 10-K for the year ended December 31, 1991, Commission File No. 1-4482). (10)(a) Investment Management Agreement, dated as of September 28, 1981, between the company and Fayez Sarofim & Co. (incor- porated by reference to Exhibit 10(b)(ii) to the company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1981, Commission File No. 1-4482). (b)(i) Arrow Electronics Savings Plan, as amended and restated through January 1, 1989 (incorporated by reference to Exhibit 10(b)(i) to the company's Annual Report on Form 10-K for the year ended December 31, 1989, Commission File No. 1-4482). (ii) Amendment No. 1, dated December 7, 1989, to the Arrow Electronics Savings Plan in (10)(b)(i) above (incorporated by reference to Exhibit 10(b)(ii) to the company's Annual Report on Form 10-K for the year ended December 31, 1992, Commission File No. 1-4482). (iii) Amendment No. 2, dated January 18, 1990, to the Arrow Electronics Savings Plan in (10)(b)(i) above (incorporated by reference to Exhibit 10(b)(ii) to the company's Annual Report on Form 10-K for the year ended December 31, 1991, Commission File No. 1-4482). (iv) Amendment No. 3, dated February 21, 1992, to the Arrow Electronics Savings Plan in (10)(b)(i) above (incorporated by reference to Exhibit 10(b)(iv) to the company's Annual Report on Form 10-K for the year ended December 31, 1992, Commission File No. 1-4482). (v) Supplement, dated September 27, 1991, to the Arrow Electronics Savings Plan in (10)(b)(i) above (incorporated by reference to Exhibit 10(b)(v) to the company's Annual Report on Form 10-K for the year ended December 31, 1992, Commission File No. 1-4482). (vi) Supplement No. 3, dated August 24, 1993, to the Arrow Electronics Savings Plan in 10(b)(i) above. (vii) Arrow Electronics Stock Ownership Plan, as amended and restated through January 1, 1989 (incorporated by reference to Exhibit 10(b)(ii) to the company's Annual Report on Form 10-K for the year ended December 31, 1989, Commission File No. 1-4482). (viii) Amendment No. 1, dated November 29, 1989, to the Arrow Electronics Stock Ownership Plan in (10)(b)(vii) above (incor- porated by reference to Exhibit 10(b)(vii) to the company's Annual Report on Form 10-K for the year ended December 31, 1992, Commission File No. 1-4482). (ix) Amendment No. 2, dated December 7, 1989, to the Arrow Electronics Stock Ownership Plan in (10)(b)(vii) above (incor- porated by reference to Exhibit 10(b)(viii) to the company's Annual Report on Form 10-K for the year ended December 31, 1992, Commission File No. 1-4482). (x) Amendment No. 3, dated January 18, 1990, to the Arrow Electronics Stock Ownership Plan in (10)(b)(vii) above (incorporated by reference to Exhibit 10(b)(iv) to the company's Annual Report on Form 10-K for the year ended December 31, 1991, Commission File No. 1-4482). (xi) Amendment No. 4, dated December 31, 1992 to the Arrow Electronics Stock Ownership Plan in (10)(b)(vii) above (incor- porated by reference to Exhibit 10(b)(x) to the company's Annual Report on Form 10-K for the year ended December 31, 1992, Commission File No. 1-4482). (xii) Supplement No. 1, dated September 8, 1992, to the Arrow Electronics Stock Ownership Plan in (10)(b)(vii) above (incor- porated by reference to Exhibit 10(b)(xi) to the company's Annual Report on Form 10-K for the year ended December 31, 1992, Commission File No. 1-4482). (xiii) Supplement No. 3, dated August 24, 1993, to the Arrow Electronics Stock Ownership Plan in (10)(b)(vii) above. (xiv) Capstone Electronics Corp. Profit-Sharing Plan, effective January 1, 1990 (incorporated by reference to Exhibit 10(b)(iii) to the company's Annual Report on Form 10-K for the year ended December 31, 1990, Commission File No. 1-4482). (xv) Supplement No. 1, dated September 8, 1992, to the Capstone Electronics Profit-Sharing Plan in (10)(b)(xiv) above (incorporated by reference to Exhibit 10(b)(xiii) to the company's Annual Report on Form 10-K for the year ended December 31, 1992, Commission File No. 1-4482). (xvi) Supplement No. 2, dated August 24, 1993, to the Capstone Electronics Profit Sharing Plan in (10)(b)(xiv) above. (c)(i) Employment Agreement, dated as of October 16, 1990, between the company and John C. Waddell (incorporated by reference to Exhibit 10(c)(i) to the company's Annual Report on Form 10-K for the year ended December 31, 1990, Commission File No. 1-4482). (ii) Employment Agreement, dated as of March 13, 1991, between the company and Stephen P. Kaufman (incorporated by reference to Exhibit 10(c)(ii) to the company's Annual Report on Form 10-K for the year ended December 31, 1990, Commission File No. 1-4482). (iii) Employment Agreement, dated as of March 13, 1991, between the company and Robert E. Klatell (incorporated by reference to Exhibit 10(c)(iii) to the company's Annual Report on Form 10-K for the year ended December 31, 1990, Commission File No. 1-4482). (iv) Form of agreement between the company and the employees parties to the Employment Agreements listed in 10(c)(i), (ii), and (iii) above providing extended separation benefits under certain circumstances (incorporated by reference to Exhibit 10(c)(iv) to the company's Annual Report on Form 10-K for the year ended December 31, 1988, Commission File No. 1-4482). (v) Form of Employment Agreement, dated as of April 1, 1989, between the company and Robert J. McInerney (incorporated by reference to Exhibit 10(c)(v) to the company's Annual Report on Form 10-K for the year ended December 31, 1989, Commission File No. 1-4482). (vi) Form of Employment Agreement, dated as of March 13, 1991, between the company and Steven W. Menefee (incorporated by reference to Exhibit 10(c)(vi) to the company's Annual Report on Form 10-K for the year ended December 31, 1990, Commission File No. 1-4482). (vii) Form of Employment Agreement, as amended and restated as of January 1, 1990, between the company and Wesley S. Sagawa (incorporated by reference to Exhibit 10(c)(vi) to the company's Annual Report on Form 10-K for the year ended December 31, 1989, Commission File No. 1-4482). (viii) Form of Employment Agreement, dated as of October 27, 1988, between the company and William J. Smith (incorporated by reference to Exhibit 10(c)(v) to the company's Annual Report on Form 10-K for the year ended December 31, 1988, Commission File No. 1-4482). (ix) Employment Agreement, dated as of October 19, 1990, between the company and Don E. Burton (incorporated by reference to Exhibit 10(c)(ix) to the company's Annual Report on Form 10-K for the year ended December 31, 1990, Commission File No. 1-4482). (x) Employment Agreement, dated as of January 7, 1991, between the company and Betty Jane Scheihing (incorporated by reference to Exhibit 10(c)(xi) to the company's Annual Report on Form 10-K for the year ended December 31, 1990, Commission File No. 1-4482). (xi) Employment Agreement, dated as of January 7, 1991, between the company and John S. Smith (incorporated by reference to Exhibit 10(c)(xii) to the company's Annual Report on Form 10-K for the year ended December 31, 1990, Commission File No. 1-4482). (xii) Employment Agreement, dated as of March 17, 1993, between the company and Jan Salsgiver. (xiii) Form of agreement between the company and all corporate Vice Presidents, including the employees parties to the Employment Agreements listed in 10(c)(v)-(xii) above, providing extended separation benefits under certain circumstances (incorporated by reference to Exhibit 10(c)(ix) to the company's Annual Report on Form 10-K for the year ended December 31, 1988, Commission File No. 1-4482). (xiv) Form of agreement between the company and non-corporate officers providing extended separation benefits under certain circumstances (incorporated by reference to Exhibit 10(c)(x) to the company's Annual Report on Form 10-K for the year ended December 31, 1988, Commission File No. 1-4482). (xv) Unfunded Pension Plan for Selected Executives of Arrow Electronics, Inc. (incorporated by reference to Exhibit 10(c)(xv) to the company's Annual Report on Form 10-K for the year ended December 31, 1990, Commission File No. 1-4482). (xvi) English translation of the Service Agreement, dated January 19, 1993, between Spoerle Electronic and Carlo Giersch (incorporated by reference to Exhibit 10(f)(v) to the company's Annual Report on Form 10-K for the year ended December 31, 1992, Commission File No. 1-4482). (d)(i) Senior Note Purchase Agreement, dated as of December 29,1992, with respect to the company's 8.29% Senior Secured Notes due 2000 (incorporated by reference to Exhibit 10(d) to the company's Annual Report on Form 10-K for the year ended December 31, 1992, Commission File No. 1-4482). (ii) First Amendment, dated as of December 22, 1993, to the Senior Note Purchase Agreement in 10(d)(i) above. (e) Amended and Restated Credit Agreement dated as of January 28, 1994 among Arrow Electronics, Inc., the several Banks from time to time parties hereto, Bankers Trust Company and Chemical Bank, as agents. (f)(i) English translation of the Agreement of Purchase and Sale, dated January 19, 1993, between Carlo Giersch and Arrow Electronics GmbH with respect to the purchase of an additional 15% interest in Spoerle Electronic (incorporated by reference to Exhibit 10(f)(i) to the company's Annual Report on Form 10-K for the year ended December 31, 1992, Commission File No. 1-4482). (ii) English translation of the Offer Agreement, with supplemental letters attached, dated January 19, 1993, between Arrow Electronics GmbH and Carlo Giersch with respect to the purchase of a second 15% interest in Spoerle Electronic (incorporated by reference to Exhibit 10(f)(ii) to the company's Annual Report on Form 10-K for the year ended December 31, 1992, Commission File No. 1-4482). (iii) English translation of the Partnership Agreement of Spoerle Electronic, dated January 19, 1993 (incorporated by reference to Exhibit 10(f)(iii) to the company's Annual Report on Form 10-K for the year ended December 31, 1992, Commission File No. 1-4482). (iv) English translation of the Articles of Spoerle GmbH, dated as of January 1, 1993 (incorporated by reference to Exhibit 10(f)(iv) to the company's Annual Report on Form 10-K for the year ended December 31, 1992, Commission File No. 1-4482). (g) Amendment and Restatement Agreement relating to a Facilities Agreement dated February 28, 1992, between Arrow Electronics (UK) Limited and National Westminster Bank PLC. (h)(i) Credit Agreement, dated April 14, 1993, between Berliner Handels- und Frankfurter Bank and Arrow Electronics GmbH. (ii) Amendment, dated January 28, 1994, to the Credit Agreement in (10)(h)(i) above. (iii) Guarantee, dated January 16, 1990, between Arrow Electronics, Inc. and Berliner Handels- und Frankfurter Bank (incorporated by reference to Exhibit 10(h)(ii) to the company's Annual Report on Form 10-K for the year ended December 31, 1989, Commission File No. 1-4482). (iv) Subordination Agreement, dated January 16, 1990, between Berliner Handels- und Frankfurter Bank, Arrow Electronics, Inc., and The First National Bank of Chicago (incorporated by reference to Exhibit 10(h)(iii) to the company's Annual Report on Form 10-K for the year ended December 31, 1989, Commission File No. 1-4482). (v) First Amendment, dated December 29, 1992, to the Subordination Agreement in (10)(h)(iv) above (incorporated by reference to Exhibit 10(h)(iv) to the company's Annual Report on Form 10-K for the year ended December 31, 1992, Commission File No. 1-4482). (vi) Second Amendment, dated January 26, 1993, to the Subordination Agreement in (10)(h)(iv) above (incorporated by reference to Exhibit 10(h)(v) to the company's Annual Report on Form 10-K for the year ended December 31, 1992, Commission File No. 1-4482). (vii) Third Amendment, dated April 12, 1993, to the Subordination Agreement in (10)(h)(iv) above. (viii) Fourth Amendment, dated January 28, 1994, to the Subordination Agreement in (10)(h)(iv) above. (viv) Assignments, dated January 16, 1990, by Arrow Electronics GmbH in favor of Berliner Handels- und Frankfurter Bank (incorporated by reference to Exhibit 10(h)(iv) to the company's Annual Report on Form 10-K for the year ended December 31, 1989, Commission File No. 1-4482). (i)(i) Arrow Electronics, Inc. Stock Option Plan, as amended (incorporated by reference to Exhibit (27)(a) to the company's Registration Statement on Form S-8, Registration No. 33-66594). (ii) Form of Stock Option Agreement under (i)(i) above (incorporated by reference to Exhibit 10(k)(ii) to the company's Annual Report on Form 10-K for the year ended December 31, 1986, Commission File No. 1-4482). (iii) Form of Nonqualified Stock Option Agreement under (i)(i) above (incorporated by reference to Exhibit 10(k)(iv) to the company's Registration Statement on Form S-4, Registration No. 33-17942). (j)(i) Restricted Stock Plan of Arrow Electronics, Inc., as amended and restated (incorporated by reference to Exhibit 10(j)(i) to the company's Annual Report on Form 10-K for the year ended December 31, 1991, Commission File No. 1-4482). (ii) Form of Award Agreement under (j)(i) above (incorporated by reference to Exhibit 10(l)(iv) to the company's Registration Statement on Form S-4, Registration No. 33-17942). (k) Form of Indemnification Agreement between the company and each director (incorporated by reference to Exhibit 10(m) to the company's Annual Report on Form 10-K for the year ended December 31, 1986, Commission File No. 1-4482). (l) Share Purchase Agreement dated as of July 2, 1993 between Baring Brothers (Guernsey) Limited and Others and Arrow Electronics (UK) Limited. (m) Share Sale Agreement dated as of August 17, 1993 between Ocean Information Holdings Limited and Arrow Electronics, Inc. (11) Statement Re: Computation of Earnings Per Share. (22) List of Subsidiaries. (24) Consent of Ernst & Young (28) (i) Record of Decision, issued by the EPA on September 28, 1990, with respect to environmental clean-up in Plant City, Florida (incorporated by reference to Exhibit 28 to the company's Annual Report on Form 10-K for the year ended December 31, 1990, Commission File No. 1-4482). (ii) Consent Decree lodged with the U.S. District Court for the Middle District of Florida, Tampa Division, on December 18, 1991, with respect to environmental clean-up in Plant City, Florida (incorporated by reference to Exhibit 28(ii) to the company's Annual Report on Form 10-K for the year ended December 31, 1991, Commission File No. 1-4482). (b) Reports on Form 8-K None. CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in the Registration Statements (Forms S-8 No. 33-66594, No. 33-48252, No. 33-20428 and No. 2-78185) and in the related Prospectuses pertaining to the employee stock plans of Arrow Electronics, Inc., in Amendment No. 1 to the Registration Statement (Form S-3 No. 33-67890) and in the related Prospectus pertaining to the registration of 1,009,086 shares of Arrow Electronics, Inc. Common Stock, and in Amendment No. 1 to the Registra- tion Statement (Form S-3 No. 33-42176) and in the related Prospectus pertaining to the registration of up to 944,445 shares of Arrow Elec- tronics, Inc. Common Stock held by Aquarius Investments Ltd. and Andromeda Investments Ltd. of our report dated February 24, 1994 with respect to the consolidated financial statements and schedules of Arrow Electronics, Inc. included in this Annual Report on Form 10-K for the year ended December 31, 1993. ERNST & YOUNG New York, New York March 25, 1994 ARROW ELECTRONICS, INC.

854884_1993.txt

854884

1993

ITEM 1. BUSINESS The Company Chicago and North Western Holdings Corp. (together with its subsidiaries, the "Company") is the holding company for the nation's eighth largest railroad based on total operating revenues and miles of road operated, transporting approximately 46 billion ton miles of freight in 1993. The railroad was chartered in 1836 and currently operates approximately 5,500 miles of track in nine states in the Midwest and West. The Company's east-west main line between Chicago and Omaha is the principal connection between the lines of the Union Pacific Railroad and the lines of major eastern railroads, providing the most direct transcontinental route in the nation's central corridor. The Company hauls a wide variety of freight, classified into five major business groups: Energy (Coal); Agricultural Commodities; Automotive, Steel and Chemicals; Intermodal; and Consumer Products. The Company's Energy business group also includes its subsidiary, Western Railroad Properties, Incorporated ("WRPI"), which transports low-sulfur coal in unit trains from the southern Powder River Basin in Wyoming (the "Powder River Basin"), part of the largest reserve of low-sulfur coal in the United States, and is one of only two rail carriers originating traffic from the Powder River Basin. WRPI provides service principally under long-term contracts and is a highly efficient, low-cost operation. WRPI's tonnage, revenues and profits have increased significantly since its inception in 1984. During the period from 1986 to 1993, WRPI's annual coal tonnage increased from 23.8 million to 73.9 million tons. In addition to these major business groups, the Company provides commuter service in the Chicago area under a service contract with a regional transportation authority. The Company, through its subsidiaries, is the successor to the business of CNW Corporation, which was acquired in 1989 in a leveraged, going-private transaction (the "Acquisition") led by Blackstone Capital Partners L.P. ("Blackstone"). The Company went public through a stock offering in 1992. Blackstone and its affiliates sold substantially all their shares in connection with a secondary stock offering in 1993. Freight Business Groups The Company groups its freight traffic into five major business groups, each of which is organized to service a particular commodity and customer base. These business groups transport coal; agricultural commodities; automotive, steel and chemical products; and consumer products; and provide intermodal services, primarily hauling containers on double-stack trains under agreements with large international marine shipping companies. The Company seeks to maintain and enhance its competitive position by tailoring its capabilities to fit its particular customer base in such areas as equipment availability, scheduling, special purpose loading facilities and flexible contract terms. Set forth below is a five-year comparison of gross revenues and volumes of the Company's five freight business groups. Overall gross freight revenues per load decreased from 1989 to 1993, due to volume growth in lower revenue per load traffic, such as the Intermodal and Energy (Coal) business groups. Revenue per load for traffic other than the Intermodal and Energy (Coal) business groups has remained stable over that same period. Energy (Coal). Coal transportation is the Company's largest revenue- producing activity, handled by both WRPI and the core railroad. WRPI, which commenced operations in 1984, transports low-sulfur coal directly from ten of the fifteen mines of the Powder River Basin in Wyoming to the lines of the Union Pacific Railroad at South Morrill, Nebraska, for forwarding to electricity generating facilities primarily in the midwestern and south central states. WRPI originated 90.7% of the total coal loads handled by the Company in 1993. In addition, the core railroad transports a substantial volume of coal over its lines, including a significant number of trains carrying WRPI coal which re-enter the core railroad at Council Bluffs, Iowa, enroute to midwestern electricity generating facilities. Western Railroad Properties, Incorporated. The Powder River Basin is part of the largest reserve of sub-bituminous coal in the United States. In recent years, coal from the Powder River Basin has experienced a growing demand from electric utilities and other industrial customers due to the comparatively low cost of the delivered product (on a BTU basis) and the low- sulfur nature of the coal. The cost of the coal is lower because the reserves are relatively close to the earth's surface. In addition to lower mining costs, competition among the Powder River Basin mines and transportation suppliers has resulted in lower delivered cost of Powder River Basin coal than the delivered cost of local coal in most regions of the United States. Demand for Powder River Basin coal has also increased due to the reduced environmental impact because of its low-sulfur content. Demand for low-sulfur coal has increased due to the passage of the 1990 Amendments to the Clean Air Act. The Clean Air Act requires electric generating facilities to reduce their sulfur dioxide emissions. Utilities can accomplish this by burning coal with low-sulfur content, such as Powder River Basin coal, or by continuing to burn high-sulfur coal through the use of scrubbing devices designed to remove the sulfur from the smoke emissions or other balancing mechanisms. WRPI Operating Statistics (in millions) 1993 1992 1991 1990 1989 Tonnage 73.9 57.2 58.4 49.0 42.6 Revenues $204.9 $169.0 $176.4 $150.8 $142.4 Operating income 1/ $ 94.6 $ 80.7 $ 68.8 $ 62.3 $ 70.2 ___________________ 1/ Operating income was reduced by a special charge of $6.8 million in 1991. 1992 tonnage and revenues decreased from 1991 levels due to abnormally mild weather, which reduced the demand for electricity. In addition, first quarter 1991 shipments were high to meet contracted minimum shipping requirements deferred from 1990. WRPI handles coal for customers principally under long-term transportation contracts, with over 93% of WRPI's 1993 revenues derived from such contracts. The large percentage of revenues under long-term contracts, combined with the inherent stability of demand for coal from WRPI's electric utility customers, has provided a stable source of revenue. During 1993, WRPI had 50 contracts with electric utilities and other industrial users of low- sulfur coal. The remaining terms of these contracts vary between four months and 21 years. The ten largest WRPI customers accounted for approximately 69% of 1993 WRPI revenues. The weighted average life (based on historical tonnages) of the transportation contracts at December 31, 1993, for these ten customers was approximately seven years. Most of these facilities have been designed to burn sub-bituminous, low-sulfur coal. Core Railroad Coal. The core railroad's coal business is comprised primarily of trains carrying WRPI coal re-entering the east-west main line at Council Bluffs, Iowa. Such traffic accounted for 80% of the core railroad's coal revenues in 1993. The top ten customers accounted for 86% of 1993 coal revenue of the core railroad. The core railroad's coal is shipped principally under long-term contracts; the weighted average life (based on historical tonnages) at December 31, 1993 of the contracts for these ten customers was approximately four years. Profit margins on the core railroad coal movements are generally lower than on WRPI movements. Agricultural Commodities. The core railroad is one of the largest rail transporters of grain in the United States, operating over 750 miles of "grain gathering" lines. More than 140 multiple-car grain loading facilities in Iowa, Minnesota, Wisconsin, Illinois and Nebraska provide shipments to processors, barge terminals or the gateways of Chicago, Omaha, Kansas City and St. Louis for delivery to other carriers. The agricultural commodities group consists of the following commodities: Percent of 1993 Agricultural Commodities Revenue Corn and soybeans 33.2% Wheat 6.3 Barley, oats and other grains 7.9 Subtotal grain 47.4% Corn syrup 8.2% Soybean meal and oil 9.6 Feed and flour 11.4 Malt 3.7 Subtotal grain products 32.9% Agricultural chemicals 8.1% Potash and sulfur 11.6 Total 100.0% In 1993, approximately 70% of grain shipments was for domestic processing and the balance was for feed lots and other users. 1993 grain shipments decreased due to flooding in the Midwest, which reduced the quantity and quality of the corn harvest in the Company's service territory. The core railroad has historically benefitted from long-term relationships with its grain customers. Continuation of these stable relationships is important because changes in weather, government farm policies and import-export demand makes the movement of agricultural products fluctuate unpredictably. The agricultural commodities business is conducted primarily with large grain firms, grain processing companies and fertilizer producers. Automotive, Steel and Chemicals. The Automotive, Steel and Chemicals business group serves domestic and international auto manufacturers, steel producers, iron ore mining operations and industrial chemical firms. The Company delivers auto parts to and handles finished motor vehicles from two assembly plants in Illinois and Wisconsin. The Company also transports finished domestic and import vehicles to the Company's regional distribution ramp facilities in West Chicago, Illinois; St. Paul, Minnesota; and Milwaukee, Wisconsin. The Company serves three industrial chemical producers and numerous chemical receivers, primarily in Illinois, Iowa, Minnesota and Wisconsin. The Company also participates in several overhead movements of industrial chemicals, primarily soda ash destined for the eastern U.S. In 1993, four auto customers accounted for 94% of total automotive revenues and seven steel and iron ore customers accounted for 85% of total steel and iron ore revenues. Intermodal. The Intermodal business group provides the transportation of various types of consumer products through a combination of railroad transport and transport by water or motor carriers. Intermodal traffic includes the movement of trailers-on-flat-car ("TOFC"); containers-on-flat-car ("COFC"); or unit trains of double-stack container cars, where the Company has been a pioneer. Intermodal transport has been among the fastest growing areas of the railroad business in the past decade and technological advances have made double-stack container service a highly cost-efficient method of transport since 1984. Double-stack container traffic now accounts for approximately 83% of the group's volume. The Intermodal business group's primary business is supplying intermodal transportation across the east-west main line directly to major international containership lines involved in intermodal trade. In addition to providing rail transportation, the Company provides terminal services to these customers at the Company's "Global I" and "Global II" double-stack terminal facilities. These facilities, located in the Chicago area, were specifically designed to economically handle modern double-stack unit trains. The Company believes that these facilities are among the nation's premier intermodal loading and unloading facilities and are of continuing strategic importance to the Company's ability to provide high quality intermodal service to its customers. While the Company's intermodal volume has grown rapidly in the past several years, from 581,000 loads in 1989 to 714,000 loads in 1993, revenues from intermodal services have grown less rapidly, from $96.4 million in 1989 to $119.5 million in 1993. Volumes have shifted from higher revenue, higher cost TOFC/COFC to the lower cost double-stack method of transport. The lower unit costs associated with double-stack movements have been shared with customers, resulting in higher profit margins for the Company and lower unit costs for the customers. Consumer Products. This business group includes a variety of consumer oriented commodities including food products, paper and related products, lumber and plywood, construction materials and some minerals such as silica sand and bentonite clay. Due to the diversity of customers and the products they ship, this business group, as a whole, closely tracks general economic conditions, and is very sensitive to other railroad and truck competition. Commuter Line Since July 1, 1975, the Company has operated Chicago suburban commuter service under a purchase of service agreement with a regional transportation authority. The present agreement expires on December 31, 1994, and provides for the Company to receive a small profit for operating the service in addition to being reimbursed for the costs of commuter operations in excess of revenue fares collected. In 1993, gross revenues from the Commuter Line were approximately $85 million. Under a related agreement, the Company received approximately $7 million from the regional transportation authority during 1993 for the regional transportation authority's share of track improvements in the commuter operations territory. Employees The Company's employment levels and gross wages paid are shown in the following table: 1993 1992 1991 1990 1989 Average employees for the year 6,158 6,269 6,841 7,397 8,140 Gross payroll (millions) $306 $292 $294 $309 $332 In 1991, the Company entered into an agreement (the "UTU Agreement") with the United Transportation Union ("UTU"), which permitted the Company to reduce crew size on all the Company's freight trains and yard crews from three to two persons by eliminating brakemen positions on those crews. This agreement resulted in the elimination of approximately 580 brakemen positions. Employees with jobs abolished pursuant to the UTU Agreement, who did not voluntarily resign, were placed on reserve boards where they remain until recalled to service. As of December 31, 1993, there were no employees currently on reserve board status due to current traffic levels. Competition The Company is subject to significant competition for freight traffic from rail, motor and water carriers. Strong competition among rail carriers exists in most major rail corridors. The principal factor in the Company's ability to compete for freight traffic is price. Quality of service and efficiency of operations are also significant factors, particularly in the intermodal area, where competition from motor carriers is substantial. Barge lines and motor carriers have certain cost advantages over railroads because they are not obligated to acquire, maintain or pay real estate taxes on the rights-of-way they use. WRPI's principal competitor is the Burlington Northern Railroad, a substantially larger carrier which has access to all of the Powder River Basin mines. Railroad Regulation The core railroad and WRPI, along with other common carriers engaged in interstate transportation, are subject to the regulatory jurisdiction of the Interstate Commerce Commission ("ICC") in various matters, including rates charged for transportation services (to the extent they are still regulated), issuance of securities and assumption of obligations or liabilities, the extension and abandonment of rail lines, and the consolidation, merger and acquisition or control of carriers. ICC jurisdiction over rate matters generally is limited to general rate increases and to situations where railroads have market dominance and rates charged exceed a stated percentage of the variable costs of providing service. The core railroad, WRPI and other railroads are also subject to the jurisdiction of the Federal Railroad Administration with respect to safety appliances and equipment, railroad engines and cars, protection of employees and passengers, and safety standards for track. The conversion to Common Stock of the Non-Voting Common Stock issued to UP Rail in connection with the Company's 1992 recapitalization (see Note 12 to Consolidated Financial Statements) requires the approval of the ICC. On January 29, 1993, UP Rail filed an application with the ICC requesting this approval. A decision is expected in late 1994. See Item 13 "Certain Relationships and Related Transactions--UP Rail and UP." Labor relations in the railroad industry are governed by the Railway Labor Act ("RLA") instead of the National Labor Relations Act. The national collective bargaining agreements with the major national railway labor organizations covering the union employees of certain railroads, including certain subsidiaries of the Company, become open for modification in January of 1995. Under the RLA, when these agreements are open for modification, their terms remain in effect until new agreements are reached, and typically neither management nor labor is permitted to take economic action (such as a strike) until an extended process of negotiation, mediation and federal investigation is completed. Railroad industry personnel are covered by the Railroad Retirement Act ("RRA") instead of the Social Security Act. Employer contributions under the RRA are currently approximately triple those under the Social Security Act. Operating Statistics Set forth below are certain operating statistics for the Company during the last five years. Freight Statistics 1993 1992 1991 1990 1989 Loadings (thousands) 2,351.6 2,192.2 2,093.4 1,993.5 1,922.9 Freight train miles (thousands) 13,219 11,809 11,365 11,353 11,756 Revenue ton miles (millions) 46,114 40,986 40,601 37,205 35,687 Average length of haul (miles) 299 288 292 296 294 Net tons per load 65.8 64.3 66.8 64.5 65.1 Distribution of Traffic (Loads) 1993 1992 1991 1990 1989 Originated 43.7% 41.5% 41.4% 38.6% 39.5% Terminated 24.1 24.4 24.8 25.4 24.1 Overhead 1/ 18.3 18.1 18.1 18.5 19.2 Local 2/ 13.9 16.0 15.7 17.5 17.2 100.0% 100.0% 100.0% 100.0% 100.0% 1/ Overhead represents traffic over the Company's rail lines that is neither originated nor terminated on such lines. 2/ Local represents traffic that is both originated and terminated on the Company's rail lines. The following table reflects the Company's operating expenses as a percentage of revenues. Operating Expense Ratios Percent of Revenue 1993 1992 1991 1990 1989 Transportation 33.5% 31.5% 33.4% 35.2% 36.7% Way and Structures 13.5 13.5 13.5 14.3 14.8 Equipment 18.9 19.4 19.0 17.6 18.4 Depreciation 6.6 6.6 6.8 7.6 6.3 Other Operating Expenses 7.0 8.3 7.8 8.2 8.5 Special Charges 1/ 0.5 3.0 11.8 1.4 2.6 80.0% 82.3% 92.3% 84.3% 87.3% 1/ Special charges comprise employee reduction and relocation costs of $3.4 million in 1993, $30.0 million in 1992, $76.8 million in 1991, $13.4 million in 1990, and $24.7 million in 1989; $39.0 million for environmental and personal injury reserves in 1991; and $1.6 million for management fees payable to a previous principal stockholder in 1993. ITEM 2.

ITEM 2. PROPERTIES Trackage and Rolling Stock. The status of the Company's trackage at December 31, 1993 was as follows: Miles of Track Main line 1,998 Branch lines 2,841 Operated under trackage rights 676 Total railroad (includes 2,880 miles of welded rail) 5,515 Additional main tracks 845 Yard switching and other track 2,515 Total railroad and yard tracks 8,875 Weight of Rail Owned (miles) 130 lbs. or greater 1,287 100 to 119 lbs. 3,319 Less than 100 lbs. 1,078 At December 31, 1993, the Company's motive power and freight train car fleets were as follows: Rolling Stock Statistics 1/ Diesel locomotive units: Owned 222 Leased 489 Total 711 Capacity (thousands of horsepower) 2,124 Average age since built or rebuilt (years) 12.0 Bad order ratio 2/ 15.2 Covered Box Flat Gondola Hopper Hopper Other Total Freight train car and auto racks - Owned 2,002 126 1,527 2,371 2,198 898 9,122 Leased 5,208 483 2,025 1,909 9,657 445 19,727 Total 7,210 609 3,552 4,280 11,855 1,343 28,849 Capacity (thousands of tons) 3/ 555 26 321 386 1,166 13 2,467 Average age since built or rebuilt (years) 21.3 Bad order ratio 6.6 1/ Does not include the Commuter Line's fleet of 53 diesel units and 293 coaches, which are leased at a nominal cost. 2/ Bad order ratio reflects the ratio of unusable rolling stock to total rolling stock. This ratio includes locomotives in shop for regularly scheduled inspections and 74 locomotives (or 9.7% of the total) being held for sale, potential rebuilding programs, spare parts or as a reserve to accommodate surges in business levels. 3/ Excludes capacity of 1,142 auto racks, which are not rated in tons. Western Railroad Properties, Incorporated. WRPI's trackage consists of a 103-mile line (the "Joint Line"), which is jointly owned with Burlington Northern Railroad, the only other railroad originating service from the Powder River Basin area, and a 107-mile line which connects the Joint Line to an existing line of the Union Pacific Railroad in western Nebraska. A trust for the benefit of a subsidiary of the Union Pacific Corporation (the "WRPI Trust") owns 101 miles of track and certain support facilities and leases them to WRPI under a 75-year lease (the "Lease"). Lease rentals by WRPI to the WRPI Trust provide a fixed return to the WRPI Trust plus a contingent return to the WRPI Trust measured by a varying percentage of available cash flow or operating revenues. Under the Lease, WRPI is required to transport substantially all of its coal over this line, where it is interchanged with the Union Pacific Railroad. WRPI owns the land under the line and leases it to the WRPI Trust. The core railroad operates the line as agent for WRPI under an operating agreement, with WRPI receiving all revenues and being responsible for all operating expenses. The Company believes that the amount and condition of its property, track and rolling stock are adequate to maintain the current level of operations. The Company anticipates future expenditures will be required to continue its strategy to achieve low-cost leadership in its markets. Capital and Maintenance Expenditures. Over the last five years, the following track improvements and maintenance have been effected and the following amounts have been spent to maintain and improve rail service. Track Improvements 1993 1992 1991 1990 1989 Ties inserted (new and reusable) 598,475 620,717 575,036 652,933 747,749 Miles of rail laid (new and reusable) 183.8 170.6 167.7 145.3 147.4 Miles of track surfaced 3,544.0 2,868.0 3,089.0 3,290.0 2,778.0 Cubic yards of ballast installed 607,283 748,496 480,275 593,256 807,553 Capital and Maintenance Expenditures (In Millions) Maintenance (excluding Capital Expenditures depreciation & rent) Year Ended December 31, Road Equipment Road Equipment Total 1993 $ 99.4 $ 16.4 $117.1 $ 93.7 $ 326.6 1992 79.4 3.9 111.3 86.0 280.6 1991 77.1 7.3 136.0 85.2 305.6 1990 60.1 1.7 120.2 90.3 272.3 1989 88.4 16.6 123.3 98.5 326.8 Total $404.4 $ 45.9 $607.9 $453.7 $1,511.9 The Company allocates funds for capital and maintenance expenditures based on its capital needs indicated by its long-term planning and availability of internally generated funds or suitable long-term financing. Capital expenditures in 1993 were $115.8 million, compared with $83.3 million in 1992, and $84.4 million in 1991. The majority of these expenditures were for improvements to the railroad plant, structures and equipment. Not included in the chart above is $202 million (excluding $97.4 million related to the sale and leaseback of certain locomotives and freight cars in 1990) representing the cost to lessors of freight cars and locomotives which the Company leased during the five-year period. The Company entered into operating lease agreements in 1993 covering 65 locomotives and 1,300 freight cars with a cost to the lessors of approximately $161 million, of which approximately $59 million of such equipment was received in 1993. The Company expects to enter into additional operating lease agreements in 1994 for 65 locomotives and approximately 300 freight cars which have a cost to the lessors of approximately $107 million. A $152 million capital expenditures program is presently budgeted for 1994. The majority of the capital expenditures program covers replacement of rail, ties and other track material system-wide, expansion of train handling capacity from the Powder River Basin by WRPI, and construction of new facilities to serve shippers. The Debt Facilities and other indebtedness of the Company impose limitations on the amount of capital expenditures by the Company and its subsidiaries. The Company does not believe that either the restrictions on capital expenditures contained in the Debt Facilities or the Company's other indebtedness should adversely affect its ability to carry out its planned capital expenditures. Other Property. The Company owns various facilities including those for maintenance, stores and yards throughout its system. It leases, and at the expiration of the lease in 1996 will at a nominal price become the owner of, an iron ore handling facility at Escanaba, Michigan, which transports ore by conveyor belts from car to boat or from car to stockpile to boat. The Company is the lessor of certain real estate under approximately 1,700 leases for commercial, agricultural and industrial uses and owns additional real estate available for such uses. The Company continues to identify and sell real estate not needed for present or planned rail operations. The Company owns several repair facilities, including a heavy freight car repair facility at Clinton, Iowa, and other facilities for locomotive heavy repair at Marshalltown, Iowa; Chicago, Illinois; and Proviso, Illinois. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS Environmental Matters The Company's operations are subject to a variety of federal, state and local environmental and pollution control statutes and regulations which govern air emissions from equipment and facilities, discharges to water and the generation, handling, storage, transportation, treatment and disposal of hazardous substances. While over time, substantial expenditures by the Company may be required to comply with such existing and future statutes and regulations, the Company believes that, based on present information, such compliance can be achieved without a material adverse effect on the financial condition or competitive position of the Company. The federal Comprehensive Environmental Response, Compensation and Liability Act, as amended ("CERCLA") and many state "superfund" laws, subject to certain limitations and defenses, impose strict, joint and several liability on current and prior owners or operators of contaminated properties and persons that arranged for disposal of hazardous substances at such properties. The Company, as owner and prior owner of properties used in rail or other industrial operations or leased to others for such purposes, is subject to liability from such laws without regard to when contamination may have occurred. The Company is the lessor of real property under approximately 1,700 leases for commercial, agricultural and industrial uses and owns or leases numerous other sites. The Company has provided reserves for environmental exposure from current and former railroad operating properties, fueling facilities, leased properties and pending litigation and enforcement actions. The Company's environmental exposure is reevaluated periodically. At December 31, 1993 the Company's reserve for environmental liabilities was $28 million. No offsets were credited for possible insurance recoveries, as the Company believes, to a large extent, it would not be able to obtain such recoveries. The reserves were determined based on the Company's anticipated cost of remediation at all known sites, including those where no claim or enforcement action has been issued, taking into consideration the extent of damage and the Company's remediation cost history. The Company has not discounted its environmental liabilities as the timing of remediation payments is uncertain. Environmental regulations and remediation processes are subject to future change, and determining the actual cost of remediation will require further investigation and remediation experience. Therefore, the ultimate cost cannot be determined at this time. However, while such cost may vary from the Company's current estimate, the Company believes the difference between its reserve and the ultimate liability will not be material. The Company has been named as a potentially responsible party in three proceedings under CERCLA and in one state superfund matter, all in the Midwest. The Company is also a defendant in one private CERCLA cost recovery action. The Company's reserves for environmental proceedings include these cases. The Company has assumed that other PRPs will pay appropriate shares of remediation obligations, except when the Company is aware they are incapable of doing so. In such instances, the Company has reapportioned the potential liability and provided a reserve. Following is a listing of the sites of which the Company is currently aware in which CERCLA or similar state superfund claims for remedial investigation, feasibility study and/or remediation costs have been made: 9th Avenue Dump -- This proceeding involves the remediation of a contaminated site in Gary, Indiana. The Company is alleged to have been a generator of hazardous waste deposited at the site. Approximately 180 other potentially responsible parties ("PRPs") have also been identified. The United States Environmental Protection Agency ("U.S. EPA") has issued Section 106 orders to a large number of PRPs, including the Company, to undertake an interim remedial action (Phase 1) and a final remedial action (Phase 2). Work on Phase 1 is nearing completion. Negotiations with respect to the terms of the final remedial action are continuing. Total remediation costs are currently estimated at $45,000,000 based on Phase 1 costs to date and a proposed revised remedy under review by U.S. EPA. Separate groups of PRPs have entered into consent decrees with the U.S. EPA to undertake the interim and final remedies and another group of de minimis PRPs has settled with the U.S. EPA. The Company and a number of PRPs have withdrawn from the Participation Agreement for the interim remedy, and the Company did not participate with the group of PRPs involved in undertaking the final remedy. A participant group is attempting to reach agreement with EPA as to the terms of a revised Phase 2 remedy. The participant group has informed the Company that it may rejoin the group if it agrees to pay approximately 6.2% of the total remediation costs. The matter is in negotiation. Moss-American Site -- The Company is the owner of approximately one-third of an area in Milwaukee County, Wisconsin, which has been identified by the U.S. EPA as a CERCLA site. The remainder of the site is owned by Milwaukee County. The site was previously operated by Moss-American, a division of Kerr-McGee Oil Company, as a wood treatment facility and is contaminated with creosote and other hazardous wastes from the wood treatment process. The Company purchased the property from Kerr-McGee in 1980. The U.S. EPA has completed a remedial investigation and feasibility study and issued a Record of Decision which specifies a remediation plan estimated by U.S. EPA at $26,000,000. Both the Company and Milwaukee County have refused to undertake the remedy. Kerr-McGee has agreed to the terms of a consent decree which obligates it to undertake the remediation and is seeking $1 million from the Company as its contribution to the remediation costs. The matter is under negotiation. Kerr-McGee has also agreed to pay $1 million of approximately $1.9 million in U.S. EPA response costs. The Company has filed comments with the Department of Justice opposing the approval of the proposed consent decree between U.S. EPA and Kerr-McGee. Milwaukee County has filed for leave to intervene in the consent decree proceeding in the U.S. District Court in Milwaukee and to oppose entry of the consent decree and to initiate suit against U.S. EPA, the Wisconsin Department of Natural Resources, Kerr-McGee and the Company. U.S. EPA has made a claim against the Company and Milwaukee County for approximately $900,000 of response costs. The matter is in negotiation. West Minneapolis Site -- The Company is a defendant in a cost recovery suit brought in the U.S. District Court in St. Paul, Minnesota, by Riverwalk Partnership ("Riverwalk"), formerly known as Stanton-Harstad Properties and the Minneapolis Community Development Agency ("MCDA"). Riverwalk is the former owner of property which, in part, was the site of a railroad yard, roundhouse and coal gassification plant owned by the Chicago, St. Paul, Minneapolis & Omaha Railroad (the "Omaha"), a company acquired by the Company. Riverwalk alleges it has incurred expenses in excess of $200,000 for remediation of contamination discovered on the property allegedly caused by prior rail operations of Omaha. MCDA is the owner of property previously owned by Stanton-Harstad and Glacier Park, an affiliate of Burlington Northern (the "BN property") which lies adjacent to the Omaha property. MCDA, subsequent to the remediation performed by Stanton-Harstad, alleges that it has incurred expenses in excess of $2 million for its remediation costs of the Omaha and BN properties together and also alleges damages for diminution in value and delay in development. Consolidated Container Corporation is a defendant in both suits, and Burlington Northern Railroad and Glacier Park are defendants in the suit brought by MCDA. The Company has cross claimed against all other defendants. Union Scrap Iron and Metal Company III - The Company and approximately eighty other parties have received a notice from the U.S. EPA requesting reimbursement of approximately $1 million for costs allegedly incurred in connection with the remediation of the Union Scrap Iron and Metal III Site in Minneapolis, Minnesota. Rock, Michigan Groundwater - The Company has been identified by the Michigan Department of Natural Resources (the "Michigan DNR") as one of five PRP's allegedly responsible for contamination of shallow residential wells in Rock, Michigan. Property owned by the Company and previously used by a bulk fuel operator is alleged to be contaminated and the source of groundwater contamination. The Michigan DNR has demanded payment of its response costs of approximately $2.2 million. The Company and other PRP's have been ordered to perform an investigation to determine the extent of contamination and to formulate a feasibility study for remediation. The Company has agreed to perform an investigation of its own property. During 1993, the Company settled environmental litigation with respect to the following sites: Holtz-Krause Landfill - During October, 1993, the Company entered into a consent and settlement agreement among a large group of participants and the Wisconsin Department of Natural Resources providing for the remediation of the site. The settlement is at a cost to the Company within its existing reserve. East Bethel Landfill - During May, 1993, the Company and other defendants settled with Sylvester Brothers, the owner and operator of the East Bethel Landfill, under the terms of which the defendants (including the Company) will undertake remediation of the site. The settlement is at a cost to the Company within its existing reserve. Litigation The Company is party to a number of other legal actions arising in the ordinary course of business, including actions involving personal injury claims. In management's opinion, the legal actions to which the Company is a party will not in the aggregate have a material adverse effect on the financial condition of the Company. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matter was submitted during the fourth quarter of 1993. Executive Officers of the Registrant Listed below are the names, present titles and ages of all executive officers of the Company or its predecessor and the positions held during the last five years. Each executive officer holds office until his successor shall have been elected or appointed or until his death, resignation or removal. There have been no arrangements or understandings between any executive officer and any other person or persons pursuant to which he was selected as an executive officer. There are no family relationships between any executive officer and any director or other executive officer. Robert Schmiege age 52, Chairman and Chief Executive Officer since August of 1988; President and a Director since July of 1988. Arthur W. Peters age 51, Senior Vice President-Sales and Marketing since June of 1988. Robert A. Jahnke age 50, Senior Vice President-Operations since December of 1988. James P. Daley age 66, Senior Vice President and General Counsel since July of 1985; and Secretary since January of 1987. Thomas A. Tingleff age 47, Senior Vice President-Finance and Accounting since June of 1989; Vice President-Finance and Assistant Treasurer from July of 1980 to May of 1989. Jerome W. Conlon age 54, Senior Vice President-Administration since June of 1989; Director from July of 1989 to February of 1990; Senior Vice President-Public Affairs, Acquisitions and Planning from July of 1988 to July of 1989. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA The following table sets forth selected consolidated financial information for the Company and the Predecessor for the periods and at the dates indicated. Information denoted "Predecessor" relates to dates or periods prior to the Acquisition. The purchase method of accounting was used to record assets acquired and liabilities assumed by the Company in connection with the Acquisition. Such method of accounting has resulted in increased depreciation. In addition, the capital structure of the Company is different from that of its Predecessor, resulting in increased interest and prior to the Recapitalization, preferred dividends. Accordingly, the financial statements for periods and dates after July 24, 1989 are not comparable in all material respects to the financial statements for periods and dates prior to July 24, 1989. As explained in Note 1(f) to the Consolidated Financial Statements, effective January 1, 1992, the Company changed its method of accounting for postretirement benefits other than pensions and effective January 1, 1991, the Company changed its method of accounting for income taxes. The historical financial information (other than operating data) for each of the five years in the period ended December 31, 1993 was derived from consolidated financial statements, of which the three most recent years are incorporated by reference herein and were audited by Arthur Andersen & Co., independent public accountants, whose reports thereon are incorporated by reference herein. Years Ended December 31, 1993 1992 1991 1990 1989 Operating Data: Revenue ton miles (millions) 4/ 46,114 40,986 40,601 37,705 35,687 Operating ratio (%) 5/ 80.0 82.3 92.3 84.3 87.3 December 31, 1993 1992 1991 1990 1989 (Dollars in millions) Balance Sheet Data: Working capital $ (51.9) $ (72.2) $ (75.6) $ (48.3) $ (31.9) Total assets 2,135.9 2,072.0 2,089.0 1,905.1 1,937.5 Long-term debt 1,142.8 1,227.9 1,224.3 1,213.1 1,313.3 Preferred Stock - - 207.4 177.1 157.5 Common stockholders' equity 226.2 144.0 (98.5) 4.4 80.5 1/ Special charges included in operating expenses consist of employee reduction and relocation costs in 1993, 1992, 1991, 1990 and 1989, a charge in 1993 for management fees payable to a previous principal stockholder, and environmental and personal injury costs in 1991. Such special charges totaled $5.0 million in 1993; $30.0 million in 1992; $115.8 million in 1991; $13.4 million in 1990; $6.3 million for the period July 24 to December 31, 1989; and $18.4 million for the period January 1 to July 23, 1989. 2/ Net income for 1993 has been reduced by a $10.8 million extraordinary loss related to the refinancing of long-term debt. The 1992 net loss includes a $91.0 million extraordinary loss related to the Recapitalization and a $2.6 million charge for the cumulative effect of a change in the method of accounting for other postretirement benefits. The 1991 net loss includes a $25.6 million charge for the cumulative effect of a change in the method of accounting for income taxes and a $3.4 million extraordinary loss on prepayment of long-term debt. 3/ Income (loss) per share is calculated after deducting preferred stock dividends and accretion to liquidation value from net income (loss). Such amounts totalled $58.7 million in 1992; $30.3 million in 1991; $19.7 million in 1990; $7.3 million for the period July 24 to December 31, 1989; and $3.0 for the period January 1 to July 23, 1989. 4/ Revenue ton miles equals the product of the weight in tons of freight carried for hire and the distance in miles carried on the Company's lines. 5/ Operating ratio is the ratio of operating expenses to operating revenues. Special charges increased the operating ratio by 0.5, 3.0, 11.8, 1.4, and 2.6 percentage points for the years ended December 31, 1993, 1992, 1991, 1990 and 1989, respectively. PART II The following items are incorporated into this report by reference to the sections of the Company's 1993 Annual Report to Stockholders shown below: Annual Report Section Title (If Applicable) Item Description and Page Number 5 Market for the Registrant's Stock Listing, Common Equity and Related inside back cover Stockholders Matters. 7 Management's Discussion and Management Discussion and Analysis of Financial Condition Analysis of Financial and Results of Operations. Condition and Results of Operations, pages 16 through 21. 8 Financial Statements, Supplementary Pages 22 through 32. Data and the Report of Independent Public Accountants. Item 9.

Item 9. Disagreements on Accounting and Financial Disclosure None. PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant Information with respect to the directors of the Company will be set forth under the caption "Nominees for Election as Directors," "Directors Continuing in Office Until 1995" and "Directors Continuing in Office until 1996" in the Company's Proxy Statement for the Annual Meeting of Stockholders and is hereby incorporated by reference. The Annual Meeting is scheduled to be held at 9:00 a.m. (CST), on May 3, 1994, at the Harris Trust and Savings Bank Auditorium, 111 West Monroe, 8th Floor, Chicago, Illinois. Information with regard to the Company's executive officers appears in Part I of this Form 10-K under the caption "Executive Officers of the Registrant." Item 11.

Item 11. Executive Compensation Information with respect to this item will be set forth under the caption "Executive Compensation" in the Company's Proxy Statement for the Annual Meeting of Stockholders and is hereby incorporated by reference. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management Information with respect to this item will be set forth under the caption "Security Ownership of Certain Beneficial Owners and Management" in the Company's Proxy Statement for the Annual Meeting of Stockholders and is hereby incorporated by reference. Item 13.

Item 13. Certain Relationships and Related Transactions Information with respect to this item will be set forth under the caption "Certain Relationships and Related Transactions" in the Company's Proxy Statement for the Annual Meeting of Stockholders and is hereby incorporated by reference. PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K Incorporated Page by Reference to Number Page Number in of this Annual Report Form 10-K to Stockholders (a) 1. Financial Statements Report of independent public accountants 32 Consolidated statement of income--years ended December 31, 1991, 1992 and 1993 22 Consolidated balance sheet-- December 31, 1992 and 1993 23 Consolidated statement of cash flows--years ended December 31, 1991, 1992 and 1993 24 Notes to Consolidated Financial Statements 25-31 (a) 2. Financial Statement Schedules Report of independent public accountants 32 Selected Quarterly Financial Data for the years ended December 31, 1992 and 1993 30 Schedule V -- Property, plant and equipment 28 Schedule VI -- Accumulated depreciation, depletion and amortization of property, plant and equipment 29 Schedule VIII -- Valuation and qualifying accounts and reserves 30 Schedule X -- Supplementary income statement information 31 (a) 3. Exhibits Many Company exhibits are incorporated by reference to previous filings of the Company as defined below: The Preliminary Proxy Statement filed on March 7, 1994 by Chicago and North Western Holdings Corp. The Form S-8 filed on December 10, 1993 by Chicago and North Western Holdings Corp., file number 33-51405 (the "1993 Form S- 8"). The Form S-4 filed by Chicago and North Western Holdings Corp., file number 33-30874 (the "Form S-4"). The Form S-1 filed on March 27, 1992 by Chicago and North Western Holdings Corp., file number 33-45265 (the "1992 Form S-1"). The Annual Report of Chicago and North Western Holdings Corp. on Form 10-K for the year ended December 31, 1992, file number 33- 30874 (the "1992 10-K"). The Annual Report of Chicago and North Western Holdings Corp. on Form 10-K for the year ended December 31, 1990, file number 33- 30874 (the "1990 10-K"). The Annual Report of Chicago and North Western Holdings Corp. on Form 10-K for the year ended December 31, 1989, file number 33- 30874 (the "1989 10-K"). Number 3.1 Restated Certificate of Incorporation of Chicago and North Western Holdings Corp. (incorporated by reference to Exhibit 4.1 to Form S-8). 3.2 By-Laws of Chicago and North Western Holdings Corp. amended November 23, 1993 (incorporated by reference to Exhibit 4.2 to Form S-8). 4.1 Specimen form of Certificate of Common Stock (incorporated by reference to Exhibit 4.1 to the 1992 Form S-1). 4.14 Second Participation and Loan Agreement dated as of December 20, 1990 among Western Railroad Properties, Incorporated as Lessee and Citibank, N.A., not individually but solely as Trustee, as Lessor, and UP Leasing Corporation, as Beneficial Owner, and Union Pacific Corporation as Beneficial Owner Parent, and Chicago and North Western Transportation Company and CNW Corporation and Chemical Bank as Administrative Agent and Continental Bank, N.A. and the Long-Term Credit Bank of Japan, Ltd., Chicago Branch, as Co- Agents, and Banque Paribas, New York Branch and Manufacturer Hanover Trust Company as Lead Managers (incorporated by reference to Exhibit 10.19 to the 1990 10-K). Number 4.16 Credit Agreement among Chicago and North Western Transportation Company, Chicago and North Western Holdings Corp., the Lenders named therein, Bank of Montreal, as issuing bank, the Co-Agents named therein and Chemical Bank, as Agent, dated as of March 27, 1992 (incorporated by reference to Exhibit 4.16 to the 1992 10-K). 4.16a First Amendment and Waiver dated as of April 7, 1992 to the Credit Agreement dated as of March 27, 1992, among Chicago and North Western Transportation Company, Chicago and North Western Holdings Corp., the Lenders named therein, Bank of Montreal, as Issuing Bank, the Co-Agents party thereto and Chemical Bank, as Agent (incorporated by reference to Exhibit 4.16a to the 1992 10-K). * 4.16b Amendment dated as of September 10, 1993, to the Credit Agreement dated as of March 27, 1992, as previously amended, among Chicago and North Western Transportation Company, Chicago and North Western Holdings Corp., the Lenders named therein, Bank of Montreal, as Issuing Bank, the Co-Agents party thereto and Chemical Bank, as Agent. * 4.16c Master Assignment and Acceptance Agreement, dated as of September 10, 1993, among Chicago and North Western Transportation Company, Chicago and North Western Holdings Corp., the Lenders named therein, Bank of Montreal, an Issuing Bank, the Co-Agents named therein and Chemical Bank, as Agent. 4.17 Senior Secured Note Purchase Agreement among Chicago and North Western Transportation Company, Chicago and North Western Holdings Corp., and the Purchasers listed on Schedule I thereto dated March 27, 1992 (incorporated by reference to Exhibit 4.17 to the 1992 10-K). 4.17a First Amendment and Waiver, dated as of April 7, 1992, to the Senior Secured Note Purchase Agreement, dated as of March 27, 1992, among Chicago and North Western Transportation Company, Chicago and North Western Holdings Corp., and The Purchasers named there (incorporated by reference to Exhibit 4.17a to the 1992 10- K). 4.18 Master Collateral Agreement and Intercreditor Agreement among certain participating creditors of Chicago and North Western Transportation Company and Chemical Bank, as agent, dated as of March 27, 1992 (incorporated by reference to Exhibit 4.18 to the 1992 10-K). Number 10.2 Second Amended and Restated Stockholders Agreement, dated as of March 30, 1992, among Chicago and North Western Holdings Corp., CNW Corporation, Chicago and North Western Transportation Company, Blackstone Capital Partners L.P., Blackstone Family Investment Partnership L.P., Blackstone Advisory Directors Partnership L.P., Chemical Investments, Inc., The Prudential Insurance Company of America, DLJ Capital Corporation, Union Pacific Corporation, UP Rail, Inc. and the Management Group (incorporated by reference to Exhibit 10.2 to the 1992 Form S-1). 10.2a Letter Agreement dated October 1, 1992 releasing certain persons from the Second Amended and Restated Stockholders Agreement (incorporated by reference to Exhibit 10.2a to the 1992 10-K). 10.2b Agreement dated as of December 1, 1992 among Chicago and North Western Holdings Corp., Blackstone Capital Partners, L.P., Blackstone Family Investment Partnership, L.P., Blackstone Advisory Directors Partnership, Chemical Investments Inc., Prudential Insurance Company of America, DLJ Capital Corporation, Union Pacific Corporation, UP Rail, inc., CNW Corporation, Chicago and North Western Transportation Company and the Management Group (incorporated by reference to Exhibit 10.2b to the 1992 10-K). 10.3 Registration Rights Agreement, dated as of July 14, 1989, among Chicago and North Western Holdings Corp., Blackstone Capital Partners L.P., DLJ Capital Corporation, Union Pacific Corporation and the Management Group (the "Registration Rights Agreement") (incorporated by reference to Exhibit 10.3 to Form S-4). 10.4 Amendment No. 1 to Registration Rights Agreement, dated as of July 24, 1989 (incorporated by reference to Exhibit 10.4 to Form S-4). 10.5 Exchange Agreement between Chicago and North Western Holdings Corp. and UP Rail, Inc. dated March 30, 1992 (incorporated by reference to Exhibit 10.5 to the 1992 10-K). 10.6 Standstill Agreement among Chicago and North Western Holdings Corp., Union Pacific Corporation and UP Rail, Inc. dated April 7, 1992 (incorporated by reference to Exhibit 10.6 to the 1992 10-K). 10.7 Gillette-Douglas Joint Line Agreement between Burlington Northern, Inc. and Chicago and North Western Transportation Company (incorporated by reference to Exhibit 10.9 to Form S-4). Number 10.8 Letter Agreement dated March 4, 1986 between Chicago and North Western Transportation Company, Western Railroad Properties Incorporated and Burlington Northern Railroad Company for the purchase of an undivided one-half interest in Burlington Northern's Coal Creek Junction and Caballo Junction, Wyoming line of railroad (incorporated by reference to Exhibit 10.10 to Form S- 4). 10.9 Agreement for Modification of Joint Line Agreement and for Interim Trackage Rights dated April 21, 1986 (incorporated by reference to Exhibit 10.11 to Form S-4). # 10.10 Chicago and North Western Transportation Company Supplemental Pension Plan, amended and restated January 1, 1984 (incorporated by reference to Exhibit 10.13 to the 1989 10-K). # 10.11 First Amendment to Chicago and North Western Transportation Company Supplemental Pension Plan, effective July 1, 1985 (incorporated by reference to Exhibit 10.14 to the 1989 10-K). # 10.12 Second Amendment to Chicago and North Western Transportation Company Supplemental Pension Plan, effective July 1, 1985 (incorporated by reference to Exhibit 10.15 to the 1989 10-K). # 10.13 Third Amendment to Chicago and North Western Transportation Company Supplemental Pension Plan, effective January 1, 1987 (incorporated by reference to Exhibit 10.16 to the 1989 10-K). # 10.13a Fourth Amendment to Chicago and North Western Transportation Company Supplemental Pension Plan, effective January 1, 1989 (incorporated by reference to Exhibit 10.63 to the 1989 10-K). 10.14 One North Western Center Lease (incorporated by reference to Exhibit 10.20 to Form S-4). # 10.15 Chicago and North Western Transportation Company Profit Sharing and Retirement Savings Program (as amended and restated January 1, 1989) (incorporated by reference to Exhibit 10.8 to the 1989 10- K). # 10.16 Bonus Plan of Chicago and North Western Holdings Corp., adopted March 9, 1992 (incorporated by reference to Exhibit 10.16 to the 1992 10-K). # 10.17 Chicago and North Western Transportation Company Executive Retirement Plan, dated January 1, 1989 (incorporated by reference to Exhibit 10.46 to the 1990 10-K). Number 10.19 Purchase of Service Agreement between Commuter Rail Division and Chicago and North Western Transportation Company, October 1, 1984 to December 31, 1988 (incorporated by reference to Exhibit 10.22 to Form S-4). 10.26 Amendments Nos. 7, 8 and 9 to Purchase of Service Agreement between the Commuter Rail Division and Chicago and North western Transportation Company (incorporated by reference to Exhibit 10.26 to the 1992 Form S-1). # 10.27 Chicago and North Western Transportation Company Excess Benefit Retirement Plan dated January 1, 1989 (incorporated by reference to Exhibit 10.36 to the 1989 10-K). # 10.28 Employment Agreement, dated as of July 14, 1989, between CNW Corporation and Jerome W. Conlon (incorporated by reference to Exhibit 10.42 to Form S-4). # 10.29 Employment Agreement, dated as of July 14, 1989, between CNW Corporation and James P. Daley (incorporated by reference to Exhibit 10.43 to Form S-4). # 10.30 Employment Agreement, dated as of July 14, 1989, between CNW Corporation and Robert A. Jahnke (incorporated by reference to Exhibit 10.44 to Form S-4). # 10.31 Employment Agreement, dated as of July 14, 1989, between CNW Corporation and Arthur W. Peters (incorporated by reference to Exhibit 10.45 to Form S-4). # 10.32 Employment Agreement, dated as of July 14, 1989, between CNW Corporation and Robert W. Schmiege (incorporated by reference to Exhibit 10.46 to Form S-4). # 10.33 Employment Agreement, dated as of July 14, 1989, between CNW Corporation and Thomas A. Tingleff (incorporated by reference to Exhibit 10.47 to Form S-4). *# 10.33a Termination Agreements each dated February 22, 1994 with respect to each of the Employment Agreements referenced in 10.28 through 10.33. # 10.34 Equity Incentive Plan for Key Employees of Chicago and North Western Holdings Corp. and Subsidiaries (incorporated by reference to Exhibit 10.48 to Form S-4). # 10.35 Form of Non-Qualified Stock Option Agreement, dated as of July 14, 1989, between Chicago and North Western Holdings Corp., and certain of the Management Investors (incorporated by reference to Exhibit 10.49 to Form S-4). # 10.42 Rollover Option Agreement, dated as of July 14, 1989, between Chicago and North Western Holdings Corp. and Robert A. Jahnke (incorporated by reference to Exhibit 10.57 to Form S-4). Number # 10.43 Rollover Option Agreement, dated as of July 14, 1989, between Chicago and North Western Holdings Corp. and Arthur W. Peters (incorporated by reference to Exhibit 10.58 to Form S-4). # 10.44 Rollover Option Agreement, dated as of July 14, 1989, between Chicago and North Western Holdings Corp. and Thomas A. Tingleff (incorporated by reference to Exhibit 10.59 to Form S-4). 10.45 Agreement for UP Trackage Rights, dated as of July 14, 1989, by and among Union Pacific Railroad Company, Missouri Pacific Railroad Company, CNW Corporation and Chicago and North Western Transportation Company (incorporated by reference to Exhibit 10.60 to Form S-4). 10.46 Supplemental Form of Agreement for UP Trackage Rights, dated as of January 31, 1990 (incorporated by reference to Exhibit 10.39 to the 1990 10-K). 10.47 Amendment to Agreement for UP Trackage Rights dated as of December 20, 1990 (incorporated by reference to Exhibit 10.40 to the 1990 10-K). 10.52 Letter of Intent, dated January 23, 1992 among Chicago and North Western Holdings Corp., CNW Corporation, Union Pacific Corporation, UP Rail, Inc. and UP Leasing Corporation (incorporated by reference to Exhibit 10.52 to the 1992 Form S-1). # 10.53 Chicago and North Western Holdings Corp. 1992 Equity Incentive Plan dated April 7, 1992 (incorporated by reference to Exhibit 10.53 to the 1992 10-K). # 10.53a Chicago and North Western Holdings Corp. 1992 Equity Incentive Plan Amendment effective April 7, 1992. *# 10.53b Second Amendment to The Chicago and North Western Holdings Corp. 1992 Equity Incentive Plan. # 10.54 Chicago and North Western Holdings Corp. 1994 Equity Incentive Plan (subject to shareholder approval incorporated by reference to Exhibit 22 to Preliminary Proxy Statement filed on March 7, 1994 via EDGAR). * 10.55 AT&T Corporate Center office sublease between AT&T Communications, Inc. (as Landlord) and Chicago and North Western Transportation Company (as Tenant) dated as of October 25, 1993. *# 10.56 Chicago and North Western Holdings Corp. Directors' Deferred Compensation Plan. *# 10.57 Chicago and North Western Holdings Corp. Directors' Pension and Retirement Savings Plan. *# 10.58 Chicago and North Western Holdings Corp. Directors' Pension and Retirement Savings Plan Trust. Number * 10.59 Agreement as of June 21, 1993 among Chicago and North Western Holdings Corp., Blackstone Capital Partners L.P., Blackstone Family Investment Partnership II L.P., Blackstone Advisory Directors Partnership L.P., Chemical Investments, Inc., The Prudential Insurance Company of America, DLJ Capital Corporation, Donaldson, Lufkin & Jenrette Securities Corporation, Union Pacific Corporation, UP Rail, Inc., CNW Corporation, Chicago and North Western Transportation Company, Chicago and North Western Acquisition Corporation, UP Leasing Corporation and certain individuals. * 13. Chicago and North Western Holdings Corp. 1993 Annual Report to Stockholders (only those portions incorporated by reference are deemed "filed"). * 21. Subsidiaries of Chicago and North Western Holdings Corp. 28. Railroad Common Control Application before the Interstate Commerce Commission, Finance Docket No. 32133, Union Pacific Corporation, Union Pacific Railroad Company and Missouri Pacific Railroad Company - Control -Chicago and North Western Holdings Corp. and Chicago and North Western Transportation Company, volumes 1 - 4 (incorporated by reference to Exhibit 28 to the 1992 10-K). * Filed herewith. # Management contract or compensatory plan or arrangement. No report on Form 8-K was filed in the fourth quarter of 1993. SIGNATURES Pursuant to the requirements of Section 12 or 15(d) of the Securities Exchange Act of 1934, Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. CHICAGO AND NORTH WESTERN HOLDINGS CORP. Principal Executive Officer By /s/ Robert Schmiege Robert Schmiege Chairman, President and Chief Executive Officer Principal Finance and Accounting Officer By /s/ T. A. Tingleff T. A. Tingleff Senior Vice President-Finance and Accounting March 18, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Date Signed /s/ Robert Schmiege Director March 18, 1994 Robert Schmiege /s/ Richard K. Davidson Director March 18, 1994 Richard K. Davidson /s/ James E. Martin Director March 18, 1994 James E. Martin /s/ James Mossman Director March 18, 1994 James Mossman /s/ Samuel K. Skinner Director March 18, 1994 Samuel K. Skinner /s/ James R. Thompson Director March 18, 1994 James R. Thompson SCHEDULE V CHICAGO AND NORTH WESTERN HOLDINGS CORP. PROPERTY, PLANT AND EQUIPMENT Millions of dollars Column A Column B Column C Column D Column E Column F Other Balance Changes at Additions add Balance beginning at cost (deduct) at end Classification of period (1) Retirements (2) of period Year Ended December 31, 1993 Road $1,301.1 $ 95.3 $ 4.2 $ (0.9) $1,391.3 Equipment 142.8 16.4 4.8 0.9 155.3 WRPI 543.3 4.1 0.2 0.1 547.3 $1,987.2 $115.8 $ 9.2 $ 0.1 $2,093.9 Year Ended December 31, 1992 Road $1,248.7 $ 65.6 $ 13.5 $ 0.3 $1,301.1 Equipment 144.5 3.9 5.3 (0.3) 142.8 WRPI 533.2 13.8 3.7 - 543.3 $1,926.4 $ 83.3 $ 22.5 $ - $1,987.2 Year Ended December 31, 1991 Road $ 941.2 $ 62.6 $ 17.2 $262.1 $1,248.7 Equipment 143.4 7.3 6.2 - 144.5 WRPI 491.4 14.5 1.2 28.5 533.2 $1,576.0 $ 84.4 $ 24.6 $290.6 $1,926.4 (1) Approximately $58.0 million in 1993, $39.0 million in 1992 and $26.8 million in 1991 represents payments to outsiders in cash, part of which was secured through long-term financing. The balance each year represents expenditures for company labor and related overheads and the use of new or reusable material from inventory used in construction. (2) Reflects adoption of SFAS No. 109, "Accounting for Income Taxes" in 1991. SCHEDULE VI CHICAGO AND NORTH WESTERN HOLDINGS CORP. ACCUMULATED DEPRECIATION, DEPLETION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT Millions of dollars Column A Column B Column C Column D Column E Column F Other Balance Additions changes- at charged add Balance beginning to cost & (deduct) at end Classification of period expenses Retirements (1) of period Year Ended December 31, 1993 Road $106.1 $ 35.6 $ 1.0 $ 1.7 $142.4 Equipment 24.6 10.2 4.8 1.9 31.9 WRPI 75.1 23.0 - 0.7 98.8 $205.8 $ 68.8 $ 5.8 $ 4.3 $273.1 Year Ended December 31, 1992 Road $ 76.9 $ 34.1 $ 9.5 $ 4.6 $106.1 Equipment 22.4 10.9 4.9 (3.8) 24.6 WRPI 57.4 19.9 3.5 1.3 75.1 $156.7 $ 64.9 $ 17.9 $ 2.1 $205.8 Year Ended December 31, 1991 Road $ 47.3 $ 33.3 $ 5.2 $ 1.5 $ 76.9 Equipment 13.4 10.8 6.4 4.6 22.4 WRPI 33.4 22.7 1.1 2.4 57.4 $ 94.1 $ 66.8 $ 12.7 $ 8.5 $156.7 (1) Principally proceeds from disposal of property, net of removal costs, credited to reserve, depreciation capitalized through overhead rates. SCHEDULE VIII CHICAGO AND NORTH WESTERN HOLDINGS CORP. VALUATION AND QUALIFYING ACCOUNTS AND RESERVES Millions of dollars Column A Column B Column C Column D Column E Additions Balance charged to at Costs Other Deductions Balance beginning and accounts describe at end Description of period expenses describe (1) of period Year Ended December 31, 1993 Reserves deducted from assets to which they apply-- Reserve for uncollectible revenues and other charges $ 4.0 $ 0.9 $ - $ 0.8 $ 4.1 Reserve for deferred tax assets 43.1 - - 5.5 (2) 37.6 Year Ended December 31, 1992 Reserves deducted from assets to which they apply-- Reserve for uncollectible revenues and other charges $ 4.0 $ 0.6 $ - $ 0.6 $ 4.0 Reserve for deferred tax assets 52.1 - - 9.0 (2) 43.1 Year Ended December 31, 1991 Reserves deducted from assets to which they apply-- Reserve for uncollectible revenues and other charges $ 4.1 $ 1.3 $ - $ 1.4 $ 4.0 Reserve for deferred tax assets 52.1 - - - 52.1 (1) Write off of uncollectible accounts, unless otherwise noted. (2) Reduction for expiring fully-reserved investment tax credits and change in estimated use of credits. SCHEDULE X CHICAGO AND NORTH WESTERN HOLDINGS CORP. SUPPLEMENTARY INCOME STATEMENT INFORMATION Millions of dollars Column A Column B Charged to Costs and Expenses Years Ended December 31, 1993 1992 1991 Maintenance and repairs (excluding payroll taxes of $22.9 million in 1993, $23.4 million in 1992 and $22.8 million in 1991. $187.9 $173.9 $198.4 Depreciation, depletion and amortization of property, plant and equipment $ 68.8 $ 64.9 $ 66.8 Taxes, other than income taxes $ 75.8 $ 75.5 $ 79.3 Depreciation and amortization of intangible assets, royalties and advertising costs are individually less than 1% of total revenues. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Chicago and North Western Holdings Corp.: We have audited in accordance with generally accepted auditing standards, the consolidated financial statements included in Chicago and North Western Holdings Corp.'s Annual Report to Stockholders incorporated by reference in this Form 10-K, and have issued our report thereon dated February 4, 1994. Our audits were made for the purpose of forming an opinion on those statements taken as a whole. The schedules listed in the Index to Financial Statement Schedules are the responsibility of the Company's management and are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. Our report on the consolidated financial statements includes an explanatory paragraph with respect to the changes in method of accounting for income taxes and other postretirement benefits as discussed in Note 1(f) to the consolidated financial statements. ARTHUR ANDERSEN & CO. Chicago, Illinois February 4, 1994

10456_1993.txt

10456

1993

ITEM 1. BUSINESS. (a) GENERAL DEVELOPMENT OF BUSINESS. Baxter International Inc. was incorporated under Delaware law in 1931. As used in this report, except as otherwise indicated in information incorporated by reference, "Baxter" means Baxter International Inc. and the "Company" means Baxter and its subsidiaries. The Company is engaged in the worldwide development, distribution and manufacture of a diversified line of products, systems and services used primarily in the health care field. Products are manufactured by the Company in 21 countries and sold in approximately 100 countries. Health care is concerned with the preservation of health and with the diagnosis, cure, mitigation and treatment of disease and body defects and deficiencies. The Company's more than 200,000 products are used primarily by hospitals, clinical and medical research laboratories, blood and dialysis centers, rehabilitation centers, nursing homes, doctors' offices and at home under physician supervision. The Company also distributes and manufactures a wide range of products for research and development facilities and manufacturing facilities. For information regarding acquisitions, investments in affiliates and divestitures, see the Company's Annual Report to Stockholders for the year ended December 31, 1993 (the "Annual Report"), page 54, section entitled "Notes to Consolidated Financial Statements -- Acquisitions, Investments in Affiliates, Divestitures and Discontinued Operations," which is incorporated by reference. (b) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS. Incorporated by reference from the Annual Report, pages 65-66, section entitled "Notes to Consolidated Financial Statements -- Segment Information." (c) NARRATIVE DESCRIPTION OF BUSINESS. Recent Developments In November 1993, the Company announced that its board of directors approved a series of strategic actions to improve shareholder value, to extend positions of leadership in health-care markets and to reduce costs. These actions are designed to make the Company's domestic medical/laboratory products and distribution segment more efficient and more responsive in addressing the sweeping changes occurring in the United States health-care system and accelerate growth of its medical specialties businesses worldwide. The Company recorded a $700 million pre-tax provision to cover costs associated with these restructuring initiatives. The actions include realigning the Company's United States sales organization; restructuring the distribution organization and investing in new systems to improve manufacturing and distribution efficiencies worldwide; seeking to divest its diagnostics-products manufacturing businesses and exiting selected non-strategic product lines in other businesses, as well as reducing corporate staff and layers of management to give business units more autonomy. These actions are expected to result in a reduction of the Company's worldwide work force by approximately 7 percent, or 4,500 positions, most of of which will occur over the next two to three years. The pre-tax restructuring charge of $700 million includes approximately $300 million for non-cash valuation adjustments as a result of the Company's decision to close facilities or exit non-strategic businesses and investments. The Company expects to spend approximately $400 million in cash related to the restructuring programs described above, with most of that expended over the next two to three years. In return, the Company expects to generate annual pre-tax savings of approximately $100 million in 1994, $200 million in 1995, $275 million in 1996, $325 million in 1997 and exceeding $350 million in 1998. Management anticipates that these savings will be partially invested in increased research and development spending and the Company's expansion into growing international markets. There is fundamental change occurring in the United States health-care system and significant change occurring in the Company's marketplace. Competition among all health-care providers is becoming much more intense as they attempt to gain patients on the basis of price, quality and service. Each is under pressure to decrease the total cost of health-care delivery, and therefore, is looking for ways to reduce materials handling costs, decrease supply utilization, increase product standardization per procedure, and to closely control capital expenditures. There has been increased consolidation in the Company's customer base and by its competitors and these trends are expected to continue. In recent years, the Company's overall price increases have been below the increases in the Consumer Price Index, and these industry trends may inhibit the Company's ability to increase its supply prices in the future. On November 30, 1992, Baxter paid a dividend to its common stockholders of all the common stock of Caremark International Inc., formerly a wholly-owned subsidiary of the Company. Industry Segments The Company is a world leader in global manufacturing and distribution of health-care products and services for use in hospitals and other health-care and industrial settings. It offers a broad array of products and services. The Company announced a significant restructuring in the fourth quarter of 1993 designed to make the Company's domestic medical/laboratory products and distribution segment more efficient and more responsive in addressing the sweeping changes occurring in the United States health-care system and to accelerate growth of its medical specialties businesses worldwide. See "Recent Developments." As a consequence, the Company has redefined its industry segments to be consistent with its strategic direction and management process. The Company's operations are reported in the following two industry segments. Medical Specialties The Company develops, manufactures and markets on a global basis highly specialized medical products for treating kidney and heart disease and blood disorders and for collecting and processing blood. These products include dialysis equipment and supplies; prosthetic heart valves and cardiac catheters; blood-clotting therapies; and machines and supplies for collecting, separating and storing blood. These products require extensive research and development and investment in worldwide distribution, marketing, and administrative infrastructure. The Company's International Hospital unit, which manufactures and distributes intravenous solutions and other medical products outside the United States is also included in this segment because it shares facilities, resources and customers with the other medical specialty businesses in several locations worldwide. Medical/Laboratory Products and Distribution The Company manufactures medical and laboratory supplies and equipment, including intravenous fluids and pumps, diagnostic-testing equipment and reagents, surgical instruments and procedure kits, and a range of disposable and reusable medical products. These self-manufactured products, as well as a significant volume of third party manufactured medical products, are primarily distributed through the Company's extensive distribution system to United States hospitals, alternate-site care facilities, medical laboratories, and industrial and educational facilities. Information about operating results by segment is incorporated by reference from the Annual Report, pages 35-46, section entitled "Financial Review" and pages 65-66, section entitled "Notes to Consolidated Financial Statements -- Segment Information." Joint Ventures The Company conducts a portion of its business through joint ventures, including a joint venture with Nestle, S.A. to develop, market and distribute clinical nutrition products worldwide. The Company also conducts a joint venture with International Business Machines Corporation to provide computer software and services to hospitals and other health-care providers. These joint ventures are accounted for under the equity method of accounting and therefore, are excluded from the two industry segments in which the Company operates. Health Care Environment A decade ago, significant changes began taking place in the funding and delivery of health-care throughout the world. Continuing cost containment efforts by national governments and other health-care payors are restructuring health-care delivery systems; and accelerating cost pressures on hospitals are resulting in increased out-patient and alternate-site health-care service delivery and a focus on cost-effectiveness and quality. These forces increasingly shape the demand for, and supply of medical care. The changes in the United States market began when Congress adopted legislation to limit reimbursement for treatment of Medicare patients. The previous system reimbursed hospitals for the reasonable costs of services. Under the prospective reimbursement system, hospitals are reimbursed at a fixed rate based on the patient's particular diagnosis, regardless of actual costs incurred. Many private health-care payors have adopted similar reimbursement plans and are providing other incentives for consumers to seek lower cost care outside the hospital. Many corporations' employee health plans have been restructured to provide financial incentives for patients to utilize the most cost-effective forms of treatment (managed care programs, such as health maintenance organizations, have become more common); and physicians have been encouraged to provide more cost-effective treatments. With the change of administrations in Washington, and continuing throughout 1993, significant national attention is being focused on the costs and shortcomings of the United States' health-care financing and delivery system. Specifically, and as a result of this attention, the administration is in the process of proposing legislation aimed at restructuring health-care funding in the United States. Based on information presently available to the Company, there will be no material adverse impact upon the Company's business or financial condition if these measures are enacted. The Company continues to believe that its strategy of providing unmatched service to its health-care customers and achieving the best overall cost in its delivery of health-care products and services is compatible with any restructuring of the United States health-care system which may ultimately occur. The future financial success of suppliers, such as the Company, will depend on their ability to work with hospitals to help them enhance their competitiveness. The Company believes it can help hospitals achieve savings in the total supply system by automating supply-ordering procedures, optimizing distribution networks, improving materials management and achieving economies of scale associated with aggregating supply purchases. Methods of Distribution The Company conducts its selling efforts through its subsidiaries and divisions. Many subsidiaries and divisions have their own sales forces and direct their own sales efforts. In addition, sales are made to independent distributors, dealers and sales agents. Distribution centers, which may serve more than one division, are stocked with adequate inventories to facilitate prompt customer service. Sales and distribution methods include frequent contact by sales representatives, automated hospital communications via versions of the ASAP-R- automated purchasing system, circulation of catalogs and merchandising bulletins, direct mail campaigns, trade publications and advertising. The Company is expanding the use of versions of the ASAP system. These versions allow customers to order supplies directly using a telephone-linked terminal. The system can be tailored to individual customer needs, enabling hospitals, laboratories and other customers to order products in predetermined groupings, as well as individually. The ASAP system can also provide the customer with computerized price information and order confirmation. The Company's Corporate program provides large hospitals and multi-hospital systems with a single point of contact for all of the Company's products, services and special value-added programs. The Company is allied with other companies through its ACCESS-TM- program. Through this program, the Company provides its Corporate customers with products and services from leading companies in related industries which go beyond the Company's scope of proprietary product offerings. The Company maintains ACCESS alliances with a subsidiary of WMX Technologies, Inc. (formerly Waste Management of America, Inc.) for handling and disposal of medical waste; with Comdisco, Inc. for high technology asset management and contingency services; with Kraft Foodservice Inc., a subsidiary of Kraft General Foods, Inc., to distribute and market a broad array of hospital food service products; with the Graphics and Technology Group, a division of North American Paper Company; and with various divisions of Trammell Crow Company for facilities management and real estate planning services. The Company's ValueLink-R- hospital inventory management service is designed to deliver health-care products in ready-to-use packaging directly to individual hospital departments on a "just-in-time" basis. As of the end of 1993, 53 hospitals were participating in the Company's ValueLink program. With ValueLink services, hospitals reduce their inventories and the related warehousing costs for medical-surgical supplies and rely on the Company for frequent, standardized deliveries and improved service levels. The Company has distribution facilities across the United States to serve the nation's hospitals. In late 1991, the Company developed the Quality Enhanced Distribution Services-TM- program, reducing the time it takes for a hospital to receive and store supplies and to process accounts payable. Based on each customer's unique requirements, the Company's products are delivered in a manner which facilitates efficient processing of products and related documents by the hospital's personnel. As a result, many hospital customers have been able to reduce the amount of labor associated with the receipt and storage of supplies. As of the end of 1993, 724 Enhanced Distribution Services initiatives were serving United States hospital customers. International sales and distribution are made in approximately 100 countries either on a direct basis or through independent local distributors. International subsidiaries employ their own field sales forces in Australia, Austria, Belgium, Brazil, Canada, China, Colombia, Czech Republic, Denmark, Finland, France, Germany, Greece, Hong Kong, Hungary Italy, Japan, Korea, Malaysia, Mexico, the Netherlands, New Zealand, Norway, Poland, Portugal, Republic of Ireland, Singapore, Spain, Sweden, Switzerland, Taiwan, Thailand, Turkey, the United Kingdom, Venezuela and Zimbabwe. In other countries, sales are made through independent distributors or sales agents. Raw Materials Raw materials essential to the Company's business are purchased worldwide in the ordinary course of business from numerous suppliers. The vast majority of these materials are generally available, and no serious shortages or delays have been encountered. Certain raw materials used in producing some of the Company's products can be obtained only from a small number of suppliers. In some of these situations, the Company has long-term supply contracts with such suppliers, although it does not consider its obligations under such contracts to be material. The Company does not always recover cost increases through customer pricing due to contractual limits on such price increases. See "Contractual Arrangements." Patents and Trademarks The Company owns a number of patents and trademarks throughout the world and is licensed under patents owned by others. While it seeks patents on new developments whenever feasible, the Company does not consider any one or more of its patents, or the licenses granted to or by it, to be essential to its business. Products manufactured by the Company are sold primarily under its own trademarks and trade names. Some products purchased and resold by the Company are sold under the Company's trade names while others are sold under trade names owned by its suppliers. Competition The Company is a major factor in the distribution and manufacture of hospital and laboratory products and services and medical specialties. Although no single company competes with the Company in all of its industry segments, the Company is faced with substantial competition in all of its markets. Historically, competition in the health-care industry has been characterized by the search for technological and therapeutic innovations in the prevention, diagnosis and treatment of disease. The Company believes that it has benefited from the technological advantages of certain of its products. While others will continue to introduce new products which compete with those sold by the Company, the Company believes that its research and development effort will permit it to remain competitive in all presently material product areas. The changing health-care environment in recent years has led to increasingly intense competition among health-care suppliers. Competition is focused on price, service and product performance. Pressure in these areas is expected to continue. See "Health Care Environment." In part through the 1993 restructuring program, the Company continues to increase its efforts to minimize costs and better meet accelerating price competition. The Company believes that its cost position will continue to benefit from improvements in manufacturing technology and increased economies of scale. The Company continues to emphasize its investments in innovative technologies and the quality of its products and services. Credit and Working Capital Practices The Company's debt ratings of A3 on senior debt by Moody's, A-by Standard & Poor's and A by Duff & Phelps were reaffirmed by each rating agency after the 1993 restructuring announcement. Standard & Poors and Duff & Phelps have indicated that continuation of these ratings in the future is dependent on the Company's successful implementation of the restructuring program announced in November 1993, and the reduction of its financial leverage which is expected to result from the planned divestiture of its diagnostics-products manufacturing businesses. Although the Company's credit practices and related working capital needs vary across industry segments, they are comparable to those of other market participants. Collection periods tend to be longer for sales outside the United States. Customers may return defective merchandise for credit or replacement. In recent years, such returns have been insignificant. Quality Control The Company places great emphasis on providing quality products and services to its customers. An integrated network of quality systems, including control procedures that are developed and implemented by technically trained professionals, result in rigid specifications for raw materials, packaging materials, labels, sterilization procedures and overall manufacturing process control. The quality systems integrate the efforts of raw material and finished goods suppliers to provide the highest value to customers. On a statistical sampling basis, a quality assurance organization tests components and finished goods at different stages in the manufacturing process to assure that exacting standards are met. Research and Development The Company is actively engaged in research and development programs to develop and improve products, systems and manufacturing methods. These activities are performed at 35 research and development centers located around the world and include facilities in Australia, Belgium, Germany, Italy, Japan, Malaysia, Malta, the Netherlands, Switzerland, the United Kingdom and the United States. Expenditures for Company-sponsored research and development activities were $337 million in 1993, $317 million in 1992 and $288 million in 1991. The Company's research efforts emphasize self-manufactured product development, and portions of that research relate to multiple product lines. For example, many product categories benefit from the Company's research effort as applied to the human body's circulatory systems. In addition, research relating to the performance and purity of plastic materials has resulted in advances that are applicable to a large number of the Company's products. Principal areas of strategic focus for research are treatments for kidney failure, blood disorders and cardiovascular disease. Government Regulation Most products manufactured or sold by the Company in the United States are subject to regulation by the Food and Drug Administration ("FDA"), as well as by other federal and state agencies. The FDA regulates the introduction and advertising of new drugs and devices as well as manufacturing procedures, labeling and record keeping with respect to drugs and devices. The FDA has the power to seize adulterated or misbranded drugs and devices or to require the manufacturer to remove them from the market and the power to publicize relevant facts. From time to time, the Company has removed products from the market that were found not to meet acceptable standards. This may occur in the future. Similar product regulatory laws are found in most other countries where the Company does business. Environmental policies of the Company mandate compliance with all applicable regulatory requirements concerning environmental quality and contemplate, among other things, appropriate capital expenditures for environmental protection. Various non-material capital expenditures for environmental protection were made by the Company during 1993 and similar expenditures are planned for 1994. See Item 3. -- "Legal Proceedings." Employees As of December 31, 1993, the Company employed approximately 60,400 people, including approximately 35,500 in the United States and Puerto Rico. Contractual Arrangements A substantial portion of the Company's products are sold through contracts with purchasers, both international and domestic. Some of these contracts are for terms of more than one year and include limits on price increases. In the case of hospitals, clinical laboratories and other facilities, these contracts may specify minimum quantities of a particular product or categories of products to be purchased by the customer. (d) FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES. International operations are subject to certain additional risks inherent in conducting business outside the United States, such as changes in currency exchange rates, price and currency exchange controls, import restrictions, nationalization, expropriation and other governmental action. Financial information is incorporated by reference from the Annual Report, pages 65-66, section entitled "Notes to Consolidated Financial Statements -- Segment Information." - -------------------------------------------------------------------------------- ITEM 2.

ITEM 2. PROPERTIES. The Company owns or has long-term leases on substantially all of its major manufacturing facilities. The Company maintains 48 manufacturing facilities in the United States, including nine in Puerto Rico, and also manufactures in Australia, Belgium, Brazil, Canada, Colombia, Costa Rica, the Dominican Republic, France, Germany, Italy, Japan, Malaysia, Malta, Mexico, the Netherlands, Republic of Ireland, Singapore, Spain, Switzerland and the United Kingdom. Many of the major manufacturing facilities are multi-product and manufacture items for both of the Company's industry segments. The Company owns or operates 98 distribution centers in the United States and Puerto Rico and 55 located in 22 foreign countries. Many of these facilities handle products for both of the Company's industry segments. The Company maintains a continuing program for improving its properties, including the retirement or improvement of older facilities and the construction of new facilities. This program includes improvement of manufacturing facilities to enable production and quality control programs to conform with the current state of technology and government regulations. Capital expenditures were $516 million in 1993, $537 million in 1992 and $503 million in 1991. In addition, the Company added to the pool of equipment leased or rented to customers, spending $89 million in 1993, $103 million in 1992 and $89 million in 1991. The Company's facilities are suitable for their respective uses and, in general, are adequate for the Company's current needs. - -------------------------------------------------------------------------------- ITEM 3.

ITEM 3. LEGAL PROCEEDINGS. As of December 31, 1993, the Company was a defendant, together with other defendants, in 3,445 lawsuits and had 1,425 pending claims from individuals, all of which seek damages for injuries allegedly caused by silicone mammary prostheses ("mammary implants") manufactured by the American Heyer- Schulte division of American Hospital Supply Corporation ("American"). The Company's responsibility for mammary implants results from the American Heyer-Schulte division of American which manufactured these products from 1974 until 1984, at which time the products and related assets were sold to Mentor Corporation. American retained the product liability responsibility for products sold before the divestiture, and that responsibility was assumed by a subsidiary of the Company as part of its 1985 acquisition of American. The Company has not manufactured or sold this product since 1984 nor does it have any of the product in its inventory. The typical case or claim alleges that the individual's mammary implants caused one or more of a wide range of ailments, including non-specific autoimmune disease, scleroderma, lupus, rheumatoid arthritis, fibromyalgia, mixed connective tissue disease, Sjogren's Syndrome, dermatomyositis, polymyositis, and chronic fatigue. The comparable number of cases and claims was 137 as of December 31, 1991 and 1,612 as of December 31, 1992. In 1991, 76 cases and claims were disposed of; in 1992, 309 cases and claims were disposed of; and in 1993, 634 cases and claims were disposed of. Continuing publicity and action taken by the U.S. Food and Drug Administration limiting the use of gel-filled silicone mammary implants has caused a significant increase in the number of product liability cases concerning these products brought against the Company. In addition to the individual suits against the Company, a class action on behalf of all women with mammary implants filed against all manufacturers of such implants has been conditionally certified and is pending in the United States District Court for the Northern District of Alabama (DANTE, ET AL., V. DOW CORNING, ET AL., U.S.D.C., N. Dist., Ala., 92-2589; part of IN RE: SILICONE GEL BREAST IMPLANT PRODUCT LIABILITY LITIGATION, U.S.D.C., N. Dist. Ala., MDL 926, (U.S.D.C., N. Dist. Ala., CV 92-P-10000-S)). Another class action has been certified and is pending in state court in Louisiana (SPITZFADDEN, ET AL., V. DOW CORNING CORP., ET AL., Dist. Ct., Parish of Orleans, 92-2589). Baxter also has been named in three purported additional class actions, none of which is currently certified. (BARCELLONA, ET AL., V. DOW CORNING, ET AL., U.S.D.C., Mich., 9300 72045 DT and MOSS, ET AL., V. DOW CORNING, ET AL., U.S.D.C., Minn., 92-P-10560-S, both of which have been transferred to and are part of IN RE: SILICONE GEL BREAST IMPLANT PRODUCT LIABILITY LITIGATION, U.S.D.C., N. Dist. Ala., MDL-926 for discovery purposes, and DOE, ET AL., V. INAMED CORPORATION, ET AL., Circuit Ct., Dade County, Fla, 92-07034.) A suit seeking class certification on behalf of all residents of the Province of Ontario, Canada, who received Heyer-Schulte implants has also been filed (BURKE, V. AMERICAN HEYER-SCHULTE, ET AL., Ontario Prov. Court, Gen. Div., 15981/93.) Additionally, the Company has been served with a purported class action brought on behalf of children allegedly exposed to silicone in utero and through breast milk. (FEUER, ET AL., V. MCGHAN, ET AL., U.S.D.C., E. Dist. N.Y., 93-0146.) The suit names all mammary implant manufacturers as defendants and seeks to establish a medical monitoring fund. These implant cases and claims generally raise difficult and complex factual and legal issues and are subject to many uncertainties and complexities, including, but not limited to, the facts and circumstances of each particular case or claim, the jurisdiction in which each suit is brought, and differences in applicable law. Many of the cases and claims are at very preliminary stages, and the Company has not been able to obtain information sufficient to evaluate each case and claim. There also are issues concerning which of the Company's insurers is responsible for covering each matter and the extent of the Company's claims for contribution against third parties. The Company believes that a substantial portion of the liability and defense costs related to mammary implant cases and claims will be covered by insurance, subject to self-insurance retentions, exclusions, conditions, coverage gaps, policy limits and insurer solvency. Most of the Company's insurers have reserved (i.e., neither admitted nor denied), and may attempt to reserve in the future, the right to deny coverage, in whole or in part, due to differing theories regarding, among other things, the applicability of coverage and when coverage may attach. The Company has been, and will continue to be, engaged in active negotiations with its insurers concerning coverages and the potential settlement described below. Also, some of the mammary implant cases pending against the Company seek punitive damages and compensatory damages arising out of alleged intentional torts. Depending on policy language, applicable law and agreements with insurers, the damages awarded pursuant to such claims may or may not be covered, in whole or in part, by insurance. On February 7, 1994, the Company filed suit against all of the insurance companies which issued product liability policies to American, American Heyer-Schulte and Baxter for a declaratory judgment that: the policies cover each year of injury or claim, the Company may choose among multiple coverages; coverage begins with the date of implant; and legal fees and punitive damages are covered. Representatives of the plaintiffs and defendants in these cases have negotiated a global settlement of the issues under the jurisdiction of the Court in the DANTE, ET AL. V. DOW CORNING, ET AL. case. The monetary provisions of the settlement proposal providing compensation for all present and future plaintiffs and claimants based on a series of specific funds and scheduled medical conditions have been agreed upon by most of the significant defendants and representatives of the plaintiffs. Under the proposal, the total of all of the specific funds, which would be paid-in and made available over approximately thirty years following final approval of the settlement by the Courts, is capped at $4.75 billion. The settling defendants have agreed to fund $4 billion of this amount. The Company's share of this settlement has been established by the settlement negotiations at $556 million. This settlement is subject to a series of court proceedings, including a court review of its fairness, and the opportunity for individual plaintiffs and claimants to elect to remove themselves from the settlement ("opt-out"). At present, the Company is not able to estimate the nature and extent of its potential future liability with respect to opt-outs. In the fourth quarter of 1993, the Company accrued $556 million for its estimated liability resulting from a potential global settlement of the mammary implant class action and recorded a receivable for estimated insurance recovery of $426 million, resulting in a net charge of $130 million. The reserves for the settlement do not include any provisions for opt-outs and are in addition to the general reserves for the mammary implant cases discussed below. In connection with its acquisition of American, the Company had established reserves at the time of the merger for product liability, including mammary implant cases and claims. At December 31, 1993, the reserve allocated to mammary implant cases and claims was approximately $42 million. Based on current information, management believes that this reserve represents the Company's minimum net exposure in connection with future mammary implant cases and claims beyond the effect of the global settlement described above. Upon resolution of any of the uncertainties concerning these cases, the Company may ultimately incur charges in excess of presently established reserves. While such a future charge could have a material adverse impact on the Company's net income in the period in which it is recorded, management believes that any outcome of this litigation will not have a material adverse effect on the Company's consolidated financial position. As of December 31, 1993, the Company was a defendant, together with other defendants, in 121 lawsuits, and has one pending claim, in the United States and Canada involving individuals who have hemophilia, or their representatives. Those cases and claim seek damages for injuries allegedly caused by anti-hemophilic factor concentrates VIII and IX derived from human blood plasma processed and sold by the Company. Furthermore, 58 lawsuits seeking damages based on similar allegations are pending in Ireland and Japan. The typical case or claim alleges that the individual with hemophilia was infected with HIV by infusing Factor VIII or Factor IX concentrates ("Factor Concentrates") containing HIV. The total number of cases and claims asserted against the Company as of December 31, 1991, was 16, and as of December 31, 1992, was 52. In 1991, 11 cases and claims were disposed of; in 1992, 9 cases and claims were disposed of; and in 1993, 11 cases and claims were disposed of. In addition to the individual suits against the Company, a purported class action was filed on September 30, 1993, on behalf of all U.S. residents with hemophilia (and their families) who were treated with Factor Concentrates and who allegedly are infected with HIV as a result of the use of such Factor Concentrates. This lawsuit was filed in the United States District Court for the Northern District of Illinois (WADLEIGH, ET AL., V. RHONE-POULENC RORER, ET AL., U.S.D.C., N. Dist., Ill. 93C 5969). A state-wide class action also has been filed on behalf of all New Jersey residents with hemophilia and HIV. (D.K., ET AL., V. ARMOUR PHARMACEUTICAL COMPANY, ET AL., Sup. Ct., Middlesex County, N.J., L8134-93.) Neither class action has yet been certified. Many of the cases and claims are at very preliminary stages, and the Company has not been able to obtain information sufficient to evaluate each case and claim. In most states, the Company's potential liability is limited by laws which provide that the sale of blood or blood derivatives, including Factor Concentrates, is not the sale of a "good," and thus is not covered by the doctrine of strict liability. As a result, each claimant will have to prove that his or her injuries were caused by the Company's negligence. The WADLEIGH case alleges that the Company was negligent in failing: to use available purification technology; to promote research and development for product safety; to withdraw Factor Concentrates once it knew or should have known of viral contamination of such concentrates; to screen plasma donors properly; to recall contaminated Factor Concentrates; and to warn of risks known at the time the product was used. The Company denies these allegations and will file a challenge to the class proceedings later in 1994. The Company is not able to estimate the nature and extent of its potential or ultimate future liability with respect to these cases and claims, but as a result of settlement discussions and opinions of litigation counsel, has established the reserve described below. The Company believes that a substantial portion of the liability and defense costs related to anti-hemophilic factor concentrates cases and claims will be covered by insurance, subject to self-insurance retentions, exclusions, conditions, coverage gaps, policy limits and insurer solvency. Most of the Company's insurers have reserved (i.e., neither admitted nor denied), and may attempt to reserve in the future, the right to deny coverage, in whole or in part, due to differing theories regarding, among other things, the applicability of coverage and when coverage may attach. Zurich Insurance Co., one of the Company's comprehensive general liability insurance carriers, on February 1, 1994, filed a suit against the Company seeking a declaratory judgment that the policies it had issued do not cover the losses that the Company has notified it of for a number of reasons, including that Factor Concentrates are products, not services, and are, therefore, excluded from the policy coverage, and that the Company has failed to comply with various obligations of tender, notice, and the like under the policies. On February 8, 1994, the Company filed suit against all of the insurance companies which issued comprehensive general liability and product liability policies to the Company for a declaratory judgment that the policies for all of the excess carriers covered both products and services. In that suit, the Company also sued Zurich for failure to defend it and Zurich and Columbia Casualty Company for failure to indemnify it. The Company is engaged in notifying its insurers concerning coverages and the potential settlement discussed below. Also, some of the anti-hemophilic factor concentrates cases pending against the Company seek punitive damages and compensatory damages arising out of alleged intentional torts. Depending on policy language, applicable law and agreements with insurers, the damages awarded pursuant to such claims may or may not be covered, in whole or in part, by insurance. Accordingly, the Company is not currently in a position to estimate the amount of its potential future recoveries from its insurers, but has estimated its recovery with respect to the reserves it has established. The National Hemophilia Foundation ("NHF") asked the U.S. commercial producers of anti-hemophilic factor concentrates (Alpha Therapeutics, Armour Pharmaceuticals, Baxter Healthcare Corporation and Miles Laboratories) to provide $1.5 billion as part of a fund for HIV positive hemophiliacs. The Company and some of the other producers made a counter-proposal that the NHF rejected. The Company is vigorously defending each of the cases and claims against it. At the same time, it is likely that the Company will continue to seek ways to resolve pending and threatened litigation concerning these issues through a negotiated resolution. In Canada, the provincial governments created a settlement fund to which all of the fractionators, including the Company, have contributed. The Company's contribution to the fund was approximately $3 million. Those Canadian claimants who avail themselves of this fund must sign releases in favor of the Company against further litigation. The period in which to file a claim against the fund expired on March 15, 1994. In the fourth quarter of 1993, the Company accrued $131 million for its estimated worldwide liability for litigation and settlement expenses involving anti-hemophilic Factor Concentrate cases, and recorded a receivable for insurance coverage of $83 million, resulting in a net charge of $48 million. The expense of the Canadian settlement is covered by this reserve. Upon resolution of any of the uncertainties concerning these cases, or if the Company, along with the other defendants, enters into a comprehensive settlement of the class actions described above, the Company may incur charges in excess of presently established reserves. While such a future charge could have a material adverse impact on the Company's net income in the period in which it is recorded, management believes that any outcome of this litigation will not have a material adverse effect on the Company's consolidated financial position. Most of the individuals who served as directors of American in 1985, including Mr. Cathcart and Ms. Evans, who currently are directors of the Company, are defendants in a pending lawsuit filed as a derivative action. LEWIS V. BAYS, ET AL. was filed on March 23, 1990, in the Circuit Court of Cook County, Illinois. The plaintiffs allege breach of fiduciary duty claims relating to American's buyout of an agreement with Hospital Corporation of America ("HCA") in connection with the Company's merger with American in 1985. In November 1992, the Board of Directors appointed a special litigation committee consisting of three current directors of the Company who were neither directors of the Company nor American at the time of the merger. The special litigation committee was appointed to determine the best interests of the Company relating to this lawsuit, which seeks $200 million in damages from the individual defendants and HCA as well as other relief. On August 9, 1993, counsel for the special litigation committee filed a motion with the Court to dismiss this case on the basis that there is no merit to the claims against any defendant and that pursuing this litigation is not in the best interests of the Company or its stockholders. The proceedings on this motion have been stayed while the parties discuss the possibility of resolving the case without further court proceedings. On January 14, 1994, the parties in this case filed with the court a Memorandum of Understanding which provides a basis for resolving the case. The parties have undertaken proceedings necessary to demonstrate the fairness of the proposed settlement. It is anticipated that these actions will be completed by April 1994, following which the parties expect to sign a settlement agreement and present it to the court for approval. Management believes that the terms of any possible resolution will have not have a material adverse effect on the Company's results of operations or consolidated financial position. At the start of 1993, the Company was a defendant in patent litigation brought by Scripps Clinic and Research Foundation ("Scripps") and Rhone-Poulenc Rorer, Inc. (formerly Rorer Group, Inc.) ("Rorer") in which the plaintiffs alleged that the Company's monoclonal anti-hemophilic Factor VIII and its recombinant Factor VIII infringed a patent originally owned by Scripps and subsequently licensed to Rorer. Trial of this litigation before a judge without a jury was concluded in 1992. Before a ruling on the trial was received, the Company entered into a worldwide settlement of the litigation with Scripps and Rorer. The settlement agreement required Baxter to pay $105 million to Rorer to settle claims relating to certain anti-hemophilic Factor VIII products manufactured and sold prior to January 1, 1993. As part of this agreement, Baxter was also granted a non-exclusive sub-license for future use of the related patents. This license agreement is royalty-bearing when used in conjunction with the Company's monoclonally purified and Recombinant Factor VIII products. Baxter Healthcare Corporation ("BHC") has been named as a defendant in a purported class action on behalf of all medical and dental personnel in the State of California who suffered allergic reactions to natural rubber latex gloves and other protective equipment or who have been exposed to natural rubber latex products. (KENNEDY, ET AL., V. BAXTER HEALTHCARE CORPORATION, ET AL., Sup. Ct., Sacramento Co., Cal., #535632.) The case, which was filed in August 1993, alleges that users of various natural rubber latex products, including medical gloves made and sold by BHC and other manufacturers, suffered allergic reactions to the products ranging from skin irritation to systemic anaphylaxis. BHC filed a demurrer to the compliant, which was granted, and the Complaint was dismissed with leave to file an amended complaint. The amended complaint was filed in December 1993, and BHC has filed a demurrer to the Amended Complaint. Management believes that the outcome of this matter will not have a material adverse effect on the Company's results of operations or consolidated financial position. On August 13, 1993, the Company received a notice from the Department of Veterans Affairs ("DVA") suspending it from competing for, or receiving, new contracts with any agency within the Executive Branch of the Federal Government on the basis of the Company's guilty plea to an information charging it with one count of violating the Anti-boycott Statute by providing information to Arab League Boycott Officials. On the same day, the Company's subsidiary, BHC, received a notice from the DVA suspending it on the basis of the Company's plea, its commonality of management with, and its ownership by, the Company, and its alleged misrepresentation concerning the status of products on its Federal Supply Schedule Contracts with the government. On the same day, Vernon R. Loucks Jr., chairman and chief executive officer of the Company, and James R. Tobin, the former president and chief operating officer of the Company, each received notices from the DVA proposing their individual debarments from competing for, or receiving, contracts on the basis of the Company's plea and on the assertion that each knew or should have known of the actions of the Company and its former senior vice president, secretary, and general counsel, G. Marshall Abbey, recited in the plea agreement. Mr. Abbey also received a notice of proposed debarment from the DVA. On December 21, 1993, the Company and the DVA reached an agreement to settle these proceedings. As a result, the Company and BHC were immediately reinstated as federal contractors by the DVA, and the suspensions imposed in August 1993, were lifted. The settlement agreement between Baxter, BHC, Messrs. Loucks and Tobin, and the DVA resolved all civil and administrative disputes involved in the suspension proceeding. The DVA also terminated debarment proceedings against Loucks and Tobin. As a part of the settlement, BHC agreed to provide the agency with $2.8 million in financial consideration over three years for past, present and future costs associated with the suspension proceedings, and establish a service center dedicated exclusively to federal accounts and staffed by customer-service representatives who will receive training emphasizing government-contracting regulations and federal procurement requirements. The payment and actions agreed to by Baxter, BHC, Messrs. Loucks and Tobin, and the DVA did not constitute an admission of liability or wrongdoing. All of the individuals who served as directors of the Company as of September 1, 1993, as well as Lester B. Knight, executive vice president of the Company, are named as defendants in a pending lawsuit ostensibly filed as a "demand excused" derivative action. SEIGEL V. LOUCKS, ET AL., was filed September 15, 1993, in the Court of Chancery in New Castle County, Delaware Cir. Ct., New Castle Co., Del., Cir. Act #13130. On October 24, 1993, a substantially identical complaint was filed in the same court by Bartholomew J. Millano. The two complaints have been consolidated. The plaintiffs allege, among other things, that the directors failed to oversee management in connection with actions which are the basis for the dispute between the Company and the DVA which are described above, failed to prevent such actions, and failed to create a compliance program to prevent or detect such actions. The complaint seeks to recover alleged damages incurred by the Company as the result of lost sales due to the proposed debarment discussed above, as well as the compensation paid to Messrs. Gantz, Knight, Loucks and Tobin since 1991. The Company and its directors have filed motions to dismiss the suit, have answered the complaint and have filed a counterclaim seeking to permanently bar and enjoin the plaintiff from prosecuting this case because her claims have been disposed of and barred in a prior suit against the Company. The Company has been named as a potentially responsible party for unsettled claims for cleanup costs at 18 hazardous waste sites. The Company was a significant contributor to waste disposed on only one of these sites, the Thermo-Chem site in Muskegon, Michigan. The company expects that the total cleanup costs for this site will be between $37 million and $82 million, of which the Company's share will be approximately $5 million. This amount has been reserved and reflected in the Company's financial statements. In all of the other sites, the Company was a minor contributor and, therefore, does not have information on the total cleanup costs. The Company has, however, in most of these cases been advised by the potentially responsible party of its roughly estimated exposure at these sites. Those estimated exposures total approximately $5 million. The Company is a defendant in a number of other claims, investigations and lawsuits. Based on the advice of counsel, management does not believe that the other claims, investigations and lawsuits individually or in the aggregate, will have a material adverse effect on the Company's operations or its consolidated financial condition. - -------------------------------------------------------------------------------- ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. PART II - -------------------------------------------------------------------------------- ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. Incorporated by reference from the Annual Report, page 67, section entitled "Notes to Consolidated Financial Statements -- Quarterly Financial Results and Market for the Company's Stock." - -------------------------------------------------------------------------------- ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA. Incorporated by reference from the Annual Report, inside back cover, section entitled "Six-Year Summary of Selected Financial Data." - -------------------------------------------------------------------------------- ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Incorporated by reference from the Annual Report, pages 35-46, section entitled "Financial Review." Also incorporated by reference is the section of this Form 10-K, Part I captioned "Recent Developments," "Health Care Environment" and "Legal Proceedings" on pages 3 to 4, 5 and 9 to 13, respectively. - -------------------------------------------------------------------------------- ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. Incorporated by reference from the Annual Report, pages 48-67, sections entitled "Report of Independent Accountants," "Consolidated Balance Sheets," "Consolidated Statements of Income," "Consolidated Statements of Cash Flows," "Consolidated Statements of Stockholders' Equity," and "Notes to Consolidated Financial Statements." - -------------------------------------------------------------------------------- ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. None. PART III - -------------------------------------------------------------------------------- ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. a) IDENTIFICATION OF DIRECTORS Incorporated by reference from the board of directors' proxy statement for use in connection with Baxter's annual meeting of stockholders to be held on April 29, 1994 (the "Proxy Statement"), pages X-X, sections entitled "Board of Directors" and "Election of Directors." b) IDENTIFICATION OF EXECUTIVE OFFICERS Following are the names and ages of the executive officers of Baxter International Inc. as of February 28, 1994, their positions with it and summaries of their backgrounds and business experience. All executive officers are elected or appointed by the board of directors and hold office until the next annual meeting of directors and until their respective successors are elected and qualified. The annual meeting of directors is held after the annual meeting of stockholders. WILLIAM B. GRAHAM, age 82, has been senior chairman of the board of directors since 1985. Mr. Graham became president of the Company in 1953 and chief executive officer in 1960 and continued in these positions until 1971. From 1971 to 1980 he was chairman of the board and chief executive officer, and thereafter he served as chairman until he became senior chairman. VERNON R. LOUCKS JR., age 59, has been chairman of the board of directors since 1987 and chief executive officer of Baxter since 1980. Mr. Loucks was first elected an officer of Baxter in 1971. LESTER B. KNIGHT, age 35, has been an executive vice president of Baxter since 1992, and a vice president since 1990. Mr. Knight previously was president of a division of a subsidiary of Baxter, and prior to that was employed in various management capacities with the same subsidiary. Mr. Knight is the son of Charles F. Knight, a director of Baxter. TONY L. WHITE, age 47, has been an executive vice president of Baxter since 1992, and a vice president since 1986, when he was first elected an officer. HENRY R. AUTRY, age 45, has been senior vice president and chief administrative officer of Baxter since 1993. Mr. Autry previously was president of a division of a subsidiary of Baxter. Before joining the Company, Mr. Autry was vice president of international sales at Federal Express Corporation. HARRY M. JANSEN KRAEMER, JR., age 39, has been senior vice president and chief financial officer of Baxter since 1993. Mr. Kraemer previously was the vice president of finance and operations for a subsidiary of Baxter. Prior to that he was employed as controller, group controller, and president of various divisions of subsidiaries of Baxter. ARTHUR F. STAUBITZ, age 54, has been senior vice president, secretary and general counsel of Baxter since 1993. Mr. Saubitz previously was vice president/general manager of the ventures group of a subsidiary of Baxter. Prior to that he was senior vice president, secretary and general counsel of Amgen, Inc. Prior to that he was a vice president of a Baxter subsidiary, and prior to that he was a vice president and deputy general counsel of Baxter. BARBARA Y. MORRIS, age 48, has been a senior vice president of Baxter since 1992. Ms. Morris was first elected an officer of Baxter in 1986. HERBERT E. WALKER, age 59, has been senior vice president of Baxter since 1993. Mr. Walker previously was vice president of human resources of a division of a subsidiary of Baxter. DALE A. SMITH, age 62, has been a group vice president of Baxter since 1979, when he was first elected an officer. RONALD H. ABRAHAMS, age 51, has been a vice president of Baxter since 1990. Mr. Abrahams previously was vice president -- quality assurance and regulatory affairs of a subsidiary of Baxter. DAVID J. AHO, age 44, has been a vice president of Baxter since 1989. Mr. Aho previously was vice president of government affairs of a subsidiary of Baxter. JAMES H. TAYLOR, JR., age 55, has been a vice president of Baxter since 1992. Mr. Taylor previously was the general manager of operations of a division of a subsidiary of Baxter, and prior to that was vice president of manufacturing of that division. BRIAN P. ANDERSON, age 43, has been the controller of Baxter since 1993. Mr. Anderson previously was the vice president of corporate audit of a subsidiary of Baxter, and prior to that was a partner in the international accounting firm of Deloitte & Touche. LAWRENCE D. DAMRON, age 47, has been treasurer of Baxter since 1992. Mr. Damron previously was a vice president and controller of a division of a subsidiary of Baxter, and prior to that was the corporate auditor of another subsidiary. Prior to that, he was vice president and controller of a division of that subsidiary. c) COMPLIANCE WITH SECTION 16(A) OF THE SECURITIES EXCHANGE ACT OF 1934. Incorporated by reference from Proxy Statement, page 17, section entitled "Section 16 Reporting." - -------------------------------------------------------------------------------- PART IV - -------------------------------------------------------------------------------- ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K The following documents are filed as a part of this report: - -------------------------------------------------------------------------------- REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULES - -------------------------------------------------------------------------------- Board of Directors BAXTER INTERNATIONAL INC. Our audits of the consolidated financial statements referred to in our report dated February 10, 1994 appearing on page 48 of the 1993 Annual Report to Stockholders of Baxter International Inc. (which report and consolidated financial statements are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the Financial Statement Schedules listed in Item 14(a) of this Form 10-K. In our opinion, these Financial Statement Schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. PRICE WATERHOUSE Chicago, Illinois February 10, 1994 SCHEDULE II - -------------------------------------------------------------------------------- AMOUNTS RECEIVABLE FROM RELATED PARTIES AND UNDERWRITERS, PROMOTERS, AND EMPLOYEES OTHER THAN RELATED PARTIES (In thousands of dollars) - -------------------------------------------------------------------------------- SCHEDULE V - -------------------------------------------------------------------------------- PROPERTY, PLANT AND EQUIPMENT (In millions of dollars) - -------------------------------------------------------------------------------- SCHEDULE VI - -------------------------------------------------------------------------------- ACCUMULATED DEPRECIATION AND AMORTIZATION OF PROPERTY, PLANT AND EQUIPMENT (In millions of dollars) - -------------------------------------------------------------------------------- The estimated lives used in determining depreciation and amortization are as follows: SCHEDULE VIII - -------------------------------------------------------------------------------- VALUATION AND QUALIFYING ACCOUNTS (In millions of dollars) - -------------------------------------------------------------------------------- SCHEDULE IX - -------------------------------------------------------------------------------- SHORT-TERM BORROWINGS (In millions of dollars) - -------------------------------------------------------------------------------- SCHEDULE X - -------------------------------------------------------------------------------- SUPPLEMENTARY INCOME STATEMENT INFORMATION (In millions of dollars) - -------------------------------------------------------------------------------- Amounts charged to (1) taxes other than payroll and income taxes, (2) royalties, and (3) advertising costs, have been omitted since each is less than 1% of net sales. SIGNATURES Pursuant to the requirements of section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. BAXTER INTERNATIONAL INC. By: /S/ VERNON R. LOUCKS JR. -------------------------------------- Vernon R. Loucks Jr. CHAIRMAN OF THE BOARD AND CHIEF EXECUTIVE OFFICER Date: March 21, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. - -------------------------------------------------------------------------------- APPENDICES - -------------------------------------------------------------------------------- EXHIBITS FILED WITH SECURITIES AND EXCHANGE COMMISSION (All other exhibits are inapplicable.) Copies of the above exhibits are available at a charge of 35 cents per page upon written request to the Stockholder Services Department, Baxter International Inc., One Baxter Parkway, Deerfield, Illinois, 60015. Copies are also available at a charge of at least 25 cents per page from the Public Reference Section of the Securities and Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549. [LOGO] Baxter International Inc., One Baxter Parkway, Deerfield, Illinois 60015

53347_1993.txt

53347

1993

Item 1. Business. (a) General Development of Business Registrant was incorporated under the business laws of the State of North Carolina in 1968 for the purpose of serving as a holding company with broad powers to engage in business and to make investments. Registrant's principal subsidiaries are: Jefferson-Pilot Life Insurance Company, Jefferson-Pilot Fire & Casualty Company, Jefferson-Pilot Title Insurance Company and Jefferson-Pilot Communications Company, all of Greensboro, North Carolina. Through these and other subsidiaries, Registrant is primarily engaged in the business of writing life, annuity, accident and health, property and casualty, and title insurance, and in the business of operating radio and television facilities. Various states, including North Carolina, have enacted insurance holding company legislation which requires the registration of, and periodic reporting by insurance companies licensed to transact business within their respective jurisdictions and which are controlled by other corporations. All of the common stock of Jefferson-Pilot Life Insurance Company, Jefferson-Pilot Fire & Casualty Company and Jefferson-Pilot Title Insurance Company is owned by Jefferson-Pilot Corporation. They are, therefore, by statutory definition, members of an "insurance holding company system", and have registered as such under all applicable state statutes. In many instances, these state statutes require prior approval by state insurance regulators of inter-corporate transfers of assets (including prior approval of payment of extraordinary dividends by insurance subsidiaries) within the holding company system. I-1 (b) Financial Information about Industry Segments Industry segment information is presented in Note 13, Segment Information of the Notes to Consolidated Financial Statements, which note is incorporated herein by reference. Premiums derived from the principal products and services of Registrant's insurance subsidiaries and revenues from the Communications segment for the years ended December 31, 1993, 1992, and 1991 are as follows (in thousands): 1993 1992 1991 Life insurance segment: Individual life and annuity premiums $ 106,073 $ 99,431 $ 93,231 Group life premiums 64,337 65,741 65,664 Interest-sensitive product considerations 63,353 57,954 55,133 Other considerations 6,433 6,908 16,341 Life premiums and other considerations $ 240,196 $ 230,034 $ 230,369 Accident and health premiums 386,608 383,552 382,624 $ 626,804 $ 613,586 $ 612,993 ========= ========= ========= Other insurance segment, casualty and title insurance premiums $ 43,044 $ 44,815 $ 45,270 ========= ========= ========= Communications segment, broadcast and media services revenue $ 144,961 $ 129,734 $ 125,045 ========= ========= ========= (c) Narrative Description of Business The following is a brief description of the principal wholly-owned subsidiaries of Registrant with a description of the principal products provided and services rendered and the markets for, and methods of, distribution of such products and services. I-2 INSURANCE COMPANY SUBSIDIARIES Jefferson-Pilot Life Insurance Company Jefferson-Pilot Life was organized under the insurance laws of North Carolina in 1890 and commenced business operations in 1903. It is authorized to write insurance in 43 states, the District of Columbia, the Virgin Islands and Puerto Rico. The Company is primarily engaged in the writing of whole life, term, and endowment policies on an individual ordinary basis and group life and group accident and health insurance. Accident and health insurance is also written on an individual basis. Approximately 13% of the ordinary life insurance in force is on a participating basis; all group life is written on a non- participating basis. Life Insurance. Life policies offered include continuous and limited-pay life and endowment policies, universal life-type and annuity contracts, retirement income plans, and level and decreasing term insurance. On most policies, accidental death and disability benefits are available in the form of riders. At times, sub-standard risks are accepted at higher premiums. At December 31, 1993, approximately 4.4% of the ordinary insurance in force, including reinsurance ceded, was represented by sub-standard risks. The Company markets its individual products through a general agency type system utilizing career agents and home service agents, and through Individual Marketing Organizations (IMO's). IMO's are intermediaries that sell financial products and services through agents they have recruited. Thirty IMO's have been appointed representing approximately 3,300 life insurance agents. Group products are marketed through group brokers, career agents, and home service agents. Individual health products are marketed through all of the Company's sales forces and brokers. I-3 The following table sets forth for the years ended December 31, 1993, 1992, and 1991, certain information relating to the life insurance operations of Jefferson-Pilot Life: 1993 1992 1991 (Percent) Voluntary terminations to mean amount of life insurance policies in force: Whole life, endowment and term 8.1 8.9 10.5 Group life 19.4 4.2 13.3 Industrial life 3.1 3.4 3.5 Actual to expected mortality: Whole life, endowment and term 38.4 36.7 38.0 Group life 95.9 90.8 85.4 Industrial life 45.4 45.7 48.7 Life insurance underwriting expense (1) to premium income (2): Industrial 84.9 89.1 81.6 Ordinary Life (4) 34.8 37.0 37.8 Annuities (4) 7.4 7.6 7.6 Credit life (3) N/A N/A 43.7 Group life 11.3 9.5 10.3 Group A & H 15.9 15.2 14.2 Credit A & H (3) N/A N/A 40.4 Other A & H 44.9 48.0 44.8 (1) Underwriting expense consists of commissions, general insurance expenses, insurance taxes (other than income), licenses and fees, and increase in loading on due and deferred premiums. NAIC basis. (2) Does not include amounts received for supplementary contracts or considerations for deposit administration funds. NAIC basis. (3) The company no longer writes any form of credit insurance. (4) 1991 percentages have been restated to report ordinary life and annuity amounts separately. I-4 Accident and Health Insurance. Jefferson-Pilot Life writes a major part of its accident and health policies on a group basis. Of the individuals covered during 1993, approximately 92.7% were written on a group basis and 7.3% on an individual basis. Group insurance is generally issued to employers covering their employees and to associations covering their members. The following table sets forth certain information on the NAIC basis with regard to the operating results of the accident and health business of Jefferson-Pilot Life for the years ended December 31, 1993, 1992, and 1991. The allocation of net investment income and general expenses to accident and health business has been made by the management of Jefferson-Pilot Life using allocation methods believed reasonable: 1993 1992 1991 (In Thousands) Premium Income: Individual $ 28,248 $ 25,781 $ 24,022 Group 358,360 357,771 358,602 Total 386,608 $383,552 $382,624 Allocated Net Investment Income: Individual $ 3,564 $ 3,216 $ 2,883 Group 26,982 26,811 26,467 Total 30,546 $ 30,027 $ 29,350 Claims and Reserve Increase: Individual $ 17,772 $ 15,895 $ 13,955 Group 288,049 301,955 311,801 Total 305,821 $317,850 $325,756 Underwriting Expenses: Individual $ 11,461 $ 11,164 $ 9,779 Group 55,935 53,218 47,650 Total 67,396 $ 64,382 $ 57,429 Net Income Before Income Taxes: Individual $ 2,579 $ 1,938 $ 3,171 Group 41,358 29,409 25,618 Total $ 43,937 $ 31,347 $ 28,789 I-5 The following table sets forth certain underwriting information with regard to the accident and health business of Jefferson-Pilot Life for the years ended December 31, 1993, 1992 and 1991, on the NAIC basis: 1993 1992 1991 (Dollar Amounts In Thousands) Net premiums written $387,084 $383,114 $388,994 Net premiums earned $387,000 $384,677 $386,892 Ratio of loss and loss adjustment expenses incurred to earned premiums 79.11% 82.91% 84.26% Ratio of underwriting expenses incurred to premiums written 17.42% 16.82% 15.80% Combined loss and expense ratio 96.53% 99.73% 100.06% Underwriting margins $ 13,391 $ 1,320 $( 560) Jefferson-Pilot Fire & Casualty Company and Jefferson-Pilot Title Insurance Company Jefferson-Pilot Fire & Casualty Company, a North Carolina corporation with its home office in Greensboro, North Carolina, and its wholly-owned subsidiaries, Southern Fire & Casualty Company, a Tennessee corporation and Jefferson-Pilot Property Insurance Company, a North Carolina Corporation, both with their home offices in Greensboro, North Carolina, offer a full line of fire, and property and casualty insurance, including homeowners, commercial multiple peril, inland marine, worker's compensation, automobile and general liability. Jefferson-Pilot Fire & Casualty Company is licensed in 14 states; Southern Fire & Casualty Company is licensed in 13 states, and Jefferson-Pilot Property Insurance Company is licensed in 4 states. Jefferson-Pilot Title Insurance Company, Greensboro, North Carolina, incorporated under the laws of North Carolina in 1962, is engaged in the business of writing title insurance. It is licensed in 7 states. I-6 Other Information Regarding Insurance Company Subsidiaries Regulation. Jefferson-Pilot Life, Jefferson-Pilot Fire & Casualty, Southern Fire & Casualty, Jefferson-Pilot Property and Jefferson-Pilot Title, in common with other insurance companies, are subject to regulation and supervision in the States in which they do business. Although the extent of such regulation varies from state to state, generally the insurance laws of the States concerned establish supervisory agencies with broad administrative powers relating to the granting and revocation of licenses to transact business, the licensing of agents, the approval of the forms of policies used, the form and content of required financial statements, reserve requirements, and, in general, the conduct of all insurance activities. The Companies are also required under these laws to file detailed annual reports with the supervisory agencies in the various states in which they do business, and their business and accounts are subject to examination at any time by such agencies. Under the rules of the National Association of Insurance Commissioners and the laws of the State of North Carolina, these Companies are examined periodically (usually at three-year intervals) by the supervisory agencies of one or more of the states in which they do business. Competition. All insurance subsidiaries of Registrant operate in a highly competitive field which consists of a large number of stock, mutual and other types of insurers. A large number of established insurance companies compete in the states in which the Companies transact business. Many of these competing companies are mutual companies, which are considered by some to have an advantage because of the fact that such companies write participating policies exclusively, under which profits may inure to the benefit of the policyholder. Jefferson-Pilot Life provides participating policies which are believed to be generally competitive with analogous policies offered by mutual companies. I-7 Employees. As of December 31, 1993, the insurance subsidiaries of the Registrant employed approximately 3,000 agents and employees, in addition to the 3,300 IMO agents mentioned previously. COMMUNICATIONS COMPANY SUBSIDIARIES Jefferson-Pilot Communications Company is a wholly-owned subsidiary of Registrant and is a corporation organized under the laws of North Carolina, with principal offices at 100 North Greene Street in Greensboro, North Carolina. The Company owns and operates (i) VHF television station WBTV and radio stations WBT and WBT-FM in Charlotte, North Carolina, (ii) radio stations WQXI in Atlanta and WSTR-FM in Smyrna, Georgia, (iii) radio stations KYGO and KYGO-FM in Denver and KWMX and KWMX-FM in Lakewood, Colorado, (iv) radio stations WMRZ in South Miami, WLYF-FM in Miami, and WMXJ-FM in Pompano Beach, Florida, (v) radio stations KSON and KSON-FM in San Diego, California, (vi) a sports production and syndication business, and (vii) a co-op advertising consulting business. Jefferson-Pilot Communications Company of Virginia, a Virginia corporation with principal offices at 5710 Midlothian Turnpike, Richmond, Virginia, is a wholly-owned subsidiary of Jefferson-Pilot Communications Company that owns and operates VHF television station WWBT in Richmond, Virginia. WCSC, Inc., a South Carolina corporation with principal offices at 485 East Bay Street, Charleston, South Carolina, is a wholly-owned subsidiary of Jefferson-Pilot Communications Company that owns and operates VHF television station WCSC in Charleston, South Carolina. Jefferson-Pilot Data Services, Inc., a North Carolina corporation, with principal offices at 785 Crossover Lane, Memphis, Tennessee, is a wholly-owned subsidiary of Registrant, and is engaged in data processing services and in providing computer equipment, software, and services to broadcast stations, advertising agencies, and station national sales representative clients. I-8 Television Operations The television stations owned and operated by Jefferson-Pilot Communications Company and its subsidiaries are WBTV, Charlotte, North Carolina; WWBT, Richmond, Virginia; and WCSC, Charleston, South Carolina. WBTV, Channel 3, Charlotte, is affiliated with CBS under a Network Affiliation Agreement expiring on December 31, 1998. Absent cancellation by either party, the Agreement will be renewed for successive two-year periods. An estimated 769,000* television homes view WBTV each week within the Charlotte Television Market, which is ranked as the 30th* television market in the nation by the Arbitron Ratings Company. Four other commercial television stations are licensed to the Charlotte metropolitan area. WWBT, Channel 12, Richmond, is affiliated with NBC under a Network Affiliation Agreement expiring August 15, 1995. Absent cancellation by either party, the Agreement will be renewed for successive two-year periods. An estimated 475,000* television homes view WWBT each week within the Richmond Television Market, which is ranked as the 61st* television market in the nation. Four other commercial television stations are licensed to that market. WCSC, Channel 5, Charleston, is affiliated with CBS under a Network Affiliation Agreement expiring on December 31, 1998. Absent cancellation by either party, the Agreement will be renewed for successive two-year periods. An estimated 279,000* television homes view WCSC each week within the Charleston Television Market, which is ranked as the 106th* television market in the nation. Four other commercial television stations are licensed to that market. *Arbitron Ratings/Television, November, 1993. I-9 Radio Operations Jefferson-Pilot Communications Company owns and operates WBT and WBT-FM in Charlotte, WQXI in Atlanta and WSTR-FM in Smyrna, KYGO and KYGO-FM in Denver, KWMX and KWMX-FM in Lakewood (a Denver suburb), KSON and KSON-FM in San Diego, WMRZ in South Miami, WLYF in Miami and WMXJ-FM in Pompano Beach. Each of these stations is authorized to operate 24 hours a day, and all normally operate for the full 24 hours. Other Information Regarding Communications Companies Competition. The radio and television stations of Jefferson-Pilot Communications Company and its subsidiaries, Jefferson-Pilot Communications Company of Virginia, and WCSC, Inc., compete for revenues with other radio and television stations in their respective market areas as well as with other advertising media. Jefferson-Pilot Communications Company's non-broadcast divisions compete with other vendors of similar products and services. Employees. As of December 31, 1993, Jefferson-Pilot Communications Company and its subsidiaries employed approximately 625 persons full time, and Jefferson-Pilot Data Services, Inc. employed approximately 225 persons. Federal Regulation. Television and radio broadcasting operations are subject to the jurisdiction of the Federal Communications Commission ("FCC") under the Communications Act of 1934 (the "Act"). The Act empowers the FCC, among other things, to issue, revoke or modify broadcasting licenses, to assign frequencies, to determine the locations of stations, to regulate the apparatus used by stations, to establish areas to be served, to adopt such regulations as may be necessary to carry out the provisions of the Act, and to impose certain penalties for violation of such regulations. The Act, and Regulations issued thereunder, prohibit the transfer of a license, or of I-10 control of a licensee without prior approval of the FCC; restrict in various ways the common and multiple ownership of broadcast facilities; restrict alien ownership of licenses; and impose various other strictures on ownership and operation. Broadcasting licenses are granted for a period of five years for television and seven years for radio and, upon application therefor and in the absence of conflicting applications or adverse claims as to the licensee's qualifications or performance, are normally renewed by the FCC for an additional term. The licenses currently in effect will expire as follows: WBTV 12/1/96; WBT and WBT-FM 12/1/95; WQXI and WSTR-FM 4/1/96; KYGO AM/FM and KWMX AM/FM 4/1/97; WMRZ, WLYF and WMXJ 2/1/96; KSON-AM/FM 12/1/97; WWBT 10/1/96; and WCSC 12/1/96. (d) Foreign Operations Substantially all of Registrant's and subsidiaries operations are conducted within the United States. Item 2.

Item 2. Properties Registrant utilizes space and personnel of its wholly-owned subsidiary, Jefferson-Pilot Life. Jefferson-Pilot Life's home office consists of a 20-story building and an adjacent 17-story building. These structures house insurance operations and provide a substantial amount of space for commercial leasing. Jefferson-Pilot Life also owns a supply and printing facility, a parking deck, and a computer center, all located on nearby properties. The life insurance company also owns 278 acres in Guilford County, North Carolina, near Greensboro. This was the former home office of Pilot Life Insurance Company. In addition, Jefferson-Pilot Life owns an Employees' Club located in north- western Guilford County, North Carolina, with approximately 500 acres of land surrounding the Club. I-11 Jefferson-Pilot Communications Company owns its radio and television studios and office buildings in Charlotte, North Carolina. It also owns the radio studios and office buildings in Denver, Colorado and Miami, Florida. The radio studios and offices are leased in Atlanta, Georgia and San Diego, California, as are the television studios and offices in Charleston, South Carolina. Jefferson-Pilot Communications Company of Virginia owns a television studio and office building in Richmond, Virginia. Item 3.

Item 3. Legal Proceedings Environmental Proceedings There are no material administrative proceedings against the Company involving environmental matters. Litigation The Registrant is involved in various claims and lawsuits incidental to its business. In the opinion of management, the ultimate liability will not have a material effect on the financial condition of the Company. Note 14, Commitments and Contingent Liabilities of the Notes to Consolidated Financial Statements, contains further information and is incorporated herein by reference. Item 4.

Item 4. Submission of Matters to a Vote of Securities Holders None. I-12 Part II Item 5.

Item 5. Market for the Registrant's Common Stock and Related Stockholder Matters (a) Market Information Shares of Jefferson-Pilot Corporation are traded on the New York, Midwest, and Pacific Stock Exchanges under the symbol JP. High and low sales prices for the past three years are listed below. 1993 1992 1991 First Quarter 57 7/8 - 45 1/2 39 1/4 - 33 1/4 29 3/8 - 22 7/8 Second Quarter 57 3/4 - 46 44 - 35 1/2 29 7/8 - 27 5/8 Third Quarter 57 7/8 - 48 5/8 43 - 38 1/2 34 3/8 - 28 3/8 Fourth Quarter 54 - 45 3/4 49 1/2 - 37 1/8 39 1/8 - 32 1/2 (b) Number of Security Holders As of March 2, 1994, the Registrant had 9,819 shareholders. (c) Dividend History 1993 1992 1991 1990 1989 Cash dividends paid: $ 75,986 $ 66,310 $ 56,120 $ 53,139 $ 50,610 ======== ======== ======== ======== ======== Cash dividends paid per share: First Quarter .34 .28 .25 .23 .21 Second Quarter .39 .34 .28 .25 .23 Third Quarter .39 .34 .28 .25 .23 Fourth Quarter .39 .34 .28 .25 .23 Total $ 1.51 $ 1.30 $ 1.09 $ .98 $ .90 ======== ======== ======== ======== ======== II-1 Item 6.

Item 6. Selected Financial Data SUMMARY OF SELECTED FINANCIAL DATA (In Thousands Except Per Share Information) 1993 1992 1991 1990 1989 Operating income before effect of initial application of FAS 106 $ 181,952 $ 171,240 $ 153,128 $ 138,962 $ 126,264 Accumulated post- retirement benefit obligation at 1-1-93, net (24,109) 0 0 0 0 Operating income 157,843 171,240 153,128 138,962 126,264 Realized investment gains, net of appli- cable income taxes 37,329 31,998 22,559 18,675 11,427 Net income $ 195,172 $ 203,238 $ 175,687 $ 157,637 $ 137,691 =========== =========== =========== =========== =========== Income per share of common stock: Operating income before effect of initial application of FAS 106 $ 3.62 $ 3.36 $ 2.98 $ 2.59 $ 2.23 Effect of initial application of FAS 106 (.48) .00 .00 .00 .00 Realized investment gains, net of taxes .74 .63 .44 .35 .20 Net income $ 3.88 $ 3.99 $ 3.42 $ 2.94 $ 2.43 =========== =========== =========== =========== =========== Average shares outstanding 50,251,676 50,952,147 51,319,143 53,636,223 56,588,878 =========== =========== =========== =========== =========== Total assets $ 5,640,621 $ 5,256,762 $ 4,945,396 $ 4,474,523 $ 4,543,474 =========== =========== =========== =========== =========== Stockholders' equity $ 1,733,071 $ 1,668,210 $ 1,544,461 $ 1,334,434 $ 1,456,109 =========== =========== =========== =========== =========== Stockholders' equity per share of common stock $ 35.04 $ 33.07 $ 30.11 $ 25.77 $ 25.98 =========== =========== =========== =========== =========== II-2 Selected Financial Data (continued) Total assets prior to 1993 were adjusted to reflect the adoption of Financial Accounting Standard (FAS) 113 "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts." The amounts shown for 1992 to 1989 were increased by $20,925,000, $20,176,000, $19,615,000, and $13,886,000, respectively, compared to amounts previously reported. Stockholders' equity was adjusted to reflect adoption of FAS 109 "Accounting for Income Taxes." The amounts shown for 1992 to 1989 were all decreased by $18,555,000 compared to amounts previously reported. Stockholders' equity per share reflects these adjustments, also. REVENUE BY SOURCES (In Thousands) 1993 1992 1991 1990 1989 Life and accident and health insurance $ 986,972 $ 965,862 $ 956,426 $ 946,262 $ 936,599 Casualty and title insurance 51,462 53,907 53,472 55,164 50,307 Communications 144,961 129,734 125,045 127,330 126,990 Other 6,282 4,656 4,570 5,656 9,074 Realized investment gains 56,947 48,170 33,963 28,201 17,228 Revenues $1,246,624 $1,202,329 $1,173,476 $1,162,613 $1,140,198 ========== ========== ========== ========== ========== NET INCOME BY SOURCES (In Thousands) 1993 1992 1991 1990 1989 Life and accident and health insurance $ 158,242 $ 156,588 $ 146,205 $ 128,153 $ 109,329 Casualty and title insurance 7,957 7,027 2,554 6,232 4,927 Communications 17,335 14,169 10,327 10,019 12,505 Other ( 1,582) ( 6,544) ( 5,958) ( 5,442) ( 497) Realized investment gains, net of taxes 37,329 31,998 22,559 18,675 11,427 Accumulated post- retirement benefit obligation, net ( 24,109) 0 0 0 0 Net income $ 195,172 $ 203,238 $ 175,687 $ 157,637 $ 137,691 ========== ========== ========== ========== ========== II-3 Item 7.

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Liquidity The Company's liquidity requirements are met primarily by cash flows from the operations of Jefferson-Pilot Life Insurance Company (JPLIFE) and other consolidated subsidiaries. Primary sources of cash from subsidiary operations are premiums, other insurance considerations, investment income and communications revenue. Primary uses of cash in subsidiary operations include payment of insurance benefits, operating expenses and costs related to acquiring new insurance business. Net cash provided by operations on a consolidated basis approximated $160 million, $156 million and $177 million in 1993, 1992 and 1991, respectively. Dividends paid to the parent company approximated $103 million in 1993, $128 million in 1992 and $129 million in 1991. While all significant subsidiaries generally pay dividends to the parent company, JPLIFE continues to be its primary source of dividends, and therefore of cash. Dividends that the insurance subsidiaries may pay without prior regulatory approval are subject to statutory limitation. In addition, life insurance companies became subject to risk-based capital requirements beginning in 1993. Neither of these factors are expected to represent practical restrictions on the dividend payment practices or other activities of the parent company in the foreseeable future. Proceeds from maturities, redemptions and sales of debt securities, mortgage loan repayments and proceeds from sales of equity securities are the primary sources of cash from investing activities. Continuing a trend related to overall interest rate declines, issuer calls and prepayments increased in 1993. This circumstance, combined with scheduled maturities and sales of certain debt securities expected to be called, resulted in cash proceeds from debt securities transactions approximating $940 million in 1993, compared to $375 million in 1992 and $266 million in 1991. Scheduled maturities for 1994 are less than the levels experienced in the three most recent years. While prediction of future calls and prepayments is complicated by interest rate uncertainties, the Company expects them to continue at some level during 1994. Net cash used in investing activities approximated $400 million in 1993, $221 million in 1992 and $228 million in 1991. Reflected for each year are reinvestment of the proceeds from investment transactions, investment of net proceeds from JPLIFE's policyholder contract deposits and investment of net cash provided by current operating activities over that used to pay stockholder dividends and reacquire the Company's common stock. During 1993, the Company also redirected certain short-term investments, primarily cash equivalents, into longer duration investments. The Company continues to select investments based on a disciplined strategy focused on long-term performance objectives. Consistent with that strategy, investments acquired during 1993 consisted primarily of investment II-4 grade debt securities, mortgage loans of quality and diversification comparable to those previously held, and common stock issues offering acceptable relationships between risk and potential total return. Continuing a three-year trend, the Company increased its investment in new mortgage loans during 1993 to approximately $86 million, compared to $60 million in 1992 and $41 million in 1991. The trend reflects an increase in lending opportunities that are acceptable under the Company's standards. The cost of common stock investments acquired in 1993 approximated $65 million. This increase over 1992 and 1991 levels is primarily due to a dividend-roll program. Provision has been made for declines in value of debt securities considered other than temporary and for estimated unrecoverable amounts related to the mortgage loan portfolio. Debt securities and mortgage loans representing credit problems continue to fall below industry averages. The Company's overall investment management strategy encompasses both internal objectives and external circumstances. Its business plan emphasizes growth of the life insurance and other core businesses, achievement of which will require investment of liquid resources. The Company monitors and evaluates securities market conditions and specific external circumstances that may impact individual investment holdings. Asset/liability management strategies may require action in response to such factors as interest rate changes and the effect thereof on prepayment risk. The above-described factors may result in future sales of selected debt securities prior to maturity. In connection with a process begun in 1993, and continuing into 1994, the Company expects that a significant portion of its debt securities will be designated as available for sale in response to these factors. In the first quarter of 1994, the Company will adopt SFAS 115. Under SFAS 115, all equity securities and debt securities classified as available for sale will be stated at value in the consolidated balance sheets. Since classification of the Company's debt securities is not complete, the effect of SFAS 115 on the stated amount of debt securities and the corresponding effects on deferred income tax liabilities, equity and other balance sheet amounts have not yet been determined. Adoption of SFAS 115 will increase the stated amount of equity securities held by the parent company as of January 1, 1994 by $70 million, with associated increases of $28 million in deferred income tax liabilities and $42 million in stockholders' equity. During 1993, the Company utilized an uncommitted bank line of credit in application of its asset/liability management strategies. The line permits the Company to request aggregate advances totaling up to $100 million until October 1994. Maximum utilization of the line approximated $40 million during the year and interest expense was not material. Management expects to increase the utilization of external financing sources as considered appropriate and consistent with its investment management and growth strategies. The Company has historically reacquired its own common stock whenever management considers it prudent. Cash used in connection with that strategy approximated $51 million in 1993, $36 million in 1992 and $18 million in 1991. The Company expects to continue reacquiring its common stock when considered appropriate, with the extent of those acquisitions to be determined based on securities market conditions and other relevant factors. II-5 Capital Resources Consolidated stockholders' equity as of December 31, 1993 amounted to $1.733 billion, compared to $1.668 billion in 1992 and $1.544 billion in 1991 as restated for the effect of adopting SFAS 109 on deferred income tax liabilities. After tax unrealized gains on equity securities included in the preceding amounts approximated $332 million in 1993, $335 million in 1992 and $311 in 1991. The Company regards the regulatory capital status of its insurance subsidiaries, with due consideration to the risk-based capital requirements which became effective for life insurance companies in 1993, to be extremely strong. Management considers existing capital resources to be adequate for the Company's present needs and its business plan places priority on redirecting capital resources presently considered under-utilized into more productive business activities. The Company has no outstanding long-term debt and is not a party to an agreement under which significant long-term financing might be provided by an outside party in the future. The Company leases data processing equipment and field office locations, generally under noncancelable lease terms of three to five years. Financing and capital resources considerations are not critical to the decision making process involving leasing activities. Cash dividends to stockholders amounted to $78.1 million in 1993, $69.1 million in 1992 and $57.4 million in 1991. The Company has consistently returned cash dividends to its stockholders and expects to continue to do so in the future. Capital resources requirements are not expected to represent practical restrictions on future dividend payment plans. Results of Operations - 1993 Compared to 1992 Premiums and other insurance considerations increased by $11.4 million in 1993, to approximately $670 million. The 1993 growth is attributable to individual life premiums and related considerations which increased by 8% over 1992 amounts and improved upon a recent annual growth trend of less than 2% per year. The increase results from implementation of various aspects of the Company's current business plan. Accident and health and casualty and title premiums remained substantially stable during 1993, with the former increasing and the latter decreasing modestly. Net investment income increased by $8.7 million (2.4%) during 1993, with the increase in the debt securities investment base offsetting the effects of a lower interest rate environment. Communications revenue increased by $15.2 million over 1992, to about $145 million, due primarily to a combination of the improved economic environment and measures taken to strengthen the market position of certain broadcast properties, including acquisitions in new and previously existing markets. Realized investment gains increased to $56.9 million in 1993, compared to $48.2 million in 1992, with call premiums and gains from sales of debt securities expected to be called more than offsetting a provision for other than temporary decline in value of certain debt securities ($8 million) and reduced gains on sales of common stocks. Life insurance benefits and other credits to policyholders increased from $279 million in 1992 to $296 million in 1993 (6%), with much of the II-6 increase attributable to interest credited on interest-sensitive products. Accident and health benefits continued to decline, decreasing from approximately $318 million in 1992 to approximately $306 million in 1993 and reflect the continued emphasis on underwriting and claims management effectiveness. Casualty and title claims decreased by about $2 million in 1993, as reinsurance recoveries on incurred losses more than offset an increase in incurred losses before reinsurance. Expenses other than those related to communications operations remained basically flat in 1993 as compared to 1992, reflecting the ongoing benefit of the Company's containment program. A significant consolidation of field offices undertaken in 1993 helped to reduce field office expenses for the year in addition to improving marketing efficiency. Expenses of the communications businesses increased by approximately $12 million due primarily to promotional expenses incurred to strengthen market position, charges related to aged syndicated programming and operating costs of newly acquired properties. Income taxes as a percent of before tax income increased to 31.9% in 1993, compared to 28.8% in 1992. The increase resulted from a combination of an increase in the federal tax rate (from 34% to 35%) prescribed by the 1993 Act and the beneficial effect on 1992 income taxes of recoveries and reductions of previously provided amounts related to prior tax assessments. Consolidated net income for 1993 reflects a charge of $24.1 million, net of deferred tax benefit, for the cumulative effect of adopting SFAS 106, which required the Company to provide for the cost of postretirement health care and life insurance benefits provided to retirees during the period of their service to the Company instead of on a cash basis after their retirement. The amount of this charge is consistent with the Company's previously reported estimate. Before the cumulative effect charge, consolidated after-tax income increased by approximately $16 million during 1993, to $219.3 million. Each of the Company's significant business activities made some contribution to the current year increase. Approximate increases by major business activity, exclusive of realized investment gains were as follows: life and accident and health insurance $2 million, casualty and title insurance $1 million, communications $3 million, and corporate level activities $5 million (primarily through expense reductions). The balance of the 1993 increase in consolidated pre-SFAS 106 income ($5 million) is attributable to the increase in realized investment gains. Results of Operations - 1992 Compared to 1991 Premiums and other insurance considerations were $658 million in both 1992 and 1991, with revenue from life, accident and health and other insurance products remaining substantially stable. Net investment income for 1992 increased by $8.1 million over 1991, due primarily to increased investment in debt securities. Revenue from communications operations increased by $4.7 million, to $129.7 million during 1992 due to overall improvement in advertising market conditions and the 1992 elections. Call premiums on debt securities and an increase of $20.3 million in gains from sales of common stocks contributed to a net increase in realized investment gains of $14.2 million, to $48.2 million, during 1992. II-7 Insurance benefits decreased 2.4% from $642.5 million in 1991 to $627.1 million in 1992. The primary contributing factors were a reduction in surrender benefits of $8.7 million and a reduction in casualty benefits of $6.6 million. The reduction in surrender benefits during 1992 continued a trend which began in 1985, and was favorably affected by declining interest rates. The reduction in casualty benefits reflects an improvement in loss experience, which was due in part to more selective underwriting practices. Increases in general and administrative expenses of the insurance businesses and communications operating expenses during 1992 were modest, reflecting ongoing aggressive expense management. Effective income tax rates for 1992 and 1991 were consistent, with each year benefitting from recoveries of amounts paid and reductions of amounts previously provided for prior year tax assessments. On a consolidated basis, net income increased from $175.7 million in 1991 to $203.2 million in 1992 ($27.5 million). Each of the Company's principal business activities contributed to the increase in net income, with net income from the core business of life and accident and health insurance increasing by $10.4 million, net income from other insurance operations increasing by $4.5 million and net income from communications operations increasing by $3.8 million. The balance of the increase in net income during 1992 is attributable to realized investment gains. II-8 Item 8.

Item 8. Financial Statements and Supplementary Data II-9 Financial statements and notes included on pages 29 through 49 of the Annual Report of Jefferson-Pilot Corporation to its shareholders for the year ended December 31, 1993, are incorporated herein by reference. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. II-10 Part III Item 10.

Item 10. Directors and Executive Officers of the Registrant (a) Identification of Directors The information included under the heading "Election of Directors," of the Proxy Statement of Jefferson-Pilot Corporation to its shareholders, in connection with the Annual Meeting to be held on May 2, 1994 (the "Proxy Statement"), is incorporated herein by reference. Louis C. Stephens, Jr., age 72, whose term as a director will expire at the May 2, 1994 Annual Meeting of Shareholders (the "Annual Meeting"), has served as a director since 1970. Mr. Stephens is not currently serving in another position or office with Jefferson-Pilot Corporation. There are no arrangements or understandings between any director and any other person pursuant to which such director was or is to be selected as a director or nominee. (b) Identification of Executive Officers The following is a list of Jefferson-Pilot Corporation executive officers, their ages and positions, as of March 7, 1994: Name Age Position (Date elected to position) David A. Stonecipher 52 President and Chief Executive Officer (March 1, 1993); Director William E. Blackwell 61 Executive Vice President (May 5, 1986); Director C. Randolph Ferguson 48 Senior Vice President (May 1, 1989); Director Dennis R. Glass 44 Senior Vice President, Chief Financial Officer and Treasurer (October 18, 1993) John D. Hopkins 56 Senior Vice President and General Counsel (April 19, 1993); Secretary (January 1, 1994) III-1 Kenneth C. Mlekush 55 Senior Vice President (February 8, 1993) John T. Still, III 46 Senior Vice President - Corporate Development (May 5, 1986) E. Jay Yelton 54 Senior Vice President (October 18, 1993) Dean F. Chatlain 43 Vice President and Tax Counsel (February 13, 1989) Gary L. McGuirk 49 Vice President - Internal Auditing (January 1, 1992) Jimmy W. Shoffner 55 Vice President and Assistant Treasurer (May 4, 1992) J. Allen Wyatt 48 Vice President - Corporate Planning (May 1, 1989) There are no arrangements or understandings between any executive officer and any other person pursuant to which such executive officer was or is to be selected as an officer. All executive officers hold office at the will of the Board. (c) Identification of Certain Significant Employees None. (d) Family Relationships There are no family relationships among the officers, directors or nominees. (e) Business Experience Directors and Nominees - The information included under the heading "Election of Directors," of the Proxy Statement is incorporated herein by reference. Louis C. Stephens, Jr., whose term as a director will expire at the Annual Meeting, has been retired since December, 1986. Prior thereto, he served as Vice President of Jefferson-Pilot Corporation and President of Pilot Life Insurance Company. III-2 Executive Officers - Messrs. Blackwell, Ferguson, Still, Chatlain, and McGuirk have served in various executive capacities with Jefferson-Pilot Corporation over the past five years. Information on Mr. Stonecipher, set forth under the heading "Election of Directors" of the Proxy Statement, is incorporated herein by reference. For the past five years, Mr. Wyatt has served in various executive capacities with either Jefferson-Pilot Corporation or Jefferson-Pilot Life Insurance Company (wholly-owned by Jefferson-Pilot Corporation). For the past five years, Mr. Shoffner has served in various executive capacities with Jefferson-Pilot Life Insurance Company. Mr. Glass joined Jefferson-Pilot Corporation in October, 1993. From 1991 to October, 1993, he was associated with Protective Life Corp., having last served as Executive Vice President and CFO of that company. From 1983 to 1991, he was associated with The Portman Companies, having last served that company as Executive Vice President and CFO. Mr. Hopkins joined Jefferson-Pilot Corporation in April, 1993 and for more than five years prior thereto was a partner in the Atlanta law firm of King & Spalding. Mr. Mlekush joined Jefferson-Pilot Corporation in January, 1993. From February, 1989 until December, 1992, he was associated with Southland Life Insurance Company and its parent, GeorgiaUS, having last served as President and Chief Operating Officer of Southland Life and Executive Vice President of GeorgiaUS. Prior to February, 1989, he was associated with Sun Life Insurance Company of America, Inc., having last served as Senior Vice President-Marketing. Mr. Yelton joined Jefferson-Pilot Corporation in October, 1993 and for more than five years prior thereto was President of The Investment Centre. III-3 (f) Involvement in Certain Legal Proceedings There have been no events under any bankruptcy act, no criminal proceedings and no judgments or injunctions material to the evaluation of the ability or integrity of any executive officer, director or nominee during the past five years. Compliance With Section 16(a) Information under the heading "Election of Directors," of the Proxy Statement, relating to delinquent filers under Section 16(a) of the Exchange Act of 1934, is incorporated herein by reference. Item 11.

Item 11. Executive Compensation The information included under the heading "Executive Compensation" of the Proxy Statement is incorporated herein by reference. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management (a) Security Ownership of Certain Beneficial Owners The information included under the heading "Principal Shareholders" of the Proxy Statement is incorporated herein by reference. (b) Security Ownership by Management Information included under the heading "Election of Directors" of the Proxy Statement is incorporated herein by reference. In addition, the following table sets forth information regarding the ownership of Jefferson- Pilot Corporation's common stock, as of March 7, 1994, by named executive officers who are not currently acting as directors: III-4 Name of Beneficial Amount and Nature of Owner Beneficial Ownership Percent of Class W. Roger Soles 113,943 ** Kenneth C. Mlekush 25,420* ** John D. Hopkins 25,500* ** Thomas Fee 41,286 ** *The number of shares owned for each of Messrs. Mlekush and Hopkins assumes that options held by each of them covering shares of common stock in the following amounts, which are exercisable within 60 days of March 7, 1994, have been exercised: Mr. Mlekush - 25,000; Mr. Hopkins - 22,500. **Less than one percent (1%) of the Corporation's outstanding common stock. (c)Change in Control The Company knows of no contractual arrangements which may at a subsequent date result in a change in control of the Company. Item 13.

Item 13. Certain Relationships and Related Transactions The information included under the heading "Compensation Committee Interlocks and Insider Participation" of the Proxy Statement is incorporated herein by reference. III-5 PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K (a) (1) and (2) -- The responses to these portions of Item 14 are submitted as a separate section of this report. (See.) (3) - See List and Index of Exhibits on page of this report. (b) There were no reports on Form 8-K for the three months ended December 31, 1993. (c) Exhibits are submitted as a separate section of this report. (See.) (d) Financial Statement Schedules -- The response to this portion of Item 14 is submitted as a separate section of this report. (See .) Undertakings For the purposes of complying with the amendments to the rules governing Form S-8 (effective July 13, 1990) under the Securities Act of 1933, the undersigned registrant hereby undertakes as follows, which undertaking shall be incorporated by reference into registrant's Registration Statements on Form S-8 Nos. 2-36778 (filed March 23, 1970) and 2-56410 (filed May 12, 1976) and 33-30530 (filed August 15, 1989), and in outstanding effective registration statements on Form S-16 included in such S-8 filings: Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. IV-1 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. JEFFERSON-PILOT CORPORATION (Registrant) BY (SIGNATURE) David A. Stonecipher (NAME AND TITLE) David A. Stonecipher, President (Principal Executive Officer) BY (SIGNATURE) Dennis R. Glass (NAME AND TITLE) Dennis R. Glass, Senior Vice President and Treasurer (Principal Financial Officer) March 29, 1994 (DATE) BY (SIGNATURE) Thomas M. Belk (NAME AND TITLE) Thomas M. Belk, Director DATE March 29, 1994 BY (SIGNATURE) William E. Blackwell (NAME AND TITLE) William E. Blackwell, Director DATE March 29, 1994 BY (SIGNATURE) Edwin B. Borden (NAME AND TITLE) Edwin B. Borden, Director DATE March 29, 1994 BY (SIGNATURE) William H. Cunningham (NAME AND TITLE) William H. Cunningham, Director DATE March 29, 1994 BY (SIGNATURE) C. Randolph Ferguson (NAME AND TITLE) C. Randolph Ferguson, Director DATE March 29, 1994 BY (SIGNATURE) Robert G. Greer (NAME AND TITLE) Robert G. Greer, Director DATE March 29, 1994 IV-2 SIGNATURES (continued) BY (SIGNATURE) A. Linwood Holton, Jr. (NAME AND TITLE) A. Linwood Holton, Jr., Director DATE March 29, 1994 BY (SIGNATURE) (NAME AND TITLE) Hugh L. McColl, Jr., Director DATE March 29, 1994 BY (SIGNATURE) Charles W. McCoy (NAME AND TITLE) Charles W. McCoy, Director DATE March 29, 1994 BY (SIGNATURE) E. S. Melvin (NAME AND TITLE) E. S. Melvin, Director DATE March 29, 1994 BY (SIGNATURE) (NAME AND TITLE) William P. Payne, Director DATE March 29, 1994 BY (SIGNATURE) Donald S. Russell, Jr. (NAME AND TITLE) Donald S. Russell, Jr., Director DATE March 29, 1994 BY (SIGNATURE) Robert H. Spilman (NAME AND TITLE) Robert H. Spilman, Chairman DATE March 29, 1994 BY (SIGNATURE) Louis C. Stephens, Jr. (NAME AND TITLE) Louis C. Stephens, Jr., Director DATE March 29, 1994 BY (SIGNATURE) Martha A. Walls (NAME AND TITLE) Martha A. Walls, Director DATE March 29, 1994 IV-3 List of Financial Statements and Financial Statement Schedules Financial Statements: The following financial statements and independent auditor's report included in the Annual Report of Jefferson-Pilot Corporation to its shareholders for the year ended December 31, 1993 are incorporated herein by reference. With the exception of the aforementioned information and the information incorporated by reference in Items 1 (b), 3, 8 and 14 (a) 1 and 2 herein, the 1993 Annual Report to shareholders is not deemed to be filed as part of this report. Annual Report -Pages- Independent Auditor's Report 29 Consolidated Balance Sheets as of December 31, 1993 and 1992 30 - 31 Consolidated Statements of Income for the Years Ended December 31, 1993, 1992 and 1991 32 Consolidated Statements of Stockholders' Equity for the Years Ended December 31, 1993, 1992 and 1991 33 Consolidated Statements of Cash Flows for the Years Ended December 31, 1993, 1992 and 1991 34 Notes to Consolidated Financial Statements 35 - 49 Financial Statement Schedules: Form 10-K -Pages- Independent Auditor's Report on Schedules Schedule I - Summary of Investments - Other Than Investments in Related Parties - Schedule III - Financial Statements of Jefferson-Pilot Corporation: Balance Sheets as of December 31, 1993 and 1992 - Statements of Income for the Years Ended December 31, 1993, 1992, and 1991 Statements of Cash Flows for the Years Ended December 31, 1993, 1992, and 1991 Notes to Financial Statements - Schedule V - Supplementary Insurance Information - Schedule VI - Reinsurance - Schedule IX - Short Term Borrowings List and Index of Exhibits - All other schedules provided for in the applicable accounting regulations of the Securities and Exchange Commission have been omitted because either they pertain to items which are not applicable or to items which are not signifi- cant or to items for which the required disclosures have been included in the financial statements or notes thereto. INDEPENDENT AUDITOR'S REPORT ON SCHEDULES To the Board of Directors Jefferson-Pilot Corporation Greensboro, North Carolina In connection with our audits of the consolidated financial statements of Jefferson-Pilot Corporation and subsidiaries as of December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993, which are referred to in our report dated February 4, 1994 and incorporated herein by reference, we also audited schedules I, III, V, VI and IX contained herein. In our opinion, these schedules present fairly, in all material respects, the information required to be set forth therein in conformity with generally accepted accounting principles. McGLADREY & PULLEN Greensboro, North Carolina February 4, 1994 (Continued) JEFFERSON-PILOT CORPORATION AND SUBSIDIARIES SCHEDULE I - SUMMARY OF INVESTMENTS - OTHER THAN INVESTMENTS IN RELATED PARTIES (CONTINUED) December 31, 1993 (a) Cost of debt securities is original cost, reduced by repayments and adjusted for amortization of premiums and accrual of discounts. Cost of equity securities is original cost. Cost of mortgage loans on real estate and policy loans represents aggregate outstanding balances. Cost of real estate acquired by foreclosure is the originally capitalized amount, reduced by applicable depreciation. Cost of other real estate held for investment is depreciated original cost. (b) Differences between cost reflected in Column B and amounts at which shown in the consolidated balance sheet reflected in Column D result from valuation allowances and declines in value that are other than temporary. (c) This line includes common stocks held by the parent company which are stated in the consolidated balance sheet at cost of $4,653,937 and have a market value of $74,754,000. JEFFERSON-PILOT CORPORATION AND SUBSIDIARIES CONDENSED BALANCE SHEETS OF JEFFERSON-PILOT CORPORATION December 31, 1993 and 1992 SCHEDULE III ASSETS 1993 1992 Cash and investments: Cash and cash equivalents $ 10,174 $ 110,287,387 Short-term investments $ 3,065,000 $ 42,248,230 Debt securities (Note 2) $ 140,660,581 $ - Equity securities (Note 2) $ 4,653,937 $ 5,349,112 Investments in subsidiaries (Note 2): Jefferson-Pilot Life Insurance Company $1,434,964,119 $1,369,488,992 Jefferson-Pilot Fire & Casualty Company 68,219,638 62,715,522 Jefferson-Pilot Title Insurance Company 25,778,108 24,761,516 Jefferson-Pilot Communications Company 54,656,615 47,985,284 Jefferson-Pilot Data Services, Inc. 14,728,420 16,918,145 Other subsidiaries $1,606,261,034 $1,527,085,481 Other investments $ 1,625,729 $ 996,995 Total cash and investments $1,756,276,455 $1,685,967,205 Amounts due from subsidiaries 38,374,033 3,311,263 Other assets $ 11,649,353 $ 2,367,321 $1,806,299,841 $1,691,645,789 ============== ============== See Notes to Condensed Financial Statements. (Continued) JEFFERSON-PILOT CORPORATION AND SUBSIDIARIES CONDENSED BALANCE SHEETS OF JEFFERSON-PILOT CORPORATION (continued) December 31, 1993 and 1992 SCHEDULE III LIABILITIES AND STOCKHOLDERS' EQUITY 1993 1992 Liabilities: Notes payable (Note 3) $ 39,700,000 $ - Accounts payable and accrued expenses 14,238,466 $ 6,283,997 Dividends payable 19,291,000 17,152,000 Total liabilities $ 73,229,466 $ 23,435,997 Commitments and contingent liabilities (Note 4) Stockholders' equity (Notes 2, 5 and 6): Common stock, par value $1.25 per share, authorized 150,000,000 shares; issued 1993 49,464,495 shares; 1992 50,438,907 shares $ 61,830,619 $ 63,048,634 Retained earnings, including equity in undistributed net income of subsidiaries 1993 $1,220,151,215; 1992 $1,133,356,587 1,339,671,590 1,270,342,008 Equity in net unrealized gains on equity securities held by insurance subsidiaries less deferred income taxes 1993 $176,201,659; 1992 $170,852,455 331,568,166 334,819,150 $1,733,070,375 $1,668,209,792 $1,806,299,841 $1,691,645,789 ============== ============== See Notes to Condensed Financial Statements. See Notes to Condensed Financial Statements. See Notes to Condensed Financial Statements. JEFFERSON-PILOT CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED FINANCIAL STATEMENTS OF JEFFERSON-PILOT CORPORATION SCHEDULE III Note 1. Basis of Presentation and Significant Accounting Policies The accompanying financial statements comprise a condensed presentation of the financial position, results of operations, and cash flows of Jefferson-Pilot Corporation (the "Company") on a separate-company basis. These condensed financial statements do not include the accounts of the Company's majority-owned sub- sidiaries, but instead include the Company's investment in those subsidiaries, stated at amounts which are substantially equal to the Company's equity in the subsidiaries' net assets. Therefore the accompanying financial statements are not those of the primary reporting entity. The consolidated financial statements of the Company and its subsidiaries are included in the Jefferson-Pilot Corporation Annual Report to Shareholders for the year ended December 31, 1993. Short-term investments are stated at cost which approximates value. Debt securities are stated at amortized cost, and equity securities are stated at cost. Other significant accounting policies of the Company and its subsidiaries are as set forth in Note 1 to the consolidated financial statements of Jefferson-Pilot Corporation and subsidiaries which are included in the Annual Report to Shareholders for the year ended December 31, 1993. Note 2. Investment Information Debt securities held by the Company consist of U.S. Treasury notes maturing in the years 2000 through 2003 and have aggregate fair value approximating $139,000,000. Equity securities held by the Company have aggregate market value approximating $74,754,000 in 1993 and $56,900,000 in 1992, resulting in unrealized gains of $70,100,000 and $51,551,000, respectively. Since the equity securities are stated at cost, related unrealized gains are not reflected in the accompanying balance sheets. Net unrealized gains on equity securities held by insurance subsidiaries, reduced by the subsidiaries' related deferred income tax liabilities, are included in the carrying amount of the Company's investments in those subsidiaries with corresponding credits included in stockholders' equity. Note 3. Notes Payable Information about notes payable is contained in Note 5 to the consolidated financial statements of Jefferson-Pilot Corporation and subsidiaries which are included in the Annual Report to Shareholders for the year ended December 31, 1993. Note 4. Commitments and Contingent Liabilities Information about commitments and contingent liabilities involving the Company and its subsidiaries is contained in Notes 11 and 14 to the consolidated financial statements of Jefferson-Pilot Corporation and subsidiaries which are included in the Annual Report to Shareholders for the year ended December 31, 1993. Note 5. Common Stock and Stock Options Information about common stock and stock options is contained in Note 6 to the consolidated financial statements of Jefferson-Pilot Corporation and subsidiaries which are included in the Annual Report to Shareholders for the year ended December 31, 1993. Note 6. Retained Earnings Information about certain limitations affecting the amount of dividends that the insurance subsidiaries may pay to the Company without the approval of the Insurance Commissioner of the State of North Carolina is contained in Note 7 to the consolidated financial statements of Jefferson-Pilot Corporation and subsidiaries which are included in the Annual Report to Shareholders for the year ended December 31, 1993. Note 7. Other Investment Income Other investment income consists principally of interest on cash equivalents, short-term investments, and debt securities and dividends on investments in common stocks. Interest from subsidiaries included in other investment income was not material in any year presented. Note 8. Income Taxes (Benefits) During 1993, the Company and its subsidiaries adopted Statement of Financial Accounting Standards No. 109 "Accounting for Income Taxes" (SFAS 109). Information about the requirements of SFAS 109 is contained in Note 9 to the consolidated financial statements of Jefferson-Pilot Corporation and subsidiaries which are included in the Annual Report to Shareholders for the year ended December 31, 1993. As disclosed in the above-mentioned consolidated financial statements, the Company and its subsidiaries elected to restate prior year financial statements to give retroactive effect to the new income tax accounting standards under SFAS 109. Accordingly, retained earnings as of December 31, 1992, as reported in the accompanying balance sheet, has been reduced by $18,555,593, with corresponding reductions in the carrying amount of investments in subsidiaries and deferred income tax assets (included with other assets) of $16,858,938 and $1,696,655, respectively. Statements of income for 1992 and 1991 have not been restated because the SFAS 109 standards had negligible effect on net income for those years. Income taxes (benefits) as reported in the statements of income differ from the amounts which result from applying the maximum federal income tax rates of 35% in 1993 and 34% in 1992 and 1991 to income before income taxes and equity in undistributed earnings of subsidiaries. The predominant reason for the difference is elimination of dividends from subsidiaries in arriving at income subject to income taxes. Net deferred income tax assets as of December 31, 1993 and 1992 are not material and have been included with other assets. The deferred components of income taxes (benefits) was not material in any year presented. The Company pays the federal income taxes indicated on its consolidated federal income tax return and collects from subsidiaries the amounts which the subsidiaries would have paid had they filed separate returns (or pays to them the benefits resulting from including their losses in the return). Information about untaxed life insurance company income and the status of the Company and its subsidiaries with respect to federal income tax return examinations is contained in Note 9 to the consolidated financial statements of Jefferson-Pilot Corporation and subsidiaries which are included in the Annual Report to Shareholders for the year ended December 31, 1993. Note 9. Postretirement Benefit Plans Information about postretirement benefit plans sponsored by the Company and its subsidiaries is contained in Note 10 to the consolidated financial statements of Jefferson-Pilot Corporation and subsidiaries which are included in the Annual Report to Shareholders for the year ended December 31, 1993. The effect of adopting SFAS 106 "Employers' Accounting for Post- retirement Benefits Other Than Pensions" during 1993 is reflected primarily in equity in undistributed net income of subsidiaries, as are substantially all postretirement benefits expenses. Note 10. New Accounting Standards Information about accounting standards issued during 1993 which will, or may have, an effect on the Company's financial statements and those of its subsidiaries when adopted is contained in Note 2 to the consolidated financial statements of Jefferson-Pilot Corporation and subsidiaries which are included in the Annual Report to Shareholders for the year ended December 31, 1993. One of the new standards is SFAS 115 "Accounting for Certain Investments in Debt and Equity Securities", which will be effective for the Company's 1994 financial statements. Among the requirements of SFAS 115 will be that the Company's equity securities be stated at market value. Adoption of SFAS 115 as of January 1, 1994 will increase the stated amount of equity securities held by the Company by $70,100,000, with corresponding credits of approximately $28,040,000 to deferred income tax liabilities and $42,060,000 to stockholders' equity. The effect of adopting SFAS 115 on the carrying amounts of debt securities and investments in subsidiaries has not yet been determined since the required classification of debt securities held by the Company and its subsidiaries is not complete. (continued) SCHEDULE V - CONTINUED (a) The life insurance segment is the Company's only insurance industry segment which meets the criteria for segment information disclosure contained in SFAS 14 "Financial Reporting for Segments of a Business Enterprise." Therefore, information related to other insurance operations (property and casualty and title insurance) has been combined with information related to life insurance operations for purposes of this schedule. (b) Future policy benefits include a provision for liabilities related to life and annuity and accident and health business. Future policy benefits as of December 31, 1992 and 1991 have been restated and increased by $12,993,000 and $11,100,000, respectively, to reflect the adoption of SFAS 113 "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts" during 1993. (c) Other policy claims and benefits payable include dividend accumu- lations and other policyholder funds on deposit, policy and contract claims (life and annuity and accident and health), dividends for policyholders, casualty insurance unearned premiums and losses payable, and other policy liabilities. Other policy claims and benefits payable as of December 31, 1992 and 1991 have been restated and increased by $7,932,000 and $9,076,000 respectively, to reflect the adoption of SFAS 113 during 1993. (d) Benefits, claims, losses, and settlement expenses for 1992 and 1991 have been increased by $16,997,000 and $16,598,000, respectively, to reflect the reclassification of dividends to participating policyholders for conformity with 1993 presenta- tion. (e) Expenses related to the management and administration of investments have been netted with investment income in the determination of net investment income. Such expenses amounted to $10,945,000 in 1993, $10,553,000 in 1992 and $10,285,000 in 1991. Other operating expenses for 1992 and 1991 have been reduced by $16,997,000 and $16,598,000, respectively, to reflect the reclassification of dividends to participating policyholders to Column H "Benefits, Claims, Losses, and Settlement Expenses" for conformity with 1993 presentation. (f) Consists of net premiums written on property and casualty insurance only. Does not apply to life insurance or title insurance. (continued) SCHEDULE VI - CONTINUED (a) Included with life insurance premiums are premiums on ordinary life insurance products and mortality charges on interest- sensitive products. (b) Percentage of amount assumed to net is computed by dividing the amount in Column D by the amount in Column E. (a) Notes payable represent unsecured bank borrowings under an uncommitted line of credit established in 1993. The Company may request aggregate advances of up to $100 million through October 1994. (b) The average amount outstanding during the period was computed on the basis of daily balances. (c) The weighted average interest rate during the period was computed by dividing actual interest expense by the average amount outstanding during the period. List and Index of Exhibits Reference Number Per Exhibit Table Description of Exhibit -Page- (3) (i) Articles of Incorporation and amendments - thereto were included in Form 10-K for the year ended December 31, 1991. Such Form is incorporated herein by reference. (ii) By-laws as currently in effect were - included in Form 10-K for the year ended December 31, 1992. Such Form is incorporated herein by reference. (4) Rights Agreement dated as of August 1, 1988 - between Jefferson-Pilot Corporation and First Union National Bank (incorporated by reference to Exhibit 1 to Report on Form 8-K dated August 5, 1988). (10) The following contracts and plans: (i) Employment contract, as amended to - date, between the Registrant and W. Roger Soles, a former officer of Registrant, was included in Form 10-K for the year ended December 31, 1992, and incorporated herein by reference. (ii) Employment contract, between the - Registrant and David A. Stonecipher, an officer of the Registrant, was included in Form 10-K for the year ended December 31, 1992, and is incorporated herein by reference. (iii) Employment contract, between the - Registrant and Kenneth C. Mlekush, an officer of the Registrant, was included in Form 10-K for the year ended December 31, 1992, and is incorporated herein by reference. List and Index of Exhibits (continued) (iv) Incentive Compensation 1993 was - included in Form 10-K for the year ended December 31, 1992, and is incorporated herein by reference. (v) The summary of the long term - incentive plan payments included under the heading "Incentive and Reward" of the Proxy Statement is incorporated herein by reference. (vi) Employment contract between the - Registrant and John D. Hopkins, an officer of the Registrant (Provided as part of the electronic filing). (vii) Employment contract between the - Registrant and Dennis R. Glass, an officer of the Registrant (Provided as part of the electronic filing). (viii) Employment contract between the - Registrant and E. J. Yelton, an officer of the Registrant (Provided as part of the electronic filing). (11) Basis For Computation of Per Share Earnings (Provided as part of the electronic filing). (13) Portion of Annual Report to Shareholders - (Provided as part of the electronic filing). List and Index of Exhibits (continued) (21) Subsidiaries of the Registrant - (Provided as part of the electronic filing). (23) Accountant's Consent (Provided as part of the electronic filing).

882240_1993.txt

882240

1993

ITEM 1. BUSINESS Each of the Grantor Trusts, (the "Trusts"), listed below, was formed by GMAC Auto Receivables Corporation (the "Seller") by selling and assigning the receivables and the security interests in the vehicles financed thereby to The First National Bank of Chicago, as Trustee, in exchange for Class A certificates representing an undivided ownership interest that ranges between approximately 91% and 94.5% in each Trust, which were remarketed to the public, and Class B certificates representing an undivided ownership interest that ranges between approximately 5.5% and 9% in each Trust, which were not offered to the public and initially were held by the Seller. The right of the Class B certificateholders to receive distribution of the receivables is subordinated to the rights of the Class A certificateholders. GRANTOR TRUST ------------- GMAC 1990-A GMAC 1991-A GMAC 1991-B GMAC 1991-C GMAC 1992-A GMAC 1992-C GMAC 1992-D GMAC 1992-E GMAC 1992-F GMAC 1992-G GMAC 1993-A GMAC 1993-B _____________________ PART II ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Each of the Grantor Trusts, listed in the table as shown below, was formed by GMAC Auto Receivables Corporation (the "Seller") pursuant to a Pooling and Servicing Agreement between the Seller and The First National Bank of Chicago, as trustee. Each Trust acquired retail finance receivables from the Seller in the aggregate amount as shown below in exchange for certificates representing undivided ownership interests in each Trust. Each Trust's property includes a pool of retail instalment sale contracts secured by new, and in some Trust's used, automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The certificates for each of the following Trusts consist of two classes, entitled Asset Backed certificates, Class A and Asset Backed certificates, Class B. The Class A certificates represent in the aggregate an undivided ownership interest that ranges between approximately 91% and 94.5% of the Trusts and the Class B certificates represent in the aggregate an undivided ownership interest that ranges between approximately 5.5% and 9% of the Trusts. Only the Class A certificates have been remarketed to the public. The Class B certificates have not been offered to the public and initially are being held by the Seller. The rights of the Class B certificateholder to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. Original Aggregate Amount ----------------------------------- Date of Pooling Retail Asset Backed Certificates Grantor and Servicing Finance ------------------------- Trust Agreement Receivables Class A Class B - ------- ----------------- --------- -------- ------- (In millions of dollars) GMAC 1990-A December 20, 1990 $1,162.6 $1,057.9 $104.7 GMAC 1991-A March 14, 1991 891.7 811.4 80.3 GMAC 1991-B September 17, 1991 1,007.4 916.7 90.7 GMAC 1991-C December 16, 1991 1,326.4 1,207.0 119.4 GMAC 1992-A January 30, 1992 2,001.4 1,851.3 150.1 GMAC 1992-C March 26, 1992 1,100.3 1,012.3 88.0 GMAC 1992-D June 4, 1992 1,647.6 1,499.3 148.3 GMAC 1992-E August 20, 1992 1,578.0 1,436.0 142.0 GMAC 1992-F September 29, 1992 1,644.6 1,496.6 148.0 GMAC 1992-G November 19, 1992 1,379.4 1,303.5 75.9 GMAC 1993-A March 24, 1993 1,403.0 1,297.8 105.2 GMAC 1993-B September 16, 1993 1,450.6 1,341.8 108.8 II-1 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (concluded) General Motors Acceptance Corporation, the originator of the retail receivables, continues to service the receivables for each of the aforementioned Grantor Trusts and receives compensation and fees for such services. Investors receive monthly payments of the pro rata portion of principal and interest for each Trust as the receivables are liquidated. ------------------------ II-2 ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. CROSS REFERENCE SHEET Caption Page - --------------------------------------------------- ------ GMAC 1990-A Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-4 Data for the Year Ended December 31, 1993. GMAC 1991-A Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-9 Data for the Year Ended December 31, 1993. GMAC 1991-B Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-14 Data for the Year Ended December 31, 1993. GMAC 1991-C Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-19 Data for the Year Ended December 31, 1993. GMAC 1992-A Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-24 Data for the Year Ended December 31, 1993. GMAC 1992-C Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-29 Data for the Year Ended December 31, 1993. GMAC 1992-D Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-34 Data for the Year Ended December 31, 1993. GMAC 1992-E Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-39 Data for the Year Ended December 31, 1993. GMAC 1992-F Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-44 Data for the Year Ended December 31, 1993. GMAC 1992-G Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-49 Data for Year Ended from December 31, 1993. GMAC 1993-A Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-54 Data for the period from March 24, 1993 to December 31, 1993. GMAC 1993-B Grantor Trust, Independent Auditors' Report, Financial Statements and Selected Quarterly II-59 Data for period from September 16, 1993 to December 31, 1993. II-3 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1990-A Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago, Trustee: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1990-A Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1990-A Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for each of the three years in the period ended December 31, 1993, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ---------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-4 GMAC 1990-A GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) ................... 207.1 459.8 ------- ------- TOTAL ASSETS ........................... 207.1 459.8 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ...................... 207.1 459.8 ------- ------- TOTAL LIABILITIES ...................... 207.1 459.8 ======= ======= Reference should be made to the Notes to Financial Statements. II-5 GMAC 1990-A GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the years ended December 31, 1993, 1992 and 1991 (in millions of dollars) 1993 1992 1991 ----- ----- ----- Distributable Income $ $ $ Allocable to Principal ............... 252.7 344.1 358.7 Allocable to Interest ............... 27.7 52.9 82.6 ----- ----- ----- Distributable Income ................... 280.4 397.0 441.3 ===== ===== ===== Income Distributed ..................... 280.4 397.0 441.3 ===== ===== ===== Reference should be made to the Notes to Financial Statements. II-6 GMAC 1990-A GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1990-A Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On December 20, 1990, GMAC 1990-A Grantor Trust acquired retail finance receivables aggregating approximately $1,162.6 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing January 15, 1991. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 8.25% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-7 GMAC 1990-A GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 70.0 9.0 79.0 Second quarter ..................... 69.0 7.5 76.5 Third quarter ...................... 61.8 6.2 68.0 Fourth quarter ..................... 51.9 5.0 56.9 --------- -------- ----- Total ......................... 252.7 27.7 280.4 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 90.4 16.0 106.4 Second quarter ..................... 90.0 14.1 104.1 Third quarter ...................... 86.1 12.3 98.4 Fourth quarter ..................... 77.6 10.5 88.1 --------- -------- ----- Total ......................... 344.1 52.9 397.0 ========= ======== ===== 1991 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 86.6 23.4 110.0 Second quarter ..................... 93.2 21.7 114.9 Third quarter ...................... 90.8 19.7 110.5 Fourth quarter ..................... 88.1 17.8 105.9 --------- -------- ----- Total ......................... 358.7 82.6 441.3 ========= ======== ===== II-8 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1991-A Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago, Trustee: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1991-A Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the two years in the period ended December 31, 1993 and the period March 14, 1991 (inception) through December 31, 1991. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1991-A Grantor Trust at December 31, 1993 and 1992 and its distributable income and distributions for the two years in the period ended December 31, 1993 and the period March 14, 1991 (inception) through December 31, 1991, on the basis of accounting described in Note 1. s/ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-9 GMAC 1991-A GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) ................... 162.0 370.4 ------- ------- TOTAL ASSETS ........................... 162.0 370.4 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ...................... 162.0 370.4 ------- ------- TOTAL LIABILITIES ...................... 162.0 370.4 ======= ======= Reference should be made to the Notes to Financial Statements. II-10 GMAC 1991-A GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the years ended December 31, 1993, 1992 and the period March 14, 1991 (inception) through December 31, 1991 (in millions of dollars) 1993 1992 1991 ----- ----- ----- $ $ $ Distributable Income Allocable to Principal ................ 208.3 290.7 230.6 Allocable to Interest ................ 21.2 41.2 46.7 ----- ----- ----- Distributable Income .................... 229.5 331.9 277.3 ===== ===== ===== Income Distributed ...................... 229.5 331.9 277.3 ===== ===== ===== Reference should be made to the Notes to Financial Statements. II-11 GMAC 1991-A GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1991-A Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On March 14, 1991, GMAC 1991-A Grantor Trust acquired retail finance receivables aggregating approximately $891.7 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing April 15, 1991. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 7.90% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-12 GMAC 1991-A GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 58.0 6.9 64.9 Second quarter ..................... 55.5 5.8 61.3 Third quarter ...................... 50.6 4.7 55.3 Fourth quarter ..................... 44.2 3.8 48.0 --------- -------- ----- Total ......................... 208.3 21.2 229.5 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 78.5 12.5 91.0 Second quarter ..................... 75.1 11.0 86.1 Third quarter ...................... 71.9 9.5 81.4 Fourth quarter ..................... 65.2 8.2 73.4 --------- -------- ----- Total ......................... 290.7 41.2 331.9 ========= ======== ===== 1991 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Second quarter ..................... 78.6 17.1 95.7 Third quarter ...................... 76.7 15.6 92.3 Fourth quarter ..................... 75.3 14.0 89.3 --------- -------- ----- Total ......................... 230.6 46.7 277.3 ========= ======== ===== II-13 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1991-B Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago, Trustee: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1991-B Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the two years in the period ended December 31, 1993 and the period September 17, 1991 (inception) through December 31, 1991. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1991-B Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the two years in the period ended December 31, 1993 and the period September 17, 1991 (inception) through December 31, 1991, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-14 GMAC 1991-B GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) ................... 306.4 582.8 ------- ------- TOTAL ASSETS ........................... 306.4 582.8 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ...................... 306.4 582.8 ------- ------- TOTAL LIABILITIES ...................... 306.4 582.8 ======= ======= Reference should be made to the Notes to Financial Statements. II-15 GMAC 1991-B GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the years ended December 31, 1993, 1992 and the period September 17, 1991 (inception) through December 31, 1991 (in millions of dollars) 1993 1992 1991 ------ ------ ------ $ $ $ Distributable Income Allocable to Principal ............... 276.3 340.7 83.9 Allocable to Interest ............... 30.4 51.5 16.5 ------ ------ ------ Distributable Income ................... 306.7 392.2 100.4 ====== ====== ====== Income Distributed ..................... 306.7 392.2 100.4 ====== ====== ====== Reference should be made to the Notes to Financial Statements. II-16 GMAC 1991-B GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1991-B Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On September 17, 1991, GMAC 1991-B Grantor Trust acquired retail finance receivables aggregating approximately $1,007.4 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing October 15, 1991. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 6.75% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-17 GMAC 1991-B GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 72.7 9.4 82.1 Second quarter ..................... 74.8 8.2 83.0 Third quarter ...................... 68.3 7.0 75.3 Fourth quarter ..................... 60.5 5.8 66.3 --------- -------- ----- Total ......................... 276.3 30.4 306.7 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 87.1 15.1 102.2 Second quarter ..................... 89.5 13.6 103.1 Third quarter ...................... 84.9 12.1 97.0 Fourth quarter ..................... 79.2 10.7 89.9 --------- -------- ----- Total ......................... 340.7 51.5 392.2 ========= ======== ===== 1991 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Fourth quarter ..................... 83.9 16.5 100.4 ========= ======== ===== II-18 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1991-C Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago, Trustee: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1991-C Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the years then ended. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1991-C Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the years then ended, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-19 GMAC 1991-C GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) ................... 496.0 874.6 ------- ------- TOTAL ASSETS ........................... 496.0 874.6 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ...................... 496.0 874.6 ------- ------- TOTAL LIABILITIES ...................... 496.0 874.6 ======= ======= Reference should be made to the Notes to Financial Statements. II-20 GMAC 1991-C GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the years ended December 31, 1993 and 1992 (in millions of dollars) 1993 1992 -------- -------- $ $ Distributable Income Allocable to Principal ...................... 378.5 451.8 Allocable to Interest ...................... 39.7 63.3 -------- -------- Distributable Income .......................... 418.2 515.1 ======== ======== Income Distributed ............................ 418.2 515.1 ======== ======== Reference should be made to the Notes to Financial Statements. II-21 GMAC 1991-C GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1991-C Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On December 16, 1991, GMAC 1991-C Grantor Trust acquired retail finance receivables aggregating approximately $1,326.4 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing January 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 5.70% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-22 GMAC 1991-C GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 96.7 12.0 108.7 Second quarter ..................... 101.1 10.6 111.7 Third quarter ...................... 95.2 9.2 104.4 Fourth quarter ..................... 85.5 7.9 93.4 --------- -------- ----- Total ......................... 378.5 39.7 418.2 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 120.6 18.3 138.9 Second quarter ..................... 115.3 16.6 131.9 Third quarter ...................... 109.9 15.0 124.9 Fourth quarter ..................... 106.0 13.4 119.4 --------- -------- ----- Total ......................... 451.8 63.3 515.1 ========= ======== ===== II-23 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-A Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-A Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period January 30, 1992 (inception) through December 31, 1992. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-A Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period January 30, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-24 GMAC 1992-A GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 370.7 1,052.5 ------- ------- TOTAL ASSETS ...................................... 370.7 1,052.5 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 370.7 1,052.5 ------- ------- TOTAL LIABILITIES ................................. 370.7 1,052.5 ======= ======= Reference should be made to the Notes to Financial Statements. II-25 GMAC 1992-A GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period January 30, 1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------- ------- $ $ Distributable Income Allocable to Principal ...................... 681.7 948.9 Allocable to Interest ...................... 35.4 72.0 ------- ------- Distributable Income .......................... 717.1 1,020.9 ======= ======= Income Distributed ............................ 717.1 1,020.9 ======= ======= Reference should be made to the Notes to Financial Statements. II-26 GMAC 1992-A GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-A Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On January 30, 1992, GMAC 1992-A Grantor Trust acquired retail finance receivables aggregating approximately $2,001.4 million from the Seller in exchange for certificates representing undivided ownership interests of 92.5% for the Class A certificates and 7.5% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing February 18, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 5.05% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-27 GMAC 1992-A GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 206.9 12.4 219.3 Second quarter ..................... 192.5 9.8 202.3 Third quarter ...................... 157.7 7.5 165.2 Fourth quarter ..................... 124.6 5.7 130.3 --------- -------- ----- Total ......................... 681.7 35.4 717.1 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 171.8 16.5 188.3 Second quarter ..................... 278.3 21.9 300.2 Third quarter ...................... 263.6 18.4 282.0 Fourth quarter ..................... 235.2 15.2 250.4 --------- -------- ------- Total ......................... 948.9 72.0 1,020.9 ========= ======== ======= II-28 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-C Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-C Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period March 26, 1992 (inception) through December 31, 1992. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-C Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period March 26, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-29 GMAC 1992-C GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 311.3 716.3 ------- ------- TOTAL ASSETS ...................................... 311.3 716.3 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) .................................. 311.3 716.3 ------- ------- TOTAL LIABILITIES ................................. 311.3 716.3 ======= ======= Reference should be made to the Notes to Financial Statements. II-30 GMAC 1992-C GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period March 26, 1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------- ------- $ $ Distributable Income Allocable to Principal ...................... 405.0 384.0 Allocable to Interest ...................... 31.0 41.2 ------- ------- Distributable Income .......................... 436.0 425.2 ======= ======= Income Distributed ............................ 436.0 425.2 ======= ======= Reference should be made to the Notes to Financial Statements. II-31 GMAC 1992-C GRANTOR TRUST (continued)) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-C Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On March 26, 1992, GMAC 1992-C Grantor Trust acquired retail finance receivables aggregating approximately $1,100.3 million from the Seller in exchange for certificates representing undivided ownership interests of 92% for the Class A certificates and 8% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing April 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 5.95% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-32 GMAC 1992-C GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 109.2 10.1 119.3 Second quarter ..................... 109.3 8.5 117.8 Third quarter ...................... 99.7 6.9 106.6 Fourth quarter ..................... 86.8 5.5 92.3 --------- -------- ----- Total ......................... 405.0 31.0 436.0 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Second quarter ..................... 133.1 15.7 148.8 Third quarter ...................... 129.8 13.7 143.5 Fourth quarter ..................... 121.1 11.8 132.9 --------- -------- ----- Total ......................... 384.0 41.2 425.2 ========= ======== ===== II-33 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-D Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-D Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period June 4, 1992 (inception) through December 31, 1992. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-D Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period June 4, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s/ DELOITTE & TOUCHE - ---------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-34 GMAC 1992-D GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 702.0 1,270.4 ------- ------- TOTAL ASSETS ...................................... 702.0 1,270.4 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 702.0 1,270.4 ------- ------- TOTAL LIABILITIES ................................. 702.0 1,270.4 ======= ======= Reference should be made to the Notes to Financial Statements. II-35 GMAC 1992-D GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period June 4,1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------ ------ $ $ Distributable Income Allocable to Principal ...................... 568.4 377.2 Allocable to Interest ...................... 55.4 48.0 ------ ------ Distributable Income .......................... 623.8 425.2 ====== ====== Income Distributed ............................ 623.8 425.2 ====== ====== Reference should be made to the Notes to Financial Statements. II-36 GMAC 1992-D GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-D Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On June 4, 1992, GMAC 1992-D Grantor Trust acquired retail finance receivables aggregating approximately $1,647.6 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing June 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 5.55% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-37 GMAC 1992-D GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 148.6 16.9 165.5 Second quarter ..................... 153.3 14.8 168.1 Third quarter ...................... 140.7 12.8 153.5 Fourth quarter ..................... 125.8 10.9 136.7 --------- -------- ----- Total ......................... 568.4 55.4 623.8 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Second quarter ..................... 50.7 7.6 58.3 Third quarter ...................... 166.9 21.4 188.3 Fourth quarter ..................... 159.6 19.0 178.6 --------- -------- ----- Total ......................... 377.2 48.0 425.2 ========= ======== ===== II-38 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-E Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-E Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period August 20, 1992 (inception) through December 31, 1992. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-E Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period August 20, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-39 GMAC 1992-E GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 885.4 1,398.0 ------- ------- TOTAL ASSETS ...................................... 885.4 1,398.0 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 885.4 1,398.0 ------- ------- TOTAL LIABILITIES ................................. 885.4 1,398.0 ======= ======= Reference should be made to the Notes to Financial Statements. II-40 GMAC 1992-E GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period August 20, 1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------- ------- $ $ Distributable Income Allocable to Principal ...................... 512.6 180.0 Allocable to Interest ...................... 55.1 23.9 ------- ------- Distributable Income .......................... 567.7 203.9 ======= ======= Income Distributed ............................ 567.7 203.9 ======= ======= Reference should be made to the Notes to Financial Statements. II-41 GMAC 1992-E GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-E Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On August 20, 1992, GMAC 1992-E Grantor Trust acquired retail finance receivables aggregating approximately $1,578.0 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing September 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 4.75% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-42 GMAC 1992-E GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 128.3 16.1 144.4 Second quarter ..................... 134.8 14.5 149.3 Third quarter ...................... 129.0 13.0 142.0 Fourth quarter ..................... 120.5 11.5 132.0 --------- -------- ----- Total ......................... 512.6 55.1 567.7 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Third quarter ...................... 46.1 6.2 52.3 Fourth quarter ..................... 133.9 17.7 151.6 --------- -------- ----- Total ......................... 180.0 23.9 203.9 ========= ======== ===== II-43 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-F Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-F Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period September 29, 1992 (inception) through December 31, 1992. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-F Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period September 29, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-44 GMAC 1992-F GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 908.7 1,492.8 ------- ------- TOTAL ASSETS ...................................... 908.7 1,492.8 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 908.7 1,492.8 ------- ------- TOTAL LIABILITIES ................................. 908.7 1,492.8 ======= ======= Reference should be made to the Notes to Financial Statements. II-45 GMAC 1992-F GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period September 29, 1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------ ------ $ $ Distributable Income Allocable to Principal ...................... 584.1 151.8 Allocable to Interest ...................... 55.0 17.9 ------ ------ Distributable Income .......................... 639.1 169.7 ====== ====== Income Distributed ............................ 639.1 169.7 ====== ====== Reference should be made to the Notes to Financial Statements. II-46 GMAC 1992-F GRANTOR TRUST (continued)) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-F Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On September 29, 1992, GMAC 1992-F Grantor Trust acquired retail finance receivables aggregating approximately $1,644.6 million from the Seller in exchange for certificates representing undivided ownership interests of 91% for the Class A certificates and 9% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing October 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 4.50% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-47 GMAC 1992-F GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 146.9 16.2 163.1 Second quarter ..................... 151.2 14.6 165.8 Third quarter ...................... 147.3 12.9 160.2 Fourth quarter ..................... 138.7 11.3 150.0 --------- -------- ----- Total ......................... 584.1 55.0 639.1 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Fourth quarter ..................... 151.8 17.9 169.7 ========= ======== ===== II-48 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1992-G Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1992-G Grantor Trust as of December 31, 1993 and 1992, and the related Statement of Distributable Income for the year ended December 31, 1993 and the period November 19, 1992 (inception) through December 31, 1992. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1992-G Grantor Trust at December 31, 1993 and 1992, and its distributable income and distributions for the year ended December 31, 1993 and the period November 19, 1992 (inception) through December 31, 1992, on the basis of accounting described in Note 1. s/ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-49 GMAC 1992-G GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 Dec. 31 1993 1992 ------- ------- ASSETS $ $ Receivables (Note 2) .............................. 335.3 1,288.5 ------- ------- TOTAL ASSETS ...................................... 335.3 1,288.5 ======= ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 335.3 1,288.5 ------- ------- TOTAL LIABILITIES ................................. 335.3 1,288.5 ======= ======= Reference should be made to the Notes to Financial Statements. II-50 GMAC 1992-G GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the year ended December 31, 1993 and the period November 19, 1992 (inception) through December 31, 1992 (in millions of dollars) 1993 1992 ------ ------ $ $ Distributable Income Allocable to Principal ...................... 953.1 91.0 Allocable to Interest ...................... 35.2 4.9 ------ ------ Distributable Income .......................... 988.3 95.9 ====== ====== Income Distributed ............................ 988.3 95.9 ====== ====== Reference should be made to the Notes to Financial Statements. II-51 GMAC 1992-G GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1992-G Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On November 19, 1992, GMAC 1992-G Grantor Trust acquired retail finance receivables aggregating approximately $1,379.4 million from the Seller in exchange for certificates representing undivided ownership interests of 94.5% for the Class A certificates and 5.5% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing December 15, 1992. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 4.30% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-52 GMAC 1992-G GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ First quarter ...................... 268.1 12.9 281.0 Second quarter ..................... 258.3 10.0 268.3 Third quarter ...................... 230.4 7.3 237.7 Fourth quarter ..................... 196.3 5.0 201.3 --------- -------- ----- Total ......................... 953.1 35.2 988.3 ========= ======== ===== 1992 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Fourth quarter ..................... 91.0 4.9 95.9 ========= ======== ===== II-53 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1993-A Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1993-A Grantor Trust as of December 31, 1993 and the related Statement of Distributable Income for the period March 24, 1993 (inception) through December 31, 1993. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1993-A Grantor Trust at December 31, 1993 and its distributable income and distributions for the period March 24, 1993 (inception) through December 31, 1993, on the basis of accounting described in Note 1. s\ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-54 GMAC 1993-A GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 ------- ASSETS $ Receivables (Note 2) .............................. 845.9 ------- TOTAL ASSETS ...................................... 845.9 ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 845.9 ------- TOTAL LIABILITIES ................................. 845.9 ======= Reference should be made to the Notes to Financial Statements. II-55 GMAC 1993-A GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the period March 24, 1992 (inception) through December 31, 1993 (in millions of dollars) ----- $ Distributable Income Allocable to Principal .................... 557.0 Allocable to Interest .................... 35.6 ----- Distributable Income ......................... 592.6 ===== Income Distributed ........................... 592.6 ===== Reference should be made to the Notes to Financial Statements. II-56 GMAC 1993-A GRANTOR TRUST (continued)) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1993-A Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On March 24, 1993, GMAC 1993-A Grantor Trust acquired retail finance receivables aggregating approximately $1,403.0 million from the Seller in exchange for certificates representing undivided ownership interests of 92.5% for the Class A certificates and 7.5% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing April 15, 1993. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 4.15% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-57 GMAC 1993-A GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Second quarter ..................... 196.7 13.9 210.6 Third quarter ...................... 194.4 11.8 206.2 Fourth quarter ..................... 165.9 9.9 175.8 --------- -------- ----- Total ......................... 557.0 35.6 592.6 ========= ======== ===== II-58 INDEPENDENT AUDITORS' REPORT March 22, 1994 The GMAC 1993-B Grantor Trust, its Certificateholders, GMAC Auto Receivables Corporation, and The First National Bank of Chicago: We have audited the accompanying Statement of Assets and Liabilities of the GMAC 1993-B Grantor Trust as of December 31, 1993 and the related Statement of Distributable Income for the period September 16, 1993 (inception) through December 31, 1993. These financial statements are the responsibility of the Trust's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. As described in Note 1 to the financial statements, these financial statements are prepared on the basis of cash receipts and disbursements, which is a comprehensive basis of accounting other than generally accepted accounting principles. In our opinion, such financial statements present fairly, in all material respects, the assets and liabilities of the GMAC 1993-B Grantor Trust at December 31, 1993 and its distributable income and distributions for the period September 16, 1993 (inception) through December 31, 1993, on the basis of accounting described in Note 1. s/ DELOITTE & TOUCHE - ----------------------- DELOITTE & TOUCHE 600 Renaissance Center Detroit, Michigan 48243 II-59 GMAC 1993-B GRANTOR TRUST STATEMENT OF ASSETS AND LIABILITIES (in millions of dollars) Dec. 31 ------- ASSETS $ Receivables (Note 2) .............................. 1,269.0 ------- TOTAL ASSETS ...................................... 1,269.0 ======= LIABILITIES Asset-backed Certificates (Notes 2 and 3) ................................. 1,269.0 ------- TOTAL LIABILITIES ................................. 1,269.0 ======= Reference should be made to the Notes to Financial Statements. II-60 GMAC 1993-B GRANTOR TRUST (continued) STATEMENT OF DISTRIBUTABLE INCOME For the period September 16, 1993 (inception) through December 31, 1993 (in millions of dollars) ----- $ Distributable Income Allocable to Principal .................... 181.6 Allocable to Interest .................... 13.9 ----- Distributable Income ......................... 195.5 ===== Income Distributed ........................... 195.5 ===== Reference should be made to the Notes to Financial Statements. II-61 GMAC 1993-B GRANTOR TRUST (continued) NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF ACCOUNTING The financial statements of the GMAC 1993-B Grantor Trust (the "Trust") are prepared on the basis of cash receipts and cash disbursements. Such financial statements differ from financial statements prepared in accordance with generally accepted accounting principles in that interest income and the related assets are recognized when received rather than when earned and distributions to certificateholders are recognized when paid rather than when the obligation is incurred. All expenses of the Trust are paid by GMAC Auto Receivables Corporation (the "Seller"). NOTE 2. SALE OF CERTIFICATES On September 16, 1993, GMAC 1993-B Grantor Trust acquired retail finance receivables aggregating approximately $1,450.6 million from the Seller in exchange for certificates representing undivided ownership interests of 92.5% for the Class A certificates and 7.5% for the Class B certificates in the Trust. The Trust property includes a pool of retail instalment sale contracts for new and used automobiles and light trucks, certain monies due thereunder, and security interests in the vehicles financed thereby. The Seller has the option to repurchase the remaining receivables as of the last day of any month on or after which the principal balance declines below 10% of the aggregate amount financed. NOTE 3. PRINCIPAL AND INTEREST PAYMENTS Principal (including prepayments) and interest are passed through and distributed pro rata to Class A and Class B certificateholders on each distribution date commencing October 15, 1993. Principal consists of payments on the receivables that are allocable to repayment of the amount sold as determined on a constant interest rate basis (the "actuarial method"). Interest is passed through and distributed to Class A certificateholders at one-twelfth of the pass through rate of 4.00% per annum. Interest consists of payments on the receivables that are allocable to finance charges, using the actuarial method, net of fees and expenses. The rights of the Class B certificateholders to receive monthly distributions with respect to the receivables are subordinated to the rights of the Class A certificateholders. A distribution date is the 15th day of each month (or, if such 15th day is not a business day, the next following business day). NOTE 4. FEDERAL INCOME TAX The Trust is classified as a grantor trust, and therefore is not taxable as a corporation for federal income tax purposes. Each certificateholder will be treated as the owner of a pro rata undivided interest in each of the receivables in the Trust. II-62 GMAC 1993-B GRANTOR TRUST (concluded) SUPPLEMENTARY FINANCIAL DATA (unaudited) SUMMARY OF QUARTERLY DISTRIBUTABLE INCOME (in millions of dollars) 1993 Quarters Principal Interest Total - ------------------------------------ --------- -------- ----- $ $ $ Fourth quarter ..................... 181.6 13.9 195.5 ========= ======== ===== II-63 PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) (1) FINANCIAL STATEMENTS. Included in Part II, Item 8, of Form 10-K. (a) (2) FINANCIAL STATEMENT SCHEDULES. All schedules have been omitted because they are inapplicable or because the information called for is shown in the financial statements or notes thereto. (a) (3) EXHIBITS (Included in Part II of this report). -- GMAC 1990-A Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1991-A Grantor Trust Financial Statement for the Year Ended December 31, 1993. -- GMAC 1991-B Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1991-C Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1992-A Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1992-C Grantor Trust Financial Statement for the Year Ended December 31, 1993. -- GMAC 1992-D Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1992-E Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1992-F Grantor Trust Financial Statements for the Year Ended December 31, 1993. -- GMAC 1992-G Grantor Trust Financial Statement for the Year Ended December 31, 1993. -- GMAC 1993-A Grantor Trust Financial Statements for the period March 24, 1993 through December 31, 1993. -- GMAC 1993-B Grantor Trust Financial Statements for the period September 16, 1993 through December 31, 1993. (b) REPORTS ON FORM 8-K. No current reports on Form 8-K have been filed by any of the above-mentioned Grantor Trusts during the fourth quarter ended December 31, 1993 ITEMS 2, 3, 4, 5, 6, 9, 10, 11, 12 and 13 are inapplicable and have been omitted. IV-1 SIGNATURE Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Trustee has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. GMAC 1990-A GRANTOR TRUST GMAC 1991-A GRANTOR TRUST GMAC 1991-B GRANTOR TRUST GMAC 1991-C GRANTOR TRUST GMAC 1992-A GRANTOR TRUST GMAC 1992-C GRANTOR TRUST GMAC 1992-D GRANTOR TRUST GMAC 1992-E GRANTOR TRUST GMAC 1992-F GRANTOR TRUST GMAC 1992-G GRANTOR TRUST GMAC 1993-A GRANTOR TRUST GMAC 1993-B GRANTOR TRUST The First National Bank of Chicago (Trustee) s\ Steven M. Wagner ---------------------------------- (Steven M. Wagner, Vice President) Date: March 30, 1994 -------------- IV-2

74208_1993.txt

74208

1993

Item 1. Business United Dominion Realty Trust, Inc. (the "Trust"), a Virginia corporation, is a self-administered equity real estate investment trust ("REIT"), formed in 1972, whose business is devoted to one industry segment, the ownership of income-producing real estate, primarily apartments. The Trust acquires, upgrades and operates its properties with the goals of maximizing its funds from operations (defined as income before gains(losses) on investments and extraordinary items adjusted for certain non-cash items, primarily real estate depreciation) and quarterly distributions to shareholders, while building equity primarily through real estate appreciation. Prior to 1991, the Trust's investment policy was to emphasize the acquisition of under-leased, under-managed, and/or under-maintained properties that could be physically or otherwise upgraded and could be acquired at significant discounts from replacement costs. At the beginning of 1991, changed economic conditions and the Trust's financial strength enabled it to embark on a major expansion of its apartment portfolio involving (i) the acquisition of more stable apartment properties having high occupancy levels and not requiring substantial renovation, and (ii) entry into new markets, most recently the Baltimore/Washington area, central Florida and Nashville, Tennessee. The properties have been acquired generally at significant discounts from replacement cost and at attractive current yields. The sellers have been primarily financially distressed real estate limited partnerships, the RTC, the FDIC, lenders who had foreclosed and insurance companies seeking to reduce their real estate exposure. Since 1991, the Trust has acquired 38 apartment properties containing 9,885 units at a total cost of approximately $277 million. As of March 28, 1994, the Trust's portfolio of income-producing real estate consisted of ninety-five properties including seventy-six apartment complexes, fifteen shopping centers, and four other properties. (See Item 2.

Item 2. Properties The table below sets forth a summary of the Trust's portfolio of rental properties owned at December 31, 1993. See also Notes 1 and 2 to Financial Statements and Schedule XI - Summary of Real Estate Owned. Item 2. Properties (continued) December 31, 1993 (1) Two anchor tenants occupying more than 60,000 square feet at this center filed for bankruptcy during 1991. (2) An anchor tenant occupying 53,000 sqaure feet at this center filed for bankruptcy. (3) An anchor tenant occupying 34,800 square feet vacated its space in May, 1992. This space has been leased as of June 1, 1994. (4) On June 30, 1993 the Trust sold a specialty medical building that had been vacant for the first half of the year. (5) Building was vacated by the anchor tenant. The space was fully leased effective June 15, 1993. Item 3.

Item 3. Legal proceedings None Item 4.

Item 4. Submission of matters to a vote of security holders No matters were submitted to a vote of the Trust's shareholders during the last quarter of its fiscal year ended December 31, 1993. Executive officers The executive officers of the Trust, listed below, serve in their respective capacities for approximate one year terms and are subject to re-election annually by the Board of Directors, normally in May of each year. Name Age Office Since John P. McCann 49 President and Chief 1974 Executive Officer James Dolphin 44 Senior Vice President 1979 and Chief Financial Officer Barry M. Kornblau 44 Senior Vice President and 1991 Director of Apartment Operations Mr. McCann, a Director, has been the Trust's managing officer since 1974, serving as its President since 1979, its Secretary from 1974 to 1980, and its Treasurer from 1982 to 1985. Mr. Dolphin, a Director, was first employed by the Trust in May, 1979 as Controller and served as Corporate Secretary from 1980 to January, 1993. He was elected Vice President of Finance in 1985 and Senior Vice President in 1987. Prior to joining the Trust, Mr. Dolphin was employed by Arthur Young and Company, Certified Public Accountants. Mr. Kornblau joined the Trust in 1991 as Senior Vice President and Director of Apartment Operations. From 1985 through 1990, he was President and Chief Executive Officer of Summit Realty Group, Inc. which managed the Trust's apartment properties during that period. He is a licensed real estate broker and a C.P.M. Part II Item 5.

Item 5. Market for registrant's common equity and related stockholder matters Incorporated herein by reference from the captions "Common Stock Price" and "Shareholders" appearing on the inside back cover of the Trust's 1993 Annual Report to Shareholders, included in Exhibit 13. Information regarding the Trust's dividend policy is included in Item 7. Item 6.

Item 6. Selected financial data Incorporated herein by reference from the caption "Selected Financial Information" appearing on page 7 of the Trust's preliminary prospectus dated March 29, 1994, included in the Form S-3 Registration Statement (Registration No. 33-52521) filed with the Securities and Exchange Commission on March 7, 1994 and amended on March 29, 1994 included in Exhibit 99(ii). Item 7.

Item 7. Management's discussion and analysis of financial condition and results of operations. Incorporated herein by reference from the caption "Management's Discussion of Financial Condition and Operations" appearing on pages 8 through 10 of the Trust's preliminary prospectus dated March 29, 1994, included in the Form S-3 Registration Statement (Registration No. 33-52521) filed with the Securities and Exchange Commission on March 7, 1994 and amended on March 29, 1994 included in Exhibit 99(ii). Item 8.

Item 8. Financial statements and supplementary data The Trust's financial statements at December 31, 1993 and 1992 and for each of the three years in the period ended December 31, 1993, and the independent auditor's report thereon and the Trust's unaudited quarterly financial data for the two-year period ended December 31, 1993 are incorporated herein by reference from pages through of the Trust's preliminary prospectus dated March 29, 1994, included in the Form S-3 Registration Statement (Registration No. 33-52521) filed with the Securities and Exchange Commission on March 7, 1994 and amended on March 29, 1994 included in Exhibit 99(ii). Item 9.

Item 9. Changes in and disagreements with accountants on accounting and financial disclosure None Part III Item 10.

Item 10. Directors and executive officers of the registrant Incorporated herein by reference from the Trust's definitive proxy statement to be filed with respect to its Annual Meeting of Shareholders to be held on May 10, 1994. Information regarding the executive officers of the Trust is included in Part I. The Trust also employs five other officers who hold the office of vice president or equivalent as follows: Curtis W. Carter, 37, joined the Trust in 1991 as Assistant Vice President in charge of apartment property management and was subsequently elected Vice President. From December 1985 through 1990, he was Vice President of Property Management for Summit Realty Group, Inc. He is a CPM. Richard B. Chess, 40, joined the Trust in October, 1987 as Director of Acquisitions. He was elected Assistant Vice President in 1988 and Vice President in 1989. From 1984 to 1987 he was employed by Manufacturers Life Insurance Company as Senior Analyst - Real Estate Syndications. He previously served in the Pennsylvania General Assembly and is admitted to the practice of law in Virginia and Pennsylvania. Jerry A. Davis, 31, joined the Trust in March, 1989 as Controller and was subsequently elected Assistant Secretary. In 1991 he was elected Vice President and Controller-Corporate Accounting. From 1986 to 1989, he was employed by Crestar Bank, Richmond, Virginia, as an officer and financial analyst. He was previously employed by Arthur Young & Company, Certified Public Accountants, Richmond, Virginia. He is a certified public accountant. Richard A. Giannotti, 38, joined the Trust as Director of Development and Construction in September, 1985. He was elected Assistant Vice President in 1988 and Vice President in 1989. Prior to joining the Trust he was employed as Project Manager by Vaughan Associates, Architects and by Beckstoffer and Associates, Architects, both of Richmond, Virginia. He is a registered architect. Katheryn E. Surface, 35, joined the Trust in 1992 as Assistant Vice President and Legal Counsel and in 1993 was elected General Counsel, Corporate Secretary and Vice President. From 1986 to 1992, she was an attorney with the law firm of Hunton and Williams, the Trust's outside counsel. Item 11.

Item 11. Executive compensation Incorporated herein by reference from the Trust's definitive proxy statement to be filed with respect to its Annual Meeting of Shareholders to be held on May 10, 1994. Item 12.

Item 12. Security ownership of certain beneficial owners and management Incorporated herein by reference from the Trust's definitive proxy statement to be filed with respect to its Annual Meeting of Shareholders to be held on May 10, 1994. Item 13.

Item 13. Certain relationships and related transactions Incorporated herein by reference from the Trust's definitive proxy statement to be filed with respect to its Annual Meeting of Shareholders to be held on May 10, 1994. Part IV Item 14.

Item 14. Exhibits, financial statement schedules, and reports on Form 8-K (a) The following documents are filed as a part of this report and are hereby incorporated by reference: Page Numbers (manually signed original) Preliminary Prospectus Dated March 29, 1994, Contained in the Trust's Form S-3 Registration Statement (Registration No. 33-52521) Filed with the Securities and Exchange Commission on March 7, 1994 and amended on March 29, 1994 Form (Exhibit 99(ii)) 10-K 1. Financial Statements: Report of Ernst & Young, Independent Auditors 27 Balance sheets at December 31, 1993 and 1992 28 Statements of operations for each of the three years in the period ended December 31, 1993 29 Statements of shareholders' equity for each of the three years in the period ended December 31, 1993 31 Statements of cash flows for each of the three years in the period ended December 31, 1993 30 Notes to financial statements through 32-39 Supplementary information - Quarterly financial data (unaudited) 39 2. Financial Statement Schedules Schedule II - Amounts Receivable from Directors, Officers, and Employees 41 Schedule VIII - Valuation and Qualifying Accounts 42 Schedule X - Supplementary Earnings Statement Information 43 Schedule XI - Summary of Real Estate Owned 44 - 45 All other schedules are omitted since the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the financial statements and notes thereto. 3. Exhibits The exhibits listed on the accompanying exhibit index are filed as part of this annual report. (b) Reports on Form 8-K (i) A Form 8-K dated December 22, 1993 was filed with the Securities and Exchange Commission on December 22, 1993 and amended by Form 8-K/A dated February 18, 1994. The filing reported the acquisition of certain properties which in the aggregate were deemed to be significant. The financial statements filed as part of this report are statements of rental operations of the Village at Old Tampa Bay Apartments, Peppertree Apartments and Beechwood Apartments. UNITED DOMINION REALTY TRUST, INC. EXHIBIT INDEX Item 14 (a) References to pages under the caption "Location" are to sequentially numbered pages of the manually signed original of this Form 10-K, and references to exhibits, forms, or other filings indicate that the form or other filing has been filed, that the indexed exhibit and the exhibit referred to are the same and that the exhibit referred to is incorporated by reference. Exhibit Description Location 3(a)(i) Restated Articles of Incorporation Exhibit 3 to the Trust's Quarterly Report on Form 10-Q for the quarter ended June 30, 1992 3(a)(ii) Amendment of Restated Articles Exhibit 6(a)(l) to the of Incorporation Trust's Form 8-A Registration Statement 3(b) By-Laws Exhibit 4(c) to the Trust's Form S-3 Registration Statement (Registration No. 33-44743) filed with the Commission on December 31, 1991 4(i) Specimen Common Stock Pages 46 through 47 Certificate 4(ii)(a) Loan Agreement dated as of Exhibit 6(c)(l) to the November 7, l991, between the Trust's Form 8-A Trust and Aid Association for Registration Statement Lutherans 4(ii)(b) Loan Agreement dated as of Exhibit 6(c)(2) November 14, 1991, between the to the Trust's Form 8-A Trust and Signet Bank/Virginia Registration Statement 4(ii)(c) Note Purchase Agreement dated Exhibit 6(c)(3) to as of February 19, 1992, between the Trust's Form 8-A the Trust and Principal Mutual Registration Statement Life Insurance Company 4(ii)(d) Credit Agreement dated as of Exhibit 6(c)(4) to the December 15, 1992, between the Trust's Form 8-A Trust and Signet Bank/Virginia Registration Statement 4(ii)(e) Note Purchase Agreement dated Exhibit 6(c)(5) to the as of January 15, l993, between Trust's Form 8-A the Trust and CIGNA Property Registration Statement and Casualty Insurance Company, Connecticut General Life Insurance Company, Connecticut General Life Insurance Company, on behalf of one or more separate accounts, Insurance Company of North America, Principal Mutual Life Insurance Company and Aid Association for Lutherans The Trust agrees to furnish to the Commission on request a copy of any instrument with respect to long-term debt of the Trust or its subsidiary the total amount of securities authorized under which does not exceed 10% of the total assets of the Trust. 10(i) Employment Agreement between Exhibit 10(v)(i)to the Trust and John P. McCann, Form 10-K for the year dated October 29, l982 ended December 31, 1982. 10(ii) Employment Agreement between Exhibit 10(v)(ii) to the Trust and James Dolphin, Form 10-K for the year dated October 29, l982 ended December 31, 1982. 10(iii) Employment Agreement between Exhibit 10(iii) to the Trust and Barry M. Kornblau, Form 10-K for the year dated January 1, 1991. December 31, 1990. 10(iv) 1985 Stock Option Plan, Exhibit B to the Trust's as amended definitive proxy statement dated April 13, 1992. 10(v) 1991 Stock Purchase and Loan Exhibit 10(v) to Plan Form 10-K for the year ended December 31, 1991. 13 Page of the Trust's 1993 Page 21 Annual Report to Shareholders that includes information incorporated by reference into this Form 10-K. 21 The Trust's only subsidiary is The Commons of Columbia, Inc., a Virginia corporation, which does not do business under any other name. 24 Consent of Independent Page 40 Auditors 99(ii) Pages 7 through 10, Pages 22 through 39 inclusive, and pages through, inclusive of the preliminary prospectus dated March 29, 1994, included in the Trust's Form S-3 Registration Statement (Registration No. 33-52521) filed with the Commission on March 7, 1994 and amended on March 29, 1994. With the exception of the information incorporated by reference into Item 5, the 1993 Annual Report to Shareholders is not deemed filed as part of this report. ANNUAL REPORT ON FORM 10-K ITEM 14(a)(1) and (2), (c) and (d) FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES CERTAIN EXHIBITS FINANCIAL STATEMENT SCHEDULES YEAR ENDED DECEMBER 31, 1993 UNITED DOMINION REALTY TRUST, INC. RICHMOND, VIRGINIA General information General Offices United Dominion Realty Trust 10 S. Sixth Street, Suite 203 Richmond, Virginia 23219-3802 (804)780-2691 (804)343-1912 FAX General Counsel Hunton & Williams Riverfront Plaza-East Tower 901 E. Byrd Street Richmond, Virginia 23219-4074 Independent Auditors Ernst & Young 901 East Cary Street Richmond, Virginia 23219 Transfer Agent Mellon Securities Trust Company Four Station Square, 3rd Floor Pittsburgh, Pennsylvania 15219-1173 Shareholders On March 1, 1994, the Trust had 4,505 shareholders of record. Employees As of February 20, 1994, the Trust had 556 full and part-time employees. Annual Meeting The Annual Meeting of Shareholders is scheduled for Tuesday, May 10, 1994, at 4:00 p.m., at the Omni Richmond Hotel in Richmond, Virginia. All Shareholders are cordially invited to attend. Member National Association of Real Estate Investment Trusts (NAREIT) National Apartment Association National Multi-Housing Council International Council of Shopping Centers Stock Listing New York Stock Exchange Symbol UDR 10-K Report The Trust offers its shareholders, without charge, copies of its Annual Report on Form 10-K, as reported to the Securities and Exchange Commission. Dividend Reinvestment and Stock Purchase Plan The Trust offers its shareholders the opportunity to purchase additional shares of common stock through the Dividend Reinvestment and Stock Purchase Plan. Information regarding the Plan can be obtained directly from the Trust's office. Requests should be addressed to Shareholder Relations, United Dominion Realty Trust, at the Trust's office. Common Stock Price The table below sets forth the range of the high and low sales prices per share for each quarter of the last two years. Dividend information reflects dividends declared for each calendar quarter and paid at the end of the following month. Information for 1992 and the first quarter of 1993 give retroactive effect to a 2-for-1 stock split in May 1993. Dividend 1992 High Low Declared 1st Quarter $11 1/2 $10 $.165 2nd Quarter 10 13/16 9 3/4 .165 3rd Quarter 12 3/16 10 9/16 .165 4th Quarter 12 11/16 10 7/8 .165 1st Quarter $14 13/16 $11 7/8 $.175 2nd Quarter 14 5/8 12 1/2 .175 3rd Quarter 16 5/8 13 1/2 .175 4th Quarter 16 7/8 12 5/8 .175 (1) In 1991, 1992 and 1993 the Trust entered into stock purchase agreements whereby certain officers purchased shares of common stock at the then current market price. The Trust provides 100% financing for the purchase of the stock with interest payable quarterly at rates escalating from 7% to 8-1/2%. The underlying notes mature beginning in November, 1998. The Trust holds as collateral all stock purchased through this plan. (1) The balance is netted against the cost of real estate owned on the balance sheet SCHEDULE X UNITED DOMINION REALTY TRUST, INC. SUPPLEMENTARY EARNINGS STATEMENT INFORMATION THREE YEARS ENDED DECEMBER 31, 1993 (DOLLARS IN THOUSANDS) Charged to Expense Description 1993 1992 1991 Advertising $1,078 $731 $652 Rental Promotions 420 650 553 Other items requiring disclosure are not shown as they are less than 1% of rental income. Depreciable Life of Date of Date Building Construction Acquired Component Apartments: 2131 Apartments/Nashville, TN 1972 12/16/92 35 yrs. Azalea/Richmond, VA 1967 12/31/84 35 yrs. Bay Cove/Clearwater, FL 1972 12/16/92 35 yrs. Bayberry Commons/Portsmouth, VA 1973/74 04/07/88 35 yrs. Beechwood/Greensboro, NC 1985 12/22/93 35 yrs. Braeland Commons/Columbia, MD 1983 12/29/92 35 yrs. Bramblewood/Goldsboro, NC 1980/82 12/31/84 35 yrs. Brynn Marr/Jacksonville, NC 1973/77 12/31/84 35 yrs. Canterbury Woods/Charlotte, NC 1968/70 12/18/85 35 yrs. Cedar Point/Raleigh, NC 1972 12/18/85 35 yrs. Cinnamon Ridge/Raleigh, NC 1968/70 12/01/89 35 yrs. Colonial Villa/Columbia, SC 1974 09/16/92 35 yrs. Colony of Stone Mtn/Atlanta, GA 1970/72 06/12/90 35 yrs. Colony Village/New Bern, NC 1972/74 12/31/84 35 yrs. Country Walk/Columbia, SC 1974 12/19/91 35 yrs. Courthouse Green/Richmond, VA 1974/78 12/31/84 35 yrs. Courtney Square/Raleigh, NC 1979/81 07/08/93 35 yrs. The Cove at Lake Lynn/Raleigh, NC 1986 12/01/92 35 yrs. Craig Manor/Salem,VA 1975 11/06/87 35 yrs. The Creek/Wilmington, NC 1973 06/30/92 35 yrs. Crescent Square/Atlanta, GA 1970 03/22/89 35 yrs. Dover Village/Orlando, FL 1981 03/31/93 35 yrs. Eastwind/Virginia Beach, VA 1970 04/04/88 35 yrs. Eden Commons/Columbia, MD 1984 12/29/92 35 yrs. Emerald Bay/Charlotte, NC 1972 02/06/90 35 yrs. English Hills/Richmond, VA 1969/76 12/06/91 35 yrs. Forest Hills/Wilmington, NC 1964/69 06/30/92 35 yrs. Forestbrook/Columbia, SC 1974 07/01/93 35 yrs. Foxcroft/Tampa, FL 1972 01/28/93 35 yrs. Gable Hill/Columbia, SC 1985 12/04/89 35 yrs. Gatewater Landing/Glen Burnie, MD 1970 12/16/92 35 yrs. Grand Oaks/Charlotte, NC 1966/67 05/01/84 35 yrs. Hampton Court/Alexandria, VA 1967 02/19/93 35 yrs. Harbour Town/Nashville, TN 1974 12/10/93 35 yrs. Heather Lake/Hampton, VA 1972/74 03/01/80 35 yrs. Heatherwood/Greenville, SC 1978 09/30/93 35 yrs. Heritage Trace/Newport News, VA 1973 06/30/89 35 yrs. The Highlands/Charlotte, NC 1970 01/17/84 35 yrs. Key Pines/Spartanburg, SC 1974 09/25/92 35 yrs. The Lakes/Nashville, TN 1986 09/15/93 35 yrs. Lake Washington Downs/Melbourne,FL 1984 09/24/93 35 yrs. Laurel Ridge/Roanoke, VA 1970/72 05/17/88 35 yrs. Laurel Village/Richmond, VA 1972 09/06/91 35 yrs. The Ledges/Winston-Salem, NC 1959 08/13/86 35 yrs. Liberty Crossing/Jacksonville, NC 1972/74 11/30/90 35 yrs. Meadow Run/Richmond, VA 1973/74 12/31/84 35 yrs. Meadowdale Lakes/Richmond, VA 1967/71 12/31/84 35 yrs. The Melrose/Dumfries, VA 1951 12/11/85 35 yrs. Mill Creek/Atlanta, GA 1972 11/11/88 35 yrs. Mill Creek/Wilmington, NC 1986 09/30/91 35 yrs. Northview/Salem, VA 1969 09/29/78 35 yrs. Olde West Village/Richmond, VA 1978/82/85/87 12/31/84 & 8/27/91 35 yrs. Orange Orlando/Orlando, FL 1971 01/21/93 35 yrs. Park Green/Raleigh, NC 1987 09/27/91 35 yrs. Parkwood Court/Alexandria, VA 1964 06/30/93 35 yrs. Patriot Place/Florence, SC 1974 10/23/85 35 yrs. Peppertree/Charlotte, NC 1987 12/14/93 35 yrs. Pinebrook/Clearwater,FL 1977 09/28/93 35 yrs. Plum Chase/Columbia, SC 1974 01/04/91 35 yrs. River Road/Ettrick, VA 1973/74 08/31/81 35 yrs. Riverwind/Spartanburg, SC 1987 12/31/93 35 yrs. Rollingwood/Richmond, VA 1974/78 12/31/84 35 yrs. St. Andrews Commons/Columbia, SC 1986 05/20/93 35 yrs. Spring Forest/Raleigh, NC 1978/81 05/21/91 35 yrs. Stanford Village/Atlanta, GA 1985 09/26/89 35 yrs. Summit-on-Park/Charlotte, NC 1963 01/17/84 35 yrs. Summit West/Tampa, FL 1972 12/16/92 35 yrs. Timbercreek/Richmond, VA 1969 08/31/83 35 yrs. Towne Square/Hopewell, VA 1967 08/27/85 35 yrs. Twin Rivers/Hopewell, VA 1972 01/06/82 35 yrs. Village at Old Tampa Bay/Oldsmar,FL 1986 12/08/93 35 yrs. Windsor Harbor/Charlotte, NC 1971 01/13/89 35 yrs. Woodland Hollow/Charlotte, NC 1974/76 11/03/86 35 yrs. Woodscape/Newport News, VA 1974/76 12/29/87 35 yrs. SCHEDULE XI. Summary of Real Estate Owned (continued) Depreciable Life of Date of Date Building Construction Acquired Component Shopping Centers: Circle/Richmond, VA 1956/62/67 11/01/73 25/35 yrs. Cumberland Square/Dunn, NC 1972/78/84 08/28/86 35 yrs. Deerfield Plaza/Myrtle Beach, SC 1979 01/17/84 35 yrs. Glen Lea/Richmond, VA 1964/85 05/25/83 25 yrs. Gloucester Exchange/Gloucester, VA 1974 11/12/87 35 yrs. Hanover Village/Richmond, VA 1971/72 06/30/86 35 yrs. Kroger Sav-On/Waynesboro, VA 1975 03/07/80 35 yrs. Laburnum Park/Richmond, VA 1988/89 09/28/90 35 yrs. Laburnum Square/Richmond, VA 1978/85 02/11/81 40 yrs. Meadowdale/Richmond, VA 1976/82 12/31/84 35 yrs. Rite Aid/Richmond, VA 1974 12/31/84 35 yrs. Rose Manor/Smithfield, NC 1972/75 08/28/86 35 yrs. The Village/Durham, NC 1965 08/28/86 35 yrs. Village Square/Myrtle Beach, SC 1978/79 05/25/88 35 yrs. Willow Oaks/Hampton, VA 1968/74 08/01/84 35 yrs. Office and Industrial Buildings: Franklin St./Richmond, VA 1890 07/01/86 35 yrs. Meadowdale Offices/Richmond, VA 1983 12/31/84 35 yrs. Statesman Park/Roanoke, VA 1974 05/22/75 33 yrs. Tri-County Buildings/Bristol, TN 1976/79 01/21/81 33 yrs. SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the registrant has duly caused this Annual Report to be signed on its behalf by the undersigned, thereunto duly authorized. United Dominion Realty Trust, Inc. (registrant) By /s/ James Dolphin James Dolphin Senior Vice President, Secretary, and Chief Financial Officer March 15, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on March 15, 1994 by the following persons on behalf of the registrant and in the capacities indicated. /s/ John P. McCann /s/ R. Toms Dalton,Jr. John P. McCann R. Toms Dalton, Jr. Director, President and Chief Director Executive Officer /s/ James Dolphin /s/ Jeff C. Bane James Dolphin Jeff C. Bane Director, Senior Vice President, Director Secretary and Chief Financial Officer /s/ Jerry A. Davis /s/ John C. Lanford Jerry A. Davis John C. Lanford Vice President, Controller-Corporate Accounting Director and Chief Accounting Officer /s/ C. Harmon Williams, Jr. /s/ H. Franklin Minor C. Harmon Williams, Jr. H. Franklin Minor Chairman of the Board of Directors Director /s/ Barry M. Kornblau /s/ Robert P. Buford Barry M. Kornblau Robert P. Buford Director, Senior Vice President and Director Director of Apartments

352363_1993.txt

352363

1993

815917_1993.txt

815917

1993

ITEM 1. BUSINESS The Jones Financial Companies, a Limited Partnership (the "Registrant" and also referred to herein as the "Partnership") is organized under the Revised Uniform Limited Partnership Act of the State of Missouri. The terms "Registrant" and "Partnership" used throughout, refer to The Jones Financial Companies, a Limited Partnership and any or all of its consolidated subsidiaries. The Partnership is the successor to Whitaker & Co., which was established in 1871 and dissolved on October 1, 1943, said date representing the organization date of Edward D. Jones & Co., L.P. ("EDJ"), the Partnership's principal subsidiary. EDJ was reorganized on August 28, 1987, which date represents the organization date of The Jones Financial Companies, a Limited Partnership. The Partnership is engaged in business as a broker/dealer in listed and unlisted securities, including governmental issues, acts as an investment banker, and is a distributor of mutual fund shares. In addition, the Partnership engages in sales of various insurance products and renders investment advisory services. The Partnership is heavily oriented towards serving individual retail customers. The Partnership is a member firm of the New York, American and Midwest exchanges, and is a registered broker/dealer with the National Association of Securities Dealers, Inc. As of February 25, 1994, the Partnership was comprised of 111 general partners, 2,000 limited partners and 54 subordinated limited partners. The Partnership employed 8,086 persons, including 2,013 part-time employees. As of said date, the Partnership employed 2,776 full-time investment representatives actively engaged in sales in 2,704 offices in 48 states. The Partnership anticipates opening its first offices in Hawaii and Ontario, Canada in 1994. The Partnership owns 100 percent of the outstanding common stock of EDJ Holding Company, Inc., a Missouri corporation and 100 percent of the outstanding common stock of LHC, Inc., a Missouri corporation. The Partnership also holds all of the partnership equity of Edward D. Jones & Co., L.P., a Missouri limited partnership and EDJ Leasing Co., L.P. a Missouri limited partnership. EDJ Holding Company, Inc. and LHC, Inc. are the general partners of Edward D. Jones & Co., L.P. and EDJ Leasing Co., L.P., respectively. In addition, the Partnership owns 100 percent of the outstanding common stock of Conestoga Securities, Inc., a Missouri corporation and also owns, as a limited partner, 49.5 percent of Passport Research Ltd., a Pennsylvania limited partnership, which acts as an investment advisor to a money market mutual fund. The Partnership owns 100% of the equity of Edward D. Jones & Co., an Ontario limited partnership and the general partner is Edward D. Jones & Co. Canada Holding Co. Inc., which is wholly owned by the Partnership. The Partnership has an equity position in several entities formed to act as general partners of various direct participation programs sponsored by the Nooney Corporation as follows: Nooney Capital Corp. (a Missouri corporation), 66-2/3% of outstanding Class B non-voting stock; Nooney-Five Capital Corp. (a Missouri Corporation), 100% of outstanding Class B non-voting stock; Nooney-Six Capital Corp. (a Missouri corporation), 100% of outstanding Class B non-voting stock; Nooney-Seven Capital Corp. (a Missouri corporation), 100% of outstanding Class B non-voting stock; Nooney Income Investments, Inc. (a Missouri corporation), 100% of outstanding Class B non-voting stock; Nooney Income Investments Two, Inc. (a Missouri corporation), 100% of outstanding Class B non-voting stock; Nooney Income Investment Three, Inc., (a Missouri corporation), 100% of outstanding Class B non-voting stock. The Partnership holds all of the partnership equity in a Missouri limited partnership, EDJ Ventures, Ltd., which acts as a partner and renders advisory and other management services to direct participation program partnerships. Conestoga Securities, Inc. is the general partner of EDJ Ventures, Ltd. The Partnership is the sole shareholder of Tempus Corporation, a Missouri corporation, which was formed strictly to facilitate the issuance of certain debt securities of the Partnership in a private transaction. The Partnership is a limited partner of EDJ Insurance Agency of New Jersey, L.P., a New Jersey limited partnership; EDJ Insurance Agency of Arkansas, an Arkansas limited partnership; EDJ Insurance Agency of Montana, a Montana limited partnership; EDJ Insurance Agency of New Mexico, a New Mexico limited partnership; EDJ Insurance Agency of Utah, a Utah limited partnership; and is a general partner in EDJ Insurance Agency of California, a California general partnership; each of which engage in general insurance brokerage activities. The Partnership owns all of the outstanding stock of EDJ Insurance Agency of Ohio, Inc., which is also engaged in insurance brokerage activities. Affiliates of the partner include EDJ Insurance Agency of Nevada, EDJ Insurance Agency of Texas, EDJ Insurance Agency of Alabama, EDJ Insurance Agency of Florida, EDJ Insurance Agency of Wyoming, EDJ Insurance Agency of Arizona and EDJ Insurance Agency of Massachusetts. The Partnership holds all of the Partnership equity of Unison Investment Trusts, L.P., d/b/a Unison Investment Trusts, Ltd., a Missouri limited partnership, which sponsors unit investment trust programs. The general partner of Unison Investment Trusts, L.P. is Unison Capital Corp., Inc., a Missouri corporation wholly owned by the Partnership. The Partnership owns 100% of the outstanding common stock of Edward D. Jones Homeowners, Inc., a Missouri corporation which, in turn, serves as the general partner of EDJ Residential Mortgage Services, a Missouri limited partnership wholly owned by the Partnership, which formerly provided mortgage brokerage and ancillary services. The Partnership owns 100% of the outstanding common stock of Cornerstone Mortgage Investment Group, Inc., a Delaware limited purpose corporation which has issued and sold collateralized mortgage obligation bonds, and Cornerstone Mortgage Investment Group II, Inc., a Delaware limited purpose corporation which has structured and sold secured mortgage bonds. The Partnership owns 100% of the outstanding stock of CIP Management, Inc., which is the managing general partner of CIP Management, L.P. CIP Management, L.P. is the managing general partner of Community Investment Partners, L.P. and Community Investment Partners II, L.P., business development companies. Other affiliates of the Partnership include Patronus, Inc. and EDJ Investment Advisory Services. Neither has conducted an active business. The Partnership owns as a general partner, 1/3 of Commonwealth Pacific Limited Partnership, a Washington limited partnership, which formerly operated as a syndicator of various real estate limited partnership programs, for which the Partnership had served as an underwriter and distributor. Revenues by Source. The following table sets forth, for the past three years the sources of the Partnership's revenues by dollar amounts, (all amounts in thousands): 1993 1992 1991 Commissions Listed $ 70,634 $ 59,256 $ 44,115 Mutual Funds 272,020 187,411 110,499 O-T-C 20,786 14,424 10,136 Insurance 64,424 42,585 34,964 Other 596 274 60 Principal Transactions 92,471 131,366 104,426 Investment Banking 45,001 60,635 67,376 Interest & Dividends 38,084 30,520 25,533 Money-Market Fees 10,048 10,751 9,320 IRA Custodial Service Fees 4,387 3,310 999 Other Revenues 13,001 9,080 4,160 _________ _________ _________ Total Revenue $ 631,452 $ 549,612 $411,588 Because of the interdependence of the activities and departments of the Partnership's investment business and the arbitrary assumptions involved in allocating overhead, it is impractical to identify and specify expenses applicable to each aspect of the Partnership's operations. Furthermore, the net income of firms principally engaged in the securities business, including the Partnership's, is effected by interest savings as a result of customer and other credit balances and interest earned on customer margin accounts. Listed Brokerage Transactions. A large portion of the Partnership's revenue is derived from customers' transactions in which the Partnership acts as agent in the purchase and sale of listed corporate securities. These securities include common and preferred stocks and corporate debt securities traded on and off the securities exchanges. Revenue from brokerage transactions is highly influenced by the volume of business and securities prices. Customers' transactions in securities are effected on either a cash or a margin basis. In a margin account, the Partnership lends the customer a portion of the purchase price up to the limits imposed by the margin regulations of the Federal Reserve Board (Regulation T), New York Stock Exchange (NYSE) margin requirements, or the Partnership's internal policies, which may be more stringent than the regulatory minimum requirements. Such loans are secured by the securities held in customers' margin accounts. These loans provide a source of income to the Partnership since it is able to lend to customers at rates which are higher than the rates at which it is able to borrow on a secured basis. The Partnership is permitted to use as collateral for the borrowings, securities owned by margin customers having an aggregate market value generally up to 140 percent of the debit balance in margin accounts. The Partnership may also use the interest-free funds provided by free credit balances in customers' accounts to finance customers' margin account borrowings. In permitting customers to purchase securities on margin, the Partnership assumes the risk of a market decline which could reduce the value of its collateral below a customer's indebtedness before the collateral is sold. Under the NYSE rules, the Partnership is required in the event of a decline in the market value of the securities in a margin account to require the customer to deposit additional securities or cash so that at all times the loan to the customer is no greater than 75 percent of the value of the securities in the account ( or to sell a sufficient amount of securities in order to maintain this percentage). The Partnership, however, imposes a more stringent maintenance requirement. Variations in revenues from listed brokerage commissions between periods is largely a function of market conditions; however, some portion of the overall increases in recent years is due to the growth in the number of registered representatives over these periods. Mutual Funds. The Partnership distributes mutual fund shares in continuous offerings and new underwritings. As a dealer in mutual fund shares, the Partnership receives a dealers' discount which generally ranges from 1 percent to 5 3/4 percent of the purchase price of the shares, depending on the terms of the dealer agreement and the amount of the purchase. The Partnership also earns service fees which are generally based on 15 to 25 basis points of its customers' assets which are held by the mutual funds. The Partnership does not manage any mutual fund, although it is a limited partner of Passport Research, Ltd., an advisor to a money market mutual fund. Over-the-Counter and Principal Transactions. Partnership activities in unlisted (over-the-counter) transactions are essentially similar to its activities as a broker in listed securities. In connection with customers' orders to buy or sell securities on an agency basis, the Partnership charges a commission. In dealing on a principal basis, the Partnership charges its customers a net price approximately equal to the current inter-dealer market price plus or minus a mark-up or mark-down from such market price. The National Association of Securities Dealers (NASD) Rules of Fair Practice require that such mark-up (or mark-down) be fair and reasonable. The Partnership has executed several agency agreements with various national insurance companies. Through its approximately 2,056 investment representatives who hold insurance sales licenses, EDJ is able to offer term life insurance, health insurance, and fixed and variable annuities to its customers. The sale of annuities is the primary product. Revenues from the sale of insurance products approximated 10% of total revenues in 1993, and this area has experienced growth in recent years largely as a result of the growth in the number of representatives licensed to engage in insurance sales. The Partnership makes a market in over-the-counter corporate securities, municipal obligations, including general obligations and revenue bonds, unit investment trusts and mortgage-backed securities. The Partnership's market-making activities are conducted with other dealers in the "wholesale" market and "retail" market wherein the Partnership acts as a dealer buying from and selling to its customers. In making markets in over-the-counter securities, the Partnership exposes its capital to the risk of fluctuation in the market value of its security positions. It is the Partnership's policy not to trade for its own account. As in the case of listed brokerage transactions, revenue from over- the-counter and principal transactions is highly influenced by the volume of business and securities prices, as well as by the varying number of registered representatives employed by the Partnership over the periods indicated. Investment Banking. The Partnership's investment banking activities are carried on through its Syndicate and Underwriting Departments. The principal service which the Partnership renders as an investment banker is the underwriting and distribution of securities either in a primary distribution on behalf of the issuer of such securities or in a secondary distribution on behalf of a holder of such securities. The distributions of corporate and municipal securities are, in most cases, underwritten by a group or syndicate of underwriters. Each underwriter has a participation in the offering. Unlike many larger firms against which the Partnership competes, the Partnership does not presently engage in other investment banking activities such as assisting in mergers and acquisitions, arranging private placement of securities issues with institutions or providing consulting and financial advisory services to corporations. The Syndicate and Underwriting Departments are responsible for the largest portion of the Partnership's investment banking business. In the case of an underwritten offering managed by the Partnership, the Departments may form underwriting syndicates and work closely with the branch office system for sales of the Partnership's own participation and with other members of the syndicate in the pricing and negotiation of other terms. In offerings managed by others in which the Partnership participates as a syndicate member, the Departments serve as active coordinators between the managing underwriter and the Partnership's branch office system. The underwriting activity of the Partnership involves substantial risks. An underwriter may incur losses if it is unable to resell the securities it is committed to purchase or if it is forced to liquidate all or part of its commitment at less than the agreed purchase price. Furthermore, the commitment of capital to underwriting may adversely affect the Partnership's capital position and, as such, its participation in an underwriting may be limited by the requirement that it must at all times be in compliance with the net capital rule. The Securities Act of 1933 and other applicable laws and regulations impose substantial potential liabilities on underwriters for material misstatements or omissions in the prospectus used to describe the offered securities. In addition, there exists a potential for possible conflict of interest between an underwriter's desire to sell its securities and its obligation to its customers not to recommend unsuitable securities. In recent years there has been an increasing incidence of litigation in these areas. These lawsuits are frequently brought for the benefit of large classes of purchasers of underwritten securities. Such lawsuits often name underwriters as defendants and typically seek substantial amounts in damages. Interest and dividend income is earned on securities held and margin account balances. Other revenue sources include money market management fees and IRA custodial services fees, accommodation transfer fees, gains from sales of certain assets, and other product and service fees. The Partnership has an interest in the investment advisor to its money market fund, Daily Passport Cash Trust. Revenue from this source has increased over the periods due to growth in the fund, both in dollars invested and number of accounts. In 1991 EDJ became the trustee for its IRA accounts. Each account is charged an annual service fee for services rendered to it by the Partnership. The Partnership has registered an investment advisory program with the SEC under the Investment Advisors Act of 1940. This service is offered firmwide and involves income and estate tax planning and analysis for clients. Revenues from this source are insignificant and included under "Other Revenues." Also included in the category "Other Revenues" are accommodation transfer fees, gains from sales of certain assets, other non-recurring gains and revenue from management fees charged by mutual funds. Research Department. The Partnership maintains a Research Department to provide specific investment recommendations and market information for retail customers. The Department supplements its own research with the services of various independent research services. The Partnership competes with many other securities firms with substantially larger research staffs in its research activities. Customer Account Administration and Operations. Operations employees are responsible for activities relating to customers' securities and the processing of transactions with other broker/dealers. These activities include receipt, identification, and delivery of funds and securities, internal financial controls, accounting and personnel functions, office services, storage of customer securities and the handling of margin accounts. The Partnership processes substantially all of its own transactions. It is important that the Partnership maintains current and accurate books and records from both a profit viewpoint as well as for regulatory compliance. To expedite the processing of orders, the Partnership's branch office system is linked to the St. Louis headquarters office through an extensive communications network. Orders for all securities are centralized in St. Louis and executed there. The Partnership's processing of paperwork following the execution of a security transaction is automated, and operations are generally on a current basis. There is considerable fluctuation during any one year and from year to year in the volume of transactions the Partnership processes. The Partnership records transactions and posts its books on a daily basis. Operations' personnel monitor day-to-day operations to determine compliance with applicable laws, rules and regulations. Failure to keep current and accurate books and records can render the Partnership liable to disciplinary action by governmental and self-regulatory organizations. The Partnership has a computerized branch office communication system which is principally utilized for entry of security orders, quotations, messages between offices and cash receipts functions. The Partnership clears and settles virtually all of its listed transactions through the National Securities Clearing Corporation ("NSCC"), New York, New York. NSCC effects clearing of securities on the New York, American and Midwest Stock Exchanges. In conjunction with clearing and settling transactions with NSCC the Partnership holds customers' securities on deposit with Depository Trust Company ("DTC") in lieu of maintaining physical custody of the certificates. The Partnership is substantially dependent upon the operational capacity and ability of NSCC/DTC. Any serious delays in the processing of securities transactions encountered by NSCC/DTC may result in delays of delivery of cash or securities to the Partnership's customers. These services are performed for the Partnership under contracts which may be changed or terminated at will by either party. Automated Data Processing, Inc., ("ADP") provides automated data processing services for customer account activity and records. The Partnership does not employ its own floor broker for transactions on exchanges. The Partnership has arrangements with other brokers to execute the Partnership's transactions in return for a commission based on the size and type of trade. If for any reason any of the Partnership's clearing, settling or executing agents were to fail, the Partnership and its customers would be subject to possible loss. While the coverages provided by the Securities Investors Protection Corporation (SIPC) and protection in excess of SIPC limits would be available to customers of the Partnership, to the extent that the Partnership would not be able to meet the obligations of the customers, such customers might experience delays in obtaining the protections afforded them by the SIPC and the Partnership's insurance carrier. The Partnership believes that its internal controls and safeguards concerning the risks of securities thefts are adequate. Although the possibility of securities thefts is a risk of the industry, the Partnership has not had, to date, a significant problem with such thefts. The Partnership maintains fidelity bonding insurance which, in the opinion of management, provides adequate coverage. Employees. Including its general partners, the Partnership has approximately 8,086 full and part-time employees, including 2,776 who are registered salespeople as of February 25, 1994. The Partnership's salespersons are compensated on a commission basis and may, in addition, be entitled to bonus compensation based on their respective branch office profitability and the profitability of the Partnership. The Partnership has no formal bonus plan for its non-registered employees. The Partnership has, however, in the past paid bonuses to its non-registered employees on an informal basis, but there can be no assurance that such bonuses will be paid for any given period or will be within any specific range of amounts. Employees of the Partnership are bonded under a blanket policy as required by NYSE rules. The annual aggregate amount of coverage is $30,000,000 subject to a $2,000,000 deductible provision, per occurrence. The Partnership maintains a training program for prospective salespeople which includes eight weeks of concentrated instruction and on-the-job training in a branch office. The first phase of training is spent reviewing Series 7 examination materials and preparing for and taking the examination. The first week of the training after passing the examination is spent in a comprehensive training program in St. Louis. The next five weeks include on-the-job training in branch locations reviewing products, office procedures and sales techniques. The broker is then sent to a designated location to establish the EDJ office, conduct market research and prepare for opening the office. After the salesperson has opened a branch office, one final week is spent in a central location to complete the initial training program. Three and nine months later, the investment representative attends additional training classes in St. Louis, and subsequently, EDJ offers periodic continuing training mechanisms to its seasoned sales force. Although the Partnership pays the broker during the transition period, the broker must fulfill special tasks before being awarded full branch status. EDJ's basic brokerage payout is similar to its competitors. A bonus may also be paid based on the profitability of the branch and the profitability of the Partnership. The Partnership considers its employee relations to be good and believes that its compensation and employee benefits which include medical, life, and disability insurance plans and profit sharing and deferred compensation retirement plans, are competitive with those offered by other firms principally engaged in the securities business. Competition. The Partnership is subject to intensive competition in all phases of its business from other securities firms, many of which are substantially larger than the Partnership in terms of capital, brokerage volume and underwriting activities. In addition, the Partnership encounters competition from other financially oriented organizations such as banks, insurance companies, and others offering financial services and advice. In recent periods, many regulatory requirements prohibiting non-securities firms from engaging in certain aspects of brokerage firms' business have been eliminated and further removal of such prohibitions is anticipated. With minor exceptions, customers are free to transfer their business to competing organizations at any time. There is intense competition among securities firms for salespeople with good sales production records. In recent periods, the Partnership has experienced increasing efforts by competing firms to hire away its registered representatives although the Partnership believes that its rate of turnover of investment representatives is not higher than that of other firms comparable to the Partnership. Regulation. The securities industry in the United States is subject to extensive regulation under both federal and state laws. The SEC is the federal agency responsible for the administration of the federal securities laws. The Partnership's principal subsidiary is registered as a broker-dealer and investment advisor with the SEC. Much of the regulation of broker-dealers has been delegated to self-regulatory organizations, principally the NASD and national securities exchanges such as the NYSE, which has been designated by the SEC as the Partnership's primary regulator. These self-regulatory organizations adopt rules (which are subject to approval by the SEC) that govern the industry and conduct periodic examinations of the Partnership's operations. Securities firms are also subject to regulation by state securities administrators in those states in which they conduct business. The Partnership is registered as a broker-dealer in 50 states and Puerto Rico. Broker-dealers are subject to regulations which cover all aspects of the securities business, including sales methods, trade practices among broker-dealers, use and safekeeping of customers' funds and securities, capital structure of securities firms, record-keeping and the conduct of directors, officers and employees. Additional legislation, changes in rules promulgated by the SEC and self- regulatory organizations, or changes in the interpretation or enforcement of existing laws and rules, may directly affect the mode of operation and profitability of broker-dealers. The SEC, self- regulatory organizations and state securities commissions may conduct administrative proceedings which can result in censure, fine, suspension or expulsion of a broker-dealer, its officers or employees. The principal purpose of regulation and discipline of broker-dealers is the protection of customers and the securities markets, rather than protection of the creditors and stockholders of broker-dealers. Uniform Net Capital Rule. As a broker-dealer and a member firm of the NYSE, the Partnership is subject to the Uniform Net Capital Rule (Rule) promulgated by the SEC. The Rule is designed to measure the general financial integrity and liquidity of a broker-dealer and the minimum net capital deemed necessary to meet the broker-dealer's continuing commitments to its customers. The Rule provides for two methods of computing net capital and the Partnership has adopted what is generally referred to as the alternative method. Minimum required net capital under the alternative method is equal to 2% of the customer debit balances, as defined. The Rule prohibits withdrawal of equity capital whether by payment of dividends, repurchase of stock or other means, if net capital would thereafter be less than 5% of customer debit balances. Additionally, certain withdrawals require the consent of the SEC to the extent they exceed defined levels even though such withdrawals would not cause net capital to be less than 5% of aggregate debit items. In computing net capital, various adjustments are made to exclude assets which are not readily convertible into cash and to provide a conservative statement of other assets such as a company's inventories. Failure to maintain the required net capital may subject a firm to suspension or expulsion by the NYSE, the SEC and other regulatory bodies and may ultimately require its liquidation. The Partnership has, at all times, been in compliance with the net capital rules. ITEM 2.

ITEM 2. PROPERTIES All of its headquarter offices are owned by the Partnership. The Partnership conducts its headquarters operations from St. Louis County, Missouri. The headquarters facilities are comprised of 17 separate buildings containing approximately 822,000 usable square feet. One additional building on the campus is leased. The Partnership acquired an existing 397,000 square foot building in St. Louis County in December, 1992, of which 170,000 square feet is occupied at December 31, 1993. This building was substantially renovated in 1993. The Partnership plans to use the unoccupied space for growth in future headquarters personnel which is planned to parallel the growth of the salesforce. The Partnership also maintains facilities in 2,655 branch locations which (as of December 31, 1993) are predominantly rented under cancellable leases. Further information concerning leased computer equipment, branch satellite equipment and other obligations of the Partnership is given in the Notes to the Consolidated Financial Statements appearing elsewhere herein. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS In recent years there has been an increasing incidence of litigation involving the securities industry. Such suits often seek to benefit large classes of industry customers; many name securities dealers as defendants along with exchanges in which they hold membership and seek large sums as damages under federal and state securities laws, anti- trust laws, and common law. There are various actions pending against the Partnership which have arisen in the normal course of business. In view of the number and diversity of claims against the Partnership, the number of jurisdictions in which litigation is pending and the inherent difficulty of predicting the outcome of litigation and other claims, the Partnership cannot definitely state what the eventual outcome of these pending claims will be. However, in the opinion of management, after consultation with legal counsel, the impact of this litigation will not have a material adverse affect on the Partnership's financial position or results of operations. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS There is no market for the Limited or Subordinated Limited Partnership interests and their assignment is prohibited. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA The following information sets forth, for the past five years, selected financial data. (All amounts in thousands, except per unit information.) Summary Income Statement Data: 1993 1992 1991 1990 1989 Revenues $631,452 $549,612 $411,588 $316,503 $280,429 Net income 66,211 62,282 40,875 22,553 15,703 Net income per weighted average $1,000 equivalent limited partnership unit outstanding $194.62 $238.41 $185.92 $130.52 $82.50 Weighted average $1,000 equivalent limited partnership units outstanding 50,381 41,160 42,616 25,874 27,274 Net income per weighted average $1,000 equivalent subordinated limited partnership unit outstanding $350.32 $418.21 $322.38 $212.86 $154.82 Weighted average $1,000 equivalent subordinated limited partnership units outstanding 16,936 12,941 10,624 10,190 9,779 Summary Balance Sheet Data: 1993 1992 1991 1990 1989 Total assets $800,478 $653,253 $513,730 $422,257 $387,618 ======= ======= ======= ======= ======= Long-term debt $ 33,317 $ 23,847 $ 24,769 $ 19,977 $ 20,075 Other liabilities, exclusive of subordinated liabilities 514,386 414,110 326,229 250,772 234,732 Subordinated liabilities 73,000 78,000 48,000 50,400 52,800 Total partnership capital 179,775 137,296 114,732 101,108 80,011 ________ ________ ________ ________ ________ Total liabilities and partnership capital $800,478 $653,253 $513,730 $422,257 $387,618 ======== ======== ======== ======== ======== ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table summarizes the changes in major categories of revenues and expenses for the last two years (Dollar amounts in thousands.) 1993 vs. 1992 1992 vs. 1991 Increase - (Decrease) Amount % Amount % Revenues Commissions $ 124,510 41 $ 104,176 52% Principal transactions (38,895) (30) 26,940 26 Investment banking (15,634) (26) (6,741) (10) Interest and dividends 7,564 25 4,987 20 Other 4,295 19 8,662 60 _________ ___ _________ ___ 81,840 15 138,024 34 _________ ___ _________ ___ Expenses Employee and partner compensation and benefits 53,859 16 88,142 37 Occupancy and equipment 10,069 20 3,867 8 Communications and data processing 4,898 17 3,556 14 Interest 3,632 23 2,155 16 Payroll and other taxes 1,767 11 3,192 24 Floor brokerage and clearance fees 781 15 691 15 Other operating expenses 2,905 7 15,014 53 ________ ___ ________ ___ 77,911 16 116,617 31 ________ ___ ________ ___ Net income $ 3,929 6% $ 21,407 52% ======== === ======== === RESULTS OF OPERATIONS (1993 VERSUS 1992) Revenues increased 15% ($82 million) over 1992 to $631 million. Expenses increased by 16% ($78 million) resulting in net income of $66 million, an increase of 6% ($4 million) over 1992. These results were significantly influenced by the Partnership's activities in connection with the expansion of its salesforce. The number of investment representatives increased 24% in 1993 to 2,745. By comparison, 1992's growth in investment representatives was 22%. The vast majority of these new investment representatives are beginners in the industry who generally achieve profitability after about 30 months. In the interim, the Partnership incurs significant training, salary and support costs. The net impact of these direct expenses amounted to nearly $21 million during 1993 ($14 million in 1992). Additionally, the Partnership made significant increases in home office overhead to support the increased salesforce. Commission revenues increased $125 million fueled by a $85 million (45%) increase in mutual fund commissions and service fees. Listed and over-the-counter agency commissions increased $18 million or 24% over 1992. Insurance commissions increased 51%, with variable annuity commissions increasing $20.6 million and fixed annuities decreasing by $5 million. The increasing level of securities prices along with lower interest rates turned individual investors to equity markets and equity based investments in search of more attractive returns. The continued strength of the securities markets led to solid increases in commission generated from the sales of securities products. Principal transaction revenues decreased 30% ($39 million). Collateralized mortgage obligations (CMOs) revenues decreased $11.3 million, government and municipal bond revenues decreased by $9.7 million and $3.7 million, respectively. Prior to 1993, municipal bond syndicate revenues were included in principal transaction revenues. In 1993, these revenues, totalling $10.3 million, were included in investment banking revenues. The majority of the principal transaction revenue decreases largely resulted from historically low interest rates and the resulting popularity of equity based investments. Investment banking revenues declined $15.6 million resulting from decreases in certificate of deposit revenues ($8 million), CMO revenues ($11 million), and equity and debt originations. Interest and dividend revenues increased 25% or $7.6 million. Customers' margin loan balances increased 36% in 1993 ($120 million) ending the year at $451 million. The increase in customers' loan balances was attributable to higher securities prices, continuation of marketing efforts targeting individuals to view their securities as access to a personal line of credit and lower interest rates. The increase in loan balances more than offset the decline in short term interest rates during the year resulting in increased interest earnings. Other revenues increased $4 million (19%) over 1992. Revenues from non-bank custodian IRA accounts resulted in an increase of $1 million in 1993. Overall expenses increased 16% ($78 million). The Partnership's compensation structure for its investment representatives is designed to expand or contract substantially as a result of changes in revenues, net income and profit margins. Similarly, non-sales personnel compensation from bonuses and profit sharing contributions expands and contracts in relation to net income. The Partnership's non-compensation related expenses are less responsive to changes in revenues and net income. Rather, these expenses are influenced by the number of salespeople, growth of the salesforce, the number of customer accounts and, to a lesser extent, the volume of transactions. As a result of its expense structure, the Partnership's compensation expense increase of 16% matched the overall increase in expenses of 16%. The Partnership's expenses other than compensation increased 15%. The increase in other expenses resulted from several items. Increased expense levels related to supporting a larger number of investment representatives and branch offices were primarily responsible for the increase in operating expenses. RESULTS OF OPERATIONS (1992 VERSUS 1991) Revenues increased 34% ($138 million) over 1991 to $550 million. Expenses increased by 31% ($117 million) resulting in net income of $62 million, an increase of 52% ($21 million) over 1991. The number of investment representatives increased 22% in 1992 to 2,216. By comparison, 1991's growth in investment representatives was 9%. The increased size of the salesforce and higher securities prices along with a very steeply sloped yield curve were significant factors contributing to 1992's financial results. Commission revenues increased $104 million fueled by a $77 million (70%) increase in mutual fund commissions and service fees. Listed and over-the-counter agency commissions increased $19 million or 36% over 1991. Insurance commissions increased 22%, with variable annuity commissions increasing $10 million and fixed annuities decreasing by $4 million. The increasing level of securities prices along with lower interest rates turned individual investors to equity markets and equity based investments in search of more attractive returns. Principal transaction revenues increased 26% ($27 million) with taxable and tax free fixed income securities increasing $21 million. At the same time, O-T-C principal stock sales increased by $3 million. Individual investors were attracted to longer term fixed income products to increase or maintain their returns compared to other shorter term alternatives. Additionally, tax free bonds experienced relatively high yields during the year when compared to treasury securities with similar maturities. The increase in O-T-C stock sales resulted from higher equity prices and investors directing their investment dollars into smaller capitalization companies. The returns experienced during the year from investing in smaller capitalization companies was higher than the investment returns of larger exchange listed securities. Investment banking revenues declined $6.7 million from substantial decreases in certificate of deposit revenues ($6 million) and CMOs revenues ($4 million). These decreases were partially offset by equity originations and syndicate equity participation increases of $3 million. Initial public offerings continued to be popular during the year along with investor interest in utility unit investment trust underwritings. The decrease in investment banking CMO revenues was partially offset by increased sales of CMOs on a principal basis. Interest and dividend revenues increased 20% or $5 million. Customers' margin loan balances increased 66% in 1992 ($132 million) ending the year at $331 million. The increase in customers' loan balances was attributable to higher securities prices, continuation of marketing efforts targeting individuals to view their securities as access to a personal line of credit and lower interest rates. The increase in loan balances more than offsets the decline in short term interest rates during the year resulting in increased interest earnings. Other revenues increased $9 million (60%) over 1991. During the last quarter of 1991, the Partnership qualified as a non-bank custodian for its IRA accounts resulting in an increase of $2.3 million in 1992 from IRA service fee revenues. Revenues for fees and services received from the Edward D. Jones & Co. Daily Passport Cash Trust money market account and a related tax free money market account offered through Edward D. Jones & Co. increased $1.4 million over 1991. Overall expenses increased 31% ($117 million). The Partnership's compensation structure for its investment representatives is designed to expand or contract substantially as a result of changes in revenues, net income and profit margins. Similarly, non-sales personnel compensation from bonuses and profit sharing contributions expands and contracts in relation to net income. The Partnership's non-compensation related expenses tend to be less responsive to changes in revenues and net income. Rather, these expenses tend to be more influenced by the number of salespeople, growth of the salesforce, the number of customer accounts and, to a lesser extent, the volume of transactions. As a result of its expense structure, the Partnership's compensation expense increase of 37% exceeded the overall increase in expenses of 31%. The Partnership's expenses other than compensation increased 22%. Other operating expenses increased 53% or $15 million over 1991. The increase in other operating expenses resulted from several items. Increased expense levels related to supporting a larger number of investment representatives and branch offices were primarily responsible for the increase in operating expenses. THE EFFECTS OF INFLATION The Partnership's net assets are primarily monetary, consisting of cash, securities inventories and receivables less liabilities. Monetary net assets are primarily liquid in nature and would not be significantly affected by inflation. Inflation and future expectations of inflation influence securities prices, as well as activity levels in the securities markets. As a result, profitability and capital may be impacted by inflation and inflationary expectations. Additionally, inflation's impact on the Partnership's operating expenses may affect profitability to the extent that additional costs are not recoverable through increased prices of services offered by the Partnership. LIQUIDITY AND CAPITAL ADEQUACY The Partnership's equity capital at December 31, 1993, was $179.8 million compared to $137.3 million at December 31, 1992. Overall, equity capital increased 31%, primarily due to the retention of earnings and issuance of partnership interests. The Partnership issued additional limited partnership interests in August 1993 of $24.8 million and additional subordinated limited partnership interest of $4.4 million in January 1993. At December 31, 1993, the Partnership had a $28.8 million balance of cash and cash equivalents. Lines of credit are in place at nine banks aggregating $445 million ($420 million of which are through uncommitted lines of credit), of which $310 million was available at December 31, 1993. The Partnership believes that the liquidity provided by existing cash balances and borrowing arrangements will be sufficient to meet the Partnership capital and liquidity requirements. As a result of its activities as a broker/dealer, EDJ, the Partnership's principal subsidiary, is subject to the Net Capital provisions of Rule 15c3-1 of the Securities Exchange Act of 1934 and the capital rules of the New York Stock Exchange. Under the alternative method permitted by the rules, EDJ must maintain minimum Net Capital, as defined, equal to the greater of $150,000 or 2% of aggregate debit items arising from customer transactions. The Net Capital rule also provides the partnership capital may not be withdrawn if resulting Net Capital would be less than 5% of aggregate debit items. Additionally, certain withdrawals require the consent of the SEC to the extent they exceed defined levels even though such withdrawals would not cause Net Capital to be less than 5% of aggregate debit items. At December 31, 1993, EDJ's Net Capital of $89,790,000 was 20% of aggregate debit items and its net capital in excess of the minimum required was $80,681,000. Net Capital and the related capital percentage may fluctuate on a daily basis. CASH FLOWS Cash and cash equivalents decreased $8,932,000 from December 31, 1992, to December 31, 1993. Cash flows were primarily provided from net income, decreases in securities owned, short and long term bank loans and the issuance of partnership interests. Cash flows were primarily used to increase net receivables from customers and brokers, purchase equipment, property and improvements, and fund withdrawals and distributions. Cash and cash equivalents increased $5,308,000 from December 31, 1991, to December 31, 1992. Cash flows were primarily provided from net income, short term bank loans and the issuance of subordinated debt. Cash flows were primarily used to increase net receivables from customers, increase securities owned, purchase equipment, property and improvements, and fund withdrawals and distributions. Cash and cash equivalents increased $5,078,000 from December 31, 1990, to December 31, 1991. Cash flows were primarily provided from net income, an increase in accounts payable and accrued expenses, short term bank loans and the issuance of long term debt. Cash flows were primarily used to increase net receivables from customers, increase securities owned, purchase equipment, property and improvements, and fund withdrawals and distributions. There were no material changes in the Partnership's overall financial condition during the year ended December 31, 1993, compared with the year ended December 31, 1992. The Partnership's consolidated statement of financial condition is comprised primarily of cash and assets readily convertible into cash. Securities inventories are carried at market value and are readily marketable. The firm carried lower trading inventory levels in 1993 as compared to 1992. Customer margin accounts are collateralized by marketable securities. Other customer receivables and receivables and payables with other broker/dealers normally settle on a current basis. Liabilities, including amounts payable to customers, checks and accounts payable and accrued expenses are non-interest bearing sources of funds to the Partnership. These liabilities, to the extent not utilized to finance assets, are available to meet liquidity needs and provide funds for short term investments, which favorably impacts profitability. The Partnership's growth in recent years has been financed through sales of limited partnership interest to its employees, retention of earnings and private placements of long-term and subordinated debt. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Financial Statements Included in this Item Page No. Report of Independent Public Accountants Consolidated Statements of Financial Condition as of December 31, 1993 and 1992 Consolidated Statements of Income for the years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Changes in Partnership Capital for the years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To The Jones Financial Companies, a Limited Partnership: We have audited the accompanying consolidated statements of financial condition of The Jones Financial Companies, a Limited Partnership (a Missouri limited partnership) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, cash flows and changes in partnership capital for each of the three years in the period ended December 31, 1993. These financial statements are the responsibility of the Partnership's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of The Jones Financial Companies, a Limited Partnership and subsidiaries as of December 31, 1993 and 1992, and the results of their operations, their cash flows and the changes in their partnership capital for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. ARTHUR ANDERSEN & CO. St. Louis, Missouri, February 22, 1994 THE JONES FINANCIAL COMPANIES, A LIMITED PARTNERSHIP CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION ASSETS December 31, December 31, (Amounts in thousands) 1993 1992 Cash and cash equivalents $ 28,798 $ 37,730 Receivable from: Customers (Note 2) 464,760 352,686 Brokers or dealers and clearing organizations (Note 3) 32,550 13,880 Securities owned, at market value (Note 4): Inventory securities 60,371 67,873 Investment securities 73,575 78,797 Office equipment, property and improvements, at cost, net of accumulated depreciation and amortization of $79,903 and $69,989, respectively 102,434 72,125 Other assets 37,990 30,162 __________ __________ $ 800,478 $ 653,253 ========== ========== The accompanying notes are an integral part of these statements. THE JONES FINANCIAL COMPANIES, A LIMITED PARTNERSHIP CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION LIABILITIES AND PARTNERSHIP CAPITAL December 31, December 31, (Amounts in thousands) 1993 1992 Bank loans (Note 5) $ 139,261 $ 123,000 Payable to: Customers (Note 2) 242,584 167,884 Brokers or dealers and clearing organizations (Note 3) 8,092 13,915 Securities sold but not yet purchased, at market value (Note 4) 17,766 9,588 Accounts payable and accrued expenses 37,419 37,600 Accrued compensation and employee benefits 69,264 62,123 Long-term debt (Note 6) 33,317 23,847 ____________ __________ 547,703 437,957 Liabilities subordinated to claims of general creditors (Note 7) 73,000 78,000 Partnership capital (Notes 8 and 9): Limited partners 71,222 47,328 Subordinated limited partners 19,163 14,716 General partners 89,390 75,252 ____________ __________ 179,775 137,296 ____________ __________ $ 800,478 $ 653,253 ========== ========== The accompanying notes are an integral part of these statements. THE JONES FINANCIAL COMPANIES, A LIMITED PARTNERSHIP CONSOLIDATED STATEMENTS OF INCOME Years Ended (Amounts in thousands, Dec. 31, Dec. 31, Dec. 31, except per unit information) 1993 1992 1991 Revenues: Commissions $ 428,460 $ 303,950 $199,774 Principal transactions 92,471 131,366 104,426 Investment banking 45,001 60,635 67,376 Interest and dividends 38,084 30,520 25,533 Other 27,436 23,141 14,479 _________ _________ _________ 631,452 549,612 411,588 _________ _________ _________ Expenses: Employee and partner compensation and benefits (Note 10) 381,805 327,946 239,804 Occupancy and equipment (Note 11) 59,549 49,480 45,613 Communications and data processing 34,167 29,269 25,713 Interest (Notes 5, 6 and 7) 19,128 15,496 13,341 Payroll and other taxes 18,180 16,413 13,221 Floor brokerage and clearance fees 6,141 5,360 4,669 Other operating expenses 46,271 43,366 28,352 _________ _________ _________ 565,241 487,330 370,713 _________ _________ _________ Net income $ 66,211 $ 62,282 $ 40,875 ======== ======== ======== Net income allocated to: Limited partners $ 9,805 $ 9,813 $ 7,923 Subordinated limited partners 5,933 5,412 3,425 General partners 50,473 47,057 29,527 _________ _________ _________ 66,211 $ 62,282 $ 40,875 ======== ======== ======== Net income per weighted average $1,000 equivalent partnership units outstanding: Limited partners $ 194.62 $ 238.41 $ 185.92 ======== ======== ======== Subordinated limited partners $ 350.32 $ 418.21 $ 322.38 ======== ======== ======== Weighted average $1,000 equivalent partnership units outstanding: Limited partners 50,381 41,160 42,616 ======== ======== ======== Subordinated limited partners 16,936 12,941 10,624 ======== ======== ======== The accompanying notes are an integral part of these statements. THE JONES FINANCIAL COMPANIES, A LIMITED PARTNERSHIP CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended Dec. 31, Dec. 31, Dec. 31, (Amounts in thousands) 1993 1992 1991 CASH FLOWS PROVIDED (USED) BY OPERATING ACTIVITIES: Net income $ 66,211 $ 62,282 $ 40,875 Adjustments to reconcile net income to net cash provided (used) by operating activities: Depreciation and amortization 16,800 14,728 11,203 Increase in net receivable from/payable to customers (37,374) (90,526) (82,200) (Increase) decrease in net receivable from/payable to brokers or dealers and clearing organizations (24,493) 13,401 9,939 Decrease (increase) in securities owned, net 20,902 2,573 (27,365) Increase in accounts payable and other accrued expenses 6,960 106 37,069 Increase in other assets (7,828) (7,744) (2,700) _________ _________ _________ Net cash provided (used) by operating activities 41,178 (5,180) (13,179) _________ _________ _________ CASH FLOWS USED BY INVESTING ACTIVITIES: Purchase of office equipment, property and improvements (47,109) (28,872) (20,284) _________ _________ _________ CASH FLOWS (USED) PROVIDED BY FINANCING ACTIVITIES: Increase in bank loans, net 16,261 50,000 63,400 Issuance of long-term debt 11,700 - 13,300 Repayment of long-term debt (2,230) (922) (8,508) (Repayment) issuance of subordinated liabilities (5,000) 30,000 (2,400) Issuance of partnership interests 29,195 2,396 802 Redemption of partnership interests (1,193) (1,326) (2,176) Withdrawals and distributions from partnership capital (51,734) (40,788) (25,877) _________ _________ _________ Net cash (used) provided by financing activities (3,001) 39,360 38,541 Net (decrease) increase in cash _________ _________ _________ and cash equivalents (8,932) 5,308 5,078 CASH AND CASH EQUIVALENTS, beginning of year 37,730 32,422 27,344 _________ _________ _________ end of year $ 28,798 $ 37,730 $ 32,422 ======== ======== ======== The accompanying notes are an integral part of these statements. THE JONES FINANCIAL COMPANIES, A LIMITED PARTNERSHIP CONSOLIDATED STATEMENTS OF CHANGES IN PARTNERSHIP CAPITAL YEARS ENDED DECEMBER 31, 1993, 1992 and 1991 Subordinated Limited Limited General Partnership Partnership Partnership (Amounts in thousands) Capital Capital Capital Total Balance, December 31, 1990 $ 46,173 $ 10,635 $ 44,300 $101,108 Issuance of partnership interests - 802 - 802 Redemption of partnership interests (2,044) (132) - (2,176) Net income 7,923 3,425 29,527 40,875 Withdrawals and distributions (5,365) (2,942) (17,570) (25,877) _________ _________ _________ _________ Balance, December 31, 1991 $ 46,687 $ 11,788 $ 56,257 $114,732 Issuance of partnership interests - 2,396 - 2,396 Redemption of partnership interests (1,175) (151) - (1,326) Net income 9,813 5,412 47,057 62,282 Withdrawals and distributions (7,997) (4,729) (28,062) (40,788) _________ _________ _________ _________ Balance, December 31, 1992 $ 47,328 $ 14,716 $ 75,252 $137,296 Issuance of partnership interests 24,763 4,432 - 29,195 Redemption of partnership interests (1,193) - - (1,193) Net income 9,805 5,933 50,473 66,211 Withdrawals and distributions (9,481) (5,918) (36,335) (51,734) _________ _________ _________ _________ Balance, December 31, 1993 $ 71,222 $ 19,163 $ 89,390 $179,775 ======== ======== ======== ======== The accompanying notes are an integral part of these statements. THE JONES FINANCIAL COMPANIES, A LIMITED PARTNERSHIP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1993, 1992 AND 1991 NOTE 1 - SUMMARY OF ACCOUNTING POLICIES The Partnership's Business and Basis of Accounting. The accompanying consolidated financial statements include the accounts of The Jones Financial Companies, a Limited Partnership, and all wholly owned subsidiaries (the "Partnership"). All material intercompany balances and transactions have been eliminated. The Partnership conducts business throughout the United States with its customers, various brokers and dealers, clearing organizations, depositories and banks. The Partnership's principal operating subsidiary is Edward D. Jones & Co., L.P. (EDJ), a registered broker/dealer. Cash and Cash Equivalents. The Partnership considers all short-term investments with original maturities of three months or less, which are not held for sale to customers, to be cash equivalents. Securities Transactions. The Partnership's securities activities involve execution, settlement and financing of various securities transactions for customers. These transactions (and related revenue and expense) are recorded on a settlement date basis, generally representing the fifth business day following the transaction date, which is not materially different than a trade date basis. They may expose the Partnership to risk in the event customers, other brokers and dealers, banks, depositories or clearing organizations are unable to fulfill contractual obligations. For transactions in which it extends credit to customers, the Partnership seeks to control the risks associated with these activities by requiring customers to maintain margin collateral in compliance with various regulatory and internal guidelines. Securities Owned. Securities owned are valued at current market prices. Unrealized gains or losses are reflected in revenues as "principal transactions." Office Equipment, Property and Improvements. Office equipment is depreciated using straight-line and accelerated methods over estimated useful lives of five to eight years. Buildings are depreciated using the straight-line method over estimated useful lives approximating thirty to forty years. Amortization of property improvements is computed based on the remaining life of the property or economic useful life of the improvement, whichever is less. When assets are retired or otherwise disposed of, the cost and related accumulated depreciation or amortization are removed from the accounts, and any resulting gain or loss is reflected in income for the period. The cost of maintenance and repairs is charged to income as incurred, whereas significant renewals and betterments are capitalized. Segregated Cash Equivalents and Securities Owned. Rule 15c3-3 of the Securities and Exchange Commission requires deposits of cash or securities to a special reserve bank account for the benefit of customers if total customer related credits exceed total customer related debits, as defined. No deposits of cash or securities were required as of December 31, 1993 or 1992. Income Taxes. Income taxes have not been provided for in the consolidated financial statements since the Partnership is organized as a partnership, and each partner is liable for its own tax payments. Reclassifications. Certain 1992 and 1991 amounts have been reclassified to conform to the 1993 financial statement presentation. Fiscal Year End Change. The Partnership changed its year end from the last Friday in September to December 31, effective December 31, 1992, for various reporting purposes. The 1991 amounts have been restated on a calendar year basis. NOTE 2 - RECEIVABLE FROM AND PAYABLE TO CUSTOMERS Accounts receivable from and payable to customers include margin balances and amounts due on uncompleted transactions. Values of securities owned by customers and held as collateral for these receivables are not reflected in the financial statements. Substantially all amounts payable to customers are subject to withdrawal upon customer request. NOTE 3 - RECEIVABLE FROM AND PAYABLE TO BROKERS OR DEALERS AND CLEARING ORGANIZATIONS The components of receivable from and payable to brokers or dealers and clearing organizations are as follows: (Amounts in thousands) 1993 1992 Securities failed to deliver $ 7,030 $ 2,485 Deposits paid for securities borrowed 22,048 9,255 Deposits with clearing organizations 2,446 1,971 Other 1,026 169 __________ __________ Total receivable from brokers or dealers and clearing organizations $ 32,550 $ 13,880 ========== ========== Securities failed to receive $ 6,580 $ 10,434 Deposits received for securities loaned 1,239 3,481 Other 273 - __________ __________ Total payable to brokers or dealers and clearing organizations $ 8,092 $ 13,915 ========== ========== "Fails" represent the contract value of securities which have not been received or delivered by settlement date. NOTE 4 - SECURITIES OWNED Security positions are summarized as follows (at market value): 1993 1992 ____________________ ___________________ Securities Securities Sold but Sold but Securities not yet Securities not yet Owned Purchased Owned Purchased Inventory Securities: Certificates of deposit $ 3,691 $ 49 $ 2,498 $ 86 U.S. government and agency obligations 4,123 15,070 5,702 7,299 State and municipal obligations 34,306 839 45,708 284 Corporate bonds and notes 10,045 818 11,108 566 Corporate stocks 8,206 990 2,857 1,353 _________ _________ _________ _________ $ 60,371 $ 17,766 $ 67,873 $ 9,588 ======== ======== ======== ======== Investment Securities: U.S. government and agency obligations $ 73,575 $ 78,797 ======== ======== NOTE 5 - BANK LOANS The Partnership borrows from banks primarily to finance customer margin balances and firm trading securities. Interest is at a fluctuating rate (weighted average rate of 4.17%, 4.35% and 4.97%at December 31, 1993, 1992 and 1991, respectively) based on short-term lending rates. The average of the aggregate short-term bank loans outstanding was $99,100,000, $57,794,000, and $23,257,000 and the average interest rate (computed on the basis of the average aggregate loans outstanding) was 4.04%, 4.40%, and 6.35% for the years ended December 31, 1993, 1992 and 1991, respectively. The highest month-end borrowing was $154,500,000, $142,000,000 and $96,200,000 during the years ended December 31, 1993, 1992 and 1991, respectively. Short-term bank loans outstanding at December 31, 1993, 1992 and 1991, consist of $139,261,000, $109,000,000 and $73,000,000 of loans collateralized by securities owned by the Partnership and customers' margin securities with a market value of $363,740,000, $197,514,000 and $140,000,000, respectively. At December 31, 1992, the Partnership had a $14,000,000 short term loan secured by property with a carrying value of $16,198,000. Cash paid during the year for interest on bank loans, capital notes and other liabilities was $14,059,000, $10,956,000, and $8,956,000 for the years ended December 31, 1993, 1992 and 1991, respectively. NOTE 6 - LONG-TERM DEBT Long-term debt is comprised of the following: (Amounts in thousands) 1993 1992 Note payable, secured by property, interest at 9.0% per annum, interest due in monthly installments, principal due on June 1, 1994. $ 9,600 $ 9,600 Note payable, secured by property, interest at 9.875% per annum, principal and interest due in monthly installments of $141,907 with a final installment of $6,840,192 due on August 5, 2001. 12,282 12,747 Note payable, secured by property, interest at 8.5% per annum, principal and interest due in monthly installments of $115,215 through April 5, 2008. 11,435 - Note payable, secured by property, interest at prime rate per annum, interest due in monthly installments. - 1,500 __________ __________ $ 33,317 $ 23,847 ========== ========== Required annual principal payments, as of December 31, 1993, are as follows: Principal Payment Year (Amounts in thousands) _____ ___________________ 1994 $ 10,540 1995 1,031 1996 1,130 1997 1,239 1998 1,359 Thereafter 18,018 __________ $ 33,317 ========== The Partnership has land and buildings with a carrying value of $45,971,000 at December 31, 1993, which are subject to security agreements that collateralize various real estate related notes payable. The Partnership has estimated the fair value of the long- term debt to be approximately $36,493,000 and $25,368,000 as of December 31, 1993 and 1992, respectively. Subsequent to December 31, 1993, the Partnership arranged to refinance its long-term debt. After the refinancing is complete, the Partnership will have a $21,759,000 8.72% note due in monthly installments of approximately $290,000 through May 5, 2003, and a $14,900,000 8.23% note due in monthly installments of $150,000 through April 5, 2008. These notes replace all long-term debt which existed as of December 31, 1993, and will have the same underlying collateral. NOTE 7 - LIABILITIES SUBORDINATED TO CLAIMS OF GENERAL CREDITORS Liabilities subordinated to the claims of general creditors consist of: (Amounts in thousands) 1993 1992 Capital notes, 10.6%, due in annual installments of $7,000,000 commencing on March 15, 1994, with a final installment on March 15, 1997 $ 28,000 $ 28,000 Capital notes, 9.375%, due in annual installments of $5,000,000 commencing on July 1, 1993, with a final installment on April 1, 1996 15,000 20,000 Capital notes, 8.96%, due in annual installments of $6,000,000 commencing on May 1, 1998, with a final installment on May 1, 2002 30,000 30,000 __________ __________ $ 73,000 $ 78,000 ========== ========== The capital note agreements contain restrictions which, among other things, require maintenance of certain financial ratios, restrict encumbrance of assets and creation of indebtedness and limit the withdrawal of partnership capital. As of December 31, 1993, the Partnership was required, under the note agreements, to maintain minimum partnership capital of $65,000,000 and Net Capital as computed in accordance with the uniform Net Capital rule of 7.5% of aggregate debit items (See Note 9). The subordinated liabilities are subject to cash subordination agreements approved by the New York Stock Exchange and, therefore, are included in the Partnership's computation of Net Capital under the Securities and Exchange Commission's uniform Net Capital rule. The Partnership has estimated the fair value of the subordinated capital notes to be approximately $76,726,000 and $81,300,000 as of December 31, 1993 and 1992, respectively. Subsequent to year end the Partnership intends to exercise its right to repay $17,000,000 of the capital notes prior to maturity. NOTE 8 - PARTNERSHIP CAPITAL The limited partnership capital, consisting of 64,280 and 40,710 $1,000 units at December 31, 1993 and 1992, respectively, is held by current and former employees and general partners. Each limited partner receives interest at seven and one-half percent on the principal amount of capital contributed and a varying percentage of the net income of the Partnership. Interest expense includes $ 3,781,000, $3,090,000, and $3,198,000 for the years ended December 31, 1993, 1992 and 1991, respectively, paid to limited partners on capital contributed. The subordinated limited partnership capital, consisting of 17,290 and 12,858 $1,000 units at December 31, 1993 and 1992, respectively, is held by current and former general partners. Each subordinated limited partner receives a varying percentage of the net income of the Partnership. The subordinated limited partner capital is subordinated to the limited partnership capital. Included in partnership capital at December 31, 1993 and 1992, are undistributed profits of $17,964,000 and $18,438,000, respectively, that will be withdrawn by the partners. NOTE 9 - NET CAPITAL REQUIREMENTS As a result of its activities as a broker/dealer, EDJ, is subject to the Net Capital provisions of Rule 15c3-1 of the Securities Exchange Act of 1934 and the capital rules of the New York Stock Exchange. Under the alternative method permitted by the rules, EDJ must maintain minimum Net Capital, as defined, equal to the greater of $150,000 or 2% of aggregate debit items arising from customer transactions. The Net Capital rule also provides that partnership capital may not be withdrawn if resulting Net Capital would be less than 5% of aggregate debit items. Additionally, certain withdrawals require the consent of the SEC to the extent they exceed defined levels even though such withdrawals would not cause Net Capital to be less than 5% of aggregate debit items. At December 31, 1993, EDJ's Net Capital of $89,790,000 was 20% of aggregate debit items and its Net Capital in excess of the minimum required was $80,681,000. Net Capital as a percentage of aggregate debits after anticipated capital withdrawals was 17%. Net Capital and the related capital percentage may fluctuate on a daily basis. EDJ's Net Capital excludes $19,782,000 of undistributed profits which will be withdrawn by the partners and $27,254,000 of cash capital contributions that were pending New York Stock Exchange approval. Subsequent to December 31, 1993, EDJ received approval from the New York Stock Exchange to add $27,254,000 of cash capital contributions that were made during 1993 as allowable Net Capital. EDJ also received permission to prepay in advance of its scheduled maturity $17,000,000 of subordinated debt. The effect of these approvals would have been to increase Net Capital to $117,044,000 and excess Net Capital to $107,935,000 as of December 31, 1993. The percentage of Net Capital to aggregate debits and the percentage of Net Capital to aggregate debits after anticipated capital withdrawals, would have been 26% and 19%, respectively. Net Capital in excess of 5% of aggregate debit items would have been $94,272,000. NOTE 10 - EMPLOYEE BENEFIT PLAN The Partnership maintains a profit sharing plan covering all eligible employees. Contributions to the plan are at the discretion of the Partnership. However, participants may contribute on a voluntary basis. Approximately $16,716,000, $15,625,000, and $10,347,000 were provided by the Partnership for its contributions to the plan for the years ended December 31, 1993, 1992 and 1991, respectively. No post retirement benefits are provided. NOTE 11 - COMMITMENTS Branch office facilities, computer system equipment and branch satellite equipment are rented under various operating leases. Additionally, branch offices are leased on a three to five year basis, and are cancellable at the option of the Partnership. The Partnership's computer system equipment and branch satellite equipment lease commitments are $10,823,000 in 1994, $5,321,000 in 1995, $3,661,000 in 1996, and $2,770,000 in 1997 and $1,221,000 in 1998 and thereafter. Rent expense was $28,385,000, $24,837,000, and $24,703,000 for the years ended December 31, 1993, 1992 and 1991, respectively. NOTE 12 - CONTINGENCIES Various legal actions, primarily relating to the distribution of securities, are pending against the Partnership. Certain cases are class actions (or purported class actions) claiming substantial damages. These actions are in various stages and the results of such actions cannot be predicted with certainty. In the opinion of management, after consultation with legal counsel, the ultimate resolution of these actions will not have a material adverse impact on the Partnership's financial condition. ITEM 9.

ITEM 9. CHANGE IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The Jones Financial Companies, a Limited Partnership, being organized as a partnership, does not have individuals associated with it designated as officers or directors. Presently, the Partnership is comprised of 111 general partners, 2,000 limited partners and 54 subordinated limited partners. Under the terms of the Partnership Agreement, John W. Bachmann is designated Managing Partner and in said capacity has primary responsibility for administering its business, determining its policies, controlling the management and conduct of the Partnership's business and has the power to appoint and dismiss general partners of the Partnership and to fix the proportion of their respective interests in the Partnership. Subject to the foregoing, the Partnership is managed by its 111 general partners. The Executive Committee of the Partnership is comprised of John W. Bachmann, James W. Harrod, Douglas E. Hill, Charles R. Larimore, Richie L. Malone, Darryl L. Pope, Ray L. Robbins, Jr., Edward Soule and James D. Weddle. The purpose of the Executive Committee is to provide counsel and advice to the Managing Partner in discharging his functions. Furthermore, in the event the position of Managing Partner is vacant, the Executive Committee shall succeed to all of the powers and duties of the managing partner. None of the general partners are appointed for any specific term nor are there any special arrangements or understandings pursuant to their appointment other than as contained in the Partnership Agreement. No general partner is or has been individually, nor in association with any prior business, the subject of any action under any insolvency law or criminal proceeding or has ever been enjoined temporarily or permanently from engaging in any business or business practice. A listing of the names, ages, dates of becoming a general partner and area of responsibility for each general partner follows: BECAME NAME AGE G.P. AREA OF RESPONSIBILITY Warren K. Akerson 51 1974 Sales Allan J. Anderson 51 1992 Sales Management John W. Bachmann 55 1970 Managing Partner Thomas M. Bartow 44 1989 Sales Training James D. Bashor 39 1990 Regional Sales Leader Robert J. Beck 39 1983 Municipal Trading John D. Beuerlein 40 1979 Sales Management John S. Borota 53 1978 Sales Hiring William H. Broderick, III 41 1986 Syndicate Morton L. Brown 47 1978 Managed Investments Alan J. Bubalo 40 1984 Regional Sales Leader Spencer B. Burke 45 1987 Investment Banking Daniel A. Burkhardt 46 1979 Investment Banking Jack L. Cahill 44 1980 Sales Management Brett A. Campbell 35 1993 Marketing Donald H. Carter 50 1994 Regional Sales Leader John J. Caruso 47 1988 Data Processing Guy R. Cascella 36 1992 Regional Sales Leader Craig E. Christell 37 1994 Regional Sales Leader Richard A. Christensen, Jr.46 1978 Mutual Funds Processing Robert J. Ciapciak 38 1988 Market Research David W. Clapp 44 1978 Sales Management Stephen P. Clement 44 1990 Video Communications Loyola A. Cronin 36 1987 Branch Staff Training Harry J. Daily, Jr. 47 1985 Regional Sales Leader A. Randal Dickinson 42 1984 Regional Sales Leader Terry A. Doyle 44 1992 Regional Sales Leader William T. Dwyer, Jr. 38 1994 Regional Sales Leader Abe W. Dye 49 1984 Sales Management Allen R. Eaker 47 1989 Regional Sales Leader Norman L. Eaker 37 1984 Securities Processing Kevin Eberle 43 1993 Regional Sales Leader Michael J. Esser 45 1983 Advanced Sales Training Kevin N. Flatt 45 1989 Fixed Income/Equity Trading John A. Fowler 46 1979 Customer Tax Support Steve Fraser 38 1993 Securities Processing Chris A. Gilkison 40 1994 Branch Locations Barbara G. Gilman 55 1988 Trust Marketing Steven L. Goldberg 35 1987 Central Services James R. Gonso 38 1986 Regional Sales Leader Ronald Gorgen 44 1993 Field Services Robert L. Gregory 51 1974 Sales Hiring Patricia F. Hannum 33 1988 Financial Services Stephen P. Harrison 45 1990 Regional Sales Leader James W. Harrod 58 1974 Sales Training David L. Hayes 38 1994 Regional Sales Leader Randy K. Haynes 38 1994 Operations John M. Hess 46 1992 Regional Sales Leader Mary Beth Heying 36 1994 Communications Douglas E. Hill 49 1974 Product Management Stephen M. Hull 49 1994 Regional Sales Leader Earl H. Hull, Jr. 48 1990 Regional Sales Leader Glennon D. Hunn 51 1984 Data Processing Gary R. Hunziker 53 1994 Regional Sales Leader Paul C. Husted 40 1990 Regional Sales Leader Thomas G. Iorio 33 1994 Regional Sales Leader Mellany F. Isom 40 1984 Sales Hiring Myles P. Kelly 40 1989 Accounting Loren G. Kolpin 48 1985 Regional Sales Leader Charles R. Larimore 53 1981 Branch Administration Ronald E. Lemonds 57 1972 Equity Marketing Michele Liebman 37 1994 Data Processing Steven F. Litchfield 38 1983 Regional Sales Leader Richie L. Malone 45 1979 Data Processing Richard G. McCarty 54 1990 Regional Sales Leader James A. McKenzie 49 1977 Regional Sales Leader Thomas Migneron 33 1993 Internal Audit Richard G. Miller, Jr. 38 1991 Regional Sales Leader Thomas W. Miltenberger 46 1985 Mutual Funds Marketing Merry L. Mosbacher 35 1986 Investment Banking Joseph M. Mott, III 36 1989 Insurance/Annuities Marketing William D. Murphy 53 1980 Regional Sales Leader Matt B. Myre 37 1988 Regional Sales Leader Rodger W. Naugle 52 1992 Regional Sales Leader Steven Novik 44 1983 Accounting Cynthia Paquette 33 1993 Data Processing Robert K. Pearce 44 1989 Human Resources Darryl L. Pope 54 1971 Operations Gary D. Reamey 38 1984 Canada Division James L. Regnier 36 1994 Sales Training Ray L. Robbins, Jr. 49 1975 Research Stephen T. Roberts 41 1981 Compliance Wann V. Robinson 43 1992 Regional Sales Leader Douglas Rosen 33 1993 Regional Sales Leader Harry John Sauer, III 36 1988 Dividend Processing Philip R. Schwab 45 1978 Syndicate Darrell G. Seibel 59 1985 Regional Sales Leader Robert D. Seibel 59 1974 Regional Sales Leader Festus W. Shaughnessy, III 38 1988 Sales Training Connie M. Silverstein 38 1988 Sales Hiring Alan F. Skrainka 32 1989 Research John S. Sloop 45 1990 Sales Management Ronald H. Smith 54 1984 Regional Sales Leader Lawrence R. Sobol 43 1977 General Counsel Edward Soule 41 1986 Accounting Lawrence E. Thomas 38 1983 Government Bond Trading Terry R. Tucker 39 1988 Data Processing Richard G. Unnerstall 38 1989 Data Processing Robert Virgil, Jr. 59 1994 Headquarters Administration JoAnn Von Bergen 44 1986 Cash Processing John R. Wagner 46 1987 Regional Sales Leader Donald E. Walter 48 1983 Compliance Director Bradley T. Wastler 41 1989 Sales Management James D. Weddle 40 1984 Sales Management Vicki Westall 34 1993 Product Review Thomas J. Westphal 35 1989 Customer Statements Heidi Whitfield 33 1993 Product Review Robert D. Williams 32 1994 Regional Sales Leader A. Thomas Woodward 47 1985 Sales Management Price P. Woodward 31 1993 Regional Sales Leader Alan T. Wright 47 1994 Investment Banking Except as indicated below, each of the General Partners has been a general partner of the Partnership for more than the preceding five years. Allan J. Anderson, joined the Partnership in 1984 as a registered representative and became a general partner in 1992. James D. Bashor, joined the Partnership in 1983 as a registered representative and became a general partner in 1990. Brett A. Campbell, joined the Partnership in 1984 as a registered representative and became a general partner in January 1993. Donald H. Carter, joined the Partnership in 1982 as a registered representative and became a general partner in January 1994. Guy Cascella, joined the Partnership in 1983 as a registered representative and became a general partner in 1992. Stephen P. Clement, joined the Partnership in 1987 as Video manager and became a general partner in 1990. Prior to this, he was a news director for an ABC affiliate television station. Craig E. Christell, joined the Partnership in 1982 as a registered representative and became a general partner in January 1994. Terry Doyle, joined the Partnership in 1981 as a registered representative and became a general partner in 1992. William T. Dwyer, joined the Partnership in 1982 as a registered representative and became a general partner in January 1994. Kevin Eberle, joined the Partnership in 1985 as a registered representative and became a general partner in 1993. Steve Fraser, joined the Partnership in 1985 in the Operations Department and became a general partner in January, 1993. Prior to this, he was employed by Automated Data Processing Inc. Chris A. Gilkison, joined the Partnership in 1987 as a registered representative and became a general partner in January 1994. Ron Gorgen, joined the Partnership in 1980 as a registered representative and became a general partner in January 1993. David L. Hayes, joined the Partnership in 1977 active in hiring and training and became a general partner in January 1994. Stephen P. Harrison, joined the Partnership in 1978 as a registered representative and became a general partner in 1990. Randy K. Haynes, joined the Partnership in 1984 as a registered representative and became a general partner in January 1994. John Hess, joined the Partnership in 1982 as a registered representative and became a general partner in 1992. Mary Beth Heying, joined the Partnership in 1984 in the Communications Department and became a general partner in January 1994. Earl H. Hull, Jr., joined the Partnership in 1975 as a registered representative and became a general partner in 1990. Steven M. Hull, joined the Partnership in 1973 as a registered representative and became a general partner in 1994. Gary R. Hunziker, joined the Partnership in 1986 as a registered representative and became a general partner in January 1994. Paul C. Husted, joined the Partnership in 1982 as a registered representative and became a general partner in 1990. Thomas G. Iorio, joined the Partnership in 1982 as a registered representative and became a general partner in January 1994. Michele M. Liebman, joined the Partnership in 1985 in the Data Processing Department and became a general partner in January 1994. Richard G. McCarty, joined the Partnership in 1980 as a registered representative and became a general partner in 1990. Thomas Migneron, joined the Partnership in 1985 as an internal auditor and became a general partner in January, 1993. Richard G. Miller, Jr., joined the Partnership in 1981 as a registered representative and became a general partner in 1991. Rodger Naugle, joined the Partnership in 1981 as a registered representative and became a general partner in 1992. Cynthia Paquette, joined the Partnership in 1985 in the Data Processing Department and became a general partner in January 1993. James L. Regnier, joined the Partnership in 1983 as a registered representative and became a general partner in January 1994. Wann V. Robinson, joined the Partnership in 1985 as a registered representative and became a general partner in 1992. Douglas Rosen, joined the Partnership in 1982 as a registered representative and became a general partner in January 1993. John S. Sloop, joined the Partnership in 1983 as a registered representative and became a general partner in 1990. Robert Virgil, Jr., joined the Partnership in 1993 as a general partner. Prior to this, he served as dean of the John M. Olin School of Business at Washington University. Vicki Westall, joined the Partnership in 1984 in the Product Review Department and became a general partner in January, 1993. Prior to this, she was an accountant with Peat, Marwick, Mitchell & Co. Heidi Whitfield, joined the Partnership in 1982 as an equity analyst and became a general partner in January 1993. Robert D. Williams, joined the Partnership in 1986 as a registered representative and became a general partner in 1994. Price P. Woodward, joined the Partnership in 1984 as a registered representative and became a general partner in January 1993. Alan T. Wright, joined the Partnership in 1985 in Investment Banking Department and became a general partner in January 1994. Daniel A. Burkhardt is a director of Essex County Gas Company, Amsebury, Massachusetts; Galaxy Cablevision Management, Inc., Sikeston, Missouri; Dial Reit, Omaha, Nebraska; Met Life Farm & Ranch Properties, Kansas City, Missouri; Southeastern MI Gas Enterprises, Port Huron, Michigan; and Community Investment Partners, L.P. John C. Heisler, Philip R. Schwab and John D. Beuerlein are directors of Cornerstone Mortgage Investment Group, Inc. and Cornerstone Mortgage Investment Group II, Inc. Ray L. Robbins, Jr. is a director of Community Investment Partners, L.P. Robert Virgil, Jr. is a director of CPI Corp., St. Louis, Missouri; Angelica Corp., St. Louis, Missouri; and Allied Healthcare Products, Inc., St. Louis, Missouri. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The following table sets forth all compensation paid by the Partnership during the three most recent years to the five general partners receiving the greatest compensation (including respective shares of profit participation). Returns to General Partner Capital _____________________ (1) (2) (3) & (4) General Net income Partner Deferred allocated invested Total Compen-to General Capital at (1) (2) Year Salaries sation Partners 12/31/93 (3) John W. Bachmann1993 120,000 10,707 2,350,562 3,213,597 2,481,269 1992 120,000 11,306 2,298,834 3,408,360 2,430,140 1991 120,000 10,111 1,556,853 2,752,555 1,686,964 Douglas E. Hill 1993 118,000 10,707 1,994,416 2,726,688 2,123,123 1992 118,000 11,306 1,948,536 2,888,991 2,077,842 1991 115,000 10,111 1,318,416 2,330,993 1,443,527 Ron Larimore 1993 118,000 10,707 1,994,416 2,726,688 2,123,123 1992 118,000 11,306 1,992,323 2,953,912 2,121,629 1991 115,000 10,111 1,346,468 2,380,588 1,471,579 Richie L. Malone1993 118,000 10,707 1,899,444 2,596,846 2,028,151 1992 118,000 11,306 1,810,493 2,596,846 1,939,799 1991 115,000 10,111 1,122,057 1,983,823 1,247,168 Darryl W. Pope 1993 118,000 10,707 1,994,416 2,726,688 2,123,123 1992 118,000 11,306 1,926,642 2,856,530 2,055,948 1991 115,000 10,111 1,304,391 2,306,195 1,429,502 (1) Each non-selling general partner receives a salary presently ranging from $78,000 - $120,000 annually. Selling general partners do not receive a specified salary, rather, they receive the net sales commissions earned by them (none of the five individuals listed above earned any such commissions). Additionally, general partners who are principally engaged in sales are entitled to office bonuses based on the profitability of their respective branch office, on the same basis as the office bonus program established for all investment representative employees. (2) Each general partner is a participant in the Partnership's profit sharing plan which covers all eligible employees. Contributions to the plan, which are within the discretion of the Partnership, are made annually and have historically been determined based on approximately twenty-four percent of the Partnership's net income. Allocation of the Partnership's contribution among participants is determined by each participant's relative level of eligible earnings, including in the case of general partners, their profit participation. (3) Each general partner is entitled to participate in the annual net income of the Partnership based upon the respective percentage interest in the Partnership of each partner. These interests in the Partnership held by each general partner currently range from 1/10 of 1% to 4.95% in 1993. (1/10 of 1% to 5.25% in 1992 and 1/10 of 1% to 5.55% in 1991). At the discretion of the Managing Partner, the partnership agreement provides that, generally, the first five percent of net income allocable to general partners be distributed on the basis of individual merit as determined by the Managing Partner. Thereafter, the remaining net income allocable to general partners is distributed based upon each individual's percentage interest in the Partnership. In 1993, 6% of net income was distributed on the basis of individual merit. (4) Net income allocable to general partners is the amount remaining after payment of interest and earnings on capital invested to limited partners and subordinated limited partners. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Being organized as a limited partnership, management is vested in the general partners thereof and there are no other outstanding "voting" or "equity" securities. It is the opinion of the Partnership that the general partnership interests are not securities within the meaning of federal and state securities laws primarily because each of the general partners participates in the management and conduct of the business. In connection with outstanding limited and subordinated limited partnership interests (non-voting securities), 82 of the general partners also own limited partnership interests and 37 of the general partners also own subordinated limited partnership interests, as noted in the table below. As of February 25, 1994: Name of Amount of Beneficial Beneficial Percent of Title of Class Owner Ownership Class Limited Partnership All General Interests Partners as a Group $ 5,448,000 8% Subordinated All General Limited Partnership Partners as Interests a Group $13,715,000 64% ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS In the ordinary course of its business the Partnership has extended credit to certain of its partners and employees in connection with their purchase of securities. Such extensions of credit have been made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with non-affiliated persons, and did not involve more than the normal risk of collectibility or present other unfavorable features. The Partnership also, from time to time and in the ordinary course of business, enters into transactions involving the purchase or sale of securities from or to partners or employees and members of their immediate families, as principal. Such purchases and sales of securities on a principal basis are effected on substantially the same terms as similar transactions with unaffiliated third parties. ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K INDEX (a) (1) The following financial statements are included in Part II, Item 8: Page No. Report of Independent Public Accountants Consolidated Statements of Financial Condition as of December 31, 1993 and 1992 Consolidated Statements of Income for the years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Cash Flows for the years ended December 31, 1993, 1992 and 1991 Consolidated Statements of Changes in Partnership Capital for the years ended December 31, 1993, 1992 and 1991 Notes to Consolidated Financial Statements All schedules are omitted because they are not required, inapplicable, or the information is otherwise shown in the financial statements or notes thereto. (b) Report on Form 8-K No reports on Form 8-K were filed in the fourth quarter of 1993. (c) Exhibits Reference is made to the Exhibit Index hereinafter contained. EXHIBIT INDEX TO ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1993 Exhibit Number Page Description 3.1 * Amended and Restated Agreement and Certificate of Limited Partnership of Registrant dated October 1, 1993. 3.2 * Form of Limited Partnership Agreement of Edward D. Jones & Co., L.P., dated November 1, 10.1 * Form of Cash Subordination Agreement between the Registrant and Edward D. Jones & Co., incorporated herein by reference to Exhibit 10.1 to the Company's registration statement of Form S-1 (Reg. No. 33-14955). 10.2(a) * Note Purchase Agreement between Tempus Corporation and Edward D. Jones & Co. dated as of April 15, 1986, incorporated herein by reference to Exhibit 10(a) to the Company's Quarterly Report on Form 10-Q for the quarter ended March 28, 1986. 10.2(b) * Note Purchase Agreement between Tempus Corporation and Edward D. Jones & Co., L.P. dated as of March 15, 1988, incorporated herein by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 25, 1988. 10.3 * Complaint for Permanent Injunction and Other Equitable Relief and Final Judgment of Permanent Injunction in re: SEC v. Edward D. Jones & Co. (U.S. Dist. Ct. for Dist. of Columbia; Civil Action No. 85-3078), incorporated herein by reference to Exhibit 10(i) to the Company's current report on Form 8-K dated September 24, 1985. 10.4 * Volume Discount Agreement dated May 27, 1987, between Digital Equipment Corporation and Edward D. Jones & Co., incorporated herein by reference to Exhibit 10.13(c) to the Company's registration statement on Form S-1 (Reg. No. 33-14955). 10.5 * Master Lease Agreement dated as of May 29, 1987, between Digital Equipment Corporation and Edward D. Jones & Co., incorporated herein by reference to Exhibit 10.13(b) to the Company's registration statement on Form S-1 (Reg. No. 33-14955). 10.6 * Master Lease Agreement dated as of October 17, 1988, between Edward D. Jones & Co., L.P., and BancBoston Leasing, incorporated herein by reference to Exhibit 10.1 to the Company's Annual Report on Form 10-K for the year ended September 30, 1988. 10.7 * Satellite Communications Agreement dated as of September 12, 1988, between Hughes Network Systems and Edward D. Jones & Co., L.P., incorporated herein by reference to Exhibit 10.1 to the Company's Annual Report on Form 10-K for the year ended September 30, 1988. 10.8 * Agreements of Lease between EDJ Leasing Company and Edward D. Jones & Co., L.P., dated August 1, 1991, incorporated herein by reference to Exhibit 10.18 to the Company's Annual Report or Form 10-K for the year ended September 27, 1991. 10.9 * Loan Agreement between EDJ Leasing Co., L.P. and Nationwide Insurance Company dated August 2, 1991, incorporated herein by reference to Exhibit 10.19 to the Company's Annual Report or Form 10-K for the year ended September 27, 1991. 10.10 * Edward D. Jones & Co., L.P. Note Purchase Agreement dated as of May 8, 1992, incorporated herein by reference to Exhibit 10.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 26, 1992. 10.11 * Purchase and Sale Agreement by and between EDJ Leasing Co., L.P. and the Resolution Trust Corporation incorporated herein by reference to Exhibit 10.21 to the Company's Annual Report or Form 10-K for the year ended December 31, 1992. 10.12 Master Lease Agreement between EDJ Leasing Company and Edward D. Jones & Co., L.P., dated March 9, 1993, and First Amendment to Lease dated March 9, 1994. 10.13 Purchase Agreement by and between Edward D. Jones & Co., L.P. and Genicom Corporation dated November 25, 1992. 10.14 Mortgage Note and Deed of Trust and Security Agreement between EDJ Leasing Co., L.P. and Nationwide Insurance Company dated March 9, 1993. 10.15 Mortgage Note and Amendment to Deed of Trust between EDJ Leasing Co., L.P. and Nationwide Insurance Company dated March 9, 1994. 24.1 Consent of Independent Public Accountants 25 * Delegation of Power of Attorney to Managing Partner contained within Exhibit 3.1. ________________________________________________________________________ * - Incorporated by reference. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized: (Registrant) THE JONES FINANCIAL COMPANIES, A LIMITED PARTNERSHIP ___________________________________________________ By (Signature and Title) /s/ John W. Bachmann __________________________________ John W. Bachmann, Managing Partner Date March 28, 1994 __________________________________ Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following person on behalf of the registrant and in the capacity and on the date indicated. (Registrant) THE JONES FINANCIAL COMPANIES, A LIMITED PARTNERSHIP ___________________________________________________ By (Signature and Title) /s/ John W. Bachmann __________________________________ John W. Bachmann, Managing Partner Date March 28, 1994 __________________________________ SUPPLEMENTAL INFORMATION TO BE FURNISHED WITH REPORTS FILED PURSUANT TO SECTION 15(D) OF THE ACT BY REGISTRANTS WHICH HAVE NOT REGISTERED SECURITIES PURSUANT TO SECTION 12 OF THE ACT. There have been no annual reports sent to security holders covering the registrant's last fiscal year nor have there been any proxy statements, form of proxy or other proxy soliciting material sent to any of registrant's security holders.

14957_1993.txt

14957

1993

ITEM 1. BUSINESS Brush Wellman Inc. ("Company") manufactures and sells engineered materials for use by manufacturers and others who perform further operations for eventual incorporation into capital, aerospace/defense or consumer products. These materials typically comprise a small portion of the final product's cost. They are generally premium priced and are often developed or customized for the customer's specific process or product requirements. The Company's product lines are supported by research and development activities, modern processing facilities and a global distribution network. Customers include manufacturers of electrical/electronic connectors, communication equipment, computers, lasers, spacecraft, appliances, automobiles, aircraft, oil field instruments and equipment, sporting goods, and defense contractors and suppliers to all of the foregoing industries. The Company operates in a single business segment with product lines comprised of beryllium-containing materials and other specialty materials. The Company is a fully integrated producer of beryllium, beryllium alloys (primarily beryllium copper), and beryllia ceramic, each of which exhibits its own unique set of properties. The Company holds extensive mineral rights and mines the beryllium bearing ore, bertrandite, in central Utah. Beryllium is extracted from both bertrandite and imported beryl ore. In 1993, 74% of the Company's sales were of products containing the element beryllium (80% in 1992 and 80% in 1991). Beryllium-containing products are sold in competitive markets throughout the world through a direct sales organization and through captive and independent distribution centers. NGK Metals Corporation of Reading, Pennsylvania and NGK Insulators, Ltd. of Nagoya, Japan compete with the Company in the beryllium alloys field. Beryllium alloys also compete with other generally less expensive materials, including phosphor bronze, stainless steel and other specialty copper and nickel alloys. General Ceramics Inc. is a major domestic competitor in beryllia ceramic. Other competitive materials include alumina, aluminum nitride and composites. While the Company is the only domestic producer of the metal beryllium, it competes with other fabricators as well as with designs utilizing other materials. Sales of other specialty materials, principally metal systems and precious metal products, were 26% of total sales in 1993 (20% in 1992 and 20% in 1991). Precious metal products are produced by Williams Advanced Materials Inc. (hereinafter referred to as "WAM"), a subsidiary of the Company comprised of businesses acquired in 1986 and 1989. WAM's major product lines include sealing lid assemblies, vapor deposition materials, contact ribbon products for various segments of the semiconductor markets, clad and precious metal preforms and restorative dental products. WAM also specializes in precious metal refining and recovery. WAM's principal competitors are Semi-Alloys and Johnson Matthey in the sealing lid assembly business and Materials Research Corporation in the vapor deposition materials - ------------------------------ As used in this report, except as the context otherwise requires, the term "Company" means Brush Wellman Inc. and its consolidated subsidiaries, all of which are wholly owned. product line. The products are sold directly from their facilities in Buffalo, New York and Singapore and through sales representatives. Technical Materials, Inc. (hereinafter referred to as "TMI"), a subsidiary of the Company, produces specialty metal systems, consisting principally of narrow metal strip, such as copper alloys, nickel alloys and stainless steels into which strips of precious metal are inlaid. TMI also offers a number of other material systems, including electron beam welded dual metal, contour milling and skiving, thick and thin selective solder coatings, selective electroplated products and bonded aluminum strips on nickel-iron alloys for semiconductor leadframes. Divisions of Handy & Harman, Texas Instruments and Metallon are competitors for the sale of inlaid strip. Strip with selective electroplating is a competitive alternative as are other design approaches. The products are sold directly and through sales representatives. SALES AND BACKLOG The backlog of unshipped orders as of December 31, 1993, 1992 and 1991 was $86,531,000, $90,201,000 and $112,620,000, respectively. Backlog is generally represented by purchase orders that may be terminated under certain conditions. The Company expects that, based on recent experience, substantially all of its backlog of orders at December 31, 1993 will be filled during 1994. Sales are made to approximately 5,900 customers. Government sales, principally subcontracts, accounted for about 6.1% of consolidated sales in 1993 as compared to 8.9% in 1992 and 9.5% in 1991. Sales outside the United States, principally to Western Europe, Canada and Japan, accounted for approximately 29% of sales in 1993, 27% in 1992 and 28% in 1991. Financial information as to sales, identifiable assets and profitability by geographic area set forth on pages 16-17 in Note M to the consolidated financial statements in the annual report to shareholders for the year ended December 31, 1993 is incorporated herein by reference. RESEARCH & DEVELOPMENT Active research and development programs seek new product compositions and designs as well as process innovations. Expenditures for research and development amounted to $7,121,000 in 1993, $7,294,000 in 1992 and $7,625,000 in 1991. A staff of 53 scientists, engineers and technicians was employed in this effort during 1993. Some research and development projects were externally sponsored and expenditures related to those projects (approximately $80,446 in 1993, $217,000 in 1992 and $164,000 in 1991) are excluded from the above totals. AVAILABILITY OF RAW MATERIALS The more important raw materials used by the Company are beryllium (extracted from both imported beryl ore and bertrandite mined from the Company's Utah properties), copper, gold, silver, nickel and palladium. The availability of these raw materials, as well as other materials used by the Company, is adequate and generally not dependent on any one supplier. Certain items are supplied by a preferred single source, but alternatives are believed readily available. PATENTS AND LICENSES The Company owns patents, patent applications and licenses relating to certain of its products and processes. While the Company's rights under the patents and licenses are of some importance to its operations, the Company's businesses are not materially dependent on any one patent or license or on the patents and licenses as a group. ENVIRONMENTAL MATTERS The inhalation of excessive amounts of airborne beryllium particulate may present a hazard to human health. For decades the Company has operated its beryllium facilities under stringent standards of inplant and outplant discharge. These standards, which were first established by the Atomic Energy Commission over forty years ago, were, in general, subsequently adopted by the United States Environmental Protection Agency and the Occupational Safety and Health Administration. The Company's experience in sampling, measurement, personnel training and other aspects of environmental control gained over the years, and its investment in environmental control equipment, are believed to be of material importance to the conduct of its business. EMPLOYEES As of December 31, 1993 the Company had 1,803 employees. ITEM 2.

ITEM 2. PROPERTIES The material properties of the Company, all of which are owned in fee except as otherwise indicated, are as follows: CLEVELAND, OHIO - A structure containing 110,000 square feet on an 18 acre site housing corporate and administrative offices, data processing and research and development facilities. ELMORE, OHIO - A complex containing approximately 676,000 square feet of building space on a 385 acre plant site. This facility employs diverse chemical, metallurgical and metalworking processes in the production of beryllium, beryllium oxide, beryllium alloys and related products. Beryllium ore concentrate from the Delta, Utah plant is used in all beryllium-containing products. SHOEMAKERSVILLE (READING), PENNSYLVANIA - A 123,000 square foot plant on a ten acre site that produces thin precision strips of beryllium copper and other alloys and beryllium copper rod. NEWBURYPORT, MASSACHUSETTS - A 30,000 square foot manufacturing facility on a four acre site that produces alumina, beryllia ceramic and direct bond copper products. TUCSON, ARIZONA - A 45,000 square foot plant on a ten acre site for the manufacture of beryllia ceramic parts from beryllium oxide powder supplied by the Elmore, Ohio facility. DELTA, UTAH - An ore extraction plant consisting of 86,000 square feet of buildings and large outdoor facilities situated on a two square mile site. This plant extracts beryllium from bertrandite ore from the Company's mines as well as from imported beryl ore. JUAB COUNTY, UTAH - The Company holds extensive mineral rights in Juab County, Utah from which the beryllium bearing ore, bertrandite, is mined by the open pit method. A substantial portion of these rights is held under lease. Ore reserve data set forth on page 16 of this Form 10-K annual report for the year ended December 31, 1993 are incorporated herein by reference. FREMONT, CALIFORNIA - A 49,000 square foot leased facility for the fabrication of precision electron beam welded, brazed and diffusion bonded beryllium structures. THEALE (READING), ENGLAND - A 19,700 square foot leased facility principally for distribution of beryllium alloys. STUTTGART, WEST GERMANY - A 24,750 square foot leased facility principally for distribution of beryllium alloys. FUKAYA, JAPAN - A 35,500 square foot facility on 1.8 acres of land in Saitama Prefecture principally for distribution of beryllium alloys. LINCOLN, RHODE ISLAND - A manufacturing facility consisting of 124,000 square feet located on seven and one-half acres. This facility produces metal strip inlaid with precious metals and related metal systems products. BUFFALO, NEW YORK - A complex of approximately 97,000 square feet on a 3.8 acre site providing facilities for manufacturing, refining and laboratory services relating to high purity precious metals. SYRACUSE, NEW YORK - A 14,000 square foot leased portion of a multi-story facility for the design and manufacture of circuits and packages using a direct bond process to combine conductive copper with insulating ceramic substrates. Production capacity is believed to be adequate to fill the Company's backlog of orders and is expected to meet demand for the foreseeable future. ITEM 3.

ITEM 3. LEGAL PROCEEDINGS The Company is from time to time a defendant in various civil and administrative proceedings that relate to the ordinary course of its operating business. These proceedings include environmental, health and safety related actions and other matters relating to the Company's present and former operations. Included in such proceedings are the matters discussed below. (a) ENVIRONMENTAL PROCEEDINGS On November 1, 1989, the Company appealed to the Ohio Environmental Board of Review to vacate or modify certain conditions in an NPDES wastewater discharge permit issued by the Ohio Environmental Protection Agency (the "Ohio EPA") for the Company's Elmore, Ohio facility. The Company challenges these conditions on several bases, including technical infeasibility and economic unreasonableness. Settlement discussions are continuing. On or about September 25, 1992, the Company was served with a third-party complaint alleging that the Company, along with 159 other third-party defendants, are jointly and severally liable under the Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA"), 42 U.S.C. Sections 9607(a) and 9613(b), for response costs incurred in connection with the clean-up of hazardous substances in soil and groundwater at the Douglassville Site (the "Site") located in Berks County, Pennsylvania. UNITED STATES OF AMERICA V. BERKS ASSOCIATES, INC., ET AL. V. AAMCO TRANSMISSIONS, ET AL., United States District Court for the Eastern District of Pennsylvania, Case No. 91-4968. Prior to the commencement of litigation, the Company responded to a request for information from the United States Environmental Protection Agency (the "United States EPA") by denying that it arranged to send any substances to the Site. Although the Company has no documents in its own files relating to the shipment of any waste to the Site, documents maintained by third-party plaintiffs suggest that 8,344 gallons of waste oil from the Company may have been taken there. Based on settlement discussions currently underway, the Company believes that its liability arising from this matter will be nominal. In April 1993, the Company learned that the Ohio EPA had recommended that the Ohio Attorney General's Office consider initiation of enforcement proceedings against the Company with respect to alleged violations of various environmental laws at its facility in Elmore, Ohio. The Company is presently involved in settlement discussions while contesting the alleged violations. The Company believes that resolution of this matter will have no material effect on the Company. (b) BERYLLIUM EXPOSURE CLAIMS The inhalation of excessive amounts of airborne beryllium particulate may present a health hazard to certain individuals. For decades the Company has operated its beryllium facilities under stringent standards of inplant and outplant discharge. These standards, which were first developed by the Atomic Energy Commission over forty years ago, were, in general, subsequently adopted by the United States Environmental Protection Agency and the Occupational Safety and Health Administration. PENDING CLAIMS. The Company is currently a defendant in the following legal actions where the plaintiffs allege injury resulting from exposure to beryllium and beryllium-containing materials and are claiming recovery based on various legal theories. The Company believes that resolution of these cases will not have a material effect on the Company. Defense for each of the cases identified above is being conducted by counsel selected by the Company and retained, with certain reservations of rights, by the Company's insurance carriers. RECENT DEVELOPMENTS RELATING TO PENDING CLAIMS. The Company has filed a motion for summary judgment in both the ROSENBAUER and HAYNES cases on which the respective Courts have not yet ruled. CLAIMS CONCLUDED SINCE THE END OF THIRD QUARTER 1993. Joseph R. Harper and his wife filed suit against the Company and several other defendants in the United States District Court for the Eastern District of Tennessee, for which service of process on the Company occurred on May 6, 1992. Mr. Harper claimed that, while he was an employee of an alleged customer of the Company, he contracted chronic beryllium disease as a result of exposure to beryllium or beryllium-containing products. Mr. Harper sought compensatory damages in the amount of $5 million; his wife claimed damages of $1.5 million for loss of consortium. Both plaintiffs sought punitive damages in the amount of $3 million. On December 28, 1993 the Court granted the Company's motion for summary judgment and dismissed the action. Although the action is dismissed as to the Company, the case remains pending as to other defendants. Plaintiffs are not expected to appeal, but any such appeal need not occur until the case is resolved as to the remaining defendants. (c) ASBESTOS EXPOSURE CLAIMS A subsidiary of the Company (the "Subsidiary") is a co-defendant in twenty-eight cases making claims for asbestos-induced illness allegedly relating to the former operations of the Subsidiary, then known as The S. K. Wellman Corp. Twenty-three of these cases have been reported in prior filings with the S.E.C. The Subsidiary is one of a large number of defendants in each case. The plaintiffs seek compensatory and punitive damages, in most cases of unspecified sums. Each case has been referred to a liability insurance carrier for defense. With respect to those referrals on which a carrier has acted to date, a carrier has accepted the defense of the actions, without admitting or denying liability. Two hundred and six similar cases previously reported have been dismissed or disposed of by pre-trial judgment, one by jury verdict of no liability and ten others by settlement for nominal sums. The Company believes that resolution of the pending cases referred to above will not have a material effect upon the Company. The Subsidiary has entered into an agreement with the predecessor owner of its operating assets, Pneumo Abex Corporation (formerly Abex Corporation), and five insurers, regarding the handling of these cases. Under the agreement, the insurers share expenses of defense, and the Subsidiary, Pneumo Abex Corporation and the insurers share payment of settlements and/or judgments. Certain expenses of handling the cases are also subject to a limited, separate reimbursement agreement with Pneumo Abex Corporation. In eleven of the pending cases, both expenses of defense and payment of settlements and/or judgments are subject to a limited, separate reimbursement agreement with MLX Corp., the parent of the company that purchased the Subsidiary's operating assets in 1986. ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not Applicable. MR. HARNETT was elected Chairman of the Board, President, Chief Executive Officer and Director of the Company effective January 22, 1991. He had served as a Senior Vice President of The B. F. Goodrich Company from November 1988. MR. WAITE was elected Senior Vice President Finance and Administration in October of 1991. He was elected Chief Financial Officer in September 1987 and served as Vice President, Finance from September 1976 until his election as Senior Vice President in September 1989. Mr. Waite was elected Secretary effective January 1, 1988. He was Treasurer from December 31, 1987 to April 24, 1990. DR. BROPHY was elected Vice President Technology effective March 31, 1988. Prior to that he was Vice President of Engineering, Engine and General Components Group, Automotive Sector of TRW Inc. He had been Vice President, Manufacturing and Materials Development, Automotive Sector of TRW Inc. from 1986 to 1987. MR. FREEMAN was elected Vice President Sales and Marketing August 3, 1993. He served as Vice President Sales and Marketing-Alloy Products since July, 1992. Prior to that, he had served as Management Consultant for Adastra, Inc. MR. HARLAN was elected Vice President Business Development in August, 1993. He had served as Senior Vice President, Sales and Marketing since October, 1991. He had served as Vice President/General Manager, Alloy Division since January 1, 1987. Prior to that he was President of TMI. MR. ROZEK was elected Vice President International in October 1991. He had served as Vice President, Corporate Development effective February 27, 1990. He was elected Vice President, Governmental and Environmental Affairs in April 1989. He had been Vice President/General Manager, International Division since November 1985. MR. SANDOR was elected Vice President Operations in October 1991. He had served as Senior Vice President since September 1989. He was appointed Vice President/General Manager, Material Systems Division effective January 1, 1988. Prior to that he was Manager of the Company's Shoemakersville, PA facility. MR. SKOCH was elected Vice President Human Resources in July 1991. Prior to that he was Corporate Director - Personnel. He had been Corporate Manager Employee Relations and Training from December 1985 to July 1987. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The Company's Common Stock is traded on the New York Stock Exchange. As of March 8, 1994, there were 2,681 shareholders of record. Information as to stock price and dividends declared set forth on page 17 in Note N to the consolidated financial statements in the annual report to shareholders for the year ended December 31, 1993 is incorporated herein by reference. The Company's ability to pay dividends is generally unrestricted, except that it is obligated to maintain a specified level of tangible net worth pursuant to an existing credit facility. ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA Selected Financial Data on pages 22 and 23 of the annual report to shareholders for the year ended December 31, 1993 is incorporated herein by reference. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Brush Wellman's engineered materials are comprised of five product lines: BERYLLIUM ALLOYS, principally beryllium copper; BERYLLIUM and materials rich in beryllium; beryllia CERAMICS; SPECIALTY METAL SYSTEMS, principally clad metals; and PRECIOUS METAL PRODUCTS. All five product lines have items that contain the element beryllium. SPECIALTY METAL SYSTEMS are produced and sold by a wholly owned subsidiary, Technical Materials, Inc. Another wholly owned subsidiary, Williams Advanced Materials Inc., specializes in PRECIOUS METAL PRODUCTS. Worldwide sales in 1993 were $295 million as compared to $265 million in 1992 and $267 million in 1991. Sales of BERYLLIUM ALLOYS increased in 1993. Solid increases domestically and in Asia offset lower sales in Europe. The improvement was led by automotive electronics and telecommunications applications, although most markets enjoyed higher volume. An increased and more focused marketing effort is the driving force behind the development of new applications as well as growth in existing applications. For example, growth in undersea telephone cable products is a result of increased market penetration and an expanding market. A significant influence was the start of the TPC-5 transpacific fiber optic cable project. This market is anticipated to continue its growth as new cable projects that have recently been announced are brought on line. A second example is in the aircraft industry. Working with the airframe manufacturers and airline maintenance facilities as "demand generators" has resulted in an increasing number of bushings and bearings being designed using beryllium copper as an enabling technology to allow lower flying weight and improved performance. This process is showing success in both new aircraft component designs and in the retrofit of the installed base of landing gear on older aircraft. Due to these and other favorable trends, continued growth of BERYLLIUM ALLOYS is expected in 1994. BERYLLIUM sales increased in 1993 from the year ago period due to AlBeMet(TM) sales of a computer disk drive component. Absent the AlBeMet(TM) sales, there was a reduction in BERYLLIUM sales due largely to lower defense spending. In 1994, sales will be lower due to completion of the Defense Logistics Agency (DLA) supply contract and reduced AlBeMet(TM) sales due to the end of an application at a computer disk drive manufacturer. To counter this reduction in volume, process improvement and cost containment are being emphasized. Marketing and product development efforts are being focused on materials and designs for the aerospace and avionics industries. CERAMIC sales increased in 1993 as compared to 1992. Demand for beryllia ceramic products was strong in United States automotive markets as well as from telecommunications growth worldwide. Sales of direct bond copper products increased 40% because of new applications in power electronics such as solid state motor controls. These products of mainly alumina and copper are bonded without the use of brazing materials. Continued growth is anticipated in 1994 from new applications in automotive electronics and additional penetration of Asian markets coupled with use of direct bond copper products in power conversion and wireless communications. SPECIALTY METAL SYSTEMS had a sizable sales increase in 1993 as compared to 1992 and exceeded the sales level of 1991. The increase resulted from recently developed applications, primarily in the automotive electronics, telecommunications and computer industries. In the telecommunications industry, for example, a precious metal clad on beryllium copper offered superior performance in a requirement in cellular telephone connector contacts. Additionally, a proprietary ductile nickel coating on beryllium copper Alloy 174 will be utilized in battery chargers for cellular telephones and other products. In 1994, the continued development of new applications, along with an effort to improve manufacturing response time, are necessary for the growth of SPECIALTY METAL SYSTEMS. PRECIOUS METAL PRODUCTS had a significant sales increase in 1993 as compared to 1992. High demand for frame lid assemblies from semiconductor manufacturers, along with added sales of a new line of vapor deposition targets, accounted for much of the increase. Sales are expected to be lower in 1994 because semiconductor demand is expected to slow. In addition, first-time vapor deposition target sales have a large precious metal content; as these spent targets are recycled and refurbished, the customer maintains ownership of the material, resulting in lower sales, but similar profit from value-added services. International sales were $86 million in 1993, $71 million in 1992 and $76 million in 1991. The increase in 1993 is primarily due to deliveries of disk drive components to Asia and the start-up of PRECIOUS METAL PRODUCT assemblies in Singapore. The distribution of BERYLLIUM ALLOYS is the major component of international sales. Lower demand in Europe, due principally to economic conditions, precluded any growth. International sales are likely to be lower in 1994 due to the end of the previously mentioned disk drive application. However, BERYLLIUM ALLOY sales should increase as economic conditions in Europe improve and marketing efforts in Asia are strengthened. Worldwide sales in 1992 were slightly under those of 1991. Gains in BERYLLIUM ALLOYS, CERAMIC and PRECIOUS METAL PRODUCTS were offset by declines in BERYLLIUM and SPECIALTY METAL SYSTEMS. The increases were primarily in automotive and semiconductor markets with the decreases primarily in defense-related applications. Gross margin (sales less cost of sales) was 22.9%, 27.2%, and 24.4% of sales in the years 1993, 1992 and 1991, respectively. The two primary factors affecting margins were a product mix shift to lower margin products, particularly those with a high precious metal content, and manufacturing problems associated with the AlBeMet(TM) disk drive component. In addition, competitive conditions limit the ability to cover cost increases. However, the Company continues to be encouraged by the favorable impact on margins from manufacturing yield and productivity improvements, especially in BERYLLIUM ALLOY strip products. Margin percentages are expected to improve in 1994 due to an anticipated shift in product mix to high value-added products, manufacturing improvements and the significant reduction of low margin AlBeMet(TM) disk drive sales. The higher gross margin in 1992 was due to improved manufacturing performance, primarily in BERYLLIUM ALLOYS, coupled with cost reduction efforts. This was in spite of relatively low capacity utilization. Other favorable factors included about $4 million in lower depreciation and amortization due to the asset impairment charge taken in 1991 and about $2 million from a weaker dollar. Selling, administrative and general expenses in 1993 were $47.8 million (16.2% of sales) compared to $46.6 million (17.6% of sales) in 1992. The increase was primarily in worldwide marketing, selling and customer service activities that support the critical issue of sales growth. This category of expense increased over 6% in 1993 from 1992 while administrative and general expenses, which include lower incentive compensation, decreased. Selling, administrative and general expenses in 1992 were down from 1991. Increased marketing, selling and distribution were more than offset by a reduction in administrative expenses. Research and Development (R&D) expenses of $7.1 million in 1993 were slightly lower than the $7.3 million spent in 1992. The Company's marketing efforts are leading to changes in R&D resource utilization. Cross-functional marketing teams, which include R&D representation, bring more focus to those activities and opportunities that offer the greatest sales and margin potential to the Company. In 1991, R&D expenses were $7.6 million. Interest expense was $3.0 million in 1993, $3.2 million in 1992 and $3.8 million in 1991. All amounts are net of interest capitalized on active construction and mine development projects. Lower interest rates and less debt, on average, favorably impacted interest costs in 1993 and 1992. The impairment and restructuring charges in 1991 had a pre-tax income impact of $39.3 million. These charges consisted of a writedown of the carrying value of the assets of Technical Materials, Inc. and Williams Advanced Materials Inc. and provisions for early retirement, severance and environmental matters. In 1991, the Company adopted Statement of Financial Accounting Standard No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions" (FAS 106). This accounting change was effective as of January 1, 1991 and resulted in recording a transition obligation that reduced earnings by $1.02 per share. In addition, the ongoing effect of adopting FAS 106 was to increase net periodic postretirement cost and reduce earnings by $.08 per share in 1991. Other-net expense was $2.2 million in 1993, $1.3 million in 1992 and $3.0 million in 1991. This category includes such expenses as amortization of goodwill and other intangibles, the effect of currency exchange and translation and other non-operating items. Included in all three years are the postretirement benefit costs pursuant to FAS 106 for a divested operation. In 1993, the Company made an adjustment to the FAS 106 demographic assumptions for the divested operation. This resulted in a reduction of the liability and resulting income of $1.3 million. The carrying value of a building from the divested operation was reduced by $0.9 million. Included in 1992 was about $1.4 million of nonrecurring gains. Income before income taxes in 1993 of $7.7 million was significantly lower than the 1992 pre-tax income of $13.7 million. The reduction is due to the lower gross margin, owing principally to the manufacturing problems with the disk drive component and lower sales of BERYLLIUM for defense related applications. The increase in selling, general and administrative expense was also a contributing factor to the lower pre-tax income. On the positive side was improved manufacturing performance in BERYLLIUM ALLOYS and CERAMICS. In 1992, pre-tax income of $13.7 million was significantly higher than the 1991 pre-tax income of $3.2 million, exclusive of the impairment and restructuring charges. The combination of better manufacturing performance, cost reduction and the ongoing effects of the previously mentioned 1991 asset impairment charges accounted for the gain. The effective tax rate employed for 1993 was 16.2% of pre-tax income as compared to a rate of 23.6% of pre-tax income in 1992. The lower pre-tax income, coupled with relatively fixed tax credits and allowances, results in the significantly lower tax rate for 1993 as compared to 1992 and to statutory rates. As shown in Note H to the consolidated financial statements, the tax credit for percentage depletion in excess of cost depletion from mining operations, along with the tax benefit of the Company-owned life insurance program, account for almost the entire reduction from statutory rates in both 1993 and 1992. In 1991, a tax benefit of 23.8% on the pre-tax loss was utilized. Earnings per share were $0.40 in 1993 and $0.65 in 1992. Loss per share of $2.74 in 1991 includes $2.93 per share of non-recurring items for the impairment and restructuring charges and the accounting change. Comparable per share earnings in 1991 were $0.19. FINANCIAL POSITION CAPITAL RESOURCES AND LIQUIDITY Cash flow from operating activities totaled $18.3 million in 1993. Cash balances increased by $3.5 million while total debt decreased by $13.4 million. Capital expenditures for property, plant and equipment amounting to $12 million in 1993 were focused on upgrades and additions to improve quality and productivity. Capital expenditures in 1994 are expected to approach $20 million with a significant portion devoted to projects at the Company's extraction facilities in Utah, including extending the life and capacity of the tailings pond. Long-term financial resources available to the Company include $60 million of medium-term notes and $40 million under a bank credit agreement (unused at December 31, 1993). In the fourth quarter of 1993, the Company borrowed the $15 million cash surrender value from a group of Company-owned life insurance policies. The proceeds were used to repay all borrowings under the bank credit agreement. Long-term debt at December 31, 1993 was $24 million or 12% of total capital. Short-term debt at December 31, 1993 was $16 million and is denominated principally in gold, yen, marks and sterling to provide hedges against assets so denominated. In addition, credit lines amounting to $54 million are available. Funds being generated from operations plus the available borrowing capacity are believed adequate to support operating requirements, capital expenditures, remediation projects, dividends and small acquisitions. Excess cash, if any, is invested in collateralized repurchase agreements and other high quality instruments. Cash flow from operating activities in 1992 was $31 million. Total debt was reduced $5.4 million while capital and mine development expenditures totaled $14 million and dividends totalled $3.2 million. Long-term debt at December 31, 1992 was 17% of total capital. ORE RESERVES The Company's reserves of beryllium-bearing bertrandite ore are located in Juab County, Utah. An ongoing drilling program has generally added to proven reserves. Proven reserves are the measured quantities of ore commercially recoverable through the open pit method. Probable reserves are the estimated quantities of ore known to exist, principally at greater depths, but prospects for commercial recovery are indeterminable. Ore dilution that occurs during mining approximates 7%. About 87% of beryllium in ore is recovered in the extraction process. The Company augments its proven reserves of bertrandite ore through the purchase of imported beryl ore (approximately 4% beryllium) which is also processed at the Utah extraction plant. INFLATION AND CHANGING PRICES The prices of major raw materials, such as copper, nickel and gold, purchased by the Company were mixed during 1993. Such changes in costs are generally reflected in selling price adjustments. The prices of labor and other factors of production generally increase with inflation. Additions to capacity, while more expensive over time, usually result in greater productivity or improved yields. However, market factors, alternative materials and competitive pricing have affected the Company's ability to offset wage and benefit increases. The Company employs the last-in, first-out (LIFO) inventory valuation method domestically to more closely match current costs with revenues. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following consolidated financial statements of the Company included in the annual report to shareholders for the year ended December 31, 1993 are incorporated herein by reference: Consolidated Balance Sheets - December 31, 1993 and 1992. Consolidated Statements of Income - Years ended December 31, 1993, 1992 and 1991. Consolidated Statements of Shareholders' Equity - Years ended December 31, 1993, 1992 and 1991. Consolidated Statements of Cash Flows - Years ended December 31, 1993, 1992 and 1991. Notes to Consolidated Financial Statements. Quarterly Data on page 17 of the Annual Report to shareholders and Ore Reserves on page 16 of this Form 10-K annual report to shareholders for the year ended December 31, 1993 are incorporated herein by reference. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information under Election of Directors on pages 2 through 5 of the Proxy Statement dated March 11, 1994 is incorporated herein by reference. Information with respect to Executive Officers of the Company is set forth earlier on pages 10 and 11 of this Report. ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION The information under Executive Officer Compensation on pages 8 through 14 of the Proxy Statement dated March 11, 1994 is incorporated herein by reference. ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information under Common Stock Ownership of Certain Beneficial Owners and Management on pages 6 through 7 of the Proxy Statement dated March 11, 1994 is incorporated herein by reference. ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information under Compensation Committee Interlocks and Insider Participation and Related Party Transactions on page 15 of the Proxy Statement dated March 11, 1994 is incorporated herein by reference. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. FINANCIAL STATEMENTS AND SUPPLEMENTAL INFORMATION Included in Part II of this Report by reference to the annual report to shareholders for the year ended December 31, 1993 are the following consolidated financial statements: Consolidated Balance Sheets - December 31, 1993 and 1992. Consolidated Statements of Income - Years ended December 31, 1993, 1992 and 1991. Consolidated Statements of Shareholders' Equity - Years ended December 31, 1993, 1992 and 1991. Consolidated Statements of Cash Flows - Years ended December 31, 1993, 1992 and 1991. Notes to Consolidated Financial Statements. Report of Independent Auditors. (a) 2. FINANCIAL STATEMENT SCHEDULES The following consolidated financial information for the years 1993, 1992 and 1991 is submitted herewith: Schedule V - Property, plant and equipment Schedule VI - Accumulated depreciation, depletion and amortization of property, plant and equipment Schedule VIII - Valuation and qualifying accounts Schedule IX - Short-term borrowings Schedule X - Supplementary income statement information All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. (a) 3. EXHIBITS (3a) Amended Articles of Incorporation of the Company as amended February 28, 1989 (filed as Exhibit 3a to the Company's Form 10-K Annual Report for the year ended December 31, 1988), incorporated herein by reference. (3b) Regulations of the Company as amended April 25, 1989 (filed as Exhibit 3 to the Company's Form 10-Q Quarterly Report for the quarter ended July 2, 1989) and further amended April 27, 1993 (filed as Exhibit 3ii to the Company's Form 10-Q Quarterly Report for the quarter ended April 4, 1993), incorporated herein by reference. (4a) Common Stock Certificate of the Company (filed as Exhibit 4c to Post-Effective Amendment No. 2 to Registration Statement No. 2-64080), incorporated herein by reference. (4b) Credit Agreement dated as of December 23, 1991 between the Company and National City Bank acting for itself and as agent for three other banking institutions (filed as Exhibit 4b to the Company's Form 10-K Annual Report for the year ended December 31, 1991), incorporated herein by reference. (4c) Rights Agreement between the Company and Society National Bank (formerly Ameritrust Company National Association) as amended February 28, 1989 (filed as Exhibit 4c to the Company's Form 10-K Annual Report for the year ended December 31, 1988), incorporated herein by reference. (4d) Issuing and Paying Agency Agreement dated as of February 1, 1990, including a specimen form of a medium term note issued thereunder, between the Company and Morgan Guaranty Trust Company of New York (filed as Exhibit 4d to the Company's Form 10-K Annual Report for the year ended December 31, 1989), incorporated herein by reference. (4e) Pursuant to Regulation S-K, Item 601-(b)(4), the Company agrees to furnish to the Commission, upon its request, a copy of the instruments defining the rights of holders of long-term debt of the Company that are not being filed with this report. (10a) * Employment Agreement entered into by the Company and Mr. Gordon D. Harnett on March 20, 1991 (filed as Exhibit 10a to the Company's Form 10-K Annual Report for the year ended December 31, 1990), incorporated herein by reference. *Reflects management contract or other compensatory arrangement required to be filed as an Exhibit pursuant to Item 14(c) of this Report. (10b) * Form of Employment Agreement entered into by the Company and Messrs. Waite, Brophy, Hanes, Harlan, Rozek and Sandor on February 20, 1989 (filed as Exhibit 10j to the Company's Form 10-K Annual Report for the year ended December 31, 1988), incorporated herein by reference. (10c) * Form of Amendment to the Employment Agreement (dated February 20, 1989) entered into by the Company and Messrs. Waite, Brophy, Hanes, Harlan, Rozek and Sandor dated February 28, 1991 (filed as Exhibit 10c to the Company's Form 10-K Annual Report for the year ended December 31, 1990), incorporated herein by reference. (10d) * Form of Employment Agreement entered into by the Company and Mr. Daniel A. Skoch on January 28, 1992 and Mr. Stephen Freeman dated August 3, 1993 (filed as Exhibit 10d to the Company's Form 10-K Annual Report for the year ended December 31, 1991), incorporated herein by reference. (10e) * Form of Trust Agreement between the Company and Society National Bank (formerly Ameritrust Company National Association) on behalf of Messrs. Waite, Brophy, Hanes, Harlan, Rozek and Sandor dated February 20, 1989, Mr. Harnett dated March 20, 1991 and Mr. Skoch dated January 28, 1992 and Mr. Stephen Freeman dated August 3, 1993 (filed as Exhibit 10k to the Company's Form 10-K Annual Report for the year ended December 31, 1988), incorporated herein by reference. (10f) Form of Indemnification Agreement entered into by the Company and Mr. C. G. Waite on June 27, 1989 and Mr. G. D. Harnett on March 20, 1991 (filed as Exhibit 10a to the Company's Form 10-Q Quarterly Report for the quarter ended July 2, 1989), incorporated herein by reference. (10g) Form of Indemnification Agreement entered into by the Company and Messrs. J. H. Brophy, A. J. Sandor, C. B. Harlan, H. D. Hanes, and R. H. Rozek on June 27, 1989, Mr. D. A. Skoch on January 28, 1992 and Mr. Stephen Freeman dated August 3, 1993 (filed as Exhibit 10b to the Company's Form 10-Q Quarterly Report for the quarter ended July 2, 1989), incorporated herein by reference. (10h) Form of Indemnification Agreement entered into by the Company and Messrs. C. F. Brush, F. B. Carr, W. E. MacDonald, J. L. McCall, W. P. Madar, G. C. McDonough, R. *Reflects management contract or other compensatory arrangement required to be filed as an Exhibit pursuant to Item 14(c) of this Report. M. McInnes, H. G. Piper and J. Sherwin Jr. on June 27, 1989 and Mr. A. C. Bersticker on April 27, 1993 (filed as Exhibit 10c to the Company's Form 10-Q Quarterly Report for the quarter ended July 2, 1989), incorporated herein by reference. (10i) * Directors' Retirement Plan as amended January 26, 1993 (filed as Exhibit 10i to the Company's Form 10-K Annual Report for the year ended December 31, 1992), incorporated herein by reference. (10j) * Deferred Compensation Plan for Nonemployee Directors effective January 1, 1992 (filed as Exhibit I to the Company's Proxy Statement dated March 6, 1992), incorporated herein by reference. (10k) * Form of Trust Agreement between the Company and National City Bank dated January 1, 1992 on behalf of NonemployeeDirectors of the Company (filed as Exhibit 10k to the Company's Form 10-K Annual Report for the year ended December 31, 1992), incorporated herein by reference. (10l) * Incentive Compensation Plan adopted December 16, 1991, effective January 1, 1992 (filed as Exhibit 10l to the Company's Form 10-K Annual Report for the year ended December 31, 1991), incorporated herein by reference. (10m) * Management Performance Compensation Plan adopted February 22, 1993, effective January 1, 1993 (filed as Exhibit 10m to the Company's Form 10-K Annual Report for the year ended December 31, 1992), incorporated herein by reference. (10n) * Supplemental Retirement Plan as amended and restated December 1, 1992 (filed as Exhibit 10n to the Company's Form 10-K Annual Report for the year ended December 31, 1992), incorporated herein by reference. (10o) * Form of Trust Agreement between the Company and Society National Bank dated January 8, 1993 pursuant to the December 1, 1992 amended Supplemental Retirement Plan (filed as Exhibit 10o to the Company's Form 10-K Annual Report for the year ended December 31, 1992), incorporated herein by reference. (10p) * Employment arrangement between the Company and Mr. Gordon D. Harnett effective January 22, 1991 (filed as Exhibit 10k to the Company's Form 10-K Annual Report for the year ended December 31, 1990) incorporated herein by reference. *Reflects management contract or other compensatory arrangement required to be filed as an Exhibit pursuant to Item 14(c) of this Report. (10q) * Amendment to the employment arrangement (effective January 22, 1991) between the Company and Mr. Gordon D. Harnett (filed as Exhibit 10o to the Company's Form 10-K Annual Report for the year ended December 31, 1991), incorporated herein by reference. (10r) * Agreement between the Company and H. G. Piper dated as of January 23, 1990 (filed as Exhibit 10i to the Company's Form 10-K Annual Report for the year ended December 31, 1989), incorporated herein by reference. (10s) * Amendment dated February 19, 1991 to the agreement between the Company and Mr. H. G. Piper dated January 23, 1990 (filed as Exhibit 10m to the Company's Form 10-K Annual Report for the year ended December 31, 1990) incorporated herein by reference. (10t) Amendment dated February 27, 1990 to the Indemnification Agreement between the Company and H. G. Piper (filed as Exhibit 10l to the Company's Form 10-K Annual Report for the year ended December 31, 1989), incorporated herein by reference. (10u) * 1979 Stock Option Plan, as amended pursuant to approval of shareholders on April 21, 1982 (filed as Exhibit 15A to Post-Effective Amendment No. 3 to Registration Statement No. 2-64080), incorporated herein by reference. (10v) * 1984 Stock Option Plan as amended by the Board of Directors on April 18, 1984 and February 24, 1987 (filed as Exhibit 4.4 to Registration Statement No. 33-28605), incorporated herein by reference. (10w) * 1989 Stock Option Plan (filed as Exhibit 4.5 to Registration Statement No. 33-28605), incorporated herein by reference. (10x) * 1990 Stock Option Plan for Nonemployee Directors (filed as Exhibit 4.6 to Registration Statement No. 33-35979), incorporated herein by reference. (10y) * 1977 Stock Appreciation Rights Plan (filed as Exhibit 4.6 to Registration Statement No. 33-28605), incorporated herein by reference. (11) Statement re: calculation of per share earnings for the years ended December 31, 1993, 1992 and 1991. *Reflects management contract or other compensatory arrangement required to be filed as an Exhibit pursuant to Item 14(c) of this Report. (13) Portions of the Annual Report to shareholders for the year ended December 31, 1993. (21) Subsidiaries of the registrant. (23) Consent of Ernst & Young. (24) Power of Attorney. (99a) Form 11-K Annual Report for the Brush Wellman Inc. Savings and Investment Plan for the year ended December 30, 1993. (99b) Form 11-K Annual Report for the Williams Advanced Materials Inc. Savings and Investment Plan for the year ended December 30, 1993. (b) Reports on Form 8-K There were no reports on Form 8-K filed during the fourth quarter of the year ended December 31, 1993. SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. March 25, 1994 BRUSH WELLMAN INC. By: /s/ Gordon D. Harnett By: /s/ Clark G. Waite ------------------------------------ ----------------------------- Gordon D. Harnett Clark G. Waite Chairman of the Board, Senior Vice President and President and Chief Executive Officer Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. *The undersigned, by signing his name hereto, does sign and execute this report on behalf of each of the above-named officers and directors of Brush Wellman Inc., pursuant to Powers of Attorney executed by each such officer and director filed with the Securities and Exchange Commission. By: /s/ Clark G. Waite ----------------------- Clark G. Waite March 25, 1994 Attorney-in-Fact Page 1 of 2 Page 2 of 2 Page 1 of 2 Page 2 of 2 Page 1 of 2 Page 2 of 2

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9892

1993

Item 1. Business General Development of Business The Company was started by Charles Russell Bard in 1907. One of its first medical products was the silk urethral catheter imported from France. In 1923, the Company was incorporated as C. R. Bard, Inc. and distributed an assortment of urological and surgical products. Bard became a publicly-traded company in 1963 and five years later was traded on the New York Stock Exchange. In 1966, Bard acquired its supplier of urological and cardiovascular specialty products - the United States Catheter & Instrument Co. In 1980 Bard acquired its major source of the Foley catheter - Davol Inc. Numerous other acquisitions were made over the last thirty-three years broadening Bard's product lines. Today, C. R. Bard, Inc. is a leading multinational developer, manufacturer and marketer of health care products. 1993 sales of $970.8 million decreased 2% from 1992. Net income for 1993 totaled $56 million or $1.07 per share, and both decreased 25 percent against 1992. Product Group Information Bard is engaged in the design, manufacture, packaging, distribution and sale of medical, surgical, diagnostic and patient care devices. Hospitals, physicians and nursing homes purchase approximately 90% of the Company's products, most of which are used once and discarded. The following table sets forth for the last three years ended December 31, 1993, the approximate percentage contribution to Bard's consolidated net sales. The figures are on a worldwide basis. Years Ended December 31, 1993 1992 1991 Cardiovascular 40% 41% 41% Urological 26% 25% 25% Surgical 34% 34% 34% Total 100% 100% 100% I-1 Narrative Description of Business General Traditionally, Bard has been known for its products in the urological field, where its Foley catheter is the leading device for bladder drainage. Today, Bard's largest product group is in cardiovascular care devices, contributing approximately 40% of consolidated net sales, with a wide range of products, including USCI balloon angioplasty catheters used for nonsurgical treatment of obstructed arteries. Additionally, Bard has important positions in the area of surgical products. Bard continually expands its research toward the improvement of existing products and the development of new ones. It has pioneered in the development of disposable medical products for standardized procedures. Bard's domestic sales may be grouped into three principal product lines: cardiovascular, urological and surgical. International sales include most of the same products manufactured and sold by Bard's domestic operations. Domestic and international sales are combined for product group sales presentation. Cardiovascular - Bard's line of cardiovascular products includes balloon angioplasty catheters, steerable guidewires, guide catheters and inflation devices; angiography catheters and accessories; introducer sheaths; electrophysiology products including cardiac mapping and electrophysiology laboratory systems, and diagnostic and temporary pacing electrode catheters; cardiopulmonary support systems; and blood oxygenators and related products used in open-heart surgery. Urological - Bard offers a complete line of urological products including Foley catheters, procedural kits and trays and related urine monitoring and collection systems; biopsy and other cancer detection products; ureteral stents; and specialty devices for incontinence, ureteroscopic procedures and stone removal. Surgical - Bard's surgical products include specialty access catheters and ports; implantable blood vessel replacements; fabrics and meshes for vessel and hernia repair; surgical suction and irrigation devices; wound and chest drainage systems; devices for endoscopic, orthopaedic and laparoscopic surgery; blood management devices; products for wound management and skin care; and percutaneous feeding devices. International - Bard markets cardiovascular, urological and surgical products throughout the world. Principal markets are Japan, Canada, the United Kingdom and Continental Europe. Approximately two-thirds of the sales in this segment are of I-2 products manufactured by Bard in its facilities in the United Kingdom, Ireland and Malaysia. The balance of the sales are from products manufactured in the United States, Puerto Rico or Mexico, for export. Bard's foreign operations are subject to the usual risks of doing business abroad, including restrictions on currency transfer, exchange fluctuations and possible adverse government regulations. See footnote 10 in the Notes to Consolidated Financial Statements for additional information. Product Recalls - In February 1990 the Mini-Profile and Probe balloon angioplasty catheters were withdrawn from the U.S. market due to claims from the FDA that the Company had failed to follow appropriate legal and regulatory procedures. In March 1990, the Company voluntarily withdrew its Sprint and Solo angioplasty catheters from the U.S. market after an internal investigation revealed the commercial versions had not received proper regulatory approval. These withdrawals, accompanied with the withdrawal in 1989 of the New Probe angioplasty catheter, had effectively withdrawn the Company from the U.S. balloon angioplasty market. In 1991 the Company received approval from the FDA to market the New Probe, Force and Sprint balloon angioplasty catheters in the U.S. During the fourth quarter of 1992 the Solo balloon angioplasty catheter was approved for U.S. marketing. See Item 3. Legal Proceedings for additional information. Competition The Company knows of no published statistics permitting a general industry classification which would be meaningful as applied to the Company's variety of products. However, products sold by the Company are in substantial competition with those of many other firms, including a number of larger well-established companies. The Company depends more on its consistently reliable product quality and dependable service and its ability to develop products to meet market needs than on patent protection, although some of its products are patented or are the subject of patent applications. Marketing The Company's products are distributed domestically directly to hospitals and other institutions as well as through numerous hospital/surgical supply and other medical specialty distributors with whom the Company has distributor agreements. In international markets, products are distributed either directly or through distributors with the practice varying by country. Sales promotion is carried on by full-time representatives of the Company in domestic and international markets. I-3 In 1993 no commercial customer accounted for more than 8% of the Company's sales and the five largest commercial customers combined accounted for approximately 22% of such sales. Combined sales to federal agencies accounted for less than 2% of sales in 1993. In order to service its customers, both in the U.S. and outside the U.S., the Company maintains inventories at distribution facilities in most of its principal marketing areas. Orders are normally shipped within a matter of days after receipt of customer orders, except for items temporarily out of stock, and backlog is normally not significant in the business of the Company. Most of the products sold by the Company, whether manufactured by it or by others, are sold under the BARD trade name or trademark or other trademarks owned by the Company. Such products manufactured for the Company by outside suppliers are produced according to the Company's specifications. Regulation The development, manufacture, sale and distribution of the Company's products are subject to comprehensive government regulation. Government regulation by various federal, state and local agencies, which includes detailed inspection of and controls over research and laboratory procedures, clinical investigations, manufacturing, marketing, sampling, distribution, recordkeeping, storage and disposal practices, substantially increases the time, difficulty, and costs incurred in obtaining and maintaining the approval to market newly developed and existing products. Government regulatory actions can result in the seizure or recall of products, suspension or revocation of the authority necessary for their production and sale, and other civil or criminal sanctions. In the United States comprehensive legislation has been proposed that would make significant changes to the availability, delivery and payment for healthcare products and services. It is the intent of such proposed legislation to provide health and medical insurance for all United States citizens and to reduce the rate of increases in United States healthcare expenditures. The Company believes it is not possible to predict the extent to which the Company or the healthcare industry in general might be affected by the enactment of such or similar legislation. Raw Materials The Company uses a wide variety of readily available plastic, textiles, alloys and rubbers for conversion into its devices. Two large, U.S.-based chemical suppliers have sought to restrict the sale of certain of their materials to the device industry for use in implantable products. Although one guiding principle in the I-4 adoption of this policy is the avoidance of negative economic effect on the health care industry, a small portion of our product lines may face a short-term threat to the continuity of their raw material supply. The companies have indicated that their action is based on product liability concerns. Bard and the medical device industry are working to resolve this problem in general and with these suppliers to assure a continuing supply of necessary raw materials. Environment The Company continues to address current and pending environmental regulations relating to its use of Ethylene Oxide and CFC's for the sterilization of some of its products. The Company is complying with regulations reducing permitted EtO emissions by installing scrubbing equipment and adjusting its processes. The Company recognizes the Montreal Protocol Treaty which plans for the reduction of CFC use worldwide and the Company has established a goal of reducing its own use of CFC's for sterilization more rapidly than is required by this treaty. Facilities, processes and equipment are required to achieve these goals and meet these regulations. The Company has eliminated over 95% of CFC use for sterilization. The Company intends to continue to reduce this use of CFC's faster than treaty goals. Capital expenditures required will not significantly adversely affect the Company's earnings or competitive position. Employees The Company employs approximately 8,450 persons. Seasonality The Company's business is not affected to any material extent by seasonal factors. Research and Development The Company's research and development expenditures amounted to approximately $66,300,000 in 1993, $60,500,000 in 1992 and $55,600,000 in 1991. Item 2.

Item 2. Properties The executive offices of the Company are located in Murray Hill, New Jersey in facilities which the Company owns. Domestic manufacturing and development units are located in California, Georgia, Kansas, Massachusetts, New Hampshire, New Jersey, New York, Ohio, Puerto Rico, Rhode Island, South Carolina, Utah, Washington and Wisconsin. Sales offices and distribution points are in these locations as well as others. I-5 Outside the U.S., the Company has plants or offices in Australia, Belgium, Canada, France, Germany, Hong Kong, Ireland, Italy, Japan, Malaysia, Mexico, Netherlands, Portugal, Singapore, Spain and the United Kingdom. The Company owns approximately 2,267,000 square feet in 21 locations and leases approximately 1,272,000 square feet of space in 61 locations. All these facilities are well maintained and suitable for the operations conducted in them. Item 3.

Item 3. Legal Proceedings On October 14, 1993, the Company entered into a Plea Agreement with the Department of Justice in connection with charges stemming from violations, primarily during the 1980s by the Company's USCI division, of the Federal Food, Drug and Cosmetic Act and other statutes. The Agreement, which is subject to approval by the court, requires the Company to pay a fine and civil damages totaling $61 million, senior management approval of all pre-market applications made by the Company's USCI division to the Food and Drug Administration (the "FDA") for the next four years, oversight of the USCI division by an outside consultant and the hiring of an officer with responsibility for regulatory and medical programs. The Company has also received notice of suspension by the Defense Logistics Agency (DLA) relative to any new federal government contracts. The Company's existing contracts, representing less than 2% of consolidated revenues, will continue to run until their expiration dates. Furthermore, the Company will continue discussions with the DLA to explore a possible resolution of this matter, but these discussions await approval by the court of the Plea Agreement. In January 1994 the Company received notification that the FDA had determined that provisions of the Applications Integrity Policy should be applied to the Company's USCI division. Consequently, the FDA suspended its review of pending pre-market applications that have been submitted by the USCI division. Based upon regulatory compliance audits to be conducted by the Company, the FDA will assess the validity of data and information in USCI's pending pre-market applications. The Company cannot predict how long the FDA's suspension of the USCI division's pre-market applications from review will last or the extent of the impact such suspension could have on USCI's competitive position. The Company is continuing discussions in certain related areas raised by the FDA to finally conclude this matter. As previously discussed, in January 1992 a civil complaint was filed in federal court regarding the Company's efforts to obtain FDA approval for and market an atherectomy device. In July 1992 the federal court dismissed certain provisions of the complaint. In January 1993 the court granted the Company's motion and entered a stay of the case. The court subsequently dissolved its previous I-6 order staying the proceedings in this case, and discovery is now under way. In late 1993 the plaintiffs filed an amended complaint which claims a breach of contract and realleges claims of fraud. The Company has answered the amended complaint and seeks to dismiss the fraud charges. During 1991 the Company settled all previously disclosed shareholder litigation brought against the Company and certain present and former officers and directors in connection with the withdrawal from the U.S. market of certain of the Company's angioplasty catheters. All claims were dismissed without any admission of liability or wrong doing. The settlement involved the payment of approximately $18 million and had no material impact on the 1991 earnings of the Company because it had been previously provided for through established reserves and insurance coverages. In November 1993, a shareholder moved in the Superior Court of New Jersey to set aside the settlement as inadequate based upon the amount which the Company had agreed to pay as a fine and civil damages in the criminal procedures as set forth above. This petition was dismissed and a notice of appeal was filed. The appeal has now been dismissed by the Appellate Division of the Superior Court and the shareholder has 20 days from March 24 to appeal to the N.J. Supreme Court. During 1992 the Company was notified by the United States Environmental Protection Agency that it had been identified as a potentially responsible party in connection with an ongoing investigation of the Solvents Recovery Service of New England site in Southington, Connecticut. Although the full extent of liability in this case is unknown, the Company has been identified with less than one-half percent of the total gallonage of waste materials. The final resolution of this matter is not expected to have a material adverse financial impact on the Company. The Company is also subject to other legal proceedings and claims which arise in the ordinary course of business. Item 4.

Item 4. Results of Votes of Security Holders Not applicable. I-7 Executive Officers of the Registrant Set forth below is the name, age, position, five year business history and other information with respect to each executive officer of the Company as of February 28, 1994. No family relationships exist among the officers of the Company. Name Age Position William H. Longfield 55 President and Chief Operating Officer and Director Benson F. Smith 46 Executive Vice President - Operations William C. Bopp 50 Senior Vice President and Chief Financial Officer Timothy M. Ring 36 Group Vice President Richard J. Thomas 44 Group Vice President William T. Tumber 59 Group Vice President Terence C. Brady, Jr. 62 Senior Vice President and Controller E. Robert Ernest 53 Vice President - Business Development Gerald L. Messerschmidt, M.D. 43 Vice President - Scientific Affairs Richard A. Flink 59 Vice President, General Counsel and Secretary Earle L. Parker 50 Treasurer All officers of the Company are elected annually by the Board of Directors. Mr. Longfield has been delegated the duties and responsibilities of Chairman and Chief Executive Officer by the Board of Directors. I-8 Mr. Longfield joined the Company in 1989 and was elected executive vice president and chief operating officer. In 1991 he was elected to his present position. Prior to joining the Company, he was chief executive officer since 1984 of the Cambridge Group, Inc., a provider of long term health services for the elderly. Prior to joining Cambridge, he was employed by Lifemark, Inc., a health care management company, and for over 20 years with American Hospital Supply Corporation. Mr. Smith joined Bard in 1980. Subsequently he was appointed general manager of Bard Electro Medical Systems, Inc. and in 1986 became vice president and general manager of Bard Home Health division. In 1987, he was promoted to president of Bard Urological division. In 1990, he was appointed to the position of group executive. In 1991, he was elected group vice president. In December 1993, he was elected to the position of executive vice president with worldwide responsibility for operations. Mr. Bopp joined the Company in 1980 as controller of Bard International, Inc., was promoted to assistant corporate controller in 1983 and was elected to the position of treasurer later that year. He was named vice president and treasurer in 1989. In 1992 he was elected to his present position. Mr. Ring joined the Company in 1992 and was elected vice president- human resources. Prior to joining the Company he had been with Abbott Laboratories Inc., a pharmaceutical company, since 1982 and his last position with their Hospital Products division had been director of personnel. In December 1993, he was elected to the position of group vice president. Mr. Thomas joined Bard in 1984. In 1986 he was promoted to vice president and general manager of the Bard Cardiovascular Ventures division. In 1990 he was appointed to the position of group executive. In October 1991, he was elected to his present position. Mr. Tumber joined Bard in 1980. In 1988 he was promoted to vice president and general manager of Davol Inc. In 1990 he was promoted to president of Davol Inc. and subsequently appointed to the position of group executive. In September 1991, he was elected to his present position. Mr. Brady joined the Company in 1969, was elected corporate controller in 1973 and vice president and controller in 1979. He was elected to his present position in 1987. Mr. Ernest joined the Company in 1977 and was elected to his present position in 1979. I-9 Dr. Messerschmidt joined the Company in January 1994 and was elected to his present position. Prior to joining the Company he had been with DNX Corporation, a molecular engineering company, where he was vice president of medical and regulatory affairs. Prior to DNX he held various positions with the Pharmaceuticals Division of Ciba Geigy Corporation, the University of Michigan Medical Center, Wilford Hall U.S.A.F. Medical Center and the National Cancer Institute of the National Institutes of Health. Mr. Flink joined the Company in 1970, was elected vice president and general counsel in 1973 and was elected to his present position in 1985. Mr. Parker joined the Company in 1979. In 1985 he was promoted to vice president and controller of the USCI division. In December 1990 he was promoted to vice president-operations for the USCI division and, later that year, was promoted to vice president and general manager of the USCI Angiography division. In 1992 he was elected to his present position. I-10 PART II Item 5.

Item 5. Market for Registrant's Common Stock and Related Stockholder Matters Market and Market Prices of Common Stock The Company's common stock is traded on the New York Stock Exchange using the symbol: BCR. The following table illustrates the high and low sales prices as traded on the New York Stock Exchange for each quarter during the last two years. Quarters 1st 2nd 3rd 4th Year High 35-1/4 28 27-5/8 26-7/8 35-1/4 Low 22-7/8 21-1/4 20-1/2 21-3/4 20-1/2 High 34 28-5/8 31-1/2 35-7/8 35-7/8 Low 26-1/8 22-1/2 23-3/4 25-1/2 22-1/2 Approximate Number of Equity Security Holders Approximate Number of Record Holders Title of Class as of February 28, 1994 Common Stock - $.25 par value 8,280* *Included in the number of shareholders of record are shares held in "nominee" name. Dividends The Company paid cash dividends of $28,200,000 or $.54 per share in 1993 and $26,500,000 or $.50 per share in 1992. The following table illustrates the quarterly rate of dividends paid per share. Quarters 1st 2nd 3rd 4th Year 1993 $ .13 $ .13 $ .14 $ .14 $ .54 1992 $ .12 $ .12 $ .13 $ .13 $ .50 In January 1994, the first quarter dividend of $.14 per share was declared, indicating an annual rate of $.56 per share. The first quarter dividend was paid on February 4, 1994 to shareholders of record on January 24. II-1 II-2 Item 7.

Item 7. Management's Discussion and Analysis of Results of Operations and of Financial Conditions General Bard is a leading multinational developer, manufacturer and marketer of products for the large and growing health care industry. Worldwide health care expenditures approximated $1.9 trillion in 1993 with about half that amount spent in the United States. Bard's segment of this industry, itself a multi-billion dollar market, is primarily specialized products used primarily in hospitals, in outpatient centers and in physician's offices to meet the needs of the medical profession in caring for their patients. The Company seeks to focus and concentrate on selected markets with cost-effective, innovative products and specialized sales forces to maximize the opportunities in these markets. Operating Results Net sales decreased 2% in 1993, reflecting the sale of the MedSystems division, the impact of foreign currency translations and the dramatic changes in the industry. Net income decreased 25%, reflecting several nonrecurring items, primarily the $61 million pretax provision for the settlement with the Justice Department. 1993 Sales Data Consolidated net sales totaled $970.8 million in 1993, a decrease of $19.4 million or 2% for the year. Sales were lowered a total of 4% by the impact of the sale of the Bard MedSystems division in February 1993 (3%) and the impact of generally lower foreign currency values (1%). Sales in 1993 were also negatively affected by a slowdown in U.S. procedural rates, consolidations of health care providers, limited FDA approvals, increasingly conservative medical practices fostered by the growth of managed care and weaker European economies. Worldwide sales increased 1% in the urological product group. Good increases in several relatively new specialty devices were partially offset by declines in other areas. Sales of surgical products decreased 1% but increased 8% after adjusting for the sale of the MedSystems division. Specialty access, endoscopic, laparo- scopic and blood management products contributed significantly to this increase. Cardiovascular product sales decreased 5% worldwide with most product areas in this group showing declines. Sales in the United States decreased 1% in 1993 to $687.9 million, representing 71% of total sales. Urological product sales increased while sales of surgical products (due to the sale of MedSystems) and cardiovascular products decreased. II-3 Sales outside the U.S. were $282.9 million in 1993, a decline of 3% from 1992 and represented 29% of total sales. Changes in foreign currency values in 1993 lowered these sales by nearly 5%. Growth in sales of surgical products were more than offset by decreases in urological and cardiovascular sales. Sales increases were good in Japan and Germany. The geographic breakdown of sales outside the U.S. for 1993 is: Europe, Middle East, Africa - 56%; Japan, Asia/Pacific - 37% and Western Hemisphere, excluding the United States - 7%. 1992 Sales Data In 1992 consolidated net sales totaled $990.2 million, an increase of $114.2 million or 13% from the prior year. U.S. sales, which were 70% of total consolidated sales, increased 13% while sales outside the U.S. increased 12% for the year. Changes in foreign currency values in 1992 accounted for approximately 2 percentage points of the sales growth outside the U.S. Operating Income Gross profit margins rose in 1993 for the third straight year. The rates were 50.9% in 1993, 48.4% in 1992 and 46.6% in 1991. Productivity gains, cost reductions and a favorable product mix in many product areas contributed to this improvement in the last three years. A pretax charge of $2.6 million for severance costs related to a plant closing is included in 1993 cost of goods sold. Bard uses the LIFO method of valuing substantially all U.S. inventories, which results in current costs (higher in a period of inflation) being charged to cost of goods sold. Bard generally has been able to recover these costs through its strong product position in its markets. The Company also strives to offset the effect of inflation through its cost reduction programs. Marketing, selling and administrative expenses (which exclude research and development) increased $2.9 million in 1993, or less than 1%. R&D expenses increased nearly 10% in 1993 as the Company works toward new technologies and enhancements for the future. Operating income of $128.5 million increased 5.0% in 1993, reflecting the increased gross profit margin and, as a percent of net sales, was 13.2% compared with 12.4% in 1992. Operating income in 1992 increased 31.6% from 1991 due primarily to a higher gross profit margin. II-4 Other Expense, Net The 1993 results included a third quarter pretax provision for the Justice Department settlement of $61 million, a fourth quarter pretax gain of $32.7 million from the sale of shares of the common stock of Ventritex, Inc., and a first quarter pretax gain of $10.9 million from the sale of the MedSystems division net of several nonrecurring charges. The 1992 results included a gain of $5.9 million from the sale of common stock of Ventritex and a comparable amount for provisions for expenses associated with legal and regulatory matters. Income Tax The effective income tax rate was 37.2% in 1993, 29.9% in 1992 and 25.6% in 1991. The increase in 1993 was primarily due to the $61 million Justice Department settlement, which was not fully deductible, and a 1% tax rate increase to 35% effective January 1, 1993. The increase in the 1992 rate was primarily due to a reduction in the portion of Bard's taxable income being generated outside the United States at lower effective tax rates. The tax benefit from operations in Puerto Rico and Ireland favorably affected the tax rate in each year. As a result of the Omnibus Tax Reconciliation Act of 1993, the effective tax rate in 1994 will be affected slightly, primarily due to a reduction in the tax benefit derived from the Company's manufacturing operations in Puerto Rico. Income Net income for 1993 totaled $56 million, or $1.07 per share, which was 25% lower than in 1992. As a percent of sales, net income was 5.8% in 1993 compared with 7.6% in 1992 and 6.5% in 1991. Nonrecurring items that affected net income in 1993 were (in millions): Gain on sale of Ventritex stock $ 19.4 Gain on sale of MedSystems division and other one-time charges 6.0 Severance costs related to plant closing (1.8) Effect of accounting change for postretirement benefits (6.1) Provision for the Justice Department settlement agreement (45.4) Net income effect of nonrecurring items $(27.9) After adjusting for these items, net income would have been higher than reported by $27.9 million, or $.53 per share. In 1992 net income was $1.42 per share, or $75 million in total, which was 31% higher than 1991. II-5 Financial Condition Bard's financial condition remained strong in 1993. Net cash provided by operating activities increased to $124 million in 1993 from $103.6 million in 1992. While the Company had cash outlays totaling $101.4 million for acquisitions of businesses, patents, trademarks and other long-term investments, total debt increased a modest $20 million from $133 million to $153 million in 1993. The ratio of total debt to total capitalization increased from 25.3% to 28.5% with total capitalization increasing $10.7 million to $536.1 million. Long-term debt was essentially unchanged at $68.5 million at the end of 1993, with $60 million of it at a fixed rate of 8.69% until scheduled repayment in September 1999. Bard maintains credit lines with banks for short-term cash needs. These facilities were used as needed during 1993. The current unused lines of credit total $141 million. As now structured, the Company should generate substantially all funds needed for operations and capital expenditures. The Company believes it could borrow adequate funds at competitive terms and rates, should it be necessary, including the payments to the Justice Department required as a result of the plea agreement reached in October 1993. Under the terms of the settlement, $30.5 million is payable 30 days after court approval plus two annual instalments of $15.25 million each. As presented in the Consolidated Statements of Cash Flows on page II-11 of this report, net cash flows from operating activities totaled $124 million in 1993. Net income, depreciation and amortization provided a total of $91.5 million, and included the gain on disposal of assets of $50.4 million. Increases in current liabilities, excluding debt, provided a total of $27 million, including $30.5 million of the $61 million payable under the Justice Department settlement. Other long-term liabilities increased by $46.2 million, of which $30.5 million is the balance of the settlement amount and $10 million is the accumulated postretirement benefit obligation charged to income in the first quarter of 1993. All other operating activities provided $9.7 million net including a total of $12.9 million provided from decreases in accounts receivable and inventories. Investing activities used $67.1 million in 1993. Capital expenditures totaled $30.7 million and proceeds from the sale of assets provided $65 million. $101.4 million was used for the acquisition of businesses, patents, trademarks and other related items, and long-term investments. Financing activities in 1993 used a total of $30.4 million. Common stock purchases used $24.4 million and dividends used $28.2 million. Other financing activities, primarily proceeds from short-term borrowings, provided $22.2 million net. II-6 Total cash flows, including a $1.3 million translation adjustment, resulted in an increase in cash and short-term investments of $25.2 million. As noted, capital expenditures in 1993 were $30.7 million compared with $30 million in the prior year. Expenditures for 1994 are anticipated at $35-$40 million. Research and development spending was $66.3 million in 1993, up 9.6% from 1992. Planned expenditures for 1994 are about $80 million, a 20% increase. Purchases of Bard common stock by the Company totaled (in millions) $24.4, $14.0 and $6.4 in 1993, 1992 and 1991, respectively. In January 1993 the Board of Directors authorized the purchase from time to time of up to 2 million shares of which 1 million were purchased in 1993. The Board of Directors declared dividends of 13 cents per share for the first two quarters of 1993 and in July 1993 increased the dividend to 14 cents per share. At February 1994 the indicated annual dividend rate is 56 cents per share. Dividends for 1993 of 54 cents per share were up from 50 cents per share paid in 1992. Legal Proceedings For a discussion of pending legal proceedings and related matters, please see Note 5, Commitments and Contingencies, of the Notes to Consolidated Financial Statements on page II-16. Acquisitions and Dispositions In 1993 the Company acquired the operations of Solco Hospital Products Group, Inc., Pilot Cardiovascular Systems, Inc. and Bainbridge Sciences, Inc. in separate transactions for a total of $70 million. The Bard MedSystems division was sold in 1993 with a pretax gain of $15.9 million. The 1993 acquisitions, and several other investments and acquisitions in 1993, 1992 and 1991 were not significant to the Company's operations as a whole. II-7 Item 8.

Item 8. Financial Statements and Supplementary Data Report of Independent Public Accountants To the Shareholders and Board of Directors of C. R. Bard, Inc.: We have audited the accompanying consolidated balance sheets of C. R. Bard, Inc. (a New Jersey corporation) and subsidiaries as of December 31, 1993 and 1992 and the related consolidated statements of income, retained earnings and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of C. R. Bard, Inc. and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993 in conformity with generally accepted accounting principles. As discussed in Note 8 to the consolidated financial statements, effective January 1, 1993 the Company changed its method of accounting for postretirement benefits other than pensions. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in Item 14(a) 2 are presented for purposes of complying with the Securities and Exchange Commission's rules and are not part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Roseland, New Jersey February 9, 1994 II-8 C. R. BARD, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Significant Accounting Policies Consolidation All subsidiaries are consolidated and intercompany transactions have been eliminated. Income Per Share The computations of income per share are based on the weighted average number of shares outstanding: 52,196,645 in 1993, 52,909,360 in 1992 and 53,062,933 in 1991. The effect of outstanding stock options and stock awards is not material and has been excluded from the computations. Inventories Inventories are stated at the lower of cost or market. Substantially all domestic inventories are accounted for using the LIFO method of determining costs. All other inventories are accounted for using the FIFO method. Inventories valued under the LIFO method were $127,000,000 in 1993, $127,000,000 in 1992 and $116,000,000 in 1991; under the FIFO method such inventories would have been higher by $15,800,000, $13,000,000 and $16,400,000, respectively. Inventories were approximately 58% and 60% finished goods at year end 1993 and 1992, 30% and 27% work in process at year end 1993 and 1992, and 12% and 13% raw materials at year end 1993 and 1992. Depreciation Property, plant and equipment are depreciated on a straight-line basis over the useful lives of the various classes of assets. Investments Long-term investments include long-term bonds and equity securities accounted for on the cost basis. The fair value of such investments, determined primarily by market quotes, approximated their carrying value at December 31, 1993 and was approximately $46,000,000 at December 31, 1992. For purposes of the Consolidated Statements of Cash Flows all short-term investments which have a maturity of ninety days or less are considered cash equivalents. Such investments are stated at cost which approximates their fair value. Intangible Assets Intangible assets are recorded at cost and are amortized using the straight-line method over appropriate periods not exceeding 40 years. As of December 31, 1993 and 1992, intangible assets include the following: (Thousands of dollars) 1993 1992 Goodwill net of amortization $ 76,500 $ 51,600 Other intangibles (primarily patents) 72,600 26,900 Intangible assets, net $149,100 $ 78,500 II-12 C. R. BARD, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Federal Income Taxes The Company has not provided for Federal income taxes on the undistributed earnings of its foreign operations (primarily in Ireland) as it is the Company's intention to permanently reinvest undistributed earnings (approximately $177,000,000 as of December 31, 1993). Effective January 1, 1993 the Company adopted Statement of Financial Accounting Standards (SFAS) No. 109, "Accounting for Income Taxes." This statement did not have a significant effect on the Company's financial position or results of operations. Translation of Foreign Currencies Annual foreign currency translation adjustments are included in retained earnings. As of December 31, 1993 the cumulative adjustment has decreased retained earnings by $11,100,000. Research and Development Research and development costs are charged to operations as incurred. New Accounting Pronouncements Effective January 1, 1994, the Company is required to adopt SFAS No. 112 "Employers' Accounting for Postemployment Benefits" and SFAS No. 115 "Accounting for Certain Investments in Debt and Equity Securities." Adoption of these statements will not have a significant effect on the Company's financial position or results of operations. 2. Acquisitions and Dispositions In 1993, the Company acquired three separate businesses for approximately $70,000,000 which served to enhance or expand upon the Company's existing product lines. Assets acquired in these acquisitions were primarily patents and other intangibles. These acquisitions together with several other minor investments made during 1992 and 1991 did not have a significant effect on the Company's results of operations. The Company sold its MedSystems division in 1993 resulting in a pretax gain of approximately $15,900,000 which is recorded in other expense, net, in the statement of consolidated income. In the fourth quarter of 1993 and 1992, the Company sold certain long-term investments resulting in pretax gains of approximately $32,700,000 and $5,900,000, respectively which are recorded in other expense, net, in the statements of consolidated income. II-13 C. R. BARD, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 3. Income Tax Expense Income tax expense consists of the following: (Thousands of dollars) 1993 1992 1991 Currently payable: Federal $31,900 $20,300 $ 4,100 Foreign 8,100 9,500 11,100 State 3,900 4,100 2,600 43,900 33,900 17,800 Deferred: Federal (6,600) (1,700) 2,900 Foreign (500) (200) (1,000) (7,100) (1,900) 1,900 $36,800 $32,000 $19,700 During 1993, the Company adopted SFAS No. 109 "Accounting for Income Taxes." The cumulative effect of the change was not significant to the Company's results of operations and the Company has not restated prior periods. The standard requires a change from the deferred to the liability method of computing deferred income taxes. Deferred income taxes are recognized for tax consequences of "temporary differences" by applying enacted statutory tax rates, applicable to future years, to differences between the financial reporting and the tax basis of assets and liabilities. At December 31, 1993, the Company's net deferred tax asset amounted to approximately $8,000,000 which is recorded in other assets. This amount is principally composed of differences between tax and financial accounting treatment of depreciation ($7,000,000) and employee benefits ($15,000,000). The following is a reconciliation between the effective tax rates and the statutory rates: 1993 1992 1991 Tax based on statutory rate 35% 34% 34% State income taxes net of Federal income tax benefits 3 2 2 Operations taxed at less than statutory rate, primarily Ireland and Puerto Rico (11) (10) (9) Justice Department settlement 7 -- -- Other, net 3 4 (1) Effective tax rate 37% 30% 26% Cash payments for income taxes were $31,400,000, $28,600,000 and $17,500,000 in 1993, 1992 and 1991, respectively. II-14 C. R. BARD, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 4. Short-Term Borrowings and Long-Term Debt Short-term bank borrowings amounted to $84,400,000 and $64,000,000 at December 31, 1993 and 1992, respectively. The maximum amount outstanding during 1993 was approximately $110,500,000 with an average outstanding balance of $80,100,000 and an effective interest rate of 3.7%. The maximum amount outstanding during 1992 was approximately $84,900,000 with an average outstanding balance of $75,100,000 and an effective interest rate of 5.1%. The maximum outstanding during 1991 was approximately $82,000,000 with an average outstanding balance of $72,300,000 and an effective interest rate of 7.8%. Unused lines of credit amounted to $141,000,000 at December 31, 1993. The following is a summary of long-term debt: (Thousands of dollars) 1993 1992 8.69% Unsecured Notes due 1999 $ 60,000 $ 60,000 Other, primarily 5.75% to 11.75% industrial development revenue bonds 8,600 9,000 68,600 69,000 Less: amounts classified as current 100 400 $ 68,500 $ 68,600 Under three deposit loan agreements with a bank, $55,000,000 has been borrowed at floating rates (4.0% at December 31, 1993) with maturity dates of September 1996, December 1999 and December 2002. At maturity, the loans are to be repaid through matured certificates of deposit held by the Company at the same bank. Since the Company has the right of offset under these agreements and it is the Company's intention to present certain certificates of deposit for repayment of these loans at their maturity, these borrowings have been offset against these certificates of deposit in the accompanying consolidated balance sheets at December 31, 1993 and 1992. The related interest income has been offset against the interest expense. The Company's long-term debt agreements contain restrictions which, among other things, require the maintenance of minimum net worth levels and limitations on the amounts of debt. The aggregate maturities of long-term debt for the five year period from 1994 through 1998 are approximately $200,000 in total and from 1999 and thereafter - $68,400,000. The fair value of the Company's long-term debt is not significantly different from its recorded value. II-15 C. R. BARD, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 5. Commitments and Contingencies On October 14, 1993, the Company entered into a Plea Agreement with the Department of Justice in connection with charges stemming from violations, primarily during the 1980s by the Company's USCI division, of the Federal Food, Drug and Cosmetic Act and other statutes. The Agreement, which is subject to approval by the court, requires the Company to pay a fine and civil damages totaling $61 million. In accordance with the terms of the Agreement, a provision has been made for this amount in the quarter ended September 30, 1993, with one-half of the amount reflected as a short-term obligation in accrued expenses and the balance reflected in other long-term liabilities. The Company has also received notice of suspension by the Defense Logistics Agency (DLA) relative to any new Federal Government contracts. The Company's existing contracts, representing less than 2% of consolidated revenues, will continue to run until their expiration dates. Furthermore, the Company is continuing discussions with the DLA to explore a possible resolution of this matter. In January 1994, the Company received notification that the Food and Drug Administration (FDA) had determined that provisions of the Applications Integrity Policy should be applied to the Company's USCI division. Consequently, the FDA suspended its review of pending pre-market applications that have been submitted by the USCI division. Based upon regulatory compliance audits to be conducted by the Company, the FDA will assess the validity of data and information in USCI's pending pre-market applications. The Company is continuing discussions in certain related areas raised by the FDA to finally conclude this matter. As previously discussed, in January 1992, a civil complaint was filed in federal court regarding the Company's efforts to obtain FDA approval for and market an atherectomy device. In July 1992, the federal court dismissed certain provisions of the complaint. In January 1993, the court granted the Company's motion and entered a stay of the case. The court subsequently dissolved its previous order staying the proceedings in this case, and discovery is now under way. In late 1993, the plaintiffs filed an amended complaint which claims a breach of contract and realleges claims of fraud. The Company has answered the amended complaint and seeks to dismiss the fraud charges. During 1991 the Company settled all previously disclosed shareholder litigation brought against the Company and certain present and former officers and directors in connection with the withdrawal from the U.S. market of certain of the Company's angioplasty catheters. All claims were dismissed without any II-16 C. R. BARD, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 5. Commitments and Contingencies (continued) admission of liability or wrong doing. The settlement involved the payment of approximately $18 million and had no material impact on the 1991 earnings of the Company because it had been previously provided for through established reserves and insurance coverages. The Company is also subject to other legal proceedings and claims which arise in the ordinary course of business. The Company believes that the pending legal proceedings and other matters discussed in this Note will likely be disposed of over an extended period of time and should not have a material adverse impact on the Company's financial position or results of operations. The Company is committed under noncancelable operating leases involving certain facilities and equipment. The minimum annual rentals under the terms of these leases are as follows: 1994 - $18,300,000; 1995 - $12,400,000; 1996 - $8,300,000; 1997 - $4,100,000; 1998 - $2,800,000; and thereafter - $2,600,000. Total rental expense for all leases amounted to $26,500,000 in 1993, $26,600,000 in 1992 and $27,500,000 in 1991. 6. Stock Rights In 1985 the Board of Directors declared a dividend distribution of one Common Share Purchase Right for each outstanding share of Bard common stock. These Rights will expire in October 1995 and trade with the common stock. They are not presently exercisable and have no voting power. In the event a person acquires 20% or more, or makes a tender or exchange offer for 30% or more of the common stock, the Rights detach from the common stock and become exercisable and entitle a holder to buy one share of common stock at $31.25 (adjustable to prevent dilution). If, after the Rights become exercisable, Bard is acquired or merged, each Right will entitle its holder to purchase $62.50 market value of the surviving company's stock for $31.25, based upon the current exercise price of the Rights. The Company may redeem the Rights, at its option, at $.025 per Right, prior to a public announcement that any person has acquired beneficial ownership of at least 20% of the common stock. These Rights are designed primarily to encourage anyone interested in acquiring Bard to negotiate with the Board of Directors. 7. Shareholders' Investment The Company has stock option, stock award and restricted stock plans under which certain directors, officers and employees are participants. At December 31, 1993, 1,938,498 shares were reserved for future issuance under these plans. II-17 C. R. BARD, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 7. Shareholders' Investment (continued) Under the Company's stock option plans, options have been granted to certain directors, officers and employees at prices equal to the market value of the shares at the date of grant, become exercisable in four annual instalments and expire not more than 10 years after the date of grant. A summary of option transactions during 1993 follows: Number Option Of Price Shares Per Share* Options outstanding, January 1 2,291,169 $20.60 Granted 558,822 26.70 Exercised (187,291) 15.98 Canceled (75,508) --- Options outstanding, December 31 2,587,192 $22.22 (1,442,773 currently exercisable) * Weighted average price Under the Company's stock award plans for key employees and directors, shares are granted at no cost to the recipients and distributed in three separate instalments. During 1993, awards for 37,860 shares (net of cancelations) were granted and 37,685 shares were issued. Awards are charged to income over the vesting period. At December 31, 1993, 43,205 awarded shares (aggregate market price at date of grant $1,142,000) have not been issued. Under the Company's restricted stock plan that was established in 1993, common stock may be granted at no cost to certain officers and key employees. Shares are issued to the participants at the date of grant entitling the participants to cash dividends and the right to vote their respective shares. Restrictions limit the sale or transfer of these shares during a five year period from the grant date. Upon issuance of stock under the plan, unearned compensation equivalent to the market value of the stock at the date of grant is reflected as a reduction in retained earnings and subsequently amortized to expense over the five year restriction period. During 1993, 60,720 restricted shares were granted, net of forfeitures. Additions to capital in excess of par value of $4,800,000 in 1993 and $2,300,000 in 1992 represents the cost of shares issued under these plans in excess of the related par value of the shares. II-18 C. R. BARD, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 7. Shareholders' Investment (continued) For shares purchased by the Company, common stock is charged for the par value of the shares retired and retained earnings is charged for the excess of the cost over the par value of shares retired. 8. Postretirement Benefits The Company has defined benefit pension plans which cover substantially all domestic and certain foreign employees and its policy is to fund accrued pension expense for these plans up to the full funding limitations. These plans provide for benefits based upon individual participants' compensation and years of service. The Company also has a supplemental defined contribution plan for certain officers and key employees. Individual participant accounts under the supplemental plan are credited annually based upon a percentage of compensation. The amounts charged to income for these plans amounted to $7,800,000 in 1993, $5,400,000 in 1992 and $5,000,000 in 1991. The following table sets forth the funded status of the defined benefit pension plans as of September 30, 1993 and 1992 and amounts recognized in the Company's consolidated balance sheets at December 31, 1993 and 1992: (Thousands of dollars) 1993 1992 Actuarial present value of accumulated benefit obligation, including vested benefits of $67,700 in 1993 and $53,300 in 1992 $ 76,300 $ 60,800 Plan assets at fair value, primarily investment securities $ 71,900 $ 63,500 Less: Actuarial present value of projected benefit obligation for service rendered to date 95,400 71,400 Projected benefit obligation in excess of plan assets (23,500) (7,900) Unrecognized (gain) loss 14,400 (500) Unrecognized prior service cost 7,200 7,700 Unrecognized net asset at transition amortized over 12 years (6,400) (7,700) Accrued pension cost included in other liabilities $ (8,300) $ (8,400) II-19 C. R. BARD, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 8. Postretirement Benefits (continued) Pension costs related to the defined benefit pension plans for the years ended December 31, 1993, 1992 and 1991 are as follows: (Thousands of dollars) 1993 1992 1991 Net pension cost includes: Service cost $ 6,300 $ 5,400 $ 4,600 Interest cost 5,800 4,700 4,400 Actual return on assets - (gain) loss (8,200) (3,900) (11,200) Net amortization and deferral 2,100 (2,300) 5,300 Net pension cost $ 6,000 $ 3,900 $ 3,100 The average discount rate used was 7% in 1993 and 8% in 1992. The decrease in the discount rate used between years is the primary factor for the increase in the Plans' projected benefit obligation and the unrecognized loss at December 31, 1993. The rate of increase in future salary levels ranged from 4% to 7% in determining the projected benefit obligation. The expected long-term rate of return on assets used in determining net pension cost ranged from 8.5% to 9.5%. The Company also provides postretirement health care benefits and life insurance coverage to a limited number of employees at a subsidiary. The health care benefits include cost-sharing features based on years of service for future retirees. Effective January 1, 1993, the Company adopted the provisions of SFAS No. 106 "Employers' Accounting for Postretirement Benefits Other Than Pensions." SFAS 106 requires the Company to recognize expense as employees earn postretirement benefits, rather than on the cash basis as paid. The Company elected to recognize the accumulated postretirement benefit obligation as a cumulative catch-up adjustment in the first quarter of 1993. This resulted in a one-time charge of approximately $10,000,000 pretax or $6,100,000 net of taxes. Postretirement benefit expense for 1993, exclusive of the accumulated postretirement benefit obligation, amounted to $850,000 which is composed of $100,000 of service cost and $750,000 of interest cost. II-20 C. R. BARD, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 8. Postretirement Benefits (continued) Actuarial assumptions included a discount rate of 7%. Health care cost trends have been projected at annual rates beginning at 13% for 1994 decreasing gradually down to 6% in 2001 and later years. The effect of a 1% annual increase in these assumed cost trend rates would increase the accumulated postretirement benefit obligation at December 31, 1993 by $1,000,000 and postretirement benefit cost by $100,000. 9. Supplementary Income Statement Information Royalty expense amounted to $8,600,000 in 1993, $10,200,000 in 1992 and $7,500,000 in 1991. Interest income amounted to $4,600,000 in 1993, $3,900,000 in 1992 and $3,300,000 in 1991. II-21 C. R. BARD, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 10. Segment Information The Company is engaged in the design, manufacture, packaging, distribution and sale of medical, surgical, diagnostic and patient care devices. Hospitals, physicians and nursing homes purchase approximately 90% of the Company's products, most of which are used once and discarded. Information pertaining to domestic and foreign operations as of December 31, 1993, 1992 and 1991 and for the years then ended is given below. Item 9.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Not applicable. II-23 C. R. BARD, INC. AND SUBSIDIARIES PART III Item 10.

Item 10. Directors and Executive Officers of the Registrant Directors of the Registrant Information with respect to Directors of the Company is incorporated herein by reference to the material contained under the heading "Proposal No. 1 - Election of Directors" appearing on pages 1 through 3 of the Company's definitive Proxy Statement dated March 10, 1994. Executive Officers of the Registrant Information with respect to Executive Officers of the Registrant are on pages I-8 through I-10 of this filing. Item 11.

Item 11. Executive Compensation The information contained under the caption "Executive Compensation" appearing on Pages 5 through 14 of the Company's definitive Proxy Statement dated March 10, 1994 is incorporated herein by reference. Item 12.

Item 12. Security Ownership of Certain Beneficial Owners and Management The information contained under the caption "Securities Ownership of Management" on pages 3 and 4 of the Company's definitive Proxy Statement dated March 10, 1994 is incorporated herein by reference. Item 13.

Item 13. Certain Relationships and Related Transactions The information contained under the caption "Compensation Committee Interlocks and Insider Participation" on page 11 of the Company's definitive Proxy Statement dated March 10, 1994 is incorporated herein by reference. III-1 C. R. BARD, INC. AND SUBSIDIARIES PART IV Item 14.

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) l. Financial Statements and Supplementary Data Included in Part II Item 8 of this report: Page II- 8 Report of Independent Public Accountants. II- 9 Statements of Consolidated Income and Statements of Consolidated Retained Earnings for the three years ended December 31, 1993. II-10 Consolidated Balance Sheets at December 31, 1993 and 1992. II-11 Consolidated Statements of Cash Flows for the three years ended December 31, 1993. II-12 Notes to Consolidated Financial Statements. II-23 Quarterly Financial Data. 2. Financial Statement Schedules Included in Part IV of this report: Page IV-5 Schedule I - Marketable Securities IV-6 Schedule V - Property, Plant and Equipment IV-7 Schedule VI - Accumulated Depreciation and Amortization - Property, Plant and Equipment IV-8 Schedule VIII - Valuation and Qualifying Accounts Schedules other than those listed above are omitted because they are not applicable or are not required or the information required is included in the financial statements or notes thereto. 3. Exhibits, No. 3a Registrant's Restated Certificate of Incorporation, as amended, as of April 19, 1989. (p. IV-11). IV-1 C. R. BARD, INC. AND SUBSIDIARIES 3. Exhibits, No. (Continued) 3b Registrant's Bylaws revised as of April 18, 1990. (p. IV-23). 4 Rights Agreement dated as of October 9, 1985 between C. R. Bard, Inc. and Morgan Guaranty Trust Company of New York as Rights Agent. (p. IV-48) 10 Plea Agreement with attachments and Civil Settlement Agreement between United States of America and C. R. Bard, Inc. dated October 14, 1993, filed as Exhibit 10 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993, File No. 1-6926 is incorporated herein by reference. 10a* George T. Maloney Severance Agreement dated as of August 18, 1981. (p. IV-105) 10b* William H. Longfield Severance Agreement dated as of July 12, 1989. (p. IV-112) 10c* William C. Bopp Severance Agreement dated as of January 14, 1991. (p. IV-139) 10d* Terence C. Brady, Jr. Severance Agreement dated as of February 22, 1988. (p. IV-166) 10e* Richard A. Flink Severance Agreement dated as of February 22, 1988. (p. IV-193) 10f* E. Robert Ernest Severance Agreement dated as of January 21, 1991. (p. IV-220) 10g* William H. Longfield Supplemental Executive Retirement Agreement dated as of January 12, 1994. (p. IV-258) 10h* 1990 Stock Option Plan. (p. IV-258) 10i* 1989 Employee Stock Appreciation Rights Plan. (p. IV-265) 10j* C. R. Bard, Inc. Agreement and Plans Trust. (p. IV-272) IV-2 C. R. BARD, INC. AND SUBSIDIARIES 3. Exhibits, No. (Continued) 10k* Supplemental Insurance/Retirement Plan, Plan I - For new corporate officer when previous agreement as non- officer exists, Plan II - For new corporate officer when no previous agreement exists. (p. IV-290) 10l* Retirement Plan for Outside Directors of C. R. Bard, Inc. (p. IV-309) 10m* Deferred Compensation Contract Deferral of Directors' Fees, as amended entered into with directors William T. Butler, M.D., Regina E. Herzlinger, and Robert P. Luciano. (p. IV-319) 10n* 1988 Directors Stock Award Plan, as amended in October 1991. (p. IV-361) 10o* Excess Benefit Plan. (p. IV-364) 10p* Supplemental Executive Retirement Plan. (p. IV-370) 10q* 1993 Executive Bonus Plan. (p. IV-380) 10r* Long Term Performance Incentive Plan. (p. IV-383) 10s* Deferred Compensation Contract Deferral of Discretionary Bonus. (p. IV-389). 10t* Deferred Compensation Contract Deferral of Salary. (p. IV-396) 10u* 1993 Long Term Incentive Plan. (p. IV-403) 21 Parents and subsidiaries of registrant. (p. IV-415) 23 Arthur Andersen & Co. consent to the incorporation by reference of their report on Form 10-K as amended into previously filed Forms S-8. (p. IV-416) 99 Indemnity agreement between the Company and each of its directors and officers. (p. IV-417) * Each of these exhibits listed under the number 10 constitutes a management contract or a compensatory plan or arrangement. All other exhibits are not applicable. IV-3 C. R. BARD, INC. AND SUBSIDIARIES (b) Reports on Form 8-K Registrant filed a Current Report on Form 8-K dated October 8, 1993 with respect to confirming Company discussions with the Department of Justice concerning a possible disposition of the subject matter of the Boston Federal grand jury investigation into its angioplasty operations. Registrant filed a Current Report on Form 8-K dated October 15, 1993 announcing it had entered into a plea agreement in connection with charges stemming from violations of the Federal Food, Drug and Cosmetic Act. Registrant filed a Current Report on Form 8-K dated October 18, 1993 disclosing the financial impact of the Justice Department settlement on the third quarter earnings. Registrant filed a Current Report on Form 8-K dated November 15, 1993 announcing the Company's decision to close its Fitzwilliam, New Hampshire facility. IV-4 C. R. BARD, INC. AND SUBSIDIARIES Signatures Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. C. R. BARD, INC. (Registrant) By: William C. Bopp /s/ William C. Bopp Senior Vice President and Chief Financial Officer Date: March 28, 1994 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signatures Title Date William H. Longfield /s/ President and March 28, 1994 William H. Longfield Chief Operating Officer and Director (Principal Executive Officer) William C. Bopp /s/ Senior Vice President March 28, 1994 William C. Bopp and Chief Financial Officer (Principal Financial Officer) Terence C. Brady, Jr. /s/ Senior Vice President March 28, 1994 Terence C. Brady, Jr. and Controller (Principal Accounting Officer) IV-9 C. R. BARD, INC. AND SUBSIDIARIES Signatures Title Date Joseph F. Abely, Jr. /s/ Director March 28, 1994 Joseph F. Abely, Jr. William T. Butler, M.D. /s/ Director March 28, 1994 William T. Butler, M.D. Raymond B. Carey, Jr. /s/ Director March 28, 1994 Raymond B. Carey, Jr. Daniel A. Cronin, Jr. /s/ Director March 17, 1994 Daniel A. Cronin, Jr. Regina E. Herzlinger /s/ Director March 28, 1994 Regina E. Herzlinger Robert P. Luciano /s/ Director March 18, 1994 Robert P. Luciano Robert H. McCaffrey /s/ Director March 28, 1994 Robert H. McCaffrey Ralph H. O'Brien /s/ Director March 28, 1994 Ralph H. O'Brien IV-10

860713_1993.txt

860713

1993

ITEM 1. BUSINESS General Snyder Oil Corporation (the "Company") is engaged in the development and acquisition of oil and gas properties primarily in the Rocky Mountain region of the United States. In addition, the Company gathers, transports, processes and markets natural gas generally in proximity to its principal producing properties. In 1992, an international exploration and development program was initiated. At December 31, 1993, the Company's net proved reserves totalled 103.6 million barrels of oil equivalents ("BOE"), having a pretax present value at constant prices of $390.4 million. The Company's properties are located in 15 states and the Gulf of Mexico and include 5,122 gross (2,187 net) producing wells and nine gas transportation and processing facilities. At December 31, 1993, the Company held undeveloped acreage totalling 539,000 gross (326,000 net) domestic acres and 4.3 million gross (3.3 million net) international acres. Approximately 90% of the present value of proved reserves is concentrated in five major producing areas located in Colorado, Wyoming and Texas. The Company operates more than 2,100 wells which account for more than 90% of its developed reserves. Headquartered in Fort Worth, Texas, the Company maintains administrative offices in Denver and New York and has eight field offices in Colorado, Wyoming, Texas, New Mexico and Nebraska. At yearend 1993, the Company had 327 employees. Between 1983 and 1990, the Company grew rapidly through a series of acquisitions. The strategy was to accumulate a critical mass of assets during a period of industry distress. This phase of the Company's growth culminated in 1990 with the acquisition of a publicly traded limited partnership formed by the Company in 1983. This transaction added 35.9 million BOE of proved reserves. Since then, the Company has pursued a balanced strategy of development drilling and acquisitions, focusing on operating efficiency and enhanced profitability through the concentration of assets in selected geographic areas or "hubs." During this eleven-year period, revenues rose from $2.5 million to $229.9 million, net income increased from $.3 million to $25.7 million and cash flow grew from $1.1 million to $84.1 million. Development drilling in the Rockies is currently the primary emphasis of the Company's growth strategy. In its largest area of operations, the Wattenberg Field in the Denver-Julesburg Basin ("DJ Basin") of Colorado, the Company drilled over 300 wells in 1993. That brought the total number of producing wells there to over 1,400. Aggressive cost cutting, the creative application of technology and the advantages of expanding gas facilities in the area have, together with acquisitions, leasing and a joint venture with Union Pacific Resources Company ("UPRC"), brought the inventory of potential drilling locations in the Basin to over 6,000. The Company expects that more than half of these locations will ultimately prove attractive to develop. The Company expects to drill approximately 500 Wattenberg wells in 1994 and to maintain that pace for the next several years. The Company has embarked on a program to apply the experience gained in Wattenberg to other large scale gas development projects in the Rockies. By the end of 1993, the Company had established two such projects. In the East Washakie Project, which builds on existing gas properties and facilities in southern Wyoming, the Company holds approximately 1,200 potential drilling locations. The Western Slope Project covers portions of the Piceance Basin of Colorado and the Uinta Basin in northeastern Utah where the Company controls approximately 1,000 drilling locations. Each of these projects are expected to become significant development drilling projects over the next few years. During 1993, the Company made substantial progress in building its international exploration and development effort. The international effort is expected to eventually provide significant growth potential for the Company. The Company's Russian venture received government approval and is expected to commence operations in the first half of 1994. A production sharing agreement covering 2.8 million gross acres was signed with the government of Mongolia and the seismic program on the Tunisian concession was completed. The Company also acquired a significant interest in a publicly traded Australian company whose international exploration experience should complement the Company's development and acquisition expertise. During 1994, the Company intends to continue to emphasize development drilling. The drilling will continue to be focused in the DJ Basin along with increasing activity in the East Washakie and the Western Slope projects. It is expected that the continuing aggressive use of technology and cost saving techniques along with the capture of downstream margins via the Company's gas facilities will steadily improve the economics of existing properties and open new areas of opportunities. Acquisitions will continue to be used to strengthen the existing asset base and secure footholds in new areas. Finally, the effort to bring a variety of international projects to fruition will continue. Development General. Since 1990, development drilling has become the primary focus of the Company's growth strategy. The Company believes that its existing properties have extensive development drilling and enhancement potential, primarily in the DJ Basin of Colorado, the Washakie Basin in southern Wyoming, the Piceance and Uinta Basins in western Colorado and Utah and in the Giddings Field in southern Texas. The Company designs its major drilling programs to assure low risk, synergies with its gas management operations and the potential for continuous cost improvement. Flexibility is crucial as changing product prices and drilling results affect economics. The Company expects to continue to drill approximately 500 wells per year in the Wattenberg Field, where the size of its operations enables it to continue to refine the application of new drilling, completion and operating techniques, and to apply the experience gained there to establish other large scale development projects in the Rockies. Assuming no material changes in product prices and capital availability, the Company estimates that it will expend from $150 to $200 million per year on development activities over the next three to five years. Development expenditures totalled $53.7 million in 1992 and $90.2 million in 1993, primarily in the Wattenberg Field. DJ Basin Wattenberg Field. The Wattenberg Field is the Company's largest base of operations, representing over 60% of total proved reserves. Between 1991 and 1993, the Company drilled a total of 667 wells in Wattenberg, of which 323 were drilled during 1993. At yearend, the Company had interests in more than 1,400 producing wells, of which over 1,100 were operated. Through complementary acquisitions, an extensive leasing program and a major joint venture with UPRC, the inventory of potential Wattenberg drilling locations currently exceeds 6,000 sites. The Company expects that over half of these sites will ultimately prove attractive to develop. The Company expects to drill approximately 500 wells per year in the Wattenberg Field for the foreseeable future. At yearend 1993, the net proved reserves attributed to the Wattenberg properties were 16.9 million barrels of oil and 229.9 Bcf of gas. The reserves were attributable to 1,437 producing wells, 51 wells in progress, 1,102 proved undeveloped locations and approximately 387 proved behind pipe zones. The Company expects proved reserves to be assigned to other locations as drilling progresses. The Company acquired its first properties in Wattenberg during 1986. In 1990, it substantially increased its acreage position by acquiring rights to the Codell and Niobrara formations underlying 32,985 net acres from Amoco Production Company ("Amoco") for $14.4 million. Several farm-ins from Amoco in 1992, financed primarily through a transfer of Section 29 tax credits, resulted in earning additional Codell/Niobrara rights as well as rights to the Sussex, J- Sand and Dakota formations in a number of locations. During 1993, a series of purchases added nearly 9 million BOE at a net cost of under $3.50 per barrel as well as several pipeline and processing facilities that complement existing facilities. In the largest of these acquisitions, the Company paid $19.7 million and, after an exchange of interests with a third party, acquired an approximate 80% working interest in 153 producing wells and 284 undeveloped locations having total proved reserves estimated to exceed 7 million BOE. A portion of the value of the transaction lay in the large volume of undedicated gas located in close proximity to the Company's gas lines. In early 1994, the Company finalized an agreement with UPRC under which the Company has the right for up to six years to drill wells on locations of its choosing on UPRC's previously uncommitted undeveloped acreage throughout the Wattenberg area. This transaction substantially increased Wattenberg's undeveloped acreage inventory. Many of the locations have the potential for improved economics through completion in one or more of the Shannon, Sussex, J-Sand or Dakota formations, as well as the Codell and Niobrara. During the venture's initial three-year term, the Company is required to drill a minimum of 120, 120 and 60 wells per year. After the initial period, the Company can, at its option, extend the venture annually for up to three additional years by drilling at least 150 wells per year. There is no limit on the maximum number of wells that can be drilled, and wells in excess of the required minimum in any year will reduce the number of wells required in the following year by up to 50%. If the Company drills less than the minimum number of wells, it is required to pay UPRC $20,000 per well for the shortfall. On each well that is drilled on UPRC's mineral acreage under the venture, UPRC retains a 15% mineral owner royalty and has the option either to receive an additional 10% royalty interest after pay-out or to participate in the well as a 50% working interest owner. On leasehold acreage, UPRC does not have the right to participate in the well but will retain a royalty interest that will result in a total royalty burden of 25%. As compensation for committing its acreage position to the Company, UPRC was granted warrants to purchase two million shares of the Company's common stock at a premium to market value. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Development, Acquisition and Exploration." Drilling. The Company began drilling operations in Wattenberg in early 1991. From 1991 to December 1993, the Company expended $149.7 million to drill 667 wells, of which 323 were drilled in 1993. At yearend, 609 of these wells were producing, 51 were in various stages of drilling and completion and seven were dry holes. The size of the Wattenberg drilling program has resulted in numerous advantages. The Company acts as operator on all its development sites in the Wattenberg Field and much of the acreage is held by production. As a result, the Company has significant operational control over the timing of the development program. The actual drilling locations and schedule are selected to minimize costs associated with rig moves, surface facilities, location preparation and gathering system and pipeline connections and to evaluate and quantify incremental reserve potential across the acreage position. The Company's success in continuing to reduce its costs of drilling and operations, as well as applying new technology, will be important to the full development of its undeveloped acreage in Wattenberg. The Company has selected procedures for drilling and completing wells that it believes maximize recoverable reserves and economics. The Company has also been able to reduce its costs of drilling, completing and operating wells significantly by negotiating favorable prices with suppliers of drilling and completion services because of the size of its drilling program. These cost reductions allow the Company to earn an attractive rate of return even on lower reserve wells. The reductions have been achieved by several methods. One of the most significant is the formation of alliances with selected vendors who work with Company personnel to improve coordination and reduce both parties' costs. The resultant reductions are credited wholly or in large part to the Company while vendors' margins are maintained or increased. In addition to cost reduction, the Company seeks to employ new technology or to creatively apply existing technology to reduce costs or to produce reserves that would otherwise remain unrecovered. One example is the drilling of four or more wells from a single drilling pad in residential areas, under reservoirs and on inaccessible acreage. The Codell formation, which is the primary objective of the drilling, is a blanket siltstone formation that exists under much of the Wattenberg acreage at depths of 6,700 to 7,500 feet. Codell reserves have a high degree of predictability due to uniform deposition and gradual transition from high to low gas/oil ratio areas. The Company generally dually completes the Niobrara chalk formation, which lies immediately above the Codell, to enhance drilling economics. The Codell/Niobrara wells produce most prolifically in the first six to twelve months, after which production declines to a fraction of initial rates. More than half of a typical well's reserves are recovered in the first three years of production. As a result, each well contributes significantly more production in its first year than in subsequent years. However, the declining production of individual wells is expected to be offset by continuing development drilling. During 1992 and 1993, the Company expanded its drilling targets to include both deeper and shallower formations. The J sand lies approximately 400 feet below the Codell. It is a low permeability sandstone generally found to be productive throughout the DJ Basin with performance varying proportionately with porosity and thickness. The Dakota formation lies approximately 150 feet below the J. It is a low permeability sand occasionally naturally fractured with less predictable commercial accumulations and varied performance results. The Sussex formation is at average depths of 4,500 feet. The Sussex sands were deposited as bars and exhibit variable reservoir quality with a moderate degree of predictability. Because the Codell, Niobrara and J formations are continuous reservoirs over a large portion of the DJ Basin, the Company believes that drilling in the Wattenberg Field is relatively low risk. In addition, the Company has compiled a comprehensive geologic and production database for approximately 12,000 wells within a 4,350 square mile area between Denver and the Wyoming border and has had considerable success in predicting variations in thickness, porosity, gas/oil ratios and productivity. Of the 667 wells drilled between 1991 and 1993, only seven have been dry holes. Dry holes cost an average of only $65,000 per well. The average net cost of a completed well approximated $193,000 during 1993 with only 30 days usually elapsing between spud date and initial production. The Company plans to develop the Wattenberg acreage within seasonal agriculture constraints which has historically reduced access to farmland between April and September. However, the expanded inventory includes a number of non-farm drillsites, which provides greater flexibility for summer drilling. Marketing and Gas Management. A portion of the gas produced in the Wattenberg Field is gathered, processed or both by third parties under long-term contractual dedications. However, the Company's gas facilities, including a processing plant and over 600 miles of gathering systems have reduced costs and afforded flexibility. These facilities, as well as gas marketing expertise, are expected to provide greater advantages in the future as the Company capitalizes on the cost savings and flexibility afforded by the recent expansion of its gathering and processing facilities and assumes marketing responsibility for gas previously committed to others. The gas produced from the majority of the new Wattenberg wells drilled on acreage acquired from Amoco is dedicated for the life of the lease to at Amoco's Wattenberg gas processing plant. If Amoco were to release the Company from supplying gas to its plant for any reason, including a shut-down of the plant, such release would have an short-term adverse impact on the Company. The Company has expanded its processing facilities in Wattenberg in order to process Company and third party gas that is not dedicated to Amoco. The Company intends to continue to expand its facilities during 1994 to handle additional gas developed though continued drilling activity. These facilities will enable the Company to partially mitigate the effects of frequent shut-downs at the Amoco plant. See "Gas Management - Colorado Facilities." In 1993, the Company extended its gathering system to collect gas from the Company and third parties, in order to control or reduce gathering costs and avoid curtailments in production caused by high line pressure on existing gathering systems. This expansion, called the Enterprise system, complements the processing and other gathering facilities in the area. While future gathering rates on the systems owned by others are expected to rise, the majority of the Company's gas will be gathered on its own gathering system. To the extent that a portion of the Company's gas remains on the KN Energy, Inc. ("KN") Wattenberg gathering system, the largest gathering system in the area, the applicable gathering rate is covered by an agreement between Amoco and KN which provides some protection from future rate increases. See "Gas Management - Colorado Facilities." Through yearend, Amoco had been responsible for marketing all residue gas and liquids attributable to the Company's gas processed through its Wattenberg plant. Historically, this arrangement has provided for average prices in excess of spot due to participation in certain fixed price contracts, many of which are expected to expire over the next two years. Under the contract with Amoco, the Company elected to market substantially all its gas and liquid products processed through the Wattenberg plant effective January 1, 1994. The Company believes that it can obtain pricing comparable to that which would have been obtainable through Amoco. Oil is sold at the average of the posted prices of Amoco, Total and Conoco in northeast Colorado. Cheyenne. During 1993, 29 wells were placed on stream in shallow gas producing area on the northeast flank of the DJ Basin. This project, known as the Cheyenne Project, began with the acquisition of five shut-in gas wells in 1990 when the Company determined that it could capitalize on new open access rules of the Federal Energy Regulatory Commission ("FERC") by constructing a gathering system to transport gas to a nearby interstate pipeline. After acquiring almost 50,000 acres of leases in the area and selling an approximate 27.5% interest to other parties on a promoted basis, the Company has drilled 54 successful wells and six dry holes in the area and constructed a gathering system having a capacity of 10 MMcf per day to transport the gas to the interstate pipeline. The Company currently operates 61 wells in this area that produce from the Niobrara formation and plans to drill approximately 20 additional wells during 1994. East Washakie During 1993, the Company initiated a major project to apply the cost-cutting and improved drilling and completion techniques learned in Wattenberg to develop fluvial Mesaverde sands in the eastern Washakie Basin. An eleven well pilot project was completed in 1993 to validate reduced cost levels and test drilling and completion techniques. A second drilling program is being initiated in March 1994. After final evaluation of the drilling, the Company may initiate a large scale drilling program in this area upon completion of a required environmental impact statement. The environmental impact statement was filed in October 1993, and completion is expected in the second half of 1994. Depending on the timing of environmental clearance and continued evaluation of drilling results, the Company expects to drill up to 60 wells in East Washakie during 1994. Since the mid-1980's, the Company's properties in the Barrel Springs Unit and the Blue Gap Field of southern Wyoming, together with its gas gathering and transportation facilities there, have been one of its most significant assets. See "Properties - Significant Properties" and "Gas Management - Wyoming Properties." The Company currently operates 128 wells in this area and has approximately 1,200 potential drilling locations, 98 of which were classified as proven at yearend 1993. More than half of the potential locations could ultimately prove attractive to develop. The Company currently holds interests in 95,000 gross (76,000 net) undeveloped acres in the Basin. This includes 36,000 gross (32,000 net) undeveloped acres added during 1993. Western Slope During 1993, the Company established a sizable position in the Piceance Basin on the Western Slope of Colorado and in the Uinta Basin in northeastern Utah. The Company formed the 53,000 acre Hunter Mesa Unit in the southeast corner of the Piceance Basin. Through purchases and farmouts, the Company obtained a majority interest and acts as unit operator. Immediately adjacent to the Hunter Mesa Unit, a 100% working interest was purchased in the 26,000 acre Divide Creek Unit for $6.2 million. The acquisition of this Unit, which has six wells producing from the Mesaverde and Cameo Coal formations, added 17.6 Bcf of proved gas reserves as well as an established operating base and access to gas transportation. Near yearend, the Company also purchased interests in 122 producing wells, 29 non-producing wells and 69 proved undeveloped locations. In total, this purchase included 55,000 net acres in various fields in the Piceance and Uinta Basins. Through these purchases, farmouts and a leasing program, the Company currently holds over 1,000 potential drilling locations, of which 40% could ultimately prove be attractive to develop. Of these locations, 101 were classified as proven at yearend 1993. The development of the Upper Mesaverde sands in the Piceance Basin began with the spudding of the initial test well near the end of 1993. The development will continue with a 10 well test program during 1994 to validate cost reductions and improved recovery techniques. If successful, the Company may drill up to 30 wells in 1994 and approximately 100 wells per year thereafter. A key issue in the Piceance Basin is the ability to profitably transport production to market. The Company is exploring options for gathering and transporting future gas production, including the possibility of constructing Company owned facilities. Other Development At the end of 1992, the Company acquired interests in four large producing fields in central Wyoming from a major oil company at a cost of $56.1 million. Two of the fields, the Hamilton Dome and Riverton Dome Fields, are operated by the Company. During 1993, the Company evaluated opportunities in the fields and instituted programs to enhance production in the latter part of the year. In the Hamilton Dome Field, improvement of the water injection system and completion of two new wells increased daily production 8% above the levels projected at the time of the acquisition. A third well should be completed in the second quarter of 1994. In the Riverton Dome Field, workovers and recompletions increased daily production over 10% above the levels projected at the time of the acquisition. Additional workovers and development drilling are scheduled for both fields during 1994. The Company is attempting to work with the major oil companies that operate the other two fields purchased, both of which are producing slightly below acquisition projections. The Company operates the Adair waterflood property in Gaines County, Texas, which it purchased in September 1991. Initial development of the Adair Unit in 1992 cost approximately $1.7 million net to the Company. Based on production response from the initial phase of development, the Company spent an additional $.9 million in 1993 to conduct a pilot program which reduced well spacing on a portion of the Unit. This program increased the unit production from 150 barrels per day to 260 barrels per day. The Company plans to spend an additional $1.1 million to implement an infill development program throughout the Unit. Once fully developed, the Adair Unit is expected to contain 52 wells operated by the Company. In the Giddings Field in Southeast Texas, the Company has undertaken a horizontal drilling program to further exploit exising properties in the area. During 1993, the Company spent $2.2 million to re-enter or drill 10 wells, of which nine were completed and one abandoned. The Company is encouraged by the results to date and plans to increase its expenditures in the field during 1994. At yearend, 25 locations were classified as having proved undeveloped reserves. Acquisition Program The Company believes that acquisitions continue to be an attractive method of increasing its reserve base and cash flow. In its acquisition efforts, the Company plans to focus on purchasing properties that strengthen its strategic position and complement its large-scale gas development projects in the Rockies, as well as provide opportunities to establish meaningful positions in new areas. From 1983 through 1993 the Company, on behalf of itself, its affiliates and other investors, purchased oil and gas properties and related assets with an aggregate cost of nearly $650 million. The Company actively seeks to acquire incremental interests in existing properties, acreage with development potential, gas gathering, transportation and processing facilities and related assets, particularly in proximity to existing properties. Purchases of incremental interests or adjacent properties are generally small in size but in aggregate represent a sizeable opportunity that is relatively easy to pursue. Due to its rate of return requirements and the high cost of pursuing potential acquisitions, the Company generally prefers negotiated transactions to auctions. Complex deals involving legal, financial or operational difficulties have frequently permitted purchase of assets at favorable prices. Past acquisitions of corporations laid the groundwork for the Wattenberg hub, and may in the future provide opportunities to expand in other areas. Acquisitions of incremental interests are being given particular emphasis to take advantage of systems and operational knowledge already in place. The Company has extensive experience in completing numerous types of acquisitions using varied financing sources in addition to internal cash flow. During 1993 domestic acquisitions having a total cost of $51.0 million were completed, primarily to strengthen Wattenberg and establish two new projects, each of which has the potential to develop into a large scale gas development program. In Wattenberg a series of purchases added nearly 9 million BOE of proved reserves at a net cost of under $3.50 per barrel as well as several pipeline and processing facilities that complement the Company's existing gathering systems. In the largest of these acquisitions, the Company paid $19.7 million and, after an exchange of interests with a third party, acquired an approximate 80% working interest in 153 producing wells and 284 undeveloped locations having total proved reserves estimated to exceed 7 million BOE. A portion of the value of the transaction lay in the large volume of undedicated gas located in close proximity to the Company's gas lines. In the Washakie Basin, the Company expended over $7.8 million to acquire a 25% incremental interest in its Barrel Springs properties and interests in 44 producing wells and 7 undeveloped locations, as well as a gathering system that expands the existing gathering infrastructure in the area. These acquisitions added approximately 3.6 million BOE of proved reserves and, together with an active leasing program, formed the basis for the East Washakie Project, the Company's second operating hub in the Rockies. See "Development - East Washakie Project." Through three purchases, farmouts and leasing, the Company established a substantial position in the Piceance and Uinta Basins during 1993, forming the foundation of the Western Slope Project, a third gas development hub in the Rockies. A $6.2 million purchase gave the Company a 100% working interest in the 26,000 acre Divide Creek Unit in the southeast Piceance Basin. The Company also formed the adjacent 53,000 acre Hunter Mesa Unit and through purchases and farmouts obtained a majority working interest position and became unit operator. Near yearend the Company also acquired interests in 122 producing wells, 29 non-producing wells and 69 undeveloped locations in various fields in the Uinta and Piceance Basins. See "Development - Western Slope Project." The following table summarizes acquisition activity since 1983: Gas Management General. The Company expanded its gas gathering and processing capacity during 1993 with the construction of the Enterprise system and expansion of the Roggen plant in Wattenberg, as well as the acquisition of additional gas facilities in Wattenberg and in Wyoming. By yearend, operated processing capacity had increased to more than 80 MMcf per day and gathering system capacity was increased to more than 200 MMcf per day, while marketed net volumes reached 100 MMcf per day. The gas management unit complements the Company's development and acquisition activities by providing additional cash flow and enhancing return. The segment is also increasingly profitable in its own right. During 1993, operating cash flow increased by approximately 23% to $10 million. See "Customers and Marketing." Colorado Facilities. The largest concentration of gas facilities is in the Wattenberg area. These facilities include two major gathering systems, the Enterprise system and Energy Pipeline, the Roggen processing plant, and a number of minor facilities. By yearend 1993, the Roggen plant capacity had reached 60 MMcf per day. During the fourth quarter of 1993, average throughput had reached 54 MMcf per day. The expanded plant is expected to process gas from currently undeveloped locations, new third party sources and permanently released locations on acreage acquired from Amoco, plus additional gas from current suppliers. Gas developed through the UPRC joint venture is not dedicated to a processing plant and will significantly increase furture volumes of gas available to be processed in the Company's facilities. At the Roggen plant, gas is processed to recover gas liquids, primarily propane and a butane/gasoline mix, from gas supplied by the Company and third parties. The liquids are then sold separately from the residue gas. The liquids are marketed to local and regional distributors and the residue gas is sold to utilities, independent marketers and end users through an intrastate system and the Colorado Interstate Gas ("CIG") pipeline. During 1993, CIG constructed approximately 14 miles of pipeline from the Roggen plant to expand residue capacity. Residue capacity is currently believed to be capable of handling 50 MMcf per day under normal conditions. A liquids line permits the direct sale of Roggen's liquids products through an Amoco line to the major interchange at Conway, Kansas. In addition, Phillips Petroleum began reactivation of an old interconnect, which should be operational by the end of the second quarter of 1994, which will connect the Roggen plant to the Phillips Powder River liquids pipeline. The Company's Wattenberg gathering systems include over 600 miles of pipeline which collect, compress and deliver gas from over 1,400 wells to the Roggen plant. During 1993, 443 new wells, including 335 Company wells, were connected to these pipelines. The Company acquired a pipeline which expands its gathering potential to the north and which could be converted to a residue line allowing for the delivery of residue gas from the tailgate of Roggen to the Williams Natural Gas System. The Company also constructed a nine mile 16" pipeline loop on the western portion of the system, which came on line in October 1993, to provide pressure relief in the area and additional capacity for further development in the area. Gas from wells in which the Company owns an interest currently accounts for approximately 86% of the gathered volumes. The Company earns fees from transportation on its gathering lines and processing at the Roggen plant under two arrangements. Most gas is gathered and processed under arrangements whereby the Company retains for its own use or sale a significant part of the liquids products recovered at the plants as well as a portion of the residue gas. The remainder of the gas is transported and processed for a fixed amount per unit. During 1993, the Company substantially expanded its gathering system. This expansion is known as the Enterprise system. Enterprise collects a portion of the Company's gas produced from acreage acquired from Amoco and delivers it to the Amoco Wattenberg plant. Enterprise includes 26 miles of 20" diameter trunk and 29 miles of associated lateral gathering lines connecting 20 of the Company's existing central delivery points ("CDP's") plus several newly drilled wells. Approximately eight miles of lower pressure 20" main trunk pipeline and ten miles of laterals connecting 11 CDP's were added during 1993, along with additional compression facilities, at a cost of $9.1 million. The Enterprise system has the capacity to deliver 75 MMcf per day to the Amoco Wattenberg plant. In conjunction with the construction of the Enterprise system, CIG constructed a high pressure 16" line which connects Enterprise to an existing CIG 16" pipeline which redelivers the gas to Amoco's Wattenberg plant. Prior to completion of the CIG line in May 1993, a portion of the Company's Wattenberg gas connected to Enterprise was delivered and processed at the Roggen plant. The Company has negotiated a transportation arrangement with CIG that, in conjunction with the gathering fees to be charged on the Enterprise system, allows the delivery of gas to the Amoco Wattenberg plant at a favorable rate. In addition to containing current and future escalation in gathering costs applicable to the Company's production, Enterprise provides an enhanced degree of operational control. Because the Enterprise system interconnects with the Company's other Colorado facilities, the Roggen plant and other plants in the area can serve as a backup for processing a portion of the Company's gas in the event of any curtailment at the Amoco Wattenberg plant. While shut downs of Amoco's plant reduce the Company's production, diversion of gas to the Roggen plant and, to a lesser degree, two other plants in the area, enabled the Company to produce significant volumes that would have otherwise been curtailed. Given the continued expansion of the Company's drilling program in 1994 and beyond and the potential for third party connections, the Company is continuing to explore opportunities to expand its Wattenberg gas facilities. Subsequent to yearend, the decision was made to double the Company's processing capacity through the construction of a new plant on the west side of the field. The new plant is scheduled to be operational in late 1994. Wyoming Facilities. The Company operates two pipeline systems in Wyoming that enhance its ability to market gas produced from its Carbon County properties. Wyoming Gathering and Production Company ("WYGAP") gathers gas produced from 53 operated wells in the Barrel Springs Unit. The system has a capacity of 26 MMcf per day. Throughput averaged 10 MMcf and 14 MMcf per day during 1992 and 1993. WYGAP delivers gas to Western Transmission Corporation ("Westrans"), a Company-owned interstate pipeline system which operates under FERC jurisdiction. At the beginning of 1993, the Company assumed operations of CIG's Carbon County Blue Gap gathering system pursuant to a lease. The Company has exercised an option to acquire the system subject to regulatory approval. The Company also purchased Blue Gap gathering facilities formerly owned by Williams Field Services. Both systems extend the Company's transportation capabilities to the south. The Westrans system consists of a 26-mile main pipeline, a smaller 9.2-mile line and related gathering facilities. The system gathers and transports gas under open access transportation service agreements on an interruptible basis. The main line extends from the Washakie Basin area of Carbon County, Wyoming to connections with Williams' and CIG's interstate pipelines in Sweetwater County, Wyoming. Gas transported on Westrans also has access to California markets through the Kern River Pipeline which was completed in February 1992 via interconnects with CIG and Williams. Westrans is located near several other interstate pipelines, providing the potential for additional interconnects that offer alternative transportation routes to end markets. In addition to the gas from WYGAP, which accounts for over 90% of its volumes, Westrans transports volumes from other operated wells and third parties. The capacity of Westrans is 65 MMcf per day. Throughput volumes generally vary from 13 to 20 MMcf per day. Daily throughput averaged 15 MMcf during 1992 and 1993. If the planned acceleration of drilling in East Washakie occurs, volumes of gas on the Company's gas pipeline in the area may be substantially increased. As the East Washakie project progresses, the Company expects to further expand its gathering network in the area. Other Facilities. The Company expanded its gathering system in southern Nebraska during 1993 to gather gas produced from newly developed Cheyenne County properties for delivery to various markets accessible through KN. The Cheyenne system includes 9.5 miles of 4" to 6" trunkline and 6 miles of 3" lateral gathering lines. During the fourth quarter of 1993, throughput averaged 3 MMcf per day of gas from 60 producing wells. Included in the December 1992 acquisition of Wyoming properties was a gas processing plant in Fremont County, Wyoming. The plant has a 20 MMcf per day capacity with current throughput of 8 MMcf per day from the 28 producing wells in the Riverton Dome Field. In conjunction with the growing level of acquisition and development activity in the Piceance and Uinta Basins, the Company is actively exploring alternatives to gather and transport future gas production in those areas. In this connection, the possibility of constructing a Company-owned gathering and transportation line is being investigated. Traditionally, the lack of sufficient pipeline capacity has been a major deterrent to development in the Piceance Basin. International Activities During 1993, the Company made significant progress in building its international exploration and development effort into a vehicle having significant future growth potential. During the year, the Company's Russian venture received government approval. The Company signed a production sharing agreement with the government of Mongolia and completed its seismic work program in Tunisia. Finally, the Company acquired a 42.8% interest in a publicly traded Australian exploration company that has significant international exploration experience and an extensive inventory of projects that greatly enhance the Company's international efforts. The Company's strategy internationally is to develop projects that have the potential for a major impact in the future. The Company attempts to structure the projects to limit its financial exposure and mitigate political risk by minimizing financial commitments in the early phases of a project and seeking industry partners and equity investors to fund the majority of the equity capital. A wholly owned subsidiary of the Company, SOCO International, Inc., is the holding company for all the Company's international operations. During 1993, the Company purchased from Edward T. Story, President of SOCO International, the 10% of SOCO International held by him and canceled Mr. Story's option to purchase an additional 20% of the company. In connection with the purchase, the Company granted Mr. Story an option to purchase 10% of SOCO International through April 1998 for $600,000. The option price is subject to adjustment, in certain circumstances. Russian Joint Venture. In early 1993, the Company formed Permtex, a joint drilling venture with Permneft, a Russian oil and gas company, to develop four major proven oil fields located in the Volga-Urals Basin of the Perm Region of Russia, approximately 800 miles east of Moscow. During 1993, Permtex was registered by the Russian authorities, representing governmental approval of the terms of the joint venture and authorization for Permtex to commence business. In early 1994, the Company executed a finance and insurance protocol with the Overseas Private Investment Corporation, an agency of the United States government that provides financing and political risk insurance for American investment in developing countries, related to the financing of Permtex. Permtex holds exploration and development rights to over 300,000 acres in the Volga-Urals Basin. The contract area contains four major fields and four minor fields as well as a number of prospects. The Company estimates that the four major fields could ultimately produce 115 million barrels of oil. The major fields have been delineated through 45 previously drilled wells, none of which had been placed on production as of yearend 1993. It is anticipated that 25 of the existing wells will be placed on production, of which four should go on stream in the first half of 1994, and that 400 additional development wells will be drilled over the next five to ten years. The joint venture will primarily utilize Russian personnel and equipment and Western technology under joint Russian/American management. As of March 1, 1994, the Company holds a 28.1% interest in Permtex, after giving effect to the subscriptions by each of Command Petroleum Holdings NL ("Command"), the Company's Australian affiliate, and Holland Sea Search NV ("HSSH"), a Dutch affiliate of Command, to purchase 6.25% interests in Permtex. Recently, a major Japanese trading company has also committed to purchase a 10 to 20% interest in Permtex, which would reduce the Company's interest to 20.6% if the full amount is purchased. Command Petroleum Holdings NL. In May 1993, the Company purchased 42.8% of the outstanding shares of Command for approximately $18.2 million. At the time of the purchase, Thomas J. Edelman, President of the Company, Edward T. Story, President of SOCO International, and two other designees were elected to Command's eight-person board of directors. Command is an exploration and production company based in Sydney, Australia and listed on the Australian Stock Exchange. At yearend 1993, Command had working capital of $35 million and no debt. Its current market capitalization approximates US$150 million. Command currently holds interests in more than 20 exploration permits and production licenses primarily in the Southwestern Pacific Rim including Australia and Papua New Guinea. Until recently, Command held a 28.7% interest in HSSH, a publicly traded Dutch exploration and production company whose primary assets are an interest in the North Sea's Markham gas field. After yearend 1993, Command increased its position in HSSH to nearly 48%. Recently, Command purchased a 6.25% interest in Permtex, acquired an interest in an offshore Tunisian permit operated by Marathon and acquired an 11.4% interest in the East Shabwa Contract Area in Yemen. Command funded the expenditures with a portion of a $16.4 million privately placed equity offering which reduced the Company's ownership to 35.7%. If as expected, all of Command's warrants expiring in November 1994 are exercised, the Company's ownership would be decreased to 29.6%. The Company believes that Command's exploration expertise, experienced technical staff and inventory of prospects complement the Company's acquisition and development expertise and position the Company to play a larger role in overseas development of oil and gas reserves. In addition, Command and HSSH provide access to international capital markets which could provide additional sources of financing for international projects. Mongolia. The Company further expanded its international efforts by entering into a production sharing agreement with Mongol Petroleum Company, the national oil company of Mongolia. The Company believes this agreement is the first such contract ever awarded by Mongolia. The agreement covers 11,400 square kilometers, or approximately 2.8 million gross acres in the Tamstag Basin of northeastern Mongolia. In addition, the Company received a right of first refusal from Mongol Petroleum for the adjacent block which covers 11,130 square kilometers. As a consequence, the Company controls over 5 million acres in this basin which, although previously unexplored and remote from existing markets, is highly prospective. These concessions offset the Hailar Basin of China, a portion of which is included in the China National Petroleum Corporation's round of invitations for bidding in 1994. During 1993, the Company initiated seismic work to broadly define the subsurface. This work is expected to continue into 1995 at relatively modest cost. Tunisia. During 1993 the Company completed its 400 kilometer seismic acquisition program in the Fejaj Permit area of central Tunisia. The permit area encompasses approximately 1.2 million gross acres and is predominately onshore, with a small portion extending into the Gulf of Gabes. After the Company integrates the newly acquired seismic work with over 1,400 kilometers of reprocessed data and extensive geological field information, the Company will seek industry partners for a 1995 exploratory well. Production, Revenue and Price History The following table sets forth information regarding net production of crude oil and liquids and natural gas, revenues and expenses attributable to such production and to natural gas transportation, processing and marketing and certain price and cost information for the five years ended December 31, 1993. (Dollars in thousands, except price and per barrel expenses) Drilling Results The following table sets forth information with respect to wells drilled during the past three years. The information should not be considered indicative of future performance, nor should it be assumed that there is necessarily any correlation between the number of productive wells drilled, quantities of reserves found or economic value. Productive wells are those that produce commercial quantities of hydrocarbons whether or not they produce a reasonable rate of return. As operator, the Company charges overhead fees to all working interest owners according to the applicable operating agreements. As of the end of 1991, 1992 and 1993, respectively, the Company operated 1,442, 1,745 and 2,176 wells. The Company received overhead reimbursements for operations and drilling of $10.1 million, $12.9 million and $15.5 million during 1991, 1992 and 1993, respectively (including reimbursements attributable to the Company's interest). The increase in reimbursements is attributable to the increase in operated drilling and producing wells and contractual escalations. Based on the time allocated to operations, these reimbursements in aggregate generally have exceeded the costs of such activities. Customers and Marketing The Company's oil and gas production is principally sold to refiners and others having pipeline facilities near its properties. Where there is no access to gathering systems, crude oil is trucked to storage facilities. In 1992 and 1993, Amoco accounted for approximately 27% and 12% of revenues, respectively, as the result of the contractual dedication of a portion of the Company's natural gas and natural gas liquids produced from certain of its Wattenberg acreage. The Company exercised its option to release its natural gas and natural gas liquids and began marketing its production beginning January 1, 1994. See "Development - D J Basin - Wattenberg Field." The marketing of oil and gas by the Company can be affected by a number of factors that are beyond its control and whose future effect cannot be accurately predicted. The Company does not believe, however, that the loss of any of its customers would have a material adverse effect on its operations. In addition to marketing a significant portion of its own gas, in 1992 the Company initiated an effort to supplement its cash flow through the purchase and resale of gas owned by third parties. Gross margins during 1992 and 1993 from third party marketing activities was $.6 million and $1.2 million, respectively, as average third party volumes increased from 58.7 to 89.9 MMcf per day. The Company expects, to continue increasing its role in third party gas marketing. In June 1991, the Company entered into a contract to supply gas to a cogeneration facility through August 2004. The contract calls for the Company to supply 10,000 MMBtu per day. This plant, which requires up to 24,500 MMBtu per day of gas, began operations in 1989 and is located at a manufacturing facility in Oklahoma City. The facility has firm fifteen-year sales agreements with a utility company for electricity and with a tire manufacturer for steam. The effect of this contract depends on market prices for gas and its choice of alternative sources of gas (including the spot market) to meet its supply commitments. Gross margin generated from the contract was approximately $1.5 million for both 1991 and 1992. A contractual limitation of the contract sales price and rising gas purchase cost, resulted in a net loss of $267,000 on the contract during 1993. At present gas price levels, the Company foresees continued negative or breakeven margins for this contract through July 1994. At that time, the share of the sales price minimum attributable to gas will increase from 45% to 65% and margins should improve. Competition The oil and gas industry is highly competitive in all its phases. Competition is particularly intense with respect to the acquisition of producing properties. There is also competition for the acquisition of oil and gas leases, in the hiring of experienced personnel and from other industries in supplying alternative sources of energy. Competitors in acquisitions, exploration, development and production include the major oil companies in addition to numerous independent oil companies, individual proprietors, drilling and acquisition programs and others. Many of these competitors possess financial and personnel resources substantially in excess of those available to the Company. Such competitors may be able to pay more for desirable leases and to evaluate, bid for and purchase a greater number of properties than the financial or personnel resources of the Company permit. The ability of the Company to increase reserves in the future will be dependent on its ability to select and acquire suitable producing properties and prospects for future exploration and development. Title to Properties Title to the properties is subject to royalty, overriding royalty, carried and other similar interests and contractual arrangements customary in the oil and gas industry, to liens incident to operating agreements and for current taxes not yet due and other comparatively minor encumbrances. The majority of the value of the Company's properties is mortgaged to secure borrowings under the bank credit agreement. As is customary in the oil and gas industry, only a perfunctory investigation as to ownership is conducted at the time undeveloped properties believed to be suitable for drilling are acquired. Prior to the commencement of drilling on a tract, a detailed title examination is conducted and curative work is performed with respect to known significant defects. Regulation The Company's operations are affected by political developments and federal and state laws and regulations. Oil and gas industry legislation and administrative regulations are periodically changed for a variety of political, economic and other reasons. Numerous departments and agencies, federal, state, local and Indian, issue rules and regulations binding on the oil and gas industry, some of which carry substantial penalties for failure to comply. The regulatory burden on the oil and gas industry increases the Company's cost of doing business, decreases flexibility in the timing of operations and may adversely affect the economics of capital projects. In the past, the federal government has regulated the prices at which oil and gas could be sold. Prices of oil and gas sold by the Company are not currently regulated. There can be no assurance, however, that sales of the Company's production will not be subject to federal regulation in the future. The following discussion of various statutes, rules, regulations or governmental orders to which the Company's operations may be subject is necessarily brief and is not intended to be a complete discussion thereof. Federal Regulation of Natural Gas. Historically, the sale and transportation of natural gas in interstate commerce have been regulated under various federal and state laws including, but not limited to, the Natural Gas Act of 1938, as amended ("NGA") and the Natural Gas Policy Act of 1978 ("NGPA"), both of which are administered by FERC. However, regulation of first sales, including the certificate and abandonment requirements and price regulation, was phased out during the late 1980's and all remaining wellhead price ceilings terminated on January 1, 1993. FERC continues to have jurisdiction over transportation and sales other than first sales. Commencing in the mid-1980's, FERC promulgated several orders designed to correct perceived market distortions resulting from the traditional role of major interstate pipeline companies as wholesalers of gas and to make gas markets more competitive by removing transportation and other barriers to market access. These orders have had and will continue to have a significant influence on natural gas markets in the United States and have, among other things, allowed non-pipeline companies, including the Company, to market gas and fostered the development of a large spot market for gas. These orders have gone through various permutations, due in significant part to FERC's response to court review of these orders. Parts of these orders remain subject to judicial review, and the Company is unable to predict the impact on its natural gas production and marketing operations of judicial review of these orders. In April 1992, FERC issued Order 636, a rule designed to restructure the interstate natural gas transportation and marketing system to remove various barriers and practices that have historically limited non-pipeline gas sellers, including producers, from effectively competing with pipelines. The restructuring process will be implemented on a pipeline-by-pipeline basis through negotiations in individual pipeline proceedings. Although Order 636 does not regulate any of the Company's material gas operations, FERC has stated that Order 636 is intended to foster increased competition in all phases of the natural gas industry. Industry commentators have predicted profound effects (which vary from commentator to commentator) on various segments of the industry as a result of this competition. Order 636 is being implemented on a pipeline-by-pipeline basis through negotiated settlements in independent pipeline service restructuring proceedings designed specifically to "unbundle" the pipelines' services (e.g., transportation, sales and storage) so that producers, marketers and end-users of natural gas may secure services from the most economical source. The restructuring proceedings continued throughout 1993, with the majority of pipelines having received FERC orders approving their compliance filings, subject to conditions, so that the 1993-1994 winter heating season is the first period during which FERC Order 636 procedures have been operative. To date, management of the Company believes the Order 636 procedures have not had any significant effect on the Company. Because the restructuring involved wholesale changes in the operating procedures of pipelines, however, the Company is not able to predict the long term effect of the new procedures. Also, the Order and many of the pipeline procedures adopted in response thereto, will be subject to lengthy administrative and judicial review, which may result in procedures that are significantly different from those currently in effect. When it issued Order 636, FERC recognized that in an effort to enable non-pipeline gas sellers to compete more effectively with pipelines, it should not allow pipelines to be penalized as competitors by any of their existing contracts which required the pipelines to pay above-market prices for natural gas. FERC recognized that it did not have authority to nullify these contracts, and instead encouraged pipelines and producers to negotiate in good faith to terminate or amend these contracts to align them with market conditions. During 1993, the Company renegotiated its contract with Southern Natural Gas Company ("SONAT") under which SONAT had purchased the Company's gas from the Thomasville Field at prices substantially above market value. As a result of the renegotiation, the Company received a $14 million payment and beginning January 1, 1994 the Company will receive a price that, while somewhat above current prices, will be substantially lower that the average 1993 contract price of $12.16 per Mcf. State Regulation of Transportation of Natural Gas. Some states have adopted open-access transportation rules or policies requiring intrastate pipelines or local distribution companies to transport natural gas to the extent of available capacity. These rules or policies, like federal rules, are designed to increase competition in natural gas markets. The economic impact on the Company and gas producers generally of these rules and policies is uncertain. State Regulation of Drilling and Production. State regulatory authorities have established rules and regulations requiring permits for drilling, reclamation and plugging bonds and reports concerning operations, among other matters. Most states in which the Company operates also have statutes and regulations governing a number of environmental and conservation matters, including the unitization or pooling of oil and gas properties and establishment of maximum rates of production from oil and gas wells. Some states also restrict production to the market demand for oil and gas. Such statutes and regulations may limit the rate at which oil and gas could otherwise be produced from the Company's properties. Some states have enacted statutes prescribing ceiling prices for gas sold within the state. During the current session of the Colorado legislature, the Colorado Department of Natural Resources has prepared a bill ("SB 177"), which gives additional authority to the Colorado Oil and Gas Conservation Commission ("COGCC") in their regulation of the oil and gas industry. The bill has currently passed the Senate Agricultural Committee and will be presented to the full legislature in March. This bill is very similar to legislation proposed during the 1993 legislature session. Legislation of this type could increase the cost of the Company's operations and erode the traditional rights of the oil and gas industry in Colorado to make reasonable use of the surface to conduct drilling and development activities. In addition, a coalition of oil and gas industry and agriculture are working on a Surface Damage Compensation bill. The group will try to have the bill sponsored and passed in this session of the legislature. This bill, if enacted, would also increase the Company's cost of doing business. Also at the statewide level, the surface owner groups have indicated that they may seek a statewide ballot initiative to overturn the traditional real property concept of the dominance of the mineral estate and put the surface estate as the dominate estate. These same groups are also active at the local level, and there have been a number of city and county governments who have either enacted new regulations or are considering doing so. The incidence of such local regulation has increased following a recent decision of the Colorado Supreme Court which held that local governments could not prohibit the conduct of drilling activities which were the subject of permits issued by the COGCC, but that they could limit those activities under their land use authority. Under these decisions, local municipalities and counties may take the position that they have the authority to impose restrictions or conditions on the conduct of such operations which could materially increase the cost of such operations or even render them entirely uneconomic. The Company is not able to predict which jurisdictions may adopt such regulations, what form they may take, or the ultimate effects of such enactments on its operations. In general, however, these ordinances are aimed at increasing the involvement of local governments in the permitting of oil and gas operations, requiring additional restrictions or conditions on the conduct of operations, to reduce the impact on the surrounding community and increasing financial assurance requirements. Accordingly, the ordinances have the potential to delay and increase the cost, or in some cases, to prohibit entirely the conduct of drilling operations. In response to the concerns of surface owners, during 1993 the COGCC adopted, regulations for the DJ Basin governing notice to and consultation with surface owners prior to the conduct of drilling operations, imposing specific reclamation requirements on operators upon the conclusion of operations and containing bonding requirements for the protection of surface owners and enhanced financial assurance requirements. Although numerous changes are expected in light of the recently adopted and pending regulatory initiatives, management is not able to predict the final form of these initiatives or their impact on the Company. In December 1992, COGCC instituted a review of "slimhole" completions (i.e., completions using pipe having a diameter of less than 4-1/2") and expressed concerns that slimhole completions could result in the loss of reserves, cause environmental damage and result in increased abandonment costs to the State. Hearings on the matter were scheduled for February 1994. Following meetings of representatives of the Company and other major Wattenberg operators with the COGCC at which the operators discussed slimhole techniques, the hearings were postponed until May. Although the Company believes that slimhole completion is a safe and economically viable completion method, the Company is unable to predict what, if any regulations might be adopted by the COGCC or their effect on the Company. Regulations that imposed significant restrictions on slimhole completions, however, could increase the cost of the Company's drilling operations and could cause certain locations to become uneconomic. Environmental Regulations. Operations of the Company are subject to numerous laws and regulations governing the discharge of materials into the environment or otherwise relating to environmental protection. These laws and regulations may require the acquisition of a permit before drilling commences, prohibit drilling activities on certain lands lying within wilderness and other protected areas and impose substantial liabilities for pollution resulting from drilling operations. Such laws and regulations also restrict air or other pollution and disposal of wastes resulting from the operation of gas processing plants, pipeline systems and other facilities owned directly or indirectly by the Company. In connection with its most significant acquisitions, the Company has performed environmental assessments and found no material environmental noncompliance or clean-up liabilities requiring action in the near or intermediate future, although some matters identified in the environmental assessments are subject to ongoing review. The Company has assumed responsibility for some of the matters identified. Some of the Company's properties, particularly larger units that have been in operation for several decades, may require significant costs for reclamation and restoration when operations eventually cease. Environmental assessments have not been performed on all of the Company's properties. To date, expenditures for environmental control facilities and for remediation have not been significant to the Company. The Company believes, however, that it is reasonably likely that the trend toward stricter standards in environmental legislation and regulations will continue. For instance, efforts have been made in Congress to amend the Resource Conservation and Recovery Act to reclassify oil and gas production wastes as "hazardous waste," the effect of which would be to further regulate the handling, transportation and disposal of such waste. If such legislation were to pass, it could have a significant adverse impact on the Company's operating costs, as well as the oil and gas industry in general. New initiatives regulating the disposal of oil and gas waste are also pending in certain states, including states in which the Company conducts operations, and these various initiatives could have a similar impact on the Company. The COGCC has enacted rules regarding the regulation of disposal of oil field waste. These rules establish significant new permitting, record-keeping and compliance procedures relating to the operation of pits, the disposal of produced water, and the disposal and/or treatment of oil field waste, including waste currently exempt from federal regulation. These rules may require the addition of technical personnel to perform the necessary record- keeping and compliance and may require the termination of production from some of the Company's marginal wells, for which the cost of compliance would exceed the value of remaining production. In addition, as indicated above, the COGCC has enacted regulations imposing specific reclamation requirements on operators upon the conclusion of their operations. Management believes that compliance with current applicable laws and regulations will not have a material adverse impact on the Company. A number of states have recently established more stringent environmental regulations to ensure compliance with federal regulations, and have either proposed or are considering regulations to implement the Federal Clean Air Act. These new regulations are not expected to have a significant impact on the Company or its operation. In the longer term, regulations under the Federal Clean Air Act may increase the number and type of Company facilities that require permits, which could increase the Company's cost of operations and restrict its activities in certain areas. Federal Leases. The Company conducts operations under federal oil and gas leases. These operations must be conducted in accordance with permits issued by the Bureau of Land Management and are subject to a number of other regulatory restrictions. Multi-well drilling projects on federal leases may require preparation of an environmental assessment or environmental impact statement before drilling may commence. Moreover, on certain federal leases, prior approval of drill site locations must be obtained from the Environmental Protection Agency. Officers In early 1993, the Company restructured its organization, dividing operations into four separate business units and decentralized a number of staff functions. Each business unit has bottom line responsibility in order to reduce administrative costs, increase efficiency and increase focus on enhancing asset value. The flatter organization structure should also assist the Company in capitalizing on opportunities that may result in significant growth, including acquisitions and additional enhancement projects. Listed below are the officers and a summary of their recent business experience. John C. Snyder (52), a director and Chairman, founded the Company's predecessor in 1978. From 1973 to 1977, Mr. Snyder was an independent oil operator in Texas and Oklahoma. Previously, he was a director and the Executive Vice President of May Petroleum Inc. where he served from 1971 to 1973. Mr. Snyder was the first president of Canadian-American Resources Fund, Inc., which he founded in 1969. From 1964 to 1966, Mr. Snyder was employed by Humble Oil and Refining Company (currently Exxon Co., USA) as a petroleum engineer. Mr. Snyder received his Bachelor of Science Degree in Petroleum Engineering from the University of Oklahoma and his Masters Degree in Business Administration from the Harvard University Graduate School of Business Administration. Mr. Snyder is a director of the Fort Worth Country Day School. Thomas J. Edelman (43), a director and President, co-founded the Company. Prior to joining the Company in 1981, he was a Vice President of The First Boston Corporation. From 1975 through 1980, Mr. Edelman was with Lehman Brothers Kuhn Loeb Incorporated. Mr. Edelman received his Bachelor of Arts Degree from Princeton University and his Masters Degree in Finance from the Harvard University Graduate School of Business Administration. Mr. Edelman is a director of Command Petroleum Holdings NL, an affiliate of the Company. In addition, Mr. Edelman serves as chairman of the board of Lomak Petroleum, Inc. and as a director of Petroleum Heat & Power Co., Inc., Wolverine Exploration Company and Total Energy Services Corporation. John A. Fanning (54), a director and Executive Vice President, joined the Company in 1987 and has been a director since 1982. Between 1985 and 1987, Mr. Fanning was a private investor. He was a director, President and Chief Executive Officer of The Western Company of North America, which provides drilling and technical services to the oil industry, until 1985. Mr. Fanning joined The Western Company in 1968 and served in various capacities including Director of Planning, Division Manager, President of Western Petroleum Services and Executive Vice President. From 1965 through 1968, he was a Planning and Financial Analyst with The Cabot Corporation. Mr. Fanning received his Bachelor of Science Degree in Physics from Holy Cross College and his Masters Degree in Industrial Management from Massachusetts Institute of Technology. Mr. Fanning is a director of TNP Enterprises Inc, a public utility holding company. Charles A. Brown (47), Vice President - Emerging Assets, joined the Company in 1987. He was a petroleum engineering consultant from 1986 to 1987. He served as President of CBW Services, Inc., a petroleum engineering consulting firm, from 1979 to 1986 and was employed by KN from 1971 to 1979 and Amerada Hess Corporation from 1969 to 1971. Mr. Brown received his Bachelor of Science Degree in Petroleum Engineering from the Colorado School of Mines. Steven M. Burr (37), Vice President - Planning and Engineering, joined the Company in 1987. From 1982 to 1987, he was a Vice President with the petroleum engineering consulting firm of Netherland, Sewell & Associates, Inc. ("NSAI"). From 1978 to 1982, Mr. Burr was employed by Exxon Company, U.S.A. in the Production Department. Mr. Burr received his Bachelor of Science Degree in Civil Engineering from Tulane University. Robert J. Clark (49), President of SOCO Gas Systems Inc. and Vice President - Gas Management of the Company, joined the Company in 1988. From 1985 to 1988, Mr. Clark was Vice President - Natural Gas for Ladd Petroleum Corporation, a subsidiary of General Electric Company. From 1967 to 1985, Mr. Clark served in various management capacities with Northern Illinois Gas Company, NICOR Exploration Company and Reliance Pipeline Company, all of which were subsidiaries of NICOR, Inc. Mr. Clark received his Bachelor of Science Degree in Accounting from Bradley University and his Masters Degree in Business Administration from Northern Illinois University. Gary R. Haefele (51), Vice President - DJ Basin, rejoined the Company in 1993. Mr. Haefele was a consultant to the Company in 1992. From 1981 to 1991, Mr. Haefele worked for the Company as Senior Vice President, Production. Mr. Haefele served as Vice President, Engineering and International Operations for Hamilton Brothers from 1979 to 1981. Mr. Haefele held various production and reservoir engineering positions for Chevron from 1965 to 1979. Mr. Haefele has a Bachelor of Science Degree in Petroleum Engineering from the University of Wyoming. Peter E. Lorenzen (44), Vice President - General Counsel and Secretary, joined the Company in 1991. From 1983 through 1991, he was a shareholder in the Dallas law firm of Johnson & Gibbs, P.C. Prior to that, Mr. Lorenzen was an associate with Cravath, Swaine & Moore. Mr. Lorenzen received his law degree from New York University School of Law and his Bachelor of Arts Degree from Johns Hopkins University. James H. Shonsey (42), Vice President - Controller, joined the Company in 1991. From 1987 to 1991, Mr. Shonsey served in various capacities including Director of Operations Accounting for Apache Corporation. From 1976 to 1987 he held various positions with Deloitte & Touche, Quantum Resources Corporation, Flare Energy Corporation and Mizel Petro Resources, Inc. Mr. Shonsey received his CPA certificate from the state of Colorado, his Bachelor of Science Degree in Accounting from Regis University and his Master of Science Degree in Accounting from the University of Denver. Edward T. Story (50), President of SOCO International, Inc. and Vice President - International of the Company, joined the Company in 1991. From 1990 to 1991, Mr. Story was Chairman of the Board of a jointly-owned Thai/US company, Thaitex Petroleum Company. Mr. Story was co-founder, Vice Chairman of the Board and Chief Financial Officer of Conquest Exploration Company from 1981 to 1990. He served as Vice President Finance and Chief Financial Officer of Superior Oil Company from 1979 to 1981. Mr. Story held the positions of Exploration and Production Controller and Refining Controller with Exxon U.S.A. from 1975 to 1979. He held various positions in Esso Standard's international companies from 1966 to 1975. Mr. Story received a Bachelor of Science Degree in Accounting from Trinity University, San Antonio, Texas and a Masters of Business Administration from The University of Texas in Austin, Texas. Mr. Story is a director of Command Petroleum Holdings NL, an affiliate of the Company. In addition, Mr. Story serves as a director of Bank Texas, Inc., a bank holding company and Hi Lo Automotive, Inc., a [distributor] of automobile parts. Diana K. Ten Eyck (47), Vice President - Investor Relations, joined the Company in 1993. From 1990 to 1993, Ms. Ten Eyck held various positions with Gerrity Oil & Gas Corporation, including Director, Senior Vice President, Chief Operating Officer, Chief Financial Officer, Chief Administrative Officer and Corporate Secretary. From 1988 to 1990, Ms. Ten Eyck held various positions with The Robert Gerrity Company including Director, Senior Vice President, Chief Operating, Chief Financial Officer and Corporate Secretary. Ms. Ten Eyck received a Bachelor of Arts Degree in Mathematics from the University of Colorado at Boulder and a Ph.D. in Mineral Economics from the Colorado School of Mines. Rodney L. Waller (44), Vice President - Special Projects, joined the Company in 1977. Previously, Mr. Waller was employed by Arthur Andersen & Co. Mr. Waller received his Bachelor of Arts Degree from Harding University. Mr. Waller serves as a director of Wolverine Exploration Company. Richard A. Wollin (41), Vice President - Asset Rationalization, joined the Company in 1990. From 1983 to 1989, Mr. Wollin served in various management capacities including Executive Vice President of Quinoco Petroleum, Inc. with primary responsibility for acquisition, divestiture and corporate finance activities. From 1976 to 1983, he was employed in various capacities for The St. Paul Companies, Inc., including Senior Vice President of St. Paul Oil & Gas Corp. Mr. Wollin received his Bachelor of Science Degree from St. Olaf College and his law degree from the University of Minnesota Law School. Mr. Wollin is a director of Oxford Consolidated, Inc., a public oil and gas company, and a member of the Minnesota Bar Association. ITEM 2.

ITEM 2. PROPERTIES General The Company's reserves are concentrated in several major producing areas. These include the Wattenberg Field in Colorado, central and southern Wyoming, the Piceance and Uinta Basins in the Western Slope of Colorado and Utah, the Giddings area in South Texas, the Spraberry Trend in West Texas, waterflood units in Texas, and the Appalachian Basin in eastern Ohio and Pennsylvania. See "Significant Properties." At December 31, 1993, the Company had interests in 5,122 gross (2,187 net) producing oil and gas wells located in 15 states and in the Gulf of Mexico. As of December 31, 1993, estimated proved reserves totalled 31.9 million barrels of oil and 430.1 Bcf of gas. In addition to its oil and gas reserves, the Company holds interests in nine gas transportation and processing facilities. See "Business - - Gas Management." Proved Reserves The following table sets forth estimated yearend proved reserves for the three years ended December 31, 1993. The following table sets forth pretax future net revenues from the production of proved reserves and the Pretax PW10% Value of such revenues. The quantities and values in the preceding tables are based on prices in effect at December 31, 1993, averaging $12.54 per barrel of oil and $2.27 per Mcf of gas. Price reductions decrease reserve values by lowering the future net revenues attributable to the reserves and will reduce the quantities of reserves that are recoverable on an economic basis. Price increases have the opposite effect. Any significant decline in prices of oil or gas could have a material adverse effect on the Company's financial condition and results of operations. Proved developed reserves are proved reserves that are expected to be recovered from existing wells with existing equipment and operating methods. Proved undeveloped reserves are proved reserves that are expected to be recovered from new wells drilled to known reservoirs on undrilled acreage for which the existence and recoverability of such reserves can be estimated with reasonable certainty, or from existing wells where a relatively major expenditure is required to establish production. Future prices received for such production and future production costs may vary, perhaps significantly, from the prices and costs assumed for purposes of these estimates. There can be no assurance that the proved reserves will be developed within the periods indicated or that prices and costs will remain constant. With respect to certain properties that historically have experienced seasonal curtailment, the reserve estimates assume that the seasonal pattern of such curtailment will continue in the future. There can be no assurance that actual production will equal the estimated amounts used in the preparation of reserve projections. The present values shown should not be construed as the current market value of the reserves. The 10% discount factor used to calculate present value, which is specified by the Securities and Exchange Commission ("SEC"), is not necessarily the most appropriate discount rate, and present value, no matter what discount rate is used, is materially affected by assumptions as to timing of future production, which may prove to be inaccurate. For properties operated by the Company, expenses exclude the Company's share of overhead charges. In addition, the calculation of estimated future net revenues does not take into account the effect of various cash outlays, including, among other things, general and administrative costs and interest expense. There are numerous uncertainties inherent in estimating quantities of proved reserves and in projecting future rates of production and timing of development expenditures. The data in the above tables represent estimates only. Oil and gas reserve engineering must be recognized as a subjective process of estimating underground accumulations of oil and gas that cannot be measured in an exact way, and estimates of other engineers might differ materially from those shown above. The accuracy of any reserve estimate is a function of the quality of available data and engineering and geological interpretation and judgment. Results of drilling, testing and production after the date of the estimate may justify revisions. Accordingly, reserve estimates are often materially different from the quantities of oil and gas that are ultimately recovered. Netherland, Sewell & Associates, Inc. ("NSAI"), independent petroleum consultants, prepared estimates of or audited the Company's proved reserves which collectively represent more than 80% of Pretax PW10% Value as of December 31, 1993. Approximately 38% of the yearend Pretax PW10% Value was estimated internally by the Company and 62% was estimated independently by NSAI. No estimates of the Company's reserves comparable to those included herein have been included in reports to any federal agency other than the SEC. Producing Wells The following table sets forth certain information at December 31, 1993 relating to the producing wells in which the Company owned a working interest. The Company also held royalty interests in 240 producing wells. Wells are classified as oil or gas wells according to their predominant production stream. Acreage The following table sets forth certain information at December 31, 1993 relating to acreage held by the Company. Undeveloped acreage is all a acreage held under lease, permit, contract, or option that is not in a spacing unit for a producing well, including leasehold interests identified for development or exploratory drilling. Significant Properties Although the Company's properties are widely dispersed geographically, emphasis has been placed on establishing "hubs" in certain producing basins. Interests in five producing areas accounted for approximately 90% of Pretax PW10% Value at December 31, 1993. This concentration of assets results in economic efficiencies in the management of assets and permits identification of complementary acquisition candidates. Summary information regarding reserve concentrations and more detailed information regarding the four most significant properties are set forth below. On March 9, 1994, the closing price of the common stock was $19-1/2. Dividends were paid quarterly at the rate of $.05 per share in 1992. Due to revised payment timing, two payments were made at the $.05 rate in the second quarter of 1992. Dividends were paid at the rate of $.05 per share in the first and second quarter of 1993. In the third quarter of 1993, dividends were increased to $.06 per share. Shares of common stock receive dividends as, if and when declared by the Board of Directors. The amount of future dividends will depend on debt service requirements, dividend requirements on the Company's preferred stock, capital expenditures and other factors. On December 31, 1993, there were approximately 3,500 holders of record of the common stock and 23.3 million shares outstanding. On March 9, 1994 the closing price of the $4 Convertible Preferred Stock was $106. Shares of $4 Convertible Preferred Stock receive quarterly dividends of $1.00 if declared by the Board of Directors. Any cumulative dividends in arrears must be paid prior to payment of any dividends on the common stock. On December 31, 1993, there were 24 holders of record of the $4 Convertible Preferred Stock and 1.2 million shares outstanding. The $4 Convertible Preferred Stock may be called beginning on January 1, 1995 at a price of $52.50 per share. On March 9, 1994 the closing price of the depositary shares representing the $6 Convertible Preferred Stock was $27-7/8. Each depositary share represents a one-quarter interest in a share of $100 liquidation value $6 Convertible Preferred Stock. Shares of $6 Convertible Preferred Stock receive quarterly dividends of $1.50 ($.375 per depositary share) if declared by the Board of Directors. A dividend was paid June 30, 1993 at the rate of $1.17 per share ($.29 per depositary share), reflecting a partial rate since issuance in April 1993. Any cumulative dividends in arrears must be paid prior to payment of any dividends on the common stock. On December 31, 1993 there were 43 holders of records of the $6 Convertible Preferred Stock and 4.1 million depositary shares outstanding. The $6 Convertible Preferred Stock may be called beginning on March 31, 1996 at a price of $104.10 per share ($26.05 per depositary share). ITEM 6. SELECTED FINANCIAL DATA The following table presents selected financial and operating information for each of the five years ended December 31, 1993. Share and per share amounts refer to common shares. The following information should be read in conjunction with the financial statements presented elsewhere herein. The following table sets forth unaudited summary financial results on a quarterly basis for the two most recent years. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations Comparison of 1993 results to 1992. Total revenues rose 91% in 1993 to $229.9 million. Net income before taxes and extraordinary items more than doubled to reach $34.9 million in 1993. The increase was led by a rapid rise in production and assisted by an increase in gas processing and transportation margins. Before the effect of a favorable $3.8 million income tax accounting change in 1992 and a $1.9 million 1993 extraordinary charge on early retirement of debt, earnings per common share were $.80 in 1993 compared to $.53 in 1992, a 51% increase. The gross margin from production operations for 1993 increased 62% to $79.7 million, which was primarily related to a 65% growth in oil and gas production. The price received per equivalent barrel decreased by 3% to $13.41. Total operating expenses including production taxes increased 60% during 1993 although operating cost per equivalent barrel ("BOE") decreased to $4.83 from $4.99 in 1992. Expense reductions gained from wells added in the DJ Basin, where operating costs averaged $2.76 per BOE, were partially offset by the late 1992 acquisition of Wyoming wells from ARCO where 1993 operating costs averaged $7.45 per BOE. For the year ended December 31, 1993, average daily production per BOE was 25,472 Bbls, a 65% increase from 1992. Average daily production in the fourth quarter of 1993 climbed to 10,314 barrels and 105.6 MMcf (27,917 barrels of oil equivalent). The production increases resulted primarily from acquisitions and continuing development drilling in the DJ Basin of Colorado. Domestically, $51.0 million in properties were acquired in 1993, primarily in and around existing hubs in Colorado and Wyoming. The acquisitions included a significant number of development locations and should continue to add to production into 1994. In 1993, 311 wells were placed on production in the DJ Basin, with 51 wells in various stages of drilling and completion at yearend. Because the majority of the wells were added in the latter part of the year, production will not be fully impacted until 1994. Additionally, significant downtime was experienced in the fourth quarter at the major processing plant in the area and much of the gas had to be diverted, which increased line pressures and hampered production. To a lesser extent, this situation continued into early 1994. The gross margin from gas processing, transportation and marketing activities for 1993 increased 23% to $10.0 million from $8.1 million in 1992. The increase was primarily attributable to a $3.0 million (33%) rise in transportation and processing margins as a result of additional DJ Basin production and the recent expansion of the related facilities. Gas marketing margins for 1993 decreased by $1.1 million due to reduced margins on the Oklahoma cogeneration supply contract, which declined as a result of an imposed limitation of the contract sales price and rising gas purchase costs. In 1993 the net contract margin was a loss of $267,000, which was $1.8 million less than 1992. At present gas price levels, the Company foresees continued negative or breakeven margins for the cogeneration contract through July 1994. At that time, the share of the sales price minimum attributable to gas will increase from 45% to 65% and the margin should improve. The cogeneration margin reduction was partially offset by a $667,000 (126%) rise in other gas marketing margins resulting from increased third party marketing. Other income was $10.4 million during 1993, compared to $4.2 million in 1992. The $6.2 million increase resulted from a $3.5 million gas contract settlement received in April, a $1.7 million litigation judgment and greater gains on the sales of securities. General and administrative expenses, net of reimbursements, for 1993 represented 3% of revenues compared to 5.6% in 1992 as expenses were held essentially flat while revenues grew 91%. Interest and other expenses increased 28% primarily as a result of a rise in outstanding debt balances. Senior debt was paid down in April 1993 with proceeds from a preferred offering, but increased through yearend as a result of development expenditures, acquisitions, the investment in Command Petroleum and the retirement of the $25.0 million in subordinated debt. Depletion, depreciation and amortization during 1993 increased 60% from the prior year. The increase was the direct result of the 65% rise in equivalent production between years. The producing depletion rate per equivalent barrel for 1993 was reduced to $4.75 from $4.79 in 1992. The rate was reduced by an ongoing drilling cost reduction program, partially offset by an increase from the discontinuation of converting Thomasville production to equivalent quantities based on relative gas prices. The Company adopted FASB Statement No. 109, "Accounting for Income Taxes," effective January 1, 1992. Net income for 1992 was increased by $3.8 million for the cumulative effect of the change in method of accounting for income taxes. In 1992 the income tax provision was reduced from the statutory rate of 34% by $5.5 million due to the elimination of deferred taxes as a result of tax basis in excess of financial basis. In 1993 the income tax provision was reduced from the newly enacted rate of 35% by $4.7 million upon full realization of the excess basis benefit. The Company anticipates deferred taxes will be provided in 1994 and beyond based on the full statutory rate. Comparison of 1992 results to 1991. Revenues rose 30% in 1992 to $120.2 million, compared to $92.5 million in 1991. Net income for 1992 was $20.6 million, a 134% jump from the $8.8 million in 1991. The increases resulted from greater oil and gas production volumes, lower interest expense, reduced general and administrative expenses and a $3.8 million reversal of the cumulative effect of prior year deferred taxes with the adoption of a change in the method of accounting for income taxes. Average daily production for 1992 rose 24% to 15,408 equivalent barrels due mostly to development drilling in the DJ Basin of Colorado as 189 wells were placed on production there. As a result, the gross margin from production increased 22% to $49.3 million in 1992. The price per equivalent barrel of oil and gas production decreased 4% during 1992. The gross margin from gas processing, transportation and marketing activities for 1992 increased 12% to $8.1 million from $7.3 million in 1991. The growth was primarily the result of increased marketing of third party gas in New Mexico, Colorado and Wyoming. Gas processing and transportation margins increased moderately as volumes were increased late in the year by expansions of pipeline and plant facilities to take advantage of increasing DJ Basin production. Other income for 1992 decreased 26% to $4.2 million from a reduction in gains on sales of securities and lower interest on notes receivable. Direct operating expenses including production taxes increased only 13% during 1992 as the operating cost per equivalent barrel decreased to $4.99 from $5.47 in 1991, due to increased DJ Basin production where operating costs have been significantly lower than average. General and administrative expenses, net of reimbursements, for 1992 represented less than 6% of revenues compared to 8% in 1991, as revenues rose 30%. Interest and other expenses dropped 39% in 1992 due to lower average outstanding senior debt after the application of proceeds from a preferred stock offering in late 1991. Development, Acquisition and Exploration During 1993 the Company incurred $93.1 million for oil and gas property development and exploration, $51.0 million for acquisitions and $22.6 million for gas facility expansion and other assets, for a total of $166.7 million in property and equipment expenditures. Additionally, the Company made an $18.2 million investment in an Australian based exploration and production company. The Company has concentrated a significant portion of its development activities in the DJ Basin of Colorado. Capital expenditures for DJ Basin development totalled $75.4 million during 1993. A total of 311 newly drilled wells were placed on production there in 1993 and 51 were in progress at yearend. Additionally, 42 recompletions were performed in 1993, with seven in process at yearend. In December 1993, 16 drilling rigs were in operation in the DJ Basin. The Company anticipates putting 500 or more wells per year on production in the DJ Basin for the next few years. With additional leasing activity and through drilling costs reductions that add infill locations as proven as they become economic, the Company has increased the inventory of available drillsites. In December, the Company entered into a letter of intent with Union Pacific Resources Corporation whereby the Company will gain the right to drill wells on UPRC's previously uncommitted acreage throughout the Wattenberg area. This transaction significantly increased the Company's undeveloped Wattenberg inventory. UPRC will retain a royalty and the right to participate as a 50% working interest owner in each well, and received grants for warrants to purchase two million shares of Company stock. Of the warrants, one million expire three years from the date of grant, and are exercisable at $25 per share, while the other one million expire in four years and are exercisable at $27 per share. One year from the date of grant (February 8, 1994), the exercise prices may be reduced to 120% of the average closing price of the Company stock for the preceding 20 consecutive trading days, but not to lower than an exercise price of $21.60 per share. At that time the expiration date of the warrants may also be extended one year if the average closing price over the 20 day trading period is less than $16.50 per share. The Company expended $14.8 million for other development and recompletion projects and $2.9 million for exploration during 1993. In Nebraska, 29 wells were added to production in 1993 as an extension of a drilling program initiated in 1992. An additional 20 wells are planned in Nebraska for 1994. In southern Wyoming, 11 wells in the East Washakie Basin development program were successfully drilled and completed during the last half of 1993 with three in process at yearend. In this program, significant cost- cutting measures were applied based on the experience gained in the DJ Basin. In central Wyoming on the properties acquired from ARCO in late 1992, efforts have been focused on increasing operating efficiency with limited development drilling and workover activity. In 1993, three successful wells were drilled in the fourth quarter and selected development and recompletion activity is scheduled for 1994. In the Piceance Basin of western Colorado, a three well test program was started in December of 1993 on acreage acquired there during the year, with one well undergoing completion, the second in progress and a third scheduled for early 1994. Current plans include a minimum of 25 wells in the basin during 1994. In South Texas, a combined operated and non-operated program was initiated, with nine wells completed in 1993 and one well abandoned. A total of 25 additional horizontal locations have been identified and drilling should continue with as many as 15 wells planned in 1994. In its domestic exploration efforts, the Company initiated a seismic program in Louisiana and began drilling early in the fourth quarter. Advanced seismic techniques are being used to identify further prospects in Louisiana and expectations are to drill up to 20 wells in 1994. A total of $51.0 million in domestic acquisitions were completed in 1993. In May 1993, the Company purchased an interest in 121 producing wells and over 70 drilling locations in the DJ Basin area for $3.3 million. In July, an incremental 25% interest in the Company's Barrel Springs and Duck Lake Fields in Wyoming was purchased for $6.1 million. The properties are 90% gas and include 44 producing wells and 46 undeveloped locations. In August, the Company acquired interests in 225 producing wells and 272 proved undeveloped locations in the DJ Basin for $19.7 million. The proved reserves are 70% gas with more than two-thirds requiring future development to produce. Late in the year, two acquisitions were completed in the Piceance and Uinta Basins of Western Colorado for a total of $12.5 million. The majority of the value was in undeveloped locations as only 128 wells were currently producing. Numerous other producing and undeveloped acquisitions totalling $9.4 million were completed, mostly in or close to the Company's principal operating areas. The Company's gas gathering and processing facilities have been undergoing significant transformation since late 1992. In 1993, the Company expended $20.1 million to further develop its gas related assets. The Company spent $9.4 million toward the second phase of its DJ Basin gathering expansion to construct a high pressure line to deliver gas directly to the major gas processing plant in the area and expand its gathering network for the increased drilling activity. An additional $2.6 million was expended to expand the Roggen Plant for the production increases. A total of $5.6 million in additional transportation and gathering facilities were constructed in the DJ Basin including a nine mile 16" interconnect line completed in October to relieve high line pressures, a 20" western gathering extension and numerous other extensions and connections. A gathering system that delivers third party gas to the Roggen Plant was purchased for $703,000. The Company expended $1.4 million to complete construction of a system to gather gas from its Nebraska drilling project. These projects are intended to take advantage of the significant increase in drilling activity in these areas. In the international arena, progress continues as well. In May 1993, the Company acquired 42.8% of the outstanding shares of Command Petroleum Holdings N.L., an Australian exploration and production company, for $18.2 million. The Sydney based company is listed on the Australian Stock Exchange, and at December 31, 1993 had 950,000 barrels of proven oil reserves and $19.9 million of working capital. In addition, it holds interests in more than 20 exploration permits and licenses and a 28.7% interest in a Netherlands exploration and production company whose assets are located primarily in the North Sea. In Russia, the Permtex joint venture received central government approval in August and the Company executed a finance and insurance protocol with the Overseas Private Investment Corporation ("OPIC"), a United States government agency. Current plans call for 25 of the existing 45 shut-in wells to be placed on production in 1994, and that 400 development wells will be drilled over the next ten years. Extensive seismic work began in the fourth quarter of 1993 for 400 kilometers of data in Tunisia and 500 kilometers in Mongolia. Financial Condition and Capital Resources At December 31, 1993, the Company had total assets of $480 million and working capital of $1.3 million. Total capitalization was $412 million, of which 28% was represented by senior debt and the remainder by stockholders' equity. During 1993, the Company fully retired its $25 million of 13.5% subordinated notes and the related cumulative participating interests. During 1993, cash provided by operations was $68.3 million, an increase of 43% over 1992. As of December 31, 1993, commitments for capital expenditures totalled $7.5 million, primarily for DJ Basin drilling. The level of future expenditures is largely discretionary, and the amount of funds devoted to any particular activity may increase or decrease significantly, depending on available opportunities and market conditions. The Company plans to finance its ongoing development, acquisition and exploration expenditures using internally generated cash flow, proceeds from property dispositions and existing credit facilities. In addition, joint ventures or future public and private offerings of securities may be utilized. In 1992, an institutional investor agreed to contribute $7 million to a partnership formed to monetize Section 29 tax credits to be realized from the Company's properties, mainly in the DJ Basin. The initial $3 million was contributed in October 1992, and at first payout in June 1993 the second contribution of $1.5 million was received. An additional $1.5 million was received in October 1993. This transaction should increase the Company's cash flow and net income through 1994. A revenue increase of more than $.40 per Mcf is realized on production generated from qualified Section 29 properties in this partnership. The Company recognized $3.8 million of this revenue during 1993. Discussions are in progress to expand this transaction so that the benefits would be extended through at least 1996. In April 1993, the Company sold 4.1 million depositary shares (each representing a one quarter interest in one share of $100 liquidation value stock) of convertible preferred stock through an underwriting for $103.5 million. A portion of the net proceeds of $99.3 million was used to retire the entire outstanding balance under the revolving credit facility at that time. The preferred stock pays a 6% dividend and is convertible into common stock at $21.00 per share. At the Company's option, the preferred stock is exchangeable into 6% convertible debentures on any dividend payment date on or after March 31, 1994. The stock is redeemable at the option of the Company on or after March 31, 1996. Effective July 1, 1993, the Company renegotiated its bank credit facility and increased it from $150 million to $300 million. The new facility is divided into a $50 million short-term portion and a $250 million long-term portion that expires on December 31, 1997. However, management's policy is to renew the facility annually. Credit availability is adjusted semiannually to reflect changes in reserves and asset values. At December 31, 1993, the elected borrowing base was $150 million. The majority of the borrowings currently bear interest at LIBOR plus 1.25% with the remainder at prime. The Company also has the option to select CD plus 1.375%. Financial covenants limit debt, require maintenance of minimum working capital and restrict certain payments, including stock repurchases, dividends and contributions or advances to unrestricted subsidiaries. Based on such limitations, $86.5 million would have been available for the payment of dividends and other restricted payments as of December 31, 1993. The Company does not currently plan to make, and is not committed to make, any advances or contributions to unrestricted subsidiaries that would materially affect its ability to pay dividends under this limitation. During 1993, the Company fully retired its $25.0 million of 13.5% subordinated notes and the related cumulative participating interests. An extraordinary charge to earnings of $1.9 million (net of income taxes) was made in 1993, representing the amount paid in excess of principal and accrued interest through the retirement dates. These notes were retired early in order to reduce the Company's ongoing cost of debt. The Company maintains a program to divest marginal properties and assets which do not fit its long range plans. For 1992 and 1993, proceeds from these sales were $3.0 million and $5.5 million, respectively. Included in the 1993 proceeds were $4.0 million of cash receipts previously accrued for late 1992 sales. The Company intends to continue to evaluate and dispose of nonstrategic assets. In 1990, the Company was granted a judgment in litigation regarding a leasehold assignment from the early 1980's. The Oklahoma Supreme Court refused certiorari and the judgment was upheld. As a result, a total of $1.7 million was accrued and reported in other income in 1993. The full amount was collected in January 1994. In April 1992, a jury found for the plaintiffs in a gas contract dispute related to an offshore property. In April 1993, the dispute was settled by an agreement to pay the Company a net of $5.3 million. The initial $3.5 million was received and reflected as other income in second quarter 1993. The remaining $1.8 million was received in third quarter 1993, but reflected as a reserve for possible contingencies. In April 1993, the Company was granted a $2.7 million judgment in litigation involving the allocation of proceeds from a pipeline dispute. The judgment has been appealed. The financial statements reflect these judgments only upon receipt of cash or final judicial determination. The Company believes that its capital resources are more than adequate to meet the requirements of its business. However, future cash flows are subject to a number of variables including the level of production and oil and gas prices, and there can be no assurance that operations and other capital resources will provide cash in sufficient amounts to maintain planned levels of capital expenditures or that increased capital expenditures will not be undertaken. Inflation and Changes in Prices While certain of its costs are affected by the general level of inflation, factors unique to the petroleum industry result in independent price fluctuations. Over the past five years, significant fluctuations have occurred in oil and gas prices. While such fluctuations have had, and will continue to have a material effect, the Company is unable to predict them. The following table indicates the average oil and gas prices received over the last five years and highlights the price fluctuations by quarter for 1992 and 1993. Average gas prices exclude the Thomasville gas production. During 1993, the Company renegotiated its Thomasville gas contract and beginning in January 1994, the Company will receive a somewhat higher than market price for its Thomasville gas sales, significantly below its 1993 average price of $12.16 per Mcf. Average price computations exclude contract settlements and other nonrecurring items to provide comparability. Average prices per equivalent barrel indicate the composite impact of changes in oil and gas prices. Natural gas production is converted to oil equivalents at the rate of 6 Mcf per barrel. Equivalent prices prior to 1993 have been restated to reflect elimination of the conversion of Thomasville gas volumes based on its price relative to the Company's other gas production. In December 1993, the Company was receiving an average of $12.54 per barrel and $2.27 per Mcf (excluding the Thomasville contract) for its production. Beginning in December 1992, the average oil price was effectively reduced by the oil production added from the Wyoming acquisition, which sells at a significant discount to West Texas Intermediate posting due to the presence of low gravity sour crude in two of the fields. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA Reference is made to the Index to Financial Statements on page 35 for financial statements and notes thereto. Supplementary schedules are presented at the end of Part III following page 55. Quarterly financial data is presented on page 28 of this Form 10-K. Schedules I, III, IV, VII, VIII, IX, XI, XII, and XIII have been omitted as not required or not applicable because the information required to be presented is included in the financial statements and related notes. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES. None. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholders of Snyder Oil Corporation: We have audited the accompanying consolidated balance sheets of Snyder Oil Corporation (a Delaware corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, changes in stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Snyder Oil Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As explained in Note 7 to the financial statements, effective January 1, 1992, the Company changed its method of accounting for income taxes. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index to financial statements and schedules are presented for purposes of complying with the Securities and Exchange Commission's rules and are not a part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Forth Worth, Texas February 25, 1994 LIABILITIES AND STOCKHOLDERS' EQUITY SNYDER OIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) ORGANIZATION AND NATURE OF BUSINESS Snyder Oil Corporation (the "Company") is engaged in the acquisition, production, development and to a lesser degree exploration of primarily domestic oil and gas properties. The Company is also involved in gas processing, transportation, gathering and marketing. The Company, a Delaware corporation, is the successor to a company formed in 1978. The Company is engaged to a modest but growing extent in international acquisition, development and exploration and maintains a number of special purpose subsidiaries which are engaged in ancillary activities including gas transmission, water disposal and management of oil and gas assets on behalf of institutional investors. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The consolidated financial statements include the accounts of Snyder Oil Corporation and its subsidiaries (collectively, the "Company"). The Company accounts for its interest in joint ventures and partnerships using the proportionate consolidation method, whereby its share of assets, liabilities, revenues and expenses are consolidated with other operations. The Company follows the "full cost" accounting method. All costs of exploration and development are capitalized as incurred. Depletion, depreciation and amortization ("depletion") is provided on the unit-of-production method based on proved reserves. Gas is converted to equivalent barrels at the rate of six Mcf per barrel. The depletion rates per equivalent barrel produced were $4.68, $4.79 and $4.75, respectively, in 1991, 1992 and 1993. In 1993, the practice of converting Thomasville production to equivalent quantities based on its price relative to other gas production was discontinued. No gains or losses are recognized upon the disposition of oil and gas properties except in extraordinary transactions. Proceeds are credited to the carrying value of the properties. Maintenance and repairs are expensed. Expenditures which enhance the value of the properties are capitalized. Depreciation on gas processing and transportation facilities is generally provided on a straight-line basis over 15 years. The Company's investment in its Australian affiliate is accounted for using the equity method, whereby the cash basis investment is increased for equity in earnings and decreased for dividends received. The affiliate's functional currency is the Australian dollar. The reported foreign currency translation adjustment is the result of the translation of the Australian balance sheet into United States dollars at year-end and the related impact of exchange rates subsequent to purchase. All highly liquid investments with a maturity of three months or less are considered to be cash equivalents. Earnings per share are computed based on the weighted average number of common shares outstanding. Differences between primary and fully diluted earnings per share were insignificant for all periods presented. General and administrative expenses are reduced by reimbursements for well operations, drilling and management of partnerships. Reimbursements amounted to $11.1 million, $14.3 million and $17.8 million, respectively, in 1991, 1992 and 1993. Certain amounts in the 1991 and 1992 financial statements have been reclassified to conform with the 1993 presentation. (3) INDEBTEDNESS The following indebtedness was outstanding on the respective dates: The Company maintains a $300 million revolving credit facility. The facility is divided into a $250 million long-term portion and a $50 million short-term portion. However, management's policy is to renew the facility annually. The elected borrowing base available under the facility at December 31, 1993 was $150 million. The majority of the borrowings currently bear interest at LIBOR plus 1.25% with the remainder at prime. During 1993, the average borrowing cost was 4.9%. The Company pays certain fees based on the borrowing base and outstanding loans. Covenants require maintenance of minimum working capital, limit the incurrence of debt and restrict dividends, stock repurchases, certain investments, other indebtedness and unrelated business activities. At December 31, 1992, the Company recorded the $49.8 million Wyoming acquisition commitment as other senior debt. The cash flow statement did not reflect the commitment as an increase in indebtedness until final payment was disbursed in February 1993. The subordinated notes bore interest at 13.5% and were due in four annual payments commencing November 15, 1993. The notes were subject to optional redemption at 102% of principal after November 1994 and at par after November 1995. Cumulative rights to receive additional interest based on net cash flow above certain minimum levels were issued in connection with the notes. Cash flow has substantially exceeded the minimum since 1991, and the Company has since made the maximum payments. At December 31, 1992, based on existing market rates the subordinated notes and cumulative interest rights had a combined fair value of $27.7 million, which the Company believes approximated its cost of funds for notes with similar terms. In March 1993, the Company retired 40% of the cumulative rights. The portion of the payment representing prepaid interest was expensed as an extraordinary item, net of income taxes, for $384,000. In August 1993, the Company retired $10 million (40%) of the subordinated notes. The portion of the payment representing prepaid interest was expensed as an extraordinary item, net of income taxes, for $462,000. In November 1993, the Company retired the remaining $15 million of the subordinated notes and the related 60% of cumulative rights, with the portion of the payment representing prepaid interest expensed as an extraordinary item, net of income taxes, for $1.1 million. The Company expensed $1.1 million, $1.1 million and $516,000 as interest expense for cumulative rights in 1991, 1992 and 1993, respectively. Scheduled maturities of indebtedness are $15,000 for 1994, $17,000 for 1995 and 1996, and $114.9 million in 1997. The long-term portion of the revolving credit facility is scheduled to expire in 1997; however, management's policy is to renew the facility annually. Cash payments for interest expense were $7.9 million, $5.4 million and $9.2 million, respectively, for 1991, 1992 and 1993. (4) INVESTMENTS The Company has investments in foreign and domestic energy companies and notes receivable, which at December 31, 1992 and 1993, had a total book value of $7.4 million and $29.4 million, respectively, with corresponding fair market values of $9.8 million and $54.2 million. In May 1993, the Company acquired 92 million (42.8%) of the outstanding shares of Command Petroleum Holdings N.L. ("Command"), an Australian exploration and production company, for $18.2 million. The Sydney based company is listed on the Australian Stock Exchange, and holds interests in more than 20 exploration permits and licenses as well as a 28.7% interest in a publicly traded Netherlands exploration and production company whose assets are located primarily in the North Sea. The market value of the Company's investment in Command based on Command's closing price at December 31, 1993 was $39.1 million. The investment is accounted for by the equity method. Command has outstanding stock options covering the issuance of up to 53.3 million common shares that expire November 30, 1994. Given that the exercise price of the options is 44% below the year-end stock price, the Company assumes they will be exercised. In January 1994, Command completed an offering of 43 million of its common shares. As a result of this offering, the Company's ownership was reduced to 35.7%. If, as expected, all of the November 1994 options were exercised, the Company's ownership would be reduced to 29.6%. The Company has investments in securities of publicly traded domestic energy companies, not accounted for by the equity method, having a book value and total cost at December 31, 1992 and 1993 of $680,000 and $9.7 million, respectively. The market value of these securities at December 31, 1992 and 1993 approximated $2.9 million and $13.3 million, respectively. In the first quarter of 1994, the Company will be required to adopt SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." Under the provisions of SFAS No. 115, at December 31, 1993 the Company would have increased its investments by $3.6 million and increased stockholders' equity by $2.3 million and deferred tax liability by $1.3 million. The Company holds $1.8 million in notes receivable due from privately held corporations. All notes are secured by certain assets, including stock and oil and gas properties. At December 31, 1992 and 1993, the fair value of the notes receivable, based on existing market conditions and the anticipated future net cash flow related to the notes, was believed to be equal to their book value. (5) OIL AND GAS PROPERTIES The cost of oil and gas properties at December 31, 1992 and 1993 includes $4.0 million and $9.8 million, respectively, of unevaluated leasehold. Such properties are held for exploration, development or resale and are excluded from amortization. The following table sets forth costs incurred related to oil and gas properties and gas processing and transportation facilities: In December 1992, the Company acquired certain producing properties located in north central Wyoming from a major oil company for $56.1 million. An initial cash payment of $6.3 million was made in December 1992. The remaining $49.8 million was recorded as senior debt on the consolidated balance sheet at December 31, 1992, but not reflected on the Company's cash flow statement as an acquisition until payment was made in February 1993. Costs incurred above also differ from the cash flow statement as a result of certain cost recoveries and accrual items. The remaining 1992 acquisitions were primarily for producing properties in Wyoming, North Dakota and Texas. In May 1993, the Company purchased an interest in 121 producing wells and over 70 drilling locations in the DJ Basin of Colorado for $3.3 million. In July 1993, an incremental 25% interest in the Company's Barrel Springs and Duck Lake Fields was purchased for $6.1 million. In August 1993, the Company acquired interests in 225 producing wells and 272 undeveloped locations in the DJ Basin for $19.7 million. In late 1993, two acquisitions were completed in the Piceance and Uinta Basins of Western Colorado for a total of $12.5 million. A number of other producing and undeveloped acquisitions totalling $9.4 million were completed during 1993 as well, mostly in or close to the Company's principal operating areas. In late 1992, the Company initiated projects to further develop its gas gathering and processing facilities. A $4.5 million DJ Basin low pressure gathering system expansion was completed to provide new sources of inlet gas to the Roggen plant. Simultaneously, a $2.0 million expansion at Roggen raised plant capacity by 60% to 55 MMcf per day. An additional $848,000 was expended in 1992 to acquire a Roggen net profits interest and a pipeline in the area. In 1993, the Company expended $9.4 million toward the second phase of its DJ Basin gathering expansion to construct a high pressure line to deliver gas directly to the major gas processing plant in the area and expand its gathering network for the increased drilling activity. A total of $5.6 million in additional transportation and gathering facilities were constructed in 1993 in the DJ Basin including a nine mile 16" diameter interconnect line completed in October to relieve high line pressures, a 20" diameter western gathering extension and numerous other extensions and connections. In 1993, the Roggen plant was further enhanced with $2.6 million of capital expenditures. The Company expended $1.4 million to complete construction of a system to gather gas from its Nebraska drilling project. A number of lesser facilities were purchased in 1993 to expand the Company's gathering and processing capabilities in its active hub areas. Acquisitions are accounted for utilizing the purchase method. The following unaudited pro forma information shows the effect on the consolidated statements of operations assuming that the 1992 significant acquisitions were consummated as of January 1, 1992. Individual 1993 acquisitions did not meet the significance test, therefore no 1993 pro forma information is presented. Future results may differ substantially from pro forma results due to changes in oil and gas prices, production declines and other factors. Therefore, pro forma statements cannot be considered indicative of future operations. (6) STOCKHOLDERS' EQUITY A total of 75 million common shares, $.01 par value, are authorized of which 23.3 million were issued and outstanding at December 31, 1993. In 1992, the Company issued 234,000 shares and repurchased 215,000 shares. In 1993, the Company issued 386,000 shares, with 309,000 shares issued primarily for the exercise of stock options by employees and 77,000 shares issued on conversion of 14,000 preferred shares. The Company made five quarterly dividend payments of $.05 per share in 1992 due to an acceleration in the quarterly payment date. In 1993, the Company paid first and second quarter dividends of $.05 per share and increased dividends to $.06 per share in the third and fourth quarters. A total of 10 million preferred shares, $.01 par value, are authorized. In December 1991, 1.2 million shares of convertible exchangeable preferred stock were sold through an underwriting. The net proceeds were $57.4 million. The preferred stock carries an 8% dividend and is convertible into common stock at $9.07 per share. The stock is exchangeable at the option of the Company for 8% convertible subordinated debentures on any dividend payment date. The stock is redeemable at the option of the Company on or after December 31, 1994. The liquidation preference is $50.00 per share, plus accrued and unpaid dividends. During 1995, the stock is redeemable at $52.50 per share if the closing price exceeds 150% of the prevailing conversion price (currently $13.61 per share) for 20 of the preceding 30 trading days. After 1995, no minimum stock price is required. The redemption price declines $.50 per year to $50.00 per share in 2000. In 1993, 14,000 preferred shares were converted into 77,000 common shares. In April 1993, 4.1 million depositary shares (each representing a one quarter interest in one share of $100 liquidation value stock) of convertible preferred stock were sold through an underwriting. The net proceeds were $99.3 million. The preferred stock carries a 6% dividend and is convertible into common stock at $21.00 per share. The stock is exchangeable at the option of the Company for 6% convertible subordinated debentures on any dividend payment date on or after March 31, 1994. The stock is redeemable at the option of the Company on or after March 31, 1996. The liquidation preference is $25.00 per depositary share, plus accrued and unpaid dividends. The Company paid $4.8 million and $9.1 million, respectively, in preferred dividends during 1992 and 1993. The Company maintains a stock option plan for Company employees providing for the issuance of options at prices not less than fair market value. Options to acquire up to 3 million shares of common stock may be outstanding at any given time. The specific terms of grant and exercise are determinable by a committee of independent members of the Board of Directors. The majority of currently outstanding options vest over a three-year period (30%, 60%, 100%) and expire five to seven years from date of grant. In 1990, the shareholders adopted a stock grant and option plan (the "Directors' Plan") for non-employee Directors of the Company. The Directors' Plan provides for each non-employee director to receive 500 common shares quarterly in payment of their annual retainer. It also provides for 2,500 options to be granted annually to each non-employee Director. The options vest over a three-year period (30%, 60%, 100%) and expire five years from date of grant. At December 31, 1993, 1.4 million options were outstanding under both plans at exercise prices of $4.53 to $19.25 per share. At December 31, 1993, a total of 600,000 of such options were vested having exercise prices of $4.53 to $13.00 per share. During 1992, 223,000 options were exercised at prices of $3.02 to $6.00 per share, and 52,000 were forfeited. During 1993, 309,000 options were exercised at prices of $4.53 to $9.13 per share, and 23,000 were forfeited. (7) FEDERAL INCOME TAXES The Company adopted FASB Statement No. 109, "Accounting for Income Taxes," effective January 1, 1992. Net income for 1992 was increased by $3.8 million for the cumulative effect of the change in method of accounting for income taxes as a result of tax basis in excess of financial basis. At December 31, 1993, the Company had no liability for foreign taxes. A reconciliation of the United States federal statutory rate to the Company's effective income tax rate follows: For book purposes the components of the Company's net deferred asset and liability at December 31, 1992 and 1993, respectively, were: For tax purposes, the Company had net operating loss carryforwards of $69.1 million at December 31, 1993. These carryforwards expire between 1997 and 2008. At December 31, 1993, the Company had alternative minimum tax credit carryforwards of $1.4 million and depletion carryforwards of $1.1 million, both of which are available indefinitely. Current income taxes shown in the financial statements reflect estimates of alternative minimum taxes due. Cash payments during 1992 and 1993 were $1.0 million and $75,000, respectively. (8) SALES TO MAJOR CUSTOMERS In 1991, 1992 and 1993, Amoco Production Company accounted for 17%, 27% and 12%, respectively, of revenues. Management believes that the loss of any individual purchaser would not have a material adverse impact on the financial position or results of operations of the Company. (9) DEFERRED CREDITS In 1992, an institutional investor agreed to contribute $7 million to a partnership formed to monetize Section 29 tax credits to be realized from the Company's properties, mainly in the DJ Basin. The initial $3 million was contributed in October 1992, and at first payout in June 1993 the second contribution of $1.5 million was received. An additional $1.5 million was received in October 1993. A revenue increase of more than $.40 per Mcf is realized on production generated from qualified Section 29 properties in this partnership. The Company recognized $780,000 of this revenue during 1992 and $3.8 million during 1993. (10) COMMITMENTS AND CONTINGENCIES The Company rents office space and gas compressors at various locations under non-cancelable operating leases. Minimum future payments under such leases approximate $2.1 million for 1994, $2.2 million for 1995, $2.3 million for 1996 and 1997, and $2.1 million for 1998. In 1990, the Company was granted a judgment in litigation regarding a disputed leasehold assignment from the early 1980's. The Oklahoma Supreme Court refused certiorari and the judgment was upheld. As a result, a total of $1.7 million was accrued and reported in other income in 1993. The full amount was collected in January 1994. In April 1992, the Company was granted a judgment in a gas contract dispute related to an offshore property. The dispute was settled in April 1993 by an agreement to pay the Company a net of $5.3 million. The Company received theses monies in 1993 and reflected $3.5 million as other income with the remaining $1.8 million recorded as a liability for possible contingencies. In April 1993, the Company was granted a $2.7 million judgment in litigation involving the allocation of proceeds from a pipeline dispute. The judgment has been appealed. The Company is a party to various other lawsuits incidental to its business, none of which are anticipated to have a material adverse impact on its financial position or results of operations. The financial statements reflect favorable legal judgments only upon receipt of cash or final judicial determination. (11) UNAUDITED SUPPLEMENTAL OIL AND GAS RESERVE INFORMATION: Independent petroleum consultants directly evaluated 51%, 74%, and 62% of proved reserves at December 31, 1991, 1992 and 1993, respectively, and performed a detailed review of properties which comprised in excess of 80% of proved reserve value. All reserve estimates are based on economic and operating conditions at that time. Future net cash flows as of each year-end were computed by applying then current prices to estimated future production less estimated future expenditures (based on current costs) to be incurred in producing and developing the reserves. All reserves are located onshore in the United States and in the waters of the Gulf of Mexico. PART II ITEM 5.

ITEM 5. MARKET FOR THE REGISTRANT'S SECURITIES AND RELATED SECURITY HOLDER MATTERS The Company's stock is listed on the New York Stock Exchange. The common stock began trading under the symbol "SNY" in March 1990. The Company's $4.00 Convertible Exchangeable Preferred Stock ("$ 4 Convertible Preferred Stock") began trading on the New York Stock Exchange under the symbol "SNY Pr" in November 1991. Depositary shares representing a quarter interest in the Company's $6.00 Convertible Exchangeable Preferred Stock ("$6 Convertible Preferred Stock") began trading on the New York Stock Exchange under the symbol "SNY Pr A" on April 14, 1993. Prior to those dates, there were no markets for these securities. The following table sets forth, for 1992 and 1993, the high and low sales prices for the Company's securities for New York Stock Exchange composite transactions reported by The Wall Street Journal. On March 9, 1994, the closing price of the common stock was $19-1/2. Dividends were paid quarterly at the rate of $.05 per share in 1992. Due to revised payment timing, two payments were made at the $.05 rate in the second quarter of 1992. Dividends were paid at the rate of $.05 per share in the first and second quarter of 1993. In the third quarter of 1993, dividends were increased to $.06 per share. Shares of common stock receive dividends as, if and when declared by the Board of Directors. The amount of future dividends will depend on debt service requirements, dividend requirements on the Company's preferred stock, capital expenditures and other factors. On December 31, 1993, there were approximately 3,500 holders of record of the common stock and 23.3 million shares outstanding. On March 9, 1994 the closing price of the $4 Convertible Preferred Stock was $106. Shares of $4 Convertible Preferred Stock receive quarterly dividends of $1.00 if declared by the Board of Directors. Any cumulative dividends in arrears must be paid prior to payment of any dividends on the common stock. On December 31, 1993, there were 24 holders of record of the $4 Convertible Preferred Stock and 1.2 million shares outstanding. The $4 Convertible Preferred Stock may be called beginning on January 1, 1995 at a price of $52.50 per share. On March 9, 1994 the closing price of the depositary shares representing the $6 Convertible Preferred Stock was $27-7/8. Each depositary share represents a one-quarter interest in a share of $100 liquidation value $6 Convertible Preferred Stock. Shares of $6 Convertible Preferred Stock receive quarterly dividends of $1.50 ($.375 per depositary share) if declared by the Board of Directors. A dividend was paid June 30, 1993 at the rate of $1.17 per share ($.29 per depositary share), reflecting a partial rate since issuance in April 1993. Any cumulative dividends in arrears must be paid prior to payment of any dividends on the common stock. On December 31, 1993 there were 43 holders of records of the $6 Convertible Preferred Stock and 4.1 million depositary shares outstanding. The $6 Convertible Preferred Stock may be called beginning on March 31, 1996 at a price of $104.10 per share ($26.05 per depositary share). ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA The following table presents selected financial and operating information for each of the five years ended December 31, 1993. Share and per share amounts refer to common shares. The following information should be read in conjunction with the financial statements presented elsewhere herein. The following table sets forth unaudited summary financial results on a quarterly basis for the two most recent years. ITEM 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations Comparison of 1993 results to 1992. Total revenues rose 91% in 1993 to $229.9 million. Net income before taxes and extraordinary items more than doubled to reach $34.9 million in 1993. The increase was led by a rapid rise in production and assisted by an increase in gas processing and transportation margins. Before the effect of a favorable $3.8 million income tax accounting change in 1992 and a $1.9 million 1993 extraordinary charge on early retirement of debt, earnings per common share were $.80 in 1993 compared to $.53 in 1992, a 51% increase. The gross margin from production operations for 1993 increased 62% to $79.7 million, which was primarily related to a 65% growth in oil and gas production. The price received per equivalent barrel decreased by 3% to $13.41. Total operating expenses including production taxes increased 60% during 1993 although operating cost per equivalent barrel ("BOE") decreased to $4.83 from $4.99 in 1992. Expense reductions gained from wells added in the DJ Basin, where operating costs averaged $2.76 per BOE, were partially offset by the late 1992 acquisition of Wyoming wells from ARCO where 1993 operating costs averaged $7.45 per BOE. For the year ended December 31, 1993, average daily production per BOE was 25,472 Bbls, a 65% increase from 1992. Average daily production in the fourth quarter of 1993 climbed to 10,314 barrels and 105.6 MMcf (27,917 barrels of oil equivalent). The production increases resulted primarily from acquisitions and continuing development drilling in the DJ Basin of Colorado. Domestically, $51.0 million in properties were acquired in 1993, primarily in and around existing hubs in Colorado and Wyoming. The acquisitions included a significant number of development locations and should continue to add to production into 1994. In 1993, 311 wells were placed on production in the DJ Basin, with 51 wells in various stages of drilling and completion at yearend. Because the majority of the wells were added in the latter part of the year, production will not be fully impacted until 1994. Additionally, significant downtime was experienced in the fourth quarter at the major processing plant in the area and much of the gas had to be diverted, which increased line pressures and hampered production. To a lesser extent, this situation continued into early 1994. The gross margin from gas processing, transportation and marketing activities for 1993 increased 23% to $10.0 million from $8.1 million in 1992. The increase was primarily attributable to a $3.0 million (33%) rise in transportation and processing margins as a result of additional DJ Basin production and the recent expansion of the related facilities. Gas marketing margins for 1993 decreased by $1.1 million due to reduced margins on the Oklahoma cogeneration supply contract, which declined as a result of an imposed limitation of the contract sales price and rising gas purchase costs. In 1993 the net contract margin was a loss of $267,000, which was $1.8 million less than 1992. At present gas price levels, the Company foresees continued negative or breakeven margins for the cogeneration contract through July 1994. At that time, the share of the sales price minimum attributable to gas will increase from 45% to 65% and the margin should improve. The cogeneration margin reduction was partially offset by a $667,000 (126%) rise in other gas marketing margins resulting from increased third party marketing. Other income was $10.4 million during 1993, compared to $4.2 million in 1992. The $6.2 million increase resulted from a $3.5 million gas contract settlement received in April, a $1.7 million litigation judgment and greater gains on the sales of securities. General and administrative expenses, net of reimbursements, for 1993 represented 3% of revenues compared to 5.6% in 1992 as expenses were held essentially flat while revenues grew 91%. Interest and other expenses increased 28% primarily as a result of a rise in outstanding debt balances. Senior debt was paid down in April 1993 with proceeds from a preferred offering, but increased through yearend as a result of development expenditures, acquisitions, the investment in Command Petroleum and the retirement of the $25.0 million in subordinated debt. Depletion, depreciation and amortization during 1993 increased 60% from the prior year. The increase was the direct result of the 65% rise in equivalent production between years. The producing depletion rate per equivalent barrel for 1993 was reduced to $4.75 from $4.79 in 1992. The rate was reduced by an ongoing drilling cost reduction program, partially offset by an increase from the discontinuation of converting Thomasville production to equivalent quantities based on relative gas prices. The Company adopted FASB Statement No. 109, "Accounting for Income Taxes," effective January 1, 1992. Net income for 1992 was increased by $3.8 million for the cumulative effect of the change in method of accounting for income taxes. In 1992 the income tax provision was reduced from the statutory rate of 34% by $5.5 million due to the elimination of deferred taxes as a result of tax basis in excess of financial basis. In 1993 the income tax provision was reduced from the newly enacted rate of 35% by $4.7 million upon full realization of the excess basis benefit. The Company anticipates deferred taxes will be provided in 1994 and beyond based on the full statutory rate. Comparison of 1992 results to 1991. Revenues rose 30% in 1992 to $120.2 million, compared to $92.5 million in 1991. Net income for 1992 was $20.6 million, a 134% jump from the $8.8 million in 1991. The increases resulted from greater oil and gas production volumes, lower interest expense, reduced general and administrative expenses and a $3.8 million reversal of the cumulative effect of prior year deferred taxes with the adoption of a change in the method of accounting for income taxes. Average daily production for 1992 rose 24% to 15,408 equivalent barrels due mostly to development drilling in the DJ Basin of Colorado as 189 wells were placed on production there. As a result, the gross margin from production increased 22% to $49.3 million in 1992. The price per equivalent barrel of oil and gas production decreased 4% during 1992. The gross margin from gas processing, transportation and marketing activities for 1992 increased 12% to $8.1 million from $7.3 million in 1991. The growth was primarily the result of increased marketing of third party gas in New Mexico, Colorado and Wyoming. Gas processing and transportation margins increased moderately as volumes were increased late in the year by expansions of pipeline and plant facilities to take advantage of increasing DJ Basin production. Other income for 1992 decreased 26% to $4.2 million from a reduction in gains on sales of securities and lower interest on notes receivable. Direct operating expenses including production taxes increased only 13% during 1992 as the operating cost per equivalent barrel decreased to $4.99 from $5.47 in 1991, due to increased DJ Basin production where operating costs have been significantly lower than average. General and administrative expenses, net of reimbursements, for 1992 represented less than 6% of revenues compared to 8% in 1991, as revenues rose 30%. Interest and other expenses dropped 39% in 1992 due to lower average outstanding senior debt after the application of proceeds from a preferred stock offering in late 1991. Development, Acquisition and Exploration During 1993 the Company incurred $93.1 million for oil and gas property development and exploration, $51.0 million for acquisitions and $22.6 million for gas facility expansion and other assets, for a total of $166.7 million in property and equipment expenditures. Additionally, the Company made an $18.2 million investment in an Australian based exploration and production company. The Company has concentrated a significant portion of its development activities in the DJ Basin of Colorado. Capital expenditures for DJ Basin development totalled $75.4 million during 1993. A total of 311 newly drilled wells were placed on production there in 1993 and 51 were in progress at yearend. Additionally, 42 recompletions were performed in 1993, with seven in process at yearend. In December 1993, 16 drilling rigs were in operation in the DJ Basin. The Company anticipates putting 500 or more wells per year on production in the DJ Basin for the next few years. With additional leasing activity and through drilling costs reductions that add infill locations as proven as they become economic, the Company has increased the inventory of available drillsites. In December, the Company entered into a letter of intent with Union Pacific Resources Corporation whereby the Company will gain the right to drill wells on UPRC's previously uncommitted acreage throughout the Wattenberg area. This transaction significantly increased the Company's undeveloped Wattenberg inventory. UPRC will retain a royalty and the right to participate as a 50% working interest owner in each well, and received grants for warrants to purchase two million shares of Company stock. Of the warrants, one million expire three years from the date of grant, and are exercisable at $25 per share, while the other one million expire in four years and are exercisable at $27 per share. One year from the date of grant (February 8, 1994), the exercise prices may be reduced to 120% of the average closing price of the Company stock for the preceding 20 consecutive trading days, but not to lower than an exercise price of $21.60 per share. At that time the expiration date of the warrants may also be extended one year if the average closing price over the 20 day trading period is less than $16.50 per share. The Company expended $14.8 million for other development and recompletion projects and $2.9 million for exploration during 1993. In Nebraska, 29 wells were added to production in 1993 as an extension of a drilling program initiated in 1992. An additional 20 wells are planned in Nebraska for 1994. In southern Wyoming, 11 wells in the East Washakie Basin development program were successfully drilled and completed during the last half of 1993 with three in process at yearend. In this program, significant cost- cutting measures were applied based on the experience gained in the DJ Basin. In central Wyoming on the properties acquired from ARCO in late 1992, efforts have been focused on increasing operating efficiency with limited development drilling and workover activity. In 1993, three successful wells were drilled in the fourth quarter and selected development and recompletion activity is scheduled for 1994. In the Piceance Basin of western Colorado, a three well test program was started in December of 1993 on acreage acquired there during the year, with one well undergoing completion, the second in progress and a third scheduled for early 1994. Current plans include a minimum of 25 wells in the basin during 1994. In South Texas, a combined operated and non-operated program was initiated, with nine wells completed in 1993 and one well abandoned. A total of 25 additional horizontal locations have been identified and drilling should continue with as many as 15 wells planned in 1994. In its domestic exploration efforts, the Company initiated a seismic program in Louisiana and began drilling early in the fourth quarter. Advanced seismic techniques are being used to identify further prospects in Louisiana and expectations are to drill up to 20 wells in 1994. A total of $51.0 million in domestic acquisitions were completed in 1993. In May 1993, the Company purchased an interest in 121 producing wells and over 70 drilling locations in the DJ Basin area for $3.3 million. In July, an incremental 25% interest in the Company's Barrel Springs and Duck Lake Fields in Wyoming was purchased for $6.1 million. The properties are 90% gas and include 44 producing wells and 46 undeveloped locations. In August, the Company acquired interests in 225 producing wells and 272 proved undeveloped locations in the DJ Basin for $19.7 million. The proved reserves are 70% gas with more than two-thirds requiring future development to produce. Late in the year, two acquisitions were completed in the Piceance and Uinta Basins of Western Colorado for a total of $12.5 million. The majority of the value was in undeveloped locations as only 128 wells were currently producing. Numerous other producing and undeveloped acquisitions totalling $9.4 million were completed, mostly in or close to the Company's principal operating areas. The Company's gas gathering and processing facilities have been undergoing significant transformation since late 1992. In 1993, the Company expended $20.1 million to further develop its gas related assets. The Company spent $9.4 million toward the second phase of its DJ Basin gathering expansion to construct a high pressure line to deliver gas directly to the major gas processing plant in the area and expand its gathering network for the increased drilling activity. An additional $2.6 million was expended to expand the Roggen Plant for the production increases. A total of $5.6 million in additional transportation and gathering facilities were constructed in the DJ Basin including a nine mile 16" interconnect line completed in October to relieve high line pressures, a 20" western gathering extension and numerous other extensions and connections. A gathering system that delivers third party gas to the Roggen Plant was purchased for $703,000. The Company expended $1.4 million to complete construction of a system to gather gas from its Nebraska drilling project. These projects are intended to take advantage of the significant increase in drilling activity in these areas. In the international arena, progress continues as well. In May 1993, the Company acquired 42.8% of the outstanding shares of Command Petroleum Holdings N.L., an Australian exploration and production company, for $18.2 million. The Sydney based company is listed on the Australian Stock Exchange, and at December 31, 1993 had 950,000 barrels of proven oil reserves and $19.9 million of working capital. In addition, it holds interests in more than 20 exploration permits and licenses and a 28.7% interest in a Netherlands exploration and production company whose assets are located primarily in the North Sea. In Russia, the Permtex joint venture received central government approval in August and the Company executed a finance and insurance protocol with the Overseas Private Investment Corporation ("OPIC"), a United States government agency. Current plans call for 25 of the existing 45 shut-in wells to be placed on production in 1994, and that 400 development wells will be drilled over the next ten years. Extensive seismic work began in the fourth quarter of 1993 for 400 kilometers of data in Tunisia and 500 kilometers in Mongolia. Financial Condition and Capital Resources At December 31, 1993, the Company had total assets of $480 million and working capital of $1.3 million. Total capitalization was $412 million, of which 28% was represented by senior debt and the remainder by stockholders' equity. During 1993, the Company fully retired its $25 million of 13.5% subordinated notes and the related cumulative participating interests. During 1993, cash provided by operations was $68.3 million, an increase of 43% over 1992. As of December 31, 1993, commitments for capital expenditures totalled $7.5 million, primarily for DJ Basin drilling. The level of future expenditures is largely discretionary, and the amount of funds devoted to any particular activity may increase or decrease significantly, depending on available opportunities and market conditions. The Company plans to finance its ongoing development, acquisition and exploration expenditures using internally generated cash flow, proceeds from property dispositions and existing credit facilities. In addition, joint ventures or future public and private offerings of securities may be utilized. In 1992, an institutional investor agreed to contribute $7 million to a partnership formed to monetize Section 29 tax credits to be realized from the Company's properties, mainly in the DJ Basin. The initial $3 million was contributed in October 1992, and at first payout in June 1993 the second contribution of $1.5 million was received. An additional $1.5 million was received in October 1993. This transaction should increase the Company's cash flow and net income through 1994. A revenue increase of more than $.40 per Mcf is realized on production generated from qualified Section 29 properties in this partnership. The Company recognized $3.8 million of this revenue during 1993. Discussions are in progress to expand this transaction so that the benefits would be extended through at least 1996. In April 1993, the Company sold 4.1 million depositary shares (each representing a one quarter interest in one share of $100 liquidation value stock) of convertible preferred stock through an underwriting for $103.5 million. A portion of the net proceeds of $99.3 million was used to retire the entire outstanding balance under the revolving credit facility at that time. The preferred stock pays a 6% dividend and is convertible into common stock at $21.00 per share. At the Company's option, the preferred stock is exchangeable into 6% convertible debentures on any dividend payment date on or after March 31, 1994. The stock is redeemable at the option of the Company on or after March 31, 1996. Effective July 1, 1993, the Company renegotiated its bank credit facility and increased it from $150 million to $300 million. The new facility is divided into a $50 million short-term portion and a $250 million long-term portion that expires on December 31, 1997. However, management's policy is to renew the facility annually. Credit availability is adjusted semiannually to reflect changes in reserves and asset values. At December 31, 1993, the elected borrowing base was $150 million. The majority of the borrowings currently bear interest at LIBOR plus 1.25% with the remainder at prime. The Company also has the option to select CD plus 1.375%. Financial covenants limit debt, require maintenance of minimum working capital and restrict certain payments, including stock repurchases, dividends and contributions or advances to unrestricted subsidiaries. Based on such limitations, $86.5 million would have been available for the payment of dividends and other restricted payments as of December 31, 1993. The Company does not currently plan to make, and is not committed to make, any advances or contributions to unrestricted subsidiaries that would materially affect its ability to pay dividends under this limitation. During 1993, the Company fully retired its $25.0 million of 13.5% subordinated notes and the related cumulative participating interests. An extraordinary charge to earnings of $1.9 million (net of income taxes) was made in 1993, representing the amount paid in excess of principal and accrued interest through the retirement dates. These notes were retired early in order to reduce the Company's ongoing cost of debt. The Company maintains a program to divest marginal properties and assets which do not fit its long range plans. For 1992 and 1993, proceeds from these sales were $3.0 million and $5.5 million, respectively. Included in the 1993 proceeds were $4.0 million of cash receipts previously accrued for late 1992 sales. The Company intends to continue to evaluate and dispose of nonstrategic assets. In 1990, the Company was granted a judgment in litigation regarding a leasehold assignment from the early 1980's. The Oklahoma Supreme Court refused certiorari and the judgment was upheld. As a result, a total of $1.7 million was accrued and reported in other income in 1993. The full amount was collected in January 1994. In April 1992, a jury found for the plaintiffs in a gas contract dispute related to an offshore property. In April 1993, the dispute was settled by an agreement to pay the Company a net of $5.3 million. The initial $3.5 million was received and reflected as other income in second quarter 1993. The remaining $1.8 million was received in third quarter 1993, but reflected as a reserve for possible contingencies. In April 1993, the Company was granted a $2.7 million judgment in litigation involving the allocation of proceeds from a pipeline dispute. The judgment has been appealed. The financial statements reflect these judgments only upon receipt of cash or final judicial determination. The Company believes that its capital resources are more than adequate to meet the requirements of its business. However, future cash flows are subject to a number of variables including the level of production and oil and gas prices, and there can be no assurance that operations and other capital resources will provide cash in sufficient amounts to maintain planned levels of capital expenditures or that increased capital expenditures will not be undertaken. Inflation and Changes in Prices While certain of its costs are affected by the general level of inflation, factors unique to the petroleum industry result in independent price fluctuations. Over the past five years, significant fluctuations have occurred in oil and gas prices. While such fluctuations have had, and will continue to have a material effect, the Company is unable to predict them. The following table indicates the average oil and gas prices received over the last five years and highlights the price fluctuations by quarter for 1992 and 1993. Average gas prices exclude the Thomasville gas production. During 1993, the Company renegotiated its Thomasville gas contract and beginning in January 1994, the Company will receive a somewhat higher than market price for its Thomasville gas sales, significantly below its 1993 average price of $12.16 per Mcf. Average price computations exclude contract settlements and other nonrecurring items to provide comparability. Average prices per equivalent barrel indicate the composite impact of changes in oil and gas prices. Natural gas production is converted to oil equivalents at the rate of 6 Mcf per barrel. Equivalent prices prior to 1993 have been restated to reflect elimination of the conversion of Thomasville gas volumes based on its price relative to the Company's other gas production. In December 1993, the Company was receiving an average of $12.54 per barrel and $2.27 per Mcf (excluding the Thomasville contract) for its production. Beginning in December 1992, the average oil price was effectively reduced by the oil production added from the Wyoming acquisition, which sells at a significant discount to West Texas Intermediate posting due to the presence of low gravity sour crude in two of the fields. ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA Reference is made to the Index to Financial Statements on page 35 for financial statements and notes thereto. Supplementary schedules are presented at the end of Part III following page 55. Quarterly financial data is presented on page 28 of this Form 10-K. Schedules I, III, IV, VII, VIII, IX, XI, XII, and XIII have been omitted as not required or not applicable because the information required to be presented is included in the financial statements and related notes. ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES. None. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholders of Snyder Oil Corporation: We have audited the accompanying consolidated balance sheets of Snyder Oil Corporation (a Delaware corporation) and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, changes in stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. These financial statements and the schedules referred to below are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Snyder Oil Corporation and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1993, in conformity with generally accepted accounting principles. As explained in Note 7 to the financial statements, effective January 1, 1992, the Company changed its method of accounting for income taxes. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index to financial statements and schedules are presented for purposes of complying with the Securities and Exchange Commission's rules and are not a part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, fairly state in all material respects the financial data required to be set forth therein in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN & CO. Forth Worth, Texas February 25, 1994 LIABILITIES AND STOCKHOLDERS' EQUITY SNYDER OIL CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) ORGANIZATION AND NATURE OF BUSINESS Snyder Oil Corporation (the "Company") is engaged in the acquisition, production, development and to a lesser degree exploration of primarily domestic oil and gas properties. The Company is also involved in gas processing, transportation, gathering and marketing. The Company, a Delaware corporation, is the successor to a company formed in 1978. The Company is engaged to a modest but growing extent in international acquisition, development and exploration and maintains a number of special purpose subsidiaries which are engaged in ancillary activities including gas transmission, water disposal and management of oil and gas assets on behalf of institutional investors. (2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The consolidated financial statements include the accounts of Snyder Oil Corporation and its subsidiaries (collectively, the "Company"). The Company accounts for its interest in joint ventures and partnerships using the proportionate consolidation method, whereby its share of assets, liabilities, revenues and expenses are consolidated with other operations. The Company follows the "full cost" accounting method. All costs of exploration and development are capitalized as incurred. Depletion, depreciation and amortization ("depletion") is provided on the unit-of-production method based on proved reserves. Gas is converted to equivalent barrels at the rate of six Mcf per barrel. The depletion rates per equivalent barrel produced were $4.68, $4.79 and $4.75, respectively, in 1991, 1992 and 1993. In 1993, the practice of converting Thomasville production to equivalent quantities based on its price relative to other gas production was discontinued. No gains or losses are recognized upon the disposition of oil and gas properties except in extraordinary transactions. Proceeds are credited to the carrying value of the properties. Maintenance and repairs are expensed. Expenditures which enhance the value of the properties are capitalized. Depreciation on gas processing and transportation facilities is generally provided on a straight-line basis over 15 years. The Company's investment in its Australian affiliate is accounted for using the equity method, whereby the cash basis investment is increased for equity in earnings and decreased for dividends received. The affiliate's functional currency is the Australian dollar. The reported foreign currency translation adjustment is the result of the translation of the Australian balance sheet into United States dollars at year-end and the related impact of exchange rates subsequent to purchase. All highly liquid investments with a maturity of three months or less are considered to be cash equivalents. Earnings per share are computed based on the weighted average number of common shares outstanding. Differences between primary and fully diluted earnings per share were insignificant for all periods presented. General and administrative expenses are reduced by reimbursements for well operations, drilling and management of partnerships. Reimbursements amounted to $11.1 million, $14.3 million and $17.8 million, respectively, in 1991, 1992 and 1993. Certain amounts in the 1991 and 1992 financial statements have been reclassified to conform with the 1993 presentation. (3) INDEBTEDNESS The following indebtedness was outstanding on the respective dates: The Company maintains a $300 million revolving credit facility. The facility is divided into a $250 million long-term portion and a $50 million short-term portion. However, management's policy is to renew the facility annually. The elected borrowing base available under the facility at December 31, 1993 was $150 million. The majority of the borrowings currently bear interest at LIBOR plus 1.25% with the remainder at prime. During 1993, the average borrowing cost was 4.9%. The Company pays certain fees based on the borrowing base and outstanding loans. Covenants require maintenance of minimum working capital, limit the incurrence of debt and restrict dividends, stock repurchases, certain investments, other indebtedness and unrelated business activities. At December 31, 1992, the Company recorded the $49.8 million Wyoming acquisition commitment as other senior debt. The cash flow statement did not reflect the commitment as an increase in indebtedness until final payment was disbursed in February 1993. The subordinated notes bore interest at 13.5% and were due in four annual payments commencing November 15, 1993. The notes were subject to optional redemption at 102% of principal after November 1994 and at par after November 1995. Cumulative rights to receive additional interest based on net cash flow above certain minimum levels were issued in connection with the notes. Cash flow has substantially exceeded the minimum since 1991, and the Company has since made the maximum payments. At December 31, 1992, based on existing market rates the subordinated notes and cumulative interest rights had a combined fair value of $27.7 million, which the Company believes approximated its cost of funds for notes with similar terms. In March 1993, the Company retired 40% of the cumulative rights. The portion of the payment representing prepaid interest was expensed as an extraordinary item, net of income taxes, for $384,000. In August 1993, the Company retired $10 million (40%) of the subordinated notes. The portion of the payment representing prepaid interest was expensed as an extraordinary item, net of income taxes, for $462,000. In November 1993, the Company retired the remaining $15 million of the subordinated notes and the related 60% of cumulative rights, with the portion of the payment representing prepaid interest expensed as an extraordinary item, net of income taxes, for $1.1 million. The Company expensed $1.1 million, $1.1 million and $516,000 as interest expense for cumulative rights in 1991, 1992 and 1993, respectively. Scheduled maturities of indebtedness are $15,000 for 1994, $17,000 for 1995 and 1996, and $114.9 million in 1997. The long-term portion of the revolving credit facility is scheduled to expire in 1997; however, management's policy is to renew the facility annually. Cash payments for interest expense were $7.9 million, $5.4 million and $9.2 million, respectively, for 1991, 1992 and 1993. (4) INVESTMENTS The Company has investments in foreign and domestic energy companies and notes receivable, which at December 31, 1992 and 1993, had a total book value of $7.4 million and $29.4 million, respectively, with corresponding fair market values of $9.8 million and $54.2 million. In May 1993, the Company acquired 92 million (42.8%) of the outstanding shares of Command Petroleum Holdings N.L. ("Command"), an Australian exploration and production company, for $18.2 million. The Sydney based company is listed on the Australian Stock Exchange, and holds interests in more than 20 exploration permits and licenses as well as a 28.7% interest in a publicly traded Netherlands exploration and production company whose assets are located primarily in the North Sea. The market value of the Company's investment in Command based on Command's closing price at December 31, 1993 was $39.1 million. The investment is accounted for by the equity method. Command has outstanding stock options covering the issuance of up to 53.3 million common shares that expire November 30, 1994. Given that the exercise price of the options is 44% below the year-end stock price, the Company assumes they will be exercised. In January 1994, Command completed an offering of 43 million of its common shares. As a result of this offering, the Company's ownership was reduced to 35.7%. If, as expected, all of the November 1994 options were exercised, the Company's ownership would be reduced to 29.6%. The Company has investments in securities of publicly traded domestic energy companies, not accounted for by the equity method, having a book value and total cost at December 31, 1992 and 1993 of $680,000 and $9.7 million, respectively. The market value of these securities at December 31, 1992 and 1993 approximated $2.9 million and $13.3 million, respectively. In the first quarter of 1994, the Company will be required to adopt SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." Under the provisions of SFAS No. 115, at December 31, 1993 the Company would have increased its investments by $3.6 million and increased stockholders' equity by $2.3 million and deferred tax liability by $1.3 million. The Company holds $1.8 million in notes receivable due from privately held corporations. All notes are secured by certain assets, including stock and oil and gas properties. At December 31, 1992 and 1993, the fair value of the notes receivable, based on existing market conditions and the anticipated future net cash flow related to the notes, was believed to be equal to their book value. (5) OIL AND GAS PROPERTIES The cost of oil and gas properties at December 31, 1992 and 1993 includes $4.0 million and $9.8 million, respectively, of unevaluated leasehold. Such properties are held for exploration, development or resale and are excluded from amortization. The following table sets forth costs incurred related to oil and gas properties and gas processing and transportation facilities: In December 1992, the Company acquired certain producing properties located in north central Wyoming from a major oil company for $56.1 million. An initial cash payment of $6.3 million was made in December 1992. The remaining $49.8 million was recorded as senior debt on the consolidated balance sheet at December 31, 1992, but not reflected on the Company's cash flow statement as an acquisition until payment was made in February 1993. Costs incurred above also differ from the cash flow statement as a result of certain cost recoveries and accrual items. The remaining 1992 acquisitions were primarily for producing properties in Wyoming, North Dakota and Texas. In May 1993, the Company purchased an interest in 121 producing wells and over 70 drilling locations in the DJ Basin of Colorado for $3.3 million. In July 1993, an incremental 25% interest in the Company's Barrel Springs and Duck Lake Fields was purchased for $6.1 million. In August 1993, the Company acquired interests in 225 producing wells and 272 undeveloped locations in the DJ Basin for $19.7 million. In late 1993, two acquisitions were completed in the Piceance and Uinta Basins of Western Colorado for a total of $12.5 million. A number of other producing and undeveloped acquisitions totalling $9.4 million were completed during 1993 as well, mostly in or close to the Company's principal operating areas. In late 1992, the Company initiated projects to further develop its gas gathering and processing facilities. A $4.5 million DJ Basin low pressure gathering system expansion was completed to provide new sources of inlet gas to the Roggen plant. Simultaneously, a $2.0 million expansion at Roggen raised plant capacity by 60% to 55 MMcf per day. An additional $848,000 was expended in 1992 to acquire a Roggen net profits interest and a pipeline in the area. In 1993, the Company expended $9.4 million toward the second phase of its DJ Basin gathering expansion to construct a high pressure line to deliver gas directly to the major gas processing plant in the area and expand its gathering network for the increased drilling activity. A total of $5.6 million in additional transportation and gathering facilities were constructed in 1993 in the DJ Basin including a nine mile 16" diameter interconnect line completed in October to relieve high line pressures, a 20" diameter western gathering extension and numerous other extensions and connections. In 1993, the Roggen plant was further enhanced with $2.6 million of capital expenditures. The Company expended $1.4 million to complete construction of a system to gather gas from its Nebraska drilling project. A number of lesser facilities were purchased in 1993 to expand the Company's gathering and processing capabilities in its active hub areas. Acquisitions are accounted for utilizing the purchase method. The following unaudited pro forma information shows the effect on the consolidated statements of operations assuming that the 1992 significant acquisitions were consummated as of January 1, 1992. Individual 1993 acquisitions did not meet the significance test, therefore no 1993 pro forma information is presented. Future results may differ substantially from pro forma results due to changes in oil and gas prices, production declines and other factors. Therefore, pro forma statements cannot be considered indicative of future operations. (6) STOCKHOLDERS' EQUITY A total of 75 million common shares, $.01 par value, are authorized of which 23.3 million were issued and outstanding at December 31, 1993. In 1992, the Company issued 234,000 shares and repurchased 215,000 shares. In 1993, the Company issued 386,000 shares, with 309,000 shares issued primarily for the exercise of stock options by employees and 77,000 shares issued on conversion of 14,000 preferred shares. The Company made five quarterly dividend payments of $.05 per share in 1992 due to an acceleration in the quarterly payment date. In 1993, the Company paid first and second quarter dividends of $.05 per share and increased dividends to $.06 per share in the third and fourth quarters. A total of 10 million preferred shares, $.01 par value, are authorized. In December 1991, 1.2 million shares of convertible exchangeable preferred stock were sold through an underwriting. The net proceeds were $57.4 million. The preferred stock carries an 8% dividend and is convertible into common stock at $9.07 per share. The stock is exchangeable at the option of the Company for 8% convertible subordinated debentures on any dividend payment date. The stock is redeemable at the option of the Company on or after December 31, 1994. The liquidation preference is $50.00 per share, plus accrued and unpaid dividends. During 1995, the stock is redeemable at $52.50 per share if the closing price exceeds 150% of the prevailing conversion price (currently $13.61 per share) for 20 of the preceding 30 trading days. After 1995, no minimum stock price is required. The redemption price declines $.50 per year to $50.00 per share in 2000. In 1993, 14,000 preferred shares were converted into 77,000 common shares. In April 1993, 4.1 million depositary shares (each representing a one quarter interest in one share of $100 liquidation value stock) of convertible preferred stock were sold through an underwriting. The net proceeds were $99.3 million. The preferred stock carries a 6% dividend and is convertible into common stock at $21.00 per share. The stock is exchangeable at the option of the Company for 6% convertible subordinated debentures on any dividend payment date on or after March 31, 1994. The stock is redeemable at the option of the Company on or after March 31, 1996. The liquidation preference is $25.00 per depositary share, plus accrued and unpaid dividends. The Company paid $4.8 million and $9.1 million, respectively, in preferred dividends during 1992 and 1993. The Company maintains a stock option plan for Company employees providing for the issuance of options at prices not less than fair market value. Options to acquire up to 3 million shares of common stock may be outstanding at any given time. The specific terms of grant and exercise are determinable by a committee of independent members of the Board of Directors. The majority of currently outstanding options vest over a three-year period (30%, 60%, 100%) and expire five to seven years from date of grant. In 1990, the shareholders adopted a stock grant and option plan (the "Directors' Plan") for non-employee Directors of the Company. The Directors' Plan provides for each non-employee director to receive 500 common shares quarterly in payment of their annual retainer. It also provides for 2,500 options to be granted annually to each non-employee Director. The options vest over a three-year period (30%, 60%, 100%) and expire five years from date of grant. At December 31, 1993, 1.4 million options were outstanding under both plans at exercise prices of $4.53 to $19.25 per share. At December 31, 1993, a total of 600,000 of such options were vested having exercise prices of $4.53 to $13.00 per share. During 1992, 223,000 options were exercised at prices of $3.02 to $6.00 per share, and 52,000 were forfeited. During 1993, 309,000 options were exercised at prices of $4.53 to $9.13 per share, and 23,000 were forfeited. (7) FEDERAL INCOME TAXES The Company adopted FASB Statement No. 109, "Accounting for Income Taxes," effective January 1, 1992. Net income for 1992 was increased by $3.8 million for the cumulative effect of the change in method of accounting for income taxes as a result of tax basis in excess of financial basis. At December 31, 1993, the Company had no liability for foreign taxes. A reconciliation of the United States federal statutory rate to the Company's effective income tax rate follows: For book purposes the components of the Company's net deferred asset and liability at December 31, 1992 and 1993, respectively, were: For tax purposes, the Company had net operating loss carryforwards of $69.1 million at December 31, 1993. These carryforwards expire between 1997 and 2008. At December 31, 1993, the Company had alternative minimum tax credit carryforwards of $1.4 million and depletion carryforwards of $1.1 million, both of which are available indefinitely. Current income taxes shown in the financial statements reflect estimates of alternative minimum taxes due. Cash payments during 1992 and 1993 were $1.0 million and $75,000, respectively. (8) SALES TO MAJOR CUSTOMERS In 1991, 1992 and 1993, Amoco Production Company accounted for 17%, 27% and 12%, respectively, of revenues. Management believes that the loss of any individual purchaser would not have a material adverse impact on the financial position or results of operations of the Company. (9) DEFERRED CREDITS In 1992, an institutional investor agreed to contribute $7 million to a partnership formed to monetize Section 29 tax credits to be realized from the Company's properties, mainly in the DJ Basin. The initial $3 million was contributed in October 1992, and at first payout in June 1993 the second contribution of $1.5 million was received. An additional $1.5 million was received in October 1993. A revenue increase of more than $.40 per Mcf is realized on production generated from qualified Section 29 properties in this partnership. The Company recognized $780,000 of this revenue during 1992 and $3.8 million during 1993. (10) COMMITMENTS AND CONTINGENCIES The Company rents office space and gas compressors at various locations under non-cancelable operating leases. Minimum future payments under such leases approximate $2.1 million for 1994, $2.2 million for 1995, $2.3 million for 1996 and 1997, and $2.1 million for 1998. In 1990, the Company was granted a judgment in litigation regarding a disputed leasehold assignment from the early 1980's. The Oklahoma Supreme Court refused certiorari and the judgment was upheld. As a result, a total of $1.7 million was accrued and reported in other income in 1993. The full amount was collected in January 1994. In April 1992, the Company was granted a judgment in a gas contract dispute related to an offshore property. The dispute was settled in April 1993 by an agreement to pay the Company a net of $5.3 million. The Company received theses monies in 1993 and reflected $3.5 million as other income with the remaining $1.8 million recorded as a liability for possible contingencies. In April 1993, the Company was granted a $2.7 million judgment in litigation involving the allocation of proceeds from a pipeline dispute. The judgment has been appealed. The Company is a party to various other lawsuits incidental to its business, none of which are anticipated to have a material adverse impact on its financial position or results of operations. The financial statements reflect favorable legal judgments only upon receipt of cash or final judicial determination. (11) UNAUDITED SUPPLEMENTAL OIL AND GAS RESERVE INFORMATION: Independent petroleum consultants directly evaluated 51%, 74%, and 62% of proved reserves at December 31, 1991, 1992 and 1993, respectively, and performed a detailed review of properties which comprised in excess of 80% of proved reserve value. All reserve estimates are based on economic and operating conditions at that time. Future net cash flows as of each year-end were computed by applying then current prices to estimated future production less estimated future expenditures (based on current costs) to be incurred in producing and developing the reserves. All reserves are located onshore in the United States and in the waters of the Gulf of Mexico. PART III ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT * ITEM 11.

ITEM 11. MANAGEMENT AND REMUNERATION * ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT * ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS * *The information required in these four items is incorporated by reference to the Company's definitive Proxy Statement for its 1994 Annual Meeting of Stockholders, which will be filed with the SEC no later than April 30, 1994. PART IV ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K. (a) 1. Reference is made to Item 8 on page 34. 2. Schedules otherwise required by Item 8 have beenomitted as not required or not applicable. 3. Exhibits 4.1.1 - Certificate of Incorporation of Registrant -incorporated by reference from Exhibit 3.1 to the Registrant's Registration Statement on Form S-4 (Registration No. 33-33455). 4.1.2 - Certificate of Amendment to Certificate of Incorporation of Registrant filed February 9, 1990-incorporated by reference to the Registrant's Registration Statement on Form S-4 (Registration No.33-33455). 4.1.3 - Certificate of Amendment to Certificate ofIncorporation of Registrant filed May 22, 1991 -incorporated by reference from Exibit 3.1.2 to the Registrant's Registration Statement on Form S-1 (Registration No.33-43106). 4.1.4 - Certificate of Amendment to Certificate ofIncorporation of Registrant filed May 24, 1993 - incorporated by reference from Exhibit 3.1.5 to the Registrant's Form 10-Q for the quarter ended June 30, 1993 (File No. 1-10509) 4.1.5 - Certificate of Designations, Powers, Preferences and Rights of the Registrant's $4.00 Convertible Exchange Preferred Stock - incorporated by reference from Exhibit 3.1.3 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 (File No.1-10509). 4.1.6 - Certificate of Designations of the Registrant's $6.00 Convertible Exchangeable Preferred Stock - incorporated by reference from Exhibit 3.1.5 to the Registrant's Form 10-Q for the quarter ended June 30, 1993 (File No. 1-10509) 10.1 - Snyder Oil Corporation 1990 Stock Option Plan for nonemployee Directors - incorporated by reference from Exhibit 10.4 to the Retistrant's Registration Statment on Form S-4 (Registration (No. 33-33455). 10.1.1 - Amendment dated May 20, 1992 to the Registrant's 1990 Stock Plan for Non-Employee Directors - incorporated by reference to the Registrant's Quartly Report on Form 10-Q for the quarterended June 30, 1993 (File No. 1-10509). 10.2 - Registrant's Restated 1989 Stock Option Plan -incorporated by reference to the Registrant's Quarterly Report on Form 10-Q for the Quarter ended June 30, 1992 (File No 1-10509). 10.3 - SOCO Holdings Inc. 1984 Stock Option Plan -incorporated by reference from Exhibit 10.6 to the Registrant's Registration Statement of Form S-4 (Registration No. 33-33455). 10.3.1 - Amendment to SOCO Holdings Inc. 1984 Stock Option Plan dated July 18, 1985 - incorporated by reference from Exhibit 10.6.1 to the Registrant's Registration Statement on Form S-4 (Registration No. 33-33455). 10.3.2 - Amendment to SOCO Holdings Inc. 1984 Stock Option Plan dated May 24, 1988 - incorporated by reference from Exhibit 10.6.2 to the Registrant's Registration Statement on Form S-4 (Registration No. 33-33455). 10.4 - Registrant's Profit Sharing & Savings Plan and Trust as amended and restated effective October 1, 1993 - incorporated by reference to the Registrant's Quarterly Report on Form 10-Q for the quarter ended September 30, 1993 (File No. 1-10509). 10.5 - Form of Indemnification Agreement - incorporated by reference from Exhibit 10.15 to the Registrant's Registration Statement on Form S-4 (Registration No. 33-33455). 10.6 - Form of Change in Control Protection Agreement -incorporated by reference from Exhibit 10.11 to the Registrant's Registration statement on Form S-1 (Registration No. 33-43106). 10.7 - Long-term Retention and Incentive Plan and Agreement between the Registrant and Charles A. Brown - incorporated by reference to the Registrant's Quartly Report on Form 10-Q forthe quarter ended June 30, 1993 (File No.1-10509). 10.8 - Agreement dated as of April 30, 1993 between the Registrant and Edward T. Story.* 10.9 - Purchase and Sale Agreement dated December 11, 1992 between Atlantic Richfield Company and Registrant - incorporated by reference to the Report on 8-K dated December 11, 1992 (File No. 1-8440). 10.10 - Warrant dated February 8, 1994 issued by Registrant to Union Pacific Resource Company.* 11.1 - Computation of Per Share Earnings.* 22.1 - Subsidiaries of the Registrant - incorporated byreference from Exhibit 22.1 to the Registrant's Annual Report on Form 10-K for the year ended December 31, 1991 (File No. 1-10509). 23.1 - Consent of Arthur Andersen & Co.* 23.2 - Consent of Netherland, Sewell & Associates, Inc.* 28.1 - Report of Netherland, Sewell & Associates, Inc. dated February 10, 1994 relating to certain of the Registrant's property interest.* 28.2 - Report of Netherland, Sewell & Associates, Inc. dated February 11, 1994 relating to their audit of reserve estimates.* (b) No reports on Form 8-K in the fourth quarter of 1993 * Filed herewith. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused the report to be signed on its behalf by the undersigned thereunto duly authorized. /s/ John C. Snyder Director and Chairman of the Board John C. Snyder (Principal Executive Officer) March 11, 1994 /s/ Thomas J. Edelman Director and President Thomas J. Edelman Principal Financial Officer) March 11, 1994 /s/ John A. Fanning Director and Executive John A. Fanning Vice President March 11, 1994 /s/ Roger W. Brittain Director Roger W. Brittain March 11, 1994 /s/ John A. Hill Director John A. Hill March 11, 1994 /s/ B. J. Kellenberger Director B. J. Kellenberger March 11, 1994 /s/ John H. Lichtblau Director John H. Lichtblau March 11, 1994 /s/ James E. McCormick Director James E. McCormick March 11, 1994 /s/ Alfred M. Micallef Director Alfred M. Micallef March 11, 1994 /s/ James H. Shonsey Vice President and Controller James H. Shonsey Principal Accounting Officer) March 11, 1994

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